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TRANSFER PRICING

Transfer pricing

Assume i do tax return, My sister comes to me and tells me i want to do the tax return. Assume that im very busy and that i operate at full capacity. I work many hours as i can and do tax return for 100 $ for every tax return. What would be my response to her?

In order to take her tax return i have to take one less tax return so i can do her tax return. What would be my minimum return for her ? 100 $ as my profits would go down if i dont do this.

What if i dont operate at full capacity? What would be my minimum price to charge my sister?

Incremental variable cost for doing tax return would be the one to charge her.

Scenario one

I operate at full capacity and after doing the tax return i have to return the tax return to them and acquire the tax return of 10$

Now that operate at full capacity what would be the minimum price to charge sister , therefore it would be 90 $ . What if im operating at capacity , my sister goes to some other tax person and can get it for 50 $ , what would be best for family. She wouldn’t be happy with me but what would be best for the family? Let her get the thing done for 50 $ and let me charge the other 90 $ for my other customer . Thats the definition of transfer price. The transfer price is price one division charge to the other division

If you are being evaluated on some measure of profitability you would want to maximize revenues and minimize expenses.

The selling division would want to charge the highest price since it is a revenue to them and higher profits

Buying division want to pay the lowest price since it is an expense to them and this results in higher profits

Transfer price is the price charged when one segment of a company provides goods or services to another segment of company. In practice , three general approaches are used in setting transfer prices

> Set transfer price at cost using

a) VMOH ( DL + DM + VOH)

b) Full absorbtion cost ( DL +DM +VMOH+FMOH)

c) set transfer price at market price

d) Set transfer price at negotiated market price

The need for transfer price?

> Responsability centres in decentralized operations often exchange products ( Responsability centres buy sell from to each other )

> Transfer price becomes expense to buying division and revenue to the selling division

> If divisions are measured on profitability, such return on investment then transfer price can have an impact on the performance of each division bonus. The higher the transfer price , other things equal , the more profitable will be the selling division and the less profitable will be the buying division.

> Choice of transfer price can be complicated by the fact that each division may be supplying portions of its output to outside customers as well as to sister divisions

> Often leads to heated disputes between responsibility centre managers : yet some transfer price must be established to evaluate the performance of the various parts of divisions of a company.

> Transfer pricing policy should allow divisional autonomy yet encourage managers to pursue corporate goals consistent with their own goals ( Goal congruence).f The reporting system must motivate responsibility centre management to pursue their own self interest which is conductive to the success of the company as a whole.

> The value placed on transfer goods and services is used to make it possible to transfer goods and services between divisions while allowing them to retain their autonomy. Transfer price can be a device to motivate managers to act in the best interest of the company.

Impact of transfer pricing of transferring divisions and company as a whole

S division seller	B division buyer
Produces componenet and sells to be at tp of 30 $ unit	Purchases the component at transfer price of 30 $ per unit
Transfer pice and revenue to s	Transfer price 30$ and expense to b
Increase revenue and net income , increase ROI and the bonus	Decrease ROI and the bonus
Transfer price revenue =	Transfer cost

Zero impact for buyer and seller for the company in general

Transfer Price should satisfy

a) Accurate performance evaluation

b) Goal congruence

c) Preservation of divisional autonomy

The minimum TP that would leave the selling division no worse off if internal transfer takes place. At this price, the selling division is indifferent between selling internally or externally as profit remains the same

The maximum TP would leave the buying division no worse off if internal transfer price takes place. At this price the buying division is indifferent between buying internally or externally as Profits remain the same

Note that it doesn’t mean lowest price and higher price, The lowest TP is the price seller willing to accept and the maximum is the highest price buyer willing to pay.

Cartoons company has a battery divison that manufactures and sell volt 20

Capacities in batteries 300000

Selling price per battery on outside market 40 $

Variable cost per battery $18

Fixed cost per battery $7

Dont think of fixed cost per unit, think of total fixed cost , the total fixed cost is therefore 300 000*7= 2.1 million

Cartoons company has a scooter division that can use a battery for each of its scooters. The scooter division is currently buying 100 000 batteries per year from outside supplier for 39 $ per battery.

Maximum TP would be 39 $.

Assume that battery division is operating at capacity , therefore currently selling all the 300 k units to the outside customers therefore if you accept the internal order , this means that you would have to forgo and give up the outside sales which is an example of an opportunity cost. If battery wants to sell to scooter division this means that it has to give up some sales.

Minimum transfer price per unit would be the incremental cost of inside sales. Whatever would go up on inside sales + loss contribution margin per unit of outside sales.

In this case the variable cost is 18 + 22 ( 40-18) = 40

Therefore they buying division was the max tp of 39 not gonna pay more than 39 and selling division wants 40. So therefore no transfer would be made.

Situation 2

Battery division now operates at capacity but can avoid 4 $ variable cost for within of company sales. ( lower packaging, lower delivery , lower commissions ect) what price should i chage the scooter division?

The minimum Tp will therefore be

New variable cost would be 18-4= 14 $

Therefore 14 +(40-18)= 36 would be the minimum transfer price

The transfer price would be the lower limit for a transfer price . In this case the transfer price could be from 36-39 $ , anywhere in this range would work

What is the impact of company if divisions cannot reach an agreement on a price between 36-39

Agree they agree at 36 $ ( min tp ) what will be impact on profits of company

Who is chaging 36 ? it is the battery division min tp , remember that at this price profits remain the same for battery division but scotter division gain a 3 $ therefore as selling 100k , profits go up by 300 k, battery division makes same profit indifferent..

Respect autonomy only iterfere if impact of company is material . ( even though managers are engaging in goal incongruent behaviour)

Situation 2

Assume that they agree at 39 $

Therefore the company still makes 300 000k but for now the buying division remains the same and indifferent but the battery division makes a profit of 3 $ per unit

Now what happens if they agree at 37.50 $ , battery profits would be 100 k * (37.50-36) therefore 150 k. Making an increase of 1.50 from what they have targeted as min TP

What about scooter? Therefore 150 k * ( 39-37.50)= 150 K

Situation 3

Now battery division has enough idle capacity to supply the scooter division needs. What price per battery should it charge to scooter division?

Therfore the maximum outside sales would be total capacity – 100000= 200 k

If there is no idle capacity there is no opportunity cost. No outside sales are given up.

Minimum transfer price would be = 18+0=18 $ therefore the transfer price should be at a price agreement of 36 $ to 39 $

Here as we can see if the divisions cannot agree between a price of 18 $ and 39 $, there would be a potential loss for company of 100 k * (39-18) = 2.1 million. Compared to the 300 000 , the 2.1 million is material therefore the CEO should interfere.

Situation 4

Assume that the scooter division wants a heavy duty battery that is not currently produced by battery division. Since it is not currently produced we need to question the accuracy of the costs.

Variable cost of heavy battery 27

Needed each year 50000

Regular battery sales to be given up from battery division 75000

Heavy duties battery consume 50 % more of the resources than regular batteries ( 150 percent of the resources)

Therefore heavy duty= 1.5 reular

50000*1.5= 75000

What transfer price should we charge for the heavy duty batteries

Selling 40

Vc 18

Cm 22

Unit sales lost 75000

Cm lost 22*75000= 1650000

Therefore 1650 000/50000 = 33 $ or 22*1.5=33 $ per unit

Minimum transfer price = VC unit inside + lost cm on outside sales ( opp cost )

Transfer price = 27+33=60

Therefore earining same profit from inside sales and outside sales

Inside= 50 k*( 60-27)=1.65 min outside = 75 k (40-18)= 1.65 M

All actions should be in the long term interest for organization. Goal congruence. Respect autonomy. Divisional heads should not be forced into agreement over a transfer price unless the lost profit for the company as a whole is material.

This price can be backed up by Decentralization which has other some forms of benefits. One person cant do everything. They need to be experts in what they do for the business.

Transfer price examples

Case one

Division s 100000

Division outside sales 100000

Division b needs 30000

Capacity excess ? no

Opportunity cost ? yes

Division s

Variable cost per unit $ 40

Fixed cost per unit 10

Selling price 70

Division B price per unit from outside supplier 68 therefore max tp

Minimum tp therefore would be 40+ (70-40 )=70 therefore no transfer

Case 2

Division s 500000

Division outside sales 500000

Division b needs 80000

Capacity excess ? no

Opportunity cost ? yes

Division s

Variable cost per unit $ 60 but can save 10

Fixed cost per unit 10

Selling price 100

Division B price per unit from outside supplier 96

Therefore case 2 minimum tp would 60-10 +100-60 = 90 therefore transfer from 90-96

Case 3

Division s 250000

Division s outside sales 200000

Division b needs 50000

Capacity excess ? yes

Opportunity cost ? no

Division s

Variable cost per unit $ 30

Fixed cost per unit 8

Selling price 45

Division B price per unit from outside supplier 43

Minimum tp would be 30+0=30

Max tp 43

Therefore tp would be from 30-43

Case 4

Division s 400 000

Division outside sales 300 000

Division b needs 100 000

Capacity excess ? yes

Opportunity cost ? no

Division s

Variable cost per unit $ 50 can save 2 $

Fixed cost per unit 12

Selling price 80

Division B price per unit from outside supplier 75

Therefore minimum tp charge B would be 50-2 +0=48

From 48 to 75 would be the transfer price

Case 5

Division s 400 000

Division s outside sales 300 000

Division b needs 150000

Capacity excess ? no

Opportunity cost ? yes

Division s

Variable cost per unit $ 50 but can save 2$

Fixed cost per unit 12

Selling price 80

Division B price per unit from outside supplier 75

case 5

excess capacity: therefore would be 400 000 -300 000= 100 000 but division b needs 150 000

you losing 50000 to outsiders but gaining 150 inside. So to satisfy division b need division s would have to give up 50000 units of outside sales, therefore the 400 000 capacity would get used as 150 000 insiders and 250 to outsiders instead of 30000

Minimum Tp per unit would be ( 50-2) + 50 000(80-50)/150000=58 $

Earning same profit ?

Insider = 150 k* (58-48)=1.5 million outsider : 250 (80-50)=1.5 million

What factors should we consider when rejecting outside sales to accept internal order?

– we should consider whether the internal order is one time only or is it every year?

– Lost future sales from regular / loyal customers which are not captured by opportunity cost.

Methodology to assess impact on the company as a whole to accept the outsider order.

– An outside order is being considered by the buying division. In order to satisfy the outside order , the buying division needs a part from other division in the company

– However the selling and buying division cant agree as selling price is too high

Approach one

Use incremental approach to assess the impact on each division and company as a whole using the minimum tp and max tp.

Change profit in buying division = max tp to pay that would use and yield 0 profit on outside order – agreed upon price

If buying division paid this price to selling division the profit for the outside sales would be zero.

2) change in profit for selling division would be agreed upon price- minimum tp

3)change in profit for company = change in profit in buying div + change in profit in the selling division = max tp – min tp

Approach 2

Good for the company ( profits would increase) If outside order price is to be received is greater than the total of all internal incremental cost ( incurred by both divisions) plus any opportunity cost.

Long question analysis for transfer pricing

UBC industries is a decentralized organization with six divisions. The company bookstore division produces a variety of books including a x52 small book. The bookstore which is operating at full capacity sells this small book to regular customers for 7.50 $ each.

The small book has a vmoh of $4.25.

The company Irvin division has asked the bookstore to suppy it with a large quantity of the x52 book for 5 $ each . The Irvin division which is operating at 50 % capacity will put the book on the shelf and will be able to sell to a large business owner. The cost of the shelf being build by Irvin would be as follow

Purchased parts from outside vendors 22.50

The small book 5.00

Other variable cost 14.00

Fixed overhead 8.00 ( ignore )

Total cost per brake = 49.50

Although the price of the small book of 5 $ represents a substantial discount from the regular 7.50 each, the manager believes that the price concession is necessary if his/ her division is to get the contract for the airplane brake units. She has heard through the grapevine that the shelf manufacturer plans to reject his bid if its more than 50 $ per brake unti. Thus if the brake division is forced to pay regular 7.50 $ price for the small book it will either not get the contract of it will suffer a substantial loss at a time when it is already operating at 50 % capacity. The manager argues that the price concession is imperative to the well being of both of his / her division and the company as a whole.

UBC uses return on investment to measure divisional performance.

Required :

1) Assume that you are the manager of the Bookstore division . Would you recommend that the division supply the x52 book to the brake division for 5 $ each as requested.? Why or why not ? show all computations

The bookstore division is operating at capacity therefore any sales of the x52 book to Irvin division would mean that the company has to forgo some outside sales.

