BU247 Managerial Accounting

with Natasha Neumann-Causi and Mike Pegutter

Updated Presentation

This presentation is up to date

- Uses material from new textbook- Follows course outline- Contains examples from prior exams

and from textbook questions- If I miss something, let us know and we

will explain it now or in an email

General Study Tips1. DON’T PANIC! 2. USE YOUR HANDOUT!3. Know the theory well, do not memorize

calculations!4. Practice homework with time constraints!!!!!5. If you get stuck on a question, leave it and

come back later6. When in doubt, GUESS! Never leave a

question blank7. Make sure you have answered everything

the question asked for!!!

Exam Outline• Multiple Choice Questions

– Definitions– Smaller calculations – Theories

• Short Answers– Big Calculations – Writing out Steps to Calculations

• Case Question– Combo

AgendaPART I: Controlling

• Transfer Pricing• Return on Investment (ROI)• Balanced Scorecard

PART II: Relevant Costs• Game-Changing Decisions• Product Pricing and Costing

PART III: Budgeting• Sales/Cash/Production/Labour Budgets• Flexible Budgets

PART IV: Analysis• Standard Costs, Variance Analysis• Profitability Analysis

PART V: Capital Budgeting• IRR, NPV, Payback

PART VI: Case Analysis

+ Midterm Review

Case AnalysisIssues

– Identify root causes of problem(s)– Primary issue: issue which needs to be

solved• Phrase in term of a question, such as, Which

special orders should the firm accept?– Secondary issues: other issues which

exist in the case

Case AnalysisKey Success Factors (KSF)• Factors critical to the success of

this specific firm • Will be part of criteria used

when evaluating solutions • These factors differ depending

on the industry and even between companies

Customer Focus

R&D

Process Design

Production

Marketing

Distribution

Customer Service

Case AnalysisIdentification of Alternatives• Make a list of feasible alternatives • Doing nothing can be an option, but it’s not

recommended

Quantitative Analysis• Analyze all of your alternatives • This will incorporate a variety of tools learnt in class

such as breakeven, contribution margin, variances....• Determine which costs are relevant and which are

not – i.e. ignoring sunk costs• Understand what the qualitative position is telling

you

Case AnalysisSensitivity Analysis• Re-do calculations if there is a 10-20% increase in

costs

Qualitative Analysis• Analyze all of your alternatives• Look back at your key success factors and see how

each alternative is contributing or taking away from KSF’s

• Can use your quantitative to guide qualitative analysis

Case AnalysisRecommendation • Based on above analysis determine the best solution • Briefly state recommended course of action • Tie back to key success factors and issue

Circumvention of Potential Problems • If you foresee any problems state them with

solutions• DO NOT say everything won’t work

BROKEN ISLAND KAYAKS

Answers on Laurier

SOS website!

Do They Have Capacity?

This has nothing to do with

capacity issues but showed up when I Googled

Kayaks!

Do Profits Increase?

Some Sensitivity

CONTROLLINGPart I

Decentralization • Decentralization is the process of spreading

decision-making authority• Responsibility Centres is the section of the

company a manager is responsible for– Cost Centres control only costs

• Examples: Accounting Department– Profit Centres costs and revenues

• Example: Cafeteria– Investment Centres costs, revenues and investments in assets

• Example: Corporate HQ

Investment CentresProfit Centres

Cost Centres

Transfer Pricing• A transfer price is the price charged by one segment

of a company to provide products to another segment– Example: KPMG Canada sharing contract fees with other

KPMG offices in different countries to help them complete an audit.

• There are three ways to calculate transfer prices1. Negotiated 2. Market Value3. Cost

Transfer Pricing: Negotiated

• This method lets each division work independently which helps promote decentralization of authority– This way is only successful if managers cooperate with each

other

• This method will produce a range of acceptable prices; – The highest point is the most the buying division is willing to

pay

– The lowest point will be as low as the selling division can afford

Negotiated Transfer Price Example

Unoriginal Inc. is a company which owns multiple grocery store chains including the famous Value Market chain, and also owns

a bakery franchise called Bakery Plus. Value Market stores strive to provide its customers with fresh produce everyday

and has recently expanded to include a baked goods aisle that sells (among other things) freshly baked pies. Given the

following information, determine the transfer price range for Value Market’s purchase of Bakery Plus pies.

Bakery PlusPie Production Capacity per Month Pie Sales per MonthVariable Cost per PieFixed Costs per MonthSelling Price

55,000 pies

45,000 pies$6/pie$80,000$15/pie

Value MarketPurchase Price of PiesMonthly Pie Sales

$12/pie20,000

Step 1: Does Bakery Plus have the capacity?No. Bakery Plus uses all of its capacity every month to serve its own customers and would therefore have to sacrifice customers to serve Value Market.

Step 2: Bakery Plus lowest transfer priceTransfer Price ≥ VC + (CM on lost sales / # of Transferred Units)Contribution of Lost Sales = ($15-$6)x 10,000 units of lost sales = $90,000Transfer Price ≥ $6 + ($90,000/20,000 units) = $6 + $4.5 = $10.5

Note: If Bakery Plus is not missing out on sales by providing to Value Market then “CM on lost sales” doesn’t apply and will equal $0

Step 3: Value Market’s highest transfer priceTransfer Price ≤ Outside Supplier CostTransfer Price ≤ $12

Step 4: RangeThe range of acceptable transfer prices is $10.5 - $12.

