Chapter 4 Flashcards
Projections
- What-if scenarios
- precursor to actual forecast
- Prepared for internal use
- Assist managers in making decisions regarding products, acquisitions, revenues, expenses etc
Sensitivity Analysis
- process of experimenting with different parameters and assumptions regarding a model and cataloging the range of results to view the possible consequences of a decision
- Use probabilities to approximate reality
- Also called “what-if” analysis
- risk management tool
- test the effect of specific variables on overall profitability
- Used to determine which variables are the most sensitive to change and will have the greatest effect on bottom-line
Drawback: implicit assumption that variables are independent
Scenario Analysis
Different scenario which represent alternative possible outcomes
Find weighted total of scenario
Forecasting Techniques
- Driven by historical data and actual expectation rather than hypothetical scenarios
- Use for both external and internal users
- Either quantitative or qualitative methods
- Qualitative is based on opinions and judgments of managements and other experts
- Quantitative use historical data and are categorized as either time series methods or causal methods
- Time series use past trends to predict future variables
- Causal methods are based on cause-and-effect relationships between variables
Forecasting Analysis
- Extension of Sensitivity Analysis
- Purpose: predicting future values of a dependent variable (one you are trying to explain) using information from previous time periods
- Forecasting Revenues = sales are dependent variable
- Forecasting Expenses = total cost are dependent variable
Regression Analysis
Linear regression is a method for studying the relationship between two or more variables
Used to predict the value of dependent variables
Simple Linear Regression Model
Explains the variation in a dependent variable as a linear function of one or more independent variables
Only one independent variable
Estimated the dependent variables
Most accurate method for classifying an object as either fixed or variable
y = a + Bx
Where:
y = dependent variable
x = independent variable (regressor)
a = y-axis intercept for the regression line
B = slope of regression line
Coefficient of Correlation (r)
- Measures the strength of the linear relationship between the independent variable (x) and dependent variable (y)
- Range of r is from -1.00 to 1.00
- Perfect Positive Correlation (+1.00): dependent and independent variable move together in the same direction
- increase in one is increase in another
- upward slope
- Prefect Inverse Correlation (-1.00): dependent and independent variables move in equivalent opposite directions
- decrease in one is increase in another
- downward slope
- No Correlation (0.00): dependent and independent variables are not related in a linear fashion
- movement in the independent variable cannot be used to predict movement in the dependent variable
- Projecting Total Cost: (dependent variable) when predicting total cost as a function of fixed costs, variable costs and volume (independent variable), management’s expectation of the correlation coefficient is between 0.00 and 1.00
Coefficient of Determination (R^2)
Coefficient of determination is the proportion of the total variation in the dependent variable (y) explained by the independent variable (x)
Between 0 and 1
Higher the R^2, the greater proportion of the total variation in Y that is explained y the variation in x
Higher the R^2, the better the fit of the regression line
Percentage of variation in the dependent variable explained by the variation in the independent variables
High-Low Method
Technique used to estimate the fixed and variable portions of cost, usually production costs
Steps:
- Gather Data
- compare high and low volumes and costs- remove outliers
- Analyze Data
- Divide the difference between the high and low dollar total costs by the difference in the high and low volumes to obtain variable cost per unit
- Use either high volume or low volume to calculate the variable costs
- Subtract the total calculated variable costs from the total cost to obtain the fixed costs
- Formulate Results
- allows for preparation of a flexible/performance budget
Flexible Budget Formula
Results of high-low method
Series of budgets that are prepared for a range of activity levels rather than a single activity
Total Cost = Fixed Costs + (Variable Cost per Unit * Number of Units)
Learning Curve
Analysis based on the premise that as workers become more familiar with a specific task, the per-unit labor hours will decline as experience is gained and production becomes more efficient
Used to set standards and to project costs, as variable costs per unit should decline until a stead-state period is achieved
Once steady state occurs, labor hours per unit will remain constant
Activity must be repetitive in nature, involve intense labor and have little to no labor force turnover or breaks in production
Cumulative average time per unit falls to a fixed percentage of the previous average time
Cost-Volume-Profit (CVP) Analysis
Used by managers to forecast profits at different levels of sales and production volume
Point at which Revenues equals costs = Breakeven Point
aka Breakeven Analysis
Assumptions:
- All costs can be separated into either variable or fixed costs depending on behavior
