AGENDA: MANAGEMENT ACCOUNTING

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1 14-1 Management Accounting Tutorial 8 (, chapter 13, 14, 1, 2, 3) Mid Module Review Bangor University Transfer Abroad Programme 1. Globalization. 2. Strategy. 3. Organizational structure. 4. Process management. Lean Production. AGENDA: MANAGEMENT ACCOUNTING AND THE BUSINESS ENVIRONMENT The Theory of Constraints (TOC). Six Sigma. 5. The importance of ethics in business. 6. Corporate governance. The Sarbanes-Oxley Act of Enterprise risk management. STRATEGY A strategy is a game plan that enables a company to attract customers by distinguishing itself from competitors. CUSTOMER INTIMACY Understanding and responding to individual customer needs better than competitors. Ritz-Carlton, Nordstrom, Home Depot OPERATIONAL EXCELLENCE Delivering products and services faster, more conveniently, and at a lower price than competitors. Southwest Airlines, Wal-Mart, and The Vanguard Group PRODUCT LEADERSHIP Offering higher quality products than competitors. BMW, Cisco Systems, and W.L. Gore PROCESS MANAGEMENT A business process is a series of steps that are followed in order to carry out some task in a business. A value chain, as shown below, consists of the major business functions that add value to a company s products and services. Lean Production In Lean Production, parts and materials are pulled through the assembly process as needed. In the push approach used in traditional production control systems, work in process is pushed through the factory from one workstation to the next with little regard to when it is actually needed. In a push system, the overriding concerns are to keep all the workstations busy and to produce as much as possible so as to spread the costs of investments in equipment and other assets across many units. THEORY OF CONSTRAINTS (TOC) A constraint is anything that limits the ability of an individual or organization to attain its objectives. If the factory cannot satisfy demand, the constraint (i.e., bottleneck) is likely to be the workstation with the least capacity. The rate of output of the entire factory is determined by the capacity of the constraint. The other, non-constraint, work stations have excess capacity. Improvement efforts should usually be focused on the constraint. Improvements that increase the capacity of the constraint will increase the output of the entire factory. Improvements that increase the capacity of workstations that are not constraints will simply increase their excess capacity. If the capacity of the current bottleneck is increased enough, the constraint will shift. Improvement efforts should then be shifted to the new constraint (bottleneck). SIX SIGMA Six Sigma relies on customer feedback and fact-based data gathering and analysis techniques to drive process improvement. The term Six Sigma refers to a process with an error rate of less than 3.4 per million. This is close to perfection zero defects. The DMAIC (Define, Measure, Analyze, Improve, and Control) framework is often used in conjunction with Six Sigma.

2 (Statement of Cash Flow) 3 (Statement of Cash Flow) A. Purpose of the statement; definition of cash. B. Basis of the statement of cash flows: analysis of balance sheet accounts. C. Sources and uses of funds. D. Organization of the statement of cash flows. E. Cash provided by operations the direct and indirect methods. F. Steps in preparing a statement of cash flows. G. Example of statement of cash flows. I. T-account approach PURPOSE The statement of cash flows shows the major uses and sources of cash during a period. It is used to diagnose what has happened to cash. DEFINITION OF CASH In the cash flow statement, cash is broadly defined to include cash and cash equivalents. Cash equivalents consist of short-term, highly liquid investments such as treasury bills, commercial paper, and money market funds. ANALYSIS OF CASH FLOWS The cash flow statement is constructed by analyzing changes in balance sheet accounts. 3 (Statement of Cash Flow) 3 (Statement of Cash Flow) ORGANIZATION OF STATEMENT OF CASH FLOWS The statement of cash flows contains three sections: 1. Operating activities. 2. Investing activities. 3. Financing activities. Each source and use of cash is classified as one of the above activities. OPERATING ACTIVITIES Activities that affect current assets, current liabilities, or net income. CASH PROVIDED BY OPERATIONS The net cash provided by operating activities can be computed using either the direct method or the indirect method. DIRECT METHOD Under the direct method, the income statement is reconstructed on a cash basis from top to bottom. Operating cash outflows are subtracted from operating cash inflows to arrive at net cash flow from operating activities. INVESTING ACTIVITIES Transactions relating to acquiring or disposing of non-current assets. FINANCING ACTIVITIES Transactions involving creditors or owners of the company. (Exception: Interest is classified as an operating activity.) INDIRECT METHOD Under the indirect method, the cash provided by operations is determined by adjusting net income to a cash basis. In practice, the indirect method is used much more frequently than the direct method on external financial reports. 3 (Statement of Cash Flow) PREPARING A STATEMENT OF CASH FLOWS Preparing a statement of cash flows involves eight basic steps: 1. Copy the title of each balance sheet account onto a worksheet, except for cash and cash equivalents. Contra-asset accounts should be listed with the liabilities. 2. Compute the change in each balance sheet account. Break the change in retained earnings down into net income and dividends. 3. Classify each change as either a source or a use. 4. Write the sources as positive numbers and the uses as negative numbers. 5. Make necessary adjustments (for example, in gains and losses) to reflect gross, rather than net, changes in noncurrent accounts due to financing and investing activities. 6. Categorize each entry on the worksheet as an operating, investing, or financing activity. 7. Copy the data from the worksheet to the statement of cash flows. 8. Prepare a reconciliation of the cash account. A. Comparative analysis of financial statements. 1. Trend analysis. (Horizontal analysis) 2. Common-size statements. (Vertical analysis) B. Ratio analysis the common stockholder 1. Earnings per share 2. Gross margin percentage 3. Price-earnings ratio 4. Dividend payout ratio 5. Dividend yield ratio 6. Return on total assets 7. Return on common stockholders equity 8. Book value per share C. Ratio analysis the short-term creditor

