Summary with the 8th edition of Fundamental Managerial Accounting Concepts by Edmonds

What is management accounting and corporate governance? - Chapter 1

What are the differences between managerial accounting and financial accounting?

Managerial accounting differs from financial accounting on several aspects. These are the key differences:

• Managerial accounting provides information for internal users, financial accounting for external users

• Managerial accounting provides economic, physical, and financial data, financial accounting provides financial data only

• Managerial accounting focuses on subunits, financial accounting on the company as a whole

• Managerial accounting is not required by the FASB (only limited by value-added principle, so it should bring more benefit than cost), financial accounting is required by the FASB, SEC, and other determiners of GAAP

• For managerial accounting, the information consists of estimates to enable timeliness and to promote relevance, for financial accounting the information is factual, objective, reliable, consistent, and accurate

• Managerial accounting focuses on the past, present, and the future whereas financial accounting only takes into account the past

• Managerial accounting involves reporting on a continual basis, financial accounting normally focuses on annual reports

• Managerial accounting is a means to an end, financial accounting is an end in itself

What is managerial accounting?

Establishing product costs is the focal point in managerial accounting, costs affect pricing strategies and financial statements and controls business operations.

There are different types of businesses:

• service

• merchandising and

• manufacturing

These businesses differ from each other to the extent that the products of manufacturing companies are not immediately consumed, whereas products of merchandising and service business are. However, all companies do have a similar range of cost sources.

Related to products, there are three types of costs:

• Upstream costs. Costs arising previous to the manufacturing process (development costs)

• Downstream costs. Costs arising after the manufacturing process (transportation costs, sales payments, advertising costs, bad debts)

• Cost related to the manufacturing process

  • Materials used to make the product
    (manufacturing components, fundamental resources)

  • Direct labor
    (wages of employees involved in the manufacturing process)

  • Manufacturing overhead (indirect costs such as utilities, depreciation)

How do costs affect financial statements?

When a company produces a product, all the costs spent on the manufacturing process (= the material-, labor- and overhead costs) do not lead to an expense, but they are recorded as inventory.

Through asset exchange transactions these costs were transformed into products. The total amount of cost are placed in a new account called Finished Goods Inventory (inventory). The costs related to one product is mostly calculated by taking the average cost per product.

No expense is recognized until the products are sold. When one product is sold, the average cost of this product shifts from the Inventory-, to the Cost of Goods Sold (COGS) account. In other cases, the general, selling and administrative costs

(G, S & A) the costs are expended in the period they were made (period costs).

The costs of the materials used to produce the product, that can be effortlessly traced to the product, are called direct raw material costs.

As already mentioned before, the costs of these materials are first registered as inventory, and when the product is sold, they are shifted to the COGS account.

The wages of employees involved in the manufacturing process and the overhead costs related to the production process, for instance the depreciation on manufacturing equipment, are recorded the same way as the costs of materials.

These costs can also be effortlessly traced to the product and are called direct labor costs and manufacturing overhead.

Other costs then product costs are general:

• operating costs selling and administrative costs

• interest costs, and

• the cost of income taxes.

These are registered as expense in the period in which they are incurred, which is why they are called period costs.

Selling and administrative wages are not part of the manufacturing process, and are therefore, expensed immediately and registered as salaries expense.

Overhead costs not related to the manufacturing process are called indirect costs and are registered as depreciation expense.

These indirect costs cannot be effortlessly traced to a certain product, and are therefore assigned to products through cost allocation.

• Cost allocation: a process of dividing a total cost into parts and assigning the parts to relevant cost objects.

There is an essential difference between manufacturing entities and service companies: the products that service companies provide are consumed immediately; they cannot be held as inventory  So, the labor – and overhead costs in service companies are normally written down as selling, general, and administrative expenses instead of inventory posts.

Remember: the assets are cash, inventory, and equipment. Equity is common stock and retained earnings.

What is an inventory?

Other expenses are related to inventory holding; theft, damage, warehouse spacing, obsolescence, and supervision. These are the visible costs, other costs include sloppy works, diminished motivation, increased production time, and inattentive attitudes. Therefore, businesses try to reduce these inventory costs through applying a Just in Time (JIT) inventory. Meeting consumers demand, while not maintaining a large inventory.

Examples: hamburgers that are cooked to order are fresher and more individualized than those that are prepared in advance and stored until a customer orders one  JIT leads to not only greater satisfaction among customers but also lowers costs through reduced wage.

Corporate governance is related to all the stakeholders that affect and determine the way the company is controlled. Management accountants have the front position in corporate governance. The report data that presents the financial condition of their business. When they present a different financial statement, through timing differences in recognizing costs, they are able to influence the timing of income tax payments, the availability of financing and compensations rewarded to management.

Next to making choices between legitimate alternatives, management accountants also might have to:

• Perform duties which they have not been trained for

• Disclose confidential information

• Be involved in falsification, bribery, etc.

• Issue misleading, biased, or incomplete reports

Fraud is common in businesses, and most of the time there are three elements present when this occurs:

• There is an opportunity available (internal controls are there to avoid this). This is the head of the triangle (See the figure below) because without opportunity the fraud would not exist.

• Some form of pressure exist leading to commit fraud (drug addiction, gambling,

• They rationalize their misbehavior

The Fraud Triangle, based on the three elements mentioned above:

1. Opportunity

2. Pressure

3. Rationalization

The U.S. have had the Sarbanes-Oxley (SOX) Act since 2002 to restore and maintain confidence. Implications for management accountants are the following:

• The CEO and the CFO are responsible for the internal controls. An annual report is required, as well as a report on how effective the internal controls are. External auditors who control the latter report have to attest to its accuracy.

• The CEO and the CFO have the ultimate responsibility for the financial statements and the notes. An international misrepresentation is punishable by a fine up to $5 million and 20 years prison.

• A code of ethics is required, as well as reports on its effectiveness.

• A hotline and other things have to be in place for anonymous reporting of fraud. Whistleblowers, employees who legally report corporate misconduct, cannot be punished.

What managerial accounting trends are there?

Reengineering might be necessary due to globalization. Benchmarking allows a company to identify world’s best practices. These practices include the following:

• Total Quality Management (TQM): systematic problem-solving, frontline employees are encouraged to achieve zero defects; customer satisfaction as key focus. The key component is continuous improvement

• Activity-Based Management (ABM): here, the value chain is assessed to reduce non value-added activities and make value-added activities optimal

How can cost behavior, operating leverage and profitability be analyzed? - Chapter 2

What are fixed and variable costs?

It is important to know how costs change relative to the level of business activity. This is called cost behavior.

Firms can have fixed, variable or mixed costs.

• When activity increases (or decreases): the total variable cost will increase or decrease and total fixed cost will remain constant.

• However, when activity changes: the variable cost per unit will stay constant and fixed cost per unit will increase or decrease.

Mixed costs include both fixed and variable costs. Mixed costs are semi-variable costs. They include both fixed and variable components.

Total costs = Fixed costs + (Variable cost per hour * Number of hours)

Fixed cost can also be variable, this depends on the activity base; the number of times this activity occurs. For instance, hiring a bike for €10 a day is a fixed cost, however, when you rent a bike several days, this cost becomes a variable.

Fixed costs can be used for operating leverage. Once the fixed costs are covered, every additional sale is profit. If you incur fix costs, you incur a risk.

Risk is the possibility that sacrifices are higher than benefits. Fixed costs are sacrifices. To avoid this, a firm can employ a variable cost structure.

The relevant range: is the range of activities over which the cost is applicable. For example, when costs are calculated for 1 to 1000 products, these costs are only applicable to these products. If more products are demanded, a new calculation has to be made.

What is meant by the contribution margin approach?

Only having variable cost gives a small risk. When there is no output, no cost occur. A 10% change in revenue will lead to a 10% change in gross margin.

A company with only fixed cost lowers the price of its products with 10%, and its revenue will also decrease with 10%, its gross margin will decrease with 90%! This is also the case when its revenue will increase with 10%, then its gross margin will increase with 90%. In general, the more fixed cost, the more fluctuations in net income.

