SOS Session: BU247 Midterm

BU247 Managerial Accounting with Natasha Neumann-Causi and Mike Pegutter

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Exam Outline Multiple Choice Questions Definitions Smaller calculations Theories Journal Entries True / False or Fill in the Blank Theories and Definitions Short Answers Big Calculations Writing out Steps to Calculations

Agenda PART I: Introduction and CVP Analysis ,[object Object]

Cost-Volume-Profit AnalysisPART II: Cost Behaviour ,[object Object]

Income Statement approachesPART III: Cost Allocation ,[object Object]

Applying OverheadPART IV: System Design and Allocation ,[object Object]

Service Departments PART V: ABC Costing

Managerial Accounting For management purposes only Cost allocations and calculations Budgeting and future planning Production decisions Product decisions Always keep in mind: Benefit versus cost tradeoff Will the systems aid management?

Framework of Cost Accounting Strategic Planning – focus on company objectives Factory location Mergers & acquisitions Management Control – focus on resource efficiency Budget analysis Variance analysis Operational Control – task efficiency Inventory control Cash management

Central Layout Management accounting involves: planning (alternative identification and budgeting) controlling (actions and evaluations of those actions) directing and motivating (smooth operations, conflict resolution, etc.)

Decisions & Information Decision Process Accounting Information Types Identify the problem Understand the Key Success Factors of the company Identify alternative solutions Quantitative and qualitative analyses Evaluation solutions and chose one Implementation of the plan Problem Solving Information– used for long-range planning Attention Directing Information– used for controlling routine operations Scorekeeping Information– used by investors, tax collectors, etc.

Key Success Factors Critical for an organization’s success Example: excellent customer service for fast food companies Differ depending on the industry and the company Managed carefully to maintain or improve the success of a business Considered in decision-making processes and always at the forefront

Professional Ethics Competence: be able to recognize limitations, follow laws, provide accurate and timely information Confidentiality: do not use confidential information and do not give that information Integrity: be open about conflicts of interest, avoid actions that would jeopardize reputation Credibility: communicate, disclose problems and all relevant information that others need to know

Professional Ethics Resolution Conflict: follow official policies, or talk to supervisors confidentially should be maintained, consult legal professionals Corporate Governance: is the set of processes, customs, policies and laws which affect the way a company is directed, administrated or controlled should provide incentives for the pursuit of goals which benefit the stakeholders

Process Management Approaches to improving processes: Lean Production – minimize inventory and “pull” units through processes in response to customer orders Six Sigma – reduce defective products to near zero by using feedback and numerical data Define, Measure, Analyze, Improve, Control Computer Technology – refers to the growing popularity of E-commerce and enterprise systems Enterprise systems– software program that combines all data Risk Management – proactively seeking out potential sources of risk, preparing yourself, or prevent it

Cost Behaviour A cost driveris source of your total costs Example: the number of man hours clocked in a laboratory will make your total cost of R&D rise Variable costsare costs that change in direction relation to changes in cost drivers (per unit) Example: lab technicians are paid more depending on how many hours they work Fixed costsare not immediately affected by changes in the driver (total amounts) Examples: rent, insurance payments, taxes

Relevant Range Relevant rangeand Step Variable Costs are ranges where your per unit variable costs and your fixed costs will stay constant Outside of this range these costs will change As long as Brick Brewery is making between 30,000 and 75,000 cases of beer, it costs $3.00 a beer to produce and fixed costs are $1.5M a month. 30 75

Cost – Volume – Profit Analysis Total Sales Total Costs Breakeven Point Fixed Costs

Breakeven Analysis Calculating how many units need to be sold before you can start making some profits Equation Approach: Contribution Margin Method:

