Understanding Managerial Accounting: Direct & Indirect Costs, Activity-Based Costing, and , Summaries of Management Accounting

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R. Garrison, E. Noreen, P. C. Brewer,

Managerial accounting

Chapter 2: Managerial Accounting & Cost Concepts Direct costs – can be conveniently traced to a cost object Indirect costs – cannot be conveniently traced Manufacturing costs Direct Materials Direct Direct Labor Indirect Manufacturing Overhead Prime costs – DM + DL (think: “prime” → “primer;” includes raw materials) Conversion costs – DL + MOH (costs to convert materials into a product) Product costs – attached to a product, costs to produce item (recorded when sold) Period costs – incurred when expensed during period; normal accrual rules apply Manufacturing costs Manufacturing overhead – depreciation, insurance on factory, property tax, costs of operating factory Raw materials – direct if integral to product, otherwise indirect Direct labor – “touch labor” Indirect labor – impossible to trace Nonmanufacturing costs (SG&A) Selling costs – order--‐giving, order--‐filling, delivery Administrative costs – management Mixed costs – the “cost structure” or cost proportions of FC vs. VC Fixed costs – constant in total Committed FC – can’t reduce easily (meant for long haul) Discretionary FC – can’t be cut in the short term Variable costs – constant per unit MC = FC + VC * number of units Relevant range – where assumptions that cost behavior is linear are valid *outside of the relevant range, fixed costs may go up or down into another tier of FC (think of it like a step function) To estimate proportions of FC to VC: High--‐low method – find VC, then plug in to MC equation to find FC VC/unit = (High cost – low cost) / (high activity – low activity) MC = FC + VC * activity

Chapter 7: Activity-based Costing (ABC)

• Internal supplement to usual costing system
• While a usual system uses all manufacturing costs as product costs and nonmanufacturing costs as period costs, ABC uses all direct costs, and includes some indirect + nonmanufacturing costs on a cost-effect basis with products (the difference between manufacturing and nonmanufacturing doesn’t matter at all for ABC, it’s about linking costs to products. If there’s a causation, the cost is included.)
• Costs must be caused by the product
• There are many cost pools, with unique measures of activity
• Links to rewards/evaluations
• Strong top management support necessary
• Cross-functional involvement Purpose of using ABC
• Used to identify areas that would benefit from process improvements
• Tries to eliminate waste, lost time, and defects
• Activity rates help us understand where waste comes from and opportunities for improvement
• Affects business decisions
• Has you look at your activities & see what’s not adding value Do not assign these to products:
• Organization-sustaining costs (these are considered period costs for this system)
• Costs of unused capacity → excluding these allows for a more stable unit product cost “Overhead” in ABC costing means all indirect costs
• If the cost is caused by the product → product cost
• If the cost is not caused by the product → period cost
• (Depends on if its traceable to the product) Activity – something that consumes resources Cost pool – where costs related to one activity measure accumulate
• Each cost pool has its own unique activity measure
• Flexible; can be whatever the company feels is generating activity Activity measure – Another word for allocation base
• Transaction driver – # times an activity occurs (iterations)
• Duration driver – length of time it takes to do an activity (how long, longevity) Levels of activity (these are unrelated to volume)

1. Unit-level – proportional to the number of units produced
2. Batch-level – incurred per batch/order (shipping, placing orders, setting up equipment)
3. Product-level – related to a specific product type (not number of units. Examples: design, advertising, paying product manager)
4. Customer-level – specific customers (sales calls, catalog mailing)

5. Organization-sustaining – carried out regardless of output (Heat, computer network, preparing annual reports) Cost Pool examples Customer orders – taking / processing orders Design changes – resources consumed by design changes Order size – based on # units produced Customer relations – self explanatory (maintaining customer relations) Other – all other unused capacity / organization sustaining costs How to do ABC costing
6. Define your cost pools and activity measures
7. 1 st^ stage allocation

