BU247 Managerial Accounting

1. BU247 Managerial Accounting with Natasha Neumann-Causi and Mike Pegutter

2. Updated Presentation This presentation is up to date • Uses material from new textbook • Follows course outline • Contains examples from prior exams and from textbook questions • If I miss something, let us know and we will explain it now or in an email

3. General Study Tips • DON’T PANIC! • USE YOUR HANDOUT! • Know the theory well, do not memorize calculations! • Practice homework with time constraints!!!!! • If you get stuck on a question, leave it and come back later • When in doubt, GUESS! Never leave a question blank • Make sure you have answered everythingthe question asked for!!!

4. Exam Outline • Multiple Choice Questions • Definitions • Smaller calculations • Theories • Short Answers • Big Calculations • Writing out Steps to Calculations • Case Question • Combo

5. Agenda PART I: Controlling • Transfer Pricing • Return on Investment (ROI) • Balanced Scorecard PART II: Relevant Costs • Game-Changing Decisions • Product Pricing and Costing PART III: Budgeting • Sales/Cash/Production/Labour Budgets • Flexible Budgets PART IV: Analysis • Standard Costs, Variance Analysis • Profitability Analysis PART V: Capital Budgeting • IRR, NPV, Payback PART VI: Case Analysis + Midterm Review

6. Case Analysis Issues • Identify root causes of problem(s) • Primary issue: issue which needs to be solved • Phrase in term of a question, such as, Which special orders should the firm accept? • Secondary issues: other issues which exist in the case

7. Case Analysis Key Success Factors (KSF) • Factors critical to the success of this specific firm • Will be part of criteria used when evaluating solutions • These factors differ depending on the industry and even between companies

8. Case Analysis Identification of Alternatives • Make a list of feasible alternatives • Doing nothing can be an option, but it’s not recommended Quantitative Analysis • Analyze all of your alternatives • This will incorporate a variety of tools learnt in class such as breakeven, contribution margin, variances.... • Determine which costs are relevant and which are not – i.e. ignoring sunk costs • Understand what the qualitative position is telling you

9. Case Analysis Sensitivity Analysis • Re-do calculations if there is a 10-20% increase in costs Qualitative Analysis • Analyze all of your alternatives • Look back at your key success factors and see how each alternative is contributing or taking away from KSF’s • Can use your quantitative to guide qualitative analysis

10. Case Analysis Recommendation • Based on above analysis determine the best solution • Briefly state recommended course of action • Tie back to key success factors and issue Circumvention of Potential Problems • If you foresee any problems state them with solutions • DO NOT say everything won’t work

11. Answers on Laurier SOS website! BROKEN ISLAND KAYAKS

12. Do They Have Capacity? This has nothing to do with capacity issues but showed up when I Googled Kayaks!

13. Do Profits Increase?

14. Some Sensitivity

15. CONTROLLINGPart I

16. Decentralization • Decentralization is the process of spreading decision-making authority • Responsibility Centres is the section of the company a manager is responsible for • Cost Centres control only costs • Examples: Accounting Department • Profit Centres costs and revenues • Example: Cafeteria • Investment Centres costs, revenues and investments in assets • Example: Corporate HQ

17. Transfer Pricing • A transfer price is the price charged by one segment of a company to provide products to another segment • Example: KPMG Canada sharing contract fees with other KPMG offices in different countries to help them complete an audit. • There are three ways to calculate transfer prices • Negotiated • MarketValue • Cost

18. Transfer Pricing: Negotiated • This method lets each division work independently which helps promote decentralization of authority • This way is only successful if managers cooperate with each other • This method will produce a range of acceptable prices; • The highest point is the most the buying division is willing to pay • The lowest point will be as low as the selling division can afford

19. Negotiated Transfer Price Example Unoriginal Inc. is a company which owns multiple grocery store chains including the famous Value Market chain, and also owns a bakery franchise called Bakery Plus. Value Market stores strive to provide its customers with fresh produce everyday and has recently expanded to include a baked goods aisle that sells (among other things) freshly baked pies. Given the following information, determine the transfer price range for Value Market’s purchase of Bakery Plus pies. Step 2: Bakery Plus lowest transfer price Transfer Price ≥ VC + (CM on lost sales / # of Transferred Units) Contribution of Lost Sales = ($15-$6)x 10,000 units of lost sales = $90,000 Transfer Price ≥ $6 + ($90,000/20,000 units) = $6 + $4.5 = $10.5 Note: If Bakery Plus is not missing out on sales by providing to Value Market then “CM on lost sales” doesn’t apply and will equal $0 Step 1: Does Bakery Plus have the capacity? No. Bakery Plus uses all of its capacity every month to serve its own customers and would therefore have to sacrifice customers to serve Value Market. Step 3: Value Market’s highest transfer price Transfer Price ≤ Outside Supplier Cost Transfer Price ≤ $12 Step 4: Range The range of acceptable transfer prices is $10.5 - $12.

