Midterm & Finals

8/7/2019 Midterm & Finals

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THE GRADUATE SCHOOL OF HEALTH SCIENCE, MANAGEMENT AND PEDAGOGYSouthwestern University

Villa Aznar, Urgello St., Cebu City, 6000 Philippines

Managerial Accounting

Submitted by: J Walter T. PalacioSubmitted to: Rolito Canene

Midterm & Final Requirements

Part I. Fundamentals of Managerial Accounting and Cost

Accumulation System

We all know that basic accounting procedures involves three

main financial statements the balance sheet, income statement,

and cash flow statement. These statements are prepared for andprovided to users external to the organization such as

shareholders, bankers, and government. Accounting focused on

the external user is known as financial accounting. The term

accounting covers many different types of accounting on the

basis of the group or groups served. Accounting information

typically provided to users internal to the organization is

another type which is known as managerial accounting.

Managerial accounting serves the needs of users within the

organization, such as managers. In order to achieve

organizational objectives, the management team is responsible

for planning, directing, motivating, and controlling the

activities of the business. Managerial accounting will show

how accounting information can and should be used by management

to carry out its mandate on a more efficient and effective

basis. In many organizations, most of the accounting is

performed to generate the financial statements required by

external users. As an entity develops and grows, managers need

information to help them manage the organization. Sometimes,

this information can be obtained from the financial accounting

system. In some organizations, whole new systems are designed to

meet the needs of the managers.

Managerial accounting is defined as the process ofidentifying, measuring, analyzing, interpreting, and

communicating financial information to the manager/s for the

pursuit of an organizations goals. Managerial accounting

information includes the following:

Information on the costs of an organizations product and

service.

Budgets.


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Performance reports.

Other information which assist managers in their planning

and control activities.

Organizations, large or small have managers and that person is

responsible for making plans, resources, directing personnel,

and controlling operations. Basically, managers carry out three

major activities namely planning, directing and motivating,

controlling, and improving.

Cost is part in managerial accounting. Having a clear

perspective about it would help give a person better

understanding about the subject. A cost may be defined as the

sacrifice made, usually measured by the resources given up, to

achieve a particular purpose. Step in studying managerial

accounting is to gain an understanding of the various types of

costs incurred by organizations and how those costs are actively

managed.

Cost accumulation system or management in general is the

organized collection of cost data via a set of procedures or

systems. Cost classification is the grouping of all

manufacturing costs into various categories in order to meet the

needs of management.

A figure indicating the total cost of production provides

little useful information about a companys operations, since

the volume of production (and therefore cost) varies from period

to period. Thus, some common denominator, such as unit costs,

must be available in order to compare various volumes and costs.Unit cost figures can be readily computed by dividing the total

cost of goods manufactured by the number of units produced. Unit

costs are stated in the same terms of measurement used for units

of output, such as cost per ton, per gallon, per foot, per

assembly, and so on. This is where cost management implies.

Cost management is defined as "the establishment of programs

that regularly analyze purchase requirements and suppliers to

identify lowest total cost and maximize total value to the

company. The development of a savings forecast by commodity is

necessary to define budget parameters for building cost-of-goods

structures." When we say strategic cost management it is aboutscrutinizing every process within your organization, knocking

down departmental barriers, understanding your suppliers'

business, and helping improve their processes".

An expense is defined as the cost incurred when an asset is

used up or sold for the purpose of generating revenue. The

terms product cost and period cost are used to describe the


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timing with which various expenses are recognized, an important

issue in both managerial and financial accounting.

A product cost is a cost assigned to goods that were either

purchased or manufactured for resale. The product cost is used

to value the inventory of manufactured goods or merchandise

until the goods are sold. All costs that are not product costs

are called period costs and are recognized as expenses during

the time period as incurred.

All costs that are not product costs are called period

costs and are recognized as expenses during the time period as

incurred.

Mass customization has been defined as the ability to

design and manufacture customized products at mass production

efficiency and speed. Customization and mass customization are

often justified because different customers can give differentvalues to the same product.

Manufacturing is the use of machines, tools and labor

to produce goods for use or sale. The term may refer to a range

of human activity, from handicraft to high tech, but is most

commonly applied to industrial production, in which raw

materials are transformed into finished goods on a large scale.

Such finished goods may be used for manufacturing other, more

complex products, such as aircraft, household appliances or

automobiles, or sold to wholesalers, who in turn sell them to

retailers, who then sell them to end users the "consumers". Inmanufacturing, raw material is transformed with the help of

labor and machinery.

Manufacturing entails costs. Manufacturing cost is the

cumulative total of resources that are directly used in the

process of making various goods and products. In some formulas,

the cost of manufacturing includes the expenses associated with

the purchase of raw materials. At other times, the cost for raw

materials is excluded. In general, factors such as labor,

equipment operation, and the general overhead for maintaining

the production facility are common components that are includedin determining the overall manufacturing costs.

Since the goal of most production companies is to earn a

profit by selling goods manufactured and sold by the company,

paying close attention to the overall manufacturing

cost/manufacturing cost flow (direct materials, direct labor,

and manufacturing overhead) is extremely important. By


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monitoring the various elements that make up the cost for

manufacturing, it is possible to ensure that available resources

are being used to best advantage, and thus earning the highest

amount of return on each unit that is sold at the current price.

Multi-product firms have to account for costs that can be

tied to a product, direct costs. They also have to account for

indirect costs not directly measurable (e.g., electricity). A

'cost object' can be a product, service, process or any items

which management requires cost information. The way that costs

are assigned depends on their nature. A direct cost is easily

traceable with a high degree of accuracy and indirect, or

overhead, cost cannot be easily identifiable with a particular

object.

Product costs are costs allocated to a product; this is not

just physical products. All other costs are period costs. Such

costs are expenses to the income statement in the period theyare incurred. Product costs are recognized as an expense in the

income statement only when the product is sold. Prior to sale

the cost of products is shown as an asset (work in progress or

finished good) due to the accrual principle.

