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Topic: MANAGEMENT ACCOUNTING OVERVIEW

Financial Accounting Management Accounting

Reports to external users (owners, creditors, Reports to managers inside the organization
tax authorities, regulators) for planning, controlling, decision making

Emphasize financial consequences of past Emphasize decisions affecting the future


activities

Objective and verifiable Relevance

Precision Timeliness

Companywide Segment reports (product lines, departments,


etc.)

Must follow GAAP/IFRS Need not follow GAAP/IFRS

Three Pillars of Accounting


1. Planning - establishing goals and outlining the steps to achieve them (which will incur costs);
involves budget for those activities
● Budget - detailed plan for the future that is usually express in formal quantitative terms
2. Controlling - gathering feedback to ensure that the plan is being properly executed or
modified as circumstances changes.
● Performance Reports - compares budgeted data to actual data in an effort to identify
and learn from excellent performance and to identify and eliminate sources of
unsatisfactory performance
3. Decision Making - course of action from competing alternatives

Topic: COST CONCEPTS

Cost Classification for Assigning Costs to Cost Objects

1.1. Cost Objects - can be products, customers, jobs, and organizational subunits
1.2. Direct Costs - can be traced to specific cost objects; caused by the cost object
1.3. Indirect Costs
● Common cost - incurred to support a number of cost objects but can’t be traced
individually
Manufacturing Costs/Inventoriable Costs

1.1. Direct Materials


2.1. Direct labor/touch labor
2.2. Indirect labor - labor costs of janitors, supervisors, material handlers, and night security
guards
3. Manufacturing overhead/indirect manufacturing cost/factory overhead/ factory burden
- all manufacturing costs except direct materials and direct labor (indirect material/labor;
maintenance and repairs on production equipment; heat and light; property taxes, depreciation,
and insurance on manufacturing facilities → associated with factory operations only)

Nonmanufacturing Costs/Selling, General, and Administrative Costs (SG&A)/ Selling and


Administrative Costs/ Period Costs

1. Selling costs/order-getting and order-filling costs - secure customer orders and get the
finished product to the customer; advertising, shipping, sales travel, sales commissions, sales
salaries, costs of finished goods warehouses, and depreciation of delivery equipment
2. Administrative costs - executive compensation, general accounting, secretarial, public
relations, depreciation of office buildings and equipment, etc.; can be direct or indirect cost

Cost Classifications for Preparing Financial Statements

1. Product Costs/Inventoriable Costs - costs involved in acquiring or making a product;


consists of direct materials, direct labor, and manufacturing overhead
- Initially assigned to an inventory account
- Expense in the income income statement during the period in which the products are
sold (COGS)
- Implication: direct materials/labor might be incurred during one period but not recognize
as expense; only recorded once the product is sold
2. Period Costs - Selling and administrative expenses; expensed on the income statement in
the period in which they are incurred

Prime Costs vs. Period Costs


1. Prime Costs - direct materials + direct labor
2. Conversion Costs - direct labor + manufacturing overhead

Cost Classifications for Predicting Cost Behavior

1. Cost behavior - how the cost will react to changes in the level of activity
1.1. Variable Cost - varies in total, in direct proportion to the changes in the level of activity;
constant per unit
● Activity Base/Cost driver - what causes the incurrence of variable costs
1.2. Fixed Cost - remains constant in total; averaged fixed cost varies inversely with changes in
activity; rent, insurance, salary
● Committed Fixed Costs - fixed over the period of time; insurance expenses → every
year we incur the same insurance cost
● Discretionary Fixed Costs - cost that arise from decisions of management
1.1.1 Relevant range - range of activity within which the assumptions made about cost
behavior are valid (applies to both fixed and variable costs); for fixed cost, the graph of the cost
is flat within the relevant range
1.3. Mixed cost/Semi-variable cost - cost that contains both variable and fixed elements;
example utility bills, laundry sa KnL
● Account analysis - based on analyst’s prior knowledge
● Engineering Approach - based upon industrial engineer’s evaluation
1.4 Cost structure - relative proportion of each type of cost in an organization

Traditional and Contribution Format for Income Statements

1. Traditional Approach - separates product costs from selling and administrative expenses; it
does not focus on cost behavior; for external users
● Sales - COGS (Product Costs) = Gross Margin
● Gross Margin - Selling & Administrative Costs (Period Costs) = Net Operating Income
2. Contribution Approach - separates costs into fixed and variable categories; for internal
users
● Sales - Variable Costs = Contribution Margin
● Contribution Margin - Fixed Costs = Net Operating Income
Cost Classification for Decision Making

