Part 1 Financial Planning, Performance and Control 30%Unit
9Budgeting Concepts, Methodologies and Preparation1- A budget is a
plan for the future expresses in quantitative terms. A budget
promotes goal congruence among operating units. A budget is a
planning, communication and coordination, control, motivation and
allocation tool. The budget sets specific goals for income, cash
flows and financial position. Budgets are primarily quantitative
not qualitative and they incorporates non-financial measures as
well as financial measures into its outputs.2- Planning is a
process of charting the future to attain desired goals. Planning
consists of selecting organization goals, predicting results under
various alternative ways to achieve those goals, deciding how to
attain the desired goals and communicating the goals and how to
attain them to the entire organization.3- Good planning helps
managers to attain goals, recognize opportunities, provide basis
for controlling operations, forces managers to consider expected
future trends and conditions, checking progress towards the
objectives of the organization and minimize the negative effects of
unavoidable events.4- Strategy is the starting point in preparing
the organization plans and budgets. It's the organization's plan to
match its strength with the opportunities in the market place to
achieve its desired goals over the short and long term. The
strategy is the path chosen by the organization to attain its long
term goals.5- Strategy, plans and budgets are interrelated and
affect one another.Strategy shows how an organization matches its
strength with opportunities to attain its desired goals in the
market place in short and long-run planning. These plans lead to
the formulation of budgets. Budgets provide feedback to managers
about the likely effects on their strategic plans. Managers use
this feedback to revise their strategic plans, and that may lead to
changes in the budgets.6- Budgeting (Targeting) is the steps
involved in preparing the budget.7- Pro forma statements is a
budgeted financial statements (budgeted income statements, budgeted
balance sheet and budgeted cash flows), are forecasts of goals for
a future period that assist in the allocation of resources.8-
Strategic plan and strategic budget An organization must complete
its strategic plan before the beginning of any budgeting process.
Strategic budget is a form of long-range planning identifying and
specifying the organization goals and objectives (usually 5
years).9- The external environment in planning and budgetingAn
organization must interact with the external environment in which
it operates, as this external environment factors affects the
company's plans and budgets. Three interrelated environments affect
management's planning and budgeting:1. The industry in which the
company operates, including the company's current market shares.2.
The country or national environment in which the company operates,
including governmental regulatory measures, labor market and the
activities of competitors.3. The wider macro environment in which
the company operates. For instance, if the economy entering a
period of lower demand.10- Budget cycleThe budget cycle includes
the following elements:1- Planning the performance of the company
as a whole, as well as planning the performance of its subunits.2-
Providing a frame of reference, a set of expectations can be
compared against actual.3- Investigation variations from plans.4-
Planning again, in light of feedback and changed conditions.11-
Advantages of budget (PCCMA)1- As a planning tool budget forces
managers to think ahead. Without budget the organization will
operate in retroactive instead of proactive manner.2- Budgets
promote coordination and communication among operating units.
Budgets promote goal congruence among operating units. Budgets
require departmental managers to make plans in conjunction with
other interdependent units. If a firm doesn't have an overall
budget, each department will set its own objectives without regards
to what is good for the firm as a whole.3- As a control tool budget
provides a frame of reference for measuring performance and provide
a means for controlling operations. The budget provides a formal
benchmark to be used in feedback and performance evaluation.
Budgeted performance is a better criterion than past performance
for judging managers.4- The budget is a motivational tool.
Challenging budgets improve employee performance because no one
wants to fail. The budget should be challenging but achievable.5-
The budget promotes efficient allocation of organization resources
among operating units.12- Types of plans:1- Strategic plans
(long-term plans): are broad, general and long-term plans (usually
5 years or longer), it's done by the company's top management. This
type of planning doesn't focus on detailed financial targets, but
looks at strategies, objectives and goals of the company by
examining the internal and external factors affecting the
company.2- Intermediate plans (Tactical plans): are designed to
implement specific parts of the strategic plan. It's made by upper
and middle manager (one to 5 years).3- Short-term or operational
plans are the primary basis of budget: refine the overall
objectives from the strategic and tactical plans in order to
develop the programs, policies and performance expectations
required to achieve the company's long-term goals.13-
Characteristics of successful budget:The common factors in a
successful budget include:1- The budget must be aligned with the
organization strategy.2- The budget must have the support of
management at all levels.3- The budget should be motivating
devise.4- The budget should be coordinated.5- People who are
charged in carrying out the budget need to feel ownership of the
budget.6- The budget should be flexible.7- The budget shouldn't be
rigid.8- To be useful, the budget should be an accurate
representation of what is expected.9- The time period of a budget
should reflect the purpose of the budget14- Time frames for budgets
Annual Budget: The budget generally prepared for a set period of
time, commonly one year, and the annual budget subdivided into
months or quarters. Rolling or Continuous Budget: Budgets can also
be prepared in continuous basis. The budget covers a set number of
months, quarters or years into the future. Each month or quarter
just completed is dropped and a new month or quarter's budget is
added to the end of the budget. At the same time the other periods
can be revised to reflect any new information available. Thus, the
budget is being updated continuously and always covers the same
amount of time in the future.15- Who should participate in the
budget process? (Budget Participants)1. Board of directors: The
budget begins with the mission statement formulated by the board of
directors. The board of directors doesn't create the budget, but
responsible for reviewing and the approval of the budget or send it
back to revision. The board usually appoints the members of the
budget committee.2. Top management: Senior management translates
the mission statement to a strategic plan, they involvement doesn't
extend to dictating the numerical contents of the budget since they
lacks the detailed knowledge of daily operations. Importance of top
management involvement1. Reviewing and the approval of the budget
ensure top management that the budget guideline is being
followed.2. Top management active involvement in reviewing and
approving the budget discourage lower-level managers from playing
budget games.3. The active top management involvement also
motivates lower-managers to attain the company goals and objectives
because they know the manager cares about the budget.4. The single
most important factor in assuring successful budget is for upper
management to demonstrate that they take the project seriously and
considers it vital to the organization's future.3. Budget
committee: (The highest authority for all matters related to the
budget). The committee directs budget preparation, approves
departmental budgets submitted by operating managers, rules on
disagreements, monitoring the budget, reviewing results, approving
revisions, draft the budget calendar and budget manual.4. Middle
and lower management: Once the middle and lower managers receive
their budget instructions, they draw up their departmental budgets
in conformity with guideline and submit them to the budget
committee16- Authoritative budget (Top-down budget, Imposed
budget): The top management sets the overall goals of the
organization and prepares the operational budget to attain those
goals. Advantages:1. Provides better decision making than
participative approach.2. Increase coordination among operating
units.3. Reduces the time required to prepare for budgeting.4.
Facilitates implementation of strategic plan. Disadvantages:1.
Reduces communication between employee and managers.2. May limit
the acceptance to goals and objectives.3. May result in a budget
not possible to achieve.4. Often lacks the commitment of lower
managers and employee responsible for implementing the budget.17-
Participative budget (bottom-up budget, self-imposed budget):Lower
managers are participants in budget preparation.Advantages of
participative budget:1. Managers are more motivated to achieve
budgeted goals.2. Greater support for budget.3. Greater
understanding of what to be accomplished.4. Greater accuracy of
budget estimates. Managers with direct operational responsibilities
have a better understanding of what results can be achieved and at
what costs.5. Managers can't blame unrealistic objectives as an
excuse for not achieving budget expectations, since they are
participants in preparing those objectives.Disadvantages of
participative budget:1. Without a review, self-imposed budgeting
may be too slack, resulting in suboptimal performance. Suboptimal
decision making is not likely to occur when guidance is given to
subunit managers about how standers and goals affect them. An
effective budgeting process combines both top down and bottom up
budgeting approaches. Divisions prepare their budget based on the
budget guidance submitted by the firm's budget committee. Senior
managers review and make suggestions to the proposed budget before
sending it back to divisions for revision.18- The budget
development process:1. Budget guidelines are set and
communicated.2. Initial budget proposals are prepared by
responsibility centers.3. Negotiations, reviewing and approval.4.
