Q1. Assume that you are preparing a Master Budget for a reputed corporation. Bring out numerical examples on the complete master budget of the corporation.(the 10 way of budget)
Q3a. Assume a company manufactures cars and currently uses only 50% of its manufacturing facility 20,000 cars). The company could utilize more of its facility by producing its own tires. It currently purchases tires at SAR 30 per set of four. If the company would incur SAR12 per set for direct materials, SAR10 for direct labor, and SAR 6 for overhead (variable) to produce the tires.
Required: Compute why the company should, make or buy the tires, in any scenario give your decision why? the book we use is
Profit Planning
Chapter 07
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
The Basic Framework of Budgeting
A budget is a detailed quantitative plan for
acquiring and using financial and other resources
over a specified forthcoming time period.
1. The act of preparing a budget is called
budgeting.
2. The use of budgets to control an
organization’s activities is known
as budgetary control.
7-2
Planning and Control
Planning –
Control –
involves developing
objectives and
preparing various
budgets to achieve
those objectives.
involves the steps taken by
management to increase
the likelihood that the
objectives set down while
planning are attained and
that all parts of the
organization are working
together toward that goal.
7-3
Advantages of Budgeting
Define goals
and objectives
Think about and
plan for the future
Communicate
plans
Coordinate
activities
Advantages
Means of allocating
resources
Uncover potential
bottlenecks
7-4
Responsibility Accounting
Managers should be
held responsible for
those items – and only
those items – that they
can actually control
to a significant extent.
7-5
Choosing the Budget Period
Operating Budget
2011
2012
Operating budgets ordinarily
cover a one-year period
corresponding to a company’s
fiscal year. Many companies
divide their annual budget
into four quarters.
2013
2014
A continuous budget is a
12-month budget that rolls
forward one month (or quarter)
as the current month (or quarter)
is completed.
7-6
Self-Imposed Budget
Top Management
Middle
Management
Supervisor
Supervisor
Middle
Management
Supervisor
Supervisor
A self-imposed budget or participative budget is a budget that is
prepared with the full cooperation and participation of managers
at all levels.
7-7
Advantages of Self-Imposed Budgets
1. Individuals at all levels of the organization are viewed as
members of the team whose judgments are valued by top
management.
2. Budget estimates prepared by front-line managers are
often more accurate than estimates prepared by top
managers.
3. Motivation is generally higher when individuals participate
in setting their own goals than when the goals are
imposed from above.
4. A manager who is not able to meet a budget imposed
from above can claim that it was unrealistic. Self-imposed
budgets eliminate this excuse.
7-8
Self-Imposed Budgets
Self-imposed budgets should be reviewed
by higher levels of management to
prevent “budgetary slack.”
Most companies issue broad guidelines in
terms of overall profits or sales. Lowerlevel managers are directed to prepare
budgets that meet those targets.
7-9
Human Factors in Budgeting
The success of a budget program depends on three
important factors:
1.Top management must be enthusiastic and
committed to the budget process.
2.Top management must not use the budget to
pressure employees or blame them when
something goes wrong.
3.Highly achievable budget targets are usually
preferred when managers are rewarded based on
meeting budget targets.
7-10
The Master Budget: An Overview
Sales budget
Ending inventory
budget
Direct materials
budget
Production budget
Direct labor
budget
Selling and
administrative
budget
Manufacturing
overhead budget
Cash budget
Budgeted
income
statement
Budgeted
balance sheet
7-11
Budgeting Example
Royal Company is preparing budgets for the
quarter ending June 30th.
Budgeted sales for the next five months are:
April
May
June
July
August
20,000 units
50,000 units
30,000 units
25,000 units
15,000 units
The selling price is $10 per unit.
7-12
The Sales Budget
The individual months of April, May, and June are
summed to obtain the total budgeted sales in units
and dollars for the quarter ended June 30th
7-13
Expected Cash Collections
• All sales are on account.
• Royal’s collection pattern is:
70% collected in the month of sale,
25% collected in the month following sale,
5% uncollectible.
• In April, the March 31st accounts receivable
balance of $30,000 will be collected in full.
7-14
Expected Cash Collections
7-15
Expected Cash Collections
From the Sales Budget for April.
7-16
Expected Cash Collections
From the Sales Budget for May.
7-17
Expected Cash Collections
7-18
The Production Budget
Sales
Budget
and
Expected
Cash
Collections
Production
Budget
The production budget must be adequate to
meet budgeted sales and to provide for
the desired ending inventory.
7-19
The Production Budget
• The management at Royal Company wants
ending inventory to be equal to 20% of the
following month’s budgeted sales in units.
• On March 31st, 4,000 units were on hand.
Let’s prepare the production budget.
7-20
The Production Budget
7-21
The Production Budget
March 31
ending inventory.
Budgeted May sales
Desired ending inventory %
Desired ending inventory
50,000
20%
10,000
7-22
The Production Budget
7-23
The Production Budget
Assumed ending inventory.
7-24
The Direct Materials Budget
• At Royal Company, five pounds of material are
required per unit of product.
• Management wants materials on hand at the
end of each month equal to 10% of the
following month’s production.
• On March 31, 13,000 pounds of material are
on hand. Material cost is $0.40 per pound.
Let’s prepare the direct materials budget.
7-25
The Direct Materials Budget
From production budget.
7-26
The Direct Materials Budget
7-27
The Direct Materials Budget
March 31 inventory.
10% of following month’s
production needs.
Calculate the materials to
be purchased in May.
7-28
The Direct Materials Budget
7-29
The Direct Materials Budget
Assumed ending inventory.
7-30
Expected Cash Disbursement for
Materials
• Royal pays $0.40 per pound for its materials.
• One-half of a month’s purchases is paid for in the
month of purchase; the other half is paid in the
following month.
• The March 31 accounts payable balance is
$12,000.
Let’s calculate expected cash disbursements.
7-31
Expected Cash Disbursement for
Materials
7-32
Expected Cash Disbursement for
Materials
Compute the expected cash
disbursements for materials
for the quarter.
140,000 lbs. × $0.40/lb. = $56,000
7-33
Expected Cash Disbursement for
Materials
7-34
The Direct Labor Budget
• At Royal, each unit of product requires 0.05 hours (3 minutes)
of direct labor.
• The company has a “no layoff” policy so all employees will be
paid for 40 hours of work each week.
• For purposes of our illustration assume that Royal has a “no
layoff” policy and workers are paid at the rate of $10 per hour
regardless of the hours worked.
• For the next three months, the direct labor workforce will be
paid for a minimum of 1,500 hours per month.
Let’s prepare the direct labor budget.
7-35
The Direct Labor Budget
–
From production budget.
7-36
The Direct Labor Budget
–
7-37
The Direct Labor Budget
–
–
Greater of labor-hours required
or labor-hours guaranteed.
7-38
The Direct Labor Budget
–
7-39
Manufacturing Overhead Budget
• At Royal, manufacturing overhead is applied to units of
product on the basis of direct labor-hours.
• The variable manufacturing overhead rate is $20 per direct
labor-hour.
• Fixed manufacturing overhead is $50,000 per month, which
includes $20,000 of noncash costs (primarily depreciation of
plant assets).
Let’s prepare the manufacturing overhead budget.
7-40
Manufacturing Overhead Budget
Direct Labor Budget.
7-41
Manufacturing Overhead Budget
Total mfg. OH for quarter $251,000
= $49.70 per hour *
Total labor-hours required 5,050
* rounded 7-42
Manufacturing Overhead Budget
Depreciation is a noncash charge.
