1.

Management accounting and the business

environment

Differences Between Financial and Management Accounting

Financial Accounting
1. Users 2. Time focus 3. Verifiability versus relevance 4. Precision versus timeliness 5. Subject 6. Requirements External persons who make financial decisions Historical perspective Emphasis on verifiability Emphasis on precision Primary focus is on the whole organisation Must follow prescribed formats (e.g.IASB)

Management Accounting
Managers who plan for and control an organisation Future emphasis Emphasis on relevance for planning and control Emphasis on timeliness Focuses on segments of an organisation Need not follow IASB or any prescribed format

Planning and Control Cycle

Formulating Long and Short-Term Plans (Planning)

Begin

Comparing Actual to Planned Performance (Controlling)

Decision Making

Implementing the Plans (Directing and Motivating)

Measuring Performance (Controlling)

Expanding Role of Management Accounting

Increasing complexity and size of organizations Regulatory environment Factors that increase the need for management accounting information World-wide competition Rapid development and implementation of technology Increased emphasis on quality

The Changing Business Environment

New tools for managers!

Just-In-Time Total Quality Management Process Reengineering Theory of Constraints

2. An Introduction to Cost Terms, Concepts and Classifications

Classifications of Costs
Manufacturing costs are often combined as follows:
Direct Materials Direct Labour Manufacturing Overhead

Prime Cost

Conversion Cost

Product Costs Versus Period Costs

Product costs include direct materials, direct labor, and manufacturing overhead.
stock
Cost of Good Sold

Period costs are not included in product costs. They are expensed on the profit statement.
Expense

Sale

Balance Sheet

Profit Statement

Profit Statement

Balance Sheet
Manufacturer
Current Assets
Cash Debtors Prepaid Expenses Stock

Raw Materials Work in Progress Finished Goods

Manufacturing Cost Flows

Costs Balance Sheet stocks Profit Statement Expenses

Material Purchases Direct labour Manufacturing Overhead

Raw Materials Work in Progress Cost of Goods Sold Selling and Administrative

Finished Goods
Period Costs

Selling and Administrative

Product Costs - A Closer Look

Raw Materials
Beginning raw materials inventory + Raw materials purchased = Raw materials available for use in production Ending raw materials inventory = Raw materials used in production

Manufacturing Costs

Work In Progress

Finished Goods
Beginning finished goods inventory + Cost of finished goods mfg. = Finished goods available for sale - Ending finished goods inventory = Cost of finished goods sold

Direct materials Beginning work in + Direct labour process stock + Mfg. overhead + Total manufacturing = Total manufacturing costs costs = Total work in process for the period Ending work in process stock = Cost of goods manufactured.

Cost Classifications for Predicting Cost Behavior

Behaviour of Cost (within the relevant range)
Cost Variable In Total Total variable cost changes as activity level changes. Total fixed cost remains the same even when the activity level changes. Per Unit Variable cost per unit remains the same over wide ranges of activity. Fixed cost per unit goes down as activity level goes up.

Fixed

Cost classifications for decision making

Differential cost and revenue - Costs and revenues that differ among alternatives. Opportunity cost - The potential benefit that is given up when one alternative is selected over another. Sunk cost - Sunk costs cannot be changed by any decision. They are not differential costs and should be ignored when making decisions.

3. Cost Behavior: Analysis and Use

The Linearity Assumption and the Relevant Range

Economists Curvilinear Cost Function A straight line closely approximates a curvilinear variable cost line within the relevant range.

Relevant Range Total Cost

Accountants Straight-Line Approximation (constant unit variable cost)

Activity

Types of Fixed Costs

Fixed Costs
Committed
Long-term, cannot be reduced in the short term.

