Managerial Accounting

WHAT IS MANAGERIAL ACCOUNTING?

The process of obtaining, creating, and analyzing relevant information to help achieve organizational goals.

Financial accounting

  • Internal and external users
  • General, aggregated financial statements
  • Reporting of the past; historical
  • Guided by principles, standards, and rules (generally accepted accounting principles)

 

Managerial accounting

  • Internal users
  • Detailed, specialized for a specific decision, setting, etc.
  • Designed for future decisions
  • Case-specific; best practices
  • Facilitates decisions: Creates, organizes, and shares the right information to allow for the best decision

  • Guides/Influences decisions: Helps align managers’ and employees’ decisions with what is best for the firm

 

Cost: It can be usage of any resources and not just money.

Cost Object: It can be a product or anything else.

COST FRAMEWORK 1: OBJECTS (Organization of costs by relation to cost object)

  • Direct costs
    • Materials
    • Labor
  • Indirect costs
    • Necessary, but difficult/infeasible to trace to the cost object
    • “Catch-all” category
    • Example scenario: Overhead

    • In multiple-product scenarios, how overhead is allocated to products influences the perceived cost of the product

    • If arbitrary or inaccurate, may lead to poor decisions

 

COST FRAMEWORK 2: BEHAVIOR
For decision making, we’ll often find it useful to classify costs based on cost behavior. That is, how costs are associated with some activity of interest.

  • Determine product profitability (i.e., choose among potential products to produce)
  • Determine whether to change product price
  • Determine whether to add/drop a product line
  • Determine whether to outsource

Total Cost = Fixed Costs + Variable Costs

Variable Costs = Variable Costs Per Activity X Volume of Activity

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Product Cost = Inventoriable Cost = Direct Product Cost + Indirect Product Cost (Overhead)

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Job Costing: Cost object is a unit or multiple units of a distinct/custom product or service. Examples – Law firms, Consulting, Planes, Yachts, etc.
Process Costing: Cost object is masses of identical or similar units of product or service. Examples – Computers, Food Products, Mail delivery, etc.

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APPLYING OVERHEAD
Predetermined Overhead Rate = Total budgeted overhead / Total volume of driver
EXAMPLE STEP 1: CALCULATE OVERHEAD RATE
Predetermined Overhead Rate = $1,500,000 / 30,000 Labor hours = $50 per hour
STEP 2: APPLY OVERHEAD (Consulting for 350 hours)
$50 per hour X 350 hours = $17,500
The predetermined OH rate is based on budgeted information. However, estimates from the beginning of the year likely do not match actual overhead at the end of the year. An adjustment is usually made to reflect this difference in the costing system.

Financial Accounting
Revenue –  Direct Material (V) –  Direct Labor (V) –  Overhead (V & F) = Gross Margin – Other Expenses (V & F) = Profit

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CREATING THE INCOME STATEMENT
What is Keith’s revenue from boats for Month 1?
$21,000 per unit x 300 units sold = $6,300,000
What are Keith’s variable manufacturing costs?
Direct materials + Direct labor = $5,000 + $3,000 = $8,000 per unit
Total = $8,000 per unit x 400 units = $3,200,000
Where are the variable manufacturing costs reported?
Income statement (COGS): $8,000 x 300 units sold = $2,400,000
Balance sheet (Inventory): $8,000 x 100 units in inventory = $800,000

What are Keith’s fixed manufacturing costs for Month 1?
Given as $1,500,000
Where are the fixed manufacturing costs reported?
How much fixed cost is allocated per unit?
$1,500,000 / 400 units produced = $3,750 per unit
Income statement (COGS): $3,750 x 300 units sold = $1,125,000
Balance sheet (Inventory): $3,750 x 100 units in inventory = $375,000

What are Keith’s other costs?
Variable selling and admin: $2,000 per unit x 300 units sold = $600,000
Fixed selling and admin: $450,000
Where are these costs reported?
All on the income statement, as they are not inventoriable costs

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Let’s envision a different version of Month 1 . . .That is, suppose that Keith manufactured 800 units (instead of the 400 units in our original scenario).

