2021 Managerial Accounting notes, exam prep.docx

Managerial Accounting 2021
Table of Contents
Important Themes for Exam ............................................................................................................2
Lecture 0, Introduction......................................................................................................................3
Lecture 1, Foundation for Managerial Accounting ........................................................................3
Chapter 1, Introduction....................................................................................................................3
Chapter 2, The Nature of Costs .......................................................................................................4
Chapter 3, Capital Budgeting..........................................................................................................7
Lecture 1, Math................................................................................................................................9
Opportunity costs .......................................................................................................................10
Cost Variation ............................................................................................................................10
CVP Analysis.............................................................................................................................10
Time Value of Money................................................................................................................12
Present Value Concept...............................................................................................................12
Interest Rate Fundamentals........................................................................................................13
Adjustment for Inflation.............................................................................................................13
IRR (Internal Rate of Return) ....................................................................................................14
Lecture 2, Organizational Architecture, Responsibility Accounting..........................................14
Chapter 4, Organizational Architecture ........................................................................................14
Chapter 5, Responsibility Accounting and Transfer Pricing.........................................................20
Lecture 2, Math..............................................................................................................................25
Return on investment (ROI).......................................................................................................25
Exercise class solutions .................................................................................................................25
Lecture 3, Budgeting........................................................................................................................28
Chapter 6, Budgeting.....................................................................................................................29

Lecture 4, Cost Allocation Theory..................................................................................................34
Chapter 7, Cost Allocation Theory ................................................................................................35
Curves ............................................................................................................................................36
Exam Topics, March 22nd 2023.......................................................................................................37
Important Themes for Exam
List of themes which are especially relevant for the lecture-part of the ordinary exam Managerial
Accounting.
o Cost-Volume-Profit-Analysis, lecture 1
o Capital budgeting, lecture 1
 Opportunity costs of capital
 Net present value
o Responsibility centers
 Cost centers
 Profit centers
 Investment centers
 Measurement of performance for each type of center
o Budget ratcheting
o Budget lapsing
o Line-item budgets
o Zero-based budgets
o Average costs as approximation for marginal opportunity costs
 Overheadrate
o Death spiral
o Joint cost allocation
o Options for disposing overabsorbed/underabsorbed overhead
o Incentive to overproduce in an absorption costing system
o Variable costing

o Inaccurate product costs in an absorption costing system
o Activity-based costing
o Standard costing
 Variance analysis (directlabour,directmaterials)
 Varianceanalysis(overhead:spending,efficiency,volume;marketing)
o TQM, JIT
o Balanced Scorecard
Lecture 0, Introduction
 What is managerial accounting?
 Accounting
o Financial accounting
 Bookkeeping
 Legally binding regulations
 Purpose: accountability and information for external stakeholders
o Managerial accounting
 Different calculations
 Voluntary standards which have stood the test of time
 Purpose: decision making and decision control
o Learning objectives
 Opportunity costs
 Organizational architecture
 How do they constitute the MA framework?
Lecture 1, Foundation for Managerial Accounting
Chapter 1: Introduction
Chapter 2: The Nature of Costs
Chapter 3: Capital Budgeting
Chapter 1, Introduction
 Purposes of internal accounting systems

o Decision making
 Provide decision makers with some
of the knowledge needed for
planning and making decisions
 Production decisions: e.g., make-or-buy decisions
 Sales decisions: e.g., which price can a company offer and still be profitable
o Decision control
 Help motivate and monitor people in
organizations
 Preventing fraud e.g., maintaining inventory records helps reducing
employee theft
 Incentivizing e.g., motivate people by rewarding them for reaching
performance targets
Chapter 2, The Nature of Costs
 Opportunity costs
o Opportunity set: Set of alternative actions available to decision maker
o Opportunity cost: Benefits forgone by choosing one alternative from the opportunity
set rather than the best non-selected alternative
 Opportunity costs:
o Include tangible and intangible benefits
o Measured in cash equivalents
o Rely on estimates of future benefits
o Useful for decision making
o Accounting expenses:
 Costs consumed to generate revenues
o Rely on historical costs of resources actually expended
o Designed to match expenses to revenues
o Useful for control
 Sunk cost
o Costs that were incurred in the past and can’t be changed no mater what future action
is taken.

