Overview of Managerial Accounting EMBA 615

Environment of Accounting Managerial reports Managerial decisions Direct cash flow Tax return Operations of the business entity Financial statements Capital market resource allocation GAAP Audit Contractual payoffs 11

Accounting Systems Financial accounting systems For external users (investors, creditors) Comparability/reliability important Rules (GAAP, IFRS), imposed externally Managerial accounting systems For internal users (managers) Guided by economic principles Not constrained by rules

Agenda Brief Introduction to the Course Fundamentals of Cost Accounting Ross Railroad Company Basics of overhead cost allocation

Resource Costs vs. Product Costs Costs arise from resources: Labor, buildings, energy, machinery, raw material, etc. Management often requires an estimate of product costs: Pricing, investments, outsourcing, product mix decisions Estimating product costs requires mapping of resources to products.

Dedicated vs. Shared Resources Resources dedicated to product line A Resources dedicated to product line B Resources shared across product lines Product A Product B 19

Allocating Costs of Shared Resources Costs of shared resources are allocated to the different products using allocation bases 19

Example – Overhead Cost Allocation Ross Jewels has two product lines: A silver ring (“Zephyr”) and a gold necklace (“Kate”). Three types of resources are used in producing the jewelry: Direct material (silver, gold) Direct labor (skilled jewelry makers) Overhead costs (supervisors, work space, tools, electricity) “Zephyr” “Kate” Total Direct material $20,000 $60,000 $80,000 Direct labor $50,000 $100,000 $150,000 Overhead costs $300,000

Example – Overhead Cost Allocation Overhead Allocation Rate = Budgeted Overhead Costs Budgeted Allocation Base Let’s assume that Ross Jewelry allocates overhead costs based on direct labor costs: Budgeted overhead cost ÷ Budgeted allocation base (Direct labor costs) Overhead rate $300,000 $150,000 200%

Example – Overhead Cost Allocation What is the reported product cost of “Zephyr”? Direct material $20,000 Direct labor $50,000 Allocated Overhead costs 200% of $50,000 $100,000 Total $170,000

Example – Overhead Cost Allocation Overhead Allocation Rate = Budgeted Overhead Costs Budgeted Allocation Base Let’s assume that Ross Jewelry allocates overhead costs based on direct material costs: Budgeted overhead cost ÷ Budgeted allocation base (Direct material) Overhead rate $300,000 $80,000 3.75

Example – Overhead Cost Allocation What is the reported product cost of “Zephyr”? Direct material $20,000 Direct labor $50,000 Allocated Overhead costs 3.75 X 20,000 $75,000 Total $145,000

Management Accounting Systems Variance Analysis Cost Accounting Systems Budgeting Systems Transfer Pricing Performance Measurement Systems

Two-Stage Cost Systems

Agenda Traditional cost systems Two-stage systems Examples Detroit Lofts Ross Parts Takeaway

Mapping Resources to Products Product costs arise from products’ use of resources Dedicated Resources Shared Resources More accurate costing systems Better track the products’ use of shared resources Design of more accurate costing systems 2 stage-costing systems

Traditional Cost Systems Materials Labor Overhead Direct Direct % Labor Cost Doors Mufflers Manifolds

Two Stage Cost Systems Traditional Systems Assumes that all shared resources exist to support direct labor Modern Manufacturing and Service Technologies Shared resources could include Machines and Technical Personnel Product and Service Designers Two Stage Costing Systems A more sophisticated method of mapping shared resources to individual products

Example: Detroit Lofts, Inc. A small loft at 3930 Cass Ave. in Detroit Originally a VFW bar Now houses two office spaces A and B of 600 sq. ft. and 400 sq. ft. respectively Each office space is used by one person The joint utility bill is $800, of which $500 is for heat, and $300 is for water Electricity and Comcast are billed individually What is the utility cost of each office space?

Traditional System Use square footage as the allocation basis Both offices together have 1,000 sq. ft. So each sq. ft. costs $800 ÷ 1000 = $0.80 Office costs A: $0.80 x 600 = $480 B: $0.80 x 400 = $320 Do the costs properly reflect resource use by the two offices?