7-43
Ending Finished Goods Inventory Budget
Production costs per unit Quantity
Cost
Direct materials
5.00 lbs. $ 0.40
Direct labor
0.05 hrs. $ 10.00
Manufacturing overhead
0.05 hrs. $ 49.70
$
$
Budgeted finished goods inventory
Ending inventory in units
Unit product cost
Ending finished goods inventory
Total
2.00
0.50
2.49
4.99
5,000
$ 4.99
$ 24,950
Direct materials
budget and information.
7-44
Ending Finished Goods Inventory Budget
Production costs per unit Quantity
Cost
Direct materials
5.00 lbs. $ 0.40
Direct labor
0.05 hrs. $ 10.00
Manufacturing overhead
0.05 hrs. $ 49.70
$
$
Budgeted finished goods inventory
Ending inventory in units
Unit product cost
Ending finished goods inventory
Total
2.00
0.50
2.49
4.99
5,000
$ 4.99
$ 24,950
Direct labor budget.
7-45
Ending Finished Goods Inventory Budget
Production costs per unit
Quantity
Cost
Direct materials
5.00 lbs. $ 0.40
Direct labor
0.05 hrs. $ 10.00
Manufacturing overhead
0.05 hrs. $ 49.70
$
$
Budgeted finished goods inventory
Ending inventory in units
Unit product cost
Ending finished goods inventory
Total
2.00
0.50
2.49
4.99
5,000
$ 4.99
?
Total mfg. OH for quarter $251,000
= $49.70 per hour
Total labor-hours required 5,050
7-46
Ending Finished Goods Inventory Budget
Production costs per unit Quantity
Cost
Direct materials
5.00 lbs. $ 0.40
Direct labor
0.05 hrs. $ 10.00
Manufacturing overhead
0.05 hrs. $ 49.70
$
$
Budgeted finished goods inventory
Ending inventory in units
Unit product cost
Ending finished goods inventory
Total
2.00
0.50
2.49
4.99
5,000
$ 4.99
$ 24,950
Production Budget.
7-47
Selling and Administrative Expense
Budget
• At Royal, the selling and administrative expense budget is
divided into variable and fixed components.
• The variable selling and administrative expenses are $0.50
per unit sold.
• Fixed selling and administrative expenses are $70,000 per
month.
• The fixed selling and administrative expenses include $10,000
in costs – primarily depreciation – that are not cash outflows
of the current month.
Let’s prepare the company’s selling and administrative
expense budget.
7-48
Selling and Administrative Expense
Budget
Calculate the selling and administrative
cash expenses for the quarter.
7-49
Selling Administrative Expense Budget
7-50
Format of the Cash Budget
The cash budget is divided into four sections:
1. Cash receipts section lists all cash inflows excluding cash
received from financing;
2. Cash disbursements section consists of all cash payments
excluding repayments of principal and interest;
3. Cash excess or deficiency section determines if the
company will need to borrow money or if it will be able to
repay funds previously borrowed; and
4. Financing section details the borrowings and repayments
projected to take place during the budget period.
7-51
The Cash Budget
Assume the following information for Royal:
➢Maintains a 16% open line of credit for $75,000
➢Maintains a minimum cash balance of $30,000
➢Borrows on the first day of the month and repays
loans on the last day of the month
➢Pays a cash dividend of $49,000 in April
➢Purchases $143,700 of equipment in May and
$48,300 in June (both purchases paid in cash)
➢Has an April 1 cash balance of $40,000
7-52
The Cash Budget
Schedule of Expected
Cash Collections.
7-53
The Cash Budget
Schedule of Expected
Cash Disbursements.
Direct Labor
Budget.
Manufacturing
Overhead Budget.
Selling and Administrative
Expense Budget.
7-54
The Cash Budget
Because Royal maintains
a cash balance of $30,000,
the company must borrow
$50,000 on its line-of-credit.
7-55
The Cash Budget
Because Royal maintains
a cash balance of $30,000,
the company must borrow
$50,000 on its line-of-credit.
Ending cash balance for April
is the beginning May balance.
7-56
The Cash Budget
7-57
The Cash Budget
$50,000 × 16% × 3/12 =
$2,000
Borrowings on April 1 and
repayment on June 30.
7-58
The Budgeted Income Statement
Cash
Budget
Budgeted
Income
Statement
With interest expense from the cash
budget, Royal can prepare the budgeted
income statement.
7-59
The Budgeted Income Statement
Sales Budget.
Royal Company
Budgeted Income Statement
For the Three Months Ended June 30
Sales (100,000 units @ $10)
Cost of goods sold (100,000 @ $4.99)
Gross margin
Selling and administrative expenses
Operating income
Interest expense
Net income
$ 1,000,000
499,000
501,000
260,000
241,000
2,000
$ 239,000
Ending Finished
Goods Inventory.
Selling and
Administrative
Expense Budget.
Cash Budget.
7-60
The Budgeted Balance Sheet
Royal reported the following account
balances prior to preparing its budgeted
financial statements:
•Land – $50,000
•Common stock – $200,000
•Retained earnings – $146,150 (April 1)
•Equipment – $175,000
7-61
Royal Company
Budgeted Balance Sheet
June 30
Assets:
Cash
Accounts receivable
Raw materials inventory
Finished goods inventory
Land
Equipment
Total assets
Liabilities and Stockholders’ Equity
Accounts payable
Common stock
Retained earnings
Total liabilities and stockholders’ equity
25% of June
sales of
$300,000.
$
$
43,000
75,000
4,600
24,950
50,000
367,000
564,550
28,400
200,000
336,150
$ 564,550
11,500 lbs.
at $0.40/lb.
5,000 units
at $4.99 each.
50% of June
purchases
of $56,800.
7-62
Royal Company
Budgeted Balance Sheet
June 30
Assets:
Cash
Accounts receivable
Raw materials inventory
Finished goods inventory
Land
Equipment
Total assets
Liabilities and Stockholders’ Equity
Accounts payable
Common stock
Retained earnings
Total liabilities and stockholders’ equity
$
Beginning balance
Add: net income
43,000
Deduct: dividends
Ending balance
75,000
$146,150
239,000
(49,000)
$336,150
4,600
24,950
50,000
367,000
564,550
$
28,400
200,000
336,150
$ 564,550
7-63
End of Chapter 07
7-64
Flexible Budgets,
Standard Costs, and
Variance Analysis
Chapter 08
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Variance Analysis Cycle
Identify
questions
Receive
explanations
Take
corrective
actions
Conduct next
period’s
operations
Analyze
variances
Prepare standard
cost performance
report
Begin
8-2
Characteristics of Flexible Budgets
Planning budgets
are prepared for
a single, planned
level of activity.
Hmm! Comparing
static planning budgets
with actual costs
is like comparing
apples and oranges.
Performance
evaluation is difficult
when actual activity
differs from the planned
level of activity.
8-3
Characteristics of Flexible Budgets
May be prepared for any activity
level in the relevant range.
Show costs that should have been
incurred at the actual level of
activity, enabling “apples to apples”
cost comparisons.
Help managers control costs.
Improve performance evaluation.
Let’s look at Larry’s Lawn Service.
8-4
Deficiencies of the Static Planning Budget
Larry’s Lawn Service provides lawn care in a planned
community where all lawns are approximately the same size.
At the end of May, Larry prepared his June budget based on
mowing 500 lawns. Since all of the lawns are similar in size,
Larry felt that the number of lawns mowed in a month would
be the best way to measure overall activity for his business.
