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and the
Business Environment
Objectives of Management
Accounting
Providing managers with information for
decision making and planning.
Assisting managers in directing and
controlling operational activities.
Assisting managers in motivating
employees toward the organizations
goals.
Measuring the performance of subunits,
managers, and other employees within
the organization.
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Cost management.
Others?
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Strategic Positioning
The role of cost analysis in the firm depends on how the
firm chooses to compete (lower costs versus superior
products).
Example: How important are standard costs in assessing
performance?
Cost leadership - Very important.
Differentiation - Not as important.
Example: How important is marketing cost analysis?
Cost leadership - Not very important.
Differentiation - Critically important.
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Cost Drivers
Cost driver - any factor whose change causes a
change in the total cost of a related cost object;
more simply, any factor that causes costs.
We assume a causal relation exists between the use
of the cost driver and the incurrence of the cost.
Cost drivers can be financial (e.g., direct materials
costs) or nonfinancial (e.g., number of equipment
setups, number of transactions processed).
Costs are often categorized based on their behavior
relative to a cost driver.
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Costs of Quality
The costs of quality are the costs that would be
eliminated if all workers were perfect in their jobs.
Every dollar and labor hour not used making scrap can
be used for making better products on time or improving
existing products or processes.
Some survey evidence suggests that poor quality leads
to losses of up to 20% to 30% of gross sales.
Costs of quality can be subdivided into the costs of
conformance and the costs of nonconformance.
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Costs of Conformance
Costs of Conformance - the costs necessary to achieve
quality products; in most firms, these costs run to 3% to 4%
of sales; can be categorized into prevention costs and
appraisal costs.
Prevention costs are associated with preventing defects
before they happen. Examples include costs of process
design, product design, employee quality training, supplier
programs, quality improvement projects, machine
inspections, inbound material inspection.
Appraisal costs include measuring, evaluating, or auditing
products to assure conformance to standards. Examples
include field testing, intermediate and end-of-process
inspections, supplies for the activities.
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Costs of Nonconformance
Costs of Nonconformance - the expenditures incurred when
operations go awry; can go as high as 20% of sales; can be
categorized as internal failure and external failure costs.
Internal failure costs are incurred before the product is
shipped. Examples include costs of scrap, rework, reinspection, opportunity cost of machine downtime.
External failure costs are incurred after the product is
shipped. They arise from product failure at the customer
level. Examples include the costs of processing customer
complaints, customer returns, warranty claims, product
recalls, product liability, marketing costs, and opportunity
costs of lost sales and reduced contribution margin.
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Cost Behavior
Cost category In Total
Per Unit
Variable
Total variable cost
Variable cost per unit
changes as the activity
remains the same over wide
level changes
ranges of the activity
Fixed
Total fixed cost remains
Fixed cost per
unit
constant even when the
decreases when the
activity level changes
activity level increases
Total costs = Fixed costs + Variable costs
= F + VX
where V is the variable cost per unit of the activity, and X is the
volume of the activity in appropriate units.
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Engineering estimates.
Account analysis.
Scattergraphs and high-low analyses.
Statistical methods.
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Engineering Estimates
Cost estimates are based on measurement and pricing of the
work involved.
Direct labor:
- Analyze the kind of work performed.
- Estimate the time required for each labor skill for each unit.
- Use local wage rates to obtain labor costs per unit.
Direct material:
- Material required for each unit is obtained from engineering
drawings and specification sheets.
- Material prices are determined from vendor bids.
Overhead costs are obtained in a similar fashion - a detailed
step-by-step analysis of the work involved.
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Advantages/Disadvantages of Engineering
Estimates
Advantages:
- Detailed analysis results in better knowledge of the
entire process.
- Data from prior activities is not required, so it can be
used to estimate costs of new activities/products.
Disadvantages:
- Detailed analysis is time-consuming (thus costly).
- Engineering expertise is usually required.
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Account Analysis
Cost estimates are based on a review of
each account making up the total cost
being analyzed.
The objective of the analysis is to relate
costs and activities in the form of the
general cost equation.
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Advantages/Disadvantages of Account
Analysis
Advantages:
Applied properly, the approach is a reasonable means
of estimating the cost function.
Takes advantage of the experience and judgment of
managers and accountants who are familiar with
company operations and the way costs react to
changes in activity levels.