1. Differential Cost - difference in costs between any two alternative (there is also differential
revenue); encompasses incremental costs (increase in cost from one alternative to another) and
decremental cost; only differential costs are relevant in decision making
2. Opportunity Cost - potential benefit that is given up when we choose one alternative over
the other; every alternative has an opportunity cost
3. Sunk Cost - costs that occurred in the past and cannot be altered

Cost of Quality/Quality Cost - cost incurred to prevent defects or incurred due to defects

Quality of conformance:
● Exceeds design specifications
● Free of defects/problems that degrade the product’s performance

A. Cost incurred to prevent selling of defective products (high quality conformance = high
prevention/appraisal costs)
1. Prevention Costs - for activities whose purpose is to reduce/eliminate defects
a. Quality circles - small groups of employees that meet on a regular basis to
discuss ways to improve quality
b. Statistical Process Control - detect whether the process is in or out of control
i. Out-of-control process - results in defective units (e.g. caused by a
miscalibrated machine)
2. Appraisal Costs/Inspection Costs - incurred to identify defective products before the
products are shipped to the customers
B. Cost incurred due to defects despite efforts to prevent them (low quality conformance = high
failure costs)
1. Internal Failure Costs - result from identifying defects before they are shipped to
customers (e.g. scrap, rejected products, reworking of defective units, downtime)
● Effect appraisal activities = high internal failure costs (but less external failure
costs)
2. External Failure Costs - result when a defective product is delivered to a customer (e.g.
warranty repairs, replacements, product recalls, liability arising from legal action against
a company, lost of sales arising from a reputation for poor quality)

Quality Cost Report - compilation of prevention, appraisal, internal, and external failure costs
related to company’s current quality control efforts (as a percentage of total sales)

ISO 9000 Standards - quality control guidelines


● Requirements:
1. Quality control system is in use; defined specific level of quality
2. Detailed documentation of quality control procedures
3. Consistent achievement of the intended level of quality

Topic: Job-Order Costing

Absorption Costing - costing method that includes all manufacturing costs in unit product costs

Job-order costing - used in situations where the organization offers many different products or
services, such as in furniture manufacturing, hospitals, and legal firms
● Direct materials, direct labor, and manufacturing overhead are assigned to jobs
● Costs of the job are divided by the number of units in the job → average cost per unit
(unit product cost)

Measuring Direct Material Cost


● Bill of materials - document that lists the quantity of each type of direct material needed
to complete a unit of product
● Production order - issued when an agreement has been reached with the customer
concerning the quantities, prices, and shipment date for the order
● Materials requisition form - document that specifies the type and quantity of materials
to be drawn from the storeroom and identifies all the job that will be charged for the cost
of the material

Job Cost Sheet - records the materials, labor, and manufacturing overhead costs charged to a
job
Measuring Direct Labor Cost
● Time ticket - document used to record the amount of time an employee spends on
various activities

Computing Predetermined Overhead Rates


● Allocation base - a measure of activity such as direct labor hours (DLH) or
machine-hours (MH) that is used to assign overhead costs to products and services
● Predetermined overhead rate - computed before the period begins
1. Estimate the total amount of the allocation base
2. Estimate the total fixed manufacturing overhead cost for the coming period and
variable manufacturing overhead cost per unit of the allocation base
3. Estimate the total manufacturing overhead cost for the coming period
4. Predetermined Overhead Rate = Total Manufacturing Overhead Cost / Total
Allocation Base
● Overhead application - process of assigning overhead cost to jobs
● Normal costing system - applies overhead cost to jobs by multiplying a predetermined
overhead rate by the actual amount of the allocation base incurred by the jobs

Choosing an Allocation Base


● Cost driver - factor such as machine-hours, beds occupied, computer time, or
flight-hours, that causes the consumption of overhead costs
● Plantwide overhead rate - uses single predetermined overhead rate
○ There is also multiple predetermined overhead rates → each production
department may be treated as a separate overhead cost pool → different
predetermined overhead rate for each cost pool
● Cost-plus pricing = Cost + Mark-up Price = Selling Price

