Top Ten Key Ideas from Managerial Accounting Suneel Udpa 1.

Most firms use internal accounting systems (that are primarily geared for external reporting purposes) for external financial reporting purposes (GAAP) as well as internal managerial decision-making, performance evaluation and control. This often leads to dysfunctional decision-making. For instance, average costs are fine for financial reporting purposes but can be misleading if used for decision-making (Medical Instruments example first class) The solution to problem (1) is not necessarily to have multiple systems (one for each function). This can be exorbitantly expensive and confusing. The key is to realize that you need different costs for different purposes. Most accounting software packages afford enough flexibility to reclassify, recombine and reorganize data for multiple purposes. For example, in the Siemens case, the company reclassified just 9% of the total costs to arrive at better cost numbers for pricing purposes. This change was critical to their survival in the new marketplace. In many instances, marketing, production, and planning departments can undertake this analysis independent of the accounting department. 2. Two Important cost terms: Product costs vs. Period costs Product costs are costs that are part of the product and go wherever the product goes. So, if the product is in WIPa/c, then the product cost is in WIPa/c as well. Under GAAP, all manufacturing costs are product costs. Period costs are not part of the product and are expensed in the period incurred. Under GAAP, all non-manufacturing costs are period costs. Classification of costs into product and period costs can have implications on the firm's net income and divisional income, and hence managerial behavior and decision making (Old Whiskey Mash example) Direct costs vs. Indirect costs (or Manufacturing overhead). Direct costs are those costs that can be conveniently and easily assigned to the product. Manufacturing overhead are those costs that cannot be easily assigned and have to be therefore allocated. Most innovations in cost systems deal with the allocation of overhead costs 3. Under Absorption Costing, all manufacturing costs (including fixed manufacturing overhead) are treated as product costs. This creates an incentive for managers to overproduce since they can defer some of the fixed manufacturing overhead into ending inventory. Also, under absorption costing, managers are inclined to include fixed costs into decision making. The solution is to use variable costing where fixed manufacturing overhead is treated as period costs and expensed in the period incurred. GAAP requires absorption costing and this is just another instance where financial accounting systems fail managers.

4. Cost allocation (of common, corporate and service department costs) is one of the most common phenomena observed in firms. Economists are right arbitrary allocation of costs hurt rather than help managerial decision-making (E.g., Blue pens, red pens case). However, cost allocation done in a manner that closely reflects economic reality can be value-enhancing. For instance, breaking the costs into fixed and variable components and allocating fixed costs using the capacity requested and variable costs using usage (measured in terms of opportunity costs) e.g., Biolabs problem. 5. There is no doubt that old cost systems that assign all manufacturing overhead to units using volume-based cost drivers (such as direct labor hours) lead to inaccurate costs. This can have a huge impact on firms that have large amounts of manufacturing overhead, carry a diverse product line, and face a competitive marketplace. The solution is to analyze the activities (hence called activity-based costing) that cause manufacturing overhead and use appropriate unit-level, batchlevel, product-level, and customer-level cost drivers. Again, Siemens is a good example of how appropriately allocating just 9% of the total costs lead to significantly more accurate costs. 6. For most service companies, customer-level economics is more important than product-level economics. For instance, two different customer segments can use the same product (say, a checking account) differently leading to different levels of resource usage for the firm. Therefore, for service firms allocation of costs (and hence determination of profitability) by customer segments (and, you can get quite creative here by using a firms existing CRM software) can lead to insightful results. 7. Decision-making should be based on opportunity costs, which may differ from historical costs obtained from the accounting system. In decision-making the goal should be to obtain realistic (unbiased and objective) not optimistic or conservative estimates of cash flows. a) Simple CVP analysis can provide a quick check on whether the idea is viable. CVP analysis or Break-even analysis is a simple model needing limited assumptions and far less data than NPV analysis. It states that the Breakeven Quantity is Fixed Costs divided by Contribution Margin per unit. Break-even in Sales Dollars is equal to Fixed Costs divided by Contribution Margin Ratio (CM per dollar of sales) Break-even in Sales Dollars is useful when the company has mulitple product lines. There are several limittions of CVP analysis: it is a linear model, it is one-period model, and it cannot provide the optinal sales mix when there are mulitple products. In spite of its limitations, CVP analysis can be used to conduct sensitivity analysis and assess the risk of the business (think the web.van example) - all using the least amount of information.

b) In capital budgeting, one can use various techniques, including Net Present Value analysis, Internal Rate of Return, Pay-back Period and Accounting Rate of Return. It is important to note that Depreciation is not a cash outflow. But, Depreciation is a tax-deductible expense. Taxes play a important role in capital budgeting typically, one quarter of the initial investment is recovered in the form of depreciation tax shields. Post-audit of capital budgeting projects yield useful insights for future projects but is rarely done by firms. Sensitivity analysis can be useful, particularly, if you can devise alternatives to reduce risk and hence the discount rate for e.g., by entering into forward contracts to reduce the volatility of the revenue stream. 8. Budgeting, another pervasive accounting phenomena, serves several purposes planning, performance evaluation, assignment of decision rights, and communication of information within the firm. There is a trade-off involved n using budgeting for these various purposes. For instance, using budgets as performance targets dilutes the effectiveness of budgets as a communication tool (e.g., biased budgets at Pfizer) 9. Although ROI is a widely used measure, it has several drawbacks when used as a performance measure. Residual Income (RI) (commercialized as EVA, Economic Profit etc) is an effective alternative. RI possesses a useful quality: NPV of the cash flows of a project = PV of its RI. Thus, if RI is correctly used in incentive contracts it can encourage managers to accept positive NPV projects (with ROI, managers may have incentives to reject positive NPV projects) 10. Incentive contracts should be structured to address typical principal-agent problems including goal incongruence, free-rider behavior, and differences in risk preferences and decision-horizons between the principal and the agent. Some pointers on incentive contracts: a) The relationship between the performance measure and bonus should be linear, one that rewards actual performance independent of budget targets no caps, no floors, no kinks. This eliminates incentives for managers to game the budgeting process and the incentive plan. b) Keep the incentive plan simple. If the incentive plan is complex or there are too many performance measures, managers will choose to focus on a few of these measures. The choice made by the managers may not be optimal from the firms point of view. c) The use of bonus banks in incentive contracts is an effective tool. Bonus bank is simply a mechanism whereby the manager can only cash out a percentage of the bonus earned in a particular period with the balance banked forward and paid out contingent on continued successful performance. Bonus bank is to managers what retained earnings is to shareholders. Ideally, you should expose the managers to the same forces

that the firm is exposed to. Bonus banks provide the necessary cushion to risk-averse managers since managers can earn a bonus even in a bad year, if there is a carried forward balance in the bonus bank. Finally, bonus banks motivates the manager to take a longer view. d) It is best to have bonus linked to changes in performance measures rather than absolute values. This helps reduce the impact of legacy factors and assumptions made in the calculation of performance measures. Finally, if none of the above 10 Key points work, call 1-800-UDPA