B405F Advanced Management Accounting Revision Lecture 11 Five-Step Decision Process 1 2 3 4 5 Gathering information Making predictions Choosing an alternative Implementing the decision Evaluating performance 2 The Meaning of Relevance Relevant costs and relevant revenues are expected future costs and revenues that differ among alternative courses of action. Sunk costs are irrelevant because they are past costs. Common fixed costs are irrelevant because they are non-differential costs. 3 Quantitative and Qualitative Relevant Information Quantitative factors are outcomes that are measured in numerical terms: – – Financial Nonfinancial Qualitative factors are outcomes that cannot be measured in numerical terms: – Nonfinancial 4 One-Time-Only Special Order Decision criteria: Accept the order if the revenue differential is greater than the cost differential. 5 Make or Buy Decision Opportunity costs are not recorded in formal accounting records since they do not generate cash outlays. These costs also are not ordinarily incorporated into formal reports. 6 Product-Mix Decisions Under Capacity Constraints Decision criteria: Aim for the highest contribution margin per unit of the constraining factor. When multiple constraints exist, optimization techniques such as linear programming can be used in making decisions. 7 Equipment Replacement The book value of existing equipment is irrelevant since it is neither a future cost nor does it differ among any alternatives (sunk costs never differ). 8 Decisions and Performance Evaluation Managers often behave consistent with their short-run interests and favor the alternative that yields best performance measures in the short run. When conflicting decisions are generated, managers tend to favor the performance evaluation model. Top management faces a challenge – that is, making sure that the performance-evaluation model of subordinate managers is consistent with the decision model. 9 Time Horizon of Pricing Decisions 1 2 Two key differences when pricing for the long run relative to the short run: Costs that are often irrelevant for short-run pricing decisions (fixed costs) are often relevant in the long run. Profit margins in long-run pricing decisions are often set to earn a reasonable return on investment. 10 Alternative Long-Run Pricing Approaches – – Market-based Cost-based (also called cost-plus) 11 Target Price is... the estimated price for a product (or service) that potential customers will be willing to pay. The target price, calculated using customer and competitors inputs, forms the basis for calculating target costs. – 12 Target Costs Target sales price per unit – Target operating income per unit = Target cost per unit 13 Implementing Target Pricing and Target Costing 1 2 3 4 Steps in developing target prices and target costs: Develop a product that satisfies the needs of potential customers. Choose a target price. Derive a target cost per unit. Perform value engineering to achieve target costs. 14 Value-Added Costs – – – – A value-added cost is a cost that customers perceive as adding value, or utility, to a product or service: Adequate memory Pre-loaded software Reliability Easy-to-use keyboards 15 Nonvalue-Added Costs – – – A nonvalue-added cost is a cost that customers do not perceive as adding value, or utility, to a product or service. Cost of expediting Rework Repair 16 Cost Incurrence and Locked-in Costs Cumulative Costs per unit Locked-in Cost Curve Cost Incurrence Curve R&D and Design Manufacturing Value Chain Functions Mktg., Dist., & Cust. Svc. 17 Cost-Plus Pricing The general formula for setting a cost-based price is to add a markup component to the cost base. Cost base $X Markup component Y Prospective selling price $X + Y 18 Life-Cycle Budgeting The product life-cycle spans the time from original research and development, through sales, to when customer support is no longer offered for that product. A life-cycle budget estimates revenues and costs of a product over its entire life. 19 Predicted Costs Many of the production, marketing, distribution and customer service costs are locked in the R&D and design stage. Life-cycle budgeting facilitates value engineering at the design stage before costs are locked in. 20 Strategy Strategy specifies how an organization matches its own capabilities with the opportunities in the marketplace to accomplish its objectives A thorough understanding of the industry is critical to implementing a successful strategy 21 The Balanced Scorecard The balanced scorecard translates an organization’s mission and strategy into a comprehensive set of performance measures. The balanced scorecard does not focus solely on achieving financial objectives. It highlights the nonfinancial objectives that an organization must achieve in order to meet its financial objectives. 