Overhead Application and the Income Statement


● Because manufacturing overhead costs are estimated, there are cases of underapplied
overhead and overapplied overhead
1. Underapplied Overhead - increase COGS; decrease net operating income
2. Overapplied Overhead - decrease COGS; increase net operating income
Subsidiary Ledger - all of a company’s job cost sheets viewed collectively → explains the
amounts reported in Work-in-Process and Finished Goods on balance sheet as well as Cost of
Goods Sold on the income statement

Activity-Based Absorption Costing - assigns all manufacturing overhead costs to products


based on the activities performed to make those products

Main Idea:
1. A customer order triggers a number of activities
2. Performing the activities consumes resources
3. The consumption of resources incurs costs

● Activity - event that causes the consumption of manufacturing overhead resources


○ Examples: setting up machines, admitting patients to hospitals, billing customers,
opening an account at a bank
● Activity cost pool - costs are accumulated that relate to a single activity
● Activity measure → Allocation base
● Activity Rate → Predetermined Overhead Rate
● Batch-level activity - costs depend on the number of batches processed rather than the
number of units produced
● Product-level activity - costs depend on the number of product supported rather than
the number of batches rin or the number of units of product produced and sold

Hierarchy of Activities:
1. Unit level activities
2. Batch-level activities (setting up equipment, shipping customer orders)
3. Product-level activity
4. Facility-level activity

Cost Measurement vs Cost Accumulation


1. Cost accumulation - recognizing and recording the costs incurred in the production
process
2. Cost measurement - cost for a particular job
Actual costing - all of the cost being recorded are actual
Normal costing - actual material and labor cost and predetermined overhead

Activity level:
Theoretical capacity - max level of activity that can be used under perfect conditions
Actual capacity -

Topic: Process Costing (Method of Cost Accumulation)

Process Costing - single product is produced on a continuing basis for a long period of time
● Accumulates cost by department and assigns them uniformly for all the products
produced during the period
● Unit cost by department
Job-order Costing - many different products having production requirements are worked on
each period
● Unit cost by job cost sheet

Processing Departments - an organizational unit where materials, labor, or overhead are


added to the product
● Activity is performed uniformly for all units passing through it
● Input of one department is an output of the other department

2 Methods in Calculating Departmental Unit Cost:


1. Weighted Average Method
2. FIFO Method

Equivalent Units - Number of partially completed units X Percentage of completion

1. Compute the Equivalent Units of Production

EUP = Units transferred to the next department or to finished goods + Equivalent units in
ending inventory
Units in beginning WIP + Units started into production/transferred in = Units in ending
inventory + Units completed and transferred out

2. Compute the Cost per Equivalent Unit

Cost Per Equivalent Unit = (Cost of Beginning WIP + Cost Added During the Period) /
Equivalent Units of Production

● Separate calculation for Materials and Conversion Cost

3. Assign Costs to Units

Ending Inventory EUP x Cost per Equivalent Unit per Cost Category per Processing
Department

Units Completed and Transferred Out x Cost Per Equivalent Unit Per Cost Category Per
Department

4. Reconciliation Report

Cost of Beg. WIP + Cost Added during the Period = Cost of Ending WIP + Cost of Units
Transferred Out

Topic: Cost-Volume-Profit Relationships

Cost-Volume-Profit (CVP) Analysis - estimate how profits are affected by the following factors:
1. Selling prices
2. Sales volume
3. Unit variable costs
4. Total fixed costs
5. Mix of products sold

Assumptions in CVP:
1. Price of a product or service will not change as volume changes
2. Variable costs are constant per unit; TOTAL fixed costs is constant
3. Mix of products sold remains constant

Contribution Income Statement - emphasizes the behavior of costs → extremely helpful to


managers in judging the impact on profits of changes in selling price, cost, or volume

Contribution Margin - amount remaining from sales revenue after variable expenses have
been deducted → amount available to cover fixed expenses and then provide profits for the
period

Break-even Point - levels of sales at which profit is zero → once reached net operating income
will increase by the amount of the unit contribution margin for each additional unit sold.

