Management Accounting So 2023 PDF

Management Accounting Management Accounting So 2023 1. The Manager and Management Accounting Management Accounting Definition: Mainly concerned with internal information for the purpose of decision making and control “An...

Management Accounting Management Accounting So 2023 1. The Manager and Management Accounting Management Accounting Definition: Mainly concerned with internal information for the purpose of decision making and control “An value-adding continuous improvement process of nonfinancial and financial information systems that guides management actions and creates the cultural values necessary to achieve an organizations strategic, tactical and operating objectives.” “management by execption purports to focus only on the most relevant issues” Financial Accounting vs. Management Accounting PDCA-Cycle 1. PLAN: define the organisation´s objectives and selects the focus and scope of its strategy 2. DO: involves the implementation of a chosen course of action 3. CHECK: includes measuring and monitoring performance and taking short-term actions based on measured performance 4. ACT: involves managers taking actions to lower costs, change resource allocations, and improve quality  Management Accounting Management Control Systems (MCS) Provide decision makers with tailored, mostly internal, and (non-)financial information. What a Management Accountant should do: o Aggregate financial and qualitative performance assessments o Assesses the profitability of investments o Develops future improvements o Motivating, monitoring and detecting noncompliance with inappropriate organizational behavior -> low regulations should not lead managers to breach ethics The analytical role of management: - Planning and decision making - Acting - Monitoring and improving 2. An Introduction to cost terms and purposes Cost: a sacrificed or forgone resource (e.g., by an activity or a contract) to achieve a specific objective − Budgeted cost: a predicted cost (ex-ante) − Actual cost: a cost that has occurred (ex-post) − Cost accumulation: the collection of cost data in an organized way by means of an accounting system − Cost assignment: gathering of accumulated costs to a cost object (direct and indirect relationships)  Management Accounting Why we have varying definition of costs: è different systems/classifications to develop cost information o Pricing and product-mix: decision about pricing and maximizing profits o Contracting with government agencies: very specific definitions of allowable costs for “costs plus profit” contracts o Preparing external-use financial statements: GAAP-driven product costs alternative ways for management to define classify costs à judgement is required (agreement on classifications and meaning of cost terms) Cost Behavior Is how the activities of an organization affect its cost: è cost behavior depends on cost drivers (variable vs. fixed) è cost behavior depends on cost objects (direct vs. indirect) Cost Driver (Kostentreiber): Variable Costs and Fixed Costs è long term, all costs are variable costs è short term, mayority of costs are fixed costs  Management Accounting Variable costs (Flexible resources) Long Term Flexible resources are resources whose costs are proportional to the amount of the resources used (i.e. the cost driver) - Wood used to make furniture in a factory (cost driver: # chairs) - Electrical power to operate machinery (cost driver: hours) - Fuel used to deliver the furniture to customers (cost driver: distance in km) Think of them on a per-unit basis: Total variable cost = #cost drivers x per-unit variable cost Fixed Costs (Capacity-related resources) Short Term Capacity-related resources are acquired in advance of the work being done Their costs depend upon how much of the resource is acquired, not used (i.e., cost driver do not affect these resources!) - PPE for furniture production - The truck used to deliver the furniture to customers è Both are independent from the cost drivers! Think of them on a total cost basis: As more units are produced, the same fixed cost is spread over more and more units, reducing the cost per unit. è total unchanged in relation to output (i.e. independent from cost drivers) è more output = lower cost per unit (change inversely with output) è Fixed costs are stable within the relevant range but may change between periods è relevant range: band or range of normal activity level in which a specific relationship between level of activity and cost is in question  Management Accounting Cost Objects (Kostenträger): Direct Cost: cost of resource/activity that is acquired for/used by single cost object, can be conveniently and economically tracked to cost object: - cost object “dining room table” àcost of wood - cost object “line of dining room tables” àcost of wood, manager’s salary IF hired Indirect Cost Cost of a resource that was acquired to be used by more than one cost object, allocated to cost object in rational and systematic manner: - cost of a saw used in furniture factory to make different products - manager’s salary if hired to supervise entire production - costs are not “indirect” by law of nature à define them as indirect by deciding how fine- grained measure resources in management accounting system: indirect cost à goes into indirect cost pool(s), then allocate portion of indirect costs to cost object (use of cost driver) Conclusion: è Direct costs can be “traced” è Indirect costs must be “allocated” Cost Functions Direct costs are simple to track but indirect costs are tricky and allocated with cost driver rates