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INTRODUCTION TO STRATEGIC COST MANAGEMENT AND MANAGEMENT ACCOUNTING

Management Accounting

 Management Accounting refers to reports designed to meet the needs of internal users, particularly the managers. The
American Association of Accountants (AAA) defined it as the application of appropriate techniques and concepts in
processing the historical and projected economic data of an entity to assist management in establishing a plan for
reasonable economic objectives and in the making of rational decisions with a view towards achieving these
objectives.

Management Accounting vs. Financial Accounting

 Managerial accounting is concerned with providing information to personnel within an organization so that they can
plan, make decisions, evaluate performance, and control operations. There are no rules and regulations associated
with this field since the information is intended solely for use within the firm.
 Financial accounting, in contrast, focuses on financial statements and other financial reports. This area deals with
reporting to groups outside of an organization (e.g., stockholders, lenders, government agencies) so that some
assessment of profitability and overall financial health can be made. Given the large number of firms in our economy
and the varying level of user sophistication, the field is heavily regulated (by the Financial Accounting Standards
Board and, to a lesser degree, by the Securities and Exchange Commission).

Strategic Cost Management

 Strategic cost management is the process of reducing total costs while improving the strategic position of a business.
This goal can be accomplished by having a thorough understanding of which costs support a company's strategic
position and which costs either weaken it or have no impact. Subsequent cost reduction initiatives should focus on
those costs in the second category. Conversely, it may be useful to increase costs that support the strategic position of
the business.
 It is almost never worthwhile to cut costs in strategically important areas, since doing so reduces the customer
experience and therefore will eventually lead to a decline in sales. Consequently, management needs to be involved in
cost reduction activities, so that they can provide input regarding how certain costs must be incurred in order to
support the competitive position of the firm.

Summary of Differences:

FINANCIAL ACCOUNTING MANAGEMENT ACCOUNTING

1. Users of information Primarily for external users Exclusively for internal users

Should be in accordance with Generally

2. Accounting principles Management wants and needs
Accepted Accounting Principles

3. Optional/Mandatory Mandatory, particularly by the government Discretionary or optional

The end-product which is the financial Monetary and also non-monetary like units
4. Type of information statements are primarily monetary (financial) produced, units sold, number of labor
in nature hours, etc.

5. Emphasis on reports Reliability (precision of data) Relevance and timeliness of data.

To assist the management in decision-

6. Purpose/End result To produce financial statements
making

From company’s (internal) information From internal and external users such as
7. Source of data
system economics, etc.

8. Amount of detail Reports are compressed and simplified Reports are more extensive and detailed

Financial statements focus mainly on
9. Focus of information
business as a whole
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Focus on segments (e.g., products,
divisions, departments within the company)
and business as a whole

10. Frequency of reports Periodic (annually, quarterly) As frequent as management need arises

11. Time orientation Mainly historical (past) data Future-oriented using current and past data

12. Unifying concept Assets = Liabilities + Equity No unifying concept or equation

The Controller: Chief Management Accountant

 Controllership – is the practice of the established science of control, which is the process by which management
assures itself that the company’s resources are obtained and utilized according to plans that are in line with the
company’s set objectives.
 Controller – is an officer of an organization who has responsibility for the accounting aspect of management control.
He generally performs two basic roles:
1. Accumulation and reporting of accounting information to all levels of management and;
2. Directing management’s attention to problems and assisting them in solving such problems.

Controller vs. Treasurer

CONTROLLER TREASURER

1. Planning & control 5. Government reporting 1. Provision of capital 5. Credit & collections

2. Reporting & interpreting 6. Protection of assets 2. Investor relations 6. Investments

3. Evaluating & consulting 7. Economic appraisal 3. Short-term financing 7. Insurance

4. Tax administration 4. Banking & custody

Chief Financial Officer

 A chief financial officer (CFO) is the senior executive responsible for managing the financial actions of a company.
The CFO's duties include tracking cash flow and financial planning as well as analyzing the company's financial
strengths and weaknesses and proposing corrective actions.
 The role of a CFO is similar to a treasurer or controller because they are responsible for managing the finance and
accounting divisions and for ensuring that the company’s financial reports are accurate and completed in a timely
manner. Many have a CMA designation.

