Management Accounting

and
Management Decisions

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 Cost Accounting
Measures and reports financial and non-
financial information
Relates to cost of acquiring or utilizing
resources in an organization
Uses various techniques to provide
reliable estimates of product/service cost
Provides information for management
accounting and financial accounting
2
 Financial Accounting
Focuses on reporting to external parties --
investors, regulators and others
Uses a standardized format to:
Record business transactions
Report aggregate results to external users
Financial statements must be free from
material misstatement
Compensation often tied to reported
income
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 Management Accounting
Focuses on reporting to internal parties
Uses a customized format to:
Report financial and non-financial
information
Provide information useful to managers to
plan, communicate and implement strategy
Monitor performance
Coordinate product design, production and
marketing

4
Managerial and Financial
Accounting Comparison

5
 Planning & Control
Planning: Choosing goals and deciding how to
attain them. How best to communicate goals?
Budget: Quantitative expression of a plan

Control: Implementing planning decisions and

evaluating actual results against expected results
Variance: Difference between actual and expected
amounts
Management by exception: Concentrate on areas not
meeting expectations

6
 Planning and Control Cycle

Formulating
Formulatinglong-
long- Begin
and
andshort-term
short-termplans
plans
(Planning)
(Planning)

Comparing
Comparingactual
actual Implementing
Implementing
to
toplanned
planned Decision plans
performance Making plans(Directing
(Directing
performance and
(Controlling) andMotivating)
Motivating)
(Controlling)

Measuring
Measuring
performance
performance
(Controlling)
(Controlling)
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 Management Accounting:
Key Guidelines
Cost-benefit approach
Net benefits from using resources should exceed
cost of those resources
Behavioral and technical considerations
Systems are not confined to technical matters
Include the role of individuals and groups
Different costs for different purposes
One concept does not fit all purposes (e.g. external
reports versus internal evaluation)

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 Ethics & Governance
Corporate social responsibility
Voluntary inclusion of social and environmental
concerns
Corporate governance
Mandatory compliance with laws, regulations
and standards
Professional accounting organizations
promote high standards of ethics
Members must adhere to standards
Provides protection to the public 9
 Cost Behaviour and
Cost-Volume Relationships

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 Cost Behaviour
Cost Behaviour: how the activities of an
organization affect its costs

Short Run: A period when productive capacity

cannot be changed and is a constraint

Long Run: A period when productive capacity

can be changed and is not a constraint

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 Cost Behaviour
Cost Driver
an activity which influences how a cost is incurred
kilometers traveled is a cost driver for gasoline costs
Variable Cost
a cost which changes in direct proportion to changes in
the cost driver
is constant per unit as volume changes
Fixed Cost
a cost which is not influenced by changes in the cost
driver over the relevant range
per unit fixed costs change as volume changes
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Cost-Volume-Profit Overview:
The CVP model examines the relationship between
firm cost structure (i.e., relative proportion of fixed and
variable costs) and sales volume and the effects of
this relationship on the profitability of a firm.

The model can be used by managers for the purposes

of planning and decision making.

This basic model combines four important variables

volume of sales, costs, revenue, and profits. The basic
model can be extended to assess the impact of price,
cost, and volume changes, along with changes in
product mix and income taxes.

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 COST-VOLUME-PROFIT ANALYSIS

Often called "breakeven analysis", but

goes beyond it to determine the
operating income or net income that is
expected to arise in specific
circumstances

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 Basic Assumptions of CVP Analysis:

1. Single Product or "Sales Mix" Remains

Constant
2. All Costs = Fixed Or Variable
3. Only "Cost Driver" = units sold
4. All Revenues & Costs have "Linear"
relationships
5. "Time Value Of Money" Is Ignored
6. Selling Price, Variable cost per unit, and
Fixed Costs are known (no uncertainty)

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 Features and terminology:
Income model:
Revenues Expenses = Income
Rev-COGS = GM
GM-Period expense = Income

