Section Topics

1. Section Topics • Cost concepts • Capital budgeting • Operating budget • Transfer pricing • Cost-volume-profit analysis • Relevant cost • Costing systems • Responsibility accounting Part 3, Section C

2. Decision making Continuous improvement Purpose of Managerial Accounting To support management activities Planning Controlling Evaluating Part 3, Section C, Introduction

3. Cost Concepts: Fill in the blanks Cost Cost object Cost driver Actual costs Part 3, Section C, Topic 1

4. Cost Concepts: Fill in the blanks Direct costs Indirect costs Differential costs Opportunity costs Sunk costs Part 3, Section C, Topic 1

5. Product vs. Period Costs Product Costs Period Costs • Also called inventoriable or manufacturing costs. When products are sold, product costs become cost of goods sold. Product costs include: • Direct materials. • Direct labor. • Manufacturing overhead. • Categorized as prime or conversion costs. • Also called operating expenses and nonmanufacturing costs. These items are expensed in the period in which they occur. Period costs include: • Marketing or selling costssuch as • advertising, shipping, and storage costs in shipping warehouses. • Administrative costs, including all • executive, organizational, and • clerical costs of the organization • (such as PR and secretarial costs). Part 3, Section C, Topic 1

6. Cost Behavior Variable Costs Fixed Costs Mixed Costs • Costs that rise and fall as a • firm’s output level rises and • falls. • Manufacturing:direct labor, raw materials, utilities, waste disposal • Merchandising:cost of goods sold, sales commissions, billing costs • Service (hospital): supplies, drugs, meals • Portions of total costs that • remain constant regardless • of changes in activity • levels over a relevant • range. Examples of fixed • costs: • Rent, depreciation • Insurance, property taxes • Supervisory and administrative salaries Costs that are a combination of fixed and variable costs. The time horizon often determines cost behavior as costs can change in the long and short term. All three cost patterns are found in most organizations. Part 3, Section C, Topic 1

7. Discussion Question Which of the following is NOT true of absorption costing? • It is required for external reporting. • It deducts fixed manufacturing costs. • It defers fixed manufacturing costs. • It uses a gross margin format. Answer: B. It defers fixed costs in ending inventory to future periods. Part 3, Section C, Topic 1

8. Classification of Costs Under Absorption and Variable Costing Part 3, Section C, Topic 1

9. Master Budget A summary of an organization’s plans that sets specific targets for sales, production, distribution, and financing activities. Operating Budget Capital Budget Master Budget Components Financial Budget Part 3, Section C, Topic 2

10. Identify, understand, and define projects and boundaries. Select projects and analyze revenues, costs, and cash flows. Monitor and review projects and modify as necessary. Capital Budgeting Process Part 3, Section C, Topic 2

11. Investment Evaluation Analysis Typical capital budgeting decisions include: Cost reduction.(Should new equipment be purchased to reduce costs?) Expansion.(Should a new plant or warehouse be acquired to increase capacity and sales?) Equipment selection.(Which machine would be the most cost-effective to buy?) Lease or buy.(Should new equipment be leased or purchased?) Equipment replacement.(Should old equipment be replaced now or later?) Part 3, Section C, Topic 2

12. Discounting Models: Net Present Value (NPV) Method • Compares present value of a project’s cash inflows to present value of a project’s cash outflows. • The difference, the net present value, determines whether the project is an acceptable investment. Where: i = interest rate n = number of periods Part 3, Section C, Topic 2

13. Discounting Models: Internal Rate of Return (IRR) Method • Most widely used capital investment technique. IRR is the rate of return or “yield” promised by a project over its lifetime. • Find discount rate that equates present value of project’s cash outflows with present value of project’s cash inflows. IRR is the discount rate that causes the net present value of a project to be equal to zero. • Computed IRR is compared to firm’s required rate of return. Greater or equal IRR means project may be acceptable. Part 3, Section C, Topic 2

14. Discussion Question Which of the following is true of the NPV decision model in relation to the IRR? • It is more complicated. • It makes more realistic assumptions. • It favors larger investments. • It is less accurate. Answer: B. NPV makes more realistic assumptions about the rate of return that can be earned on cash flows from a project. Part 3, Section C, Topic 2

15. Nondiscounting Models: Payback Method • Focuses on the payback period, the time required for an organization to recover its original investment. • Some organizations set a maximum payback period for all projects and reject any that exceed that level. This provides a rough measure of risk and provides information about controlling risks of obsolescence and uncertainty of cash flows. (if cash flows are equal amount each period) Part 3, Section C, Topic 2

