BUS105 Study Guide

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Study Guide Structure

In this study guide, the sections in each unit (1a., 1b., etc.) are the learning outcomes of that unit. 

Beneath each learning outcome are:

• questions for you to answer independently;
• a brief summary of the learning outcome topic;
• and resources related to the learning outcome. 

At the end of each unit, there is also a list of suggested vocabulary words.

How to Use this Study Guide

1. Review the entire course by reading the learning outcome summaries and suggested resources.
2. Test your understanding of the course information by answering questions related to each unit learning outcome and defining and memorizing the vocabulary words at the end of each unit.

By clicking on the gear button on the top right of the screen, you can print the study guide. Then you can make notes, highlight, and underline as you work.

Through reviewing and completing the study guide, you should gain a deeper understanding of each learning outcome in the course and be better prepared for the final exam!

Unit 1: Managerial Accounting

1a. Explain the differences between financial accounting and managerial accounting

• What are the main differences between financial accounting and managerial accounting?
• Who are the users that are being targeted in managerial accounting reports?
• Why do managerial accounting reports include projections about the future?
• Why do managerial accounting reports tend to be more detailed than financial accounting reports?

The main differences between financial accounting and managerial accounting lie in who the intended users of the accounting information are. For the most part, financial accounting is aimed at outside users, such as shareholders, investors, and creditors. Managerial accounting, on the other hand, is focused on internal users such as managers and upper-level management. Managerial accounting provides information to managers in order to enable them to make informed and timely decisions regarding operations within the organization. 

Managerial accounting, aimed at helping managers make informed decisions, generally includes both historical information as well as projections about the future. In contrast, financial accounting only includes information regarding a firm's past performance. Additionally, managerial accounting tends to include details like non-financial information in addition to financial information. Finally, financial accounting is governed by the Financial Accounting Standards Board (FASB), while managerial accounting has no such governing body. Each organization is free to produce whatever reports it feels are necessary and helpful in aiding management's decisions. 

Review Table 1.1 in Characteristics of Managerial Accounting.

1b. Explain the functions of various accounting personnel, such as the controller and accounting staff

• What are the two main functions of managerial accounting personnel?
• How are these two functions manifested in the managerial accounting process?
• What role do managers play in the managerial accounting process?

The two main functions of managerial accountants are planning and control. Planning is the process of establishing goals for an organization and communicating these goals to the entire organization. After a plan is implemented, managers review the effectiveness of the plan and make any changes that are necessary for the next accounting period and beyond. This is referred to as control. 

Organizations usually formalize their plans with a budget. A budget is a group of interrelated reports on the expectations of the performance of various components of the organization. The various budgets (such as production, sales, and cash budgets) all come together to form the master budget. Each employee should have a clear picture of the budget in order to properly fulfill their specific duties while staying aligned with the goals of the organization as a whole. 

In most organizations, the controller is the top management accountant. The controller has the responsibility of preparing the proper managerial accounting reports at the proper time. The controller must determine what information is important at that particular time for decision-making. The controller leads the accounting staff who manage the day-to-day managerial accounting of the company. The accounting staff generally reports to the controller, who in turn reports to the Chief Financial Officer (CFO).

Review Planning and Control Functions Performed by Managers and Key Finance and Accounting Personnel.

1c. Describe standards of ethical conduct in the field of accounting and how the field addresses ethical conflicts

• What sort of ethical dilemmas may arise as a managerial accountant?
• What resources are provided by the managerial accounting industry to assist in ethical decision-making?
• What are the four core responsibilities as defined by the Institute of Management Accountants? 

As a managerial accountant, ethically unclear situations arise occasionally. To help accountants make ethically sound decisions, the Institute of Management Accountants (IMA) developed a Statement of Ethical Professional Practice. This statement provides standards and guidelines that assist accountants in choosing an ethically acceptable course of action. The statement includes four core responsibilities for every accountant. These are competence, confidentiality, integrity, and credibility. The statement also provides guidelines on how to resolve ethical conflicts.

When an ethical dilemma does occur, the IMA recommends always following policies that have been established by the organization. If these policies do not exist or do not help in resolving the problem, the IMA recommends discussing the situation with an immediate supervisor, an objective adviser, or an attorney, if necessary. 

Aside from that provided by the IMA, further guidance on ethical issues is also provided by other organizations such as the AICPA, the IFAC, and the SEC. 

Review Figure 1.2 in Ethical Issues facing the Accounting Industry.

1d. Explain the benefits of computerized accounting systems

• Why are computerized accounting systems important for companies and organizations?
• What are some of the things to look for when setting up a company's accounting system?
• How does an enterprise resource planning system aid in beneficial managerial accounting practices? 

Information technology has a big effect on managerial accounting. Companies use computerized systems for all components of a business from ordering and purchasing to manufacturing, sales, and collections. A good computerized accounting system provides relevant and up-to-date information that assists managers in making informed and timely decisions. 

In order to provide accurate, relevant, and up-to-date information, computer systems must be integrated with all segments of a business. An enterprise resource planning (ERP) system is designed to record and share information across many divisions of a firm, as well as across geographical areas. This enables everyone involved in a company to share and access information in an easy and timely manner. In turn, this leads to better decision-making.

For a smaller company that is first starting out, a large system such as an ERP may not be cost-effective. There are many smaller software packages that are available and that can help with managerial accounting. When choosing software for a business, care must be taken to ensure that the costs do not outweigh the benefits. 

Review Computerized Accounting Systems.

1e. Use cost terminology to describe the flow of manufacturing costs

• What are the two broad categories of costs used in managerial accounting?
• What are the three types of manufacturing costs?
• What costs are included in manufacturing overhead?
• How do manufacturing costs flow through the balance sheet and income statement accounts?
• What is the difference between selling costs and general and administrative costs?

One of the main methods of making managerial decisions involves classifying costs. There are two broad categories of costs: Manufacturing costs (also called product costs) and non-manufacturing costs (also known as period costs). Manufacturing costs consist of any cost that is directly and easily traceable to a product being produced (or service provided). These include costs such as direct materials and direct labor. It also includes manufacturing overhead which consists of items that are part of the product but not as easily traceable. These include indirect materials and indirect labor as well as other manufacturing costs. Manufacturing costs are sometimes called product costs as they are the costs that are included in the products. Throughout the production process, these costs are listed on the balance sheet as inventory. Originally, they are debited to a raw materials inventory account. As they are used in production, they move to a work-in-process (WIP) inventory account and then to a finished goods inventory account when they are completed into finished products. These costs are only expensed as the cost of goods sold when the finished products are sold. 

Non-manufacturing costs include any costs that are not associated with the production of a product (or providing a service). These are divided into selling costs, which are costs associated with selling the goods, and general and administrative costs which include all other costs such as rent for office space, insurance, human resources, and legal costs. Non-manufacturing costs are sometimes called period costs as they are the costs that are not included in the products, but rather are expensed each period, regardless of production or sales.

