Post on 22-Dec-2015
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Management vs. Financial Accounting (1 of 6)
Necessity Financial Accounting (FA): SEC (or banks or
suppliers) requires publicly traded companies to publish financial statements according to GAAP.
Management accounting (MA) is optional. Purpose.
FA: Produce financial statements for outside users.
MA: Help managers plan, implement and control.
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Management vs. Financial Accounting (2 of 6)
Users. FA: faceless group, external users, present
or potential shareholders. MA: Known managers who influence what
information is needed. Underlying structure.
FA: built around: Assets = Liabilities + Stockholders’ Equity.
MA: 3 purposes each with its own set of concepts and constructs (addressed later).
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Management vs. Financial Accounting (3 of 6) Source of principles.
FA: GAAP. MA: whatever managers believe is useful.
Time orientation. FA: historical, tell it like it was. MA: future/decision oriented, tell it like it will
be. (However, the past is often a good predictor of the future.)
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Management vs. Financial Accounting (4 of 6) Information content.
FA: financial statements are the end product and include primarily financial info.
MA: non-monetary as well as monetary info. Information precision.
FA: Uses approximations but as a generalization is more precise than MA.
MA: Management needs info rapidly to be useful in decision making and therefore precision is sometimes sacrificed.
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Management vs. Financial Accounting (5 of 6) Report frequency:
FA: Publicly traded, SEC: quarterly, with more detailed info annually.
MA: Up to management.
Report timeliness. FA: Usually, several weeks to months after
fiscal close of accounting period. MA: Quickly to be useful for decision making.
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Management vs. Financial Accounting (6 of 6)
Report entity. FA: Organization as a whole. MA: Relatively small parts
(responsibilities centers such as departments, product lines, divisions, subsidiaries as well as organization as a whole.)
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Uses of Management Accounting
1. Measurement of revenues, costs, and assets.
2. Control.3. To aid in choosing among
alternative courses of action.
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Measurement Full cost accounting measures the
resources used in performing some activity.
Full cost of producing goods or providing services = direct costs + indirect costs. Direct costs = costs directly traced to the
goods or services. Indirect costs = a fair share of costs incurred
jointly in producing goods or services.
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Control Costs (also, revenues and assets) are
identified to and measured by responsibility center. A manager heads each responsibility center. Corrective action can only be taken by
individuals. To help identify problems (and
opportunities) actual costs are measured and compared to a benchmark (budget, last year, industry average).
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General Observations on MA
Different numbers for different purposes. Many different types of costs: historical,
standard, overhead, variable, fixed, differential, marginal, opportunity, direct, estimated, full, etc.
Clarify which type you are talking about. Accounting numbers are approximations. Best that we can with incomplete data. Accounting evidence is only partial evidence
other factors help make decisions. People not numbers get things done. How you
use the numbers is as important as how the numbers are produced.
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What will be covered A general overview of how costs
“behave.” Several applications of how this
knowledge can help you make better, informed, decisions.
Some examples of what we will be able to solve:
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Breakeven analysis You are considering offering a new
service (such as delivery of take-out) and you wish to determine what volume you will need to generate to cover your costs.
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Close a location decision You are responsible for several
locations. One location consistently shows a “loss” on its income statement. Should it be closed? If so, will your region be better off?
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Special orders decisions You have been offered a one-time
special order. You need to determine if you should accept the order given the price is lower than the normal charge for comparable meals you serve.
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Relation of Costs to Volume
Variable costs = items of cost that vary, in total, directly and proportionately with volume.
Fixed costs = items of cost that, in total, do not vary at all with volume
Semi-variable costs (semi-fixed costs) = costs that include a combination of variable cost and fixed cost items.
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Variable Costs Items of cost that vary, in total,
directly and proportionately with volume. Volume refers to activity level. Examples:
Material costs varies with units sold. Electricity costs varies with production hours. Stationery and postage costs varies with
number of letters written.
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Fixed costs Items of cost that, in total, do not
vary at all with volume. Examples:
Building rent, property taxes, management salaries.
Fixed cost per unit of activity decreases as the level of activity increases.
Fixed costs are fixed for a range of activity and a limited period of time.
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Beware of how cost behave! Fixed costs should not be treated
as variable in decision making. Senate gym example.
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Cost-volume (C-V) diagram
Y or vertical axis reflects total cost. X or horizontal axis reflects volume. y = mx + b.
y is the cost at a volume of x; m is the rate of cost change per unit of
volume change, or the slope (variable costs).
b is the vertical intercept, which represents the fixed cost component.
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Profit-graph Add revenue line to C-V diagram. Assumes constant selling price. UR = unit revenue TR = total revenue
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TC = TFC +(UVC*X)
TC = total cost; TFC = total fixed cost (per time
period), UVC = Unit variable cost (per unit
of volume), X = volume.
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Cost Relations
Average costs = total cost/volume. Average cost behaves differently
than total cost. As volume goes up
Total fixed cost remains constant, total variable costs goes up, per unit variable costs stays the same, per unit fixed cost goes down, per unit total cost goes down.
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Step-function costs
Incurred when costs are added in discrete chunks, e.g., a manager for every 10 workers.
