Introduction to Managerial Accounting Test Bank by kjn11951

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									I. Introduction:
We now shift or focus away from financial accounting and toward managerial
accounting. Financial accounting primarily deals with financial statement preparation for
use by interested external parties. Managerial accounting primarily has an internal focus.
While the financial statements are intended for an external audience, that does not mean
they are useless for internal management. Unfortunately financial statements, out of
necessity, are aggregated into summary data. Internal uses usually require information in
a more detailed form. For example, while simply knowing the total cost of goods sold
may be sufficient for determining the overall profitability of the entire enterprise,
managers may wish to know the profitability of an individual product. Cost accounting, a
subset of managerial accounting, is used to provide such information.

Managerial accounting can be categorized into several different processes. Probably the
most widely know process is the above- mentioned area of cost accounting. This involves
the process of identifying, measuring, and categorizing costs so that managers have
information on what individual products and services “cost.” A second sub-category of
managerial accounting involves control. Included are p rocesses designed to analyze
performance and motivate and reward individuals such that firm performance is
enhanced. Strategic planning and budgeting are examples of the control process. A third
sub-category involves decision- making, often referred to as alternate choice decisions.
Examples of these decisions are whether to outsource rather than provide internally,
whether to lease or buy, or whether to discontinue a product. Related to these alternate
decision problems are long-term capital allocation decisions. Management accounting
procedures provide managers with techniques to aid in determining how to allocate
capital to future projects. We will concentrate on this third aspect of managerial

A few things about managerial accounting needs to be said up front, and always kept in
mind. First, and probably most important, managerial accounting processes are very
flexible. In fact, they are so flexible that they can be done any way the user wishes (with
a few exceptions such as government contracts). Unlike financial accounting that is
governed by a detailed set of GAAP, managerial accounting is voluntary. The only
“rule” that should always be followed is that the benefits are greater than the costs. Cost
allocations should be done only if knowing costs more accurately yields benefits greater
than the resources used to measure and allocate the costs. Budgets should be done only if
the benefits from their control are greater than the resources needed to create and analyze
the budgets. The detail used to do any procedure should only be as fine as the greater
effort justifies. This is very much in contrast to financial reporting that is required,
regardless of the benefit the firm derives.

Second, and related to the first item, there is no right or wrong way to do many of these
procedures. Although there certainly are accepted methods, these are only suggestions.
If, for example, good enough results can be obtained using a simple payback method for
capital budgeting, there is no need to do an extensive discounted cash flow for net present
value projection. While fancy activity-based costing (ABC) systems may look quite sexy
in a textbook example, few firms find the benefits justify the costs and more often
maintain much simpler costing systems 1 .

Third, there is often a serious internal conflict within managerial accounting systems
because of the multiple purposes these systems serve. The problem lies in the need to get
“good” data. Consider, for example, the area of budgeting. In decentralized operations
budget data is essential for coordination among different units. In most cases, it is
managers further down the line that has the best knowledge. The sales manager will
likely have the best idea of what future sales will be because of her closeness to the
customer. Future sales are the key driver for the production department’s future budget
of units to produce. Production needs naturally drive raw materials procurement.
Unfortunately the budget is used in another way in addition to information gathering, it is
also used to measure and reward. Bonuses are often based on the manager’s ability to
“make budget.” This provides incentives to “pad” the budget. Of course if the sales
manager’s budget is too loose, production and procurement will likely be too low. This
may cause serious problems if sales then prove to beat budget by a wide margin, but the
firm is unable to produce sufficient quantities because of material shortages.

Fourth, different managers will likely need different information. The managerial
accounting system needs to be flexible enough to suit these differing needs. For example,
costs should be treated differently depending on what one is trying to determine the cost
of. Rent on a factory is likely an unavoidable cost if one is analyzing the cost to produce
a pair of jeans. Rent, in contrast, is avoidable if one is determining if the entire factory
should be shut down.

Fifth, managerial accounting information is of no use if it is not timely for decision-
making. There are often situations where it is necessary to work with approximations
and incomplete data. While this may cause a degree of discomfort, it is the way the real
world works. The slogan “good enough and on time” definitely applies to managerial

Sixth, it is people, not numbers that accomplish tasks. Numbers can assist people, but by
themselves they are just data. Therefore it is important to determine what numbers will
help people, how people will react to these numbers, and how best to present them.
Whether we accountants like it or not, people skills do matter 2 . Further, as noted in the
third item above, it is critical to consider the possible incentives related to the numbers.

Finally, there is a tremendous amount of jargon associated with managerial accounting,
probably even more than with financial accounting 3 . Be very careful so that you are clear
what is being asked/told. For example, the word “cost” is somewhat meaningless without
a modifier in front of it. A very short partial list of possible modifiers include, fixed,
variable, avoidable, differential, sunk, opportunity, full, direct, indirect, overhead,
conversion, prime, product, job, process, standard, joint, and on and on.

  ABC is most likely only v iewed as sexy to an accountant.
  For the most part we do not choose the accounting profession because of our peop le skills.
  At this point you probably do not think this is possible. Just wait!
II. Comparisons with financial accounting:
The following table summarizes many of the differences between financial and
managerial accounting.

