Business

Chapter 5

2011-Baker

Target Market analysis: (who is our customer?)

Careful analysis of the target market is essential to development of a consistent strategy that will contribute to the success of a company. Selling price * Volume = Sales high price and low volume OR low price and high volume. e.g. Mercedes vs. Hyundai Sales volume variance: a flexible budget variance that distils volume from other sales performance components. Sales volume variance = (actual units sold - budgeted unit sales) * standard contribution margin per unit Sales mix variance: evaluates the impact of the company's departure from the planned mix of products anticipated by its budget Sales mix variance = (actual product sales mix ratio - budgeted product sales mix ratio) * actual sold units * budgeted contribution margin per unit of that product Sales quantity variance: is a measure of the change in the number of actual sold units from those budgeted . Sales quantity variance = (actual units sold - budgeted unit sales) * budgeted sales mix ratio * budgeted contribution margin per unit Market size variance: measure of the effect the size of the entire market for the product has on the contribution margin for the firm. (e.g. total sales of luxury cars) Market size variance = (actual market size in units - expected market size in units) * budgeted market share * budgeted contribution margin per unit weighted avg Market share variance: measures the effect of firm's market share on the firm's contribution margin.( our % of luxury car sales). when the market share variance is favorable, it is a sign that the company is successful in a strategy designed to build market share. Market share variance (actual market share - budgeted market share) * actual industry units * budgeted contribution margin per unit weighted avg Selling price variance: aggregate impact of selling price different from budget. o Lower price >> cost leadership strategy o Higher price >> product differentiation strategy Selling price variance = (actual SP per unit - budgeted selling price per unit) * actual units sold Risk analysis: Risk analysis is integral to an organization's strategic planning process. Analysis of risk includes a number of specific components identified by the committee on Sponsoring Organizations (COSO) There are different types of risk that entities are going to need to assess: A. Objective setting: 1. Entity wide objectives are established (e.g. market position, profitability) 2. sub objectives associated with operations, reporting, etc. support entity wide objectives. 3. objectives are set within an organization's risk appetite a) (the organization's willingness to bear risk); level of risk aversion b) the more the org. has risk appetite, the more rate of return is expected, and vice versa. c) Risks are identified in terms of possible events which are in turn characterized by their likelihood (probability) and impact (severity) 1

Business

Chapter 5 2011-Baker d) Risk averse organizations are generally willing to assume high impact risks if there is a low likelihood of occurrence, and similarly, accept a higher likelihood of occurrence of low impact risk. Risk averse don't combine high probability with high impact. B. Event identification: Events are classified as either positive (opportunities that require consideration in establishing objectives) or negative (risks that require assessment and response) organizations may use a variety of event identification techniques: 1. Event inventories: management develops listings of potential events based on internal or generic data. 2. Event workshops: cross functional team that develop a listing of events that could pose risks 3. interviews: to solicit the candid views of staff 4. questionnaires and surveys: provided to the most relevant staff for responses. 5. process flow analysis: flow chart analyses of processes are prepared and reviewed for potential risks. 6. leading event indicators and escalation triggers: potential events and their lead indicators are identified. a threshold associated with the lead indicator is identified for management to act. 7. loss event tracking: statistics pertaining to loss events are documented in a schedule. information such as lost time and associated costs are developed and distributed to relevant staff. 8. ongoing event identification: data sources of possible event discovery are listed and classified by both external and internal factors. C. Risk assessment 1. risks are assessed on an inherent and residual basis a) inherent risk represents the risk to an org. when management takes no action to limit likelihood or impact of risk. b) residual risk is the risk that remains after management has taken action to mitigate the risk. if management takes no action, inherent and residual risks are the same. c) risk maps define risk exceeding the risk appetite as the amount of residual risk the org. is not willing to bear. 2. risks are evaluated from the perspective of their likelihood (probability of occurrence) and impact. 3. risks are evaluated on a qualitative and quantitative basis a) qualitative methods: 1) nominal measurements: grouping of events into like kinds 2) ordinal measurements: listing of events in order of importance b) quantitative methods: 1) interval measurement: numerical scale measurements of events 2) ratio measurement: proportional scale measurements of events D. International risk assessment- accounting practices 1. international business carries with it the risk that reported financial data are inconsistent with U.S GAAP and IFRS. these differences cause the following types of risk: a) process risk: the inability to simultaneously report the financial data according to two different reporting systems. b) system risk: new configuration settings need to be added to the reporting system to facilitate dual reporting in U.S GAAP and IFRS. c) general business risk: existing daily transactions ( contract terms, entities, legal agreements) will need to be reassessed to see if and how they conform to requirements under IFRS. 2. International Accounting Standards Board (IASB) seeks to make standards equivalent or compatible through the issuance and use of international financial reporting standards (IFRS) as a means of mitigating the risk of inconsistent reporting. it promote consistency in international financial reporting. a) some countries replaced their local standards with those of IFRS like EU. Some have hybrid reporting requirements; (blending with IFRS over time) like US 2