22 The Balanced Scorecard Flowchart Financial Customer Internal Business Process Learning & Growth 23 Aligning the Balanced Scorecard to Strategy Different strategies call for different scorecards. What are some of the financial perspective measures? – Operating income – Revenue growth – Cost reduction is some areas – Return on investment 24 Aligning the Balanced Scorecard to Strategy – – – – What are some of the customer perspective measures? Market share Customer satisfaction Customer retention percentage Time taken to fulfill customers requests 25 Aligning the Balanced Scorecard to Strategy – What are some of the internal business process perspective measures? Innovation Process Manufacturing capabilities Number of new products or services New product development time Number of new patents 26 Aligning the Balanced Scorecard to Strategy – Operations Process Yield Defect rates Time taken to deliver product to customers Percentage of on-time delivery Setup time Manufacturing downtime 27 Aligning the Balanced Scorecard to Strategy – Post-sales service Time taken to replace or repair defective products Hours of customer training for using the product 28 Aligning the Balanced Scorecard to Strategy – – – – – What are some of the learning and growth perspective measures? Employee education and skill level Employee satisfaction scores Employee turnover rates Information system availability Percentage of processes with advanced controls 29 Features of a Good Balanced Scorecard Tells the story of a firm’s strategy, articulating a sequence of cause-and-effect relationships: the links among the various perspectives that describe how strategy will be implemented Helps communicate the strategy to all members of the organization by translating the strategy into a coherent and linked set of understandable and measurable operational targets 30 Features of a Good Balanced Scorecard Must motivate managers to take actions that eventually result in improvements in financial performance Limits the number of measures, identifying only the most critical ones Highlights less-than-optimal tradeoffs that managers may make when they fail to consider operational and financial measures together 31 Balanced Scorecard Implementation Pitfalls Managers should not assume the cause-andeffect linkages are precise: they are merely hypotheses Managers should not seek improvements across all of the measures all of the time Managers should not use only objective measures: subjective measures are important as well 32 Balanced Scorecard Implementation Pitfalls Managers must include both costs and benefits of initiatives placed in the balanced scorecard: costs are often overlooked Managers should not ignore nonfinancial measures when evaluating employees Managers should not use too many measures 33 Evaluating Strategy Strategic Analysis of Operating Income – 3 parts: 1. 2. 3. Growth Component – measures the change in operating income attributable solely to the change in the quantity of output sold between the current and prior periods Price-Recovery Component – measures the change in operating income attributable solely to changes in prices of inputs and outputs between the current and prior periods Productivity Component – measures the change in costs attributable to a change in the quantity of inputs between the current and prior periods 34 Revenue Effect Analysis Price Recovery Component P2 P1 Q2 Growth Component Q1 35 Cost Effect Analysis Price Recovery Component P2 P1 Q2 Productivity Component Q Q1 Growth Component 36 The Management of Capacity Managers can reduce capacity-based fixed costs by measuring and managing unused capacity Unused Capacity is the amount of productive capacity available over and above the productive capacity employed to meet consumer demand in the current period 37 Analysis of Unused Capacity Two Important Features: 1. Engineered Costs result from a cause-andeffect relationship between output and the resources used to produce that output 2. Discretionary Costs have two parts: 1. They arise from periodic (annual) decisions regarding the maximum amount to be incurred 2. They have no measurable cause-and-effect relationship between output and resources used 38 Managing Unused Capacity Downsizing (Rightsizing) is an integrated approach of configuring processes, products, and people to match costs to the activities that need to be performed to operate effectively and efficiently in the present and future Because identifying unused capacity for discretionary costs is difficult, downsizing, or otherwise managing this unused capacity, is also difficult. 