Two-Stage Costing System One approach is to adopt a “two-stage” cost system First stage Split overhead into the two departments (heat and water) Second stage Calculate separate overhead rates using different allocation bases (cost drivers) Note: use allocation base levels that combine all offices’ usage Calculate individual office costs using the new rates

Two-Stage Cost System Comcast Internet Electricity Overhead Direct Heat Water Square feet Headcount Office A Office B

Detroit Lofts: Resource Usage First stage Total utilities bill is $800 = $500 (heat) + $300 (water) Second stage Heat allocated by square footage (allocation base) Heat rate = $500 ÷ (600 + 400) = $0.50 per sq.ft. Water allocated by headcount (allocation base) Water rate = $300 ÷ (1 + 1) = $150 per person Office A cost = $0.50 x 600 + $150 = $450 (down from $480) Office B cost = $0.50 x 400 + $150 = $350 (up from $320) A better reflection of the offices’ true usage of shared resources

Agenda Traditional cost systems Two-stage systems Examples Detroit Lofts Ross Parts Takeaway

Another Example: Ross Parts Ross Parts produces two products through two production departments (machining and assembly) Product 1 (“Cutting Edge”) is a new product that requires many hours in Machining Product 2 (“Old Faithful”) is a standard product that requires few hours in Machining Both products require the same time in Assembly

Ross Parts Product and cost data Old Faithful Cutting Edge Direct materials cost $30 Machine hours – Machining 1 2 Labor hours – Machining Machine hours – Assembly Labor hours – Assembly Estimated production (units) 1,000 2,000 Direct labor rate – All depts. $25/hour Overhead cost – Machining $120,000 Overhead cost – Assembly $30,000

Ross Parts Ross Parts uses a traditional cost system and allocates all overhead costs using direct labor costs What is the reported cost for the two products?

Ross Parts Product costs (per unit): Overhead rate: Total overhead cost ($120,000 + $30,000) = $150,000 Total labor cost (1,000 x 4 + 2,000 x 4) x $25 = $300,000 Overhead rate ($150,000 ÷ $300,000) = 50% Product costs (per unit): Old Faithful Cutting Edge Direct materials $30 Direct labor (@$25) 100 Overhead (@50% of labor cost) 50 Product cost $180

Do the Reported Costs Make Sense? Unit costs are the same for each product Cutting Edge “uses” twice as much of the Machining Department resources Old Faithful requires 1 machine hour per unit Cutting Edge requires 2 machine hours per unit How can we better reflect the physical resource usage?

Ross Parts Cost System Materials Labor Overhead Direct Direct 50 % Labor Cost Old Faithful: Materials $30 Labor $100 Overhead $50 Cutting Edge: Materials $30 Labor $100 Overhead $50

Two-Stage Cost System Materials Labor Overhead Direct Direct Machining Assembly Machine Hours % Labor Cost Old Faithful Cutting Edge

Two-Stage System Overhead rates: Machining Department Total overhead cost $120,000 Total machine hours (1,000 x 1 + 2,000 x 2) = 5,000 Overhead rate ($120,000 ÷ 5,000 hours) = $24/machine-hour Assembly Department Total overhead cost $30,000 Total labor cost (1,000 x 2 + 2,000 x 2) x $25 = $150,000 Overhead rate ($30,000 ÷ $150,000) = 20%

Two-Stage System Product costs Old Faithful Cutting Edge Direct materials $30 Direct labor – Machining 50 Direct labor – Assembly Overhead Machining (@$24/machine-hour) 24 48 Assembly (@20% Assembly labor) 10 Total $164 $188

Takeaway Traditional cost systems are an “easy” and intuitive approach to cost allocation Usually adequate for financial reporting However, traditional systems assume all shared resources exist to support the same input factor (e.g., direct labor) Two-stage systems More complex Offer a better mapping scheme from shared resources to products

Activity-Based Costing (ABC)

