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Course Book MANAGEMENT ACCOUNTING DLBMAE01 iu INTERNATIONAL UNIVERSITY OF APPLIED SCIENCES MANAGEMENT ACCOUNTING DLBMAE01 iu INTERNATIONAL UNIVERSITY OF APPLIED SCIENCES BASIC READING Atkinson A A Kaplan R Matsumura E M Young S M 2012 Management accounting Information for decisionmaking and strategy execution 6th ed Pearson Drury C 2019 Management accounting for business 7th ed Cengage INTRODUCTION MASTHEAD Publisher IU Internationale Hochschule GmbH IU International University of Applied Sciences JuriGagarinRing 152 D99084 Erfurt Mailing address AlbertProellerStraße 1519 D86675 Buchdorf mediaiuorg wwwiude DLBMAE01 Version No 00220240123 N N 2024 IU Internationale Hochschule GmbH This course book is protected by copyright All rights reserved This course book may not be reproduced andor electronically edited duplicated or dis tributed in any kind of form without written permission by the IU Internationale Hoch schule GmbH hereinafter referred to as IU The authorspublishers have identified the authors and sources of all graphics to the best of their abilities However if any erroneous information has been provided please notify us accordingly 2 TABLE OF CONTENTS MANAGEMENT ACCOUNTING Introduction Signposts Throughout the Course Book 6 Basic Reading 7 Further Reading 8 Learning Objectives 10 Unit 1 Introduction to Management Accounting 11 11 Definition of Management Accounting 12 12 Definition of Cost 13 13 Cost Behavior Fixed and Variable Costs 14 14 External Factors Influencing Costs 19 Unit 2 CostVolumeProfit Analysis 23 21 BreakEven Analysis 24 22 CVPCalculations 25 23 Cost Structure and Operating Leverage 29 24 Cost Structure and Variabilization 31 Unit 3 Simplistic Methods of Cost Allocation 33 31 Cost Behavior Direct and Indirect Costs 34 32 The Need for Cost Allocation 36 33 Overhead Rates 37 Unit 4 ActivityBased Costing 43 41 Basics of ActivityBased Costing 44 42 Implementing ActivityBased Costing 45 Unit 5 Overhead Analysis Sheet 53 51 Departmental Cost Allocation 54 52 Reciprocal Method 55 53 Step Method 58 3 Unit 6 Relevant Cost Concepts 63 61 Foundational Cost Concepts 64 62 Cost Decisions 65 Unit 7 Budgets 73 71 The Budgeting Process 74 72 Different Types of Operating Budgets 76 73 Financial Budgets 81 Appendix List of References 88 List of Tables and Figures 89 4 WELCOME SIGNPOSTS THROUGHOUT THE COURSE BOOK This course book contains the core content for this course Additional learning materials can be found on the learning platform but this course book should form the basis for your learning The content of this course book is divided into units which are divided further into sec tions Each section contains only one new key concept to allow you to quickly and effi ciently add new learning material to your existing knowledge At the end of each section of the digital course book you will find selfcheck questions These questions are designed to help you check whether you have understood the con cepts in each section For all modules with a final exam you must complete the knowledge tests on the learning platform You will pass the knowledge test for each unit when you answer at least 80 of the questions correctly When you have passed the knowledge tests for all the units the course is considered fin ished and you will be able to register for the final assessment Please ensure that you com plete the evaluation prior to registering for the assessment Good luck 6 BASIC READING Atkinson A A Kaplan R Matsumura E M Young S M 2012 Management account ing Information for decisionmaking and strategy execution 6th ed Pearson Drury C 2019 Management accounting for business 7th ed Cengage 7 FURTHER READING UNIT 1 Dobbs R Koller T Ramaswamy S 2015 The future and how to survive it Harvard Business Review 9310 4862 Van der Linden B Freeman R E 2017 Profit and other values Thick evaluation in decision making Business Ethics Quarterly 273 353379 UNIT 2 Barbu IM 2015 Cost behavior analysis Review of General Management 211 185 197 Machuga S 2012 A case method approach to teaching costvolumeprofit analysis Jour nal of Accounting and Finance 125 104109 UNIT 3 Boon J Wynen J 2017 On the bureaucracy of bureaucracies Analyzing the size and organization of overhead in public organizations Public Administration 951 214 231 Norfleet N A 2007 The theory of indirect costs AACE International Transactions 121 126 UNIT 4 Cokins G Capusneanu S 2010 Cost drivers Evolution and benefits Theoretical Applied Economics 178 716 Fito M A Llobet J Cuguero N 2018 The activitybased costing model trajectory A path of lights and shadows Intangible Capital 141 146161 UNIT 5 Atik M Köse Y Yilmaz B 2014 Allocation of the general production costs to the cost centers by linear programming method MVU 71 5365 Togo D 2013 Reciprocal cost allocations for many support departments usingbspread sheet matrix functions Journal of Accounting and Finance 134 5559 8 UNIT 6 Churchill N C 1984 Budget choice Planning vs control Harvard Business Review 624 150164 Howell R A 2004 Turn your budgeting process upside down Harvard Business Review 8278 2122 UNIT 7 Churchill N C 1984 Budget choice Planning vs control Harvard Business Review 624 150164 Howell R A 2004 Turn your budgeting process upside down Harvard Business Review 8278 2122 9 LEARNING OBJECTIVES Decisionmaking is an essential managerial task and activity in businesses and other organizations A major source of information guiding decisions of farreaching importance are accounting data Management Accounting provides and processes such data in order to provide a sound basis for managerial decisions In this course book you will discover different perspectives on cost and related account ing data You will become familiar with proven concepts of cost analysis in support of managerial decisionmaking Furthermore you will gain insight into various techniques that help management make decisions You will also consider major aspects of the contemporary business environment as con textual background After examining reallife occurrences presented as short introductory stories at the beginning of each unit you will learn to apply basic managerial accounting methods Moreover you will acknowledge the complexity of the field You will come to understand managerial accounting as a task full of ambiguities despite some clearcut approaches to deriving figures You will acknowledge the need to interpret data and the requirement of understanding contextual factors and specifics along with the need to adapt the basic tools to each respective business or situation 10 UNIT 1 INTRODUCTION TO MANAGEMENT ACCOUNTING STUDY GOALS On completion of this unit you will have learned the purpose of management accounting the definition of cost the difference between fixed and variable costs the concepts of step cost and mixed cost to calculate and distinguish between total and perunit cost methodologies 1 INTRODUCTION TO MANAGEMENT ACCOUNTING Introduction Management or managerial accounting often referred to as cost accounting is a task most managers or responsible experts within businesses and other organizations must conduct to facilitate support and contrast decisions and decision alternatives based on financial data There are many potential forms and sources within their business that managers can use to derive financial data Organizational decisionmakers receive infor mation from data generated in financial accounting databases and reports as well as infor mation derived from enterprise resource software which measures operational processes Managers retrieve and interpret information relevant to making decisions Data tell stories through numbers with obvious and sometimes more obscure meanings so understanding the data sometimes requires interpretation It is important to be aware that there is no such thing as the truth in finance or accounting data There is just plentiful information compiled following certain rules or logic that requires interpretation to derive responsible decisions that will affect the future of the organization This course book explores basic concepts and typical cost analysis techniques of business processes to provide not only a toolset but also a way of thinking 11 Definition of Management Accounting The information provided by accounting is important for internal users within a company as well as for external stakeholders ie shareholders and creditors Thus there are two different types of accounting each providing different types of information Whereas man agement accounting provides information for people within an organization to help them to make better decisions and to improve the effectiveness and efficiency of a companys operation financial accounting has the task of providing information eg an annual report primarily to external stakeholders Drury 2018 Therefore Atkinson et al 2012 define management accounting as follows Management accounting is the process of supplying the managers and employees in an organization with relevant information both financial and nonfinancial for making decisions allocat ing resources and monitoring evaluating and rewarding performance p 26 Typical financial information provided in management accounting are costs and revenues Typical nonfinancial information provided in management accounting includes measures that are related to customer satisfaction and customer loyalty employee motivation and process and product quality 12 Asset An asset is a resource with an economic value that is controlled by a business expecting that it will provide a future ben efit As illustrated in the following table financial accounting and management accounting are mainly distinguished according to their users the provided information the time dimen sion and the existence of formal requirements Table 1 Overview of Major Differences between Management and Financial Accounting Management accounting Financial accounting Audience Internal eg managers and other decisionmakers External eg tax authorities investors Emphasis of information Relevance for the purpose of decisionmaking Precision conformitycompli ance and reliability of financial data Time horizon Future orientation Flexible time horizons Coverage of the past Defined periods eg a busi ness year Formal requirements Not mandatory No formal rules Mandatory Defined by law and rulesets eg US GAAP or IFRS Source Hastenteufel 2020 based on Drury 2019 When looking at financial data it is important to keep in mind that it is not objective and is mostly a matter of interpretation On the one hand the data provided in financial account ing are collected according to different accounting laws and rulesets that at least partly reflect cultural traditions and political interests Moreover the balance sheet policy of a company is reflected in these data On the other hand the internally produced informa tion in management accounting reflects mainly the values and attitudes of company man agers Therefore to be able to understand financial data regardless of whether it is con ducted for internal or external purposes they always need to be put into a context and interpreted 12 Definition of Cost At the outset it is important to have a closer look at costs Generally speaking cost is the amount or equivalent paid or charged for something MerriamWebster nd There are two ways that cost is incurred in organizations Firstly cost is incurred when an organiza tion consumes an asset The consumption of an asset occurs through its use for example printing paper used in the copy machine and sent out as letters or raw material trans formed into a finished product when used in a manufacturing companys production line The consumption of an asset also occurs through depreciation which is the allocation of the purchase price of a fixed asset such as a car machine or building over its useful life time This allocation procedure must be performed following the accounting ruleset valid in the respective country 13 Depreciation This is an accounting method to allocate the costs of tangible or physi cal assets over their use ful life and represents how much of an assets value has been used Services Services are typically intangible products or activities such as account ing banking consulting insurance or banking The second way of incurring cost is the use of a paid service Companies use various serv ices while conducting business Examples include utilities eg electricity water and gas work performed by employees who receive salaries or by external service providers eg repair or maintenance work financial services for which the respective institution typi cally charges fees or interest eg insurance or bank loans and consulting eg IT or business consulting It is worth noting that cost incurred does not mean the same as money being paid out There is a difference between costs or expenses and cash payments For example organi zations may purchase some goods or services against an invoice which means that while they incur a cost at the point of purchase they do not have to make a cash payment at that time In addition some costs are noncash items This is the case with depreciation where a cost is incurred on the financial statement of an organization without any cash transaction taking place direct and indirect costs period and product costs fixed and variable costs and relevant and irrelevant costs Drury 2018 Some of these cost types are considered in this course book 13 Cost Behavior Fixed and Variable Costs As mentioned before there is no obligation for the internal analysis of costs Managers and consultants brought in to provide organizations with advice will have to develop their own systems and rationality to make sense of costrelated data There are however widely used basic categorizations of cost and cost behavior helpful for indepth analysis To be able to make essential decisions managers must understand how costs and reve nues will vary with different activity levels different units of production or sales One such method of categorization is the distinction between fixed and variable costs This information is required to answer questions such as How will costs and revenues change if volume is increaseddecreased by X percent What is the impact on profits if the selling price is reduced by X percent How many product units must be sold to break even In this context fixed and variable costs can be differentiated Drury 2018 Definition of Fixed and Variable Costs Costs that remain constant in their total amount regardless of the level of organizational activity within a certain period are called fixed costs FC For example if a company has committed to paying a monthly rent of 3500 for an office building this cost is not affec 14 Fixed costs These costs remain con stant regardless of the level of output within a certain time period ted by how many customers are served by the sales representatives working at that office Even if the company does not conduct any business in the office the rent still must be paid but in the long run there are no fixed costs because any contract forcing the com pany to pay rent salaries license fees etc can be terminated or can expire according to its terms and conditions Insofar as payment obligations are part of the contracts in ques tion any new contract signed contract alteration or termination will change an organiza tions total amount of fixed costs Management accounts can express the total fixed costs on a monthly quarterly or annual basis or define a different time horizon that is meaning ful for their analysis Atkinson et al 2012 When looking at fixed costs there is a special feature to consider Costs that remain fixed within a certain range and then increase in increments are referred to as step costs Drury 2018 For example a gate at the airport with fixed costs of 6000 can process up to 2000 passengers per day If an airline wants to operate additional flights and handle more pas sengers at this airport they must add another gate Increasing the capacity in this manner will lead to a doubling of fixed costs 2 6000 12000 but will allow the airline to proc ess a maximum of 4000 passengers per day Figure 1 Step Costs Source Hastenteufel 2020 Operating at capacity is most attractive from a management perspective in step cost sce narios Management will typically be reluctant to add capacity even if there is more demand potential unless it is likely that the increased capacity can be fully utilized within the foreseeable future In the airport example assuming fixed cost is also shown daily the actual handling of 2000 passengers per day results in the following FC per unit Total FC output 6000 2 000 3 per passenger If an airport wants to fully capitalize on for example a 2500passenger demand potential the required additional gate doubles fixed cost to 12000 The extra passengers there fore amount to perunit fixed cost of 120002500480per passenger That means to increase the passenger capacity by 25 percent 2000125 2500 the fixed costs rise by 15 Variable costs These costs vary in direct proportion to the level of output 60 percent 480 compared to 300 Hence managers will often stretch the existing capacity as far as possible to squeeze the higher demand into the existing infrastructure before they will commit to enlarging their capacities Costs that vary in direct proportion to the level of activity are called variable costs VC For example if a restaurant incurs 550 of food costs for each meal served the total food cost will equal 550 multiplied by the number of guests who ordered meals Variable costs are also valid for specific time horizons that become input in the production or serv ice provision process at the negotiated price A change in that price resulting from a new or adapted contract will translate into an altered variable cost level Atkinson et al 2012 The following figure shows the graphic representation of fixed costs FC and variable costs VC Fixed costs are shown on the left side of the graph as a straight line parallel to the xaxis That axis shows the output or activity level At the yaxis the fixed cost line shows that the total fixed cost amount does not change it remains 3500 regardless of the number of guests served because the rent will not change until the contract is altered Variable costs are shown on the right side of the graph as a line with a linearly increasing slope With each additional output the company incurs additional variable costs Figure 2 Fixed and Variable Costs Source Drury 2018 Please note that the linear function of variable cost is a simplification of reality In many reallife business settings the rate of change in costs with increasing activity or output is typically curvilinear The following figure illustrates the standard relationship between production and variable costs The following graph on the left side shows decreasing vari able cost as would be the case with volume discounts where additional units can be pur chased at lower unit prices if specified thresholds are reached The following graph on the right shows increasing variable costs that could apply when increasing wagesbonuses are paid for higher production output For reasons of simplification however a linear cost trend is assumed throughout this course book 16 Figure 3 Curvilinear Variable Costs Source Hastenteufel 2020 Total Costs Total costs TC also referred to as mixed costs include both fixed costs and variable costs Note that the total cost line in the graph starts with the fixed costs at output level zero at the yaxis because even with no