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Exam Notes

63 Pages

Course Code
ECON 2720
Elizabeth Farrell

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ACTG 2020 Ch. 1: Managerial Accounting and the Business Environment  The Role of the Management Accountant in Value Creation • Managerial accounting: the form of accounting concerned with providing information to managers for use in planning and controlling operations and for decision making o Provides data that help organizations run more efficiently • Financial accounting: the form of accounting concerned with providing information to shareholders, creditors, and other outside the organization o Provides the scorecard by which a company’s past performance is judged The Work of Managers and Their Need for Managerial Accounting Information • Planning: developing objectives and preparing budgets to achieve these objectives o Identify alternatives and select the one that best meets the organizations objectives o Budget: a quantitative plan for the acquisition and use of financial and other resources over a specified future time period o Controller: the manager in charge of the accounting department in an organization • Directing and motivating: mobilizing people to carry out plans and run routine operations o Data such as daily sales reports • Controlling: ensuring that the plan is actually carried out and is appropriately modified as circumstances change o Control: steps taken by management that attempt to increase the likelihood that the objectives developed at the planning stage are attained and to ensure that all parts of the organization function in a manner consistent with organizational policies o Feedback: accounting and other reports that help managers monitor performance and focus on problems and/or opportunities that might otherwise go unnoticed 1  Performance report: a detailed report comparing budgeted data to actual data • Strategy: a game plan that enables a company to attract and retain customers by distinguishing itself from competitors • Customer value propositions tend to fall into three broad categories: o Customer intimacy o Operational excellence o Product leadership • Planning and control cycle: the flow of management activities through planning, directing and motivating and controlling, and then back to planning again • Business plan (pg. 7, Exhibit 1-2) • Differences between financial accounting and managerial accounting o Emphasis on the future o Relevance of data  Data must be suited for purposes which may include estimates o Less emphasis on precision o Segments of an organization  Segments: any part of an organization that can be evaluated independently of other parts and about which the manager seeks financial data o Generally Accepted Accounting Principles  Managerial accounting is not bound by GAAP.  Set own ground rules concerning the content and corm of internal reports Organizational Structure • Decentralization: the delegation of decision making throughout an organization by providing manager at various operating levels with the authority to make key decisions relating to their areas of responsibility • Organization chart: a diagram of a firm’s organizational structure that depicts formal lines of reporting, communication, and responsibility between managers 2 • Line position: a job position that is directly related to the achievement of the organization’s basic objectives • Staff position: a job position that is only indirectly related to the achievement of the organization’s basic objectives. Such positions are supportive in nature in that they provide service or assistance to line positions or to other staff positions Professional Ethics • Corporate governance: a system by which a company is directed and controlled o Enhances shareholders’ confidence that a company is being run in their best interests rather than in the interests of top managers • Corporate social responsibility: a concept whereby organizations consider the needs of all stakeholders when making decisions Process Management • Business process: a series of steps that are followed in order to carry out some task in a business • Value chain: consists of the major functions that add value to a company’s products and services o R&D, product design, manufacturing, marketing, distribution, customer service • Lean Production o Raw materials: materials that are used to make a product o Work in process: inventories consisting of units of product that are only partially complete and will require further work before they are ready for sale to a customer o Finished goods: inventories consisting of units of product that have been completed but have not yet been sold to customers o The push process in traditional manufacturing starts by accumulating large amounts of raw material inventories from suppliers so that operations can proceed smoothly even if unanticipated disruptions occur o Lean thinking model: a five-step management approach that organizes resources around the flow of business processes and pulls units though in response to customer orders  Identify value in specific products/services 3  Identify the business process that delivers value  Organize work arrangements around the flow of the business process • Manufacturing cell  Create a pull system that responds to customer orders • Just-in-time (JIT) production: a pull system in the lean thinking model where production is not initiated until a customer has ordered a product  Continuously pursue perfection in the business model o Supply chain management: the coordination of business processes across companies to better serve end consumers • Six Sigma: a process improvement method that relies on customer feedback and fact- based data gathering and analysis techniques to drive process improvements o Technically a process that generates no more than 3.4 defects per million opportunities, usually referred to as zero defects o DMAIC: define, measure, analyze, improve, and control o Non-value-added-activities: activities that customers are not willing to pay for because they add no value  Should be eliminated wherever possible • Enterprise system: a software system designed to overcome problems in data inconsistency and duplication by integrating data across an organization into a single software system • Enterprise risk management: a process used