Lesson 14 Managerial Accounting: Applications Task Team of FUNDAMENTAL ACCOUNTING School of Business, Sun yat-sen University Outline • Segmented Reporting and Responsibility Accounting System • Cost-Volume-Profit Analysis • Budgeting and Budgetary Control • Standard Costs and Variance Analysis • Managerial Decision Making 2 Introduction • Let’s look at the XYZ Company example. – A manager at XYZ Company wants to replace an old machine with a new, more efficient machine. New machine: List price Annual variable expenses Expected life in years Old machine: Original cost Remaining book value Disposal value now Annual variable expenses Remaining life in years 3 900000 800000 5 720000 600000 150000 1000000 5 Introduction • XYZ’s sales are $2000000 per year. • Fixed expenses, other than amortization, are $700000 per year. • Should the manager purchase the new machine? 4 Introduction • The manager recommends that the company not purchase the new machine since disposal of the old machine would result in a loss: Remaining book value Disposal value Loss from disposal 5 600000 -150000 450000 Introduction • Is it correct? • What’s your comment to the manager’s decision? • After learning this chapter, you will know how to employ the tools of managerial accounting and make decisions correctly. 6 Segment Reporting • Organizations may break down their operations into various segments – divisions, stores, services, or departments. • Management needs reports on each segment for – cost management – performance evaluation 7 Segment Reporting • Segments may be evaluated as – a cost centre – a profit centre • Profit centre reports include information on a segment’s revenues and costs. – an investment centre. • Some costs are direct and some are indirect. – Indirect costs may be allocated to various departments. 8 Segment Reporting • Service department costs are shared indirect expenses of operation departments. • They may be allocated using a variety of bases. Service Department General Office Personnel Payroll Advertising Purchasing Cleaning Maintenance Common Allocation Bases Number of employees Number of employees Number of employees Sales Number of Purchase Orders Floor space occupied Floor space occupied 9 Responsibility Accounting System Responsibility Accounting System • • • An accounting system assigns managers the responsibility for costs and expenses under their control. 10 Responsibility Accounting System • Responsibility accounting budgets – are prepared prior to each accounting period • Responsibility accounting performance reports – compare actual costs and expenses to budgeted amounts 11 Cost-Volume-Profit Analysis (CVP) • CVP analysis is used to answer: – How much must I sell to earn my desired income? – How will income be affected if I reduce selling prices to increase sales volume? – How will income be affected if I change the sales mix of my products? – ……? 12 Assumptions of CVP Analysis • CVP analysis assumes relations can be expressed as straight lines within the relevant range. Unit selling price remains constant. Unit variable costs remain constant. Total fixed cost remain constant. • If the expected cost and revenue behaviour is different from the assumptions, then the results of CVP analysis are of limited use. 13 Scatter Diagram Total Cost in 1,000’s of Dollars Change in cost Unit Variable Cost = Slope = Change in units 20 * 10 0 * * * ** * * ** Vertical distance is the change in cost. Horizontal distance is the change in activity. 0 1 2 3 4 Activity, 1,000’s of Units Produced 14 14 High-Low Method Total Cost in 1,000’s of Dollars Unit Variable Cost = 30 - 20 = $2.50/unit 5-1 30 20 10 0 * * * * * * * * ** Horizontal distance is the change in activity. (5 - 1) 0 1 2 3 4 5 Activity, 1,000’s of Units Sold 15 Vertical distance is the change in cost. (30 - 20) Least-Squares Regression • Least-squares regression – is usually covered in advanced cost accounting courses. – is commonly used with computer software because of the large number of calculations required. – The objective of the cost analysis remains the same: determination of total fixed cost and the variable unit cost. 16 • The break-even point is the unique sales level at which a company neither earns a profit nor incurs a loss. Costs and Revenue in Dollars Break-Even Analysis Sales Total costs Volume in Units 17 Break-Even Analysis • The break-even point may be expressed in units or in dollars of sales. Fixed Costs Break-even point in units = Contribution margin per unit Unit sales price less unit variable cost 18 Break-Even Analysis • The break-even formula may also be expressed in sales dollars. Break-even point in dollars = Fixed Costs Contribution margin ratio Unit sales price Unit variable cost 19 Computing Income from Expected Sales • What is the income given a predicted level of sales? Pre-tax Income Pre-tax Income or 20 Sales Volume Needed to Earn a Target Income • Break-even formulas can be adjusted to show the sales volume needed to earn any amount of income. Unit sales = Dollar sales = Fixed costs + Target income Contribution margin per unit Fixed costs + Target income Contribution margin ratio 21 Margin of Safety • Margin of safety – How much sales can decrease before the company incurs a loss? Expected sales - Break-even sales Margin of = safety (%) Expected sales 22 Sensitivity Analysis • The effects of changes in variables such as sales price, variable costs, and fixed costs. • CVP analysis can be used to show the effects of such changes. New breakeven point = in dollars New fixed costs New contribution margin ratio 23 Budgets • Budgets – formal statements of a company’s plans expressed in monetary terms – attempt to capture the future activities of an organization – are used by businesses, not-for-profit, government, educational, and other types of organizations. 