Professional Documents
Culture Documents
Foundations of
Management Accounting
Chapter 1
Chapter 2
Chapter 3
Chapter 4
Chapter 5
Chapter 6
Management Accounting
|1
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
Concepts
Fixed and variable costs
Escapable and inescapable costs
Relevant costs
Incremental costs
Sunk costs
Opportunity costs
Common costs
Direct and indirect cost
Contribution margin
Planning
Control
Standards
Organization
From the above listing, it is apparent that the subject matter of management
accounting has little to do with transactions analysis and the preparation of statements
from historical data. However, management accounting is not independent of financial
accounting. Financial accounting is a foundation requirement for management
accounting and a study of financial accounting must precede the study of management
accounting. The basic carryover from the study of financial accounting is a solid
understanding of financial statements. An understanding of how to analyze and
record the effects of individual transactions of assets, liabilities, capital, and revenue
is helpful but not essential.
Management: The Focal Point of Management Accounting
The term management accounting obviously consists of two words each of which
represents highly developed areas of study. The term management accounting
suggests an important relationship between management and accounting.
Management Accounting
|3
President
Marketing
Department
Production
Department
Finance
Department
Accounting
Department
Management Accounting
|5
Financial
Instiltutions
Business Firms
Labor Unions
Consumers
Business
Professions
Investors
President
Financial Accounting
Accounting System
Production
Marketing
Balance
Sheet
Income
Statement
Finance
Cash Flow
Statement
Jourlnals
General Ledger
Accounting
Special Journals
Auditing
Cost Accounting
Systems
Budgeting
Payroll
General
Accounting
Assumptions
Management Accounting
Accounting Department
Accounting transactions are processed by means
of journals, accounts and ledgers. Now done
primarily by use of accounting software and computers.
Outputs
Income Statement
Balance Sheet
Statement of Cash Flows
Other types of financial reports
Accounting Department
Data for decision-making and performance
evaluation are processed by means of budget
models, forecasting models, cost analysis
techniques, etc.
Outputs
Operating budgets
Capital budgets
Flexible budgets
Special reports (graphic, tables)
Summaries and Schedules
Segmental income statement
|7
1. CASH
What is the balance?
Emphasis is on:
General journal entries,
bank reconciliations, petty cash.
1. CASH
How much cash should be on hand?
Emphasis is on:
Cash budgeting, cash flow, alternative
uses of cash.
2. ACCOUNTS RECEIVABLE
What is the amount that is collectible?
Emphasis is on:
Estimation of bad debts, factoring,
recording of collections.
3. ACCOUNTS RECEIVABLE
What should the credit terms be?
Emphasis is on:
Effect of different credit terms, bad debt
factors, analysis of credit revenue and
expenses.
3. INVENTORY
What is the historical dollar amount that
should be assigned to inventory?
Emphasis is on:
Inventory cost methods, methods of
estimating inventory.
3. INVENTORY
What is the optimum level of inventory?
Emphasis is on:
EOQ models, safety stock, quantity
discounts.
4. FIXED ASSETS
What is the unamortized amount?
Emphasis is on:
Depreciation methods, journal entries or
trades and retirements.
4. FIXED ASSETS
How much plant and equipment is
needed?
Emphasis is on:
Capacity requirements, capital
budgeting, replacement of equipment.
5. SHORT-TERM DEBT
What amount is owed?
Emphasis is on?
Recording accrued liabilities and interest
expense.
5. SHORT-TERM DEBT
How much short-term debt is needed?
Emphasis is on:
Cost of capital, debt/equity ratios, cash
budgeting, and risk.
6. LONG-TERM DEBT
What amount is owed?
Emphasis is on:
Amortization of bond premium and
discount, accrued interest, and bond
refunding.
6. LONG-TERM DEBT
How much long-term debt should be
issued?
Emphasis is on:
Cost of capital, debt/equity ratio, cash
budgeting, issuance of different types
of securities.
Management Accounting
7. STOCKHOLDERS EQUITY
What is the amount of stock issued?
How should different types of stock
transactions be recorded?
Emphasis is on:
Recording different types of stock
transactions, recording of different types
of dividends.
7. STOCKHOLDERS EQUITY
How much stock should be issued?
What kind of stock security should be
issued?
Emphasis is on:
Cost of capital, debt/equity ratio, cash
flow, and amount of dividends.
8. SALES
How much were sales?
Emphasis is on:
Recording of sales and purchases
transactions.
8. SALES
What will the amount of sales be?
Emphasis is on:
Sales forecasting, pricing, cash
budgeting, methods of increasing
sales.
9. EXPENSES
How much were expenses?
Emphasis is on:
Journal entries, accrued expenses,
depreciation, bad debts.
9. EXPENSES
What should the amount expenses be?
Emphasis is on:
Budgeting, flexible budgeting costvolume-profit analysis.
|9
Q.1.1
List six examples of tools that the management accountant could use
to help management to make decisions.
Q.1.2
Q.1.3
Q.1.4
Q.1.5
Management Accounting
Statement/item
1
10
11
12
13
14
15
16
17
18
19
20
Financial
Accounting
Management
Accounting
| 11
10
Financial
Accounting
Management
Accounting
Management Accounting
General Ledger
Cost-volume-profit tool
Accounts
10
11
12
Subsidiary ledgers
13
14
15
16
17
18
19
20
Financial
Accounting
Management
Accounting
| 13
Management Accounting
| 15
Board of
Directors
President
Vice-President
Marketing
Manager
Cutting Dept
Vice-President
Production
Manager
Finishing Dept.
Vice-President
Finance
Manager
Finishing Dept.
Accounting
Department
Income
Statement
Balance Sheet
Management Accounting
the major assumptions will be detailed below. Five categories of assumptions will be
presented:
1. Basic goals
2. Role of management
3. Nature of Decisionmaking
4. Role of the accounting department
5. Nature of accounting information
Basic Goal Assumptions - The basic goals or objectives the business enterprise
may be multiple. For example, the goal may be to maximize net income. Other goals
could be to maximize sales, ROI, or earnings per share. Management accounting
does not require a specific of type of goal. However, whatever form the goal takes,
management will at all times try to achieve a satisfactory level of profit. A less than
satisfactory level of profit may portend a change in management.
Role of Management Assumptions - The success of the business depends
primarily upon the skill and abilities of managementwhich skills can vary widely
among different managers. The business is not completely at the mercy of market
forces. Management can through its actions (decisions) influence and control events
within limits. In order to achieve desired results, management makes use of specific
planning and control concepts and techniques. Planning and control techniques
which management may use include business budgeting, costvolumeprofit
analysis, incremental analysis, flexible budgeting, segmental contribution reporting,
inventory models, and capital budgeting models. Management, in order to improve
decisionmaking and operating results, will evaluate performance through the use of
flexible budgets and variance analysis.
Decisionmaking Assumptions A critical managerial function is decision
making. Decisions which management must make may be classified as marketing,
production, and financial. Decisions may also be classified as strategic and tactical
and longrun and shortrun. A primary objective of decisionmaking is to achieve
optimum utilization of the businesss capital or resources. Effective decisionmaking
requires relevant information and special analysis of data.
Accounting Department Assumptions The accounting department is a primary
source of information necessary in makingdecisions. The accounting department
is expected to provide information to all levels of management. Management will
consider the accounting department capable of providing data useful in making
marketing, production, and financial decisions.
Nature of Accounting Information - In order for the accounting department to
make meaningful analysis of data, it is necessary to distinguish between fixed and
variable costs and other types of costs that are not important in the recording of
business transactions. Some but not all of the information needed by management can
be provided from financial statements and historical accounting records. In addition to
historical data, management will expect the management accountant to provide other
types of data, such as estimates, forecasts, future data, and standards. Each specific
| 17
Marketing
Production
Pricing
Sales forecast
Number of sales people
Sales people compensation
Number of products
Advertising
Credit
Units of equipment
Factory workers wages
Overtime, second shift
Replacement of equipment
Inventory levels
Order size
Suppliers
Financial
Issue of bonds
Issue of stock
Bank loan
Retirement of bonds
Dividends
Investment in securities
Management Accounting
Cash, accounts receivable, inventory, fixed assets, accounts payable, etc. can be too
large or too small. Given this fact, then, for each item there must be the right amount
or optimum. It is managements responsibility to make the best decision possible
regarding each item on the financial statements. Gross mismanagement of any single
item could either result in the failure of the business or the downfall of management.
Following are some examples of decisions associated with specific financial
statement items:
Decision
Minimum level
Credit terms
Order size
Capacity size
Amount and interest rate
Income Statement Items
Sales
Salesmen compensation
Advertising
| 19
Decision items
Strategic Decisions
Tactical Decisions
Cash
Accounts receivable
Inventory
Price
Once a strategic decision has been made, then a specific management tool can be
used to aid in making the tactical decision. For example, if the strategic decision has
been made to avoid stock outs, then a safety stock model may be used to determine
the desired level of inventory.
Management Accounting
Decision
Price
Inventory order size
Purchase of new equipment
Credit terms
Sales people compensation
Quantitative Criterion
Maximum income
Minimum total inventory cost
Lowest operating costs
Maximum net income/sales
Minimum total compensation
| 21
Balance Sheet:
Cash
Accounts receivable
Inventory
Fixed assets
Cash budget
Capital budgeting models
Incremental analysis
EOQ models, Safety stock model
Incremental Analysis, Capital budgeting
Income Statement:
Sales
Expenses
Net income
Management Accounting
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Tools
Flexible budget
Variance analysis
EOQ models
Incremental analysis
Capital budgeting models
Costvolumeprofit analysis
Required Information
Variable cost rates
Standard costs
Purchasing cost, carrying cost
Opportunity cost, escapable costs
Future cash inflows, future cash
outflows
Variable cost percentage, fixed cost,
desired income
| 23
Strategic
Decisions
Tactical
Decisions
Tools
Management
Accounting
Information
Management Accounting
Tactical
Decisions
Management
Accounting Tool
Required
Information
Assets
Cash
Risk
Minimum
balance
Amount needed
Cash budget
Cash inflows
Cash outflows
Accounts
receivable
Credit
Credit terms
Incremental analysis
Additional sales
Additional ex
penses
Inventory
Materials
Risk
Quality
Risk
EOQ model
Purchasing cost
Carrying cost
Demand
Probability
distributions
Finished Goods
Safety stock
Safety models
Fixed Assets
Capacity
Purchase/
lease
Depreciation
methods
Rate of return
Capital budgeting
Cash inflows/out
flows
Present value
tables
Investments
Risk/
diversification
Number of
shares
Capital budgeting
Potential dividends
/ earnings
Accounts pay
able
Leverage
Amount to pay/
not pay
Cost analysis
Interest rate
Terms of credit
Notes payable
Leverage
Short-term vs.
long-term
Amount borrow/
repay
Interest rate/
lender
ROI analysis
Incremental analysis
Interest rate
Cost of capital
Bonds payable
Leverage
Short-term
versus
long-term
Shares to issue
Shares to retire
ROI analysis
Incremental analysis
Cost of capital
analysis
Interest rate
Cost of capital
ROI data
Common stock
Leverage / risk
Shares to issue
Amount needed
ROI analysis
Incremental analysis
Cost of capital
analysis
Cost of capital
Cost of issuing
ROI data
Retained
earnings
Internal
financing
Risk
Amount of
dividend
Type of dividend
Incremental analysis
Cost of capital
analysis
ROI data
Cost of capital
Liabilities
Stockholders
Equity
| 25
Tactical
Decisions
Management
Accounting
Tool
Required
Information
Sales
Market share
Growth
Price
Number of
territories
Credit
Additional
volume
Incremental
analysis
C-V-P analysis
Cost behavior
Demand curve
Fixed & variable
costs
(See exhibit 3)
Risk
Amount of
safety stock
EOQ model
Safety stock
model
Probability of
stock out
Purchasing costs
Carrying costs
Selling
Sales people salaries
Commissions
Sales people training
Travel
Advertising
Packaging
Bad debts
Sales office rentals
Office operating
Home office
Motivation/turnover
Salary
Number of
sales people
Commission
rate
Number of new
people
Incremental
analysis
C-V-P analysis
Price of product
Calls per month
Fixed and vari
able costs
Sales forecast
Market potential
Bad debt prob
ability
Effective service
Turnover
C-V-P analysis
Gross profit
Expenses
Net income
Motivation/turnover
Risk/volume
Risk
Amount of
advertising
Bad debt
estimate
Amounts of
salaries
Management Accounting
Tactical
Decisions
Management
Accounting Tool
Required
Information
Lead time
Demand
Budgeted pro
duction
Suppliers
Order size
Number of orders
Sales forecast
Budgeted production
Incremental analysis
EOQ model
Carrying cost
Purchasing cost
Demand
Suppliers
Incremental analysis
Quantity discount
schedule
List prices
Materials Used
Materials (BI)
Material
Purchases
Quality
Standards
Freight-in
Direct labor
Productivity
Motivation
Capacity
Industry repu
tation
Wage rate
Number of
workers
Second shift/
overtime
New equipment
Incremental analysis
Business budgeting
C-V-P analysis
Variable
manufacturing
overhead
Capacity
Keep or replace
Wage rates
Incremental analysis
Capacity
Keep or replace
Incremental analysis
C-V-P analysis
Utilities
Capacity
Keep or replace
Incremental analysis
Production
planning
Capacity
Incremental analysis
Purchasing &
receiving
Capacity
Incremental analysis
Factory
insurance
Capacity
Incremental analysis
Depreciation,
equipment
Capacity
Incremental analysis
Deprecation,
building
Capacity
Incremental analysis
Factory supplies
Capacity
Incremental analysis
Keep or replace
| 27
Q. 2.1
Q. 2.2
Q. 2.3
What type of financial goals may management set for the business?
Q. 2.4
Q. 2.5
Q. 2.6
Q. 2.7
Q. 2.8
1.
2.
3.
4.
5.
6.
7.
Business Budgeting
Cost-volume-profit analysis
Flexible budgeting
Return on investment analysis
Segmental contribution income statements
Economic order quantity model
Incremental analysis
Management Accounting
10
11
12
13
14
15
Tactical Decision
| 29
Helpful information
Types of Information
1. Increase in price
A. Fixed expenses
2. Increase in advertising
C. Demand curve
6. Closing of a territory
H. Escapable expenses
I. Inescapable expenses
J. Cost of capital
K. Direct costs
L. Indirect costs
M. Price of product
N. Quantity discount schedule
O. Cost of equipment- different
suppliers
Management Accounting
Revenue
Sales
Interest Income
Rental income
Asset Inflow
Cash or Accounts receivable
Cash or interest receivable
Cash or rent receivable
| 31
Asset outflow
Prepaid insurance
Expired life of the service value
Supplies
Expired cost of a building
Technically, the asset outflow associated with salaries is not cash. Payments are
made to workers and other employees because they create something of value. In
more technical terms an expense is the expired value of an asset. A janitor is paid
to clean floors. The thing of value acquired is a clean floor and as long as the floor
remains clean, it is something of value. However, when the clean floor becomes dirty
again, then the value of the clean floor asset has expired. Because many assets have
a very short life, the accountant often simply records the expense even though the
value of the assets at the time of recording has not yet expired.
Often the acquisition of an asset is not paid for immediately and the amount then
owed is called a liability. Liabilities are debts or obligations to pay at some future date
and are a common form of financing in a business. There are three primary sources
of assets in a business: (1) revenues (2) liabilities (3) capital. The five key words
from an accounting viewpoint and also from a management viewpoint are assets,
liabilities, capital, revenue, and expenses.
In one sense, the purpose of management is to make asset, liabilities, capital,
revenue, and expense decisions. Since the income statement shows revenues,
expenses and net income and the balance sheet shows assets, liabilities, and capital,
we can say that the purpose of management is to manage assets, liabilities, capital,
revenue, and expenses. Stated simply, the purpose of management is to manage
financial statements.
Because of the importance of sound operations and financial condition, it is critically important for both management and accountants to have a sold understanding
of financial statements. While accountants prepare financial statements, it is management that creates financial statements through the decisions it makes. Because of
the importance of financial statements, the rest of this chapter is concerned with
presenting the fundamentals of financial statements for a manufacturing business.
The four financial statements of critical value in this text are as follows:
1.
2.
3.
4.
Balance sheet
Income statement
Cost of goods manufactured statement
Statement of cash flow
Management Accounting
Depreciation
Direct cost
Dividends
Finished goods
Fixed assets
Factory labor
Fixed cost
Gain/loss on sale
Gross profit
Indirect cost
Inventory
Income taxes
Investment
Manufacturing overhead
Material used
Net income
Net operating income
Net income after taxes
Perpetual inventory
Periodic inventory
Retained earnings
Premium/discount on stock
Premium/discount on bonds
Stockholders equity
Tax expense
Treasury stock
Trade-in value
Variable cost
Hopefully, you have learned these terms in a previous accounting course and
only some review of these terms is needed.
In addition to terminology, there are some accounting concepts and conventions
of a broader nature that involve theory and even, in some cases, considerable
differences of opinion. Some of the important concepts involved in this book are
shown as follows.
Accounting Concepts
Absorption costing
Accrual basis accounting
Accounting control
Cash basis accounting
Cost
Control
Deferred charges
Direct costing
Earned/unearned revenue
Inventory costing methods
Matching
Planning
Standards/principles of accounting
Full costing reporting
Contribution basis reporting
| 33
Management Accounting
$1,940,160
4,892,160
__________
6,832,320
2,065,114
__________
4,767,206
2,787,840
323,424
__________
$7,878,470
___
_________
________
Units manufactured
Cost
per unit
57,027
$138.16
_________
________
___
V. K. Gadget Company
Balance Sheet
Dec. 31, year 1
Assets
Current Assets
Fixed assets
Other assets
Total Assets
Liabilities
Current liabilities
Long-term
Total liabilities
Stockholders Equity
Common stock
Premium on common stock
Retained earning
Total stockholders equity
Total liabilities and equity
V. K. Gadget Company
Income Statement
For the 4th quarter, Year 1
Sales
$17,123,428
Cost of goods sold
7,878,470
Gross profit
9,244,958
Expenses
Selling
8,733,425
General and Admin.
924,313
Fixed mfg. overhead
1,889,574
Total expenses
11,547,312
Net loss
($1,448,912)
V. K. Gadget Company
Statement of Cash Flow
For the quarter Ended, Dec. 31, year 1
$3,731,277
6,400,000
-0
$10,131,277
5,630,523
-0
$5,630,523
-0Cash flow from financing activities
Sources
-0Uses
-0
-0
$6,000,000
1,000,000
(2,499,246)
$4,500,754
$10,131,277
Sources
Uses
$ 17,123,428
17,123,428
| 35
Decision(s)
Information
Required
Material
Supplier A, B, C, or D
Order size, material X
Number of orders, material X
Order size, material Y
Number of orders, material Y
List prices
Quantity discounts
Carrying cost
Cost of placing an order
Units of equipment
Wage rate function
Production budget
Manufacturing overhead
Capacity required
Management Accounting
Decisions
Information Required
Sales
Price
Credit terms
Advertising
Commission rate
No. of sales people
Sales people salary
Demand schedule
Sales-calls function
Advertising rates
Commission rate function
Calls per quarter
Advertising budget
Advertising cost
Demand curve
Sales people compensation
function
Credit terms function
Credit department expenses
Operating costs
Expenses
Advertising
Sales people
compensation
Credit expense
Depreciation
Depreciation rates
Bad debts
Credit terms
Interest expense
Bank loans
Issue of bonds
Line of credit
Interest rate
Cost of capital
Discount rate
| 37
Procedure
Average costing
Average costing
Depreciation of equipment
Straight-line
Income format
Income taxes
Bond discount
Management Accounting
8.
9.
10.
11.
13.
14.
15.
16.
Incremental analysis
Inventory management analysis
Keep or replace analysis
Performance evaluation
Return on investment
Sales people compensation analysis
Segmental contribution reporting
Wage rate analysis
If your instructor has adopted this simulation in connection with this text book,
then hopefully your participation in The Management/Accounting Simulation
will give you an experience that will solidly persuade you that in any business the
accounting department is a vital function in the process of decisions being made
and executed. With a proper attitude on the part of accounting towards management
and management towards accounting, the likelihood of better decisions and a more
successful business is greatly increased.
Comparison of Merchandising and Manufacturing Businesses
In order to understand financial statements for a manufacturing business, as a
student you first need a good understanding of financial statements for a merchandising
business. In general, merchandising and manufacturing statements are the same, In
fact, in terms of basic components they are identical.
Figure 3.5
Retail Business
Manufacturing Business
Income Statement
Income Statement
1. Sales
2. Cost of goods sold
3. Gross profit
4. Expenses
5. Net income
$100,000
60,000
40,000
10,000
$ 30,000
1. Sales
2. Cost of goods sold
3. Gross profit
4. Expenses
5. Net income
$100,000
60,000
40,000
10,000
$ 30,000
The major difference is in the need to know how to compute cost of goods
manufactured as seen in the following comparison.
| 39
Manufacturing
$15,000
75,000
90,000
30,000
$60,000
$15,000
75,000
90,000
30,000
$60,000
Materials used
Factory labor
Manufacturing overhead
Manufacturing costs incurred this period
Work in process inventory (B)
Total manufacturing costs to be acct. for
Work in process inventory (E)
$ 20,000
35,000
25,000
80,000
20,000
100,000
25,000
$ 75,000
The purpose of the cost of goods manufactured statement is to compute the cost
of goods completed or finished in a given time period. The cost of goods manufactured
is the cost of goods finished this period. Cost of goods manufactured consists of three
basic cost elements: (1) materials, (2) factory labor, and (3) manufacturing overhead.
Materials used is a computation:
Management Accounting
Materials Used
1. Materials inventory (B)
2. Material purchases
$ 5,000
25,000
30,000
10,000
$20,000
Materials available
3. Materials inventory (E)
There are two types of inventory systems that may be used in a manufacturing
business: (1) periodic and (2) perpetual. If a periodic inventory system is used, then it
is necessary to compute materials used. If perpetual inventory is used, the inventory
system keeps an accurate perpetual record of materials used and, consequently, it
is not necessary to compute materials used. A record in the cost accounting system
called Materials Used Summary is to record each use of material.
Balance Sheets: Merchandising and Manufacturing Compared
The balance sheet of a manufacturing business in terms of basic elements is
identical to the balance sheet of a merchandising business. The only difference
is in one area, the current asset section. Instead of one inventory account, the
manufacturing business has three inventory accounts:
Merchandising Business
1. Assets
Current assets
Cash
$ 50,000
Accounts receivable
30,000
Merchandise inventory
65,000
Fixed assets
$ 55,000
$200,000
2. Liabilities
Current liabilities
Long-term liabilities
3. Stockholders Equity
Paid-in capital
Retained earnings
$ 20,000
30,000
30,000
120,000
$200,000
Manufacturing Business
1. Assets
Current assets
Cash
Accounts receivable
Inventory
Work in process
Materials
Finished goods
Fixed assets
2. Liabilities
Current liabilities
Long-term liabilities
3. Stockholders Equity
Paid-in capital
Retained earnings
$ 50,000
30,000
25,000
10,000
30,000
55,000
$200,000
$ 20,000
30,000
30,000
120,000
$200,000
| 41
The most common of these three types of transactions are the following:
1. Purchase of raw materials
2. Freight on material purchased
3. Material returns and allowances
4. Incurrence of direct factory labor
5. Incurrence of manufacturing overhead
Journal Entry
Debit
Material purchases
Accounts payable
120,000
Freight-in - materials
Accounts payable
2,000
Accounts payable
Material returns
5,000
200,000
50,000
Manufacturing overhead
Accounts payable
Factory utilities $5,000
Repairs and main. $3,000
Factory insurance $4,000
Factory supplies $1,000
13,000
2,000
Credit
120,000
2,000
5,000
250,000
13,000
2,000
Management Accounting
177,000
Accounts receivable
4,000
Materials inventory
6,000
8,000
12,000
50,000
Credit
5,000
Accounts payable
9,000
Common stock
40,000
Retained earnings
100,000
Sales
500,000
Material purchases
120,000
Materials returns
5,000
Freight-in materials
200,000
Manufacturing overhead
65,000
8,000
2,000
5,000
659,000
659,000
Additional information:
Materials inventory (ending)
Work in Process (ending)
Finished goods (ending)
2,000
$ 8,000
$12,000
$11,000
| 43
Based on this adjusted trial balance, the end-of-period entries for manufacturing
costs would be as follows:
General Journal - End of Period Entries
Date
Dec. 31
Debit
Cost of good manufactured
Materials return
Dec. 31
131,000
5,000
Materials inventory
Materials purchases
120,000
Materials - freight in
2,000
Work in process
8,000
6,000
200,000
200,000
65,000
Manufacturing overhead
Dec. 31
Materials inventory
Work in process
65,000
8,000
12,000
Credit
20,000
388,000
12,000
376,000
Management Accounting
General Journal
Date
Dec. 31
Finished goods
Debit
11,000
Sales
11,000
500,000
Income Summary
Dec. 31
Income Summary
500,000
452,000
377,000
50,000
20,000
Office supplies
Dec. 31
Credit
Income Summary
5,000
48,000
Retained earnings
48,000
Step 2
Step 3
| 45
Step 5
Step 6
Step 7
Please note that the above steps assume that making journal entries and posting
are part of the same step.
Summary
In many respects, the financial statements of a manufacturing firm are similar
to those of a retail type business. However, the existence of certain transactions
concerning material, labor and overhead means that a manufacturing firm does
have basic differences concerning inventory. Whereas a retail firm has one inventory
account, typically called merchandise inventory, a manufacturing business has three
basic inventory accounts: raw materials, work in process, and finished goods. In
addition, because the cost of goods manufactured is critical, a manufacturing firm
typically has a statement called cost of goods manufactured. The accounting for
overhead in a manufacturing firm involves many complexities. The theory of accounting
for manufacturing overhead is usually taught in courses in cost accounting. Except
when necessary, the complexities of manufacturing overhead are not discussed in
this text
Q. 3.1
Q. 3.2
Q. 3.3
Q. 3.4
Q. 3.5
Q. 3.6
Q. 3.7
How does the current asset section of the balance sheet for a
manufacturing business differ from the current asset section of the
balance sheet for a retail business?
Management Accounting
Manufacturing Business
$ 10,000
$ 50,000
$ 12,000
$ 1,000
$ 200,000
$ 20,000
$ 50,000
Cash
Accounts receivable
Cost of goods manufactured
Finished goods (beginning)
Finished goods (ending)
Selling expenses
$ 20,000
$ 60,000
$ 150,000
$ 25,000
$ 15,000
$ 60,000
Based on the above information, compute cost of goods sold for both types of
businesses. Some of the above information is not required.
$90,000
Factory labor
$60,000
Manufacturing overhead
$30,000
$25,000
$10,000
Freight-in, Materials
$ 5,000
Selling expenses
$85,000
$30,000
$15,000
$20,000
| 47
$ 50,000
$ 30,000
$ 25,000
Materials used
$ 70,000
Factory labor
$ 45,000
Manufacturing overhead
$ 30,000
$ 11,000
$ 5,000
Cash
$ 40,000
Selling expenses
$ 35,000
$ 25,000
Accounts receivable
$ 15,000
$ 60,000
$ 100,000
$ 10,000
Cash
$ 80,000
$ 15,000
$ 55,000
Accounts payable
$ 15,000
Bonds payable
$ 60,000
Retained earnings
$ 80,000
Common stock
$ 120,000
Payroll payable
$ 20,000
$ 20,000
$ 15,000
$ 80,000
$ 10,000
Management Accounting
Credit
Cash
11,700
Accounts receivable
400
Materials inventory
2,600
1, 800
1,200
5,000
500
Accounts payable
8,600
Common stock
6,000
Retained earnings
11,000
Sales
40,000
13,600
Material purchases
11,900
2,000
Freight-in materials
1,100
200
5,800
5,500
2,300
Additional information:
Materials inventory (ending)
Work in Process (ending)
Finished goods (ending)
1,000
66,100
66,100
$ 2,800
$ 3,200
$ 2,100
Continued on following page
| 49
Management Accounting
| 51
Depending on the type of activity and the passage of time, the cost of an asset in
accounting can be classified in several ways. Proper financial reporting and correct
decisionmaking require an understanding of the different ways in which costs can
be classified. In Figure 4.2 is a list of costs that pertain to both financial statement
preparation and decisionmaking analysis.
For purposes of management accounting, there are three important dual classifica
tions of cost that require some understanding: Expired and unexpired, manufacturing
and non manufacturing, and fixed and variable. These three classifications are
somewhat interrelated, particularly concerning financial statements.
Expired and Unexpired Costs
Expired costs or expenses are the used up value of assets. Expired costs are
always shown on the income statement as deductions from revenue. Expired costs
may be thought of as that portion of the asset value benefitting current operations.
It is helpful to think of expired costs as former assets values. To illustrate, supplies
expense is an expired cost. The cost allocated to supplies expense, of course, is
the used portion of supplies, an asset. The relationship between asset values and
expired costs is further illustrated in Figure 4.3.
Management Accounting
Figure 4.2
Financial Statements Cost Concepts
Direct and indirect
Prime
Joint
Fixed and variable
Manufacturing and non manufacturing
Expired and unexpired
Expenses
Fixed and variable expenses
Manufacturing Costs/Expenses
The difference between a cost and an expense is frequently misunderstood.
Because the terms variable costs and variable expenses will be used later in this
chapter, and also throughout this book, the difference in meaning between a cost and
a expense will now be clarified.
Technically, there is a difference between a manufacturing cost and a manufac
turing expense. The term manufacturing costs usually refers to material used, direct
labor incurred, and overhead incurred in a manufacturing business. Material used,
direct labor, and manufacturing overhead at the time incurred are not expenses; rather
they incurred costs. In the manufacturing process, material, labor, and overhead do
not expire; rather through manufacturing activity they become transformed from one
type of utility to another.
In a manufacturing business, the accountant will debit work in process for mate
rials used, direct labor incurred, and manufacturing overhead. Since work in process
is an asset account, it would not be logical to regard material used, direct labor, and
manufacturing overhead as expenses. Expenses cannot be transformed back into
asset values.
Figure 4.3
Asset Values and Related Expenses
Asset
Accounts receivable
Finished goods
Prepaid insurance
Supplies
Building
Expired
Bad debts expense
Cost of goods sold
Insurance expense
Supplies expense
Depreciation
| 53
Materials
Direct Labor
Work in Process
Manufacturing Overhead
Note: The flow lines denote journal entries at the end of the
accounting period to transfer cost.
Management Accounting
| 55
Date
Accounts
Debit
Dec. 31
100,000
250,000
20,000
50,000
Credit
Materials inventory
120,000
Factory labor
300,000
Example of Decisions
Manufacturing
Material
Labor
Manufacturing Overhead
Commission rate
Media, advertising budget
Salary, working hours
Management Accounting
Figures 4.6, and 4.7 present a type of income statement, cost of goods manufac
tured statement, and balance sheet commonly used in manufacturing businesses.
Certain income statement and balance sheet items have been identified by number.
Fourteen items have been selected. To test your understanding of each cost selected,
categorize the selected costs as follows:
1. Manufacturing
2. Non Manufacturing
3. Expired
4. Unexpired
5. Variable cost
6. Variable expense
7. Fixed cost
8. Fixed expense
Figure 4.6
Acme Manufacturing Company
Cost of Goods Manufactured Statement
Material used
(1)
Direct labor
(2)
Manufacturing overhead
(3)
Work in process
Total manufacturing costs
Work in process (ending)
Cost of goods manufactured (4)
$3,000
4,000
5,000
2,000
________
14,000
1,000
________
$13,000
___
_______
______
| 57
$20,000
2,000
13,000
15,000
3,000
Total assets
8,000
Liabilities
Accounts payable
Bonds payable
2,000
800
200
3,000
(9)
(10)
1,500
500
2,000
Total expenses
Net income
Assets
Cash
Materials
Work in process
Finished goods
Plant and equipment
12,000
Expenses
Selling
Sales people commissions (6)
Advertising
(7)
Rent
(8)
Administrative
Salaries
Supplies
5,000
(11)
(12)
(13)
(14)
$ 1,500
500
1,000
3,000
10,000
$16,000
2,000
5,000
$ 7,000
Stockholders equity
Common stock
Retained earnings
$ 8,000
1,000
Total liabilities and
stockholders equity
9,000
$16,000
$ 3,000
Management Accounting
Summary
The importance of understanding different kinds of cost in management
accounting can not be understated. Management accounting, as stated several times
before, consists of various decision-making tools. Each tool requires different kinds
of cost information. Without a good understanding of different kinds of cost and cost
behavior, it is highly unlikely any specific tool could be used in a meaningful way to
improve the quality of decisions.
The cost concepts that need to be understood in order to fully understand and be
able to use the various management accounting tools are the following:
1.
2.
3.
4.
5.
Q. 4.1
Q. 4.2
Q. 4.3
Q. 4.4
Q. 4.5
| 59
Materials
Non Manufacturing
Factory
Labor
Manufacturing
Overhead
Selling
Expenses
General and
Administrative
Executive salaries
Material X purchases
Factory supplies
Advertising
Depreciation, factory
equipment
Freight-in - material X
Finished goods
Supervision laborfactory
Factory labor,
assembling department
Secretarial salaries
Utilities, factory
Material Y purchases
Cash
Management Accounting
Item
1.
Interest expense
2.
Supplies
3.
Insurance expense
4.
Building cost
5.
Accounts receivable
6.
7.
Bad debts
8.
9.
Prepaid insurance
10.
Supplies expense
11.
Prepaid Interest
Expired cost
Unexpired Cost
2.
3.
Salaries of executives
4.
Compensation of accountants
5.
6.
7.
Executives compensation
8.
9.
10.
Variable Cost/expense
Fixed Cost/expense
| 61
Management Accounting
| 63
120000
250000
100000
200000
80000
150000
Cost
60000
40000
50000
20000
Volume
00
90
00
15000
70
10000
00
5000
50
00
0
00
100000
10
Cost
Economic Theory
30
Volume
The ability to identify and measure variable costs from historical cost data is often
important. The measurement of variable cost is enhanced by an understanding of why
some costs are variable in nature. Variable costs increase or decrease with activity
because there is a fixed relationship between a single unit of output and certain
Management Accounting
physical and cost factors. For example, assume that a furniture manufacturer makes
a table consisting of four 30 legs and a plywood top measuring 3x 5. Each leg costs
$2 and the plywood top can be purchased for $4.00. Therefore, due to the material
design specifications of the table, the material cost of each table manufactured is
$12( 4 legs x $2 + $4 for top). Assuming production increments of 100, at different
levels of production total material cost would be:
Cost per
Total Material
Production
Unit
Cost
100
$12
$1,200
200
$12
$2,400
300
$12
$3,600
400
$12
$4,800
Notice that the increase in total cost is directly proportionate to the increase
in volume. For example, an increase from 200 to 400 units (a 100% increase)
would result in a corresponding 100% increase in total cost. The physical material
specifications of the table design create a fixed relationship between a unit of product
( the table) and the amount of material used. As unusual as it may sound, it is this
fixed relationship that causes the direct variability of cost. For other types of variable
costs such as direct labor, there are similar fixed relationships.
Methods of Explaining and Presenting Cost Behavior
The concept of variable cost is obviously important to both accountants and
management. Communication of cost behavior from the accountant to management
is also critically important. The presentation of cost behavior may be done in three
ways: tabular, mathematical, and graphical.
