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SIR AGULTOS SYLLABUS U.P. MBA PROGRAM BA 220 (MANAGERIAL ACCOUNTING AND CONTROL I) PEOPLE, NOT NUMBERS, GET THINGS DONE OBJECTIVE. From this tool course, the student shall (1) learn accounting as an information system that is useful in planning and controlling enterprise operations, and (2) acquire essential skills that are valuable for other courses or purposes. MODULE I (Sessions 1 - 2) LINKAGE WITH FINANCIAL ACCOUNTING: BASIC ANALYSIS OF PERFORMANCE. Analyzing performance through the accounting reports shall fortify the students grasp of basic financial accounting (a prerequisite to this course). To firm up such understanding and underscore this courses information-user orientation this module focuses on understanding (not preparing) such reports. Principal module objectives are for the student to clearly understand (1) why the financial statements are prepared, (2) essential relationships among the financial reports, and (3) financial accounting concepts met often in management accounting. READINGS: Some Foundation Accounting Concepts; Some Foundation Concepts on Appreciating Financial Statements; Louderback chapter 18 MODULE II (Sessions 3 - 7) FOUNDATION TOPICS: FUNDAMENTAL CONCEPTS, MANAGEMENT OF COSTS. This module introduces the student to managerial accounting, particularly on understanding cost, a key topic in the planning and controlling of enterprise operations. This module introduces the student to cost concepts and their significance. The module sets foundations for later topics in this course and is useful for other courses. BOOK READINGS: Maher ch. 1 - 3; Horngren ch. 1 - 2, 4, 10, 17; Atkinson ch. 1 - 3. TEXTBOOK EXERCISES/PROBLEMS: Ch. 1 (All Self-Study Problems, Questions 15, 19, 22); Ch. 2 (Self-Study Problems 2.1, 2.2, 2.3, Questions 7, 12, 21, 35); Ch. 3 (Questions 4 - 7) CASE: NetCom, Inc. MODULE III (Sessions 8 - 13) DECIDING WITH THE USE OF ACCOUNTING INFORMATION, PART I. This module covers the use of accounting in making operating decisions, particularly in analyzing planned activities. The crucial topic of the behavior of costs is applied on planning operating level, cost structure and profit. BOOK READINGS: Maher ch. 4 - 6; Horngren ch. 3, 5; Atkinson ch. 3 - 4. TEXTBOOK EXERCISES/PROBLEMS: Ch. 5 (Self-Study Problems 5.2, 5.4, Questions 3, 8, 12, 16, 22); Ch. 6 (All SelfStudy Problems, Questions 4 - 6, 10 - 13, 15, 17 - 19, 22 - 25, 31) CASES: Hospital Supply, Inc. and Bill French MODULE IV (Sessions 15 - 19) DECIDING WITH THE USE OF ACCOUNTING INFORMATION, PART II. In this module, the student shall learn to further use accounting to make operating decisions, particularly in marketing management and in production management. BOOK READINGS: Maher ch. 7; Horngren ch. 11, 12; Atkinson ch. 5 - 6. TEXTBOOK EXERCISES/PROBLEMS: Ch. 7 (All Self-Study Problems, Questions 2, 5, 14, 15, 19, 23, 25, 27, 30, 33, 37, 55) CASES: Troy Manufacturing, Inc. (Question 61, Ch. 7), Liquid Chemical Co. (Question 65, Ch. 7) MODULE V (Sessions 20 - 24) EVALUATING PERFORMANCE. The student shall be introduced in this module to using accounting information/systems to influence behavior of enterprise personnel. Module topics include planning operating levels and analyzing deviations/variances of actual results from those planned.

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BOOK READINGS: Maher ch. 9 and 10 ; Horngren ch. 6 - 8; Atkinson ch. 7. TEXTBOOK EXERCISES/PROBLEMS: Ch. 9 (Questions 7, 10, 14, 19, 23, 35); Ch. 10 (All Self-Study Problems, Questions 7 - 14, 23) By-Session Assignments Session 2 3 4 5 6-7 8 9 - 10 11 12 13 15 16 17 18 - 19 20 - 21 22 23 24 Topic / Activity Exercises; Quiz Fundamental concepts Product cost measurement; Exercises Activity-based costing NetCom Inc; Quiz. Behavior of costs and their estimation CVP analysis; Quiz Hospital Supply, Inc.; Quiz Bill French Summation of Modules I III; Quiz Analysis of differential costs Exercises; Quiz Troy Manufacturing, Inc. Liquid Chemical Budgeting Responsibility accounting Summation of Modules IV and V; Quiz Summation of the course Read Ch 7 Read Ch 7 Case solution Case solution Read Ch 9 Read Ch 10 Q9-14, Q9-23 Q7-15, Q7-23 Q7-27 Do before Exercises Read Ch 1 Read Ch 2 Read Ch 3 Case solution Read Ch 4 - 5 Read Ch 6 Case solution Case solution Q6-16 Q5-8, Q5-12 Q6-10 Submit on Q1-15, Q1-19 Q2-21 Q3-11 and Q316

Notes from Sir Agulto Chapter 2: Measuring Product Costs 1. Product Costs in Manufacturing Companies a. Manufacturing Costs Categories: i. Direct Materials (DM): Costs of raw-form resources transformed into the intended finished product, by applying manufacturing (transforming) processes. Easily and cost-effectively traceable to the finished product. (Indirect materials, classified as Manufacturing Overhead, are not so traceable). ii. Direct Labor (DL): Costs of personnel who transform the raw materials into the finished product, so traceable to the finished product. (Labor costs not so traceable are Indirect Labor, part of Manufacturing Overhead.)

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iii. Manufacturing Overhead (MO): All other costs of transforming the material to finished product. Other names for this group of costs are factory burden, factory overhead, or just overhead. This group can be a significant percentage of the total of product costs. 1. Manufacturing v. Non-mfg costs in a mfg firm 2. Why/How types evolved 3. Effect of high technology on significance of categories 4. DM and DL are also variable costs; total MO items are more fixed in behavior 5. Product v. Period mfg costs 2. Reckoning Costs by Department: To plan and evaluate cost incurrence, accounting gathers cost info on byresponsibility center basis. 3. Fundamental Accounting Model of Cost Flows a. The Basic Cost Flow Equation: Beginning Balance + Transfer In = Transfers Out + Ending Balance, or BB + TI = TO + EB b. Costs flow through the accounting system the same way that material moves. i. Material starts in raw materials area, so do costs (DM). ii. Next, material is sent to the work area where labor and overhead (DL and MO) are applied/incurred. Similarly, costs are incurred and flow to WP. iii. Once production is completed, the goods move to the finished goods area. Again, costs too move from WP to FG. iv. Lastly, goods are sold and shipped to customers. Similarly, costs move from FG to CGS when sale occurs. Here, CGS is compared with revenues earned from selling the product (matching principle). 4. Cost Measurement: Actual v. Normal a. Normal Costing assigns actual DM and DL, plus an amount representing normal MO. i. In normal costing, the firm derives a rate for applying/assigning MO to produced units. ii. An alternative to assigning normal MO is to assign MO as actually incurred. iii. Accounting systems can quickly provide actual DL and DM info. But, it may take time to learn about the actual overhead costs (fixed, period). b. The basic problem with actual costing is that info is not available in a timely manner. This can delay decision-making. Also, if overheads are incurred at different rates at different times, using actual costing will end up with erratic fluctuations of product cost over time [so what?]. c. Applying Overhead Costs to Production. Accountants apply overheads to production using four steps. These steps establish overhead rates for both fixed and variable overhead costs. i. Select a cost driver, or allocation base, to be used in applying overhead to production. (Note: Cost drivers cause an activitys costs.) ii. Estimate the amount(s) of overhead and the level(s) of activity for the entire target period (usually a year, or long enough; why?). iii. Compute the predetermined/projected (normal) overhead rate using the following: Predetermined Manufacturing = _Estimated Total Manufacturing Overhead_ Overhead Rate Normal/Estimated Activity Level iv. Apply overhead to production by multiplying the predetermined rate (step 3) by the actual activity level in the product. 1. The first three steps take place before the target period begins.