CVP Analysis Example A Playstation3 console is priced at $300 but costs about $250 each to make. Sony’s fixed costs for its gaming departments total about $17M a month and they manage to sell about 1M consoles a month. Calculate Sony’s breakeven point in dollars Step 1: Which formulas? We need to end up with a breakeven, point in dollars, which means we need to To calculate contribution margin as a %. Step 2: Contribution Margin % CM = $300 - $250 = $50/unit CM% = $50/$300 = 0.16667 Step 3: BEP in Dollars $17M x 12 months = $204M/year fixed costs $204M/0.16667 = $1,123.976M Step 4: Concluding Sentence Sony will have to sell $1,123,976,000 worth of PS3 in order to breakeven

Changes in Volume and Sales It helps to create simple income statements to help show what the contribution margin is and how it changes when multiple components are changing Also consider using this formula:

CM Changes Example Assume basketballs can be made at a variable cost of $5/unit and with fixed costs totalling $50,000 per month. Each basketball is sold for $15/each and current sales total 5,000 units per month. Consider the following: A) What is the profit impact if variable costs decrease by $2/unit, advertising costs are increased by $25,000 per month and therefore sales increase by 1,500 units? B) What price should be charged in order to achieve $75,000 in monthly profits (keeping everything else the same)? Condition B Required: $75,000 in Net Income $75,000 = (Price - $5)(5,000 units) – $50,000 $125,000 = Price(5,000 units) - $25,000 $150,000 = Price(5,000) Price = $30

Margin of Safety The excess of budgeted (or actual) sales over the break-even volume of sales Sports Illustrated sells 3.5 million magazines a month at an average price of $5. The cost to produce one magazine is approximately $0.50. Fixed expenses per month are $15M. What is their margin of safety? Step 1: Breakeven Unit Sales Breakeven Point in Units = (Fixed Costs)/(CM per unit) Breakeven Point in Units = $15M/(5-0.5) = 3,333,333.33 Round up to 3,333,334 units Step 2: Margin of Safety Margin of Safety = Total Sales – Breakeven Sales MOS = 3.5M – 3.33M Margin of Safety is 166,667 units

CVP with Product Mixes Companies which sell more than one product involves a ratio called a ‘sales mix’ Management will try playing around with ratios like these to see which combination is more profitable In situations with sales mixes the calculations for CM will change to ‘average contribution per unit’:

Multiproduct Example Bob’s tree farm sells two types of trees: pine and maple. The sales mix is 3:1 respectively. Each pine tree sells for $20 and each maple sells for $30. Bob estimates that each pine tree costs about $12 to grow and maintain until it is sold and about $15 for maples since they need more water. Bob’s fixed costs are $27,000 per year. Calculate Bob’s breakeven point in units. Step 1: Contribution Margin for Each Product Maple = $30-$15 = $15 Pine = $20 - $12 = $8 Step 2: Average Contribution Margin per Unit =(CM of pines x Sales mix %) + (CM of maples x Sales mix %) = ($8 x 75%) + ($15 x 25%) = $9.75 Step 3: Breakeven Point in Units BEP = Fixed Costs / Average CM per Unit BEP = $27,000 / $9.75 BEP = 2,769.23 Bob needs to sell 2,770 trees to breakeven

Cost Structure and Operating Leverage Cost structure is relative proportion of fixed costs and variable costs Operating leverage shows the proportion of your fixed costs The higher the operating leverage, the higher a company’s fixed costs are compared to variable costs so small changes in the volume of sales will result in large changes in income (and opposite)

Cost Structure and Operating Leverage Sales Sales $ $ Total Expenses Total Expenses Volume Volume High Operating Leverage High Fixed / Low Variable Costs Higher CM/Unit Higher Break-even Point Greater Risk Greater Potential Returns Low Operating Leverage Low Fixed / High Variable Costs Lower CM/Unit Lower Break-even Point Reduced Risk Lower Potential Returns