Internal Auditor

 An internal auditor (IA) is a trained professional employed by companies to provide independent and objective
evaluations of financial and operational business activities, including corporate governance. They are tasked with
ensuring that companies comply with laws and regulations, follow proper procedures, and function as efficiently as
possible.

Line Function vs. Staff Function

 Line Function is the authority to give command or orders to subordinates. It exercises direct downward authority over
line departments (e.g., VP for operations over operations manager).
 Staff Function is the authority to advise but not to command others; the function of providing line and staff managers
with specialized service and technical advice for support. It is exercised laterally or upward.
 When it comes to the whole organization, a controller usually exercises staff functions since its primary function
is to give advice. But when it comes to its own department, a controller exercises line functions among its own
staff.
 A Treasurer usually exercises line functions within an organization.
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Standards of Ethical Conduct for Management Accountants

 Management accountants have responsibility for ethical behavior in four broad areas, Competence, Confidentiality,
Integrity and Objectivity.

1. Competence - In order to be competent, management accountants must:

 Maintain an appropriate level of professional competence.
 Follow applicable laws, regulations, and standards.
 Provide accurate, clear, concise, and timely decision support information.
 Recognize and communicate professional limitations that preclude responsible judgment.

2. Confidentiality - Management accountants must:

 Not disclose confidential information acquired in the course of their work unless legally obligated to do so.
 Ensure that his subordinates do not disclose confidential information.
 Not use confidential information for unethical or illegal advantage.

3. Integrity – Management accountants must:

• Mitigate conflicts of interest and advise others of potential conflicts.
• Refrain from conduct that would prejudice carrying out duties ethically.
• Abstain from activities that might discredit the profession.

4. Objectivity – Management accountants must:

• Communicate information fairly and objectively.
• Disclose all relevant information that could influence a user’s understanding of reports and recommendations.
• Disclose delays or deficiencies in information timeliness, processing, or internal controls.

 To sum up, Competence means having the capacity to function in a particular manner. Confidentiality means having
the ability to maintain or keep information undisclosed. Integrity is defined as adherence to a code of moral values.
Objectivity is defined as expressing or using facts without distortion by personal feelings or prejudices.

Cost-Volume-Profit & Break-Even Analysis

Variable Costing Income Statement

Sales xx

Less: Variable cost of goods sold xx

Manufacturing margin xx

Less: Variable selling & administrative cost xx

Contribution margin xx

Less: Fixed costs:

Fixed factory overhead xx

Fixed selling & administrative costs xx xx

Profit (loss) xx

 CVP Analysis – is a useful management tool that helps managers in planning for profit by way of a systematic
examination of the interrelationship among costs, volume (activity level) and profit.

Factors affecting profit

Ceteris paribus, If there is an increase in… Then profit will…

1. Selling Price Increase

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2. Variable Cost Per Unit Decrease

3. Fixed Cost Decrease

4. Unit Sales (Volume) Increase

CVP-related terminologies

 Contribution Margin – is the difference between sales and variable cost. It is otherwise known as marginal income,
profit contribution, contribution to fixed cost or incremental contribution.
 CM Ratio = CM ÷ Sales; or

CM per unit ÷ SP per unit; or

∆ CM ÷ ∆ Sales

Note: Under CVP assumptions, CM ratio is constant regardless of the number of units sold or produced.

 Break-Even Point – is a level of activity, in units (break-even volume) or in pesos (breakeven sales), at which total
revenues equal total costs, i.e., there is neither a profit nor a loss.
 BEP unit = Fixed costs ÷ CM per unit
 BEP peso sales = Fixed costs ÷ CM ratio

 Margin of Safety – is the difference between actual sales volume and break-even sales. It indicates the maximum
amount by which sales could decline without incurring a loss.
 MS = Actual sales – Breakeven sales
 MS Ratio = MS ÷ Actual sales

 Indifference Point – is the level of volume at which two alternatives being analyzed would yield equal amount of
total costs or profits.

Alternative A Alternative B

 (CM per unit x Q) – FC = (CM per unit x Q) – FC

OR;

 FC + (VC per unit x Q) = FC + (VC per unit x Q)

Note: Q = number of units (indifference point)

 Sales Mix – is the relative combination of quantities of sales of various products that make up the total sales of a
company.
 BEP units = Fixed costs ÷ Weighted average CM per unit
 BEP peso sales = Fixed costs ÷ Weighted average CM ratio

 Degree of Operating Leverage – measures how a percentage change in sales from the current level will affect
company profits. It indicates how sensitive the company to sales volume increases and decreases. It is also known as
operating leverage factor.