Following are the three broad elements of cost:

1. Material

The substance from which a product is made is known as

material. It may be in a raw or a manufactured state. It can bedirect as well as indirect.

a. Direct MaterialThe material which becomes an integral part of a

finished product and which can be conveniently assigned to

specific physical unit is termed as direct material. Following

are some of the examples of direct material:

o All material or components specifically purchased,produced or requisitioned from stores

o Primary packing material (e.g., carton, wrapping,cardboard, boxes etc.)

o Purchased or partly produced componentsDirect material is also described as process

material, prime cost material, production material, stores

material, constructional material etc.


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b.Indirect MaterialThe material which is used for purposes ancillary to

the business and which cannot be conveniently assigned to

specific physical units is termed as indirect material.

Consumable stores, oil and waste, printing and stationery

material etc. are some of the examples of indirect material.

Indirect material may be used in the factory, office

or the selling and distribution divisions.

2. Labor

For conversion of materials into finished goods, human

effort is needed and such human effort is called labor. Labor

can be direct as well as indirect.

a.Direct LaborThe labor which actively and directly takes part in

the production of a particular commodity is called direct labor.

Direct labor costs are, therefore, specifically and conveniently

traceable to specific products.

Direct labor can also be described as process labor,

productive labor, operating labor, etc.

b.Indirect LaborThe labor employed for the purpose of carrying out

tasks incidental to goods produced or services provided, is

indirect labor. Such labor does not alter the construction,

composition or condition of the product. It cannot be

practically traced to specific units of output. Wages of

storekeepers, foremen, timekeepers, directors fees, salaries of

salesmen etc, are examples of indirect labor costs.

Indirect labor may relate to the factory, the office

or the selling and distribution divisions.

3. Expenses

Expenses may be direct or indirect.

a.Direct Expenses


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These are the expenses that can be directly,

conveniently and wholly allocated to specific cost centers or

cost units. Examples of such expenses are as follows:

y Hire of some special machinery required for a particularcontract

y Cost of defective work incurred in connection with aparticular job or contract etc.

Direct expenses are sometimes also described as

chargeable expenses.

b.Indirect ExpensesThese are the expenses that cannot be directly,

conveniently and wholly allocated to cost centers or cost units.

Examples of such expenses are rent, lighting, insurance chargesetc.

4. Overhead

The term overhead includes indirect material, indirect

labor and indirect expenses. Thus, all indirect costs are

overheads.

A manufacturing organization can broadly be divided into

the following three divisions:

y Factory or works, where production is doney Office and administration, where routine as well as policy

matters are decided

y Selling and distribution, where products are sold andfinally dispatched to customers

Overheads may be incurred in a factory or office or

selling and distribution divisions. Thus, overheads may be of

three types:

a.Factory Overheads

They include the following things:

y Indirect material used in a factory such as lubricants,oil, consumable stores etc.

y Indirect labor such as gatekeeper, timekeeper, worksmanagers salary etc.


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y Indirect expenses such as factory rent, factory insurance,factory lighting etc.

b.Office and Administration OverheadsThey include the following things:

y Indirect materials used in an office such as printing andstationery material, brooms and dusters etc.

y Indirect labor such as salaries payable to office manager,office accountant, clerks, etc.

y Indirect expenses such as rent, insurance, lighting of theoffice.

c.Selling and Distribution OverheadsThey include the following things:

y Indirect materials used such as packingmaterial, printing and stationery material etc.

y Indirect labor such as salaries of salesmen andsales manager etc.

y Indirect expenses such as rent, insurance,advertising expenses etc.

The stages in the allocation of overheads to products are

as follows;

1) Identify overhead costs collected from production andservice cost centers and apportion as appropriate and

possible.

2) Once identified allocate to production departments.3) Allocate overheads to a single product by dividing the

number of products into the total overhead. The resulting

sum can then be applied as cost to the product.

Total Overheads of a Production Costs Centre ($s)/Level of

Activity (units)

Predetermined overhead absorption rates are estimates offuture expenditures. Estimates are used because some overhead

costs are not known for some time until after they have incurred

(e.g., electricity). Normal costing is where the cost object is

determined using the actual costs for the direct the direct

costs and a predetermined rate for the allocation of indirect

costs.


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Functional-based cost accounting classifies all costs as

either fixed or variable in relation to changes in the volume of

units produced.

Activity-based costing tries to capture changes in

technology by apportioning overheads to product costs taking

into account activity and transactions that drive the cost. An

activity cost pool is where the costs of an activity under the

ABC system are accumulated. Drives are factors that cause

changes in the use of resources. The focus in ABC is managing

activities instead of costs.

Absorption costing is where the cost of inventories is

determined in order to include an appropriate share of variable

and fixed costs. Fixed costs are allocated on the basis of

normal operating capacity. In variable costing, only the

production costs are used.

Using absorption costing, production overhead costs are

included as a product cost whereas in variable costing they are

treated as a period cost. This leads to different values of

inventory and therefore different net profit figures.

The difference in profits derived from the application of

the two methods can be reconciled by the following:

Fixed Overhead Absorption Rate x Movement of Inventories in a

period = Difference in Profits

Part II. Cost Management Systems, Activity-Based Costing, and

Activity-Based Management

Activity-based cost management is an accounting method used

by companies which allocates overhead costs for each activity

based on the specific circumstances of each activity. This is in

contrast to the common method of allocating costs based solely

on the hours spent manufacturing a product or catering to a

specific customer. The main advantage of activity-based cost

management is that it provides a truer representation of the

worth of each specific activity conducted by a business, thusreducing wasteful overhead costs. It can be a difficult process

to implement, but, used effectively, can save a company a

significant amount of money.

As a business grows, the costs of maintaining and operating

that business usually grow in kind. When these costs grow,

companies must have accounting practices in place to allocate


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the necessary funds for each specific business activity. These

activities can include either the manufacturing of a specific

product or the cultivation of a specific client. By using

activity-based cost management, a company can separate these

activities according to the actual costs incurred and their

importance in the company's operations.

