BUS105: Managerial Accounting

As you read this section, pay attention to the differences between financial accounting and managerial accounting. These differences are illustrated in Table 1.1. Also, evaluate what types of managerial accounting information you use or produce in your job. Were you surprised to realize that you are already familiar with some parts of managerial accounting?

The subtopics below will discuss how managerial accounting contributes to the planning and controlling functions. The four functions of management -- planning, organizing, leading, and controlling -- are covered in Saylor Academy's BUS208: Principles of Management course.

This article provides an extensive discussion of financial and managerial accounting.

As you read this chapter, identify the various needs managerial accounting meets and how various participants in the management process would use the many outcomes of managerial accounting. You do not need to attempt the review quiz at the end of the reading as its content exceeds the narrower scope of this reading.

From your text, you read that Dana Matthews, president of Sportswear Inc., a publicly-traded company, has many responsibilities. Like most managers of large publicly-traded companies, she has delegated much responsibility to her managers and has many questions that need answers.

Although Dana has delegated much responsibility she cannot delegate accountability and she must ensure that her organization is effective and the information she receives is accurate. Best practices require an efficient organization to ensure that management accounting is done in a timely and accurate manner. This section considers what a typical organization may look like.

Mark Twain told us that there are three types of lies, “lies, damned lies and statistics.” Management accountants produce many statistics! How expenses are allocated and how revenue is accounted for is far from set in stone. For example, the owner of a restaurant and bar could choose to take his salary as a dividend and thereby pump up profitability, perhaps to impress or mislead a potential buyer! As a management accountant you need to be aware of ethical issues and studiously avoid practices that mislead and misdirect those who will use your information.

Selection of a computer system for a company is more than a software or hardware decision—it is a complex problem that usually requires scrupulous research and a full rethinking of the organization's culture and reporting relationships. Today, most companies have a computerized financial system that creates financial and management accounting reports.

In accounting, classifying costs and revenue correctly is critical to consistent financial reporting. A consistent report has uniform meaning within the company. In this section you will learn some of the basic terminology used to classify costs. This section of the textbook is important to your success in this course, so be sure to complete the exercises at the end of the section before you move on.

Costs are associated with, and accumulated in, broad accounts out of necessity. In this section you will learn how costs are assigned to those accounts and how those costs can "flow" through another cost account. For example, inventory costs will become costs of goods sold, and work in progress (WIP) cost will become inventory costs. Be sure to complete the exercises at the end of this section before you move on.

Manufacturing companies, such as Ford Motor Company, necessarily have different income statements than other types of companies. Service companies, such as Ernest and Young, have a dramatically different income statement from Ford and dramatically different management accounting needs. Similarly, merchandisers, such as Home Depot, also require different income statement and management accounting information. In this section you will consider what the income statements of manufacturers look like—this is probably the most complex type of income statement.

Most of us learned the math skills required to be successful in management accounting in high school. The following video reviews these basic math skills.

Read all of Chapter 2. In this chapter, you discover that Custom Furniture Company is in a predicament. The company is not doing as well as its owner, Dan, thought it would. Dan prices his unique tables at 70 percent above what he thinks his production costs are, but his income statements do not reflect that markup. Dan may not be estimating his costs correctly and is, as a result, underselling his products.

Job costing systems record revenues and costs for unique products, like Dan’s tables; each table can be easily distinguished from other tables.

An alternate costing method that some companies chose is process costing. Process costing systems record revenues and costs for batches of identical units of product. When deciding whether to use a job costing or process costing system, you must understand a company’s products and production processes.

Job costing systems can do more than simply track the costs of each job. Companies also use these systems to track revenue and the resulting profit for each job. Also a job costing system can be used to identify areas of concern by comparing the cost estimate prepared before starting the job with information on the completed job cost sheet. This type of analysis often leads to changes in the production process and revised estimates for future jobs.

By the end of this unit, you will know why Custom Furniture Company is experiencing less profit than Dan had planned for. Job cost analysis confirmed that he was underestimating his costs and helped Dan focus on what management decisions he needed to make to remedy the issue.

Read sections 18.7 to 18.13 on pages 555 to 577. After you finish reading, work through the demonstration problems and self-test at the end of this chapter.

Watch this series of four videos from Tony Bell, which shows several good examples of job order costing.

Like Custom Furniture Company, SailRite Company, a maker of fine sail boats, is earning less profit than expected. Because SailRite makes many boats but only two models, job costing is not an appropriate costing system. Activity-based costing (ABC) is another method to allocate  costs.

