EDSPIRA’S GUIDE TO

Managerial Accounting
By Michael McLaughlin

TABLE OF CONTENTS
Introduction to Managerial Accounting .............................................................................. 1
Basic Cost Concepts............................................................................................................ 2
Job-order Costing ............................................................................................................... 3
Support Department Costs ................................................................................................. 4
Joint Costs and Byproducts................................................................................................. 5
Process Costing .................................................................................................................. 6
Operation Costing .............................................................................................................. 7
Activity-based Costing ........................................................................................................ 8
Cost Behavior..................................................................................................................... 9
Cost Volume Profit Analysis ............................................................................................. 10
Variable Costing ............................................................................................................... 11
Budgeting ........................................................................................................................ 12
Flexible Budgeting............................................................................................................ 13
Standard Costing .............................................................................................................. 14
Capital Budgeting ............................................................................................................. 15
Key Performance Indicators ............................................................................................. 16
The Balanced Scorecard ................................................................................................... 17
Segment Reporting .......................................................................................................... 18
Relevant Costs ................................................................................................................. 19
Transfer Pricing ................................................................................................................ 20
Product Pricing................................................................................................................. 21
Inventory Management ................................................................................................... 22
 EDSPIRA 1

Lesson 1: Introduction to Managerial

Accounting
Definition Benefits

Managerial Accounting is the creation Managerial Accounting helps with

of accounting information to help planning, control, and performance
managers make better decisions. evaluation.

History

While Financial Accounting has been around since the Renaissance (15th century),
the core concepts of Managerial Accounting were developed during the Industrial
Revolution:
• The rise of factories led to new demands for accounting information.
• Tasks previously performed by independent artisans were now performed by
employees who all worked under the same roof and earned a wage rate,
which necessitated the construction of new systems for measuring the cost
per unit.
• The rise of railroads spanning entire continents led to further innovations in
Managerial Accounting (evaluating the performance of a firm by its geographic
region in addition to evaluating the performance of the company as a whole).
• i.e. Managerial Accounting uses more disaggregated data.

Financial Accounting vs. Managerial Accounting

For external use (investors & creditors) For internal use (managers)

Mandatory (required by GAAP) Not mandatory

Must follow GAAP Need not follow GAAP (for the most part)

Focuses on the past (what happened) Focuses on the future (predictions)

Emphasizes objectivity Emphasizes relevance

Presents info for the entire firm Presents info by segment, product, etc.
 EDSPIRA 2

Lesson 2: Basic Cost Concepts

Definitions

• A cost is a resource sacrificed or forgone to achieve a particular objective.

• A cost object is anything to which you can assign a cost.
• A direct cost can be easily traced to a cost object.
• An indirect cost can NOT be easily traced to a cost object.
• A product cost is a manufacturing cost that is capitalized to a manufacturer’s
inventory account. Product costs are later expensed through Cost of Goods Sold.
• The 3 types of product costs are: direct materials, direct labor, and
manufacturing overhead
• A period cost does not pertain to manufacturing and is expensed when incurred.
• An opportunity cost is the benefit given up by choosing one option over another.
• A sunk cost is a cost incurred in the past that cannot be changed by future decisions
and should be irrelevant to decision-making.
• A cost driver is an activity that causes costs to be incurred (e.g., machine hours).
• The relevant range is the normal activity level or volume for the cost in question.
• If the total cost changes with the level of activity, it is a variable cost.
• If the total cost does NOT change with the level of activity, it is a fixed cost.

Manufacturer’s Inventory Types Product Cost Formulas

1. Raw materials inventory

Prime costs = DM + DL
2. Work-in-process inventory
Conversion Costs = DL + MOH
3. Finished goods inventory

Manufacturer’s Cost of Goods Sold

A manufacturer can’t use FIFO, LIFO, etc. like a retailer because a manufacturer builds its
own inventory. Cost of Goods Sold (COGS) for a manufacturer is calculated as follows:
• COGS = Finished Goods Inv. (beg.) + COGM – Finished Goods Inv. (end.)
• Cost of Goods Manufactured (COGM) is calculated as follows:
• COGM = TMC + WIP (bb) – WIP (eb)
1. Total Manufacturing Cost (TMC) is calculated as follows:
2. TMC = DM used + DL + MOH
 EDSPIRA 3