For example, imagine a company that has to account for the

manufacturing of two specific products. Product A is produced at

low cost but at a high volume, meaning that a lot of hours are

spent on it. On the other hand, Product B is only rarely

produced, but it requires a great deal of technical expertise

and it costs the company a significant amount to produce a

single unit. A traditional accounting approach might allocate

more overhead to Product A based on the amount produced and the

time spent. Activity-based cost management would account for the

fact that Product B requires a much-more cost-intensive approach

and would allocate costs for it accordingly.

In the same manner, a company that serves clients in some

manner can also allocate costs accordingly based on activity-

based cost management. Imagine a law firm dealing with many

clients that pay less in retainer fees but require more man

hours of labor than a few high-paying clients that only call on

the firm in rare occasions. An activity-based approach would see

the worth of the higher-paying clients, since the man hours

spent serving them might not represent the costs associated with

that time.

Some companies shy away from activity-based cost management

because it can be a much more intricate process that simply

divvying up overhead based on the hours spent on an activity.

Several well-known international companies have benefitted from

this approach though, saving on overhead costs in the process.

Software programs devoted to activity-based allocation of costs

can make implementation the technique a bit easier.

Activity-Based Costing Sample Data:

Mode l Board Mode ll Board Mode lll BoardProduction: Units 10,000 20,000 4,000

Runs 1 run of 10,000 4 runs of 5,000 each 10 runs of 400 eachDirect Material:(raw boards and components) 50.00 90.00 20.00Direct Labor:(not including setup time) 3 hrs/board 4 hrs/board 2 hrs/boardSetup time 10 hrs/run 10 hrs/run 10 hrs/run


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Machine time 1 hr/board 1.25 hrs/board 2 hrs/board

Direct labor and setup labor costs is 20.00 per hour, including fringe benefits.

Product Cost,TVBPCS Mode l Board Mode ll Board Mode lll Board

Direct Marerial(raw boards , component) 50.00 90.00 20.00Direct Labor(not including setup time) 60.00(3hrat20) 80.00(4hrat20) 40.00(2hrat20)Manufacturing overhead 99.00(3hrat33) 132.00(4hrat33) 66.00(2hrat33)Total 209.00 302.00 126Calculation of predetermine overhead rate:

Budget manufacturing overhead 3,894,000Direct labor, budgeted hours:Made 1 10,000 units x 3 hours 30,000Mode ll 20,000 units x 4 hours 80,000

Mode lll 4,000 units x 2 hours 8,000Total direct labor hours 118,000 hrs

Activity-Based Cost Identification of Activity Cost Pools:Overhead Costs

Total budgeted cost 3,894,000

Activity Cost PoolsUnit Level Batch Level Product Sustaining Facility Level-Machinery -Setup -Engineering -Facility1,212,600 3,000 700,000 507,400

Receiving/Inspection-200,000Material handling-600,000Quality Assurance-421,000Packaging/shipping-250,000

Activity-Based Costing: Machinery Cost Pool

Stage 1 Various overhead costs Maintenance Lubricationrelated to machinery Depreciation Electricity

Computer Calibration

Activity cost pool Machinery cost poolTotal budgeted cost 1,212,600


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Stage 2Allocation to product lines Total budgetedBased on production of engineering cost = 700,000Engineering transaction

25% of 45% of 30% of

transactions transactions transactions

Cost assignment: Mode 1 Mode 2 Mode 3Cost allocated to each 25%x700,000 45%x700,000 30%x700,000Product line/number 10,000 unit 20,000units 4,000 unitsOf units of each product = 17.5 per unit = 15.75 per units =52.5 per unit

Activity-Based Costing: Facility Cost PoolStage 1Various overhead costs

Related to facilities Plant depreciation Property taxesand general operation Plant management InsurancePlant maintenance Security

Activity Cost Facility cost poolpool Total budgeted cost = 507,400

Stage 2Calculation of Total budgeted facilities cost 507,400pool rate Total budgeted direct labor hrs 118,000

= 4.30/direct-labor hr

Cost assignment: Mode 1 Mode 2 Mode 3Pool rate/direct-labor 4.30/direct-labor hr 4.30/direct-labor hr 4.30/direct-labor hrHr x Direct-labor hrs x 3 hr per unit x 4 hr per unit 2 hr per unitPer unit 12.9 per unit 17.2 per unit 8.60 per unit

Part III. Planning and Control

As business environments have become increasingly dynamic

and competitive, it has become increasingly important formanagers to develop coherent, internally and logically

consistent business strategies and to have tools and models

which provide useful information to support strategic decision-

making, planning and control. In response to these needs, there

have been many important developments, in both management

accounting research and practice that focus on the use of

accounting data and related information regarding strategy and


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operations for these purposes. Some of the most important

developments in strategic planning and control have been: (a)

the balanced scorecard, a comprehensive set of performance

measures designed to assist managers in implementing competitive

strategies and monitoring performance with respect to them (see

Kaplan and Norton 2000), (b) strategic variance/profitability

analysis, systems which decompose measures of budgeted versus

actual net income into variances which managers can relate

logically to a firm's or strategic business unit's (SBU's)

mission and business strategy and therefore use to analyze

performance from a strategic

perspective (Shank and Govindarajan 1993; Simons 2000), (c)

profit-linked performance measurement systems, models which

decompose measures of changes in profitability over time into

measures of changes in constructs such as productivity and price

recovery, which can be logically linked to a firm's/SBU's

mission and business strategy and analyzed from those

perspectives (American Productivity Center (APC; now theAmerican Productivity and Quality Center) 1981; Banker, Chang

and Majumdar 1993; Banker, Datar and Kaplan 1989; Banker and

Johnston 1989), and (d) levers of control, a comprehensive

framework for organizing and employing management control

systems to promote strategic objectives.

THE DESIGN OF STRATEGIC COST MANAGEMENT AND CONTROL SYSTEMS

If management accounting information systems are to be

useful for strategic purposes, that is, to help managers

increase the likelihood that they can achieve their strategicgoals and objectives, their designs and use must follow from

firms' missions and competitive strategies. In Porter's

framework, strategy should follow from an analysis of the

determinants of the nature and intensity of competition: the

firm's/SBU's bargaining over its consumers and suppliers,

threats from new entrants and substitute products (barriers to

entry and exit), and the intensity of rivalry in product

markets. To generate a sustainable competitive advantage, a

strategy must: (a) establish a unique market position based on

low cost leadership, product differentiation, or a workable

combination of the two, with an appropriate scope of markets(broad or focused/niche); (b) be differentiated from

competitors' strategies, through unique product variety, ability

to satisfy customer needs, and/or access to particular customer

segments; and (iii) employ chains of complementary, value-adding

activities which are difficult for competitors to replicate.