Cost Driver: activity that consumes a resource Cost Pool: all costs of the defined, indirect resource /Practical Capacity: the available units of the cost drivers =Cost Driver Rate: the amount to allocate to the cost object è Each cost driver has one cost pool, and each cost pool has one cost driver  Management Accounting Cost function: è mathematical description of how cost changes with changes in level of activity relating to that cost è help managers make decisions and evaluate outcomes è estimate cost functions based on: 1. cause-and-effect relationship: Variations in level of single activity (costdriver) explain variations in related total costs 2. Cost behavior approximated by linear cost function within relevant range Goal of cost-function: understanding relationships between costs and cost drivers allows to: - Make better operating, marketing, production decisions - Plan and evaluate actions - Determine appropriate costs for short-run and long-run decisions Cost Objects anything for which cost measurement is desired è Costs have to be allocated to cost objects Planning Using cost as a basis for determining the selling price of a prospective product è Determining whether a process is cost efficient compared to similar internal or external processes è Using cost in a budgeting model to forecast costs under different levels of activity Evaluation Deciding whether the market price for an existing product makes the product profitable è Determining whether a process is cost efficient compared to similar internal or external processes è Assessing the performance of employees for bonuses Cost Drivers “any output measure that causes costs” Cost drivers measure resource consumption è Ideally, they are used as the allocation base è Allocation base not necessarily equal to the cost driver Total cost = number of units produced x variable costs + fixed cost number of units produced was driver of variable cost è products and services can differ: Total cost = number of cost drivers x cost driver rate + fixed cost  Management Accounting Standards for Cost Drivers: (Cost drivers must fulfil the scientific standards of relevance, reliability and validity) Relevance (significance) è Consider the cost driver that is most relevant è For instance, the resource might be so cheap that it makes no sense to account for it as a variable cost Goodness of fit (reliability) è Cost drivers must reliably conform with actually observed costs è So does the cost driver measure the resource consumption, ideally 1:1? è Is the cost driver a truly variable cost, or is it mixed? Otherwise, there will always be errors in the measurement Economic plausibility (validity) è Is there a logical link between the resource consumption and the chosen cost driver? Do you find the cost driver plausible? è For instance, can you think of examples where a machine is consumed rather by the number of units it processes than the time it is running? Choosing the right cost driver is important to estimate costs! Cost Pool: A cost pool is a subset of total support cost that can be associated with a cost driver A cost pool is a grouping of individual indirect cost items that can be associated with a single cost driver è Combine costs in one pool that are triggered by the same cost driver Indirect costs are not known in the beginning of the year, which makes a hypothetical allocation necessary: - One pool for the actual indirect costs - Another pool for the applied indirect costs è The actual and applied indirect cost pools must be reconciled at year end Stable Cost Drivers / Idle Capacity: Practical Capacity: - Rate remains fixed over the year - Rate does not fluctuate as activity levels change in - the short run caused by: - Internal factors, e.g., overtime payments - External factors that do not affect the efficiency or price of the activity resources, e.g., seasonal demand  Management Accounting Fluctuating Cost Drivers / No Idle Capacity: Actual, planned or average capacity as a basis: - Rate is based on e.g., quarterly cost driver levels - Rates fluctuate with demand Rates (and bid prices) increase as the demand - decreases (and vice versa) ->Vicious circle Rates do not account for the costly idle capacity Cost Driver Rates Determining the appropriate cost driver rate requires cost drivers and cost pools Benefits of realistic cost driver rates: - Increase in support costs as percentage of total cost - Several factors drive support costs rather than one or even two factors Formula: Cost Driver Rate = Cost of support activity / level of cost driver Level of cost driver: è use practical Capacity, NOT actual capacity 3. Job Costing è All cost systems work in essentially the same way – they only differ in their linkage of indirect costs and their definitions of activities Job Order Costing System è The cost object is a unit or multiple units of a distinct product or service which we call a “job” è Applicable for different jobs required for specific customer orders è Each job is a single unit of output, è Heterogeneous products  Management Accounting Process Costing System è The cost object is masses of identical or similar units of a product or service è Applicable when all units produced during a specified time frame are treated as one unit/ one type of output (Continuous/stepwise flow; batch processing) è Homogenous products Actual vs. Normal Costing: Seven-Step Framework to job costing: è to assign costs to an individual job using normal (actual) costing 1. Identify the job that is the chosen cost object 2. Identify the direct costs of the job 3. Select the cost-allocation