 They are irrelevant for decision making and are excluded when talking
opportunity costs.
 Cost Variation - Cost Drivers
o Cost driver: Measure of physical activity most highly associated with total costs in
an activity center.
 Examples of cost drivers:
 Quantity produced
 Direct labor hours
 Number of set-ups
 Number of different orders processed
o Use different activity drivers for different decisions. Costs could be fixed, variable,
or semi-variable in different situations.
 Cost-Volume-Profit Analysis - Definitions
o Cost-Volume-Profit (C-V-P) analysis can be useful for production and marketing
decisions.
o Contribution margin
equals price per unit minus variable cost per unit: CM = (P – VC).
Total contribution margin
equals total revenue minus total variable costs: (CM Q) = (P - VC) Q.
 C-V-P: Assumptions
o Assumptions of simple linear C-V-P analysis:
 Price does not vary with quantity
 Variable cost per unit does not vary with quantity
 Fixed costs are known
 The analysis is limited to a single product
 All output is sold
 Tax rates are constant for profits or losses
 Does not consider risk or time value of money
 Multiple products

o When there are multiple products for a single company you must assume a known
and constant sales mix
 Then a break-even number of bundles can be calculated
By knowing the sales mix, the volume of individual product sales can be determined
o Opportunity Costs Versus Accounting Costs
o Recording
 Accounting cost: Record after decision implemented
 Opportunity cost: Estimate before decision made
o Time perspective
 Accounting: Backward-looking (historical)
 Opportunity: Forward-looking (future projections)
o Link to financial statements
 Accounting: direct link - Assets are unexpired costs.
 Opportunity: no direct link
 Accounting Costs: Product vs. Period Costs
o Product Costs
 Accounting costs related to the purchase or manufacture of goods
 Accumulated in inventory accounts (asset)
 Expensed when sold (cost of goods sold)
 Include fixed and variable cost of goods
o Period Costs
 All accounting costs not included in product costs
 Expensed in period incurred
 Include fixed and variable selling and administrative expenses
 Accounting Costs: Direct vs. Overhead Costs
o Direct Costs
 Costs easily traced to product or service produced or sold.
 Include direct materials (materials used in making product)
 Include direct labor (cost of laborers making product)
 Direct costs are usually variable.
o Overhead Costs
 Costs that cannot be directly traced to product or service produced or sold.

 Include general manufacturing (supervisors, maintenance, depreciation, etc.).
 Include other administrative, marketing, interest, and taxes.
 Overhead costs are primarily fixed with respect to number of units produced
or sold, but may include some variable costs related to number of units
produced or sold.
 Cost Estimation Methods
o Account Classification
 Each account in a financial accounting system is classified as fixed or
variable.
 This method is simple, but not precise.
o Motion and Time Studies
 Estimate to perform each work activity efficiently under standard conditions.
 Expensive to conduct study.
 Should be redone as conditions and processes change.
Chapter 3, Capital Budgeting
 Opportunity Cost of Capital
o Opportunity cost of capital: benefits of investing capital in a bank account that is
forgone when that capital is invested in some other alternative.
 Importance for decision making when expected cash flows occur in different
time periods.
o Capital budgeting: analysis of investment alternatives involving cash flows received
or paid overtime.
 Capital budgeting is used for decisions about replacing equipment, lease or
buy, plant acquisitions, etc.
 Present value (as a concept)
o Since investment decisions are being made now at beginning of the investment
period, all future cash flows must be converted to their equivalent dollars now
 Beginning-of-year-DKK*(1+interest rate)=end-of-year-DKK
 Beginning-of-year-DKK=end-of-year-dkkk/(1+interest rate)
 Net Present Value (NPV) Basics

o 1. Identify after-tax cash flows for each period
2. Determine discount rate
3. Multiply by appropriate present-value factor (single or annuity) for each
cash flow. PV factor is 1.0 for cash invested now
4. Sum of the present values of all cash flows = net present value (NPV)
5. If NPV 0, then accept project
6. If NPV < 0, then reject project
NPV is also known as discounted cash flow (DCF).
Some Factors are Difficult to Quantify, but Important to Consider
 Consider the example of a worker considering returning to school to get an MBA degree.
 How would you account for the additional utility the worker would receive from the prestige
of earning an advanced degree?
 Capital Budgeting - Warnings
o Discount after-tax cash flows, not accounting earnings
 Cash can be invested and earn interest. Accounting earnings include accruals
that cannot be invested or earn interest.
o Include working capital requirements
 Consider cash needed for additional inventory and accounts receivable.
o Include opportunity costs but not sunk costs
 Sunk costs are not relevant to decisions about future alternatives.
o Exclude financing costs
 The firm’s opportunity cost of capital is included in the discount rate.
 Alternative Capital Budgeting Methods
o Methods that consider time value of money:
 Net present value (NPV), also known as discounted cash flow (DCF) method
 Internal rate of return (IRR)
o Methods that do not consider time value of money:
 Payback method
 Accounting rate of return on investment (ROI)

 Alternative: Internal Return (IRR)
o Internal rate of return (IRR) is the interest rate that equates the present value of
future cash flows to the cash outflows.
 By definition: PV = FV (1 + irr)
 Solution for a single cash flow: irr = (FV PV) - 1
o Comparison of IRR and DCF/NPV methods
 Both consider time value of cash flows
 IRR indicates relative return on investment
 DCF/NPV indicates magnitude of investment’s return
 IRR can yield multiple rates of return
 IRR assumes all cash flows reinvested at project’s constant IRR
 DCF/NPV discounts all cash flows with specified discount rate
 Alternative: Payback Method
o Payback = the time required until cash inflows from a project equal the initial cash
investment.
 Rank projects by payback and accept those with shortest payback period
o Advantages of payback method:
 Simple to explain and compute
o Disadvantages of payback method:
 Ignores time value of money (when cash is received within payback period)
 Ignores cash flows beyond end of payback period
 Capital Bugeting in Practive
Lecture 1, Math