by a company to proactively identify and manage foreseeable risks Ch. 2: Cost Terms, Concepts, and Classifications General Cost Classifications • Manufacturing Costs o Direct materials: those materials that become an integral part of a finished product and can be conveniently traced to it o Indirect materials: small items of material such as glue and nails that may become an integral part of a finished product but the costs of tracing them exceed the benefits 4  Included in manufacturing overhead o Direct labour: those factory costs that can be traced easily to individual units of product. Also called touch labour o Indirect labour: the labour costs of janitors supervisors, materials handlers, and other factory workers that cannot be conveniently traced directly to particular products  Included in manufacturing overhead o Manufacturing overhead: all costs associated with manufacturing except direct materials and direct labour  Only costs associated with operating the production facility are included in the manufacturing overhead category o Conversion costs: Direct labour cost plus manufacturing overhead  Direct labour costs and overhead are incurred to convert materials into finished products o Prime costs: direct materials cost plus direct labour cost • Classification of Labour Costs of Manufacturing o Overtime premium: the extra hourly wage rate paid to workers who must work above their normal time requirements  Can be attributed to direct labour or overhead depending on how it is classified • Non-Manufacturing Costs o Marketing or selling costs: all costs necessary to secure customer orders and get the finished product or service to the customer  Order-getting and order-filling costs o Administrative costs: all executive, organizational, and clerical costs associated with the general management of an organization rather than with manufacturing, marketing, or selling Product Costs versus Period Costs • Product costs: all costs that are involved in the purchase or manufacture of goods. In the case of manufactured goods, these costs consist of direct materials, direct labour, and manufacturing overhead. Also called inventoriable costs 5 o Cost of goods sold o Inventoriable costs: same as product costs • Period costs: those costs that are taken directly to the income statement as expenses in the period in which they are incurred or accrued; such costs consist of selling (marketing) and administrative expenses Cost Classifications on Financial Statements • The Balance Sheet o A merchandising company has only one class of inventory – goods purchased o A manufacturing company has three classes of inventory – raw (direct) materials, work in process and finished goods  Typically only the sum of these three categories is shown on the balance sheet of external report • The Income Statement o Basic equation for inventory accounts  Beginning balance + additions to inventory = ending balance + withdrawals from inventory o Cost of goods sold in a merchandising company  Beginning inventory + purchases = ending inventory + cost of goods sold o Cost of goods sold in a manufacturing company  Beginning finished goods inventory + cost of goods manufactured = ending finished good inventory + cost of goods sold o Cost of goods manufactured: costs that include the direct materials, direct labour, and manufacturing overhead used for the products finished during the period.  (pg. 39, Exhibit 2-4) Schedule of Cost of Goods Manufactured • Schedule of costs of goods manufactured: a schedule showing the direct materials, direct labour, and manufacturing overhead costs incurred for a period and assigned to work in process and completed goods 6 • Total manufacturing costs: costs that represent the direct materials, direct labour, and manufacturing overhead used to perform the production work for finished or unfinished products for the period o Total manufacturing costs need to be adjusted for the change in work in process inventory to arrive at costs of goods manufactured • Cost flow requires balances of raw materials account be transferred to work in process to finished goods inventory and finally to cost of goods sold when product is sold o (Pg. 41, Exhibit 2-5) Cost Classifications for Predicting Cost Behaviour • Cost behaviour: the way in which a cost reacts or responds to changes in the level of activity • Variable cost: a cost that varies, in total, in direct proportion to changes in the level of activity. A variable cost is constant per unit • Fixed cost: a cost that remains constant, in total, regardless of changes in the level of activity within the relevant range. If a fixed cost is expressed on a per unit bases, it varies inversely with the level of activity o Relevant range: the range of activity within which assumptions about variable and fixed cost behaviour are valid • Mixed cost: a cost that contains both variable and fixed cost elements o Ex. Sales wages (salary + commission) Cost Classifications for Assigning Costs to Cost Objects • Cost object: anything for which cost data are desired • Direct cost: a cost that can be easily and conveniently traced to the particular cost object under consideration • Indirect cost: a cost that cannot be easily and conveniently traced to the particular cost object under consideration o Ex. Salary of factory manager cannot be traced to a specific product if many different are made  Common cost: a cost that is incurred to support a number of cost objects but cannot be traced to them individually Cost Classification for Decision Making 7 • Differential cost: a difference in cost between any two alternatives • Differential revenue: a difference in revenue between any two alternatives • Incremental cost: an increase in cost between two alternatives o Cost of switching from one alternative to another • Opportunity cost: the potential benefit that is given up when one alternative is selected over another o Not usually entered in the accounting records of an organization, but must be considered in every decision • Sunk cost: any cost that has already been incurred and that cannot be changed by any decisions made now or in the future o Ignored when calculating differential costs Ch. 3: System Design: Job­Order Costing • The essential purpose of any managerial costing system should be to provide cist data to help managers plan, control, direct, and