Summary

Summary: Management Accounting

and Control Stef van Grieken – Juli 2010 Index Chapter I: Management Accounting and Corporate Governance .................................2

Chapter II: Cost Behaviour, Operating Leverage and Profitability Analysis.................4

Chapter III: Analysis of cost, volume and pricing to increase profitability...................6

Chapter IV: Cost Accumulation, Tracing and Allocation...............................................8

Chapter V: Relevant information for special decisions ................................................11

Chapter VI: Cost Management in an Automated Business Environment ABC, ABM, and TQM ....................................................................................................................... 14

Chapter VII: Planning for profit and cost control........................................................ 16

Chapter VIII: Performance Evaluation ........................................................................ 17

Chapter IX: Performance Evaluation........................................................................... 21

Chapter X: Planning for Capital Investment................................................................25

Chapter XI: Product Costing in Service and Manufacturing .......................................26

Chapter XII: Job order, Process and Hybrid costing systems.....................................28

Literature: Fundamental Managerial Accounting – Edmonds, Tsay, Olds

Stef van Grieken / Technische Bedrijfskunde / 1509152

Summary Management Accounting and Control

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Chapter I: Management Accounting and Corporate Governance Management Accounting A value-adding continuous improvement process of planning, designing, measuring and operating both nonfinancial and financial information systems that guides management action, motivates behaviour, and supports and creates the cultural values necessary to achieve an organization’s strategic, tactical and operating objectives. Management Accounting is only restricted by the value added principle. Financial Accounting Is designed to generate information for the general public like investors, tax offices, shareholders and suppliers. Securities and exchange commission An American governmental authority to regulate public financial reporting practices. The SEC governs the Financial Accounting Standards Board (FASB) that regulates accounting though the Generally Accepted Accounting Principles (GAAP). Product costing Is a major focus of managerial accounting. There are different costing strategies for product costing. A well-known strategy is cost-plus pricing. With product costing business operations are controlled. Main components of product cost are:

1. Materials 2. Labour 3. Overhead

Asset Exchange Cost for materials, labour and overhead are not expensed directly when incurred in the production process. Rather, the conversion of money in materials, goods, and overhead that is than converted into physical asset is called an Asset exchange. Cost for goods are expensed when they are sold. The costs of the products are hold in an asset account called Finished Goods Inventory. Average cost per unit Is the number of units divided by the total cost. Unit cost is usually average cost per unit because it removes cost variations for individual products. Expensing Cost If products remain unsold in a certain period of time, a part of the product cost is reported as an asset (inventory) on the balance sheet, while the other part is reported as an expense (cost of goods sold) on the income statement. Cost that are not classified as product costs are normally expensed in the period they were incurred. These cost include general operating costs, selling and administrative costs, interest costs, and the cost of income taxes.



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Product and Period Cost Product costs are traceable to an individual product for example direct material costs or direct labour costs. Period cost are not directly traceable and are usually expensed in the period they are incurred for example general selling and administrative costs. Indirect costs Are not traceable to individual products and are usually classified as overhead cost Cost allocation Cost allocation methods are meant to assigning costs to products. Upstream cost Are costs that are incurred before the manufacturing process begins (i.e. research & development) Downstream cost Are costs that are incurred after the manufacturing process ends (i.e. transportation, advertising, sales commission) Product vs. Services Company’s The primary difference between manufacturing entities and service companies is that the products provided by service companies are consumed immediately. Therefore there is no finished goods inventory. Just In Time inventory Companies want to minimize the costs of holding inventory. With JIT they can reduce the costs of financing, warehouse, space, supervision etc. This reduces these costs dramatically. Furthermore, inventory is stored value in assets. If this value can be freed by maintaining lower inventory, a company has more money to invest. This is called opportunity costs. Corporate Governance Is the set of relationships between the board of directors, management, shareholders, auditors and other stakeholders that determine how a company is operated. Fraud Fraudulent activities in financial statements and reporting can cause a wrong representation of a company’s financial situation. These temporary effects may influence:

