ACCA - P5 Study text - Emile Woolf INT - 2010
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Chapter 1: Revision: ABC and other accounting methods
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Recordinginitialcosts:
Debit:Rawmaterialsinventory $25,600
Credit:Creditors/payables $25,600
Debit:Conversioncosts $15,700
Credit:Creditors/payables $15,700
Whentheunitshavebeenproduced:
Debit:Finishedgoods(1,000×$25) $25,000
Credit:Rawmaterialsinventory $25,000
Debit:Finishedgoods(1,000×$15) $15,000
Credit:Conversioncosts $15,000
Whentheunitsaresold:
Debit:Costofsales(990×$4
0) $39,600
Credit:Finishedgoods $39,600.
This leaves a closing balance in finished goods of $400 (ten units). There is also a
balance on the raw materials and conversion costs accounts. The raw materials
balance may be a closing inventory value or may represent cost v
ariances for
materials. The conversion costs account balance will represent cost variances for
conversioncosts.
These accounting entries, made in retrospect, are sufficient to account for
productioncostsandcostofsalesintheperiod.
4.5 Backflush accounting with one ‘trigger point’
An even simpler backflush accounting system has just one trigger point, the
manufacture of finished units. Using the same example, the cost accounting entries
would be as follows:
Finished goods inventory account
$ $
Creditors
(100,000 × 20)
2,000,000
Cost of goods
sold
(98,000 × 50)
4,900,000
Conversion
costs
(100,000 × 30)
3,000,000
Closing
inventory
(2,000 × 50)
100,000
5,000,000
5,000,000
Conversion costs account
$ $
Bank (labour cost) 775,000
Finished goods inventory 3,000,000
Creditors (overheads) 2,260,000
Balance
35,000
3,035,000
3,035,000
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The only difference is that there is no raw materials inventory account. The $30,000
of materials that has been purchased but not used is simply not recorded in the
costing system, and is therefore not included in closing inventory at the end of the
period.
4.6 Backflush accounting: conclusion
The examples above should illustrate that with backflush accounting, costs are not
‘tracked’ sequentially from raw materials through work in progress to finished
goods and cost of sales. They are applied in retrospect, from finished goods and
back to raw materials and conversion costs.
Backflush accounting therefore avoids the need to maintain a detailed cost
accounting system, which can be regarded as a non-value added activity.
Management must monitor performance, but performance measurement is more
likely to consist of non-financial performance indicators, rather than detailed cost
variances.
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Paper P5
Advanced performance management
CHAPTER
2
Accounting for
decision-making
Contents
1 Decision-making and relevant costs
2 Short-term decisions
3 Cost-Volume-Profit (CVP) analysis
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Decision-making and relevant costs
Relevant costs
Non-relevant costs
Relevant cost of materials
Relevant cost of labour
Quantitative and qualitative factors in decision-making
1 Decision-making and relevant costs
Business decisions are often based on choosing a course of action that maximises
profit or value. When a decision is made, there must be a choice between at least
two different possible options. If the decision is based entirely on financial
considerations, the choice should be the option with:
the lowest expected cost, or
the highest expected profit or return on capital.
When decisions are made to maximise profit or value, relevant costs and relevant
revenues must be used in the financial evaluation of the decision.
1.1 Relevant costs
A relevant cost is a future cash flow arising as a direct consequence of the decision.
Relevant revenue is the extra revenue arising as a direct consequence of a decision.
Relevant costs include:
Incremental costs: an incremental cost is an extra cost (cash flow) that will be
incurred as a direct consequence of a decision.
Opportunity costs: An opportunity cost is the benefit forgone by choosing one
opportunity instead of the next best alternative course of action. It is often
measured as the extra contribution or profit that would have been earned by
choosing the next best course of action.
Avoidable costs. Avoidable costs are future cash payments that will be avoided
as a consequence of the decision. They are costs that can be identified with an
activity or a business sector that would be avoided (saved) if that activity or
sector did not exist. Avoidable costs are usually associated with shutdown or
disinvestment decisions.