            Item                 Management Accounting            Financial Accounting

1. Necessity                   Optional                        Required
2. Underlying rules            None other than cost/benefit    GAAP
3. Underlying structure        Varies by needs                 A = L + OE
4. Primary users               Internal                        External
5. Time orientation            Future                          Past
6. Content                     Mix of monetary and non-        Mostly monetary
7. Precision                   Mostly approximations           Less approximations
8. Frequency                   As needed                       Quarterly and annual
9. Timeliness                  Good enough and on time         After the fact
10. Entity                     Responsibility/cost center      Enterprise

III. Cost Behavior:
In this section I will discuss the relationship between activity levels and costs. This is
often referred to as cost-volume, or cost-volume-profit (CVP) relationships. The key
concepts will be that of fixed and variable costs. It is important to keep in mind that the
terms fixed and variable, when applied to any given cost object, are situation specific.
We always need to keep in mind what is being analyzed. Important considerations,
among other things, include the time dimension, the level of activity, and the scope of the
cost object (the thing we are trying to determine the cost of).

Logically, one should expect that as the amount of goods or services produced goes up,
the corresponding amount of resources used to produce these good or services should
also increase. The key question is how does the use of these resources increase as
activity increases? In other words, what is the percentage increase in X as Y increases?
This leads us to the concepts of fixed and variable costs.

Here is one area where we need to be careful. Do not confuse total costs with per unit
costs! Total costs are the sum of all the unit costs combined. Per unit costs is simply the
sum of all costs going into an individual unit.

Variable costs are costs that vary, in total, with activity. The relation is direct and
proportional. For example, if the number of widgets goes up by 30%, and direct material
is a variable cost, one would expect the cost of direct material to increase by 30%. A
good example of this is the relationship between autos produced and tires. An auto is the
cost object, the item we are determining the cost of, in this example. Each tire costs $50,
and five tires (including a spare) are needed for each auto. The following table
demonstrates this variable cost:

      Number of autos                 Tire cost per auto             Total variable cost
                           1                               250                            250
                           5                               250                          1,250
                          10                               250                          2,500
                         100                               250                         25,000

Notice that total variable costs vary proportionally with the number of autos produced. A
five- fold increase in autos results in total variable costs increasing five-fold. Cost per
auto, however, remains fixed at $250. See how this can be co nfusing? Variable costs
mean that the costs, in total, are variable, but are fixed on a per unit basis.

Key assumptions in this example are that we remain in a feasible area of production. If,
for example, production ramps up so fast that we are not able to get enough tires from our
preferred supplier, then cost per tire may increase and the relationship above may not
hold. Also, in the long run, we may be able to negotiate a better price on tires.

Fixed costs remain fixed, in total, as the level of activity changes. The per-unit fixed
cost, however, varies since you have a fixed amount being allocated to a changing
number of units. Again, keep in mind the assumptions about a relevant range of activity
and time horizon. For example, the rent on the factory where the autos are being
produced will likely be fixed for the month, regardless of the number of autos produced.
If, however, production ramps up to a point that a larger facility is needed, rent will likely
change. Also, in the long run, rent will likely change. The following example
demonstrates the concept of fixed costs using rent of $10,000 per month.

      Number of autos                Rent cost per auto                Total fixed cost
                            1                         10,000                          10,000
                           10                          1,000                          10,000
                          100                            100                          10,000
                        1,000                             10                          10,000

Notice now that total costs remain fixed, while per unit costs varies. This is just the
opposite from variable costs. So when discussing fixed and variable costs, we are
referring to how the costs vary, in total, with changes in activity.

To complicate matters, many costs exhibit a combination of fixed and variable attributes.
These costs can be referred to as semivariable or mixed costs. For example, the cost of
operating an auto varies with the miles driven. Part of this variability is proportional to
miles driven, for example fuel costs, and is therefore a variable cost. Other components,
such as registration fees, remain fixed regardless of miles driven.

One further type of cost that is sometimes encountered is referred to as a step-function
cost. The name comes from how the costs appear when plotted. The plot looks like a
stair step. These costs basically occur in chunks. A given chunk of costs is sufficient for
a certain range of output, and then another chunk is needed. An example is a hair solon
that is equipped with 10 stations. Currently only six stylists are employed. These six
employees can handle 42 customers per day. If business increases to over 42 customers,
another stylist will be needed, and then the stylists will be able to handle up to 49

The following plots represent fixed, variable, semivariable, and step costs. In each case,
costs are represented on the vertical axis and volume on the horizontal axis.
Fixed costs

Variable costs
Step function

If you combine total costs and revenues on the same plot you create what is referred to as
a profitgraph. Based on the obvious relationship that breakeven occurs when total
revenues are equal to total costs, you can use such a graph to compute breakeven volume
(or revenue), along with profit or loss at each level of volume. We simplify things by
assuming linear relationships, i.e., the same variable cost and revenue per unit along the
entire relevant range. Total costs can be calculated using the following formula:

TC = FC + (UVC * X)

where TC is total cost, FC is fixed cost, UVC is unit variable cost, and X is the number of
items being sold. For example, if fixed costs are $300, and variable cost per unit is $10,
and we sell 500 items, total costs will be $5,300. Further assume that the selling price is
$15. If we then sell 500 items total revenue will be $7,500 and our profit will be $2,200.

While all this could easily be graphed (actually if it were really that easy I would include
a plot), using an easy formula and basic algebra allows us to do break-even analysis
without graphing skills.

Simply start with the breakeven condition that total revenue must equal total expense to
earn zero profit, i.e. breakeven.

X * UP = FC + (UVC * X)

where UP is unit price. Next factor out X, the number of units we are attempting to
X * (UP – UVC) = FC
X = FC / (UP – UVC)

UP – UVC is how much additional money we make on each one we sell, the price we get
less the variable (additional) cost to sell a unit. This is also called the contribution
margin since it is how much each unit contributes to our profit.

