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Management accounting vs financial accounting

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Financial accounting is retrospective, used primarily externally by investors, and governed by rules set by the SEC and FASB. Also more aggregated Management accounting is prospective, used internally by managers, and is not governed by any set rules

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Strategy

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About an organization making choices about what it will do and what it will not do. At the highest level, strategic planning involves choosing a strategy that provides the best fit between the organization's environment and its internal resources in order to achieve the organization's objectives.

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Plan Do Check Act Cycle

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Originally developed for improving the quality of products and processes. We can view the iterative strategy execution process through the lens of the PDCA cycle. Also called the Deming cycle.

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PDCA Cycle: Plan

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Plan - Identify objectives - Choose a course of action to achieve the desired objectives

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PDCA Cycle: Do

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Do - Implement the chosen course of action

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PDCA Cycle: Check

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Check - Monitor (measure) the results of the implemented course of action - Evaluate the results by comparing them with the results expected when the plan was developed

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PDCA Cycle: Act

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Act - Maintain the current direction if results are acceptable. Otherwise, return to the plan stage to develop and implement an alternative course of action

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Balanced Scorecard (BSC)

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Provides a framework that continues to measure financial outcomes but supplements these with non-financial measures derived from the company's strategy. Not restricted to private-sector companies; many non-profits and public sector entities also have adopted this framework to manage their creation of social value.

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Four Perspectives on the BSC

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Financial: How is success measured by our shareholders? Customer: How do we create value for our customers? Process: At which processes must we excel to meet our customer and shareholder expectations Learning and growth: What employee capabilities, information systems, and organizational capabilities do we need to continually improve our processes and customer relationships?

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BSC process perspective

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Describes "how" the strategy will be executed; it identifies the processes that are most important to meet the expectations of shareholders and customers.

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BSC learning and growth perspective

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The learning and growth perspective uses a measure of employees' capabilities to predict improvements in process quality and cycle times.

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Two principal functions of a strategy

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1. Creates a competitive advantage by positioning the company in its external environment where its internal resources and capabilities deliver something to its customers that is better than or different from its competitors. 2. Having a clear strategy provides clear guidance for where internal resources should be allocated and enables all organizational units and employees to make decisions and implement policies that are consistent with achieving and sustaining the company's competitive advantage in the marketplace.

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Two essential components of any company's strategy

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1. A clear statement of the company's advantage in the competitive marketplace, what it does or intends to do differently, better, or uniquely compared to competitors 2. The scope for the strategy, where the company intends to compete most aggressively, either for targeted customer segments, technologies employed, geographic locations served, or product line breadth

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BSC: Objectives

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Objectives: The first level of the BSC. Word statements of strategic objectives that describe what it is attempting to accomplish with its strategy Examples - Increase revenues through expanded sales to existing customers (financial) - Offer complete solutions to our targeted customer (customer)

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BSC: Measures

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Measures: Describe in more precise terms how success in achieving an objective will be determined. They reduce the ambiguity that is inherent in word statements.

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BSC: Targets

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Targets: Once the objectives have been translated into measures, managers select targets for each measure. A target establishes the level of performance or rate of improvement required for a measure.

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Strategy map

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Companies use a picture, called a strategy map, to illustrate the causal relationships among the strategic objectives across the four BSC perspectives. Only includes objectives. The addition of measures and targets turns a strategy map into a BSC

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A company's financial performance improves through two basic approaches

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Productivity improvements and revenue growth

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Two components of productivity improvements

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1. Companies reduce costs by lowering direct and indirect expenses. 2. By utilizing their financial and physical assets more efficiently, companies reduce the working and fixed capital needed to support a given level of business.

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Two areas of revenue growth

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1. Companies can generate more revenue and income from existing customers, such as by selling them additional products and services beyond the first product or service they purchase. 2. Companies generate additional revenues by introducing new products, selling to new customers, and expanding operations into new markets.