The chosen strategy, in turn: (1) determines the SBU's critical

success factors, such as delivering superior product and service


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quality and achieving high price recovery for SBUs pursuing

differentiation strategies, or achieving economies of scale,

improving productivity and delivering threshold product and

service quality at low prices for SBUs pursuing low cost

leadership strategies, and (2) informs choices regarding the

design of products and configuration of operations which drive

costs and revenues. For a set of performance measures to exhibit

content validity in a strategic context, then, it must measure

constructs related to the mission and strategic framework, the

selected strategies, the firm's/SBUs' critical success factors,

and operating choice variables.

In addition, the constructs, and their measures, must be

causally linked. Performance measurement systems should

explicitly incorporate models of profit-generating processes,

so, when managers take actions the models suggest will improve

performance along one or more dimensions, the intended

improvements are likely to materialize. Thus, the models shouldincorporate relationships over time as well as contemporaneous

relationships and linkages capturing cause-and-effect

relationships between constructs and measures of performance

throughout the firm (horizontally and vertically; aggregated to

disaggregated; across the entire value chain). Finally, the

measures should also have 'good' theoretical and empirical

measurement properties (see, for example, Johnston and Banker

2000a,b).

STRATEGIC VARIANCE ANALYSIS

Shank and Govindarajan (1993) decompose profit variances

into mutually exclusive, collectively exhaustive sets of

variances which capture the separate impacts of key underlying

causal factors, for example, deviations between actual and

budgeted sales volumes and mixes, market sizes and shares,

manufacturing costs, contribution margins, and discretionary

costs. Conceptualizing mission in terms of profitability and a

build, hold or harvest perspective and strategy in terms of low

cost leadership or product differentiation, Shank and

Govindarajan show that, by analyzing the variances with explicit

reference to a firm's/SBU's mission and business strategy, theycan determine the extent to which deviations between actual and

budgeted performance are or are not consistent with the mission

and strategy and identify specific dimensions of performance

which need improvement. Analyzing the variances without

reference to mission and strategy can be uninformative or

misleading.

Simons (2000) decomposes profit variances into


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effectiveness variances (market size, market share, selling

prices, and product volume and mix variances) and efficiency

variances (materials and labor price and efficiency,

discretionary and committed cost spending variances, and/or

activity-based cost variances). Simons points out that

effectiveness variances are of particular importance to business

units pursuing differentiation strategies and efficiency

variances to units pursuing low cost, high volume strategies.

PROFIT-LINKED PERFORMANCE MEASUREMENT SYSTEMS

Profit-linked models decompose measures of return-on-

investment and net income into measures of productivity, price

recovery, capacity utilization, and other managerially relevant

dimensions of performance. Practitioners led the development

efforts, with models which decompose measures of profitability

into measures of productivity and price recovery (APC 1981;

Miller 1984, 1987). Academics have contributed by refining andextending the models from the perspectives of management

accounting, business strategy and the economic theory of

production, showing how the models can be used to analyze cross-

sectional differences and time-series changes in performance in

the context of changing competitive environments and strategies,

and examining the measures' mathematical, economic and empirical

properties (see, for example: Banker, Chang and Majumdar 1993,

1996; Banker, Datar and Kaplan 1989; Banker and Johnston 1989;

Grifell-Tatj and Lovell 1999; Johnston and Banker 2000a,b).

COST ESTIMATIONCost estimation is the determination of cost behavior in a

way of analyzing historical data concerning costs and activity

levels.

Diagram:

Cost estimation Cost behavior Cost prediction

The process of The relationship Using knowledgedetermining between cost and of cost behavior tocost behavior. activity. Forecast the level

of Cost at a particularOften focuses on level of activity.historical data. Focus is on the

future.

Cost Behavior Patterns is also called cost functions.

y Variable Costs change in total in direct proportion to a


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change in activity level. As the activity level changes,

total variable cost increase in direct proportion to the

change in activity level but the variable cost per unit

remains constant.

yStep-Variable Costs a nearly variable cost that increasein small step instead of continuously and usually include

inputs that are purchased and used in relatively small

increment.

y Fixed Costs remain unchanged in total as the activitylevel varies. As the activity level increases, total fixed

cost does not change but unit fixed cost declines.

y Step-Fixed Costs some cost remain fixed over a wide rangeof activity but jump to a different amount for the activity

levels outside that range.

y Semi-variable Cost a mixed cost that has both a fixed anda variable component.

y Engineered Cost bears a definitive physical relationshipto the activity measure.

y Committed Cost result from an organizations ownership oruse of facilities and its basic organization structure.

y Discretionary Cost arises as a result of a managementdecision to spend a particular amount of money for some

purpose.

Using Cost Behavior Patterns to Predict Costs:

A sales forecast is made for each month during the budget year.Cost Item Cost Prediction

(15,000 dozen of items per month)Direct material 12,500Direct labor 10,000

Overhead: Facilities Costs 30,000Indirect labor 15,000Delivery trucks 6,000Utilities 2,500


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SHIFTING COST STRUCTURE IN THE CONTEMPORARY MANUFACTURING

ENVIRONMENT

Fixed costs are becoming more prevalent in many industries

due to two factors such as: Automation is replacing labor to an

increasing extent and labor unions have been increasingly

successful in negotiating agreements that result in a relatively

stable workforce. This makes management less flexible in

adjusting a firms workforce to the desired level of production.

Advanced manufacturing environment is emerging and costs

were largely variable have become fixed, most becoming committed

fixed costs.