Transfer Pricing• Transferring at cost the transfer price to cost

or the full absorption cost*• There are a lot of problems with this:

– If cost is used for transfer price, the selling division will never get a profit out of it

– Cost-based transfer prices give the selling division no incentive to lower costs

• Market price is the price for a product on the open market and is often the best solution

Return on Investment (ROI)

• Where “Operating Income” is Earnings Before Interest and Taxes (EBIT)

• Where “Average Operating Assets” is (beginning assets + ending assets) / 2– Net Book Value (Cost – Accumulated Amortization)

• This will cause ROI to over time as the book value of assets • Adding a new asset will cause ROI

– Purchase Cost can be used as well to value assets which would make ROI impervious to asset purchases

•  There are three ways to improve ROI– Increase Sales– Reduce Operating Expenses– Reduce Operating Assets

Return on Investment (ROI)• Another way to calculate:

• Criticisms of ROI– Management may not know good ways to

increase ROI– Managers of segments take on a lot of costs they

have no control over– Acts as a negative incentive for investment out of fear of skewing ROI

ROI

Margin = Operating

Income/ SalesTurnover =

Sales/Average Operating

Assets

Residual Income• Residual income is the operating income

that an investment centre earns above the minimum required return on its assets

The Old Navy division of The Gap has average operating assets of $220,000 and is required to earn

a return of 14%. In 2010, Old Navy has earned $60,000. Calculate residual income.

Step 1: Minimum Required ReturnOperating Assets x Required ROI = Minimum Return$220,000 x 14% = $30,800

Step 2: Residual IncomeActual Income – Minimum Required Return = Residual Inc.$60,000 - $30,800 = $29,200

The Balanced Scorecard• The balanced scorecard method uses

multiple interconnected perspectives of performance measurement to come up with one comprehensive measure

• Uses both financial and non-financial measures

• Can be an excellent performance review tool if done right

Balanced

Financial

Customers

Learning and

Growth

Internal Processes

Quality Costs• Quality of Conformance is when the majority of products

conform to design specifications and are defect-free – Anything that does not meet design specifications is a defect and

is indicative of low quality of conformance

• There are four categories of quality costs:– Prevention Costs – Activities done to reduce the number of

defects • (i.e. Training)

– Appraisal Costs – The cost of identifying defects • (i.e. Testing)

– Internal Failure Costs – The cost of fixing defective products before they are shipped

• (i.e. Reworking costs)– External Failure Costs – The costs which result from defective

products they have been shipped • (i.e. Warranty costs)

• Four key points on the relationships between these costsi. When the quality of conformance is low, total

quality cost is highii. Total quality costs drop rapidly as the quality of

conformance increasesiii. Reduce their total quality costs by spending on

prevention and appraisaliv. Total quality costs are minimized when the

quality of conformance is slightly less than (or equal to) 100%

RELEVANT COSTSPart II

Relevant Costs• Relevant costs are those that differ between

alternatives – These costs are avoidable because they are eliminated

through choosing one alternative over another– Costs that are relevant in one decision may not be relevant

in another context• Unavoidable costs are irrelevant to decision

making because they’re going to be incurred no matter what– Sunk Costs which are costs already incurred and were

paid for and cannot be changed; therefore they have no bearing on future decisions

– Future Costs that do not differ between alternatives

Game Changing Decisions1) Add or Drop segments of a company2) Make or Buy decisions3) Special Orders4) Joint Costs (Sell or Process)

Add or Drop Segments• Decision Rule: Drop the segment if overall profits

increase– Drop the segment if fixed cost savings > lost contribution

margin• It’s sometimes more profitable to keep a division

even when it’s losing money• The decision to keep this division lies in the way

common fixed costs are allocated– Example: If unavoidable costs are included in the analysis the product linemay appear to be less profitable than it actually is

Add or Drop ExampleConsider the following financial information for RCA

which is losing money on its CD Player division. Should RCA drop it?CD

PlayersSales $375,000Less Variable Expenses:

Manufacturing Expenses

$100,000

Contribution Margin

$275,000

Less Fixed Costs:Factory Rent

Fixed OverheadDepreciation

Direct AdvertisingGeneral Admin

ExpensesTotal Fixed Expenses

$45,000$10,000$80,000$100,000$50,000

$285,000

Net Loss ($10,000)

Drop CD Players$ -

$ -

$ -

$ - $ 10,000$80,000$ -$50,000

$140,000($140,000)

Difference$375,000

$100,000

$275,000

$ 45,000$ - $ - $ 100,000$ -

$145,000$130,000

Game Changing DecisionsMake or Buy Decisions

– Do an activity internally or outsource it– A company is vertically integrated when it takes care of

multiple functions within its value chain • The main drawback is losing out on cost savings because other

companies have economies of scale

Special Orders– A special order is a one-time order that is not normally

received– Decision Rule: incremental benefits > incremental costs– Steps

1. Do we have the available capacity?• If not, we will have to sacrifice regular business to make this order

2. Is it worth it? Yes, as long as you’re making a profit

Example in handout!

