The Nature of Management
Accounting
Management vs. Financial
Accounting (1 of 6)

Necessity



Financial Accounting (FA): SEC (or banks or
suppliers) requires publicly traded companies
to publish financial statements according to
GAAP.
Management accounting (MA) is optional.
Purpose.


FA: Produce financial statements for outside
users.
MA: Help managers plan, implement and
control.
2
Management vs. Financial
Accounting (2 of 6)

Users.



FA: faceless group, external users, present or
potential shareholders.
MA: Known managers who influence what
information is needed.
Underlying structure.


FA: built around: Assets = Liabilities +
Stockholders’ Equity.
MA: 3 purposes each with its own set of concepts
and constructs (addressed later).
3
Management vs. Financial
Accounting (3 of 6)

Source of principles.



FA: GAAP.
MA: whatever managers believe is useful.
Time orientation.


FA: historical, tell it like it was.
MA: future/decision oriented, tell it like it will be.
(However, the past is often a good predictor of the
future.)
4
Management vs. Financial
Accounting (4 of 6)

Information content.



FA: financial statements are the end product and
include primarily financial info.
MA: non-monetary as well as monetary info.
Information precision.


FA: Uses approximations but as a generalization is
more precise than MA.
MA: Management needs info rapidly to be useful
in decision making and therefore precision is
sometimes sacrificed.
5
Management vs. Financial
Accounting (5 of 6)

Report frequency:



FA: Publicly traded, SEC: quarterly, with more
detailed info annually.
MA: Up to management.
Report timeliness.


FA: Usually, several weeks to months after fiscal
close of accounting period.
MA: Quickly to be useful for decision making.
6
Management vs. Financial
Accounting (6 of 6)

Report entity.


FA: Organization as a whole.
MA: Relatively small parts (responsibilities
centers such as departments, product
lines, divisions, subsidiaries as well as
organization as a whole.)
7
Uses of Management Accounting
1.
2.
3.
Measurement of revenues, costs, and
assets.
Control.
To aid in choosing among alternative
courses of action.
8
Measurement


Full cost accounting measures the resources
used in performing some activity.
Full cost of producing goods or providing
services = direct costs + indirect costs.


Direct costs = costs directly traced to the goods or
services.
Indirect costs = a fair share of costs incurred
jointly in producing goods or services.
9
Measurement example


Be careful of how you allocate that
overhead.
How expensive is that ashtray?
10
Control

Costs (also, revenues and assets) are
identified to and measured by responsibility
center.



A manager heads each responsibility center.
Corrective action can only be taken by individuals.
To help identify problems (and opportunities)
actual costs are measured and compared to a
benchmark (budget, last year, industry average).
11
Alternative Choice Decisions

Differential costs of alternative possible
actions are developed.
12
General Observations on MA





Different numbers for different purposes.
 Many different types of costs: historical, standard,
overhead, variable, fixed, differential, marginal,
opportunity, direct, estimated, full, etc.
 Clarify which type you are talking about.
Accounting numbers are approximations.
Best that we can with incomplete data.
Accounting evidence is only partial evidence other
factors help make decisions.
People not numbers get things done. How you use
the numbers is as important as how the numbers are
produced.
13
The Behavior of Costs and
Decision-Making
14
What will be covered



A general overview of how costs
“behave.”
Several applications of how this
knowledge can help you make better,
informed, decisions.
Some examples of what we will be able
to solve:
15
Breakeven analysis

You are considering offering a new
service (such as delivery of take-out)
and you wish to determine what volume
you will need to generate to cover your
costs.
16
Close a location decision

You are responsible for several
locations. One location consistently
shows a “loss” on its income statement.
Should it be closed? If so, will your
region be better off?
17
Special orders decisions

You have been offered a one-time
special order. You need to determine if
you should accept the order given the
price is lower than the normal charge
for comparable meals you serve.
18
Behavior of Costs

Cost-volume relationships.


Fixed and variable costs.
Step-function costs.
19
Relation of Costs to Volume



Variable costs = items of cost that vary, in
total, directly and proportionately with
volume.
Fixed costs = items of cost that, in
total, do not vary at all with volume
Semi-variable costs (semi-fixed costs) =
costs that include a combination of variable
cost and fixed cost items.
20
Variable Costs

Items of cost that vary, in total, directly
and proportionately with volume.