output fixed costs are incurred Atkinson et al 2012 Total costs are calculated with the following formula Total costs total fixed costs variable costs per unitoutput TC FC vc x The following example shows the development of the total costs with a rising output Table 2 Total Costs Example Number of guests Fixed costs Variable costs Total costs 100 100000 500 150000 150 100000 500 175000 200 100000 500 200000 250 100000 500 225000 300 100000 500 250000 350 100000 500 275000 400 100000 500 300000 Source Hastenteufel 2020 17 Figure 4 Mixed Costs Source Atkinson et al 2012 The fixed cost portion of mixed cost or total cost remains constant regardless of the activ ity level The variable cost portion of mixed cost or total cost increases linearly so that the cost increase of mixed cost or total cost with an increased number of units corresponds exactly with the change in total variable cost Per Unit Costs The cost characteristics of fixed and variable costs in terms of their relationship to the level of organizational activity invert when we consider the perunit costs instead of the total costs In the previous example we looked at the relationship between fixed and variable costs and total output When total output costs are calculated fixed costs remain static while variable costs are proportional to the number of units produced However the relation ship between fixed and variable costs changes when costs per unit produced are deter mined In this calculation fixed costs become proportional to the number of units pro duced while variable costs remain the same Drury 2018 In other words fixed costs per unit change depending on the output while variable costs do not change This perspective is often important for cost analysis Pricing decisions rely upon accurate cost information A products price per unit is the first step in setting a profitable sale price In fact the cost per unit strongly influences sale price feasibility For example a total rent of 3500 per month divided by 100 customers equals 35 rent per customer If the busi ness has 200 customers this turns into 1750 per customer The formula to calculate FC per unit is as follows FC per unit total FC output However variable costs per unit do not change with increasing activity levels The follow ing illustration provides an overview of fixed cost per unit versus variable cost per unit cost behavior 18 Figure 5 Fixed and Variable Costs per Unit Source Drury 2018 To evaluate whether a company can afford a certain amount of fixed costs this kind of analysis is essential If the fixed costs are due monthly the output should also be conver ted to monthly figures to provide meaningful comparability Unlike fixed costs that change per unit according to the activity level variable costs remain constant However some times there are exceptions Consider a contract with a supplier that factors in volume dis counts if the company purchases at least 2000 goods per month the purchase price offered by the supplier may fall from 100 to 95 per unit 14 External Factors Influencing Costs In the constantly changing contemporary business environment there is a strong empha sis on costs In the past companies mainly focused on producing as many units as possi ble or gainingincreasing market share Nowadays controlling and cutting costs has become the major driving force behind management activity in many corporate cultures The reasons for such a paradigm shift include but are not limited to 1 global competition and supply chains 2 shortening product life cycles and 3 technology Global Competition and Supply Chains In the past competition in certain market segments was limited to local or regional com petitors Nowadays businesses must compete with providers from all over the world And there is always someone offering a cheaper product Supply chains have also become glo balized Thus products and product components are shipped around the world at mini mal perunit costs in large container vessels granting global availability Drury 2018 Nowadays due to globalization sourcing the cheapest input units has become common practice for many organizations Every cent saved per unit produced can contribute to a competitive advantage or a substantially higher profit generated on aggregate Many com panies buy their products or product components abroad to make sure they get the cheapest price 19 Shortening Product Life Cycles In many industries new generations of products are rolled out faster each year Previously new designs and upgrades often went to market a few years apart this development period has now been shortened drastically Occasionally it will be enough to update a few design features to keep up with the competition and maintain customer loyalty eg fea ture improvements such as more power or improved energy efficiency The development of new features or even entirely new products or product generations is costly Expenses associated with product development typically include the salaries of personnel responsi ble for product innovation such as engineers or software programmers specialized facili ties like laboratories or office buildings and materials consumed in the process of experi mentation This trialanderror process is required to prepare a product for mass production and distribution Cost control and an understanding of the costbenefit rela tionship of each product version over its expected lifetime is therefore vital for an organi zation to remain competitive and avoid lossmaking projects Drury 2018 Technology Enterprise resource and workflow software with integrated counting and measuring appli cations have especially enabled managers to obtain precise and almost endless streams of data That allows for a more sophisticated cost pattern analysis of even the most com plex manufacturing or service delivery processes Smart and mobile tools with massive storage capacity and online communication capabilities referred to by Friedman 2006 as the steroids of a globalized business world transmit all relevant data to managers in near realtime whether they are sitting in their office waiting for their connecting flight at the airport or networking at the golf course Furthermore the results of digitization and increased connectivity have yet to be fully realized Due to the massive surge in data crea tion and availability online processes hold the potential for more targeted managerial analysis Drury 2018 SUMMARY Management accounting or cost accounting is an important function that supports the decisionmaking process within organizations It relies on internal financial data as well as published financial reports Unlike financial accounting which is governed by national laws and even inter national rulesets to protect various external stakeholders there are no formal guidelines for management accounting However there are some proven basic concepts and ways of thinking about costs Fixed costs do not change in in response to activity level whereas variable costs do change proportionally with the level of activ ity 20 It is important to acknowledge that data selected for decisionmaking require interpretation Furthermore thorough understanding of internal processes is essential to finding meaningful answers to urgent business questions Management accounting has elevated in importance over recent years The strong focus on costs in most businesses nowadays is owed to a business environment It is characterized by technological advances and by competition putting pressure on companies to be costefficient 21 MANAGEMENT ACCOUNTING UNIT 2 COSTVOLUMEPROFIT ANALYSIS STUDY GOALS On completion of this unit you will have learned what the breakeven point is how to apply a breakeven analysis the concept of contribution to perform basic costvolumeprofit analysis calculations how to distinguish the cost structures of organizations what operating leverage is why many businesses try to transform fixed costs into variable costs Breakeven This means that total rev enue equals total cost so that neither a profit nor a loss shows at the bottom line 2 COSTVOLUMEPROFIT ANALYSIS Introduction about whether a world economy driven by oil is viable considering that crude oil like all natural resources extracted from Earth is a finite resource and that its consumption dam ages the environment eg SchneiderMayerson 2015 On the one hand visionary andor environmentally concerned people try to outline a future without oil amid our still oil dependent era on the other hand economic thinkers point out that there may still be much more oil than we envisioned but that its extraction is not profitable because of the high costs associated with extracting it from difficult terrains Recently global oil prices have recovered after a decline for several years Costly shale oil extraction projects become viable at around 70 per barrel The Economist Daily Chart 2018 and the pros pect of achieving that price sparked new production highs This context illustrates the core of costvolumeprofit CVP analysis that will be examined in this unit In this unit breakeven analysis and cost structure with a special focus on operation lev erage and variabilization are discussed in detail 21 BreakEven Analysis This type of analysis works with both fixed costs and variable costs Breakeven analysis is useful in understanding the relationship between sales revenues costs and profits in sce narios of changing activity or output levels Based on the assumption that the manage ment of a company can decide the activity level ie how many units to produce or to sell calculations can be made to understand how changes in volume will yield profit or loss BreakEven Point BEP The activity level resulting in zero profit or loss which means that the amounts of both total revenues and total costs are equal is referred to as breakeven In a graphical dis play the BEP is located at the point where the volume or quantity Q shown on the xaxis and the costrevenue shown on the yaxis results in neither a profit nor a loss Total costs and revenues are equal hence the BEP represents the intersection of the total costs TC and total revenue TR lines Drury 2018 The total cost line corresponds to the mixed cost line shown before It intersects with the yaxis at the amount of the fixed costs FC as even at zero output fixed cost is still incur red The total revenue line TR starts at zerozero because zero sales will result in zero revenues Each additional unit sold will add to the revenue by the corresponding sales price per unit For a matter of simplification it is assumed that the total cost and the total revenue line are both linear functions 24 Figure 6 BreakEven Point Source Drury 2018 Contribution Margin Another essential concept in management accounting is called contribution margin It is the amount remaining from revenue after variable costs VC are deducted It is called con tribution because this amount contributes to covering the fixed costs FC of the organiza tion Drury 2018 To distinguish the perunit variable cost from the total amount of variable costs VC the lowercase acronym of vc is introduced The following example illustrates the idea of the contribution margin A company sells a product for 250 per unit and vc amounts to 175 The contribution margin per unit is 25017575 Hence with each unit the company sells it contributes 75 toward covering the fixed costs 22 CVPCalculations The following sections will show major calculations that can be made in CVP analysis by using the appropriate formulas However it is important to note the calculations rest on several assumptions simplifying the complexity of realworld business situations to aid in understanding and interpreting costs The following assumptions apply Atkinson et al 2012 Total costs and revenues are linear functions of volume All costs can be accurately distinguished as either fixed or variable costs The analysis applies to a relevant range determined by eg capacity If these simplifications are applied CVP analysis can be used to understand the costs and revenues of a business An example is used to illustrate the following calculations and approaches For a specified period a business has total fixed costs FC of 135000 It sells products at 12 per unit The selling price is shown as P in CVP formulas and calcula tions Furthermore each unit sold incurs variable costs vc of 750 25 BreakEven Point in Units This calculation determines how many units a company must sell to break even Drury 2018 p 176 BEP in units FC P vc For the example the calculation of BEP in units is as follows BEP in units 135 000 12 7 50 BEP in units 30 000 In this example the company would need to produce 30000 units to break even BreakEven Point in Revenue To calculate the breakeven point in revenue ie currency value resulting from sales instead of volume or quantity the formula is as follows BEP in revenue FC profit volume ratio PVR with PVR P vc P BEP in revenue FC P P vc For our example the calculation of BEP in revenue is as follows BEP in revenue 135 000 12 12 750 BEP in revenue 360 000 Total cost for this example is calculated as follows TC FC VC TC 135 000 30 000750 TC 360 000 neither profit nor loss In this example the company would need to earn revenue of 360000 to break even 26 Units Required for Targeted Profit To determine how many units a company must sell to achieve a specific profit figure add the targeted profit to the fixed cost amount The logic behind this is that companies do not just need to cover all costs through sales but they also must earn a profit Atkinson et al 2012 p 92 Units sold for target profit FC target profit Pvc In the example the management of our business examines the possibility of generating a profit of 45000 The calculation then looks like this Units sold for target profit 135 000 45 000 12 750 Units sold for target profit 40 000 To reach its target profit the company would have to sell 40000 units Profit from the Sale of Predetermined Volume This calculation makes sense if the management of a company relies on market analysis data indicating how large the demand is ie how many units the company will be able to sell at the current price Profit P x FC vc x P vc x FC In the example market research leads to the optimistic outlook of selling 50000 units To determine how much profit would yield the calculation would be Profit 50 000 12 7 50 135 000 Profit 90 000 With a predetermined sales volume of 50000 units the company would be able to make a profit of 90000 Price to Charge for Predetermined Profit and Volume Provided that management relies on market research indicating how many units can be sold in the market and that a certain profit level is targeted this approach determines the selling price per unit required Formulas P revenue required x with revenue required FC vc x target profit 27 Regarding the previous example 50000 units can be sold to add a target profit of 100000 The calculation of the selling price perunit is as follows P 135 000 7 50 50 000 100 000 50 000 12 20 If profit and volume are predefined the company needs to sell its products for 1220 per unit Margin of Safety The margin of safety is a valuable consideration for business managers in volatile markets or ones prone to periods of economic downturn where a drop in demand is always possi ble It shows how much sales may decrease before a loss occurs by connecting the expec ted revenue figure to the one required to break even Drury 2018 p 179 Margin of safety expected salesbreakeven sales expected sales 100 Taking up our previous example the expected sales volume is 40000 units which then amounts to a revenue of 480000 40000 units 12 Since the BEP is reached at 30000 units see above the revenue needed to break even will be 360000 equals 30000 units 12 Margin of safety 480 000 360 000 480 000 100 Margin of safety 0 25 25 The amount by which the expected sales exceed the breakeven sales is expressed as a percentage in this case it is 25 percent In general higher margins of safety are associated with lower risk of business activity Graphical Representation To show a complete graphical representation of a typical CVP analysis the previous busi ness example is again refered to FC 135000 for a specified period P 12 vc 750 BEP is reached at a volume of x 30000 units The total costs and the total revenue are both 360000 Total revenue P x 12 30 000 360 000 Totalcosts FC vc x 135 000 7 50 30 000 360 000 28 Figure 7 CVP Analysis Source Drury 2018 The graph illustrates that with a quantity above 30000 units a profit is generated whereas a quantity below 30000 will result in a loss However the maximum quantity depends on the capacity of the business Assuming the maximum quantity is 60000 the profit at that point would be 135000 Total revenue P x 12 60 000 720 000 Total costs 135 000 750 60 000 585 000 Profit total revenue total costs 720 000 585 000 135 000 23 Cost Structure and Operating Leverage For analytical purposes it is helpful to not just look at the total cost of an organization but to distinguish how much of the total cost are fixed costs and variable costs That differen tiation is a simple step in looking at a companys cost structure An organization with total costs of 750000 in any given year 500000 of which are fixed costs and 250000 of which are variable costs operates with twothirds fixed costs and onethird variable costs Whether twothirds is a high fixed cost proportion and if that is a favorable position cannot be answered easily As mentioned in the introduction accounting data are a matter of per spective subject to interpretation which also depends on contextspecific aspects The nature of companies and industries determines to some degree typical cost struc tures A company that needs office or retail buildings or manufacturing machinery to oper ate tends to have higher fixed costs because of rent depreciation maintenance repair costs and fixed salaries than for example a business providing software that program 29 Operating leverage a measure of profits sen sitivity to changes in salesrevenues mers could design from home However in almost every industry there are cases of higher and lower fixed cost proportions reflecting managerial decision making and strategic choices rather than being part of a certain industry Operating leverage for example helps measure how sensitively the bottom line result responds to changes in revenues Drury 2018 The sensitivity is higher in cases of a high fixed cost as the following example illustrates A massage parlor employs a masseur who can treat a maximum of five patients per shift The following data are known FC per shift consisting of rent insurance premium salary etc 120 vc per patient consisting of massage oil and towel laundry 5 Price per massage 49 Experience shows that on average four patients book a massage per masseur per shift Hence the corresponding data are considered a standard scenario for calculations To understand the implications of differing demand levels the management of the parlor compares three scenarios the standard of four clients per masseur and the variations of three or five clients for one masseur per shift are inserted into the following table to com pare the different outcomes Table 3 Operating Leverage Data per mas seurshift Scenario minimum 3 patients change Scenario average 4 patients change Scenario maximum 5 patients Revenue Q P P 49 147 25 196 25 245 FC per shift 120 120 120 120 VC Q vc vc 5 15 20 25 Profit Rev FC VC 12 786 56 786 100 Source Hastenteufel 2020 We notice that the percentage change in revenue 25 either up or down from