Formula for calculating percentage change:

(Alternative measure – Base measure) / Base measure = % Change

The base measure is the starting point

The contribution margin is the amount of revenue accessible to cover fixed costs, and thereafter to provide company profits.

Making an income statement using this approach:

• The first step is to deduct the variable costs from the sales revenue. The amount left is the contribution margin.

• After this, the fixed costs are deducted and this results in the net income. This measure allows managers to measure the operating leverage more easily. Businesses apply operating leverage to magnify a small percentage in change in the revenue into a large change in profitability.

Contribution margin = Sales revenue – Variable cost

The magnitude of operating leverage = Contribution margin / Net income

Through calculating the magnitude of operating leverage, the change of net income can be calculated:

Change in net income = Magnitude of operating leverage * Change in revenue

What is the High-Low Method?

The high-low method is a simple method to calculate fixed and variable costs. One drawback is its vulnerability to inaccuracy. Fixed and variable costs can be calculated by the following four steps:

1. Collect cost history and sales volume

2. Find the highest and lowest point of units sold in this set of data

3. Calculate the estimated amount of variable cost per unit
   Variable cost per unit = Difference in total costs/ Differences in volume

4. Calculate the estimated total amount of fixed costs
   Fixed costs = Total cost – (Variable costs per unit * High point OR low point)

How can the scatter graph method be used?

The scatter graph is another way to estimate total fixed and variable costs. It is also used to check the accuracy of the high-low method by plotting the data in a graph and drawing a line through the highest and lowest point of units sold. When much of the data points are above this line, the estimation can be inaccurate, and therefore a new line is drawn; the visual fit line. This line is a closer estimation of the real costs because it minimizes the space between the data points and the line.

How can the regression method be used?

Using a statistical program like SPSS one can do least-squares regression. The R² then represents the relative change in the independent variable (the number of units sold). Multiple regression analysis can be used to find out how several independent variables influence the dependent variable.

It is important to know how costs change relative to the level of business activity. This is called cost behavior.

Firms can have fixed, variable or mixed costs.

• When activity increases (or decreases): the total variable cost will increase or decrease and total fixed cost will remain constant.

• However, when activity changes: the variable cost per unit will stay constant and fixed cost per unit will increase or decrease.

How can cost, volume, and pricing to increase profitability be analyzed? - Chapter 3

What is the break–even point?

The break-even point is the point where the costs are of the same height as the revenues, were the profit equals zero.

There are three methods to calculate this point:

• Equation Method
  Sales – Variable costs – Fixed costs = Profit (Net income)= 0

• Contribution Margin per Unit Method
  Break-even point in units = Total fixed costs / Contribution margin per unit
  (Contribution margin per unit = Sales price per unit – Variable cost per unit)

• Contribution Margin Ratio Method

Break-even point in dollars = Total fixed costs / Contribution margin ratio

(Contribution margin ratio = Contribution margin / Sales)

(Contribution margin = Sales revenue – Variable cost)

There are different pricing strategies a firm can apply:

• Cost plus pricing
  Price of products are the variable cost + a fixed percentage of the variable costs

• Prestige pricing
  Price your products with a premium price because they are new or have a prestigious brand name

• Target pricing/target costing
  Determining the market price as target, and developing the product at such a cost that the sale will be profitable

What is a cost-volume-profit graph?

One can draw a cost-volume-profit graph (CVP graph) to analyze revised projections. The horizontal axis is the activity (in number of units) and the vertical axis is the number of dollars. Then, draw the fixed-cost line, the total cost line, and the sales line. The limitations of this method is that it assumes that the following elements are constant:

• Selling price

• Costs (variable costs, fixed costs, efficiency and productivity)

• Sales mix

• Inventory levels

Drawing the CVP graph:

1. Draw and label the axes

2. Draw the fixed-cost line

3. Draw the total cost line

4. Draw the sales line

What is meant by the margin of safety?

Most companies created a buffer between the budgeted sales and the break-even point. This is created so that if the amount of sales falls short, the firm does not immediately incur losses.

This margin of safety calculates the percentage by which the firm can fall short:

Margin of safety = (Budgeted sales – Break-even sales) / Budgeted sales

Sensitivity analysis: investigating a multitude of what-if possibilities involving simultaneous changes in fixed, variable cost and volume.

What is the multiple product break-even analysis?

The method to calculate the break-even point when a company constructs more products (sales mix) is somewhat similar to the contribution margin method. However, in this case it is necessary to use the weighted average of the products to determine the per-unit contribution margin. The weighted average can be determined by calculating the share of the products as a total, times the contribution margin of each product.

Break-even point = Fixed costs / Weighted average contribution margin per unit

Weighted average contribution margin per unit = (Share product A * Contribution margin product A) + (Share product B * Contribution margin product B)

For example, a company produces 9 pencils and 3 ballpoint, thus pencils account for 75% and the ballpoints for 25% of the total range of products. The sales per unit are €15 and €8, and the variable cost are €5 and €4. The contribution margins are subsequently €10 and €4 for both products. Subsequently, you calculate the weighted average of both products as follows: (€10*0.75) + (€4*0.25) = € 8.50.

How can the desired profit be calculated?

When a firm wants to have a certain amount of profit after all the costs are deducted, this can be calculated in the following ways:

• Equation method
  Sales – Variable costs – Fixed costs = Desired profit

• Contribution margin method
  Sales volume in units

  = (Fixed costs + Desired profit)/ Contribution margin per unit

If they sell several products, the latter becomes like this:

• Contribution margin method
  Sales volume in units = (Fixed costs + Desired profit) / Weighted average contribution margin per unit

When a firm wants to have a certain amount of profit after all the costs are deducted, this can be calculated in the following ways:

• Equation method
  Sales – Variable costs – Fixed costs = Desired profit

• Contribution margin method
  Sales volume in units

  = (Fixed costs + Desired profit)/ Contribution margin per unit

How can cost accumulation, tracing and allocation be determined? - Chapter 4

How can the cost of cost objects be determined?

Cost accumulation is the process by which the total amount of costs related to one particular event or object are calculated.

This begins with determining the cost objects; the total amount of factors that contribute costs to this specific event. (A party needs invitations, music, drinks) The cost driver is the quantity of a certain cost object (the amount of invitations).

Sometimes it is difficult to trace back and allocate certain costs to one specific event. Indirect costs, also called overhead costs and common costs, are more difficult to trace back than direct costs.

Direct costs can be directly allocated to a specific event or product in a cost-effective manner, which indirect costs cannot. Cost allocation is assigning the total amount of costs to different cost objects. This can be done by the two step process:

1. Calculate the allocation rate by dividing the total costs by the cost driver
   Allocation rate =Total cost to be allocated / Cost driver (allocation base)

2. To determine the allocation per cost object, you multiply the weight of the cost driver (the amount of invitations, the number of square feet) by the allocation rate
   Allocation per cost object = Allocation rate * Weight of cost driver

Because the amount of production does not drive fixed cost, cost allocation is distributed to the rational share of these costs. This is also called equal allocation. This way of allocating costs is suitable as long as the products are homogeneous.

Identifying the cost driver can sometimes cause difficulties, whereas there are often more than one affecting the costs (direct labor hours, units, direct material). Therefore, the most practical cost driver is the one with the greatest cause-and-effect relationship on the costs, volume is a good measure for this. However, in a firm, most of the management decides.

Predetermined overhead rates: is given this name because the overhead allocation rate is determined before actual cost and volume data are available. This is done by companies to make pricing decisions and cost estimations.

Frequently, companies accumulate certain cost, for instance electricity and gas, in cost pools, which they subsequently allocate to cost objects. This is done to simplify the whole process of cost allocation.

Joint cost occur when a company uses one process to make two or more joint products. The split-off point is the point in the production process at which the products become separate and identifiable products. In the beginning of the process the costs have to be allocated, and the cost occurring from the split-off point can be separately allocated to the products.

What are Operating and Service departments?

Operating departments are departments that are assigned tasks leading to the accomplishment of the primary objectives of the organization.

Service departments of a company provide supporting services to the operating departments. Also, costs made by the service department are related to the production process. Consequently, these costs must be allocated to the products.