The minimum TP would be 4.50+(7.50-4.25)=7.50

Therefore the UBC division should not transfer the fitting to the brake division for 5 $ each . The UBC division should get a 7.50 $ on it as management performance is measured by ROI,it would negatively affect manager bonus evaluation if it sells for 5 $

2)Would it be to the economic advantage of company as a whole for UBC division to supply it to Irvin if shelves can be sold for 50 ? show all computations and explain your answer?

The key issue here is that the 8 $ in the fixed overhead cost and administrative costs contained in the Irvin division shelf unit is irrelevant as total fixed cost doesn’t cHage per unit. There is no indication that winning the contract would affect any of the fixed cost . if these costs would be incurred regardless of whether or not the Irvin division get the contract , they should be ignored when determining the effects on the company profits . Another key issue to grasp is that the variable cost of the Irvin division is not relevant either as whether they are used in the shelf or sold to outsiders, the production cost of the would be the same. The only difference between the two alternatives is the revenue on outside sales that is given up are transferred within the company.

Looking at company as a whole

Selling price 50

Less Variable cost would be 7.50

Irvin division : 36.50

Better off by 6 $

3) In principle should it be possible for the two managers to agree to a transfer price in this particular situation?

UBC bookstore would insist on a min tp of 7.50 for the book. Would the Irvin division make any money at this price? Once again the fixed cost are not relevant and it is evident that Irvin would make 6 $ per brake unit.

	Tp 7.50	Tp 0	TP 13.50
Selling price	50	50	50
Less Purchase outside Book Other vc	22.50 7.50 14	22.50 0 14	22.50 13.50 14
IRVIN CM	6	13.50	0

Therfore any tp from 7.50-13.50 will improve the profits of both divisions. The managers should agree on the transfer price..

Would the manager of Irvin pay 13.50( even profits will not increase)

50 % of capacity> avoid layoffs

Other factors qualitative to consider

a) Lost future sales to regular customers

b) The rich guy buying the book , more future opportunies

c) Alternative suppliers for the same book?

Approach one

a) change in profit for the buying division ( Irvin )=

max tp willing to pay – agreed upon pice

therefore max willing to pay would be the profit on outside order without considering the other division price . 50- ( 22.50+14)=13.50-7.50=6

b) Change in profit for selling division: agreed upon price – minimum tp= 7.50-7.50=0

c) Change in profit for comp= Profit for buying division( Irvin) + profit for selling ( bookstore)

=6 +0 =6

Approach two:

Change in profit for Company:

Outside price received – total ( of all incremental cost plus opportunity cost)

=50- ( VC brake 22.50+14+ 4.50+3.50 opp cost )

= 6 $ per unit

4) Discuss the organizational and behavioural problems . If any inherent in this situation , what would you advise the company president to do in this situation?

It is in the best interest of the company and the divisions to come to an agreement concerning the transfer price. As demonstrated in part 3 above any transfer price within 7.50-13.49 would improve the profits of both divisions. What happens to two managers if they do not come to an agreement .

In this case top management knows that there should be a transfer and could step in and force a transfer at some price within an acceptable range. However such action if done on a frequent basis would undermine the autonomy of the managers and company would lose benefits of decentralization.

Advise would be to ask the top managers to meet and discuss the transfer pricing decision. Top management should not dictate a course of action or what is to happen in the meeting but should carefully observe what happens in the meeting. If there is no agreement, It is important to know why. There are at least three possible reasons. First there may have been better information than top managers ( information asymmetry) and refuse to transfer for very good reasons. Second the managers may be uncooperative and unwilling to deal with each other even if it results in lower profits for the company and for themselves. Third the managers may not be able to correctly analyze the situation and may not understand what is actually in their best interest. For example , the manager of the irvin division may believe that the fixed overhead of 8 $ does have to be covered to avoid a loss

If the refusal come to an agreement , is the result of an uncooperative attitudes or an inability to correctly analyze the situation, top management can take some positive steps that are completely consistent with decentralization. If the problem is uncooperative attitudes, there are many training companies that would be happy to put on a short course in team building for company. If the problem is that the managers are unable to correctly analyze the alternatives, they can be sent to executives training courses that emphasize economics and managerial accounting – ie transfer pricing seminar

Respect autonomy , don’t interfere unless dysfunctional behavior has a material impact or negative effect on the company

If the division has an excess capacity ,why would it be willing to accept the minimum transfer price( even though profits stay same)? So as to avoid layoffs.

Uncategorized

INVESTMENT CENTRES

Investment centers have responsibility over revenues , costs and investments

Return on investment has been used for performance evaluation and bonus purposes

ROI= Net operating income / average operating assets

Average operating assets = ( beg + ending )/2

Ending assets 2011 = beginning assets 2012

Why do we use average assets

NOI comes from the income statement whereas Assets come from the balance sheets

Why break up ROI into margin and turnover volume ?

Can be cost leadership and differentiation

Automobile industry.

High Margin vs Low Volume example : Lamborghini

Low Margin vs High volume example : Civic

Management control ROI by looking at assets , revenue and expenses

Net operating income : Before tax and interest : we use NI before expense since we are not interested in how assets are financed.

Operating assets

For using NBV in ROI calculation

: a) Consistent with how property , plant and equipment are reported on the balance sheet

b) Consistent with calculation of net operating income

Against NBV in ROI calculation

a) Over time , ROI Increases as NBV decreases

b) If Managers are evaluated based on ROI , it discourages replacement of old worn out equipment because it can have significant negative effect on ROI

Consequences of using NBV to calculate ROI : If you use net book value , then ROi keeps improving every year even nothing happens as net book value gets smaller and smaller. Over time Net book value goes down as amortization expense get accumulated

Managers would be reluctant to invest in new technology. Managers evaluation since it is based on ROI. As decrease in ROI, more pronounced , therefore managers evaluated on ROI, they would be reluctant to invest in new assets as ROI Decreases as their bonus decreases. The decrease in ROI becomes more pronounced if AOA is based on NBV instead of cost .

The managers would be aligned with goal congruence.

For company replacement is god but for manager replacement is bad because ROI will decrease as his/ Her bonus would decrease. This is an example of dysfunctional behaviors since it is a goal in congruent behaviour

There are three ways for manager to improve ROI

UBC reports following operation

NOI 30000

Sales 500 000$

Average operating assets 200000 $

ROI = NOI/ AOA , therefore current 30000/200 000 = 15 %

Increase Sales :

If my sales increase to 600000 and my NOI increase by 50000 , therefore this sales increase operation would make my ROI , 50 000/600 000= 25 %

CM % = sales increase by 100 000 and NIBT increase by 20 000 therefore 20 000 / 100 000= 20%

Therefore fixed cost would be 600 ( 0.2)- 70= 30 . therefore fixed cost would be 70 k

Reduce expenses:

Assume UBC reduce expenses by 50000, sales and operating assets remain unchanged.

ROI new = 30+5/200=17.5 %

Reduce assets :

Assume UBC reduced its assets from 200 000 to 180 000 by adopting JIT, therefore the sales and net operating income remained the same . Therefore the ROI new would be 30/180= 16.67 %

Advantage of ROI :

Pay attention to relationship of sales, expenses , and investment in assets as should be the case for manager of investment centre.

Encourages cost efficiency

Discourages excessive investment in assets

Disadvantages:

a) Discourages managers from investing in projects that decrease divisional ROI but increase Overall profitability of company as a whole

b) encourages managers to focus on the short run of the expense of the long term. ( myopic behavior) net operating income is a short term measure ( for the year ended)

c) It is not consistent with cash flow models. Ignores time value of money

d) May not be fully controllable due to presence of commited costs

does not capture key non financial measures ( quality , customer satisfaction ect)

How to overcome these?

Use a balance scorecard, where use multiple measures in evaluating performance , growth in market share, profitability increase, product innovation , quality ratings, surveys ect…

Use financial, non financial, qualitative, quantitative.

Residual income

Net operating income that investment centre is able to earn above MRR on its operating assets

Objective is to maximiz total amount of residual income , the larger the residual income the better it is for the company.

It is good for the manager and the company.

Example UBC division A has an opportunity to make an investment of 250000 that would generate a return of 16 % on invested assets

The investment would reduce the division ROI

Present New project Overall

Average operating assets	1 million	250 k	1.25 million
Net operating income	200 k	40k	240k
ROI	200 k/1 m= 20 %	16%	19.2%

*250000*16%=40000

Managers might reject the project as overall ROI goes down . The marginal ROI, the next investment which is 16 percent is less than the current ROI of 20 %

If evaluated on residual income therefore

Therefore new project income was 250000 and cost of capital was 12 % where ROI of new project was 16%

Residual income would be = 250 000 * ( 16%-12%) =10 000 $ .

Accept any project whose return is greater than cost of capital. The overall result is goal congruence since it is good for both managers and company. The only disadvantage of residual income approach is cant be use to compare performance divisions of different sizes.

ROI doesn’t suffer from this problem as its per dollar of average operating assets.

Divisions can lead to not good division for Residual income

Assume that the company bonus plan says that as long u improve ROI you get bonus

2010 : 20%

2011: Projected to be 16 %

To get a bonus in 2011 , ROI should be greater than 20 % , as of 2011, IT is unlikely that the manager get a bonus

In December 2011 , there is a project under consideration . The project ROI is 8 percent and that the company cost of capital is 16 % . Accordingly the project is bad for the company as return is less than cost of capital. The residual income will decrease.

Will or might the manager accept this project?

If project accepted , ROI will decrease even further, therefore this would increase the chances of manager getting the bonus in 2012. Taking a big bath. IF things are bad , make them look really bad as the future would look better.

You get what you measure so you’d be better want what you measure. What behavior does the system motivate and what behavior should the system motivate.?

Critical success factors: Specifically determine which performance measures harmonize with overall company strategy and limit attention to these measures.

Incentives

Have reward for favorable performance and punish some unwanted behaviors

Monetary incentives ( salary , bonus and retirement plans )

Non monetary incentives ( Titles, office location and furnishings , reserved parking spaces)

It is in the best interest of the firm to base incentive in long term performance so as to avoid overemphasis on short term performance to the possible detriment of the firm.

Management by objectives

Set goals for work performance , evaluating progress towards these goals which would therefore lead to more goal congruence

May improve motivation

Strengthens planning process, and appraisal criteria

UBC . a subsidiary of New age industries , manufactures books and materials for university . As a results , UBC has been receiving some pressure from new age management to diversify into some other aspects. SFU one of the largest university is looking for a friendly buyer. New age management believes that sfu assets can be acquired for 3.2 million and strongly urged bill division manager of UBC to aquire sfu

Bill has reviewed sfu financial statements and he said that the acquisition is not in the best interst of UBC. If we decide not to do this the new age people would bnot be happy. IF we convidce them to base our bonus on something other than return on investment maybe this acquisition would look more attractive. How would we convince them to base our bonus on something other than return on investment maybe this would look more attractive. How would we do if bonus were based on residual income using the company cost of capital of 15 % ?

New age industries has evaluated all divisions on the basis of return on investment. The desired rate of return for each division is 20 percent. Thus top management expect that each division earn at least that amount . The management of any division reporting an increase in 20 % ROI would get the bonus. The management of divisions reporting a decline in the ROI must provide convincing explanations for the decline in order to get the bonus. However the bonus is limited to ½ of bonus paid to divisions reporting an annual ( year to year ) increase in the ROI ( above 20 percent). UBC ROI last year was 24 %

UBC SFU

Sales revenue	9.5 million	–
Leasing revenue	–	3.1 million
Variable expenses	-6 million	-1.3 million
Fixed expenses	-1.5 million	-1.2 million
Operating Income	2 million	600k
Current liabilities	1.4 million	850 k
Long term liabilities	3.8 million	1.2 million
Shareholders equity	2.8 million	950k
Total Liabilities and S.equity	8 million	3 million

1) If new age industries continue to use ROI as a sole measure of divisional performance explain why UBC would be reluctant to acquire SFU?

UBC SFU Combined

Operating Income	2 million	0.6 million	2.6million
Assets	8 Million	3.2 million	11.2 million
Return on investment	25 %	18.75 million	23.21 %

Therefore they would be reluctant to acquire SFU as their Marginal ROI would decrease from 25 % to 23.21 %. The results would therefore be that UBC divisional manager would not get a bonus or would have bonus limited to ½ of the regular bonus.

