Introduction to Accounting

Prof. W. Bentz A&MIS 212 1

Introduction to Accounting

FINAL EXAM REVIEW

Chapters 10,11,12, 13, 14, & 15


Standard Cost Card – Variable Production Cost

A standard cost card for one unit of product might look like this:

A A x BStandard Standard StandardQuantity Price Cost

Inputs or Hours or Rate per Unit

Direct materials 3.0 lbs. 4.00$ per lb. 12.00$ Direct labor 2.5 hours 14.00 per hour 35.00 Variable mfg. overhead 2.5 hours 3.00 per hour 7.50 Total standard unit cost 54.50$

B


Are standards the same as budgets?

A standard is the expected cost for one

unit.

A budget is the expected cost for all

units.

Standards vs. Budgets


A General Model of Variances

Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price

Price Variance Quantity Variance

Standard price is the amount that should have been paid for the resources acquired.





Standard quantity is the quantity allowed for the actual good output.



AQP(ap - sp) sp(AQU - SQ)

AQP = Actual Quantity sp = Standard Price ap = Actual Price SQ = Standard Quantity


Actual Quantity Actual Quantity Standard Quantity × × × actual price standard price standard price


Hanson Inc. has the following direct material standard to manufacture one Zippy:

1.5 pounds per Zippy at $4.00 per pound

Last week 1,700 pounds of material were purchased for $3.90 per pound, at total cost of $6,630, and used to make 1,000 Zippies.

Material Variances Example Zippy


Material Price Variance

Based on purchases:

AQP(ap - sp)

= 1,700 lbs. ($3.90 - $4.00)

= - $170 Favorable Based on usage:

AQU(ap - sp)

= 1,700 lbs. ($3.90 - $4.00)

= - $170 Favorable


Material Quantity Variance

Standard quantity = output sq per unit

= 1,000 units 1.5 lbs./unit

= 1,500 lbs.

Quantity variance = (AQ – SQ) sp

= (1,700 -1,500 lbs.) $4

= $800 Unfavorable


1,700 lbs. 1,700 lbs. 1,500 lbs. × × × $3.90 per lb. $4.00 per lb. $4.00 per lb.

= $6,630 = $ 6,800 = $6,000

Price variance$170 favorable

Quantity variance$800 unfavorable


Material Variances Summary Zippy


Material Variances

Hanson purchased and used 1,700 pounds.

How are the variances computed if the amount purchased differs from

the amount used?

The price variance is computed on the entire

quantity purchased.

The quantity variance is computed only on the

quantity used.


Hanson Inc. has the following material standard to manufacture one Zippy:

1.5 pounds per Zippy at $4.00 per pound

Last week 2,800 pounds of material were purchased at a total cost of $10,920, and 1,700 pounds were used to make 1,000 Zippies. Compute the price variance.

Material Variances ContinuedZippy


Material Variances Continued

Actual Quantity Actual Quantity Purchased Purchased × × Actual Price Standard Price 2,800 lbs. 2,800 lbs. × × $3.90 per lb. $4.00 per lb.

= $10,920 = $11,200

Price variance$280 favorable

Price variance increases because quantity

purchased increases.

Zippy


Actual Quantity Used Standard Quantity × × Standard Price Standard Price 1,700 lbs. 1,500 lbs. × × $4.00 per lb. $4.00 per lb.

= $6,800 = $6,000

Quantity variance$800 unfavorable

Quantity variance is unchanged because actual and standard

quantities are unchanged.

Material Variances Continued

Zippy


Hanson Inc. has the following direct labor standard to manufacture one Zippy:

1.5 standard hours per finished Zippy at $6.00 per direct labor hour

Last week 1,550 direct labor hours were worked at an average cost of $6.20 per hour, for a total labor cost of $9,610, to make 1,000 Zippies.

Labor Variances ExampleZippy


Labor Rate Variance

Based on labor usage:

AQ (ar - sr)

= 1,550 hrs.($6.20 - $6.00)

= $310 Unfavorable

Zippy


Labor Quantity Variance


= 1,000 units 1.5 hrs./unit

= 1,500 hrs.