COST BEHAVIOUR AND COST SYSTEMSPart II

Cost Behaviours Step costschange abruptly at intervals of activity because the resources and their costs come in indivisible chunks (example: salaries) Mixed costscontain both variable and fixed cost elements Example: maintenance costs – supplies + labour Management Influenced Costs Capacity costs- fixed costs incurred when achieving a desired production level (example: building a plant) Committed fixed costs-large indivisible chunks of cost that the company is obligated to pay Example: mortgage payments Discretionary fixed costsare heavily influenced by management’s decisions each period on how much to spend on things like advertising, research and development, training, etc. Example: no more lavish award ceremonies every quarter for top salesmen These costs do not have clear connections to production output levels Every cost could essentially be committed / discretionary but it depends on contracts you have and your ability to change it

Measuring Cost Behaviour The mixed cost function is an equation of the cost and its driver; a linear equation looks like this Salesmen are paid guaranteed salaries of $50,000 per year plus 2% commission on sales. The dollar value of sales each salesman brings in is the cost driver. Calculate the total cost of wages given the following situations: Situation A Total Cost = $50,000 + ($400,000)2% = $58,000 Situation B Total Cost = $50,000 + ($600,000)2% = $62,000

Activity Analysis Methods ,[object Object]

Account Analysis– review of accounting records and the subjective evaluation of patterns

High-Low Analysis– simple linear algebra method (unreliable results)

Scattergraph Analysis– line of fit method on a graph; where the intercept is the total fixed costs and every point on the line is an estimated total level of activity (X) and total costs (Y)- this method heavily uses the mixed cost function ,[object Object],Activity analysesare used to identify appropriate cost drivers for each individual activity and their effects on the costs of making a product Measuring Cost Behaviour

High-Low Analysis Example Given the following information, determine the cost equation for custodial services Step 1: High and Low Levels of Activity High  500 hours at $6,345 Low  250 hours at $4,375 Step 2: Change in Activity and Variable Cost Change in Cost = $6,345 - $4,375 = $1,970 Change in Hours = 500 – 350 = 250 hours Variable cost = $1,970/250 hours = $7.88 Step 3: Fixed Cost Estimate (Using July Numbers) Total Fixed Cost = Total Cost – Total Variable Cost Total Fixed Cost = $5,570 – (360 x $7.88) = $2,733.20 Step 4: Cost Equation Y = $2,733.20 + $7.88X

Regression Analysis All the points are considered whereas the scattergraph considers only the points on the line of best fit The goal is to minimize the sum of the square errors This is the most accurate method Regression Analysis Output - The word “Constant” which appears on an output is the fixed cost - “R-squared” is an indicator of the accuracy of the results, the closer this number is to 1, the more X (independent) explains changes in Y (dependent) - “X-Coefficient” is the variable cost which is multiplied by the cost driver Excel Commands - LINEST() gives the slope of the line of best fit - INTERCEPT () gives the intercept of the line (fixed cost) - RSQ() gives the ‘r-squared’ value

Cost Behaviour: Product and Period Costs Product Costs– all costs involved in the purchase or manufacture of products which are expensed when the product is sold For a manufacturer these would include direct labour, direct materials, etc. Inventory for a manufacturer (DM, WIP, FG) For a retailer these would include freight costs, purchases, etc. Period Costs– costs expensed immediately without ever being included in inventory Selling & administrative costs

Cost Methods: Absorb & Vary Absorption Costing –includes manufacturing overhead in the costs which are assigned to inventory “Full Costing”, in accordance with GAAP Costs are classified by function (selling vs. manufacturing) Inventory costs consider both variable and fixed costs This method produces a higher inventory value since it includes fixed costs With this method, fixed manufacturing overhead costs are included in inventory, and a formula is used in order to allocate costs to ‘work-in-process’

Cost Methods: Absorb & Vary Variable Costing – this approach tries harder to separate fixed costs from variable costs and uses a style of income statements which highlights the total fixed costs “Direct Costing” Costs are classified by behaviour (variable vs. fixed) Inventory costs consider only variable costs This method helps with CVP analyses Production does not affect operating income under this approach Under variable costing fixed costs can be attributed to separate divisions and therefore controlled more easily

