Managerial Accounting by James Jiambalvo

Managerial Accounting by James Jiambalvo
Chapter 1: Introduction to Managerial Accounting Slides Prepared by: Scott Peterson Northern State University

Chapter 1: Introduction to Managerial Accounting
Chapter Themes: It’s all about using information to plan, control and make decisions. Accountants produce information and managers use information. Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO).

Primary Goal of Managerial Accounting
Effective managers must be adept at planning, controlling and decision making. Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO).

Planning Planning has to do with budgeting in a managerial context. It is in this way that a company’s goals are communicated to all employees. Budgets include profit budgets, cash-flow budgets, production budgets and many others. Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning. Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO). Instructor Note! In a general sense, when we discuss budgeting in a managerial context, operational budgeting is implied. We are not, at least at this point, talking about capital budgeting. We are talking about next year, next month and next week—and maybe tomorrow.

Controlling Related Learning Objectives:
The notion of managerial control has to do with measuring and evaluating the performance of both the manager and the operation(s) for which the manager is responsible. There is an important distinction to be made here. A manager is evaluated, at least in part, based on her overall performance. Each operation for which she is responsible is evaluated in order to optimize future goals and objectives. Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning. Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO).

Decision Making An integral part of the planning and controlling process, decision making includes both rewarding or punishing managers for their performance AND dropping, adding or otherwise changing some aspect of operations going forward. Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning. Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO).

A Comparison of Managerial and Financial Accounting
Managerial accounting: Is meant primarily for internal users while financial accounting is meant for external users. Is not driven by GAAP. May be much more detailed than financial (external) accounting reports. May include much nonfinancial data. Is forward looking rather than retrospective. Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning. Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO).

Similarities Between Financial and Managerial Accounting
Although managerial accounting is meant for internal users (management) and financial accounting is meant for external users, managers DO make use of financial accounting information. Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning. Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO).

Cost Terms The term “cost” appears in many contexts and carries a number of meanings. Different categories of cost terms are merely different ways to look at costs or to slice and dice cost information. They are not necessarily complementary to or mutually exclusive of other cost categories. Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning. Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO). Julie: do you think these slides should contain examples?

Variable and Fixed Costs
Variable costs: costs that increase or decrease (in total) relative to increases or decreases in the level of business activity. Fixed costs: costs that do not change (in total) relative to changes in business activity. Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning. Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO).

Sunk Costs Sometimes called “past costs.” These costs are NOT relevant to the decision making process. Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning. Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO). Julie: do you think these slides should contain examples?

Opportunity Costs These are the values of potential benefits foregone when a decision is made. Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning. Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO). Julie: do you think these slides should contain examples?

Direct and Indirect Costs
Direct costs: costs that are directly traceable to some object such as a product, activity or department. Indirect costs: costs that are NOT directly traceable to a product, activity or department. Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning. Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO). Julie: do you think these slides should contain examples?

Controllable and Noncontrollable Costs
Yet another way to slice and dice costs. This time it has to do with the degree of influence a manager has over the cost. If a management decision can impact the cost in the short term, it is considered controllable. Conversely, if a manager cannot influence (control) the cost in the short term, then it is noncontrollable. A manager’s performance should NOT include an assessment of noncontrollable costs. Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning. Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO). Julie: do you think these slides should contain examples?

Two Key Ideas in Managerial Accounting
They are: Decision making relies on incremental analysis—an analysis of revenues and costs that increase or decrease if a particular decision alternative is selected. You get what you measure! Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning. Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO). Julie: do you think these slides should contain examples?

Decision Making Relies on Incremental Analysis
Incremental means “difference.” Here decision making looks at the difference between revenues and expenses if selection (a) is made as opposed to selection (b). Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning. Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO). Julie: do you think these slides should contain examples? Any textart or clipart might be helpful here.

You Get What You Measure
Performance measurement impacts management behavior. Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning. Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO). Julie: do you think these slides should contain examples? Any textart or clipart might be helpful here.

The Controller As the Top Management Accountant
Controller: The top management accountant responsible for preparing information for planning, controlling and decision making. Treasurer: The treasury function is custodial in nature; custody of assets. Chief Financial Officer (CFO): The senior executive to whom both the controller and CFO report. Related Learning Objectives: State the primary goal of managerial accounting. Describe how budgets are used in planning. Describe how performance reports are used in the control process. Distinguish between financial and managerial accounting. Define cost terms used in planning, control and decision making. Explain the two key ideas in managerial accounting. Discuss the duties of the controller, the treasurer and the chief financial officer (CFO). Julie: do you think these slides should contain examples? Any textart or clipart might be helpful here.

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Chapter 2: Manufacturing Costs and Job-Order Costing Systems Slides Prepared by: Scott Peterson Northern State University

Chapter 2: Manufacturing costs and Job-Order Costing Systems
Chapter Themes: It’s all about the concept of inventories. Think about how costs can be attached to products. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems. More

Chapter Themes: It’s all about the concept of inventories. Think about how costs are attached to products. Related Learning Objectives: Explain the relation between the cost of jobs and the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. Describe how direct material, direct labor, and manufacturing overhead are assigned to jobs. Explain the role of a predetermined overhead rate in applying overhead to jobs. More

Chapter Themes: It’s all about the concept of inventories. Think about how costs are attached to products. Related Learning Objectives: Explain why the difference between actual overhead and overhead allocated to jobs using a predetermined rate is closed to Cost of Goods Sold or apportioned among Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. Discuss changes in the manufacturing environment of U.S. companies and how they affect product costing.

Cost Classifications for Manufacturing Firms
Unlike retailers who purchase goods for resale, manufacturers make what they sell. Therefore, the manufacturer must differentiate between manufacturing and nonmanufacturing costs to determine what their goods cost. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Manufacturing Costs Manufacturing costs, by definition, are all costs which are associated with the production of goods. The three traditional categories of manufacturing costs include: Direct Materials Direct Labor Manufacturing Overhead Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Direct Material Direct material costs include raw materials and components that are directly traceable to the final finished product. Here think of a home builder’s direct material costs. Raw materials include lumber and sheetrock. Components include light fixtures and sprinkler system components. Materiality IS important here… Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems. More

Direct Material …because direct materials DO NOT include minor material costs which are not easily or cost justifiably traced to the final finished product. The home builder would probably not include nails, screws and other small, inexpensive fasteners in direct materials. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Direct Labor Direct labor costs, like direct material costs, include labor that is directly traceable to the final finished product. Using the home builder example, salaries of carpenters are considered direct labor. Construction supervisory salaries, though, are not. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Manufacturing Overhead
Manufacturing Overhead includes all manufacturing costs that are not considered Direct Materials or Direct Labor. By definition, it includes Indirect Materials and Indirect Labor. Using the home builder example, Manufacturing Overhead might include construction supervisor salaries and fasteners such as screws, nails and tape. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Nonmanufacturing Costs
Nonmanufacturing costs are simply costs which are not associated with the production of goods. Sometimes called period costs, this category includes selling, general and administrative costs. For the home builder, this includes the bookkeeper’s salary. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Selling Costs As the name implies, selling costs include costs associated with securing and filling customer orders. Examples include advertising, sales salaries and commissions, and other support costs for this function. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

General and Administrative Costs
As the name implies, General and Administrative Costs include costs associated with the firm’s general management. Often associated with corporate headquarters including executive salaries, depreciation on office equipment and buildings etc.. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Product and Period Costs
These two terms are synonymous with Manufacturing and Nonmanufacturing costs, respectively, discussed previously. They are important because they refer to the timing of expenses as much as the description. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Product Costs Product costs, a.k.a. manufacturing costs, are also called inventoriable costs. The reason is that these costs, Direct Materials, Direct Labor and Manufacturing Overhead, are inventoried until which time they are sold and become expenses; Cost of Goods Sold. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Period Costs Period Costs, a.k.a., nonmanufacturing costs, include Selling, General and Administrative. They are called Period Costs because they are expensed in a certain accounting period regardless of production schedules. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Product Cost Information in Financial Reporting and Decision Making
Often the information needed by internal managers stands in sharp contrast to external reporting requirements promulgated by Generally Accepted Accounting Principles (GAAP). GAAP requires Full Costing and management decision making requires incremental information. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Balance Sheet Presentation of Product Costs
Until sold, Product Costs (Inventoriable Costs) are carried in one of three inventory accounts on the balance sheet: Raw Materials Inventory. Work in Process Inventory. Finished Goods Inventory. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Raw Materials Inventory
Raw Materials Inventory includes the cost of raw materials on-hand which are to be used in forthcoming production. Using the home builder example, Raw Materials might include lumber, sheetrock, shingles etc… Bear in mind, however, most home builders do not often carry inventory, rather they use a form of Just-in-Time and rely on delivery. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Work in Process Inventory
Work in Process inventory includes production which was begun but not completed during the accounting period. At December 31, for example, a home builder may have several different projects started and enclosed, but all completed to varying degrees, 20%, 35%, 60% and so on. The value of these projects are included in this inventory account. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Finished Goods Inventory
Finished Goods Inventory includes products which are complete, in inventory and ready for sale. For the home builder this would include a spec home which is completed, ready for sale, for for which an owner has not yet been found. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Flow of Product Costs in Accounts
In an accounting system, product costs (does anyone remember the buzzwords here?) flow from one inventory account to another. The final resting place prior to sale for all Product Costs is Finished Goods Inventory. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems. Instructors, click on the words Product Costs to reveal the terms for students.

