Man Acc Exam 3
Short Term Decisions: Generally, covers a short time period (a year or less), using "relevant" information regarding cost behavior to make decisions.
How do Managers make Decisions?
1. Identify or define a problem, need or opportunity
Develop alternative, then gather and analyze relevant information. Relevant for short term decision making includes:
• Expected future benefits vs. costs
Differences between alternatives
The information must have impact on the decision being made!
• Relevant information can be quantitative or qualitative
Chose best alternative (usually, highest contribution margin per unit)
Implement the Decision
Review decision: compare actual results with anticipated results; make adjustments as needed
Irrelevant Costs: Do NOT affect a decision
Costs that are the same between different alternatives are irrelevant
Sunk costs are irrelevant because the costs cannot be recovered or changed regardless of a
future action taken
Incremental Analysis for Short Term Decisions: Looks at how operating income will change under each alternative, relating to the immediate future.
Some rules:
Ignore costs and revenues that will not differ between alternatives.
Ignore past or sunk costs.
Ignore fixed costs unless they are impacted by the short-term decision. Then, only consider the fixed costs that are impacted (Not all of them!).
Make sure contribution margin per unit is positive. If so, go with alternative where the company will be the "best off."
Make sure to consider any qualitative aspects (customer service and satisfaction, long term effects, quality of products, etc.)
Types of Short-Term Decisions:
Special order: Customer asks for one time order at a reduced sales price. Should the company accept a special order? Generally speaking, accept if contribution margin per unit is positive (incremental costs of filling the order-variable costs and any additional fixed costs), and have productive capacity to accept the special order. Also want to make sure that regular sales will not be affected in the long run by this special order being filled. Profits will increase by amount of contribution margin per unit is positive x # of units produced
Dropping or Adding a Product Line: Decide whether to drop or add an additional product line.General rule is to drop when CM per unit is negative, add or keep if CM per unit is positive. Still need to consider effects on fixed overhead (which could still continue to exist even if drop the product line) and the effect of dropping a product line on other product lines.
Product Mix Decisions: If resources are limited, need to choose alternative with the maximum Contribution Margin per critical factor. Labor, Materials, Demand, Time could all be constraints.
4. Making or Buying a Product: Company has to decide whether to make its own product or outsource it elsewhere (buy). After looking at financial considerations, also need to consider control over quality, customer satisfaction, supplier reliability, etc. Rule: Buy if can purchase at a cheaper price (must consider fixed costs and how they will be affected). Make if can make more cheaply, or for other qualitative reasons.
5. Sell or Process Further (Joint Costing): Joint costs incurred up until split off are irrelevant,because will have to pay for these regardless of the product lines produced. Ignore joint costs Gup for this decision. Only look at Net Realizable Value (NAV) for each product do that spinoff and if process further. Only consider additional costs to process further when making the decision.
Regular Pricing Decisions: Management has to determine how to set prices for regular products. Considerations include target profit, how much customers will pay for the product, and how the market dictates the price for the product.
Price takers: Market dictates the price of a product; company must manage all costs (target costs-including variable and fixed costs) to remain profitable. Market price of product - desired profit = Target cost of product
ACG 2071
Dr. Jennifer Cainas
Price Setters: Company can dictate price of a product because demand is high, and little or no competition. (Example - Mac computer). Company uses "cost plus" pricing to determine sales price of
the product. Target cost of product + desired profit level = Price of product
Example: Apple is getting ready to release its latest personal computer, MacBook Air. Current variable costs per computer are $500, with current fixed costs of $400 per unit. If Apple wants to earn a desired profit of 40% on each MacBook sold, what does the current market price need to be for the new MacBook Air?
7. Cost effective alternatives for defective products: Defective products are those products that do not meet production standards. Need to decide to scrap or rework. Consider both quantitative and qualitative factors. Look at incremental revenue to sell the scrap vs. revenue it can generate to rework, less additional costs.
Capital Investments: Investment a company makes in capital (long-term) assets.
Capital Budgeting Process: Focuses on cash flows from a particular investment. Process looks at both cash coming in (cash inflows) and cash going out (cash outflows). Cash inflows should be > cash outflows over the life of the investment!
• Inflows: Can consist of cash coming in (from revenues, etc.) or cash savings as a result of the investment, or any residual value left in the asset at the end of its useful life.
Outflows: Can consist of any cash initially spent on the investment, any operating costs, including ongoing costs or one time maintenance and repairs, etc. to maintain the investment, and any costs to dispose of the asset at the end of its useful life.