Discretionary
May be altered in the shortterm by current managerial decisions

Examples
Depreciation on Buildings and Equipment, Taxes on Real Estate, Salaries of Top Management

Examples
Advertising, R&D, Public Relations, Student Internships

Mixed Costs
Y Total Utility Cost

Variable bX Utility Charge

Fixed Monthly a X Activity (Kilowatt Hours) Utility Charge

The Analysis of Mixed Costs

Account Analysis Engineering Approach High-Low Method Scattergraph Method Least-Square Regression Method

 Account Analysis - Each account is classified as either variable or fixed based on the analysts knowledge of how the account behaves. Engineering Estimates - Cost estimates are based on an evaluation of production methods, and material, labour and overhead requirements.

The High-Low Method

High activity level Low activity level Change Units 9,000 5,000 4,000 Cost 9,700 6,100 3,600

Unit variable cost = 3,600 4,000 units = 0.90 per unit Fixed cost = Total cost Total variable cost Fixed cost = 9,700 (0.90 per unit 9,000 units) Fixed cost = 9,700 8,100 = 1,600 Total cost = Fixed cost + Variable cost (Y = a + bX) Y = 1,600 + 0.90X

Least-Squares Regression Method

Accountants and managers may use computer software to fit a regression line through the data points. The cost analysis objective is the same: Y = a + bx
Least-squares regression also provides a statistic, called the adjusted R , that is a measure of the goodness of fit of the regression line to the data points.

The Contribution Format

Used primarily for external reporting.

Used primarily by management.

4. Systems design: job-order costing

Job-Order Costing
Manufacturing overhead (OH) Applied to each job using a predetermined rate

Direct material

THE JOB
Direct labour

Job-Order Cost Accounting

materials requisition form

time tickets

Application of Manufacturing Overhead

Based on estimates, and determined before the period begins.
Overhead applied = POHR Actual activity

Actual amount of the cost driver such as units produced, direct labour hours, or machine hours. Incurred during the period.

Job-Order System Cost Flows

Salaries and Wages Payable
Direct labour Indirect labour

Work in Progress (Job Cost Sheet)

Direct Materials Direct labour Overhead Applied

Mfg. Overhead
Actual Indirect Materials Indirect labour Applied Overhead Applied to Work in Process

If actual and applied manufacturing overhead are not equal, a year-end adjustment is required.

Job-Order System Cost Flows

Work in Progress (Job Cost Sheet)
Direct Materials Direct labour Overhead Applied Cost of Goods Mfd.

Finished Goods
Cost of Goods Mfd. Cost of Goods Sold

Cost of Goods Sold

Cost of Goods Sold

Overapplied and Underapplied Manufacturing Overhead - Summary

PearCos Method
Alternative 1 Close to Cost of Goods Sold INCREASE Cost of Goods Sold Alternative 2 Allocation INCREASE Work in Progress Finished Goods Cost of Goods Sold DECREASE Work in Progress Finished Goods Cost of Goods Sold

If Manufacturing Overhead is . . . UNDERAPPLIED (Applied OH is less than actual OH) OVERAPPLIED (Applied OH is greater than actual OH)

DECREASE Cost of Goods Sold

Cost Flows Labour

The cost of direct labour incurred increases Work in Progress and the cost of indirect labour increases Manufacturing Overhead.

Cost Flows Actual Overhead

In addition to indirect materials and indirect labour, other manufacturing overhead costs are charged to the Manufacturing Overhead account as they are incurred.

Cost Flows Overhead Applied

Work in Progress is increased when Manufacturing Overhead is applied to jobs.

Cost Flows Period Expenses

Non-manufacturing costs (period expenses) are charged to expense as they are incurred.

Cost Flows Sales

When finished goods are sold, two entries are required: (1) to record the sale; and (2) to record Cost of Goods Sold and reduce Finished Goods.

5. Systems design: process costing

Differences Between Job-Order and Process Costing

Job order costing
Many jobs are worked during the period. Costs are accumulated by individual jobs. Job cost sheet is the key document. Unit cost computed by job.

Process costing
A single product is produced for a long period of time. Costs are accumulated by departments. Department production report is key document. Unit costs are computed by department.