Business Chapter 5 2011-Baker b) differences in reporting standards can lead to inconsistencies in accounting terminology and detract from U.S GAAP's goal of financial reporting transparency. Strategy development Strategy is developed after consideration of a range of choices. choices must be evaluated relative to their likelihood of success. strategy development considers risk. companies must establish a risk tolerance (risk appetite), which measures acceptable levels of variation to the achievement of management's objectives. components of strategy: SR ORC 1. strategic objectives: the high level goals that support the mission of the organization and the manner in which shareholder value will be created. 2. related objectives: a) operations objectives: efficiency and effectiveness of operations b) reporting objectives: relevance, accuracy and timeliness internal and external reporting. c) compliance objectives: compliance with laws, rules and regulations. Organizational performance measures Performance measures used by the business is first comparing with actual results and second comparing with other competitors (market share). So, measurement should also take into consideration the entire economy that is affecting the industry. the company should measure financial and non financial performance. Different types of scorecards or reports used to measure either financial or qualitative issues: Financial scorecards: Types of responsibility segments: sometimes referred to as Strategic business units (SBU), are generally classified around 4 financial measures based on the responsibility levels assigned to managers: 1) Cost SBU: managers responsible for controlling costs ( materials, labor & overhead) . has the least amount of responsibility 2) Revenue SBU: managers responsible for generating revenue ( # units sold x selling price per unit), creating demand, marketing & selling the product 3) Profit SBU: managers responsible for producing target profit (accountability for both revenues and costs) 4) Investment SBU: managers responsible for return on the assets invested (most like an independent business) (highest level > the board of directors). has the highest level of reasonability Financial scorecards: Feedback function links planning, control, and performance evaluations and is integral to evaluating and reporting performance. Feedback should be: 1) accurate and timely 2) understandable 3) specific accountability (each SBU is subdivided into additional categories:) a. product lines b. Geographic areas c. customer Allocation of common costs: managers' performance is assessed by controllable costs. managers have control over variable costs and over controllable fixed costs (i.e. insurance). common costs are NOT controllable (i.e. rent on factory, long term lease) 3

Business

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contribution margin: controllable >> the excess of revenues over fixed cost (revenues - variable costs) controllable margin: Refinement of contribution margin reporting and represents the difference between contribution margin and controllable fixed costs. (contribution margin - controllable fixed costs) controllable fixed costs: costs that managers can impact in less than one year (i.e. advertising) Non financial scorecards: 1) Qualitative: measurements that may be difficult or imprecise and are not numerical. ex. employee morale, customer satisfaction 2) Quantitative: numerical measurements but not in dollars. ex. reduction in travel time, distance displayed in hours or miles Balanced scorecards: gathers information on multiple dimensions of an organization's performance defined by critical success factors necessary to accomplish firm strategy. Critical success factors to accomplish a firm strategy are FICA: 1) Financial: profit (financial scorecards) 2) Internal business processes: efficient production 3) Customer Satisfaction: market share 4) Advancement of innovation and human resource development (learning & growth): employee morale, retaining key employees _ The purpose of a balanced scorecard is to emphasize that No one dimension of operations will accomplish an organization's business objectives Planning techniques: forecasting and projection Financial models used for operating decisions Cost volume profit analysis: all costs can be either variable or fixed costs volume is the only relevant factor affecting cost within the relevant range, variable costs increase with volume and fixed costs remain constant but all costs eventually (over long term) behave in a linear fashion with volume total cost = fixed cost + (variable cost per unit * volume) the point at which revenues equal total costs is termed the breakeven point Contribution approach: (variable costing/ direct costing) It doesn't follow GAAP, but it is very useful for internal decision making. Revenue Less: Variable Costs (DM + DL + Variable OH + Variable SG&A) Contribution Margin Less: Fixed Costs (Fixed OH + fixed SG&A) Net Income variable costs include DL, DM, variable OH, shipping and packaging, and variable selling expenses Fixed costs include fixed OH, fixed selling, and most general and administrative expenses unit contribution margin: is the unit sales minus the unit variable cost, amounts that are assumed to remain constant. contribution margin = selling price - variable cost The contribution margin ratio = contribution margin/revenue ($ or units) To maximize profit at full capacity, contribution margin per hour should be maximized. 4