Joint Costs• Joint Products are produced from a common input • The Split-off Point is the point in manufacturing

where the products can be distinguished – Example: Mined ore

• Joint costs are allocated between these products at the split-off point (but are sunk costs)

• It is profitable to continue processing if increase in value > extra costs

Joint Costs ExampleSawmill Inc. cut logs from which unfinished lumber and sawdust

are the immediate joint products. Unfinished lumber is sold “as is” or processed further into finished lumber. Sawdust can also be sold “as is” to gardening wholesalers or processed further into “presto-logs”. Should Sawmill Inc sell or process these

products?Lumber SawdustSales Value at Split Off $140 $40Sales Value after ProcessingAllocated Joint Product CostsCost of Further Processing

$270$176$50

$50$24$20

Step1: Incremental Value of ProcessingIncremental Value = Sale Value after Process – Sale Value at Split Off Lumber = $270 - $140 = $130Sawdust = $50 - $40 = $10

Step 2: Profit from Processing FurtherProfit after Processing = Incremental Value – Cost of ProcessingLumber = $130 - $50 = $80Sawdust = $10 - $20 = ($10)Conclusion: Lumber should be processed further and sawdust should be sold as it is

Constrained Resources• A constraint is a limited resource that

restricts a company’s abilities – The specific thing constraining the activity is

called the bottleneck• Pick the product mix that maximizes

contribution margin

Constrained Resource Example

In Proctor & Gamble’s Crest division, there is a mixing machine that is working at 100% capacity. It has a

capacity of 90,000 minutes per week and is used to mix the ingredients for Crest’s special extra whitening

toothpaste and its regular toothpaste. Should P&G focus machine time on the whitening toothpaste or regular

toothpaste?Whitening

Regular

Selling PriceLess Variable ExpensesContribution MarginCurrent Weekly Demand Contribution Margin RatioMixing Time Required

$7.00$3.00$4.006,00036%10 minutes

$4.00$2.00$2.003,00050%15 minutes

Step 1: Contribution Margin per MinuteCM/minute = Contribution Margin per Unit / Mixing TimeWhitening CM per Minute = $4.00 ÷ 10 minutes = $0.40 / minuteRegular CM per Minute = $2.00 ÷ 15 minutes = $0.13 / minuteConclusion: Make all the whitening toothpaste needed first then make the regular toothpaste with the remaining capacity.

Step 2: Allocating Constrained Resource6,000 units x 10 minutes = 60,000 minutesTime Remaining = 90,000 mins – 60,000 mins = 30,000

mins30,000 minutes ÷ 15 minutes per regular toothpaste =

2,000 toothpaste

Step 3: Total Contribution MarginWhitening Toothpaste = 6,000 x $4.00 = $24,000Regular Toothpaste = 2,000 x $2.00 = $4,000Total CM = $28,000

Product Pricing• The Cost Plus Pricing method uses the product

markup to determine price– Markup is the difference between its selling price and its

cost• The Absorption Costing method uses the

absorption cost per unit rather than the variable cost to calculate markup– Steps

• Divide fixed costs by number of units produced• Add up all per unit costs to come up with the total unit cost• Multiple the unit cost by the markup percentage and add it on

to get the target selling price

BUDGETINGPart III

Budgeting• A budget is a detailed quantitative plan for acquiring

and using resources over the next period• An operating budget covers one year of the

company’s life at a time • A continuous budget always has the next 12 months

planned out by adding a month on the end• The most effective budget is one where managers

are only responsible for the costs they have control over– Participative budgets achieve this because all levels

contribute– Other benefits: creating a team environment, better

accuracy, increased motivation and the elimination of excuses for poor performance

Budgeting• The master budget is the summary of

many smaller budgets which are all interrelated

Sales Budget

Production Budget

Cash Budget

Direct Materials Budget

Direct Labour Budget

Overhead Budget

Cash Collections S&A

Expenses

Sales Budget & Cash Collections

Company ABC makes custom coffee mugs and is getting ready to make its sales budget for the quarter ended June 30, 2011.

The sales forecast is given below and the average price for a mug is $15. Only 5% of Royal York’s sales are in cash. The rest

of the sales are typically collected as follows: 60% collected within the month, 35% collected in the following month, 5%

uncollectibleApril May June July1M units 0.85M

units1.35M units

0.9M units

Step 1: Dollar Value of Estimated SalesApril = $15 x 1M mugs = $15M, May = $15 x 0.85M mugs = $12.75M, June = $15 x 1.35M mugs = $20.25M

Step 2: Cash and Sales on AccountApril Cash = $15M x 5% = $750,000 May Cash = $12.75M x 5% = $637,500April A/R = $15M x 95% = $14.25M May A/R = $12.75M x 95% = $12,112,500