• Assign your overhead (indirect) costs to your cost pools using estimated percentages. o What portion of each overhead cost (production, etc.) belongs in which cost pool? (customer relations, design changes, etc.)
• Then convert the percentages to actual numbers
• Horizontal totals are from financials, totals for each overhead cost; percentages should = 100
• Vertical totals are how much is allocated to each cost pool o Goal here is to find the total cost of each cost pool (add vertically)

3. Calculate activity rates (how much each unit of activity costs) Activity Rate of Cost Pool = Total of Cost Pool / Total Activity of Cost Pool (Similar to POHR, but that was one calculation; this is several calculations because you have several different bases)
4. 2 nd^ stage allocation Apply rates to overhead; assigning costs to cost objects* thru activity rates ABC cost of cost pool = activity rate * actual activity Total overhead cost = sum of ABC costs of all the cost pools *Cost objects may include customers, customer orders, and products. Product Margin:
5. Gather product cost data—direct costs & costs from cost pools (except for customer relations pool & unused capacity/organization sustaining pool) and delegate those costs to the products they’re associated with
6. Subtract product costs from sales to get product margin
7. To get net income, subtract all other non-product costs from product margin Customer Margin: same as product, but you include customer relations pool Key Distinctions ABC – only assigns MOH costs related to specific products as product costs Traditional – allocates all MOH to products as product costs

Chapter 8 – Master Budgeting Budget – detailed plan for the future in numbers Purposes of Budgeting Planning – developing goals and budgets to get there Control – getting feedback to make sure plan is going well, even if there are changes Advantages of Budgeting

• Communicating management’s plans
• Forcing managers to plan for future
• Way to allocate resources effectively
• Uncover bottlenecks before they happen
• Coordinate activities of organization, integrating different departments
• Pulls everyone in the same direction
• Defines goals/benchmarks for evaluation Responsibility Accounting – the manager is responsible for only the items they can significantly control
• Personalizes accounting info by holding individuals responsible
• Can respond quickly to deviations, learn from feedback in comparing budget to results
• Not supposed to penalize managers for not meeting budget Budget Periods
• Operating Budgets o 1 year (FY of company) o 4 quarters; each quarter divided into months as year progresses o little participation from lower-level managers
• Continuous (Perpetual) Budget – 12 mo. budget, as each month/quarter is completed, the budget adds one month/quarter to the end of the budget o Keeps managers focused on long-term Self-imposed (Participative) Budget – prepared with all managers on deck (they help participate in the process)
• Individuals at all levels are involved
• Higher motivation because of self-imposed goals (creates commitment)
• The front-line managers are best at estimating what they need
• Managers can’t say the budget is unrealistic because they made it themselves
• Limitations o Lower-level managers may not be thinking in the big picture o Lower-level managers may create too much slack (they’re going to be held accountable, so might as well make the budget easy to attain)
• Problems with not using self-imposed budgets o Top managers setting goals too high → motivation suffers o Too much slack/too little slack → waste

Human Factors in Budgeting

• Budgets unfortunately used to pressure/blame employees; should instead be used to establish goals and evaluate results
• Some bonuses based on achieving/exceeding budgets
• Highly achievable budgets may build confidence & commitment to budgeting, less likely to cheat to meet target Master Budget – separate but interdependent budgets that detail company’s sales, production, & financial goals

1. Sales budget (expected) a. Schedule of cash collections
2. Production budget (how much to produce) o Would be a merchandise purchases budget instead for a merchandising company
3. Manufacturing cost budgets a. DM budget + cash disbursements for material purchases b. DL budget c. MOH budget
4. Ending FG Inventory budget
5. SG&A budget
6. Cash budget (how cash resources are acquired and used)
7. Budgeted income statement & balance sheet (estimated net income & ALE) There’s also a beginning balance sheet & budgeting assumptions Excel sheet, which is where a lot of numbers are derived from. Sales budget – includes budgeted unit sales & estimated sale prices. Also includes expected cash collections; there’s often a beginning A/R amount, which is how much they were scheduled to receive—this is in the beginning balance sheet. Other collections are based on estimated percentages of (usually credit) sales for subsequent months. Production budget – based on the cost flow below.