24 Importance of Budgeting Defines goals and objectives Promotes analysis and a focus on the future Communicates plans and instructions Advantages Coordinates business activities Motivates employees Provides a basis for evaluating performance 25 Budget Committee • Budget Committee – Consists of managers from all departments of the organization – Provides central guidance • to insure that individual budgets submitted from all departments are realistic and coordinated. 26 Budget Committee Top Management Middle Management Supervisor Middle Management Supervisor Supervisor Supervisor Flow of budget data is a bottom-up process. 27 Budget Cycle • Budget horizons are usually for one year • but may extend for several years. Operating Budget 2005 2006 2007 2008 The annual operating budget may be divided into quarterlyor monthly budgets. 28 Rolling Budgets Continuous or Rolling Budget 2005 2006 2007 The budget may be a twelve-month budget that rolls forward one month as the current month is completed. 29 2008 Master Budget • Master Budget – A formal, comprehensive plan • for the future of a company – consists of several budgets linked together • to form a coordinated plan for the organization 30 Master Budget Prepare sales budget Develop production budget Prepare manufacturing budgets: material labour overhead Prepare financial budgets: cash income balance sheet Prepare capital expenditure budget Prepare selling and general administrative budgets 31 Sales Budget • Sales budget – the starting point in the budgeting process. – Most of the other budgets are linked to the sales budget. – Sales personnel are often involved in developing the sales budgets. 32 Sales Budget Sales Budget Estimated Unit Sales Estimated Unit Price Analysis of economic and market conditions + Forecasts of customer needs from marketing personnel 33 Merchandise Purchases Budget • Merchandise Purchases Budget – Provides detailed information about the purchases – necessary to fulfill the sales budget and provide adequate inventories. Merchandise inventory to be purchased = Budgeted ending inventory + 34 Budgeted sales for the period _ Budgeted beginning inventory Merchandise Purchases Budget • The quantity purchased is affected by: – Just-in-time inventory systems • enable purchases of smaller, frequently delivered quantities. – Safety stock inventory systems • provide protection against lost sales caused by delays in supplier shipments. 35 Selling Expense Budget • Selling Expense Budget – lists the types and amounts of selling expenses – Predictions of expenses are based on the sales budget and past experience. 36 General and Administrative Expense Budget • General and Administrative Expense Budget – lists the predicted operating expenses not listed in the sales budget – Includes both cash and non-cash expenses – Often prepared by the office manager or person responsible for general administration 37 Capital Expenditures Budget • Capital Expenditures Budget – lists the cash inflows or outflows pertaining to the disposal or acquisition of capital equipment. – is usually affected by the organization’s long-term plans. 38 Cash Budget • Cash Budget – lists the expected cash inflows and outflows for the period – a tool used by management to avoid excess cash balances or cash shortages – Information from other budgets is used in its preparation – Information from the cash budget is used to prepare the budgeted income statement and balance sheet 39 Production and Manufacturing Budgets • Manufacturing companies need to prepare additional budgets that include: – Production budgets – Direct materials purchase budgets – Direct labour budgets – Manufacturing overhead budgets 40 Production and Manufacturing Budgets • Production and Manufacturing Budgets – Provides detailed information about the production necessary to fulfill the sales budget and provide adequate inventories. Number of units to be produced = Budgeted ending inventory + Budgeted sales for the period 41 _ Budgeted beginning inventory Production and Manufacturing Budgets • Direct Materials Budget – Provides detailed information about the purchases of raw materials necessary to fulfill the production budget and provide adequate inventories. Units of raw materials to be purchased = Cost of raw materials to be purchased Materials needed for production = + Budgeted ending inventory Units of raw materials to be purchased 42 × _ Budgeted beginning inventory Material price per unit of raw material Production and Manufacturing Budgets • Direct Labour and Manufacturing Overhead Budgets – Provides information about the labour and manufacturing overhead costs given the level of production for the period. 