Allocation of direct labor and direct materials are allocated the same regardless of which system is used. But overhead, an indirect manufacturing cost, can be allocated a number of ways, which each result in different cost for the same product. The goal is to find a system of allocation that best approximates the amount of overhead costs caused by each product.

ABC allocates overhead based on the activities that are driving the costs. The four steps to apply ABC are relatively straightforward. The key is to determine the appropriate cost driver for each activity. Note that job costing, process costing, and ABC use the same pool of costs. They are just three different ways of analyzing and allocating the cost pool.

At the end of “3.3: Using Activity-Based Costing to Allocate Overhead Costs” be sure to find out what is going wrong at SailRite and what two management actions or decisions could remedy the lower-than-expected profit.

Read sections 20.7 to 20.18 on pages 62 to 77. Remember to work through the demonstration problem and self-test at the end of this chapter.

In this series of three videos, Tony Bell covers the concepts that underlie activity-based costing. He considerers Zannon Corporation who, like SailRite, are experiencing sales growth but worryingly shrinking profits.

Work through each video, pen and pencil in hand, or create your own spreadsheets to follow along.

Desk Products Inc. mass produces wood desks. It maintains an advantage over its competitors by producing one desk in large quantities: 4,000 to 8,000 desks each month. Changes in the market are causing the CEO, Ann Watkins, to be prioritize keeping costs as low as possible.  The most efficient method to respond to this concern is to use process costing.

A process costing system is used by companies that produce similar or identical units of product in batches and employ a consistent process. A job costing system is used by companies that produce unique products or jobs. Process costing systems track costs by processing department, whereas job costing systems track costs by job.

Process costing is best used in an assembly-line production environment.  As you read this chapter, pay attention to how department costs are allocated based on the concept of equivalent units.

Be sure to pay close attention to the production cost report and the information it gives Ann Watkins. How does this improve her management decision making?

Read sections 19.1 to 19.13 on pages 9 to 35. Remember to work through the demonstration problem and self-test at the end of this chapter.

Bikes Unlimited is planning its monthly sales. They have recently concluded a successful advertising campaign and expect that sales will increase 10 to 20 percent. They need to know what happens if they adjust manufacturing to meet the predicted increase in sales and their predictions of sales are in fact true. How will increased sales volumes impact profit? First, you have to identify how costs behave with changes in sales and production—behavior depends upon whether the costs are variable, fixed, or mixed. Once you have classified our costs, you can set up an income statement in a "contribution-margin" format, that will give management a major tool in their decision making.

Variable Costs

The key to understanding and being able to classify a variable cost is to remember that you are thinking about how costs behave relative to production. Variable costs will fluctuate based on how much product is sold. The cost of purchasing chrome tubing for Bikes Unlimited is an obvious variable cost, some variable costs are not so obvious.

Fixed Costs

Fixed costs are incurred whether Bikes Unlimited sells zero units or a billion units. The payment of the annual lease on Bikes Unlimited's factory/warehouse is a good example of a fixed cost: Even if Bikes Unlimited chose to make no bikes, it would have to continue to pay its lease. There are two kinds of fixed costs: (1) some are "committed," those that must happen, such as the lease payment stated above, and others that are discretionary, such as advertising or research and development. Both of these activities could be suspended in the short term.

Mixed Costs

Bikes Unlimited also has mixed costs which have both a fixed and a variable components. You can think of your cell phone bill as a mixed cost. You pay a flat fee (fixed cost) for a certain number of minutes. If you exceed the set amount of minutes, then you have to pay by the minute (variable cost). Bikes Unlimited pays its sales staff based on a base salary plus a commission based on units sold and, finally, a year-end bonus based on overall profitability, which demonstrates all three cost behavior patterns.

Short/Long Term and the Relevant Range

Both short- and long-term costs are important factors in managerial decision-making. This section covers these variables and discusses them in terms of what is called the “relevant range” (also covered in the final section in this unit). The relevant range is the portion of the total cost curve that is beyond increasing returns to scale and before decreasing returns to scale. Within the relevant range, a doubling of variable cost inputs should approximately result in a doubling of output.

The following two video presentations by Tony Bell supplement and reinforce what your text has described. In the first video, Bell explores the actual behavior of costs and how you might normalize that behavior and use the costs in developing management decision tools.  In the second video, he extends his graphic model to explain cost behavior. Follow along with paper/pencil or your own spreadsheet program.

