Managerial Cost and Budgeting Skills: Easily learn management productivity to become a super star

1. Managerial Accounting Introduction: How can your business reduced risk of failure during a hit to the economy? How much labor should you have for the year? What impact will poor quality materials have on your business performance? When those questions come up, you can improve your decision-making using tools in managerial accounting. I want to welcome you to this managerial accounting course. My name is Eric night. I'm a CPA. I have degrees in accounting and a doctrine in Business Administration. I spent many years in business and academics. This course is designed to help you learn the basic building blocks and managerial accounting. The tools you will learn will improve decision-making as a manager. What we'll start by developing basic terminology. Then we use those concepts to analyze the business. We then use that analysis to improve decisions. We also spend a lot of time when budgeting both the nuts and bolts of building a budget and the use of the budget to improve efficiency. I will use real-world types of businesses and cases to explain each topic. Each lesson is concise and to the point, I am passionate about helping individual succeed in their endeavors. So let's begin. 2. An Overview of Managerial Accounting: In this lecture, we're going to start from the beginning, we're going to look at what managerial accounting is. Manager accounting basically is providing information to help managers the tools that managers need to make their decisions. It's very different from financial accounting. We won't need to do any kind of journal entries in this class are building a new financial statements. Instead, what we're gonna focus on is the tools that students need to learn in order to the outcome good managers later. So that's gonna be the key to this, to this class and what we're gonna focus on. Now that we understand kind of what management accounting is all about. Managerial accounting is more about management than it is about financial accounting. Providing you with tools that we're going to learn that you're going to need for things like setting up costs, making decisions on how much capital you need. And we're gonna get the capital, where to put the capital, how to plan from budgets, how to use budgets. So those are all big parts of this course throughout this entire class. First of all, let's see who is it useful for? For any organization? It's usually for any organization is useful for, for-profit organization, is useful for corporations, useful for small businesses. That's useful for non-profits. Governments. Basically, any business that has managers is quite a need. This type of work that I assume would mean most students are going to be working for some business as a manager. At some point, who uses who in the organization or who associated with the organization uses this managerial reports? That's a good question. Well, basically internal users, what we're looking at is people inside the organization, managers and employees that work for the company. The information that developed in managerial accounting is not for the general public, specifically for the management inside the organization. So when we talking about management, we are talking about three different areas. So managers do these three things within their jobs. That is planning, directing, and controlling. So this is really just management discussion here. There's not any kind of accounting. A man, planning is focused on forward thinking it. So when we're planning, when you're planning, you want to think about where you want to go. If you are going to, for example, fly an airplane, you would first determine where you would want to go with plan out your, your flight. So this is the same thing with management. They're going to plan out where they want the business to go ultimately. Now, directing is about putting that into into play, putting those plans into play the day to day decisions. That would be as if you were the pilot and the plane. Now you have a plan, now you get into Plan, follow all the procedures to start it and you put it in the air. You move the control stick to point in the right direction. And you're directing, you're putting the plan into action. And then you find, and then we're going to finalize this with controlling. Controlling as getting feedback. Evaluations. In other words, how good of a job are you doing when you start the flight and if you wanted to fly to to Canada, you would point north. But then things might change. You might need to make adjustments to get you to your destination. You probably haven't place-specific in Canada, so maybe Toronto. And so you have to fly to the north east from where you are. And you have to make these adjustments to keep yourself going in their direction that you want to go. The same thing goes in business, even though you have a plan, things change as we all know, and you'd have to make these adjustments. And so what we're doing in managerial accounting is providing you with the reports that you're going to need a manager to plan, budgets, strategies, hire people, directing. How many people do you need? How much material do you need? How much? What kind of building do you need me in? And then controlling, and that's getting feedback. What kind of variants do you have from your budget or you're way off on your budget? You need to hire more people than you thought. You need to buy material from a different place. So these are all the different areas that we're going to focus on in managerial accounting to become effective managers. 3. Managerial and Financial Accounting: In this lecture, we're going to talk about an important concept in understanding managerial accounting. And that is that managerial accounting is very different from the financial accounting that you might have taken in the past. Financial accounting and that you took in the past where you built financial statements like income statements, balance sheets, and you had to use what they call GAAP, or generally accepted accounting principles. That's very different from the managerial accounting that we're gonna be doing in this course. The most important and the key difference between the two is who the user is. The user is the key difference between these. So the managerial accounting focuses on a user that's internal. By internal users we mean managers, employees, people who are associated with the business because they have some type of job or some type of contract the business. Financial accounting focuses on external users. By external users, what we're talking about are chiefly focusing on investors. By that I mean shareholders, stockholders and creditors, banks or other lending institutions. So the user really creates all the differences between managerial and financial accounting. Remember, financial accounting is designed to provide information to these people who are external to the business, meaning they don't have access. So remember that they don't have access. Internal use. Internal users use the managerial reports. So these are, these are like managers and employees. They have access to the information because they work there. And they have the ability to get information that external users don't. The managerial reporting. The purpose is to create reports and provide tools for the managers, for the employees and managers, financial accounting, we're going to be creating financial statements, income statement, and balance sheet. All right, so again, the users are what's generating the differences between these two. So the financial statements are created using Generally Accepted Accounting Principles or GAAP. In other words, this is a standard that must be met. There is no flexibility in creating the financial statements. If you remember from financial accounting, income statements and balance sheets have to be done in a very specific way. You can't make them based on how you would like to make them. Whereas management, Management reports, we don't have to worry about protecting external users. We don't have to worry about protecting people because they are internal and they have access. There are no strict standards. And that allows managers to have flexibility to do things the way they want to, because investors and creditors aren't depending on those reports. There's management reports aren't are not available to external users, they're only available internally. And because of that, we don't have to protect anybody. Protected shareholders. We don't have a particular banks, whoever, depending on the reports because they're not using these reports, they're using financial statements. Because they financial statements are being used by external users that don't have really a way to check to see if the numbers are accurate, they must be audited. A third party goes in and double-check to make sure that the financial statements represent the business. In other words, the income statement and balance sheet show the business in their true light. That's what the independent auditor has to do with managerial accounting. We don't have to worry about protecting the investors and creditors. Since we don't have to worry about protecting them, there's no need for independent audit. Now, there may be an internal audit and things of that nature, but that's different from the need for an independent audit, which is necessary for financial accounting, but not for managerial accounting. Very important to understand this and if you think about it, every single one of these we've talked about so far, these differences are all derived because of the users that we're focusing on. The financial accounting reports, the income statement balance sheets, you may recall are based on what they call historical basis. In other words, we're looking at things that happened in the past. You could also include that kind of focus on past activity. So think about it. You do the balance sheet, you're doing it for previous years or previous months. You're not doing the balance sheet for next year because it hasn't happened yet. However, with a managerial reporting, we're going to project forward. The reason for that is because managers want to make decisions today that are based on what they think will happen in the future. What happened in the past is of no relevance to them. What happened in the past? Happened in the past, it's already occurred. Managers want to make a decision today and they want to make the decision based on what they think is going to best benefit the business in the upcoming future. They're going to look at reports, management reports that are estimating what is likely to occur or are ones projected to occur in the future. There's more of a focus on the future. Financial accounting makes reports that are done at specific times, definitely done annually. They are often done quarterly by quarter. I mean, three months, January, February, March would be one-quarter, and even monthly, depending on the business. But these specific timeframes are when the financial statements would have to be done. With managerial accounting, however, these can be done anytime. Remember, management has flexibility. So anytime managers want them, then we can do them. That's another huge difference. And again, why is that? Difference exists? Because of who the user is. External users are looking for information at specific time-frame so that they can make their decisions as an external user, an internal user might have decision to coming up at odd times, you know, they might have, they might be thinking about building a new factory. And that happens to be in the middle of May, for example. They want reports at that point. They don't have to have the reports annually, quarterly, monthly. They can have them when they need them. That flexibility is a key element, is the key element to managerial accounting because the internal users are allowed to be flexible since we do not need to protect them because they have internal access. Financial accounting though does not have that flexibility. We've already talked about this a little bit. They must follow standards and the reporting. They're not flexible and reports because the external users need to know the exact way to financial statements are gonna be made when they're gonna be made and how they're going to be made so that they can use them as external users. Because their external we need to protect them because they don't have access to the information. They're not insiders. Another difference that we have between these two is financial accounting. We had to make the reports based on the entire business. However, in managerial accounting, we have flexibility depending on how managers want to see the reports. Maybe they want to see them by product. Maybe they want to see the reports by geographic region. In other words, the businesses in the North versus South and the East, so forth. Maybe they want to see the business, the business split up by departments, or maybe they want to see the businesses split by segments. I'll just put etc, because managers can split the business up and look at reports any way they want. Maybe they're thinking about expanding their line of sporting goods, but they're not really worried about their other lines of products. So they want to get a report just on the sporting goods. They can do that in managerial accounting because they're allowed flexibility. Again, because the internal users have access and we don't need to protect them. However, with financial accounting, we can't just pick apart the business and report any piece we want. We need the investors and creditors to know about the entire business. Make sure you have a thorough understanding of the difference between managerial and financial accounting. 4. Trends in Managerial Accounting: This lecture we're gonna talk about trends in managerial accounting. What that really means is trends in management. So this is where management is heading as far as making their decisions. What kind of tools or have they have coming up? Most of this is based on on new technologies and how we're using these new technologies to make management decisions a little bit different than they'd been made in the past. So these are some of the key areas that we're going to focus on. Well, one of the first things we're gonna talk about is critical thinking. Right? Now this may not be a new trend. It shouldn't be a new trend. We should always be thinking critically as a manager. And the way I want you to think of critical thinking is that you ask yourself, why? Why are we doing this? You may have worked in a place before you go to do a certain transaction a certain way. And you wonder I wonder what's going on with this transaction and you ask somebody, why do we do it this way? And they tell you something like, well, that's how it's always been done. Critical thinking isn't like that. Critical thinking is more and long lines of when we do something, we make decisions and management, we know the rationale for doing that. We know why we've done in the past and maybe if we should continue to do it in the future. This is something that we should always consider in this class and something I want to try to keep in mind with every lecture, in every discussion we have. And that is, instead of just learning about some of the tools we learned, like for example, learning about budgeting are learning about break-even points are variances. All along the way. I'm going to talk about why, why do we learn those things? And I'm going to bring in some experience I've had in the past from my real-world work. And hopefully that will illuminate the rationale for you and learning this. Let's look at the neck mixture and we have, the next trend we'll look at is something called an ERP system, that stands for enterprise resource planning system. So an enterprise resource planning system is a system that integrates the company information. It streamlines everything. What I mean by that is instead of the accounts payable having a system where they track and deal with accounts payable and HR having a system where they account and deal with hiring and firing and benefits. And instead of accounting, having a system, instead of supply chain management having their own system. The ERP system basically is one system the dictator organization uses. By using once organization we integrate and we're able to better communicate. Obviously, each department and each area will have security over their area, but when information is needed from one area to the next and that is allowed, then it's much easier to get that information. One of the things you probably have noticed is that our world is generating more and more data. We're generating what they call big data. Big data is the massive amounts of massive quantities of data that we now have access to. The statistics show, at least at the time of this recording, is that 90% of the world's data has been generated in the last two years. Amazing is that we're talking about enormous amounts of data. Well, the data is only useful if we can understand it. Because of new software, a new hardware, and new algorithms that we have. We're now able to use that data to make decisions that we've never been able to make before. And even to go a step beyond that and not just make decisions that we weren't able to make before. But know about trends that are coming out of the data that we didn't even know to look for in the first place. That's what big data does for us. An example you might know of as all the Google searches that are out there. All the information that's available on Facebook, all this data that's just massive quantities of data, can help provide management with information that they didn't have in the past and it can have an influence on their decisions. So just keep in mind big data is something that's definitely coming up. Another thing to consider is management by way of Lean thinking. By Lean thinking, what we're talking about is basically focusing on quality and minimal waste. Lean thinking is about focusing on inequality and minimizing waste. This idea that managers get certifications. In Lean thinking means that managers are being specifically trained in order to help their businesses get higher-quality and reduce their waste. Certifications include Six Sigma and Six Sigma. As a qualification you might be interested in as a manager because it's a really highly sought after certification and it can reap benefits for you financially. You'd get different levels of Six Sigma Certifications. And the higher level you have than the better off you are. That's six Sigma is a certification that management managers can get to allow them to be experts in this approach to lean thinking. One of the trends we know of is that the economy is changing. It's going to a knowledge based economy rather than manufacturing. This has been a trend that's been going on for quite awhile. We see it all the time. Technology is one of the big drivers of this. Even if we did a lot of manufacturing in the United States, think about it. We're not going to do is do that manufacturing the same way that we did in the past. We use more robotics, more technology versus more pure human effort. So what do we do instead? Well, the, especially the US economy focuses on the service industry and retail industries versus the manufacturing side. That means managers needed to, need to understand this and they needed to be aware of the shift in the economy. This goes along with another trend which is called globalization. Globalization, as you know, just means that we're able to impact a larger area of the globe, were able to reach farther across the globe and easier than we were in the past. Again, this has been a trend that's been going on for many decades. So it's not anything new that you would not know about. But we should be aware that this does affect management. One of the ways that affects management is who is your competition? Competition used to be very well-defined and used to be people that were fairly close to you. Now your competition can be across the globe and the other side of the world. This understanding globalization is going to mean that managers need to be aware of a broader scope when they make their management decisions. My understand that a lot of times managers are thought of as just being the people, the employees in an organization that are in charge of making profits for the company. Profits are important. However, there's been a change recently in the focus of organizations and what makes a successful organization. This change is now meaning that more organizations are focusing on sustainability rather than just purely on profits. Sustainability means you'll be around for the long haul. Making profits is great, but if you make all your profits early on and then later on, you don't have any room for yourself because you exhausted all your resources, then you're not going to be very successful. So we need to understand that sustainability in our, in our business. There's a more of a push instead of just looking at profitability to look at what they call a triple bottom line. So the bottom line in business has historically meant the very bottom revenue minus expenses gives you the bottom line under the expenses is the bottom line and that is the profit that you have. But a triple bottom line means that you look at, you do look at the economic element, but you also look at social elements. Are you able to sustain yourself socially? Are you a good social citizen? Are you causing public Relations nightmares with your management style? And are you, How are you on sustainability? The environment that we know that plants and other petroleum industry has had to keep this in mind because they can't just be focused on making as much profit as they want. Because if their impact to the environment is so detrimental that they get put out of business, then they didn't really do themselves any favor. That's what sustainability is all about management. Management focusing on broader scope of their success rather than just an economic success looking at social and environmental success to Along those lines, we also have something called integrated reporting. With integrated reporting, it's similar to this triple bottom line. Instead of looking at just the financial profitability, you're going to look at various elements, various segments of the impact your business has on the world around it. With integrated reporting, you report on, you do an actual report on the financial, So the financial capital that you have. You all split. You also look in your report on your manufacturing, and then you report on your intellectual capital. What kind of intellectual advances have you made? What about your human capital? If you recall, in typical business, your typical financial statements like your balance sheet, does not show you the value of your human capital. But this integrated reporting would try to bring that into the mix because that's a very important part of who you are as a business. What about your social and relationship capital? Reporting on what kind of a social citizen you are. What kind of relationships do you have with your vendors, with your customers? Those are all key elements in management being successful. And so we want to keep that in mind. And that's why this integrated reporting includes a report on that element too. So, so far we are integrated reporting would include five elements of reporting rather than just financial. Finally, we have a natural capital. Like, what kind of natural capital is your business based on? What kind of natural capital do you require for your business to sustain itself? How is your management doing, managing their needs of their natural capital? So those are all different and important elements. Our last little section of our trends is based on the ethics in business. And so we'll talk briefly about the Sarbanes Oxley Act of 2002. After certain very high-profile situations occurred. Enron and WorldCom for example, those were two very high-profile situations where management acted unethically and a lot of people, stockholders and employees who were fairly innocent in the situation, they got hurt really bad. And so the public store to lose confidence and what they could rely on. The Sarbanes Oxley Act came about that really allow the public to feel more confident about relying on those financial statements. Basically, in a nutshell, Sarbanes-Oxley Act, which is also shortened to socks. You often, you often see it like that. Basically says that the executives, the managers that are in charge, the CEO and CFO can be held personally accountable for the things that go on, the controls to take, to make sure things go right on their financial reporting. What that means is in the past, the managers or CEO and CFO might sound like a big name, but really all they are as an employee of the company. And as an employee, when things went bad for Enron and WorldCom, they basically step back and said, Hey, it's not my fault. I'm just an employee, I just work here. They were fairly successful. I mean, that they did go to jail, but it was kind of difficult to hold them accountable. And these new rules from Sarbanes-Oxley made it easier to hold the executives accountable for their lack of controls that were going on in their organization. Those are our trends in accounting. 5. Foundational Concepts: In this lecture, we're going to focus on some of the building blocks, some of the foundational level terms and ideas that we need to be effective managers. So if you recall, managerial accounting is basically providing tools for managers in order to make better decisions. Let's start with just a general overview of the different types of businesses that we run into. Basically, we were going to break it down into three general categories. We have a service in business and merchandising business and a manufacturing business. For purposes of this class, we're going to keep our businesses very, very pure, meaning. There's a lot of businesses out there that do multiple things. Take a company like Amazon, there are service. They also manufacture some things and they also obviously sell a lot of things. That's not a very good company to help learn the basics with. So when we talk about any of this stuff in this course, we're going to try to keep this pure. Like for example, a service company that just provides a service. With a service company, you're getting, you're selling a service. We're going to look at pure service. Meaning we're not going to sell any kind of products and we're not going to do any kind of manufacturing. We're providing a service which is intangible, meaning there's nothing physical associated with it. The service provides value to the customer. For example, a service of cutting down trees for residential customers in your ACT getting kind of manufacturing or retail sales or anything like that. The next one is merchandising. With merchandising, what we're doing is we re-selling tangible products. So products that have physical presence. Now we have two types of merchandising retailers and a retailer sales to the final consumer. So that would be like Walmart sells to you and then you use the product. And then we have wholesalers, wholesaler would buy from the manufacturer and then sell to the retailer. And then we have manufacturers with manufacturers were converting raw material into finished goods. So we have a raw material and we wanted to convert that to a finished good. So because of that, we have various types of inventory which will learn There's actually three. One, we have raw material, That's the basic material that we're going to use to build the finished good. We can convert that to the finished goods. Finished good is what we're going to sell in the middle here. And number two is what we call work in process. Work in process would be anything that we're building that's not quite done yet and by the manufacturer. So throughout this class we're going to think about the company as either being a pure service, a pure merchandiser, and a pure manufacturer. We're not looking at companies that are going to crossover and do different things. It's much easier to learn that way. Now these businesses create what they call a value chain. Let's talk about that for a second. Value chain is basically activities that add value to a product or service. Let's take us basic company that we're all familiar with. Let's take forward for doesn't just build cars, Ford builds cars, but they're not just doing the car building to load up on car somewhere. They're building the cars and then they're selling them. So there's a sales element. There's the logistics of delivering the cars to the dealerships. All those things go into it. So let's look at a typical value chain that you might see it forward. So we have research and development. So that's part of the value chain, developing better parks for the car, better cars in general. Then we have to take that research and development in the engineer's needs to put that into the design of the car. Then we have the production of the vehicles, right? So that's gonna be going on in the factory. Then we have the marketing. You've got to get word out to buy our cars. Then we have distribution, and then we have stuff like customer service after the sale. So this is a good example of a value chain. And it might not be complete, but just a good example and every business is going to have their own value chain slightly different. The thing that I want you to remember is that this value chain is integrated. Meaning that that if you're in marketing, you're going to have implications on the design of the car. If your InDesign, you can have implications into how things are produced. Your production facilities are going to have implications on the customer service. Because it's a chain that the cliche is only a strongest to weakest link is important for business to understand their value chain. Now a key element of managerial accounting is what they call cost management. That's one of the main focus areas that we're going to have in this class, and that is on managing costs. So let's get an overview of how that's going to look. First of all, managers, do you want to Categorize the different things that are going on in their business. They're going to take a business that does a bunch of things and they're going to break it up into parts and analyze each of the different parts. It's very common for managers to do that kind of thing. So one way for the managers to analyze the organization is by looking at the cost object. The cost object is anything for which the managers want to know the cost. Think of it as what they're going to focus on. Regarding cost. Here's some common ways we can look at cost objects. First of all, we might looked at the product as a cost object. So if you have multiple products, you sell shoes, we sell hats, you sell tie. Each of those would be the cost object, or you can do it another way, you can look at geographic regions. So your cost object might be the North division or the south division or departments in your organization like we have the accounting department, we have HR department. So those might be cost objects. So all we're doing is we're looking at breaking up the business into these cost objects. We can see how much they cost in those areas. And managers will be looking at these and for different reasons. So when you're looking at the cost object, anything that's a direct cost, the direct association with the cost object. Let's say you look at your cost object as one of your department stores. Let's say that's your cost object is this department store than anything this is directly associated with a department store is a direct cost. Indirect cost, or indirectly associated. It takes something like the delivery of goods in your store to the customers, maybe having some delivery. But this has done for all the department stores, not just the one you're looking at is your cost object. That's an indirect association. And we have something like that. You have to do an allocation. Allocation of cost object. Basically just means that it means that you're going to split up the cost and some way to assign it to the cost object. Let's think of an example here. Let's say our cost object is the Ford Focus. The Ford Focus. So anything that's a direct association with the cost object is going to be a direct cost. So this means it's anything that's directly with the Ford Focus. Just that particular product is going to be a direct costs. So it can be the cost of the engine, the battery that goes into the Ford Focus, the steering wheel, the tires. These are costs that go directly into the Ford Focus. These costs, I have a direct association, but then what about indirect costs? These would be my direct cost for the Ford Focus as the cost object. And then let's say indirect cost, the utility cost, the electricity. Electricity using the whole factory, not just to build the Ford Focus, to build a Ford Focus and the F150 and the other cars two, that means that needs to be allocated. So we need to take some of that cost and we need to put it towards the Ford Focus. By allocation we have that means we have to divide up between the different areas, in this case the different cars that are being built in the factory. So let's say we have the insurance on the factory. We have insurance on the factory. The factory Bill is a bunch of different things. One of the things they voted the Ford Focus, so we have to take some of the cost of the insurance and we have to put it towards the Ford Focus. So those are indirect costs because they don't have a direct association. It's not like insurance just on the Ford Focus. That would be a direct cost. This is insurance for all the cars that are made. There are different kinds of cars and we just need to take part of it put towards the Ford Focus. If it was something that directly went into the Ford Focus, that would be a direct cost in this case. The first question you have to ask yourself is, what is the cost object? 