Volume refers to activity level.
Examples:



Material costs varies with units sold.
Electricity costs varies with production hours.
Stationery and postage costs varies with
number of letters written.
21
Fixed costs

Items of cost that, in total, do not vary
at all with volume.

Examples:



Building rent, property taxes, management
salaries.
Fixed cost per unit of activity decreases as
the level of activity increases.
Fixed costs are fixed for a range of activity
and a limited period of time.
22
Beware of how cost behave!


Fixed costs should not be treated as
variable in decision making.
Senate gym example.
23
Cost-volume (C-V) diagram



Y or vertical axis reflects total cost.
X or horizontal axis reflects volume.
y = mx + b.



y is the cost at a volume of x;
m is the rate of cost change per unit of volume
change, or the slope (variable costs).
b is the vertical intercept, which represents the
fixed cost component.
24
Profit-graph




Add revenue line to C-V diagram.
Assumes constant selling price.
UR = unit revenue
TR = total revenue
25
TC = TFC +(UVC*X)




TC = total cost;
TFC = total fixed cost (per time period),
UVC = Unit variable cost (per unit of
volume),
X = volume.
26
Cost Relations



Average costs = total cost/volume.
Average cost behaves differently than
total cost.
As volume goes up 

Total fixed cost remains constant, total
variable costs goes up, per unit variable
costs stays the same, per unit fixed cost
goes down, per unit total cost goes down.
27
Step-function costs




Incurred when costs are added in discrete
chunks, e.g., a manager for every 10
workers.
Adding the “chunk” of costs increases
capacity.
Height of a stair step (riser) indicates the cost
of adding incremental capacity.
Step width (tread) shows how much
additional volume of that activity can be
serviced by this additional increment of
capacity.
28
Contribution


Unit contribution margin = marginal
income = unit selling price - variable
cost per unit = UR - UVC.
What is contribution:


First it is the contribution to cover fixed
costs.
Then it is the contribution toward profit.
29
Breakeven Volume




TR = UR*X
TC = TFC + (UVC*X)
Breakeven: TR = TC
Substituting: UR*X = TFC + (UVC*X) 
X = TFC/(UR - UVC)
30
Break-even Volume


In units = Fixed costs/unit contribution
In revenue dollars just compute breakeven in units and multiply by the selling
price.
31
A simple example




You run a restaurant that serves one
type of meal that sells for $5.
The variable costs (ingredients,
container, etc.) total $3.
Monthly fixed costs (rent, salary, etc.)
total $4,000.
What is the breakeven amount in
volume and in sales dollars?
32
Target Profit

Add to breakeven analysis to show units
or dollar of sales to achieve a target (T)
level of profit:
UR*X = TFC + (UVC*X) + T
X = (TFC+T)/(UR - UVC)
33
A simple example - continued


Instead of just breaking even, you
would like to make a profit of $2,500.
What volume of meals will you need to
serve?
34
Now your turn.

Take-out problem.
35
Up the ante

Some slightly harder problems

Grizzly Express

Store 201 example
36
Limitations of C-V Relations

A straight line approximates cost
behavior only within a certain range of
volume, the relevant range.


When volume approaches zero,
management takes steps to reduce fixed
costs.
When volume exceeds relevant range,
fixed costs increase.
37
Limitations (continued)

Amount of variable costs depends on
the time period over which behavior is
estimated (the relevant time period).


If the time period is one day, few costs are
variable.
Over an extremely long time period, no
costs are fixed.
38
Linear Assumption

C-V relationship is often not linear.


Some cost functions are curved
(curvilinear).
Segments of the curve can be
approximated by a straight line, each with
its own relevant range.
39
Short-Run Alternative Choice
Decisions
40
Highlights


Alternative choice decisions: manager
seeks to choose best of several
alternative courses of action.
Introduces construct of differential costs
and revenues for several types of
problems, each having a relatively short
time horizon.
41
Differential Costs and
Revenues


Costs that are different under one set of
conditions than they would be under
another.
Revenues that are different under one
set of conditions than they would be
under another.
42
Nature of Full and Differential
Costs


Full cost of a product or other cost
object = sum of direct cost + fair share
of applicable indirect costs.
Differential costs include only those cost
elements of cost that are different
under a certain set of conditions.
43
Historical, Full and Differential
Costs