Revision.5. Reporting on variances.6. Use of the variance
reports.19- Best practice guidelines for the budgeting process
include the following:1. The development of the budget should be
linked to corporate strategy.2. Communication is vital.3. Funding
resources should be allocated strategically.4. Managers should be
evaluated on performance measures other than meeting budget
targets.5. Reduce budget complexity and budget cycle time.6. Link
cost management effort to budgeting.7. Reviewing the budget on
regular basis throughout the year.8. The strategic use of variance
analysis. For a budget to be useful, it must be finalized before
the fiscal year begins.20- Budget planning calendar: is the
schedule of activities for the development and adoption of the
budget.21- Budget manual: is the details of the budget process and
who can the departmental managers prepares their own budgets.22-
Goal congruence: Refers to the aligning of goals of the individual
managers with the goals of the organization as a whole.23-
Budgetary slack and its impact on goal congruence: Budgetary slack
or padding the budget: is a serious ethical issue in budgeting. It
describes the practice of underestimating budget revenues or
overestimating budgeted costs, to make budget targets easier to
achieve. On the positive side Budgetary slack can provide managers
an excuse against unforeseen circumstances. On the negative side
budgetary slack misrepresents the true profit potential of the
company, and can lead to inefficient resources allocation and poor
coordination of activities among the company.24- Avoiding problems
of budgetary slack: The best way to avoid problems of budgetary
slack is to use the budget as a planning and control tool, but not
for managerial performance evaluation.25- Standard costs: are costs
for direct materials, direct labor and manufacturing overhead that
are estimated to apply under specific conditions. Four reasons for
using standard costing1. Cost management (costing inventory).2.
Pricing decisions.3. Budgetary planning and control.4. Financial
statement preparation.26- Ideal standard costs vs. Practical
standard costs1. Ideal (Theoretical, Perfection, Maximum
efficiency, tight) standard costs Attainable only under the best
possible conditions. Based on no allowance for waste, spoilage,
machine breakdown, or other downtime. Encourages continuous
improvement.2. Practical (Currently attainable) standard costs
Challenging but attainable. Based on allowance for normal waste,
spoilage and downtime. Serve as a better motivating target for
manufacturing personnel. Discourages continuous improvement. When
the level of outputs (denominator) is low in absorption costing,
that means that high amount of overhead will be inventoried in
finished goods, consequently result in higher income.27- Setting
standard costs: standard costs can be derived from several
resources:1. Activity analysis: Activity analysis is the most
accurate way to estimate standard costs. It's a team development
approach performed by people from several different areas, based on
investigating all factors involved in producing a product. The cost
of Activity analysis itself can be so high2. Historical data:
Historical data based on using the data of costs involved in
similar product in prior periods to determine standard costs.
Standard costs based on past data may make inefficiencies to
continue.3. Benchmarking: Based on using the best performance
company or unit as a standard. Factors affecting the selection of
budget methodology:1. Types of business.2. Organizational
structure.3. Complexity of operations.4. Management
philosophy.Budgeting systems/approaches:1- Master budget. 2-
Flexible budget. 3- Project budget. 4- Continuous (rolling budget).
5- Kaizen budget. 6- Activity-based budget. 7- Zero-based budget.
1- Master/Static/Comprehensive Budget (Annul business plan): Is
made up of several deferent budgets, and some budgets can't be
developed until other budgets have already been completed. The
development of master budget: Sales budget: Shows the expected
sales in units and its expected selling price. Production budget:
Follows the sales budget, and it shows the resources needed to
carry out the manufacturing operations that allow the firm to
satisfy its sales goals and desired amount of inventory at the end
of the budget period.Budgeted sales (units)+ Ending finished goods
inventory (units) Beginning Finished goods inventory (units)=
Budgeted production (units) Direct labor budget Factory overhead
budget Ending inventory budget
Direct material used+ Direct labor+ Manufacturing overhead= Cost
of goods manufactured Beginning finished goods inventory+ Cost of
goods manufactured= Goods available for sale Ending finished goods
inventory= Cost of goods sold
Sales revenue Cost of goods sold= Gross margin Other expenses=
Operating income Cash budget: Shows cash flows (receipts,
disbursement and cash balances) for a firm over a specified period.
Master budget based on one level of activity (one year). The
relationship between strategic goals, objectives, budgets,
operations and control: The budget expresses the strategy by
describing the sales plan, the costs needed to achieve sales goals
and cash flows needed. The master budget reflects the impact of
operating budget and financial budget.
The benefits of master budget: Master budget is relatively easy
to prepare, and ensure that comprehensive attention is given to
resources requirement. The limitation of master budget: Master
budget amounts are confined to one year at one level of activity.
Budget amounts may be much different from actual results.2-
Flexible budget: Is prepared for many levels of activity. Flexible
budgets represent budgets that provide the ability to accommodate
comparison with many levels of actual sales or production volume.
Benefits of flexible budget:1. Can be displayed on any number of
volume levels within the relevant range.2. Offer managers more
realistic comparison of budgeted and actual revenue and cost items
under their control.3. Most appropriate for firms facing a
significant level of uncertainty in unit sales volume for next
year. Limitation of flexible budget:1. Flexible budgets are highly
dependent on the accurate identification of fixed and variable
costs and the determination of the relevant range.2. Errors in
determination of the relevant range or misestimates in anticipated
outputs expected from variable costs could distort performance
evaluation.3- Project budget: Is used when a project is completely
separated from other elements of a company, or is the only element
of the company.4- Continuous/Rolling/Perpetual budget: Add budgeted
month or quarter, as each current month or quarter expires.5-
Kaizen (Continuous improvement) budget: Depends on continuous
improvement not only from the organization but also from the
suppliers.6- Activity based budget (ABB): Focuses on costs of
activities or cost drivers necessary for operations.7- Zero-based
budget: Requires justification of all expenditures every year.8-
Incremental budget: Starts with prior year's budget and uses
projected changes to estimate the future budget.9- Life cycle
budget: Estimates a product's revenue and expenses over its entire
life (value chain), which includes:a. Upstream costs (researches
and development).b. Manufacturing costs (production costs).c.
Downstream costs (marketing, distribution and customer service).10-
Probabilistic budget: Based on expected values and their
probabilities.Unit 8Analysis and Forecasting Techniques Forecasting
Techniques
Causal forecasting methods (regression analysis)Expected
valueLearning curveTime series methods
Simple moving averageWeighted moving averageExponential
smoothing
Quantitative methods of forecasting rely on managers experience.
Quantitative methods use mathematical models and graphs.1- Causal
forecasting (regression analysis)(least-squares analysis): Looks
for a cause and effect relationship between the dependent variable
we trying to forecast and one or more independent variables, if
it's a linear relationship within the relevant range.a. Simple
linear regression: Is the linear relationship between one dependant
variable and one independent variable. (y = a + b x )Y= value of
the dependent variable, estimated cost.A= the y intercept (fixed
cost).B= the slop of the regression line (unit variable cost, the
coefficient of independent variable measuring the increase in y for
each unit increases in x).X= the independent variable. The
regression analysis is almost necessary for computing the fixed and
variable portion of mixed costs. Regression doesnt determine
causality. Correlation analysis Coefficient of correlation (R): Is
the strength of the linear relationship between tow variables. A
value of 1 indicates perfect inverse linear relationship between x
and y. A value of 0 indicates no linear relationship between x and
y. A value of + 1 indicates direct linear relationship between x
and y. Coefficient of determination (R2) (coefficient of
correlation square): Is the explanatory power of the regression
that measures the percentage of the total variance in cost that can
be explained by the regression equation. T value: Measures if the
independent variable has a valid long-term relationship with
dependent variable. Standard error of the estimate (SE): A measure
of the accuracy of the regression's estimate.b. Multiple regression
analysis: It's also possible for one dependant variable to be
affected by more than one independent variable. Advantages or
benefits of regression analysis:1. Regression analysis is the only
way to compute the fixed and variable portions of costs that
contain mixed costs.2. The results from the regression equation can
be used in conclusions and forecasts. Disadvantages, limitations or
shortcomings of regression analysis:1. To use regression analysis,
historical data is required for the dependent variable or
independent variable. If historical data is not available,
regression analysis can't be used.2. If there has been significant
change in the conditions surrounding historical data, the use of
the regression in estimating the future will be questionable.3.
Analysis is valid only with relevant range.4. If the choice of the
independent variable is inappropriate, the results will be
misleading.2- Time series methods: forecasts the pattern of the
desired variable's activity in the future by looking at its
patterns in past periods. Patterns (components) of Time series:a.
Trend (secular) pattern: Resulting from long-term, multiyear
factors.b. Cyclical pattern: Resulting from long-term, multiyear,
cyclical movement in the economy.c. Seasonal pattern: resulting
from factors within one day or one year.d. Irregular (Random)
pattern: resulting from short-term, unanticipated factors. Using
time series methods:1. Simple moving average: = total amount of
sales number of months.2. Weighted moving average: the more recent
data is assigned a greater weight. This method can be used to
remove seasonal fluctuations from data.Example: Forecasting May
sales from actual sales of 4 months sales (1+2+3+4 = 10)
3. Exponential smoothing: requires less data than moving average
method.Forecasts month = percentage X actual of last month +
(Percentage 1) X forecasts of last month. EXAMPLE: In January, ABC
Corporation began using exponential smoothing to forecast sales for
each month. Actual and forecasted sales, in millions, for ABC for
the months of January, February, March and April are as follows.
Forecasted sales for January through April have been calculated
using exponential smoothing and an alpha of .1.