1. The availability of financing 2. Management motivation: incorrect bonuses 3. Income tax: pay less

Fraud Triangle Fraud can occur when the three elements of the fraud triangle are available:

1. The availability of opportunity 2. The existence of some form of pressure leading to an incentive 3. The capacity to rationalize



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Chapter II: Cost Behaviour, Operating Leverage and Profitability Analysis Cost behaviour The way that costs behave when changes in volume, costs, price or profitability (target) occur. Understanding cost behaviour allows managers to asses risk and improve profitability. Fixed cost and variable cost The fixed cost doesn’t change when the volume (or level of activity) changes, vice versa: variable costs changes when the volume (e.g. number of units) changes.

Operating Leverage Is a measure of the extent to which fixed costs are being used in an organization. When the operating leverage is high, an increase in activity will generate a large percentage change in profits.

Operating Leverage Example



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Contribution Margin Is a classification in the income statement that contains a subtraction of variable cost from the revenue. The contribution margin represents the amount available to cover fixed expenses and provide company profits. Contribution Margin = Total Sales Revenue – Total Variable costs Calculating the Contribution Margin using the operating leverage

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Magnitude of operating leverage = Contribution marginnet income

Mixed costs Mixed costs (semi variable costs) include both fixed and variable components. For example: a manager can receive a monthly salary + a bonus component. Relevant range The range of activity over which the definitions of fixed and variable costs are valid. Cost averaging In some company’s it is difficult to classify actual costs of products, especially over time. To establish the real costs a huge effort and record keeping would be required. Therefore, sometimes cost averaging is applied. Cost estimation method: High-low To analyse the average cost using the high low method, do the following:

1. Assemble volume and cost history for any product or store 2. Select the high and the low points in the data set 3. Determine the estimated variable cost per unit (difference in total cost /

difference in volume) 4. Determine the estimated fixed cost (using either high or low point) Fixed cost

= total cost – (variable cost per unit X number of units



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Cost estimation method: Scatter graph To analyse the average cost using the scatter graph method, do the following:

1. Draw total costs and unit’s data points on a chart 2. Visually draw a line that minimizes the distance between all the points and the

line 3. Use aX+b method to find total costs and variable costs per unit

Cost estimation method: Regression (least squares) To analyse the average cost using the regression method, do the following:

1. Use excel and enter data in a spreadsheet 2. Use data analysis tools to find the best line fit (line fit, r2 statistics)

Chapter III: Analysis of cost, volume and pricing to increase profitability Break Even Analysis The break even point describes the point where the total costs equals the total income for a certain product or service. There are three common ways to calculate the break even point:

1. Equation Method

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Sales - variable costs - fixed costs = 036N - 24N - 60.000 = 0N = 5000 units

2. Contribution Margin Per Unit Method

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Break even point in units = Fixed costContribution margin per unit

3. Contribution margin ration method

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Break even point in dollars = Fixed costContribution margin ratio

When you want to calculate the break even point for a certain profit (i.e. how many units you need to sell for a certain profit) just add the desired profit to the fixed cost Pricing Strategy’s There are different strategy’s to determine the price of a product. Three commonly uses strategy’s are:

1. Cost plus pricing: price products at the variable cost, plus some percentage of the variable (i.e. 50%)

2. Prestige pricing: price products with a premium because they are new or have a prestigious brand name

3. Target pricing: price products at the market price and then control costs to be profitable at the market price.



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Developing new products with Target Costing Target costing is a technique to manage future profits and costs of products. It determines the cost of the entire lifecycle of a product by using an iterative process of cost analysis. With this method analysis of cost is an input to the development of a product.

