cost accounting cost management basics 1. agenda accounting overview financial accounting budgetary...
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COST ACCOUNTINGCOST MANAGEMENT BASICS
1
Agenda
• Accounting Overview• Financial Accounting• Budgetary Accounting• Management Accounting• Output Costs• Transfer Pricing
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Accounting Overview
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“is the production of financial records about an organization. Accountancy generally produces financial statements that show in money terms the economic resources under the control of management; selecting information that is relevant and representing it faithfully. The principles of accountancy are applied to accounting, bookkeeping, and auditing.”
Source Wikipedia
Definition of Accounting
4
Accounting Domains
Financial Accounting – focuses on reporting to external users (e.g. investors, creditors, and governmental agencies) to communicate a financial position
Budgetary Accounting - the process of implementing a budget and the consumption of the budget utilizing special subset of accounts. An additional accounting requirement for State or Federal Government funded entities
Cost Accounting – records, measures, analyzes and reports financial and non-financial information to managers to aide in making decisions to meet objectives. Commonly referred to as managerial accounting
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Financial Accounting
• Concerned with preparation of financial statements for external users (e.g. investors, creditors, and governmental agencies) to communicate a financial position
• Primary users are external looking to judge the health of the entity and for comparison with other entities
• Not intended for day-to-day running of the company/organization since historical in nature (monthly, quarterly, annual reports)
• Govern by local and international accounting standards; e.g. Financial Accounting Standards Board (FASB)
• Follows Generally Accepted Accounting Principles (GAAP)• Certification/Professionals are CPAs• Has limited influence on employee behavior outside of
employee stock holding
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Budgetary Accounting
7
• Concerned with preparation of budgetary statements for external users (e.g. governmental agencies) to communicate a budget position
• Primary users are external looking to judge the compliance of a government entity to funded Budgets
• Not intended for day-to-day running of the company/organization since historical in nature (monthly, quarterly, annual reports)
• Govern by oversight entities; e.g. Government Accounting Standards Board (GASB),
• Typically follows Generally Accepted Accounting Principles (GAAP) with some differences
• Certification/Professionals are CGFMs• Has limited influence on employee behavior (influences
when to consume budget)
Cost/Managerial Accounting
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• Concerned with preparation of statements for internal users (e.g. Product Line or Customer Managers) to communicate a Profit/Loss position
• Primary users are internal management looking to benchmark the management of inputs with corresponding outputs
• Intended for day-to-day running of the company/organization since predictive in nature (daily, monthly, quarterly, annual, forecasts, simulations)
• Not governed to a specific rule or formatting; focus is information to make appropriate decisions
• Typically follows Generally Accepted Accounting Principles (GAAP) with some differences
• Certification/Professionals are any focusing on efficiency/effectiveness or performance improvements (e.g. CMAs, Internal Auditors, PMPs)
• Designed to influence employee behavior (change process to decrease costs, spend $ to increase market-share, etc.)
Summary of Accounting Domains
Financial Accounting
Budgetary Accounting
Managerial Accounting
Purpose Communicate financial position to outsiders
Communicate Budget position to outsiders
Decision making
Primary Users
External users External users Internal managers
Regulating Bodies
SEC, IRS, FASB, IASB OMB, GASB, GAO IMA/IFAC
Focus/ Emphasis
Past-oriented Past-oriented Future-oriented
Rules GAAP compliant; CPA audited
Modified GAAPDo not have to follow
GAAP; cost vs. benefit
Time Span Historical monthly, quarterly reports
Historical monthly, quarterly reports
Ultra current to very long time horizons
Behavioral Impacts
Indirect effects on employee behavior
Indirect effects on employee behavior
Designed to influence employee behavior
4
Financial Accounting
10
Accounting Methods
• Cash Basis: Record when Pay
• Accrual Basis: Record when receive the Benefit
Plan Order Receive Pay
Plan Order Receive Pay
11
The Accrual Basis of Accounting
• Focuses on exchange of Economic Resources• Records Revenues in the period in which they
are EARNED– Providing a service– Selling a product
PlanTake
Orders
Complete Service or
Ship Product
Collect Cash
Revenue & Non-Cash Asset12
Revenue Comparison
• Cash Basis:
• Accrual Basis:
PlanTake
Orders
Complete Service or
Ship Product
CollectCash
PlanTake
Orders
Complete Service or
Ship Product
CollectCash
Revenue & Non-Cash Asset13
The Accrual Basis of Accounting
• “Matches” Revenues with Expenses • It takes money to make money
• Records Expenses in period INCURRED• Resources Consumed
Plan Order Receive Pay
Asset & Liability Remove Liability Expense
14
What is the Accounting Cycle?