39 Customer-Profitability Profiles Customer profitability reports often highlight that a small percentage of customers contribute a large percentage of operating income. It is important that companies devote sufficient resources to maintaining and expanding relationships with these key contributors to profitability. 40 Other Factors in Evaluating Customer Profitability Likelihood of customer retention Potential for sales growth Long-run customer profitability Increases in overall demand from having wellknown customers Ability to learn from customers 41 Sales Volume Variance Sales Mix aMi aQ bMi bQ Sales Quantity BCMi aX Market Share aZ Market Size BCM bX bZ 42 Purposes of Cost Allocation 1 2 3 4 There are four essential purposes of cost allocation: To provide information for economic decisions To motivate managers and other employees To justify costs or compute reimbursement To measure income and assets for reporting to external parties 43 Cost Allocation Criteria Cost Allocation by Cause and Effect Cost Allocation by Ability to Bear How many resources are consumed by the cost object? Cost Object Cost Allocation by Benefit Received How many benefits are received by the user from using the cost object? The ability for the cost object to absorb additional cost given reasonable profit margin User 44 Allocating Costs of a Supporting Department to Operating Departments Supporting (Service) Department – provides the services that assist other internal departments in the company Operating (Production) Department – directly adds value to a product or service 45 Allocation Method Tradeoffs Single-rate method is simple to implement, but treats fixed costs in a manner similar to variable costs Dual-rate method treats fixed and variable costs more realistically, but is more complex to implement 46 Allocation Bases Under either method, allocation of support costs can be based on one of the three following scenarios: 1. Budgeted overhead rate and budgeted hours 2. Budgeted overhead rate and actual hours 3. Actual overhead rate and actual hours Choosing between actual and budgeted rates: budgeted is known at the beginning of the period, while actual will not be known with certainty until the end of the period 47 Budgeted versus Actual Rates Budgeted rates let the user department know in advance the cost rates they will be charged. Users are better equipped to determine the amount of the service to request. Budgeted rates also help motivate the manager of the supplier department to improve efficiency. 48 Budgeted versus Actual Usage Allocation Bases When budgeted usage is the allocation base, user divisions will know in advance their allocated costs. This information helps the user divisions with both short-run and long-run planning. The main justification given for the use of budgeted usage to allocate fixed costs relates to long-run planning. 49 Allocating Support Departments Costs 1 2 3 Three methods are widely used to allocate the costs of support departments to operating departments: Direct allocation method Step-down method Reciprocal method 50 Direct Method Support Departments Production Departments Information Systems Manufacturing Packaging Accounting 51 Step-Down Method Support Departments Production Departments Information Systems Manufacturing Packaging Accounting 52 Reciprocal Method Support Departments Production Departments Information Systems Manufacturing Packaging Accounting 53 Allocating Common Costs Common Cost – the cost of operating a facility, activity, or like cost object that is shared by two or more users at a lower cost than the individual cost of the activity to each user Two methods for allocating common cost are: 1 Stand-alone cost-allocation method 2 Incremental cost-allocation method 54 Joint-Cost Basics Joint costs are the costs of a single production process that yields multiple products simultaneously. Industries abound in which a single production process simultaneously yields two or more products. 55 Joint Products and Byproducts Main Products Byproducts Joint Products High Low Sales Value 56 Approaches to Allocating Joint Costs The two basic approaches to allocating joint costs are: Approach 1: Allocate costs using marketbased data such as revenues. Approach 2: Allocate costs in some physical measure-based data such as weight or volume. 