the stand ardaverage perspective of four clients is much smaller than the resulting percentage change in profit approximately 78 in both directions Hence small changes in demand have a dramatic effect on the bottom line Mathematically we can explain that quite sim ply the base figure for the application of the respective percentages is much smaller in the case of profit compared to revenue 196 for the standard scenario equals 100 of reve nue but only 56 equals 100 of profit The absolute change however is almost the same 49 revenue per client and 44 profit That phenomenon is typical in organizations 30 Variabilization This is the attempt to transform fixed costs into variable costs with a high proportion of fixed costs leveraging profits up or down In the case of the mas sage parlor assuming the standard scenario of four patients the following cost struc ture is shown Total costs FC vc x 120 5 4 140 FC share 120 140 100 85 71 high FC proportion VC share 20 140 100 14 29 24 Cost Structure and Variabilization The previous section on the operating leverage effect illustrated how a change in revenue results in a much more substantial change in profit or loss This effect is true both ways ie for revenue increases as well as decreases and it is stronger the higher the fixed cost proportion of a company If managers are convinced that their business operates in a per manently growing market with everincreasing revenues it would be a wise decision to build a cost structure with a high fixed cost proportion to benefit from the positive operat ing leverage effect On the other hand if managers are convinced that their business is operating in declining markets with revenue decreases a cost structure characterized by a high variable cost proportion would be more favorable to reduce the negative operating leverage effect although the overall situation in a declining market is of course unfavora ble Obviously neither managers nor other stakeholders can realistically foresee the future despite thorough market analyses and economy outlook reports published by various experts The reality of the business world is that unforeseen developments occur and there is fluctuation in demand behavior In many markets there is a considerable degree of volatility which means that the demand for goods and services is subject to frequent andor unpredictable changes Furthermore prices may frequently change due to com petitive pressures so that a decrease in revenue is not only triggered by fewer customers willing or able to buy goods and services but also by selling the same quantity as before at lower unit prices To reduce the risk resulting from revenue fluctuations especially from downturns or even shortterm decreases many companies nowadays try to convert fixed costs into variable costs a process called variabilization Unlike fixed costs variable costs are usually cov ered directly by revenues as they are incurred only when there is output to be sold Partic ularly businesses facing seasonal eg European beach resorts with booming business during summer holidays and weak demand during the winter months or other typically recurring fluctuations in their industry due to the nature of their product or service prac tice variabilization One way of achieving it is outsourcing This means services or prod ucts previously provided inhouse ie by departments and employees belonging to the organization are now purchased from thirdparty suppliers Instead of internal depart ments the suppliers are external business partners supplying what is purchased based on business contracts Own employees typically mean fixed costs due to fixed salaries social 31 Outsourcing This is the process of con tracting out activities so that goods are purchased from external suppliers instead of being produced inhouse security duties etc In addition buildings and machinery owned inhouse result in fixed costs such as rent depreciation and maintenance Purchasing from outside suppliers makes costs variable OUTSOURCING BY VARIABILIZATION The hotel sector provides a good example of this trend many hotels have con tracted out housekeeping to specialized service firms The hotel orders the cleaning service only for rooms actually sold and pays per room cleaned That makes the personnel cost of housekeeping variable as only rooms sold cause housekeeping cost and that cost is covered by the revenue generated through guests Employing their own staff would mean fixed costs that become problem atic whenever not enough rooms are sold to cover their salaries SUMMARY Costvolumeprofit analysis draws on the differentiation of fixed and var iable costs It is useful to understand the relationship between sales rev enue costs and profit in scenarios of changing activity levels Based on the assumption that the management of a company can decide the activity level ie how many units to produce or sell calculations can be made to understand how changes in volume will result in changes in profit or loss A key concept to that end is the breakeven analysis in which the total revenue and total cost amounts are equal so that neither profit nor loss is incurred Calculations within the breakeven analysis determine how many units must be sold to break even or to achieve a predetermined profit or to calculate a price for which price units have to be sold for a certain profit etc Many businesses are concerned about their cost structure ie the pro portion of fixed and variable costs There is a trend toward converting fixed costs into variable costs wherever possible Fixed costs are consid ered a higher risk in times of volatile demand and potential disruptions in the market because fixed costs are not matched by revenues and thereby put pressure on the financial bottom line in times of decreasing sales 32 UNIT 3 SIMPLISTIC METHODS OF COST ALLOCATION STUDY GOALS On completion of this unit you will have learned to distinguish direct from indirect costs to distinguish product from period costs which costs need to be allocated and why the meaning of cost objects how to allocate costs based on simple approaches Direct costs These can be traced back to a specific output 3 SIMPLISTIC METHODS OF COST ALLOCATION Introduction This unit examines the problem of dividing total costs fairly and appropriately so that all cost is accounted for and no unit a product a department etc bears too much or too little cost in the end Such a result could lead to deflected management decisions with a high likelihood of negative consequences It is a bit like splitting a virtual pie so that each person gets their share whereas the intuitive practice for real pies cutting the pie into equal slices may not be the best solution On the contrary in management practice this approach would almost always represent the worst solution To understand this problem we resort to another challenge known from everyday life dis tributing utility costs among the tenants of an apartment building Besides the vested interests of landlords and leasers there are complex legal regulations In Germany there is for example a law requiring the regular testing of centralheatingwater tanks or boil ers for Legionella Who bears the cost of this It can be distributed among the tenants as ancillary expenses eg real estate tax waste collection fees but what if the hot water consumption pattern varies widely across the ten ants Some families use the washing machine more often some people take a hot bath every day and others are hardly at home because they often go on business trips Investors buying apartment buildings just as a safe easycare investment are likely to hit a moment of truth when the first clearing is due eg Schütrumpf 2012 31 Cost Behavior Direct and Indirect Costs Besides the categorization of costs as fixed and variable there is another widely used approach that is helpful for certain types of cost analyses the distinction between direct and indirect costs Direct Costs Costs that can be clearly traced to a specific output of a company are referred to as direct costs In a further step of categorization direct costs are often divided into direct labor DL and direct material DM costs The former includes all costs incurred due to labor activity performed directly on output for example the salary of a worker at the assembly line of a manufacturer or the salary of a service person directly working with customers The latter includes the costs of all materials arising from the output for example the steel that becomes part of a car Drury 2018 34 Indirect costs These costs cannot be clearly traced back to a specific output Indirect Costs Indirect costs cannot be traced to a specific output of an organization Once more there is the subcategorization of indirect labor and indirect materials The former encompasses costs of labor activity that go beyond working on a specific output such as the salaries of supervisors in charge of several production lines The latter refers to materials that do not directly become part of the output such as lubricants used for machines that in turn are deployed to produce different output types in a factory such as different car models or different pieces of furniture In addition there is manufacturing overhead This subtype of indirect costs denotes costs incurred in operations that are not adequately captured as either labor or material These include for example rent or insurance costs for production buildings or costs for utilities such as electricity If electricity is used at a manufacturer to operate machines that produce different types of output or at a bakery for an oven baking different types of bread and cakes the costs cannot be associated with a specific output All the aforementioned costs are related to the production of goods or services and can therefore be summarized as product costs Furthermore some costs are not even related to production such as selling and administrative expenses These costs include for exam ple salaries of salespeople rent and depreciation for office buildings or human resource management department costs All these costs are unrelated to the core activity of a busi ness and are often referred to as period costs to differentiate them from costs incurred in operations Drury 2018 The following table provides an overview of these direct indi rect and period costs Figure 8 Product Costs Source Hastenteufel 2020 35 Figure 9 Period Costs Source Hastenteufel 2020 If a company only provided exactly one specific product or one service without variations a rather hypothetical case all costs could be considered direct costs because they all are fully caused by that one productservice The need to differentiate direct indirect and period costs arises through the variety in goods and services offered 32 The Need for Cost Allocation Most cost analysis and cost accounting activities within organizations deal with the chal lenge of allocating indirect and period costs to specific units of products or services Knowing the costs of one unit of a certain output as precisely as possible enables manage ment to make better decisions One example would be pricing since managers usually want to know at which minimum price the products offered will be profitable Whereas direct costs can be associated with a specific output indirect costs cannot Therefore cost allocation is required That means these costs are allocated to cost objects such as prod ucts in some systematic way The factual starting point of cost analysis is usually the figure of total costs These are exact and known eg from the invoices the organization has to pay or from the cash already paid for expenses Total costs are also featured in income statements produced in the domain of financial accounting as required by law or by international rulesets depend ing on the size legal form and financial market context of the organization What is not known is how much of the total costs belong to specific products or departments As soon as there are several cost objects in an organization there is no unified natural logic for determining how much of the total indirect and period cost belongs to each one No cost allocation approach is 100 percent accurate there is always a notion of arbitrary interven tion The terminology featured in the table below is essential for subsequent cost analysis 36 Table 4 Important Cost Terminology Cost Expenses incurred through the consumption of an asset or the use of a service Cost object The target of which managers want to know the price incurred to buildhaveoperate it For example products manufactured in the company departments of the organization or customers of company services Cost allocation The process of allocating costs that cannot be traced to cost objects Cost driver An object activity or phenomenon that causes a change in the costs incurred Source Hastenteufel 2020 33 Overhead Rates Predetermined Overhead Rate To allocate indirect or period costs systematically there must be a basis of cost allocation a socalled cost driver This term points to the underlying assumption that the use of a cost driver will also increase costs The most simplistic way of allocating costs to cost objects is to use the same cost driver across an organization Such cost drivers are often volumebased as they refer to an amount produced or provided in operations For exam ple the number of units produced can be a volumebased cost driver as can the number of direct labor hours worked There are four steps involved in establishing a predeter mined overhead rate Accountingformanagement 2020 These are as follows 1 Estimate the total amount of overhead for the operating period 2 Select the cost driver 3 Estimate the total volume of the cost driver for the operating period 4 Divide the estimated overhead figure by the estimated cost driver volume To allocate overhead based on this rate multiply the rate by the number of cost driver units applied in production Consider the following example a company estimates a total overhead of 700000 and a total of 87500 direct labor hours DLH for the next operating year The predetermined overhead rate then is 700 000 87 500 8 per DLH The company produces three different products A B and C The following table shows the respective DLH for all three products and the companywide overhead rate which is sometimes also referred to as the blanket rate Table 5 Predetermined Overhead Rate Example Dataset Total A B C Overhead costs 700000 Direct labor hours 87500 22250 33050 32200 37 Total A B C Overhead rate per DLH 8 Source Hastenteufel 2020 With the following calculation we can allocate the total overhead to the three products based on the predetermined rate of 8 per DLH A 22250 DLH 8 178000 B 33050 DLH 8 264400 C 32200 DLH 8 257600 total overhead allocated 178000 264400 257600 700000 Departmental Overhead Rate Continuing with the previous example the company now wants to achieve a more precise cost allocation with a little more information available The number of direct labor hours in the different departments is known for each product as shown in the table below Table 6 Departmental Overhead Rate Example Dataset 1 A B C Total DLH in department I 2500 1800 8200 12500 DLH in department II 4750 7250 13000 25000 DLH in department III 15000 24000 11000 50000 Total DLH 22250 33050 32200 87500 Source Hastenteufel 2020 Moreover the following overview of department overhead and DLH which leads to a sep arate overhead rate per department is known Table 7 Departmental Overhead Rate Example Dataset 2 Dept I Dept II Dept III Total Overhead costs 150000 450000 100000 700000 Direct labor hours 12500 25000 50000 87500 Overhead rate per DLH 12 18 2 8 Source Hastenteufel 2020 38 This leads to a new calculation of overhead allocation to products Differentiating the DLH each product requires in each of the departments respectively The total amount allocated remains the same But there is a shift between the products Product C absorbs much more of the total cost as it did with the blanket rate because it requires the most hours in department II which has the highest rate Products A and B each absorb much fewer of the total costs as with the predetermined overhead rate Table 8 Comparison of Predetermined Overhead Rate and Departmental Overhead Rate All amounts in Predetermined overhead rate Departmental over head rate Difference A 178000 145500 32500 B 264400 200100 64300 C 257600 354400 96800 Total allocated 700000 700000 0 Source Hastenteufel 2020 Over and UnderApplication of Overhead Companies often rely on budgeted overhead rates for the upcoming operating year rather than waiting until the actual figures are available at the end of the period This delay would be a major disadvantage for example by hindering management from making accurate pricing decisions At the latest a selling price needs to be calculated when sales start It can still be adjusted later if necessary Example A business estimates its overhead and activity for the following period as activity of 400000 DLH total overhead of 8 million The predetermined overhead rate is 8 000 000 400 000 20 per DLH As production goes along the companys accountant will apply this rate and allocate 20 of overhead whenever one DLH is worked on a product Assuming that the actual data at the end of the period are activity of 425000 DLH more than planned and overhead incurred 8 million as planned then the overhead applied is 425 000 20 8 500 000 In this case there is an overapplication of overhead which means that more costs were allocated to products than were incurred 39 If the actual data at the end of the period are assumed to be as follows activity of 375000 DLH less than planned and overhead incurred 8 million as planned The overhead applied is 375000 DLH 20 7500000 In this case there is an underapplication of overhead which means that not all costs incurred were allocated to the products The following table provides an overview of various scenarios to illustrate how either over or underapplication of overhead can occur Even though an exact application is possible it is rather unlikely Table 9 Overhead OverUnderApplication Scenarios Actual DLH Predetermined rate per DLH Overhead applied Actual over head Consequence 250000 20 5000000 7750000 Underapplication of 2750000 m 350000 20 7000000 8500000 Underapplication of 1500000 m 450000 20 9000000 9000000 Exact application 500000 20 10000000 7250000 Overapplication of 2750000 m Source Hastenteufel 2020 Any misapplied overhead will have to be adjusted That can either be done by using the socalled costs of goods sold COGS account which is used in financial accounting or by using productionrelated accounts such as workinprocess WIP or finished goods inven tory It is important that all costs incurred are absorbed by appropriate accounts Usually such adjustments will be made only at the end of the year as seasonal fluctuations during the year are likely to lead to over and underapplications offsetting each other Adjustments in this domain show a strong link between financial and managerial account ing the total cost figures are factual and therefore appear in both systems For accurate reporting as required by financial accounting rules however it does not matter how you internally allocate the factual cost figures to your cost objects such as departments prod ucts or units of a product 40 SUMMARY Another differentiation of costs separates direct from indirect costs The former can be traced directly to a specific output such as one product out of the product range of a factory whereas the latter cannot