One way to look at the formula is to think that we start off in the whole by all of our fixed
costs. These will be there regardless of how many we sell, even if we sell zero. Each
unit we sell first contributes to covering these fixed costs. Once we sell enough such that
the contribution margin on each unit, times the number of units, exactly equals the fixed
costs, we have broken even. From that point on each unit sold goes toward our profit.

As an example, assume that we have fixed costs of rent, salaries, etc. of $5,000 per
month. Further assume we sell a product for $40, with the variable costs consisting of
materials, labor, etc. totaling $30 per unit. How many units must we sell to breakeven?
The answer is 500 units per month.

Suppose would like to have a profit of $600 per month instead of just breaking even.
How many units do you need to sell?

To solve this simply treat the desired profit as additional fixed costs. Each unit sold first
goes toward fixed costs, then toward desired profit. In this case it will require selling 560

Keep in mind the simplifying assumptions we are using in this procedure. We are
assuming unit costs and revenues are linear in the range of sales we are considering.
Further, in this breakeven analysis we are assuming either a one-product firm or a firm
with one common contribution margin among its products.
IV. Alternative choice decisions:
This section is sort of the culmination of what we will be covering regarding managerial
accounting. In addition to the cost concepts already covered, we will be borrowing some
concepts from microeconomics. In essence, what we will be doing is developing a
systematic procedure to choice between alternate courses of action. What is important is
to overcome certain behavioral tendencies and proceed in a logical manner. The concepts
in this section can certainly be applied to many decision- making situations, not just those
arising in a business setting.

The first thing we need to do is change the way many of us think of “costs.” The cost of
something is often though of as being synonymous with full costs. Unfortunately that
way of thinking can lead to faulty decision- making as the following example illustrates.

Example: A company manufactures and sells 2-channel vacuum tube amps. The cost
accounting records indicate the full cost of the 30-watt El34-based amp is $700. Suppose
that a customer offered to purchase an amp for $600 in order to modify it and resell under
a different name. Further assume this purchase will have no effect on the companies
other sales. Should the company agree to this offer?

If the company only considered full costs then the answer is no since it would mean
losing $100. But what if the out-of-pocket costs of the amp, for things such as tubes,
capacitors, chassis, labor, etc. only amounted to $500? Assume the additional $200
represents allocated indirect cost of such things as rent and insurance. Therefore
accepting the order will actually increase revenue by $600 and costs by only $500,
resulting in an increase of $100 to profit. Relying on full costs would lead to faulty

So what is the cost of the amp? Is it $700 or is it only $500? The answer depends on the
question that you are using the cost to answer. In alternate decision problems we focus
on differential costs and revenues. These are costs and revenues that differ between
alternatives. In the above example, differential revenues are $600, since under one
alternative, no sale, revenue would be zero. Under the other alternative, sell the amp,
revenues amount to $600. Notice the allocated costs of $200 are not differential because
they do not change between alternatives. Only the $500 of cost differs, therefore that is
the only relevant cost to the decision.

It should be noted here a key difference between differential costs and full costs. Full
cost primarily comes from historical costs. Differential cost only deal with future costs.
What will differ if A occurs rather than B or C occurs?

At this point another example will help review many of the costs terms and relate them to
the alternative decision- making methodology.

 Conventional Income Statement for the month of January
Revenues                                         $42,000
 Salaries           $19,800
 Supplies            10,800
 Utilities            2,400
 Marketing            1,200
 Rent                 4,200
 Depreciation         4,800
 Other                1,800
   Total expenses             $45,000
Income (loss)                 $(3,000)
               Contribution Margin Format Income Statement for January
                                       Dry Cleaning                  Laundry
                        Revenues                   $32,400                   $9,600
              Variable expenses
                          Wages         $7,800                     $4,200
                         Supplies        9,000                      1,800
                         Utilities       1,500                        300
        Total variable expenses                     18,300                    6,300
            Contribution margin                     14,100                    3,300
           Direct fixed expenses
                     Depreciation                     3,600                   1,200
              Total contribution                    10,500                    2,100
         Indirect fixed expenses
                         Salaries                     7,800
                         Utilities                      600
                       Marketing                      1,200
                             Rent                     4,200
                           Other                      1,800
   Total indirect fixed expenses                                   15,600
                    Income (loss)                                $(3,000)

If we look only at the conventional income statement we see a loss and figure at least one
of the two departments is to blame. Perhaps we should close one down and things will
get better.

The contribution margin format helps us make that decision. First, before we look
closely at that statement, lets review the cost classifications:

Variable costs: These are the costs that vary proportionately with the volume of dry
cleaning and laundry.

Fixed costs: These costs will be the same regardless of the activity volume. These fixed
costs can be either directly traceable to a department, such as depreciation on equipment
used in the department, or common fixed costs, such as marketing for the business in

Direct costs: These are all the costs that can be directly traced to the cost object.

Indirect costs: These costs are common costs shared by more than one cost object and
not easily, or feasibly, traced directly to a cost object.

Full costs: These include both direct costs and an allocation, by some method, of a share
of the indirect costs.
Note that both dry cleaning and laundry contribute to the bottom line because they bring
in more revenue than the costs that would go away if they were to be closed down (at
least in the short term). For example, closing laundry would eliminate $9,600 of revenue
(differential revenue) and $7,500 of expenses (differential costs). Therefore laundry
contributes $2,100 towards covering the additional $15,600 of costs that will not go away
if laundry is closed down.