43 Preparing Financial Budgets Cash Budget Expected Receipts and Disbursements Budgeted Income Statement 44 Budgeted Balance Sheet Budgetary Control Develop the budget from planned objectives. Revise Compare objectives and prepare a new budget. actual with budget and analyze any differences. Take corrective and strategic actions. 45 Capital Budgeting • Capital Budgeting – Analyzing alternative long-term investments and deciding which assets to acquire or sell. – These decisions require careful analysis since: • • • • The outcome is uncertain. Large amounts of money are usually involved. Investment involves a long-term commitment. Any decision may be difficult or impossible to reverse. 46 Zero-based Budgeting • Zero-based Budgeting – are prepared assuming no previous activities for the activities being planned – Managers must justify the amounts budgeted for each activity – is popular among government and non-profit organizations. 47 Fixed Budget • Fixed budgets – are prepared for a single, predicted level of activity – Performance evaluation is difficult when actual activity differs from the predicted level of activity. • Example: How much of the unfavourable cost variance is due to higher activity, and how much is due to poor cost control? • To answer these questions, we must flex the budget to the actual level of activity. 48 Flexible (Variable) Budgets • Flexible budgets – are prepared after a period’s activities are complete. – Show revenues and expenses that should have occurred at the actual level of activity. – Reveal cost variances due to good cost control or lack of cost control. – Improve performance evaluation. 49 Flexible (Variable) Budgets • Flexible budgets – To prepare a budget for different activity levels • we must know how costs behave with changes in activity levels – Total variable costs change in direct proportion to changes in activity. – Total fixed costs remain unchanged within the relevant range. 50 Fixed Standard Costs • Standard Costs – are preset costs for delivering a product or service under normal conditions. – are established through personnel, engineering, and accounting studies using past experience. – are benchmarks used in evaluating performance. – are often used in setting budgets. 51 Standard Costs • Example: A standard cost card Cost factor Direct materials Direct labour Variable mfg. overhead Total standard unit cost Standard Quantity or Hours 1 kg 2 hours 2 hours 52 Standard Price or Rate $ $ $ Standard Cost 25 per kg $ 20 per hour 10 per hour $ 25.00 40.00 20.00 85.00 Variance Analysis Prepare standard cost performance reports Analyze variances Take action Investigate causes 53 Variance Analysis • Management By Exception – Standard cost accounting provides management with information about costs that differ from budgeted amounts (variances). – Management may choose to focus only on variances that are significant. – This approach is referred to as Management by Exception. 54 Variance Analysis • Material Variances Actual Quantity × Actual Price Actual Quantity × Standard Price Price Variance AQ(AP - SP) AQ = Actual Quantity AP = Actual Price Standard Quantity × Standard Price Quantity Variance SP(AQ - SQ) SP = Standard Price SQ = Standard Quantity 55 Variance Analysis • Labour Variances Actual Hours × Actual Rate Actual Hours × Standard Rate Standard Hours × Standard Rate Rate Variance Efficiency Variance AH(AR - SR) SR(AH - SH) AH = Actual Hours AR = Actual Rate SR = Standard Rate SH = Standard Hours 56 Variance Analysis • Variable Overhead Variances Actual Variable Overhead Incurred AH × AVR Flexible Budget for Variable Overhead at Actual Hours AH × SVR Spending Variance AH AVR SVR SH = = = = Applied Variable Overhead at Standard Hours SH × SVR Efficiency Variance Actual Hours of Activity Actual Variable Overhead Rate Standard Variable Overhead Rate Standard Hours Allowed 57 Variance Analysis • Fixed Overhead Variances Actual Fixed Overhead Incurred Fixed Overhead Budget Fixed Overhead Applied SH × SFR Spending Variance Volume Variance SFR = Standard Fixed Overhead Rate SH = Standard Hours Allowed 58 Standard Costs • Standard cost accounting systems record variances in the accounts simplify recordkeeping and help in the preparation of reports 59 Discussions • ABC Company has the following direct material standard to manufacture one unit product: 3.0 kilograms per unit at $8.00 per kilogram • Last week 6600 kilograms of material were purchased and used to make 2000 units. The material cost a total of $53000. 60 Discussions What is the actual price per kilogram paid for the material? a. $7.26 per kilogram. b. $8.13 per kilogram. c. $8.03 per kilogram. d. $8.00 per kilogram. 61 Discussions What is the actual price per kilogram paid for the material? a. $7.26 per kilogram. b. $8.13 per kilogram. c. $8.03 per kilogram. d. $8.00 per kilogram. AP = $53000 ÷ 6600 kg AP = $8.03 per kg 62 Discussions ABC’s material price variance (MPV) for the week was: a. $198 favourable. b. $198 unfavourable. c. $189 favourable. d. $189 unfavourable. 