good management accounting is a
competitive tool because management accounting is a competitive tool the
practice of management accounting involves innovation experimentation
diversity success since sometimes failure as businesses tinker with their
management accounting systems remember that a good business is always
reexamining its internal information system to see whether it can coax any
better data out of the system as a result there are best practices in
management accounting which you will learn in the succeeding topics the only
reason a company uses management accounting is to satisfy a competitive
need and competitive need often dictates that one organization's management
accounting system will not look like another's managers are always making
choices using the available management accounting information what should be
produced what should be sold how should the service be delivered the three
management functions of planning controlling and evaluating generally
follow a natural order at least in theory in practice managers are often
expected to work with processes customers and employees requiring all
three decision-making functions at once planning controlling and evaluating are
often part of the everyday duties of managers our objective here is to add a
little structure to that everyday analysis you management planning involves
of recognizing problems or opportunities identifying alternatives analyzing those
alternatives and then choosing and implementing the best alternatives there
are two basic types of planning first long-run planning which includes
strategic planning and capital budgeting and second short-run planning which
includes production and process prioritizing and operational budgeting
or profit planning long-run planning involves making decisions with effects
that extends several years into the future usually three to five years but
sometimes longer than that this includes broad-based decisions about products
markets productive facilities and financial resources long run planning is
often called strategic planning strategic planning likely the most
critical decision-making process that takes place at the executive level in
any organization today usually involves identifying an organization's mission
the goals flowing from that mission and strategies and action steps to
accomplish those goals successful executives such as William Weldon of
Johnson & Johnson or Warren Buffett of Berkshire Hathaway have always displayed
great skill and studying the market identifying customer needs analyzing
competitors strengths and weaknesses and defining the right investments in
processes their organizations need for success good management accounting
supports good strategic planning by providing the internal information
needed by executives to evaluate and adjust their strategic plans with
strategic planning in place or in process the company can then plan for
the purchase and use of major assets like building their equipment to help
the company meet its long-range goals for example if a University's long-run
strategic plan includes making its football team more competitive the
university should consider improving or replacing its existing football stadium
and practice facility this type of long-run planning of the acquisition of
assets is called capital budgeting short-run planning is divided into two
categories production prioritizing and operational budgeting once the
organization has made long-term resource commitments that is
land building equipment management personnel and the like
then managers need to determine how to best use those committed resources to
maximize the return on their capital investment a process often referred to
as production prioritizing now did you catch the phrase return on capital
investment in the last sentence that sound familiar the DuPont ROI concept is
one way to establish priorities on products service processes or divisions
that make the largest contributions to the goals of the organization
once the organization has determined what to provide to the marketplace in
order to maximize its goals then managers are ready to go on to the next
phase of short-run planning operational budgeting sometimes known as profit
plans operational budgets are used by managers to establish and communicate
daily weekly and monthly goals also known as standards for the organization
many individuals face severe personal financial problems because they fail to
use even the most basic techniques of regular operational budgeting you managerial accounting involves
collecting and using information relating the planning controlling and
evaluating planning involves looking into the future
controlling involves managing the present and evaluating relates to
looking to the past controlling involves a process of tracking actual performance
these data are then used in the evaluating process to compare against
the budgets and measure deviations from the goals or standards deviations from
standards are called variances controlling also involves the real-time
day-to-day management of all of a company's business processes a good
example of a control device is the radar gun used by major league baseball teams
to measure the speed of the pitcher is throwing his pitches these measurements
can be used at the end of the season in evaluating which pitchers are most
valuable to the team but they can also be used by the manager during the course
of a game to indicate when a pitcher is getting tired and should be replaced the
radar gun measurements are useful for evaluating individual performance after
the fact but are also useful in effectively managing the team during the
game evaluating involves analyzing results providing feedback to managers
and other employees rewarding performance and identifying problems
evaluating is typically a process of comparing actual performance against
