Management accounting 2 summary

CH 1.

Management accounting
Info provider to management
Analytical investigations of business engine
Figures do not speak for themselves, its the interpretation that counts

Accounting discipline overview

Managerial accounting (controller) measures, analyzes and reports financial and
nonfinancial information to help managers make decisions to fulfill organizational goals.
Managerial accounting need not to be IFRS compliant.
Financial accounting (accountant) focus on reporting to external users including investors,
creditors, and governmental agencies. Financial statements must be IFRS compliant.

MAC vs. FAC

Management accounting and value chain

Value chain is the sequence off business functions in which customer usefulness (value) is
added to products or services
The value-chain consists of:
1. Research & Development
2. Design
3. Production
4. Marketing
5. Distribution
6. Customer service
Production and distribution is referred to as the supply chain

Exercise value chain

Burger king, a hamburger fast food restaurant, incurs the following costs. Classify each of the cost
items as one of the business functions of the value chain.
Cost of oil for the deep fryer production
Cost of childrens toys given away free with kids meals marketing
Cost of to-go bags customer service
Costs of frozen onion production
Salaries of the food specialists who create new sandwiches for the restaurant chain R & D
Decision making
1. Identify problem and uncertainties
2. Obtain information
3. Make predictions about the future
4. Make decision by choosing among alternatives
5. Implement, evaluate and learn

Exercise decision making

Mr. Brook decides to buy the paint sprayers rather than hire additional painters make
decisions by choosing among alternatives.
Mr. Brook discusses with his employees the possibility of using paint sprayers instead of hand
painting to increase productivity and thus profits identify the problem and uncertainties
Mr. Brook learns of a large potential job that is about to go out for bids obtain information
and/or make predictions about the future
Mr. Brook compares the expected cost of buying sprayers to the expected cost of hiring more
workers who paint by hand and estimates profits from both alternatives obtain
information and/or make predictions about the future
Mr. Brook estimates that using sprayers will reduce painting time by 20% make predictions
about the future
Mr. Brook researches the price of paint sprayers online obtain information

Management accounting guidelines

Cost-benefit approach
Behavioral and technical considerations
Different costs for different purposes

Professional ethics
The four standards of ethical conduct for management accountants as advanced by the Institute of
Management accountants:
Competence
Confidentiality
Integrity
Objectivity

CH 2.

Actual cost vs. budgeted cost

Direct costs (tracking) vs. indirect costs (allocation)
Variable costs vs. fixed costs
Total costs vs. unit costs
Inventoriable costs vs. period costs
Prime costs vs. conversion costs

Direct & indirect costs

Direct costs can be conveniently and economically traced (tracked) to a cost object
Indirect costs cannot be conveniently or economically traced (tracked) to a cost object.
Instead of being traced, these costs are allocated to a cost object in a rational (but artificial)
and systematic manner
Factors affecting direct/indirect cost classification
The materiality of cost in question
Availability of information-gathering technology
Design of operations

Variable & fix costs

Variable costs changes in total in proportion to changes in the related level of activity or
volume
Fixed costs remain unchanged in total regardless of changes in the related level of activity
or volume
Costs are fixed or variable only with respect to a specific activity or a given time period

Cost behavior visualized

Other cost concepts
Cost driver a variable that causally affects costs over a given time span
Relevant range the band of normal activity level (or volume) in which there is a specific
relationship between the level of activity (or volume) and a given cost
- For example, fixed costs are considered fixed only within the relevant range

Relevant range visualized

Multiple classification of costs

Costs may be classified as:
- Direct/indirect, and
- Variable/fixed
These multiple classifications give rise to important cost combinations:
- Direct & variable
- Direct & fixed
- Indirect & variable
- Indirect & fixed
Multiple classification of costs, visualized

Different types of firms

Manufacturing-sector companies create and sell their own products
Merchandising-sector companies product resellers
Service-sector companies provide services (intangible products)

Types of manufacturing inventories

Direct materials resources in-stock and available for use
Work-in-process (or progress) products started but not yet completed. Often abbreviated as
WIP
Finished goods products completed and ready for sale

Types of product costs

Also known as Inventoriable costs
- Direct materials
- Direct labor
- Indirect manufacturing factory costs that are not traceable to the product. Other
common names for this type of cost include manufacturing overhead costs or factory
overhead costs