Capital Budgeting Process
Develop an action plan based on the company's goals and identify potential capital investments:
"Wish List" of possible investmentsIdentify relevant information and key inputs to the decision.
Analyze potential investments: First, use quick computations (Payback and ARR) to determine which investments should immediately be discarded. For those investments left to consider, company uses time value of money concepts to determine highest yield to the company (NPV or IRR).
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Incorporate feasibility factors, taxes, and tangible and intangible benefits.
Choose between different alternatives, generally that yield highest NPV or profitability (could involve capital rationing) and manage the implementation.
6. Perform Post Audits: Did the investment perform as expected?
How do Companies make decisions regarding capital investments? Normally analyze costs of new investment vs. expected savings/benefits over the long run. Use many estimates and assumptions when modeling different investment decisions. Four techniques are used to accomplish this:
1. Payback Period: Length of time it takes to get "paid back" for an original investment. The shorter the "payback," the more desirable the investment. Benefit is that its easy to compute.
Major drawback is that it ignores time value of money and ignores any other cash flows that occur after the payback period.
Payback period =
Amount of initial investment
Expected annual net cash inflows
2. Accounting Rate of Return: Is a ratio of average operating income versus the initial investment made in a capital project. (it focuses on income statement profitability rather than cash flows).
Investment is "ok" if ARR exceeds required rate of return; if not, should disregard. Drawback is that it Ignores time value of money.
Accounting rate of return = Annual (average) net cash inflows - depreciation expense /Initial investment
Internal Rate of return: Represents the expected rate (interest rate) a company can earn on an investment, based on discounted cash flows (time value of money). If IRR > company's required rate of return, should invest!
Net Present Value: Uses time value of money concept to see if net cash flows from the investment exceed the original investment. If net cash flows > initial investment, should invest!
Review of Time Value of Money: Concept that money is worth more today than the same amount in the future, because it can be used to earn interest.
Time Value of Money Questions:
Present value: What is something worth today?
Future value: What is something worth in the future?
Single Sum: When calculating present or future value, only one lump sum of money Annuity: A series of cash payments that is equal in amount for each interest period
N = number of compounding interest periods
| = market rate of interest
Examples of Present Value:
1. Suppose I want to invest a certain amount of money today for my child's college education, to make sure I will have $10,000 when she leaves for college in 3 years. If I expect to earn 8% interest in my investment, how much do I need to invest today?
Answer: I am solving for the present value of a single sum ($10,000). See Appendix A for present value factor:
PV single sum = $10,000 x (PV ss n = 3 periods, interest rate = 8%) = (10,000 × 0.7938) = $7,938
2. Now suppose I am going to receive a guaranteed $5,000 bonus for the next 3 years. Assuming an 8% interest rate, what is the bonus worth to me today?
Answer: I am solving for the present value of an annuity (equal series of payments over time) and I want to know what this bonus is worth to me TODAY.
PV of an annuity = $5,000 x (PV ann., n = 3 per., interest = 8%) = ($5,000 × 2.5771) = $12,885.50
IRR: When solving for IRR, you are solving for the "i" in the problem. If IRR is greater than the company's required return, the company should proceed with the investment!
Profitability Index: Used to determine which project a company should invest in, if dealing with limited resources and have several projects with positive NPVs. Computes the number of dollars returned for every dollar invested. Helps to consider different investments and the different initial costs of each investment.
Residual values: Treat the residual value as a single sum and include in NPV calculations.
Sensitivity Analysis: Determines how sensitive a change in assumptions could change calculations for an investment decision. For instance, changing the interest rate from 12% to 10%... how would this change the NPV or IRR of an investment and the decision made?
Other Factors Affecting Capital Budgeting Decisions
Taxes: Taxes impact a company's cash costs and savings, so they must be considered when making a capital budgeting decision. A taxpayer can elect to use straight line depreciation or modified accelerated cost recovery system (MACRS) for tax purposes. Profitable companies will generally use MACRS for tax purposes because depreciation expense is generally higher than straight line in the earlier years, thus saving money on their tax bill! But, your book uses straight line, so we will use it here.
Look at purchase of new machine, and if can currently dispose of old machine, plus any additional working capital investments (all happening now)
Cash flows from operations: Annual after tax cash flow from operations
Consider non-cash expenses, that lower reported net income (which saves the company on taxes they would pay otherwise!)
Example: Cainas Cookies is considering whether to invest in project A or project B. Each would require a $10,000 initial investment and have a useful life of 5 years. Assume a 40% tax rate.
Project A will save the company $2,000 per year. It will be depreciated using straight line depreciation, over 5 years. Salvage value is estimated to be $1,500.