Profit → Net Operating Income


Profit = (Sales - Variable Expenses) - Fixed Expenses
Unit Contribution Margin = Selling price per unit - Variable cost per unit

Cost-Volume-Profit Graph or Break-even Chart: Unit Volume (X) and & Money (Y)
1. Line parallel to the volume axis to represent the total fixed expense
2. Choose a volume of unit sales and plot the point representing total expense (fixed and
variable); Draw a line through the point back to the point where the fixed expense line
intersects with the Y axis
3. Choose a volume of units sales; plot the point representing the total revenue at the
selected activity level; draw a line through this point back to the origin

Profit Graph - Simpler form of the CVP graph


1. Profit = (Unit CM x Q) - Fixed Expense
2. Compute the profit at two different sales volumes
3. Connect the points with a straight line
4. Break-even point → volume of sales at which profit is zero

Contribution Margin Ratio = CM / Sales = Unit CM / Unit Selling Price

Variable Expense Ratio = Variable Expense / Sales = Var Expense per Unit / Unit Selling Price

CM Ratio + Variable Expense Ratio = 1

Change in CM = CM Ratio X Change in Sales

Profit = (CM Ratio X Sales) - Fixed Expense

NOTE: CM Ratio is valuable in situations where dollar sales of one product must be traded off
against dollar sales of another product → products that yield the greatest CM Ratio should be
emphasized

Incremental Analysis - consider only the costs and revenues that will change if the new program
is implemented

Break-even Point Calculation:


→ Profit = 0

Target Profit Analysis - We estimate what sales volume that is needed to achieve a specific
target profit

Margin of Safety - amount by which sales can drop before losses are incurred; excess of actual
sales over the break-even volume sales; higher margin of safety = lower risk of incurring a loss

Margin of Safety = Budgeted Sales - Break-even Sales


Margin of Safety Percentage = Break-even Sales / Budgeted Sales
Cost Structure - relative proportion of fixed and variable costs in an organization
Operating Leverage - measure of how sensitive the net operating income is to a given
percentage change in dollar sales; high operating leverage → small percentage increase in
sales would produce high percentage increase in net operating income

Degree of Operating Leverage (at a given level of sales): greatest at sales levels near the
break-even point and decreases as sales and profits rise → might explain why management will
often work very hard for only a small increase in sales volume

Degree of Operating Leverage = Contribution Margin / Net Operating Income

Structuring Sales Commission (Insight) - Commissions can be based on the contribution


margin rather than sales price → the salesperson will want to sell the mix of products that
maximizes contribution margin → the company’s profit will be maximized.

Sales Mix - relative proportion in which a company’s products are sold → profits will be greater
if high-margin rather than low-margin items make up a relatively large portion of total sales

Break-even for Sales Mix: Profit = (Overall CM Ratio x Total Sales) - Fixed Expenses
Topic: Differential Analysis (Choosing between alternatives based on their differential costs and
benefits)

Decision Making Six Concepts:


1. Every decision involves choosing among alternatives. First step in decision making is to
define the alternatives being considered
2. After identifying the alternatives, identify the criteria for choosing among them
[distinguish between relevant and irrelevant costs and benefits]
3. Differential analysis - focus on the future costs and benefits that differ between the
alternatives
● Differential cost(revenue) - future cost (revenue) that differs between any two
alternatives
● Incremental cost - increase in cost between two alternatives
● Avoidable cost - cost that can be eliminated by choosing one alternative over
another
4. Sunk cost - cost that has already been incurred and cannot be changed regardless of
what a manager decides to do; no impact on future cash flows and they remain the same
no matter what alternatives are considered
5. Future costs and benefits that do not differ between alternatives are irrelevant to the
decision-making process
6. Opportunity cost - potential benefit that is given up when one alternative is selected
over another

● Real or Economic Depreciation - reduction in resale value of an asset through use


over time
● Decision Analysis: Total Cost vs Differential Cost Approach

Adding and Dropping Product Lines and Other Segments:


● Loss Contribution Margin vs. Avoidable/Traceable Fixed Costs
● Exclude common fixed expenses

Make or Buy Decisions: decision to carry out one of the activities in the value chain internally,
rather than to buy externally from a supplier
● Value Chain - all activities from development, to production, to after-sales service
○ Separate companies may carry out each of the activities in the value chain or a
single company may carry out several
○ Vertically integrated - company involved in more than one activity in the entire
value chain

NOTE: Assume that allocated common costs are irrelevant to the decision unless you are
explicitly told otherwise. If explicitly told that a portion of allocated common costs can be
avoided by choosing one alternative over another, treat the explicitly identified avoidable costs
as relevant costs.