57 Allocating Joint Costs Approach 1: The sales value at splitoff method The estimated net realizable value (NRV) method The constant gross-margin percentage NRV method 58 Constant Gross-Margin Percentage NRV Method Step 1: Compute the overall gross-margin percentage. Step 2: Use the overall gross-margin percentage and deduct the gross margin from the final sales values to obtain the total costs that each product should bear. Step 3: Deduct the expected separable costs from the total costs to obtain the joint59 cost allocation. Comparison of Methods – – – – Why is the sales value at splitoff method widely used? It is objective. It does not anticipate subsequent management decisions on further processing. It uses a meaningful common denominator. It is simple. 60 Irrelevance of Joint Costs for Decision Making No techniques for allocating joint-product costs should guide decisions about whether a product should be sold at the splitoff point or processed beyond splitoff. 61 Accounting for Byproducts Although byproducts have much lower sales value than do joint or main products, the presence of byproducts can affect the allocation of joint costs. Byproduct accounting methods differ on whether byproducts are recognized in the financial statements at the time of production or the time of sale. 62 Production Method Revenue Sales Method MP Only MP + BP COGS Total Cost – BP NRV EI (MP) COGS Total Cost EI COGS Total EI = EI (MP) + EI (BP) 63 Operation Costing Job-costing Systems Operation Costing Process-costing System Systems A hybrid costing system of customized manufacturing (job-order) and mass production (process) systems Produce batches of similar products with each batch being a variation of one design. 64 Operation Costing Materials Batch B Batch C Operation 3 Batch A Operation 2 The production system is a sequence of operations or processes that a product must go through. All products may not go through all of the processes Operation 1 Finished Goods Inventory 65 Accounting for Operation Costing Separate WIP for each operation (or process). As the product moves between operations, debit receiving operation's WIP, credit sending operation's WIP. Direct materials are traced directly to each batch (or order). Conversion costs are accumulated by operation. A single average conversion cost is then applied to units that go through the operation, regardless of which batch they belong to. 66 Spoilage, Rework and Scrap Terminology There are three types of costs that arise as a result of defects: 1 Spoilage (損壞品) 2 Rework (重製品) 3 Scrap (剩餘物資) Some amount of spoilage, rework, or scrap appears to be an inherent part of many production processes. 67 Abnormal Spoilage Abnormal spoilage costs are written off as losses of the accounting period in which detection of the spoiled units occurs. Companies record the units of abnormal spoilage and keep a separate Loss from Abnormal Spoilage account. 68 FIFO: Spoilage The FIFO method of process costing keeps costs in the beginning inventory separate from the costs in the current period when determining the costs of good units (which includes a normal spoilage amount) and the costs of abnormal spoilage. 69 Job Costing: Spoilage or Rework Normal spoilage or rework can be assigned to a specific job or, if common to all jobs, as part of manufacturing overhead. Abnormal spoilage or rework is written off as a cost of the period. 70 Recognizing Scrap Scrap, if material in dollar amount, is recognized in the accounting records either at the time of its sale or at the time of its production. Scrap, if immaterial, is often recognized as other revenues at time of sale. 71 Recognizing Material Scrap at Time of Sale Recognizing sale of scrap specific to Job #10: Cash or Accounts Receivable 300 Work-in-Process (Job #10) 300 Recognizing sale of scrap common to all jobs: Cash or Accounts Receivable 300 Manufacturing Overhead Control 300 72 Recognizing Material Scrap at Time of Production Recognizing scrap specific to Job #10 is returned to the storeroom: Materials Control 300 Work-in-Process (Job #10) 300 Recognizing scrap common to all jobs is returned to the storeroom: Materials Control 300 Manufacturing Overhead Control 300 73 Quality and Failure Actual Performance Design Specifications Conformance Quality Failure Customer Satisfaction Design Quality Failure 74 The Financial Perspective: Costs of Quality The costs of quality (COQ) refer to costs incurred to prevent, or costs arising as a result of, the production of a low-quality product. These costs focus on conformance quality and are incurred in all business functions of the value chain. 75 The Financial Perspective: Costs of Quality 1 2 Prevention costs--costs incurred in precluding the production of products that do not conform to specifications. Appraisal costs--costs incurred in detecting which of the individual units of products do not conform to specifications. 