Review: 

• Cost Terminology
• Table 1.4 and Figure 1.6 in How Product Costs Flow through Accounts

1f. Prepare an income statement for a manufacturing company

• What is the main difference between a manufacturing company and a merchandising company?
• What is the basic cost flow equation?
• What three schedules are necessary in order to create an income statement for a manufacturing company?

As opposed to a service company that has no cost of goods sold, or a merchandising company that buys and sells finished goods, a manufacturing company will have inventory at different stages of production. As such, the calculation of the cost of goods sold for a manufacturing company is more complex than for a merchandising company. 

In order to properly calculate the Cost of Goods Sold, a manufacturer makes use of the basic cost flow equation which states:

Beginning balance (BB) + Transfers in (TI) - Ending balance (EB) = Transfers out (TO)

Using this equation, the manufacturer can calculate the cost of raw materials used in production, cost of goods manufactured, and cost of goods sold. Using a schedule of raw materials placed in production, and a schedule of cost of goods manufactured, manufacturers can create a schedule of cost of goods sold which will produce the cost of goods sold that will appear on the income statement.

Review Income Statements for Manufacturing Companies.

Unit 1 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• basic cost flow equation
• budget
• control
• controller
• cost of goods sold
• direct labor
• direct materials
• enterprise resource planning (ERP) system
• ethical dilemma
• finished goods inventory
• indirect labor
• indirect materials
• managerial accounting
• manufacturing costs
• manufacturing overhead
• non-manufacturing costs 
• period costs
• planning
• product costs
• raw materials inventory
• work-in-process (WIP) inventory

Unit 2: Job Costing

2a. Describe how job costing systems assign direct material costs, direct labor costs, and manufacturing overhead costs to jobs

• How does a manufacturer determine the cost of each unit of a good produced?
• How are overhead costs such as electricity, rent, and insurance applied to individual goods?
• Aside from tracking costs, what are some other benefits provided by job order costing?
• What are some examples of jobs that would lend themselves well to using job order costing?

Companies that produce items or provide services that are unique, generally use job costing. In job costing, all costs of a particular job are traced and applied to that job. Direct material cost is traced using material requisition forms. Direct labor costs are traced using timesheets. Finally, manufacturing overhead costs are applied using a manufacturing overhead rate. Each job is assigned a unique number and the costs are accumulated on a job cost sheet. 

Job costing allows managers to track revenue and resulting profit from each job. Additionally, in a job costing system, companies can compare pre-production cost estimates with the completed job cost sheet. Inefficiencies can then be noted and addressed for the future.

Review How a Job Costing System Works.

2b. Use a job costing system to track costs and evaluate profitability for each job

• What types of manufacturing jobs lend themselves well to job order costing?
• What is the name of the paper that collects all the costs for a specific job?
• How is a job costing system helpful in tracking profits?

A job costing system accumulates all costs for a specific job on a job cost sheet. These sheets serve as a subsidiary ledger for the work-in-process inventory account. Direct materials and direct labor are recorded on these cost sheets. Managerial overhead is also recorded by using a predetermined overhead rate. 

Managers can then apply revenue earned for each job and determine the profitability for that job. If there are differences between these amounts and what was originally estimated, further investigation into what caused these differences may be necessary. 

Review How a Job Costing System Works.

2c. Demonstrate how the plant-wide, departmental, and activity-based methods each allocate manufacturing overhead costs

• What are some common cost drivers that are used in determining overhead allocation rates?
• How should managers determine which cost driver to use?
• Which method of allocating overhead costs, plant-wide or departmental, leads to a more precise allocation of costs?

Manufacturing overhead costs can be allocated in different ways. For any method, an allocation rate must be established. This is done by dividing the estimated overhead costs by some allocation base. This is usually done using a cost driver. The cost driver can be anything which is related to the overhead costs. Some common examples are labor hours, labor costs, or materials costs. Once the allocation rate is determined, overhead costs can be allocated based on actual activity.

In the plantwide allocation method, one predetermined overate rate is used across production. Each unit produced in the plant would have overhead costs added to it based on the same allocation rate. In departmental allocation, individual cost pools are formed for each department as opposed to the entire plant, resulting in separate predetermined overhead rates for each department. This leads to a more precise allocation of the overhead costs. Finally, activity-based costing (ABC) allocates overhead costs based on different activities and requires a number of different overhead allocation rates to be calculated.

Review Approaches to Allocating Overhead Costs and Using Activity-Based Costing to Allocate Overhead Costs.

2d. Use activity-based costing to make business and management decisions

• What are the five steps of activity-based costing?
• How can managers make use of ABC to improve efficiency?
• What are the three steps of activity-based management?

Activity-based costing (ABC) uses the idea that since all production requires numerous activities, and these activities incur costs, the cost of various activities should be allocated to products based on the products' use of the activities. ABC makes use of cost pools, organized by activity, to allocate overhead costs. These activities can include anything such as purchasing materials, setting up machinery, assembling products, and inspecting finished products.

A cost driver, or action associated with each activity, is identified. A separate allocation rate is determined for each activity. When jobs are completed, overhead costs are allocated based on the numerous different cost pools in use. Since each activity has costs associated with it, managers can determine which activities are value-added and which are non-value-added. Thus, efficiency can be improved by trying to minimize the number of non-value-added activities. This is part of the process referred to as activity-based management (ABM).

Review Using Activity-Based Costing to Allocate Overhead Costs and Using Activity-Based Management to Improve Operations.

Unit 2 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam. 

• activity-based costing (ABC)
• activity-based management
• allocation base
• allocation rate
• cost driver
• cost pools
• departmental allocation
• job costing
• job cost sheet
• manufacturing overhead rate
• material requisition forms
• non-value-added
• plantwide allocation method
• predetermined overhead rate
• timesheets
• value-added

Unit 3: Process Costing

3a. Explain the differences between the job costing and process costing methods

• Why is there a difference in costing methods between manufacturing and service companies?
• What types of services or goods would lend themselves to job order costing?
• Why is it not a good idea to use job order costing for all manufacturers? 

As opposed to job costing, where costs are assigned to unique jobs, process costing assigns costs to individual processes. This is used when many similar goods are produced in batches. Many manufacturers who produce a large quantity of the same product use process costing. 

In process costing, costs are assigned to products at the different stages of production. Thus, revenues and costs are gathered for batches of identical goods. From this, costs per unit can be calculated. As opposed to job costing, in process costing, costs are assigned to departments, and unit cost information comes from the departmental production cost report. There usually will be several different work-in-process (WIP) inventory accounts in use. 

Review Figure 4.1 and Table 4.1 in Comparison of Job Costing with Process Costing.

3b. Use a process costing system to assign direct material, direct labor, and manufacturing overhead costs to production departments

• How are costs assigned to different production departments?
• What happens to the costs of goods as the goods are moved from one production department to another?
• What is the final account where all costs of goods are accumulated, prior to their being sold?

In process costing, costs are assigned to products at different stages of production. Different departments in the production process incur costs and these costs are assigned to the products as they pass through the various production stages. If direct materials are added in a particular production department, those costs will be added to a WIP account for that department. The same is true with direct labor and manufacturing overhead. 

