Comparison of Financial and
Managerial Accounting
Financial Accounting
Managerial Accounting
External persons who
make financial decisions
Managers who plan for
and control an organization
Historical perspective
Future emphasis
3. Verifiability
versus relevance
Emphasis on
verifiability
Emphasis on relevance
for planning and control
4. Precision versus
timeliness
Emphasis on
precision
Emphasis on
timeliness
5. Subject
Primary focus is on
the whole organization
Focuses on segments
of an organization
6. GAAP
Must follow GAAP
and prescribed formats
Need not follow GAAP
or any prescribed format
Mandatory for
external reports
Not
Mandatory
1. Users
2. Time focus
7. Requirement
Opportunity Costs
The potential benefit that is given up
when one alternative is selected over
another.
Example: If you were
not attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college for
one year is $15,000.
Sunk Costs
Sunk costs have already been incurred and cannot be changed now
or in the future. They should be ignored when making decisions.
Example: You bought an automobile that cost $10,000 two years
ago. The $10,000 cost is sunk because whether you drive it, park
it, trade it, or sell it, you cannot change the $10,000 cost.
Manufacturing Costs
Direct
Materials
Direct
Labor
The Product
Manufacturing
Overhead
Non-manufacturing Costs
Marketing or
Selling Cost
Administrative
Cost
Costs necessary to get
the order and deliver
the product.
All executive,
organizational, and
clerical costs.
Product Costs Versus Period Costs
Product costs include direct
materials, direct labor, and
manufacturing overhead.
Cost of Good Sold
Inventory
Period costs include all
marketing or selling costs
and administrative costs.
Expense
Sale
Balance
Sheet
Income
Statement
Income
Statement
Comparing Merchandising and
Manufacturing Activities
Merchandisers . . .
– Buy finished goods.
– Sell finished goods.
Manufacturers . . .
– Buy raw materials.
– Produce and sell finished
goods.
Types of Product Costing Systems
Process
Costing
Job-order
Costing

A company produces many units of a single
product.

One unit of product is indistinguishable from
other units of product.

The identical nature of each unit of product enables
assigning the same average cost per unit.
Types of Product Costing Systems
Process
Costing
Job-order
Costing

Many different products are produced each period.

Products are manufactured to order.