3 14-3 C. Ratio analysis the short-term creditor 1. Working capital 2. Current ratio 3. Acid-test (quick) ratio 4. Accounts receivable turnover and average collection period 5. Inventory turnover and average sale period D. Ratio analysis the long-term creditor 1. Times interest earned ratio 2. Debt-to-equity ratio FINANCIAL STATEMENT ANALYSIS Few figures on financial statements have much significance by themselves. The relation of one figure to another and the amounts and directions of changes are important. Several techniques are commonly used to help analyze financial statements: Dollar and percentage changes. Common-size statements. Ratios. Trend Percentages Trend percentages state several years financial data in terms of a base year. EXAMPLE: Translate the following data into trend percentages, using Year Gross Margin Percentage The gross margin percentage is often monitored by managers and investment analysts. It is computed as follows: Gross margin Gross margin percentage = Sales Earnings For this per year, Share the gross margin percentage was: Earnings per share (EPS) refers to the earnings that are available to the owners of common stock after preferred dividends have been paid. Earnings per share is defined as follows: Net income - Preferred dividends Earnings per share = Average common shares outstanding Price-Earnings Ratio The relation between the market price of a share of stock and the stock s current earnings per share is often stated in terms of a priceearnings ratio. Assume that Molin Corporation s stock is now selling for $72 per share. Market price per share Price-earnings ratio= Earnings per share Dividend Payout Ratio The dividend payout ratio shows what portion of current earnings were paid out as dividends to common stockholders. The dividend this year was $2.60 per share ($130 thousand 50 thousand shares), and last year it was $2.40 per share ($120 thousand 50 thousand shares). Dividends per share Dividend payout ratio= Earnings per share $2.60 = =27.1% $9.60 There is no right dividend payout ratio, although companies in the same industry tend to have similar dividend payout Copyright ratios by The McGraw-Hill Companies, Inc. All rights reserved. Dividend Yield Ratio The dividend yield ratio measures the cash return being provided by a stock. Dividends per share Dividend yield ratio= Market price per share $2.60 = =3.6% $72.00 A low dividend payout ratio and a low dividend yield ratio indicate that the company is retaining its earnings for internal reinvestment. Return on Common Stockholders Equity Common stockholders equity consists of total stockholders equity less preferred stock. Return on common Net income - Preferred dividends = stockholders' equity Average total stockholders' equity - Average preferred stock $510-$30 = =19.8% ($2,600+$2,250)/2 Because the return on common stockholders equity is greater than the return on total assets, financial leverage is positive in both years. Return on Total Assets The return on total assets is a measure of how well assets have been employed by management. Return on = Net income+[interest expense (1-Tax rate)] total assets Average total assets $510+[$ ] = =12.1% ($5,000+$4,000)/2 By adding interest expense back to net income, the return on assets is not influenced by the way in which the assets were financed. Book Value per Share Book value per share shows the amount of common stockholders equity per share of common stock. Book value = per share Common stockholders' equity Number of common shares outstanding Total stockholders' equity - Preferred stock = Number of common shares outstanding $3,000 - $400 = =$52 per share 50 shares