At this point it needs to be stated that it is likely more than just quantitative factors will
enter into any decision. For example, in the laundry example, the business may feel a
moral obligation to provide the neighborhood a place to have their clothes cleaned. The
process we are describing provides the quantitative data so that the decision maker can
evaluate whether the moral obligation is worth the quantitative cost of providing the

It all comes down to differential costs. Sometimes the terms “out-of-pocket costs,”
“avoidable costs,” “incremental costs,” or “relevant costs” are used interchangeab ly with
differential costs. Be careful, however, not to simply assume variable costs are
differential and fixed costs are not. It all depends on the situation. For example, as we
see in the laundry example, some of the fixed costs could be directly traced to
departments, and therefore were differential if the question was whether to close a
department. The key is that if something does not change under alternative choices, it
can be ignored for decision- making. Only things that differ between alternatives matter.
This concept is illustrated in the following example.

Example: A firm is deciding whether to manufacture a part internally or to outsource the
part. The ultimate selling price will not change since the part is only a component in a
larger product and the part will be identical regardless of who does the manufacturing.
Likewise, SG&A will not change. The cost of outsourcing is $1,700 per part.

                   Internal            Outsource                         Difference
                                                                   -                  +
Direct material                 $570                 $0                 $570
Purchase part                      0              1,700                                   $1,700
Direct labor                     600                  0                  600
Power                             70                  0                   70
Other                            150                  0                  150
Insertion labor                   50                 50
 Total                        $1,440             $1,750                $1,390              $1,700
Net differential                                                        $310

Note that the cost of inserting the part, $50, does not differ between the two alternatives
and can therefore be ignored in the analysis.

Be very careful in these alternative choice problems with full costs. Full costs usually
include some allocated indirect costs. Many times these indirect costs will not change
under alternative choices, but because they are allocated, they may appear to be
differential. For example, overhead costs (rent, utilities, etc.) may be allocated at the rate
of 200% of direct labor costs. This does not mean, however, that if direct labor costs are
decreased by $1000, rent and utilities will decrease by $2,000.

Two more cost concepts are important in working these alternative decision problems.
The first is opportunity cost. Opportunity costs are covered in economic classes, but
unfortunately are largely ignored by accountants. An opportunity cost is the benefit
given up by doing one thing that prevents doing something else. Because they are not
“real” costs in the sense that some resource is given up, the accounting system does not
record them. For example, if a certain product is being manufactured in a factory, the
machines are occupying some floor space. Assume that the company must rent other
warehouse space to store certain items at a cost of $1,000 per month. If the product
manufactured is discontinued, the company could use the factory space for storage. In
this example, an opportunity cost of producing the product is the $1,000 rent that could
be saved if the product is discontinued. For an additional example, assume a tax attorney
is fully booked up during tax season. Further assume her billing rate is $150 per hour.
Finally, assume she does three hours of voluntary work each week. The opportunity cost
of the volunteer work is $450.

Opportunity costs are not always relevant in alternative choice problems. They do
become relevant, however, in resource-constrained situations, such as the example with
the attorney, or the floor space example. If the attorney had plenty of slack time, or if
there was already plenty of unused floor space, the opportunity cost would be zero.

The following example demonstrates how overlooking opportunity costs can lead to a
faulty decision. In this example, an airline manager is considering adding an addition
flight between California and Washington. An analysis showed that expected additional
revenue would exceed additional costs by $30,000. Therefore it seems like a go.
However, what if another airline is willing to rent unused hanger space for $40,000?
Unfortunately, if the new route is added that excess capacity in the hanger will no longer
be available to the other airline. In this case the opportunity cost of the new route is the
$40,000 rent income foregone. The correct decision is therefore to not add the new route
since the airline would be better of by $10,000.

Another cost concept common in economics is sunk cost. A sunk cost is a cost that has
already occurred. As such, it cannot change and is therefore not relevant. Unfortunately,
these costs often enter into decisions because of behavioral influe nces that go beyond
logic. For example, assume in year 1 a certain machine with a three-year life is
purchased for $50,000. After one year a new machine comes out that is far superior to
the one recently purchased. In fact operating costs will be cut in half. Unfortunately
there will no longer be a market for the used machine. While it will likely be the best
alternative to scrap the recent purchase and buy the improved model, management will
often consider the book value of the current machine as rele vant. It is no fun to “take a
loss” on it, so the machine may be kept for the remaining two years of its depreciable life.
The following situation provides an example where sunk costs can lead to faulty
decisions, but where they may also be hard to overcome.

Kate International Airport has a three-year-old loader truck that is used to load in- flight
meals onto planes. The box is lifted to the level of the side doors. The current book
value of the loader is the original cost of $100,000, less $75,000 accumulated
depreciation. The loader has one more year of useful life, at which time its salvage value
is zero. It could be sold today for $5,000. Depreciation next year will be the remaining
$25,000. Annual cost to operate the loader is $80,000.

A new conveyor belt loader is now available that would lower operating costs to $45,000.
The new loader is much cheaper, only $15,000 to purchase, but only has a one-year life
with zero salvage value. Should the new loader be bought now?

There may be a strong tendency to stick with the old loader. The thinking would be that
we paid $100,000 for something with a four life and we still have a year’s life left in it. If
we dispose of it now we will take a bath since the book value is $25,000 and we will only
get $5,000 for it. Dumb thinking! The book value is a sunk cost and does not matter.

                                               Cost of Two Alternatives
                                Do not replace        Replace         Differential Cost
Depreciation of old                     $25,000
Write-off of old                                             $25,000
Proceeds from sale                                            (5,000)                  $5,000
Depreciation (cost) of new                                     15,000                (15,000)
Operating costs                           80,000               45,000                  35,000
                                        $105,000             $80,000                  $25,000

Note the $25,000 remaining book value is not a differential cost. It already happened and
cannot be changed. It is either a “loss” or depreciation expense.