Accounting distinction between costs

Inventoriable costs product manufacturing costs. These costs are capitalized as assets
(inventory) until they are sold and transferred to cost of goods sold
Period costs have no future value and are expensed as incurred

Cost flows
The cost of goods manufactured and the cost of goods sold section of the income statement are
accounting representations of the actual flow of costs through a production system.
Note the importance of inventory accounts in the following accounting reports, and in the
cost flow chart
Cost flows visualized

Cost of goods manufactured

Multiple-step income statement

Inventoriable vs. period costs

Inventoriable costs are capitalized as assets (inventory) until they are sold and transferred
to cost of goods sold
- Direct material inventory
- Work-in-process inventory
- Finished goods inventory
Period costs have no future value and are expensed as incurred

Prime vs. conversion costs

Prime cost = Direct material costs + direct manufacturing labor
Conversion cost = direct manufacturing labor + manufacturing overhead costs
Overtime labor costs and idle time costs are considered part of manufacturing overhead costs

CH 12.

Strategy
Strategy specifies how an organization matches its own capabilities with the opportunities in
the marketplace to accomplish its objectives(LT Plan)

Basic business strategies

Product differentiation an organizations ability to offer products or services perceived by
its customers to be superior and unique relative to the products or services of its competitors
- Leads to brand loyalty and the willingness of customers to pay high prices
Cost leadership an organizations ability to achieve lower costs relative to competitors
through productivity and efficiency improvements, elimination of waste, and tight cost
control
- Leads to lower selling prices
Strategy
A thorough understanding of the industry is critical to implementing a successful strategy
Five aspects of industry analysis (Michael Porters 5 forces analysis)
1. Number and strength of competitors
2. Potential entrants to the market
3. Availability of equivalent products
4. Bargaining power of customers
5. Bargaining power of input suppliers

Implementation of strategy
Many companies have introduced a balanced scorecard to manage the implementation of
their strategies

The balanced scorecard

The balanced scorecard translates an organizations mission and strategy into a set of
performance measures that provides the framework for implementing its strategy
It is called the balanced scorecard because it balances the use of financial and nonfinancial
performance measures to evaluate performance

Four perspectives (BSC)

Financial
Customer
Internal business
Learning & growth

Companies that adopt the balanced scorecard usually have specific objectives they wish to achieve
within each of the four perspectives. Once management clearly identifies the objectives, they
develop KPIs that will assess how well the objectives are being achieved. To focus attention on the
most critical elements and prevent information overload, management should use only a few KPIs for
each perspective.

Strategy and the balanced scorecard illustrated

Balanced scorecard implementation
Must have commitment and leadership from top management
Must be communicated to all employees

Features of a good BS
Tells the story of a firms strategy, articulating a sequence of cause-and-effect relationships:
the links among the various perspectives that describe how strategy will be implemented
Helps communicate the strategy to all members of the organization by translating the
strategy into a coherent and linked set of understandable and measurable operational targets
Must motivate managers to take actions that eventually result in improvements in financial
performance
Applicable in both profit and non-profit organizations
Limits the number of measures, identifying only the most critical ones
Highlights less-than-optimal tradeoffs that managers may make when they fail to consider
operational and financial measures together

Balanced scorecard implementation Pitfalls

Managers should not assume the cause-and-effect linkages are precise: they are merely
hypotheses
Managers should not seek improvements across all of the measures all of the time
Managers should not use only objective measures: subjective measures are important as well
Managers must include both costs and benefits of initiatives placed in the balanced
scorecard: costs are often overlooked
Managers should not ignore nonfinancial measures when evaluating employees
Managers should not use too many measures
Evaluating strategy
Strategic analysis of operating income three parts:
Growth component measures the change in operating income attributable solely to the
change in the quantity of output sold between the current and prior periods
Price-Recovery Component measures the change in operating income attributable solely to
changes in prices of inputs and outputs between the current and prior periods
Productivity component measures the change in costs attributable to a change in the
quantity of inputs (efficiency) between current and prior periods

Evaluating strategy (check)

Strategic analysis of change in operating income

The management of capacity

Most complex choice
Managers can reduce capacity based fixed costs by measuring and managing unused
capacity (=overcapacity)
Unused Capacity is the amount of productive capacity available over and above the
productive capacity employed to meet consumer demand in the current period
Complexity: How to control your fixed and variable overhead cost(!), since they determine
capacity

How to run complex company?