Disadvantages:
The person estimating the cost function may not be
objective and may misclassify costs as fixed and
variable.
Accounting and managerial expertise are required.
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High-Low Method
Similar to the scattergraph method.
Rather than eyeballing the line, two points in the scatterplot
are chosen and a straight line drawn to connect them.
The two points should be representative of the cost and
activity relationships over the range of activity for which the
estimation is made. These are usually the highest and lowest
levels of the activity (not the cost).
Slope of line = V = (Costhigh Costlow) / (Unitshigh Unitslow).
Intercept of line = F = Costhigh V x (Unitshigh), or
= Costlow V x (Unitslow).
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Advantages/Disadvantages of
High/Low and Scattergraph Methods
Advantages:
- Plotting cost/activity data is useful in assessing
associations
and possible structural changes.
- Involve relatively simple calculations.
- Easy methods to apply.
Disadvantages:
- Inherently subjective in application.
- Model parameter estimates do not use all of the data.
- No statistical means of assessing model fit.
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Regression Analysis
Regression analysis is a statistical procedure that is
used to estimate the parameters of a model that
can be used for forecasting purposes.
The general cost equation estimated is still:
Total costs = F + VX.
In the context of regression analysis, we call total
costs the dependent variable and we call X the
independent variable. The dependent variable is
whatever we are attempting to estimate or forecast.
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Multiple Regression
We can extend the simple regression model (i.e., one
independent variable) to include multiple cost drivers
(i.e., multiple independent variables).
The resulting model can be specified as:
TC = F + V1X1 + V2X2 + . . . + VkXk.
where TC = total costs, and the rest of the variables have
the same meanings as in the simple model.
In concept, we will apply this general model to the
activity-based accounting model we will cover later:
TC = F + VuXu + VbXb + VpXp.
The subscripts (u, b, and p) indicate various categories of
cost drivers.
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Cost-Volume-Profit (C-V-P)
Relationships
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Cost-Volume-Profit Relationships
Cost-Volume-Profit (C-V-P) Analysis - the study of the
interrelationships between costs and volume and how
they impact profit.
Surveys suggest that over 50 percent of responding firms
use some form of C-V-P analysis.
Useful in answering such questions as:
How will revenues and costs be affected if we sell
1,000 more units? If we raise or lower our selling
prices? If we cut fixed costs by 20 percent?
How many units must we sell in order to break even?
How might changes in product mix affect our profits?
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Assumptions
Linear C-V-P analysis assumes that . . .
Revenues change proportionately with volume.
Total variable costs change proportionately with volume.
Fixed costs do not change at all with volume.
Product mix is constant.
All output is sold (equivalently, there is no net change in
inventory levels).
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C-V-P Models
Using the previous assumptions and definitions, we
can derive the following equivalent expressions:
Equation approach to C-V-P Model:
(1 t) [(P V) X F ] = NI.
Contribution approach to C-V-P Model:
X = {F + [NI /(1 t)]} / (P V).
The term (P V) is called contribution margin per
unit (or CM/unit).
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Operating Leverage
The extent to which a firms cost structure is made up of
fixed costs is called operating leverage.
Everything else being equal, the higher a firms operating
leverage, the higher its break-even point.
Higher leverage is associated with more rapidly increasing
losses if demand is less than that required to break even.
Higher leverage is associated with more rapidly increasing
profits after reaching the break-even point.
Firms with lower (higher) leverage tend to have greater
(lower) flexibility in reacting to changes in demand.
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Relevant Costs
Relevant cost - a cost that differs between
alternatives.
Relevant cost or benefit information:
Has some bearing on the future.
Is different across competing alternatives.
Use of relevant costs and benefits in decision making:
Eliminate costs and benefits that do not differ
between alternatives.
Use the remaining costs and benefits that do differ
across alternatives in making the decision.
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Sunk Costs
Sunk Costs - costs which have already been
incurred and cannot be changed by any
current or future action. This implies that sunk
costs are irrelevant in decision making.
Examples: Book value of equipment, cost of
inventory on hand.
Both of these items represent costs that
were incurred at some time in the past;
write-offs of these amounts are irrelevant
unless they affect cash flows.
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Opportunity Costs
An opportunity cost is the potential benefit
given up when the choice of one action
precludes choosing a different option.