Work through this exercise to check your understanding of variable, fixed, and mixed costs.

Chapter 5, Section 2 of your textbook continues the story of Bikes Unlimited. You consider the four principle cost estimation methods to estimate fixed and variable costs. Each method has its advantages and disadvantages. The choice of a method will depend on the situation at hand. Experienced employees may be able to effectively estimate fixed and variable costs by using the account analysis approach. If a quick estimate is needed, the high-low method may be appropriate. The scatter-graph method can be used to identify any unusual data points which can be thrown out when estimating costs. Finally, regression analysis can be run using computer software and its precise results will provide more accurate cost estimates.

Special Note:

This unit makes extensive use of the algebraic equation of a straight line. Remedial help with the form and use of this equation is available at “Equation of a Straight Line” here.

In this video, Tony Bell demonstrates how the high-low method is applied to Danny Office Supplies to estimate the next month’s shipping costs. The account analysis is a method of cost analysis that requires a review of accounts by  experienced employees to determine whether the costs in each account are fixed or variable. This approach is perhaps the most common starting point for estimating fixed and variable costs. The high-low method starts with the highest and lowest activity levels and uses four steps to estimate fixed and variable costs.

In this video, Bell demonstrates how the scattergraph method is applied to Danny Office Supplies to estimate the next month’s shipping costs. The scattergraph method has five steps and starts with plotting all points on a graph and fitting a line through the points. This line represents costs throughout a range of activity levels and is used to estimate fixed and variable costs. The scattergraph is also used to identify any outlying or unusual data points.;

Regression analysis forms a mathematically determined line that best fits the data points. Software packages like Excel are available to perform regression analysis. This method is also called the Least Squares Regression.

In the following video, Bell demonstrates how regression analysis is applied to Danny Office Supplies to estimate the next month’s shipping costs. Bell does this by using Microsoft Excel where regression analysis is a built in function. See the optional appendix to Unit 3 if you would like to learn how to use this Excel function.

This section considers the contribution margin income statement, which shows fixed and variable components of cost information. Revenue minus variable costs equals the contribution margin. The contribution margin minus fixed costs equals operating profit . This statement provides a clearer picture of which costs change and which costs remain the same with changes in levels of activity.

In Chapter 5, Section 4 of the textbook, you will return again to the relevant range. Along with the  assumption of linearity, the relevant range must be considered when estimating costs using the methods described in this unit. When costs are estimated for a specific level of activity, the assumption is that the activity level is within the relevant range. Costs are estimated assuming that they are linear. Both assumptions are reasonable as long as the relevant range is clearly identified, and the linearity assumption does not significantly distort the resulting cost estimate.

This section is optional because it specifically addresses Microsoft Excel software, which you are not required to have in order to take this course. Regardless, regression analysis is an important part of managerial accounting. It provides the best fit between independent variables and allows the best estimations to be made, through extrapolation. The following section provides students with a guide to performing regression analysis with Microsoft Excel. Most spreadsheet programs provide this function.

In this unit, Snowboard Company uses CVP analysis to determine its break-even point and what additional volumes it would need to sell to achieve a decent profit. CVP assumes that the selling price per unit is the same throughout the relevant range. Cost-volume-profit analysis involves finding the break-even point and target profit point in units and in sales dollars. The key formulas for an organization with a single product are developed and explained in the reading.

In this video, Tony Bell walks through an example of applying CVP analysis.

Seldom are financial predictions exactly correct; there is a natural variance in predictions. As a result of this natural variance, managers should always be aware of how sensitive are their predictions to fluctuations in the model’s variables. Sensitivity analysis shows how the cost-volume-profit model will change with changes in any of its variables. Although the focus is typically on how changes in variables affect profit, accountants often analyze the impact of uncertainty on the break-even point and target profit as well.

This section explores the effects that various loads of fixed costs have on CVP analysis. The amount of fixed costs (cost structure) that a company carries is often established by the type of industry it operates in. The cost structure of a firm describes the proportion of fixed and variable costs to total costs. Operating leverage refers to the level of fixed costs within an organization. The term “high operating leverage” is used to describe companies with relatively high fixed costs. Firms with high operating leverage tend to profit more from increasing sales, and lose more from decreasing sales than a similar firm with low operating leverage

In this section, you will examine the case of Kayaks-For-Fun, which has limited amounts of labor. How do they manage those constrained units of labor to maximize profits? Many organizations operate with limited resources in areas such as labor hours, machine hours, facilities, or materials. The contribution margin per unit of constraint is a helpful measure in determining how constrained resources should be allocated.

