Management
Accounting
Course Text
Professional, Practical, Proven
www.AccountingTechniciansIreland.ie
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Table of Contents
FOREWORD ............................................................................................................................v
SYLLABUS: MANAGEMENT ACCOUNTING .......................................................................xi
PART 1 – INTRODUCTION
Chapter 1: Introduction to Management Accounting .............................................................. 3
PART 2 – COST CLASSIFICATION
Chapter 2: Classifying Costs ................................................................................................17
Chapter 3: Analysing and Predicting Mixed Costs ............................................................... 27
PART 3 – LABOUR COSTS
Chapter 4: Labour Costs ......................................................................................................37
PART 4 – MATERIALS COSTS
Chapter 5: Materials-Related Administration........................................................................47
Chapter 6: Managing Inventory Levels.................................................................................53
Chapter 7: Valuing Inventory ................................................................................................59
PART 5 – OVERHEAD COSTS
Chapter 8: The Traditional Approach to Overheads ............................................................. 75
Chapter 9: The Activity-Based Approach to Overheads ....................................................... 95
Chapter 10: Comparing the Two Different Approaches........................................................ 105
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Table of Contents
Management Accounting
PART 6 – COST MEASUREMENT SYSTEMS
Chapter 11: Overview of Cost Measurement Systems ........................................................ 115
Chapter 12: Job Costing Calculations .................................................................................. 119
Chapter 13: Recording Job Costs in the Accounting Records ............................................. 127
Chapter 14: Batch Costing ...................................................................................................133
Chapter 15: Process Costing ...............................................................................................141
PART 7 – BUDGETING AND STANDARD COSTING
Chapter 16: Introduction to Budgeting..................................................................................157
Chapter 17: Introduction to Standard Costing ......................................................................165
Chapter 18: Operational Budgets.........................................................................................173
Chapter 19: Budgeted Financial Statements........................................................................181
Chapter 20: Cash Budgets ...................................................................................................191
Chapter 21: Flexible Budgeting & Limitations of Budgeting ................................................. 199
PART 8 – MARGINAL COSTING FOR DECISION-MAKING
Chapter 22: Marginal Costing and Contribution ...................................................................209
Chapter 23: Single-Product Cost-Volume-Profit Analysis..................................................... 227
Chapter 24: Multi-Product Cost-Volume-Profit Analysis ....................................................... 237
PART 9 – RELEVANT COSTS FOR DECISION-MAKING
Chapter 25: Introduction to Relevant Costs .........................................................................247
Chapter 26: Special Pricing Decisions .................................................................................255
Chapter 27: Product Continuation / Discontinuation Decisions............................................ 263
Chapter 28: Make-or-Buy Decisions ....................................................................................271
Chapter 29: Limiting Factor Decisions .................................................................................277
PART 10 – STANDARD COSTING VARIANCE ANALYSIS
Chapter 30: Introduction to Variance Analysis......................................................................285
Chapter 31: Cost Variances – Calculations and Causes...................................................... 293
Chapter 32: Revenue Variances – Calculations and Causes............................................... 311
Chapter 33: Reconciling Budgeted Profit to Actual Profit ..................................................... 317
INDEX...................................................................................................................................329
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FOREWORD
Foreword
T
his text has been developed by Accounting Technicians Ireland for use by students participating
in our programme of study and preparing for our examinations based on the syllabus published
for the Academic Year 2016-2017.
While every effort is made to ensure that the information outlined in this text is accurate, Accounting
Technicians Ireland cannot accept the responsibility for lack of, or perceived lack of, information
contained herein.
The text is intended to be a sufficiently detailed synopsis of the 2016-2017 syllabus material (and
knowledge level required thereof) in relation to this module.
Students should take particular note of the weighting attaching to this module, as clearly outlined in the
syllabus. It is on the basis of this weighting that students should prepare their own timetable for study.
This text also includes questions related to the topics for this module. These questions are part of a
larger database of questions that students (and also Lecturers) can access online for this subject. These
questions (and suggested solutions) are available through your “TouchPoint” portal in the MyRevision
area.
We recommend that students refer to MyRevision having completed each chapter or a section of this
module. This resource allows students to study and revise online through ‘self-test’ questions. Exam
standard questions are also available here.
We also recommend students refer to the past exam papers for this module. These papers are published
on our website (www.AccountingTechniciansIreland.ie) along with suggested solutions and comments
from the Examiner. Attempting these “under exam conditions” will help students to prepare for the
examination and plan their study time appropriately.
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Copyright
This text is issued by Accounting Technicians Ireland to students taking its examinations. It may not
be used in whole, or in part, for any course of study and/or examination of any other body whatsoever
without prior permission in writing from Accounting Technicians Ireland. This publication, or any part
thereof, may not be made available in any library, and it may not be reproduced, in whole or in part,
stored in a retrieval system or transmitted in any form or by any means – photocopying, electronic,
electrostatic, magnetic, pdf, mechanical, recording or otherwise, without prior permission in writing
from Accounting Technicians Ireland, 47-49 Pearse Street, Dublin 2.
Acknowledgement
This edition was reviewed and updated by Mr. Richie Hoare. Richie is a Senior Lecturer in Accounting
at Galway-Mayo Institute of Technology (GMIT) and a Member of CIMA.
Referencing
For the purposes of consistency, all references to “he” or “she” will be referred to as “he” in this
publication. No other implication whatsoever is implied from this policy.
For the purposes of presentation, all references to “euro” or “sterling” will be referred to as “euro” is
this publication. No other implication whatsoever is implied from this policy.
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ix
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SYLLABUS: MANAGEMENT ACCOUNTING
Module:
Management Accounting
Mandatory Module
SYLLABUS 2015-2016
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Syllabus 2015-2016 : Mandatory Module
Management Accounting
Management Accounting
Subject Status
Mandatory
Terminal Exam
100%
Module Pass Mark
50%
Learning Modes
Direct Lectures, Workshops, Online Tutorials, Self Directed Learning
Pre-requisite
Financial Accounting, Taxation and either Law & Ethics or Business
Management
Key Learning Outcome
The key learning outcome of this module is to provide learners with knowledge and technical
competency in the area of management accounting to support business functions, activities and
decision-making.
Key Syllabus Elements and Weightings
1. The Nature and Purpose of Management Accounting, Costing Terms and concepts .............10%
2. Cost Accumulation for Inventory and Profit Measurement ......................................................35%
3. Standard Costing, Budgetary Planning and Control................................................................30%
4. Information for Decision Making..............................................................................................25%
Learning Outcomes linked to Syllabus Elements
The Nature and Purpose of Management Accounting, Costing Terms and Concepts
On completion of this aspect of the module, learners will have acquired the following knowledge,
competencies and know-how: (a)
A knowledge of the role of management accounting in a business organization;
(b)
An appreciation of business and stakeholder objectives and goals;
(c)
An ability to contribute to business planning and control exercises through the use of management
accounting;
(d)
An understanding of principles and techniques used in management accounting.