Opportunity costs tend to be overlooked or
underestimated, but are usually extremely
important in making a decision. Typically,
opportunity costs are as important as (and
sometimes more important than) initial out-ofpocket costs in the decision.
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Outsourcing Decisions
Relevant factors in the decision to outsource a product or
service:
What are the relevant costs in producing the product or
providing the service?
How important is it to have control over quality and
availability?
What amount of productive capacity is foregone by
producing the product or service internally?
Decision rule: Everything else being equal, outsource the
product or service if the incremental benefit of outsourcing
exceeds the incremental benefit derived from sourcing
internally; otherwise, generate the product or service
internally.
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Pitfalls to Avoid
Sunk costs - These costs occurred in the past and cannot be
changed by any current or future course of action.
Unitized fixed costs - Fixed costs are unitized for product
costing purposes, thus appearing to be variable (and, hence,
avoidable if production were to cease). Fixed costs should
be considered in total rather than on a per-unit basis.
Allocated fixed costs - Allocated fixed costs may or may not
be avoidable even though the product or operating unit to
which the costs are allocated has been discontinued.
Opportunity costs - Opportunity costs are just as real and
important to making a correct decision as are out-of-pocket
costs.
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2.
3.
4.
5.
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Activity-Based Costing
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Identifying Activities
Activity - any event that causes the consumption of overhead resources.
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Activity-Based Costing
Activity-based costing (ABC) system - A product costing system in
which costs are assigned to products or services on the basis of their
consumption of an organizations fundamental activities.
Activity-based costing is designed to provide managers with cost
information for strategic and other decisions that potentially affect
capacity and, therefore, fixed costs.
ABC systems are usually supplemental to the firms formal cost system
(which computes product costs for external reporting purposes).
The linkage between resources and costs:
Products/services
resources
Activities
Firm
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Activity-Based Management
Porters concept of the value chain motivates
implementation of activity-based management
(ABM).
An organization is a causal chain of activities that
add profit or customer value through the
transformation of inputs into delivered services or
products.
The strategic organizational design issue is
configuring an organizations value chain effectively
and efficiently.
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Activity-Based Management
Activity-based cost management - Key objectives:
To measure the cost of the resources consumed in
performing the organizations significant activities.
To identify and eliminate non-value-added costs.
These are the costs of activities that can be
eliminated with no deterioration of product quality,
performance, or perceived value.
To determine the efficiency and effectiveness of all
major activities performed in the enterprise.
To identify and evaluate new activities that can
improve the future performance of the organization.
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Pricing Policy
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Pricing Policy
Pricing policy is generally informed using one of
two basic approaches:
Cost-based pricing.
Market-based pricing.
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Cost-Based Pricing
Cost-based pricing assumes that:
Cost-Based Pricing
Possible cost bases include:
Cost-Based Pricing
The general expression for computing
the markup ratio is given by:
(Costs not included in the cost base + Desired profit) /
Cost base
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Cost-Based Pricing
Potential problems with cost-based pricing:
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Target-Costing
Target-costing starts with determining what
customers are willing to pay for a product or service
(the target price).
The target cost is defined when a target profit is
subtracted from the target price.
Whether the organization can produce the product
or service at the target cost is the issue that
management must address.
The target cost is generally achieved by the
decisions made in the product development phase.
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Target-Costing
Steps in target costing:
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What is a Budget?
A budget is a detailed plan for the acquisition and use of
financial and other resources over a specified period of
time. Good budgeting practice should provide for both
planning and control.
Planning - developing objectives and preparing various
budgets to achieve these objectives.
Control - the steps taken by management to increase the
likelihood that the objectives set down at the planning
stage are attained, and to ensure that all parts of the
organization function in a manner consistent with
organizational policies.
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Responsibility Accounting
Responsibility accounting is based on the notion
that managers should be held responsible for
those (and only those) cost/revenue items that the
manager can control to a significant extent.
However, while some costs may be uncontrollable,
a manager may still be able to mitigate the
incurrence of the cost through appropriate actions.
From a control point of view, someone in the
organization must take ownership for each
budget item or else no one will be responsible.
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Long-range
strategic plan
Individual goals
and values
Anticipated
conditions
Individual
beliefs
Master
budget
Strategic
evaluation
Actual period
results
Performance
evaluation
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Performance Evaluation
Performance evaluation requires a benchmark or standard
for comparison.