Cost flows in a process cost system

Wages Payable Work in Progress Department A

Direct labour Indirect labour

Manufacturing Overhead
Actual Applied

Direct Materials Direct labour

Work in Progress Department B

Other Overhead Indirect Materials Indirect labour

Direct Materials Direct labour

Cost flows in a process cost system

Work in Progress Department B Finished Goods Cost of Goods Sold

Direct Cost of Cost of Materials Goods Goods Direct Manufactured Manufactured labour Applied Overhead Transferred Cost of Goods Sold from Dept. A Cost of Goods Sold

Equivalent Units of Production

Equivalent units are partially complete and are part of work in progress stock. Partially completed products are expressed in terms of a smaller number of fully completed units.

Equivalent Units of Production Weighted Average Method

The weighted average method . . .

Makes no distinction between work done in prior and current period. Blends together units and costs from prior period and current period.
Equivalent units of production always equals: Units completed and transferred + Equivalent units remaining in work in progress

Weighted Average Example

Conversion
Beginning Work in Progress 300 Units 20% Complete
6,000 Units Started

5,100 Units Started and Completed

Ending Work in Progress 900 Units 30% Complete

5,400 Units Completed 270 Equivalent Units 5,670 Equivalent units of production 900 30%

Production Report
Shows the flow of units and costs through work in progress Provides cost information for financial statements

Production Report
Becomes the job cost sheet in process costing Helps managers control their departments

Production Report
Production Report
A quantity schedule showing the flow of units and the computation of equivalent units. A computation of cost per equivalent unit. A reconciliation of cost flows for the period, including: Total cost for units completed and transferred from the processing department.

Section 1 Section 2 Section 3

Total cost for partially completed units remaining in work in progress.

Production Report Example

Section 2: Compute cost per equivalent unit
Total Cost Cost to be accounted for: Work in progress, May 1 Costs added in the Shipping and Milling Department Total cost Equivalent units 4,000 144,000 148,000

Materials 3,000 74,000 77,000 4,960

Conversion 1,000 70,000 71,000 4,900 14.490

Cost per equivalent unit 15.524 Total cost per equivalent unit = 15.524 + 14.490 = 30.014

71,000 4,900 units = 14.490 (rounded)

6. Profit reporting under variable costing and absorption costing

Overview of Absorption and Variable Costing

Absorption Costing Direct materials Direct labour Variable mfg. overhead Fixed mfg. overhead Period costs Period costs Selling & admin. exp. Variable Costing

Product costs

Product costs

Selling and administrative expenses are always treated as period expenses and deducted from revenue.

Profit Comparison of Absorption and Variable Costing

Lets compare the methods.

Impact of JIT stock Methods

In a JIT stock system . . .

Production tends to equal sales . . .

So, the difference between variable and absorption profit tends to disappear.

7. Profit planning and the role of budgeting

Planning and Control

Planning -involves developing objectives and preparing various budgets to achieve these objectives. Control - involves the steps taken by management that attempt to ensure the objectives are attained.

The Master Budget

Sales Budget

Ending stock Budget Direct Materials Budget

Production Budget Direct labour Budget

Selling and Administrative Budget Manufacturing Overhead Budget

Cash Budget

Budgeted Financial Statements

Participative Budget System

Top Management

Middle Management

Middle Management

Supervisor

Supervisor

Supervisor

Supervisor

Flow of Budget Data

The Production Budget

April 20,000 10,000 30,000 4,000 26,000 May 50,000 6,000 56,000 10,000 46,000 June 30,000 5,000 35,000 6,000 29,000 Quarter 100,000 5,000 105,000 4,000 101,000

Budgeted sales Add desired ending stock Total needed Less beginning stock Required production

Expected Cash Collections

Accounts rec. - 3/31 April sales 70% x 200,000 140,000 25% x 200,000 May sales 70% x 500,000 25% x 500,000 June sales 70% x 300,000 Total cash collections 170,000 April 30,000 May June Quarter 30,000 140,000 50,000 350,000 125,000 210,000 905,000