June Cash = $20.25M x 5% = $1,012,500June A/R = $20.25M x 95% = $19,237,500

AprilCash $750,000

Within Month 60% x 14.25M = $8,550,000

Next MonthTotal Cash $9,300,000

May$637,50060% x 12,112,500 = $7,267,50035% x 14.25M = $4,987,500

$12,892,500

June$1,012,50060% x 20.25M= $11,542,50035% x 1,211,250 = $4,239,375

$16,794,375

Production BudgetUsing the projected sales, determine how many coffee

mugs need to be produced by Company ABC during the next quarter (ending June 30). Assume ending

inventory for March was 500,000 units. Assume that management wants ending inventory to equal 15%

of the next month’s budgeted sales.April May June July

1M units 0.85M units

1.35M units

0.9M unitsStep 1: Total Demand for Each MonthTotal Demand = Targeted Sales + Desired Ending InventoryApril = 1M units + (0.85M x 15%) = 1,127,500 unitsMay = 0.85M units + (1.35M x 15%) = 1,052,500 unitsJune = 1.35M units + (0.9M x 15%) = 1,485,000 units

AprilBudgeted Sales 1,000,000

Add: Desired End Inv.

127,500

Total Demand 1,127,500Less: Begin

Inventory500,000

Production 627,500

May

850,000202,5001,052,500127,500925,000

June

1,350,000135,0001,485,000202,5001,282,500

Quarter

3,200,000135,0003,335,000500,0002,835,000

Materials/Labour Budgets• The Direct Materials budget outlines all the raw

materials that are required to meet the production budget

• The Direct Labour Budget outlines all the labour hours required to meet the production budget

• The Manufacturing Overhead Budget estimates how much overhead will be incurred during the forthcoming period – Include all other costs besides direct labour and direct

materials involved with production

Direct Labour Budget Example

Using the production budget determined above, create the direct labour budget for Company ABC for the next quarter (ending June 30). Assume each coffee mug required 0.5 hours of labour and about $0.75

worth of materials. Company ABC currently has 2000 employees which work at least 40 hours a week at a

rate of $12/hour. There are no plans to layoff anyone.

AprilProduction 627,500

unitsDirect Labour/

Unit0.5 hours

Labour Hours Req’d

313,750 hours

Minimum Hours 320,000 hours

Labour Hours Paid

320,000 hours

Hourly Wage Rate

$12

Total Labour Cost

$3.84M

May925,000 units0.5 hours462,500 hours320,000 hours462,500 hours$12$5.55M

June Quarter1,282,500 units

2,835,000 units

0.5 hours 0.5 hours641,250 hours 1,417,500

hours320,000 hours 960,000 hours641,250 hours 1,423,750

hours$12 $12$7.695M $17.085M

Step 1: Minimum Labour CostSince ABC Inc. is not going to lay anyone off, they will have to pay 2000 employees for 40 hour work weeks (assuming 4 weeks in a month).

Minimum Labour Hours = 2000 employees x 40 hours/week x 4 weeks/month = 320,000 hoursMinimum Labour Cost = 320,000 hours x $12/hour = $3,840,000 per month

Manufacturing Overhead Budget

Using the direct labour budget determined above, create the manufacturing overhead budget for Company ABC for the next quarter (ending June 30). Assume manufacturing overhead is applied based on labour hours (cost driver). Company ABC believes about $1.7 of overhead costs are

incurred per direct labour hour. Fixed manufacturing overhead costs total $2,000,000 (including $1,000,000 of

amortization).April May June Quarter

Labour Hours Req’d

313,750

462,500

641,250

1,417,500

Step 1: Variable Manufacturing OverheadApril = 313,750 hours x $1.7/hour = $533,375May = 462,500 hours x $1.7/hour = $786,250June = 641,250 hours x $1.7/hour = $1,090,125

Step 2: Total Manufacturing OverheadApril = $533,375 + $2,000,000 = $2,533,375May = $786,250 + $2,000,000 = $2,786,250June = $1,090,125+ $2,000,000 = $3,090,125Quarterly Total = $8,409,750

Step 3: Predetermined Overhead Rate (POHR)Total Overhead for the Quarter = $8,409,750Total Labour Hours Required = 1,417,500 hoursPOHR = $5.93

Step 4: Monthly Cash DisbursementsApril = $2,533,375 - $1,000,000 amortization = $1,533,375May = $2,786,250 - $1,000,000 amortization = $1,786,250June = $3,090,125 - $1,000,000 amortization = $2,090,125Quarterly Total = $5,409,750

Ending Finished Goods Budget

• The Ending Finished Goods Budget determines the expected value of the ending inventory for the upcoming period for which all of these budgets have been made– This is typically referred to when estimating storage costs

• Sum the per unit production costs– From the “Company ABC” example, “total per unit cost”

would be $6.30:• $12 hourly direct labour x 0.5 hours required in production = $6• $0.75 direct materials per mug • $5.93 manufacturing overhead per mug

• Multiply the per unit cost by expected leftover inventory– From “Company ABC” example, June ending inventory is

135,000 coffee mugs– Value of ending inventory will be ($12.68 x 135,000 units =

$1,711,800)

Cash Budget• The Cash Budget pulls everything together

into one nice summary! There are four sections:1. Cash receipts listing all cash inflows

• excluding borrowing, so basically just cash from sales2. Cash disbursements listing all payments

• excluding repayments of principal and interest3. Cash excess or deficiency

• resultant of step 1 – step 24. The financing section listing all borrowings,

repayments and interest

Cash Budget Example• Create an entire cash budget for Company ABC!!