Agenda Introduction A hospice example: Hospice of Central Kentucky Mechanics of Activity-based costing (ABC) A manufacturing example: Ross Parts Takeaway

Two-Stage Cost Systems Recall the two-stage cost system Stage 1: Partition shared resources into pools Move “BIG and DIFFERENT” resource to a separate pool Stage 2: Allocate each pool using the relevant allocation base How to design two-stage cost systems for any given company? Activity Based Costing (ABC) provides a systematic approach It relies on a thorough understanding of the production process

HCK Example The Hospice of Central Kentucky (HCK) traditional cost system computed administrative cost per patient-day by dividing total administrative cost by total patient-days. Reported administrative cost per patient day $112,565 ÷ 3,593 patient-days = $31.33. How accurately does this cost number track the costs of servicing patients using the modern technologies of terminal care? Source: Sidney J. Baxendale and Victoria Dornbusch, “Activity-Based Costing for a Hospice,” Strategic Finance, March 2000, pp. 65-70. www.imanet.org. The case does not disclose the time period over which the costs were measured (e.g., monthly).

Business Model of HCK Cost Cost Cost Process Care Admit Discharge

Activity Levels over ALL Patients at HCK 74 referrals* 46 admissions 46 deaths 2,080 service calls 3,200 calls 5,553 patient-days* 192 billings 75 volunteers _______ * Referrals and patient-days are weighted by the stage of the disease. For example, the actual number of patient-days is 3,593, but a day for a patient whose death is imminent is counted as equivalent to three patient-days for a patient in slow decline due to the more intensive care such patients receive.

TOTAL Resource Usage over ALL patients Resource Resource Supporting Activity Allocation Rate Type Cost Pool Levels over all Patients Prereferral $ 24,611 74 referrals* $332.58 per referral Referral $10,873 74 referrals* $146.93 per referral Admission $1,960 46 admissions $42.61 per admission Post-admission $3,649 46 admissions $79.33 per admission Post-death $1,476 46 deaths $32.09 per death Bereavement $12,670 46 deaths $275.43 per death Med. services $5,588 2,080 service calls $2.69 per service call Reception $8,597 3,200 calls $2.69 per call Acc./Fin $13,566 5,553 patient-days* $2.44 per patient-day Management $17,107 5,553 patient-days* $3.08 per patient-day IT Systems $6,191 5,553 patient-days* $1.11 per patient-day Billing $2,899 192 billings $15.10 per billing Volunteer $3,378 75 volunteers $45.04 per volunteer Total $112,565

True cost of an INDIVIDUAL Patient A patient’s administrative cost is that patient’s use of administrative resources times the usage charge Consider a patient who had one referral, one admission, one call, no service call, 4 billings, 5 volunteers, stayed for two days and died.

A Specific Patient’s Admin. Cost Prereferral 1 X $332.58 per referral Referral 1 X $146.93 per referral Admission 1 X $42.61 per admission Post-admission 1 X $79.33 per admission Post-death 1 X $32.09 per death Bereavement 1 X $275.43 per death Medical services 0 X $2.69 per service call Reception 1 X $2.69 per call Accounting/finance 2 X $2.44 per patient-day Management 2 X $3.08 per patient-day Information systems 2 X $1.11 per patient-day Billing 4 X $15.10 per billing Volunteer services 5 X $45.04 per volunteer Total: $1,178.43

Summary of Cost Analyses at HCK Traditional cost data $112,565 ÷ 3,593 patient-days = $31.33 The management then measured the levels of resource consumption by various categories of patients. The estimates of the average cost per patient-day for patients in various stages of their diseases are:   Stage of Disease Cost per Patient-Day Slow decline $27.39 Rapid decline $29.84 Imminent death $62.88 Death $381.57

Activity-Based Costing (ABC) Activity-Based Costing: Shared resources are mapped to products by analyzing the production processes: Production Processes Shared Resources Products Mapping

Steps of ABC Identify key activities that are required to produce the good or service by analyzing the production processes. Assign the overhead costs to the different activities. Identify the cost driver (allocation base) for each activity. Calculate the overhead rate for each activity: (Rate = Overhead cost ÷ Cost driver volume) Using the activity rates, charge each product based on the amount of activities it uses as it moves through the production process.