base(s) (cost driver) to use for allocating indirect costs to the job 4. Identify the indirect costs associated with each cost-allocation base (Determine the appropriate cost pools that are necessary) 5. Compute the Rate per Unit (cost driver rate) of each cost-allocation base used to allocate indirect costs to the job Budgeted (Actual) manufacturing overhead rate = budgeted (actual) manufacturing overhead costs / budgeted (actual) total quantity of cost-allocation base 6. Compute indirect costs allocated to job Budgeted (Actual) manufacturing overhead rate x actual base activity for the job 7. Compute total job costs by adding all direct + indirect costs together  Management Accounting 3. Process Costing è Process costing is a system where the unit cost of a product or service is obtained by assigning total costs to many identical or similar units of output. è Unit costs are calculated by dividing total costs incurred by the number of units of output from the production process. è Each unit receives the same or similar amounts of direct materials costs, direct manufacturing labor costs, and indirect manufacturing costs (manufacturing overhead) è These overheads are called conversion costs o Support Resources (variable direct cost, just as in job costing) o Sum of Direct Labor (Difference to job order costing) Unit Costs = total costs incurred / number of units of output from production process 5-Step framework to Process Costing 1. Summarize the flow of physical units of output 2. Compute output in terms of equivalent units 3. Summarize total costs to account for 4. Compute cost per equivalent unit 5. Assign total costs to è units completed and to è units in ending work-in-process EQUIVALENT UNITS is a derived amount of output units that: Takes the quantity of each input in units completed and in unfinished units of work in process and Converts the quantity of input into the amount of completed output units that could be produced with that quantity of input. They are calculated separately for each input (direct materials and conversion cost)  Management Accounting Multistage process costing: Process-costing systems separate costs into cost categories according to when costs are introduced into the process Prerequisites: è Determine costs for each stage of the process è Assign their costs to individual products At each successive process stage: è Trace all direct material è Allocate conversion costs equally along the production process (general approach). Three cases in Process Costing: è No beginning or ending work-in-process inventories è No beginning work-in-process inventory and some ending work-in-process inventory è Both beginning and ending work-in-process inventories are present Case #1: No beginning or ending work-in-process inventories All costs that were introduced to the process are assigned to the finished units at the end of the period Case #2: No beginning, some ending WIP Direct costs are traced to all started units and Conversion cost are just applied to the finished units and the % of WIP. Process costing must apply the equivalent units of production (EUP) to the conversion costs  Management Accounting Case #3a: Beginning and ending WIP - Weighted-average process-costing method WAPCM calculates cost per equivalent unit of all work done to date (regardless of the accounting period in which it was done) WAPCM assigns this cost to equivalent units a) completed and b) transferred out of the process, and to c) equivalent units in ending work-in-process inventory Case #3b: Beginning and ending WIP - First-in-first-out (FIFO) method FIFO keeps the cost of beginning inventory apart from the cost of work done in the current period FIFO assigns this cost to equivalent units è assigns the cost of the previous accounting period’s equivalent units in beginning work-in-process inventory to the first units completed and transferred out of the process. è the cost of equivalent units worked on during the current period first to complete beginning inventory, next to started and completed new units, and finally to units in ending work-in-process inventory. WAPCM vs. FIFO Transferred-in costs (“previous department costs”) è Transferred-in costs are costs incurred in previous departments that are carried forward as the product’s cost when it moves to a subsequent process in the production cycle. è Journal entries are made to mirror the progress in production from department to department. è Transferred-in costs are treated as if they are a separate type of direct material added at the beginning of the process.  Management Accounting 4. Cost-volume-profit analyses Breakeven Point Cost-volume-profit (CVP) indicates the amount sold at which a company “breaks even” (=profit of zero) è CVP indicates quantity a company must sell until the sum of individual contribution margins cover all fixed costs (= zero operating profit) è If we would rather know the break-even point in monetary units, we need to multiply the units with the unit price. Then, the zero profit can be exchanged – of course – for any amount of desired profit. Operating Profit = Total Revenues – Total Cost Net Profit = Operating Profit +Non-operating Revenues –Non-operating Costs –Profit Taxes Each unit adds a contribution margin at “breakeven”, they are sufficient to cover all fixed costs Two methods for CVP will be discussed: è Contribution margin method è Equation method  Management Accounting Contribution margin method The contribution margin method divides fixed costs by the contribution margin per unit (or the contribution margin ratio) Contribution