Forecasts for May = (.1 * 20) + (.9 * 21.6).3- Learning curve:
Describes that the more experience people have in doing a task, the
more efficient they become in doing this task. Benefits of learning
curve analysis: Can be used in life-cycle costing decisions. Can be
used in development a production plans and labor requirements.
Limitation of learning curve analysis: Appropriate only in
labor-intensive operations involving repetitive tasks. The learning
rate assumed to be constant.1- Expected value: is the sum of the
conditional profit (loss) for each event times the probability of
each event's occurrence.1) The decision alternative is under the
managers control.2) The state of nature is the future events will
occur.3) The payoff is the financial results of the combination of
the managers decision and the actual state of nature.4) Benefits of
expected value: Expected value analysis forces managers to think of
all the possibilities that could happen with each decision, and to
evaluate decisions in a more organized manner.5) Criticisms of
expected value: It depends on repetitive trials, but in reality,
most business decisions involve only one trial.4- Expected value of
perfect information (EVPI): is the difference between the expected
profit under certainty and the expected monetary value of the best
act under uncertainty. EVPI = EVwPI EvwoPI. EVPI = Expected value
of perfect information. EVwPI = Expected value with perfect
information. EVwoPI = Expected value without perfect information.
The dealer is not willing to pay more than the EVPI to obtain
information about future demand.
Section C: Cost management 20%Unit 4Cost management terminology
and concepts1- Management accounting (Internal reporting): Measures
and reports financial and nonfinancial information that helps
managers make decisions to attain an organization's goals.2-
Financial accounting: External reporting based on generally
accepted accounting principles (GAAP).3- Cost accounting: Provides
information for management accounting and financial accounting.4-
Cost management: Describe approaches and activities of managers in
short-run and long-run planning, and control decisions that
increase value for customers and lower costs of products and
services.5- Cost, Cost Pool and Cost object:1. Cost: is a resource
sacrificed or forgone to achieve a specific objective.2. Cost pool:
Costs are often collected into meaningful groups.3. Cost object:
Anything for which a measurement of costs is desired (product,
service, customer, activity or organization unit).6- Cost
accumulation and Cost assignment:1. Cost accumulation: is the
collection of cost data in some organized way by an accounting
system.2. Cost assignment: After accumulating costsa. Tracing:
Accumulated costs that have a direct relationship with a cost
object.b. Allocating: Accumulated costs that have an indirect
relationship with a cost object.7- Direct cost of a cost object:
Easily traced (direct row material and direct labor).8- Indirect
cost of a cost object: Not easily traceable to a cost pool or cost
object (Indirect material, indirect labor, other indirect costs
(Common costs)). Overhead allocation using allocation bases (Cost
driver):When direct tracing isn't possible management accountants
uses allocation bases (cost drivers).9- Cost drivers: Are
Activities that cause costs increase as the activity increases.
10- Cost allocation is necessary for: Product costing. Pricing.
Investment and disinvestment decisions. Managerial performance
measures. Make-or-buy decision. Determination of profitability.
Measuring income and assets for external reporting.11-
Manufacturing costs (Product costs):1- Direct materials (traced).2-
Direct manufacturing labor costs (traced).3- Indirect manufacturing
costs (Factory over head) (allocated).12- Prim costs:
(DM&DL).13- Conversion costs: (DL&MOH).14- Nonmanufacturing
costs (Period costs): Selling, general and administrative costs.15-
Types of inventory in manufacturing firms1. Direct material
inventory.2. Work-in-process inventory.3. Finished goods
inventory.16- Cost behavior:1. Variable cost: (fixed per unit,
variable in total).2. Fixed cost: (variable per unit, fixed in
total in short-term and within a relevant range). Relevant range:
Is the range for which the cost relationships hold constant.
Marginal cost: is the cost incurred by a one-unit increase in the
activity level of a particular cost driver (constant within the
relevant range).3. Simi-variable costs (Mixed costs): It includes
both fixed and variable costs. Methods of estimating mixed costs:a.
High- low method.b. Regression method.17- Cost of goods sold in
merchandising firms:Beginning inventory+ Purchases_ Ending
inventory= Cost of goods sold
18- Cost of goods sold in manufacturing firms: Beginning row
materials inventory XXX+ Purchases XXX_ Returns and discounts XXX+
Fright-in XXX -----------= Row materials available for use XXXXX_
Ending Row materials inventory XXX -----------= Direct materials
used in production XXXXX+ Direct labor XXX+ MOH XXX----------=
Total manufacturing costs XXXXX+ Beginning work-in process
inventory XXX_ Ending work-in process Inventory XXX----------= Cost
of goods manufactured XXXXX+ Beginning finished goods inventory
XXX----------= Goods available for sale XXXXX_ Ending finished
goods inventory XXX-----------= Cost of goods sold XXXXX19- Cost
classification for decision making:1. Controllable Vs. Non
controllable costs:a. Controllable are those that are under
discretion of a particular manager.b. Non controllable are those
that are committed to another level of the organization.
Controllability of a given cost differs according to the levels of
the organization. A given cost may be controllable to some level of
the organization, and non controllable to another levels.2.
Avoidable Vs. Committed costs:a. Avoidable are those that may be
eliminated by not engaging in an activity, or performing it more
efficiently (Direct materials).b. Committed is the cost that
governed mainly by past decision, and can't be eliminated in the
short-run. It arises from holding property, plant or equipment.
(Insurance, real estate taxes, lease payment and depreciation).
They are by nature long-term and can't be reduced by lowering the
short-term level of production.3. Incremental Vs. Differential
cost:a. Incremental is the additional cost inherent in a given
decision.b. Differential is the difference in total cost between
two decisions.4. Engineered Vs. Discretionary costs:a. Engineered
are those that have a direct, observable cause-and-effect
relationship between the level of output and the quantity of
resources consumed (Direct material and direct labor).5.
Discretionary is the cost that management decides to incur in the
current period. It's a periodic cost that has no strong impact
input-output relationship (advertising and research &
development).6. Outlay (explicit) Vs. Opportunity (Implicit)
cost:a. Outlay (explicit, accounting, and out-of-pocket costs)
requires actual cash disbursements.b. Opportunity (implicit) is the
benefit lost when choosing one option that stops receiving the
benefits from alternative option.7. Economic Vs. Imputed cost:a.
Economic is the sum of explicit and implicit costs.b. Imputed are
those that should be involved in decision making even though no
transaction has occurred. They may be explicit or implicit).8.
Relevant Vs. Sunk cost:a. Relevant costs are those future costs
that will vary depending on the decision taken when choosing
between two or more options to determine the best option that
offers the highest benefit to the organization. Relevant cost has
two properties: It differs for each decision option. It will be
incurred in the future.b. Sunk cost is the cost that incurred in
the past, thus, it has no impact on the decision (irrelevant
cost).
9. Joint costs, separable costs and by-product: Split-off point:
Is the point that multiple end products become separately
indentified from the input of a single product.a. Joint cost is the
cost incurred before the split-off point. Since it's not traceable
it must be allocated.b. Separable cost is the cost incurred beyond
the split-off point.c. By products are products of relatively small
total value that produced from the same process of manufacturing
products with greater value and quantity (Joint products).
10. Normal Vs. abnormal spoilage:a. Normal spoilage is the
spoilage that occurs under normal operating conditions. It's
essentially uncontrollable in the short-run. It's treated as
product cost.b. Abnormal spoilage is the spoilage that not expected
to occur under normal, efficient operating conditions. The cost of
abnormal spoilage should be separately identified and reported to
management. Abnormal spoilage thought to be more controllable by
production management than normal spoilage. Abnormal spoilage
treated as period cost (loss).11. Rework, scrap and waste:a. Rework
consists of products that need more efforts to meet salable
conditions.b. Scrap consists of row materials left over from the
production cycle, but can be used in other production or to be sale
to customers for a nominal price.c. Waste consists of row materials
left over from the production cycle, but can't be reused, and is
not saleable at any price. It must be discarded.12. Carrying cost:
Is the cost of storing or holding the inventory.13. Transferred in
cost: Is the cost incurred in a department before transferring the
product to another department.14. Value adding cost: Is the cost of
activities that adds a value to the customer and can't be
eliminated without reducing the quality or quantity of the output
required by the customer.20- Capacity levels in production:1. Ideal
capacity (Theoretical): Don't allow for any plant maintenance,
holidays or downtime.2. Practical capacity: = theoretical capacity
normal holidays.21- Capacity levels in demand:1. Master-budget
capacity: Is the expected level of demand for the current budget
period.2. Normal capacity: Is the long-term average level of
master-budget capacity.22- Costing techniques:1. Absorption Vs.
variable costing;a. Absorption costing (inventory costing) treats
all manufacturing costs as production costs (required for reporting
under GAAP).b. Variable costing considers only variable
manufacturing costs as product costs.c. Super variable (throughput)
costing considers only material costs as a production
costs.Absorption (inventory) costing Sales revenue XXX_ Cost of
goods soled (DM+DL+Fix OH+Vari OH) XXX Gross margin XXX_ Period
cost XXX Operating income XXXVariable costing Sales revenue XXX_
Cost of goods soled (DM+DL+ Vari OH) XXX Manufacturing Contribution
margin XXX_ nonmanufacturing variable costs XXX Contribution margin
XXX _ Fixed MOH XXX _ Fixed non MOH XXX Operating income XXX
Horngreen equation: (1) The difference in operating income
between absorption and variable costing = Fixed cost per unit X the
inventory per unit.(2) The difference in operating income between
absorption and variable costing = Fixed manufacturing cost per unit
X (beginning inventory ending inventory). (3) Actual Vs. normal
costing and budgeted cost:a. Actual costing = Actual DM+ Actual DL+
Actual OH Overhead = Actual rate X Actual allocation baseb. Normal
costing = Actual DM+ Actual DL+ Applied OH Applied OH = Budgeted
rate X Actual allocation base. Budgeted rate = Budgeted OH Budgeted
allocation base. Over-applied O.H.: Applied O.H. > Actual O.H.c.
