Cost Concepts, Terms and Measurement

Management Accounting - provide useful and relevant information to the manager

MS to help them to their decision making
Financial Accounting

Characteristics of MA Financial Accounting

Users Management(Manager) External Users
CEO below
Guidance No accounting standard PFRS
Use of Data Relates to Future Past Transaction
Issuance of Report as needed Quarterly/Annually
Type of Data Quantitative Data (Objective) Non/Quantitative Data (Subjective)

Classification by Type:
Direct Material Prime Cost Income &
1)Manufacturing Cost (PRODUCT) Direct Labor Balance
*Incurred as manufacturing the product Factory Overhead Conversion Cost Statement

2)Operating Expense (PERIOD) Selling Epenses Income Statement

*Related to Office Admin Expenses

Formula:
DM used
Direct Labor
Factory Overhead
Total Manufacturing Cost
W/P beg
(W/P end)
Cost of Goods Manufactured
FG beg
(FG end)
Cost of Goods Sale Income Statement

Classification by Traceability:
Direct Direct Materaial and Direct Labor

Indirect Factory Overhead

Classification by Behavior: Total Cost

Variable Cost Fixed Cost VC
Direct Material ✔
Direct Labor ✔ FC
Factory Overhead ✔ ✔
S&A Expenses ✔ ✔
TC = VC + FC
 Total Per Unit
Variable: Cost
Direct Constant

Unit

Fixed:
Constant Inversely

Segregation of Mixed Cost

1. High-Low Method - based to the COST DRIVER not cost
2. Scattergraph
3. Least Square/ Regression Analysis
y = a + bx
∑y = na + b∑x
∑xy = a∑x + b∑x²

Cost Function (Linear Equation)

y = a + bx y = TC a = FC b = VC x = unit sold

Goodness of Fit - accuracy or reliability

1. Coefficient of Correlation - measure the degree of relationship between 2 variable
-1 perfect inversely relationship
0 no relationship at all
1 perfect directly relationship

2. Coefficient of Determination - amount of variation in the dependent variable explained by

the independent variable
- The closer to 1 much better
- Between 0 to 1 only

Cost - Volume - Profit Analysis

Contribution Margin Income Statement

Formula:
Sales Mfg cost (DM,DL,Variable OH)
(Variable Cost) Variable S&A
Contribution Margin Factory Overhead
(Fixed Cost) Fixed S&A
Profit/ Operating/Net Income
Sales Mix
1. Break Even Analysis Fixed Cost Composite Break Even Point
Units =
Sales = TC (VC + FC) CM/unit Weighted Average CM
CM = FC
Profit = 0 Fixed Cost CM
Pesos =
CMR Sales
 before tax
2. Target Profit Fixed Cost + Target Profit
Units =
Sales = TC (VC + FC) CM/unit
CM = FC
Profit = 0 Fixed Cost + Target Profit
Pesos =
Contribution Margin Ratio

3. Margin of Safety
amount by which actual sales may be reduced WITHOUT incurring a loss

MS in Pesos = Sales - BEP in Pesos *Sales may be Actual or Planned

MS in Units = Sales - BEP per unit
MS in Ratio = MS/ Sales

4.Degree of Operating Leverage (DOL)

measures the percentage change in profit as a result a change ( ) in sales

Formula:
Contribution Margin
DOL =
Profit

5. Sensitivity Analysis
Selling Price, Variable Cost and Fixed Cost ---> Profits

Absorption Vs. Variable Costing

Income Statement Absorption Costing Variable Costing
Sales DM DM
(COGS) --Product DL VOH (COGS) DL
Gross Profit OH FOH VOH
(OPEX) -- Period S&A V (OPEX) S&A V
Profit F FOH F

AC ------> product ------> inventory ------> COGS

FOH (B/S) (I/S)
VC -------> period ----------------------------> OPEX
(IS)

Summary: Absorption Costing Variable Costing

Profit = Sales
10,000 ↓ 10,000 COGS ↓ 10,000 OPEX

10,000 Profit > Sales ↑ 2,000 Ending inv

8,000 ↓ 80,000 COGS ↓ 10,000 OPEX

Profit < Sales

14,000 ↓ 14,000 COGS ↓ 10,000 OPEX
↑ 4,000 (last year)
Reconciliation:
Variable Cost Net Income
in inventory X FOH/unit
Absoption Cost Net Income

Standard Costing & Variance Analysis

*Ideal, benchmark, measure of performance
*Should be cost, best estimate of the management
*Measures of quality, achievement that is considered desirable or acceptable

Uses:
1 Evaluate Performance
2 Simplify Costing

Direct Material
AP X AQ MPV Material Price Variance (purchase)
SP X AQ
SP X SQ MQV Material Quantity Variance (production)

Direct Labor Note:

AR X AH LRV Labor Rate Variance If higher the 1st row the result is
SR X AH UNFAVORABLE
SR X SH LEV Labor Efficiency Variance Budget - Internal
Standard - External
Overhead
V Spending Var F Spending Var 3 way 2 way 1 way
Actual AVR X AH + AFR X AH
BAAH SVR X AH + BFC Spending Controllable Total
BASH SVR X SH + BFC Efficiency
Standard SVR X SH + SRC X SH Volume Uncontrollable

Budgeting
-Is a plan expressed in quantitative terms on how to acquire & use the resources of the
entity during a certain future period of time.

