Chapter 1: Financial Accounting

Sunday, 6 May 2018

7:15 PM
Beginning Assumptions
Economic entity assumption – financial activities of a business can be separated from the financial
activities of business’ owners
Time period assumption – assume that economic information can be meaningfully captured and
communicated over short periods of time. Many companies communicate to users on both a half-
yearly and yearly basis
Monetary unit assumption – assumes the dollar is the most effective means to communicate
economic activity
Going concern assumption – assumes that a company will continue to operate into the foreseeable
future. Not going concerns are often in the process of liquidation

Principles Used to Measure Economic Information

Revenue recognition – a revenue should be recorded when a resource has been earned and not just
when the cash is received
Matching – expenses should be recorded in the period resources are used to generate revenues
Cost – assets are recorded and maintained at their historical costs

Qualitative Characteristics of Accounting Information

Understandability – being comprehensible to those who have a ‘reasonable understanding of
business and economic activities and accounting and a willingness to study the information with
reasonable diligence’
Relevance – capacity of accounting information to make a difference in decisions. This means that it
has feedback value (ability to access past performance) and predictive value (form expectations of
future performance)
Reliability – extent it represents what it purports to represent, both in description and in number.
Reliable when information is verifiable (proven to be free from error), has representational
faithfulness (description corresponds to underlying phenomenon) and neutral (unbiased in reporting
entity)
Comparability – use accounting information to be weighed against or contrasted to the financial
activities of different businesses
Consistency – to be able to compare or contrast financial activities of same entity over time
Materiality – threshold at which a financial item begins to affect decision making
Conservatism – way accountants deal with uncertainty regarding economic situations so as to
present the least optimistic alternative. Accountants use the method least likely to overstate assets
and revenues or to understate liabilities and expenses
 
 
 
Chapter 2: Financial Statements
Sunday, 6 May 2018
7:20 PM
Business Forms
Sole proprietorship (sole trader) – business owned by one person which is most common. For
accounting purposes, owner is separated from business but for tax purposes, income from business
is reported on owner’s personal tax return
Partnership – business that is formed when two or more proprietors join together to own a business
Company (corporation) – separate legal entity that is established by registering with Australian
Securities and Investments Commission (ASIC) who protects investors and maintains the integrity of
securities markets. Two types of companies proprietary (private) and public. Public company has
shares that can be bought/sold on open exchange like Australian Securities Exchange (ASX).

Generally Accepted Accounting Principles (GAAP)

 Accounting standards, rules, principles and procedures that comprise authoritative practice
for financial accounting
 Developed by Australian Accounting Standards Board (AASB) whose mission is ‘to develop
and maintain high-quality financial reporting standards’

The Balance Sheet (statement of financial position)

 Reports assets, liabilities and equity at a specific point of time

The Income Statement

 Reports revenues and expenses over a specific period of time
 Purpose to demonstrate financial success or failure

Cash Flow Statement

 Reports business' source and use of cash over specific period of time

Statement of Changes in Equity

 Reports change in equity over a specific period of time

Horizontal and vertical Analyses

Horizontal analysis – method of analysing a company’s account balances over time by calculating
absolute and percentage changes in each account
Vertical analysis – method of comparing a company’s account balances within one year by dividing
each account balance by a base amount to yield a percentage

 Product of vertical analysis sometimes referred to common-size financial statement which is

where all accounts have been standardised by overall size of company. It determines
importance of each account overall and compares it to other companies

Information Beyond the Financial Statements

Notes to the financial statements – additional textual and numerical information immediately
following the financial statements which discloses accounting methods, additional detail and
explanation of account balances and provides information not recognised in financial statements
Independent auditor’s report – report prepared by a registered company auditor for the
shareholders stating an opinion on whether the financial statements present fairly, in conformity
with Australian Accounting Standards, the company’s financial condition and results of operations
and cash flows
Management’s discussion and analysis – discussion and analysis of financial activities of the
company by the company’s management such as results of operations, ability to satisfy obligations
and expansion plans
Sustainability reporting
 Likely refers to maintaining for the long-term rather than environment matters
 No requirement but many businesses see providing such information as useful for
stakeholders
Governance information
 Information about board of directors, senior management, board activities and
remuneration of directors and managers
 
 
 
Chapter 3: Recording Accounting Transactions
Sunday, 6 May 2018
7:32 PM
The Accounting Information System
 Identifies, records, summarises and communicates various transactions of a company to
produce financial statements
Chart of accounts – list of accounts that a company uses to capture its business activities and tells a
lot about what a company does

Accounting Transactions and the Accounting Equation

Dual nature of accounting – every accounting transaction must affect at least two accounts
The Dual-entry Accounting System
 Based on the dual nature of accounting
Debit and credit rules:
 To increase an account balance – record transaction on same side as normal balance
 To decrease an account balance – record transaction on opposite side as normal balance

  Summary of Debit and Credit Rules  

Type of account Normal balance Increase with a Decrease with a

Asset Debit Debit Credit

Liability Credit Credit Debit

Equity Credit Credit Debit

Revenue Credit Credit Debit

Expense Debit Debit Credit

Dividend Debit Debit Credit

Recording Transactions in the Accounting System

Journal – chronological record of transactions

 Total debit balance and credit balance should be equal

Date Account and explanation Debit Credit

Date of transaction Account(s) debit Amount  

Account(s) credited Amount
(Explanation of transaction)
Ledger – collection of account and their balances
 Posting – journal entries are transferred to debit and credit columns of respective T-
accounts in ledger

Account name

Debit side Credit side

Trial balance – listing of accounts and their balances at a specific point in time
 Proves total debit balance equals total credit balance
 Helpful in making adjustments

  Debit Credit

Asset account(s) Amount  

Liability account(s)   Amount
Equity account(s)   Amount
Revenue account(s)   Amount
Expense account(s) Amount
Dividends Amount

Totals Total debits Total credits

 
 
 
 
Chapter 4: Accrual Accounting and Adjusting Entries
Sunday, 6 May 2018
7:46 PM
Accrual and Cash Bases of Accounting
 Cash basis – records revenues when cash is received and records expenses when cash is
paid. E.g. personal bank account
 Accrual basis – records revenues when earned and expenses when they are incurred which
applies revenue recognition and matching principles
o Required by Generally Accepted Accounting Principles (GAAP)
E.g. You are paid $100 to collect mail for neighbour who is gone for December and January. You pay
a friend $40 to collect mail but don’t pay them until end of January when work is completed.
  Cash basis     Accrual basis    

  December January Total December January Total

Revenues $100 $0 $100 $50 $50 $100

- Expenses 0 40 40 20 20 40

Profit (Loss) $100 $(40) $60 $30 $30 $60

 Accrual makes more sense and provides better representation
Reporting Accrual- and Cash-based Income
 Company never generating cash but has accrual income is a business that will soon fail
 Cash-based income reported on cash flow statement and is useful in understanding financial
condition of company. Cash from operating activities is the cash-based income
Adjusting Journal Entries
 Entries made in the general journal to record revenues earned and expenses incurred but
not recorded
 Fourth step in accounting cycle after trial balance is prepared
 Occurs because timing of revenue and expense recognition differs from exchange of cash
 Cash is NEVER affected
Classification of Scenario Adjusting Entry

1. Cash received Deferred revenue is earned

before revenue

2. Cash is received Accrued revenue is earned

after revenue

3. Cash is paid before Deferred expense is incurred

 expense

4. Cash is paid after Accrued expense is incurred

expense
Deferred Revenue
 
 Receiving cash before providing the service (E.g. Airlines)
 Must be deferred until revenue is earned.
E.g. Subscription revenue. On 1 October, company receives $1200 for 20x 12 month subscriptions
As of 31 October, company earned one month worth of revenue and adjusting entry would be:
31 Oct. Unearned Subscription Revenue 100

  Subscription revenue 100

(To record revenue earned during October)
 General rule – deferred revenue should always increase a liability account. As service is
provided, liability account decreases while revenue account increases.
o Exception is when it is first recorded as revenue instead of liability, the adjustment
made is different but balances after adjustment is the same
Accrued Revenue
 Earned revenue before receiving cash and is a receivable
E.g. Accounting firm provides service on 23 September for $1000 and bills customer on 10 October.
Customer pays on 21 October and firm prepares financial statements monthly
30 Sep. Accounts Receivable 1 000

  Service Revenue 1 000

(To record revenue earned during
September)

21 Oct. Cash 1 000

  Accounts Receivable 1 000

(To record receipt of cash)
 General rule – increase a receivable account and revenue account for amount earned. When
receivable is collected, receivable decreases and cash is increased.
Deferred Expense
 Paying cash before incurring an expense
E.g. On March 1, company purchases 12-month insurance for $36 000
1 Mar. Prepaid Insurance 36 000

  Cash 36 000
(To record purchase of insurance)
Company prepares financial statements at 31 March and has consumed one month of insurance ($3
000)
31 Mar. Insurance Expense 3 000

  Prepaid Insurance 3 000

(To record insurance expense incurred in March)
Depreciation expense – recognition that part of an asset has been used. Everything is an estimate
apart from original cost
E.g. Delivery truck is purchased for $40 000 at 1 Aug. and was used for one month at expense $1
000.
31 Aug. Depreciation Expense 1 000

  Accumulated Depreciation 1 000

(To record expense incurred during August)
 General rule – paying cash before incurring an expense, increases asset account. As asset is
used, the account should be decreased, and related expense account is increased
Accrued Expense
 Incurring expense and paying for them later
E.g. Daily payroll is $1 000, and employees are paid on Sat. for previous Mon-Fri work. Financial
statements are prepared on 30 April (Friday).
30 Apr. Salaries Expense 5 000

  Salaries Payable 5 000

(To record salaries incurred during April)
When employees are paid:
1 May. Salaries Payable 5 000

  Cash 5 000
(To record payment of cash)
 General rule – accrued expense should always increase a payable account and an expense
account. When liability is paid, liability account is reduced, and cash account is reduced
Scenario Classification Entry before Adjusting entry at Entry after end
end of period end of period of period

Cash is received Deferred Cash Liability  

before revenue is revenue Liability Revenue
earned

Cash is received Accrued   Receivable Cash

after revenue is revenue Revenue Receivable
earned

Cash is paid before Deferred Prepaid Asset Expense  

expense is incurred expense Cash Prepaid Asset

Cash is paid after Accrued   Expense Payable

expense is incurred expense Payable Cash
Closing Process
 When all revenue, expense and dividend account balances are transferred to the Retained
Earnings account
 Revenue, expense and dividend account balances are temporary accounts – accumulate
balances only for current period
 Updates Retained Earnings to end-of-period balance
 Closing entries – eliminate balances in all temporary accounts and transfer those balances to
Retained Earnings account

The Accounting Cycle: Summary

 1. Recording journal entries in the journal
2. Post information into the ledger
3. Prepare a trial balance
4. Adjusting process – record and post of adjusting entries
5. Prepare financial statements
6. Closing process
 
Article:
Earnings management - deliberate distortion of communication between entities and shareholders
because financial statement preparer alters content of messages transmitted
 Occurs when they misapply or ignore accounting rules since abiding by them produces
accounting results that are not satisfactory (want higher profits)
 This could be using LIFO instead of FIFO in Australia since LIFO is not allowed or the method
to record bad debts; direct write off, aging of accounts receivables and recording depreciation,
sales, etc.
 Demonstrates unjust use of power and tends to weaken authority of regulations
 Legal issues such as fraud --> jail time or fines
 Could lead to trust issues and develop negative reputation for preparers
 Benefits manager if high profit since it shows they deserve more pay
 Benefits business if low profits since they're not ripping off the public and should have more
government protection and be taxed less
 

 
 
Chapter 5: Cash and Internal Controls
Wednesday, 9 May 2018
8:52 AM
Internal Control
 Process management uses to its operational and financial reporting objectives
 Provides reasonable assurance that:
o Operations are effective and efficient
o Financial reporting is reliable
 o Compliance with laws and regulations
 In 1992, Committee of Sponsoring Organisations (COSO) of Treadway Commission released
Internal control – integrated framework which aims to provide a common understanding of
internal control and has become standard for understanding what good internal control is

Components of Internal Control

Control environment – atmosphere members of an organisation conduct activities and carry out
responsibilities.
 Reflects overall control consciousness of an organisation
 Factors affecting control environment:
o Overall integrity and ethics of personnel
o Management's philosophy and operating style
o Assignment of authority and responsibility
o General structure of organisation
Risk assessment – identification and analysis of the risks that threaten the achievement of
organisational objectives

External Sources Internal Sources

 New competitors  Inadequate workforce

 Changing customer training
expectations  Errors in financial reporting
 Natural catastrophes of activities
 Theft of assets by
employees
 Risks can be analysed by:
o Estimating significance of risk
o Assessing likelihood of risk occurring
o Considering what actions should be taken to manage risk
 Risks of minor significance can be ignored while significant risks demand considerable
attention
Control activities – policies and procedures that address risks
 Establishing responsibility :
o Employee knows they will be held accountable for completion of task
o Management knows who to consult on said task
 Maintaining adequate documentation – accounting information only useful when reliable or
free of error
o Sales are documented on sales invoice and numbered with employee's password
and multiple copies sent electronically
 Segregation of duties – limits one person’s control over particular task or area
 o Spreading responsibility among multiple employees so work can be a check against
other’s work
o E.g. ordering, receiving and paying for inventory has three different people in charge
of each task
 Physical security
o Prevents and detects loss of assets
 Independent verification – reviewing and reconciling information
o Most effective verifications are conducted by surprise and by individuals with no
connection to process or employee being verified
o E.g. bank reconciliation for cash account
Information and communication – required for open flow of relevant information throughout an
organisation
Monitoring – assessment of quality of internal control.
 Done by ongoing activities. E.g. supervisors can check for evidence that control activity is
functioning properly and ask employees if they understand control in place and if they are
being completed
 Having a separate evaluation
Limitation of internal control:
 Human element – based on human judgement and action. People make mistakes or for
disregard control for personal gain
 Cost-benefit analysis – cost of implementing a control activity versus benefit that control
provides
o E.g. retina-scanning security systems
Cash Controls
Bank reconciliation – reconciling differences between cash balance on bank statement and cash
balance in company’s record
 Confirms accuracy of bank's and company's cash records
 Determines actual cash balance
 Reconciling bank balance to actual cash balance
o Needs adjustment because of deposits and payments not reflected on bank
statement such as deposits in transit and outstanding cheques respectively
o Also needs adjustment due to errors such as recording $1450 as $1540
 Reconciling company's book balance (ledger) to actual cash balance
o Caused by bank activities that have not been recorded such as credit memorandum
(addition as bank collects cash on behalf of company) and debit memorandum
(subtraction due to fees and customer cheques returned for insufficient funds)
o Caused by errors
 Adjusting company's book balance
o Done by recording necessary journal entries such as errors
Petty cash funds – amount of cash kept on hand to pay for minor expenditures such as postage and
miscellaneous funds.
 Establishing fund:

1 May Petty Cash 100  

Cash 100
(To establish $100 petty cash fund)
 Making payments from fund – cash taken from fund to make payment or employees can
seek reimbursement for payments personally made
o Custodian collects receipts
o No journal entries are made until replenishment of fund
 Replenishing fund – remaining cash in fund is counted and company cashes cheque for
amount that brings total cash in fund back to original balance

31 May Postage Expense 25

Supplies Expense 47
Miscellaneous Expense 13
Cash 85
(To replenish petty cash fund and record various expenses)
 Cash over and short – temporary account created when petty cash fund replenishment has
discrepancy

Reporting Cash and Cash Equivalents

Cash equivalent – any investment that is readily convertible into known amount of cash and may be
limited to a maturity of six months or less
 Reported as current asset on statement of financial position (balance sheet)
 Some cases, cash is restricted for specific purpose like payment of interest

Analysing Cash
If a company can’t keep enough cash, it can quickly run into major problems
 Start with horizontal and vertical analyses
 Find out reasons for change in cash by looking at statement of cash flows
Free cash flow – excess cash generated beyond what it needs to invest in productive capacity and
pay dividends
 Measures ability to generate cash for expansion, other forms of improved operations or for
increased return to shareholders
 
 
Article:
Accrual components affecting future cash flow are:
 Changes in accounts receivable --> positive relation. As accounts receivables increase so
does cash flow
 Changes in inventory --> positive relation
 Changes in accounts payable --> negative relation. As accounts payable increases, cash flow
decreases
 Depreciation --> positive relation
 Amortization --> positive relation
 Other accruals --> positive relation
 
 

 
 
Chapter 6: Receivables
Wednesday, 9 May 2018
8:52 AM
Recording and Reporting Accounts Receivable
Recording Accounts Receivable
 Recorded at time of sale
 When collected, increase cash and eliminate receivable.
 Some cases, customer will return a product instead of paying for it

10 Jun. Sales Returns and Allowances 150 

  Accounts Receivable   150

(To record sales return)
Sales Returns and Allowances is a contra-revenue account (balance is subtracted from sales when
calculating a company’s net sales) and is a temporary account used to maintain record of returns in
each period
 Sometimes, discount is provided
o E.g. sales are commonly made with terms 2/10, n/30 where customers can receive
2% discount if they pay within 10 days of invoice

12 Jun. Cash 833 

Sales Discount 17

  Accounts Receivable   850

(To record payment)
Reporting accounts receivable
 Must follow principle of conservatism
 Net realisable value – amount of cash that a company expects to collect from its total
accounts receivables
  Allowance – amount a company does not expect to collect

Uncollectible Receivables
Bad debt expense – expense resulting from inability to collect all accounts receivable
 Usually combined with other operating expenses so it is rare to find a company’s bad debt
expense listed separately
 If listed separately, it is bad news as it is significant enough
Direct write-off method
 Company determines that receivable is uncollectible and removes from records
E.g. Chan makes $4000 credit sale in October 2015 to Baron. In April 2016, Chan determines it will be
unable to collect from Baron.
Oct. 2015 Accounts Receivable 4 000 

  Sales   4 000
(To record sale on account)

April 2016 Bad Debt Expense 4 000 

  Accounts Receivable   4 000

(To record bad debt expense and write off receivable)
 Major advantage is simplicity
 Major disadvantage is violation of matching principle
 GAAP prohibits use and only exception is when bad debt expense is immaterial
Allowance method
 Uses two entries to account for bad debt expense and to write off receivables
 Match expense from uncollectible receivables to period receivables were created
 Company has to record bad debt expense at end of period but uncollectible receivable is
unknown so allowance needs to be created which is a contra-account called Allowance for
Doubtful/Bad debt
E.g. Duncan has $800 000 credit sales during 2015 and estimates $8 000 is uncollectible from past
experience

During 2015 Accounts Receivable 800 000 

  Sales   800 000

(To record sales on account)

End of 2015 Bad Debt Expense 8 000 

  Allowance for Doubtful Debts   8 000

(To record bad debt expense)
 After recording bad debt expense, company needs to write off receivable. Since bad debt
expense already estimated, company needs to reduce allowance account
E.g. Duncan determines in 2016 that $2500 is uncollectible and writes it off

2016 Allowance for Doubtful Debts 2 500 

  Accounts Receivable   2 500
(To record write-off)
 Sometimes, company will collect receivable previously written off

2016 Accounts Receivable 2 500 

  Allowance for Doubtful Debts   2 500

(To reverse original write-off)

  Cash 2 500 

  Accounts Receivable   2 500

(To collect the receivable)
Estimating Bad Debt Expense
Percentage-of-sales approach
 Estimates bad debt expense as a percentage of sales
E.g. company has $250 000 of sales in 2016 estimates it will not collect 4% of sales which is $10 000.
End of 2016 Bad Debt expense 10 000 

  Allowance for Doubtful Debts   10 000

(To record bad debt expense)
 Advantages are simplicity and it results in very good matching
 Main disadvantage: no consideration to Allowance for Doubtful Debts account balance. It is
simply the existing balance plus current estimate
 Results in less meaningful net realisable value of receivables
Percentage-of-receivables approach
 Estimates bad debt expense as percentage of receivables
 Calculate balance in allowance as set percentage of receivables then adjust allowance
balance to calculated balance and adjusted amount is bad debt expense
 Debit balance for allowance means company experienced greater write-offs during year than
expected.
 Credit balance indicates write-offs being less than expected
E.g. company has a receivable balance of $24 000 at end of 2016 and past experience of 2% of
receivables being uncollectible ($480). Assume allowance has credit balance of $100
Allowance for Bad Debts

  100
380

  480

End of 2016 Bad Debt Expense 380 

  Allowance for Doubtful Debts   380

(To record bad debt expense)
 Major advantage: results in very meaningful net realisable value
 Disadvantage: not matching expenses as well as percentage-of-sales approach since current
expenses are affected by prior-year experiences
  Recognising receivables becoming less collectible as they get older, so often ageing
schedules are created where receivables are grouped together in 30-day increments and has
an assigned percentage which rises the older the receivables
Analysing accounts receivable
Better collection means better management of receivables
 Can be done with horizontal and vertical analyses
Receivable turnover ratio
 Comparison of credit sales to receivables and measures ability to generate and collect
receivables

 Higher the better as it indicates company collects or turns overs its receivables faster
 Days-in-receivables ratio – conversion of receivables turnover ratio into days

Allowance ratio
 Comparison of allowance to receivables and measures percentage of receivables expected
to be uncollectible in the future
 Higher ratio indicates more receivables expected to be uncollectible

Gross Receivables = Receivables + Allowance for Doubtful Debts

Notes Receivable
Promissory note – written promise to pay specific sum of money on demand or in the future
 Formalise a receivable or to loan money to another entity
 Requires payment of principle and interest
Recording the note at its face value

1 Oct. 2016 Notes Receivable 92 000  

  Sales   92 000
(To record sale in exchange for a promissory note)
Recording interest
E.g. Fiji’s note receivable is outstanding for only 6 months with 8% p.a. So, interest for note is $3 680
and Fiji prepares financial statements at 31 Dec.

31 Dec. 2016 Interest Receivable 1 840  

  Interest Revenue   1 840

(To record interest earned on note)
Collecting the note
 Requires collection of note and interest

31 Mar. 2017 Cash 95 680  

  Interest Receivable   1 840

Note Receivable 92 000
Interest Revenue 1 840
(To record collection of note)
 
 
 
 
Existing balance
Adjustment required = Bad debt expense
Desired balance
 
 
Chapter 7: Inventory
Thursday, 10 May 2018
9:04 PM
 
Recording, Expensing and Reporting Inventory
Recording inventory
Recorded at acquisition cost which includes all cost incurred for delivery and prepared for resale due
to cost principle
Items affecting cost of inventory would include but not limited to:
 Purchase price
 Taxes or duties paid
 Cost of shipping the product
 Insurance during transit
 Labour required
 Returns to and allowances from supplier
 Purchase discounts from supplier
Two inventory systems can be used to record inventory:
1. Perpetual inventory system – updates inventory account each time inventory is bought or
sold
2. Periodic (physical) inventory system – updates inventory account only at the end of
accounting period
E.g. Perpetual inventory system where Devon Gifts purchases $20 000 of inventory on account on 10
October

10 Oct. Inventory 20 000 

  Accounts Payable   20 000

(To record purchase of inventory)
Some cases, company must pay for transportation which is called transportation-in. Devon Gifts pays
$300 for transport.

10 Oct. Inventory 300 

  Cash   300
(To record transportation-in)
Sometimes, company will return inventory to vendor (purchase return) or seek reduction due to
defects (purchase allowance) which reduces inventory. On 12 Oct., Devon is granted $1000
reduction.

12 Oct. Accounts Payable 1 000 

  Inventory   1 000
(To record purchase allowance granted by vendor)
Companies can receive discounts if payment made within certain time period (purchase discounts).
Devon pays $19 000 to vendor on 15 Oct. which qualifies for 1% discount.

15 Oct. Accounts Payable 19 000 

  Inventory   190
Cash 18 810
(To record payment)
Devon’s net purchases of inventory can be calculated by:

Gross purchases $20 000

Add: Transportation-in 300

Less: Purchase returns and allowances (1 000)

Purchase discounts (190)

Net purchases $19 110

 

Expensing inventory
Inventory is an expense once sold and is account Cost of Goods Sold (COGS) which varies based on
inventory system used
E.g. 2 Nov. Devon sells inventory to customer $600, inventory cost them $400.

2 Nov. Cash 600 

  Sales   600
(To record sale of inventory)
2 Nov. Cost of Goods Sold 400 

  Inventory   400
(To record sale of inventory)
Net effect is $200 increase and is gross profit that Devon earned on sale
Reporting inventory and cost of goods sold
Inventory is on balance sheet as current asset since it is expected to be sold within a year
Cost of goods sold is reported on income statement just below sales

Inventory Costing Methods

How company determines cost of inventory sold by using either:
 Specific identification
 First-in, first-out (FIFO)
 Last-in, first-out (LIFO) - not allowed by AASB 102 in Australia but used elsewhere like US and
Japan
 Moving average
E.g. Wombat General Store sells goanna oil purchased from Dingo Manufacturing. During
September, following inventory activity occurred:

    Units Unit cost Total

1 Sep. Beginning inventory 40 $12 $480

4 Sep. Purchase 60 $13 $780

10 Sep. Sale (65)    

15 Sep. Purchase 30 $14 $420

23 Sep. Purchase 45 $15 $675

30 Sep. Sale (50)    

 

Specific identification
Determines cost of goods sold based on actual cost of each inventory item sold but rarely used
Most likely used by companies whose inventory is unique such as antiques store or jeweller
E.g. Wombat General Store

  Transaction Inventory     Inventory     Inventory    

purchased sold on hand

1 Beginning             40 $12 $480

Sep. inventory

4 Purchase #1 60 $13 $780       40 $12 $480

Sep. 60 $13 $780
100 $1260

10 Sell 65 units       30 $12 $36010 $12 $120

Sep. 35 $13 45525 $13 325
 65 $81535 $445
 

15 Purchase #2 30 $14 $420       10 $12 $ 120

Sep. 25 $13 325
30 $14 420
65   $ 865

23 Purchase #3 45 $15 $675       10 $12 $ 120

Sep. 25 $13 325
30 $14 420
45 $15 675
110 $1540

30 Sell 50 units       10 $12 $120 0 $12 $0

Sep. 20 $13 260 5 $13 65
10 $14 140 20 $14 280
10 $15 150 35 $15 525
50 $670 60 $870
Together, COGS for Sept. is $1485
First-in, first-out (FIFO)
Calculates COGS based on assumption that first unit of inventory available for sale is first unit sold
Matches actual physical flow of inventory but companies are not required to choose assumption
that matches their physical flow
E.g. Wombat General Store:

  Transaction Inventory     Inventory     Inventory    

purchased sold on hand

1 Beginning             40 $12 $480

Sep. inventory

4 Purchase #1 60 $13 $780       40 $12 $480

Sep. 60 $13 $780
100 $1260

10 Sell 65 units       40 $12 $4800 $12 $0

Sep. 25 $13 32535 $13 455
65 $80535 $445
 

15 Purchase #2 30 $14 $420       35 $13 $ 455

Sep. 30 $14 420
65   $ 875

23 Purchase #3 45 $15 $675       35 $13 $ 455

Sep. 30 $14 420
45 $15 675
110 $1540

30 Sell 50 units       35 $13 $455 0 $13 $0

Sep. 15 $14 210 15 $14 210
50 $665 45 $15 675
 60 $885
COGS is $1470 ($805 + $665)
Last-in, first-out (LIFO)
Calculates cost of goods sold based on assumption that last unit of inventory available for sale is first
unit sold

  Transaction Inventory     Inventory     Inventory    

purchased sold on hand

1 Beginning             40 $12 $480

Sep. inventory

4 Purchase #1 60 $13 $780       40 $12 $480

Sep. 60 $13 $780
100 $1260

10 Sell 65 units       5 $12 $6035 $12 $ 420

Sep. 60 $13 7800 $13 0
65 $84035 $420
 

15 Purchase #2 30 $14 $420       35 $12 $ 420

Sep. 30 $14 420
65   $ 875

23 Purchase #3 45 $15 $675       35 $12 $ 420

Sep. 30 $14 420
45 $15 675
110 $1540

30 Sell 50 units             35 $12 $ 420

Sep. 5 $14 $70 25 $14 350
45 $15 675 0 $15 0
50 $745 60 $770
COGS for Sept. is $1585 ($840 + $745)
Moving average
Calculates cost of goods sold based on average unit cost of all inventory available for sale

  Transaction Inventory     Inventory     Inventory    

purchased sold on hand

1 Beginning             40 $12 $480

Sep. inventory

4 Purchase #1 60 $13 $780       40 $12 $480

Sep. 60 $13 $780
100 $1260
10 Sell 65 units       65 $12.60 $81935 $12.60 $441
Sep.

15 Purchase #2 30 $14 $420       35 $12.60 $ 441

Sep. 30 $14 420
65   $ 861

23 Purchase #3 45 $15 $675       35 $12.60 $ 441

Sep. 30 $14 420
45 $15 675
110 $1536

30 Sell 50 units       50 $13.96 $698 60 $13.96 $838

Sep.
After selling 65 units on 10 Sept., Wombat’s COGS is $819 and cost of 35 units on hand is $441.
For 30 Sept., Wombat must recalculate average unit cost which is why the term ‘moving average’ is
used.
Therefore, COGS for September is $1517 ($819 + $698)

Comparing Inventory Costing Methods

Choice of inventory costing method affects both COGS and ending inventory
  Units FIFO Moving Average LIFO

Beginning inventory 40 $ 480 $ 480 $ 480

Add: Net purchases 135 1875 1875 1875

Cost of goods available for sale 175 $2 355 $2 355 $2 355

Less: Ending inventory 60 885 838 770

Cost of goods sold 115 $1 470 $1 517 $1 585

Represents total cost of inventory that could have been sold which is separated to either what was
sold (COGS) or what was not sold (ending inventory)
Cost of goods available for sale does not change regardless of inventory costing system chosen
  Ending inventory Cost of goods sold

FIFO yields: Highest Lowest

Moving average yields: Middle Middle

LIFO yields: Lowest Highest

Must disclose inventory costing method used and should be same consistently which allows for
meaningful comparisons
LIFO results in tax deferral which allows company to keep and use cash for a longer period of time
LIFO shows less profit compared to FIFO and is not used as it places an out of date value for
inventory

Inventory Errors
Physical count of inventory done at least once a year to match inventory balance from accounting
system to actual inventory on hand (internal control). It can determine if inventory is lost due to
theft, damage or errors in accounting
Errors in counting inventory affect both balance sheet and income statement which can affect next
period
E.g. Baggett Company has 3000 units of inventory on 1 July 2016, and purchases 34 000 units during
financial year including 1000 units that ship on 29 June 2017. However, Baggett counts inventory on
30 June 2017 and omits the 1000.