Absorption and Variable Costing

Absorption Costing
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 Absorption costing (also called the full costing) treats all costs of production as product costs, regardless of whether
they are variable or fixed. Since no distinction is made between variable and fixed costs, absorption costing is not
well suited for CVP computations. Under absorption costing, the cost of a unit of product consists of direct materials,
direct labor, and both variable and fixed overhead. Variable and fixed selling and administrative expenses are treated
as period costs and are deducted from revenue as incurred.
 Supporters of absorption costing believe that all manufacturing costs – variable and fixed – are necessary ingredients
for production to take place and should not be ignored in determining product costs.

Variable Costing

 Variable costing (also called direct costing) treats only those costs of production which vary with output as product
costs. This method is called variable costing because it only includes “variable” manufacturing costs in determining
the total cost of a product. This approach is compatible with the contribution approach income statement and supports
CVP analysis because of its emphasis on separating variable and fixed costs. The cost of a unit of product consists of
direct materials, direct labor, and variable overhead. Fixed manufacturing overhead, and both variable and fixed
selling and administrative expenses are treated as period costs and deducted from revenue as incurred.
 Supporters of variable costing argue that FFOH costs are incurred in order to have the capacity to produce units in a
given period. These costs are incurred whether or not the capacity is actually used to make output. Thus, FFOH,
having no future substantial service potential, should be charged against the period and not included in the product
cost.

Advantages of Using Variable Costing:

1. Reports are simpler and more understandable.

2. The problems involved in allocating fixed costs are eliminated.
3. Data needed for break-even and cost-volume-profit analyses are readily available.
4. More compatible with the standard cost accounting system.
5. Reports provide useful information for pricing decisions and other decision-making problems encountered by
management.

Disadvantages of Using Variable Costing:

1. Not in accordance with GAAP; hence, it is not acceptable for external reporting.
2. Segregation of costs into fixed and variable might be difficult.
3. The matching principle is violated.
4. Inventory costs and other related accounts, such as working capital, current ratio, and acid-test ratio are
understated because of the exclusion of FFOH in the computation of product cost.

Reconciliation of Income under Absorption and Variable Costing

 The difference between the absorption costing income and variable costing income is primarily a timing difference –
when to recognize the FFOH as an expense.
 In variable costing, it is expensed when FFOH is incurred, while in absorption costing, it is expensed in the period
when the related units are sold.
 The relationship between production and sales generally indicates the following income patterns:
 When production is equal to sales, there is no change in inventory. FFOH expensed under absorption costing equals
FFOH expensed under variable costing.
 When production is greater than sales, there is an increase in inventory. FFOH expensed under absorption costing is
less than FFOH expensed under variable costing. Therefore, absorption income is greater than variable income.
 When production is less than sales, there is a decrease in inventory. FFOH expensed under absorption costing is
greater than FFOH expensed under variable costing. Therefore, absorption income is less than variable income.

POINT OF RECONCILIATION:

Profit/Loss using Absorption Costing P xxx

Add: Fixed FOH in Beginning Inventory xxx

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Total P xxx

Less: Fixed FOH in Ending Inventory xxx

Profit/Loss using Variable Costing P xxx

 Throughput costing – is a technique that assigns only the unit-level spending amounts for direct costs as the cost of
products or services. In this case, direct material is the only item that qualifies as a throughput cost.
 is also known as super-variable costing. Throughput costing considers only direct materials as true variable cost
and other reaming costs as period costs to be charged in the period in which they are incurred. Thus, in throughput
costing, only direct materials costs are inventoriable costs.

Relevant Costing

 Decision Making – is the process of choosing a course of action from at least two alternatives.

Short-Term Decision Alternatives

1. Accept or reject a special order

2. Sell or process further a product line
3. Make or buy a part or product line
4. Continue or shutdown a business segment
5. Choosing the best product combination
6. Selecting a change in profit factors

Decision Making Process

1. Defining the problem.

2. Specifying the objective and criteria.
3. Identifying the alternative courses of action.
4. Determining and evaluating the possible consequences of the alternatives.
5. Choosing the best alternative and making the decision.
6. Evaluating the results of the decision.