6. Product Costs: In this lecture, we're going to continue on with the basic concepts of managerial accounting that we're going to use throughout this course. As you recall last lecture we did and we talked about the cost object. And just to refresh our memory, that means any aspect of a business, the manager wants to know the cost and managers can divide up a business in many different ways, by geographic region, by the product, by the functions of the business. One of the most common is the product costs. Businesses that make different products often want to know how much each of those products cost. So this is a very, very common tool that managers use and are likely to use. Let's start out by just getting an understanding of this. We're going to want to take all the costs, all 100% of the cost of the organization. We want to divide it up, put it into either costs for the product or we want to put it as what they call a period cost. That the period costs are not related to the product directly But to the period of time. So we'll, we'll see what that means in a second. So as you recall, there are three types of organizations. There's the service, the merchandising in the manufacturing business. If you are a service business, then you're going to, you're not going to have any product cost. So if you are a service business, there are no product costs, are all costs end up being period costs. For example, your marketing, your customer service, payroll, electricity, anything, they're all considered period costs. What about the merchandising costs? How are we going to divide those up between the product cost and period cost? So remember with a merchandising company, we are selling products they're already made. So when we look at a merchandising company, the product costs are gonna be the cost of the inventory that we get from whoever manufactured it. The cost of the inventory. So the inventory cost, and then any costs to get that inventory to us ready for sale to the customer. So for eight, which is a fancy word for shipping, any other costs that we have to pay, like if we have to pay customs or duties or tariffs, those would all be costs that we need to do in order to get the merchandise inventory on the shelf. That leaves the rest of the cost of the period costs. So for example, marketing, customer service, accounts receivable, people that owe us money, businesses owe us money. Those would all be examples of period costs. These are not directly associated with the inventory costs, which are what we would consider product costs for merchandising type organization. What about the manufacturing business? With a manufacturing business is going to be a little bit more complicated because we're converting raw material into the finished good when we looked at the manufacturing business, if we want to do is we want to look at three areas that are associated with building the product in our factory. Now one thing that you want to keep in mind, you want to put this in your notes as to know the product cost and manufacturing is to focus on what happens in the factory. It has to be in the factory, for it to be a product cost for manufacturing has to be in the factory. We have three types. We have direct material, we have direct labor and manufacturing overhead. So those are the three costs that we're going to be using throughout this course. So it's very important that we get a grasp of these direct material. This is the primary material that's used in manufacturing our product. If we were manufacturing cars for Ford, it would be the steel, the rubber, the plastic that goes into the car itself, primary material. These are physically part of the car. You know, it's a direct material because you can go up and you can touch it. Isn't our tires of direct material. You can go up to the product and you can put your hand on the tire. So obviously it is. Then you have your direct labor. Direct labor are the people in the factory who are directly building the car. I call them like the hands-on people in the assembly line because they're the ones putting the steering wheel on the car, the other ones Installing the radio in the car. Now there's other people in the factory, but those are not direct labor. So there's somebody who's working there to fix the machinery. That's not direct labor. There's somebody who's in charge of the supervisor of the place that's not direct labor. You see inside the factory. There's other things going on and the rest of the stuff that goes on in the factory is manufacturing overhead. Let's look at a couple. First of all, we have the indirect material. What if we need some oils or lubricants for the machinery that does not end up in the car, it's used for the machinery. That's indirect material. Or what if we need some cleaning solvent to clean the floors of the factory? That's indirect material. It's a manufacturing overhead because it's in the factory. We had the same thing that's going on for indirect labor. You have a person who's in charge of fixing the machinery that breaks, that's indirect labor because that person is not actually putting the course together. So anybody in the factory, and if you want to get these right, you just have to think of this as in the factory. Product costs are in the factory. So anything that goes on in the factory is going to be a product cost if it's not direct material and direct labor than that product cost has to be manufacturing overhead, some other indirect costs associated with manufacturing and the Factory. We can have the insurance on the factory. There'll be careful here because if you have insurance on the sales office, that's a period cost because it's not in the factory. Remember, think in the factory. What about property tax on the factory? That would be an indirect cost associated with manufacturing, that would be overhead. But property tax on the home office, that would be a period cost because it's not in the factory. So all this stuff you could think of as being in the factory. All this stuff is anything else that goes on with the business with who's not in the factory, depreciation on equipment, that's definitely going to be manufacturing overhead, it's in the factory, but depreciation on the office equipment. That would not be utilities in the factory. That would be a manufacturing overhead, but utilities at the headquarters, that would be something else. We're assuming that the factory is not the same as the headquarters or the home office, just to make it simpler. Also remember that there's other things that could be period costs, anything that's not in the factory. But as a cost is a period cost. If it's not in the factory like a delivery van, that would be an example of a period costs are shipping. That would be an example of a period cost or marketing. None of these, none of these things go on in the factory. So that means that their period costs. To finish up this lecture, let's look at a few other concepts. These are concepts that we're going to use more later on in the course. But we're going to get an introduction to them now. First of all, we'll look at something called a differential cost. Differential cost is a cost where you compare two alternatives and you look at the cost difference between the two. When you look at differential analysis, that sounds like a big term, but all differential analysis mean is that you do an analysis and you compare costs that are different. Costs that are different are relevant costs. Relevant costs differ between alternatives. If they're the same between alternatives. So if you have two choices, we can go, we can ship to Houston or we can ship to Los Angeles. It costs the same. Well, that's not gonna help a manager make a decision. That's why it's not relevant. Relevant costs differ between the two alternatives. Comparing those costs is called differential analysis or differential costs. It's irrelevant. If there's no difference between the two. It's controllable. If managers have influence over the cost, we only want to evaluate managers, see if they're doing a good job on things that they have control over fixed costs. We're going to use this a lot later on. On. It's very useful to know your fixed costs because these costs are the same. No matter how many cars you make in your Ford factory or whatever business you have, no matter how much activity, no matter how many products you make, no matter how many people we service, no matter how many items you sell, a fixed cost is the same. So an example that might be rent. Rent might be a fixed cost because no matter how many Junior Department blouses you sell, the rents the same usually, variable costs are going to go up or down depending on how much you make or sell. For example, the more cars you make, the more steel you use. That's a variable cost. The cost is going to increase because the cost of steel increases, because you use more of it. It varies by volume of cars you made. The same for anything. The more people stay at your hotel. So the more breakfasts costs you have. So every person who exceeds your hotel and gets a free breakfast, that's a variable cost. If nobody stays there, you have no cost for breakfast. Makes sure you understand the difference between those two. We're gonna use them a lot in future lectures in this course. 7. Profitability: In this lecture, we're going to focus on profitability. And I think as managers, we all understand that to some degree we have to have an understanding of what that means to be profitable. Important part of making management decisions and what we call sustainability, meaning the ability to be around for the long haul and didn't know our profitability. Let's go ahead and look at the income statement, because that's the statement that's going to tell us the profitability. So income statement takes to sales revenue. Sales meaning what we sold. And that revenue from those sales. We subtract the cost of goods sold, and we get gross profit. Then from there we take away our operating expenses like marketing expenses, customer service expenses, things like that, that are needed but are not in the goods that we sold. And we get to operating income. And that's gonna help us to begin to understand profitability as managers. We're gonna look at the three different businesses, right? So we have the service business, we have the merchandising and the manufacturing business. What if we're a service business? Service organization, a pure service organization like for example, someone who maybe pains houses. They're just selling the service of pain house. They don't have any goods sold, so that makes it easy. Then a pure service business looks like this on the income statement. We take sales minus operating expenses and we get operating income. So that's a service business for you. If it's a pure service, what if you're a merchandiser? A merchandiser, they don't make the goods, they sell things that are already made. The cost of the goods sold needs to be determined how much they didn't cost of the goods we ended up selling to the customer's cost us. To do a cost of goods sold schedule, we need to know how much of the goods that we bought from the manufacturer end up being sold. We look at the balance sheet. The balance sheet tells us a value of the business. And so one of the valuable things of a merchandiser is the inventory they have. What we need to know is the value of the inventory on the balance sheet. Now we need to know the beginning inventory and the ending inventory. If we look at the balance sheet at the beginning of the year, and then we'll look at the balance sheet at the end of the year. Here's our business, let's say we're escape board business. We have a retail shop where we sell skateboards to people. We have inventory at the beginning of the year of $100, and then we have inventory at the end of the year of skateboards that we have in our shop like these are the skateboard on our shelves. $500 if we wanted to do a cost of goods sold schedule, if we took the beginning inventory, 10000, we compared it to the ending inventory of a 500. We might say, well, that's gonna help us to get our cost of goods sold. But we can't do that. We can't just take 1000 minus 500 and get that as our cost of goods sold. Because what if we purchased inventory? Let's say we purchased $10 thousand worth of skateboard inventory. Then we had cost of goods available to sell. That would be $11 thousand worth of skateboards that we had available to sell. We didn't sell them all. We we ended with $500 for the skateboard. So if we were to subtract that because we didn't we didn't sell it. If it's ending inventory, it's still there, then we have $10,500 worth of skateboards that we sold and that's our cost of goods sold for a merchandiser. And it goes right here. So it goes from here into the schedule and we can figure out the profitability. Now things get a little trickier when you're looking at a manufacturer, let's say we manufacturer skateboard and instead, well, if we manufacturer skateboards, we have three types of inventory. We don't just have the finished goods inventory, the escape course that are ready. We also have raw material, That's one inventory. And we have work in process. Some skateboards are working on. We have the skateboards that we've finished and we're ready to send to the skateboard shops that want them. Those are called finished goods. We have three inventories. So we're gonna have raw materials, the wheels, the decking that we would have, the stickers, the bearings for the wiggles. Those would all be raw material. We're gonna put those together. And while we're putting it together to work in process. And then when we finish it, it's called finished goods. When we're looking at this from the standpoint of doing this calculation, we need to know all three of those. So let's say the beginning of the year, we have some skateboards that we're working on valued at $2 thousand, work in process at the end of the year, skateboards that we didn't finish the end of the year worth 5 thousand. And then we have the finished goods, six thousand and eight thousand. Now for the raw material, we started out with the raw material and it was valued at 9 thousand. And at the end of the year, if we look on our balance sheet, we see that our ending raw material was 22 thousand. These are all dollar amounts. So the beginning inventory would be the finished goods we had to start with. So that would be 6 thousand and then purchases well, we don't make purchases of skateboard, rebuild them. We're gonna have to. Instead change that to cost of goods manufactured. That's going to be what we're going to use instead of purchasing, we're going to manufacture them. And that will give us cost of goods available and our ending inventory. Finished goods we had at the end of the year. So we have that information. The balance sheet tells us the value of the inventory at the beginning of the year. It tells us the value at the end of the year. We need to get this information to create this cost of goods sold schedule. But to do the cost of goods manufactured, let's go over here and do another schedule called the cost of goods manufactured schedule. So with the cost of goods manufactured, we need to know the three costs that go into manufacturing direct materials, direct labor and manufacturing overhead. We want under the direct materials that we used in the skateboards, not what we had leftover in raw material, but their direct materials we used. Now just note that at some points we use direct materials and some of these schedules, and sometimes we call it raw material. It's the same thing for our purposes. Direct materials used for now I'm going to tell you that and then we're going to look at how to calculate it in a little while. So direct materials used 14 thousand and then direct labor. So this would come from the payroll. And we have $19 thousand and payroll. And now we get to the manufacturing overhead. So we would have to know what our manufacturing overhead is. So this would be anything that happens in the factory. There's not direct material, direct labor, not period costs, but product costs that are in the factory that are not direct material, direct labor, for example, it would be insurance on the factory, depreciation, on factory equipment, rent, factory building. Those are kinds of things that would be manufacturing overhead. Let's say these total to $12 thousand. This gives us a good start on understanding what the cost of goods manufactured are. However, we're missing an element here and that's at the beginning of the year. We had some skateboards. We had already started where we hadn't finished. We call that work in process. So what about the skateboards? We're working process of beginning of the year. And what about the skateboards at the end of the year that we're not finished, that we're working process. If they're not finished, they're not manufactured. Manufactured means completely manufactured. We need to add the work in process at the beginning of the year and take out the work in process at the end of the year since it wasn't finished. So what we'll do is we'll add the beginning work in process and we'll subtract. Okay, so what I did was I added the beginning work in process of $2 thousand. Then I added all the costs. Work in process materials, labor manufacturing overhead. That gives me my total manufacturing cost of 47 thousand. So from here down to here give me 47 thousand. And this is my ending work in process of 5 thousand. My total manufacturing costs beginning work in process plus all those other costs with five or 47 thousand, I subtract from that the ending work in process of 5 thousand and I get 42 thousand. And then that is what goes over here. And my cost of goods sold, that means I have 48 thousand and cost of goods available for sale. My ending inventory is eight. That leaves me with 40 thousand as my cost of goods sold, and then that will then be pulled over into the income statement. Now one problem we have is that I just gave you the direct materials used. But we really need to figure out what those are. What we need to do with the direct materials used as figure out how much of the raw material was there in the beginning, how much was there at the end? And figure out how much of it was used to get this 14 thousand. Let's look at us another schedule. For my direct material used schedule. I'm gonna take my beginning raw material and my ending raw material from the balance sheet. If we go back up to my balance sheets, my beginning and ending balance sheet, my raw materials started out as 9 thousand at the end of the year. My balance sheet shows that I have raw material of 22 thousand. So I'll put that in my schedule. Beginning raw material nine, ending raw material 22 thousand. And then we also purchased some raw material. And during the year this is going to have to be given to you of 27 thousand. You could actually go to your purchasing department and find this out. So if you add up what you started with, with what you purchased, that means you had $36 thousand worth of material available for use. If you subtract what you ended with. Because if you ended with $22 thousand of raw material, that means you didn't use it. You want to know what you used? Well, that gives me the 14 thousand and that's where I got the 14 thousand that we used up here to get the cost of goods manufactured. It used over here to get the cost of goods sold, will use over here. 8. Processing vs Job Costing: In this lecture, we're going to discuss costs. Managers know that understanding the costs of their organization as an important part of decision-making. However, there are many types of businesses and therefore many types in many ways, costs can be approached. This lecture, we're going to consider costs in manufacturing. If you remember, we discussed manufacturing costs and we said there were three basic manufacturing costs. And those were the direct materials, the direct labor, and the manufacturing overhead. So we're going to look at those. And when we look at manufacturing, we're going to consider two pretty standard ways to cost products. One is called process costing and the other is called job costing, sometimes called job-order costing, but those are the same thing. The reason that you use one or the other is not because manager likes one or the other more than the other one. But the reason is basically the type of product that you have with product caught with process costing, what you're looking for, or large amounts of the same thing. It's something that you're producing over and over. For example, manufacturing M&Ms, that candy, or if you're manufacturing Coca-Cola, our potato chips. I know it seems I'm just looking at junk food, but the idea is that if you look at any of those products, they're all exactly the same. One bottle of Coke is the same as another bottle of Coke. One bag of M&M's is exactly the same as another bag of M&Ms. And these work well with process costing. So this system is what would probably pick if we were a manager. And that situation, job order costing is when you have a unique custom order or small batches of the same thing. Small batch order or custom order. Think about, for example, if you are manufacturing homes, every home would be unique and have a whole set of different costs. So unlike the bottle of Coke, where everything is the same between one bottle and the other. Every home, it's going to be unique in its own way. A large job like a Boeing aircraft, are, for example, if you're doing jewelry like wedding bands, or if you were making furniture, maybe not just mass-producing furniture, but you're making small batches of furniture for specific things. Like you're making a batch of sofas that go into a hotel lobby. Our chairs, they're gonna be used in a waiting room for a hospital. Even though they're the same thing, there's relatively small batches. Those work better with job order costing in that situation, what you're trying to do is get the cost of the job, because the cost of that job are gonna be slightly different from the cost of other jobs. Looking at process costing, again, we want to look for products that are very similar. So let's say you are a manager of a hot sauce manufacturing plant. Every bottle of your hot sauce is going to be similar to every other bottle. I think like Tabasco, for example. All you need to do is take your total cost. Just divide by the number of bottles that you produce. And then you can just use that as your cost for each bottle. That's very simple and that's one of the things about process costing. Is it simple to allocate those costs? Because everything is the same. One bottle of hot sauce is not going to be any different as far as the amount of resources that you need versus another bottle. We don't need to put more costs than one bottle versus another bottle because they should, theoretically at least, I'll use the same amount of resources. Let's say to make a batch of hot sauce, we need to clean the vegetables and other ingredients that we use. Chop them up, mix everything up, and then bottle it up and put a label on it. That's basically the process that we're going to go through to make a bottle. And that will work for all the bottles that we made. We figure out our costs for the year for manufacturing our bottles of hot sauce is $750 thousand is what we expect it to be. And then we were gonna manufacturer million bottles. Pretty big operation. So that comes out to seventy-five cents per bottle. Whenever we look at any bottle of hot sauce, we assume they're all going to be the same amount because they all are using the same amount of ingredients. They're using the same amount of electricity, they're using the same amount of resources. They take the same amount of time to set up any of the baskets that we put out. This fairly simple, fairly straightforward, as you can tell. Now, job-order costing is a little bit different because with job order costing, what we have is a situation where every job is unique. So if we make one wedding band, it might take more gold, it might take more stones, it might take more time. In other wedding band would take a different amount. Anything with homes, one home, even though they might have the same floor plan, one might use tile versus wood floor versus light fixtures that are more expensive than one versus the other. So every custom job or small batch that we do is unique. That's going to mean that it's going to be much more difficult to capture the cost along the way. For our example, we're going to use accompany that. Manufacturers skateboards, among other things. That'll be our job order costing example. So here's the overview of what's going to happen. We're going to take raw material for our skateboards. And that would be like the axles, the decking, the EU's, the labels, the wheels, the bearings, all those things. And we're going to convert them into the finished good. And while we're making the skateboard, while what's in the process of making they call that work in process. And then after it's finished, once we sell those skateboards, will have a good idea of what it costs us and that way we can figure out our profitability. And which is a key component to management understanding the profits for each product that you make. So it's important for, for example, a custom home builder to know the profits that he or she made in one house versus another. Profits that we make. And jewelry with each piece of jewelry is very different. So we can, again price it out. We can plan, we can manage the resources that we need. If you look at these raw material, it's an inventory, inventory of raw material that we have N a warehouse ready to be turned into skateboards. Just as on the balance sheet. The balance sheet tells us our resources. Work in process that's in the factory and it's partially built skateboards. So this inventory of partially built skateboards is also on the balance sheet. And then we have the skateboards that are completed, and these skateboards are now ready for a sale. There everything has been done. They've been completely finished. These are also inventory. These are also on the balance sheet, but none, none of this information in and of itself helps us to understand that profitability. It just tells us what we have available as managers. We can manage that, this process as we go through it, what they call a conversion from raw material into finished goods. Now when we finally get to the part where we make the sale, that is going to be on the income statement and this is not going to be an inventory. It's going to be the cost of the goods sold. And the better we understand the cost of goods sold, the better we understand our organization or business, the better management decisions we can make. Let's go ahead and delve into the process of capturing the cost as we go along. The manufacturing of skateboards in our factory. 9. Job Costing Material Costs: In this lecture, we're going to focus on costs, specifically cost in manufacturing custom orders or small batches. For that type of situation, we will probably use our management will probably decide to use job order costing. Well, first looked at capturing the direct material used in the job. As you may recall from the last lecture, what we're gonna do is we're going to look at converting the raw material needed and skateboards into the final skateboard that we plan to sell. You don't know the profitability of the skateboard until you figure out the cost of the skateboard that you manufactured. To figure out the cost of the skateboard that you manufactured, you take their raw materials and then you run them through the process of manufacturing. And then whilst running through the process of manufacturing, when you finally finished, you haven't finished good. Once that good is sold, we can figure out the profitability. So first things first in our factories, the first schedule we have is called the production schedule. So it's basically just a list of jobs. The salespeople, the marketing people have gone out and they've made sales. We now have to complete those jobs in the factory. Company sells in three different products. We sell the skateboard, we sell scooters and we sell and accessories like helmets. So as those jobs are promised, we need to put them on the production schedule so our managers know in the factory to be ready. As you see, we have three jobs that we need to complete in the factory. We have job 60364625. So we have a batch of skateboards. We need 50 of those. Those are to be completed from February second until February six. Then we have 50 scooters, 125 helmets, and those are gonna be completed between February 12th and February 15th. Now, these schedules are not the exact same at every business. As a matter of fact, every factory is going to have their own way of doing things. But this is just a typical thing you might see in order to organize the manufacturing process and give them, the managers their ability to do their job. The first thing we want to do is create a system uses schedule where we can track the costs for each of these jobs are first job being jobs 603. So let's look at a mechanism that we can use to track the job and the cost of going to a job 603, you will clear off some of this other information to make it easier to follow. The way we do that is we use what we call a job cost record. And the job cost record is gonna have the direct material and direct labor and manufacturing overhead. It's being applied to each job. So this is going to be for a job, 603, the 50 skateboards. And so what we wanna do is we want to track the direct materials that go into these 50 skateboards. The direct materials, as you recall, are materials that are specifically in skateboards. So it'd be the wheels and the bearings and the decking and the labels and the actual all those things that go into specifically into the skateboards are direct materials. If it's used in the factory as a material, but it doesn't end up in a skateboard like for example, if it's cleaning solvent for cleaning the factory floors, that is an indirect material. That's more of the manufacturing overhead side. What we want is just the stuff that we have in the skateboard as our direct materials. Later we'll look at direct labor, which is the people that specifically put the skateboard together. I call them hands-on people. And then we'll see how we can take all the costs that are associated with our factory that are not direct material and direct labor. And how we can carve out a chunk of those costs and assign it to this job of 50 skateboards in a way that makes sense. As we're going through and doing this job. The materials, the labor, and the overhead that's all being used in this job. This is part of how we track our work-in-process. This job cost record is going to be our work in process and once it's finished, that'll become a finished good and later on, cost of goods sold. But we're tracking the work in process as we go along with this job cost record. So when we look at the direct materials, the first thing we'll look at the first schedule that's going to be helpful for us, is called the bill of material. The bill of material. Think of it like a recipe card. It tells you how much you need of each of the parts to build the 50 skateboards or whatever job you're making. This job is going to be 50 skateboards. So we need a parts list of all the things that we would need to make 50 skateboards, just like, just like a recipe. A recipe to make our 50 skateboards. We need decking, we need axles and we need wheels. Now, there might be more things that you need, like labels for the graphics. A polyurethane and bearings and all that stuff, but we're just keeping it simple. I'm just taking up a few of the parts that we need. So you'd probably need more than this, but just to keep it simple for us, these are the three parts that we're going to focus on. To make it we need 50 decks because there's 50 skateboards, one per skateboard to access per skateboard and four wheels obviously. So we'll start with that. And then the next thing we'll look at is getting the materials from the warehouse where all the raw materials are kept and move them over into the factory or the schedule will use for that is called the material requisition. So this would be like the manager's job, maybe the manager of building these 50 skateboards. And he or she then needs to tell the warehouse or tell the whoever is in charge of the logistics of moving the parts around to go ahead and grab this these parts for me to put them into process. They would do that by using a material requisition and you would have one of these for each job. So our managers in charge of his job, go ahead and set up a material requisition. These are the three parts we're looking at and focusing on. We need 50 of the first part of the decks, one hundred and two hundred wheels. We have the cost for each and the total cost. And this now helps us to understand the costs that are going into the job from the direct material standpoint. Now that the workers in charge of moving the material around, No. Hey, does this requisition is telling us to move parts around. What they'll do is they'll go ahead and get those parts and move them and we'll use a direct material record to tell us how much inventory we have of these parts. And it'll also tell us what's been used in the jobs and what's available for the next jobs. Each part is going to have its own raw material record. Raw material records gonna show you everything that's going on with that part. The past we received a 100 deck boards and we use 70 of them in previous jobs. And so what we have available now in the warehouse are 30. Now this is a problem because in order to do jobs 603, the requisition is asking for 50. That means we need an additional 20 at least. Usually what happens or what's supposed to happen is that the managers in charge of purchasing are going to see, Hey, the bill of materials is out there. The requisition is going to come through soon. We know that the dates are February second for this skateboards. For that reason, what we need to do is we need to go ahead and order some more decks because we don't have enough. So we have 30 available. Let's generate a purchase order for some more. So a purchase order will be generated for 75 more decks from supplier. Why did we get 75 instead of 20? Usually you get more than than the exact amount. And that way you have some extra on inventory and case, some things get damaged or in case on or another, or it comes through for those kinds of reasons and how much extra inventory you get. It's really up to the management's discretion. They get to 75 and they go ahead and I use up 50 for the job. Now we have 55 left. Why do we have 5575 minus 50 is 25. Well, the reason is because we had 30 available. So we had 30 to start with. Then we received another 75 more received. Then we used 50. So that's why we have 55 available. Our factory needs some way of tracking this stuff and so there'll be some method you use for that to track that. Now it's time for it to go into the job cost record. The job cost record is tracking all the materials, labor, and overhead that is applied to this job. Well, at this point what we've done is we've taken the decks and move them into the job. That's all that we've seen happen so far. And because of that, moving into the job cost record and we're able to track the materials as they get put into the job. The other the other parts get brought in. We would also add those into the job as they get put onto the factory floor where the gate boards would be put into production, where they are being built. The flow so far for direct materials for our job. And we get the production schedule, we can get a plan and then we go to the bill of materials. Then that bill of materials, Let's the managers know what they need. Then the material records is the managers that are actually part of the building process asking that materials get pulled from the warehouse into the factory, onto the floor. Then once those materials are pulled into the factory on the factory floor, now they're in the process of building the skateboards. Now we need to put that in the job cost record so that we know what the materials that we've used. So that's an idea of the direct material flow. We also need to look at direct labor and manufacturing overhead. 