BAF 2202 Management accounting

Question one
a) Outline the objectives of management accounting (5 marks)

Objectives of Management Accounting:

1. Assistance in Planning and Formulation of Future Policies
2. Helps in the Interpretation of Financial Information
3. Helps in Controlling Performance
4. Helps in Organizing
5. Helps in the Solution of Strategic Business Problems
6. Helps in Coordinating Operations
7. Helps in Motivating Employees
8. Communicating Up-to-date Information
9. Helps in Evaluating the Efficiency and Effectiveness of Policies
Objective # 1. Assistance in Planning and Formulation of Future Policies:
Management accounting assists management in planning the activities of the business. Planning is
deciding in advance what is to be done, when it is to be done, how it is to be done and by whom it is
to be done. It involves forecasting on the basis of available information, setting goals, framing
policies, determining the alternative courses of actions and deciding on the programme of activities
to be undertaken.
Thus, planning is making intelligent forecasting. This forecasting is based on facts. Facts are provided
by past accounts on which forecast of future transactions is made. Management accounting helps
management in its function of planning through the process of budgetary control.
Objective # 2. Helps in the Interpretation of Financial Information:
Accounting is a technical subject and may not be easily understandable by everyone till the user has
a good knowledge of the subject. Management may not be able to use the accounting information
in its raw form due to lack of knowledge of accounting techniques.
Management accountant presents the information in an intelligible and non-technical manner. This
will help the management in interpreting the financial data, evaluating alternative courses of action
available and guiding the management in taking decisions and having the most desired financial
results.
Objective # 3. Helps in Controlling Performance:
Management accounting is a useful device of managerial control. The whole organisation is divided
into responsibility centres and each centre is put under the charge of one responsible person. He will
be associated with the planning and framing of the budgets and be required to execute the plans and
standards and deviations are analysed in order to pinpoint the responsibility.
Thus, management accountant helps in controlling the performance of the different responsibility
centres and take suitable actions in order to correct the adverse deviations by revising the budgets
if need be.
Management accounting assists management in location of weak spots and in taking corrective
actions against such spots which are not in conformity with the budgeted performance. Thus,
management accounting helps management in discharging its control function successfully through
budgetary control and standard costing.
Objective # 4. Helps in Organizing:
Thus management accountant recommends the use of budgeting, responsibility accounting, cost
control techniques and internal financial control. This all needs the intensive study of the
organisation structure. In turn, it helps to rationalise the organisation structure.
Objective # 5. Helps in the Solution of Strategic Business Problems:
Whenever there is a question of starting a new business, expanding or diversifying the existing
business, strategic business problem has to be faced and solved.
Similarly when in a particular situation, there are different alternatives as whether labour should be
replaced by machinery or not, whether selling price should be reduced or not, whether to export the
item or not etc., a management accountant helps in solving such problems and decision-making.
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 He provides accounting data to a management with his recommendation as to which alternative will
be the best. For such decisions, the management accountant may take the help of marginal costing,
cost volume profit analysis, standard costing, capital budgeting etc.
Management accounting provides feedback to the management such as what business to engage in
or diversify how to run that business efficiently. This is most important contribution which the
management accountant has made.
Objective # 6. Helps in Coordinating Operations:
Management accounting helps the management in co-coordinating the activities of the concern by
getting prepared functional budgets in the first instance and then co-coordinating the whole
activities of the concern by integrating all functional budgets into one known as master budget. Thus,
management accounting is a useful tool in coordinating the various operations of the business.
Objective # 7. Helps in Motivating Employees:
The management accountant by setting goals, planning the best and economical course of action
and then measuring the performance tries his best to increase the effectiveness of the organisation
and thereby motivate the members of the organisation.
Objective # 8. Communicating Up-to-date Information:
Management accounting assists management in communicating the financial facts about the
enterprise to the persons who are interested in these facts so that they may be guided to a line of
action to be pursued. Management needs information for taking decisions and for evaluating
performance of the business.
The required information can be made available to the management by means of reports which are
an integral part of the management accounting. Reports are means of communication of facts which
should be brought to the notice of various levels of management so that they may be guided for
taking suitable action for the purposes of control.
Objective # 9. Helps in Evaluating the Efficiency and Effectiveness of Policies:
Management accounting also lays emphasis on management audit which means evaluating the
efficiency and effectiveness o£ management policies. Management policies are reviewed from time
to time to make an improvement in them so that maximum efficiency may be achieved.

b) Assume that a certain process has an 95% learning curve effect and the first unit took 4000hrs
Required

Wright's Cumulative Average Model

In Wright's Model, the learning curve function is defined as follows:

Y = aXb

where:
Y = the cumulative average time (or cost) per unit.
X = the cumulative number of units produced.
a = time (or cost) required to produce the first unit.
b = slope of the function when plotted on log-log paper.
= log of the learning rate/log of 2.