expected inputs of costs outputs of quality and timelines this comparison
typically results in variances that tell management how well the organization is
achieving its plans if performance is in accordance with the plan the variances
signal that operations are in control and no unusual management action is
necessary if performance is substantially different from the plan
management needs to decide how to alter operations in order to improve future
performance for example most students in college classes are asked to evaluate
their instructors near the end of the term these evaluation results can be
used by conscientious faculty members trying to improve their teaching and
also used by the Cartman heads in deciding which teachers
should be retained or replaced now the third function in the management
process evaluating brings us back to the point where we started planning the
information gained through the evaluating function is used for planning
for the following period remember that as managers evaluate performance in the
last period they may also be making planning decisions to improve operations
for the next period while gathering and receiving results to control the current
period you this chapter introduces
cost-volume-profit analysis also called CVP analysis which is a management tool
primarily used in the planning process the basic objective of CVP analysis is
determining how a company's sales impact profits you will often hear CVP analysis
referred to as breakeven analysis for example before opening a new Thai
restaurant the would-be restaurateur should calculate how many customers a
day on average must be served in order to pay the rent and generate a
reasonable profit if the necessary number of customers to break-even
seems unreasonably high the business plan must be revised or abandoned now
this sounds like an obvious planning exercise but too many small business
owners neglect doing even this basic analysis to use CVP analysis
successfully a manager must categorize cost is either fixed or variable the
concept of fixed and variable costs is fairly simple total variable cost change
in direct proportion to changes in some particular activity levels such as
production or sales volume one example of a variable cost is the cost of
materials such as bags of rice used in a Thai restaurant which vary
proportionally with the number of units produced sales commissions which vary
proportionally with sales volume are also an example of a variable cost
another way to think of a variable cost is that the cost is a set amount per
unit $10 per meal or $12,000 per cart or $20 per book the more meals or cars or
books that are sold the higher the total variable cost
in contrast fixed costs remain constant in total regardless of activity level at
least over a certain range of activity examples of fixed costs are rent
insurance equipment depreciation and supervisor salaries regardless of
changes in sales or production output these costs typically remain constant
using the Thai restaurant example the rent on the restaurant location is a
fixed cost because no matter how many customers are attracted to the
restaurant during the month the monthly rent is typically still the same amount
obviously to be successful a business must first be able to pay for all its
costs however a good understanding of variable and fixed costs provides the
organization with a clear view of how it can make a profit using CVP analysis the
basic CVP concept is that the difference or margin between sales and variable
costs must first be used to cover fixed costs once the organization achieves
that break-even point then the remaining margin becomes profit for example if the
average variable cost to create a meal at a restaurant is $10 and the average
price of a meal is $16 then each meal on average contributes 6 dollars to cover
the fixed costs of running the restaurant if monthly fixed costs such
as rent insurance and so forth at the restaurant are nine thousand dollars
then the owner needs to sell 1500 meals that's nine thousand dollars divided by
six dollars each month in order to break even you contribution margin calculations are
very useful when analyzing cost-volume-profit relationships in the
management planning process doing CVP analysis using contribution margin
calculations is a straightforward process though it does require some
simple algebra we begin this topic with the assumption that all cost can be
described as either fixed or variable to highlight the important idea that CVP
analysis depends on dividing costs and the fixed and variable behavior patterns
we will develop the CVP equation as follows first because all cost can be
classified as either variable or fixed we can express the calculation of profit
with the following basic formula sales revenues less variable costs less fixed
costs equals our profit and second we can specify the formula more precisely
by expressing the equation in units that is our sales price times the number of
units less our variable costs times the number of units less our fixed costs
equals profit this equation is a quick and useful method for examining the
financial aspects of CVP analysis problems CVP analysis using this
equation is basic math you merely insert the known elements into the formula and
solve for the one unknown element you in many cases as a manager you'll want
to know how many units need to be sold to break-even the break-even point is
defined as the volume of activity at which total revenues equal total costs
or in other words where profit is zero the break-even point may also be thought
of as the volume of activity at which the contribution margin equals the fixed
costs although the goal of business planning is to make a profit not just to
break even knowing the break-even point can be useful in assessing the risk of