be traced to a specific output as it is caused indirectly by the entire product range or the manufacturing facility itself Whenever a business produces more than one product or provides more than one service there is no natural way of knowing how much of the known total cost incurred is caused by each single one Therefore there is a need for cost allocation Cost allocation is defined as the process of assigning costs to cost objects especially to products produced or services provided There are simplistic cost allocation methods like the predetermined overhead rate however this approach tends to deliver imprecise results that are inap propriate for decisionmaking The more differentiated cost and proc essrelated information is available the more precise allocation proce dures can be The goal of each cost allocation procedure is to gain a precise under standing of how much it costs a business to produce and sell its prod ucts or services This foundational concept is important to understand ing how to make appropriate pricing decisions The more accurate the results the more likely a business is to make meaningful decisions 41 BACKMATTER UNIT 4 ACTIVITYBASED COSTING STUDY GOALS On completion of this unit you will have learned how to split business processes into activities the assumption underlying the implementation of activitybased costing how to implement activitybased costing to understand different outcomes in terms of profit or figures resulting from different approaches to cost allocation why activitybased costing tends to be more accurate than simplistic cost allocation methods 4 ACTIVITYBASED COSTING Introduction Lowcost airlines offer hundreds of routes from and to Germany throughout the sum mer Most routes connect Germany to Spain Italy and the UK For an airline every route is a product and is under scrutiny for its profitability Lowcost airlines face very intense cost pressure and tough competition They cannot afford to hold on to lossmaking routes so they frequently change their routes and timetables Every business that has several product lines needs an overview of how profitable each of these product lines is With many products or even product types on offer and with com plex manufacturing or service delivery operations it is not easy to determine the contribu tion of each product to the overall bottom line Simplistic cost analysis such as the prede termined overhead rate approach often generates a distorted cost picture and may provide data that lead the management to misguided decisions Activitybased costing is more complex to perform than simplistic overhead allocation methods but it also prom ises a much more accurate and more reliable result so it is preferred by most companies with complex operations and a variety of different products or product lines 41 Basics of ActivityBased Costing Activitybased costing is a cost analysis approach that promises a much more precise and accurate allocation of overhead to cost objects It is widely considered stateof theart in terms of cost allocation methods in todays business world The idea of this approach is to break down productionservice provision processes analytically into all the activities involved in it This allows the analyst to apply a separate cost driver to each of these activi ties The simplistic overhead allocation methods are based on just one cost driver which does not allow for a differentiated picture and tends to generate potentially distorted cost allocations Drury 2018 Of course there are multiple activities involved in business operations and the exact activities involved will be unique to each business An understanding of these activities is crucial to working with activitybased costing While each organization requires individual analysis there are some typical activities you will find in certain industries or among cer tain types of business The following table provides a few examples 44 Facilitylevel activities The facilitylevel activities are necessary for sustain ing the whole business Batchlevel activities These activities are costs incurred every time a group of units is pro duced Productlevel activities The productlevel activi ties are those activities that support a specific product or an entire prod uct line Unitlevel activities These activities relate to a single unit of a product or a service Table 10 Activities of Businesses Manufacturing companies Service companies Ordering supplies Handling materials Setting up machines Assembly Inspection Transport Ordering supplies Scheduling Greetingmeeting clients Customer registration Providing core service Billing customers Source Hastenteufel 2020 For cost analysis of processes it is useful to classify activity levels at which costs are incur red In this context four levels are usually distinguished Drury 2018 These are as fol lows 1 Facilitylevel activities The costs of these are incurred to sustain the entire organiza tion which means that they are incurred independent of separate products produced These costs are mostly fixed costs such as factory building depreciation manage ment salaries accounting department salaries or insurance premiums 2 Batchlevel activities The costs related to these are incurred in the production of product batches rather than individual units which means that a certain number of units is produced together in a certain step or sequence of steps for instance 30 loaves of bread baked as a group in the oven Examples of typical costs related to batches include machine setup costs machine running costs and packing shipments of goods 3 Productlevel activities These activities relate to specific products Costs incurred at this level are for example product design costs or producttesting costs 4 Unitlevel activities These activities relate to individual units of a product Costs incurred in this category are mostly direct labor or material which are direct costs and therefore irrelevant for cost analysis aimed at overhead allocation WINERY EXAMPLE At a winery the different activity levels apply as follows each barrel or each bot tle to sell can be seen as a unit Barrels of the same production age together before the wine is ready to be bottled form a batch Each red or white wine the winery produces is a separate product 42 Implementing ActivityBased Costing To implement activitybased costing a thorough understanding of the organizations pro cesses is required A detailed often consultantaided internal process analysis must pre cede the design of activitybased costing As a result of a preliminary analysis inefficient 45 nonvalueadding or redundant activities or steps in the productionmanufacturing or service delivery process are discovered so that the process can be economized That should result in an overall costsaving effect The implementation of activitybased costing requires a lot of effort and is only feasible if the company has sophisticated data analysis tools at hand such as enterprise resource software tracing the flow of materials power consumption machine hours etc even in complex andor fastpaced settings Drury 2018 To illustrate how activitybased costing can provide a much more accurate picture than simplistic overhead allocation methods a furniture manufacturer can be used as an exam ple This smalltown company currently manufactures two lines of seating furniture a large sofa bed that has become very popular among students and is produced in large quantities and a classy calfskin office swivel chair that has found its niche market among young dynamic managers and is only produced in small quantities The following data from last year are available Table 11 Initial Data Sofa bed Office chair Total Units produced 1200 240 DLH 5000 1500 6500 Overhead 520000 Direct labor 75000 25500 100500 Direct material 180000 264000 444000 Source Hastenteufel 2020 So far the company has used a predetermined overhead rate based on DLH to allocate the overhead Last year the overhead rate was 520000 6500DLH 80 per DLH After adding the respective revenue data the profitability analysis featuring the two products is below Table 12 Predetermined Overhead Rate Sofa bed Office chair Price per unit 499 2499 Units sold 1200 240 Revenue 598800 599760 DLH 5000 1500 Overhead rate 80 80 Overhead allocated 400000 120000 46 Sofa bed Office chair Direct labor 75000 25500 Direct material 180000 264000 Profit 56200 190260 Source Hastenteufel 2020 The overall profit generated last year was 190 260 56 200 134 060 According to this analysis the only profit generator was the office chair whereas the sofa bed accu mulated a loss The manufacturer does not want to drop the sofa bed and thinks that increasing its selling price would turn many customers away The company would cer tainly regret losing this customer base either way Thus the business brings in an expert who suggests implementing activitybased costing to get a more precise picture of prod uct profitability and then reconsider its options Activitybased costing is done in six steps Drury 2018 p 263 1 Identify all separate activities involved in the production process 2 Determine how much of the total overhead belongs to each activity 3 Define a cost driver for each activity and establish its total volume 4 Calculate a separate overhead application rate for each activity 5 Determine the cost driver volume each cost object consumes for each activity 6 Apply all activity rates to the cost objects In the case of this furniture manufacturer the analysis of steps one to four is provided as follows Table 13 Activity Analysis Activity Overhead Cost driver Volume Rate in Materials handling 57720 DM worth 444000 013 Machine setup 203392 Setup hours 10119 2010 Assembly 179400 DLH 6500 2760 Quality inspection 34992 Units produced 1440 2430 Shipment 44496 Units produced 1440 3090 520000 Source Hastenteufel 2020 The activity cost driver volume consumption of both cost objects sofa bed and office chair is determined step five and provided in the following table 47 Table 14 Activity Analysis with Cost Driver Volumes Activity Cost driver Cost driver volumes Sofa bed Office chair Materials handling DM worth 180000 264000 Machine setup Setup hours 2100 8019 Assembly DLH 5000 1500 Quality inspection Units produced 1200 240 Shipment Units produced 1200 240 Source Hastenteufel 2020 In the final sixth step the respective activity rates are applied to the cost objects to allo cate the overhead accordingly To retrieve the total cost figures the direct costs must not be forgotten they feature in the last lines of the following overview Table 15 Cost Driver Rate Application Sofa Bed Cost position Cost driver Cost Rate Volume Handling materials 013 180000 2340000 Machine setup 2010 2100 4221000 Assembly 2760 5000 13800000 Quality inspection 2430 1200 2916000 Shipment 3090 1200 3708000 Total overhead 26985000 Direct materials 18000000 Direct labor 7500000 Total 52485000 Source Hastenteufel 2020 Table 16 Cost Driver Rate Application Office Chair Cost position Cost driver Cost Rate Volume Handling materials 013 264000 3432000 48 Cost position Cost driver Cost Rate Volume Machine setup 2010 8019 16118200 Assembly 2760 1500 4140000 Quality inspection 2430 240 583200 Shipment 3090 240 741600 Total overhead 25015000 Direct materials 26400000 Direct labor 2550000 Total 53965000 Source Hastenteufel 2020 Based on this activitybased costing implementation a new profitability table can be con structed The following table shows the calculated profit of the two products according to the predetermined overhead rate and the activitybased costing Table 17 Predetermined Overhead Rate versus ActivityBased Costing Predetermined overhead rate Activitybased costing Sofa bed Office chair Sofa bed Office chair Price per unit 49900 249900 49900 249900 Units sold 1200 240 1200 240 Revenue 59880000 59976000 59880000 59976000 Overhead alloca ted 40000000 12000000 26985000 25015000 Direct labor 7500000 2550000 7500000 2550000 Direct materials 18000000 26400000 18000000 26400000 Profit per prod uct 5620000 190 26000 7395000 6011000 Total profit 13406000 13406000 Source Hastenteufel 2020 According to activitybased costing both products are profitable and the sofa bed con tributes even more to the total bottom line profit than the office chair The manufacturer will decide to continue both products Note that the factual total figures such as the total revenue 598 800 599 760 1 198 560 the total allocated overhead 49 520000 and the total costs 1064500 as well as the overall profit revenue cost 134 060 have not changed They are independent of how overhead is allocated to the cost objects within the company In this example the dramatic differences in the overhead allocated mainly come from the setup costs That is a typical result costly setup procedures preparing machines for pro duction runs are unfavorable if only a small number of units are produced Under DLH based simplistic allocation methods highvolume products often look unprofitable and lowvolume products with few DLH required look profitable but that can be misleading as it provides only part of the whole picture But one must keep in mind that there is no fully accurate cost allocation method Some arbitrariness remains in all methods even in activitybased costing due to the need to determine cost drivers However activitybased costing is much more precise than sim plistic cost allocation methods and therefore delivers more reliable results for manage ment decisions such as pricing or keepingabandoning product lines SUMMARY Activitybased costing is a stateoftheart cost analysis approach that enables more precise and accurate allocation of overhead to cost objects The essence is to break down production or service provision processes into the individual activities involved This allows us to apply a separate cost driver to each of these activities unlike simplistic over head allocation methods that rely on only one cost driver for the entire process The implementation of activitybased costing requires a thorough analy sis of the internal production or service provision processes In this con text there is the potential for streamlining and optimizing various activi ties by identifying and getting rid of redundancies In complex production settings however activitybased costing is not trivial and quite likely a substantial investment into IT and software will be neces sary in order to gather the sufficiently differentiated and realtime infor mation required for analysis As a tendency activitybased costing tends to show highvolume ie massproduced goods in a more favorable light than simplistic old fashioned cost allocation methods It reveals that lowvolume jobs tend to be more expensive per unit because certain fixed costs like machine setup in preparation of production runs can only be split between a few 50 units of output Activitybased costing therefore helps to evaluate the profitability of individual products more accurately than simplistic approaches 51 UNIT 5 OVERHEAD ANALYSIS SHEET STUDY GOALS On completion of this unit you will have learned the meaning of companywide cost allocation to cost objects the rationale of profit centers in organizations the three phases of the overhead analysis sheet procedure two different approaches to the overhead analysis sheet 5 OVERHEAD ANALYSIS SHEET Introduction It is a widespread phenomenon in the corporate world to scrutinize the contribution of every branch or segment to the organizations bottom line Some corporations are known for quickly dropping unprofitable business lines or closingoutsourcing internal service departments that are considered to be too costly General Electric and Siemens are two oftenquoted examples of global players that frequently reassess their corporate struc tures Business fields and departments are rapidly opened or closed in efforts to optimize efficiency and profitability Such an approach contributes to streamlining organizations and puts pressure on managers It can also reduce bureaucracy However it can also be unproductive If eventually every department is declared to be a profit center coming under pressure to prove its positive contribution to the overall bottom line of the business the overall strategy and common goal of the organization are easily lost In the worst case internal and reciprocal invoicing and questioning of tasks hinder efficient processes Stocker 2006 Eventually a costprofitcenter obsession can ruin the corporate culture of a business with everyone focused on justifying their existence within the organization andor on denying other departments justification of existence 51 Departmental Cost Allocation Many departments functions or activities are not directly related to operations and yet are required to sustain the organization such as human resource management legal departments and accounting Large companies with multibranch operations often con centrate such administrative or supporting functions at centralized places servicing all branches or outlets This is predominantly a costsaving effort as maintaining these serv ices at every location of operation would be costlier but does not add any value unlike operational activities that generate revenues These internal support services are often referred to as shared services since several branches or outlets share the service provided by the centralized departments Drury 2018 Over the past few decades management paradigms like the focus on core competencies competitive pressures and the focus on profit maximization have led to the out sourcing of assorted support functions In some cases however support functions have even become separate legal entities providing their services as spinoffs to not only the parent company but also any interested player in the market and possibly even the parent com panys competitors Lufthansa for example has entities such as Lufthansa Technik which provides aircraft maintenance services both for Lufthansa and for many airlines that do not have the competency or have decided that maintaining it inhouse would not be efficient Even LSG SkyChefs another Lufthansa spinoff provides catering serv ices for many airlines in need of meals for their passengers 54 Wherever administrative or support services are still provided inhouse the challenge of allocating their costs along with the product costs to the final output of the business ari ses This entails a process usually consisting of three phases Figure 10 Different Phases of Overhead Analysis Source Drury 2018 52 Reciprocal Method This method allows for integrating the costs of service departments that not only provide their support activities for production departments but also for other service departments considering their reciprocal proportions Drury 2018 The following example will illus trate the application of this method The initial data of the business is shown below Table 18 Reciprocal Method Initial Data Serv 1 Serv 2 Prod 1 Prod 2 Total Labor hours 240000 350000 140000 620000 1350000 Machine hours 000 000 860000 280000 1140000 Direct labor costs 4000000 18000000 22000000 Direct material costs 5000000 2000000 7000000 Indirect labor costs 9000000 Indirect material costs 4500000 55 Serv 1 Serv 2 Prod 1 Prod 2 Total Total costs 42500000 Source Hastenteufel 2020 The first phase of this analysis requires the allocation of all costs to all departments The company allocates indirect labor costs based on labor hours and indirect material costs based on machine hours to all departments Table 19 Phase One Overhead Analysis Sheet Phase 1 Serv 1 Serv 2 Prod 1 Prod 