For an 95% learning curve b = log .95/log 2 = -0.02228/0.301 = -0.074

If the first unit required 4,000 hours, the equation would be:

Y = 4,000X-0.074

The equation for cumulative total hours (or cost) is found by multiplying both sides of the
cumulative average equation by X.
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 Since X times Xb = X 1+b, the equation is:
XY = a X 1+b

Thus, the equation for cumulative total labour hours is,

XY = 4,000 X 1-0.074 = 4,000 X 0.926

i) Compute the number of hours required to produce the first 34 units (4 marks)

XY = 4,000 X 0.926
= 4,000 x 34 0.926
= 4,000 x 26.191
= 104,764 hours

ii) Compute the number of hours required to produce 34th unit (3 marks)

XY = 4,000 X 0.926
= 4,000 x 33 0.926
= 4,000 x 25.4767
= 101,907 hours

No of hours to produce the 34th unit = cumulative hours for (34 units - 33 units)
= 104,764 – 101,907
= 2,857.2 hours

iii) Assume that the wage rate is Kshs. 100 per hour, compute the labour cost of producing the
last 16 units (4 marks)

Labour Cost of producing the last 16 units out the total of 34 units
= wage rate per hour x total hours for producing the last 16 units

Given that cumulative hours for producing first 18 units: X = 18 units

= 4,000 X 0.926
= 4,000 x 18 0.926
= 4,000 x 14.534
= 58,136 hours

then total hours for producing the last 16 units

= cumulative hours for (34 units – (34-16) units)
= cumulative hours for (34 units – 18 units)
= 104,764 – 58,136
= 46,628 hours

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c) Differentiate between management accounting and financial accounting (5 marks)
Difference between Management Accounting and Financial Accounting
Sr. No. Management Accounting Financial Accounting
1 For external reporting to various Only used for internal purposes of
stakeholders and mandatory by law in the firm
most cases
2 Is not under the regulation of any law or Is governed by Standards, Laws,
regulations regulations, etc
3 The main purpose is to help internal Helps investors, creditors, etc. take
management take decisions investment decisions
4 Includes both financial and non-financial Is only concerned with financial
information information
5 Not subject to any audits or investigation Financial records are audited as per
the norms

d) Highlight the assumptions of cost volume profit analysis (4 marks)

Some of the key assumptions underlying cost-volume-profit analysis are as follows:

1. All costs can be classified as fixed and variable

while developing and applying cost-profit-analysis including the break-even analysis, it is assumed
that all costs can be classified into fixed and variable costs. In fact, it is difficult to identify each and
every cost element as fixed and variable. In the traditional type of recording costs, it is very difficult
to segregate costs into fixed and variable. Moreover, the flexible policy of the company also makes
it more difficult to identify the cost as fixed and variable.
If anyone fails to identify the cost as fixed and variable, the application of cost-volume-profit analysis
becomes almost impossible.
2. Behaviour or costs will be linear within the relevant range
Cost-volume-profit (CVP) analysis assumes that total fixed costs do not change in the short-run within
the relevant range. Total variable costs are exactly proportionate to sales volume. But in reality, cost
behaviour may not remain constant.
3. Difficulty of steps fixed costs
Relevant range for many costs is very short. In that case it becomes very uncomfortable to compute
the required volume because it is difficult to say that which the relevant range for our needed volume
is.
4. Selling price remains constant for any volume
Indeed, most often quantity discount is offered for different lots of purchase. This causes difficulty
in determining the contribution margin per unit (CMPU) and contribution margin ratio.
5. There is no significant change in the size of inventory
Application of cost-volume-profit (CVP) analysis is possible only under following two situations:
* Either the company should follow variable costing for the inventoriable product cost.
* Or all the production volume should be sold within the same period.
6. Cost-volume-profit (CVP) analysis applies only to a short-term time horizon
CVP analysis is a short-term planning tool, because nothing remains stable in the long-run. In the
condition of changing variables, all equations of CVP analysis need readjustment of figures.