Opportunity costs
Opportunity set: Set of alternative actions available to the decision maker
Opportunity cost: benefits forgone by choosing one alternative from the opportunity set rather than
the best non-selected alternative
Cost Variation
FC, MC, AC
FC: Costs incurred when there is no production
MC: Cost of producing one more unit. (on cost curve, this is the slope of the tangent at one
partuclar production level)
AC: TC/Q
Linear Approximation
TC=FC+(VC*Q)
For Q in relevant range
Approximation: Total opportunity costs (TC) are a linear function of quantity (Q)
Variable cost (VC): VC is a linear approximation of marginal opportunity costs
FC: Predicted total costs with no production; Q=0
Relevant Range: Range of production quantity, Q, where a constant variable cost is a reasonable
approximation of opportunity costs.
CVP Analysis
Cost-Volume-Profit analysis can be useful for production and marketing decisions
Contribution margin
CM=(P-VC)
Total contribution margin

Time Value of Money
A dollar today is worth more than a dollar tomorrow, because it could have been invested
Present Value Concept
Because investments decisions are being made now at the beginning of the investment period, all
future cash flows must be converted to their equivalent dollar now.
Beginning-of-year DKK * (1+interst rate) = end-of-year DKK
Beginning-of-year DKK= end-of-year DKK / (1+ interest rate)

Interest Rate Fundamentals
FV= future value
PV= present value
r= interest rate per period (usually per year)
n=periods form now (usually years)
Present value of a perpetuity (a stream of equal periodic payments for infinite
periods)
PV = FV r
Present value of an annuity (a stream of equal periodic payments for a fixed
number of years)
PV = (FV r ) { 1 – [1 (1 + r)n]}
Adjustment for Inflation
If inflation exists in the economy, then the discount rate should be adjusted for said inflation
1. Restate future cash flows into nominal DKK (after inflation)
2. Discount nominal cash flows with nominal interest rate
How to adjust for inflation in excel
https://www.youtube.com/watch?v=sWTZK_zzgn8&ab_channel=MumblingProfessor

IRR (Internal Rate of Return)
Internal rate of return (IRR) is the interest rate that equates the present value of future cash flows to
the cash outflows.
By definition: PV = FV / (1 + irr)
Solution for a single cash flow: irr = (FV /PV) – 1
Comparison of IRR and DCF/NPV methods
o Both consider time value of cash flows
o IRR indicates relative return on investment
o DCF/NPV indicates magnitude of investment’s return
o IRR can yield multiple rates of return
o IRR assumes all cash flows reinvested at project’s constant IRR
o DCF/NPV discounts all cash flows with specified discount rate
Lecture 2, Organizational Architecture, Responsibility Accounting
Chapter 4: Organizational architecture
o Principal-agent-model
o Setting the right incentives
Chapter 5: Responsibility Accounting and Transfer Pricing
o Cost centers and profit centers
o Transfer prices between centers
Agenda: how to design an organization so that it produces value to shareholders
Chapter 4, Organizational Architecture
o Self-interested behavior (from micro  homo economicus
o Homo economicus assumption: individual act in their own self-interest to max out
utility
o Opportunity set
 Work for employer, work on other projects, relax etc.
o Resource constraint
 Time, money, knowledge etc.

o Utility
 Preferences for money, working conditions leisure, etc.
o Team production
o Individual form teams/firms because
 It’s more productive to work within a team/firm
 Generate a larger opportunity set
 Firm is defined as a nexus of contracts among resource owners who
voluntarily contract with individual team members to benefit both the
firm and the individuals.
 Firms in an economic sense include for-profit corporations, divisions
within a corporation, not-for-profit organizations, and other entities.
o Firm as a nexus of contracts
o Nexus, a connection or series of connections linking two or more things.
o The firm is a legal entity that can contract with many parties and enforce the
contracts in courts of la
o Different types of contracts
 Labor contracts: employee, union, independent contractors
 Supply contracts: inventory, materials, utlilities
 Customer contracts: sales, warranties
 Finance contracts: Insurance, leases, franchises, debt, stock
o Some contracts are explicit written documents while others are implicit oral
agreements supported by the reputation of the parties.
o Principal-Agent model
o Principal agent model
 Economic model of relationships in a firm
 Principals are managers or firm owners
 Agents are employees or independent contractors
 Agents perform functions for principals
 Numerous principal-agent relationships exist in firms
o Agency costs
 Reductions in firm value caused when agents pursue their own interest to the
detriment of the principal