The unique nature of each order requires tracing or
allocating costs to each job, and maintaining cost
records for each job.
Direct Manufacturing Costs
Direct Materials
Job No. 1
Direct Labor
Manufacturing
Overhead
Job No. 2
Job No. 3
Charge
direct
material and
direct labor
costs to
each job as
work is
performed.
Indirect Manufacturing Costs
Direct Materials
Job No. 1
Direct Labor
Manufacturing
Overhead
Job No. 2
Job No. 3
Manufacturing
Overhead,
including
indirect
materials and
indirect labor,
are allocated to
jobs rather than
directly traced
to each job.
Manufacturing Overhead
Application
The predetermined overhead rate (POHR) used to
apply overhead to jobs is determined before the
period begins.
POHR =
Estimated total manufacturing
overhead cost for the coming period
Estimated total units in the
allocation base for the coming period
Ideally, the allocation base
is a cost driver that causes
overhead.
The Need for a POHR
Using a predetermined rate makes it
possible to estimate total job costs sooner.
Actual overhead for the period is not
known until the end of the period.
Application of Manufacturing
Overhead
Based on estimates, and
determined before the
period begins.
Overhead applied = POHR × Actual activity
Actual amount of the allocation
based upon the actual level of
activity.
Overhead Application Rate
POHR =
POHR =
Estimated total manufacturing
overhead cost for the coming period
Estimated total units in the
allocation base for the coming period
$640,000
160,000 direct labor hours (DLH)
POHR = $4.00 per DLH
For each direct labor hour worked on a
particular job, $4.00 of factory overhead
will be applied to that job.
Job-Order Cost Accounting
Cost Classifications for Predicting
Cost Behavior
How a cost will react to
changes in the level of activity
within the relevant range.
– Total variable costs change
when activity changes.
– Total fixed costs remain
unchanged when activity
changes.
Cost Classifications for Predicting
Cost Behavior
Behavior of Cost (within the relevant range)
Cost
In Total
Per Unit
Variable
Total variable cost changes
as activity level changes.
Variable cost per unit remains
the same over wide ranges
of activity.
Fixed
Total fixed cost remains
the same even when the
activity level changes.
Average fixed cost per unit goes
down as activity level goes up.
The Activity Base
Units
produce
d
Machine
hours
A measure of what
causes the
incurrence of a
variable cost
Miles
driven
Labor
hours
Extent of Variable Costs
The proportion of variable costs differs across
organizations. For example . . .
A public utility with
large investments in
equipment will tend
to have fewer
variable costs.
A service company
will normally have a high
proportion of variable costs.
A manufacturing company
will often have many
variable costs.
A merchandising company
usually will have a high
proportion of variable costs
like cost of sales.
Examples of Variable Costs
1. Merchandising companies – cost of goods sold.
2. Manufacturing companies – direct materials,
direct labor, and variable overhead.
3. Merchandising and manufacturing companies –
commissions, shipping costs, and clerical costs
such as invoicing.
4. Service companies – supplies, travel, and
clerical.
The Linearity Assumption and the Relevant Range
Total Cost
Economist’s
Curvilinear Cost
Function
Relevant
Range
A straight line
closely
approximates a
curvilinear
variable cost
line within the
relevant range.
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
Activity
Types of Fixed Costs
Committed
Discretionary
Long-term, cannot be
significantly reduced
in the short term.
May be altered in the
short-term by current
managerial decisions
Examples
Examples
Depreciation on
Equipment and
Real Estate Taxes
Advertising and
Research and
Development
The Trend Toward Fixed Costs
The trend in many industries is toward
greater fixed costs relative to variable costs.
As machines take over
many mundane tasks
previously performed
by humans,
“knowledge workers”
are demanded for
their minds rather
than their muscles
Knowledge workers
tend to be salaried,
highly-trained and
difficult to replace. The
cost to compensate
these valued employees
is relatively fixed
rather than variable.
Rent Cost in
Thousands of Dollars
Fixed Costs and Relevant Range
90
Relevant
60
Range
30
0
0
Total cost doesn’t
change for a wide
range of activity, and
then jumps to a new
higher cost for the
next higher range of
activity.
1,000
2,000
3,000
Rented Area (Square Feet)
Let’s put our
knowledge of cost
behavior to work by
preparing a
contribution format
income statement.
The Contribution Format
Sales Revenue
Less: Variable costs
Contribution margin
Total
$ 100,000
60,000
$ 40,000
Less: Fixed costs
Net operating income
30,000
$ 10,000
Unit
$ 50
30
$ 20
The contribution margin format emphasizes
cost behavior. Contribution margin covers fixed
costs and provides for income.
The Contribution Format
Used primarily for
external reporting.
Used primarily by
management.
Break-Even Analysis
Here is the information from Racing Bicycle Company:
Total
Sales (500 bikes)
$ 250,000
Less: variable expenses 150,000
Contribution margin
$ 100,000
Less: fixed expenses
80,000
Net operating income
$ 20,000
Per Unit
$
500
300
$
200
Percent
100%
60%
40%
Contribution Margin Method
The contribution margin method has two key
equations.
Break-even point
=
in units sold
Break-even point in
total sales dollars =
Fixed expenses
Unit contribution margin
Fixed expenses
CM ratio
Contribution Margin Method
Let’s use the contribution margin method to
calculate the break-even point in total sales
dollars at Racing.
Break-even point in
total sales dollars =
Fixed expenses
CM ratio
$80,000
= $200,000 break-even sales
40%
Contribution Margin Method
Let’s use the contribution margin method to
calculate the break-even point in units sold at
Racing.
Break-even point in
=
Units sold
Fixed expenses
Unit CM
$80,000
= 400 break-even units
$200/unit
Target Profit Analysis
The contribution margin method can be used to
determine the sales volume needed to achieve a target
profit.
Suppose Racing Bicycle Company wants to
know how many bikes must be sold to earn a
profit of $100,000.
The Contribution Margin Approach
The contribution margin method can be used to
determine that 900 bikes must be sold to earn the
target profit of $100,000.
Unit sales to attain
=
the target profit
Fixed expenses + Target profit
Unit contribution margin
$80,000 + $100,000
= 900 bikes
$200/bike