When goods are finished being worked on in a particular department, they are transferred out of the WIP-inventory account from that department into the WIP account of the next department in the production process. These costs are referred to as transferred-in costs. This is repeated until the goods are finished when they are transferred to the finished goods inventory account. 

Review Product Cost Flows in a Process Costing System.

3c. Define equivalent units and use them to assign costs to products using the weighted average method

• How are partially finished goods accounted for in inventory on the balance sheet?
• What are the four steps used in assigning costs to WIP inventory and units transferred out?
• What method is used to determine costs for the current period?

In order for companies to report an accurate amount of inventory on their balance sheet, units of production that are still in process need to be converted to equivalent units. This is done by multiplying the number of units in process by the percentage of completion. Since direct materials, direct labor, and manufacturing overhead enter into the production at varying stages (usually, direct material is added at the beginning and direct labor and overhead is added over time), equivalent units have to be calculated individually for each of these types of costs. 

When calculating the costs remaining in a work in process account and those that have already been transferred out, we use the weighted average method. This method adds costs in beginning inventory to current costs to determine total costs for the period. This is then used to determine the costs associated with the units transferred out to finished goods inventory and those left in work in process. 

Review Determining Equivalent Units and The Weighted Average Method.

3d. Prepare a production cost report for a processing department

• In a process costing system, how is cost information periodically summarized?
• What can management learn from a production cost report?
• What effect will fixed costs have on per-unit cost data in a production cost report? 

For every reporting period, a production cost report is prepared. This report summarizes production and cost activity within a department. It uses the four steps performed to assign costs to units transferred out and units in ending work-in-process (WIP) inventory.

The production cost report is a very valuable resource for managers. They can use it to identify higher than normal costs and to see which departments in the production process may be spending too much or may be inefficient. However, care must be taken as some of the costs included in this report may be fixed and will not change with changes in production levels. 

Review Preparing a Production Cost Report.

Unit 3 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam. 

• departmental production cost report
• equivalent units
• finished goods inventory
  
• process costing
• production cost report
• transferred-in costs
• weighted average method
• work-in-process (WIP) inventory

Unit 4: Cost Behavior Patterns

4a. Identify typical cost behavior patterns

• What are the different types of cost behavior patterns?
• What type of cost behavior does total costs have?
• What do you call a cost that has both a fixed component as well as a variable one?

Costs that increase in total with total production are called variable costs. These costs are constant on a per-unit basis. Fixed costs are costs that are constant, in total, regardless of the level of production. However, on a per-unit basis, these costs decrease as production increases. Fixed costs that can be easily changed are called discretionary fixed costs. If a fixed cost can not be easily changed, it is called a committed fixed cost. A mixed cost consists of a fixed component as well as a variable component. Total costs, which include both fixed and variable costs, are an example of mixed costs.

The range of activity for which cost behavior patterns are likely to be accurate is referred to as the relevant range. Outside that range, cost estimates and behaviors are not necessarily accurate and need to be reevaluated.

Review Cost Behavior Patterns.

4b. Estimate costs using account analysis, the high-low method, the scattergraph method, and regression analysis

• What are the four common methods used to estimate costs?
• What are the four steps used in the high-low method?
• What are the five steps used in the scattergraph method?
• Which method will provide the most accurate cost estimates?

There are four ways to estimate fixed variable costs. All four methods attempt to define the equation: 

 Y = f + vX 

Where Y = total costs, f = fixed costs, v = variable costs and X = level of output. 

In account analysis employees review the applicable accounts to determine whether costs are fixed, variable, or mixed. The high-low method consists of four steps and uses the highest and lowest output levels with their related costs to estimate fixed and variable costs. The scattergraph method has five steps and involves plotting all points on a graph and fitting a line through the points. Regression analysis is a mathematical method that fits a line through the data points. 

The choice of a method will usually depend on the situation. While account analysis and the high-low method are easier and less costly, a scattergraph or regression analysis are more accurate, but may require the use of computer software. Many times, two or more methods will be used simultaneously. 

Review Cost Estimation Methods.

4c. Prepare a contribution margin income statement

• What differentiates the contribution margin income statement from a traditional income statement?
• Why is it useful to separate fixed and variable costs in an income statement?
• How is the contribution margin useful in cost analysis?

A contribution margin income statement breaks down cost information into fixed and variable components Revenue is shown followed by variable costs. Revenue less variable costs equals the contribution margin. Fixed costs are then subtracted from the contribution margin to reach operating profit. This statement is able to provide a clearer idea of cost behavior when there are changes in levels of activity.

The contribution margin is very important in analyzing cost behavior. It equals revenue from sales left over after deducting variable costs and represents how much revenue remains to cover fixed costs. The higher the contribution margin, the more each sale will help offset fixed costs. 

Review The Contribution Margin Income Statement.

4d. Provide for nonlinear costs that occur outside of a predetermined relevant range for linear costs

• What are two assumptions always made in estimating costs?
• What happens to cost behavior if production is at a level outside of the relevant range?
• How do nonlinear costs affect cost behavior?

All cost behavior estimates assume that the production activity level is within a given relevant range. Additionally, within that range, it is assumed that costs are linear and not nonlinear. If costs are outside this range, cost behavior may change. For example, if production increases by a large amount, a new plant may be needed, increasing fixed costs. Additionally, if within the relevant range, costs are nonlinear, cost estimates will be distorted.

Although cost estimates are not perfect, companies generally clearly define a relevant range and assume that costs are linear within that given range. These assumptions usually lead to reasonably good cost estimations. 

Review The Relevant Range and Nonlinear Costs.

Unit 4 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam. 

• account analysis
• committed fixed cost
• contribution margin
• contribution margin income statement
• discretionary fixed cost
• fixed costs
• high-low method
• linear costs
• mixed cost
• nonlinear costs
• regression analysis
• relevant range
• scattergraph method
• total costs
• variable costs

Unit 5: Cost-Volume-Profit Analysis

5a. Perform cost-volume-profit analysis for single-product and multiple-product companies

• What is the profit equation?
• How is the profit equation used in conjunction with the contribution margin?
• Why is it important to separate fixed costs from variable costs in the profit equation?
• What is the break-even point, and why is it important?

Cost-volume-profit analysis identifies how changes in key assumptions such as costs, volume, or profit may impact financial projections. This analysis begins with the profit equation, which states that profit equals total revenues minus total variable costs and total fixed costs. This is sometimes known as the cost-volume-profit equation. This equation is useful to companies to help determine the break-even point in units, the break-even point in sales dollars, as well as the number of units needed to sell to reach a target profit.

For a company with multiple products, the equation must be expanded to include multiple products. This can be accomplished with the use of the contribution margin for each individual product. This equation states that profit is equal to the sum of the contribution margin for each product multiplied by the quantity sold for that product, minus fixed costs. So for a company with two products, called River and Sea, and fixed costs notated as F, the equation would be: 

Profit = (Unit CM for River × Quantity of River) + (Unit CM for Sea × Quantity of Sea) − F

Review Cost-Volume-Profit Analysis for Single-Product Companies and Cost-Volume-Profit Analysis for Multiple-Product and Service Companies.

