SOS Session: BU247 Midterm

BU247 Managerial Accounting with Natasha Neumann-Causi and Mike Pegutter

Updated PresentationThis presentation is up to dateUses material from new textbook

Contains examples from prior exams and from textbook questions

If I miss something, let me know and I will explain it now or in an email General Study TipsDON’T PANIC! USE YOUR HANDOUT!Know the theory well, do not memorize calculations!Practice homework with time constraintsIf you get stuck on a question, leave it and come back laterWhen in doubt, GUESS! Never leave a question blankMake sure you have answered everythingthe question asked for!!!

Exam OutlineMultiple Choice QuestionsDefinitionsSmaller calculations TheoriesJournal EntriesTrue / False or Fill in the BlankTheories and Definitions Short AnswersBig Calculations Writing out Steps to Calculations

AgendaPART I: Introduction and CVP AnalysisWhat is management accounting?

Cost-Volume-Profit AnalysisPART II: Cost BehaviourVariations in cost behaviours

Income Statement approachesPART III: Cost AllocationOverhead Rate Calculation

Applying OverheadPART IV: System Design and AllocationJob Order vs. Process

Service Departments PART V: ABC Costing

Managerial AccountingFor management purposes onlyCost allocations and calculationsBudgeting and future planning Production decisionsProduct decisionsAlways keep in mind:Benefit versus cost tradeoffWill the systems aid management?

Framework of Cost AccountingStrategic Planning – focus on company objectivesFactory locationMergers & acquisitionsManagement Control – focus on resource efficiencyBudget analysisVariance analysisOperational Control – task efficiencyInventory controlCash management

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

Decisions & InformationDecision ProcessAccounting Information TypesIdentify the problemUnderstand the Key Success Factors of the companyIdentify alternative solutions Quantitative and qualitative analyses Evaluation solutions and chose oneImplementation of the plan Problem Solving Information– used for long-range planning Attention Directing Information– used for controlling routine operations Scorekeeping Information– used by investors, tax collectors, etc.

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

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

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

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

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

Relevant RangeRelevant rangeand Step Variable Costs are ranges where your per unit variable costs and your fixed costs will stay constantOutside of this range these costs will change As long as Brick Brewery is making between 30,000 and 75,000 cases of beer, it costs $3.00 a beer to produce and fixed costs are $1.5M a month. 3075

Cost – Volume – Profit AnalysisTotal SalesTotal CostsBreakeven PointFixed Costs

Breakeven AnalysisCalculating how many units need to be sold before you can start making some profitsEquation Approach:Contribution Margin Method:

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

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

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

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

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

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

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

Cost Structure and Operating LeverageSalesSales$$TotalExpensesTotalExpensesVolumeVolumeHigh Operating LeverageHigh Fixed / Low Variable CostsHigher CM/UnitHigher Break-even PointGreater RiskGreater Potential ReturnsLow Operating LeverageLow Fixed / High Variable CostsLower CM/UnitLower Break-even PointReduced RiskLower Potential Returns

COST BEHAVIOUR AND COST SYSTEMSPart II

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

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

Activity Analysis MethodsEngineering Analysis– review of costs from past experiences

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

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

Scattergraph Analysis– line of fit method on a graph; where the intercept is the total fixed costs and every point on the line is an estimated total level of activity (X) and total costs (Y)- this method heavily uses the mixed cost functionRegression Analysis– a process of finding the equation that best fits the dataActivity analysesare used to identify appropriate cost drivers for each individual activity and their effects on the costs of making a product Measuring Cost Behaviour

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

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

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

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

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

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

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

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

Segmented Income StatementsSegment margin is the best gage of the long-run profitability of a segmentTraceable costs of one segment may be common costs to anotherNot in Handout

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

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

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

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

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

Underapplied / OverappliedSince the POHR contains estimates, the manufacturing overhead that we actually incur and the amount applied to Work in Process using the POHR will differ 99% of the timeUnderapplied overhead- overhead applied to jobs is less than the total amount of overhead actually incurredthis will result in a remaining debit balance in the manufacturing overhead accountOverapplied overhead- overhead applied to jobs is greater than the total amount of overhead actually incurredthis will result in a remaining credit balance in the manufacturing overhead accountThe difference between applied overhead and actual overhead can be dealt with in three ways:Close directly to Cost of Goods Sold ExpenseAllocate proportionately between WIP, Finished Goods, and COGS Expensebased on their relative dollar valueCarry the balance in manufacturing overhead over to the next year

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

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

Professional EthicsHow will understating the estimated direct labour hours in the base for the POHR affect operating income?Remember: Artificially high overhead rate

Overapplied overhead  debit balance in manufacturing overhead account

This will reduce COGS when the account is closed

This will result in higher net incomeNot in Handout

SYSTEM DESIGN AND ALLOCATIONPart IV

Product Costing SystemsProcess Costing– the company mass produces one homogenous productCosts are accumulated by departments and thus calculates unit costs by department as wellProduction is uniform on all units Job – Order Costing System– the company builds to order a range of unique productsDirect materials and labour will be allocated to each job as they are incurredIndirect costs (like overhead) will accumulate over time and then be allocated

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

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

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

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

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

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

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

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

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

Activity-Based CostingA non-traditional way of allocating costsABC costing is more careful about which costs are considered; only costs that are affected by product-related decisions are usednot all manufacturing costs, some non-manufacturing costsABC costing has the highest number of cost pools and overhead application ratesPOHR applies to the entire factory and all its departmentsProcess costing uses different overhead rates for departmentsABC costing has as many rates as there are activities The ABC costing method has the ability to segregate costs associated with unused capacity

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

Implementation of ABCIdentify and define activitiesThere is no ‘right’ or ‘wrong’, there is ‘accurate’ and ‘less accurate’Assign overhead costs to activity cost poolsOnly overhead, no direct or indirectCalculate activity ratesUsing total activity estimates for each activityAssign overhead costs to cost objectsCommon cost objects: products, orders, customers Prepare management reports

Management ReportsProduct Margin CalculationThese costs are assigned using other cost systemsCalculated using the ABC Costing process This company is losing money every time it makes Product BWith this we can make big decisions such as whether we should consider cutting out Product BProduct A did not do any product design

Management ReportsCustomer Profitability AnalysisCalculated using the ABC Costing process (Stage 4)Notice that we now add customer relations costsHere we can make decisions such as whether or not it is worth keeping this customer

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

Cons of ABC CostingABC costing is not typically used for external reporting becauseDon’t need all the detailCost too muchto start using ABC CostingGAAP standards don’t like ABCThere is a lot of subjectivityABC costing has its own limitations tooIt costs a lot of moneyResistance from the employeeswhen new systems are put in placeMisinterpretation of the resultsMany companies like to allocate all their costs to the productsrather than to customers and ordersEveryone needs to conform to GAAP

SOS Session: BU247 Midterm

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