50,000 350,000 125,000 210,000 335,000

400,000

The Direct Materials Budget

Production Materials per unit Production needs Add desired ending stock Total needed Less beginning stock Materials to be purchased April 26,000 5 130,000 23,000 153,000 13,000 140,000 May 46,000 5 230,000 14,500 244,500 23,000 221,500 June 29,000 5 145,000 11,500 156,500 14,500 142,000 Quarter 101,000 5 505,000 11,500 516,500 13,000 503,500

Expected Cash Disbursement for Materials

Accounts pay. 3/31 April purchases 50% x 56,000 50% x 56,000 May purchases April 12,000 28,000 28,000 May June Quarter 12,000 28,000 28,000

June purchases Total cash disbursements

40,000

140,000kgs .40/kg = 56,000

The Direct Labour Budget

April 26,000 0.05 1,300 May 46,000 0.05 2,300 1,500 2,300 10 23,000 June 29,000 0.05 1,450 1,500 1,500 10 15,000 Quarter 101,000 0.05 5,050

Production Direct labour hours Labour hours required

Guaranteed labour hours 1,500 Labour hours paid 1,500 Wage rate 10 Total direct labour cost 15,000

5,300 10 53,000

Manufacturing Overhead Budget

April Production in units 26,000 Variable mfg. OH rate 1 Variable mfg. OH costs 26,000 Fixed mfg. OH costs 50,000 Total mfg. OH costs 76,000 Less noncash costs 20,000 Cash disbursements for manufacturing OH 56,000 May 46,000 1 46,000 50,000 96,000 20,000 June 29,000 1 29,000 50,000 79,000 20,000 Quarter 101,000 1 101,000 150,000 251,000 60,000

76,000

59,000

191,000

Depreciation is a noncash charge.

Ending Finished Goods Stock Budget

Production costs per unit Quantity Cost Direct materials 5.00 kgs. 0.40 Direct labour 0.05 hrs. 10.00 Manufacturing overhead 0.05 hrs. 49.70 Budgeted finished goods stock Ending stock in units Unit product cost Ending finished goods stock
Total mfg. OH for quarter 251,000 Total labour hours required 5,050 hrs.

Total 2.00 0.50 2.49 4.99

4.99

= 49.70 per hr.*

*rounded

The Cash Budget

Beginning cash balance Add cash collections Total cash available Less disbursements Materials 40,000 Direct labour 15,000 Mfg. overhead 56,000 Selling and admin. 70,000 Equipment purchase Dividends 49,000 Total disbursements 230,000 Excess (deficiency) of cash available over disbursements - 20,000 April 40,000 170,000 210,000 May 30,000 400,000 430,000 72,300 23,000 76,000 85,000 143,700 400,000 June 30,000 335,000 365,000 72,700 15,000 59,000 75,000 48,300 270,000 Quarter 40,000 905,000 945,000 185,000 53,000 191,000 230,000 192,000 49,000 900,000

30,000

95,000

45,000

Financing and Repayment

April Excess (deficiency) of Cash available over disbursements - 20,000 Financing: Borrowing 50,000 Repayments Interest Total financing 50,000 Ending cash balance 30,000
50,000 16% 3/12 = 2,000 Borrowings on April 1 and repayment of June 30.

May

June

Quarter

30,000 30,000

95,000 (50,000) (2,000) (52,000) 43,000

45,000 50,000 (50,000) (2,000) (2,000) 43,000

The Budgeted profit Statement

Royal Company Budgeted Income Statement For the Three Months Ended June 30 Sales (100,000 units @ 10) Cost of goods sold (100,000 @ 4.99) Gross margin Selling and administrative expenses Operating profit Interest expense Net profit 1,000,000 499,000 501,000 260,000 241,000 2,000 239,000

Royal Company Budgeted Balance Sheet June 30 Current assets Cash Debtors Raw materials stock Finished goods stock Total current assets Property and equipment Land Building Equipment Total property and equipment Total assets Creditors Common stock Retained earnings Total liabilities and equities 43,000 75,000 4,600 24,950 147,550