This is most often done through a two-stage allocation process:

1. The first step, is assigning the costs of the service center to the several operating departments.

2. The second stage: the costs in the operating departments are allocated to the products. This can be done by three different approaches:

• The direct method: The simplest allocation approach. This method allocates service department costs directly to the cost pools of the operating departments.

• The step method: This method differs from the direct method to the extent that it recognizes that the service departments also provide services to each other, for instance, the IT department supports the personnel department. These services are also called interdepartmental services. The step method first allocates the costs of the IT department, taking the personnel department into account as a cost object, and then allocates the costs of the personnel department to the operating departments.

• Reciprocal method: This method recognizes the fact that the services that are provided between departments have a two-way working relationship. These services are also called reciprocal relationships.

Cost accumulation is the process by which the total amount of costs related to one particular event or object are calculated.

This begins with determining the cost objects; the total amount of factors that contribute costs to this specific event. (A party needs invitations, music, drinks) The cost driver is the quantity of a certain cost object (the amount of invitations).

Sometimes it is difficult to trace back and allocate certain costs to one specific event. Indirect costs, also called overhead costs and common costs, are more difficult to trace back than direct costs.

Direct costs can be directly allocated to a specific event or product in a cost-effective manner, which indirect costs cannot. Cost allocation is assigning the total amount of costs to different cost objects.

How to deal with automated cost management? - Chapter 5

What is meant by company-wide allocation rate?

Direct labor is the driver of many costs. Therefore, the direct labor hours are often used as the only basis for a company-wide allocation rate. But the increasing automation affects cost allocation and volume-based cost drivers, like direct labor hours and material dollars, may not be a proper basis anymore. Therefore, many companies use activity-based cost drivers (ABC).

First, essential activities and then their costs should be identified. An activity is for instance the setup or start-up of a new batch. Activities are often put into groups; the activity centers.

So, instead of by department, cost are pooled by activity center. Then, activity-based cost drivers (possibility in combination with volume-based cost drivers) are used to allocate costs instead of volume-based cost drivers only.

The four categories usually used to organize activities are the following:

• Unit-level activities (occur every time a unit is produced)

• Batch-level activities (occur for every new batch, number of units is irrelevant)

• Product-level activities (for products (lines) like engineering development costs, raw materials inventory holding costs, legal fees for patents, etc.)

• Facility-level activities (benefit the production process as a whole, and are not related to any specific product, batch or unit of production)

How can ABC be used to trace costs to product lines?

Sometimes under- and over-costing occurs. If a company uses a target-pricing strategy, it first determines the price that customers want to pay. Then, the production costs are attempted to be low enough to sell the products at the customer demanded price.

Companies have upstream costs (costs arising previous to the manufacturing process) and downstream costs (costs arising after the manufacturing process). Both can be relevant for product elimination decisions.

Companies must tell their employees that using ABC often result in redirecting workers rather than displacing them (which workers often fear).

What is Total Quality Management (TQM)?

Quality is ‘the degree to which products or services conform to design specifications’. Four cost categories are incurred to ensure quality:

• Prevention cost (to avoid nonconforming products)

• Appraisal costs (identify nonconforming products)

• Internal failure costs (correcting defects before the products reach customers)

• External failure costs (result from delivering defective goods to customers)

The first two are voluntary costs (because they depend on management). The last two are failure costs. The higher voluntary costs, the lower failure costs, and the other way around. Voluntary costs and failure costs move in opposite directions.

Total quality cost = Voluntary costs + Failure costs

Total quality management (TQM): achieving the highest level of customer satisfaction by managing quality costs. Accountants help achieve this by making a quality cost report.

Direct labor is the driver of many costs. Therefore, the direct labor hours are often used as the only basis for a company-wide allocation rate. But the increasing automation affects cost allocation and volume-based cost drivers, like direct labor hours and material dollars, may not be a proper basis anymore. Therefore, many companies use activity-based cost drivers (ABC).

What is relevant information for special decisions? - Chapter 6

What does relevant information include?

Relevant information has two characteristics:

• It differs among alternatives

• It is future-oriented

Costs that are already incurred in the past are sunk costs. They cannot be recovered and they are not relevant for current decisions. They can be useful for predictions because it provides insight into the future.

Opportunity cost is the sacrifice that has been made to get something. For example: you have two options, keep your car or sell it for €10,000. If you keep it, the opportunity cost is €10,000. This cost is relevant to current decisions (in this case keep/sell the car). That costs will be incurred does not always mean that they are also relevant. For instance, when you have the choice between selling tables or chairs, and the material costs per table are €100 and for the chair €75, then €25 is relevant since you incur €50 anyway.

The context is important here, sometimes a cost is relevant in one situation and irrelevant in another. For instance, the €50 in the example above is not relevant for the decision between tables and chairs, but when another option would be not to sell anything, it would be a relevant cost.

Relevant information can be quantitative or qualitative. If you can choose between a more expensive phone that looks nicer or a cheaper one that looks crappy, you can still take the expensive one because of its qualitative characteristics.

The relevant revenue is called differential revenue because it shows the difference between alternatives. The relevant costs are called avoidable costs, since they can be eliminated by making a certain decision.

Cost avoidance and the cost hierarchy:

• Unit-level costs: can be avoided by eliminating the production of a single unit

• Batch-level costs: can be avoided by elimination the production of a whole batch (and that also eliminates the unit-level costs of that batch)

• Product-level costs: can be avoided by stopping a product line (that also eliminates batch-level and unit-level costs)

• Facility-level costs: can only be eliminated by dissolving the entire company, or sometimes also by stopping a business segment

What is the link between Relevant Information and Special decisions?

Relevant information can be used to decide on the following five types of special decisions:

Special order:

• The firm must make a special order decision to accept or reject a specific offer (for instance 10 chairs in a specific color, affects unit-level and sometimes batch-level costs)

Quantitative Analysis:

• Determine the amount of relevant (differential) revenue. Premier will be earned by taking the special order

• Determine the amount of the relevant (differential) cost

• Accept the special order if the revenue>costs, reject the order if cost>revenue

• Outsourcing: (can eliminate unit-, batch-, and product-level costs)

Quantitative Analysis:

• Determine avoidable production costs

• Compare these with the buying cost of the product, select the lowest option

Here, also involve any opportunity costs, as well as potential growth because some avoidable costs are fixed and if the volume increases the cost per unit decreases. Qualitative features here include loss of control. A supplier may use low-ball pricing; he asks a very low price first and then increases it.

• Segment elimination: (may eliminate all four levels of costs)

Quantitative Analysis:

• Determine amount of (differential) revenue that will be earned by accepting the special order

• Determine amount of relevant (differential/avoidable) cost that will be incurred

• Accept if relevant revenue > relevant cost

Also, take into account opportunity cost, for instance if the space where the extra chairs are made can also be leased out for €10,000, the €10,000 should be added to the cost! If the space where a segment used to be produced is now used for something else, the profit of the former segment is an opportunity cost. Qualitative features are also important. If you sell a special order for a lower price than the normal price, other customers might demand that price too. Or if you eliminate a segment employees will be discharged or investors think the company faces financial difficulties.

• Equipment replacement: should be based on profitability analysis instead of physical deterioration

  • Determine relevant costs that will be incurred when keeping the old machine (The market value – Salvage costs + Operating expenses)

  • Determine costs that will be incurred when buying the new machine (Cost new machine – Salvage costs + Operating expenses)

• Take the one with the lowest costs

Note: now we calculate it over a certain period, but if we look at it on the short-term, it might be more profitable to choose the other option. Sometimes managers do that because they feel a pressure to obtain good financial results.

• Scarce resource allocation: It is possible that resources are scarce, so that a company has to chose how to distribute them. Such factors that limit the ability to satisfy demand are constraints. For instance, if there is not enough warehouse space, then the warehouse is the bottleneck because its size limits the ability of the company to sell all the products they want to sell. The theory of constraints (TOC) can be used to manage bottlenecks/scarce resources. It tries to find the bottlenecks and then ‘opens’ them, this is called ‘relaxing the constraints’. As long as additional resources (extra warehouse space) can be bought for a price that is less than the contribution margin, profitability can be increased.