Define aim
Translate into objectives & delegate (Management by objectives)
Set out ways to achieve objectives = strategy=plan=budget
Define milestones and Targets in budgets or KPIs
Compare actuals with budget = control
Intervene (act) only when required (Management by Exception)
Involve bottom up, active participation of all (Empowerment)/Collective
Dare to translate strategy into quantifiable targets & be flexible in your judgment given
exogenous changes
CH 4.

Income statement

Building block of costing

Cost object: finding the cost of a particular product
Cost assignment = cost tracing (direct cost) and cost allocation (indirect cost)
Cost driver: a variable affecting costs over a span of time
Inventoriable cost: asset when incurred and cost of goods sold when sold
Periodic cost: all cost in income statement other than inv. cost
Logically extended
Cost pool grouping of individual indirect costs
Cost-allocation base or key is an artificial cost driver used as a basis to assign indirect costs to
indirect related cost objects
- For example, if in a certain case direct labor hours cause indirect costs to change.
Accordingly, direct labor hours will be used to distribute or allocate costs to objects based
on their usage of that cost driver

Job-costing system distinct product/service

Process-costing system masses of identical or similar product/service

Costing systems
Job-costing: system accounting for distinct cost objects called Jobs. Each job may be different from
the next, and consumes different resources
Wedding announcements, aircraft, advertising
Process-costing: system accounting for mass production of identical or similar products
Oil refining, orange juice, soda pop

Costing systems illustrated

Costing approaches
Actual costing or normal costing (budgeted costing)
Costing approaches
Actual costing allocates:
- Indirect costs based on the actual indirect-cost rates times the actual activity
consumption
Normal costing allocates:
- Indirect costs based on the budgeted indirect-cost rates times the actual activity
consumption
Both methods allocate direct costs to a cost object the same way: by using actual direct-cost
rates times actual consumption

Costing approaches normal costing

Indirect costs cost object
Normal costing = Budgeted IDC rate x Actual Q
An artificial rate = predetermined rate (before the period starts/an estimation in advance)

Normal costing
To compute indirect-cost rate longer time interval (usually one year) required
- Numerator reason (indirect cost pool)
- Denominator reason (cost-allocation base)

Allocation base job order costing

Numerator/denominator = IDC/allocation base

Timeline
Before period predetermined MOH allocation rate
During the period customers ask you to bid for products and services
End of the period actual results of MOH revealed

Aim of costing
Full cost recovery. If not, bankruptcy, in the end
Direct costs + indirect costs = full costs
Cost objects are final full cost carriers for pricing
Calculating cost price
Direct cost tracing; obvious
Indirect costs allocation; artificial allocation base
Final full cost price always arbitrary but necessary

7 steps of job order costing

Step 1: Cost objects
Step 2: DC of each job
Step 3: cost-allocation base
Step 4: match allocation base with respective IDC
Step 5: calculate IDC allocation rate
Step 6: IDC for the job
Step 7: DC + IDC for the job

Seven-step job costing!

1. Identify the Job that is the Chosen Cost Object
2. Identify the Direct Costs of the Job
3. Select the Cost-Allocation base(s) to use for allocating Indirect Costs to the Job
4. Match Indirect Costs to their respective Cost-Allocation base(s)
 5. Calculate an Indirect cost (Overhead) Allocation Rate
6. Calculate the indirect costs allocated to the job
7. Calculate the total costs of the job by adding up all direct and indirect costs assigned to the
job

Two possible allocation bases for Job order:

Direct manufacturing labour hours, as allocation base $ per hour
Or
Direct manufacturing labor cost, as allocation base %
Keep in mind:
Manufacturing overhead/total direct labor hours
Or
Manufacturing overhead/total direct labor costs

CH 5.

Over & undercosting

Overcosting = a product consumes a low level of resources but is allocated high cost per unit
Undercosting = a product consumes a high level of resources but is allocated low costs per
unit
Product cross subsidization: calculated profit margins are misleading; wrong prices > wrong
marketing > wrong sales > losing sales & markets > wrong strategy

Rationale for selecting a more refined costing system

Profit margins under pressure
Increase in product diversity
Increase in indirect costs
Advances in IT
Competition in foreign markets

Activity Based Costing (ABC)

Professor Kaplan
Company is collection of activities
Focus on activities not just on products

History costing
Historically, firms produced a limited variety of goods while their indirect costs were relatively
small
Allocating overhead costs was simple
Peanut-butter Costing
The end-result: overcosting & undercosting
Nowadays: more indirect costs, less direct costs

Over and undercosting refer to allocation of indirect cost to cost per unit;
Under and over allocation refers to allocation of indirect cost over accounting period.