10. Job Costing Labor and Overhead: In this lecture, we're going to continue tracking the cost of jobs 603. We've already looked at how the flow of direct materials is tracked. Now we need to look at how he would track the costs for the direct labor and manufacturing overhead. Direct labor is the part of the job. There's going to be tracked through the use of payroll and human resource tools. There's a lot of very fancy and useful software and hardware products that are out there to help us track our labor. We're just going to look at a very simple schedule that might be used. However, just keep in mind that every business is going to have their own way of doing this with the information they want. It will be the same. The information is how much time do our workers spend on that particular job? So we need to know how much time our employees spend on job 603. Will you have a labor-time record for each employee? And each employee will report the time that he or she spends on each of the jobs that she works on. So this employee tracks her job. Her employee number is three to three. And so on February second, she finished up jobs 600 to so she worked from eight to 11. Then after launch, she came back and she started working on jobs 603, which was slated to begin on February second. So they're on time. She worked the rest of the day and that's five hours. And so notice the total cost is $100, so that would be $20 per hour. Now, maybe she doesn't make $20 per hour. That's the total cost including benefits and payroll tax and all that, wouldn't be $20 an hour. So the total cost at $20 an hour or five hours at $100. And then she worked again on February 3rd on jobs 603. She worked the entire day. I guess you've worked through lunch and got off early, but you can see that she worked in both February second, third, a total of $260 were spent by her on job 603. As we track the employee working on the job, that cost for the employee is moving into the job cost records so we can track how much is spent on direct labor. Now, this employee is obviously working to build the skateboards. She is what I call a hands-on person, like an assembly line person, not a supervisor or a maintenance person, that would be indirect labor. Directly. It has to be someone putting the skateboard together. Now there is a lot of indirect labor, there is a lot of indirect materials and going into factory. There's also things like utilities, overhead that include insurance, property tax, rent, depreciation on the equipment in the factory. All those things that happen in the factory that are not direct material and labor, those get turned into what we call manufacturing overhead. Now the problem with manufacturing overhead is that we can't find out what it is for quite awhile. It might be months before we get all of the information in on the costs for insurance, etc. What we need to do is do a quick calculation, an estimate that's based on something and that's something that we base it on. It's going to be like a mechanism that gives a cause and effect. So for example, the more hours we work on the skateboard, then the more overhead will give to it. So we want to carve out all of those overhead costs and carve out a chunk of it to give the job 603 based on some basis. So let's look at that in more detail. So in order to guesstimate this overhead are, and that's really what we're doing. We're estimating overhead. We need to start out at beginning of the year making a rate that we're going to charge. First, we'll estimate how much overhead we think we'll have for the year. So this would be the beginning of the year estimating overhead for the current year. So let's say, for example, we estimate that we'll have, let's say, a million dollars and overhead for the year. So remember that overhead includes things like utilities in the factory, insurance on the factory depreciation and the factory. Property tax, supervisor salaries, inspection costs, all of those things that happened in the factory, as long as it's not direct material labor and goes into this overhead category. And so this overhead is estimated for the year based on past years and what we expect to happen in the current year coming up once we get that estimate for the year. And now step two, use a base that's going to be the bottom node that we can divide by. That has some kind of cause and effect relationship. We can use many different things. Some examples of common numbers that we use as a basis. Direct labor hours, direct labor cost. That's very similar. That's just the dollar amount we spend on labor or machine hours. Meaning how many hours you run the machines. In our case, we're going to use direct labor hours. We're going to say that we expect for the year estimate based on our sales that we expect to have for the year, $62,500 and the direct labor hours. That's what we expect for the year. So now that means that we can come up with a rate. We take the million dollars divided by 62,500 and that gives us a rate that we can use. We call that a predetermined meaning at the beginning of the year, predetermined overhead rate, $16.50 per direct labor hour. So every job we have, for every hour our workers spend on it. Our direct labor workers. We're going to give of that million dollars. We won't give $16.50 of overhead. We're going to say a cost of $16, pretty sensitive worth of overhead to do that job. So we'll use this rate for the remainder of the year for any jobs that come in. So let's say for example, we have a job that comes in, jobs 603. We're going to apply the overhead based on how much time they work. Now, in our case, so far, we've only work based on the direct labor that we had before. A few hours pulled up our direct labor again and we see that we worked five hours and eight hours. We have a total of 13 hours. So foreign direct labor hours at this point for jobs 603, we're gonna have 13 hours at a rate of $16.50. And we're just looking at the manufacturing overhead. We saw from the labor schedule that there's 13 hours of direct labor used at the rate that we already determined where we're going to use for the year is $16.50. At this point in the project, we have another $214.50 worth of cost that we want to apply to this job. So at this point in the process and the skateboards aren't made yet. But this batch of 50 skateboards has cost us $974.50 and we'll continue this. The more raw material bringing into the process, the more artery materials will go up, the more labor we use, the more that will go up. And then, because manufacturing overhead is based on labor in our situation, the more labor we use, the more manufacturing overhead is going to increase to. And that's going to give us an estimate for our job, 603 that we'll be able to use to determine and to analyze the effectiveness of the management on that job. There's a lot of benefits and uses the job cost system. We can use it to estimate future job costs. We can use it to make us more efficient, reduce future cost, or make improvements in some way to efficiency, we can use it for comparative purposes, comparing profitability for different jobs, different products, different batches, different managers. We can use it for bidding. If we wanted to bid on a project, then we need to have some kind of idea what their costs are gonna be so we can make our bid. Finally, we need to prepare reports and this is a really big help for making from an initial statements. 11. Allocating Costs for Multiple Products: This lecture we're going to look at the cost to manufacturer product. Now we've already looked at the three costs that are associated with manufacturing product, direct materials, direct labor, and manufacturing overhead. However, what if we have a business that manufactures more than one product? Let's consider how we might allocate our divide the cost up between the various products that we manufacturer. Our business. We're manufacturing skateboards and scooters. We manufactured just basically two products. To keep it simple. Like with any manufacturing business, we have three major cost. We have the direct materials. These are the parts used to build a skateboard or the scooter. We had the direct labor. This is the cost of the workers that put the skateboards and scooters together. We have the manufacturing overhead. Basically all the rest of the costs that are in the factory. In a multiple products situation like our business that manufacturer skateboards and scooters. We have the two costs that are associated with direct cost. These are direct materials and direct labor. These are not a problem for us. These costs are directly specific to the product. In other words, if you look at drug material, you don't really have much of a question as to how much you spent on wheels for the scooters versus the skateboards. Because you just would be able to see this number of wheels if you looked at the skateboards and the scooters, in other words, there's no there's no real question about how we would divide that cost up. The same thing with direct labor. You just basically measure how much time the labor spent on making scooters versus the skateboards. If they spend an hour manufacturing scooters and four hours manufacturing skateboards, than the direct laborers split up one hour versus four hours. It's not really a problem. However, manufacturing overhead is much more problematic because these costs are based on production in the entire factory. How is it we're going to split the cost up between the two products. Let's review some of the costs that are associated with manufacturing overhead. As you recall, manufacturing overhead are costs that only occur in the factory or the plant. But they're not the direct materials and direct labor. So basically anything else in the factory, utilities in the factory, insurance in the factory, property tax on the factory. The rental of the equipment that they use for making both escaped Morton scooters, any kind of indirect labor like security guards are maintenance personnel or supervisors that are in the factory, but they're not building the products. And then indirect materials would be anything else like supplies that are used up and thus the factory, but they're not used in the actual products they're making. Those are all examples of what you typically see as manufacturing overhead. Because these costs are so diverse and they're used throughout the entire factory, we need to come up with a way to split those cost up between the various products that we manufacturer to keep it simple, like we said, we're only doing two products. In this lecture, what we're gonna do is look at various options that we have to divide the manufacturing overhead up. Now, we're not worried about dividing up direct materials and direct labor. So the various options we'd look, look at our not to divide up all the costs, just the overhead costs. One option that we have to split up the manufacturing overhead between the scooters and skateboards is to use a single plant-wide overhead rate. This method is often called traditional costing. Basically we're gonna do is we want to determine an activity in the factory that leads to more costs. In other words, more activity, more cost. We have to determine what that activity is. Dating. We're going to use that to determine a single rate that we're going to apply to both the products that we have. And we'll look at that in some detail. The first thing we'll do is determine an activity in the factory that leads to more costs. So think of all the activities that are going on in the factory, moving materials around, purchasing materials, putting materials together, inspecting materials, all those things are going on, but we're going to think of what activity is an overriding factor that would lead to more costs. One example that has been used for many decades is direct labor hours. Basically the idea is this, the more time workers spend working, the more overhead is used up. One easy example would be say that the more time the workers are in the factory working, the more utilities are used up, two more air conditioning use it up, the more electricity is used up. So there's a definite definite cause and effect relationship there. Notice I've said there is a cause and effect relationship. The more activity goes on, the more in other words, in this case, the more direct labor hours are used, the more overhead cost we incur. They call that a cost driver because there's that cause and effect relationship is like driving a car. The more miles you drive, the more fuel you use that miles driven as the cost driver for the amount of the amount you pay for fuel. This cost driver is going to become our allocation base. And we'll see that in a second when we apply it to our formula that we're going to have. Just to let you know though, direct labor hours is not the only cost driver that you might find in a factory. You might also have something like machine hours. So the number of hours you run the machines than the more overhead is allocated. So if we run the machines for two hours to build skateboards and six hours to build scooters, didn't you would give six hours worth of overhead to the scooters and only two to the skateboards. So it can be other cost drivers. You could actually have any cost driver that management determines is the best cause and effect relationship. These are the two most common that you'll see. We're going to use that activity that cost driver direct labor hours to allocate or in other words, give some of the overhead to each of the product. In order to do this, we also need to estimate how much we're going to spend on overhead for the entire year. We're only going to come up with this rate once a year or once every so often, but in most cases once a year, then we're going to use that that rate every time we do a job, so we'll continue to use it. So we'll take that, that the estimated overhead cost for the year, and we'll take the cost driver that we decided to use it, our allocation base. We're going to use that to calculate what they call it predetermined overhead rate. The formula for getting the plant-wide overhead rate is to take the estimated annual overhead that we just calculated and divide it by the allocation base. We had determined that the estimate for manufacturing overhead for the year would be a million dollars. And then our estimate for our allocation base was our cost driver, which was direct labor hours. We estimate 62,500 direct labor hours for the year. And so if we divide those two, we get $16 per direct labor hour. So in other words, $16 of overhead is given to any product that uses an hour of direct labor. If we spend an hour manufacturing skateboards, we're going to give $16 of overhead to the skateboards. Let's look at this in more detail. We'll look at a little spreadsheet here and we're have two jobs where we manufacturer and job 101 skateboards and job 102, scooters to manufacturer the skateboards. It's gonna take us ten direct labor hours to manufacture the scooters. It's gonna take us ten direct labor hours. We're gonna have to apply these to apply this to both the skateboard and the scooter jobs. Since the radius $60 per direct labor hours. We just take ten hours spent on labor for the skateboards times $16 and we get $160 of manufacturing overhead that we're going to give our allocate to the job 101. And since job wanted to use the same number of direct labor hours, we'll use the same amount, $160. And manufacturing overhead. Direct materials we used came basically from the specific raw material that was put into building the skateboards. It came to $450. We could've track that using a job cost system and saying, Well exactly how much material went in it. Then for the scooters, we can see that we tracked direct materials, went directly into the scooter. 650. Direct labor was 250 versus 150. When you calculate the total, you get 864 of the skateboards and 964 the scooters. But what we want to see here is that this method of calculating a plant-wide overhead rate is really all about trying to determine how much overhead to give to each product. Not gonna have any implication on the materials or labor. Those are gonna be what they are, whatever you use for material and direct labor goes directly into those products. But it's how much we put an overhead that we're going to see is what is in question. This method is the plant-wide overhead rate. There's other methods that we'll look at. The plant-wide overhead rate like anything else, has its benefits and its weaknesses. Benefits of using the plant-wide overhead rate. Like I said it was. This is also commonly referred to as the traditional costing method. Is that it simple? We saw we only needed to do one calculation and then we could apply it to the jobs for the rest of the year. It's less expensive to implement in the other methods because it's so simple, it's not very complex. We don't need a lot of special software. And it does work well for products that have just one cost driver. Let's take a product where really the most important thing that you need is somebody to put it together. So that direct labor hour becomes really an overwhelming factor in the manufacturing process and that kind of situation. This works well. However, there are some problems with the traditional costing method. And that is that first of all, it doesn't account for complex manufacturing process with many kinds of activities and many kinds of cost drivers. Let's say you have a factory where there's some people that build the product, but you also have some robotics involved. And then you also have a lot of inspections and then you also have a lot of material movement around the factory to bring things to different places. So there's so many activities going on that really one thing is not going to work as just an it's just a single cost driver. Because of that, if you have a situation where that's the case, using traditional costing could lead to cost distortion of the manufacturing overhead because you're trying to make everything fit under direct labor hours. Direct labor hours work well in and the part of the factory where they use robotics might not. That's some of the things that we need to consider before we look at the other cost methods. 13. Activity Based Costing: We've done in the last two lectures is look at multiple methods to split the overhead up between multiple products. In our factory, we manufactured two or more products. In our case, we're going to use an example of a factory that manufactures skateboards and scooters. And what we're gonna do is we're looking for ways to divide up the cost of the overhead between both of these products. We've looked at two methods so far. One was basically call the traditional costing method, and one was called the departmental costing method. Now we're gonna look at an activity-based costing method. Activity-based costing, or ABC, works well when we have a situation where we have a more complicated manufacturing process with many activities that are all important in making the product. Maybe you have your purchasing department and then it comes shipped in and you have material moving the material around and then you have fabrication and you have parts assembly, and then you have packaging and all those things. We have a lot of different activities going on. And each of those activities are very different from each other. And there's no overriding activity that would be the best cost driver for every one of those activities. Maybe in each of these activities you don't have a cost driver that really works well for the entire factory. And each of these jobs will note that they used the activities to a different extent. Let's take the skateboard, Let's say it uses a lot more of the fabrication activity than the scooter. So we're going to look and focus in on that activity by itself and giving overhead for that part of the process to do. The activity-based costing method is very similar to the departmental overhead rate method. Basically the same type of calculation. It's just all you'll have to do is change the words department to the word activity and then apply the method. So let's go ahead and look at a cleared out spreadsheet. So it's going to be very similar. First, we need to find the activities that are associated with manufacturing and our plant will list out all the activities that management thinks are key activities and manufacturing for the skateboard scoot. The key managers have identified, let's see, about six activities they believe or the key activities to the manufacturing process for skateboard scooters. There's the setup, Then there's the raw material requisition, then the activity is the fabrication of part, and then we have factory supervisors. Then we need to inspect the finished goods and then we package them. It's worth noting here that these activities were determined by our management team, but at different management team might come up with different activities. For our purposes, we're going to stick with these activities. The next thing we want to do is pull the cost together just like we did with the departmental. This time, instead of having departmental costs pool, we're going to have the activity cost pool will have the cost pool or the pooling together of all the overhead costs and each of these activities. Now we wanted to determine our cost drivers. The cost drivers for each of these activities are going to be what we use for our formula, for our allocation base. In other words, the bottom part of our formulas, we're going to have, if you notice a rate for each of these activities. So we're gonna have six different rates that we're going to apply. Each activity has a different cost driver, meaning a cause and effect relationship. The number of times we set up is going to be one of the cost drivers. The more parts we use, that's gonna be our next cost driver. The number of parts fabricating costs are based on the use of machine hours. So the MH is for machine hours. For supervisors, we decided to use the cost driver as the direct labor hours. Then we have the inspections. We decided to go with a number of inspections and then for final packaging is the number of cubic feet and the packaging area. Now again, it's important to notice that these cost drivers, the number of setups and number of parts, the number of machine hours, etc. Those cost drivers were determined by our current management team. However, different management teams might determine that a different cost driver would be a better fit. Since you have multiple options for cost drivers. Having a management team that truly understands the process usually leads to a better allocation of the cost and the end. Let's go ahead and divide the cost pool by the allocation rate. By dividing the cost pool by the allocation base, we get to activity overhead rate. We get a different activity overhead rate for each activity. So every time we set up for their skateboards, $10 of overhead goes to the skateboards. Every time. We spend an hour on direct labor hours for the scooters, $3 goes for the supervisory overhead, goes to the scooters. And on and on. So then the next thing we do is we want to go ahead and drop down to the second parts. And we're going to apply these rates. Again, these rates would be determined at the beginning of the year and then use throughout the year or at least for a significant amount of time. Then every time we did a job, we would apply these same rates. We have a job for skateboards 101 and scooters 102. And we're going to see how much for each of these activities we use to make each of these jobs. So the next thing to do is take whatever is here and just drop it down to here. So the question is, how many setups did we have for job 101? You have to find that information out and have to be provided for you. How many setups that we have for job 102 for the scooters? Looks like we had to do two setups for the skateboards. The rate is to knowledge per setup. And so we are going to give $20 of overhead to jobs 101. Because of that. There's four setup, so we get $40 of overhead for job 102. So then we'll do the same thing. We'll ask ourselves, well, how many parts than we use on job 101, because that's going to determine how much overhead we give to the material requisition activity. We use 20 parts at $0.50 apart. That means $10 of overhead, $13 for the scooters because we use more parts for fabrication of parts. We want to know how many machine hours because that's the rate we have. How many machine hours. So we'll get that information. We used one machine hour for the skateboards and for the scooters. So more machine hours at $24 an hour means more overhead, $96 for the scooters. For factory supervisors. We look at how many direct labor hours there were associated with each. There were nine direct labor hours to manufacture the skateboard. So they're going to get overhead based on nine hours versus the scooters, which was six. Now the rate is $3 per hour, so that comes to twenty-seven dollars and overhead for 101 versus 18 for job 102. They're more inspections for the scooters, six versus three. For the skateboards. The rate is $5 of overhead for every inspection. Then the final packaging areas based on the amount of space for the packaging. Turns out we need a little bit more cubic feet of space for packaging the scooters. At the rate of twenty-five cents per cubic foot. That means there's gonna be a little bit more overhead applied to the scooters. Now that we have looked at each of the activities, we can add them up. We see the total overhead for the skateboards at a 140 versus the scooters at 212. Let's compare this to the other cost allocation methods for overhead. We see that these three methods ended up resulting in different amounts of overhead applied to each of our products. Again, this doesn't mean that one method is going to lead to less overhead being used in the factory. It just means that less of overhead using the factory gets applied to one job versus the other. It doesn't mean that, that means that by going with the cheapest one, we're saving money of it in any way. It just really means that we're looking for the allocation method that best reflects the true nature of the product. Which product is really sucking up a lot of the overhead. The methods do not change the direct materials and direct labor. The direct materials and direct labor are the same. Remember, direct materials and direct labor are specifically and directly associated with each product. So these different methods that we looked at these lectures was really about how we're going to split up the overhead costs. Because those are much more challenging to split up. When management determines that 11 of the allocation methods, either traditional or departmental or activity-based costing, is the most effective for their factory, then they get some benefits out of that. First of all, they get the benefit, a better pricing and understanding how they should, what kind of product mix they should have so they get better information to make better management decisions. They get better information to help them cut costs. Even though determining which method to use it doesn't directly and specifically lead to savings right away, leads to better understanding of the manufacturing process and the cost associated with manufacturing so that decisions can be made in the future to be more efficient in that plant. It helps for better planning and control of the manufacturing process. The bottom line is that the benefits of having an effective cost allocation system for your overhead to each of your multiple products results in better understanding of the cost by management. That results in better cost allocation. In other words, dividing up the cost of overhead between the different products. And then that results in better management decisions. Determining the pricing of the products and which product mix you should go with. That will lead to a competitive advantage for the organization. 14. Cost Behavior: In this lecture, you'll be introduced to cost behavior. Now whether you know it or not, different costs behave differently. And understanding cost behavior is very important for management to make improved business decisions. It's important to note that we're not talking about different costs, were talking about the exact same cost that we use before. Direct materials, direct labor, insurance, all the costs that were associated with many manufacturing overhead. What's different is we're looking at categorizing them differently like in the past when we categorize them based on whether or not they were associated with the product or the period. Now we're categorizing based on what time of behavior each of these costs have. And when we understand the behavior of each of these costs and we can put them in a category based on variable, fixed or sometimes mixed cost. So let's first look at the variable cost behavior. A variable cost is a cost incurred for every unit of volume. The more of the factory makes them more than variable cost if they make less of a product or service than they have lower variable cost. If it's a service company instead of a manufacturing firm, then it's the more customers that are served, the more than variable costs will be. Less customers serve, less variable costs will be. Some common examples. Direct material. We looked at the example of the skateboard factory. The more skateboards we make, the more wheels we use, the less skateboards we made, the less wheels we use. See what I'm talking about. Commissions. Commission based on, for example, purely on sale. So if you get 10% of your sales than the more sales you make, the higher the commissions are. If you have 0 sales, in that case you would have 0 commissions. Fuel would be a good example. Let's take, let's take Southwest Airlines. The more they fly, the more fuel they use. If they park all their planes, they don't use hardly any fuel. The same with shipping. So you can see the common thread here. The more that happens, the more than variable costs are. Let's look at an example company. For our example company, and we're gonna look at a bed and breakfast business. So a good example of a variable cost for bed and breakfast would be the coffee. The more guests they have at their bed in practice, the more coffee they're gonna use it up. If they have no guests, they'll probably use very little coffee. Let's look at the variable costs in a graph. And on the bottom part of the graph, we have the volume, meaning the more customers we have, the more we're going to go to the right. So 0 customers would be on the left. And then the higher the customer account, the farther we go on the right. And then the cost is gonna be the vertical line. So we're gonna go from 0 cost to a higher cost. First, let's look at a variable cost for each unit. So what this means is the variable costs for each guest we have. Since, let's say the coffee costs is a dollar to brew the coffee and put it in a go cup for the customer. Notice how the cost stays flat because for every customer and only costs a dollar no matter how many customers you have, each person, we only spend $1. That's why it's a flat line. But what's interesting is when we look at the variable cost and total, when we look at the variable cost and total will notice that the cost goes up the more volume we have. Note what I said earlier. The volume is how many products that are made in the factory or how many customers are served. So the more customers we have, the more we spend on coffee. If each cup of coffee costs us a dollar, then if we have very few customers than our cost is very low, but it has our cost is our volume goes up with more bed and breakfast. Customers are coffee goes up. That's the idea of a variable cost. It varies by volume, by the number of customers or products we make. Keep in mind a variable cost doesn't mean it varies per unit. In other words, it's not like something like, let's take the price of gasoline going up and down per, per gallon. That's a fluctuating costs. We're not talking about fluctuating costs were talking about variable costs. And variable costs only going to change based on the volume of customer or the volume of product that we made, not a fluctuation per unit change in total cost. Next, let's consider what they call a fixed cost behavior. We'll look at a couple of graphs to explain fixed costs behaviors in a second. But first of all, fixed cost behavior is a cost that remains constant regardless of volume. Meaning you're going to have to pay that amount no matter how many customers or how much product you making your factory. Common examples would be something like rent. At a common rent setup is that you pay a set amount every month. It doesn't matter if you have a lot of customers. A lot of you make a lot of your product and your factory or not, you still got to pay the same amount. Other common examples are property tax or straight-line depreciation or salaries. Think about it. The salary for your manager is $80 thousand a year. It doesn't it's not going to change the salary if there's a lot of things made are a lot of customers are very low number of customers. The salary would remain the same, at least in the short run for our bed and breakfast. Let's look at the fixed cost for each unit, for each customer. Will also use look at the fixed cost and total. Let's look at the fixed cost and total first, notice that the fixed cost in total stays flat, meaning no matter how much volume we have, no matter how many customers data of bed and breakfast I rent remains the same. If I rent us $2 thousand a month, then it's gonna be the same $2 thousand a month, no matter how many customers we have. Now of course, we have to keep in mind this is for a relevant range. What that means is you can't have a million customers at your bed breakfast. This is within the range that we're able to fill the capacity of our bed breakfast. And the same thing goes for if you have, you know, a factory, then the factory is only going to be able to put out a certain capacity of product. So the fixed cost stays the same within that relevant range. Within that relevant, relevant range, you'll notice that it does stay the same. Now when you look at the fixed cost for each unit, what you're saying is, well, if we have a certain set fixed cost, but we have a lot of people. How much does each customer, how much does this person at our bed and breakfast have to cover for the fixed cost? Let's look at that and a little bit more detail. Notice that the fixed cost for each unit goes down. Now, this is usually showed as shown as a concave line, but for our purposes we'll just use a straight line. What that says is that the more customers you have then fixed costs are easier to cover. So let's look at some numbers to make it easier. If your fixed cost and total or a $100 thousand for the year, let's say your rent, your property tax, the salaries, those fixed costs that have to be paid each and every month come to a $100 thousand for the year. And then you have 2 thousand guests, then that means that each guest, you would have to charge at least $50 per gas and other in order to cover those fixed costs. So that'll be the minimum you'd have to charge to cover those fixed costs. However, if you have more guests, then the cost goes down per unit and you, let's say you have 4 thousand gaps in your bed and breakfast. You would only have to cover twenty-five dollars per guest. This is also called the economies of scale. You might have heard it in other classes in that capacity. Now some costs don't fit nicely as either a fixed or variable cost. They act like both. Now some costs don't fit nicely as either a fixed costs or variable costs. They have components of both and the way they behave. So a common example could be a delivery truck. That the delivery truck, you pay $50 a day and then you pay $0.20 per mile. So there's a there's a variable amount. You pay more by driving more more miles, and then there's a fixed amount is $50 a day, whether you drive at all. Utilities are typically mixed costs. Although it just kinda depends, but think about it like this. You usually don't have 0 utilities. When you, when you leave, let's say for a vacation, you come back, there's usually minimal amount because you have your refrigerator in your air conditioner heater running. And then at the same time, if you are at the house a lot using a lot of electrical components, then you're going to have more utilities, maintenance. You can't, for example, just park a vehicle and expect it to run a year from now, there's a minimum amount of maintenance that needs to be done. But we also know that the more you use the vehicle, the more maintenance you're gonna have to do. One more example, a commission with a base salary. Let's say the base salary is 50 thousand a year plus 10% commission. So you have both a fixed amount, $50 thousand a year, and a variable amount. Let's look at that on a graph. So in our example, we're going to look at a mixed cost for utilities and our bed and breakfast. We know that no matter what we do if and if we have 0 gas, we're going to have a minimum amount of utilities. This amount is the fixed amount. You notice it starts on the cost line. It doesn't go to 0, it starts at a certain amount. Let's say we know we weren't to spend $100 a month on utilities no matter what that level from there down as the fixed amount. But then the more guests we have, the more we use the air conditioner, more we use the refrigerator, the more we use a television, etc. Then your utility is gonna go up. So that amount from the line down to the fixed line is the variable amount. Now when we look at this, we're become aware of a formula that we can develop. And that is that in our business, the business is total cost equal all the variable plus all the fixed costs. We can look at the formula over here to the right. The total cost we'll use the variable y is equal to the variable cost. The V times X are the variable costs per person or per product that we manufacturer times the number of people or the number of products we manufacturer. That's why it's V times x plus the fixed cost, which is a constant. We can use this formula and a lot of different ways for a lot of different analysis. It's important to note that variable costs and fixed costs and fixed costs are not the only types of costs behavior. There are other kinds of costs behaviors out there. Some examples would be step cost or curvilinear cost and other things that describe the cost behavior in a specific business. But for our purposes, we're going to focus on fixed and variable costs as they are not really common, but they exist in all businesses. And so all managers need to be aware of these costs behaviors so that they can use that to improve their business decisions. 