2 Total Labor hours 240000 350000 140000 620000 1350000 Proportion of total 1778 2593 1037 4593 Machine hours 000 000 860000 280000 1140000 Proportion of total 000 000 7544 2456 Direct costs traced indirect costs allocated based on labormachine hours proportion Direct labor costs 4000000 18000000 22000000 Direct material costs 5000000 2000000 7000000 Allocated indirect labor 1600000 2333333 933333 4133333 9000000 Allocated indirect material 3394737 1105263 4500000 Total costs 1600000 2333333 13328070 25238596 42500000 Source Hastenteufel 2020 The second phase requires the allocation of the service department costs to the pro duc tion departments while considering a reciprocal service department provision The recip rocal cost absorption of Serv 1 and 2 is performed first before moving on to allocate the derived figures to Prod 1 and 2 In this context the business has analyzed the work pattern of Serv 1 and 2 deriving the proportions in the following table Table 20 Phase Two Additional Information Serv 1 Serv 2 Prod 1 Prod 2 Serv 1 works for na 20 30 50 Serv 2 works for 30 na 40 30 Source Hastenteufel 2020 56 Therefore Service 1 department accounting for 1778 of labor hours gets allocated 1778 of the indirect labor cost of 90000 which amounts to 16000 and so on Keep verifying that the total cost figure of the company of 425000 never changes because that is factual and not impacted by allocations That leads to the following two cost allocation equations Serv 1 16000 allocation from phase 1 30 of Serv 2 Serv 2 2333333 allocation from phase 1 20 of Serv 1 We now have two simultaneous equations ie two equations with the same two varia bles One approved way of solving this mathematical problem is to substitute one into the other Now insert x as Serv 1 into the second equation The cost figures of Serv 1 and 2 plus the already known cost figures from phase one are accumulated to derive the costs allocated to Prod 1 and 2 For example Prod 1 gets alloca ted 30 of Serv 1 because Serv 1 works 30 for it 30 of 2446809 equals 734043 Table 21 Phase Two Overhead Analysis Sheet Phase 2 Prod Prod 2 Cost from Phase 1 13328070 25238596 Allocated from Serv 1 30 2446809 734043 50 1223405 Allocated from Serv 2 40 2822695 1129078 30 846809 Total costs 15191191 27308809 42500000 Source Hastenteufel 2020 The third phase requires the allocation of the production costs of the departments to cost objects The business produces Gadget A and Gadget B The costs of Prod 1 are allocated based on machine hours the costs of Prod 2 are allocated based on labor hours The table below contains all the necessary information Table 22 Phase Three Overhead Analysis Sheet Phase 3 Gadget A Gadget B Total Labor hours 702000 648000 1350000 Proportion of total 5200 4800 Machine hours 387600 752400 1140000 57 Phase 3 Gadget A Gadget B Total Proportion of total 3400 6600 Cost of Prod 1 5165005 10026186 15191191 Cost of Prod 2 14200581 13108229 27308809 Total costs 19365586 23134415 42500000 Source Hastenteufel 2020 For example Gadget A causes 34 of all machine hours and Prod 1 department costs of 15191191 derived in the previous phase are allocated to the products based on machine hours so that Gadget A gets 34 of 15191191 amounting to 5165005 Please note that the complexity of the reciprocal method increases considerably the more departments or functional areas an organization has The accurate capture of all recipro cal uses of services the departments provide requires reliable and measurable data that tend to come in large volumes and still need fine differentiation To that end IT systems with the capacity to trace various processes in realtime are necessary 53 Step Method This method is mostly applied as it forms the basis of performing the three phases of cost allocation Costs are allocated step by step until the cost objects absorb all costs incurred within the business Even the reciprocal method exercised in the previous section per forms essentially the same steps of cost allocation through the phases The major differ ence is that the step method does not consider the reciprocal work relationships of service departments in the second phase The step method will be illustrated with another exam ple focusing on the typical complexity of various overhead cost positions that need to be allocated and also through the availability of various potential cost drivers Drury 2018 A manufacturer runs two production departments a machine hall where largely automa ted production steps are performed and a finishing department performing mostly man ual labor in the finalization of assembly and inspection of finished goods There are also two service departments material storage in charge of handling materials and technical support providing help for staff in the production departments The following cost over view is available Table 23 Cost Overview Total Machine hall Finishing Materials storage Tech support Direct labor 3850000 250000 3600000 0 0 Direct materi als 3700000 2400000 1300000 0 0 58 Total Machine hall Finishing Materials storage Tech support Indirect labor 2100000 350000 250000 400000 1100000 Indirect mate rials 4370000 360000 230000 3000000 780000 Depreciation 1010000 920000 77000 7000 6000 Building insurance 250000 Machine insurance 520000 Rent for buildings 1800000 Heating light ing cooling 2400000 Total cost 20000000 Source Hastenteufel 2020 There are no direct costs shown for the service departments as these costs are by definition incurred in operations and traceable there When looking at the three phases of cost allocation the total cost of 20000000 will never change To allocate the last four cost positions of the table above the following information is provided Table 24 Overview of Potential Cost Drivers Total Machine hall Finishing Materials storage Tech sup port DLH 192000 12000 180000 0 0 Area sqm 3350 1800 800 500 250 Machine hours 6500 6000 500 0 0 Book value of mach 3400000 2750000 620000 12000 18000 Power con sumption 100 62 23 6 9 Source Hastenteufel 2020 This second table provides a list of potential cost drivers To allocate the remaining costs to all departments in phase one of the allocation process the causeandeffect relation ship must be considered For each cost position we need to determine which of the five available parameters is most closely causally linked to the respective cost position to allo cate to all departments Although there is no perfect cost driver to use consider the fol lowing assignment of cost drivers 59 Building insurance is allocated based on the area occupied by each department which isbased on the assumption that each sqm is insured at the same premium Machine insurance is allocated based on the book value of the machinery Rent for buildings is allocated based on the area in sqm Heating lighting and cooling are allocated based on the power consumption Once the cost drivers are selected the costs can now be allocated Each department absorbs each cost position in question in the same proportion as it uses the cost driver The calculation applied in the table below therefore inserts direct proportion For exam ple to allocate the appropriate building insurance amount to the machine hall depart ment the calculation is total costssqm occupied by the machine hall total sqm 250 000 1 800sqm 3 350sqm Finally the following cost allocation is the result of phase one Table 25 Phase One Cost Allocation for Overhead Analysis Sheet Phase 1 in Machine hall Finishing Materials storage Technical support Total Direct labor 25000000 360000000 3850000 Direct materials 240000000 130000000 3700000 Indirect labor 35000000 25000000 40000000 110000000 2100000 Indirect materials 36000000 23000000 300000000 78000000 4370000 Deprecia tion 92000000 7700000 700000 600000 1010000 Building insurance 13432836 5970149 3731343 1865672 250000 Machine insurance 42058824 9482353 183529 275294 520000 Rent for buildings 96716418 42985075 26865672 13432836 1800000 Heat light cooling 148800000 55200000 14400000 21600000 2400000 Total costs 729008077 659337577 385880544 225773802 20000000 Source Hastenteufel 2020 60 In phase 2 the service department costs are allocated to production departments Mate rial storage costs are reallocated based on direct material values and technical support costs are reallocated based on machine hours Again the costs to distribute are allocated in the same proportion as the cost driver used by the production departments For exam ple to calculate the cost the machine hall absorbs from materials storage we would use total costs of materials storagecosts for direct materials machine hall total costs for direct materials 385880544 2 400 000 3 700 000 Table 26 Phase Two Cost Allocation for Overhead Analysis Sheet Phase 2 in Machine hall Finishing Materials storage Technical support Total Total costs phase 1 729008177 659337577 385880544 225773802 2000000000 From materi als storage 250300894 135579651 385880544 From sup port 208406586 17367216 225773802 Total Costs 1187715557 812284443 2000000000 Source Hastenteufel 2020 The sum of the costs from phase 1 and the costs allocated from the service departments is still 20000000 In phase 3 the costs will finally be allocated to cost objects Instead of products in this case the manufacturer wants to know the total costs per DLH or machine hour The costs of the machine hall are allocated to machine hours as automated production is strongly machinebased and features only a few DLH in comparison whereas the costs of finishing are allocated to DLH Table 27 Phase Three Cost Allocation for Overhead Analysis Sheet Phase 1 in Machine Hall Finishing Total Total costs phase 2 1187715557 812284443 2000000000 Machine hours 600000 DLH 18000000 Costs per hour 197953 4513 Source Hastenteufel 2020 The total costs per hour are 197953 for the machine hall and 45 for the finishing 61 SUMMARY An overhead analysis sheet allows the inclusion of all costs of a large company into the cost analyses of individual products or product ranges Even cost positions that are completely unrelated to operations such as the rent paid for administrative offices are considered and thus can become part of the analysis In a threestage process all costs are re allocated to the cost objects in consideration Firstly all costs incurred and registered by financial accountants are allocated to all departments of the organization In the second step sup port or service department costs are reallocated to operating or pro duction departments In the final step costs are allocated to specific cost objects usually products produced by the company In the process of this analysis department or functional unit costs for the company become transparent However there is still the potential problem that the cost allocation methods applied are not fully without error or are at least debatable due to some unavoidable arbitrariness in cost driver selection As many organizational cultures spark internal competition department heads may find themselves under attack for lack of cost efficiency in an internal competition Conflicts of interest may arise particularly where departments are treated unfairly through inappropriate cost allocation approaches 62 UNIT 6 RELEVANT COST CONCEPTS STUDY GOALS On completion of this unit you will have learned the definitions of relevant and irrelevant revenue and cost data the major criteria to consider in outsourcing decisions the most important quantitative and qualitative criteria in makeorbuy decisions to differentiate when the acceptance of special orders is viable to evaluate whether dropping a product line improves the bottom line Relevant costs These costs differ between decision alterna tives 6 RELEVANT COST CONCEPTS Introduction In past decades following the rise of China to the workbench of the world many compa nies all over the world outsourced and offshore production to Chinese factories They were attracted by low wages huge availability of labor and tremendous production capacities of suppliers willing to provide the desired quantity and specification of any goods During recent years however an increasing number of European manufacturers production has returned to their home countries as cost advantages diminish Labor costs in China are still lower than in Western European countries but are sharply rising and other costs such as logistics transportation and direct material to be purchased at the same price worldwide diminish labor cost advantages A German case in point is the plush toys company of Steiff known as a premium brand In 2009 the company halted some of its overall production in China because the Chinese supplier often missed delivery deadlines and had a high staff turnover leading to quality problems detrimental to a highquality and traditionrich brand Erling et al 2008 With labor costs in China increasing by 20 per year and many miscalculated offshoring ven tures fears that manufacturing would disappear from Germany altogether were prema ture Schlandt 2012 China still is an option for offshore production despite diminishing cost advantages but it is much more interesting as a sales market especially for export driven nations such as Germany 61 Foundational Cost Concepts There are many decisions managers face in their daily business Some decisions have a bigger impact than others and some have longterm consequences Closing factories out sourcing departments expanding production and investing in new business segments are examples of larger decisions with consequences Cost data are a major source of informa tion when making such decisions In an extension of that idea both cost and revenues are important to consider because the relationship between revenues and costs determines the bottomline outcome of profit or loss For a reasonable picture of likely outcomes of decisions current data and projections of future benefits are often required The concept of relevant costs refers to the consideration only of data that are relevant for the specific decision in question and ignoring all irrelevant data In terms of costs only the costs that differ between decision alternatives are relevant All other costs are considered to be irrelevant Drury 2018 A typical case of irrelevant costs are sunk costs These are costs incurred or committed in the past that cannot be changed Such costs would include for example license fees already paid for a product that cannot be recovered regardless of the use of the license to produce this product Drury 2018 64 Sunk costs These are costs that can not be recovered with a decision alternative and are therefore considered irrelevant Opportunity costs These costs represent the benefits a business misses out on when choosing one alternative over another Time value of money This assumes that the same amount of money is more valuable today than it is in the future 62 Cost Decisions Replacement of Equipment One classic type of decision relying on relevant cost data is the replacement of equipment which may entail a significant investment Major criteria to consider in such decision sce narios include calculating and deciding on the purchase price and financing options incorporating opportunity costs and the time value of money powerfuel consumption new machines tend to be more efficient the difference in other operating costs new equipment tends to promise efficiency gains but may require additional staff training modification requirements at existing factory buildings the projected lifetime of old versus new equipment the projected development of the market demand and economic environment There is no optimum time to replace equipment or it would at least be almost impossible to know it if there was one Replacing equipment too early means that the remaining life time of the old machines is given up along with the profit potential of fully depreciated assets A major financialinvesting burden would also be incurred Replacing equipment too late means that frequent or costly repairs of old equipment are incurred probable downtime or disruption in production can happen and efficiency gains of new genera tions of machines are likely missed Drury 2018 The following example illustrates the application of relevant costs in the case of replace ment decisions A business has encountered a machine breakdown The equipment in question can be repaired rather quickly but the management is now also considering replacing the old machine to prevent another breakdown Thus the data the machine manufacturer provide for the new machine and the internal data for the old machine must be compared to make a decision Table 28 Replacement of Equipment Full Cost Analysis in Repairing the old machine Buying the new machine Revenue 15000 units sold at 1200 1800000000 1800000000 Operating costs Staff costs 9500 hours at 35 each 33250000 Staff costs 5000 hours at 35 each 0 17500000 Power costs 8400000 7500000 65 in Repairing the old machine Buying the new machine Staff training costs 2400000 Repair costs 800000 Deduction of the machine 1150000 11 50000 Current disposal value of old 450000 Price of new machine 12500000 Total costs 43600000 40600000 Operating income 136400000 139400000 Source Hastenteufel 2020 This table includes some irrelevant information which will not change according to the chosen decision The table yields the same bottom line when only considering the rele vant cost positions Table 29 Replacement of Equipment Relevant Cost Analysis in Repairing the old machine Buying the new machine Operating costs summarized 41650000 25000000 Staff training costs 2400000 Repair costs 800000 Current disposal value of old 450000 Price of new machine 12500000 Total costs 42450000 39450000 Source Hastenteufel 2020 The decision whether to keep and repair the old machine results in 30000 higher cost or less operating income than the replacement decision We achieve the same overall differ ence by considering only the relevant positions The revenue is irrelevant as it does not change with either decision The book value of the old machine is irrelevant because it can be considered sunk costs either it is depreciated as a lump sum when replaced now or periodically if repairing and keeping it Relevant costs include the different operating costs repair versus staff training costs the current disposal value of the old machine which will be a benefit realized in case of replacement and the price of the new machine Note that for reasons of simplification and a focus on relevant information we ignore the time value of money in this example and that the actual useful lifetime for both machines from the time of decision is assumed the same for both decision alternatives 66 Outsourcing This is the process of pay ing to have a part of a companys work done by another company MakeorBuy Another type of decision relying on relevant cost data is the makeorbuy scenario Com panies with the capacity and expertise to manufacture products or components neverthe less often consider contracting out production to suppliers and purchasing the goods parts needed if this move has costsaving effects Beyond mere costsaving sometimes additional aspects such as freedup capacity and resources can be beneficial Various strategic considerations may also drive outsourcing decisions One important basis of makeorbuy decisions is relevant cost information Atkinson et al 2012 Consider the following example McMullen Ltd of Galway Ireland requires 5000 units of an electronic component for their manufacturing process Currently these components are produced inhouse The management considers an outsourcing