Quantity variance = (AQ – SQ) sp

= (1,550 -1,500 hrs.) $6

= $300 UnfavorableZippy


Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate

Labor Variances Summary

Rate variance$310 unfavorable

Efficiency variance$300 unfavorable

1,550 hours 1,550 hours 1,500 hours × × × $6.20 per hour $6.00 per hour $6.00 per hour

= $9,610 = $9,300 = $9,000

Zippy


Labor Efficiency Variance –A Closer Look

UnfavorableEfficiencyVariance

Poorlytrainedworkers

Poorquality

materials

Poorlymaintainedequipment

Poorsupervisionof workers


Hanson Inc. has the following variable manufacturing overhead standard tomanufacture one Zippy

1.5 standard hours per Zippy at $3.00 perdirect labor hour

Last week 1,550 hours were worked to make 1,000 Zippies, and $5,115 was spent forvariable manufacturing overhead.

Variable Overhead Variances (VOH) Example

Zippy


VOH Spending Variance

Based on labor usage:

AQ (ar - sr)

= 1,550 hrs. ($3.30 - $3.00)

= $465 Unfavorable

Zippy


Variable Efficiency Variance


= 1,000 units 1.5 hrs./unit

= 1,500 hrs.

Efficiency variance = (AQ – SQ) sp

= (1,550 -1,500 hrs.) $3

= $150 UnfavorableZippy


Spending variance$465 unfavorable

Efficiency variance$150 unfavorable

1,550 hours 1,550 hours 1,500 hours × × × $3.30 per hour $3.00 per hour $3.00 per hour

= $5,115 = $4,650 = $4,500

Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate

Variable ManufacturingOverhead Variances Zippy


Fixed Manufacturing Overhead

Suppose budgeted fixed overhead associated with the production of Zippys is $9,000 and the budgeted labor hours at standard total 1,800 hours per period. The standard fixed overhead cost per unit is determined as follows:

POR = $9,000/1,800 standard hours (DQ)

= $5 per standard labor hour


Unit FOH Standard

The standard fixed overhead cost per unit is computed as

= sq POR

= 1.5 hours $5 per standard hour

= $7.50 per complete unit


Fixed Overhead Variances

Assume the fixed overhead cost incurred (actual) was $9,350.

Fixed overhead budget variance (BV)

= Actual – Budgeted fixed overhead

= $9,350 - $9,000

= $350, Unfavorable


Fixed Overhead Variances

Fixed overhead volume variance (VV)

= Budgeted FOH – Applied FOH

= $9,000 – 1,000 units @ $7.50

= $9,000 - $7,500

= $1,500, Unfavorable


Volume Variance Check

What was the production level used to find the denominator quantity (DQ)?

1,800 standard hours/1.5 hours per unit

= 1,200 units

Volume variance in unit = 1,000 – 1,200 U

Volume variance in $ = 200 units @ $7.50

= $1,500, Unfavorable


Per Unit Standard Cost

Direct material (1.5 lbs. @ $5) $ 7.50

Direct labor (1.5 hrs. @ $6) 9.00

Variable overhead (1.5 hrs. @ $3) 4.50

Fixed overhead (1.5 hrs. @ $5) 7.50 Total standard cost per unit $28.50

Zippy


Chapter 12 Topics

Segment margin Report format Omission of costs Treatment of traceable costs Treatment of common costs Telescoping of segments


E12-2

Parts 1 & 2

Sales 500,000$ 100.0% 200,000$ 100.0% 300,000$ 100.0%Variable expenses 240,000 48.0% 60,000 30.0% 180,000 60.0%Contribution margin 260,000$ 52.0% 140,000$ 70.0% 120,000$ 40.0%Traceable fixed costs 126,000 25.2% 78,000 39.0% 48,000 16.0%Office segment margin 134,000$ 26.8% 62,000$ 31.0% 72,000$ 24.0%

Common expenses 63,000 12.6%Net income 71,000$ 14.2%

Raner, Harris & Chan

Total Company Chicago Minneapolis

Income StatementFor the Year Ending December 31, 2001


E12-2E12-2

Sales 300,000$ 100.0% 200,000$ 100.0% 100,000$ 100.0%Variable expenses 180,000 60.0% 128,000 64.0% 52,000 52.0%Contribution margin 120,000$ 40.0% 72,000$ 36.0% 48,000$ 48.0%Traceable fixed costs 33,000 11.0% 12,000 6.0% 21,000 21.0%Office segment margin 87,000$ 29.0% 60,000$ 30.0% 27,000$ 27.0%

