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managerial accounting notes...

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CVP Income Statement:

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Margin of Safety: ○ Tells us how far sales can drop before the company will be operating at a loss ○ Can be expressed in units or as a ratio

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Sales Mix ○ Relative percentage in which a company sells multiple products ○ Eg. Company XYZ’s unit sales are 80% printers and 20% PCs → their sales mix is 80% printers to 20% PCs ○ Important to managers because different products often have substantially different contribution margins ○ Can compute break-even sales for a mix of two or more products by determining the weighted-average unit contribution margin of all the products ○ Management should continually review the company’s sales mix → At any level of units sold, net income will be greater if higher contribution margin units are sold rather than lower contribution margin units ■ Determining how many units of each model needs to be sold so the company breaks even → Multiply Sales Mix by break-even units ○ Sales mix with limited resources ■ All companies have limited resources ■ When discussing limited resources, companies must decide which products to make and sell in order to maximize net income

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Important to find contribution margin per unit of limited resource → Divide CM of each product by the # of units of the limited resource

Effects on Contribution Margin ● Lower VC → Higher CM ● Eg) CM of 0.4 → Every dollar of sales generates 40 cents, every dollar decrease in sales loses 40 cents Effects on Break-Even Point ● Company with higher break-even point is more risky Effects on Margin of Safety Ratio ● Higher margin of safety is better ● Company with a 30% margin of safety ratio could sustain a 30% decline in sales before it would be operating at a loss Operating Leverage ● Provides a measure of a company’s earnings volatility and can be used to compare companies ● Measures the company’s sensitivity to changes in sales ● % Change in Income → Divide the higher degree of operating leverage with the lower degree of operating leverage ○ The percent change in income would be (number) times as much with the better alternative

Absorption Costing vs Variable Costing ● Absorption Costing → all manufacturing costs are charged to the product ○ Approach used for external reporting under GAAP ● Variable Costing → Only direct materials, direct labour, and variable manufacturing overhead costs are considered product costs ● Under both costing methods, selling and administrative expenses are period costs ● Companies may not use variable costing for external financial reports because GAAP requires that fixed manufacturing overhead be accounted for as a product cost ● One main difference: Under variable costing, companies charge the fixed manufacturing overhead as an expense in the current period ○ Therefore, absorption costing will show a higher net income number than variable costing whenever units produced exceed units sold

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Add DIRECT MATERIALS, DIRECT LABOUR AND VARIABLE MANUFACTURING OVERHEAD to get manufacturing cost of one unit Manufacturing cost per unit is higher for absorption costing because fixed manufacturing overhead costs are a product cost under absorption costing Under variable costing, they are a period cost, so they are expensed

Absorption Costing Example

Variable Costing Example

Decision-Making Concerns ● GAAP require that absorption costing be used for the costing of inventory for external reporting purposes ● When production exceeds sales, absorption costing reports a higher net income than variable costing ○ Some manufacturing costs are not expensed in the current period but are deferred to future periods as part of inventory ○ As a result, management may be tempted to overproduce in a given period in order to increase net income

Relevant Costs ● Costs and revenues that differ across alternatives

Budgeting ● Budget is a formal written statement of management’s plans for a specified future time period, expressed in financial terms ● Consider the role of budgeting as a control device ● Benefits of budgeting

Essentials of Effective Budgeting ● Budgets based on research and analysis are more likely to result in realistic goals that will contribute to the growth and profitability of a company ○ And the effectiveness of a budget program is directly related to its acceptance by all levels of management ● Budgeting is an important tool for evaluating performance Length of the budget period ● A budget doesn't have to be one year in length ● A budget may be prepared for any period of time ● Various factors influence the length of the budget ○ Type of budget ○ Nature of the organization ○ The need for periodic appraisal ○ Prevailing business conditions ● Budget period should be long enough to provide an attainable goal under normal business conditions ● Most common budget period is one year ● Many companies use continuous 12-month budgets → these budgets drop the month just ended and add a future month ○ A benefit of continuous budgeting is that it keeps management planning a full year ahead Budgeting Process ● Budgeting process usually starts several months before the end of the current year ● Budgets are developed within the framework of a sales forecast

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This forecast shows potential sales for the industry and the company’s expected share of such sales ○ Sales forecasting involves a consideration of various factors ■ General economic conditions ■ Industry trends ■ Market research studies ■ Anticipated advertising and promotion ■ Previous market share ■ Changes in price ■ Technological developments In larger companies, a budget committee has responsibility for coordinating the preparation of the budget