In the financial year of the error (2016-17)      

  Correct As counted Effect

Beginning inventory $ 3 000 $ 3 000 Not affected

Add: Net purchases 34 000 34 000 Not affected

Cost of goods available for sale $37 000 $37 000 Not affected

Less: Ending inventory 5 000 4 000 Understated

Cost of goods sold $32 000 $33 000 Overstated

Effect is not limited to year of the error. Suppose Baggett purchases 41 000 units of inventory and
properly count ending 6000 units.

In the financial year after the error (2017-18)      

  Correct As counted Effect

Beginning inventory $ 5 000 $ 4 000 Understated

Add: Net purchases 41 000 41 000 Not affected

Cost of goods available for sale $46 000 $45 000 Understated

Less: Ending inventory 6 000 6 000 Unaffected

Cost of goods sold $40 000 $39 000 Understated

Beginning inventory was understated by 1000 units so, inventory available for sale is also
understated. If ending inventory on 30 June 2018 is properly counted, inventory sold is understated
by same 1000 units
Balance sheet is not affected as ending inventory has correct balance, but COGS is understated so
income statement is affected
The scenario with Baggett was an example of counterbalancing inventory error (error whose effect
on net income is corrected in period after error)
Overstatement in COGS in 2016-17 was followed by equal understatement in 2017-18 so inventory
error is counterbalancing

  If inventory is understated   If inventory is overstated  

  Current period Next period Current period Next period

Inventory Understated Correct Overstated Correct

Cost of goods Overstated Understated Understated Overstated

sold

Net income Understated Overstated Overstated Understated

Total assets Understated Correct Overstated Correct
 

Estimating Ending Inventory

Company must sometimes estimate inventory due to natural catastrophe or preparing interim
financial statements
Gross profit (margin) method:

Current quarter sales (actual) $400 000

Historical gross profit percentage X 45%

Gross profit (estimated) $180 000

   

Current quarter sales (actual) $400 000

Gross profit (estimated) (180 000)

Cost of goods sold (estimated) $220 000

 Assume Howard Hardware is preparing interim financial statements at end of first quarter
and needs to estimate COGS and ending inventory. Howard has quarterly sales of $400 000.
Past gross profit percentage has averaged 45% and assuming this quarter is similar, Howard
estimates gross profit on current quarter is $180 000
Retail method – estimating cost of inventory knowing the selling price and reducing it by the gross
profit percentage
 Ending inventory is counted and selling price (can be determined by price docket or
computer records) is recorded. The total sales value is reduced by profit margin
 E.g. Woolworths has a gross profit margin of 27.1% (gross profit/sales), 26.9% in 2013. The
COGS margin is then 72.9% (100%-27.1%)

Lower-of-cost-and-net-realisable-value (LCNRV)
Principle of conservatism requires inventory be reported on balance sheet at its net realisable value
(NRV) if market value is lower than inventory’s cost which can be referred as lower-of-cost-or-
market rule
Applied at end of each accounting period by comparing inventory costs to NRV (net amount that an
entity expects to realise from the sale of inventory in ordinary course of business)
Cost is lower than NRV, nothing happens
NRV is lower than cost, company must adjust inventory down to lower NRV
E.g. Loyeung Company provides inventory information on 30 June below

Item Units Unit cost Unit NRV Total cost Total NRV LCNRV Gain or (Loss)

A 5 $40 $70 $200 $350 $200 $150

B 8 $65 $50 $520 $400 $400 ($120)

Gain in item A is greater than loss in item B, but standard does not allow losses in one inventory item
to be offset by gains in another. The two items report a net gain of $30 but conservatism requires
recognition of loss

30 June Loss on Inventory 120  

  Inventory   120

  (To record loss on inventory item B)    

Journal entry increases loss to reflect loss in value of inventory and decrease Inventory to adjust
account down to the $600 lower of coast and net realisable value

Evaluating a Company’s Management of Inventory

Analysis done with inventory and cost of sales
Start with horizontal and vertical Analyses
E.g.

Source Accounts 2015 2014

Income Statement Net Sales $62 884 $61 471

  Cost of Sales $44 157 $42 929

Balance Sheet Inventory $6 705 $6 780

  Total Assets $44 106 $44 560

Horizontal analysis:
 Inventory = 6705-6780
= (75)
= 1.1%
 Cost of Sales = 44 157-42 929
= 1 228
= 2.9%
Vertical analysis:
 Inventory: 2015 = 15.2%,
2014 = 15.2%
 Cost of Sales: 2015 = 70.2%,
2014 = 69.8%
Inventory turnover ratio
Compares cost of goods sold during a period to average inventory balance during period

Indicates how many times a company is able to sell its inventory balance in a period
Higher ratio indicates company sold more inventory while maintaining less inventory on hand.
Company generated more sales revenue while reducing costs of stocking inventory on the shelves

Appendix: Periodic Inventory System

Must calculate and update inventory and COGS accounts at the end of the period
Recording Inventory
Uses four temporary accounts to capture cost of inventory:
 Purchases – accumulates cost of all purchases
 Transportation-in – accumulates transportation costs of obtaining inventory
 Purchases Returns and Allowances – accumulates cost of all inventory returned to vendors
and cost reductions from vendor allowances
 Purchase Discounts – accumulates cost reductions generated from supplies discounts grants
for prompt payment
E.g. Devon Gifts purchases $20 000 of inventory on account on 10 Oct.

10 Oct. Purchases 20 000 

  Accounts Payable   20 000

(To record purchase of inventory)
Devon pays carrier $300 cash to transport inventory to warehouse

10 Oct. Transportation-in 300 

  Cash   300
(To record transportation-in)
12 October, Devon granted $1000 reduction in cost due to blemishes.

12 Oct. Accounts Payable 1 000 

  Purchase Returns and Allowances   1 000

(To record purchase allowance granted by vendor)
Devon pays remaining $19 000 bill to vendor on 15 October and qualifies for 1% discount

15 Oct. Accounts Payable 19 000 

  Purchases Discounts   190

Cash 18 810
(To record payment)
Net purchases – value of inventory purchased and transportation-in less purchase returns and
allowances and purchase discounts
Devon’s net purchases shown below:

Purchases $20 000

Add: Transportation-in 300

Less: Purchase returns and allowances (1 000)

Purchases discounts (190)

Net purchases $19 110

Periodic and perpetual system has same cost of net purchases but just in different accounts
Inventory costing methods
Accomplished by following three steps:
1. Count inventory on hand at end of period
 2. Use an inventory costing method to assign a cost to ending inventory
3. Calculate cost of goods sold using the cost of goods sold model
E.g. Wombat General Store has following inventory purchases

    Units Unit cost Total

1 Sep. Beginning inventory 40 $12 $480

4 Sep. Purchase 60 $13 $780

15 Sep. Purchase 30 $14 $420

23 Sep. Purchase 45 $15 $675

At end of month, Wombat counts 60 units on hand. COGS model for September is as follows

  Units Cost

Beginning inventory 40 $ 480

Add: Net purchases 135 1 875

Cost of goods available for sale 175 $2355

Less: Ending inventory 60 ???

Cost of goods sold 115 ???

To calculate cost of ending inventory and COGS, Wombat must use one of four inventory costing
methods
Specific Identification
Based on actual cost of units on hand
Suppose that Wombat knows costs of 60 units with 5 x $13 units, 20 x $14 units and 35 x $15 units
so ending inventory is calculated as:

  Units Unit cost Total cost

4 Sep. purchase 5 $13 $ 65

15 Sep. purchase 20 $14 $280

23 Sep. purchase 35 $15 $525

Ending inventory 60   $870

First-in, first-out (FIFO)

Cost of inventory Units Unit cost Total cost

23 Sep. purchase 45 $15 $675

15 Sep. purchase 15 $14 $210

Ending inventory 60   $885

Last-in, first-out (LIFO)
Provides the most up to date COGS values
Cost of ending inventory is:

 Cost of inventory Units Unit cost Total cost

Beginning inventory 40 $12 $ 480

4 Sep. purchase 20 $13 280

Ending inventory 60   $740

Weighted average

Average cost does not change during the period that’s why it is called weighted average not moving
average
Wombats weighted average = $2355/175 = $13.46

  Units Unit cost Total cost

Ending inventory 60 $13.46 $808

 
 

Managerial
Saturday, 19 May 2018
11:05 AM
 
 
Chapter 1: Introduction to Managerial Accounting
Saturday, 19 May 2018
11:05 AM
Data – reports like financial statements, customer lists and inventory records
Information – data that have organised, processed and summarised
Knowledge – information that is shared and exploited so that it adds value to an organisation

Accounting Information
Usually provided by company’s accounting information system (AIS); a transaction-processing
system that captures financial data resulting from accounting transactions within a company
E.g. transaction to purchase materials is documented in journal entry
This only represents financial information

Non-financial information like number of units of inventory on hand and number of budgeted labour
hours are likely collected and processed outside traditional AIS
Use of multiple systems can cause problems such as being costly and difficulty integrating
information from various systems and making decisions from them
Enterprise resource planning (ERP) systems have been developed to address these shortcomings as
the integrate traditional AIS with other information systems to have both quantitative and
qualitative data

Comparison of Financial and Managerial Accounting

Financial accounting – primarily concerned with the preparation and use of financial statements by
creditors, investors and other users outside the company (external users)
Managerial accounting – primarily concerned with generating financial and non-financial information
for use by managers in their decision-making roles within a company (internal users) and is not
usually shared to outsiders
Both are generated from same AIS
External Users
Shareholders, potential investors, creditors, suppliers, etc.
Shareholders and potential investors want information to help analysis current and future
profitability
If company is/going public, information is in annual reports, registration statements and
prospectuses where accounting methods are governed by Australian Accounting Standards Board
(AASB) and ASIC
Info banks want differs as they assess overall financial health and cash flow or ability to repay loans
Donors might want both financial information
Government agencies have specific info needs such as measurement of income, payroll and assets
for purposes of assessing taxes
Info provided to shareholders, creditors and government agencies characterised by lack of flexibility,
reporting past events at historical costs and emphasis on organisation as a whole
Suppliers and customers accounting information needs are likely to be very different and may be
more clearly aligned with the needs of internal users
E.g. suppliers of car parts to GM Holder Australia need detailed information on inventory
levels of specific parts to know when to manufacture
Customers may want to check on expected delivery date for a computer or whether product is
back-ordered before placing an order
Internal Users
Employees, teams, departments and top management (managers)
Information needs to be more flexible and detailed as managers are involved:
Planning activities – development of short-term (operational) and long-term (strategic)
objectives and identification of resources needed for achievement
Operational planning – development of short-term objectives and goals (<one year). E.g.
hospital would budget for number of doctors and nurses for upcoming month
Strategic planning – addresses long-term questions of how organisation positions and
distinguishes itself from competitors. E.g. where to locate plants and other facilities and
investing in new production equipment
Operating activities – day-to-day operations
E.g. For manufacturing companies, whether to accept special orders and deciding to
advertise
Controlling activities – motivation and monitoring of employees and evaluation of people and
other resources used in operations of organisation
E.g. incentives to motive employees and using mechanisms to detect and correct
deviations from those goals
Often involves comparison of actual outcomes (cost of products and sales) with desired
outcomes
Decisions include questions of how to evaluate performance, what measure to use and
types of incentives
Functional Areas of Management
Operations and production function – produces product/service that organisation sells to customers
Need information that affects how and when products are produced, and services are
provided
Need to know costs of producing and storing products and costs of labour
Marketing function – involved with process of developing, pricing, promoting and distributing
Need to know production cost to establish price, how advertising campaign impacts number of
units sold and how changes in product affects cost
Finance function – responsible for managing financial resources of organisation
 Need to know whether money should be raised through borrowing or selling shares and
whether to purchase or loan new equipment
Human resource function – concerned with utilisation of human resources to help reach goals
Need information on redesign and whether to train employees via cost and benefit analysis
Information Needs of Internal and External Users
Due to differing information needs, managerial accounting is more flexible than financial accounting

  Users Type of Accounting Information Needed Source

External Shareholders Sales, gross profit, net income., cash flow, assets and Annual reports,
and creditors liabilities, earnings per share, etc. Primarily financial financial statements
but may include non-financial info (units in inventory). and other available
Often provided in summary form and typically documents
historical in nature

External Government Varies by agency but includes taxable income, sales, Tax returns and
bodies assets, comparisons of actual expenditures to other reports
budgets, etc. Often provided as a whole and historical
in value. It can include financial and non-financial
information

External Customers and Order status, shipping dates, inventory levels, etc. Limited-access
suppliers Must be very detailed and timely to be useful databases available
to specific
customers and
suppliers

Internal Business Timely and detailed info on sales and expenses, Cost reports,
function product costs, budget info and measures of budgets and other
managers performance. Often includes non-financial data internal documents
(direct labour hours, units to break even, etc.) Often
needed for segments of an organisation and more
likely future oriented than historical
Managerial accounting can be customised to specific company/segment and emphasises on various
segments such as divisions, departments, sale regions and product lines
Role of Managerial Accounting
Managerial accountants focus on analysing information and creating knowledge rather than
collecting data in order for managers to plan, control and evaluate
Became decision-support specialists who interpret information making it into a useful format and
facilitate management decision making

Relevant Factors and Decision Making

Decision making – process of identifying different courses of action and selecting one appropriate to
a given situation
Best decision is the decision that encompasses all factors reasonably considered
All decisions require judgement and quality of decision often depends on depth of judgement
Relevant Costs
Costs that differ among alternatives
Identify costs that are avoidable or those that are eliminated by choosing one alternative rather than
another
Sunk Costs
Costs that have been already incurred
E.g. cost that you paid for a car
Irrelevant and should not be considered in your decision
Opportunity Costs
Benefits forgone by choosing one alternative over another
E.g. choosing to go university, you forgone the salary you could receive by working full time
Can be non-financial such as time or experientially driven