 Their goals are incongruent
 A major use of internal accounting systems is to control agency costs.
o Contract issues to consider
o Agents cannot be compensated on effer (input) which is not observable by the
principal
 Portfolio performance (output) can be selected as a performance measure
o However, since factors not under the control of the agent can influence this output
performance measure, possibly negating the value of all his effort (input), the agent
must be compensated for the higher risk inherent in an output measure contract.
o Agency problems
o Free-rider problem: Agents have incentives to shirk because their individual efforts
are not directly observable.
 Solutions: Incentive contracts, monitoring, etc.
o Horizon problem: Agents expecting to leave firm in near future place less weight on
long-term consequences.
 Solutions: Incentive contracts, monitoring, etc.
o Employee theft: Employees take firm resources for unauthorized purposes.
 Solutions: Monitoring, inventory control, etc.
o Empire-building: Managers seek to manage larger number of agents to increase their
own job security or compensation.
 Solutions: Modify incentive contracts, benchmarking, etc.
o Agency asymmetry problems
o Adverse selection: Prior to contracting, agents have better private information than
principals.
 Solutions: pre-contract investigation, post-contract penalties.
o Moral hazard: After contracting, agents have an incentive to deviate because the
principal cannot readily observe deviations (hidden action or hidden information).
 Solutions: inspecting, monitoring.
o Decision rights
o Decision right are restriction on how economic assets of a firm can or cannot be used
o Management determines how decision rights are to be allocated among various
agents within a firm

o Alternative styles of allocating decision rights:
 Centralize  “micromanage”
 Decentralize  employee empowerment
o Role of Knowledge
o Some knowledge useful for decision making is costly to acquire, store, and process.
o Linking knowledge and decision rights is a key issue for organizational architecture.
o Example where knowledge and decision rights are linked:
 Machine operator schedules own machine
o Example where knowledge and decision rights are not linked:
 Sales representatives know customer’s demand curve best, but only sales
manager may approve sales price changes. Giving pricing decision rights to
representatives could result in customer kickbacks.
o Markets versus firms
o Firms can obtain goods and services by either
 Making within the firm itself
 Outsourcing
o Factors to consider in make-versus-buy
 Efficiency and effectiveness
 Cost of acquiring knowledge
 Contract costs
 Monitoring costs
o Influence costs
o Problem: agent spend time and other resources trying to influence decision makers
o Solution: limit active decision making by imposing bureaucratic rules
o Example: employees influencing manager who allocates work tasks
 Solution: rules for allocating work tasks
o Organizational architecture
o Organizational architecture depends on three leges
 Measure performance
 Reward and punish performance
 Partition decision rights
o In external markets these functions are served by market prices, as well as S&D

o For transactions inside the firm, management must implement administrative devices
to accomplish these functions
o All three legs must be both balanced and coordinated
o 1st leg: Measure
o Types of performance measures
 Objective criteria: production rates, sales, meeting budgets and schedules
 Subjective criteria: helping others, innovation, improving team spirit, etc.
 Financial measure: profits, costs, revenues, inventory level, etc.
 Nonfinancial measures: quality defects, customer satisfaction, employee
turnover, etc.
o Design issues
 Determining relative weight for each measure
 Costs to collect and analyze measures
 Internal accounting system provides some of these measure
o 2nd
leg: Reward and punish performance
o Types
 Pecuniary rewards: salary, bonuses, retirement benefits, etc.
 Nonpecuniary rewards: prestifious job titles, better office location, better
office furnishings, reserved parking places, country club membership, etc.
 Punishments: reprimands, ridicule, demotion, termination, etc.
o Design issues
 Linked to performance measures
 External job market
 Employment and tax law
o 3rd
leg: Partition decision rights
o Types
 Centralize decision right with top executives
 Decentralize decision right to lower levels
o Design issues
 Board of director has ultimate authority
 Linking knowledge and decision rights
o Span of control: “how many employees does one manager manage?”

o Seperation of management and control
o Separation is particularly important for actions with large impact across many
agents, such as employee hiring, plant contruction, etc.
o Hierarchical structure of organization allocated the decision rights over these four
steps to different manager or agent
Ratification: the action of signing or giving formal consent to a treaty, contract, or agreement,
making it officially valid.
o Seperation of management and control, example: building a new plant
o Initiation: division managers with specialized knowledge of production process and
customers initiate construction proposal
o Ratification: proposal is analyzed by specialists in finance, marketing, human
resources, real estate etc. senior management uses all this information to decide
whether to accept, reject or modify proposal
o Implementation: Employees and outside agents contruct facilities
o Monitoring: internal accountants prepare financial report on project
o Accounting’s role in the organization’s architecture
o Accounting reports are more useful for control than for decision management
o Decision management requires forwards-looking opportunity cost, but accounting
data is primarily backward-looking historical results.
o Accounting also reduces some agency costs such as employee theft and shirking
 Shirking: to avoid or neglect (a duty or responsibility).
o Accounting measures of performance
o Effective control systems require that accounting and audit functions are independent
of the people being monitored
o Accounting data may aggregate so many individual transactions that they are not
useful for decision making