COST BEHAVIOR IN THE INDUSTRIES:

In manufacturing firms, production quantity, direct

labor hours and machine hours are common cost drivers. Direct

material and direct labor costs are usually considered variable

costs. Other variable costs include some manufacturing over headcost such as indirect material and indirect labor. Fixed

manufacturing costs are generally the cost of creating

production capacity.

In merchandising firms, the activity base is sales

revenue. The cost of merchandise sold is a variable cost. Most

labor costs are fixed or step-fixed costs.

Cost behavior in one industry is not necessarily

transferable to another industry.

COST ESTIMATION

- is the process of determining how a particular costbehaves.

Cost Estimation Methods

y Account-Classification Method of cost is also calledaccount analysis involves a careful examination of the

organization ledger accounts.

y Visual-Fit Method - The cost is semi-variable or analysthas no clear idea about the behavior of a cost item, it is

helpful to use this method to plot recent observations of

the cost at various activity levels. Historical data forthe companys utility cost is the basis to help visualize

the relationship between cost and level of activity to be

presented in scatter diagram.


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Sample diagram:

Companys utility costs: (per dozen)

Month Utility cost/month Items sold/month

January 5,100 75,000

February 5,300 78,000

March 5,650 80,000

April 6,300 92,000

May 6,400 98,000

June 6,700 108,000

July 7,035 118,000

August 7,000 112,000

September 6,200 95,000

October 6,100 90,000

November 5,600 85,000

December 5,900 90,000

HIGH LOW METHOD

Semi-variable cost approximation is computed using exactly

two data points. Its activity levels are chosen from the

available data set. The associated cost levels are used to

compute the variable and fixed cost components as follows:

Difference between the costs correspondingVariable cost of items = to the highest and lowest activity levels

(by dozen) Difference between the highestand lowest activity levels

= 7,035 5,100 = 1,935118,000 75,000 = 43,000

= .045 per dozen

ENGINEERING METHOD OF COST ESTIMATION

-A completely different method of cost estimation is to

study the process that results in cost incurrence and called as

engineering method of cost estimation. In a manufacturing firm,

a detailed study is made of the production technology,

materials, and labor used in the manufacturing process rather

than asking what the cost of material was last period. The

engineering approach is to ask how much material should beneeded and how much it should cost.

COST-VOLUME-PROFIT ANALYSIS

Examines the behavior of total revenues, total costs, and

operating income as changes occur in the output level, selling

price, variable costs or fixed costs.


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Assumptions of CVP Analysis:

y revenues change in relation to production and salesy costs can be divided in variable and fixed categoriesy revenues and costs behave in a linear fashiony costs and prices are knowny if more than one product exists, the sales mix is constanty we can ignore the time value of money

CONTRIBUTION MARGIN

Contribution margin is equal to the difference between

total revenue and total variable costs.

Contribution margin per unit

Selling price - Variable cost per unit

Contribution margin percentage

Contribution margin per unit / selling price per unit

Total forPer Unit 2 units %

Revenue $200 $400 100%Variable costs 120 240 60%Contribution margin $80 $160 40%

CONTRIBUTION MARGIN INCOME STATEMENT

Income statement that groups line items by cost behavior to

highlight the contribution margin.

Packages Sold0 1 2 25 40

Revenue $0 $200 $400 $5,000 $8,000Variable costs 0 120 240 3,000 4,800Contribution margin 0 80 160 2,000 3,200Fixed costs 2,000 2,000 2,000 2,000 2,000Operating income $(2,000) $(1,920) $(1,840) $0 $1,200

BREAK-EVEN POINT

y Quantity of output where total revenues equal total costs.y Point where operating income equals zero.

Breakeven point in units Breakeven point in dollars=Fixed costs / Contribution margin per unit =Fixed costs / contribution margin %=$2,000 / $80 =$2,000 / 40%= 25 units = $5,000


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COST-VOLUME-PROFIT GRAPH

TARGET OPERATING INCOMEFor most firms in the private sector, the main objective is not to breakeven

Convert after-tax desired net income to its before-tax equivalent operating income

Target operating income:=Target net income / (1 - tax rate)

Target Unit Sales:= (Fixed costs + Target operating income)

/ Contribution margin per unit

Target Dollar Sales:= (Fixed costs + Target operating income)

/ Contribution margin %

SENSITIVITY ANALYSIS

y sensitivity analysis is a what-if technique that examineshow a result will change if the original predicted data are

not achieved or if an underlying assumption changes

y What will happen to operating income if volume declines by5%?

y What will happen to operating income if variable costsincrease by 10% per unit?


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y sensitivity analysis broadens managements perspectivesabout possible outcomes

CVP helps managers assess the risks and potential benefits

of adopting alternative cost structures.

Example: Alternative rental arrangements

REVENUE MIX

Revenue mix (or sales mix) is the relative combination of

quantities of products or services that make up total revenue.

Ex:

Sales mix of Do-All : Superword = 2 : 1

Breakeven point in units

= 30 units 20 units of Do-All

10 units of Superword

MULTIPLE COST DRIVERS

In many cases there may be multiple cost drivers.

Do-All Software Example

Variable costs: $40 per software package sold$15 per invoice issued

Operating income= Revenue ($40 x packages sold) ($15 x invoices issued) Fixed costs


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In cases where there are multiple cost drivers there are

multiple breakeven points.

CONTRIBUTION MARGIN & GROSS MARGIN

Merchandising Sector

Manufacturing Sector

DECISION MODELS AND UNCERTAINTY

y Managers make predictions and decisions in a world ofuncertainty.

y Estimate events that are likely to occur and assignprobabilities to each outcome.

y Probability distribution describes the likelihood of eachmutually exclusive and collectively exhaustive set of

events (must add to 1.00).

y Expected value is a weighted average of the outcomes withthe probability of each outcome serving as the weight.