Ethics and Decision Making

Business ethics results from interaction of personal morals and processes and objectives of business
Integrity is cornerstone of ethical business practices and failure to do so carries costs such as
decrease employee productivity, reduce customer loyalty, build resentment and harm standing in
community
Ethics Programs
Company programs/policies created for the purpose of establishing and maintaining an ethical
business environment
E.g. written codes of conduct, employee hotlines and processes to register anonymous complaints
Corporate Wrongdoing
When people in high positions commit fraud
Sarbanes-Oxley Act of 2002
May apply to Australian organisations that are subsidiaries of US parent companies
Includes a number of significant provisions like law requires management to assess whether internal
controls over financial
Requires companies to establish procedures to allow employees to make complaints about
accounting and auditing matters directly to members of the audit committee
Increased level of scrutiny of public companies’ financial statements
Accounting Professional and Ethical Standards Board (APESB)
Define ethical obligations of accountants in practice which includes public interest (collective
wellbeing of the community of people and institutions that an accountant serves) first and foremost
Professional is a higher standard of behaviour like a professional accountant (CPA or CA)
Five broad governing principles in APESB guidelines
Integrity – being straightforward and honest, implying fair dealing and truthfulness
Objectivity – not compromising judgement owing to bias, conflict of interest or undue influence
Professional competence and due care – continuing awareness and understanding of relevant
technical professional and business developments
Confidentiality – disclosing information relating to firm that is otherwise private (unless legal
obligation) or using private information for personal gain
Professional behaviour – complying with relevant laws and regulations and avoiding any action or
omission that may bring discredit to profession
Breach of these risk professional membership being revoked and possible further legal action
 
 
Chapter 2: Product Costing: Manufacturing Processes,
Cost Terminology and Cost Flows
Saturday, 19 May 2018
11:06 AM
Manufacturing companies – purchase raw materials from other companies and transforms then into
a finished product, usually with assistance of labour and other supporting activities, technologies
and infrastructure (overheads)
Merchandising companies – sell products that someone else has manufactured
Service Companies – do not sell a tangible product as their primary business

Production Process
Manufacturing in a Traditional Environment
Traditionally, similar machines were grouped together like a furniture manufacturer might have
areas devoted to cutting and rough sanding, shaping cut wood into furniture pieces, etc.
Grouping together machinery greatly increase time necessary to manufacture products and makes it
harder to meet special orders or unexpected increase in demand
Raw material is processed in each area and ‘pushed’ to next area
Not unusual for one or more of these areas to be in different building or different plants
Normal to accumulate raw materials and finished goods
Raw material inventory – material not yet moved to production area and usually sits in warehouse,
awaiting transfer into factory
Finished-goods inventory – product waiting for sale and shipment to customers
Work in process (WIP) inventory – process of being transformed

Lean Production and Manufacturing in a JIT Environment

Lean production – system focused on eliminating waste associated with holding more inventory than
required, making more product than is needed, over-processing a product, moving products (and
people) further than required and waiting
Manages inventory so only things needed in immediate future is carried to prevent storage and
insurance costs
Reduces risk of lower-quality products with more defects as workers may pay less attention to detail
and work less efficiently
Just-in-time (JIT) manufacturing – philosophy of having raw materials arrive just in time to be used in
production and for finished goods inventory to be completed just in time to be shipped to customers
Begins with customer order and products are ‘pulled’ through manufacturing process
Reduces inventory of raw materials, work in process and finished goods to very low levels or even
zero
Typically, relies on few suppliers that have proven to be highly reliable
Higher risks that might arise in satisfying customer demand as the less stock for customer to buy, the
more you need your suppliers to guarantee availability and quick delivery
Typically organised so machinery and equipment needed to make a product is available in one area
(manufacturing cells)
Companies must be able to manufacture products very quickly to successfully implement lean
production and JIT manufacturing systems
Benefits of lean production and JIT are:
Reduced waste and scrap
Improved product quality
Lower overall production costs (costs of raw materials may increase in some cases)
Lower labour costs
Reduced inventory
Reduced processing time
Increased manufacturing flexibility’
Increased customer satisfaction, motivation and profits

Product Costs in a Manufacturing Company

Manufacturing costs – incurred in factory or plant to produce a product, typically consist of thee
elements: direct materials, direct labour and manufacturing overhead

Direct material Direct labour Manufacturing overhead

Various materials that can be directly Labour costs of Indirect materials such as welding
and conveniently traced to a product assembly-line workers material, glue, screws, etc.
Indirect labour such as factory
maintenance workers and factory
cleaners
Other factory costs
Direct material
Amount used in making products can be accurately measured by engineering studies and accounting
systems are capable of tracing materials used and costs of them to specific products
Differentiating a direct and indirect cost by having it be economically feasible linked to a cost object
Direct labour
Sometimes referred to as touch labour to reflect hands-on relationship
Time sheet may be used to keep track of work employees perform and wages paid
Manufacturing overhead
Includes indirect materials and labour which are not directly traceable to specific product
Includes utilities, depreciation of equipment and building, rent, repairs and maintenance
Accountants have various methods of allocating manufacturing overhead to products such as using
job, process and operations costing or activity-based costing
Also called product costs (costs that attach to products as they go through manufacturing process;
inventoriable costs. Appear as inventory and only become expenses when products are sold
Non-manufacturing costs
Costs not related to production are classed as selling and administrative costs. Cannot be classed as
inventory and must be expensed in profit and loss statement
Costs that occur when product is not being produced (rule of thumb)
Include advertising costs, commissions, administrative an accounting salaries and office supplies
Period costs – costs that are expensed in period incurred; attached to period as opposed to product

Cost Flows in a Manufacturing Company – Traditional Environment with Inventory

To accurately determine cost of manufactured products, company must trace or allocate
manufacturing costs to each individual product as it is being products and follow those costs through
various inventory accounts as product progresses toward completion and sale
Cost-of-goods-sold Model for Traditional Manufacturing Company with Inventory
E.g. Northern Territory Lights sells custom-ordered kitchen and bathroom cabinets.
Once design phase is done, materials are ordered which is stored in the raw materials warehouse
until needed then moved to production area
Three distinct areas of production factory: cutting, assembly and finishing
While materials are in warehouse, costs of raw materials are included in a raw materials inventory
account.
Began in 2011 with raw materials costing $10 000 on hand and purchased an additional $40 000 of
raw materials during the year

Purchase of Raw Materials    

Description Item Amount

Raw materials on hand to start period Beginning inventory of raw materials $10 000

Purchases of raw materials during period + Cost of raw materials purchased + 40 000

Pool of raw materials available for use during = Raw materials available for use = $50 000
period
Journal entry to record purchase of raw materials is:

Raw Material Inventory 40 000  

Accounts payable (or cash)   40 000

When raw materials are moved to the factory, raw material costs move with material to a WIP
inventory account
Any raw materials not used remain in raw material inventory account
If Northern Territory Lights has $5 000 of raw materials in ending inventory

Transferring Raw Materials to Work in Process    

Description Item Amount

Raw materials on hand to start period Beginning inventory of raw $10 000
materials

Purchases of raw materials during period + Cost of raw materials purchased + 40 000

Pool of raw materials available for use during period = Raw materials available for use = $50 000

Raw materials on hand at end of period - Ending inventory of raw - 5 000

materials

Amount of raw materials used in production (and = Raw materials used in = $45 000
moved to WIP) production
Journal entry of transfer from raw materials to WIP inventory is:

Work in Process Inventory 45 000  

 Raw Material Inventory   45 000
Direct labour costs of $65 000 and $85 000 of manufacturing overhead incurred and added to raw
material cost in WIP. Journal entries for both shown below:

Work in Process Inventory 65 000  

Salaries and Wages Payable (or cash)   65 000

Work in Process Inventory 85 000  

Accounts Payable (or cash)   85 000

Actual costing – product costing system where actual overhead costs are entered directly into WIP
Most companies use normal costing – product costing system where estimated or predetermined
overhead rates are used to apply overhead to WIP
If no beginning inventory for WIP, cost of goods manufactured is sum of raw materials used, direct
labour and manufacturing overhead
Assume beginning of 2011 had $15 000 of unfinished cabinets that were completed in early 2011
and $20 000 of partially finished cabinets at end of the year
Cost of goods manufactured in 2011 is transferred to finished goods

Calculation of Cost of Goods Manufactured    

Description Item Amount

Work in process on hand at beginning of period Beginning inventory of WIP $15 000

Amount of raw materials used in production + Raw materials used + $45 000

Amount of direct labour cost incurred + Direct labour + 65 000

Amount of manufacturing overhead incurred + Manufacturing overhead +85 000

Work in process at end of period - Ending inventory of WIP - 20 000

Cost of goods manufactured during period = Cost of goods manufactured = $190 000
Journal entry to record transfer of finished goods from WIP is:

Finished Goods Inventory 190 000  

Work in Process Inventory   190 000

When sold, accumulated costs in finished goods inventory are moved to the cost of goods sold
account
Assume there was one order ($30 000) that was not delivered at end of 2010 and $5 000 of finished
cabinets but not yet sold

Calculation of cost of goods sold    

Description Item Amount

Finished goods on hand at beginning of period Beginning inventory of finished goods $30 000

Cost of goods manufactured during period + Cost of goods manufactured + 190 000
Finished goods on hand at end of period - Ending inventory of finished goods - 5 000

Cost of goods sold during period = Cost of goods sold = $215 000
Journal entry to record COGS is:

Cost of Goods Sold 215 000  

Finished Goods Inventory   215 000

Cost Flows in Manufacturing Company – JIT Environment
Direct materials, direct labour and overhead costs can be accumulated directly in a cost of goods
sold account
Raw materials are immediately put into production so no need to record purchases nor WIP and
finished products are all goods are typically finished and shipped immediately

Calculation of cost of goods sold – JIT environment    

Description Item Amount

Amount of raw material purchased and used in Raw materials purchased and used $50 000
production

Amount of direct labour costs incurred + Direct labour + 65 000

Amount of overhead cost incurred + Manufacturing overhead + 85 000

Cost of goods sold during period = Cost of goods sold = $200 000
Merchandising Companies and Cost of Products
Cost of wholesaler/retailer is purchase price of merchandise sold
On balance sheet, merchandising companies use single account, merchandise inventory
Cost of goods sold not necessarily equal to cost of merchandise purchased
If merchandise is purchase and not sold or if purchased in another period and sold in current period,
COGS must be adjusted
E.g. Cheryl’s Bike Ship has beginning inventory of $15 000 in 2011 and makes purchases of $63 000.
Merchandise available for sale is $78 000. At end of 2011, $18 000 of merchandise inventory
remains on hand resulting in $60 000 of COGS.

Calculation of cost of goods sold for a merchandising    

company

Description Item Amount

Merchandise on hand at start of period Beginning inventory $15 000

Acquisitions of merchandise during period + Cost of goods purchased + 63 000

Pool of merchandise available for sale during period = Cost of goods available for = 78 000
sale

Merchandise on hand at end of period - Ending inventory - 18 000

Expense recognised on income statement = Cost of goods sold = $60 000

Service Companies and Cost of Services
Service providers typically refer to ‘cost of services’ as ‘cost of revenue’
Cost of services includes direct materials, direct labour and overhead but proportions may vary
dramatically
Typically, little materials and large amount of labour and overhead
Generally, have larger proportions of indirect costs
WIP accounts are commonly used on projects that were incomplete at month end such as audits by
CPA firms, lengthy legal cases an consulting engagements

Product Costs and Period Costs

Until sale of product, costs of manufacturing are included in one of three accounts: raw materials,
work in process and finished goods which is recorded on balance sheet
When sold, manufacturing costs are expensed as COGS on income statement
Period costs or non-manufacturing costs are expensed immediately on income statement
 
 
Chapter 3: Cost Behaviour
Saturday, 19 May 2018
11:06 AM
Cost behaviour – how costs react to changes in production volume or other levels of activity

Fixed and Variable Costs

Fixed costs – costs that remain same in total when production volume increase or decrease but vary
per unit
E.g. rent, depreciation of building, salary of plant manager, insurance and property taxes
Common example is rent: if rent costs $10 000 per year, rent cost per unit of product will be $2 for
5000 products and $4 if 2500 products produced
Variable costs – costs that stay same per unit but change in total as production volume increase or
decreases
E.g. direct material, direct labour (if paid per unit of output), factory supplies, energy costs
Consider materials used: if production of classroom desk costs $20, total direct materials will
increase or decrease proportionately with production volume
Trend is to automate and replace direct factory labour with robotics. This leads to increasing fixed
costs (depreciation) and decreasing variable costs (direct labour)
When cost carries in direct proportion to changes in volume, it is linear (straight-line) relationship
between cost and volume. In reality, costs may behave in a curvilinear fashion. For example, utility
costs per kilowatt-hour may decrease at higher levels of use or buying in bulk to save per unit.
Accountants assume relationship is linear within a relevant range of production.
Relevant range – normal range of production that can be expected for a particular product and
company. Can also be viewed as volume of production from which fixed cost stays the same
Step costs
Costs that vary with activity in steps and may look like and be treated as either variable or fixed
costs; not technically fixed costs but may be treated as such if they remain constant within relevant
range of production
Batch-level costs related to transportation may vary with number of batches produced but not with
every unit of product
E.g. cleaning services within a company where production is below 7 500 desks. Company can just
hire one cleaner with salary and fringe benefits totalling $25 000. If production exceed 7 500, it may
be necessary to hire second cleaner for $25 000. But relevant range of production between 7501
and 15 000 units, cost is essentially fixed
Relevant costs and cost behaviour
Relevant costs (differential or incremental costs) – costs that are avoidable/eliminated by choosing
one alternative over another
Vary with the level of production
Fixed costs not generally relevant but variable costs can remain same between two alternative and
fixed costs can vary between alternatives. E.g. direct material cost of a product is same for two
competing designs, material cost is not relevant factor. However, factors like durability of material
may still be relevant. Fixed costs can be relevant if they vary between alternative like how rent is
relevant to a decision to reduce inventory storage costs through JIT
Cost equation

Mixed Costs
Costs that include both fixed and variable components, making it difficult to predict how cost
changes as production changes unless cost is separated into fixed and variable components
Increase at a constant rate and costs per unit decrease as more units produced which depicts
characteristics of both fixed and variable costs
E.g. overhead costs of Adelaide Pizza Emporium (APE) has both fixed and variable components such
as rent and insurance for fixed and utilities and supplies for variable. APE incurs following costs:

Week Pizzas Total overhead costs Cost per unit

1 (start-up) 0 $679 N/A

2 423 1842 $4.35

3 601 2350 3.91

4 347 1546 4.46

5 559 2250 4.03

6 398 1769 4.44

7 251 1288 5.13

Costs not fixed as it changes each week, but not variable as costs do not vary in proportion to
changes in production
When we know cost is mixed, we need to separate them into fixed and variable components using
statistical tool called regression analysis to estimate the components
Separation done by generating an equation of a straight line with y-intercept estimating foxed cost
and slope estimating variable cost per unit
Regression analysis
Procedure that uses statistical methods (least squares regression) to fit a cost line (regression line)
through a number of data points
Data points do not have to lie along straight line as the procedure finds line that minimises sum of
the squared distances from each data point
Line selected is line closest to all points identified (line of best fit)
1. Using a spreadsheet program to perform regression analysis:
2. Enter actual value for our mixed costs (dependent variable) and related volume of
production (independent variable)
3. Click on data and choose data analysis. Scroll down, highlight regression and press ok.
4. Input y-range which is overhead costs in this case and x-range which is volume of pizzas then
click ok
5. Estimated coefficient value of intercept is estimated fixed cost and coefficient of x-value is
variable cost