Cost Structure and Profit Stability
Cost structure refers to the relative proportion
of fixed and variable costs in an organization.
Managers often have some latitude in
determining their organization’s cost structure.
Operating Leverage
• A measure of how sensitive net operating income is to
percentage changes in sales.
Degree of
Contribution margin
=
operating leverage
Net operating income
Operating Leverage Example
Low-Lev Company
High-Lev Company
(1,000,000 units)
(1,000,000 units)
Amount
%
Amount
%
Sales
$1,000,000
100
$1,000,000
100
Var. Costs
750,000
75
250,000
25
CM
250,000
25
750,000
75
Fixed Costs
50,000
5
550,000
55
Operating
Profit
200,000
20
200,000
20
Breakeven
Point
200,000 units
733,334
CM per unit
$0.25/unit
$0.75/unit
Operating
Leverage
1.25
3.75
Operating Leverage Example
10% increase in sales
Low-Lev Company
High-Lev Company
(1,100,000 units)
(1,100,000 units)
Amount
%
Amount
%
Sales
$1,100,000
100
$1,100,000
100
Var. Costs
825,000
75
275,000
25
CM
275,000
25
825,000
75
Fixed Costs
50,000
5
550,000
55
Operating
Profit
225,000
20
275,000
20
Breakeven
Point
200,000 units
Operating
Leverage
1.25
10% * 1.25 = 12.5%
CM per
unit
$0.25/unit
increase
in profit
733,334
10% * 3.75 = 37.5%
$0.75/unit in profit
increase
3.75
Cost Structure and Profit Stability
There are advantages and disadvantages to high
fixed cost (or low variable cost) and low fixed
cost (or high variable cost) structures.
An advantage of a high fixed
cost structure is that income
will be higher in good years
compared to companies
A disadvantage of a high fixed
with lower proportion of
cost structure is that income
fixed costs.
will be lower in bad years
compared to companies
with lower proportion of
fixed costs.
The Basic Framework of Budgeting
A budget is a detailed quantitative plan for
acquiring and using financial and other resources
over a specified forthcoming time period.
1. The act of preparing a budget is called
budgeting.
2. The use of budgets to control an
organization’s activity is known as
budgetary control.
Planning and Control
Planning –
involves developing
objectives and preparing
various budgets to
achieve these objectives.
Control –
involves the steps taken
by management that
attempt to ensure the
objectives are attained.
Advantages of Budgeting
Define goal
and objectives
Communicate
plans
Think about and
plan for the future
Advantages
Coordinate
activities
Means of allocating
resources
Uncover potential
bottlenecks
Responsibility Accounting
Managers should be held responsible for those items —
and only those items — that
the manager can actually control
to a significant extent.
Human Factors in Budgeting
The success of budgeting depends upon three important
factors:
1. Top management must be enthusiastic and committed to
the budget process.
2. Top management must not use the budget to pressure
employees or blame them when something goes wrong.
3. Highly achievable budget targets are usually preferred
when managers are rewarded based on meeting budget
targets.
The Master Budget: An Overview
Sales
Budget
Ending
Finished Goods
Budget
Direct
Materials
Budget
Production
Budget
Selling and
Administrative
Budget
Direct
Labor
Budget
Manufacturing
Overhead
Budget
Cash
Budget
Budgeted Financial Statements
Budgeting Example
 Royal Company is preparing budgets for the quarter ending
June 30.
 Budgeted sales for the next five months are:
April
20,000 units
May
50,000 units
June
30,000 units
July
25,000 units
August
15,000 units.
 The selling price is $10 per unit.
Expected Cash Collections
• All sales are on account.
• Royal’s collection pattern is:
70% collected in the month of sale,
25% collected in the month following sale,
5% uncollectible.
• The March 31 accounts receivable balance of $30,000
will be collected in full.
Expected Cash Collections
Expected Cash Collections
From the Sales Budget for April.
Expected Cash Collections
From the Sales Budget for May.
Quick Check 
What will be the total cash collections for the quarter?
a. $700,000
b. $220,000
c. $190,000
d. $905,000
The Production Budget
Production must be adequate to meet budgeted
sales and provide for sufficient ending inventory.
The Production Budget
• The management at Royal Company wants ending
inventory to be equal to 20% of the following month’s
budgeted sales in units.
• On March 31, 4,000 units were on hand.
Let’s prepare the production budget.
The Production Budget
The Production Budget
March 31
ending inventory
Budgeted May sales
Desired ending inventory %
Desired ending inventory
50,000
20%
10,000
Quick Check 
What is the required production for May?
a. 56,000 units
b. 46,000 units
c. 62,000 units
d. 52,000 units
The Cash Budget
The Budgeted Income Statement
Royal Company
Budgeted Income Statement
For the Three Months Ended June 30
Sales (100,000 units @ $10)
Cost of goods sold (100,000 @ $4.99)
Gross margin
Selling and administrative expenses
Operating income
Interest expense
Net income
$ 1,000,000
499,000
501,000
260,000
241,000
2,000
$ 239,000
Royal Company
Budgeted Balance Sheet
June 30
Current assets
Cash
Accounts receivable
Raw materials inventory
Finished goods inventory
Total current assets
Property and equipment
Land
Equipment
Total property and equipment
Total assets
Accounts payable
Common stock
Retained earnings
Total liabilities and equities
$
43,000
75,000
4,600
24,950
147,550
50,000
367,000
417,000
$ 564,550
$
28,400
200,000
336,150
$ 564,550
Cost, Profit, and Investments Centers
Cost
Center
Cost, profit,
and investment
centers are all
known as
responsibility
centers.
Profit
Center
Responsibility
Center
Investment
Center
Cost, Profit, and Investments Centers
Cost Center
A segment whose manager has control over costs,
but not over revenues or investment funds.
Cost, Profit, and Investments Centers
Profit Center
A segment whose manager
has control over both costs
and revenues,
but no control over
investment funds.
Revenues
Sales
Interest
Other
Costs
Mfg. costs
Commissions
Salaries
Other
Cost, Profit, and Investments Centers
Investment Center
A segment whose manager has control over costs,
revenues, and investments in operating assets.
Evaluating Investment Center Performance:
Return on Investment (ROI) Formula
Income before interest
and taxes (EBIT)
Net operating income
ROI =
Average operating assets
Cash, accounts receivable, inventory,
plant and equipment, and other
productive assets.
Calculating Residual Income
Residual
=
income
Net
operating income
(
Average
operating
assets