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2. Determining a predetermined MO rate is not an exact science, that it is an estimate, computed from two different estimates. 3. The predetermined cost is not used on financial statements but adjusted to actual cost basis before the accounting period ends. 5. Choosing the Right Cost System: An effective cost system has all of the following a. Characteristics: i. Decision focus: it meets the needs of decision-makers. ii. Different costs for different purposes: it is adaptable enough to provide different cost information for different purposes. iii. Cost-benefit test: the benefits from the cost system must exceed its costs. b. Companies producing customized products use job costing to record the cost of products. Companies using continuous flow processing are at the other end of the spectrum from firms producing by-job. These firms mass-produce homogeneous products in a continuous flow and use process costing to account for product costs. c. Organizations may use job systems for some products and process systems for others. d. Many companies use a hybrid of job and process costing, called operational costing. Companies using operational costing produce products using standardized production methods. Typically the same amount of labor and overhead is assigned to each product but the amount of material varies depending on the specifications. e. Exhibit 2.3 shows how production methods vary across organizations depending on the type of product. 6. Job and Process Costing Systems: This section compares job and process costing. a. In job costing, firms collect costs for each unit produced. A unit is defined as a job that the entity completes. It is relatively easy to see the profitability of different jobs when this method of costing is used. b. In process costing, the firm accumulates costs in a department or production process during a given period then spreads those costs evenly over the units produced in that period. This helps the firm compute an average cost per unit during the period. c. Process costing does not require as much record keeping as job costing because it does not require keeping track of the cost of each job. However, process costing only informs decision-makers about the average cost of the units, not the cost of each particular unit or job. d. Job Versus Process Costing: Cost-Benefit Considerations i. In general, the costs of record keeping under job costing systems exceed those under process costing. This is because there are typically more jobs than there are processes. Management and accountants must examine the costs and benefits of information and pick the method that best fits the organizations production operations. e. Teaching Suggestion: This is a good time to have a discussion about what kind of costing is used in students organizations. The discussion might help classify different characteristics of products and manufacturing which lead to job order costing versus characteristics which are more suited for process costing. 7. Flow of Costs Through Accounts a. Service organizations, like manufacturing companies, need good managerial accounting information. This section uses an example of a service company to show how costs flow through the system.

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b. Service organizations must be especially sensitive to the timeliness and the quality of the service they provide to their customers. i. The flow of costs in service organizations is similar to that in manufacturing organizations. One difference is that (typically in service organizations) major costs are labor, overheads, and some material, as opposed to significant amount of material, labor, and overheads in a manufacturing organization. ii. Service organizations differ from manufacturing or merchandising organizations in that service organizations do not show inventories on the financial statements for external reporting. They do maintain work in process accounts on their internal books that record services performed but not yet billed. Ethical Issues in Job Costing a. Many organizations have been called to task for improprieties in the way they assign costs to jobs. One or more of the following usually causes improprieties: misstating the stage of completion of the job, charging costs to the wrong job or categories, or simply misrepresenting the costs of the job. b. It is important to ensure that fraud or improprieties are not present when organizations account for the cost of their jobs. Just-In-Time (JIT) Methods a. Management uses just-in-time (JIT) methods to obtain materials just in time for production and to provide finished goods just in time for sale. Using a just-in-time system, production does not begin on an item until the firm receives an order. This practice reduces, or potentially eliminates, inventories and the cost of carrying them. b. Since just-in-time production responds to an order receipt, JIT accounting can charge all costs directly to cost of goods sold. If inventories remain at the end of the period the cost is removed from cost of goods sold and moved to inventory accounts. Backflush Costing a. Companies that record costs directly in Cost of Goods Sold can use a method called backflush costing to transfer any costs back to the inventory accounts, if necessary. b. Backflush costing is a method that works backward from the output to assign manufacturing costs to work-in-process inventories. Spoilage and Quality of Production: Accountants typically include the cost of normal waste in the cost of work done in a period.

Chapter 3: Activity-Based Management 1. Primary Issues: (Nice!) a. The concept of ABC b. Traditional cost allocation methods v. ABC c. The steps in ABC d. The cost hierarchy to organize cost information for decision-making e. Resources used, resources supplied, and unused resource capacity 2. ABCM rests on the premise Products require activities; activities consume resources. a. To be competitive, the manager must know: i. The activities to make/provide the product. ii. The cost of those activities.

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b. To reduce costs significantly, the manager must first identify the activities the product needs. Next, he must figure out how to rework those activities to improve product efficiency. c. Separate checks, please leads to ABC; everyone pays for what he consumes. 2. Activity Analysis a. Activity analysis is a fundamental aspect of ABM. An activity is any discrete task that an organization performs to make or deliver the product. b. Four steps of activity analysis: i. From start to finish, chart the activities to complete the product. ii. Classify activities as value-adding (VA) or non-value-adding (NVA). iii. Eliminate NVA activities. iv. Continuously improve and re-evaluate the efficiency of VA activities or replace them with more efficient activities. (continuous improvement, kaizen) c. The VA activities identified in step 2 make up the value chain. i. Value chain analysis is a continuing process. The manager continually analyze the value chain activities to classify, eliminate, and improve the classifications. ii. Activity analysis provides a systematic way to identify NVA costs. d. The following activity types are good candidates for elimination as they are usually NVA: i. Storage [JIT] ii. Moving items [S&M] iii. Waiting for work iv. Production process components 3. Traditional Methods versus ABC a. Traditional methods of costing are simplistic and inaccurate. But, ABC is more expensive. b. Method to Use: A Cost-Benefit Decision. This decision is typically made in one of three ways: i. The manager rejects activity analysis and stays with the simpler traditional methods. ii. He uses ABC because he wants info to help him be competitive. iii. He uses ABC as a special analysis, but not as an ongoing information system c. Cost Pools: Plant vs. Department vs. Activity Center. The manager who uses traditional costing chooses depending on which cost pool he uses. He can use plant-wide allocation, which uses the entire plant as a cost pool (plant doesnt only refer to a manufacturing facility and could refer to a store, department, etc.). d. Organizations may also use the department allocation method where there is a separate cost pool for each department. e. Both these methods are traditional costing methods where overheads are allocated using one activity (direct labor hours or other direct input which is typically not a causal cost driver). f. ABC assigns costs first to activities, then to products based on each products use of activities. ABCs goal is to better estimate the costs of products, product lines, or departments. g. ABC requires four steps: i. Identify the activities that consume resources, and assign costs to those activities. 1. The manager identifies the activities with the greatest impact on costs. 2. Costs are a function not only of volume, but also complexity. Products that require complex set-up time, or many parts to order and inspect, usually consume more resources than products with short set-up times or less parts