make decisions • Absorption costing: a costing method that includes all manufacturing costs – direct materials, direct labour, and both variable, and fixed overhead – as part of the cost of a finished unit of product o Full costing: another name for absorption costing Process and Job-Order Costing • Process costing system: used in those manufacturing situations where a single, homogenous product (such as cement or oil) flows in a continuous stream out of the production process o Accumulate costs in a particular operation or department for an entire period and then divide this total cost by the number of united produced during the period Totalmanufacturingcost o Unit productcost= Totalunitsproduced • Job-order costing: used in situations where many different product, jobs, or services are produced each period o Batches of jobs can be categorized together and the costing system uses same idea as a process costing system, but on a per-product basis 8 Job-Order Costing – An Overview • Measuring Direct Materials Cost o Bill of materials: a record that lists the type and quantity of each major item of the materials required to make a product o Materials requisition form: a detailed source document that specified the type and quantity of materials that are to be drawn from the storeroom and identifies the job to which the costs of materials are to be charged  Serves as a means for controlling the flow of materials into production and also for making entries in the accounting records • Job cost sheet: a form prepared for each job that records the materials, labour, and overhead costs charged to the job • Measuring Direct Labour Cost o Time ticket: a detailed source document that is used to record an employee’s hour-by-hour activities during a day Calculating Predetermined Manufacturing Overhead Rates • Assigning manufacturing overhead to units of product can be a difficult task o Manufacturing overhead is an indirect cost. This means it is either impossible of difficult to trace these costs directly to a particular product or job o Manufacturing overhead consists of many different items o Even though output may fluctuate due to seasonal or other factors, manufacturing overhead costs tend to remain relatively constant due to the presence of fixed costs o The timing of payment of manufacturing overhead costs often varies. Items such may be paid annually, quarterly, monthly, or as acquired, but production of finished items is continuous and rather uniform all year long • Allocation base: a measure of activity such as direct labour-hours or machine-hours that is used to assign costs to cost objects • Predetermined overhead rate: a rate used to charge overhead costs to jobs; the rate is established in advance for each period by use of estimates of total manufacturing overhead costs and the total allocation base for the period 9 Estimatedtotalmanufacturingoverheadcost o Predeterminedoverheadrate= Estimatedtotalunits∈theallocationbase • Overhead application: the process of charging manufacturing overhead cost to job cost sheets and to the work in process account o overheadapplied=predeterminedoverheadrate×amountof allocationbaseincurredbythe job • Normal cost system: a costing system in which overhead costs are applied to jobs by multiplying a predetermined overhead rate by the actual amount of the allocation base incurred by the job • The Need for a Predetermined Rate o Managers would like to know the accounting system’s valuation of completed jobs before the end of the accounting period o If actual overhead rates were computed frequently, seasonal factors in overhead costs or in the allocation base could produce fluctuations in overhead rates o The use of a predetermined overhead rate simplifies record-keeping • Choice of an Allocation Base for Overhead Cost o Cost driver: a factor that causes overhead costs, such as machine-hours, beds occupied, computer time, or flight hours • Computation of Unit Costs o Total cost should be calculated for the job and then divided by number of units o Unit cost is an average cost and should not be interpreted as the cost that would actually be incurred if another unit was produced • Summary of Document Flow (pg. 79, Exhibit 3-5) o Sales Order  Production Order  Materials requisition form, direct labour time ticket, predetermined overhead rates  job cost sheet Job-Order Costing – The Flow of Costs • The Purchase and Issue of Materials o Purchase of raw materials goes into “Raw Materials Inventory” asset account 10 o Materials requisitioned for use in production goes into “Work in Process Inventory” and “Manufacturing Overhead” depending on whether they are direct or indirect materials from the “Raw Materials Inventory” account • Labour Cost o Labour is debited into the “Work in Process Inventory” or “Manufacturing Overhead” accounts depending on whether it is direct or indirect labour • Manufacturing Overhead Costs o All additional costs are debited to the “Manufacturing Overhead” account The Application of Manufacturing Overhead • Overhead is applied to the “Work in Process Inventory” account using the predetermined overhead rate. “Manufacturing Overhead” is then credited o The account is said to be a clearing account o Actual overhead costs are charged to the account as they are incurred o Overhead is applied to Work in Process using the predetermined overhead rate • Actual overhead costs are not charged to jobs o They do not appear on the job cost sheet nor do they appear in the Work in Process account o Only the applied overhead costs, based on the predetermined overhead rate, appears on the job cost sheet and in the Work in Process account • Non-Manufacturing Costs o These costs should not go into the overhead account, but rather charged directly to the income statement Cost of Goods Manufactured • The costs of the completed job are transferred out of the Work in Process account and into the Finished Goods account o The sum of all amounts transferred between these two accounts represents the cost of goods manufactured for the period • As units in finished goods are shipped to customers, their cost is transferred from the Finished Goods account into the Cost of Goods Sold account 11 • Summary of Cost Flows (pg. 87, Exhibit 3-9; pg. 88, Exhibit 3-10; pg. 89, Exhibit 3-11, 3- 12) Complications of Overhead Application • Underapplied and Overapplied Overhead o Since the predetermined overhead rate is established before a period begins and is based on estimates, there will be a difference between the amount of overhead cost applied and the amount incurred o Underapplied overhead: a debit balance in the Manufacturing Overhead account that arises when the amount of overhead cost actually incurred is greater than the amount of overhead cost applied to Work in Process during a period o Overapplied overhead: a credit balance in the Manufacturing Overhead account that arises when the amount of overhead cost applied to Work in Process is greater than the amount of overhead cost actually incurred during a period • Disposition of Underapplied or Overapplied Overhead Balances o Close out to Cost of Goods Sold o Allocate amount account  More accurate than previous method  Assigns overhead costs to where they would have gone in the first place had it not been for the errors in the estimation of the predetermined overhead rate • Necessary to first calculate the percentage of overhead that had applied to each account • For inventory accounts necessary to find per-unit overhead cost and multiply by remaining units in the account • Another way to do it (but less accurate) is to divide the balance of each account by the total balance to arrive at the percentage o Cost of goods sold should be calculated by using recorded amount and subtracting Work in process inventory and Finished goods inventory from the beginning of the period to isolate for cost of goods sold of the current period o Carry the balance forward 12  Done if fluctuations exist among different periods  This method helps smooth out overhead differences o A General Model of Product Cost Flows (pg. 93, Exhibit 3-13) o Plantwide overhead rate: a single predetermined overhead rate that is used throughout the plant o Multiple predetermined overhead rates: a costing system in which there are multiple overhead cost pools with a different predetermined rate for each cost pool, rather than a single predetermined overhead rate for the entire company. Frequently, each production department is treated as a separate overhead cost pool Appendix 3A: The Predetermined Overhead Rate and Capacity • If the predetermined overhead rate is calculated using a budgeted output, the overhead rate will change as production changes o Products are charged for resources that they do not use o Can cause prices to increase at times of falling demand • If the predetermined overhead rate is calculated using the full capacity output, the overhead rate will be constant o Will almost always result in underapplied overhead o However this then has to be adjusted which defeats the purpose of its use Ch. 5: Activity­Based Costing: A Tool to Aid Decision Making • Activity-based costing (ABC): a costing method based on activities that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore fixed costs o Typically used as a supplement, rather than a replacement for a company’s usual costing system The Treatment of Costs under the Activity-Based Costing Model • Traditional absorption costing is designed to provide data for external financial reports • Activity-based costing is designed for use in internal decision making o Non-manufacturing as well as manufacturing costs may be assigned to products but only on a cause-and-effect basis o Some manufacturing costs may be excluded from product costs 13 o Numerous overhead cost pools are used, each of which is allocated to products and other cost objects using its own unique measure of activity  Overhead cost pool: a group of overhead cost elements o Overhead rates, or activity rates, may be based on the level of activity at capacity rather than on the budgeted level of activity • Non-Manufacturing Costs and Activity-Based Costing o In activity-based costing, products are assigned all of the overhead costs, non- manufacturing as well as manufacturing, that they can reasonably estimate to have caused  Determining the entire cost of a product, not just manufacturing cost • Manufacturing Costs and Activity-Based Costing o In activity-based costing, a cost is assigned to a product only if there is a good reason to believe that the cost would be affected by decisions concerning the product  Costs that are unaffected by product-related decisions are treated as period expenses instead of product costs • Cost Pools, Allocation Bases, and Activity-Based Costing o The activity-based approach has appeal in today’s business environment because it uses more cost pools and unique measures of activity to better understand the costs of managing and sustaining product diversity o Activity: any event that causes the consumption of overhead resources o Activity cost pool: a “bucket” in which costs are accumulated that related to a single activity measure in the activity-based costing system o Activity measure: an allocation based in an activity-based costing system; ideally, a measure of the amount of activity that drives the costs in an activity cost pool; also called a cost driver  Transaction driver: a simple count of the number of times an activity occurs  Duration driver: a measure of the amount of time required to perform an activity 14 o Unit-level activities: activities that arise as a result of the total volume of goods and services that are produced and that are performed each time a unit is produced o Batch-level activities: activities that are performed each time a batch of goods is handled or processed, regardless of how many units are in a batch. The amount of resources consumed depends on the number of batches run rather than on the number of units in the batch o Product-level activities: activities that relate to specific products that must be carried out regardless of how many units are produced and sold or batches run o Customer-level activities: activities that are carried out to support customers but that are not related to any specific product o Organization-sustaining activities: activities that are carried out regardless of which customers are serviced, which products are produced, how many batches are run, or how many units are made • The Costs of Idle Capacity in Activity-Based Costing o In activity-based costing, products are charged for the costs of capacity they use, not for the costs of capacity they do not sue  