ALTERNATIVE VERSION
What is Keith’s revenue from boats for Month 1?
$21,000 per unit x 300 units sold = $6,300,000
What are Keith’s variable manufacturing costs?
Direct materials + Direct labor = $5,000 + $3,000 = $8,000 per unit Total = $8,000 per unit x 800 units = $6,400,000
Where are the variable manufacturing costs reported?
Income statement (COGS): $8,000 x 300 units sold = $2,400,000
Balance sheet (Inventory): $8,000 x 500 units in inventory = $4,000,000

What are Keith’s fixed manufacturing costs for Month 1?
Given as $1,500,000
Where are the fixed manufacturing costs reported?
How much fixed cost is allocated per unit?
$1,500,000 / 800 units produced = $1,875 per unit
Income statement (COGS): $1,875 x 300 units sold = $562,500
Balance sheet (Inventory): $1,875 x 500 units in inventory = $937,500

 

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Revenue = Selling Price * # of units sold

Variable Costs per unit = Direct Material + Direct Labor + Overhead

Total Variable Cost = per unit Variable Cost * # of units produced

Where are the variable costs reported?
Income statement (COGS): per unit Variable Cost * # of units sold
Balance sheet (Inventory): per unit Variable Cost * # units in inventory

Where are the fixed costs reported?
How much fixed cost is allocated per unit?
Fixed Cost per unit = Total fixed cost / # of units produced
Income statement (COGS): per unit fixed cost * # of units sold
Balance sheet (Inventory): per unit fixed cost * # of units in inventory

INCENTIVE IMPLICATIONS
Assume the boating business unit manager’s evaluation and compensation is determined by operating income . . .Certainly, the manager is aligned with the organization. However, the “accounting” story might induce inventory build-up!

WHAT IS THE ROOT OF THE PROBLEM?
Accounting for fixed costs is complicated. Absorption costing (required for financial accounting purposes) treats fixed costs as product costs. Financial accounting information may not be the best for internal decision-making.
POTENTIAL FIX?
For internal purposes, firms can account for costs however they like. Variable costing is one such method. Separate costs according to behavior, and account for variable costs on a per unit basis, and leave fixed costs in aggregate.

Activity Based Costing system

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Resources: Owned by the firm and consumed by the activities. Example – wages, equipment maintenance cost, supplies, utilities, etc.

Activities: Processes engaged in by the firm, employees, managers, etc. Example – logistics, setup, production, support, maintenance, etc.

Activity Pools: Grouping of activities according to type. Helps to simplify the system so that its more manageable. Example – unit-level, product-level, etc.

Cost Object: Defined earlier. Example – units, product lines, departments, customers, etc.

Driver: Measure of activity that allows for assignment of costs to cost objects. Example – # of units, # of batches, inspections, orders, etc.

ADVANTAGES OF ABC SYSTEM

  • More accurate cost information
    • Better decisions
    • Activity-based management
  • Flexibility
    • Choice in level of specification, cost object, etc.

DISADVANTAGES OF ABC SYSTEM

  • Development/implementation
  • Maintenance

Steps for implementing ABC costing system:

  1. Identify Resources
  2. Identify Activities
  3. Create Activity Pools
  4. Compute Drivers
  5. Assign Costs

EXAMPLE

C-Brook Enterprises produces four models of its flavored health drink. Managers have used a simplified cost system in the past, in which all overhead was compiled in a single cost pool. Managers are now switching to an ABC system.

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WHO NEEDS ABC?

Operational characteristics

  • Product lines are diverse.
  • Overhead is a substantial portion of cost structure.

