Basic Concepts and Cost Behavior

Financial accounting focuses on reliability and creates aggregated reports, while management accounting prioritizes relevance with detailed information for internal decision-making. In organizations, the controller handles financial reporting, cost accounting, and financial analysis, serving primarily as a staff function (advising rather than commanding).

Understanding cost behavior is crucial for business decisions. When analyzing costs, several methods help determine how costs change with activity:

• High-Low Method calculates variable costs using highest and lowest activity points
• Scatter Diagrams visually represent cost relationships
• Least-Square Regression creates the most accurate "line of best fit"

💡 The coefficient of determination (r²) tells you how well one variable predicts another. The closer to 1.0, the stronger the relationship!

Cost-Volume-Profit (CVP) analysis examines relationships between costs, volume, and profits. The break-even point shows where total revenue equals total costs (zero profit). Key formulas include:

• Break-even in units = Fixed Cost ÷ Unit Contribution Margin
• Break-even in pesos = Fixed Cost ÷ CM Ratio
• Margin of Safety = Sales - Break-even Sales

When making decisions using relevant costing, focus only on costs that differ between alternatives. Remember that fixed costs are typically irrelevant unless avoidable, while variable costs and opportunity costs (what you give up) are relevant.

Budgeting

A master budget is an organization's comprehensive financial plan. It starts with a sales forecast (the most difficult part) and includes production, inventory, expense, and cash budgets, ultimately creating projected financial statements.

Operating budgets cover revenues and expenses, while financial budgets deal with assets, liabilities, and equity. Budget approaches include:

• Authoritative $top-down$ prepared by management
• Participatory $bottom-up$ involves staff input
• Zero-based requires justifying all expenses periodically

Variance analysis compares actual results with budgeted figures. A favorable gross profit variance means actual profit exceeded budget, while an unfavorable variance indicates underperformance.

Standard Costing and Responsibility Centers

Standard costing establishes predetermined costs for products and services, allowing companies to analyze deviations. When actual results differ from standards, companies calculate variances to understand why.

For direct materials, key variances include:

• Material Price Variance (MPV): difference between actual and standard prices
• Material Quantity Variance (MQV): difference between actual and standard quantities used

For direct labor:

• Labor Rate Variance (LRV): difference between actual and standard wage rates
• Labor Efficiency Variance (LEV): difference between actual and standard hours worked

💡 Variance analysis helps managers identify problems quickly. A favorable variance isn't always good—it might mean your standards were set too loosely!

In responsibility accounting, organizations divide into centers based on controllable factors:

• Cost Centers: responsible for costs only (like assembly departments)
• Revenue Centers: responsible for revenue generation (like sales departments)
• Profit Centers: responsible for both costs and revenues
• Investment Centers: responsible for costs, revenues, and investments

The segmented income statement separates controllable and non-controllable costs to evaluate both manager performance and segment profitability:

1. Sales
2. Less: Variable Manufacturing Cost
3. Manufacturing Contribution Margin
4. Less: Variable Non-Manufacturing Cost
5. Contribution Margin
6. Less: Controllable Direct Fixed Cost
7. Controllable Margin (evaluates manager performance)
8. Less: Non-controllable Direct Fixed Cost
9. Segment Margin (evaluates segment performance)
10. Less: Allocated Common Cost
11. Profit

Investment centers use performance measures including:

• Return on Investment (ROI) = Income ÷ Assets
  • Can be broken down as (Income ÷ Sales) × (Sales ÷ Assets)
• Residual Income (RI) = Income - Required Income
  • Better than ROI for encouraging profitable investments
• Economic Value Added (EVA) = Income after tax - Required Income

Transfer Pricing, Balanced Scorecard, and Economics

Transfer pricing determines values for products and services exchanged between divisions of the same company. The best transfer pricing systems promote goal congruence—ensuring division managers' decisions align with overall company objectives. Options include:

• Market Price: best when competitive markets exist and divisions operate independently
• Cost-based Price: based on the selling division's variable or full costs
• Negotiated Price: used when no market exists or prices fluctuate significantly
• Arbitrary Price: imposed by higher management with no clear basis

The Balanced Scorecard provides a comprehensive view of organizational performance through four perspectives:

1. Financial: ROI, EVA, operating margin
2. Customer: customer satisfaction, returns, complaints
3. Internal Business Process: manufacturing cycle efficiency
4. Learning and Growth: employee training and satisfaction

💡 Financial measures are "lagging indicators" showing past performance, while the other three perspectives are "leading indicators" that predict future financial performance!

In economics, understanding supply and demand is fundamental. The demand curve shows an inverse relationship between price and quantity demanded—as price increases, quantity demanded decreases. Factors affecting demand include:

• Price of substitutes (direct relationship)
• Price of complements (inverse relationship)
• Consumer income (direct for normal goods, inverse for inferior goods)
• Consumer preferences and population size

The elasticity of demand measures how sensitive quantity demanded is to price changes:

• Elastic demand (E>1): quantity changes more than price
• Inelastic demand (E<1): quantity changes less than price
• Unitary elastic $E=1$: quantity and price change proportionally

Supply curves show a positive relationship—as price increases, quantity supplied increases. Key economic measurements include:

• GDP (Gross Domestic Product): total value of final goods and services
• Inflation: increase in general price level (measured by CPI or GDP Deflator)
• Unemployment: categorized as cyclical, frictional, or structural