The Accounting Cycle is the systematic process by which accounting information is recorded, compiled, and reported to users.
15
The Financial Accounting Cycle
Record Transactions
Post to Ledger
Prepare Trial
Balance
Adjust AccountsAdjusted
Trial Balance
Prepare Statements
Close Accounts
Post-Closing Trial Balance
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The Journal
• Accounting events are recorded in the JOURNAL– The Journal is a chronological record of all
transactions• Each transaction requires a journal entry• Each journal entry consists of at least one Debit and
one Credit: “Double Entry” Accounting• Debit amounts must equal Credit amounts• Debit: an entry on the left-hand side of the account• Credit: an entry on the right-hand side of the account
17
Debits and Credits
• Debits and credits are neutral– Debit ≠ decrease – Credit ≠ increase– It depends on the type of account
• Some accounts types record increases with a debit, some record increases with a credit
• The side of the account which records an increase is the account’s NORMAL BALANCE
18
Anatomy of a Journal Entry
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Amount Debited & CreditedExplanation of
Transaction
2 Basic Types of Adjustments
• Prepayments: Cash is paid before the resource is consumed– When cash is paid in advance, an asset is created– At the end of the period, some of the asset may have
been consumed expense
ConsumePay
Record Asset Reduce Asset, Record Expense
20
2 Basic Types of Adjustments
• Accruals: Resources have been consumed but no cash has been paid– Results in a liability
Consume Pay
Expense & Liability Remove Liability
21
Equipment and Depreciation
• Depreciation is the accounting process of assigning a portion of equipment’s cost to the periods in which it is used
• A portion of the benefit of owning the equipment has been received in the current period expense
• The future benefit is reduced• There is Financial depreciation which tends to
be straight-line (Tank life is expected to be 10 years) and Cost Depreciation which tends to be usage-based (Tank life is 100000 kilometers)
22
Budgetary Accounting
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Budgetary Accounting
• Provides a control mechanism to prevent overspending funds
• Does proper budgetary accounting prevent deficits? Why or why not?• It DOES prevent overspending• It does NOT prevent revenue shortfalls• It does NOT prevent over-appropriating by the
legislative body
24
Current Army Focus
• Focused on the “Budget” domain• The “Budget” domain consists of creation of the budget
requests/submissions, determination of the year of execution budget (e.g. availability control and informal budgets), actual execution, and reporting of the status of execution against the budget (e.g. the PPB&E process)
• Primary focus of budget execution is the Obligation (consumption of the budget)
• Budget Accounting focuses on 4 series accounts – status of Budget and consumption
• Budget Management focuses on the status of available funds, which includes both current and prior years funds
25
Budget Terms
• Budget = What Can Be Spent• Commitment = a thought to procure a product/service• Obligation = a promise to procure a product/ service
(e.g. to spend)• Budget Obligations• Budget – Obligations = Availability (e.g. what is left to
spend)• Expenditure is the receipt of the product/service
which was obligated (e.g. what was spent)• Expenditures or collection of expenses/expenditures
determines Costs • Disbursement is the outlay of cash
26
Budgetary Comparison
• Cash Basis:
• Accrual Basis:
• Budgetary Basis:
Plan Order Receive Pay
Plan Order Receive Pay
Commitment Obligation Expenditure Disbursement
Plan Order Receive Pay
27
The Budgetary Accounting Cycle
Obtain Budget Revenue
Distribute to
Allotment
CommitFunds
Obligate FundsExpense
Funds
Disburse Cash
Manage Availability
Close Budget Year
28
The Budgetary Accounts
• Exist solely for the purpose of recording and tracking the budget– Budget = a legally binding spending plan
• Account Titles:– Estimated Revenue = Expected Income– Appropriations = Authorized Spending– Budgetary Fund Balance = Planned Change– Unreserved Fund Balance = Savings
29
Procurement Process
ExpenditureObligationCommitment Liability Payment
30
Budgeting Participation
Encourage bottom-up flow of
information
Encourage bottom-up flow of
information
Encourage top-down flow of information
and plans
Encourage top-down flow of information
and plans
Budgets
attempt to
Budgets
attempt to
31
IMCOM
Jackson Benning Knox
Budget - Color of Money
$
$ BOS$
$
Appropriations Program Elements Fund Centers
ElementsOf Resources
Supplies Training Travel Equipment Labor Etc.