20. Transfer Pricing • Transferring at cost the transfer price to cost or the full absorption cost* • There are a lot of problems with this: • If cost is used for transfer price, the selling division will never get a profit out of it • Cost-based transfer prices give the selling division no incentive to lower costs • Market priceis the price for a product on the open market and is often the best solution

21. Return on Investment (ROI) • Where “Operating Income” is Earnings Before Interest and Taxes (EBIT) • Where “Average Operating Assets” is (beginning assets + ending assets) / 2 • Net Book Value (Cost – Accumulated Amortization) • This will cause ROI to  over time as the book value of assets  • Adding a new asset will cause ROI  • Purchase Cost can be used as well to value assets which would make ROI impervious to asset purchases • There are three ways to improve ROI • Increase Sales • Reduce Operating Expenses • Reduce Operating Assets

22. Return on Investment (ROI) • Another way to calculate: • Criticisms of ROI • Management may not know good ways to increase ROI • Managers of segments take on a lot of costs they have no control over • Acts as a negative incentive for investment out of fear of skewing ROI

23. Residual Income • Residual incomeis the operating income that an investment centre earns above the minimum required return on its assets The Old Navy division of The Gap has average operating assets of $220,000 and is required to earn a return of 14%. In 2010, Old Navy has earned $60,000. Calculate residual income. Step 2: Residual Income Actual Income – Minimum Required Return = Residual Inc. $60,000 - $30,800 = $29,200 Step 1: Minimum Required Return Operating Assets x Required ROI = Minimum Return $220,000 x 14% = $30,800

24. The Balanced Scorecard • The balanced scorecard method uses multiple interconnected perspectives of performance measurement to come up with one comprehensive measure • Uses both financial and non-financial measures • Can be an excellent performance review tool if done right

25. Quality Costs • Quality of Conformanceis when the majority of products conform to design specifications and are defect-free • Anything that does not meet design specifications is a defect and is indicative of low quality of conformance • There are four categories of quality costs: • Prevention Costs – Activities done to reduce the number of defects • (i.e. Training) • Appraisal Costs – The cost of identifying defects • (i.e. Testing) • Internal Failure Costs – The cost of fixing defective products before they are shipped • (i.e. Reworking costs) • External Failure Costs – The costs which result from defective products they have been shipped • (i.e. Warranty costs)

26. Four key points on the relationships between these costs • When the quality of conformance is low, total quality cost is high • Total quality costs drop rapidly as the quality of conformance increases • Reduce their total quality costs by spending on prevention and appraisal • Total quality costs are minimized when the quality of conformance is slightly less than (or equal to) 100%

27. RELEVANT COSTSPart II

28. Relevant Costs • Relevant costsare those that differ between alternatives • These costs are avoidable because they are eliminated through choosing one alternative over another • Costs that are relevant in one decision may not be relevant in another context • Unavoidable costsare irrelevant to decision making because they’re going to be incurred no matter what • Sunk Costswhich are costs already incurred and were paid for and cannot be changed; therefore they have no bearing on future decisions • Future Coststhat do not differ between alternatives

29. Game Changing Decisions • Add or Drop segments of a company • Make or Buy decisions • Special Orders • Joint Costs (Sell or Process)

30. Add or Drop Segments • Decision Rule: Drop the segment if overall profits increase • Drop the segment if fixed cost savings > lost contribution margin • It’s sometimes more profitable to keep a division even when it’s losing money • The decision to keep this division lies in the way common fixed costs are allocated • Example: If unavoidable costs are included in the analysis the product line may appear to be less profitable than it actually is

31. Add or Drop Example Consider the following financial information for RCA which is losing money on its CD Player division. Should RCA drop it?