Full cost accounting system collects historical
costs.
Differential costs always relate to the future.
Differential costs are intended to show what
costs will be if a certain course of action is
adopted in the future.
44
Steps in the Analysis





Define the problem.
Select possible alternative solutions. (Status quo may
be the benchmark against which other alternatives
are measured.)
For each alternative, measure and evaluate
consequences that can be expressed in quantitative
terms.
Identify those consequences that cannot be
expressed in quantitative terms and evaluate them
against each other and against the measured
consequences.
Reach a decision.
45
Opportunity costs


A measure of the value that is lost or
sacrificed when the choice of one course
of action requires giving up an alternative
course of action.
Not measured in accounting records.
46
Sunk Cost


A cost that has already been incurred and
therefore cannot be changed by any
decision currently being considered.
Not a differential cost.
47
Importance of Time Span

The longer the time span the more
items of cost that are differential.

In the very long run full costs are
differential costs.
48
Sensitivity Analysis

Considers how sensitive the quantitative
measurements of the alternatives are to
changes in assumptions.
49
Just One Fallacy



Each additional unit of production adds just
variable costs.
If many units are added, then step function
costs (i.e., fixed costs) are added.
Therefore, step function costs are averaged
out over the additional units of volume.
50
Sell Now or Process Further

Assume that the product being offered
can either be sold currently as is for a
certain sum or processed further, with
additional costs, at which time it can be
sold for a greater amount than now.
51
Sell Now or Process Further
Cost per
unit to date
$300
Cost per
unit to
complete
$200
Labor
200
100
Var. OH
100
100
Fixed OH
200
Total
$800
Material
$400
52
Sell Now or Process Further




The product is being discontinued and its
price has fallen. If the product is processed
to completion it can be sold for only $1,000
(less than cost incurred of $1,200 = $800 +
$400)
If sold now they will bring in $500.
What should we do?
Should we incur $400 more cost knowing we
will end up losing money overall? Is this
throwing good money at bad?
53
Differential costs
Revenue
Current
costs
New
costs
Total
costs
Profit
Sell
Process
Now Further
$500 $1,000
Difference
$500
800
800
0
0
400
<400>
800
1,200
<400>
<300>
<200>
100
54
Sunk Costs



Cost that have already been incurred
and cannot be changed.
Not relevant to any decision
Cost of $800 already incurred in the
previous example are sunk and should
be ignored. They do not change the
situation in any way.
55
Variation on a theme

Restaurant 314
56
Make or Buy




Often a company will purchase an ingredient
externally that is part of what they are
making.
They could make this ingredient internally if it
is to their benefit to do so.
These decisions usually only involve costs,
not revenues.
Qualitative factors must be considered.
57
Make or Buy


XYZ Co. is considering an offer to
supply 50,000 units of ingredient D at a
cost of $.32 per unit.
The company is currently producing
ingredient D internally with the
following costs:
58
Variable costs
Direct material ($.10/unit)
Direct labor ($.12/unit)
Variable OH ($.08/unit)
Total variable costs
$5,000
6,000
4,000
15,000
Fixed costs:
Depreciation – equip.
Depreciation – Bldg
Supervisor's salary
Other
Total fixed costs
Total costs
800
600
500
350
2,250
$17,250
59
Make or Buy

Cost to manufacture internally is $.345 =
$17,250 / 50,000
Outside offer is for $.320

Other information:


Market value of the machine we use to produce D
is zero if we try to dispose of it
60
Internal
Costs
External
Costs
Difference
Variable costs
Direct material ($.10/unit)
$5,000
$0
$5,000
Direct labor ($.12/unit)
6,000
0
6,000
Variable OH ($.08/unit)
4,000
0
4,000
15,000
0
15,000
Depreciation – equip.
800
800
0
Depreciation – Bldg
600
600
0
Supervisor's salary
500
Other
350
350
0
2,250
1,750
500
0
16,000
(16,000)
$17,750
($500)
Total variable costs
Fixed costs:
Total fixed costs
Cost of buying outside
Total costs
$17,250
500
61
Avoidable Costs