• Desired EI can usually be computed; it’s often a percentage of next month’s sales
• *keep in mind that the amounts listed under “Year” aren’t just sums; the BI and EI are the BI for the first quarter/month and the EI for the last quarter/month
• If it was a merchandising company, it would be COGS instead of sales (because COGS are based on sales); instead of anticipated production, it’s budgeted purchases o Schedule of cash disbursements, just like the one that goes in DM o If it’s a schedule of units, not money, it’s called budgeted “unit sales”

2. Disbursements – all cash outflows (dm/dl/moh payments, equipment purchases, dividends)
3. Cash excess/deficiency (= receipts – disbursements) o If deficiency: must borrow money to meet minimum requirement for cash on hand o If excess: invest the excess funds, or repay principal and interest
4. Financing – details all borrowings/principal/interest repayments projected to take place during budget period o Borrowings should = repayments at the end, if possible o Pay attention to bank’s loan terms; sometimes they’ll require you to borrow in certain kinds of increments (e.g. increments of $10,000) o Assume company will repay loan + interest on last day of final period, as far as it is able to Desired ending cash balance + Deficiency of cash available = Minimum required borrowings (then adjust for bank stipulations) Budgeted income statement

• Sales budget → Sales
• Ending FG Inventory → COGS
• SG&A → SG&A expenses
• Cash budget → operating income

Chapter 9: Flexible Budgets & Performance Analysis

• How to adjust budgets to ensure meaningful comparisons between actual results Variance – difference between actual & expected (budgeted) Variance Analysis Cycle – used to evaluate & improve performance.

1. Prepare performance report, highlighting good and bad variances
2. Analyze variances
3. Raise questions – why did the variance occur?
4. Identify root causes
5. Take actions – eliminate or replicate root causes, depending on if the variance was good or bad
6. Conduct next period’s operations, & repeat Management by exception – management system that focuses on most important variances and puts less emphasis on more trivial variances.

• Compares actual results to budget
• Significant deviations flagged as exceptions and further looked into
• Pay attention to unusually large variances or a pattern of variances (Ex. Steadily mounting variances) Planning budget – prepared before period begins, only valid for the planned (budgeted) level of activity
• Static
• Best suited for planning, not good for evaluation of cost control
• Comparing actual results to a planned budget when the two data sets show different levels of activity is like comparing apples & oranges.
• “How much of the cost variances are due to higher activity and how much are due to cost control?”
• This is where the flexible budget comes in: Flexible budget – estimates what revenues & costs should have been based on actual level of activity
• Good for evaluating actual results
• Keep in mind that even though fixed costs don’t vary with activity, they can still differ from whatever you estimated them to be *Both planning and flexible budgets are hypothetical, although planning tends to be further off from the actual results because it often accounts for a different level of activity *Keep in mind that sometimes unfavorable variances don’t necessarily indicate bad performance and vice versa. Sometimes a variance will be a necessary cost of serving more customers, and thus may be “unfavorable” but not because the company performed poorly Activity Variances – difference between actual level of activity and level in planning budget

Chapter 10 – Standard Costs & Variances Standards – benchmark for performance Quantity standard – how much should be used Price standard – how much should be paid Direct Materials Standards Standard quantity/unit – materials/unit of product