15. Fixed and Variable Costs: When we left our last lecture, we were looking at mixed cost and we determined that a formula can be derived from the mixed cost. And that is that an a business. The total cost is made up of variable and fixed costs. If you have a mixed costs, such as utilities, we need to do is we need to break it apart and we need to take the variable element and use it for the variable cost part of the formula and the fixed element of the mixed costs and take it and use it on the fixed part. In order to do that, we need to have some method that we can use to break those mixed cost up into their variable and fixed components. They are very various options that managers have in order to split up those mixed costs. They can use a scatter plot graph. And then there's regression analysis, which is a statistical way to approach the problem. Those are fairly complicated and outside the scope of this course. However, there is a method that we can use to get introduced into splitting up the mixed costs called the high-low method. So in our example, we're going to use the total cost for each month, for the first half of the year. For a florist, the florist has a delivery van, and the florist wants to understand the cost of the delivery van, make estimates, and understand what kind of prices should be included when determining the cost per delivery. Here's the historical look at the number of miles driven, That's the activity. And then the total cost. We noticed that February seems to have the highest mountain that makes sense for Flores with Valentine's Day. And then we look at the different months and we note that, Let's see, it looks like January with the lowest number of miles driven. Once we know this, we can go ahead and we can apply the high-low method. The first step is to make that determination, determine which month has the highest number of activity, the highest number of miles in this case. And then which month has the lowest? The first step is to find the high-end, low-level activity, which we've already looked at. The formula is the change in cost over the change in volume from the high month to the low month. So the change in cost from February, which is the high month minus the low month of January, and then the activity of February minus the low month. And what you get is $0.20 per mile. That's the variable costs per mile. Every time we drive the van, It's quite a cost is about $0.20. Next, what we want to do is determine the total variable cost. We know that cost is $0.20 per mile. But what is the total variable costs for the period either February or January. So pick either the higher, the low. Well, do both. But we'll start with just looking at the high because we don't need to do both If we don't have to, but we'll look at both of them just to show you that it doesn't matter. We'll start with the high. The high month is 18,400 miles times $0.20. That means that our total variable costs for the month of February is 3,680. So in our next part of the step, this is part of step b of step two, will take that formula that we used earlier. Our total cost is equal to the variable costs plus fixed costs. And we'll use that to determine the fixed cost since we know the total amount, the total amount of costs for high month of February, and we know the variable cost, then we can figure out the fixed cost. So first we'll just do the high month. The total costs for the month of February is 5,180. The variable cost of 18,400 miles times $0.20 a mile. And then what's left will be our fixed cost. The total cost is 5,180, our total variable cost is 3,680. Then what does f or what is the fixed costs need to be? The answer would be $1500 each month. It costs us $1500 in fixed costs to drive our bands. Now, I said before there, it doesn't matter whether you do the higher, the low, unless look at that real quick. If we had chosen the low month instead, we see that we get the exact same number. You see the low month, 13,800 times $0.20 a mile. In step two, we get total variable cost of 2760. All right, Then when we go down, we can figure out the total fixed cost. The total cost in January were 4,260, variable cost and total 2760. So that means the rest are $1500 must be our fixed cost. That makes sense since fixed costs are gonna be the same each month, no matter how much we draw the van, it makes sense that the fixed costs are always going to be the same in each month. Once we know this, we can create our formula that we can use for the management of this florist. The equation is why our total cost is equal to 0.2 or $0.20 times x, x being the number of miles you drive, plus $1500. Let's say we want to go ahead and estimate the month of July. If we estimate that we're gonna drive 15 thousand miles for deliveries in July, based on maybe historical data from the last couple of years, then we can determine what our delivery costs are gonna be. We just use the formula, but this time instead of x, we plug in the 15 thousand miles of activity and we get 4,500. You can see how the high-low method is a useful method for management and understanding their cost and making predictions and making other decisions that they have to make. We see that there's different ways we can look at costs. We looked at cost based on product, based on periods and based on cost behavior, whether it is variable or fixed. What implications does this have for management? For management and the management decisions that they make? We can look at this through two methods that are used for applying cost to profitability. One has absorption and one is variable costing. Absorption costing is often called full costing. In other words, all the costs, all the fixed, all the variable. They're all included in the product. So their inventory includes the costs that are based on fixed and variable. Both. This is used in GAAP accounting or financial accounting that you might have learned in the past. They use this kind of costing method for financial statement reporting because it provides us some useful information for external users such as investors and creditors. And as we know in financial accounting, that's the focus of the reports that we make. Another option is variable costing. Now this is not to be confused with a variable cost. This is variable costing method. And the variable costing method, just the variable cost themselves, are going to be included in the product costs for the inventory. This is also known as direct costing. Fixed costs are treated as a period cost and basically go directly into the income statement. Now this method is better for internal decision-making. In other words, managers can use this for improvements of internal decisions that they make. Let's look at this in some more detail. So here's some cost. Then we have them split up based on cost behavior. Direct materials, direct labor is pure. Commissions and shipping are on good examples of variable costs. In rent, insurance, security costs for the factory supervisor salaries. These are all good examples of fixed costs. So if, how do we compare absorption costing to variable costing? Well, if we use absorption costing and all of these costs go into the inventory themselves and be included as product costs. With absorption costing, all the costs first go into the inventory. There are captured as part of the inventory and they sit in inventory until the product is sold. Only after it's sold as it hit the income statement. As long as the units are stuck in inventory, not going to reduce our, our profitability because it hasn't become a cost yet, hasn't become an expense yet. Let's compare that to variable costing. With variable costing, we see that the variable costs go into the product only the variable cost. Only the variable costs are trapped in inventory until it's sold. The other costs, the fixed costs, are expensed in the period in which they occur. So if rent is paid in January, then it's going to go to the income statement for January. It doesn't have to go into the inventory and wait until the inventory is sold, maybe in February, March, or April. So variable costing is different in that the fixed costs are expensed in the period they occur. Absorption costing absorbs all of the cost, hence the name absorption costing into the inventory, our product cost, a traditional income statement that we normally see with financial accounting, uses absorption costing. As we learned, all of the costs, variable and fixed costs that are associated with the product first go into the inventory and they don't hit cost of goods sold until the product is sold. So this is what the income statement would look like. Now using absorption costing, what we can do is we can take our income statement and we can collect all the costs that are variable and all the costs that are fixed. Notice with the traditional income statement that the cost of goods sold has cost. Some costs are variable and some costs are fixed. And then the selling and admin, the same thing occurs. The cost are put into the different parts of the income statement based on whether or not as part of the cost of the goods sold or whether it's part of the period costs of the selling and admin side. But that is a problem for managers who need to know the variable and fixed cost. Because these variable and fixed components mixed up together in the cost of goods sold and the selling and admin. Now this traditional income statement might be very useful for investors and creditors to use. But the managers, they need to know what the variable cost or with a fixed cost or so they can make additional analysis and other decisions that are associated with across behavior. What we need to do is we need to take the variable costs and put them together in the fixed cost of put together on a contribution margin income statement. We're gonna take all the variable costs and we're going to put down together and subtract that from the revenues. It doesn't matter whether it's a product cost and period costs, selling and admin, whatever, as long as it acts like a variable cost, meaning it increases with the more activity in our factory. As long as it acts like that, we're going to put it in this area. On the income statement. We subtract the variable costs from the revenue and we get what we call a contribution margin, meaning that's what's leftover to contribute towards our fixed cost. The fixed cost or likewise gathered together, no matter whether their cost of goods sold are selling and admin, if it's a fixed cost, meaning if it's a cost that's the same no matter how much activity goes on. We're going to put it in this part of our income statement and subtract that total fixed costs from the contribution margin to get to operating income. So we have two different income statements here. One is more useful for the investors and creditors, and one is more useful for management decision-making. Now it's important to note that these income statements may or may not be the same results as far as profit. If the number of units manufactured in the factory is the same as the number of units sold by our company, then both of these income statements will end up being the same. Traditional income statement is with profitability called operating income is going to equal to the contribution margin income statement. This would be like if our factory built 10 thousand cars and sold 10 thousand cars. If it's the same, that's being manufactured is the same as being sold, then both of these income statements are gonna be the same. However, if you make more cars or make less cars than you sell, that's gonna have an That's going to change things up. The operating income is higher for traditional income statement, if the number of units manufactured is greater than the number of units sold. The reason for that is because with a traditional income statement using absorption costing, more costs are, are tied to the products and the inventory until it's sold. Now this creates a little bit of an issue for us because if managers are being evaluated on the traditional income statement, if they're getting, for example, a bonus based on the profit from a traditional income statement, then there's an incentive for them to manufacturer as much as possible. Because by manufacturing more, they're tying up more costs into the product. And that leaves less cost to bring down the profitability. So they look like they have more profit just because they are producing more than they're selling. Now if they manufacturer less than a cell, which eventually will happen, eventually, you're going to sell. If you've been producing a lot more than you need, you have extra extra cars that you built last, last month because you didn't sell them all. While eventually you're going to sell more than you produce because of those extra cars that are leftover. And what that's gonna do is that's going to release those costs and that's going to lead to lower profit, lower operating income. For the traditional income statement, which keeps management always trying to produce more and more and more and more whether or not they sell it. And so because of that, using a traditional income statement is not the best option when it comes to evaluating your managers. A better option is to use a contribution margin income statement. A contribution margin income statement is also much more useful for managers for making other types of analysis that we're going to learn soon. One, for example, is understanding the risk of the business. As you could probably imagine, a fixed cost which has to be paid no matter what. It's gonna be a riskier cost, then a variable cost. It only has to be paid if you have a customer or if you manufacture that product. There'll be some analysis for future lectures. At this point, it's just important for us to see first of all, what a contribution margin income statement is because we're gonna use that a lot. And also the different results that can occur from using absorption costing versus variable costing. 16. Break Even Point: This lecture we're going to use the cost volume profit income statement that we learned about in a previous lecture. We're going to use it to do analysis to determine things like break-even point, the level of sales that are needed to get to a certain profitability. And we'll learn about sales mix to. In order to do that, we're going to use margins custom silkscreen as an example. Company. Margins business is to print out silkscreens in order to make custom-made t-shirts, to order morphemes, cells or t-shirts at thirty-five dollars a piece. She has variable cost of $21 for every t-shirt. As you might recall, variable costs are incurred when Margie has a sale when she needs to produce one of her t-shirts. So in her case, the variable costs would include the t-shirt itself and then the ink that's used to do the silk screening. When you subtract that you get $14 is leftover. At this point, Margie is selling a quantity of 550 t-shirts. Her sales our total at 19,250. And I got that by taking the 550 t-shirts times thirty-five dollars, then the variable cost they are incurred every time she sells t-shirts, since you sold 550 t-shirts, she had $21 each t-shirt. So the total variable cost is 11,550. That gives her what's leftover as the contribution margin, which is supposed to be how much you have leftover to contribute to the fixed cost and leave the rest of profitability. Since her fixed costs are $7 thousand, then she's leftover with operating income or profit of 700. As you recall, fixed costs would be something like like rent on the building or the salary of the manager of the social screenshot. Those are all fixed costs because she has to pay those whether or not she's sells any any ever strict shirts at all. Let's take a closer look at variable and fixed costs. Remember those are considered cost behaviors. A cost that is incurred only when margin makes a sale is called a variable cost. So you can see that if she sells one more shirt, 551 shirts, the variable cost goes up by another $21. If she sells one less shirt, 549 shirts, that would be $11,529 in variable cost. It's 549 shirts times $21. You notice how you can see the variable costs increasing incrementally every time she makes a sale and asked to produce a shirt, the fixed cost are not changing. That's her rant or salaries to her to her manager, that kind of thing. And you notice that they stay the same seven thousand, seven thousand, seven thousand, as long as she's within the relevant range. One of the terms that we need to get familiar with is called the contribution margin ratio. Contribution margin ratio is the percentage of the contribution margin as compared to the sales. In other words, for every dollar in sales, how much is leftover as a contribution margin? You can get that by taking the contribution margin and dividing it by the sales. Notice if you take the contribution margin of 14 and dot divided by thirty-five dollars, you get 40%. That's the contribution margin ratio. You can take the contribution margin ratio from any level of sales. Let's take it from, let's say 549 units. So if you take the contribution margin at 549 sales, which is $7,686, and divide it by the sales at that level of 19,215, you still get 40%. So as long as you take any contribution margin divided by any sales, as long as it's the same level of quantity, you'll get the same percentage. Basically that just shows you the percentage of the contribution margin, the sales. So if the contribution margin is 40%, then that means that the variable cost must be 60% of the sales. And that's because the variable cost and the contribution margin together add up to give you your sales revenue. So if one's 40%, the other one has to be 60%. We can determine that sales units must equal the fixed cost plus the operating income divided by the contribution margin. When we use this, we can make a lot of analysis. And one of those key analysis we can make is called break-even point. The break-even point is the minimum number of sales needed in order to cover all costs. This is a really important number to understand for the management team. By understanding the break-even point. They understand sustainability. It helps to managers, investors, creditors, anybody really that is trying to understand the company, determine what is needed in order of, in terms of sales, in order to break-even. We can think of this as sustainability of the business. How will they sustain themselves over the long run of the business? Since break-even point is equal to 0 profit or 0 operating income. In other words, that's the minimum number of sales that are needed in order to cover all your costs. So once you cover all your costs, you're at 0 profit. You're not at negative profit, which is good, but you're not at positive either at 0. And we can change the operating income to 0. And so the formula becomes fixed cost plus 0 divided by the contribution margin. And math, we just get rid of the 0 and we'd say fixed cost divided by the contribution margin. Using the numbers that we have available to us, the fixed costs are $7,014 is the contribution margin. 500 shirts would be the result. So if Margie sells 500 shirts, she'll cover all her costs. Again, that shows her what kind of level of sales she needs to get to to sustain her business. So let's look at this example. Let's say she only sells 480 shirts. Her net income was negative $280. The reason is because her contribution margin was below the fixed cost. The problem is that she still has to come up with a $7 thousand. What she needs to do is find a way to come up with that extra $280 so she could invest it from her savings. She could save up profits from previous months. She could take a loan out. She'd get another investor. Those are all options for her. But if you think about it, those are only short-term opsin options. In the long run, a manager or an owner of a business can't continue to take out loans or put money into a business that doesn't break even. This allows her to understand what kind of situation she's in and where she needs to get in order to stay in her business. If she gets to 500 shirts, it might not sound like fun to make $0 profit, but she's at least cover costs and she getting at least be around for the next month in order to try to make a profit. Then what about if he wants to target a profit? Let's say she wants to get to a profit of $4,900. Well, now instead of putting 0 is the targeted operating income. We're gonna put is 4,900. And so that makes you you need to sell 850 shirts. So this allows her to see what kind of sale She needs to get to in order to get to the targeted amount of profitability that she wants to get to you. Sometimes managers want to determine the break-even point and amount of sales dollars instead of the amount of units they need to sell. In the case for Margie, maybe she wants to know how much sales in dollars she needs to have in her cash register, her bank account from sales, it's just changed the contribution margin to the contribution margin ratio. Instead of using 14, we're going to use the percentage as we found in the contribution margin ratio. Using the 40% that we found earlier, we see that she needs to sell $17,500 worth of merchandise in order to break-even. You can use this to target sales and dollar instead of sales in units. In other words, the only difference between targeting sales and dollar versus units as you change the contribution margin, the contribution margin ratio. So 7 thousand plus the targeted income of 4,900 divided by 40%, which is the contribution margin ratio, gives you 29,750. So that's the sales that she needs to collect. Let's look at this on a graph just to kind of get a big picture. Understanding of break-even point is we'll graph all the variables, fixed cost, variable cost and the sales. Start with the fixed cost. So we'll start out with a fixed costs and we'll put it as a straight line across. So in the case of Margie would be $7 thousand. Next we'll graph the variable cost. Now the reason I started out with variable costs at the fixed cost level is because we want to look at the total cost, which is the variable cost plus the fixed cost. So we're going to start out at 0 units of sales. And at that level the variable costs would be 0, but the fixed cost would be $7 thousand. Then as we make more sales of t-shirts, the variable costs are going to creep up. When we add the sales in there. We see that some point the sales are going to overtake the variable cost at the point where the sales equal to variable cost plus the fixed cost. That is where our break-even point is. 17. Changes in Break Even Point: In our last lecture, we looked at Marge's custom silkscreen, and we learned about break-even point. And we looked at our cost volume profit income statement. What we're gonna look at this time is to take that same example company and see what happened when there's changes that occur. So one thing you learn about in business and in life is that changes will always happen. So let's get some tools to analyze those changes and see what kind of impact they have. Margie cells are silkscreen shirts for thirty-five dollars a piece. The variable cost is the cost of the shirt and the ink. And that's $21 and we get a contribution margin of $40 each. Now, currently Margie selling 950 of these shirts each month, that gives her an operating income, a profitability of 6,300. Her break-even point is 500 shirts. However, the manager of our social screenshot found out that the competitors are running a sale and she wants to run a sale too. And that would drop the price of the shirt down from thirty-five dollars down to $31. Margin looks at her new cost volume profit income statement to feel good fuel for the impact of this. If they change the price from 35 down to 31, then the sales revenues are going to be reduced. But her variable costs are still $21 a piece. So that brings the profit down from six thousand, three hundred thousand to 2500. Now the manager says, Yeah, but hold on a second. If we dropped the price and have a sale, we're gonna sell more shirts. She estimates about 10% increase in the number of shirts that they would sell. We need to add this to the situation two, we need to increase the quantity as well as dropping the price. When you add the, the change of quantity and the price at $31, you get sales revenue of 32,395. And the variable costs have now increased by the amount per unit, but by the mountain total, because now they're selling 1045 shirts at $21 instead of 950. The profit has rebounded from 2500 to 3,450, but still not getting back to that original 6,300. And also impacts the break-even point. Because when the, when the sales price is reduced, that means your contribution margin is reduced and you only have a $10 contribution margin. And that means you have to sell 700 shirts, an increased from five hundred and seven hundred just to break-even. Marches decided that she hasn't liked that change. So she wants to go back to thirty-five dollars a piece and just stay there and keep everything the same. But even if she wants to keep things the same, The world doesn't necessarily want that. So she finds out that the price of the t-shirts that she that she sells, the cost to her are going to go up by a couple of dollars. Now her variable costs are no longer gonna be $21. They're going to increase the twenty-three dollars. She's still selling the church at thirty-five dollars a piece. But now she's lost some of her contribution margin because the variable cost has increased. How much will that impact her? Well, we see that that will drive down her profit from 6,300 down to 4,400. That means that she's going to have to sell more shirts to break-even to if you do the math, it comes to $583.33 shirts that needs to be sold. However, when it comes to break-even point, you always want to round up. Even if it's a low number like 0.33, we can't sell just 0.33 shirts, so we have to round that up to the next number. So 584 shirts would be the minimum number she needs to sell in order to break-even. If he round down to 583, then you're not going to break-even. You're going to be a little bit short. So always round up on break-even point. Now Margie is a little concerned about this and so she decides that she might want to find some other areas to cut cost because having her variable costs go up, she wants to try to maintain the same level of profit that she had before. What she does is she looks around and she says, Well, I can get my fixed cost down if our renegotiate my rent. So she renegotiate your rent and she gets it down by $700. Now, her contribution margin hasn't changed. It's still lower than it was before because of the change the variable cost, but her fixed costs have been reduced. Now when we add this to the mix for our calculation, we see that her new break-even point is only 525 shirts. And she hasn't quite rebounded on the profit yet. She's still making less than the 6,300 she was in the beginning, but it is closer at 5,100. The purposes of this, this lecture was to demonstrate how when managers have these tools such as break-even point target, net income, cost-volume-profit income statement. We can use those to see the impact changes will have on our business and it'll help us to make decisions if we kind of have a feel for what kind of impact those changes will make beforehand. 18. Sales Mix: As you might guess, many businesses sell more than one product. When you sell more than one product, we learn a new concept called sales mix. And this is a concept you're probably already familiar with. Basically it's just a percentage of each product that you sell when you have more than one product. For example, if you have a restaurant and you sell sandwiches and pizza slices, if you sell 300 sandwiches and 700 slices, that's a total of 1000 units, you sell. Well, the percentage is just a breakdown of the two. So 300 over 1000 gives you 30% sandwiches and 70% slices. So that's your sales mix. 30%, 70 percent. That's all it is. And you can have as many products as you want and you can just have a percentage for each one. It should add up to 100% to cover all your sales. Margin has decided that in addition to selling t-shirts, she wants to sell custom silkscreen flags. She hurts a thing now and she wanted to get in on that. So she figures her sales mix is going to be 70% shirts and 30% flags. Let's look at a quick income statement at yourselves, the shirts at thirty-five dollars a piece. And then she has determined that her variable costs are going to be back at $21. She has a contribution margin of $14. So every shirt she says she has $14 leftover to contribute to the fixed cost. The flag, she can sell for $70. The variable costs are gonna be higher. There are a lot larger. And so that's gonna be $40 each flag for contribution margin of $30. Margin wants to figure it out her break-even point when she adds this new product to the mix. As you recall, the break-even point is fixed cost divided by the contribution margin. However, we have two contribution margins, $14.30, in which one do you use? The answer is that you want to take an average of the tube, but you want to do a weighted average of the two. When you do a sales mix, you're going to do the fixed cost divided by the weighted average contribution margin. How did we get that weighted average contribution margin? We want to take the contribution margin times the sales mix. Will do that contribution margin on sales mix for each product that's sold. We have the flags and we have the shirts. The sales mix is a 7030 mix. The contribution margin, we just pull from the table above $14.30 and then you multiply the two together and that gives you the weighted average contribution margin for each one and you just add them up. So in this case the weighted average contribution margin is going to be $18.80. Now when we apply that way to average contribution margin to the break-even formula, we see that we need 372.34 shirts and flags together in order to break-even. We can't sell 0.3 for an item. Break-even points always round up. They want to know how much of those 373 units need to be shirts. We just multiply it by the sales mix, 70%. So that means we need to sell 262 shirts again, we round it up. And 112 flags. Another useful tool for doing analysis called the margin of safety. The margin of safety is a fairly simple formula. It's just taking the actual sales, in other words, what you really sell to the customers and subtracting from it the break-even point. And that gives you your safety net. It's your margin of safety, meaning, how far away, how much bigger are your actual sales than your break-even point needs to be in order to cover your costs. So that tells you how much you can drop in sales before you have to worry about starting to go into a loss situation. So in this case, we know that our actual sales or 950 shirts, we're just going to ignore the sales mix right now. We're just going to look at one product while we learn this new concept. So 950 shirts. Then we learned the break-even point was 500 non-hairy, funny shirts minus the break-even point at 500 shirts means you have a margin of safety of 450 shirts. You can lose sales and the amount of 450 shirts before you get to the point where you're at break-even and if you lose anymore, you lose money. So the margin of safety gives us the safety net that we have. Now a lot of times managers want to see this in terms of dollar amounts, how far their dollar sales can drop since he shirts, so for thirty-five dollars, then we just multiply the 950 shirts times 35500 shirts now 35 and we can figure out the dollar amount that we can lose. Ratio can help us to make comparisons because it puts things into percentages. So the margin of safety ratio is just taking the margin of safety and making a ratio and the margin of safety divided by the sales is going to be your marginal safety ratio formula. So the margin of safety that we learned above was 450 shirts divided by 950 shirts was our sales. We get 47.4%. And so this is just telling us that instead of looking at the number of shirts, we can drop as a margin of safety. The of the break-even, it just says the percentage of sales. So we can drop 47%, actually, a little bit over 47% before we have to worry about losing money. When we put the dollar amounts in 15,750 as the margin of safety and 33,250 as the actual sales. We get the same percentage. So you can do it either way depending on the situation you find yourself in. Now, another term that we can use for doing analysis of a business is called the degree of operating leverage. The degree of operating leverage says how much the operating income will change when the sales increase or decrease. So if there's a change in sales, how much of that will hit the bottom line, the formula for the degree of operating leverage is just to take the contribution margin divided by operating income. So let's go back and look at Marge's custom silkscreen and its original contribution margin income statement that we started with. We're at 950 units. That's the actual sales that she that she has. And then we have the variable cost of $21 each and we get an operating income of 6,300. So we can use this to determine the degree of operating leverage will just take the contribution margin of 13,300 divided by the operating income of 6,300. When we do this, we get an degree of operating leverage of 2.11. What that means is that for every dollar in sales that changes, goes up or goes down, the operating income, the profit, the bottom, It's going to change by twice that much by $2.11. So if my sales change my 1%, then the operating income will increase by more than twice that 2.11%. If my sales were to go up by 10%, my operating income would go up by 21 1%. Dollar change in sales means more than a $2 change in operating income. Now this is a good thing to have a high degree of operating leverage if you're increasing your sales. However, it goes the other way to, in other words, if your sales drop than the profit goes down faster, if you lose a dollar in sales, you will lose $2 in profit. So it really depends on the situation as to whether or not operating leverage is gonna work for you or against you. But it's important for managers to understand their operating leverage. So they can understand the risk from changes that they might make in their business. 