Accounting

Definition:

• Measures how sensitive net profit is to changes in sales due to fixed costs.

Higher Operating Leverage Means:

1. Greater Profit Sensitivity:

   • Small sales changes → Large profit changes.

2. Higher Break-Even Point:

   • More sales needed to cover fixed costs.

3. Higher Risk and Reward:

   • Sales ↑ → Profits amplified.

   • Sales ↓ → Losses magnified.

4. Common in Industries:

   • Manufacturing, Airlines, Software, Telecom.

20%*3=60%

-> the company´s net profit increases in 60%

A: The proportion of fixed and variable costs in an organization.

1. High Fixed Costs → Greater risk but higher profit potential.

2. High Variable Costs → Lower risk but limited profit growth.

Yes, managers have some flexibility in adjusting fixed and variable costs.

1. Sales ↑ → Large profit increase.

2. Sales ↓ → Large profit decrease (greater risk).

Tip: Fixed = Risky, Variable = Stable.

Income will be higher in good years because fixed costs are covered, and additional revenue contributes directly to profit.

Income will be lower in bad years because fixed costs remain constant, even when sales decline.

Greater income stability across good and bad years due to lower financial risk.

Fixed costs amplify profit changes:

• Sales ↑ → Profits increase significantly.

• Sales ↓ → Profits decrease significantly.

1. High Fixed Costs = High risk, high reward.

2. Low Fixed Costs = Stability, lower risk.

1. A budget is a quantitative plan for using resources over a specific time.

2. Budgeting refers to the process of preparing a budget.

3. Budgetary control is using budgets to manage and control organizational activities.

4. Budgets typically cover one fiscal year, but some companies use a perpetual budget, which rolls forward continuously for 12 months.

1. An annual budget typically covers a one-year period, aligned with the company’s fiscal year.

2. Many companies break it down into four quarters for better tracking and adjustments.

3. A continuous budget (also called a rolling budget) is a 12-month plan that rolls forward as each month or quarter is completed.

1. Planning: Involves developing budgets to achieve organizational objectives by setting clear goals and outlining strategies.

2. Control: Ensures that the goals set during planning are attained and all parts of the organization are aligned and working together.

3. Management takes proactive steps to increase the likelihood of meeting objectives effectively.

1. To compare budgets to actual results for better insights.

2. To improve efficiency and effectiveness of operations.

3. To evaluate and reward employees based on performance.

1. Organizations use a mix of top-down budgeting and self-imposed budgeting.

2. Self-imposed (participative) budgeting involves the full cooperation and participation of managers at all levels, ensuring alignment and accountability.

1. Accuracy: Budgets prepared by front-line managers are often more accurate than those prepared by top managers.

2. Respect: Involving lower-level managers shows respect for their opinions.

3. Motivation: Participation in budgeting increases motivation by giving individuals a sense of ownership.

4. Accountability: Empowers managers to take ownership and be accountable for deviations from the budget.

1. Management Review: Self-imposed budgets should be reviewed to avoid budgetary slack (intentionally underestimating revenues or overestimating costs).

2. Guidelines: Higher management provides broad guidelines (e.g., profit or sales targets) to ensure budgets align with organizational goals.

3. Collaboration: Lower-level managers prepare budgets within these guidelines to meet targets set by higher management.

A master budget is a comprehensive financial plan based on key estimates and assumptions, including:

1. Budgeted Unit Sales – How many units are expected to be sold?

2. Budgeted Selling Price Per Unit – What is the expected price for each unit sold?

3. Accounts Receivable Collection – What percentage of accounts receivable will be collected in the current and subsequent periods?

1. Cash Receipts: Lists all cash inflows (excluding financing cash).

2. Cash Disbursements: Includes all cash payments (excluding principal and interest repayments).

3. Cash Excess/Deficiency: Determines if the company needs to borrow money or can repay borrowed funds.

4. Financing Section: Details borrowings and repayments projected during the budget period.

1. Screening Decisions:

   • Evaluates whether a proposed project meets a preset standard of acceptance.

2. Preference Decisions:

   • Involves selecting the best option from multiple competing alternatives.

