Financial managerment - Essay Example

?TASK Traditional Full Costing: Ouse Lendal Clifton Total Production volume (units) 9,000 3,000 500 13,500 Direct Labour hours per unit 2 2 4 Total Direct Labour hours 18,000 6,000 6,000 30,000 Percentage of total Direct Labour hours allocated to Ouse, Lendal and Clifton shall be calculated as follows: Direct Labour Hours (A) Total Direct Labour Hours (B) Percentage (A/B*100%) Ouse 18,000 30,000 60% Lendal 6,000 30,000 20% Clifton 6,000 30,000 20% The overheads shall also be absorbed by each of the product at the percentage calculated above. Overheads Cost per Unit: Overheads absorbed = Total Overheads * Percentage calculated Direct Labour Hours Percentage Total Overheads (?) Overheads absorbed (?) Ouse 18,000 60% 3,000,000 1,800,000 Lendal 6,000 20% 3,000,000 600,000 Clifton 6,000 20% 3,000,000 600,000 Overheads cost per unit may be calculated as follows: Per unit Overhead cost = Overheads absorbed / Production volume Production volume (units) Overheads absorbed (?) Per Unit Overhead Cost (?) Ouse 9,000 1,800,000 200 Lendal 3,000 600,000 200 Clifton 1,500 600,000 400 Direct Labour Cost per Unit: Per Unit Direct Labour cost = Direct Labour hours per unit * Direct Labour cost per hour Direct Labour hours per unit Direct labour cost per hour (?) Per Unit Direct Labour Cost (?) Ouse 2 20 40 Lendal 2 30 60 Clifton 4 10 40 Cost Per Unit and Profit per Unit: Ouse Lendal Clifton Direct Material Cost per Unit (?) 30 40 15 Direct Labour Cost per Unit (?) 40 60 40 Overheads Cost per Unit (?) 200 200 400 Total Direct Labour Cost (?) 270 300 455 Selling price per unit (?) 300 400 500 Total Direct Labour Cost (?) (270) (300) (455) Profit per Unit (?) 30 100 45 Activity Based Costing: Ouse Lendal Clifton Total Machine hours per unit 4 3 10 17 Number of production runs 30 20 50 100 Number of deliveries 18 7 25 50 Number of receipts 50 70 580 700 The percentage may be calculated as follows: Percentage = Number of overhead units consumed by Product / Total overhead units consumed Ouse (%) Lendal (%) Clifton (%) Total Machine hours per unit 23% 18% 59% 17 Number of production runs 30% 20% 50% 100 Number of deliveries 36% 14% 50% 50 Number of receipts 7% 10% 83% 700 These percentages, when applied on the total overheads cost, will give the amount of overheads consumed in producing each of these products. Overhead Cost driver ?’000 Percentage Overheads cost Ouse Lendal Clifton Ouse Lendal Clifton Set up costs Number of production runs 350,000 30% 20% 50% 105,000 70,000 175,000 Machine related costs Number of machine hours 900,000 23% 18% 59% 211,765 158,823 529,412 Receiving costs Number of receipts 350,000 7% 10% 83% 25,000 35,000 290,000 Packing Number of deliveries 650,000 36% 14% 50% 234,000 91,000 325,000 Engineering Number of production runs 750,000 30% 20% 50% 225,000 150,000 375,000 800,765 504,823 1,694,412 Overheads Cost per Unit: Per unit Overhead cost = Overheads absorbed / Production volume Production volume (units) Overheads absorbed (?) Per Unit Overhead Cost (?) Ouse 9,000 800,765 89 Lendal 3,000 504,823 168 Clifton 1,500 1,694,412 1130 Cost Per Unit and Profit per Unit: Ouse Lendal Clifton Direct Material Cost per Unit (?) 30 40 15 Direct Labour Cost per Unit (?) 40 60 40 Overheads Cost per Unit (?) 89 168 1130 Total Per Unit Cost (?) 159 268 1185 Selling price per unit (?) 300 400 500 Total Direct Labour Cost (?) (159) (268) (1185) Profit per Unit (?) 141 132 (685) TASK 2: Traditional Full Costing: Full costing is defined as a method of costing of products in which all the manufacturing costs are included in the cost of the products being manufactured. The raw materials, direct labour involved in the production of the product and all fixed and variable products become the part of the items produced. Full costing is also termed as absorption costing. Activity Based Costing: Activity Based Costing is a costing method in which the consumption of resources are traced first and then charged to final products. However, the resources are not directly assigned to manufacturing products in this costing method. Rather resources are allocated to the activities and these activities are then assigned to the products produced on the basis of the cost drivers. Difference between Full Costing and Activity Based Costing: Direct material cost and direct labour cost are allocated to the products in a similar way in both types of costing methods. These cost elements are allocated to the products as per their production volume. Each of these elements is allocated to each unit of the product that is manufactured. However, the overheads are absorbed in both of these products differently. In full costing method, the traditional approach is adopted while allocating costs to the product units. The approach is simple in which the resources are