Finance Cliff Notes
Written by Edvin Eshagh   

Review Finance Key Concepts (source: ISBN:978-0-07--352699-7)

Chapter 1

p5
Accounting process produces accounting information used by decision makers in making economic decisions and taking specific actions.

Accounting types include:

1) Financial - Information describing financial resources, obligations, activities, financial position.  Information for investors and creditors

2) Managerial - setting goals, evaluating performance, introduce/remove product line

3) Taxation - Income tax preparation

p7
Basic Accounting functions - 1) record transaction, 2) classify transaction, 3)summarize/report

p8
Internal Control - Desinged to provide reasonable assurance that orginzation provides reliable financial reports.  Its components include:  1) Control environment, 2) Risk assignment, 3) Control activity (policy adress risk), 4) information and communications, 5) Monitoring

p9
Financial accounting provides information about the financial resources, obligations, and activities; intended to be used primarly by external decision makers (investors, creditors)

p12
Financial statement - Monetary declaration of what is belived to be true about an enterprise.

Primary financial statement are:
1) Statement of financial position (balance sheet - where company stands as a specific date)
2) Income statement (Activity statement that shows details and results of company's profit-related activities for a time period)
3) Statement of cash flows  (statement shows details of cash activities)

Financial statemetns are a subset of the total information encompassed by financial reporting

p15
Objectives of accounting system begins at the most general level with the objectives and mission of the enterprise.

Management is intended primarly for planning and control decisions

p16
Timely information for planning purposes, enterprises are constantly monitoring and controlling ongoing activities.

p17
Generally A?ccepted Accounting principles (GAAP)  - framework for determining what information is included in financial statements and how this information is to be prepared

In United States, there organizations are particularly important for establishing accounting principles, which include: Secuirities and Exchange Commission (SEC), Financial Accounting Standards Board (FASB), International Accounting Standards Board (IASB)

Securities and Exchange Commission (SEC) - a government agency with legal power to establish accounting principles and financial reporiting requirements for publicly owned corporations

p18
Financial Accounting Standards Board (FASB) - The most authortative source for Generally Accepted Accounting Principles. 

International Accounting Standards Board (IASB) - Attempts to harmonize the diffierence in financial reporting practices between countries 

International Financial Reporting Standards (IFRS) - Countries either require the use of IASB standards or have plans to require their use in the future

p19
Public Company Accounting Oversight Board (PCAOB) is a quasi-govenmental body charged with oversight of public accounting profession.  Any accounting firm wishing to audit a public company must register with PCAOB, which sets auditing standards for audits of publicly traded companies

An audit is an investigation of a company's financial statements, designed to determine the fairness of these statement.

Congress passed the Sarbanes-Oxley Acti in 2002; creating PCAOB, among other things, it ban's auditors from providing many nonaudit services for their audit clients.  It is the responsibility of CEO and CFO of companies to certify the fairness of the company's financial statements.

American Institute of CPAs (AICPA) - prior to FASB, AICPA provided generally accepted accounting resources.  It works closely with FASBin establishing and interpeting GAAP

p20
Institute of Management Accounts - provides development opportunities through education, association with business professionals, and certifications

Institute of Internal Auditors (IIA) - dedicated to the promotion and devlopment of the practice of internal auditing

American Accounting Association (AAA) -Improving accounting education by better preparing acounting professors and on advancing knowledge in accounting dicipline through research and publication.  Its impact is through accounting faculty and students

Commitee of Sponsoring Organizations of Treadway Commission (COSO) - best known for developing the standards for evaluating internal control - particularly internal control over financial reporting.

p21
Certified Public Accountants (CPA) - licensed by state, much the same way state linces physicians and attorneys.

Certified Management Accountant (CMA) - issued by IMA and IIA; managers may voluntairly earn CMA  

p23
Accountants serve public interest; just like medicine is concerned with public health, engineering is concerned with public safety, accounting is concerned with well pubilc being

Accountants may specialize in: public accounting, management accounting, governement accounting, Accounting education

 p24
Chief Accounting Officer (CAO) - Controller - aids in in controlling business operations - responsible for running business, setting its objectives, and seeing that objectives are meet.