Types of Costs used in Decision Making

 Relevant Costs – Future cost expected to be different between or among alternatives.

 Differential Costs – Increases (increments) or decreases (decrements) in total costs that result from selecting one
alternative instead of another.
 Avoidable Costs – (Relevant) Costs that will be saved or those that will not be incurred if a certain decision is
made.
 Sunk Costs – (Irrelevant) Costs incurred already and cannot be avoided regardless of what a manager decides to
do.
 Out-of-Pocket Costs – (Relevant) Costs that will require expenditure or cash or incurrence of a liability as a
consequence of a management decision.
 Opportunity Costs – (Relevant) Income sacrificed or foregone when a certain alternative is chosen over another
alternative.
 Joint Costs – (Irrelevant) Costs incurred in simultaneously manufacturing two or more (joint) products that are
difficult to identify individually as separate types of products until the products reach a certain processing stage
known as the split-off point.
 Split-off Point – A point in the manufacturing process where some or all of joint products can be distinctively
recognized as individual products.
 Further Processing Costs – (Relevant) Costs incurred beyond the split-off point if product is to be processed
further.
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 Bottleneck Resources – Any resource or operation where the capacity is less than the demand placed upon it.

Approaches in solving problems that involve decision-making

 Total approach – The total revenues and costs are determined for each alternative, and the results are compared to
serve as a basis for making decisions.
 Differential approach – Only the differences or changes in costs and revenues are considered.

« « Make or Buy a Part or a Product » »

 Choose the option that involves the lower cost. In most cases, fixed costs are irrelevant. Consider opportunity costs, if
any.

« « Accept or Reject a Special Order» »

 Accept the order if the additional revenue from the special order exceeds additional cost, provided the regular market
will not be affected. In most cases, fixed costs are irrelevant.

« « Continue or Shutdown a Business Segment » »

 Continue if avoidable revenue of the segment involved is greater than its avoidable costs; otherwise, consider shutting
down the segment. Since allocated fixed cost is usually unavoidable, it is considered irrelevant.

« « Sell-as-is or Process Further a Product » »

 A product must be processed further if additional revenue from processing further is greater than further processing
costs. Joint costs, since already incurred, are considered sunk costs and irrelevant.

« « Optimization of Scarce Resources » »

 Identify and measure the constraint on the limited resource(s). Rank the products according to the highest CM per unit
of scarce resources.

Budgeting

Budget

 A budget is a plan, expressed in quantitative terms, on how to acquire and use the resources of an entity during a
certain future period of time.

Uses of Budgeting

 It compels periodic planning.

 It provides a means of allocating resources efficiently and effectively.
 It enhances cooperation, coordination, communication and motivation.
 It provides network for performance evaluation.
 It satisfies some legal and contractual requirements.
 It directs the activities toward the achievement of organizational goals.

Limitations of Budgeting

 Considerable time and costs are required.

 Budgets are merely estimates, employing certain amount of judgment, requiring certain modification or revision if
necessary.
 To be successful, budgetary system requires cooperation of all members of the organization.
 Budgets sometimes restrict decision-making process.
 The budget program is merely a guide, not a substitute for good management ability.
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Budgets vs. Standards

BUDGETS STANDARDS

Standards pertain to what costs ‘might be’ if

1. Purpose Budgets are statements of expected costs.
certain highly desirable performances are attained.

Budgets emphasize cost levels that should not Standards emphasize the levels to which costs
2. Emphasis
be exceeded. should be reduced.

Budgets are customarily set for all

Standards are usually set only for the
3. Completeness departments in the firm – from sales,
manufacturing divisions of the firm.
administration, to manufacturing.

When actual costs differ from standards, the

4. Analysis & Breakdown
When actual costs differ from the budget, it
nature and cause of the difference or variance is
may be an indication of either goods or bad
investigated so that necessary corrective actions
performance.
are taken in time.

Based on the foregoing comparisons between budgets and standards, the following general statements may be made:

 Standards cannot be used for forecasting.

 Costs are not to exceed budgets; they are to approach standards.
 Budgets include both income and expenses, while standards are normally set for costs and expenses only.
 Budgets help us to keep away from trouble, while standards lead us to the right road to improvement.

