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.
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).
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.)
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.
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.
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.)
Uses of Management Accounting • Measurement of revenues, costs, and assets. • Control. • To aid in choosing among alternative courses of action.
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.
Measurement example • Be careful of how you allocate that overhead. • How expensive is that ashtray?
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).
Alternative Choice Decisions • Differential costs of alternative possible actions are developed.
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.
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:
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.
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?
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.
Behavior of Costs • Cost-volume relationships. • Fixed and variable costs. • Step-function costs.
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.
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.
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.
Beware of how cost behave! • Fixed costs should not be treated as variable in decision making. • Senate gym example.
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.
Profit-graph • Add revenue line to C-V diagram. • Assumes constant selling price. • UR = unit revenue • TR = total revenue
TC = TFC +(UVC*X) • TC = total cost; • TFC = total fixed cost (per time period), • UVC = Unit variable cost (per unit of volume), • X = volume.
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.
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.
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.
Breakeven Volume • TR = UR*X • TC = TFC + (UVC*X) • Breakeven: TR = TC • Substituting: UR*X = TFC + (UVC*X) X = TFC/(UR - UVC)
Break-even Volume • In units = Fixed costs/unit contribution • In revenue dollars just compute break-even in units and multiply by the selling price.
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?
Target Profit • Add to breakeven analysis to show units or dollar of sales to achieve a target (T) level of profit: UR*X = TFC + (UVC*X) + T X = (TFC+T)/(UR - UVC)
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?
Now your turn. • Take-out problem.
Up the ante • Some slightly harder problems • Grizzly Express • Store 201 example
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.
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.
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.
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.
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.
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.
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.
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.
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.
Sunk Cost • A cost that has already been incurred and therefore cannot be changed by any decision currently being considered. • Not a differential cost.
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.
Sensitivity Analysis • Considers how sensitive the quantitative measurements of the alternatives are to changes in assumptions.
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.