Business Absorption approach (GAAP)

Chapter 5

2011-Baker

Revenue Less: COGS (DM + DL + Variable OH + Fixed OH) Gross Margin Less: Operating Expenses (Fixed SG&A, Variable SG&A) Net Income

GAAP requires absorption approach but for internal decision making, contribution approach (variable costing) is used. Variable costing and absorption costing are the same except that: o Under contribution approach (variable (direct) costing): all fixed mfg costs are treated as period costs and expensed immediately. i.e. COGS includes only variable mfg costs. NOT GAAP The variable selling, general , and administrative expenses (S,G, &A) are part of the total variable costs for the contribution margin calculation. fixed selling and administrative expenses are used in the computation of operating income but not included in contribution margin. o Under the absorption approach (absorption costing): all fixed mfg OH is treated as a product cost and included in inventory values; expensed when sold. i.e. COGS includes both fixed and variable costs. GAAP the selling , general, and administrative expenses are part of operating expenses and are reported on the income statement separately from COGS >> selling and administrative fixed expenses are not a component of gross profit, but rather are a deducted from gross profit to arrive at net income. The difference between variable costing and full absorption costing lies in the treatment of fixed manufacturing costs . full absorption costing treats fixed manufacturing costs as product costs, while variable costing expenses these as period costs. Steps to compute the difference between variable and absorption costing net income: 1) Fixed cost per unit = fixed mfg OH units produced 2) Change in net income = change in inventory units * fixed cost per unit 3) Determine the following: No change in inventory: absorption NI = Variable NI Increase in inventory: Absorption NI > Variable NI [because less fixed OH expensed under absorption] Decrease in inventory: Absorption NI < Variable NI [because more fixed OH expensed under absorption] Gross Margin VS. Contribution Margin Absorption (full cost) method Sales Less: Cost of goods sold = Gross Margin Less: variable selling and administrative expenses Fixed selling and administrative expenses = Operating income Variable (Direct) cost method Sales Less: variable cost of goods sold (excludes fixed OH) = Contribution Margin from manufacturing Less: variable selling and administrative expense = Contribution Margin Less: Fixed expenses: Fixed manufacturing OH Fixed selling and administrative expenses = Operating income 5

Business Chapter 5 2011-Baker Breakeven computation: contribution margin = sales - variable cost Contribution margin ratio = contribution margin revenue Contribution margin per unit = selling price per unit * contribution margin ratio - If we have a contribution margin of 60% , then sales are 100% , and variable cost is 40% since the formula is: Revenue (selling price) - variable cost = contribution margin. Per unit costs & % stay the same regardless of volume. So if selling price is $126, then contribution margin per unit is $75 Breakeven in units = total fixed costs contribution margin per unit Break even in dollars = total fixed costs contribution margin ratio Break even in dollars = unit price * break even point in units Breakeven point occurs when sales equals total cost (variable plus fixed costs) Total sales dollars at the breakeven point = total variable costs + total fixed costs Unit sales price * units at breakeven point = (units at BEP * variable cost per unit) + total fixed costs Required sales volume for target profit Sales in units= (fixed cost + target profit) contribution margin Sales = (Fixed cost + target profit) contribution margin ratio OR Sales = variable costs + fixed costs + net income (target profit) before taxes Sales = cost + profit. >> if profit is 15% of sales then cost is 85% of sales Target profit before tax = target profit after tax + tax OR Target profit before tax = target profit after tax (1 - tax rate) profit after breakeven = units sold after breakeven * contribution margin per unit Margin of safety (in dollars) = total sales in dollars - breakeven in dollars Margin of safety % = margin of safety in dollars total sales SEE EXAMPLE ON PAGE B5-43... Step 1: TC = FC + (VC per unit * units produced) Step 2: FC = y intercept = $150,000 not dependent on volume Step 3: VC per unit slope = change in DV(total cost) = 280,000 150,000 = $50 change in IV(volume) 2600 - 0 Step 4: TC = 150,000 + 50 (2,600) = 280,000 Target costing: a technique used to establish the product cost allowed to ensure both profitability per unit and total sales volume. market price: cost leader. it is set by the market Target cost = Market price - Required profit Ex. if market price is $10 and profit required is 30% then 10-3 = 7 target cost - the selling price of the product determines the production costs allowed - May have to compromise on quality (by reducing costs) = loss of sales due to the poor quality - Increase downstream cost (differentiate their products, create brand loyalty, competitive advantage) - Advanced cost management techniques _ to attain a higher productivity level - Redesign product to reduce costs throughout the life cycle of a product (The Kaizen Method). 6