16. Nondiscounting Models: Accounting Rate of Return (ARR) Method • Also called simple rate of return. Unlike other methods, it measures the return on a project in terms of net operating income instead of cash flow. • Estimated revenues generated by a project are deducted from the projected operating expenses; this figure is then related to the initial investment. Part 3, Section C, Topic 2

17. Payback and ARR Compared • ARR method does not consider a project’s profitability; however, it can ensure that new investments don’t adversely affect financial accounting ratios. • Critical deficiency is that both methods ignore the time value of money. • Used less frequently than discounting models; however, still commonly used as screening measures. • Payback method can help identify proposals managers should consider further. Part 3, Section C, Topic 2

18. Economic Value Added (EVA) • Residual income calculation to help determine whether the money an organization makes is more than the money it takes to make it. • Value is created if after-tax operating income is greater than cost of capital. • Key point is emphasis on after-tax operating profit and the actual cost of capital. EVA = After-Tax Operating Income – (Actual Percentage Cost of Capital x Average Capital Employed) Part 3, Section C, Topic 2

19. Capital Budgeting Models: Fill in the blanks NPV IRR Payback ARR EVA Part 3, Section C, Topic 2

20. Operating Budgets • Identify resources (and sources) to support organization’s daily activities. • Are used in conjunction to develop overall operating budget. • Are tools for short-term planning and control. • Typically cover a one-year period and state revenues and expense planning. • Fine-tune an organization’s strategic plan. • Help coordinate activities of several parts of an organization. • Assign responsibilities to managers, authorize budget amounts, and set performance expectations. • Are the basis for evaluating a manager’s performance. Part 3, Section C, Topic 3

21. Sales Budget Basis for all other budgets. Defines capacity needed throughout organization, including production, selling, and administrative costs. Part 3, Section C, Topic 3

22. Production Budget Plan for acquiring resources, meeting sales goals, and maintaining a specific level of inventory. Part 3, Section C, Topic 3

23. Direct Materials Budget Determines required materials and quality of materials used to meet production. Often broken down into usage and purchase budgets. Part 3, Section C, Topic 3

24. Direct Labor Budget (All figures in USD) Part 3, Section C, Topic 3

25. Overhead Budget All production costs other than direct materials and direct labor. Includes fixed and variable costs such as rent, insurance, utilities, etc. (All figures in USD) Part 3, Section C, Topic 3

26. Cost of Goods Sold Budget Total and per unit production cost budgeted for a period. (All figures in USD) Part 3, Section C, Topic 3

27. Selling and Administrative Expenses Budget Nonmanufacturing expenses and sales expenses make up this budget. (All figures in USD) Part 3, Section C, Topic 3

28. Project budgeting Zero-based budgeting Activity-based budgeting Kaizen budgeting Alternative Budget Approaches Part 3, Section C, Topic 3

29. ABB vs. Traditional Budgeting Part 3, Section C, Topic 3

30. Zero-based Budgeting • Managers exhaust resources unnecessarily. • Can encourage waste through budget slack. • Annual reviews are expensive. • Omitting prior budgets can lead to ignoring lessons learned from prior years. • Creates lean, efficient organization. • Forces constant cost justification. • Encourages annual reviews. Pros Cons Part 3, Section C, Topic 3

31. Reinforcing Activity 3-8 • Part 3, Section C, Topic 3 • Operating Budget Part 3, Section C, Topic 3

32. Transfer Pricing Transfer pricing is a system for pricing products or services transferred from one responsibility center to another. Decentralized Organization Unit A “sells” a product to Unit B. Responsibility Unit B Responsibility Unit A Unit B “pays” a transfer price to Unit A. Part 3, Section C, Topic 4

33. Transfer Pricing Issues • Control • Used to provide incentives and performance measures • Ensures that costs are assigned to correct responsibility center • Decentralized planning decisions • Purchasing decisions are consistent with organization’s goals • Considers effect on selling and buying units’ incentives • International issues • Minimize tax liability, expropriation risks, taxes, and tariffs • Incorporate alternative performance measures if necessary • Comply with all national laws and regulations Part 3, Section C, Topic 4

34. Discussion Question The overriding reason for using transfer pricing is to • motivate managers to make decisions consistent with organizational goals. • hold managers responsible for problems. • generate tax savings. • improve economic performance. Answer: A. Transfer pricing also affects B, C, and D, but the primary reason for using it is A. Part 3, Section C, Topic 4

