CHAPTER 1: COST CONCEPTS AND CLASSIFICATION
(LECTURE 2)
COST AND COST OBJECT
o
o
o
o
A cost is a resource sacrificed or forgone to achieve a specific objective, such as obtaining
revenue.
A budgeted cost is a forecasted future expense that the company is expected to incur in the
future. In other words, it's an estimated expense that management anticipates will be
incurred in a future period based on projected revenues and sales.
An actual cost is the amount of money that was paid to acquire a product or asset. This cost
could be either a historical, past, or present day cost of the product or asset.
A cost object is anything for which costs are being separately measured. It is often a product,
process, department, or customer that costs originate from or are associated with. In other
words, it’s something that costs can be identified with and traced back to.
 Examples: a product is the cost object for direct materials, direct labor and
manufacturing overhead. The factory maintenance department is a cost object for
the cost of the maintenance employees and the maintenance supplies.
DIRECT AND INDIRECT COSTS
Costs assigned to cost objects can be divided into 2 categories:
o
o
Direct costs are expenses that can be accurately traced back to a cost object like a product,
production process, department, or customer.
 Example: the cost of materials to produce a tire.
Indirect costs are expenses that cannot be traced back to a single cost object or cost source.
This calls for a cost allocation system.
 Example: the cost of the electricity used while manufacturing the tire.
VARIABLE AND FIXED COSTS
o Cost behavior: How costs respond to a change in activity level within the relevant range.
o Relevant range: The relevant range of operations is the normal or average scope of business
activities. In the other words, the relevant range of operations is the average volume of sales
and production that a business experiences.
o A fixed cost is an expense that does not change as production volume increases or decreases
within a relevant range. In other words, fixed costs are locked in place as long as operations
stay within a certain size.
o Variable costs are production costs that change in proportion to the amount of goods that
are produced. In other words, for every good that is produced, variable costs increase by the
same amount.
o Semi-variable costs are costs that have both fixed and variable components and are also
known as mixed costs.
o
A cost driver is any factor which causes a change in the cost of an activity.
PERIOD AND PRODUCT COSTS
o
o
Product costs are expenses that are associated with goods purchased or produced for sale.
They are included in inventory evaluation when the cost is incurred and, when sold, they are
recorded as expenses and matched against sales.
 Example: direct materials, direct labor, and factory overhead.
Period costs are expenses that are easier to attribute to times and accounting periods than
actual production processes or finished goods. They are not included in inventory evaluation.
Period costs are all costs in the income statement other than costs of goods sold.
 Example: advertising and administrative expenses.
PRIME COST AND CONVERSION COST
o
o
A prime cost is an expenditure that directly relates to the production of finished goods.
Prime costs consist of direct materials and direct labor. Direct materials include all tangible
components of a product. Direct labor includes the wages paid to employees who produce
finished products.
A conversion cost is the amount incurred during the transformation of raw materials into
finished goods. Conversion costs consist of overhead costs and direct labor. Overhead costs
are expenses used to produce products that can’t be attributed directly to a production
process. Direct labor is the cost associated with workers who actively produce products.
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FLOW OF COSTS
Manufacturing companies typically have 3 types of inventory: Direct materials inventory, Work in
process inventory and Finished goods inventory.
See lecture 2 slides 63 – 82.
PRESENTATION OF COSTS
See summarizing example exercise on slides 93 – 97 of lecture 2.
2
CHAPTER 2: JOB ORDER COSTING (LECTURE 3)
TYPES OF PRODUCT COSTING SYSTEMS
o
Process cost accounting system
A process cost accounting system is a method of assigning direct materials, direct labor, and
factory overhead expenses to specific processes, departments, or cost objects in an effort to
value finished goods inventory. In other words, this is a systematic way to allocate all
conversion and prime costs to a process.
The process cost accounting system looks at the different steps in each process and allocates
costs to them. After all the expenses are identified, they are added up to equal the finished
goods cost and divided by the number of units that we produced in the process to get the
cost per equivalent unit. This is allowed because the products made in a process are all
identical to each other so that we can assign the same average cost per unit.
o
Job order cost accounting system
A job order cost accounting system uses job cost sheets (a record of all expenses relating to
a single job), material cost flow documents, labor cost flow documents, and overhead cost
flow documents to track the production expenses of producing a job. In other words, a job
order cost accounting system tracks each and every expenditure the company makes in
order to manufacture an order.
Most manufacturers produce many different products. Each of these products requires a
slightly different production process. The unique nature of each order requires tracing or
allocating costs to each job, and maintaining cost records for each job.
 Direct material and direct labor costs are charged to each job as work is performed.
 Manufacturing overhead costs (including indirect materials costs and indirect labor
costs) are allocated to all jobs rather than directly traced to each job.
THE JOB COST SHEET
A job cost sheet is a record of all direct and indirect costs incurred for a single given job. A job
number uniquely identifies each job. Companies that use a job order cost accounting system try to
segregate costs by job to see how much each product or job costs to make. In other words, they
want to know what the unit price is per product produced. In order to figure out how much each unit
costs to produce, the company has to track the work that was done to each product before it was
completed.
The costs for the job are recorded on the sheet during the production process. This usually happens
in three categories: direct materials, direct labor, and manufacturing overhead. As soon as a
supervisor incurs a costs, he or she records it on the job cost sheet.
3
Measuring direct materials cost
Once a sales order has been received and a
production order issued, the Production
Department prepares a materials requisition form
to specify the type, quantity, unit cost and total cost
of materials needed for the job. A materials
requisition form is a source document that the
production department uses to request direct and
indirect materials for the manufacturing process.
Indirect material costs are included in the
manufacturing overhead.
Once the materials have been issued, they are charged to the job cost sheet for the specified job
number.
Measuring direct labor costs
Direct labor costs are measured using employee
time tickets. A time ticket or time card is the
document used to record the amount of hours an
employee worked on a specific job. It includes the
starting time, ending time, hourly rate, total amount
and job number.
Any labor charges that are not directly traceable to
a particular job are known as indirect labor cost.
Indirect labor is not included in direct labor cost and
becomes a part of the manufacturing overhead.
The Accounting Department records the labor costs from each time ticket onto the job cost sheet.
Manufacturing Overhead Application
Manufacturing costs other than direct materials and direct labor are known as manufacturing
overhead (also known as factory overhead). It usually consists of both variable and fixed
components. Examples of manufacturing overhead cost include indirect materials, indirect labor,
depreciation, salary of production manager, property taxes, fuel, electricity, grease used in machines,
insurance etc.
Unlike direct materials and direct labor, manufacturing overhead is an indirect cost that cannot be
directly assigned to each individual job. This problem is solved by using a rate that is computed at
the beginning of each period. This rate is known as the predetermined overhead rate (POHR).
The predetermined overhead rate is computed at the beginning of the period and is used to apply
manufacturing overhead cost to jobs throughout the period.
𝑃𝑂𝐻𝑅 =
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜𝑡𝑎𝑙 𝑚𝑎𝑛𝑢𝑓𝑎𝑐𝑡𝑢𝑟𝑖𝑛𝑔 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑐𝑜𝑠𝑡 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑐𝑜𝑚𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜𝑡𝑎𝑙 𝑢𝑛𝑖𝑡𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑎𝑙𝑙𝑜𝑐𝑎𝑡𝑖𝑜𝑛 𝑏𝑎𝑠𝑒 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑐𝑜𝑚𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑
4
The allocation base for determining the POHR can for example be the direct labor hours, the direct
labor dollars or the machine hours.
Predetermined overhead rates that rely upon estimated data are often used because actual
overhead costs for the period are not known until the end of the period, thus inhibiting the ability to
estimate job costs during the period.
Manufacturing overhead cost is applied to jobs as follows:
𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑎𝑝𝑝𝑙𝑖𝑒𝑑 = 𝑃𝑂𝐻𝑅 × 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑙𝑙𝑜𝑐𝑎𝑡𝑖𝑜𝑛 𝑏𝑎𝑠𝑒 𝑖𝑛𝑐𝑢𝑟𝑟𝑒𝑑 𝑏𝑦 𝑡ℎ𝑒 𝑗𝑜𝑏
If we estimate the total manufacturing overhead
cost for the coming period to be $640,000 and
choose direct labor hours as the allocation base with
an estimate of 160,000 hours in the coming period,
$640,000
the POHR will be: 𝑃𝑂𝐻𝑅 = 160,000 ℎ𝑜𝑢𝑟𝑠 = $4.00
per direct labor hour. This means that for each
direct labor hour worked on a particular job, $4.00
of factory overhead will be applied to that job.
Finally, the direct material cost, direct labor cost and
manufacturing overhead cost are summed to reveal
the total cost of the job. This total cost is then
divided by the number of units produced in the job
to give the average unit production cost.
Interpreting the average unit cost: The average unit
cost should not be interpreted as the costs that
would actually be incurred if an additional unit were
produced. Fixed overhead would not change if
another unit were produced, so the incremental cost of another unit may be a bit less than $118.
JOB ORDER COST FLOW
1. When raw materials are purchased they are debited to the raw materials inventory account
and credited to accounts payable.
2. The cost of direct materials is debited to Work in Process and added to the job cost sheet
and credited to the Raw Materials account.
3. Indirect materials are removed from raw materials inventory with a credit and debited to the
manufacturing overhead account.
4. Direct labor is debited to Work in Process and added to the job cost sheet and credited to
salaries and wages payable.
5
5. Indirect labor is debited to Manufacturing Overhead and credited to salaries and wages
payable.
6. Additional manufacturing overhead amounts are debited to the manufacturing overhead
account. The debit side of the manufacturing overhead account represents actual overhead
incurred during the period.
7. When we apply overhead to a particular job, we debit work in process inventory, add it to
the job cost sheet and credit the manufacturing overhead account. Amounts on the credit
side of the manufacturing overhead account represent overhead applied.
It is not likely that actual and applied overhead will be equal during a period. We normally
make an adjusting entry at the end of the period to reconcile actual and applied overhead.
8. As jobs are completed, the Cost of Goods Manufactured is transferred from Work in Process
to Finished Goods Inventory.
9. When a finished job is sold to the customer, the cost of that job is transferred from Finished
Goods Inventory to Cost of Goods Sold. Recall that cost of goods sold is an income statement
account. If only a portion of the units associated with a particular job are shipped, then the
unit cost figure from the job cost sheet is used to determine the amount of the journal entry.
