The Nature of Management Accounting

1. The Nature of Management Accounting

2. Management vs. Financial Accounting (1 of 6) • Necessity • Financial Accounting (FA): SEC (or banks or suppliers) requires publicly traded companies to publish financial statements according to GAAP. • Management accounting (MA) is optional. • Purpose. • FA: Produce financial statements for outside users. • MA: Help managers plan, implement and control.

3. Management vs. Financial Accounting (2 of 6) • Users. • FA: faceless group, external users, present or potential shareholders. • MA: Known managers who influence what information is needed. • Underlying structure. • FA: built around: Assets = Liabilities + Stockholders’ Equity. • MA: 3 purposes each with its own set of concepts and constructs (addressed later).

4. Management vs. Financial Accounting (3 of 6) • Source of principles. • FA: GAAP. • MA: whatever managers believe is useful. • Time orientation. • FA: historical, tell it like it was. • MA: future/decision oriented, tell it like it will be. (However, the past is often a good predictor of the future.)

5. Management vs. Financial Accounting (4 of 6) • Information content. • FA: financial statements are the end product and include primarily financial info. • MA: non-monetary as well as monetary info. • Information precision. • FA: Uses approximations but as a generalization is more precise than MA. • MA: Management needs info rapidly to be useful in decision making and therefore precision is sometimes sacrificed.

6. Management vs. Financial Accounting (5 of 6) • Report frequency: • FA: Publicly traded, SEC: quarterly, with more detailed info annually. • MA: Up to management. • Report timeliness. • FA: Usually, several weeks to months after fiscal close of accounting period. • MA: Quickly to be useful for decision making.

7. Management vs. Financial Accounting (6 of 6) • Report entity. • FA: Organization as a whole. • MA: Relatively small parts (responsibilities centers such as departments, product lines, divisions, subsidiaries as well as organization as a whole.)

8. Uses of Management Accounting • Measurement of revenues, costs, and assets. • Control. • To aid in choosing among alternative courses of action.

9. Measurement • Full cost accounting measures the resources used in performing some activity. • Full cost of producing goods or providing services = direct costs + indirect costs. • Direct costs = costs directly traced to the goods or services. • Indirect costs = a fair share of costs incurred jointly in producing goods or services.

10. Measurement example • Be careful of how you allocate that overhead. • How expensive is that ashtray?

11. Control • Costs (also, revenues and assets) are identified to and measured by responsibility center. • A manager heads each responsibility center. • Corrective action can only be taken by individuals. • To help identify problems (and opportunities) actual costs are measured and compared to a benchmark (budget, last year, industry average).

12. Alternative Choice Decisions • Differential costs of alternative possible actions are developed.

13. General Observations on MA • Different numbers for different purposes. • Many different types of costs: historical, standard, overhead, variable, fixed, differential, marginal, opportunity, direct, estimated, full, etc. • Clarify which type you are talking about. • Accounting numbers are approximations. • Best that we can with incomplete data. • Accounting evidence is only partial evidence other factors help make decisions. • People not numbers get things done. How you use the numbers is as important as how the numbers are produced.

14. The Behavior of Costs and Decision-Making

15. What will be covered • A general overview of how costs “behave.” • Several applications of how this knowledge can help you make better, informed, decisions. • Some examples of what we will be able to solve:

16. Breakeven analysis • You are considering offering a new service (such as delivery of take-out) and you wish to determine what volume you will need to generate to cover your costs.

17. Close a location decision • You are responsible for several locations. One location consistently shows a “loss” on its income statement. Should it be closed? If so, will your region be better off?

18. Special orders decisions • You have been offered a one-time special order. You need to determine if you should accept the order given the price is lower than the normal charge for comparable meals you serve.

19. Behavior of Costs • Cost-volume relationships. • Fixed and variable costs. • Step-function costs.

20. Relation of Costs to Volume • Variable costs = items of cost that vary, in total, directly and proportionately with volume. • Fixed costs = items of cost that, in total, do not vary at all with volume • Semi-variable costs (semi-fixed costs) = costs that include a combination of variable cost and fixed cost items.

21. Variable Costs • Items of cost that vary, in total, directly and proportionately with volume. • Volume refers to activity level. • Examples: • Material costs varies with units sold. • Electricity costs varies with production hours. • Stationery and postage costs varies with number of letters written.

22. Fixed costs • Items of cost that, in total, do not vary at all with volume. • Examples: • Building rent, property taxes, management salaries. • Fixed cost per unit of activity decreases as the level of activity increases. • Fixed costs are fixed for a range of activity and a limited period of time.