(e)
An understanding of costing system terminology and the ability to discuss various elements of
a costing system;
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Management Accounting
Syllabus 2015-2016 : Mandatory Module
Module: Management Accounting
Specific Functional Knowledge and
Competencies
Understanding
Application
Analysis
NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING, COSTING
TERMS AND CONCEPTS (10%)
Role of Management Accounting
The role of management accounting in
support of business decision making
l
Comparison and inter-relationship with
financial accounting
l
l
Management by objectives
l
l
Group and individual decision making
processes
l
Organizational control and performance
measurement
l
Business Planning and Control
Costing Terminology
Cost centres and drivers
l
l
Cost classification and coding systems
l
l
COST ACCUMULATION FOR INVENTORY & PROFIT MEASUREMENT (35%)
Costing Systems
Cost Behaviour (including fixed, variable,
semi-variable & stepped cost, and inflation)
l
l
Types of costing systems
l
l
Concepts of cost accumulation
l
l
Stores routines
l
l
Materials handling
l
l
Pricing of store issues
l
l
Purchasing procedures
l
l
Inventory control ratios
l
l
Stockholding calculations
l
l
Under and Over absorption of overheads
l
l
Administrative, selling and distribution
overheads
l
l
l
Costing of materials
l
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Specific Functional Knowledge and
Competencies
Management Accounting
Understanding
Application
Analysis
Understanding and calculation of labour
remuneration systems
l
l
Remuneration and incentive schemes
l
l
Cost centre and cost units
l
l
l
Overhead apportionment and absorption
calculations
l
l
l
Service Department Costing
l
l
l
Under and Over absorption of overheads
l
l
Administrative, selling and distribution
overheads
l
l
Key principles and terminology of Activity
Based Costing (ABC)
l
l
Classification of costs using ABC
l
l
Transaction based cost drivers
l
l
Overhead absorption calculations using ABC
l
l
Advantages and disadvantages of ABC
l
l
Benefits and problems of traditional and
modern costing systems
l
l
Comparison of marginal and absorption
costing
l
l
l
Contribution and marginal costing
calculations and costing statements
l
l
l
Marginal costing in management decision
making
l
l
l
Job, Batch and Service costing calculations
l
l
l
Theory of process costing, including
equivalent units, normal and abnormal
gains/losses
(Note: Joint and by-products are excluded)
l
l
Labour costing
Overhead Costing
Activity Based Costing
l
Marginal Costing Techniques
Other Costing Techniques
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Management Accounting
Specific Functional Knowledge and
Competencies
Syllabus 2015-2016 : Mandatory Module
Understanding
Application
Analysis
STANDARD COSTING, BUDGETARY PLANNING AND CONTROL (30%)
Standard Costing – Theoretical aspects
Concept of Standard Costing – including
definition, types of standards, standard
setting, relationship with budgets
l
l
Advantages and disadvantages of standard
costing
l
l
l
l
l
– Materials price and usage
l
l
l
– Labour rate and efficiency
l
l
l
– Variable overhead expenditure and
efficiency
l
l
l
– Fixed overhead expenditure and volume
l
l
– Sales volume and price
l
l
l
l
Standard Costing – Practical Application
Standard cost per unit calculations using
absorption and marginal costing
Calculation of variances, including
Preparation and explanation of variance
analysis reports
l
Budgetary Planning & Control Processes – Theoretical aspects
Theory of budgetary planning and control
l
l
Budgetary factors
l
l
Budgetary processes
l
Budgetary techniques, benefits and
problems
l
l
Behavioural and motivational aspects of
budgeting
l
l
Budgetary Planning & Control –Practical Application
Preparation of operational budgets,
including
l
l
l
– sales
l
l
l
– production
l
l
l
– materials
l
l
l
– labour
l
l
l
– overhead
l
l
l
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Specific Functional Knowledge and
Competencies
Management Accounting
Understanding
Application
Preparation of projected Statements of
Profit and Loss and Statements of Financial
Position
l
l
Cash Budgeting and flexible budgeting
l
l
Analysis
INFORMATION FOR DECISION MAKING (25%)
Management accounting for Decision Making
Cost-Volume Profit and Breakeven Analysis,
including
l
l
– margin of safety
l
l
– target profit
l
l
– contribution/sales ratio
l
l
Breakeven charts and formulae
l
l
Application of cost-volume-profit analysis to
multi-product scenarios
l
l
l
l
– product elimination
l
l
– consideration of limiting factors
l
l
– make or buy
l
l
– mark-up
l
l
– margin
l
l
– full price
l
l
l
l
Relevant Costing in decision making
Preparation of cost estimates for decision
making including relevant, opportunity and
sunk costs
Short term decision making calculations ,
including
Pricing decisions, including:
Preparation of management accounting
statements appropriate to typical decision
making situations
l
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Management Accounting
Syllabus 2015-2016 : Mandatory Module
Assessment Criteria
Assessment Techniques
100% Assessment based on the final exam.
Format of Examination Paper
The Paper Consists of SIX Questions which will examine all
key syllabus elements to ensure that learning outcomes are
achieved
SECTION A (Marks awarded per question may vary)
THREE Compulsory Questions. One question from each of
the three major syllabus areas.
SECTION B (All questions carry equal marks)
THREE Questions in total – Answer any TWO of these.
Sample Paper
Each of the 3 sample papers will examine appropriate parts
of this syllabus.
Essential Reading
Management Accounting (Second Year)
Author: Accounting Technicians Ireland
Web Resources
www.accountancymag.co.uk
Other Resources
Cost and Management Journal
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Part 1 – Introduction
In first year, you studied financial accounting – which is largely concerned with recording
transactions that have happened in the past and presenting a summary of those transactions in
the form of financial statements.
However, as running a business requires managers to continually make decisions that will
improve the future of their businesses, a different kind of information – management accounting
information - is required.
This part of the course will focus mainly on what kinds of information managers require,
how management accounting differs from financial accounting and the job of management
accountants / financial managers.
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Chapter 1:
Introduction to Management Accounting
CHAPTER 1
Introduction to Management
Accounting
CHAPTER OVERVIEW
A
ccounting is the ‘language’ used by businesses to communicate both financial information and
non-financial information to individuals and groups who have an interest in how the business is
performing.
This chapter considers how management accounting information is communicated and why managers
need this information.
LEARNING OUTCOMES FOR THIS CHAPTER
After studying this chapter, you should be able to:
1. Identify users of accounting information and their information needs
2. Understand the difference between management accounting and financial accounting
3. Appreciate the nature, purpose and uses of management accounting
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Chapter 1 : Introduction to Management Accounting
Management Accounting
USERS OF ACCOUNTING INFORMATION AND THEIR INFORMATION NEEDS
Users Of Accounting Information
Users of accounting information can be broadly classified into two categories:
•
Users who are external to the organisation (dark-shaded circles below).
•
Users who are internal to the organisation (light-shaded circles below).
Each user / user group has its own information requirements. Access to accounting information differs
according to the relationship between the business and the user / user group.
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Management Accounting
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USERS’ INFORMATION REQUIREMENTS
An organisation’s stakeholders, and their respective information requirements, include the following:
Stakeholder
Information Required
Equity Investors
Information on investment values and the potential return to be
earned from their investments
Managers
Information for decision-making, planning and control purposes
Employees
Information about the organisation’s ability to provide secure
employment and pay market-rate wages / salaries
Suppliers & Lenders
Information about the organisation’s ability to meet current and
future financial obligations
Governments & Regulators
Information to assess tax liabilities, for economic projections,
and for enforcement of legislation
Special-interest groups (such as
environmental groups, community
groups and lobby groups)
Information related to their specific interests
MANAGEMENT ACCOUNTING VERSUS FINANCIAL ACCOUNTING
Two branches of accounting have evolved to deal with the information needs of user groups - both
internal and external:
1. Financial accounting is primarily concerned with providing information to external users.
2. Management accounting is concerned with providing information to users within the organisation to
assist with effective decision making by managers.