76 The Financial Perspective: Costs of Quality 3 4 Internal failure costs--costs incurred by a nonconforming product detected before it is shipped to customers. External failure costs--costs incurred by a nonconforming product detected after it is shipped to customers. 77 Cost of Quality Exclusions Opportunity Costs resulting from poor quality: 1. Contribution Margin and Income forgone from lost sales 2. Lower Prices Excluded due to estimation difficulties and being unrecorded as to the financial accounting records 78 Nonfinancial Measures Nonfinancial measures of customer-satisfaction Nonfinancial measures of internal performance Measures of learning and growth 79 Evaluating Quality Performance Advantages – – – of Financial COQ measures: Financial measures are helpful to evaluate tradeoffs among prevention costs, appraisal costs, and failure costs. Financial COQ measures assist in problem solving by comparing different quality-improvement programs and setting priorities for achieving maximum cost reduction. COQ provides a single, summary measure of quality performance. 80 Evaluating Quality Performance Advantages of nonfinancial measures of quality: – – Nonfinancial measures of quality are often easy to quantify and understand. Nonfinancial measures direct attention to physical processes and hence focus attention on the precise problem areas that need improvement. 81 Control Charts Defect Rate Production Line B m + 2s m+s m m-s m - 2s 1 2 3 4 5 6 7 8 9 10 Days 82 Number of Times Defect Observed Pareto Diagram 700 500 200 Copies are Copies are fuzzy and too unclear light/dark Paper gets jammed 83 Cause-and-Effect Diagrams Methods and Design Factors Human Factors Inadequate supervision Poor training New operator Flawed part design Incorrect manufacturing sequence Inadequate tools Incorrect speed Poor maintenance Multiple suppliers Incorrect specification Variation in purchased components Machine-related Factors Materials and Components Factors 84 Time as a Competitive Weapon Companies need to measure time in order to manage it properly. Two common operational measures of time are: 1 Customer-response time 2 On-time performance 85 Customer-Response Time Order is placed Order is received Order is set up Waiting Time Receipt Time Order is manufactured Order is delivered Mfg. Time Manufacturing Lead Time Delivery Time Customer-Response Time 86 Theory of Constraints The objective of TOC is to increase throughput contribution while decreasing investments and operating costs. TOC considers a short-run time horizon and assumes operating costs to be fixed costs. 87 Theory of Constraints The theory of constraints emphasizes the management of bottlenecks as the key to improving the performance of the production system as a whole. 88 Methods to Relieve Bottlenecks Eliminate idle time at the bottleneck operation Process only those parts or products that increase throughput contribution, not parts or products that will remain in finished goods or spare parts inventories Shift products that do not have to be made on the bottleneck operation to nonbottleneck processes, or to outside processing facilities 89 Methods to Relieve Bottlenecks Reduce setup time and processing time at bottleneck operations Improve the quality of parts or products manufactured at the bottleneck operation 90 Costs Associated with Goods for Sale 1 2 3 4 5 Five categories of costs associated with goods for sale are: Purchasing costs Ordering costs Carrying costs Stockout costs Quality costs 91 Economic-Order-Quantity Decision Model The formula for the EOQ model is: EOQ = 2 DP C D = Demand in units for a specified time period P = Relevant ordering costs per purchase order C = Relevant carrying costs of one unit in stock for the time period used for D 92 Considerations in Obtaining Estimates of Relevant Costs Obtaining accurate estimates of the cost parameters used in the EOQ decision model is a challenging task. What are the relevant incremental costs of carrying inventory? – Only those costs of the purchasing company that change with the quantity of inventory held 93 Considerations in Obtaining Estimates of Relevant Costs – – What is the relevant opportunity cost of capital? It is the return forgone by investing capital in inventory rather than elsewhere. It is calculated as the required rate of return multiplied by those costs per unit that vary with the number of units purchased and that are incurred at the time the units are received. 