move and a first offer from a sup plier is received to buy the components at 30 each The cost data of the currently prac ticed inhouse production are as follows Table 30 MakeorBuy Initial Data in Total costs Costs per unit Fixed costs Rent 2500000 500 Depreciation 1250000 250 Variable costs Direct materials 2000000 400 Direct labor 10000000 2000 Total 15750000 3150 Source Hastenteufel 2020 When looking at the initial data the external offer of 30 per unit looks more attractive as it seems to save 150 per unit produced However a closer look at only the relevant costs of the outsourcing option changes the picture Table 31 MakeorBuy Cost Comparison Costs in Make Buy Variable costs 2400 30 Source Hastenteufel 2020 Neither fixed cost positions are relevant for this decision because in the short run these costs cannot be avoided even if outsourcing and stopping inhouse production is chosen The contract for the rent is still running and depreciation continues assuming the machines in use so far for production cannot be sold immediately Thus only the variable cost of production could be avoided assuming that the workforce so far performing direct labor can be released or deployed otherwise in the company A total cost comparison would therefore add the fixed costs per unit of 750 to the offer of 30 making it 3750 versus 3150 for continued inhouse production The relevant cost analysis is sufficient to 67 get the same bottom line a difference of 6 per unit in favor of continuing the production Based on this information the company could of course renegotiate with the supplier to possibly get an offer below 24 per unit which would turn the picture around But a business needs to be aware that cost should not be the only criterion in favor of out sourcing As mentioned before such a shortsighted or limited view can and most likely will backfire Problems can arise in areas such as quality Foreign suppliers may not meet a companys quality standards Especially at the beginning of a new supply relationship much time and many trial production runs may be required before the defined parameters are met reliability It cannot always be taken for granted that suppliers will be punctual in deliv ery andor capable of delivering the promised goods or services logistics The coordination of international supply chains is complex especially in the case of justintime patterns In addition there may be costly disruptions to interna tional transportation due to regional material shortages volcano ashes hindering air cargo piracy threatening ships local workforce strikes etc image Many customers of highpriced goods wonder why they should pay so much for goods made overseas ie in lowcost countries and may refrain from consuming that brand or at least react critically Special Order The third type of decision relying on relevant cost data is related to whether exceptional offers should be made in response to special requests The typical challenge is to decide whether a onetime batch is sold at a lower price than normally calculated and offered Atkinson et al 2012 Consider the following case a manufacturer produces as part of their standard product range a highquality table that is sold via exclusive furniture retail ers at 2500 The company has the capacity to manufacture 1000 units of this table per year and currently operates at 75 of its capacity 750 units per year The following costs apply Table 32 Special Order Initial Data Variable costs Direct materials 600 each 45000000 Direct labor 1000 each 75000000 Fixed costs 37500000 Total costs 157500000 Source Hastenteufel 2020 It is assumed that a furniture retailer looking for a onetime special product to sell at their 150th company anniversary approaches the manufacturer and wants to buy 150 units of the table at 1800 To analyze whether accepting this request is viable the following anal ysis is conducted comparing the difference in the bottom line resulting from the varying cost and revenue figures for the two options 68 Table 33 Special Order Cost Analysis Scenario 1 in Without special order With special order Revenue Regular 187500000 187500000 Special order 27000000 Costs Variable costs 120000000 144000000 Fixed costs 37500000 37500000 Gross profit 30000000 33000000 Source Hastenteufel 2020 In this case it is only relevant to regard the difference in gross profit as with the special order the revenue increases by 270000 and the total costs increase by 240000 Thus the special order generates an additional profit of 30000 and is therefore attractive and should be realized As long as an extra orders revenues exceed its variable costs the result will always be an increased income Be aware that the result would look different if a special order resulted in production exceeding capacity In this case the regular production would have to be cut to fulfill the extra batch reducing regular revenue Consider the following alteration of the example the regular sales now are 1000 units meaning that the company already operates at full capacity utilization Accepting the special order would result in regular production being reduced from 1000 units to 850 to fit the 150 units for the special order into the produc tion schedule Hence regular unit revenue is cut Table 34 Special Order Cost Analysis Scenario 2 in Without spe cial order With special order Revenue Regular 250000000 212500000 Special order 27000000 Costs Variable costs 160000000 160000000 Fixed costs 37500000 37500000 Gross profit 52500000 42000000 Source Hastenteufel 2020 In this scenario the schedule with the special order only leads to diminished overall reve nue Fixed and variable costs are identical under either schedule because the number of units produced would be the same In this scenario the company should not accept the additional order That is a very typical outcome of these types of analysis Whenever capacity constraints require a special order to give up at least some portion of a compa 69 nys regular production and sales the lower contribution of the special offer units com pared to their regular counterparts contribution bites into the profit If a company runs at 100 percent capacity utilization with regular products accepting a special offer will never be more profitable if the sales price for the special order is lower than the regular sales price However if there is some capacity left while the special offer still requires a cut in regular production only the analysis will show whether accepting the offer yields a better bottom line Drop Product Line A similar logic applies in the case of the fourth type of decision relying on relevant cost data which is whether to drop or hold on to product lines Drury 2018 Consider the fol lowing example the management of a manufacturing company is looking at the current product profitability analysis table Table 35 Drop Product Line Initial Data in Product 1 Holiday sandal Product 2 Business loafer Product 3 Hiking boot Total Units sold 16000 10000 14000 40000 Selling price per unit 2950 8950 9950 Revenues 47200000 89500000 139300000 276000000 Variable costs Direct materials 11 each 17600000 17600000 Direct materials 33 each 33000000 33000000 Direct materials 44 each 61600000 61600000 Direct labor 8 each 12800000 12800000 Direct labor 55 each 55000000 55000000 Direct labor 42 each 58800000 58800000 Fixed costs 12000000 7500000 10500000 30000000 Operating income 4800000 6000000 8400000 7200000 Source Hastenteufel 2020 Being unhappy with the lossmaking business loafer the management considers dropping this product That would leave the company with the holiday sandals and the hiking boots as their remaining products The resulting scenario analysis with all other data remaining the same would be as follows 70 Table 36 Drop Product Line Analysis in Product 1 Holiday sandal Product 3 Hiking boot Total Units sold 16000 14000 30000 Selling price per unit 2950 9950 Revenues 47200000 139300000 186500000 Variable costs Direct materials 11 each 176000 61600000 71600000 Direct materials 44 each 61600000 Direct labor 8 each 128000 12800000 Direct labor 42 each 58800000 58800000 Fixed costs 16000000 14000000 30000000 Operating income 800000 4900000 5700000 Source Hastenteufel 2020 Now the two remaining products are both profitable but the overall operating income will decrease from 72000 to 57000 This is because dropping product 2 means that both its revenue and its variable costs are eliminated The revenue given up is 895000 while the variable costs saved amount to 880000 As revenue minus variable cost is the contribution one can say that product 2 contributes 15000 That is exactly the difference between the two operating income figures Note that fixed costs in total remain the same but are now distributed over just two instead of three products Therefore the fixed costs per unit went up from 750 to 10 Thus keeping the loafer in the production program is advisable But in the long run drop ping the product could change fixed cost SUMMARY The concept of relevant costs represents a specific view of costs in deci sionmaking situations It assumes that only those costs that differ across available alternatives are relevant for consideration when trying to make an appropriate decision Any costs that dont differ are consid ered irrelevant This perspective is not limited to costs but also applies for revenues Thus revenue figures that differ across alternatives should be considered 71 In most cases fixed costs are irrelevant at least in the short run For that reason any decision taken now will not change them For example the rent a business has committed to pay for a year cannot be altered even if the management decides right now not to use the rented building any longer But there are no fixed costs and no irrelevant costs in the long run because at some point each con tract ends or can be terminated Typical decision scenarios where relevant cost concepts are applied include the replacement of old equipment the nonacceptance of spe cial orders at discount selling prices makeorbuy decisions and drop ping or continuing product lines Potential alternative uses of freedup resources finance principles such as the time value of money and long term qualitative consequences make such decisions more complex than the basic relevant cost analysis suggests 72 UNIT 7 BUDGETS STUDY GOALS On completion of this unit you will have learned the major characteristics of a budget the components of a master budget the interdependence of budgets within the master budget how to assemble operating budgets the importance of liquidity the components of a cash budget how to derive budgeted cash collections and payments resulting from operating budg ets Budget A budget is a plan to show how much money a busi ness will earn and how much it will be able to spend 7 BUDGETS Introduction For some time now budgeting has been one of the central instruments of successorien ted corporate management in many companies This management tool was developed to keep increasingly complex and diversified companies controllable Therefore the intro duction of budgets was a reaction to the growing complexity of companies and makes it possible to handle the planning process by systematically comparing the various knowl edge bases centralized overall company view decentralized detailed production and market knowledge A budget can be defined as follows budgets in organizations reflect in quantitative terms how to allocate financial resources to each part of an organization based on planned activities and shortrun objectives of that part of the organization Atkinson et al 2012 p 420 Based on this budgets fulfill different functions including coordinating initiating motivating planning allocating resources indicating and controlling 71 The Budgeting Process Budgeting is a crucial activity in businesses A budget is the quantified formulation of a plan of an organizations activities for the following business periods Hence budgets largely consist of figures of units revenues and costs into which the planned activity is translated Budgeting is crucial insofar as it directs the activity of the following month quarter or year sometimes even several years which will have consequences such as costs incurred staff hired or fired and capacity buildup or reduction Major aspects to consider in the budgeting process include Drury 2018 vision and mission of the organization longterm and shortterm strategic objectives and external environment The budgeting process is quite complex A large amount of interdependent data much of which consists of projections of an insecure future is evaluated and generated Even the organizational culture is considered in this process In some companies a topdown approach is practiced Only a secluded circle of executives devises the targets everyone else must live with for the period covered The opposite approach bottomup considers 74 input from the shopfloor ie frontline employee level In reality most organizations practice an inbetween approach with an emphasis on goals defined and devised from the top floor but integrating input from operational departments to some degree The budget is like an overarching stage direction guiding the activity of ultimately every section branch department and employee of a company To be meaningful and effective budg ets should be ambitious setting targets too high triggers frustration and setting them too low results in little motivation to go the extra mile realistic setting targets beyond reach leads to capacity buildup and causes significant costs that cannot be covered as sales lag behind crafted with the input of operating departments omitting the knowhow of operational staff will result in less realistic data wellcommunicated to avoid rumors frustration and lack of orientation and to enable department heads to organize resources The way of deriving building interacting with and communicating budgets and related information reveals a lot about organizational cultures Highly hierarchical companies will more or less dictate targets topdown Lower levels must comply with the rules and deliver what higher levels or just the top floor want to be delivered Startups will fre quently adjust budgeting data especially in dynamic growth phases and possibly play more by ear than by accurate analysis Corporations listed in stock markets usually have a shortterm orientation and investors want to read optimistic if not enthusiastic sales and particularly profitable forecasts Even warnings if there are indications that budgeted profits will most likely not be achieved in the current market situation have to be pro claimed timely according to stock market rules and regulations In contrast familyowned traditional businesses tend to look at longer terms since they try to protect the family business and therefore plan more cautiously Atkinson et al 2012 The budgeting process requires the alignment of interdependent data to prepare for the next business period The package of interrelated budgets covering separate business functions or activities is often referred to as the master budget Within it we can distin guish between operating budgets schedules of activities and financial budgets financial data in particular vital projections of cash flows The overview of a simplified master budget can look as follows 75 Figure 11 Operating Budgets Source Atkinson et al 2012 The master budget consists of operating and financial budgets The operating budgets usually include the sales budget the production budgets and the administrative expense budget The cash budget the budgeted balance sheet and the budgeted cash flow statement are part of financial budgeting The budget income statement lies in between Atkinson et al 2012 72 Different Types of Operating Budgets Sales Budget The first budget to draft is the sales budget It drives all other budgets since generally all activities and expenditures depend on how many units a company intends to sell in the next period The sales budget contains quantities of output and the resulting revenue 76 which means the sales price also needs to be decided or projected at that point Drury 2018 In the following example the budget is designed for the next year and the data are shown per quarter Table 37 Sales Budget Example Q1 Q2 Q3 Q4 Units 5000 6000 5000 4000 Price per unit 350 350 350 350 Revenue 1750000 2100000 1750000 1400000 Source Hastenteufel 2020 As the starting point of the budgeting process and the initial component of the master budget meaningful content is crucial for the sales budget There is much leeway for the key decisionmakers of the company to set the sales goals and translate them into their respective budget figures There is considerable responsibility in setting targeted sales figures as the characteristics of meaningful budgets mentioned before need to be consid ered thoroughly Besides the decisionmakers leeway much of the data are derived from previous periods through forwardprojection of past data which helps the process remain realistic How ever in new markets no such data are available In any case market research may feed data into the budgeting process Furthermore knowledge of the market context and anticipated behavior of competitors such as their pricing moves market share ambi tions or planned capacity changes are relevant Production Budgets Knowing intended sales the company must now determine how many units need to be produced Consider a company that wants to sell 5000 units of its product in the first quarter of next year In principle that is the number of units they need to produce How ever there may be another variable inventory reserve It is a typical policy to have some inventory of finished units in reserve in case there is a disruption of productionlogistics or to prevent lost sales opportunities in case the demand is higher than anticipated Lets assume the policy is to have 10 of the following periods budgeted units as a reserve inventory on hand at all times The units budget would look like this 77 Figure 12 Production Units Budget Source Hastenteufel 2020 Once the number of units to produce is known the direct material budget DM budget can be extrapolated The information required is the volume of raw material needed to produce each unit expressed in gallons tons kilograms or whatever is applicable Drury 2018 In this example three kilograms of raw material are needed per product unit Again there is a policy of stocking 10 of the following quarters need as ending inventory each quarter Furthermore the cost of the material is considered if no contracts have been negotiated yet with suppliers this figure is also a projection or an estimate Each kilo gram of the raw material is expected to be procured at 8 The bottom line of the budget shows the cost incurred for the purchase of the raw material corresponding to the inten ded sales and production Figure 13 Direct Materials Budget Source Hastenteufel 2020 78 In the next step the direct labor budget DL budget is conducted Effectively a company could build this one parallel to the DM budget because it likewise draws its essential infor mation from the units budget Once a company knows how many units to produce the corresponding labor force can be planned Drury 2018 The following information is available for this case each unit to be produced requires five direct labor hours at 20 of semiskilled labor and two direct labor hours at 25 of skilled labor The bottom line of the DL budget will show the projected total cost of direct labor for each quarter Table 38 Direct