Project B will have cash flow savings of the following: $5,000 in Year 1-2, $3,000 in years 3-4, $2,000 in year 5. It will be depreciated using straight line. Salvage value is estimated to be $500. The Company's Cost of Capital is 10%. Compute the NPV for each alternative and determine which is the better investment.
SEE EXCEL SHEET TO ANALYZE!
Feasibility Factors: Includes management, operations, and promise. (MOP)
Management: commitment to the project plays a key role in the project's feasibility.
Operations: Company must have the infrastructure to develop, implement, and operate the capital project.
Promise: Investments must be made based on reality, which requires due diligence and proper analysis of expected cash flows before making a commitment.
Also must consider benefits vs. costs of a capital budgeting decision. Includes both tangible benefits and intangible benefits.
Purpose of Budgets:
Planning: Implement strategic plans and estimate revenues and expenses that will be incurred to help meet its goals
Control: To review actual results to budgeted results, and use information to make any corrections or adjustments necessary
Benefits of Budgeting: Forces company/managers to have a plan!
Planning: Forces a company to plan and estimate their outcome, so they have more time to act on the plan or make corrections if necessary. Helps focus actions to meet strategic goals.
Coordination and Communication: A budget helps to coordinate a company's activities to meet a common goal. It forces managers to consider all aspects of the value chain, and how their decisions impact other areas. It also communicates a consistent plan and expectations throughout the company.
Benchmarking: It provides a "benchmark" or expectation to help motivate managers to achieve or surpass the benchmark.
Components of a Master Budget (see Exhibit 10-5)
Operating Budget: Budget for normal operations of a business (budget for revenues and expenses)
Capital Expenditures Budget: Budget for large purchases over long term (plan for purchasing
PP&E, long term assets, etc.)Financial Budget: Analyzes cash flows and impacts on the balance sheet
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Budgets are prepared in the following order:
Operating Budgets:
Sales Budget: Must project sales before any other budget, because level of sales affect expenses and almost all other components of the master budget. Normally a company will estimate their credit sales and their cash sales (because this information will affect the cash budget).
Inventory, Purchases, and COGS Budget: Prepared after the sales budget, but based on sales data. Used to estimate COGS (based on sales), inventory levels, and what will need to be purchased to meet sales demand.
Operating expenses budget: Includes all other expenses other than COGS. These expenses can be fixed or can vary, depending on the expense category.
Sales Budget - COGS Budget - Operating Expenses Budget = Budgeting Income Statement
Some notes:
If company is a manufacturer. Will start with a production budget (similar to purchases) but then will prepare a direct materials, direct labor, and manufacturing OH budget, which is then used to prepare the COGS budget.
* If a company is a service company, the company will not have COGS or any of the production/purchases/inventory budgets
Financial Budgets:
4. Cash Budget: Includes both cash collections and cash payments. Must complete the operating budget (for revenues and expenses) before you can calculate the cash budget. Estimate cash inflows and outflows, and then determine any financing needed (if cash balance falls below desired amounts). See Exhibit 10-14
• Cash collections: Can be from cash sales, or collections on Accounts Receivable
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Cash payments: Can include cash payments for purchases of inventory, cash payments for operating expenses, cash payments for capital expenditures, and cash financing (repayment of loans).
• Once the cash budget is complete, can estimate a budgeted balance sheet and budgeted statement of cash flows.
Once budgets are created, all budgets are "rolled up" into one master budget!
Participatory Budgeting: Employees become part of the process and assume an active role in preparing the budgets. Normally, a company has better employee buy-in and budgets are more accurate because those closest to the work have actually prepared the budget. ("Bottom-Up" Approach)
Top-Down Approach: Managers decide the budget and then communicate the expectations to subordinates. Can be unrealistic, because budgets are not prepared by individuals that are most familiar with the work.
Zero-based budgeting: Each activity within the budget starts at base of zero, and every item added has to be justified.
Budgetary Slack: Problem where managers will build "cushion" into their budget. Problem: do not get a true picture of what is expected for the following year.
Scenario planning: Management accounting tool used to create possible scenarios based on changing assumptions in the business environment (which can include both internal and external factors).
Flexible Budget: A budget that changes as a result of a change in activity level. (Discussed more in Chapter 11).
Rolling Forecast: The number of periods of a budget stay constant (for example, 12 months) but the forecast is continually updated or "rolling forward". The budget is continually re-evaluated and updated on a rolling basis, rather than 1x per year.
Management by Exception: Only look at important differences between actual and budget. Could be favorable or unfavorable differences. Use information to control or take corrective actions, if necessary.