assigned directly to the units produced. A single volume measure is usually selected on the basis of which all overhead costs are allocated to the products. Thus, this allocation may depend upon a volume measure which may not be suitable for the purpose. Consequently, allocation of overheads may not be suitable and may reflect unrealistic cost of the products. In Activity Based Costing methodology, the overhead costs are accumulated and assigned to the activities of the production and non-production departments. The costs of these departments are then allocated to the product units. However, the activity costs are allocated to the products on the basis of the cost drivers. The cost drivers for each activity are determined by the organization itself which is also a handy task. However, this type of allocation method helps to determine the actual cost of the products being manufactured. Thus, it becomes easy for the company to make decisions regarding the production of a certain product or a certain product-line. ANALYSIS: “Full costing is not relevant for decision making and activity based costing provides better management information.” As full costing method allocates overheads on the basis of a single volume measure, so it generalizes the allocation of the overheads. This method fails to provide a logical basis for such distribution of overheads expenses. As a result, the overheads may be absorbed by some products or product-lines for which such costs are not incurred. This will increase the costs of such products unjustifiably and decreases their profit margins. On the other hand, the products for which such costs have been incurred will not bear the whole portion of these costs. As a result, their costs will appear at lower than the actual and will consequently increase the profit margins. In Activity-based costing, the costs of overheads are allocated to the activities and not to the product units directly. Thus, all the products depict the real costs and profit margins. This system also possesses the flexibility of preparation and provision of reports regarding the costs allocation regarding different activities. This assists the management in making useful decisions which are based on actual data. In the provided scenario, the result of absorption costing shows that per unit profit for the company is ?175. ?30 has been contributed by Ouse, ?100 by Lendal and ?45 by Clifton. The overheads have been absorbed by these products on the basis of direct labour hours. Thus, the biggest contributor to the profits is Lendal, then Clifton and Ouse contributes the least. On the basis of this information, the management may decide to continue production of all these products as all of them are generating profits but it will give the least priority to the production of Ouse as it is generating the least profit. The company produces Ouse most. However, to obtain an increase in profits, management may decide to divert available resources towards the production of Lendal and Clifton as these two may generate them maximum profits. The Activity Based costing depicts the real situation of the scenario as all the overheads costs are allocated to the activities of production and then to the products using those activities in the course of their production. According to this costing methodology, the company is bearing a per unit loss of ?412. Ouse contributes profit of ?141 per unit and Lendal ?132 per unit while Cifton is bearing loss of ?685 per unit. As a whole the company is suffering a loss as a whole. Activity Based Costing method has made it quite clear that the loss is being suffered due to production of Clifton as both Ouse and Lendal are generating profits. This assists the management to make a useful decision-making. Recommendations: The company York Ltd. should adopt Activity-Based costing method as this method depicts the real costs and profits of the products and may assists the management to make useful decisions. However, it must be assured that the cost drivers used and setup by the company for using ABC costing approach should be justified and logical. Any illogical cost driver may cause the anagement to make illogical decisions. Ignoring fixed overheads, management may decide to stop the production of Clifton, on the basis of ABC costing methodology as it is generating heavy losses for the company. On the other hand, ABC costing also shows that the Ouse which appears to generate minimum per unit profit as per full costing approach is actually generating maximum per unit profit. So, the management may decide to transfer their resources from Clifton to Ouse. TASK 3: Sales Variances: Sales Volume Variance = (Budgeted Sales Quantity – Actual Sales Quantity) * Budgeted Profit = (3,000 – 2,850) * ?3.5 = ?525 (Adverse) Sales Price Variance = Actual Sales Revenue – (Actual Sales Quantity * Standard Price) = 56,430 – (2,850 * ?20) = ?570 (Adverse) Materials Variances: Materials Price Variance = Actual cost of Materials used – (Actual Quantity * Standard cost) = ?7,722 – (4,290 * ?2) = ?858 (Favourable) Materials Usage Variance = (Actual Quantity – Flexed Budgeted Quantity) * Standard cost = (4,290 – (2,850 * 1.5)) * ?2 = ?30 (Adverse) Labour Variances: Direct Labour Rate Variance = Actual Direct Labour cost – (Actual Direct Labour hours * Standard rate) = ?17,384 – (2,120 * ?8) = ?424 (Adverse) Direct Labor Efficiency Variance = (Actual Hours worked –Flexed Budget Hours worked) * Standard rate = (2,120 – (2850 * 0.75)) * ?8 = ?140 (Favourable) Fixed Overheads Variances: Fixed Overheads Expenditure Variance = Budgeted Fixed Overheads – Actual Fixed Overheads = (3,000 * ?7.5) – ?22,000 = ?500 (Favourable) Fixed Overheads Volume Variance = (Budgeted Sales – Actual Sales) * Standard Absorption rate = (3,000 – 2,850) * ?7.5 = ?1,125 (Adverse) RECONCILIATION BETWEEN BUDGETED AND ACTUAL PROFIT ? ? ? Budgeted Profit 10,500 Variances (F) (A) Sales Volume 525 Sales Price 570 Direct Material Price 858 Direct Material Usage 30 Direct Labour Rate 424 Direct Labour Efficiency 140 Fixed Overheads Expenditure 500 Fixed Overheads Volume 1,125 1,498 (2,674) (1,176) Actual Profit 9,324 REPORT TO MANAGEMENT OF YORK LIMITED INTRODUCTION: This report has been prepared for the management of York Limited on December 3, 2012 highlighting significant variances and explaining reasons for these variances. FACTS AND FINDINGS: We have worked out various variances for the financial data prepared by York Limited regarding the product ‘Foss’. We have found both favourable and adverse variances. The list of variances and their nature is given below: Variances Sales Volume 525 Adverse Sales Price 570 Adverse Direct Material Price 858 Favourable Direct Material Usage 525 Adverse Direct Labour Rate 570 Adverse Direct Labour Efficiency 140 Favourable Fixed Overheads Expenditure 500 Favourable Fixed Overheads Volume 1,125 Adverse CONCLUSIONS AND REASONS: Variance in actual and budgets is caused due to difference between the both. This difference occurs when the actual course of action taken by management does not follow or vary from the budgets. Sometimes, such variation is beneficial to the company and gives rise to ‘favourable variance’. On other occasions, it may hamper the performance of the company and thus, gives rise to ‘adverse variance’. Sales volume variance is adverse. The basic reason is that the sales in this month are lesser than expected. The reasons of lower sales may be sales team poor performance and decline in market conditions. Sales price variance is also adverse. The basic reason is lower sale price than expected. The reasons of lower sale price may be the poor market conditions reducing price for the product. Material price variance is favourable. The basic reason is that the cost of material purchased and used is lower than expected. This may be due to efficient performance by buying department and favourable market conditions for purchasing materials. Direct materials usage variance is adverse. The basic reason is higher usage of materials than expected. This may be due to ineffective performance by the production personnel, purchase of substandard materials or use of faulty production machinery leading to waste of materials. Direct labour rate variance is adverse. The basic reason is higher labour rate than expected. The reasons may be Human Resource department poor performance, changes in market conditions effecting labour and use of high grade labour than expected or required. Direct labour efficiency variance is favourable. The basic reason is that the labour is working more efficiently than expected. The reasons may be high quality supervision, good maintenance and working of the production machinery and good quality of material used in production. Fixed Overheads expenditure variance is favourable. The basic reason is that the actual fixed overheads are less than expected. This may be due to good supervision and lower costs of fixed overheads than budgeted. Fixed overheads volume variance is adverse. The basic reason is that the fixed overheads absorbed are less than the budgeted overheads. This may occur due to poor management and supervision of fixed overheads. RECOMMENDATIONS: It is recommended that the management should take actions to remove adverse variances and convert these into favourable. The following actions may be taken by management. Improve the performance of sales, production and Human Resource departments. Develop market for the company’s products. Maintain the production machinery and purchase good quality materials to avoid their loss. Assign the task of supervision of overheads to more experienced personnel. Avoid