6. Equation can be used to predict total amount of overhead costs incurred for any number of
pizzas within relevant range (range expected to operate or where equation is useful or
meaningful)
Regression statistics
 Provides useful diagnostic tools
 Multiple R (correlation coefficient) measures proximity of data points to regression line and
sign of statistic (+ or -) tells direction of correlation which is positive for APE
 R square (R2) called coefficient of determination – measure or goodness of fit
 R2 of 1.0 indicates perfect correlation between independent and dependent variables
 Outliers can also result in low R2 values
Estimating regression results using the high/low method
Uses two data points (related to high and low levels of activity) and derives an equation for a straight
line

Forces a line between the two points and disregards other points

Impact of Income Taxes on Costs and Decision Making

First key to understanding impact of taxes on costs and revenue is recognising that many costs of
operating businesses are deductible for income tax purposes and most revenues are taxable.
Company tax rate is currently 30%
After-tax costs and revenue
E.g. taxable cash revenue is $100, and tax deductible cash expenses is $60. Assume tax rate is 30%
and net income is $40 so, tax paid is $12 and $28 is the income after tax
  Current Increase spending by $20 Increase revenue by $20

Revenue $100 $100 $120

Expense -60 -80 -60

Taxable income $40 $20 $60

Tax (rate=30%) - 12 -6 - 18

After-tax cash flow $28 $14 $42

Before- and after-tax income

Similar to above, managers can calculate impact of income taxes on income

Tax laws are very complex and computing tax due is rarely seen like above. Estimating impact of
income tax and other taxes on cash receipts and disbursements is important

Comparison of Absorption Costing and Variable Costing

Absorption costing
Aka full costing – method of costing where product costs include direct materials, direct labour and
fixed and variable overhead; required for external financial statements and for income tax reporting
Required for both external financial statements under GAAP, the Australian Account Standards
Board and for income tax reporting
Selling, general and administrative costs are known as period costs and expensed in period when
incurred
If units of production remain unsold at year-end, fixed overhead remains attached to those unit and
is included in balance sheet as part of cost of inventory
Variable costing
Method of costing where product costs include direct material, direct labour and variable overhead;
fixed overhead is treated as period cost; consistent with a focus on cost behaviour
Provides useful information for internal decision making that is often not apparent when using
absorption costing
Difference between absorption and variable costing is treatment of fixed overhead
Impact is evident when company’s production and sales are different (i.e. number of units produced
is greater than or less then number of units sold)
All fixed overhead is expensed at end of period regardless level of production and sales

Absorption costs   Variable Costs  

Product costs Period costs Product costs Period costs

Direct materials   Direct materials  

Direct labour Selling, general and Direct labour Selling, general and
 administrative costs administrative costs

Variable   Variable  
overhead overhead

Fixed overhead     Fixed overhead

When production is greater than sales and inventories increase, absorption costing will result in
higher net income than variable costing

Impact of Absorption and Variable Costing on the Income Statement

Using LuLu’s Lockets, a custom jeweller, as an example where selling price is $2 for each locket.
Produces 100 000 units each year with per unit costs of: $0.30 for direct material, $0.35 direct
labour, 0.10 variable overhead and fixed manufacturing overhead costs of $30 000. Also selling and
admin costs of $0.05 per unit sold and fixed selling and admin costs of $10 000.

Product Costs      

Absorption costing   Variable costing  

Direct material $0.30 Direct material $0.30

Direct labour 0.35 Direct labour 0.35

Variable overhead 0.10 Variable overhead 0.10

Fixed overhead 0.30 Variable selling and admin 0.05

Total per unit $1.05 Total per unit $0.80

Year 1 income comparison
Assume all 100 000 units are sold

Absorption costing   Variable costing  

Sales $200 000 Sales $200 000

Less: Cost of goods sold 105 000 Less: Variable costs 80 000

Gross profit $95 000 Contribution margin $120 000

Less: S&A costs 15 000 Less: Fixed costs 40 000

Net income $80 000 Net income $80 000

Year 2 income comparison
Assume that 100 000 units produced but only 80 000 sold

Absorption costing   Variable costing  

Sales $160 000 Sales $160 000

Less: Cost of goods sold 84 000 Less: Variable costs 64 000

Gross profit $76 000 Contribution margin $96 000

Less: S&A costs 14 000 Less: Fixed costs 40 000

Net income $62 000 Net income $56 000

Year 3 income comparison
Assume that 100 000 units produced but 120 000 sold

Absorption costing   Variable costing  

Sales $240 000 Sales $240 000

Less: Cost of goods sold 126 000 Less: Variable costs 96 000

Gross profit $114 000 Contribution margin $144 000

Less: S&A costs 16 000 Less: Fixed costs 40 000

Net income $98 000 Net income $104 000

Note that total income over 3 years is the same for both since units produced are equal to units sold
When units produced exceeded units sold, absorption costing had higher net income than variable
costing
When units sold exceeded units produced, variable costing reported higher net income than
absorption costing

Variable Costing and Decision Making

Use of absorption costing for internal decision making can lead to less-than-optimal decisions.
E.g. unemployed executive offered services to manufacturing company for only $1 per year in salary
and bonus of 50% of any increase in net income generated for year. Reviewing absorption costing
income statement for previous year, units produced was 10 000 although there was the capacity to
produce 20 000. Variable production costs were $40 per unit, variable selling and admin (S&A) costs
were $10 per unit sold, fixed manufacturing overhead costs equals $300 000 ($30 per unit) and fixed
S&A costs were equal to $100 000 with net income of $100 000.

Absorption costing income (10 000 units produced)  

Sales (10 000 units) $1 000 000

Less: COGS 700 000

Gross profit $300 000

Less: S&A costs 200 000

Net income $100 000

Increasing production to 20 000 units, fixed manufacturing overhead is reduced to $15 per unit. This
leads to $150 000 increase in net income leading to manager being entitles to $75 000 bonus

Absorption costing income (20 000 units produced)  

Sales (10 000 units) $1 000 000

Less: COGS 550 000

Gross profit $450 000

Less: S&A costs 200 000

Net income $250 000

If income measured using variable costing approach, net income would be the same each year

Variable costing income      

10 000 units produced   20 000 units produced  

Sales (10 000 units) $1 000 000 Sales (10 000 units) $1 000 000

Variable costs 500 000 Variable costs 500 000

Contributed margin $500 000 Contributed margin $500 000

Fixed costs 400 000 Fixed costs 400 000

Net income $100 000 Net income $100 000

Problems like this are less common in JIT environment
Choosing best method for performance evaluation
No choice but to use absorption reporting for external reporting as it is required by AASB and GAAP
and for submitting company tax returns
Internal decision making, variable costing is often best
If income used to evaluate performance of manger or segment, it’s logical that measure of income
should reflect managerial effort and skill
If sales decrease, with on changes in production or other factors, logical that income should
decrease like in variable costing
Variable costing removes impact of changing production levels on income
More likely to reflect managerial skill so if compensation package based on net income, managers
are more likely to make optimal production volume decisions
Advantages of variable costing
Changes in production and inventory levels do not impact calculation of profits
Focuses attention on relevant product costs; more attention on variable product costs
Cost behaviour emphasised, and fixed costs are separated from variable costs on income statement
Consistent with use of variance analysis
Income is more closely aligned with a company’s cash flow

 
 
Chapter 9: Cost-volume-profit Analysis
Saturday, 19 May 2018
11:07 AM
Cost-volume-profit (CVP) analysis – tool that focuses on relationship between company’s profits and
selling prices, volume sold, per unit variable costs, total fixed costs and mix of products or services
produced
Assumptions that must be reflected prior to use of CVP analysis:
 Selling price is constant throughout entire relevant range. Assume selling price will not
change as volume changes
 Costs are linear throughout relevant range
 Sales mix used to calculate weighted-average contribution margin is constant
 Amount of inventory is constant. Number of units produced equals number of units sold

Contribution Margin and its Uses

Behaviour of COGS and gross profit is hard to predict when production increases or decreases since
COGS has both fixed and variable costs
Contribution margin profit and loss statement is structured by behaviour rather than by function
which means costs are separated by variable and fixed components
Combines product and period costs
Contribution margin = sales revenue – variable costs
Informs how much in revenues to cover fixed costs as managers are most concerned with this
since if nothing is made or sold, there is no variable costs but there always will be fixed costs
Difference shown below:

Traditional     Contribution margin    

Sales   $1000 Sales   $1000

Less: Cost of goods sold     Less: Variable costs    

Variable costs $350   Manufacturing costs $350  

Fixed costs 150   S, G & A costs 50  

Total cost of goods sold   500 Total variable costs   400

Gross profit   $500 Contribution margin   $600

Less: S, G & A costs     Less: Fixed costs    

Variable costs $50   Manufacturing costs $150  

Fixed costs 250   S, G & A costs 250  

Total S, G & A costs   300 Total fixed costs   400

Net profit   $200 Net profit   $200

Contribution margin per unit (CMU)
Sales price per unit of product less all variable costs to produce and sell unit of product, used to
calculate chance in contribution margin resulting from a change in unit sales
E.g. Contribution margin profit and loss statement for Happy Daze Game Company:

  Total Per unit

Sales (8000) $100 000 $12.50

Less: Variable costs 72 000 9.00

Contribution margin $28 000 $3.50

Less: Fixed costs 35 000  

Net profit (loss) $(7 000)  

Every games sold adds $3.50 to contribution margin and if fixed costs don’t change, net profit
increase by the same $3.50. So, if sales increase by 100 games, net profit with increase by $350
($3.50 x 100).
Contribution margin ratio (CMR)
Calculates change in contribution margin resulting from a dollar change in sales

Can be viewed as amount of each sales dollar contributing to payment of fixed costs and increasing
net profit

What-if Decisions Using CVP

Three options to increase net profit:
1. Reducing variable costs of manufacturing product or offering a service
2. Increasing sales through change in sales incentive structure, or commission (increases
variable costs)
3. Increasing sales through improved features and increased advertising
Option 1 – reduce variable costs
Could find less expensive supplier of raw materials. Reduce amount of labour used in production
process or use lower-wage employees
Qualitative factors must be considered since cheaper supplier could lead to lower quality of
material and shipments being late
Qualitative and quantitative factors for labour since machines can increase fixed costs and
lower-skilled workers can lead to more defective products and affect employee morale
E.g. Happy Daze reduces costs of direct labour which leads to decrease in variable costs by 10%

Impact of reducing variable costs by 10 %    

  Current Option 1

Sales $100 000 $100 000

Less: Variable costs 72 000 64 800

Contribution margin $28 000 $35 200

Less: Fixed costs 35 000 35 000

Net profit (loss) $(7 000) $ 200

Option 2 – increase sales incentives (commissions)
E.g. Happy Daze manager estimates that if sales commission is raised by 10% on all sales above
present level, sales will increase by $40 000 or 3200 games.
New variable costs are calculated by using a variable -cost percentage of 72% for sales up to $100
000 and 82% on all sales more than $100 000.

Impact of increasing sales incentives    

  Current Option 2

Sales $100 000 $140 000

Less: Variable costs 72 000 104 800

Contribution margin $28 000 $35 200

Less: Fixed costs 35 000 35 000

Net profit (loss) $(7 000) $ 200

Option 1 and 2, ultimate change in net profit can be determined by focusing solely on change in
contribution margin and fixed costs are not relevant
Option 3 – change game features and increase advertising
Changes in cost, price and volume normally affects one or both other variables
E.g. Happy Daze decides to change some key features which adds $0.25 to variable cost per game.
Manager estimates additional advertising of $5000 will increase sales volume by 40%. To offset some
of the costs, sales price is raised by $0.75 per unit.

Impact of changes in cost, price and volume    

  Current Option 3

Sales $100 000 (8000 x $12.50) $148 400 (11 200 x $13.50)

Less: Variable costs 72 000 (8000 x $9.00) 104 800 (11 200 x $9.25)

Contribution margin $28 000 (8000 x $3.50) $35 200 (11 200 x $4.00)

Less: Fixed costs 35 000 40 000

Net profit (loss) $(7 000) $ 4 800

CEO must assess risk inherent in each option including sensitivity of decision on key assumptions

Break-even Analysis
Break-even point – level of sales at which contribution margin just covers fixed costs and net profit is
equal to zero
Variation of CVP analysis where volume is increased or decreased to find point at which net profit is
equal to zero
Traditionally seen as critical figure for establishing ‘floor’ level of any operations (minimum
performance attained without making a loss)

SP is sales price per unit, VC is variable costs per unit and X is number of units sold

 
Break-even calculations with multiple products
Requires calculation of ‘average’ contribution margin for all products produced and sold
Requires estimation of sales mix (relative percentage of total units or total sales dollars expected
from each product)
If estimation is not accurate, the break-even analysis will change based on past experience
E.g. Happy Daze adds new games that is expected to have sales of approx. 4500 units.

Happy Daze Game Company        

  Old games (8000) units Per unit New game (4500) Per unit

Sales (8000) $100 000 $12.50 $67 500 $15.00

Less: Variable costs 72 000 9.00 49 500 11.00

Contribution margin $28 000 $3.50 $18 000 $4.00

Less: Fixed costs 35 000   15 000  

Net profit (loss) $(7 000)   $3 000  

Average contribution margin can be found by weighting contribution margin per unit for old games
and new game by relative sales mix and summing products
Old game = 0.64 x $3.50 = $2.24
New game = 0.36 x $4.00 = $1.44
Average contribution margin for Happy Daze is $3.68 per unit (2.24 + 1.44)
Can also be calculated by dividing total contribution margin by total number of units sold

If volume shifts towards selling more of product with highest contribution margin, weighted-average
contribution margin increases, and break-even point will decrease
Target Profit Analysis (before and after tax)

Which is for single products.