Costs of idle capacity are not charged to products o Results in more stable unit costs o Consistent with the objective of assigning only those costs to products that are actually caused by the products o Idle costs are considered to be period costs that flow through to the income statement • Designing an Activity-Based Costing System o Managers must support the initiative, data is properly linked to how people are evaluated and rewarded, and a cross-functional team should be created to design and implement the ABC system o 5 Steps  Identify and define activities, activity cost pools, and activity measures  Assign overhead costs to activity cost pools  Calculate activity rates 15  Assign overhead costs to cost objects using the activity rates and activity measures  Prepare management reports • Step 1: Identify and Define Activities, Activity Cost Pools, and Activity Measures o Balancing specificity and cost o Figuring out how each activity will be measured The Mechanics of Activity-Based Costing • Step 2: Assign Overhead Costs to Activity Cost pools o First-stage allocation: the process by which overhead costs are assigned to activity cost pools in an activity-based costing system o Interviewing employees and collecting data to figure out percentage of time spent on various activities, or how a machine’s operation is used • Step 3: Calculate Activity Rates o Figuring out total cost of activity by unique number of times activity was performed o Other cost pool does not have a specific rate, it is just a total o Direct materials, direct labour, and shipping costs are not calculated because they are already directly traced Second-Stage Allocation of Overhead Costs • Second-stage allocation: the process by which activity rates are used to apply costs to products and customers in activity-based costing • Step 4: Assign Overhead Costs to Cost Objects o Products  Identifying how much of each activity a product uses  Then multiply using the rates calculated in Step 3, and summing them  The total for the products will not add up to the total overhead costs because customer-level activities and organization-sustaining activities are not included in the product calculation o Customers 16  Identify how much of each activity the customer uses  Then multiply using the rate calculated in Step 3, and summing them  Add the customer-level activity for a single customer Product and Customer Margins • Step 5: Prepare Management Reports o Product profitability report o Customer profitability report • Targeting Process Improvements o Activity-based management (ABM): a management approach that, in conjunction with ABC, improves processes and reduces costs o Benchmarking: a systematic approach of comparing the performance of some aspect of an organization’s operations to that of outstanding external companies or to other divisions within the same organization Comparison of Traditional and ABC Product Costs • Product Margins Computed Using the Traditional Cost System o The traditional system does not include selling and administrative expenses in calculating margins on each product o A plantwide overhead rate is used o Although the total profit/loss will always be the same using either system, it is the per-product profit/loss that will be different o Action analysis report: a report showing what costs have been assigned to a cost object, such as a product or customer, and how difficult it would be to adjust the cost if there is a change in activity • The Difference between ABC and Traditional Product Costs o The traditional cost system allocated all manufacturing costs to products regardless of whether they consumed those costs. The ABC system does not assign manufacturing overhead costs to products for either Customer Relations activities or Other activities because they are not cause by any particular product 17 o The traditional cost system allocated all manufacturing overhead costs using machine hours. The AVC system uses unique activity measures to allocate the cost of each activity cost pool  Traditional cost system over-cost high-volume products and under-cost low-volume products because they assign batch-level and product-level costs using volume-related allocation bases o The ABC system assigns non-manufacturing overhead such as shipping to products on a cause-and-effect basis. The traditional cost system excludes these costs because they are classified as period costs • Activity-Based Costing and External Reports o Not used because:  External reports are less detailed than internal reports  Difficult to change accounting systems on computers  ABC typically does not follow GAAPs The Limitations of Activity-Based Costing • Major undertaking requiring substantial resources to implement • More costly to maintain than a traditional costing system • Difficult to use if managers use traditional costing systems to make decisions Appendix 5A: ABC Action Analysis • It is vital to identify which costs would be avoided and which costs would continue if a product was discontinued • Costs would have to be eliminated or the resources shifted to a work centre that is currently a constraint • Specific people have to be responsible for eliminating costs • Activity Rate – Action Analysis Report o Begins with the results of the first-stage allocation o Use of a cost matrix, not just single cost number for each cost pool like in a regular ABC system • Color coding to identify how each cost can change 18 Appendix 5B: Using a Modified Form of Activity­Based Costing to Determine Product Costs for  External Reports • A modified form of activity-based costing can be used to make external reports • Products costs include all manufacturing overhead costs, including organization- sustaining costs, and costs of idle capacity, and excludes all non-manufacturing costs, even costs clearly cause by products Ch. 6: Cost Behaviour: Analysis and Use • Cost behaviour refers to how a cost will react or change as changes take place in the level of business activity • Cost structure: the relative proportion of fixed, variable, and mixed costs found in an organization Types of Cost Behaviour Patterns • Variable o Total dollar amount varies in direct proportion to changes in the activity level o Stays constant on a per unit basis o Activity base: a measure of whatever causes the incurrence of a variable cost.  