When finished goods are sold, two entries are required one to record the sale and one to
record Costs of Goods Sold and reduce Finished Goods Inventory.
See slides 37 – 52 of lecture 3 for the journal entries associated with these cost flows.
6
OVERAPPLIED AND UNDERAPPLIED OVERHEAD
The difference between the overhead cost applied to Work in Process and the actual overhead costs
of a period is referred to as either underapplied or overapplied overhead.
o
Underapplied overhead exists when the amount of overhead applied to jobs during the
period using the predetermined overhead rate is less than the total amount of overhead
actually incurred during the period.
o
Overapplied overhead exists when the amount of overhead applied to jobs during the
period using the predetermined overhead rate is greater than the total amount of overhead
actually incurred during the period.
The actual applied overhead for jobs during a period is computed via following formula:
𝑇𝑜𝑡𝑎𝑙 𝑎𝑝𝑝𝑙𝑖𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑎 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝑃𝑂𝐻𝑅 × 𝑎𝑐𝑡𝑢𝑎𝑙 𝑢𝑛𝑖𝑡𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑎𝑙𝑙𝑜𝑐𝑎𝑡𝑖𝑜𝑛 𝑏𝑎𝑠𝑒
With the estimations made in the previous example, we found the POHR to be $4.00 per direct labor
hour. At the end of the period, management finds the actual incurred overhead for the period to be
$650,000 and the actual direct labor hours worked on jobs was found to be 170,000 hours. This
means that, for the period, the 𝑎𝑝𝑝𝑙𝑖𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 = $4.00 × 170,000 = $680,000. However, the
actual incurred overhead only amounted to $650,000. This means the company has overapplied
overhead by $680,000 − $650,000 = $30,000. Thus the Manufacturing overhead account has a
$30,000 credit balance.
This $30,000 may be allocated to either one of the following accounts: Work in Process, Finished
Goods or Cost of Goods Sold. Let’s say we choose to adjust the Cost of Goods Sold. Then we need to
make the following adjustments:
At the end of the year, we need to debit the manufacturing overhead account for $30,000, and
credit, or reduce, cost of goods sold by the same amount.
Summary:
7
CHAPTER 3: PROCESS COSTING (LECTURE 4)
THE NATURE OF PROCESS COST ACCOUNTING SYSTEMS
The process cost accounting system is a costing method that is used to calculate the unit costs for the
finished goods at the end of a large production process. In contrast to the job order cost accounting
system, there exist no individual or separate orders and so no individual allocation of costs to a job is
required. Any costs incurred is due to the whole production process and so all the costs make part of
the end product.
The system looks at the different steps in each process and allocates costs to them. After all the
expenses are identified, they are added up to equal the cost of finished goods and divided by the
number of units that we produced in the process to get the cost per equivalent unit. As such, process
cost accounting systems are used when a large volume of identical or fairly similar products are
manufactured.
JOB ORDER VERSUS PROCESS COST SYSTEMS
Similarities
o
o
o
The cost elements: Both job order costing and process costing systems are used to allocate
expenses like direct material, direct labor and manufacturing overhead to the end products
of a manufacturing process.
The accumulation of the costs: Both systems accumulate costs by debiting Raw Materials
Inventory, Factory Labor, and Manufacturing Overhead accounts.
The flow of costs: Both systems assign costs to Work in Process, Finished Goods, and Cost of
Goods Sold. The method of assigning costs is significantly different, however.
Differences
o
o
o
o
The number of work in process accounts used: A job order cost system uses only one Work
In Process (WIP) account for each job. Process cost systems use a separate work in process
account for each production department or manufacturing process.
Documents used to track costs: In a job order cost system, costs are charged to individual
jobs and summarized on a job cost sheet. In a process cost system, costs are summarized in a
production cost report for each department.
The point at which costs are totaled: In job order cost system, total costs are often
determined when the job is completed. In a process cost system, total costs are determined
at the end of a period of time, such as a month or year.
Unit cost computations: In a job order cost system, the unit cost is the total cost per job
divided by the units produced. In a process cost system, the unit cost is total manufacturing
costs for the period divided by the units produced during the period.
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THE COST FLOW AND JOURNAL ENTRIES IN PROCESS COSTING SYSTEM
As indicated earlier, the accumulation of the costs of materials, labor, and manufacturing overhead is
the same in a process cost system as in a job order cost system. However, unlike job order costing
systems in which materials, labor and overhead costs are traced to a large number of individual jobs,
the process costing system traces costs to only a few processing departments.
o
o
o
All raw materials are debited to Raw Materials when purchased.
All factory labor is debited to Factory Labor when the labor costs are incurred.
Overhead costs are debited to Manufacturing Overhead as they are incurred.
The assignment of the three cost elements to Work in Process in a process cost system is different
from a job order system. In process costing system, a separate work in process account is
maintained for each department. The cost flows in parallel to the flow of physical units. When the
processing work in a department is completed, the units along with their cost are transferred to the
next department to be undergone for further processing.
Material costs
In a process cost system, fewer materials requisition forms are usually required than in a job order
cost system, since materials are used for processes rather than for specific jobs. Materials are usually
added to production at the beginning of the first process. However, in subsequent processes, other
materials may be added at various points.
Labor costs
The labor costs in a process costing system are traced to processing departments rather than
individual jobs. Time tickets may still be used, however, since labor costs are assigned to a process
rather than a job, the labor cost chargeable to a process can alternatively be obtained from the
payroll register or departmental payroll summaries.
Manufacturing overhead
Like job order costing, the process costing system usually uses predetermined overhead rates to
apply manufacturing overhead costs. A separate predetermined overhead rate is computed for each
processing department and applied to production as the units move through the department.
Because a primary driver of overhead costs in continuous manufacturing operations is the machine
time used, machine hours are widely used in allocating manufacturing overhead costs.
Transfer of cost and completion of cost flow
Upon completion of processing in a department, the units and their cost are transferred to the next
department where partially completed units are further processed.
When units are completed, they become finished goods and the total cost of completed units would
be transferred from the last processing department to Finished Goods Inventory account.
When goods are sold to a customer, the cost of units sold would be transferred from Finished Goods
Inventory account to Cost of Goods Sold account.
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Summary:
EQUIVALENT UNITS OF PRODUCTION
The equivalent units may be defined as the partially complete units expressed in terms of fully
complete units.
The processing departments often have partially complete units in ending inventory. In order to
compute the per unit cost of a department, we need to determine the total output of that
department. As the partially complete units cannot be considered as fully complete units for the
purpose of determining the department’s total output and per unit cost for a particular period, it is
convenient to mathematically convert those units into a smaller number of fully complete units.
Equivalent units = Number of partially completed units × Percentage of completion
The total output of a department during a particular period of time is called the equivalent units of
production. There are two methods for computing equivalent units of production – the weighted
average method and the FIFO method. Only the weighted average method will be discussed in this
course.
Weighted average method of equivalent units of production
Under the weighted average method, the equivalents units of production in a department are equal
to the units completed and transferred out plus the equivalent units in ending work in process
inventory.
Equivalent units of production = Completed units + Equivalent units
Treatment of Direct Labor
Direct labor costs may be small in comparison to other product costs in process cost systems. In this
case, direct labor costs and manufacturing overhead may be combined into one classification of
product cost called conversion costs.
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When materials are not added evenly throughout the processing (such as when all materials are
added at the beginning of a process), work in process will have different completion percentages at
the end of the period for materials and conversion costs. Two equivalent unit computations will
then be needed, one for the material costs and one for the conversion costs.
Example:
COST OF PRODUCTION REPORT (CPR)
The cost of production report (CPR) is a document used in process costing systems that summarizes
the information about the flow of units and costs through the work in process account of a
processing department. It is equal to the job cost sheet prepared in a job order costing system. A
separate cost of production report is prepared for each processing department.
The cost of production report is considered a key management document because it provides
managers with the following crucial information about production and cost of a processing
department:
o
o
o
o
o
o
The number of units transferred in and transferred out by a department during the period.
The per unit processing cost incurred by a processing department. It includes total per unit
cost (i.e., total cost incurred divided by total output) as well as per unit cost for individual
cost elements like direct materials, direct labor, and manufacturing overhead.
The highest production cost among materials, labor and manufacturing overhead.
The impact of a recent improvement in production process on per unit cost in a processing
department.
A significant change in per unit cost due to unexpected change in one or more cost elements
like direct materials, direct labor and manufacturing overhead.
The hurdles or limiting factors present in one or more processing departments that could
potentially disturb the overall output efficiency of the firm.
SECTIONS OF A COST OF PRODUCTION REPORT
A cost of production report consists of the following three sections:
o
o
o
Quantity schedule section
Cost per equivalent unit section
Cost reconciliation section
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Quantity schedule section
Quantity schedule is the first section of a cost of production report. This section summarizes the flow
of physical units through the relevant processing department and shows the equivalent units for
materials and conversion costs. The percentage of completion of any units in work in process
beginning and ending inventory is also shown in this section. The quantity schedule also guides in
preparing the other two sections of the cost of production report.
Cost per equivalent unit section
In this section, the cost per equivalent unit is computed. Under the weighted average method, this
is done by dividing the total of beginning inventory cost and cost added during the period by the
equivalent units of production computed under the weighted average method.
Cost reconciliation section
In this section, the cost charged to the department is reconciled or accounted for. Usually, the total
cost charged to a department consists of the following:
o
o
o
Cost of beginning work in process inventory
Materials, labor overhead costs incurred by the department during current period
Cost transferred in from preceding department during the period
The total of above costs is accounted for by computing the following amounts:
o
o
Cost of units transferred to the next department or finished goods storeroom.
Cost in ending work in process inventory.
See slides 48 – 70 of lecture 4 for a comprehensive example of the process costing system and a
step-by-step elaboration of a cost of process report.
Example
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13
CHAPTER 4: ACTIVITY BASED COSTING (LECTURE 5)
INTRODUCTION TO ACTIVITY BASED COSTING
Traditional costing systems allocate overhead using a single predetermined overhead rate. In job
order costing, direct labor cost is assumed to be the relevant allocation base. In process costing,
machine hours is the relevant allocation base. However, complex manufacturing processes may
require multiple allocation bases. This calls for a new costing approach, thus introducing Activity
Based Costing.
Activity Based Costing (ABC) is a methodology for more precisely allocating overhead costs by
assigning them to activities. Once costs are assigned to activities, then the costs can be assigned to
the cost objects that use those activities, in this case the products that are actually demanding the
activities. The system can be employed for the targeted reduction of overhead costs. ABC works best
in complex environments, where there are many machines and products, and tangled processes that
are not easy to sort out.