25%of June sales of 300,000

11,500 kgs. at 0.40/kg. 5,000 units at 4.99 each

50,000 175,000 192,000 417,000 564,550 28,400 200,000 336,150 564,550

Beginning balance 146,150 Add: net profit 239,000 Deduct: dividends (49,000) Ending balance 336,150

50% of June purchases of 56,800

8. Standard Costs and Variance Analysis

A General Model for Variance Analysis

Actual Quantity Actual Price Actual Quantity Standard Price Standard Quantity Standard Price

Price Variance
AQ(AP - SP) AQ = Actual Quantity AP = Actual Price

Quantity Variance
SP(AQ - SQ) SP = Standard Price SQ = Standard Quantity

Direct Materials Variance: Current and future use

Price per unit of material, P

Price variance = (AP SP) * QB Quantity variance = (AQ SQ) * SP

Price variance

AP SP In W-I-P Inventory Quantity variance Raw materials inventory

SQ

AQ

BQ Units of material, Q

Direct Labor Variance

Rate per hour, R

Total labor variance = ARAH SRSH Labour rate variance = (AR SR) * AH Efficiency variance = (AH SH) * SR
Rate variance

AR SR Efficiency variance

SH

AH

Hours of Work, H

9. Flexible budgets and overhead analysis

Preparing a Flexible Budget

CheeseCo
Machine hours Variable costs Indirect labour Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs 4.00 3.00 0.50 7.50 12,000 2,000 Cost Formula Per Hour Total Fixed Cost Flexible Budgets 8,000 10,000 Hours Hours 8,000 32,000 24,000 4,000 60,000 12,000 2,000 14,000 74,000 10,000 40,000 30,000 5,000 75,000 12,000 2,000 14,000 89,000 12,000 Hours 12,000 48,000 36,000 6,000 90,000 12,000 2,000 14,000 104,000

Flexible Budget Performance Report

Cost Formula Per Hour Total Fixed Costs

CheeseCo
Machine hours Variable costs Indirect labour Indirect material Power Total variable costs Fixed Expenses Depreciation Insurance Total fixed costs Total overhead costs

Flexible Budget 8,000

Actual Results 8,000 34,000 25,500 3,800 63,300 12,000 2,050 14,050 77,350

Variances 0 2,000 U 1,500 U 200 F 3,300 U 0 50 U 50 U 3,350 U

4.00 3.00 0.50 7.50 12,000 2,000

32,000 24,000 4,000 60,000 12,000 2,000 14,000 74,000

Flexible Budget Performance Report

Overhead Variance Analysis

Static Overhead Budget at 10,000 Hours 89,000

Flexible Overhead Budget at 8,000 Hours 74,000

Actual Overhead at 8,000 Hours 77,350

Activity This 15,000F variance is due to lower activity.

Cost control This 3,350U flexible budget variance is due to poor cost control.

Overhead Rates and Overhead Analysis

Recall that overhead costs are assigned to products and services using a predetermined overhead rate (POHR):
Assigned Overhead = POHR Standard Activity

Overhead from the flexible budget for the denominator level of activity POHR = Denominator level of activity

Overhead Rates and Overhead Analysis Example

ColaCo prepared this
Total Variable Overhead 4,000 8,000 Variable Overhead Rate 2.00 2.00

budget for overhead:

Total Fixed Overhead 9,000 9,000 Fixed Overhead Rate 4.50 2.25

Machine Hours 2,000 4,000

The total POHR is the sum of the fixed and variable rates for a given activity level.

Variable Overhead Variances

Actual Variable Overhead Incurred AH AR Flexible Budget for Variable Overhead at Actual Hours AH SR Flexible Budget for Variable Overhead at Standard Hours SH SR

Spending Variance

Efficiency Variance

Spending variance = AH(AR - SR) Efficiency variance = SR(AH - SH)

Variable Overhead Variances - A Closer Look Spending Variance Results from paying more or less than expected for overhead items and from excessive usage of overhead items. Efficiency Variance Controlled by managing the overhead cost driver.