Income Statement Presentation of Product Costs
Ultimately when manufactured goods are sold they are moved from Finished Goods to Cost of Goods Sold. This is how costs of manufacturing goods is matched with revenue resulting from sales of those goods. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Cost of Goods Manufactured
Cost of Goods Manufactured is an important concept. It represents the sum of costs attached to products which were transferred form Work in Process to Finished Goods during any given time period. It is calculated as follows: Beginning Work in Process + Total Manufacturing Costs – Ending Work in Process. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Cost of Goods Sold This is also an important concept and one that most students have seen before. It represents the total cost of all goods sold during a particular accounting period. It is calculated as follows: Beginning Finished Goods + Cost of Goods Manufactured (previous slide) - Ending Finished Goods. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Types of Costing Systems
There are two major types of product costing systems, Job-Order Costing Systems and Process Costing systems. Generally speaking, Job-Order costing is applicable to situations where each unit or batch of output is at least somewhat unique. A good example here is the homebuilder. Process Costing applies to situations where all units of output are essentially the same. An example here is food processing. Related Learning Objectives: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs. Discuss the three inventory accounts of a manufacturing firm. Describe the flow of product costs in a manufacturing firm's accounts. Discuss the types of product costing systems.

Overview of Job Costs and Financial Statement Accounts
In a Job-Order Costing System, the three product costs are attached to products via the Job-Cost Sheet. It is important to recognize here that cost flows through a Job-Order system are based on the status of jobs. That status could be either in process, in finished goods or sold. Related Learning Objectives: Explain the relation between the cost of jobs and the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. Describe how direct material, direct labor, and manufacturing overhead are assigned to jobs. Explain the role of a predetermined overhead rate in applying overhead to jobs.

Job-Order Costing System
In Job-Order Costing systems the primary document (likely electronic) is called a job-cost sheet. It is used to capture costs of producing that product. Using the home builder example, a job-cost sheet would be prepared for each home. And the costs it captures are the usual suspects, materials, labor and overhead! Related Learning Objectives: Explain the relation between the cost of jobs and the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. Describe how direct material, direct labor, and manufacturing overhead are assigned to jobs. Explain the role of a predetermined overhead rate in applying overhead to jobs.

Direct Material Cost The document used to request the release of materials to production is called a materials requisition. This requisition indicates the type, quantity and cost of material as well as the job number to which it will be assigned. Related Learning Objectives: Explain the relation between the cost of jobs and the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. Describe how direct material, direct labor, and manufacturing overhead are assigned to jobs. Explain the role of a predetermined overhead rate in applying overhead to jobs.

Direct Labor Cost The document which is used to trace direct labor cost to production is called a time ticket (or job ticket or work ticket or time card…). The time ticket indicates how much time was spent on which job. Note that when several employees all work on the same job, the time card data will be aggregated and then applied to each job. Related Learning Objectives: Explain the relation between the cost of jobs and the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. Describe how direct material, direct labor, and manufacturing overhead are assigned to jobs. Explain the role of a predetermined overhead rate in applying overhead to jobs.

Manufacturing Overhead
Unlike Direct Materials and Direct Labor which are directly traceable to the job, manufacturing overhead is added to each job in a slightly more complex manner. Manufacturing Overhead is applied to specific jobs as opposed to being traced. And it is applied based on some common characteristic referred to as an allocation base. Related Learning Objectives: Explain the relation between the cost of jobs and the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. Describe how direct material, direct labor, and manufacturing overhead are assigned to jobs. Explain the role of a predetermined overhead rate in applying overhead to jobs.

Overhead Allocation Rate
The rate at which Manufacturing Overhead is applied to various jobs is a function of the the Overhead Allocation Rate. It is calculated by dividing the estimated overhead by the allocation base discussed in the previous slide. Related Learning Objectives: Explain the relation between the cost of jobs and the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. Describe how direct material, direct labor, and manufacturing overhead are assigned to jobs. Explain the role of a predetermined overhead rate in applying overhead to jobs.

Assigning Costs to Jobs: A Summary
How are costs attached to jobs? Direct Material: Material Requisition Forms. Direct Labor: Labor Time Tickets. Manufacturing Overhead: Overhead Application Rate. Related Learning Objectives: Explain the relation between the cost of jobs and the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. Describe how direct material, direct labor, and manufacturing overhead are assigned to jobs. Explain the role of a predetermined overhead rate in applying overhead to jobs.

Activity-Based Costing (ABC) and Multiple Overhead Rates
Although companies apply overhead based on a single factor such as direct labor, ABC is a method of assigning overhead based on a number of different allocation bases. ABC groups overhead costs into cost pools. Related Learning Objectives: Explain the relation between the cost of jobs and the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. Describe how direct material, direct labor, and manufacturing overhead are assigned to jobs. Explain the role of a predetermined overhead rate in applying overhead to jobs.

Predetermined Overhead Rates
Most companies develop overhead application rates based on estimates of total overhead costs (numerator) and the estimated level of the allocation base (denominator) as follows: Estimated total overhead cost Estimated level of allocation base Related Learning Objectives: Explain the relation between the cost of jobs and the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. Describe how direct material, direct labor, and manufacturing overhead are assigned to jobs. Explain the role of a predetermined overhead rate in applying overhead to jobs.

Eliminating Overapplied or Underapplied Overhead
Recording Manufacturing Overhead is a two-step process. First, actual costs are accumulated in the Manufacturing Overhead Account and second, overhead is applied to production based on the Predetermined Overhead Rate. Related Learning Objectives: Explain why the difference between actual overhead and overhead allocated to jobs using a predetermined rate is closed to Cost of Goods Sold or apportioned among Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. Discuss changes in the manufacturing environment of U.S. companies and how they affect product costing. More

As a result, unless estimates are perfect, there will be either a debit or credit balance in the Manufacturing Overhead account. If actual costs are more than estimates applied, a debit balance will result and we have underapplied overhead. If applied overhead is more than actual overhead, the result is overapplied overhead. Related Learning Objectives: Explain why the difference between actual overhead and overhead allocated to jobs using a predetermined rate is closed to Cost of Goods Sold or apportioned among Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. Discuss changes in the manufacturing environment of U.S. companies and how they affect product costing. More

So what happens to this underapplied or overapplied amount at the end of the year? Since the Manufacturing Overhead account should have a zero balance at year-end, we often close it out to Cost of Goods Sold. Theoretically, though, it should be allocated to Work in Process, Finished Goods and Cost of Goods Sold. Materiality is the key here. Related Learning Objectives: Explain why the difference between actual overhead and overhead allocated to jobs using a predetermined rate is closed to Cost of Goods Sold or apportioned among Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. Discuss changes in the manufacturing environment of U.S. companies and how they affect product costing.

Job-Order Costing for Service Companies
Although we have used primarily manufacturing examples so far, Job-Order Costing is also used by service companies. Examples include hospitals (patients) and automobile repair firms. Related Learning Objectives: Explain why the difference between actual overhead and overhead allocated to jobs using a predetermined rate is closed to Cost of Goods Sold or apportioned among Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. Discuss changes in the manufacturing environment of U.S. companies and how they affect product costing.

Changes in Manufacturing Practices and Product Costing Systems
In an effort to become more globally competitive, U.S. companies have made fundamental changes in their operations and philosophies. Here are some examples: Just-in-Time (JIT) Production Computer-Controlled Manufacturing Total Quality Management (TWM) Related Learning Objectives: Explain why the difference between actual overhead and overhead allocated to jobs using a predetermined rate is closed to Cost of Goods Sold or apportioned among Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. Discuss changes in the manufacturing environment of U.S. companies and how they affect product costing.

Just-in-Time (JIT) Production
In JIT, physical inventories (Direct Materials and Work in Process) are kept to a minimum. In the case of Direct Materials, manufacturers rely on suppliers to deliver raw materials “Just-in-Time” for production. The home builder is a good example of this, usually waiting until nearly the day of building to take delivery of various materials such as lumber and shingles. Related Learning Objectives: Explain why the difference between actual overhead and overhead allocated to jobs using a predetermined rate is closed to Cost of Goods Sold or apportioned among Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. Discuss changes in the manufacturing environment of U.S. companies and how they affect product costing.

Computer-Controlled Manufacturing
Companies also rely heavily on Computer-Controlled Manufacturing systems. Computers are used to control equipment and robots and to increase flexibility and accuracy of the production process. Related Learning Objectives: Explain why the difference between actual overhead and overhead allocated to jobs using a predetermined rate is closed to Cost of Goods Sold or apportioned among Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. Discuss changes in the manufacturing environment of U.S. companies and how they affect product costing.

Total Quality Management
Total Quality Management (TQM) has to do with ensuring that products and processes are of the highest quality. It is also a matter of continuous improvement. This is achieved by listening to the needs of customers, making products right the first time, reducing the number of defective products that must be reworked and encouraging workers to continuously improve their production processes. Related Learning Objectives: Explain why the difference between actual overhead and overhead allocated to jobs using a predetermined rate is closed to Cost of Goods Sold or apportioned among Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. Discuss changes in the manufacturing environment of U.S. companies and how they affect product costing.

Chapter 3: Process Costing Slides Prepared by: Scott Peterson Northern State University

Chapter 3: Process Costing
Chapter Themes: Inventories are still very important. Think about how costs can be attached to large numbers of homogeneous products. Compare and contrast Job-Order and Process Cost systems. Learning Objectives: Describe how products flow through departments and how costs flow through accounts. Discuss the concept of an equivalent unit. Calculate the cost per equivalent unit. Calculate the cost of goods completed and the ending Work in Process balance in a processing department. Describe a production cost report.

Product Cost Flows Just as a product passes through several departments prior to completion, costs flow through several accounts before the product is recorded in finished goods. Related Learning Objectives: Describe how products flow through departments and how costs flow through accounts. Discuss the concept of an equivalent unit. Calculate the cost per equivalent unit. Calculate the cost of goods completed and the ending Work in Process balance in a processing department. Describe a production cost report.

Product Flows Through Departments
Products typically flow through two or more departments. Materials, labor and overhead are added in each department. Material is often added at the beginning of the process. Labor and Overhead are often grouped together and added uniformly throughout the process. Recall that Labor and Overhead are referred to as conversion costs. Related Learning Objectives: Describe how products flow through departments and how costs flow through accounts. Discuss the concept of an equivalent unit. Calculate the cost per equivalent unit. Calculate the cost of goods completed and the ending Work in Process balance in a processing department. Describe a production cost report.