Adding the “chunk” of costs increases capacity.
Height of a stair step (riser) indicates the cost of adding incremental capacity.
Step width (tread) shows how much additional volume of that activity can be serviced by this additional increment of capacity.
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Contribution Unit contribution margin = marginal
income = unit selling price - variable cost per unit = UR - UVC.
What is contribution: First it is the contribution to cover fixed
costs. Then it is the contribution toward profit.
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Breakeven Volume TR = UR*X TC = TFC + (UVC*X) Breakeven: TR = TC Substituting: UR*X = TFC +
(UVC*X) X = TFC/(UR - UVC)
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Break-even Volume In units = Fixed costs/unit
contribution In revenue dollars just compute
break-even in units and multiply by the selling price.
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A simple example You run a restaurant that serves
one type of meal that sells for $5. The variable costs (ingredients,
container, etc.) total $3. Monthly fixed costs (rent, salary,
etc.) total $4,000. What is the breakeven amount in
volume and in sales dollars?
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Target Profit Add to breakeven analysis to show
units or dollar of sales to achieve a target (T) level of profit:
UR*X = TFC + (UVC*X) + T
X = (TFC+T)/(UR - UVC)
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A simple example - continued Instead of just breaking even, you
would like to make a profit of $2,500.
What volume of meals will you need to serve?
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Limitations of C-V Relations A straight line approximates cost
behavior only within a certain range of volume, the relevant range. When volume approaches zero,
management takes steps to reduce fixed costs.
When volume exceeds relevant range, fixed costs increase.
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Limitations (continued)
Amount of variable costs depends on the time period over which behavior is estimated (the relevant time period). If the time period is one day, few
costs are variable. Over an extremely long time period,
no costs are fixed.
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Linear Assumption C-V relationship is often not linear.
Some cost functions are curved (curvilinear).
Segments of the curve can be approximated by a straight line, each with its own relevant range.
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Highlights
Alternative choice decisions: manager seeks to choose best of several alternative courses of action.
Introduces construct of differential costs and revenues for several types of problems, each having a relatively short time horizon.
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Differential Costs and Revenues
Costs that are different under one set of conditions than they would be under another.
Revenues that are different under one set of conditions than they would be under another.
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Nature of Full and Differential Costs
Full cost of a product or other cost object = sum of direct cost + fair share of applicable indirect costs.
Differential costs include only those cost elements of cost that are different under a certain set of conditions.
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Historical, Full and Differential Costs
Full cost accounting system collects historical costs.
Differential costs always relate to the future.
Differential costs are intended to show what costs will be if a certain course of action is adopted in the future.
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Steps in the Analysis
Define the problem. Select possible alternative solutions. (Status
quo may be the benchmark against which other alternatives are measured.)
For each alternative, measure and evaluate consequences that can be expressed in quantitative terms.
Identify those consequences that cannot be expressed in quantitative terms and evaluate them against each other and against the measured consequences.
Reach a decision.
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Opportunity costs
A measure of the value that is lost or sacrificed when the choice of one course of action requires giving up an alternative course of action.
Not measured in accounting records.
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Sunk Cost A cost that has already been incurred
and therefore cannot be changed by any decision currently being considered.
Not a differential cost.
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Importance of Time Span
The longer the time span the more items of cost that are differential.
In the very long run full costs are differential costs.
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Sensitivity Analysis
Considers how sensitive the quantitative measurements of the alternatives are to changes in assumptions.
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Just One Fallacy
Each additional unit of production adds just variable costs.
If many units are added, then step function costs (i.e., fixed costs) are added.
Therefore, step function costs are averaged out over the additional units of volume.
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Sell Now or Process Further Assume that the product being
offered can either be sold currently as is for a certain sum or processed further, with additional costs, at which time it can be sold for a greater amount than now.
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Sell Now or Process Further
Cost per unit to date
Cost per unit to
complete
Material $300 $200
Labor 200 100
Var. OH 100 100
Fixed OH 200
Total $800 $400
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Sell Now or Process Further The product is being discontinued and
its price has fallen. If the product is processed to completion it can be sold for only $1,000 (less than cost incurred of $1,200 = $800 + $400)
If sold now they will bring in $500. What should we do? Should we incur $400 more cost
knowing we will end up losing money overall? Is this throwing good money at bad?
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Differential costs
Sell Now
Process
Further
Difference
Revenue $500 $1,000 $500
Current costs
800 800 0
New costs
0 400 <400>
Total costs
800 1,200 <400>
Profit <300>
<200> 100
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Sunk Costs Cost that have already been
incurred and cannot be changed. Not relevant to any decision Cost of $800 already incurred in
the previous example are sunk and should be ignored. They do not change the situation in any way.
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Make or Buy Often a company will purchase an
ingredient externally that is part of what they are making.
They could make this ingredient internally if it is to their benefit to do so.
These decisions usually only involve costs, not revenues.
Qualitative factors must be considered.
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Make or Buy XYZ Co. is considering an offer to
supply 50,000 units of ingredient D at a cost of $.32 per unit.