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3. Low-volume or special-order products add complexity to the operation by disrupting the production flow of the high volume items. ii. Identify the cost driver associated with each activity. 1. Three criteria for selecting cost drivers: (1) casual relation, (2) benefits received, and (3) reasonableness. 2. The manager chooses a cost driver that causes the cost (ideal, not always possible). 3. The manager chooses a cost driver to assign cost in proportion to benefits received. 4. The manager chooses a cost driver based on fairness or reasonableness when costs cannot be linked to products on the basis of causality or benefits received. iii. Compute a cost rate per unit of cost driver. Computing a cost rate per cost driver is similar to establishing pre-determined overhead rate in traditional costing (primarily a causalitybased method). This process is applicable to any indirect cost, whether mfg overhead, administrative, distribution, selling, or any other indirect cost. iv. Assign the cost to products by multiplying the cost driver rate by the volume of cost drivers of the product. h. Cost hierarchies help the manager find the major factors that drive costs. i. Resources used and resources supplied i. Resources used are: cost driver rate times the cost driver volume. This is applied or absorbed cost. ii. Resources supplied are the expenditures or the amounts spent on the activity. iii. The difference between resources supplied and resources used is unused capacity. Finding this unused capacity helps the manager reduce or use it productively. j. Companies concerned about quality production do not treat waste or spoiled goods as normal. Instead they segregate waste and spoilage costs to prevent waste costs being buried in product costs. 10. Do Integrated Accounting Systems Satisfy Managerial Needs? a. Many companies have implemented Enterprise Resource Planning Systems that integrate the various aspects of the business. Yet, some managers maintain a shadow system to help with decision-making. This suggests that the enterprise-wide systems dont meet the needs of the managers. The most successful way to ensure the success of ERPS is by pulling the plug on the shadow system(s). 11. Appendix 2.1: Computing Costs of Equivalent Production a. The appendix describes product-costing methods when a firm has partially completed work on a product at the beginning or end of a period. Five steps are required to compute product costs, the cost of ending work-in-process inventory, and the cost of finished goods. The five steps are: i. Summarize the flow of physical units. ii. Compute equivalent units (EU). EU of work done = EU transferred + EU in ending - EU in beginning this period out inventory inventory iii. Summarize costs to be accounted for. iv. Compute unit costs for the current period. v. Compute the cost of goods completed and transferred out of work-in-process and the cost of ending work-in-process inventory. b. Note: FIFO or the weighted average method can be used for the calculations.

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Chapter 5: Cost Drivers & Cost Behavior 1. The total cost equation is: Total Cost during = Fixed Cost Period during period

(Variable Cost per X Units of Activity) (Unit of Activity during Period )

TC = F + VX a. In reality, many costs do not fall neatly into these 2 categories, and the manager uses statistical and other techniques to estimate cost behavior. These techniques help him identify cost behavior patterns to help control and cut costs and lead to more informed decision-making. 2. Nature of Fixed and Variable Costs a. Short Run v. Long Run i. Variable Costs - also known as engineered costs, change in total as the level of activity changes. Direct material is an example of an engineered cost. ii. Fixed Costs - do not change in total with changes in activity levels, in the short run. iii. In the long run, no costs are fixed because changes can be made. iv. The concepts of variable and fixed costs are short-run in nature. They apply to a particular period of time and relate to a particular level of production capacity. v. Mgmt acctg makes variable costs a straight line (despite due to quantity discounts, e.g., the costs are really non-linear way) to deal with demands of short-term decision-making. b. Relevant Range: range of activity over which cost behaviors are expected to be consistent (i.e., variable remains variable, fixed remains so). i. Alternatively, its the range where the firm can operate given present capacity. Below the range, the firm will be out of business because it cant cover fixed costs; above it, the firm must expand capacity, which increases costs. c. Estimates of variable and fixed costs apply only if the contemplated level of activity lies within the relevant range. If the alternative level of activity is outside the relevant range, the different structure requires new computations. 3. Types of Fixed Costs: Fixed costs are classified to explain the relationships between current capacity and particular types of fixed costs a. Capacity Costs: provide the firm with the capacity to produce, sell, or both. i. The firm will incur some capacity costs (also, committed costs) even if it temporarily shuts down operations. These costs result from ownership of facilities and basic organization structure. ii. Over the long-run, no costs are committed; the firm can get out of a long-term lease or sell assets no longer needed. b. Discretionary Costs (sometimes called programmed or managed) are discretionary because the firm need not incur them in the short-run to operate. They are usually essential for achieving long-run goals. They reflect top management policies and commitments to particular programs. Examples include research and development cost, and advertising cost. 4. Other Cost Behavior Patterns a. Curved Variable Costs Functions: indicate costs that vary with activity volume, but not in constant proportion. b. Learning Curves

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i. As employees experience increases on tasks performed, productivity improves and cost per unit decreases. This occurs with new products or new employees. ii. The effect of this learning is often expressed as a learning or experience curve. iii. Accountants model the learning curve as a constant percentage reduction in the average direct labor input time required per unit as the cumulative output doubles. iv. The possible consequences of learning on costs can affect decision-making and performance evaluation. v. Even though the learning curve works, doing the same job all the time can lead to disinterest, lack of motivation, and frustration. These may explain why students come back to school for an MBA. vi. Learning curves apply to any labor-related costs but can also affect material costs if the cost of wasted material (scrap) decreases as experience increases. c. Semi-variable Costs i. Semi-variable costs refer to costs that have both fixed and variable components. Also refers to mixed costs. ii. An example of a mixed cost is the cost of a new BMW that the MBA student will be able to acquire when he earns the degree. He will lease the BMW at a special deal that allows him to park it at the driveway and impress the neighbors for, say PHP 25,000 per month (fixed portion of mixed cost) but, as soon as he drives it, the cost increases by, say, PHP 300 per km. (variable portion of mixed cost) d. Semi-fixed Costs i. Semi-fixed costs refers to costs that increase in steps, hence, sometimes called step fixed costs. e. Simplifying Cost Analyses i. To simplify analysis, decision-makers assume costs to be strictly fixed or linearly variable. This is done because the incremental cost of analyzing the more complex data often exceeds the incremental benefits of doing so. 5. Cost Estimation Methods, Estimating Costs Using Historical Data a. When a firm has been carrying out activities for some time and expects future activities to be similar to those of the past, the firm can analyze historical data to estimate variable and fixed components of total cost and to estimate likely future costs. The procedure requires two steps: i. Make an estimate of the past relation. ii. Update this estimate so that it is appropriate for the present or future period for which management wants the estimate. b. Preliminary Steps In Analyzing Historical Cost Data i. Before using cost estimates, the analyst should be confident that the estimates make sense and result from valid assumptions. Otherwise we will have GIGO. ii. The idea is to find fixed costs per period, F, and variable cost per unit, V, of some activity variable, X, in the relation TC = F + VX iii. Here, TC is the total cost or the dependent variable, and X is the independent variable. iv. The following steps should be taken in analyzing cost data:

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1. Review alternative cost drivers (independent variables). A cost driver ideally measures the activity that causes costs. The cost drivers, if not the sole cause of costs, should directly influence cost incurrence. 2. Plot the data. 3. Examine the data and method of accumulation. c. Statistical Regression Analysis i. The task is to estimate the relation between total cost and the activities that cause the cost. ii. Regression analysis statistically fits a line to the data using least squares. Least squares fits the data points to the line to minimize the sum of the squares of the vertical distances between the observation points and the regression line. Virtually every computer system and spreadsheet software package for personal computers can execute regression analysis. d. Using Regression to Estimate Cost Driver Rates i. Be wary of predicting total costs for activity levels outside the range of observations. Also, be wary of estimates of fixed costs if they are outside the range of observations. e. Multiple Regression i. Multiple regression has more than one independent variable. ii. It is likely that multiple regression results are more accurate if the cost drivers in the multiple regression model are appropriate. iii. Multiple regression usually increases the predictive ability of the historical data, even if there can be potential problems when adding additional variables. f. Financial Planning i. The cost estimation spreadsheet using multiple regression can become a financial planning model and the basis for decision-making. g. Customer Profitability Planning i. In practice, managers and analysts use estimates derived from cost estimation for many applications including customer profitability planning, cost management, standard setting, planning, all sorts of decision-making, etc. h. Account Analysis i. Under the account analysis method, analysts review each cost account and classify it according to its relation to a cost driver. ii. Requires detailed examination of the data, by accountants and managers who are familiar with the data. iii. Cost analysis is judgmental in nature; so different cost estimates will result. i. Engineering Method of Estimating Costs i. Engineering Method indicates what a cost should be. ii. The engineering method is used by both manufacturing and non-manufacturing entities. iii. Analysts study the physical relation between the quantities of inputs and outputs. Next, the accountant assigns costs to each of the inputs to estimate the cost of outputs. iv. The engineering method is costly to use. v. The engineering method is most useful when input/output relations are well defined and fairly stable over time. 6. Data Problems a. Collecting appropriate data is complicated by the following problems: i. Missing data