Decision-making characteristics

  • Accounting department spends significant resources customizing information.
  • Product line profitability information is difficult to rationalize.
  • Line managers do not believe product cost reports.
  • Competitors ignore higher profitability products and compete on lower profitability products

 

WHEN DO ABC SYSTEMS FAIL?

Garbage in, garbage out:

  • Cost estimates in activity pools are unreliable.
  • Difficult to identify and measure drivers.

When the system increases complexity, without the benefits:

  • Activity-cost rates need to be updated regularly – can lead to confusion.
  • The system is costly to operate and difficult to understand because of the high level of detail.

 

COST-VOLUME-PROFIT (CVP) Analysis

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Operating Profit = Revenues – Total VC – Total FC

To calculate the break even point, set the Operating Profit to 0.

0 = Revenues – Total VC – Total FC
0 = (Selling price x Q) – (VC per unit x Q) – Total FC
Total FC = Q x (SP – VC)
Q = Total FC / (SP – VC) = Total FC / CM

EXAMPLE #1:
Taves Donuts sells donuts, coffee, and other related food items. The following information is available:
Service varies from a single coffee to multiple dozen donuts.
The average revenue earned for each customer is $8.00.
The average cost of food and other variable costs for each customer is $3.00.
Total fixed costs for the year is $450,000.
The income tax rate is 30%.
Target (i.e., desired) net income is $105,000.

Data: SP = $8.00; VC = $3.00; FC = $450,000; Target income = $105,000; Tax Rate = .30
How many customers are needed to break even?
# of customers for Break Even = Total FC / CM = 450,000/8 – 3 = 90,000 customers

How many customers are needed to reach the desired profit?
Desired Net Income (NI) = $105,000
Net Income Before Tax (NBIT)
NBIT – (NBIT * tax rate) = NI
NIBT = NI / (1 – tax rate)
NIBT = 105000 / (1 – 0.30)
NIBT = 150,000
# of customers for $105,000 profit = (450,000 + 150,000) / (8 – 3) = 120,000 customers

 

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Break Even for Product X = 10,000 / 10 – 6 = 2,500 units
Break Even for Product Y = 12,000 / 15 – 12 = 4,000 units

HOSA’s sales are 60% Product X and 40% Product Y.

Weighted Average Contribution Margin (CM) = 0.60 * (10 – 6) + 0.40 * (15 – 12) = 3.60
Break Even with Weighted Average CM = 10,000 + 12,000 / 3.60 = 6,111 units
60% of 6,111 units = 3,667 product X
40% of 6,111 units = 2,444 product Y

 

IMPORTANT INFORMATION CHARACTERISTICS: Accurate, Timely, Relevant

WHAT IS RELEVANT INFORMATION?
Relevant information reflects what differs across decision alternatives.
Or it reflects what potentially differs. The focus is on what makes a difference in the decision being made.
What don’t we care about?
Revenues and/or costs that do not differ across decision alternatives are irrelevant.

 

SUNK COSTS: Costs that have been incurred or committed to and cannot be avoided in the feasible decision alternatives. Usually irrelevant to a decision. Examples: Rent, Contracted salary. Avoidability: If a cost can be avoided, it is NOT sunk cost.

OPPORTUNITY COSTS: Value of “next best alternative”. Usually relevant to a decision.

COMMON MISTAKES
Sunk costs: There is a tendency to overweight that which has occurred in the past and/or that which cannot be changed.
Fixed costs per unit: Under some approaches, fixed costs are divided by some activity measure and assigned to units of product (i.e., they appear variable and are deemed more important than they really are).
Allocated fixed costs: A possible result is that a product or department may appear unprofitable as a function of the allocation method chosen.

Opportunity costs: People tend to overlook opportunity costs or to treat them as less important than out-of-pocket costs.

 

KEEP or DROP a Product Line?