Special Order Decisions: Decision on whether a special order should be accepted, and if the
order is accepted, the price that should be priced
● Special order - one-time order that is not considered part of the company’s normal
ongoing business
● A special order should be accepted if the incremental revenue from the special order
exceeds the incremental costs of the order
○ Important: Make sure that there is indeed idle capacity and that the special order
does not cut into normal unit sales or undercut prices on normal sales

Volume Trade-off Decisions: When companies do not have enough capacity to produce all of
the products and sales volume demanded by their customers; companies must trade off, or
sacrifice production of some products in favor of others in an effort to maximize profits (which
products should they sell and which sales opportunities should they bypass?)
● Fixed costs remain the same regardless of how a constrained resource is used,
managers should ignore them when making volume trade-off decisions; focus the
attention on identifying the mix of products that maximizes the total contribution margin
● Constraint or Bottleneck - step that limits total output because it has the smallest
capacity
● Favor the products that provide the highest contribution margin per unit of the
constrained resource: (Product’s CM per unit) / (Amount of constrained resource
required to make a unit of that product)
● Managers can also increase profits by increasing the capacity of the bottleneck
operation
● Relaxing (or Elevating) the Constraint - when managers increases the capacity of the
bottleneck

Joint Product Costs and Sell or Process Further Decisions: Should a joint product be sold
at the split-off point or processed further?
● Joint products - two or more products produced from a single raw material input (terms:
intermediate products and end products)
● Split-off point - point in a manufacturing process where joint products can be
recognized as separate products
● Procedure:
○ Always ignore all joint costs (all costs incurred up to the split-off point)
○ Determine the incremental revenue that is earned by further processing the joint
product (revenue earned after further processing the joint product - revenue that
could be earned by selling the joint product at the split off point)
○ Incremental Revenue - Incremental Costs (costs associated with processing the
joint product beyond the split-off point)
Master Budgeting

Budget - detailed plan for the future that is usually expressed in formal quantitative terms

Budgets are used for two distinct purposes:


1. Planning - developing goals and preparing various budgets to achieve those goals
2. Control - Gathering feedback to ensure that the plan is being properly executed or
modified as circumstances change

Responsibility Accounting - a manager should be held responsible for those items, and only
those items, that the manager can actually control to a significant extent; each line of item (i.e.
revenue or cost) in the budget is the responsibility of a manager who is held responsible for
subsequent deviations between budgeted goals and actual results; someone must be held
responsible for each cost or else no one will be responsible and the cost will grow inevitably out
of control

Continuous or Perpetual Budget - 12 month budget that rolls forward one month (or quarter)
as the current month (quarter) is completed; one month (quarter) is added to the end of the
budget as each month (or quarter) comes to a close

Self-imposed or Participative Budget - budget that is prepared with the full cooperation and
participation of managers at all levels
● Limitations:
○ Lower-level managers may make suboptimal budgeting recommendations if they
lack the broad strategic perspective possessed by top managers
○ Self-imposed budgeting may allow lower-level managers to create too much
budgetary slack

Master Budget - a number of separate interdependent budgets that formally lay out the
company’s sales, production, and financial goals
Procedure:
1. Beginning Balance Sheet
2. Budgeting Assumptions

3. Sales Budget - detailed schedule showing the expected sales for the budget period;
based on the company’s sales forecast, which may require the use of sophisticated
mathematical models and statistical tools
● With schedule of expected cash collections
4. Production Budget/Merchandise Purchases Budget - lists the number of units that
must be produced to satisfy sales needs and to provide for the desired ending finished
goods inventory
5. Direct Materials Budget - details the raw materials that must be purchased to fulfill the
production budget and to provide for adequate inventories
● With schedule of expected cash disbursements for purchases of materials

6. Direct Labor Budget - shows the direct labor hours required to satisfy the production
7. Manufacturing Overhead Budget - lists all costs of production other than direct
materials and direct labor
● With cash disbursements for manufacturing overhead

8. Ending Finished Goods Inventory Budget - shows the cost of unsold units

9. Selling and administrative Expenses Budget - lists the budgeted expenses for areas
other than manufacturing
● With cash disbursements for selling and administrative expenses
10. Cash Budget - detailed plan showing how cash resources will be acquired and used
● Cash receipts section - lists all of the cash inflows, except from financing,
expected during the budgeting period
● Cash disbursement section - summarizes all cash payments that are planned
for the budget period
● Cash excess or deficiency section
○ Cash deficiency or cash less than the minimum required cash balance -
the company will need to borrow money
○ Cash excess greater than the minimum required cash balance - the
company can invest the excess funds or repay principal and interest to
lenders