OMA
AFH
SRM$
GFEBS$
RDT&E
32
Cost Vs.Budget
Knowing your obligations is not the same as knowing your costs!
ObligationsA legally binding commitment by the federal government that will result in outlays, immediately or in the future. Budgetary resources must be available before obligations can be incurred legally.
The price or cash value of resources used (expenditures) to produce a program, project or activity. All relevant costs may not appear in the organization’s budget.
Costs
Costs
Obligations
Cost ObligationFull cost can exceed
individual business unit
budget allocations
Cost will contain expenses from different years, source of funds, organizations, etc.
33
Budget Formulation Budget Execution Cost Management
Budget–President’s financial plan
and the priorities for the Federal Government
Cost–Valuation of resources
used to produce outputs, basis for decision making
Budget Authority–Authority to incur
obligations
Focus–requirements
Key Data Elements–appropriation, FTE
Focus–availability, obligations
Key Data Elements–appropriations, EOR’s,
PE, MDEP, projects, BLIN, etc.
Key Data Elements–operational entity (e.g.
cost centers), services, rates, products, projects, etc.
Focus– full costs, Plan vs. Actual
Questions–What do I need?–What will I ask for?
Questions–What funding did I get?–What obligations were
executed?
Questions–What was expensed? –What did I get for it?–How well was it used?
Budget vs Cost Domains
34
Managerial Accounting
35
Three Common Features of Cost Accounting
1. Calculates the cost of products, services, and other cost objects
2. Tracks information for planning & control, and performance evaluation
3. Analyzes relevant information for decision making
36
An Easy Definition of Cost…. “a cost is the value of money that has been used up to produce something”
# Clean Dishes
37
Basic Cost Terms
• Cost: a sacrifice of resources• Cost Object: any item or activity for which a separate
measurement of cost is desired – cost objects are the “something” in a statement
• Cost Driver: any factor whose change ‘causes’ a change in the total cost of a related cost object – cost drivers can be factors other than volume
38
The Many Types of ‘Cost’
• Direct Cost: a cost such as labor, material/supplies that can be directly traced to producing a specific output of organization, product, or service
• Indirect Cost: a cost that cannot be directly traced to a specific organization, product or service output
• Funded Cost: the value of goods or services received because of an obligation of funds (obligation authority), by an organization performing the work
• Unfunded Cost: a cost that is financed by another organization’s or activity’s appropriations
• Variable Cost: a cost that changes with change in the output• Fixed Cost: a cost that remains the same regardless of the
change in output• Recurring Cost: a cost that is incurred repeatedly for each
organization and/or product and service produced• Non-recurring Cost: a cost that is unusual and unlikely to occur
again• Avoidable Cost: a cost incurred on an object that will no longer
be incurred due to a decision to change the output• Unavoidable Cost: a cost incurred on an object that will be
incurred regardless of the decision to change
• Common understanding of different types of costs is necessary for informed decision making
• Each decision should be focused on ONLY relevant cost that impact the decision
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Costs may be:• Direct or indirect• Recurring or nonrecurring• Burdened or unburdened• Variable or fixed
Some Characteristics of Costs
40
Direct Cost• Can be easily and conveniently traced to a specific cost
element/objective– Example: The cost of ammunition fired in a training event at the firing
range
Indirect Cost• Cannot be easily and conveniently traced to a specific cost
element/objective– Example: Installation support to the firing range (utilities, upkeep, etc)
Direct vs. Indirect
41
Recurring vs. Non-recurring
Recurring Cost• Cost that is incurred regularly in producing a product or providing a service
– Examples: Civilian and military personnel who conduct the activity, recurring sustainment of facilities, supplies, personnel training, utilities, equipment maintenance, janitorial service, office supplies
Non-Recurring Cost• Cost that only occur once or infrequently.
– Examples: Major items of equipment, major and minor construction, one-time training in new procedures, activities conducted in direct support of individual process improvement efforts
42
Burdened vs. Unburdened
Unburdened Cost• Cost of a product/service that does not consider other related costs necessary
to provide that product/service.– Examples: Direct compensation, cost of a gallon of fuel in a theater of
operations, etc.