94 Economic-Order-Quantity Decision Model What are the relevant total costs? The formula for relevant total costs (RTC) is: RTC = Annual relevant ordering costs + Annual relevant carrying costs RTC = ( )×P+( ) D Q Q 2 DP QC ×C= + Q 2 Q can be any order quantity, not just EOQ. 95 Relevant Total Costs (Dollars) 10,000 Economic-Order-Quantity Decision Model 8,000 Annual relevant total costs 6,000 5,434 Annual relevant ordering costs 4,000 2,000 Annual relevant carrying costs Order Quantity (Units) 600 988 1,200 EOQ 1,800 96 2,400 Reorder Point 988 Reorder Point Reorder Point 494 Weeks 1 2 3 4 5 6 7 8 Lead Time 2 weeks 97 Safety Stock Safety stock is inventory held at all times regardless of the quantity of inventory ordered using the EOQ model. Safety stock is used as a buffer against unexpected increases in demand or lead time and unavailability of stock from suppliers. 98 Evaluating Managers and Goal-Congruence Issues Goal-congruence issues can arise when there is an inconsistency between the EOQ decision model and the model used to evaluate the performance of the manager implementing the inventory management decisions. 99 Materials Requirement Planning (MRP) Materials requirements planning (MRP) systems take a “push-through” approach that manufactures finished goods for inventory on the basis of demand forecasts. MRP predetermines the necessary outputs at each stage of production. Inventory management is a key challenge in an MRP system. 100 Just-In-Time Production Systems Just-in-time (JIT) production systems take a “demand pull” approach in which goods are only manufactured to satisfy customer orders. Demand triggers each step of the production process, starting with customer demand for a finished product at the end of the process, to the demand for direct materials at the beginning of the process. 101 Major Features of a JIT System 1 2 3 4 5 The five major features of a JIT system are: Organizing production in manufacturing cells Hiring and retaining multi-skilled workers Emphasizing total quality management Reducing manufacturing lead time and setup time Building strong supplier relationships 102 Benefits of JIT Systems – – Benefits of JIT production: Lower carrying costs of inventory Eliminating the root causes of rework, scrap, waste, and manufacturing lead time. 103 Performance Measures and Control in JIT Production To manage and reduce inventories, the management accountant must design performance measures to control and evaluate JIT production. What information may management accountants use? – – Personal observation by production line workers and managers Financial performance measures, such as inventory turnover ratios 104 Performance Measures and Control in JIT Production What are nonfinancial performance measures of time, inventory, and quality? – – – – – Manufacturing lead time Units produced per hour Days’ inventory on hand Total setup time for machines/Total manufacturing time Number of units requiring rework or scrap/Total number of units started and completed 105 Backflush Costing A unique production system such as JIT often leads to its own unique costing system. Organizing manufacturing in cells, reducing defects and manufacturing lead time, and ensuring timely delivery of materials enables purchasing, production, and sales to occur in quick succession with minimal inventories. 106 Backflush Costing Where journal entries for one or more stages in the cycle are omitted, the journal entries for a subsequent stage use normal or standard costs to work backward to flush out the costs in the cycle for which journal entries were not made. 107 Trigger Points Stage A: Purchase of direct materials Stage B: Production resulting in work in process Stage C: Completion of a good finished unit or product Stage D: Sale of finished goods 108 Trigger Points Assume trigger points A, C, and D. This company would have two inventory accounts: Type Combined materials and materials in work-inprocess inventory Account Title 1. Inventory: Material and In-Process Control 2. Finished goods Finished Goods Control 109 Trigger Points Assume trigger points A and D. This company would have one inventory account: Type Account Title Combines direct materials Inventory inventory and any direct Control materials in work-in-process and finished goods inventories 110 Special Considerations in Backflush Costing Backflush costing does not necessarily comply with GAAP – However, inventory levels may be immaterial, negating the necessity for compliance Backflush costing does not leave a good audit trail – the ability of the accounting system to pinpoint the uses of resources at each step of the production process 111
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