MANAGEMENT SERVICES BULLET NOTES – MAY 2024 CPALE

by: HCU, CPA

Cost Concepts

• Managerial accounting information is generally prepared for managers.

• Relevance and Usefulness – major reporting standards for representing managerial
accounting information.
• Relevant range – range over which cost relationships are valid.
• The scatter-diagram method considers more than two points.
• Least Squares Method / Regression analysis separates a semi-variable cost into fixed
and variable components with the highest degree of precision.
• Coefficient of correlation – a measure of the extent to which two variables are related
linearly.
• For the dependent and independent variable to have a strong relationship, their
correlation coefficient must not exceed 1 or -1.
• Coefficient of determination – the amount of variation in the dependent variable
explained by the independent variables.
• Managerial accounting places LESS EMPHASIS on precision and more emphasis on
flexibility and relevance than financial accounting.
• Basis for the high-low method should be the cost driver.

Cost-Volume-Profit Analysis

• According to CVP analysis, a company could never incur a loss that exceeded its
TOTAL COST.
• Introducing income taxes into cost-volume profit analysis increases UNIT SALES needed
to earn a particular target profit.
• If a firm’s net income does not change as its volume changes, the firm’s sales price
must equal its variable costs.
• In a multiple-product firm, the product that has the highest contribution margin per unit
will generate the most profit for each unit sold.
• Degree of Operating Leverage (DOL) affects net operating income.
• DOL = Total Contribution Margin / Net Operating Income.
• In CVP analysis, sales and production are assumed to be equal.
• All other things the same, the margin of safety in pesos at a given level of sales will tend
to be lower for a capital-intensive company than for a labor-intensive company with
high variable expenses.
• The margin of safety is an effective measure of risk for a company.
• Margin of Safety = 1 / DOL
• In computing for the breakeven sales, ALL fixed and variable costs should be
considered (production, selling, admin, etc.)
• % of Increase/Decrease in sales x DOL = % Increase/Decrease in income before
income taxes.

Absorption vs Variable Costing

• Variable costing = Direct costing

• Absorption costing = Full costing / Conventional costing
• Under variable costing, ALL product costs are variable.
• Under variable costing, period costs should be currently expenses because period
costs will occur whether or not production occurs, it is improper to allocate these costs
to production and defer a current cost of doing business.
 • Under variable costing, fixed expenses are used in the computation of operating
income, but not in the computation of the contribution margin.
• In preparation of external financial statements, FASB requires Absorption Costing to be
used.
• If a firm uses absorption costing, fixed manufacturing overhead will be included on
both balance sheet and income statement (sold = income statement, unsold =
balance sheet).
• Produce > sell = HIGHER INCOME and ASSETS for Absorption Costing
• An ending inventory valuation on an absorption costing balance sheet would always
be greater than OR equal to the ending inventory valuation under variable costing.
• When calculating for the difference between the AC and VC profit, change in the
quantity of all units in inventory times the relevant fixed costs per unit.
• Only fixed manufacturing overhead is inventoried. Fixed selling expenses are expensed
outright.
• Fixed cost per unit = Fixed costs / number of units PRODUCED

Standard Costing

• Price = Actual Quantity

• Quantity/Efficiency = Standard Price
• Four-Way Variance:

a b
VARIABLE FIXED
1 Actual AVR x AH + AFR x AH
2 BAAH SVR x AH + Budgeted FC
3 BASH SVR x SH + Budgeted FC
4 Standard SVR x SH + SFR x SH

SEV Variance (Spending, Efficiency, Volume)

Spending Variance = 1 vs 2
à Variable spending variance = 1a vs 2a
à Fixed spending variance = 1b vs 2b

Efficiency Variance = 2 vs 3

Volume Variance = 3 vs 4

(Un)Controllable Variance

Controllable variance = 1 vs 3
Uncontrollable variance = 3 vs 4
Total Variance = 1 vs 4

• If Budgeted Fixed Cost (BFC) is not given: Standard Output x Standard Rate
• If standard hours is not given, always based it on the ACTUAL OUTPUT (actual output x
standard direct labor hour per unit)
• Budget – internal and expressed in TOTAL.
• Standard – external and expressed in PER UNIT
• Primary purpose of using a standard cost system is to provide a distinct measure of cost
control.
• The purpose of standard costing is to simplify costing procedures (by applying
overhead rate)
 • Standard costs may be used for product costing, planning, and controlling.
• If a company is using very tight (high) standards in a standard cost system, it should
expect that most variances will be UNFAVORABLE.
• Normal standard – challenging, yet attainable results.
• Fixed overhead volume variance – least significant variance for purposes of controlling
costs, but most useful in evaluating plant utilization.
• Standard price excludes any discount availed/taken.
• Standard labor price includes taxes (e.g. employment taxes imposed on the basic
wage rate).
• Based on xxx DLHs = Budgeted Fixed/Variable Cost

Budgeting

• Budgets are a quantitative expression of an organization’s goals and objectives.