The company is currently producing ingredient D internally with the following costs:
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Variable costs
Direct material ($.10/unit) $5,000Direct labor ($.12/unit) 6,000Variable OH ($.08/unit) 4,000 Total variable costs 15,000Fixed costs:
Depreciation – equip. 800Depreciation – Bldg 600Supervisor's salary 500Other 350 Total fixed costs 2,250Total costs $17,250
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Make or Buy Cost to manufacture internally is $.345
= $17,250 / 50,000 Outside offer is for $.320
Other information: Market value of the machine we use to
produce D is zero if we try to dispose of it
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Internal Costs
External Costs
Difference
Variable costs
Direct material ($.10/unit)
$5,000 $0 $5,000
Direct labor ($.12/unit) 6,000 0 6,000
Variable OH ($.08/unit)
4,000 0 4,000
Total variable costs 15,000 0 15,000
Fixed costs:
Depreciation – equip. 800 800 0
Depreciation – Bldg 600 600 0
Supervisor's salary 500 500
Other 350 350 0
Total fixed costs 2,250 1,750 500
Cost of buying outside 0 16,000 (16,000)
Total costs $17,250 $17,750 ($500)
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Avoidable Costs Not all fixed costs are irrelevant sunk costs Some fixed costs are avoidable (i.e., they
can be avoided under one alternative) In the previous example we can terminate
the supervisors, hence this fixed costs is avoidable and therefore relevant and differential.
Since avoidable costs of $15,500 is less than the cost of the external part, we should reject the offer based on financial grounds.
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Cost of buying externally (50,000 x $.320)
($16,000)
Cost savings (avoidable costs)
Variable costs 15,000
Supervisor salaries 500
Net costs ($500)
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Opportunity Cost The value of foregone benefits from
selecting one choice over an alternative. You give up earning money at a job by
going to school full time.
Assume that, in the previous example, if we no longer make ingredient D internally, we can save $600 in rent by using the space for another operation that is currently leasing warehouse space.
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Cost of buying externally (50,000 x $320)
($16,000)
Cost savings (avoidable costs)
Variable costs 15,000
Supervisor salaries 500
Opportunity cost of using the plant to produce part D
600
Net savings $100
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Dropping a Product Need to calculate the change in
profit if the product is dropped versus retained.
Both differential costs and revenues are considered.
Procedure differs if there is excess capacity versus at capacity
If at capacity need to consider opportunity costs.
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Dropping a Store Region 5 is considering dropping Store
#2. Direct fixed costs are items directly
traceable to the division Example – salary of a worker who spends all
his time in this restaurant Allocated fixed costs are fixed costs that
are shared between divisions Example – Salary of the regional manager
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#1 #2 #3 Total
Sales $100,000
$150,000 $210,000
$460,000
Cost of sales 45,000 60,000 90,000 195,000
Gross Margin 55,000 90,000 120,000 265,000
Other variable costs
15,000 20,000 30,000 65,000
Contribution Margin
40,000 70,000 90,000 200,000
Direct fixed costs 20,000 65,000 40,000 125,000
Allocated fixed costs
15,000 20,000 25,000 60,000
Total fixed costs 35,000 85,000 65,000 185,000
Net Income $5,000 $(15,000)
$25,000
$15,000
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Dropping a Product Should #2 be dropped?
It is showing a loss of ($15,000)! What would happen to the division’s total net
income if the store was dropped?
Assume the direct fixed costs are building rent that can be avoided.
Allocated fixed costs are the regional manager’s salary and some corporate costs.
If Store #2 were dropped, there would not be any impact on the other store’s volume.
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Lost revenue $(150,000)
Cost savings
COGS 60,000
Other variable costs 20,000
Direct fixed costs 65,000
Total cost savings 145,000
Net loss from dropping division
$(5,000)
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The Death Spiral This phenomena is sometimes referred to
as the Dearth Spiral. You drop one product because it is “a
loser.” Suddenly other products become losers. You drop them. Now other products become losers. And the spiral continues until you are out
of business!
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Decisions Involving Constraints Basic decision is to keep any
product/store with a positive contribution margin as long as you can keep selling it.
That changes if making one product affects another product.
An example is when there is a constraint such as a limited amount of skilled labor or machine time
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Decisions Involving Constraints
Product A
Product B
Selling Price
$100 $80
Variable costs
50 60
Contribution Margin
$50 $20
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Decisions Involving Constraints Suppose that both products require
time on a specialized machine. A total of 1,000 hours are available. Product A requires 10 hours Product B requires 2 hours
Which product should be produced assuming we can sell as much of either as we produce at the given prices?
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Decisions Involving Constraints Product A has the highest CM, we
make $50 for every one sold versus only $20 for each B.
But what about those machine hours?
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Decisions Involving Constraints Since A requires 10 hours and we have
1,000 total, we can produce 100 A. At $50 each = $5,000 CM
Since B requires only 2 hours we can produce 500 total. At $20 each = $10,000
Company is better off producing all Product B.
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Decisions Involving Constraints Decision rule:
Under conditions of a constraint, produce the product with the highest contribution margin per unit of the constraint.
A has $50/10 hours or $5 per machine hour.
B has $20/2 hours or $10 per machine hour.