The three videos in this subunit continue Tony Bell's series on CVP analysis. Watch parts two through four below to see more real applications of CVP analysis. Bell continues the ABC Company's project begun in Part 1.

Read the introduction to Chapter 7, and then click the link at the top right for "Next Section" to read Section 1. Best Boards will use differential revenues and costs to show the difference in revenues and costs among alternative courses of action. Differential analysis is useful in making managerial decisions related to making or buying products, keeping or dropping product lines, keeping or dropping customers, and accepting or rejecting special customer orders. Later in this subunit, you will examine each of these four scenarios for which differential analysis can be used to assist managers' decision-making.

Watch this video, in which Tony Bell lays out the relevant costs for decision-making and defines some of the terms that he will use in the remainder of this series. Remember, sunk costs are not relevant to decision-making, but differential costs (different costs between alternatives) are relevant.

The important terms discussed in this unit are outlined here for your reference.

Managers often use differential analysis to determine whether to keep or drop a product line. Direct fixed costs are typically eliminated if a product line is eliminated and are therefore considered differential costs. Allocated fixed costs are typically not eliminated if a product line is eliminated and are not differential costs. Managers compare sales revenue and costs for each alternative (keep or drop) and select the alternative with the highest profit.

Bell considers Jen’s Sweaters which has been experiencing losses and is considering eliminating a product line. Be sure to follow along in your notes.

Best Board's decisions is whether to make its own wakeboards or buy them from a supplier. Differential analysis requires the identification of all revenues and costs that differ from one alternative to another. In general, managers select the alternative with the highest profit. If the only differences between the alternatives are with costs (as in the make-or-buy decision for Best Boards), decision-makers would select the alternative with the lowest cost.

In this video, Tony Bell examines a make-or-buy decision that Snazzy Jazzi Footwear is trying to make and how differential analysis can be used to assist with that snappy decision.

Managers use differential analysis to determine whether to keep or drop a customer. The format is similar to the differential analysis format used for making product line decisions. However, sales revenue, variable costs, and fixed costs are traced directly to customers rather than to product lines.

Tony’s T-shirts makes shirts for local sports teams, and occasionally Tony will receive special orders that involve additional costs. How does Tony go about deciding whether or not to accept these special orders? Managers often use differential analysis to decide whether to accept a special one-time order made by a customer. Managers compare sales revenue and costs for each alternative (accept or reject the special order) and select the alternative with the highest profit. Organizations must be careful to consider the long-run implications of reducing prices for special orders.

Kaatz is the only producer of Ting. Kaatz has received a special order for 5000 units. How can Kaatz make a sound financial decision? Bell explores the thing about Ting and if Kaatz can.

In this section, you will explore other pricing systems and why companies may choose to use them. Cost-plus pricing starts with an estimate of the costs incurred to build a product, and a certain profit percentage is added to establish the price. Companies often use this method when it is difficult to determine a reasonable market price. Target costing integrates the product design, desired price, desired profit, and desired cost into one process beginning at the product development stage.

Although accountants are responsible for providing relevant and objective financial information to help managers make decisions, qualitative factors also play a significant role in the decision-making process.

Read the introduction to Chapter 9. When you have finished, click on the link at the top right to go to the next section and read "9.1 Planning and Controlling Operations."

Jerry’s Ice Cream knows that a good budget is the result of consulting with all levels of the company and having a well-rounded budget committee to prepare the master budget. As a planning document, it is essential that all levels of the company share in the creation of the master budget and are prepared to fully implement it. 

Budgeting is vital to the planning and controlling phases of the management cycle. For a company that has ends its fiscal year on December 31, the budgeting process may start as early as August.

The master budget for Jerry’s Ice Cream has numerous schedules, including budget schedules for sales, production, direct materials, direct labor, manufacturing overhead, selling and administrative, the income statement, capital expenditures, cash, and the balance sheet. The sales budget is most important because sales projections drive the other budgets.

To get the most out of this unit, you should attempt to recreate your own master budget for Jerry’s Ice Cream using Microsoft Excel. Furthermore, watch the series of videos below for more practice with master budgets.

Note this is an extensive section of Chapter 9 with five subsections that are unnumbered in the text. They are:

• Sales and Production Budgets
  
• Direct Materials Purchases Budget
  
• Selling and Administrative Budget
  
• Capital Expenditures Budget /Cash Budget  and 
  
• Budgeted Balance Sheet.
  