Labor Budget Q1 Q2 Q3 Q4 Units in production 5100 5900 4900 3950 Semiskilled hours Number of hours 25500 29500 24500 19750 Costs 20 per hour 51000000 59000000 49000000 39500000 Skilled hours Number of hours 10200 11800 9800 7900 Costs 25 per hour 25500000 29500000 24500000 19750000 Total direct labor hours 3570000 41300 34300 27650 Total costs in 76500000 88500000 73500000 59250000 Source Hastenteufel 2020 The last production budget is the factory overhead budget The company assumes from experience that per direct labor hour 325 of variable overhead is incurred consisting of indirect materials The budgeted number of direct labor hours is taken from the direct labor budget Fixed overhead costs are also projected These include depreciation which is deducted to get the disbursement amounts for each quarter Remember that deprecia tion is a noncash expense and therefore relevant for income projections but not for cash flow planning Drury 2018 The factory overhead budget would look as follows Table 39 Overhead Budget in Q1 Q2 Q3 Q4 Direct labor hours 35700 41300 34300 27650 Variable overhead 11602500 13422500 11147500 8986250 Fixed overhead 15000000 15000000 17000000 17000000 Total overhead 26602500 28422500 28147500 25986250 Less depreciation 3500000 3500000 5500000 5500000 79 Bad debt expense This is a provision for uncollectable receivables eg due to insolvent cus tomers who cannot pay their invoices anymore in Q1 Q2 Q3 Q4 Direct labor hours 35700 41300 34300 27650 Total disbursement 23102500 24922500 22647500 20486250 Source Hastenteufel 2020 Administrative Expense Budget The next budget is the administrative expense budget It includes all administrationrela ted selling and marketing expenses it is essentially grouping all expenses that are not productionrelated Besides variable selling expense cost data are not derived from any other operating budget but are projected as a separate activity for the respective depart ments Variable selling expense may contain several items but it primarily refers to sales commissions or bonus payments granted to employees retailers or other sales force part ners in direct relation to how much they sell during the defined time Therefore such posi tioning of the administrative expense budget depends on sales budget figures although it cannot be directly retrieved The total budgeted sales figure does not yet differentiate who sells how much of it and some bonuscommission schemes would require more detailed input in this regard to determine the total variable selling expense Drury 2018 Once again there is a position of noncash expenses consisting of depreciation plus bad debt expense For this example it is assumed that there is 250 of variable selling expense per unit sold eg for packaging The total expense figures will be relevant for the budgeted incomes statement whereas the disbursement figures will be needed for the cash budget Table 40 Administrative Expense Budget in Q1 Q2 Q3 Q4 Variable selling expenses 12500 15000 12500 10000 Fixed selling expen ses 89500 89500 89500 89500 Total expense 102000 104500 102000 99500 less noncash 14000 15200 13000 12450 Total disbursement 88000 89300 89000 87050 Source Hastenteufel 2020 Budgeted Income Statement Having finished all the operating budgets companies can use their respective bottom lines to compile a summary of the projected revenues and expenses to be generated or incurred during the budgeted period Compiling all revenue and costrelated information 80 Income statement The income statement is a financial statement fea turing all revenues and costs of an organization for a specified period ie all sales and expense data they receive the expected profit or loss for the budgeted period Hence the document is referred to as a budgeted income statement It corre sponds with a normal income statement with the exception that the latter is assembled at the end of the business period being reported and therefore contains actual instead of projected data The budgeted income statement shows in a summarized format the bottom line ie profit or loss to expect if business is conducted according to budgets If the result is not satisfying the budgeting process will have to be started anew Remember to keep in mind that realistic data are key to meaningful budgeting However there are adjustable ele ments such as negotiable purchase prices of input or stacking up capacities for any plan ned expansion that can play a role in achieving more desirable results in the budgeted income statement Drury 2018 In this example the following result is achieved by incorporating all operating budgets as a budgeted income statement The costs of goods sold comprise direct material direct labor and overhead ie the typical three components of product costs In the example below a 30 income tax rate is assumed Table 41 Budgeted Income Statement in Q1 Q2 Q3 Q4 Sales revenue 175000000 210000000 1750000 1400000 Cost of goods sold 113080882 133304237 115721939 95915190 Admin expenses 10200000 10450000 10200000 9950000 Income before tax 51719118 66245763 49078061 34134810 Income tax 30 15515735 19873729 14723418 10240443 Net income 36203382 46372034 34354643 23894367 Source Hastenteufel 2020 73 Financial Budgets Cash is king is a famous motto in the business world It holds a truth without liquidity companies cannot meet their obligations such as paying bills taxes and salaries Liquid ity is even more important than profitability at least in the short run Especially for start ups with little to no experience in a market they enter it is difficult to come up with mean ingful projections Monthly planning is advisable and frequent updates of budgets upon reality checks are helpful Successful budgeting depends on accuracy and on the ability to enact it Many businesses get into trouble due to budgeted cash from customer collections that do not materialize and ultimately fail to be paid 81 Cash Budget The cash budget projects the availability generation and use of cash throughout the budgeted period It is a crucial source of information because it helps identify whether and if so when cash shortages threaten the viability of a business Early knowledge about expected cash gaps helps companies to arrange financial options well ahead of trouble If the projected cash situation is unviable at any time covered by the budget the entire planning process might either have to restart or adjustments may be required to steer the company toward a more viable path Drury 2018 The figures generated in the cash budget result directly from the previous example The cash budget summarizes all receipts and disbursements In the basic scenario col lections are only generated from sales so the data are transferred from there All other operating budgets provide information on how much cash will be spent for various purpo ses such as production or administration Cash collections build the first part of the cash budget Revenue from the sales budget is expected to be collected However depending on col lection policies and terms of payment extended to customers it is not granted that the revenue figure and the collections in the same quarter are identical In this context the following information is available Eighty percent of sales are made on account and 20 percent are made against cash Of the sales on account 75 percent of the collections happen in the same quarter as the sales are made 23 percent happen in the next quarter and the remaining 2 percent are likely to be bad debt The revenues in the fourth quarter of the previous year were 1300000 This information can be displayed as follows 82 Figure 14 Cash Collection Scheme Source Hastenteufel 2020 The resulting cash collections part of the cash budget is assembled as follows Table 42 Cash Collections in Q1 Q2 Q3 Q4 From same quarter 1400000 1680000 1400000 1120000 From previous quarter 239200 322000 386400 322000 Total 1639200 2002000 1786400 1442000 Source Hastenteufel 2020 In addition to the cash collection the cash disbursements must be calculated The data needed for the overview of cash payments come from the direct materials purchase budget the direct labor budget the overhead budget and the administrative expense budget In the case of DM purchases the total cash disbursement for the quarter does not equal the actual value of purchases That is once again owed to the payment pattern as follows Seventy percent of the purchases are made on account and 30 percent are made against cash Of the purchases on account 75 percent of payments happen in the same quarter as the purchase is made the other 25 percent in the next quarter The DM purchase value in the fourth quarter of the previous year was 125000 83 The cash disbursement scheme for DM purchases is displayed as follows Figure 15 Cash Disbursement Scheme Source Hastenteufel 2020 The resulting cash disbursement section of the cash budget looks as follows Table 43 Direct Materials Cash Disbursement in Q1 Q2 Q3 Q4 For the same quar ter 102564 114840 95139 77319 For the last quarter 21875 21756 24360 20181 Total 124439 136596 119499 97500 Source Hastenteufel 2020 It is assumed that all further disbursements are made in the same quarter as the related cost is incurred Additional disbursements are summarized as follows Table 44 Further Cash Disbursement in Q1 Q2 Q3 Q4 Direct labor budget 76500000 88500000 73500000 59250000 Overhead budget 23102500 24922500 22647500 20486250 Admin expense budget 8800000 8930000 8900000 8705000 84 in Q1 Q2 Q3 Q4 Direct labor budget 76500000 88500000 73500000 59250000 Total 108402500 122352500 105047500 88441250 Source Hastenteufel 2020 To assemble the overall cash budget the following additional information is provided The cash balance at the beginning of the first quarter is 250000 At the beginning of the third quarter a new machine is purchased for 200000 and paid for in cash With this information the cash budget is completed through the assembly of all relevant portions Table 45 Completed Cash Budget in Q1 Q2 Q3 Q4 Cash balance beginning 25000000 68073600 132261500 173904100 Collections 163920000 200200000 178640000 144200000 Direct materials budget 12443900 13659600 11949900 9750000 Direct labor budget 76500000 88500000 73500000 59250000 Overhead budget 23102500 24922500 22647500 20486250 Admin expense budget 8800000 8930000 8900000 8705000 Machine purchase 20000000 Total 68073600 132261500 173904100 219912850 Source Hastenteufel 2020 The budgeted cashflow statement will correspond with the cash budget Please note that conducting the budgeted balance sheet here is not part of this course SUMMARY A budget is the quantified formulation of a plan of an organizations activities for the following business periods Budgeting is crucial for business insofar as it directs the activity of the budgeted period which 85 will have consequences such as costs incurred staff hired or fired and capacity buildup or reduction Major aspects to consider in the budget ing process include the vision and mission of the organization long term and shortterm strategic objectives and the external environment The budgeting process is quite complex as a lot of data are generated and evaluated The organizational culture is important in the process as it determines how important hierarchy is within a company To achieve realistic projections which in turn are vital for allocating appropriate resources the incorporation of operating staff input is also advisable The budgeting cycle starts with the setup of the sales budget determin ing how much the business intends to sell during the budgeted period Productionrelated budgets follow in logical sequence and then the administrative expense budget is provided These operating budgets lead to the assembly of a proforma income statement showing how much profit or loss is expected resulting from the projected business activity Cash is king without liquidity companies cannot meet their obliga tions such as paying bills taxes and salaries At least in the short run liquidity is even more important than profitability Therefore the cash budget is highly important It projects the cash inflows and outflows of the budgeted period Thus it also helps detect potential cash shortages which can then be prevented by arranging shortterm loans or through collection or payment policy changes The cash budget comprises both cash collections and disbursements The former result from projected sales the latter from projected produc tion procurement and administration activity which all lead to expen ses that will have to be paid It is important to be ambitious yet realistic if the projected sales figures are too high the projected cash collections may not materialize 86 LIST OF REFERENCES Accountingformanagementorg 2020 May 25 Predetermined overhead rate httpsww waccountingformanagementorgpredeterminedoverheadrate Atkinson A A Kaplan R Matsumura E M Young S M 2012 Management account ing Information for decisionmaking and strategy execution 6th ed Pearson Drury C 2018 Management and cost accounting 10th ed Cengage Drury C 2019 Management accounting for business 7th ed Cengage The Economist Daily Chart 2018 February 7 Rising oil prices are making more extrac tion methods viable The Economisthttpswwweconomistcomblogsgraphicdetail 201802dailychart3 Erling J Grabitz I Hartmann J 2008 July 7 Was deutsche Unternehmen an China stört What German companies dislike about China Die Welt httpwwwweltdewirt schaftarticle2187955WasdeutscheUnternehmenanChinastoerthtml Friedman T L 2006 The world is flat The globalized world in the twentyfirst century Penguin Griffin J M Teece D J 2018 OPEC behavior and world oil prices Routledge MerriamWebster nd Cost In MerriamWebstercom dictionary Retrieved May 27 2020 from httpswwwmerriamwebstercomdictionarycost Schlandt J 2012 March 16 China adéFirmen kehren nach Deutschland zurück China ade Companies return to Germany Video Frankfurter Rundschau httpswwwfrd ewirtschaftchinafirmenkehrennachdeutschlandzurueck11311898html SchneiderMayerson M 2015 Peak oil Apocalyptic environmentalism and libertarian political culture University of Chicago Press Schütrumpf K 2012 January 22 Wie Vermieter Nebenkosten abrechnen How landlords settle service charges Handelsblatt Retrieved from httpwwwhandelsblattcomfin anzenimmobilienratgeberhintergrundimmobilienwievermieternebenkostenabr echnen6092396allhtml Stocker G 2006 Avoiding the corporate death spiral ASQ Quality Press 88 LIST OF TABLES AND FIGURES Table 1 Overview of Major Differences between Management and Financial Accounting 13 Figure 1 Step Costs 15 Figure 2 Fixed and Variable Costs 16 Figure 3 Curvilinear Variable Costs 17 Table 2 Total Costs Example 17 Figure 4 Mixed Costs 18 Figure 5 Fixed and Variable Costs per Unit 19 Figure 6 BreakEven Point 25 Figure 7 CVP Analysis 29 Table 3 Operating Leverage 30 Figure 8 Product Costs 35 Figure 9 Period Costs 36 Table 4 Important Cost Terminology 37 Table 5 Predetermined Overhead Rate Example Dataset 37 Table 6 Departmental Overhead Rate Example Dataset 1 38 Table 7 Departmental Overhead Rate Example Dataset 2 38 Table 8 Comparison of Predetermined Overhead Rate and Departmental Overhead Rate 39 Table 9 Overhead OverUnderApplication Scenarios 40 Table 10 Activities of Businesses 45 89 Table 11 Initial Data 46 Table 12 Predetermined Overhead Rate 46 Table 13 Activity Analysis 47 Table 14 Activity Analysis with Cost Driver Volumes 48 Table 15 Cost Driver Rate Application Sofa Bed 48 Table 16 Cost Driver Rate Application Office Chair 48 Table 17 Predetermined Overhead Rate versus ActivityBased Costing 49 Figure 10 Different Phases of Overhead Analysis 55 Table 18 Reciprocal Method Initial Data 55 Table 19 Phase One Overhead Analysis Sheet 56 Table 20 Phase Two Additional Information 56 Table 21 Phase Two Overhead Analysis Sheet 57 Table 22 Phase Three Overhead Analysis Sheet 57 Table 23 Cost Overview 58 Table 24 Overview of Potential Cost Drivers 59 Table 25 Phase One Cost Allocation for Overhead Analysis Sheet 60 Table 26 Phase Two Cost Allocation for Overhead Analysis Sheet 61 Table 27 Phase Three Cost Allocation for Overhead Analysis Sheet 61 Table 28 Replacement of Equipment Full Cost Analysis 65 Table 29 Replacement of Equipment Relevant Cost Analysis 66 Table 30 MakeorBuy Initial Data 67 Table 31 MakeorBuy Cost Comparison 67 Table 32 Special Order Initial Data 68 90 Table 33 Special Order Cost Analysis Scenario 1 69 Table 34 Special Order Cost Analysis Scenario 2 69 Table 35 Drop Product Line Initial Data 70 Table 36 Drop Product Line Analysis 71 Figure 11 Operating Budgets 76 Table 37 Sales Budget Example 77 Figure 12 Production Units Budget 78 Figure 13 Direct Materials Budget 78 Table 38 Direct Labor Budget 79 Table 39 Overhead Budget 79 Table 40 Administrative Expense Budget 80 Table 41 Budgeted Income Statement 81 Figure 14 Cash Collection Scheme 83 Table 42 Cash Collections 83 Figure 15 Cash Disbursement Scheme 84 Table 43 Direct Materials Cash Disbursement 84 Table 44 Further Cash Disbursement 84 Table 45 Completed Cash Budget 85 91 Hari om kannadi glass om andgern om ore 15 k dono tprueony of ncrrir hun the oninig op 5 ares gannsing car for us or harling legsis in sening h un 12 auriny wlth ene 9Jse ares ciconica rnsunt J roo kson 10 SI loa 2945 Eta Agunmo 324 Jon IU Internationale Hochschule GmbH IU International University of Applied Sciences JuriGagarinRing 152 D99084 Erfurt Mailing Address AlbertProellerStraße 1519 D86675 Buchdorf mediaiuorg wwwiuorg Help Contacts FAQ On myCampus you can always find answers to questions concerning your studies page 1 of 5 EXAMINATION OFFICE IUORG COMBINED ASSESMENT Guidelines for the Creation of a Combined Assessment CONTENT 1 Objectives of Academic Writing 2 2 Structure of a Written Assignment 2 21 Introduction 2 22 Main Body 2 23 Conclusion 3 3 Formal Guidelines and Submission Requirements 3 31 Components of the Written Assignment 3 32 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Management Accounting CONTENT 1 Task 2 11 Task 1 Management Accounting 101 2 12 Task 2 CostVolumeProfit Analysis and Cost Allocation 2 13 Task 3 Budgets 2 2 Additional information for the evaluation of the written assignment 3 3 Tutorial Support 3 Seite 2 von 3 EXAMINATION OFFICE IUORG 1 TASK Please choose one of the topics listed below to write your assignment on The starting point for your term paper will be the course book the contents of which will serve as the basis for an indepth examination of one of the following questions You are expected to research and cite from sources corresponding to your chosen topic Note on copyright and plagiarism Please take note that IU Internationale Hochschule GmbH holds the copyright to the examination tasks We expressly object to the publication of tasks on thirdparty platforms In the event of a violation IU Internationale Hochschule is entitled to injunctive relief We would like to point out that every submitted written assignment is checked using a plagiarism software We therefore suggest not to share solutions under any circumstances as this may give rise to the suspicion of plagiarism 11 Task 1 Management Accounting 101 1 Financial Accounting vs Management Accounting Define both management and financial accounting and describe them in detail Critically compare financial and management accounting and list advantages and disadvantages for both types of accounting 2 Compare and contrast the key stakeholders of financial accounting vs management accounting their areas of application and the tools that managers employ to execute their functions 12 