Budgeting and Long-Range Planning ● One important difference between budgeting and long-range planning is the time period involved ● The maximum length of a budget is usually one year, and budgets are often prepared for shorter periods of time ○ A few months vs 5 years ● Another difference is emphasis ○ Budgeting focuses on achieving specific short-term goals, such as meeting annual profit objectives ○ Long-range planning identifies long term goals, selects strategies to achieve those goals and develops policies and plans to implement the strategies ● Final difference related to the amount of detail presented ○ Budgets can be very detailed while long-range plans contain considerably less detail ○ The data in long-range plans are intended more for a review of progress toward long term goals ○ The primary objective of long-range planning is to develop the best strategy to maximize the company’s performance over an extended future period The Master Budget ● Master budget is a set of interrelated budgets that constitutes a plan of action for a specified time period ● Master budget contains two classes of budgets ○ Operating Budgets: Individual budgets that result in the preparation of the budgeted income statement ■ These budgets establish goals for the company’s sales and production personnel ○ Financial Budgets: Focus primarily on the cash resources needed to fund expected operations and planned capital expenditures

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Includes the capital expenditure budget, the cash budget, and the budgeted balance sheet Master Budget Operating Income (Loss) = # Units x (Selling Cost - Prime Cost MOH per unit - Selling & Admin expense per unit ) - MOH - Selling & Admin Expenses

Sales Budget ● Sales budget is prepared first ● Derived from the sales forecast ● Represents management’s best estimate of sales revenue for the budget period ● An inaccurate sales budget may adversely affect net income ● Created by multiplying the expected unit sales volume for each product by its anticipated unit selling price

Production Budget ● Shows the number of units of a product to produce to meet anticipated sales demand ● A realistic estimate of ending inventory is essential in scheduling production requirements

Direct Materials Budget ● Shows both the quantity and cost of direct materials to be purchased ● The desired ending inventory is again a key component in the budgeting process ○ Inadequate inventories could result in temporary shutdowns of production

Direct Labour Budget ● Direct Labour budget contains the quantity (hours) and cost of direct labour necessary to meet production requirements ● Direct labour budget is critical in maintaining a labour force that can meet the expected level of production

Manufacturing Overhead Budget ● Shows the expected manufacturing overhead costs for the budget period ● This budget distinguishes between variable and fixed overhead costs ● The accuracy of budgeted overhead cost estimates can be greatly improved by employing activity based costing

Selling and Administrative Expense Budget ● In some cases, you can combine your operating expenses into one budget, the selling and administrative expense budget ● This budget anticipates selling and administrative expenses for the budget period

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It also classifies expenses as either variable or fixed

Budgeted Income Statement ● Budgeted income statement is the important end-product of the operating budgets ● This budget indicates the expected profitability of operations for the budget period ● The budgeted income statement provides the basis for evaluating company performance

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Determine the total unit cost of one product Then, you determine cost of goods sold by multiplying the units sold by the unit cost

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Cash Budget ● Shows anticipated cash flows ● Because cash is so vital, this budget is often considered to be the most important financial budget ● Contains three sections: ○ Cash receipts ○ Cash Disbursements ○ Financing

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The cash receipts section includes expected receipts from the company’s principal source(s) of revenue. There are usually cash sales and collections from customers on credit sales ○ This section also shows anticipated receipts of interest and dividends and proceeds from planned sales of investments, plant assets and the company’s capital stock

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The cash disbursements section shows expected cash payments. Such payments include direct materials, direct labour, manufacturing overhead, and selling and administrative expenses ○ This section also includes projected payments for income taxes, dividends, investments and plant assets The financing section shows expected borrowings and the repayment of the borrowed funds plus interest ○ Companies need this section when there is a cash deficiency or when the cash balance is below management’s minimum required balance

Standard Costs and Balanced Scorecard: Predetermined unit costs, which companies use as measures of performance ● Standards and budgets are predetermined costs and both contribute to management planning and control ○ Standard is a unit amount ○ Budget is a total amount

Flexible Budgets ● Projects budget data for various levels of activity ● The flexible budget is a series of static budgets at different levels of activity Setting Standard Costs ● To determine standard costs of direct materials, management consults purchasing agents, product managers, quality control engineers and production supervisors ● In setting the standard cost for direct labour, managers obtain pay rate data from the payroll department ● To be effective in controlling costs, standard costs need to be current at all times Ideal vs. Normal Standards ● Ideal standards represent optimum levels of performance under perfect operating conditions ● Normal standards represent efficient levels of performance that are attainable under expected operating conditions ● Some managers believe ideal standards will stimulate workers to ever-increasing improvement ● However most managers believe that ideal standards lower the morale of the entire workforce because they are difficult, if not impossible to meet ● Most companies that use standards set them at a normal level ● Properly set, normal standards should be rigorous but attainable ● Normal standards allow for rest periods, machine breakdowns and other “normal” contingencies in the production process Direct Materials Price Standard ● Cost per unit of direct materials that should be incurred ● This standard is based on the purchasing departments best estimate of cost of raw materials ● Cost can include ○ Purchase price ○ Freight ○ Receiving, storing, handling ● The direct materials quantity standard is the quantity of direct materials that should be used per unit of finished goods ○ This standard is expressed as a physical measure, such as pounds, barrels or board feet ○ This standard includes ■ Required materials ■ Allowances for unavoidable waste and normal spoilage ○ The standard direct materials cost per unit i s the standard direct materials price multiplied by the standard direct materials quantity