Cost Flows Through Accounts
In addition to materials, labor and overhead, a processing department may have a cost called transferred-in cost. This cost is incurred in one department and then transferred to the next. And it is treated like any other manufacturing cost (material, labor, overhead) with respect to that department. Related Learning Objectives: Describe how products flow through departments and how costs flow through accounts. Discuss the concept of an equivalent unit. Calculate the cost per equivalent unit. Calculate the cost of goods completed and the ending Work in Process balance in a processing department. Describe a production cost report.

Calculating Unit Cost Process Costing is essentially a system of averaging. Specifically, manufacturing costs incurred during a specific time period are divided by a number called equivalent units to calculate an average unit cost. Related Learning Objectives: Describe how products flow through departments and how costs flow through accounts. Discuss the concept of an equivalent unit. Calculate the cost per equivalent unit. Calculate the cost of goods completed and the ending Work in Process balance in a processing department. Describe a production cost report.

Equivalent Units In calculating unit cost, it is necessary to compute equivalent units. When partially completed units are converted to whole units they are referred to as equivalent units. A good analogy is the concept of a full-time equivalent (FTE) employee. 6 half-time (20 hours per week) employees make 3 full-time equivalents. Related Learning Objectives: Describe how products flow through departments and how costs flow through accounts. Discuss the concept of an equivalent unit. Calculate the cost per equivalent unit. Calculate the cost of goods completed and the ending Work in Process balance in a processing department. Describe a production cost report.

Cost Per Equivalent Unit
The average unit cost in a process costing system is referred to as a cost per equivalent unit. The formula is as follows: Cost per equivalent unit = (Cost in beginning WIP + Cost incurred in current period)/(Units completed + Equivalent units in ending WIP). Related Learning Objectives: Describe how products flow through departments and how costs flow through accounts. Discuss the concept of an equivalent unit. Calculate the cost per equivalent unit. Calculate the cost of goods completed and the ending Work in Process balance in a processing department. Describe a production cost report.

Calculating and Applying Cost per Equivalent Unit: Mixing Department Example
See if you can calculate cost per equivalent unit based on the following information in the Mixing Department. Unit Information: Beginning WIP 10,000 gallons, 80% complete with respect to labor and overhead. 70,000 gallons started and 60,000 completed. Ending WIP 20,000 gallons 50% complete. Related Learning Objectives: Describe how products flow through departments and how costs flow through accounts. Discuss the concept of an equivalent unit. Calculate the cost per equivalent unit. Calculate the cost of goods completed and the ending Work in Process balance in a processing department. Describe a production cost report. More

Calculating and Applying Cost per Equivalent Unit: Mixing Department Example
Cost Information: Beginning WIP $18,000 materials, $7,800 labor and $23,400 overhead. During the month $142,000 of material cost and $62,200 of labor cost was added. Overhead is applied at a predetermined rate of $3 per dollar of labor or $186,600. See the next slide for the solution. Related Learning Objectives: Describe how products flow through departments and how costs flow through accounts. Discuss the concept of an equivalent unit. Calculate the cost per equivalent unit. Calculate the cost of goods completed and the ending Work in Process balance in a processing department. Describe a production cost report. More

Calculating and Applying Cost per Equivalent Unit: Mixing Department Example (solution)
$6 per unit. Related Learning Objectives: Describe how products flow through departments and how costs flow through accounts. Discuss the concept of an equivalent unit. Calculate the cost per equivalent unit. Calculate the cost of goods completed and the ending Work in Process balance in a processing department. Describe a production cost report.

Production Cost Report
A Production Cost Report is an end-of-the-month report for a process costing system that provides a reconciliation of units and a reconciliation of costs as well as details of the cost per equivalent unit calculations. Related Learning Objectives: Describe how products flow through departments and how costs flow through accounts. Discuss the concept of an equivalent unit. Calculate the cost per equivalent unit. Calculate the cost of goods completed and the ending Work in Process balance in a processing department. Describe a production cost report.

Reconciliation of Units
Assuming no units are lost due to shrinkage, the number of units in beginning WIP plus the number of units started should be equal to the number of units completed plus the number of units left in ending WIP. [Inventory is very important.] Related Learning Objectives: Describe how products flow through departments and how costs flow through accounts. Discuss the concept of an equivalent unit. Calculate the cost per equivalent unit. Calculate the cost of goods completed and the ending Work in Process balance in a processing department. Describe a production cost report.

Reconciliation of Costs
For each period, the total cost that must be accounted for is the sum of the costs in beginning WIP plus costs incurred during the period. This sum must be equal to the costs transferred out plus whatever cost is left over in ending WIP. Related Learning Objectives: Describe how products flow through departments and how costs flow through accounts. Discuss the concept of an equivalent unit. Calculate the cost per equivalent unit. Calculate the cost of goods completed and the ending Work in Process balance in a processing department. Describe a production cost report.

Basic Steps in Process Costing: A Summary
Account for the number of equivalent units. Calculate the cost per equivalent unit for material, labor and overhead. Assign cost to items completed and items in ending WIP. Account for the amount of product cost. Related Learning Objectives: Describe how products flow through departments and how costs flow through accounts. Discuss the concept of an equivalent unit. Calculate the cost per equivalent unit. Calculate the cost of goods completed and the ending Work in Process balance in a processing department. Describe a production cost report.

Chapter 4: Cost-Volume-Profit Analysis Slides Prepared by: Scott Peterson Northern State University

Chapter 4: Cost-Volume-Profit-Analysis
Chapter Themes: It’s all about how costs change in total with respect to changes in activity. C-V-P-A is linear. You must be able to put all costs into either variable or fixed cost categories. Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Common Cost Behavior Patterns
To perform Cost-Volume-Profit-Analysis (C-V-P-A), you need to know how costs behave when business activity (production volume, sales volume…) changes. Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Variable Costs By definition, Variable Costs are costs that change (in total) in response to changes in volume or activity. It is assumed, too, that the relationship between variable costs and activity is proportional. That is, if production volume increases by 10%, then variable costs in total will rise by 10%. Examples include direct labor, raw materials and sales commissions. Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Fixed Costs By definition, Fixed Costs are costs that do not change (in total) in response to changes in volume or activity. Examples include depreciation, supervisory salaries and maintenance expenses. Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Mixed Costs Mixed Costs are costs that contain both a variable cost element and a fixed cost element. These costs are sometimes referred to as semi-variable costs. An example would be a salesperson’s salary where she receives a base salary plus commissions. Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Cost Estimation Methods
Managers need to be able to predict (plan) costs at various activity levels. And because cost information is often not broken out in terms of fixed and variable components, managers use cost estimation methods to do just that. Four common methods are: Account analysis Scattergraph High-Low Regression Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Account Analysis Account Analysis is a common approach to estimating fixed and variable costs. This method requires the manager to exercise professional judgment to classify costs into variable and fixed categories. Once this is done, total variable costs are divided by the activity level to determine variable costs per unit of activity. Costs classified as fixed costs are used to estimate total fixed cost. Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Scattergraph Approach
The Scattergraph Approach uses cost information from a number of reporting periods (monthly for example) to determine how costs change with respect to changes in activity. The periodic cost data are then plotted on a graph to get a visual picture of the correlation between costs and activity levels. A sample Scattergraph appears on the next slide. Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Sample Scattergraph Related Learning Objectives:
Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

High-Low Method Using the same periodic data as the scattergraph method, the High-Low Method may be used to estimate the fixed and variable components at various levels of activity. This method “fits” a line to the data, but uses only the high and low data points. Here, the slope of the line (total cost curve) represents the variable cost. The Y-intercept represents the estimate of the fixed costs. Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Regression Analysis Regression Analysis is a statistical technique that uses all available data points to estimate the slope and intercept. That is, unlike the High-Low method which uses only the high and low data points, regression uses ALL of the data points to find the “best fit.” It should be noted that Regression Analysis is a superior method of cost estimation. Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

The Relevant Range The Relevant Range is the activity level within which cost behavior holds true. Most models have limits and this type of linear analysis is not different. Above or below this range, forecasts of cost behavior may not be accurate. Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Cost-Volume-Profit Analysis
Cost-Volume-Profit Analysis (C-V-P) explores the relationship between costs (fixed and variable), activity levels and profits. That is, once the variable and fixed elements have been determined using the tools discussed in the preceding slides, we use the following profit equation: Profit = SP(x) - VC(x) – TFC=Net Income. Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Break-Even Point Related Learning Objectives:
One of the primary purposes of C-V-P is to calculate the Break-Even Point. It simply represents the number of units the firm must sell to generate exactly zero net income– to earn neither profit nor loss. Graphically, as shown in the next slide, Break-Even is the point where the sales curve and cost curve cross. It should be noted here that managers are seldom interested in merely breaking even. But the Break-Even is an important benchmark! Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Break-Even Point (Graphic)
Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Margin of Safety The Margin of Safety is the difference between the expected level of sales and break-even sales. It may be expressed in units or dollars of sales. Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Contribution Margin The Contribution Margin is the difference between selling price and variable cost per unit. It measures the amount each unit sold contributes to covering fixed cost (first) and increasing profit (once fixed costs are covered). The relationship is as follows: SP-VC Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Contribution Margin Ratio
The Contribution Margin Ratio expresses the contribution of every sales dollar to covering fixed cost (first) and operating profit (second). It is calculated as follows: SP – VC SP In other words, for every dollar of sales, X% of that will contribute to covering the fixed costs, and once fixed costs are covered X% of every dollar of sales will be contribute to net income. Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