- Volume is only relevant factor affecting cost
- All costs behavior in a linear fashion in relation to production volume
- Cost behaviors are to remain constant over the relevant range of production b/c assumption that efficiency of production does not change
- Cost show greater variability over time
- Assumes that product mix remains constant
- Direct Costing or Contribution Approach is used -→ No Absorption Approach
- Selling Price Remains Unchanged
Absorption Approach
Required for financial reporting under (GAAP)
Does not segregate fixed and variable costs
Encourages management to reduce inventory
Revenue
Less: COGS
= Gross Margin
Less: Operating Expenses
Equals Net Income
Difference between Contribution Approach is the treatment of fixed factory overhead
All fixed factory OH is treated as a product cost and is included in inventory values
COGS is both variable and fixed
Selling, general, and admin expenses are period costs used in the determination of net income
Reported on income statement separately from COGS
Contribution Approach
aka Variable Costing Method
To the income statement uses variable costing (direct)
Useful for internal decision making
Revenue
Less: Variable Cost
= Contribution Margin
Less: Fixed Costs
= Net Income
Variable costs include direct labor, direct materials, variable manufacturing OH, shipping and packaging, and variable selling expenses
Fixed costs include fixed OH, fixed selling, and most G&A expenses
- Total or Per Unit: revenue, variable costs, and contribution margin may be expressed in total and on per-unit
- Unit Contribution Margin: unit sales price minus the unit variable cost
- Contribution Margin Ratio: contribution margin expressed as a percentage of revenues
Difference between Absorption Approach is the treatment of fixed factory overhead
All fixed factory OH is treated as a period cost and is expenses in the period incurred
Inventory costs only include variable manufacturing costs
Selling, general, and admin expenses are period costs used in the determination of net income
Above are a part of the total variable costs for the contribution margin
Breakeven Point in Units
= Total Fixed Costs
Contribution Margin per Unit
Where Contribution Margin = Selling Price - Variable Cost
Breakeven Point in Dollars using Contribution Margin per Unit
= Unit Price * Breakeven Point (in Units)
Breakeven Point in Dollars using Contribution Margin Ratio
= Total Fixed Costs
Contribution Margin Ratio
Required Sales Volume for Target Profit
pretax profits used
Sales (units) = (Fixed Cost + Pretax Profit)
Contribution Margin Per Unit
Sales Dollars Needed to Obtain a Desired Profit
- Summation of Total Costs & Profits
Sales Dollars = Variable Costs + Fixed Costs + Pretax Profit
- Contribution Margin Ratio
Sales = Fixed Costs + Pretax Profits
Contribution Margin Ratio
Predicting Profits Based on Volume
Profit = Units Above Breakeven Point * Contribution Margin Per Unit
Setting Selling Prices Based on Assumed Volume
Sales Price per Units = (Fixed Costs + Variable Costs + Pretax Profits)
Number of Units Sold
Margin of Safety Concepts
- Sales Dollars
= Total Sales (in $) - Breakeven Sales (in $)
- Percentage
= Margin of Safety in Dollars
Total Sales
Breakeven Charts
Graphically display the results of breakeven analysis
Target Costing (Used for Target Pricing)
concept of target costing uses the selling price of the product to determine the product costs to be allowed
When competition (cost leader) sets prices, any chance in price could easily cause a customer defection
Firs step establishing cost controls to ensure ongoing profitability
Target Cost = Market Price - Required Profit
Implication:
- if management commits to target costs, serious measures must be employed to reduce costs
- firms may sacrifice quality by reducing costs which can cause a loss in sales
- may incur increased down stream costs in attempt to differentiate their produces and create brand loyalty and competitive advantage
- advanced cost management techniques may have to be employed to attain a higher productivity level
- product may have to be redesigned for the reduction of costs throughout the life cycle of a product (Kaizen Method)
Probability (Risk) Analysis
Is an extension of Sensitivity analysis
used to examine the possible outcomes given different alternative
Cost Determination
concept of target costing uses the selling price of the product to determine the product costs to be allowed
Cost-Based Pricing
Associated with:
Price stability
Price justification
Fixed-cost recovery
Weighted Average Contribution Margin Per Unit
Contribution Margin = Selling Price - Variable Cost
Weighted Average Contribution Margin Per Unit = (Contribution Margin * % Sold) + (Contribution Margin * % Sold) + etc
Ratio Analysis
Quick and easy way to evaluate a company’s past, present and future performance and financial standing
Liquidity Ratios
Focus is on current liabilities side of the company’s balance statement
Focus on whether a company will have enough current assets and other funds to pay the liabilities when they are due
Examples:
Current Ratio
Quick Ratio
Cash Ratio
Operating Cash Flow Ratio
Working Capital Turnover Ratio
Working Capital Ratio
= Current Assets - Current Liabilities
Components come from Balance Sheet
Current Ratio
= Current Assets
Current Liabilities
Components come from Balance Sheet