o But aggregate accounting data are useful for control by averaging out random
fluctuation
 Aggregate: formed or calculated by the combination of several separate
elements; total.
o Nonaccounting measure of performance
o Useful information for decision making, such as product quality, customer demand,
machine performance, etc.
o Non-accounting measures are oftn custom-designed for each individual or team
o Executive compensation contracts
o Agency problem: align interest of shareholders (principals) and top executives
(agents.)
 (1) measure performance: board of directors’ compensation committee sets
performance goals based on financial and nonfinancial measures
 (2) reward and punish performance: compensation consists of base salary and
bonuses. Bonus plan may have lower and upper limits.
 (3) partition decision rights: directors initiate contracts. Shareholders ratify
contracts. Accountants monitor performance.
Chapter 5, Responsibility Accounting and Transfer Pricing
o Responsibility accounting
o Characteristics of responsibility centers are:
 Knowledge of the center’s managers is difficult to acquire, maintain or
analyze at higher levels
 Decision rights are specified for each center
 Performance measurement is obtained from internal accounting system
o Types of responsibility center
 Cost
 Profit
 Investment
o Cost center – design
o Knowledge
 Central managers know optimal production quantity and budget

 Cost center manager know optimal mix of inputs
o Decision rights:
 Cost center manager chooses quantity and quality of inputs used in cost
center (labor, material, supplies)
o Measurement
 Minimize total cost for a fixed output
 Maximize output for a fixed budget
o Cost center – problems
o Minimizing average costs does not necessarily maximize profits. Cost centers have
an inventive to produce more units to spread fixed costs over many units
o Quality of products produced by cost center must be monitored
o Profit center – design
o Knowledge:
 Profit center managers’ knowledge of product mix, demand, and pricing is
difficult to transfer to central management
o Decision rights
 Can chose input mix, product mix, and selling prices
 Given fixed capital budget
o Measurement
 Actual profit
 Actual profits compared to budget
o Profit center – problems
o Setting apporprate transfer prices on good and services transferred within the firm
o How to allocate corporate overhead costs to responsibility centers
o Profit centers that focus only on their own profits often ignore how their action affect
other responsibility centers
o Investment center
o Knowledge
 Investment center manager has knowledge of investment opportunities and
operating decisions
o Decision rights
 Ratify ad monitor decisions of cost and profit centers

 Decide amount fo capital invested and disposed
o Measurement
 ROI
 Residual income, RI
 Economic value added, EVA
o Return on investment, ROI
o ROI=Accounting net income for an investment center / total assets invested in that
investment center
o DuPont formulate separates ROI into two components:
 (1) ROI = Sales turnover * Return on sales
 (2) ROI = (Sales/Total investment) *(Net income/sales)
o Roi increases with smaller investments and larger profit margins
 Focusing on ROI can cause underinvestment
o Residual income, RI
o RI = Accounting net income of investment center – (Required rate of return *
Capital invested in that center)
 RI is determined with financial accounting measurements of net income and
capital
 Each investment center could be assigned a different required rate of return
depending on its respective risk
 RI can be increased by increasing income or decreasing investment
o EVA, Economic Value Added
o EVA is the same as residual income with some adjustments to accounting the
reported accounting numbers
 EVA = Adjusted accounting net income of investment center – (Weighted
average cost of capital * capital invested in that center)
o Examples of EVA adjustments to accounting
 R&D is amortized over 5 years for EVA, but expensed immediately for
financial accounting
 Unamortized R&D is included in capital for EVA, but treated is treated as an
expired cost (zero value) for financial accounting
 Amortized, write of the initial cost of (an asset) over a period

o EVA can be increased by three basic methods
 Increase the efficiency of existing operations, and thus the spread between
the investment return and the firm’s weighted average cost of capital
 Increase the amount of capital invested in projects with positive spreads
between investment return and the firm’s weighted average cost of capital
 Withdraw capital from operations where the investment return is less than the
firm’s weighted average cost of capital
o Investment Center – Problems
o Disputes over how to measure income and capital
o Difficult to compare investment centers of different sizes
o Firms’ central management must monitor product quality and market niches of
investment centers to reduce possibility for self-interested investment center to
damage firms’ reputation
o Controllability principle
o Hold center managers responsible for only those costs and decisions for which they
have authority
o Drawback of controllability principle
 If managers suffer no consequences from events outside their direct control,
they have no incentive to take action that can affect the consequences of
uncontrollable events (such as storms, corporate income taxes, etc.)
o Transfer pricing – defined
o Transfer pricing defined:
 The internal price (or cost allocation) charged by one segment of a firm for a
product or service supplied to another segment of the same firm
o Examples of transfer prices:
 Internal charge paid by final assembly division for components produced by
other divisions
 Service fees to operating departments for telecommunications, maintenance,
and services by support services departments
 Cost allocations for central administrative services (general overhead
allocation)
o Transfer prices and firm value