5b. Perform sensitivity analysis using the cost-volume-profit model

• How can the cost-volume-profit equation be used to determine the effects of changes to one or more of its variables?
• How will changes to one or more variables of the CVP model affect the break-even point or target profit?

The cost-volume-profit model (CVP) can be used to analyze how changes to any of its variables will affect profitability. This is known as sensitivity analysis. This analysis can also be used to determine how changes to one or more of the variables can affect the break-even point and target profit. Managers can use sensitivity analysis to determine changes to things like production or sales prices or to analyze costs. 

For example, managers can use the CVP model to see what would happen if prices were increased by a few dollars. The contribution margin per unit would increase but would sales decrease? How would the break-even point change? What would happen if variable costs per unit would be decreased? The contribution margin would obviously increase. How would that affect the break-even point or target profit?

Review Using Cost-Volume-Profit Models for Sensitivity Analysis.

5c. Use an alternative form of contribution margins, such as contribution margin per unit of constraint, when faced with resource constraints

• When faced with a constraint, why is it important to calculate an alternative form of the contribution margin?
• What are three examples of production constraints?
• How is the contribution margin per unit of constraint helpful to managers in decision-making?

Some companies may have limited resources in areas such as labor hours, machine hours, or materials. In that case, the normal contribution may not be very informative on its own. This is because although a company would like to produce more products with a higher contribution margin, if the constraint does not allow them to produce that many units, they will be unable to meet those production goals. Thus, an alternative measure called the contribution margin per unit of constraint is usually used in addition to the regular contribution margin per unit. This is the contribution margin per unit divided by the units of constrained resources required to produce one unit of product.

The contribution margin per unit of constraint allows management to see, within the framework of the constraints, which product has the highest contribution margin. Thus, the company can set its goals to produce more of these products. This will increase profits while working with the limited resources that are available. 

Review Using a Contribution Margin When Faced with Resource Constraints.

5d. Demonstrate the effect of income taxes on the cost-volume-profit model

• Why is it important to account for income taxes when performing cost-volume-profit analysis?
• What are the three steps needed for a company that incurs income taxes to find a break-even point or target profit?
• What is the equation to convert target profit after taxes to target profit before taxes?

Since most companies pay income taxes on their profit, when using the cost-volume-profit equation, tax expense must be accounted for. This is done by determining the desired target profit after taxes, converting this amount to target profit before taxes and then using that new amount in the target profit formula. The formula to convert target profit to target profit after taxes is:

Target profit before taxes = Target profit after taxes + (1 − tax rate)

By making use of the target profit before taxes, firms can ensure that the desired profit will be met subsequent to paying taxes.

Review Income Taxes and Cost-Volume-Profit Analysis.

5e. Discuss the effects of absorption and variable costing on profits

• What is the difference between absorption costing and variable costing?
• Which method is required by Generally Accepted Accounting Principles (GAAP) and why?
• Which method will lead to higher Gross Profit?
• Which method will lead to higher net income?

Absorption costing is the costing method required by US GAAP. It requires that all costs associated with manufacturing costs, including fixed manufacturing costs, are included (or absorbed) into the cost of the product. Only non-manufacturing costs are treated as period costs. In managerial accounting, managers sometimes prefer the use of variable costing. This method only includes variable costs as part of the cost of goods sold while all fixed costs are treated as period costs. Thus, the use of absorption costing, with its higher cost of goods sold, will lead to a lower gross profit than the use of variable costing. 

Review Using Variable Costing to Make Decisions.

Unit 5 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• absorption costing
• break-even point in sales 
• break-even point in units
• constraint
• contribution margin per unit of constraint
• cost-volume-profit analysis
• cost-volume-profit equation
• profit equation
• sensitivity analysis
• target profit
• variable costing

Unit 6: Using Differential Analysis to Make Decisions

6a. Use differential analysis for make-or-buy, product line, and special order decisions

• How can cost information be used in managerial decision-making?
• When considering two or more alternative courses of action, why is it important to use differential analysis?
• Why are fixed costs generally excluded from differential analysis?

The idea of differential analysis is that when faced with two or more alternatives, we only look at and compare the differences in revenue and expenses associated with each option. Any costs that are common to every alternative can be ignored. For a make or buy decision, a decision to keep or drop a product line, or a decision about whether or not to accept a special order, we will only look at the incremental changes in variable costs as well as the changes in revenue for each alternative. In each of these cases, fixed costs will not change (provided we are within the relevant range) and can therefore be ignored.

Review Make-or-Buy Decisions, Product Line Decisions, and Special Order Decisions.

6b. Use differential analysis to decide whether to keep or drop customers

• Why may a firm decide that it may be worth dropping a customer?
• When making a determination whether or not to drop a customer, which costs should be traced to the customer?
• How are fixed costs traced to individual customers?

If a company feels that a customer may be costing more than the revenue brought to it by that customer, they can use differential analysis to determine whether to keep or drop that customer. The method for doing this is similar to the format used for making product line decisions except that in this case, sales revenue, variable costs, and fixed costs are traced directly to customers rather than to product lines. Since fixed costs are not directly traceable to specific customers, they must be allocated among all the customers. Thus, although dropping a customer will eliminate variable costs associated with that customer, such as cost of goods sold, shipping, maintenance, and support, the fixed costs will continue but their allocation will be shifted to another customer. 

Review Customer Decisions, especially Figure 7.10, for an example of keep or drop analysis. 

6c. Use cost-plus pricing and target costing to establish prices

• What methods are used to determine selling prices?
• Which costs should be included when calculating cost-plus pricing?
• What are the four steps involved in target costing?

Aside from differential analysis, there are two other methods used to establish selling prices. Cost-plus pricing begins with an estimate of what costs will be incurred to produce a certain product or provide a certain service. Then, the manufacturer will determine a percent markup required for profit above the cost. This then becomes the selling price. Care must be taken to ascertain which costs are to be included when calculating cost-plus pricing.

Target costing is a costing method that involves a four-step process to determine a selling price and product cost. Here, a firm starts with the price customers are willing to pay and needs to engineer the product in a way where the costs are low enough to produce the desired profit. 

Review Cost-Plus Pricing and Target Costing.

Unit 6 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• cost-plus pricing
• differential analysis 
• keep or drop a customer decision
• keep or drop a product line decision
• make or buy decision
• special order
• target costing

Unit 7: Budgets

7a. Apply the time value of money to capital budgeting decisions

• How do companies make decisions regarding long term capital investments?
• What does it mean that a dollar today is worth more than a dollar in the future?
• For decision making purposes, why is it important that future cash flows be discounted back to their present values?

The process of analyzing and deciding which long-term investments a company should pursue is referred to as making capital budgeting decisions. These decisions will affect the cash flows of a company for many years in the future. Therefore, when capital budgeting decisions are made, care must be taken to ensure that the time value of money is taken into account. 

This idea of time value of money is that a dollar today has more value than a dollar in the future. This is because the sooner I have the dollar, I can invest it and earn a return on it. Thus, the future value of all future cash flows, both inflows and outflows need to be discounted to their present value in order to make informed decisions. 