The process consists of three levels with different steps:

1. Market driven target costing a. Determine long term sales and profit targets b. Structure product line c. Determine target selling price (considering internal and external

factors) d. Establish target profit margin e. Compute allowable cost = target selling price – target profit margin

2. Product level costing a. Determine product level target costs

i. Product level target = current costs less target cost reduction ii. Strategic cost reduction challenge = target cost less allowable

costs b. Achieving target costs: different techniques

i. Quality Function Deployment (QFD), ii. Value Analysis/Value Engineering (VE)

iii. Design for Manufacture and Assembly (DFMA) c. Conditioning target cost

i. Monitoring process ii. Apply cardinal rule

iii. Exceptional circumstances 3. Component level costing

a. Decompose product level target costs of major functions b. Determine component level target costs c. Managing suppliers: d. selection of suppliers

i. put pressure on them ii. support creativity (via incentives)

iii. collaboration is important Margin of safety Measures the cushion between budgeted sales and the break even point. It quantifies the amount by which actual sales can fall short of expectations before the company will begin to incur losses.

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Margin of safety = Budgeted sales - Break even salesBudgeted sales



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Multiple product break even Is the calculation of a break even point using different products in a sales mix.

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Break even sales = Fixed costWeighted average per unit cont. margin

There are some limitations to this method because it assumes that products and sales behave linearly (is often false, multiple products with shared recourses, discounts etc). It doesn’t include the idea of inventory (assumes sales and production are equal) and it is only reliable within the relevant range.

Chapter IV: Cost Accumulation, Tracing and Allocation Cost accumulation Is a method to determine the cost of a particular object. An accountant must accumulate many individual costs and add them together. Cost objects Is an activity, product, or service to which an accountant wishes to trace costs. Cost driver Has a cause and effect relationship with a cost object. For example the number of hours, units etc. Those drivers are usually volume based and preferably behave linearly. Managers can use estimations instead of actual volume’s and costs to make decisions about the future. Cost tracing Finding costs and their cost drivers Cost allocation Allocating cost to a certain cost object Common cost Are costs that support multiple cost objects, but cannot be directly traced to any specific object. Controllable cost Are costs that can be influenced by a manager’s decision and action.



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Cost allocation procedure When dividing the total costs into parts and assigning them to cost objects the following method can be used.

1. Compute the allocation rate y dividing the total cost to be allocated by the cost driver. The cost driver is also called the allocation base, this computation produces the allocation rate.

2. Multiply the allocation rate by the weight of the cost driver to determine the allocation per cost object

Assigning using units of production ( $60,000 ÷ 5,000 units = $12 per unit , $12 per unit × 4,000 chairs = $48,000 , $12 per unit × 1,000 desks = $12,000)

Assigning using direct labour hours( $60,000 ÷ 6,000 hours = $10 per hour, $10 per hour × 3,500 hours = $35,000, $10 per hour × 2,500 hours = $25,000)

Fixed overhead cost allocation Fixed cost are difficult because they cannot easily be traced to one individual product. The objects that rely on the overhead are usually distributed with a relation share of the overhead cost. It is calculated by:

1. Determining the total cost to be allocated and dividing that by the cost driver = the allocation base

2. Multiply evenly using the weight of the cost driver



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Timing problems Sometimes a certain volume cost driver can vary strongly over time. For example units of production may increase or decrease over time. However, managers should receive a steady monthly income on a varying cost driver. Therefore one can use the predetermined overhead rate to determine overhead before actual cost and volume data are available.

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POHR = Estimated overhead for the yearEstimated allocation base for the year

Cost pool Allocating for every single indirect cost would be an enormous job especially for large company’s. Therefore, many individual costs are joined into a singe cost pool and allocated to a cost object. Joint cost Are common costs incurred in the process of making two or more joint products. The point in the production process at which products become separate and identifiable is the split-off point.

