MANAGERIAL ACCOUNTING Course Guide PDF

COURSE GUIDE To the Open University Students: Welcome to BA 2 Managerial Accounting. This course is designed to prepare you for effective financial decision making at a managerial level. This will introduce you to managerial accounting: the accounting process that uses financial information to organize and govern finances within an organization. It includes topics such as Introduction to Managerial Accounting, Financial Analysis, Cost and Cost Classification and Cost- Volume-Profit Analysis. I am Prof. Estrellita R. Siclat, from URS Antipolo Campus. I am a graduate of BSC major in Accounting from Tomas Claudio Memorial College. I love teaching accounting since it has been the course that I wanted to pursue since my grade school days and I love dealing with numbers. But due to financial difficulty, I was not able to take the CPA Board Examination. For this reason, I decided to study once again and take up education. Before finishing my second course I was recommended by Dr. Isabel Inlayo in Our Lady of Peace School where I taught for 19 years. While teaching in OLPS, I took up my MA in Mathematics in St. Paul University Surigao. I decided to resign and applied in URS in 2012. Yours truly is one of the writer contributors of the modules in BA 2. With me are: Prof. Loida T. Masinsin from URS Pililla Campus. She is a graduate of Bachelor in Accountancy from Polytechnic University of the Philippines and a Certified Public Accountant. She has a Certificate in Professional Education from URS Pililla and is currently taking up her MBA in Tomas Claudio Colleges (TCC); Prof. Sam Cedrick H. Calites from URS Binangonan Campus. He is a graduate of BS Accountancy from URS Binangonan and currently taking up Master in Management Studies in URS Binangonan also; Prof. Roscel M. Aguirre from URS Tanay Campus. She is a graduate of Bachelor of Science in Secretarial Administration from Rizal State College, a graduate of Master in Business Administration from URS Binangonan Campus and has DBA units in URS Binangonan also; and Prof. Elsa Mia G. Madriaga from URS Rodriguez Campus. She is a graduate of Bachelor of Science in Business Administration major in Accountancy from the National College of Business Administration in Manila and has MBA units in URS Should you want to get in touch with me, you may contact me through my email address: [email protected]. 2 COURSE TITLE: BA 2 MANAGERIAL ACCOUNTING COURSE DESCRIPTION: This course is designed to prepare the students for effective financial decision making. This course will introduce the students specifically to managerial accounting: the accounting process that uses financial information to organize and govern finances within an organization. COURSE OBJECTIVES General Objectives: Apply the basic managerial accounting concepts, principles and techniques needed for decision-making. Specific Objectives: At the end of the course, the student should be able to: 1. Define managerial accounting 2. Identify/Enumerate the objectives, scope and limitations of managerial accounting 3. Describe the role of managerial accounting in the management process 4. Explain the directions of managerial accounting toward a specific field 5. Discuss the management functions and appreciate the need for management of accounting on planning, directing and motivating, and controlling 6. Differentiate management accounting and financial accounting 7. Understand the need of management accounting to business and non- business organization 8. Describe the Management Accounting Information System (MAIS) 9. Assess the significance of Management Accounting Information System 10. Classify external and internal users of management Accounting Information System 11. Understand the standards of ethical conduct for management accountants 12. Identify the duties and responsibilities of management accountant in accordance with relevant laws, regulations and technical standards 13. Apply the standards of ethical conduct in resolving ethical conflicts 14. Discuss ethical issues in management accounting 15. Identify the six (6) financial statements and their contents 16. Explain the objectives of financial statement analysis 17. Understand the limitations of financial analysis 18. Define the vertical and horizontal analysis 19. Prepare a vertical and horizontal analysis with their interpretation. 20. Define financial ratio 21. Understand the functions of financial ratio 22. Prepare a ratio analysis 23. Identify and give examples of each classification of costs; 3 24. Define and illustrate a cost object; 25. Understand the difference between/among the following: 25.1 Material Costs, Labor Costs and Expenses 25.2 Production Costs and Commercial Costs 25.3 Direct Costs and Indirect Costs 25.4 Product Costs and Period Costs 25.5 Variable Costs, Fixed Costs and Mixed Costs 26. Identify and differentiate costs classification by relevance to decision making 27. Identify and give examples of each of the three basic manufacturing cost categories 28. Understand cost classifications used for assigning costs to cost objects: direct costs and indirect costs 29. Understand cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs 30. Properly account for labor costs associated with idle time, overtime, and fringe benefits 31. Identify the four types of quality costs and explain how they interact 32. Understand how fixed and variable costs behave and how to use them to predict costs 33. Use a scatter graph plot to diagnose cost behavior 34. Analyze a mixed cost using the high-low method 35. Prepare an income statement using the contribution format 36. Analyze a mixed cost using the least-squares regression method 37. Compute for the different types of cost; 38. Analyze the different types of cost; 39. Interpret the graphical presentation of each type of cost 40. Understand the sections of an income statement of a manufacturing company; and, 41. Prepare the income statement of a manufacturing company 42. Identify and describe the different components of the income statement using the variable costing approach 43. Explain the advantages of variable costing approach 44. Describe how each component affects the contribution margin 45. Solve/Compute for the missing component of the income statement 46. Compute for the breakeven point in unit and in peso 47. Calculate the contribution margin in unit and in peso 48. Compute for the margin of safety 49. Explain the importance of margin of safety in decision making 50. Utilize or use the CVP analysis formula in solving problems COURSE STRUCTURE The course BA 2 consists of four (4) instructional units divided into fourteen (14) modules namely: 4 Units 1 – Introduction to Managerial Accounting Module Writers 1. Definition, Objectives, Scope and Limitations Prof. Estrellita R. Siclat of Managerial Accounting 2. Role of Managerial Accounting and Its Prof. Elsa Mia Madriaga Direction Toward a Specific Field 3. Management Accounting Information Prof. Elsa Mia Madriaga System 4. Standards of Ethical Conduct for Management Prof Elsa Mia Madriaga Accountants Unit 2 – Financial Analysis Module Writers 5. Objectives and Limitations of Financial Prof. Roscel Aguirre Statement Analysis 6. Vertical and Horizontal Analysis Prof. Roscel Aguirre 7. Ratio Analysis Prof. Roscel Aguirre Unit 3 – Cost and Cost Classification Module Writers 8. Different Cost Classification Prof. Loida T. Masinsin 9. Uses of Costs Prof. Sam Cedrick Calites 10. Basics of Cost Behavior Prof. Sam Cedrick Calites 11. Solving for the Different Types of Cost Prof. Loida T. Masinsin 12. Income Statement of a Manufacturing Prof. Loida T. Masinsin Company Unit 4 - Cost-Volume-Profit Analysis 5 Module Writers 13. Different Components of the CVP Analysis Prof. Estrellita R. Siclat 14. Break-Even Analysis Prof. Estrellita R. Siclat COURSE REQUIREMENTS The following are the major course requirements: 1. Activities and Assignments 2. Self-Assessment Quizzes 3. Project 4. Exam GRADING SYSTEM Your final grade will be based on your performance in the following: 1. Activities and Assignments 10% 2. Project 20% 3. Self-Assessment Quizzes 30% 4. Exam 40% SCHEDULE Registration …………………………………………………………… August 24, 2020 Classes Start Orientation - Submission of agency plans or certification Study Session 1 - Submission of Activities and Assignments for Sept. 7, 2020 Modules 1, 2, 3 & 4 Study Session 2 - Submission of Activities and Assignments for Sept. 28, 2020 Modules 5, 6, & 7 Study Session 3 - Submission of Activities and Assignments for Nov. 2, 2020 Modules 8, 9, 10, 11 & 12 Study Session 4 - Submission of Activities and Assignments for Dec. 7, 2020 6 UNIT 1 INTRODUCTION TO MANAGERIAL ACCOUNTING MODULE #1 DEFINITION, OBJECTIVES, SCOPE AND LIMITATIONS OF MANAGERIAL ACCOUNTING Introduction Different kinds of organizations affect our lives. Manufacturers, wholesalers, retailers, agribusiness companies, non-profit organizations and even government agencies provide us with an enormous array of goods and services. These organizations have two things in common: First, each organization has a set of goals or objectives. Second, in pursuing the organization’s goals, managers need information. The information needed by the management range across financial, production. Marketing, legal, and environmental issues. Generally speaking, the larger the organization is, the greater is the management’s need for information In this module, we will explore the definition, objectives, scope and limitations of managerial accounting within the overall management process. Learning Objectives: At the end of this module, the student should be able to: 1. Define managerial accounting; 2. Describe the role of managerial accounting in the management process; 3. Define managerial accountants; 4. Identify the four fundamental management processes that help the organizations attain their goals DEFINITION OF MANAGERIAL ACCOUNTING There are many definitions of managerial or management accounting. Managerial accounting is the process of identifying, measuring, analyzing, interpreting, and communicating information in pursuit of an organization’s goals (Platt, 2011). Managerial accounting is the process of analyzing, interpreting, and presenting financial statements using the statements prepared under financial accounting (Aliling and Anastacio, 2015). 