margin per unit: Contribution margin p. u. = Selling price p.u. – Variable costs p.u. Contribution margin ratio: Contribution margin ratio % = Selling price % – Variable costs % Equation method The equation method solves the profit equation for the number of units to be sold Formulas: Break-even volume in Units = Fixed Expenses / Contribution margin per unit Break-even volume in Sales = Fixed Expenses / Contribution margin ratio % Cost-volume-profit (CVP) assumptions Full information è The unit selling price, unit variable costs and fixed costs are known and constant Linearity è Number of units (product or service) produced and sold is the only driver of changes in the level of revenues and costs è When graphed, the behavior of total revenues and total costs is linear (straight-line) in relation to output units within the relevant range (and time period). Static view è Time value of money is ignored è Competitor reactions, decreasing demand function, (negative) synergies, economics of scale etc. are ignored è Costs are assumed to be either fully “fixed” or “variable” è The analysis: - either covers a single product or - assumes that the sales mix of multiple products remains constant  Management Accounting Cost Volume Profit (CVP) analysis with target profit Breaking even is often not enough – companies want to make profits Target Profit = Revenue – Variable Costs – Fixed Costs = (Units sold x revenue per unit) – (units sold x variable cost per unit) – fixed costs = [Units sold x (revenue per unit – variable cost per unit)] – fixed costs = (Units sold x contribution margin per unit) – fixed costs Cost Volume Profit Analysis Operating leverage è Operating leverage measures the relationship between a company’s variable and fixed expenses è Operating leverage is greatest when − fixed costs are high, and − variable expenses per unit are low è The degree of operating leverage shows how a percentage change in sales volume affects profit Formula: Operating Leverage = Contribution Margin / Operating Profit Multiple break-even points products vary in their contribution margin è a sales mix helps to conduct such multiple break-even analysis Sales mix is the quantity/proportion of various products/services that constitute a company’s total unit sales We can use the same formula in our CVP calculations but must use an average contribution margin for the products è This technique assumes a constant mix at different levels of total unit sales  Management Accounting Decision making Differential Analysis Opportunity, outlay, and differential costs: è Differential cost is the difference in total cost between two alternatives è Differential revenue is the difference in total revenue between two alternatives è Incremental costs are additional costs (or reduced benefits) generated by the proposed alternative è Incremental benefits are the additional revenues (or reduced costs) generated by the proposed alternative è An incremental analysis is an analysis of the incremental costs and benefits of a proposed alternative è An outlay cost requires a cash disbursement Make or Buy Make or buy decisions must be made if third parties can provide a product or a service of higher quality or lower cost: Internal make costs that can be avoided: è Typically all variable costs è Any avoidable (direct) fixed costs - Direct material - Direct labor - Manufacturing overhead External costs incurred to buy è Cost to purchase the product or service è Any Transportation Costs è Costs involved with dealing with a supplier such as ordering, receiving, and inspection make-or-buy decisions For make-or-buy decisions, managers must make qualitative and financial considerations – thereby, overheads can be tricky Financial considerations: è Alternative use for freed capacity  Management Accounting Qualitative considerations: è Permanence of lower price è Reputation è Certification è Technical standards è Reliability of the supplier - Quality - Time - Etc. Considerations for dropping products All the relevant costs and revenues need to be considered before dropping a product etc. Often, existing businesses will want to expand or contract their operations to improve profitability Decisions about whether to add or to drop products/departments will use the same analysis: examining all the relevant costs and revenues Check avoidable vs. unavoidable costs è Avoidable costs are costs that will not continue if an ongoing operation is changed or deleted è Unavoidable costs are costs that continue even if an operation is halted è Common costs are costs of facilities and services that are shared by the user Also consider strategic issues è Market position è Synergies / complementary products Limiting factors A limiting factor or scarce resource restricts or constrains the production or sale of a product or service Limiting factors include è labor hours and machine hours that limit production (and hence sales) in manufacturing firms and è square feet of floor space or cubic meters of display space that limit sales in department stores è Scarce inputs (salts; metals; skilled employees) If a company has scarce resources they have to be taken into account as well when looking at the contribution margin  Management Accounting 5. Relevant information for decision making Relevant costs definition: management accountants need to differentiate between è the costs that will be affected by a decision (relevant) è costs that will still be there irrespective of the course of action the manager takes (irrelevant). the types of cost we look at can be divided into relevant and non-relevant