Tabular presentation - A common method is to present cost behavior in the form of
a table. For example, in the illustration above cost behavior was presented in tabular
form. In terms of including more manufacturing costs at different levels of activity, the
table on the next page is an example of the tabular method.
The advantage of this method is that the variable cost at set intervals of activity
can be seen without first doing any math. However, some computations are necessary
when cost is needed at an activity level for which a special column does not exist.
Mathematical Presentation - Because in management accounting the relationship
between variable cost and volume is assumed, linear total variable cost may be
defined by the following equation:
TVC = V(Q)
(1)
Where:
V = variable cost rate and Q = quantity (units sold or units manufactured).
Mathematically, TVC represents the dependent variable and Q or quantity
represents the independent variable. Mathematically speaking, V may be called
the constant of variation.
Let V = $12 and Q = 1,000
Then TVC = 12(1,000) = $12,000
| 65
2,000
3,000
4,000
5,000
Material
$10
$10,000
$20,000
$30,000
$40,000
$50,000
Factory Labor
$ 8
$ 8,000
$16,000
$24,000
$32,000
$40,000
Manufacturing overhead
$ 5
$ 5,000
$10,000
$15,000
$20,000
$25,000
Total variable cost is completely determined by the variable cost rate and the level
of activity. Given a specified value for V, total variable cost for any level of activity can
be easily computed.
The key to understanding variable cost behavior is a knowledge of V, the variable
cost rate. V represents the average variable cost rate. The major assumption
underlying the equation, TVC = V(Q), is that regardless of the level of activity the
average variable cost rate will remain the same. From this assumption results the
linear relationship between volume and total variable costs. As long as V remains
unchanged, the effect of changes in volume will be direct and proportionate. In other
words, the relationship is linear. Regardless of how cost behavior is communicated,
the foundation of cost behavior remains at its core mathematical in nature.
Graphical Presentation The behavior of variable cost can be illustrated graphically.
As true of all mathematical equations, by assigning different values to Q, the
independent variable, the resulting dependent values can be plotted on a graph. To
illustrate, assume a variable cost rate of $12 and activity increasing in increments of
100. The graph in Figure 5.2 may be drawn:
Figure 5.2
Variable Cost Graph
TVC
100
200
300
400
$12
$12
$12
$12
1,200
2,400
3,600
4,800
7,200
Cost
4,800
2,400
0
200
400
Volulme (quantity)
2A
2B
600
Management Accounting
In Figure 5.2A, the relationship between volume and variable cost is shown
in tabular form. In many cases, management prefers to see costs is this fashion.
However, the graphical portrayal is more effective in demonstrating the theoretical
nature of variable costs from a management accounting viewpoint. The increase in
cost resulting from increases in volume can easily be visualized. It is interesting to
note that V, the variable cost rate, from a mathematical viewpoint measures the slope
of the total variable cost line. The greater the value of V the steeper the slope. The
affect on slope of the line for different values of V is illustrated in Figure 5.3. As the
rate increases, the slope also become steeper.
Figure 5.3
Variable Cost: Effect of change in slope of line
200000
Cost
150000
V = 12
V= 14
100000
V = 16
50000
0
0
5000
10000
150000
Volume (quantity)
Figure 5.4 B
Economic Theory: Average Fixed Cost
7.00
6.00
6.00
5.00
4.00
Cost
3.00
3.00
2.00
2.00
1.00
1.00
Volume (quantity)
10000
9000
7000
8000
5000
6000
3000
4000
9000
8000
7000
6000
5000
4000
3000
1000
2000
Volume (quantity)
1000
4.00
2000
Cost
5.00
| 67
Vm Vl Vo Vs Va -
In theory the variable cost rate, or V, also may be computed from historical data
by dividing the total variable cost by the related level of activity; that is, from a macro
point of view V = TVC / Q. However, in practice the computation of V in this manner
is not always easy. Very seldom is the total variable cost known without considerable
analysis of cost data at a subclassification or micro level. The computation of V is,
therefore, likely to be preceded by an analysis of variable cost in terms of material,
labor, manufacturing overhead, selling, and administrative costs. After measurement
of the individual rates, the aggregate rate is simply the sum of the individual variable
cost rates.
Illustration of Using Cost Behavior
The management of K. L. Widget Company is considering closing out a plant
that has been operating at a loss. Management is tentatively planning to increase
advertising and certain other fixed expenses that should increase sales to $300,000
or 15,000 units. The selling price of the Widget is currently $20.00. Fixed expenses
including the proposed increases is $110,000.
Variable costs have been determined to be:
Material (Vm)
Labor (Vl)
o
-
Variable M/O (V )
Selling (Vs)
a
Administrative (V )
$5
$3
$1
$3
$1
If the increased expenditures do not result in a profit, then the plant will be closed.
Should the proposed expenditures be made and the plant kept open?
Management Accounting
Analysis:
V =
$195,000
$110,000
Total expenses
$305,000
Net loss
($
5,000)
Decision: Close the plant as the plant would still operate at a loss. The computation
of total cost at the new level of activity is still greater than revenue.
Managerial Decisions and Variable Costs
An important point that needs understanding is that some costs are not inherently
fixed or variable but become one or the other by management exercising its
decisionmaking powers. Management has the discretionary power to make some
costs either variable or fixed. For example, sales people compensation can be either
fixed or variable. If management decides to reward sales people on the basis of a
commission, then sales peoples compensation is variable. If the basis for rewarding
sales effort is a salary, then sales peoples compensation is a fixed expense. If factory
workers are paid a wage rate, then factory workers compensation is variable. The
decision to pay workers a salary would make the factory labor compensation a fixed
cost in the short- run.
Some expenditures are unavoidably variable. For example, the direct use of
material will always be a variable cost. However, this per unit cost of material is to a
large extent controllable by the decisionmaking powers of management. The total
material variable cost may be defined by the equation:
TVMC = Vm(Q)
(2)
In this equation Vm, represents the variable material cost rate. Vm is the amount
of material cost incurred per unit of product manufactured. The variable material rate,
Vm,; however, is the result of two factors: units of material per unit of product and the
cost per unit of material. For example, if a product requires 6 units of material and the
material cost per unit is $2, then the material variable cost rate would be $12. Vm,
then, may be defined by the following equation:
Vm = Um x Cm
Where:
Um = number of units of material and Cm = cost per unit of material.
As this example illustrates, the number of units and the cost per unit are, within
limits, controllable by management. For example, in the manufacture of furniture the
variable cost rate for material could be decreased by the decision to use less material.
| 69
(3)
VL
In this equation,
represents the variable labor cost rate. It is the dollar amount
of labor incurred each time one unit of product is manufactured. As in the case of
material, VL is the result of two factorslabor hours per product and the wage rate.
For example, if a product requires two hours of labor and the wage rate is $10 per
hour, then the variable direct labor rate would be $20. VL then may be defined by the
following equation:
VL = HL x RL
Where:
HL denotes the standard hours per product and RL the wage rate.
The important principle to remember is that for most types of variable costs,
the factors that determine the variable cost rates can be identified. Furthermore,
in all cases these fixed factors, within limits, can be changed by explicit decisions
on the part of management. In Figure 5.5, a summary of the fixed factors for the
five classifications of variable costs is presented. In addition, managements ability
to affect the magnitude of the variable cost rates through decision-making is also
revealed. For example, management may be able to reduce the variable cost rate
for material by finding a supplier willing to sell the same grade of material at a lower
price.
Variable Cost Behavior and Linearity
In management accounting, the relationship between activity and total variable
cost is assumed to be linear. There are several reasons for this assumption.
First, mathematical equations involving curvilinear relationships can be quite
complex. Furthermore, fitting cost data to nonlinear equations may be difficult.
Although the use of nonlinear equations may be preferable, the use of linear equations
which are much easier to use has been found to be useful.
Also, in many cases, actual cost behavior for a significant portion of the activity
range tends to be linear. The use of standard measurements and automated equipment
in many cases results in a uniform rate of output. Within a relevant range of activity,
the cost per unit of output is the same. Consequently, the use of linear relationships
in management accounting is justified only in what is called the relevant range of
activity. If the cost per unit of output sharply changes outside of this range of activity,
Management Accounting
Figure 5.5
Material
units of material
cost per unit
(Um)
(Cm)
Vm = Um x Cm
Direct labor
(HL)
(R L)
VL = HL x RL
Overhead *
units of service
(Uo)
cost per unit of service (Cs)
Vo = Uo x Cs
Selling **
units of service
(Us)
cost per unit of service (Cs)
Vs = Us x Cs
Administrative
units of services
(Ua)
cost per unit of service (Cs)
Va = Ua x Cs
* Examples of units of overhead service include factory supplies, quarts of oil, kilowatt hours,
repair hours, etc.
** Examples of selling service units include supplies, credit checking time, wrapping
or packaging, accounting time, etc.
then the use of a constant average cost per unit values should be avoided. The
concept of the relevant cost range is illustrated in Figure 5.6.
Management Accounting Theory of Fixed Costs
In order to be used, many management accounting decision-making models
explicitly require that all costs be classified as either fixed or variable. On the surface,
it would appear that the measurement and use of fixed costs is fairly simple matter.
After variable costs have been measured, the remaining costs may be treated as
fixed. However, the very nature of fixed costs presents conceptual problems that far
exceeds those pertaining to variable costs.
While direct material and direct labor are variable in nature, manufacturing
overhead may be both variable and fixed. The accounting for fixed costs is at the same
time a problem of accounting for manufacturing overhead. An understanding of fixed
manufacturing overhead also requires an understanding of the concepts underlying
the setting of fixed overhead rates. Because of the complexity of accounting for fixed
manufacturing costs, two theories exist, absorption costing and direct costing. These
two approaches treat fixed manufacturing overhead quite differently.
Fixed costs provide capacity to manufacture or to sell. When actual activity is
less than capacity available, a major problem exist. Theoretically, the portion of
unused capacity cost should be measured as idle capacity cost and not treated as
| 71
Relevant Range
Relevant Range
A Fixed
Q
B Step
Despite the more realistic portrayal in Figure 5.6B, fixed costs are usually
illustrated as shown in Figure 5.6A. To justify the assumption of non variation of fixed
costs as illustrated in Figure 5.6A, the concept of the relevant range is used. As long
as activity remains within the relevant range, no harm is done by portraying step
costs as fixed over the entire range of activity. The relevant range may be defined as
that range of activity in which actual sales or production are likely to occur. Outside
of this range, fixed costs on the lower end of volume are smaller and outside of the
high end of the relevant range fixed costs are higher. However, the magnitude of
these costs outside the relevant range is not likely to be known; and even if known,
Management Accounting
they are irrelevant. Consequently, to draw fixed costs as in Figure 5.6A is a matter of
convenience rather than a portrayal of reality. In the following discussion, therefore,
you should remember that the definition and discussion of fixed costs actually refers
to the costs incurred within the relevant range of activity.
Another interesting aspect of fixed costs is that as soon as fixed costs exist, a
business automatically has a break even point. Conceptually, no business can report
net income until all fixed costs have been covered. Break even point analysis will be
discussed in detail in the next chapter.
Fixed costs are those cost that do not change with increases or decreases in
volume, that is, sales or production. In the short run, fixed costs such as rent and
salaries remain the same regardless of the level of activity. Fixed costs, unlike
variable costs which relate to activity, are timerelated costs. For example, rent is
always for a period of time such as a month or year. Likewise salaries also relate to
a period of time such as a month or year. Consequently, fixed costs are commonly
called period charges because these costs expire in the same time period in which
they are incurred.
While variable costs are incurred directly as activity takes place, fixed costs are
incurred in anticipation of providing services for an estimated level of activity, and,
consequently, the expenditure is contractually made or committed prior to actual
activity. Fixed cost expenditures are determined prior to the period of activity for a
defined quantity of service potential. Building rent, for example, reflects the right to
use a defined amount of floor space. The lease of equipment provides the right to
a defined number of operating hours per period. Fixed cost expenditures are then
capacity costs. An understanding of fixed costs requires an understanding of the
different facets of capacity. Fixed costs, therefore, make a range of production activity
possible.
The term capacity in the singular is somewhat misleading. Rather than use the
term capacity, a more accurate statement would be that fixed costs provide the
capacities to produce. Each type of fixed cost provides a different capacity service
and, unless management has exercised exceptional care in planning, the capacity
related to each cost might not be in balance. Imbalance in capacities created by fixed
costs can create bottlenecks or constraints in both production and sales.
Examples of different fixed costs and the corresponding capacities provided are
shown in Figure 5.7.
Figure 5.7 Examples of Fixed Cost and Capacities Provided
Type of Fixed Cost
Manufacturing:
Equipment lease/rent
Utilities
Insurance
Indirect labor
Service Provided
Material processing services
Heat, power, lights
Financial protection
Supervision of factory workers
continued on next page
| 73
As implied in the discussion above, fixed costs are those expenditures that are
not caused by activity but rather make activity or production possible. Fixed cost
provide both the ability or capacity to manufacture and also determine the limits to
production. For example, without the services provided by buildings, equipment, and
supervision production could not take place. Expenditures for fixed costs represent
the acquisition of the various capacities necessary for actual activity to take place.
The K. L. Widget Company has 15 machines capable of producing a total
of 15,000 units per quarter. One production supervisor is required for every
5 machines. Currently two supervisors are each paid a $10,000 salary. Five
machines are not in use because of a lack of a supervisor. The building which
the company rents has enough space to hold 20 machines. Consequently,
the company has a machine capacity of 15,000 units while it has supervision
capacity of 10,000 units. The building space capacity is adequate to manufacture
20,000 units.
This example illustrates that different types of fixed costs provide different types of
production services each of which provides a different capacity level. In this example,
there are three capacities: machine, supervision, and space. A major concern of
management is to have a balance or equality among the different ranges of capacity
services. Also, in this example, each type of fixed cost provide different output limits.
Actual production is limited to the lower of the three levels. Furthermore, production
cannot exceed 10,000 units, even though machine and space capacity is larger. A
major responsibility of management is to make those fixed cost decisions that create
a balance among the different types of capacity services.
In contrast to variable costs, fixed costs expire with the passing of time. Fixed
costs are expenditures that contractually provide services for a defined period of
time. At the end of the contract period, the services are no longer available without a
new contract or time commitment of resources by management.
For example, the decision to rent ten automobiles for a year provides management
with transportation services for a year. If one auto has the potential to be driven 200
miles a day, then ten autos for a year provide a capacity of 730,000 miles (200 x 365
x 10). At the end of the year, the years purchase of transportation has fully expired.
Management Accounting
The unused portion of miles driven cannot be transferred to the next year. The rent
expenditure for autos is the same whether or not the potential services are used.
The passing of each day proportionately reduces the service potential regardless of
whether activity is ongoing.
Inherent in the nature of fixed cost is the potential for idle capacity. Consequently,
from a management accounting viewpoint, the measurement of idle capacity is
important. The cost of idle capacity cannot be transferred to another period in the
manner in which unused material can be stored and used in a later period. The
constant relationship between fixed costs and capacity or volume can be explained
and illustrated from three points of view: tabular, mathematical, and graphical.
Tabular Presentation - The presentation of fixed costs in a table at different levels
of activity is basically unnecessary for the reason that regardless of the level of
activity the cost is the same. However, for illustrative purposes, a simple table of fixed
costs will be presented for three types of fixed costs common in all manufacturing
businesses:
Table of Fixed Costs
Volume (units of product)
1,000
2,000
3,000
4,000
Manufacturing
$ 50,000
$ 50,000
$ 50,000
$ 50,000
Selling expenses
$180,000
$180,000
$180,000
$180,000
$ 90,000
$ 90,000
$ 90,000
$ 90,000
(4)
Where:
TFC represents total fixed cost and F is the amount or magnitude of fixed costs for a
given period of time such as a quarter or a year.
The interpretation of this equation is that regardless of the level of activity, the
amount of fixed cost is totally independent of actual quantity. The importance of
defining fixed cost mathematically as presented in the above equation will be appre
ciated in a later section when fixed and variable cost are combined in a total cost
equation.
For some decisions such as price, a knowledge of cost per unit or average cost is
very important. Mathematically, average fixed cost may be defined as follows:
AFC = F/Q
(5)
where AFC represent average fixed cost and Q is the current level of activity; that is,
units manufactured or units sold. In the following section, the importance of average
fixed cost will be discussed and illustrated.
| 75
TFC
100
10,000 100.00
200
10,000
50.00
300
10,000
33.33
400
10,000
25.00
AFC
Q
Total Fixed Cost
Q
Average Fixed Cost
(6)
In practice, the amount of total fixed cost, F, will simply be the sum of the individual
fixed cost elements. Some of the techniques used to measure the individual fixed
rates will be discussed later in this chapter.
Management Control of Fixed Costs - An important point that must be understood
by both management and management accountants is that fixed costs are subject
to a high degree of control. The management accountant as well as management
must understand the consequences of making a cost fixed or variable. In order to
Management Accounting
understand the consequences of decisions that convert variable costs to fixed costs,
a more detailed discussion of capacity is required.
To illustrate the importance of the decision to make a cost either fixed or variable, the
following example is presented.
The Acme Retail Company is a new retail company. Ten sales people are required
to sell the product. The sales forecast indicates that average sales per sales person
should be $200,000. Management is contemplating a 10% commission versus a
salary of $20,000. How should sales people be compensated?
This is not an easy decision. There are important cost and psychological factors
involved. A commission is likely to motivate sales people, but at the same time for
an individual inexperienced sales person, the inability to attain sufficient sales may
result in discouragement and thus quitting. Sales people content with a salary of
$20,000 may never be tempted to quit, but because of the lack of motivation may
never reach their quota. If sales due to a recession or competition decreases, then
the sales peoples compensation remains the same. With a commission, a decrease
in sales would be accompanied with a proportionate decrease in compensation. A
fixed salary would increase the risk of operating at a loss, but in times of prosperity
and easy sales, compensation of sales people on a salary basis might maximize
net income. In practice, management often compromises by paying sales people a
combination of salary and commission.
As another example, management might be able to control the nature of costs by
changing the type of equipment. Current production equipment that now requires a
high degree of direct labor might be replace with automated equipment that requires
considerable less direct labor and more indirect labor. For example, in many compa
nies computerized tooling and machining equipment have replaced direct labor. The
effect on cost behavior has been a shift from a variable cost to a fixed cost.
Control over Capacity Limits - As true of variable costs, fixed costs are also
subject to the decisionmaking powers of management. Fixed costs and their related
capacities provide some difficult choices concerning the amount of capacity that is
available at any given time. The greater the expenditure the greater the capacity. For
example, the lease on a medium size computer might be $500 per month, but for a
larger computer the cost might be $1,500. The capacity of the larger machine might
be five times greater. However, now only the smaller machine is needed. Would
management be better off to invest in the larger machine in anticipation of growth?
For the short run, profits might be less, but in the long run profits might be greater, if
the machine with the greater capacity is purchased.
Definition of Capacity - A major task of management is to manage the level of
expenditures for fixed cost; that is, to make decisions determining the capacity to
manufacture and to sell. Therefore, a major question is: what is capacity? This concept
is without question the most important concept related to fixed cost. Unfortunately, the
concept is elusive and very difficult to define quantitatively. In cost accounting, various
degrees of capacity are recognized and defined: theoretical, practical, normal, and
| 77
expected actual. In a general sense, capacity refers to the maximum number of units
that can be manufactured in a given time period. However, this concept of capacity is
a flexible quantity when such factors as overtime, employee training, second shifts,
speed of equipment, holidays, and vacations are taken into account.
In management accounting, capacity is a strictly a shortrun notion that imposes
limits on sales and production capacity. Consequently, any increase in the spending
for fixed manufacturing costs will normally increase capacity. For example, the
leasing of additional equipment or the hiring of an additional production supervisor
will increase capacity. In this sense, the short run is that length of time in which
expenditures cannot be immediately increased.
Other costs such as rent are inherently timeoriented and, consequently, fixed
in nature. The production services provided do not easily, if at all, divide into small
discrete units. Material, for example, is easily divided and associated with individual
units; however, the services of a manufacturing plant, is not easily unitized and
allocated to individual units of finished product. The major problem created by fixed
costs is that for costing and pricing purposes fixed costs must be converted to a per
unit basis. Various methods of unitizing fixed costs have been developed including
various allocation and overhead rate methodologies. The following table indicates
some possible bases for allocation of various types of fixed costs.
Cost Item
Service Provided
Building rent
Equipment
Indirect labor
Insurance
Computer Cost
Staff
Utilities
Preventive maintenance
Shelter, protection
Processing of material
Supervisor
Financial protection
Processing time
E.g., secretarial services
Lighting
Efficiency and safety
Basis of Allocation
Space
Direct labor hours
Number of workers
Value of equipment
CPU time
Hours of service
Floor space
Value of equipment
TC -
V -
Q -
F
-
total cost
variable cost rate
quantity
fixed cost
(7)
Management Accounting
Given that we know V, the variable cost rate and F, the amount of total fixed cost,
we are able to compute total cost at any level of activity. For example, if we assume
that V = $10.00 and F = $100,000, then total fixed cost at different assumed levels of
activity would be as shown in the following table. The change in costs is due to the
increase in the variable costs. The change in activity had no affect on total fixed cost.
If fixed costs change, it is because of the change in some other factor than volume,
for example, an increase in monthly rent of equipment.
Volume
TVC
TC
10,000
$10.00
$100,000
$100,000
$200,000
20,000
$10.00
$200,000
$100,000
$300,000
30,000
$10.00
$300,000
$100,000
$400,000
40,000
$10.00
$400,000
$100,000
$500,000
Total costs can sometimes be better understood when presented graphically as shown in
Figure 5.9 and Figure 5.10:
Figure 5.9 Total Fixed and Variable Cost
$
g
Q
Figure 5.10 Total Variable and Fixed Cost
$
e
c
a
b
h
| 79
(8)
In this equation, we start with total variable cost and add to this amount total fixed
cost. It might seem trivial whether we define total cost using equation 7 or equation
8. However, the two equations are quite different when it comes to showing total cost
graphically.
Most students have difficulty in visualizing the graph shown in Figure 5.10 because
it seems that fixed cost is increasing with volume. Admittedly, Figure 5.9 is easier to
understand because the top line of the fixed cost is horizontal. However, it is not the
line that is fixed in amount but rather the distance from the horizontal line as shown
in Figure 5.9 to the base line that is fixed. As shown in Figure 5.10, the lines a - b,
c - d and e - f are equal in length, and are also the same length as the same lines
in Figure 5.9. Line g - h in Figure 5.10 represents total cost and is the same as line
g - h in Figure 5.9.
It would seem that it is irrelevant which graph is used to portray fixed and variable
costs. Figure 5.9 which shows the top line of total fixed cost as a horizontal line might
be to be the preferred method. However, in fact, this is not the case. The preferred
method is to graphically show fixed and variable cost as shown in Figure 5.10. The
reason is that when total sales is introduced, as will be discussed in the next chapter,
it is possible then to illustrate an important concept, total contribution margin, which
can not be illustrated if Figure 5.9 is used. Cost-volume-profit analysis (chapter 7)
can be more effectively presented graphically using the graph as shown in Figure
5.10.
Average Total Cost
The use of averages to communicate information and greater understanding
is quite common in business, economics, and also government issued statistics.
Relationships are often easier to understand when averages are used. For example,
rather than say that disposable net income in the USA is $600,000,000,000, it is easy
to understand if one were to say that the average disposable income per person in
the USA is $20,000 per person.
In equation (5), average fixed cost was defined as follows:
AFC = F / Q
It is also possible to define average variable cost as follows:
AVC = V(Q) / Q = V
(9)
The variable cost rate as previously discussed earlier in this chapter is simply
average variable cost under the condition that regardless of the change in volume the
average remains constant; that is, the total variable cost line is linear.
Consequently, average total cost now may be defined mathematically as
follows:
AVC = V + F/Q
Management Accounting
Variable
Cost
Rate
Average
Fixed
Cost
Average
Total
Cost
10,000
$10.00
$20.00
$30.00
20,000
$10.00
$10.00
$20.00
30,000
$10.00
$ 6.67
$16.67
40,000
$10.00
$ 5.00
$15.00
The above analysis reveals a very important business principle. The cost of a
product per unit is highly dependent on volume when the fixed cost in a business
represents a major portion of the total cost. As volume (production) increases, the
total cost per unit of output decreases and as the volume decreases the total cost per
unit of output increases. In modern business where fixed costs tend to be very high
relative to variable costs, the key to getting a low production cost per unit is to have
a high volume of production and sales. Many products in our modern economy are
available to consumers as a whole only because of mass production.
Since the middle of the 19th century, in large businesses the fixed costs of
production have become dominant while the variable costs associated with materials
and labor have decreased significantly in total amounts. This shift in costs where
fixed costs are significantly greater percentage wise means that the break even point
in these businesses have become much greater. Consequently, a high volume of
sales and production is required first to break even and secondly, required to make a
reasonable profit. The benefit to customers is that at high volumes the cost per unit
becomes relatively low. Therefore, because of this fact, it is absolutely critical that
management has a good understanding of average fixed and average variable cost.
Like total fixed and variable cost, average fixed and variable cost may be presented
graphically.
Figure 5.11 Graph A
B
C
Q
| 81
B
C
Q
In Figure 5.12, graph B, we again show average fixed and variable cost. As before,
line A - C represents total average cost. However, now line B - C represents average
fixed cost whereas in graph A line B - C represents average variable cost. Similarly,
in Figure 5.12 now line A - B represents average variable cost.
Strange as it may sound, it is correct to say that in terms of average costs, it is
the variable costs that are constant and the fixed costs that are variable. Increases
in volume have no effect on the average variable cost, but do decrease the average
fixed cost with each successive increase in volume.
Illustrative Problem
The K. L. Widget Companys fixed manufacturing costs including depreciation,
supervisor salaries, and equipment leasing costs total $100,000. Material and
direct labor cost $12 per unit. Currently the company has the potential capacity to
manufacture 1,000 units, but is actually operating at an 80% level or 800 units. The
company can sell 200 units of its product to the Ace Retail Company which has
offered to pay $120 per unit. If the company accepts this special offer, would a profit
be made?
Obviously the company should charge $12 to recover its variable cost. The problem
is: how much should be charged for fixed expenses? The obvious answer is to divide
fixed cost by capacity. However, there are two levels of capacity: actual capacity
utilized and full capacity. If the company divides fixed cost by actual capacity utilized,
the charge for fixed expenses would be $125 ($100,000/800) per unit; whereas the
charge for fixed expenses based on maximum capacity, the charge would be $100. If
the company sells to the Ace Retail Company and uses actual activity, a loss would
Management Accounting
of $17 a unit would be reported. On the other hand, charging fixed costs on the basis
of maximum capacity would result in a gain of $8 per unit.
Full
Actual
Capacity Capacity used
Sales price
Variable cost
Fixed overhead
Total cost
Profit per unit (special offer)
(1,000)
$120
$ 12
$100
$112
$ 8
(800)
$120
$ 12
$125
$137
$(17)
Therefore, for many businesses the accounting for fixed costs determine whether
or not new business is obtained. However, as discussed in a later chapter, an incorrect
treatment of fixed manufacturing overhead can result in a wrong decision. In the
above example, fixed manufacturing overhead is actually irrelevant to the decision,
if it can be assumed that the difference between 1,000 units and 800 units is idle
capacity
Separating Fixed and Variable Costs
In many cases, identifying what costs are fixed and variable is fairly easy. For
example, regarding sales people commissions, if the price of the product is $300
and the commission rate is 10%, then it is fairly obvious that the variable rate is $30
per unit of product sold. Similarly for many expenses, it is obvious that the expenses
are fixed in nature. For example, assume that the monthly lease on equipment is
$5,000 per month. Again, it is fairly obvious that the annual cost of $60,000 is a fixed
expense. However, some expenses contain both elements and are, therefore, both
fixed and variable in nature.
Expenses that are both fixed and variable in nature are commonly called mixed
expenses or semi-variable. A cursory examination of these types of expenses does
not reveal what amount is fixed and what amount is variable. For example, it is not
uncommon for utility charges for electricity or for water to contain a fixed charge for
the service and a variable charge for usage. If, as a consumer, you were able to not
use any electricity for a month, you would still receive a bill of a set amount for the
fact that the service was available. The same principle is true of many expenses in
business.
If the mixed expenses are important in terms of amounts, then it is important that
the fixed and variable portions be measured and separated. Three methods exists
for separating fixed and variable components from mixed expenses. These methods
are :
1. Scatter graph method
2. High-low method
3. Least-squares regression equation method
Scatter graph Method - The scatter graph method requires that actual cost values
from preferably four or more operating periods be obtained and then plotted on a
graph. Since is it highly unlikely that the plotted points will fall in a straight line, the
graph is called a scatter graph. The remaining steps are to identify fixed and variable
costs:
| 83
Step 2
Step 3
Determine the total cost on the line of best fit by selecting any point on
the line of best fit other than the point on the Y axis.
This point will then be a measure of the total expense which includes
both the variable and fixed portion.
Step 4
Step 5
2,000
4,000
3,000
1,000
$12,500
$20,000
$13,500
$ 8,500
Cost
20000
15000
Volume
10000
5000
0
0
1000
2000
3000
Volume
4000
5000
Management Accounting
1.
2.
3.
4.
Obtain data points (volume and related cost) from several periods of
operations.
Step 2
Select two different levels of activity and arrange the data as follows:
(Values here are assumed for illustrative purposes.)
High
Low
Step 3
Volume
Cost
10,000
5,000
$50,000
$30,000
Volume
10,000
5,000
5,000
Cost
$50,000
$30,000
$20,000
Compute the variable cost rate by dividing the difference in cost by the
difference in volume.
Variable cost rate = ($20,000 / 5,000) = $4.00
Step 5
| 85
Summary
An understanding of cost behavior is critical in management accounting because
several of the management accounting tools require using fixed and variable costs.
Since the general ledger does not contain separate accounts for fixed and variable
costs nor labels them as such if a cost is clearly all fixed or all variable, it is necessary
by one method or another to determine what costs are fixed and what are variable.
The assumption that costs are either pure fixed or pure variable is an arbitrary
assumption. In fact, costs in some businesses may be curvilinear in nature or mixed
as previously discussed. The assumption that costs are linear in nature makes it
much easier to use various management accounting tools. The question is whether
this simplicity in assumption causes the results of analysis to be inaccurate and
misleading. The argument generally is that as long as the user of management
accounting tools stays within a relevant range of activity, the use of linear fixed costs
and variable costs will produce very useful results. When using tools that require fixed
and variable costs, it is important to realize there will always be a margin of error.
Management Accounting
Q. 5.1
Q. 5.2
Q. 5.3
Q. 5.4
What are the two primary measures of volume that determine total
costs and expenses.
Q. 5.5
Q. 5.6
Q. 5.7
Q. 5.8
Q. 5.9
Q. 5.10
Q. 5.11
Q. 5.12
Q. 5-13
a. Variable cost
b. Fixed cost
c. Average fixed cost
d. Average variable cost
Identify the following:
a.
b.
c.
d.
V(Q)
F/Q
F + V(Q)
V
| 87
Required:
Select the appropriate graph to illustrate the costs listed on the next page.
continued on next page
Management Accounting
Cost Behavior
Cost Items
Graph
1.
2.
3.
Salaries of management
4.
5.
6.
7.
8.
9.
$250,000
$270,000
| 89
Computation
Material
Factory Labor
Variable manufacturing
overhead
Variable selling
Total variable cost per
unit
Fixed cost:
Manufacturing
40,000 units
45,000 units
50,000 units
55,000 units
60,000 units
Selling
40,000 units
45,000 units
50,000 units
55,000 units
60,000 units
Management Accounting
1. Which type of cost is responsible for total cost per unit to vary with
production?
2. If cost varies with production and production will vary with sales demand,
then what cost figure should be used to determine price?
Exercise 5.4 Computing Variable Cost Rates
You have been provided the following information:
Variable Costs
Material
Cost per unit of material
$ 2.00
Units of material required per unit of product
6
Factory labor
Wage rate per hour
$ 12.00
Labor hours required per unit of product
4
Manufacturing overhead
Utilities
Cost per kilowatt hour
$
.06
Number of kilowatt hours per unit of product
10
Supplies
One unit of supplies
2
Cost per unit of supplies
$ 4.00
Repairs and maintenance
Hours of maintenance per unit of product
.5
Repair cost per hour
$ 15.00
Selling
Commission rate (price of product - $300)
10%
Packaging cost per unit of product
$ 2.00
General and administrative
Clerical and staff (hours)
1.50
Average wage rate $10.00
Fixed costs/expenses
Manufacturing overhead
Production salaries
Equipment depreciation
Insurance and taxes
Selling
Advertising
General and administrative
Salaries
$ 100,000
$ 10,000
$ 5,000
$ 50,000
$ 80,000
| 91
(2)
(3)
10,000
15,000
18,000
8,000
$40,000
$56,000
$65,000
$36,000
$ 82,000
$115,000
$133,000
$ 64,000
Required:
Based on the above data, compute the fixed and variable cost components of the
above costs/expenses:
1. Assuming the high-low method is used
2. Assuming the scatter-graph method is used.
Management Accounting
| 93
Management Accounting
into the cost of inventory and cost of goods sold by means of using manufacturing
overhead rates. Absorption costing as pointed out by advocates of direct costing has
an inherent and potentially serious flaw in that it is possible to manipulate net income
by deliberately manufacturing more units than is required to meet the needs of the
production budget. This flaw exists only in regard to fixed manufacturing overhead. In
a company with only variable manufacturing overhead, the deliberate act of increasing
production in excess of sales can not cause net income to become larger.
Some accounting theorists in the 1930s and 1940s began suggesting an
alternative method of applying fixed overhead to inventory. It was argued that fixed
manufacturing costs were not true inventory costs but were periodic costs and that
this charge should be shown on the income statement as an operating expense. Fixed
manufacturing overhead, it was argued, was not caused by the act of producing and,
therefore, could not properly be called a production cost. Since fixed manufacturing
overhead tends to remain the same from period to period, treating it as a periodic
charge on the income statement is more appropriate. The proposed solution to the
problem of absorption costing was called direct costing and in some cases variable
costing. The term variable costing was often used because the argument now was that
only variable manufacturing overhead was properly allocated to inventory. However,
the real problem was not variable costs but fixed manufacturing overhead.
Most text books on cost accounting have a chapter devoted to discussing
absorption costing versus direct costing. However, it should be pointed out now that
the conflict between the two theories for the most part has been resolved in favor
of absorption costing. Authoritative bodies such as the IRS and the FASB have not
approved direct costing as an acceptable alternative for external financial statement
reporting. However, direct costing is acceptable as part of an internal reporting system
to management. The question that remains today is: is the use of direct costing a
better means of reporting financial results to management for the purpose of making
decisions?
Absorption Costing Versus Direct Costing
While the main difference between absorption costing and direct costing lies in
the treatment of fixed manufacturing overhead, there are consequences that makes
the two methods different in other respects:
Basis Features of Absorption Costing - Absorption costing which is traditional cost
accounting may be summarized as follows:
1. Both fixed and variable overhead are applied to inventory (work in
process).
2. Manufacturing overhead is usually applied by means of a predetermined
overhead rate. The single rate, in fact, consists of two rates: a fixed
overhead cost rate and a variable overhead cost rate.
3. The use of a predetermined overhead rate generally will result in
manufacturing overhead being over-applied or under-applied.