Although there are many differences between management accounting and financial accounting, the
primary information used for the preparation of both management accounting reports and financial
accounting reports stems from the same source – costs incurred by the organisation and revenues
earned by the organisation.
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Chapter 1 : Introduction to Management Accounting
Management Accounting
The major differences between management accounting and financial accounting can be summarised
as follows:
Legal Requirements
Management Accounting
Financial Accounting
No legal requirements.
Legal and accounting regulations
requirements.
No audit requirement.
Statutory audit requirement
(for certain types and sizes of
businesses).
Frequency Of Reports
As required (normally monthly).
Annually, semi-annually, Quarterly.
Primary Users
Internal management.
External users.
Time Focus
Present and future.
Historic.
Format & Content Of
Reports
Detailed information in a format to
suit management requirements.
Summary information in a
format prescribed by accounting
regulations and law.
The above differences are discussed in more detail below:
Legal Requirements
Businesses have a legal obligation to produce financial statements every year. These financial
statements must be prepared in accordance with published accounting principles and, depending on
certain criteria, are subject to statutory audit. Although there is no legal requirement or obligation to
prepare management accounts, it is good business practice to regularly produce accounting information
as a useful tool to assist management in carrying out their duties in a proper manner. There is no
requirement to audit management accounts.
Frequency of Reporting
Financial statements must be prepared annually. There are sometimes regulatory requirements to
present less-detailed accounting reports on a semi-annual or Quarterly basis. Where there is benefit
to be gained from producing management accounts, the frequency of production is at management’s
discretion, typically ranging from daily, to weekly, to monthly, or ad-hoc, to suit management needs.
Primary Users
Financial accounting presents accounting information for use by a wide variety of external users, as well
as internal managers. Management accounts are solely for the use of the internal management of the
organisation.
Time Focus
Financial accounting reports focus on what has happened in the past. Management accounting uses
accounting information to project future trends and control, or attempt to control, current and future
business performance.
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Management Accounting
Chapter 1 : Introduction to Management Accounting
Format & Content of Reports
Both the law and accounting regulations provide templates for the presentation of financial statements
and instruction on minimum information disclosure. As financial accounting information is in the public
arena, there is an inherent acknowledgment by regulators of the sensitivity surrounding the disclosure
of certain information and the main focus of these disclosure requirements is on summarised financial
data. Financial statements focus on the business in its entirety. Management accounting operates
on the basis of meeting the needs of internal management. The format and content of management
accounts depend upon the specific requirements of management. Different businesses will have different
information requirements and their individual management accounts will reflect this. As internal reports,
management accounts will often contain business-sensitive information for a restricted audience and
can focus on both financial information and non-financial information, such as critical success factors
(measures of factors or aspects of an organisation’s performance deemed to be critical, or essential, to
its competitive advantage and thereby its success). In addition, management accounts will often present
very detailed information at a department level or product-line level.
THE NATURE, PURPOSE AND USES OF MANAGEMENT ACCOUNTING
Management accounting involves applying accounting and financial management principles to
the provision of information to managers within an organisation to help them plan and control the
organisation’s activities and to make business decisions.
Management accounting information for managers
1. What is the cost of making a product or delivering a service
2. How do actual costs compare to budget costs (control information)
3. How should the managers use scarce resources to get the best return for the company.
As a consumer, you may not pay much attention to these questions, but as a manager of a business,
you must pay attention to the factors, both financial and non-financial, that underpin these decisions.
Failure to do so may result in the failure of the business.
PLANNING, CONTROL AND DECISION-MAKING
Every organisation has managers. These managers have a responsibility to the organisation’s
stakeholders to manage the organisation in the most-effective and most-efficient way, to maximise the
organisation’s potential. This involves the managers undertaking adequate planning for the short-term
and long-term future of the business, ensuring that the business is being properly controlled to ensure
plans succeed, and making decisions that will enable the business to survive and grow in the future.
Management accounting equips managers with information required to carry out these tasks.
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Chapter 1 : Introduction to Management Accounting
Management Accounting
PLANNING
The fundamental objective of planning is to assist management in deciding how to allocate an
organisation’s resources.
There are 4 main types of planning:
1 - Strategic Planning
This establishes, for management, the shape and direction to be taken by the organisation. This type
of planning is normally ad-hoc and is driven by the recognition of a need for the revision / change of
priorities. This normally results from seeing actual results achieved and / or projected outcomes under
a variety of proposed strategies.
2 - Long-Range Planning
This covers periods of anything from 2-10 years which plans for the proper gearing of the organisation
to achieve its goals / objectives.
3 - Project and Situation Planning
This is normally to do with planning the short-term use of a segment of the organisation’s resources,
such as the investment of surplus cash or, if spare capacity was identified, how best to use it (say for a
once-off order).
4 - Short-Range Periodic Planning
This type of planning is concerned with deciding how resources will be used in the short-term and
predicting the financial outcome of these decisions (i.e. budgeting). Budgeting is a quantitative expression
of a plan. It shows the expected financial implications of decisions taken and proposed decisions and
helps identify the resources required to achieve goals set.
CONTROL
Control is a key feature of management accounting and follows on from planning. Control can be
exercised at a strategic and / or an operational level.
•
Strategically, the business plan of an organisation will be reviewed in light of developments to assess
if the objectives of the plan can be achieved.
•
Operationally, the performance of the organisation is reviewed in the context of detailed plans
(including budgets) so that corrective action can be taken, if necessary.
Control is not practical without initial planning and planning, without control, is somewhat pointless.
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Management Accounting
Chapter 1 : Introduction to Management Accounting
Types Of Controls
There are 3 main types of controls
1 - Action Controls / Behavioural Controls
These involve observing the actions of individuals as they go about their daily work (eg: work studies:
quality and quantity controls) to assess whether both quantity targets and quality targets are being met,
and, if not, to inform corrective action.
EXAMPLE
If a supervisor observes the workers on an assembly line and ensures that the work is done exactly as
prescribed, then the expected quality and quantity of the work should ensue.
2 - Personnel and Cultural Controls
Personnel and cultural controls involve establishing expected values, behaviours and norms which are
used to support the achievement of targets. These are controls which help employees do a good job, by
building on their natural tendencies. Cultural controls represent a set of values, social norms and beliefs
that are shared by members of the organisation and that influence their performance.
3 - Results / Output Controls
These involve collecting, analysing and reporting information about the outcomes of work effort. This
type of control is focused on quantitative information and can be most-closely related to management
accounting information produced. Such information may include variance analysis and other key target
statistics. Results controls require performance targets to be set, establishment of actual results,
measurement of performance and taking action accordingly. Management accounting controls are
mostly defined in mandatory terms such as revenues, costs, profits, or ratios. Organisations should
have a system of management reporting that produces control information in a specified format at
regular intervals.
Harmful Side-Effects Of Control
When controls motivate behaviour that is organisationally desirable, they are described as encouraging
“goal congruence”. However, when controls motivate employees to engage in behaviour that’s not
organisationally desirable, they can lead to a lack of “goal congruence”.
It is by achieving “goal congruence” that desired objectives are achieved.
DECISION-MAKING
The first stage in the decision-making process should be to specify the goals or objectives of the
organisation. These goals / objectives will vary depending on the type of organisation.
It is simplistic to say that the only objective of a business is to earn profit - and clearly this would not be
the case in a not-for-profit, or charitable, organisation.