Larry’s Budget
8-5
Deficiencies of the Static Planning Budget
Larry’s Planning Budget
8-6
Deficiencies of the Static Planning Budget
Larry’s Actual Results
8-7
Deficiencies of the Static Planning Budget
Larry’s Actual Results Compared with the Planning Budget
8-8
Deficiencies of the Static Planning Budget
Larry’s Actual Results Compared with the Planning Budget
F = Favorable variance that occurs when actual
revenue is greater than budgeted revenue.
U = Unfavorable variance that occurs when
actual costs are greater than budgeted costs.
F = Favorable variance that occurs when
actual costs are less than budgeted costs.
8-9
Deficiencies of the Static Planning Budget
Larry’s Actual Results Compared with the Planning Budget
Since these variances are unfavorable, has
Larry done a poor job controlling costs?
Since these variances are favorable, has
Larry done a good job controlling costs?
8-10
Deficiencies of the Static Planning Budget
I don’t think I
can answer the
questions using
a static budget.
Actual activity is above
planned activity.
So, shouldn’t the variable
costs be higher if actual
activity is higher?
8-11
Deficiencies of the Static Planning Budget
▪ The relevant question is . . .
“How much of the cost variances are
due to higher activity and how much
are due to cost control?”
▪ To answer the question,
we must
the budget to the
actual level of activity.
8-12
How a Flexible Budget Works
To
a budget, we need to know that:
• Total variable costs change
in direct proportion to
changes in activity.
• Total fixed costs remain
unchanged within the
relevant range.
Fixed
8-13
How a Flexible Budget Works
Let’s prepare a
budget
for Larry’s Lawn
Service.
8-14
Preparing a Flexible Budget
Larry’s Flexible Budget
8-15
Revenue and Spending Variances
Flexible budget revenue
Actual revenue
The difference is a revenue variance.
Flexible budget cost
Actual cost
The difference is a spending variance.
8-16
Revenue and Spending Variances
Now, let’s use
budgeting
concepts to compute revenue and
spending variances for Larry’s Lawn
Service.
8-17
Revenue and Spending Variances
Larry’s Flexible Budget Compared with the Actual Results
$1,750 favorable
revenue variance
8-18
Revenue and Spending Variances
Larry’s Flexible Budget Compared with the Actual Results
Spending
variances
8-19
Flexible Budgets with Multiple Cost
Drivers
More than one cost
driver may be needed to
adequately explain all of
the costs in an organization.
The cost formulas used
to prepare a flexible
budget can be adjusted
to recognize multiple
cost drivers.
8-20
Flexible Budgets with Multiple Cost
Drivers
Because of the large unfavorable wages and salaries spending
variance, Larry decided to add an additional cost driver for
wages and salaries. The variance is due primarily to the number
of hours required for the additional edging and trimming. So
Larry estimates the additional hours and builds those hours into
both his revenue and expense budget formulas.
Larry’s New Budget
8-21
Flexible Budgets with Multiple Cost
Drivers
Larry’s Budget Based on More than One Cost Driver
8-22
Standard Costs
Standards are benchmarks or “norms” for
measuring performance. In managerial accounting,
two types of standards are commonly used.
Quantity standards
specify how much of an
input should be used to
make a product or
provide a service.
Price standards
specify how much
should be paid for
each unit of the
input.
Examples: Firestone, Sears, McDonald’s, hospitals,
construction, and manufacturing companies.
8-23
Setting Direct Materials Standards
Standard Price
per Unit
Standard Quantity
per Unit
Final, delivered
cost of materials,
net of discounts.
Summarized in
a Bill of Materials.
8-24
Setting Direct Labor Standards
Standard Rate
per Hour
Standard Hours
per Unit
Often a single
rate is used that reflects
the mix of wages earned.
Use time and
motion studies for
each labor operation.
8-25
Setting Variable Manufacturing Overhead
Standards
Price
Standard
Quantity
Standard
The rate is the
variable portion of the
predetermined overhead
rate.
The quantity is
the activity in the
allocation base for
predetermined overhead.
8-26
The Standard Cost Card
A standard cost card for one unit of
product might look like this:
Inputs
Direct materials
Direct labor
Variable mfg. overhead
Total standard unit cost
A
B
AxB
Standard
Quantity
or Hours
Standard
Price
or Rate
Standard
Cost
per Unit
3.0 lbs.
2.5 hours
2.5 hours
$
$ 4.00 per lb.
14.00 per hour
3.00 per hour
$
12.00
35.00
7.50
54.50
8-27
Using Standards in Flexible Budgets
Standard costs per unit for direct materials, direct
labor, and variable manufacturing overhead can be
used to compute activity and spending variances.
Spending variances become more
useful by breaking them down into
quantity and price variances.
8-28
A General Model for Variance Analysis
Variance Analysis
Quantity Variance
Price Variance
Difference between
actual quantity and
standard quantity
Difference between
actual price and
standard price
8-29
Quantity and Price Standards
Quantity and price standards are
determined separately for two reasons:
The purchasing manager is responsible for raw
material purchase prices and the production manager
is responsible for the quantity of raw material used.
The buying and using activities occur at different times.
Raw material purchases may be held in inventory for a
period of time before being used in production.
8-30
A General Model for Variance Analysis
Variance Analysis
Quantity Variance
Price Variance
Materials quantity variance
Labor efficiency variance
VOH efficiency variance
Materials price variance
Labor rate variance
VOH rate variance
8-31
A General Model for Variance Analysis
(1)
Standard Quantity
Allowed for Actual Output,
at Standard Price
(SQ × SP)
(2)
Actual Quantity
of Input,
at Standard Price
(AQ × SP)
Quantity Variance
(2) – (1)
(3)
Actual Quantity
of Input,
at Actual Price
(AQ × AP)
Price Variance
(3) – (2)
Spending Variance
(3) – (1)
8-32
A General Model for Variance Analysis
Actual quantity is the amount of direct materials, direct
labor, and variable manufacturing overhead actually used.
(1)
Standard Quantity
Allowed for Actual Output,
at Standard Price
(SQ × SP)
(2)
Actual Quantity
of Input,
at Standard Price
(AQ × SP)
Quantity Variance
(2) – (1)
(3)
Actual Quantity
of Input,
at Actual Price
(AQ × AP)
Price Variance
(3) – (2)
Spending Variance
(3) – (1)
8-33
A General Model for Variance Analysis
Standard quantity is the standard quantity allowed
for the actual output of the period.
(1)
Standard Quantity
Allowed for Actual Output,
at Standard Price
(SQ × SP)
(2)
Actual Quantity
of Input,
at Standard Price
(AQ × SP)
Quantity Variance
(2) – (1)
(3)
Actual Quantity
of Input,
at Actual Price
(AQ × AP)
Price Variance
(3) – (2)
Spending Variance
(3) – (1)
8-34
A General Model for Variance Analysis
Actual price is the amount actually
paid for the input used.
(1)
Standard Quantity
Allowed for Actual Output,
at Standard Price
(SQ × SP)
(2)
Actual Quantity
of Input,
at Standard Price
(AQ × SP)
Quantity Variance
(2) – (1)
(3)
Actual Quantity
of Input,
at Actual Price
(AQ × AP)
Price Variance
(3) – (2)
Spending Variance
(3) – (1)
8-35
A General Model for Variance Analysis
Standard price is the amount that should
have been paid for the input used.
(1)
Standard Quantity
Allowed for Actual Output,
at Standard Price
(SQ × SP)
(2)
Actual Quantity
of Input,
at Standard Price
(AQ × SP)
Quantity Variance
(2) – (1)
(3)
Actual Quantity
of Input,
at Actual Price
(AQ × AP)
Price Variance
(3) – (2)
Spending Variance
(3) – (1)
8-36
Materials Variances – An Example
Glacier Peak Outfitters has the following direct
materials standard for the fiberfill in its mountain
parka.