Standard costing Overhead = budgeted rate X standard allocation
base(1) If the over-applied overhead balance is immaterial: Dr.
Applied O.H. Cr. Cost of good soled Cr. Actual O.H.(2) If the
over-applied overhead balance is material:Dr. Applied O.H. Cr.
Work-in-process inventory Cr. Finished goods inventory Cr. Cost of
goods soled Cr. Actual O. H. Under-applied O.H.: Applied O.H. <
Actual O.H.(1) If the under-applied overhead balance is
immaterial:Dr. Applied O.H.Dr. Cost of goods soled Cr. Actual
O.H.(2) If the under-applied overhead balance is material:Dr.
Applied O.H.Dr. Work-in-process inventoryDr. Finished goods
inventoryDr. Cost of goods soled Cr. Actual O.H.d. Budgeted cost:
is what expected to occur.(4) Cost accumulation:a. Traditional
costing:1- Job-order costing: appropriate for customized
(heterogeneous) product (single or departmental rate).2- Process
costing: appropriate for similar (mass, homogeneous) product
(single or departmental rate).3- Operation costing: appropriate for
organizations that uses both job-order and process costing (e.g.,
leather and fabric bags).b. Activity based costing (ABC): every
activity has its own cost pool.c. Life-cycle costing (value chain):
R&D and design (Upstream cost), manufacturing costs and
marketing, distribution and customer service (down-stream cost).(5)
Standard costing, flexible budgeting, and variance analysis:a.
Standard costing estimates what should be.b. Flexible budgeting is
the calculation of the cost that should have been consumed given
the achieved level of production.c. Variance analysis is the
difference between standard and flexible budget.(6) Cost
allocation:a. Allocating joint cost.b. Allocating service
departments costs.(7) Target costing: market price of the product
taken as a given.
Unit 5Cost accumulation systems Standard cost represents what
costs should be. Budgeted cost represents expected actual costs.
Product costing is the process of accumulating, classifying and
assigning direct material, direct labor and factory overhead costs
to products or services. Types of product costing systems:(1) Cost
accumulation methods: The nature of the industry forces managers to
use job, process or operation costing systems.(2) Cost measurement
methods (management decision): actual, normal or standard costing
systems.(3) Overhead allocation methods (management decision):
traditional (peanut-butter) or activity-based costing system.
1- Process costing accounting: is used to assign costs to
inventoriable goods or services, it's applicable for homogenous
(mass) products. Process costing accumulates costs by process or
department and then assigns them to large number of nearly
identical products. Steps in process costing:1. Accounting for all
units (physical flow of quantities): important to determine any
normal spoilage, ignores the % percentage of completion.1- Account
for all units (same for FIFO and weighted average)
Beginning WIP XXX+ Started units this period XXX Total units to
account for XXXX
2. Computing equivalent units of production:(1) First in first
out (FIFO) costing: Material Conversion Total units completed and
transferred XXX XXX_ Beginning WIP (regardless % of completion) XXX
XXX Units started and completed this period XXX XXX+ Amount needed
to complete BWIP XXX XXX+ Amount completed on EWIP XXX XXX EUP
under FIFO XXX XXX
If materials added at the beginning of the processTotal Units
Completed XX+ Amount of materials needed to Complete BWIP zero+
Amount of materials added to Date on EWIP 100% _____EUP for
Materials XXX
If materials added at the end of the processTotal Units
Completed XX+ Amount of materials needed to Complete BWIP 100%+
Amount of materials added to Date on EWIP zero _____EUP for
Materials XXX
(2) Weighted average costing: Material Conversion Total units
completed and transferred XXX XXX+ Amount added to EWIP XXX XXX EUP
under weighted average XXX XXX
3. Compute unit cost:A. Under FIFO(1) DM: Current cost EUP
(FIFO) = unit cost(2) Conversion: Current cost EUP (FIFO) = Unit
cost(3) Total unit cost under (FIFO) = (1) + (2)B. Under weighted
average:(1) DM: BWIP cost + Current manufacturing cost EUP (WA) =
Unit cost(2) Conversion: BWIP + Current MC EUP (WA) = Unit cost(3)
Total unit cost = (1) + (2) Accounting for spoilage: For costing
the finished goods inventory and there are normal spoilage, we add
the number of good units to the number of normal spoilage units,
then multiplying this number by the unit cost, then dividing the
total amount by the number of good units to have the cost of
finished goods inventory.2- Operation costing: is mixed from job
and process costing.3- Activity-based costing (transaction-based
costing): is a cost accounting system based on the activity level
as a cost object. Characteristics of ABC:1. ABC applies more
focused and detailed approach for gathering costs.2. ABC can be
part of job order or process costing systems.3. ABC can be used in
manufacturing or service businesses.4. ABC treats production costs
as variable.5. The costs driver in ABC is often a non-financial
variable.6. ABC may be used for internal and external purposes.4-
ABC (volume-base) Vs. traditional (peanut-butter)
(non-volume-based) costing:1. Traditional costing involve:
Accumulating costs in general ledger accounts. Using a single cost
pool to combine the costs from all the related accounts. Selecting
a single cost driver to use for the entire indirect cost pool.
Allocating the indirect cost pool to final cost object using a
single rate or departmental rate. The effect is an averaging of
costs that may result in significant inaccuracy when products or
service units don't use similar amounts of resources. All overhead
costs don't fluctuate with volume.2. Activity-based costing
involves: Identifying the organization's activity that constitutes
O.H. and defining activity cost pools and activity measures
(resource cost driver). Assigning the costs of resources consumed
to activity centers. Calculating activity rates by dividing total
cost of each activity by its cost driver. Assigning overhead costs
to cost object.5- ABC terms: Activity: is a work performed within
an organization. Resource: is an economic element used to perform
activities. Resource cost driver: is a measure of the amount of
resources consumed by an activity. It's used to assign resource
cost consumed by an activity to a particular cost pool (percentage
of total square feet required to perform an activity). Activity
cost driver: measures how much activity used by a cost object. It's
used to assign cost pool costs to cost object (machine hours
required to produce product). 6- Benefits of ABC costing:1. Helps
reduce distortion caused by traditional cost allocation.2. Provides
more accurate product cost.3. Provides more accurate measurement of
activity-driving costs.4. Provides managers easier access to
relevant costs for making business decisions.7- Limitations of
ABC:1. Even if activity data are available, for some costs it might
be not practical to find a specific activity that caused the
incurrence of the cost.2. ABC reports are not GAAP.3. ABC system is
time and money consuming.4. ABC usually requires more than a year
for successful development and implementation.5. ABC generates vast
amount of information. Too much information can mislead
managers.
Unit 6Cost allocation techniques1- Four purposes for cost
allocation:1. To provide information for economic decisions.2. To
motivate managers and employees.3. To justify costs or compute
reimbursement.4. To measure income and assets for reporting to
external parties.2- Criteria to guide cost allocation decisions:1.
Cause an effect (most preferred): Identifies the variables that
cause resources to be consumed.2. Benefits received (used when a
cause-and-effect relationship can't be determined): Identifies the
beneficiaries of the outputs of the cost object. The costs are
allocated among the beneficiaries in proportion to the benefits
each received.3. Fairness or equity (least preferred): This
criterion is often used in government contracts when cost
allocation is the base for establishing a price satisfactory to the
government and its suppliers.4. Ability to bear (least preferred):
This criterion allocates costs to the cost object according to its
ability to absorb costs allocated to it. 3- Joint cost allocation:
Joint costs are those costs incurred before the split-off point.1.