1. Cash Flow Focus Methods:

   1. Payback Method

   2. Net Present Value (NPV)

   3. Internal Rate of Return (IRR) These methods analyze the cash flows associated with capital investment projects.

2. Operating Income Focus Method:

   • Simple Rate of Return Method: Focuses on incremental net operating income rather than cash flows.

Weaknesses:

1. Ignores time value of money.

2. Excludes cash flows after the payback period.

3. A shorter payback period does not always indicate a more desirable investment.

Strengths:

1. Useful as a screening tool.

2. Identifies investments that recoup cash quickly.

3. Highlights projects/products that recover the initial investment efficiently.

1. All cash flows, except the initial investment, occur at the end of periods.

2. All cash flows are immediately reinvested at a rate of return equal to the discount rate.

1. The minimum required rate of return for an investment.

2. Reflects the average return the company must pay to long-term creditors and stockholders (debt + equity).

3. Used as the discount rate in NPV calculations.

1. The rate of return at which the NPV of cash flows = 0.

2. Represents the actual return a project is expected to generate.

3. Calculated based on the project’s specific cash inflows and outflows.

A project is accepted if:

IRR≥Cost of capital

This ensures the project generates a return at least equal to the company’s required rate of return.

• The IRR is the rate of return promised by an investment project over its useful life.

• It is the discount rate that causes the Net Present Value (NPV) of a project to equal zero.

• Works best when cash flows are identical (e.g., annuities).

• For uneven cash flows, IRR must be found using a trial-and-error process or computational tools.

1. Cost of Capital = The minimum required rate of return (hurdle rate) for a project.

2. Acceptance Rule:

   • IRR ≥ Cost of Capital → Project is acceptable (meets or exceeds the hurdle rate).

   • IRR < Cost of Capital → Project is rejected (fails to meet the minimum requirement).

1. IRR Assumption: Assumes cash inflows are reinvested at the IRR, which can be unrealistic.

2. NPV Simplicity: NPV assumes cash inflows are reinvested at the cost of capital, which is a more practical assumption.

• IRR Method: Assumes cash inflows are reinvested at the internal rate of return (IRR).

  • Unrealistic if the IRR is very high.

• NPV Method: Assumes cash inflows are reinvested at the discount rate (cost of capital), which is more practical and realistic.

1. The total cost approach evaluates all cash inflows and outflows for each alternative project over its entire lifespan.

2. It involves calculating the total present value (PV) of each alternative to compare their overall profitability.

3. This method ensures a comprehensive analysis by including all costs and benefits for decision-making.

• Managers should select the alternative with the least total cost when evaluated from a present value (PV) perspective.

• This ensures that the most cost-efficient option is chosen over time.

1. roblem Setup:

   • The NPV of all cash flows (excluding salvage value) is negative $1.04 million.

   • Discount rate = 12%.

   • The salvage value must offset the negative NPV to make the investment attractive.

2. Formula to Calculate Required Salvage Value:

   Required salvage value =negative NPV/PV Factor of 12% over 20 years

   =1,040,000​/0.104=10,000,000

3. Conclusion:

   • The salvage value must be at least $10,000,000 for the investment to have a positive NPV and be acceptable.

• Screening Decisions:

  • Determine whether a proposed investment is acceptable based on preset criteria.

  • These decisions are made first.

• Preference Decisions:

  • Rank acceptable alternatives from most to least appealing.

  • Made after screening to prioritize investments.

• Net Present Value (NPV):

  • NPVs cannot be directly compared between projects unless the initial investments are equal.

  • Focuses on total value added to the firm.

• Internal Rate of Return (IRR):

  • Higher IRR = More desirable project.

  • Preference Rule: Rank projects by their IRR, selecting the project with the highest IRR, as long as it meets or exceeds the cost of capital.

Preference Rule:

• Higher PI = More desirable project.

• A PI > 1 indicates a profitable investment.

• Definition: Focuses on accounting net operating income rather than cash flows.

Shortcomings:

1. Ignores the time value of money.

2. The same project may appear desirable in some years and undesirable in others due to accounting fluctuations.

3. May lead to biased decisions if managers prioritize ROI over projects with positive NPV.

Behavioral Implication:

• Managers may bypass profitable investments (positive NPV) to maintain short-term ROI goals.