19. Pricing: In this lecture, we're going to consider pricing. Pricing is a very important and a very complicated decision that management has to make. What we're gonna look at is not the entire pricing decision, but more the decision based on the information that managerial accounting and reporting can provide. So it's one of the elements that are part of the pricing process. We're going to look at both long-term and short-term pricing decisions. First, let's consider long-term pricing. Basically our regular price, meaning our regular price has to meet all costs. In other words, all costs have to be covered in the long run. There are two strategies in our long-term pricing decision. And one struck strategy is based on cost plus and then cost-plus, we just take whatever the cost is and add a desired profit to it, and that will be our price. The other option is target costing. In that case, the market determines the price. So we're not really setting the price at all. The market sets the price. But we have to do is back out our desired profit to see if the cost that we're expecting is going to be low enough for us to get the profit that we want. These, these two strategies are going to be based on the situation that we find ourselves in. Not really a choice between the two, but what the situation is, let's look at these in more detail. And costs plus the total cost are taken whatever they may be, and we just add the desired profit. Now this works for us because we are the seller and we have power to control the price. The reason we have powers because these situations, there are no substitute products. Target costing is a situation where the buyer, meaning the market has the power over the price. So there's usually a lot of substitutes out there. Let's look at a couple of examples of pricing and this situation. We're going to consider the decision to make Star Wars action figures and one of our factories. This is going to cost us in the form of legal fees and it's also going to cost us in order to have the equipment necessary to make the action figures. We expect to have to invest $10 million in order to make the Star Wars action figures. However, we do expect to sell 2,000,500 thousand units. The cost per figure and variable costs wouldn't example would be like materials would be a variable cost would be $1.50 per figure. The fixed cost 3,000,250 thousand per year. We want to make a 10% return on the $10 million investment. First of all, what works better for us cost plus the target costing situation? Well, this is probably a situation for cost-plus. There's no real substitutes for Star Wars action figures. Since there's no substitute for our product, we get to choose the price. We have the power over setting the price, where a price giver with cost-plus, we just add up all the costs are variable costs would be 2,000,500 thousand at a $1.50 each. Fixed costs 3,000,250 thousand. So our total costs would be 7 million. Since we want a 10% return, that's a million dollars. So our sales revenue needs to be $8 million. If we divide that by the 2,000,500 thousand we expect, then our unit selling price would be $3.20. We can look at this from an alternative perspective. Let's look at it on a per unit basis. When we look at this on a per unit basis, we know that our variable costs are a $1.50. So then we just have to take our fixed cost and total, divide them by two main five hundred, ten hundred units to get a fixed costs of a $1.30 Each. Our total cost or $2.80. If we wanted a million dollars profit, that means we want a $0.40 per unit. We just took the million dollars and divided it by 2,000,500 thousand units. So our selling price needs to be $3.20. These approaches, one is just a total approach and one is just a per unit approach. You get the same result. Both of them take the cost and added desired profit, and that's what cost-plus pricing is all about. Our second situation, we decide we're going to sell star battle action figures. We're looking at the situation. And with star battle, that's a generic action figure. And because of that, we expect to have competition. And because we're in this competitive market of generic action figures, the most we can get for each action figure is $3. We need to invest $10 million in our factory. We had the same fixed cost and variable cost per action figure. We have a 10% desired profit. Target costing situation. We're not setting the price. The price is already set for us by the market, $3 each. All we want to know is if the cost is going to be low enough for this to work for us. If we take the revenue, $3 each, 252,000,500 thousand units, that's 7,000,500 thousand. Then. Compare that to the profit that we want, domain knowledge and profit. That means the cost needs to be $6,000,500 thousand. If we look at the expected costs though from earlier, we see that the variable cost or 3,000,750 thousand and fixed costs remain 250. So our total cost at this point or $7 million, when we look at this and see that what we determined is that our costs are higher than what works for us, for us to sell this product. So what we can do then is one, we can reduce the amount of profit that we want. We be willing to accept less profit to. We can try to find some cost-cutting possibilities and cut those costs from $7 million down to this targeted 6,000,500 thousand. Then the third option would be just to inject this and pass on the option. Don't sell these action fingers, look for some other opportunity. We can also look at this from a per unit basis is the same result. It's just that we're looking at it from per unit perspective. The revenue is $3 because we're going to sell each unit for $3 based on the market price. If we take the desired profit, $1 and divide it by the 2,000,500 thousand, we get $0.40. So our target cost would have to be $2.60 per unit. We see that $7 million is our expected cost, and so that gives us $2.08 per unit. There's no difference between these two except that one looks at the total cost in one looks at a per unit amount. Another situation that often occurs is what they call special orders, short-term decision-making. In this situation, we've been approached for a onetime offer for a special price. For example, instead of just buying one action figure, maybe they want to buy bulk for their, for their retail outlet and they want to buy thousands of our action figures. That case, they're not going to pay us our normal price. We need to come up with a strategy for considering these special orders. Let's say we determined that we're going to do a store battle action figure. And we've got a special offer from a retail outlet that wants to buy from us 20 thousand units. Now they're not going to pay the normal $3 because they're buying 20 thousand units, they're willing to pay a $1.60 each. So again, the variable costs and fixed costs are the same as before. If we look at this from a knee-jerk reaction and we say, well, the variable costs 3,000,750 thousand. The fixed cost or 3,000,250 thousand. That gives us a total cost of seven million, seven million dollars total divided by 2 million in 500 thousand units. That means that each unit cost is $2.80. Should we take a $1.60? And maybe the knee-jerk reaction, our initial impulses to, as to say no. But that's not what incremental analysis all about. That's not a short-term or special offers situation. Well, we need to look at as a comparison between our two alternatives, which is to take this offer or not take this offer. They call that incremental analysis. Incremental analysis is an analysis of a decision based on the differences between the alternatives. When we were doing an incremental analysis, we want to only focus on the relevant cost. Relevant costs are costs that will occur in the future. We're not looking for past costs because we can't change those. Were looking for costs that differ between the alternatives. Relevant costs are only helpful if they're different between our choices. For example, if your debt trying to decide between two cars and they're both four doors, because that's the same. It doesn't help you decide between the two cars. But if one car gets 30 miles per gallon and then one car gets 35 miles per gallon. That's a difference and that might help you in making your decision. So we need to keep that in mind. We are looking for differences between the alternatives. So let's go back and look at the store battle action figure, special offer. What are our two alternatives? What are our two options? We can either reject the offer or we can accept the offer. If we reject the offer, will get revenue of 0. They're not going to pay us because we've rejected their offer. If we accept it, then we're going to get revenue of $32 thousand. Now the variable cost will be 0 if we reject it because that's how variable costs work. They only occur if we, if we manufacturer one of our action figures, take for example, the plastic and action figure, if we decide to pass on the offer, we won't use plastic. And if the contribution margin then is going to be positively impacted if we accept by $2 thousand, what about the fixed cost? Well, typically fixed costs are ignored. And these decisions, and the reason is because you have to pay $3,000,250 thousand whether you make the action figures are don't make the action figures. However, there may be some fixed costs that will be different in this situation because the buyer is a foreign purchaser, we're going to have to pay some special international shipping. So that extra $1000 and shipping is a fixed cost. And it is different between the two alternatives. So ignore the normal fixed costs because you pay them whether you reject or accept. So there's no difference. But include the fixed costs that do differ. In this case, the only fixed cost that differs is to shipping. So should we accept this offer? Well, there's two questions that we have to ask ourselves and they both must both be yes in order for it to make sense to accept. We've already asked the first one, does the offer cover the incremental cost? And it does because the revenue is going to be higher than the incremental cost, that cost that differ by $1000, then we're going to have an extra $1000 if we accept it. The second question then there is, is there additional capacity in our factory? If we're making 2,000,500 thousand action figures and that's all we can make. That's the maximum capacity and we're selling them all. So if we're making the maximum capacity and we're selling every one of them, then it doesn't make any sense to take an offer of a $1.60 per action finger because we'd have to take away from our normal, from our normal sales of 2,000,500 thousand. However, if our factory has additional capacity, let's say our factory could make 3 million action figures if we wanted. Both of these. Both these questions need to be yes. Now if we want to look at this from a per unit consideration from this approach is really the same thing. It's just looking at a per unit amount. The revenues and Alex 60 each, their variable costs are $1.50 each. So that leaves us with an additional $0.10. Since our fixed costs are $1000 in extra shipping, we just have to turn that into a per unit amount. Since there's 20 thousand units, that's $0.05 each. So our operating income would be affected by each in each unit by $0.05. In this lecture, we consider pricing from both a long-term or regular price perspective and a short-term special offer perspective. 20. Short Term Decision Making: In this lecture, we're going to look at other short-term decision-making situations that management might find themselves in. These include discontinued business segment, make or buy and sell now or process further. The first situation is the discontinued business segment. First of all, what is a business segment? And really that means any method or any segment or piece of your business that you want to divide your business up. Managers can divide their business up in multiple ways by product type, by geographic location, by business function. Those are all options that are commonly used as business segments. So a business segment in shortage just any way you want to divide your business up. And there's usually a business can be divided up in multiple ways. Then we have to decide should we just continue to unprofitable business segment. And obviously if it's something is unprofitable, you don't want to just, you want to discontinue it. But we need to consider this from an incremental analysis because we can unexpectedly hurt our business. Let's look at this example. We have a business and they've they've brought to us this information, this report. And it shows us that our company that makes three different products, mowers, chainsaws, and tremors, has one of the business segments based on product type that seems to have a negative operating income. That negative profitability of 38 thousand managers and other departments figured the best thing to do is to get rid of the trimer division. And if we get rid of the tremor division, that would logically make our operating income go up by 38 thousand hover. What we'll see is that getting her to the trimer division will actually hurt us. If you look at this financial statement, you noticed that it doesn't give us cost behavior. We understand that variable costs and fixed costs behave differently. Our fixed costs are going to be there whether we sell the tremor or not. So we need to get another report, one that shows us cost behavior. So here's another income statement. And what we're doing is we're just saying that instead of looking at cost of goods sold and selling and operating expenses, we're looking at cost behavior. So any cost is a variable. Cost is put together and put it on the line for variable costs and indirect costs. That's a fixed cost is putting the fixed cost area. So when we look at this, let's consider what would happen if we eliminated the tremors based on cost behavior. So if we eliminate the tremors, we're obviously going to eliminate the sales from the tremors and we're going to eliminate the variable costs. But then a question comes up. What about the fixed cost? We understand that if we have fixed cost, they may not all be eliminated. So we have to get further details into our fixed cost and understand which cost will go away if we get rid of the tremors in which costs will stay. The avoidable costs are costs that will go away if the tremors or discontinued. What is included in avoidable cost? Well, always the variable costs are avoidable, but we've already seen that. We've, we've taken the variable cost out. And then sometimes the fixed cost will be avoidable depending on the situation. So if we look at our list of our fixed cost, we see that the building lease, equipment, lease, advertising, makeup, our fixed cost, well, the building least is unavoidable. So that's gonna be there. The equipment lease. We can avoid 32 thousand and equipment that's only used to make the tremor, so we quit making the tremors. We would avoid the 32 thousand and equipment lease for the tremor equipment, the advertising we could avoid 45 thousand. And the reason is because there's some advertising that just advertisers for the tremors and we would quit doing that. So our total avoidable cost would be seventy seven thousand one hundred and sixty two thousand fixed costs, 77 thousand avoidable. That means that we would have 85,500. That would be unavoidable. So the 85,500 that's unavoidable now needs to be split up and put in the other departments needs to be put in the mowers and chainsaw divisions because we will no longer have the tremor division to absorb those costs. So looking at this now, since we've taken the fixed costs that were in the tremors and moved it over into the mowers and the chainsaws. Those unavoidable fixed costs now add two additional cost and those divisions. And what we see is that our total operating income is actually been harmed or reduced. If we look at the initial situation, when we looked at the first financial statement, we saw that our operating income was 2,024,500. Now we look at it with the tremor being eliminated and we see that it's gone down to 1,000,977 thousand. The reason is because we lost out on the contribution margin that we were making earlier when we were selling to tremors. And we didn't get rid of all of the costs that were fixed costs. We only got rid of some of the fixed cost. Understanding cost behavior helps you to make decisions like whether or not you should just continue business segment. Let's look at this from an incremental analysis where we have two options. So this is the same situation. It's just that instead of looking at it from each of our products, we're just looking at it from the two options. Continue the tremors or eliminate the good tremors. And we see that by continuing the tremor will get the sales, will get the variable cost, of course. And we'll have all of the fixed cost. If we eliminate the tremors, will end up getting rid of the sales and variable costs, but we will only get rid of 77 thousand of the fixed costs, leaving us 85,500. What that means is that our operating income is going to be harmed by 47,800. Even though the continuing brings us a negative 38 thousand, if we eliminate, it's going to bring us down by 85,800. What that means is that our difference is that we do better by continuing with the tremors of 47,800. Understanding cost behavior can help us from making a poor decision whether or not to eliminate a business segment. Our next short-term business decision is a situation of whether or not to make or buy a product or component product. Our company is I link and we make earbuds. And we currently manufacturer to a million units. The total cost to make the earbuds $4 for a material that's a variable cost, direct labor hours, $0.50, That's another variable cost. And the variable manufacturing overheads a $1.50 for each earbud. So those are all three our variable costs. Then we have some fixed cost, F $4 million. Now, if we look at that on a per unit amount, that's $2 per ear bud. We have an offer from an outside manufacturers saying they will make the ear buds for us for $7 each week. When we consider this, the knee jerk or initial reaction is to add up all of our costs. Adding a Holocaust brings us to $8. The earbuds they're offering to make for us at $7. So we say, okay, well, it's cheaper to buy the earbuds from an outsider. How remember that we need to consider the cost behavior. Fixed costs and variable costs aren't going to behave the same in this situation, we need to look at incremental analysis is a way to make this determination. With incremental analysis, we want to look at two alternatives. One is making one to spy. So if we make the earbuds, it costs us $6 in variable costs $4 plus $1.50 plus the $0.50, that's $6. If we accept the offer, that would be $7. So the $7 per unit, the 40 million buying the product from the outside third party manufacturer, it would cost us 14 million. Variable cost or 12 million. What about the fixed cost? Again, we have to determine which costs are going to remain in, which costs are going to go away. The fixed cost for the current situation of making the ear buds and house is $4 million. If we buy them from a third party, we're going to get rid of some of the equipment. And what that's gonna do is result in our fixed cost being reduced, but not in total, only by 500 thousand. So now we look at our total cost. An opportunity cost is when we give up a benefit, when one choice is made over another. Another concept is important in these decisions is called sunk cost. Sunk costs are costs that incurred in the past. So even though we purchased the machinery to make that ear buds, we don't want to consider those costs that we already spent in the past to buy that machinery. We only want to look at what are the implications of our decision in the future. So past costs are what they call sunk cost. In our situation, the management determines that they can take the extra space now being used to manufacture earbuds in the factory. And they can lease out that space to another manufacturer who's looking for space. In other words, they can sublet some of their factory to a third party and that would bring in $2,000,500 thousand. That's what we call an opportunity cost. If we continue to make the product, we won't get any of that 2,000,500 thousand. But if we decide to go and buy from an outside manufacturer, then that's going to free up the space and provide the opportunity. And that $2,000,500 thousand is going to reduce our cost and our factory by 2,000,500 thousand. When we factor in the opportunity cost, we see it reduces net cost, more costly to continue to make the product. Understanding opportunity cost is important for managers because it can have an impact on the decision-making. Our final decision-making concept that we're going to look at today is the cell as is, or process further decision. So a lot of times products go through a process and you can sell them at any point. You could take a dairy farm where they have milk and they could turn that into cheese or yogurt. They could continue to process it and sell it at any point. Petroleum oil could be turned into diesel, which could be then turned to gas to jet fuel. Another example is unfinished furniture, which could be sold as is our painted and sold at a higher price. And then finally we have whole peanuts and agricultural product and we can take that and sell them as is, or we can sell them shelled are crushed, our tinning to further process them as peanut oil. The point is that we needed to determine whether or not the additional cost to further process is going to be more than the additional revenue that we can make from the more refined product. In our example, we have peanuts and our factory can either Shell them and sell them as is, or they could sell them crushed to be used in recipes. So the estimated sales if we sell them shelled is 50 thousand units. If we crushed them, we expect to sell 40 thousand units. The price will be $5. If we sell them shelled, $7. If we sell them crushed, it will cost us an additional $0.75 per bag to crush the peanuts. So in our incremental analysis, we have two options. Cell now sell them as shelled peanuts are processed further and sell them as crushed peanuts. The revenue that we would make if we sell them now is 250 thousand. The revenue that we would make if we sell them as crushed peanuts would be 40 thousand bags at $7 each or 280 thousand. We do have an added cost if we want to crush them and that's Seventy-five cents Unit at 40 thousand units, That's thirty-seven thousand, five hundred dollars. But we just want to look at the impact to operating income if we sell them now, we would bring in 250 thousand. If we process them further, 242,500. It seems that the cost of crush the peanuts is more than the additional revenue that we would make the cell as is or process. Further situations, thick key to this is to determine whether or not the additional cost for processing are going to be more than the revenue that we're going to bring in from additional processing. 21. Introduction to Budgeting: This lecture, we're going to begin our discussion of budgeting. Budgeting is one of the most widely used tools across the globe. Mall organizations to large corporations that are multinational, they all use budgeting. Governmental organizations and non-profits. They all use budgeting. All types of business managers and business functions all incorporate budgeting in their management decisions. Whether you're in marketing area of supply chain or operations. It doesn't matter whether you're a beginning manager or upper-level manager. All levels of management are involved in the budgeting process. It's very important that we get a good understanding of what budgeting is and look at some examples. But it is involved in all types of management planning, directing and controlling whatever type of management decision-making, budgeting There's involved in that. Now when we think about the benefits of budgeting, most of the time, what I hear is that budgeting is important because it has to do with the money that's involved with the business. Well, that's true. But there's a lot more to it than that. There's a lot more benefits to budgeting. First of all, it forces managers to plan. You'll find is a manager that you are often involved in your day-to-day decisions. And just trying to get through the challenges of the day. Budgeting forces managers to sit back and think about the future and what they plan to do. Another benefit of budgeting is it provides clear objectives and goals for managers and employees to try to meet. Budgeting also provides an early warning system. What do I mean by that is, let's say you have a budget for your supplies of a certain amount. Well, if you burn through half your budget within the first couple of months of the year, then that early warning system will let managers know they need to address that. Budgeting also is part of the coordination of activity. So managers tend to focus on with their area of expertise is, and not really think about what's going on in the other areas of the business. And so if you are in the budgeting process, you have to coordinate your business function, your area of expertise with the other managers involved in your business. It also requires managers to be aware of the overall business instead of just being focused on their business function, like just just focusing on customer service, for example, they have to think about what's going on with the rest of the organization in order to make their budget fit. Within that big scheme of things. Typically, managers prefer a participative budget. With this type of budget, it requires kind of a grassroots effort from the employees and the lower-level management, management all the way up to the higher level executives. And what that means is that instead of the executives, the CFO, for example, make the budget and passing it down. What usually what happen with a participative budget is that the lower managers will create with their budget needs are, and it'll flow up through the system until it gets to the upper-level managers who will then review it. This is a preferred system. Then just telling the managers what they need to do and just giving them the budget without having any input from them because it really leads to more motivation. In other words, it means that the managers have been part of the process. And when they're part of the process, they tend to be more motivated to make that budget work. They have what they call buy-in because they were part of it instead of it being told to them, they were allowed to be part of the creation process of the budget. One thing we need to be careful of is something called budgetary slack. Basically what that means is when managers create their budget, they put a little extra in there. And the reason they do it is because they worry that perhaps they'll run out of money and they don't want that to occur and they don't want to go over budget because that looks bad. And so by putting a little bit of slack in there, they, they hope to give them some wiggle room, but that's a very big problem. The potential problem with that is that if every manager does this in every area of the budget, in that little bit of extra slack can turn into a lot. And it really doesn't give us a very effective and efficient budget process. So all along the way, we want to be cognizant of the potential from budgetary slack and try to stop it as much as possible. Typically, budgets are made on an annual basis. A lot of times they start the budgeting process in October, November to be ready to roll out the budget in January, and the budget will go from January until December. That's a kind of a typical process that they use. There are something called rolling budgets. And what that means is they'll do a twelv month budget and then they'll keep doing it every month. So they'll do January until December, and then in February, the new February until January of the next year. And then in March they'll do March until February the next year, and then they'll constantly be rolling out the budget. And what that does is it makes the budgeting process a little bit less cumbersome because they're not doing 12 months. They're just updating and adding a month every every time they do the budget. And it also keeps the budgeting process on the forefront of their mind all the time. Whereas an annual budget, you might think of budgeting only when it comes to budget season, when it gets to around October or November with a rolling budget, you're always thinking about how the budget is going to be impacted each and every month. Both of these options are are good at just kinda depends on the management team and what they wanted to do. Annual budgets are much more common, but rolling budgets are starting to get more attention. In our lectures on budgeting, we're going to focus more on an annual type of budget or quarterly budget. We're not going to really look at rolling budgets. But keep in mind that those are up and coming. There is a difference between a budget and a strategic plan. Budget is usually done on an annual basis. Usually budgets aren't done for more than a twelv month timeframe. And they're fairly specific as far as how much the spending is expected to be. Strategic plan is more of a long-term situation like five to ten years into the future. And it's more, a little bit more vague and general in nature. It doesn't look at specific, so it just looks at the direction that the company wants to go. If you try to do a budget for more than a year and do a buddy for, say, five years, you're making estimates so far for the future that it would be very difficult for those estimates to be very useful. So budgeting is more of an annual situation as strategic plan is a long-term outlook is a little bit more general in nature. Let's look at a master budget. Now. One thing to understand is that a master budget is not in and of itself. And budget, a master budget is really a bunch of smaller budgets put together like a jigsaw puzzle. Each of the smaller budgets are a piece of the puzzle and they all give some information. But in order to get the big picture, you have to put it all together. The master budget is really not a single budget, but a bunch of the budgets put together and they all start with the sales budget. It's important to understand the sales budget is the first budget. It has to be the first budget, because before you can determine what you want to spend your money, you need to know how much money you're gonna bring in. The sales budget is going to come from the marketing department. They're going to develop a sales budget. Then if you're a manufacturer, you're going to have a production budget. Production budget is only used for manufacturing. You wouldn't use this for service business. The production budget, what you're doing is you're looking at how many units you want to manufacturing based on the sales budget that was provided. If your sales budget says that they think you'll sell 1000 units than the production budgets can be used to make sure that you can meet that goal of selling 1000 units. The sales budget has to come first. The production budget would have to come next before we can do the materials, labor, and overhead, we have to do the production budget because you're not going to know how much direct materials to buy until you know how many products that you want to make. This example we're going to use. For our example company, a potato chip manufacturer. Opportunity to choke manufacturing company needs to know how many potatoes they need to buy, and that would be their major direct material. But before they can determine how many potatoes too Bye, they need to figure out how many, how many cases of potato chips they're going to produce. Production budget would lead to the material budget. The production budget also leads to the direct labor budget. They're going to need people to work at the factory, to manufacturer the potato chip cases. We're going to need to know how many cases of potato chips we're going to manufacture in order to know how much labor to have in the factory. So that's why production budget comes before direct labor budget. And then the manufacturing overhead budget includes your other areas such as the utilities in your factory insurance, all these other things. After you get all of those together, then you go into the operating expenses. The operating expenses would be like your selling expenses, like your marketing, would be your human resources. It would be supplies for your offices. It would be those types of general and administrative type expenses. You would want to do these after you've completed the production part of your budget so that you understand what's leftover. To go towards those. After that, you can create a budgeted income statement. So remember the budgeted income statement or any income statement provides you with your profits for the period. A budget income statement is going to say, well, based on the budgets that we have, this is our estimates for our profit for that period of time. All those budgets we just talked about are called the operating budgets because those are part of your day to day operations. Then we have the financial budgets. Financial budgets include your capital investment budget, cash budget, and your balance sheet. The capital investment budget is your big ticket items. This would be where you buy new equipment or build a new plant, our open a new factory. Then of course, there's cash budgeting because income and profits aren't the same thing as cash. So it's important that we a budget our cash so that we are aware if we're going to have any low points of cash so we can take care of that before the time comes and we get blind-sided with that problem. And then finally we have the budgeted balance sheet. The balance sheet tells you the kind of resources you have. In this case, because we're doing a budgeted balance sheet, these are expected resources, we call those assets expected liabilities, and expected equity. Now we have an overview of the budgets. Let's go ahead and look at some of these. 