If you are going to use Excel, each schedule should be a separate sheet. Be sure to include all sums and linkages as you prepare your own master budget.

The examples used thus far to describe a master budget have been limited to manufacturing companies. Manufacturing companies tend to have comprehensive operating budgets and therefore serve as a good starting point in learning how to develop a master budget. However, all types of organizations use operating budgets. This section describes operating budgets for merchandising, service, and not-for-profit organizations.

This section considers the inherent conflict that can exist between the planning and control phases of budgeting. During the planning phase, organizations are most concerned about getting accurate estimates that lead to positive results. The control phase requires evaluating performance of CEOs, managers, and employees by comparing actual results to the operating budget. CEOs, managers, and employees often must decide between doing what is best for them and what is best for the organization.

Read the introduction to Chapter 10. When you have finished, click on the link at the top right to read the next section. Rarely will the assumptions of the master budget be completely accurate. As a result, organizations use a modified budget called a flexible budget. A flexible budget is a revised master budget based on the actual activity levels. The flexible budget represents what costs should be – based on the actual levels of sales/activity. In this unit, the text assumes beginning and ending finished goods inventory are the same and therefore units produced and sold will be the same.

As you read this Section follow along with how Jerry’s Ice Cream handles a doubling of expected sales -- sweet news! The summer was hotter and longer than usual! As they modify their master budget, follow along with the budget you created in Excel and modify it. as well, but keep your mater budget intact. All you have to do is save a copy of the master file with a different file name.

Tony Bell provides us with two examples of how flexible budgets may be prepared and used. You should work along with Tony. Pencil and paper are okay, of course, but creating an Excel file will provide a more permanent record. In the first video, Bell provides a general discussion of flexible budgets and their use. In the second budget he solves a typical exam question about flexible budgets.

In this section you examine what happens when the master budget plan deviates significantly from the assumptions used to develop it. When deviation from the master budget becomes apparent, one of the possible causes is that actual costs were not known when the master budget was developed and standard costs were used.  Standard costs are those costs that management expects to incur to provide a good or service and are typically stated as a cost per unit. Standard cost is based on the combination of price (or rate) and quantity (or hours) . They serve as the “standard” by which performance will be evaluated and are used to produce the master budget.

This section continues the story of Jerry’s Ice cream – follow along and document how they used standard costs to develop a master budget and how that contributes to variance from the actual results.  You should note that a standard cost is  a per unit cost while a master budget cost is total cost at a given standard level of activity/standard quantity of units.

Jerry’s Ice Cream is concerned about cost overruns in direct materials. This section examines "causation" in direct materials variance. The master budget amount allocated to direct materials is made up of two estimated parts, the quantity (Q) of materials included and the price (P) of those materials. Any variance in this cost category from the master budget can be accounted for by an increases or decrease in P and/or Q. Attribution of the variance to its cause(s) is critical to management decisions.

Bell continues on with examples from Steve’s Sausages. He uses a diagrammatic method to calculate direct materials variance. His diagram integrates standard and actual measures of price and quantity. By following his method you will be able to break down variance into those factors associated with quantity changes and price changes.

Jerry’s Ice Cream wants to know why there are cost overruns for direct labor. This section considers another significant factor in variance: direct labor. Like direct material variance, direct labor variance has two possible causes: labor rate variance and labor efficiency variance. As with materials any variance in this cost category from the master budget can be accounted for. Attribution of the variance to its cause(s) is critical to management decisions.

In this video, Bell demonstrates his diagrammatic method of separating causes of variance and their attribution. Bell works with Frank’s Bikes. Frank has fixed amounts of labor, a slight twist on the Jerry’s Ice Cream case where they have a variable amount of labor. Small and large companies differ in how they manage their labor supply, as do companies with one product as compared to companies with many products.

Your final piece of the puzzle for Jerry’s Ice Cream is variable manufacturing overhead variance.  Variable manufacturing overhead variance has two distinct variances. When you calculate both variances, one is favorable and the other not.  The two variances are the spending variance and efficiency variance. The variable overhead spending variance is the difference between actual costs for variable overhead and budgeted costs based on the standards.

In this Module Bell demonstrates his diagrammatic method of finding the variances. His client Widgets R Us – has unfavorable variances and he explores reasons why this could happen.

In reality at Jerry’s Ice Cream or any other company each budget line item could have/has an associated variance. The question becomes which variances should be investigated? As a decision maker you have limited resources and should allocate those resources to their most productive use. Every investigation consumes resources and has a direct expense associated with it. Being judicious in selecting and investigating variances is required of all managers. Let’s return to Jerry’s Ice Cream and determine which variance you would track and examine.