selling a new product setting sales goals and commission rates deciding on
marketing and advertising strategies and making other similar operating decisions
because the break-even point is by definition that activity level at which
no profit or loss is earned the basic CVP equation can be modified to
calculate the break-even point as follows all that you need to do to
compute the breakeven point is simply set income equal to zero and then solve
for the unknown such as the number of units to be sold or the total revenues
to be achieved once you understand the basic CVP formula you just set it up and
solve for whatever unknown you're interested in planning another way we
can use CVP analysis in the planning process is to determine what level of
activity is necessary to reach a target level of income instead of setting
profit at zero to do a break-even analysis we can just as easily set
income in the formula at the targeted level and then use the formula to plan
or predict what fixed cost variable cost sales price and sales volume are needed
to achieve the target level of income target income is usually defined as the
amount of income that will enable management to reach its objectives
paying dividends meeting analysts predictions purchasing a new plant and
equipment or paying off existing loans target income can be expressed as either
a percentage of revenue or as a fixed amount the power of the CVP equation
lies in understanding the relationship between sales variable costs and fixed
costs once we quantify those relationships we can do some pretty
simple analysis that yields some pretty powerful results you the foundation of management accounting
is cost control to really understand management accounting you need to grasp
the flow of costs in manufacturing service and merchandising organizations
understanding cost flows is a useful way to understand how a business is
structured or organized without accurate cost information it is difficult to set
prices evaluate performance reward employees or make production decisions
it is even difficult to know whether a company should be competing in a
specific market as we discussed previously costs of manufacturing
products can be broken down into three elements direct materials direct labor
and manufacturing overhead to briefly review direct materials include the
costs of raw materials that are used directly in the manufacture of products
and are kept in the raw materials warehouse until use direct labor
includes the wages and other payroll related expenses of factory employees
who work directly on products manufacturing overhead includes all
manufacturing costs that are not classified as direct materials or direct
labor one of the best ways to understand how an organization works is to follow
the money in other words observe how costs flow
through an organization since management accounting systems were originally built
to support the manufacturing process we'll start there you responsibility accounting is a system in
which managers are assigned and held accountable for certain costs revenues
and or assets there are two important behavioral considerations in assigning
responsibilities to managers first the responsible manager should be involved
in developing the plan for the unit over which the manager has control current
research indicates that people are more motivated to achieve a goal if they
participate in setting it such participation assures that the goals
will be reasonable and perhaps more importantly that they will be perceived
to be reasonable by the managers second a manager should be held accountable
only for those costs revenues or assets over which the manager has substantial
control some costs may be generated within a segment but control over those
costs lies outside that unit for example the manager of the venture a
manufacturing division may be held responsible for labour costs but
employer wages may be determined by a Union scale controlled elsewhere
admittedly determining substantial control requires a judgement based on
circumstances but if all relevant factors are considered careful and fair
judgments can be made if managers are to be held responsible for the costs
incurred in their centers they must have control over those costs have
information relevant to those costs and have a system that focuses on and
supports effective cost controls traditionally companies have used a
standard costing system that isolates differences between actual and standard
or budgeted costs to determine whether costs are too high or too low as well as
whether costs are improving or getting worse this is critical information if
the organization expects to be competitive in a standard cost
management system standard costs are compared to actual costs and variances
are computed service merchandising and manufacturing firms that use standard
costing will design their accounting systems to incorporate standard costs
and variances this type of system called a standard
cost system is a cost accumulation process based on cost that should be
incurred rather than cost that were incurred the steps in establishing and
operating a standard cost system are as follows first standard cost must be
developed how much material should be used in a product how much should that
material cost how much labour should be required to assemble the product how
much should that labor cost answers to these questions requires research and
analysis but that time is well worth the effort at the end of this first step you
know how much a product or service should cost you second then is to
collect the actual costs the accounting system should be designed to gather
actual cost information you will be able to say how much material was used in a
product how much that material did cost how much labor was used in assembling a