Physical measure at split-off point: weight or volume. Weight or
volume of product Y Total weights or volumes of all joint products
X joint costs = Amount allocated to joint product Y Advantages:(1)
Easy to use.(2) The criterion for the allocation of the joint costs
is objective. Limitations:(1) Each product can have its own unique
physical measure.(2) Focusing on physical nature of the products
can lead to cost distortion of products.2. Sales value at split-off
point: values at split-off point. Sales value of product Y Total
sales value of all joint products X joint costs = Amount allocated
to joint product Y Advantages:(1) Easy to calculate.(2) Costs are
allocated according to the individual product's value.
Limitations:(1) Market prices for some industries change
constantly.(2) Sales price at split-off point might be not
available, because additional processing is necessary for sale.3.
Net realizable value (NRV): Estimated NRV = Final sales value after
adding separable costs Added processing costs (separable costs that
incurred after split-off point). Estimated NRV of product Y *Total
NRV of all joint products X joint costs = Amount allocated to joint
product Y* If one of the two products is not processed further, we
will add the NRV of the further processed product to the sales
value at split-off point of the other product. Advantages:(1) It
produces an allocation that yields an incremental profit among
products.(2) Selling price at spilt-off point doesn't have to be
available. Limitations:(1) More difficult to calculate than the
other two methods.(2) Based on an estimated value. The by-product:
when using any method of joint cost allocation, the sales revenue
of by-products if inventoried, treated as a reduction of the costs
of production of the main product, and the remaining costs are
allocated to the main products not to the by-product, and at any
way no joint costs are allocated to by-product.4- Inventory costing
choices: Absorption (Full) Vs. Variable (Direct) costing:1.
Absorption costing (GAAP costing): Advantages:(1) Absorption
costing is GAAP.(2) The Internal Revenue Service requires the use
of absorption costing in financial reporting. Limitations:(1) The
level of inventory affects net income because fixed costs are
component of product costs.(2) The net income reported under
absorption method is less reliable than under variable method
(especially for use in performance evaluation) because the level of
inventory affects the net income as it includes fixed costs into
its components.2. Variable costing (Direct costing): Variable
costing is a management tool used to calculate breakeven point CPV
(Cost volume profit analysis). Advantages:(1) Variable costing
attains the objective of management control systems as costs are
listed separately so that they may be easily traced and controlled
by managers.(2) The net income reported under contribution method
is more reliable than under absorption method (especially for use
in performance evaluation) because the cost of the product doesn't
include fixed costs into its component, and therefore the level of
inventory doesn't affect net income.(3) The contribution margin
yield from variable costing aids in decision making.
Limitations:(1) Variable costing is not GAAP.(2) The Internal
Revenue Service doesn't allow the use of variable costing in
financial reporting.
5- Service cost allocation:1. Direct method: costs of services
between service departments are ignored, and all costs are
allocated directly to production departments.2. Step-down method:
Service department costs are allocated to other service departments
and to production departments, starting with service department
that provides the greatest amount of services to other
departments.3. Reciprocal method: Service department costs are
allocated to each other; this will generate new overhead costs for
service departments to be allocated to other departments.6-
Allocating service department costs to production departments by
Dual rate for SBU evaluation: The cost allocation method that
separates fixed and variable costs. Variable costs are allocated to
production units by multiplying budgeted rate times the actual
usage of allocation base, and fixed costs are allocated by
multiplying budgeted fixed costs times the capacity demanded.
Dual-rate example:Fact Pattern: Longstreet Companys Photocopying
Department provides photocopy services for both Departments A and B
and has prepared its total budget using the following information
for next year: Fixed costs $100,000 Available capacity 4,000,000
pages Budgeted usage Department A 1,200,000 pages Department B
2,400,000 pages Variable cost $0.03 per pageAssume that Longstreet
uses the dual-rate cost allocation method, and the allocation basis
is budgeted usage for fixed costs and actual usage for variable
costs. How much cost would be allocated to Department A during the
year if actual usage for Department A is 1,400,000 pages and actual
usage for Department B is 2,100,000 pages? A. $42,000 B. $72,000 C.
$75,333 D. $82,000Answer (C) is correct. Based on budgeted usage,
Department A should be allocated 33 1/3% [1,200,000 pages
(1,200,000 pages + 2,400,000 pages)] of fixed costs, or $33,333
($100,000/3). The variable costs are allocated at $.03 per unit for
1,400,000 pages, or $42,000. The sum of the fixed and variable
elements is $75,333. Single rate example:Assume that Longstreet
uses the single-rate method of cost allocation and the allocation
base is budgeted usage. How much photocopying cost will be
allocated to Department B in the budget year? A. $72,000 B.
$122,000 C. $132,000 D. $138,667Answer (D) is correct. Department B
is budgeted to use 66 2/3% of total production (2,400,000
3,600,000), so it should be allocated fixed costs of $66,667
($100,000 66 2/3%). The variable cost allocation is $72,000
(2,400,000 pages $.03 per page), and the total allocated is
therefore $138,667 ($66,667 + $72,000).Unit 7Operational efficiency
and business process performance1- Just-in-time system(JIT) (demand
pull): A comprehensive production and inventory system that
purchases or produces materials and parts only as needed and just
in time to be used at each stage of the production process.
Just-in-time production (lean production): A demand-pull
manufacturing system that produces each component of a production
line as soon as and only when needed by the next step in the
production line. Just-in-time purchasing: the purchase of goods or
materials so that they are delivered just as needed for production.
JIT (demand pull) systems vs. traditional (demand push) systems:
Lot sizes based on immediate need are typical of just-in-time
systems, while lot sizes based on formulas are characteristics of
traditional inventory management systems. Benefits:1. Reduces
carrying costs and non-value adding activities.2. Increases
inventory turnover (cost of goods sold average inventory).3.
Decreases setup costs.4. Lower investments on space.5. Greater
emphasis on improving quality. Limitations:1. Increases stock-out
costs.2. Not appropriate for high-mix manufacturing environments.
JIT system depends on reliable suppliers which can ensure on-time
deliveries of high quality goods for just-in-time use. Wok cells:
describes multi-skilled workers that can do multi-tasks. The
employee in work cells in a strong need to have a strong
training.2- Enterprise resources planning (ERP)(Demand Push): A
material requirement planning (MRP) is an approach that uses
computer software to help manage a manufacturing process. MRP
system translates the finished goods when entered to the system
into row materials needed and the time required to deliver it.
Benefits of MRP systems:1. Less coordination required between
functional areas.2. Lower setup time.3. Lower inventory carrying
cost.4. Reduces idle time.5. Better manufacturing process control.
Limitations: Potential inventory accumulation. Workstations may
receive parts that they are not ready to process. MRP basic goals
is: Right part, right time, and right quantity.3- Manufacturing
resource planning (MRP II): MRP II system translates the finished
goods when entered to the system into row materials needed and time
required to deliver it and cash flows.4- Enterprise resource
planning (ERP):a. ERP is a software program that is used to plan
and keep records of resources, including1. Finances,2. Labor
capabilities and capacity,3. Materials, and4. Property. b. MRP is a
common function contained in ERP.1. Although ERP and MRP are
similar, they are not interchangeable since ERP includes functions
not included in MRP.2. An ERP system would allow a company to
determine what hiring decisions might need to be made or whether a
company should invest in new capital assets.a) A company that only
need to maintain inventory and materials levels would only need to
implement a MRP system.c. Operational benefits of ERP:1) Reducing
operational costs through improved communication across
departments.2) Facilitating inventory management.3) Facilitating
day-to-day operations through real-time information.5- Outsourcing:
Is a process of purchasing goods or services from outside rather
than producing it within the organization. Benefits:1. Can be
cheaper.2. Having a reliable service, reduced cost.3. Can improve
efficiency and effectiveness by gaining outside expertise.
Limitations:1. Can result in a loss of in-house expertise and
capabilities.2. Can reduce process control.3. May reduce control
over quality.4. It depends on outside parties.6- Theory of
constraints (TOC) and throughput costing: Throughput margin = Sales
revenue DM cost material handling cost. Inventory = (Material costs
in direct material, work-in-process, and finished goods
inventories) + (R&D costs) + (costs of equipment and
buildings). Operating expenses = All costs of operations, not
including direct materials. The basic principle of TOC is to
maximize the throughput contribution margin through the constraint.