Absorption vs. Variable ABC Company Absorption Income Statement Sales $75,000 Cost of Goods Sold: Direct Material 10,000 Direct Labour 15,000 Overhead 7,000 Gross Profit $43,000 Selling Expenses 15,000 Admin. Expenses 17,000 Operating Income $11,000 ABC Company Variable Costing Income Statement Sales $75,000 Variable Expenses: Direct Material 10,000 Direct Labour 15,000 Overhead 3,000 Variable Selling 8,000 Variable Admin 8,000 Contribution Margin $31,000 Fixed Expenses: Overhead 4,000 Selling & Admin 16,000 Operating Income $11,000

Absorption vs. Variable Variable costingstatements are considered easier to understand because net operating income is only affected by changes in unit sales We cannot do CVP analysis with absorption costingbecause it considers overhead to be a variable cost Both methods can be used when filing tax returns, but only absorption costingis allowed for external purposes For absorption costing we use units produced; whereas with variable costing we use units sold

Segmented Income Statements Income statements for parts of a whole company A contribution format is used and traceable fixed costs should be separated from common fixed costs to allow for CVP analysis and segment margin calculations Absorption formation may be used anyway Traceable fixed costsare fixed costs incurred by that particular segment alone such as the rent for its facility Common fixed costsare incurred by the whole company such as the executive salaries or patent protection legal fees Common costs cannot be arbitrarily assigned to segments because managers will be put in charge of costs they have no control over

Segmented Income Statements Segment margin is the best gage of the long-run profitability of a segment Traceable costs of one segment may be common costs to another Not in Handout

Cost Management Systems Costs are sacrifices of resources for a particular purpose (such as money for materials) Acost objectiveis a department or product for which cost information is collected Direct costscan be identified exclusively with a given cost objective (i.e. – a product) in an economical way (can be easily and reliable measured) Indirect costs cannot... Overtime premium– an indirect cost which includes wages paid to workers in excess of their regular hours Idle time– wages paid for unproductive time (when everyone is standing around) Defects– scrap, warranty claims, the cost of poor customer relationships (if you can figure out a $ for that)

Cost Management Systems Differential Costs (Revenues) are the difference in cost (revenue) between two alternatives Example: If you are decided between buying a car that costs $20,000 or buying a bus pass for the next 5 years which will in total cost $15,000 The differential cost is $5,000 Opportunity Costsare the potential benefit that is given un when one alternative is selected over another Example: You are deciding to either buy a car that costs $20,000 or spend the money on a college diploma which would raise your salary from $10,000/year to $25,000/year The opportunity cost of buying the car would be the $15,000 in increased wages. Sunk Costsare costs already incurred and paid for that are in the past and cannot be changed and therefore have no bearing on future decisions Example: If you are decided between buying a car that costs $20,000 or buying a bus pass for the next 5 years which will in total cost $15,000 but you’ve already bought your bus pass for this month which cost $80. You’ve bought the pass already, it’s in the past and shouldn’t affect your decision here.

Manufacturing Costs For companies who create their inventory from scratch, there are three main categories of costs: Direct Material Costs– cost of acquiring materials used Direct Labour Costs – wages or labour that is exclusive to production Factory Overhead Costs – all other costs (utilities, equipment depreciation, etc.) These costs can be combined and reduced to two categories Prime Costsinclude direct labour and material costs Conversion Costsinclude the costs of converting material into finished products (direct labour and factory overhead costs) Prime Costs Direct Materials Direct Labour Factory Overhead Conversion Costs

Cost Allocation Cost Allocationis the process of linking costs or cost pools (multiple costs grouped together) with one or more cost objects through identifying and selecting cost drivers Synonyms of cost allocation  cost tracing, assignments, distributions, apportionment Synonyms of cost drivers  allocation base, activity measure