For multiple-product environments, contribution margin becomes weighted-average contribution
margin per unit
Impact of taxes

Before tax profit is calculated to determine amount of sales needed to obtain after tax profit

Cost Structure and Operating Leverage

Cost structure – relative proportion of fixed and variable costs
Generally, greater proportion of fixed costs, more sensitivity of profits to changes in sales volume
E.g. Two furniture companies have same sales and net profit, but Company A is highly automated
while Company B is highly labour intensive

  Company A Company B

Sales $200 000 $200 000

Less: Variable costs $40 000 $80 000

Contribution margin $160 000 $120 000

Less: Fixed costs 80 000 40 000

Net profit $80 000 $80 000

Contribution margin ratio 80% 60%

Operating leverage 2.0 1.5

Increasing sales will benefit Company A more than B
Decrease in sales by 10% ($20 000), profit of Company A will decline by $16 000 whereas profit of
Company B will decline by $12 000
Large proportion of fixed costs relative to variable costs will have wider fluctuations in net profit as
sales change than company with large proportion of variable costs which leads to greater volatility
Operating leverage
Indicator of how sensitive net profit is to a change in sales
Company with high fixed costs to variable costs will have a high level of operating leverage so, net
profit will be very sensitive to changes in sales volume
Small percentage increase in sales dollars will result in large percentage increase in net profit
Company with high variable costs, profit will not be as sensitive
E.g. Operating leverage of Company A is 2.0 which means that if sales increase by 10%, profits
increase by 20% and if sales decrease by 10%, profits decrease by 20%
Operating leverage changes when sales changes
As company gets closer to break-even point, operating leverage will continue to increase and profit
will be very sensitive to changes in sales
 
 
Chapter 8: Activity-based Costing
Saturday, 19 May 2018
11:07 AM
Unit-, Batch-, Product- and Facility-level Costs
Unit-level costs – incurred each time a unit is produced such as supplies for factory, depreciation,
energy costs and maintenance of factory machinery
Batch-level costs – incurred each time a batch of goods is produced such as salaries related to
purchasing, receiving and moving material, quality control costs and depreciation of setup
equipment
Product-level costs – incurred as needed to support production of each type of product such as
salaries of engineers, depreciation of engineering equipment, product developing costs and quality
control costs
Facility-level costs – incurred to sustain overall manufacturing process such as rent, depreciation,
insurance and tax of factory building, salary of plant manager and employee training

Activity-based Costing (ABC)

A system that allocates overhead costs that assumes that activities, not volume of production, cause
overhead costs to be incurred
Activities – procedures or processes that cause work to be accomplished
Stage 1 – identification of activities
Overhead costs can be traced to more than one activity

Activity Level Typical cost drivers

Repair and Unit Machine hours, labour hours or number of units of factory
maintenance equipment

Machining of products Unit Machine hours

Purchasing Batch Number of purchase orders or number of parts

Receiving Batch Amount of material or number of receipts

Setting up equipment Batch Number of setups

Product testing Product Number of change orders number of tests or hours of testing
time

Engineering Product Number of engineering hours or number of products

Product design Product Number of new or revised products

Quality control Unit, batch Number of inspections, hours of inspection or product number
of defective units
Stage 2 – identification of cost drivers
Often limited to what firm is able to measure using information systems implemented by
management
ABS systems in non-manufacturing environment
Problem is type of work done by service companies tend to be non-repetitive
Analysing activities can be difficult when activities differ greatly for each customer or service
Service-oriented companies are likely to have proportionately more facility-level costs than
manufacturing companies
Goal is to determine total cost of product or service
Can be used to determine cost of providing particular non-manufacturing activity such as cost of
providing payroll services

Traditional Overhead Allocation and ABC – an example

DownUnder Construction asked to construct ‘Ayers Cottage’ which will be used in areas impacted by
floods to provide safe, temporary housing. 300 units are build each year taking 2 weeks to assemble
components and 1-2 days to assemble units on site. Purchasing department that handles ordering of
raw materials and processing of purchase orders.

Overhead item Estimated cost

Indirect materials $1 800 000

Indirect labour:  

Construction supervisors 500 000

Part-time workers 200 000

Other overhead:  

Allocated service department costs 780 000

Tools 150 000

Trucks and other equipment 400 000

Total $3 830 000

If DownUnder produced only one type of modular home, overhead allocation process would be very
simple due to assumption that all homes share overhead costs equally if same process and came
resources are used
DownUnder build 2 basic models – 1200-square-foot two bedroom unit and 1600-square-foot three
bedroom unit. So, overhead is based on square footage of each model. Based on expected
production of 150 two bedroom units and 150 three bedroom units in 2014, DownUnder estimates
that it will manufacture units with total floor space of 420 000 square feet. Therefore,
predetermined overhead rate for 2014 is $9.12 ($3 830 000 ÷ 420 000). Two bedroom model will
1200 square feet will be allocated $10 944 overhead and three bedroom unit with 1600 square feet
will have $14 592 overhead.
DownUnder has to design new 500-square-foot cottage which can be constructed and shipped to sit
within one week receiving order and is expected to have 1000 manufactured in 2014. Cottage’s total
price may not exceed $37 500 and estimated cost is $30 000 to have sufficient profit. The estimated
manufacturing overhead is expected to increase to $6 720 000.
If traditional method for overhead used, predetermine overhead rate would be $7.30 per square
foot so, $8760 for 2 bedroom unit, $11 680 for 3 bedroom and $3 650 for new cottage. Cost of new
cottage is $30 650 which exceeds cost target by $650.

  Two-bedroom unit Three-bedroom unit Cottage

Number of units 150 150 1 000

Direct material $30 000 $40 000 $16 500

Direct labour 18 000 24 000 10 500

Overhead 8 760 11 680 3 650

Total cost per unit $56 760 $75 680 $30 650
CFO recommended to investigate use of ABC to provide more accurate allocation of overhead
DownUnder’s stage 1: identification of activities

Activity Estimated cost

Inspections $900 000

Purchasing 500 000

Supervision 1 400 000

Delivery and setup 3 920 000

Total overhead $6 720 000

Primary activities that consume company resources:
Inspections
Purchasing
Supervision
Delivery and setup
DownUnder’s stage 2: identification of cost drivers and allocation of costs

Activity Cost driver

Inspections Number of inspections

Purchasing Number of purchase orders

Supervision Hours of supervisory time

Delivery and setup Setup time (days)
1200-square-foot two bedroom unit estimated to have 25 inspections, 1600-square-foot estimated
to require 35 while cottage will only need 10. Also, cottage requires 10 purchase orders and 10 hours
supervision hours.

Cost driver Two-bedroom unit Three-bedroom unit Cottage Total

Number of inspections (25 x 150) = 3 750 (35 x 150) = 5 250 (10 x 1000) = 10 000 19 000

Number of purchase orders (30 x 150) = 4 500 (40 x 150) = 6 000 (10 x 1000) = 10 000 20 500

Hours of supervisory time (72 x 150) = 10 800 (96 x 150) = 14 400 (10 x 1000) = 10 000 35 200

Days of delivery and setup (4 x 150) = 600 (6 x 150) = 900 (1 x 1000) = 1 000 2 500
time
 

Activity Total estimated cost Cost drive and estimated Predetermined overhead
amount rate

Inspections $900 000 No. of inspections (19 000) $47.37 per inspection

Purchasing 500 000 No. of purchase orders (20 500) $24.39 per purchase order

Supervision 1 400 000 Hours of supervision (35 200) $39.77 per supervisory hour

Delivery and 3 920 000 Setup time (days) (2 500) $1568 per day
setup
 

Cost Two-bedroom unit Three-bedroom unit Cottage

Direct materials $30 000 $40 000 $16 500

Direct labour 18 000 24 000 10 500

Inspections 1 184 1 658 474

Purchasing 732 976 244

Supervision 2 864 3 818 398

Delivery and setup 6 272 9 408 1 568

Total cost per unit $59 052 $79 860 $29 684
Traditional costing methods resulted in over-costing cottage and under-costing two- and three-
bedroom units. ABC systems eliminate cross subsidies between products which occurs when high-
volume products are assigned more than their fair share of overhead costs and low-volume products
have too little overhead.

Benefit and Limitations of ABC

Benefits:
Provide more and more accurate cost information that focuses managers on opportunities for
continuous improvement
Increased accuracy of cost information provided for day-to-day decision making such as adding or
dropping products, making or buying components
Allows managers to better see what causes costs to be incurred which leads to better control
Limitations:
High measurement costs as costs can be higher than benefit of implementing ABC systems
If price is mainly based on market, company has little control on price so ABC may not be necessary
Companies with high potential for cost distortion are more likely to benefit form ANS such as having
diverse products (products that consumer resources in different proportions)
Companies with large proportion of non-unit-level costs are also likely to benefit from ABC
Four key questions to know if you should implement ABC:
Do we make more than one product?
Do we make multiple products using different processes?
Do we have a high proportion of non-unit level costs?
Are overheads a significant proportion of our total costs?
 
 
Chapter 12: Fixed and Rolling Budgets for Planning
and Decision Making
Saturday, 19 May 2018
11:07 AM
Article:
Budgetary slack creation - resources and effort towards activities (budgets) cannot be justified easily
(immediate contribution to objectives)
 Often involves overestimating expenses and underestimating revenue
Budgetary control style - how significant meeting the budget is to salary, resources and career
prospects
 Rigid budgetary control style having salary, resources and career prospects highly dependent
on meeting the budget
Managerial short-term orientation - extent managers focus on business matters affecting
performance within current budgeting period (one year)
Budgetary slack is negatively related with managerial short term orientation and budgetary control.
Budgetary control style does not directly affect managerial short term orientation
Other possible variables affecting these three factors are cost leadership and differentiation
strategies and past business unit performance
 
Budgets – plans dealing with acquisition and use of resources over a specified time period
Planning – cornerstone of good management; involves developing objectives and goals for
organisation as well as actual preparation of budgets
Operating -involves day-to-day decision making by managers, which is often facilitated by
budgeting
Control – ensures objectives and goals developed by organisation are being attained; often
involves comparison between actual performance to budgets and use of budgets for
performance-evaluation purposes

Budget Development Process

 Budgeting is a management task, not a bookkeeping task and requires great deal of planning and
thoughtful input from a broad range of managers in a company.
Budgeting is an integral part of mangers’ planning, operating and control activities.
More and more companies are using enterprise resource planning (ERP) systems as a key
budgeting tool which links data across all areas of a business, ensuring same assumptions are
used throughout different budgets and speeding up budgeting process.
Companies can start budget process based on last year’s numbers or zero-based budgeting
Zero-based budgeting – requires managers to build budgets form the ground up each year rather
than a percentage increase to last year’s numbers
 Must justify all items in budget not just changes from last year’s budget
 Can be very time consuming
 May only be required every few years or rotate among departments
Companies frequently use monthly budgets and rolling 12-month budgets to provide mechanism
for adjusting items in response to unforeseen circumstances
Participation in budget development process
Participatory budgeting – budgeting process that starts with departmental managers and flows
up through middle management and then to top management. Each new level of management
has responsibility for reviewing and negotiating any changes to proposed budget
Budget development must be guided by strategic plan that focuses attention on whole company
and integrate individual budgets. This causes managers to be more focused on important aspects
of budget and less worried about irrelevant details.
Motivation to meet objectives and goals could be bonuses, merit pay and other tangible and
intangible rewards
Behavioural implications of budgeting
Conflicts may arise when budgets used for both planning and controlling.
If Managers who must ‘meet the budget’ have incentives to pad it, so targets are made to be
easier to reach which is known as budget ‘gaming’
 E.g. sales manager knows bonus will be received if sales exceed budget, so she may
attempt to set sales budget at an unrealistically low level
This kind of gaming refers to managers attempting to manipulate budget numbers, gaming can
have more real effects such as recording an expected sale that will occur in next period in
current period which affects profit and loss statement. Leading to overstating current period’s
profit and understating next period’s profit.
Managers with compensation tied to targeted budgets may shift revenues and expenses across
periods (fraud) which can be reduced by holding managers accountable and punishing unethical
behaviour with strong sanctions.
Advantages of budgeting:
 Compels communication to occur throughout organisation
 Forces management to focus on future and not be distracted by daily crises in
organisation
 Can help identify and deal with potential bottlenecks/constraints before they
become major problems
 Can increase coordination of organisational activities and help facilitate goal
congruence (aligning personal goals of managers with goals of organisation)
 Can define specific goals and objectives that become benchmarks/standards of
performance for evaluating future performance
 
Master budget
 Consists of interrelated set of budgets prepared by business
 Starting point is forecasting sales and preparing a sales budget
 Merchandising company master budget is less complex than manufacturing

 
The Sales Budget
Sales forecast – combines with sales budget to form starting points in preparation of production
budgets for manufacturing companies, purchase budget for merchandising companies and
labour budgets for service companies
Sales budget – used in planning cash needs for manufacturing, merchandising and service
companies
 Key component used in overall strategic planning process
Main starting point of sales forecast is last year’s level of sales.
Other factors and information sources are:
 Historical data such as sales trends
 General economic trends or factors such as inflation rates, interest rates
 Regional and local factors expected to affect sales
 Anticipated price changes in both purchasing costs and sales prices
 Anticipated marketing or advertising plans
 Impact of new products or changes in product mix on entire product line
Every organisation will have unique factors and different levels of importance to each factor.
Size and complexity of organisation will often determine complexity of sales forecasting system.
All remaining budgets and decisions are made of the basis of their forecasts are dependent on
this estimate of sales

Sales Forecast  

January 250 000 bottles

February 325 000 bottles

March 450 000 bottles

Operating budgets – used to plan for short term (<1 year)
E.g. Bob’s Bewdiful Juices, orange juice bottle sells juice for $1.05 per litre bottle in cartons of 50
bottles
 Sales Budget        

  January February March 1st Quarter

Budgeted sales in bottles 250 000 325 000 450 000 1 025 000

Selling price per bottle $1.05 1.05 1.05 1.05

Total budgeted sales $262 500 $341 250 $472 500 $1 076 250
 

Production Budget
 Used to forecast how many units of product to produce in order to meet sales
projections; next step in budgeting process for manufacturing companies
Traditional manufacturing companies often choose to hold an established minimum level of
finished-goods inventory in case of unexpected demands for product or unexpected problems in
production. So, sales forecast must be adjusted to account for any expected increase/decrease in
finished goods inventory

E.g. Bob’s Bewdiful Juices tries to maintain at least 10% of next month’s sales forecast in
inventory at end of each month

  January February

Budgeted sales 250 000 325 000

Desired end finished goods 32 500 45 000

Total budgeted production 282 500 370 000

Begin finished goods 25 000 32 500

Required production 257 500 337 500

Material, Labour, Overhead and Selling & Administrative Expense Budgets

Material purchases budget
 Used to project dollar amount of raw materials purchased for production
 Adjustment is needed due to keeping extra materials
 E.g. Bob’s Bewdiful Juices needs two purchases budgets: one for orange concentrate and
another for bottles. One litre of concentrate ($4.80) produces 32 bottles of finished product. Bob
requires 20% of next month’s direct materials on hand.

Material Purchases Budget – orange        

concentrate

  January February March 1st Quarter

Required production 257 500 337 500 455 000 1 050 000

Orange concentrate needed (L) 8 047 10 547 14 210 32 813

Add: Desired ending inventory of orange 2 109 2 844 3 063 3 063

Total budgeted needs of orange 10 156 13 391 17 282 35 876

Less: Beginning inventory of orange 1 609 2 109 2 844 1 609

Orange to be purchased 8 547 11 282 14 438 34 267

Cost per litre of orange $4.80 $4.80 $4.80 $4.80

Cost of orange concentrate to be purchased $41 026 $54 154 $69 302 $164 482
 

Direct labour budget

 Used to project dollar amount of direct labour cost needed for production
E.g. Bob’s Juices has 5 machines with one person assigned to each. Each machine can process
600 bottle an hour and workers are paid $15 per hour. Dividing labour rate by time required per
bottle shows that amount of direct labour is $0.025 per bottle

Direct labour budget        

  January February March 1st Quarter

Required production 257 500 337 500 455 000 1 050 000

Direct labour hours per bottle 1/600 1/600 1/600 1/600

Total direct labour hours needed for production 429.17 562.50 758.33 1750.00

Direct labour cost per hour $15.00 $15.00 $15.00 $15.00

Total direct labour cost $6 438 $8 438 $11 375 $26 250
 

Manufacturing overhead budget

 Used to project dollar amount of manufacturing overhead needed for production
 Estimating overhead can be done by using plantwide or departmental
predetermined overhead rates or activity-based costing
E.g. Bob’s Juices overhead costs are mostly incurred during mixing and bottling process, so Bob
chose to use plantwide cost drive (machine hours). The variable and fixed costs are separated. It
is estimated that $438 000 is variable overhead and machines will run approx. 8000 hours (4 775
000 bottles). Therefore, predetermined variable overhead rate is $54.75 ($438 000/8000) per
 machine hour and fixed overhead is $1 480 000 per year with $1 240 000 of it being
depreciation.