Direct Labour Price Standard ● The rate per hour that should be incurred for direct labour ● Based on ○ Current wage rates ○ Adjusted for anticipated changes such as cost of living adjustments (COLA) ○ Payroll taxes ○ Fringe benefits (paid holidays and vacations) ● The direct labour quantity standard is the time that should be required to make one unit of the product ○ This standard is especially critical in labour-intensive companies ○ Allowances should be made in this standard for ■ Actual production time ■ Rest periods ■ Cleanup ■ Machine set up ■ Machine downtime ○ The standard direct labour cost per unit is the standard direct labour rate times the standard direct labour hour Manufacturing Overhead ● For MOH, companies use a standard predetermined overhead rate in setting the standard ● This overhead rate is determined by dividing budgeted overhead costs by an expected standard activity index

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The standard manufacturing overhead cost per unit is the predetermined overhead rate multiplied by the activity index quantity standard

TOTAL STANDARD COST PER UNIT ● After a company has established the standard quantity and price per unit of product, it can determine the total standard cost ● The total standard cost per unit is the sum of the standard costs of direct materials, direct labour and MOH Analyzing and Reporting Variances ● One of the major management uses of standard costs is to identify variances from standards ● Variances are the differences between total actual costs and total standard costs

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Companies determine total standard costs by multiplying the units produced by the standard cost per unit ○ Then, (Actual Costs - Standard Costs) = Total Variance (in $)

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When Actual Costs > Standard Costs: Variance is unfavourable ○ Negative connotation ○ Suggests that the company paid too much for one or more of the manufacturing cost elements or that it used the elements inefficiently ● When Actual Cost < Standard Costs: Variance is favourable ○ Positive connotation ○ Efficiencies in incurring manufacturing costs and in using DM, DL, and MOH To interpret Variance properly, you must analyze its components:

Direct Materials Variance ● Total materials variance is computed as the difference between the amount paid (actual quantity times actual price) and the amount that should have been paid based on standards Eg)

Causes of Materials Variances ● The causes may relate to both internal and external factors ● Investigation of a materials price variance usually begins in the purchasing department

Direct Labour Variances

Causes of Labour Variances ● Labour price variances usually result from two factors: ○ (1) paying workers different wages than expected ○ (2) misallocation of workers Manufacturing Overhead Variances ● Total overhead variances is the difference between the actual overhead costs and overhead costs applied based on the standard hours allowed for the amount of goods produced

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To find the total overhead variance in a standard costing system, we determine the overhead costs applied based on standard hours allowed  ave been worked for the units Standard Hours Allowed are the hours that should h produced

Equations:

Residual Income = Controllable Margin - (Minimum rate of Return x Average Operating Assets Average Operating Assets = Operating Income / ROI

Pricing ● In the long run, a company must price its product to cover its costs and earn a reasonable profit ● Target Costing: ○ Prices are affected greatly by the laws of supply and demand ○ To earn a profit, companies must focus on controlling costs. This requires target cost that provides a desired profit

Cost-Plus Pricing ● In less competitive markets, companies have greater ability to set the product price

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When a company sets a product price, it does so as a function of, or relative to, the cost of the product or service ○ This is referred to as cost plus pricing Under cost-plus pricing, a company first determines a cost base and then adds a markup to the cost base to determine the target selling price

How to choose selling price per unit:

TRANSFER PRICING Example

No Excess Capacity ● The Sole Division has no excess capacity and sells 80,000 units of soles to outside customers. Therefore, the Sole Division must receive from the Boot Division a payment that will at least cover its variable cost per sole plus its lost contribution margin per sole ○ The lost contribution margin is often referred to as opportunity cost ● If the Sole Division cannot recover that amount (the minimum transfer price), it should not sell its soles to the boot division

Excess Capacity ● If Sole Division has excess capacity (Can only sell 700,000 units when they can produce 800,000), it has available capacity of 100,000 units ● Because it has excess capacity, the Sole Division can provide 10,000 units to the Boot Division without losing its $7 contribution margin on these units

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Given excess capacity, net income will increase if the Boot Division purchases the 10,000 soles internally ○ This is true as long as the Sole Division’s variable cost is less than the outside price of $17 ○ At any price above $17, the Boot Division will go to an outside supplier

Variable Costs ● In the minimum transfer price formula, variable cost is defined as the variable cost of units sold internally ● In some instances, the variable cost of units sold internally will differ from the variable cost of units sold externally ● Special Order Requests...