Master Budget

 Master Budget is a comprehensive budget that consolidates the overall plan of the organization within a budget
period. It consists of all the individual budgets for each of the segments of the organization aggregated or consolidated
into one overall budget for the entire firm. (Other terms: pro forma budget, planning budget, forecast budget, master
profit plan)

Operating Budget

 Sales budget
 Production budget (Direct materials budget, Direct labor budget, Factory overhead budget, Inventory budget)
 Budgeted cost of goods sold
 Budgeted operating expense
 Budgeted operating income
 Budgeted net income
 Budgeted income statement

Financial Budget

 Cash budget
 Budgeted balance sheet
 Budgeted cash flow statement
 Capital expenditure budget
 Working capital budget

Appropriation-type budget

 Advertising budget
 Research and development budget
 Joint venture budget
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Budgeting-Related Terminologies:

 Fixed Budget A budget prepared for one level of activity within a certain period. (Other term: static budget)
 Flexible Budget A budget prepared for different levels of activity within a certain period. (Other terms: variable
budget, sliding scale budget)
 Continuous Budget A 12-month budget that rolls forward one month as the current month is completed (Other
terms: perpetual budget, rolling budget)
 Incremental A budgeting process wherein the current period’s budget is simply adjusted to allow for changes
planned for the coming period.
 Zero-Based Budget A method of budgeting in which managers are required to justify all costs as if the programs
involved were being proposed for the first time.
 Life-Cycle Budget A product’s revenues and expenses are estimated over its entire life cycle (from research and
development to withdrawal of customer support).
 Activity-Based A budgeting that applies the ABC principles and procedures to budgeting.
 Kaizen Budgeting Kaizen is a Japanese term that means continuous improvement. Thus, Kaizen budgeting assumes
the continuous improvement of products and processes; the effects of improvement and the costs of their
implementation are estimated.
 Imposed Budgeting A process wherein budgets are prepared by top management with little or no inputs from
operating personnel.
 Participatory A process wherein budgets are developed through joint decisions by top management and operating
personnel.
 Budget Committee A group of key management persons (usually composed of the sales manager, production
manager, chief engineer, treasurer and controller) responsible for over-all policy matters relating to the budget
program and for coordinating the budget preparation.
 Budget Manual This describes how a budget is prepared and includes a planning calendar and distribution for all
budget schedules.
 Budget Report It shows a comparison of the actual and budget performance. The budget variances are also
shown on the report.
 Budgetary Slack Results when revenues are intentionally underestimated or expenses are intentionally
overestimated during the budgeting process

RESPONSIBILITY ACCOUNTING

 Decentralization – refers to the separation or division of the organization into more manageable units wherein each
unit is managed by an individual who is given decision authority and is held accountable for his or her decisions.

 Goal Congruence – is the term which describes the situation when the goals of different interest groups coincide. A
way of helping to achieve goal congruence between shareholders and managers is by the introduction of carefully
designed remuneration packages for managers which would motivate managers to take decisions which were
consistent with the objectives of the shareholders.

 Sub-Optimization – happens when one segment of a company takes action that is in its own best interests but is
detrimental to the firm as a whole.

 Responsibility Center – is a segment of organization that is engaged in the performance of a single function or a
group of closely related functions. This segment is usually governed by a manager, who is accountable and
responsible for the activities of the segment.

Types of Responsibility Centers:

1) Cost Center – managers are held responsible for the costs incurred by the segment.
2) Revenue Center – managers are held responsible primarily for revenues of the segment.
3) Profit Center – managers are held responsible for both revenues and costs of the segment.
4) Investment Center – managers are held responsible for revenues, costs and investments. The central performance is
measured in terms of the use of the assets as well as revenues earned and the costs incurred.
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 Responsibility Accounting – is a system of accounting that is implemented to an organization so that performance, in
terms of costs and/or revenues, are recorded and reported by levels of responsibility within an organization.

Financial Performance Measures for Responsibility Accounting

A. Cost Center – Variance analysis

B. Revenue Center – Sales Variance Analysis (Sales Volume, Market size, Market share)
C. Profit Center – Segment Margin, Return on Sales
D. Investment Center – Return on Investment, Residual Income, Economic Value-Added

Return on Investment (ROI) = Operating Income ÷ Operating Assets

= Return on Sales x Asset Turnover (DuPont formula)

Where: ROS = Operating Income ÷ Sales

Asset Turnover = Sales ÷ Operating Assets

Total Assets, excluding idle plant assets

 Residual Income – encourages managers to maximize pesos of profit after a required ROI has been achieved.