Relevant information has two characteristics:

• It differs among alternatives

• It is future-oriented

Costs that are already incurred in the past are sunk costs. They cannot be recovered and they are not relevant for current decisions. They can be useful for predictions because it provides insight into the future.

How can profit and cost control be planned? - Chapter 7

What are the benefits of planning?

Planning and budgeting have several advantages. Through budgeting the manager’s objectives are represented, and it communicates a clear overview of manager’s business plan. Furthermore, the process of budgeting strengthens coordination between departments, and clearly visualizes the department’s position. Finally, it helps identify potential deficiencies and other weak points in the operating process.

In businesses there are three levels of planning:

• Long-term, strategic planning:
  Decisions made on long-term, defining which products to produce, identifying the scope of the business.

• Intermediary-term, capital budgeting:
  In between long and short-term planning, decisions to stimulate sales, buy or lease equipment.

• Short-term, operations budgeting:
  Short-term decisions, with the master budget as key component. This budget illustrates the companies short-term objectives like its production goals or sales targets.

People often see budgeting as constraining, and a majority has a negative attitude towards budgeting. However, to promote budgeting, the participative budgeting technique was invented. This technique invites people from the whole business to participate in the creation of the budget. Because of this responsibility, people are more likely be more cooperative and motivated.

What is the master budget?

The master budget is mostly covering one year, and is divided into monthly or quarterly predictions. It is often called continuous or perpetual budgeting.

The master budget is a summary of a company’s plans for the coming accounting period and includes several smaller budgets including:

• Operating budgets
  Sales budget, inventory purchases budget, selling and administrative expense budget, cash budget. Information flows: cash receipts, cash payments for inventory, cash payments for S&A expenses.

• Capital budgets
  Plans for investment in equipment, products, outlets and facilities. Information flows: sales budget, inventory purchases budget, S&A expense budget, cash budget.

• Pro forma financial statements
  The operating budget is used to set up the pro forma financial statements; balance sheet, income statement, statement of cash flows (information flows), which are based on projected data.

What is the sales budget?

The sales budget is the core of the master budget, all other budgets are derived from it. Therefore, accuracy is needed.

The sales budget comprises of two sections:

1. The projected sales for a certain month, (these sales are estimated by studying historical sales data) which are the cash sales

2. And sales on account made in that month.

Note: the last amount of sales on account is listed as accounts receivable on the pro forma balance sheet, and the total amount of budgeted sales (total of cash and on account sales) is listed as sales revenue on the pro forma balance sheet.

And secondly the schedule of cash receipts, cash sales and sales on accounts receivable that are collected in a certain month. The schedule of cash receipts is used to estimate the cash budget.

Inventory purchases budget

This budget enables the estimation of the amount of inventory needed to satisfy estimated demand. This is calculated in the following way:

Cost of budgeted sales XXX
PLUS: desired ending inventory XXX
Total inventory needed XXX
LESS: beginning inventory (XXX)
Required purchases XXX

Sometimes a firm has a requirement that the ending inventory has to equal a certain percentage of the next month’s projected cost of goods sold.

The schedule of cash receipts is calculated somewhat similar to the one in the sales budget. In most cases firms pay a certain amount in the month they make the purchase, and the remaining part in the month after.

Note: the sum of the total amount of budgeted sales is listed as cost of goods sold on the pro forma income statement. The desired ending inventory in the last month of the purchases budget is listed as ending inventory on the pro forma balance sheet. The amount of purchases that still has to be paid in the last month is listed as accounts payable on the pro forma balance sheet.

What are the selling and administrative expense budgets?

This budget is based on projections of several expenses and is together with the schedule of cash payments self-explanatory.

However, keep in mind that depreciation expense is not an expense and therefore does not occur on the schedule of cash payments.

Note: expenses that are listed in the last month of the budget, and are paid one month later, are listed as accounts payable on the pro forma balance sheet. (for instance, utilities payable). The total amount of depreciation is listed as accumulated depreciation on the pro forma balance sheet. Finally, the sum of the total amount of expenses are listed on the pro forma income statement.

What is the cash budget?

The cash budget comprises of the cash receipts section, the cash payments section and a financing section. Preparing a cash budget enables the manager to keep track of the profitability of the business, and enables them to anticipate on cash shortages. The amounts occurring in this budget are derived from the earlier discussed budgets.

Note: the ending cash balance is listed as an asset on the pro forma balance sheet, and is also listed as the ending cash balance on the pro forma statement of cash flows. The other accounts are listed on the pro forma statement of cash flows, which we will discuss.

What are pro forma financial statements?

The pro forma income statement supplies an estimation of the firms expected profitability, and comprises of amounts mentioned before. The same with the pro forma balance sheet. The pro forma statement of cash flows is derived from the earlier mentioned cash budget. These accounts however, have to be listed under the right subheading; cash flows from operating activities, cash flows from investing activities and cash flows from financing activities.

Planning and budgeting have several advantages. Through budgeting the manager’s objectives are represented, and it communicates a clear overview of manager’s business plan. Furthermore, the process of budgeting strengthens coordination between departments, and clearly visualizes the department’s position. Finally, it helps identify potential deficiencies and other weak points in the operating process.

How can a performance evaluation be made? - Chapter 8

What are flexible and static budgets?

A flexible budget is not a static budget, like the master budget. The flexible budget is a budget prepared at various levels of volume and is mostly used for evaluating planning and performance. A static budget remains unchanged even if the actual volume of activity differs from the planned volume.
The differences between the (estimated) standard budget and actual results are called variances.

What types of variances are there?

Flexible budget variances are the differences between actual results and the estimated flexible budget results. These flexible budget amounts are calculated by multiplying standard per-unit amounts by the actual volume of production. The actual budget amounts are calculated by multiplying actual per-unit amounts by the actual volume of production.

There are several types of variances:

• The sales volume variance: difference between static budget (based on planned volume) and flexible budget (based on actual volume). This budget can have a favorable variance when actual sales are higher that expected, or unfavorable, when the actual sales are less than expected.

• Variable costs volume variances: difference between static and flexible budget based on amounts. When estimated costs turn out lower than expected, this is a favorable variance (lower costs). Unfavorable costs volume variances arise when actual costs are higher than expected.

• Sales price variance: difference between actual sales price and sales volume and estimated sales price and sales volume. Whether this variance is favorable or unfavorable depends on the degree to which sales prices and volume are increased or decreased.

• Fixed costs spending variance: difference between budgeted and actual fixed costs. This variance however, is not affected by the level of production, and is not taken into account in comparing flexible and static budget.

• Fixed costs volume variance: difference between the applied fixed cost, based on actual volume and the budgeted fixed costs based on planned volume.

  These variances offer insight into the efficiency of management and workers. More effective use of equipment means a smaller usage than expected. Additionally, a lower price of material could mean management has made better (cheaper) deals with suppliers. Standard cost systems

Management by exception is a management style that focuses managers attention on areas not performing as expected, the exceptions or inconsistencies. This type of management is frequently used by the standard costing system. The areas that show large variances are areas that need the most attention.

Establishing the standard costs is the focal point of budgeting and also the most difficult. The standard represents the amount that a quantity, price or cost was estimated to be. The estimation of standard costs is done by evaluating historical data of the production process and adjusting it to the current situation (new equipment, development of new technologies, employee ability level).

It is also important that the different business circumstances are incorporated:

• Ideal standards: represent the costs under the ideal circumstances. Most efficient use of material, labor and equipment

• Practical standards: represent the costs under more realistic circumstances. This estimation is based on normal levels of efficiency in material, labor and equipment

• Lax standards: represent the costs under circumstances that can be achieved with a minimum of effort. However, these standards have the drawback that they not encourage employees

Managers consider the materiality of variance (whether it could influence management decisions), the frequency, the capacity they have to control it, and the characteristics of the items that cause the variance (those three influence materiality).