4. Under-applied overhead is generally charged to cost of goods sold or
shown on the income statement as a separate line item.
| 95
Factory Labor
Work in process
Finished goods
Income summary
Variable Overhead
Fixed Overhead
This diagram shows that before fixed manufacturing can be a deduction from net
income it must first flow through the work in process and finished goods account. To
the extent that finished goods is not sold, the amount of fixed manufacturing overhead
in finished goods has been absorbed off the income statement.
Basis Features of Direct Costing - The basic points of direct costing or variable
costing as it is often called may be summarized as follows:
1. Fixed manufacturing overhead is not considered to be a production
cost properly included in the cost of inventory.
2. Fixed manufacturing overhead is regarded as a periodic charge, an
operating expense. Regardless of the level of activity, it remains the
same in a given time period.
Management Accounting
Factory Labor
Work in process
Finished goods
Income summary
Variable Overhead
Fixed Overhead
This cost flow diagram shows that fixed manufacturing overhead does not
flow through inventory but rather is a direct charge against revenue on the income
statement. When both cost flow diagrams are compared, the only difference between
direct costing and absorption become quite obvious. The observed difference clearly
is how fixed manufacturing overhead is handled. The accounting for variable costs
including variable manufacturing overhead is also obviously the same as in direct
costing.
Effect of Variations in Production Units and Sales Units
In order to fully understand the difference consequences of using absorption
costing as opposed to using direct costing, the effect of production being more or
less than units sold needs to be clearly understood. Some important relationships
are the following:
1. When production units equals sales units, there is no difference in net
income between absorption costing and direct costing. Under this
| 97
Management Accounting
Figure 7.1
Absorption Costing
Direct Costing
I
II
III
IV
II
III
IV
Production (units)
80
90
100
60
Production (units)
80
90
100
60
Sales (units)
70
70
70
70
Sales (units)
70
70
70
70
$2,800 $2,800
$2,800
Sales
$2,800
Sales
$2,800
Variable Expenses
Cost of goods sold 700
Expenses
Cost of goods.sold $1,400
Other expenses
Under-applied o/h
$1,400 $1,400
$1,400
50
50
50
50
200
100
400
______
______ _______
_______
Total expenses
$1,650
$1,550 $1,450
$1,850
Ending inventory
$1,150
$200
Material
Direct labor
Manufacturing:
Variable rate
Fixed rate
$1,250 $1,350
$400
$600
700
0
______
0 _ ____0
______
$ 700
______
$700 $ 700
______ _ ____
700
_____0
$700
______
Fixed expenses
Manufacturing
Net income
700
Other variable
$1,000
50
Other operating ______
50 _ ____
50
______
$1,050
$950
Net income
______
$1,050
___
_____
____
______
$1,050_
______
______
$200)
50
______
_ ____
______
$1,050_ $1,050
__ ____
____ ___
_____
____
$ 200 $ 300
($ 100)
$ 5
Material
$ 3
Direct labor
$ 5
Manufacturing (variable)
$ 2
$ 2
$10
$20
$10
| 99
- net income
+ Vga
Fm - fixed manufacturing
P - price
Fgas - fixed gen., admin., and selling
expenses
Va - absorption costing Variable cost
Qs - quantity sold
rate
Qm - quantity manufactured (Note: Va includes the fixed
Management Accounting
1.
2.
3.
4.
5.
6.
7.
8.
9.
Absorption costing
Direct costing (variable)
Capacity
Inventory changes
Quantity sold
Planned quantity
Variable costs (direct)
Fixed expenses
Manufacturing costs
10.
11.
12.
13.
14.
15.
16.
17.
Quantity manufactured
Fixed overhead rate
Variable overhead rate
Period charges
Cost of inventory
Under-over-applied overhead
Contribution margin
Fixed manufacturing cost
Period 1
100 units
0 units
$1,000
100 units
$15
Period 2
0 units
100 units
Based on this information income statements for periods 1 and 2 would show the
following
| 101
Period 1
Income Statements
Absorption Costing
Sales
Cost of goods sold
Gross profit
Expenses
Selling
Direct costing
-0-0______
-0-
Net
income
-0______
-0-0______
______
$1,000
Sales
-0Cost of goods sold
-0
_ _____
Gross profit
-0Expenses
-0Selling
Fixed manufacturing overhead $1,000
_ _____
$1,000
Net income (loss)
($1,000)
__ _____
_____
Inventory
-0-
For the period 1, two completely different net income pictures are painted.
Absorption costing shows income to be zero and ending inventory to be $1,000.
Direct costing shows the business operating at a loss of $1,000 and that the ending
inventory has a zero cost. Which point of view is correct many years ago was the
subject of considerable debate.
Period 2
Income Statements
Absorption Costing
Direct costing
Sales
$ 1,500
Cost
of goods sold ______
1,000
Sales
$ 1,500
Cost of goods sold -0-
1,000
1,000
______
Net income (loss)
($______
500)
______
Inventory
(0 units)
-0-
______
Net income
$ 500
In period 2, direct costing shows net income to be $500 and under absorption
costing a net loss of $500 is reported. Absorption costing shows the loss to be
greater when the company had sales. As long as it is manufacturing at capacity
under absorption costing, the company will not show a loss. Proponents of direct
costing would point out this does not seem to be reasonable. However, proponents
of absorption costing would argue that in period 1, direct costing shows the value
of inventory to be zero. They would argue that a zero value assigned to inventory is
unrealistic. Both absorption costing and direct costing show that for the two periods
combined the company lost $500.
Management Accounting
For absorption costing and direct costing separately compute the change
in inventory:
Absorption costing Direct Costing
Ending inventory
$_ ____________ $______________
$_ ____________ $______________
The difference in the change in inventory will be equal to the difference in net
incomes. In short, as the amount of fixed overhead in inventory increases the difference
in net income increases. The above calculation is simply a method of computing the
amount of fixed manufacturing overhead in inventory.
To illustrate assume the following:
Variable costs (per unit of product)
Cost of goods manufactured
Selling
Price
Capacity
$
10
$
20
$ 100
2,000 units
Beginning inventory
Units
Absorption costing
Direct costing
Fixed manufacturing overhead
Production
Sales
100
$ 3,500
$ 1,000
$ 50,000
1,500 units
1,000 units
| 103
$ 100,000
10,000
20,000
$ 25,000
12,500
-0-
$ 37,500
$ 32,500
$ 3,500
$ 21,000
Net income
Beginning inventory
Ending inventory
$ 100,000
10,000
20,000
$ 30,000
$ 70,000
$ 30,000
$ 70,000
Contribution margin
Fixed expenses
Cost of goods sold (1,000 x $25)
Under-applied F M/O (500 x @ $25)
Fixed manufacturing overhead
Direct
Costing
$ -0-0 50,000
$ 50,000
$ 20,000
$ 1,000
$ 6,000
In this example, the difference in net income is $12,500 ($32,500 - $20,000) (see
Figure 7.2). This difference in net incomes can be reconciled as follows:
Ending inventory
Beginning inventory
Change in inventory
Absorption Costing
$21,000
$ 3,500
$17,500
Difference in change
Absorption costing change
Direct costing change
Change in difference
Direct Costing
$6,000
$1,000
$5,000
$17,500
$ 5,000
_______
$12,500
Management Accounting
than showing fixed manufacturing overhead as a separate line item on the income
statement, there is no requirement to show any other costs as fixed or variable.
However, the general practice in preparing direct costing is to identify all costs are
fixed and variable. Nevertheless, as shown above even with absorption costing, it
is also possible to show all costs as either fixed or variable. Which format to use is
determined at the discretion of the management accountant and the preference of
management.
Summary
The issue of absorption costing versus direct costing for purposes of external
reporting has long been settled in favor of absorption costing. Financial reports to
stockholders, banks, Internal Revenue Service, and other regulatory agencies are
required to be based on absorption costing. However, for purposes of reporting to
management, direct costing may be used. If the business in question is subject to
considerable variation in production and sales from period to period and the amount
of fixed manufacturing overhead is quite large, then management may prefer for
internal reporting purposes to have income reported based on direct costing. If there
is little or no significant variation in sales and production from operating period to
period, then either method will result in approximately the same net incomes. Only
when inventory fluctuates greatly will direct costing make a real difference in the
amount of net income reported. Whether or not direct costing is used, it is still possible
to identify and use fixed and variable cost on the income statement.
Q. 6.1
Q. 6.2
Q. 6.3
Q. 6.4
Q. 6.5
Q. 6.6
Q. 6.7
Q. 6.8
Q. 6.9
| 105
Q. 6.14 How can the difference in net income between absorption costing and
direct costing be reconciled?
0
10,000
15,000
20,000
$ 30,000
$ 45,000
$ 60,000
$ 140,000
$ 60,000
$ 30,000
$ 400,000
Required:
Based on the above information, prepare income statements assuming both
direct costing and absorption costing. The fixed overhead rate is to be based on
capacity to manufacture.
Income Statements
Direct Costing
Absorption
Costing
Management Accounting
2.
Compute the cost of ending inventory under both direct costing and
absorption costing.
__________________________________________________________
__________________________________________________________
__________________________________________________________
3.
4.
What would be the difference in net income had actual sales been
15,000 rather than 10,000?
__________________________________________________________
Exercise 6.2
The K. L. Widget Company just completed its first year of operations. The following
was presented by the companys accountant:
Fixed manufacturing overhead
Normal capacity
Variable overhead rate
Actual production
Units sold (price per unit - $50.00)
Direct labor per unit
Material cost per unit
Expenses (selling and general & admin.)
$5,000
1,000 units
$6.00
1,000 units
800 units
$10.00
$5.00
$10,000
Required:
Compute net income first assuming absorption costing and then direct costing.
__________________________________________________________
__________________________________________________________
__________________________________________________________
__________________________________________________________
__________________________________________________________
__________________________________________________________
__________________________________________________________
| 107
Absorption Costing
Direct Costing
Sales
$2,800
Sales
Expenses
Variable expenses:
Cost of goods sold
1,120
Cost of goods sold
Selling
350
Selling
U/A
fixed
mfg.
o/h
200
______ _______
Total expenses
$1,670
Net income
$1,130
Contribution margin
Fixed expenses
Fixed mfg. overhead
Selling
Ending inventory
Ending inventory
$ 160
$2,800
420
200
______
620
$2,180
1,000
150
Net income
1,150
$1,030
60
70 units
$40
0
0
$1
$2
$3
$1,000
100 units
80 units
$200
$150
Management Accounting
Required:
1.
Compare net income under direct costing with absorption costing net
income. Which is greater?__________________________________
List all the differences that you observe in the direct costing income
statement:
_______________________________________________________
_______________________________________________________
_______________________________________________________
_______________________________________________________
_______________________________________________________
2.
Now use the direct costing/absorption costing tool. Enter the above data
as requested by the program. (If the software package is not available,
then you will have to manually make the required computations.)
3.
b. Direct costing?_______________________________
4.
Now change the units manufactured to 60 units. What effect did this
change have on net income under:
b. Direct costing?_______________________________
5.
Using the direct costing/absorption costing tool, enter the starting level
of activity as 60. Set the increment in production at 10 units.
What happen to net income as production increased but sales remained
the same?
______________________________________________
______________________________________________
6.
7.
| 109
8.
9.
What general rule can be given regarding the difference in net income
between absorption costing and direct costing, assuming no beginning
inventory?
______________________________________________
______________________________________________
10.
Absorption Costing
Number of units
Total cost
Direct Costing
20
20
320
120
Now compute net income again assuming absorption costing and direct
costing. What is the difference in absorption costing and direct costing
income?
______________________________________________
______________________________________________
Part II
Management Accounting
Decision-Making Tools
Chapter 7
Cost-Volume-Profit Analysis
Chapter 8
Chapter 9
Chapter 10
Chapter 11
Chapter 12
Chapter 13
Management Accounting
Cost-Volume-Profit Analysis
The success of a business as measured in terms of profit depends upon
adequate sales; that is; the volume of sales must be sufficient to cover all costs
and allow a satisfactory margin for net income. When the proportion of fixed costs
in a business becomes large in relation to total costs, then volume becomes an
extremely important factor in achieving profitability. For example, a business with
only variable costs would be able to report net income at any level of sales as long
as price exceeds the variable cost rate. However, a business with only fixed costs
cannot show a profit until the contribution from sales is equal to the amount of fixed
expenses. Therefore, a minimum level of sales is absolutely essential in a business
that incurs fixed expenses.
Because changes in volume can have a profound impact on the profits of a
business, cost-volume-profit analysis has been developed as a management tool to
enable analysis of the following variables:
1. Price
2. Quantity
3. Variable costs
4. Fixed costs
The focal point of cost-volume-profit analysis is on the effect that changes in
volume have on fixed and variable costs. Volume may be regarded as either units
sold or the dollar amount of sales. Typically, the theory of cost-volume-profit analysis
is explained in terms of units. However, using units as the measure of volume for
computing break even point or target income point requires that the business sell
| 113
(1)
S = P(Q)
S - sales
P - price
Income may be defined as:
(2)
R
E
I
I
-
-
-
= R - E
revenue
expense
income
(3)
When equations (1) and (2) are substituted into equation (3), equation (3) becomes
I = P(Q) - V(Q) - F
(4)
Equation (4) is recognized in this chapter as the foundation of cost-volumeprofit analysis. Quantity (Q) is generally treated as the independent variable; that is,
income is regarded as a function of quantity (Q). The variable cost rate (V) and fixed
expenses (F) are assumed to be constants. However, for certain analytical purposes,
the values of V and F may be assigned different values in order to determine the
effect of the changes in these values on net income.
Equation 4, it should be noted, may be used as a tool of analysis only for a single
product business. For firms that have more than one product, another equation which
emphasizes sales as volume in dollars must be used:
I = S - v(S) - F
(5)
S - sales in dollars
v - variable cost percentage
In a multiple product business, it is necessary to express variable cost as a
percentage of sales. This percentage will be discussed in detail in a later section of
this chapter.
Management Accounting
Q(P - V)
I+F
Q =
P-V
(6)
Equation (6) may be used to determine the quantity of sales required to attain
any desired level of income. For example, assume that the Acme Companys selling
price is $10 and its variable cost rate is $8. Also, assume that it has fixed expenses of
$5,000. Suppose that management desires to earn $8,000 for the period. How many
units must the company sell in order to attain the desired net income?
Answer: This question may be answered simply by substituting these given revenue and cost values into equation 6:
I + F $8,000 + $5,000 $13,000
Q = = =
P - V
$10 - $8
2
= 6,500 units
Therefore, the Acme Company must sell 6,500 units to earn $8,000. The validity
of this answer can be demonstrated as follows:
Sales (6,500 x $10)
$65,000
Expenses:
Variable (6,500 x $8)
$52,000
Fixed
5,000
_______
Total expenses
$57,000
_______
Net income
$ 8,000
In management accounting literature, considerable emphasis is given to the
concept of a break even point. While it is an interesting academic exercise to compute
break even point, it should be stressed that a company does not set a goal to break
even. The primary object of management in using cost-volume-profit analysis is to
determine target income point and not break even point.
Nevertheless, assuming for some reason that it is considered desirable to know
the break even point of a business, the break even point is calculated exactly in the
same way as target income point. Equation (6) may be used to compute break even
point. Break even point is simply the quantity of sales that achieves zero net income.
It is that level of sales where total sales equals total expenses.
Using the same data from the example above, break even point may be computed
as follows:
| 115
= 2,500 units
Net income
$ 0
Where:
TVE
v =
S
(7)
v
- variable cost percentage
TVE - total variable expenses
S
- sales ($)
$ 10,000
.7
$ 7,000
$100,000
.7
$ 70,000
$200,000
.7
$140,000
$400,000
.7
$280,000
Management Accounting
In order for the variable cost percentage to hold constant in a multiple product
business, it is necessary for the sales mix ratio to remain the same. The sales mix
ratio is discussed later in this chapter.
As in the case of a single product firm, it is desirable to ask the question: how
many units must be sold in order to attain a desired income level? Equation 5 may
be used to answer this question; however, it is first necessary to solve for S (sales)
as follows:
I = S -
v(S) - F
S(1 - v) - F = I
S(1 - v) = I + F
I+F
S =
1-v
(8)
This equation may be used to compute the dollar level of sales required to attain
a desired level of income. For example, assume that the Barton Companys variable
cost percentage is 80% and its fixed cost is $10,000. Furthermore, assume that
management has set a profit goal of $50,000. What must the dollar volume of sales
be in order to attain the $50,000 income objective?
Answer:
I + F 50,000 + 10,000
S = = =
1 - v
1 - .8
60,000
.2
= $300,000
Sales
Expenses:
Variable ($300,000 x .8)
Fixed
$300,000
$240,000
10,000
Net income
250,000
$ 50,000
| 117
Management Accounting
even point contributes $2 to income. If 2,600 units are sold, net income would be
$200 ($2 x 100).
Contribution Margin Percentage - In a multiple product firm, it is necessary to talk
in terms of contribution as a percentage. Mathematically, the contribution margin
percentage rate is 1 - v. The contribution margin percentage requires that the
variable cost percentage be first computed. If the variable cost percentage is 70%,
then the contribution margin percentage would be 30% (1 - .70). The importance of
the contribution margin percentage is apparent from examining equation 8:
S =
I + F
1 - v
The contribution margin percentage is the percentage that each dollar of sales
contributions towards fixed expenses and desired net income. The total contribution
required to attain the desire income goal can be computed by simply dividing total
desired contribution by the contribution margin percentage.
Contribution Margin Income Statement - Cost-volume-profit analysis may be
made an integral part of financial reporting. Companies who do this generally prefer
to prepare income statements in which fixed costs, variable cost, and contribution
margin are explicitly shown. For example, assume that during the year the Acme
Company had sales of $50,000 and fixed and variable costs as follows:
Fixed Expenses
Variable Expenses
Selling
Selling
Advertising
$5,000
Sales people commissions $ 5,000
Sales people salaries $3,000
Sales people travel
$ 2,000
Supplies
$ 500
Cost of goods sold
$20,000
General & Admin.
General & Admin.
Utilities
$ 500
Supplies
$ 5,000
Supplies
$ 500
Other
$ 2,000
Executive salaries
$2,000
Depreciation
$1,000
Based on the above data, the following income statement may be prepared as
shown in Figure 7.1.
Graphical Illustration of Cost-volume-profit Analysis
Because the fundamental relationships of cost-volume-profit analysis are basically
mathematical in nature, the elements of cost-volume-profit analysis can be illustrated
graphically. The general procedure is to plot the revenue and cost functions on the
same graph. In order to illustrate the cost-volume-profit graphically, the following data
has been assumed:
Price
$10
Variable cost rate
$6
Fixed expenses
$20,000
For purposes of preparing the graph, assume different levels of quantity starting
with 1,000 units and increasing activity by increments of 1,000 units. The following
calculations are helpful in plotting the graph.
| 119
General & Admin.
Supplies
$ 5,000
Other
2,000
7,000
Contribution Margin
Fixed Expenses:
Selling:
Advertising
$ 5,000
Sales people salaries
3,000
Supplies
500
$8,500
General & Admin.
Executive salaries
$ 2,000
Utilities
500
Supplies
500
Depreciation
1,000
4,000
Net income
Revenue (sales)
Q
1,000
2,000
3,000
4,000
5,000
P
$10
$10
$10
$10
$10
Total Sales
$10,000
$20,000
$30,000
$40,000
$50,000
$50,000
$34,000
$16,000
$12,500
$ 3,500
________
________
V
$6
$6
$6
$6
$6
$ 6,000
$12,000
$18,000
$24,000
$30,000
Management Accounting
Figure 7. 2
2a
2b
Fixed Cost
Cost $
Cost $
40000
20000
30000
20000
10000
2000
4000
6000
Volume
8000
2000
4000
6000
8000
Volume (Quantity)
2c
Cost-Volume-Profit Chart
70000
Sales/Cost ($)
60000
50000
40000
30000
20000
10000
0
2000
4000
6000
8000
Volume (Quantity)
| 121
(000)
(000)
80
80
70
70
60
60
Net Income
50
Net Loss
40
50
40
30
30
20
20
10
10
2,500
Contribution
margin
5,000
Volume (units)
6,750
Contribution margin =
fixed expenses
2,500
5,000
6,750
Volume (units)
Price and the variable cost rate are constant within the relevant
range of activity.
This assumption simply means that variable costs and revenues are
assumed to vary linearly with changes in volume. State differently,
changes in volume have no effect on price, the variable cost rate,
and fixed costs.
3.
Management Accounting
4.
| 123
P/V Chart
$10
$8
$5,000
6000
5000
Net Income $
Price (P)
Variable cost rate (V)
Fixed Costs (F)
Q
P(Q)
V(Q)
F
NI
1,000
10,000
8,000
5,000
(3,000)
2,000
20,000
16,000
5,000
(1,000)
3,000
30,000
24,000
5,000
1,000
4,000
40,000
32,000
5,000
3,000
5,000
50,000
40,000
5,000
5,000
4000
3000
2000
1000
0
2000
-1000
4000
6000
-2000
-3000
-4000
Volume (units)
Net Income
Net Income
Net Income
Increase in Price
Decrease in Price
Net Income
Net Income
Net Income
Net Income
In Figure 7.5 is illustrated the effect on break even point and net income of changes
in price, variable cost, and fixed expenses. In chart A, an increase in price shifts the
line upwards and to the left. The result is a decrease in break even point. In Chart B,
a decrease in price has the opposite effect. Break even point has increased in chart
C. The increase in variable expenses caused the income line to shift downwards and
to the right. The opposite is true of a decrease in the variable expense rate. Break
even point has decreased. An increase in fixed expenses will cause the income line
to shift to the left and upwards. The result is a decease in break even point. The
Management Accounting
opposite is true for an increase in fixed expenses. Whether a given change is good
or bad for fixed expenses such as advertising can not be stated. For example, an
increase in advertising might cause an increase in sales with a resulting increase in
net income.
The P/V graph can effectively be used to illustrate changes in price, the variable
cost rate, and fixed costs. A change in one of these variables will cause a shift or
movement in the net income line.
Changes in Price - An increase in price will most likely result in a decrease
in sales. However, a decrease in sales does not necessarily mean a decrease in
net income. Regarding the units that are sold, the contribution margin is greater.
Consequently, less units of sales are required to attain a profit goal. Given an increase
in price, management will probably want to ask the question: how many units of sales
can be lost and the same net income earned?
This question can be answered by using the following equation:
I + F
Q =
Figure 7.6 P/V Chart
P - V
The procedure is simply to
$
P/V Chart
compute Q, or quantity, at the new
P=$12.00
10000
price and then subtract this quantity
from the quantity of sales before
7500
the price change.
Illustration
Last year, at a sales volume of 5,000
units, the Ace Manufacturing Companys
income statement show the following:
Sales (5,000 x $10)
Expenses
Variable ($8 x 5000)
Fixed
Net income
$50,000
40,000
5,000
45,000
$ 5,000
P=$10.00
5000
2500
0
1,250
2,500
3,750
5,000
units
-2500
-5000
-7500
Management is considering increasing price to $12 per unit. At the new price, the
quantity necessary to earn the same income would be:
Q =
5,000 + 5,000
=
12 - 8
10,000
4
2,500
At the new price, only 2,500 units need to be sold to earn $5,000. The company
can lose one half of its sales without suffering any loss in income. The effect of the
change in price on break even point and net income at different levels of sales is
shown in Figure 7.5A. Note that in Figure 7.6, the income function shifts upward and
to the left. BEP point is now 1,250 units and the income previously earned at 5,000
units can now be earned at 2,500 units.
| 125
(9)
i = 1, n
v
Vi
Qi
Pi
-
-
-
-
Product A
$12.00
$ 8.00
1,000
$300
Product B
$ 8.00
$ 2.00
400
$1,000
Based on the above information, the variable cost percentage may be calculated
as follows:
PiQi = 12(1,000) + 8(400) = 12,000 + 3,200 = 15,200
ViQi) = 8(1,000) + 2(400) = 8,000 + 800 = 8,800
ViQi
8,800
v =
=
PiQi 15,200
= .5789
Management Accounting
1,300
1,300
BEP = = =
1 - .5789
.4211
3,087
Suppose, in fact, the ratio become the opposite; that is 1:2.5. The variable cost
percentage then becomes.
8.00(400) + 2.00(1000)
v = =
12.00(400) + 8.00(1000)
5,200
=
12,800
.40625
1,300
.59375
= 2,189
If a significant change is the sale mix ratio occurs, then the previous computation
of the break even point based on the original sales mix is unreliable.
Computing Break even Point for each Product - It is still possible to compute a
break even point for each product separately; however, now care must be taken to
not include common fixed costs in the total fixed costs for each product. Common
fixed costs are those costs that occur whether or not the particular product is sold.
For example, salaries to top management are most likely to be common in nature.
Assuming there are no common costs in the fixed costs of products A and B, then the
individual product break even points may be computed as follows:
Product A
Product B
300 300
1,000 1,000
BEP = = = 900
BEP = = = 1,333
1 - .67 .33
1 - .25
.75
Contribution Margin Rate Differences - It is highly unlikely that the contribution
margin rate of each product will be the same. The question is: will the product with the
largest contribution margin rate be the most profitable? The answer is no. Net income
also depends on the quantity sold. Because the contribution rate is the greatest, this
is no guarantee that this product will even be profitable. Using the same data as
previously, net income for products A and B may be computed as shown in Figure
7.7:
As can clearly be seen, product B which has a greater contribution margin rate
| 127
Product A
Income Statement
Sales ($12 x 1,000)
Variable expenses ($8 x 1000)
Contribution margin
Fixed Expenses
Net income
$12,000
8,000
4,000
1,000
$ 3,000
Product B
Income Statement
Sales ($8 x 400)
Variable expenses ($2 x 400)
Contribution margin
Fixed Expenses
Net income
$3,200
800
2,400
300
$2,100
($6.00 versus $4.00 for product A) is not the most profitable product. While product
A does have the greater sales volume in dollars this does not mean that the product
with the highest sales volume will be the most profitable. Profitability also depends on
the contribution margin rate and the amount of fixed expenses.
Increasing Sales, Constant Costs, and Decreasing Net Income - One of the
unusual phenomenons in a business is that sales can be increasing and costs can
be constant yet the business is experiencing a decrease in net income. This situation
can happen when there is a substantial shift in the sales mix from the product with
the greatest contribution margin rate to the products with a lower contribution margin
rate.
To illustrate, assume that all costs remain the same in our example except that
the sales mix becomes 1,100 to 300. Based on this mix, net income for each product
may be computed as seen in Figure 7.8:
Figure 7.8 Effect of a Change in Sales Mix Ratio
Product A
Product B
Income Statement
Income Statement
$13,200
8,800
4,400
1,000
$ 3,400
$2,400
600
1,800
300
$1,500
Management Accounting
Income Statement
Sales
Variable expenses
Contribution margin
Fixed Expenses
Net income
$15,600
9,400
6,200
1,300
$ 4,900
| 129
If the desired net income after tax is $120,000 and the tax rate is 40%, then net
income before tax is:
Nibt = $120,000 / ( 1 - .4) = $120,000 / .6 = $200,000
If price is $100, V is $70,00, and fixed expenses $400,000, then we can compute
target income point using a slightly modified version of equation 6.
Q =
I+F
P-V
(6)
NIAT / (1 - T) + F
Q =
P - V
Based on this equation, then target income point maybe be computed as
follows:
120,000 /( 1 - .4) + 400,000 200,000 + 400,000
Q = = =
100 - 70
30
600,000
= 20,000
30
Contribution margin
$ 600,000
Fixed expenses
$ 400,000
Management Accounting
Summary
Cost-volume-profit analysis is a powerful analytical tool. It can be effectively used
in many different kinds of decisions. Cost-volume-profit analysis is based on the
theory of cost behavior and as such it is imperative that the management accounting
and also management have a good understanding of cost behavior. Because
cost-volume-profit analysis is based on a number of critical assumptions, it is also
important to recognize when the use of this tool is valid and when it is not. If the data
used in cost-volume-profit analysis extends too far beyond the relevant range, the
results obtained can be inaccurate and misleading. Nevertheless, as long as the
assumptions on which cost-volume-profit analysis is based hold true, then the tool
can provide very useful information concerning decisions to be made and the evaluation of results already obtained.
Q. 7.1
Q. 7.2
Fixed cost
Variable cost
Semi-variable cost
Step cost
Average fixed cost
Average variable cost
Relevant range
Contribution margin
Sales
Total variable cost
Total fixed cost
Net income
Q. 7.3
What are the two basic equations from which formulas for break even
point or target income point may be derived?
Q. 7.4
Q. 7.5
Q. 7.6
What equation may be used to answer the question: how many units
must be sold in order to attain a desired level of net income?
Q. 7.7
| 131
Q. 7.8
P(Q) - V(Q)
P-V
1-v
Q(P - V)
Q. 7.9
Q. 7.10
When total fixed expenses equals total contribution margin, then this
point is called?
Q. 7.11
Increase in price
Decrease in price
Increase in the variable cost rate
Decrease in the variable cost rate
Increase in fixed expenses
Decrease in fixed expenses
Q. 7.12
Q. 7.13
What effect does a change in the sales mix ratio have on the variable
cost percentage?
Q. 7.14
Q. 7.15
Q. 7.16
Given that price, the variable cost rates, and fixed costs have not
changed, explain how net income can decrease even though total sales
has increased.
Management Accounting
Sales
Expenses
Net income
Income Statement
(Sales - 10,000 units)
$200,000
$150,000
$ 50,000
| 133
K
M
J
L
A
D
B
F
H
Q
Based on the above cost-volume-profit chart, identify the following line segments:
Line Segments
1 A - B
2 C - D
3 E - F
4 G - H
5 I - J
6 K - L
7 M - N
Management Accounting
Contribution margin
$10,000
Fixed expenses
$ 6,000
Net income
$ 4,000
Advertising, if increased, will change from $2,000 to $4,000. The maximum market
potential is probably between 1,300 and 1,400 units of product.
Required: Evaluate this proposed increase in advertising. To offset the increase in
advertising, by how much must sales increase in units.
Exercise 7.6 Computing Break even point and Target Income Point
The following information from the records of the Ajax Manufacturing Company has
been provided to you:
Sales price:
Product A
Product B
Product C
$ 60.00
$ 40.00
$ 100.00
Variable costs:
Product A
Product B
Product C
$ 45.00
$ 30.00
$ 40.00
Units sold:
Product A
Product B
Product C
$ 1,000
$ 2,000
$ 3,000
Product A
Product B
Product C
$ 40,000
$ 30,000
$ 80,000
| 135
Management Accounting
The budgeting process is an all encompassing task that brings in focus all short
and long run goals and objectives of the business. The process of preparing a
budget compels management to explicitly recognize and assign quantitative values
to all marketing, production, and financial decisions. A major reason for preparing a
comprehensive budget is to obtain a measure of the impact of interrelated decisions
on net income, financial position, and cash flow. However, the benefits of budgeting
extend beyond the expression of decisions into numbers. Benefits often cited for
budgeting include:
1. Recognition/improvement of organizational structure
2. Increased emphasis on setting of long-term objectives
3. Increased motivation to achieve objectives
4. Explicit recognition of important decision relationships
5. Better coordination of activities by managers
6. Improved profit performance
7. Better performance evaluation
| 137
Vice-President
Marketing
Manager
Cutting Dept
Vice-President
Finance
Vice-President
Production
Manager
Finishing Dept.
Manager
Finishing Dept.
Accounting
Department
Income
Statement
Balance Sheet
Management Accounting
dations for decisions to be approved at a higher level. Because all businesses have
three primary functions, marketing, production and finance, top management in each
of these areas has primary responsibility for the final stages of the budgeting process.
A business that is well organized and has well planned channels of communication is
more likely to achieve the standards set forth in a comprehensive budget.
A simple but typical organization charge for a manufacturing business is as shown
in Figure 8.1. Each vice president has the major responsibility in his or her own
area. The vice presidents, however, will involve his or her managers below them to
participate in the budgeting process and provide much of the needed information.
Because medium to large businesses tend to be very complex in organizational
structure, the comprehensive business budget can be an excellent means of
coordinating various activities and facilitating communication among managers at the
same level and also at different levels of management. It is essential after a business
budget has been finally approved that management at all levels give full support to
the profit plan.
The Comprehensive Business Budgeting Process
The process of preparing a budget is somewhat complex. Actually, there are two
major activities that more or less happen at the same time in the budgeting process.
The sales forecast which is the first component requires that a set of tentative basic
marketing decisions have been made. Other components such as the direct labor
budget require specific decisions. In other words, the final budgeting product consists
of various components each of which require certain tentative decisions at a minimum
to have been made. Otherwise, without these decisions the process can not continue
further. The first phase is making decisions and the second major process involves
preparing the final budget documents.
In a manufacturing business, the formal components of the comprehensive
budget beyond the sales forecast consists of the following:
Operating Budgets
1. Sales budget
2. Ending inventories budget
3. Production budget
4. Materials purchases budget
5. Direct labor budget
6. Manufacturing overhead budget
7. Manufacturing overhead budget
8. Cost of goods manufactured
9. Operating expense budget
Financial Budgets
10. Income statement
11. Cash Budget
12. Capital expenditures budget
13. Budgeted balance sheet
| 139
Management Accounting
2. Sales Budget
Required Decisions
1 Price
2 Advertising
3 Credit terms
4 Sales people compensation plan
5 Number of products
6 Number of territories
7 Special Offers
4. Production Budget
(No new decisions are required)
9. Expense Budget
Required Decisions
1 Estimates of various expenses at the
budgeted level of sales
Required Decisions
1 Desired ending cash balance
2 Issue of stock
3 Issue of bonds
4 Bank loans
5 Payment of accounts payable
6 Payment of dividends
7 Investment in stock
| 141
10
8
Materials
Purchase Budget
Sales Forecast
4
Ending
Inventory
Budget
6
Direct
Factory
Labor
Production
Budget
Income
Statement
Cost of Goods
Manufactured
Budget
11
Cash Budget
9
13
Balance
Sheet
Expense
Budget
2
7
Sales
Budget
Manufacturing
Overhead
Budget
12
Capital
Expenditures
Budget
admirable, profit maximization is not necessarily the goal because of the extreme
difficulty of obtaining all the required information. A more realistic and attainable goal
is to construct a business budget that will result in a satisfactory profit. Profit can be
considered satisfactory when the planned profit stated as a rate of return is equal to
or greater than the rate of return desired by management. The basic fundamentals of
return investment are discussed in chapter 16.
An important assumption in management accounting is that the value of a budget
can be greatly enhanced by the use of all relevant management accounting tools.
Management accounting tools such as cost-volume-profit analysis and incremental
analysis make possible effective what-if analysis. Also, management accounting
tools when used properly compel management and the management accountant
to acquire the relevant data needed by the tool. The proper use of management
accounting tools make the budget more realistic and attainable.
In order for management to effectively engage in the total budgeting process, it is
helpful and perhaps necessary that management have some knowledge of accounting
fundamentals. That the accountant has this knowledge is a given. However, on the
part of management, some knowledge and understanding of the following would be
very helpful:
1. Financial statement relationships
2. Absorptions costing and direct costing fundamentals
3. Cost behavior (fixed and variable costs)
4. Fundamentals of accounting for overhead
5. Accrual basis and cash basis accounting
Sales Forecasting
The starting point of preparing a comprehensive business budget is a sales
forecast. Sales forecasting can be a challenging but somewhat less than a scientific
Management Accounting
process. A sales forecast is an estimate of future sales in units and dollars for a given
time period. Budgets are often prepared on an annual basis and then sub divided into
quarters. The key to making a successful forecast is to first understand the factors,
particularly marketing decision variables, that directly impact sales. These factors
can vary widely among different types of businesses and, consequently, one of the
first prerequisites to a good sales forecast is an understanding of the business and
the market in which the business operates.
| 143
1.