UBC is being evaluated based on ROI therefore it must be an investment centre. Investment centre . Investment centres have responsibility over investment in assets. Does UBC has autonomy in assets ? No as it has been receiving pressure from top management to diversify in the other areas, IF we decide not to do this the new people are not going to be happy. Also they have strongly consider bill to aquire SFU

2) IF new age industries could be persuade to use residual income to measure performance of UBC would they be more willing to acquire SFU? Show computations and explain.

Residual income is the profit earned that exceeds an amount charged for funds commited to a business unit. The amount changed for funds is equal to an imputed interest rate ( Cost of capital) multiplied by the business unit invested capital.

If new age industries could be persuaded to use residual income to measure performance UBC would be more willing to acquire SFU, since 18.75% is greater than 15 %

UBC SFU Combined

Total assets	8 million	3.2 million	11.2 million
Operating income	2 million	0.6 million	2.6 million
Less interst charge 15 %	1.2 million	0.48 million	1.68 million
Residual income	0.8 million	0.12 million	0.92 million

Quick way of calculating residual income : 3.2 million * ( 18.75-15)=120 000

3 . Discuss how the behaviour of the division managers is likely to be affected by the use of the following performance measures a) ROI b) Residual income . What change would you recommend to the bonus arrangement?

a) The likely effect on behaviour of division managers whose performance is measured by ROI includes incentives to do :Reluctant to invest in new project since roi would decrease and not get bonus. Also reluctant to invest in projects whose return is greater than cost of capital but less than the current ROI ( Goal incongruent behaviour)

b) For residual income : They would invest in any projects whose return is greater than the cost of capital which gives a goal congruent behaviour.

Recommended changes to bonus arrangement:

Base bonus on RI instead of ROI

If company wants to use ROI base the ROI bonus greater than 15 percent and that the marginal roi is also greater than 15 %

Use multiple measures to evaluate managers performance

Uncategorized

Responsability Centres and Segmented Reporting

Post author By avibooluck
Post date June 10, 2012
No Comments on Responsability Centres and Segmented Reporting

Segmented Reporting

Decentralization means delegating decision making authority towards individuals and allowing managers to make key decisions relating to areas of responsibility.

Centralized organizations

Decisions made by relatively few individuals who are in the high ranks of organization

Decentralized organizations

Decisions are spread amond many divisional and departmental managers. Many companies start as centralized but become more decentralized as they grow.

Pure centralization is when age of firm is young and size is small, growth rate is slow and impact of decisions is high and the confidence in lower level managers is low

Pure decentralization is when age of firm is mature and size is large, growth rate is rapid and impact of bad decisions is small where the confidence of lower level managers is high

Reasons for decentralizations

A) Access to local information , best knowledge of local operating conditions ( Competition , nature of labour force ect.

b) Cognitive limitations , large organizations, operating in numerous markets , it is impossible for single individual to possess all the expertise and training needed to process all the information

c) more timely response possible: A manager with decision making power can act more quickly

d) Focus on central management: Strategic planning and decision making power

e) Training and evaluation of segment mangers

f) Motivation of segement of management: Decentralization decision making can foster more creativity and initiative and lead to greater job satisfaction.

Disadvantages

a) Goal congruence: Managers may make decisions that are not congruent with the preference of top management and shareholders

b) Require a control system. Decentralized companies occur the cost of monitoring and controlling the activities of local managers.

c) Require that managers delegate authority

d) Training cost

e) Increase cost with poor decisiomns

Responsability centre

a) cost centre : responsible for only controlling specific cost, There is no responsabilities for revenues as doesn’t sell any product service. Typically the centre is evaluated through comparison of actual cost to budgeted or standard costs

b) Revenue centre : A revenue centre has a responsibility for generating revenues and the evaluation is comparison of actual revenue to budgeted revenue : factory outlet

C) Profit centre : Has responsibility for revenues and costs. Comparison of actual profit to budgeted profit

d) Investment centre: Responsability for revenues, costs and assets. Centre is evaluated based on comparison of actual and expected ROI or expected Residual Income

You get what you measure so you better wnat what you measure. For each type of responsibility centre , The performance measures must be carefully designed to

a) reflect organizational goals and objectives

b) Be specific, understandable, and measurable

c) Promote harmony among subunits

d) Consider the extent to which they many be manipulated by divisional managers

Performance measures has to be carefully measured. It should be specific , measurable

It should be based on qualitative measures and quantitative measures which is based on financial ( roi, residual income ect), and non financial ( on time delivery ect, customer complaints)

For example McDonalds measures Service, Quality and Cleanliness

Food served on time , Quality service for the price you paying and cleanliness ( washrooms ect)

Financial measures for evaluating profit and investment centres

Profit centres based on Divisional income ( segment margin)

Investment centres would be ROI and Residual income

Cost assignment necessaru for

a) Product costing and pricing

b) Appraisal of managerial performance

c) Making decisions

Income statement , managers need more that that for decision making. As only provides summary of operations. We need to find numerous segments for operations

For example Jim pattison : Dealership cars, : A lot of dealerships , Honda ect

We need to break the automobile business into different dealerships like service , body shops , A lot of segments into dealership. Or maybe even cars dealership

Media company : How much is each media company generating, Media: Outdoor signs ect. Each segment that you will be analysing has different operations .

Now the only thing we do is that we break down fixed cost to traceable fixed cost and common fixed cost. Traceable fixed cost can be traced to division a and b whereas Common fixed cost would be allocated to the whole company

For example

General motors

Traceable fixed cost	Total company	Division A :Cardillac is cool , advertising	Division B : Chevrolet is heavy

Common fixed cost	200000 , advertising can say general motors is great

Or can be broken down to more segments of division B Chevrolet

Sales	Division b	Product line volt	Product line corvette
Vc
Cm
Less traceable fc		40 000 : Ads where can say volt + environments	50000 : Corvette and performance. So its directly traceable to corvette
Product line seg
Less common fc	Cheavy is heavy
Divsional seg Margin

Traceable can be traced to segment, but when we drop segment these costs can be avoided. Common fixed cost cant be traced to segment, The cost would continue even if segment continues. Shouldnt be allocated to segment. Common fixed cost shouldn’t.

Cost are allocated

: variable or fixed,

Once they are fixed are they traceable or not , or common

Is it traceable controllable ( manager bonus) , not traceable controllable ( no manager bonus)

Traceable fixed cost example: Maybe the salary of the cheavy division president salary as its directly traceable, Chevy is heavy advertising, Cheavy Retail and development, some retail and development keep secrets from other divisions.

Common fixed cost , “ Parent” , Gap, old navy ect.. : The GM CEO salary, Gm salary expenses , GM head office adv

Segment margin : Amount after segment has covered all its own traceable costs , Variable and fixed . Applied towards organization common fixed cost, then towards profit.

After that the rest goes towards the profit of the company.

Contribution margin is only used to make short term decision, temporary excess use of capacity, pricing on special orders, and which product to promote.

The segment margin on the other hand would analyze the long run profitability of a segment . In the long run if a segment cannot cover its costs the segment should discontinue .

Long term decisions:

Capacity changes

Long run oricing policy

Provide adequate return on investment

Discontinuation of a segment

If you allocate then its reduce the usefulness of segmented statements , If they are allocated the results can be misleading to management or may obscure segment profitability, thereby lead to incorrect decisions.

What will happen for total company nibt if product A is dropped? How much and why?

Sales 400 000

Vc 160000

CM 240 000

Lessfc 220000 ( 120 000 +100 000 )

NIBT 20 000 (35000 – 15000 segment of A)

NIBT would decrease by 15000 as the product a margin would be no longer available to be applied for covering common fc

Keep or drop segment decisions

Soap segment < 0 Exfoliating stuff SM> 0 After Shave Segment margin > 0

Before deciding to drop soap segment what must we consider ?

We need to consider the sales of other products before dropping segment even the soap is a loss leader. Ex when you come to buy toothpaste, you will buy other things too if they are out there.

Cost allocation has behavioral consequences. If you allocate certain cost , it will reduce profitability of segments and profits are being used towards it.

Example:

Assume that a real estate company has a sales support department that offers administrative help to its sales staff. The real estate company has two employees. Ben and Guan. Ben is hardworking and Guan is disorganized. Guan is using it more than Ben. Now the company is allocating it assume 100000 to sales people based on sales dollars to generate

Sales generated Ben Guan Total sales

900 k 100 k 1 m

Allocation 900/1 m 100 / 1 m

If Ben increase her sales to 1 million she’ll be allocated 1 million / 1.1 million ; 10/11 of the ssd cost , She will be punished for increasing the sales matrix.

Break down of Traceable fixed costs

The traceable fixed cost now is broken down into controllable fixed cost and non controllable traceable fixed cost

Traceable fixed cost which are controllable are done for performance evaluation of the manager whereas the traceable not controllable which would become the segment margin have segment margin evaluation.

The fomat would be

Sales

Less variable costs

Contribution margin

Less controllable fixed costs

Controllable segment margin ( manager performance evaluation)

Less Non controllable fixed cost

Segment margin ( Segment performance evaluation)

Less common fixed cost

= NiBT

Manager shouldn’t have anything thats not under their control

Example

Head office in Toronto long term contract for Vancouver office space, its segment. The manager of the Vancouver division was not involved in its division.

Head office controller

Vancouver division would have to rent office space for itself if its head office hadn’t enter the long term contract. Ie The manager would have to find suitable office controllable

Vancouver division manager:

WE could have found suitable office space for 80000 per year. Thus only 80000 should be controllable and 20 000 should be non controllable

Thought process:

Was division manager involved in decision :

Can division manager influence cost of rental agreement

If asked if division manager have a proposal of office space

Yes

Therefore controllable traceable would be 80 k and non controllable would be 20 k

Example 2

The manager of Canadian operations met with Vancouver manager . The head office is in Toronto. One of the items for the meeting was the high property taxes of Vancouver was paying . The company want to get the land rezonded to industrial so that property taxes would be minimal. The Canadian manager has suggested that there would be 6—12 weeks . For 2012 Property tax was 500 000 . Had the land been rezoned to industrial , the properties tax would have been 300 000

Head office :

500 000 should have been controllable because Vancouver division manager did not get the land rezoned as suggested by Canadian manager

Vancouver division Manager

I do not set property tax therefore its not controllable by me . the city of Vancouver sets property of taxes based on value of plant . I have no control over property taxes

Should property tax expense be normally treated as controllable.? No property tax are decided by city

Thought process:

Was division manager involve in the decision of property tax ? No

Can division manager influence amount of property tax? Yes , could have get it rezone

Does that manager have alternate manufacturing space ? No

How much is controllable = 200 k where non controllable was 300 k

Long question analysis

Ben is hired by an export company, fed ex to manager the Vancouver warehouse. Fed ex has seven divisions in North America. Fed ex facilitates the importing and exporting of products on behalf of customers. The head office is in New York

Each warehouse is viewed as a profit centre and manager wants a return of investment of at least 15 % .. Fed ex earns a profit by chaging customer a cost plus basis to bring the clients merchandise into Canada. ( ROi here as we can see is not a perfect measure since it is a profit centre, Roi is used to measure investment centres)

Ben was not happy at the year end of 2011. Head office has sent him the yearly income statement and they say he hasn’t met any targets this year . They added that he has to show and improvement next year or they will be forced to make an unpleasant decision

Sales	Cost behaviour	5000 000
Cogs	Variable	-2300 000
Admin expenses	Fixed	-275000
Building secuirity	Fixed	-150 000
Entertainment	Fixed	-350000
Maintainance of equipment : regular intervals unless usage	Fixed	-145000
Property taxes	Fixed	-20000
Salaries	Fixed	-950000
Utilities	Fixed	–75000
Income		$605000
Divison assets at year end		600 0 000
ROI on investment		10.1 %
		Therefore as 10.1 % is less than 15 % , he is not earning bonus

Tony was unhappy with results immediately reviewed his employement contract which stated that he has to be able to earn a bonus of 20 % of salary if he achieved target return. He negotiates the salary with head office therefore this is controllable . The contract was silent on the definition of income and on whether his bonus was based on division performance or his performance.

ben dug into the details of fs and discovered the following

The other expernces includes 25000 amortization in atlantic city. It does work for all the dicisions. The other expenses also includes a 30 000 for amortization of the head office building in New York ( Therefore 25 000 and 30 000 are both common fixed cost)

Also included int he other expenses are 18000 for the amortization process centre9 equipment ( the 18 000 would be a common fixed cost ) Therefore the remaining (275-25-30-18) would be traceable and controllable ( 202000)

> Ben would like to purchase and additional warehouse that would cost 1 million . Despite this would increase efficiency and provide a 250 000 increase income. Therefore An ROI of 25 percent therefore would be better than the 15 % they want .It appears that he doesn’t have any control over the assets and investment centre.