Agenda Introduction A hospice example: Hospice of Central Kentucky Mechanics of Activity-based costing (ABC) A manufacturing example: Ross Parts Takeaway

Another Example: Ross Parts Manufacture two (substitutable) parts D-12 and M-24 Current production information D-12 M-24 Units produced annually 100,000 25,000 Material costs per unit $10 $12 Direct labor hours per unit 0.8 Direct labor rate per hour $20 Machine-hours per unit 2.0 Set-up hours per run (batch) 5.0 Annual production runs 110 10 Wastewater generated per unit (liters) 10.0 0.0

Ross Parts Example Overhead cost by department and category Department/Category Annual Budgeted Overhead Supervision $ 240,000 Material handling 325,000 Wastewater treatment 250,000 Equipment depreciation 625,000 Setup labor 60,000 Total $1,500,000

Ross Parts Example Company uses a single overhead pool Allocation base is direct-labor cost Which product is less costly to produce? Total labor hours = 100,000 (= 100,000 x 0.8 + 25,000 x 0.8) Total labor cost = $2,000,000 (= 100,000 hours x $20/hour) Overhead rate = 75% (= $1,500,000 ÷ $2,000,000)

Ross Parts Example Unit product costs under this system D-12 M-24 Direct material $10.00 $12.00 Direct labor 16.00 Overhead (@ 75% of direct labor) 12.00 Unit cost $38.00 $40.00 Decision: Only produce D-12

What’s “Wrong” With the Decision? Only D-12 uses the wastewater treatment The wastewater treatment costs are “spread” between both products This is the result of using a single cost pool Tendency to “overcost” products making less use of overhead resources One solution might be a two-stage cost system

Two-Stage Cost System Materials Labor Overhead Direct Direct Wastewater Treatment Other Overhead Wastewater Machine hours D-12 M-24

Two-Stage Overhead Rates The rates for the two overhead pools: Cost Pool Costs ÷ Allocation Base = Overhead rate Wastewater $250,000 1,000,000 liters $0.25/liter Other overhead $1,250,000 250,000 machine-hours $5.00/hour

Two-Stage Product Costs Product costs for the two-stage system D-12 M-24 Direct material $10.00 $12.00 Direct labor 16.00 Overhead Wastewater (@ $0.25 per liter) 2.50 0.00 Other overhead (@ $5 per mh) 10.00 Unit cost $38.50 $38.00 Decision: Only produce M-24

What’s “Wrong” Now? Company produces M-24 in “longer” runs, requiring fewer set-ups But, M-24 uses more expensive material, which might require different handling However, the overhead costs are based entirely on volumes produced

A Thought Experiment Two production areas (buildings) within a single plant that produce identical numbers (volumes) of markers One building only produces black markers (by far the most popular model) The second produces all the other colors Both buildings use the same amount of direct labor, machine hours, and material cost

A Thought Experiment What do you observe in the multi-color building relative to the black marker building? More machine set-ups More material handling To and from the production line More inventory movement More orders In general, a lot more activity

ABC Cost System Diagram Direct Costs Overhead Direct Supervise Handle … Setup Labor $ Material $ Setup hours D-12 M-24

ABC Overhead Rates There are five overhead pools Cost Pool Costs ÷ Total Activity* = Overhead rate Supervise $240,000 100,000 hours $2.40/hour Handle material $325,000 $1,300,000 25% material $ Treat wastewater $250,000 1,000,000 liters $0.25/liter Use equipment $625,000 250,000 hours $2.50/hour Setup $60,000 600 hours $100/hour Cost Pool *Total Activity Supervision (labor hours) 100,000 units x 0.8 hours + 25,000 units x 0.8 hours Handle material (material dollars) 100,000 units x $10 + 25,000 units x $12 Treat wastewater (wastewater) 100,000 units x 10 liters + 25,000 units x 0 liters Use equipment (machine hours) 100,000 units x 2 hours + 25,000 units x 2 hours Setup machines (setup hours) 110 runs x 5 hours + 10 runs x 5 hours