● Financing section - details the borrowings and principal and interest


repayments projected to take place during the period
○ Assume that all borrowings take place on the first day of the borrowing
period and all repayments take place on the last day of the final period
included in the cash budget.
11. Budgeted Income Statement - shows the company’s planned profit and serves as
benchmark against which subsequent company performance can be measured

12. Budgeted Balance Sheet - estimates the company’s assets, liabilities, and
stockholders’ equity at the end of the budget period
→ Dividends paid are deducted from retained earnings
Flexible Budgets and Performance Analysis

Management by Exception - management system that compares actual results to a budget so


that significant deviations can be flagged as exceptions and investigated further; enables
managers to focus on the most important variances while bypassing trivial discrepancies
between the budget and actual results.
● How much variance should be flagged?
○ Large variance relative to the amount of spending
○ Run of steadily mounting variances even though none of the variances is large
enough by itself to warrant investigation

Variance Analysis Cycle:

Planning Budget
- Prepared before the period begins
- Static; Valid for only the planned level of activity
- Inappropriate for evaluating how well costs are controlled; If the actual level of activity
differs from what was planned, it would be misleading to compare actual costs to the
static, unchanged planned budget
Flexible Budget
- Estimate of what revenue and costs should have been, given the actual level of activity
for the period
- Take into account how changes in activity affect costs

Activity Variances - differences between the actual level of activity (flexible budget) and the
level of activity in the planning budget from the beginning period.

Revenue and Spending Variances - difference between actual total revenue (expenses) and
what the total revenue (expenses) should have been, given the actual level of activity for the
period.
● While fixed costs do not depend on the level of activity, the actual amount of a fixed cost
can differ from the estimated amount included in a flexible budget

Flexible Budget Performance Report:

Performance Report in Nonprofit Organizations


● Revenue in governmental and nonprofit organizations may consist of both fixed and
variable elements (e.g. donations and grants, and sales)
Performance Reports in Cost Centers
● For managers in departments that are responsible for costs, but not revenues (cost
centers)
● Revenue and Net Operating Income are excluded from the report

Flexible Budgets with Multiple Cost Drivers


STANDARD COSTS AND VARIANCES

Standard - benchmark for measuring performance


● Quantity standards - how much of input should be used to make a product or provide a
service
● Price standards - how much should be paid for each unit of input
>>> If either the quantity or acquisition price of an input departs significantly from the standard,
managers investigate the discrepancy to find the cause of the problem and eliminate it.

Setting Direct Material Standards (Standard Direct Material Cost):

Standard quantity per unit - amount of direct material that should be used for each unit of
finished product, including an allowance for normal inefficiencies, such as scrap and spoilage

Standard price per unit - price that should be paid for each unit of direct materials; should
reflect the final, delivered cost of the materials

>>> When faced with rising raw material costs, companies can:
1. Maintain existing selling price and consequently operate with lower margins
2. Pass the cost increases along to customers in the form of higher prices
3. Lower their raw material costs (e.g. hedging contracts)

Setting Direct Labor Standards (Standard Direct Labor Cost):

Standard hours per unit - amount of direct labor-hours that should be used to produce one unit
of finished goods → via time and motion study → consider reasonable allowances for breaks,
personal needs of employees, cleanup, and machine breakdown

Standard rate per hour - expected direct labor wage rate per hour, including employment taxes
and fringe benefits; reflects expected “mix” of workers, even though the actual hourly wage
rates may vary somewhat from individual to individual

Setting Variable Manufacturing Overhead Standards (Standard Variable Manufacturing


Overhead Cost):
Standard hours per unit for variable overhead - amount of the allocation base from a
company’s predetermined overhead rate that is required to produce one unit of finished goods

Standard rate per unit - variable portion of the predetermined overhead rate

Standard cost card - shows the standard quantity (or hours) and standard price (or rate) of the
inputs required to produce a unit of a specific product

Q: Was the high direct material cost due to higher than expected prices for materials? Or was it
due to too much material being used?