Service centre allocation Service centres support the primary process and therefore have no ‘internal’ cost drivers. Allocation of these costs can be done:

1. Direct: allocating the service department directly to a cost driver of the operating department cost pool

2. Step method: allocating the service department to cost drivers of the operating department, but also to other services departments when they use a certain other service department



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Chapter V: Relevant information for special decisions Relevant information Relevant information differs among the alternatives under consideration. Furthermore, relevant information is future oriented. Sunk cost A sunk cost has been incurred in a past transaction and cannot be changed. It is not relevant for making current decisions. Opportunity cost Is the sacrifice that is uncured in order to obtain an alternative opportunity. Relevant cost Are the cost that can be avoided when making a certain decision. Relevant cost are independent from the concept of cost behaviour and can only be decided upon in a certain context. Information doesn’t need to be exact to be relevant and can have a quantitative and qualitative nature. Relevant cost can be incurred on different levels.

Deferential revenue Is the revenue that can be incurred when choosing a certain alternative. Avoidable cost Are the cost that managers can eliminate by making a specific choice. Types of special decisions In business practice five types of special decisions are frequently encountered in business practice:

1. Special orders 2. Outsourcing 3. Segment elimination 4. Asset replacement 5. Scarce resource allocation



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Special order decision Occasionally a company receives an offer to sell its goods at a price significantly lower than it’s normal selling price. A company is then faced with a special order decision. To decide on the special order the following steps have to be made:

1. Quantitative Analysis a. Determine the amount of the relevant differential revenue the company

will earn by accepting the special order b. Determine the amount of relevant differential cost the company will

incur by accepting the special order c. Accept the special order if the relevant revenue exceeds the relevant

(avoidable) cost, otherwise reject it. 2. Opportunity cost

The situation may arise that the company has excess capacity it can use for the special order.

3. Relevance and decision context Although facility and product level costs are not relevant to the special order decision, they are relevant to the operation of the business as a whole. If a better alternative arises, this will have the preference

4. Qualitative characteristics It could be that with this sale will open up new territories, or potential for future orders can be granted. In this case incurring a loss could be interesting.

Outsourcing Buying goods and services from other companies rather than producing them internally. Deciding on an outsourcing opportunity can be done through the following steps:

1. Quantitative analysis a. Determine the production cost the company can avoid if it outsources

production b. Compare the avoidable (relevant) production cost with the cost of

buying the product and select the lower-cost option 2. Opportunity cost

Determine whether the outsourcing deal causes other opportunities like for example leasing out a factory

3. Evaluating the effect of growth on the level of production It is important to evaluate what would happen if production volume increases or decreases. What happens to the avoidable cost relative to production.

4. Qualitative features Some qualitative features like risk of failure, quality etc. must be taken into consideration

Vertical Integration When a company controls the full range of activities from acquiring raw materials to distributing goods and services. Low-ball pricing Luring a manufacturer into an outsourcing decision with low prices, making them dependent on the outsourcing company, after which they start to slowly increase the price.



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Certified Suppliers Lists of reliable suppliers selected by companies to protect themselves from unscrupulous or incompetent suppliers. Relationship between avoidable cost and business activity The more complex the decision level, the more opportunities there are to avoid costs.

1. Special order decisions affect unit-level and possibly batch-level costs. 2. Outsourcing can avoid many product-level as well as unit- and batch-level

costs. 3. Segment elimination can avoid some of the facility-level costs.

Segment elimination decision Businesses organize their operations in to subcomponents called segments. Segment data are used to make comparisons among different products, departments or divisions. The steps to make a segment elimination decisions are as follows:

1. Quantitative aspects a. Determine the amount of relevant differential revenue that pertains to

eliminate a segment b. Determine the amount of cost the company can avoid if it eliminates

the segment c. If the relevant revenue is less than the avoidable cost, eliminate the

segment, if not, continue to operate it 2. Qualitative Considerations in Decisions to eliminate segments

