WEEK 1: How Management Accounting Information Supports Decision Making

Financial Accounting Managerial Accounting

 retrospective  retrospective and prospective
 external stakeholders (investors, creditors,  needs of employees and
regulators) and tax authorities managers
 the form is important  no prescribed form

BALANCED SCORECARD (BSC)

The balanced scorecard enables companies to:

 track financial results
 monitor how they are building the capabilities for future growth and profitability:
a) with customers (customer satisfaction and loyalty, on-time delivery and market share)
b) with their processes (cost, quality, rate and speed of new product introductions)
c) with their employees and systems (employee satisfaction, retention, capabilities and
motivation)

BEHAVIORAL IMPLICATIONS
 “What gets measured gets done.”
 “If you don’t measure it, you can’t manage and improve it.”
 employees may do undesirable actions to change their score on the performance measure

measurements are used:

 for information, planning, and decision-making
 to control, evaluation, and reward, employees
 WEEK 1: Using Costs In Decision Making

USE OF COST INFORMATION

 pricing (cost-plus pricing)  performance evaluation
 product planning  contracting (cost reimbursement
 budgeting contracts)

cost object = any item for which a cost is to be determined

- activities, products, product lines, departments, or even entire organizations

direct cost = a cost that is uniquely and unequivocally attributable to a single cost object

indirect cost = a cost that is not classified as direct

TC (total cost) = FC + VC x units

VARIABLE COSTS
= a cost that changes in direct proportion to changes in the activity level of some variable
- the variable is called a cost driver
total variable cost = variable cost per unit of the cost driver x cost driver units

INDIRECT VARIABLE COSTS

- low-cost items (napkins for a pizza), can’t link to an item (rent for the facility)
- in manufacturing they are called manufacturing overhead (MOH)

FIXED COSTS
= an asset not wholly consumed when one unit of product is made
 fixed manufacturing overhead = FC related to manufacturing assets
 equipment, factory building, insurance, marketing
 depends on the amount of a resource that is acquired rather than amount used
 when it is acquired, it is called the historical cost (expenditure not an expense)
 provides the capacity to produce
 cost per unit goes down with volume
 depreciation, wages
capacity costs
cost driver rate = practical capacity of activity ($1,000,000/20,000 machine hours = $50/h)

depreciation: if it depreciates $10k a year  expenditure goes down by 10 and will be charged
as an expense against MOH

STEP VARIABLE COST — a cost that is fixed over a limited range of activity
MIXED COST — a cost that has variable and fixed components (base salary + commission,
phone plan, y = ax + b)

COST BEHAVIOR ESTIMATION

1. high-low method — use 2 data points: the highest level of activity, and the lowest
VC per unit = (highest – lowest cost) / (highest – lowest activity)
- easy, only uses 2 data points (what if they are exceptions, draw a scatter graph)
2. visual inspection method — plot the data points and visually identify the line that represents
the best fit
- only 2 data points, no real theory, 2 data points could be exceptions
3. regression analysis (we won’t use this)
- most accurate but most complex, Excel, used in economics
 WEEK 1: Decision Making And Management Accounting Information

MANUFACTURING COSTS
Direct Material = materials that can be traced easily to a unit of output and are of significant
economic consequence to final product (ingredients)
Direct Labor = labor costs that can be traced easily to the creation of a unit of output
Manufacturing Overhead = all other costs incurred by a manufacturing facility (thread, glue,
rent of the factory, not rent for the office)

relevant costs = a cost that will change because of a decision

- salary of manager that we consider laying off
- not: salary of manager that we consider laying off but will be replaced by another manager

incremental cost = the cost of the next unit of activity (one more pizza)
- not just variable, could have a fixed cost
avoidable cost = a cost that can be avoided by taking a specific course of action (stop selling a
pizza that isn’t selling)
opportunity cost = the maximum value forgone when a course of action is chosen (0 or
positive, cannot be negative)

sunk cost = a cost that results from a previous commitment and cannot be changed

ASSUMPTIONS:
unit sold = unit made
- all cost is variable or fixed
- the unit selling price and variable cost per unit remain the same over all levels of
production
- fixed cost remains the same over all levels of production

WEEK 2: Cost-volume-profit (CVP) analysis

A) CONTRIBUTION MARGIN = Total Revenue - Total Variable Costs

contribution margin per unit—the contribution each unit makes to covering fixed costs and
providing a profit
contribution margin per unit
contribution margin ratio = selling price per unit

B) THE CVP EQUATION

Profit = (Contribution Margin per Unit X Units Sold) – Fixed Costs
FC +target profit
Required Unit Sales = contribution margin per unit
 target profit
FC +( )
Required Unit Sales (With Taxes) = 1−Tax Rate
contribution margin per unit
¿ cost
Required Unit Sales = contribution margin per unit−( Profit margin x Price per unit )

Profit
Profit Margin = Revenue

C) WHAT-IF ANALYSIS
Incremental Profit = Incremental Contribution Margin– Incremental Cost
EXAMPLE: $20,000 ad campaign will sell 2000 crates for $12
incremental profit = (2000 x $12) – $20,000 = $4,000