• The primary role of the budget committee is to decide on general policies, compile the
budget, and manage the budget process.
• The first part of the master budget to be prepared would be the sales budget.
• Master budget – comprehensive set of budgets that serves as a company’s overall
financial plan.
• Continuous/Rolling – a budget that includes 12-month planning period at all times.
• Capital budget – company’s plan for the acquisition of long-lived assets.
• The budgeted income statement, budgeted balance sheet, and budgeted statement
of cash flows comprise the final portion of the master budget.
• Budgeted production = planned ending inventory + budgeted sales + actual
beginning inventory
• Budgets are prepared in the following order: Sales, Production, Manufacturing
Overhead (SPMo)

Incremental Analysis/Relevant Costing

• Incremental Analysis – the process of evaluating financial data that change under
alternative courses of action.
• Incremental Analysis = Differential Analysis
• Relevant costs are anticipated FUTURE COSTS that will differ among various alternatives.
• Differential cost refers to the difference in total costs that results from selecting one
alternative instead of another.
• Opportunity cost will ALWAYS be a relevant cost. There are instances where variable
cost becomes irrelevant.
• Relevant costs are ALWAYS avoidable costs.
• Avoidable fixed costs are relevant costs.
• The minimum selling price that should be acceptable in a special-order situation is
equal to the variable costs.
• Allocated costs are considered as irrelevant costs.
• Salvage value of the old equipment is a relevant cost in a decision whether old
equipment presently being used should be replaced by new equipment. Book value is
considered as irrelevant cost.
• Split-off point – point in the production process when joint products are readily
identifiable.
• Joint costs – costs incurred prior to the split-off point.
• When a scarce resource, such as space, exists in an organization, the criterion that
should be used to determine production is the contribution margin per unit of scarce
resource.
• Avoidable costs are costs which can be eliminated in whole or in part if particular
business segment is discontinued.
 • A cost may be relevant for one decision making situation but irrelevant for another
situation.
• If operating at capacity, the relevant costs are total variable costs + lost contribution
margin.
• If operating below the capacity, the relevant cost is only equal to the total variable
cost.
• Annual operating costs that are common to both the old and the new
equipment/machine are an example of irrelevant cost. Only the difference is
considered as relevant.
• Cost of the original machine/equipment (old) is considered as a sunk cost.
• The estimated salvage value of an existing machine represents an opportunity cost of
selling the existing machine now.
• Allocated common costs are not considered in deciding whether to close a division or
not. Traceable fixed costs are considered.
• If a product is considered as obsolete, the relevant cost/minimum price is equal to the
variable selling price + opportunity cost, if any.

Responsibility Accounting

• Responsibility accounting – operations of the business are broken down into reportable
segments and the control function of a foreperson, sales manager, or supervisor is
emphasized.
• Goal congruence – when managers of subunits throughout an organization strive to
achieve the goals set by top management.
• Sub-optimization – opposite of goal congruence where a management decision may
be beneficial for a given profit center, but not for the entire company.
• Responsibility center – cost object under the control of a manager.
• Responsibility centers: revenue, cost, profit, and investment (standalone).
• Controllable costs are costs that are likely to respond to the amount of attention
devoted to them by a specified manager.
• The profit figure that is preferred in connection with the analysis of a division or
department is the operating income.
• Variance analysis would be appropriate to measure performance in revenue, profit,
and cost centers.
• Residual Income = Operating Income – (Minimum Rate of Return x Operating Assets @
BV)
• Economic Value Added (EVA) = Operating Income After Tax – (Average Operating
Assets @ Market Value x WACC).
• Return = Net Income (Numerator)
• Turnover/Margin = Sales (Numerator)
• Profit margin = income / sales
• Du Pont model measures return on investment (ROI)
• Service departments costs can be allocated using the following: direct, step, and
algebraic method (the most accurate method)
• The primary purpose of a balanced scorecard is to give managers a way to forecast
future performance. Balanced scorecard considers qualitative and quantitative
factors.
• Segment profit margin considers both controllable and noncontrollable fixed costs.
• In deciding whether to invest or not, uncontrollable fixed costs are considered.
• Imputed interest rate = Minimum rate of return
• Capital = Asset
• Invested capital = Operating assets
• In step method, if the problem is silent, allocate the HIGHEST cost.
Transfer Pricing