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Chapter 1 : Introduction to Management Accounting
Management Accounting
In private-sector businesses, some managers might seek to establish a power base, build an empire, or
ensure security. However, a commonly-held view, supporting the profit objective is that profit maximisation
leads to the maximisation of overall economic welfare.
In a not-for-profit, or charitable, organisation, the driver is social / welfare principles, not profit. In the
public-sector, the primary goal / objective might be to provide a quality service to the public. Although the
driver in these organisations is not profit, it would be desirable that they would at least be self-financing
and not require government subvention.
The planning, decision-making, and control process
PERFORMANCE MANAGEMENT
Performance management is a term used to describe the various activities carried out to ensure that an
organisation’s goals and objectives are being met in an effective and efficient manner.
Performance management normally operates at 3 levels:
1. for the organisation as a whole
2. within departments or sections
3. in teams or for individuals.
Performance management is used both in businesses and, increasingly, in not-for-profit organisations
(eg: public service departments).
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Management Accounting
Chapter 1 : Introduction to Management Accounting
Performance management can involve a range of qualitative and quantitative activities, but a main
aim is to create ‘goal congruence’ within an organisation. Goal congruence means that the aims and
objectives of individuals match the aims and objectives of the organisation as a whole.
Performance management targets are likely to include:
Financial Targets
•
market share
•
manufacturing efficiencies
•
gross profit / net profit
Service Targets
•
customer satisfaction measures
•
service output measures
•
repeat business
•
innovative developments or improvements
The benefits of good control and performance management can include:
•
direct financial gains
•
improved motivation and employee satisfaction and
•
improved efficiency in systems and processes
The design of a performance measurement system is essential to allow a company achieve its
objectives. An organisation should identify the Critical Success Factors (CSF’s) that are key to the
achievement of the overall company objectives. For each CSF identified the management need to
identify a Key Performance Indicator (KPI). The KPI’s are then used as the basis for the development of
the performance measurement system.
Armstrong & Baron defined PM as “A strategic and integrated approach to increasing the effectiveness
of organisations, by improving the performance of the people who work in them and by developing the
capabilities of teams and individual contributors.”
Benefits of PM may include:
1. Direct financial gains, e.g. increase sales, reduce costs
2. Create transparency in cultivating goals, thus creating confidence in the process for determining
bonus payments.
3. Improved management controls
4. Achievement of long-term corporate objectives.
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Chapter 1 : Introduction to Management Accounting
Management Accounting
Performance Appraisal
This applies where individual performance is formally monitored and feedback is delivered. This is done
by establishing Key Performance Indicators (KPIs) for individuals, against which performance is rated
or measured and the ratings summarised. Top performance is normally rewarded. The performance
appraisal process should be seen as part of guiding and managing career development. It is also a
method of measuring an employee’s worth to the organisation.
COST ACCOUNTING
Management Accounting is concerned with both costs and revenues. The part of management
accounting that is concerned with costs is often known as Cost Accounting. A Cost Accounting system
is generally made up of the following five parts:
1. an input measurement basis
2. an inventory valuation method
3. a cost accumulation method
4. a cost flow assumption
5. a capability of recording inventory cost flows at certain intervals
These five parts, and the alternatives under each part, are presented below.
Many possible cost accounting systems can be designed from the various combinations of the available
alternatives, although not all of the alternatives are compatible. Selecting one part from each category
provides a basis for developing an operational definition of a specific cost accounting system.
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Management Accounting
Chapter 1 : Introduction to Management Accounting
PRACTICE QUESTIONS
The following questions will test your knowledge of the material you have just covered in this chapter.
You should also review the questions available online through MyRevision for this topic, as these will
assist you significantly in your preparation for your examination in May/August. In addition, Sample
papers for this subject can be downloaded from www.AccountingTechniciansIreland.ie
Question 1.1 (ref: 1460)
Outline the main users of accounting information and the information requirements of each user / user
group.
Question 1.2 (ref: 1463)
What types of financial information and non-financial information would the following people require:
1. A buyer in a retail clothing business
2. A production manager in a toy factory
3. The managing director of a private hospital
4. Project managers in an overseas charity aid organisation
Question 1.3 (ref: 1465)
Describe a typical planning and control cycle.
Why is it important for businesses to implement this cycle ?
Question 1.4 (ref: 1467)
Explain the basic principle of performance management and its potential benefits to organisations.
Question 1.5 (ref: 1468)
Give three examples of ways in which a cost accounting system could aid cost control in a haulage
business.
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Part 2 – Cost Classification
A fundamental part of management accounting is managing costs. However, in order to be able
to properly manage costs, managers must first be able to understand the different types of costs
in their businesses and how these costs change, or don’t change, as the business changes.
This part of the course is concerned with understanding, analysing and predicting the various
types of costs incurred by businesses.
CHAPTER 2
Classifying Costs
CHAPTER 3
Analysing & Predicting Mixed Costs
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Chapter 2:
Classifying Costs
CHAPTER 2
Classifying Costs
CHAPTER OVERVIEW
I
n order to plan properly, control properly and make good business decisions, managers need to know,
not just total cost data, but cost data broken down under different headings (called cost classifications).
This chapter outlines common cost classifications used by managers.
LEARNING OUTCOMES FOR THIS CHAPTER
After studying this chapter, you should be able to:
1. Understand the meaning of cost, cost objects and cost centres
2. Understand the most common ways of classifying costs
3. Understand how cost classification impacts upon the design of costing systems
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Chapter 2 : Classifying Costs
Management Accounting
COSTING TERMINOLOGY
What is cost ?
‘Cost’ is one of the most common words used by managers in business, but what exactly does it mean?
There is no one single definition of cost, however one definition could be: The expenditure (actual or
notional) incurred on, or attributable to, a specific thing or activity. In management accounting, there is a
cost vocabulary which provides meanings for cost in the context of the managerial activities of planning,
control and decision-making.
Cost unit/cost object
Is an identifiably product or service for which an organisation wishes to measure costs.
Cost Measurement Systems
Cost measurement systems collect cost data and then assign these costs to cost objectives i.e. products
or services.
Cost Centre
A cost centre can be defined as ‘a function, a location, activity or an item of equipment for which costs
can be measured’ and directly related to the cost units / cost objects for control purposes. A cost centre
is used as a ‘collecting place’ for costs (similar to a General Ledger account). .
EXAMPLE – Indirect Costs
Cost centre
Cost unit/cost objective
Accounting department
Preparation of accounts for clients
Furniture making department
Table/chairs
Telephone manufacturing department
Telephone
Legal department
Legal advice to client
Cost Classifications
The most commonly-used classifications of costs are as follows:
1. Direct costs & indirect costs
2. Product costs & period costs
3. Fixed costs, variable costs & mixed costs
Whether a particular cost is a direct cost or an indirect cost is determined by the relationship of the cost
to the cost object (eg. a product).
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Management Accounting
Chapter 2 : Classifying Costs
Whether a particular cost is a product cost or a period cost is determined by whether the level of cost is
related to the volume of activity or related to the passage of time (eg. the cost is payable each month,
irrespective of output)
Whether a particular cost is a fixed cost, a variable cost or a mixed cost is determined by the way the
cost increases / decreases as the business’ volume of activity (eg. output) changes. This relationship
between changes in cost and changes in volume is known as ‘cost behaviour’.