Residual Income = Operating Income – Required Income

Where: Required Income = Operating Assets x Minimum ROI

 Economic Value Added (EVA – is a more specific version of residual income that measures the investment center’s
real economic gains. It uses the weighted-average cost of capital (WACC) to compute the required income.

EVA = Operating Income after Tax – Required Income

Where: Required Income = (Total Assets – Current Liabilities) x WACC

CONTROLLABLE vs. NON-CONTROLLABLE COSTS

 Generally, all costs are controllable. The key difference lies in the level of management who can control the costs:
 Controllable Costs – are those items of cost that may be directly regulated at lower levels of management.
 Non-controllable Costs – are costs that cannot be regulated at a particular management level other than the top
level.
 Of most relevance in deciding how or which costs should be assigned to a responsibility center is the degree of
controllability.
 Costs may also be classified into Direct (attributable to a particular segment) or Indirect (common to a number of
segments), the latter being subject to arbitrary allocation.

Note: All controllable costs are also direct costs, but not all direct costs are controllable.

Performance Report and Segmented Income Statement

 A Performance Report is the end product of responsibility accounting process. It is a report that shows and compares
actual results with the intended (budgets or standards) results of a responsibility center, thereby highlighting
deviations that need corrective actions.

 The “contribution format” to computing results of operations (income) is emphasized in responsibility accounting.
This income statement presentation highlights controllability of costs by behavioral classification. In addition to the
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usual variable costs and fixed costs, a more detailed classification of costs may be made. Consider the following
illustrative example:

Sales xxx

Less: Variable manufacturing costs xxx

Manufacturing contribution margin xxx

Less: Variable selling and administrative costs xxx

Contribution margin xxx

Less: Controllable fixed costs:

Manufacturing xxx

Selling and administrative xxx xxx

Short-run performance margin xxx

Less: Non-controllable fixed costs:

Depreciation xxx

Rent and leases, insurance xxx xxx

Segment margin xxx

Less: Allocated/common costs xxx

Income xxx

Transfer Pricing

 A transfer price is the price charged when one segment of a company provides goods or services to another segment
of the company. The fundamental objective in setting transfer prices is to motivate managers to act in the best
interests of the overall company.

Primary Objective

 To evaluate performance by virtually transforming cost centers into profit centers so that performance of the manager
of mainly cost centers can be measured reliably in terms of both revenues and expenses.

Secondary Objective

 To save on costs involved in producing or buying a product by in-sourcing rather than outsourcing.

Three primary approaches to setting transfer prices:

1. Negotiated transfer prices

2. Transfers at the cost to the selling division (Cost-based transfer price)
3. Transfers at market price (Market-based transfer price)

Negotiated Transfer Prices

 A negotiated transfer price results from discussions between the selling and buying divisions.

Advantages of negotiated transfer prices:

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1. They preserve the autonomy of the divisions, which is consistent with the spirit of decentralization.
2. The managers negotiating the transfer price are likely to have much better information about the potential costs
and benefits of the transfer than others in the company.

Transfers at the Cost to the Selling Division

 Many companies set transfer prices at either the variable cost or full (absorption) cost incurred by the selling division.

Drawbacks of this approach include:

1. Using full cost as a transfer price can lead to suboptimization.

2. The selling division will never show a profit on any internal transfer.
3. Cost-based transfer prices do not provide incentives to control costs.

Transfers at Market Price

 A market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the
transfer pricing problem.

1. A market price approach works best when the product or service is sold in its present form to outside customers
and the selling division has no idle capacity.
2. A market price approach does not work well when the selling division has idle capacity.

Maximum vs. Minimum Transfer Prices

 For transfer pricing not to defeat its purpose, organization normally sets a limitation as to the transfer price being
charged by one segment to the other segments. To minimize the effect of sub-optimization, a range for transfer price
must be set based on the following limits:

 UPPER LIMIT: Maximum transfer price = Cost of buying from outside suppliers or selling price to outside
customers, whichever is higher
 LOWER LIMIT: Minimum transfer price = Variable cost per unit + Lost CM per unit on outside sales

 When a company segment is operating at full capacity, the lost CM per unit on outside sales is the opportunity cost of
transferring products to another company segment, instead of selling products to outside customers.