Government Accountability Office (GAO) - audits many agencies of federal govenment

p25
Public accountants have the unusal opportunity of getting an inside look at many different business organizations, which makes them particularly whell suited for top management positions in other organizations

p27
COSO framework elements include: 1) control environment, 2) risk assessment, 3) control activities, 4) information and communication, 5) monitoring

 

 

 

 

Chapter 19

p852
Value added activity - product/service activity is visible in the eyes of the customer.
Design meet customer specification; suppliers providing timely & high quality inputs, Just-In-Time output, Timely and accessible distribution of goods, Competent & helpful customer support

non-value-added activity - raw materials, work in progress, finished goods inventory, design meets engineering spec (not customers), poor quality, rework/scraps, distribution delays

Value Chain activity:  1) R&D and design, 2) Suppliers and production, 3) Marketing and Distribution, 4) Customer services

p854
Activity Based management (ABC) - Process of using activity-based cost to help reduce and eliminate non-value-added activities.
1) Identify activity, 2) Create associated cost pool, 3) Identify activity measure, 4) Create cost per unit of activity

P857
Target costing - business process aimed at the earliest stages of new product and service development, before creation and design of production methods.  Focusing simultaneously on profit and cost planning over the entire value chain organization.

Research shows 80% of production-related expenses are committed once the production process begins

p858
Target costing process begins with customer desires about functionality, quality, price

Target Cost = Target Price - Profit Margin

Components of Target Cost: 

  1. Planning & Market analysis (finds customer nitch)
  2. Concept development (production feasibility)
  3. Production design and value engineering (determine least costly method) - Used for target costing
  4. Production and continuous improvement (attain target cost)  - Used for target costing

P859
All members of value chain should participate in new product creation

p861
Life-Cycle-Costing - consideration of all potential resources consumed by the product over its entire life

Characteristics of Target Costing:

  1. Entire Value-Chain involved
  2. Understand connection between key components and customer
  3. Focus on production function characteristics
  4. Reduce development time via cross-organization team approach
  5. Determination of change is customer driven

p862
Just-In-Time manufacturing - pull supply - acquire and manufacture goods based on customer orders.
Push supply - produces as many goods as possible

p863
Cycle time - Time required for product to pass completely through a manufacturing process.  It includes:
1) procession time (value added) 2) Storage and waste time, 3) Moving time, 4) Inspection time

Manufacturing Efficiency Ration = Value Added Time / Cycle time   => goal is 100%

Measuring Quality - defects per million units produced, number of merchandise returns, number of waranty claims

Total Quality Management - assigning responsibility for managing quality, providing good quality measures for decision making, and evaluating and rewarding quality performance

p864
Components Quality

  1. Prevention Costs - i.e. training, quality audits
  2. Appraisal costs - inspect incoming supply, monitoring production process (testing, quality, etc)
  3. Internal failure costs - rework, downtime, engineering change order, scrap, retesting, re inspection
  4. External failure cost - Most difficult to measure - returns, warranty costs, product liability, lost good-will

Interconnectedness of the value chain - when quality is low in one part of the value chain, the quality costs can increase for all components in that chain.

p866
In quality cost report - "Percentage of Sales" is a productivity measure.

p867
Cost management techniques:  1) activity-based management, 2) target costing process, 3) just-in-time procedure, 4) total quality management

p868
Value chain - set of activities and resources necessary to create and deliver product/service valued by customer.  Made of R&D, production/supplier, marketing/distribution, customer service

Activity based management requires an understanding of the link between activities that consume resources and the costs associated with those resources.   The objective of activity-based management is to manage the activities a that drive those costs

Target costing is a business process aimed at the earliest states of new product/services.  It's primary objective is to reduce development time.  The cross functional, cross-organizational value chain approach allows for simultaneous, rather than sequential, consideration of possible solution.  It's components include:  1) concept development via planning and marketing, 2) product development using engineering, 3) production with continuous improvement

 

Chapter 20

p890
Cost Volume Profit (CVP) - learning how costs and profit behave in response to changes in the level of business activity.  It used to 1) determine break-even point, number of units to sell for specific operating income, profitability vs expanding capacity, change from fixed to commission salary, increase in marketing and sales volume

Managing CVP starts by identifying the activities that cause costs to vary.  Increase/decrease in activities are matched with increase/decrease in cost

Activity Based Management is defined in terms of output - i.e. units sold, dollars of sales revenue; in terms input activities includes direct labor hours, machine-hours, passenger miles flow, etc

p891
Variable cost - total rise/fall of cost is proportional to change in an activity.  i.e. increase in customer mean increase in fuel usage

Fixed cost- remain constant; include: administrative and executive salary, property taxes, rent, leases, insurance