CLASSIFYING COSTS AS EITHER DIRECT COSTS OR INDIRECT COSTS
In order to gather cost data regarding a specific cost object, it is necessary to identify the relationship
between the cost object and the item of cost. The key question involves establishing the traceability of
the item to the cost object.
Direct Costs
Direct costs are costs that can be traced in full to a particular product or service (cost object). It can only
be classified as a direct cost if the exact amount that relates to a product or service is known. Where
costs are shared between products or services they are not classified as direct costs.
EXAMPLE – Direct Costs
A business manufactures two types of chairs – a Regency chair and a Wicker chair. The Regency
chair uses Material A, the wicker chair uses Material B. Labour Team X works on the Wicker chair and
Labour Team Y works on the Regency chair. As both the materials costs and the labour costs can be
traced to a particular cost object, the costs can be classified as direct costs, as follows:
Cost Object 1: Regency Chair
Direct Costs
1. Cost of Material A
2. Labour cost of Labour Team Y
Cost Object 2: Wicker Chair
Direct Costs
1. Cost of Material B
2. Labour cost of Labour Team X
Indirect Costs
Indirect costs are costs that cannot be traced in full to a product or service. This means that indirect
costs must be shared between different products or services. Indirect manufacturing costs are also
known as production overheads.
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Chapter 2 : Classifying Costs
Management Accounting
EXAMPLE – Indirect Costs
Continuing the example (above), suppose that one supervisor is used to supervise the work of both
Labour Group X and Labour Group Y. We know that each Labour Group works on a specific chair
(cost object) and that the associated labour cost of each group is a direct cost of the individual chair
(cost object). As the cost of employing the supervisor relates to both cost objects, it must be shared
between them, using an appropriate estimation method. The cost of employing the supervisor is
therefore an indirect cost of both cost objects.
Sometimes some direct costs will be treated as indirect costs because the amount of the cost may be
insignificant and tracing it to the cost object might not be cost-effective.
EXAMPLE – Direct Costs v Indirect Costs
Continuing the example (above), suppose that glue and nails are used in making both chairs. It is
probably possible to directly assign the amount of glue used and the number of nails used in the
production of each chair, thereby classifying the cost of the glue and the cost of the nails as direct
costs. However, in reality, the cost of the effort made in making this direct allocation will far outweigh
the benefit to be gained from the more-accurate product cost. In this case, the business will treat the
cost of the glue and the cost of the nails as indirect costs of manufacturing the chairs and share them
between the two cost objects, using an appropriate estimation method.
Using direct and indirect cost classifications ensures a more-accurate product costing for the cost object
– a factor very important for pricing and decision-making. The more costs that can be classified as direct
costs, the more-accurate the product cost, but it is also important to be conscious of the associated
costs / benefits to be derived from making the classifications.
Distinguishing between direct costs and indirect costs
The distinction between direct costs and indirect costs relies on the cost object itself. A cost may be a
direct cost for one cost object and an indirect cost for another cost object. In the example above, the
supervisor’s salary was considered to be an indirect cost of the two individual cost objects (because it
couldn’t be traced to just one of them). If there was one supervisor for Regency chairs and a different
supervisor for Wicker chairs, the cost of employing each supervisor would be a direct cost, because the
cost of employing each supervisor could be directly traced to a specific cost object.
CLASSIFYING COSTS AS EITHER PRODUCT COSTS OR PERIOD COSTS
Product Costs
Product costs are costs that are related to the manufacturing process and consist of both direct
manufacturing costs and indirect manufacturing costs. The terms product cost and manufacturing cost
are often used interchangeably.
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Management Accounting
Chapter 2 : Classifying Costs
The cost of manufacturing a product is made up as follows:
DIRECT COSTS
£
Direct Materials Cost
X
Direct Labour Cost
X
Direct Manufacturing Expenses Cost
X
Prime Cost (Total Direct Costs)
X
INDIRECT MANUFACTURING COSTS
Indirect Materials Cost
X
Indirect Labour Cost
X
Manufacturing Overhead Cost
X
Total Manufacturing Cost = Total Product Cost
X
Period Costs
Period costs are costs that are associated with a reporting period, rather than related to the manufacturing
process. All non-manufacturing costs are treated as period costs. Examples of period costs include the
following:
1. Advertising costs
2. Administration costs
3. Legal costs
4. Audit fees
5. Rent of an office building
CLASSIFYING COSTS AS EITHER FIXED COSTS, VARIABLE COSTS OR MIXED
COSTS
Cost Behaviour Patterns
Different costs vary in different ways in response to changes in a business’ activity level. The business’
activity level most commonly means its output level, but could also mean some other measure of activity,
such as the number of labour hours worked or the number of machine hours used. The different ways
in which costs vary are known as cost behaviour patterns. For decision-making purposes, management
requires costs to be classified in accordance with cost behaviour patterns.
Typical cost behaviour patterns
Fixed costs
Total fixed costs do not change in direct proportion with activity (units produced or sold). For example,
regardless of the units made or sold the company will still pay the same rent on its factory.
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Chapter 2 : Classifying Costs
Management Accounting
Total Fixed cost behaviour pattern
Although the total amount of fixed cost does not change as a business’ activity level changes, the
amount of fixed cost per unit of output:
•
will decrease as output volume increases and
•
will increase as output volume decreases
EXAMPLE – Total Fixed Cost and Fixed Cost Per Unit
A business pays rent of €10,000 per month. Rent is normally a fixed cost.
Output Volume
Total Fixed Cost
Fixed Cost Per Unit of Output
50,000 units
€10,000
€10,000 / 50,000 units = €0.20 per unit
100,000 units
€10,000
€10,000 / 100,000 units = €0.10 per unit
200,000 units
€10,000
€10,000 / 200,000 units = €0.05 per unit
QUESTION
Draw a graph of the above fixed cost per unit.
ANSWER
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Management Accounting
Chapter 2 : Classifying Costs
Variable Costs
Variable costs vary in direct proportion to activity. Examples of variable costs include direct materials
costs and direct labour costs. A business’ total variable cost:
•
will increase as the business increases output volume
•
will decrease as the business decreases output volume.
Total Variable cost behaviour pattern
Although the total amount of variable cost will change as output changes, the amount of variable cost
per unit (the total variable cost divided by the number of units of output) does not change as output
changes.
A graph of Variable cost per unit would look as follows:
Mixed costs (semi-variable costs)
Mixed costs are costs that contain a variable cost element and a fixed cost element. For example,
a telephone bill will contain both a fixed and variable element. The line rental is the fixed element
(regardless of the number of calls made this remains constant) and the number of calls is the variable
element (the greater the number of calls the higher the bill)
Total Cost
= Total Fixed Cost + Total Variable Cost
= Total Fixed Cost + (Variable Cost Per Unit x Output Volume)
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Chapter 2 : Classifying Costs
Management Accounting
Mixed cost behaviour pattern
Step Costs
A step-fixed cost is fixed within a given range of activity but once that level of activity is reached the cost
increases and becomes fixed again within a new range of activity.
EXAMPLE – Step Costs
Production output up to 10,000 units can be accommodated at an existing factory, incurring a premises
overhead of €150,000 per year.
Production output in the range 10,000 units – 15,000 units can be facilitated at an adjoining facility,
incurring additional premises overhead of €60,000 per year
Production output in excess of 15,000 units will require an additional new factory premises, at an
estimated premises overhead cost of €150,000 per year
QUESTION
Draw a graph of the premises overhead cost.