Contribution Margin Format

Revenues $200Variable costs:Cost of goods sold $120Other variable 43 163Contribution margin 37Fixed costs:Cost of goods sold 5

Other fixed 19 24Operating income $13

Gross Margin FormatRevenues $200Cost of goods sold (120+5) 125Gross margin 75Operating costs (43+19) 62Operating income $13

Contribution Margin Format

Revenues $1,000Variable costs:Manufacturing $250

Non-manufacturing 270 520Contribution margin 480Fixed costs:Manufacturing 160Non-manufacturing 138 298O eratin income 182

Gross Margin Format

Revenues $1,000

Cost of goods sold (250+160) 410Gross margin 590Non-manufacturing (270+138) 408Operating income $182


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Uncertainty Example

Proposal A: Spy Novel

Expected value= (0.1x$300,000) + (.02x$350,000) + (.04x$400,000) + (0.2x$450,000) + (0.1x$500,000)= $400,000

RESPONSIBILITY ACCOUNTING

Responsibility accounting is an underlying concept of

accounting performance measurement systems. The basic idea is

that large diversified organizations are difficult, if not

impossible to manage as a single segment, thus they must be

decentralized or separated into manageable parts. These parts or

segments are referred to as responsibility centers that include:

1) revenue centers, 2) cost centers, 3) profit centers and 4)

investment centers. This approach allows responsibility to be

assigned to the segment managers that have the greatest amount

of influence over the key elements to be managed. These elementsinclude revenue for a revenue center (a segment that mainly

generates revenue with relatively little costs), costs for a

cost center (a segment that generates costs, but no revenue), a

measure of profitability for a profit center (a segment that

generates both revenue and costs) and return on investment (ROI)

for an investment center (a segment such as a division of a

company where the manager controls the acquisition and

utilization of assets, as well as revenue and costs).

Controllability Concept

An underlying concept of responsibility accounting is

referred to as controllability. Conceptually, a manager should

only be held responsible for those aspects of performance that

he or she can control. In my view, this concept is rarely, if

ever, applied successfully in practice because of the system

variation present in all systems. Attempts to apply the

controllability concept produce responsibility reports where


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each layer of management is held responsible for all subordinate

management layers as illustrated below.

Advantages and Disadvantages

Responsibility accounting has been an accepted part of

traditional accounting control systems for many years because it

provides an organization with a number of advantages. Perhaps

the most compelling argument for the responsibility accounting

approach is that it provides a way to manage an organization

that would otherwise be unmanageable. In addition, assigning

responsibility to lower level managers allows higher level

managers to pursue other activities such as long term planning

and policy making. It also provides a way to motivate lower

level managers and workers. Managers and workers in an

individualistic system tend to be motivated by measurements thatemphasize their individual performances. However, this emphasis

on the performance of individuals and individual segments

creates what some critics refer to as the "stovepipe

organization." Others have used the term "functional silos" to

describe the same idea. Consider 9-6 Exhibit below. Information

flows vertically, rather than horizontally. Individuals in the

various segments and functional areas are separated and tend to


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ignore the interdependencies within the organization. Segment

managers and individual workers within segments tend to compete

to optimize their own performance measurements rather than

working together to optimize the performance of the system.

Summary and Controversial Question

An implicit assumption of responsibility accounting is that

separating a company into responsibility centers that are

controlled in a top down manner is the way to optimize the

system. However, this separation inevitably fails to consider

many of the interdependencies within the organization. Ignoring

the interdependencies prevents teamwork and creates the need for

buffers such as additional inventory, workers, managers and

capacity. Of course, a system that prevents teamwork and creates

excess is inconsistent with the lean enterprise concepts ofjust-in-time and the theory of constraints. For this reason,

critics of traditional accounting control systems advocate

managing the system as a whole to eliminate the need for buffers

and excess. They also argue that companies need to develop

process oriented learning support systems, not financial

results, fear oriented control systems. The information system

needs to reveal the company's problems and constraints in a


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timely manner and at a disaggregated level so that empowered

users can identify how to correct problems, remove constraints

and improve the process. According to these critics, accounting

control information does not qualify in any of these categories

because it is not timely, disaggregated, or user friendly.

This harsh criticism of accounting control information leads us

to a very important controversial question. Can a company

successfully implement just-in-time and other continuous

improvement concepts while retaining a traditional

responsibility accounting control system? Although the jury is

still out on this question, a number of field research studies

indicate that accounting based controls are playing a decreasing

role in companies that adopt the lean enterprise concepts. In a

recent study involving nine companies, each company answered

this controversial question in a different way by using a

different mix of process oriented versus results oriented

learning and control information. Since each company isdifferent, a generalized answer to this question for all firms

in all situations cannot be provided.

Part IV. Using Accounting Information in Decision Making

The Managerial Accountants Role in Decision Making

Managerial Accountant

Designs and implements Cross-functional managementaccounting information teams who make production,system marketing and finance decisions

Make substantive economicdecisions affecting operations

Steps in the Decision-Making Process1.Clarify the decision problem

- The decision to be made is clear.

Accept or Reject is the decision problem

2.Specify the criterion- Once a decision problem has been clarified, the

manager should specify the criterion upon which a decision will

be made. Determining the objective of the decision


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3.Identify the alternatives- A decision involves selecting between two or more

alternatives. Determining the possible alternatives is a

critical step in the decision process

IDENTIFYING RELEVANT COSTS AND BENEFITS:

Sunk Costs are costs that have already been incurred. They

do not affect any future cost and cannot be changed by any

current or future action. Sunk costs are irrelevant to

decisions.

Example:

Book Value of Equipment that has a three year old used

to transport product from production area to storage room. The

book value of the equipment defined as the assets acquisition

cost less the accumulated depreciation to date.

Acquisition cost of older equipment-----100,000.00

Less: Accumulated depreciation----------75,000.00

Book value------------------------------25,000.00

==========

A decision to take since old equipment has one year useful life

with excessive additional variable cost. The decision is about

the replacement of the old equipment. It could be sold to 20% of

its useful life and annual cost- 80,000.

The new kind of equipment is much cheaper than the old and

cost less to operate. However, the new equipment would be

operable for only one year before it would need to be replaced.