Must use budgets to have a plan and to evaluate against actual results to assist in making a better plan; budgets should not be used as a tool for punishing managers but rather to assist them in assessing their unit's performance. Can cause behavioral issues (such as budgetary slack) if managers perceive budgets as being used in a punitive way. Budgets should only be one tool that is used to evaluate management performance.
See videos throughout the etext that show you how to prepare each budget.
Also, see the extra problems for practice!
Centralized Operations: All decisions on day-to-day operations are made in central location, usually by just a few individuals
Decentralized Operations: Operations are split into different divisions or departments. Top management delegates decision making to unit managers for day to day running of the organization; top management tends to focus on long term, strategic decisions.
Advantages of decentralization include:
Frees top management time
Supports use of expert knowledge
Improves customer relations
Provides training
Improves motivation and retention
Disadvantages of decentralization include:
Duplication of costs
Problems achieving goal congruence
Can have communication problems across the organization
Responsibility Accounting: System for evaluating performance of each responsibility center and its manager. Compares budgets with actual results.
Types of responsibility centers include:
Cost center: Manager is only responsible for expenses within his or her own cost center.
Expense focus only. Comparisons are made between actual expenses and budgeted expenses.Revenue center: Manager is primarily focused on increasing revenues. Could be responsible for the costs of their own sales operations.
Profit Centers: Managers are accountable for both revenues and expenses within their center.
• investment center: Manager are in charge of investments
Management by Exception: Only look at important differences between actual and budget. Could be favorable or unfavorable differences. Use information to control or take corrective actions, if necessary.
Must use budgets to have a plan and to evaluate against actual results to assist in making a better plan; budgets should not be used as a tool for punishing managers but rather to assist them in assessing their unit's performance. Can cause behavioral issues (such as budgetary slack) if managers perceive budgets as being used in a punitive way. Budgets should only be one tool that is used to evaluate management performance.
Why have performance evaluation systems? Performance measurement provides a framework for top management to maintain control over the organization. Why do it?
Promotes goal congruence and coordination
Communicates expectations
Motivates Unit Managers
Provides feedback
Benchmarking: Compare against other units, other companies in same industry, or market
"leaders"
Limitations on Financial Performance Measurement
Tendency to focus on short-term achievements
Tends to be a lag indicator (focused on past financial results) rather than lead indicators (current financial indicators that could signal what things will look like in the future)
Performance Reports: Help to evaluate financial performance of each of the responsibility centers
Cost Centers: Focus on flexible budget variances from actual vs. the flexible budget, given the level of activity.
Management by exception: Determines what variances are worth the time and energy to investigate!
Investigate both favorable and unfavorable variances. Need to understand why significant variances have occurred.
Revenue Centers: Look at both the flexible budget variance for sales (different sales $ given the flexible budget sales) and the sales volume variance (based on actual units sold vs. static budget). Need to understand both price and quantity variances!
Profit Centers: Also looks at flexible budget variances for both sales and revenues. Usually also has a component allocated to the unit for support level charges. (H/R, accounting, etc.)
Performance reports for profit centers and investment centers are oftentimes prepared in a contribution margin income statement style. Separate direct fixed expenses (calculating a segment margin) vs. common fixed expenses, which cannot be traced to individual cost centers, etc.
Investment Centers: Look at maximizing income on invested assets.
Financial evaluation must measure:
Income generatedEffective use of center's assets
Performance measures:
Return on investment (ROI)Residual income (RI)
Return on Investment: Calculates how much income and investment center generates relative to the size of its assets. Computed by: Operating Income/Total Assets.
Residual Income: Has the investment center created any residual income?
Residual Income = Operating income - (Target rate of return x Total assets). A positive number
indicates that the investment center exceeded management's expectations, A negative number means they did not meet the target rate of return.
Drawbacks of performance management:
Short-term focus by using ROl and RI calculations
May hurt company's long term competitive advantages, etc. if only manage by short-term performance measures.
Product life cycles could have a slow start (even incurring losses in earlier years) - managers may be hesitant to invest in new things if being evaluated on short-term basis only.
Transfer Pricing: When one division or subsidiary from a company "buys" products or services from another division or subsidiary of the company. The price charged for the internal sale is the transfer price. Setting a reasonable transfer price affects the operating income, ROl, sales margin, and residual income of each division affected, so setting a fair transfer price is necessary. The "sale" should take place only if it makes sense for both sides of the transaction! Possible strategies for determining transfer pricing include:
Market Price - if outside market exists
Negotiated Price - negotiated between buying and selling division; buying division trying to minimize cost, selling division trying to maximize revenues
Cost - variable cost or possible variable cost plus a markup percentage, assuming there is excess capacity. Less incentive to control costs on the selling side, also problem determining fair markup %
Purpose of Budgets:
Planning: Implement strategic plans and estimate revenues and expenses that will be incurred to help meet its goals
Control: To review actual results to budgeted results and use information to make any corrections or adjustments necessary.