Dual Pricing Concept

 The “selling” center could transfer to another segment at the usual market price that would be paid by an outsider. The
“buying” center, however, would record a purchase at the variable cost of production. This practice is now rarely
applied because neither manager from both the buying and selling center must exert much effort to show a profit on a
segmental performance reports.

Transfer pricing decision considerations

 Goal congruence factors

Will the transfer price promote the goals of a company as a whole?

 Segmental performance factors

Will the transfer price promote the interest of the segment under the manager’s responsibility?

 Capacity factors

Does the seller have excess capacity to accommodate further inter-segment transfer?
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 Cost structure factors

What portions of production costs are variable or fixed, direct or indirect?

Summary:

 The negotiated price is determined through agreement of division managers. Under a cost-based approach, the transfer
price may be based on variable cost alone or on variable cost plus fixed costs. Companies may add a markup to these
numbers. The cost-based approach often leads to poor performance evaluations and purchasing decisions. A market-
based transfer price is based on existing competing market prices and services. A market-based system is often
considered the best approach because it is objective and generally provides the proper economic incentives.

MANAGEMENT ADVISORY SERVICES

CAPITAL BUDGETING

CAPITAL INVESTMENT – involves significant commitment of funds to receive a satisfactory return – increase in
revenue or reduction in costs over an extended period of time. Example: purchase of equipment for expansion,
replacement of old equipment.

GENERAL CHARACTERISTICS OF CAPITAL INVESTMENT DECISIONS

• AS TO COST – usually involves large expenditure of resources, relative to business size

• AS TO COMMITMENT – usually funds invested are tied up for a long period of time
• AS TO FLEXIBILITY – usually more difficult to reverse than short-term decisions
• AS TO RISK – usually involves so much risks and uncertainties due to operational and economic changes over an
extended period of time

CAPITAL BUDGETING – is the process by which management identifies, evaluates, and makes decision on capital
investment projects of an organization. It is the process of planning expenditures for assets, the return on which are
expected to continue beyond one-year period.

CAPITAL INVESTMENT FACTORS

Net Investments (for decision-making purposes)

• Costs less savings incidental to the acquisition of the capital investment projects
• Cash outflows less cash inflows incidental to the acquisition of the capital investment projects

Costs or cash outflows

1. Purchase price of the asset, net of related cash discount

2. Incidental project-related expenses such as freight, insurance, handling, installation, test-runs, etc.

 Consider also the following, if any:

 Additional working capital needed to support the operation of the project at the desired level.
 Market value of existing idle assets to be used in the operation of the proposed capital project.
 Training cost, net of related tax

Savings or cash inflows

1. Proceeds from sale of old asset disposed, net of related tax

 Consider also the following, if any:

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 Trade-in value of old asset
 Avoidable cost of immediate repairs on the old asset to be replaced, net of related tax

Net Returns

 ACCRUAL BASIS: Accounting net income (after tax)

 CASH BASIS: Net cash inflows
 DIRECT METHOD (Cash inflows – Cash outflows)
 INDIRECT METHOD (Net income after tax + Noncash expenses)

CAPITAL BUDGETING TECHNIQUES IN EVALUATING PROJECTS

 Non-discounted methods – methods that do not consider the time value of money

a. Payback period method c. Bail-out payback method

b. Payback reciprocal method d. accounting rate of return method

 Discounted methods – methods that consider the time value of money

a. Net present value method c. Internal rate of return method

b. Profitability index method d. Present value payback method

I. NON-DISCOUNTED METHOD

= Payback Period Method =

Payback period = Net initial cost of investment / Annual net after-tax cash inflows

Advantages:

1. Payback is simple to compute and easy to understand.

2. Payback gives information about the liquidity of the project.
3. It is a good surrogate for risk. A quick or short payback period indicates a less risky project.

Disadvantages:

1. Payback does not consider the time value of money.

2. It gives more emphasis on liquidity rather than on profitability of the project.
3. It does not consider the salvage value of the project.
4. It ignores cash flows that may occur after the payback period (short-sighted)

= Payback Reciprocal =

Payback reciprocal = Net cash inflows / Investment

= 1 / Payback period

= Accounting Rate of Return Method =

Accounting rate of return (ARR) = Average annual net income / Investment *

* May be based on original or average investment.