making unrealistic assumptions and making budgets on the basis of those assumptions. TASK 4; STANDARD COSTING: A practice in which the actual costs of material, labour and overheads are replaced with the budgeted costs in the company’s records is called standard costing. The company using standard costing also periodically records the variances which are the differences between the actual and expected costs. EVALUATION OF USE OF STANDARD COSTING: The standard costing is used for the purpose of ease as it is, sometimes, difficult to calculate the actual costs of the products and activities. It also consumes much time to calculate the actual costs incurred on the production of the product. But it also provides some other benefits which may not be achieved without using standard costing. Many of these benefits are of managerial nature and assist the management in making useful decisions when comparing the budgets with actual results. The shortcomings and deficiencies are also identified at the time of variance analysis. Standard costing assists the management to assess the performance of the production department, sales department and HR department. The performance standards may be fixed easily and assists the management in devising production and selling policies and plans. The inefficiencies in actual performance may be eliminated through taking corrective actions and costs may be controlled. The system of cost reporting may also become effective through the use of standard costing. However, there are also certain limitations related to the use of standard costing. For small businesses, standard costing may appear to be expensive. It is also sometimes difficult to prepare budgets and standards for the products. This appears when there is lack of personnel holding technical expertise. Technological changes which are quite frequent may not suit the standard costing system. Though the division produces only one product, standard costing may appear to be useful due to administrative decision making. The variance analysis shows that the results are far adverse than expected and the profits are lesser than budgeted. In such situations, the standard costing may assist the management in taking corrective actions as this may be happening due to inefficient use of labour, materials and other resources. It may also helps management in setting correct prices and developing new and improved production plans. The differences in budgeted and actual results may also occur due to inappropriate setting of standard costs. However, this may be correcting standard costs that may be appropriate in the circumstances. The performance according to plans may also be examined and judged by the management. Though the division is producing only one product, it is quite reasonable to use standard costing. It will not only help to improve the performance of the whole division but will also assist the management to identify the deficiencies in the division which may be removed to improve production quality, labour efficiency and overall profits for the company. References 1. Accounting for Management., 2012. Full Costing Definition. Available through Accounting website [Accessed 30 November 2012]. 2. Activity Based Costing Advantages and Disadvantages. Available through: [Accessed 2nd December 2012]. 3. Activity Based Costing., 2004. Introduction to Activity Based Costing. Available through: Accounting Coach website [Accessed 30 November 2012]. 4. Atrill, P. and McLaney, E., 2007. Management Accounting for Decision Making. 5th Ed. London: Harlow FT: Prentice Hall. 5. Carecows., 2011. Full Cost Accounting. Available through: Accounting website [Accessed 2nd December 2012]. 6. CIMA, 2008. Activity Based Costing [pdf] Available at: [Accessed 30 November 2012]. 7. Dyson, J., 2007. Accounting for non- Accounting Students. 7th Ed. USA. 8. Miller, F., 2012. The Disadvantages of Absorption Costing. Available through: ehow Contributor [Accessed 1st December 2012]. 9. Nayab, N., 2010. Absorption Costing vs. Activity- Based Costing. Available through: Bright Hub website [Accessed 30 November 2012]. 10. Palmer, D., 2012. Financial Management Development [pdf] Available at: [Accessed 2nd December 2012]. 11. Sales Variances, Variances Based on Turnover Homework Help, Tutoring., 2011. Standard Costing-Sales Variances. Available through: Tutor Sonnet website [Accessed 1st December 2012]. 12. Standard Costing and Variance Analysis [pdf] Available at: [Accessed 1st December 2012]. 13. Standard Costing., 2012. Standard Costing Overview. Available through: Accounting Tools website [Accessed 2nd December 2012]. 14. Usry and Martz., 1985. Cost Accounting: Planning and Control. 9th Ed. USA: South- Western Publishing Co. 15. Weetman, P., 2006. Financial and Management Accounting. 4th Ed. UK: Perseus. Read More