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Transfer pricing: is the price charged for a good or service by one division of a business to another division of a business. Transfer pricing may be based on: 1) market price: It is the best transfer pricing model. If transfer set below market price, this will motivate division managers to sell to outsiders, and if above the market then will motivate managers to buy from outside vendors. 2) cost (variable or full): is used when a division can get a better price from an outside vendor. 3) negotiated amount 4) dual pricing: multiple bases > the revenue to one segment is not the same as the cost to another segment. Divisional selling authority: the degree to which a division may sell to outsiders Divisional buying authority: the degree to which a division may buy from outside sources Cost volume profit analysis: provides analysts with the tool to project target profits based on additional sales Target costing: requires the organization to hold costs to a predetermined level as a means of establishing price and projecting operating results. Transfer pricing: is generally used as a means of distributing costs between segments and although it should not impact overall contribution margin, should be instrumental in coordinating the economic activity of multidivisional organizations and establishing a basis for evaluating individual segment performance. Marginal analysis: focuses on the relevant revenues and costs. Marginal costs: the sum of the costs required for a one unit increase in activity. It include all variable costs and any avoidable fixed costs associated with a decision. I. special order should be accepted or rejected: special orders are short term that often assume excess capacity. fixed costs will not be relevant to these decision because fixed costs will change within the short term. a. presumed excess capacity: compare the incremental(additional) costs of the order to the incremental revenue generated by the order. this process compares the variable cost per unit to the revenue generated per unit. b. presumed full capacity: the opportunity cost of producing the special order should be included in the analysis. check example p. B5-108 opportunity cost per unit = CM in $ forego/ size special order II. make or buy (in sourcing or out sourcing) comparing the cost of making the product internally to the cost of buying the product externally. a.excess capacity: the cost of making the product is the cost that will be avoided if the product is not made which should be the maximum outside purchase price b. no excess capacity: the cost of making the product is the cost that will be avoided if the product is not made plus the opportunity cost associated with the decision. check example P. B5111 controllable costs: those cost that can be authorized at a specific level of management uncontrollable costs: costs that were authorized at a different level. differential cost: the difference in cost between two alternatives an incremental cost: an increase in cost from one alternative to another III. Sell or process further: 7

Business Chapter 5 2011-Baker joint costs are sunk costs and are never relevant to decisions of whether to sell or process further. separable costs: are relevant to decisions of whether to sell or process further. the decision of sell at the split off point is made by comparing the incremental cost and the incremental revenue generated after the split off point. IV. Add or Drop a segment: The fixed costs associated with the segment must be identified as either avoidable or unavoidable, even if the segment is discontinued. compare the fixed costs that can be avoided if the segment is dropped to the contribution margin that will be lost if the segment is dropped. - when a segment net income is negative, it doesn't mean that we should drop this segment because dropping it might cause more loss; this segment is covering some of the fixed cost. So, compare the contribution margin to the fixed cost that can be avoided. Economic value added (EVA) - measures the excess of income after taxes earned by an investment over the return rate defined by the company's cost of capital. It is expressed as an amount and is considered a form of economic profit. Investment * cost of capital = required rate of return Income after taxes - required return = economic value added >> compare income to the required return income after taxes = operating profit less taxes Forecasting and projection techniques Budget Policies: technique for developing forecasts and budgets. Involves a budget committee, which includes members of senior management Resolve dispute and make final decisions for major budget changes Management give guidelines based on strategic goals and long-term plan. Those guidelines include: o Evaluation of current conditions: consideration of the changes to the environment since the adoption of the strategic plan, organizational goals for the coming period & operating results year-to-date o Management instructions: setting the tone for the budget(e.g. contain costs, have more innovation, expand sales), corporate policies (e.g. mandated downsizing) Standards and benchmarking : can be used in manufacturing or service Standards set below expectations to motivate productivity and efficiency _ revised at least once a year Ideal standards :based on perfect efficiency and effectiveness. Not historical, but future. Unrealistic because no provision for normal spoilage or down time. Advantage: emphasis on continuous quality improvement (CQI) to meet ideal Disadvantage: de-motivation b/c unrealistic standards Currently attainable standards : generally used with flexible budgets. Costs that result from work performed by employees with appropriate training and experience but without extraordinary effort. Provision for normal spoilage and down time. Advantage: reasonable standards Disadvantage: use of judgment and potential manipulation Authoritative standards : set by management 8