General Model for Standard Cost Variance Analysis:


- Decomposes spending variances from the flexible budget into two elements – due to
price paid for the input and due to the amount of input that is used

Price Variance - difference between the actual amount paid for an input and the standard
amount that should have been paid

Quantity Variance - difference between how much of an input was actually used and how much
should have been used for the actual level of output (stated in dollar terms using the standard
price for the input)
>>> Positive difference == unfavorable; negative difference == favorable

Predetermined Overhead Rates and Overhead Analysis in a Standard Costing System

Budget Variance = Actual fixed overhead - Budgeted fixed overhead

Volume Variance = Budgeted fixed overhead - Fixed overhead applied to WIP (Standard fixed
overhead cost X Standard quantity of allocation base allowed)
PERFORMANCE MEASUREMENT IN DECENTRALIZED ORGANIZATIONS

>>> When a company’s owners (e.g. stockholders) delegate decision-making authority to top
managers → Corporate Governance Systems → provide incentives and feedback
mechanisms to help ensure that a company’s board of directors and top managers pursue goals
that align with the owner’s interests

>>> When a company’s top managers delegate decision-making to subordinates →


Management Control Systems → provide incentives and feedback mechanisms to help
ensure that all of company’s employees are pursue goals that align with its interests

Decentralized Organization - decision-making authority is spread throughout the organization


rather than being confined to top executives
>>> strongly centralized organizations - decision-making authority is reluctantly delegated to
lower-level managers who have little freedom to make decisions
>>> strongly decentralized organizations - even the lowest-level managers are empowered to
make as many decisions as possible

Advantages of Decentralization:
1. Top-level managers can concentrate on bigger issues
2. Puts the decision-making in the hands of those who tend to have the most detailed and
up-to-date information about day-to-day operations
3. Can respond more quickly to customers and other changes in the operating environment
4. Trains lower-level managers for higher-level positions
5. Increase motivation and job satisfaction

Disadvantages of Decentralization:
1. Lower-level managers may make decisions without fully understanding the company’s
overall strategy
2. Coordination may be lacking
3. Lower-level managers may have objectives that clash with the objectives of the entire
organization
4. Spreading innovative ideas may be difficult
Responsibility Accounting

>>> Responsibility accounting systems - link lower-level managers decision-making authority


with accountability for the outcomes of those decisions
>>> Responsibility center - any part of the organization whose managers has control over and
is accountable for cost, profit, or investments

Responsibility Centers

Type Control Performance Measure

Cost Center Costs Standard cost variances and flexible


budget variances

Profit Center Costs and Revenue Actual profit vs targeted or budgeted


profit

Investment Costs, Revenue, and Investments Return of Investment (ROI) or


Center in Operating Assets residual income measures
>>> Cost centers - manufacturing facilities, accounting, finance, general administration, legal,
and personnel

Evaluating Investment Center Performance - Return on Investment

>>> Return on Investment (ROI): The higher the business segment’s ROI, the greater the
profit earned per dollar invested in the segment’s operating assets

>>> Net Operating Income - income before interest and taxes


>>> Operating Assets - cash, accounts receivable, inventory, plant and equipment, and all
other assets held for operating purposes [NOTE: the operating assets base used in the formula
is typically computed as the average of the operating assets between the beginning and end of
the year]

>>> Other formula for ROI:


How can managers improve the margin?
→ increase selling prices >> increases NOI
→ reduce operating expenses >> increases NOI
→ increase unit sales >> increases operating leverage

Insight provided by the turnover?


→ Excessive funds tied up in operating assets depress turnover and lowers ROI

Residual Income/Economic Value Added (EVA) - net operating income that an investment
center earns above the minimum required return on its operating assets
>>> When comparing investment centers, it is probably better to focus on the percentage
change in residual income from year to year rather than on the absolute amount of the residual
income

Operating Performance Measures

>>> Throughput (Manufacturing Cycle) Time - elapsed time from when production is started
until finished goods are shipped to customers

→ process time - amount of time work is actually done on the product


→ inspection time - amount of time spent ensuring that the product is not defective
→ move time - time required to move materials or partially completed products from
workstation to workstation
→ queue time - amount of time product spends waiting to be worked on, to be moved, to be
inspected, or to be shipped
NOTE: inspection time, move time, and queue time are non-value added activities

>>> Delivery Cycle Time - elapsed time from when a customer order is received until finished
goods are shipped

→ Wait time - elapsed time from when a customer order is received until production of order is
started; non-value added activity

>>> Manufacturing Cycle Efficiency - relates value-added time to throughput time

→ a non-value added time results in an MCE of less than 1


→ Example: MCE = 0.5 would mean that half of the total production time consists of non-value
added time
BALANCED SCORECARD

Balanced Scorecard - integrated set of performance measures that are derived from and
support a company’s strategy
>>> Top management translates its strategy into performance measures that employees can
understand and influence.
>>> Strategy - how to achieve the organization’s goals

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