Some qualitative considerations may be relevant (i.e. employee loss) Equipment replacement Decisions Equipment may become technologically obsolete before it physically fails. The decision to replace equipment should be based on profitability analysis. The steps to make a segment elimination decision are as follows:

1. Determine what relevant cost the company will incur by keeping the machine 2. Determine what relevant cost will be incurred if the company purchases the

new machine (include the investment cost as well)



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Chapter VI: Cost Management in an Automated Business Environment ABC, ABM, and TQM Single Cost drivers For a long time companies have been focussing on developing one company wide cost driver (i.e. hours) to allocate cost. In those days overhead cost were low and labour hours were a good cost driver. Nowadays, in automated processes Overhead costs are relatively large. Inaccurate overhead allocation can lead to questionable product cost information. So instead of Volume based cost drivers many companies have adopted activity-based cost drivers to improve accuracy. Activity Based Costing (ABC) Allocates cost to activities rather than to volume measures. Indirect costs are allocated in a two-stage process. In the first stage, costs are assigned to pools based on the activities that cause the cost to be incurred. In the second stage, the costs in the activity cost pools are allocated to products using a variety of cost drivers. Activity Centres As part of stage one, activities (could be thousands) have to be categorised into hubs called activity centres. The overhead cost of these related activities are combined into a cost pool for each activity centre. Determining the optimal number of activity centres requires cost/benefit analysis

Activity Cost Driver Is the unit of measurement for the quantity of the activity used to produce individual products or services identify the linkage between activities and cost objects products, services, and customers rate is the ratio of the cost of the resources required to provide an activity to the total quantity of the cost driver (that is, the practical capacity quantity made available by those resources).



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Levels of activity On each level of activity different cost can occur. At the unit-level activities occur each time a unit of product is made. For example, each shirt you make will require quality control. The indirect costs on this level can be pooled in a unit level activity center. Batch-level activities relate to producing groups of products. Batch levels are fixed regardless of the number of units produced in a single batch. For example, the cost of machine setup could fall in this category. The number of batches could be a cost driver for machine setup. On the product level activities relating specific products or product lines can be allocated. For example, the raw materials inventory holding cost, engineering development etc. At the facility level everything that is not related to a product is pooled together. Overhead costs associated with each category are pooled together and allocated to products according to how those products benefit from the activities. A company can incorporate other forms of activity classification if they see fit. Under and Over costing In a competitive environment sometimes products might not be sold at a certain price because of market demand. In this case a company can choose to allocate cost differently over products. Thereby lowering the cost of some product and increasing another making it possible to deliver the product at a lower price. Total Quality Management Quality represents the degree to which products or services conform to design specifications. The cost that companies incur to ensure quality can be classified into four categories:

1. Prevention: avoid non-conforming products 2. Appraisal: identify nonconforming products produced in spite of prevention 3. Internal Failure: correcting defects 4. External failure: delivering defective goods to customers

These costs are often called voluntary costs because management chooses how much to spend on these cost. Total Quality Cost The cost of total quality control plus failure costs. Accountants support TQM by preparing a quality report that analyses the quality cost.



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Chapter VII: Planning for profit and cost control Planning Planning addresses short, intermediate and long-range time horizons. Businesses describe three levels of planning as:

1. Strategic planning: involves making long term decisions such as business scope

2. Capital budgeting: focuses on intermediate rage planning such as buying or leasing equipment

3. Operations budgeting concentrates on short term plans. Contains a key component: the master budget

Budget planning can be perpetual or continues covering a 12 month reporting period. Advantages of budgeting Budgeting is a costly and time-consuming activity. Budgeting has four general advantages:

1. Planning: communicates a clear goal and planning 2. Coordination: budget planning forces coordination among departments to

promote a decision that is best for all 3. Performance: budgets determine the requested level of performance 4. Corrective action: if costs exceed a budget, action can be taken.