One more example is in order to emphasize the idea that the answer of that is a relevant
cost depends on the question being asked. Assume the following costs apply to the
operation of an automobile:
                                   Average per mile
Variable costs:
 Fuel and oil                                   $.066
 Maintenance                                     .058
 Tires                                           .018
 Total variable costs                           $.142
                                    Amount per year
Fixed costs
 Insurance                                      $1,201
 Registration                                      183
 Depreciation                                    3,721
  Total fixed costs                             $5,105

1. First assume you already own a car like the one in the example. You are considering
   using it for an upcoming 1,000 mile trip. The alternative is to take a train for $110.
   What are the relevant costs?

   Answer: Since you already own the car, the fixed costs will not change regardless of
   your trip decision. Therefore the relevant costs to consider are the variable costs of
   14.2 cents per mile, times 1,000 miles; $142.

2. Now assume you own the car, but it is not currently registered. You are considering
   whether to register it and drive 10,000 next year. The alternative is to use alternate
   public transportation, which you estimate will run $3,400. Should you register the
   Answer: Now the variable cost of 14.2 cents per mile times 10,000, plus insurance
   and registration costs become relevant. S ince this totals $2,804 you should register
   the car.

3. Now assume you do not own a car, but are considering purchasing one like in the
   example. Again, you estimate you will drive 10,000 miles and that alternative
   transportation will cost $3,400. Should you purchase the car?
   Answer: Now the relevant costs are the entire fixed costs of $5,105 plus variable
   costs of $1,420, or $6,525. Without considering other non- monetary aspects such as
   convenience or prestige, you should not buy the car.

One final caveat. Be careful not to fall for the “just one more” fallacy. As an example
of this fallacy, consider the checkout of a grocery store. You wish to consider the extra
cost of serving an additional customer. You would probably only think of such things as
the bags used, and perhaps a little bit of register tape. Certainly there is no additional
cost for the checker; they simply serve the additional customer at their current hourly
wage. But what happens if you keep adding one more customer? Eventually you will
need to add an additional checker. The problem is that some costs act more like the step-
function costs we previously mentioned.
So how should these step function costs be treated in the decision process? The
maintenance costs for the auto in the previous example illustrates the correct procedure.
Although maintenance is not really a pure variable cost, treating it as such avoids the
pitfalls of the just one fallacy.
V. Cost Accounting:
We will not be going into any depth regarding cost accounting in this class. Still, it may
be helpful to include a short primer since we will be alluding to some of these terms and

Cost accounting is a subset of the more inclusive area of managerial accounting. Cost
accounting deals with the “how to” of determining the cost of a cost object. A cost object
is simply anything, be it a product, service, responsibility center, that we wish determine
the cost of. Again, let me caution that the term “cost” needs a qualifier to give it
meaning. First I will discuss full costs.

Cost is a measurement of the amount of resources, measured in monetary terms, used to
do something. Full cost simply means all resources used, not just those that are easily
traceable to the cost object. For example, it is easy to determine the cost of an auto to the
consumer of that auto. The cost is what you pay to purchase the auto. But what was the
cost of the auto to the manufacturer? That one is considerably more difficult. Think of
what it takes to build an automobile. You have direct materials such as tires,
windshields, axles, etc. You also have the direct labor of those working on the assembly
lines. But what about the rent on the factory? Or what about the supervisor in the
factory? These indirect costs must also be allocated to the automobile to determine full

The first terms that apply, therefore, are direct costs and indirect costs. Direct costs of a
cost object are those costs that can be specifically traced to the cost object. Typical direct
costs are raw materials and direct labor. Indirect costs are costs that are associated with
the cost object, but are caused by two or more cost objects jointly. It is either not
possible, or not feasible, to directly trace these costs to a particular cost ob ject. These
indirect costs are allocated, based on some rational criteria, to individual cost objects.
Indirect costs are often referred to as overhead costs.

Two more terms that often come up are product costs and period costs. Product costs
are all the costs that comprise the full cost of the product (or service). These are the
direct materials, direct labor, and overhead costs of production. All product costs are
included in the capitalized cost of the product. In other words these costs become
inventory, and then are expensed as cost of goods sold when the inventory is sold. In
contrast, certain costs, called pe riod costs, are expensed in the period they occur.
Examples of period costs are marketing, selling, general, and administrative costs.

How do you allocated indirect costs to a cost object? There is not any one particular way
this is accomplished. In essence, what you need to do is determine what causes the
resources to be used. In other words, what drives the costs? This is called the cost
drive r. For example, a common cost driver is direct labor hours. The more hours
working on something are associated with more utilities, indirect supplies, etc. consumed
by the cost object. Using one cost driver, such as direct labor or machine ho urs is a
relatively simple costing method. More complex systems, such as activity-based costing
(ABC) utilize many cost drivers for a single cost object. Still, the basic idea is the same;
find a rational way to allocate indirect costs to a particular cost object.

The following examples demonstrate the basic idea behind full cost allocation.