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Three value propositions

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1. Lowest total cost: Wal-Mart, Southwest Airlines, McDonald's, and Toyota 2. Product leadership: Apple, Mercedes, Armani, and Intel 3. Complete customer solutions: IBM, J.P. Morgan, and Nordstrom

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Customer management processes

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Expand and deepen relationships with targeted customers. We can identify three objectives for a company's customer management processes: 1. Acquire new customers 2. Satisfy and retain existing customers 3. Generate growth with customers

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Innovation processes

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Develop new products, processes, and services, often enabling the company to penetrate new markets and customer segments. Two important innovation subprocesses: 1. Develop innovative products and services 2. Achieve excellence in research and development processes

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Regulatory and social processes

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Make up the final process group. Companies must continually earn the right to operate in the communities and countries in which they produce and sell.

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Four process groups

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Operations management, customer management, innovation, and regulatory and social.

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Timing for the four process groups

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Operational processes: Improvements deliver quick benefits (within 6 to 12 months) to productivity objectives in the financial perspective. Customer relationships: Revenue growth deriving from these improvements accrues in the intermediate term (12 to 24 months) Innovation processes: Generally take longer to produce customer and revenue and margin improvements (24 to 48 months). Regulatory and social processes: Typically take longer to capture as companies avoid litigation and shutdowns and enhance their image as employers and suppliers of choice in all communities in which they operate.

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Learning and growth: Strategic competency availability

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The company's employees have the appropriate mix of skills, talent, and know-how to perform activities required by the strategy

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Learning and growth: Strategic information availability

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The company's information systems and knowledge applications contribute to effective strategy execution by facilitating process improvements and better linkages with suppliers and customers

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Learning and growth: Culture and climate

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Employees have an awareness and understanding of the shared vision, strategy, and cultural values needed to execute the strategy

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Learning and growth: Goal alignment

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Employee goals and incentives are aligned with the strategy at all organization levels

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Learning and growth: Knowledge sharing

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Employees and teams share best practices and other knowledge relevant to strategy execution across departmental and organizational boundaries

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Barriers to effective use of the BSC

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1. Senior management is not committed (the largest source of failures occurs when the BSC project is led by or gets delegated to a middle-management project team) 2. Scorecard responsibilities do not filter down 3. The solution is over-designed, or the scorecard is treated as a one-time event 4. The BSC is treated as a systems or consulting project (as opposed to a management project)

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Variable cost

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One that increases proportionally with changes in the activity level of some variable

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Cost driver

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A common term used for a variable that causes a cost

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Variable cost formula

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VC = VC per unit of cost driver x cost driver units

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Fixed cost

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Cost that does not vary in the short run with a specified activity. Often called capacity-related costs

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CVP analysis

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Cost-volume-profit analysis uses the concepts of variable and fixed costs to identify the profit associated with various levels of activity.

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Contribution margin

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The difference between total revenue and total variable cost

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Contribution margin per unit

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The contribution that each unit makes to covering fixed costs and providing a profit.

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Contribution margin ratio

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The ratio of contribution margin per unit to selling price per unit.

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Assumptions underlying the CVP analysis

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1. The price per unit and variable cost per unit (and therefore the CM per unit) remain the same over all levels of production 2. All costs can be classified as either fixed or variable or can be decomposed into a fixed and variable component. 3. Fixed costs remain the same over all contemplated levels of production. 4. Sales equal production.

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Mixed cost

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A cost that has a fixed component and a variable component. For example, your cell phone bill may have a fixed component that you pay each month, independent of how many calls you make, and a variable component that depends on the quantity of calls you make.

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Step variable cost

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Increases in steps as quantity increases For example: A company has a policy of hiring one factory supervisor for every 20 factory workers. If each factory supervisor is paid $60k, the total cost of supervisory salaries increases in a series of steps with the number of workers.

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Incremental cost

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The cost of the next unit of production and is similar to the economist's notion of marginal cost. In a manufacturing setting, incremental cost is generally defined as the variable cost of a unit of production. However, the concept is not that simple for two reasons.

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Two reasons why the concept of incremental cost is not simple

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1. The variable cost per unit may change as production volume changes. For example, in the presence of a learning effect, the variable cost of labor will decrease as cumulative production increases. Also, if a firm operates using overtime, the variable cost of units produced during the overtime period could increase by 50% (time-and-a-half). 2. If the cost is a step variable, treating the cost as a variable cost will lead to estimation errors.