Manufacturing Overhead Cost Allocation The POHR is used no matter what the real overhead costs are and what the actual allocation activity is The per unit cost calculated above ≠ marginal cost of the product; if an additional unit was produced the per unit cost would slightly decrease Journal Entry Examples in “Extras”

Underapplied / Overapplied Since the POHR contains estimates, the manufacturing overhead that we actually incur and the amount applied to Work in Process using the POHR will differ 99% of the time Underapplied overhead- overhead applied to jobs is less than the total amount of overhead actually incurred this will result in a remaining debit balance in the manufacturing overhead account Overapplied overhead- overhead applied to jobs is greater than the total amount of overhead actually incurred this will result in a remaining credit balance in the manufacturing overhead account The difference between applied overhead and actual overhead can be dealt with in three ways: Close directly to Cost of Goods Sold Expense Allocate proportionately between WIP, Finished Goods, and COGS Expense based on their relative dollar value Carry the balance in manufacturing overhead over to the next year

Overhead Application Example Toyota has incurred a total of $15.0M in manufacturing overhead this month with a total of 500,000 labour hours worked on cars. Calculate the manufacturing overhead applied to Work-in-Progress cars over the month using a predetermined overhead rate of $12/hour. Was the manufacturing overhead overapplied, underapplied, or perfect ? Provide the journal entry required to close any unapplied overhead to cost of goods sold. Step 1: Apply Overhead Applied Overhead = POHR X Actual Direct Labour Hours Applied Overhead = $12/hour X 500,000 Applied Overhead = $6.0M Step 3: Journal Entry Debit : Cost of Goods Sold $9M Credit : Manufacturing Overhead $9M Step 2: Over/Underapplied? = Actual Overhead – Applied Overhead = $15M - $6M = $9M Underapplied

POHR and Capacity Biggest criticisms of using the POHR: Using estimates and budgeted activity levels will result in product costs that fluctuate all the time Applies costs that had nothing to do with products like idle time Using capacity limits instead of the estimated number of allocation base will reduce the overhead rate the difference between the capacity rate and the POHR is the idle capacity cost Equipment is leased for $400,000 / year. A plant working at full capacity can produce 80,000 units, but the company estimates 60,000 will be made. The POHR will be $6.67/unit using the regular formula but if we use capacity units instead it will only be $5/unit.

Professional Ethics How will understating the estimated direct labour hours in the base for the POHR affect operating income? Remember: ,[object Object]

Overapplied overhead  debit balance in manufacturing overhead account

This will reduce COGS when the account is closed

This will result in higher net incomeNot in Handout

SYSTEM DESIGN AND ALLOCATIONPart IV

Product Costing Systems Process Costing– the company mass produces one homogenous product Costs are accumulated by departments and thus calculates unit costs by department as well Production is uniform on all units Job – Order Costing System– the company builds to order a range of unique products Direct materials and labour will be allocated to each job as they are incurred Indirect costs (like overhead) will accumulate over time and then be allocated

Process Costing A processing departmentis any part of a company where work is performed on a product Transferred-in costsare those that were used in one department and then sent to another department The Processing Story in “Extras”

Equivalent Units (Weighted Average Method) The number of complete units you could get from putting together all the partially complete units that are sitting around in Work in Process inventory at the end of a period Example: one unit that is 70% done put together with another unit 30% complete makes one completely finished equivalent unit

Equivalent Units Example (Weighted Average Method) Given the information below, calculate the equivalent units both in terms of materials and conversion costs and also calculate the total cost per equivalent unit. (answer in the handout)

Service Department Cost Allocations Operating departmentsare the ‘heart and soul’ of the organization and carry out its purpose in life Service departmentssupport the company and its operating departments; their costs incurred by these departments are allocated unto the operating departments which in turn allocate all costs to units produced Reciprocal Servicesis the term used to describe the concept of service departments and operating departments provided services to each other

Service Allocation Methods: Direct Ignore transactions between service departments and assume service departments only provide to operating departments All costs are allocated to operating departments based on the proportion of total allocation base

Direct Method Example The accounting department of Cars Inc. has incurred $2.5M in costs over the year. Management has calculated that the accounting team has worked 50,000 hours this year and employs 110 people. The cafeteria has incurred $1M in costs over the year, employs 20 and has worked 8,000 hours. Cars Inc.’s manufacturing plant has incurred $10M in costs this year, has worked 60,000 hours and employs 200 people. The customization plant incurred $15M in costs, has worked 40,000 hours and employs 100 people. Assume the allocation bases for accounting and cafeteria departments are hours and employees, respectively.