Higher Current Ratio is better b/c it implies that more current assets are available to pay short-term liabilities
Quick Ratio
= Cash & Cash Equivalents + Short-term Marketable Securities + Receivables (Net)
Current Liabilities
Only includes more liquid sections of the current assets
Higher Quick Ratio the better b/c it implies that more current liquid assets are available to pay short-term liabilities
Operating Cash Flow Ratio
= Cash Flow from Operations
Ending Current Liabilities
Measures how much cash a company has generated from operating activities to cover current liabilities
Higher ratio is more desirable and implies company is generating more cash from its core activities to pay current liabilities
Working Capital Turnover Ratio
= Sales
Average Working Capital
Sales come from the Income statement
Working capital is calculated as the difference between current assets and current liabilities
Measures how well a company converts its working capital into sales
Higher the better
Activity Ratios
Used to assess how efficient a company is at utilizing its resources to generate sales and profits
Examples:
Days in Inventory
Days Payable Outstanding
Days Sales in Accounts Receivable
Operating Cycle
Cash Conversion Cycle
Days in Inventory
= Ending Inventory
COGS / 365
Indicates the average number of day required to sell inventory
Use Ending Inventory Data if not provided with multiple years
Output is in days
Lower the number of days the more efficient in converting inventory into sales
Days Sales in Accounts Receivables
= Ending Accounts Receivable (Net)
Sales (Net) / 365
Indicates the receivables quality and the success of the firm in collecting outstanding receivables
Net Sales number is taken from the Income Statement and is equal to the Gross Sales minus Sales Return & Allowance
Receivables are often averaged in this ratio to align to the period covered by net sales
Use ending receivables if multiple year data is not provided
Computes Average number of days it takes to convert sales into cash
Days Payables Outstanding
= Ending Accounts Payable
COGS/ 365
Accounts Payable will typically be averaged to align with the time period associated with the COGS
Use ending accounts payable if multiple year data is not available
Measures how long it takes for a company to pay its vendors for goods purchased on credit
Cash Conversion Cycle
= Days in Inventory + Days Sales in Accounts Receivables - Days Payables Outstanding
The lower the cash conversion cycle the better because a company would want to minimize the number of days it takes to convert inventory into sales and sales into cash while taking as long as possible to pay its vendors
Cash Conversion Cycle
= Days in Inventory + Days Sales in Accounts Receivables - Days Payables Outstanding
The lower the cash conversion cycle the better because a company would want to minimize the number of days it takes to convert inventory into sales and sales into cash while taking as long as possible to pay its vendors
Debt Ratios
Measure the extent to which a company employs financial leverage in its capital structure
Although debt is cheaper than equity from a cost standpoint because of the tax benefits and lower interest rates, too much debt is risky
Examples:
Debt-to-Equity Ratio
Debt-to-Assets Ratio
Debt-to-Total Capital Ratio
Interest Coverage Ratio
Debt Service Coverage Ratio
Debt-to-Equity Ratio
= Total Liabilities
Total Equity
Indicates the degree of protection to creditors in case of insolvency
Lower ratio is better
Lowering ratio can happen by paying down debt
Higher ratio implies more risk
Total Debt Ratio
= Total Liabilities
Total Assets
or
= Debt / ( Debt + Equity)
Higher ratio indicates higher risk
Similar to debt-to-equity ratio
To improve, company must either reduce its liabilities or increase its total assets
Times Interest Earned (Interest Coverage) Ratio
= Earning Before Interest Expense and Tax
Interest Expenses
Higher number implies a company has more funding to cover its required interest expenses associated with debt
Profitability Ratios
Focus on determining how profitable a company is at various levels of its business
Examples:
Gross Margin
Operating Margin
Net Margin
Return on Equity
Return on Assets
Gross Margin
= Sales (net) - COGS
Sales (net)
All else being equal, the higher the better
COGS is often forecasted to a specific percentage of sales– keeping gross margin constant
Profit Margin
= Net Income
Net Sales
Goal is to increase the ratio done by controlling growth in costs while continuing to increase sales
Higher the better
Means a company is profitable after taking into account all costs associated with generating sales and operating its business
Return on Equity (ROE)
= Net Income
Average Total Equity
Net Income comes from the Income Statement
Shareholder’s Equity comes from the Balance Sheet
Common to use average shareholder’s equity in the denominator
Higher is better = greater profitability, earnings per share and probable future stock growth
Return on Assets (ROA)
= Net Income
Average Total Assets
Common practice is to take the average balance of assets from the beginning and end of the period in order to align with the period covered by net income
Higher implies that a company is generating more profits relative to its base of assets
Inventory Turnover Ratio
= COGS / Average Inventory Balance
Prime Costs
Prime Cost = Raw Material Cost + Direct Labor Cost.