7 According to the Institute of Management Accountants (IMA): “Managerial accounting is a profession that involves partnering in management decision making, devising planning and performance management systems, and providing expertise in financial reporting and control to assist management in the formulation and implementation of an organization’s strategy”. OBJECTIVES OF MANAGERIAL ACCOUNTING 1. Measuring the performance of activities, subunits, company officials like managers, and other employees within the organization in discharging their respective duties and responsibilities to contribute to the total business operating efficiency. 2. Providing information for decision making and planning, and proactively participating as part of the management team in the decision-making and planning processes. 3. Assisting the managers in directing and controlling domestic and international operational activities. 4. Motivating managers and other employees toward the organization’s goals. 5. Assessing the organization’s competitive position, and working with other managers to ensure the organization’s long-run competitiveness in its industry. SCOPE OF MANAGEMENT ACCOUNTING 1. Financial Accounting Financial accounting is relating to the recording of business transactions immediately soon after the transaction has taken place. The business transaction may be related to income, expenses, assets, liabilities, cash receipts, cash disbursements and so on. The process of financial accounting includes the preparation of financial statements regularly at the end of each accounting year for knowing operating results for a definite period. The term financial statements include income statement and balance sheet. Management is unable to exercise the coordination and control out of the information supplied by financial accounting system. But, the financial accounting system information is the basis of future business planning and financial forecasting. 8 2. Cost Accounting Cost accounting is concerned with the ascertainment of various elements of costs for different business operation and activities. These cost data are used in the management accounting system for further analysis so as to solve business problems and take quality decision. 3. Budgeting and Forecasting Management accounting includes budgetary control and forecasting techniques also. Under budgetary control system, the budgets are prepared on functional basis and measure the actual performance, find the difference between the actual and standard for taking corrective actions. In this way, budgeting assists the management for identifying responsibility and ensuring coordination. 4. Revaluation Accounting This type of accounting is ensuing that the capital is maintained intact in real terms. By keeping this in mind, correct amount of profit is calculated and used for managerial decision making. 5. Cost Control Procedures Cost control procedures are an integral part of management accounting process. These include inventory control, cost control, budgetary control, standard costing, and others. 6. Statistical Methods In order to analyze the financial accounting data, tables, diagrams and graphs are used in the management accounting system. These are nothing but statistical methods. 7. Inventory Control Inventory control refers to exercising control over the utilization of raw materials, processing of work in progress and disposal of finished goods for a specific period. 8. Reporting Reporting is divided into two types: interim reporting and external reporting. Interim reporting is supplying information to the top management. This includes the submission of financial results by means of weekly, fortnightly, monthly, quarterly or half yearly accounts or statements to the top management. On the other hand, external reporting is supplying information to outsiders like shareholders, banks and financial institutions. 9. Taxation 9 This includes the computation of corporate income tax in accordance with the tax laws, filing of income tax returns and making tax payments. 10. Methods and Procedures Design and Installation Management accounting is relating to the most efficient and economic system of accounting suitable to any size and type of undertaking. Moreover, it employs the best use of mechanical and electronic devices. 11. Internal Audit This is conducted by the business organization with the help of paid employee who has a thorough accounting knowledge. All the relevant records are maintained under the management accounting system so that the internal audit is conducted in an effective manner. 12. Office Services This includes the maintenance of proper data processing and other office management services. 13. Financial Management Owners of business firms expect fair rate of return on investments. It is possible through the effective utilization of the finance. Hence, it is termed as financial management and considered as a separate discipline. The tools in financial management are developed through management accounting system. 14. Interpretation Management accounting is relating to the interpretation of financial data to the management and advising them on decision making. You can watch the video scope of management [email protected] LIMITATIONS OF MANAGERIAL ACCOUNTING The following points highlight the ten major limitations of management accounting. 1. Based on Records The management accountant takes into consideration the past records provided by the financial and cost accounting while making decisions for the future. The accuracy and utility of past records will limit the dependence of the management accountant for 10 future decisions. If the past data is not reliable, the decisions suggested by management accountant may be misleading. 2. Lack of knowledge and understanding of related subjects For taking a sound decision, it is necessary that the management must have knowledge of various fields like accounting, statistics, economics, taxation, production, engineering and so on. But it has been observed that the person who is taking the decisions may not have comprehensive knowledge of all such subjects. 3. Intuitive Decisions Though it has been realized that scientific decisions must take into consideration the quantitative techniques yet because of simplicity and personal factors, the management tends to persistence intuitive decision-making. 4. Lack of Continuity and Coordination In order to make the conclusions drawn by management accountant meaningful, they must be implemented in the organization at various levels. But in actual practice they lose their significance because it is not feasible to implement such conclusions. 5. No Substitute of Administration The techniques and tools suggested by the management accountant are not alternatives or substitutes of good administration but in fact these are only to supplement the sound management and administration. 6. Lack of Objectivity There is every possibility of personal bias and manipulation from the collection of data to the interpretation stage in financial accounting. Thus, these loss objectivity and validity. 7. Unquantifiable Variables There are various problems in business which cannot be expressed in monetary terms. Such problems cannot be interpreted for the future. 8. Costly The installation of management accounting system in a concern requires large organization and a wide network of rules and regulations and thus requires a heavy investment. Therefore, it cannot be utilized by a small organization profitably. 9. Not in Final Stage 11 Management accounting has not reached the final stage and is in the process of development. That is why its techniques suffer from fluidity of concepts, diversity in opinions and various interpretations. 10. Psychological Resistance For introduction and operation of management accounting system in any organization, it requires a lot of changes in the organization structure, rules and regulations. These changes are resisted by the management itself as it creates difficulties in its successful operations. 12 MODULE #2 ROLE OF MANAGERIAL ACCOUNTING AND ITS DIRECTION TOWARD A SPECIFIC FIELD Introduction This module deals with the role of managerial accounting in the management process as well as the direction of accounting toward a specific field. Furthermore, this will tackle about the functions of management accounting on planning, directing, motivating and controlling; the comparison of financial and managerial accounting and the need of business and non-business organizations for management accounting. Learning Objectives: At the end of this module, the student should be able to: 1. Describe the role of managerial accounting in the management process; 2. Explain the direction of managerial accounting toward a specific field; 3. Discuss the management functions and appreciate the need for management of accounting on planning, directing and motivating, and controlling; 4. Differentiate management accounting and financial accounting; 5. Understand the need of management accounting to business and non-business organization. THE ROLE OF MANAGEMENT ACCOUNTING Provide information for costing out of services, products, and other objects of interest to management. Provide information for planning, controlling, and continuous improvement. Helps managers make operational decisions – intended to help increase the company’s operational efficiency. Also helps in making long term investment. MANAGEMENT FUCTIONS AND THE NEED FOR MANAGEMENT ACCOUNTING INFORMATION 1. PLANNING – involves the following: a. Setting of immediate, as well as long range goals for the organization b. Predicting future conditions that are expected to prevail c. Considering the different means or strategies by which the goals set maybe achieved d. Deciding which of the strategies should be used to attain such goals 13 2. DIRECTING AND MOTIVATING – involves overseeing the day to day activities, seeing to it that the organization is functioning smoothly and the members of the organization are mobilized to carry out plans. 3. CONTROLLING – involves checking the performance of activities against the plan of standards set and deciding what corrective actions to take should there be any deviation between the actual planned/standard performance. Note: All the aforementioned management functions involve decision making. In performing the decision-making functions, managers need information. Such information is provided by management accountants. You can watch the video on Introduction to Managerial [email protected] ACTIVITIES INVOLVED IN MANAGEMENT ACCOUNTING 1. Determining, accumulating and explaining cost – both manufacturing and non- manufacturing costs. 