Can be referred to as a cost driver • True Variable versus Step-Variable Costs o Step-variable cost: a cost (such as the cost of a maintenance worker) that is obtainable only in large chunks and that increases and decreases only in response to a fairly wide change in the activity level  Cannot be stored in inventory unlike most true variable costs • The Linearity Assumption and the Relevant Range o Curvilinear costs: a relationship between cost and activity that is a curve rather than a straight line. (pg. 234, Exhibit 6-4)  can be satisfactorily approximated with a straight line within a narrow band of activity known as the relevant range • Fixed Costs o Remain constant within the relevant range of activity 19 o Average fixed cost per unit becomes progressively smaller as the level of activity increases • Types of Fixed Costs o Committed fixed costs: those fixed costs that are difficult to adjust and that relate to the investment in facilities, equipment, and the basic organizational structure of a firm  Cannot be significantly reduced, even for a short time period, without making fundamental changes that would impair a firm’s long-run goals or profitability o Discretionary fixed costs: those fixed costs that arise from annual decisions be management to spend in certain fixed cost areas, such as advertising and research  Often called managed fixed costs  Planning horizon for a discretionary fixed cost is short term  Can be cut for short time periods with minimal damage to the long-run organizational goals o Trend toward fixed costs  More automation  More demand for “knowledge workers” who usually operate on salary • More fixed and are committed rather than discretionary costs o Is Labour a Variable or a Fixed Cost?  Complex mix depending on conditions • Reluctance to decrease workforce in economic downturns • Reluctance to increase workforce in economic booms o Hire more temporary wage workers • Fixed Costs and the Relevant Range o Important in the discussion of fixed costs (particularly discretionary fixed costs) o Once the total discretionary fixed costs have been budgeted, they are unaffected by the actual level of activity 20 o The relevant range of activity for a fixed cost is the range of activity over which the graph of the costs is flat o Difference between step-variable costs and fixed cost fluctuations  Step-variable costs can often be adjusted quickly as conditions change  Width of step for a step-variable cost is much narrower than the width of the steps depicted for the fixed costs • Mixed Costs o Y = a + bX  Y = The total mixed cost  a = The total fixed cost (the vertical intercept of the line)  b = The variable cost per unit of activity (the slope of the line)  X = The level of activity The Analysis of Mixed Costs • The fixed portion of a mixed cost represents the basic minimum cost of just having a service ready and available for use • The variable portion represents the cost incurred for actual consumption of the service • Account analysis: A method for analyzing cost behaviour in which each account under consideration is classified as either variable or fixed based on the analyst’s prior knowledge of how the cost in the account behaves • Engineering approach: a detailed analysis of cost behaviour based on an industrial engineer’s evaluation of the inputs that are required to carry out a particular activity an of the prices of those inputs • Diagnosing Cost Behaviour with a Scattergram Plot o Identifies non-linearities or other problems with the data o Linear: cost behaviour is linear when a straight line is a reasonable approximation for the relationship between cost and activity o Relationship can be found by subtracting total cost from found fixed cost (the intercept) and dividing by X-variable to find cost per increase in variable 21 • High-low method: a method of separating a mixed cost into its fixed and variable elements by analyzing the change in cost between the high and low levels of activity o Used assuming scattergram confirms a linear relationship Rise Y2−Y 1 o Variablecost=slopeof theline= Run = X −X 2 1 Y2−Y 1= Costatthehighactivitylevel−Costatthelowactivity≤vel o X2−X 1 Highactivitylevel−Lowactivitylevel Variablecost= Change∈cost o Change∈activity o Problems  It utilizes only two data points  Periods with highest and lowest activity tend to be unusually in that they represent extremes The Contribution Format • Contribution approach: an income statement format that is geared to cost behaviour in that costs are separated into variable and fixed categories • Why a New Income Statement Format o Splitting costs facilitates planning, control, and decision making • Contribution margin: the amount remaining from sales revenue after all variable expenses have been deducted o Often assumes expenses use volume activity as a cost driver  Best to include inventory levels to compute volume activity Ch. 7: Cost­Volume­Profit Relationships • Cost-volume-profit (CVP) analysis is a powerful tool that helps managers understand the relationship among cost, volume, and profit • Focuses on how profits are affected by: o Prices of products 22 o Volume or level of activity o Per unit variable costs o Total fixed costs o Mix of products sold The Basics of Cost-Volume-Profit Analysis • Beginning with contribution income statement o Important to know behaviour of costs o Reports sales, variable expenses and contribution margin on both per unit basis and total basis • Contribution margin is the amount remaining from sales revenue to cover fixed expense and then provide profits for the period • Break-even point: the level of sales at which profit is zero. The break-even point can also be defined as the point where total sales equals total expenses, or at the point where total contribution margin equals total fixed expenses o Sales – variable expenses – fixed expenses = $0 CVP Relationships in Graphic Form • Cost-volume-profit graph: the relationship among revenues, costs, and levels of activity presented in graphic form • Preparing the CVP Graph (breakeven chart) o Unit volume is commonly represented on the horizontal x-axis, and dollars on the vertical y-axis o Draw a line parallel to the volume axis to represent total fixed expenses o Draw the total expenses line o Draw the revenue line (from origin) • The profit/loss is represented by the vertical