Assume Stone Co. builds mobile homes. For the current seasons budgeted output of
homes Stone makes the following projections:

Forecasted production                                          200 homes
Direct material per home                                       $35,000
Direct labor per home (50 hours @ $20/hour)                    $1,000
Miscellaneous overhead costs (i.e., rent, utilities,           $80,000
supervision, etc.) Allocated based on direct labor hours.
Estimated direct labor hours for the period = 10,000

In order to compute the total (full) cost of each mobile home Stone adds the direct costs
of labor and materials to the allocated overhead costs. While it is possible to wait until
the period end in order to more accurately compute overhead costs, since at period end
the actual overhead costs and the actual direct labor hours cost driver are known, firms
usually want cost information sooner. In order to estimate these costs a predetermined
overhead rate is computed as budgeted costs divided by the amount of the budgeted cost
driver. In this example the application rate would be $8 per direct labor hour computed
as $80,000 / 10,000 direct labor hours. Therefore the estimated cost of a mobile home is
$36,400 computed as $35,000 materials + $1,000 direct labor, + $400 overhead (50 hours
x $8/hour).

The above procedure will fully allocate all overhead to the individual cost objects, in this
case the mobile homes, provided both estimated overhead costs are the same as actual
overhead costs, and estimated direct labor hours are the same as actual direct labor hours.
If this is not the case there will be either over or under-applied overhead as illustrated in
the continuation of the Stone example.

Assume Stone ends the period producing 190 homes, each of which averaged 52 direct
labor hours to complete. Also assume total overhead costs totals $85,000, $5,000 more
than anticipated. The amount of overhead that needs to be allocated to the 190 mobile
homes is therefore $85,000, however the amount that was allocated is &79,040 (190
homes x 52 hours/home x $8/hour). The under-allocated overhead of $5,960 is either
charged to cost of goods sold or ending inventory, or some combination, depending upon

Critics of traditional costing systems such as the one used by Stone, argue that the cost
estimates may be quite inaccurate if the cost driver does not really bear a strong
relationship to the cause of overhead type costs. This is certainly a valid criticism in
today’s manufacturing environment where technology is replacing labor in the value
chain. Standard costing is also criticized in situations where the firm produces multiple
products, some of which are relatively simple but utilize a lot of the chosen cost driver
where other low volume products are much more complex. This is illustrated in the
following example.

LeWind Cycles produces two bikes, a high- volume basic mountain bike and a low-
volume, specialized road bike. Overhead is allocated to the cost objects, the bikes, at the
rate of five times direct labor costs. The following table presents the costing data for the
two types of bikes produced.

                                Mountain Bikes Road Bikes
Direct materials                          $100        $200
Direct labor                                 30         60
Overhead                                    150        300
Full cost                                 $280        $560

LeWind sells their bikes to bike shops for ultimate sale to the end-user. Management was
a bit surprised that they were having trouble competing in the mountain bike market with
the price charged by competitors consistently lower by about $30. LeWind felt that they
have a very efficient process and cannot see where they can reduce costs by enough to be
profitable at a lower selling price. In contrast, management is having no problem selling
their higher cost road bike. Due to the lower volume, management is especially surprised
because they feel that this product is less efficiently manufactured due to lower
economies of scale. They decided to do a special Activity Based Costing (ABC) project
to see if there is a problem in the way they allocate costs.

Instead of allocating all the overhead based on the single cost driver direct labor dollars,
management determined there are really four main activities that cause the overhead
costs. These activities, along with their cost drivers, estimated total costs, estimated
amount of the cost driver, and overhead application rates, are given in the following
      (1)                 (2)                (3)            (4)                     (5)
    Activity           Cost driver       Estimated      Estimated                  Rate
                                       Overhead Cost Number of Cost              (Column
                                       of the Activity Driver Units            3/column 4)
Purchasing         Number of                  $200,000 10,000 frames           $20 per frame
materials          frames
Machine setups     Number of                  800,000          400 setups         $2,000 per
                   machine setups                                                      setup
Inspections        Hours of                   400,000         4,000 hours      $100 per hour
Running            Machine hours              600,000      20,000 hours         $30 per hour
  Total                                    $2,000,000

January was selected as the test month for the ABC system. The following data was
collected for the month.

                                     Mountain Bikes             Road Bikes
Purchasing materials                       1,000 frames              200 frames
Machine setups                                 13 setups               30 setups
Inspections                                   200 hours               200 hours
Running machines                            1,500 hours               500 hours

The following table is used to compute the allocation of overhead to the two types of

                                    Mountain Bikes                      Road Bikes
  Activity          Rate       Actual Cost      Cost            Actual Cost       Cost
                              Driver Units   Allocated          Driver Units   Allocated
Purchasing            $20 per 1,000 frames      $20,000          200 frames        $4,000
materials              frame
Machine            $2,000 per     13 setups      26,000            30 setups         60,000
setups                  setup
Inspections          $100 per    200 hours       20,000           200 hours          20,000
Running          $30 per hour 1,500 hours        45,000           500 hours          15,000
 Total                                             $111,000                         $99,000
 Total                                                             $210,000
The following table compares the allocated costs to the two types of bikes for both the
traditional costing method and the ABC method.

                   Activity-Based Costing                  Mountain Bikes Road Bikes
Direct materials                                                     $100       $200
Direct labor                                                           30         60
Overhead                                                             1111       4952
 Total Cost                                                          $241       $755
                    Traditional Costing
Direct materials                                                       $100          $200
Direct labor                                                             30            60
Overhead                                                                150           300
  Total Cost                                                           $280          $560
  $111,000 / 1,000 units
  $99,000 / 200 units

Note that the total allocated overhead of $210,000 is the same under each method,
however the low volume complex road bikes are allocated a higher percentage of the total
overhead cost. This makes sense since they require relatively more of each activity
except purchasing. This also helps explain the puzzling finding that the low volume road
bike was seeing little competition at the former cost of $560, whereas the high volume
mountain bike was being under priced at the former cost of $280.