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Should Scout Corp. drop Product C?
Status quo: 200,000 + 40,000 – 20,000 = $220,000 profit
If we drop Product C:
Lost Revenue: $100,000
Saved Variable Cost: $90,000
Profit after dropping Product C: 220,000 – 100,000 + 90,000 = $210,000
Does not make sense to drop Product C. It is helping Scout Corp. to recover some of the Fixed Cost.
If the Fixed Cost could also be avoided:
Saved Fixed Cost: $30,000
Profit after dropping Product C: 210,000 + 30,000 = $240,000
It does make sense to drop Product C.

MAKE or BUY?

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The above cost analysis is incorrect. Here is the correct analysis.
Components: $120,000
Assembly labor: $300,000
Manufacturing Overhead: 150,000 + 300,000
$150,000 Variable cost in manufacturing overhead might be acceptable but $300,000 Fixed cost is not acceptable because the case says that no additional space, equipment, or supervision will be needed.
General & administrative overhead: $87,000 is also not needed for the same reason.
120,000 + 300,000 + 150,000 = $570,000 to produce 10,000 units.
$57 per unit, which is less than $67 per unit. It makes sense to make the pumps in-house.

REPLACE or RETAIN equipment
Scout Corporation uses an older machine in its main production line. Given its age, the machine creates some inefficiencies (e.g., requires frequent maintenance, significant amount of downtime, higher labor costs, etc.).
Managers are deciding whether to replace the machine with a new one.

Old
Original purchase cost:  $110,000
Accumulated depreciation: $70,000
Estimated life: 4 years

New
Original purchase cost:  $120,000
Estimated life: 4 years

Further, the new machine will provide annual cost savings of $35,000. The old machine can be sold for $5,000. If used for their entire lives, the machines will have zero value.

If Scout Corp. buys the new machine:
Cost Savings (35,000 * 4) = $140,000
Benefit: 140,000 – 120,000 + 5000 = $25,00

ADDITIONAL INFORMATION
Managers have identified an investment opportunity not related to machinery and equipment. An investment can be made only if the new machine is not purchased. That is, the investment is made with the cash used to purchase the new machine.
What percentage return does the alternative investment need to lead the manager to retain the old equipment?

25,000 / 120,000 = 20.83%

SELL ‘AS IS” or PROCESS FURTHER

Whaler, Inc. produces toddler and child-sized furniture. The following information is available for its arts and crafts table.

Per-unit data for an unpainted, unassembled version is as follows:

Selling price

$25

Variable costs

$12

Fixed costs

$8

Whaler managers are considering a completely finished version of its table – painted and assembled. Managers estimate that painting and assembling would incur per-unit variable costs of $9 and per-unit fixed costs of $2. The completely finished version of the table would be sold for $35 per unit.

Sell ‘AS IS’:
Revenue: $25
Variable Cost: $12
Fixed Cost: $8
Profit: 25 – 12 – 8 = $5

Process Further:
Revenue: $35
Variable Cost: $21
Fixed Cost: $10
Profit: 35 – 21 – 10 = $4

Selling ‘AS IS’ makes more sense.

SPECIAL ORDERS
Baron Company produces 100,000 coffee grinders per month. The monthly capacity is 125,000. Per-unit data for the past month is as follows:
Selling price: $20
Variable costs: $8
Fixed costs: $4
A special order has been received from North-Star, Inc. They offered to purchase 2,000 grinders at $11 per unit.
Total Cost: 8 + 4 = $12, which is more than the offer price.
But the FC is unavoidable so we shouldn’t include that into consideration.
The real cost to produce an extra 2,000 grinders is VC * 2,000 = $16,000
Revenue from the special offer: 11 * 2,000 = $22,000
Profit: 22,000 – 16,000 = $6,000

Suppose that current projected sales is 124,000 units. Monthly capacity is still 125,000.
Will the manager still accept the special order?
We can only produce 1000 extra units with 11 – 8 = $3 per unit profit
We will have to take out 1000 units from existing sales making $12 in profit to complete the special order. It doesn’t make sense to accept the special order in this situation.