distance between the total revenue line and the total expenses line o Breakeven is the intersection of the two lines • Simpler form of the CVP graph is the profit graph 23 Profit=UnitCM ×Q−¿expenses o Contribution Margin Ratio • Add column to income statement which represents every account as percentage of sales • Contribution margin (CM) ratio: the contribution margin as a percentage of total sales Contributionmargin o CMratio= Sales o Shows how the contribution margin will be affected by a change in total sales o The effect on operating income of any dollar change in total sales can be computed by simply applying the CM ratio to the dollar change Some Applications of CVP Concepts (pg. 277 – 280) • Incremental analysis: an analytical approach that focuses only on those items of revenue, cost, and volume that will change as a result of a decision • Contribution margin is very important in making all these calculations o The greater the contribution margin, the greater the amount the company may be willing to spend in order to increase unit sales Break-Even Analysis • Equation method: a method of computing break-even sales using the contribution- format income statement o Profits=(Sales−Variableexpenses)−¿expenses o Sales×Quantity=Variable expenses×Quantity+¿expenses+Profits o Variable expense ratio: the ratio of variable expenses to sales dollars • Contribution margin method: a method of computing the break-even point where the fixed expenses are divided by the contribution margin per unit ¿expenses o Breakeven point∈unitssold= Unitcontributionmargin 24 ¿expenses o Breakeven point∈totalsalesdollars= CM Ratio Target Operating Profit Analysis • Either use CVP equation unaltered • Or use contribution margin method simply by adding target profit to numerator to find units sold to attain target profit or dollar sales to attain target profit (depending on which CM method equation is used) • After-Tax Analysis o Profitaftertaxes=Beforetax profit−Taxes=B−t(B)=B(1−t) B= Profitaftertaxes o (1−t) The Margin of Safety • Margin of safety: the excess of budgeted (or actual) sales over the break-even volume of sales o Marginof safety=Totalbudgeted∨actualsales−breakevensales marginof safety∈dollars o Marginof saf ety percentage=totalbudgeted∨actualsales CVP Considerations in Choosing a Cost Structure • Cost Structure and Profit Stability o Higher fixed cost and lower variable cost firms will experience wider swings in operating income as changes take place in sales  higher contribution margin  Greater profits in good years, and greater losses in bad year o Lower fixed cost and higher variable cost firms will enjoy greater stability in operating income  Higher margin of safety 25  More protected from losses during bad years, but at the cost of lower operating income in good years • Operating leverage: a measure of how sensitive operating income is to a given percentage change in sales. It is computed by dividing the contribution margin by operating income o Degree of operating leverage: a measure, at a given level of sales, of how a percentage change in sales volume will affect profits. The degree of operating leverage is computed by dividing contribution margin by operating income contributionmargin degreeof operatingleverage=  operatingincome  Highest at sales levels near the breakeven point • Explains why management will often work very hard for only a small increase in sales volume  Percentage change in operating income before taxes • ΔOIBT= ΔSales×Degreeof operatingleverage • Indifference Analysis o Determine the unit CM times the number of units minus total fixed costs of each alternative o Set up an equation with each alternative on opposite sides of the equals sign o Solve for number of units, the indifference point ¿ cost1−¿cost 2 o CM −1M 2 The Concept of Sales Mix • Sales mix: the relative proportions in which a company’s products are sold. Sales mix is computed by expressing sales of each product as a percentage of total sales o Try to achieve the mix that will yield the greatest amount of profits • Breakeven analysis is more difficult when dealing with different products because of different costs, prices and sales volumes • Multi-Product CVP Analysis 26 o Overall contribution margin ratio Totalcontributionmargin,all products  OverallCM ratio= Total Sales,all product o Breakeven (shortcut Formula) Sales dollars ¿expenses  Totalsalesdollars¿breakeven= OverallCM ratio o Target Operating Profit (Shortcut Formula) Sales Dollars ¿expenses+ Targetaftertax profit  [ 1−taxrate ] Dollarsales¿attaintarget profit= OverallCM ratio Assumptions of CVP Analysis • Selling price is constant throughout the entire relevant range. The price of a product or service will not change as volume changes • Costs are linear throughout the entire relevant range, and they can accurately be divided into variable and fixed elements. The variable element is constant per unit, and the fixed element is constant in total over the entire relevant range • In multi-product companies, the sales mix is constant • In manufacturing companies, inventories do not change. The number of units produced equals the number of units sold Ch. 12: Relevant Costs for Decision Making • Relevant cost: a cost that differs among the alternatives in a particular decision and will be incurred in the future. In managerial accounting, this term is synonymous with avoidable cost and differential cost Cost Concepts for Decision Making • Identifying Relevant Costs and Benefits o Only costs and benefits that differ in total among alternatives and that will be incurred in the future are relevant in a decision  If a cost will be the same regardless of the alternative selected, then it can be ignored 27 o Avoidable cost: any cost that can be eliminated (in whole or in part) by choosing one alternative over another in a decision-making situation. In managerial accounting, this term is synonymous with relevant cost and differential cost  Two broad categories of costs are irrelevant in decisions • Sunk costs • Future costs that do not differ between the alternatives o To identify the costs and benefits that are relevant in a particular decision situation  Eliminate costs and benefits that do not differ between alternatives. These irrelevant costs consist of (a) sunk costs and (b) future costs and benefits that do not differ between