D) WEIGHTED AVERAGE CONTRIBUTION MARGIN APPROACH (WACMU)

- CVP Analysis for Multiple Products
- multiple breakeven points
WACMU = (contribution margin x product mix percent) + (contribution margin x product mix
percent)
¿ cost +Target income
Total unit sales = WACMU
 WEEK 3/4: RELEVANT COST ANALYSIS IN DECISION MAKING

1. MAKE OR BUY: THE OUTSOURCING DECISION

Are the costs saved by not making the product internally greater than the costs incurred when
purchasing it?
- meeting quality and delivery requirements, strategic importance of the activity being
outsourced

Internal Cost Avoided External Costs Incurred

 all variable costs  acquisition cost
 any avoidable fixed costs  any transportation costs
 any fixed costs
examples: ordering, receiving, inspection, and other costs involved with dealing with a supplier

2. THE DECISION TO DROP A PRODUCT

Do the costs saved by dropping the product outweigh the lost revenue and any costs incurred to
stop production?

The analysis of what costs are avoided can be very difficult to determine
- costs that are attributed to a product may only be avoidable in the intermediate or long run
- sales of one product may affect sales of other products

Internal Cost Avoided Lost Revenue and Discontinuance Cost Incurred

 all variable costs  lost contribution margin
 any avoidable fixed costs  discontinuance costs
 any other costs

3. COSTING ORDERS (Special Order)

- relevant cost analysis suggests that only costs that will change because of changing from the
existing product to the proposed product should be considered

Floor Price = the minimum price per unit that keeps the company profitable

1. VC per special order unit

2. Idle Production Capacity = (Practical capacity – Production level)
Opportunity cost of the order = CM per unit x units given up
OC
Opportunity cost per unit of the order = number of new orders
VC for the order + FC increase for theorder +Opportunity cost per unit
3. Minimum acceptable price= number of units ∈the order
4. SHORT-TERM PRODUCT MIX DECISIONS
- in situations where resources (like labor hours) are limited
- focus on the contribution margin per unit of the limited resource to determine which products
to prioritize
- for multiple resource constraints, linear programming can be used to find the optimal solution

WEEK 5: Accumulating and Assigning Costs to Products

Manufacturing, retail, and service organizations have different patterns of cost flows resulting
in different management accounting priorities.

MANUFACTURING ORGANIZATIONS
 Manufacturing costs are classified into three groups:
1. Direct Materials
2. Direct Labor
3. Manufacturing Overhead
 The manufacturing operation consumes labor and overhead items and these costs are
added to the work in process inventory.
 When the goods are sold, their costs are moved from the finished goods account on the
balance sheet to the cost of goods sold account on the net income statement.

Transferring cost on the balance sheet from raw materials to selling them:

Retail Organizations
 The primary focus in retail operations is the profitability of product lines or departments.
Transferring cost from purchase to the sale of the goods (cost of merchandise sold)
Service Organizations
 The major expense in service organizations is often employee pay.
 In service organizations, the focus is on determining the cost of a project or service.
 The potential for cost system distortions is less for a service organization than for a
manufacturing operation.

Cost Classification and Context

 Direct costs are assigned to the appropriate cost object.
 Indirect costs are collected into cost pools and then allocated to cost objects in a
reasonable way and should reflect a cause-and-effect relationship.

Indirect Cost Pools: Manufacturing

 The simplest structure in a manufacturing system is to have a single indirect cost pool for
the entire manufacturing operation.
 Indirect cost pools may have separate pools for variable and fixed manufacturing
overhead costs.
Indirect Cost Pools
 One indirect cost pool collects the actual indirect costs incurred for the period.
 Indirect Cost Incurred
 A second indirect pool accumulates the indirect cost that has been applied (allocated) to
production for the same period.
 Indirect Cost Applied

Predetermined Overhead Rates

 Because the total indirect costs for the year are not known until after the year-end,
organizations allocate indirect costs to production during the year using predetermined
indirect cost rates.
 First step—Determine the cost driver that will be used to allocate the indirect costs to
production.
 Cost analysts try to choose a cost driver that best explains the long-run behavior of the
indirect cost.
 Next, the estimated total factory indirect costs are divided by the practical capacity in
cost driver units to compute the predetermined overhead rate.
 Most organizations use multiple indirect cost pools in order to more accurately cost the
resources used by the cost object.
 Design of the indirect cost pools is considered to be one of the most important choices in
costing system design and requires an understanding of the manufacturing system.