• From the standpoint of the company, the important question in transfer pricing is
whether or not the transfer should take place.
• Transfer pricing system should reflect organization goals.
• Market-based transfer prices are best for the company when the selling division is
operating at capacity.
• Negotiated pricing – the transfer pricing method that allows managers the greatest
degree of authority and control over the profit of their unit.
• The price of goods transferred between the division needs to be approved by BOTH
divisional managers.
• The minimum potential transfer price is determined by incremental costs in the selling
division (variable costs).
• Transfer prices for sales between divisions located in different countries should consider
the tax structures in the two countries.
• Transfer price based on full production = variable + fixed manufacturing costs only
• Minimum transfer price = variable costs
• Maximum transfer price = Market price (if not given, selling price)
• If the excess capacity is not enough to supply the quantity demanded, the minimum
transfer price is computed as: variable cost + (lost contribution margin x excess/total
demand)

Capital Budgeting

• Accounting Rate of Return = Expected Net Income / Average Investments

• Payback period is the length of time over which the initial investment is recovered.
• Payback period does not consider the time value of money and ignores performance
beyond the payback period.
• The interest rate to find the present value of a future cash flow is the discount rate.
Other terms for discount rate are required return, cost of capital, hurdle rate.
• A firm’s discount rate is typically based on its cost of capital.
• Cost of capital – combined weighted average interest rate that firm incurs on its long-
term debt, preferred stock, and common stock.
• The project profitability index and the internal rate of return will sometimes result in
different preference ranking for investment projects.
• Internal Rate of Return – the rate of interest that produces a zero net present value
when a project’s discounted cash operating advantage is netted against its
discounted net investment. Can be solved through interpolation or trial and error.
• IRR > Discount Rate, Positive NPV.
• IRR < Discount Rate, Negative NPV.
• The profitability index is the ratio of the present value of cash flows to the original
investment.
• Capital budgeting uses financial and nonfinancial criteria when evaluating projects.
• Most capital budgeting techniques focus on cash flows.
• If the problem is silent in computing for the rate of return, use the average method if
there is salvage value.
• Basis for the computation of rate of return is ANNUAL.
• In computing for the net present value, only the cash inflows are discounted.
• Tax Shield Savings:
o Cash expenses – 70%
o Noncash – 30%
Assuming the tax rate is 30%
• Increase in working capital = tax rate not considered since the values considered are
balance sheet items.
Cost of Capital

• CAPM Approach = RF + beta (RM – RF ) ; RM – RF is also called as Market Risk Premium.

• DCF Approach = (D1 / P0 ) + G; DI PO G
D1 = Next Dividend, P0 = Current Price, G = Growth Rate (usually given)
• Cost of New Common Stock = [D1 / (P0 – Flotation Cost)] + G;
Flotation cost à the cost of issuing new securities.
• Cost of capital à the cost the company must incur to obtain its capital resources.
• WACC represents the overall cost of capital from all organization financing resources.
• Cheapest to most expensive cost of capital:
1. Debt
2. Preferred Stocks
3. Retained Earnings
4. Common Stocks
• When calculating the cost of capital, the cost assigned to retained earnings should be
lower than the cost of external common equity.
• Cost of Debt = Interest Rate x (1- Tax)

Financial Statement Analysis

• Financial ratios can help identify the reasons for success and failure in business, but
decision making requires information beyond the ratios.
• Long-term creditors are usually most interested in evaluating the profitability and
solvency of a company.
• Ratio analysis – a technique for evaluating financial statements that expresses the
relationship among selected items of financial statement data.
• Horizontal Analysis = Trend Analysis
• Vertical Analysis = Common Size Analysis
• If the ratio uses both balance sheet items, no need to average.
• If the ratio uses an income statement account and a balance sheet account, the
amount of the balance sheet account must be the average amount.
• Days Sales Outstanding = AR Turnover
• Inventory Turnover – if COGS is not given, use sales as the numerator.
• Times Interest Earned (TIE) = EBIT / Interest Expense
• EBITDA Coverage = EBITDA / Interest Expense
• Cash Flow per Share = (Net Income + Depreciation) / No. of Shares
• Equity Multiplier = Total Assets / Total Equity
• Dividend Payout Ratio = (Total Dividends to CS / OCS) / EPS
• Dividend Yield Ratio = (Total Dividends to CS / OS) / Market Price