If a company, such as Jerry’s Ice Cream is using ABC (activity-based costing) it cannot establish one standard variable overhead rate and standard quantity based on one cost driver. The ABC companies must establish several standard variable overhead rates and quantities, each having its own cost driver. Regardless of whether a company uses the traditional costing approach or an activity-based costing approach, the process of performing variance analysis is consistent. Suppose Jerry’s Ice Cream identified three significant activities, let’s see how ABC can be used with variance analysis!

Recall that fixed overhead in the Master Budget is the same as fixed overhead in the Flexible Budget because, fixed costs do not change with changes in units produced. Fixed manufacturing overhead variance analysis involves two separate variances: the spending variance and the production volume variance.  This unit applies this management measure to Jerry’s Ice Cream. Calculating the two variances informs management if they are applying enough overhead to the operation.

This section provides an overview, summary and conclusion to this unit. In this unit you examined a standard costing system, where all inventory accounts reflect standard cost information. The differences between standard and actual data are recorded in the variance accounts and the manufacturing overhead account, which are ultimately closed out to cost of goods sold at the end of the accounting period.

Jackson’s Quality Copies, a store that makes photocopies for its customers and that has several copy machines wants to evaluate the purchase of an expensive new copier, that could reduce expenses, increase productivity and increase profits. It costs $50,000. Julie Jackson the President has to make the decision if the new copier is actually a good or bad addition. Managerial accounting methods can give her several tools to evaluate this investment. You use two methods to evaluate long-term investments, both of which consider the time value of money. The first is called the net present value (NPV) method, and the second is called the internal rate of return method. Before you start to consider the two methods, let’s discuss the time value of money (present value) concept first.

NPV combines the present value of all cash flows associated with an investment - both positive (for example from sales)  and negative (from expenses) into one figure suitable for management decisions making. The term discounted cash flows is also used to describe the NPV method. One critical factor in determining the NPV is the discount rate: that is, what time value (forgone interest rate) does you associate with future receipts of money.

The concept “the time value of money” is vital to understanding Net Present Value. The time value of money basically is that a dollar received today is worth more than a dollar received in the future.

A hundred dollars given up today is not worth $100 upon its return in three years because there is an opportunity cost of forgoing the use of that money for those three years. If I invested $100 this year for three years at an annual rate of 4%, that $100 would be worth about $112.33 at the end of year three (given compounding). So if I was to forgo that $100 now and receive it in three years, I would want to receive at least $112.33 at term. Similarly, if someone said I will pay you $100 in three years I would not give them $100 now – it would be less!

For capital budgeting decisions, the issue is how to value future cash flows in today’s dollars. The term cash flow refers to the amount of cash received or paid at a specific point in time. The term present value describes the value of future cash flows (both in and out) in today’s dollars.This resource provides an introduction to the time value of money. It is important to understand the basics of time value of money.

Using the internal rate of return (IRR) to evaluate investments is similar to using the net present value (NPV) in that both methods consider the time value of money. The IRR represents the time-adjusted rate of return for the investment being considered. The IRR decision rule states that if the IRR is greater than or equal to the company’s required rate of return (recall that this is often called the hurdle rate), the investment is accepted; otherwise, the investment is rejected. This method ensures that any capital investments the company makes are at least equal to the existing rate of return on capital or exceed it. The ‘hurdle rate’ will vary from company to company.

This resource is an excellent guide to the present value of money and its many applications.

Julie Jackson’s life would be easier if all she had to do was find a number and use it to make a decision. “Yes! I will buy the new copier. The NPV, and IRR say yes.” Unfortunately life is seldom as easy as following a formula. Other factors affect what Julie Should do. In this section you consider some of those factors.

You hear people talk about "payback period." "I live in Nevada where there are 280 days each year are bright and sunny. Yes, I am going solar! My payback period is seven years on a domestic hot water system powered by the sun.” The payback period, typically stated in years, is the time it takes to generate enough cash receipts from an investment to cover the cash outflows from the investment. The method uses a simple sum of future earnings/savings over an arbitrary time period to evaluate capital improvements. It is a quick way to look at an investment and sort potential investments, but the payback method is somewhat lacking in rigor.

When you have finished reading chapter 8.6, click the link at the top right to move on to 8.7 and read it. There are three additional items related to estimating cash flows that must be considered:

1. Investment cash outflows
2. Working capital
3. Effect of income taxes

These two sections will discuss how these considerations impact long-term investment decisions.