– A line of credit of up to $2,000,000 is available at a 10% interest rate

– Company ABC aims to maintain a minimum of $50,000 in cash at the end of each month

– Borrowing are on the first day of the month and are repaid on the last day of the month (for simplicity)

– Company ABC paid a dividend of $1M in June– Company ABC purchased equipment for $6.2M in cash in May– Opening cash balance for April 1 is $70,000– Assume monthly Selling and Administrative costs of $1M,

$1.5M and $2M in April, May and June respectively– Assume monthly Direct Material expenses of $0.75M, $1.25M

and $1.75M in April, May and June respectively

Flexible Budgets• Static budgets are prepared for a single planned

level of activity which is hard to work with• Flexible budgets address this problem by

simultaneously showing multiple activity levels– Planned level of activity and the actual level of activity

• This method therefore exposes variances related to cost controls

Example in handout!

ANALYSISPart IV

Standard Costs• Standards are the per unit costs used in

budgeting– Quantity Standards say how much input should

be used• These are found in a “Bill of Materials”• Example: Each Toyota car should have four Bridgestone

tires– Cost Standards are how much each input should

cost• Includes delivery costs, final price with discounts

deducted• Example: Each Bridgestone tire should cost Toyota about

$20 each

Pros/ Cons in

handout!

Standard CostsDirect Labour Standards• Direct Labour Rate Standards will include wages, benefit costs

(rate per hour) • Time Standards are the time required to build a product (hours

per unit)Variable Overhead Standards• Manufacturing Overhead Rate Standards represent the

variable cost portion of the Predetermined Overhead Rate (POHR)

• Activity Standards are the estimates of allocation base occurrences used in the denominator of the POHR – Such as # of direct labour hours expected or # of products

expected to be made, etc.Direct Materials• There will be expected or ‘standard’ prices for direct materials

as well as a ‘standard’ amount of materials used per unit as indicated by the design specifications of the product

Variance AnalysisPrice Variance• (actual – standard price)

– Materials Price Variance– Labour Rate Variance– Variable Manufacturing

Overhead Variance

Quantity Variance• (actual – standard

quantity)– Materials Quantity

Variance– Labour Efficiency Variance– Variable Manufacturing

Overhead Efficiency Variance

Analysis

Q Variance

Standard Q X Standard

PActual Q x Standard P

P Variance Actual Q x Actual P

Material Variance ExampleIn order to make light bulbs, Company XYZ requires

about 20g of glass at an expected price of about 2 cents per gram. Company XYZ spent $500,000

buying 21,000 kgs of glass to make 1 million light bulbs in March. Calculate the quantity and price

variances. Step 1: Quantity VarianceQuantity Variance = (Standard Q x Standard P) – (Actual Q x Standard P)

Standard Quantity = 20g/bulb x 1 million bulbs = 20 million grams of glass (or 20,000 kgs)

Standard Price Conversion = 1000 grams/kg x $0.02/gram = $20/kg

Quantity Variance = (20,000 kgs x $20/kg) – (21,000 kgs x $20/kg) = $20,000 unfavourable

Step 2: Price VariancePrice Variance = (Actual Q x Standard P) – (Actual Q x Actual P)Actual Price = $500,000/(21,000 kgs) = $23.81/kgPrice Variance = (21,000 kg x $20/kg) – (21,000 kg x $23.81/kg) = $80,010 unfavourable

Note: In this example the amount of material bought was the same about

used. If these two quantities differ the price variance is calculating using

quantity purchased; whereas the quantity variance is calculated using

quantity used.

Variable Manufacturing Overhead Variance

ExampleIn order to make light bulbs, Company XYZ requires variable manufacturing overhead of about 6 minutes

per bulb at a standard price of $4 per hour. Company XYZ hired 620 employees working 40 hour

weeks (4 weeks a month) to make 1 million light bulbs in March and spent a total of $0.5M. Calculate

the quantity and price variances. Step 1: Quantity VarianceQuantity Variance = (Standard Q x Standard P) – (Actual Q x Standard P)

Standard Quantity = 6 minutes ÷ 60 mins/hour =10 bulbs/hour 1M bulbs ÷ 10 bulbs/hour = 100,000 hours

Actual Quantity = 620 employees x 40 hr week x 4 weeks = 99,200 hours

Quantity Variance = (100,000 hours x $4/hour) – (99,200 hours x $4/hour) = $3,200 favourable

Step 2: Price VariancePrice Variance = (Actual Q x Standard P) – (Actual Q x Actual P)Actual Price = $0.5M/99,200 hours = $5.04/hour Price Variance = (99,200 hours x $4/hour) – (99,200 hours x $5.04/hour) = $103,200 unfavourable