2.
3.
4.
5.
6.
Territory 2
Territory 3
Territory 4
100,000
150,000
75,000
100,000
b. Estimated percentage
of market requesting
demonstration at current
price
c. Estimated potential
customers requesting
demonstration before
seasonal variation
v(a x b)
20,000
37,500
11,250
22,000
d. Seasonal index
e. Estimated customers
requesting demonstration
(c x d)
24,000
45,000
13,500
26,400
d. Estimated percentage
purchasing (sales-calls ratio)
.3
.3
e. Sales forecast (d x e)
7,200
7,920
.20
1.2
.25
1.2
.3
13,500
.15
1.2
.3
4,050
.22
1.2
Management Accounting
10,000
2,000
______
12,000
______
However, there is no need to manufacture what already exists and, therefore, the
number of units in beginning inventory should be deducted from the above total:
Sales forecast (units)
Desired finished goods (EI)
Finished goods inventory (BI)
10,000
2,000
______
12,000
1,000
______
11,000
______
| 145
44,000
Desired materials inventory (EI)
4,000
48,000
Less: Materials inventory (BI)
500
47,500
Cost per unit of material
$5.00
Planned purchases
$237,500
Management Accounting
budget only one type of labor will be assumed. Assume for the moment that the
product being budgeted requires 2 hours of labor and that the wage rate is $12.00 per
hour. The direct labor budget basically involves the following formula:
Production budget
Direct labor hours required per product
Total hours required
Wage rate
11,000
2
22,000
$ 12.00
$264,000
The wage rate in theory should include an allowance for payroll taxes and fringe
benefits. However, in practice these are treated as manufacturing overhead.
Manufacturing Overhead Budget
The manufacturing overhead budget consists of two types of overhead cost:
fixed and variable. Manufacturing overhead can consist of a myriad of items. Major
examples include expenditures such as utilities like electricity and gas. If the company
has elected to measure net income based on direct costing, then fixed manufacturing
overhead would be treated as an operating expense. If absorption costing is being
used, then fixed manufacturing overhead is a production cost that is properly included
in inventory. Even under absorption costing, it is helpful to separate fixed and variable
overhead. A vary simple overhead budget might be as follows:
Variable overhead
Fixed overhead
Total
$200,000
400,000
$600,000
| 147
Management Accounting
initially made on credit. Furthermore, assume that of this amount only 70% will be
collected. The following calculation is then necessary to determine the amount of
cash collected from sales.
Accounts receivable (beginning balance)
Collection of budgeted sales (70% x 600,000)
$150,000
$430,000
$580,000
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
Assets
Liabilities
Capital
Revenue
Expense
Net income
Sales forecast
Production Budget
Purchases budget
Direct labor budget
Manufacturing overhead budget
Depreciation
Accrued expenses
14.
15.
16.
17.
18.
18.
19.
20.
21.
22.
Cash budget
Budgeted balance sheet
Budgeted income statement
Cost of goods manufactured
Capital expenditures budget
Direct costing
Absorption costing
Inventory costing methods
Decisions
Accrual basis accounting
| 149
Sales forecast
Price
12,000 units
$40
Units
Cost
7,000
1,000
$35,000
$31,500
Desired Ending Inventory:
Raw materials
Finished goods
Materials Standards:
Units of material per product
Material cost per unit
Labor:
Labor Standards:
Labor hours per product
Labor rate per hour
Manufacturing Overhead:
Units
Fixed:
Utilities
Insurance
Depreciation
$ 3,000
$ 1,000
$ 6,000
5,000
2,000
2
$4
2
$7
Management Accounting
Selling Expenses
General and administrative
Advertising
$40,000 Executive salaries
Sales people travel
$14,000 Secretarial salaries
Sales people training
$ 5,000 Depreciation, bldg.
Sales people compensation $ 16,000
Planned Data - Financial
Desired ending cash balance
-
Accounts receivable collection rate -
Accounts payable payment rate
-
Interest rate of bonds
-
Additional financing, if needed
-
$ 5,000
$ 2,000
$ 5,000
$200,000
60% of sales first quarter
Remainder next quarter
80% first quarter
Remainder next quarter
8%
Sale of stock
Assets
Current
Cash
$100,000
Accounts receivable
50,000
Materials inventory
35,000
Finished goods inventory
31,500
Fixed
Plant and equipment
$250,000
Accumulated depreciation
30,000
Liabilities
Accounts payable
$ 40,000
Bonds payable
100,000
Stockholders Equity
Common stock
$200,000
Retained Earnings
96,500
Total Liabilities and Equity
$216,500
220,000
$436,500
$140,000
296,500
$436,500
| 151
Price
Units
Total
40.00
12,000
$480,000
4 Production Budget
Sales (units)
Finished goods (EI)
Finished goods (BI)
2,000
$27.3076
$ 54,615
5,000
$ 4.00
$20,000
Production (units)
Standard hours
Standard wage rate
Finished Goods
Units
Unit cost
Materials Inventory
Units
Unit cost
Production
Units per product
+ Materials (EI)
- Materials (BI)
Cost per unit
13,000
2
_______
26,000
5,000
_______
31,000
7,000
24,000
$ 4. 00
_______
$96,000
26,000
$
7.00
$182,000
Fixed overhead
Utilities
Insurance
Depreciation
Variable overhead
Utilities ( $.50)
Repairs & Main. ($2.00)
Supplies ($1.50)
$ 3,000
1,000
6,000
$10,000
$ 6,500
26,000
19,500
$52,000
$62,000
Management Accounting
Materials used:
Materials (BI)
Purchases
Materials (EI)
$ 35,000
96,000
$131,000
$ 20,000
111,000
Direct labor
Mfg. Overhead
Goods in process (BI)
Goods in process (EI)
CPU
$182,000
62,000
$355,000
-0
$355,000
-0
$355,000
$27.3076
Advertising
Sales people travel
Sales people training
Sales people compensation
$480,000
31,500
355,000
386,500
54,615
331,885
$148,115
$ 75,000
12,000
$87,000
$ 61,115
2,000
$ 59,115
$40,000
14,000
5,000
16,000
$75,000
$ 5,000
2,000
5,000
$12,000
11 Cash Budget
Beginning Cash Balance $100,000
Cash Receipts
Collection of1
Accounts. received.
$338,000
Other
$0
__338,000
______
$438,000
Cash expenditures
Materials purchases2
$116,800
Manufacturing labor
182,000
3
Manufacturing overhead
56,000
Selling expenses
75,000
4
Administrative expenses
7,000
Bond interest
2,000
Other
-0 $438,800
________
Ending cash before financing:
$ (800)
Bank loan
0
Sale of stock
200,800
Sale of bonds
0
$200,800
________
Ending
cash
balance
_$200,000
_______
________
| 153
20,000
54,615
________
$466,615
Fixed
Plant and equipment (net)
$209,000
________
$200,000
192,000
Total assets
Liabilities
Current
Account payables
Long-term
Bonds payable
Stockholders Equity
Common stock
Retained earnings
__$675,615
_
_______
______
$675,615
___
_______
______
$119,200
100,000
$ ______
119,200
$400,800
155,615
________
556,415
________
$ 7,000
Management Accounting
Summary
Of all the management accountings tools, comprehensive business budgeting
is one of the most powerful and useful in making decisions. No other tools is as
comprehensive in scope and touches directly and indirectly all the decisions made in
a business. Comprehensive business budgeting brings into the planning process a
logical and orderly procedure to decision-making. The second phase of the budgeting
process is often called the control phase. The use of budgets and budgets standards
to evaluate performance as reflected in the actual financial statements is discussed
in some depth in the chapter 14.
Q. 8.1
Q. 8.1
Q. 8.3
List the basic management concepts that are explicitly used in the
business budgeting process.
Q. 8.4
Q. 8.5
Q. 8.6
Q. 8.7
Q. 8.8
Q. 8-9
Q. 8.10
Q. 8-11
Q. 8-12
a. Material purchases
b. Sales
When the comprehensive business budget is completed, what four
documents make up the final product of the budget?
| 155
10,000
8,000
$40
500
10,000
9,000
$108,000
$2.00
$ 20,000
$8.00
Note: Some of the above data may not be relevant to the budgeted cost of goods
manufactured statement.
Management Accounting
Sales budget
Finished goods beginning inventory
Desired finished goods inventory (units)
Budgeted expenses:
Selling
General and administrative
Budgeted cost of goods manufactured
Production budget (units)
Tax rate
$800,000
$50,000
3,000
$100,000
$ 60,000
$600,000
20,000
40%
$400,000
$ 60,000
$ 3,000
$ 20,000
$ 19,000
$108,000
$ 20,000
$ 72,000
$
$
$
$
30,000
25,000
50,000
10,000
$ 5,000
$ 10,000
80%
60%
| 157
15,000 units
$40
Materials Inventories:
Beginning:
Raw materials
Finished goods
Units
Cost
8,000
3,000
$40,000
$16,000
Desired Ending Inventory:
Raw materials
Finished goods
Labor:
Units
5,000
2,000
Materials Standards:
Units of material per product
Material cost per unit
2
$4
Labor Standards:
Labor hours per product
Labor rate per hour
2
$8
Manufacturing Overhead:
Fixed:
Utilities
Insurance
Depreciation
Selling Expenses
Advertising
Sales people travel
Sales people training.
Sales people compen.
$4,000
$2,000
$9,000
$35,000
$12,000
$ 4,000
$14,000
$ .50
$2.00
$1.50
Planned Data - Financial
Desired ending cash balance
-
Accounts receivable collection rate -
Accounts payable payment rate
-
Interest rate of bonds
-
Additional financing, if needed
-
$300,000
60% of sales first quarter
Remainder next quarter
80% first quarter
Remainder next quarter
8%
Sale of stock
Management Accounting
Assets
Current
Cash
$110,000
Accounts receivable
50,000
Materials inventory
40,000
Finished goods inventory
16,500
Fixed
Plant and equipment
$250,000
Accumulated depreciation
30,000
Liabilities
Accounts payable
$ 40,000
Bonds payable
100,000
Stockholders Equity
Common stock
$200,000
Retained Earnings
96,500
Total Liabilities and Equity
Required:
$216,500
220,000
$436,500
$140,000
296,500
$436,500
| 159
Sales forecast
( ) ( ) ( ) ( )
(2)
Sales budget
( ) ( ) ( )
( )
( )
( )
(3)
( )
( )
(4)
Production Budget
( ) ( ) ( ) ( )
( )
( )
(5)
( )
(6)
( )
(7)
(8)
(9)
Expense Budget
Selling
( ) ( ) ( ) ( ) ( ) ( )
General and Administrative
( ) ( ) ( ) ( ) ( ) ( )
( )
( )
( )
( )
( )
( )
( )
( )
( )
( )
( )
( )
( )
( )
( )
( )
( )
( )
( )
Decisions
Marketing decisions
(1) Price
(2) Advertising
(3) Credit terms
(4) Sales people compensation plan
(5) Number of products
(6) Number of territories
(7) Special offer
(8) Number of sales people
Production Decisions
(9) Wage rate
(10) Labor productivity
(11) Materials inventory (ending)
(12) Finished goods inventory ( ending)
(13) Overtime/second shift
(14) Purchased of additional equipment
(15) Variable Manufacturing Overhead
Rates
(16) Fixed Manufacturing Overhead
estimates
(17) Materials order size
(18) Number of materials order
(19) Units of material per product
(20) Suppliers of material
Financial Decisions
(21) Desired ending cash balance
(22) Direct Costing or Absorption Costing
(23) Issue of stock
(24) Issue of bonds
(25) Bank loans
(26) Investment in stock
(27) Accounts payable payments
(28) Dividends
Parameters and Constraints
(29) Material spoilage factor
(30) Need for Capacity
(31) Depreciation rates
(32) Tax rates
(33) Collection of A/R rate
(34) Payment of accounts payable rate
(35) Production potential of existing
equipment
(36) Quantity discount schedules
(37) Various expense cost factors
(38) Various overhead cost factors
(39) Bad debt rates
Management Accounting
| 161
Management Accounting
The key element in these definitions of relevant costs is that between the two
alternatives each cost should be different in amount. Secondly, the cost must be a
future cost. Historical costs, as will be explained, are always irrelevant and may be
safely excluded from the analysis;
To illustrate, suppose a company is about to make a decision to purchase six
months of office supplies. The needed supplies can be purchased from supplier A for
$5,000 and from Supplier B for $4,800. However, Supplier B is in another state and, if
the purchase is made from supplier B, the company must pay freight in the amount of
$300. Also, the company has $500 of supplies on hand. One approach is to include
all costs including irrelevant costs:
Supplier A
Cost of supples to be purchased
$5,000
Cost of supplies on hand
500
Freight
______
$5,500
______
Supplier B
$4,800
500
300
______
$5,600
______
Difference
$200
-0(300)
_____
($100)
_____
Tenant A
$500
$ 50
$550
Tenant B
$500
0
$500
Difference
$ 0
$ 50
$ 50
The above comparison of revenue clearly shows the monthly rental revenue of
$500 to be irrelevant as to which tenant is accepted for occupancy because it is rent
that is the same between both alternatives. The inclusion of the monthly revenue
| 163
Relevant
Future costs that are not the same
Opportunity costs
Trade-in allowance
Cost of new assets
Irrelevant
Sunk Costs - Two costs that are often misunderstood or used incorrectly in
incremental analysis are sunk costs and opportunity costs. Sunk costs are, first of
all, always irrelevant costs. They maybe excluded in any analysis or cost comparison
review. Sunk costs are historical costs; that is, past expenditures. Because they
are expenditures already made the expenditure can not be changed. To incur or not
incur is not an option now. Examples of a sunk cost are cost of fixed assets such as
buildings or equipment. By the same token, depreciation is also a sunk cost. The
book value of a fixed asset (cost - accumulated depreciation) is also a sunk cost.
To illustrate, assume that an asset currently in use (old asset) has a book value of
$1,000 and that this piece of equipment is tentatively under review for replacement.
The purchase price of the new asset is $5,000 and is estimated to have a useful life
of 10 years. The old asset can also last 10 years with some repairs now and then.
The operating expenses of the old asset is now $800 per year but the new asset
is projected to have only an operating expenses of $200 per year. The old asset
has no trade-in value. The alternatives are to keep the old asset or to replace it.
The replacement should take place if the relevant costs of replacing is less than the
relevant costs of keeping.
10 Years Basis
Keep Old Asset Purchase New Asset Difference
Cost of new asset
$ 5,000
($5,000)
Book value of old asset
$ 1,000
1,000
0
Operating expenses
$ 8,000
2,000
6,000
$ 9,000
$ 8,000
$1,000
The difference of $1,000 is a net benefit of purchasing and replacing the old asset
with the new asset. However, since the book value of the old asset is shown in both
columns and is, therefore, the same between both alternatives, the book value of the
old asset is irrelevant. You may wonder how this is so? If the old asset is kept, then
Management Accounting
the book value of $1,000 will be shown on the books as depreciation cost over the
remaining life of the old asset. If the new asset is purchased, then the book value of
the old asset will be recorded as a $1,000 loss. In either event, an expense of $1,000
during the next 10 years will be recorded. Whether the old asset is replaced or not,
the cost of the old asset results in a deduction from revenue in the same amount
either as depreciation or a loss from the trade-in.
Opportunity Costs - Opportunity costs are always relevant to making decisions;
however, the concept of opportunity cost is somewhat abstract and difficult to
understand because it is not an out-of-pocket cost. Following are some commonly
used definitions of opportunity cost:
1. Earnings that would be realized if the available resources would be put to
some other use.
2. Alternative earnings that might have been obtained if the productive good,
service, or capacity had been applied to some other alternative use.
The definition preferred in this chapter is the following: opportunity cost is
the amount of revenue forgone (given up) by not choosing one alternative over
another.
The key word for understanding opportunity cost is not cost but revenue
forgone. For example if you decide to take a vacation rather than invest $5,000 in a
savings account that earns 6% per annum, then the opportunity cost is the interest
you could have earned. At 6% interest you could have earned $300 for a full year.
Therefore, the decision to take a vacation should include as a cost the interest that
was not earned
Other examples of opportunity cost may be given. If you have been given a choice
of two jobs and job A pays $60,000 per year and job B pays $55,000 per year, then
the opportunity cost of accepting job A is $55,000. Other things equal, you are only
$5,000 better off financially with job A.
If you own land that could be sold for $100,000 and the land is not now earning
any income other than appreciation in value, then there is an opportunity cost of not
earning interest. Assuming you could earn at a minimum 6% interest in a CD, the
opportunity cost of keeping the land and not selling is $6,000 per year. Interest in
the amount of $6,000 is being forgone each year in favor of the land appreciating in
value.
You own a building that you can easily rent for $10,000 a month. If you decide to
use the building to open a business for yourself, then you incur an opportunity cost in
the amount of $10,000, (rent given up, forgone, or sacrificed) by going into business.
If you are a student and you spend 30 hours a week in class and in studying, there is
an opportunity cost of being a student. The opportunity cost is the income you could
be earning by working rather than attending class or studying.
Fixed and Variable Costs - Costs in management accounting are often assumed
to be either fixed or variable. The classification of a cost as either fixed or variable
does not necessarily mean the cost is relevant or irrelevant. Whether a fixed cost or
a variable cost is relevant or irrelevant depends on the whether the cost is different
| 165
Difference
(500)
$5,000
( $4,000)
$1,000
Note: For simplistic purposes, the cost of machine B was ignored. However, in order to make
the decision, the cost of machine B must be included as a relevant cost.
In this particular case, both sales and cost of goods sold are relevant. However,
had volume not been greater with the machine B, then sales and cost of goods sold
would have been the same and, therefore, irrelevant. Then other cost or revenue
factors would have had to be found to make the decision. Whether a fixed cost or
variable cost is relevant then depends more on the circumstances than the nature of
the cost.
Incremental Analysis Model
The basic incremental analysis model used in this program may be mathematically
summarized as follows:
IC
i
=
=
RCia -
RCib -
n
-
RCia - RCib
1,n
relevant costs of alternative A
relevant costs of alternative B
number of relevant cost items
Incremental analysis is a flexible tool. Data may computed and presented for
the life of a decision alternative on a per period basis such as a month or year.
This procedure would require the relevant cost items to be divided either by the
number of years of the number of months in the life of the assets under consideration.
Incremental analysis does not require that irrelevant data be included. However, at
the option of the analyst irrelevant costs may be included. The inclusion of irrelevant
data will in no way affect the ultimate decision.
The action of classifying an expense as irrelevant or relevant does not mean that
the irrelevant cost is not important. In fact, in the execution of the decision, it may
be very important. To illustrate, assume that you are about to go to a movie and you
are in the midst of choosing which movie theater to attend. You have narrowed your
Management Accounting
choices to movie A and movie B and you want to see the movie which will cost the
least. You have made the following cost analysis:
Movie A
Movie B
Difference
Cost of popcorn
$3.00
$3.50
($ .50)
Large drink
$3.50
$4.25
($ .75)
Transportation cost
$1.00
.75
$ .25
$7.50
$8.50
($ 1.00)
The net benefit of attending movie A is $1.00. The cost of tickets is $8.00, the
same at each movie theater. Therefore, since the ticket cost is the same, you have
correctly omitted this irrelevant cost from your analysis. Consequently, you decide in
favor of movie A and you put $7.50 in your pocket. However, at this point taking only
$7.50 would be a mistake since the total cost of attending movie A would be $15.50.
The execution of the decision requires this amount. The cost of the tickets is only
irrelevant in making the decision but not irrelevant in the execution of the decision.
Use of Present Value in Incremental Analysis
The above discussion of incremental analysis was based on the assumption that
the timing of expenditures was not important and, therefore, can be ignored. In most
instances, this is most likely true, however, there may be decisions where even though
two alternatives involve identical future costs, the timing of when the expenditures
are actually made is the important factor. The student software package for The
Management/Accounting Simulation contains a set of management accounting
tools. One of these tools is an incremental analysis tool that contains a present value
option.
When present value and net-of-tax options are selected, this program becomes
a highly sophisticated tool requiring considerable skill to use. Each cost or revenue
must be analyzed in terms of the following questions:
1. Does this cost affect both pre-tax net cash flow and taxable income?
For example, a disallowed expense for tax purposes would affect pre-tax net
cash flow but not taxable income. For example, the incurrence of a $200 disallowed expenditure for tax purposes would decrease pre-tax net cash flow.
However this disallowance would not cause a change in taxable income. In
other words, additional expenditures for disallowed tax deductions would not
change taxable income.
2. Does this cost affect only taxable income? Some cost items such as depreciation or losses have no affect on pre-tax net cash flow. However, after-tax
net cash flow is increased by such items. Also, tax credits affect net cash
flow after-tax but not before. Items that affect only taxable income must be
explicitly designated as having such affect.
Since the present value calculations are always based on cash flows, then the
tax treatment of cost items is critically important. Tax treatment of items can either
| 167
Management Accounting
Keep Old
Buy New
Equipment
Equipment
Difference
| 169
Q. 9.1
Relevant cost
Irrelevant cost
Incremental analysis
Sunk cost
Incremental cost
Opportunity cost
Direct cost
Indirect cost
Q. 9.2
Q. 9.3
Q. 9.4
Q. 9.5
Explain the difference between the majority and minority view of sunk
costs.
Q. 9.6
Q. 9.7
If new equipment is purchased, then the old equipment will be sold for
$10,000 and a loss of $2,000 will in incurred. Is the loss a relevant
cost? Is the proceeds from the sale of the old machine relevant?
Q. 9.8
Q. 9.9
Q. 9.10
Explain how the introduction of income taxes into the analysis can make
a historical cost relevant.
Management Accounting
Inescapable
Escapable
Incremental
Sunk
Opportunity
Variable
Fixed
Relevant
Irrelevant
Semi-variable
Costs
A. Presidents salary
B. Factory workers wages
C. Installation cost of new machine
D. Cost of old machine
E. Monthly rental value of warehouse
F. Repairs and maintenance
Machine A
$2,000
Machine B
$2,000
G. Utilities
Machine A
$1,500
Machine B
$2,000
You have been provided the following keep or replace decision information:
Old Machine
New Machine
Cost
$ 50,000
$ 100,000
Salvage value
$ 10,000
$ 5,000
Trade-in allowance
$ 15,000
Required:
Determine whether or not the old machine should be replaced.
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
| 171
If equipment is owned:
Purchase price of equipment
Repairs and maintenance (monthly)
Utilities (monthly)
Interest on financing (annual)
Useful life of equipment (years)
If equipment is leased:
Monthly lease payments
Repairs and maintenance
(Cost is included in lease agreement)
Utilities (monthly)
$ 50,000
$ 100
$ 200
$ 1,500
10
$
$
600
150
Required:
Determine which is more desirable, own or lease?
Exercise 9.4 Sell now or Process Further
You have been provided the following information concerning the sell now or
process further decisions.
Current production method cost data:
Selling price
$ 20
Units manufactured 100
Production capacity (units) 150
Labor hours required (per unit)
2
Manufacturing costs:
Material (per unit)
Factory labor (per unit)
Fixed manufacturing overhead
Variable manufacturing cost (per hour)
$ 1.00
$ 15.00
$ 5.00
$ .50
*If the additional processing is undertaken the variable manufacturing cost rate
will remain the same.
Required:
Use incremental analysis to determine whether processing further should be
undertaken.
Management Accounting
$_________________________________________________________
5. Assume that the companys marginal tax rate is 40%. What is the incremental
cost on an after-tax basis? $
_
__________________________________________________________
__________________________________________________________
__________________________________________________________
__________________________________________________________
__________________________________________________________
| 173
_____________________________________________________
$____________________________________________________
_____________________________________________________
Management Accounting
| 175
176 | CHAPTER TEN Incremental Analysis and Cost Volume Profit Analysis: Special Applications
substantially in population density and income distribution. Also, cultural differences
regarding tastes and preferences can play an important role in whether to expand or
not expand the business. For example, while catfish restaurants are very popular in
the South they are not likely to be equally received in the Northeast. Differences in
laws, state regulations, and tax structures also can have a bearing on the decision.
Incremental analysis can be used either to measure segmental net income or
segmental contribution. The advantages and disadvantages of using segmental net
income and segmental contribution is discuss in some depth in chapter 15. Which
measure is best is somewhat controversial; however, in the example to follow
segmental contribution will be the criterion. Segmental net income requires the
allocation of common expenses and all allocations of costs tend to be somewhat
arbitrary and can obscure the potential profitability of a segment. The segmental
contribution approach is favored here. However, if done properly, both approaches
can be used in the same analysis.
In using incremental analysis to evaluate potential decision, irrelevant revenue and
expenses may be omitted in the final analysis. Irrelevant revenues and expenses are
those items that will not be affected or changed by the making of the decision. What
is relevant or irrelevant depends on the particular circumstances under investigation
and can vary from situation to situation. For this reason, providing examples of
irrelevant revenues or expenses is not always easy. However, in most cases, for
example, it would be difficult to see how in the short run opening a territory would
affect the salaries of top management Therefore the salaries of top management are
likely to be irrelevant.
The evaluation of the opening of a new territory generally involves the following
steps:
1. Gather all relevant revenue information. An initial but tentative price should
be set. The normal market potential should be estimated. Normal market
potential can be defined as the number of customers likely to benefit from
purchasing the product.
2. Factors that directly impact sales volume should be evaluated. These factors
include such decisions as selling on credit, compensation of sales people,
and advertising.
The economic environment should be carefully evaluated. The impact
that seasonal factors have on sales is important and should be examined.
Analysis should be made in terms of quarters and some attempt should be
made to estimate an seasonal index for each quarter. Based on the various market demand factors identified, a sales forecast of sales in units and
dollars should be made.
If sales of the product in the territory being evaluated tends to be seasonal
in nature, then this fact can also have a major impact on available capacity.
Opening a new territory must be based on the premise that the capacity
to manufacture is adequate, given the increased demand from opening a
new territory.
Management Accounting
Figure 10-1
100,000
150,000
200,000
$ 5,000,000
$ 10,000,000
$ 15,000,000
$ 20,000,000
$ 3,000,000
$ 6,000,000
$ 9,000,000
$ 12,000,000
250,000
750,000
1,000,000
500,000
1,000,000
1,500,000
2,000,000
Credit expenses
150,000
( $3)
500,000
300,000
450,000
500,000
3,900,000
7,800,000
11,700,000
15,600,000
Contribution margin
$ 1,100,000
$ 2,200,000
$ 3,300,000
$ 5,000,000
$ 2,000,000
$ 2,000,000
$ 2,000,000
$ 2,000,000
Advertising
1,000,000
1,000,000
1,000,000
1,000,000
$ 150,000
150,000
150,000
150,000
350,000
350,000
350,000
4,000,000
4,000,000
4,000,000
4,000,000
Total expenses
$ 7,900,000
$ 11,800,000
$ 15,700,000
$ 19,600,000
Segmental contribution
($2,900,000)
($1,800,000)
($ 700,000)
$1,000,000
350,000
500,000
500,000
500,000
Other fixed expenses could include such expenses as additional home office staff needed such as accounting,
credit department, marketing department employees, additional staff needed in the production department.
| 177
178 | CHAPTER TEN Incremental Analysis and Cost Volume Profit Analysis: Special Applications
The above analysis reveals the following:
1. At the sales volume range of 50,000 - 150,000 the territory is not profitable.
2. At a volume of 200,000 or greater the territory appears to be profitable. The
question that must be asked and answered is this: Does a sales level of
200,000 appear reasonable or likely to happen? If the most optimistic estimate is that sales will not in the distance future ever exceed 150,000, then
the decision not to open the territory would be the right decision.
Illustrative Problem
The management of the L. K. Widget Company is considering opening a new
territory to be called the Western Territory. In the last quarter, the companys sales of
8,500 units were far below the volume required to make the company profitable. The
marketing department through marketing research and analysis of internal financial
data has made available the following information relevant to the opening of the
Western Territory.
Direct Costs
Selling:
General and administrative
Variable
Per Unit
Variable
Cost of goods sold
$ 69.00 Travel
$2.20
Packaging
$ 2.00 Supplies
$1.00
Sales people travel
$ 5.40
Sales people commission
$ 20.00
Bad debts expense
1.5% of sales
Credit department
$ 1.00
Direct fixed (Selling)
Salaries of sales people
Sales people training
Advertising
Territorial office operating
Home office sales expense
$ ______
$ ______
$ ______
$ 50,000
$ 30,000
If the Western Territory is opened, then approximately 600 sales people would
be hired at a per quarter salary of $2,000 per sales person. The training of each
new sales person will cost $200. After the initial hiring of the full sales force, it is
expected each quarter, because of some sales people quitting for various reasons
that on the average 50 new sales people will be hired each quarter. The market
potential of this territory is estimated to be 110,000 customer per quarter. On the
average, each customer will purchase one Gadget a a price of $200. An analysis
of demand indicates approximately 28% of the potential customers would request
demonstrations per quarter.
If the Western territory is opened, management will seriously consider granting
customers three months of credit. These credit terms would be offered in all territories.
If three months credit is granted, then sales should increase at least 20%. Last quarter
Management Accounting
the sales-calls ratio without credit was 30%. The amount budgeted for advertising
would be $1.20 per potential customer and the selling price of the Gadget would be
$200.
Based on the information provided, a what-if profitability analysis as shown above
may be made. It is important for management to estimate sales for the first operating
period. Based on the provided information above, this estimate may be computed
as follows:
Normal market potential
110,000
Percentage requesting demonstration
.28
Number requesting demonstration
30,800
Sales-calls ratio (.30 x 1.20)
.36
This estimate of 11,088 units for the first quarter of operations falls between the
range of 10,000 and 15,000 unit. As the above analysis shows, at a sales level of
15,000 units, segmental contribution is a negative $66,000. At sales of 11,088, it can
easily be computed that a net loss of $443,177 would be experienced. Based on the
initial analysis of the available data, it appears that opening the territory might not
be a wise decision. However, if it is expected that the required sales level can be
attained through rapid growth in sales because of advertising and an effective sales
force, perhaps the territory should be opened. The break even point for this territory
is 15,684 units (1,512,000/ (200 - 103.60). All decisions involve a degree of risk and
there is never a 100% certainty a profit goal can be achieved, even if the analysis is
positive at all volume levels of operation.
Selling on Credit
In todays modern economy, selling on credit is hardly a choice but a necessity.
However, a business does not directly have to run a credit department. Practically all
businesses can now sell indirectly on credit by accepting credit cards. Until recently
some restaurants did not accept credit cards but required a purchase of a meal to be
paid for in cash. For example, Waffle House recently began to accept credit cards
for the first time. The discussion here, however, pertains more to the decision to sell
on credit by granting and maintaining credit internally rather than to the use of credit
cards. When credit cards are accepted, cash flow is not affected adversely in the
short run or substantially decreased as in the case of granting credit for three months
or longer. Also, a number of other problems inherent in the offering of credit internally
are avoided such as bad debts.
When a company begins to sell on credit, a number of activities have to take
place regularly. One of the first major activities, and not an inexpensive one, is to
establish a credit department including hiring a credit manager and a staff to perform
the duties of a credit department. Some of the periodically occurring activities not
existing before granting credit include the following:
1. Requiring a prospective credit customer to fill out a credit application
form
| 179
180 | CHAPTER TEN Incremental Analysis and Cost Volume Profit Analysis: Special Applications
Figure 10-2
Opening New Territory
Sales (units)
10,000
15,000
20,000
25,000
$ 2,000,000
$ 3,000,000
$ 4,000,000
$ 5,000,000
$ 690,000
$ 1,035,000
$ 1,380,000
$ 1,725,000
Commissions ($20.00)
200,000
300,000
400,000
500,000
Packaging ($2.00)
20,000
30,000
40,000
50,000
Travel ($5.40)
54,000
81,000
108,000
135,000
30,000
45,000
60,000
75,000
15,000
20,000
25,000
Credit ($1.00)
Travel - G & A ($2.20)
22,000
33,000
44,000
55,000
10,000
15,000
20,000
25,000
Total ($103.60)
$ 1,036,000
$ 1,554,000
$ 2,072,000
$ 2,590,000
$ 1,200,000
$ 1,200,000
$ 1,200,000
$ 1,200,000
100,000
100,000
100,000
100,000
Advertising
132,000
132,000
132,000
132,000
Office operating
50,000
50,000
50,000
50,000
Home office
30,000
30,000
30,000
30,000
Total
$ 1,512,000
$ 1,512,000
$ 1,512,000
$ 1,512,000
Total expenses
$ 2,548,000
$ 3,066,000
$ 3,584,000
$ 4,102,000
Segmental contribution
($548,000)
($ 66,000)
$ 416,000
$ 898,000
Fixed-direct
2.
3.
4.
5.
6.
7.
8.
Management Accounting
credit risks. The screening of customers, of course, can be time consuming and it is
not necessarily inexpensive. Third party companies may be hired to evaluate credit
risks. However, this service still involves a cost.
One of the first important steps is to analyze the impact that offering credit will
have on sales. The normal expectation is that the granting of credit will increase
sales. However, since credit also increases operating expenses, an increase per se
in sales is not necessarily enough. The increase must be sufficient to cover the cost
of maintaining a credit department and the other costs associated with credit and at
the same time make a major contribution to the over-all net income of the business.
Consequently, it is imperative that the percentage effect on sales be somewhat
accurately measured. Given a reliable estimate of the increase in sales, the variable
expenses associated with an increase in sales from offering credit can then be
determined. Following is an example of the type of analysis required in evaluating
the credit decision:
The following analysis (Figure 10.3) shows that unless sales increase by nearly
2,000 units, the granting of credit will have a detrimental affect on net income. The
contribution margin without credit was approximately $27.00 ($100 - $73.00) The
contribution margin with credit decreased to $17.05 ($27.00 - $9.95). To recover
the increase in fixed credit department expense, sales must increase by at least
1,715 units per quarter (29,250 / 17.05). The decision to sell on credit then depends
on managements estimate of by how much credit will increase sales and by
managements willingness to assume risk.
Sales People Decisions
Sales reps or sales people, as they are called in The Management/Accounting
Simulation, are a necessary part of most businesses. However, the nature of the
services that sales people perform can vary greatly from business to business. In
some instances, sales people simply serve as a order taker and may simply ring up
the sale. In other cases, they perform a series of related services and the last step
in this process is the closing of the sale. In the first instance, the customer more or
less makes the decision to purchase with little or no persuasion and simply expects
someone to take payment. In the second instance, the potential customer is found
by the sales person and then the product is displayed or demonstrated and a sales
pitch is made to convince the customer to buy. In this instance, a highly trained and
skilled sales person is needed.