Budgeted performance may be a better criterion than past
performance as a benchmark.
Past performance:
may hide inefficiencies.
may not reflect changes in opportunities in the external
business environment.
However, budgets induce additional problems, primarily in
the area of effects on human behavior (e.g., budget
administration may induce budget bias or budgetary
slack).
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Sales/revenue budget.
Ending inventory budget.
Production budget.
Materials requirements (in units and dollars) budget.
Labor costs budget.
Overhead costs budget.
Cost of sales budget.
Marketing and administrative costs budget.
Budgeted income statement.
Capital budget.
Cash budget.
Budgeted balance sheet.
Budgeted statement of cash flows.
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Sales Budget
The sales budget is the basis for all other budget
components.
Units to be sold are a function of the forecasted selling
price.
The budget requires a forecast of sales, typically involving
sales staff and market research. Various statistical
techniques may also be used. Sales may be forecasted in
units and in dollars.
Budgeted revenues can be computed as:
Forecasted sales (in units) x Forecasted selling price.
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Materials
We use the following relationship to forecast
material purchase requirements:
Required
purchases
in units
Materials
Budgeted
to be used in +
ending
production
inventory
Budgeted
beginning
inventory
Estimated
Budgeted
Budgeted
production + cost of beginning cost of ending
costs
inventory
inventory
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Cash Budget
We now need to incorporate the sales cycle in forecasting cash
requirements:
Cash => Inventory => Sales => Accts. Recv. => Cash
Cash budget - a statement of cash on hand at the start of the budget
period, expected cash receipts, expected cash disbursements, and
the resulting cash balance at the end of the period.
Cash disbursements - amounts required to pay for purchases,
operating expenses, taxes, interest, dividends, etc.
Cash receipts - collections from accounts receivable, cash sales, sales
of assets, borrowing, issuing stock, etc.
The cash budget requires that all revenues, costs, expenses, and
other transactions be examined in terms of their effects on cash.
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Sales forecast
Budgeted cost
of sales
Marketing and
admin. budget
Budgeted
income
statement
Cash budget
Budgeted balance
sheet
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Flexible Budgets
Budgets are usually used to evaluate
performance after the fact, using a process
known as variance analysis.
Since some costs are variable with respect to
output and some are fixed, changes in output
will automatically lead to increases/decreases
in costs absent any input from managers.
Since static budgets reflect planned output
rather than actual output, they are not a good
basis of comparison to actual costs.
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Flexible Budgets
In order to use the budget as a control tool (i.e., to evaluate
cost and revenue performance at the end of the period),
budgets usually require revisions to reflect actual output
during the period rather than planned output.
A flexible budget is designed to facilitate these revisions, as
the budget is prepared with full consideration of variable
costs, fixed costs, and the associated cost-volume relations.
Flexible budgets tell managers what costs should have
been given the actual level of output. This makes for a
more equitable basis for comparison with actual costs, and
makes variances easier to interpret.
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Standard Costs,
Performance Reports, and
the Balanced Scorecard
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Standard Costs
Definition: Standard costs are benchmarks for the cost of
a product, process, or subcomponent.
Used for Planning and Decision Making:
Standards can be better predictors of future costs
than actual past costs.
Can be used in product pricing, bidding, and
outsourcing decisions.
Used for Controlling Operations:
Set performance expectations.
Variances from standards get attention of managers.
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Purpose of Variances
Variances measure the difference between
actual and standard costs:
Controlling operations:
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Variance Computation
Symbols: A = Actual; S = Standard; P = Price; Q = Quantity
Total Variance
Standard Cost
Actual Cost
Total Variance =
(AQ AP)
(SQ SP)
= (AQ AP) (SP AQ) + (SP AQ) (SQ SP)
= [(AQ AP) (SP AQ)] + [(SP AQ) (SQ SP)]
= [ AQ (AP SP) ] + [ (AQ SQ) SP ]
=
Price Variance
+
Quantity Variance
Total Variance
Quantity Variance
Price Variance
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Unfavorable: Material purchased for more than planned prices; could also
indicate material had to be rush/special-ordered, due to late requisitioning
by production. More material used than expected.
Favorable: Material purchased for less than planned prices; could indicate
lower quality material purchased or excess quantities purchased (quantity
breaks). Less material used than expected
Higher-quality material resulted in less waste and scrap; may also result in
a favorable labor efficiency variance.