0.1 kg. of fiberfill per parka at $5.00 per kg.
Last month 210 kgs. of fiberfill were purchased and
used to make 2,000 parkas. The materials cost a
total of $1,029.
8-37
Materials Variances Summary
Standard Quantity
×
Standard Price
Actual Quantity
×
Standard Price
Actual Quantity
×
Actual Price
200 kgs.
×
$5.00 per kg.
210 kgs.
×
$5.00 per kg.
210 kgs.
×
$4.90 per kg.
= $1,000
= $1,050
Quantity variance
$50 unfavorable
= $1,029
Price variance
$21 favorable
8-38
Materials Variances Summary
Standard Quantity
×
Standard Price
Actual Quantity
×
Standard Price
Actual Quantity
×
Actual Price
200 kgs.
210 kgs.
210 kgs.
0.1 kg per parka 2,000 parkas
×
×
×
= 200 kgs
$5.00 per kg.
$5.00 per kg.
$4.90 per kg.
= $1,000
= $1,050
Quantity variance
$50 unfavorable
= $1,029
Price variance
$21 favorable
8-39
Materials Variances Summary
Standard Quantity
×
Standard Price
Actual Quantity
×
Standard Price
Actual Quantity
×
Actual Price
200 kgs.
×
$5.00 per kg.
210 kgs.
× 210 kgs
$1,029
$5.00
per kg.
= $4.90
per kg
210 kgs.
×
$4.90 per kg.
= $1,000
= $1,050
Quantity variance
$50 unfavorable
= $1,029
Price variance
$21 favorable
8-40
Materials Variances:
Using the Factored Equations
Materials quantity variance
MQV = (AQ × SP) – (SQ × SP)
= SP(AQ – SQ)
= $5.00/kg (210 kgs – (0.1 kg/parka 2,000 parkas))
= $5.00/kg (210 kgs – 200 kgs)
= $5.00/kg (10 kgs) = $50 U
Materials price variance
MPV = (AQ × AP) – (AQ × SP)
= AQ(AP – SP)
= 210 kgs ($4.90/kg – $5.00/kg)
= 210 kgs (– $0.10/kg) = $21 F
8-41
Responsibility for Materials
Variances
Materials Quantity Variance
Materials Price Variance
Production Manager
Purchasing Manager
The standard price is used to compute the quantity variance
so that the production manager is not held responsible for
the purchasing manager’s performance.
8-42
Responsibility for Materials Variances
I am not responsible for
this unfavorable materials
quantity variance.
You purchased cheap
material, so my people
had to use more of it.
Production Manager
Your poor scheduling
sometimes requires me to
rush order materials at a
higher price, causing
unfavorable price variances.
Purchasing Manager
8-43
Labor Variances – An Example
Glacier Peak Outfitters has the following direct labor
standard for its mountain parka.
1.2 standard hours per parka at $10.00 per hour
Last month, employees actually worked 2,500 hours
at a total labor cost of $26,250 to make 2,000
parkas.
8-44
Labor Variances Summary
Standard Hours
×
Standard Rate
Actual Hours
×
Standard Rate
Actual Hours
×
Actual Rate
2,400 hours
×
$10.00 per hour
2,500 hours
×
$10.00 per hour
2,500 hours
×
$10.50 per hour
= $24,000
= $25,000
= $26,250
Efficiency variance
$1,000 unfavorable
Rate variance
$1,250 unfavorable
8-45
Labor Variances Summary
Standard Hours
×
Standard Rate
2,400 hours
×
$10.00 per hour
= $24,000
Actual Hours
×
Standard Rate
Actual Hours
×
Actual Rate
2,500 hours
2,500 hours
1.2 hours per
× parka 2,000
×
parkasper
= 2,400
$10.00
hour hours$10.50 per hour
= $25,000
Efficiency variance
$1,000 unfavorable
= $26,250
Rate variance
$1,250 unfavorable
8-46
Labor Variances Summary
Standard Hours
×
Standard Rate
Actual Hours
×
Standard Rate
Actual Hours
×
Actual Rate
2,400 hours
2,500 hours
×
× hours
$26,250 2,500
$10.00 per hour = $10.50
$10.00per
perhour
hour
2,500 hours
×
$10.50 per hour
= $24,000
= $25,000
Efficiency variance
$1,000 unfavorable
= $26,250
Rate variance
$1,250 unfavorable
8-47
Labor Variances: Using the Factored
Equations
Labor efficiency variance
LEV = (AH × SR) – (SH × SR)
= SR (AH – SH)
= $10.00 per hour (2,500 hours – 2,400 hours)
= $10.00 per hour (100 hours)
= $1,000 unfavorable
Labor rate variance
LRV = (AH × AR) – (AH × SR)
= AH (AR – SR)
= 2,500 hours ($10.50 per hour – $10.00 per hour)
= 2,500 hours ($0.50 per hour)
= $1,250 unfavorable
8-48
Responsibility for Labor Variances
Production managers are
usually held accountable
for labor variances
because they can
influence the:
Mix of skill levels
assigned to work tasks.
Level of employee
motivation.
Quality of production
supervision.
Production Manager
Quality of training
provided to employees.
8-49
Responsibility for Labor Variances
I am not responsible for
the unfavorable labor
efficiency variance!
You purchased cheap
material, so it took more
time to process it.
I think it took more time
to process the
materials because the
Maintenance
Department has poorly
maintained your
equipment.
8-50
Variable Manufacturing Overhead
Variances – An Example
Glacier Peak Outfitters has the following direct
variable manufacturing overhead labor standard for
its mountain parka.
1.2 standard hours per parka at $4.00 per hour
Last month, employees actually worked 2,500 hours
to make 2,000 parkas. Actual variable
manufacturing overhead for the month was
$10,500.
8-51
Variable Manufacturing Overhead
Variances Summary
Standard Hours
×
Standard Rate
2,400 hours
×
$4.00 per hour
= $9,600
Actual Hours
×
Standard Rate
2,500 hours
×
$4.00 per hour
Actual Hours
×
Actual Rate
2,500 hours
×
$4.20 per hour
= $10,000
= $10,500
Efficiency variance
$400 unfavorable
Rate variance
$500 unfavorable
8-52
Variable Manufacturing Overhead
Variances Summary
Standard Hours
Actual Hours
Actual Hours
×
×
×
Standard Rate
Standard Rate
Actual Rate
2,400 hours
2,500 hours
2,500 hours
×
× parka 2,000
×
1.2 hours per
$4.00 per hour
$4.00 per
hour hours $4.20 per hour
parkas
= 2,400
= $9,600
= $10,000
Efficiency variance
$400 unfavorable
= $10,500
Rate variance
$500 unfavorable
8-53
Variable Manufacturing Overhead
Variances Summary
Standard Hours
Actual Hours
×
×
Standard Rate
Standard Rate
2,400 hours
2,500 hours
×
× hours
$10,500 2,500
$4.00 per hour
$4.00 per
per hour
hour
= $4.20
= $9,600
= $10,000
Efficiency variance
$400 unfavorable
Actual Hours
×
Actual Rate
2,500 hours
×
$4.20 per hour
= $10,500
Rate variance
$500 unfavorable
8-54
Variable Manufacturing Overhead
Variances: Using Factored Equations
Variable manufacturing overhead efficiency variance
VMEV = (AH × SR) – (SH – SR)
= SR (AH – SH)
= $4.00 per hour (2,500 hours – 2,400 hours)
= $4.00 per hour (100 hours)
= $400 unfavorable
Variable manufacturing overhead rate variance
VMRV = (AH × AR) – (AH – SR)
= AH (AR – SR)
= 2,500 hours ($4.20 per hour – $4.00 per hour)
= 2,500 hours ($0.20 per hour)
= $500 unfavorable
8-55
Materials Variances―An Important
Subtlety
The quantity variance
is computed only on
the quantity used.