Semi variable costs - mixed costs - contain both fixed and variable costs

Volume variation and change in fixed and variable costs:

 Variable CostsFixed Costs
IncreaseDecreaseIncreaseDecrease
Per-Unit CostStay the sameStay the sameDecreaseIncrease
Total CostsIncreaseDecreaseStay the sameStay the same


p894
Economies of Scale - Fixed cost per unit at higher levels of activity; representing efficient use of company's productive assets.  In general, most businesses can reduce unit costs by using their facilities more intensively.
 Cost Behaviors - Lump sum step (increment cost at step, during each step remaining fixed for some volume), curve line rather than straight line cost (unusual patterns of cost behavior is most likely to occur at extremely high or extremely low levels of volume) .  Unusual patterns of cost behavior tend to offset one another; which is why we can use straight line estimate
relevant range - range over which production output may be expected to vary - observed in semi-variable cost  pattern.
Break Even Point - Total Revenue = Total Cost
Operating Income = Revenue - Variable Cost - Fixed Cost    => The profit here is Not Net Income, because it excludes non-operating gains and expenses (i.e. taxes are excluded because they depend on taxable income rather than operating volume.)
p898
Contribution Margin - amount by which revenue exceeds variable costs
Contribution Margin Units = Unit Selling Price - Variable Cost Per Unit
Contribution Margin Ratio = Contribution Margin Per Unit  / Unit Sales Price
p900 
Desired level of operating income  =
sales volume (units) = [ Fixed Costs + Target Operating Income ] / Contribution Margin per Unit
sales volume (dollars)=[ Fixed Costs + Target Operating Income ] / Contribution Margin Ratio
Operating Income = Margin of Safety * Contribution Margin Ratio
Margin of Safety - Dollar amount by which actual sales volume exceeds the break-even sales volume.  i.e. dollars in excess of the break-even point
Change in Operating Income = Change in Sales Volume * Contribution Margin Ratio
p901
Projected Operating Income = (Fixed Cost  + Projected Operating Income ) / Contribution Margin Ratio
p902
Unit Contribution Margin = Selling Price - Unit Variable Cost
Projected Unit Sales = ( Fixed Costs + Target Operating Income ) / Unit Contribution Margin
p903
Sales mix = relative percentage of total sales provided by different products. 
Managers apply cost-volume relationship to the business viewed as a whole.  thus, they use the average contribution margin ratio, reflecting the company's current sales mix.
Average contribution ratio - computed by weighting the contribution margin ratios of each product line by percentage of total sales which that product represents
p904 
Semi variable Cost - contains both fixed and variable cost.  
high-low estimate -  Average( high, low) of the total sales and units per month
p905
Contribution Margin = Sales Revenue - Total Variable Costs
Unit Contribution Margin = Unit Sales Price - Variable Costs per Unit
Contribution Margin Ratio = ( Unit Sales Price - Variable Costs per Unit  ) / Unit Sales Price
                                    = Sales - Total Variable Costs ) / Sales
Sales Volume (in units) = ( Fixed Costs + Target Operating Income ) / Unit Contribution Margin
Sales Volume (in dollars) =  ( Fixed Costs + Target Operating Income ) / Contribution Margin Ratio
Operating Income = Margin of Safety * Contribution Margin Ratio
Change in Operating Income = Change in Sales Volume *  Contribution Margin Ratio
Chapter 21 
p928
Incremental decision - short-run decision - focus on common concepts used for short-run decisions such as sunk costs, opportunity costs, out-of-pocket costs, and incremental costs and revenues
relevant costs - important for a particular business decision - p931 and vary among the courses of action being considered
p929
Sunk costs - Costs already incurred and can not be changed and can not affect future decisions.  Should you drive or fly... already paid car insurance is a sunk cost
p930
Incremental costs - differential costs - incremental revenue -
The differences in the costs incurred and the revenue earned under the alternative courses of action (i.e. renting or not renting)
Business decision must consider 1) opportunity costs, 2) sunk costs, 3) out-of-pocket costs 
p931
Opportunity cost - benefit that could have been obtained by pursuing an alternative course of action.  Passing $4000/mo job to go to school is $4000 opportunity cost of attending school
Out-of-pocket-cost - costs that have not yet been incurred and that may vary among the possible courses of action.
p932 - it usually refers to planned cash outflow.  Many businesses fail because of poor, short-run cash planning 
p933
Only additional variable costs per unit are relevant to a decision, because fixed costs remain constant
Contribution margin enables managers to decide what products to eliminate in order to maximize the contribution margin per unit of limited input
p934
Unit Contribution Margin = Unit Selling Price - Unit Variable Costs
Contribution Margin Per Hour = Unit Contribution Margin / Direct Labor Hours Required Per Unit  
Complementary products - Products for which sales of one contributes to the sales of another 
p935
Not all variable costs are incremental, and some fixed costs may be incremental in a given situation
p936
Company will be indifferent between buying and making the part when the total incremental costs of making the part equals the total incremental cost of buying the part 
Price * Volume = Total Incremental fixed costs + incremental variable costs * Volume
p938
Joint products - result from a shared manufacturing process
Joint costs - costs related to joint products