costs on a general level: è Avoidable costs è Incremental costs è Opportunity costs Relevant Costs Avoidable Costs will vanish as another course of action is taken è Variable costs are always avoidable è Sometimes, resources causing fixed costs can be redeployed and are thus avoidable Incremental Costs Incremental costs are the cost of the next unit of production – they are NOT the same as marginal costs Mixed Costs is a cost that has a fixed component and a variable component Step Variable Costs Step variable costs increase in steps as the quantity increases Challenges with Step Variable Costs è In practice, we often do not know when the next step kicks in è All variable cost are step variable—at some level. è Sometimes it is not sensible to assume that adding resources is variable if the resource is very costly  Management Accounting Opportunity Costs is the maximum value forgone when a course of action is chosen There might be multiple opportunity costs at the same time Irrelevant Costs Sunk Costs Is a cost that results from a previous commitment è It cannot be recovered è It remains the same regardless of any action or the alternative chosen è They are not relevant for decisions as they cannot be influenced (“spilled milk”) Sunk costs are not relevant for decision making as their derivative is “zero” when determining the marginal cost Mathematical Explanation of Sunk Costs: Why managers cling onto sunk costs for several reasons: è Need to justify / turn around a loss è Selective perception è Framing / mental accounting è Impression management for reputation (“I never lose a case”)  Management Accounting 6. Joint-Cost Situations Split-off Point Joint production costs are (1) significant and (2) are not separately identifiable until the split- off point of their products Joint Costs are the costs of a single production process that yields multiple products simultaneously Split-off Point is the juncture in the production process where one or more products in a joint-cost setting become separately identifiable Separable Costs are all costs (manufacturing, marketing, distribution, etc.) incurred beyond the split-off point that are assignable to one or more individual products Difference between Joint Products and By-Products Joint products have relatively high sales value at the split-off point è Main product is the result of a joint production process that yields only one product with a relatively high sales value. è By-products are incidental products resulting from the processing of another product. They have a relatively low sales value compared with the sales value of a joint or main product. è Some outputs of the joint production process have zero sales value (viz: no journal entries are made) Reasons for allocating joint costs to individual products: è Stock costing and cost-of-goods-sold computations are important for reporting (internal, external, and taxes) è Cost reimbursement contracts require cost allocation under contracts when only a portion of a business’s products or services is sold or delivered to a single customer (government agency) è Insurance settlement computations require cost allocation when damage claims made by businesses with joint products, main products or by-products are based on cost information è Rate regulation if one or more of the jointly produced products or services are subject to price regulation è Litigation involving one or more joint products  Management Accounting Allocating joint Production Costs The two basic approaches to allocate joint costs use (1) market-based data or (2) physical measure-based data The 4 Allocation Methods Approach 1a: The Sales value at Split-off Method (SV) è SV allocates joint costs on the basis of the relative sales value at the split-off point (viz. separable cost not included) è This method uses the joint costs that were incurred on all(!) units produced, not just those sold. è The sales value at split-off method produces an identical gross margin percentage for each product.  Management Accounting Approach 1b: Estimated Net Realizable Value (NRV) Method è The estimated NRV method allocates joint costs to joint products on the basis of the relative estimated NRV è Products are processed beyond the split-off point to make them marketable or to increase sales value è The estimated NRV is the expected final sales value minus the expected separable costs Approach 1c: Constant gross-margin percentage NRV method è Under the constant gross-margin percentage NRV method, the overall gross- margin percentage is identical for each products  Management Accounting Approach 2: Physical Measure (PM) Method è PM uses relative weight, volume or other physical measures è This has no relationship to the profit-producing power of the individual products è Hence, the physical measure method is less preferred than the sales value at split- off method under the benefits-received criteria Determining the right Allocation Method: The purpose of the joint-cost allocation determines the allocation method è The sales value at split-off method (1a) is widely used where market prices exist at split-off because it is: -...simple -...objective (meaningful common denominator) -...not making assumptions on future management decisions è The physical measure method (2) is used in rate regulation Accounting for By-Products By-products can either be accounted at their time of production, or their time of sale è Method A, the production by-product method, recognises by-products in the financial statements at the time their production is completed è Method B, the sale by-products