Budgets and People Budgeting is a sensitive operation that requires interpersonal skills. Participative budgeting has frequently proved successful in creating a healthy atmosphere. This technique invites participation in the budget process by all personnel. Master budget Is a group of detailed budgets and schedules representing the company’s operating and financial plans for a future accounting period. The master budget includes:

1. Operating budgets: focus on detailed operating activities 2. Capital budget: describes the company’s intermediate range plans for

investment in facilities, equipment etc 3. Pro forma financial statements: based on projected rather than historical

information



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Example Tip: Check page 307 for a budgeting case example

Chapter VIII: Performance Evaluation Types of Budgeting Is an extension of the master budget (which is based solely on the planned volume of activity. The master budget is static because it remains unchanged even if actual volumes change. Flexible budgeting can cope with variety of volume and cost.

1. Fixed – based on one level of activity, master plan for year 2. Flexible – recognises different cost behaviours when volume of activity

changes 3. Incremental – assumes little or no change allowances increased for inflation 4. Zero based – each allowance justified

Variances Are the differences between the standard and actual amounts. Variances can be favourable or unfavourable. Sales volume variance is the difference between the static budget and the flexible budget based on actual volume. Spending variance is the difference in fixed cost (budget) and fixed cost (actual). By definition both are the same, but sometimes they can change. Fixed cost volume variance is used to change fixed cost predictions over time. Flexible Budget Variance The difference between the flexible budget figures and the actual results are flexible budget variances. The sales price variance can occur if special orders are accepted or certain promotions have been given out. Standard cost systems Standard cost systems help managers plan and also establish benchmarks against which actual performance can be judged. Management can then attend to the exceptions (management by exception). A standard represents the amount that a price, cost or quantity should be under certain anticipated circumstances. How standards are set 1. Performance levels of a prior period – based on experience. 2. Estimates of expected performance – based on experience and knowledge of future changes. 3. Performance to meet organisational objectives – calculated from set targets (particularly useful if target costing is used). Types of standards

1. Ideal Standards a. maximum theoretical outcomes b. do not motivate as impossible to exceed

2. Attainable standards a. high but exceedable by efficient operating b. motivate by offering a challenge



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Limits of standards There are limits to setting standards. First of all, the subjective nature of setting accurate and attainable standards often difficult. Secondly, short-term plans of limited usefulness due to accelerating rate of change (long-term planning no longer seen as useful). Finally, predetermined plans stifle innovative solutions to unexpected events. Budget Development The budget is developed using the following steps:

1. Under the leadership of a top management a budget is set up 2. Facilitated by controllers that help management 3. Apply budgeting rules and time planning 4. Include an overview of current situation 5. Account for external and internal influences 6. Negotiate and reach agreement 7. Adjust if necessary

Budget preparation

Budget process



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Variance Formulae The variance formulae is as follows: Cost variance = Budgeted cost − Actual cost Cost = Price × Quantity Cost variance = Price variance + Quantity variance Where B = Budget or standard A = Actual P = Price Q = Quantity Price variance = | AP − BP | × AQ Quantity variance = | AQ − BQ | × BP Types of variance There are different types of variance that can occur.

1. Price variance Reflects the total difference paid in money for supplies due to price changes (Budgeted price − Actual price) × Actual quantity

2. Quantity variance Reflects the difference in the cost of supplies due to changes in quantity only (i.e. it is not distorted by any price change) (Budgeted quantity − Actual quantity) × Budgeted price

3. Usage variance Is readily apparent from the quantity data. It reflects the difference in the cost of used materials

4. Labour Reflects the difference in price of labour. Also has a usage variance option.

5. Fixed manufacturing overhead cost spending is the fixed manufacturing cost incurred in a certain period. With changes in this cost a new predetermined overhead rate can be calculated

Flexed budget The flexed budget is a redraft of the original budget at the actual level of activity. It can only be prepared after the budget period has ended. It uses the same standard rates as the original budget. For meaningful variances the actual results must be compared to the FLEXED budget.