1.2 Non-relevant costs
A non-relevant cost is a cost that is not relevant to a decision. Non-relevant costs
must be ignored for the financial analysis of a decision. They are costs that are or
will be incurred anyway, regardless of the decision that is made.
Chapter 2: Accounting for decision-making
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Non-relevant costs include:
sunk costs
committed costs
notional costs (or imputed costs)
Sunk costs
Sunk costs are costs that have already been incurred. Since they have been incurred,
they are not relevant to any decision about the future.
An example of a sunk cost is the purchase cost of an asset that has already been
acquired. (The relevant cost of an existing asset that would be used if a decision is
taken is the benefit that would be obtained from using the asset in the next-most-
profitable way. For example, the relevant cost of an asset might be the net revenue
obtainable from disposing of it).
Historical costs are sunk costs. They are irrelevant for decision-making. However,
historical costs might be used to estimate future costs that are relevant to a decision.
Committed costs
Committed costs are also irrelevant and should be ignored in the financial analysis
of decisions. A committed cost is a future cost that will be incurred anyway,
whatever decision is taken now.
A committed cost is a future cost that exists because of an existing obligation.
Notional costs (or imputed costs)
Notional costs are non-relevant costs. They are costs that do not represent cash
flows. Examples of non-relevant costs, which must be ignored in decision-making,
are:
apportioned or absorbed overhead costs
depreciation charges.
1.3 Relevant cost of materials
The relevant cost of raw materials is usually their current replacement cost. The
relevant cost is the replacement cost when:
the materials will be purchased as a direct consequence of the decision
the materials have been purchased and are held in inventory, but if they are
used as a consequence of the decision, they will be replaced (additional
quantities will be purchased).
When materials are already held in inventory, and will not be replaced if they are
used, the relevant cost is the higher of:
their current net disposal value, and
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the savings or contribution that would be obtained by putting them to another use.
If the materials are already held in inventory and have no resale value and no other
possible use, the relevant cost of using them is 0.
Relevant cost of materials
Relevant cost =
opportunity cost
(variable cost of
the material plus the
Contribution forgone)
Example
Entity Blue has been asked by a customer to quote for a job, and it is prepared to
quote a price based on the relevant costs of the job plus a mark-up for profit. The job
would require the following materials:
Material item
Total units
required
Units held in
inventory
Original
purchase
cost
Net disposal
value
Replacement
cost
$ per unit $ per unit $ per unit
W 800 0 - - 10.00
X 1,000 400 4.00 5.00 12.00
Y 1,000 700 6.00 4.00 8.00
Z 300 300 5.00 6.00 11.00
Material X is used regularly for other work.
Some units of materials Y and Z are held in inventory as the result of buying too
many units in the past. There is no alternative use for Material Y which could be
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disposed of. The units of material Z could be used in another job as substitute for
400 units of Material V, which currently costs $7 per unit. Entity Blue currently has
no units of Material V in inventory.
Required
Calculate the relevant costs of the materials for deciding whether or not to accept
the contract.
Answer
Relevant costs of materials $
Material W: (800 × $10)
8,000
Material X: (1,000 × $12)
12,000
Material Y: (700 × $4) + (300 × $8)
5,200
Material Z: (400 × $7)
2,800
28,000
Notes on relevant costs
All the units of Material W will have to be purchased in full at a cost of $10 per
unit.
Material X is in regular use. 400 units are held in inventory, but if these are used
for the job, they will have to be replaced. Relevant costs are therefore 1,000 units
at the replacement cost of $12 per unit.
1,000 units of Material Y are needed and 700 are already held in inventory. If
they are used for the job, 300 extra units must be bought at $8 each. The existing
inventory of 700 units will not be replaced when they are used. However, if they
are not used for the job, they could be sold at $4 each. The disposal value of
these 700 units is an opportunity cost.