> The building security of 350000 includes 250000 for the corporate contract entered by head office to capone security services. Thus non controllable. Ben division revealed each of the divisions is chargerd 25000 and that Vancouver uses 10 % of the toal time to capone security service. Therefore 25 000*7*10% therefore this 17500 would be considered traceable. The remaining 7500 ( 25000-17500) would be a common fixed cost

> The building security also includes 100 k for johny big knuckles . He is not allowed in the Canadian border and his wages is charged to all divisions equally . Therefore it is a common fixed cost.

> Salaries expense covers all the employees and executieves in Vancouver. They are under the direction of head office. ( 125000 therefore is doing work in Vancouver but is not controllable)

> Property tax of 20 000 is low to tony . The real assessment is 50 000. He collects the extra in cash when he visits new York, therefore the amount is traceable and non controllable and the amount should be increased to 50 000 ( add 30 k)

> At the beginning of the year there was 4 000 000 in assets . To calculate RoI we should use the average of the assets.

Required the statement is not prepared appropriately for the Vancouver division. Seperately identify and indicate any common fixed cost

Sales 50 00 000

COGS -2300000

CM 2700000

FC traceable

Other expenses 275000-25000-30000-18000 = ( 202000)

Administrative exp ( 150000)

Secutity 350 000 -25000-100000 = 225000

Entertainment 130000

Maintainance 145000

Utilities 75000

Salaries 950000-125000 = 825000

Segment margin Controllable = 948000 ( Ben performance)

Fixed cost traceable but non controllable

Security 25000*7*10% -17500

Property Tax 30000 should be added ( 50 000)

Salaries ( 125000)

Segment Margin : Vancouver warehouse : 755500

Ben bonus therefore would be ROI = 948000/5000 000= 18.96 %

Assets average = 4+6 m/ 2 = 5 million

Therefore Ben should get the bonus as it is greater than bonus

Was Roi the better measure?

No , as the question say that each warehouse was the profit centre. Also it says that Ben was denied by head office to purchase an additional warehouse even though the roi purchase was greater than 15 % , where it was 25 percent)

Use multiple measure of performance

Balance scorecard: Quantitative and Qualitative measures for performance evaluation

Customer complaints, warranty claims , product returns, delivery time and average time for the receipt of customer order and delivery of goods, manufacturing cycle time or total production time per unit,

Use multiple measure for performance evaluation : Quantitative, Qualitative, Financial and non financial.

Has our financial improved , has the internal business processes , have we improved key business processes so we can deliver more value to customers , Are we maintaining our ability to change and improve, Do customers recognize we are delivering more value?

Uncategorized

BUDGETING

Budgeting

A budget is a detailed plan, part of the company business plan outlining the acquisition and use of financial and other resources over some given time period, a plan expressed in formal quantitative terms

The planning process involves the development of future objectives and the preparation of various detailed budgets to achieve these objectives.

The control process involves the steps taken by management to ensure taht the objectives set down at the planning stage are attained.

To have a decision making process , you need to plan , to implement the plans where you direct and you motivate, you need to measure performance control and then in the end you need to evaluate the differences between plans and actual performance ( controlling)

Control , compare actual results vs planned results and calculate the differences

Management by exception

If variances are significant , investigate and take corrective action right, then focus on the areas that need attention

( actual – budget )/ budget >= 5 % then take corrective action

UBC has budgeted sales to occur evenly throughout the year at 1 million . The income statement for the quarter ended march 31 indicates 2.94 million in sales

Sales revenue actual : 2.97

Budjet : 3

Variance : – 0.03 M

Significant 2.97-3/3 = 1 percent , this means that it is not significant

Advantages of budgeting :

a) Planning top priority and provides managers to formalize planning efforts and thing about the future

b) Managers can communicate their plans in an orderly way throughout the organization

c) Coordination between departments

d) Evaluate performance and evaluate performance, however since you know that you will be evaluated, mangers play games such as padding the budget

e) Uncover potential bottlenecks before it occurs , cash shortage , labour shortage, machine capacity and such.

Responsability accounting

a) Each managers performance should be evaluated how he manages this items directly under his/ her control

b) Personalizes the accounting system , looking at cost from a personal control standpoint , rather than an institutional ( company ) standpoint.

Behavioural aspects of budgeting

The success of any budget program will be determined in large part by the way in which the budget itself is developed

Self imposed participative buget ( bottom up)

Advantages

a) Individuals are recognized as team members whose views and judgements are valued by top management . ( joint decision making )

b) The person in direct contact with an activity is in the best position to make the estimates since he has the best knowedge of local conditions, thus the budget will be more accurate and reliable ( realistic)

c) An individual is more motivated to work at achieving the budget if she had a say in developing it

d) The participative budget has its own unique system of control; If people are not able to meet the budget they only have themselves to hold responsible, if the budget is imposed from above , they can make excuses that the budget was unreasonable or unrealistic

e) However with such freedom given to management, top management must review and approve the budget

Budgetary slack

Budgetary slack is the difference between a budget estimate that a person that a person provides and the realistic estimate. Creatign a budgetary slack is also known as padding the budget

The incentive bias is to understate budgeted revenues and over state the budgeted expenses.

An organization can reduce the problem of budgetary slack in several ways

a) Avoid relying on the budget as a negative ( punitive ) evaluative tool.

b) Managers can be given incentives not only to achieve budgetary projections but also to provide accurate projections

Whether or not a budget is accepted by lower management personnel is reflective of

– how top management use budgeted data

– acceptance and support of the persons who occupy key management positions

– should not use budgets to use to pressure employees and use it for blame settings

– budgets should be use as a positive / constructive instrument

– establishing goals

– isolating areas in need of attention( management by exception)

Management must keep in mind that human dimension in budgeting is a key of importance. Easy for manager to become preoccupied with technical aspects of the budgets to motivate employees to achieve the companys objectives

Imposed budgets ( top down approach )

Best time to use would be during :

Start up of new organisations, small businesses , economic crisises, lack of budgetary skills and when the organizational units require precise coordination of efforts

The advantages of this system would be probably that the organization plans to be incorporated into planned activities, coordination among divisional plans , top management knowledge of overall resource availability, reduce possibility of input from inexperienced or uninforment lower level employees, time frame.

The disadvantage would be dissatisfaction , reducing feeling of team work , may limit the acceptance of the new stated goals , punitive budget psychology for employees, and may result in unachievable budgets for international divisions if the local operating and political environment is not adequately considered. Also it may stifle initiative of lower level managers

Participatory budgets ( Bottom up approach )

Best times

> in well established organisations

> large businesses

> economy booming

> Operating managers have strong budgetary skills

> Budgetory departments are quite autonomous ( independent)

Advantages :

> Obtains information from those persons most familiar with the needs and constraints of the organizational units

> better morale and job satisfaction and also motivation

> realistic budget

> Develop fiscal responsibility and budgetary skills of employees

> Specific resource requirements of organizational units

> Top management overview with operating details

> Knowledge diffused among various levels of management.

Disadvantages

> Requires more time

> Slack introduction in budgets

> unrealistic budget sometimes as managers may be unqualified to participate in the budgeting process.

Key features of a sound budgetary system

a) Frequent feedback on performance. Managers have to know how they are doing as the year unfolds and take corrective action as needed.

b) Flexible budgeting , a static budjet is for a particular level of activity. It is not reasonable to compare actual costs at one level of activity with budgeted cost for a different level of activity.

c) Monetary and nonmonetary incentives. – used to induce a manager to work towards the organization goals

d) Participative budget- allow managers in the budgetary process to increase goal congruence , creativity and such

e) Realistic standards- efficiency , seasonal variations, general economic conditions

f) Controllability

g) Multiple measures of performance

Zero base budgeting

Non profit , governmental and service type organizations

A) Starts at zero budget and justify all costs as if the program involved being initiated for the first time

B) No cost ongoing

C) Priotizing

Traditional budgeting

Based on incremental approach ,. Start with last year budget and add/ substract from it according to anticipated inflation

Expenses can fluctuate , zero based budgeting would ask if we need to spend that money , is it justified to spend it. It is time consuming and expensive

Master budget preparation

Starts with sales budget , The sales budget has a domino effect – a chain reaction because the other budgets are based on it , Production is dependent on sales, direct materials and moh budgets based on production

Sales forecasting is critical

1) Past experience

2) Prospective pricing policy ( price elasticity considerations)

3) Unfilled order backlogs

4) Market research studies

5) Economic conditions

6) Advertising and product promotion

7) Industry outlook

8) Competition

Cash Budget

Why is cash budget so critical?

Avoids unnecessary supplies. If the company short of cash it is best to know as early as possible that the company can plan to raise cash at the lowest cost or find the best value and use for excess cash – invest it or decrease debt or pay dividends.

Creditors require cash budget as part of the business plan.

One of management key tasks is to control costs

How ? By controlling prices paid and or quantity used

We need to develop standard “ should be doing “ , Based on expectations

Groupd decision making process

a) Compare ideal standards vs practical standards

Lets say practical standards are 90 % but ideal standards are 100 percents

If you want to do corrective actions to fix , if you get an 80 % then you can fix it but if you are on the noramal standards then you need to look into it

Standards need to reflective of efficient future operations not inefficient past operations.

Standards need to realistic and practical if the variations from them are used fairly and constructively then employees will generally be motivated to work for the organizational objectives covered by standards

Direct materials standards

a) Quality of materials

b) Quantity purchased

c) Method of freight

d) Receiving and handling costs

The standard per unit should reflect the final delivered cost of the material involved

Standard quantity per direct material

Used for direct material should reflect the amount of material needed to produce a good finished unit of product. In determining standard quantity

a) Design patterns

b) Unavoidable waste

c) Expected spoilage

d) Normal rejects

All of these are non value added activities, we want to eliminate them and reduce them to efficient levels

3.5 metres here means that for every jogging suit manufactured we should use 3.5 metres

If 200 suits was actually manufactured we should use 3.5 metres*200= 700 metres

Threfore the standard cost would be material * cost = 3.5 m *6 m=21 $ per jogging suit

Direct labour standards

The standard rate per hour should reflect all cost with direct labour workers

This include

Union hourly rate

Expected labour mix

Benefits

Employment/ payroll taxes

Standard rate per hour would be basic wage weight

Standard hours per unit would be direct labour amount we should be using for one good finished unit of product

This time should include the following elements

> Engineered time per unit

> allowance for breaks , personal needs and cleanup

> aloowance for machine downtime

> allowance for rejects “ defective units”

The standard should take if its normal .

Standards hours here

Allowance for breaks and cleanup, allowance for machine downtime and allowance for rejects ect

For every jogging suit actually manufactured we should use 2 hours then if i make 300 suits i shoud use 600 hours

Therefore the standard cost for direct labour would be 2 hours * 18=36 per jogging suit

Variable overhead standards

Variable overhead standards are expressed in terms of rate per activity

The rate is the variable portion of the predetermined overhead rate ( poh )

POH rate = estimated variable overhead / estimated activity level.

Therefore if its said that the variable portion is 4 $ per dlh

Then we can say that the variable overhead cost would be 2 hours * 4 hour = 8 $

The standard cost card would be direct materials , direct labour and variable overhead , a standard cost card can be prepared. The standard cost card shows the manager what the final , manufactured cost should be for a unit of product

Direct materials standard q * price = standard cost

Direct labour standard q* price = standard cost

Variable overhead= standard q * price = standard cost

Total variable cost = dm +dl + voverhead

Knowing the standard price per unit help management price special orders or bid on contracts

When there is excess capacity the 65 would be the minimum price variable selling and administration

Prepare a flexible budget for any level of production.

Standard vs Budget

A standard is a unit amount, a budget is a total amount , the standard is the budgeted cost for one unit of product.

What are the budgeted variable costs of producing 1000 jogging suits

1000*65= 65 000

What is the expected increase in production if we produce 50 more jogging suits= 50*65 = 3250 $

But ignore fixed cost as they dont change with total , but make sure that understand that total fixed cost doesn’t change within the relevant range

Advantages of standard costs

Management by exception

a) Actual vs standard = variance

b) Material significance are followed

1) Facilate planning

2) Expected costs are available before operations are conducted

3) Can be used to assist in strategic and operational analysis

Promote Economy and efficiency

Resposability accounting

Disadvantages of standard costs

How do we know which variances are material / significant ?

How do we know which variances are material ?