Split-off point - Once joint products can be separated and maybe sold independently of the other, or may be processed further
p940
Incremental analysis - comparing one course of action to another by determining differences expected to arise in revenue and costs
Unless company selects best possible course of action, it incurs an opportunity cost
Chapter 22
p964
Responsibility center - describe a subunit within a business organization; where manager is responsible for directing the activities
Income statement measures the overall profit performance of a business entity
Management Responsibility: 
1)  Planning and allocating resources - to set future performance goals and allocate resources
2) Controlling operations - Identify those portions performing inefficiently or below expectations to focus management attention
3) Evaluating the performance of center  - evaluating the skills of the center manager
p965
Cost center - business section that incurs costs but does not directly generate revenue ( accounting, finance, data processing, legal, laundry, maintenance, janitorial)
Cost centers are evaluated on:  1) their ability to control costs, 2) quantity and quality of the services that they provide.
At times, costs serve as an objective basis for evaluating the performance of the cost center
 p966
Profit center - is part of a business that generates both revenue and costs.  
Their managers have decision-making responsibility over both input and output related resources.
The managers do not have authority or responsibility for major capital acquisitions (belongs to CEO, board members, etc)
p963
Investment center - is a profit center for which management has been given decision making responsibility for making significant capital investments related to the center's business activities.
Not all profit centers can be evaluated as investment centers.
p968
Responsibility accounting system - Accounting system designed to measure the performance of each center within a business.  It holds individual managers responsible.  It identifies strength/weakness of organizational unit.
Components of successful responsibility system:  1) budgets are prepared for each center, 2) Measure performance 3) evaluate performance report with budget
Responsibility income statement - shows revenue, expense, and operating results of a center
p970
Cost assigned to a center by either:  1) Fixed and Variable costs, or 2) direct traceable cost
Variable costs are related to specific revenue dollars, they are usually traced directly to the profit center responsible for generating that revenue
Change in sales volume =
1) Change in unit sales * contribution margin per unit
2) or, dollar change in sales volume * contribution margin ratio
p971
Contribution margin ignores fixed costs;, thus it is primarily a short-run planning tool
Traceable fixed costs - are easily traced to a specific business center - Salaries, depreciation specifically used by center
Responsibility Margin - Contribution margin - Fixed costs  
Common fixed costs - indirect fixed costs - jointly benefit several parts of the business
They can not be assigned to specific sub-units except by arbitrary means (i.e. proportion to relative sales volume , square feet, etc)
Traceable fixed costs usually includes only those fixed costs traceable to profit centers.
Costs traceable to service departments (cost centers like accounting, janitorial, etc), benefit many parts of business, thus, they are classified in responsibility income statement as fixed costs
p972
Common costs at the lower levels of management responsibility become traceable costs as they fall under the control of the managers of larger responsibility centers
Responsibility margin - useful for longer-run measure of profitability than contribution margin because it considers traceable fixed costs for business units
p974
Controllable costs - are under manager's immediate control (i.e. salaries, advertising, etc)
Committed fixed costs - manager cannot change  (i.e. depreciation, property tax)
Performance margin = contribution margin - controllable fixed costs
It includes only the revenue and costs under manager's direct control; making it useful for evaluating manager's ability to control costs
Responsibility margin = Performance Margin - Committed Fixed Costs
p975
In income statement, Operating Income = Responsibility Margin - Fixed Costs
It is not recommended because:
1) common fixed costs often would not change even if a business center were eliminated.  Allocation of these costs only distorts the amount contributed
2) Common fixed costs are not under direct control of the center's manager
3) Allocation of common fixed costs may imply changes in profitability that are unrelated to the center's performance.
Transfer price - the transfer price of a product when it is transferred from one department to another (wholesale vs retail outlet).
p976
If costs were used as a transfer price, the profit center would be using some of its resources in a manner that produces no profit.
Cost as a transfer price would shift margin from department that originated the product to the departments that eventually sell that product to outside customers
Transfer price via
1) Market value - profit margin winds up in the profit center that originated the product rather than the center that transferred it
2) Negotiated transfer price - used when market price does not exist.  Negotiated transfer price allocated the profits associated with the transferred product between the two divisions by agreeing on a price.
3) Cost-plus-transfer - add a predetermined markup to the cost of the transferred product when market value does not exist
p978
Transfer prices are usually not paid in cash; they are only entries made in the accounting records to record the "flow" of goods and services