• Allowances for spoilage/scrappage Standard price/unit – price of materials/unit of product
• Reflects final + delivery costs Standard DM cost/unit = SQ/unit * SP/unit Direct Labor Standards Standard hours/unit – direct labor hours/unit
• Includes allowances for breaks, personal needs, cleanup, downtime Standard rate/hour – expected dl/hr rate ($/hr)
• Includes fringe benefits, employment taxes
• Reflects mix of workers Standard DL/unit = standard dl hrs/unit * standard rate/hr Variable Manufacturing Overhead Standards Standard hrs/unit – amount of allocation base to make 1 unit (often in dl hrs) Standard rate/unit – variable portion of POHR Standard VMOH/unit = SH/unit * SR/unit Standard Cost Card – shows standard quantity (hours) and standard price (rate) of inputs needed to make one unit (what’s needed to make one unit) Can split spending variances into price & quantity Price variance – difference between actual paid & standard paid, x actual purchased Quantity variance – difference between actual used and standard used; stated in $ using standard price Why two categories?
• Price & quantity variances may have different causes
• Different managers buy & use inputs Notes
• Price & quantity variances can be calculated for DL, DM, & VMOH but have different names sometimes
• Based on actual output

DM Variance Formulas Materials Price Variance (MPV) = AQ (AP-SP) Materials Quantity Variance (MQV) = SP (AQ-SQ allowed) SQ allowed = actual produced units * materials/unit DL Variance Formulas Labor Rate Variance (LRV) = AH (AR-SR) Labor Hours Variance (LHV) = SR (AH-SH allowed) SH allowed = actual produced units * hours/unit VMOH Variance Formulas Labor Rate Variance (LRV) = AH (AR-SR) Labor Hours Variance (LHV) = SR (AH-SH allowed) SH allowed = actual produced units * hours/unit How to know if it’s favorable or unfavorable: If actual > standard: U If actual < standard: F

Chapter 11: Performance Measurement in Decentralized Organizations Advantages of Decentralization

• Top managers can focus on the big picture
• Lower-level managers know day-to-day operations best
• Quicker response, more adaptive
• Giving lower-level managers more authority trains them for job mobility
• Increased motivation + satisfaction Disadvantages of Decentralization
• Lower-level managers may not understand company strategy and make decisions regardless
• Clashing objectives (department vs organization)
• Spreading innovation more difficult (no strong central direction to spread idea)
• Lack of coordination in decision-making if decisions made independently Cost center – controls costs
• Usually service departments or manufacturing facilities
• Administrative foundation of a company
• Evaluated based on costs (with standard cost and flexible budget variances) Profit center – controls costs and revenues
• Deals with consumers
• This is where you get money to run everything
• Evaluated based on profit, by comparing actual to target profit Investment center – controls costs, revenues, and investments in operating assets
• Higher-up executive; maybe vice president
• Evaluated based on profit, with return on investment (ROI) or residual income measures Return on Investment (ROI) = Net operating income / average operating assets The higher the ROI, the more you’re “getting back” on your investment Net operating income – EBIT (earnings before interest & taxes) Operating assets – assets held for operating purposes (cash, A/R, inventory, plant, equipment, etc.)
• Average between beginning & end of the year
• Most companies use net book value to calculate average operating assets o Discourages replacement of equipment o Depreciation makes ROI increase steadily over time, whereas new equipment would have a way higher NBV because it hasn’t depreciated yet → higher ROI o Alternative – using gross cost (which ignores depreciation) ROI = Margin * Turnover

Margin = Net operating income / sales Turnover = Sales / average operating assets Margin – increased with

• Higher selling prices
• More unit sales
• Fewer operating expenses Turnover – decreases (bad) if too many funds are tied up in operating assets
• Must balance management of margin & turnover Criticisms of ROI
• Managers might increase it in the short-run but harm the company in the long-run
• New managers inherit committed costs → hard to fairly access that manager’s performance
• Manager evaluated on ROI might not want investments that are good for the company but bad for their own report Residual Income – net operating income an investment center earns above the minimum required rate of return on its operating assets (how well they did above the baseline)
• Goal – to maximize/grow this number
• EVA (Economically value added) similar to this concept
• Managers assessed on residual income will make better investment decisions with respect to the entire firm
• ROI is more segment-based, while RI is more about the company as a whole
• Large divisions inevitably have more RI because they’re bigger o In comparing divisions, better to focus on percentage change in residual income from year to year than on absolute RI Residual Income = Net Operating Income – (avg operating assets * minimum required rate of return) Operating/Nonfinancial performance measures – measures causes of better performance, while financial measures measure the results but not the causes Delivery Cycle Time – timespan from customer order to shipment Delivery cycle time = Wait time + Throughput time Throughput Time (manufacturing cycle time) – amount of time to turn raw materials into finished goods o Process – time spent actually working on product (only value-added time) o Inspection – checking that the product isn’t defective o Move – time it takes to move the product to the next step in the assembly line o Queue – time spent waiting for next step