Manufacturing overhead budget        

  January February March 1st Quarter

Budgeted machine hours 429.17 562.50 758.33 1750.00

Variable overhead rate $54.75 $54.75 $54.75 $54.75

Manufacturing $23 497 $30 797 $41 519 $95 813

Fixed manufacturing overhead $123 333 $123 333 $123 333 $123 333

Total manufacturing overhead $146 830 $154 130 $164 852 $465 812
 

Selling and administrative expense budget

E.g. Bob’s includes variable expenses such as commissions, shipping costs and supplies as well as
fixed costs such as rent, insurance, salaries and advertising. Commission is 10% of projected sales

Selling and Administrative Expenses budget        

  January February March 1st Quarter

Variable seeling and administrative expenses        

Commissions $26 250 $34 125 $47 250 $107 625

Shipping costs $10 500 $13 650 $18 900 $43 050

Supplies $2 100 $2 750 $3 780 $8 630

Fixed selling and administrative expenses        

Rent $20 000 $20 000 $20 000 $20 000

Insurance $5 000 $5 000 $5 000 $5 000

Salaries $8 000 $8 000 $8 000 $8 000

Total selling and administrative expenses $86 850 $98 525 $117 930 $303 305
 

Cash Budgets
Why focus on cash?
 Timing of cash inflows and outflows is critical to overall planning process as cash
pays the bills. When cash inflows are delayed because of extension of credit to buyers, there
may not be sufficient cash to pay supplies, creditors and employee wages.
 Timely payment is necessary to maintain good business relationships with supplies,
keep employees happy and to take maximum discounts that may be available on purchases.
 Cash budgeting forces managers to focus on cash flow and to plan for purchase of
materials, payment to creditors and payment of salaries. Cash must be sufficient to pay
dividends
Cash receipts budget
 Used to project that amount of cash expected to be received from sales and
collections from customers
E.g. Bob’s Juices sales are made on account and is estimated that 50% of sales each month will
be paid for in the month of sale. Also, 35% of each month’s sales will be collected in the month
following sale and 15% in the month after that.

Cash Receipts operating Activities            

Budget -

  Sales January   February   March   1st Quarter

November $200,000 $30,000 15%        $30,000

December $250,000 $87,500 35% $37,500 15%    $125,000

January $262,500 $131,250 50% $91,875 35% $39,375 15% $262,500

February $341,250    $170,625 50% $119,438 35% $290,063

March $472,500        $236,250 50% $236,250

Total cash   $248,750  $300,000  $395,063  $943,813

receipts from
sales
 

Cash disbursement budget

 Used to project amount of cash to be disbursed during budget period
 Includes cash outflows from operating activities such as payments to supplies,
salaries and other labour costs
 Difficult since purchases of materials are often made on account, resulting in lags
between date purchased and date cash actually changes hands
E.g. Bob has a policy of paying 50% of direct material purchases in month of purchase and the
balance in month after purchase. All direct labour costs are paid in month incurred.
Manufacturing overhead is paid with 50% in month incurred and 50% in following month but
must be adjusted since depreciation does not have direct impact on cash flow.

Cash disbursements budget - operating        

activities

  January February March 1st Quarter

Purchases of orange        

December (given) $17,279    $17,279

January $20,513 $20,513  $41,026

February   $27,077 $27,077 $54,154

March     $34,651 $34,651

Purchases of bottles        

December (given) $12,146    $12,146

 January $13,675 $13,675  $27,350

February   $18,050 $18,050 $36,100

March     $23,100 $23,100

Total disbursements for material $63,613 $79,315 $102,878 $245,806

Disbursements for direct labour $6,438 $8,437 $11,375 $26,250

Manufacturing overhead        

December (given) $20,917    $20,917

January $21,748 $21,749  $43,497

February   $25,398 $25,399 $50,797

March     $30,759 $30,759

Total disbursements for manufacturing $42,665 $47,147 $56,158 $145,970

overhead

Disbursements - selling and admin $86,850 $98,525 $117,930 $303,305

expenses

Total cash disbursements $199,566 $233,424 $288,341 $721,331

 

Summary cash budget

 Consists of three sections:
 Cash flows from operating activities
 Cash flows from investing activities
 Cash flows from financing activities
 The three sections are same as those used in cash flow statement prepared under
GAAP
E.g. Bob plans to buy some new machinery in February for $75 000, plans to pay dividend of $50
000 in January and have cash balance of $50 000 on hand at end of any month. If cash is less
than that, Bob draws line of credit from bank with 10% interest charge and is borrowed at
beginning of month and repaid at end of months with surplus cash. Income tax (30%) is paid
quarterly on income earned.

Summary cash budget        

  January February March 1st Quarter

Beginning cash balance $50,000 $50,000 $50,000 $50,000

Cash Flows from operating activities        

Cash receipts $248,750 $300,000 $395,063 $943,813

Cash disbursements -$199,566 -$233,424 -$288,341 -$721,331

Income taxes     -$1,849 -$1,849

Cash Flows from investing activities        

 Equipment purchases   -$75,000  -$75,000

Cash Flows from financing activities        

Payment of Dividends -$50,000    -$50,000

Interest on Long Term debt*     -$30,000 -$30,000

Borrowing from line of credit $1,757 $8,394  $10,151

Repayments of line of credit     -$10,151 -$10,151

Interest on line of credit     -$184 -$184

Ending cash balance $50,941 $49,970 $114,538 $115,449

         

*Long term debt is $1 500 000, and interest is        

paid quarterly at 8% pa
 

Budgeted Financial Statements

Pro forma financial statements – budgeted financial statements that are sometimes used for
internal planning purposes but more often are used by external users

Budgets for Merchandising Companies and Service Companies

Service companies may still prepare modified ‘production’ budgets such as CPA firm may budget
for total revenue and amount of revenue for each engagement (tax, audit). Main focus will often
be labour budget and overhead expenditures.
Merchandising companies will prepare sales budget and purchases budget instead of
production, direct material purchases, direct labour and manufacturing overhead budgets.

Static vs. Flexible Budgets

Static budgets – budgets that are set at beginning of period and remain constant throughout
budget period
 Useful for planning and operating purpose but can be problematic when used for
control
 When static budgets are used, and actual sales are different from budgeted sales,
it’s like comparing apples and oranges
 If actual sales are lower than budgeted sales, actual costs of materials, labour and
variable overhead should be lower than budgeted costs
 Difference does not necessarily mean company spent less or was more efficient than
budgeted
E.g. Bob’s Bewdiful Juices produces 250 000 bottles of juice in January instead of budgeted
amount of 257 500. Projected direct labour cost based on static budget of 257 500 bottles was
$6438 but actual direct labour costs was $6300. Comparison of actual labour costs with
budgeted labour costs does not make sense. We want to know labour costs if we knew
production was going to be 250 000 bottles instead of 257 500.
Flexible budgets – budgets that take differences in spending owing to volume difference out of
the analysis by budgeting for labour (and other costs) based on actual number of units produced
   Flexible budget Actual Difference

Production (bottles) 250 000 250 000  

Direct labour time per 600 bottles 1 hour    

Direct labour hours needed for production 416.67    

Direct labour rate per hour X $15    

Direct labour cost $6250 $6300 $(50)

 Removed any difference in cost caused by difference in volume of production and
focuses only on difference arising from other factors such as increased pay or more labour hours

Explain and Understand Concept of Rolling Budgets in Modern Organisations

Annual budget is prepared for the full year ahead and often strategic or operational events
happen during that year that are unexpected causing budget to become redundant such as
competitors.
When faced with such uncertainty. Many organisations implement rolling budget which are a
series of short-term budgets that are updated periodically.
E.g. we construct 6 quarterly rolling budgets in January 2012. At end of first quarter, we update
remaining five quarters based on consideration of any change in circumstances that might
impact them and also construct a new sixth quarter for 1 July 2013-30 September 2013.
Every 3 months, we look forward another 18 months and rethink how we might change budget
numbers

Rolling budget periods              

    Jan-Mar Apr-Jun Jul-Sep Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec

12 12 12 12 13 13 13 13

Date 31/12/11 Period 1 Period 2 Period 3 Period 4 Period 5 Period 6    

prepared

  31/03/12   Period 1 Period 2 Period 3 Period 4 Period 5 New  

Period 6

  30/06/12     Period 1 Period 2 Period 3 Period 4 Period 5 New

Period 6
Less suitable for performance evaluation of individuals due to continual ‘shift of goalposts’ which
is why Australian organisations prepare both annual budgets and rolling budgets.
Helps plan shorter term future activities
 
 
Chapter 10: Relevant Costs and Product Planning
Decisions
Tuesday, 12 June 2018
7:17 PM
Special Orders
Special-order decisions – short-run pricing decisions where management must decide which sales
price is appropriate when customers place orders that are different from those placed in regular
course of business (onetime sale to foreign customer, etc.)
Affected by whether company has excess production capacity and can produce additional units with
existing machinery, labour and facilities
Almost never accepted if company does not have excess capacity since It will have to turn away
current customers which could permanently damage relationship with current customer
Should consider if special order is profitable and impact on customer relations
Important to recognise if selling price offered is attractive enough that companies may well ignore all
risks in pursuit of higher short-term profits
E.g. Qantas Airlines was asked by BHP Billiton to provide 150 seats for Melbourne to Brisbane return
flight offering $125 per ticket, although normal fare is $275. Tickets can be used on only one day, but
executives need to be able to flow on one of five flights offered that day. Each aircraft carries 180
passengers so there is a capacity of 900 seats with normal passenger load on the day being between
77-78%. Objective of Qantas is to maximise profit in short run without reducing profit in the long
run. Options are selling tickets for $125, letting marketplace determine level of sales at a
predetermined price of $275 or selling tickets at another price

  Per passenger Per round trip

Cost of meals and drinks $6.50 $1 170

Cost of fuel 88.89 16 000

Cost of cabin crew (four flight attendants) 6.11 1 100

Cost of flight crew 11.11 2 000

Depreciation of aircraft 16.67 3 000

Aircraft maintenance 8.33 1 500

Total $137.61 $24 770

Special order price is less than total cost per passenger so based on full costs, Qantas would be
losing $12.61 but only relevant costs should be considered. These are costs that will differ depending
on whether special order is accepted.
Costs such as maintenance, flight and cabin crew and depreciation are fixed with respect to number
of passengers. Only variable cost is cost of drinks and meals and any dales price above variable costs
of providing seats will increase profit of company. So, Qantas should be willing to accept special
order at any price over $6.50
General rule to maximise profit – special-order price must be higher than additional variable costs
incurred in accepting special order if there is excess capacity
If no excess capacity, opportunity costs are considered

Outsourcing and Other Make-or-buy Decisions

Strategic aspects of outsourcing and make-or-buy decisions
Mark-or-buy decisions – short-term decisions to outsource labour or to purchase components used
in manufacturing from another company rather than to provide services or produce components
internally
Requires in-depth analysis of relevant quantitative and qualitative factors and consideration of costs
and benefits of outsourcing and vertical integration
Vertical integration – accomplished when a company is involved in multiple steps of value chain
All elements of value chain form initial research and development through design, manufacture,
marketing distribution and customer service must be considered
Advantage of making components internally since they are not dependent on suppliers for timely
delivery
Disadvantages could be suppliers provide high-quality part for a less cost. Thus, computer
manufacturers do not produce own computer chips
Make-or-buy decision
E.g. Birdie Maker Golf Company produces custom sets of golf clubs and are sold $1000 per set with
1000 sold per year. Birdie currently makes all golf clubs but is considering acquiring putter from Ace
Putter, Inc.

Costs incurred in manufacture of putter    

  Total (1000 putters) Per unit

Direct materials $5 000 $5.00

Direct labour 9 000 9.00

Variable manufacturing overhead 3 000 3.00

Fixed manufacturing overhead 9 500 9.50

Total cost $26 500 $26.50

Ace Putters is offering $25 per putter. Decision is more complex since considerations of quality and
potential impact on sales of clubs.
Key is to identify costs that can be avoided/eliminated if putter purchased by Ace. It costs $26 500 if
Birdie produces it and $25 000 plus any manufacturing costs that are not avoidable (fixed).

  Cost to make (per unit) Cost to buy (per unit)

Direct materials $5.00  

Direct labour 9.00  

Variable manufacturing overhead 3.00  

Fixed manufacturing overhead 9.50 $9.50

Purchase price from Ace Putters   25.00

Total cost $26.50 $34.50

Company must be convinced that it can manufacture putter of acceptable quality and be able to
keep technological changes.
Sometimes, fixed costs are relevant to analysis such as machinery being rented on a month-to-
month contract for $5500.

  Cost to make (per unit) Cost to buy (per unit)

Direct materials $5.00  

Direct labour 9.00  

Variable manufacturing overhead 3.00  

Fixed manufacturing overhead 9.50 $4.00

Purchase price from Ace Putters   25.00

Total cost $26.50 $29.00

Another way to compare is by total avoidable costs to purchase price.
E.g. if putter is purchased, avoidable costs include direct materials, direct labour, variable
manufacturing overhead and $5.50 for fixed manufacturing overhead so, $22.50 is avoidable.
Opportunity costs should be considered.

  Cost to make (per unit) Cost to buy (per unit)

Direct materials $5.00  

Direct labour 9.00  

Variable manufacturing overhead 3.00  

Fixed manufacturing overhead 9.50 $9.50

Purchase price from Ace Putters   25.00

Rental or unused factory space   (10.00)

Total cost $26.50 $24.50

 

Decision to Drop a Product or Service

Decision hinges on analysis of relevant costs and qualitative factors
E.g. Clayton Herring Tyre Company is considering dropping one of 10 models of types since sales has
been disappointing and type appears to be losing money.