2. Computing or determining product cost/service cost. 3. Determining cost behavior. 4. Assisting the management in profit planning/budgeting. 5. Accumulating and presenting data which may be used by managers in decision making. 6. Providing basis for cost control with the use of standard cost and other planned objectives. 7. Assisting managers in developing the company’s prices for external transactions. APPLICATION OF MANAGEMENT ACCOUNTING 1. BUSINESS – Managerial accounting provides the economic information needed by the business managers so they can attain their profit/economic goals. 2. NON-PROFIT ORGANIZATIONS –These organizations likewise need the economic information provided by management accountants in attaining their organizations’ objectives. PRINCIPLES GOVERNING THE DESIGN OF MANAGEMENT ACCOUNTING SYSTEM 1. The system should help to establish the decision-making authority over the organizations’ assets. 2. The information generated by the system should support planning and decision making. 3. The reports should provide a means for performance monitoring and evaluation. 14 DISTINCTIONS BETWEEN MANAGEMENT ACCOUNTING AND FINANCIAL ACCOUNTING The accounting system is part of the organization’s management information system (MIS). COST ACCOUNTING SYSTEM – Accumulates data about the cost of producing goods and services which is part of the organization’s overall accounting system. It accumulates cost information for both management accounting and financial accounting. MANAGEMENT ACCOUNTING VS. FINANCIAL ACCOUNTING MANAGEMENT ACCOUNTING FINANCIAL ACCOUNTING Users of Internal users: officers and External users: stockholders, Report managers creditors, and concerned government agencies Purpose To provide internal users with To provide external users with information that may be used by information about the managers in carrying out the organization’s financial position functions of planning, controlling, and results of operations. decision making and performance evaluation. Types of Different types of reports, such as Primarily, financial statements Report budgets, financial projections, cost and the accompanying notes to analyses, etc., depending on the such statements. specific needs of management. Basis of Reports are based on combination Reports are based almost Report of historical, estimated and exclusively on historical data. projected data. Standards of In preparing reports the Reports are prepared in Presentation management of the company can accordance with generally set rules to produce information accepted accounting principles most relevant to its specific needs. and other pronouncements of authoritative accounting bodies. Reporting Focus of reports is in the Financial reports relate to the Entity company’s value chain, such as a business as a whole. business segment, product line, supplier or customer. Period Reports may cover any time period Reports usually cover a year, a Covered – year, quarter, month, week, day, quarter or a month. etc. and may be required as frequently as needed. 15 MODULE #3 - MANAGEMENT ACCOUNTING INFORMATION SYSTEM Introduction The problem of most business organizations is not just how to motivate their employees to do their job well but also how to compile and keep their business data in such a way that these will still be available for future use as basis for decision making. This problem has been answered by the use of Management Accounting Information System which is to be dealt with by this module. This module will deal with the significance and advantages of the Management Accounting Information system as well as the difference between its internal and external users. Learning Objectives: At the end of this module, the student should be able to: 1. Describe the Management Accounting Information System (MAIS); 2. Assess the significance of Management Accounting Information System (MAIS); 3. Classify external and internal users of management Accounting Information System. MANAGEMENT ACCOUNTING INFORMATION SYSTEM Management Accounting Information System (MAIS) refers to a set of highly technological systems and procedures that gather information from a wide range of sources, compiling and converting these to a readable format for decision-makers. This will provide managers with comprehensive reports of all financial information to aid them in making sound decisions. The system is also responsible for providing timely and accurate financial statistical reports for internal management decision-making. You can watch the video on management information [email protected] SIGNIFICANCE OF MANAGEMENT ACCOUNTING INFORMATION SYSTEM 1. It provides the manager a logical set of data to provide the decision-maker with everything he or she needs for making well-informed decisions and performing a deeper analysis of operational issues affecting the business. 16 2. The employees can work more efficiently. 3. Employees in all levels can check the status of inventory or any information related to their department or group. As a result, transactions can be done with ease and confidence. DISADVANTAGES OF MANAGEMENT ACCOUNTING INFORMATION SYSTEM Although MAIS is very efficient and employees can be more productive in their respective jobs, it has the following disadvantages: 1. It is costly and therefore, financially burdensome on the part of the company. 2. It requires an extra IT personnel to oversee and maintain the system. 3. It requires training of employees for the system to be used effectively. 4. It requires payment for upgrading later on because of the knowledge about the system. DIFFERENCE BETWEEN INTERNAL AND EXTERNAL USERS OF ACOUNTING INFORMATION Internal users of accounting information are the people or group of people inside the business organization. They are: 1. Potential Investors – They are interested to know the financial health of the company and the potential return of their investment. 2. Creditors – They want to know the ability of their customers to pay their obligations on time. 3. Government – They want to know if the business pays the right taxes. 4. Research Scholars – They are interested in the accounting information because they make financial study of a particular company. External users are the people or group of people who are outside the business organization such as: 1. Owner/s – They want to know the real health status of their business as well as the return of their investment. 2. Accountants – They will use the financial statement as part of their monitoring function. 3. Managers – They will use the financial statement for directing, controlling, planning, and for their daily decision-making activities. 4. Auditors – They will use the financial statement as gauge in checking activities. 17 MODULE #4 STANDARDS OF ETHICAL CONDUCT FOR MANAGEMENT ACCOUNTANTS Introduction This module deals with the ethical standards of managerial accountants. It focuses on how a managerial accountant should perform his or her duties and responsibilities in accordance with relevant laws, regulations and technical standards. Learning Objectives: At the end of this module, the student should be able to: 1. Understand the standards of ethical conduct for management accountants; 2. Identify the duties and responsibilities of management accountant in accordance with relevant laws, regulations and technical standards; 3. Apply the standards of ethical conduct in resolving ethical conflicts; 4. Discuss ethical issues in management accounting. STANDARDS OF ETHICAL CONDUCT FOR MANAGEMENT ACCOUNTANTS (From the American Institute of Management Accountants) Management accountants have an obligation to the organization. They serve as their profession, the public and themselves to maintain the highest standards of ethical conduct. In recognition of this obligation, the Institute of Management Accountants formerly the National Association of Accountants, has promulgated the following standards of ethical conduct for management accountants. Adherence to the standards is integral to achieving the Objectives of Management Accounting. Management accountants shall not commit acts contrary to these standards nor shall they condones the commission of such acts by others within their organizations. COMPETENCE Management accountants have the responsibility to: 1. Maintain an appropriate level of professional expertise by continually developing knowledge and skills. 2. Perform their professional duties in accordance with relevant laws, regulations and technical standards. 18 3. Provide decision support information and recommendations that are accurate, clear, concise and timely. 4. Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity. CONFIDENTIALITY Management accountants have the responsibility to: 1. Keep information confidential except when disclosure is authorized or legally required. 2. Inform all relevant parties regarding appropriate use of confidential information. Monitor subordinate activities to ensure compliance. 3. Refrain from using confidential information for unethical or illegal advantage. INTEGRITY Management accountants have the responsibility to: 1. Mitigate actual conflicts of interest. Regularly communicate with business associates to avoid apparent conflicts of interest. Advice all parties of any potential conflicts. 2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. 3. Abstain from engaging in or supporting any activity that might discredit the profession. CREDIBILITY Management accountants have the responsibility to: 1. Communicate information fairly and objectively. 2. Disclose all relevant information that could reasonably be expected to influence an intended user understanding of the reports or recommendations. 