Really hard to know until end of year

1) Other useful information may be missed by focussing only on material variances , other information may be noticed at an early stage

2) Behavioural consequences

– Subordinates may be tempted to cover up negative exceptions or not report them at all

Subordinates may not receive recognition for the positive things they do

3) Supervisors adversely affected by management by exception

– not receiving complete review of operations focussing only on the problem areas being bad cop, morale may suffer.

5) Variances reports are not timely ; they are not prepared until the actual costs are collected , may not be useful for controlling ongoing operations

5) A tendency to cut costs to meet standards which may result in a lower quality and higher warranty costs

7) in a competitive environment , meeting standards may not be good enough, we need to strive for continual improvement .

Variance analysis

General model for dm dl and voh exists which is very useful in variance analysis . This model helps to distinguish between price variances and quantity variances

Why is it helpful

For dm , decisions relating to price paid and quantity used occur at different points in time when purchased vs when used ( Not much an issue when considering jit)

Consider price paid and quantity used,responsibility of different managers

Variance is difference between actual prices and quantities and standard price and quantities

Variance price and quantity

/————————————————-/————————————————————-/

Aq*AP AQ*SP SQ*SP

Price variance materials quantity variance

1-2 2-3

HERE AQ IS ACTUAL QUANTITY SP, STANDARD PRICE , SQ= STANDARD QUANTITY AND STANDARD PRICE ( SP)

The term standard quantity allowed in the case of dm dl and vmoh means the amount should have been used to calculate the actual output, for dm / dl / moh sq is based on actual output since dm dl and moh are variable costs and the more less the output , the more

Direct material variance

Following data are available for feb 2012 production

Num of suits 5000

Cost of material purchased ( 2000 m @ 5.40) 108000$

Metres of material used 20000

STANDARD QUANTITY THEREFORE 5000*3=15000

Material price and quantity

/—————————————-/—————————————————-/

AQ*QP AQ*SP SQ*SP

20000*5.40 20000*6 17500*6

108000 120000 105000

Price variance therefore 12000 f quantity = 15000 u

Paid less than should have paid more than should have

Total variance therefore 3000 u

If variance would be favourable the sign would be negative vc as ap < sp

Unfourable would be positive sign as positive variance AP> SP , PAID MORE THAN SHOUD HAVE

Whos is responsible , generally purchasing department but sometimes maybe the responsibility of the production manager due to last minute scheduling

for quantity variance it would be production manager but its inferior of quantity purchased then purchasing agent would be responsible

favourable vs unfourable – doesn’t mean good or bad but look at total ictial

favourable ( underbudget) actual income > budgeted income

Low quality materials would result in more usage and defective units and thus unfavourable would mean in more usage and thus an unfavourable materials quantity variance.

Low quality materials may result in higher warranty cost, which would result in lower sales due to unhappy customers

Purchase in bults you will get a better price but increase storage costs and usage there fore money is tied up in inventory materials which is also going to be an opportunity cost.

Direct labour RATE and efficiency variance

Gortex inc jogging suit , the following data are available for February 2012 production

Number of jogging suits completed 5000

Cost of direct labour ( 10500 hours at 20 $) 210000

AH* AR AH* AR SH*SR

/——————————————/————————————————-/

10500*20 10500*18 10000*18

RATE EFFICIENCY

5000* 2 =10000 hours

Rate variance : 21 000 U 9000 U

Total variance : 30 000 U

Labour rate variance 10500 ( 20-18 ) = 21000 u

Who is responsible : the result of the way labour is used skilled workers doing unskilled work, overtime ect , thus responsibility for the LRV with the supervisor in charge of the use of labour time

Labour efficiency variance ( LEV)

9000 u

Poossible cause

Poorly trained new causes , taking longer, poor quality materials , faulty equipment

Unskilled workets doing work

Who is responsible ? Supoervisor In charge of the use of labour time , rest with the purchasing department though if inferior quality materials purchased or the maintainance department purchased or maintainance department agegnt quality materials purchased or maintainance department manager for work stoppage due to equipment breakdowns

Variable overhead variances

What base was used to apply overhead? DLH

VOH is comprised of power, supplies , ect , utilities and maintainance

The following data are available for feb production

Number of suits overhead 5000

Actual dl hours 10500

Cost of variable overhead 40950

Actual voh actual hrs at sr ( AH*SR) SH*SR

40950 10500*4 ( POH ) 10000*4

42000 40000 (Applied)

/———————————————————–/———————————————————/

Spending variance 1050 f efficiency 2000 U

Where 5000 hours *2.0 hours per suit = 10000 hours

Total variance 950 u

Key thing to note is that in the applied overhead , the standard costing system it is the SQ*SR

The variable overhead spending variance = Actual voh – ( AH*SR) = 10 50 F

The spending variance contains elements of waste or excessive usage as well as price differentials ( unlike dm and dl which have separate price and usage variances)

Variable efficiency variance

Is not a measure of the efficiency of variable overhead, instead it is a measure of the efficiency of the base used to apply variable overhead that was used .

Since overhead is applied using DLH , if the LEV is unfavourable , then the LEV is unfavourable ( U then will the vohev be favourable ( F ) or U ?

Unfavourable since DLH is being used to apply overhead

Variance analysis and management by exception

What is an exception ?

> Materiality is the guidelines that differs from budget by 5 % or more

> Supplemented with some minimum absolute figure ( depending on the size of company )

Actual = 2 $ and budget = $ 1 , what is the percentage variance and should we investigate?

% of variance =2-1/1= 100% but insignificant

1) Consistency of occurrence – if variance comes clost to limits of materiality consistently , then it may be some indication that the standard cost need updating

2) Ability to control some cost that are largely beyond management control like property taxes thus no follow up action is needed even if variances are material

3) Nature of item , some costs are much more critical to long run profitability than others , thus these cost variances are more closely monitored

4) Statistical analysis is viewed as a range rather than a point , as these variations within control limits are viewed as occurring due to random causes therefore not followed up.

Direct materials variances

AQ*AP AQ*SP AQ* SP SQ*SP

PRICE QUANTITY

/—————————–/ /————————————/

Quantity purchased Quantity used

Quantity purchased ( Aqp)= Quantity used if

Company uses JIT

Ending inventory would be Beginnning inventory if inventory levels haven’t changed,

BI+P- used thus if BI = EI then p= used

If quantity purchased is not the same as quantity used then then we cant compute the total variance

Note that the quantity purchased vs quantity used is not applicable for DL because DL cant be stored.

Example

Static master budget was 12000*65 = 65000 $

Now the end of the year the company produced 9000 jogging suits , the actual moh was 600000 $

To determine whether company has done a good job of controlling variable moh cost we would

Choice one

Compare actual costs vs master budjet

Actual cost was 600000 ( 9000 suits )

Static budget 780000 then the variance would be 180 000 F

However we looking at actual costs which vary in total with the number of jogging suits actually produced

Therefore we cant compare actual variable costs for 9000 jogging suits ith a budget for 12000 jogging suits. We should compare results with a flexible budget ( 9000 suits)

Choice two

Actual costs 600000

Flexible costs would be 9000*65 = 585 k therefore variance would be 15000 U , therefore it was based on the actual number of joggin suits produced

Conclusion would be that gortex in has not done a good job of controlling variable moh costs.

Significance of variance investigation

To determine if mpv is significant you compare to AQ*SP

To determine if quantity is significant you compare to SQ*SP

THEREFORE IF ITS GREATER THATN 5 PERCENT of the standard amount , should have paid or should have used amount

Question one ¸

UBC manufactures books for use in classes. The standard cost for material and labour is 89.20$ per book ( 8 kg *5 ) +( 6hours * 8.20). This includes 8 kilograms of direct material at a standard cost of 5.00 $ per kilogram and 6 hours of direct labour at a standard rate of 8.20 per hour the data pertains to November :

a) Wip inventory November one : none

b) Work in process on November 30 : 800 units ( 75 percent complete as to labour , material is issued at the beginning of processing )

c) Units completed is 56000units

d) Purchases of materials : 50000 kg for 249 250 $

e) Total actual labour costs are $ 300 760

f) Actual labour costs are 300760 $

g) Direct material quantity variance : 1500 unfavourable

What is the equivalent finished products of direct materials in November ewip and what is the November output

DM in ewip is 100 percent complete because material is added/issued at the beginning fo the period November actual output is 5600+800 (100 %)= 6400 units

What is the equivalent finished units of direct labour in November ewip and what is November output

RE DL in ewip is 75 percent

November actual output re DM would be

5600+ 800 ( 75 %)= 6200 units

Direct materials

AQ*AP AQ*SP AQ*SP SQ*SP

/————-750 f—————-/ /—————1500u——————–/

50000*4.95 50000*5 51200*5 51200*5

249250 250000 257500 256000

Standard quantity would be actual output 6400 units *8 kg= 51200

For total variance aqp not equal aqu then cant compute total variance

Direct labour variance

/—————-1460U——————————–/—————————-5740F————/

AH *AR AH*SR SH*SR

36500*8.24 36500*8.20 37200*8.20

300760 299300 305040

SH= 6200 UNITS * 6 HOURS = 37200 HOURS

TOTAL VARIANCE WOULD BE 1460U +5740 F=4280 F

Uncategorized

COST, VOLUME AND PROFIT ANALYSIS

Post author By avibooluck
Post date June 3, 2012
No Comments on COST, VOLUME AND PROFIT ANALYSIS

Why is it important to understand cost behaviour?

> It helps in decision making, If there is excess capacity accept any price greater than variable cost

> Helps in planning and control.

> Helps in performance evaluation . Segmented reporting based on cost behaviour and whether cost is controllable or not

We say normally that fixed cost is more controllable than non variable cost

The more debt you have the more leverage you have, fixed cost vs variable cost.

High fixed cost companies > Cell phone companies, utilities , they are really capital intensive companies.

Low fixed cost companies > Retailers , online web based companies

Variable cost behaviour

Examples

Type of organization Variable costs

Merchandising firm Cost of goods sold

Manufacturing firm DM DL

Both Merc and manufacturing Commisions and the delivery of goods ( selling costs

Service organizations Pharmaceuticals , Laundry , Food , Cleaning.

Variable cost patterns

Variable cost changes in total in direct proportion to changes in level of activity

Variable cost is constant on a per unit basis

Activity base

For a cost to be variable it must be variable with something

Usual cost drivers are production and sales activities.

True variable costs are amount not used can be stored and carried forward next period , for example direct materials

Step variable > cant be stored , increases in small steps , available in chunks

For example 2 hours or 4 hours chunks

Strategy of management would be to obtain the fullest use of services

Relevant range is the range of activity management expect to operate. Fc will remain fixed at certain amount within relevant range and VC will be constant per unit within relevant range.

Fixed cost behabiour

Commited fixed behaviour

– Investment in plant , equipment , basic organizational structure of a firm

These costs are : 1 ) Long term in nature

1) Usually continue even in times of economic difficulty

Control of commited costs comes through utilization ( used as effectively and efficiently achieving firms objectives and goals

Discretionary fixed costs

Cost arising from annual decisions that management tend to spend the fixed cost in certain specific areas

These costs are short term in nature

Period of economic difficulty , possible to cut back for short periods of time with minimal damage to long run goals of organization.

Examples are labour , advertising , travel and training and R & D

Trend toward Fixed costs

The Trend today is toward greater fixed cost relative to variable costs

Reasons are > Guaranteed contracts , Automation

Is there a trend toward variable costs too ? outsourcing , JIT

Fixed cost pattern remains constant in total throughout wide ranges of activity

Unitary fixed cost varies inversely with activity if expressed per unit based

Always think of fixed cost in total ,

Step fixed cost are a bit the same as step variable costs except that

1) It cannot be changed as easily as step variable

2) Width of steps is much greater than step variable..

Mixed cost

Is a combination of a fixed cost element and a variable cost element

Example would be home phone bill and salary + commission

Analysis of mixed cost

Fixed cost represents the basic minimum charge for having ready and available service for use

Variable cost represents the actual consumption of the service

Analysis of mixed cost is done on an aggregate basis by looking at past behaviour of a costs at a various levels of activity in order to predict future costs

The results obtained are good approximations of fixed and variable cost

Chapter 7

CVP concepts

Cost Volume Profit

For management accounting as its is a decision making focus we have to understand concepts before coming to a solution

We are going to understand a few concepts and then we will solve problems to see if you understand the topic or not

Sales

-Variable costs ( dm, dl , vmoh, Vselling&A)

= Contribution margin

– All fixed cost ( FMOH, Fs&A)

= Net income before tax ( NIBT)

– Taxes

= Net income ( AFTER Tax)

Where sales – VC = CM and CM % = CM/ Sales

B) Sales per unit – VC per Unit = CM per unit

$ CM per unit is the incremental profit of selling one more unit

IF current NIBT = 10000 and cm per unit = 12 what if we sell 10 more units then NIBT would increase by 120.