Traditional product costing:
Costs
Consumed by
Products
Activity based costing:
Costs
Consumed by
Activities
Consumed by
Products
Unlike traditional cost measurement systems that depend on volume count, such as machine hours
and/or direct labor hours to allocate indirect or overhead costs to products, the ABC system classifies
at least 4 broad levels of activity that are, to a certain extent, unrelated to how many units are
produced.
o
o
o
Unit level: Activities on the unit level are performed for each unit of product produced and
sold.
 Examples: cost of raw materials, cost of inserting a component, utilities cost of
operating equipment, some costs of packaging, sales commissions.
Batch level: Activities on the batch level are performed for each batch of product produced
and sold.
 Examples: cost of processing sales order, cost of issuing and tracking work order, cost
of equipment setup, cost of moving batch between workstations, cost of inspection
Product level: Activities on the product level are performed to support each different
product that can be produced.
 Examples: cost of product development, cost of product marketing, such as
advertising, cost of specialized equipment, cost of maintaining specialized equipment
14
o
Facility level: Activities on the facility level are performed to maintain general manufacturing
capabilities.
o Examples: cost of maintaining general facilities, cost of non-specialized equipment,
cost of maintaining non-specialized equipment, cost of real property taxes, cost of
general advertising, cost of general administration
THE ACTIVITY BASED COSTING PROCESS FLOW
To successfully implement an Activity Based Costing system, following steps need to be followed.
1. Identify all the activities required to create the product. An activity is an event that causes
the consumption of overhead resources. As such, it can also be useful to identify those costs
that we want to allocate.
2. Divide the activities into activity cost pools and identify the activity measures. These activity
cost pools include all the individual costs related to an activity. It is some sort of “cost
bucket” in which costs related to a single activity measure are accumulated. It is very
common to have separate cost pools for each product line, since costs tend to occur at this
level.
An activity measure (also called cost driver/activity driver) is any factor or activity that has a
direct cause-effect relationship with the resources consumed. There are 2 common types of
activity measures:
o Transaction drivers: involves counting how many times an activity occurs.
o Duration drivers: measure how long an activity takes to complete.
3. Assign the proper activity measures to each activity cost pool.
4. Calculate the total overhead of each cost pool.
5. Calculate the cost driver rate. This is done by dividing the total overhead cost in each cost
pool by the total amount of activity in the activity measure of that cost pool. This way, we
have calculated the cost per unit of activity.
6. Assign the overhead costs to products. Finally, by multiplying the cost driver rate with the
amount of an activity measure that a product used, the cost per unit is computed.
7. Convert the results into reports for management consumption.
See slides 28 – 70 of lecture 5 for a comprehensive step-by-step example of the Activity Based
Costing system and a comparison with a traditional costing system. The same example was also
handed out on paper during the lecture.
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DIFFERENCES BETWEEN ABC AND TRADITIONAL COSTING SYSTEMS
From the example mentioned above, it is clear that the traditional cost system overcosts one product
and thus reports a lower product margin for this product, while undercosting another product and
thus reporting a higher product margin for that product.
There are three reasons why the reported product margins for the two costing systems differ from
one another.
o
Traditional costing allocates all manufacturing overhead to products. ABC costing only
assigns manufacturing overhead costs consumed by products to those products.
o
Traditional costing allocates all manufacturing overhead costs using a volume-related
allocation base. ABC costing also uses non-volume related allocation bases.
o
Traditional costing disregards selling and administrative expenses because they are assumed
to be period expenses. ABC costing directly traces shipping costs to products and includes
nonmanufacturing overhead costs caused by products in the activity cost pools that are
assigned to products.
ACTIVITY BASED COSTING AND EXTERNAL REPORTING
Most companies do not use ABC for external reporting because:
o
o
o
o
External reports are less detailed than internal reports.
It may be difficult to make changes to the company’s accounting system.
ABC does not conform to GAAP.
Auditors may be suspect of the subjective allocation process based on interviews with
employees.
LIMITATIONS OF ACTIVITY BASED COSTING
o
o
o
o
o
Substantial resources required to implement and maintain.
Desire to fully allocate all costs to products.
Resistance to unfamiliar numbers and reports.
Potential misinterpretation of unfamiliar numbers.
Does not conform to GAAP so two costing systems may be needed.
See slides 67 – 75 and 76 – 80 of lecture 5 for 2 more examples comparing the Activity Based
Costing system with a traditional costing system.
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CHAPTER 5: ACTIVITY BASED MANAGEMENT AND
RESPONSIBILITY ACCOUNTING (LECTURE 6)
ACTIVITY BASED MANAGEMENT
Activity Based Management (ABM) is a system for determining the profitability of every aspect of a
business. Management uses past production activities and costs as a benchmark to adjust current
activities as well as current company goals. This way, the company’s strengths can be enhanced and
its weaknesses can either be improved or eliminated altogether. The information used in Activity
Based Management analysis is derived from the Activity Based Costing system.
Several examples of how ABM can be used are:
o
o
o
To determine the total profitability of a customer, based on its purchases, sales returns, and
use of the time of the customer service department.
To determine the total profitability of a new product, based on its sales, warranty claims,
and repair time required for returned goods.
To determine the total profitability of the R&D department, based on the funds invested
and outcome of new products developed.
The information derived from an ABM analysis can also be carried forward into a company's
forecasting models and budgets, which gives management a better idea of the future prospects of
the business.
ABC AND ABM
Activity Based Costing seeks to identify and reduce cost drivers by optimizing resources. It does this
by:
o providing an improved understanding of the way resources are used in the current processes
o measuring product costs more accurately by analyzing costs associated with identified
activities in the processes
Activity Based Management focuses on business processes and managerial activities driving
organizational business goals by:
o identifying value-added and non-value added activities;
o identifying the customer-perceived value of each activity;
o identifying opportunities to enhance value-added activities and reduce or eliminate nonvalue-added activities.
PROCESS VALUE ANALYSIS
Process Value Analysis (PVA) is the examination of an internal process that businesses undertake to
determine if it can be streamlined. Process value analysis involves a review of each step in a process
to see if the activity provides value to the customer. If the activity does not provide value, the
analysis team looks for ways to eliminate it from the process. By going through a comprehensive
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process value analysis, a business can strip costs out of the organization while also shortening the
duration of the process. When the incurred expenses and length of a process are reduced,
customers experience a shorter turnaround time for their orders and can acquire them at a lower
cost, which increases customer satisfaction levels.
Process value analysis is concerned with:
o
o
o
Driver analysis
Activity analysis
Activity performance measurement
Activity analysis and activity performance measurement
Activity analysis is the process of identifying, describing, and evaluating the activities (a selected area
of) an organization performs. This analysis can then be used to improve the effectiveness and
efficiency of operations. Activity analysis should produce 6 outcomes:
o
o
o
o
o
o
Which process steps are being executed
Which personnel are involved with each step
The amount of time required to complete each step
The amount of resources consumed by each step
Which process steps should be measured and which measurements to use
The value produced by each step
Driver analysis
Activity driver analysis involves reviewing the activity drivers built into an Activity Based Costing
system. The intent of the analysis is to evaluate the following:
o
o
o
Whether there is an actual causal relationship between the drivers and their associated cost
objects.
Whether different drivers can be used, for which data accumulation is easier and/or less
expensive.
Whether costs can be reduced by minimizing certain activities.
THE IMPORTANCE OF CUSTOMER-PERCEIVED VALUE
Customer-perceived value is the customers' evaluation of the merits of a product or service. It may
have little or nothing to do with the product's market price, and depends on the product's ability to
satisfy his or her needs or requirements.
The activities a company perform consume resources to produce goods or create services for their
customers.
o
o
Value-added activities enhance the value of products and services in the eyes of the
customer while meeting the goals of the organization.
Non-value-added activities do not contribute to customer-perceived value.
Side-note: Activities needed to comply with the reporting requirements, such as the SEC (Securities
and Exchange Commission), are value-added by a mandate.
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NON-VALUE-ADDED ACTIVITIES
A non-value-added activity is an action taken that does not increase the value of what is delivered to
the customer. Some likely sources of non-value-added activities are:
o
o
o
o
o
producing defective products;
producing to build up inventory;
time and effort to move products from place to place;
waiting time for processing;
transporting workers to work sites.
It is important that companies try to eliminate non-value-added activities for 2 reasons:
o
o
The elimination of these activities reduce costs while at the same time increasing the speed
of processes. The organization can then apply these freed-up resources to value-added
activities or distribute them to the owners and employees of the organization.
Competitors are also constantly striving to create more value for customers at lower cost. So
in order to stay in the race, non-value-added activities need to be eliminated.
IDENTIFYING VALUE-ADDED AND NON-VALUE-ADDED ACTIVITIES
REDUCING COSTS
Activity Based Management reduces costs in 4 ways:
o
o
o
o
Activity elimination: focuses on non-value-added activities.
Activity reduction: decreases the time and resources required by an activity.
Activity selection: involves choosing among different sets of activities that are caused by
competing strategies.
Activity sharing: increases the efficiency of necessary activities by using economies of scale.
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CHAPTER 6: COST-VOLUME-PROFIT RELATIONSHIPS
(LECTURE 7)
WHAT IS COST-VOLUME-PROFIT ANALYSIS?
The Cost Volume Profit analysis (CVP) is a method designed to show how changes in costs, product
margins, selling prices and unit volumes impact the profitability of a business. The cost-volumeprofit analysis, also commonly known as break-even analysis, looks to determine the break-even
point for different sales volumes and cost structures, which can be useful for managers making shortterm economic decisions. This is a key concept because it shows management that the revenue from
a project will be able to cover all the costs associated with it.
The cost-volume-profit analysis makes several assumptions:
o Selling price is constant
o Costs are linear and can be accurately divided into variable (constant per unit) and fixed
(constant in total) costs
o In multiproduct companies, the sales mix is constant
o In manufacturing companies, inventories do not change (units produced = units sold)
CONTRIBUTION MARGIN
The contribution margin (CM) is equal to sales revenue less total variable expenses incurred to earn
that revenue. Total variable expenses include both manufacturing and non-manufacturing variable
expenses. It is the amount by which an item contributes towards covering fixed costs. Any remaining
contribution margin contributes to the net operating income of the business.