The units of Material Z needed for the job are already held in inventory. They
will not be replaced if they are used for the job. However, there is an
opportunity cost of using the materials because the units could either be
disposed of for $6 per unit ($1,800 in total) or used instead of other materials
(Material V) that would cost 400 × $7 = $2,800. Since substituting the Material Z
in place of Material V is more beneficial, the opportunity cost is $2,800.
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1.4 Relevant costs of labour
The relevant cost of labour should be established as follows:
Relevant cost of labour
Relevant cost =
opportunity cost
of the labour
(cost of labour +
contribution forgone)
Example
A printing company has been asked by a regular customer to do a special job at a
competitive price. The management accountant has been asked to identify the
minimum price to charge that would leave the printing company no worse off but
no better off by doing the job.
The following estimates for the job have been prepared:
$
Grade 1 labour (4 hours at $20 per hour) 80
Grade 2 labour (3 hours at $30 per hour) 90
Grade 3 labour: (2 hours at $15) 30
Paper 150
Variable overhead (9 hours at $5 per hour) 45
Fixed overhead (9 hours at $25 per hour) 225
620
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(a) Grade 1 employees are paid a fixed wage for a 40-hour working week. This
job could be done mostly in normal working time, but two hours of Grade 1
overtime would be needed.
(b) Similarly, all Grade 2 employees are paid for a 40-hour working week. Two
hours of Grade 2 overtime would be needed to do the work.
(c) All overtime is paid at 50% above normal hourly rates.
(d) The Grade 3 employees are already working at full capacity, and if they are
used to do this job for the customer, a Grade 3 employee would be switched
from doing other work where he is earning a contribution of $10 per hour.
(e) The paper will have to be purchased for the job.
Required
What is the price the company should charge for the job to make a 20% mark-up on
the minimum price at which it would make no profit but no loss?
Answer
Relevant costs $
Grade 1 labour: (2 hours × $20) plus 50%
60
Grade 2 labour: (2 hours × $30) plus 50%
90
Grade 3 labour: (2 hours × $25)
50
Paper 150
Variable overheads: (9 hours × $5)
45
Minimum price (relevant costs) 395
Mark-up (20%) 79
Price for the customer 474
Notes on relevant costs
Grade 1 and Grade 2 labour. Labour in normal time is a committed cost, and is
not relevant to decision about the minimum price. However, overtime hours,
paid at 50% over the normal rate, are relevant because they will be incremental
costs.
Grade 3 labour. There is an opportunity cost of using the labour on this job
instead of on another job, which would earn a contribution of $10 per hour.
Opportunity cost = $15 + $10 = $25 per hour.
It is assumed that variable overhead is a relevant cost.
It is assumed that fixed overhead spending would be unaffected and the
absorbed fixed overheads for the job are not relevant.
1.5 Quantitative and qualitative factors in decision-making
Relevant cost analysis is based on the assumption that the decision should be to
choose the option where the financial benefit will be the greatest. For decisions with
a short-term payback (short-term decisions), a decision should be taken if:
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there is a net cash flow benefit and no other option offers a better net cash flow
benefit
the net cost, measured in relevant cash flows, is less than with any other option.
For longer-term decisions (capital expenditure decisions), the timing of cash flows
and the time value of money should be taken into consideration, using discounted
cash flow analysis.
The assumption that decisions should be based on financial considerations alone
might not be valid. Financial considerations are important, but a decision might be
taken for non-financial reasons, or non-financial factors might affect the choice
between two or more different courses of action.
Non-financial factors that could affect a decision include:
customer satisfaction: it may be better to spend more to provide customers with
a better service, or a higher quality of product
reputation: a company might choose one course of action in preference to
another in order to protect its reputation in the market
speed: it is sometimes worth paying more to get a job finished more quickly, or
to provide a faster delivery service
customer relationships: a company might be willing to spend money in the
short-term in order to protect a well-established relationship with a customer.