The most important advantage of a standard cost system is that the use of management to control costs is the most efficient. However, there are also some secondary benefits:

• It can motivate employees by linking reward systems to accomplishments that surpass the estimated standards. However, attention should be paid Intentional underestimation of revenues and/or overestimation of expenses by managers to make their performance appear more positive. This practice is also known as budget slack.

• It encourages planning and proper estimation of material usage, inventory, etc.

• By handling a standard cost system, problem sources are more easily located through the (inconsistent) variances

Gamesmanship is employees playing with the budgeted and actual variances to create a more positive picture.

What is meant by a flexible budget?

When the variance is calculated, managers want to analyze this in further detail, to see what has caused the variance.

The budget can be split in three parts, variable overhead, material and labor variances. Each variance can be subdivided into spending and volume variances.

The variance between actual fixed costs and budgeted cost are named spending variances. With fixed costs, the allocation rate is determined before actual amounts are known (predetermined overhead rate).

If the volume of production will be larger than estimated, this will result in a favorable variance (more volume = more overhead rate returns). This variance is called a fixed cost volume variance. However, the actual costs, the actual price of overhead, may differ from the budgeted costs.

This can lead to a favorable variance, the actual costs are less than budgeted, or unfavorable when it is more (fixed cost spending variance). These two costs together make up the total amount of variance of the fixed manufacturing cost.

Formula:

Fixed manufacturing overhead cost volume variance = Applied overhead costs – Budgeted fixed overhead costs

Fixed manufacturing overhead costs spending variance = Actual fixed overhead costs – Budgeted fixed overhead costs

The variable cost variances are also separated into two parts: the quantity of material used, and the price per unit variance. These two variances are calculated in the following way:

Usage variance = |Actual quantity – Standard quantity| x Standard price

Price variance = |Actual price – Standard price| x Actual quantity

When the actual hours or the price per unit are less than estimated, this will result in a favorable variance. Similarly, when the actual hours or the price per unit are more than standard estimated, this will result in an unfavorable variance. With this similar sum structure, you are also able to calculate labor price and labor usage variance.

Labor usage variance = |Actual quantity – Standard quantity| x Standard rate

Labor price variance = |Actual rate – Standard rate| x Actual quantity

Who is responsible for variances?

With the fixed overhead costs this is hard to determine since they are pooled together. However, an unfavorable volume variance could be the result of underutilization of manufacturing facilities. In the case of materials variances the purchasing agent is responsible for the price variance. Unfavorable variances could imply an agent’s bad practices, however, this must be identified carefully in case of false accusations. The material usage variances is part of production department’s responsibility. Various factors could have caused this variance, workers, planning, material, etc.

Labor price variances are not common since they are determined by a contract. Labor usage variances are mainly caused by the productivity of the workforce.

Variable overhead costs are normally not calculated because it is difficult to say where they come from since they have many inputs. Selling, general, and administrative cost variances can be in terms of price and usage. The formulas used are the same as above.

With the fixed overhead costs this is hard to determine since they are pooled together. However, an unfavorable volume variance could be the result of underutilization of manufacturing facilities. In the case of materials variances the purchasing agent is responsible for the price variance. Unfavorable variances could imply an agent’s bad practices, however, this must be identified carefully in case of false accusations. The material usage variances is part of production department’s responsibility. Various factors could have caused this variance, workers, planning, material, etc.

Labor price variances are not common since they are determined by a contract. Labor usage variances are mainly caused by the productivity of the workforce.

What is responsibility accounting? - Chapter 9

What is meant by Responsibility Accounting?

Decentralization is the practice of delegating authority and responsibility. Decentralization has several advantages:

• Improvement of performance evaluation; clear view of who is responsible

• Trains lower-level managers for increased responsibilities (for if they are promoted later)

• Motivates productivity improvement, more freedom encourages individuals

• Improves quality of decision making; better knowledge about decision, able to react faster

• Top management can focus on strategy

Businesses who work with decentralization generally have centers that are responsible for the revenues and expenses. These centers are called responsibility centers. There are three categories of responsibility centers:

• Investment center: responsible for the expenses, revenues and investment of capital. These are mostly situated on upper firm level.

• Profit center: incurs costs and generates revenues.

• Cost center: only incurs costs. These centers are mostly situated on lover levels of the firm.

Each manager of a center has to prepare a responsibility report. These reports compare current to expected performance. These reports support the earlier mentioned management style, management by exception.

Some things need to be taken into account:

• Controllability concept: only evaluate managers on basis of revenues/cost they control (does not have to be absolute, predominant control is enough)

• Qualitative reporting features: (simple terms, only budgeted and actual amounts of controllable revenues/expenses, relevant information, in time)

• Managerial performance measurement: (that is what the responsibility accounting system is for)

What is meant by a return on investment?

One way to evaluate managerial potential is using the return on investment (RIO) ratio. This ratio displays the proportion between the investment and the actual returns. It is often used to compare different departments to see which has the best returns. This ratio is calculated as follows:

ROI = Operating income / Operating assets

Selecting the value of the operating assets is rather difficult. Most of the companies use the book value of their assets as the valuation base. This value has some shortcomings, but is still most used.

However, the formula can also be written in a different manner:

ROI = (Operating income / sales) * (Sales / operating assets)

In this way, you can clearly see the different factors that influence the RIO ratio. The first ratio (o/s) is called the margin. This margin measures management’s ability to control the operating expenses relatively to the sales. The higher the margin, the better the performance. The other ratio (s/o) is called the turnover, the amount of operating assets used to manufacture the realized amount of sales.

The more elaborate formula clearly shows how the ratio can be improved

• Reduction of investment base (operating assets), for example by implementing a just-in-time inventory.

• Reducing expenses (operating income), work more efficient, less waste, improve the production process

• Increasing sales

What is a residual income?

Managerial evaluation is frequently based on residual income. This is a way to avoid sub-optimization; managers who benefit themselves at the expense of their corporations. The residual income is calculated as follows:

Residual income = Operating income – (Operating assets x Desired ROI)

One drawback of this method is that managerial performance is only estimated by looking at real numbers. If a manager's investment base is large, their residual income is also large. This however, does not say anything about their performance.

What is meant by transfer pricing?

Companies often have several divisions. When goods are transferred between these divisions, a price is charged; the transfer price. It is a benefit to the selling division since it makes a profit, but the buying division’s earnings will decrease.

There are three common ways to set transfer prices:

• Based on market forces: (most frequently used, also preferable because it promotes efficiency and fairness)

• Based on negotiation: (somewhere between the market price and the avoidable product costs is a reasonable transfer price)

• Based on cost: (cost can be only the (standard) variable cost but also the (standard) full cost)

Decentralization is the practice of delegating authority and responsibility. Decentralization has several advantages:

• Improvement of performance evaluation; clear view of who is responsible

• Trains lower-level managers for increased responsibilities (for if they are promoted later)

• Motivates productivity improvement, more freedom encourages individuals

• Improves quality of decision making; better knowledge about decision, able to react faster

• Top management can focus on strategy

Businesses who work with decentralization generally have centers that are responsible for the revenues and expenses. These centers are called responsibility centers.

Fundamental Managerial Accounting Concepts - Edmonds et al. - 8th edition - List of important Terms

Activity-Based Management (ABM)

The value chain is assessed to reduce non-value-added activities and make value-added activities optimal

Appraisal costs

Identify nonconforming products

Batch-level activities

Occur for every new batch, number of units is irrelevant

Break-even point

The point where the costs are of the same height as the revenues, were the profit equals zero.

Budgeting

Through budgeting the manager’s objectives are represented, and it communicates a clear overview of manager’s business plan

Cash budget

Comprises of the cash receipts section, the cash payments section and a financing section. Preparing a cash budget enables the manager to keep track of the profitability of the business, and enables them to anticipate on cash shortages. The amounts occurring in this budget are derived from the earlier discussed budgets.

Capital budgets

Plans for investment in equipment, products, outlets and facilities. Information flows: sales budget, inventory purchases budget, S&A expense budget, cash budget.

Contribution margin

The amount of revenue accessible to cover fixed costs.

Controllability concept

Only evaluate managers on basis of revenues/cost they control (does not have to be absolute, predominant control is enough)

Corporate governance

Related to all the stakeholders that affect and determine the way the company is controlled.

