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 accounting. 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 accounting. 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. 1 ABC is most likely only v iewed as sexy to an accountant. 2 For the most part we do not choose the accounting profession because of our peop le skills. 3 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 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 customers. 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. TR = TC X * UP = FC + (UVC * X) where UP is unit price. Next factor out X, the number of units we are attempting to calculate. 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 units. 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 decisions. 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 Expenses: 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 general. 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 service. 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 (1,390) 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 OR 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 car? 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 concepts. 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 cost. 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 materiality. 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 table. (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 purchased 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 inspections Running Machine hours 600,000 20,000 hours $30 per hour machines Total $2,000,000 estimated overhead 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 bikes. 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 hour Running $30 per hour 1,500 hours 45,000 500 hours 15,000 machines Total $111,000 $99,000 Allocated costs Total $210,000 overhead 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 1 $111,000 / 1,000 units 2 $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 is: -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 great. 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. Year 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 inflows 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.
Pages to are hidden for
"Introduction to Managerial Accounting Test Bank"Please download to view full document