Business Chapter 5 Advantage: implemented quickly and will include all costs Disadvantage: workers might not accept

2011-Baker

Participative standards : set by managers and individuals that are held accountable Advantage: workers will accept Disadvantage: slower to implement

Benchmark : adopting the best practices of different firms to establish standards Purpose: promotes achievement of competitive advantage

Data driven Techniques for forecasting and projection: Sensitivity analysis: experimenting with different parameters (i.e. size of fixed cost, size of var. cost per unit, volume) and assumptions regarding a model and calculating a range of results to view the possible consequences of a decision. Forecasting analysis (probability/risk analysis): it is an extension to sensitivity analysis. predicting future values of depending variables (total cost) using information from previous time periods (FC, VC per unit, volume) Regression analysis : studying the relationship between two or more variables. statistical model that can estimate the dependent cost variable (e.g. total cost) based on changes in the independent variable(e.g. fixed cost, variable cost per unit, production). Regression analysis can be used to separate costs into fixed and variable components by means of least squares. simple regression: involves only one independent variable Multiple regression: involves more than one independent variable. components of the simple linear regression model: y = A + Bx y = the dependent variable (e.g. total cost) x = the independent variable (e.g. output) A = the y-intercept of the regression line. (e.g. total fixed costs) B = the slope of the regression line (e.g. variable cost per unit) Statistical measures to evaluate regression analysis: The coefficient correlation: (r) measures the strength of the linear relationship between the independent variable and the dependent variable. The range from -1.0 to +1.0 - 1.0 >> perfect inverse relationship. Example , the relationship between pricing of a product and its demand. 0 >> no relationship +1.0 >> perfect direct relationship. Example, the relationship between total cost and output The coefficient of Determination (R2) the proportion of the total variation in the dependent variable (y) explained by the independent variable (x). Its value lies between zero and one.(ex. how much of the change in total cost is explained by the change in volume) 9

Business Chapter 5 2011-Baker 2 The higher R , the greater is the proportion of the total variation in y that is explained by the variation in x. When selecting cost drivers, choose the one with the highest r/R2 Learning curve analysis - used to determine increases in efficiency or production as experience is gained. Both products have long production runs, making learning curve analysis the best method for estimating the cost of the competitive bid. Learning rate: percentage expression of the decrease in avg time (or total time) as production doubles. ex. a manufacturing job learning curve is 80%. The first unit required 50 labor hours cumulative # of units average time per unit 1 50 hours 2 40 hours (50*.8) 4 32 hours (40*.8) High-Low method: used to estimate the fixed and variable portions of cost. Total cost = Fixed cost + [variable cost per unit x number of units] steps of high low method: 1) find the lowest and the high IV (volume/units) and subtract them from each other to get the difference and that will be the denominator 2) subtract the DV (total cost) of the lowest and highest IV to get the difference and that will be the nominator. change in DV 3) variable cost per unit = change in IV 4) use either high or low to get the total fixed cost as follows: - multiply the variable cost by the # of units (volume) - subtract the total calculated variable cost from total costs to obtain fixed costs. 5) you can use the information now to get the total cost of any volume by using the formula. check example P. B5-54 Planning/budgeting overview and planning/budget techniques Operational and tactical planning: is the process of determining the specific objectives and means by which strategic plans will be achieved. Tactical plans are short term and cover periods up to 18 months. Tactical plans are called single use plans because they are developed to apply to specific circumstances during a specific timeframe. Annual budget: is a type of single use tactical plan. Budgets translate the strategic plan into a period specific operational guide. Part of the manager's job function is achieving the strategic goals. A master budget : also called annual business plan, static budgets, profit planning, or targeting budgets It documents specific short term operating performance goals for a period of time, normally one year or less Its purpose is to provide comprehensive and coordinated budget guidance for an organization consistent with overall strategic objectives. It is appropriate for most industries. an overall budget, consisting of many smaller budgets(operating budgets and financial budgets), that is based on one specific level of production (usually begins with sales budget) for a specified period of time. 10