Common expenses 15,000 5.0%Net income 72,000$ 24.0%

Minneapolis Medical Dental

Raner, Harris & ChanIncome Statement

For the Year Ending December 31, 2001


Chapter 12 Topics

Return on investment ROI = Net income from operations

Average Operating Assets ROI = Margin Turnover ROI = NIO/Sales Sales/Avg. Op. Assets


Chapter 12 Topics

Residual income RI = NIO – (Cost of Capital Average

Operating Assets Instead of the cost of capital, a problem

might refer to the rate of return required by management, or the minimum rate of return expected


Example

Sales$25,000,000

Net operating income $ 3,000,000

Average operating assets$10,000,000


Example

ROI = $3,000,000/$10,000,000

= 30%

Or

Margin = $3M/$25M = 12%

Turnover = $25M/$10M = 2.5

ROI = 12% 2.5 = 30%


Example

Residual income

= $3M – 20% $10M

= $3M - $2M

= $1M


Points Regarding ROI & RI

Both start with net income from operations (aka, operating income)

Both utilize average operating assets as their measures of investment

Both would exclude non-operating items from consideration because the purpose is to monitor operations.


Other Comments

The discussion of ROI in chapter 12 is in the context or evaluations the accounting return on investment earned by an entity (division or investment center), not a project being evaluated. In chapters 13, 14, and 15, we sometimes talk about the incremental ROI of a project, which is somewhat different, yet similar.


Overview of Ch. 13

In chapter 13, we consider the use of accounting information to analyze the impact of decisions on the profitability of an organization. In general, profitability is a function of the income and cash flow generated by a business. Specific projects or options about which a decision must be made are the subject of this chapter.


Chapter 13 - Assumptions

The approach to decisions outlined in chapter 13 is based on some key assumptions

◈The incremental investment is too small to affect the decision under consideration

◈Revenues, variable costs and fixed costs can be adequately modeled with linear models.


Chapter 13 - Assumptions

◈Total fixed costs will not change unless a problem or case specifies otherwise.

◈As in chapter 6, any changes in per-unit prices or variable costs will be made explicit. Otherwise, assume no changes in the per-unit amounts


Maximizing Income

Given the above assumptions, one can focus on the impact of decision options on the income from operations and ignore changes in investment. Also, since the incremental investment is small, we can ignore the time value of money (chapter 14).


Decisions Mentioned in Ch. 13

Replace equipment (or not) Adding or dropping product lines Make or buy component parts Accept or reject special order Utilizing constrained resources Sell or process further


Incremental Perspective

The first four categories of decisions mentioned above can be approached by looking at changes in contribution margin less any change in fixed costs incurred to determine the impact on income from operations. If you are not told of any specific change in total fixed cost, then assume that it is indeed fixed.


Resource Environments

Unconstrained – If there are no important constraints, then we will evaluate the effects of the decision options on contribution margin or income from operations. If fixed costs do not change, then we can focus on the effects on contribution margin. If fixed costs do change, then evaluate the effects on income from operations.



Single constraint – If there is a single binding constraint, we must determine the contribution margin per unit of the constrained resource. Then we use this information to determine how best to use the constrained resource to maximize contribution margin and income from operations.


Example of a Single Constraint

Unit Information X Y ZSelling price 40$ 30$ 35$ Variable cost 24 16 20 Contribution margin 16$ 14$ 15$

Capacity (labor hours) 60,000 Maximum demand for X (units) 10,000 Maximum demand for Y (units) 8,000 Maximum demand for Z (units) 9,000

Product


Unconstrained Production

Product Unit cm Units CMX 16.00$ 10,000 160,000$ Y 14.00$ 8,000 112,000 Z 15.00$ 9,000 135,000

Total 15.07$ 27,000 407,000$

Production capacity unconstrained

Sales With No Constraint on Production


Constrained Labor Case

Unit Information X Y ZSelling price 40$ 30$ 35$ Variable cost 24 16 20 Contribution margin 16$ 14$ 15$ Direct labor hours 4 2 3 Contribution margin per labor hour 4$ 7$ 5$

Product



Product Labor Hrs. Units Hrs. Req.X ($4**) 4.00 4,250 17,000 Y ($7) 2.00 8,000 16,000 Z ($5) 3.00 9,000 27,000 Total 2.82 21,250 60,000