Fixed Overhead Variances

Actual Fixed Overhead Incurred Fixed Overhead Budget Fixed Overhead Applied SH FR

Budget Variance
FR = Standard Fixed Overhead Rate SH = Standard Hours Allowed

Volume Variance

Fixed Overhead Variances A Closer Look

Budget Variance Results from paying more or less than expected for overhead items. Volume Variance Results from operating at an activity level different from the denominator activity.

Fixed Overhead Variances

Cost

3,200 machine hours 3.00 fixed overhead rate

9,600 applied fixed OH 9,000 budgeted fixed OH 8,450 actual fixed OH

600 favourable Volume Variance

{ 550 { favourable
Budget Variance

Volume 3,000 Hours Expected Activity 3,200 Standard Hours

10. Cost Volume Profit Relationships

Agenda
The Basics of CVP-Analysis The Contribution Approach Contribution Margin Ratio Changes in Fixed Costs and Sales Volume Equation Method Contribution Margin Method Target Profit Analysis The Margin of Safety Operating Leverage Sales Mix

CVP Analysis
Helps to understand the relationship between: Prices of products Volume or level of activity Per unit variable costs Total fixed costs Mix of products sold

Contribution Margin Ratio

The contribution margin ratio is:

CM Ratio =

Contribution margin Sales For Wind Bicycle Co. the ratio is: 200 = 40% 500

Break-Even Analysis
Break-even analysis can be approached in two ways:

Equation method. Contribution margin method.

Equation Method
Profits = Sales (Variable expenses + Fixed expenses) OR Sales = Variable expenses + Fixed expenses + Profits

At the break-even point profits equal zero.

Contribution Margin Method

The contribution margin method is a variation of the equation method. Break-even point in units sold Break-even point in total sales
=

Fixed expenses Unit contribution margin Fixed expenses CM ratio

CVP Graph
450 000 400 000 350 000 300 000 250 000 200 000 150 000 100 000 50 000 100 200 300 400 500 600 700 800

Break-even point

Units

The Margin of Safety

Excess of budgeted (or actual) sales over the break-even volume of sales. The amount by which sales can drop before losses begin to be incurred. Margin of safety = Total sales - Break-even sales Lets calculate the margin of safety for Wind.

Operating Leverage
A measure of how sensitive net profit is to percentage changes in sales. With high leverage, a small percentage increase in sales can produce a much larger percentage increase in net profit.
Degree of operating leverage

Contribution margin Net profit

Operating Leverage
The degree of operating leverage is greatest at sales levels near the break-even point
(1) Sales Less: Variable Expenses Contribution Margin (a) Less: Fixed Expenses Profit (b) Degree of operating leverage (a/b) 75,000 45,000 30,000 30,000 0 (2) 80,000 48,000 32,000 30,000 2,000 16 (3) 100,000 60,000 40,000 30,000 10,000 4 (4) 150,000 90,000 60,000 30,000 30,000 2 (5) 225,000 135,000 90,000 30,000 60,000 1.5

The Concept of Sales Mix

Sales mix is the relative proportions in which a companys products are sold. Different products have different selling prices, cost structures, and contribution margins. Lets assume Wind sells bikes and carts and see how we deal with break-even analysis.

11. Relevant Costs for Decision Making

Topics
Identifying Relevant Costs Adding / Dropping Segments Make or Buy Decisions Special Orders Utilization of a Constrained Resource Joint Product Costs

Identifying Relevant Costs

A relevant cost is a cost that differs between alternatives. Costs that can be eliminated (in whole or in part) by choosing one alternative over another are avoidable costs. Avoidable costs are relevant costs.

Unavoidable costs are never relevant and include: Sunk costs. Future costs that do not differ between the alternatives.