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Sunk cost

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A cost that results from a previous commitment and cannot be recovered. Sunk costs should not be considered in subsequent decisions because they cannot be changed. Examples: Depreciation on a building reflects the historical cost of the building, which is a sunk cost. Lease payment required by long term lease is also a sunk cost

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Sunk cost phenomenon

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Also called the Concorde effect or the Concorde fallacy. Because sunk costs so often affect managerial decisions, the term sunk cost phenomenon has evolved. Even though it was apparent that the Concorde, a supersonic passenger jet that was a joint project of England and France, would be unprofitable, the two countries kept investing money in it because they had already invested huge sums of money.

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Relevant cost

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A cost that will change as a result of some decision

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Opportunity cost

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The maximum value forgone when a course of action is chosen.

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Avoidable cost

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A cost that can be avoided by undertaking some course of action. The most obvious avoidable costs are variable costs. If production ceases, all variable costs associated with that production processes are avoided. Less obvious and more problematic in practice are fixed costs that can be avoided as a result of a course of action.

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Make-or-buy decision

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The analysis in which you decide whether to contract out for a product or service.

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Direct materials costs

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Include materials that can be traced easily to a unit of output and are of significant economic consequence to the final product.

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Direct labor costs

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Those labor costs that can be traced easily to the creation of a unit of output. Direct laborers are those who physically construct a unit of output.

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Manufacturing overhead costs

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All costs incurred by a manufacturing facility that are not direct materials costs or direct labor costs. In particular, materials (such as thread or glue) that are not of significant economic consequence to the final product are treated as indirect materials and their cost is included in manufacturing overhead costs.

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Floor price

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The minimum price that a company would normally consider for the order. Relates to the relevant cost idea -- floor price considers the costs that will change as a result of taking the order.

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Finished goods inventory

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When manufacturing is completed, work is transferred to finished goods inventory, and costs are moved from the work-in-process inventory account to the finished goods inventory account. Finally, when goods are sold, their costs are moved from the finished goods inventory account to cost of goods sold.

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Cost object

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Anything for which a cost is computed. Examples of cost objects are activities, products, product lines, departments, or even entire organizations.

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Consumable resource

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Also called a flexible resource. The defining characteristic of a consumable resource is that its cost depends on the amount of resource that is used. Examples of consumable resources are wood in a furniture factory and iron ore in a steel mill. The cost of a consumable resource is often called a variable cost because the total cost depends on how much of the resource is consumed.

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Capacity-related resource

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The defining characteristic of a capacity-related resource is that its cost depends on the amount of resource capacity that is acquired and not on how much of the capacity is used. Examples of capacity-related costs are depreciation on production equipment (the capacity-related resource) and salaries paid to employees (the capacity-related resource) in a consultancy. The cost of a capacity-related resource is often called a fixed cost because the cost of the resource is independent of how much the resource is used in the short run.

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Direct cost

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A cost that is uniquely and unequivocally attributable to a single cost object.

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Indirect cost

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Any cost that fails the test of being a direct cost. This may sound simple, but disputes in costing about whether a cost (more correctly the resource that created the cost) should be treated as direct or indirect outnumber all other costing disputes.

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Cost pool

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The first step to allocating indirect costs is to classify as indirect or direct; if the cost is indirect, it is assigned to an indirect cost pool. The simplest structure in a manufacturing system is to have a single indirect cost pool for the entire manufacturing operation.

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Fixed manufacturing overhead

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Indirect costs in a factory setting. These include heating, lighting, depreciation on factory equipment, factory taxes, and supervisory salaries.

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Variable overhead

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Includes costs for such items such as machine electricity usage, minor materials groups as indirect materials (thread, glue, etc.) and machine supplies. Variable overhead costs are actually direct costs that are too costly and too immaterial (in relation to total product cost) to trace to individual cost objects. An example of this is the cost of glue used to make each piece of furniture. These variable costs are accumulated in a variable cost account. Variable costs may be assigned as direct costs. Alternatively, for simplicity, variable overhead costs may be grouped together with fixed overhead in developing methods for allocating overhead to cost objects. In this chapter, we maintain the "indirect cost" terminology for overhead to emphasize the challenges in allocating fixed manufacturing overhead to cost objects.

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Applied indirect costs

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Organizations use a separate account to record applied indirect costs (indirect costs allocated as production occurs during the year). The resulting situation shows one indirect cost account that accumulates the actual indirect costs that have been incurred, and a second indirect cost account that accumulates the indirect costs that have been applied to production.