Non-financial performance measures:
* Product Quality - # of defective parts, # of customer returns, # of customer complaints
* Personnel - # of sick days taken, employee turnover, # of grievances filed
* Marketing - # of new customers, # of sales calls initiated, # of product stock outs, Market share
* Efficiency & Capacity - Cycle time (manufacturing business), Occupancy rates ( hotels & motels), Passenger miles flown (airline industry), patient-days (hospitals), Transaction processed (banking)

 

Chapter 24

p1002
Use budget to : 1) assign decision-making authority to company's resources, 2) to coordinate and implement plans, 3) to hold employees accountable for the results of their decision making

Gross profit % = gross profit / sales

Net income % = net income / sales

Return on equity = net income / average shareholder's equity

Return on assets = net income / average total assets

Current ratio = current assets / current liabilities

Inventory turnover = cost of goods sold / average inventory

Accounts receivable turnover = net sales / average receivable

p1003
Master budget - comprehensive plan  to control operating activities

Budget - is a comprehensive financial plan setting forth the expected route for achieving the financial and operational goals of an organization

Controlling costs means keeping actual costs in line with the financial plan.

p1004
Inadequate or sloppy budgeting is a characteristics of companies with weak or inexperienced management

Financial forecasting - process of budgeting

Benefits of formal budget

  • Enhanced management responsibility
  • Assignment of decision-making responsibility - For example, if the budget shows that the company will run short of cash during the summer months, the responsible manager has advanced warning to hold down expenditures or obtain additional financing
  • Coordination of activities - written budget shows managers in quantities terms exactly what is expected
  • Performance evaluation - expected output or revenue to be earned

 p1005
Budgeting methods for evaluating performance: 1) Behavior approach, 2) total quality management approach

Behavior approach theory - manager will be most highly motivated if they view the budget as a fair basis for evaluating responsibility center's performance.  Therefore, budgeted amounts are set at a reasonable and achievable levels.  Highly efficient managers should be able to exceed the budget

Total quality management approach - every individual and segment of the organization should strive for improvement constantly.  Goal of completely eliminating inefficiency and non-value-added activities. 

Achieve perfection across the entire value chain

Even small failures to achieve the budget performance serve to direct management's attention toward those areas in which there is room for improvement.

Managers should participate actively in the budgeting process

Managers also should understand both the intended purpose of the budget and philosophy under the development of the budgeted amounts.

If a behavioral approach is employed, a highly efficient unit may exceed the budgeted level of performance. 

If total quality management approach is used, a highly efficient unit should fall slightly short of the budget standards

p1006
A period covered by a budget should be long enough to show the effect of management policies but short enough so that estimates can be made with reasonable accuracy.

Capital expenditures budgets - summarize plans for major investments in plant and equipment, might be prepared to cover plans for as long as 5 to 10 years

Financial budgets cover a period of one fiscal year.  Companies often divide these budgets into four quarters and then subdivide into each month.  As end of quarter nears, the budget for the next quarter is reviewed/revised

Budgeted figures for relatively short periods of time enable managers to compare actual performance to the budget without waiting until the end of the year (i.e. milestones/gates in project management)

p1007
Rolling budget - new quarter or month is added to the end of the budget as the current quarter or month draws to a close.  Thus the budget always covers the upcoming 12 months.
Advantage:  Stabilizes the planning horizon at one year ahead; forces managers into a continuous review and reassessment of the budget.