It should be noted that while ABC makes a lot of sense theoretically, it may not make
sense from a practical point of view. As with all things managerial, a cost benefit
analysis is needed. In many cases the extra cost of compiling the data needed for the
more complex ABC method does not justify the more precise cost figures. In many cases
it has been determined the standard costing system is good enough, especially at the
much lower cost to implement.
VI. Budgeting
Annual operating budget
The annual budget process is a mainstay among most firms. The importance of this
process varies, however, depending upon the degree of centralization/decentralization
and the degree with which specific knowledge is spread out among the firms workforce.
The reason for this variation in importance results from just what the budget is supposed
to accomplish.

The budget process has really two major goals. The first is as a planning tool to guide
operational decision making into the future. This is accomplished by bringing together
knowledge in the form of forecasts from all across the firm. Closely related to this first
goal, the budget provides a mechanism to partition decision rights. For example, the
budget formally gives individuals the rights to spend amounts within their budget. The
second goal of the budget is to aid in the control process. Providing a benchmark with
which to judge performance does this.

The trouble with these multiple goals is that they are often (usually) in conflict with each
other. This can best be illustrated with a simple example from a manufacturing setting.
While the example is manufacturing, the same consequences are present in all types of
firms where there are interdependencies (e.g., consulting where the hiring and training of
new and existing professionals is dependent upon the type of engagements the firm’s
“salespeople” are able to bring in).

Acme Inc. has four primarily departments, sales, production, procurement, and
administration. The annual budget for the next year begins with the sales department
forecasting sales of each of the firm’s products. Because the sales force is much closer to
the customer, it is felt that they have the unique knowledge necessary for an accurate
forecast. The production department next forecasts its needs in order to have the
necessary materials, equipment, and workers to complete the production needed to fulfill
the forecasts of the sales department. The procurement department then takes the
forecasted needs of the production department in order to forecast its planned
procurements and logistics for storage and related holding costs. Administration then
puts it all together in order to forecast the next year’s projected financial results to the
many analysts following Acme Inc.

You can imagine that the interdependencies could become even more complex. For
example, instead of one production department, there could be several that are structured
in a sequential process. The output from the first department becomes the input for the
next, and so on. Even with the simple structure, we can easily see how the firm can get
into serious trouble if the forecasts are not accurate. Let’s take the realistic situation
where the manager of the sales department knows that her bonus next year will be based
on her ability to “make” budgeted sales. She will have a natural inventive to lowball her
estimate by building in slack. Unfortunately, the sales estimate forms the basis for the
production department’s forecast of production inputs. If this forecast is based on an
unrealistically low sales forecast, the resulting production forecast would also be low.
This, of course, leads to a procurement budget that is also too low. Now when the actual
sales turn out to be far better than budgeted, the firm is forced to scramble to catch up
with its production needs since there will likely not be sufficient inputs in place to service
the actual production needs. This will likely result in inefficient ordering, hiring, etc.
Unfortunately it is a natural consequence of a budgeting process that serves to conflicting
goals, planning and control.

So we know that there is a built- in conflict within the budgeting process since the results
are used for two conflicting purposes, planning and control. The manager may wish to
convey truthful forecasts, but not at the cost of facing lower bonuses and possible
termination for not “making budget.” A method has been developed that is able to
incorporate these two conflicting goals into one formula such that it is always better to
provide truthful forecasts, even with the knowledge that the budget will be used for
control through a bonus formula.

Assume that the Ridgeback Hunting Co. has each district manager provide forecasts of
district sales. These sales forecasts become budgets that upper management compares to
actual sales to determine bonus payouts. Under normal budgeting, the district manager
has an incentive to build slack into the forecasts in order to have an easier time beating
budget and earning a larger bonus. Even if the award system shifted to one where
accuracy was rewarded, the district manager would simply forecast an easy budget, and
then manage sales at year-end such that the budget was met, but not beat by too much.
This is even worse, since now there are disincentives to work hard to beat budget.

The new plan has three components:

   1. Bonuses are positively related to forecasted sales such that the higher the sales the
      higher the bonus. This gives incentives to forecast “stretch” budgets. If b 1 is a
      bonus coefficient that is a percent of forecasted sales, and forecasted sales are
      Yhat, then this component is:
                         b1 Yhat

   2. The plan also provides incentives to beat budget. If b 2 is the bonus coefficient for
      the excess of Y over Yhat, then this component is:
                          b2 (Y-Yhat), for Y>=Yhat
   3. The formula penalizes the manager if actual sales Y fall below forecasted sales
      Yhat. If b3 is the bonus coefficient for the shortfall, Y-Yhat, then this component
                          -b3 (Yhat-Y), for Yhat > Y.

The coefficients must be set such that b 3 >b1 >b2 >0. As a rule of thumb, b3 should be at
least 30% greater than b1 , and b1 should be at least 20% greater than b2 . This will reward
both accuracy and outstanding performance. The bonus amount B, will be equal to:
B = b1 Yhat + b2 (Y-Yhat) when Y>=Yhat (actual sales meet or exceed forecasted sales)
B = b1 Yhat – b3 (Yhat – Y) when Yhat>Y (actual sales fall short of forecasted sales)
The following table shows bonuses that result from various combinations of forecasted
and actual sales. Notice as you read down a column, for any level of forecast higher
actual sales generate a higher bonus. Notice also that as you read across any row, for any
level of actual sales, a larger bonus is earned for accuracy.

