Considerations when interpreting ratios
Trends over time (big/small/up/down/good bad)
Comparison to industry averages or competitor ratios or predetermined targets
Remember both the numerator and denominator affect the ratio
When interpreting ratios, we hope for...
INcreasing rates of profit on shareholders equity, capital employed and sales
Adequate liquidity ( assets to liabilities of not less than 100%) to ensure debts can be paid
Satisfactory return on the investment made by shareholders VS the risk and other opportunities
A level of debt commensurate with the business risk taken (depends on industry)
When are control systems used?
Generally in strategic planning.
They are considered part of the broader process of the strategic planning process
Involves measuring financial and non financial performances
What are the elements of a control system?
- A detector or sensor that measures what is happening
- An assessor that determines the significance of what is happening by comparing it with a standard or expectation
An effector (feedback) that alters behaviour if the assessor indicates the need to do so
A communication network that transmits information between the other elements (to report out)
What are Balanced scorecards?
- Looks at four perspectives:
- 1. Financial perspective
- 2. Customer perspective
- 3. Internal Processes
- 4. Learning and Growth
What are period costs?
Period costs relate to the accounting period (year, month) in which it was incurred (operating expenses)
What are product costs?
Product costs relate to the cost of goods sold or services produced
what is another term for period costs?
What happens to this years profits if a cost ends up in inventory and that inventory isn't sold this year?
Inventory is on balance sheet; so it reduces profits because it is part of the inventory... not in this years expenses
What are the two types of production costs?
What are direct costs?
Traceable to product/services - direct materials or labour, other direct costs
What are indirect costs?
- necessary to make the product/service, but not readily traceable to particular product/services... indirect materials, indirect labour
What is prime cost?
Refers to the total of all direct costs ... includes the total of direct materials and direct labour
What is manufacturing over head?
All production costs other than direct costs (the total of all indirect material, indirect labour, and all other indirect costs)
What are conversion costs?
The production costs, other than direct materials, used to make a product or provide a service. This includes labour and manufacturing overhead
Cost do convert direct material is also known as...
What is absorption costing?
says that all manufacturing overhead should be allocated to the units produced (GAAP requirement).
Fixed overhead rate = estimated fixed overhead expenditure for the period/estimated activity for the period
Traditional costing is a type of
What are examples of overhead costs?
ANYTHING that is not direct labour or material.
- Plant manager
- Rent/property tax/interest expense
What is divisional based overhead rate?
An overhead rate calculated using the total overhead costs for the company, divided by the total of the allocation base for the overhead
Activity based costing steps
- 1. accumulate the indirect costs of significant business activities into separate cost pools
- 2. Identify what activity (driver) causes cost pool to change
- 3. calculate overhead cost per driver for that pool
- 4. identify how much of that driver the product consumes
- 5. assign the costs from the cost pools to products based on cost drivers consumed
accumulate the indirect costs of business process.
What is a driver for purchasing?
number of purchase orders
What is a driver for equipment maintenance?
number of machine hours
what is a driver for scheduling?
number of production orders
Purchasing, material handling, scheduling, equipment maintenance are all examples of....
overhead costs; cost pools
In order to identify a cost driver... categorize costs as follows
- unit level
- batch related
- product sustaining (distribution system)
- Customer sustaining system (return of system/warranty)
- facility sustaining activities (for the entire plant)
What happens when over/underallocation of overhead occurs?
The overhead rate is normally established prior to the production year.
At the end of the year when actual cost and actual activity volumes are known, there is going to be a difference between actual and budgeted overhead
Adjusting records of a company... using two approaches
- 1. Assign allocation or underallocation to COGS
- 2. prorate overallocation or underallocation to COGS, work in progress inventory, and finished goods inventory. We can do this because all three of these items have overhead in them already.
Why is estimated vs actual overhead important?
If it's we've overestimated, we could have issues with pricing (too high).
If underestimated, might not be able to recoup costs.
Marketing and accounting helps us answer...
What is the volume of products/services that we need to sell to maintain profitability?
nWhat sales mix will optimize our profitability?
nWhat alternative approaches to pricing can we adopt?
nShould we keep or drop product lines that are underperforming?
do not change with increases in business activity
increase/decreases in proportion to an increase or decrease in business activity
Step costs (fixed cost with smaller relevant range)...
Constant within a particular level of activity, but can increase when activity reaches a critical level
have both fixed and variable components...
i.e. cellphone cost (fixed monthly charge plus per minute rate)
total of both fixed and variable costs divided by the total number of units produced
This is dangerous to use in management accounting because fixed costs remain the same... average cost is not that useful... it's useful at a conceptual level
Dangerous to use for short run or special order decisions because it may lead you to believe that the fixed costs will change the unit level - they don't!!
cost of producing one extra unit.... there are no fixed cost component to marginal cost. IF I produce one more unit, fixed costs still stay the same.
Marginal cost = variable costs only
change based on the activity level (number of units sold)
Cost volume profit analysis...
- 1. looks at changes in activity and changes in selling prices and costs
- 2. only over a relevant range in the short term
- 3. sensitivity analysis is an approach to understanding how changes in one variable (such as price) affect other variables
Operating profit =
revenue - (fixed costs+variable costs)
(units sold x selling price) - [fixed costs+(units sold unit variable costs)]
contribution margin =
selling price - variable costs
it's contribution towards fixed costs and profit.
When costs are covered it's called...
the break even point
If you have't paid for your fixed costs you are still losing money. It's not until you've covered all your costs that you are making profit.
contribution margin percentage/ratio
is the contribution margin divided by the revenues
CM% = CM/SP
if selling price is 10, and variable costs are 8, what is the contribution margin? and the ratio?
2/10 = 20%
What is the break even point and equation?
the point at which the total costs equal revenue (there is neither a profit or revenue)
= Fixed costs/contribution margin
Why is relavent range important?
Because fixed costs don't' change within it; but could move outside of it
Margin of safety
a measure of the difference between expected sales and breakeven sales
=(expected sales-breakevensales)/expected sales TIMES 100
refers to a mix of variable and fixed costs
what are some cost profit assumptions?
- costs can be split between fixed and variable
- the behaviour of costs is linear
- Changes in costs occur only because of the changes in the number of units sold or the level of service provided
- a single product/service or product/service mix remains constant
- only applies to relavent range
- short-term focus and cannot be used as a long term planning tool
What are some approaches to pricing?
- cost plus pricing
- target or rate of return pricing
- market pricing (whats the competition doing?)
shift work; i.e. server, etc
Cost of goods sold
- Opening inventory
- plus purchases
- INv available for saleless closing inventory
Used, damaged, stolen, shrinkage...spoilage
3 inventory types
- raw materials
- work in process
- finished goods
schedule of COG manufactured ("working schedule")
- Raw material (inventory first)
- Direct labour
- Manufacturing overhead (rent, depereciation, light and power)
- WIP at beginning of period, less WIP at end of period
- COG manufactured
valuation of inventory
accounting principle, current assets are normally reported at the lower of their original cost or their net realizable value (aka market value)
individually purchased inventory (called "specific identification)
Similar/undifferentiated products (bulk) - weighted average cost, FIFO, LIFO (not allowed in canada)
weighted average cost
average out the cost of all goods purchased and sold; as both can fluctuate
Anything that is sold during the year is sold from the inventory that we already have