Master budget for a manufacturing company:

  1. Operating budgets
    1. sales budget
    2. Production budget
      • Units to produce
      • Direct materials
      • Direct labor
      • Overhead
    3. Cost of goods manufactured and sold budget
    4. Selling and administrative expense budget
      • Marketing
      • Administrative expenses
      • Research and development
    5. Cash budget
  2. Financial budget
    1. Budgeted income statement
    2. Budgeted balance sheet
    3. Budgeted cash flow statement
    4. Capital expenditures budget

Responsibility budget - portion of the budget relating to an individual responsibility center

Two categories of budgeting:
1) Operating budget - internal working budgets used by employees of the company
2) Financial budget - information is more externally focused and more likely to be shared with creditors, investors, customers, labor unions.

Logical stteps for preparing annual master budget

  1. Prepare a slaes forecast
  2. Prepare budgets for production, manufacturing costs, and operating expenses
  3. Prepare a budgeted income statement
  4.  Prepare a cash budget - forecasting fo the cash receipts and cash payments for the budget period
    Anticipated borrowing, debt repayment, cash dividends, and issuance of capital stock also are reflected in the cash budget.
  5. Prepare a budgeted balance sheet - a projected balance sheet cannot be prepared until the effects of cash transaction on various assets, liabilities, and owner's equity accounts have been determined.  Additionally, the balance sheet is affected by budgeted capital expenditures and budgeted net income.

p1013
Cost Of Goods sold = beginning finished goods inventory + cost of goods manufactured during period - ending finished goods inventory

p1014
Cash budget estimate - estimates and data necessary to prepare the cash budget and budgeted balance sheet.  It includes disbursements for payable, prepayments, debt service, and taxes.

Operating budget estimates - used to prepare the budgeted income statement

Current payable budget - cash payment in the near future.  Certain expenses will not require an outlay of cash (i.e. expenses that result from expiration like insurance, depreciation of plant assets).  Thus, only costs/expenses financed by current payable require cash payments.

p1016
Prepayment budgets - expected cash payments for prepayments made during the year

Debt service budget - summarize the cash payments (both principal and interest) required to service.

p1021
Primary benefits of budgeting

  1. Advanced warning of an assignment  of responsibility for conditions that require corrective action
  2. Coordination of activities among all departments within the organization
  3. Creation of standards for evaluating performance

Flexible budget - budget that can be adjusted easily to show budgeted revenue, costs, and cash flows at different levels of activity.

Performance report - compares manufacturing costs originally budgeted with the department's actual performance for the period.

p1025
Companies must often tie up large sums of cash in direct materials, work in process, and finished goods inventories.  As finished goods are sold, cash continues to remain tied up in accounts receivables

Logical sequence of preparing master budget: 1) sales forecast, 2) Operating budget ( prepare budgeted income statement), 3) cash flow estimate, 4) balance sheets

Operating cycle - average time required for the cash invested in inventories to be converted into cash

 

Chapter 24

p1048
Standard Cost System - and accounting system that accumulates costs using standard input prices and quantities

Standard cost -per unit cost expected to be incurred during normal operating conditions

Variance - Difference between actual and input prices or quantities.  Its favorable when actual input costs/quantities are less than standard; and it is unfavorable when actual exceeds standard

p1050
Direct Labor standard is a function of wage and time for producing specific product

Manufacture standard - estimate of total overhead at normal level of production.

p1051
Fixed manufacturing costs - costs that are not affected by short-term changes in the level of production (i.e. supervisor salaries, depreciation on machinery, property tax

Variable manufacturing costs - rise/fall in approximate proportion to changes in production volume

Standard Quantity excludes waste

p1052
Variance from standard does not provide enough detailed information to adequately assess manufacturing efficiency.  Only by comparing actual costs of direct materials, direct labor, and overhead to their related standard costs can we begin to understand the dynamics of the numerous relationships illustrated

Standard materials cost for each unit of product considers: 1) quantity of materials required, 2) price that should be paid to acquire materials

p1053
Material Price Variance = Actual Quantity Used * ( Standard Price - Actual Price)

Materials Quantity Variance = Standard Price * ( Standard Quality - Actual Quantity )

p1054
Work in process inventory account is debited for standard cost of materials used
Direct Materials Inventory account is credited for the actual cost of materials used
Difference between standard and actual total cost is recorded in the two cost variance accounts

Labor rate variance - shows the extend to which hourly wage rate contributed to deviations from standard costs

Labor efficiency  variance - indicates the extent to which the number of labor hours worked during the period contributed to deviations from standard costs

Labor Rate Variance = Actual Labor hours ( Standard Rate - Actual Rate )

Unfavorable labor rate variance can occur when using highly paid employees to perform lower grade tasks, poor scheduling, overtime

