The Nature of Management Accounting

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The Nature of Management Accounting
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Management vs. Financial Accounting (1 of 6)

• Necessity
• Financial Accounting (FA) SEC (or banks or
  suppliers) requires publicly traded companies to
  publish financial statements according to GAAP.
• Management accounting (MA) is optional.
• Purpose.
• FA Produce financial statements for outside
  users.
• MA Help managers plan, implement and control.

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Management vs. Financial Accounting (2 of 6)

• Users.
• FA faceless group, external users, present or
  potential shareholders.
• MA Known managers who influence what information
  is needed.
• Underlying structure.
• FA built around Assets Liabilities
  Stockholders Equity.
• MA 3 purposes each with its own set of concepts
  and constructs (addressed later).

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Management vs. Financial Accounting (3 of 6)

• Source of principles.
• FA GAAP.
• MA whatever managers believe is useful.
• Time orientation.
• FA historical, tell it like it was.
• MA future/decision oriented, tell it like it
  will be. (However, the past is often a good
  predictor of the future.)

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Management vs. Financial Accounting (4 of 6)

• Information content.
• FA financial statements are the end product and
  include primarily financial info.
• MA non-monetary as well as monetary info.
• Information precision.
• FA Uses approximations but as a generalization
  is more precise than MA.
• MA Management needs info rapidly to be useful in
  decision making and therefore precision is
  sometimes sacrificed.

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Management vs. Financial Accounting (5 of 6)

• Report frequency
• FA Publicly traded, SEC quarterly, with more
  detailed info annually.
• MA Up to management.
• Report timeliness.
• FA Usually, several weeks to months after fiscal
  close of accounting period.
• MA Quickly to be useful for decision making.

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Management vs. Financial Accounting (6 of 6)

• Report entity.
• FA Organization as a whole.
• MA Relatively small parts (responsibilities
  centers such as departments, product lines,
  divisions, subsidiaries as well as organization
  as a whole.)

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Uses of Management Accounting

• Measurement of revenues, costs, and assets.
• Control.
• To aid in choosing among alternative courses of
  action.

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Measurement

• Full cost accounting measures the resources used
  in performing some activity.
• Full cost of producing goods or providing
  services direct costs indirect costs.
• Direct costs costs directly traced to the goods
  or services.
• Indirect costs a fair share of costs incurred
  jointly in producing goods or services.

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Measurement example

• Be careful of how you allocate that overhead.
• How expensive is that ashtray?

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Control

• Costs (also, revenues and assets) are identified
  to and measured by responsibility center.
• A manager heads each responsibility center.
• Corrective action can only be taken by
  individuals.
• To help identify problems (and opportunities)
  actual costs are measured and compared to a
  benchmark (budget, last year, industry average).

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Alternative Choice Decisions

• Differential costs of alternative possible
  actions are developed.

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General Observations on MA

• Different numbers for different purposes.
• Many different types of costs historical,
  standard, overhead, variable, fixed,
  differential, marginal, opportunity, direct,
  estimated, full, etc.
• Clarify which type you are talking about.
• Accounting numbers are approximations.
• Best that we can with incomplete data.
• Accounting evidence is only partial evidence
  other factors help make decisions.
• People not numbers get things done. How you use
  the numbers is as important as how the numbers
  are produced.

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The Behavior of Costs and Decision-Making
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What will be covered

• A general overview of how costs behave.
• Several applications of how this knowledge can
  help you make better, informed, decisions.
• Some examples of what we will be able to solve

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Breakeven analysis

• You are considering offering a new service (such
  as delivery of take-out) and you wish to
  determine what volume you will need to generate
  to cover your costs.

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Close a location decision

• You are responsible for several locations. One
  location consistently shows a loss on its
  income statement. Should it be closed? If so,
  will your region be better off?

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Special orders decisions

• You have been offered a one-time special order.
  You need to determine if you should accept the
  order given the price is lower than the normal
  charge for comparable meals you serve.

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Behavior of Costs

• Cost-volume relationships.
• Fixed and variable costs.
• Step-function costs.

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Relation of Costs to Volume

• Variable costs items of cost that vary, in
  total, directly and proportionately with volume.
• Fixed costs items of cost that, in total, do
  not vary at all with volume
• Semi-variable costs (semi-fixed costs) costs
  that include a combination of variable cost and
  fixed cost items.

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Variable Costs

• Items of cost that vary, in total, directly and
  proportionately with volume.
• Volume refers to activity level.
• Examples
• Material costs varies with units sold.
• Electricity costs varies with production hours.
• Stationery and postage costs varies with number
  of letters written.

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Fixed costs

• Items of cost that, in total, do not vary at all
  with volume.
• Examples
• Building rent, property taxes, management
  salaries.
• Fixed cost per unit of activity decreases as the
  level of activity increases.
• Fixed costs are fixed for a range of activity and
  a limited period of time.

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Beware of how cost behave!

• Fixed costs should not be treated as variable in
  decision making.
• Senate gym example.