3. Disclose delays or deficiencies in information, timeliness, processing, or internal control in conformance with organization policy and/or applicable law. 19 Watch a video on Standards of Ethical Conduct of Mangement [email protected] RESOLUTION AND ETHICAL CONFLICT In applying the standards of ethical conduct, management accountants may encounter problems in identifying unethical behavior or in resolving an ethical conflict when faced with significant ethical issues, management accountants should follow the established policies of the organization bearing on the resolution of such conflict. If these policies do not resolve the ethical conflict, management accountants should consider the following courses of action: 1. Discuss such problems with the immediate superior except when it appears that the superior is involved, in which case, the problem should be presented to the next higher managerial level. If satisfactory resolution cannot be achieved when the problem is initially presented submit the issues to the next higher managerial level. If the immediate superior is the chief executive officer, or equivalent, the acceptable reviewing authority may be a group such as the audit committee, board of directors, board of trustees or owners. Contact with levels above the immediate superior should be initiated only with the superior’s knowledge, assuming the superior is not involved. Communication of such problems to authorities or individuals not employed or engaged by the organization is not considered appropriate, unless you believe there is a clear violation of the law. 2. Clarify relevant ethical issues by confidential discussion with an impartial advisor to obtain a better understanding of possible courses of action. Consult your own attorney as to legal obligations and right concerning the ethical conflict. 20 UNIT 2 – FINANCIAL ANALYSIS MODULE #5 – OBJECTIVES AND LIMITATIONS OF FINANCIAL ANAYSIS Introduction This module deals with the six basic financial statements and their contents. The objectives of financial statements as well as the limitations of financial analysis will also be discussed. Learning Objectives At the end of this module, the student should be able to: 1. Identify the six (6) financial statements and their contents; 2. Explain the objectives of the financial statements; and 3. Understand the limitations of financial analysis. Financial Statements Financial statements are the most widely used and most comprehensive way of communicating financial information about a business enterprise to users of the information provided on the reports. Different users of financial statements have different information needs. General-purpose financial statements have been developed to meet the needs of users of financial statements, primarily the needs of investors and creditors. The basic output of the financial accounting process is presented in the following interrelated general-purpose financial statements: 1. Income statement. It contains the income and expense accounts and shows the results of the business operation or the performance of the business. The income statement has two forms: the multiple step form and the single step form. The single step form is commonly used by service concern. 21 Income Statement – Single Step Form The multiple-step profit and loss statement segregates the operating revenues and operating expenses from the nonoperating revenues, nonoperating expenses, gains, and losses. The multiple-step income statement also shows the gross profit (net sales minus the cost of goods sold). Income Statement – Multiple Step Form 22 2. Statement of comprehensive income provides a summary of a company’s net assets over a given period of time. In other words, the statement highlights the adjustments on equity during a given timeframe. A statement of comprehensive income contains two main things: the net income and other comprehensive income (OIC). The net income is the result obtained by preparing an income statement. On the other hand, OIC consists of all the other items that are excluded from the income statement. 23 3. Statement of financial condition is another name for the balance sheet. It is one of the main financial statements. The statement of financial condition reports an entity’s assets, liabilities, and the difference in their totals as of the final moment of an accounting period. This would provide answers on the following questions: How much does the company own at any point in time? How much does the company owe at a particular time? How much is left for the owners at a certain point in time? 24 4. Statement of cash flows. This report reveals the cash inflows and outflows experienced by an organization during the reporting period. These cash flows are broken down into three classifications, which are operating activities, investing activities, and financing activities. 5. Statement of changes in equity. This report documents all changes in equity during the reporting period. These changes include the issuance or purchase of shares, dividends issued, and profits or losses. 25 6. Notes to financial statements This component would give you narrative explanations and important notes about the figures, details on the amounts, and other vital information intended to enhance your understanding of the audited financial statements in the Philippines. Securities and Exchange Commission (SEC) normally prescribes accounting and financial reporting standards that would dictates what items and information needs to be noted upon or disclosed in here. Bureau of Internal Revenue (BIR) is likewise prescribing some information on the audited financial statements from time to time such as details about taxes and licenses. This component could go for pages or for volume of pages depending on the complexity of the business entity financial reporting. An overview of Financial Statement Analysis Financial statement analysis involves tools and techniques which enable analysts to examine past and current financial statements so that a company’s performance and financial position can be evaluated and future risks and potential estimated. Financial statement analysis can yield valuable information about trends and relationships, the quality of a company’s earnings, and the strengths and weaknesses of its financial position. The purpose of financial analysis is to diagnose the current and past financial condition of the firm to give some clues about its future condition. The output of financial analysis is a useful tool in decision-making. It may also be defined as the process of interpreting the past, present and future financial condition of the company. 26 Objectives and Importance of Financial Analysis 1. Knowing Profitability of Business Financial statements are required to ascertain whether the enterprise is earning adequate profit and to know whether the profits have increased or decreased as compared to the previous year(s), so that corrective steps cab be taken well in advance. 2. Knowing the Solvency of the Business Financial statements help to analyze the position of the business as regards to the capacity of the entity to repay its short as well as long term liabilities. 3. Judging the Growth of the Business Through the comparison of data of two or more years of business entity, we can draw a meaningful conclusion as regard to growth of the business. For example, increase in sales with simultaneous increase in the profits of the business, indicates a healthy sign for the growth of the business. 4. Judging Financial Strength of Business Financial statements help the entity in determining solvency of the business and help to answer various aspects viz., whether it is capable to purchase assets from its own resources and/or whether the entity can repay its outside liabilities as and when they become due. 5. Making Comparison and Selection of Appropriate Policy To make a comparative study of the profitability of the entity with other entities engaged in the same trade, financial statements help the management to adopt sound business policy by making intra firm comparison. 6. Forecasting and Preparing Budgets Financial statement provides information regarding the weak-spots of the business so that the management can take corrective measures to remove these short comings. Financial statements help the management to make forecast and prepare budgets. 7. Communicating with Different Parties Financial statements are prepared by the entities to communicate with different parties about their financial position. Hence it can be concluded that understanding the basic financial statements is a necessary step towards the successful management of a commercial enterprise. 27 Limitations of Financial Statements 1. Manipulation or Window Dressing Some business enterprises resort to manipulate the information contained in the financial statements so as to cover up their bad or weak financial position. Thus, the analysis based on such financial statements may be misleading due to window dressing. 2. Use of Diverse Procedures There may be more than one way of treating a particular item and when two different business enterprises adopt different accounting policies, it becomes very difficult to make a comparison between such enterprises. For example, depreciation can be charged under straight line method or written down value method. However, results provided by comparing the financial statements of such business enterprises would be misleading. 3. Qualitative Aspect Ignored The financial statements incorporate the information which can be expressed in monetary terms. Thus, they fail to assimilate the transactions which cannot be converted into monetary terms. For example, a conflict between the marketing manager and sales manager cannot be recorded in the books of accounts due to its non-monetary nature, but it will certainly affect the functioning of the activities adversely and consequently, the profits may suffer. 4. Historical Financial statements are historical in nature as they record past events and facts. Due to continuous changes in the demand of the product, policies of the firm or government etc., analysis based on past information does not serve any useful purpose and gives only postmortem report. 5. Price Level Changes Figures contained in financial statements do not show the effects of changes in the price level. i.e. price index in one year may differ from price index in other years. As a result, misleading picture may be obtained by making a comparison of figures of past year with current year figures. 