Job order costing

Indirect costs: rent, admin, ICT, travel allowance. Total $200,000
1 allocation bases (hours)
1 allocation rate
All IDC based on hours
Cost object: finding the cost of a particular product
Cost assignment = cost tracing (direct cost) and cost allocation (indirect cost)
Cost driver: a variable affecting costs over a span of time
Inventoriable cost: asset when incurred and cost of goods sold when sold
Periodic cost: all cost in income statement other than inv. cost

ABC
Indirect costs: acquisition $50,000, rent $60,000, admin/ict $80,000, travel $10,000. Total $200,000
Budgeted per year 2,000 hours used; 1000 km travelled.
ABC:
Multiple allocation bases
Multiple allocation rates
Acquisition : hours used ($50,000/2,000hr)
Rent : hours used ($60,000/2,000)
Admin/ICT : hours used (80,000/2,000hr)
Travel : KM ($10,000/1000km)

Indirect cost rate $2,358,000/795,000 = $3 per labour $ simple costing

ABC
Investigate activities of the company
Split up indirect cost pool into independent ones
Determine the best allocation base for each activity
Determine rate
Multiply usage of base * rate = allocated indirect costs

Mold and cleaning maintenance can be easily traced direct cost

Remaining indirect cost $ 2,115,000
Cost hierarchies
ABC uses a four-level cost structure to determine how costs will react:
Unit level
- Costs related to each individual unit of product
Batch-level
- Costs related to a group of products rather than to individual unit (setup for machines)
Product-sustaining-level
 - Costs undertaken to support individual products regardless of the units or batches
produced (design the product)
Facility-sustaining-level
- Cannot be traced to individual products but support the organization as a whole
(administration, rent of the organization)

ABC vs. Job costing

Each method is mathematically correct and acceptable
Each method is acceptable
Each method yields a different cost figure, which will lead to different gross margin
calculations
Only overhead is involved. Total costs for the entire firm remain the same how
Selection of the appropriate cost drivers based on experience, industry practices, cost-
benefit analysis of each option

ABC vs. Simple costing schemes

ABC is generally perceived to produce superior costing figures due to the use of multiple
drivers across multiple levels, but more costly
ABC is only as good as the drivers selected, and their actual relationship to costs. Poorly
chosen drivers will produce inaccurate costs, even with ABC

Activity-Based Costing Management

Used in critical decision-making situations, including:
- Pricing & product-mix decisions
- Cost reduction & process improvement decisions
- Design decisions
- Planning & managing activities

Signals suggesting ABC implementation could help a firm:

Significant overhead costs allocated using one or two cost pools
Most or all overhead is considered unit-level
Products that consume different amounts of resources
Products that a firm should successfully make and sell consistently show small profits
Operations staff disagreeing with accounting over manufacturing and marketing costs

ABC for service/merchandising firms

ABC implementation is widespread outside manufacturing, including:
- Health care
- Banking
- Telecommunications
- Retailing
- Transportation

CH 17 (IMPORTANT!)

Job-costing system
Each car has different amount of DM, DL, MOH

Process-costing system
Each car has similar amount of DM, DL, MOH
Flow of cost of manufacturing company

Flow of costs for assembly department (process costing)

Process-costing assumptions
Direct Materials are added at the beginning of the production process, or at the start of work
in a subsequent department down the assembly line
Conversion Costs are added equally along the production process
Process-costing
Process-costing is a system where the unit cost of a product or service is obtained by
assigning total costs to many identical or similar units
Each unit receives the same or similar amounts of direct materials costs, direct labor costs,
and manufacturing overhead
Unit costs are computed by dividing total costs incurred by the number of units of output
from the production process

Five-step process-costing allocation

1. Summarize the flow of physical units of output
2. Compute output in terms of equivalent units
3. Summarize total costs to account for
4. Compute cost per equivalent unit
5. Assign total costs to units completed and to units in ending Work-in-Process

Equivalent units
A metric that converts partially finished units into completely finished units
E.g. when an unit in process is 60% finished it is equivalent to 0.6 complete unit
Equivalent units are calculated separately for DM and CC (conversion costs and direct
material)