Control includes analysis of why actual results differ from budgeted results. Managers use this information to identify problems and take corrective actions.
Static Budget: Budget that is prepared with one planned level of sales volume. Once it is prepared, the budget does not change!
Flexible Budget: Summarized budgets for different levels of sales volumes; allows managers to analyze what costs should have been related to actual sales numbers. Managers need to understand cost behavior to prepare these! (Variable costs vary in direct proportion to sales volume, but fixed costs remain the same within the relevant range)
Variance Analysis: Compares actual amounts (revenues and expenses) against budgeted amounts.
Variances can be Favorable (F) or Unfavorable (U).
Sales Volume Variance: Difference between the static budget for sales volume and the flexible budget (based on number of outputs). The variance arises only because the number of units sold is either more or less than what was budgeted in the static budget.
Flexible Budget Variance: Difference between the flexible budget (what revenues and costs SHOULD HAVE BEEN at a given activity level) vs. the ACTUAL results. This variance occurs only because the company earned more or less (revenues - expenses) than expected for the ACTUAL level of output.
Both variances together = Static Budget Variance
The Balanced Scorecard:
Developed by Kaplan and Norton in the early 1990s
Recognized management needed to focus on both financial and nonfinancial measures when evaluating an organization's effectiveness
Link these measures with the goals and strategies of the organization to determine company performance
Stressed that if do the other three aspects well, financial profitability will be the end result Different focus from previously, where analyzed past financial performance and just made adjustments... this much more forward looking
4 aspects include:
Employee's Learning and Growth
Operational Efficiency/Internal Business
Customer Satisfaction
Financial profitability
Planning: Implement strategic plans and estimate revenues and expenses that will be incurred to help meet its goals
Control: To review actual results to budgeted results, and use information to make any corrections or adjustments necessary
Control includes analysis of why actual results differ from budgeted results. Managers use this information to identify problems and take corrective actions.
Standard costs: What the cost of a unit SHOULD be. Can have quantity standards and price standards.
Types of standards include:
Ideal standards: based on perfect conditions (not realistic!)
Perfection standards: Do not allow poor quality raw materials, waste, inefficiencies (best used by companies in a lean environment)
Practical standards: develop standards based on currently attainable conditions
How do managers set standards?
Consider historical costs, quantities, etc.
Consider current costs for inputs, labor, negotiated prices or negotiated purchase commitments,
Try to estimate future impacts on standards (costs, time, technology, etc.)
Standard Costing and Variance Analysis: Used by management to further isolate why costs differ from expected results! Standards are used to prepare the flexible budgets.
To isolate cost variances in more detail, companies look at direct materials, direct labor, and manufacturing overhead (both price and quantity variances) to analyze variances and make better decisions on how to control costs.
Benefits of Standard Costing:
• Allows managers to use management by exception
Provides a basis for reasonable cost comparisons
Provides a means of evaluating performance of employees
Provides motivation to employees to adhere to standards
Results in more stable product costs
Should variance analysis be used in evaluating performance? Should be used to raise questions and help make better decisions - not to penalize managers.
Some variances can be caused by factors that management cannot control (i.e. economic downturn)
Variances could be result of inaccurate or outdated standards
Can make "trade-offs" among variances
Evaluations based solely on variances can encourage managers to take a "short run" approach to cost cutting, etc. at the expense of the company's long-term goals.
Should consider looking at financial and non-financial measures when evaluating performance
Standards are used at the beginning of the period, to help develop budgets. Standards are then used after the actual results are posted (along with flexible budgets) to perform variance analysis. This helps management evaluate performance and identify areas of possible improvement.
The following are variance analysis tools:
Direct Materials Price Variance ($): (AP-SP) x Purchased Quantity (PQ) -
Direct Materials Quantity Variance #): (AQ-SQ) SP -
Direct Labor Rate Variance (S): (AR-SR) x AH - Paid workers?
Direct Labor Efficiency Variance (#): (AH-SH) × SR
Variable Overhead Spending Variance ($): (AP-SP) x AH
Fixed Overhead Budget ($): Actual $ - Budgeted $
Variable Overhead Efficiency Variance (#): (AH-SH) x SR
Fixed Overhead Volume Variance (#): Budget - Applied (based on predetermined OH rate)