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Advantages:

1. The ARR closely parallels accounting concepts of income measurement and investment return.
2. It facilitates re-evaluation of projects due to ready availability of data from the accounting records.

Disadvantages:

1. Like traditional payback methods, the ARR method does not consider the time value of money.
2. With the computation of income and book value based on the historical cost accounting data, the effect of
inflation is ignored.

Other terms used to denote the ARR:

 Book value rate of return  Approximate rate of return method

 Unadjusted rate of return  Financial statement rate of return method

 Simple rate of return  Average return on investment

= Bail-out Payback Period =

 It is a modified payback period method wherein cash recoveries include the estimated salvage value at the end of each
year of the project life.

II. DISCOUNTED METHODS

 The time value of money is an opportunity cost concept. A peso on hand today is worth more than a peso to be
received tomorrow because of interests a peso could earn by putting it in a savings account or placing it in an
investment that earns income. The time value of money is usually measured by using a discount rate that is implied to
be the interest foregone by receiving funds at a later time.

COSTS OF CAPITAL

 The ‘costs of capital’ used in capital budgeting is the Weighted Average Costs of Capital (WACC). These are specific
costs of using long-term funds, obtained from the different sources: borrowed (debt) and invested (equity) capital.

SOURCES COSTS
Debt Interest rate (after tax)
Preferred Stock (PS) Dividend yield
Common Stock (CS) Dividend yield plus growth rate
Retained Earnings (RE) Dividend yield plus growth rate

 The after-tax cot of debt is computed based on: yield rate (1 – tax rate)
 Dividend yield = dividend per share ÷ price per share
Costs of CS and RE = (Expected Cash DPS / MPPCS) + Dividend growth rate
Where: DPS = Dividend per share, MPPCS = Market price per common share
 The dividend growth rate is assumed to be constant over time.
 In computing cost of CS & PS, the market price should be net of flotation costs (e.g., underwriting fees).
 In computing the cost of RE, flotation costs should be ignored.
 Alternatively, the cost of equity capital may be computed based on Capital Asset Pricing Model (CAPM).

Other terms used to denote the weighted average cost of capital (WACC):
 Minimum required rate of return  Desired rate of return
 Minimum acceptable rate of return  Standard rate
 Cut-off rate  Hurdle rate
 Target rate
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Capital Asset Pricing Model

Formula: K = Rf + B (Rm – Rf)

Market premium = (Rm – Rf)

Risk premium = B (Rm – Rf)

Where: K = Cost of equity

Rf = Risk-free rate

B = Beta coefficient

Rm = Market rate

= Net Present Value Method =

Net present value = Present value of cash inflows – Present value of cash outflows

 Cash inflows include cash infused by the capital investment project on a regular basis (e.g., annul cash inflow) and
cash realizable at the end of the capital investment project. (e.g., salvage value, return of working capital
requirements)
 The net investment cost required at the inception of the project usually represents the present value of the cash
outflows.

Advantages:

1. Emphasizes cash flows

2. Recognizes the time value of money
3. Assumes discount rate as reinvestment rate

Disadvantages:

1. It requires determination of the costs of the discount rate to be used.

2. The net present values of the different competing projects may not be comparable because of differences in
magnitudes or sizes of the projects.

= Profitability Index Method =

Profitability index = Present value of cash inflows / Present value of cash outflows

NPV index = NPV / Investment

 The profitability index method is designed to provide a common basis of ranking alternatives that require different
amounts of investment.

Note: Profitability index method is also known as desirability index, present value index and benefit-cost ratio.

= Internal Rate of Return Method =

 IRR is the rate of return that equates the present value of cash inflows to present value of cash outflows. It is also
known as discounted cash flow rate of return, time-adjusted rate of return or sophisticated rate of return.
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Guidelines in determining IRR:

1. Determine the present value factor (PVF) for the internal rate of return (IRR) with the use of the following
formula:
 PVF for IRR = Net investment cost / Net cash inflows
2. Using the present value annuity table, find on line ‘n’ (economic life) the PVF obtained in No. 1. The
corresponding rate is the IRR. If the exact rate is not found on the PVF table, ‘interpolation’ process may be
necessary.

Advantages:

1. Emphasizes cash flows

2. Recognizes the time value of money
3. Computes the true return of project

Disadvantages:

1. Assumes that IRR is the re-investment rate.

2. When project includes negative earnings during its life, different rates of return may result.