CM % on the other hand is the incremental profit of selling one more dollar

For example if NIBT= 10000 and CM % = 40 % then assuming if we sell 1000 $ more NIBT would increase by $400

C) Taxes

NIBT- TAX = NIAT

Therfore NIBT = NIAT / ( 1- Tax rate)

Or NIAT= NIBT ( 1- Tax rate)

D) Break even points in units

Given is sales per unit = $ 500 , VC per unit = 300 $ and Fc = 80 000

There fore let x be the amount of units sold

500 x- 300 x – 80 000 = 0 ( BEP nibt=o)

X=400 units

BEP in dollars

Let x be $ 1 of sales

Therefore 300/500 = 0.6 and CM = 0.4

x- 0.6x – 80 000 = 0

x= 200 000 BEP dollars = Units sold at break even and Sales per unit

E ) High degree of operating leverage ( DOL ) = Higher fixed cost , lower variable cost and higher Contribution margin which is more sensible to degree of change in sales

LOW degree of Operating leverage means a lower fixed cost , higher variable cost and lower Contribution margin.

E) Indifference analysis would be where the level of sales where profit under bothe alternative would be the same

Alternative one VS Alternative 2

S – VC – FC S- VC- FC

F) Don’t forget opportunity costs ( for example salary forgone to open a business)

You are willing to quit your job and open a coffee shop. If you currently get an amount of 50 000 and benefits ( 20 % of salary ) at your present job what would be the break even point for the coffee shop?

At break even point the NIBT should be 50 000 * 1.2 = 60 000 $

G) When dealing with sales mix situations always think of weighted average when calculating the selling price , the variable cost and the variable CM

1^st example : UBC COMPANY

	Sales total	Per unit	Percent
Sales – 500 unit	$250000	500 $	100 %
Less vc – Same 500	150000	300	60
Cm	100 000	200	40
Less fc	80 000	200
Net income before tax	20000

Contribution margin per unit = 500 – 300 = 200

This amount would be covering first toward fixed cost and then toward profit

Cm per unit means incremental profit from selling one more unit

CM Ratio ( CM % ) = Contribution margin / sales = 200 / 500 = 40 %

Cm ratio means the incremental profit from selling one more dollar. The Cm ratio is very important in a way that it shows the manager how the CM and the NIBT would be affected by a given change in sales

VC ratio would be the VC / sales or SALES – CM

Therefore here for example VC for ABC = 300 / 500 = 60 % or 100- 40 = 60 %

Assume that UBC company sales increase by 15 0 000 next month . What would be the effect on the CM ? And what about the NIBT?

Effect on CM ?

Increase in sales $ 150 000

Therefore the increase in CM would be the 0.40 * 150 000 = 60 000 $

On the other hand the NIBT would increase by 60 000 as FC doesn’t change

The effect on NIBT of any dollar change in sales can be computed by multiplying the change by the cm ratio assuming the fixed cost doesn’t change

Management pont is that with everything equal , the manager would search out and promote sales that have highest cm ratio..

Example A- sp of 100 and cm = 30 percent

B- sp = 100 and CM= 40 percent.

The sale of which product will result in a higher NIBT?

Sales of A would increase NIBT by 30 $

B would increase by 40 $

Therefore there is a change of 10 $ that could be spent on advertising and we would accept product B considering the fact of a higher NIBT

At the break even point ( BEP ) can be defined as where the amount of total sales revenue = total costs or even the point where the total CM = total fixed cost.

For example

UBC food club manufactures pies and the cost and revenue data is as follows :

Selling price 500 $, 100 percent

Variable cost 300$, 60 percent

Contribution M 200 $ , 40 percent

Fixed cost are 80 000 per month

Calculate : Sales in units :

500 x – 300 x- 80 000 =0

X= 400 units

Sales in dollars

x-0.6 x – 80 000 = 0

x= 200 000 $ or also we can do 400 units * selling price = 200 000 $

Other useful formulas to use can be BEP units = fixed costs + nibt ( 0 ) / cm unit

BEP ( $) = Fixed cost + nibt (0) / cm %

Targeted profit

Sales= vc + fc +target profit before tax ( nibt)

Target after tax profit

Niat= Nibt ( 1- tax rate) , therefore NIBT= NIAT/ ( 1- T)

Applications of CVP concepts

1 ) Compare incremental CM to incremental fixed cost to derive incremental NIBT

3) Understand the equations and use them as necessary

Example

UBC bookstore is currently selling 500 books per month. The sales manager believes that a $10 000 increase in the monthly advertising budjet would increase sales by 15 % ( 500 *15 =75 more bikes ) Should the advertising budjet be increased?

Increase in Cm = 75 * 200 = 15 000 Increase in fixed cost = 10000 therefore the total

Increase in NIBT would be 5000 $ , Thus we should increase advertising budjet as profits would increase.

Management point

1) The size of the unit CM figure ( and the CM ratio ) should have a heavy influence on which the steps the company is willing to take to improve profits . The greater the CM/ Unit for a product , the greater the amount the company will be willing to spend for advertising to increase the sales for that particular product

2 ) some firms should base sales persons commissions on CM generated rather than sales generated

Assume that a firm should base sales persons commissions on CM rather than sales generated

	Product a	Product b
Sales price	100	150
Vc	75	132
Cm	25	18
	Greater	lower

What product will salespeople push if they are paid a commission of 10 % of sales

Commission 10 $ A

Commissions 15 $ B

From a standpoint of copany which product would company like to push

Product A as higher contribution margin

How can the company achieve its objective

Base commissions on CM rather than sales ( goal congruence), or provide greater commission for sales of product A

Indifference analysis

Sometime the company has to choose between alternatives that involves Higher fc / lower Vc or lower VC and higher VC

Examples Automation vs labour and salary vs commission etc

Alternative one labour intensive	Alternative 2 Automation
Sales – vc- fc	= Sales –vc –fc
600 x -320x -900 000	=600 x-240x-1200 000
X	=3750 units
Cm of 280	Cm of 360

If expected sales are greater than 3750 units i would push option two as it yields a greater Cm per unit of sales which makes an increase in 80 $ more in NIBT

If expected sales are less than 3750 Units i would push option one more as it yields a lower cm per unit of sales and which makes NIBT 80 $ less

Dont ignore qualitative factors when changing compensation from commission to salary , consider the effects on employees motivation

Operating leverage

A measure of fixed cost in an organization

Firms with high leverage are considered to be more risky in the terms that the company has to pay the same amount of loan payments and fixed costs

If the company has a high operating leverage which means a greater proportion of fixed costs in relation to variable costs, its profits are really more sensitive when we compare it to changes in sales. Higher operating leverage results in a larger change in NIBT with only a smaller change in sales. NIBT change more is cm % is higher

Degree of operating leverage is calculated when CM/ NIBT

Assume NIBT company x and company y is both 60 000

The cm for company x is 15 0 000 and CM for company Y is 400 000

Sales for company x is 500 000 and Sales for company Y is 500 000

Therefore DOL for x is 150 000/60 000 = 2.5 and Company Y is 400 000/60000 = 6.67

Therefore assuming Companies experiences a 10 Percent increase in sales what will be the new NIBT be :

1) Using DOL

Company x NIBT increase by 2.5 *10 % = 25 % therefore new nibt would be 60 000 * 1.25 = 75 k

Company y would be 6.67 *10 % = 66.67 %

Therefore New NIBT would be old NIBT * 66.67 *60000=100k

Therefore we can conclude that the greater the change in DOL ther greater the fluctuation in NIBT

Or we can use cm %

If sales increase by $1 then NIBT increase by 30 cents for company x , Therefore the sales in Company x would be 500 k * 10 percent= 50 000 wwhich would implement a change in the sales of 50 000 * 30 percent to give an additional nibt of 15 k

Therefore the new nibt for company x would be 60 k + 15 k= 75 k

Margin of safety is the excess of sales( actual/ budgeted over the break even level of sales ( actual/ budjeted )

Total sales- Break even sales = MS in $

MS in $/ Total sales= MS in percent

What does it means in words

MS means that it shows the amount where sales can drop before losses begin to be incurred

	Company x		Company y
	Amount	Percent	Amount	Percent
Sales	500 000	100	500 000	100
Vc	350000	70	100 000	20
CM	150000	30	400 000	80
FC	90 000		340000
NIBT	60 000		60000

BEP ( in dollar ) = 90 000 +0 / 0.3= 300 000 company x , company y = 425000

MS in $ = 500-300= $ 200 k where for company Y it would be 75 000 $

MS in %= 40 % where 200/500 whereas for company Y it would be 15 %

Why is the Ms of Company Y smaller than that of company X

For every dollar of sales Y Nibt would decrease 80 – 30 =50 cents more than x NIBT

Company x , to eliminate the 60 000 $ , 200 000* 30%= 60 000

Company Y , to eliminate the 60 000 $ , we take 75000 *80 percent which gives 60 000.

Sales mix ( multi product firm )

The relative combination in which companys products are sold. The managers try to achieve the combination of sales mix that yield the greatest amount of profits. Profits are greater if high margin items make up a relatively large proportion of total sales than if sales consist mostly of low margin items

Changes in the sales mix can have a heavy impact on both profits and the BEP. A significant shift in the sales mix from the high margin items to low margin items can cause total profits to decrease the even though total sales may increase

	Product a	Product b
Sales Price	100	75
VC	50	55
Cm	50	20 ( low margin )

The company sells a total of 300 units ( sales mix 2a :1 B ) and sales increase to 400 units. ( sales mix changes 1 A : 3 B) . What will be the effect on sales & CM?

A = 2/3 B=1/3

Sales ( Current sales mix)

Product A : 2/3*300= 200 units

Product B : 1/3* 300= 100 units

Total sales : ( 200*100 + 100*75)= $27500

Total Cm= ( 200*50+100*200)=12000

Sales new mix = Product A ( 400* 1/ 4) = 100

Product B (units ) = 400* ¾= 300

Total sales ( 100 * 100+ 300 *75)= 32500, Total CM = ( 100*50+300*20)= 11000

If Cm decrease and Fc remain the same , NIBT would decrease by the same amount

Multiproduct break even analysis

The BEP depends on the mix in which the products are sold. Why ? because of different selling variable costs and everything and most likely different contribution margins

The break even point is calculated by dividing the FC by the company weighted average CM/ Unit sales mix . IF sales mix change then BEP also changes

Cm % of A * ( DOLLAR SALES A/ TOTAL DOLLAR SALES ) + CM % OF B * ( DOLLAR SALES B / TOTAL DOLLAR SALES )

Weighted average Cm %

Examples

Weighter cm : 30 % * 100/400 + 60% * 300/400 = 52.5

NiBT quick way = 52.5 % * 400 000= -141750

Break even point total sales = 141750 +0 / 0.525 = 270 000

Break even point sales A = 270 000 * ¼= 67500

Break even point sales B= 270 000 * ¾ =202 500

Proof of correctness would be that if sold 67500, therefore this me that every dollar i sold made me 30 cents whereas if i sold 202500 each dollar i sold made me 60 cents

Break even point therefore would be 67500 ( 0.3)+ 202500 ( 0.6 )= 141 750

Different example

	Contribution Margin per unit	Total units sold 2010 2009	Total cm 2010 2009
Product M	$5	1000 2000	5000 10000
Product N	$3	3000 2000	9000 6000
		*4000 4000*	*14000 1600*

Weighted CM per unit when sales mix is given in units ie 1000 Units of M and 3000 Units of N

Weighted average Cm per unit

Cm/unit for M * ( Units of X/ total units ) + CM/unit of N * ( Units of Y/total Units )

2009 : Weighted average CM Unit ( 16000/ 4000 units ) = $ 4

Using formula : 5 * 2/4 + 3*3/4

2010 : Weighted average CM unit ( 14000/4000)= $3.50

Using formula = 5 *1/4 + 3*3/4= $3.50

Assuming Fc are $210 000 what is the BEP in unit sales of M and N for 2010 ?