Objective: Goals
Targets *Budget Committee - preparation
Performance Review

Types: Short Term - 1 year (Master Budget)

Long Term - more than 1 year (Capital Budget)

Operating Sales, DM, DL,

------> budgeted I/S
Master Budget OH,COGS, S&A
F/S
 Financial Beg Balance
Receipts ---> budgeted
(Disbursements) SCF,B/S
(Min Cash Balance)
+ - bank loan
Excess financing
EB EB shares

Incremental Analysis/ Relevant Costing

Choosing the BEST OPTION among alternatives

Types:
1. Make or buy
2. Accept or reject special order
With Excess Capacity GR

Without Excess Capacity GR + OC (Opportunity Cost)

3. Retain or replace equipment

4. Retain or eliminate unprofitable segment/product
Sales
(VC)
(FC) avoidable + Retain
Segment Margin - Eliminate

5. Sell immediately or process further

Rule:
Split Point Process further if: IR > IC
↑ SP FPC
Joint Cost PFC

6. Which product to produce given scarse resources

Ranking limited
Basis: CM/scarce resoures

Relevant Cost related to FUTURE General Rule:

All Variable cost are relevant
Incremental/differential All Fixed Cost are irrelevant except if
- differ among alternatives avoidable
 Responsibility Accounting
Objective:
Proper evaluation of responsibility centers (divisions, department, branches, segments)

Types of Responsibility Centers

1. Cost Center Variance Analysis (Actual vs. Standard)
Responsible for Cost & Expenses (Minimize the Cost)
2. Revenue Center Variance Analysis (Actual vs. Target)
Responsible for Generating Sales (maximize Revenue)
3. Profit Center Sales
Responsible for Both Cost & Revenue - Variable Cost
- Fixed Cost (controllable)
Profit Margin (Controllable)
4. Investment Center
Responsible for Both Cost, Revenue & Investment;
Independent, Stand alone business
Performance Measure
Return of Investment
Operating Income Income Before Interest and Tax
ROI =
Ave. operating asset Beg Balance + Ending Balance/2
Invested Asset/ Capital @ Book Value

Residual Income
RI = OI - (Ave. operating asset X Min Rate of Return)
Required Return/ Acceptable

Economic Value Added (EVA)

EVA = OI after Tax - (Ave. operating asset X WACC)
@ Market Value
Total Assets - Current Liability
(Long Term Capital: NAL and Equity)

Service Allocation Method

1. Direct Method
2. Step Method
3. Reciprocal/Algebraic Method

Balanced Scorecard - financial and non-financial

more holistic; future performance
1. Financial - ROI
2. Customer - pricing, quality, customer service
3. Internal Process - production, delivery
4. Learning and Growth - development of employess, training, compensated
 Transfer Pricing
Price charged by one division to another
Objective: Set Transfer Price to achieve goal congruence

Maximum TP Market Price

Rule With Excess Capacity VC
Minimum TP
Without Excess Capacity VC + CM
Equals to Selling Price
Other types of Transfer Price:
1. Cost Plus - cost + 20% or any percentage
2. Variable Cost
3. Full Production Cost - (DM,DL,OH) Manufacturing Cost
4. Negotiated Price

Capital Budgeting
Long term invetment decision
Top management and BOD will decide if accept or reject

Payback Period
Non- discounting
Techniques Accounting Rate of Return

Net Present Value

Discounting Profitability Index
(Time Value of Money) Internal Rate of Return

Non- Discounting
1. Payback Period
Time it takes tao recover the initial investment (years) Initial Investment
Advantage: Easy to compute and Understand Annual Cash Flow
Disadvantage: Ignores TVM and beyond the PP

2. Accounting Rate of Return

Measures the profitability based on Income

Annual Income w/ Salvage Value ------ Average Initial Inv + SV

Investment 2
w/o Salvage Value ------- Simple

Remember:
1. To convert Net Income to Cash Flow
Net Income + Depreciation expense @ 100% = Cash Flow
2. Tax Shield/Savings (Increase Deduction; Decrease Taxable Income & Tax
Depreciation Expense X 30% = Tax Shield
Discounting
1. Net Present Value
Present Value Cash Inflow
- Present Value Cash Outflow (initial investment)
Net Present Value Time Value of Money
Ordinary Annuity
2. Profitability Index Sample Rate: 10% 1.1
used in mutually exclusive projects In my Calculation: ÷ Twice
PVCI =
PI =
PVCO M+ Years
MRC
3. Internal Rate of Return (trial & error) Annuity Due 1.1
interest rate that makes ÷
PVCI = PVCO (NPV=0) M+
IRR > Cost of Capital ---- Accept MRC
IRR < Cost of Capital ---- Reject