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Cost-volume (C-V) diagram

• Y or vertical axis reflects total cost.
• X or horizontal axis reflects volume.
• y mx b.
• y is the cost at a volume of x
• m is the rate of cost change per unit of volume
  change, or the slope (variable costs).
• b is the vertical intercept, which represents the
  fixed cost component.

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Profit-graph

• Add revenue line to C-V diagram.
• Assumes constant selling price.
• UR unit revenue
• TR total revenue

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TC TFC (UVCX)

• TC total cost
• TFC total fixed cost (per time period),
• UVC Unit variable cost (per unit of volume),
• X volume.

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Cost Relations

• Average costs total cost/volume.
• Average cost behaves differently than total cost.
• As volume goes up ?
• Total fixed cost remains constant, total variable
  costs goes up, per unit variable costs stays the
  same, per unit fixed cost goes down, per unit
  total cost goes down.

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Step-function costs

• Incurred when costs are added in discrete chunks,
  e.g., a manager for every 10 workers.
• Adding the chunk of costs increases capacity.
• Height of a stair step (riser) indicates the cost
  of adding incremental capacity.
• Step width (tread) shows how much additional
  volume of that activity can be serviced by this
  additional increment of capacity.

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Contribution

• Unit contribution margin marginal income unit
  selling price - variable cost per unit UR -
  UVC.
• What is contribution
• First it is the contribution to cover fixed
  costs.
• Then it is the contribution toward profit.

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Breakeven Volume

• TR URX
• TC TFC (UVCX)
• Breakeven TR TC
• Substituting URX TFC (UVCX) ? X TFC/(UR
  - UVC)

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Break-even Volume

• In units Fixed costs/unit contribution
• In revenue dollars just compute break-even in
  units and multiply by the selling price.

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A simple example

• You run a restaurant that serves one type of meal
  that sells for 5.
• The variable costs (ingredients, container, etc.)
  total 3.
• Monthly fixed costs (rent, salary, etc.) total
  4,000.
• What is the breakeven amount in volume and in
  sales dollars?

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Target Profit

• Add to breakeven analysis to show units or dollar
  of sales to achieve a target (T) level of profit
• URX TFC (UVCX) T?
• X (TFCT)/(UR - UVC)

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A simple example - continued

• Instead of just breaking even, you would like to
  make a profit of 2,500.
• What volume of meals will you need to serve?

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Now your turn.

• Take-out problem.

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Up the ante

• Some slightly harder problems
• Grizzly Express
• Store 201 example

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Limitations of C-V Relations

• A straight line approximates cost behavior only
  within a certain range of volume, the relevant
  range.
• When volume approaches zero, management takes
  steps to reduce fixed costs.
• When volume exceeds relevant range, fixed costs
  increase.

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Limitations (continued)

• Amount of variable costs depends on the time
  period over which behavior is estimated (the
  relevant time period).
• If the time period is one day, few costs are
  variable.
• Over an extremely long time period, no costs are
  fixed.

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Linear Assumption

• C-V relationship is often not linear.
• Some cost functions are curved (curvilinear).
• Segments of the curve can be approximated by a
  straight line, each with its own relevant range.

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Short-Run Alternative Choice Decisions
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Highlights

• Alternative choice decisions manager seeks to
  choose best of several alternative courses of
  action.
• Introduces construct of differential costs and
  revenues for several types of problems, each
  having a relatively short time horizon.

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Differential Costs and Revenues

• Costs that are different under one set of
  conditions than they would be under another.
• Revenues that are different under one set of
  conditions than they would be under another.

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Nature of Full and Differential Costs

• Full cost of a product or other cost object sum
  of direct cost fair share of applicable
  indirect costs.
• Differential costs include only those cost
  elements of cost that are different under a
  certain set of conditions.

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Historical, Full and Differential Costs

• Full cost accounting system collects historical
  costs.
• Differential costs always relate to the future.
• Differential costs are intended to show what
  costs will be if a certain course of action is
  adopted in the future.

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Steps in the Analysis

• Define the problem.
• Select possible alternative solutions. (Status
  quo may be the benchmark against which other
  alternatives are measured.)
• For each alternative, measure and evaluate
  consequences that can be expressed in
  quantitative terms.
• Identify those consequences that cannot be
  expressed in quantitative terms and evaluate them
  against each other and against the measured
  consequences.
• Reach a decision.

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Opportunity costs

• A measure of the value that is lost or sacrificed
  when the choice of one course of action requires
  giving up an alternative course of action.
• Not measured in accounting records.

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Sunk Cost

• A cost that has already been incurred and
  therefore cannot be changed by any decision
  currently being considered.
• Not a differential cost.

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Importance of Time Span

• The longer the time span the more items of cost
  that are differential.
• In the very long run full costs are differential
  costs.

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Sensitivity Analysis

• Considers how sensitive the quantitative
  measurements of the alternatives are to changes
  in assumptions.