Definition: It describes methods to maximize operating income when
faced with some bottleneck and some non-bottleneck operations. It's
a means of making decisions for a company to be competitive when it
needs to be able to respond quickly to customer orders. Theory of
constraint is an important way for a company to speed up its
manufacturing time so it can improve its customer response time and
its profitability. Manufacturing cycle time (manufacturing lead
time) (throughput time):It's the amount of time between receiving
customer's order and the shipment of the order. Drum-buffer-rope
system: Is a TOC system that balancing the flow of production
through the constraint so reducing the amount of inventory at the
constraint and improving overall productivity. The drum is the
constraint, the buffer is the minimum amount of work-in-process
input needed to keep the drum busy, and the rope is the sequence of
processing and including the constraint. The steps in TOC
analysis:1. Identifying the constraint.2. Determine the most
profitable product mix given the constraint.3. Maximize the flow
through the constraint.4. Increase the capacity at the
constraint.5. Redesign the manufacturing process for greater
flexibility and speed.7- Capacity management:1. Capacity
planning:a. Capacity planning is an element of strategic planning
that is closely related to capital budgeting.8- Value-chain
analysis: Is a strategic analysis tool used to identify the value
added activities to be increased and non-value added activities to
be decreased.1. Upstream activities (research & development,
design).2. Manufacturing activities.3. Downstream activities
(marketing and distribution, customer service). Value adding cost:
is the cost of activities that adds value to the customer (material
and labor for regular repairs). Non-value adding cost: is the cost
of activities that don't add value to the customer (rework and
warehousing costs), and can be eliminated without affecting the end
products.9- Value-chain analysis:1. The value chain: R&D,
design, production, marketing, distribution, and customer
service.2. Value chain analysis: is a strategic tool that allows
the firm to focus on the activities that add value and reduce
cost.1) The first step in the value chain analysis is to identify
the firms value-creating activities.2) The second step is to
determine how each value-creating activity can produce competitive
advantage for the firm.3. The supply chain (the supplier, the firm,
and the customer): describes the flow of goods, services and
information from their original sources of materials and services
to the delivery of products to customers, regardless of whether
those activities occur in the same organization or in other
organizations. It usually encompasses more than one firm.1) Supply
chain management: refers to the coordination of business processes
across companies to better serve end customer.2) Customers want
companies to use the value chain and supply chain to deliver
products that are: Lower cost with increased efficiency. High level
of quality. Constant innovation. Supply chain analysis should
extend to all parties in the chain.3) Goals of supply chain
management:1. Maximizing customer value.2. Achieving sustainable
competitive advantages.4) Supply chain activities involves: Product
development. Sourcing. Production. Logistics. Information system
needed to coordinate these activities.5) Benefits of effective
supply chain management:1. Generally improve performance and reduce
costs.2. Reduces stock-out costs and carrying costs.6) Issues and
problems in supply chain management:1. Communication problems
between companies.2. Trust issues.3. Incompatible information
system.4. Required increases in personnel resources and financial
resources. 10- Activity based management (ABM): Is the management
decisions and activity analysis that use activity-based costing
information to satisfy customers and improve operational control,
management control and profitability. ABM applications can be
classified into two categories:1. Operational ABM: Enhances
operation efficiency and asset utilization and lowers costs. Its
focuses are on doing things right and performing activities more
efficiently. Operational ABM applications use management techniques
such as activity management, business process reengineering, total
quality management, and performance measurement.2. Strategic ABM:
Its focuses are on choosing appropriate activities for the
operation, eliminating nonessential activities and selecting the
most profitable customers. Strategic ABM applications use
management techniques such as process design, customer
profitability analysis, and value chain analysis. Advantages of
ABM:1. Uses continuous improvement to maintain the firm's
competitive advantages.2. Eliminates non-value-added activities.3.
Works well with just-in-time processes.4. Allocates more resources
to activities, products that add value. Disadvantages of ABM:1. Not
used to external financial reporting.2. Implementing ABC/ABM is
expensive and time-consuming.3. Changing to ABC/ABM will result in
different pricing, process design, manufacturing technology, and
product design decision.11- Process analysis and business process
reengineering: Reengineering: Is the process innovation and core
process design. Instead of improving existing products. Business
process reengineering (BPR) involves changes that are:1.
Fundamental.2. Radical.3. Dramatic.12- Benchmarking: Is the
continuous, systematic process of measuring products, services, and
practices against the best level of performance. Thus helping the
organization to be competitive.13- Best practice analysis: Refers
to the collective steps in a gap analysis. A gap analysis is the
space between what is and what an organization hopes to be.14- Cost
of quality analysis (COQ): Refers to the costs incurred to prevent,
or arising as a result of producing low-quality product.a.
Conformance costs: Preventive costs and appraisal costs.b. Non
conformance costs: Internal failure costs and external failure
(lost opportunities) costs.
15- Efficient accounting processes: benefits of improving
accounting processes that it increases companys ability to minimize
the costs of these processes and maximize the efficiency.1. Areas
for improvement:1) Accounts payable.2) Cash cycle.3) Closing and
reconciliation processes.4) Data analysis.2. Techniques for
creating future vision for finance function.1) Benchmarking.2)
Current use assessment (customer-centered approach).3. Steps needed
to improve accounting processes:1) Process walk-throughs
(understanding current process).a. Benefits of process
walk-throughs:1. Identifying waste and over-capacity (duplication
of effort, tasks done are not necessary, output not being done).2.
Identify the root cause of errors.2) Process design: to cover every
aspect of the internal users need.3) Risk-benefit evaluation: The
greater the changes being made, the less the firm can be sure of a
successful outcome. If the risks are determined to be too great, a
return to the process design step may be necessary.4) Planning and
implementing the redesign (top-down implementation):5) Process
training:4. Reducing the accounting close cycle: soft closes can be
used for month-end closes, and more detailed closing for
quarter-end and year-end closes. To speed up the closing:1) A
standardized chart of account should be used across all company
locations.2) Bank reconciliation can be done daily.3) Depreciation
can be calculated a few days before the closing.4) Standardized
accounting procedures.5. Centralization of accounting as a shared
service: Benefits of shared service:1) Utilizing a smaller number
of highly trained people.2) The result is usually fewer errors.3)
Greater efficiency can be generated by assigning tasks to a smaller
number of managers.4) Accounting errors can be searched more
easily.
Unit 10Cost and variance measures Performance evaluation is the
process by which managers at all levels gain information about the
performance of tasks within the firm and judges that performance
against pre-established criteria as set out in budgets, plans, and
goals. Operational control (management-by-exception approach):
means the evaluation of operating level employees by middle-level
managers. Operational control Focuses on detailed short-term
performance measures. Has a management-by-exception approach that
is identifies units or individuals whose performance does not
comply with expectations so that the problem can be promptly
corrected. The use of standards: To set performance expectations.
To evaluate and control operations. To motivate employees. To
manage by exception. The use of variances: Variance analysis
enables management by exception. Variance analysis assigns
responsibilities. Variance will guide managers to seek explanations
and take early corrective action. Sometimes variances suggest a
change in strategy. Variances may signify that standards need to be
reevaluated. Effectiveness and efficiency: An operation is
effective if it attained or exceeded its goals (can be measured by
the sales volume variance). An operation is efficient if it has not
wasted resources (can be measured by the flexible budget variance).
We can assess the effectiveness of a company by comparing the
actual results with its master budget. To be able to calculate
variances we need to calculate 3 columns.1- Actual amount column =
actual price/cost X actual output.2- Static/master-budget =
budgeted price/cost X budgeted output.3- Flexible budget = budgeted
price/cost X actual output.
1- Static-budget variance (operating income variance) = Actual
result static-budget amount. A flexible budget will help in
evaluating efficiency: the flexible budget calculates budgeted
revenues and budgeted costs based on actual output level in the
budgeted period.2- We can calculate flexible budget depending on
budgeted selling price, budgeted variable OH and budgeted fixed OH
multiplied by actual output.3- Flexible budget variance = actual
amounts flexible budget. (Measures the efficiency of resources).4-
Sales volume variance = flexible budget static budget. (Inaccurate
forecasting of output units sold) (As the only different is in the
amount of sales volume).5- Static budget variance = flexible budget
variance + sales volume variance (the difference due to the
performance of the company)6- Sales volume variance for operating
income = budgeted contribution margin per unit X (actual units sold
budgeted units to be sold). The three elements causes the flexible
budget variance is:1. Selling price variance.2. Variable cost
variance (DM, DL, and variable O.H.3. Fixed cost variance7- Selling
price variance = (actual selling price budgeted selling price) X
Actual units sold. Direct costs variance (DM & DL): we can
investigate the favorable/unfavorable variance in DM or DL by
calculating the price variance (the difference between actual and
budgeted input price costs), and efficiency variance (the
difference between the actual and budgeted input quantity).8- Price
variance (input-price variance) (rate variance) = (Actual price
standard price) X Actual quantity of input.9- Efficiency variance
(usage variance) = (actual quantity of input budgeted quantity of
input that should have been used to produce the actual
output){standard material X actual output} X standard price.
Variable and fixed manufacturing overhead variance. To be able
to calculate variances we need to calculate 4 columns.1- Actual
amount = actual per unit cost X actual allocation base.2- Budget
according to normal costing = budgeted rate X actual allocation
base.3- Flexible budget = standard per unit cost X actual output X
budgeted rate.4- Applied O.H. according standard costing = standard
per unit cost X actual output X budgeted rate.
