COMM 112

1. COMM 112 Intro to Management Accounting

2. Variable Costing The cost of a making a cog is the product cost Product Costs

3. Variable Costing The costs of running the business are the period cost Period Costs

4. Quick Check Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing b. Variable costing c. They produce the same values for theseinventories d. It depends

5. Example Units are sold at $30 Revenue Cost of Goods Sold Gross Margin Sell & Admin Costs Net Income Revenue Variable Costs Contribution Margin Fixed Costs Net Income Absorption Costing Variable Costing

6. A Comparison EI Prod’n EI Fixed Costs Fixed Costs Income Sales Income Fixed Costs Sales Income Fixed Costs Prod’n EI Income Fixed Costs Fixed Costs Prod’n Sales Income Income EI

7. Segment Costing • To operate effectively, managers need more information than a single, company-wide income statement. • Segments: A segment is any part or activity of an organization about which a manager seeks cost or revenue data. (E.g. sales territories, manufacturing facilities, product lines and individual customers) • Sales and contribution margin: Sales for each segment should be identified along with variable costs, resulting in a contribution margin. • Traceable vs. Common Fixed Costs: Whether a fixed cost is assigned to a segment should depend on whether it is traceable to that segment or is a common cost. • We will see this again in relevant costing

8. Budgeting • A good budgeting system must provide for both planning and control. • Self-imposed participative budget: • A budget that is prepared with the full cooperation and participation of managers at all levels

9. Budgeting • Step 1: Sales revenue budget • Step 2: Production budget (in units) • Step 3: Direct materials usage budget and direct materials purchases budget • Step 4: Direct manufacturing labour budget • Step 5: Manufacturing overhead budget • Step 6: Ending inventory budget • Step 7: Cost of goods sold budget • Step 8: Other costs budget • Step 9: Budgeted income statement

10. The Sales Budget Units of sales x Selling price = Dollars of sales • Most of the planned activities of the organization depend upon forecasted sales

11. The Production Budget • Converts the sales forecast into production plans by incorporating desired inventory policy: Units of sales + Ending inventory in units - Beginning inventory in units = Units to be produced • Forms the starting point for materials, labour, and overhead budgets

12. The Materials Purchases Budget • The total merchandise needed will be the sum of the desired ending inventory plus the amount needed to fulfill budgeted sales demand. The total will be partially met by the beginning inventory, the remainder must come from planned purchases. Units to be produced + Ending inventory in units = Total whole unit quantities needed - Beginning inventory in units = Purchases required in whole unit quantities x Appropriate quantity measure of input material = Quantity of input material needed x Price per unit measure of unit quantity = Cost of purchases

13. The Direct Labour Budget Budgeted production, in units Direct labour hours required per unit Wages per hour Cost of direct labour compensation Total direct labour hours required x = x =

14. Overhead Budget and Selling & Admin Budget Selling and Admin. Budget Predicted sales x Variable S&A rate per sales dollar = Total variable S&A cost + Fixed S&A cost = Total S&A cost Overhead Budget Predicted activity base x VOH rate per unit of activity = Total variable overhead cost + Fixed overhead cost = Total overhead cost

15. Budgeting Example • Prepare the following budgets: production, purchases, direct labour hours (only) and overhead.

16. Cash Budget • Cash budget is a schedule of expected cash receipts and disbursements • Predicts the effects on cash position at the given level of operations • Plans for the borrowing and repayment of loans EXAMPLE: Beginning cash balance $30,000 Cash receipts 913,700 Cash available 943,700 Cash disbursements (including minimum balance) 1,100,880 Ending Balance (157,180) Minimum Balance 40,000 Excess (deficiency) (197,180) Financing: Borrow (repay) 198,000 Ending cash balance $40,820

17. Standards • Quantity standards specify how much of an input should be used to make a product or provide a service. For example: • Labour: Auto service centers like Firestone and Sears set labour time standards for the completion of work tasks. • Materials: Fast-food outlets such as McDonald’s have exacting standards for the quantity of meat going into a sandwich. • Cost (price) standards specify how much should be paid for each unit of the input. For example: • Materials: Hospitals have standard costs for food, laundry, and other items. • Labour: Home construction companies have standard labour costs that they apply to sub-contractors such as framers, roofers, and electricians.

18. Variance • The difference between and actual operating result and a budgeted amount • A favourable variance (F) has the effect of increasing short-run operating profit • An unfavourable variance (U) has the effect of decreasing short-run profits • *Note: a negative variance does not automatically equal an unfavourable variance. Look at the effect on profit, not whether the sign is positive or negative. Also, a favourable variance is not necessarily good and an unfavourable variance is not necessarily bad.