ABC Product Costs Unit product costs for the ABC system D-12 M-24 Direct material $10.00 $12.00 Direct labor 16.00 Overhead Supervise (@ $2.40 per hour) 1.92 Handle material (@25% material $) 2.50 3.00 Treat wastewater (@ $0.25 per liter) 0.00 Use equipment (@2.50 per machine-hour) 5.00 Setup machines (@ $100 per setup hour) 0.55* 0.20 Unit cost $38.47 $38.12 *Because these are unit costs, we need to first determine cost of setups and then divide by the number of units produced (e.g., 0.55 = [110 x 5 x $100] ÷ 100,000).

Takeaway Resource level ABC assumes resources arise from activities ABC then divides each resource’s cost by the total level of activities it supports This division calculation yields a activity charge for each activity Product level As the product progresses through the production process, it accumulates costs based on how much activities it uses The product cost thus more accurately reflects its true use of shared resources

Introduction to Budgeting

Agenda Introduction To Budgeting Budgeting Example: Ross Jewelers Takeaway

Motivation for Budgeting Costs are driven by Resources Resources are used by Products First half of this course Understand how Resource Costs map into Product Costs Organizations need to compute Product Costs in advance Planning and pricing cannot wait till actual costs are realized Resource acquisition decisions must also be made in advance

Budgeting Budgeting: Process of developing a forecast of business activities in future periods Budgets: Result from the budgeting process Expressed in financial measures (sales, expenses, income) Primary uses of budgets: Planning (e.g., resource acquisition decisions) Performance measurement: Actual results are compared to budget

The Budgeting Process Run the production or the business model in reverse Forecast sales Forecast production volume Forecast various resource commitments and purchases

Budgeting Example Ross Jewelers currently has 10 rings in inventory Forecast sales for next month is 20 rings Production target is set for 15 rings (5 rings safety stock) Producing this volume requires committing to $300 in factory resources In addition, producing each ring is forecast to Require $50 in raw material Require $10 in labor Budgeted Product Cost = [$300 + ($50 + $10) x 15] ÷ 15 = $80 per ring

Budgeting Challenges Key challenge: Information that is important for developing budgets is spread throughout the organization. E.g., managers of foreign divisions have superior knowledge about local market trends. → Top management can’t prepare budgets by themselves. What is the best way to collect all the information? Which employees should make forecasts? Are employees going to report their “true” forecasts?

Takeaway The budgeting process runs the business model in reverse: Forecast: Sales  Production Volume  Input Resources Budgets typically have a dual role: Planning Performance evaluation Key challenge: Information is spread throughout the organization

Variance Analysis

Agenda Motivate the need for variance analysis Describe the organizational use of variances Discuss the mechanics of variance analysis Example: Ross Parts Takeaway

Variance Analysis Organizations that have a budget typically compare the actual results to the budget at the end of the period. Variance: Difference between actual and budgeted results: Actual Budget Variance Revenue: $1,150 $1,000 $150F Direct Material: $450 $400 $50U Direct Labor: $425 $25F Overheard: $100 $0 Profit $175 $50 $125F

Labeling Convention Variance that implies a higher profit: favorable (F) Actual revenue is higher than budgeted Actual costs are lower than budgeted Variance that implies a lower profit: unfavorable (U) Actual revenue is lower than budgeted Actual costs are higher than budgeted

Goal of Variance Analysis Quantify the impact of the individual factors on the total variances Actual Budget Variance Possible reasons for the variance Sales: $1,150 $1,000 $150F Sales volume, sales price Direct Material: $450 $400 $50U Sales volume, material costs, material usage Direct Labor: $425 $25F Sales volume, labor costs, labor usage Overheard: $100 $0 Sales volume, resource costs, resource usage Profit $175 $50 $125F - All of the above -

Purpose of Variance Analysis Performance evaluation: Who is responsible for the overall results? How well did our sales/ marketing people do? How efficiently did our production dept. use the resources? How well did our sourcing dept. negotiate with suppliers? Planning: Should we change our product mix? Should we change our suppliers?