𝐶𝑀 = 𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 – 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠
𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒 = 𝐶𝑀 − 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
So if the contribution margin is larger than the fixed costs, the company’s net operating income is
positive and they make profit. If the contribution margin is smaller than the fixed costs, the
company records a loss.
The contribution margin can be computed for a single product, multiple products together, a
particular profit center (a unit of a business that is responsible for generating revenue for the
business) and the business as a whole depending on the need of the management. It can also be
computed on a per unit basis. The unit contribution margin (unit CM) is defined as the sale price per
unit less the variable cost per unit.
𝑈𝑛𝑖𝑡 𝐶𝑀 = 𝑆𝑎𝑙𝑒 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
Finally, the contribution margin ratio (CM ratio) is given by dividing the contribution margin by total
sales. It tells what percentage of sales revenue is available to cover fixed cost and generate profit.
𝐶𝑀 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑀
𝑈𝑛𝑖𝑡 𝐶𝑀
=
𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢 𝑆𝑎𝑙𝑒 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
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BREAK-EVEN POINT ANALYSIS
The contribution margin is used in the
determination of the break-even point of
sales. The break-even point gives the sales
volume at which total revenue for a
product equals total expenses or, put
differently, it is the level of sales at which
profit is zero.
The break-even point of sales can give
either the volume of sales needed to
operate at the break-even point or the
total sales revenue needed to operate at
the break-even point depending on what
formula is used.
To calculate the volume of sales needed to operate at the break-even point, following formula may
be used:
𝐵𝑟𝑒𝑎𝑘 𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 =
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝑈𝑛𝑖𝑡 𝐶𝑀
To calculate the total sales revenue needed to operate at the break-even point, following formula
may be used:
𝐵𝑟𝑒𝑎𝑘 𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 =
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝐶𝑀 𝑟𝑎𝑡𝑖𝑜
The estimated profit at a particular sales volume can also be calculated by simply multiplying the
number of units sold above the break-even point by the unit contribution margin.
𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒 = # 𝑢𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑 𝑎𝑏𝑜𝑣𝑒 𝑏𝑟𝑒𝑎𝑘 𝑒𝑣𝑒𝑛 × 𝑈𝑛𝑖𝑡 𝐶𝑀
Other ways to calculate the net operating income are:
𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒 = 𝐶𝑀 − 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
= 𝑈𝑛𝑖𝑡 𝐶𝑀 × 𝑈𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑 − 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
= 𝐶𝑀 𝑟𝑎𝑡𝑖𝑜 × 𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
See slides 38 – 48 of lecture 7 for examples of the impact of changes in variable costs, fixed costs,
selling price, and volume on the net operating income. These examples were also handed out
during the lecture.
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TARGET PROFIT ANALYSIS
Target profit is the expected amount of profit that the managers of a business expect to achieve by
the end of a designated accounting period. Target profit analysis is about finding out the estimated
business activities needed to perform to earn a target profit during a certain period of time. Among
these activities, management is especially interested to find out the sales volume required to
generate a target profit.
To calculate the sales volume required to generate a predetermined target profit, we start from an
equation for calculating the net operating income that was already shown in the previous section.
𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒 = 𝑈𝑛𝑖𝑡 𝐶𝑀 × 𝑈𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑 − 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
Realizing that the net operating income can be seen as the target profit that has to be achieved, this
formula becomes:
𝑇𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑈𝑛𝑖𝑡 𝐶𝑀 × 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 𝑣𝑜𝑙𝑢𝑚𝑒 − 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
Finally, solving for the required sales volume gives:
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 𝑣𝑜𝑙𝑢𝑚𝑒 =
𝑇𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 + 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝑈𝑛𝑖𝑡 𝐶𝑀
It is also possible to compute the required total sales revenue to generate the predetermined target
profit. In this case, we start form the following equation also already shown in the previous section.
𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒 = 𝐶𝑀 𝑟𝑎𝑡𝑖𝑜 × 𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
Solving for the required total sales revenue gives:
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 =
𝑇𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 + 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝐶𝑀 𝑟𝑎𝑡𝑖𝑜
MARGIN OF SAFETY
The Margin of Safety (MOS) is the difference between actual sales and break even sales. In other
words, all sales revenue above the break-even point represents the margin of safety. The margin of
safety is an important figure for any business because it tells management how much reduction in
revenue will result in break-even. A higher MOS reduces the risk of business losses.
Margin of safety = Actual or budgeted sales – Sales required to break even
Margin of safety can also be expressed in the form of a ratio or percentage of actual sales, the MOS
ratio:
𝑀𝑂𝑆
𝑀𝑂𝑆 𝑟𝑎𝑡𝑖𝑜 =
𝐴𝑐𝑡𝑢𝑎𝑙 𝑜𝑟 𝑏𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠
Finally, it is also possible to express the margin of safety in terms of units:
𝑀𝑂𝑆 (𝑢𝑛𝑖𝑡𝑠) =
𝑀𝑂𝑆
𝑆𝑎𝑙𝑒 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
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COST STRUCTURE AND PROFIT STABILITY
Cost structure refers to the types and relative proportions of fixed and variable costs that a
business incurs. The concept can be defined in smaller units, such as by product, service, product
line, customer, division, or geographic region.
You can alter the competitive posture of a business by altering its cost structure, not only in total,
but between its fixed and variable cost components. For example, you could outsource the functions
of a department to a supplier who is willing to bill the company based on usage levels. By doing so,
you are eliminating a fixed cost in favor of a variable cost, which means that the company now has a
lower break-even point, so that it can still earn a profit at lower sales levels.
There are advantages and disadvantages to high fixed cost (or low variable cost) and low fixed cost
(or high variable cost) structures.
o
o
An advantage of a high fixed cost structure is that income will be higher in good years
compared to companies with lower proportion of fixed costs.
A disadvantage of a high fixed cost structure is that income will be lower in bad years
compared to companies with lower proportion of fixed costs.
Companies with low fixed cost structures enjoy greater stability in income across good and bad years.
OPERATING LEVERAGE
Operating leverage is a measure of how sensitive net operating income is to percentage changes in
sales revenue. The operating leverage formula is used to calculate a company’s break-even point and
help set appropriate selling prices to cover all costs and generate a profit.
𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =
𝐶𝑀
𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒
It is important to compare operating leverage between companies in the same industry, as some
industries have higher fixed costs than others. The concept of a high or low ratio is then more clearly
defined.
High operating leverage: A large proportion of the company’s costs are fixed costs. In this case, the
firm earns a large profit on each incremental sale, but must attain sufficient sales volume to cover its
substantial fixed costs. If it can do so, then the entity will earn a major profit on all sales after it has
paid for its fixed costs. However, earnings will be more sensitive to changes in sales volume.
Low operating leverage: A large proportion of the company’s costs are variable costs, so it only
incurs these costs when there is a sale. In this case, the firm earns a smaller profit on each
incremental sale, but does not have to generate much sales volume in order to cover its lower fixed
costs. It is easier for this type of company to earn a profit at low sales levels, but it does not earn
outsized profits if it can generate additional sales.
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Example:
𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =
$100.000
=5
$20.000
With an operating leverage of 5, a 10% revenue increase
should result in a 50% increase in net operating income.
STRUCTURING SALES COMMISSIONS
Companies generally compensate salespeople by paying them either a commission based on sales or
a salary plus a sales commission. Commissions based on sales dollars can lead to lower profits.
Example:
Pipeline Unlimited produces two types of surfboards, the XR7 and the Turbo. The XR7 sells for $100
and generates a contribution margin per unit of $25. The Turbo sells for $150 and earns a
contribution margin per unit of $18. The sales force at Pipeline Unlimited is compensated based on
sales commissions.
If you were on the sales force at Pipeline, you would push hard to sell the Turbo even though the XR7
earns a higher contribution margin per unit. To eliminate this type of conflict, commissions can be
based on contribution margin rather than on selling price alone.
BREAK-EVEN ANALYSIS WITH MULTIPLE PRODUCTS
The sales mix is a calculation that determines the proportion of sales for each product a business
sells relative to total sales of all products. The sales mix is significant because some products or
services may be more profitable than others, and if a company's sales mix changes, its profits also
change.
Sales mix is continually analyzed by management because a company’s sales mix directly affects the
company’s break-even point and cost volume profit analysis. Depending on the sales mix or the
ratio of low cost products to high cost products carried by the business, the breakeven point might
be higher or lower.
A multi-product company can compute its break-even point using the following formula:
𝑏𝑟𝑒𝑎𝑘 𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 =
𝑇𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 − 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠
The weighted average selling price is worked out as follows:
(Sale price of product A × Sales percentage of product A)
+ (Sale price of product B × Sale percentage of product B) + ⋯
The weighted average variable expenses are worked out as follows:
(Variable expenses of product A × Sales percentage of product A)
+ (Variable expenses of product B × Sales percentage of product B) + ⋯
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When weighted average variable expenses per unit are subtracted from the weighted average selling
price per unit, we get weighted average contribution margin per unit. Therefore, the above formula
can also be written as follows:
𝑏𝑟𝑒𝑎𝑘 𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 =
𝑇𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑢𝑛𝑖𝑡 𝐶𝑀
Example
The Monster company manufactures three products – product X, product Y and product Z. The
variable expenses and sales prices of all the products are given below. The total fixed expenses of the
company are $50,000 per month. For the coming moth. Monster expects the sale of three products
in the following ratio:
Product X: 20%;
Product Y: 30%;
Product Z: 50%
Compute the break-even point of Monster company in units and dollars for the coming month.
Monster company is a multi-product company. Its break-even point can be computed by applying the
aforementioned formula using weighted average selling price and weighted average variable costs.
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 = ($200 × 20%) + ($100 × 30%) + ($50 × 50%)
= $40 + $30 + $25 = $95
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 = ($100 × 20%) + ($75 × 30%) + ($25 × 50%)
= $20 + 22.50 + 12.50 = $55
𝑏𝑟𝑒𝑎𝑘 𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 =
𝑇𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
$50,000
=
= 1250 𝑢𝑛𝑖𝑡𝑠
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑢𝑛𝑖𝑡 𝐶𝑀 $95 − $55
The company will have to sell 1,250 units in total to break-even. The number of units of each product
to be sold is:
Product X:
Product Y:
Product Z:
(1,250 × 20%): 250 𝑢𝑛𝑖𝑡𝑠
(1,250 × 30%): 375 𝑢𝑛𝑖𝑡𝑠
(1,250 × 50%): 625 𝑢𝑛𝑖𝑡𝑠
The break-even point in dollars can then be computed as follows and verified by preparing a
contribution margin income statement.