Profitability Analysis• Compares sales from budgeted sales to

actual results using flexible budgets

Actual versus Flexible

Actual Results•Actual

Quantities•Actual Selling

Price & Costs

Flexible Budget•Actual

Quantity•Budgeted

Selling Price & Costs

Master Budget•Budgeted

Quantity•Budgeted

Selling Price & Costs

Profitability Analysis• Compares sales from budgeted sales to

actual results using flexible budgets

Flexible versus Master

Actual Results•Actual

Quantities•Actual Selling

Price & Costs

Flexible Budget•Actual

Quantity•Budgeted

Selling Price & Costs

Master Budget•Budgeted

Quantity•Budgeted

Selling Price & Costs

Sales Volume Calculations

Alterative Calculation #1

Sales Volume Calculations

Alterative Calculation #2

Profitability Analysis Example

• Calculate:a) Sales Price Varianceb) Sales Volume Variancec) Sales Volume Variance

using market volume and market share

d) Sales Volume Variance using sales mix and quantity

Budget ActualSales in

Units:Ceramic

PlatesChina Plates

20,0008,000

18,00010,000

Price per Unit:

Ceramic PlatesChina Plates

$10$25

$12$20

Budget ActualMarket

Volume:Ceramic

PlatesChina Plates

80,00032,000

90,00028,000

Variable Cost per

Unit:Ceramic

PlatesChina Plates

$7$12

$7$12

Profitability Analysis Example

• Calculate:a) Sales Price Variance

Budget ActualSales in

Units:Ceramic

PlatesChina Plates

20,0008,000

18,00010,000

Price per Unit:

Ceramic PlatesChina Plates

$10$25

$12$20

Budget ActualMarket

Volume:Ceramic

PlatesChina Plates

80,00032,000

90,00028,000

Variable Cost per

Unit:Ceramic

PlatesChina Plates

$7$12

$7$12

Profitability Analysis Example

• Calculate:b) Sales Volume Variance

Budget ActualSales in

Units:Ceramic

PlatesChina Plates

20,0008,000

18,00010,000

Price per Unit:

Ceramic PlatesChina Plates

$10$25

$12$20

Budget ActualMarket

Volume:Ceramic

PlatesChina Plates

80,00032,000

90,00028,000

Variable Cost per

Unit:Ceramic

PlatesChina Plates

$7$12

$7$12

Profitability Analysis Example

• Calculate:c) Sales Volume Variance using market volume and market

share Budget ActualSales in

Units:Ceramic

PlatesChina Plates

20,0008,000

18,00010,000

Price per Unit:

Ceramic PlatesChina Plates

$10$25

$12$20

Budget ActualMarket

Volume:Ceramic

PlatesChina Plates

80,00032,000

90,00028,000

Variable Cost per

Unit:Ceramic

PlatesChina Plates

$7$12

$7$12

Profitability Analysis Example

• Calculate:c) Sales Volume Variance using sales mix and quantity

varianceBudget ActualSales in

Units:Ceramic

PlatesChina Plates

20,0008,000

18,00010,000

Price per Unit:

Ceramic PlatesChina Plates

$10$25

$12$20

Budget ActualMarket

Volume:Ceramic

PlatesChina Plates

80,00032,000

90,00028,000

Variable Cost per

Unit:Ceramic

PlatesChina Plates

$7$12

$7$12

CAPITAL BUDGETINGPart V

Capital Budgeting Decisions

• Capital Budgeting involves making decisions on projects and equipment that are really expensive!– Screening decisions are when we are trying to figure out

if the project meets our standards– Preference decisions are when we are picking the best

candidate from a group of possible projects

• Most common types of capital budget decisions:– Plant Expansion– Equipment Selection– Lease or Buy– Cost Reduction– Equipment Replacement

Time Value of Money “A dollar received today is worth more

than a dollar received tomorrow”

Time Value of Money “A dollar received today is worth more

than a dollar received tomorrow”

Not in

Handout

The Payback Method• One of two methods used to determine if a

project is worth while• A payback period is the time that it takes for

a project to earn enough money to recover its cost

Remember: You need to calculate partial years.

Payback ExampleDairy Queen is contemplating ice cream slurry

machines which will cost $1M and last approximately 4 years. The company expects these machines to improve operational efficiency which equates to a

$200,000 cash flow in the first year, $250,000 cash flow in the 2nd, and $275,000 and $300,000 in the 3rd

and 4th year, respectively. If the standard payback period is 3 years, will they take it on?

Year 1 + Year 2 + Year 3 = $725,000 $1,000,000 needed - $725,000 earned = $275,000 still requiredYear 4 earn $300,000 in total but only need $275,000 therefore3 years + (275,000/300,000) = 3.92 years

Dairy Queen will not take on this project.