Predetermined Overhead Rates Other Names:

 Predetermined indirect cost rate
 Cost driver rate

Reconciling Actual and Applied Capacity Costs

 The actual and applied indirect cost pools must be reconciled at year-end.
 There are three options to reconcile the differences in the actual and applied indirect cost
pools:
 Charge the difference directly to cost of goods sold.
 Prorate the difference to the ending balances of work in process inventory, finished
goods inventory, and cost of goods sold, based on the ending balances of these
accounts.
 Decompose the difference between actual and applied indirect costs into the
difference between.
 Actual and budgeted indirect costs
 Budgeted and applied indirect costs

Cost Driver Level

 There are four commonly proposed activity levels used to compute the cost driver rate:
  Actual level of operations
 Planned level of operations
 Average level of operations
 Practical capacity level of operations

Actual Level of Operations

 The actual rate is developed after completion of the period by dividing the actual indirect
costs by the actual level of the cost driver.
 This approach is called actual costing.
 Many management accountants reject this approach because it disguises managerial
insights that the other approaches provide.

Planned Level of Operations

 Planned indirect costs are divided by the planned level of the cost driver.
 This approach attempts to allocate all planned indirect costs.
 Problem
 Often, most of the indirect costs are fixed; when the planned level of production
changes, so does the cost driver rate, making it seem that the product cost has
changed even if total fixed cost has not changed.

Planned Level of Operations

 When demand decreases, the cost driver rate will increase, making it seem that product
cost has increased. Increasing the price in response can lead to cycle of further decreases
in demand and increases in the cost driver rate, which will cause a death spiral of
continuing decreases in demand.

Average Level of Operations

 The average use of capacity is the likely activity rate used to justify the acquisition of the
capacity; would seem to reflect the economic basis for the level and cost of capacity.
 Buries the cost of idle capacity in product cost.
 No clear incentive for management to increase its use of idle capacity.
 This will create a competitive advantage for a competitor that has lower idle-capacity
costs.

Practical Capacity Level of Operations

 Using practical capacity to estimate product costs provides clear decision-making insights
and incentives related to dealing with the cost of idle capacity.
 Estimating practical capacity begins with an estimate of the theoretical capacity available.
 Subtract capacity that is not available.
 Machines: equipment downtime for maintenance
 Labor: vacation time, breaks, training
Job Order Costing
 Job order costing accumulates the costs for a specific customer orders because the orders
tend to vary from customer to customer.
 Examples: consulting work, treating a patient in a hospital, and automobile repairs
 Each job is assigned a unique job order number for collecting costs.
 The company collects the actual direct material and direct labor used for a specific job.
 Indirect overhead costs are allocated to the job.
 Once the work is completed, the collected costs are summarized.

Process Costing
 Process costing is used when all products are identical.
 Examples: soda drinks and breakfast cereal
 Process costing systems use two different cost terms:
 Direct material
 Conversion costs—all manufacturing costs that are not direct material costs

Weighted Average Process Costing

 Equivalent number of units are calculated for the period as follows:
 For completed units, the number of equivalent units will equal the number of
physical units.
 Partially completed units (units in ending work in process) are converted into
equivalent completed units based on the level of completed work.
 If all materials are added at the beginning of the process, 100% of the direct
material for unfinished units is in ending work in process.

Weighted Average Process Costing

 Costs per equivalent unit (EU)
 Materials cost per EU = The total cost of direct material (cost in opening inventory
and cost incurred this period) divided by the equivalent units of material
 Conversion cost per EU = The total conversion costs (costs in opening inventory
and costs incurred this period) divided by the equivalent units of conversion
 Use the materials cost per EU and conversion cost per EU to allocate manufacturing costs
to the completed units and ending work in process inventory.

ALLOCATING SERVICE DEPARTMENT COSTS

Types of Departments
 Production Departments—departments that directly produce goods or services
 Service Departments—departments that do not directly produce goods or services for
customers but provide support for the production departments
  Service departments include maintenance and administration.
 Service department costs have been traditionally allocated to production departments and
then accumulated with the production department’s costs and allocated to cost objects.

Approaches to Allocating Service Department Costs

1. Direct Method
2. Sequential Method
3. Reciprocal Method

1. Direct Method
 Ignores the services provided to other service departments.
 Costs for each service department are directly allocated to the production departments.
 The direct method is easy to implement but doesn’t recognize the support given to other
service departments.

2. Sequential Method
 Also referred to as the Step Method or Step-Down Method.
 One of the service departments is chosen to allocate its costs first.
 The service costs are allocated to production departments and other service departments
in proportion to the services provided to each department.
 Once a service department’s costs have been allocated, it is dropped from consideration
and the process moves to the next service department.
 The process continues until all of the service departments have allocated their costs to the
production departments.
 The sequential method recognizes that a service department may support other service
departments as well as production departments.
Shortcomings
 Although the method considers some of the support services provided among
services, it does not consider all of them.
 The order in which the service departments’ costs are allocated makes a difference
in the cost allocation.

3. Reciprocal Method
 The reciprocal method is a more complicated approach that addresses the shortcomings
of the direct and sequential methods.
 There are two steps in the reciprocal method:
1. Develop a reciprocal equation for each service department. Calculate the reciprocal
costs of each department—the sum of its direct costs and its share of reciprocal
costs of all service departments, including itself.
2. Use these reciprocal costs to allocate the service departments’ costs to the
production departments based on usage of the service departments.
Chapter 4 pp. 76-95