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CHAPTER 7: RELEVANT INFORMATION AND DECISION
MAKING (LECTURE 8)
RELEVANT AND IRRELEVANT COSTS
Relevant cost
A relevant cost is an avoidable cost that is incurred only when making specific business decisions.
As a consequence, such cost can change in the future as a result of the decision that was made. The
relevant cost concept is extremely useful for eliminating unnecessary data that could complicate the
decision-making process because it prevents management from focusing on information that might
incorrectly affect its decision. Examples of relevant cost decisions are continue operating vs. closing
business units, make vs. buy and factoring in a special order.
Costs that are relevant in one decision situation may not be relevant in another context. Thus, in
each decision situation, the manager must examine the data at hand and isolate the relevant costs.
Relevant benefit
Relevant benefits are benefits (such as additional gains, revenues and net income) that a company
will receive if management chooses a particular course of action over another. The benefits thus
differ depending on the chosen alternative. Relevant benefits are used by management to evaluate
different strategic options or actions a company can take.
Irrelevant cost
An irrelevant cost is a cost that will not change as the result of a management decision. Examples
of irrelevant costs are sunk costs and overheads as these cannot be avoided. A sunk cost is a cost
that an entity has incurred, and which can no longer be recovered. Examples of sunk costs are a
marketing study or R&D.
DECISION MAKING
Based on the previous definitions of relevant cost, relevant benefit and irrelevant cost, decision
making is a two-step process.
o Step one consists of eliminating costs and benefits that do not differ between alternatives.
o Step two involves using the remaining relevant (avoidable) costs and benefits that differ
between alternatives in making the decision.
DIFFERENTIAL COST APPROACH
Differential cost is the difference between the cost of two alternative decisions, or of a change in
output levels. The concept is used when there are multiple possible options to pursue, and a choice
must be made to select one option and drop the others. The differential cost approach compares the
costs of the possible decisions in order to choose the best one, that is, the one with the least costs.
See slides 15 – 16 of lecture 8 for an example of the differential cost approach.
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ADDING OR DROPPING A PRODUCT LINE OR SEGMENT
One of the most important decisions managers make is whether to add or drop a business segment.
Ultimately, a decision to drop an old segment or add a new one is going to depend primarily on the
impact the decision will have on net operating income. To assess this impact, it is necessary to
carefully analyze the costs.
Contribution margin approach
Using the contribution margin approach, the decision to add a product line or segment is made by
comparing the contribution margin that would be gained to the costs that would be incurred if the
product line or segment was to be added.
The decision to drop a product line or segment is made by comparing the contribution margin that
would be lost to the costs that would be avoided if the product line or segment was to be dropped.
See slides 20 – 24 of lecture 8 for an example of the contribution margin approach. This example
was also handed out on paper during the lecture.
Comparative income approach
In this approach, the net operating income of the current situation and the situation where a product
line or segment is added/dropped are compared by preparing comparative income statements. This
approach will yield the same results as the contribution margin approach.
See slides 26 – 31 of lecture 8 for an example of the comparative income approach. This example
was also handed out on paper during the lecture.
MAKE OR BUY ANALYSIS
The make or buy decision analysis is an evaluation of manufacturing something in-house versus
buying that product from an external supplier. Also referred to as an outsourcing decision, a makeor-buy decision compares the costs and benefits associated with producing a necessary good or
service internally to the costs and benefits involved in hiring an outside supplier for the resources in
question. The outcome of this analysis should be a decision that maximizes the long-term financial
outcome for a company.
There are a number of factors to consider when making the decision, including the following:
o
o
o
o
Cost: Which alternative presents the lowest total cost? Only direct costs should be included
in the compilation of the internal cost to manufacture a product in-house. This amount
should be compared to the quoted price of a supplier.
Capacity: Will the company have sufficient capacity to produce the product in-house?
Alternatively, is the supplier reliable enough to be able to produce the goods in sufficient
quantities and in a timely manner?
Expertise: Does the company have sufficient expertise to make the goods in-house?
Invested funds: Does the company have enough cash to purchase the equipment needed for
in-house production? If the equipment is already on site, could outsourcing the work allow
the equipment to be sold, so that the cash can be used elsewhere?
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o
o
Drop shipping option: A supplier may offer to store the goods at its facility and then ship
them directly to the company's customers as they place orders. This approach shifts the
burden of investing in inventory to the supplier, which can represent a substantial reduction
in working capital.
Strategic importance: How important is the product to the corporate strategy? If it is very
important, then it could make more sense to manufacture the product, in order to maintain
complete control over it.
See slides 41 – 46 of lecture 8 for an example of a make or buy analysis. This example was also
handed out on paper during the lecture.
OPPORTUNITY COST
An opportunity cost is the economic concept of potential benefits that a company gives up by
pursuing an alternative course of action. While financial reports do not show opportunity cost,
business owners can use it to make decisions when they have multiple options before them.
ACCEPTING A SPECIAL ORDER
A special order is a one-time order that is not considered part of the company’s normal business.
When analyzing a special order, only the incremental costs and benefits are relevant. Existing fixed
manufacturing overhead costs would not be affected by the order, and are therefore not relevant.
See slides 52 – 54 of lecture 8 for an example of a special order.
PROFITABLE USE OF A CONSTRAINED RESOURCE.
When a limited resource of some type restricts the company’s ability to satisfy demand, the company
is said to have a constraint. It essentially establishing an upper limit on the amount of output that
can be created. If a machine or process is limiting overall output, it is called the bottleneck.
Fixed costs are usually unaffected in these situations, so the product mix that maximizes the
company’s total contribution margin should ordinarily be selected. A company should not necessarily
promote those products that have the highest unit contribution margins. Rather, total contribution
margin will be maximized by promoting those products or accepting those orders that provide the
highest contribution margin in relation to the constraining resource.
It is often possible for management to increase the capacity of a bottleneck, which is called relaxing
(or elevating) the constraint. This can be done in numerous ways:
o Working overtime on the bottleneck.
o Subcontracting some of the processing that would be done at the bottleneck.
o Investing in additional machines at the bottleneck.
o Shifting workers from non-bottleneck processes to the bottleneck.
o Focusing business process improvement efforts on the bottleneck.
o Reducing defective units processed through the bottleneck.
See slides 62 – 82 of lecture 8 for an example of utilizing a constrained resource.
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JOINT PRODUCTS AND COSTS
Joint products are multiple products generated by a single production process at the same time.
These products incur undifferentiated joint costs until they reach a split-off point. A joint cost is an
expenditure that benefits more than one product, and for which it is not possible to separate the
contribution to each product.
A split-off point is the location in a production process where jointly manufactured products can be
recognized as a separate products and after which each product incurs separate processing. Thus,
their costs can be identified individually after the split-off point. Prior to the split-off point,
production costs are allocated to jointly manufactured products.
Joint costs are traditionally allocated among different products at the split-off point. A typical
approach is to allocate joint costs according to the relative sales value of the end products. Although
allocation is needed for some purposes such as balance sheet inventory valuation, allocations of this
kind are very dangerous for decision making.
SELL OR PROCESS FURTHER
Joint costs are irrelevant in decisions regarding what to do with a product from the split-off point
forward. Therefore, these costs should not be allocated to end products for decision-making
purposes.
With respect to sell or process further decisions, it is profitable to continue processing a joint product
after the split-off point so long as the incremental revenue from such processing exceeds the
incremental processing costs incurred after the split-off point.
See slides 90 – 94 of lecture 8 for an example of selling or processing further a joint product after
the split-off point. This example was also handed out on paper during the lecture.
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CHAPTER 8: FINANCIAL STATEMENTS ANALYSIS
(LECTURE 9)
WHAT IS FINANCIAL STATEMENT ANALYSIS
Financial statement analysis is the process of analyzing a company's financial statements for
decision-making purposes. External stakeholders use it to understand the overall health of an
organization as well as to evaluate financial performance and business value. Internal constituents
use it as a monitoring tool for managing the finances.
This analysis involves identifying the following items for a company's financial statements over a
series of reporting periods:
o
o
Trends: Create trend lines for key items in the financial statements over multiple time
periods, to see how the company is performing. Typical trend lines are for revenue, the gross
margin, net profits, cash, accounts receivable, and debt.
Proportion analysis: An array of ratios are available for determining the relationship
between the size of various accounts in the financial statements. These analyses are
frequently between the revenues and expenses listed on the income statement and the
assets, liabilities, and equity accounts listed on the balance sheet.
There are two key methods for analyzing financial statements. The first method is the use of
horizontal and vertical analysis. The second method for analyzing financial statements is the use of
many kinds of ratios.
HORIZONTAL ANALYSIS
Horizontal analysis (also known as trend analysis) is a financial statement analysis technique that
shows changes in the amounts of corresponding financial statement items over a period of time. It
is a useful tool to evaluate the trend situations.
The statements for two or more periods
are used in horizontal analysis. The
earliest period is usually used as the
base period and the items on the
statements for all later periods are
compared with items on the statements
of the base period. The purpose of this
technique is to determine the increases
and decreases that have taken place.
The changes are generally shown both
in dollars and percentage.
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𝐷𝑜𝑙𝑙𝑎𝑟 𝑐ℎ𝑎𝑛𝑔𝑒 = 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑖𝑡𝑒𝑚 𝑖𝑛 𝑐𝑜𝑚𝑝𝑎𝑟𝑖𝑠𝑜𝑛 𝑦𝑒𝑎𝑟 − 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑖𝑛𝑡𝑒𝑚 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 =
𝐷𝑜𝑙𝑙𝑎𝑟 𝑐ℎ𝑎𝑛𝑔𝑒
𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑖𝑡𝑒𝑚 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
Horizontal analysis may be conducted for balance sheet, income statement and statement of
retained earnings.
VERTICAL ANALYSIS
Vertical analysis (also known as common-size analysis) is a method of financial statement analysis
that shows each financial item on a statement as a percentage of a base amount within the
statement.
To conduct a vertical analysis of balance
sheet, the total of assets and the total of
liabilities and stockholders’ equity are
generally used as base figures. All individual
assets (or groups of assets if condensed form
balance sheet is used) are shown as a
percentage of total assets. The current
liabilities, long term debts and equities are
shown as a percentage of the total liabilities
and stockholders’ equity.
To conduct a vertical analysis of income
statement, the sales figure is generally used
as the base and all other components of
income statement like cost of sales, gross
profit, operating expenses, income tax, and
net income etc. are shown as a percentage of
sales.