The price variance is
computed on the entire
quantity purchased.
8-56
Materials Variances―An Important
Subtlety
Glacier Peak Outfitters has the following direct
materials standard for the fiberfill in its mountain
parka.
0.1 kg. of fiberfill per parka at $5.00 per kg.
Last month 210 kgs. of fiberfill were purchased at a
cost of $1,029. Glacier used 200 kgs. to make
2,000 parkas.
8-57
Materials Variances―An Important
Subtlety
Standard Quantity
×
Standard Price
Actual Quantity
×
Standard Price
200 kgs.
×
$5.00 per kg.
200 kgs.
×
$5.00 per kg.
= $1,000
= $1,000
Quantity variance
$0
8-58
Materials Variances―An Important
Subtlety
Actual Quantity
×
Standard Price
Actual Quantity
×
Actual Price
210 kgs.
×
$5.00 per kg.
210 kgs.
×
$4.90 per kg.
= $1,050
= $1,029
Price variance
$21 favorable
8-59
Variance Analysis and Management by
Exception
How do I know
which variances to
investigate?
Larger variances, in
dollar amount or as
a percentage of the
standard, are
investigated first.
8-60
Advantages of Standard Costs
Management by
exception
Promotes economy
and efficiency
Advantages
Simplified
bookkeeping
Enhances
responsibility
accounting
8-61
Potential Problems with Standard Costs
Emphasizing standards
may exclude other
important objectives.
Standard cost
reports may
not be timely.
Invalid assumptions
about the relationship
between labor
cost and output.
Potential
Problems
Favorable
variances may
be misinterpreted.
Emphasis on
negative may
impact morale.
Continuous
improvement may
be more important
than meeting standards.
8-62
PREDETERMINED OVERHEAD
RATES AND OVERHEAD
ANALYSIS IN A STANDARD
COSTING SYSTEM
Appendix 8A
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Fixed Overhead Volume Variance
Fixed
Overhead
Applied
Budgeted
Fixed
Overhead
Actual
Fixed
Overhead
Volume
variance
Volume
variance
=
Budgeted
fixed
overhead
–
Fixed
overhead
applied to
work in process
8-64
Fixed Overhead Volume Variance
Fixed
Overhead
Applied
Budgeted
Fixed
Overhead
DH × FR
SH × FR
Actual
Fixed
Overhead
Volume
variance
Volume variance
=
FPOHR × (DH – SH)
FPOHR = Fixed portion of the predetermined overhead rate
DH = Denominator hours
SH = Standard hours allowed for actual output
8-65
Fixed Overhead Budget Variance
Fixed
Overhead
Applied
Budgeted
Fixed
Overhead
Actual
Fixed
Overhead
Budget
variance
Budget
variance
=
Actual
fixed
overhead
–
Budgeted
fixed
overhead
8-66
Computing Fixed Overhead Variances
ColaCo
Production and Machine-Hour Data
Budgeted production
Standard machine-hours per unit
Budgeted machine-hours
Actual production
Standard machine-hours allowed for the actual production
Actual machine-hours
30,000 units
3 hours
90,000 hours
28,000 units
84,000 hours
88,000 hours
8-67
Computing Fixed Overhead Variances
ColaCo
Cost Data
Budgeted variable manufacturing overhead
Budgeted fixed manufacturing overhead
Total budgeted manufacturing overhead
$
Actual variable manufacturing overhead
Actual fixed manufacturing overhead
Total actual manufacturing overhead
$
$
$
90,000
270,000
360,000
100,000
280,000
380,000
8-68
Predetermined Overhead Rates
Predetermined
Estimated total manufacturing overhead cost
=
overhead rate
Estimated total amount of the allocation base
Predetermined
$360,000
=
overhead rate
90,000 Machine-hours
Predetermined
= $4.00 per machine-hour
overhead rate
8-69
Predetermined Overhead Rates
Variable component of the
predetermined overhead rate
$90,000
=
90,000 Machine-hours
Variable component of the
predetermined overhead rate
= $1.00 per machine-hour
Fixed component of the
predetermined overhead rate
$270,000
=
90,000 Machine-hours
Fixed component of the
predetermined overhead rate
= $3.00 per machine-hour
8-70
Applying Manufacturing Overhead
Overhead
applied
=
Predetermined
overhead rate
Standard hours allowed
×
for the actual output
Overhead
applied
=
$4.00 per
machine-hour
× 84,000 machine-hours
Overhead
applied
=
$336,000
8-71
Computing the Volume Variance
Volume
variance
=
Budgeted
fixed
overhead
–
(
Fixed
overhead
applied to
work in process
)
$3.00 per
$84,000
×
machine-hour
machine-hours
Volume
variance
= $270,000 –
Volume
variance
= $18,000 Unfavorable
8-72
Computing the Volume Variance
Volume variance
=
FPOHR × (DH – SH)
FPOHR = Fixed portion of the predetermined overhead rate
DH = Denominator hours
SH = Standard hours allowed for actual output
(
)
Volume
variance
$3.00 per
90,000
84,000
=
–
×
machine-hour
mach-hours
mach-hours
Volume
variance
= 18,000 Unfavorable
8-73
Computing the Budget Variance
Budget
variance
=
Actual
fixed
overhead
Budget
variance
=
$280,000 – $270,000
Budget
variance
=
$10,000 Unfavorable
–
Budgeted
fixed
overhead
8-74
A Pictorial View of the Variances
Fixed Overhead
Applied to
Work in Process
252,000
Budgeted
Fixed
Overhead
270,000
Volume variance,
$18,000 unfavorable
Actual
Fixed
Overhead
280,000
Budget variance,
$10,000 unfavorable
Total variance, $28,000 unfavorable
8-75
Fixed Overhead Variances –
A Graphic Approach
Let’s look at a
graph showing
fixed overhead
variances. We will
use ColaCo’s
numbers from the
previous example.
8-76
Graphic Analysis of Fixed
Overhead Variances
Budget
$270,000
Denominator
hours
0
0
Machine-hours (000)
90
8-77
Graphic Analysis of Fixed
Overhead Variances
Actual
$280,000
Budget
$270,000
{ Budget Variance 10,000 U
Denominator
hours
0
0
Machine-hours (000)
90
8-78
Graphic Analysis of Fixed
Overhead Variances
Actual
$280,000
Budget
$270,000
Applied
$252,000
{ Budget Variance 10,000 U
{ Volume Variance 18,000 U
Standard
hours
Denominator
hours
0
0
Machine-hours (000)
84
90
8-79
Reconciling Overhead Variances and
Underapplied or Overapplied Overhead
In a standard
cost system:
Unfavorable
variances are equivalent
to underapplied overhead.
Favorable
variances are equivalent
to overapplied overhead.
The sum of the overhead variances
equals the under- or overapplied
overhead cost for the period.