63 Discussions ABC’s material price variance (MPV) for the week was: a. $198 favourable. b. $198 unfavourable. c. $189 favourable. d. $189 unfavourable. MPV = AQ(AP - SP) MPV =6600 kg × ($8.03 - 8.00) MPV = $198 unfavourable 64 Discussions The standard quantity of material that should have been used to produce 2000 units is: a. 6500 kilograms. b. 6000 kilograms. c. 7000 kilograms. d. 5000 kilograms. 65 Discussions The standard quantity of material that should have been used to produce 2000 units is: a. 6500 kilograms. b. 6000 kilograms. c. 7000 kilograms. d. 5000 kilograms. SQ = 2000 units × 3 kg per unit SQ = 6000 kg 66 Discussions ABC’s material quantity variance (MQV) for the week was: a. $4300 unfavourable. b. $4300 favourable. c. $4800 unfavourable. d. $4800 favourable. 67 Discussions ABC’s material quantity variance (MQV) for the week was: a. $4300 unfavourable. b. $4300 favourable. c. $4800 unfavourable. d. $4800 favourable. MQV = SP(AQ - SQ) MQV = $8.00(6600 kg - 6000 kg) MQV = $4800 unfavourable 68 Managerial Decision Making • Managerial Decision Making – Cost accounting information is often used by management for short-term decisions. – Decision making involves five steps: • • • • • Define the problem. Identify alternatives. Collect relevant information on alternatives. Select the preferred alternative. Analyze decisions made. 69 Managerial Decision Making • Accepting additional business – should be based on incremental costs and incremental revenues – Incremental amounts are those that occur if the company decides to accept the new business 70 Managerial Decision Making • Make or Buy Decisions – Incremental costs also are important in the decision to make a product or purchase it from a supplier • The cost to produce an item must include – direct materials – direct labour – incremental overhead • We should not use the predetermined overhead rate to determine product cost 71 Managerial Decision Making • Scrap or Rework Defects – Costs incurred in manufacturing units of product that do not meet quality standards are sunk costs and cannot be recovered. – As long as rework costs are recovered through sale of the product and rework does not interfere with normal production, we should rework rather than scrap. 72 Managerial Decision Making • Sell or Process Further – sell partially completed products vs. process them to completion – As a general rule, process further only if incremental revenues exceed incremental costs 73 Managerial Decision Making • Selecting Sales Mix – When a company sells a variety of products, some are likely to be more profitable than others. To make an informed decision regarding sales mix, management must consider . . . • The contribution margin of each product, • The facilities required to produce each product and any constraints on the facilities, and • The demand for each product. 74 Managerial Decision Making • Eliminating a Segment – A segment is a candidate for elimination if its – Revenues are less than its avoidable expenses 75 Managerial Decision Making • Qualitative factors in decisions – Qualitative factors are involved in most all managerial decisions • • • • • • Quality Delivery schedule Supplier reputation Employee morale Customer opinions …… 76 Summary • Segments may be evaluated as a cost centre, a profit centre, and an investment centre. • CVP Analysis: break-even analysis, computing income from expected sales, sales volume needed to earn a target income, margin of safety, and sensitivity analysis. • Importance of budgeting, master budget, and budgetary control • Standard costs, variance analysis and standard cost accounting systems • Managerial decision making: accepting additional business, make or buy decisions, scrap or rework defects, sell or process further, selecting sales mix, eliminating a segment 77 Discussions • Consider the beginning XYZ case 78 Discussions Relevant Cost Analysis Savings in variable expenses provided by the new machine ($200000 × 5 yrs.) 1000000 Net effect $1000000 - $800000 = $200000 variable cost savings 79 Discussions Relevant Cost Analysis Savings in variable expenses provided by the new machine ($200000 × 5 yrs.) 1000000 Cost of the new machine (900000) Disposal value of old machine 150000 Net effect 250000 80 Case Study • ABC Corporation, a merchandising company, has provided the following budget data: May June July August September Purchases Sales $84000 $96000 $72000 $108000 $120000 $144000 $132000 $120000 $156000 $132000 81 Case Study • Collections from customers are normally 75% in the month of sale, 15% in the month following the sale, and 8% in the second month following the sale. The balance is expected to be uncollectible. ABC pays for purchases in the month following the purchase. Cash disbursements for expenses other than merchandise purchases are expected to be $28,800 for September. ABC's cash balance on September 1 was $44,000. 82 Case Study • Required: – Compute the expected cash collections during September. – Compute the expected cash balance on September 30. 83 The End of Lesson 14