Contribution margin: Revenues Variable costs

Calculated per unit: Selling price/unit Variable cost/unit
Calculated as a percent of price or ratio: Contribution Margin/price
Calculated as a total: Sales (Revenues) Total Variable costs

Multiple-step-type income statement:

Rev TVC = TCM
TCM FC = OI

Operating income versus Net income

OI + Nonoperating Rev. Nonoperating Costs Income Tax = NI
For CVP analysis we assume that nonoperating revenues and expenses are
zero
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 Example:
Per Unit For 2 units %

Revenue $200 $400 100%

Variable costs 120 240 60%

Contribution margin $80 $160 40%

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 Breakeven concept:
Definition of breakeven point: operating income is zero

Example: Price -$20, Variable Cost- $10 & Fixed Cost- $1,000

Contribution Margin per unit Contribution Margin %

(or CM per unit) (or CM%)
= Revenue - Variable cost = CM per unit / revenue per unit
= $20 - $10 = $10 / $20
= $10 per unit = 50%

Break-Even Point in Units Break-Even Point in Dollars

= Fixed costs / CM per unit = Fixed costs / CM%
= $1,000 / $10 = $1,000 / 50%
= 100 units = $2,000

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 Target Income

Example: Target Income- $750

Target Sales in Units Target Sales in Dollars

= (Fixed costs + Target income) = (Fixed costs + Target income)

/ CM per unit / CM%

= ($1,000 + $750) / $10 = ($1,000 + $750) / 50%

= 175 units = $3,500

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 Example 1:

A recent income statement of ABC Corporation reported the following data:

Units sold 5,000

Sales revenue $5,000,000
Variable costs 3,000,000
Fixed costs 800,000

If the company desired to earn a target net profit of $820,000, the number of
units it would have to sell?

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 Target Income and Income Tax:
Example: Target Income- $750; Income tax 25%

- note that income taxes are neither a variable nor a fixed cost

- convert desired after-tax net income to its before-tax equivalent before adding into the
target sales formula

Target income before income taxes

= Target after-tax net income / (1 - tax rate)

= $750 / (1 - .25) = $750 / .75 = $1,000

Therefore target sales in units to achieve a after tax income of $750

= ($1,000 + $1,000)/ $10 = 200 Units

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Example 2
Suppose you were an executive at GM in 2008 and you were
planning to reduce fixed labour costs by $10 billion. Assume that
the variable cost ratio on GMs automotive sales was 0.15. Before
performing any calculations, answer the following question: Would
GMs break-even point also decrease by $10 billion? Why or why
not?

GMs automotive revenue in 2008 was $147.7 billion, and the

automotive cost of sales was $149.3 billion. Sales and
administrative expenses were $14.3 billion; assume these were all
fixed. Calculate GMs break-even point on automotive sales
(excluding financial services and interest revenue) given these
assumptions for 2008, and again assuming that fixed labour
costs were cut by $10 billion. Was your answer to the first question
correct? Why or why not?

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 Other topics:

Margin of Safety
Operating Leverage
CVP analysis with multiple products

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 Margin of Safety

Margin of safety (in units)

= Expected sales (in units) Sales at break-even (in
units)

Margin of safety ($)

= Expected sales ($) Sales at break-even ($)

Margin of safety in dollars

Margin of safety percentage =
Total sales

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 Margin of Safety
The margin of safety ratio is a useful measure of
comparing the relative risk among alternative
products or for assessing the riskiness in any
given product.

A relatively low margin of safety ratio for a

product is usually an indication that the product
is riskier than higher margin of safety products.

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 Operating Leverage & Cost Structure

Cost Structure
Cost structure refers to the relative proportion of
fixed and variable costs in an organization.
The optimal cost structure for a company
depends on many factors, including the long-run
trend in sales, year-to-year fluctuations in the
level of sales, and the attitudes of owners and
managers towards risk.
Understanding a companys cost structure is
important for decision making as well as for
analysis of performance.