23. Beware of how cost behave! • Fixed costs should not be treated as variable in decision making. • Senate gym example.

24. Cost-volume (C-V) diagram • Y or vertical axis reflects total cost. • X or horizontal axis reflects volume. • y = mx + b. • y is the cost at a volume of x; • m is the rate of cost change per unit of volume change, or the slope (variable costs). • b is the vertical intercept, which represents the fixed cost component.

25. Profit-graph • Add revenue line to C-V diagram. • Assumes constant selling price. • UR = unit revenue • TR = total revenue

26. TC = TFC +(UVC*X) • TC = total cost; • TFC = total fixed cost (per time period), • UVC = Unit variable cost (per unit of volume), • X = volume.

27. Cost Relations • Average costs = total cost/volume. • Average cost behaves differently than total cost. • As volume goes up  • Total fixed cost remains constant, total variable costs goes up, per unit variable costs stays the same, per unit fixed cost goes down, per unit total cost goes down.

28. Step-function costs • Incurred when costs are added in discrete chunks, e.g., a manager for every 10 workers. • Adding the “chunk” of costs increases capacity. • Height of a stair step (riser) indicates the cost of adding incremental capacity. • Step width (tread) shows how much additional volume of that activity can be serviced by this additional increment of capacity.

29. Contribution • Unit contribution margin = marginal income = unit selling price - variable cost per unit = UR - UVC. • What is contribution: • First it is the contribution to cover fixed costs. • Then it is the contribution toward profit.

30. Breakeven Volume • TR = UR*X • TC = TFC + (UVC*X) • Breakeven: TR = TC • Substituting: UR*X = TFC + (UVC*X)  X = TFC/(UR - UVC)

31. Break-even Volume • In units = Fixed costs/unit contribution • In revenue dollars just compute break-even in units and multiply by the selling price.

32. A simple example • You run a restaurant that serves one type of meal that sells for $5. • The variable costs (ingredients, container, etc.) total $3. • Monthly fixed costs (rent, salary, etc.) total $4,000. • What is the breakeven amount in volume and in sales dollars?

33. Target Profit • Add to breakeven analysis to show units or dollar of sales to achieve a target (T) level of profit: UR*X = TFC + (UVC*X) + T X = (TFC+T)/(UR - UVC)

34. A simple example - continued • Instead of just breaking even, you would like to make a profit of $2,500. • What volume of meals will you need to serve?

35. Now your turn. • Take-out problem.

36. Up the ante • Some slightly harder problems • Grizzly Express • Store 201 example

37. Limitations of C-V Relations • A straight line approximates cost behavior only within a certain range of volume, the relevant range. • When volume approaches zero, management takes steps to reduce fixed costs. • When volume exceeds relevant range, fixed costs increase.

38. Limitations (continued) • Amount of variable costs depends on the time period over which behavior is estimated (the relevant time period). • If the time period is one day, few costs are variable. • Over an extremely long time period, no costs are fixed.

39. Linear Assumption • C-V relationship is often not linear. • Some cost functions are curved (curvilinear). • Segments of the curve can be approximated by a straight line, each with its own relevant range.

40. Short-Run Alternative Choice Decisions

41. Highlights • Alternative choice decisions: manager seeks to choose best of several alternative courses of action. • Introduces construct of differential costs and revenues for several types of problems, each having a relatively short time horizon.

42. Differential Costs and Revenues • Costs that are different under one set of conditions than they would be under another. • Revenues that are different under one set of conditions than they would be under another.

43. Nature of Full and Differential Costs • Full cost of a product or other cost object = sum of direct cost + fair share of applicable indirect costs. • Differential costs include only those cost elements of cost that are different under a certain set of conditions.

44. Historical, Full and Differential Costs • Full cost accounting system collects historical costs. • Differential costs always relate to the future. • Differential costs are intended to show what costs will be if a certain course of action is adopted in the future.

45. Steps in the Analysis • Define the problem. • Select possible alternative solutions. (Status quo may be the benchmark against which other alternatives are measured.) • For each alternative, measure and evaluate consequences that can be expressed in quantitative terms. • Identify those consequences that cannot be expressed in quantitative terms and evaluate them against each other and against the measured consequences. • Reach a decision.

46. Opportunity costs • A measure of the value that is lost or sacrificed when the choice of one course of action requires giving up an alternative course of action. • Not measured in accounting records.

47. Sunk Cost • A cost that has already been incurred and therefore cannot be changed by any decision currently being considered. • Not a differential cost.

48. Importance of Time Span • The longer the time span the more items of cost that are differential. • In the very long run full costs are differential costs.

49. Sensitivity Analysis • Considers how sensitive the quantitative measurements of the alternatives are to changes in assumptions.

50. Just One Fallacy • Each additional unit of production adds just variable costs. • If many units are added, then step function costs (i.e., fixed costs) are added. • Therefore, step function costs are averaged out over the additional units of volume.