Net Present Value• Steps to Calculate:

1. Calculate present value of cash inflows (cash received)• (i.e.) salvage value, cost reductions, revenues

2. Calculate present value of cash outflows (cash paid)• (i.e.) repairs, working capital required, operating costs• Depreciation is not an outflow

3. Subtract (1) from (2)• If the answer is zero or positive, the project is

acceptable• The cost of capital is the minimum required rate of

return• Three methods of NPV

1. Total-Cost Method NPV of all costs and revenues (highest NPV wins)

2. Incremental-Cost Method NPV of the differences (NPV > 0, 1 wins)

3. Least-Cost Method used when you only have costs (lowest NPV wins)

NPV ExampleEmpire Theatres is considering installing a new popcorn maker. The average popcorn maker costs

$70,000 and lasts for 5 years. As a result of installing this new popcorn maker will increase

capacity, reduce operating costs and increase profits by $20,000 with a cost of capital of 10%. At the end of 5 years Empire Theatres will be able to sell the

popcorn maker for $10,000.Map Out the Cash Flows:•Time 0: Cash Outflow of $70,000 to purchase the machine •Yrs 1-5: Cash Inflows of $20,000 of increased profits•Yr 5: Cash Inflow of $10,000 when sold at salvage value

Calculate NPV Values:-present value of annuity table, for 20,000 pmt each yr•Periods=5•N=10%•Annuity factor = 3.791•$20,000 x 3.791= $75,820

Calculate overall NPV:(70,000) + 75,820+ 6,210 = $12,030

Calculate NPV Values:-present value of salvage value, present value of single future amount •Period: 5•n=10%•factor: 0.621•$10,000 x 0.621 = $6,210

Internal Rate of Return• Is the rate of return which will make the NPV

of a project equal zero• If the IRR is greater than the company’s

targeted rate of return, it is acceptable• The higher the IRR, the more desirable the

project

IRR ExampleCheapCar2Go is looking to invest in a new car

washing facility. It will cost $104,320 and will save $20,000 per year in operating costs.

Assume that the new facility will last for 10 years. The company has a policy that all

projects must have an IRR of 20%. Investment required Net annual cash flows

PV factor for theinternal rate of return =

$104, 320 $20,000 = 5.216

Corresponds to an IRR value of 14%

(see Present Value Annuity Table)

Final Study Tips- Your textbook is good- Read your end-of-chapter summaries

posted on MyLearningSpace- Practice questions in order to

understand concepts better- Do not memorize how to do calculations- Look over in-class cases

MIDTERM REVIEWPart VII

Cost – Volume – Profit Analysis

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50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

- 100 200 300 400 500 600 700 800

Total Sales

Total Costs

Fixed Costs

Breakeven Point

Relevant Range• Relevant range and Step Variable

Costs are ranges where your per unit variable costs and your fixed costs will stay constant– Outside of this range these costs will

change As long as Brick Brewery is making between 30,000 and 75,000 cases of beer, it costs $3.00 a beer to produce and fixed costs are $1.5M a month. 30 75

Breakeven Analysis• Calculating how many units need to be sold

before you can start making some profits• Equation Approach:

• Contribution Margin Method:

CVP with Product Mixes• Companies which sell more than one product

involves a ratio called a ‘sales mix’ • Management will try playing around with ratios like

these to see which combination is more profitable• In situations with sales mixes the calculations for CM

will change to ‘average contribution per unit’:

Cost Behaviours• Step costs change abruptly at intervals of activity because

the resources and their costs come in indivisible chunks (example: salaries)

• Mixed costs contain both variable and fixed cost elements – Example: maintenance costs – supplies + labour

Management Influenced Costs• Capacity costs - fixed costs incurred when achieving a

desired production level (example: building a plant)• Committed fixed costs -large indivisible chunks of cost that

the company is obligated to pay– Example: mortgage payments

• Discretionary fixed costs are heavily influenced by management’s decisions each period on how much to spend on things like advertising, research and development, training, etc. – Example: no more lavish award ceremonies every quarter for top

salesmen – These costs do not have clear connections to production output

levels

Every cost could essentially be committed /

discretionary but it depends on contracts

you have and your ability to change it

Cost Methods: Absorb & Vary

Absorption Costing –includes manufacturing overhead in the costs which are assigned to

inventory– “Full Costing”, in accordance with GAAP– Costs are classified by function (selling vs. manufacturing)– Inventory costs consider both variable and fixed costs– This method produces a higher inventory value since it

includes fixed costs• With this method, fixed manufacturing overhead costs are

included in inventory, and a formula is used in order to allocate costs to ‘work-in-process’

Cost Methods: Absorb & Vary

Variable Costing – this approach tries harder to separate fixed costs from variable costs

and uses a style of income statements which highlights the total fixed costs

– “Direct Costing”– Costs are classified by behaviour (variable vs.

fixed)– Inventory costs consider only variable costs– This method helps with CVP analyses– Production does not affect operating income

under this approach – Under variable costing fixed costs can be

attributed to separate divisions and therefore controlled more easily

Absorption vs. Variable

ABC CompanyAbsorption Income Statement

Sales $75,000Cost of Goods Sold:

Direct Material 10,000Direct Labour 15,000Overhead 7,000

Gross Profit$43,000Selling Expenses 15,000Admin. Expenses 17,000Operating Income $11,000

Product Costs Period CostsAbsorption Costing Variable Manufacturing

Costs+ Fixed Manufacturing Overhead

Variable Selling & AdministrativeFixed Selling & Administrative

Variable Costing Variable Manufacturing Costs

Variable Selling & AdministrativeFixed Selling & Administrative+ Fixed Manufacturing Overhead

ABC CompanyVariable Costing Income Statement

Sales $75,000Variable Expenses:

Direct Material 10,000Direct Labour 15,000Overhead 3,000Variable Selling

8,000Variable Admin 8,000

Contribution Margin $31,000Fixed Expenses:

Overhead 4,000Selling & Admin 16,000

Operating Income $11,000

Absorption vs. Variable• Variable costing statements are considered easier

to understand because net operating income is only affected by changes in unit sales

• We cannot do CVP analysis with absorption costing because it considers overhead to be a variable cost

• Both methods can be used when filing tax returns, but only absorption costing is allowed for external purposes

• For absorption costing we use units produced; whereas with variable costing we use units soldRelationships b2n

Product and SalesInventory Effects Comparison b2n

IncomeProduction > Sales Inventory Absorption > VariableProduction < Sales Inventory Absorption < VariableProduction = Sales No Change Absorption = Variable

Manufacturing Overhead Cost Allocation

• The POHR is used no matter what the real overhead costs are and what the actual allocation activity is

• The per unit cost calculated above ≠ marginal cost of the product; if an additional unit was produced the per unit cost would slightly decrease

Underapplied / Overapplied• Since the POHR contains estimates, the manufacturing overhead that

we actually incur and the amount applied to Work in Process using the POHR will differ 99% of the time

• Underapplied overhead - overhead applied to jobs is less than the total amount of overhead actually incurred– this will result in a remaining debit balance in the manufacturing overhead

account• Overapplied overhead - overhead applied to jobs is greater than

the total amount of overhead actually incurred– this will result in a remaining credit balance in the manufacturing overhead

account

• The difference between applied overhead and actual overhead can be dealt with in three ways:1. Close directly to Cost of Goods Sold Expense2. Allocate proportionately between WIP, Finished Goods, and COGS

Expense• based on their relative dollar value

3. Carry the balance in manufacturing overhead over to the next year

Product Costing Systems• Process Costing – the company mass produces one

homogenous product– Costs are accumulated by departments and thus calculates unit costs by department as well– Production is uniform on all units

• Job – Order Costing System – the company builds to order a range of unique products– Direct materials and labour will be allocated to each job as they are incurred– Indirect costs (like overhead) will accumulate over time and then be allocated

Equivalent Units (Weighted Average

Method)• The number of complete units you could get

from putting together all the partially complete units that are sitting around in Work in Process inventory at the end of a period

Example: one unit that is 70% done put together with another unit 30% complete makes one completely

finished equivalent unit

Service Department Cost Allocations

• Operating departments are the ‘heart and soul’ of the organization and carry out its purpose in life

• Service departments support the company and its operating departments; their costs incurred by these departments are allocated unto the operating departments which in turn allocate all costs to units produced

• Reciprocal Services is the term used to describe the concept of service departments and operating departments provided services to each other

Service Department Costs

Operating Department Costs

Products

Service Allocation Methods: Direct

Ignore transactions between service departments and assume service

departments only provide to operating departments

All costs are allocated to operating departments based on the proportion of total

allocation base

Service

Operating

Service Allocation Method: Step-Down

Service Department “A” provides services to Service Department “B” (but no reciprocation) and both pass

on to the Operating Departments

All costs incurred by service departments are allocated to operating departments based on the proportion of

total allocation base

TIPS- Order matters, we need to know which service

department serves the other

Service

A

Service

B

Operating

Service Allocation Method: Reciprocal

Service Department “A” provides services to Service Department “B” and vice versa

Know what it is, but not how to do it.

Service A

Service BOperating

Activity-Based Costing• A non-traditional way of allocating costs• ABC costing is more careful about which costs are

considered; only costs that are affected by product-related decisions are used– not all manufacturing costs, some non-manufacturing costs

• ABC costing has the highest number of cost pools and overhead application rates– POHR applies to the entire factory and all its departments– Process costing uses different overhead rates for

departments– ABC costing has as many rates as there are activities

• The ABC costing method has the ability to segregate costs associated with unused capacity

Activity Costing• An activity is an event that causes the consumption

of overhead resources (i.e. taking customer orders)

Five Levels of Activity1. Unit-Level Activities – activities that arise each time a

product is produced (i.e. electricity)2. Batch-Level Activities – activities that involve processing or

handling batches of product (i.e. moving them) 3. Product-Level-Activities – activities related to products that

must be done regardless of production (i.e. marketing and engineering design)

4. Customer-Level-Activities – have to do with the customers themselves (i.e. customer service)

5. Organization-Sustaining-Activities – are done no matter what else is going on

This is the only type of activity

directly related to volume of production

Implementation of ABC1. Identify and define activities

– There is no ‘right’ or ‘wrong’, there is ‘accurate’ and ‘less accurate’

2. Assign overhead costs to activity cost pools

– Only overhead, no direct or indirect3. Calculate activity rates

– Using total activity estimates for each activity4. Assign overhead costs to cost objects

– Common cost objects: products, orders, customers

5. Prepare management reports

Cons of ABC Costing• ABC costing is not typically used for external

reporting because– Don’t need all the detail– Cost too much to start using ABC Costing– GAAP standards don’t like ABC– There is a lot of subjectivity

• ABC costing has its own limitations too– It costs a lot of money– Resistance from the employees when new systems are

put in place– Misinterpretation of the results– Many companies like to allocate all their costs to the

products rather than to customers and orders– Everyone needs to conform to GAAP