19. Level 1 Variance: Static Budget Variance • the difference between actual operating results and the static budget • through variance decomposition mangers can explain the reasons for the static budget variance (i.e. level two and level three variance)

20. Example

21. Level 2 Variance: Flexible Budget Variance and Sales Volume Variance • Management now decomposes the static-budget variance to determine how much of the variance was due to a change in price and how much was due to a change in volume. • Sales Volume Variance: the difference between the static budget and the flexible budget based on output. It measures the effects of changes in the output on revenues, expenses and operating income. • Flexible budget variance (sales price variance): the difference between actual operating results of the period and the flexible budget based on output. It measures the effects of efficiencies in using resources on expenses and the effects of changes in selling price on revenues.

22. Variance due to price/cost control Variance due to activity change

23. Level 3 Variance Price variance = (AP - SP) x AQ Actual inputs purchased Standard price per unit of input Actual price per unit of input x – Efficiency variance = (AQ - SQ) x SP Also known as standard quantity allowed or budgeted input allowed for actual output units Standard price per unit of input Actual output x standard input per unit of output – x Actual inputs used

24. Example Calculate the price and efficiency variances for direct labour and direct materials given the following information: Plans and Standards: • Plans and Budgets: Produce 7,500 finished units • Price Standards (per unit of output): Direct Materials = $6.70/lbs; Direct Labour = $8.50/hr Quantity Standards (per unit of output): Direct Materials = 4 lbs; Direct Labour = 8 hrs Actual Results: • Actual Production: 6,500 finished units • Direct Materials: Price: $6.80/lbs; Quantity: 25,000 lbs • Direct Labour: Rate (Price): $7.20/hr; Hours (Quantity): 63,000 hrs

25. Example (Overhead) BushCompany applies fixed and variable overhead on the basis of machine hours. Below are Bush Company's results for the month just past: Machine hours used to set the predetermined overhead rate40,000 Variable overhead per machine hour$ 2.80 Actual variable overhead cost incurred117,000 Actual fixed overhead cost incurred302,100 Variable overhead cost applied to production117,600 Variable overhead efficiency variance (unfavourable)8,400 Fixed overhead budget variance (unfavourable)2,100 Compute the following: i.Budgeted fixed overhead ii.Fixed portion of the predetermined overhead rate iii.Standard hours allowed for units produced • iv. Fixed overhead volume variance • v. Fixed overhead cost applied to production • vi. Variable overhead spending variance • vii. Actual machine hours worked • viii. Underapplied or (overapplied) overhead

26. Centralization and Decentralization Board of Directors Decentralized structure CEO A B C D X Y X Y W X Y Z X Y Z X a b c d Centralized portion • Firms can mix and match for the best fit given their goals and circumstances

27. Responsibility Accounting • Responsibility accounting is an accounting system that provides information to top management about segment or subunit performance.

28. Responsibility Centres Cost centre – an organizational unit in which the manager has the authority only to incur costs and is specifically evaluated on the basis of how well costs are controlled Revenue centre – an organizational unit in which the manager is accountable only for the generation of revenues and has no control over selling prices or budgeted costs Profit centre – an organizational unit in which the manager is responsible for generating revenues, and planning and controlling all expenses Investment centre – an organizational unit in which the manager is responsible for generating revenues, planning and controlling costs, and acquiring, disposing of, and using plant assets to earn the highest feasible rate of return on the investment base

29. Transfer Pricing • Methods of determining transfer prices • Market-based transfer prices • The market for the transferred item is competitive • Cost-based transfer prices • No reliable market price is available • Intermediate good that is not sold in that form • Unique requirements from internal customer • Must always use standard costs to avoid possibility of passing on one division’s inefficiencies to the next • Negotiated transfer prices • Bargain reached between buying and selling divisions: • Generally will result in a transfer price between market and cost

30. Setting Transfer Prices • Where there is a market for the intermediate good: • Maximum price – is usually set by the market (ie market price) • Minimum Price – depends on whether there is excess capacity variable costs market price • Where there is no market for the intermediate good: • Negotiation usually based in part on cost No Yes

31. Example Two of the divisions of Heavy-Duty Equipment Company are the Motor Division and the Dragline Division. The Motor Division produces motors that are used by both the Dragline Division and a variety of external industrial customers. For external sales, sales orders are generally produced in 100-unit lots. Motor Division normally has earned a profit margin of 20% on internal sales but has set the external selling price at $5,400. Because a significant number of sales are being made internally, Motor Division managers have now decided that $5,400 is the appropriate price to use for all future transfers to the Dragline Division. Previous transfers have been based on full cost plus the stipulated per unit profit. When the managers' in Dragline Division hear of this change in the transfer price, they become very upset since the change will have a major negative impact on Dragline's net income. Because of competition, corporate management has asked Motor Division tolower its sales price and consider reducing the transfer price. At the same time, Dragline Division management has asked to be allowed to buy motors externally. Bill Bird, Dragline's president, has gathered the following price information in order to help the two divisional managers negotiate an equitable transfer price: Current external sales price $5,400 Total variable production cost plus 20% profit margin ($2,100 x 1.2) 2,520Total production cost plus 20% profit margin ($3,000 x 1.2) 3,600 Unit bid price from external supplier (if motors are purchased in 100-unit lots) 4,800 Mr. Bird is a former classmate of yours and has asked you to help him analyze the following matters: a. Discuss advantages and disadvantages of each of the above transfer prices to the selling and buying divisions and to Heavy-Duty Equipment Company. Explain what circumstances would make each of the alternative prices the most appro­priate choice. b. If Motor Division can sell all of its production externally at $5,400 per unit, what is the appropriate transfer price and why?