The pertinent data of new equipment are:

Acquisition cost-----------------15,000.00

Useful life---------------------- 1 year

Salvage value after one year----- 0

Annual depreciation--------------15,000.00

Annual operating costs-----------45,000.00


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Equipment Replacement Decision: Worldwide Airways

Cost of Two Alternatives(a) (b) (c)

Do not replace Replace Differential

(Sunk Cost) old equipment old equip. costDepreciation (old) 25,000Write-off book value 25,000 0

(Relevant Data)Proceed from disposal 0 (5000) 5000Depreciation (cost) new 0 15,000 (15,000)Operating costs 80,000 45,000 35,000

Total 105,000 80,000 25,000======= ====== ========

Obsolete Inventory Decision: Worldwide Airways

Cost of Two Alternatives(a) (b) (c)

Modify and Dispose of Differential(Sunk Cost) use parts Parts cost

Asset value written off 20,000 20,000 0(Relevant Data)

Proceed from disposal 0 (17,000) 17,000Cost of modify parts 12,000 0 12,000Cost to buy new parts 0 26,000 (26,000)Total 32,000 29,000 3,000

======= ======= =======

Analysis of Special Decisions:

a. Accept or Reject a Special Offer

b. Outsource a Product or Service

c. Add or Drop a Service, Product, or Department

d. Joint Products: Sell or Process Further

Manager in all organizations periodically face major

decisions that involve cash flows over several years. Decisionsinvolving the acquisition of machinery, vehicles, buildings, or

land are examples of such decisions. Other examples include

decisions involving significant changes in a production process

or adding a major new line of products or service to the

organizations activities.

Capital-budgeting decision is a decisions involving


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cash inflows and outflows beyond the current year.

Type:

1. Acceptance-or-Rejection Decisions: managers mustdecide whether they should undertake a particular

capital investment project. In such a decision,

the required funds are available or readily

obtainable and management must decide whether the

project is worthwhile.

2. Capital-Rationing Decision: managers must decidewhich of several worthwhile projects makes the

best use of limited investment funds.

Aspect of Capital Expenditure Decision:

y Discounted-Cash-Flow Analysisa method of evaluating an investment by estimating

future cash flows and taking into consideration the

time value of money, also called capitalization of

income.

Steps in constituting net-present-value analysis:

1. Prepare a table showing the cash flows during each yearof the proposed investment.

2. Compute the present value of each cash flow, using adiscount rate that reflects the cost of acquiring

investment capital.

3. Compute the net present value, which is the sum of thepresent values of the cash flows.

4. If the net present value is equal to or greater thanzero, accept the investment proposal.

ANALYTICAL TECHNIQUE:

Discounted-Cash-Flow Analysis

The managerial accountant or controller of Mountain

view Hotel routinely advises the mayor and city council on major

capital-investment decisions. Currently under consideration in

the purchase of a new street cleaner, the controller has

estimated that the citys old street-cleaning machine would lastanother five years. A new street cleaner, which also would last

for five years, can be purchased for $50,470. It would cost the

city $14,000 less each year to operate the new equipment than it

costs to operate the old machine. The expected cost savings with

the new machine are due to lower expected maintenance costs.

Thus, the sew street cleaner will cost $50,470 and save $70,000

over its five-year life. ($70,000= 5 X $14,000 savings per


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year). Since the $70,000 in cost savings exceeds the $50,470

acquisition cost, one might be tempted to conclude that the new

machine should be purchased. However, this analysis is flawed,

since it does not account for the time value of money. The

$50,470 acquisition cost will occur now, but the cost savings

are spread over a five years period. It is a mistake to add cash

flowsoccurring at different points in time.Method:

Net-Present-Value Method

Mountainview City Government

Step 1 Time 0 Time 1 Time 2 Time 3 Time 4 Time 5

Acquisition cost $(50,470)

Annual cost saving $14 k $14 K $ 14 k $ 14 k $ 14 k

Step 2 Present value of annuity=$14,000 (3.791)

Annuity discount factor for r=.10 n=5

Present value $(50,470) $53,074

Step 3 Net present value $2,604Step 4 Accept proposal, since net present value is positive

INTERNAL-RATE-OF-RETURN METHOD

- It is an alternative discounted-cash-flow method for

analyzing investment proposals.

Internal rate of return or Time-adjusted rate of

return of an asset is the true economic return earned by the

asset over its life. An assets internal rate of return is the

discount rate that would be required in a net-present-value

analysis in order for the assets net present value to beexactly zero.

The higher the discount rate used in a net-present-

valueanalysis, the lower the present value of all future cashflows will be.

Finding the internal rate of return for the investment

proposal:

- It could be a trial and error presenting with a

different discount rates until to yields a zero net-present-

value.

where r=IRR (Internal Rate of Return)

IRR of an annuity:


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where:

Q (n,r) is the discount factor

Io is the initial outlay

C is the uniform annual receipt (C1 = C2 =....= Cn).

Example 1:

What is the IRR of an equal annual income of $20 per annum which

accrues for 7 years and costs $120?

= 6

From the tables = 4%

Economic rationale for IRR:

If IRR exceeds cost of capital, project is worthwhile, i.e. itis profitable to undertake.

Example 2:

r

10% : ( 3.791 ) ($14,000 ) - $ 50,470 = $2,604 Yields a positive NPV12% : ( 3.605 ) ($14,000 ) - $ 50,470 = $ 0 Yields a zero NPV

14% : ( 3.433 ) ($14,000 ) - $50,470 = $(2,408) Yields a negative NPV

Cash-Inflows in 5 years timeTime 0 1 2 3 4 5

cash flow $(50,470) $14,000 $14,000 $14,000 $14,000 $14,000

Initial cash outflow(acquisition cost) Equal cash inflow

( Operating CostSaving)

A cash flows exhibit a very special pattern, the rate of

return is determined in two steps:

1. Divide the initial cash outflow by the equivalentannual cash inflows.

$50,470 / 14,000= 3.605 equal to Annuity discount factor

2. Refer to the above table.

N=5 10% 12% 14%3.791 3.605 3.433


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Recovery of Investment

- Provide benefits in the future such as expected

future operating-cost saving.

- Expected future benefits must be sufficient for the

purchaser to recover the investment and earn a return on the

investment equal to or greater than the cost of acquiring

capital.