Labor efficiency variance - labor usage variance - is a measure of worker productivity

Labor Efficiency Variance = Standard Hourly Rate * ( Standard hours - Actual hours )

Unfavorable labor efficiency variance indicates that direct labor workers were unable to manufacture product in allowed time

p1055
Labor efficiency variance and the labor rate variance are closely related.  For example, excess direct labor hours may cause both the labor efficiency variance and labor rate variance to become unfavorable if due to excess hours employees must be paid overtime

Process Inventory account is debited for the standard labor cost allowed, and Direct labor account is credited for the actual labor cost incurred.  The unfavorable labor rate and efficiency variances are recorded by debit entries, because they both represent costs in excess of the budgeted standards

Overhead variance - the difference between actual manufacturing overhead costs incurred and the standard overhead costs charged to production

Variable costs = direct materials + direct labor

Manufacturing overhead = Fixed cost + variable cost

Elements of overhead costs: 1) Spending variance, 2) Volume variance

p1056
Spending variance - Controllable variance- difference between standard overhead allowed for a given level of output and the actual overhead costs incurred during the period.  It is typically the responsibility of production manager

Volume Variance - difference between the overhead applied to work in process (at standard cost) and overhead expected at the actual level of production.

Volume variance = normal volume output - actual volume output

Standard cost system treats all overhead as a variable cost.  In reality, however, manufacturing overhead includes many fixed costs.  Treating manufacturing overhead as a variable cost automatically causes a cost variance whenever the level of production varies from the normal volume.

Access volume variance is considered favorable

Volume variances are simply the natural result of fluctuations in the level of production from month to month.  These fluctuations often occur because of seasonal sales demand, efforts to increase/decrease inventory levels, holidays, vacations. 
Unless production department fails to produce a scheduled number of units, no manager should be considered responsible for a volume variance

p1058
Balances in the variance accounts represent difference between actual manufacturing costs and the standard costs used to value the finished inventory and cost of goods sold

Favorable and unfavorable variances will balance out during the year, leaving small amount in each variance account at the year end; thus it can be closed into the cost of goods sold account.
However, if the variance is a material dollar amount then the amount should be apportioned among the work in process inventory, finished goods inventory, and cost of goods sold account

p1063
to compute overhead cost variance, compare the actual overhead to the budgeted overhead and compare the budgeted overhead to the applied overhead.  Cost variance can result from spending more than budgeted or from difference between the projected volume used to created the overhead application rate and the actual production used to apply overhead

Materials variances may be caused by the quality and price of materials purchased and by the efficiency with which those materials are used.  Labor variances stem from workers' productivity, pay scales of workers placed on the job, and the quality of the materials with which they work.  Overhead variances result both from actual spending and from differences between actual and normal levels of production

 

Chapter 25

p1088
Accounting information can align employees' goals with the organization's and provide feedback and incentives that guide

Motivation factors via accounting:  1) Create and set objective goals, 2) measure progress / feedback, 3) reward progress

p1090
Return On Investment (ROI) = Operating Income / Average Total Assets

Invested capital in a segment or product line refers to expenditures made to purchase plant assets, develop new product lines, acquire subsidiary companies, purchase equipment, pay for significant training costs, etc.

ROI = Capital Turn Over * Return On Sales

Return On Sales = Earning / Sales

Capital Turn Over = Sales / total investment

p1091
Capital Turnover (CT) - tells managers about how the invested capital is generating sales dollar - the amount of monetary sales that can be expected from a dollar of invested capital

Return On Sales (ROS) = the operating earning or profitability that can be expected from one dollar of sales.

Operating earning rather than net income is used to compute the  ROS because operating earning better reflects the resources that manager can control

p1092
Managers can reduce invested capital by selling equipment, warehouse space, and such

p1093
Managers who are measured and rewarded on basis of ROI may decide to increase profits and decrease capital in their divisions in the way that are inconsistent with the best interests of the whole company

Short-Horizon problem with ROI can occur when manager leaves from one job to another (i.e. sells assets to reduce the average invested capital to improve current ROI; reduce cost of goods sold expenses by purchasing inferior-quality merchandise from suppliers at a lower price.  This reduction in cost of goods sold expense increases the annual operating earnings for the period)

ROI can present incentive for a manager to reject a good project that would increase the ROI for the firms as a whole because ROI of a new project maybe less than existing project

p1094
ROI presents difficulty in measuring both the average invested capital and the actual operating earnings associated with that capital.  Organizations share invested capital and often the allocation of capital between the units is arbitrary