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Variance family tree

Problems with variance analysis

1. Standards for discretionary costs: how do you set the budget for advertising, training, etc.?

2. Out-of-date standards: systematic updating essential. 3. Planning errors (e.g. a grossly inaccurate sales forecast): distinguish planning

from operational variances. 4. Lines of authority not always clearly defined: avoid duplication of

management responsibility. 5. Delegation vs. central control: budget decisions centralised: possible

demotivation Limitations variance analysis

1. Planning variances waste management time 2. Unforeseeable events 3. Accelerating rate of change in environment 4. Difficulty of allocating responsibility for variances 5. Corrective action not always possible

10 Points for budgeting control

1. Clearly defined areas of responsibility 2. Budgets held at lowest practical management level 3. Routine reporting system 4. Short reporting periods 5. Exclusion of non-controllable items 6. Reports produced soon after period end 7. Pre-established significance levels for variances 8. Significant variances always investigated 9. Corrective action taken where possible and appropriate 10. Senior managers exemplify importance of budgetary control (i.e. ‘walk the

talk’)



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Chapter IX: Performance Evaluation Responsibility accounting An accounting system that provides information relating to the responsibilities of individual managers to evaluate managers on controllable items. Decentralization Is the practice of delegating authority and responsibility to lower levels of the company. The advantages of decentralization are:

1. Encourages upper-level management to concentrate on strategic decisions 2. Improves the quality of decisions by delegating authority down a chain of

command 3. Motivates managers to improve productivity 4. Trains lower-level managers for increased responsibilities 5. Improves performance evaluation

Responsibility centre A decentralized business usually subdivides into distinct reporting units called responsibility centres. A responsibility centre can be categorised as:

1. A cost center: an organizational unit that incurs only expenses 2. A profit center: incurs cost, but also generates revenue 3. An investment center: appear usually at the upper level, they can incur costs,

generate revenue and control investment of capital



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Responsibility reports Is a document prepared for each manager who controls a responsibility center. The report compares the expectations for the manager’s center with the centers actual performance. A typical report lists the items under managers control, both the budgeted amount and the actual amount spent for each item, and the differences between budgeted and actual amounts.

Management by exception The responsibility reports are arranged to support using the management by exception doctrine. It focuses on showing the information a manager has control over and minimizes detail. This has a positive effect on the manager. Upper-level management does not receive operating detail unless problems arise. Controllability concept Managers should only be evaluated on revenues or costs they control. Since the exercise of control may be clouded, managers are usually held responsible for items over which they have predominant rather than absolute control. Qualitative reporting features To be of maximum benefit, responsibility reports should, be timely, issued regularly, understandable, compare budgeted and actual amounts of controllable items. Return on investment (ROI) Return on investment is the ratio of income to the investment used to generate the income.

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Return on investemen = Operating incomeOperating asset



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ROI Example Panther Holding Company provides the following information for the company’s second level investment centers.

Measuring Operating Asset Depreciation of assets should not be taken into account when calculating the ROI. Otherwise, a fair comparison of assets can’t take place. The original purchasing cost or the replacement costs can be used to measure operating asset when calculating the ROI. Factors affecting ROI Dividing the formula into two ratios can gain insight into performance. The Margin is a measure of managements ability to control operating expenses relative to the level of sales. High margins indicate superior performance. Turnover is a measure of the amount of operating assets employed to support the achieved level of sales.

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Return on investemen = Margin • Turnover = Operating incomeSales

•Sales

Operating asset

Improving ROI The ROI can be improved by increasing sales, reducing expenses or reducing the investment base. Misleading performance signals Division managers are encouraged to retain assets beyond their optimal life and not to invest in new assets. Corporate managers may be induced to over-allocate resources to divisions with older assets. Combined with the suboptimization issue, managers of entities with older assets, and hence a higher ROI, are likely to be more reluctant to invest in “desirable” projects with an IRR higher than the corporate cost of capital. Suboptimization ROI-measures can lead division managers to make decisions that improve division ROI even though the decisions are not in the corporation's best interest



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Residual Income Is a measure of managerial evaluation based on the managers ability to maximize earnings above some targeted level. The targeted level of earnings is based on a minimum desired ROI.