Step 1 & 2

Step 3, 4 & 5 illustrated

Five step process costing allocation
1. Summarize the flow of physical units of output
2. Compute output in terms of equivalent units
3. Summarize total costs to account for
4. Compute cost per equivalent unit
5. Assign total costs to units completed and to units in ending Work-in-Process

When Begin Inventory = 0 simple process costing

When Begin Inventory is not 0 be aware of weighted-average method or first in first out method

Weighted-average process-costing method

Weighted-average costs is the total of all costs in the Work-in-Process Account to date,
divided by the total equivalent units of work done to date
The beginning balance of the Work-in-Process account (work done in a prior period) is mixed
with current period costs!
Calculates cost per equivalent unit of all work done to date (regardless of the accounting
period in which it was done)
Assigns this cost to equivalent units completed & transferred out of the process, and to
incomplete units in still in-process

Steps 1
Steps 1 & 2 illustrated

Steps 3, 4 & 5 illustrated

Previous period manufacturing cost 80 + 60 = 140

What could be possible reasons for this change?
- decline in material cost and conversion cost
- Less waste
- work more efficiently

General approach
use the 5 steps
- summarize flow of physical units
- compute output in equivalent units
- summarize total cost to account for
- compute cost per equivalent unit
- assign costs to complete units and WIP
use format, even if it takes (more) time
structure provides proof of right calculations:
- units to account for beginning = units accounted for in the end
- costs to account for beginning = costs accounted for in the end
First-in, first-out process-costing method
The beginning balance of the Work-in-Process account (work done in a prior period) is kept separate
from current period costs (units)

WA versus FIFO

First-in, First-out process costing method

Assigns the cost of equivalent units worked on during the current period first to complete
beginning inventory, then to start and complete new units, and lastly to units in ending work-
in-process inventory

WA versus FIFO
WA:
- Assign the total cost to:
- Part A: 100% finished and transferred out units
- Part B: units remained in the ending work in process inventory
- Part A: mix the finished units from beginning inventory and new units started in current
period
FIFO:
- Assign cost added in the current period to:
- Part A1: to complete beginning work in process inventory
- Part A2: to complete new units from this period
- Part B: ending work in process inventory
- A1 and A2 are separate

FIFO steps 1 & 2

FIFO steps 3, 4 & 5

Transferred-in costs
Costs incurred in previous departments that are carried forward as the products cost when it
moves to a subsequent process in the production cycle
Transferred-in costs are treated as if they are a separate type of direct material added at the
beginning of the next process

Transfer-in costs in process costing (previous department costs)

Assembly department $20,000 transfer to testing department (DM added at the end)
Treated as a separate type of DM for tested department
Steps 1 & 2 illustrated (WA)

Steps 3, 4 & 5 illustrated

Use the 5 steps

Summarize flow of physical units
Compute output in equivalent units
Summarize total cost to account for
Compute cost per equivalent unit
Assign costs to complete units and WIP

CH 14.

Cost allocation so far

Job order costing, ABC and Process costing
All have given indirect costs and allocate to products
Cost allocation now
Given indirect costs and allocate to divisions (refrigerator or clothes dryer division) or
customers (high margin or low margin customer) macro level.
Learning objectives
Understand purposes for allocating cost to cost objects
Understand the criteria to guide cost-allocation decisions
The ability to allocate corporate cost to divisions
Determine customer profitability

Cost allocation
Extending indirect costs allocation to cost objects in
General (departments, customers, budgets)
- Corporate costs
Marketing chapter how to use the computed information
CH 14 focuses a bit on allocation to departments or divisions and then more on customers
Benefit & cost (allocation) in budgeting

Purpose of cost allocation

To provide information for economic decisions
- Selling price of a customized product
To motivate managers and employees
- Sales representative focuses on high margin products
To justify costs or compute reimbursement amounts
- US government contracts explicitly exclude marketing costs to keep the price fair
To measure income and assets
- To report to external parties
Criteria for cost-allocation decisions
How to allocate corporate treasury costs for a new machine?
- Cause and effect variables are identified that cause resources to be consumed (machine
hours)
Benefits received cost objects are charged with costs in proportion to the benefits received
(more outputs, revenues = more costs should be allocated to)
Fairness or equity
- A matter of judgment than operational criterion
Ability to bear