Capital budgeting decisions are made using time value of money techniques both for whether or not to invest in a given project, as well as when there are multiple competing projects with limited funds available with which to invest, and a firm is trying to decide which project to invest in. 

Review Capital Budgeting and Decision Making.

7b. Evaluate investments using the net present value (NPV), internal rate of return (IRR), and the payback method

• What methods do companies use in order to evaluate possible capital projects?
• What is meant by the cost of capital utilized in determining the net present value?
• What is the advantage of using the internal rate of return method over the net present value method?

There are numerous methods companies employ in capital budgeting decision-making. Two of the more popular ones, both of which use time value of money techniques, are the net present value (NPV) method and the internal rate of return (IRR) method.

In the net present value (NPV) method, all future cash flows are discounted back to today to determine the net present value of the investment. The interest rate used in these calculations is usually the firm's cost of capital. If the NPV for the prospective investment is greater than 0, the project is accepted. If it is less than 0, it is rejected.

In the internal rate of return (IRR) method, a rate of return that generates an NPV of zero is determined. This is known as the internal rate of return (IRR). The IRR represents the time-adjusted rate of return for this investment. The IRR is then compared to a company's required rate of return (also known as the hurdle rate). If the IRR is greater than or equal to the internal rate of return, the investment is accepted. Otherwise, it is rejected. 

A third method used is called the payback method. This method evaluates how long it will take to "pay back", or recover the initial investment. The payback period is the time, stated in years, that it will take to generate enough cash inflows from an investment to cover the cash outflows. Although easier to calculate, this method has significant disadvantages. It doesn't take the time value of money into account at all. It also ignores cash inflows that are to occur subsequent to the payback period.

Review Net Present Value, The Internal Rate of Return, and The Payback Method.

7c. Explain the effects of cash flows, qualitative factors, and ethical issues on long-term investment decisions

• Why may making decisions based on cash flows possibly be not prudent when the accounting system uses accrual accounting?
• What are some qualitative factors that may outweigh quantitative factors when making long-term investment decisions?
• What is an example of an ethical issue that may arise when evaluating long-term investment opportunities?

The methods discussed to evaluate long-term investments focus on cash flows and the timing of cash flows. This differs from financial accounting where the timing of revenues and expenses are based on accrual accounting regardless of cash flows. When making a decision on long-term investments, care must be exercised in recognizing that the cash flows being calculated will likely not match up with the revenues and expenses appearing on a company's income statement. 

The methods discussed in long-term investment decision-making all involve the use of quantitative factors to make decisions. This is used because it allows managers to make informed decisions using data that is observable and measurable. However, there may be other, nonfinancial factors known as qualitative factors that need to be considered as well. For example, an NPV or IRR analysis may lead to the conclusion to not undertake an investment, but there may be some other strategic reason why the company may want to make the investment anyway. 

Finally, all investment decisions may include ethical issues. For example, managers who are evaluated based solely on short-term financial results may consider forgoing an investment opportunity that may have a positive return in the long term since right now it will hurt them. Care must be taken in order to encourage managers to make decisions based on the best interest of the company knowing that they will not be penalized for any side effect that may result because of it. 

Review Other Factors Affecting NPV and IRR Analysis.

7d. Demonstrate the effects of income taxes, working capital, and investment cash outflows on capital budgeting decisions

• What are the effects that income taxes have on investment opportunities?
• What is an example of an investment project that will entail multiple cash outflows by a company?
• Why may cash sometimes be spent early on in an investment project but then returned to the company later in the project?
• Why is depreciation expense referred to as the depreciation tax shield?

Most companies pay income taxes and must consider the impact on long-term investments that these taxes have on future cash flow. Revenue producing cash inflows and expenses producing cash outflows are adjusted by multiplying the cash flow by (1 – tax rate), such that: 

After-tax revenue cash inflow = Before-tax cash inflow × (1 − tax rate)

After-tax revenue cash outflow = Before-tax cash outflow × (1 − tax rate)

Investment and working capital cash flows are not adjusted because these cash flows do not affect taxable income. Depreciation expense is not itself a cash flow, but it does provide tax savings by lowering net income. The depreciation tax savings cash inflow is equal to depreciation expense × Tax rate. This is often referred to as the depreciation tax shield. 

Most investment proposals will include cash outflows at varying points throughout the life of the project. All of these future cash flows, both inflows and outflows, need to be included when evaluating investment proposals using NPV, IRR, or the payback period methods. Many investments will also include working capital cash flows required to fund items such as inventory and accounts receivable while the investment is being undertaken. Many times, working capital is included as a cash outflow at the beginning of the project, but later in the project will be a cash inflow when the cash is returned back to the company.

Review Additional Complexities of Estimating Cash Flows and The Effect of Income Taxes on Capital Budgeting Decisions.

7e. Explain the components of a master budget and the process for creating a master budget that includes multiple schedules

• For performance evaluation purposes, why is it important that each division or department of a company have a budget related to their operations?
• How is a master budget that includes multiple schedules constructed?
• Why does the process of putting together a master budget begin with a sales budget?

For a manufacturing company, the master budget includes all the budget schedules for all parts of the organization. These can include the sales budget, production budget, direct materials budget, direct labor budget, as well as budgets for manufacturing overhead and selling and administrative expenses. The master budget will also include a budgeted income statement, a capital expenditures budget, a cash budget, and a budgeted balance sheet. 

The master budget begins with the sales budget as sales projections drive the other budgets. Once the sales budget is set, the production budget is prepared next because the budget preparers now know how much should be produced. This allows them to then create budgets for direct materials and direct labor and manufacturing overhead. Following directly from this all the other budget schedules can be set as well.

Review The Budgeting Process and The Master Budget.

Unit 7 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• budgeted balance sheet
• budgeted income statement
• capital budgeting decisions
• capital expenditures budget
• cash budget
• cost of capital
• depreciation tax shield
• direct labor budget
• direct materials budget
• future value
• hurdle rate
• internal rate of return (IRR) method
• master budget
• net present value (NPV) method
• payback method
• present value
• production budget
• required rate of return
• sales budget
• time value of money
• working capital

Unit 8: Variance Analysis

8a. Explain the purpose of flexible budgeting

• How is the level of activity for a budget determined?
• Why are flexible budgets necessary?
• What would happen if performance evaluation was based on the original budget without adjusting for the actual level of activity?

Budgets are based on assumptions and estimates regarding production activity levels. Usually, the actual level of production activity levels differs from the budgeted amount, due to changing or unforeseen circumstances. Therefore, for control purposes, flexible budgets are used. A flexible budget is a revised master budget that is based on the actual level of activity.

A flexible budget can be used to compare budgeted costs at the actual level of activity to actual costs. This plays a crucial role in the control function of management. In order to review the results of the current period's operation and make improvements for the next period, results must be compared to budgeted amounts at actual levels and not budgeted amounts at estimated levels. 

Review Flexible Budgets.

8b. Explain how standard costs are established

• Why is it important to determine standard costs?
• How are standard costs determined?
• What is the difference between standard costs and budgeted costs?
• Why would managers generally prefer to use attainable standards as opposed to ideal standards?