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝑏𝑎𝑠𝑒 =
𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝑖𝑡𝑒𝑚
𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑏𝑎𝑠𝑒 𝑖𝑡𝑒𝑚
A basic vertical analysis needs an individual statement for a reporting period but comparative
statements may be prepared to increase the usefulness of the analysis.
RATIO ANALYSIS
Ratio analysis expresses the relationship among selected items of financial statement data (the
relative size of one number in relation to another). A single ratio by itself is not very meaningful.
Therefore, after a ratio is calculated, you can then compare it to the same ratio calculated for a prior
period, or that is based on an industry average, to see if the company is performing in accordance
with expectations.
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In a typical financial statement analysis, most ratios will be within expectations, while a small number
will flag potential problems that will attract the attention of the reviewer. Sometimes, relationships
between numbers can be used by companies to detect fraud The numeric relationships that can
reveal fraud can be such things as financial ratios that appear abnormal, or statistical abnormalities
in the numbers themselves.
LIQUIDITY RATIOS
Liquidity ratios measure the short term ability of the company to pay its maturing obligations and
to meet unexpected needs for cash using the company's current or quick assets. This is the most
fundamentally important set of ratios, because they measure the ability of a company to remain in
business.
Short term creditors such as bankers and suppliers are particularly interested in assessing liquidity.
CURRENT RATIO
Current ratio (also known as working capital ratio) is a popular tool to evaluate short-term solvency
position of a business. Short-term solvency refers to the ability of a business to pay its short-term
obligations when they become due. Short term obligations (also known as current liabilities) are the
liabilities payable within a short period of time, usually one year. Both the components are available
from the balance sheet of the company.
A higher current ratio indicates strong solvency position and is therefore considered better.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
QUICK RATIO / ACID-TEST RATIO
Quick ratio (also known as acid test ratio) is used to test the ability of a business to pay its shortterm debts. It measures the relationship between liquid assets and current liabilities. Liquid assets
are equal to total current assets minus inventories and prepaid expenses. Inventories and prepaid
expenses are excluded from current assets for the purpose of computing quick ratio because
inventories may take long period of time to be converted into cash and prepaid expenses cannot
be used to pay current liabilities.
𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 =
𝐿𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑎𝑠ℎ + 𝑠ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 + 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 (𝑛𝑒𝑡)
=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
RECEIVABLES TURNOVER
Receivables turnover ratio is computed by dividing the net credit sales during a period by average
receivables and simply measures how many times the receivables are collected during a particular
period. It is a helpful tool to evaluate the liquidity of receivables.
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑁𝑒𝑡 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑒𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
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Only credit sales should be included in the numerator. However, if this information is not given, total
sales should be used assuming all the sales are made on credit. Average receivables are equal to
opening receivables plus closing receivables divided by two.
AVERAGE COLLECTION PERIOD
Average collection period is computed by dividing the number of working days for a given period
(usually, 365 days is used) by receivables turnover ratio. It is expressed in days and is an indication of
the quality of receivables. A short collection period means prompt collection and better
management of receivables. A longer collection period may negatively affect the short-term debt
paying ability of the business in the eyes of analysts.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 =
# 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑑𝑎𝑦𝑠
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
INVENTORY TURNOVER
Inventory turnover ratio is a tool to evaluate the liquidity of company’s inventory. It measures how
many times a company has sold and replaced its inventory during a certain period of time.
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
Cost of goods sold is equal to cost of goods manufactured plus opening inventory less closing
inventory. Average inventory is equal to opening balance of inventory plus closing balance of
inventory divided by two.
A high ratio indicates fast moving inventories and a low ratio indicates slow moving inventories. A
low ratio may also be the result of maintaining excessive inventories needlessly and indicates poor
inventory management because it involves tiding up funds that could have been used in other
business operations.
DAYS IN INVENTORY
The average days in inventory is computed by dividing the number of working days for a given
period (usually, 365 days is used) by inventory turnover ratio. It is expressed in days and measures
the average number of days the company holds its inventory before selling it. In other words, it
measures the number of days that funds are tied up in inventory.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
# 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑑𝑎𝑦𝑠
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
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PROFITABILITY RATIOS
Profitability ratios show how well a company can generate profits from its operations. They
measure the income or operating success of a company for a given period of time. Income, or the
lack of it, affects the company’s ability to obtain debt and equity financing, as well as its liquidity
position, and the ability to grow.
GROSS PROFIT MARGIN
Gross profit margin is a profitability ratio that shows the relationship between gross profit and total
net sales revenue. It is a popular tool to evaluate the operational performance of the business . The
ratio is computed by dividing the gross profit figure by net sales.
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
=
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
Gross profit is equal to net sales minus cost of goods sold. Net sales are equal to total gross sales less
returns inwards and discount allowed. The information about gross profit and net sales is normally
available from income statement of the company.
OPERATING PROFIT MARGIN
Operating profit margin is a profitability ratio that shows relationship between net operating
income and net sales. It is computed by dividing the net operating income by net sales.
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
Net operating income is equal to gross profit minus operating expenses.
NET PROFIT MARGIN
Net profit margin is a profitability ratio that shows relationship between net profit after tax and net
sales. It measures the net income generated by each dollar of sales. It is computed by dividing the
net profit after tax by net sales.
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
Net profit is equal to gross profit minus operating expenses and income tax. All non-operating
revenues and expenses are not taken into account because the purpose of this ratio is to evaluate
the profitability of the business from its primary operations. Examples of non-operating revenues
include interest on investments and income from sale of fixed assets. Examples of non-operating
expenses include interest on loan and loss on sale of assets.
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ASSET TURNOVER RATIO
Assets turnover ratio measures the efficiency with which assets are used by a company to generate
sales by calculating the dollar sales generated by each dollar of assets. It is computed by dividing
net sales by average total assets for a given period. Average total assets are equal to total assets at
the beginning of the period plus total assets at the ending of the period divided by two.
𝐴𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜 =
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
RETURN ON ASSETS
Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
ROA gives a manager, investor, or analyst an idea as to how efficient a company's management is at
using its assets to generate earnings. Return on assets is displayed as a percentage.
𝑅𝑂𝐴 =
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
RETURN ON COMMON STOCKHOLDERS’ EQUITY
Return on common stockholders’ equity ratio measures the success of a company in generating
income for the benefit of common stockholders. It is computed by dividing the net income available
for common stockholders by common stockholders’ equity. The ratio is usually expressed in
percentage.
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦 =
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦
In the numerator, preferred dividend may be subtracted from the net profit after tax if the company
pays out dividends. Average common stockholders’ equity is equal to common stockholders’ equity
at the beginning of the period plus common stockholders’ equity at the ending of the period
divided by two.
Return on common stockholders’ equity ratio shows how many dollars of net income have been
earned for each dollar invested by the common stockholders. This ratio is a useful tool to measure
the profitability from the owners’ view point because the common stockholders are considered the
real owners of the corporation. A higher return on common stockholders’ equity ratio indicates high
profitability and strong financial position of the company and can convert potential investors into
actual common stockholders.
EARNINGS PER SHARE
Earnings per share (EPS) ratio measures how many dollars of net income have been earned by each
share of common stock during a certain time period. It is computed by dividing net income by the
number of shares of common stock outstanding during the period. It is a popular measure of overall
profitability of the company and is expressed in dollars.
35
𝐸𝑃𝑆 =
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
In the numerator, preferred dividend may be subtracted from the net profit after tax if the company
pays out dividends.
The shares are normally purchased to earn dividend or sell them at a higher price in future. EPS
figure is extremely important for actual and potential common stockholders because the payment
of dividend and increase in the value of stock in future largely depends on the earning power of
the company. EPS is the most widely quoted and relied figure by analysts and investors.
PRICE-EARNINGS RATIO
Price earnings ratios (P/E ratio) measures how many times the earnings per share (EPS) has been
covered by current market price of an ordinary share. It is computed by dividing the current market
price of an ordinary share by earnings per share.
𝑃/𝐸 𝑟𝑎𝑡𝑖𝑜 =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
P/E ratio is a very useful tool for financial forecasting. It gives information about the amount that
the investors are willing to invest in the company to earn $1. It also helps in knowing whether the
market price of share is reasonable or not. A higher P/E ratio is the indication of strong position of
the company in the market.
DIVIDEND PAYOUT RATIO
Dividend payout ratio shows what portion of the current earnings the company is paying to its
stockholders in the form of dividend and what portion the company is putting back in the business
for growth in the future. It is computed by dividing the dividend per share by the earnings per share
for a specific period.
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
A low dividend payout ratio means the company is keeping a large portion of its earnings for growth
in future and a high payout ratio means the company is paying a large portion of its earnings to its
common shareholders.
SOLVENCY RATIOS
Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets,
equity, and earnings to evaluate whether a company can stay afloat in the long-term by paying its
long-term debt and interest on the debt. Solvency ratios therefore are a measure of the ability of a
company to survive over a long period of time.
36
DEBT TO TOTAL ASSETS RATIO
Total-debt-to-total-assets is a leverage ratio that defines the total amount of debt relative to assets.
This metric enables comparisons of leverage to be made across different companies. The higher the
ratio, the higher the degree of leverage and, consequently, financial risk. The total debt to total
assets is a broad ratio that analyzes a company's balance sheet by including long-term and shortterm debts as well as all assets.
𝐷𝑒𝑏𝑡 𝑡𝑜 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑟𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
Investors use the ratio not only to evaluate whether the company has enough funds to meet its
current debt obligations but also to assess whether the company can pay a return on their
investment.
Creditors use the ratio to see how much debt the company already has and whether the company
has the ability to repay its existing debt, which will determine whether additional loans will be
extended to the firm.
TIMES INTEREST EARNED
Times interest earned (TIE) ratio shows how many times the annual interest expenses are covered
by the net operating income (income before interest and tax) of the company. It is a long-term
solvency ratio that measures the ability of a company to pay its interest charges as they become due.
𝑇𝑖𝑚𝑒𝑠 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑎𝑟𝑛𝑒𝑑 =
𝐼𝑛𝑐𝑜𝑚𝑒 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 & 𝑡𝑎𝑥
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
Times interest earned ratio is very important from the creditors view point. A high ratio ensures a
periodical interest income for lenders. The companies with weak ratio may have to face difficulties
in raising funds for their operations.
