Chapter 1: Management Accounting and Corporate Governance

Differences between managerial accounting and financial accounting

Managerial accounting differs from financial accounting on several aspects (figure 1.2, p. 6 for clarification).

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

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 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 cost 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.

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.

Managerial accounting trends

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

Chapter 2: Cost Behavior, Operating Leverage, and Profitability Analysis

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. (Examples of mixed cost: fig. 2.20, p. 65)

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.

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

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)

Scatter graph method

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.

Regression method

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.

Chapter 3: Analysis of Cost, Volume, and Pricing to Increase Profitability

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

Cost-volume-profit graph

One can draw a 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

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.

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.

Desired profit

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

Chapter 4: Cost Accumulation, Tracing, and Allocation

Determine the cost of cost objects

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.

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. (Fig.4.5, p.172)

• 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. (Fig 4.6, p. 173, Fig 4.7, p.175)

• 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.

Chapter 5: Cost Management in an Automated Business Environment: ABC, ABM, and TQM

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)

(Fig. 5.6, p. 213) --> ABC Overhead Cost Allocation

Using ABC 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).

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. (Fig. 5.9, p. 218)

List of main terms (Intermediate, chapter 1-5)

Managerial accounting: establishing product costs is the focal point. Cost affect pricing strategies and financial statements and control business operations.

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:

1. Materials used to make the product = manufacturing components, fundamental resources)

2. Direct labor = wages of employees involved in the manufacturing process

3. Manufacturing overhead = indirect costs such as utilities

Direct raw material costs: the costs of the materials used to produce the product, that can be effortlessly traced to the product

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

Just in Time (JIT) inventory: business minimize try to reduce these inventory costs through applying JIT (delivering when ordered)

Corporate governance: related to all the stakeholders that affect and determine the way the company is controlled.

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.

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

Cost behavior: it is important to know how costs change relative to the level of business activity

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

The contribution margin: is the amount of revenue accessible to cover fixed costs.

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

Cost plus pricing: price of products are the variable cost plus a fixed percentage of the variable costs

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

Target pricing: determining the market price as target, and develop the product at such a cost the sale will be profitable

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

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

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

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

Cost objects: the total amount of factors that contribute costs to this specific event

Cost driver: the quantity of a certain cost object (the amount of invitations).

Cost allocation: assigning the total amount of costs to different cost objects.

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.

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.

Joint cost: occur when a company uses one process to make two or more joint products.

The 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.

Service departments: of a company provide supporting services to the operating departments of a company

A two-stage allocation process:

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

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

The direct method: 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.

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.

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, materials inventory holding costs, legal fees for patents, etc.

Facility-level activities: production process as a whole

Prevention cost: to avoid nonconforming products

Appraisal costs: identify nonconforming products

Internal failure costs: correcting defects before they reach customers

External failure costs: delivered defective goods

Voluntary costs: depends on the management, these are prevention and appraisal costs

Total quality management (TQM): achieving the highest level of customer satisfaction by managing quality costs

Chapter 6: Relevant Information for Special Decisions

Relevant information

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

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 costs. 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.

Chapter 7: Planning for Profit and Cost Control

Benefits of planning

Planning and budgeting has 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 business 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.

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.

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.

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.

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.

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.

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.

Chapter 8: Performance Evaluation

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.

Types of variances

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 (less 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.

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

Responsibility

Who is responsible for these 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.

Chapter 9: 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)

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

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.

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)

List of main terms (Final, chapter 6-9)

Managerial accounting: establishing product costs is the focal point. Cost affect pricing strategies and financial statements and control business operations.

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:

1. Materials used to make the product = manufacturing components, fundamental resources)

2. Direct labor = wages of employees involved in the manufacturing process

3. Manufacturing overhead = indirect costs such as utilities

Direct raw material costs: the costs of the materials used to produce the product, that can be effortlessly traced to the product

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

Just in Time (JIT) inventory: business minimize try to reduce these inventory costs through applying JIT (delivering when ordered)

Corporate governance: related to all the stakeholders that affect and determine the way the company is controlled.

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

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

Cost behavior: it is important to know how costs change relative to the level of business activity

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

The contribution margin: is the amount of revenue accessible to cover fixed costs.

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

Cost plus pricing: price of products are the variable cost plus a fixed percentage of the variable costs

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

Target pricing: determining the market price as target, and develop the product at such a cost the sale will be profitable

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

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

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

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

Cost objects: the total amount of factors that contribute costs to this specific event

Cost driver: the quantity of a certain cost object (the amount of invitations).

Cost allocation: assigning the total amount of costs to different cost objects.

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.

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.

Joint cost: occur when a company uses one process to make two or more joint products.

The 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.

Service departments: of a company provide supporting services to the operating departments of a company

A two-stage allocation process:

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

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

The direct method: 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.

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

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, materials inventory holding costs, legal fees for patents, etc.

Facility-level activities: production process as a whole

Prevention cost: to avoid nonconforming products

Appraisal costs: identify nonconforming products

Internal failure costs: correcting defects before they reach customers

External failure costs: delivered defective goods

Voluntary costs: depends on the management, these are prevention and appraisal costs

Total quality management (TQM): achieving the highest level of customer satisfaction by managing quality costs

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

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.

Opportunity cost: the sacrifice that has been made to get something.
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.

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

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

The master budget: 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.

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

The 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.

The schedule of cash receipts: used to estimate the cash budget.

Inventory purchases budget: this budget enables the estimation of the amount of inventory needed to satisfy estimated demand.

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.

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.

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

Variances: the differences between the (estimated) standard budget and actual results

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 than 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 (less 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: 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.

The 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).

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.

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

Spending variances: the variance between actual fixed costs and budgeted cost
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.

Decentralization: the practice of delegating authority

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.

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)

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

Suboptimalization: managers who benefit themselves at the expense of their corporations.

The transfer price: when goods are transferred between these divisions, a price is charged