Managers must determine costs they are expected to incur in order to provide a good or service. These expected costs are known as standard costs. Standard costs are usually established for all parts of production such as direct labor, direct material, and manufacturing overhead. Standard costs are used not only for monetary costs but can also apply to hours worked, minutes taken to prepare something, or similar items. Whatever it is measuring, it is the standard by which the actual production will be judged.

Establishing standard costs entails collecting information from various sources. Information can come from previous periods' experience, suppliers, competitors, or industry standards. Some of the standards that can be set include standard quantity for direct materials, standard price for direct materials, standard hours for direct labor, and standard rate for direct labor. Standard quantity for variable manufacturing overhead and standard rate for variable manufacturing overhead can be established as well.

Generally, managers prefer using attainable standards which take into account unforeseen events such as broken equipment or employee illnesses that may occur during a production period. The other option would be to use ideal standards which are set assuming that production conditions are always perfect. Judging against ideal standards will generally reflect poorly on management as conditions are seldom perfect. 

Review Standard Costs.

8c. Calculate variances from direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead

• Why is it important to measure variances in direct material and direct labor in two different dimensions?
• When evaluating variances, why are negative differences considered favorable and positive differences unfavorable?
• Is it possible that a favorable materials quantity difference may actually be caused by something negative?

There are two types of variances that can be used to explain the difference between actual costs and budgeted costs of direct materials. These are the materials price variance and the materials quantity variance.

The materials price variance measures the difference between actual costs for materials purchased and budgeted costs based on established standards. This is measured as:

Materials price variance = (AQ^P × AP) −(AQ^P × SP)

where AQ^P is the actual quantity purchased, AP is the actual price and SP is the standard price. A negative difference would indicate that direct materials cost less than the standard amount. This would be called a favorable variance. A positive difference would be an unfavorable variance and indicate that the cost was more than the standard. Care must be taken though, to ensure that a favorable price difference is not because cheaper quality raw materials were used. 

The materials quantity variance is the difference between the actual quantity of materials used in production and budgeted materials based on standards. This is measured as:

Materials quantity variance = (AQ^U × SP) − (SQ × SP)

where AQ^U is the actual quantity used, and as above, AP is the actual price and SP is the standard price. Here also a negative amount would be favorable as it would indicate fewer materials than standard were used and a positive amount would be unfavorable.

For differences in labor cost, we use the labor rate variance and labor efficiency variance. The labor rate measures the difference between actual costs for direct labor and budgeted costs based on established standard rates. This is measured as:

Labor rate variance = (AH × AR) − (AH × SR)

where AH is actual hours worked, AR is the actual labor rate and SR is the standard rate. A negative difference indicates that labor costs less than the standard amount. This would be called a favorable variance. A positive difference would be an unfavorable difference and indicate that the cost was more than the standard. Here too, care must be taken that not too few hours were worked that may harm the product's quality. 

The labor efficiency variance is the difference between the actual hours of labor worked in production and budgeted hours based on standards. This is measured as:

Labor efficiency variance = (AH × SR) − (SH × SR)

where AH is actual hours worked, AH is the standard hours budgeted for and SR is the standard labor rate. Here too, a negative amount would be favorable as it would indicate fewer hours were needed than originally thought, but a positive amount would be unfavorable.

Finally, for variable overhead, we use a variable overhead spending variance and a variable overhead efficiency variance. The variable overhead spending variance is the difference between actual costs for variable overhead and budgeted costs based on the standards. It is calculated as:

Variable overhead spending variance = Actual costs − (AH × SR)

 where SR is the standard rate for that company's allocation base. This measures if there were overhead costs above what was expected for this level of production. 

The variable overhead efficiency variance is measured as:

Variable overhead efficiency variance = (AH × SR) − (SH × SR)

This measures if more or less of the company's allocation base was used compared to what was expected based on standards.

Review Direct Materials Variance Analysis, Direct Labor Variance Analysis, and Variable Manufacturing Overhead Variance Analysis.

8d. Analyze a set of variances to determine which ones to investigate

• Why are all variances not automatically investigated?
• What is meant by management by exception?
• What are some methods that can be used to determine which variances to investigate and which not to?
• What are some of the drawbacks associated with only investigating variances that are above a certain percentage of a flexible budgeted amount?

Investigating variances can become very costly. These costs may involve employees spending time talking with personnel from different areas of an organization to determine the cause of variances as well as fighting out how to control costs in the future. Thus, managers tend to only invest time and energy into investigating variances that seem significant. This is known as management by exception.

Every company needs to establish criteria for themselves to use in determining which variances to investigate and which can be safely ignored. Many times a company will only investigate a variance that is above a certain percentage of the flexible budget. However, if the item in question has a relatively small dollar amount, a large percentage variance might not indicate any real issue. Other companies may investigate all variances above a certain dollar amount. Here too, depending on how large the item in question is, this may or may not indicate a real issue. Some companies may combine the two options and investigate variances that are above a certain dollar amount as well as being above a certain percentage of the flexible budget.

Review Determining Which Cost Variances to Investigate.

8e. Explain how to use cost variance analysis with activity-based costing

• Why is there a need to slightly modify cost variance analysis when using activity-based costing?
• Why will a company using activity-based costing always have to calculate more variances than those using a traditional costing method?
• How would you calculate a spending variance or an efficiency variance when using activity-based costing?

If a company is using activity-based costing, that means that instead of one overhead rate, there are numerous overhead rates; one for each cost activity. Therefore, the process of variance analysis will entail several standard variable overhead rates and quantities, each having its own cost driver. Other than that, the method to analyze variances would be the same as under traditional costing. 

Namely, the variable overhead spending variance for activity-based costing would be calculated for each activity as follows (repeated from 8c.):

Variable overhead spending variance = Actual costs − (AH × SR)

AQ = actual quantity of whatever activity we are measuring and SR = the standard rate for that activity.

The variable overhead efficiency variance for each activity would be calculated as follows (repeated from 8c.):

Variable overhead efficiency variance = (AH × SR) − (SH × SR)

SQ is the standard quantity for that activity.

Review Using Variance Analysis with Activity-Based Costing.

Unit 8 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• attainable standards
• favorable variance
• flexible budgets
• ideal standards
• labor efficiency variance
• labor rate variance
• management by exception
• materials price variance
• materials quantity variance
• production
• standard costs
• standard hours for direct labor 
• standard price for direct materials
• standard quantity for direct materials
• standard quantity for variable manufacturing overhead
• standard rate for direct labor
• standard rate for variable manufacturing overhead
• unfavorable variance
• variable overhead efficiency variance
• variable overhead spending variance

Unit 9: Performance Evaluation

9a. Explain the advantages and disadvantages of decentralizing an organization

• What is meant by a decentralized organization?
• What are some advantages of having a decentralized organization?
• What are some disadvantages of having a decentralized organization?
• Why would the goals of managers of individual units sometimes conflict with the goals of the company as a whole?