LIMITATIONS OF RATIOS
o
o
o
Measurability: Financial statements reflect what can be reliably measured. This results in
non-recognition of certain assets, often internally developed assets, the very assets that are
most likely to confer a competitive advantage and create value. Examples are brand name, a
superior management team, employee skills, and a reliable supply chain.
Non-capitalized costs: Related to the concept of measurability is the expensing of costs
relating to “assets” that cannot be identified with enough precision to warrant capitalization.
Examples are brand equity costs from advertising and other promotional activities, and
research and development costs relating to future products.
Historical costs: Assets and liabilities are usually recorded at original acquisition or issuance
costs. Subsequent increases in value are not recorded until realized, and declines in value are
only recognized if deemed permanent.
37
DUPONT ANALYSIS
DuPont analysis breaks down the components of the return on equity formula to reveal the different
ways in which a business can alter its return on equity. This analysis is used by organizations that
want to enhance the returns that they provide to investors.
Return on equity
Return on equity (ROE) is a measure of overall profitability of the business and is computed by
dividing the net income after interest and tax by average stockholders’ equity. It is usually expressed
in percentage.
𝑅𝑂𝐸 =
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦
The numerator consists of net income after interest and tax because it is the amount of income
available for common and preference stockholders. The denominator is the average of stockholders’
equity. The information about net income after interest and tax is normally available from income
statement and the information about preference and common stock is available from balance sheet.
A higher ratio means higher return on shareholders’ investment and a lower ratio indicates
otherwise. Investors always search for the highest return on their investment and a company that
has higher ROE ratio than others in the industry attracts more investors.
Components of the ROE ratio
The DuPont analysis decomposes the ROE ratio into 3 major financial metrics that drive return on
equity:
o NET PROFIT MARGIN
The net profit margin was already discussed under the section of profitability ratios of this
chapter. It measures the net income generated by each dollar of sales and is calculated with
following formula:
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
o ASSET TURNOVER RATIO
The asset turnover ratio was also already discussed under the section of profitability ratios of
this chapter. It measures the dollar sales generated by each dollar of assets and is
calculated with following formula:
𝐴𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜 =
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
o FINANCIAL LEVERAGE
Financial leverage is the use of debt to buy more assets. Leverage is employed to increase
the return on equity. However, an excessive amount of financial leverage increases the risk
of failure, since it becomes more difficult to repay debt. Therefore, financial leverage It may
be positive or negative.
38
A positive financial leverage means that the assets acquired with the funds provided by
creditors and preferred stockholders generate a rate of return that is higher than the rate of
interest or dividend payable to the providers of funds. Positive financial leverage is beneficial
for common stockholders.
A negative financial leverage occurs when the assets acquired with the debts generate a rate
of return that is less than the rate of interest or dividend payable to the providers of debts or
preferred stock. Negative financial leverage is a loss for common stockholders.
Equity multiplier
The equity multiplier is a financial leverage ratio that measures the amount of a firm’s assets
that are financed by its shareholders by comparing total assets with total shareholder’s
equity. In other words, it measures the total assets a company owns per dollar of its
stockholders' equity. The equity multiplier formula is calculated by dividing total assets by
total stockholder’s equity.
𝐸𝑞𝑢𝑖𝑡𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦
Companies finance assets through the process of issuing equity and debt. The equity multiplier
reveals how much of the total assets of a company are made up of debt and equity. Essentially, this
ratio is a risk indicator in that it shows how leveraged the company is to investors and creditors.
A higher equity multiplier number indicates that the debt portion of total assets is increasing which
translates to more financial leverage for the company. Companies with a higher debt burden will
have higher debt servicing costs which means that they will have to generate more cash flows to
sustain optimal operating conditions.
A low equity multiplier implies that the company doesn’t like to take on debt, which is usually seen
as positive as their debt servicing costs are lower, but it could also mean that the company is unable
to entice lenders to loan them money, which would be a negative.
Return on equity revisited
By combining the 3 components discussed above, we can see that the return on equity ratio can be
calculated as:
𝑅𝑂𝐸 = 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 × 𝐴𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜 × 𝐸𝑞𝑢𝑖𝑡𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟
As can be seen from the net profit margin and asset turnover ratio formulas, they can be combined
to form the return on assets (ROA).
𝑅𝑂𝐸 = 𝑅𝑂𝐴 × 𝐸𝑞𝑢𝑖𝑡𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
=
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
×
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦
Which is exactly the same formula for ROE as was given before on the previous page.
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What DuPont analysis tells you
As shown above, the DuPont analysis is an expanded return on equity formula consisting of 3
components. These 3 performance measures present opportunities for a business to generate a high
ROE, namely by maintaining a high profit margin, increasing asset turnover, or leveraging assets
more effectively.
Whereas an ordinary ROE calculation alone reveals how well a company utilizes capital from
shareholders, a DuPont analysis is used to evaluate the 3 components of a company's ROE to
determine which of these factors are most responsible for changes in ROE. That is, a DuPont
analysis can help deduce whether it’s profitability, use of assets or debt that’s driving ROE.
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CHAPTER 9: SPECIAL TOPICS: CONTROL
RESPONSIBILITIES AND CORPORATE GOVERNANCE
AND ORGANIZATIONAL MISCONDUCT (LECTURE 11)
CONTROL RESPONSIBILITIES AND CORPORATE GOVERNANCE
Controls and exposures
Controls are needed to reduce exposures. An exposure consists of the potential effect of an event
multiplied by its probability of occurrence. Controls rarely affect the causes of exposures.
Examples of common exposures are:
o Deficient revenues
o Loss of assets
o Statutory sanctions
o Competitive disadvantages
o Fraud and embezzlement
o Inaccurate accounting
o Business interruption
o Excessive costs
Internal control
Internal control is a procedure or policy, effected by an entity’s board of directors, management, and
other personnel, designed to provide reasonable assurance regarding the achievement of objectives
relating to:
o Operations (Effectiveness, efficiency, safeguarding assets)
o Reporting (Reliability, timeliness, transparency)
o Compliance with regulatory environment
Another way of looking at internal controls is that these activities are needed to mitigate the
amount and types of risk to which a firm is subjected.
Management has a fundamental responsibility to develop and maintain effective internal control.
Characteristics of internal controls:
o Continuous (Built into operations, not into one single event, dynamic)
o Effected by people
o Able to provide reasonable assurance, not absolute assurance
o Adaptable to the entire entity or to a particular division, to a business process, etc.
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Risks of weak internal controls:
o Financial misstatement
o Business loss
o Loss of funds or materials
o Incorrect or untimely management information
o Fraud or collusion
o Tarnished reputation with the public
o Missed goals
Common basic internal control principles
o Establish responsibility: Assign each task to only one person.
o Segregate duties: Don’t make one employee responsible for all parts of a process.
o Restrict access: Don’t provide access to systems, information, assets, etc. unless needed to
complete the assigned responsibilities.
o Document procedures and transactions: Prepare documents to show that activities have
occurred.
o Independently verify: Check others’ work.
COSO framework for internal control
The COSO, or Committee of Sponsoring Organizations of the Treadway Commission, is a joint
initiative to combat corporate fraud.
42
Components of internal control
o Control environment:
 Set of standards, processes, and structures that provides the basis for carrying out
internal control across the organization.
 Includes the tone at the top regarding importance of internal control and expected
standards of conduct.
o
Risk assessment:
Process for identifying and assessing risks that may affect organizations from achieving
objectives.
o
Control activities:
Actions established by policies and procedures. They help ensure that management’s
directives regarding internal control are carried out.
o
Information and communication:
 Information from internal and external sources.
 Communication is the process of providing, sharing, and obtaining necessary
information.
o
Monitoring:
Helps determine whether the controls are present and continuing to function effectively.
Internal audit
Definition (Institute of Internal Auditing – IIA, 1999): Internal auditing is an independent, objective
assurance and consulting activity designed to add value and improve an organization's operations.
It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to
evaluate and improve the effectiveness of risk management, control, and governance processes.
In general, head of internal audit will have direct reporting line to top in the organization/board level
(audit committee).
Auditing is the accumulation and evaluation of evidence about information to determine and
report on the degree of correspondence between the information and established criteria.
Auditing should be done by a competent and independent person or firm.
To do an audit, there must be information in a verifiable form and some standards (criteria) by which
the auditor can evaluate the information. Evidence is any information used by the auditor to
determine whether the information being audited is stated in accordance with the established
criteria.
The auditor must be qualified to understand the criteria used and must be competent to know the
types and amount of evidence to accumulate to reach the proper conclusion after the evidence has
been examined. The competence of the individual performing the audit is of little value if he or she is
biased in the accumulation and evaluation of evidence.
43
The final stage in the auditing process is preparing the audit report, which is the communication of
the auditor’s findings to users.
Information risk reflects the possibility that the information upon which the business risk decision
was made was inaccurate. Auditing can have a significant effect on information risk.
Causes of information risk:
o Remoteness of information
o Biases and motives of the provider
o Voluminous data and (or) Complex Transaction
Example of internal audit regarding operation:
Internal control vs. internal audit:
Audit of financial statements
The objective of the audit of financial statements is to express an opinion whether the financial
statements present fairly, in all material respects, the financial position, results of operations and
changes in financial position in accordance with generally accepted accounting principles.
Distinction between audit of financial statements and accounting:
Accounting is the recording, classifying, and summarizing of economic events for the purpose of
providing financial information used in decision making.
Financial statement auditing is determining whether disclosed financial reports properly reflects the
economic events that occurred during the accounting period.
44
Internal audit versus financial statements audit:
Senior management
Senior management is responsible for day-to-day management as well as financial reporting and
risk management. The CEO and CFO must personally certify to the:
o Accuracy of financial statements
o Adequacy & effectiveness of disclosure controls and procedures
o Adequacy & effectiveness of internal controls over financial reporting
o Completeness of all disclosures that materially impact the financial statements or relate to
frauds involving management with a significant role in internal controls over financial
reporting
Board of directors
The board of directors has the duties of:
o Reviewing and guiding: corporate strategy, major plans of action, risk policy, annual budgets
and business plans, setting performance objectives; monitoring implementation and
corporate performance; and overseeing major capital expenditures, acquisitions and
divestitures
o Monitoring the effectiveness of the company’s governance practices and changing them as
required
o Selecting, compensating, monitoring and replacing key executives and overseeing succession
planning
o Aligning key executive and Board remuneration with the longer term interests of the
company
o Ensuring a formal and transparent Board nomination and election process
o Monitoring and managing potential conflicts of interest of management, Board members and
shareholders, including misuse of corporate assets and abuse in related party transactions
o Ensuring the integrity of the corporation’s accounting and financial reporting systems
o Overseeing the process of disclosure and communications.