Read the introduction to Chapter 11. When you have finished, click on the link at the top right and read Section 1. Game Products, Inc. has experienced significant growth in volume, market area and products. It is now operating internationally and has three broad product lines board games, computer game making, and sporting goods. Games Inc. has three distinct marketing areas and three distinct product lines. Management decided to decentralize its operation and needed to revamp its management information system to provide relevant and timely information about its different product lines in its different location. Decentralization has both pros and cons.

Responsibility centers can be based on such attributes as sales regions, product lines, or services offered. In Game Inc. case there are three responsibility centers based on product line. The purpose of establishing responsibility centers within organizations is to hold managers responsible for only the assets, revenues, and costs they can control. The level of control a manager has over a segment’s assets, revenues, and costs will help determine the type of responsibility center used for each manager.

With this approach responsibility centers are allocated budgets and their revenues and costs (variable and fixed) are tracked. Each center has a responsibility income statement. Responsibility center expenses are allocated to direct variable costs and direct fixed costs. The responsibility center contribution margin is determined by reducing revenue by variable costs. Subtracting allocated fixed costs from the contribution margin yields the responsibility margin.

Games Inc. President’s starting point for evaluating investment centers is with reviewing segmented income for each investment center (or division). Segmented income is segment revenues minus segment expenses. She is interested in the level of profit that each of the three divisions generates, and segmented income gives her this information, but as you will see there are limitations to using this method solely.

Games Inc. will also consider the Return on Investment (ROI) generated by each division as an evaluative metric. ROI is one of the most common measures of performance for managers responsible for investment centers. ROI is a basic measure but the method of its calculation can vary between organizations – like different types/brands of peanut butter.

A further evaluative metric that Games Inc. can use is residual income. Residual income (RI) provides a measure of income that is available to the whole organization. A manager’s goal is to increase her RI from year to year. Most organizations that use RI also use ROI. Using both measures has the benefit of comparing one division to another by using ROI and minimizes the conflict between company goals and division goals by using RI.

Mandy Dwyer, the President of Game Products, Inc., meets with her management accountant and goes over his work. They chose three metric to help with controlling their decentralized divisional operation – net income, profit margin ratio, and ROI. Their final step is to integrate these performance measures with a compensation plan for their operations managers.

The statement of cash flow provides cash receipt and cash payment information and reconciles the change in cash for a period of time. Cash receipts and cash payments are summarized and categorized as operating, investing, or financing activities. Simply put, the statement of cash flows indicates where cash came from and where cash went for a given period of time. Time is the important point of a cash flow, as in life, in business timing is everything. Without adequate cash flow suppliers could well refuse to deliver essential inputs and choke of your production and revenue stream. Once you have learned some of the basics of cash flow you will look at a typical case. The CEO of Home Store wants to know “where has the money gone”? Home Store is profitable but there is no money in the bank. You will soon see why this might be.

In this video, Tony Bell provides a rationale for cash flow statements and introduces basic terms.

Cash flow is essential and because of this it take many forms and can be measured in numerous ways. The following considers the usual methods of describing cash flow.

Operating activities include cash activities related to net income (revenues and expenses are included in net income).

Investing includes cash activities related to noncurrent assets. Noncurrent assets include (1) long-term investments; (2) property, plant, and equipment; and (3) the principal amount of loans made to other entities.

Financing includes cash activities related to noncurrent liabilities and owners’ equity. Noncurrent liabilities and owners’ equity items include (1) the principal amount of long-term debt, (2) stock sales and repurchases, and (3) dividend payments.

The statement of cash flows is based on cash only, and when used for accrual accounting based companies, adjustments must be made to convert accrual basis information to a cash basis. In addition to reconciling the three statement activities (the income statement, balance sheet, and statement of owners’ equity), cash flows need to have certain adjustments made to them. One of the main ones is adjusting the statement for ‘non-cash transactions’, the main one being depreciation. There are four steps used to create a cash flow statement.

You can now get to Home Store and the CEO's question: “where’s the money?” The information needed to prepare Home Store’s statement of cash flows includes the balance sheet, income statement, and other selected data.

This video provides a walkthrough of the indirect method of preparing a statement of cash flows.