Business Chapter 5 2011-Baker limitations of the annual plan (master budget): o it confined to one year at a single level of activity. Budget amounts may be much different from actual results (due to more cost for example). Thus there is a need for flexible budgets. o the product of the process is a set of pro forma financial statements that may not provide the type of management information most useful to decision making. The annual plan is driven by the sales budget. o unit sales drives unit production. o sales volume drives support cost (a product of actions taken to stimulate sales) Budget reports: o Operating budgets: describe the resources needed and the manner in which those resources will be acquired. they include: 1) sales budgets 2) production budgets 3) selling and administrative budgets 4) personnel budgets support cast o Financial budgets: define the detail sources and uses of funds to be sues in operations. Include: 1) pro forma financial statements 2) cash budgets Check the overview flowchart on page B5-57 Appendix 1: Annual profit plan and supporting schedules: A master budget is a comprehensive set of an organization's budget schedules and pro forma(projected) financial statements. Master budgets are generally comprised of operating budgets and financial budgets prepared in anticipation of achieving a single level of sales volume for a specific period of time. Operating budgets are comprised of the sales budgets and related costs and expenses. Financial budgets are comprised of pro forma financial statements. Operating budgets: Sales budget: represent the anticipated sales of the organization in both units and dollars. Sales budgets (particularly unit) are the foundation of the entire budget process. Sales budgets are the first budgets prepared, and they drive the development of most other components of the master budget. Forecast of sales volume is the first step in the budget development process. sales volume will drive product supply requirements and, by extension, purchasing and inventory requirements. Sales budgets represent the sales forecast associated with planned or anticipated conditions. The sales forecast becomes the sales budget after revision and acceptance by management as an objective. Selection of the forecast to be used for the budget will be based on the guidance the two have received with regard to the mission and strategy of the company. check example p. B5-91 Production budget: is comprised of the amounts spent for DL, DM, and Factory OH. The amount of the production budget is primarily defined by the amounts of inventory on hand and the planned inventory amounts necessary to sustain sales. the production budget process begins with sales budget and then adds in the effect of any changes in inventory levels. Formula: Budgeted Sales + Desired ending inventory Beginning inventory = Budgeted production 11

Business check example p. B5-93

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Direct Material budget: the number of units of DM to purchase is calculated from the production budget. Units of direct materials needed for a production period + Desired ending inventory at the end of the period Beginning inventory at the start of the period = Units of direct materials to be purchased for the period cost of direct material to be purchased: Units of DM to be purchased for the period * cost per unit = cost of DM to be purchased for the period Direct material usage budget (cost of DM used) Beginning inventory at cost + purchases at cost Ending inventory at cost = Direct materials usage (cost of material used)

Direct Labor budget: Budgeted production (in units) * Hours (or fractions for hours) required to produce each unit = Total number of hours needed * Hourly wage rate = Total wages see example p. B5-96 for DM & DL Factory overhead budget: Factory overhead is applied to inventory (cost of goods manufactured and sold) based on a representative statistic. Frequently, the rate is applied using DL hours. Cost of goods manufactured and sold budget: it represents the sum of the DL , DM, and factory OH budgets for matching the cost of a budgeted sales. Cost of goods manufactured + Beginning finished goods inventory Ending finished goods inventory = cost of goods sold check example p. B5-99 Selling and administrative expense budget: represent the non manufacturing expense anticipated during the budget period. portions of the selling and administrative expenses are variable while others are fixed. Selling and administrative expenses are not inventoried and are budgeted as period costs. 12