o Transfer prices have multiple effects on firm value
 Performance measurement
 Reallocate total company profits among business segments
 Influence decision making by purchasing, production, marketing and
investment managers
 Rewards and punishment
 Compensation for divisional managers
 Partitioning decision rights
 Disputes over determining transfer prices
o Ideal transfer pricing
o Opportunity cost, or the value forgone by not using the transferred product in its next
best alternative use
o Opportunity cost is the greater of variable production cost or revenue available if
thee product is sold outside of the firm
o Transfer pricing methods
o External market price
 If external markets are comparable
o Variable cost of production
 Exclude fixed costs which are unavoidable
o Full cost of production
 Average fixed and variable cost
o Negotiated prices
 Depends on bargaining power of divisions
o Transfer pricing implementation
o Disputes over transfer pricing occur frequently because transfer prices influence
performance evaluation of managers
o Internal accounting data are often used to set transfer prices, even when external
market prices are available
o Classifying costs as fixed or variable can influence transfer prices determined by
internal accounting data
o To reduce transfer pricing disputes, firms may reorganize by combining
interdependent segments or spinning off some segments as separate firms

o Transfer Pricing for International Taxation
o When products or services of a multinational firm are transferred between segments
located in countries with different tax rates, the firm attempts to set a transfer price
that minimizes total income tax liability.
o Segment in higher tax country:
 Reduce taxable income in that country by charging high prices on imports
and low prices on exports.
o Segment in lower tax country:
 Increase taxable income in that country by charging low prices on imports
and high prices on exports.
o Government tax regulators try to reduce transfer pricing manipulation.
Lecture 2, Math
Return on investment (ROI)
o ROI=Accounting net income for an investment center / total assets invested in that
investment center
o DuPont formulate separates ROI into two components:
o (1) ROI = Sales turnover * Return on sales
o (2) ROI = (Sales/Total investment) *(Net income/sales)
Exercise class solutions
Question 1: Vandeschmidt’s
Joop doesn’t have the same specific knowledge as his father to run the company, thus, it must be
held by other people in the company. Given distribution of knowledge Joop will probably have to
decentralize decision rights. This will come with associated changes in the performance evaluation
and reward system; to balance the three legs of the stool balance. Joop will maybe have to increase
the emphasis on performance-based pay to motivate the newly empowered workers to make
decisions that are in the interest of the company.
Question 2: American InterConnect
The question describes a procedure for employee satisfaction. They wanted to include employee
satisfaction as a performance criterion to get people to work own self-reported satisfaction surveys,
thus making employees inclined to say that they were very satisfied with their job. This would only
not happen if the group didn’t expect any bonus cause the overall target are not met or they want to
punish a manager, by reporting low satisfaction.
Another problem. With this scheme is that it discourages managers from setting tight targets and
providing frank feedback to employees. To improve employee satisfaction managers will propose
higher than optimum pay increases for their direct reports. These incentives are mitigated to the

extent other targets are also adversely affected, such as earning. However, at the margin, managers
will substitute some earning for more employee satisfaction.
Why pay for employee satisfaction?
Question 3: Organizational architecture
Advantage of allowing coach to make personnel choices: personal knowledge about the skills of the
players. The coach has been around for many years and have directly observed the different player.
Disadvantage: don’t have the perspective of the owners of the organization. The general managers
responsibility is to direct the team in accordance with the wishes of the owners. The coach may
want the best players, but there isn’t capital for it. General managers also usually have a more long-
term view about the progress of the team (they have longer-term employment contracts with the
team than the coaches.
Question 4: Phipps Electronics
Assuming Phipps has positive taxable income in Low Country against which to offset the loss
of transferring the boards at variable cost, then the variable cost transfer pricing method minimizes
the combined tax liability.
Question 5: Sunder Properties
ROA (return on assets) = Net income/Assets invested
a. Calculate Sunder’s ROA last year
Should it include interest or not? Interest should be excluded because ROA is a measure of the
return on total assets, not the return to equity investors.

b. Will the manager of Sunder Properties purchase Valley View?
Because the ROA of the new project (20.05%) is less than the firm’s ROA (26.25%), Sunder’s
ROA will fall if the new project is accepted. Hence, management is expected to reject the
new project.
c. If they had the same information about Valley View as Sunder’s management, would the
shareholders of Brighton holdings accept or reject the acquisition of Vallley view in part
(b)?
The shareholders of Brighton Holdings will want the managers of Sunder Properties to purchase
Valley View if it has a positive residual income.
Since residual income is positive, the shareholders will want to see the apartment complex be

purchased. Alternatively, since Valley View has a return on investment of 20.05% that exceeds
Sunder’s weighted-average cost of capital of 15%, Valley View is a profitable acquisition.
d. What advice would you offer the management team of Brighton Holdings?
Compensating the managers of Sunder Properties based on ROA gives them incentives to
under-invest. We see in part (b) managers in Sunder reject the apartment complex because it
lowers their overall average ROA, even though the apartment has a return in excess of its cost
of capital (i.e., residual income is positive in part (c)).
One suggestion is that Brighton Holdings compensate Sunder Properties’ management based on
residual income, not ROA. By making this change, Sunder does not have the incentive to reject
positive residual income
projects.
Question 6: Wegmans
Question 7: Responsibility Centers
Question 8: Canadian Subsidiary
Question 9: Beckett Automotive Group.
Question 10: Cogen
Lecture 3, Budgeting
Chapter 6: Budgeting
o Examples for budgeting systems
o Trade-off between decision management and decision control
o Resolving organizational problems