method, delays recognition of by-products until the time of their sale  Management Accounting è The production by-product method yields a greater profit and margin than the sale by-product method 8. Allocation of Support-Department Costs Production vs. support functions Support functions lack a direct link to the production process – hence, their costs needs to be allocated to the production departments  Management Accounting Service department cost allocations Direct method The direct cost allocation method forms the basis for the sequential and the reciprocal cost allocation methods Conventional product costing systems assign all indirect costs to jobs or products in two stages: Prerequisite: Identify all indirect costs with production and service departments 1. Stage: è Allocate indirect costs from service departments directly to production departments è Basis: each production department’s relative use of the applicable cost driver 2. Stage: è Assign accumulated indirect costs from production departments to individual jobs or products è Basis: predetermined departmental cost driver rates  Management Accounting Sequential Cost Allocation Method The sequential method is used if service departments consume services provided by other service departments in a sequential order Reciprocal Cost Allocation Method The reciprocal method is appropriate if both service departments consume each other’s services  Management Accounting 9. Income effects of variable vs. absorption costing Stock-Costing methods Terminology: Costs reflect resource consumption to achieve an objective Expenses are decreases in ownership claims (equity) arising from delivered goods or services or using up assets Inventoriable costs (or: stock-related cost) are a sub-category of capitalized costs. These capitalized costs are associated with the è purchase (merchandize stock) or the è acquisition and conversion (manufacturing stock) of all manufacturing inputs into goods for sale Variable costing and absorption costing treat fixed manufacturing overhead (FMO) differently  Management Accounting Three formal analysis of the differences in profit è Under absorption costing, managers can increase inefficient “book”-profits by producing costly stock Problems and Solutions of Absorption Costing  Management Accounting Denominator-Level Concepts Four denominator-level concepts: è The ‘practical’ capacity is the maximum amount of work a resource is actually employable Effect of denominator-level capacity on profit and costs è we can see that the smaller the denominator level chosen, the larger the proportion of fixed manufacturing overhead cost per output unit that can be allocated to stock è This will mean that reported stock costs will therefore be higher and the operating profit figure will be lower è The smaller the denominator level chosen, the larger the proportion of fixed manufacturing overhead cost per output unit Production Volume Variance = (Denominator Level – Actual Level) x Budgeted Fixed Manufacturing Overhead Rate  Management Accounting 11a. Budgeting -Theory The budgeting process is subject to gaming and arbitrary decisions Drafting Budgets Budgets are quantitative (mostly financial) plans and describe operations over some future time period Budget Definitions: Budget è A quantitative expression of the money inflows and outflows that reveal whether the current operating or business plan will meet the organization’s financial objectives. Budgeting è The process of preparing budgets Budgeting involves forecasting the demand for four types of resources over different time periods: è Flexible resources that create variable costs è Intermediate-term capacity resources that create fixed costs è Resources that, in the intermediate and long run enhance the potential of the organization’s strategy but need not to contribute directly to capacity (e.g. R&D, marketing) è Long-term capacity resources that create fixed costs Goals of budgeting by usage type Budgeting has various goals from initial planning to final performance assessment Diagnostic use è Planning è Resource allocation è Coordination, e.g. synchronization of subunits ▪ Performance assessment  Management Accounting Interactive use è Communication of goals è Fostering of understanding of corporate objectives and correction of misperceptions è Anticipation of potential problems, e.g. concerning - Cash shortage and credit lines - Inventory management - Mismatch of demand and capacity Process of composing a “master budget” Based on the sales forecast and the production plan (operative), expected financial results can be estimated (financial) Step 1. Define the Organizations Goals Step 2. Sales Plan è Sales plans are needed for each key line of goods/services to determine labor, materials, production capacity, and financials Step 4. Inventory Policy The inventory policy can build on ‘push’ or ‘pull’ principles and thereby shape the production plan  Management Accounting Pull è Produce only at order è Flexible è No inventory è Moving toward a JIT by shortening each interim’s period Push è Use resources all time efficiently è Reflects a lack of flexibility è Build up inventory è Specialized employees and equipment Step 5. Production Plan è The production plan is determined by matching the sales plan with the organization’s inventory policy and capacity level Capacity is the lesser of: è The long-term capacity è The intermediate-term capacity è The short-term capacity Production is the lesser of: è Total demand è Production capacity Selection of orders by highest contribution margin per customer Intended