Customer cost allocation: customer revenues and costs

Customer-Profitability Analysis is the reporting and analysis of revenues earned from
customers and costs incurred to earn those revenues
An analysis of customer differences in revenues and costs provides insight into why
differences exist in the operating income earned from different customers

Customer cost hierarchy

1. Customer output unit-level costs (product handling of each unit sold)
2. Customer batch-level costs (costs to deliveries)
3. Customer-sustaining costs (sales rep. visits)
4. Distribution-channel costs (salary of retail distribution channel)
5. Corporate sustaining costs (top executive salary)

Customer profitability analysis illustrated

Other (qualitative) factors in evaluating customer profitability
Likelihood of customer retention
Potential for sales growth
Long-run customer profitability
Increases in demand from having well-known customers (image)
Ability to learn from customers

CH 15.
Allocation of support-department costs and common costs

Departments

Departments
Supporting (service) Department provides the services that assist other departments in the
company
Operating (production) department directly adds value to a product or service
Service used, should be charged in the end to operations i.e. products (=final cost carriers), to
be recovered via sales
Allocation method single rate

Allocation method dual rate

Methods to allocate
Support department costs
Single-rate method allocates costs in each cost pool (service department) to cost objects
(production departments) using the same rate per unit of a single allocation base
- No distinction is made between fixed and variable costs in this method
Dual-rate method segregates costs within each cost pool into two segments: a variable-cost
pool and a fixed-cost pool
- Each pool uses a different cost-allocation base

Allocation method trade offs

Single-rate method is simple to implement, but treats fixed costs in a manner similar to
variable costs
Dual-rate method treats fixed and variable costs more realistically, but is more complex to
implement, but better

Allocating costs of multiple support departments

Direct method, step-down method, reciprocal method

Direct method
Direct method
Allocates support costs only to operating departments
No interaction between support departments prior to allocation

Step down method

Step-down method
Allocates support costs to other support departments and to operating departments that
partially recognizes the mutual services provided among all support departments
One-way interaction between support departments prior to allocation
The department that renders most services (%) to others comes first

Reciprocal allocation method (repeated interactions) illustrated

Reciprocal method
Allocates support departments costs to operating departments by fully recognizing the
mutual services provided among all support departments
Full two-way interaction between support departments prior to allocation

Methods of allocating support costs to production departments

Differences
Single method, dual method
- Distinction made between separate fixed and variable costs or not
Direct method, step-down method, reciprocal method
- Allocates support costs to other support departments

Choosing between methods

Reciprocal is the most precise
Direct and step-down are simple to compute and understand
Direct method is widely used

Allocating common costs

Common cost the cost of operating a facility, activity, or like cost object that is shared by
two (or more) users at a lower cost than the individual cost of the activity to each user

Methods of allocating common costs

Stand-alone cost-allocation method uses information pertaining to each user of a cost
object as a separate entity to determine the cost-allocation weights
Individual costs are added together and allocation percentages are calculated from the
whole, and applied to the common cost
Example book.

Methods of allocating common costs

Incremental Cost-Allocation Method ranks the individual users of a cost object in the order of
users most responsible for a common cost and then uses this ranking to allocate the cost
among the users
- The first ranked user is the primary user and is allocated costs up the cost as a stand-alone
user
- The second ranked user is the First Incremental User and is allocated the additional cost
that arises from two users rather than one

Consider the trip for the first ranked (most important or first) deduct this from round trip charge. Rest
is paid by second user. (and same for subsequent users).

Example book
CH 7.
Flexible budgets direct cost variance

Basic concepts
Variance difference between an actual and an expected (budgeted) amount
Management by exception the practice of focusing attention on areas not operating as
expected (budgeted)
Static (master) budget is based on the output planned at the start of the budget period

Basic concepts
Static-budget variance (level 1) the difference between the actual result and the
corresponding static budget amount
Favorable variance (F) has the effect of increasing operating income relative to the budget
amount
Unfavorable variance (U) has the effect of decreasing operating income relative to the
budget amount

Variances
Further analysis decomposes (breaks down) the Level 1 analysis down into progressively
smaller (level 2) and smaller components (level 3)

Flexible budget
Starting of level 2 analysis
The ideal budget we would have had if we would have known the right (actual) quantity
before we started
Level 3 variances
All product costs can have level 3 variances
DM
DL
MOH
Level 3 including
1. Price variance (caused by price)
2. Efficiency variance (caused by quantity)
Formula given in exam