8-80
Reconciling Overhead Variances and
Underapplied or Overapplied Overhead
ColaCo
Computation of Underapplied Overhead
Predetermined overhead rate (a)
Standard hours allowed for the actual output (b)
Manufacturing overhead applied (a) × (b)
Actual manufacturing overhead
Manufacturing overhead underapplied or
overapplied
$
$
$
4.00 per machine-hour
84,000 machine-hours
336,000
380,000
$
44,000 underapplied
8-81
Computing the Variable Overhead
Variances
Variable manufacturing overhead efficiency variance
VMEV = (AH × SR) – (SH × SR)
= $88,000 – (84,000 hours × $1.00 per hour)
= $4,000 unfavorable
8-82
Computing the Variable Overhead
Variances
Variable manufacturing overhead rate variance
VMRV = (AH × AR) – (AH × SR)
= $100,000 – (88,000 hours × $1.00 per hour)
= $12,000 unfavorable
8-83
Computing the Sum of All Variances
ColaCo
Computing the Sum of All variances
Variable overhead rate variance
Variable overhead efficiency variance
Fixed overhead budget variance
Fixed overhead volume variance
Total of the overhead variances
$
$
12,000 U
4,000 U
10,000 U
18,000 U
44,000 U
8-84
GENERAL LEDGER ENTRIES TO
RECORD VARIANCES
Appendix 8B
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Glacier Peak Outfitters ― Revisited
We will use information from the Glacier Peak Outfitters
example presented earlier in the chapter to illustrate journal
entries for standard cost variances. Recall the following:
Material
Labor
AQ × AP = $1,029
AQ × SP = $1,050
SQ × SP = $1,000
MPV = $21 F
MQV = $50 U
AH × AR = $26,250
AH × SR = $25,000
SH × SR = $24,000
LRV = $1,250 U
LEV = $1,000 U
Now, let’s prepare the entries to record
the labor and material variances.
8-86
Recording Materials Variances
GENERAL JOURNAL
Date
Description
Raw Materials
Post.
Ref.
Page 4
Debit
Credit
1,050
Materials Price Variance
21
Accounts Payable
1,029
To record the purchase of material
Work in Process
Materials Quantity Variance
Raw Materials
1,000
50
1,050
To record the use of material
8-87
Recording Labor Variances
GENERAL JOURNAL
Date
Description
Post.
Ref.
Page 4
Debit
Work in Process
24,000
Labor Rate Variance
1,250
Labor Efficiency Variance
1,000
Wages Payable
Credit
26,250
To record direct labor
8-88
Cost Flows in a Standard Cost System
Inventories are recorded at standard cost.
Variances are recorded as follows:
Favorable variances are credits, representing
savings in production costs.
Unfavorable variances are debits, representing
excess production costs.
Standard cost variances are usually closed out
to cost of goods sold.
Unfavorable variances increase cost of goods sold.
Favorable variances decrease cost of goods sold.
8-89
End of Chapter 08
8-90
Performance
Measurement in
Decentralized
Organizations
Chapter 09
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Decentralization in Organizations
Benefits of
Decentralization
Top management
freed to concentrate
on strategy.
Lower-level decisions
often based on
better information. Lower-level managers
can respond quickly to
customers.
Lower-level managers
gain experience in
Decision making.
Decision-making
authority leads to
job satisfaction.
9-2
Decentralization in Organizations
May be a lack of
coordination among
autonomous
managers.
Lower-level manager’s
objectives may not
be those of the
organization.
Lower-level managers
may make decisions
without seeing the
“big picture.”
Disadvantages of
Decentralization
May be difficult to
spread innovative ideas
in the organization.
9-3
Cost, Profit, and Investment Centers
Cost
Center
Cost, profit,
and investment
centers are all
known as
responsibility
centers.
Profit
Center
Investment
Center
Responsibility
Center
9-4
Cost Center
A segment whose manager has control
over costs, but not over revenues or
investment funds.
9-5
Profit Center
A segment whose
manager has control
over both costs and
revenues,
but no control over
investment funds.
Revenues
Sales
Interest
Other
Costs
Mfg. costs
Commissions
Salaries
Other
9-6
Investment Center
Corporate Headquarters
A segment whose
manager has control
over costs,
revenues, and
investments in
operating assets.
9-7
Return on Investment (ROI) Formula
Income before interest
and taxes (EBIT)
Net operating income
ROI =
Average operating assets
Cash, accounts receivable, inventory,
plant and equipment, and other
productive assets.
9-8
Net Book Value versus Gross Cost
Most companies use the net book value of
depreciable assets to calculate average
operating assets.
Acquisition cost
Less: Accumulated depreciation
Net book value
9-9
Understanding ROI
Net operating income
ROI =
Average operating assets
Net operating income
Margin =
Sales
Sales
Turnover =
Average operating assets
ROI = Margin Turnover
9-10
Increasing ROI – An Example
Regal Company reports the following:
Net operating income
$ 30,000
Average operating assets
Sales
Operating expenses
$ 200,000
$ 500,000
$ 470,000
What is Regal Company’s ROI?
ROI = Margin Turnover
ROI =
Net operating income
Sales
Sales
× Average operating assets
9-11
Increasing ROI – An Example
ROI = Margin Turnover
ROI =
Net operating income
Sales
$30,000
ROI =
$500,000
Sales
× Average operating assets
$500,000
×
$200,000
ROI = 6% 2.5 = 15%
9-12
Investing in Operating Assets to Increase
Sales
Assume that Regal’s manager invests in a $30,000
piece of equipment that increases sales by
$35,000, while increasing operating expenses
by $15,000.
Regal Company reports the following:
Net operating income
Average operating assets
Sales
Operating expenses
$ 50,000
$ 230,000
$ 535,000
$ 485,000
Let’s calculate the new ROI.
9-13
Investing in Operating Assets to Increase
Sales
ROI = Margin Turnover
ROI =
Net operating income
Sales
ROI = $50,000
$535,000
Sales
× Average operating assets
$535,000
×
$230,000
ROI = 9.35% 2.33 = 21.8%
ROI increased from 15% to 21.8%.
9-14
Criticisms of ROI
In the absence of the balanced
scorecard, management may
not know how to increase ROI.
Managers often inherit many
committed costs over which
they have no control.
Managers evaluated on ROI
may reject profitable
investment opportunities.
9-15
Residual Income – Another Measure of
Performance
Net operating income
above some minimum
return on operating
assets
9-16
Calculating Residual Income
Residual
=
income
Net
operating income
(
Average
operating
assets
Minimum
required rate of
return
)
This computation differs from ROI.
ROI measures net operating income earned relative
to the investment in average operating assets.
Residual income measures net operating income
earned less the minimum required return on average
operating assets.
9-17
Residual Income – An Example
•The Retail Division of Zephyr, Inc., has
average operating assets of $100,000 and is
required to earn a return of 20% on these
assets.
•In the current period, the division earns
$30,000.
Let’s calculate residual income.
9-18
Residual Income – An Example
Operating assets
$ 100,000
Required rate of return ×
20%
Minimum required return $ 20,000
Actual income
$ 30,000
Minimum required return (20,000)
Residual income
$ 10,000
9-19
Motivation and Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.
9-20
Divisional Comparisons and Residual
Income
The residual
income approach
has one major
disadvantage.
It cannot be used
to compare the
performance of
divisions of
different sizes.
9-21
Zephyr, Inc. – Continued
Recall the following
information for the Retail
Division of Zephyr, Inc.
Assume the following
information for the Wholesale
Division of Zephyr, Inc.
Retail
Wholesale
Operating assets
$ 100,000 $ 1,000,000
Required rate of return ×
20%
20%
Minimum required return $ 20,000 $ 200,000
Retail
Wholesale
Actual income
$ 30,000 $ 220,000
Minimum required return
(20,000)
(200,000)
Residual income
$ 10,000 $
20,000
9-22
Zephyr, Inc. – Continued
The residual income numbers suggest that the Wholesale Division outperformed
the Retail Division because its residual income is $10,000 higher. However, the
Retail Division earned an ROI of 30% compared to an ROI of 22% for the
Wholesale Division. The Wholesale Division’s residual income is larger than the
Retail Division simply because it is a bigger division.