6. Subjectivity and Personal Bias Conclusions drawn from the analysis of figures given in financial statements depend upon the personal ability and knowledge of the analyst. For example, the term ‘Net profit’ may be interpreted by an analyst as net profit before tax, while another analyst may take it as net profit after tax. 7. Lack of Regular Data/Information 28 Analysis of financial statements of a single year has limited uses. The analysis assumes importance only when compared with financial statements, relating to different years or different firm. 29 MODULE #6 - VERTICAL AND HORIZONTAL ANALYSIS Introduction This module deals with the analysis of financial statements to allow the financial analyst to compare companies with different sizes. It will focus of the vertical and horizontal analysis. Learning Objectives Ate the end of this module, the student should be able to: 1. Define the vertical and horizontal analysis; and 2. Prepare a vertical and horizontal analysis with their interpretation. Financial Analysis Financial analysis involves using financial data to assess a company’s performance and make recommendations about how it can improve going forward. The most common types of financial analysis are vertical and horizontal analysis. Vertical Analysis This type of financial analysis involves looking at various components of the income statement and dividing them by revenue to express them as a percentage. This process is also sometimes called a common-sized income statement, as it allows an analyst to compare companies of different sizes by evaluating their margins instead of their money. To do vertical analysis, these are the steps that one needs to follow through: For the balance sheet, the items of the sheet are divided by total assets. After which they’re multiplied by 100 to get a percentage value. For the income statement, the items of the statement are divided by revenue. After which they’re multiplied by 100 to get a percentage value. Perform analysis on the result regardless of it showing a positive or negative outcome on why that happened. 30 31 Horizontal Analysis Horizontal analysis spotlights trends and establishes relationships between items that appear on the same row of a comparative statement. Horizontal analysis discloses changes on items in financial statements over time. Each item (such as sales) on a row for one fiscal period is compared with the same item in a different period. Horizontal analysis can be carried out in terms of changes in amounts, in percentages of change, or in a ratio format. To do horizontal analysis, these are the steps that one needs to follow through: Calculate for the comparing year index. This is done by doing comparing year/base year. Once the index is calculated for the comparing year, multiply the result by 100 and then subtract it by the base year index. Once the result is out showing either the increase of decrease, find out why the result is so. This need to be done even when the result is positive. 32 MODULE #7 - FINANCIAL RATIO ANALYSIS Introduction A very useful method in financial analysis is the use of financial ratios. The relation of one part of the financial statement to another is expressed through financial ratios. The net profit, for instance, may be measured in relation to gross sales. Learning Objectives Ate the end of this module, the student should be able to: 1. Define the financial ratio; 2. Understand the functions of financial ratios; 3. Prepare a ratio analysis. Financial Ratio Defined Financial ratio may be defined as a relationship between two quantities on a firm’s financial statement or statements, which is derived by dividing one quantity by another. Functions of Financial Ratios Financial ratios serve the following purposes: 1. As a starting point for detailed financial analysis; 2. To help diagnose a situation; 3. To monitor performance; 4. To help plan forward; and 5. To reduce the amount of data to workable form and to make the data more meaningful. CLASSES OF FINANCIAL RATIOS Financial ratios may be classified as follows: 1. liquidity; 2. activity; 3. profitability; and 4. solvency. 33 LIQUIDITY RATIO Liquidity refers to the ability of the firm to pay its bills on time or to meet its current obligations. Ratios which are used to measure this ability of the firm are called liquidity ratios. Those classified as liquidity ratios are the following: 1. Current ratio 2. Acid test ratio 3. Sales to receivable ratio 4. Sales to inventory ratio; and inventory to net working capital ratio Current Ratio This ratio indicates the margin of safety by which a firm can meet its obligations falling due within the year from such assets easily convertible into cash within the year. It may be derived with the use of the following formula: Current Ratio = Current Assets / Current Liabilities Acid Test Ratio The acid test ratio, also called quick ratio, is the ratio of cash assets to current liabilities. It is calculated by deducting inventories from current assets and dividing the remainder by current liabilities. Acid Test or Quick Ratio = Current Assets – Inventory / Current Liabilities Sales to Receivable Ratio This ratio may be computed into two ways: 1) in terms of annual turnover; and Annual Turnover = Annual Net Sales / Account Receivables 2) in terms of collection period. 360 days Collection Period = ------------------------------------ Sales/Account Receivable When sales to receivables ratio is computed in terms of collection period, what is being determined is the average length of time for which credit is being extended by the business to its customers. 34 Sales to Inventory Ratio This ratio is a measure of inventory turnover. Firms with excessive inventories will show a low ratio. Annual Receipts from Sales Sales to Inventory Ratio = --------------------------------------------- Inventory at the end of the year Inventory to Net Working Capital Ratio This ratio shows the proportion of net current assets tied up in inventory, indicating the potential loss to the company in the event of a decline in inventory values. Inventory Inventory to Net Working Capital Ratio = ------------------------------------------------- Current Assets – Current Liabilities ACTIVITY RATIO Ratios that are used to measure how effectively the firm employs the resources at its command are called activity ratios. Four types of ratios are classified as activity ratios. These are the following: 1. Sales to receivable ratio; 2. Sales to inventory ratio; 3. Inventory to net working capital ratio; and 4. Sales to net worth ratio Sales to Net Worth Ratio The ratio of net sales to owner’s equity represents the turnover of owner’s equity. Net Sales Net Sales per peso of owner’s equity = ----------------------------------------- Tangible owner’s equity PROFITABILITY RATIOS Profitability ratios are those which measure management’s effectiveness as shown by the returns generated on sales and investment. Ratios indicating profitability consist of the following: 1. Sales to inventory ratio; 2. Profit to net sales; 35 3. Profit to net worth; and 4. Profit to assets Profit to Net Sales This ratio, also called profit margin on sales, is computed by dividing net income after taxes by sales. The result is the profit margin expressed in percentage. Profit Margin = Net Income / Sales Profit to Net Worth This ratio, also referred to as return on net worth ratio, measures the rate of return on the owner’s investment. Return on Net Worth = Net Income / Net Worth Profit to Assets. This ratio is also called return on total assets ratio. It measures the return on total investment in the firm. Return on Total Assets = Net Income / Total Assets SOLVENCY RATIOS Solvency ratios refer to those which measure the ability of the firm to pay its debt eventually, if it is not paid on time. The solvency ratios include the following: 1. Current ratio; 2. Sales to inventory ratio; 3. Inventory to net working capital ratio; 4. Debt to net worth ratio; 5. Net worth to fixed assets ratio; and 6. Sales to net worth ratio Debt to Net Worth Ratio This ratio shows the relative proportion of debt to equity. In effect, it measures the debt exposure of the firm. The ratio is calculated with the use of a formula as follows: Debt to Net Worth Ratio = Total Debt / Net Worth Net Worth to Fixed Assets. This ratio indicates to what extent fixed assets have been financed by the contribution of the stockholders. 36 Net Worth to Fixed Assets = Net Worth / Fixed Assets ILLUSTRATIVE EXAMPLE 37 Financial Ratios Based on the Balance Sheet Financial statement analysis includes financial ratios. Here are three financial ratios that are based solely on current asset and current liability amounts appearing on a company's balance sheet: 38 To illustrate these financial ratios, we will use the following income statement information: 39 40 The next financial ratio involves the relationship between two amounts from the balance sheet: total liabilities and total stockholders' equity. 41 Financial Ratios Based on the Income Statement Statement of Cash Flows 42 The statement of cash flows is a relatively new financial statement in comparison to the income statement or the balance sheet. This may explain why there are not as many well-established financial ratios associated with the statement of cash flows. We will use the following cash flow statement for Example Corporation to illustrate a limited financial statement analysis: 43 The cash flow from operating activities section of the statement of cash flows is also used by some analysts to assess the quality of a company's earnings. For a company's earnings to be of "quality" the amount of cash flow from operating activities must be consistently greater than the company's net income. The reason is that under accrual accounting, various estimates and assumptions are made regarding both revenues and expenses. When it comes to cash, however, the money is either in the bank or it isn't. 44 UNIT 3 COSTS AND COST CLASSIFICATION MODULE #8 DIFFERENT CLASSIFICATION OF COSTS Introduction Cost Classification refers to a complete and transparent idea of separation of expenses in the different sector as like manufacturing cost, product cost, sunk cost, variable cost, direct cost, and indirect cost etc. Classifications of cost are a vital part of a company. It is almost impossible to operate a business without understanding it properly. Learning Objectives: At the end of this module, the learners should be able to: 1. Identify and give examples of each classification of costs; 2. Define and illustrate a cost object; 3. Understand the difference between/among the following: a. Material Costs, Labor Costs and Expenses b. Production Costs and Commercial Costs c. Direct Costs and Indirect Costs d. Product Costs and Period Costs e. Variable Costs, Fixed Costs and Mixed Costs 4. Identify and differentiate costs classification by relevance to decision making Classification of Costs A. Classification by Nature This is the analytical classification of costs. Let us divide as per their natures. So basically, there are three broad categories as per this classification, namely Labor Cost, Materials Cost and Expenses. These heads make it easier to classify the costs in a cost sheet. They help ascertain the total cost and determine the cost of the work- in-progress. 