Burdened Cost• Cost of a product/service plus an apportioned cost of other related costs
necessary to provide that product/service.– Examples: Salary plus the cost of benefits (health, retirement, etc.),
facilities support cost allocated to an activity or personnel– There are degrees of burden in a CBA. For example:
• Direct compensation for military and civilian personnel is always burdened with the cost of personnel benefits
• Facilities support cost is allocated to a COA only if it can demonstrated that the COA causes the cost to be incurred
43
Variable vs. Fixed
Variable Cost• A cost that varies based on the level of activity or output. This can be either a linear
relationship or a step function.– Examples: Fuel cost for vehicles varies in a linear fashion relative to the number of
miles driven. The number of instructors needed to teach a class can vary in a step function based on the number of students (e.g., 1 instructor for 25 students, 2 instructors for 26-50 students, etc).
Fixed Cost• A cost that does not vary based on the level of activity or output.
– Example: At an Army installation, the cost associated with the commander and his/her immediate staff is unlikely to vary as the installation population or other variables change.
100 200 300 4000
20
40
60
80
100
Fuel Cost as a Func-tion of Miles Traveled
5 11 17 23 29 35 41 47 530
1
2
3
4
5
Instructors as a Func-tion of Class Size
Variable Semi-Variable
5,000 10,000
15,000
20,000
0200400600800
1000
Cost of Cmd Gp ($K) as a Function of Instal-
lation Population
Fixed Cost
Note: Most costs are semi-variable
44
Example: Paul is assembling his new home theatre system. He has spend 5 hours thus far and estimates he will complete the assembly in 2 more hours. Joan informs him he is doing it the hard way and describes a simpler approach which will take one hour to undo his work and re-assemble the system completely
Example: Paul is assembling his new home theatre system. He has spend 5 hours thus far and estimates he will complete the assembly in 2 more hours. Joan informs him he is doing it the hard way and describes a simpler approach which will take one hour to undo his work and re-assemble the system completely
Sunk Costs
Costs that have already been incurred and cannot be changed no matter what action is taken in the future are called Sunk Costs
45
Opportunity Costs
• The size of a foregone opportunity of using a resource is the Opportunity Cost
Example
• The opportunity cost of accepting a job is forgoing the opportunity to do something else with our time
• If our best alternative to working is playing golf the opportunity cost of working is the forgone opportunity of playing golf
46
Marginal Costs
• Marginal Costs are the costs to produce one more additional unit of output
• Marginal costs are highest at very low output rates and at output rates near capacity
• The slope of the ‘Total Cost Curve’ at any given level of production is the marginal cost for one more unit
47
Marginal Costs
Output
Cost Total cost
High marginal costs
A
CHigh marginal costs
BLowest marginal costs
48
Average Costs
Average Cost is very high at low levels of output
Average Cost is very high at low levels of output
Average Cost is calculated by dividing the total cost by the total
units produced
Average Cost is calculated by dividing the total cost by the total
units produced
49
Cost Behavior
• Variable costs: changes in total in proportion to changes in the related level of activity or volume– Variable costs are constant on a per-unit basis– If a product takes 5 pounds of materials each, it stays the same per unit
regardless of number of units produced
• Fixed costs: remain unchanged in total regardless of changes in the related level of activity or volume– Fixed costs change inversely with the level of production – As more units are produced, the same fixed cost is spread over more units,
reducing the cost per unit
• Costs are fixed or variable only with respect to a specific activity or a given time period
50
Cost Behavior Summarized
Total Dollars Cost per Unit
Variable Costs
Change in proportion with
outputMore output = More cost
Fixed CostsUnchanged in
relation to output
Change inversely with output
More output = lower cost per unit
Total Dollars Cost Per Unit
Variable Costs
Change in proportion with output
More output = More cost
Unchanged in relation to output
Fixed CostsUnchanged in
relation to output
Change inversely with output
More output = lower cost per unit
51
Cost in More Detail
“Cost” is a monetary measure of the sacrifice associated with:• expending resource functionality to achieve a specific objective, or• utilizing resource output required to achieve a specific objective, or• the provision of resource functionality or resource output while not
using it
Resources ResourcesConsumed
52
Cost = Converting and Measurement of Work
Cost Center
Asset / Equipment
Project / Program
Internal Order
WBS / Work Order
Organization - Labor, Materials, Supplies
Res
ourc
es/I
nput
sO
utpu
ts
Plant, Property & Equipment
Building Project, Weapon System
Services, Events (SSP, Course)
Job (Set of Tasks) – Maint & Repair
53
Problems in Identifying and Measuring Costs
Planning DecisionsPlanning Decisions
What is the cost of a dissatisfied customer? What is the cost of a
dissatisfied customer?