product and how much that labor did cost the third step is then to compare the
actual costs with what you expected those costs to be the result will be
what accountants call variances the difference between what we expected and
what was actually incurred analyzing these variances allows you to determine
the cause of the variance did we use too much labor or material did we pay too
much for our labor or material this variance analysis is a crucial step in
using standard costing techniques fourth and finally we are now down to asking
the important question why we know there is a variance but now we need to
investigate why was our standard unreasonable did we use labor
inefficiently we can now ask a host of why questions that will allow us to
identify is there a problem and what can we do about it these steps describe a
typical standard cost system you are likely to find an extensive standard
cost system in most manufacturing firms which usually have standard cost for
direct materials direct labor and manufacturing overhead however many
service and merchant firms also use standard cost systems to
effectively manage critical costs in their organizations you a budget is a plan technically it's a
quantitative expression of a plan of action that shows how someone or
something will acquire and use resources over a specific period of time the
budget identifies and allocates resources necessary to effectively and
efficiently carry out the mission of the organization
although budgeting may sound to you like an unappealing activity successful
budgeting is absolutely critical to the success of a business whether we're
talking about an individual a family or a large organization the overall purpose
of a budget is to clearly establish a plan so that performance in relation to
a goal can be carefully monitored thus budgeting has a two-fold purpose the
first purpose is to allow individuals or companies to develop a plan to meet a
specified goal the second purpose is to allow ongoing comparison between actual
results and the plan in order to better control operations or activities
budgeting is such an important activity that the top executives of most
companies coordinate and participate in the process now research and experience
has shown that several behavioral factors determine how successful the
budgeting process will be first the process must have the support of top
management second managers and other employees are more motivated to achieve
budget goals that they understand and help design and third deviations or
variances from the budget must be addressed by managers in a positive and
constructive manner a firm-wide operations budget could be prepared by
top management distributed to the major segments of the firm and then further
spread out to each lower-level segment manager this is the top-down approach
sometimes referred to as authoritative budgeting the alternative is the
bottom-up approach also known as participated budgeting each division
manager in a bottom-up approach prepares a budget request for his or her segments
these requests are combined and reviewed as they move their way up the
organizational hierarchy with adjustments being made to coordinate the
needs and goals of within the overall organization because
both top-down and bottom-up approaches are legitimate most organizations use
some combination of the two the blending of these are two approaches will vary
among organizations a smaller organization with a few management
levels will rely more on a top-down approach than with a larger organization
top management in smaller organizations tends to be more knowledgeable about and
more involved in the operating details you the primary objective of a business is
to generate a profit for its owners profitable businesses can be based on a
low-cost strategy like Walmart a customer service strategy like FedEx a
product branding strategy like coca-cola or a variety of other business
strategies no matter what a company's underlying strategy is it must make
long-term investment decisions in buildings equipment information
technology personnel and so forth capital budgeting is the process of
determining whether the future benefits stemming from these strategic decisions
are sufficient to justify the significant upfront associated costs in
short capital budgeting involves a comparison of the magnitude of upfront
costs to the magnitude of estimated future multi-year benefits in business
capital is defined as the total amount of money or other resources owned or
used by an individual or company to acquire future income or benefits
thus capital is something to be invested with the expectation that it will be
recovered along with a profit and capital budgeting is the planning for
that investment now from a quantitative standpoint the success of the investment
depends on the amount of net future cash inflows or futurecast savings in
relation to the costs the current cash outlays on the investment ignoring the
time value of money for a moment if a company invests $10,000 and receives
only $10,000 in the future there's been no profit in other words
there has been no return on the investment however if $15,000 is
received in the future the original investment has been preserved and an
additional return on the investment or profit of $5,000 has been earned other
things being equal investors obviously wish to receive the greatest
future benefit for the least investment cost now three aspects of capital
investment decisions are critical to long-run profitability first a large
initial outlay decisions to invest in as that's like land buildings and equipment
usually require large outlays of capital firms making poor decisions involving
these large assets will struggle to survive
second the potential long-term impact on earnings long-term investments by
definition extend over several years thus poor capital budgeting resulting in