In a decentralized organization, managers of each segment, or division, of the organization are tasked with decision-making and operational responsibilities for their particular division or segment. Decentralized organizations have the advantage of increased expertise for leaders of each division, as well as quicker decisions, better use of time at top management levels, and increased motivation of division managers. 

However, there can also be disadvantages to having a decentralized organization. Disadvantages can include the duplication of services, such as support staff, conflicts amongst division managers, and division managers' goals being misaligned with company-wide goals. Finally, decentralized organizations can result in a loss of control at the top management level.

Review Using Decentralized Organizations to Control Operations.

9b. Differentiate between the three types of responsibility centers commonly used to evaluate segments: cost centers, profit centers, and investment centers

• Why is it important to divide organizations into different responsibility centers?
• Why should a manager of a cost center not be evaluated at all based on sales?
• What is the difference in responsibility between a manager of a profit center and a manager of an investment center?

In a decentralized organization, divisions or segments of the organization are divided into three types of responsibility centers. A segment that is responsible for costs, but not revenue or investments in assets is known as a cost center. Most service departments, such as marketing and human resources, are cost centers. These segments are only responsible for costs, not generating revenues or providing a return on investment. Thus, managers of these departments are evaluated based on providing services while keeping costs low.

A segment that is responsible for costs and revenues (and profit), but not investments in assets, is called a profit center. An example of a profit center would be a retail store that is part of a larger company. A manager of a profit center would be responsible for revenues and costs, and the resulting profits but not for assets.

The third type of responsibility center is known as an investment center. This is a segment that is responsible for costs and revenues (and profit), as well investments in assets. Unlike the other managers in the organization, a manager of an investment center has control over asset investment decisions and is thus evaluated on those as well. 

Review Maintaining Control over Decentralized Organizations, especially the part on the three types of responsibility centers.

9c. Calculate segmented net income and interpret the results to evaluate the performance of investment centers

• In a decentralized organization, how are the managers of each segment evaluated?
• What are the two weaknesses that are evident in using segmented net income as a way to evaluate segment managers?
• Why would segmented net income be a more accurate measure of [performance for a manager of a profit center than for a manager of an investment center?

Managers of investment centers are many times evaluated using segmented net income. This is simply the revenues for that particular segment minus the expenses of the segment. In this way, managers are evaluated against an expected segmented net income level and also against managers of other segments. 

However, there are two weaknesses associated with this measure. First, it fails to consider the fact that larger segments will likely have higher revenues and thus higher net income. A way to get around this is to compare profit margins (net income ÷ sales) for each segment. This way the segments are being compared and scaled by their respective sales. 

The second weakness lies in the fact that investment centers also have control over assets. Comparing net income ignores the use of assets in generating this net income and the managers efficiency in the use of the assets. This can be mitigated by making use of some efficiency ratios that include the use of assets such as return on investment.

Review Comparing Segmented Income for Investment Centers.

9d. Calculate return on investment (ROI), residual income (RI), and extra value added (EVA) and interpret each to evaluate the performance investment centers

• What are three measures used to evaluate the performance of investment centers?
• What is the purpose of including assets in these performance measures?
• Why does the residual income method and the extra value added method make adjustments to net income for their measures?

Three common measures used to evaluate the performance of investment centers are return on investment (ROI), residual income (RI), and extra value added (EVA).

Return on investment is a measure that incorporates the use of assets. It is calculated as: 

Return on investment = Operating income ÷ Average operating assets

Operating income is income produced from daily activities and excludes items such as taxes, interest, and unusual gains and losses. Average operating assets is the beginning balance plus ending balance of assets divided by two. ROI can be interpreted as showing how many dollars of operating income are generated for every dollar of assets invested in the segment.

Residual income (RI) is similar to ROI, but rather than using a ratio, it uses a dollar amount to evaluate performance. It is the segment's operating profit in excess of the segment's cost of acquiring capital to purchase operating assets. RI is calculated as follows:

Residual income = Operating income − (Percent cost of capital × Average operating assets)

Percent cost of capital is the company's percentage cost to obtain investment funds (often called capital). If an investment produces an operating profit higher than the division's cost of acquiring capital, managers evaluated with RI have an incentive to accept the investment. A manager's goal in such a situation is to increase the RI from period to period.

The third measure, economic value added (EVA) is calculated as: 

Economic value added = Net operating profit after taxes adjusted − (Percent cost of capital × Average operating assets adjusted)

The calculation is very similar to RI, but certain adjustments are made to the financial information to better reflect the economic results of the division. First, operating profit is calculated net of income taxes. This is done by simply deducting income taxes from operating income. Second, adjustments are made to operating income and average operating assets. There are many different types of adjustments that can be made. Some of the more popular ones are capitalizing research and development costs, capitalizing advertising costs, and deducting non-interest-bearing current liabilities from average operating assets. 

Review Using Return on Investment (ROI) to Evaluate Performance, Using Residual Income (RI) to Evaluate Performance, and Using Economic Value Added (EVA) to Evaluate Performance.

Unit 9 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• average operating assets
• cost center
• decentralized organization
• residual income (RI)
• extra value added (EVA)
• investment center
• operating income
• percent cost of capital
• profit center
• profit margins
• responsibility centers
• return on investment (ROI)
• segment
• segmented net income

Unit 10: Statement of Cash Flows

10a. Explain the purpose of the statement of cash flows

• Why is the purpose of the statement of cash flows?
• What is fundamentally different about the statement of cash flows, as compared to the other financial statements such as the balance sheet and income statement?
• Why is the statement of cash flows the last of the financial statements to be prepared?

Although Generally Accepted Accounting Principles (GAAP) require the use of accrual accounting, which recognizes revenues when earned and expenses when incurred, there is one statement dedicated to tracking the changes in cash. The statement of cash flows provides information on all inflows and outflows in cash for a company in a given time period. It also reconciles the change in cash balance from the beginning of the period to the end.

The statement of cash flows is used by managers, investors, creditors, and other stakeholders of a company to ensure that company always has sufficient cash flows for their needs. A company may show excellent performance on its income statement and balance sheet, but without adequate cash flows, it will be unable to survive.

Review Purpose of the Statement of Cash Flows.

10b. Explain what each of the three categories of cash flows (operating, investing, and financing) represents

• What are the three sections on the statement of cash flows?
• What do all the items in the operating section have in common?
• Why are dividends paid part of the financing section but dividends received part of the operating section?

The statement of cash flows breaks down all cash flows of a company into three categories: Operating activities, investing activities, and financing activities.

The first section of the statement of cash flows is always the section containing cash flows from operating activities. This includes any and all cash activities that factor into the determination of net income. For example, cash inflows from the sale of goods and cash outflows for raw materials or merchandise are operating activities. Interest revenue and expense as well as dividend revenue are also included in operating activities. 

The second section of the statement of cash flows is the cash flows from investing activities. This includes all cash activities related to noncurrent assets such as the purchase and sales of property, plant, and equipment, or long-term investments as well as loans made to other entities. 

The third and final section of the statement is the cash flows from financing activities. This includes all cash activities related to noncurrent liabilities such as the payment of long-term debt as well as any items related to owners' equity such as stock issuances and repurchases, and dividend payments.