Cost accumulation

The process by which the total amount of costs related to one particular event or object are calculated

Cost allocation

A process of dividing a total cost into parts and assigning the parts to relevant cost objects.

Cost behavior

It is important to know how costs change relative to the level of business activity

Cost center

Only incurs costs. These centers are mostly situated on lover levels of the firm.

Cost driver

The quantity of a certain cost object (the amount of invitations).

Cost objects

The total amount of factors that contribute costs to this specific event

Cost plus pricing

Price of products are the variable cost plus a fixed percentage of the variable costs

Decentralization

The practice of delegating authority

Direct labor

Wages of employees involved in the manufacturing process

Direct method

Method allocates service department costs directly to the cost pools of the operating departments.

Direct raw material costs

The costs of the materials used to produce the product, that can be effortlessly traced to the product

Downstream costs

Costs arising after the manufacturing process (transportation costs, sales payments, advertising costs, bad debts)

Estimation of standard costs

Done by evaluating historical data of the production process and adjusting it to the current situation (new equipment, development of new technologies, employee ability level).

Equal allocation

Because the amount of production does not drive fixed cost, cost allocation is distributed to the rational share of these costs. This way of allocating costs is suitable as long as the products are homogeneous.

External failure costs

Delivered defective goods

Facility-level activities

Production process as a whole

Fixed costs spending variance

The difference between budgeted and actual fixed costs. This variance, however, is not affected by the level of production, and is not taken into account in comparing flexible and static budget.

Fixed costs volume variance

The difference between the applied fixed cost based on actual volume and the budgeted fixed costs based on planned volume.

Flexible budget

A budget prepared at various levels of volume and is mostly used for evaluating planning and performance.

Gamesmanship

Employees playing with the budgeted and actual variances to create a more positive picture.

Ideal standards

Represent the costs under the ideal circumstances. Most efficient use of material, labor and equipment

Internal failure costs

Correcting defects before they reach customers

Intermediary term, capital budgeting

In between long and short term planning, decisions to stimulate sales, buy or lease equipment.

Inventory purchases budget

This budget enables the estimation of the amount of inventory needed to satisfy estimated demand.

Investment center

Responsible for the expenses, revenues and investment of capital. These are mostly situated on upper firm level.

Joint cost

Occur when a company uses one process to make two or more joint products.

Just in Time (JIT) inventory

Business minimize try to reduce these inventory costs through applying JIT (delivering when ordered)

Lax standards

Represent the costs under circumstances that can be achieved with a minimum of effort. However, these standards have the drawback that they not encourage employees.

Long-term, strategic planning

Decisions made on long-term, defining which products to produce, identifying the scope of the business.

Managerial accounting

Establishing product costs is the focal point. Cost affect pricing strategies and financial statements and control business operations.

Managerial performance measurement

What the responsibility accounting system is for

Manufacturing components, fundamental resources

Materials used to make the product

Manufacturing overhead

Indirect costs such as utilities

Margin of safety

Calculates the percentage by which the firm can fall short

Master budget

A summary of a company’s plans for the coming accounting period and includes several smaller budgets.

Mixed cost

Include both fixed and variable costs. Mixed costs are semi-variable costs. They include both fixed and variable components

Operating budgets

Sales budget, inventory purchases budget, selling and administrative expense budget, cash budget. Information flows: cash receipts, cash payments for inventory, cash payments for S&A expenses.

Opportunity cost

The sacrifice that has been made to get something.

Practical standards

Represent the costs under more realistic circumstances. This estimation is based on normal levels of efficiency in material, labor and equipment.

Predetermined overhead rates

Called this because the overhead allocation rate is determined before actual cost and volume data are available. This is done by companies to make pricing decisions and cost estimations.

Prestige pricing

Price your products with a premium because they are new or have a brand name

Prevention cost

To avoid nonconforming products

Pro forma financial statements

The operating budget is used to set up the pro forma financial statements; balance sheet, income statement, statement of cash flows (information flows), which are based on projected data.

Pro forma income statement

Supplies an estimation of the firms expected profitability, and comprises of amounts mentioned before. The same with the pro forma balance sheet.

Product-level activities

For products (lines) like engineering development costs, materials inventory holding costs, legal fees for patents, etc.

Profit center

Incurs costs and generates revenues

Qualitative reporting features

Simple terms, only budgeted and actual amounts of controllable revenues/expenses, relevant information, in time

Reciprocal method

This method recognizes the fact that the services that are provided between departments have a two-way working relationship. These services are also called reciprocal relationships

Relevant costs

Are called avoidable costs, since they can be eliminated by making a certain decision.

Relevant information

Has two characteristics: It differs among alternatives & it is future-oriented. Relevant information can be quantitative or qualitative

Relevant revenue

Is called differential revenue because it shows the difference between alternatives.

Return on investment (RIO) ratio

This ratio displays the proportion between the investment and the actual returns. This ratio is often used to compare different departments, to see which has the best returns

Sales budget

The core of the master budget, all other budgets are derived from it. Therefore, accuracy is needed.

Sales budget comprises of two sections

The projected sales for a certain month, (these sales are estimated by studying historical sales data) which are the cash sales and sales on account made in that month.

Sales price variance

Difference between actual sales price and sales volume and estimated sales price and sales volume. Whether this variance is favorable or unfavorable depends on the degree to which sales prices and volume are increased or decreased.

Sales volume variance

Difference between static budget (based on planned volume) and flexible budget (based on actual volume). This budget can have a favorable variance when actual sales are higher than expected, or unfavorable, when the actual sales are less than expected.

Scatter graph

Another way to estimate total fixed and variable costs. It is also used to check the accuracy of the high-low method by plotting the data in a graph and drawing a line through the highest and lowest pint of units sold

Schedule of cash receipts

Used to estimate the cash budget.

Selling and Administrative expense budget

This budget is based on projections of several expenses and is together with the schedule of cash payments self-explanatory.

Sensitivity analysis

Investigating a multitude of what-if possibilities involving simultaneous changes in fixed, variable cost and volume

Service departments of a company

Provides supporting services to the operating departments of a company

Short-term, operations budgeting

Short-term decisions, with as key component the master budget. This budget illustrates the companies short-term objectives like its production goals or sales targets

Spending variances

The variance between actual fixed costs and budgeted cost

Split-off point

The point in the production process at which the products become separate products. In the beginning of the process the costs have to be allocated, the cost occurring from the split-off point can be separately allocated to the products.

Step method

This method differs from the direct method to the extent that it recognizes that the service departments also provide services to each other, for instance, the IT department supports the personnel department. These services are also called interdepartmental services.

Suboptimalization

Managers who benefit themselves at the expense of their corporations.

Sunk costs

Costs that are already incurred in past. They cannot be recovered and they are not relevant for current decisions. They can be useful for predictions.

Target pricing

Determining the market price as target, and develop the product at such a cost the sale will be profitable

Total Quality Management (TQM)

Systematic problem-solving, front-line employees are encouraged to achieve zero defects; customer satisfaction as key focus. The key component is continuous improvement

Transfer price

When goods are transferred between these divisions, a price is charged

Two-stage allocation process

• The first step, is assigning the costs of the service centre to the several operating departments.
• The second stage the costs in the operating departments are allocated to the product. This can be done by three different approaches

Unit-level activities

Occur every time a unit is produced

Upstream costs

Costs arising previous to the manufacturing process (development costs)

Variable costs volume variances

Difference between static and flexible budget based on amounts. When estimated costs turn out lower than expected, this is a favorable variance (less costs). Unfavorable costs volume variances arise when actual costs are higher than expected.

Variances

The differences between the (estimated) standard budget and actual results

Voluntary costs

Depends on the management, these are prevention and appraisal costs

Fundamental Managerial Accounting Concepts - Edmonds et al. - 8th edition - BulletPoints

What is management accounting and corporate governance? - BulletPoint 1

• Managerial accounting differs from financial accounting, with regards to:

  • Users and types of information

  • Level of aggregation

  • Regulation

  • Information characteristics

  • Time horizon and reporting frequency

• Product Cost consists of three components, namely 1) the materials used to make the products, 2) the labor costs of the people that turn the materials into products and 3) the overhead costs, e.g. utilities and equipment consumed in the process of producing the products. The payments in cash for these types of cost are also called asset exchange transactions. When the goods are finished but not sold yet, they are put in the finished goods inventory.