Operational and Tactical Planning
process of determining the specific objectives and means by which strategic plans will be achieved
short-term, cover periods of up to 18 months
Types:
- Single-Use Plans: developed to apply to specific circumstances during a specific time frame
- Annual Budget: type of single-use that translates the strategic plan and implementation into a period-specific operational guide
Budget Policies
- organization should implement formal budget policies
- usually will extend for one year and involves numerous individuals
- budget committee -→ which includes senior management
- charged with dispute resolution and making final decisions
- Guidelines
- provided by management
- based on entity’s short-term and long-term goals
- Should include:
- consideration of changes to the environment since the adoption of the strategic plan
- organizational goals for the coming period
- operating results year-to-date
- Management Instruction will set the tone and corporate policy
Standards and Benchmarking
- Standards are often set below expectations to motivate productivity and efficiency, but those standard costs much be revised periodically to reflect changes in previously determined standards
-
Ideal Standards: represent the costs that results from perfect efficiency and effectiveness in job performance
- generally not historical → forward thinking
- No provision is made for normal spoilage or downtime
- Advantages: implied emphasis on continuous quality improvement CQI to meet the ideal
- Disadvantages: demotivation of employees by the use of unattainable standards
-
Currently Attainable Standards: represent costs that results from work performed by employees with appropriate training and experience but without extraordinary effort
- Provisions for normal spoilage and downtime
- Advantages: fosters the perception that standards are reasonable
- Disadvantages: required use of judgment and potential manipulation
-
Authoritative Standards: Set exclusively by management
- Advantages: can be implemented quickly and will likely included all costs
- Disadvantages: workers might not accept imposed standards
-
Participative Standards: set by both managers and individuals who are held accountable to those standards
- Advantages: workers are more likely to accept participative standards
- Disadvantages: participative standards are slower to implement
Master Budgets
- Called Annual Business Plan
- documents specific goals for a period, normally one year or less
- Includes an Operating (nonfinancial) budget and financial budget that outlines the sources of funds and detailed plans for their expenditure
- Purpose: provide comprehensive and coordinated budget guidance for an organization consistent with overall strategic objectives
- Control Objective: serves to communicate the criteria for performance over the period covered by the budget
- AKA Static Budgets, Annual Business Plans, Profit Planning or Targeting Budgets
- Use: useful for most industries but particularly useful for manufacturing settings
-
Components:
- Compromises operating budgets and financial budgets prepared in anticipation of achieving a single level of sales volume for a specific period
- Pro Forma Financial Statements
- Assumptions: Pro Formas are supported by schedules that reflect the underlying operating assumptions that produce those statements
-
Limitations:
- Master Budget confined to one year at a single level of activity
- Seasonality not considered
- Pro Forma might not provide the type of information useful in decision making
Mechanics of Master Budgeting
Operating Budgets: established to describe the resources needed and the manner in which those resources will be acquired
Includes:
- Sales Budgets
- foundation of entire budget process
- units and dollars
- first to be produced
- Production Budgets
- Selling and Admin Budgets
- Personnel Budgets
Financial Budgets: define the detailed sources and used of funds to be used in operations
Includes:
- Pro Forma Financial Statements
- Cash Budgets
Sales Forecasting and Budgeting
Sales Budget: based on the sales forecast which are derived from input received from numerous organizational resources including opinions of sales staff, statistical analysis of correlation between sales and economic indicatory and opinions of line managements
Consider the following:
- Past patterns of sales
- sale force estimates
- general economic conditions
- competitors’ actions
- changes in the firm’s prices
- changes in product mix
- results of market research studies
- advertising and sales promotion
First step in sales planning process is to develop management guidelines specific to sales planning, including the sales planning process and planning responsibilities
Operating Budgets: Production Budgets
Production. Inventory Budgets are prepared for each product or each department based on the amount that will be produced, stated in units
- includes amount spent on direct labor, direct materials, and factory overhead
- amount is based on the amounts of inventory on hand and inventory necessary to sustain sales
Establishing Required Level of Production