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ii. Outliers - extreme observations may affect cost estimates. iii. Allocated and discretionary costs. Fixed costs may appear to be variable because they are allocated on a volume basis. iv. Inflation. During periods of inflation, historical cost data do not accurately reflect future cost estimates. v. Mismatched time periods. The time period for the independent variable and dependent variable do not match. vi. Trade-offs in choosing the time period. Short-term vs. long-term. 7. Ethical Issues in Data Analysis a. Managers might have an interest in pressuring analysts to come up with the right answer. This might help managers get approval for a project or might help managers achieve forecasts. b. Contrasting Approaches to Openness in Knowledge Sharing. Managers in different cultures behave differently when an error has been made in decision-making. In research conducted, it was shown that Chinese managers put the interest of the company ahead of their own interest. The reverse was shown to be true in the American context. 8. Strengths and Weaknesses of Cost Estimation Methods a. Each method has advantages and disadvantages. Probably using several methods together would be the best approach. b. Two most common simplifications by analysts are: i. Assume the cost behavior depends on just one cost driver. In reality, this is usually not the case. ii. Assume cost behavior patterns are linear within the relevant range. In reality, most costs are curvilinear. c. Cost/benefit analysis must be done to determine the optimum combination of tools to be used for analysis. Chapter 6: Financial Modeling for Short-term Decision-making 1. Overview a. The chapter demonstrates the interrelation of cost, volume, and profit. The CVP model is used to find break-even points, target profit volumes, and margin of safety. The model is also applied to multiple-product cost settings is shown as useful in making decisions. Finally, the underlying assumptions and simplifications are highlighted. 2. What is Financial Modeling? a. A financial model works in the same fashion as a simulator, allowing the manager to pre-test the interaction of economic variables in a variety of settings. These models require the development equations to represent operating and financial relationships. b. Financial models can avoid being overwhelmed by the related numbers-crunching. However, be warned about GIGO. A model is only as good as its assumptions; faulty assumptions or bad data result in faulty output. 3. The CVP Model a. Summarizes the effect of volume changes on costs, revenues, and profit. The user can extend analysis with the model to the effect on profit of changes in revenues and costs [the independent

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variables]. Despite the use of the word profit, the model can be used routinely in non-profit organizations. Key Equation: Profit = Revenues Costs = [USP * Vol] [ (UVC * Vol) + TFC ] = [ (USP UVC) * Vol ] TFC A variation is: Profit = Revenues (TVC + TFC) = Revenues (% Revenues + TFC) b. A key concept is that contribution margin conceptually covers fixed costs first, and then contributes to enterprise profitability. c. Target-profit analysis helps determine the sales volume to make a desired profit. The break-even case (profit = zero) is merely an extension of target-profit analysis. d. Warning: Using the CVP model gives answers that are estimates (best guesses). e. Applications of Financial Modeling i. Sensitivity Analysis and Spreadsheets: showing how the model responds to changes in any or all of its variables. ii. Step Costs: make the analysis a little more complicated when these step costs are present, due to different fixed costs for each step. f. Margin of Safety is the excess of projected (or actual) revenues over the breakeven revenues level. MOS can be measured in units, revenue amount, or in relative terms. 4. Cost Structure and Operating Leverage a. The cost structure significantly affects the sensitivity of profit to volume changes. b. The extent to which cost structure is made up of fixed costs is operating leverage. Operating leverage is high in firms with a high proportion of fixed costs, a small proportion of variable costs, and the resulting high contribution margin per unit. c. Sales Amount as a Measure of Volume d. Income Tax i. The effect of income tax can be incorporated in the model by substituting after-tax profit for before-tax profit using the basic relationship. 5. Multiple Product Financial Modeling a. In multiple-product firms, it is more useful to perform breakeven analysis using contribution margin ratio. These firms can use alternatives: i. Assume the Same Contribution Margin (Products can be grouped such that they have equal or nearly equal contribution margins.) ii. Assume a Weighted-Average Contribution Margin iii. Treat Each Product Line as a Separate Entity (This method can involve allocating costs on the basis of, say, relative sales amounts or on the basis of quantities of the product lines.) 6. Simplifications and Assumptions a. The popular CVP model has three underlying assumptions: i. Total costs can be separated into fixed and variable components. ii. Cost and revenue behavior is linear. (That fixed costs do not change in total, variable costs per unit remain constant, and the selling price per unit remains constant are assumptions that may be acceptable within the relevant range of activity; thus, this can also be called the relevant-range assumption.) iii. The product mix remains constant.

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b. This is another instance, as in dealing with multiple product lines, where accuracy vs. usefulness is a controlling issue. Chapter 7: Differential Cost Analysis for Operating Decisions 1. Two questions to keep in mind: a. What activities differ among the alternatives? b. How does that difference affect operating profits? 2. Differential Principle a. Each alternative will result in costs and revenues. A differential cost changes due to changing activities among choices. The same applies to differential revenue. b. Differential analysis is also relevant cost analysis identifying the costs (or revenues) relevant to each choice. A cost/revenue is relevant if its amount varies among the choices. c. Differential analysis focuses mostly on differential cash flows. 3. Uncertainty and Differential Analysis a. The types, levels, and costs are all estimates and subject to error. Those for the status quo are usually more certain than for the alternatives. b. The manager would avoid too much risk and bear it only if compensated. Hence, he may reject, because of risk, an alternative expected to be more profitable than the status quo. 4. Information Overload, Sunk Costs, Qualitative Factors a. It is important, but difficult, for the manager to ignore sunk costs. Sometimes he makes a bad decision and feels like the decision will become a good one if he throws enough money at it. This typically does not happen. 5. Major Influences on Pricing. Companies have become customer-driven, focusing on delivering quality products at competitive prices. Three major influences on pricing are: a. Customers. Managers examine pricing problems through the eyes of their customers. b. Competitors. Competitors reactions influence pricing decisions. i. Competitors aggressive pricing may force a price decrease. Lack of competition may lead to higher prices. ii. Knowledge of competitors technology, capacity, and operating policies can aid in price setting. iii. Managers consider both domestic and international competition in making pricing decisions. c. Costs i. Products consistently priced below cost can drain resources. d. In pricing, managers weigh customers, competitors, and costs differently. In a highly competitive market, it sets the price. With little competition, the manager has more discretion. e. Pricing is an area where newly evolving themes, such as customer satisfaction, continuous improvement, and the dual internal/external focus come together. f. Typically, the manager understands costs (depending on the quality of accounting info system) better than the other factors. 6. Short-Run Versus Long-Run Pricing Decisions a. Time horizon of the decision is critical in analyzing relevant costs for a pricing. b. Short-run pricing decisions would include a one-time-only special order with no long-term implications.