4 14-4 Working Capital The excess of current assets over current liabilities is known as working capital. Molin Corporation s working capital is: Working capital = Current assets - Current liabilities = $2,350 - $1,400 = $950 Working capital is viewed as a cushion of protection for short-term creditors. Acid-Test Ratio The acid-test ratio (or quick ratio) provides a more rigorous test than the current ratio of a company s ability to settle its short-term liabilities. Acid-test ratio= Cash + Marketable securities + Accounts receivable + Short-term notes receivable Current liabilities $90+ $0 + $800 + $0 = =0.64 $1,400 Current Ratio The relation between current assets and current liabilities can also be expressed in terms of the current ratio: Current assets Current ratio= Current liabilities $2,350 = =1.68 $1,400 A declining current ratio may be a sign of a deteriorating financial condition. Accounts Receivable Turnover The accounts receivable turnover indicates how quickly accounts receivables are collected. Accounts receivable = turnover Average collection = period Sales on account Average accounts receivable balance $9,000 = =13.8 ($800 + $500)/2 Accounts receivable turnover = =26.4 days 13.8 Inventory Turnover The inventory turnover ratio measures how quickly inventory is converted into sales. Assume that Molin Corporation s inventory balance was $700 thousand at the beginning of last year. Cost of goods sold Inventory turnover= Average inventory balance $5,930 = =5.2 ($1,400 + $900)/2 Average sale period= Inventory turnover Times Interest Earned The times interest earned ratio is a widely used measure of the ability of a company s operations to provide protection for long-term creditors. Times interest earned= Debt-To-Equity Ratio Earnings before interest and taxes $910 = =15.2 $60 Interest expense The debt-to-equity ratio measures the amount of assets being provided by creditors for each dollar of assets being provided by owners. Total liabilities Debt-to-equity ratio= Stockholders' equity $2,000 = =0.67 $3,000 = =70.2 days 5.2 There is no right amount of debt for a company to carry. Because different industries face different risks, the level of debt that is appropriate will vary from industry to industry. AN OVERVIEW OF COST TERMS 1. The work of management. 2. Management accounting contrasted with financial accounting. 3. Cost concepts for preparing external financial reports. 4. Cost concepts for predicting changes in costs due to changes in activity. 5. Cost concepts for assigning costs to costing objects. 6. Cost concepts for making decisions. Purpose of classification Preparing an income statement and a balance sheet Predicting changes in cost due to changes in activity Assigning costs to cost objects Making decisions Cost classifications Product costs Direct materials Direct labor Manufacturing overhead Period costs (nonmanufacturing costs) Selling costs Administrative costs Variable costs Fixed costs Direct costs Indirect costs Differential costs Sunk costs Opportunity costs

5 14-5 COST CLASSIFICATIONS TO DESCRIBE COST BEHAVIOR To describe how costs react to changes in activity, costs are often classified as variable or fixed. VARIABLE COSTS Variable cost behavior can be summarized as follows: Variable Cost Behavior In Total Total variable cost increases and decreases in proportion to changes in activity. Per Unit Variable cost per unit is constant. FIXED COSTS Fixed cost behavior can be summarized as follows: Fixed Cost Behavior In Total Per Unit Total fixed cost is not affected Fixed cost per unit decreases by changes in activity (i.e., total as the activity level rises and fixed cost remains constant even increases as the activity level if activity changes). falls. A GRAPHIC VIEW OF COST BEHAVIOR Total Variable Cost Total Fixed Cost $6,000 $9,000 $3, Microwaves produced Microwaves produced RELEVANT RANGE If activity changes enough, fixed costs may change. For example, if microwave production were doubled, another factory building might have to be rented. The relevant range is the range of activity within which the assumptions that have been made about variable and fixed costs are valid. For example, the relevant range within which total fixed factory rent is $9,000 per month might be 1 to 200 microwaves produced per month. COST OBJECT A cost object is anything for which cost data are desired. Examples of cost objects: Products Customers Departments Jobs DIRECT COSTS A direct cost is a cost that can be easily and conveniently traced to a particular cost object. Examples of direct costs: INDIRECT COSTS An indirect cost is a cost that cannot be easily and conveniently traced to a particular cost object. Examples of indirect costs: DIFFERENTIAL COST Every decision involves choosing from among at least two alternatives. Any cost that differs between alternatives is a differential cost. Only the differential costs are relevant in making a decision. OPPORTUNITY COST An opportunity cost is the potential benefit given up when selecting one course of action over another. SUNK COST A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Sunk costs are irrelevant and should be ignored in decisions. A. The documents and flow of costs in job-order costing. 1. Materials requisition form. 2. Direct labor time ticket. 3. Job cost sheet. B. Applying overhead using a predetermined overhead rate. 1. Computing the predetermined overhead rate. 2. Using the predetermined overhead rate to apply overhead to jobs. C. Underapplied and overapplied overhead. How is it determined? What is it? What is done with it? D. Journal entries and T-accounts in job-order costing.