“What If” Analysis Once the cost structure is modeled (variable and fixed costs are estimated) managers can do sensitivity analyses or “What If” Analyses. This analysis examines what will happen if a particular action is taken. For example, what will happen if fixed costs rise by X dollars and variable costs decrease by Y dollars? Or what will happen if selling price is decrease by Z dollars? Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Multiproduct Analysis
Up until now we looked at C-V-P analysis for a single product. The next few slides examine C-V-P as it applies to multiple product scenarios. There are two approaches we will consider in this section: Contribution Margin Approach (for similar products) Contribution Margin Ratio Approach (for substantially different products). Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Contribution Margin Approach
As indicated, if the products under analysis are similar (e.g., various flavors of ice cream, various models of boats), the Weighted Average Contribution Margin Approach can be used. For example, if the contribution margin of product A is $8 and the contribution margin of product B is $5, and if two units of B are sold for each unit of A, the Weighted Average Contribution Margin is $6.00. Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Contribution Margin Ratio Approach
If the products under analysis are substantial different (e.g., products in a department store), the Contribution Margin Ratio Approach should be used. It makes little sense in this case to ask how many units to break even. The question should be “how many dollars of sales to break even.” Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Assumptions in C-V-P Analysis
As with most models, there are certain assumptions which are made that affect the validity of the analysis. Costs can be accurately separated into variable and fixed components. Fixed costs remain fixed. Variable costs per unit do not change over the relevant range. Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Operating Leverage Operating Leverage relates to the level of fixed versus variable costs in a firm’s cost structure. The higher the degree of fixed costs, the more operating leverage a firm is considered to have. Firms with lower variable and higher fixed costs have higher contribution margins. This translates into greater profit or loss as sales increase or decrease. Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Constraints In the real world there are constraints on how many items can be manufactured or how much service can be delivered. So the focus shifts from contribution margin per unit to contribution margin per unit of the constraint. Examples of constraints include manufacturing space, labor, parts and materials etc… Related Learning Objectives: Identify common cost behavior patterns. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. Perform cost-volume-profit-analysis for single products. Perform cost-volume-profit-analysis for multiple products. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Chapter 5: Cost Allocation and Activity-Based Costing Slides Prepared by: Scott Peterson Northern State University

Chapter 5: Cost Allocation and Activity-Based Costing
Chapter Themes: Think about how much products really cost to produce. How do you measure that? Focus on indirect costs (not direct labor or direct materials). Remember—You Get What You Measure! Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Purposes of Cost Allocation
Companies allocate costs for four major reasons: To provide information needed for decision making. To reduce the frivolous use of common resources. To encourage managers to evaluate the efficiency of internally provided services. To calculate the full cost of products for financial reporting purposes and for determining cost-based prices. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Purpose #1: To Provide Information for Decision Making
Generally, as resources are consumed during production, cost allocations are made to the products, departments etc… much like a fee or charge. From a decision making standpoint, the allocated cost should measure the opportunity cost of using a company resource. Unfortunately this is difficult to implement in practice as opportunity costs can change quickly. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Purpose #2: To Reduce Frivolous Use of Common Resources
It may be argued that fixed costs should not be allocated at all. But without charging a fee (or allocating these costs), resources are often used frivolously or for nonessential purposes. Consider fixed costs associated with computer resources. Examples include recreational web surfing, playing games, sending personal etc… One way to eliminate frivolous use is to charge for it. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Purpose #3: To Encourage Evaluation of Services
Cost allocation is also useful because is causes management to evaluate the services for which they are being charged (e.g. costs allocated to their departments or products). For example, centrally administered services such as janitorial or computer services should be allocated to various departments. If these services were free and no allocation were made, users would not consider them. But if a charge is levied, management has a strong incentive to evaluate these services and charges and consider alternatives. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Purpose #4: To Provide “Full” Cost Information
First of all, GAAP requires “Full Costing” for external reporting purposes. As a result indirect production costs must be allocated to goods produced. Furthermore, full cost information is required when a contract calls for “Cost Plus” pricing. In this case not only is manufacturing overhead allocated, but so are other general and administrative costs. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Process of Cost Allocation
Cost allocation has three steps: identify the cost objectives, form cost pools, select an allocation base to relate the cost pools to the cost objectives. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Determining the Cost Objective
The first step in the cost allocation process is to determine the product, service or department that is to receive the allocation. The object of this cost allocation is called the cost objective. See the next slide for examples. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Determining the Cost Objective (Graphic)
Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Forming Cost Pools The second step in the cost allocation process is to form cost pools. A cost pool is a grouping of individual costs whose total is allocated using one allocation base. For example, maintenance department costs might constitute a cost pool. Cost pools are often formed along department lines. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Selecting an Allocation Base
The third step in the allocation process is to select an allocation base that relates the cost pool to the cost objectives. If the cost objectives are manufactured products, then direct labor hours, direct labor dollars or machine hours are examples of characteristics that could be used as allocation bases. Ideally, the allocation base should relate costs to cost objectives. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM). More

Selecting an Allocation Base
When indirect costs are fixed, establishing a cause-and-effect relationship is infeasible. So, accountants use other criteria: Relative benefits (the allocation base should result in more costs being allocated to the cost objectives that benefit most from incurring the cost). Ability to bear costs (the allocation base should result in more costs being allocated to products which are more profitable). Equity (the allocation base should result in allocations which are fair and equitable. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Allocating Service Department Costs
Organizational units in most manufacturing firms are often classified by department; either production or service. Since service departments, like maintenance, are support departments, their costs are pooled and allocated to production departments. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Direct Method of Allocating Service Department Costs
The text book uses a method of allocating service department costs called the direct method. Here, service departments are allocated to production departments, but not other service departments. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Allocating Budgeted and Actual Service Department Costs
Budgeted rather than actual service costs should be allocated to production departments. Because if budgeted costs are allocated, service department inefficiencies cannot be passed on to production departments. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Problems With Cost Allocation
A number of problems may arise when costs are allocated. They may be brought about by allocations of costs that are not controllable, arbitrary allocation, allocations of fixed costs that make the fixed costs appear to be variable costs, allocation of manufacturing overhead to products using too few overhead cost pools, and use of only volume-related allocation bases. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Responsibility Accounting and Controllable Costs
Responsibility accounting requires tracing revenues and costs to organizational units and individual managers with related responsibility for generating revenue and controlling costs. Furthermore cost allocations are consistent with responsibility accounting. But, only costs for which the individual manager has control. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Arbitrary Allocations
As might be expected, cost allocation fairness is the topic of heated management discussions. Unfortunately, allocations of costs are inherently arbitrary. It is impossible to determine the “true” or “correct” allocation. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Unitized Fixed Costs and Lump-Sum Allocations
Another potential problem is that cost allocation may make fixed costs appear variable. This happens when fixed costs are unitized or stated on a per unit basis. Examples include fixed general and administrative costs like administrative salaries. These costs should be allocated in a lump-sum regardless of total production. The reason is that as production rises, more and more fixed costs are added, despite the fact that, by definition, fixed costs are static and do not change with respect to changes in activity levels. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

The Problem of Too Few Cost Pools
Assigning costs using just one or two cost pools can cause serious product costing distortions. While easy to implement and use, this approach is not as accurate. Ultimately, a cost-benefit decision has to be made. The question is “does the benefit of more accurate allocation methods (e.g. more accurate product costs) outweigh the cost of obtaining this information?” Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Using Only Volume-Related Allocation Bases.
Some manufacturers allocate manufacturing overhead to products using only measures of production volume (labor hours, machine hours). The problem is that not all overhead costs vary in relation to volume. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Activity-Based Costing
Activity-Based Costing (ABC) is a relatively recent development in management accounting. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

The Problem of Using Only Measures of Production Volume to Allocate Overhead
As discussed a few slides ago, companies commonly use labor hours or machine hours as allocation bases for assigning overhead to products. This “Traditional Approach” assumes that all costs are proportional to production volume. In reality this is not true. For example, setup costs are not proportional. A setup might work for a 400,000 unit production run just as well as a 200,000 production run. As a result, low-volume items are undercosted and high-volume items are overcosted. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

The ABC Approach Related Learning Objectives:
In the ABC Approach, companies identify the major activities that cause overhead costs to be incurred. Some of these are related to production volume, but others are not. The steps are as follows: Identify activities. Group costs of activities into cost pools. Identify measures of activities (the cost drivers) Relate costs to products using the cost drivers. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Major Activities Related Learning Objectives:
Following are examples of major activities under ABC: Processing purchase orders. Handling materials and parts. Inspecting incoming material and parts. Setting up equipment. Producing goods using manufacturing equipment. Supervising assembly workers. Inspecting finished goods. Packing customer orders. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Associated Costs Costs associated with the preceding major activities have to do with salaries and wages, depreciation on equipment and the like. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Cost Drivers Related Learning Objectives:
Following are examples of cost drivers under ABC: Number of purchase orders processed. Number of material requisitions. Number of receipts. Number of setups. Number of machine hours. Number of assembly labor hours. Number of inspections. Number of boxes shipped. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Pros and Cons of ABC Benefits: First, ABC is less likely than traditional costing to undercost or overcost products. Second, ABC may lead to improvements in cost control. Limitations: It’s expensive relative to a traditional system! Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Activity-Based Management
Activity-Based Management (ABM) is a management tool with the goal of improving efficiency and effectiveness. It is similar to ABC, except that where ABC focuses on cost measurement, ABM focuses on the the activities themselves. Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Remember—You Get What You Measure!
How does this statement relate to cost allocation? Allocations affect the profit that managers have reported on their performance reports! Related Learning Objectives: Explain why indirect costs are allocated. Describe the cost allocation process. Discuss allocation of service department costs. Identify potential problems with cost allocation. Discuss activity-based costing (ABC) and cost drivers. Discuss activity-based management (ABM).

Chapter 6: The Use of Cost Information in Management Decision Making. Slides Prepared by: Scott Peterson Northern State University

Chapter 6: The Use of Cost Information in Management Decision Making
Chapter Themes: It’s all at the margin! Look at what changes. The only thing that matters is what is different. Learning Objectives: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions. Define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions. Analyze decisions involving joint costs. Discuss the importance of qualitative consideration in management decisions.

Incremental Analysis The solution to all business problems involves incremental analysis—the analysis of incremental revenues and incremental expenses. Incremental revenue: the additional revenue received as a result of selecting one decision over another. Incremental cost: the additional cost incurred as a result of selecting one alternative over another. Related Learning Objectives: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions. Define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions. Analyze decisions involving joint costs. Discuss the importance of qualitative consideration in management decisions.