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Corporate governance
Definition of corporate governance (IIA): “The combination of processes and structures,
implemented by the board to inform, direct, manage and monitor the activities of the organization
towards the achievement of its activities.”
In the last decades, there were many scandals concerning corporate governance. Therefore,
corporate government codes were developed to re-establish the performance-conformance
balance. E.g. Guidelines of the European Commission.
Problems with corporate governance
o Most issues seen in large public companies, where the separation of ownership and control
is a major problem.
o History of corporate failures due largely or entirely to bad corporate governance and
misleading financial reporting.
o Particular problem has been the domination of companies by an all-powerful CEO/chairman
e.g. Maxwell and the Daily Mirror.
Benefits of corporate governance
o Higher quality financial reporting
o Better stakeholder relations
o Enhanced reputation
o Good communication
o Better risk management
o Market confidence from positive messages
o More investor support when ‘non-compliant’ or when problems arise
Objectives of corporate governance
The objectives of corporate governance should be to ensure that:
o The directors act in the best interests of the shareholders (and not in their own self-interest)
o The board provides suitable strategic leadership
o There is proper accountability of the directors to the shareholders, and a constructive
relationship between the directors and shareholders
To achieve these objectives, there must be principles, guidance or rules for companies to follow.
One of the most influential guidelines has been the OECD (The Organization for Economic Co operation and Development) Principles of Corporate Governance.
Unsuccessful corporate governance
o CFO with aggressive M&A strategy
o Poor strategic choices • Aggressive targets and earnings management
o Misaligned incentives
o Poor ethical standards at the top
o Poor execution
o Failure to respond quickly to change
o Too dominant/charismatic CEO
o Weak internal controls
o Weak board of directors (too cozy with CEO)
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Three lines of defense
1. First line of defense
Under the first line of defense, operational management has ownership, responsibility and
accountability for directly assessing, controlling and mitigating risks.
⇒ This refers to the implementation of internal controls (see p. 42 – 44).
2. Second line of defense
The second line of defense consists of activities covered by several components of internal
governance (compliance, risk management, quality, IT and other control departments). This line
of defense monitors and facilitates the implementation of effective risk management practices
by operational management and assists the risk owners in reporting adequate risk related
information up and down the organization.
3. Third line of defense
Internal audit forms the organization's third line of defense. An independent internal audit
function will, through a risk-based approach to its work, provide assurance to the organization's
board of directors and senior management. This assurance will cover how effectively the
organization assesses and manages its risks and will include assurance on the effectiveness of the
first and second lines of defense.
Swiss cheese model
In the Swiss cheese model,
an organization's defenses
against failure are modeled
as a series of barriers,
represented as slices of
cheese. The holes in the
slices represent weaknesses
in individual parts of the
system and are continually
varying in size and position
across the slices. The system
produces failures when a
hole
in
each
slice
momentarily aligns, permitting a trajectory of accident opportunity, so that a hazard passes through
holes in all of the slices, leading to a failure.
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ORGANIZATIONAL MISCONDUCT
Definition: A knowing misrepresentation of the truth or
concealment of a material fact to induce another to act to his or her
detriment.
It’s easy to assume that organizational misconduct is committed by
dishonest or unprincipled individuals or psychopaths. Yet what
happens when people who appear to be highly moral in their
personal lives commit unethical actions?
Example: Betty Vinson from WorldCom
o Vinson was asked by her superiors to make improper accounting entries to “save the
company.”
o The first several times she was asked, she refused.
o Constant pressure and the belief that it was the only way to help the firm convinced her to
go against what she knew was right.
o She pled guilty to conspiracy and was sentenced to five months in prison and five months of
house arrest.
Common Reasons for Misconduct
Pressure
o Superiors or co-workers
 “If you can’t meet these goals, you’re fired.”
 Enron’s rank-and-yank system—nobody wanted to be in the lowest tier
o
Time
 “This must be done by this weekend or else we’ll lose the account!”
 Incentive to cut corners, ignore red flags
o
Market/shareholder
 “We need to engage in this risky behavior to remain competitive.”
 Big financial firms engaged in risky behaviors to earn quick profits prior to the latest
recession
Foot in the Door
o First somebody gets you to agree to a small favor, then they ask for a bigger one.
 If you agree to commit a small ethical infraction, you are much more likely to commit a
larger one next time you are asked.
 Studies show that those who have agreed to do something small are much more likely to
agree to do something bigger.
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o
Escalation of commitment is a similar concept. At first misconduct may start off small, but
then it requires more and more misconduct to meet performance targets and cover up the
previous misconduct.
 Jerome Kerviel is a former Societe Generale trader engaged in aggressive risk taking that
nearly destroyed the bank; $69 billion in rogue trades, sentenced to three years in jail.
After his early trades earned money, Kerviel engaged in riskier and riskier trades.
The Greater Good
o This occurs when an employee commits misconduct not to benefit him- or herself but to help
the firm.
o
Organizational misconduct is more likely to come from employees trying to reach
performance goals or benefit the organization rather than personal greed.
 “I have to do this to save the organization.”
 WorldCom’s board of directors continued to loan CEO Bernie Ebbers ridiculously large
sums of money so he could meet his margin calls. Without these loans they knew Ebbers
would have to sell his stock, which would drive down the price and harm the firm.
Rationalization
o Coming up with reasons to reduce cognitive dissonance in a misconduct situation.
 When faced with an unethical decision, the employee faces a dilemma because the
action conflicts with his or her values and knowledge of what constitutes ethical conduct.
 Rationalizations are excuses used to reduce this uncomfortable feeling by attempting to
provide a valid reason for the misconduct.
 Andy Fastow (Former chief financial officer of Enron Corporation) confessed he used
rationalization when he committed fraud. He used phrases such as “everyone was doing
it” and “it’s to help shareholders” to justify his misconduct.
o
Common rationalizations include “Everyone is doing it”; “I deserve it,”; “It’s only one time.”
 Employee theft and employee sabotage are likely to make use of rationalization to justify
their behavior—“I’m not getting treated the way I deserve, so this is a way to make it
even.”
Groupthink
o Occurs when an employee goes along with the crowd even when he or she believes the
decision or action is wrong.
 Asch experiments: To test whether a participant would give an obviously wrong answer
because everyone else did so; 75% of participants gave an incorrect answer to at least
one question.
o
Best way to avoid trap of groupthink: Be willing to stand out from the crowd.
 In the Asch experiments, those participants that resisted complying with the crowd
exhibited more confidence or simply seemed to feel like they had a responsibility to give
what they felt was the right answer despite their discomfort.
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Authority
o Individuals commit acts that conflict with their ethical beliefs because somebody in authority
tells them to do so.
o
The Milgram experiments: Although the participants were uncomfortable, many were willing
to continue administering electric shocks if the “authority figure” agreed to take
responsibility.
 65% of participants administered the maximum 450-volt shock, even though doing it
caused them severe distress.
o
One of the strongest sources of power is legitimate power, which occurs when a person is
perceived to be in charge.
o
“My boss told me to do it” is not an excuse that holds up in court.
o
Being willing to ask questions and assume personal responsibility—no matter what the
authority figure says—appear to be good ways to avoid this trap.
No Way Out
o When an individual feels trapped by his or her circumstances
o
In business ethics, this might include:
 Continuing in misconduct because to do otherwise would expose it and lead to
punishment
 Weston Smith, the former CFO who blew the whistle on fraud at HealthSouth,
expressed that while the fraud started as a one-time thing, the company was forced
to continue to make the numbers.
 Smith felt compelled to sign off on the numbers under the Sarbanes-Oxley law
though he knew they were false and he could go to prison for it; he felt trapped by
the situation.
 Eventually admitted his part in the misconduct and faced punishment; he comments,
“I was scared. But there was an even stronger emotion: gratitude. I was just so
relieved that the lying was over.”

Allowing misconduct to go unchecked due to fears of punishment
 Employees at Enron who observed misconduct were afraid to step forward.
 Whistleblower Sherron Watkins faced retaliation for trying to alert company
leadership.
 Former Enron executive Lynn Brewer claims Enron’s downfall was due to a culture of
“complacency.”
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Self-Serving Bias
o Self-serving bias is our tendency to view ourselves as more ethical than the average person.
 The Blind Spot: Why We Fail to Do What’s Right and What To Do About It
 When asked how they compared “ethically” to other people on a scale of 1 to 100,
the average score was 75. People tend to believe they are more ethical than those
around them.
 It is believe that the reason why many accountants perform bad audits is not so much
due to fraud, but due to unconscious bias.
 There is often a gap between our ethical intentions and our behavior; those that believe
they are more ethical than the general population are more likely to turn a “blind eye”
toward this gap and not recognize problematic situations.
Greed and Narcissism
o The definition of greed is “an intense and selfish desire for something, especially wealth,
power, and food.”
 Dennis Kozlowski was making $170 million as CEO of Tyco; accused of stealing millions
from Tyco; almost ruined the company
o
Narcissism—Thinking you are above the law
 Mark Whitacre worked with the FBI to expose his employer Archer Daniels Midland for
price fixing; however, he also committed his own fraud worth $9 billion.
 In a presentation at the John Cook School of Business, he said the following: “If I had to
put in one word what we went in prison for, we went to prison for narcissism. We
thought we were above the law and we all failed drastically because of it.”
o
The Need to Win
 Closely related is the need to win; many fraudsters claim they couldn’t bear the thought
of failing
Final Thoughts
o Many of these are not mutually exclusive. For instance, misconduct will often start with
rationalizations, escalate in severity, and result in the person feeling that he or she has no
way out but to continue the misconduct.
o
What can we learn from this?
 Companies should regularly reinforce shared values and emphasize that everyone—
whether lower-level employees or high-levels manager—must abide by them.
 Mechanisms should be put in place that allow employees to report misconduct, including
anonymous mechanisms such as hotlines.
 Unlike what happened with Enron, these reports should be investigated and acted
upon.
 Realize that misconduct is misconduct, no matter how much it is perceived to be “small.”
Rationalizations do nothing to change this fact.
 Recognize that most misconduct starts off small but then snowballs into greater
misconduct.
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https://www.myaccountingcourse.com/
https://www.accountingtools.com/
https://www.accountingcoach.com/
https://www.accountingformanagement.org/
https://www.investopedia.com/
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