10- Variable manufacturing overhead variance:1. Calculating
allocated (applied) V. M.O.H. according to standard costing.
Applied O.H. = budgeted V.O.H. rate X standard allocation base for
actual output. Standard allocation base for actual output =
budgeted (standard) per unit rate X actual output. When comparing
allocated input allowed for actual output according to standard
costing (4) with flexible budget (3), there will be never variance
because they are the same.2. Calculating V.M.O.H. variance
(variable O.H. flexible budget variance) = actual amount flexible
budget amount (applied O.H.).3. Efficiency variance = (actual
quantity of allocation base budgeted quantity for actual output) X
budgeted O.H. rate.4. Spending variance = (actual rate per unit
budgeted rate per unit) X actual allocation base. Under/over
applied V.O.H. = flexible budget variance = efficiency variance +
spending variance. If O.H. is applied based on amount of the
allocation base used for the actual units of output rather than
standard amount allowed, there will be no variable O.H. efficiency
variance.11- Fixed manufacturing overhead variance:1. Calculating
allocated (applied) fixed M.O.H. according standard costing.
Applied O.H. = budgeted F.O.H. rate X standard allocation base for
actual output. Standard allocation base for actual output =
budgeted (std.) per unit allocation base X actual output.2.
Calculating F.M.O.H. variance = actual amount applied O.H. Flexible
budget (F.M.O.H. in the flexible budget is the same budgeted
F.M.O.H.).3. Calculating production volume variance
(denominator-level variance) = budgeted O.H. applied O.H.
(Uncontrollable).4. Calculating spending (budget) variance = actual
F.O.H. flexible (budgeted) F.O.H. Under/over applied F.O.H =
production volume variance When comparing between budgeted amount
and flexible budget there will be no variance because flexible
budget with respect to F.M.O.H. depends on budgeted amount.
Efficiency variance for materials or labor can be divided into mix
variance and yield variance.12- Two-way analysis (volume and
controllable): Overhead variance = (Budgeted V.O.H. rate X Standard
allocation base allowed for actual output) + budgeted F.O.H Actual
total O.H.13- Three-way analysis (spending, efficiency, and
volume): Spending variance = (Budgeted V.O.H. rate X actual
allocation base) + budgeted F.O.H Actual total O.H.14- Sales
volume, mix, and quantity variances:1. Sales volume variance =
sales mix variance + sales quantity variance.2. Sales volume
variance = Budgeted contribution margin per unit X (actual units
sold budgeted units to be sold).3. Sales mix variance = (actual
sales mix ratio for a product budgeted sales mix ratio for a
product) X actual units sold for the two products X budgeted
contribution margin per unit for a product.4. Mix ratio for actual
input = sum of (actual quantity X standard price total actual
quantity.5. Mix ratio for budgeted input = sum of (standard
quantity X standard price) total standard quantity.15- Yield
variance = (total standard quantity total actual quantity) X
budgeted sales ratio.16- Partial and total factor productivity:1.
Total productivity = total output total input.2. Partial
productivity for materials = total output total material costs.3.
Partial productivity for labor = total output total labor
costs.
Unit 11Responsibility accounting and performance measuresCMA
EXAM: The performance measurement portions focus on a few
performance measures, specifically Return on Investment (ROI) and
Residual Income (Rl). For these measurements you need to know what
they are, how they are calculated and how they are used. You also
need to be able to identify the weaknesses that are inherent in
each one. Responsibility accounting is the breaking down of costs
into those costs that can be controlled by the manager and those
that cannot be controlled by the manager. There are a number of
different cost classifications and allocation methods within this
section that you need to be aware of. Transfer pricing is a topic
that you need to know from both a theoretical standpoint and a
numerical one as well. The questions may require you to understand
the issues that company faces in establishing the transfer price as
well as being able to calculate an acceptable transfer price under
certain situations. The final topic covered in this Section is
performance feedback, and more specifically the balanced scorecard,
you need to know conceptually what the balanced scorecard is and
how it works as well as be familiar with Its application.
The objective of this unit is (management control) which provide
variety of tools that top managers (such as CFOs) use to evaluate
middle-level managers (such as plant managers, product-line
managers, heads of (R&D) departments, and regional sales
managers) and the organization as a whole. The mid-level managers
have a significant responsibility in helping the organization
achieve its strategic goals. Management control: refers to the
evaluation by upper-level managers to the performance of mid-level
managers. Management control: Focuses on higher level managers and
long-term, strategic issue. Is more consistent with
management-by-objectives. The objectives of management control:1.
Motivate managers to exert more effort to achieve the
organization's goals.2. Promotes goal congruence among the
organization.3. Determine fairly the rewards earned by manager's
effort and skills and the effectiveness of their decisions.
Management control issues: Responsibility centers (strategic
business units). Contribution and segment reporting. Common costs.
Transfer pricing. Performance measures & financial measures
(ROI, RI and EVA). The balanced scorecard.1- Responsibility centers
(strategic business units) (SBUs): consists of a well-defined set
of controllable operating activities over which the SBU manager is
responsible Responsibility accounting: is a system measures the
plans-by-budgets and actions-by-actual results of each
responsibility center. Types of responsibility centers:1. Cost
center: the manager is accountable for costs only. Cost SBU: is the
production or support SBUs within the firm that have the goal of
providing the best quality product or service at the lowest cost.
(E.g. maintenance department.) Strategic issues related to
implementing cost SBUs: Cost shifting. Excessively focusing on
short-term objectives. The criteria to choose the cost allocation
method, are the same objectives for management control: To motivate
managers to exert more effort. To promote goal congruence. To
provide a bases for fairly evaluation for managers performance.
Responsibility and controllability: Controllability: is the degree
of influence that a specific manager has over costs, revenues and
related items for which he/she is responsible for. Controllable
cost: is any cost that primarily subjected to the influence of a
given responsibility center manager for a given period. In
practice, controllability is difficult to pinpoint for two
reasons:1. Few costs are under the sole influence of one manager.2.
With a long enough time, all costs will come under deferent
manager's control. A current manager may be affected by the
previous manager's decisions.2. Revenue center: the manager is
accountable for revenues only. Revenue SBU: is SBU that responsible
for sales, defined either by product line or geographical area.3.
Profit center: the manager is accountable for revenues and costs.
Profit SBU: is the SBU that generates revenues and incurs the major
portion of the costs for producing these revenues. Strategic role
of profit SBUs: Three strategic issues cause firms to choose profit
SBUs rather than cost or revenue SBUs:1. It provides incentive for
desired coordination among the marketing, production, and support
functions. (The handling of rush orders is a good example).2. It
motivates managers to consider their product as marketable to
outside customers.3. It motivates managers to develop new ways to
make profit from their products and services.4. Investment center:
the manager is accountable for investments, revenues and costs.
Investment SBU: is the SBU that includes assets employed by the SBU
as well as profits in performance evaluation. (Is most like an
independent business). Products that have little need to
coordination between manufacturing and selling functions are good
candidates for cost centers (e.g. food and paper products).
Products that need close coordination between manufacturing and
selling functions are good candidates for profit centers (e.g.
high-fashion products). Firms that have many profit SBUs because of
its many different product lines; its preferred approach is to use
investment SBUs.2- The contribution income statement for
performance evaluation purposes: Gross margin = sales revenue
variable M. costs fixed M. costs. Manufacturing contribution margin
= sales revenue variable M. costs. Contribution margin = sales
revenue variable M. costs variable selling& administration
expenses. A segment is a product line, geographical area, or any
meaningful subunit of the organization. Segment margin =
contribution margin fixed costs (controllable &
non-controllable. Segment operating income = segment margin
allocated common costs. Economic performance = Revenue all costs
except fixed manufacturing costs allocated to the segment.3- Common
costs: are the indirect joint costs that allocated to operating
units in some logical way. Two specific approaches in common cost
allocation:1. Stand-alone method: the costs are allocated according
to the percentage.2. Incremental method: the primary party receives
the stand-alone costs and the second party receives the balance of
the common costs.4- Financial measures:1. Product profitability
analysis allows management to determine whether a product is
providing any coverage of fixed costs.2. Business unit
profitability analysis performs the same function on the segment
level.3. Customer profitability analysis enables a firm to make
decisions about whether to continue servicing a given customer.5-
Performance measures: Types of performance measures:A) Financial
measures:1) Internal financial measures (such as operating
income).2) External financial measures (such as stock price).B)
Non-financial measures:1) Internal non-financial measures based on
internal non-financial information (such as defect rates and
manufacturing lead time).2) External non-financial measures based
on external non-financial information (such as customer
satisfaction ratings and market share). Return on investment (ROI),
accounting rate of return, or accrual accounting rate of return:
ROI = Income (profit) investment = (income revenue) X (revenue
investment). Or ROI = return on sales (ROS) (profit margin) X
investment turnover. Or ROI = [(revenue cost) / revenue] X revenue
/ investment. ROS: Tells how much of each revenue dollar becomes
income; the goal is to get higher income per revenue dollar. ROS:
measures the manager's ability to control expenses and increase
revenues to improve profitability. Investment turnover: Tells who
many revenue dollars are generated by each dollar of investment,
the goal is to make each investment dollar work harder to generate
more revenues. In investment SBUs managers can increase ROI in
basically 3 ways:1. Increase sales.2. Reduce expenses.3. Reduce
assets. Residual income (RI) = Income (required rate of return X
investment). Required rate of return is the imputed cost of the
investment. Goal congruence is more likely to be achieved by using
RI rather than ROI as a measure of the subunit manager's
performance. Advantages and Limitations of ROI and Residual
IncomeROIEasily understood Comparable to interestrates and to rates
of returns on alternative investments Widely used Disincentive for
high ROI units to invest in projects with ROI higher than the
minimum rate of return but lower than the unit's current ROI.