Incremental Analysis: Additional Processing Decision
One application of incremental analysis is the additional processing decision. The key here is what the incremental revenues and costs are from this point forward. Sunk costs (past costs) are irrelevant here. Related Learning Objectives: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions. Define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions. Analyze decisions involving joint costs. Discuss the importance of qualitative consideration in management decisions.

Incremental Analysis: Make-or-Buy Decisions
Another application of incremental analysis is the make-or-buy decision. The key here rests solely on incremental costs since there are no incremental revenues. It is important to note that not all fixed costs are irrelevant. If they are avoidable, then they should be factored into the decision, just like variable costs. Related Learning Objectives: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions. Define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions. Analyze decisions involving joint costs. Discuss the importance of qualitative consideration in management decisions.

Incremental Analysis: Dropping a Product Line
Another application of incremental analysis is whether or not to drop a product line. The key is to determine what the change in net income will be as a result of dropping the product line. If net income increases, do it; if not don’t do it! Related Learning Objectives: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions. Define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions. Analyze decisions involving joint costs. Discuss the importance of qualitative consideration in management decisions.

Beware of the Cost Allocation Death Spiral
When dropping a product or service, beware of allocating common fixed costs. These costs are not incremental and are therefore irrelevant. They just end up being allocated to other products which in turn may appear unprofitable. Beware! Related Learning Objectives: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions. Define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions. Analyze decisions involving joint costs. Discuss the importance of qualitative consideration in management decisions.

Summary of Incremental, Avoidable, Sunk, and Opportunity Costs
Incremental Cost: a cost incurred as a result of selecting one alternative over another. Avoidable Cost: a cost that can be avoided if a certain decision is made. These are relevant. Sunk Cost: a cost that is already incurred and irreversible. These are not relevant. Opportunity Cost: a cost that represents the benefit forgone by selecting on alternative over another. Related Learning Objectives: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions. Define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions. Analyze decisions involving joint costs. Discuss the importance of qualitative consideration in management decisions.

Decisions Involving Joint Costs
When two or more products always result from common inputs, they are known as joint products. The costs of the common inputs are referred to as joint costs. For example, raw milk is processed into the following joint products: cream, skim milk and whole milk. Note: the stage of production at which individual products are identified is called the split-off-point (see the next slide). Related Learning Objectives: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions. Define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions. Analyze decisions involving joint costs. Discuss the importance of qualitative consideration in management decisions.

The Split-Off-Point Related Learning Objectives:
Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions. Define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions. Analyze decisions involving joint costs. Discuss the importance of qualitative consideration in management decisions.

Allocation of Joint Costs
For financial reporting purposes, the cost of the common inputs must be allocated to the joint products. But care must be taken to ensure that the resulting information does not mislead managers about the profitability of the joint products. Joint costs are not relevant to individual products beyond the split-off-point, but are relevant to decisions involving the joint products as a group. Related Learning Objectives: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions. Define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions. Analyze decisions involving joint costs. Discuss the importance of qualitative consideration in management decisions.

Additional Processing Decisions and Joint Costs
Joint costs do not play a part in this decision because they are not incremental. That is, at the split-off-point, the only factors that matter are additional revenues and additional costs. Related Learning Objectives: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions. Define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions. Analyze decisions involving joint costs. Discuss the importance of qualitative consideration in management decisions.

Qualitative Considerations in Decision Analysis
Until now, the discussion has focused on quantitative factors (revenues and costs). But qualitative factors are important too. Consider the make-or-buy decision. On the one hand, it is easier to use outside suppliers because when demand slows, fewer components can be ordered from a supplier. If components were made in-house, the fixed costs would continue. On the other hand, some degree of control is lost. And employee morale is a factor. Related Learning Objectives: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions. Define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions. Analyze decisions involving joint costs. Discuss the importance of qualitative consideration in management decisions.

Appendix A: Pricing Decisions
Pricing decision play a very important role in the success of a company. Most managers consider pricing to be an art. Economists focus on the “demand function.” In this section we consider the following: Cost-Plus Pricing. Pricing Special Orders. Taking Demand Into Consideration in Setting Prices. Related Learning Objectives: Calculate a price based on marking up cost. Perform incremental analysis for a special order. Explain how to consider demand in setting prices.

Cost-Plus Pricing Perhaps because of the difficulty of estimating demand functions, many companies use so-called cost-plus pricing. Here, the firm begins with an estimate of cost and then adds a markup to arrive at the price which allows for a reasonable level of profit. This method is simple, but limited. Related Learning Objectives: Calculate a price based on marking up cost. Perform incremental analysis for a special order. Explain how to consider demand in setting prices.

Pricing Special Orders
Generally, products are not sold for less than full cost. In some cases it may be beneficial to charge a lower price. If the special order will not affect demand for a firm’s other products (or current sales), a company may be better off charging a price below full cost. Note: in this situation, all fixed costs are considered irrelevant because they will not change whether the special order is accepted or not. Related Learning Objectives: Calculate a price based on marking up cost. Perform incremental analysis for a special order. Explain how to consider demand in setting prices.

Taking Demand Into Consideration in Setting Prices
Pricing should not be determined by cost alone. Demand for the product is highly important. If managers can determine what demand for products will be at various prices, it is a simple task of calculating the optimal price. Related Learning Objectives: Calculate a price based on marking up cost. Perform incremental analysis for a special order. Explain how to consider demand in setting prices.

Chapter 7: Capital Budgeting Decisions Slides Prepared by: Scott Peterson Northern State University

Chapter 7: Capital Budgeting Decisions
Chapter Themes: It’s all about rates of return. Cash inflows and outflows are NOT the same as revenues and expenses. A dollar today is worth more than a dollar tomorrow. Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes. More

Chapter 7: Capital Budgeting Decisions
Chapter Themes: It’s all about rates of return. Cash inflows and outflows are NOT the same as revenues and expenses. A dollar today is worth more than a dollar tomorrow. Learning Objectives: Use the payback period and the accounting rate of return methods to evaluate investment opportunities. Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values.

Capital Budgeting Decisions
Investment decisions involving the acquisition of long-lived assets are often referred to as capital expenditure decisions because they require that capital (company funds) be expended to acquire additional resources. Investment decisions are also sometimes called capital budgeting decisions. Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Evaluating Investment Opportunities: Time Value of Money Approaches
Crucial to understanding capital budgeting decisions is an understanding of the time value of money. In short, the time value of money says that a dollar today is worth more than a dollar tomorrow. Because of this we need a way to convert future dollars into their equivalent present value. Two methods for evaluating investments are discussed: the net present value method and the internal rate of return method. Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Basic Time Value of Money Calculations
Before studying these two basic methods, a brief review is in order. To convert a future value to its present value, consider the following formula: P = F (1 + i)n Where: P = the present value F = the future value i = the rate of return Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Before moving on, let’s say you will receive $1 exactly 1-year from now. What is its present (current) value? Assume i = 6% and use the following formula: P = F (1 + i)n The answer is … Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

… 94 Cents. P = 1 ( )1 Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

The Net Present Value Method
The time value of money forms the basis of the net present value method for evaluating capital investments. As discussed in the previous chapter, recall that only incremental cash flows are relevant. Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

The Net Present Value Method, Step 1:
Identify the amount and time period of each cash flow associated with a potential investment. Investment projects have both cash inflows and cash outflows. Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

The Net Present Value Method, Step 2:
Equate or discount the cash flows to their present values using a required rate of return (a.k.a. hurdle rate). This is the minimum return that management will accept. Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

The Net Present Value Method, Step 3: (final)
Evaluate the net present value. This is the sum of all of the cash inflows and cash outflows. If the net present value (NPV) is greater than or equal to zero, the investment should be made. If less than zero, it should not be made. Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

The Internal Rate of Return Method
The internal rate of return method is an alternative to the net present value method. It too uses the time value of money. Specifically, the internal rate of return (IRR) is the rate of return that equates the present value of future cash flows to the investment outlay. Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Summary of Net Present Value and Internal Rate of Return Methods
Although both the net present value method and the internal rate of return method take into account the time value of money, they differ in their approach to evaluating investment alternatives. Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Estimating the Required Rate of Return
In the problems presented earlier, we stated a required rate of return that could be used to calculate an investment’s net present value or that could be compared with an investment’s internal rate of return. In practice, the required rate of return must be estimated by management. Under certain conditions, the required rate of return should be equal to the cost of capital for the firm. Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Additional Cash Flow Considerations
To be useful in investment analysis, both the net present value methods and the internal rate of return methods require a proper specification of cash flows. In particular, remember that only cash inflows and cash outflows are discounted back to the present, not revenues and expenses. Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Cash Flows, Taxes, and the Depreciation Tax Shield
In the previous examples, we ignored the effect of income taxes on cash flows. However, tax considerations play a major role in capital budgeting decisions. Although depreciation does not directly affect cash flow, it indirectly affects cash flow because is reduces the amount of tax (which is paid in cash) a company must pay. Thus we call these tax savings the depreciation tax shield. Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Depreciation Tax Shield at Amazon.com
Amazon.com has yet to generate a profit. See the most recent figures here! When companies have net losses, they can carry the losses forward and offset future income in the determination of federal income taxes. Depreciation expense in loss years will not act as a tax shield until the firm begins to show a profit, say in the year 2005. Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Adjusting Cash Flows for Inflation
If inflation is ignored in net present value analysis, many worthwhile investment opportunities may be rejected. The reason is that current rates of return for debt and equity financing already include estimates of future inflation. Inflation is factored into the equation by multiplying the current level of cash flow by the expected rate of inflation. Related Learning Objectives: Define capital expenditure decisions and capital budgets. Evaluate investment opportunities using the net present value approach. Evaluate investment opportunities using the internal rate of return approach. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Simplified Approaches to Capital Budgeting
Although the net present value and the internal rate of return methods are widely used in industry to evaluate products, many companies continue to use simpler approaches. Two of these are: payback period accounting rate of return Related Learning Objectives: Use the payback period and the accounting rate of return methods to evaluate investment opportunities. Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values.