production during each interim period comprising the master budget period (annual) Step 3. + 6. Capital spending plan and productive capacity plan If planners find the tentative production plan infeasible, then they have to make provisions to: è Reduce the planned level of production, or è Adjust capacity Adjusting capacity è Flexible resources ready for the short term è Capacity resources that must be acquired intermediate-/ long-term  Management Accounting Minimize the waste of capacity by reviewing activities Activities that create the need for resources (and resource expenditures) in the short-term è Value-adding? è Restructuring possible, e.g. for improved in customer satisfaction? Activities undertaken to acquire capacity for the intermediate-/long-term è Alternative, less expensive forms of capacity available? è Objectives still valid? è Increase flexibility? Step 7.-9. Material, labor and spending Purchasing Group è Plan to acquire the required raw materials and supplies è Since sales and production plans change, the organization and its suppliers must be able to adjust their plans quickly based on new information Personnel and Production Group è Labor hiring and training plans è When an organization is contracting, it will: - Use retraining plans to redeploy employees to other parts of the organization, or - Develop plans to discharge employees Senior Managers è Discretionary expenditures to provide required infrastructure for the proposed production and sales plan è “Discretionary” means the actual sales and production levels do not drive the amount spent è Discretionary activities become fixed for the budget period and are unaffected by product volume and mix è A long-term planning process rather than the one-year cycle of the operating budget drives the capital spending plan Step 11. Cash Flow è Assess Cash inflow è Assess Cash outflow è Add Cash Flows from operations, financing and investing  Management Accounting Step 12. Pro forma income statement and balance sheet è A pro forma income statement as well as a projected balance sheet can be derived from this information as well Scenarios, sensitivities and simulations Comparison sensitivity- and scenario analysis è Budgets must be tested for robustness through sensitivity and scenario analysis Sensitivity Analysis è Varies existing parameters è Evaluates best case and worst case of current plans Scenario Analysis è Introduces new parameters è Evaluates opportunity costs of alternatives Common methods for budget analysis Single point estimates (“most likely” value): è Insert the most likely value, average value, etc. in the spreadsheet to determine outcome è Result in a single outcome Sensitivity analysis (“what-if” analysis): è Methodically entering even increments of values to view the projected outcomes è Results in a range of possible outcomes, but no associated probabilities  Management Accounting Scenario analysis: è Adds factors to the model è Estimate most-likely, best case, and worst-case scenarios – Result in a range of possible outcomes Simulations can enhance these methods by assigning probabilities Selected Issues of Budgeting Budgeting is also important in non-manufacturing organizations, but it may serve different purposes Periodic vs. continuous budgeting è The budget process can either be periodic or continuous Periodic: è Budgets are prepared once a year and the budget period is typically 1 year (and the budget is typically divided into months) è Could be revised during the year under certain circumstances è Is often criticized for being myopic Continuous: è As one budget period passes, planners drop that budget period from the master budget and add a future budget period in its place è The length of the budget period reflects the competitive forces, skill requirements, and technology changes that the organization faces è Is often criticized for being too time demanding  Management Accounting Discretionary Expenses Discretionary expenses can continue or be justified continuously Approaches to budget setting Budgets can be designed in many different ways, involving different stakeholder groups Methods: Authoritarian: superior simply tells subordinates what their budget will be Participation: all parties agree about setting the budget targets, using a joint decision-making process Consultation: managers ask subordinates to discuss their ideas about the budget but determine the final budget alone Variations Research shows that......most motivating types of budgets are those that are tight...targets need to be perceived as ambitious but attainable Stretch targets exceed previous targets by a significant amount àEmployees reevaluate the ways in which they produce products and services  Management Accounting 12 Principles of Beyond Budgeting 12. Budgeting – variance analysis Definition variance analysis: Variance analysis explains the effects from changes in price and quantity on differences between PLANNED and ACTUAL results è A variance is the difference between planned and actual results è Should be investigated to determine: - What caused the variance (price or quantity?) - What should be done to correct that variance Managers focus separately on prices and quantities since several departments are responsible for the purchase (price) and uses (quantities) of the resource  Management Accounting 3 Levels of Variance Analysis More advanced variance analysis includes three constitutive steps Formula for 1. and 2. Level Variance:  Management Accounting 3rd Level Variance Analysis: decomposing the flexible budget variances Management Accounting