A postaudit is a follow-up process conducted after a project is completed to determine whether the expected results (e.g., costs, benefits, or returns) were actually realized.

1. Favorable (F):

   • Occurs when actual revenue > budgeted revenue.

   • Occurs when actual costs < budgeted costs.

2. Unfavorable (U):

   • Occurs when actual costs > budgeted costs.

• Key Question:

  • “How much of the cost variances are due to higher activity and how much are due to cost control?”

• Solution:

  • Adjust (flex) the planning budget to reflect the actual level of activity.

  • This allows for a clearer comparison between expected and actual costs at the same activity level.

• Activity Variance:

  • Arises solely from the difference between the actual level of activity and the planned level of activity in the budget.

  • Reflects the impact of activity changes on costs or revenues.

1. Revenue Variance:

   • The difference between actual revenue and flexible budget revenue.

2. Spending Variance:

   • The difference between actual cost and flexible budget cost.

• Standards: Benchmarks or norms for measuring performance.

Types of Standards:

1. Quantity Standards:

   • Specify how much of an input should be used to make a product or provide a service.

2. Price Standards:

   • Specify how much should be paid for each unit of input.

Examples of Usage: Firestone, Sears, McDonald’s, hospitals, construction, and manufacturing companies.

• Standard Price per Unit:

  • Includes the final, delivered cost of materials, net of discounts.

• Standard Quantity per Unit:

  • Summarized in a Bill of Materials to specify the exact input amount needed for one product unit.

1. Standard Hours per Unit:

   • Determined using time and motion studies for each labor operation.

2. Standard Rate per Hour:

   • Reflects the average wage rate for the mix of wages earned by employees.

1. Price Standard:

   • The rate reflects the variable portion of the predetermined overhead rate.

2. Quantity Standard:

   • Based on the activity in the allocation base used for predetermined overhead.

1. Activity and Spending Variances:

   • Standard costs for direct materials, direct labor, and variable manufacturing overhead are used to calculate these variances.

2. Breaking Down Spending Variances:

   • Spending variances are more useful when divided into:

     1. Price Variances (difference in cost per unit).

     2. Quantity Variances (difference in amount of input used).

1. Price Variance:

   • The difference between actual price and standard price for an input.

2. Quantity Variance:

   • The difference between actual quantity used and standard quantity allowed for the output.

1. Responsibility Difference:

   • Purchasing Manager: Responsible for raw material purchase prices.

   • Production Manager: Responsible for the quantity of raw material used.

2. Timing Difference:

   • Buying and using activities occur at different times.

   • Raw material purchases may be held in inventory before being used in production.

No, materials variances are not always fully controllable. Examples include:

1. Purchasing Manager's Decisions:

   • Buying lower-quality raw materials can cause an unfavorable quantity variance for the production manager.

2. Production Manager's Decisions:

   • Scheduling production requiring express delivery of materials can lead to an unfavorable price variance for the purchasing manager.

1. Quantity Variance:

   • Computed only on the quantity used in production.

2. Price Variance:

   • Computed on the entire quantity purchased, regardless of usage.

Production Managers are usually held accountable for labor variances because they influence key factors like:

1. Mix of skill levels assigned to tasks.

2. Level of employee motivation.

3. Quality of production supervision.

4. Quality of training provided to employees.

Advantages:

1. Management by Exception: Focus on significant variances for better control.

2. Promotes Economy and Efficiency: Standards act as benchmarks to improve performance.

3. Simplifies Bookkeeping: Standard costs streamline accounting processes.

4. Supports Responsibility Accounting: Encourages accountability for variances.

Potential Problems:

1. Employee Morale: Misuse of variances to punish can harm morale and lead to dysfunctional decisions.

2. Outdated Information: Standard cost reports, often monthly, may lag behind real-time needs.

3. Automation Impact: Labor variances assume labor is variable, which may not be valid in automated environments where labor is a fixed cost.

4. Excessive Emphasis on Standards: May overshadow other objectives like quality, delivery, and customer satisfaction.

5. "Favorable" Variances: Sometimes a favorable variance can harm long-term goals (e.g., cutting costs but reducing quality).

6. Continuous Improvement Needed: Just meeting standards may not suffice in competitive environments.