Capital Budgeting and Investment Analysis

Capital budgeting involves evaluating long-term investments like purchasing equipment or expanding facilities. These decisions are typically:

• Difficult to reverse
• Involve significant uncertainty
• Require large funding
• Have long-term implications

When analyzing projects, consider these key elements:

1. Net Investment (initial cash outflow)
2. Annual Cash Flow After Tax (ACFAT)
3. Termination Cash Flow (at project end)

Capital budgeting techniques fall into two categories:

Non-Discounted Methods (ignore time value of money):

• Payback Period: time required to recover the investment
• Accounting Rate of Return: average annual income ÷ investment

Discounted Methods (account for time value of money):

• Net Present Value (NPV): present value of all cash flows
• Profitability Index (PI): ratio of present value of inflows to outflows
• Internal Rate of Return (IRR): discount rate that makes NPV equal zero
• Discounted Payback Period: time to recover investment in present value terms

💡 For comparing projects, NPV is generally the most reliable method because it directly measures value added to the company!

When evaluating project types:

• Independent projects: Accept if NPV > 0, PI > 1, or IRR > discount rate
• Mutually exclusive projects: Choose the one with highest NPV

Investment risk analysis evaluates uncertainty in future cash flows:

• Standard deviation measures risk (variability)
• Expected return measures potential reward
• Coefficient of variation (standard deviation ÷ expected return) helps compare investments with different risks and returns

Remember that diversification can reduce unsystematic risk $company-specific$ but not systematic risk $market-wide$.

Cost of Capital and Financial Statement Analysis

The cost of capital represents the minimum return required on investments. It's used for capital budgeting decisions and maintaining optimal capital structure. Components include:

1. Cost of Debt (KD): interest rate adjusted for tax benefits

   • KD = Yield rate × $1 - Tax rate$
   • Usually the cheapest source due to tax deductibility

2. Cost of Preferred Stock (KP): dividend yield

   • KP = Preferred dividend ÷ Market price

3. Cost of Equity (KE): return required by shareholders

   • Dividend Growth Model: KE = (Dividend ÷ Price) + Growth rate
   • Capital Asset Pricing Model: KE = Risk-free rate + β$Market return - Risk-free rate$
   • Most expensive source of capital

A company's beta coefficient (β) measures a stock's volatility relative to the market:

• β > 1: more volatile than market
• β = 1: same volatility as market
• β < 1: less volatile than market

Financial leverage affects risk and return. Key metrics include:

• Degree of Operating Leverage (DOL): Contribution Margin ÷ EBIT
• Degree of Financial Leverage (DFL): EBIT ÷ $EBIT - Financial Fixed Costs$
• Degree of Total Leverage (DTL): DOL × DFL

💡 Higher leverage magnifies both profits and losses. When sales increase by 10%, a company with a DTL of 3 will see profits increase by 30%!

Financial statement analysis provides insights into company performance:

• Horizontal Analysis: compares figures across time periods
• Vertical Analysis: expresses items as percentages of a base figure

Key financial ratios include:

• Liquidity Ratios: Current Ratio, Quick Ratio
• Solvency Ratios: Debt Ratio, Interest Coverage Ratio
• Profitability Ratios: Gross Profit Margin, Return on Assets, Return on Equity
• Activity Ratios: Inventory Turnover, Accounts Receivable Turnover
• Market Value Ratios: Earnings Per Share, Price-Earnings Ratio

The Cash Conversion Cycle measures the time between paying for inventory and collecting from customers: CCC = Inventory Conversion Period + Collection Period - Payable Period

Working Capital Management and Financial Markets

Working capital management involves optimizing current assets and liabilities. Companies can adopt different strategies:

• Conservative Policy: High working capital, lower risk, less profitable
• Aggressive Policy: Minimal working capital, higher risk, more profitable
• Moderate Policy: Balanced approach
• Matching Policy: Aligning financing duration with asset life

Cash is held for four primary reasons:

• Transaction motive: for normal operations
• Precautionary motive: as a buffer against uncertainties
• Speculative motive: to capitalize on opportunities
• Contractual motive: to meet requirements like compensating balances

Cash management techniques help optimize cash flows:

• Using lockbox systems to accelerate collections
• Establishing lines of credit to reduce precautionary cash
• Implementing zero-balance accounts to slow disbursements
• Calculating optimal cash balances using the Baumol model

💡 The Cash Conversion Cycle can be shortened by accelerating collections, optimizing inventory, and extending (without defaulting on) payables!

For inventory management, the Economic Order Quantity (EOQ) model helps determine optimal order sizes by balancing ordering and carrying costs:

EOQ = √$2DO/C$ where:

• D = Annual demand
• O = Cost per order
• C = Annual carrying cost per unit

When financing working capital, companies can use:

• Trade credit (accounts payable)
• Short-term loans
• Lines of credit

In the broader financial landscape, companies interact with:

• Money Markets: for short-term financing (typically under one year)
• Capital Markets: for long-term financing through debt and equity
  • Primary Markets: where new securities are issued (like IPOs)
  • Secondary Markets: where existing securities are traded (like stock exchanges)

Competitive strategies include:

• Cost leadership: minimizing costs
• Differentiation: creating unique products/services
• Focus strategy: targeting specific market segments