Level 3 variance of DL
Level 3 variance of DM
Management uses of variances
To understand underlying causes of variances
Recognition of inter-relatedness of variances
Performance measurement
- Managers ability to be effective
- Managers ability to be efficient

Considerations
Flexible budget variance
- Price variance
o Price change materials
o Quality of materials
o Discounts
o Supplier
Sales volume variance:
- Market situation
o Demand
o Competitors
o Conditions
- Taste/preferences
- Quality
 Efficiency variance
- Labor hours
- Machine time
- Planning

Benchmarking and variances

Benchmarking is the continuous process of comparing against the best levels of performance
in competing companies
Variance analysis can be extended to include comparison to other entities in the same
Industry branch

Summary
Level 1 variance: difference between all actual and budget figures for Revenue (SP), Quantity
(Q) and Costs (Direct and Overhead (OH)).
Level 2 variance: split up in Revenue difference and Quantity difference or split up in Flexible
Budget and Sales Vol Variance (=Marktg Variance, Ch14)
Level 3 variance: split up of Flexible Budget variance in input cost variances; Direct Materials
(with Quantity and Price component), Direct Labour (Q&P), Variable OH (Q&P, e.g.
maintenance) and Fixed OH (only P, e.g. rent)
Chapter 8 special on OH variances due to special character Overheads=Ind.costs
Level 4 variance: Special additional variance caused by allocating Overheads, since only an
artificial connection (Indirect) between cost and objective
Especially this one causes misunderstanding
In VOH there cannot be a difference between Flexible Budget (FB)and allocated amount because FB
based on known quantity at the end and allocated is based on the same, hence they are always
equal.
In FOH there is always a difference between FB and allocated, because FB is the known quantity at
the end and the allocated is based on a guestimate at the beginning.

CH 11.
Decision models
A decision model is a formal method of making a choice, often involving both quantitative
and qualitative analysis
- One-time-only special orders
- Make or buy
- Product-mix and customer profitability
- Branch/segment: continue or drop
- Equipment replacement

Five-step decision-making process

Step 1: obtain information
Step 2: make predictions about future costs
Step 3: choose an alternative
Step 4: implement the decision
Step 5: evaluate performance

Relevance
Relevant information:
- Occurs in the future
- Differs among the alternatives
Relevant costs expected future costs
 Relevant revenues expected future revenues

You are left with parts at a book value of $78,000 (irrelevant). The parts are no longer used in your
production line.
Two alternatives
Re-machine at costs of $24,500 to be sold at $33,000
Sell for scrap for $6,500
Decision rule: one with highest operating income
Which alternative do you choose?

Irrelevant information
Example sunk costs: historical costs are past costs that are irrelevant to decision making

Types of information
Quantitative factors can be measured in numerical terms
Qualitative factors are difficult to measure accurately in numerical terms, such as satisfaction
- As important as quantitative factors even though they are difficult to measure

Qualitative factors
May be extremely important in an evaluation process, yet do not show up directly in
calculations:
- Quality requirements
- Reputation of outsourcer
- Logistical considerations distance from plant, etc

One-time-only special orders

Only when there is idle production capacity and the special orders has no long-run
implications
Decision rule: which one has the highest operating income (with special order or without
special order)

Insourcing vs. outsourcing

Also called the make or buy decision
Decision rule: select the option with the lowest costs
Potential problems with relevant-cost analysis
Avoid incorrect general assumptions, especially:
- All variable costs are relevant and all fixed costs are irrelevant
Problems with using unit-cost data:
- Including irrelevant costs
- Using the same unit-cost with different output levels

Avoiding potential problems with relevant-cost analysis

Focus on total revenues and total costs, not their per-unit equivalents
Continually evaluate data to ensure that it meets the requirements of relevant information

Product-mix decisions
The decisions made by a company about which products to sell and in what quantities
Decision rule (with a constraint): choose the product that produces the highest contribution
margin per unit of the constraining resource
Adding or discontinuing branches or segments
Decision rule: does adding or discontinuing a branch or segment add operating income to the
firm
- Yes add or dont discontinue
- No discontinue or dont add
Decision is based on profitability of the branch or segment, not how much revenue the
branch or segment generates

Adding or dropping customers

Decision rule: does adding or dropping a customer add operating income to the firm?
- Yes add or dont drop
- No drop or dont add
Decision is based on profitability of the customer, not how much revenue a customer
generates

