Decentralization
the degree of decision making authority granted to subordinates in the firm (makes performance evals. hard)
Control System Design
1st-best solution: base compensation & promotion on actions/hard work & effort (behavior based, rarely feasible so...) 2nd best solution: rewards based on results (outcome based)
Responsibility Centers
separate, identifiable segments of an organization that have decision rights/control over cost, revenue, or investment/asset decisions
3 types - cost, profit, investment centers
Types of Responsibility Centers
Cost Center - managers have control over costs/input mix
Profit Center - managers have control over revenues & costs
Investment center - managers have control over costs, revenues, & investment decisions
Controllable Costs
Definition
costs incurred directly by a level of responsibility that are controllable at that level
Non-Controllable Costs
costs incurred indirectly which are allocated to a responsibility level
Common/Indirect Costs
caused by activities throughout the company that don't relate to one particular segment
Actions taken by a segment won't affect Total Common Cost - only the amount allocated to that segment
Differences w/ Internal Reports & GAPP
1-Cost is organized by Behavior (VC/FC); use contribution format
2-Only direct costs included (don't allocate common costs to Responsibility Centers)
ROI
sales margin x asset turnover
=income/sales x sales/avg. assets
RI (residual income)
income - target income
=income - (hurdle rate x avg. assets)
Problems w/ financial performance measures
accounting manipulations
short-run opportunistic behavior
financial entrepreneurship
Advantages with financial performance measures
innovation
balanced scorecard
activity based management
operational measures
Transfer Price
price paid for intracompany transfers of goods/services b/w segments or divisions
intracompany sales are all eliminated in consolidation; therefore, the company as a whole doesn't care about the dollar amount
Revenues include...
sales to outsiders at market price & sales to other segments at transfer prices
Costs include...
payments to external companies at market price & to other segments at transfer price
Transfer Price Considerations
interdependence, decentralization, taxes, & financial reporting (GAPP)
Transfer Price Objectives
1 - goal congruence
2 - cost efficiency
3 - divisional autonomy
Transfer Price Pricing Systems
1 - cost based
2 - market based
3 - negotiated
When can all transfer pricing objectives be met?
when prices are based on opportunity cost to seller
Market Based System at Excess Capacity
opportunity cost is the incremental cost of output - close to variable cost (transfer at minimum of VC b/c FC stay the same)
Problems of Market Based System
Lack of an active market, biased external quotes, outside buying may be limited, & seller may have excess capacity
Cost-Based System
always leads to sub-optimization
(only meets 3rd objective (divisional autonomy)but it's easy to understand/calculate)
Negotiated Based Sytem
meets all 3 objectives & is consistent w/ decentralization
BUT sub-optimization may occur
Should/Will they transfer???
Should they? consider the effects on company profits.
Will they? consider effects on segment margin.
Incremental Analysis
decisions involve a choice among alternative courses of action (aka differential analysis)
Relevant Data
data that vary/change in the future among alternatives
Steps in Management's Decision Process
1. Identify problem & assign responsibility
2. Determine & evaluate possible courses of action
3. Make a decision
4. Review results of decision
Avoidable Cost
future cost that differ or change b/w alternatives. Any cost that can be eliminated in whole or in part as a result of choosing one course of action over another (aka differential, relevant, or incremental costs)
Opportunity Cost
potential benefit that's given up when one course of action is chosen over another
Sunk Cost
costs that have already been incurred & can't be changed by any decisions made now or in the future (ex: NBV & depreciation)
Outsourcing
the decision to buy parts/services rather than make
Advantages of making product internally
1-reduces dependence on suppliers
2-ensures smoother flow of parts & materials for production
3-quality control may be easier
4-company can realize profits on parts & materials
Advantages of buying from a supplier
1-supplier can realize economies of scale
2-specialized supplier may be able to respond quicker & at less cost to changing future needs of the company
3-changing technology makes making one's own parts riskier than purchasing
Joint-Products
multiple-end products
Joint Costs
all costs incurred prior to the point at which the products are separately identifiable (aka the split-off point)
Sunk Costs - they're not relevant in any sell-or-process-further decisions
allocated to individual products on the basis of relative sales value
Decision Rules for Joint-Processing
process further as long as the incremental revenue from such processing exceeds the incremental processing costs
Joint Processing costs are sunk at split-off point & aren't relevant
Decision Rules on eliminating unprofitable segments
retain the segment unless fixed costs eliminated exceed the contribution margin lost
total CM - directly traceable/avoidable FC = segment margin
If total CM > directly traceable & avoidable FC = keept the segment
Constrained Resource
when a constraint exists, a company should select a product mix that maximizes the total CM (contribution margin) earned since fixed costs usually remain unchanged
promote products that have the highest CM when there are no restraints
When constraints exist, promote the product that earns the highest CM in relation to the constraining resource
Bottleneck
the machine or process that is limiting overall output/the constraint
Constraint
when a limited resource is limiting/restricting the company's ability to satisfy demand
Selling Price =
Selling Price = [1 + Markup]x Cost
Economist's Approach to Pricing
fixed costs have no variance, cost always refers to variable costs
markup % is based on price elasticity of demand
cost is based on variable cost