1. Material Costs: Material costs are the costs of any materials we use in the production of goods. We divide these costs further. For example, let’s divide material costs into raw material costs, spare parts, costs of packaging material etc. 2. Labor Costs: Labor costs consists of the salary and wages paid to permanent and temporary employees in the pursuit of the manufacturing of the goods 45 3. Expenses: All other expenses associated with making and selling the goods or services. B. Classification by Functions This is the functional classification of costs. So, the classification follows the pattern of basic managerial activities of the organization. The grouping of costs is according to the broad divisions of functions such as production, administration, selling etc. 1. Production Costs: All costs concerned with actual manufacturing or construction of the goods 2. Commercial Costs: Total costs of the operation of an enterprise other than the manufacturing costs. It includes the admin costs, selling and distribution costs etc. C. Classification by Traceability This aspect one of the most important classification of costs, into direct costs and indirect costs. This classification is based on the degree of traceability to the final product of the firm. 1. Direct Costs: So, these are the costs which are easily identified with a specific cost unit or cost centers. Some of the most basic examples are the materials used in the manufacturing of a product or the labor involved with the production process. 2. Indirect Costs: These costs are incurred for many purposes, i.e. between many cost centers or units. So, we cannot easily identify them to one particular cost center. Take for example the rent of the building or the salary of the manager. We will not be able to accurately determine how to ascertain such costs to a particular cost unit. D. Classification by Normality This classification determines the costs as normal costs and abnormal costs. The norms of normal costs are the costs that usually occur at a given level of output, under the same set of conditions in which this level of output happens. 1. Normal Costs: This is a part of the cost of production and a part of the costing profit and loss. These are the costs that the firm incurs at the normal level of output in standard conditions. 46 2. Abnormal Costs: These costs are not normally incurred at a given level of output in conditions in which normal levels of output occur. These costs are charged to the profit and loss account, they are not a part of the cost of production. E. Classification by Timing of Charges against Revenue 1. Product costs - are inventoriable costs. They form part of inventory and are charged against revenue, i.e. cost of sales, only when sold. All manufacturing costs (direct materials, direct labor, and factory overhead) are product costs. 2. Period Costs - are not inventoriable and are charged against revenue immediately. Period costs include non-manufacturing costs, i.e. selling expenses and administrative expenses. F. Classification by Behavior in Accordance with Activity 1. Variable costs - vary in total in proportion to changes in activity. Examples include direct materials, direct labor, and sales commission based on sales. 2. Fixed costs - costs that remain constant regardless of the level of activity. Examples include rent, insurance, and depreciation using the straight-line method. 3. Mixed costs - costs that vary in total but not in proportion to changes in activity. It basically includes a fixed cost potion plus additional variable costs. An example would be electricity expense that consists of a fixed amount plus variable charges based on usage. G. Classification by Relevance to Decision Making 1. Mixed costs - costs that vary in total but not in proportion to changes in activity. It basically includes a fixed cost potion plus additional variable costs. An example would be electricity expense that consists of a fixed amount plus variable charges based on usage. 2. Relevant cost - cost that will differ under alternative courses of action. In other words, these costs refer to those that will affect a decision. 3. Standard cost - predetermined cost based on some reasonable basis such as past experiences, budgeted amounts, industry standards, etc. The actual costs incurred are compared to standard costs. 4. Opportunity cost - benefit forgone or given up when an alternative is chosen over the other/s. Example: If a business chooses to use its building for production rather 47 than rent it out to tenants, the opportunity cost would be the rent income that would be earned had the business chose to rent out. 5. Sunk costs - historical costs that will not make any difference in making a decision. Unlike relevant costs, they do not have an impact on the matter at hand. 6. Controllable costs - refer to costs that can be influenced or controlled by the manager. Segment managers should be evaluated based on costs that they can control. 48 MODULE #9 - USES OF COSTS Introduction The term cost is used in many different ways. The reason is that there are many types of costs, and these costs are classified differently according to the immediate needs of management. For example, managers may want cost data to prepare external financial reports, to prepare planning budgets, or to make decisions. Each different use of cost data demands a different classification and definition of costs. For example, the preparation of external financial reports requires the use of historical cost data, whereas decision making may require predictions about future costs. This notion of different cost for different purposes is a critically important aspect of managerial accounting. Learning Objectives: At the end of this module, the student should be able to: 5. Identify and give examples of each of the three basic manufacturing cost categories; 6. Understand cost classifications used for assigning costs to cost objects: direct costs and indirect costs; 7. Understand cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs; 8. Properly account for labor costs associated with idle time, overtime, and fringe benefits; 9. Identify the four types of quality costs and explain how they interact COST CLASSIFICATIONS FOR MANUFACTURING COMPANIES Manufacturing Costs Most Manufacturing companies separate manufacturing costs into three broad categories: direct material, direct labor, and manufacturing overhead. A discussion of each of these categories follows. 1. Direct Materials are those materials that become an integral part of the finished product and whose costs can be conveniently traced to the finished product. This would include, for example, the seats that Airbus purchases from subcontractors to install in its commercial aircraft and the tiny electric motor Panasonic uses in its DVD players. Sometimes it is not worth the effort to trace the costs of relatively insignificant materials to end products. Such minor items would include the 49 solder used to make electrical connections in a Sony TV or the glue used to assemble an Osim massage chair. Materials such as solder and glue are called indirect materials and are included as part of manufacturing overhead. 2. Direct Labor consists of labor costs that can be easily (i.e., physically and conveniently) traced to individual units of product. Direct labor is sometimes called touch labor because direct labor workers typically touch the product while it is being made. Examples of direct labor include assembly-line workers at Toyota, carpenters at home builder Kaufman and Broad, and electricians who install equipment on aircraft at Bombardier Learjet or Airbus. 3. Manufacturing Overhead the third element of manufacturing cost, includes all manufacturing costs except direct materials and direct labor. Manufacturing overhead can be further classified into three categories: (1) indirect materials such as glue and product wrappers; (2) indirect labor such as payroll for factory supervisors and product inspectors; and (3) others. Manufacturing overhead “others” includes many items such as depreciation on factory facilities, property taxes on factory buildings, utilities, and insurance relating to manufacturing activities. Nonmanufacturing Costs Nonmanufacturing costs are often divided into two categories: (1) selling costs and (2) administrative costs. A. Selling Costs include all costs that are incurred to secure customer orders and get the finished product to the customer. These costs are sometimes called order-getting and order-filling costs. Example of selling costs include advertising, shipping, sales travel, sales commissions, sales salaries, and cost of finished goods warehouse. B. Administrative Costs include all costs associated with the general management of an organization rather than with manufacturing or selling. Examples of administrative costs include executive compensation, general accounting, secretarial, public relations, and similar costs involved in the overall, general administration of the organization as a whole. Nonmanufacturing costs are also often called selling, general, and administrative (SG&A) costs or just selling and administrative costs. 50 COST CLASSIFICATIONS FOR ASSIGNING COST TO COST OBJECTS Cost are assigned to cost objects for a variety of purposes including pricing, preparing profitability studies, and controlling spending. A cost object is anything for which cost data are desired--- including products, customers, jobs, and organizational subunits. For purposes of assigning costs to cost objects, costs are classified as either direct or indirect. 