Cost
ANSWER
Premises Overhead Cost
Activity Level (Volume of Output)
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Management Accounting
Chapter 2 : Classifying Costs
COSTING SYSTEMS
Cost Coding
Businesses will set-up cost codes in their accounting software, so that cost data can be analysed
according to how management wants to classify costs. It is important not to over-complicate this task.
If a long, complicated list of codes is developed, too much time might be spent collecting and collating
data.
EXAMPLE – Cost Codes
On a building site, the coding might be as follows:
1. Labour cost
• Ground workers
• Block layers
• Carpenters
• Electricians
• Roofers, etc.
2. Materials cost
• Concrete
• Blocks
• Steel reinforcing
• Timber
• Slates / tiles
3. Machinery cost
• Rented
• Owned
4. Sub-contract cost
• (by category)
5. Security cost
• Labour
• Fencing
• Lighting
Each of the above would be given a code number for the purpose of cost allocation.
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Chapter 2 : Classifying Costs
Management Accounting
PRACTICE QUESTIONS
The following questions will test your knowledge of the material you have just covered in this chapter.
You should also review the questions available online through MyRevision for this topic, as these will
assist you significantly in your preparation for your examination in May/August. In addition, Sample
papers for this subject can be downloaded from www.AccountingTechniciansIreland.ie
Question 2.1 (ref: 1472)
Although methods such as the high-low method appear to make the task of predicting future costs a
very simple one, there are issues that need to be borne in mind when using such methods. Outline
three such issues.
Question 2.2 (ref: 1469)
Using examples, explain the following terms:
1.
Cost Object
2.
Relevant Range
3.
Product Costs
4.
Period Cost
5.
Direct Cost
6.
Indirect Cost
7.
Cost Behaviour
Question 2.3 (ref: 1470)
Using examples, explain the following:
1. why total fixed cost does not change as the level of activity changes but fixed cost per unit does
change, as the level of activity changes, and
2. why the opposite happens with variable costs (total variable cost does change as the level of
activity changes but variable cost per unit does not change, as the level of activity changes).
Question 2.4 (ref: 1471)
Discuss cost classification with specific reference to:
1. Fixed Costs & Variable Costs.
2. Direct Costs & Indirect Costs.
3. Product Costs & Period Costs.
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Chapter 3:
Analysing and Predicting Mixed Costs
CHAPTER 3
Analysing and Predicting
Mixed Costs
CHAPTER OVERVIEW
A
s variable costs change in proportion to output, but fixed costs do not, in order to predict the
total cost of some future activity level, it is necessary to identify all costs as either fixed costs
or variable costs. For some costs this is easy but, as mixed costs (also known as semi-variable
costs) are partly fixed and partly variable, businesses need a method to break down mixed costs into
their fixed cost and variable cost components. The most-common techniques for working out the amount
of fixed cost and variable cost in a total (mixed) cost are:
1. account analysis;
2. regression analysis; and,
3. the high-low method.
Once the amounts of fixed cost and variable cost in a total (mixed) cost are known, that information can
be used to predict the cost associated with planned future activity levels.
This chapter focuses on the high-low method of working out the amount of fixed cost and variable cost
in a total (mixed) cost.
LEARNING OUTCOMES FOR THIS CHAPTER
After studying this chapter, you should be able to:
1. Analyse current mixed costs into fixed cost and variable cost elements, using the High-Low
method
2. Use the fixed cost / variable cost breakdown of current mixed costs to predict future mixed costs
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Chapter 3 : Analysing and Predicting Mixed Costs
Management Accounting
High-low method of analysing mixed costs
The high-low method involves working out the total cost at various activity levels. As fixed costs will
remain constant, even when the activity level changes (within the relevant range), the difference in total
cost between the low activity level and the high activity level must be a variable cost. By dividing the
cost difference by the difference in activity levels, we can estimate the variable cost per unit. By using
the cost equation for mixed costs, we can solve the equation for the fixed cost element. Once the total
fixed cost and the variable cost per unit are known, it will be possible to predict total costs at any activity
level (within the relevant range).
EXAMPLE 1 – High-Low Method
The following cost data has been collected by a business.
Activity Level
(Production Volume)
Total (Mixed) Cost
1,000 units
€7,000
2,000 units
€9,000
3,000 units
€11,000
4,000 units
€13,000
5,000 units
€15,000
It is obvious from the above table, that the total mixed cost increases as production volume increases.
QUESTIONS
1. Calculate the business’ variable cost per unit
2. Calculate the business’ total fixed cost
ANSWERS
Working out the amount of fixed cost and variable cost in a total (mixed) cost, using the
high-low method
The High-Low method examines the difference in cost between the highest activity level and the
lowest activity level. By choosing these two points, the cost over the full range of activity is examined
whereas, if two other points were chosen we would be examining the difference in cost over a smaller
range of activity.
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Management Accounting
Chapter 3 : Analysing and Predicting Mixed Costs
Using the highest level of activity and the lowest level of activity, we can identify the variable cost and
fixed cost components of the total cost as follows:
High / Low Volume
Activity Level
(Production
Volume)
Total (Mixed) Cost
High
5,000 units
€15,000
Low
1,000 units
€7,000
Difference
4,000 units
€8,000
Variable cost per unit = cost difference / activity level difference = €8,000 / 4,000 units = €2 per unit
We can work out the fixed cost element using the cost equation for mixed costs and the cost details
for either the high level or the low level. As fixed costs will remain constant, it doesn’t matter which
one we use.
Total (Mixed) Cost = Total Fixed Cost + Total Variable Cost
Total Cost = Total Fixed Cost + (Variable Cost Per Unit x Level Of Output)
Using the high level ….
Total Cost = Total Fixed Cost + (Variable Cost Per Unit x Level Of Output)
€15,000 = Total Fixed Cost + (€2 per unit x 5,000 units)
Total Fixed Cost = €15,000 - €10,000
Total Fixed Cost = €5,000
Using the low level ….
Total Cost = Total Fixed Cost + (Variable Cost Per Unit x Level Of Output)
€7,000 = Total Fixed Cost + (€2 per unit x 1,000 units)
Total Fixed Cost = €7,000 - €2,000
Total Fixed Cost = €5,000
Using this Analysis to Predict Future Mixed Costs
The business wants to know what the total (mixed) cost would be for 6,000 units. This can be done as
follows:
Total Cost = Total Fixed Cost + (Variable Cost Per Unit x Level Of Output)
Total Cost = €5,000 + (€2 x number of units)
Total Cost = €5,000 + (€2 x 6,000 units)
Total Cost = €5,000 + €12,000
Total Cost = €17,000
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Chapter 3 : Analysing and Predicting Mixed Costs
Management Accounting
EXAMPLE 2 – High-Low Method
The following cost data has been collected by a business for the most-recent six months
Month
Activity Level
(Production Volume)
Total (Mixed) Cost
June
5,000 units
€10,200
July
5,550 units
€11,200
August
4,500 units
€9,750
September
4,750 units
€10,100
October
6,500 units
€12,750
November
6,250 units
€11,500
QUESTIONS
1. Calculate the business’ variable cost per unit
2. Calculate the business’ total fixed cost
ANSWERS
If we re-arrange the above data in volume order, instead of month order, we get the following:
Activity Level
(Production Volume)
Total (Mixed) Cost
4,500 units
€9,750
4,750 units
€10,100
5,000 units
€10,200
5,550 units
€11,200
6,250 units
€11,500
6,500 units
€12,750
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Management Accounting
Chapter 3 : Analysing and Predicting Mixed Costs
It is now obvious from the above table, that the total mixed cost increases as production volume
increases (although not necessarily proportionately). If we graphed the data, the graph would look
as follows:
We could estimate the total mixed cost for any activity level:
1. from the above graph, or,
2. using the high-low method
Using the High-Low Method
Using the highest level of activity and the lowest level of activity, we can identify the variable cost and
fixed cost components of the total (mixed) cost as follows:
High / Low Volume
Month
Activity Level
(Production
Volume)
Total (Mixed) Cost
High
October
6,500 units
€12,750
Low
August
4,500 units
€9,750
2,000 units
€3,000
Difference
Variable cost per unit = cost difference / activity level difference = €3,000 / 2,000 units = €1.50 per
unit
We can work out the fixed cost element using the cost equation for mixed costs and the cost details
for either the high level or the low level. As fixed costs will remain constant, it doesn’t matter which
one we use.