Behavioral implications
Despite the quantitative nature of some aspects of decision making, not all managers will
choose the best alternative for the firm
Managers could engage in self-serving behavior such as delaying needed equipment
maintenance in order to meet their personal profitability quotas for bonus consideration

CH 23.
Chapter 13.
Two basic strategies
- Product differentiation
- Cost leadership
Five forces analysis
- Competitors
- Potential entrants
- Equivalent products
- Bargaining power consumer
- Bargaining power supplier
Balances score card
- Four perspectives: financial, customer, internal-business-process, learning and
growth
- Features of a good BSC:
o Tell a companys strategy
o Communicate the strategy to all members
o Identify only the most critical measures
- Financial: income, revenue & cost, income & investment
- Customer: market share, number of customer complaints
- Internal business process: innovation, operations and postsale
service
- Learning & growth: employee, technology

Evaluating strategy
Strategic (variance) analysis of operating income. Three parts:
Growth component operating income attributable solely to the change in the quantity of
output sold
Price-recovery component operating income attributable solely to changes in prices of
inputs
 Productivity component operating income attributable to a change in the quantity of inputs
(efficiency) with a special focus on overheads

Chapter 23.
Selection of financial and non-financial performance measures to use in BSC
Evaluate business unit performance

Know the following

Return on sales
ROI
Residual income
Economic value added
How to calculate them and their differences

Return on investment (ROI)

ROI is an accounting measure

ROI= Income/Investment
Income = operating income
Investment = assets

Most popular metric for two reasons:

1. Blends all the ingredients of profitability (revenues, costs, and investment) into a single
percentage
2. May be compared to other ROIs both inside and outside the firm

Dupont method of profitability analysis

ROI may be decomposed into its two components as follows:

ROI = return on sales x investment turnover

Residual income (RI)

RI = income (RRR * investment)
- RRR = Required Rate of Return

ROI or RI
Current situation business unit:
Operating income: 240,000
Investment : 1,000,000

Investment opportunity:
Operating income : 70,000
Investment: 400,000

Required rate of return 12%

Accept or reject investment opportunity based upon ROI and RI.

Pre-upgrade ROI = 240,000/1,000,000 = 0.24 or 24%
Post-upgrade ROI = 240,000 + 70,000/ 1,000,000 + 400,000 = 310,000/1,400,000 = 0.221 or 22.1%

Pre-upgrade RI = 240,000 (0.12 x 1,000,000) = $120,000

Post-upgrade RI = $310,000 (0.12 x 1,400,000) = $142,000

Economic value added (EVA)

EVA is a type of RI calculation that has recently gained popularity

Accounting-based performance measures

Requires a three-step design process:
1. Choose Performance Measures that align with top managements financial goals
- Operating income, net income or revenue
2. Choose the details of each performance measure
- Weekly, monthly or annually
3. Choose a target level of performance and feedback mechanism
- Same targets for subunits? Report to top management weekly, monthly or
annually

Step 1: choosing among different performance measures

1. Return on investment
2. Residual income
3. Economic value added
4. Return on sales

Step 2-details: choosing alternative definitions for performance measures

Four possible alternative definitions of investment:
1. Total assets available
2. Total assets employed
3. Total assets employed minus current liabilities
4. Stockholders equity
Possible alternative definitions of assets:
1. Current costs
2. Gross value of fixed assets
3. Net book value of fixed assets

Step 3: choosing target levels of performance

Historically driven targets used to set target goals
Goal may include a continuous improvement component

Step 3: choosing the timing of the feedback

Timing of feedback depends on:
- How critical the information is for the success of the organization
- The specific level of management receiving the feedback
- The sophistication of the organizations information technology
Distinction between managers and organization units
The performance evaluation of a manager should be distinguished from the performance
evaluation of that managers subunit, such as a division of the company
- If a unit does well, does the manager do well?
Best managers needed in division the perform poorly
External (economic) climate

The trade-off: creating incentives vs. imposing risk

An inherent trade-off exists between creating incentives and imposing risk
- An incentive should be some reward for performance
- An incentive may create an environment in which suboptimal behavior may occur: the
goals of the firm are sacrificed in order to meet a managers personal goals

Caution with ratios

Ratios are simplification of reality, be careful in using
Remember relations between ratios (Du Pont)
Know economy, sector and branch (benchmark)
It is the interpretation that counts, not the ratio value