*Constrained to 60,000 labor hours

**cm per labor hour

Sales With Constrained* Labor Hours



Product cm/hour Units CMX 16.00$ 4,250 68,000$ Y 14.00$ 8,000 112,000 Z 15.00$ 9,000 135,000

Total 14.82$ 21,250 315,000$

Constrained to 60,000 direct labor hours

Sales With Constraint on Direct Labor


Constrained Machine Hours

Unit Information X Y ZSelling price 40$ 30$ 35$ Variable cost 24 16 20 Contribution margin 16$ 14$ 15$ Machine hours 5 7 4 Contribution margin per machine hour 3$ 2$ 4$

Product


Constrained Machine Hours

Product Mach. Hrs. Units Hrs. Req.X ($3**) 5.00 10,000 50,000 Y ($2) 7.00 2,000 14,000 Z ($4) 4.00 9,000 36,000 Total 4.76 21,000 100,000

*Constrained to 100,000 machine hours

**cm per machine hour

Sales With Constrained* Machine Hours


CM - Constrained Mach. Hrs.

Product Unit cm Units CMX 16.00$ 10,000 160,000$ Y 14.00$ 2,000 28,000 Z 15.00$ 9,000 135,000

Total 15.38$ 21,000 323,000$

*Constrained to 100,000 machine hours

Sales With Constrained* Machine Hours


Recapitulation

Recap: CMUnconstained case 407,000$ Constrained labor case 315,000$ Constrained machine hours 323,000$



Multiple constraints – In the case of multiple constraints in a complex environment, we would maximize an objective function subject to a set of constraints (in Mgt. Sci. 331 & A&MIS 525).


Sell or Process Further

A B CSales value at split-off 120$ 150$ 60$ Sales value after further processing 160 240 90 Allocated joint costs 80 100 40 Separable cost of processing 50 60 10

Pp. 636-9 of text


Sell or Process Further

Analysis of Sell or Process FurtherA B C

Incremetal revenue:Sales value after further processing 160$ 240$ 90$ Sales value at split-off point 120 150 60 Incremental revenue 40$ 90$ 30$ Cost of further processing 50 60 10 Incremental operating income (10)$ 30$ 20$

Pp. 636-9 of text


Introduction to Accounting

Capital Budgeting


Objective

To initiate and maintain projects and activities that earn an adequate rate of return on the required investment. To be adequate, the returns must be consistent with investor expectations, management plans, and business opportunities.


Capital Budgeting

Capital budgeting concerns the analysis and evaluation of projects that require investment in working capital or property, plant & equipment. These tend to be large projects that involve significant cash inflows and outflows over several fiscal years. However, the methods covered are applicable to investment decisions made by individuals as well as organizations.


Internal rate of return

The internal rate of return (IRR) is that interest return, positive or negative, that equates the present value of the investment with the present value of the cash inflows. In cases where there are multiple investments over time, it is that rate that equates the present value of the cash inflows with the present value of the cash outflows.



Thus, it as the discounted rate of return for which the net present value is zero.



Symbolically,

PV = i =0

CFi (1+r)-i

To find the internal rate of return, find that value of r such that

0.0 = i=0

CFi (1+r)-i

N


Internal Rate of Return (IRR)

Alternatively, one can write out the terms of the above expression as follows:

0 = CF0 + CF1(1+r)-I + CF2(1+r)-2 +… + CFN(1+r)-N

Again, the objective is to find a rate r such the above expression is satisfied.



Next we illustrate use of the annuity table to find IRR when the cash flows are uniform from one period to the next


Interpolation Example (p. 676)

Investment required $6,000

Annual cost savings $1,500

Life of project 15 years


Table method (equal cash flow)

PV = CF [1 – (1 + r)-N] / r

$6,000 = $1,500 PVOA (10 periods, r %)

PVOA (10, r %) = $6,000 = 4.000$1,500


Factor Interpolation

20% factor (table) 4.1924.192

Project factor (computed) 4.000

22% factor (table) 3.923

Difference 0.1920.269


For example one

Investment of $6,000 and annual cash flows of $1,500 for 10 years:

0.0 = - $6,000 + $1,500(1+ r)-1 +

$1,500(1+ r)-2 + + $1,500(1+ r)-10

IRR (r) = 21.406% (using Excel worksheet)


IRR Interpolation

IRR = 20% + (0.192 / 0.269) (2%)