35. Transfer Pricing Models • Market price: A true arm’s-length model that sets the internal transfer price at the going market price. • Full cost (absorption): Starts with seller’s variable cost for an item and then allocates fixed costs to the prices. • Variable cost: Sets transfer prices at the unit’s variable cost, or the actual cost to produce the good or service less all fixed costs. • Negotiated price: Sets the transfer price through negotiation between buyer and seller. Part 3, Section C, Topic 4

36. Transfer Pricing Models: Fill in the blanks Market price Full cost Variable cost Negotiated price Part 3, Section C, Topic 4

37. Discussion Question Which of the following in NOT a key factor in transfer pricing? • The seller’s variable cost vs. market price • If selling unit is operating at full capacity • If there’s an outside supplier • Organization’s market share Answer: D. Other factors are more important. Part 3, Section C, Topic 4

38. CVP Analysis • Helps managers understand interrelationships among cost, volume, and profit by focusing on interactions among: • Prices of products. • Volume or level of activity. • Per unit variable costs. • Total fixed costs. • Mix of products sold. • Decision-making applications include: • Setting prices. • Product introductions. • Replacing equipment. • Make or buy decisions. • “What-if” analyses. Part 3, Section C, Topic 5

39. CVP Model Tracks how costs, revenues, and profits change in a predictable way as the volume of activity changes. Profit = Revenues – Total Costs or Revenues = Fixed Costs + Variable Costs + Profit Part 3, Section C, Topic 5

40. Break-even Analysis • Determinant of CVP analysis used to assess how “what-if” decision alternatives will affect operating income. • Break-even point is output level at which total revenues and total costs are equal. + Above break-even, operating income levels are profitable. 0 At break-even, operating income is zero. – Below break-even, there is a loss. Part 3, Section C, Topic 5

41. Break-even Analysis—Equation Method • Where: • USP is the unit selling price. • Q is the quantity sold. • UVC is the unit variable costs. • FC is the fixed costs. • OI is the operating income. Part 3, Section C, Topic 5

42. Break-even Analysis—Contribution Margin Method Algebraic adaptation of the equation method • Where: • USP is the unit selling price. • Q is the quantity sold. • UVC is the unit variable costs. • FC is the fixed costs. • OI is the operating income. • UCM is the unit contribution margin (USP − UVC). Part 3, Section C, Topic 5

43. Break-even Analysis—Graph Method CVP graph (or break-even chart) shows interrelationships among cost, volume, and profit graphically. Part 3, Section C, Topic 5

44. Relevant Costs: Irrelevant Costs: Relevant vs. Irrelevant Costs • Are yet to be incurred (future costs). • Differ for each option. • Are avoidable. • Are focused on short-term decisions. • Have already been incurred. • Have already been committed. • Will be the same regardless of alternative chosen. • Can be ignored. Part 3, Section C, Topic 6

45. Discussion Question Which of the following BEST describes a relevant cost? • A cost that is the same for both choices • A cost that has already been incurred • A cost yet to be incurred • A cost that is unavoidable Answer: C. Costs that have already been incurred (sunk costs) are irrelevant. Part 3, Section C, Topic 6

46. Keep or drop decisions Make or buy decisions Sell or process further decisions Special order decisions Relevant Cost Analysis Applications Part 3, Section C, Topic 6

47. Relevant Cost Analysis: Fill in the blanks Make or buy Special order Sell or process further Keep or drop Part 3, Section C, Topic 6

48. Types of Product Costing Systems: Cost measurement (allocation) systems Cost accumulation systems Product Costing Systems Product costing is the process of accumulating, classifying, and assigning direct materials, direct labor, and factory overhead costs to products and services. Part 3, Section C, Topic 7

49. Actual Costing Records actual costs incurred for direct materials, direct labor, and overhead (by allocating actual amounts). • Limitations of actual costing: • Cannot provide accurate unit cost information on a timely basis. • Difficult to assign overhead items to unit cost without direct relationship. • Can distort period costs due to irregular overhead items. Part 3, Section C, Topic 7

50. Normal Costing Most widely used costing method; applies actual costs for direct materials and direct labor to a job, process, or other cost center and uses a predetermined rate to assign overhead to cost centers. • Advantages of normal costing: • Actual overhead costs are not readily available. • Helps keep product costs current by allowing for immediate cost calculation using standard overhead rate. • Helps smooth out or “normalize” factory overhead rate fluctuations. Part 3, Section C, Topic 7