Correct Analysis
Look at the comparative cost and revenue for the next five years.
For Five Years Sales Variable expenses Other fixed expenses Depreciation - new Depreciation - old Disposal of old machine Total net profit Keep Old Machine 1 000 000 (500 000) (350 000) (60 000) 90 000 Purchase New Machine 1 000 000 (400 000) (350 000) (90 000) (60 000) 15 000 115 000 Difference 100 000 (90 000) 15 000 25 000

Would you recommend purchasing the new machine even though we will show a 45,000 loss on the old machine?

Adding / Dropping Segments

Segment Profit Statement Digital Watches Sales 500,000 If the Less: variable expenses digital watch line is dropped, the fixed general factory overhead and general Variable mfg. costsadministrative expenses will be allocated 120,000 Variable shipping costsother product lines because they 5,000 to are not 75,000 avoidable. Commissions 200,000 Contribution margin 300,000 Less: fixed expenses General factory overhead 60,000 Salary of line manager 90,000 Remember, depreciation on equipment50,000 resale value is not with no Depreciation of equipment relevant to the decision since it is a sunk cost and is not Advertising - direct 100,000 avoidable. Rent - factory space 70,000 General admin. expenses 30,000 400,000 Net loss 100,000

A Contribution Margin Approach

DECISION RULE Lovell should drop the digital watch segment only if its fixed cost savings exceed lost contribution margin. Lets look at this solution.

The Make or Buy Decision

The special equipment has no resale value and is a sunk cost.
Cost Per Unit

Outside purchase price Direct materials Direct labour Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost

25 9 5 1 3 2 10 30

Cost of 20,000 Units Buy Make 500,000 180,000 100,000 20,000 40,000 340,000

500,000

Not avoidable and is irrelevant. If the product is dropped, it will be reallocated to other products.

The Make or Buy Decision

DECISION RULE In deciding whether to accept the outside suppliers offer, Essex isolated the relevant costs of making the eliminating: part by eliminating The sunk costs. The future costs that will not differ between making or buying the parts.

Utilization of a Constrained Resource

Lets calculate the contribution margin per unit of the constrained resource, machine A1.
Product 1 Contribution margin per unit Time required to produce one unit Contribution margin per minute 2 24 15 1.00 min. 0.50 min. 24 min. 30 min.

Product 2 should be emphasised. Provides more valuable use of the constrained resource machine A1, yielding a contribution margin of 30 per minute as opposed to 24 for Product 1.

Managing Constraints
Produce only what can be sold.

Finding ways to process more units through a resource bottleneck

At the bottleneck itself: Improve the process Add overtime or another shift Hire new workers or acquired more machines Subcontract production

Eliminate waste. Streamline production process.

Joint Products
Joint Costs

Oil

Separate Processing

Final Sale

Joint Input

Common Production Process

petrol

Final Sale

Chemicals

Separate Processing
Separate Product Costs

Final Sale

SplitSplit-Off Point

Chapter 10
12. Capital investment decisions

Typical Capital Budgeting Decisions

Plant expansion

Equipment selection

Equipment replacement

Lease or buy

Cost reduction

Cost reduction

Lease or buy

Typical Capital Budgeting Decisions

Capital budgeting tends to fall into two broad categories . .. Screening decisions. Does a proposed project meet some present standard of acceptance? Preference decisions. Selecting from among several competing courses of action.

Typical Cash Outflows

Repairs and maintenance

Working capital

Initial investment

Incremental operating costs

Typical Cash Inflows

Salvage value

Release of working capital

Reduction of costs

Incremental revenues

The Net Present Value Method

Years Now Now 1-5 3 5 5 Cash Flows - 160 000 (100 000) 80 000 (30 000) 5 000 100 000 10% Factor 1,000 1,000 3,791 0,751 0,621 0,621 Present Value - 160 000 (100 000) 303 280 (22 530) 3 105 62 100 85 955

Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equip. Working capital released Net present value

Accept the contract because the project has a positive net present value.

The Internal Rate of Return Method

Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows:

Investment required PV factor for the = internal rate of return Net annual cash flows 104, 320 20,000 = 5.216