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c. In the short-run, there is no concern for profit margin. With one-time-only special orders and with excess capacity only differential/variable costs as a minimum need to be covered. d. Doing special-order problems must not miss the point that long-run prices must be high enough to cover not only variable and fixed costs but also be sufficient to generate profits. It is not the price of choice! e. If customers talk with each other there may be resentment from customers who dont receive the special price. Further, special-order customers may expect to get the units at the same price in the future also. Differential Approach to Pricing a. The differential approach to pricing is useful for short-run and long-run decisions and presumes the price must at least equal the differential cost of producing and selling. In the short-run, this will result in a positive differential/contribution margin. Both fixed and variable costs are differential in the long-run, requiring covering all costs. Long-Run Pricing a. Many firms rely on full-cost information reports when setting prices. Full-cost, the total cost of producing and selling a unit, includes all costs incurred in the value chain. b. Using full costs for pricing can be justified in three circumstances: i. When a firm enters into a long-term contractual relationship to supply a product. ii. When there are many contracts for the development and production of customized products, and many contracts with governmental agencies that specify prices as full costs plus a markup. iii. Managers sometimes initially set prices based on full costs plus a profit, and then make short-term adjustments to prices to reflect market conditions. Life-Cycle Product Costing and Pricing a. Product life cycle covers the time from initial R & D to when customer support is withdrawn. b. Life-cycle costs provide important information for pricing. To be profitable, the company must generate revenue to cover all costs in the value chain. Target Prices and Target Costs a. Target costing is price-based costing (instead of cost-based pricing). b. Target price is estimated product price customers will be willing to pay. Target cost is the estimated long-run cost that will enable target profit. Target cost is target price less target profit. c. Value engineering is the systematic evaluation of all aspects in the value chain in order to reduce costs while satisfying customer needs. Customer Profitability and Differential Analysis a. Differential costing is useful for deciding which customers should be kept and which should be abandoned. b. The 80/20 rule: 20% of customers generate 80% of sales, 20% of the customers cause 80% of the problems. c. Customer costs are generally composed of those to: acquire the customer, provide the product, maintain the customer, and retain the customer. Product Choice Decisions a. In the short-run, capacity limitations will sometimes affect this decision.

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b. Because many accounting systems provide unit cost information, including allocation of fixed costs, short-run decisions can be incorrect. This is especially likely with systems using full-absorption costing. Theory of Constraints and Throughput Contribution Analysis a. Theory of constraints (TOC) focuses on increasing the excess of differential revenue over differential costs when the firm faces bottlenecks, an operation where work to be performed equals or exceeds the available capacity. b. The focus on bottlenecks encourages the manager to find ways to increase profits by relaxing constraints and increasing throughput. c. Key Steps in Managing Bottleneck Resources are: i. Recognize that bottleneck resource determines throughput contribution of the plant. ii. Search for and find the bottleneck resource by identifying resources with large quantities of inventory waiting to be worked on. iii. Subordinate all non-bottleneck resources to the bottleneck resource. The needs of the bottleneck resource determine the production schedule of non-bottleneck resources. iv. Increase bottleneck efficiency and capacity. The intent is to increase throughput contribution minus the differential costs of taking such actions. v. Repeat steps 1 through 4 for any new bottlenecks. d. TOC assumes few costs are variable generally only materials, purchased parts, piecework labor, and energy to run machines. Most direct labor and overhead costs are assumed to be fixed. This is consistent with the idea that the shorter the time period, the more costs are fixed, and the idea that the TOC focuses on the short run. Make-Or-Buy Decisions a. The manager facing a make-or-buy choice must decide how to satisfy company needs internally or from external sources (outsourcing). b. Outsourcing may lead to unrest and downsizing. c. Good decision-makers use quantitative factors as well as qualitative factors. Joint Products: Sell or Process Further a. Joint product decisions deal with multiple products from a single production process. b. Split-off point is where identifiable products emerge. Costs before split-off are joint costs, those after are additional processing costs. The manager must decide at split-off whether to sell or process further. Adding and Dropping Parts of Operations a. Managers must decide when to add or drop products and when to open or abandon territories. While this is another example of a decision that has tremendous long-run implications, the impact on current profits can also be calculated using differential analysis. The decision rule is: If the product/territory differential revenue exceeds the differential costs to have the product/territory, the product/territory should be maintained/developed.

17. Inventory Management Decisions a. Inventories are costly to maintain. Key questions include: i. How many units should be on hand and available for use/sale? ii. How often should each order be given? What is the orders optimal size?

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b. Inventory management decisions involve two opposing differential costs: setup or ordering costs, and carrying costs. c. The manager could minimize these two costs by minimizing the number of orders or production runs. By ordering or producing less frequently, though, each order or production run must be for a larger number of units which in turn would lead to higher inventory carrying costs. d. Economic Order Quantity (EOQ) could be used to determine the optimal trade-off between the two costs. e. Order costs should include differential costs of receiving and inspecting orders, costs of processing invoices from suppliers, and freight costs. Differential carrying costs include insurance, inventory taxes, the opportunity cost of funds invested in inventory, and other costs that differ with the number of units held in inventory. Chapter 9: Profit Planning and Budgeting 1. Introduction: a. Managers in all forms of organizations rely on budgets extensively for planning and performance evaluation. A budget is a financial plan of the resources needed to carry out tasks and meet financial goals. b. These notes focus on the short-term operating budget, one that states managements plan of action for the coming year in quantitative terms. 2. Strategic Planning a. Companies start the strategic planning process by stating their critical success factors, which are the most important things for a company to be successful. Subsequently, companies build on these factors to expand operations. 3. The Organizational Plan a. A master budget is part of an overall organizational plan for the next few years. Its components are: (1) organizational goals, (2) strategic long-range plan, and (3) the master budget. i. Organizational Goals are broad objectives established by company management. These goals indicate managements philosophy about the company. ii. Strategic or Long-Range Plan contains the specific steps required to achieve the goals of a company. Plans could include strategies related to (1) cost control and (2) market share. iii. The Master Budget b. Long-range plans are achieved in year-by-year steps. The plan for the coming year is called the master budget. The master budget is also known as the static budget. The income statement part of the budget is called the profit plan. The individual budgets, within the master budget, are used to construct a budgeted statement of financial position. 4. The Human Element in Budgeting a. A number of factors (including their personal goals and values) affect managers beliefs about the coming period. Budget preparation rests on human estimates of an unknown future. The importance of this human factor cannot be overemphasized. One challenge in an organization is to identify who is best able to provide the most accurate information about particular topics. b. Value of Employee Participation in Developing Budgets i. The use of input from lower and middle management is called participative budgeting. While time consuming, it enhances employee motivation and provides information that enables employees to associate rewards and penalties with performance.

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c. Motivating Employees i. When assessing the effect of budgets or any other part of a motivation system, two questions are asked: ii. What type of behavior does the system motivate? iii. Is this the desired behavior? d. Cultural Impact on the Budgeting Process i. Researchers have found cultural differences in the way people accept top-down budgeting. e. Goal congruence. This occurs if members of an organization have incentives to perform in the common interest. While goal congruence is rare, team efforts are observed in many cases. 5. Tools for Planning and Performance Evaluation a. Budgets provide estimates of expected performance. Comparing budgeted with actual results provides a basis for evaluating past performance and guiding future action. b. Responsibility Center (RC) i. An RC is a division or department in a firm responsible for managing a particular group of activities in the organization. 1. Cost center management is responsible for costs. 2. Revenue center management is responsible primarily for revenues. 3. Profit center management is responsible for both revenues and costs. 4. Investment center management is responsible for revenues, costs, and assets. ii. There are two categories of cost centers, based on the types of costs incurred in the center. 1. Engineered cost centers have input-output relations sufficiently well established so that a particular set of inputs will provide a predictable measurable set of outputs. 2. Discretionary cost centers are where input-output relations are not well defined. Managers typically receive a cost budget that provides a ceiling on the center costs. c. Flexible Budgets i. A flexible budget shows the expected relation between costs and volume. It has two components. 1. A fixed cost expected to be incurred regardless of the level of activity. 2. A variable cost per unit of activity. (Recall: Variable costs change in total as the level of activity changes.) d. Establishing Budgets using Cost Hierarchies i. There are five categories of costs used in the budgeting process, as follows: 1. Unit-level activities 2. Batch-level activities 3. Product-level activities 4. Customer-level activities 5. Facility-level activities 6. Developing the Master Budget a. After organizational goals, strategies, and long-range plans have been developed, work begins on the master budget. Although budgeting is an on-going process, the bulk of the work is done in the six months preceding the beginning of the coming fiscal year. 7. Where to Start? With the Customers (Forecasting Sales) a. Sales Staff: The sales staff, given their proximity to customers, may be in the best position to provide information about customer needs.