• Accountants often calculate the costs per unit as an average, therefore cost per unit also means average cost per unit. When a product is sold, the average cost of this product is transferred from the Inventory account to the Cost of Goods Sold account. Costs that are not classified as product costs on the other hand, are normally expensed in the period in which they are incurred.

• The costs of materials that are directly related to the producing of products are called direct raw material costs. The cost of labor that is directly related to the producing of product is called direct labor cost. Nonproduct expenses are sometimes called period costs. Costs that are not directly related to the producing of products are called indirect costs. The indirect costs incurred to make products are called manufacturing overhead.

• Upstream costs are incurred before the actual production of a certain product. Downstream costs are incurred after the manufacturing process of a product. Companies that minimize their amount of inventory by only shortly before the order of a customer producing the product is also called Just-In-Time-Inventory.

• Corporate governance the relationship between all the stakeholders that affect and determine how the company is controlled. The temporary effects on the financial statements can influence the availability of financing, the motivations of management and the timing of income tax payments. Management accountants have to be ready for making difficult choices and also to face conflicts of more troubling natures. The following elements are most likely to be present when fraud occurs:

  • The availability of an opportunity

  • The existence of some form of pressure leading to an incentive

  • The capacity to rationalize

• The Sarbanes-Oxley Act was enforced in order to prevent large fraud fiascos to happen. It affects four groups: 1) management, 2) boards of directors, 3) external auditors, 4) Public Company Accounting Oversight Board.

• Benchmarking enables a company to identify world’s best practices. These practices include both Total Quality Management (TQM) and Activity-Based Management (ABM).

How can cost behavior, operating leverage and profitability be analyzed? - BulletPoint 2

• Fixed costs are costs that do not increase as the amount of (sold) units increase. Therefore, the fixed costs per unit decrease as the amount of units increase. Operating leverage helps to identify small changes in revenue into dramatic changes in profitability. Variable costs are costs that increase as the amount of (sold) units increase. Therefore, the variable costs per unit remain the same as the amount of units increase. A shift in cost structure, so for example from fixed to variable, does not only reduce the level of risk but also the potential for profits.

• Formula for calculating the percentage change: (alternative measure – base measure) / base measure = % change, where the base change is the starting point.

• The contribution margin represents the amount that is available to cover fixed costs and therefore to provide company profits. It is calculated as follows:

  • Contribution margin= revenue – variable costs

  • Net profit = contribution margin – fixed costs

  • Magnitude of operating leverage= contribution margin / net income

  • Mixed costs (also referred to as semi variable costs) include both fixed and variable components. Therefore total costs are:

  • Total cost = fixed cost + (variable cost per hour x number of hours)

• There are several techniques to divide total cost into estimated and fixed and variable components:

  • High-Low Method: A simple method to calculate fixed and variable costs. Fixed and variable costs can be calculated by the following steps:

1. Assemble sales volume and cost history for an existing store.

2. Select the high and low points in the data set

3. Determine the estimated variable cost per unit

4. Determine the estimated total fixed cost.

• Scatter graph Method: Another way to estimate fixed and variable costs. It is used to check the preciseness of the high-low method by plotting the data in the graph and drawing a line through the highest point and the lowest point. When a lot of points are above the drawn line the estimation is very likely to be inaccurate. In order to solve this a new line, also referred to as the visual fit line, can be drawn which visually minimizes the total distance between the data points and the line.

• Regression method: because the scatter graph is made by humans it is subject to errors.

How can cost, volume, and pricing to increase profitability be analyzed? - BulletPoint 3

• The break-even-point is the point where profit is zero, or where total cost equals total revenue. There are three methods that can compute the break-even point:

  • Equation method
    sales – variable costs – fixed costs = profit (net income) = 0

  • Contribution margin per unit method
    Break-even point in units = total fixed costs / contribution margin per unit

  • Contribution margin ratio method
    Break-even point in dollars = total fixed costs / contribution margin ratio

• A cost-volume-profit graph can be used in order to analyze the revised projections. The procedure is as follows:

1. Draw and label the axes

2. Draw the fixed-costs line

3. Draw the total cost line

4. Draw the sales line

• When a company sells multiple products, the break-even point can be calculated as follows: Break-even point = fixed costs / weighed average per unit contribution margin. Where the weighted average per unit contribution margin is calculated as follows: Weighted average per unit contribution margin = (Share product A x contribution margin product A) + (share product B x contribution margin product B).

• When a company wants to acquire a specific amount of profit after all costs have been deducted, this can be computed in the following ways:

  • Equation method
    sales – variable costs – fixed costs = desired profit

  • Contribution margin method

• Sales volume in units = (fixed costs + desired profit) / contribution margin per unit

• When a company sells several products, the last method will look like this”

  • Contribution margin method
    sales volume in units = (fixed costs + desired profit) / weighted average contribution margin per unit

• The margin of safety measures the cushion between budgeted sales and the break-even point. It is calculated as follows: (budgeted sales – break-even sales) / budgeted sales.

• A sensitivity analysis investigates a multitude of what-if-possibilities involving simultaneous changes in fixed and variable costs and volume.

How can cost accumulation, tracing and allocation be determined? - BulletPoint 4

• Cost allocation is used by accountants to determine the cost of a particular object. A cost driver has a cause and effect relationship with a cost object (e.g. the number of advertisements –cost driver- and the advertising cost – cost object).

• Whereas direct costs can be directly allocated back to a product in a cost-effective manner, indirect costs cannot. Cost allocation is assigning the total amount of costs to different cost objects. It can be done by the two step process:

1. Compute the allocation rate by dividing the total costs to be allocated by the cost driver: total cost to be allocated / cost driver (Allocation base) = allocation rate

2. Multiply the allocation rate by the weight of the cost driver to determine the allocation per cost object: allocation rate x weight of cost driver = allocation per cost object.

• Equal allocation is distributing the cost allocation to the rational share of these costs. It is only suitable as long as the products are homogenous.

• Identifying the cost driver can occasionally cause difficulties, as there are often more than one that affect the costs. As a result, the most practical cost driver is the one with the largest cause-and-effect relationship on the costs. A good measure of this is volume.

• As the overhead allocation rate is determined prior to when actual cost and volume data are available, it is called the predetermined overhead rate. This is completed by companies in order to make pricing decisions and cost estimations.

• Joint costs are costs that are incurred in the process of making two or more joint products. The point in the production process at which products become separate and identifiable is the split-off point.

• Operating departments are departments that are assigned to tasks leading to the accomplishment of the primary objectives of the company. The ones that provide support to operating departments are called service departments. Costs related to these kinds of departments are frequently distributed to products through a two-stage allocation process:

• The assigning of costs of the service center to the several operating departments

1. The allocating of costs in the operating departments to the product. This can be done by three different approaches:

   1. The direct method: Allocates the service department costs directly to the cost pools of the operating departments.

   2. The step method: Recognizes that the service departments also provide services to one another. These are also called interdepartmental services. This method first allocates the costs of the IT department, taking the personnel department into account as a cost object, and then allocates the costs of the personnel department to the operating departments.

   3. The reciprocal method two-way interdepartmental relationships, which are also called reciprocal relationships.

How to deal with automated cost management? - BulletPoint 5

• Direct labor is a driver for many types of costs. For this reason, the direct labor hours are often used as the sole base for establishing a companywide allocation rate. Because automation has changed the nature of manufacturing processes, volume-based cost drives such as direct labor hours may not be a suitable basis anymore. For this reason, many companies now use activity-based cost drivers. First, essential activities and the costs of performing those activities are identified. Activities are often put into the activity centers (groups).