Retail
Wholesale
Operating assets
$ 100,000 $ 1,000,000
Required rate of return ×
20%
20%
Minimum required return $ 20,000 $ 200,000
Retail
Wholesale
Actual income
$ 30,000 $ 220,000
Minimum required return
(20,000)
(200,000)
Residual income
$ 10,000 $
20,000
9-23
Delivery Performance Measures
Order
Received
Wait Time
Production
Started
Goods
Shipped
Process Time + Inspection Time
+ Move Time + Queue Time
Throughput Time
Delivery Cycle Time
Process time is the only value-added time.
9-24
Delivery Performance Measures
Order
Received
Wait Time
Production
Started
Goods
Shipped
Process Time + Inspection Time
+ Move Time + Queue Time
Throughput Time
Delivery Cycle Time
Manufacturing
Cycle
=
Efficiency
Value-added time
Manufacturing cycle time
9-25
The Balanced Scorecard
Management translates its strategy into
performance measures that employees
understand and influence.
Customer
Financial
Performance
measures
Internal
business
processes
Learning
and growth
9-26
The Balanced Scorecard: From
Strategy to Performance Measures
Performance Measures
What are our
financial goals?
Vision
and
Strategy
What customers do
we want to serve and
how are we going to
win and retain them?
What internal business processes are
critical to providing
value to customers?
Financial
Has our financial
performance improved?
Customer
Do customers recognize that
we are delivering more value?
Internal Business Processes
Have we improved key business
processes so that we can deliver
more value to customers?
Learning and Growth
Are we maintaining our ability
to change and improve?
9-27
The Balanced Scorecard:
Non-financial Measures
The balanced scorecard relies on nonfinancial measures
in addition to financial measures for two reasons:
Financial measures are lag indicators that summarize
the results of past actions. Nonfinancial measures are
leading indicators of future financial performance.
Top managers are ordinarily responsible for financial
performance measures, not lower-level managers.
Nonfinancial measures are more likely to be
understood and controlled by lower-level managers.
9-28
The Balanced Scorecard for Individuals
The entire organization
should have an overall
balanced scorecard.
Each individual should
have a personal
balanced scorecard.
A personal balanced scorecard should contain measures that can be
influenced by the individual being evaluated and that
support the measures in the overall balanced scorecard.
9-29
The Balanced Scorecard
A balanced scorecard should have measures
that are linked together on a cause-and-effect basis.
If we improve
one performance
measure . . .
Then
Another desired
performance measure
will improve.
The balanced scorecard lays out concrete
actions to attain desired outcomes.
9-30
The Balanced Scorecard and
Compensation
Incentive compensation should be linked to
balanced scorecard performance
measures.
9-31
The Balanced Scorecard ─ Jaguar
Example
Profit
Financial
Contribution per car
Number of cars sold
Customer
Customer satisfaction
with options
Internal
Business
Processes
Learning
and Growth
Number of
options available
Time to
install option
Employee skills in
installing options
9-32
The Balanced Scorecard ─ Jaguar
Example
Profit
Contribution per car
Number of cars sold
Customer satisfaction
with options
Results
Satisfaction
Increases
Strategies
Increase
Options
Increase
Skills
Number of
options available
Time to
install option
Time
Decreases
Employee skills in
installing options
9-33
The Balanced Scorecard ─ Jaguar
Example
Profit
Contribution per car
Results
Number of cars sold
Customer satisfaction
with options
Number of
options available
Cars sold
Increase
Satisfaction
Increases
Time to
install option
Employee skills in
installing options
9-34
The Balanced Scorecard ─ Jaguar
Example
Profit
Results
Contribution per car
Contribution
Increases
Number of cars sold
Customer satisfaction
with options
Number of
options available
Time to
install option
Satisfaction
Increases
Time
Decreases
Employee skills in
installing options
9-35
The Balanced Scorecard ─ Jaguar
Example
Profit
If number
of cars sold
and contribution
per car increase,
profit should
increase.
Results
Profits
Increase
Contribution per car
Contribution
Increases
Number of cars sold
Cars Sold
Increases
Customer satisfaction
with options
Number of
options available
Time to
install option
Employee skills in
installing options
9-36
End of Chapter 09
9-37
Differential Analysis: The
Key to Decision Making
Chapter 10
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Relevant Costs and Benefits
A relevant cost is a cost that differs
between alternatives.
A relevant benefit is a benefit that
differs between alternatives.
10-2
Identifying Relevant Costs
An avoidable cost is a cost that can be
eliminated, in whole or in part, by choosing
one alternative over another. Avoidable costs
are relevant costs. Unavoidable costs are
irrelevant costs.
Two broad categories of costs are never relevant in
any decision. They include:
Sunk costs.
A future cost that does not differ between the
alternatives.
10-3
Keys to Successful Decision-Making
1. Focus only on relevant costs (also called avoidable
costs, differential costs, or incremental costs) and
relevant benefits (also called differential benefits or
incremental benefits).
2. Ignore everything else including sunk costs and
future costs and benefits that do not differ between
the alternatives.
10-4
Different Costs for Different Purposes
Costs that are
relevant in one
decision situation
may not be relevant
in another context.
Thus, in each
decision situation,
the manager must
examine the data at
hand and isolate the
relevant costs.
10-5
Total and Differential Cost Approaches
Using the differential cost approach is
desirable for two reasons:
1. Only rarely will enough information be
available to prepare detailed income
statements for both alternatives.
2. Mingling irrelevant costs with relevant costs
may cause confusion and distract attention
away from the information that is really
critical.
10-6
Adding/Dropping Segments
One of the most important
decisions managers make
is whether to add or drop a
business segment.
Ultimately, a decision to
drop an old segment or add
a new one is going to hinge
primarily on the impact the
decision will have on net
operating income.
To assess this
impact, it is
necessary to
carefully analyze
the costs.
10-7
A Contribution Margin Approach
DECISION RULE
Lovell should drop the digital watch
segment only if its profit would
increase.
Lovell will compare the contribution
margin that would be lost to the costs
that would be avoided if the line was to
be dropped.
10-8
The Make or Buy Analysis
When a company is involved in more than
one activity in the entire value chain, it is
vertically integrated. A decision to carry
out one of the activities in the value chain
internally, rather than to buy externally
from a supplier is called a “make or buy”
decision.
10-9
Key Terms and Concepts
A special order is a one-time
order that is not considered
part of the company’s normal
ongoing business.
When analyzing a special
order, only the incremental
costs and benefits are
relevant.
Since the existing fixed
manufacturing overhead costs
would not be affected by the
order, they are not relevant.
10-10
Key Terms and Concepts
When a limited resource of
some type restricts the
company’s ability to satisfy
demand, the company is
said to have a constraint.
The machine or
process that is
limiting overall output
is called the
bottleneck – it is the
constraint.
10-11
Utilization of a Constrained Resource
• Fixed costs are usually unaffected in these situations,
so the product mix that maximizes the company’s
total contribution margin should ordinarily be
selected.
• A company should not necessarily promote those
products that have the highest unit contribution
margins.
• Rather, total contribution margin will be maximized by
promoting those products or accepting those orders
that provide the highest contribution margin in
relation to the constraining resource.
10-12
Managing Constraints
It is often possible for a manager to increase the capacity of a
bottleneck, which is called relaxing (or elevating) the constraint,
in numerous ways such as:
1. Working overtime on the bottleneck.
2. Subcontracting some of the processing that would be done
at the bottleneck.