Payback Period Method The payback period is the length of time it takes to recover the initial cost of an investment. For example, if an investment costs $1,000 and returns $500 per year, it has a payback period of 2-years. There are two serious limitations with this method. First, it does not consider cash inflows in years beyond the payback year (e. g. years 3, 4 and 5 in the example above. Second, it does not consider the time value of money. Related Learning Objectives: Use the payback period and the accounting rate of return methods to evaluate investment opportunities. Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values.

Accounting Rate of Return
The accounting rate of return (ARR) is equal to the average after-tax income from a project divided by the average investment in the project. ARR = Average Net Income Average Investment Unfortunately, this method also ignores the time value of money. Related Learning Objectives: Use the payback period and the accounting rate of return methods to evaluate investment opportunities. Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values.

Conflict Between Performance Evaluation and Capital Budgeting
An NPV greater than zero or an IRR greater than the required rate of return informs managers that an investment opportunity will increase their firm’s value. Managers should use these techniques to maximize shareholder wealth. However, a manager’s performance (and bonus) is often measured in the short-term on accounting income. Thus, there is an inherent conflict between what is good for the firm and what is good for the manager. Related Learning Objectives: Use the payback period and the accounting rate of return methods to evaluate investment opportunities. Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values.

Appendix A: The Internal Rate of Return with Unequal Cash Flows
Within the chapter, the use of the IRR method is presented for the case where cash flows are equal in all years. What if cash flows are not equal? We cannot use a single cash-flow annuity to yield a present value factor. Instead, we estimate the IRR and use the estimate to calculate the net present value of the project. By trial-and-error, we can interpolate the actual internal rate of return. Related Learning Objectives: Explain how the internal rate of return is calculated when there are uneven cash flows.

Appendix B: Criticisms of Time Value of Money Approaches to Evaluating Investments
Although methods (NPV or IRR) employing the time value of money are preferred approaches, they have also been the subject of some criticism. Specifically critics argue that companies tend to underinvest in high-tech projects of strategic importance. Related Learning Objectives: Discuss criticism of time value of money approaches to evaluating investment opportunities.

Excessively High Required Rates of Return Discourage Investment
Some managers set unreasonably high required rates of return because is counteracts overly optimistic cash flow projections form subordinates who want “pet projects” funded. Managers should address the real problem in these cases and follow-up on funded projects with audits of cash flows. This way subordinates will be held accountable for their projections. Related Learning Objectives: Discuss criticism of time value of money approaches to evaluating investment opportunities.

Ignoring Cash Inflows Far in the Future Discourages Investment
The time value of money approach requires that all cash inflows and outflows be considered. Rather managers tend to project out only several years. The rationale is that cash flows far out in the future are highly uncertain. As with assigning excessively high required rates of return, this behavior also leads to underinvestment in certain projects. Related Learning Objectives: Discuss criticism of time value of money approaches to evaluating investment opportunities.

Failure to Consider “Soft” Benefits Discourages Investment
Perhaps the most significant problem in applying time value of money approaches is that so-called soft benefits are often not taken into account. Ignoring “hard to quantify” benefits often leads to underinvestment. Consider the ERP example and the “soft benefit” of being able to close the books in five days rather than three weeks. Related Learning Objectives: Discuss criticism of time value of money approaches to evaluating investment opportunities.

Calculating the Value of Soft Benefits Required to Make an Investment Acceptable
It is one thing to include soft benefits in analyzing investment opportunities but it is sometimes quite another to quantify those benefits. It may be too costly to determine those benefits. Here, if the NPV is negative, managers should calculate the amount of additional cash inflows needed to have a positive NVC. Then, if management believes the value of the soft benefits exceeds the additional cash flows, it can decide to fund the project. Related Learning Objectives: Discuss criticism of time value of money approaches to evaluating investment opportunities.

Should Time Value of Money Approaches be Rejected?
As we have seen, time value of money approaches can lead to poor investment decisions if excessively high required rates of return are used, if cash flows far in the future are ignored, or if soft benefits are ignored. The problem lies with the misapplication of these time value methods, not the use of the method itself. Related Learning Objectives: Discuss criticism of time value of money approaches to evaluating investment opportunities.

Chapter 8: Budgetary Planning and Control Slides Prepared by: Scott Peterson Northern State University

Chapter 8: Budgetary Planning and Control
Chapter Themes: Budgeting helps management quantify plans and measure performance. You get what you measure! Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Use of Budgets in Planning and Control
The entire planning and control process of many companies is built around budgets. Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Planning Budgets are useful in the planning process because they enhance communication and coordination. The process of developing a formal plan (budget) forces managers to consider carefully their goals and objectives and to specify means of achieving them. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Control Budgets are useful in the control process because they provide a basis for evaluating performance (both management and operations). Often, performance evaluation is carried out by comparing actual performance with planned or budgeted performance. Significant deviations from planned performance are associated with three potential causes… Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Control: Reasons for Deviations From Planned Performance
Poorly conceived budgets. Business conditions may have changed. Managers have done a particularly good or bad job managing operations. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Control: Illustration of the Role of Budgets in Planning and Control
Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Developing a Budget Related Learning Objectives:
Budgets are prepared for departments, divisions, and the company as a whole. Often the group that is responsible for approval of the various budgets is the budget committee which includes the senior managers, president, CFO, various vice-presidents and controller. A top-down approach is where goals are pushed down from top management. A bottom-up approach is where lower-level managers are the primary source of information used in setting the budget. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Budget Time Period Before a budget can be prepared, managers must decide on an appropriate budget period. There are a wide variety of budgets ranging from months to several years or more. The key point is that there is an inverse relationship, generally, between the length of the budget period and the detail contained within the budget. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Zero Base Budgeting Related Learning Objectives:
A common starting point for a budget is a prior period. These amounts are adjusted up or down based on current information and assumptions or estimates of what will happen in the future. On the other hand, Zero Base Budgeting (ZBB) is a method of budget preparation which begins each period with a clean slate. Managers must start from zero and justify budgets every period. Although used in government, ZBB is not commonly used in for-profit organizations. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

The Master Budget The master budget is a comprehensive planning document that incorporates a number of individual budgets. These budgets include: sales Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

The Master Budget The master budget is a comprehensive planning document that incorporates a number of individual budgets. These budgets include: sales production Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

The Master Budget The master budget is a comprehensive planning document that incorporates a number of individual budgets. These budgets include: sales production direct materials Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

The Master Budget The master budget is a comprehensive planning document that incorporates a number of individual budgets. These budgets include: sales production direct materials direct labor Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

The Master Budget The master budget is a comprehensive planning document that incorporates a number of individual budgets. These budgets include: sales production direct materials direct labor manufacturing overhead Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

The Master Budget The master budget is a comprehensive planning document that incorporates a number of individual budgets. These budgets include: sales production direct materials direct labor manufacturing overhead selling and administrative Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

The Master Budget The master budget is a comprehensive planning document that incorporates a number of individual budgets. These budgets include: sales production direct materials direct labor manufacturing overhead selling and administrative capital acquisitions Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

The Master Budget The master budget is a comprehensive planning document that incorporates a number of individual budgets. These budgets include: sales production direct materials direct labor manufacturing overhead selling and administrative capital acquisitions cash receipts Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

The Master Budget Related Learning Objectives:
The master budget is a comprehensive planning document that incorporates a number of individual budgets. These budgets include: sales production direct materials direct labor manufacturing overhead selling and administrative capital acquisitions cash receipts cash disbursements Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

The master budget is a comprehensive planning document that incorporates a number of individual budgets. These budgets include: sales production direct materials direct labor manufacturing overhead selling and administrative capital acquisitions cash receipts cash disbursements budgeted income statement Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