• The following categories organize activities:

  • Unit-level activities

  • Batch-level activities

  • Product-level activities

  • Facility-level activities

• Occasionally under- and over-costing happens. When a company first determines the price that customers want to pay, it uses a target-pricing strategy. Afterwards, attempts are made to lower the production costs enough to sell it at the demanded price.

• Upstream costs are costs that arise prior to the manufacturing process. Downstream costs are costs that arise after the manufacturing process. Yet, both of them can be used for product elimination decisions.

• Companies are obliged to inform their employees that using ABC is likely to result in redirecting workers rather than displacing them (which is the fear of many workers).

• Quality is the extent to which products or services conform to design specifications. There are four cost categories that ensure quality:

  • Prevention costs

  • Appraisal costs

  • Internal failure costs

  • External failure costs

• The first and the second of these costs are also called voluntary costs, because they rely on management. The third and fourth type are called failure costs. The higher the voluntary costs are, the lower are the failure costs and the other way around.

• TQS (total quality cost) = voluntary costs + failure costs

• Total quality management (TQM) entails achieving the highest level of customer satisfaction by managing quality costs. Accountants offer support to achieve this by creating a quality cost report.

What is relevant information for special decisions? - BulletPoint 6

• Relevant information is characterized by the following:

  • It differs among the alternatives

  • It is future oriented

• Costs that have been incurred in the past are also referred to as sunk costs. They cannot be changed and are therefore not of importance for making current decisions.

• An opportunity cost is the sacrifice that has to be made in order to get an alternative opportunity.

• Important or relevant information can be quantitative or qualitative. For example, when one has to choose between an expensive high-end smartphone or a cheap low-end one, one might still pick the expensive one because of its excellent qualitative characteristics.

• The relevant revenue is also referred to as differential revenue, as it illustrates the difference between alternatives. The relevant costs are therefore referred to as avoidable costs, as these can be eradicated by making a specific decision.

• Costs can be classified in one of the following four hierarchical levels which helps to identify avoidable costs:

1. Unit-level costs

2. Batch-level costs

3. Product-level costs

4. Facility-level costs

• There are five types of special decisions:

1. Special order: when a firm obtains an offer to sell its finished goods at a price that is significantly lower than its normal selling price.

2. Outsourcing: when a firm decides to buy products and services from other companies instead of manufacturing these themselves (because of e.g. lower cost).

3. Segment elimination: When a firm organizes their operations into sub components. These segmented data can be used in order to compare different products, departments or divisions.

4. Equipment replacement: As equipment may become technologically outdated a while before it starts to fail physically. Therefore management ought to base these types of decisions on profitability analysis rather than physical deterioration.

5. Scarce resource allocation: Sometimes there is a situation in which resources are scarce, meaning that a company ought to think carefully of how to distribute them.

How can profit and cost control be planned? - BulletPoint 7

• There are three levels of planning:

1. Strategic planning

2. Capital budgeting

3. Operations budgeting

• The master budget is a group of detailed budgets and schedules that represent the firm’s operating and financial plans for the future. It includes:

  • Operating budgets

  • Capital budgets

  • Pro forma financial statements

• The sales budget is the center of the master budget, and therefore all other budgets are derived from it. Accuracy is necessary. It consists of two sections:

  • The projected sales for every month

  • A schedule of the cash receipts for the projected sales

• The total cash receipts are determined by adding the current month’s cash sales to the cash collected from the previous month’s credit sales.

• The inventory purchases budget allows management to estimate the amount of inventory required to satisfy the estimated demand. It is calculated as following:

Cost of budgeted sales
+ desired ending inventory
- - - - - - - - - - - - - - - - - - - -
Total inventory needed
- beginning inventory
- - - - - - - - - - - - - - - - - - - -
Required purchases

• The selling and administrative expense budget is built on projections of multiple expenses and is self-explanatory, together with the schedule of cash payments.

• The cash budget consists of the cash receipts part, the cash payments part and the financing part. It allows a manager to keep track of the profitability of the firm, and allows him to forestall on cash shortages.

• The pro forma income statement gives an estimation of the firms anticipated profitability, and consists of amounts mentioned previously. This statement is derived from the previously mentioned cash budget. Yet, these accounts must be listed under the correct subheading: Cash flows from operating activities, cash flows from investing activities and cash flows from financing activities.

How can a performance evaluation be made? - BulletPoint 8

• A flexible budget is an extension of the master budget discussed earlier, yet they differ. The flexible budget is not a static one, unlike the master budget. It is also one that is prepared at various levels of volume and used most of the times to evaluate planning and performance. The differences between the standard budget and the achieved results are referred to as variances.

• There are several types of variances:

  • The sales volume variance

  • The variable cost variance

  • The sales price variance

  • The fixed costs spending variance

  • The fixed costs volume variance

• The previously mentioned variances may offer managers an insight into the efficiency of the company’s management and workers. Making use of equipment in a more efficient way will lead to a smaller usage than expected. Additionally, a lower price of materials might imply that management has made better deals with suppliers.

• Management by exception is a management style that entails managers concentrating on areas that are not performing as expected. A standard represents the amount that a price, cost or quantity should be under certain predicted circumstances. The estimation of standard costs is done by evaluating historical data of the production process and altering it to the new situation.

• Next to that, dissimilar business circumstances have to be incorporated. Difficulty standards include the following:

1. Ideal standards

2. Practical standards

3. Lax standards

• The biggest advantage of a standard cost system is that the use of management to control costs is the most efficient.

• Gamesmanship is a situation in which employees play with the budgeted and actual variances to establish a more positive picture.

• After the variance has been calculated, managers wish to analyze this more closely, in order to see what has been the source of this variance. The budget consists of three parts, namely the variable overhead, the material and labor variances, of which each can be subdivided into spending and volume variances.

• Spending variance is the variance between actual fixed costs and budgeted costs. The fixed cost volume variance is a favourable variance, because when the volume of production will be more than expected, this will result in a favorable variance. Yet, the actual costs may differ from the budgeted costs. Together these two cost make up the total amount of variance of the fixed production cost. In formula this is the following:

  • Fixed manufacturing overhead cost volume variance = applied overhead costs – budgeted fixed overhead costs

  • Fixed manufacturing overhead costs spending variance = actual fixed overhead costs – budgeted fixed overhead costs

• The variable cost variances can also be split up into two segments: the quantity of material used and the price per unit variance. The formulas are as follows:

  • Usage variance = (actual price – standard quantity) x standard price

  • Price variance = (actual price - standard price) x actual quantity

• When there is a situation in which the actual hours/price per unit are less than expected, there is a favorable variance. Likewise, when the real amount of hours/price per unit is more than standard expected, there will be an unfavorable variance. In this situation, the labor price variance and labor usage variance can be computed as follows:

  • Labor usage variance = (Actual quantity – standard quantity) x standard rate

  • Labor price variance = (actual rate – standard rate) x actual quantity

What is responsibility accounting? - BulletPoint 9

• Decentralization is the practice of delegating authority. Firms that work with this are likely to have centers that are responsible for the revenues and expenses. These are also referred to as responsibility centers. There are three types:

  • Investment centers

  • Profit centers

  • Cost centers

• Every manager of such a responsibility center is expected to make a responsibility report, which compare present to expected performance. They support the management by exception style. There are a few things that have to be considered:

  • Controllability concept

  • Qualitative reporting features

  • Managerial performance measurement

• The return on investment (ROI) shows the proportion between the investment and the actual returns, and is used to compare and contrast various departments, in order to find out which one has the best returns. It is calculated as follows:

  • ROI = operating income / operating assets OR

  • ROI = (operating income / sales ) x (sales / operating assets)

• By using the second one, one can very clearly notice the different factors that influence the RIO ratio. The first one (o/s) is referred to as the margin and the latter (s/o) is referred to as the turnover, the amount of operating assets used to produce the realized number of sales.

• Suboptimalization is a situation in which managers benefit themselves at the expense of their corporations. The residual income is computed as follows:

  • Residual income = operating income – (operating assets x desired ROI)

• Whenever goods are transferred between multiple divisions, a specific price is charged, which is also called the transfer price. There are three common ways to set transfer prices:

  • Based on market forces

  • Based on negotiation

  • Based on cost