Services performed by sales people in general include the following
1. Finding new customers
2. Meeting with potential customers to introduce or demonstrate the
product
3. Answer all questions concerning the product
4. Explain the terms of financing, if that is required
5. Closing the sale
6. Deliver the product
7. Completing the paper work involved in the sale
8. Calling upon existing customers
| 181
182 | CHAPTER TEN Incremental Analysis and Cost Volume Profit Analysis: Special Applications
Figure 10-3
Increase in Sales
1,000
2,000
3,000
4,000
Sales ($100)
$ 100,000
$ 200,000
$ 300,000
$ 400,000
Expenses
Variable Credit
Bad debts ($3.00)
$ 3,000
$ 6,000
$ 9,000
$ 12,000
Credit check ($5.00) 5,000 10,000 15,000 20,000
Bookkeeping ($1.00) 1,000
2,000 3,000 4,000
Statement preparation ($0.15)
150
300
459 600
Postage and stationery ($0.30)
300
600
750 1,000
Payments processing ($.50)
500 1,000 1,500 2,000
Payment processing
_______
_______
_ ______
________
Total variable (credit)
$ 9,950
$ 19,900
$ 29,209
$ 39,600
Variable Non Credit
Cost of goods sold ($60.00)
$ 60,000
$ 120,000
$ 180,000
$ 240,000
Commissions ($10.00) 10,000 20,000 30,000 40,000
Packaging ($2.00) 2,000 4,000 6,000 8,000
Travel ($1.00) 1,000 2,000 3,000 4,000
_______
_______
_ ______
________
Total variable (non credit)
$ 73,000
$ 146,000
$ 219,000
$ 292,000
Total variable expenses
$ 82,950
$ 165,900
$ 248,209
$ 331,600
Fixed Credit
Salary Manager
$ 15,000
$ 15,000
$ 15,000
$ 15,000
Salaries-staff 12,500 12,500 12,500 12,500
Equipment expense
1,250 1,250 1,250 1,250
Other fixed
1,000 1,000 1,000 1,000
_______
_______
_ ______
________
$ 29,250
$ 29,250
$ 29,250
$ 29,250
Fixed non Credit
0
0
0
0
_______
_______
_ ______
________
Total direct expenses
$ 112,200
$ 195,150
$ 277,459
$ 321,250
Increase in net income
$ 12,000)
_______
_______
$
4,950
_______
_______
22,541
_$
_ ______
______
$
78,750
________
________
Management Accounting
In each step of this process expenses are incurred. While a sales force is expected
to generate revenue, the maintenance of a sales force also involves considerable
expense. A sales force should be neither too small nor too large. Lost sales from an
inadequate sales force or unnecessary expenses from too large a force can equally
be detrimental to the success of a business. The evaluation of the effectiveness
of a sales force in terms of sales generated and expenses incurred is a periodic
requirement.
Expenses created from creating and maintaining a sales force includes the
following activities:
1. Hiring costs
2. Training costs
3. Supervision cost
4. Compensation of sales people
5. Travel costs
6. Termination costs
Two of the more important costs concern (1) sales people compensation and (2) number
of sales people needed.
Number of Sales People
Many factors can affect the number of sales people needed in a business. If
customers are simply expected to walk in and browse on their own and then on their
own walk to a check out stand to pay, then only a few sales people at any given
time are needed. However, if the customer must be found and then persuaded to
purchase, then a much larger sales force may be needed.
If the a full range of sales services as listed above is required of a sales person,
and assuming the prospective customer must be found and called upon, then perhaps
only one or two calls a day at most can be made. The complexity of the product, the
number of competing similar products, and the sales resistance of the customer are
factors that may cause each sale to require considerable time to initiate and close.
The number of calls that a sales person can make in a given period of time and
the sales-calls ratio, then, are important factors in determining the need for sales
people. If a sale person can make four calls a day and each call results in a sale,
then the number of sales people needed should greatly be reduced. However, if the
only one call can be made per day and the sales-calls ratio is only 25%, then more
sales people undoubtedly would be required. However, as the number of calls per
period and the sales-calls ratio gets smaller, the dollar amount of sale when it is made
would be expected to be much greater. If the price of a product is fairly low, then the
investment of considerable time in personal sales is most likely not economically
wise.
When a lot of personal sales effort is required to close a sale, the number of
sales people to hire depends to a large extent on how many calls a sales person can
make in a given period of time. The motivation of sales people to makes calls is also
extremely important. Consequently, the prospect for financial reward when a sale is
made is also an important in motivating factor.
| 183
184 | CHAPTER TEN Incremental Analysis and Cost Volume Profit Analysis: Special Applications
Assume that the K. L. Widget Company has determined that the number of
potential customers per quarter is 100,000 and at the current price of the product
20% of these potential customers will request a demonstration or will listen to a sales
pitch. A sales person on the average can make 120 calls per quarter. The number of
sales people required can be computed as follows:
Potential customers x requesting percentage
Number sales people required =
Calls per quarter
Number sales people required =
100,000 x .2
120
= 167
Management Accounting
person can make and given a growth in the business, in the long run total salaries
can increase because the number of sales people is increasing.
Rewarding sales people in the form of a commission may provide an incentive for
sales people to make more calls and, consequently, create more sales. The potential
for reward is much greater, particularly in the event there is a substantial increase
in demand for the product. However, in the event of a temporary decline in demand,
the compensation of sales people can substantially decline when based solely on a
commission rate. As a result of a decline in compensation sales people may quit.
The proper balance of a salary and a sales commission is a challenging decision
and one that is often difficult to make. The commission rate should not be so high as
to unduly compensate sales people to the detriment of the company nor too low so
as to discourage sales people and, therefore, cause a high turnover rate. Also, the
payment of a salary should not be so high as to adversely affect the motivation to sell.
Since many combinations of salaries and commission rates are possible, the various
mix of these two means of compensation should be analyzed. The job of analyzing
various sales compensation plans may by request of management fall into the hands
of the management accountant.
Use of Management Accounting Tools in Making Sales People Decisions
The management accountant is an expert is the use of various decision making
tools. Three tools that the management accountant can used in analyzing the sales
compensation plan are:
1. C-V-P Analysis
2. Incremental Analysis
3. Segmental reporting
C-V-P Analysis-Cost-volume-profit analysis can answer questions such as the
following: Given an increase in the number of sales people, by how much must sales
increase in order to make the same income as before.
For example, assume the following information has been provided to you.
Price of the product
Current sales (per quarter)
Variable cost rate (includes commissions)
Fixed expenses
Salary per sales person
Proposed number of new sales people
Commission rate
$300
10,000 units
$180
$800,000
$5,000
100
10%
Analysis: - An increase in sales of people by 100 means that fixed expenses would
increase by $500,000 (100 x $5,000). The question to be answered is: by how much
must sales increase if 100 new sales people are hired and for net income to not be
less?
Based on the above information, the companys contribution margin is $120
($300 - $180). The increase in sales necessary to offset the $500,000 increase in
fixed expenses can be computed as follows:
| 185
186 | CHAPTER TEN Incremental Analysis and Cost Volume Profit Analysis: Special Applications
$500,000
Quantity (increase in sales) =
$120
= 4,160
$ 5,000
1,248
______
$ 6,248
______
$500,000
124,800
_______
$624,800
_______
61.67
$5,000
1,850
______
$6,850
In order to earn an additional $240,000 of net income, sales people must average
approximately 62 sales per quarter. This required level of sales is almost 1 sale per
day.
To effectively evaluate this plan further, an analysis should be made of the sales
effort and compensation of currently hired sales people. If the average sales for current
Management Accounting
sales people last quarter was 30 units per person, then the desired profitability from
hiring of new sales people does not seems appears to be a bit optimistic. However,
if the sales per sales person last quarter was 70 or more, then the plan to hire 100
new people might work, given that the market potential in the area in which new sales
people will work is equal to the market potential of current territories. While costvolume-profit can not predict what will happen, this tool can provide a bench mark for
what must happen in order for a plan to work.
Incremental Analysis - Another valuable tool for evaluating decisions such as the
sales compensation decision is incremental analysis. This tool is basically a work
sheet method in which the relevant costs/expenses and revenues of each alternative
are compared.
In order to illustrate the use of this method, assume that you have been provided
the following information:
Market potential
1,00,000
Price
$300
Percentage requesting demonstration
30%
Sales-calls ratio
25%
Credit terms
3 months
In addition, six compensation plans for sales people have been developed as
follows:
Salary
Commission
Calls per quarter
Rate
Plan A
$4,000
2%
60
Plan B
$3,500
6%
100
Plan C
$3,000
10%
150
Plan D
$2,500
14%
200
Plan E
$2,000
25%
225
Plan F
$1,500
30%
250
The essence of the above plans is that as the commission rate increases the
salary will be decreased. In addition, the assumption is that as the commission rate
increases, the sales people will be motivated to make more calls. Furthermore, as
the commission rate increases the number of sales people needed is less with the
consequence that total salaries paid will be less.
To evaluate these six plans, the following must be computed.
1. Number of sales people needed
2. Sales (units per quarter)
3. Total salaries for each sales compensation plan
4. Total commissions paid for each compensation plan
5. Total compensation for each plan
6. Compensation per sales person
7. Sales compensation cost per unit sold (optional)
The number of sales people need may be computed as follows:
| 187
188 | CHAPTER TEN Incremental Analysis and Cost Volume Profit Analysis: Special Applications
Management Accounting
Plan B
Plan C
Plan D
Plan E
Plan F
Computation of
Total Salaries
Customers
requesting
demonstrations
Calls per quarter
Sales people needed
Salary
Total salaries
300,000
300,000
300,000
300,000
300,000
300,000
60
100
150
200
225
250
5,000
3,500
3,000
2,500
2,000
1,500
$4,000
$3,500
$3,000
$2,500
$2,000
$1,500
$9,000,000
$6,250,000
$4,000,000
$2,250,000
$20,000,000
Computation of Total
Commissions
Sales (units)
Sales (dollars)
Commission rate
Total commissions
75,000
75,000
75,000
75,000
75,000
75,000
$22,500,000
$22,500,00
$22,500,000
$22,500,000
$22,500,00
$22,500,000
.02
.06
.10
.14
.25
.30
$450,000
$1,350,000
$2,250,000
$3,150,000
$5,625,000
$6,750,000
Plan B
Plan C
Plan D
Plan E
Plan F
$4,000
$3,500
$3,000
$2,500
$2,000
$1,500
.02
.06
.10
.14
.25
.30
$20,000,000
$12,250,000
$9,000,000
$6,250,000
$4,000,000
$2,250,000
$450,000
$ 1,350,000
$2,250,000
$3,150,000
$5,625,000
$6,750,000
$20,450,000
$13,600,000
$11,250,000
$9,400,000
$9,625,000
$9,000,000
$4,090
$3,886
$3,750
$3,760
$4,813
$6,000
$273
$!81
$150
$125
$128
$120
decisions for the current period. Because the management accountant has knowledge
of tools useful in making these decisions, it is important for the management accountant
to have a solid grasp of the basic fundamentals and problems in the making of sales
| 189
190 | CHAPTER TEN Incremental Analysis and Cost Volume Profit Analysis: Special Applications
force decisions. Tools such as cost-volume-profit analysis, incremental analysis, and
segmental contribution reporting can be useful in making these decisions.
Q. 10.1
Q. 10.2
Q. 10.3
What costs are incurred by the granting of credit that would not otherwise
be incurred?
Q. 10.4
Q. 10.5
How can cost volume profit analysis be used to help make the credit
decision?
Q. 10.6
How can cost volume profit analysis be used to help make the open a
new territory decision?
Q. 10.7
Q. 10.9
Q. 10.10
Per Unit
$
69.00
$
2.00
Management Accounting
$
$
$
$
20.00
6.00
3.00
1.00
Direct Fixed (Annual)
Salaries of sales people
Sales people training
Advertising
Territory sales office lease
Office operating expense
Home office sales expense
$ 4,500,000
$ 124,000
$ 1,380,000
$ 60,000
$ 240,000
$ 96,000
$
$
Direct fixed
Indirect costs:
Selling
Credit
General and administrative
Executive salaries
Secretarial & clerical salaries
Supplies
Deprecation, building
Depreciation, furniture and fixtures
Fixed manufacturing overhead
2.50
1.00
None
96,000
$ 1,080,000
$ 240,000
$ 60,000
$ 18,000
$ 30,000
$ 3,600,000
Note: the indirect costs/expenses are expenses that were incurred last year. The opening
of the Midwest territory will have no effect on these expenses.
| 191
192 | CHAPTER TEN Incremental Analysis and Cost Volume Profit Analysis: Special Applications
Required:
1. Prepare an income statement for the Midwest territory based on direct costing.
Also, show segmental contribution.
2. Compute the break even point of the Midwest territory.
3. Compute the target income point of the Midwest territory.
Exercise 10.2 Credit Analysis
The management of the K. L. Widget Company has tentatively decided to offer
its customers credit. The management believes that credit will increase sales as
follows:
3 months credit 20%
6 months credit 35%
12 months credit 50%
Selling on credit will increase the salesmens sales-calls ratio. Extending credit
will not result in an increase in demonstrations or an expansion of market potential.
Therefore, the offering of credit terms does not increase the need for more sales
people to call on customers.
In addition to increasing revenue, selling on credit will also increase operating
expenses. Excessive credit terms could have the negative effect of decreasing net
income. If credit terms are extended to customers, then a credit department would
have to be established to handle the administration of credit processing and collection.
Estimated cost of operating a credit department include the following:
Salary (annual) of a credit manager
$35,000
Salary (annual) of an assistant manager
$25,000
Hourly wages of two clerks
$ 12.00
(The number of working hours in a typical year is 2,112)
Selling on credit requires that a credit check be run on each purchaser. The cost
of this credit check will average $5.00 per application. In addition, selling on credit
involves additional bookkeeping. Credit terms of 3 months involves four basic journal
entries while 12 months credit would result in 13 entries. The average cost per entry
is estimated to be $.15.
Even though credit is offered to all, some customers will still prefer to pay cash.
Also, some customers that can afford to pay cash will choose credit simply because
it available. Consequently, the percentage of customers using credit may be higher
than the percentage increase in sales due to credit. The percentage of customers
that will buy on credit is estimated as follows;
3 months credit
30%
6 months credit
50%
12 months credit
80%
Management Accounting
69.00
$
$
31.00
3.40
Fixed expenses:
Selling expenses
General and administrative
Fixed manufacturing costs
$ 10,800,000
$ 1,400,000
$ 3,600,000
Required:
1.
Prepare a work sheet with the following headings:
Credit Terms
3 Months
6 Months
12 Months
2.
3.
Identify and briefly discuss decisions that could be made that would make
selling on credit more desirable.
| 193
194 | CHAPTER TEN Incremental Analysis and Cost Volume Profit Analysis: Special Applications
Exercise 10.3 Sales People Compensation
The K. L. Widget Company has developed two plans for compensation of its
sales people. However, only one plan can be implemented. The two plans, labeled
plan A and Plan B are as follows:
Salary
Commission rate
Sales-calls ratio
Number of calls per sales person
Plan A
$12,000
12%
30%
1,000
Plan B
$24,000
6%
30%
600
The marketing department believes that in the coming year plan A will result in
more calls per sales person. However, if insufficient calls are made or sales resistance
is greater than anticipated, then the turnover of sales people will be greater under
plan A.
Analysis by the marketing department of past sales and the exiting marketing
environment projects the potential number of customers per year at 1,000,000. Of
this number 30% will be receptive to a call and a sales pitch by the sales people.
Under plan A less sales people will be needed; however, the commissions paid will
be much greater.
The price of the production is currently $200 and will remain the same throughout
the coming year.
Required:
Compute the cost sales people compensation cost under each plan.
What is the break even point of each plan?
Management Accounting
Inventory Decision-Making
To be successful, most businesses other than service businesses are required
to carry inventory. In these businesses, good management of inventory is essential.
The management of inventory requires a number of decisions. Poor decision making
regarding inventory can cause:
1. Loss of sales because of stock outs.
2. Depending on circumstances, inadequate production for a period of time.
3. Increases in operating expenses due to unnecessary carrying costs or
loss from discarding obsolete inventory.
4. An increase in the per unit cost of finished goods.
Of all the activities in a manufacturing business, inventory creation is the most
dynamic and certainly the most visible activity. In one sense, inventory involves all
production activity from the purchase of raw materials to the delivery of finished goods
inventory to the customer. The financial accounting for inventory is concerned primarily
with determining the correct count and the assignment of historical cost. However,
from a management accounting viewpoint, the central focus is on manufacturing the
right amounts at the lowest cost consistent with a quality product. From a financial
viewpoint, poor management of inventory can adversely affect cash flow. Also,
excessive inventory can cause a decrease in ROI. An over stock of inventory causes
total assets to be larger and certain expenses to increase. Consequently, in addition
to a reduced cash flow, the effect of poor inventory management can be a lower rate
of return.
| 195
Work in Process
Finished goods
To have finished goods inventory, production must take place at a rate greater
than sales. Inventory decisions have a direct impact on production. For example, a
decision to increase safety stock means that the production rate must increase until
the desired level of safety stock is achieved.
From an accounting standpoint, there are two main areas of concern. First, from
a financial accounting viewpoint, the main accounting problems concern:
1.
2.
3.
4.
Management Accounting
Production Budget
For the Quarter Ending March 31, 20xx
Sales forecast
Back orders
Desired
ending Finished Goods Inventory
Finished goods (BI)
$100,000
5,000
20,000
________
25,000
10,000
________
$115,000
| 197
18,000
Average
Inventory
9,000
0
60
120
180
240
300
360
Work Days
Management Accounting
At its highest level inventory would be 18,000 units and at its lowest level inventory
would be 0. Based on the above equation average inventory is:
AI = (18,000 + 0)/ 2 = 9,000
The major factor here that affects the level of inventory is order size ( the number
of units purchased in each order). If demand for materials for a full year is 108,000
units, then the extremes for purchasing could be one large order of 108,000 or
108,000 orders of one unit per order. Given these extremes, then average inventory
could be as low as .5 unit (1 /2) or as large as 54,000 (108,000 / 2). The best order
size, as will be explained and illustrated now, is determined by the cost of ordering
(purchasing) and the cost of carrying inventory.
Purchasing Cost
The purchase of materials or parts necessary to make a finished product
involves a process that needs to be understood. The process begins with a purchase
requisition and finally ends with payment of the materials purchases. This process
may be illustrated as follows:
Purchase
Requisition
Purchase
Order
Delivery
of
Order
Receiving and
Preparation
Inspection of
of Voucher
order
Payment of
Purchase
and
Accounting
| 199
Management Accounting
Order Size
Order size
10,000
30,000
50,000
70,000
90,000
10,000
120,000
Number of orders
120,000
12
2.4
1.7
1.33
1.09
Total purchasing
cost
$12,000,000
$1,200
$400
$240
$170
$133
$109
100
4000
Total
Purchasing
Cost
3000
2000
1000
0
0
20000
40000
60000
80000
100000
120000
140000
Order Size
An order size of one unit per order results in a total and most likely unacceptable
cost of $12,000,000. While an order size of 120,000 minimizes total purchasing cost
at $100, this order size is also most likely to be unacceptable, because of the high
carrying cost that would inevitably result due to the high average carrying cost that
would invariably follow. The main point to observe is that as order size increases total
purchasing cost decreases.
There has been developed a tool that can determine the right order size and,
therefore, the right number of times to purchase. This tool is commonly called an
EOQ model. However, before this tool is mathematically introduced, it is necessary
to first discuss carrying costs.
Carrying Cost
The purchase of materials or the production of finished goods normally requires that
the materials or finished goods be stored until used or sold. The storage of materials
| 201
If
then:
Carrying cost =
E
-
S
-
TCC -
TCC =
Order size
2
(4)
The cost of carrying inventory sizes may be illustrated the following table:
A = 120,000
S = $5.00
Order Size
Order size
10,000
30,000
50,000
70,000
90,000
110,000
120,000
Average inventory
.5
5,000
15,000
25,000
35,000
45,000
55,000
60,000
$2.50
$25,000
$75,000
$125,000
$175,000
$225,000
$275,000
$300,000
Management Accounting
200000
Total
Carrying
Cost
150000
100000
50000
0
0
50000
100000
150000
Order Size
Total
Purchasing
Cost
25000
20000
Total
Carrying
Cost
15000
10000
Total Cost
5000
0
0
1000
2000
3000
4000
5000
Order Size
As order size increases, the total carrying cost increases. With an order size of
1 unit carrying cost for the entire period is only $2.50. However, if the entire periodic
need for material is purchased one time, then the total carrying cost is $300,000, the
maximum cost that can be incurred.
Close observation of the above schedule reveals that as order size increases,
total carrying cost also increases directly, just the opposite of total purchasing cost.
A paradox then exists. Any attempt to minimize total purchasing cost, then increases
total carrying cost and vice versus. The goal of inventory management becomes
apparent: The goal should be then to minimize total purchasing cost and carrying cost
and not each cost separately. The two illustrations above concerning total purchasing
cost and total carrying cost can now be combined as follows:
| 203
Order Size
Order size
10,000
30,000
50,000
70,000
90,000
110,000
120,000
Total purchasing
cost
$12 M
$1,200
$400
$240
$170
$133
$109
100
Total carrying
cost
$2.50
$25,000
$75,000
$125,000
$175,000
$225,000
$275,000
$300,000
Total cost
$12 m
$26,200
$75,400
$125,240
$175,170
$225133
$275,109
$300,100
It is apparent by observation that the order size of 10,000 shows the lowest total
cost of carrying and purchasing inventory. However, whether an order size of 10,000 is
the best order size has not been yet determined. An order size less than 10,000 might
result in lower costs. This table may be graphically presented as shown above.
From this graph the following observations may be made
1. As order size increases, total purchasing cost decreases.
2. As order size increases, total carrying cost increases
3. Total cost is minimized where total purchasing cost equals total carrying
cost.
The observation that total cost of managing inventory can be minimized where
total purchasing cost equals total carrying cost allows us later to derive a formula for
determining the best economic order size.
EOQ Formula
Earlier total purchasing cost was defined as follows:
TPC
TPC
A
P
E
-
-
-
-
A
(P)
E
total purchasing cost
periodic demand for material
cost of placing each order
order size
A
= (P) +
E
E
(S)
2
(5)
Management Accounting
Since the best order size is where TPC = TCC, we can mathematically solve for
the best order size as follows:
A
E
(P) =
(S)
E
2
Solving for E using basic algebra (see appendix to this chapter), we then get:
E =
2 A P
(6)
E =
2 (120,000) ($100)
$5.00
= 2,191
| 205
E =
2 (100) ($10)
$5.00
= 20
Using the same values given above, the following schedule may be prepared:
Schedule of Costs of Carrying and Purchasing Inventory
Order
size
Number of
Orders
100.00
20.00
10
15
Average
Inventory
.50
Total
Purchasing
Total
Carrying
Total
Cost
$ 1,000.00
$ 2.50
$ 1,002.50
1.0
$ 200.00
$ 12.50
$ 212.50
10.00
5.0
$ 100.00
$ 25.00
$ 125.00
6.67
7.5
66.67
$ 37.50
$ 104.17
20
5.00
10.0
50.00
$ 50.00
$ 100.00
25
4.00
12.5
40.00
$ 62.50
$ 102.50
30
3.30
15.0
33.00
$ 75.00
$ 108.00
35
2.85
17.5
28.50
$ 87.50
$ 116.00
40
2.22
20.0
22.00
$ 100.00
$ 122.00
45
2.50
22.5
25.00
$ 112.50
$ 137.50
50
2.00
25.0
20.00
$ 125.00
$ 145.00
The most economical order size is 20. When order size is 20, then total carrying
cost equals total purchasing costs and total cost is minimized at $100.
The EOQ formula just discussed is based on several assumptions which if not
true may result in values that are not helpful in making order size decisions. First, this
EOQ model requires an accurate estimate of demand under conditions of certainty.
Extreme and frequent fluctuations in demand requires other approaches to the order
size decision. Secondly, The EOQ model requires fairly accurate estimates of carrying
and purchasing costs. Multiple products and numerous types of material for a single
product may make the computation of these costs very difficult.
Making the Reorder Point Decision
When to reorder materials or parts is a decision that must be thoughtfully
considered. If the decision to reorder is made too late, then undesirable consequences
such as stock outs and delays in production may happen. If the decision to reorder
is made too soon, then unnecessary carrying costs will be incurred. The important
question then concerning reordering is: at what level of inventory should a new order
be placed? Obviously, if inventory has reached zero, then the time to place an order
has been missed. In formulating an answer to this question, a number of factors must
Management Accounting
be considered including:
1. Lead time
2. Average usage per day
3. Desired safety
Lead Time -Lead time is time between placing and order and receiving an order. Lead
time can vary greatly depending on a number of factors. It could be as little as a few
hours or as great as many months. Lead time can be affected by factors or conditions
such as bad weather, strikes on the part of the suppliers workers, production problems
on the part of the suppliers, and unexpected problems in shipping. Because lead time
can vary with each order placed, the normal approach to developing a reorder point
is to use average lead time. When the variations are small, the use of average lead
time is workable. Lead time should be measured in terms of work days rather than
calendar days. If lead time is one day but the supplier of the material in question
is closed on Saturdays and Sundays, then a order placed on Friday might not be
received until Tuesday of the next week. The problem of unpredictable variations in
lead time can usually be solved by carrying safety stock.
Average Usage per Day - It goes without saying that some level of materials inventory
is required to manufacture finished goods. A primary objective in the management
of the production process is to main a steady flow with minimal interruptions. A
consistent daily production rate is highly desirable. If this goal is achieved, then the
amount of material used each day is easily computed. Average usage per day will
tend to be the same.
To illustrate, if the production budget shows a planned production of 50,000
widgets per year and each widget requires 10 units of material Z, then 500,000 units
of material Z need to be purchased annually. If the year consists of 250 work days,
then the following simple equation can be used to compute average usage per day
Annual requirement for material
500,000
AUPD = = = 2,000
Work days
250
There is a connection between lead time and average usage per day. To avoid
a stock out, the level of inventory at the time an order is placed must be sufficient to
last until the new shipment arrives. This level of inventory, assuming no safety stock,
can be computed simply by multiplying lead time times average usage per day
Reorder point = Lead time x Average Usage per Day (7)
Safety Stock - Because both lead time and average usage per day can vary
significantly in the short run and to avoid stock outs during a critical time in the
production process, it is normally desirable to carry some safety stock. The question
as to how much safety stock to carry is a difficult question to answer. If safety stock is
too small, then stock outs can still occur. If safety stock is to large, then unnecessary
carrying cost will be incurred. When average usage during lead time tends to be
volatile, safety stock models tend to be based on probability theory and requires
knowing the probability of different levels of demand during lead time. The use of
probability models for safety stock is beyond the scope of this chapter.
| 207
(8)
Illustrative Problem
Assume the following:
Annual demand for raw materials
Number of work days
Desired safety stock level
Lead time (days)
25,000
250
100
5
Computing the reorder point requires, first of all, determining the average usage
per day:
25,000
AUPD = = 100
250
Reorder point then may be computed as follows:
RP = AUPD x Lead time + safety stock = (100 x 5) + 100 = 600
When inventory level becomes 600, then a new order should be placed.
Theoretically, the new order should be received on the day the inventory reaches the
safety stock level of 100 units.
Economic Order Quantity and Quantity Discounts
The previous discussion on order size was based on the assumption that quantity
discounts were not available. The EOQ formula as explained above is not able to
determine the most economic order size, given the availability of quantity discounts.
Suppliers will often provide incentives to purchasers to buy in bigger quantities. A
typical discount schedule might look as follows:
Quantity Discount Schedule for Material Z
Order Size
Price
99
$5.00
100
199
$4.00
200
299
$3.00
$2.50
300 +
When quantity discounts are available, the basic EOQ formula can not be used
to directly solve for the best order size. However, it must be used on an iterative (trial
and error) basis to find the best order size.
When quantity discounts were not available, the cost of inventory itself,
(purchases), was not relevant and could be ignored. However, because now the
order size affects the cost per unit, the total cost of inventory purchases must be
Management Accounting
taken into account. Without quantity discounts, the total cost of inventory purchased
remained the same regardless of order size. In order to solve for the best order size,
the following equation must be used.
A
E
TC = (P) + (S) + C(A)
(9)
E
2
The EOQ formula now has C(A), the total inventory purchase cost, as a cost element.
When quantity discounts exists, the cost of inventory becomes relevant in the order
size decision. C represents the cost of one unit of inventory. The other mathematical
symbols have the same meaning as before:
E
- represents order size
S
- represents carrying cost per unit
TCC - denotes total carrying cost
TPC - total purchasing cost
A
- periodic demand for material
P
- cost of placing each order
Equation (9) above cannot be used to directly solve for order size (E). The reason
is that there are two unknowns: (1) order size and (2) cost per unit of inventory.
Order size affects cost per unit and cost per unit affects order size. Because of the
dependency of price on order size and order size on cost per unit of inventory, the
total carrying cost curve and the total cost curve is now discontinuous as shown in
figures 11-7 and 11-8.
The trial and error procedure based on equation 9 that must be used is as
follows:
Step 1
Step 2
Compute total cost at each price break, including an order size of one
unit.
Step 3
Determine the order size range which minimizes total cost. (In many
cases the best order size is a price break quantity.)
4,000
4,000
3,500
3,500
3,000
3,000
2,500
2,500
2,000
2,000
1500
1500
1,000
1,000
500
500
50
100
150
200
Order Size
250
300
50
100
150
200
Order Size
250
300
| 209
4,000
4,000
3,500
3,500
3,000
2,500
2,000
2,000
1500
1500
1,000
1,000
500
500
100
150
200
Order Size
250
Total Cost
3,000
Purchases
2,500
50
Purchases
300
50
100
150
200
Order Size
250
Step 4 Use the basic EOQ model to see if a better order size exists.
Illustration
The K. L. Widget Company may purchase Material Z at a quantity discount. The
company annually purchases 100 units. The cost of placing 1 order is $1. Carrying
cost is $2.00 per unit. The following discount schedule is available:
Quantity Discount Schedule for Material Z
Order Size
Price
19
$5.00
20
29
$4.90
30
49
$4.80
$4.70
50 +
Work Sheet for Determining Best Order Size (Quantity Discounts Available)
Order
Size
(E)
Number
of
Orders
(A/E)
Total
Purchasing
Cost
(A/E) P
Average
Inventory
( E/2)
Total
Carrying
Cost
(E/2)S
Inventory
Cost
C( A)
Total
Cost
100
$ 100.00
.5
$ 1.00
$500
$601.00
20
$ 5.00
10
$ 20.00
$490
$515.00
30
3.3
$ 3.30
15
$ 30.00
$480
$513.30
50
$ 2.00
25
$ 50.00
$470
$522.00
EOQ
Order size
10
$ 10.00
$ 10.00
$500
$520.00
300
Management Accounting
Step 1
Step 2
The price break quantities are 1, 20,30 and 50. For example, when 20
units or more are ordered, then price decreases from $5.00 to $4.90 per
unit. In the above work sheet, then at each price break quantity, total cost
was computed.
Step 3. The range that results in the lowest cost is the range between 30 and 50
units. At an order size of 30 units, the total cost is $513.30. Normally, in
this range the lowest cost results in the smallest order size in this range,
which in this case would be 30 units.
Total cost if order size is 30 $514.22
Total cost if order size is 31 $525.12
If an order size greater than 30 is used, then the total cost is
greater as seen above.
Step 4
Occasionally, the best order size can be found by using equation (6). In
other words, a better solution can be found than the one indicated by the
trial and error work sheet method.
E =
2 (100) ($1.00)
$2.00
= 10
However, if an order size of 10 is made, the total cost is $520. Clearly, this is not
the best solution since at an order size of 30 units the total cost is less ($513.30). The
use of the equation (1), therefore, did not find a better solution.
Summary
Good inventory decisions are critical to the success of a business. Excessive
inventory levels may lead to inventory write-off losses, and even if eventually sold,
excessive inventory levels will result in unnecessary carrying costs. Inadequate
inventory on the other hand can result in stock outs and production delays. In
modern business, some products involve hundreds of different parts and material.
Consequently, the purchasing of parts and materials at the appropriate time is highly
critical. The purchasing function in many business is extremely important.
Order size is one of the more important inventory decisions. Improper management
of the order size will result in excessive total inventory management costs. The use
of EOQ models provide a valuable insight as to factors that must be considered
in making inventory decisions. Both management and the management accountant
need a solid understanding of inventory management principles.
Making good inventory decisions required considerable knowledge and skill. To
make good inventory decisions requires understanding of the follow terms.
1. Carrying cost
8. Safety stock
2. Purchasing costs
9. Reorder point
| 211
Inventory cost
Demand for inventory
Number of orders
Average inventory
AP
=
E
ES
AP
=
1
E 2S
2AP
S
E =
E2
2AP
S
Calculus Derivation
TIC =
AP
+
E
ES
d(TIC) d(AP/E)
= +
d E
dE
d(TIC) d- (APE-2) )
= +
d E
dE
d(.5ES)
dE
d(TIC)
=
dE
(.5S)
- (APE-2) )
- (APE-2) )
+
d(.ES)
dE
(.5S) = 0
- (APE-2) ) = - (.5S)
AP
=
E-2
AP
.5S
E =
.5S
-
AP
E2
2AP
S
As illustrated above the EOQ formula can be derived using either calculus or
algebra. Actually, for his version of the EOQ formulas using simply algebra is much
easier. The algebra approach begins with recognizing that optimum order size is
where total purchasing cost = total carrying cost. The calculus approach finds the
first derivative of the total cost equation and then sets that equation to zero in order
to solve for E, the order size.
Management Accounting
Q. 11.1
Q. 11.2
Q. 11.3
Q. 11.4
Q. 11.5
Q. 11.6
Q. 11.7
Q. 11.8
Q. 11.9
Explain the effect that quantity discounts have on the EOQ model.
Q. 11.10
Q. 11.11
Q. 11.12
Q. 11.13
What is the total cost equation when quantity discounts are available?
Q.11.14.
| 213
Q.11.15
Q.11.16
What procedure must be used to identify the best order size when
quantity discounts are available?
Q. 11.17
Prepare a work sheet with the proper headings that may be used to find
the optimum order size when quantity discounts are available.
Q. 11.18
For what order sizes should total cost be computed on the work
sheet?
Management Accounting
10,000
$ .10
$ .30
$2.00
$
$
$
$
.05
.10
.45
.20
Required:
1. Compute the optimum order size that minimizes total cost.
2. Graphically illustrate the above data.
Exercise 11.4 Optimum Order Size-Quantity Discounts
Single Discount
The ABC Manufacturing Company annually purchases 10,000 units of material
X. The companys accountant has determined that it costs the company $10.00 each
time an order is placed and that the cost of carrying inventory is $1.00 per unit per
year. The company has been purchasing material X at a cost of $25.00 per unit.
If material X is purchased in quantities of 5,000 or more, then material X can be
purchased at $20.00 per unit..
Required:
Determine whether the company should take advantage of the quantity discount?
Exercise 11.5 Optimum Order Size-Quantity Discounts
| 215
Management Accounting
| 217
Identifying projects
The object of capital budgeting is typically called a project. An investment project may be a:
a.
b.
c.
d.
e.
f.
Step 3
Rank the projects in order of profitability. The term profitability is an ambiguous term and, consequently, has different meanings. For this reason
different techniques of measuring profitability have been developed. The
more important of these techniques include the following:
a. Average rate or return method (accounting method)
Management Accounting
b. Payback method
c. Time adjusted rate of return method (Internal rate of return)
d. Net present value method
The selection of a project should be taken very carefully. The project should fall
within the experience and capabilities of management. New products are consequently being developed everyday. If a company is in the restaurant business, then
it is highly unlikely management would want to expand into the electronics business.
However, having a diversified business with different products or divisions can under
the right circumstances be a good strategy. All projects involve risk and the risk potential in a given project should be evaluated. An important question is: if the project is
undertaken, will failure of the project risk putting the company into bankruptcy?