The master budget is a comprehensive planning document that incorporates a number of individual budgets. These budgets include: sales production direct materials direct labor manufacturing overhead selling and administrative capital acquisitions cash receipts cash disbursements budgeted income statement budget balance sheet Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Sales Budget Related Learning Objectives:
The sales budget is the first step in the budget process. It comes first because other budgets cannot be prepared without an estimate of sales. For example, production estimates are based on forecast sales. Companies use a variety of methods to estimate sales. These estimates are calculated by various methods including econometric models, previous sales trends, trade journals and magazines, and sales force estimates. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Production Budget Once the sales budget has been prepared, the production budget can be developed. Production forecasts are based on the following relationships: Finished units to be produced = expected sales in units + desired ending inventory of finished units – beginning inventory of finished units. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Direct Material Purchase Budget
The amount of direct materials that must be purchased depends on the amount needed for production and the amount need for ending inventory. The amount that must be purchased can be calculated as follows: Required purchases of direct materials = amount required for production + desired ending inventory of direct materials – beginning inventory of direct materials. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Direct Labor Budget The direct labor budget is generally calculated by multiplying the number of units to be produced by the labor hours per unit and the rate per hour. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Manufacturing Overhead Budget
Here the cost per unit of production of each variable cost item is multiplied by the quantity of units produced. Fixed costs remain relatively constant. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Selling and Administrative Expense Budget
Although we have concentrated on production-related budgets, selling and administrative expense budgets include salaries, advertising, office expenses and other general expenses. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Budgeted Income Statement
Much of the data for the budgeted income statement come from other budgets already prepared. For example, sales figures come from the sales budget. Cost of goods sold is based on unit cost of production (and the direct materials budget). The direct labor budget provides labor cost information. And the manufacturing overhead budget provides overhead cost information. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Capital Acquisition Budget
Acquisitions of capital assets such as property plant and equipment must be carefully planned because they consume substantial cash reserves. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Cash Receipts and Disbursements Budget
In the cash receipts and disbursements budget, managers plan the amount and timing of cash flows. This is a VERY important budget. And it is a necessary supplement to the budgeted income statement because the timing of cash inflows and outflows may diverge substantially from the recognition of revenues and expenses on an accrual-based income statement. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Budgeted Balance Sheet
The last component of the master budget that we consider is the budgeted balance sheet. It is a function of all of the other budgets and is sometimes referred to as a pro-forma balance sheet. It is used to assess the effect of planned decisions on future financial position. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Review of Budget Relationships
Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Use of Computers in the Budget Planning Process
Computers are very useful in the preparation of budgets. Spreadsheets, like Excel or Lotus 1-2-3, are very effective in modeling budget relationships. Furthermore, spreadsheets allow for “what if” analysis. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Budgetary Control As noted earlier, budgets are used to facilitate control of operations. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Budgets as a Standard for Evaluation
Budgets facilitate control by providing a standard for evaluation. The standard is the budgeted amount against which actual results are compared. Differences between budgeted and actual amounts are referred to as budget variances which are reported on performance reports. If material differences between actual costs and budgeted costs emerge, management should investigate. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Static and Flexible Budgets
In evaluating performance using budgets, care must be taken to make sure that the level of activity used in the budget is equal to the actual level of activity. As we discussed earlier, production budgets are a function of planned sales. If sales suddenly rise, production must increase to meet demand and in turn total variable production costs will rise. Without considering levels of activity, this increase in cost may be construed as negative when, in fact, it is a necessary cost of production More… Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Static and Flexible Budgets
A static budget is not adjusted for the actual level of production and is ill suited for performance measurement. A flexible budget is a set of budget relationships that can be adjusted to various activity levels. And it is more appropriate for use in performance analysis. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Investigating Budget Variances
Variances may have three causes: it may be ill conceived conditions have changed job performance Variances should be investigated. And management by exception is an approach that is economical and often used. Under this approach, only exceptional variances are investigated. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Conflict in Planning and Control of Budgets
Conflict is inherent in the planning and control uses of budgets. Top management would like managers responsible for carrying out plans also participate in budgeting. However, because the management performance is evaluated in relation to the budget, managers have an incentive to build slack into their budgets. That is, budgets they can easily achieve. Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Evaluation, Measurement, and Management Behavior
Managers pay close attention to those aspects of their jobs that are measured and evaluated. Historically, budgets have measured dollars and cents, but some nonmonetary measures of performance are likely to be advantageous. A certain maximum level of defects, for example. Remember, “You Get What You Measure!” Related Learning Objectives: Discuss the uses of budgets in planning and control. Prepare the budget schedules that make up the master budget. Explain why flexible budgets are needed for performance evaluation. Discuss the conflict between the planning and control sues of budgets.

Chapter 9: Standard Costs and Variance Analysis Slides Prepared by: Scott Peterson Northern State University

Chapter 9: Standard Costs and Variance Analysis
Chapter Themes: It’s all about standards and benchmarks. It is important to measure actual values against goals and standards. Responsibility should be commensurate with controllability. Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Standard Costs The term standard cost refers to the cost that management believes should be incurred to produce a good or service under anticipated conditions. The primary benefit of a standard cost system is that it allows for comparison of standard versus actual costs. Differences are referred to as standard cost variances and should be investigated if significant. Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Standard Costs and Budgets
At the outset, it is important to understand the subtle differences in definitions of standard cost and budgeted cost. Standard cost: the standard cost of a single unit. Budgeted cost: the cost, at standard, of the total number of budgeted units. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Development of Standard Costs
Standard costs are developed in a variety of ways. They are specified in engineering plans. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Standard costs are developed in a variety of ways. They are specified by formulas or recipes. developed from price lists provided by suppliers. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Standard costs are developed in a variety of ways. They are specified by formulas or recipes. developed from price lists provided by suppliers. determined time and motion studies conducted by industrial engineers. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Standard costs are developed in a variety of ways. They are specified by formulas or recipes. developed from price lists provided by suppliers. determined time and motion studies conducted by industrial engineers. developed from analyses of past data. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Ideal Versus Attainable Standards
In developing standard costs, there are two schools of thought. Ideal standards: developed under the assumption that no obstacles to the production process will be encountered. They are sometimes referred to as perfection standards. Attainable Standards: developed under the assumption that there will be occasional problems in the production process such as equipment failure, labor turnover, and materials defects. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

A General Approach to Variance Analysis
An analysis of the difference between a standard cost and and actual cost is called variance analysis. The process decomposes the difference in two components. For direct material: materials price and materials quantity variance. For direct labor: labor rate (price) and labor efficiency (quantity) variance. For overhead: overhead volume variance and controllable overhead variance. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Material Price Variance
The material price variance is expressed as (AP – SP)AQp where: (AP) = actual price per unit of material. (SP) = standard price per unit of direct material. (AQp) = actual quantity of material purchased. If actual price > standard price, then the variance is unfavorable. If actual price < standard price, then the variance is favorable. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Material Quantity Variance
The material quantity variance is expressed as (AQu – SQ)SP where: (AQu) = actual quantity of material used. (SQ) = standard quantity of material allowed. (SP) = standard price of material. If actual quantity > standard quantity, then the variance is unfavorable. If actual quantity < standard quantity, then the variance is favorable. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Labor Rate Variance Related Learning Objectives:
The labor rate (price) variance is expressed as (AR – SR)AH where: (AR) = actual wage rate (price). (SR) = standard wage rate (price). (AH) = actual number(quantity) of labor hours. If actual rate > standard rate, then the variance is unfavorable. If actual rate < standard rate, then the variance is favorable. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Labor Efficiency Variance
The labor efficiency (quantity) variance is expressed as (AH – SH)SR where: (AH) = actual number of hours worked. (SH) = standard number of hours worked. (SR) = standard labor wage rate. If actual hours > standard hours, then the variance is unfavorable. If actual hours < standard hours, then the variance is favorable. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Controllable Overhead Variance
The controllable overhead variance is expressed as (actual overhead - flexible budget level of overhead) for actual level of production. It is referred to as controllable because managers are expected to control costs so they are not substantially different from budget. If actual > budget, then the variance is unfavorable. If actual < budget, then the variance is favorable. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Overhead Volume Variance
The overhead volume variance is expressed as (flexible budget level of overhead for actual level of production - overhead applied to production using standard overhead rate). This variance is solely the product of more or less units being produced than planned in the static budget. Its usefulness is limited. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Investigation of Standard Cost Variances
It is important to note that standard cost variances are not a definitive sign of good or bad performance. These variances are merely indicators of potential problems which must be investigated. And there are many plausible explanations for them. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Management by Exception
Because investigation of standard cost variances is itself a costly activity, management must decide which variances to investigate. Most managers practice management by exception. What is “exceptional?” Usually an absolute dollar amount or a percentage dollar amount. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

“Favorable” Variances May Be Unfavorable
The fact that a variance is “favorable” does not mean that it should not be investigated. Raw materials are good examples of this phenomenon, especially considering the competitive pricing environment for most commodities. Suppose inferior, low-priced materials are ordered. One the one hand, a favorable price variance will arise. On the other hand, most likely there will be substantially more scrap and rework, and thus a higher quantity variance. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Responsibility Accounting and Variances
As noted previously, managers should be held responsible only for costs they can control. This is true in the area of variance analysis. For example, a purchasing agent may be held responsible for direct material price variances, but certainly not direct material quantity (usage) variances. Related Learning Objectives: Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Appendix A: Recording Standard Costs in Accounts
In a standard costing system, the costs added to the Raw Materials Inventory, Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts are all recorded at standard rather than actual cost. Variances are also calculated and recorded for management’s use in performance evaluation. Related Learning Objectives: Record standard costs in the account of a manufacturing firm.

Recording Material Costs
Purchase of raw materials inventory: Account dr. cr. Raw Material Inventory (std.) x Material Price Variance x Accounts Payable (actual) x (This is an unfavorable price variance) Usage of raw materials inventory: Work in Process Inventory x Material Quantity Variance x Raw Material Inventory x (This is an unfavorable quantity variance) Related Learning Objectives: Record standard costs in the account of a manufacturing firm.

Recording Labor Cost Related Learning Objectives: Account dr. cr.
Work in Process Inventory (std.) x Labor Rate Variance x Labor Efficiency Variance x Salaries Payable (actual) x (Note: both the labor rate variance and efficiency variance are unfavorable) Related Learning Objectives: Record standard costs in the account of a manufacturing firm.

Recording Manufacturing Overhead
Recording manufacturing overhead in a standard costing system is a three-step process: Actual overhead is recorded in the manufacturing overhead account. Overhead is applied to Work in Process Inventory at the standard cost. The difference between actual overhead and overhead applied at standard is closed and overhead variances are identified. More Related Learning Objectives: Record standard costs in the account of a manufacturing firm.

Recording Manufacturing Overhead (Step 1)
To record actual overhead cost: Account dr. cr. Manufacturing Overhead x *Various Accounts x *Various accounts include indirect wages payable, utilities payable and accumulated depreciation. Related Learning Objectives: Record standard costs in the account of a manufacturing firm.

To apply overhead cost to work in process inventory at cost: Account dr. cr. Work in Process Inventory x Manufacturing Overhead x Related Learning Objectives: Record standard costs in the account of a manufacturing firm.

To close out manufacturing overhead cost to work in process inventory at cost: Account dr. cr. Manufacturing Overhead x Overhead Volume Variance x Controllable Overhead Related Learning Objectives: Record standard costs in the account of a manufacturing firm.

Recording Finished Goods
To record completed units sent to finished goods: Account dr. cr. Finished Goods Inventory x Work in Process Inventory x Related Learning Objectives: Record standard costs in the account of a manufacturing firm.

Recording Cost of Goods Sold
To apply overhead cost to work in process inventory at cost: Account dr. cr. Cost of Goods Sold x Finished Goods Inventory x Related Learning Objectives: Record standard costs in the account of a manufacturing firm.