Total (mixed) Cost = Total Fixed Cost + Total Variable Cost
Total Cost = Total Fixed Cost + (Variable Cost Per Unit x Level Of Output)
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Chapter 3 : Analysing and Predicting Mixed Costs
Management Accounting
Using the high level ….
Total Cost = Total Fixed Cost + (Variable Cost Per Unit x Level Of Output)
€12,750 = Total Fixed Cost + (€1.50 per unit x 6,500 units)
Total Fixed Cost = €12,750 - €9,750
Total Fixed Cost = €3,000
(The same result will be achieved if you use the low level)
Using this Analysis to Predict Future Mixed Costs
Supposing we estimate that the activity level in December will be 7,250 units, it is possible to predict the
total costs for December as follows:
Total Cost = Total Fixed Cost + (Variable Cost Per Unit x Level Of Output)
Total Cost = €3,000 + (€1.50 x number of units)
Total Cost = €3,000 + (€1.50 x 7,250 units)
Total Cost = €3,000 + €10,875
Total Cost = €13,875
EXERCISE
Estimate the total mixed cost if the business’ output level was:
1. 7,000 units
2. 8,000 units
Limitations of the High-Low Method of Analysing Mixed Costs
A great advantage of the high-low method over alternative methods of working out the amount of fixed
cost and variable cost in a total (mixed) cost is that it is easy to apply. However, the method provides
only a very rough estimate of costs, for the following reasons:
1. The data points chosen (the highest point and the lowest point) are ‘outliers’. As such, they
do not provide any indication of recurring cost patterns over a period of time and may distort
cost patterns. For example, if you re-do the figures in Example 2 above using two different
data points, you will get a slightly-different result – because the change in costs is not exactly
proportionate to output (as can be seen from the graph).
2. Using only two data points is not generally believed to provide sufficiently-accurate results in
cost analysis.
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Management Accounting
Chapter 3 : Analysing and Predicting Mixed Costs
PRACTICE QUESTIONS
The following questions will test your knowledge of the material you have just covered in this chapter.
You should also review the questions available online through MyRevision for this topic, as these will
assist you significantly in your preparation for your examination in May/August. In addition, Sample
papers for this subject can be downloaded from www.AccountingTechniciansIreland.ie
Question 3.1 (ref: 1473)
The following information relates to the activities of a research and development laboratory during the
last two months:
Month 1
Month 2
1,500 (low)
1,740 (high)
€
€
Volume of Activity
Number of tests undertaken
Costs Incurred
Scientists Salaries
10,940
10,940
Technicians Salaries
26,420
26,420
Chemistry Costs
30,250
32,670
Clinical Assessment Costs
20,900
23,617
Laboratory Lease Cost
37,930
37,930
Cost of Chemical Compound F1
25,000
29,000
Administration Costs
13,850
13,850
REQUIREMENTS
1. Classify each of the above costs as either a fixed cost, a variable cost, or a mixed cost.
2. Use the high-low method to separate each of the mixed costs into their fixed cost and variable cost
components.
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Part 3 – Labour Costs
In all businesses, whether manufacturing businesses, service businesses, retail businesses etc.,
labour costs (the cost of employing people) are a significant part of the business’ cost base – and
therefore, need to be given due attention by management.
CHAPTER 4
Labour Costs
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Chapter 4:
Labour Costs
CHAPTER 4
Labour Costs
CHAPTER OVERVIEW
One of the most-common ways of classifying total costs is to divide total costs into the following headings:
1. Materials Costs
2. Labour Costs
3. Overhead Costs
This chapter is concerned with labour costs (the cost of employing staff). (Subsequent chapters will
address materials costs and overhead costs).
LEARNING OUTCOMES FOR THIS CHAPTER
After studying this chapter, you should be able to:
1. Distinguish between direct labour cost and indirect labour cost.
2. Understand how labour costs are accounted for.
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Chapter 4 : Labour Costs
Management Accounting
Accounting for Labour Costs
As labour costs generally comprise a significant percentage of a business’ cost base, it is important
that these costs are controlled. The information necessary for this control should be recorded in the
business’ accounting software.
There are two main elements of accounting for labour costs:
1. Payroll Accounting
2. Labour Cost Accounting
1 - Payroll Accounting
Although an employee’s gross pay may be a fixed salary, or may be calculated as the number of
hours worked multiplied by the rate paid per hour worked, payroll accounting is more complicated than
this. Payroll accounting involves calculating the net pay to be paid to each employee. As well as the
number of hours worked and the hourly rate of pay, payroll accounting must take into account holidays,
absenteeism and deductions, such as pension, trade union subscriptions, benefit-in-kind deductions,
tax and social insurance.
The information required for payroll accounting includes HR records of salary and terms of employment,
data from a time-recording system (where applicable), absenteeism reports, holiday requisitions and tax
credit certificates received from Revenue.
2 - Labour Cost Accounting
Labour costs can be either
1. direct costs or
2. indirect costs
depending on the ability to trace labour costs to individual products or services (cost object).
Remuneration / Performance Measurement / Incentive Schemes
Measuring the performance of employees is an important aspect in controlling labour costs.
Performance appraisal / performance review / performance measurement / career development
discussions are all terms used to describe methods by which the performance of employees is
evaluated, generally in terms of quality, quantity, cost and time. This evaluation is generally done by
an employee’s ‘line’ manager or supervisor. A performance appraisal is a part of guiding and managing
career development. It is the process of obtaining, analysing and recording information about the relative
worth of an employee to the organisation. It is also a tool to be used by employees to measure their own
performance against key performance indicators (KPIs) or targets, as reaching, or surpassing, these
can assist in negotiations for increased pay, by way of salaries or bonuses.
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Management Accounting
Chapter 4 : Labour Costs
Having a sound employee-evaluation process in place will help:
• Improve morale
• Reduce labour turnover
• Increase productivity
• Reduce friction and frustration
• Enhance communication between managers and employees
• Instil a higher level of accountability for performance
• Link performance to pay, in a way that can easily be understood
• Improve the overall culture within a business
Ideally, employers should agree KPIs / targets with each employee at the outset, so as to make the
employee-appraisal process as objective as possible.
Remuneration methods for employees
1. Time based method
Under this method employees are paid an hourly rate for each hour worked and once a set level is
reached overtime is paid. For example an employee is paid €20 per hour for the first 35 hours and time
and half for any hours worked after 35 hours.