Cost of Capital
Discount Rate, Required Rate, Minimum Rate of Return, Hurdle Rate

Sources: Cost Formula

1. Creditors Interest Int Rate X (1-tax rate)
(bank loan) (cost of debt) Fixed Rate
P/S D
2. Shareholders Dividends P
(issue shares) (cost of equity) O/S

Ordinary Share
1. Dividend Discount Model (Gordon Growth Model)
Retained Earnings Ordinary Share
D1 D1
+g +g
Po Po
gross of flotation cost net of flotation cost
- stock issuance cost
2. Capital Asste Pricing Model (CAPM)
R = RF + B (MR - RF)
Market risk Premium

WACC ----> Capital Structure

Financial Statement Analysis

Tools:
1. Horizontal (Trend Analysis)
evaluate FS items over a period of time (change in percentage)
Formula: Y2
-1
Y1
 B/S
2. Vertical (Common Size) Analysis Total Asset
evaluate items within the FS as a percent of a base amount
comparing 2 companies - intercompany I/S
Sales
3. Ratio Analysis
evaluate relationships among FS items

Characteristics:
a) Liquidity - ability to pay Short Term obligations (suppliers)
b) Solvency - ability to pay Long Term obligations (bank)
c) Profitability - performance

Pattern:
1) Return ------------ Net Income (Numerator)
2) Turnover ------------ Sales (Numerator) *not always
3) Margin ------------ Sales (Denominator)
 Working Capital Management
Resources of the business used in everyday operations Achieve Balance between:
WC = CA - CL Risk and Return(Income)
CASH
Meet Cash Requirements
- Maintain optimal level of cash
Avoid Idle Cash
Baumol Model
2 X D X TC D = Annual CC = Carrying Cost
OCB =
CC TC = Transaction Cost
Positive + Bank > Book Maximized
- Manage Float Delay (Outstanding Check)
Negative - Bank < Book Minimized
(Deposit in Transit)
Mail Float - mailed by customer but not yet received by the seller
Processing Float - received by the seller but not yet deposited
Clearing Float - deposited but have not cleared yet
- Cash Budget
Beg Balance
Receipts
(Disbursements)
(Min Cash Balance)
+ - bank loan
Excess financing
EB EB shares
INVENTORY
Meet Customer Demands 1. How many units to order? EOQ
- Maintain optimal
Economic Order Quantity
level of inty
Minimize Cost 2. When to Order? ROP
Reorder Point
w/o Safety Stock - Normal Lead Time
EOQ = 2 X D X TC ROP
CC w/ Safety Stock - Normal Lead time + SS
ACCOUNTS RECEIVABLE
credit policy Conservative (2/10;n/30) Decrease Credit Sales; A/R; Bad
credit terms (n/30) Debts
cash discount (2/10) Aggressive (5/10;n/50) Increase Credit Sales; A/R; Bad
relaxed Debts
to accelerate collection
ACCOUNTS PAYABLE
Increase positive float
Delay payment to supplier
Discount 360
X
Cost of Giving Up Cash Discount = 100 - Discount n
(credit period - discount period)
SHORT TERM LOANS
Financing Charges (interest)
Effective Interest Rate =
Net Proceeds (usable amount)
annual
 Quantitative Techniques
Application of mathematics in solving business problems

Techniques:
1. Linear Programming - optimization model
optimal/ best solution
Maximize Income
Objective: Constraints(limited/scarce resources)
Minimize Costs

2. Decision Tree Analysis - calculate the expected monetary value (EMV)

of each outcome based on the decisions

ACA --- Probabilities --- EMV --- Decision

3. Program Evaluation and Review Techniques (PERT) - Critical Path Method (CPM)
is developed to aid managers in controlling large scale (complex)
Terminologies:
Pert Diagram - probabilistic diagram; free form network
Events - discrete moment; representing start or finish of an activity
Activities - tasks to be accomplished
Series - cannot be done unless another activity is undertaken first
Parallel - can be performed simultaneously with another activity
Critical Path - longest path; minimum time to complete the project
Slack Time - time that can be added to an activity without increasing the total time (delay)
Crash Time - time to complete an activity under rush or urgent condition

4. Learning Curve - efficiency arising from learning an efficiency

-reduced time; complete a task of each doubling of cumulative production

5. Forecasting - use of mathematics to predict future behavior

Time Series:
Trend - Increase - Decrease Cyclical - Christmas
Seasonal - Summer or Winter Irregular - random days

Economics
Demand (buyer)
Microeconomics
Branches individual, business Supply (seller)
Macroeconomics
entire company

LAW OF DEMAND:Increase in Price; Decrease in Demand

Price Movement along the demand curve
Inversely
Shift In Demand - other factors
Demand
Downward slopes
1. Substitution Effect
If price Increase, the buyer buy substitute product

If price of Complementary (related) Increase, Demand will Decrease

2. Income Effect
As Income Increase, Demand for Normal Goods Increase (Starbucks)

As Income Increase, Demand for Inferiror Goods Decrease (3in1 Coffee)