Chapter 6, Budgeting
 Budgets and organizational architecture
o A budget is management’s forecast of revenues, expenses, or profits in a future time
period.
o Knowledge: Budgets communicate key planning assumptions such as product prices,
units’ sales, and input prices.
o Partition Decision Rights: Budget sets guidelines on resources available for each
segment.
o Performance Evaluation: Responsibility center’s actual performance is compared to
budget.
 Example 1, Country Club
 Responsibility Centers: 1 profit center and 2 cost centers
 Measurement: Monthly reports compare actual revenues and expenses to budget.
 Favorable (F) variance: actual revenue > budgeted revenue actual expense <
budgeted expense
 Unfavorable (U) variance: actual revenue < budgeted revenue actual expense >
budgeted expense
 Budget process separates decision rights. Initiation and implementation by professional
managers. Ratification and monitoring by Board of Directors and members.
 Example 2, Private University
o Responsibility centers in 4 colleges: 2 cost centers, 2 profit centers.
o Knowledge:
 Number of students drives revenue forecasts.
 Faculty market drives faculty salary expense.
o Decision rights:
 Lower levels prepare initial budgets.
 Higher levels review and ratify budget.
o Agency problems:
 Empire building: request “too large” a budget.
 Externalities: Cost centers are more likely to add unprofitable programs than
profit centers.
o Is Auxiliary Services a responsibility center? How should it be evaluated?

 Example 3, Large Corporation
o Responsibility centers:
 2 cost (manufacturing and marketing)
 1 profit (paper and toner supplies)
o Knowledge:
 Vertical transfers (lower to higher levels)
 Horizontal transfers (marketing to manufacturing)
 Identify potential bottlenecks in production
 Identify financing needs
o Contracting:
 Budgets are internal contracts between operating segments
 Divisional managers negotiate budgets
 Executive managers negotiate disputes and review budgets for consistency
with corporate strategy
 Trade-off: Communication vs. Evaluation
o Budgets are used for both decision management and decision control.
o Optimal decision making requires managers fully reveal private knowledge about
production and market conditions during budget negotiations.
o When budgets are also used for performance evaluation, managers have an incentive
to make biased budget forecasts so that their actual performance will look good
relative to budget.
 Budget Rachet
o Ratchet effect: basing next year’s standard of performance on this year’s actual
performance
 Disadvantage
 Performance targets usually adjusted upward
 Employees reduce output to avoid being held to higher standards in
the future
 Possible solution
 Eliminate budget targets
 Estimate next year’s sales
 More frequent job rotation

 Summary: while the ratchet effect creates dysfunctional behavior, the
alternatives might produce even greater problems
 Trade-off: Bottom-up vs. Top-down
o Top-down budgets:
 Knowledge: top management can make accurate aggregate forecasts
 Decision rights: begin with. Aggregate forecasts for firm, and then
disaggregate down to lower levels
 Decision control more important than decision management
 Decision management is the combination of machine learning with
business rules to help organizations understand the appropriate
actions to take in a process. Typically, companies use decision
management as part of a larger business automation approach for
business operations.
 Decision control: A statement or set of statements that is executed
when a particular condition is True and ignored when the condition is
False is called Decision Control Structure. The decision to execute a
particular section is based on checking a condition.
o Bottom-up budgets (participative budgeting):
 Knowledge: Lower levels have more knowledge than top
 Decision rights: Person being held responsible for meeting the target makes
the initial budget forecast
 Decision management is more important than decision control
 New approaches to budgeting
o Building the budget in two distinct steps
 Step 1: construct budgets in operational terms (lowest levels of the
organization)
 Step 2: developing a financial plan based on the operational plans from step
1.
o Constructing budgets for financial planning (decision management), but not using
budgets as performance targets (decision control)
 Units are judged by comparing their actual performance with the actual
performance of defined “peer units”