How do I measure the cost of setting my
price too high?
How do I measure the cost of setting my
price too high?
How do I measure the cost of poor quality?
How do I measure the cost of poor quality?
What is the cost of postponing this year’s
training program?
What is the cost of postponing this year’s
training program? What is the cost of using current
facilities?
What is the cost of using current
facilities?
What is the cost of requiring employees to
work overtime?
What is the cost of requiring employees to
work overtime?
What is the cost of using raw materials in
inventory?
What is the cost of using raw materials in
inventory?
54
Costing Philosophies
55
Costing Philosophies
When determining how to develop the cost model to be utilized to generate the Cost Accounting data there are multiple Costing Philosophies to be considered:
• Standard Costing• Traditional Costing• Activity-based Costing• Grenzplankostenrechnung (GPK)• Resource Consumption Accounting (RCA)
56
Standard Costing
• Traces direct costs to output by multiplying the standard prices or rate by the standard quantities of inputs allowed for actual outputs produced
• Allocates overhead costs on the basis of the standard overhead-cost rates time the standard quantities of the allocation bases allowed for the actual outputs produced
• Replaced by Traditional Costing once actual data collection was automated
57
Activities Based Costing
• “ABC as an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attach activity costs to outputs1”
• ABC seeks to improve the tracing of indirect costs to products/customer by recognizing the different levels of activities that lead to indirect product/customer costs
• ABC is useful to provide visibility into support activities required to address complexities in products or customers
• Typically Full-absorption (all costs associated to the product) which caused inappropriate product/customer decisions
58 1 Source Wikipedia
Cost Allocation & Assignments
59
Accounting for Overhead
• Actual costs will almost never equal budgeted/planned costs
• Accordingly, an imbalance situation exists between the two overhead accounts– If Overhead Control > Overhead Allocated, this is
called Under-allocated Overhead– If Overhead Control < Overhead Allocated, this is
called Over-allocated Overhead
60
Accounting for Overhead
• This difference will be eliminated in the end-of-period adjusting entry process, using one of three possible methods
• The choice of method should be based on such issues as materiality, consistency and industry practice
61
Cost Allocation
• Assigning indirect costs to cost objects• These costs are not traced• Indirect costs often comprise a large percentage
of Total Overall Costs
62
Purposes of Cost Allocation
63
Criteria for Cost-Allocation Decisions
• Cause and Effect: variables are identified that cause resources to be consumed– Most credible to operating managers– Integral part of ABC
• Benefits Received: the beneficiaries of the outputs of the cost object are charged with costs in proportion to the benefits received
64
Criteria for Cost-Allocation Decisions
• Fairness (Equity): the basis for establishing a price satisfactory to the government and its suppliers– Cost allocation here is viewed as a “reasonable” or “fair”
means of establishing selling price
• Ability to Bear: costs are allocated in proportion to the cost object’s ability to bear them– Generally, larger or more profitable objects receive
proportionally more of the allocated costs
65
Cost Allocation Illustrated
66
GFEBS Manual Cost Allocation
67
Allocating Costs of a Supporting Department to Operating Departments
• Supporting (Service) Department: provides the services that assist other internal departments in the company
• Operating (Production) Department: directly adds value to a product or service
68
Methods to Allocate Support Department Costs
• Single-rate method: allocates costs in each cost pool (service department) to cost objects (production departments) using the same rate per unit of a single allocation base– No distinction is made between fixed and variable
costs in this method
69
Methods to Allocate Support Department Costs
• Dual-Rate method: segregates costs within each cost pool into two segments: a variable-cost pool and a fixed-cost pool
• Each pool uses a different cost-allocation base
70
Allocation Method Tradeoffs
• Single-Rate method is simple to implement, but treats fixed costs in a manner similar to variable costs
• Dual-Rate method treats fixed and variable costs more realistically, but is more complex to implement
71
Allocation Bases
• Under either method, allocation of support costs can be based on one of the three following scenarios:
1. Budgeted overhead rate and budgeted hours2. Budgeted overhead rate and actual hours3. Actual overhead rate and actual hours
• Choosing between actual and budgeted rates: budgeted is known at the beginning of the period, while actual will not be known with certainty until the end of the period
72
Allocating Common Costs
• Common Cost: the cost of operating a facility, activity, or cost object that is shared by two or more users at a lower cost than the individual cost of the activity to each user
73
Title IX
• Unequal aggregate expenditures for members of each sex or unequal expenditures for male and female teams if a recipient operates or sponsors separate teams will not constitute noncompliance with this section, but the Assistant Secretary [of Education for Civil Rights] may consider the failure to provide necessary funds for teams for one sex in assessing equality of opportunity for members of each sex.