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e) Describe any five cost estimation methods applied in management accounting. (5 marks)
Methods of Cost Estimation
A number of methods can be used to analyse semi variable costs into their fixed and variable
elements.
The main methods are:
1) High/Low Method
2) Least Square Regression Method
3) Visual Fit (Scatter Graph Method
4) Accounts Analysis
5) Industrial Engineering Method
1) High/Low Method
High low method is calculated in the following steps:
1. Select the highest and lowest activities and record their respective costs.
2. Calculate the Variable Cost (b).
3. Calculate the Fixed cost (a).
Generate the total cost formula by replacing (a) and (b) with their calculated values obtained above
2) Least Square Regression Method
Linear Regression analysis is a statistical technique for calculating the line of best fit from a set of
data.
Linear Regression analysis formula
𝒚=𝒂+𝒃𝒙
But Fixed Cost (a) and Variable Cost (b) are calculated by
𝒂=𝜮𝒚/𝒏−𝒃𝜮𝒙/𝒏, while 𝒃=(𝒏𝜮𝒙𝒚−∑128▒𝒙 𝜮𝒚)/(𝒏𝜮𝒙^𝟐−(𝜮𝒙)^𝟐 )
Where
a = fixed cost per period (the intercept)
b = variable cost per unit (the gradient)
x = activity level (the independent variable)
y = total cost
∑ = sum of
n = sample size
3) Visual Fit (Scatter Graph Method
Scatter graph cost estimation involve plotting of costs and activity data on a graph to give a cost
behaviour picture.
A line of best fit is drawn to cover most of the plotted points on the scatter graph.
Its intersection with the vertical axis indicates the fixed costs while the gradient indicates the variable
cost per unit.
4) Accounts Analysis
Account analysis the cost accountant examines and classifies each cost into variable, fixed or mixed
types.
They base their classifications on experience, inspection of cost behaviour for several past periods or
personal intuitive feelings.
Therefore, account analysis as a cost estimation method is highly subjective.
As a remedy of this personal bias, the cost accountant needs to carry out further cost analysis before
accepting the cost-behaviour obtained as true.
5) Industrial Engineering Method
Under this Industrial engineering method of cost estimation, the cost accountant analyses the
relationship between inputs and outputs in physical terms and has the following
characteristics:
i. It involves carrying out time and motion studies
ii. It is a very thorough and detailed method
iii. It is therefore very costly and time consuming
Another name for Industrial engineering method of cost estimation is work-measurement
Method.
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Question two
Shell ltd is trying to decide whether or not to drill for oil on a particular site in north eastern Kenya. The chief
engineer has assessed the probabilities that there will be oil as follow, based on past experience.
Oil 0.2
No oil 0.8
It is possible for shell ltd to hire a firm of international consultants to carry out a complete survey of the site.
Shell ltd has used the firm many times before and has made the following estimates:
1. If there is oil, then there is a 95% chance that the report will be favourable.
2. If there is no oil then there is only a 10% chance that the report will indicate that there is oil.
The following additional information is also provided:
• The cost of drilling is sh. 10 million
• The value of the benefits if oil is found is sh 70 million
• The cost of obtaining information is sh. 3 million
Required:
a) Advise the company on whether to acquire additional information from the consultants (16 marks)

EV (' to Drill') = (70 m × 0.2) + (-10 m × 0.8) = 14 m – 8 m = 6 m.

We should drill, because the expected value from drilling is 6 m, versus nothing for not drilling.

We will calculate the Expected Value of profits if incur cost of obtaining information.
If the expected value exceeds 6m, then it would be worth incurring the cost of obtaining information i.e.
as long as the benefit from cost of obtaining information exceeds the cost of 3 m.

P (favorable report) = 0.2 x 0.95 + 0.8 x 0.1 = 0.19 + 0.08 = 0.27

EV (at max profit) = (0.19 / 0.27 x 70 m) – 10m = 49.28 -10 = 39.28 m

Expected value after cost of obtaining information is

= P (favourable report) x EV (at max profit)
= 0.27 x 39.28 m
=10.61 m

Therefore, the company should acquire additional information from the consultants as Expected Value
of 10.61 m is greater than cost of obtaining additional information of 3 m.

b) Compute the value of imperfect information.

Value of imperfect information

= P (favourable report) x EV (at max profit) – cost of drilling
= 0.27 x 39.28 m – 10 m
= 0.61 m

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