Ch. 12 – Differential Analysis in Decision-Making

• In decision-making, important to weed out what’s important vs. what’s not
• Only inputs relevant to decision-making are differential costs & revenues
• Ignore irrelevant data Differential (relevant) cost – difference in cost between any two alternatives Differential revenue (relevant benefit) – difference in revenue between any two alternatives Costs relevant to decision-making
• Avoidable cost – a cost that can be eliminated if you choose one alternative over another
• Opportunity cost – potential benefit you give up when you select one alternative over another Costs irrelevant to decision-making
• Unavoidable cost – a cost that doesn’t change regardless of the solution you choose
• Sunk cost – already incurred and can’t be avoided regardless of a decision
• In identifying relevant costs and benefits, remember that real/economic depreciation pertains to a reduction in the resale value of an asset either over time or with use, whereas accounting depreciation is more about matching sunk costs with the periods that benefit from that cost
• You can either identify which costs are relevant first and then make a decision (differential approach), or make a decision with full information (total approach). o Produces same result o Why use the differential approach? ▪ Total approach often impractical; won’t always have enough information to create a detailed comparison ▪ Using all costs can be confusing and detract from key information ▪ Irrelevant data can be used incorrectly → bad decision results Adding or dropping product lines/segments
• Key question: How does it affect net operating income?
• Tradeoff between losses in contribution margin vs. a lessened burden of fixed costs traceable to that product/segment
• Pay attention to costs that are allocated over all products; these costs won’t disappear if the product line does o Allocated fixed costs makes products appear less profitable than they actually are
• Unprofitable products may be kept if they help sell other products or serve as a “magnet” for customers Make or buy decision
• Value chain – activities from development to production to after-sales service

• Make or buy decision – decision to carry out a value-chain activity instead of buying externally from a supplier
• Vertical integration – when a company is involved in more than one activity in the entire value chain
• Advantages of vertical integration o Less dependent on suppliers o Smoother flow of parts & materials o May control quality better o May realize profits from parts & materials
• Advantages of using suppliers o Economies of scale → higher quality, lower price
• Relevant costs o Variable costs associated with making the product (DM, DL, MOH) o Supervisor salary o Opportunity cost of space proposed for making the parts ▪ Op cost of space w/o a better use = zero ▪ Op cost of space w/ a better use = the profit that would’ve been made if the space was used to produce something else (segment margin forgone on a potential new product line)
• Irrelevant costs o Common fixed costs o Sunk costs (depreciation of equipment) Make if avoidable costs of making < total costs of buying Buy if avoidable costs of making > total costs of buying Special Orders – one-time order that isn’t part of the company’s normal ongoing business
• Consider variable product costs (DM, DL, MOH)
• Profitable if incremental revenue from order > incremental costs of the order
• Make sure there’s enough space to create this special order, and that it doesn’t cut into normal sales or undercut prices Constraint – anything that prevents you from getting more of what you want
• Bottleneck – a step in a chain that limits total output because it has the smallest capacity
• Must decide which products/services make the best use of the bottleneck/constrained resource
• Calculate contribution margin per unit of the constrained resource (not just product with highest overall CM) and pick the product with the higher number Contribution margin per unit of the constrained resource = (CM/unit) / how much of the constrained resource a unit uses
• One way to verify that you’ve chosen the highest-yielding product (given the constraint) is to compare additional CM: Which product yields higher CM if capacity of the constraint were to increase?
• Strengthening chains o Identify weakest link o Don’t strain system past the weak link’s limit