Investing activities focus on the effect that changes in noncurrent assets have on cash. Noncurrent asset balances found on the balance sheet, coupled with other information (e.g., cash proceeds from sale of equipment) are used to perform this step. The financing activities section focuses on the effect changes in noncurrent liabilities and owners’ equity have on cash. Noncurrent liabilities and owners’ equity balances found on the balance sheet, coupled with other information (e.g., cash dividends paid) are used to perform this step.

Investing activities focus on the effect that changes in noncurrent assets have on cash. Noncurrent asset balances found on the balance sheet, coupled with other information (e.g., cash proceeds from sale of equipment) are used to perform this step. The financing activities section focuses on the effect changes in noncurrent liabilities and owners’ equity have on cash. Noncurrent liabilities and owners’ equity balances found on the balance sheet, coupled with other information (e.g., cash dividends paid) are used to perform this step.

In this video, Tony Bell explains how to prepare the investing and financing sections of a cash flow statement.

The same four steps apply to preparing a statement of cash flows using the direct method as with the indirect method. The only difference is how the operating activities section is presented in step one; all other steps are the same as presented in the chapter. Although presentation of the operating activities section using the direct method differs from the indirect method, the end result is exactly the same.

In this video, Tony Bell uses the direct method to prepare a statement of cash flows for Turner Inc. You will note that this method yields the same results as the indirect method.

There are numerous ways to analyze financial statements. Cash flow has two major ratios, the operating cash flow ratio and the capital expenditure ratio, and a "dollar-number" (the free cash flow) that are used to interpret and communicate information about cash flow within the company and make comparisons among companies.

In this video, Tony Bell finishes his cash flow work on Turner Inc. by doing a rudimentary analysis of Turner Inc.’s cash flow statements.

Financial stability is an important attribute of how your company is perceived by customers and competitors. Similarly your company will be evaluated by others – customers, supplier or stakeholders. All but privately held corporations published annual financial information; even privately held corporation can be and often are asked for their financials. The principles of managerial accounting are used to determine trends and ratios to evaluate the strength of each company’s income statement and balance sheet. Trends and "common size analysis" and ratio analysis are all used to make intra- and inter- comparisons of performance.  This unit should give you a better idea about how financial stability is determined and used for any company.

Financial analysis is an important skill set which integrates all that you have learned so far in this course. Think about your own skills, having completed most of this course. Can you do what it is that Tony is talking about?

You have already seen ‘trend analysis’. You called it ‘least squares’ or ‘regression analysis’, better still linear regression analysis. This was discussed in Unit 3. Here you look at how relevant variables move (increase or decrease) over time. The idea is to use that movement to spot problems, i.e. declining profits or increasing sales. Trend analysis looks for both strengths and weaknesses. It separates out one-time events and negates the need for anecdotal evidence. It is an objective measure of performance over time. The time measured can be year to year or for multiple years. This method is also known as horizontal analysis.

Watch as Bell does an horizontal/trend analysis for Elky Co.

When you are dealing with many numbers of comparatively large magnitudes, it becomes difficult to distinguish important features or attributes of those numbers. With common size analysis, you reduce numbers to percentages and then compare percent difference. For example if you have a company that has $450,000 in profit on sales of $2,220,000, while another has profit of only $375,000 on sales of  $1,500,000, how do you compare these numbers? This is the strength of common size analysis, which is also known as vertical analysis.

Tony Bell helps a client, Harpreet Gill, compare his financial statements to another company's statements with vertical analysis.

The most robust type of analysis is ratio analysis. A ratio is a comparison of two numbers and normally takes the form of a fraction, decimal or percentage. A ratio can be specific to a company, to companies within a region, to an industry or to a stock exchange. Ratios are versatile and powerful. Ratios are powerful. In the text you are shown how to use ratios to explain and compare companies, to companies or companies to industries.

There are four basic types of ratios that you will learn about: 

1. Ratios used to measure profitability
   
2. Ratios used to measure short-term liquidity
   
3. Ratios used to measure long-term solvency
   
4. Ratios used to measure market valuation.
   

In these two videos, Tony Bell examines the financial statements for Squirrel Co. and develops several examples of useful ratios.

Before you read the final two sections of Chapter 13, go back to the beginning of this chapter and review the problem Chicken Deluxe had. Review the analysis that the management accountants at Chicken Delux produced and note the use of all the elements you have been reading about in this unit. In coming to a management decision, seldom will numbers provide an answer on their own. A good CEO and a good team will also consider nonfinancial performance measures in coming to a decision. This process of considering nonfinancial performance measures is considered and you will note how similar the methodology  is to those we have discussed above for financial performance measures.