Not all fixed costs are irrelevant sunk costs
Some fixed costs are avoidable (i.e., they can
be avoided under one alternative)
In the previous example we can terminate
the supervisors, hence this fixed costs is
avoidable and therefore relevant and
differential.
Since avoidable costs of $15,500 is less than
the cost of the external part, we should reject
the offer based on financial grounds.
62
Cost of buying externally (50,000
x $.320)
Cost savings (avoidable costs)
Variable costs
Supervisor salaries
Net costs
($16,000)
15,000
500
($500)
63
Opportunity Cost



The value of foregone benefits from selecting
one choice over an alternative.
You give up earning money at a job by going
to school full time.
Assume that, in the previous example, if we
no longer make ingredient D internally, we
can save $600 in rent by using the space for
another operation that is currently leasing
warehouse space.
64
Cost of buying externally (50,000
x $320)
Cost savings (avoidable costs)
Variable costs
($16,000)
15,000
Supervisor salaries
500
Opportunity cost of using the
plant to produce part D
Net savings
600
$100
65
Your turn

Sauce It Up
66
Dropping a Product




Need to calculate the change in profit if
the product is dropped versus retained.
Both differential costs and revenues are
considered.
Procedure differs if there is excess
capacity versus at capacity
If at capacity need to consider
opportunity costs.
67
Dropping a Store


Region 5 is considering dropping Store #2.
Direct fixed costs are items directly traceable
to the division


Example – salary of a worker who spends all his
time in this restaurant
Allocated fixed costs are fixed costs that are
shared between divisions

Example – Salary of the regional manager
68
#1
Sales
$100,000
#2
#3
Total
$150,000 $210,000 $460,000
Cost of sales
45,000
60,000
90,000
195,000
Gross Margin
55,000
90,000
120,000
265,000
Other variable costs
15,000
20,000
30,000
65,000
Contribution Margin
40,000
70,000
90,000
200,000
Direct fixed costs
20,000
65,000
40,000
125,000
Allocated fixed
costs
Total fixed costs
15,000
20,000
25,000
60,000
35,000
85,000
65,000
185,000
Net Income
$5,000 $(15,000) $25,000 $15,000
69
Dropping a Product

Should #2 be dropped?





It is showing a loss of ($15,000)!
What would happen to the division’s total net
income if the store was dropped?
Assume the direct fixed costs are building
rent that can be avoided.
Allocated fixed costs are the regional
manager’s salary and some corporate costs.
If Store #2 were dropped, there would not be
any impact on the other store’s volume.
70
Lost revenue
Cost savings
COGS
Other variable costs
Direct fixed costs
Total cost savings
Net loss from dropping division
$(150,000)
60,000
20,000
65,000
145,000
$(5,000)
71
The Death Spiral






This phenomena is sometimes referred to as
the Dearth Spiral.
You drop one product because it is “a loser.”
Suddenly other products become losers.
You drop them.
Now other products become losers.
And the spiral continues until you are out of
business!
72
Your turn.

Drop store 103 example.
73
Variation on a theme

Try your hand at a special order
problem.

Girl Scouts example

How Special
74
Decisions Involving
Constraints



Basic decision is to keep any product/store
with a positive contribution margin as long as
you can keep selling it.
That changes if making one product affects
another product.
An example is when there is a constraint such
as a limited amount of skilled labor or
machine time
75
Decisions Involving
Constraints
Product A Product B
Selling Price
$100
$80
Variable
costs
Contribution
Margin
50
60
$50
$20
76
Decisions Involving
Constraints

Suppose that both products require time on a
specialized machine. A total of 1,000 hours
are available.



Product A requires 10 hours
Product B requires 2 hours
Which product should be produced assuming
we can sell as much of either as we produce
at the given prices?
77
Decisions Involving
Constraints


Product A has the highest CM, we make
$50 for every one sold versus only $20
for each B.
But what about those machine hours?
78
Decisions Involving
Constraints

Since A requires 10 hours and we have 1,000
total, we can produce 100 A.


Since B requires only 2 hours we can produce
500 total.


At $50 each = $5,000 CM
At $20 each = $10,000
Company is better off producing all Product B.
79
Decisions Involving
Constraints

Decision rule:



Under conditions of a constraint, produce the
product with the highest contribution margin per
unit of the constraint.
A has $50/10 hours or $5 per machine hour.
B has $20/2 hours or $10 per machine hour.
80
A Few More Examples To Try

Drew

Walter’s

Wasted Away
81