Business Chapter 5 2011-Baker contribution margin: production budget components can be developed using a variable costing format that segregate fixed and variable costs. Contribution margin per unit displays are used to reflect earnings on each additional unit of sales. Financial budgets: (Cash budgets and pro forma financial statements) the pro forma income statement is a result of the operating budgets the pro forma balance sheet and statement of cash flows are the results of the pro forma income statement plus financing decisions and capital purchase decisions. cash budgets provide management with information regarding the availability of funds for distribution to owners, for repayment of debt and investment. a significant portion of cash budgeting is to convert accrual assumptions to cash basis assumptions The cash budget, which displays the cash receipts and disbursements of the organization, is one of the last budgets to be prepared in a normal budget process. Cash budget data, however, is used to derive cash balance data displayed in the pro forma balance sheet. cash budgets are generally divided into three major sections: 1. cash available: is associated with both balances available at the beginning of the period and cash collections a) cash balances: summarized by the amounts of cash on hand that can be used to liquidate expenses. b) cash collections: cash collection budgets commonly specify the amounts of cash that will be received from sales, based on the sales budget and from anticipated loan proceeds 2. cash disbursements: represent the cash outlays associated with purchases and with operating expenses. cash disbursements budgets eliminate non cash operating expenses such as depreciation. 3. financing : financing budgets consider the manner in which operating (line of credit) financing will be used to maintain minimum cash balances or the manner in which excess or idle cash will be invested to ensure both liquidity and adequate returns. cash budget formats: 1. beginning cash 2. add cash collections from sales 3. subtract cash disbursements for purchases and operating expenses 4. computed ending cash 5. subtract cash requirements to sustain operations 6. working capital loans to maintain cash requirements. A flexible budget - a series of budgets based on different activity levels within the relevant range. it allows for adjustments for changes in production or sales and accurately reflects expected cost for the adjusted output. analysis focuses on substantive variances from standards rather than simple changes in volume or activity. flexible budgets represent adjustable economic models that are designed to predict outcomes and accommodate changes in actual activity. Flexible budgets include consideration or revenue per unit (which is not dictated by volume), variable cost per unit (which doesn't change with volume), and total fixed costs over the relevant range (which doesn't change with volume), where the relationship between revenues and variable costs will remain unchanged and fixed cost will remain stable. Flexible budgets derive the expenses and revenues allowed from the output achieved for purposes of comparison to actual activity and performance evaluation. advantage: can be displayed on any number of volume levels within the relevant range. 13

Business Chapter 5 2011-Baker disadvantage: highly dependent on the accurate identification of fixed and variable costs and the determination of the relevant range. Check example P. B5-59 , important to understand. standard costs usually means that a flexible budget is being used. Standard costs per unit can be used to adjust the flexible budget to the actual volume. Standard cost _ flexible budget. Zero-budget starts with zero, and all cost is justified. Static budget is opposite of flexible budget, and is used only for one specific volume. Strategic budget is long-term and does not use standard cost. Budget Variance Analysis comparison of actual results to the annual business plan is the first and most basic level of control and evaluation of operations. Actual results may be easily compared to budgeted results (master budget); however, the usefulness is limited by the existence of variances from budget that may strictly related to volume. Thus we move to flexible budgets to analyze performance. flexible budgets are based on a cause and effect relationship. check example p. B5-61 Variance Analysis using standards: the computation of per unit variances normally associated with the use of standard cost systems. The objective of using standard cost system is to attain a realistic predetermined or budgeted cost for use in planning and decision making. Variances: the differences between actual amounts and standard amounts. favorable variance: when actual cost is lower than standard cost unfavorable variance: when standard cost is lower than actual cost controllable variance: if a variance from standard could have been prevented. (variable cost as DM, DL) uncontrollable variance: if a variance from standard could NOT be prevented. (fixed cost are less controllable than variable cost) mimics: PURE , SAD (Standard - Actual = Difference), DADS (Difference * Actual , Difference * Standard) DM price variance = actual quantity purchased * (actual price - standard price) DM usage (quantity) variance = standard price * (actual quantity used - standard quantity allowed) DL rate variance = actual hours works * (actual rate - standard rate) DL efficiency variance = standard rate * (actual hours worked - standard hours allowed) Standard quantity(hours) allowed (SQA) = actual output * standard per unit B5-63 variance chart. review because it will help to memorize the material in a different way check examples p. B5-64/66 Overhead Variance: applied to production based on the predetermined rate per cost driver times the achieved volume identified by the cost driver (hours worked, units produced, etc.). the difference between planned volumes and actual volumes is called the production volume variance. check example p. B5-69 and the explanation on the next page on those notes. Actual production * std. hours per unit = standard hours allowed standard hours allowed * predetermined overhead rate = applied overhead Production Overhead Variance 1 Actual(db.) 4 OH applied(cr.) One way variance