Service Allocation Method: Step-Down Service Department “A” provides services to Service Department “B” (but no reciprocation) and both pass on to the Operating Departments All costs incurred by service departments are allocated to operating departments based on the proportion of total allocation base TIPS - Order matters, we need to know which service department serves the other

Step-Down Method Example The accounting department of Cars Inc. has incurred $2.5M in costs over the year. Management has calculated that the accounting team has worked 50,000 hours this year and employs 110 people. The cafeteria has incurred $1M in costs over the year, employs 20 and has worked 8,000 hours. Cars Inc.’s manufacturing plant has incurred $10M in costs this year, has worked 60,000 hours and employs 200 people. The customization plant incurred $15M in costs, has worked 40,000 hours and employs 100 people. Assume the allocation bases for accounting and cafeteria departments are hours and employees, respectively.

Service Allocation Method: Reciprocal Service Department “A” provides services to Service Department “B” and vice versa Know what it is, but not how to do it.

Activity-Based Costing A non-traditional way of allocating costs ABC costing is more careful about which costs are considered; only costs that are affected by product-related decisions are used not all manufacturing costs, some non-manufacturing costs ABC costing has the highest number of cost pools and overhead application rates POHR applies to the entire factory and all its departments Process costing uses different overhead rates for departments ABC costing has as many rates as there are activities The ABC costing method has the ability to segregate costs associated with unused capacity

Activity Costing An activity is an event that causes the consumption of overhead resources (i.e. taking customer orders) Five Levels of Activity Unit-Level Activities– activities that arise each time a product is produced (i.e. electricity) Batch-Level Activities– activities that involve processing or handling batches of product (i.e. moving them) Product-Level-Activities – activities related to products that must be done regardless of production (i.e. marketing and engineering design) Customer-Level-Activities – have to do with the customers themselves (i.e. customer service) Organization-Sustaining-Activities – are done no matter what else is going on This is the only type of activity directly related to volume of production

Implementation of ABC Identify and define activities There is no ‘right’ or ‘wrong’, there is ‘accurate’ and ‘less accurate’ Assign overhead costs to activity cost pools Only overhead, no direct or indirect Calculate activity rates Using total activity estimates for each activity Assign overhead costs to cost objects Common cost objects: products, orders, customers Prepare management reports

Management Reports Product Margin Calculation These costs are assigned using other cost systems Calculated using the ABC Costing process This company is losing money every time it makes Product B With this we can make big decisions such as whether we should consider cutting out Product B Product A did not do any product design

Management Reports Customer Profitability Analysis Calculated using the ABC Costing process (Stage 4) Notice that we now add customer relations costs Here we can make decisions such as whether or not it is worth keeping this customer

ABC vs. Traditional Costing Traditional costing uses one plant wide manufacturing overhead rates All shipping, marketing and administrative expenses are not allocated to the product Same in for traditional and ABC Only one cost pool: overhead We are not losing money on this product according to this method Product B is “undercosted” giving it a much higher product margin than it should

Cons of ABC Costing ABC costing is not typically used for external reporting because Don’t need all the detail Cost too muchto start using ABC Costing GAAP standards don’t like ABC There is a lot of subjectivity ABC costing has its own limitations too It costs a lot of money Resistance from the employeeswhen new systems are put in place Misinterpretation of the results Many companies like to allocate all their costs to the productsrather than to customers and orders Everyone needs to conform to GAAP

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