IRR = 20% + 0.7137 (2%)

IRR = 20% + 1.4247%

IRR = 21.4247%

Note that the true IRR was 21.406%


Example 2

PV = CF [1 – (1 + r)-N] / r

$10,000 = $2,432.50 [1 – (1 + r)-N] / r

$10,000 = $2,432.50

PVOA (6 years, r %)

PVOA (6 years, r %) = $10,000.00

$ 2,432.50

= 4.111


Example 2

From Exhibit 14C-4, we see that in row 6 (6 periods) we find the PVOA factor 4.111 in the column 12%. What luck! The internal rate of return on this project is exactly 12% per year.


Example 3

Investment is $10,000 Annual cash flows are $3,000 per year for

six years

0.0 = -$10,000 + $3,000(1+ r)-1 +

$3,000(1+ r)-2 + + $3,000(1+ r)-6

IRR (r) = 19.905% (using Excel worksheet)


Example 3

PV = CF [1 – (1 + r)-N] / r

$10,000 = $3,000 [1 – (1 + r)-N] / r

$10,000 = $3,000 PVOA (6 years, r %)

PVOA (6 years, r %) = $10,000/$ 3,000

= 3.333


Example 3

From Exhibit 14C-4, we see that in row 6 (6 periods) we find the PVOA factor 3.333 is between the columns for 18 and 20%. What rotten luck! The internal rate of return on this project has to be estimated by interpolation!


Factor Interpolation

18% factor (table) 3.498 3.498

Project factor (computed) 3.333

20% factor (table) 3.326

Difference 0.165 0.172


IRR Interpolation

IRR = 18% + (0.165 / 0.172) (2%)

IRR = 18% + 0.9593 (2%)

IRR = 18% + 1.9186%

IRR = 19.9186%

Notice that this is very close to the true IRR of 19.905%


IRR Summary

The internal rate of return is a method that recognizes the time-value of money through determining the interest return earned by investments.

If cash flows are constant from period to period, we can use the annuity table to approximate the IRR.


IRR Summary

If the cash flows vary from period to period, the best way to determine an IRR is to use a financial calculator or a computer program such as Excel to compute an exact rate.


Project ROI

Project ROI (Simple rate of return) =

Incremental income from operations Incremental investment

Incremental revenue –incremental expenses Incremental investment

OR

ΔROI = Incremental IOIncremental investment


Payback period

Payback period is the number of periods it takes to recover the cash investment in a project without regard to any income on that investment.

Payback period = Project investment

Annual net cash inflow


Payback for Example 3 Above

Payback = $10,000/$3,000

= 3.33 years or

3 years, 4 months


Payback for Example 4

Period Investment Cash inflow

Unrecovered Investment

1 $10,000 $2,000 $8,000

2 $4,000 $4,000

3 $6,000


Payback: Uneven Cash Flows

Payback = 2 + (4,000 / 6,000)

= 2 2/3 years or 2 years, 8 mo.


Assumptions for Chapter 14

When working with discounted cash flow, assume cash inflows come at period end. (p. 672)

Assume all cash flows generated by an investment are immediately reinvested at the project discount rate.


Discount rate for NPV

Cost of capital Target rate of return set by financial

managers for this purpose The opportunity cost of capital


Chapter 15

Chapter 15 brings the issue of taxes into our study of capital budgeting.


Taxable Events

The following events affect income taxes and should be analyzed on an after-tax basis on the exam for capital budgeting questions.

1. Revenue from operations2. Operating expenses (other than

depreciation)3. Income tax savings due to the

reduction in income for depreciation


Taxable Events

4. Disposal of an asset for gain or loss5. Disposal of a fully-depreciated asset

(tax methods) for its salvage value6. Special expenses usually described as

repairs, overhaul, or renovation, which represent tax-deductible items

7. Dividend income, interest income, and interest expense


Non-taxable Events

The following events do not affect income taxes when they occur and should be analyzed on a pre-tax basis on the exam for capital budgeting purposes.

1. Deposits made for possible damages or the return of equipment if the deposits are returnable.

2. Increases and decreases in working capital


Non-taxable Events

3. Purchase of an operating asset or an investment

4. Borrowing money (taking out a loan)

5. Repaying the principal (not the interest) on a loan

6. Payment of dividends by a corporation

Introduction to Accounting

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