bad investment decisions is likely to have an adverse effect on earnings over
a longer period and third these decisions are difficult to reverse long
term investments in land buildings and specialized equipment are much less
liquid than other investments investments in stocks and bonds for
example can usually be sold through regularly established markets at almost
any time it's much more difficult to dispose of capital assets now all
long-term investment decisions are important the larger the investment
however the more critical is the need to budget for that expenditure and the
longer the time period the more difficult it is to assess future
outcomes and a plan accordingly now following are some typical business
decisions that can be better understood with capital budgeting techniques should
a machine that breaks down be repaired or replaced should a pharmaceutical
company hire a renowned research scientist and commit to supporting this
scientist and her staff for the next 10 years should a company add to its
existing manufacturing facility or should have build a new larger factory
situations like these require careful consideration of many factors
qualitative as well as quantitative and it is just as important for nonprofit
organizations to make sound strategic and capital investment decisions as for
for-profit organizations to do that now the concepts and techniques discussed in
this topic are applicable to all types of organizations companies governmental
agencies school districts hospitals municipalities and so forth
capital budgeting analysis can help by answering two basic questions first
relating the screening does the investment make sense
that is doesn't meet a minimum standard of financial acceptability and the
second relates to ranking is an investment the best among the acceptable
alternatives you the four most commonly used capital
budgeting techniques are the payback method the unadjusted rate of return the
net present value method and the internal rate of return method this
sequence parallels the pattern of most companies as they grow larger and become
more sophisticated in the way they make investment decisions that is companies
generally first use the payback method or the unadjusted rate of return method
because these techniques are relatively simple both of these techniques however
have a serious weakness in that they ignore the time value of money as a
result most companies eventually turn to either the net present value method or
the internal rate of return method both of which are more theoretically correct
approaches to capital budgeting the last two techniques are referred to as
discounted cash flow methods because they use a discount rate in comparing
the cash flows of investments the payback method is widely used in
business because it is simple to apply and it provides a preliminary screening
of investment opportunities it can also be used as a crude measure of a project
risk basically this method is used to determine the length of time it will
take the net cash inflows of an investment to equal the initial cash
outlay the payback period is a particularly important consideration for
companies in tight cash positions assuming that the payback period is to
be computed in years actually any time period can be applied and that equal
cash flows are generated for each period the simple formula for a project's
payback period is we take the investment cost and we divide it by the annual net
cash inflows the result will be our payback period to illustrate the payback
method consider that you are trying to decide to purchase a personal computer
printer and software for typing and printing essays and term papers for
students a reasonably good PC printer and appropriate software will cost a
total of about $1000 let's assume for simplicity's sake that you can borrow
the thousand dollars from a family member who requires no interest but
needs to be repaid at the end of 12 months you expect to make
$125 a month after paying for supplies and other related expenses the payback
period in months may be computed as follows we take $1,000 our initial
investment and divide it by our net cash inflows each month of $125 the result is
8 months because you would generate sufficient cash to recover the
investment in 8 months you would repay the family member within the agreed upon
period of time assuming you spend none of the money
like that's gonna happen this is one of the strengths of the
payback method it can be used to determine whether an investment fits
within an acceptable period for the use of the funds the payback method has
several weaknesses however one is that it measures the time needed to recover
the initial outlay but does not consider the investments overall profitability
most investments are made in order to earn an acceptable return not just to
recover their costs for example you are not solely interested in recovering the
thousand dollars in the shortest time possible your purpose in buying the
equipment is to earn some extra money assuming that the equipment will ask for
more than eight months you not only will recover your initial investment but you
will also generate subsequent earnings at at least $125 a month
although the payback method may provide some clues about the advisability or
risks of investment it does not directly measure profitability the other major
weakness of the payback method it does not take into account the time value of
money you two widely used capital budgeting
techniques recognize the time value of money the net present value method and
the internal rate of return method both methods applied discounted cash flow
principles in determining the acceptability of an investment the net
present value method uses a standard discount rate that is the hurdle rate to