1. Direct Cost is a cost that can be easily and conveniently traced to a specified cost object. The concept of direct cost extends beyond just direct materials and direct labor. For example, if Reebok is assigning costs to its various regional and national sales offices, then the salary of the sales managers in its Tokyo office would be a direct cost of that office. 2. Indirect Cost is a cost that cannot be easily and conveniently traced to a specified cost object. For example, a Champbell Soup factory may produce dozens of varieties of canned soups. Common Cost is a cost that is incurred to support a number of cost objects but cannot be traced to them individually. A common cost is a type of indirect cost. COST CLASSIFICATIONS FOR DECISION MAKING Costs are an important feature of many business decisions. In making decisions, it is essential to have a firm grasp of the concepts differential cost, opportunity cost, and sunk cost. 1. Differential Cost and Revenue Decisions involve choosing between alternatives. In business decisions, each alternative will have costs and benefits that must be compared to the costs and benefits of the other available alternatives. A difference in costs between any two alternatives is known as a differential cost. A difference in revenues between any two alternatives is known as differential revenue. The accountant’s differential cost concept can be compared to the economist’s marginal concept. In speaking of changes in cost and revenue, the economist uses the terms marginal cost and marginal revenue. The revenue that can be obtained from selling on more unit of product is called marginal revenue, and the cost involved in producing one more unit of product is called marginal cost. The economist’s marginal concept is basically the same as the accountant’s differential concept applied to a single unit of output. 2. Opportunity Cost is the potential benefit that is given up when one alternative is selected over another. To illustrate this important concept, consider the following example: 51 Example Steve is employed by a company that pays him a salary of $38,000 per year. He is thinking about leaving the company and returning to school. Because returning to school would require that he give up his $38,000 salary, the forgone salary would be an opportunity cost of seeking further education. 3. Sunk Cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Because sunk costs cannot be changed by any decision, they are not differential costs. And because only differential costs are relevant in a decision, sunk costs can and should be ignored. FURTHER CLASSIFICATION OF LABOR COSTS Idle time, overtime, and fringe benefits associated with direct labor workers pose particular problems in accounting for labor costs. Are these costs a part of the costs of direct labor or are they something else 1. Idle Time Machine breakdowns, materials shortages, power failures, and the like result in idle time. The labor costs incurred during idle time may be treated as manufacturing overhead cost rather than as a direct labor cost. This approach spreads such costs over all the production of a period rather than just the jobs that happen to be in process when breakdowns or other disruptions occur. To give an example of how the cost of idle time may be handled, assume that a press operator earns $12 per hour. If the press operator is paid for a normal 40-hour workweek but is idle for 3 hours during a given week due to breakdowns, labor cost would be allocated as follows: Direct Labor ($12 per hour x 37 hours) $444 Manufacturing overhead (idle time: $12 per hour x 3 hours) 36 Total cost for the week $480 2. Overtime Premium The overtime premium refers to the additional payment on top of the basic paid (i.e., the base rate on the overtime hour is not considered a premium, only extra proportion qualifies as a premium). The overtime premium paid to factory workers (direct labor as well as indirect labor) is usually considered to be part of manufacturing overhead and is not assigned to any particular order. 52 Let us again assume that a press operator in a plant earns $12 per hour. She is paid time and a half for overtime (time in excess of 40hours a week). During a given week, she works 45 hours and has no idle time. Her labor cost for the week would be allocated as follows: Direct Labor ($12 per hour x 45 hours) $540 Manufacturing overhead (overtime premium: $6 per hour x 5 30 hours) Total cost for the week $570 Observe from this computation that only the overtime premium of $6 per hour is charged to the overhead account--- not the entire $18 earned for each hour of overtime work ($12 regular rate per hour x 1.5 hours = $18). However, some companies may treat overtime premium as part of the production cost rather than overhead. 3. Labor Fringe Benefits Labor fringe benefits are made up of employment-related costs paid by the employer and include the costs of insurance programs, retirement plans, various supplemental unemployment benefits, and hospitalization plans. The employer also pays the employees’ share of Social Security, Medicare, workers’ compensation, federal employment tax, and state unemployment insurance. These costs often add up to as much as 30% to 40% of base pay. Many companies treat all such costs as indirect labor by adding them to manufacturing overhead. Other companies treat the portion of fringe benefits that relates to direct labor as additional direct labor cost. The latter approach is conceptually superior because the fringe benefits provided to direct labor workers clearly represent an added cost of their services. COST OF QUALITY A company may have a product with high-quality design that uses high- quality components, but if the product is poorly assembled or has other defects, the company will have high warranty repair costs and dissatisfied customers. People who are dissatisfied with a product are unlikely to buy the product again. To prevent such problems, companies expend a great deal of effort to reduce defects. The objective is to have high quality of conformance. 1. Quality of Conformance – a product that meets or exceeds its design specifications and is free of defects that mar its appearance or degrade its performance. Quality Cost- refers to all of the costs that are incurred to prevent defects or that result from defects in products. 53 2. Prevention Costs – support activities whose purpose is to reduce the number of defects. Quality Circle – consist of small groups of employees that meet on a regular basis to discuss ways to improve quality. Statistical process control – is a technique that is used to detect whether a process is in or out of control. 3. Appraisal Costs – are sometimes called inspection costs, are incurred to identify defective products before the products are shipped to customers. 4. Internal Failure Costs – result from identifying defects before they are shipped to customers. 5. External Failure Costs – result when a defective product is delivered to a customer. 54 MODULE #10 - COST BEHAVIOR Introduction In this topic, we stated that costs can be classified by behavior. Cost behavior refers to how a cost will change as the level of activity changes. Managers who understand how costs behave can predict how costs will change under various alternatives. Conversely, attempting to make decisions without a thorough understanding of cost behavior patterns can lead to disaster. Managers must be able to accurately predict what costs will be at various activity levels. Learning Objectives: At the end of this module, the student should be able to: 1. Understand how fixed and variable costs behave and how to use them to predict costs; 2. Use a scatter graph plot to diagnose cost behavior; 3. Analyze a mixed cost using the high-low method; 4. Prepare an income statement using the contribution format; 5. Analyze a mixed cost using the least-squares regression method DEFINITION OF COST BEHAVIOR A. Cost behavior is nothing more than the sensitivity of costs to changes in production or sales volume. The Range Output or sales over which cost behavior patterns remain unchanged is called relevant range. B. Cost Behavior is the general term for describing whether a cost changes when the level of output changes. It is an indicator of how a cost will change in total when there is a change in some activity. In cost accounting and managerial accounting there are three types of cost behavior usually discuss: 1. Fixed Cost 2. Variable Cost 3. Mixed Cost TYPES OF COSTS BEHAVIOR PATTERNS In last topic we mentioned only variable and fixed costs. In this topic we examine a third cost behavior pattern, known as a mixed or semi variable cost. All three cost behavior patterns---- variable, fixed and mixed--- are found in most organizations. 55 A. Behavior in Accordance with Activity 1. Fixed costs- costs that remain constant regardless of the level of activity. Examples include rent, insurance, and depreciation using the straight-line method. 2. Variable costs- vary in total in proportion to changes in activity. If the activity level doubles, the total variable cost also doubles. If the activity level increases by only 10%, then the total variable cost increases by 10% as well. Examples include direct materials, direct labor, and sales commission based on sales. 56 3. Mixed costs- costs that vary in total but not in proportion to changes in activity. It is the combination of variable and fixed costs. An example would be electricity expense that consists of a fixed amount plus variable changes based on usage. MEASURES OF OUTPUT AND RELEVANT RANGE The terms fixed and variable costs do not exist in vacuum (a place where virtually all matter) H. Cost Driver – is any factor that has the effect of changing the level of total cost. I. Relevant Range – limits the cost relationship to the range of operations that the firm normally expects to occur. COMMITTED FIXED COST VS. DISCRETIONARY FIXED COST Committed Fixed Cost – Investments in facilities, equipment, and basic organization often cannot be significantly reduced even for short periods of time without making fundamental changes. Examples include depreciation of buildings and equipment, real estate taxes, insurance expenses, and salaries of top management and operating personnel. Even if operations are disrupted or cut back, committed fixed costs remain largely unchanged in the short term. Once a decision is made to acquire committed fixed resources, the company may be locked into that decision for many years to come. Consequently, such commitments should be made only after careful analysis of the available alternatives. 