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b. Market Researchers: Management may turn to market researchers to provide a check on forecasts from local sales personnel. c. The Delphi Technique: This method is used to enhance forecasting and reduce bias in estimates. Under this method, members of the forecasting group prepare individual forecasts and submit them anonymously. Each member of the group receives copies and the results are discussed. d. Trend Analysis: This analysis may be helpful in preparing sales forecasts. The analysis can range from simple visual extrapolation of points on a graph to a highly sophisticated computerized time series analysis. e. Econometric Models: Another approach is to enter past sales data into a regression model to obtain a statistical estimate of factors affecting sales. Sophisticated analytical models are not widely available. Incentives for Accurate Forecasts a. The sales budget drives the entire budgeting process and care should be taken that the budgets are accurate and useful. Companies use many different methods of providing incentives for both accurate forecasting and good performance. Comparison of the Flexible and Master Budgets a. A comparison between the master budget with a flexible budget forms the basis for analyzing differences between planned and actual results. b. Flexible vs. Master Budget. Flexible budgets are based on the actual sales and production volume. i. Sales volume variance ii. Favorable vs. Unfavorable 1. A favorable (unfavorable) variance means that the variance increases (decreases) operating profits. Budgeting in Non-profit Organizations a. The master budget has added importance in non-profit organizations because it is used as a basis for authorizing the expenditure of funds. Ethical Issues in Budgeting a. Not only do managers and employees provide information for the budget, their performance is evaluated by comparing the budget to actual results. This can lead to serious ethical dilemmas. Incentive Model for Accurate Reporting

Chapter 10: Investment Center Performance Evaluation 1. Introduction: a. As companies grow in size, they acquire or create affiliates and/or divisions. Corporate management measures and controls the performance of the divisions by relying on accounting systems. These concepts and methods are used in manufacturing and non-manufacturing organizations. 2. Divisional Organization and Performance a. A division is a segment that conducts both production and marketing activities. b. A profit center is responsible for both revenues and operating costs. An investment center is responsible for assets in addition to revenues and operating costs. In some companies, the investment center is treated as an almost-autonomous company. c. In reality, two organization charts often exist: the formal one and the real one that sometimes differs in the actual chain of command.

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d. The Nature of Divisionalized Organizations i. Top managers delegate or decentralize authority and responsibility (?). Major advantages of decentralization are: 1. Allows local personnel to respond quickly to changing environment. 2. Frees top management from detailed operating decisions. 3. Divides large, complex problems into manageable pieces. 4. Helps train managers and provides a basis for evaluating their decision-making performance. 5. Motivates. Ambitious managers will be frustrated if they implement only the decisions of others. Delegation allows managers to make their own decisions. ii. Decentralization also has disadvantages. Local managers may not act to achieve the overall goals of the organization. One way to overcome this disadvantage is to design divisional planning and control systems that create behavioral (or goal) congruence to encourage division mangers to act in ways consistent with organizational goals. e. Separating a Managers Performance Evaluation from Divisional Performance Evaluation i. In general, top management should distinguish between the performance of an organizational division and the division manager. At issue would be controllability. Ideally, accountability goes only as far as what can be controlled. 3. Return on Investment as the Performance Measure a. Managers expect each division to contribute to the companys profit. But, simply comparing the amounts of operating profit between divisions may not tell the whole story since the amounts of investment may be different between divisions. Thus, management uses return on investment (ROI) to relate the division profit measure to the amount of capital invested in the division. b. Division Return on Investment (ROI) = Division Operating Profit Division Investment = (Division Revenue - Division Operating Costs) Division Investment c. Management must answer several important questions before applying ROI as a control measure. i. How does the firm measure revenues, particularly when it transfers part of a divisions output to another division rather than selling it externally? ii. Which costs does the firm deduct in measuring divisional operating costs only those that the division can control, or also a portion of allocated central corporate administration and staff costs? iii. How does the firm measure investment: total assets or net assets; at historical cost or some measure of current cost? 4. Transfer Pricing: Measuring Divisional Revenue and Costs for Transactions inside the Organization a. A transfer price is the value assigned to goods or services that are transferred from one division of an organization to another division of that organization. b. Transfer prices are widely used for decision-making, product costing, and performance evaluation. Considerable discretion can be used in putting a value on the transactions (if only because of the organization-wide zero-sum effect of such value). Still, it is important to consider alternative transfer pricing methods and their advantages and disadvantages. c. Applying Differential Analysis to Transfer Pricing: Two applications of differential analysis: i. Transfer pricing when the supplying division has otherwise-excess capacity. ii. Transfer pricing when the supplying division is at full capacity. 5. Alternative Ways to Set Transfer Prices

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a. Managements problem is to set transfer prices so the buyer/recipient and seller/supplier have goal congruence with respect to total organization goals. b. Three general ways to set transfer prices are: i. Top management intervenes to set transfer prices. ii. Top management establishes transfer price policies that divisions follow. iii. Division managers negotiate transfer prices among themselves. c. Top Management Intervention. Direct intervention may give the right transfer price for a particular transaction, but it reduces the benefits from decentralization, since top management may become swamped with pricing disputes. d. Centrally-Established Transfer Price Policies i. A transfer pricing policy should allow divisional autonomy yet encourage managers to pursue corporate goals consistent with their personal goals. e. The Economic Transfer Pricing (General) Rule: Differential Outlay Cost plus Opportunity Cost i. The economic transfer pricing rule for making transfers to maximize a companys profits is to transfer at the differential cost to the selling division (typically variable costs) plus the opportunity cost to the company of making the internal transfer (zero if the seller has otherwise-excess capacity, or selling price minus variable costs if the seller is otherwise operating at full capacity). f. Transfer Prices Based on Market Price i. Externally-based market price-based transfer pricing is generally considered the best basis when there is a competitive market for the product and market prices are readily available. An advantage of using market prices in a competitive market is that both the buying and selling divisions can buy and sell as many units as they want at the market price. Managers of both buying and selling divisions are indifferent between trading with each other or with outsiders. g. Transfer Prices Based on Costs i. Full-absorption costs ii. Activity-based costs (improved accuracy of costs) iii. Cost-plus transfers (based on variable or on full-absorption costs) iv. Standard costs or actual costs h. Other Motivational Aspects of Transfer Pricing Policies i. Problems can arise when the supplier does not get a profit on the transaction. ii. Dual transfer prices provide the selling division with a profit but the buying division is charged with costs only. iii. Other incentives for internal transfers 1. Recognize internal transfers and incorporate them explicitly in reward systems. 2. Base part of a supplying managers bonus on the purchasing centers profits. i. Division Managers Negotiate Transfer Prices i. An alternative to a centrally administered transfer pricing policy is to permit managers to negotiate the price for internally transferred gods and services. ii. Major advantage is that autonomy of division managers is preserved. iii. The disadvantages are: (a) a great deal of management effort may be consumed in negotiating, and (b) the final price and its implications for performance measurement may