32. Game Changing Decisions Example in handout! Make or Buy Decisions • Do an activity internally or outsource it • A company is vertically integratedwhen it takes care of multiple functions within its value chain • The main drawback is losing out on cost savings because other companies have economies of scale Special Orders • A special orderis a one-time order that is not normally received • Decision Rule: incremental benefits > incremental costs • Steps • Do we have the available capacity? • If not, we will have to sacrifice regular business to make this order • Is it worth it? Yes, as long as you’re making a profit

33. Joint Costs • Joint Productsare produced from a common input • The Split-off Pointis the point in manufacturing where the products can be distinguished • Example: Mined ore • Joint costs are allocated between these products at the split-off point (but are sunk costs) • It is profitable to continue processing if increase in value > extra costs

34. Joint Costs Example Sawmill Inc. cut logs from which unfinished lumber and sawdust are the immediate joint products. Unfinished lumber is sold “as is” or processed further into finished lumber. Sawdust can also be sold “as is” to gardening wholesalers or processed further into “presto-logs”. Should Sawmill Inc sell or process these products? Step1: Incremental Value of Processing Incremental Value = Sale Value after Process – Sale Value at Split Off Lumber = $270 - $140 = $130 Sawdust = $50 - $40 = $10 Step 2: Profit from Processing Further Profit after Processing = Incremental Value – Cost of Processing Lumber = $130 - $50 = $80 Sawdust = $10 - $20 = ($10) Conclusion: Lumber should be processed further and sawdust should be sold as it is

35. Constrained Resources • A constraint is a limited resource that restricts a company’s abilities • The specific thing constraining the activity is called the bottleneck • Pick the product mix that maximizes contribution margin

36. Constrained Resource Example In Proctor & Gamble’s Crest division, there is a mixing machine that is working at 100% capacity. It has a capacity of 90,000 minutes per week and is used to mix the ingredients for Crest’s special extra whitening toothpaste and its regular toothpaste. Should P&G focus machine time on the whitening toothpaste or regular toothpaste? Step 1: Contribution Margin per Minute CM/minute = Contribution Margin per Unit / Mixing Time Whitening CM per Minute = $4.00 ÷ 10 minutes = $0.40 / minute Regular CM per Minute = $2.00 ÷ 15 minutes = $0.13 / minute Conclusion: Make all the whitening toothpaste needed first then make the regular toothpaste with the remaining capacity. Step 2: Allocating Constrained Resource 6,000 units x 10 minutes = 60,000 minutes Time Remaining = 90,000 mins– 60,000 mins = 30,000 mins 30,000 minutes ÷ 15 minutes per regular toothpaste = 2,000 toothpaste Step 3: Total Contribution Margin Whitening Toothpaste = 6,000 x $4.00 = $24,000 Regular Toothpaste = 2,000 x $2.00 = $4,000 Total CM = $28,000

37. Product Pricing • The Cost Plus Pricingmethod uses the product markup to determine price • Markup is the difference between its selling price and its cost • The Absorption Costingmethod uses the absorption cost per unit rather than the variable cost to calculate markup • Steps • Divide fixed costs by number of units produced • Add up all per unit costs to come up with the total unit cost • Multiple the unit cost by the markup percentage and add it on to get the target selling price

38. BUDGETINGPart III

39. Budgeting • A budgetis a detailed quantitative plan for acquiring and using resources over the next period • An operating budgetcovers one year of the company’s life at a time • A continuous budgetalways has the next 12 months planned out by adding a month on the end • The most effective budget is one where managers are only responsible for the costs they have control over • Participative budgetsachieve this because all levels contribute • Other benefits: creating a team environment, better accuracy, increased motivation and the elimination of excuses for poor performance

40. Budgeting • Cash Collections • S&A Expenses • The master budgetis the summary of many smaller budgets which are all interrelated

41. Sales Budget & Cash Collections Company ABC makes custom coffee mugs and is getting ready to make its sales budget for the quarter ended June 30, 2011. The sales forecast is given below and the average price for a mug is $15. Only 5% of Royal York’s sales are in cash. The rest of the sales are typically collected as follows: 60% collected within the month, 35% collected in the following month, 5% uncollectible Step 2: Cash and Sales on Account April Cash = $15M x 5% = $750,000 May Cash = $12.75M x 5% = $637,500 April A/R = $15M x 95% = $14.25M May A/R = $12.75M x 95% = $12,112,500 • June Cash = $20.25M x 5% = $1,012,500 • June A/R = $20.25M x 95% = $19,237,500 Step 1: Dollar Value of Estimated Sales April = $15 x 1M mugs = $15M, May = $15 x 0.85M mugs = $12.75M, June = $15 x 1.35M mugs = $20.25M

42. Production Budget Using the projected sales, determine how many coffee mugs need to be produced by Company ABC during the next quarter (ending June 30). Assume ending inventory for March was 500,000 units. Assume that management wants ending inventory to equal 15% of the next month’s budgeted sales. Step 1: Total Demand for Each Month Total Demand = Targeted Sales + Desired Ending Inventory April = 1M units + (0.85M x 15%) = 1,127,500 units May = 0.85M units + (1.35M x 15%) = 1,052,500 units June = 1.35M units + (0.9M x 15%) = 1,485,000 units