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 Operating Leverage & Cost Structure
Operating leverage
Operating leverage is named for the lever effect that
comes from the use of fixed costs to generate more profit.
If the choice exists to incur fixed or variable cost, and
fixed is chosen, then variable cost would be less, yielding
a larger contribution margin and the possibility of larger
profit. Once the fixed costs are recovered, the
contribution margin is profit.
This effect can be seen on a breakeven graph. The
intersecting revenue and total cost lines create equal and
opposite angles at the intersection point.
One can note that the risk (downside) is equal to the
reward (upside). The larger the fixed cost, the wider the
intersection angles usually: the greater the opportunity for
reward, the greater the possibility of loss.
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 Cost Structure and Profit Stability
There are advantages and disadvantages to high fixed cost (or
low variable cost) and low fixed cost (or high variable cost)
structures.

An advantage of a high fixed

cost structure is that income A disadvantage of a high fixed
will be higher in good years cost structure is that income
compared to companies will be lower in bad years
with lower proportion of compared to companies
fixed costs. with lower proportion of
fixed costs.
Companies with low fixed cost structures enjoy greater
stability in income across good and bad years.
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 Operating Leverage

A measure of how sensitive net operating

income is to percentage changes in sales.

Degree of Contribution margin

=
operating leverage Net operating income

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 Operating Leverage
At Racing, the degree of operating leverage is 5

Actual
Actual sales
sales
500
500 Bikes
Bikes
Sales
Sales $$ 250,000
250,000
Less:
Less: variable
variable expenses
expenses 150,000
150,000
Contribution
Contribution margin
margin 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000
Net
Net income
income $$ 20,000
20,000

$100,000 = 5
$20,000 30
 Operating Leverage

With an operating leverage of 5, if Racing

increases its sales by 10%, net operating
income would increase by 50%.

Percent increase in sales 10%

Degree of operating leverage 5
Percent increase in profits 50%

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 CVP Analysis for Multiple Products

Sales Mix:
- The term sales mix means the relative proportions in
which a companys products are sold. Most companies
produce a number of different products with different
selling prices, costs, and contribution margins. Thus,
changes in the sales mix can cause variations in a
companys profits.
- As a result, the break-even point in a multi-product
company is dependent on the mix in which the various
products are sold.

Constant sales mix assumption

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 Two Methods
Weighted Average CM method
Use Simple Algebra

33
 Cost-Volume-Profit Analysis
Multiple Product Situations

A A Sales Mix in units

$5 $5 relative mix based on the # of units sold
A = 40%; B = 60%
B B B Sales Mix in dollars
$10 $10 $10
relative mix based on the $ value of sales
A = 25%; B = 75%

Average contribution margin per unit

= ($CM A x SM% units A ) + ($CM B x SM% units B )
Average contribution margin percentage
= (CM% A x SM% $ A ) + (CM% B x SM% $ B )

Break-even point in units Break-even point in dollars

= Fixed costs / Average CM per Unit = Fixed Costs / Average CM %

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Example 3

Assuming a constant mix of 3 units of X for

every 1 unit of Y, a selling price of $18 for X and
$24 for Y, variable costs per unit of $12 for X and
$14 for Y, and total fixed costs of $89,600, the
break-even point in units would be?

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 Example 4
The International Engineering Company provides its customers three types of services: Design,
Construction and Consulting. Following information presents the results for year 2010:
Design Construction Consulting Total
Sales ..............................................................................................................
$560,000 $280,000 $560,000 $1,400,00
Variable expenses .........................................................................................
336,000 196,000 448,000 980,000
Contribution margin ......................................................................................
$224,000 $ 84,000 $112,000 420,000
Fixed expenses ...........................................................................................$120,000

Required:

a. Calculate the margin of safety in sales dollars for 2010.

b. If total revenues for 2011 increased by $700,000 and everything else remained the same
as in 2010, what is the expected net income for 2011?

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