Economist's Approach: Elasticity of Demand
the price elasticity of demand measures the degree to which the unit sales of a product/service is affected by a change in price
Economist's Approach: Inelastic Demand
differs since change in price has little effect on # units sold
Economist's Approach: Elastic Demand
dramatically changes # units sold when price changes
Cross Elasticity
occurs if a change in price affects demand for other substitute products
Profit Maximizing Price =
(1 + (-1 / (1+Ed) ) ) x VC per unit
Problem with the Economist's Approach
if there's multiple cost-drivers you may not be able to separate into VC & FC
Absorption Costing Approach
assumes that customers need the forecasted unit sales & will pay whatever price the company decides to charge
careful: may not always be a valid assumption
Markup % on absorption cost
[ ((required ROI x investment) + SGA expenses)) / (absorption product cost x unit sales) ]
Target Costing
the process of determining the max. allowable cost for a new product & then developing a prototype that can be made for that max. target cost figure
target cost = anticipated selling price - desired profit
market research determines the selling price, management computer mfg. cost for an acceptable profit margin, & engineers/cost analysts design product for the allowable cost
Capital Investment Decision
concerned with process of planning, setting goals & priorities, arranging financing & using certain criteria to select long-term assets
Steps in Budgeting Process
1-estimate feasibility
2-estimate benefits & cash flows
3-approval procedures
4-perform financial analysis
5-schedule & controlling implementations
6-post audit (to keep managers honest)
Typical Cash Outflows
repairs, maintenance
initial investment
working capital (at time zero)
incremental operating costs
depreciation is NOT a current cash outflow
Typical Cash Inflows
salvage value of old machine
release of working capital (at end of project)
incremental revenues
recovery of initial investment
reduction of costs
Working Capital =
current assets - current liabilities
Screening decisions
pertain to whether or not some proposed investment is acceptable
Discount Methods: NPV or IRR
Non-Discount Methods: Payback or Simple Rate of Return
Preference Decisions
attempt to rank acceptable alternatives from most to least appealing (present value or profitability index)
NPV =
PV of Cash Inflows - PF of Cash Outflows
cost of capital usually is min. req. rate of return used in NPV
NPV > 0 = accept
<0 = reject
NPV & IRR Assumptions
all cash flows other than initial investment occur at end of periods & all are generated by an investment project immediately reinvested at a rate of return equal to the discount rate
Internal Rate of Return (IRR)
ROR promised by an investment project over its useful life
computed by finding the discount rate that will cause the NPV of the project to be zero
if annual cash flows aren't identical, a trial & error process must be used to find the internal ROR
if IRR >/= Cost of Capital = Accept
IRR < Cost of Capital = reject
Cost of Capital acts as a Hurdle Rate a project must clear
Profitability Index
PV of Cash Inflows / Investment Required
or
(NPV+Initial Investment) / Investment Required
The higher the PI, the more desirable the project
Payback Period
investment required/net annual cash inflow
FYI: Payback method wants just CASH FLOWS NOT NI so don't include Depreciation!
Simple Rate of Return
annual incremental NOI / (initial investment - salvage value of any sale of old equip.)
or
(cost savings - deprec. expense) / (initial investment - SV of sale of old equip.)
SRR >/= company's cost of capital = accept
NI =
Revenues - Expenses - Depreciation = NI
FYI: Payback method wants just CASH FLOWS NOT NI so don't include Depreciation!
Interest =
principle x interest rate x time
Money has a time value.
Table approach =
PV =
FV = PV x FV$1factor
PV = FV x PV$1factor
Annuity requires...
1. periodic payments/receipts (called RENTS) of the same amount
2. same-length interval b/w such RENTS,
3. compounding of interest once each interval
2 Types of Annuity
Ordinary Annuity: payments occur at end of each period
Annuity Due: payments occur at beginning of each period
PV of Ordinary Annuity
PV = Payment x PVordinary annuity factor
Process Costing
identical products
same avg. cost per unit
Job-Order Costing
unique products
mfg. to order
allocate cost to each job
Job Cost Sheet
a form prepared for a job that records the materials, labor & mfg overhead costs charged to that job
Cost Driver
a factor that causes overhead costs
(actual activity, allocation base, denominator level; always per DM, DLH, DL, or machine hours)
Overhead Applied =
OHD rate x actual activity
CGS Statement
Beg. FG Inv
+ CGM
= CGA
- End FG Inv
= Unadj. CGS
+ underapplied OHD
- overapplied OHD
= adjusted CGS
Variable Costs
vary in total with respect to activity changes, but stay constant on a cost/activity basis
Fixed Costs
stay constant in total regardless of activity changes, but decrease on a cost/activity basis
Mixed costs
increase in total w/ respect to changes in activity level & decrease on a cost/activity basis
TC = FC + VC(x)
Committed Fixed Costs
long-term cost decisions that can't be changed w/o seriously affecting the firm
ex: purchase of land, building or equip
Discretionary Fixed Costs
short-term (annual) cost decisions that can be changed for periods of time w/o affecting long-term goals of the firm
ex: training or advertising
GAPP Income Statement
Sales
-CGS (product cost)
=GP
-S&A (period costs)
-Admin
=NI
Contribution Method Income Statement
Internal Use Only - by behavior
Sales
-VC
=CM
-FC
=NI/PBT
Contribution Margin
the amount each unit contributes towards covering the fixed costs of the firm
Sales Mix
refers to the relative proportion in which a firm's products are sold
must stay constant for us to do calculations
Cost Volume Process
the study of how profits respond to changes in the level of selling prices, sales volume, variable costs/unit, total fixed costs, & mix of products sold
CM Ratio
unit CM / unit Sales price
Profit Before Tax (PBT) =
Total Sales - Total Cost
= Sales(x) - TC
TC = FC + VC(x) so...