6 14-6 APPLYING OVERHEAD In a job-order costing system, the cost of a job consists of: 1. Actual direct material costs traced to the job. 2. Actual direct labor costs traced to the job. 3. Manufacturing overhead applied to the job using a predetermined overhead rate. Actual overhead costs are not assigned to jobs. A predetermined overhead rate is used to assign overhead cost to products and services. It is: Based on estimated data. Established before the period begins. Why use estimated data? Waiting until the year is over to determine actual overhead costs would be too late. Managers want cost data immediately. Overhead rates, if based on actual costs and activity, would vary substantially from month to month. Much of this variation would be due to random changes in activity. PREDETERMINED OVERHEAD RATE FORMULA The formula for computing a predetermined overhead rate is: Predetermined = Estimated total manufacturing overhead cost overhead rate Estimated total amount of the allocation base The company in the preceding example applies overhead costs to jobs on the basis of direct labor-hours. In other words, the allocation base is direct labor-hours. At the beginning of the year the company estimated that it would incur $320,000 in manufacturing overhead costs and would work 40,000 direct labor hours. The company s predetermined overhead rate is: Predetermined $320,000 = = $8 per DLH overhead rate 40,000 DLHs APPLICATION OF OVERHEAD TO JOBS The process of assigning overhead to jobs is known as applying overhead. In the preceding example, Job 2B47 required 27 direct labor-hours. Therefore, $216 of overhead cost was applied to the job as follows: Predetermined overhead rate... $8 per DLH Direct labor-hours required for Job 2B DLHs Overhead applied to Job 2B47... $216 Chapter 3 (Activity Based Costing) UNDERAPPLIED AND OVERAPPLIED OVERHEAD Since predetermined overhead rates are based on estimated data, at the end of an accounting period overhead costs are usually either underapplied or overapplied. In the example, overhead is underapplied by $10,000, which can be determined by examining the balance in the Manufacturing Overhead account: Manufacturing Overhead Actual (b) 24,000 (h) 300,000 Applied Overhead (c) 85,000 Overhead Costs (d) 40,000 Costs (e) 16,000 (g) 145, , ,000 Underapplied Bal. 10, Basic concepts of activity-based costing. 2. Computing activity rates 3. Computing unit product costs. 4. Contrasting activity-based costing and traditional costing. 5. Cost flows in activity-based costing. The $10,000 difference between the actual overhead costs and the applied overhead costs in this case is called underapplied overhead because actual overhead costs exceeded the overhead costs that were applied to inventory. Alternatively, the amount of the underapplied or overapplied overhead Chapter 3 (Activity Based Costing) Chapter 3 (Activity Based Costing) An activity is any event or transaction that causes the consumption of overhead resources. Examples of activities include: Setting up a machine. Processing a purchase order. Inspecting for defects. Performing a blood test. Billing customers. COST FLOWS IN ACTIVITY-BASED COSTING Cost flows and journal entries are the same under activity-based costing as they are under more traditional costing systems. The only difference is that overhead is applied to products using multiple activity rates instead of just one predetermined overhead rate. Activity-based costing is a costing process in which: 1. Each major activity has its own activity cost pool to which overhead costs are assigned. 2. Each activity cost pool has its own activity measure. 3. An activity rate (i.e., predetermined overhead rate) is computed for each activity cost pool. 4. The activity rates are used to apply overhead costs to products.

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