alternatives  Use the remaining costs and benefits that do differ between alternatives in making the decision. The costs that remain are the differential (avoidable) costs • Different Costs for Different Purposes o Costs that are relevant in one decision situation are not necessarily relevant in another • Reconciling the Total and Differential Approaches o Focusing only on relevant costs yields the same answer as focusing on total costs  Saves time and effort in doing so Analysis of Various Decision Situations • Adding and Dropping Product Lines and Other Segments o If by dropping a product line the company is able to avoid more in fixed costs than it loses in contribution margin, then it will be better off if the line is eliminated  Overall operating income should improve o Activity-based costing analysis may be used to help identify the relevant costs o Comparing change in contribution margin to change in costs  Figure out which costs will decrease and which will stay the same 28 • A Comparative Format o Create a comparative income statement showing the effects on the company as a whole of either keeping or dropping a product line (pg. 564, Exhibit 12-3) • Beware of Allocated Fixed Costs o Why keep a line that is showing a loss?  Common fixed costs that are being allocated to product lines • Makes a product line look unprofitable • Important to figure out the segment margin o Sum of loss of segment margin plus loss of sunk costs totals total loss that would result in dropping a line  Managers may choose to retain an unprofitable product line if the line if necessary to the sale of other products • Serves as a “magnet” to attract customers • The Make or Buy Decision o Separate companies may carry out each step in the value chain or a single company may carry out several step in the value chain o Vertical integration: the involvement by a single company in more than one of the steps of the value chain from production of basic raw materials to the manufacture and distribution of a finished product o Make of buy decision: a decision as to whether an item should be produced internally or purchased from an outside supplier • Strategic Aspects of the Make or Buy Decision o An integrated firm is less dependent on its suppliers and may be able to ensure a smoother flow of parts and materials for production o By pooling demand from a number of firms, a supplier may be able to realize economies of scale in research and development and in manufacturing o Decision is made by exploring only relevant costs  Eliminating sunk costs and future costs that will continue regardless of make or buy decision 29  Important to also consider opportunity cost • Opportunity Cost o Consideration of idle space  In a make or buy decision, important to consider what factory space would be used for • If it sits idle, no additional calculations are necessary • However, if the company could produce other inventory, it is important to factor that into the decision o Economic benefits forgone • Special Orders o Special order: a one-time order that is not considered part of the company’s normal ongoing business o The objective in setting a price for special orders is to achieve positive incremental operating income o A special order is profitable as long as the incremental revenue from the special order exceeds the incremental costs of the order o If there is an opportunity cost  Calculate contribution margin forgone  Figure out relevant costs  Sum together to find total cost of production • If below selling price, special order should not be accepted • Joint Product Costs and the Sell or Process Further Decision o Joint product: two or more items that are produced from a common input o Joint product costs: costs that are incurred up to the split-off point in producing joint products o Split-off point: that point in the manufacturing process where some or all of the joint product can be recognized as individual products • The Pitfalls of Allocation 30 o Joint product costs are really common costs incurred to simultaneously produce a variety of end products o A typical approach is to allocate the joint produce costs according to the relative sales value of the end products o Although allocation of joint product costs is needed for some purposes, such as inventory valuation for financial reporting, allocations of this kind should be viewed with great caution internally in the decision making process o Allocated joint product costs should never be used when making decisions about what to do with the joint produces beyond the split-off point  Sunk costs • Sell or Process Further Decisions o Sell or process further decision: a decision as to whether a joint produce should be sold at the split-off point or processed further and sold at a later time in a different form  It will always be profitable to continue processing a joint product after the split-off point as long as the incremental revenue from processing exceeds the incremental processing costs incurred after the split-off point Utilization of a Constrained Resource • Constraint: a limitation under which a company must operate that restricts the company’s ability to satisfy demand for its products • Theory of constraints (TOC): a management approach that emphasizes the importance of managing constraints • Contribution Margin in Relation to a Constrained Resource o To maximize total contribution margin, a firm should not necessarily promote the produces that have the highest unit contribution margins  Total contribution margin will be maximized by promoting those products or accepting those orders that provide the highest unit contribution margin in relation to the constrained resource o Profitability index = contribution margin per unit ÷ Quantity constrained resource required per unit • Managing Constraints 31 o If the constraint is a bottle neck in the production process, the manager should select the product mix that maximized the total contribution margin o Management should focus efforts on increasing the efficiency of the bottleneck operation and on increasing its capacity o Relaxing (or elevating) the constraint: an action that increases the capacity of a bottleneck  Working overtime on the bottleneck  Subcontracting some of the processing that would be done at the bottleneck
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