3 Prong Test:• Providing athletic participation opportunities that are substantially proportionate to
the student enrollment. This prong of the test is satisfied when participation opportunities for men and women are "substantially proportionate" to their respective undergraduate enrollment.
• Demonstrating a continual expansion of athletic opportunities for the underrepresented sex. This prong of the test is satisfied when an institution has a history and continuing practice of program expansion that is responsive to the developing interests and abilities of the underrepresented sex (typically female).
• Accommodating the interest and ability of underrepresented sex. This prong of the test is satisfied when an institution is meeting the interests and abilities of its female students even where there are disproportionately fewer females than males participating in sports.
74
Output Costs
75
Capture Output CostsOverview
In addition to capturing cost, non-financial quantity information is necessary to support Cost Management
Non-financial quantity information can be:Quantitative, e.g. # of helpdesk tickets, # studentsQualitative, e.g. average # days to close helpdesk ticket, % Completion Rate
76
Capture Output Costs Decisions
Does the output quantity support the cost by BCT/ARFORGEN? HQ Need? or Field product/services?
(e.g. ammo used for training, # soldiers)Is the output quantity currently used by scheduling/operational managers on a timely basis?Can an output change the behavior of an organization/individual to be more efficient and effective (e.g. # cancelled course registrations in ATAARS)Are output quantities used for justifications and/or requests for funding?If it supports cost management – efficiently & effectively - then it is considered
77
Capturing Output CostsAnalysis
Understanding the dollar amount of unit provided, based on number delivered Cost/Per
Understanding the relationship between Resource Capacity to Output generation (e.g. 3 Hrs: 1 Output)
0%
20%
40%
60%
80%
100%
Month 1 Month 2 Month 3 Month 4 Month 5 Month N
Capacity
Actual Output
78
Capturing Output CostsAnalysis
Cost of Closing Tickets
Num
ber
of T
icke
ts
• Visibility across the Army as to what tasks should costs
– Supports comparative analysis between sites, tasks, types of work, and groups of resources to identify best practice vs. inefficiencies
– Allows for realization of trade-offs between delivery and resource consumption
79
2ABM0014: LEGAL (ILO)
Name Cost Element
Amount Quantity
Perm 6100.11B1 $5,000 100 hrs
Capture Output Costs Analysis
Training Event (UIC)10 roundsat $50
Qty is valuated with rate
2ABM0065: AMMO SUPPLY
Name Cost Element Amount Quantity
Ammo 9400.AMMO 10 EA
Name Cost Element
Amount
Quantity
Ammo 9400.AMMO $500 10 EA
AMMO FIRED
WARS
AMOUNT AND QUANTITY ARE THE OUTPUTS OF THIS PROCESS
80
Agency Problems
81
Various Types of Agency Problems
• Moral Hazard– Tendency to take risks because the costs that could incur will not
be felt by the party taking the risk. In other words, a tendency to be more willing to take a risk, knowing that the potential costs or burdens of taking such risk will be borne, in whole or in part, by others.
• Free rider– Benefiting from resources, goods, or services without paying for
the cost of the benefit.
• Adverse Selection– The buyer of a good (or the seller) attracts potential sellers (or
borrowers) that offer low quality goods (have a high probability of default). The quality of the goods is not readily observable.