Working Capital Management

• Cash Conversion Cycle = Days in Inventory + Days in AR – Days in AP

• Operating Cycle = Days in Inventory + Days in AR
• A lockbox plan is used to speed up the collection of checks received.
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 • Total order cost = (Annual Demand / EOQ) x Cost per Order
• At EOQ, ordering cost is ALWAYS equal to the carrying cost.
• Reorder point = (Daily stock x lead time) + safety stock, if any.
• Cost of giving up the cash discount = [discount / (100%-discount%)] x [number of
annual days/(credit period-discount period)]

Quantitative Analysis

• Linear Programming – a quantitative technique used for selecting the combination of

resources that maximize profits or minimize costs.
• The constraints in a linear programming model are scarce resources.
• Simplex Method Analysis – generally employed to arrive at an optimal solution. A linear
programming that is more accurate and complex.
• Four components of a time series: trend, cyclical, seasonal, and irregular
• Decision Tree Analysis – the modeling technique to be used for situations involving a
sequence of events with several possible outcomes associated with each event.
• In a decision tree analysis, the sum of the probabilities of the events is ALWAYS equal
to 1.
• Probability Distribution Theory -a quantitative technique useful in projecting a firm’s
sales and profits. More accurate and complex than the decision tree.
• Sensitivity Analysis – a popular approach to recognize uncertainty about individual
items and to obtain an immediate financial estimate of the consequences of possible
predicting errors.
• PERT-CPM – the critical path through the network is the LONGEST path.
• In the PERT, slack is the number of days an activity can be delayed without forcing a
delay for the entire project.
• Crashing – the process of adding resources to shorten selected activity times on the
critical path in project scheduling.
• Learning Curve: y = axb
y = cumulative average time
a = time to produce initial quantity
x = cumulative units of production
b = learning curve coefficient
• Critical path – only crash activities that are within the critical path.
• Learning Curve – process is improved overtime due to learning and efficiency.
• Learning curve assumption: output doubles due to learning and efficiency.

Economics

• Demand – downward sloping

• Supply – upward sloping

>1 Elastic = luxury goods, with close substitutes

1 Unitary Elastic = Electronic Products
<1 Inelastic = Necessities, no close substitutes

Perfectly inelastic – medical products

Perfectly elastic – gold

• Short run – 1-5 years (produce until price = marginal cost)

• Long run – 6 years onwards (economies of scale, average cost of the business
decreases)
• When markets are perfectly competitive, consumers have goods and services
produced at the lowest cost in the long run.
• A monopolist tends to produce substantially less but charge a higher price.
• In an oligopoly market, there is mutual interdependence of firm pricing and output
decisions (suppliers talk about the pricing – e.g. PLDT and Globe).
• Monopolistic competition is characterized by a relatively large group of sellers who
produce differentiated products (e.g. Divisoria).
• Movement along the demand curve = change in the quantity demanded
• Boycott = decrease in the demand for the product
• Short run – law of diminishing returns
• Long run – economies of scale
• The law of diminishing marginal utility states that marginal utility will decline as a
consumer acquires additional units of a specific product.
• During the recessionary phase of a business cycle, potential national income will
exceed the actual national income.
• Economists and economic policy makers are interested in the multiplier effect because
the multiplier explains why a small change in investment can have a much larger
impact on gross domestic product.
• M1 = cash
• M2 = cash + cash equivalents
• M3 = cash + cash equivalents + investment
• In order for the BSP to increase the money supply, the appropriate policy would be to
engage in open-market purchases of government securities.
• The BSP’s reserve ratio is the specified percentage of a commercial bank’s deposit
liabilities that must be deposited in the central bank.
• Maximum increase/(decrease) in the money supply = Amount of government securities
/ required reserve ratio
• The discount rate of the BSP is the rate that the central bank charges for loans granted
to commercial banks.
• To reduce demand-pull inflation à increase taxes and decrease government
spending
• A period of rising inflation increases the price level, which is negatively related to the
purchasing power of money.
• The Laffer Curve predicts that if taxes rates are too high and they are raised, tax
revenues will decrease.
• Frictional unemployment – unemployment that is caused by a mismatch between the
composition of the labor force.
• Marginal Propensity to Consume = increase in purchases of goods and services /
increase in equilibrium