Evaluating the profitability of a project perhaps is the most important and difficult
task. First of all, it is important to have an accurate estimate of the cost of the project.
Under estimating the cost can cause the eventual actual rate of return to be far less
than the desired rate of return. Secondly, the expected net cash flow for each period
of the life of the project must be measured. It is normal to expect that the farther the
estimates are made into the future, the less reliable the will be estimates.
After the cost and future net cash flows have been determined, the next step is to
actually compute the resulting rate of return. If the methods used are present value
methods, then a discount rate must be determined. Theory holds that the discount
rate should not be less than the companys cost of capital. Because companies use
a combination of different sources of capital such as both debt and equity and use
both internal financing and eternal financing, the companys cost of capital is usually
an average. Computing cost of capital is a fairly complex subject and the techniques
for doing so are beyond the scope of this book.
When several investment opportunities are being evaluated and the source
of funds to invest is limited, then a decision has to be made concerning which of
the available projects are the most profitable and most affordable. Modern capital
budgeting theory maintains that the tools used to evaluate projects should be present
value based. The two tools have received the most attention in the capital budgeting
literature are the following:
1. Net present value method
2. Time adjusted rate of return method.
The Basic Present Value Equation
The basic fundamentals of present value are explained in Appendix B. If you have
forgotten the basic fundamentals of computing present value, it is recommended that
you first read and study this appendix before proceeding further. In order to understand the basic principles of capital budgeting, a sound understanding of present
value is required.
When using present value methods, the net cash flows of the project is regarded
as a series of future amounts. Because they are future amounts, the process of
discounting these amounts is logical. The cost of the project is an outlay in period
zero and, therefore, does not require any discounting, After the individual future net
| 219
NI
D
-
-
net income
depreciation
Management Accounting
Example 1
Equal periodic net cash flows where the desired rate of return is 10% and the life
of the project is 4 years:
100 100
100
100
PV = 1 +
+
+
= $316.98
2
3
(1 +.1) (1 + .1) (1 +.1)
(1 +.1)4
Example 2
One net cash flow amount at the end of 4 years where the desired rate of return
is 10%:
0
0
0
100
PV =
+ +
+
(1 +.1)1 (1 + .1)2
(1 +.1)3
=
1+.1)4
$68.30
In this example, it is easy to recognize that the present value of a zero amount is
zero.
Example 3
Unequal net cash flows where the desired rate of return is 10% and the life of the
project is 4 years:
PV =
100
200
300
400
+
+
+
1
2
3
(1 +.1) (1 + .1) (1 +.1)
(1 +.1)4
= $754.80
If net cash flows are equal, then the net cash flows may be treated as though they
are an annuity and the use of present values of an annuity of $1 tables may be used
to compute the answer. An annuity may be defined as a series of equal payments at
equal intervals of time.
As explained in chapter 8, Comprehensive Business Budgeting, the capital
expenditures budget was one of the four elements of the final product of the total
budget. The capital expenditures budget affects the following:
Cash balance
Amount of stock issued or debt incurred
Interest expense, if debt financing is used
The size of the plant and equipment accounts
Future depreciation
Net income
In Figure 12.1 a diagram of capital budgeting as discussed above is illustrated.
Net Present Value Method
The net present value method is commonly used to evaluate capital budgeting
projects. The steps involved in this method are the following:
Step 1
Determine the net cash flows for each period (normally each year) of the
life of the project. This step involves estimating both cash inflows and
cash outflows. Net cash flow is simply Cash inflows less cash outflows.
Step 2
Determine the cost of the project. The cost of the project might be a
single contracted amount or the sum of many individual expenditures.
| 221
Compute the present value of the project using the net cash flows as the
future amounts. The discount rate is the desired minimum rate of return
as determined by management.
Step 4
$250,000
5
$ 50,000
$100,000
$150,000
$ 75,000
$ 25,000
10%
Present Values
PV Factor
Net Cash Flow
$ 50,000
.909090
45,454.54
$ 100,000
.826446
82,644.62
$ 150,000
.751314
$ 112,697.72
$ 75,000
.683013
51,225.99
$ 25,000
.620921
15,523.27
$ 307,546.14
The present value of each net cash flow is computed by multiplying the present
value factor times each net cash flow amount. The present value of the project is,
therefore, the sum of the individual present values. The present values could have
been easily computed without the use of tables. For example, the present value of
Management Accounting
the net cash flow in year 2 ($100,000) could have been calculated as follows:
$100,000 $100,000
PV =
= = $82,644.62
( 1.1)2
1.21
A simple four function calculator makes the computation of present value fairly
easy. Is the project in the illustration above acceptable? The answer is yes as the
following comparison shows.
Present value of project
$ 307,546.14
Cost of project 250,000.00
Net present value
$ 57,546.14
The true rate of return of this project is greater than the discount rate because the
net present value is positive.
The main disadvantage of this method is that the true rate of return is not
computed. This method only determines the present value of the project and indicates whether or not the project is acceptable. For this reason, many analysts prefer
the time adjusted rate of return method.
Time Adjusted Rate of Return Method
The time adjusted rate of return method is a present value method that determines the true rate of return of a project. If the true rate of return is equal to or greater
than the desired rate of return, then the project is acceptable. This method works
Figure 12.1 Outline of Capital Budgeting
CAPITAL BUDGETING
EVALUATION
TECHNIQUES
Accounting rate of
return
Payback period
Timed adjusted rate
of return
Net present value
TYPES OF
PROJECTS
New products
Replacement of assets
New plants and
equipment
Opening a new territory
Purchase of an existing
business
CONCEPTS
Cost of capital
Depreciation
Desire rate of return
Net cash flows
Present value
Future value
Discount rate
EVALUATION
OF INDIVIDUAL
PROJECTS
Quantity factors
Cash inflows
Cash outflows
Useful life
Present value
Recoverable value
Qualitative factors
Management ability
Management experience
Economic enviroment
Risk
| 223
Select any interest rate to begin the process. The only guideline is to
select a rate you intuitively think might be close to the answer.
Step 2
Using the selected rate in step 1, compute the present value of the project in the same manner used in the net present value method.
Step 3
Compare the computed present value to the cost of the project. If the
present value if greater than the cost, then the true rate is greater than
the discount rate used. If the present value is less than cost, then the
true rate is less than the rate used.
Step 4
If the present value did not equal cost, then select a second rate. This
rate should be greater or less than the rate first used according to the
rules specified in step 3. A smaller rate will increase the present value
while a greater rate will make the present value smaller.
Step 5
$250,000
5
$ 50,000
$100,000
Management Accounting
Year 3
Year 4
Year 5
Desired rate of return
$150,000
$ 75,000
$ 25,000
10%
The first step is to compute present value using the first estimated rate. Since the
desired rate of return is 10% this rate will be used. However, the use of the desired
rate of return is an arbitrary decision. Any rate, however, may be used.
First Attempt- Discount rate is 10%
Present Value
Year
Factor
Year 1
$ 50,000
.909090
45,454.54
Year 2
$ 100,000
.826446
82,644.62
Year 3
$ 150,000
.751314
$ 112,697.72
Year 4
$ 75,000
.683013
51,225.99
Year 5
$ 25,000
.620921
15,523.27
Present Value
$ 307,546.14
Cost
$ 250,000.00
$ 57,545.14
The present value exceeds the cost by $57,545.14.This excess of present value
over cost means the true rate of return is greater than 10%. A second attempt to find
the true rate should be made now. This time the selected rate used will be 15%.
Second Attempt- Discount rate is 15%
Present Value
Year
Factor
Year 1
$ 50,000
.869565
$ 43,478
Year 2
$ 100,000
.075614
$ 75,614
Year 3
$ 150,000
.657516
$ 98,627
Year 4
$ 75,000
.571753
$ 42,881
Year 5
$ 25,000
.497176
$ 12,294
$ 272,894.00
Present Value
Cost
$ 250,000.00
$ 22,894.00
In this second trial, our computations come up with an answer greater than cost.
So we now know that the true rate of return is greater than 15%, however, we still do
not know the true rate of return. Consequently, a third trial is required, and this time
the discount rate used will be 20%.
| 225
Factor
Year 1
$ 50,000
.833333
$ 41,666.00
Year 2
$ 100,000
.694444
$ 69,444.00
Year 3
$ 150,000
.578704
$ 86,805,00
Year 4
$ 75,000
.482253
$ 36,169.00
Year 5
$ 25,000
.401877
$ 10,047.00
Present Value
Cost
$ 244,131.00
$ 250,000.00
($ 5,869.00)
The true rate of rate is a bit less than 20%. If more accuracy is desired than
another trial would be necessary. All we can say after three trials is that the true rate
of return is between 15% and 20%. The true rate is actually between 19% and 20%.
The internal rate of return method as this method is often called is based on a
critical assumption. The true rate is earned only if the periodic net cash flows are
reinvested as a rate equal to the true rate. For example, assume that the net cash
flows are reinvested at 10%
Management Accounting
2
Illustration of Average Rate of Return Method - In order to illustrate this, method
the following information is assumed:
Cost of project
$80,000
Life of project (years)
5
Net cash flows of project:
Year 1
$10,000
Year 2
$20,000
Year 3
$30,000
Year 4
$40,000
Year 5
$50,000
Total net income is the sum of the net cash flows less the cost of the project.
Therefore, average net income per year is:
(10,000 + 20,000 + 30,000 + 40,000 + 50,000) - 80,000) 70,000
ANI = = =
5
5
AI =
$80,000
2
AROR =
$14,000
$40,000
$14,000
$40,000
=
35%
If more than one project is under evaluation, then the most profitable project is the
one with the greater rate of return.
The major weaknesses of this method are the following:
| 227
Project B
$ 50,000
5
$ 5,000
$ 10,000
$ 15,000
$ 20,000
$ 25,000
$ 5,000
20%
Cost
Life of project (years)
Net cash flow:
Year 1
Year 2
Year 3
Year 4
Year 5
ANI
=
AROR% =
$ 50,000
5
$ 25,000
$ 20,000
$ 15,000
$ 10,000
$ 5,000
$ 5,000
20%
In the above example, both projects have the same average net income and
same AROR. However, the projects are quite different. In project A, the net cash flow
increases each year and in project B, the projects decrease each year. If we compute
the present value of both projects using a 10% discount rate we learn the following:
Present value of project A:
$52,969.93
$60,460.65
Project B is the better project when present value is computed because it has the
greater present value. Also project B is the better project in terms of the true rate of
return.
True Rate of Return
Project A
12.0%
Project B
20.0%
Clearly when timing and the pattern of net cash flow are considered, it is clear
that the AROR method can be very misleading.
Payback Method
One of the basic concerns of investors in a project is the return of the capital
invested in the project. If a project, even if profitable eventually, requires a long period
of time for the capital invested to be recovered, then investors are inclined to not
invest. They will seek out projects with a much shorter payback period even though
the other projects do not initially promise to be as profitable. A payback period of ten
years is considered too long. A payback period of three years is often considered
ideal.
Management Accounting
The payback method is not a present value method nor a method that requires
that accounting net income be computed. The payback period is that period of time it
takes to recover the cost of the project. After the cost of the project has been recovered, any net cash flow from then is considered as profit. Payback has been reached
when the accumulated net cash flows from the project equals the cost of the project.
The basic payback period formula is as follows:
Cost of project
Payback period =
Average net cash flow
The steps involved in using the payback method are as follows:
Step 1 The cost of the project and the net cash flow of the project
for each year of its life must be determined.
Step 2 The next step is to compute the average net cash flow.
Step 3 Now that the cost and the average net cash flow is known,
the payback period can be computed.
Illustration of Using the Payback Method-This method will now be illustrated using
the same data as used for the net present value method and the time adjusted rate
of return method.
Cost of project
Life of project
Estimated net cash flow:
Year 1
Year 2
Year 3
Year 4
Year 5
Desired rate of return
$ 250,000
5 years
$ 50,000
$ 100,000
$ 150,000
$ 75,000
$ 25,000
10%
= 3.125 Years
In addition to not being a present value method, the method just illustrated also
ignores the pattern of net cash flows. This use of average net cash flow has the
same weakness as the use of average accounting net income. Unless the cash flows
are uniform from year to year, a more refined procedure for computing the payback
period is to not use average net cash flows but to accumulate the net cash flows until
the sum of the net cash flows equal the cost of the project.
The use of a work sheet is helpful when using this method:
| 229
Cumulative
Net Cash Flow
$ 50,000
$ 50,000
$ 100,000
$ 150,000
$ 150,000
$ 300,000
Using this approach, it is clear that the payback period is more than 2 years and
less than three years. The fractional part of year 3 can be computed as follows:
Cash needed in the third year to reach payback period - $100,000
The payback period then is:
$100,000
2 + :
=
$150,000
2 .67 years.
Another weakness of the payback method is that the method does not measure
profitability. Two projects can have the same payback period, but one can be
completely superior to the other.
Project C
Cost of project
Life of project (years)
Net cash flow per year
Project D
$8,000
4
$2,000
Cost of Project
Life of project (years)
Net cash flow per year
Payback period (years)
$8,000
8
$2,000
4
At the end of 4 years, project C has recovered the capital invested. However,
the project has also reached the end of its life. Project C is obviously not profitable.
Project D which also has a payback period of 4 years. However, Project D continues
to generate income in years 5 through 8.
Net Cash Flow After Taxes (NCFat)
In this chapter to this point, it was not specified whether net cash flow was before
or after taxes. When the objective is to use net cash flow after tax in computing
present value, some additional fundamentals must be considered and understood.
In the simplest terms possible, net cash flow after tax is:
NCFat = NCFbt - T
Where:
T - tax expense
Basically, net cash flow after tax is net cash flow before tax less the tax liability.
When net cash flow before tax is used, obviously taxable income is not a factor
to be considered. However, when the goal is to use net cash flow after tax, then
Management Accounting
various provisions of the tax law become important. Important factors that must be
considered in determining taxable income include the following:
1. Depreciation and the selection of a depreciation method
2. Disallowed expenditures
3. Tax credits
4. Rules regarding capitalization and recording of expenses
5. Capital gains
In order to compute net cash flow after tax, it is necessary to compute the effect
of a tax rate on net cash flow. The most obvious way is to compute taxable income
and then compute the amount of tax. Then the tax determined must be subtracted
from net cash flow before taxes. While tax laws can be exceedingly complex, the
goal in capital budgeting is not necessarily to be 100% accurate in computing the tax,
but to derive a tax amount that is basically in the ball park. Some simplified methods
have been developed to allow the analyst to quickly determine the amount of tax.
The basic difference in many cases between net cash flow before taxes and taxable
income is deprecation. For this reason, the effect of depreciation on net cash flow
must be considered.
Depreciation - Depreciation is a recognized expense in accounting theory and must
be taken into account when computing net income. However, students learn from
the study of accounting that depreciation is not an expense that involves an outlay of
cash in the period in which it is recorded. The outlay of cash occurs at the time the
depreciable asset is purchased or the incurred liability is paid. In capital budgeting,
the cost of the depreciable asset is strictly the cost of the project at time period zero.
Depreciation in each year of the life of the project is a non cash expense. It is simply
an amortized historical cost. In addition, depreciation has no effect on net cash flow
before tax regardless of the amount of depreciation. However, depreciation has a
profound impact on net cash flow after taxes. The greater the depreciation charge for
tax purposes, the larger is net cash flow after taxes.
Depreciation is always an allowable deduction in computing taxable income. The
relationship between net cash flow before taxes and taxable income can be stated
mathematically as follows:
TI = NCFbt - D.
Where:
TI
- Taxable income
NCFbt - Net cash flow before tax
D
- Depreciation
| 231
$6,000
+
(1.1)2
$6,000
+
(1.1)3
$19,019.19
NCFbt
Depreciation.
Taxable
Income
Tax
NCFat
$ 8,000
$ 3,000
$ 5,000
$2,000
$ 6,000
$ 8,000
$ 3,000
$ 5,000
$2,000
$ 8,000
$ 3,000
$ 5,000
$ 8,000
$ 3,000
Totals
$32,000
$12,000
Years
$6,000
=
(1.1)4
NCFbt
Depreciation.
Taxable
Income
Tax
NCFat
$ 8,000
$ 4,800
$ 3,200
$1,280
$ 6,720
$ 6,000
$ 8,000
$ 3,600
$ 4,400
$1,760
$ 6,340
$2,000
$ 6,000
$ 8,000
$ 2,400
$ 5,600
$2,240
$ 5,760
$ 5,000
$2,000
$ 6,000
$ 8,000
$ 1,200
$ 6,800
$2,720
$ 5,280
$20,000
$8,000
$24,000
Totals
$32,000
$12,000
$20,000
$8,000
$24,000
Years
Management Accounting
$5,760
5,280
+ =
3
(1.1)
(1.1)4
$19,282.64
Net-of-Tax Approach
Another approach to computing net cash flow after tax is to use the net-of-tax
approach. In most businesses, if not all, profitable businesses have to pay income
tax. In the long term, a tax liability is inescapable. If the tax rate is 40%, and the
businesss sales is $100,000, then the amount of sales net-of-tax is $60,000. Forty
per cent has to be used to pay the tax on the revenue and, therefore, only 60%
remains. If expenses are $60,000, then net-of-tax the expense is $36,000. Of the
total expenditure of $60,000 , 40% or $24,000 is an offset to the $40,000 tax on
the revenue. Therefore, the net liability would be ($40,000-24,000) = $16,000. The
same answer could have been derived by multiplying 40% x $40,000 ( $100,000 $60,000).
Rather than compute the tax effect by first computing taxable income and then
computing the total tax, net cash flow after tax can be computed on a net-of tax basis
by applying the net-of-tax idea to each individual item that affects net cash flow. This
idea can be seen mathematically as follows
The amount of tax equals the rate times taxable income and taxable income
equals revenue less expenses. Let Revenue = S and expenses = E1 + E2 + E3.
Then the tax would be R( S - E1 - E2 - E3) = R(S) - R(E1) - R(E2) - R(E3)
We see here mathematically that the tax rate can also be logically applied to each
separate tax item. Assuming the tax rate is 40% and if we let S = $10,000 and E1, E1,
and E3 be $1,000, $2,000, and $3,000 respectively, then we have the following:
T = .4($10,000) - .4($1,000) - .4($2,000) - .4($3,000) =
$4,000 - $400 - $800 - $1,200 = $1,600
The same answer results if we use a more traditional approach
T = ($10,000 - $6,000).4 = $1,600.
It is clear that, if we choose to do so, that we can apply the tax rate to each
individual item that makes up taxable income. The same amount of tax will result.
Under some circumstances, the analyst may find this method easier to use, even it is
conceptually more difficult to understand.
Mathematically, the net of tax approach can be presented as follows;
NCFat = S(1 - R) - E(1 - R) + R(D)
Where:
S
E
D
T
R
-
-
-
-
-
Revenue (sales)
Cash expenses
Depreciation
Amount of tax
Income tax rate
| 233
$12,000
4 years
$12,000
$ 4,000
10%
NCF after tax for Years
Item
Amount
per year
(before
taxes)
Net-of-tax
NCF
percentage
Cash revenue
12,000
.6
Cash expenses
- 4,000
.6
- 2,400
7,200
7,200
-2,400
7,200
7,200
-2,400
-2,400
Depreciation:
Year 1
3,000
.4
Year 2
3,000
.4
Year 3
3,000
.4
Year 4
3,000
.4
1,200
1,200
1,200
1,200
6,000
Total NCFat
Present value
5,454.54
6,000
4,958.67
6,000
4,507.88
6,000
4,098.08
$19,019.19
$12,000.00
$ 7,019.19
Since the net cash flows after tax remains the same, then the present value
remains the same at $19,019.16. The net-of-tax method does not give a different
answer. It is simply a different approach to determining tax and net cash flow after
taxes.
Management Accounting
Summary
Capital budgeting involves a body of literature that has grown and developed in the
last fifty years. In finance, a significant body of literature has developed which dwells
heavily on using present value concepts to make capital budgeting decisions and to
measure the value of a firm. To understand this body of theory, a good knowledge of
the following terms is necessary.
1. Simple interest
9. Depreciation and net cash flow
2. Compound interest
10. Minimum desired rate of return
3. Principal
11. Internal rate of return
4. Future amount
12. Discounting
5. Present value
13. Discounted cash flow
6. Annuity
14. Cost of capital
7. Present value of a future amount 15. Net present value
8. Net cash flow
Appendix: Derivation of the Net-of-Tax approach to computing
net cash flow after taxes:
The computation of tax can be done in two different ways:
1.
taxable income = S - E - D
Tax = R(S - E - D)
Where :
S - Sales
E - Cash expenses
D - Depreciation
R - tax rate
2. It can be computed where the tax rate is applied individually to each revenue
and to each expense:
Tax = R(S) - R(E) - R(D)
Based on this approach NCFat is :
NCFat = S(1- R)
E(1 - R) +
RD
| 235
= $100
= $ 70
= $ 20
=
.4
42 + 8
NCFat = 26
Q. 12.1
Q. 12.2
Q. 12.3
Q. 12.4
Q. 12.5
Q. 12.6
Q. 12.7
Explain how net cash flow may be easily converted to net income?
Q. 12.8
Q. 12.9
Q. 12.10
Management Accounting
Q. 12.11
Q. 12.12
When using the net present value method, how does one know whether
the true rate of return is greater or less than the discount rate?
Q. 12.13
When using the time adjusted rate of return method, how does one
know when the true rate of return has been found?
Q.12.14
Problem A
$10,000
8%
4
Problem B
$50,000
10%
6
Problem C
$5,000
6%
8
Problem D
$100,000
20%
5
Required:
Compute the future amount at the end of the stated number of years.
Exercise 12.2 Present Value
Problem A
Problem B
Problem C
Problem D
Future Amount
Desired rate
Future years
$5,000
8%
10
$8,000
10%
12
$20,000
12%
10
$1,000,000
15%
40
Problem A
$5,000
8%
10
Problem B
$8,000
10%
12
Problem C
$20,000
12%
10
Problem D
$1,000,000
15%
40
Problem C
$8,000
$2,000
$1,000
Problem D
$15,000
$10,000
$ 3,000
Required:
Compute the present value of each annuity.
Exercise 12.4 Net Cash Flow
Cash revenue
Cash expenses
Depreciation
Problem A
$1,000
$ 600
$ 200
Problem B
$2,000
$1,200
$ 500
Required:
Compute the net cash flow in each problem.
| 237
10%
Required:
1. Based on the above information compute the present value of the
project.
2. Is the true rate of return greater than or less than the discount rate?
Exercise 12.6 Net Present Value Method (Uniform net cash flows)
You have been provided the following information:
Cost of project
$20,000
Useful life (years)
8
Annual net cash flow
$ 4,000
Desired rate of return
12%
Required:
1. Based on the above information compute the present value of the
project.
2. Is the true rate of return greater than or less than the discount rate?
Exercise 12.7 Net Present Value Method (Nonuniform net Cash Flows)
You have been provided the following information:
Problem A Problem B Problem C
Cost of project
$15,000
Useful life
5
Discount rate
12%
Net cash flow:
Year 1
$2,000
Year 2
$3,000
Year 3
$4,000
Year 4
$5,000
Year 5
$8,000
Year 6
Year 7
Year 8
$18,000
8
8%
$40,000
4
10%
$1,000
$ 6,000
$3,000
$ 8,000
$5,000
$10,000
$7,000
$20,000
$3,000
$2,000
$1,500
$1,000
Problem D
$10,000
6
6%
$5,000
$4,000
$3,000
$2,000
$1,000
$ 500
Required:
1. Based on the above information compute the present value of the
project.
2. Is the true rate of return greater than or less than the discount rate?
Management Accounting
Exercise 12.8 Time Adjusted Rate of Return Method (Uniform Net Cash Flows)
Problem A Problem B Problem C Problem D
Cost of Project
$15,000
$50,000
$20,000 $100,000
Useful life (years)
5
15
8
10
Net cash flows (annual)
$5,000
$6,000
$4,000
$15,000
Required:
For each problem, compute the projects internal rate of return.
Exercise 12.9 Time Adjusted Rate of Return Method (Nonuniform Net Cash Flows)
You have been provided the following information:
Problem A Problem B Problem C
Cost of project
$15,000
$18,000
$40,000
Useful life
5
8
4
Net cash flow:
Year 1
$2,000
$1,000
$ 6,000
Year 2
$3,000
$3,000
$ 8,000
Year 3
$4,000
$5,000
$10,000
Year 4
$5,000
$7,000
$20,000
Year 5
$8,000
$3,000
$ 1,000
Year 6
$2,000
$ 500
Year 7
$1,500
Year 8
$1,000
Problem D
$10,000
6
$5,000
$4,000
$3,000
$2,000
Required:
Based on the above information compute the true rate of return of each product.
Exercise 12.10 Average Rate of Return Method
Problem A
Cost of Project
Useful life (Years)
Depreciation per year
Net Cash Flow
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Problem B
Problem C
Problem D
$75,000
5
$15,000
$60,000
6
$10,000
$125,000
5
$25,000
$10,000
$18,000
$10,000
$20,000
$10,000
$25,000
$10,000
$30,000
$25,000
$15,000
$15,000
$15,000
$20,000
$50,000
$60,000
$30,000
$35,000
$40,000
$45,000
$50,000
$30,000
4
$ 7,500
Required:
For each problem, compute the average rate of return.
| 239
Problem B
Cost of Project
$30,000
$75,000
Useful life (Years)
4
5
Depreciation per year
$7,500
$15,000
Net income per year:
Year 1
$10,000
$20,000
Year 2
$10,000
$20,000
Year 3
$10,000
$20,000
Year 4
$10,000
$20,000
Year 5
$15,000
$15,000
Year 6
Problem C
Problem D
$60,000
6
$10,000
$125,000
5
$25,000
$15,000
$15,000
$15,000
$15,000
$30,000
$15,000
$30,000
$30,000
$30,000
$30,000
Required:
For each problem, compute the payback period.
Exercise 12.13 Payback Method (Nonuniform Cash Flow)
Problem A
Cost of Project
$30,000
Useful life (Years)
4
Depreciation per year
$7,500
Net income per year:
Year 1
$10,000
Year 2
$12,000
Year 3
$14,000
Year 4
$16,000
Year 5
Year 6
Problem B
Problem C
Problem D
$75,000
5
$15,000
$60,000
6
$10,000
$125,000
5
$25,000
$20,000
$22,000
$24,000
$26,000
$28,000
$15,000
$14,000
$13,000
$12,000
$11,000
$10,000
$32,000
$34,000
$36,000
$38,000
$40,000
Required:
For each problem, compute the payback period using the cumulative cash flow
method.
Management Accounting
Income
Statement
Approach
Sales
$12,000
Cash expenses
$ 7,000
Depreciation
$ 2,000
Total expenses
$ 9,000
$ 3,000
Case 2
Income
Statement
Approach
Net-of-tax
Approach
Case 3
Income
Statement
Approach
Net-of-tax
Approach
Tax
Net cash flow (BT)
$ 5,000
$ 3,800
40%
30%
20%
Required:
Compute the net cash flow after tax in each case using the net-of-tax method.
In case 1 the net cash flow after tax has already been computed in the traditional
manner. Enter the income statement data in case 1 also in the appropriate
columns for cases 2 and 3.
| 241
Management Accounting
| 243
Price $
110
100
90
80
70
60
50
40
30
20
10
0
200
400
600
800
1,000
Quantity
When three or more firms compete in the same market and basically sell the same
product, the market is called an oligopolistic market. How price is set in this type of
market has been and still continues to be the subject of much debate. In general, it is
believed that eventually the firms will come to an equilibrium price. Any firm then that
significantly raises its price will face a large loss of sales. If a firm attempts to gain
greater profits and market share by lowering price, then the other firms in the industry
will also immediately lower their price. The consequence of all firms lowering price
will eventually be an overall decrease in industry net income.
Management Accounting
While the exact nature or slope of the demand curve is seldom known in a given
industry, the academic question still remains: what is the best price assuming the
demand curve is known? As indicated in Figure 13.1, assume that we have the
following demand schedule
Price
Quantity
Revenue
$ 100
$ 90
$ 80
$ 70
$ 60
$ 50
$ 40
$ 30
$ 20
$ 10
100
200
300
400
500
600
700
800
900
1,000
$10,000
$18,000
$24,000
$28,000
$30,000
$30,000
$28,000
$24,000
$18,000
$10,000
The above schedules seems to indicate that the best price is either $60 or $50. In
each case, sales is maximized at $30,000. However, the objective of a business is not
to maximize sales dollars but to maximize net income. In this instance, an expense or
cost function is needed. In management accounting, as in economics, it is assumed
that there are two types of expenses: fixed and variable: Fixed and variable expenses
in management accounting may be graphically presented as shown in Figure 13.2
Figure 13.2 Illustration of Total Expenses
Expenses
(000)
20
15
10
300
600
Fixed = $5,000
Variable = $10.00
900
1,200
1,400 Quantity
| 245
40
30
Sales
20
Net Income
Total cost
10
300
500
700
900
Quantity
The demand curve in Figure 13.1 and the expense function shown in figure 13.2
can be mathematically defined as follow:
P
Po - k(Q)
P - Price
Po - Price at the Y-intercept
k - The slope of the demand curve line
F + V(Q)
(1)
(2)
(3)
Consequently, using equation (1), we can now define net income as:
Po - P Po - P
I = P - V - F
(4)
k
k
If the goal is to maximize net income, then the price that maximizes net income
can be found by finding using calculus and finding the first derivative of equation 3.
The first derivative of equation 4 using turns out to be:
Management Accounting
1
(Po - 2P + V)
k
(5)
Profit is maximized at the point where the slope of equation 5 is zero. So if we set
the first derivative to zero we have the following:
1
(Po - 2P + V) = 0
k
Solving for P we get
Po + V
P =
(6)
2
This equation allows us to determine the best price without preparing a complete
schedule of price, quantity, and net income as has been done in Figure 13.4.
In Figure 13.4, the best price is shown as $60. This price agrees with the price
determined by our price formula derived above:
110 + $10
$120
P = = = $60
2
2
A companys marketing strategy can have a profound effect on its demand curve.
Even though the demand curve is not known with any precision, it is still generally
recognized by economists and marketing analysts that the following marketing
decisions can shift the demand curve upwards and to the right.
1. Advertising
2. Increase in size of sales force
3. Increase in sales peoples compensation
4. Increase in the quality of the product
However, any change in the above must be approached cautiously and also be
based on adequate analysis of the known economic and marketing environment.
Even though changes in these marketing factors may increase sale, any increase in
sales can be easily offset by increases in the associated expenses.
Figure 13.4
Price
$ 100
$ 90
$ 80
$ 70
$ 60
$ 50
$ 40
$ 30
$ 20
$ 10
Quantity
100
200
300
400
500
600
700
800
900
1,000
Revenue
Total Expenses
Net income
$10,000
$18,000
$24,000
$28,000
$30,000
$30,000
$28,000
$24,000
$18,000
$10,000
$ 6,000
$ 7000
$ 8,000
$ 9,000
$ 10,000
$ 11,000
$ 12,000
$ 13,000
$ 14,000
$ 15,000
$ 4,000
$ 11,000
$ 16,000
$ 19,000
$ 20,000
$ 19,000
$ 16,000
$ 11,000
$ 4,000
($ 1,000)
| 247
P -
I F
P = +
Q Q
V
+
(7)
$ 500,000
$
60
$1,000,000
10,000
Based on equation 7, the required price to attain the net income goal of $1,000,000
may be computed as follows:
$1,000,000
P = +
10,000
$500,000
+ $60 = $100 + $50 + $60 = $210
10,000
The major fault of this approach is that it does not necessarily follow that customers
will pay $210 per unit and that at this price 10,000 units can be sold. In order to lower
price, management has four options:
1. Set a lower net income goal
2. Reduce fixed expenses
Management Accounting
Sales
$ 4,000
$ 4,660
Expenses:
Cost of goods sold ($12)
$ 1,200
$ 1,560
Selling ($5)
500
650
Fixed 1,000
$ 1,000
$ 2,700
$ 3,210
Net income
$ 1,300
$ 1,450
If the offer is accepted, net income should increase by $150.
| 249
While the acceptance of an offer now and then can add to company profits, the
practice of selling below total average cost can not work, if that practice becomes the
rule rather than the exception. Consider the following examples which in each case
the price is just above the variable costs
Sales
Sale
Sale
Sale
Total
No. 1
No. 2
No. 3
No. 4
________
_______
________
_______
_______
Sales
$1,000
$ 800
$1,200
$ 500
$3,500
Variable expenses
800
640
$ 960
400
2,800
Contribution
$ 200
$ 160
$ 240
$ 100
$ 700
Fixed expenses
$1,000
Net loss
($ 300)
In this example, all sales make a contribution and without any one of the four
sales the loss would be even greater. However, the fact that all the sales make a
contribution does not mean the company will be profitable, as is clearly illustrated
above. Even though all sales make a contribution, the company is still operating at
a loss.
Accepting offers at less than normal price should not become a regular practice.
Eventually, all customers will expect preferential treatment. In the short run and for
Management Accounting
several reasons, it might be prudent to accept such an offer to add to overall net
income or to keep factory workers employed. In the long, run such a practice will not
make a company profitable that is already operating at a loss.
Summary
Because pricing is such an important decision, any change in price should be
approached cautiously and should be based on an analysis of all available economic
and marketing information. Even though a demand curve may exist is a general
way, the lack of specific information on its exact nature means that in many if not
most cases price tends to be based on cost. When price is based on cost, hopefully
the companys marketing strategy will generate the sales required to cover cost and
generate the desired net income.
Cost-volume-profit analysis can be used to set a tentative price. However, the
major flaw in this approach is that the required volume to attain the desired net
income at that price may not happen. Assuming some type of demand curve exists,
the volume indicated by the C-V-P price may not occur.
Q. 13.1
Explain why it is difficult for a company to just set any price and have
the volume necessary to make the company profitable.
Q. 13.2
Q. 13.3
Q. 13.4
Q. 13.5
A special offer has been made to the Acme Company. However, the
company does not have excess capacity and to accept the offer it
would have to decrease its sales to regular customers. If this offer is
accepted, what would be the effect on net income?
Q. 13.6
Q. 13.7
Based on the cost volume profit equation, what are the three elements
that management must consider in setting price?
| 251
10,000
$50,000
$30,000
$80,000
$20,000
$ 20,00
$ 12.00
$ 2,000
12,000
Management Accounting
Required:
If the offer is accepted, then by how much will net income increase or decrease?
(Show your analysis in detail.)
Exercise 13.3 Schedule of Net Income Based on Demand Curve and Cost
Function
The K. L. Widget Company has determined its demand curve and cost function
as follows:
P = $1,000 - .1(Q)
TC = $80(Q) + $500,000
Required:
Using a work sheet with the headings as suggested below, determine net income at a
price of $1,000 and decrement the price by $100 until price is equal to $100.
Price (P)
Quantity(Q)
Revenue
P(Q)
Variable
Cost
Fixed
Cost
Total
Cost
Net
Income
| 253
Part III
Management Accounting
Performance Evaluation Tools
Chapter 14
Chapter 15
Chapter 16
Return on Investment
Chapter 17
Chapter 18
Management Accounting
Step 2
Step 3
Step 4
Step 5
Step 6
| 267
Management Accounting
encourage improvement in efficiency and productivity. The basic assumption underlying the use of standards is that costs or revenues are controllable through managerial decision-making.