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depend more on the managers ability to negotiate rather than on whats best for the company. j. Summary: The ultimate decision must be that which provides the greatest return for the company, while keeping division managers happy. Look at the overall impact of the decisions on the company and not just on the individual division. Global Transfer Pricing Practices a. Surveys of corporate practices indicate that nearly half of companies using transfer prices base them on costs. About 1/3 use a market price-based system, and the rest rely on negotiations between division managers. When prices were negotiated, transfer prices fell between the market price at the upper limit and some measure of cost at the lower limit. b. There is no optimal transfer pricing policy. Managers must weigh the cost of any system against its benefits. Management tends to settle for a system that seems to work reasonably well rather than to devise a textbook-perfect system. Multinational Transfer Pricing a. International transactions may affect tax liabilities, royalties, and other payments because of different laws in different countries or territories. Since tax rates are also different, companies have incentives to set transfer prices that will increase revenues in low-tax countries, and increase costs in high-tax countries. Measuring Division Operating Costs a. In measuring divisional operating costs, manager must decide how to treat the following: i. Direct Costs Management virtually always deducts a divisions direct operating costs from divisional revenues in measuring divisional operating profits. If top management believes that division managers should not be held responsible for things outside their control, it can separate the measure of costs assigned to a division from the costs assigned to a division manager. ii. Indirect Controllable Operating Costs Firms usually centralize particular services due to scale economies. Top management then allocates these costs based on usage. iii. Indirect Non-controllable Operating Costs Indirect, non-controllable operating costs may be necessary costs to the company. The most frequent arguments against allocating these costs down to divisions are based on the divisions inability to control the amount of costs incurred. Measuring the Investment in Divisions a. Assets included in the Investment Base are those physically located in a division and used only in the divisions operations. Management often allocates the cost of shared manufacturing facilities among divisions. b. Valuation of Assets in the Investment Base i. Most firms use acquisition cost as the valuation base. ii. In general, the older the assets, the higher the ROI under net book value compared to gross book value. If replacement cost increases over time, ROI is higher under historical cost compared to current replacement cost. iii. Consider the impact of inflation on the accounting numbers, such as the accuracy of the ROI calculation using historical cost as opposed to some sort of inflation-adjusted number. Contribution Approach to Division Reporting a. Consistency should be maintained when computing ROI from period to period.

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11. Components of Return on Investment a. The rate of return on investment has two components: profit margin percentage and investment (or asset) turnover ratio. b. Return on Investment = Profit Margin Percentage X Investment Turnover Ratio Profit Margin Profit Margin Divisional Revenues ------------------------- = ----------------------- X -------------------------Divisional Investment Divisional Revenues Divisional Investment i. The profit margin percentage indicates the portion of revenue amount that is profit. Management often uses it as a measure for assessing efficiency in producing and selling goods and services (thus, effectively measuring management of costs). ii. The investment turnover ratio is the ratio of divisional sales to the investment in divisional assets. It indicates useful information on how effectively management used the capital invested (or assets) in the division. iii. Studying profit margin percentages and investment turnover ratios for a given division over several periods will provide more useful information than comparing these ratios for all divisions in a particular period. c. Setting Minimum Desired ROIs i. Management usually specifies a minimum desired ROI for each division, given its particular operating characteristics. Management should recognize the particular characteristics of a division in setting such minimum ROI. 12. Economic Value Added a. Critics of ROI argue that managers may turn down investment opportunities that are above the minimum acceptable rate but below the ROI currently being earned. b. The alternative of economic value added (EVA) is the amount of earnings generated above the cost of capital required to generate those earnings. MY NOTES Chapter 2: Measuring Product Costs 1. Product Costs in Manufacturing companies Direct Materials: costs of raw-form resources transformed into intended into finished goods by manufacturing (transforming) processes, easily traceable to the finished product Direct Labor: costs of personnel who transform resources into finished goods, easily traceable to the finished product Manufacturing overhead: all others costs related to transform raw resources into finished goods not easily traceable to the product Why/How types evolved? Direct Materials, Direct Labor: Directness of a cost traceability to the cost object 2. Cost Flows: Beginning Balance + Transfers In = Transfers Out + Ending Balance 3. Cost Measure: Actual or Normal Costing Normal Costing assigns costs to product with actual direct material and labor plus the normal manufacturing overhead. Actual Costing is not readily available. This may delay decision-making. Overhead costs incurred at different rates at different time lead to erratic fluctuations of product costs. 4. Choosing the right cost system Effectiveness:

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i. Decision focus needs of the decision-makers ii. Different costs for different purposes iii. Cost-benefit test Other Types of Costing i. Job costing companies producing customized product to record costs of products ii. Process costing-companies producing homogenous products iii. Operational Costing-hybrid of job and process costing; companies produce products using standard production methods. iv. Backflush Costing works backward from output to assign manufacturing costs to work in progress inventories v. Just in Time obtain materials just in time for production; and provide finished goods just in time for sale. Equivalent Units done during the period = EU transferred out + EU Ending EU Beginning 5. Computations to Consider: Normal Costing pre-determine rate, Overhead rate Equivalent Units of Product

Chapter 3: Activity-based Costing/Management 1. Concepts ABC Management rests on the premise that product requires activities, activities consume resources. Know the activities and the costs associated in these activities 4 Steps of Activity Analysis: i. Chart the activities to complete the product ii. Classify activities into VA (value chain) and NVA iii. Eliminate NVA iv. Continuously improve and re-evaluate the VA Traditional Costing versus ABC i. Traditional Costing is simple and inaccurate. ABC is expensive. ii. Method to use is a cost-benefit decision iii. Traditional Costing assigns costs to product by cost pools: plant-wide allocation or department allocation method. Allocate overhead costs by using one activity iv. ABC assigns first to activities, then to product based on each products use of activities. Better estimate of product costs, product lines and departments. 4 steps of ABC i. Identify the activities ii. Identify the cost driver iii. Compute a cost rate per unit of cost driver iv. Assign the cost to product by multiplying the cost driver rate by the volume of cost drivers of the product Chapter 5: Cost Driver & Cost Behavior 1. Concepts: Short run and Long run o Variable Costs/Engineered Costs change in total as the level of activity changes. o Fixed Costs do not change in total with changes of activity levels. o Variable and Fixed costs are short-run concepts. They apply to particular period of time and apply for a particular level of production of capacity. o In the long run, no costs are fixed because changes can be made.

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2.

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In the short run, there is only one capacity level. Production levels outside this range require different plant capacity and total cost line will change. Relevant Range the range of activity wherein the set of cost behaviors remain consistent. o Within this range, the firm can operate given present capacity. o Within this range, the firm assumes that certain costs are fixed and some costs are variable. Outside this range, the firm doesnt assume that the fixed costs would still remain fixed. o Estimates of variable and fixed costs apply only if the contemplated level of activity lies within the relevant range. o A new computation of fixed and variable costs is needed outside this relevant range. Type of fixed costs o Capacity costs/committed costs fixed cost incurred to provide firm the capacity to produce or sell o Discretionary costs programmed or managed costs such as R&D, advertising; the firm need not incur them in the short run to operate. Essential for long-run Other Cost Behavior Patterns o Curved variable costs vary in volume but not in constant proportion o Learning curves as employees experience increases, productivity increases, cost per unit decreases; affect labor-related costs but also apply to material costs as wastage decreases due to employee productivity increases. o Semivariable costs mixed costs. Combination of fixed and variable costs o Semifixed costs increase in steps, step fixed cost Simplifications: Cost varies with the volume of activity in several ways. Within the relevant range, variable costs change with the level of activity, and fixed costs remain fixed. Decision makers assume that costs are either strictly fixed or linearly variable for the reason of costbenefit issue. Incremental cost of identifying costs outweighs the incremental benefits of doing so. The assumed linear variable-fixed cost behavior usually sufficiently approximates the reality for decision-making purposes. Cost Estimation Methods: How to obtain costs? (HSMCA) Historical Cost Data i. carrying out the same activities, expect future activities to be the same as those of the past; use historical data to estimate fixed and variable costs ii. make an estimate of the past relation iii. update estimate to effect changes such as inflation and for changes in relation to costs and activity. For example, from production process from labor intensive to capital intensive. Statistical Regression Analysis Multiple Regression Customer Profitability Analysis Account Analysis Data Problems Missing data Outliers extreme observations affect cost estimates Allocated and discretionary costs Inflation Mismatched time period Trade-offs in choosing time period. Short run versus long run Strengths/Weaknesses of Cost Estimated Methods using several methods together is better. Cost/benefit of using the method should be considered. Simplifications o

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Assume cost behavior depends on just one cost driver. Assume cost behavior is linear within the relevant range.