RI Supports incentive to accept all projects with ROI above the
minimumrate of return Can use the minimum rate of return to adjust
for differences in risk Can use a different minimum rate of return
for different types of assets
Favors large units when the minimum rate of return is low Not as
intuitive as ROI Can be difficult to obtain a minimum rate of
return
Both ROI and RI Congruent with top management goals for return
on assets Comprehensive financial measure. Includes all elements
important to topmanagement revenues,costs, and investment
Comparability ,expands top management's span of control by
allowingcomparison of businessunits Can mislead strategic decision
making, not as comprehensive as the balanced scorecard, which
includes customer satisfaction, internal processes and learning as
well as financial measures, the balanced scorecard is linked
directly to strategy. Measurement issues.Variations in the
measurement of inventory and long-lived assets and in the treatment
of nonrecurring items, income taxes. Foreign exchange effects, and
the use/cost of shared assets Short-term focus;investments with
long-term benefits might be neglected
Economic value added (EVA): is a more specific version of
residual income. Economic value added (EVA) = after tax operating
income [weighted average cost of capital (WACC) X (total assets
current liabilities)]. When a company's EVA is positive then it has
added to shareholders value.6- Transfer pricing: is the price of
the product transferred from one subunit (department or division)
to another unit in the organization or to the outside customer.
Motivation and performance evaluation: The transfer price creates
revenue for the selling subunit and purchase cost to the buying
subunit affecting each subunit's operating income. This operating
income can be used to evaluate subunit performance and to motivate
their managers. Intermediate product: is the product or service
transferred between subunits of an organization. Objectives of
transfer pricing:1. Motivate subunit's managers to exert a high
level of effort.2. Goal congruence.3. Reward managers fairly.
Transferred pricing methods:1. Market-based transfer prices (the
price of a similar product).2. Cost of production plus opportunity
cost.3. Full absorption cost (there is no motivation to the seller
to minimize costs).4. Variable cost (should be used only when the
selling division has excess capacity).5. Negotiated transfer
prices. Dual pricing: For example the seller could record the
transferred product at the market price. However, the buyer could
record the purchases at the variable price. Choosing the right
transfer-pricing method: (exhibit 19.10 page 26) A general
guideline (formula) for transfer pricing situations: Minimum
transfer price when working at full capacity = incremental cost per
unit incurred up to the point of transfer + opportunity cost per
unit to the selling subunit. 7- Balanced scorecard: is a single
report includes financial and non-financial performance measures
for subunits. Organizations can translate its strategy into a set
of performance measures by developing a balance scorecard. Balance
scorecard measures performance from four perspectives.1.
Financial.2. Customer satisfaction.3. Internal business process.4.
Learning and growth. The balance scorecard is an accounting report
that connects the firm's key performance indicators to measurement
of its performance. Key performance indicators (KPIs): are specific
measurable financial and non-financial factors that are critical to
the success of the organization. Balance scorecard should include
lagging indicators (such as output and financial measures) and
leading indicator (such as many types of non-financial
measures).
Unit 12Internal control Important introduction: The shareholders
make the election of the board of directors, which establishes the
overall policies. The board of directors makes the selection
(appointment) of the officers (management). The management
responsibility is to run day-to-day operations and reporting the
financial statements. The traditional rule to the external
independent auditor is to express his opinion about the fairness of
the financial statements according to GAAP, and to address this
report to the board of directors or the shareholders. The internal
auditor department rule is to audit the management performance,
financial and non-financial, and address his report to the board of
directors. The audit committee is a sub-committee from the board of
directors, and its responsibility is the appointment of the
internal and external auditors, review internal and external
auditor's reports. IMA definition of internal control (IC): The
whole system of control (financial and otherwise) established by
management to:1. Carry on the business of the organization in a
regular and efficient manner.2. Ensure adherence to management
policies, and safeguard the assets.3. Ensure as far as possible the
completeness and accuracy of the records. Benefits of strong
internal control system:1. Lower external control cost.2. Better
control over the assets.3. Reliable information for use in decision
making. A company with weak internal control system putting itself
at risk for employee theft, loss of control over the information
relating to operations, and other inefficiencies in operation and
decision-making that can damage business. As a process, internal
control is a means to an end, not an end in itself. Internal
control can provide a reasonable assurance not a guarantee. The
concept of internal control is based on two promises:1.
Responsibility: Management and the board of directors are
responsible for establishing and maintaining the internal control
process. External and internal auditors are responsible for
internal control process, but the final and ultimate responsibility
for the control remains with management and the board of
directors.2. Reasonable assurance: Management shouldn't spend more
on control than the benefits received. Management must exercise its
judgment to attain reasonable assurance that its control objectives
are being met. Objectives of internal control according to (COSO
model): (COSO) defines IC framework in the following categories
(FOCS):1. Effectiveness and efficiency of operations.2. Reliability
and integrity of financial reporting.3. Compliance with lows,
regulation, and contracts.4. Safeguarding assets. The effective
internal control reduces the need of management to review exception
report on day to day basis. Major component of internal control
according to COSO model(CRIME):(1) Control Environment.(2) Risk
assessment.(3) Control procedures.(4) Information and
communication.(5) Monitoring.1- Control environment (the tone at
the top): establishes the foundation for an internal control system
by providing discipline and structure. It encompasses the attitude
of the board of directors and upper management regarding the
significance of control. Environment control components (IC
HAMBO):(1) I - Integrity and ethical values.(2) C - Commitment to
competence.(3) H - Human resource policies and practices.(4) A -
Assignment of authority and responsibility.(5) M - Managements
philosophy and operating style.(6) B - Board of directors or audit
committee participation.(7) O - Organizational structure.1.
Integrity and ethical values: Integrity and ethical values are
essential because they affect all aspects of control. Management
creates an atmosphere leads to better risk management by:A)
Removing incentives for dishonest, illegal, or unethical
behaviors.B) Setting an example in its own behavior.C) Communicate
entity values and behavioral standard by means of codes of conduct.
The following would increase material misstatement. Excessive
interest in increasing stock price, unduly aggressive forecast,
interesting in minimizing profit for tax purpose, and the decision
dominated by one individual or small group.2. Commitment to
competence: Competence consists of knowledge and ability necessary
by members of the organization to complete tasks. In the final
analysis, it's the quality and competence of the employees that
ensure the ability to carry out the control process.3. Human
resource policies and practices: This component concern, among
other things, hiring, training, evaluating, promoting, and
compensating employees. Personnel are the key component of any
control system, so supervision is necessary to ensure that duties
are being carried out as assigned. Supervision becomes very
important in small firms, or where segregation of duties is not
possible. Job rotation and forced vacation allow employees to check
the operations of other employees by performing their duties for a
period of time.4. Assignment of authority and responsibility: This
component of control environment pertains to the authority and
responsibility of the operations as well as to determination of
reporting relationships and authorization of transactions.5.
Management's philosophy and operating style: Management philosophy
and operating style represents the attitude toward business risk in
every action in areas such as financial reporting, accounting
estimates, and the selection of accounting principles. Effective
control in an organization begins with and ultimately rests with
management philosophy.6. Board of directors and audit committee
participation: The board of directors consists of inside (officers
and employees) and outside members (nonemployees who held the
company's stock).1) The board is the governing authority of the
corporation and is responsible for establishing overall corporate
policy. Day-to-day operations are delegated to management.2) The
directors have a fiduciary duty to the organization and its
shareholders. They must exercise reasonable care in the performance
of their duties.3) Director will not be responsible for honest
error of judgment or act in good faith.4) Directors typically:b.
Select and remove officers and set the compensation of officers.c.
Determine the capital structure.d. Add, amend, and repeal bylaws.e.
Initiate fundamental changes, such as mergers.f. Declare dividends.
The audit committee is a subcommittee made up of outside directors
(not employee) who are independent of management. Its purpose is to
keep external and internal auditors independent of management. The
effectiveness of audit committee may be limited by the close
persona