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Cost driver rate

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Once the cost driver is chosen, cost analysts divide expected indirect factory costs by the number of cost driver units to compute what is called the predetermined indirect cost rate. Another common name for this rate is the predetermined overhead rate Cost driver = (Est. total factory indirect cost)/(practical capacity in cost driver unit)

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Why do we use the planned, not actual, level of capacity-related costs in computing the cost driver rate?

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1. The annual actual capacity-related costs are not known until the end of the accounting period (usually a year) and cost analysts want to compute the costs for cost objects such as customers, products, and jobs, before the year end. 2. Using planned rather than actual capacity-related costs sets a benchmark against which to compare actual capacity-related costs at the end of the accounting period.

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Three options in reconciling actual and applied capacity costs

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1. Charge the difference between actual and applied indirect costs to COGS 2. Prorate the difference between actual and applied indirect costs to work in process, finished goods, and cost of goods sold. 3. Decompose the difference between actual and applied indirect costs into two parts: 1. The difference between actual and budgeted indirect costs 2. The difference between budgeted in and applied indirect costs

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Which of the options to reconcile actual/applied capacity costs is best?

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The first option is simplest. The second is a bit more complex. The third option is the most complex. However, it focuses on developing information that helps identify the reasons for the difference between actual and applied costs and is, therefore, relevant for internal decision-making purposes. In Option 3, management receives more detailed information on reasons for the difference.

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Four commonly proposed activity levels used to compute the cost driver rate

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Practical capacity is the most commonly used of the proposed activity levels used to compute the cost driver rate. The other three are: 1. The actual level of operations 2. The planned level of operations 3. The average level of operations

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Objections to using planned capacity

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Proponents of using practical capacity are most concerned with providing what they call "accurate" costs in the income statement and inventory valuations on the balance sheet. Objections to the approach of using planned: 1. All cost allocations are arbitrary and it is inappropriate to talk about an actual or accurate cost. 2. The approach makes no economic sense. Whether costs are used for financial reporting or decision making, most observers argue that they should reflect some economic sense. The problem with this approach is that given capacity-related costs that are fixed, when the planned level of production goes down the cost driver rate will increase, causing the product cost to increase. When the planned level of production goes up, the cost driver rate will go down, causing the product cost to decrease. Given that capacity-related costs are driven by the amount of capacity that was acquired rather than what is used, the notion of a varying cost driver rate does not align with the reality that the capacity-related cost is not changing. 3. Third objection is the consequence when management uses cost-plus pricing. Note that as expected demand goes down, the cost driver rate will increase, causing the cost-plus price to increase. Increasing prices in the face of falling demand is never a good strategy and can can cause a death spiral.

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Death Sprial

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Increasing prices cause demand to fall, which leads to further price increases as the cost driver rate increase the cost-plus price.

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What capacity should we use to estimate product cost?

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Using practical capacity to estimate product cost provides an approach that is not only practical but provides clear decision-making insights and incentives related to dealing with the cost of idle capacity.

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Job order costing

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An approach to costing that estimates costs for specific customer orders because the orders vary from customer to customer. At an extreme, each product or service may be unique Sell first, then create the product

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Process costing

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An approach to costing that is used when all products are identical. Total cost of all products is determined by adding up all of the direct and indirect costs used to produce the products and then dividing by the number of products produced to get a cost per unit. Create product first, sell later The focus in process costing is to identify the cost that each process or activity used to make a product contributes to the product's total cost. This cost information is used to highlight opportunities to reduce the overall product cost either by re-engineering the process or possibly looking to an outsider to undertake one or more of the processes.

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Equivalent unit of production

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If all of the production in a process had been completed, the process costing would be trivial since the cost of each item would be easily computed. The issue that arises in process costing, particularly for financial reporting purposes, is how to account for partially completed work in process. To do this, we use the concept of EUP, which expresses the work equivalent, in finished units of the work, that has been invested in work in process.

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Conversion costs

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Process costing systems use two different cost terms: direct materials costs and conversion costs. CCs include all manufacturing costs that are not direct materials costs; conversion costs consist of labor and factory overhead

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