Chapter 6: Cost-Volume-Profit Analysis 1. Concepts CVP: i. Interrelation of cost, volume and profit; determine the break-even point, the target sales and margin of safety. ii. Summarizes the effect of changes of volume to costs, revenues & profit iii. Extend analysis with the model to determine the effect on profit of changes of costs and revenues with changes of some activities. CVP can aid the analysis: ABS-CBN changes a segment of its new program; effect on profit if Mercedez Benz builds a larger SUV; break-even for the year of Figaro coffees hop i. Contribution margin a key concept that covers the fixed costs first, and contributes to the profit of the enterprise. ii. Target profit-analysis determines the sales volume to make the target profit. Break-even analysis is an extension of this analysis. Applied to multiple-product costing is shown as a good basis for decision making Financial model/Simulator/Sensitivity analysis: shows the framework, manipulate the changes and will be able to determine the results; allow managers to pre-test the interaction of economic variables in a variety of settings Be warned of GIGO the model is contingent on assumptions. The model is as good as the assumptions ascertained. Bad data inputted results in faulty output Be warned that this model gives answers that are estimates (best guesses) 2. Application (SMCP) Sensitivity Analysis/Spreadsheet: CVP allows managers to pre-test the interaction of economic variables in various settings. Through the spreadsheet, the user can input data, manipulate the different variable and determine the results by changing any or all of the variables. For the purpose of predicting results by knowing how the model responds to changes of any or all variables. Do you like what you see? Margin of Safety: excess of the projected actual revenues over the break-even revenues level measured in units, revenue amount, or in relative terms. Knowing the percentage of margin of safety vis--vis the break-even level would help evaluate the risks involved in a particular product of the company. Cost Structure and operating leverage: Profit is contingent to the cost structure of the enterprise. Cost structure significantly affects the sensitivity of profit to volume changes. o The extent to which cost structure is made up of more fixed costs is operating leverage. High in firms with high fixed costs, low variable costs and high contribution margin. Technology trade-off. o Since cost structure is a managerial decision. It measures the relative risk of managers in choosing the cost structure of the enterprise. o Operating leverage hinges in the identification of fixed costs. o Knowing the Costs? Cost-control. What you dont know, you cant control. Product Mix: Applied to Multiple-product costing which is useful in making decisions. o Use contribution margin ratio to determine the breakeven Treat each product line as a separate entity Assume same contribution margin (if they are equal or nearly equal contribution margin) Weighted average contribution margin (?????????)

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o Which product should I drop? Useful for planning and budgeting; good approximation for faster decision-making 3. Simplifications & Assumptions (TRP) Total costs can be separated into fixed costs and variable costs. Relevant Range Assumption: Cost and revenue behavior is linear. This assumption implies that Total Fixed Costs do not change in total, variable costs per unit and selling price per unit remain constant during the relevant range of activity. Product mix remains constant throughout the relevant range of activity. Cost-benefit analysis. Accuracy vis--vis usefulness issue. Cost/benefit analysis must be done to determine the optimum combination of tools to be used for analysis. http://websites.swlearning.com/cgiwadsworth/course_products_wp.pl?fid=M20b&product_isbn_issn=9780324639766&discipline_nu mber=400 Managerial Accounting First Exam Answers from Sir Agulto Operating Leverage is the extent to which operating costs are composed of fixed costs. Examples are capital-assets-intensive enterprises (that thereby have comparatively higher depreciation cost) and professional service enterprises (that typically have staff members with compensation in the form of fixed salaries). I would venture on high OL if business prospects are favorable, aiming for (all others equal) more profits compared with keeping a low OL. I would go for low OL if projections are unfavorable, going for a slower decline in profits. Thus, setting OL will call for taking calculated risks. At a business volume of about 13,300 customers per year, either company is projected to earn a PhP 0.5 million profit. As volume exceeds 13,300 customers, J Companys profit will increasingly be greater than S Companys profit. As volume falls below 13,300 customers, J Companys profit will increasingly be lower than S Companys profit. (A cost structure with a lower break-even level is not necessarily more profitable. In fact, break-even is not a profitability measure/indicator.) Reckoning risk as the relative chance of going below break-even volume, J Companys 10,000-unit hurdle is double that of S Companys break-even. Also, with comparatively more fixed costs, J Companys profit fluctuation, due to revenue changes, will be relatively more pronounced. Thus, J Companys cost structure will be viewed as riskier. Either model will bring in a P 14.56 million profit at 95,000-unit sales. Due to a higher OL [TFC/TCM = 32%], OO Model would be preferred if expected sales volumes exceed 95,000 units yearly. XX Models OL of 26% will be preferred if expected volumes are below 95,000 units. The conservative manager could go for the XX Model due to its lower break-even (25,000 units vs. 30,000 for OO Model).

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If sufficient time goes into the long-run, the statement is proper in that it suggests that there will be no fixed costs in the long-run. Since CVP requires the variable-fixed dichotomy, the non-existence of fixed costs in the long-run also indicates that CVP is, by definition, only applicable with a short-run perspective. BES = FC / CMR = 2,160 / 40% = 5,400 BES = 2,160 / 48% = 4,500 Lester should bring the ethical issue up and recommend that other alternatives be explored. Pushed to the edge, he can resign. Immediate-term survival will not be acceptable if at the cost of long-term citizenship. That others are doing the same thing or that it exists do not necessarily make the thing right.

Hospital Supply Answers (from Sir Agulto)

Pre-Calculations Unit VC: Materials Labor Overhead Mfg Costs Mktg Total P 550 825 420 1,795 275 P2,070

Normal Unit CM = 4,350 2,070 = P 2,280 Normal TFC: Unit O/H Unit Mktg Total Volume (000) Total (000) P 660 770 1,430 3 P4,290

(1) Normal Pre-tax Profit = (P 2,280 * 3) 4,290 = P 2,550 1. 1,880 units or P8,185,000 2. New profit = P 1,940 k (lower) as UCM 22% but volume 3. Sales TVC TCM TFC Mfg Costs Reimbursement w/o contract 17,400 8,280 9,120 <4,290> w/ contract 15,225 8,142.5 7,082.5 <4,290> 1,145 17% only

Managerial Accounting and Control I * Page 28 of 28 * rpe Comprehensive Exams Preparations

Tolling fee Pre-tax Profit _____ 4,830

275 _____ 4,212.5

Hence, govt contract should not be accepted as it will bring in lower profit 4. Minimum price shd be the additional costs HS will need to incur by taking the order (ie, not incurred if order rejected): Variable mfg costs 1,795 Shipping costs 410 Mktg costs 22 Total 2,227 5. Minimum price shd be the additional costs HS will need to incur to dispose of obsolete units. Interpretation: must be sold through regular channels means variable mktg costs are not avoidable. Assumption: Holding or carrying costs of obsolete units are negligible (otherwise added to variable mktg cost). Hence, 275/unit is minimum 6. Maximum price shd be costs to be incurred additionally if 1,000 units are mfd in-house instead. Variable mktg costs (55 * 1) Variable mfg costs Fixed mktg costs Total 55 (= 275 220) 1,795 594 (= 1,980 1,386) 2,444/unit

Hence: 2,475 proposal is not acceptable 7. Maximum price shd be costs to be incurred if 1,000 units are mfd in-house instead, plus additional CM from 800 modified units Total in Q6 above 2,444 Previously saved fixed mktg < 594> CM of modified units 1,100 = [(4,950 3,025 550) * 800] / 1,000 Total 2,950 Hence: 2,475 proposal is acceptable.