14

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Net overhead variance 1 Actual 3

Budget amount based on standard hours allowed for production (units) achieved (output)

4 OH applied

Two way variance

Budget(controllable)

volume (uncontrollable)

1 Actual

2
Budget amount based on actual hours worked (inputs)

3
Budget amount based on standard hours allowed for production (units) achieved (output)

4 OH applied

three way variance

spending

efficiency

volume

To get Overhead variance , follow those steps: 1) Find the standard allowed per unit ( ex. each unit requires how many labor hours) > given 2) Find the standard quantity allowed >> SQA = actual output x std. allowed per unit Column#1 3) Actual overhead incurred = column #1 Column#4 4) OH applied = column #4 >> Applied overhead = standard hours (SQA) * standard total OH rate 5) Net overhead variance Favorable if actual is less than applied (over-applied, credit balance); unfavorable if actual is more than applied(under-applied, debit balance). Column#3 budgeted variable overhead 6) Budget based on standard hours allowed = column #3 Budget based on std hours = budgeted fixed OH + (std DLH allowed [SQA] * std variable OH rate) 7) Budget variance = the difference between column #1 & column #3 It is favorable if actual is less than budget based on standard hours. Focus on variable OH 8) volume variance = the difference between column #3 & column #4 Note: when volume change, only fixed cost per unit change. Focus on fixed OH the difference between column #3 and column #4. It is favorable if applied is more than Budget based on standard hours allowed, and vice versa, Or compare actual production to budgeted production. the more actual production, the better because fixed cost per unit will be less. Multiply the difference between the two by the fixed OH rate per unit to get the volume variance Colulmn#2 budgeted variable overhead 9) budget based on actual hours worked = column # 2 Budget based on actual hours = budgeted fixed OH + (actual DLH worked * std variable OH rate) 10) spending variance = the difference between column #1 and column #2 the less actual spending is, the better. So, if actual spending is less , it is favorable. Efficiency variance = the difference between column #2 and column #3. the less hours worked, the better. Favorable if budget based on actual hours works is less than budget based on standard hours allowed. 15

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Notes: o

Chapter 5

2011-Baker

budgeted variable overhead is the same formulas without adding the budgeted fixed OH.

Budget variable OH based on std hours = (std DLH allowed [SQA] * std variable OH rate) Budget variable OH based on actual hours = (actual DLH worked * std variable OH rate) o Different way to get applied overhead: (Std Var OH Rate x Std DLH Allowed) + (Std Fixed OH Rate x Actual Production) o Different way to get Budgeted overhead based on standard hours: (Std Var OH Rate x Std DLH Allowed) + (Std Fixed OH Rate x Standard Production)
o The fixed overhead rate is $5 per machine hour [$1,200,000 / 240,000 = $5]. The amount of FIXED manufacturing overhead planned for November is $100,000. Therefore, the standard production for FIXED overhead is 20,000 machine hours [$100,000/$5 = 20,000.] Planning techniques Information and communication are major components in integrated planning. I. Information: A. strategic and integrated systems: Information systems are designed to support business strategy. internal and external communications have become more integrated B. Integration with operations 1. data comes in two forms a) historical data: used to track actual performance against targets b) present data: used to determine if results indicated by the information are within established tolerances. 2. integration: web assist with the integration of knowledge and information with the entire enterprise. transaction data may be developed in real time and deployed throughout the organization enabling managers to use data timely and achieve information quality objectives. C. depth and timeliness of information: information must be captured in the level of detail and in time for the entity to identify, assess and respond to risk. risk response is significant for the entity to stay within risk tolerance. D. information quality: is defined by: a) appropriate content (relevant) b) timely presentation c) current (most recent) d) accuracy e) accessibility challenges to information quality include: a) conflicting functional needs b) systems constraints c) non integrated processes II. Communication: A. Internal: management provides specific communication regarding expectations and includes statement of both risk management philosophy and delegation 1. Personnel understand acceptable and unacceptable behavior 2. channels of communication exist and employees are encouraged to use them 3. communications outside normal reporting lines exist which employees can use without fear of reprisal. B. External: 1. external communications allow customers and suppliers to provide input 2. regulatory bodies receive appropriate mandated communication C. means of communication: policy manuals, memoranda, emails, webcasts, etc.

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