22. Master Budget: Let's begin walking through the budgeting process. We're going to start with the sales budget. And to do a sales budget, we need a sales forecast. Sales forecasts, you don't go to accounting or finance, you go to the marketing or sales area because those are gonna be the experts that are going to understand what is coming down the road as far as the sales that are expected. Sales forecast come usually from the marketing department. And they'll have sales that they know that are already on their books that they've already made that are coming down the road. And then they'll take that information and they'll kind of tweak it. It'll kinda look at the economy. The economy strong as Economy week. How is that going to affect their sales and the next and the upcoming period. And then they'll maybe look at the industry that they're in. They in an industry that's on the upswing, are they in an industry that's maybe a mature industry? Then what about the business like, how is their specific business doing against the competitors? What kind of market share do they have and are they gaining or losing it? Historical trending information? Where are their sales typically at that point in the year, take a retailer, retail and usually gets a lot of sales in the fourth quarter. So that historical understanding of how the sales will change throughout the period is very useful. Then what about technology? New technology coming into the business could help them with efficiencies. It could mean new products, it could mean faster turnaround times. So understanding the technology that could be changing could be helpful in forecasting their sales. Advertising, for example, do they have an advertising campaign? Are they going to advertise a product? Then finally, I just put etc, because every business is different, everybody, every business has their own nuances that need to be understood in marketing, experts are the ones to go-to when you want to know that the sales forecasts and all those extra elements that are involved. Once you have your sales forecasts, you can move forward with. We have one tab called our given tab, and it provides us with all the information that we're gonna need to do. Our budgets. Managers are going to have to gather this information and put it together. And we'll notice that we have a sales forecast here. The sales forecast from January, all the way to me, but we're only going to do the first quarter. That extra information, however, might be helpful for budgets as we move along. But just grab from here what information you need for each of the budgets that you do. So we'll take our sales forecasts and we'll bring it to our budgets area. Our company is tasty potato chips. Of course we make potato chips. And we'll start by just taking the information from this given sales information and we'll put it in our sales budget. We're just going to do for the first quarter, January, February, March. We expect to sell thirty thousand, twenty thousand and twenty-five thousand cases of potato chips in each of those months. Then we look at the selling price per unit. So that's in the given information. We were given that the price was $20 per case, and we're not expecting that price to change anytime soon. If we take our unit sales of 30 thousand cases of potato chips times $20 per case, we get our total sales in dollars. We're gonna use this information now to go down to our production budget. The production budget is how many cases of potatoes we want to make in our factory. It's different from how many cases we expect to sell. Now why would we have differences from what we want to sell and we want to make, well, a lot of times managers want to make a little bit of extra because these expected or estimated sales could be a little bit higher. So they might want to have extra leftover. That's why the amount of production is not the exact same as the amount of sales. But we do want to start with the sales budget, will take the information from the sales budget and move it to our production budget. We just drop that in. Now notice also we have December and April, even though we're doing the quarter, which is January, February, March, I'm adding a couple of extra columns. That's just for your benefit. You won't see this on the actual budget. I'm just adding those extra column to the beginning and the end. So you can see the flow of information. That's the only reason is just for the learning process. So the next thing we want to see is the desired ending inventory of potato chips. In other words, how many cases of potato chips do we expect to have leftover at the end of each period? The reason we want to have some ending inventory is because first of all, what if we sell more than we expected? Then we need to have some extra ending inventory. And also we want to have some leftover for February. We don't want to start February having sold everything in January. That's the reason we want to have a little bit extra and how much we have extras up to you, the manager, if you want to have a lot of extra inventory, so you never run out. Well, that's fine. You can have a lot of extra inventory. That's why it's called desired. In that case, you run a low risk of running out, but you run a high risk because stuff can happen to that inventory. You have to store it in a warehouse. It could get damaged, obsolete. Another problem is that it's costly to store extra inventory. If you go lean and only make just enough for you to cover your sales. Well, that's great. You'll save money, but you run a risk. So how much do you want to have this up to you? In our case, we're going to go to the given tab to see how much inventory they want to have. When we look at the finished goods area, it says that we want to have 10% of next month's estimated unit sales. The 10% of next month's sales means that you take the next month and you drop 10% into the current month, January, you want 10% of the next month, which is February. February, you want 10% which of the next month, which is March. Then you see we have April up there. And now you can see why, because we want to have 10% of April's in March and we need to know what April is so we can figure that out. That's why I put that April column in there. Again, you wouldn't use that in your in your real budget because you wouldn't want to have that extra column there. But we're going to use it to learn with. And we'll see why we have to simpler there for now. For now. Just keep in mind it's going to be useful in a little while. So the total amount of finished goods we need would be for January 32 thousand units of potato chips. However, we don't want to make 32 thousand units of potato chips. What if we already have some cases leftover from last month? If we have cases leftover, then we want to use those up and not manufacture those. So let's use those up and we'll get that from our ending inventory. So notice that the ending inventory from the previous month becomes the next month's beginning inventory. In other words, if you ended with 3 thousand units of potato chips in December, that means you started January with 3 thousand cases of potato chips. So January's ending inventory becomes February's beginning inventory. Now we're gonna subtract that because we don't want to make it. So the amount of units to produce, it's gonna be the total finished goods needed minus the beginning inventory. For January, we needed 32 cases of potato chips, but we already had 3 thousand leftover from Jane from December. And so that means we need to produce 29 thousand cases of potato chips. What we need is not the same as what we produce because we have beginning inventory leftover. Now notice for the quarter. If you notice the quarter, our ending inventory comes from March and our beginning inventory for the quarter comes from January. If you want the unit sales, you add those up with the beginning inventory comes from the beginning of the period and ending inventory come from the end of the quarter. Next, we're going to do direct materials budget. So the main material that we need for making the cases of potato chips would be potatoes. So how many cases of potatoes do we need? Well, we're gonna start with how many cases of potato chips we're going to manufacturer that. The amount from the production budget gets moved down into the direct materials budget. That's how you begin your direct materials budget. If each case of potato chips needs £5 of potatoes, then the direct material for production would be a £145 thousand in January. That's all we're doing really is taking the cases of potato chips and turning them into how many pounds of potatoes. Now, we're not going to end here because we might want some extra potatoes we don't want to buy just enough. Because we could have a situation where some of the potatoes are damaged or are some of the potatoes get messed up in the process of making them in, a batch, gets thrown out. And then all of a sudden they have to make some more potato chips and they need extra potatoes. So how many potatoes should they have extra? That will be their desired ending inventory. But to get that information, we go to the given tab. It shows us that each case of potato chips needs £5 of potatoes, which we saw. And it also shows us that the managers desire 10% of next month's direct materials as they're ending inventory. And also shows us the cost per pound as a $1.50 per pound. The ending inventory, as it stated in a given area, is desired to be 10% of the next month's production needs of the number of pounds they need for production. So 10% of February's. Direct material needs would be 102,500 times 10% gives you £10,250 of potatoes. That means that for January we need £155,250 of potatoes. February, we need 10% of marches. And then we're going to use April to determine how much to have as an ending inventory for Mark. We did December, so we would have the beginning inventory for January, which we'll see in a second. As you can see, the ending inventory from December becomes the beginning inventory for January. The reason we want to know what the beginning inventory is is so that we don't buy potatoes that we already have. If we're expecting to have £14,500 of potatoes the beginning of January. We don't want to buy those. We want to take those out of our number of pounds of potatoes to purchase. Instead of buying £155,250, we already have 14,500. We only need to buy a £140,750. We also want to make sure we have enough money to purchase that material. As we saw earlier. And the given information, each pound of potatoes cost us a $1.50. So that means the total cost that we need for direct material would be $211,125. This allows the financing and accounting department to make sure that they have the cash or the credit in place to get the materials. Purchasing wants to know how much to buy. And then our finance and accounting area wants to make sure we have the cash to cover those costs. Next, we are going to look at the direct labor budget. Now this budget is very important for the HR people. They want to make sure they have enough people in place at the time they need them. If you don't have enough people to make the potato chips, it doesn't matter if everything else is right. You're not gonna make any potato chips. You need to have the labor in place. We'll start by taking the production budget and moving that information into the direct labor budget. We want to know, in other words, how much we're going to need to produce in each periods that we know how many people to have to produce that. When we go into the given tab, it tells us that each it takes us 0.05 hours, which is far laborers to make a batch of potato chips. And our wages are $22 per hour. Now, that's not necessarily how much we pay the workers. That's the total cost of the workers including benefits, payroll tax, all of those things. In January we need to make 29 thousand cases of potato chips. Each case takes us 0.05 hours. That means we need 1450 hours of labor. February went 1025 hours, and March 1285 hours of labor. This is very useful for the Human Resources area. Again, this is what they need to know so that they can have the right people in place if there's going to be a spike in labor. For example, we all know that retail needs a lot more people and November and December than they need and other times of the year. So we need to have estimates for labor needs in order for the human resources to have the time to get the right people in place, to get people trained and get people hired and go through and make sure they've had security checks and all that. Now knowing how many hours of labor is very useful for them, but they also want to make sure and the accounting and finance area that we have enough money to pay the payroll. We saw from the given area that it's $22 per hour. So that shows us how much we need and available funds to pay the labor. And January, February, March 31,900 and January 22,550, and February and 20,270 in March. 23. Operating Budgets: We've completed the sales budget, production direct material and direct labor budget. Now we're gonna go ahead and look at the manufacturing overhead budget. To do this, we're gonna need some information from management and that's provided in a given tab. In the given tab, we see that we have some information on the variable cost, meaning indirect material is a $1.20-five per unit, which is a case. Indirect labor would be $0.75 per case a potato chip. We're gonna use this information and we're going to move it along with the fixed costs into the budget tab. The fixed costs would be costed or the same amount every month, no matter how many cases of potato chips we were to manufacturer. We first need our production budget. We need to move that information into the manufacturing overhead budget. The reason is because each of those variable costs are gonna be a per unit amount. So indirect materials, a $1.25 per case. We got that from the given tab. A $1.20-five per case times 29 thousand cases that we're going to produce gives us the expected overhead for indirect materials for January. And we'll do the same for each of those months. We're gonna take the production needs times the per unit amount that was provided in the given tab. Now the fixed costs are the same amount, whether or not we make a few cases of potato chips are lots of cases of potato chips. They're not variable based on volume, depreciation, property tax, indirect labor, utilities that was all given to us and they given tab. And we just put that information into our budget based on what management tells us they're going to need for those areas. That gives our total fixed manufacturing overhead. If we add that to our variable manufacturing overhead, we get our total manufacturing overhead budget. Next we have our operating expense budget. Again, this is going to be dependent on information given to us by management. We're going to go ahead and look at the given tab. Management has given us estimated expenses for commissions, shipping, and bad debt, those are all variable costs. We're also going to look at the fixed cost salaries, rent depreciation, advertising. These are all costs that are the same amount each month no matter how much it sold. Now notice I said is sold and not produced to commissions are paid on the number of cases of potato chips or sold. The shipping is based on how many cases of potato chips they are sold and bad debt percentage of sales. So we'll take the number of units to sell and we'll drop that down into the operating budget. Then we're going to use the variable expenses that were provided for us. So if we sell 30 thousand cases in January, like we expect, two times the commission amount times the shipping amount times the bad debt percentage. We get our variable overhead. The more we sell, the more the commissions or the shipping and the bad debt is, the fixed cost are just carried straight over. Those are not dependent on the sales that information is carried through. And we see our total operating budget, which is the fixed operating expenses, plus the variable operating expenses added up. Now that we have the manufacturing overhead and makes operating expense budgets, we can go ahead and do the budgeted income statement. In other words, what expected profits are? Our income statement is just going to be for the month of January, not for the entire quarter. So we're looking at January. We're going to start out with the revenue. The revenue is going to come from the sales budget. So that information for sales is going to be the dollar amount of sales that are expected to be made it straight from the sales budget, then we have the cost of goods sold. So let's break that down. So the cost of goods sold is the cost of the case of potato chip, including material, labor and overhead that goes into each. So the drug materials we get from the information provided. Each case of potato chips takes £5 of potatoes, a $1.50 each. £5 times 150 gives us 750. Direct labor is 0.05 hours per case. If potato chip, that's about six minutes for case of potato chips. And that means 0.05 times $22 an hour gives us our direct labor per case. So direct labor then is a $1.10 per case. The variable manufacturing overhead is calculated as follows. All the manufacturing overhead information is provided in the given tab and then transferred over to the cost of goods sold. We have the indirect materials is a $1.20-five per case, and direct labor seventy-five cents per case. Utility is $0.50 per case. The fixed manufacturing overhead is the total divided by how many units we expect to make coming to the income statement information provided by management, we see that it's going to be $0.90 per unit for a fixed manufacturing overhead. Cost. For the case of potato chips, added up is going to give us our cost of goods sold. If each case a potato chip cost us $12. And we looked at the sales budget, we see 30 thousand cases at $12 each. That gives us 360 thousand for our cost of goods sold, gross profit is the remainder, which is 600 thousand minus the 360 thousand. The operating expenses comes from the operating expense budget. January's operating expenses were estimated to be 142,800. So the operating income is going to be 97,200. We don't have any interest payments, but we do have income tax. The income tax rate is provided in a given area. We're told it's thirty-five percent. Net income after income tax is 63,180. Now that we've got the information to do the income statement, we have all the operating budgets in place. Next, we'll look at the financial budgets. 24. Cash Budget: The financial budgets pull a lot of information from the operating budgets. But there are two areas that we need to focus on. First, before we can get you the budgeted balance sheet. First, we need to look at expected capital investments. And then when you look at the cash budget, in order to do the capital expenditure budget, we need to get information from managers. Capital expenditures are a big ticket items. These are not things we do every day. This would be like purchasing new equipment, are expanding to a new facility, asking management about the upcoming capital needs for January, February, and March. They tell us they're only expected to use capital expenditures in January. They expected by a computer and delivery van and so production equipment. So our capital expenditure budget is fairly straightforward. It just includes that information. What's not straightforward is our cash budgets. That's a more complicated calculation. A cash budget is very important. Managers need to know how much cash to expect to have available to them for paying your payroll, for buying supplies. Knowing how much profit they have is nice, but that doesn't mean they're going to have that in cash. For example, what if one of their vendors owes them money and they haven't paid them yet. So a cash budget is a crucial element for making sure managers reduced the risk of running on the cash. To do this, they're going to need to have two budgets that flow into one. They're going to need to have our cash collection budget estimating the cash that's gonna come in and the timing of when the cash comes in. And cash payment budget estimating when the cash is going to be needed. And then they're going to combine that together for a combined cash budget. We're just going to look at both cash coming in as compared to cash going out. Let's start with the cash collection budget. We're going to do January, February, March, but we have a few extra columns, December, April and May. Again, those are not part of the formal budget, but part of the learning process. I'm gonna show you the flow of the numbers as they go through the budget. Let's start with cash sales versus credit sales. So we expect sales to come in and January, February, March, but not all of it's gonna be cash. We see that 20% of the sales are going to be cashed in, 80% are going to be credit. If we take 20% for the January is expected sales, we're gonna know that's gonna be our cash sales. For January, we take the sales that we expect times 20%, that gives us the $120 thousand. February 20%, March 20%. Now let's look at the credit sales. Before we can do the credit sales, we have to see how the cash is going to flow. Cash collections is given to us as eighty-five percent in the first month, meaning that we will make a sale on credit 85% of the time we're gonna get the money in that month. Just not right away, but within that month, the rest of the money, the 14% is going to come in the second month, and then 1% of the money is going to be considered bad debt. So we want to start with November. Why don't we start with November if we're doing a January cash budget? Well, even though we're going to make sales of 480 thousand and November, those sales or credit sales in November. So those credit sales, which are provided in the given information, are going to flow to us at eighty-five percent in December and then 14% in January. So even though we made some sales in November, we won't see the cash until January. We can counter that cash in January based on our estimates, will do the same thing for December. Our December credit sales or five hundred, ten hundred expect to get 85% of that in January. For January the credit sales or 480, that means that the first month after January they expect to collect 85%. In March, 14% will go all the way down. Notice that in February some of those sales are not gonna arrive until April and in March some of them are not going to arrive to April or May. The reason that we want to put these in the system is so we can see what's expected. Those April and May amounts are receivables. So we want to know that for future reference. It helps us to see the flow of the cash as it goes through. We see their total cash collections or 612 thousand, our revenue for the month and our profit for the month, there's not 612 thousand, but we can expect to have that much in cash, but we also need to know how much cash we're going to need. So again, this is a timing situation. Our cash payments, we're going to first look at direct materials. Direct materials we buy, but we don't necessarily pay for it all on the same one that we buy. Let's go ahead and look at that information. So we've set up a little side calculation for the direct material purchase cashflow. And what this shows is that the direct materials are purchased and one month and then they pay for them the next month. So their shoes, your 30-day payment period for paying for materials. If we bought materials in December. We paid for them in January. There's a timing difference. As you recall, our direct material budget says that January we're going to make purchases of £211,125 of potatoes, but we're not going to pay for them with cash. What about operating expenses? Operating expenses are very similar. We take the total operating expenses from our operating expense budget. But some of those expenses are not cash. Depreciation, for example, is not a cash amount that they're going to have to spend. So we're going to subtract that from our operating expense needs. The same thing for bad debt. Think about bad debt is that represents cash that we're never going to get. So we move that information into the cash paid on budget. Looking at the capital investment budget, we see that we're going to make some significant cash and capital investments in January. And based on the information from management, we're going to pay for that and cash. Finally, in our given tab, it tells us that we have some dividends. Dividends are payments to our owners, to our stockholders. Basically, we're giving them their part of the profits. We only want to show that in the month in which the cash is sent to the stockholders and that would be in January. And in our given tab, it shows us that there's going to be 25 thousand in a dividend. We can see that in a given tab. Now we combine these together. We'll take the beginning cash and that's going to be given to us. This is from last year's balance sheet. So last year's balance sheet shows us thirty-six thousand, one hundred dollars in cash. Then we add the cash collections from the cash collections budget. Then we're going to look at the cash available. The cash available is 36,100 we started with plus the cash collections that we expect in January. The cash payments comes from the cash payments budget. We just bring that information down. It seems we're gonna have a shortage of cash and this is the whole point of having a cash budget and that has to see the shortages in advance. This way we can approach the bank and say, look, we know, we already know we're gonna be a little short. Maybe we have some reasons for that. And we want to go ahead and secure a loan, or if we have some other way of getting cash, we can go ahead and get that ready so that we don't get blindsided and taken by surprise in January, that would be the worst-case scenario. Because we already know that January it's going to be short. We're going to go ahead and plan to have some new borrowing for January to make sure we have enough cash. The given tab shows that for the cache information, we need to have a minimum cash balance of 15 thousand. That's how much management wants to have to make sure that we have a little cushion of cat. We're going to get a loan for $20 thousand. And then notice that our ending cash balance is going to become February's beginning. Then again, we take the cash collections from above. We take the cash payments from the cash payment budget from above. And then because we have plenty of cash and February, we're going to go ahead and pay off our $20 thousand in February or at least plan to. And then the interest is calculated based on information. And the given tab, it shows a 9% per year. So we take 9% divided by 12 times the $20 thousand. Notice that my beginning cash balance for the quarter comes from January and then my ending amount comes from March. The reason is because March end of the quarter and what IN March width is what they end up quarter width. Now that we have all those pieces together, we can go ahead and look at the master budget again, and we see that we have everything we need to go ahead and do a budgeted balance sheet. 25. Budgeted Balance Sheet: Finally, we can see how we can complete our master budget with a budgeted balance sheet. We had to go ahead and do everything else first to get to that point where we had all the information. We'll do our budgeted balance sheet for January 31st for tasty potato chip will start with the assets. So let's just look at the cash at this point. So this comes from our cash budget. So we just go to our cash budget and we pull the ending amount for January for cache data, we looked at accounts receivable. Accounts receivable are based on credit sales. In other words, we've made some credit sales to customers off our potato chips and we're waiting for them to pay us. We've already made the sale. We have December credit sales, and we have January credit sales. So this information is going to come from us from the sales information we see here from the cash collection budget that we have January sales, cash sales of 480 thousand that's provided for us from the sales information. Then we add the December credit sales that we do have an allowance for doubtful accounts. What that means is these are the sales that we are credit sales, but we're not expecting to collect based on historical estimates, and we base that on 1% from the given information. So our January credit sales is 480 thousand and we had a previous balance of $750 for our allowance for doubtful accounts. This was provided for us again in the given information from our previous year, the net accounts receivable, credit sales minus the allowance would be 549,400. And then we have our inventory. So our raw materials inventories from our direct material budget, our finished goods inventory from our production budget, and then our property tax is from our cash budget. So all these information flow in from those various budgets, property, plant, and equipment is information that we have to get from our previous balance sheet that's provided for us in the given information. Plus we're going to add any new property, plant equipment from the capital expenditures minus any depreciation. Our beginning balances in property, plant and equipment, and accumulated depreciation come from our given tab. The balance sheet information was provided for us from our previous balance sheet. But now we're going to add to our property, plant and equipment new capital investments. So that would be from our capital expenditure. We can see that capital expenditure budget here. We can also, we also wanted to take note of the depreciation that's in our operating budget, as well as our overhead budget because that's going to be factored into our accumulated depreciation. So our beginning amount to come from previous balance sheet at our capital investment. Our accumulated depreciation. This starch with our previous balance sheet, add the current year's depreciation from both manufacturing and from operating depreciation. We get our total here and then these amounts are moved over into our balance sheet. We have our accounts payable. Now this is going to come from our direct materials budget. In other words, what we purchased in our previous month is what we owe in our current month. We look at our direct materials. We noticed that the January purchases don't get paid until February. That means that those are our payables. So that's where we get our accounts payables far our balance sheet, the income tax liability is from the income statement. Remember, we saw that the income tax from our income statement was 34,020. We calculated that in income statement but we haven't paid it yet. Now are other liability would be that loan that we're going to have to get because we're expecting a shorter cashflow. So that $20 thousand loan is going to be our other liability. The stock starts out at 1,000,025 thousand days that amount for the entire year. No changes there, but the retained earnings that does change. The retained earnings is the beginning retained earnings plus the profit from the income statement, 63,180 minus the dividends that we are going to pay a 25 thousand. So our ending retained earnings will be 3000758735. Notice our assets equal our liabilities and stockholders equity. At the completion of the budgeted balance sheet, we have the master budget completed and our managers have information. They need to make their decisions throughout that particular period. 