43. Materials/Labour Budgets • The Direct Materialsbudget outlines all the raw materials that are required to meet the production budget • The Direct Labour Budgetoutlines all the labour hours required to meet the production budget • The Manufacturing Overhead Budgetestimates how much overhead will be incurred during the forthcoming period • Include all other costs besides direct labour and direct materials involved with production

44. Direct Labour Budget Example Using the production budget determined above, create the direct labour budget for Company ABC for the next quarter (ending June 30). Assume each coffee mug required 0.5 hours of labour and about $0.75 worth of materials. Company ABC currently has 2000 employees which work at least 40 hours a week at a rate of $12/hour. There are no plans to layoff anyone. Step 1: Minimum Labour Cost Since ABC Inc. is not going to lay anyone off, they will have to pay 2000 employees for 40 hour work weeks (assuming 4 weeks in a month). Minimum Labour Hours = 2000 employees x 40 hours/week x 4 weeks/month = 320,000 hours Minimum Labour Cost = 320,000 hours x $12/hour = $3,840,000 per month

45. Manufacturing Overhead Budget Using the direct labour budget determined above, create the manufacturing overhead budget for Company ABC for the next quarter (ending June 30). Assume manufacturing overhead is applied based on labour hours (cost driver). Company ABC believes about $1.7 of overhead costs are incurred per direct labour hour. Fixed manufacturing overhead costs total $2,000,000 (including $1,000,000 of amortization). Step 4: Monthly Cash Disbursements April = $2,533,375 - $1,000,000 amortization = $1,533,375 May = $2,786,250 - $1,000,000 amortization = $1,786,250 June = $3,090,125 - $1,000,000 amortization = $2,090,125 Quarterly Total = $5,409,750 Step 1: Variable Manufacturing Overhead April = 313,750 hours x $1.7/hour = $533,375 May = 462,500 hours x $1.7/hour = $786,250 June = 641,250 hours x $1.7/hour = $1,090,125 Step 2: Total Manufacturing Overhead April = $533,375 + $2,000,000 = $2,533,375 May = $786,250 + $2,000,000 = $2,786,250 June = $1,090,125+ $2,000,000 = $3,090,125 Quarterly Total = $8,409,750 Step 3: Predetermined Overhead Rate (POHR) Total Overhead for the Quarter = $8,409,750 Total Labour Hours Required = 1,417,500 hours POHR = $5.93

46. Ending Finished Goods Budget • The Ending Finished Goods Budget determines the expected value of the ending inventory for the upcoming period for which all of these budgets have been made • This is typically referred to when estimating storage costs • Sum the per unit production costs • From the “Company ABC” example, “total per unit cost” would be $6.30: • $12 hourly direct labour x 0.5 hours required in production = $6 • $0.75 direct materials per mug • $5.93 manufacturing overhead per mug • Multiply the per unit cost by expected leftover inventory • From “Company ABC” example, June ending inventory is 135,000 coffee mugs • Value of ending inventory will be ($12.68 x 135,000 units = $1,711,800)

47. Cash Budget • The Cash Budgetpulls everything together into one nice summary! There are four sections: • Cash receipts listing all cash inflows • excluding borrowing, so basically just cash from sales • Cash disbursements listing all payments • excluding repayments of principal and interest • Cash excess or deficiency • resultant of step 1 – step 2 • The financing section listing all borrowings, repayments and interest

48. Cash Budget Example • Create an entire cash budget for Company ABC!! • A line of credit of up to $2,000,000 is available at a 10% interest rate • Company ABC aims to maintain a minimum of $50,000 in cash at the end of each month • Borrowing are on the first day of the month and are repaid on the last day of the month (for simplicity) • Company ABC paid a dividend of $1M in June • Company ABC purchased equipment for $6.2M in cash in May • Opening cash balance for April 1 is $70,000 • Assume monthly Selling and Administrative costs of $1M, $1.5M and $2M in April, May and June respectively • Assume monthly Direct Material expenses of $0.75M, $1.25M and $1.75M in April, May and June respectively

49. Flexible Budgets • Static budgetsare prepared for a single planned level of activity which is hard to work with • Flexible budgetsaddress this problem by simultaneously showing multiple activity levels • Planned level of activity and the actual level of activity • This method therefore exposes variances related to cost controls Example in handout!

50. ANALYSISPart IV