Favorable price variance with unfavorable quantity variance:
Lower-quality material resulted in more waste and scrap; may also result
in an unfavorable labor efficiency variance.
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Customer Perspective:
How Do Our Customers See Us?
Customer concerns fall into four basic
categories:
Time.
Quality.
Performance and service.
Cost.
Firms should articulate goals for each of these
factors, and then translate these goals into
specific measures.
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Financial Perspective:
How Do Our Share/Stakeholders See
Us?
Financial performance measures indicate whether the companys
strategy, implementation, and execution are contributing to
bottom-line improvement.
Typical financial goals have to do with:
Profitability.
Growth.
Shareholder wealth.
Financial goals have been criticized for various reasons (reflect
historical costs, conservatism, assets not reflected on the
balance sheet, etc.).
But improved operating performance does not automatically
translate into financial success; therefore, attention to financial
goals is necessary.
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An Example
Financial:
Customer:
Customer loyalty
On-time delivery
Internal business:
Process quality
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Segment Reporting
and Decentralization
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Decentralization
Decentralization - a form of organization in which sub-unit
managers are given authority to make substantive
decisions.
Micro-level decentralization - a work group of five shop
workers making various quality decisions.
Macro-level decentralization - a stand-alone division of a
firm making product or capital budgeting decisions.
Firms choose to decentralize operations because of
information asymmetries between top managers and local
managers.
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Advantages of Decentralization
Top management is freed to concentrate on strategic and
other high-level issues.
Lower level managers have greater and better
information, which leads to greater responsiveness to
local needs and quicker and better decision making.
Increases motivation and job satisfaction.
Aids management development and learning.
Sharpens the focus of managers and aids in performance
evaluation.
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Disadvantages of Decentralization
Lower-level managers may pursue goals that are
incongruent with the goals of the organization as
a whole.
Activities may be uncoordinated among lowerlevel managers.
Communication among divisions may be hindered.
Lower-level managers may not see the big
picture and may have less loyalty toward the
organization as a whole.
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Responsibility Accounting
Characteristics of responsibility centers are:
The knowledge held the centers managers is difficult
to acquire, maintain, or analyze at higher levels.
The duties that a particular individual in an
organization is expected to perform are specified for
each center.
Types of responsibility centers:
Cost center.
Profit center.
Investment center.
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Segmented Reporting
Effective decentralization requires segmented
reporting.
A segment is a subunit of an organization for
which performance measures (e.g., revenues,
costs, expenses, profit) are needed.
However, the concept of segmented reporting
can be extended to the customer level as well
(e.g., customer profitability analysis).
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The
The
The
The
profitability
profitability
profitability
profitability
of
of
of
of
individual
individual
individual
individual
patients.
physicians.
payer/insurance groups.
departments.
Investment Centers
Given that managers have decision rights over
the activities and net assets of the subunit of
the firm, performance measurement should
address the efficiency and effectiveness of
managers stewardship over those net assets.
Performance measurement for investment
centers:
Return on investment (ROI).
Residual income (RI).
Economic value added (EVA).
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Return on Investment
Return on investment (ROI) for an investment center =
Accounting net income / Total investment in that investment
center
Residual Income
Residual income (RI) =
Accounting income of investment center
(Required rate of return x Capital invested in that center).
Transfer Pricing
Transfer Price - the internal price (or cost allocation)
charged by one segment of a firm for a product or service
supplied to another segment of the same firm.
Examples of transfer prices:
Internal charge paid by final assembly division for
components produced by other divisions.
Service fees to operating departments for
telecommunications, maintenance, and services by
support services departments.
Cost allocations for central administrative services
(general overhead allocation).
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Capital Budgeting/Investment
Alternatives
Opportunity cost of capital: The benefits of investing capital
in one investment alternative that are foregone when that
capital is invested in some other alternative.
When expected cash flows occur in different time periods, the
opportunity cost of capital becomes relevant to our decision.
Capital budgeting: The analysis of investment alternatives
involving cash flows received or paid over time.
Capital budgeting is used for decisions about replacing
equipment, leasing or buying equipment, and plant
acquisitions.
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FV = Future Value
PV = Present Value
r = Interest rate per period (usually per year)
n = Periods from now (usually years)
Then:
Future Value of a single flow:
FV = PV (1 + r)n
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