The value of using standards is not without some differences in approach and
theory. A general theory of using standards, however, has evolved and the rest of
this chapter is concerned with setting forth this theory and illustrating the application
of standards. As mentioned above, two types of standards are generally recognized:
static budget standards and flexible budget standards.
A conceptual foundation underlies both these types of standards. The major
components of this foundation are the following:
1. The most important classification of costs when it comes to standards is
fixed and variable costs.
2. The concept of the activity variable, Q (quantity), is of critical importance
in setting standards and computing variances.
3. Q (quantity) is an activity variable that may either have as its frame of
reference units sold or units produced. Q as used here refers to the
quantity of output.
4. There are two types of activity whether the frame of reference is units sold
or units produced.
a. Planned quantity of output
b. Actual quantity of output
5. The question that has received considerable attention and debate is:
Should the standards for computing variances be based on actual
quantity or planned quantity of output?
6. Static budget standards are always based on planned quantity of output.
Flexible budget standards are always based on actual quantity of
output.
7. The use of flexible budgets automatically removes volume variances that
is created when static budget standards are used. In terms of units, the
volume variance is simply actual output less planned output.
8. In addition to total cost or total revenue standards, standards should also
be set for the individual factors that create the total cost standards.
9. The purpose of performance evaluation is to identify problems in cost or
revenue causing activities. A problem is indicated when a variance is
considered significant. Variances are commonly labeled as favorable and
unfavorable. The fact that a variance has been identified as favorable
does not mean the absence of problems. For example, a favorable
variance for material usage could mean that the workers are causing the
product to be of lower quality.
In order to understand these general principles, a detailed discussion of flexible
budgeting and static budgeting follows:
| 269
As previously discussed in chapter 7, the aggregate total cost equation was given
TC = V(Q) + F
(1)
TC - total costs
V - variable cost rate
Q - quantity
In equation (1), Q or quantity may be either units sold or units produced.
Furthermore, the aggregate variable cost rate, V, may be defined in terms of individual components as previously discussed in chapter 6.
V = VM
+ VL + VO + VS + VA
(2)
Where:
VM
VL
VO
VS
VA
-
-
-
-
-
In a similar manner the aggregate fixed cost standard, F, may be defined in terms
of its individual components:
F = FL + FO + FS + FA
(3)
Where:
FL
FS
FO
FA
-
-
-
-
The process of setting standards is, therefore, larger in scope than simply
setting a standard for the aggregate variable rate and the aggregate amount of fixed
expenses/costs. In less mathematical terms, standards for a manufacturing business
need to be set for the following:
Manufacturing Costs
Operating Expenses
1. Material (variable)
4. Selling (fixed and variable)
2. Direct labor (variable)
5. General and administrative
3. Manufacturing overhead
(Fixed and variable)
(Fixed and variable)
The above general theory can be summarized mathematically as follows:
Flexible budget standard equation: TC = VS(QA) + F
Static budget standard equation: TC = VS( QP) + F
TVC - total cost
- aggregate standard variable cost rate
VS
F
- planned fixed cost
Management Accounting
Flexible Budget
Equation
1. Material
TSVMC = VSM(QA)
TSVMC = VSM(QP)
2. Direct labor
TSVLC = VSL(QA)
TSMLC = VSL(QP)
3. Manufacturing Overhead
TSVMO = VSO(QA)
TSVMO = VSO(QP)
4. Selling expenses
TSVSE = VSS(QA)
TSVSE = VSS(QP)
TSVGA = VSG(QA)
TSVGA = VSG(QP)
The only difference in flexible budget and static budget standards, as explained
before, is quite obvious. Flexible budget standards are based on actual quantity of
output, QA, and static budget standards are based on planned quantity of output, QP.
Standards for manufacturing costs are based on production quantity while operating
expenses such as selling expenses are based on sales quantity. The difference in
planned Q and actual Q output is now critically important.
Setting Standards for Individual Flexible Budget Factors
Setting standards for total costs is important; however, the first step is to set standards for the factors that make up the component parts as discussed in this chapter.
Setting standards for the variable cost rates is the first and most difficult step. This
step is actually done at the beginning of the operating period. The factors involved
that create the variable cost rates for manufacturing costs are easier to identity than
the factors for selling and general and administrative expenses. The table on the
next page shows the factors typically associated with manufacturing and operating
expenses.
Because selling and general and administrative expenses cover a much wider
range of items, it is not as easy to identify specific factors that require standards.
However, for some items such as sales people commissions, the factors can be
easily identified. For example, if the sales commission rate is 10% and the price
of the product is $300. In this instance, the cost factor is $30 and the unit factor is
simply 1.
| 271
Factors
Legend
Material
Direct labor
Overhead (V)
Selling
USG
CSG
service units
standard cost of one service unit
Although the foundation of flexible budgets are always the equations for variable
costs as just explained, the preferred practice for purposes of reporting to management is to present flexible budgets in tabular form. The following is an example of a
tabular flexible budget:
Figure 14.3 Flexible Budgeting- Manufacturing Costs
VM = $ 2
VL = $3
VO = $4
200
300
400
500
600
TVMC
$200
$ 400
$ 600
$ 800
$1,000
$1,200
TVLC
$300
$ 600
$ 900
$1,200
$1,500
$1,800
TMVO
$400
$ 800
$1,200
$1,600
$2,000
$2,400
Total
$900
$1,800
$2,700
$3,600
$4,500
$5,400
If actual units manufactured were 500, then the standard cost for material would
$ 1,000 ($2.00 x 500). For variable manufacturing overhead, the standard would be
$2,000 ($4.00 x 500).
Comprehensive Illustration of Variance Analysis
Management Accounting
Actual
$5.60
$250,000
$100,000
$500,000
Actual
$201,500
$ 39,000
$ 14,300
$125,000
$550,000
Actual
$8,450
$4,225
$220,000
$ 80,000
The first step in the evaluation process is to create the flexible budgets
from the planned data provided. Typically, this would be done at the
beginning of the operating period. Based on the above information,
flexible budgets are shown in Tables 1 and 2.
| 273
(Units of Product)
Variable costs
Rate
2,000
4,000
6,000
8,000
10,000
Materials
Factory Labor
Manufacturing
30,000 40,000
300,000
50,000
Fixed Costs
Manufacturing
Total costs
Table 2
Revenue
Rate
2,000
4,000
6,000
8,000
10,000
$ 2,400,000 $ 3,000,000
Commissions
$ 240,000 $ 300,000
Packaging
5.00 10,000
Travel
2.00
Sales
Variable Costs
Selling
4,000
20,000
30,000
40,000
50,000
8,000
12,000
18,000
24,000
$ 1.00 $ 2,000 $
4,000 $
6,000
8,000 $ 10,000
Postage
0.50
2,000
3,000
4,000
Total variable
$ 310,000 $ 389,000
Advertising
$ 100,000 $ 100,000
500,000
500,000 500,000
500,000 500,000
Executive salaries
$ 200,000 $ 200,000
Building rent
50,000
Total fixed
850,000
850,000 850,000
850,000 850,000
Total expenses
$ 1,160,000 $ 1,209,000
1,000
5,000
Fixed
Selling
50,000
50,000
50,000
50,000
Management Accounting
Table 3
Standard
Variance
$ 134,784
$ 117,000
$ 17,784
312,000
234,000
78,000
Manufacturing (V)
43,680
39,000
4,680
Manufacturing (F)
250,000
200,000
50,000
$ 740,464
$ 590,000
$ 150,464
Table 4
Planned activity
6,000 units
Sales
Actual
Standard
Variance
$ 2,015,000
$ 1,950,000
$ 65,000
Variable expenses
Selling
$ 408,720
$ 325,000
$ 83,720
Commissions
$ 201,500
$ 195,000
$ 6,500
Packaging
39,000
32,500
6,500
Travel
14,300
13,000
1,300
Supplies
8,450
6,500
$ 1,950
Postage
4,225
3,250
975
676,195
575,250
100,945
$ 1,338,805
$ 1,374,750
$ 35,945
$ 125,000
$ 100,000
$ 25,000
550,000
500,000
50,000
Contribution margin
Fixed expenses
Selling
Advertising
Executive salaries
220,000
200,000
20,000
Building rent
80,000
50,000
30,000
250,000
200,000
50,000
$ 1,275,000
$ 1,050,000
$ 225,000
$ 324,750
$ 260,945
Net Income
63,805
| 275
The third step is to identify the proper standards to be entered into the
standards column. In our example here, actual production output was
7,800 and sales output was 6,500. The planned values were 7,000 units
of production and 6,000 units of sales. These two values are no longer
of any importance and it is the actual outputs that are used to set the
flexible budget standards. For example, the standard for material is:
SMVC = $15.00 (7,800) = $117,000. In flexible budgeting, the standard
is always based on actual output which in this case for production is
7,800.
Step 4
The 4th step is to compute the total variances by subtracting from actual
values the standard values. The differences should be labeled favorable
or unfavorable as shown in Tables 3 and 4.
Management Accounting
material and labor required or used. For example, if 1,000 chairs are made, then
output is 1,000 and if each chair requires 6 units of material, then the quantity of
material inputs would be 6,000. When the term quantity is being used in computing
variance, it is important to realize at all times whether the term quantity is referring
to outputs or inputs.
The total material cost variance equation is simply:
Total material variance = actual material cost - standard material cost
The actual material cost is: AMC = VMA (QA)
Where:
AMC - actual material cost
VMA - actual variable material cost rate
QA - actual output
In order to know the quantity of materials used, the company must have a good
system for tracking usage of inventory. The system used most likely will be some type
of perpetual inventory system. The quantity used per product then is simply the total
quantity of material used divided by the actual output.
Actual material cost is the number of units of product (output) times the actual
material cost per unit of product or alternatively, it can be computed by multiplying
the actual quantity of material used times the cost of one unit of material. In this type
of analysis, there are two variable cost rates, actual and standard. The standard
material cost is the number of actual units of output times the standard variable cost
per unit of product. The total variance computed from using a flexible budget standard
can be analyzed into the two factors:
1. Price
2. Quantity (per units of product)
There, consequently, exists two variances commonly called:
Material price variance
Material quantity variance
The material cost variance is more commonly called the material price variance.
In terms of variance analysis for materials, the term price almost always means the
price of one unit of raw material. In the analysis that follows, the term price will be
used rather than cost in order to be consistent with the use of the term in management and cost accounting literature generally.
The mathematical definitions of these variances are as follows:
Material Price Variance:
MPV = (PMA - PMS) QMA
Where:
MPV
PMA
PMS
QMA
-
-
-
-
| 277
MQV -
QMA -
QMS -
Production
1,000
1,200
Units of material per product
4.0
4.2
Cost per unit of material
$2.00
$2.50
Analysis of Material - Based on this information, the flexible budget standard
equation is:
TSMC = $8.00 (QA)
The actual variable material cost rate is $10.50 (4.2 x $2.50).
Step 1
Step 2
$12,600
$ 9,600
_______
$2.50
$2.00
_____
.50
Actual quantity of materials used (1,200 x 4.2) 5,040
Material price variance
Step 3
$3,000
$2,520
5,040
4,800
240
$2.00
Material quantity variance $ 480
$3,000
Management Accounting
Analyzing the Total Labor Cost Variance - It is clear regarding labor that an
increase in the wage rate above the standard wage rate will result in an unfavorable
variance. Furthermore, if the number of actual labor hours incurred are greater
than planned, then these additional labor hours also add to the unfavorable total
labor variance. The standard variable cost rate for labor, as previously explained, is:
VLS = HSL x RSL where HSL is the number of labor hours required per unit of product
and RLS is the standard wage rate per hour. After the total labor cost variance has
been determined, then the question becomes: how much of the total variance is due
to the labor wage rate and how much is due to labor hours usage?
As mentioned previously, it is also important in analyzing labor to distinguish
between quantity of inputs and quantity of outputs. Labor hours incurred is a measure
of input quantity. Output still remains the quantity of finished goods.
The total labor cost variance equation may be defined as:
Total labor cost variance = actual labor cost - standard labor cost
The actual labor cost is:
Where:
ALC - actual labor cost
VLA - actual variable labor cost rate (per unit of product)
- actual output (units of product)
QA
In other words, actual labor cost is the number of units of product (output) times
the actual labor cost per unit of product. In this type of analysis, there are two variable
cost rates, actual and standard. The standard labor cost is the number of units of
product (output) times the standard variable labor cost per unit of product. The total
labor variance computed from using a flexible budget standard can be analyzed into
two factors:
1. Wage rate
2. Number of labor hours (per unit of product)
There, consequently, exists two variances commonly called:
1. Labor rate variance
2. Labor hours variance
The mathematical definitions of these variances are as follows:
Labor Rate Variance:
LRV = (RLA - RLS) HLA
Where:
LRV
RLA
RLS
HLA
-
-
-
-
HLs)RLs)
| 279
Step 2
Step 3
$12,000
$ 6,000
$ 6,000
$12,000
Analysis of Total Variance for Overhead - One of the more difficult and
challenging areas of analysis is manufacturing overhead. Accountants decades ago
developed some sophisticated procedures for analyzing the manufacturing overhead
account. The procedure adopted was to analyze the balance of the account rather
than simply analyze the charges to the account. The balance of the manufacturing
overhead account represents under- or over-applied overhead. However, since
Management Accounting
Actual
330,000
Balance
90,000
The analysis of this account can get very complex depending on what assumptions
are made. Generally, overhead is applied based on an overhead rate. An overhead
rate requires:
1. An assumed capacity level on which the rate is based
2. A basis of application such as direct labor hours
Technically, overhead should be applied based on standard hours at actual output.
This will be the assumption in this discussion.
The above account was based on the following assumptions:
Capacity (normal)
100,000 DLH
Standard fixed overhead
$200,000
Variable rate
$1.00 per DLH
Actual output
16,000 units of product
Full capacity
20,000 units of product
Standard DLH per product
5
Actual direct labor hours
85,000
The total overhead rate would be:
Fixed rate (200,000/100,000)
$2.00 per DLH
Variable rate
$1.00 per DLH
$3.00 per DLH
Based on output of 16,000 units of product, the standard direct labor hours would
have been 80,000 hours (16,000 x 5)
There are three possible explanations for the balance of $90,000. These reasons
are commonly called:
1. Spending variance
2. Efficiency variance
3. Volume variance
The spending variance is defined:
Spending variance = actual overhead - budgeted overhead at actual
output (e.g., hours)
| 281
Management Accounting
Pa
C
Ps
Material
Quantity
Variance
D
Standard
Material cost
B
Qs
Qa
Material
Quantity
| 283
1. At 18,000 actual hours of direct labor, the budgeted overhead (fixed plus
variable) is $244,000.
$300,000
SV
$275,000
$260,000
$244,000
$228,000
EV
VV
$208,000
$100,000
Hc
20,000
Ha
18,000
16,000
12,000
8,000
4,000
Hs
Management Accounting
3. At 20,000 hours (full capacity) the budgeted overhead (fixed plus variable)
is $260,000.
$ 2.50
$ 2.00
$ .50
5,040
$2,520
Actual quantity of materials used (1,200 x 4.2)
5,040
Standard quantity of material (1,200 x4)
4,800
240
Standard price
$ 2.00
Material quantity variance
Sum of material variances
$ 480
$4,600
| 285
Flexible Budgeting
$4,600
$4,600
Material price variance
$2,520
Material quantity variance $ 480
$3,000
Summary
Variance analysis can be highly effective in highlighting areas of decision-making
that need improvement. Traditionally, the discussion of variances has been in the
framework of a manufacturing business and in particular to material, labor, and
overhead. However, variance analysis can be used in any type of business and can
be applied not only to manufacturing costs but also to all types of expenses. Flexible
budgeting can be used in all types of businesses, because all businesses have
variable costs and expenses.
Management Accounting
Unless these two values are computed, a complete variance analysis of material
and direct labor cannot be accomplished.
Standard units of material allowed is simply: UmS (QA0). In other words, standard
material allowed is the material required per unit of product times the number of units
manufactured commonly called output. Total standard cost is VMS(QA0), where VMS
is the standard material cost per unit of output. Stated more simply, VMS(QA0), is the
equation for computing flexible budgeting standards for material.
The material variance equations presented in this chapter may be expanded as
follow:
Material Variances
Material Price Variance
(PMA - PMS) QMA = PMA( QMA) - PMS (QMA)
Material Quantity Variance
PMs(QMA) - PMS(QMS)
(QMA - QMS)PMS =
If we take the variance analysis equations for material on the right hand side and
place them in close proximity, then we can easily see that the price variance and the
quantity variance have one term in common.
MPV = PMA( QMA) - PMS (QMA)
MQV = PMs(QMA) - PMS(QMS)
The term PMS(QMA) may be read as the cost of material actually used at standard
price. This cost value would be the same as the flexible budgeting standard cost
value only when there is no variance in the quantity of material used. Because of the
difficulty in following the logic of these right hand definitions, most cost accounting
text authors present the following graphical analytical tool.
Figure 14.6 Material Variance Graph
Actual Material
Cost
$3,410
Standard
Material Cost
Standard Cost of
Actual Material used
(Flexible Budget)
$3,300
$3,000
MPV
MQV
$110
$300
TMCV
PMA(QMA) - QMS(PMS)
$410
| 287
500
2
$3.00
$3.10
1,100
Labor Variances
In a similar manner, the definition of labor variances may be expanded:
LRV
= (RLA - RLS)HLA =
As for the case with material, if we take variance equations for labor on the right
hand side and place them in close proximity we can easily see that the price variance
and the quantity variance have one term in common.
LRV =
LHV =
RLS(HLA) - RLS(HLS)
The term RLS(HLA) may be read as the cost of labor hours actually incurred at
the standard wage rate. Thi cost value would be the same as the flexible budgeting
value only when there is no variance in the actual labor hours incurred. Because of
the difficulty in following the logic of these right hand definitions, most cost accounting
text authors present the following graphical analytical tool.
Figure 14.7 Labor Variance Graph
Actual Labor
Cost
Standard
Labor Cost
Standard Cost of
Actual Labor hours
(Flexible Budget)
$18,000
$15,000
$18,900
LRV
LHV
$900
$3,000
TMCV
$3,900
500
3
$10.00
Management Accounting
$10.50
1,800
Q. 14.1
Q. 14.2
Q. 14.3
Q. 14.4
Q. 14.5
Q. 14.6
What activity level must be known in order to select the correct standard
for purposes of computing variances?
Q. 14.7
Q. 14.8
Q. 14.9
At what point in time are the standards under flexible budgeting actually
known for purposes of computing variances?
Q. 14.10
Q. 14 .11
Q. 14.12
Q. 14.13
List the steps involved in analyzing the total variances for material and
labor.
Q. 14.14
Q. 14.15
Q. 14.16
Q. 14.17
Q. 14 .18
(PMA - PMS) QA
(QMA - QMS) PMS
( RLA - RLS) HA
( HLA - HLS) RLS
| 289
2,500
2,000
Material Data:
Actual:
Units of material used
Cost of material per unit
5,200
$3.00
Material standards:
Cost of one unit of material
Units of material required per product
$2.80
2
Labor Data:
Actual :
Actual labor hours
Wage rate per hour
6,500
$15.00
Labor standards:
Labor hours per unit of product
Wage rate per hour
3
$14.00
$60,000
$25,000
$50,000
$22,500
10,000
7,500
8,000
Required:
Based on the above information:
1. Compute the flexible budget standards for material and labor.
2. Compute the total variances for material and labor.
3. For materials compute the material price variance and the material quantity
variance.
4. For labor, compute the labor rate variance and the labor hours variance.
5. For manufacturing overhead, compute:
a. The spending variance
Management Accounting
$ 2.00
4.00
$ 3.00
5.00
$10.00
3
$11.00
2.5
$
$
$
2. Based on the above information, compute the following for direct labor:
1. Actual direct labor hours (input) (
)
2. Actual output (units)
3. Actual direct labor cost
4. Standard direct labor cost:
) $
a. Flexible budgeting
b. Static budgeting
(
(
) $
) $
(
(
)
)
| 291
(
(
(
)
)
)
(
(
(
)
)
)
(
(
(
(
)
)
)
)
(
(
(
(
)
)
)
)
Management Accounting
At the beginning of the first quarter, the vice presidents were asked to submit cost
estimates for their respective areas. Each vice president was informed that sales of
8,500 units was forecasted but that production would be 10,000 units. The following
reports were submitted to the president of the company.
Report from Vice President of Production
Material:
Material X
Freight-in, material X
Material Y
Cost Per
Units
$6.00
$.50
$10.00
Labor (Variable):
Cutting department
Assembly department
Finishing department
Rates
$8.00
$7.00
xxxxx
Number of
Units
4.0
2.00
Hours
1.2
0.9
xxxxx
Fixed Manufacturing Overhead:
Fixed direct labor
$120,000
Utilities
$ 4,000
Production planning &
control
$ 8,000
Purchasing & receiving $ 75,000
Factory insurance
$ 1,500
Depreciation, prod. equip. $ 21,125
Depreciation, building
$ 4,000
Factory supplies
$ 1,000
Workers training cost
$ 8,250
Fixed selling:
Sales peoples salaries
Sales people training
Advertising
Sales offices rents
Terr. offices oper. exp.
Home office sales exp.
$483,000
$ 30,600
$280,000
$ 9,000
$ 65,000
$ 30,000
$95,000
$ 9,000
$14,253
$ 1,667
$ 2,500
| 293
Management Accounting
Cost of goods sold
Sales peoples commissions
Packaging
Sales people travel
Bad debts
Credit department
Total variable selling
$
$
$
$
$
$
$
_____________
_____________
_____________
_____________
_____________
_____________
_____________
Estimated-Rate per
Unit of Product
Total Cost
$ _____________
$ _____________
$
$
$
$
$
$
$
_____________
_____________
_____________
_____________
_____________
_____________
_____________
$ _ ___________
$ _ ___________
$ _ ___________
$ ____________
$ _____________
Labor:
Cutting department (_ __ x ___ )
Assembly department (_ __ x ___ )
Finishing Dept. (labor is fixed in this department)
Manufacturing overhead - variable rates
Utilities
$ _____________
Repairs & maintenance
$ _____________
Supplies
$ _____________
Material spoilage loss
$ _____________
Total variable overhead
$ _____________
Total variable mfg. cost
$ _____________
$ ____________
$ ____________
$
xxxxx
____________
$
$
$
$
$
____________
____________
____________
____________
____________
| 295
4,000
6,000
8,000
10,000
12,000
14,000
Management Accounting
4,000
6,000
8,000
10,000
12,000
14,000
| 297
$
$
$
61,336
6.90
.60
32,912
10.08
none
17,600
$
8.50
$149,600
13,876
$
6.50
$90,194
-0$ 5,000
$ 23,000
$ 9,000
$ 12,000
In the first quarter of the year, the V. K. Gadget Company operated at a loss. The
following is a summarized version of the companys income statement:
Management Accounting
V. K. Gadget Company
Income Statement
For the quarter ended March 31, 20xx
(Direct Costing Basis)
Sales
Variable Expenses:
Cost of goods sold
Selling expenses
General and administrative
Fixed Expenses:
Selling
General and Administrative
Fixed manufacturing overhead
Total Operating expenses
Net operating loss
Other income
Other expense (interest)
Income taxes
Net loss
Actual units sold
- 8,734
Actual units manufactured - 14,960
$605,669
274,489
30,344
_ _______
$887,735
109,107
310,149
________
-028,181
-199,454
________
$1,746,800
$910,502
1,306,991
_________
2,217,493
_________
($ 470,693)
171,273
$(299,420)
__________
Required:
1. Based on the above information, compute total variances for all items which
appear on the cost of goods manufactured statement and income statement. Standards for purposes of this analysis should be based on the use
of the flexible budgets prepared in problem 1. Use Forms A and B to compute total variances.
2. Based on the flexible budgets prepared in problem 1 compute:
a. Total material variance
b. Material price variance
c. Material quantity variance
d. Total labor variance
e. Labor rate variance
f. Labor efficiency variance
3. If static budgeting concepts had been used, what level of activity would have
been the basis of the standards used for computing variances?
| 299
Selling
Fixed:
Selling
Fixed manufacturing
Total fixed
Total expenses
Other income
Other expense
Net income/loss
Management Accounting
Materials used: Y
Actual
Standard
Variance
Cutting department
Assembly department
Utilities
Supplies
Total
| 301
Management Accounting
| 303
Management Accounting
DE - AIE
(1)
Direct expenses are those expenses that can be eliminated by the closing of a
segment. These types of expenses are also sometimes called escapable and indirect
expenses called inescapable. Variable expenses because they are activity expenses
are always considered escapable. For example, if in a clothing store the decision
has been made to no longer sell children shoes, then the cost of goods sold for
children shoes would no longer exist. Cost of costs sold, a variable expense, is a
good example of an escapable segmental expense.
Fixed expenses may either be direct or indirect depending on the circumstances.
If a store is closed but the contract for rent is a five year lease and only one year has
expired on the lease, then for the next four years the rent is inescapable. However,
if the sales manager of the store is let go, then his or her salary, a fixed expense, is
escapable. The contractual nature of fixed expenses must be examined carefully to
determine whether or not the expense is direct.
Segmental Contribution Approach
The major problem of the full cost approach is that it is technically possible for
a segment to show an operating loss yet at the same time be making a positive
contribution to net income. In other words, if the seemingly unprofitable segment is
closed, then the overall net income of the business will decrease. The paradox will be
examined more closely later in this chapter.
To overcome this adverse feature of the full cost approach, many businesses
prefer to use the contribution approach to measuring segmental profitability. The
segmental contribution approach as indicated by its name measures segmental
contribution. Segmental contribution may simply be defined as sales less direct
expenses. As a student, you should be careful to distinguish between segmental
contribution and contribution margin. Contribution margin, which was discussed and
defined in chapter 7, is sales less variable expenses. Because some fixed expenses
can be direct expenses, segmental contribution and contribution margin are not the
same.
The basic principles of computing segmental contribution may be outlined as
follows:
1. Only the contribution of each segment is computed. No attempt is made
to compute the net income of the segment.
2. Indirect or common expenses of each segment are not allocated.
3. Indirect or common expenses, however, are usually deducted from total segmental contribution in order to arrive at overall business net income.
4. A segment is considered profitable if sales of the segment exceed the
direct expenses of the segment.
| 305
(4)
DE - direct expenses
P - price of the product in the segment
V - variable cost rate for the segment
Q - units of sales in a specific segment
(5)
Widget Company
Segmental Income Statement
Widget Company
Segmental Income Statement
Sales
Total
Expenses
Executive salaries
27,000
7,000
5,000
12,000
6,000
4,000
10,000
Sales salaries
Sales
Total
Direct expenses:
15,000
12,000 27,000
7,000
5,000 12,000
_______ _______ _______
$
2,000 ($1,000)
1,000
___
_______ $___
______
_____ _______
______
_____
Executive salaries
Net
Income/loss
10,000
_______
$ 1,000
_______
_______
Management Accounting
In the above example, cost of goods sold and sales salaries are direct expenses
of each segment. Executive salaries, an indirect expense, consequently were
charged to the segments by being allocated. In the segmental contribution approach,
executive salaries are not allocated.
A number of observations from the above example should be made. First, the full
cost approach shows that segment B is operating at a net loss of $1,000. It would
appear that the business would be better off by $1,000 if this segment is closed.
However the segmental contribution approach shows that segment B is making
a contribution of $3,000. Secondly, it should be observed that executive salaries
were allocated in the ratio of 60:40. The allocation percentages were determined by
dividing segmental sales by total sales.
The question that needs to be asked and analyzed is this: will the company be
better off if segment B is closed, or stated differently, will overall net income of the
business increase by $1,000? The answer is NO. To prove this answer, suppose
segment B is closed and, therefore, the companys entire operations consists only of
segment A. The companys income statement would, therefore, be as shown below.
Surprisingly, rather than net income increasing by $1,000, the closing of segment
B causes the company to be operating at a total net loss of $2,000.The company is
worse off without segment B in the short run than with the segment closed. Eliminating
the $1,000 loss of segment B had the opposite effect of the desired result. Rather
than increasing net income of the business, it caused the income of the business to
substantially decline.
Widget Company
Income Statement
(Segment A Only)
Sales
Expenses
Cost of goods sold
Sales salaries
Executive salaries
Net
loss
$30,000
15,000
7,000
10,000
_ ______
32,000
_______
$ 2,000
_______
The obvious reason why net income did not increase is that executive salaries
are an inescapable expense. Where before $4,000 had been allocated to segment
B, segment A must now be charged with the entire $10,000 of executive salaries.
The $3,000 contribution of segment B towards common expenses was lost when
this segment was closed. The loss of $3,000 segmental contribution means that the
overall net income of $1,000 now becomes an overall company loss of $2,000.
However, the segmental contribution approach to measuring segmental profitability
is not without its own flaws. The questions needs to be asked: is it possible for each
| 307
$11,000
12,000
________
Net
loss
($
1,000)
________
Sales
A
$200,000
________
Variable expenses
150,000
Direct fixed expenses
20,000
________
170,000
________
B
$100,000
________
C
__$50,000
______
Total
$350,000
________
60,000
30,000
240,000
30,000
15,000
65,000
________
________
________
90,000 ________
45,000
305,000
________
________
The question then remains: which method is best for evaluating overall profitability
of a segment? To answer this question, another question needs to be asked. What
does net loss mean when a segment is shown to be operating at a loss under the full
cost approach?
Assuming the allocation of indirect expenses has been done as fairly as possible,
a segmental net loss means that the contribution of the segment is not considered
adequate. In the long run, each segment should make a fair share contribution to
the indirect expenses. In the short run, the segment clearly should not be closed,
if segmental contribution is positive. The existence of segmental net loss is a clear
signal that ways should be found to increase the segmental contribution. If this can
not be done in the long run, then it might be wise to consider closing the segment and
devoting the resources, both financial and human, to another segment.
Improving Segmental Contribution
When the use of the full cost approach reveals that a segment is operating at
a loss, the first step is not to discontinue the operations but to search for ways to
increase the amount of contribution. There are two rather obvious ways to increase
contribution: (1) increase sales and (2) decrease direct expenses. In order to increase
Management Accounting
V =
Where:
V
l
V
o
V
s
V
a
V
V
-
-
-
-
-
+ Vl + Vo + Vs
+ Va
F1 + Fo + Fs + Fa
l
F - fixed labor cost
o
F - fixed overhead costs
Equations (1) and (2) reveal that each type of cost/expenses consist of components
that need to be examined separately. These equations indicate that opportunities for
expense/cost reductions exist in five cost areas:
1. Materials
4. Selling
2. Factory labor
5. General and administrative
3. Manufacturing overhead
Material cost may decreased in several ways. A search for a different supplier
with a lower cost might be in order. Also, purchasing in larger quantities might be
considered. Furthermore, the amount of material put into a product might be examined.
A more efficient use of material with less waste might be explored. Ways to increase
the productivity of labor should be considered .
Reduction in fixed expenses should also be considered. Those fixed expenses
that are considered to be direct in nature should be analyzed. Advertising obviously
could be cut to zero, but the consequences might be a substantial decrease in sales.
However, the advertising budget still needs to be examined closely and the budget
spent wisely in advertising media that will be the most effective for the company.
| 309
Business budgeting
Incremental analysis
Segmental contribution reporting
Cost-volume-profit analysis
Cost behavior analysis
ROI analysis
Flexible budgeting and variance analysis
Economic order quantity models
One of the more effective tools is cost-volume-profit analysis which was discussed
in some depth in chapter 7. Earlier in this chapter, the contribution approach to
segmental evaluation, was presented in the form of the following equation:
D
SC = P(Q) - V(Q) - F
(5)
P(Q) + V(Q) = SC + F
Q(P - V) = SC + FD
SC + FD
Q =
P - V
(6)
To illustrate, assume that the following information was taken from the K & L
Widget Company for one of its segments:
Price
$ 100
Variable cost rate
$ 80
Direct fixed expenses
$ 5,000
The company has set a target segmental contribution at $10,000. How many
units must be sold to attain this desired level of contribution? Equation (6) above may
be used to answer this question:
10,000 + 5,000
15,000
Q = =
100 - 80
20
750
Management Accounting
90
80
70
60
50
40
Direct Fixed
Expenses
Negative
Segmental
Contribution
30
Variable
Expenses
20
10
0
0 100
300
500
700
Volume (units)
900
| 311
Q. 15.1
Q. 15.2
Q. 15.3
Q. 15.4
Q. 15.5
What is the basic profitability formula for the full cost approach?
Q. 15.6
Q. 15.7
Q. 15.8
Q. 15.9
Under the full cost approach, what type of costs require allocation?
Q. 15.10
Q. 15.11
What terms may be used as synonyms for direct and indirect costs?
Q. 15.12
- AIE
Management Accounting
Total
$175,000
$ 90,000
$ 55,000
$ 25,000
_______
$170,000
_______
$
5,000
________
Segment A
Cost of goods sold
Selling
Gen. and administrative
Segment B
Cost of goods sold
Selling
Gen. & administrative
Required:
Variable
Direct Fixed
Common (Indirect)
$30,000
$10,000
$ 8,000
$6,000
$2,000
$4,000
$5,000
$60,000
$20,000
$ 6,000
$8,000
$2,000
$7,000
$2,000
Case I
Dept. W
Case II
Dept. X
Case III
Dept. Y
Case IV
Dept. Z
$50,000
45,000
$ 5,000
8,000
($3,000)
$ 1,000
$50,000
45,000
$ 5,000
8,000
($ 3,000)
$ 6,000
$50,000
55,000
( $ 5,000)
6,000
($11,000)
$ 4,000
$50,000
40,000
$10,000
5,000
$ 5,000
$ 2,000
For each case, show whether or not the department is making a contribution to
the business.
| 313
Terr. 1
Terr. 3
Terr. 4
$20
2,000
$55
4,000
$12
$ 2
$ 1
$ 2
$19
$ 3
$ 2
$ 3
$28
$ 1
$ 2
$ 5
$25
$ 3
$ 3
$ 4
Fixed costs/expenses:
Advertising(s)
Sales people salaries (s)
Salaries (g & a)
$20,000
$14,000
$ 2,000
$25,000
$21,000
$ 3,000
$45,000
$18,000
$ 2,000
$26,000
$15,000
$ 3,000
Price
Quantity
Terr. 2
$75
3,500
$55
3,000
Direct expenses:
Indirect Costs\Expenses:
$15,000
$35,000
$25,000
$40,000
$12,000
The allocation base for indirect costs should be the sales measured in dollars.
Required:
1. Compute the segmental net income of each territory.
Terr. 1 _ _____ Terr. 2 _______ Terr. 3 ________ Terr. 4 _______
Which territories, if any, are operating at a loss?_____________________
Explain the meaning of segmental net loss._________________________
___________________________________________________________
Management Accounting
b.
Explain why the net income of the business decreased when territories 4 was
closed:
4. If the unprofitable territory 1 were closed what would be:
a.
$ _______________
b.
Explain why the net income of the business increased when territory 1 was
closed:
__________________________________________________________
__________________________________________________________
5. Assume that in territory 1:
Price is increased to $25, cost of goods sold is reduced to $10, and that
advertising is increased by $5,000. As a consequence of these decisions,
assume that sales will increase to 3,000 units. Given these changes:
a.
$ _______________
b.
$ _______________
| 315
Sales records on an operating hours basis shows average sales per hour
to be:
Hours
Product A
Product B
$ 8.00
$ 10.00
$ 5,000 per month
$ 1,500 per month
$ 500
$ 800
60% of sales
45% of sales
Required:
1.