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Just One Fallacy

• Each additional unit of production adds just
  variable costs.
• If many units are added, then step function costs
  (i.e., fixed costs) are added.
• Therefore, step function costs are averaged out
  over the additional units of volume.

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Sell Now or Process Further

• Assume that the product being offered can either
  be sold currently as is for a certain sum or
  processed further, with additional costs, at
  which time it can be sold for a greater amount
  than now.

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Sell Now or Process Further
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Sell Now or Process Further

• The product is being discontinued and its price
  has fallen. If the product is processed to
  completion it can be sold for only 1,000 (less
  than cost incurred of 1,200 800 400)
• If sold now they will bring in 500.
• What should we do?
• Should we incur 400 more cost knowing we will
  end up losing money overall? Is this throwing
  good money at bad?

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Differential costs
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Sunk Costs

• Cost that have already been incurred and cannot
  be changed.
• Not relevant to any decision
• Cost of 800 already incurred in the previous
  example are sunk and should be ignored. They do
  not change the situation in any way.

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Variation on a theme

• Restaurant 314

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Make or Buy

• Often a company will purchase an ingredient
  externally that is part of what they are making.
• They could make this ingredient internally if it
  is to their benefit to do so.
• These decisions usually only involve costs, not
  revenues.
• Qualitative factors must be considered.

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Make or Buy

• XYZ Co. is considering an offer to supply 50,000
  units of ingredient D at a cost of .32 per unit.
  
• The company is currently producing ingredient D
  internally with the following costs

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Make or Buy

• Cost to manufacture internally is .345 17,250
  / 50,000
• Outside offer is for .320
• Other information
• Market value of the machine we use to produce D
  is zero if we try to dispose of it

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Avoidable Costs

• Not all fixed costs are irrelevant sunk costs
• Some fixed costs are avoidable (i.e., they can be
  avoided under one alternative)
• In the previous example we can terminate the
  supervisors, hence this fixed costs is avoidable
  and therefore relevant and differential.
• Since avoidable costs of 15,500 is less than the
  cost of the external part, we should reject the
  offer based on financial grounds.

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Opportunity Cost

• The value of foregone benefits from selecting one
  choice over an alternative.
• You give up earning money at a job by going to
  school full time.
• Assume that, in the previous example, if we no
  longer make ingredient D internally, we can save
  600 in rent by using the space for another
  operation that is currently leasing warehouse
  space.

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Your turn

• Sauce It Up

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Dropping a Product

• Need to calculate the change in profit if the
  product is dropped versus retained.
• Both differential costs and revenues are
  considered.
• Procedure differs if there is excess capacity
  versus at capacity
• If at capacity need to consider opportunity costs.

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Dropping a Store

• Region 5 is considering dropping Store 2.
• Direct fixed costs are items directly traceable
  to the division
• Example salary of a worker who spends all his
  time in this restaurant
• Allocated fixed costs are fixed costs that are
  shared between divisions
• Example Salary of the regional manager

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Dropping a Product

• Should 2 be dropped?
• It is showing a loss of (15,000)!
• What would happen to the divisions total net
  income if the store was dropped?
• Assume the direct fixed costs are building rent
  that can be avoided.
• Allocated fixed costs are the regional managers
  salary and some corporate costs.
• If Store 2 were dropped, there would not be any
  impact on the other stores volume.

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The Death Spiral

• This phenomena is sometimes referred to as the
  Dearth Spiral.
• You drop one product because it is a loser.
• Suddenly other products become losers.
• You drop them.
• Now other products become losers.
• And the spiral continues until you are out of
  business!

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Your turn.

• Drop store 103 example.

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Variation on a theme

• Try your hand at a special order problem.
• Girl Scouts example
• How Special

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Decisions Involving Constraints

• Basic decision is to keep any product/store with
  a positive contribution margin as long as you can
  keep selling it.
• That changes if making one product affects
  another product.
• An example is when there is a constraint such as
  a limited amount of skilled labor or machine time

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Decisions Involving Constraints
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Decisions Involving Constraints

• Suppose that both products require time on a
  specialized machine. A total of 1,000 hours are
  available.
• Product A requires 10 hours
• Product B requires 2 hours
• Which product should be produced assuming we can
  sell as much of either as we produce at the given
  prices?

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Decisions Involving Constraints

• Product A has the highest CM, we make 50 for
  every one sold versus only 20 for each B.
• But what about those machine hours?

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Decisions Involving Constraints

• Since A requires 10 hours and we have 1,000
  total, we can produce 100 A.
• At 50 each 5,000 CM
• Since B requires only 2 hours we can produce 500
  total.
• At 20 each 10,000
• Company is better off producing all Product B.

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Decisions Involving Constraints

• Decision rule
• Under conditions of a constraint, produce the
  product with the highest contribution margin per
  unit of the constraint.
• A has 50/10 hours or 5 per machine hour.
• B has 20/2 hours or 10 per machine hour.

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A Few More Examples To Try

• Drew
• Walters
• Wasted Away