BEP ( total units)= 210 000/ 3.50 = 60 000 units

Note that each unit is ¼ M and ¾ N

BEP ( total Units for 2010 )= 210 000 / 3.50 = 60 000 Units

Therefore for unit sales we would have M : ¼ * 60 000 units = 15000

N: ¾ *60 000 units = 45000

Proof of correctness

15000* ( 5) + 45000* (3)=210 000 which is equal to the fixed cost

Linear assumptions in cvp analysis :

1) Assume a linear revenue function and a linear cost function

2) Assume that price ( total fixed cost and Unit variable cost can be accurately identified and remain constant over the relevant range)

3) Assume what is produced and what is sold – ie no change in inventories during the period.

4) For Multiple product analysis , the sales mix is assumed to be known.

5) The selling prices and cost are assumed to be known with certainty

Summary of equations

1) Operating income ( NIBT) = ( price* units )- ( Unit variable cost * units ) – Fixed cost.

2) Break even point in units= Fixed cost/ Cm per unit

3) Break even in sales dollars= Fixed cost / contribution margin ratio

= Fixed cost / ( 1- variable cost ratio)

= Break even point in units * selling price per unit

4) Variable cost ratio = total variable cost / sales

= Unit variable cost / Price

5) Contribution margin ratio = contribution margin / sales

6) Margin of safety= sales- Break even sales

7) Degree of operating leverage= total contribution margin / NIBT

8) % change in NIBT= Degree of operating leverage* % change in sales

9) After Tax income= Operating income ( or NIBT)- ( Tax rate * operating income)

10) Income taxes= Tax rate * Operating income

11) Before tax income= After tax income / ( 1- tax rate)

UBC manufactures and sells compact discs ( CDS) . Price and costs are as follows

Forecasted annual sales ( 120 000 units ) @ 25 $ $ 3000 000

Variable costs per unit

Direct material $ 10.50

Direct labour $ 5.00

Manufacturing overhead $ 3.00

Selling expenses $ 1.30

Total variable costs 19.80

Annual fixed costs 468000

1) What is ubc break even point in units?

= fixed cost / cm unit = 468000/ ( 25-19.8) =90000 units to break even

2) What is UBC break even point in Sales dollars ?

468000/ cm ratio= 468000/ 0.208=2.25 M

Cm % = cm / Sales= 5.2/25= 0.208

3) How many units would sfi have to sell in order to earn 260 000 $?

(468000 + 260 000) / 5.20 = 140 000 units

4) How many units UBC have to sell in order to earn a profit of 10 % of sales ?

Therefore UBC has to sell :

5.20 x- 468000 = 2.5 x

X= 173334

5) If SFI expects to sell 120 000 units what selling price would result in a 20 % of sales ?

120000 x – 19.8 ( 120000 x)- 468000= 0.20 ( 120000 x)

X= 29.63

6) What is the firm margin of safety?

Total sales – break even sales = margin of safety

Break even sales = fc + nibt / cm %

= 3 M- 2.25 M = 0.75 M

0.75 m/3= 25 % margin of safety

7) Management estimates that direct labour cost would increase by 8 percent next year ? How many units does ubc has to sell to break even ?

New cm per unit = 5.20 – ( 5* 0.08) = 4.80

Break even point = 468000 +0 / 4.8= 97 500 units

All other things equal as cm per unit increase break even point decrease

There is an inverse relationship that happens and it is the same case for the other scenario.

8) If UBC direct labour cost do increase by 8 percent next year, What price must it charge to maintain the same contribution margin ratio?

Contribution margin ratio = cm / sales =

x-(20.2) / x = 0.208

Uncategorized

Job order costing ( system design ) ( 3 )

Post author By avibooluck
Post date May 13, 2012
No Comments on Job order costing ( system design ) ( 3 )

Managerial accounting chapter 3 System design ( Job order costing )

Management accounting includes the field of product costing , process of assigning manufacturing costs to manufactured goods.

Why do we say that it is important?

We say it is important as the purpose of a costing system is to provide information to the manager for the role of decision making .

The unit cost is needed for :

a) Pricing products and services ( dont ignore market forces or competition)

Examples : Pharmaceuticals, Beverages, cosmetics.

You sell normally at a higher prices for those products.

b) Adding and dropping products. Make bunch of products , focus on products that making higher margins of sales. Could make or buy decisions. Do we make something or do we buy from someone else. UBC starbucks, Do we make it or do we buy from someone else ( outsourcing ) . Another example is hotels. Do i clean the towels and laudry or do i outsource it for someone else to do it for me. Make 10000 towels the day , not enough to spread out the economies of scale. Another example is white spot, do i make my own desserts or do i get it from someone else.

c) Access or reject special orders ( excess capacity ) , we need product cost information for balance sheet , We will accept a project if the price is greater than the variable cost as you will have higher margin of profit.

Process costing system : homogenous product , things like beer and milk.

The only thing you will do in theory would be single homogenous products that is produced for a long time.

The basic approach would be to take cost for entire period and divide by the number of units producted during the period

Job order costing

Used in situations where many different jobs , products and services are being manufactured or provided each period.

Service industry for example. Different products , different clients , Make to order.

The manufacturing of any product involves what kind of costs ?

Direct labout, direct material and manufacturing overhead.

Production process begins with transfer of raw material to production line , transfer may be direct materials and also may include indirect materials. Why is it important to distinguish between both ?

It is because direct materials go into work in process whereas indirect materials go into actual Manufacturing overhead.

Manufacturing overhead ?

IT is easy to assign materials and labour costs to product and services . why?

Because they are direct costs

However its is difficult to assign manufacturing overhead costs to product and services since they are indirect costs.

Predetermined overhead rate is used to assign overhead costs to products and services. It is based on estimated data and it is established before a period begins ( at the beginning of the period )

Why do we use estimated data ?

Waiting until the period ( month or year ) to actually determine actual overhead cost would be too late. Managers need timely information for decision making purposes such as setting price for cost plus contracts and bidding for contracts and requests for proposals.

2 ) Overhead cost sometimes are uniform from month to month while activity may change substantially from month to month and vice versa. We need to average sometimes.

Predetermined overhead rate ( POH) =

Estimated total fixed and variable moh costs/ estimated activity level ( MH, DLH, ETC)

Assumes ubc allocates overhead cost to jobs on the basis of machine hours , for the coming year in 2013 we estimates that we will incur an amount of 600 000$ in manufacturing overhead and work 75000 machine hours.

My POH RATE = 600 000 / 75000= $8 PER MH

Refer to previous example now we will apply the manufacturing overhead. If the particular job requires 5000 $ for direct material and 3000 $ for labour, and the job requirement is 500 machine hours to complete the cost of the job therefore will be

Direct materials ( actual ) $ 5000

Direct Labour ( actual ) $3000

Applied MOH $ 4000 ( 500*8), as 8$ was my poh rate

What drives an overhead cost?

Cost driver , the incurrence of cost like machine hours as machine hours go up , moh goes up its a direct relationship.

Nowadays since automation we see a divergence towards more fixed costs since automation

Therefore the importance of direct labour is that it is decreasing and that MOH is increasing.

If an inaccurate base is used therefore we would yield inaccurate results.

A reminder of the rules of debits and credits would be

Dead = debits increase for (expenses, assets and dividends)

Assets liabilities

Dr + DR –

Cr – CR+

Shareholders equity is comprised of common shares and retained earnings

Common shares Retained earnings

Dr – DR –

CR + CR+

Retained earnings is comprised of expenses , dividends and revenues

Expenses dividends Revenues

Dr + DR + DR –

Cr – CR + CR +

Now lets take this as an example

a) UBC purchases raw material ( direct and indirect ) purchased on account for an amount of $ 150 000

Raw material inventory 150000

Accounts payable 150000

b) UBC purchases and issues / and requisitioned for used in production $ 160 000 ( 85 % direct materials and 15 % indirect materials )

Work in process inventory 0.85 *160000= 136000

MOH 0.15*136000= 24000

Raw material inventory 160000

c) UBC employee service costs : Direct labour of 200000, Indirect labour 85000, Selling and administrative salaries 90000

Work in process 200000

MOH 85000

Salaries expense 90000

Salaries and wage payable 90000

d) UBC Utilities cost for their wood processing factory 40000

MOH 40000

Cash 40000

e) Prepaid insurance expired during the year , 20000 ( 80 % factory operations , 20 % selling and administrative expenses)

MOH 0.8 *20000 $16000

Insurance expense 0.2*20000 4000 period cost

Prepaid insurance 20000

f) UBC Sauder school of business advertising costs incurrence $ 100 000

Advertising expense $ 100 000 Period cost

Cash $ 100000

G) Amortization/ Depreciation was recorded on UBC factory assets $ 145000, and selling and administrative assets $ 15000

Manufacturing overhead 145000

Amortization expense 15000 ( Period cost )

Accumulated amortization 160000

We will never see wage expenses ( factory workers or amortization expense as separate line items on a manufacturing company income statement ? No, these are product costs.

Dm used , dl and applied moh go into WIP, which goes into Finished goods when completed which goes into cogs when sold, therefore cogs is the ultimate expense for all manufacturing costs.

But, wage expense and amortization expense are period costs for the office equipment , ( Expensed as incurred)

g) Manufacturing overhead was applied to WIP. UBC predetermined overhead rate ( poh ) for 2011 was based on the following estimated data. Manufacturing overhead : 315 000 , Direct labour cost 210000

Estimate therefore would be 315000/210000= 150 % of direct labour cost

Therefore manufacturing overhead would be activity * rate

200000 * 150 %= 300 000

Therefore the journal entry to record the actual moh would be

Work in process inventory 300 000

Manufacturing overheard 300000

h) Costs of good manufactured of 650000 was transferred into finished goods.

Therefore this is the cost of goods manufactured.

We will :

Finished goods inventory 650000

Wip 650000

i) Sales for the entire year was on account an amount of 900000 $

Account receivable 900 000

Sales reveunue 900 000

J ) The company gross margin therefore would be 33 .333 % which means the company cost of goods sold is ( 67% )

Cost of goods sold 600000

Finished goods 600000

Raw material inventory

20000
a) 150000	B ) 160000

Balance 10000

Manufacturing overhead

b) 24000
c) 85000
d) 40000
e) 16000
f) 145000
	g) 300000

Therefore actual 310000 applied moh 300 000

Therefore balance 10000

Underappplied moh as actual is greater than applied moh, just to note that the ubc moh is 310000 actual one but what has been applied is only 300 000

Work in process inventory

Balance 74000
136000
200000
300000	650000

Balance 60000

Finished goods inventory

Balance 40000
I ) 650 000	600 000 ( k) cogs
Balance 90 , 000

Nothe that whatever was credited from Gogm was debited in Finished goods

And also Whatever would be credited from Finshed goods ( GOGS ) would be debited in GOGS

GOGS

j) 600 000

We need to dispose under and overapplied overhead since its is put into wip account which goes into finished goods and eventually into cogs. Applied overhead is based on a predetermined overhead rate ( poh rate ) at the beginning of the year.

By the end of the year then we know that the actual overhead is known. We want to include the actual moh in the wip , FG and GOGS account , however we cant until the the end of the year. During the year , for planning and decision making purposes , we calculate a poh rate and apply overhead to wip.

We prorate if its material , which means we allocate the under and over applied overhead to WIP , FG and COGS account if ( material) which is under over applied / actual >=5 %

Whereas we close under/over applied into gogs if immaterial <5 %

Therefore as 10 000/310000 = 3.2 %

Close the balance to cost of goods sold

Cost of goods sold 10000

Manufacturing overhead 10 000 Which is immaterial we want to make the underapplied overapplied which is immaterial zero

But if the results were Material >=5 %

Work in process inventory

60000

Finished goods

90000

12%

Cost of goods sold

Total

600 000

750000

80%

100%

Therefore we can close the journal entry to get rid of MOH

WORK IN PROCESS 8 % *10000 800

FINISHED GOODS 12 %*10000 1200

GOGS 0.8* 10000 8000

MANUFACTURING OVERHEAD 10000

Also note that whatever is prorated to wip and finished goods will eventually end up as cost of goods sold next year.

What are managers biased to do :

Sometimes managers, based on bonus measure on profitability

Underapplied means that MOH will have a DR balance and then to close we will debit cost of goods solds and credit MOH. Thus COGS would be higher, there fore managers would want to prorate as it will result in a higher profit based since less than 100 % of cost of goods sold..

If overapplied this means that moh will have a CR balance and to clise we will credit cost of goods sold and debit MOH. Thus Cost of goods sold will be lower and therefore managers would prefer to Close to cost of goodsd sold as it will result in a higher profit. ( Since it will result in a higher profit. Since 100 % would be cr into cost of goods sold and a higher bonus thereby.