restate all cash flows in terms of present values and then makes
comparisons in choosing a discount rate a company's cost of capital as well as
the riskiness of a project should be considered if the company were
considering a very high-risk project a higher discount rate would be used
because high-risk projects must yield higher than average returns in order to
compensate for the increased probability of low or negative returns the selection
of the right discount rate is critical in the execution of a useful capital
budgeting analysis the net present value method compares all expected cash
inflows associated with an investment with the current and future cash
outflows all cash flows are discounted to their present values giving
recognition to the time value of money for this reason the net present value
method is superior to both the payback method and the unadjusted rate of return
method in general the net present value method involves the following five steps
1 estimate the amount and timing of all cash flows associated with the
investment to evaluate the riskiness of the cash flows in order to determine the
appropriate discount rate to be used in your present value calculations 3
compute the present values of all the expected cash inflows and outflows of
the investment 4 subtract the total present value of the cash outflows from
the total present value of the cash inflows the difference is the
investments net present value and 5 decide whether they undertake the
investment if the net present value of the investment is positive or at least 0
the project is acceptable from a financial standpoint now steps 1 and 2
are the most difficult steps in evaluating a
long-term investment these steps are our business judgment experience and careful
analysis of details separate managers that make good long-term investment
decisions from those who make bad ones steps three through five require
familiarity with present value concepts and computations those concepts and
computations are well beyond the scope of this course but they are not well
beyond your grasp suffice it to say that the net present value method recognizes
the time value of money and factors that into the calculations in determining if
a project is worth undertaking or not you the internal rate of return method also
known as the time adjusted rate of return method or the discounted rate of
return method is similar to the net present value approach in that it
emphasizes the profitability of investments and takes into account the
time value of money as a discounted cash flow method it is superior to either the
payback method or the unadjusted rate of return method some managers consider the
internal rate of return meth and more difficult than present value method
because the computations can be challenging other managers however
prefer to analyze investment alternatives in terms of comparative
rates of return rather than net present values the internal rate of return is
defined as the true discount rate that an investment yields mathematically the
internal rate of return is the discount rate that yields a net present value of
$0 when applied to the cash flows into an investment both inflows and outflows
to determine the value of an investment management must compare the project's
internal rate of return with the company's usual discount rate often
called the hurdle rate or the rate that must be cleared for a project to be
acceptable if the internal rate of return is higher than or equal to the
company's hurdle rate the project is acceptable if the internal rate of
return is lower than the hurdle rate the project is usually rejected as with any
of the capital budgeting techniques even if the investment is acceptable from an
internal rate of return standpoint qualitative factors must still be
considered before a final decision can be made you in explaining the fundamental concepts
of capital budgeting we have focused on the numbers however a discussion of
capital budgeting is incomplete without mentioning factors that cannot be
reduced to numbers sometimes qualitative factors can override quantitative
analysis in strategic and capital investment decisions here we'll consider
3 types of qualitative factors and investments effect on the quality of
products and services offered and investments effect on the time with
which products and services can be produced and delivered to customers and
other qualitative factors so far we've made the determination of whether a
capital investment decision is a good one based solely on the financial return
computed using one of four methods if the financial return was positive our
conclusion was to invest if the financial return was negative we
recommended that the project not be undertaken
however organizations must carefully manage and balance decisions across
three important aspects of decision-making cost quality and time
quality and time considerations can sometimes dictate that a capital
investment should be main even if the financial returns don't justify the
expenditure for example if buying a new machine will help the company produce
higher quality products or deliver those products to its customers faster the
machine may be a good investment the impact of quality and time on capital
budgeting decisions must not be underestimated in addition to quality
and time there are a number of other qualitative factors that must be
considered when making capital budgeting decisions these factors include such
things as government regulations pollution control and Environmental
Protection worker safety and the preferences of owners and management
many more examples could be mentioned but the point is that numbers alone do
not control the investment decisions of a good manager quality time and other
qualitative as well as quantitative factors should be considered in reaching
long term investment decisions you