Mechanics of Variance Analysis We can quantify the impact of the individual factors by decomposing the variances: The decomposition uses a common unit of measure, namely $ It is difficult to compare #units, kg, $/unit, etc., across products

Variance Analysis - Mechanics We can quantify the impact of the individual factors by decomposing the variances: Sales variance: Cost variances: Actual Sales (AV x AP) Flexible Budget (AV x EP) (Master) Budget (EV x EP) Output Price Variance Sales Volume Variance Actual Costs (AO x AI x AP) Flexible Budget (AO x EI x EP) (Master) Budget (EO x EI x EP) (AO x AI x EP) Input Price Variance Efficiency Variance Production Volume Variance A: actual; E: expected; V: sales volume; O: output quantity; P: price (sales price or price of input unit); I: amount of input used per unit of output

Example: Ross Parts Ross Parts produces the RP-24 Budget for 2011: Per Unit Total: 100,000 Units Sales: $20 $2,000,000 Costs: Direct materials: 2kg @ $3 = $6 $ 600,000 Direct labor: 0.2 hrs. @ $25 = $5 $500,000 Overhead : $300,000 Profit: $600,000 *Print this out. A552: Variances

Example: Ross Parts Actual results for 2011: Total Sales: 100,000 units @ $20.50 $2,050,000 Costs: Direct materials: 194,000 kg @ $3.50/kg $ 679,000 Direct labor: 21,000 hrs. @ $23/hr. $483,000 Overhead : $300,000 Profit: $588,000 Actual Direct Material usage per unit: 194,000 kg/ 100,000 units = 1.94kg/ unit Actual Direct Labor usage per unit: 21,000 hrs./ 100,000 units = 0.21 hrs.

Example: Ross Parts Sales variance (Volume is Sales Volume): 100,000 x $20.50 100,000 x $20 100,000 x $20 = $2,050,000 = $2,000,000 = $2,000,000 Actual Sales (AV x AP) Flexible Budget (AV x EP) (Master) Budget (EV x EP) Price Variance Volume Variance Output Price Variance: $50,000 F Volume Variance: $0 A: actual; E: expected; V: sales volume; O: output quantity; P: price (sales price or price of input unit); I: amount of input used per unit of output

Cost variances (Volume is Production Volume): Direct Material 100,000 x 1.94 x $3.50 100,000 x 1.94 x $3 100,000 x 2 x $3 100,000 x 2 x $3 = $679,000 = $582,000 = $600,000 = $600,000 $97,000 U $18,000 F 0 Direct Labor 100,000 x 0.21 x $23 100,000 x 0.21 x $25 100,000 x 0.2 x $25 100,000 x 0.2 x $25 = $483,000 = $525,000 = $500,000 = $500,000 $42,000 F $25,000 U 0 Overhead $300,000 $300,000 Actual Costs (AO x AI x AP) Flexible Budget (AO x EI x EP) (Master) Budget (EO x EI x EP) (AO x AI x EP) Input Price Variance Efficiency Variance Volume Variance “Spending Variance” A: actual; E: expected; V: sales volume; O: output quantity; P: price (sales price or price of input unit); I: amount of input used per unit of output

Variance Decomposition Summary Sales variances Price variance $50,000 F Volume variance $0 Direct material variances 97,000 U Efficiency variance 18,000 F 79,000 U Direct labor variances 42,000 F 25,000 U 17,000 F Overhead Variance Profit Variance $12,000 U Q: Why is this summary useful to management?

Takeaway Variance: Difference between actual results and budget. Variance Analysis: Quantitative decomposition of total variances into individual components (volume variance, price variance, cost variance, efficiency variance). Purpose of variance analysis: Performance evaluation: Who is responsible for the overall results? Planning