Mountainview City Gorvernment

Purchase of Street Cleaner(r=.12 n=5)

1 2 3 4 51.) unrecovered investment

at beginning of year ----------------------- 50,470 42,526 33,629 23,664 12,504

2.) Cost saving during year------------------------- 14,000 14,000 14,000 14,000 14,000

3.) Return on unrecovered 6,056 5,103 4,035 2,840 1,500investment 12% x amount in row 1

4.) Recovery of investment 7,944 8,897 9,965 11,160 12,500during year raw 2 amount minus row 3 amount

5.) Unrecovered investment at 42,526 33,629 23,664 12,504 4*end of year raw 1 amount minus row 4 amount

*There is an unrecovered investment of $4 because of accumulated

rounding errors in the table. If it had carried out each numberto cents, the table would have finished up with an unrecovered

investment of zero.

Comparing the NPV and IRR

Net-Present-Value:

1. Compute the investment proposals net present valueusing the organizations hurdle rate as the

discount rate.

2. Accept the investment proposal if its net presentvalue is equal to or greater than zero, otherwisereject it.

Internal-Rate of Return:

1. Compute the investment proposals internal rate ofreturn which is the discount rate that yields a zero

net present value for the project.

2. Accept the investment proposal it its internal rate of


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return is equal to or greater than the organizations

hurdle rate, otherwise reject it.

PROFIT MAXIMIZATION

In economics, profit maximization is the process by which a

firm determines the price and output level that returns the

greatest profit. There are several approaches to this problem.

The total revenue -- total cost method relies on the fact that

profit equals revenue minus cost, and the marginal revenue --

marginal cost method is based on the fact that total profit in a

perfect market reaches its maximum point where marginal revenue

equals marginal cost.

Basic Definitions

Any costs incurred by a firm may be classed into two

groups: fixed cost and variable cost. Fixed costs are incurred

by the business at any level of output, including none. Thesemay include equipment maintenance, rent, wages, and general

upkeep. Variable costs change with the level of output,

increasing as more product is generated. Materials consumed

during production often have the largest impact on this

category. Fixed cost and variable cost, combined, equal total

cost.

Revenue is the total amount of money that flows into the

firm. This can be from any source, including product sales,

government subsidies, venture capital and personal funds.

Average cost and revenue are defined as the total cost or

revenue divided by the amount of units output. For instance, if

a firm produced 400 units at a cost of 20000 USD, the average

cost would be 50 USD.

Marginal cost and revenue, depending on whether the

calculus approach is taken or not, are defined as either the

change in cost or revenue as each additional unit is produced,

or the derivative of cost or revenue with respect to quantity

output. For instance, taking the first definition, if it costs a

firm 400 USD to produce 5 units and 480 USD to produce 6, themarginal cost of the sixth unit is approximately 80 dollars,

although this is more accurately stated as the marginal cost of

the 5.5th unit due to linear interpolation. Calculus is capable

of providing more accurate answers if regression equations can

be provided.


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Total Cost-Total Revenue Method

To obtain the profit maximizing output quantity, we start

by recognizing that profit is equal to total revenue minus total

cost. Given a table of costs and revenues at each quantity, we

can either compute equations or plot the data directly on a

graph. Finding the profit-maximizing output is as simple as

finding the output at which profit reaches its maximum. That is

represented by output Q in the diagram.

There are two graphical

ways of determining that Q is

optimal. Firstly, we see that

the profit curve is at its

maximum at this point (A).

Secondly, we see that at the

point (B) that the tangent on

the total cost curve (TC) isparallel to the total revenue

curve (TR), the surplus of

revenue net of costs (B,C) is

the greatest. Because total

revenue minus total costs is

equal to profit, the line

segment C,B is equal in

length to the line segment

A,Q.

Computing the price at which to sell the product requiresknowledge of the firm's demand curve. The price at which

quantity demanded equals profit-maximizing output is the optimum

price to sell the product.

Marginal Cost-Marginal Revenue Method

If total revenue and total cost figures are difficult to

procure, this method may also be used. For each unit sold,

marginal profit equals marginal revenue minus marginal cost.

Then, if marginal revenue is greater than marginal cost,

marginal profit is positive, and if marginal revenue is lessthan marginal cost, marginal profit is negative. When marginal

revenue equals marginal cost, marginal profit is zero. Since

total profit increases when marginal profit is positive and

total profit decreases when marginal profit is negative, it must

reach a maximum where marginal profit is zero - or where

marginal cost equals marginal revenue. This intersection of

marginal revenue (MR) with marginal costs (MC) is shown in the


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next diagram as point A. If the industry is competitive (as is

assumed in the diagram), the firm faces a demand curve (D) that

is identical to its Marginal revenue curve (MR), and this is a

horizontal line at a price determined by industry supply and

demand. Average total costs are reprsented by curve ATC. Total

economic profits are represented by area P,A,B,C. The optimum

quantity (Q) is the same as the optimum quantity (Q) in the

first diagram.

Profit Maximization - The Marginal Approach

If the firm is operating in a non-competitive market, minor

changes would have to be made to the diagrams.

Modes of Operation

It is assumed that all firms are following rational

decision-making, and will produce at the profit-maximizing

output. Given this assumption, there are four categories in

which a firm's profit may be considered.

A firm is said to be making an economic profit when its

average total cost is greater than the price of the product at

the profit-maximizing output. The economic profit is equal to

the quantity output multiplied by the difference between the

average total cost and the price.

A firm is said to be making a normal profit when its

economic profit equals zero. This occurs where average total

cost equals price at the profit-maximizing output.

If the price is between average total cost and average

variable cost at the profit-maximizing output, then the firm is


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said to be in a loss-minimizing condition. The firm should still

continue to produce, however, since its loss would be larger if

it was to stop producing. By continuing production, the firm can

offset at least its fixed cost and part of its variable cost,

but by stopping completely they would lose equivalent to their

fixed cost.

If the price is below average variable cost at the profit-

maximizing output, the firm is said to be in shutdown. Losses

are minimized by not producing at all, since any production

would not generate returns significant enough to offset any

fixed cost and part of the variable cost. By not producing, the

firm loses only its fixed cost.

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