 Actual rewards can include consideration of both financial and non-financial
performance measures
 Trade-off: resolving disagreements
o Top executive officers of firms have final decision rights over the entire budget
process
o Top executives resolve disputes among lower levels
o After adoption, the budget is an informal set of contracts among the various units of
the firm
 Short-run vs. Long-run
 Firms that use only short-term (annual) budgets do not create adequate incentives for
long-term maintenance and responding to new opportunities.
 Strategic planning requires long-term budgets (2, 5, or 10 years).
 Financial lending institutions often require cash flow projections for the length of any
proposed borrowing.
 Many firms require managers to prepare both short-term and long-term budgets as part
of the periodic budget review.
 Line-item budgets
 A line-item budget is one in which the individual financial statement items are grouped
by category. It shows the comparison between the financial data for the past accounting
or budgeting periods and estimated figures for the current or a future period.
 Line-item budgets authorize managers to spend only up to the specified amount
on each line item.
 Advantages:
 Tight control reduces opportunities for managers to take actions
inconsistent with firm goals
 Disadvantages:
 Inflexible in responding to unanticipated needs
 Little incentive for cost savings¨
 Facilitating rolling budgets
 A rolling budget, also known as a continuous budget or rolling forecast, changes
constantly throughout the year. When one month ends, add another month at the end of

the budget. For example, your budget covers January-December of 2021. When January
2021 finishes, you can add January 2022.
 Cisco uses an 18-month rolling budget versus a static budget
 Advantages:
1. Keeps budget more current in changing environment
2. Manager may react in a more timely manner by better integrating
planning and execution
 Disadvantages
1. Costs of software and management time
2. Key solution: Use a single standardized web page for data entry
and automatic roll up to the company-wide budget
 Budget lapsing
 A department or organization with a lapsing budget must return any unspent budget
funds to the authority that issued them at the end of the budget period. As such, a lapsing
budget is a "use it or lose it" proposition. Both government agencies and private sector
companies use lapsing budgets.
 Budget lapsing is a requirement that funds allocated for a particular year cannot
be carried over to the following year.
 Advantages
 Tighter control than budgets that do not lapse
 Prevent risk-averse managers from accumulating funds
 Disadvantages
 Encourages wasteful spending near end of fiscal year
 Static budgets
 A static budget is a budget that uses predicted amounts for a given period prior to the
period beginning. The unique aspect of a static budget is that it does not change
regardless of deviations in revenue and expenses.
 Does not vary with volume, such as costs that should be fixed
 Volume changes may create budget variances
 Since manages are not insulted from volume changes, they have incentives to
mitigate impact of adverse volume changes
 Flexible budgets

 Do adjust for changes in volume, such as semi-variable costs that include both a
fixed and a variable component
 Evaluate performance after adjusting for volume effects
 Manager is not held responsible for volume changes
 Incremental vs. zero-based budgets
 Incremental budgeting:
 Begin with current year’s core budget and make incremental changes
 Review focuses on incremental changes and may ignore inefficiencies
in core budget
 Zero-based budgeting (ZBB)
 Zero-based budgeting is a budgeting method that requires all expenses to be
justified and approved in each new budget period.
 Mandates each line item in total must be justified each year
 Motivates manager to eliminate inefficient expenses
 Useful when firm is changing in strategic direction
 Becomes less useful when same justifications are used each year
Lecture 4, Cost Allocation Theory
Connection of Cost Allocation to Other Chapters in this Book
o Chapter 2 (costing for decision making): Cost allocations might be used as proxies for
opportunity costs.
o Chapter 4 (organizational architecture): Cost allocations are a form of transfer pricing and
are useful for control.
o Chapter 5 (responsibility centers): Cost allocations influence decision rights and.
performance measurement.
o Chapter 6 (budgeting): Cost allocations influence how resources are allocated within the
firm.
o Chapter 8 discusses practical problems of cost allocation.
o Chapters 9 through 13 (product costing): Indirect manufacturing costs are allocated to
products.
Definition and glossary

 Cost allocation is the assignment of indirect, common, or joint costs to cost objects.
 Cost object is a product, process, department, or program that managers wish to cost.
 Common cost is a cost shared by two or more cost objects.
o Examples: Accounting, building maintenance, supervisors.
 Allocation base is the measure of activity used to allocate costs. Examples: hours,
floor space, sales dollars.
o An allocation base is the basis on which Cost accounting allocates overhead costs
(??). An allocation base can be a quantity, such as machine hours that are used,
kilowatt hours (kWh) that are consumed, or square footage that is occupied.
Chapter 7, Cost Allocation Theory
 External Reasons for Cost Allocation
o External financial reports:
 Allocate production costs between expenses (expired costs, such as cost of
goods sold) and assets (unexpired costs, such as ending inventory)
o Income taxes:
 Most tax laws prescribe when product costs can be deducted.
o Cost-based reimbursement:
 Some regulated industries use cost-plus contracts
o Bookkeeping costs are reduced if the same costs are used for external and
internal reporting.
 Internal Reasons for Cost Allocation
o Decision Making
 Managers will try to reduce their use of common resources that have
relatively high-cost allocation rate
o Decision Control
 Central executives can control behavior of operating managers with cost
allocation policy
 Allocating more costs to a center constrains that center from using other
resources

Exam Topics, March 22nd
2023
Overhead cost
Overhead rate
Overhead absorption rate
Death spiral
Activity based budgeting
What are the differences between the three main centers, and how can they be measured?
 Cost center
 Investment center
 Profit center

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