Closing Variance Accounts
At the end of the accounting period, the temporary variance accounts must be closed. As a practical matter this is usually accomplished by debiting or crediting the variances to cost of goods sold. Account dr. cr. Cost of Goods Sold x Overhead Volume Variance x Controllable Overhead Variance x Material Price Variance x Material Quantity Variance x Labor Rate Variance x Labor Efficiency Variance x Related Learning Objectives: Record standard costs in the account of a manufacturing firm.

Chapter 10: Decentralization and Performance Evaluation Slides Prepared by: Scott Peterson Northern State University

Chapter Chapter 10: Decentralization and Performance Evaluation
Chapter Themes: Decentralized is all about pushing decision-making down to those in the best position to do it. Responsibility should be commensurate with authority. You get what you measure! Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI). More

Chapter Chapter 10: Decentralization and Performance Evaluation
Decentralized is all about pushing decision-making down to those in the best position to do it. Responsibility should be commensurate with authority. You get what you measure! Learning Objectives: Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Advantages of Decentralization
Better information leading to superior decisions. Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Better information leading to superior decisions. Faster response to changing circumstances. Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Better information leading to superior decisions. Faster response to changing circumstances. Increased motivation of managers. Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Better information leading to superior decisions. Faster response to changing circumstances. Increased motivation of managers. Excellent training for future top level executives. Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Disadvantages of Decentralization
Costly duplication of activities. Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Disadvantages of Decentralization
Costly duplication of activities. Lack of goal congruence. [Note: goal congruence has to do with the compatibility of goals of the manager versus goals of the organization.] Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Why Companies Evaluate the Performance of Subunits and Subunit Managers
Decentralization leads naturally to the need to evaluate subunits and their managers. Companies evaluate the performance of subunits and subunit managers for two reasons. First, evaluation identifies successful operations and areas needing improvement. Second, evaluating performance influences manager behavior. Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Responsibility Acocunting and Performance Evaluation
In Chapter 5 the topic of responsibility accounting was introduced. Recall that this technique holds managers responsible for only those costs and revenues which they can control. Taken one step further, to implement responsibility accounting in a decentralized organization, costs and revenues are traced to the organizational level where they can be controlled. (see chart) Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Responsibility Acocunting and Performance Evaluation
Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Cost Centers, Profit Centers, and Investment Centers
Subunits are organizational units with identifiable collections of related resources and activities. A subunit may be a department, a subsidiary, or a division. Subunits are sometimes referred to as responsibility centers and include cost centers, profit centers, and investment centers. Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Cost Centers Related Learning Objectives:
A cost center is a subunit that has responsibility for controlling costs but does not have responsibility for generating revenue. Examples: janitorial, computer service, and production departments. Managerial goal: to provide services at a reasonable cost to the company. Evaluation: compare budgeted/standard costs with actual costs. Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Profit Centers Related Learning Objectives:
A profit center is a subunit that has responsibility for generating revenues as well as for controlling costs. Examples: copier and camera divisions of an electronics firm. Managerial goal: to maximize profit (revenues – expenses) for the division. Evaluation: profit from the current year may be compared with budget or previous years or compared with with other profit centers on a relative basis. Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Investment Centers An investment center is a subunit that has responsibility for generating revenues, controlling costs, and investing in assets. Since managers of investment centers have control over inventory, receivables, equipment purchases and so on, it makes sense to hold them responsible for generating some kind of return on them. More Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Investment Centers Examples: Nordstrom, Inc. subunit Faconnable.
Managerial goal: to maximize return on investment. Evaluation: rate of return (%) relative to a benchmark/budget rate of return or relative to other investment center rates of return. Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Evaluating Investment Centers with ROI
One of the primary tools for evaluating the performance of investment centers is return on investment. ROI is calculated as follows: ROI = Income Invested Capital Since ROI focuses on income and investment, it has a natural advantage over income (alone) as a measure of performance. It removes the bias of larger investment over smaller investment. More Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Evaluating Investment Centers with ROI
Some companies break ROI down into two components: profit margin and investment turnover as follows: Prof. Marg. Turnover ROI = Income x Sales Sales Inv. Capital Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Measuring Income and Invested Capital When Calculating ROI
In calculating ROI, companies measure “income” in a variety of ways; net income, income before interest and taxes, controllable profit… The text uses the commonly used net operating profit after taxes, NOPAT. This formula does not hold managers responsible for interest. More Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Measuring Income and Invested Capital When Calculating ROI
Further, invested capital is measured in a variety of ways In the text, invested capital is measured as total assets - noninterest-bearing current liabilities (accounts payable, income taxes payable, and accrued liabilities). Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Problems with Using ROI
A major problem with ROI is that the denominator, invested capital, is based on historical costs net of depreciation. As those assets become fully depreciated, the invested capital denominator becomes extremely low and the ROI number quite high. And to compound the problem, managers may therefore be compelled to put off purchases of new equipment necessary for long-term success. They “underinvest.” Related Learning Objectives: List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Problems of Overinvestment and Underinvestment: You Get What You Measure
Additional problems with ROI exist. Managers of investment centers with high ROI’s may be unwilling to invest in assets that will dilute their current ROI. This will lead to underinvestment. Conversely, evaluation in terms of profit can lead to overinvestment. Related Learning Objectives: Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Evaluation in Terms of Profit Can Lead to Overinvestment
As noted in Chapter 7, we would like managers to invest in assets that earn a return in excess of the cost of capital. Since “You Get What You Measure,” managers may overinvest to grow profits (because their compensation package is based on total profits) even though the return on invested capital is less than the cost of capital. Related Learning Objectives: Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Evaluation in Terms of ROI Can Lead to Underinvestment
Perhaps the solution to the overinvestment problem on the previous slide is to measure performance based on ROI. The problem here is that managers will have a tendency not to invest at less than their current ROI even if this reduced return is greater than the cost of capital. Related Learning Objectives: Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Other Measures Used in Evaluation
An approach to solving the overinvestment and underinvestment problems involves use of residual income or a related method, economic value added. A new approach, the Balanced Scorecard, goes beyond financial measures to include multiple performance dimensions. Related Learning Objectives: Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Residual Income (RI) and Economic Value Added (EVA)
Residual Income (RI) is the net operating profit after taxes of an investment center in excess of the profit required for the level of investment. Specifically: RI = NOPAT - Cost of Capital x Investment RI has the potential to solve both the overinvestment and underinvestment problem because it compels investment in the range between cost of capital and current ROI. More Related Learning Objectives: Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Residual Income (RI) and Economic Value Added (EVA)
Economic Value Added, EVA, is a performance measure developed by the consulting firm Stern Stuart. It is basically RI adjusted for “accounting distortions.” A primary distortion is related to research and development (R&D). Under GAAP R&D is required to be expensed. Under EVA, R&D is capitalized and amortized over a number of future accounting periods. EVA has gained considerable attention in the financial press. Related Learning Objectives: Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Using a Balanced Scorecard to Evaluate Performance
A problem with assessing performance with only financial measures, like profit, ROI, and RI/EVA, is that financial measures are “backward looking.” Balanced Scorecard is a set of performance measures constructed for four dimensions of performance: Financial Customer Internal processes Innovation More Related Learning Objectives: Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Balanced Scorecard uses performance measures that are tied to the company’s strategy for success. Balance is a key factor using this technique. More Related Learning Objectives: Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Note how balance is achieved: Performance is assessed across a balanced set of dimensions (financial, customer, internal processes, and innovation). Quantitative measures are balanced with qualitative measures. There is a balance of backward-looking measures More Related Learning Objectives: Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Related Learning Objectives: Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Appendix A Transfer Pricing Market Price as the Transfer Price
Market Price and Opportunity Cost Variable Cost as the Transfer Price Full Cost Profit as the Transfer Price Negotiated Transfer Prices Transfer Pricing and Income Taxes in an International Context Related Learning Objectives: A1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

Transfer Pricing In many cases, subunits “sell” goods or services to other subunits within the same company. For example in the automobile manufacturing industry, batteries manufactured in one division may be sold to other divisions which manufacture autos. Various approaches to pricing exist in practice: (1) market prices, (2) variable costs, (3) full cost plus profit, and (4) negotiated prices. Related Learning Objectives: A1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

Market Price as the Transfer Price
The transfer price in this method would be the same as between the subunit and any other customer at “arm’s length.” The external market price is an excellent choice because the buying and selling divisions are treated as independent companies. Related Learning Objectives: A1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

Market Price and Opportunity Cost
Opportunity cost is the foregone benefit or increased cost of selecting one alternative over another. The selling division has a choice between selling to the related division or into an open market. The determining factor in deciding whether or not to sell to the related division is the impact to the firm (overall) of the decision, not one or the other of the divisions involved. Related Learning Objectives: A1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

Variable Cost as the Transfer Price
In some cases the transferred product is unique and is not sold in the open market. In this case variable cost may be a good transfer price. The main reason is that it conveys accurate opportunity cost information. And when not external market for the product exists, the opportunity cost of producing and selling the product is variable cost per unit. Related Learning Objectives: A1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

Full Cost Plus Profit as the Transfer Price
The problem with variable cost transfer pricing is that the selling division cannot earn a profit on production on the transferred product. Therefore, the price may not be acceptable to management of the selling company. So, many companies add a profit margin to the full cost of production and use this sum as the transfer price. The problem is that Full Cost Plus Profit may not measure the opportunity cost of producing the product. Related Learning Objectives: A1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

Negotiated Transfer Prices
One of the benefits of decentralization is that managers who are delegated decision-making responsibility tend to be highly motivated. To encourage autonomy, some companies allow managers to negotiate transfer prices. Again, the problem is that this price may not reflect the opportunity cost of producing and selling the product. More likely it will reflect the relative bargaining prowess of individual managers. Related Learning Objectives: A1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

Transfer Pricing and Income Taxes in an International Context
Income tax rates vary significantly between countries. And when goods are transferred between countries, these tax situations may create incentives for relatively high or low transfer prices. All else equal, this creates a bias toward having high transfer prices when selling a product from a low tax country to a high tax country and having a low transfer price when selling a product from a high tax country to a low tax country. Related Learning Objectives: A1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

Managerial Accounting by James Jiambalvo

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