26. Performance Evaluation: In this lecture, we're gonna be looking at performance evaluation. We're gonna be using budgets like we learned in prior lectures, but we're also going to be comparing them to reality. By comparing what we expected with what really happened, we can get an idea of the level of performance the management is doing. Are they doing a good job or are they doing a bad job? Well, if you take what you expected, aka the budget and compare it to what really happened, then you can get a feel for their performance. They call that a performance evaluation. There are two ways to approach decision-making with a business. One is a centralized approach. This is a top-down approach in which the one of the main managers are owners of the business, will make all the decisions and pass them down to the other people. Usually this is a smaller business where there's a single individual. They can understand every aspect of the organization. However, with large organizations that comes very difficult for one single person to be, to be an expert and to understand everything that's going on. In a decentralized approach, the business is broken up into different pieces. How are these? Are these pieces broken up? Well, you can have it broken up based on geographic regions, north division, south division, East division, West division. You can have a broken up by product line. We have our Sporting Goods Division and we have our juniors division. Based on distribution channels. For example, you might have sales and the actual store versus sales online. That would be a distribution channel division. You might have broken up based on the customer base or the business function of business functions such as accounting department versus human resources department. Those are just ways to break the business of the different chunks and give each management team their own piece of it. This is what they call the decentralized approach. The advantages of the decentralized approaches that you have, the ability to use expert knowledge, managers are usually put into areas in which they are experts, rather than having to know everything about the business, they only have to know about the area that they are an expert in. You might have customer and supplier relations that are more clearly understood when you're decentralized. For example, you might have your management team over the state that they're in and they understand the culture of their state. It's easier to train this kind of a situation with de-centralized breakup because a decentralized structure means you can train in a very specific area. And it's good for retention and for motivation because people tend to like a certain area of business. And so they get to do what they like to do. Now there are disadvantages and one of that is duplicate cost. For example, if you have a north and the south division, each division might need human resources. And so that kinda duplicates the cost that you have. And then they have what they call lack of goal congruency. Now that's not a good thing. Goal congruency means that the goals of the managers line up with the goals of the organization. So if this, if the management goals are similar to the businesses goals, That's goal congruency. When you have a de-centralized organization, there tends to be a lack of goal congruency. You may want what's good for customer service because you're the customer service manager. But that may not necessarily be what's good for the entire organization as a whole. An effective performance evaluation system basically just means how we grade our managers. So a good way of grading managers would be to provide them with clear expectations. They understand we are looking for them to do. We don't have vague expectations. If you say Just do a good job, that's not very clear. But if you say you want to cut costs by 10%, that's much more clear. Another thing that would be part of a good effective performance evaluation system would be good feedback. Did you do a good job? Here's why did a good job. Here's why you didn't do a good job. Give them good feedback, give them benchmarks. Benchmarks are set standards that they have to meet. If they have benchmarks than they know what kind of goals they need to attain. An effective performance evaluation system. As good for motivation, it leads to employees being motivated to not only improve their jobs and their performance, but to improve the organization as a whole. An important part of the evaluation system is called responsibility accounting. And that's basically evaluating the management based on what the managers can control. If they can't control something, then they shouldn't get graded on it. They shouldn't get into an evaluation. For example, if they can't have any kind of control over the property taxes that are assessed on the company. Then why would we want to evaluate them if the property taxes went up that had nothing to do with their performance. But if they are evaluated on the efficiency of their labor force, then they have control over that. That's a good thing to evaluate them on responsibility, accounting and evaluating based on what the managers can't control. Most businesses have an organizational chart where you have more responsibility at the higher levels. What I mean by that is that the higher level, for example, the CFO has more control over multiple parts of the business than the manager of customer service. So the customer service manager's responsibility, accounting, what they have control over is going to be much different from what the CFO hash control over. If you gave the bonus to the CFO based on profits of the entire company, that might make sense. But if you told the manager of customer service that her bonus was based on the profits of the entire company. That might be frustrating because she can only control customer service. So the higher up you go, the more the bigger the umbrella is that you have of control. Responsibility accounting leads us to what we call responsibilities centers. And each responsibility center, the managers have specific control over what they're going to be held accountable for. A cost center. The managers only held responsible for the cost are spending of that area, a revenue center? The manager is only responsible for what sales revenues they bring in. Profit centers. The managers are responsible for how much profit is leftover when they take the cost away from the revenue, costs minus revenue equals profit. And the investment center means what kind of percentage return they have on the investment of the assets in that part of the business. So a cost center would be, for example, the human resources department, the manager there would probably only be held accountable for how much he or she spends. You don't really bring revenue in through the human resources area. So it would be silly to evaluate the managers on revenue they bring in since they don't bring any. But they're probably given a budget to follow for how much they can spend. And that's why it's usually a good idea to make those kinds of departments into a cost center. Revenue center is usually for the sales or marketing area. And in this case, what you're looking for is how much revenue the managers bring in, just the revenue that they're bringing in, not the cost, the profit or anything else, just how much revenue they bring. And let's look at an example. First, we'll look at an example of a revenue center for the sales departments, for the different products that we have. Our business sells chips, beverages, and candy. So what we'll do is we'll compare the actual sales with what the budgeted sales were. So they had a budget to bring in x number of sales. What really happened? So we'll get that information from the given information. Once that information is provided, Damo going to look at what we call a variance. A variance is the difference between what the actual sales were and what the budgeted sales were. Thinking about it like this. You want your actual sales to be higher than your budgeted sales. If you want more sales than what you expected, right? So that's what we're looking for in our variance to see if we are above or below the budget for our first product that shifts. The budgeted sales were 2.4 million. But see, we only brought in actual sales of two million, three hundred forty eight. That's a variance of 52 thousand. We call that an unfavorable variance. We don't call it a negative or positive variance because that can be confusing. We'll see why there can be confusing when we look at expenses. But if we say we have an unfavorable revenue variance, then we know that that means the revenue didn't meet expectations. But we put U for unfavorable and we'll do the same for beverage and candy. Notice for the beverages, they made more in sales, 154990 compared to 150 thousand for the budgeted sales. That's a favorable That's why there's an F there next to the variance that's favorable. But the candy was below the budgeted sales, that's unfavorable. So by using favorable and unfavorable, it's clear whether or not we met our expected budget and sales are not. What we might want to look at is the percentage difference rather than the dollar amount. We see that the chips have a variance of 52 thousand and the candy has a variance of 63,031. Those variances in dollars are kind of similar dollar wise. But when you look at the percentage difference, we see that the candy is much bigger percentage. When you look for a large percentage variances, they call that management by exception. In other words, what they're saying is that if something is big enough difference than we want to investigate it, but if it's a small difference, we don't need to investigate it. It doesn't matter if it's favorable or unfavorable. If it's a large enough variance percentage wise, then we would go ahead and investigate it. Usually management looks at something like 5% variance as something they would investigate. Although that's really up to the management team to determine the calculation, to get these variances as a percentage would just be to take the actual sales minus the budgeted sales and then divide by the budgeted sales. When you do that, that's how you get the percentage. And then you know, if it's favorable or unfavorable based on if the actual amount is higher than the budgeted amount for sales. 27. Performance Evaluations with Variances: In our last lecture, we talked about responsibility centers. And we saw that the cost center is basically evaluating managers and how much they spent an only spending revenue centers we looked at was how much revenue they brought in. And only looking at revenue. We're going to look at a profit center and we're going to look at investment centers in this lecture. Profit center means you're gonna take the revenues minus the costs. It doesn't matter if you are short on revenue as long as you make up board by cutting your cost. At the same time, it doesn't matter if your cost go overboard as long as you make the profit up, it's the two of them combined. So we'll start out by looking at a profit center. Remember, we're going to be comparing actual to budget. So we're going to want to look at the revenue from sales and then subtract the cost from that to see what profit is leftover. And we want to keep in mind that we only want to look at the things that the management managers can control. If they're so cost that they can't control, then we wouldn't want to include that in this report. So we'll start out by looking at the sales revenue and then we'll subtract from that the variable costs. Now we have variable costs put into two sections, the cost of goods sold and then the operating expenses. If you subtract that, we get the contribution margin and then you subtract from that the fixed costs. Now these are called direct fixed cost. The reason they're called direct fixed costs. These are costs the managers can control anything in this area and managers can control, they call that the segment margin. That means the profit that the manager and that segment has control over. Anything from the sales revenue down to segment margin is something we would hold the manager accountable for. We're going to get the information for actual and budget from the given information, the sales revenue of 4,314 minus variable and fixed costs leaves the segment manager with a actual profit of 445. The budgeted profit was 435. Now that we know that actual and a budget, we can look at this and do a comparison to see the variance that we have. The dollar variance for the sales revenue is just taking the actual minus the budget and we get a $14 difference. We get a difference for cost of goods sold of $8.107 to eight minus 1720. We need to determine if these variances are favorable or unfavorable. And this is important that you're careful here. Let's look at how we can determine the sale side if it's favorable or unfavorable. While the sales revenue was higher than the budgeted sales revenue, that's a good thing. You bring in more sales than you expected. However, the cost of goods sold, notice how the actual cost is higher than the budgeted cost. That's not good. You want your cost to be lower than the budget. Because of that, we call that unfavorable. We don't use positive and negative because that can be confusing. Then for these other areas, you have variances for operating expenses, fixed cost. And you notice that for any of these costs, if the actual amount is higher than the budget, it's unfavorable. If the actual amount is lower, it's favorable. That's how you can make that determination. The final part of this report shows where they call common fixed cost. These are fixed costs that the entire company has that the managers have no control over. So for example, we might have property tax there. So the manager has no control over property tax. We put it here, we keep it out of the segment margin because the segment margin only shows what the managers can control. That is what we're going to evaluate. The manager would take the actual minus the Budget and then whatever that is divided by the budget, that'll give you a percentage. By using percentages, we can determine if any of these variances are large enough, either favorable or unfavorable, it doesn't matter for us to investigate. Investment centers are based on the return that we have on the investment. The owners invest money into the business and that money is used to buy equipment, buildings, other things that the business needs. What kind of return is the management getting on that investment? Let's say we have a business that has two areas. A manager is over beverages and another managers over snacks. Their return on investment means we're going to take the profit or operating income that each manager makes, divide it by the total assets, which are the resources the manager has control over. The beverage division has a lot more reef sources than the snack division. The snack division makes more profit investment division. Notice how much more money profit wise to snag division makes. They are returning on the investment 80% versus the beverage managers that are only returning 9.9. You can see if differentiation is involved by the sales margin. If there's no substitute, you can charge a higher price and you can make a bigger sales margin on your product. The beverages have a 13.5% markup X-inactivation, which is making 29.1% probably less substitute for their product from their competitors, less substitute they can charge a higher price. The capital turnover ratio helps us to determine if we are efficient as managers. Meaning how efficient are we with our operations? They call this the low-cost leader strategy. The reason they call it that is because if you can't be different, in other words, if you don't have low substitution, then that means you have to be more efficient in order to charge less. If there's a lot of substitutes for your product, that means you're not going to get the price that you want because people can buy the substitute, it's at a lower price. So if you want to drop your prices, you better get your cost down. Capital turnover shows how well managers are doing at being efficient. If you take the sales over total assets, we get 20,618 over 28,100 to eight. That's how many times they've turned over there, their assets into sales. The more times this is, the better the management team is doing. Unfortunately, they're not even turning it over one time. The more times the better, but they're only turning it over about 0.73 times for the beverage side, the snack management team, however, are turning over their assets to 0.75 times, close to three times. They've taken the assets of 5,375 and they've made almost three times the amount of sales from those assets. That shows that the snack division is much more efficient than the beverage division. 28. Flexible Budgets: In our last lecture, we were discussing an investment center or an investment center is a part of the business that management is evaluated based on what kind of profit or return they can bring in on assets they have access to in the organization, those assets or investments that the owners made. And so they call that the return on investment or the profit that was made on the investment owners put into the business. We looked at an example where we looked at the return on investment and we looked at the sales margin and the capital turnover. The return on investment is how good of a job, how much profit to managers are making with the assets. The sales margin helps us to determine if the managers are getting a high return on investment because they have clear differentiation, meaning they have low substitution of their product. If there's a low substitution their product, they can get a higher profit margin. We're saying a sales margin on that product. They can charge more if the business is instead, maybe doesn't have differentiation. They can also have a strategy based on being a low cost leader. In order to be a low-cost leader, you have to be an efficient management team. If you look at the return on investment, you can break it down based on the sales margin or the capital turnover to help you understand what is driving that return on investment, another tool we can use is called residual income. And residual income just says how much profit or operating income are we making? The yawned the minimum amount. When an investment team puts money into a business, they want a minimum return that they have in mind. You're not going to invest money unless you have some kind of an idea about what kind of profit return you want to make. If you make more than that, then that's called residual income. How much more you make it in the minimum now, the residual income than as just taking the operating profit, the operating income which are profit, minus the target rate of return, times the assets that were invested in our business. We wanted a minimum of 25% return. This is information would be given to us. The operating income is 2785 for the beverage division. So the minimum return that they would accept is 25%. Of the 28,128, that would be 7,032. They're not making the minimum, so that's why they have a negative residual income. They don't have residual income making less than the minimum. Now, the snack division has a minimum required return of Twenty-five percent. Twenty-five percent of 5,375 is 1344. Basically, they're making $2960 more than their minimum required return. So they're making a lot more residual income. The reason this is a useful tool for evaluation is because oftentimes, if you look at the snack division, they're making an 80% return on investment. So the snack managers are going to probably reject any, any new business plan that lower than 80%. But if a project comes in at say, 50%, that might be a great project. But they're already making 80, so they're going to reject it. But that can be detrimental to the business as a whole. So by using residual income, it says anything above twenty-five percent the managers are going to want to accept. This is more of a situation where residual income can really benefit the snack management team because it allows them to take on projects that are above twenty-five percent, but allows them take on projects that are below the return on investment that they are already making and still be useful for them as managers wouldn't hurt them as a manager. To accept that. Next, we're gonna look at a tool that management has called the flexible budget format. Now, it's important to understand a flexible budget does not mean in budget has a wiggle room. It does not mean that at all what a flexible budget means is that we're going to make our budget comparable to our actual level of volume. Remember, variable cost are gonna change the more activity the more you manufacture, the more you sell. So the more the volume is, the more those variable costs will be. Let's look at what we mean by that. First of all, start out with your basic contribution margin income statement where we take the sales revenue minus the variable costs minus the fixed cost. We have the per unit amounts that include how much we're gonna sell the product for minus the different variable costs. So each unit cost us for the cost of goods sold with the commission for the shipping, etc. The actual cost and master budget information is provided for you. So each unit cost $20. So your master budget is going to be derived by taking. 30 thousand units times 20 equals $600 thousand. And then you do the same thing for each cost. 30 thousand units times $12 equals 360 thousand. The actual amount is determined by what was actually collected in which was actually spent. So that information is not based on multiplying the sales volume times the per unit amounts. That information is based on from what happened when the business was actually an operations. When we compare these two, we get a master budget variance. Notice the sales volume did very well. We sold 2370 more units than we expected to. Our master budget, expected 30 thousand in sales, we sold more. That's a favorable variance. So when sales are higher than the budget, that's favorable. But when the costs are higher than the budgets unfavorable. Notice how every single one of those variable costs are unfavorable. This might seem like a bad thing for managers, but it really doesn't mean that not yet, at least. Remember, each variable cost is going to increase with more, with the more products you sell. So since the master budget is only based on selling 30 thousand units, but we actually sold 32,370 units. Then of course, our variable costs are going to be higher. What we need to do is change the master budget to be the same level of activity of sales as the actual sales volume. When we change the flexible budget to be the same level as the actual sales from 30 thousand master budget to 32,370. Our budget for our variable costs are going to change, but our budget for our fixed costs will not. Fixed costs are gonna be the same whether it's the master budget at 30 thousand units or 32,370. But the variable costs will change. So now you take 32,370 times $20 and you get what the sales would be if the volume of sales were 32,370. The difference between the flexible budget in the master budget is called a volume variance because the only difference between the numbers and the master budget column and the flexible budget column. The only reason you have that difference is because of the change in volume. So the volume variance only occurs because of the change from 30 thousand units to 32,370. This variance is okay. It's not a bad variance. So all those unfavorable for variable costs are not really a problem because they are unfavorable because a good thing happened because the sales volume went up. So a volume variance is an understood variance of I invariances and expected variance of volume variance is not something that would be that would show poorly to a management team. However, the difference between the actual and the flexible budget. Now that could be a problem. Any difference between actual results and the flexible budget column will help us to understand management capabilities. They call this column the flexible budget variance. This flexible budget variance is based on management. Doing a good job or poor job is not based on changes in volume. Looking at the flexible budget variance, we see differences that are based on management's performance. None of these differences in this column have anything to do with the volume change. The variable costs were increased to match the same level as the actual sales volume. So the cost of goods sold being favorable means that the management was favorable or efficient, and deriving the cost of goods sold, commissions being unfavorable means that the commissions were higher than $2. They must have paid more. This only way it would be unfavorable to shipping being favorable by 2560. Well, that just means that the shipping must have been less than $2. Management was very efficient with their shipping bad debt, I corrected it was supposed to be 1%. Notice the fixed costs. Looking at fixed cost, we get the actual amounts versus the budget amounts. Now, the flexible budget is gonna be the same as the master budget because there are no volume variances for fixed costs are gonna be the same at whatever level, but the reality can be different from what was budgeted. In other words, the salaries, they might have been a race that was not accounted for advertising. They might've been an increase from the advertising company they didn't account for, because they didn't account for it. We got an actual variance. But that variant had nothing to do with the volume because it was a fixed cost. Using the flexible budget format, we can get a better understanding of what management should be held accountable for, what they had responsibility for, which is the efficiencies that they build into the system and the job they do. It takes out any factors based on the variable costs changing based on the volume changes. 29. Standard Setting: This lecture we're going to learn about a concept called standard cost. Now, the nice thing is that standard cost is something that we all use in our daily lives. I mean, if you've ever been to buy gasoline for your car, you know that before you went to the gas station, you had an idea in your mind about how much you expect it to pay for the gas per gallon. And that's really what a standard cost is for managers. It's an amount they expect to pay per unit, per unit budgeted or expected cost. Let's look at an example. Let's say you're a manager at a pizza restaurant. Well, one of the things you needed to make sure you plan for is that you have the ingredients for pizza. And one of the ingredients you're going to need as pepperoni. So when you go to plan for this, one of the benefits of using standard cost is he's gonna make things easier for you. In order for the manager to plan for the pepperoni. The manager needs to know how much pepperoni he or she's gonna need. The cost of the pepperoni. A standard is going to look at this by making a determination of how much pepperoni is needed for each pizza. So this would be a per unit amount. Our restaurant likes to put three ounces of pepperoni per pizza. Then they need to know how much they're going to pay. So the expected amount they're going to pay per ounce would be the standard cost. Notice these are amounts that they are expecting to have. Not necessarily what will happen when they start actually buying the pepperoni and making the pizzas. This is expected per unit amounts. But we need to know these in order to plan for our pizza needs. Going back to our flexible budget from a previous lecture, we see that one of the expected amounts, we have four tasty potato chips is the cost of goods sold. We have a cost of goods sold at $12 per unit, in this case, $12 per case. How did we come up with that? Let's look at how managers might have calculated what they expect the cost of goods sold to be. So for a case of potato chips, we're going to need direct materials. In that case, the potatoes who only direct labor. The people that are going to manufactured the potato chips. And we're gonna have our manufacturing overhead. Let's first focus on the direct material and direct labor. So when we manufacturer a case of potato chips, we expect to use £5 of potatoes. Now again, this might not be what is actually going to happen when they're actually manufacturing the potato chips. But this is what we are expecting to use. This is what the budgeted amount of potatoes are, four case of potato chips. And then our cost is a $1.50 per pound. It's just like when you go to buy gas, if you expect to pay $2 for a gallon of gas, you might get there and it'll be different from that to dollars. Same thing here. We're expecting to pay a $1.50 per pound. We don't know what it's going to be when we actually pay for the potatoes. But that's our best guess at this time. For direct labor, we give our employees approximately three minutes as their budgeted amount of time. That's 0.05 hour to go through the process of manufacturing case of potato chips. Then we have the cost per hour, That's the rate that we pay. Remember that total cost per hour is not just how much we pay the employee, but the cost for their benefits and payroll tax and all that stuff. These are what we call our standard amounts and standard costs. These are expected amounts. When you set how much you need the £5, That's an estimate. You can set that amount to be very strict or to have some flexibility in it. The same thing for the labor. How much time do you give the employees to make? The case of potato chips? Do you give them some flexibility? Argue make a very strict standard. If you set a very strict standard, they call that an ideal standard. Ideal standards optimum performance under perfect conditions. In other words, we do not allow for any amount of problems into the use of the materials are the efficiency of the workers. Basically, if you have an ideal standard, that means that you have to use exactly £5 of potatoes. You can't have a situation where some of the potatoes are bad or rotten or that some other potatoes get dropped and don't get used, it would have to be perfect amount £5. If it's set as an ideal standard, then that means the workers have very little flexibility. If something were to happen to some of the materials, they would be over budget. The same thing goes for the price of potatoes, an ideal standard, we'd be the perfect price, maybe the lowest price you can get anywhere. A practical standard is different. A practical standard means you allow some flexibility. It's efficient performance under expected conditions. You might allow for some waste of potatoes in case something were to happen or some of them would have become rotten. From the same thing for the employees. You allow the employee some flexibility in case they have to take a short break or they lose their concentration and they have to store a batch over. It allows them a little bit of flexibility. Most places have some type of practical standard. They also call that a normal standard. In a lot of places, it's an attainable standard. Deal standard is very hard to attain. It's very difficult for employees to be perfect with the materials and the time that they have. You rarely see ideal standards set, but practical standards are attainable. However, there is a range in that practical standard. Practical standards can be harder to meet or more challenging to meet. And then they can be loosely set. So it really depends on management to make that decision. We're going to assume that our business, our management team, has set practical standards. The £5 are attainable. And if it's £5.50, then we expect the direct materials in each case to cost us 750. Direct labor, $22 per hour. If you only need three minutes, that's 0.05 hours. That's a $1.10 per case for the direct labor. When it comes to manufacturing overhead, It's a little bit more complicated. First of all, we needed to determine a cost driver, some activity that's occurring in the factory that causes more costs to happen in the factory. And for us, our management team thinks, is the machine hours this the key cost driver? What they mean by that is the more they run the machines, the more overhead tends to get generated. For example, the more we run the machines, the more we need inspections, the more we run the machines, the more we need maintenance, the more you run the machines, the more heat degenerate. And so the more utility to use. The management decided that machine hours, we're going to be our basis for determining overhead. Then we have to estimate the overhead for every machine hour that we're going to generate. So if we look at an estimate for the entire year, we see that we estimate overhead for the year to be a 1,000,360 thousand. Then we expect to use the machines 40 thousand machine hours. We're going to run them about 40 thousand hours and the upcoming year. Based on that information, we figure it's $34 per machine hour. That's where we got the information above. So if each case of potato chips takes about six minutes on the machines, that means we need about 0.1 machine hour for each case of potato chips. That comes to $3.40 per case. If we add all these up, we see the standard cost for a case of potato chips is about $12 per case. That's where we get the number that we're going to use for our flexible budget, $12 per case using the standards we were able to come up with that estimate. However, we see that there is a variance and that variance is $3,100. We're not exactly sure what caused that variance. We just know that we need to figure it out. We needed to determine why we have a variance of $3,100 so that management can make adjustments. Managers typically want to set up a budget to have some estimates. And then when actual numbers come in compared to those budgeted numbers, then they'll use these variances to try to determine where they need to make improvements. And they can also determine if anything was done exceptionally well, how they can do that over and over again, how they can replicate it. 30. Standard Cost Variances: In a previous lecture, we discussed the use of standards to help management make decisions. We saw how we came up with a standard amount for the cost of manufacturer case of potato chips. We came up with $12 per case manager able to use that to plan. One thing they can do is plan using a budget and this flexible budget we looked at previously. We saw how the standard amount could be used as part of the budgeting process to come up with the cost of goods sold $12 a case. However, as we run through the period is through went through the month, we also found that what actually happened, what really happened does not necessarily match up with what we expected to happen on our standard costs. We call those variances. And we need to track down the cause of these variances, whether they're good variances, meaning they're favorable or they're not so good variances, meaning they are unfavorable using the standards that we set up for direct materials, direct labor, and overhead. We're going to look at how we can find variances for each of these. We'll start by looking at the direct materials. We see here our standards or £5 per case, and we expect the potatoes to cost us a $1.50 per pound. Let's look at what really happened and how that's different from what was expected to calculate a total direct material variance. We take the actual situation and what we actually did, how many pounds of potatoes did we actually use and the actual price we paid per pound and then compare it to the standards that we looked at earlier. So we're going to use those standards on the right side of this equation, standard quantity and standard price. We look at our records at the end of the month and we see that we use to a £160 thousand of potatoes. That's what we really ended up using. And the amount that we paid for the potatoes were a $1.40 per pound. Let's compare that to the standard. Now the standard quantity is a little tricky. We want to know how many pounds of potatoes we should have used to make the potato chips that we actually made. That means we need to do a little side calculation here. We're gonna calculate the standard quantity to use in the above formula. So what you do is you say, well, how many cases of potato chips did we really make the actual number of finished goods? How many cases we really did make this situation? We made 31 thousand cases of potato chips. That's really what we generated in our factory. Now remember the standard amount of potato chips. We said we should use £5 per case. That's what we expect the employees, the workers to use when they're making a case potato chips. So if they made 31 thousand cases and they were expected to use £5 per case, then the amount that they should've used are a £155 thousand. So we'll put that in the standard quantity area. Often this is where students miss. This problem is because they don't do the side calculation before they put the number in the standard quantity than the standard price was the price that manager is expected to pay. We saw that was a $1.50 per pound. So when we multiply out the left side, we get 224 thousand and the right side is 232,500. That's a variance of $8,500. We need to determine if this is a favorable variance or unfavorable. If you look at the left side, that's what really happened. And we see that it is lower than the right side, which is what we expected to happen. If your costs are lower than you expected, that's