32. Return on Investment (ROI) Income Investment Return on Investment = • Most popular approach to incorporate the investment base into the performance measure • Includes all the major ingredients of profitability (revenues, costs, and investment) • Varied definitions for numerator and denominator Can be operating income or net income (incl. taxes, interest, divs) Can be total assets or net assets Return on Investment Revenues Investment Income Revenues x = Highlights benefits of increasing profitability Highlights benefits of reducing investment by reducing idle cash, managing credit judiciously, determining proper inventory levels and spending carefully on fixed assets Return on sales Turnover

33. Illustrative Example • At the present, Relax Inns does not allocate the total long-term debt of the company to the three separate hotels. Brisbane Current assets$350,000 Long-term assets 550,000 Total assets $900,000 Current liabilities $ 50,000 Revenues $1,100,000 Variable costs 297,000 Fixed costs 637,000 Operating income $166,000 Melbourne Revenues $1,200,000 Variable costs 310,000 Fixed costs 650,000 Operating income $ 240,000 Current assets $ 400,000 Long-term assets 600,000 Total assets $1,000,000 Current liabilities $ 150,000 Sydney Current assets $ 600,000 Long-term assets 5,000,000 Total assets $5,600,000 Current liabilities $ 300,000 Revenues $3,200,000 Variable costs 882,000 Fixed costs 1,166,000 Operating income $1,152,000

34. Economic Value Added (EVA®) Economic Value Added After-tax operating income Weighted average cost of capital Total assets Current liabilities = – x – • EVA uses the weighted-average cost of capital (WACC) as the minimum required rate of return • WACC represents the after-tax cost of capital from all debt and equity sources • Many companies also make adjustments to the accounting definition of operating income such as capitalizing (and amortizing) R&D, restructuring costs, and leases • Value created if after-tax operating income exceeds the cost of investing the capital

35. Economic Value Added • Assume that Accor Hotels has two sources of long-term funds: • Long-term debt with a market value and book value of $4,800,000 issued at an interest rate of 10% • Equity capital that also has a market value of $4,800,000 and a book value of $2,200,000 • Assume that the tax rate is 30%. • The after-tax cost of capital = 0.10 × (1 – Tax rate) = 0.07 or 7% • Assume that Accor Hotels’ cost of equity capital is 14%. • What is the weighted-average cost of capital? WACC = [(7% × Market value of debt) + (14% × Market value of equity)] ÷ (Market value of debt + Market value of equity) WACC = [(0.07 × 4,800,000) + (0.14 × 4,800,000)] ÷ $9,600,000 WACC = ($336,000 + $672,000) ÷ $9,600,000 WACC = 0.105, or 10.5%

36. What is the economic value added for each hotel? Brisbane Hotel: NOPAT = $166,000 × 0.7 = $116,200 WACC x Investment = WACC x (Total assets - Current liabilities) = 10.5% x ($900,000 – $50,000) = $89,250 EVA = NOPAT – WACC x Investment = $116,200 – $89,250 = $26,950 Melbourne Hotel: NOPAT = $240,000 × 0.7 = $168,000 WACC x Investment = WACC x (Total assets - Current liabilities) = 10.5% x ($1,000,000 – $150,000) = $89,250 EVA = NOPAT – WACC x Investment = $168,000 – $89,250 = $78,750 Sydney Hotel: NOPAT: $1,152,000 × 0.7 = $806,400 WACC x Investment = WACC x (Total assets - Current liabilities) = 10.5% x ($5,600,000 – $300,000) = $556,500 EVA = NOPAT – WACC x Investment = $806,400 – $556,500 = $249,900

37. Relevant Costing • Relevant costs are costs that are pertinent to or logically associated with a specific problem or decision and that differ between alternatives General Rules for Determining Relevant Costs • Avoidable costs are relevant costs, but unavoidable costs are never relevant costs • Costs that are never relevant: • Sunk costs (which are costs that are incurred in the past) are irrelevant since they will be the same for any alternative • Future costs that do not differ between alternatives are irrelevant • Unavoidable fixed costs • Costs that are sometimes relevant • Variable costs • Avoidable fixed costs