Therefore for the income statement we will have

UBC

Income statement

For the year ended December 31, 2011

Sales revenue $900 000

Cost of goods sold $ 610 000

Gross Margin $ 290 000

Summary of the overhead concepts

Estimated overhead costs = Amount of overhead cost that management will be incurred. The estimate is made before period begins in order to compute the predetermined overhead rate

Actual overhead Cost

The amount of overhead cost that is actually incurred in a period ( IDM, IDL, Utilities, rent and so on for the factory )

Applied overhead cost ( DR WIP. CR MOH) amount of overhead cost applied to work in process. Amount is computed by multiplying actual actvity used during a period by predetermining overhead rate

General models of cost flow

Raw material inventory


Debited for purchases	Credited for Dm added to WIP
	Credited for IM added to MOH

Work in process inventory

Debited for cost of DM used , DL incurred, Applied moh	Credited for COGM

Wage Payable

Debited for wages paid ( direct and indirect)	Credited for labour into WIP
	Credited for indirect labour into moh

Manufacturing overhead

ACTUAL MOH

APPLIED MOH

UNDERAPPLIED

OVERAPPLIED

FINISHED GOODS INVENTORY

GOGM	GOGS

GOGS

DEBITED COGS

WORK IN PROCESS

Beginning balance
Dm used ( this period)	Cogm
Dl incurred this period
Applied MOH this period

Where COGM = dm used + dl +applied moh + bwip – ewip

BWIP= dm used + dl uncured + applied moh

Incomplete at the period

EWIP

Dm USED + dl incurred + applied moh

Only jobs incomplete at the end of the period

Accounts receivable

Beginning
Credit sales	Collection
Ending balance

Accounts payable

	Beginning balance
	Credit purchase
Payments
	Ending balance

Wage payable

	BEGINNING
	WAGES INCURRED
WAGES PAID
	ENDING BALANCE

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Cost terms , Concepts and Classifications ( 2)

Post author By avibooluck
Post date May 13, 2012
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Chapter 2

What is cost ?

Ø Financial accounting : generally , cash and or fair market value ( FMV ) or non cash consideration given up

Ø Management accounting has various definitions

Merchandising : These firms buy finished from the manufacturer and resell them.

Manufacturing : They buy raw materials and convert them ( add labour and overhead ) into finished goods which are sold to retailers.

Cost of manufactured products/ service

1 ) Direct materials 2) Direct labour 3) Manufacturing overhead

Direct materials

Raw material become an important of the finished product , can be conveniently traced to the product or service.

Cost benefit do the benefits outweigh the cost?

Materiality : Will being exact make a difference in a decision ?

Examples of dm used in a manufacturing a sofa : leather , wood

Indirect materials ( IDM)

What about glue and nails ? Indirect materials

Indirect materials become a part of moh

Direct Labour> Can be physically traced to the creation of the product and be traced to the product / service without undue cost and inconvenience.

Examples : assembly workers

Examples : car repair : Mechanic

Indirect labour : Cannot be physically traced, becomes part of moh

Examples of manufacturing would be janitorial , factory manager

Examples: Service advisor,reception

Compared to a decade ago, now dl is less due to automation
Manufacturing overhead ( MOH )

All cost are manufacturing except dm and dl

Examples indirect material , indirect labour , amortization expense.

Conversation : DL + MOH

Prime cost : DM used + DL

Non Manufacturing costs : Marketing costs and administrative costs.

Marketing cost/ selling costs : Examples : Advertising , shipping , sales commissions.

Administrative cost : Top management , CEO, Marketing / selling

Period costs : All expenses related to a revenue should be recognized in the same period as that related revenue.

All marketing / selling and administrative expenses are period costs.

Manufacturing

Cost of goods sold=

Beginning finished good

+ GOGM

= Gogafs

– Ending finished goods

= GOGS

where GOGM= dm used + dl incurred + moh + bwip – ewip

One example

UBC

Cost of goods manufactured

For the year ended January 31 2012

Direct materials

Beginning raw material

+ purchase

Raw material available for use

– Ending raw material

= Raw material used ans

Direct labour ans

Manufacturing overhead

Indirect materials and indirect labour

Utilities factory

Properties tax and insurance factory

Amortization factory

Total overhead ans for this

Total manufacturing cost would be dm used + dl + total moh

Add BWIP which is previous year ending wip December 31 2011

Deduct EWIP which is jan 31 2012

= Cost of goods manufactured

Cost classification is

1) Variable

2) Fixed

3) Period

4) Product

5) Administrative – period

6) Selling – period

7) Manufacturing – product

8) Direct labour – manufacturing cost

9) Direct material – manufacturing cost

10) Manufacturing overhead – manufacturing cost

a) Cost of fabric in tshirt : Variable cost , product cost , manufacturing cost , direct material

b) Wages of shirt makers ( piece meal)- variable, product , manufacturing , direct labour

c) Cost of advertising for tshirts – fixed , selling ,period

d) Wages for employee per hour for tshirt sewn- fixed cost

e) Cost of electricity used in sewing department – variable, product, manufacturing overhead, manufacturing cost

f) Salaries of Sales personnel : fixed , period, selling cost

g) Amortization on the sewing machines- fixed, product cost, manufacturing cost, manufacturing overhead

h) Rent on building – fixed

1) Part of the first floor used to make tshirts – product cost, manufacturing cost , manufacturing overhead

2) Part of building used for retailes sales shop – product cost, selling cost

3) Second floor was used for administrative offices- Administrative cost , period

4) Part of second floor was used for storage of raw materials- Product, manufacturing, manufacturing overhead

i) Salary of the CEO – Fixed , administrative , period

Behaviour of cost

Total fixed cost is not affected by change in activity level , total fixed cost remains constant

fixed cost per unit drops as activity level increases and vice versa, inverse relationship

Total variable cost increases and decreases in direct proportion with activity level

Variable cost per unit remains constant per unit

Short term costs tend to be fixed and non controllable

Long term costs tend to be variable and controllable

Other types of cost tend to be

Differential costs

Where in making deciosions we say that a cost is relevant when it differs among alternatives. Ex cost in one alternative but absent in the other alternative

Opportunity costs

Potential benefit lost or sacrificed when selecting one course of action meaning to also withdraw a competing course of action

Ex land.

Sunk costs

Cost already incurred and cannot be changed, those costs should be ignored since they are totally irrelevant.

One long example to finish chapter 3

We recently had an earthquake in British Columbia and UBC was part of it and lost all its particular records for their next accouting process but one of its students managed to recover some of the information.

DL this year = 290000

Raw material purchased = 290 000

Sales = 1200 000

Gross Margin rate was 40 % of sales

Cost of goods available for sales was 810 000

Prime cost was 410 000

Manufacturing overhead was 70 % of conversion cost

Beginning Finished goods was 45000

Beginnning raw materials 18000

Work in process beginning 65000

Now UBC wants to know the ending raw materials, ending wip and ending finished goods for their date of the earthquake, what should they do?

Lets solve this piece by piece

Sales 1200 000

COGs 60%* 1200000 = 720000

Gross margin 40 % 1200000 = 480 000

Prime cost = dm + dl

410000 = dm + 180000

DM used = 410 000 – 180 000= 230 000

Conversion cost = dl + moh

Dl = 30 % cc

180 000 = 30 % cc

180 000 / 0.3 = CC

CC= 600 000

Therefore moh = 600 000 – 180 000= 420 000

Ending raw materials

Beginning + purchase – ending = raw material used

18000+290000- ending = 230000

Ending = 78000

Ending finished goods

Beginning finished goods + COGM – Ending finished goods = COGS

Cogafs- Ending finished goods = COGS

810 000- x =720000

X= 90 000

Ending Work in process

DM + DL + Moh + BWIP- Ewip= COGM

230 k+ 180 k+ 420 k+ 65 k -765k

EWIP= 130 K

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What is managerial accounting (1)

Post author By avibooluck
Post date May 12, 2012
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Chapter one is a broad interview of managerial accounting. The purpose of financial accounting would be to provide useful information to external users such as investors and creditors. For managerial accounting the decisions are for the internal decision makers such as managers and board of directors. You need information to solve and evaluate information.

We have three objectives for managerial accounting:

A ) To provide information for costing products, services and other objects of interest to management

B) To provide information for planning , control and performance evaluation.

C) Providing information for decision making.

Managers need accounting information, why?

1) How are the information being used

2) Managers can identify problems , solve problems and evaluate performance

3) Accounting information used in all organizations: Manufacturing, Merchandising, service, non profit and government

Imagine you are a CEO of gap store and what are the types of information they need and what decisions going to help you make.

What are the types of information:

Sales Volume, Expense ect

Conceptual framework of management accounting

Four legs of management accounting

1) Planning 2) Control 3) Performance evaluation 4) decision making

Planning : short term planning vs long term planning

Long term planning is more of a strategic plan , what do you want to achieve in the future whereas short term planning is more of a budjet.

For example Telus, beating shaw with optic tv, stealing business from shaw. Strategic planning .

Control : Am i sticking to my plan? We compare actual results to planned results ( budjeted result and material differences ( performance report)

For example new year resolution . I want to work out 5 times a week in the upcoming year but if i only work out 2 times in one week there is huge difference.

For big businesses with large volume we have to delegate decisions making authority since management and CEO cant really delegate authority. Delegation creates a need for performance evaluation.

The planning and the Control cycle

We plan long term and short term first , then implement plans ( directing and motivating) , Then we measure the performance ( controlling ) , after then we evaluate the differences between plans and actual performances.

Professional judgment , we say that the results is material if its >= 5 % of budget.

(Actual – budget) / budget >= 5 % , then we say that the results is significant

Decision making

-In order to make decision there must be choices, thus decision making must be choosing among competing alternatives

– because of information asymmetry ( managers know more about current condition and future prospects of firm than outside investors/ owners and cant be observed continuously.

Managers not always act in the best interest of the company. ( Goal in congruence)

Management accounting

Cost accounting systems

Knowing how cost behave is crucial for successful enterprise

Knowing how cost behave is important for flexible budgeting and cost volume profit analysis ( cvp ) and decision making

Cost behaviour can be fixed vs Variable

Fixed can be rent and salary whereas variable can be commissions and such

Knowing how cost behave can help us plan and its only variable cost will change as output changes.Imagine your are ceo of air Canada and last minute i want to go to vegas. The ceo of air Canada is there and i run to him for a private conversation. 20 $ take it or leave it to go to vegas. What would be decision of CEO?

1) Accept if the price is greater than the variable cost, exess capacity , request is a special order

Now i say , ill give ceo nothing and just put me on the plane. Take it or leave it?

Knowing the cost going up and down , you will make your decision on this request.

Cost of making , increase in revenue vs increase in cost. Cost going up would be variable cost.

Comaparison of Financial vs Managerial accounting ( purpose is the same )

Providing ( Useful information to users for decision making )

Financial accounting focus on external users : Investors and creditors

Managerial accounting : Management and board of directors

Financial accounting use gap for external report, but management accounting dont have to use it only guided by usefulness to managers

The structure of practice tends to be rigid whereas managerial accounting is relatively flexible.

From comm 294 class and Libby

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Using Blogs.ubc.ca, to actively share what i am learning at the university with the world

Post author By avibooluck
Post date May 12, 2012
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After being done my marketing class with Elaine Sprague , i intend to use this blog to share my knowledge of what im learning at the University of British Columbia, especially at the Sauder school of Buisness with the world. From now on , my blogs will share the notes and the applied material of in class notes from the world class Professors . It would be amazing to demonstrate what it takes to be an active student in one of the most prestigious University in the country.

Sincerely

Avi x

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Journey through comm 296

For my final blog post, I wanted to reflect my journey through the course and how it applies to real life. Coming from a middle class family, I was to aim high, so that I can lead a better life than my father and forefathers. Living in both Mauritius and Canada, the life that I knew and grew up in was filled with ease, respect and fulfillment. My parents came to Canada for the education of their kids. They always wanted me to become a doctor but instead i decided to do something that fully develops my potential and I believed Sauder was the right choice. Before starting class, I assumed marketing was only about advertising. In the end, I saw how it impacts and add value to our community.

The first thing that came to my head when I saw Elaine was that the class would be a really interesting. Elaine’s personality is simply amazing and the way she branded herself leaded to a better class experience. A lot of my learning came from her lectures, when she made sure we get and understand the marketing concepts. Outside the classroom, using what I learned in class, i was able to was more analytical to real world examples. I understood the advertisements I saw on TV and was able to decode the message the marketer wanted to convey. Now that I know more about consumer behavior, I have a better perspective about life in general. One can reap a destiny if he knows how to market and brand himself as a person.