Output Manipulation
• Managers may seek to manipulate income by producing too many units
• Production beyond demand will increase the amount of inventory on hand
• This will result in more fixed costs being capitalized as inventory
• This will leave a smaller amount of fixed costs to be expensed during the period
• Profit increases, and potentially so does a manger’s bonus
83
Countermeasures for Output Manipulation
• Careful budgeting and inventory planning• Incorporate an internal carrying charge for
inventory• Change (lengthen) the period used to evaluate
performance• Include non-financial as well as financial
variables in the measures to evaluate performance
84
Transfer Pricing
85
Transfer Pricing
• The amount charged when one division sells goods or services to another division
• The transfer price affects the profit measure for the selling division and the buying division
86
The External and Internal Transfer of Products
ExternalSupplier
Division A
Division B
ExternalCustomer
Intermediate
Product
Finished Product
Raw Materials
87
Reasons for Transfer Pricing
1. Control (incentives and performance measures)
2. Decentralized planning decisions3. International/tax reasons
88
Summary of Transfer Pricing Methods
Method Advantages Disadvantages
Market-Based •Approximates opportunity cost if competitive market exists •Excludes effects of internal transaction costs on transfer price
•May not have external market for intermediate goods•Excludes effects of internal transaction costs of transfer price
Variable Cost •Approximates opportunity cost if fixed costs are sunk
•Does not allow selling division to recover fixed costs•Provides incentive for selling division to convert fixed costs to variable costs
Full Cost •Reduces disputes as the figure is objective •Simple to compute as it parallels accounting system figures•Approximates opportunity cost if division is operating at capacity
•Overstates opportunity cost if excess capacity exists
Negotiated •Maintains managerial autonomy •Preserves upper-management time
•Is time consuming and relies on negotiation skills of divisional managers •May not be the optimal transfer price for the firm as a whole •Can lead to conflicts between responsibility centers
89
Control Issues
Transfer prices can be used as inputs to the performance measurement system
Transfer prices can be used as inputs to the performance measurement system
Transfer pricing assigns costs to managers who are responsible for the costs
Transfer pricing assigns costs to managers who are responsible for the costs
90
Transfer Pricing
Parts Division £ Assembly Division £
Revenue per unit 12 Revenue per unit 23
Parts cost per unit 10 Parts cost per unit 12
Profit per unit 2 Assembly costs 4
Profit per unit 7
The ‘Parts’ division manufactures parts that it sells to the ‘Assembly’ division
The ‘Parts’ division manufactures parts that it sells to the ‘Assembly’ division
The cost to the ‘Parts’ division is £10 per unit.
The ‘Assembly division’ assembles the part at a cost of £4 per unit and sells the product to another organization for £23 per unit.
What is the profit per unit if the transfer price is £12 each
The cost to the ‘Parts’ division is £10 per unit.
The ‘Assembly division’ assembles the part at a cost of £4 per unit and sells the product to another organization for £23 per unit.
What is the profit per unit if the transfer price is £12 each
What is the profit per unit if the transfer price is £10 eachWhat is the profit per unit if the transfer price is £10 each
Parts Division £ Assembly Division £
Revenue per unit 10 Revenue per unit 23
Parts cost per unit 10 Parts cost per unit 10
Profit per unit 0 Assembly costs 4
Profit per unit 9
91
Transfer Pricing for Decentralized Planning Purposes
• Some divisions are required to buy internally produced items
• The internal producer may not have an incentive to keep costs down
• When managers have the choice to buy “outside,” the internal producer must stay competitive on both quality and cost
• Some divisions are required to buy internally produced items
• The internal producer may not have an incentive to keep costs down
• When managers have the choice to buy “outside,” the internal producer must stay competitive on both quality and cost
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Transfer Prices for Decentralized Planning Decisions
Circumstance Transfer Price
Market price exists Market price
No market price exists; supplying division has no alternative use of capacity
Variable cost
No market price exists; supplying division has alternative use of capacity
Full Cost*
*The full cost is intended to be a rough approximation of the forgone opportunity of using the facilities of the supplying division to do something else
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Choosing Transfer Prices
A transfer price that maximizes firm value (a planning issue) may not maximize a manager’s
performance measure (a control issue)
A transfer price that maximizes firm value (a planning issue) may not maximize a manager’s
performance measure (a control issue)
Negotiated transfer prices are more effective when there is an external market alternative
Negotiated transfer prices are more effective when there is an external market alternative
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Globalization and Transfer Pricing
Tax Minimization: if a multi-national transfers products between two countries with different tax rates the company will try to set a transfer price to minimize its total tax liability in the two countries
Tax Minimization: if a multi-national transfers products between two countries with different tax rates the company will try to set a transfer price to minimize its total tax liability in the two countries
Political Considerations can affect the transfer-pricing decision, if there is a risk of
expropriation of assets the company may use high transfer prices to reduce the apparent
profitability of their foreign subsidiaries
Political Considerations can affect the transfer-pricing decision, if there is a risk of
expropriation of assets the company may use high transfer prices to reduce the apparent
profitability of their foreign subsidiaries
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Conclusion
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