Residual Income (RI) measurement - Amount by which the operating earnings exceed a minimum acceptable return on average invested capital

Residual Income = Operating Earnings - ( Minimum Acceptable Return * Invested Capital )

Economic Value Added (EVA) measurement - Encompasses the average after tax cost of long-term borrowing and the cost of equity

p1095
EVA = After Tax Operating Income - ( Division total Asset - Division Current Liabilities) * Weighted Average Cost of Capital

ROI, RI, EVA performance evaluation tools focus only on business financial outcome 

p1096
Balanced Score Card -a system of performance measurement that links a company's strategy to specific goals and objectives, provides measures for assessing progress towards those goals, and indicates specific initiatives to achieve those goals.  The objective is across the value chain.

Balanced Score Card looks through four Lenses/perspectives:  1) Financial, 2) customer, 3) business, 4) learning and growth.

 p1097

Balanced Scorecard LensStrategiesMeasures
Financial Perspective

1) Improve Shareholder perceptions

 

 

 

2) Improve credit rating - reduce risk

  • Net income
  • ROI
  • CT
  • ROS
  • EVA
  • Residual Income

  • Bond ratings
Customer Perspective

1) Improve Customer relations

 

 

 

2) Increase orders from profitable customers

  •  Customer retention
    • Wholesale
    • Retail
  • # of returns
  • Customer satisfaction
  • Market share
  • Customer Profitability
Business Process Perspective

1) Improve supplier relations

 

 

2) Improve quality of manufacturing processes

 

3)Improve delivery

  •  # of Quality certified
  • # of vendors
  • % of on-time deliveries
  • % machine downtime
  • Velocity/cycle time
  • % of orders filled
  • Scrap as a % of raw materials
  • Standard cost variance
  • # of on-time deliveries
Learning and growth perspective

1)Improve retention of employees

 

2) Improve employee productivity

 

3) Increase new product development

  •  Turnover
  • Employee satisfaction
  • # and cost savings from process improvements
  • Hours of employee training
  • # of new patents
  • % of sales from new products

 Balance Sheet Lenses:

Financial perspective - View company through eyes of creditors and share holders.  Balance sheet, income statement, and statement of cash flows are the underlying financial measures associated with this category

Customer perspective - examines how the organization strategies, products, and services add value for the customer (i.e. customer retention, satisfaction, quality perceptions, etc)

Business process perspective - Focus on internal business processes and external business relations with suppliers and distributors. Standard cost variance analysis, just-in-time inventory, total quality management embodies this category.   Quality measures # of scrap, downtime, # of defects, cost of rework, # of warranty claims, etc

Learning & growth perspective - focuses on people, information system, organizational procedures in place, employee satisfaction, retention, skill development, # of patents awarded, etc. 

Problems with balance score card:

Difficulty assessing the importance or weighting of various perspectives on a score card

Measuring, quantifying, and evaluating some of the qualitative components pose significant technical hurdles

Difficulties arise due to lack of clarity and sense of direction because of the large number of performance measures used

Time and expense required to maintain and operate a fully designed and functioning balanced scorecard system can be significant

Management compensation 

  • Fixed Salary
  • Bonus
  • Stock options
  • life insurance
  • Use of company aircraft for personal use
  • Apartments purchased and furnished for high level executives
  • Company pays for financial consulting for employees

p1101
"Perks" have been controversial because of the occasional employee abuse; however to retain and attract talents among the small pool of elite management, these perks are necessary.

Design management compensation

Time horizon - emphasis management should place on current performance versus future. Current cash bonus versus current bonus of restricted stock options

Fixed vs. Variable Bonus. 
Some organizations offer fixed bonus when X percent above ROI is achieved.

Choice of Stock vs. Accounting Based Performance Evaluation.
Base compensation on accounting information and/or stock market information.
Stock market approach creates too much risk for managers (consider risk averse managers)

Choice of rewarding local vs. company wide performance

Choice of Cooperative vs. Competitive incentive plans
Stock intensive vs Promotional or scholarships

p1102
Residual Income (RI) is the amount by which operating earning exceed a minimum acceptable return on the average invested capital.

Economic Value Added (EVA) - like RI, but it makes many adjustments for items like as taxes, interest, amortization.  Like RI, it does not motivate managers to turn down investments expected to earn a return below their current ROI, but above the minimum acceptable return to the firm.