  Mud and snow All other tyres Total

Sales $25 500 $150 000 $175 500

Less: Direct materials 12 000 50 600 62 600

Less: Direct labour 5 000 30 000 35 000

Less: Variable overhead 2 000 12 000 14 000

Contribution margin $6 500 $57 400 $63 900

Less: Fixed overhead 7 000 21 000 28 000

Net profit $(500) $36 400 $35 900

Types required more machine time so, they were allocated a greater portion of fixed overhead.
There is only $2000 of fixed costs are avoidable and relevant while other $5000 will be allocated
elsewhere
  With mud and snow tyres Without mud and snow tyres Difference

Sales $175 500 $150 000  

Less: Direct materials 62 600 50 600  

Less: Direct labour 35 000 30 000  

Less: Variable overhead 14 000 12 000  

Contribution margin $63 900 $57 400 $(6500)

Less: Fixed overhead 28 000 26 000 2000

Net profit $35 900 $31 400 $4500

Another way is to compare contribution margin lost if product line is dropped to fixed costs that are
avoided

Resource Utilisation Decisions

Constraint – restriction that occurs when capacity to manufacture product or provide service is
limited in some manner
Resource utilisation decision (typically short-term) – decision requiring analysis of how best to use a
resource that is available in limited supply
Limited resource can be rare but more likely is related to time required to make product or provide
service or to space required to store a product. E.g. shelf space in grocery stores and other retail
stores or skilled craftspeople for custom furniture.
Decision must consider impact of qualitative factors such as customer reaction if product is not
carried and impact on sales of other products.
In the long run, new machines can be purchased, additional skilled labourers can be hired, and
stores expanded.
Must focus on contribution margin provided by each product per unit of limited resource rather than
on profitability of each product.
E.g. Birdie Maker produces two types of golf balls: pro model and tour model and are sold in cartons
containing 360 balls (30 boxes with 4 sleeves per box). Constraint is number of hours machines can
run with pro model golf ball taking 30 minutes for 360 balls and tour ball taking 45 minutes.

  Pro model Tour model

Sales price (per carton) $450 $540

Less: Direct materials 200 265

Less: Direct labour 50 50

Less: Variable overhead 50 75

Contribution margin $150 $150

Required machine time (hours) ÷ 0.50 ÷ 0.75

Contribution margin per machine hour $300 $200

Contribution margin is equal but if we compute contribution margin per unit of constrained or
limited resource, there is a difference. If demand and qualitative considerations are not important,
Birdie will maximise profit by producing and selling only pro model golf balls. If demand for either
product is limited, company must decide on optimal product mix.
E.g. if machine time is limited to 300 hours per month, and demand of tour model is 150 cartons and
pro model is 400 cartons, only 200 hours of machine is needed for 400 cartons of pro model so
remaining 100 can be for tour model. Birdie can maximise profit by producing 400 cartons of pro
balls and 133 cartons of tour balls each month.
Qualitative factors should be considered such as impact of discontinuing sale of tour ball and
exposure of tour ball on professional tour.

Theory of Constraints
Management tool for dealing with constraints; identifies and focuses on bottlenecks in production
process
Bottlenecks – production-process steps that limit throughput or number of finished products that go
through production process such as machine time from previous example
Once bottleneck identified, management must focus on relieving bottleneck. E.g. Birdie discovered
that delays in delivery of golf clubs to customers result from extra time taken to order and receive
putter from Ace Putters, so Ace might have to speed up delivery or Birdie finds a new supplier

Decisions to Sell or Process Further

For example, furniture manufacturers may sell furniture unassembled and unfinished, assembled
and unfinished or assembled and finished.
Key is that all costs that re incurred up to point where the decision is made are sunk costs and not
relevant
Relevant costs are incremental or additional processing costs. Comparison show be made with
additional sales revenue that can be earned form processing product further to additional processing
costs. If revenue is greater than costs, product should be processed further. If cost is higher, product
should be sold as is.
 
 
Chapter 11: Long-term (Capital Investment) Decisions
Tuesday, 12 June 2018
7:17 PM
Capital investment decisions – long-term decisions involving purchase/ease of new machinery and
equipment and acquisition or expansion of facilities used
Time value of money – concept that a dollar received today is worth more than a dollar received in
the future

Net Present Value (NPV)

Technique for considering time value of money whereby present value of all cash inflows associated
with project is compared with present value of all cash outflows
Cost of capital – what firm would have to pay to borrow (issue bonds) or raise funds through equity
(issue stock) in financial marketplace
Discount rate – used as hurdle rate, or minimum rate of return, in calculations of time value of
money; adjected to reflect risk and uncertainty
Referred to as minimum required rate of return for this chapter
Often adjusted to reflect risk and uncertainty of cash flows expected to occur many years in the
future
If present value of inflows is greater than or equal to present value of outflows (NPV greater than or
equal to zero), investment provides return at least equal to discount rate and is acceptable.
E.g. Bud and Rose’s Flower Shop is considering purchase of a new refrigerated delivery van costing
$50 000. This is expected to increase cash income from sales by $14 000 per year for six years and
not have any value at the end of 6 years. Bud and Rose have minimum required rate of return of
12% and use that as discount rate.

Transaction Cash flow Year Amount 12% factor Present

value

Purchase of Initial investment Now $(50 000) 1.000 $(50 000)

refrigerated van

Sales of flowers Annual cash income (net of 1-6 14 000 4.1114 57.559.60
increased expenses)

  Net present value       $7 559.60

Built-in function in Microsoft Excel, =PV(12%,6,-14000) shows present value
We can find out what the return is by guess and check until NPV equals zero. Also, present value of
annuity table can also be used.

Internal Rate of Return (IRR)

Actual yield, or return, earned by an investment
One way of looking at IRR is that it is the discount rate that makes NPV=0
Can be calculated using financial calculator of Excel
Problem of Uneven Cash Flows
Calculations are more difficult when cash inflows and outflows are more numerous and uneven.
E.g. Royal Prince (RPA) hospital is considering purchase of X-ray machine for cardiac care patients
and wishes to earn minimum rate of return of 10% along with improving care of cardiac patients.
Machine costs $1 200 000 plus installation costs of $50 000 and will be useful for 6 years. RPA
expects to be able to sell machine for $20 000 and have revenue of $400 000 per year with 2
technicians costing $40 000 each and maintenance of $20 000 annually. Also, new X-ray tubes
expected to be installed at end of year 3 & 5 at $50 000 each.

Transaction Cash flow Year Amount 10% factor Present

value

Purchase of new machine Initial investment Now $(1 250 000) 1.0000 $(1 250 000)

Increased patient revenue less Net annual cash 1-6 300 000 4.3553 1 306 590
related expenses inflows

Repairs and maintenance Cash outflow 3 (50 000) 0.7513 (37 565)
Repairs and maintenance Cash outflow 5 (50 000) 0.6209 (31 045)

Sale of machine Cash inflow 6 20 000 0.5645 11 290

  Net present value       $(730)

RPA should also consider qualitative factors since it will improve quality of patient care while it is just
slightly below normal acceptable level
Time value of money is considered in capital investment decisions by suing one of two techniques:
NPV method or IRR method
Key assumptions of discounted cash flow analysis
All cash flows are assumed to occur at end of each period since this simplifies present value
calculations.
All cash flows are immediately reinvested in another project or investment which is analogous to
immediate reinvesting of dividends in a stock investment.
Rate of Return assumed to be earned on the reinvested amounts on whether NPV or IRR is used.
Under IRR, cash inflows are assumed to be reinvested at internal rate of return of original
investment. Under NPV, cash inflows are assumed to be reinvested at discount rate used in analysis.
Importance of qualitative factors
Benefits of automating production processes:
Decrease labour costs
Increase in quality of finished product or reduction in defects
Increase speed of production process
Increased reliability of finished product
Overall reduction in amount of inventory
Benefits save cost and increases market share

Screening and Preference Decisions

Screening decisions – decisions about whether an investment meets a predetermined company
standard
Preference decisions – decision that involve choosing between alternatives
Typical problem addressed in capital investment decisions:
Should old equipment be replaced?
Should new delivery vehicle be purchase or leased?
Should manufacturing plant be expanded?
Should new retail store be opened?
Once problem is identified, objectives are identified. Analysing options involves both quantitative
analysis of option with tools recognising time value of money and qualitative analysis
Both NPV and IRR can be used as screening tools as they identify and eliminate undesirable projects.
Important to remember that they are used in different ways: NPV – cost of capital is used as
discount rate to compute NPV of each proposed investment and IRR – cost of capital or other
measure of company’s minimum required rate of return is comparted to computed internal rate of
return.
Advantage of NPV is that it adjusts discount rate to take into account increase risk and uncertainty of
cash flows expected to occur. IRR – users have to modify cash flows directly.
However, NPV (without adjustment) cannot be used to compare investments unless competing
investments are of similar magnitude. E.g. two competing investments each with 5-year useful life.
First is an investment of $10 000 and generates cash savings with present value of $12 000 (cash
inflows of $3165.56 per year for 5 years at 10%). Second requires initial investment of $20 000 and
generates present value of $22 000 (cash inflows of $5803.52 per year for 5 years).

  Investment 1 Investment 2

Initial investment $(10 000) $(20 000)

Present value of cash inflows 12 000 22 000

Net present value $2 000 $2 000

Intuitively, $10 000 investment should be preferred since you could invest in two $10 000 projects
and generate cash inflows of $6331.12 instead of $5803.52.
Profitability index (PI)
Calculated by dividing present value of cash inflows by initial investment
PI greater than 1.0 means NPV is positive and project is acceptable
When comparing PI of competing projects, project with highest PI is preferred
In cases where investment lives are equal and cash flows follow similar patterns (annual cash flows
for five years), IRR can be used to make preference decisions but if asset lives are unequal and cash
flows follow different patterns, IRR can result in incorrect decisions.
E.g. Two $20 000 projects where project A reduces cash operating costs by $12 500 per year for next
two years, where as project B reduces operating costs by $5 000 per year for 6 years and assume
discount rate is 10%.

  Project A Project B

Initial investment $(20 000) $(20 000)

PV of cash inflows 21 693.73 21 776.50

NPV $1693.75 $1776.50

PI 1.085 1.089

IRR 16.26% 12.98%

IRR indicates project A is preferable but NPV and PI indicate project B is better. IRR generally favours
short-term investments with high yields, whereas NPV favours longer-term investments even if
return is lower.

Impact of Taxes on Capital Investment Decisions

Company income tax rates in Australia currently 30% of taxable income.
Disposal of assets may also have tax consequences since gain or loss is calculated on excess of sales
price over book value (usually original cost less accumulated depreciation). After-tax cash flow
associated with sale of asset at a gain on sale is found by multiplying difference between selling price
and salvage value by (1-tax rate). We will assumer a gain on disposal of asset is taxed at same rate as
operating income but in practice tax calculation can be quite complicated
Depreciation tax shield
Depreciation is a tax-deductible expense that does not involve direct payment of cash. It results in an
indirect cash inflow owing to impact of depreciation on income taxes paid. Depreciation expense
reduces company’s taxable income and income tax which results in an increase in cash flow.
E.g.

  Company A   Company B  

  Income Cash flow Income Cash flow

Cash revenue $100 000 $100 000 $100 000 $100 000

Cash expense $60 000 $60 000 $60 000 $60 000

Depreciation 0 0 10 000 0

Income (before tax) $40 000   $30 000  

Income tax (40% rate) 16 000 16 000 12 000 12 000

Net income $24 000   $18 000  

Cash flow   $24 000   $28 000

Depreciation tax shield – tax savings from depreciation and can be found by multiplying depreciation
expense by tax rate

Payback Method
Fast and easy approximation of more complicated, discounted cash-flow methods
Payback period – length of time needed for a long-term project to recapture or pay back the initial
investment
Quicker the payback, the more desirable the investment

Payback method ignores time value of money and any cash flow received after initial investment is
paid for so, it must be used with caution.
Useful in screening decisions if cash flow is a serious concern and management wants to eliminate
projects that would have adverse cash flow consequences
 
 
WEEK 12: Review
Friday, 8 June 2018
1:40 PM
Objectives:
Current business events
Assumed knowledge
Need to know (weekly review)
Final exam format:
  22 MCQ (26 minutes)
o Covers journal articles and current business
o Concentrates on topics not covered in second half exam
 Q1: Practical + Theory – Financial accounting
o Financial accounting (recording and analysing accounting information)
 Q2-4: Practical + Theory – Management Accounting
o ABC, CVP, General management accounting
o Determine optimal decision (quantitatively)
 Relevant revenue and costing of special orders and capacity utilisation
 Qualitative factors like short and long term consideration
 Q5: Theory – Earnings management
o 1 case and 6 parts to answer
Current business events and be able to evaluate it
ASX market index
Australian dollar compared to other currencies
Price of tapis crude oil
Interest rates
Assumed knowledge
Lecture 1-3 (financial accounting):
Financial statements (communicate)
Entity (boundary)
Money (attribute of interest) – describe, measure success and failure
Transaction (money across boundary) – success and failure of business, numerical value on it
A=L+SE(shareholders’ equity) dual effect (money shareholder invests and money earned for
shareholders)
A+E = L+R+SE
Use accrual accounting but cash flows are important
Lecture 4 (adjusting entries):
Bring accounts up to date and occurs at the end
Involves revenue and an asset or liability or expense and asset or liability
Never involves cash
Depreciation, inventory costing and bad debts are the link to earnings management
Theory – understand why and effect of using it and what it means for the accounts
Lecture 5 (cash and internal control):
Role of internal control
Why it is important? Worried about theft of cash since it has value
Analyse and protect cash
Five components of internal control
Focus on bank reconciliation and petty cash
Reporting cash (balance sheet)
Evaluation of cash (cash balance decreasing; issue in liquidity)
Lecture 6 (receivables):
Recording and reporting receivables
Sales, discounts, returns
Bad debts (two methods):
Direct write off
Allowance method
Choices for earnings management:
Direct write off – this affects profitability since timing issues, so you can shift bad debts to a
different period
Allowance method
Analysis of receivables
Quality of receivables – chances of getting the money
Horizontal and vertical analysis
Accounts receivable ratio
Allowance ratio
Days-in-receivable ratio
Lecture 7 (retail operations):
Sales and revenue recognition
Adds inventory and COGS
Purchases
Inventory flow assumption (LIFO, FIFO, etc.) and concept of earnings management
LCNRV (conservatism)
Physical (periodic) or perpetual inventory (updates every time inventory purchased/sold)
Analysing a retailer
Lecture 8 (management accounting and costing):
Look into the future
External vs. internal user needs
Relevant factors in decision making
Business model and ethical issues
Manufacturer costing:
DM, DL and Manufacturing OH
Manufacturer financial statements
Lecture 9 (CVP analysis):
Behaviour of costs (fixed and variable)
Fundamental decision making tool
Contribution margin = Price – VC/unit
CM – FC = profit
Break-even is essential
Decision making user CVP analysis
Operating leverage = CM/net income
High OL means high fixed costs profit increases by a lot more if you exceed fixed costs. Bad thing
because it is harder to break-even. Lower OL easier to break even
Lecture 10 (Budgeting and ABC):
Planning, operating and controlling
Master budget – different components:
Sales, production
ABC:
Classify overhead costs
Cost drivers
Product costing using ABC
 Compare traditional
Takes overhead costs and distributes them more equally and evenly
Lecture 11 (relevant costing and long-term decision making):
Price of special order, outsourcing, adding or dropping a product line
Limited resource situations
Theory of constraints
Processing further
Capital investment decisions:
NPV method
Payback method