Review Three Types of Cash Flow Activities.

10c. Prepare a statement of cash flows using the direct and indirect methods

• What is the main difference between the direct and indirect methods of preparing the statement of cash flows?
• Why do the majority of companies prefer to use the indirect method in preparing the statement of cash flows?
• In the preparation of the statement of cash flows, why are changes in certain balance sheet items such as accounts receivables and payables added or subtracted to net income?

There are two methods to prepare a statement of cash flows. The more popular method is known as the indirect method. This first step of this method begins with net income from the income statement as the starting point. From here, several adjustments related to changes in current assets, current liabilities, and other items are made in order to arrive at cash provided by operating activities. Essentially, it is converting net income as reported using the accrual method to what net income would be using the cash method. After this, steps two and three are preparing the investing and operating sections using any cash inflows or outflows that fall under those categories. The fourth step is reconciling the change in cash from the beginning to the ending balance. 

The direct method differs from the indirect method only in the first step. Rather than starting with net income and backing into the cash basis net income, net income is directly determined using the cash method (Hence the name, "direct" method). The other three steps are the same under each method. 

Review Four Key Steps to Preparing the Statement of Cash Flows, Using the Indirect Method to Prepare the Statement of Cash Flows, and Appendix: Using the Direct Method to Prepare the Statement of Cash Flows.

10d. Evaluate an organization's performance by analyzing its cash from operating activities

• What can be gained from knowing the cash from operating activities of a company?
• What are the three measures used to evaluate a company's cash flows?
• Why are capital expenditures subtracted from cash flows from operating activities to arrive at free cash flow?

There are three common cash flow measures that are used to evaluate companies. The first is the operating cash flow ratio: 

Operating cash flow ratio = Cash provided by operating activities ÷ Current liabilities

This ratio measures a company's ability to generate enough cash to cover its current liabilities. In other words, for every dollar owed as a current liability, how many dollars in cash are generated by a company's operations.

The second measure is the capital expenditure ratio:

Capital expenditure ratio = Cash provided by operating activities ÷ Capital expenditures

This ratio measures a company's ability to generate enough cash to cover its capital expenditures. It tells us for every dollar spent on capital expenditures, how many dollars in cash are generated by a company's operations.

The third measure, free cash flow, is not a ratio, rather it is a dollar amount:

Free cash flow = Cash provided by operating activities − Capital expenditures

The idea behind this measure is that organizations need to be able to invest in fixed assets (capital expenditures) in order to continue to stay competitive. That being the case, this measures how much cash from operations is left over (is "free") after investing in capital assets.

Review Analyzing Cash Flow Information.

Unit 10 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• capital expenditure ratio
• direct method
• financing activities
• free cash flow
• indirect method
• investing activities
• operating activities
• operating cash flow ratio
• statement of cash flows

Unit 11: Using Managerial Accounting: Trends and Ratios

11a. Use a trend analysis and a common-size analysis to evaluate financial statement information

• What is the difference between trend analysis and common-size analysis?
• When using trend analysis, why would it be prudent to convert the changes to percentages and not only focus on dollar amounts?
• In common-size analysis of a balance sheet, why is it smart to convert all line items as a percentage of total assets?
• How can trend and analysis and common-size analysis be used in tandem?

Trend analysis analyzes a company's data over a period of time. This is done by examining the changes in specific line items on either the income statement or the balance sheet. These changes can be measured in dollars and percentages or both. Trends over several periods can be identified and examined by calculating the trend percentage as the current year divided by the base year.

A second way to analyze financial data is by using common-size analysis. This method converts each line of a financial statement to a percent. When analyzing an income statement, items are usually stated as a percentage of net sales. When analyzing a balance sheet, items are usually stated as a percentage of total assets. Common-size analysis allows for the evaluation of information from one period to the next both within a company (for example net income as a percentage of sales from year to year) and between competing companies (net income as a percentage of sales of each company). 

Review Trend Analysis of Financial Statements and Common-Size Analysis of Financial Statements.

11b. Use ratio analysis to measure profitability, short-term liquidity, long-term solvency, and market valuation

• What are the four categories of ratios used to measure financial performance?
• What are some of the limitations inherent in using ratio analysis?
• What is the difference between liquidity ratios and solvency ratios?

Managers, investors, and other stakeholders usually use various ratios to assess the financial performance and financial condition of organizations. Ratio analysis could be used to measure a firm's performance against a benchmark, against a previous period's performance, against a competitor, or against an industry standard.

There are four categories of ratios used to measure financial performance. Each category includes many different individual ratios. 

1. Profitability ratios (focus is on the income statement). These ratios focus on trends in the company's profitability and ability to continue generating a profit. The five ratios used to evaluate profitability are: gross margin ratio, profit margin ratio, return on assets, return on common shareholders' equity, and earnings per share.
2. Liquidity ratios (focus is on short-term liabilities). These ratios are focused on a company's ability to meet its short-term cash needs such as to pay suppliers and interest expenses. The four ratios used to evaluate liquidity are the current ratio, quick ratio, receivables turnover ratio (often converted to average collection period), and inventory turnover ratio (often converted to average sale period). These ratios are of special interest to suppliers and banks who may have extended short-term loans to the company.
3. Solvency ratios (focus is on long-term liabilities). These ratios focus on a company's ability to meet its long-term obligations such as to pay back long-term debt and bond principal. The three measures used to evaluate solvency are debt to assets, debt to equity, and times interest earned. These measures are of special interest to debt and bondholders.
4. Valuation ratios (focus is on the market value of the company). These ratios are used to evaluate a company's market value. The two ratios used for this are the market capitalization and the price-earnings ratio. These ratios are of special interest to current and potential investors. 

Review Ratio Analysis of Financial Information.

11c. Create a balanced scorecard to analyze non-financial performance

• Why is it important to include non-financial information when evaluating a company or a manager within a company?
• What are the four perspectives that are included in the balanced scorecard?
• What are some examples of non-financial items that can be incorporated into the balanced scorecard?

While financial measures are very important for evaluation purposes, many organizations prefer to use a mix of financial and non-financial measures in order to evaluate performance. Many organizations do this by using a balanced scorecard approach which incorporates both financial and non-financial measures.

The balanced scorecard approach uses a balanced set of measures separating performance into four perspectives—financial, internal business process, learning and growth, and customer. All, except the first perspective, can include non-financial measures, such as customer satisfaction, employee retention, and other such measures in order to evaluate performance. The primary idea is to link financial and non-financial measures to the company's strategies and goals.

Review Nonfinancial Performance Measures: The Balanced Scorecard.

Unit 11 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• average collection period
• average sale period
• balanced scorecard
• common-size analysis
• current ratio
• debt to assets
• debt to equity
• earnings per share
• gross margin ratio
• inventory turnover ratio 
• liquidity ratios
• market capitalization
• price-earnings ratio
• profit margin ratio
• profitability ratios
• quick ratio
• receivables turnover ratio
• return on assets
• return on common shareholders' equity
• solvency ratios
• times interest earned
• trend analysis
• valuation ratios