1. Overview of Managerial Accounting
EMBA 615

2. 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

3. 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

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

5. 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.

6. 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

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

8. 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

9. 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%

10. 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

11. 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

12. 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

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

14. Two-Stage Cost Systems

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

16. 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

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

18. 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

19. 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?

20. 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?

21. 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

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

23. 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 ÷ ( ) = $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 $150 = $450 (down from $480)
Office B cost = $0.50 x $150 = $350 (up from $320)
A better reflection of the offices’ true usage of shared resources

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

25. 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

26. 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

27. 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?

28. 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
100
Overhead of labor cost) 50
Product cost
$180

29. 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?

30. 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

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

32. 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%

33. Two-Stage System Product costs Old Faithful Cutting Edge
Direct materials
$30
Direct labor – Machining 50
Direct labor – Assembly
Overhead
Machining 24 48
Assembly Assembly labor) 10
Total
$164
$188

34. 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

35. Activity-Based Costing (ABC)

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

37. 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

38. 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 The case does not disclose the time period over which the costs were measured (e.g., monthly).

39. Business Model of HCK
Cost
Cost
Cost
Process
Care
Admit
Discharge

40. 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.

41. TOTAL Resource Usage over ALL patients
Resource Resource Supporting Activity Allocation Rate Type Cost Pool Levels over all Patients Prereferral $ 24, referrals* $ per referral Referral $10, referrals* $ per referral Admission $1, admissions $42.61 per admission Post-admission $3, admissions $79.33 per admission Post-death $1, deaths $32.09 per death Bereavement $12, deaths $ 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, billings $15.10 per billing Volunteer $3, volunteers $45.04 per volunteer Total $112,565

42. 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.

43. A Specific Patient’s Admin. Cost
Prereferral 1 X $ per referral Referral 1 X $ 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 $ 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

44. 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

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

46. 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.

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

48. 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

49. 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

50. 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 ,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)

51. 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

52. 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

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

54. 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

55. 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

56. 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

57. 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

58. 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

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

60. 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 $ ,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

61. 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 material $)
2.50
3.00
Treat wastewater $0.25 per liter)
0.00
Use equipment 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).

62. 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

63. Introduction to Budgeting

64. Agenda Introduction To Budgeting Budgeting Example: Ross Jewelers
Takeaway

65. 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

66. 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

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

68. 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

69. 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?

70. 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

71. Variance Analysis

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

73. 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

74. 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

75. 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 -

76. 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?

77. 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

78. 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

79. 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: $3
= $6
$ 600,000
Direct labor:
0.2 $25
= $5
$500,000
Overhead :
$300,000
Profit:
$600,000
*Print this out.
A552: Variances

80. Example: Ross Parts Actual results for 2011: Total Sales:
100,000 $20.50
$2,050,000
Costs:
Direct materials:
194,000 $3.50/kg
$ 679,000
Direct labor:
21,000 $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.

81. Example: Ross Parts Sales variance (Volume is Sales Volume):
100,000 x $ ,000 x $ ,000 x $20
= $2,050, = $2,000, = $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

82. Cost variances (Volume is Production Volume):
Direct Material
100,000 x 1.94 x $ ,000 x 1.94 x $3 100,000 x 2 x $ ,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 $ ,000 x 0.21 x $ ,000 x 0.2 x $ ,000 x 0.2 x $25
= $483,000 = $525,000 = $500,000 = $500,000
$42,000 F $25,000 U 0
Overhead
$300, $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

83. 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?

84. 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