Task 2 CostVolumeProfit Analysis and Cost Allocation 1 BreakEven Analysis for Decision Making Explain what a breakeven analysis is and how it works Also describe how a breakeven analysis can be used to analyze costs and to calculate prices and critically examine whether it is a beneficial instrument for firms 2 Methods of Cost Allocation Define and briefly describe the different types of cost allocation Also explain its purpose and describe its role in management accounting Critically review the pros and cons of the different cost allocation methods 13 Task 3 Budgets 1 Operating Budgets Explain what operating budgets are and what they are used for In this context also describe the budgeting process and name and explain different types of operating budgets 2 Financial Budgets Explain what financial budgets are and what they are used for Also describe the budgeting process and name and explain different types of financial budgets 3 Operating vs Financial Budgets Point out the differences and similarities between both types of budgets and describe whether they are connected in the budgeting process Seite 3 von 3 EXAMINATION OFFICE IUORG 2 ADDITIONAL INFORMATION FOR THE EVALUATION OF THE WRITTEN ASSIGNMENT When conceptualizing and writing the written assignment the evaluation criteria and explanations given in the writing guidelines should be considered 3 TUTORIAL SUPPORT In this written assignment task several support channels are open as the student it is your responsibility to select your preferred support channel The tutor is available for technical consultations and for formal and general questions regarding the procedure for processing the written assignment However the tutor is not required to approve outlines or parts of texts and drafts Independent preparation is part of the examination work and is included in the overall evaluation However general editing tips and instructions are given in order to help you get started with the written assignment Análise Comparativa Contabilidade Financeira e Contabilidade Gerencial SUMÁRIO 1 Introdução2 2 Desenvolvimento2 21 Definição de Contabilidade Financeira e Contabilidade Gerencial2 22 Comparação e Contraste Benefícios e Limitações3 23 Stakeholders Áreas de Aplicação e Ferramentas3 24 Exemplo de Contabilidade Financeira4 25 Exemplo de Contabilidade Gerencial4 3 Estudos de Casos4 31 Fusão Corporativa e Contabilidade Financeira4 32 Implementação de Contabilidade Gerencial em Startup5 33 Expansão Internacional e Contabilidade Financeira5 34 Transformação Digital e Contabilidade Gerencial6 4 Desafios Contemporâneos na Contabilidade6 5 Perspectivas Futuras7 7 Referências Bibliográficas9 1 Introdução A contabilidade além de ser um aspecto crucial para a existência de uma empresa também é crucial para a sua viabilidade financeira e operacional Ela se divide em duas categorias principais contabilidade financeira e contabilidade gerencial A contabilidade financeira se concentra na criação de relatórios para partes interessadas externas da empresa enquanto a contabilidade gerencial é voltada para análise interna ajudando gestores a tomar decisões informadas sobre a operação diária e o planejamento estratégico Esse artigo expõe as definições funções e prós e contras de cada tipo de contabilidade além de fazer uma comparação entre os dois métodos ilustrando como atendem necessidades distintas de diferentes partes interessadas De acordo com Drury 2019 a contabilidade financeira se dedica principalmente à elaboração de relatórios que são usados por entidades externas para avaliar a situação financeira da empresa Já para Atkinson et al 2012 a contabilidade gerencial é uma prática que proporciona dados internos para ajudar os gestores a fazer escolhas bem informadas e melhorar a eficiência das operações Com o estudo desses dois métodos de contabilidade poderemos reconhecer melhor como essas informações podem ser empregadas para moldar decisões estratégicas e operacionais nas organizações 2 Desenvolvimento 21 Definição de Contabilidade Financeira e Contabilidade Gerencial Contabilidade Financeira Colin Drury 2019 define a contabilidade financeira como a metodologia focada na criação de relatórios financeiros que refletem as atividades passadas de uma organização Esses relatórios incluindo balanços demonstrações de resultados e fluxos de caixa são cruciais para fornecer transparência e manter a confiança entre a empresa e suas partes interessadas externas Um exemplo clássico de sua aplicação é na empresa multinacional X Corp que utilizou seus relatórios financeiros para negociar melhores condições de empréstimo com bancos demonstrando solidez e crescimento estável através de seus balanços auditados Contabilidade Gerencial Atkinson et al 2012 descreve a contabilidade gerencial como essencial para a gestão interna focando em fornecer informações que ajudam os gestores a tomar decisões operacionais e estratégicas Esta flexibilidade é ilustrada no caso da startup tecnológica Innovatech onde os gestores utilizaram relatórios gerenciais para reajustar rapidamente suas estratégias de marketing em resposta a mudanças no comportamento do consumidor analisando os custos e benefícios de campanhas publicitárias em tempo real 22 Comparação e Contraste Benefícios e Limitações Vantagens Financeira A contabilidade financeira é indispensável para manter a credibilidade financeira externa Por exemplo a empresa GlobalTech foi capaz de atrair investimentos significativos após publicar seus relatórios financeiros que claramente demonstravam um forte retorno sobre o investimento e crescimento de receita sustentável Gerencial A flexibilidade da contabilidade gerencial mostra seu valor quando gestores precisam de informações adaptáveis para decisões rápidas Um gestor de produção na Manufacturing Solutions usou relatórios gerenciais para decidir sobre a compra de novo equipamento baseandose na análise de custo de manutenção versus aquisição facilitada por previsões financeiras detalhadas Desvantagens Financeira A rigidez da contabilidade financeira pode ser uma barreira para insights operacionais rápidos Por exemplo na Beverage Corp os gestores expressaram frustração devido à incapacidade de usar relatórios financeiros para decisões operacionais rápidas devido ao atraso no fechamento e na revisão financeira Gerencial Por outro lado a adaptabilidade da contabilidade gerencial pode resultar em inconsistências A empresa Tech Innovations enfrentou desafios ao comparar sua eficiência operacional com a de concorrentes pois cada empresa utilizava diferentes métodos de custeio e alocação de despesas 23 Stakeholders Áreas de Aplicação e Ferramentas Stakeholders Financeira Focada nas partes interessadas externas a contabilidade financeira atende a investidores e reguladores No caso da PharmaCorp os relatórios financeiros ajudaram a demonstrar conformidade com novas regulamentações fiscais evitando multas significativas Gerencial Destinada aos stakeholders internos como no caso da FastRetail onde os gerentes utilizaram relatórios gerenciais para otimizar a logística e reduzir custos de distribuição baseandose em análises de eficiência interna detalhadas Ferramentas Financeira A análise de rácios financeiros e as auditorias externas são essenciais para assegurar a precisão dos dados financeiros Gerencial Ferramentas como orçamentos flexíveis e modelagem financeira são usadas para a tomada de decisão interna 24 Exemplo de Contabilidade Financeira Um dos exemplos citados por Drury 2019 envolve uma empresa manufatureira que precisava avaliar sua capacidade de servir dívidas em face de uma expansão planejada A contabilidade financeira foi usada para preparar projeções de fluxo de caixa e demonstrações de resultados futuros fornecendo aos credores as informações necessárias para avaliar a viabilidade do financiamento A clareza e objetividade desses relatórios garantiram a aprovação rápida dos empréstimos necessários 25 Exemplo de Contabilidade Gerencial No contexto apresentado por Atkinson et al 2012 um varejista online utilizou contabilidade gerencial para otimizar suas operações de estoque durante a temporada de festas Através de análises de custobenefício a empresa pôde decidir se seria mais vantajoso manter um estoque maior para evitar falta de produtos ou reduzir o estoque para minimizar os custos de armazenamento As decisões baseadas nesses relatórios resultaram em uma redução significativa de custos e melhoraram a satisfação do cliente devido à disponibilidade eficiente de produtos populares 3 Estudos de Casos 31 Fusão Corporativa e Contabilidade Financeira No estudo apresentado por Colin Drury 2019 a fusão de duas gigantes tecnológicas serve como um exemplo ilustrativo da vital importância da contabilidade financeira em processos de reestruturação corporativa A transparência financeira foi um pilar essencial para manter a confiança dos investidores e reguladores durante um período potencialmente turbulento Os relatórios financeiros consolidados forneceram uma visão clara de como os ativos e passivos de ambas as empresas foram unificados revelando sinergias operacionais que resultaram em melhorias substanciais de liquidez e patrimônio líquido Esses relatórios não apenas sinalizaram uma gestão competente mas também destacaram o aumento do valor agregado para os acionistas fundamental para sustentar e aumentar o interesse de investidores existentes e potenciais A análise detalhada desses relatórios permitiu que os stakeholders entendessem como a fusão criaria valor a longo prazo otimizando as operações e explorando novas oportunidades de mercado resultantes da combinação de recursos e capacidades tecnológicas 32 Implementação de Contabilidade Gerencial em Startup O caso de uma startup de software explorado por Atkinson et al 2012 exemplifica como práticas de contabilidade gerencial podem ser cruciais para empresas em estágio inicial A startup utilizou intensivamente análises de custo detalhadas para identificar quais processos consumiam mais recursos e não geravam retorno proporcional Ajustando suas estratégias de alocação de recursos a empresa conseguiu reduzir custos desnecessários e realocar fundos para áreas com maior potencial de retorno As projeções financeiras jogaram um papel crucial permitindo que a gestão antecipasse cenários futuros e planejasse expansões de forma sustentável Estas projeções foram fundamentadas em uma variedade de cenários de mercado desde o mais otimista ao mais conservador fornecendo aos gestores uma base sólida para tomar decisões estratégicas informadas Este planejamento proativo foi essencial para a sobrevivência e crescimento da startup demonstrando a importância de uma contabilidade gerencial adaptativa e focada no futuro 33 Expansão Internacional e Contabilidade Financeira Este estudo de caso reflete as discussões encontradas em Drury 2019 onde é enfatizado o papel da contabilidade financeira na gestão de operações internacionais Drury destaca que ao expandir globalmente a aderência a normas contábeis internacionais e a conformidade com as regulamentações fiscais locais são essenciais para manter a integridade financeira e operacional de uma empresa Drury 2019 p 342 A contabilidade financeira fornece os meios através dos quais as corporações podem garantir essa conformidade usando relatórios padronizados que permitem comparações e análises consistentes por parte de investidores e reguladores independentemente das fronteiras geográficas 34 Transformação Digital e Contabilidade Gerencial Para o caso da transformação digital no varejo Atkinson et al 2012 fornecem insights relevantes sobre como a contabilidade gerencial pode ser adaptada para suportar mudanças significativas nos modelos de negócios Os autores discutem que a contabilidade gerencial deve evoluir para responder rapidamente às mudanças tecnológicas e de mercado oferecendo análises que suportem decisões estratégicas e operacionais em tempo real Atkinson et al 2012 p 258 Este pensamento é exemplificado no caso da empresa de varejo onde ferramentas de contabilidade gerencial como análise de dados e projeções financeiras são utilizadas para ajustar dinamicamente as operações e estratégias de marketing à medida que o cenário digital se desenvolve Ambas as citações desses textos sobre contabilidade reforçam a aplicação prática dos princípios contábeis em cenários complexos e dinâmicos de negócios Eles também destacam a necessidade de uma abordagem contábil que não apenas mantenha a conformidade e a eficiência mas também promova a inovação e a adaptação em um ambiente empresarial global e digitalmente orientado 4 Desafios Contemporâneos na Contabilidade O ambiente de contabilidade está enfrentando desafios complexos que demandam uma evolução constante dos profissionais e das práticas do setor Um dos principais desafios é a integração de critérios de sustentabilidade nos relatórios financeiros À medida que as empresas se tornam mais conscientes de seu impacto ambiental e social surge a necessidade de refletir essas preocupações em suas demonstrações financeiras Como apontado por Drury 2019 essa integração não é apenas uma questão de adicionar novas linhas nos relatórios mas de repensar a forma como os valores são atribuídos aos recursos e atividades A contabilidade financeira tradicionalmente focada em números agora deve considerar fatores não financeiros que afetam a reputação e a viabilidade a longo prazo da empresa Além disso a gestão de big data representa um desafio significativo para a contabilidade gerencial como discutido por Atkinson et al 2012 Com o volume crescente de dados disponíveis os contabilistas gerenciais devem ser capazes de não apenas coletar e armazenar grandes quantidades de informações mas também de extrair insights relevantes para a tomada de decisão A habilidade de analisar e interpretar grandes conjuntos de dados rapidamente está se tornando uma competência essencial permitindo aos gestores responder de maneira ágil às mudanças do mercado e às oportunidades emergentes Esses desafios exigem que os contabilistas desenvolvam novas habilidades e adotem tecnologias avançadas como software de análise de dados e sistemas integrados de relatórios para permanecerem eficazes e relevantes no cenário atual 5 Perspectivas Futuras O futuro da contabilidade promete ser significativamente influenciado pelas tendências atuais que estão moldando tanto a contabilidade financeira quanto a gerencial de maneiras profundas A digitalização está na vanguarda com tecnologias como inteligência artificial e blockchain previstas para transformar radicalmente os processos contábeis Essas tecnologias não apenas automatizam tarefas tradicionais reduzindo erros e aumentando a eficiência mas também oferecem novas maneiras de garantir a precisão e a transparência dos registros contábeis Além disso a contabilidade está se movendo em direção a uma integração ainda maior com questões de sustentabilidade e responsabilidade social Isso é refletido na crescente demanda por relatórios integrados que combinam financeiro com social e ambiental conforme discutido por Drury 2019 Este desenvolvimento sugere que futuros contabilistas precisarão entender de regulamentações ambientais ética empresarial e responsabilidade social além de suas competências tradicionais Para navegar neste futuro complexo os contabilistas precisarão de competências diversificadas incluindo proficiência em tecnologia compreensão de sustentabilidade e habilidades analíticas avançadas Eles também precisarão ser adaptáveis continuamente buscando atualização e aprendizado para manter suas habilidades relevantes à medida que novas ferramentas e conceitos emergem Conforme os setores enfrentam essas mudanças rápidas a educação contábil também deve evoluir Programas de formação contínua workshops especializados em tecnologia e sustentabilidade e parcerias entre academias e indústrias serão essenciais para preparar os contabilistas para os desafios do futuro Isso garantirá que a profissão continue a agregar valor significativo às empresas e à sociedade mantendo os princípios de precisão ética e transparência que são a base da contabilidade 6 Conclusão Ao longo deste estudo exploramos as nuances e funcionalidades distintas da contabilidade financeira e gerencial identificando como cada uma serve propósitos complementares dentro do ambiente corporativo Este exame revelou que apesar de suas diferenças ambas as formas de contabilidade são essenciais para uma gestão corporativa eficaz e sustentável A contabilidade financeira assegura a transparência e a conformidade fundamentais para a confiança dos investidores e a estabilidade financeira a longo prazo Por outro lado a contabilidade gerencial oferece as ferramentas necessárias para decisões operacionais e estratégicas ágeis permitindo que as empresas se adaptem e prosperem em mercados em constante mudança Importância da Transparência e Flexibilidade A contabilidade financeira com sua estrutura rigorosa e normativa é essencial para fornecer uma visão clara e confiável da saúde financeira de uma empresa Esta transparência não é apenas uma exigência regulatória mas uma necessidade para atrair e manter o investimento e o financiamento externos No entanto essa rigidez pode ser uma limitação quando se trata de necessidades operacionais rápidas onde a contabilidade gerencial entra em cena com sua flexibilidade e foco interno Os gestores utilizam a contabilidade gerencial para obter insights que direcionam decisões rápidas e fundamentadas adaptandose a novas oportunidades e desafios com agilidade Desafios de Integração e Síntese Embora cada tipo de contabilidade tenha seu próprio conjunto de forças elas não operam isoladamente A análise revelou a importância de uma abordagem integrada onde as informações detalhadas e adaptativas da contabilidade gerencial complementam os dados estruturados e abrangentes da contabilidade financeira Esta síntese pode ser desafiadora dado que as demandas e expectativas de diferentes stakeholders muitas vezes exigem equilíbrios delicados entre transparência externa e utilidade interna Futuro das Práticas Contábeis No futuro a interação entre a contabilidade financeira e gerencial provavelmente se tornará mais dinâmica e interdependente À medida que as empresas enfrentam um ambiente de negócios globalizado e tecnologicamente avançado a capacidade de integrar eficazmente informações financeiras e gerenciais será crucial Os profissionais de contabilidade precisarão desenvolver habilidades em ambas as áreas não apenas para manter a conformidade e a eficiência mas também para impulsionar inovações e estratégias que sustentem o crescimento e a competitividade a longo prazo Conclusão Final Este estudo ressalta a necessidade contínua de desenvolvimento profissional e educacional em contabilidade preparando os contabilistas para uma era onde a integração eficiente de contabilidade financeira e gerencial será não apenas benéfica mas essencial As empresas que cultivarem uma compreensão profunda de ambas as disciplinas estarão melhor equipadas para enfrentar os desafios do futuro e aproveitar as oportunidades que essas competências integradas trazem Portanto o diálogo entre as práticas contábeis financeiras e gerenciais continuará a ser um tema central na busca pela excelência empresarial no cenário global contemporâneo 7 Referências Bibliográficas 1 Drury C 2019 Management Accounting for Business 7th ed Cengage Learning 2 Atkinson A A Kaplan R S Matsumura E M Young S M 2012 Management Accounting Information for DecisionMaking and Strategy Execution 6th ed Pearson