38. Adding or Dropping a Segment • To evaluate performance of products or product lines, operating results are presented by product or product line. • If all costs (variable and fixed) are allocated to the products or product lines, some may be perceived to operate at a loss when they are not. • Decision Rule: Add or retain product lines when their contribution margin is greater than their avoidable fixed costs. Drop product lines when their contribution margin is less than their avoidable fixed costs. • Remember segments and common vs traceable costs

39. Example Should the bar be closed down?

40. Make or Buy • A make or buy decision is concerned with whether an item should be made internally or purchased from an external supplier. • A firm’s make or buy choices should be based on the following considerations: • Cost to make (variable costs + avoidable fixed costs) vs. cost to buy • Opportunity costs (idle resources have no opportunity costs) • Available capacity

41. Example Newman Enterprises Ltd. manufactures Widgiesfor use in the production of Winkle, a major sales product for the company. The cost per unit for 10,000 Widgiesis as follows: Direct Materials $ 3.00 Direct Labour 15.00 Variable Overhead6.00 Fixed Overhead 8.00 Total $32.00 John Black Corporation has offered to sell Newman 10,000 Widgies for $30.00 each. Also $5 per unit of the fixed overhead applied to Widgies would be totally eliminated. What decision would you make and why? Next: Assume that if Newman accepts Black’s offer, the released facilities could be rented out for $45,000 annually . This is an opportunity cost incurred by using the facilities rather than renting them. Now what is the decision ?

42. Special Order • Special orders are one-time orders that do not affect a company’s normal sales. • As long as the incremental revenue from the order exceeds its incremental costs, the order should be accepted • If idle capacity is not available, opportunity costs should be included as part of the incremental costs

43. Constrained Resource • When a company has limited resources (floor space, raw materials, or machine hours etc.), management must decide which products to make and sell • The proper criterion that maximizes operating income when operating at capacity is to obtain the highest contribution margin per unit of the resource (factor) that limits the production or sale of products. • This is obtained by dividing the contribution margin per unit of each product by the number of units of the limited resource required for each product. • Decision Rule: Production should be geared to the product with the highest contribution margin per unit of constrained resource

44. Example The Beach Comber is a takeout food store at a popular beach resort in Brighton, England. Susan, owner of the Beach Comber, is deciding how much shelf space to devote to four different drinks. Pertinent data on these four drinks are as follows: Susanhas a maximum front shelf space of 12 metres to devote to the four drinks. She wants a minimum of 1 metre and a maximum of 6 metres of front shelf space for each drink. Required • What is the contribution margin per case of each type of drink? • A coworker of Sexton’s recommends that she maximize the shelf space devoted to those drinks with the highest contribution margin per case. Evaluate this recommendation. • What shelf space allocation for the four drinks would you recommend for the Beach Comber?

45. Joint Process • A joint process is a single process in which one product cannot be manufactured without others being produced • Joint products - multiple end products • Petroleum – gasoline, lubricating oil, kerosene • Once products reach the split-off point, the joint cost is a sunk cost • The only relevant items in the decision to sell or process further are the incremental costs after the split-off point Decision Rule: Continue processing a joint product after the split-off point so long as the incremental revenue from such processing exceeds the incremental processing costs. Further Processing Cream Cottage Cheese Sell Raw Milk Common Process Condensed Milk Further Processing Skim Milk Sell Joint Products Joint Costs Split-Off Point

46. Example Costs (per day) Expected Revenues from Products (per day)

47. Capital Budgeting • When a firm makes money it can • Invest in new projects • Pay Dividends • Keep it in the Bank • Capital Budgeting is used to determine which projects to invest in so as to increase the profitability of the firm

48. Payback Period • Length of time required to recoup, in the form of cash flows from operations, the initial outlay • If cash flows are uniform (identical per period), then it can be determined by the following formula: Payback = Net initial investment time Uniform increase in annual cash flows • If cash flows are uneven, then: • Construct a table of cumulative cash inflows

49. Example The John Radcliffe Hospital intends to acquire a new machine costing $50,000 which is expected to have a life of 5 years, with a scrap value of $10,000 at the end of that time. Cash flows arising from operation of the machine are expected to arise on the last day of each year as follows: Calculate the actual payback period. The pack back requirement is 3 years and the hurdle rate is 20% End of year $ 1 10,000 2 15,000 3 20,000 4 25,000 5 25,000

50. Accounting Rate of Return • Accounting rate of return is calculated by taking the average annual profits expected from a project as a percentage of the capital invested Increase in expected Accounting = average annual operating income rate of return Net initial investment • Can also use average book value of fixed assets as the denominator (Initial Investment-Salvage)/2 • Return to previous example