2.
Management Accounting
Return on Investment
Profit or net income without question is a primary goal of any business. Any
business that fails to be profitable in the long run will not survive or will find itself in
bankruptcy. However, the mere existence of profit alone can not guarantee continuity
of a business. Profit must be satisfactory from the viewpoint of the investors and,
for this reason, profit while a measure of success itself must be evaluated. For
example, if company A has net income of $100,000 and company B has net income
of $1,000,000, which company is the most successful? It appears Company B
might be more successful, however, the size of net income is not the measure of
satisfactory. If company As total assets is $1,000,000 while company Bs total assets
is $100,000,000, the rate of return respectively for companies A and B is 10% and
1%. Company A is, therefore, more likely to be evaluated favorably.
In order to compare companies in terms of profitability, net income must be
expressed as a rate of return. To start a business, an entrepreneur must raise
capital. The term capital is a somewhat ambiguous term which can either refer to
the investment of money or funds in assets (plant and equipment) or to the source
of the funds. The use of the term capital tends to have a more narrow meaning in
accounting than in finance. In accounting, the term capital refers to the contribution
of assets by the owners (either a proprietor, partners, or stockholders.)
In finance, the term capital is employed to encompass all sources of funds
including both creditors and owners. The terms debt capital and equity capital
are commonly employed. The accounting equation is typically expressed: Assets =
Liabilities + Capital. In finance terms, the same equation would be Assets = Debt
Capital + Equity capital. Regardless of how the equation is expressed, the fact remains
that the two primary sources of assets are debt capital and equity capital. In other
words, a business looks to both creditors and owners for initial financial support.
Both parties, creditors and owners, expect a return of the capital that they have
invested in the business. The creditors expect a reward in the form of interest and the
| 305
Net income
$ 60,000
This particular format clearly shows two types of earnings: net operating income
and net income.
The management of a business has a responsibility to see that investors recover
the investment they have in the business. Net operating income represents the total
return in a given period of time before any distribution is made to investors and other
Management Accounting
claimants. Creditors have first claim on net operating income. If interest is equal to net
operating income, then net income is zero and there is nothing that can be claimed by
governments in the form of taxes and the return to equity capital providers would be
zero. In the above example, the return to creditors is $100,000 and the share of net
operating income to governments (state and federal) is $40,000. The return to equity
investors is $60,000. In order to state net income as a rate of return, it is necessary
to know how much has been invested in the business.
Investors, both owners and creditors, have defined investment in two different
ways. Some investors have defined investment as meaning total assets while others
define investment to mean total equity. Either definition is acceptable, however, care
must be taken to use the right measure of earnings. When investment is defined as
total assets, then the correct measure of earnings is net operating income. When
investment is defined as total equity, then the correct measure of earnings is net
income. Net income is the amount of net operating income remaining exclusively for
the equity capital providers.
Consequently, in the real world of business and finance, two concepts of return
on investment have emerged: (1) return on investment-assets and (2) return on
investment - equity. Mathematically, we have:
Net operating income
ROIa =
Total assets
(1)
Net income
ROIe =
Total equity
(2)
(3)
Net operating income is Revenue less all expenses except taxes and interest. It
is rather obvious that net operating income can be computed by simply starting with
net income and adding back taxes and interest. This can be demonstrated by using
the data from the above income statement.
Net operating income = $1,000,000 - $800,000 = $200,000
or
Net operating income = $60,000 + $100,000 + $40,000 = $200,000
The concept of return on investment-assets should be used when the objective
is to evaluate managements performance for the whole business. Management has
a responsibility to provide a return on all of the assets intrusted in its care regardless
of their source. In one sense, managements first responsibility is to see that net
operating income is sufficient to pay the creditors the interest contractually owed. If net
income is not adequate for this purpose, then the creditors could force the company
into bankruptcy and eventual failure. When net operating income is sufficient for this
purpose, then management must consciously strive to make net operating income
sufficient to provide the equity investors the rate of return they also expect. If the
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Balance Sheet
December 31, 20xx
Income Statement
For the year ended, 20xx
Current asset
$ 4,000
Sales
$ 10,000
Fixed assets 6,000
Cost of goods sold 7,000
$ 10,000
Gross profit
$ 3,000
Expenses
Liabilities
$ 2,000
Operating
$ 700
Interest
200
Capital 8,000
Taxes
100
$ 10,000
$ 1 ,000
Net income
$ 2,000
Management Accounting
It is apparent that ROIe is larger than ROIa. Now suppose management decides
to replace $3,000 of equity with debt. In this event, total liabilities would be $5,000
and total capital would be $5,000. With a debt of $5,000 at 10% interest rate, total
interest becomes $500 and net income becomes $1,700. Based on these numbers,
ROI becomes:
2,300
1,700
ROIa = = 23%
ROIe = = 34%
10,000
5,000
Even though net income decreased by $300, the rate of return on equity
increased substantially from 23% to 34%. The problem with this strategy is that
the risk of bankruptcy increases as the amount of debt increases relative to equity.
Clearly this strategy increases the return to the remaining equity holders but this
strategy also puts the business at greater risk. Notice that the ROIa did not change.
It remained at 23%. The use of ROIa to evaluate the adequacy of net income
reduces the temptation to incur debt for the single purpose of increasing the rate
of return.
The principle of leverage does not always work. In order for the principle to
increase ROI, the necessary condition is that the rate of return on assets must be
greater than the interest rate. If not, then the principle will have the opposite effect.
The return on investment-equity will be less. In the above example, the interest
rate was 10%, but the return on assets was 23%. In this instance, the principle of
leverage can be applied effectively.
Return on Investment and the duPont Approach
There is another approach to ROI analysis that was made popular in the 1940s
by the duPont company. This approach introduced into ROI analysis two factors
considered important at that time: (1) Profit margin percentage and Investment
turnover. This modified ROI equation can be stated as follows:
ROI =
Earnings
x
Sales
Sales
Investment
| 309
= 30% x 2 = 60%
Company B
200,000 1,000,000
ROI = x = 20% x 4 = 80%
1,000,000
250,000
Based on profit margin percentage, company A appears to be the better company;
however, this is misleading because company B, in fact, has the higher rate of return
(60% vs 80%). Company B has a higher investment turnover rate because of less
investment in assets.
It is well recognized among those professionals that analyze financial statements
that different industries have different profit margin percentages. A furniture store
would have a high gross margin percentage but a much lower investment turnover
than many other companies in different industries. Using profit margin percentage or
investment turnover alone to evaluate profit is not a good idea. Some typical gross
margin percentages of different industries are the following:
Supermarkets
Furniture stores
Discount stores
Gasoline stations
Petroleum refining
1.0%
2.5%
2.0%
4.5%
7.0%
If ROIa is the means of evaluating profit, then the ROI formula can be stated as
follows:
Net operating income
Sales
ROIa = x
Sales Total Assets
Using the numbers above in the discussion on leverage we have:
2,000 10,000
ROIa = x =
10,000 10,000
.2 x 1 = 20%
The duPont formula reveals two important weaknesses of relying on profit margin
percentage as the sole criterion of evaluating net income. The first weakness is the
failure to consider the amount of investment in the business and the second weakness
is the failure to consider the impact of volume (sales) on the rate of return. The use
of this approach does not change the ROI answer. Rather it breaks the rate down
into two major components that many believe are important factors in evaluating net
income.
Return on Investment Weaknesses
While ROI formulas of the type discussed so far are useful, they do have a
recognized weakness. The return on investment equation is also often used to evaluate
future business opportunities. To do this it is necessary to project net income into the
future for the estimated life of the projects. Assume that two business projects are
Management Accounting
being evaluated and that each opportunity as a useful life of 5 years. The cost of each
project is $40,000. Net income for each project has been estimated as follows:
Proposed Project
Project A
Project B
Net income
$10,000
$20,000
$10,000
$15,000
Total
$10,000
$10,000
$10,000
$ 2,500
$10,000
$ 2,500
$50,000
$50,000
Both projects have the same total net income and the same average net income
per year of $10,000. The annual average rate of return for both projects is 25%
(10,000/40,000). But the question is: are both projects in fact equal in terms of
profitability? Project A has the same net income each year but project B has more
net income in years 1 and 2 and less in years 4 and 5. If net income is the same as
net cash flow (this would be the case if there is, for example, no depreciation), then
project B is the better project. The reason is that if the present value of each project
is computed, then project B has a larger present value and, consequently, a higher
time adjusted rate of return. The time adjusted rate of return method is presented in
chapter 12. The average rate of return method ignores the difference in the timing of
net income. For this reason, many theorists argue that using present value methods
is the better approach to evaluating profitability.
Planning and Control Approach to Return on Investment
Formal profit planning (comprehensive business budgeting) results in a set of
planned financial statements and, as a consequence, also results in a planned return
on investment. After the budget is completed, the planned rate of return can be
computed by dividing planned net operating income by planned total assets.
However, a more insightful and analytical approach is to consider the following:
Previously net income was defined as:
I = P(Q) -
) - F
In addition, total assets maybe defined as working capital and fixed capital.
Working capital tends to vary directly with volume and, therefore, maybe defined as
follows:
WC = C(Q)
where C is the rate of increase in working capital per dollar change in sales
volume.
Total assets therefore may be defined as:
TA = C(Q) + FC
where FC represents total investment in fixed capital.
Given the equation for ROI as
equation:
ROI
ROI
P(Q) - V(Q) - F
=
C(Q ) + FC
| 311
100,000
620,000
= 16.12%
This formula makes clear that a rate of return is dependent on many different
kinds of decisions. To achieve a satisfactory rate of return, management must make
good decisions in all aspects of the business including good management of working
capital and investment in plant and equipment.
Summary
Return on investment is primarily a performance evaluation tool. As a decisionmaking tool it is somewhat limited. However, for certain decisions such as starting
a new business or expanding an existing businesses, ROI can be very helpful. If
management has a goal or objective of earning no less than a return of 20% and
under the most optimistic of assumptions, the return will not be greater than 15%, then
proposed venture should not be taken. Return on investment is also an excellent tool
to use in connection with comprehensive business budgeting. Every comprehensive
budget has inherent within it a planned rate of return. This rate of return should be
explicitly recognized.
The terminology that is important in this chapter is the following:
1. Earnings
8. Debt capital
2. Return on investment-assets
9. Equity capital
3. Return on investment-equity
10. Total assets
4. Interest
11. Leverage
5. Net income
12. Profit margin percentage
6. Net operating income
13. Investment turnover
7. Working capital
Management Accounting
Q. 16.1
Q. 16.2
Q. 16.3
Q. 16.4
Q. 16.5
Q. 16.6
Q. 16.7
Q. 16.8
Q. 16.9
Q. 16.10
Q. 16.11
Q. 16.12
E/I
NI/TE
NOI/TA
E/S
S/I
| 313
$1,000
$ 100
$ 900
Income Statement
Sales
Operating expenses
$ 1,850
Interest
10
Taxes
56
Total expenses
Net income
Required:
$2,000
$1,916
$ 84
1.
Compute ROIa
2.
Compute ROIe
3.
What effect does the amount of debt relative to equity have on return on
investment (equity)?
4.
What effect does the amount of debt relative to equity have on return on
investment (assets)?
Management Accounting
Net income
$62,000
Required
Based on the above information compute the following
1. Return on investment-assets ______________________________________
2. Return on investment-equity _ _____________________________________
3. Assuming return on investment-assets: ______________________________
| 315
$1,000
$ 900
$ 100
Sales
Operating expenses
$1,850
Interest
90
__$_____
$2,000
Total expenses
Net income
_$1,940
_
_____
$
60
__
_______
_____
Required:
1. Compute ROIa
2. Computer ROIe
3. What effect does the amount of debt relative to equity have on return on investment
(equity)?
What condition is necessary in order for the principle of leverage to increase the
rate of return.
4. What effect does the amount of debt relative to equity have on return on investment
(assets)?
Management Accounting
$ 100
900
_ _____
$1,000
______
______
$2,000
Required:
1. Based on the information presentation in Case I, compute the following:
2. Assume that long term liabilities originally were $900 and that common stock was
$100.
Based on these changes, compute the following:
__________
__________
__________
__________
__________
__________
__________
__________
Observations:______________________________________________________
_____________________________________________________________________
| 317
100
900
_$______
1,000
__$______
______
$2,000
1,200
700
_______
1,900
_ ______
100
10
_______
$ 90
_______
_______
_________
_________
_________
_________
________
________
________
________
Management Accounting
| 319
Nature of Mismanagement
Production
Inadequate capacity
Poor quality of material
Marketing
Inadequate credit
Excessive prices
Inadequate advertising
Production
Unused plant capacity
Unused plant capacity
Excess inventory
Finance
Funds shortage
Finance
Excessive debt
Finance
Finance
Marketing
Production
-
-
-
-
decreased ROI
poor credit
loss of sales
inadequate inventory;
The survival of the business in the long run requires a balanced and coordinated
effort in all business functions. Broadly speaking, it is managements task to manage
the capital of the business; that is, the resources, (assets) and the sources of assets
(debt and equity capital). In general, there are five broad areas as indicated by
financial statements that must be managed: assets, liabilities, capital, revenue, and
expense.
What are the financial statement tools that are available to discover broad areas of
mismanagement that need corrective action? The major tools as typically presented
in books on financial statement analysis are:
1. Ratios analysis
2. Trend analysis
3. Common size statements
In this chapter, we are primarily concerned with ratio analysis. The ratios that
have been recognized to be of value or are following:
Income Statement Ratios
Operating ratio
Management Accounting
ASSETS
Current assets
Fixed assets
Current ratio
Quick ratio
Inventory turnover
LIABILITIES
Current liabilities
Current ratio
Debt/equity ratio
CAPITAL
Contributed capital
Net income
| 321
Management Accounting
in chapter 2. Accounts receivable are created by the use of credit terms and inventory
levels are largely determined by order size and safety stock decisions.
In most cases, the most important short term debt is accounts payable. The
amount of accounts payable is generally determined by the credit terms that supplier
offer. If a company, for example, purchases $1,200,000 in raw materials each year
and the creditor offers 30 days to pay, then the on the average we would expect
accounts payable to be $100,000.
A business that has a considerably higher current ratio than another company
is not necessarily in a better financial condition. To illustrate, let us assume the
following:
Company A Company B
Current Assets
Cash
$ 1,000
$20,000
Accounts receivable
$ 9,000
$15,000
Merchandise inventory
$30,000
$ 5,000
Total
$40,000
$40,000
Current Liabilities
Accounts payable
$15,000
$ 5,000
Notes payable
$ 5,000
$25,000
$20,000
$30,000
Current ratio
2
1.33
Company A with the better current ratio is not superior to company B regarding
its ability to pay short term debt. For this reason, the quick ratio (cash + receivables /
current liabilities) is often regarded as a better measure to pay short term debt. In the
above example, the quick ratios are;
Company A Company B
Quick ratio
.5
1.1667
Debt/Equity Ratio - The debt/equity ratios is:
D/E ratio =
Total debt
Total equity
| 323
Management Accounting
is important. One of the tools that is commonly used is the inventory turnover ratio
which may be defined as follows:
Cost of goods sold
Inventory turnover =
Average inventory
This ratio may be applied to either finished goods or raw materials.
As discussed in chapter 11, it is important to understand that cost of goods sold
is simply in the current period is the cost of finished goods sold. If the cost of one
unit of finished goods is $30.00 and 1,000 units are sold, then cost of goods sold is
$30,000, assuming no beginning inventory. This fixed relationship between inventory
and costs of goods sold makes possible for a meaningful inventory turnover ratio
to be computed. Assume for the moment that cost of goods sold was $360,000
and that average inventory is $30,000. Consequently, the inventory ratio is 12
($360,000/30,000). What does this turnover number mean?
First of all, if the company was open for business during the year for 360 days,
then this means that on the average sales at cost were $1,000 or $30,000 per month.
A turnover of 12 means it takes 30 days (one month) to sell $30,000 of finished
goods. A turnover ratio expressed in calendar days is easier to understand.
The following schedule shows the calendar days associated with different
inventory rates:
Inventory Turnover
Calendar Days
1
2
4
6
9
12
360
180
90
60
40
30
One of the important questions is: what is the ideal turnover rate? In general, it
is believed the higher the turnover rate the better has been the control of inventory
by management. A rapid turnover of inventory is thought to be generally desirable.
However, a higher turnover rate is not always desirable. Inventory levels are primarily
determined by order size and the amount of safety stock. In terms of the affect on
profit, it might be better to have a lower turnover rate.
To illustrate, assume that the K. L. Widget Company may, if it chooses to do so,
purchase material as a discount if it purchases in larger quantities:
Order Size
Price
1 - 10,000
$10.00
10,001 +
$ 6.00
For the moment, let us assume that material is the only cost and that 1 unit of
finished goods requires only 1 unit of material. Price of the product is $20 per unit
and the company produces and sells 20,000 units at this price.
Based on this information, we can prepare the following revenue and cost
comparisons:
| 325
$400,000
$200,000
$200,000
$ 20,000
10
$400,000
$120,000
$280,000
$ 30,000
4
We see in this example that a lower turnover is far more profitable. However,
unless the additional carrying cost caused by the higher levels of inventory offsets
any advantage, the best decision is to take advantage of the quantity discount, even
though doing so lowers the inventory turnover.
Accounts Receivable TurnoverAccounts receivable are generally considered a fairly liquid asset. They rank
number two behind cash which is obviously the most liquid of assets. However, if
accounts receivable are not paid on a timely basis or not collected at all, then they
can easily become an expense. Poor management of accounts receivable can quickly
become a signal that management is doing a poor job of running the business. It is
commonly believed that the accounts receivable turnover ratio is an indicator of how
well accounts receivable are being managed. The accounts receivable turnover ratio
is:
Credit sales
Accounts receivable turnover =
Average accounts receivable
The general belief is that this ratio measures the number of times that accounts
receivable are collected in a years times. However, this point of view is a bit difficult
to grasp. In fact, the collection of receivables is an ongoing process. In order to make
this ratio more understandable most writers then discuss how this turnover ratio can
be used to compute how long it would take to collect the accounts receivables in
days.
This procedure is based on this equation:
365
Number of days in A/R =
Accounts receivable turnover
To Illustrate:
Assume that the average balance of accounts receivable was $100,000 and that
annual credit sales were reported as $1,200,000. The turnover ratio is therefore:
A/RTO =
$1,200,000
100,000
= 12
Management Accounting
The author, however, prefers another point of view regarding the meaning of this
ratio. The turnover ratio is an indicator of the credit terms the company is offering.
If credit terms are three months, then one would expect from the time the sale is
made to the time of payment that the amount due would be paid in full when 90
days have passed. A accounts receivable turnover of 12 should imply credit terms
of 1 month. As just demonstrated, it is fairly easy to convert the turnover to days.
The following schedule shows what credit terms may be associated with different
accounts receivable turnover ratios:
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Company B
(Installment Credit)
Credit
Terms
A/R TO
(months)
Maximum
A/R
Balance
$10,800
4.00
$21,600
12
Days
Credit
Terms
A/R TO
Days
(months)
Maximum
A/R
Balance
90
$ 9,000
2.00
180
$12,600
3.42
105
$32,400
1.23
270
$18,000
2.40
150
$43,200
1.00
360
12
$23,400
1.846
195
4.8
75
In this example, the use of installment credit increases the accounts receivable
turnover. In other words, the average balance is less and the balance is collected on
the average sooner. This is true even though monthly sales are the same and the
length of time to pay the full amount of purchase is the same.
The question is whether the traditional interpretation of the accounts receivable
turnover ratio is valid concerning installment credit. In the above example, company
Bs accounts receivable turnover was 4.8 indicating a turnover every 2.5 months (75
days). However, in fact, the full length of time to collect a sale is 3 months. Since
payments are being made each month, the average balance of accounts receivable
will be lower than under standard credit terms. In addition, the above example did
not take into account an interest charge that is usually added to the account balance
each month on the unpaid balance. In this event, the addition of interest would cause
the principal payments to be smaller in the early payments and greater with the latter
payments.
The value of measuring accounts receivable turnover is not in examining just
the ratio of one operating period, but in comparing the current turnover ratio to prior
ratios. If the ratio is getting smaller, this may mean that the customers are not making
regular payments or are skipping some payments.
Other Ratios
In a corporation, one of the objectives of management is to increase the value
of the stockholders stock. Two ratios are commonly used to provide a gauge of
performance regarding common stock:
1. Price earnings ratio
2. Earnings per share
The price earnings ratio is:
Market value of stock
Price earnings ratio =
Net income per share
Management Accounting
Q.17-1
Q. 17-2
Q. 17-3
Q 17-4
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Q. 17-5
Q. 17-6
If a company has a current ratio of less than one, what kinds of problems
are suggested by this extremely low ratio:
Q. 17-7
Q. 17-8
Q. 17-9
Q. 17-10
Q. 17-11
Q.17-12
Total expenses
Net operating income
Other Income:
Gain on sale of equipment
Net income
Note: All sales were made on credit.
$131,000
$ 19,000
10,000
$29,000
Management Accounting
K. L. Widget Company
Balance Sheet
Assets
Current
Cash
Accounts receivable
Finished goods
Materials inventory
Total current assets
Plant and Equipment
Plant and equipment
Allowance for deprecation
Total plant and equipment
Total assets
Liabilities
Current
Accounts payable
Notes payable
Taxes payable
Total current
Long term:
Bonds payable
Total Liabilities
$ 95,000
60,000
25,000
110,000
$290,000
$ 78,000
82,000
50,000
80,000
$290,000
$100,000
20.000
$80,000
$370,000
95,000
18.000
$ 77,000
$367,000
$150,000
20,000
8,000
$ 78,000
$ 60,000
30,000
13,000
$103,000
$150,000
$250,000
$ 90,000
$190,000
Stockholders Equity
Common stock
$100,000
$120,000
Retained earnings
12,000
44,000
$112,000
$164,000
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Debt/equity ratio
Accounts receivable turnover
Finished goods inventory turnover
Earnings per share
Price earnings ratio
Exercise 17.2
As one of the accountants for the K. L. Widget Company, you have you been
provided the following comparative financial statements. You have been asked to
computer various ratios based on these statements.
K. L. Widget Company
Income Statement
For the Year Ended, December 31, 2008
Sales
Expenses
Cost of goods sold
$90,000
Operating expenses
35,000
Interest
13,000
Income tax
15,000
$200,000
Total expenses
$153,000
$ 47,000
8,000
$39,000
K. L. Widget Company
Balance Sheet
Assets
Current
Cash
Accounts receivable
Finished goods
Materials inventory
Total current assets
Plant and Equipment
Plant and equipment
Allowance for deprecation
$100,000
80,000
51,000
90,000
$321,000
$ 82,000
92,000
40,000
100,000
$314,000
$150,000
30.000
125,000
25,000
Management Accounting
$150,000
$464,000
$100,000
50,000
13,000
$163,000
$100,000
$263,000
$90,000
11,000
$101,000
$464,000
Based on the above financial statements, compute the following ratios for the year
2008:
1. Profit margin percentage
2. Operating ratio
3. Return on investment (assets)
4. Current ratio
5. Debt/equity ratio
6. Accounts receivable turnover
7. Finished goods inventory turnover
8. Earnings per share
9. Price earnings ratio
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Based on these statements identify the various problems the company has
experienced by computing various ratios.
Ace Manufacturing Company
Balance Sheets
Dec. 31, 2007 Dec. 31, 2008
Assets
Cash
$30,000
$ 15,000
Accounts receivable
100,000
120,000
Merchandise inventory
40,000
100,000
Store building
500,000
500,000
Accumulated depreciation
(20,000)
(40,000)
Furniture and Fixtures
100,000
100,000
Accumulated depreciation
(5,000)
(10,000)
________
________
Total assets
$745,000
$785,000
________
________
Liabilities
Accounts payable
$80,000
$150,000
Notes payable (6 month note)
50,000
75,000
Bonds payable
200,000
200,000
Note payable (10 year note)
150,000
250,000
________
________
Accrued taxes payable
Total liabilities
480,000
675,000
________
________
Stockholders Equity
Common stock
300,000
300,000
Retained earnings
(35,000)
(190,000)
________
________
Total liabilities & Equity
265,000
110,000
________
________
$745,000
$785,000
________
________
Ace Manufacturing Company
Income Statements
Sales
Cost of goods sold
2007
$1,001,000
400,000
2008
$ 900,000
390,000
Management Accounting
Gross margin
Operating expenses
Selling expenses
General and administrative
Net operating income/(loss)
Income tax expense
Interest
Net income/(loss)
$601,000
$ 510,000
450,000
200,000
$650,000
($49,000)
-0-
$38,000
($77,000)
300,000
315,000
$ 615,000
($105,000)
-0$50,000
($155,000)
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Management Accounting
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Credit
Sales
Sale of property
Receipt of dividends
Issue of stock
Issue of bonds
Issue of stock
Receipt of interest income
Purchases
Operating Expenses
Purchase of materials
Purchase of property
Payment of dividends
Payment of expenses
Purchase of investments
Purchase of treasury stock
Retirement of bonds
Purchase of treasury stock
Payment of interest
The technical aspects of preparing a statement of cash flow can be quite complex
and initially rather intimidating. A variety of methods and work sheet techniques can
be found that suggest how to prepare the cash flow statement. The purpose here
is not to make you an expert in preparing the statement, but rather the purpose is to
help the you as a student understand the issues and problems involved in preparing
the statement. There are two methods used to prepare the statement. Depending on
which method is used, the appearance of the statement can be quite different. These
two methods are commonly called the:
a. Direct method
b. Indirect method.
Interest expense
Issue of stock
Decrease in cash
Uses:
Sources:
Payment of dividends
Uses:
Sale of bonds
Sources:
Uses:
Sources:
25,000
32,000
5,000
20,000
10,000
$20,000
8,000
24,000
165,000
($69,000)
$78,000
-
95,000
($17,000)
$ 7,000
$45,000
Add:
10,000
22,000
Decrease in cash
Uses:
Sources:
Sale of bonds
Sources:
25,000
25,000
$32,000
5,000
20,000
10,000
$20,000
90,000
25,000
Deduct:
$30,000
Depreciation
Net income:
$128,000
(Indirect Method)
(Direct Method)
Figure 18.1
$78,000
-
95,000
-
$ 7,000
($17,000)
$45,000
($111,000)
($69,000)
$42,000
Management Accounting
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Accounts receivable
of $100,000 is
$20,000
$80,000
a period be:
1.
current production.
Assume no sales
were made.
Not used
amount only
material. Of this
Cash $60,000
$60,000 of raw
$48,000
Finished goods
purchased
$12,000
Materials inventory
2. The company
was collected.
amount on 80%
recorded. Of this
Cash
Sales $100,000
Transactions
Figure 18.2
Sales $80,000
$80,000
Cash $60,000
Cash
Cash sales
Sales
Deduct Increase in FG
Deduct: Increase in FG
Cash flow-oper. Activities
Net income
Deduct: increase in Mat
Indirect Method:
Direct Method:
Net income
Indirect Method:
Direct Method:
to cash basis)
($60,000)
$48,000
$12,000
($60,000)
$48,000
$12,000
$80,000
$ 20,000
$ 100,000
$ 80,000
20,000
$ 100,000
Management Accounting
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$60,000 in
materials. Only
Finished goods
$60,000 in
materials. Only
in cash. Of the
sold.
in production.
$60,000
48,000
Cash $45,000
purchased
$36,000
Materials inventory
60,000 only
$60,000
4. The company
production.
purchased
Cash $45,000
Materials inventory
3 The company
Cash $45,000
Cash $45,000
$15.000
$60,000
$48,000
$12,000
($45,000)
$24,000
$15,000
($36,000)
($45,000)
$24,000
$15,000
($36,000)
$15,000
($45,000)
($60,000)
Add: increase inA/P
$48,000
Deduct: Increase in FG
$12,000
Net income
Deduct: increase in Mat
Deduct Increase in FG
Direct Method:
Net loss
Indirect method:
Direct method:
equipment which
of $12,000 was
$10,000
$12,000
Gain on sale
$ 2,000
Cash
6. Plant and
recorded
of $10,000 was
in the amount
Operating expenses
5. Depreciation
No entry
$12,000
Cash
Less: depreciation
Operating expenses
Other income
Deduct: gain on sale
methods.
$2,000
$2,000
$2,000
$2,000
Net income
Indirect Method:
Direct Method
($10,000)
Deduct depreciation
($10,000)
( $10,000)
($ 10,000)
Net loss
Indirect method:
Direct method:
Management Accounting
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Management Accounting
5. Under the direct method, the operating expense category needs to be adjusted
since it contains charges for depreciation under accrual basis accounting.
The adjustment is simply to deduct the amount of depreciation from the
amount total operating expenses. Since we are assuming the depreciation is the only transaction for the period, operating expenses would be
$10,000. After the adjustment, it would be zero.
Under the indirect method, net income would actually be a loss of $10,000.
Adding back depreciation to the net loss then the cash flow for the period
is zero.
6. In this investing transaction the amount of cash inflowing is $12,000 and is
required to be shown as a source of funds in the Cash Flow from Investing
Activities and not the operating activities section. Since the gain on loss
appears as part of net income, the gain needs to be deducted in both the
direct method and the indirect method as illustrated. The gain is actually
reflected in the $12,000 sales price. Of the $12,000, $10,000 is actually a
recovery of the cost of the old asset and $2,000 is a gain. To not deduct the
gain in the operating activities section would be tantamount to showing the
gain twice.
Indirect Method for computing Cash Flow from Operations
The indirect method is the generally used method to prepare the cash flow
statement. The starting value in this method is net income. While net income could
be the correct measure of the increase in cash flow from operating activities, this is
highly unlikely for the following reason: Accrual basis accounting requires that many
types of revenues and expenses to be recorded, even though no cash has yet been
received or paid. Accrual based entries affect the following accounts:
Depreciation
Materials inventory
Accounts receivable
Accrued wages payable
Accounts payable
Accrued interest payable
Prepaid expenses
Accrued interest receivable
Figure 18.3 identifies the net income adjustments required when various accrued
items increase or decrease.
Classification of Transactions:
The FASB chose to place all transactions that affect cash into three categories,
as previously mentioned. While for the most part the classification scheme is logical,
there are several areas of difficulty. Interest paid on debt is clearly a type of financing
activity; however, interest paid is shown as an operating activity. The reason is that
interest paid is an expense and directly affects net income. Obviously, the expense
can not be shown in two different categories. Consequently, the Board chose to let the
item remain an operating activity. Also, it appears at first rather strange that dividend
income is treated as an operating activity item while dividends paid is a financing
activity item. Figure 18.4 shows how various transactions are categorized:
| 345
Add to Net
Income
+
+
+
+
Figure 18.4
Operating transactions
Revenue from sales
Operating expenses
Dividend income
Interest expense
Financing transactions
Issue of stock
Issue of bonds
Bank loans
Purchase of treasury stock
Retirement of bonds
Payment of dividends
Investing transactions
Purchase of stock in other companies
Purchase of bonds
Purchase of plant and equipment
Sale of plant and equipment
Deduct from
Net Income
+
+
+
+
Management Accounting
The first step is have the a copy of income statement and a comparative balance sheet at hand. If a work sheet approach is desired, then
the comparative balance sheet data should be copied onto a work sheet
having at least 6 columns. The first two columns should contain the balance sheet data.
Step 2
The difference in the first two columns should be determined and copied
into the third column. It is these differences that are used to make the
necessary adjustments to net income or income statement items.
Step 3
Regarding the plant and equipment account, the examination of the account itself and other sources, the major transactions affecting this account should be identified. The difference between the 2008 plant and
equipment amount and the 2007 plant and equipment amount may be
a $5,000 decrease. However, this difference does not reveal the cause
of the decrease. Similarly, the retained earnings account should be examined for entries other than net income such as dividends paid or other
special transaction credited or debited to this account.
Step 4
Given the changes in balance sheet items and a list of important events
not directly revealed on the balance sheet, the statement of cash flow
may be prepared. A complete work sheet is not necessary but many
might find it helpful. However, since this chapter is primarily concerned
with understanding the statement rather than preparing the statement,
preparing the statement of cash flow from a total work sheet approach
will not be illustrated. Those students who understand the nature and
purpose of adjustments to net income should not have any difficulty in
preparing the cash flow statement without a total work sheet.
| 347
2007
Use/
Source
Class
Difference
Assets
Current
Cash
80,000
95,000
-15,000
Accounts receivable
82,000
60,000
+22,000
Operating
Finished goods
50,000
25,000
+25,000
Operating
Materials inventory
80,000
110,000
-30,000
Operating
95,000
100,000
-5,000
Investing
367,000
370,000
60,000
150,000
-90,000
Operating
Fixed Assets
Total assets
Liabilities
Current:
Accounts payable
Management Accounting
Notes payable
30,000
20,000
+10,000
Financing
+20,000
Financing.
Long term
Bonds payable
100,000
80,000
Total liabilities
190,000
250,000
120,000
100,000
+20,000
Financing.
52,000
20,000
+32,000
S/U
Operating/
Financing
177,000
120,000
367,000
370,000
Stockholders Equity
Common stock
Retained earnings
Total equity
Note: In this example, net income was $42,000 for the year 2008. Cash dividend paid was $5,000.
Q. 18.1
What basic information does the statement of cash flow provide that is
not found on a balance sheet or income statement?
Q. 18.2.
What are the activity categories that the statement of cash flow uses to
classify cash events?
Q. 18.3
What two methods are used to determine cash flow from operating
activities?
Q. 18.4
Q. 18.5
Q. 18.6
Q. 18.7
Q. 18.8
Q. 18.9
Q. 18.10
Q. 18.11
Q. 18.12
Q. 18.13
Equipment which has a book value of $50,000 is sold for $55,000. How
| 349
Q.18.14
When all the transactions and events that affect cash flow have been
accounted for, what on the latest balance sheet serves as a check
figure?
Cash Flow
from
Operating
Activities
Cash Flow
from Investing
Activities
Management Accounting
Exercise 18.2 Determining net cash Flow from Operating Activities (indirect
method)
For the following item current asset current liabilities changes indicate by
( 4 ) whether the item should be deducted or added to net income.
Changes in Current Assets
Item
Add
Deduct
Add
Deduct
Item
| 351
2007
$ 69,000
$ 12,500
21,000
26,000
Change
Assets
Cash
Accounts receivable
Prepaid expenses
4,100
2,600
Materials inventory
33,400
36,400
Finished goods
10,000
12,000
75,000
60,000
(9,000)
( 5,000)
Total assets
$183,500
$144,500
$ 13,000
$ 14,000
1,200
1,800
47,000
35,000
115,000
90,000
27,300
3,700
$183,500
$144,500
Liabilities
Accounts payable
Stockholders Equity
Common Stock
Retained earnings
Management Accounting
Change
Assets
Cash
$72,400
$23,200
28,000
26,000
Prepaid expenses
2,000
2,600
Materials inventory
40,000
36,000
Finished goods
15,000
12,000
100,000
80,000
(15,000)
(10,000)
$242,400
$169,800
$15,000
$8,000
2,400
1,800
50,000
35,000
145,000
115,000
30,000
10,000
$242,400
$169,800
Accounts receivable
Total assets
Liabilities
Accounts payable
Income taxes payable
Notes payable (long term)
Stockholders Equity
Common Stock
Retained earnings
Total Liabilities and Stockholders
Required:
Prepare a statement of cash flow using the indirect method.
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