favorable. So we'll say this variance is favorable. Why is the variance favorable? Well, it's either because we were efficient with the use of potatoes. Are we get the potatoes at a really good price or combination of the two. We're going to break this down and looked at the material price and material quantity variance. First looking at the direct material price variance, we're using the same, the same numbers, the same variables from above, just in a different order. We're going to do the actual quantity times the actual price than the actual quantity times the standard price. When you take that, you can rearrange it mathematically and you can put actual quantity together and then subtract the actual price from the actual quantity. This is just the same. It's the same formula just rearranged using math. When we plug the numbers into the formula, we have the £160 thousand that was given to us before. And then we had the actual price, a $1.40 that we paid, the standard price. And when we multiply this out, we get $16 thousand. Now, don't put positive or negative, make whatever number you have positive, and then you have to determine whether it's favorable or unfavorable, rather than using positive and negative to make that determination. Think about it like this. At the actual price is higher than the standard price, then that's unfavorable. If you pay more than you expected, that's not good. In this case, the actual price was lower than the standard price we paid less. When you see that, you can say that is favorable. Our material budget was very favorable, 16 thousand. Let's next look at the material quantity variance. We want to take the actual quantity times the standard price. Again, this is information that we already used in the total direct material variance. We're just rearranging the variables. So actual quantity times standard price minus standard quantity times standard price. We can rearrange that formula to put, since we have standard price in two areas, we can just get together mathematically and then multiply that by the actual quantity minus the standard quantity. So we're just taking the formula in, rearranging it mathematically, the standard price is a $1.50. That was what we had set up earlier. And then we figured out the actual quantity was given to us for the month at £160 thousand. So total number of potatoes that we actually used, the standard quantity we figured out earlier at £155 thousand. That's how many potatoes we should've used to make the 31 thousand cases of potato chips. We ended up with $7,500 again, instead of looking at this as a positive or negative number, forget about positive and negative and think about it as favorable or unfavorable. We see the actual quantity is higher than the standard quantity. When you see that you actually used more than you should have, we see that unfavorable. So using more than you expected is not a good thing. What happens with these variances now is that we need to give a reason for these. This is what managers do. This is where they come into play for the reason that they're doing these variances in the first place. For the direct material price variance, you have to ask yourself, who would you talk to? And typically you would talk to the purchasing or supply chain. And you would ask the person who purchased these, what happened? Why was my price variance so good? Some reasons for the price being different from what they expected would be something like they got a new vendor. They shopped around for a new vendor or a new vendor started selling potatoes, and that vendor was, had a better price. Maybe they decided to buy and bigger bulk. Or there was some kind of economic influences such as the economy had a deflation instead of inflation. Or there was a bumper crop of potatoes, they caused the supply to be much higher than they expected. Then I'll put etc, because every business is different, every situation is different. So what you're looking for is the reason why the price was different, whether it was favorable or unfavorable. Looking at material quantity variance that has to do with efficiency, that has to do with being efficient with the use of our material. So who do you speak to? Well, you have to go to operations and see what the employees are doing in the factory. Some reason is that they might find for the efficiency being in this case worse. It could be the quality of material. I mean, if the potatoes are rotten, then they have to throw a lot out or if the bags are all torn, potatoes come in and they're falling all over the place. Training of the employees that can have a big impact as to how efficiently employees are, the working conditions. Are they employees comfortable and able to concentrate? What about supervision? Proper supervision and makes sure that the employees are concentrating on the job and not doing something they shouldn't be doing or taking. Too many are too long or breaks in the machinery maintenance. If the machinery is in good maintenance, then it's not going to cause them problems. If the machinery is poorly maintained, it could lead to more potatoes getting destroyed and having to start over with new potatoes. These are some of the reasons that managers typically find for variances for price and quantity for the materials. Next, we'll look at the direct labor variance. The labor variance is going to help us to see an HR and an operations where we have an expected need for improvements are where we've made improvements that are working for us. What we're gonna do is we're gonna get the actual hours and actual rate of pay from the payroll in human resources. And we're going to then compare that to what we expected them to use, the employees to use in the hours and what we expected to pay the employees will start with the actual hours and the actual rate. Again, this is stuff that would be given to us. We would have to get it from either human resources or payroll. And we see how many actual hours were worked to make the potato chips and how much we actually paid. Then we're going to compare this to the standards. Now the standard hours again, it's something that we need to do a side calculation for. This is the standard number of hours or the expected amount of hours we would need to make the cases of potato chips that we completed. So we'll start with the actual number of finished cases of potato chips. And we got that number earlier as 31 thousand cases. This is the potato chips that we completed. Earlier. We determined that the standard amount of hours to manufacturer a case potato chips. Is 0.050.05 hours is how much time our employees need to manufacturer case, then we would expect the employees to spend 1550 hours. While multiple apply that by the standard rate which we came up with earlier at $22 per hour as our standard rate for employees. When we multiply this out, we get our actual side at 34,875 and our standard or expected side to be 34,100. So the variance is 775. Let's not think about positive or negative, but favorable or unfavorable. If the actual side is higher than the expected standard, and it is, then that's unfavorable. In our case, $775 unfavorable. However, if the actual amount is lower than the standard, then that would be favorable. Again, think about it like a cost. If the cost comes in to be actually lower than what you expected, that would be favorable if it comes into be higher than that would be unfavorable. We need to break this down and look at the quantity of hours and the price that we paid for their labor to determine what's causing this unfavorable variance. Looking at the rate variance, we're going to take the actual hours times the actual rate we got that earlier. Then we're going to compare that to the actual hours times the standard rate. We're going to take this formula and just rearrange it mathematically to get actual hours times actual rate minus standard rate. We see we get a difference of 1875. Again, don't look at this as a positive or negative number, just whatever number you get put as a positive. And then we need to determine if it's favorable or unfavorable. Since the actual rate is higher than the standard rate, we see this as unfavorable, meaning we paid employees more than we expected. So that leads to an unfavorable variance, labor efficiency variance. Let us know how efficient our workers are at doing their job. Actual hours times standard rate minus standard hours times standard rate. You can use that formula or you can change it mathematically to see standard rate times actual hours minus the standard hours. The standard rate we have is twenty-three dollars per hour. The actual number of hours we found earlier, we're 1500 hours and the standard hours. We determined from our side calculation as 1550. When we do the math, we get a difference of 1100. Again, don't think of it as positive or negative. We need to think as favorable or unfavorable because the actual hours are lower than the standard hours. What we can say is that this is a favorable variance. Our workers worked less hours than were expected. That's a good thing, that's favorable. So what we need to do is figure out the story behind these variances. That's really the benefit management gets from the variances. Knowing the numbers doesn't help them at all. You need to find out why. Who would we go to discuss the variance for the labor rate? Well, probably HR or payroll. And then we would ask, are trying to figure out what caused this difference between what was actually paid in what was expected. It could've been, for example, negotiations by the union, negotiation by the employees to get a pay raise, bonuses that came in different from what was expected or what if the benefits change. So maybe health insurance changed and they weren't expecting it in this case, let's say, for example, that some employees became sick on the line and so the supervisors stepped in to take over for those employees while the supervisors, maybe they make more per hour. And so that caused a difference of variance between what was expected to be paid and what was actually paid to manufacture those potato chips. The labor efficiency variance helps us to understand what was going on as force efficiency for the employees. In this case, we have a favorable efficiency variance. We wouldn't want to understand why our efficiency variance was favorable, so we could maybe replicate it later. Some of the reasons are similar to the direct material quantity variance. Do we have good quality of materials because poor materials, for example, potatoes that are, that are rotten, means that we're going to take longer as employees to set up the machines. Working conditions can cause employees to be tired and work slower. Supervision. Workers that are being supervised are going to work more efficiently. Machinery maintenance. Again, machinery that's been maintained well, it's going to work properly and make their employees more efficient. This case we had some better skilled workers stepping in for sick leave. Remember the supervisors stepped in to take over for the regular workers that were sick? Well, perhaps these supervisors or supervisors because they're very good at the job. And so because they are better, they are more efficient. Now that the managers know what was going on, they can make decisions to either try to fix our reduce unfavorable variances and try to get favorable variances to happen again in the future. The use of variances can be a very useful tool for managers. 31. Capital Investment Decisions: Capital investment decisions are some of the most important decisions that managers have to make. All managers across all types of organizations must make capital investment decisions at some point. From the smallest of the business, just run from your kitchen table to a largest corporation, from the governmental entities to not-for-profits, every single one of them. At some point, we'll have managers that need to make capital investment decisions. This lecture is going to focus on an approach and analysis of capital investment decisions. First of all, let's discuss what is capital investment. While capital investment is an investment into assets. So capital means money invested into assets, but not just any assets. These are resources that are used for a long period of time. In business. A long period of time means greater than a year. We're not talking about your day-to-day operations. When we talk about capital investments in capital assets, we're talking about big ticket items. Capital investments are for the long-term sustainability of the organization. A business is going to use capital investments for some important reasons. First of all, for innovation, new equipment, new software, for becoming a more efficient business, for expanding, opening new locations, for reducing obsolescence of the organization. It's a key strategy to keeping a business going for the long haul. Capital investments are for sustainability and improvement of the organization. Again, capital investments or about investing in big ticket items, not in day-to-day operating type of decisions like hiring people are buying supplies. We're talking about big ticket stuff because we're spending a lot of money when we talk about capital investment. We usually have a capital budgeting committee. The Capital Budgeting committee is usually comprised of an expert in capital investments. May be some people in accounting and finance, but you're also going to have people from other parts of the organization understand operations. And typically you might have the CFO or some other high-level executive, this part of the committee. First of all, what is the process that the capital budget committee he's going to make? Now, first of all, remember that capital investments are important for managers. If you're a manager, you want your idea, your project, your expansion to occur for your area. If, if that's the case, if your project gets chosen, then that could be big deal for you as a manager in four-year department. The Capital Budgeting committee is looking for these ideas that it will help the business grow, that will help the business succeed in long run. So they're really looking for managers to step up and bring really good ideas to them. First of all, they're going to have managers from different parts of the organization bringing their proposals. In other words, that's their identifying possible investments. Managers from HR, from operations, from customer service, from any area. Really, the managers that have ideas for expansion, innovation, or growth will bring their ideas as possible proposal. Then the budgeting committee is going to look at this and an estimate the impact on the company. They're going to analyze each of these proposals. Then they're gonna do what they call capital rationing. Capital rationing means that they have only so much money to put forth towards capital projects. They're going to decide if they're going to put all the money on one project, or they're going to split it up between different projects. They're gonna rationale the available funds. And then they have somebody who's very important called a post audit. What that means is that a lot of times managers be going to this committee and they really want their proposal to get selected. The reason they want their proposal considered lattice, it can be really beneficial to them as an individual manager moving on up the ladder. It can also be beneficial to their department. So there could be a potential for managers being a little enthusiastic, a little aggressive with their estimates for their proposed impact their project will have. For that reason, managers need to know there'll be a post audit. If a manager says our project is going to bring up 15% return, they need to understand it after the project is completed, they're going to review the results and see if it brought it 15% return. Let's look at this analysis element to capital budgeting committee. When the capital budgeting community decides to analyze the proposals that come in, they're going to consider different questions like how much funds are available? Do they have enough funding for all proposals? Are they going to have to ration out the funds? How expensive are the proposals that are bringing, brought to the table? They're gonna look at the risk of each. So there's a couple of risks that you have. With capital budgeting, what is it that proposed project is not going to bring in two returns that were promised by the managers. That is one of the risk and also there's the risk that you missed out on other proposals. If I've taped proposal from manager a, manager B, and manager A's project doesn't bring in the return that was expected, then we missed out on managers beat proposal. Remember, once the money is invested in these projects, It's stuck in that project. So that's one of the risks there. We can't like go back and get the money again, and we've already implemented the project. We have to look at the relationship with other projects. Some projects can be beneficial to each other. Finally, we have to look at the ratio analysis. We're going to look at different financial ratios. So in this lecture we're going to focus on the ratio analysis. But keep in mind, there's both qualitative and quantitative analysis by the budgeting committee. What that means is the quantitative side is the ratio analysis. Quantitative meaning to do with quantities are do with numbers. But there is a qualitative element to the qualitative element is all about whether or not the proposals makes sense for other reasons, for example, safety or within the strategy of the organization, or does the proposal work from a public relations standpoint or from a community standpoint. So in other words, there's things that are not number of related to the managers are going to have to consider two. The first ratio we looked at is called the cash payback period. Let's look at an example in an Excel spreadsheet. The idea of cash payback period is basically how long it takes for an investment to pay for itself. In this case, we have a factory and there are considering manufacturing either skateboards or a scooter product. So what we have provided below for both skateboard and scooters are the potential cashflows. These are called net cash-flows. So a net cashflow can come from one of two ways. It can be a savings. For example, you're saving money by buying and investing in a new delivery truck. Because delivery truck that's new is more efficient and you're saving on maintenance and fuel. That's one way that cashflows can come in. Or another cache where cashflow come in is from a different revenue source, a new revenue source. So for example, if you are a restaurant selling sandwiches and you decide to invest in a pizza oven, now you're going to have revenue from pizza, so he would have a new revenue source. This example, we have an investment in a factory of a million dollars to create a new revenue source from either skateboards are scooters. These are the potential cashflows that we expect for the next five years. Expect this project to be about a five-year project. The cash payback period we're going to see is just how long it takes for each of these investments to pay for themselves. Let's look at the skateboards for first of all, notice that between these two proposed projects to meet either make skateboards or scooters in our factory, that the skateboard cashflows is gonna be very consistent. The same amount every year, whereas the scooters are going to bring more money, more cashflows in early years, and then less later years. So the cashflows are gonna be different. When we look at the skateboards, we see that the cashflows are going to be the same every year. So we can use a formula for this. We can take the initial investment of a million dollars and we can divide it by the expected annual cash-flows. Looking at this example, we see that the skateboards have an initial investment of a $1,000,000.325 thousand as your annual cash-flows. So 3.08, a little over three years for the skateboards to pay for themselves, for the skateboard investment to pay for itself, as you might expect, to shorter cash payback period, the better the faster you get a product to pay for itself, the better. Let's compare that to the scooters. Now the scooters, again, we can't use the same formula as we did before because each year we have a different expected cash inflow. We have to follow a different strategy. We'll start out with the initial investment and we see that the first year we have 560 thousand. And we have to ask ourselves a question. Is that going to be enough to pay for the initial investment? Well, the answer is no, 560 thousand is not enough to pay for the initial investment. So therefore we subtract. We have a remaining amount of an investment of 440 thousand remaining. Then we look at the next year, 390 thousand. We ask a question, does the 390 thousand cover the remaining 440 thousand? If the answer is no, we subtract. So now we have 50 thousand remaining. Then we go to the next year. We asked the same question as 350 thousand in year three enough to cover the remaining 50 thousand. The answer is yes. When the answer is yes, we divide. When we divide 50 thousand by 350 thousand, we get 0.14. So that means we took one whole year, two whole years, and then 0.104 of the third year. We took 2.14 years to pay back the initial investment with the cash inflows. When we compare scooters to skateboards, the project for scooters pays for itself a lot faster than the skateboards. Some of the good things and bad things about the cash payback period. Well, first of all, what's good about is it simple and quick? You can see how easy it is to make that calculation. But the problem is that cash payback ignores cash flow after payback. In other words, after the project's paid for itself, it might still be bringing cash in. Cash payback period isn't using those additional cash-flows. Also, it doesn't consider profitability. It just looks at cash flows. It doesn't consider the time value of money, meaning that the 350 thousand at the project makes in year one is considered the same as the 350 thousand the project makes in year five. But we should all be aware of that. When you receive cash earlier, it's got a higher value than if you have to wait for it. Waiting for cash makes the cash less useful because we can't take advantage of it until later. Cash payback period, a good initial step in analysis. In the next lecture, we'll look at some additional ratios that can be useful in considering are different proposed projects. 32. Capital Investment Analysis: In our last lecture, we looked at the cash payback period as our first tool for analyzing capital investments. One of the problems with the cash payback period, we said was it doesn't consider profitability. So let's look at another ratio that does consider profitability. Another option we have is the accounting rate of return. Let's look at how that would be calculated using the same situation we had for the cash payback. So as you recall, we had a factory and we had a million dollars that we could invest. And we can either invest in equipment to build skateboards or scooters. We couldn't do both. So we had to decide between one or the other. Let's look at the accounting rate of return for skateboards. So the formula is taking the average annual operating income. Now that's different from cash inflows. We take the average annual operating income and we're going to divide by the initial investment. To get the average annual operating income, we need to take the average annual net cash flows. So the average cashflows and subtract from it the depreciation expense. Let's look at the average cashflows first. The average annual net cash flows is it's taking the total cash-flows and dividing by how many years. If we're doing the skateboards first, we see that the total cash-flows is a 1,000,625 thousand divided by five and that gives us 325 thousand. We would have known that anyhow because the cash flows are the same each year. But that's the method that we would use to figure out the average, will put that in the formula. Now let's look at getting the depreciation expense. The depreciation is calculated by taking the initial cost minus the residual value. In this case, we've been given additional information that the residual value is 0. That just means how much we think the equipment is going to be worth at the end of the five years that we're going to produce skateboards. Then for the depreciation expense, divide that by the useful life. The cost of the initial investments of million dollars residual values 0 divided by five and we get $200 thousand. Let's put that into the formula. We've added the 200 thousand to the formula. Now we just need to divide by the initial investment. For the skateboards, we get an accounting rate of return of 12.5%. Let's compare that to the scooter investment. For the scooters, a lot of it is the same, but we see that we have to get calculate an average annual net cash flow would take the 1,000,610 thousand divided by five years in our average cash flows is 322 thousand. The depreciation expense is the same because the residual value for the scooter equipment is 0. Also divide by five, we get 200 thousand, So that didn't change and then the initial investment then change. We compare the skateboards accounting rate of return of 12.5% to the scooters at 12.2%. And we see that the skateboards are slightly leading. The larger the accounting rate of return, the better. One thing that we have to consider is that there's potential in these proposals for managers to have some flexibility that they could use to their advantage. Let's just say it that way. For example, residual value of the equipment is based on an estimate. If managers wanted to, let's say, change the estimate for the residual value. Let's say they scooter manager wanted to change it a little bit to that so that he or she would win the proposal with the budgeting committee. Let's see what the results might be. When the managers for the scooter proposal change the residual value to 175 thousand. We see that changes the depreciation expense. It reduces the depreciation expense. That's going to have a positive influence on the accounting rate of return. Now the accounting rate of return for the scooters as 15.7%. By changing the estimate, they've been able to have an impact on the results. This is something we need to keep in mind. A lot of times we have estimates with some flexibility in them. And this needs to be, we need to be aware of this. Now the nice thing about the accounting rate of return is it uses accrual basis accounting, which is very common and very understood by most managers in most investors. It also considers profitability. But one of the problems is that it doesn't consider time value of money. Again, the cashflows that come in later on and years 2345 are given the same weight as cash flows that come in the first year. The time value of money says that that's not accurate. And time value of money, we say getting money sooner is better than getting money later because we can utilize it sooner. So not considering the time value of money is a big weakness. The accounting rate of return is also more complicated to calculate than the cash payback period. The next ratio we're gonna look at is called the net present value. The benefit of the net present value is it looks at the proposals using time value of money. So let's look at this example. We have the blue note music store. Now the blue note music store sells musical instruments, but they're considering adding another building, an extension to the building. And honor, to get private lessons, if anybody's ever been to a music store, that it'd be very hard to get private lessons inside a music store because people are always tinkering with the instruments. By offering private lessons that can really enhance the business for the managers, for the blue note music store, that he'd get clients from learning how to play the instruments, to buy new instruments. So the investment to extend the music store would be $420 thousand. They expect an annual cash flow each year, the same amount of 125 thousand. They expect the useful life of this to be five years, but they want the return of their $420 thousand to be 14%. Managers or owners are not going to make investments unless they can get a certain return. Otherwise it's not worth their time. They'll put the money into some other investment. The residual value of the building is expected to be $50 thousand. So we'll look at the annuity first. Cashflow coming in. The cashflow coming in as 125 thousand. It's called an annuity because it's the same amount every year. It's the same amount every year, then that's an annuity and we can use a present value table for annuities. Let's get the present value factor from a present value of an annuity table. This table was generated using Excel. However, present value tables are available and a lot of places you can just Google or do some kind of web search for present value of annuity tables and find them. Most textbooks have them. If you look at this one, what you want to do is you want to go to the percentage that you want, 14%. And then you want to go down to how many years, that's five periods and see where they crossover. That would be that would be 3.433. That's the fact that we want to use in the formula. So that means the annuity is worth 429,125 today, that's the present value of receiving five cashflows of a 125 thousand discounted for time value of money. We also are going to receive $50 thousand onetime only at the end of the useful life of the building, because the 50 thousand is a onetime situation. We can't use the annuity tables. We have to use the present value of a lump sum, a onetime lump sum. So this table is a little different. It shows the present value of a onetime amount. So we go to 14% 5 periods. We get the factor for onetime payment or receipt of $50 thousand. That's the fact that we want to use when you add the present values up for the annuity and the residual value, you get 455 thousand. Subtract the initial investment. And what we have is $35,075 as our net present value. Whenever them, the net present value is positive. That means we're getting at least a minimum required return. In this case, we're getting more than the required return. What if the cash flows for the music store? We're going to be different. The cashflows, we're gonna be different amounts each year. Well, we can't use the present value of the annuity tables. Instead, we have to look at each year individually and we have to consider how much each year's cash flow is going to be worth discounted for the present value. Year one, we have cashflows of 80 thousand. What would our present value factor B for one year from now of 80014%, 1 year from now is 0.8772 years is 0.700693 years is 0.6075. So we'll just use those present values for each year's cash flows. We use those present value factors for each year's cash flow. And we also include the residual value that's coming at the end of year five. And we see that the total present value is going to be 429,225. The initial investment is 420 thousand. So we have a net present value in this situation, two of $9,225. The positive net value means that the required rate of return at 14% is being met. The higher the net present value, the better if you're comparing multiple options, you would say that the one with the higher net present value is better. One of the good things about net present values, it uses the time value of money, but it doesn't give the actual return. In our example, we just saw that we got at least 14%, but we didn't know if it was 151617. It also is more complicated. Complicated. Another tool we can use called the internal rate of return. The internal rate of return. We'll see what the rate of return actually is, and then we can compare it to the minimum return. So in calculating the internal rate of return for the blue note music store, we have to make a little bit of change. We're going to look at a simplified version of internal rate of return. We changed the residual value to 0. So the first step is to calculate the factor. So step one, take the initial investment, 420 thousand divided by the annual cash flows, a 125 thousand. This is going to give you a factor of 3.360. Now we know it's five years, we just don't know what the return is. If we go to our annuity table and we go to the period of five years. We want to get as close to 3.360 as possible. So we start, we go along the five-year line, the five-year row, until we get as close to 3.36 as possible. This case it gets closest at 3.352 and we see which column we're in, we're in the 15% column. So for step two, use the factor that we got in step one with the table, used a number of years provided as the useful life. And then see which column you're in. And we were about the 15% column. This investment is going to give us a 15% internal rate of return. As we said, if we have multiple projects, we can compare these returns to see what each return brings us. We can also compare it to the required return and see if we're meeting that minimum required return. In this case, we are. The benefits of the internal rate of return is it uses time value of money and it gives us an actual return. Internal rate of return is very, very common in investment and management decisions. But the downside is that the internal rate of return is much more complicated, especially if you have different cashflows coming in. And also if you have residual value or other types of income that are coming throughout the life of the project. For this reason, most of the time we use internal rate of return calculators are apps and arch simplify the process for, for our purposes of this class, we just wanted to get a feel for how internal rate of return would be calculated. We did a simplified version. Capital investment decisions are universal for all managers. At some point, managers will have to invest money back into the business. If the business is profitable. Some of those profits need to go back to make the business expand or more innovated are more efficient. Capital investment decisions are exciting. Managers and employees are always excited to see the company that they worked for doing better. It also means that the company is more secure. When you see your company investing in itself, you feel your job is more secure than if the company is just holding on. 33. Managerial Accounting Conclusion: Congratulations on completing the managerial accounting course. In this course, we covered the many tools and strategies that are available for supporting managements decisions. We began by understanding what managerial accounting was and how useful it is for managers in any organization. We discussed cost behavior and how understanding cost behavior could provide a useful tool for managing risk. We covered break-even point, which is an important topic for the management strategy. Then we delve into the world of budgeting, which is a crucial resource for running your business. Enjoyed working to provide you with another course on accounting. Thank you for taking this course, and I truly hope you come back for more topics in business and accounting.