3. Investing in additional machines at the bottleneck.
4. Shifting workers from non-bottleneck processes to the
bottleneck.
5. Focusing business process improvement efforts on the
bottleneck.
6. Reducing defective units processed through the bottleneck.
These methods and ideas are all consistent with the Theory
of Constraints, which was introduced in Chapter 1.
10-13
Joint Costs
• In some industries, a number of end
products are produced from a single raw
material input.
• Two or more products produced from a
common input are called joint products.
• The point in the manufacturing process
where each joint product can be
recognized as a separate product is called
the split-off point.
10-14
Sell or Process Further
Joint costs are irrelevant in decisions regarding
what to do with a product from the split-off point
forward. Therefore, these costs should not be
allocated to end products for decision-making
purposes.
With respect to sell or process further decisions, it is
profitable to continue processing a joint product
after the split-off point so long as the incremental
revenue from such processing exceeds the
incremental processing costs incurred after the
split-off point.
10-15
End of Chapter 10
10-16
Capital Budgeting Decisions
Chapter 11
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Typical Capital Budgeting Decisions
Plant expansion
Equipment selection
Equipment replacement
Lease or buy
Cost reduction
11-2
Typical Capital Budgeting Decisions
Capital budgeting tends to fall into two broad
categories.
1. Screening decisions. Does a proposed
project meet some preset standard of
acceptance?
2. Preference decisions. Selecting from
among several competing courses of action.
11-3
Time Value of Money
A dollar today is worth
more than a dollar a
year from now.
Therefore, projects that
promise earlier returns
are preferable to those
that promise later
returns.
11-4
Time Value of Money
The capital
budgeting
techniques that best
recognize the time
value of money are
those that involve
discounted cash
flows.
11-5
The Net Present Value Method
To determine net present value we . . .
• Calculate the present value of cash
inflows,
• Calculate the present value of cash
outflows,
• Subtract the present value of the outflows
from the present value of the inflows.
11-6
The Net Present Value Method
If the Net Present
Value is . . .
Then the Project is . . .
Positive . . .
Acceptable because it promises
a return greater than the
required rate of return.
Zero . . .
Acceptable because it promises
a return equal to the required
rate of return.
Negative . . .
Not acceptable because it
promises a return less than the
required rate of return.
11-7
The Net Present Value Method
Net present value analysis
emphasizes cash flows and not
accounting net income.
The reason is that
accounting net income is
based on accruals that
ignore the timing of cash
flows into and out of an
organization.
11-8
Choosing a Discount Rate
• The firm’s cost of capital is usually
regarded as the minimum required rate of
return.
• The cost of capital is the average rate of
return the company must pay to its longterm creditors and stockholders for the use
of their funds.
• The cost of capital is usually regarded as
the minimum required rate of return. When
the cost of capital is used as the discount
rate, it serves as a screening device in net
present value analysis.
11-9
Preference Decision – The Ranking of Investment
Projects
Screening Decisions
Preference Decisions
Pertain to whether or
not some proposed
investment is
acceptable; these
decisions come first.
Attempt to rank
acceptable
alternatives from the
most to least
appealing.
11-10
Net Present Value Method
The net present value of one project cannot
be directly compared to the net present
value of another project unless the
investments are equal.
11-11
The Payback Method
The payback period is the length of time that it
takes for a project to recover its initial cost out
of the cash receipts that it generates.
When the annual net cash inflow is the same
each year, this formula can be used to compute
the payback period:
Payback period =
Investment required
Annual net cash inflow
11-12
Simple Rate of Return Method
Does not focus on cash flows – rather, it focuses on
accounting net operating income.
The following formula is used to calculate the simple
rate of return:
Simple rate Annual incremental net operating income
=
of return
Initial investment*
*Should be reduced by any salvage from the sale of the old equipment
11-13
Postaudit of Investment Projects
A postaudit is a follow-up after the project
has been completed to see whether or not
expected results were actually realized.
11-14
End of Chapter 11
11-15
Statement of Cash Flows
Chapter 12
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Statement of Cash Flows
Income
Statement
Balance
Sheet
Statement of
Cash Flows
The statement of cash flows highlights the major activities
that impact cash flows and ,hence, affect the overall cash
balance.
12-2
Purpose of the Statement of Cash Flows
Are cash flows
sufficient to
support ongoing
operations?
Will the company
have to borrow
money to make
needed
investments?
Can we pay
debts?
Why is there a
difference
between net
income and net
cash flow?
Can we pay
dividends?
12-3
A Fundamental Principle
Cash Balance = Noncash Balance Sheet Accounts
This principle ensures that properly
analyzing the changes in all noncash
balance sheet accounts always
quantifies the cash inflows and
outflows that explain the change in the
cash balance.
12-4
A Review of Basic Equations
Basic Equation for Asset Accounts
Beginning balance + Debits – Credits = Ending balance
Basic Equation for Contra-Asset, Liability, and
Stockholders’ Equity Accounts
Beginning balance – Debits + Credits = Ending balance
12-5
Statement of Cash Flows: Key Concepts
The term cash on the statement of cash flows refers
broadly to both currency and cash equivalents.
Cash
Currency and
Bank Accounts
Cash
Equivalents
Treasury Commercial Money Market
Funds
Bills
Paper
12-6
Organizing a Statement of Cash Flows
Operating
Activities
Revenue and expense
transactions that affect
net income.
Investing
Activities
Acquiring or disposing of
noncurrent assets.
Financing
Activities
Borrowing from and
repaying principal to
creditors and transactions
with stockholders.
12-7
Organizing a Statement of Cash Flows
12-8
Operating Activities: Direct or Indirect
Method?
Direct Method
Indirect Method
Reconstructs the
income statement
on a cash basis
from top to bottom
Accrual net
income is adjusted
to a cash basis;
Used by 99%
Both methods result in the exact same amount of
cash provided by operating activities.
12-9
The Indirect Method: A Three-Step
Process
Step 1
Add depreciation
charges to net
income.
Step 2
Analyze net changes
in noncash balance
sheet accounts.
Step 3
Adjust for gains and
losses.
12-10
Summary of Key Concepts
12-11
Summary of Key Concepts
12-12
Free Cash Flows
Free cash flow measures a company’s ability to
fund its capital expenditures and dividends from
its net cash provided by operating activities.
Net Cash Provided by
Free Cash Flow =
Operating Activities
–
Capital
Expenditures
– Dividends
12-13
Earnings Quality
Managers generally perceive that
earnings are of higher quality
when the earnings:
1. are not unduly influenced by
inflation,
2. are computed using
conservative accounting
principles and estimates, and
3. are correlated with net cash
provided by operating
activities.
12-14
Computing Net Cash Provided by
Operating Activities
The direct method computes
net cash provided by operating
activities by reconstructing the
income statement on a cash
basis from top to bottom.
Net cash provided by operating
activities under the direct method will
always agree with the amount
computed using the indirect method.
12-15
Similarities and Differences in Handling
Data
Adjustments for accounts
that affect revenue are the
same in the direct and
indirect methods.
Adjustments for accounts
that affect expenses are
handled in opposite ways
for the direct and indirect
methods.
12-16
Similarities and Differences in Handling
Data
Under the direct method,
no adjustments for gains
and losses on the sale of
assets are needed.
12-17
Special Rules—Direct and Indirect Methods
Direct Method
Indirect Method
Requires a
reconciliation
between net
income and the net
cash provided by
operating
activities
Requires
disclosure of
amount of interest
and income taxes
paid during the
year
12-18
End of Chapter 12
12-19
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