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Residual Income = Operating Income - (Operating Asset • Desired ROI)

Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.

The Balanced Scorecard Is an evaluation system that assesses the accomplishments of the full range of financial and nonfinancial measures that align with the company mission.

Transfer Pricing Goods and services are often transferred internally from one division (selling division) to another (buying division). In decentralized organizations each division is likely to be defined as an investment center. This causes mangers to try and maximize their profits when selling goods to a different division. The amount of profit included in the transfer price will increase as the selling devisions earnings and decrease the purchasing divisions earnings. Transfer prices can be:

1. Market price based 2. Negotiated based 3. Cost-based



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Chapter X: Planning for Capital Investment This part of the summary only contains LO4 and 8

Internal Rate of Return The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. Use the following example. Year (n)

Cash Flow (Cn)

0 −4000 1 1200 2 1410 3 1875 4 1050

R=14,3 % Unadjusted Rate of Return The unadjusted rate of return method is another capital budgeting technique that does not involve discounted cash flows. Unlike the other capital budgeting methods , the unadjusted rate of return method does not focus on cash flows. Rather, it focuses on accounting net operating income. The approach is to estimate the revenue that will be generated by a proposed investment and then to deduct from these revenues all of the projected expenses associated with the project. The net operating incomes then related to the initial investment in the project, as shown in the following example formula: Unadjusted rate of return = ($90,000 Incremental revenues) − ($40,000 Cash operating expenses + $20,000 Depreciation) / $180,000 Initial investment = 16,7%



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Chapter XI: Product Costing in Service and Manufacturing

This part of the summary only contains LO1-5 Cost flow in manufacturing companies In previous chapters an implicit assumption was tha all inventory started and ended in an accounting period. This is not true because inventory and finished goods could be ‘in transit’ between periods. For example work in progress could start in one period and end in the other. Cost flow in manufacturing companies therefore works as follows:

Cost flow in service companies In service companies goods are consumed immediately so service companies don’t have work in progress and finished goods inventory accounts. Labour and Material flow Within a production process, labour and material costs flow through the accounts like this:



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Manufacturing overhead Manufacturing overhead is calculated based on an estimation made at the beginning of an accounting period (year). Throughout the year, actual manufacturing overhead may vary from the estimate. If more overhead has been applied the account balance will represent an amount of over applied overhead. If less overhead was applied the account balance is under applied overhead.

Absorption costing When all products costs, both variable and fixed are reported as inventory until the products are sold.

Variable costing When only variable costs are reported as inventory until the products are sold. In this case it is easier to increase profitability by moving variable to fixed cost accounts. Variable costing is controversial because of its use for external reporting

1. Proponents: fixed portion of manufacturing cost is related to capacity to produce and not to the production of units

2. Opponents (proponents of AC): both fixed and variable costs necessary to produce goods therefore should be inventorable



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Chapter XII: Job order, Process and Hybrid costing systems

This part of the summary only contains LO1-5 Job order costing systems Accumulate costs by individual products for example airplanes, building construction or boat. These systems identify costs per job to average the costs over the total amount of jobs. Overhead is added based on predetermined overhead rates. This system requires detailed information about each job.

Process costing systems Accumulate costs evenly over homogeneously products for example oil production and chemicals production. Process systems are suitable for homogenous products running multiple processes. The cost accumulates per process step wich provides an average cost per unit (i.e. liter). The average cost per unit is the total processing cost when multiplied times the amount of units. Partially finished products are converted to equivalents at the end of the period.

Hybrid costing systems Contain elements from both costing systems. An example is the computer industry.

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