)
Minimum
required rate of
return
This computation differs from ROI.
ROI measures net operating income earned relative
to the investment in average operating assets.
Residual income measures net operating income
earned less the minimum required return on average
operating assets.
Residual Income – An Example
• The Retail Division of Zepher, Inc. has average operating
assets of $100,000 and is required to earn a return of 20%
on these assets.
• In the current period the division earns $30,000.
Let’s calculate residual income.
Residual Income – An Example
Operating assets
$ 100,000
Required rate of return ×
20%
Minimum required return $ 20,000
Actual income
Minimum required return
Residual income
$ 30,000
(20,000)
$ 10,000
ROI vs. Residual Income
The residual income numbers below suggest that the Wholesale Division
outperformed the Retail Division because its residual income is $10,000 higher.
However, the Retail Division earned an ROI of 30% compared to an ROI of 22% for
the Wholesale Division. The Wholesale Division’s residual income is larger than
the Retail Division simply because it is a bigger division.
Retail
Wholesale
Operating assets
$ 100,000 $ 1,000,000
Required rate of return ×
20%
20%
Minimum required return $ 20,000 $ 200,000
Retail
Wholesale
Actual income
$ 30,000 $ 220,000
Minimum required return
(20,000)
(200,000)
Residual income
$ 10,000 $
20,000
The Balanced Scorecard
Management translates its strategy into
performance measures that employees
understand and accept.
Customers
Financial
Performance
measures
Internal
business
processes
Learning
and growth
The Balanced Scorecard: From
Strategy to Performance Measures
Exh.
10-11
Performance Measures
Financial
Has our financial
performance improved?
Customer
Do customers recognize that
we are delivering more value?
Internal Business Processes
Have we improved key business
processes so that we can deliver
more value to customers?
Learning and Growth
Are we maintaining our ability
to change and improve?
What are our
financial goals?
What customers do
we want to serve and
how are we going to
win and retain them?
What internal business processes are
critical to providing
value to customers?
Vision
and
Strategy
The Balanced Scorecard:
Non-financial Measures
The balanced scorecard relies on non-financial measures
in addition to financial measures for two reasons:
 Financial measures are lag indicators that summarize
the results of past actions. Non-financial measures are
leading indicators of future financial performance.
 Top managers are ordinarily responsible for financial
performance measures – not lower level managers.
Non-financial measures are more likely to be
understood and controlled by lower level managers.
The Balanced Scorecard
A balanced scorecard should have measures
that are linked together on a cause-and-effect basis.
If we improve
one performance
measure . . .
Then
Another desired
performance measure
will improve.
The balanced scorecard lays out concrete
actions to attain desired outcomes.
The Balanced Scorecard
and Compensation
Incentive compensation
should be linked to
balanced scorecard
performance measures.
You get the behavior
you reward!!
Exh.
10-13
The Balanced Scorecard
Jaguar Example
Profit
Financial
Contribution per car
Number of cars sold
Customer
Customer satisfaction
with options
Internal
Business
Processes
Learning
and Growth
Number of
options available
Time to
install option
Employee skills in
installing options
The Balanced Scorecard
Jaguar Example
Profit
Contribution per car
Number of cars sold
Customer satisfaction
with options
Results
Satisfaction
Increases
Strategies
Increase
Options
Increase
Skills
Number of
options available
Time to
install option
Employee skills in
installing options
Time
Decreases
The Balanced Scorecard
Jaguar Example
Profit
Contribution per car
Results
Number of cars sold
Customer satisfaction
with options
Strategies
Increase
Options
Number of
options available
Time to
install option
Employee skills in
installing options
Cars sold
Increase
Satisfaction
Increases
The Balanced Scorecard
Jaguar Example
Results
Profit
Contribution per car
Contribution
Increases
Number of cars sold
Customer satisfaction
with options
Number of
options available
Time to
install option
Strategies
Increase
Skills
Employee skills in
installing options
Time
Decreases
The Balanced Scorecard
Jaguar Example
Results
Profit
If number
of cars sold
and contribution
per car increase,
profits
increase.
Profits
Increase
Contribution per car
Contribution
Increases
Number of cars sold
Customer satisfaction
with options
Satisfaction
Increases
Strategies
Increase
Options
Increase
Skills
Number of
options available
Time to
install option
Employee skills in
installing options
Time
Decreases