                          Let b1 = 5%, b2 = 3%, and b3 = 7%
                    Then B = .05Yhat + .03(Y-Yhat) if Y>=Yhat and
                        B = .05Yhat + .07(Yhat-Y) if Yhat > Y.
Actual Sales Y                              Forecasted Sales Yhat
                             $1,000                $1,100                     $1,200
       $1,000                  50                    48                         46
       $1,100                  53                    55                         53
       $1,200                  56                    58                         60

Capital budgeting

Capital budgeting problems can be thought of as long-term alternative decision problems,
where the choice is how to spend your capital dollars. These problems generally are
solved with the use of present value methods similar to wha t we covered earlier in the
class. One slight complication is the fact that the cash flows are usually not simple
annuities, rather they differ by period.

These problems can be looked at in a similar way to how a banker looks at making a
loan. The bank lends out money today, the investment, with an expectation that it will
receive future cash flows, interest and principle repayment, in an amount sufficient to
earn a satisfactory return on its investment. The main difference is the greater difficulty
in predicting the future cash flows in capital budgeting problems. Still, the similarity is

The basic problem comes down to whether it is worth it to invest dollars now with the
expectation that it will pay off in the future. The key then is whether the present value of
all the future cash flows, both inflows and outflows, is greater than the amount invested
now. Really not that hard conceptually, but often very difficult practically. The
difficulty is in the estimation of future cash flows and the proper discount rate to use. In
this section I will assume that you can estimate these things (that is why you take courses
in addition to accounting, isn’t it?) and we will concentrate on how to set up the problem
and then solve it.

There are actually two methods utilizing present value techniques that are used to solve
these capital budgeting problems. The first method determines the net present value
(NPV) at time zero. Net present value is simply the sum of all the individual cash flow
present values, including the initial investment. If the NPV is greater than zero, then the
project is worth doing. A positive NPV means the project is estimated to earn a return
greater than the rate used to discount the cash flows. The rate used should be the fir m’s
risk adjusted required rate of return.

The second method solves for the rate of return that would create a zero NPV. In other
words, what discount rate applied to the individual cash flows will yield a zero NPV?
This is known as the internal rate of return (IRR). The decision rule is to compare the
calculated IRR with the firm’s required rate of return, sometimes called the hurdle rate,
and accept projects where the IRR is greater than the hurdle rate.

There are certain plusses and minuses with the IRR method relative to the NPV method.
As long as you have a decent calculator, the calculation of either is straight- forward, so
that is not a consideration. The IRR method does avoid the problem of trying to
determine a discount rate. A rate is simply solved for. Of course you still need to decide
if the calculated IRR is high enough to justify the investment risk. The minuses of the
IRR method are several. First, you cannot use different rates for different cash flows.
This can be done with NPV to take risk into account. Second, and this is a big one. The
IRR method assumes any cash inflows during the life of the investment are reinvested at
the calculated IRR. This is often quite a leap. Assume there is a very good investment
that has an IRR of 20%, whereas every thing else yields, at best, 14%. It is not realistic
to assume that the investment cash inflows in each of the early years will be reinvested at
the 20% rate.

The following example illustrates both the NPV and IRR methods.

Savanna Corp is considering the purchase of some new technology to replace some old
equipment. The hope is that it will help expand into new markets. The following is a
projection of the future cash flows from this $90,000 investment assuming a 12%
discount rate.

                               0           1          2            3          4         5
New asset acquisition      ($100,000)
Old asset sale                 10,000
New revenue cash                        $120,000   $80,000       $60,000   $50,000    $40,000
Expenditures                            (70,000)   (40,000)   (30,000)     (25,000)   (25,000)
Taxes                                   (12,400)    (8,400)    (4,400)      (2,400)      (400)
Sale of new equipment                                                                    5,000
Net cash flows              ($90,000)    $37,600   $31,600       $25,600   $22,600    $19,600
Present value @ 12%          (90,000)     33,572    25,191        18,222    14,363      11,122
NPV                           $12,469

Since the NPV, at 12%, is positive, the project is a go based on the quantitative analysis.
We will not consider non-quantitative items at this time.
What return is the project actually earning? To answer this we calculate the IRR. The
IRR turns out to be 18.2%. If our required return is 12%, we would again say this is a go
based on the IRR method.

There is another simplistic method used in practice that does not consider the time value
of money. The technique, know as the payback method, simply computes the number of
years until the initial investment is recouped. In the above example, the payback is three
years (90,000 – 37,600 – 31,600 – 25,600). Then it is a subjective call to decide if the
payback period is short enough. This method is obviously deficient in that all cash flows
beyond the payback period are ignored, as is any time value of money considerations.

All of the discussion so far has been with screening projects. In other words, should the
project be done or not. A second type of problem involves how to rank multiple
proposals. This can be difficult if each project promises an adequate return, but there is
not sufficient funding for all of them. The problem becomes more difficult if project
differ from one another in lives, size, or risk.

Either the NPV or the IRR method can be used. IRR is relatively easy. The decision
rule is simply the project with the highest IRR is the highest ranked, assuming equal risk.
If risks differ than subjectivity enters the decision.

NPV analysis is not quite as straight- forward. Risk, however, can be incorporated
through different discount rates. But what about different size investments? I think we
can all agree that a $1,000 investment that yields a $2,000 NPV is better than a
$1,000,000 that also yields a $2,000 NPV. This size difference is taken care of by
computing a profitability index. The index is computed simply by dividing the present
value of the inflows by the initial investment. A zero NPV project will therefore have a
profitability index of 1. The profitability index in the Savanna Corp example is 1.14.
The reference rule is the higher the profitability index; the higher the project is ranked.

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