Budgeted Sales
+ Desired Ending Inventory
- Beginning Inventory
Budgeted Production
Other Factors:
- Company policy regarding stable production
- Condition of production equipment
- Availability of productive resources
- Experience with production yields and quality
Direct Materials Budget
Direct materials required to support the production budget are defined by the direct materials purchases budget and direct materials usage budget
-
Direct Materials Purchases Budget: represents the $ amount of purchases of direct materials required to sustain production requirements
- Number of Units to be Purchased: # of units of direct materials to purchase is calculated from production budget
Units of Direct Materials Needed for a Production Period
+ Desired Ending Inventory at the End of the Period
- Beginning Inventory at the Start of the Period
Units of Direct Materials to be Purchases for the Period
- Cost of Direct Materials to be Purchased:
Units of Direct Material to be Purchased for the Period
X Cost per Unit
Cost of Direct materials to be Purchased for the Period (purchased at cost)
- Direct materials Usage Budget (Cost of Direct Materials Used) represents the number of units of direct materials required for production along with the related cost of those direct materials
Beginning Inventory at Cost
+ Purchases at Cost
- Ending Inventory at Cost
Direct Materials Usage (cost of materials used)
- effected by philosophy regarding required inventory levels, safety stock and OOS decisions
Direct Labor Budget
anticipated the hours and rates associated with workers directly involved in meeting production requirements
Budgeted Production (in units)
* Hours (or fractions of hours) required to produce each unit
Total Number of Hours Needed
* Hourly Wage Rate
Total Wages
Factory Overhead Budget
Includes fixed and variable production costs that are not direct labor or direct materials
Applied to inventory (COG manufactured and sold) based on a representative statistic (cost driver) (ex. Direct Labor Hour)
Cost of Goods Manufactured & Sold Budget
Accumulated the information from the direct labor, direct material, and factory overhead budgets
Cost of Goods Manufactured = Direct Labor + Direct materials + Factory overhead
(also includes WIP inventory budgets)
Cost of Goods Sold = Cost of Goods Manufactured + Beginning Finished Goods Inventory - Ending Finished Goods Inventory
COGS & Pro Forma Financial Statements
- COGS Budget feeds directly into the pro forma income statement
- Budgeted COGs is matched with Budgeted sales as the basis for budgeted gross margin
Operating Budgets: Selling and Administrative Expenses Budget
expenses represent the fixed and variable nonmanufacturing expenses anticipated during the budget period
Need to be detailed in order that the key assumptions can be better understood
Components:
Variable Selling Expenses:
- Sales commissions
- Delivery expenses
- Bad-debt Expenses
Fixed Selling Expenses
- Sales salaries
- Advertising
- Depreciation
General Administrative Expenses (All Fixed)
- Administrative Salaries
- Accounting and Data Processing
- Depreciation
- Other
Selling & Admin Expenses and the Pro Formas
are not inventoried and are budgeted as period costs
matched against their entirety against the sales budget
Order of Four Budget Types
Sales → Production → Direct Materials Purchased → Cash Disbursements
Cash Budget
- Cash budget shows itemized cash receipts and disbursements during the period, including the financing activities and the beginning and ending cash balances
- Cash budget alerts management to period when there will be excess cash available for investment
- Cash budget is usually broken down into monthly periods
Engineering Standards Based on Attainable Performance
best basis upon which cost standards should be set to measure controllable production inefficiencies
Sequence for Preparing Budgets
Production Budget → Material Purchases Budget → Budgeted Income Statement → Budgeted Balance Sheet
Manufacturing Variances
purpose of determining and assigning responsibility is to use the knowledge about the variances to promote learning and continuous improvement.
Labor Usage Variance
Difference between stand hours at standard wage and actual hours at standard wage
Flexible Budget Variance
difference between the actual amounts and the flexible amounts for the actual output achieved
Revenue Variance or Sales Price Variance
due to change in unit selling prices
found by comparing actual results with the flexible budget
Materials Efficiency Variance
= Standard Price * (Standard Quantity Use - Actual Quantity Used)
Spending Variance
Balance in OH Account is equal to the sum of that variances
Debit balances are unfavorable
credit balances are favorable
Relevant Cost Examples
Differential Cost, Incremental Costs, Avoidable Costs
Not = Variable costs
Most Direct Way to Prepare a Cash Budget?
Projected sales and purchases → percentages of collections, and terms of payments
Information from a Cash Budget
- Availability of funds for investment purposes
- Availability of funds for distribution to owners
- Availability of funds for the repayment of debt