Sales (x) - VC (x) - FC = PBT
OR
CM(x) - FC = PBT
Breakeven Point
Total CM - Total FC
CM(x) - FC
or CM(x)-FC=0
Objective Desired Profit
CM(x) - FC = ___desired profit
Margin of Safety
excess of budgeted (or actual ) dollar sales over the break-even sales level
= Total Sales - Break-even Sales
Margin of Safety Ratio
margin of safety/total sales
CM ratio for predicting increase in PBT
Increase in Sales
x CM ratio
=Increase in CM
- Increase in FC
=Increase in PBT
Operating Leverage
a measure of how sensitive net operating income is to %change in sales
Degree of Operating Leverage = CM/PBT
must be recalculated at every sales level
Using Operating Leverage to find % increase in Profits
% increase in sales
x degree of operating leverage
= % increase in profits
Point of Indifference
PBTold - PBTnew = CMold(x) - FC old = CMnew(x)-FCnew
Absorption costing / Full cost method
Cost of Product & Income Statement
all mfg. costs are product costs
Cost of Product = DM + DL + VOHD + FOHD
Income Statement:
Sales
-CGS
=GP
-VSGA
-FSGA
=NI
*changes in production levels affect NI*
Variable Costing
Cost of Product & Income Statement
only variable mfg. costs are product costs
Cost of Product = DM + DL + VOHD
Income Statement:
Sales (total sold x selling price)
- VC (beg fg inv + cgm - end fg inv)
-VSGA
=CM
-FOHD
-FSGA
=NI
Reconciliation of Net Income
Variable Costing NI
+ FOHD deferred in EI (# units in EI x FOHD/unit)
- FOHD released from BI (# units in BI x FOHD/unit)
=Absorption Costing NI
Behavioral Implications of Budgeting
Budgetary Slack - "padding the budget", intentionally underestimating revenue or overestimating costs in order to enhance the person's performance evaluation
Self-Imposed/Participative Budgeting: people perform better & make greater attempts to achieve a goal if they have been consulted in setting the goals
Production Budget
shows what must be produced to meet sales forecasts
Budgeted unit sales
+ desired EI
= Total Needs
- beg inv
= Required production
Direct Materials Budget
details the amount of raw materials that must be acquired to support production & provide adequate inventories
Req. production in units
Quantity measure needed per unit
= raw materials req for production
+ desired EI
= total raw material needs
- beg inv
= raw materials to be purchased
x cost of raw materials per qty measure
= cost of raw materials to be purchased
Cash Budget
Beg Cash Balance
+ receipts
= Total Cash Available
- disbursements
= excess (deficiency)
+ financing
= cash balance, ending
Actual Cost Systems
charge actual DM, actual DL, & actual OHD costs to products
no OHD rate
rarely used
Normal Cost Systems
charge actual DM & actual DL costs to products
OHD rate used to apply OHD to products
often used
Standard Cost Systems
charge standard DM & standard DL costs to products
OHD rate used to apply standard amount of OHD to products
standard input allowed for actual output at standard rate
often used
DM Price Variance =
AQpurchased (AP vs SP)
DM Quantity (Usage) Variance
SP (AQused vs. SQallowed)
Favorable Variance =
standard > actual
DL Rate Variance
AH (AR vs SR)
DL Efficiency Variance
SR (AH vs SHallowed)
VOHD Spending Variance
AH (AR vs SR)
VOHD Efficiency Variance
SR (AH vs SHallowed)
The balanced scorecard & it's performance measures
management translates its strategy into performance measures that employees understand & accept
Performance Measures:
Financial
Customer
Internal Business Processes
Learning & Growth
Delivery Performance Measures:
Throughput =
Mfg. Cycle Efficiency =
Order received - wait time - Production started - Process time+Inspection time+Move time+Queue time - Goods Shipped
Throughput time (aka mfg cycle time or lead time)=process+inspection+move+queue
Mfg Cycle Efficiency = value-added time (process time) / throughput
Process time is the only value-added time