57 Discretionary Fixed Costs – usually arise from annual decision by management to spend on certain fixed cost items. Examples of discretionary fixed costs include advertising, research, public relations, management development programs, and internships for students. Two key differences exist between discretionary fixed costs and committed fixed costs. First, the planning horizon for a discretionary fixed cost is short term--- usually a single year. By contrast, committed fixed costs have a planning horizon that encompasses many years. Second, discretionary fixed costs can be cut for short periods of time with minimal damage to the long-run goals of the organization. TRUE VARIABLE VS. STEP-VARIABLE COSTS Not all variable costs have exactly the same behavior pattern. Some variable costs behave in a true variable or proportionately variable pattern. Other variable costs behave in a step-variable pattern. A. True Variable Costs Direct material is a true or proportionately variable cost because the amount used during a period will vary in direct proportion to the level of production activity. Moreover, any amounts purchased but not used can be stored and carried forward to the next period as inventory. B. Step-Variable Costs The cost of a resource that is obtained in large chunks and that increases or decreases only in response to fairly wide changes in activity is known as a step-variable cost. For example, the wages of skilled repair technicians are often considered to be a step-variable cost. Such a technician’s time only be obtained in large chunks---- it is difficult to hire a skilled technician on anything other than a full-time basis. Exhibit contrasts the behavior of step-variable cost with the behavior of a true variable cost. Notice that the cost of repair technicians’ changes only with fairly wide changes in volume and that additional technicians come in large, indivisible chunks Great care must be taken in working with these kinds of costs to prevent “fat” from building up in an organization. There may be a tendency to employ additional help more quickly than needed, and there is a natural reluctance to lay people off when volume declines. 58 Direct Material (true variables) Repair Technician Wages (step variable) Cost Cost Volume Volume SEMIVARIABLE COST (MIXED COSTS) Semi Variable Cost (Mixed Costs) contains both variable and fixed cost elements. Mixed costs are also known as semi variable costs. Sample Problem: The company must pay a license fee of $25,000 per year plus $3 per rafting party to the state’s Department of Natural Resources. If the company runs 1,000 rafting parties this year, then the total fees paid to the state would be $28,000, made up of $25,000 in fixed cost plus $3,000 in variable cost. The following equation for a straight line can be used to express the relationship between mixed cost and the level of activity. Y = a + bX In this equation, Y = The total mixed cost a = The total fixed cost (the vertical intercept of the line) b = The variable cost per unit of activity (the slope of the line) X = The level of activity Because the variable cost per unit equals the slope of the straight line, the steeper the slope, the higher the variable cost per unit. 59 The equation is written as follow: Y = $25,000 + $3.00X Total Total Variable Activity mixed fixed cost per level cost cost unit of activity This equation makes it easy to calculate the total mixed cost for any level of activity within the relevant range. For example, suppose that the company expects to organize 800 rafting parties in the next year. The total fees would be calculated as follows: Y = $25,000 + ($3.00 per rafting party x 800 rafting parties) Y = $27,400 The Analysis of Mixed Costs Mixed costs are very common. For example, the overall cost of providing X-ray services to patients at National Taiwan University Hospital, a world-renowned center for treating liver diseases, is a mixed cost. The costs of equipment depreciation and radiologists’ and technicians’ salaries are fixed, but the costs of X-ray film, power, and supplies are variable. The fixed portion of a mixed cost represents the minimum cost of having a service ready and available for use. The variable portion represents the cost incurred for actual consumption of the service; thus, it varies in proportion to the amount of service actually consumed. DIAGNOSING COST BEHAVIOR WITH A SCATTERGRAPH PLOT The first step in analyzing the cost and activity data is to plot the data on a scatter graph. This plot immediately reveals any nonlinearities or other problems with the data. Two things should be noted about this scatter graph: 1. The total maintenance cost, Y, I plotted on the vertical axis. Cost is known as the dependent variable because the amount of cost incurred during a period depends on the level of activity for the period. (That is, as the level of activity increases, total cost will also ordinarily, increase.) 2. The activity, X, is plotted on the horizontal axis. Activity is known as the independent variable because it causes variations in the cost. 60 In addition, the scatter graph reveals that the relation between maintenance costs is approximately linear. In other words, the points lie more or less along a straight line. Cost behavior is considered linear whenever a straight line is reasonable approximation for the relation between cost and activity. Note that the data points do not fall exactly on the straight line. THE HIGH-LOW METHOD The scatter graph plot indicates a linear relation between cost and activity, the fixed and variable cost elements of a mixed cost can be estimated using high-low method or the least-squares regression method. The high-low method is based on the rise-over- run formula for the slope of a straight line. The relation between cost and activity can be represented by a straight line, then the slope of the straight line is equal to the variable cost per activity. To analyze mixed costs with the high-low method, begin by identifying the period with the lowest level of activity and the period with the highest level of activity. Based on cost observed at both the high and low level of activity within the relevant range Y = FC + VX or Y = FC + VC Where: Y = Total Cost FC = Fixed Cost V = Variable Cost per Unit X = Activity Level VC = Total Variable Cost THE LEAST-SQUARES REGRESSION METHOD The least-squares regression method, unlike the high-low method, uses all of the data to separate a mixed cost into its fixed and variable components. A regression line of the form Y = a + bX is fitted to the data, where a represents the total fixed cost and b represents the variable cost per unit of activity. Least-squares regression method can be done by solving two simultaneous linear equations which are based on the condition that the sum of deviations above the line equals the sum of deviations below then line Y = a + bX Two linear equations that are used to solve for a and b are: Equation (1) ∑Y = Na + b∑X Equation (2) ∑XY = ∑Xa + b∑X² 61 Where: Y = Total Cost a = Fixed Cost b = Variable Cost Rate X = measure of activity N = number of observations ∑ = summation COST ESTIMATION Estimating variable and fixed cost of a mixed cost. This can be done through estimating the relation between costs and the factors affecting the costs Strengths and Weaknesses of Cost Estimation Methods Method Strengths Weaknesses Provides a detailed expert Subjective Account Analysis analysis of the cost behavior in each account Based on studies of what Not particularly useful Engineering future costs should be when the physical Method rather than what past relation between inputs costs have been and outputs is indirect Simple to apply Uses only two data High-low Method points which may not produce accurate results Uses all the observations The fitting of the line to of cost data. Relatively the observations is Scatter graph easy to understand and subjective. Difficult to do Method apply where several independent variables are to be used Uses all the observations The regression model of cost data. The line is requires that several statistically fit to the relatively strict observations. A measure assumptions be satisfied Least-square of the goodness of fit to for the results to be valid Regression the line to the Method observations is provided. Relatively easy to use with computers and sophisticated calculators. 62 CONTRIBUTION FORMAT INCOME STATEMENT Costs into fixed and variable cost elements helps to predict cost and provide benchmarks. Separating costs into fixed and variable elements is also often crucial in making decisions. This crucial distinction between fixed and variable costs is at the heart of the contribution approach to constructing income statements. The unique thing about the contribution approach is that I provide managers with an income statement that clearly distinguishes between fixed and variable costs and therefore facilities planning, control, and decision making. The Contribution Approach Notice that the contribution approach separates costs into fixed and variable categories, first deducting variable expenses from sales to obtain the contribution margin. The contribution margin is the amount remaining from sales revenues after all variable expenses have been deducted. It is important to note that variable expenses include production variable expenses as well as selling and administrative variable expenses. This amount contributes toward covering fixed expenses and then toward profits for the period. The contribution format income statement is used as an internal planning and decision-making tool. Comparison of the Contribution Income Statement with the Traditional Statement (the data are given) Traditional Approach Contribution Approach (cost organized by function) (costs organized by behavior) Sales $12,000 Sales $12,000 Cost of goods sold 6,000 Variable expenses Variable 6,000 $2,000 Gross Margin production Selling and 600 Administrative Expenses: Variable selling Variable $3,100 400 3000 Selling administrative Administrative 1,900 5,000 Contribution margin 9000 Net operating income $10,000 Fixed expenses Fixed 4,000 production Fixed selling 2,500 Fixed

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