2. Incentive schemes. (Piecework schemes)
Incentive schemes link remuneration to output. For example for every product an employee makes they
receive €5.
There are various forms of incentive schemes.
(i)
Straight piecework
For every good unit an employee produces they get paid an agreed amount.
(ii)
Piecework with guaranteed day rates
For every good unit an employee produces they receive an agreed amount, however the employee
is guaranteed a minimum amount of pay regardless of the units produced (this will usually be the
minimum wage as set by a government).
(iii) Piecework minute
Under this method an employee is allowed a certain time to produce each product (standard
piecework minute) and will only be paid for this allowed time regardless of the actual time taken.
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Chapter 4 : Labour Costs
Management Accounting
EXAMPLE
Mark was allowed 15 minutes to produce each product (standard piecework minute). He is be paid
at the rate of 25 cents per piecework minute. In one week Mark worked 38 hours and produced 150
units. Calculate Marks’s Gross wages.
ANSWER
150 units x 15 minutes x 25 c = €562.5
Even though he actually worked 38 hours he is only paid for (150 units x 15 minutes) 37.5 hours
EXAMPLE – How an Incentive Scheme Works
A manufacturing business, which has 5 employees in its finishing department, is considering
introducing a piece-work incentive scheme in that department.
Details of how the 5 employees are currently paid are as follows:
Basic working week
Overtime premium
35 hours
25%
The average hours currently worked, and output currently produced, by each employee, together
with their pay rates, are as follows:
Employee
Total Weekly
Hours Worked
Basic
Hourly Pay Rate
Number of Units
Produced Weekly
Employee 1
38 hours
€18 per hour
160 units
Employee 2
40 hours
€18 per hour
160 units
Employee 3
36 hours
€20 per hour
140 units
Employee 4
35 hours
€20 per hour
140 units
Employee 5
35 hours
€20 per hour
150 units
The proposed incentive scheme would operate as follows:
The piecework rate per unit would be calculated based on:
1. the standard time allowance per unit would be 15 minutes per unit.
2. a standard hourly rate of €18 per hour, with a standard piecework enhancement of 6%.
All employees would receive the same piecework rate per unit.
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Management Accounting
Chapter 4 : Labour Costs
QUESTIONS
1. Calculate the normal weekly total pay due to each employee, on current pay terms.
2. On the basis of the proposed incentive scheme, calculate a piecework rate per unit.
2. Calculate the pay due to each employee, under the proposed incentive scheme.
4. Calculate the total weekly cost of producing 800 units per week, using current payroll terms
(assuming all employees produce equal amounts at current rates of production).
5. Calculate the total weekly cost of producing 800 units per week, using the proposed incentive
scheme.
6. Advise the business which (number 4 above or number 5 above) is the more cost-effective
option.
ANSWER
1 - Current Normal weekly Total Pay per employee
Employee
Employee 1
Calculation
Total Hours
- Standard Hours
= Overtime Hours
Result
38 hours
35 hours @ €18 per hour
3 hours @ (€18 + 25%) per hour
630.00
67.50
€697.50
Employee 2
Total Hours
- Standard Hours
= Overtime Hours
40 hours
35 hours @ €18 per hour
5 hours @ (€18 + 25%) per hour
630.00
112.50
€742.50
Employee 3
Total Hours
- Standard Hours
= Overtime Hours
36 hours
35 hours @ €20 per hour
1 hour @ (€20 + 25%) per hour
700.00
25.00
€725.00
Employee 4
Total Hours
- Standard Hours
= Overtime Hours
35 hours
35 hours @ €20 per hour
0 hours
€700.00
€0
€700.00
Employee 5
Total Hours
- Standard Hours
= Overtime Hours
35 hours
35 hours @ €20 per hour
0 hours
€700.00
€0
€700.00
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Chapter 4 : Labour Costs
Management Accounting
2 - Proposed Piecework Rate per unit
Calculation
Result
Standard Weekly Basic Pay
35 hours @ €18 per hour
€630.00
Standard Weekly Production
35 hours = 2,100 minutes / 15
OR
1 per 15 minutes = 4 per hour
x 35 hours
140 units
Basic Piecework Rate
€4.50 per unit
Incentive Enhancement 6%
0.27 per unit
Standard Incentive Piecework Rate
€4.77 per unit
3 - Pay due to each employee for current output under proposed incentive scheme
Employee
Calculation
Result
Employee 1
160 units x €4.77 per unit
€763.20
Employee 2
160 units x €4.77 per unit
€763.20
Employee 3
140 units x €4.77 per unit
€667.80
Employee 4
140 units x €4.77 per unit
€667.80
Employee 5
150 units x €4.77 per unit
€715.50
4 - Cost of producing 800 units on Current Payroll Terms (assuming all employees produce equal
amounts at current rates of production)
Target total production per week
Number of employees
Target average production per
employee
800 units per week
5 employees
160 units per employee per
week
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106091 Management Acc Manual 2016.indb 43
36
hours
35
hours
35
hours
140
Units
140
Units
150
Units
Employee 3
Employee 4
Employee 5
160
units
800 units
Total Output
800 units @ €4.77 per unit = €3,816
40 hours 35 hours
38 hours 35 hours
37.29 hours 35 hours
40 hours 35 hours
2.29
hours
5
hours
6.13
hours
5
hours
3
hours
Basic Overtime
Hours
Hours
41.13 hours 35 hours
The proposed incentive scheme is the more cost-effective option
6 – More Cost-effective Option
160
units
160
units
160
units
160
units
Weekly
Target
Output
4.29
units per hour
4.00
units per hour
3.89
units per hour
4.00
units per hour
5 - Pay Cost with Incentive Scheme
40
hours
160
Units
Employee 2
4.21
units per hour
38
hours
160
Units
Employee 1
Employee
Current
Output per
hour
Current Current
Output
Hours
per
per
week
week
Time
required
for target
(Target /
current
output per
hour)
€20
per hour
€20
per hour
€20
per hour
€18
per hour
€18
per hour
€700.00
€700.00
€700.00
€630.00
€630.00
€757.25
€825.00
€853.25
€742.50
€697.50
Total Pay
Total Weekly
€3,875.50
Pay
€57.25
€125.00
€153.25
€112.50
€67.50
Basic Pay Overtime Pay
Basic
(Basic
(Overtime
Hourly
Hours x Hours x Basic
Pay Rate Basic Pay
Pay Rate +
Rate)
25%)
Management Accounting
Chapter 4 : Labour Costs
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Chapter 4 : Labour Costs
Management Accounting
PRACTICE QUESTIONS
The following questions will test your knowledge of the material you have just covered in this chapter.
You should also review the questions available online through MyRevision for this topic, as these will
assist you significantly in your preparation for your examination in May/August. In addition, Sample
papers for this subject can be downloaded from www.AccountingTechniciansIreland.ie
Question 4.1 (ref: 1476)
Outline 3 examples of direct labour cost and 3 examples of indirect labour cost, giving reasons for your
selections.
Question 4.2 (ref: 1477)
Outline the purpose of an incentive scheme.
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Part 4 – Materials Costs
In manufacturing businesses, materials are a significant part of the business’ cost base. It is
therefore necessary to manage the cost of materials. This part of the course outlines simple
procedures for doing this. These procedures can equally be applied to inventory of finished
goods in non-manufacturing businesses.
CHAPTER 5
Materials-Related Administration
CHAPTER 6
Managing Inventory Levels
CHAPTER 7
Valuing Inventory
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