Lesson 3: Job-order Costing

Definition

Job-order Costing is a system for assigning costs to jobs, projects, engagements, etc.
• A “job” could be nine wooden tables, a consulting engagement, etc.
• Costs are tracked on a job cost sheet. To calculate the per-unit cost of the job, divide
the total cost of the job by the number of units produced in the job

Job-order Costing vs. Process Costing

For purposes of determining COGS for the Income Statement and Ending Inventory for the
Balance Sheet (i.e., to produce GAAP financial statements):

A manufacturer that produces a variety of A manufacturer that produces large

different products (e.g., custom furniture) in amounts of an identical product (e.g., oil)
low volumes would most likely use Job-order would most likely use Process Costing
Costing

Manufacturer’s Costs of a Job

• Direct Materials Used

• Direct Labor
• Manufacturing Overhead Applied
o Manufacturing Overhead is applied to jobs using a predetermined rate
o The predetermined MOH rate is calculated at the beginning of the period by dividing the
budgeted MOH by the budgeted activity level (e.g., the number of machine hours)
o The MOH rate is used to apply MOH to jobs, because the actual MOH is not yet known when
the cost of the job is being determined

Under- or Overapplied Manufacturing Overhead

• Because MOH is applied to jobs using a predetermined rate that is calculated using budgeted
figures, the MOH applied will most likely differ from the actual MOH
• Most firms dispose of the over- or underapplied MOH balance by closing it to COGS
• If you underapplied MOH by $2,000, you would increase COGS by $2,000
▪ You didn’t apply enough MOH to jobs during the period, so you under-costed your
products. This is why you would increase COGS
▪ If you overapplied MOH, this means you over-costed your products. You would then
reduce COGS by the amount of the overapplied MOH balance
• However, it’s more accurate to dispose of the over- or underapplied MOH by prorating it
among (1) Work-in-Process Inventory, (2) Finished Goods Inventory, and (3) COGS

Issues/Drawbacks

1. MOH can be seasonal (products appear more or less costly based on the time of year)
2. Some MOH charges occur infrequently (year-end maintenance on equipment)
3. It is time-consuming for employees to keep track of the time spent on each job
4. The cost of data entry can be very high if you have thousands of jobs
 EDSPIRA 4

Lesson 4: Support Department Costs

Definitions

• An operating department engages in the main operations of an organization

• e.g., the production department at Tesla
• A support department (also known as service departments) provides assistance to an
organization’s operating departments
• e.g., the maintenance department at Tesla, the IT department at a university

How is this related to Cost Systems?

• Firms measure the cost management and/or profitability of their operating departments
• Because operating departments use the services of support departments, the support
department costs should be charged to the operating departments
• Allocating support department costs to operating departments allows the firm to more
accurately measure the cost management and/or profitability of operating departments
• Particularly relevant for manufacturers that calculate different manufacturing
overhead rates for each production department in a two-stage allocation

3 Ways to Allocate Support Department Costs

• The complication is that support departments provide services not just to the operating
departments; support departments also provide services to other support departments.
• The only difference between the 3 methods listed below is the extent to which they take the
aforementioned fact into consideration.
1. The Direct Method (easiest method, most commonly used)
• Ignores the fact that support departments provide services to each other
2. The Step-down Method
• Partially accounts for the fact that support departments provide services to each
other
• Rank the support departments and then allocate support department costs
sequentially
• The support department that provides services to the largest number of other
support departments is ranked first (in case of a tie, an arbitrary decision must be
made)
• The costs of support department #1 are then allocated first, the costs of support
department #2 are allocated second, etc.
3. The Reciprocal Method (most accurate method, used the least)
• Fully accounts for the fact that support departments provide services to each other
• This is the most difficult method because you have to set up a system of linear
equations
 EDSPIRA 5

Lesson 5: Joint Costs and Byproducts

Definitions

• Joint products are two or more products made from a common input
• Byproducts occur if there are additional products produced that have a relatively low sales value
• The split-off point is the point in the manufacturing process where joint products can be
recognized as separate products
• Joint costs are any costs incurred before the split-off point
• When deciding whether to sell a joint product or process it further, we should ignore
joints costs because they are sunk (and therefore irrelevant)
• However, joint costs are relevant when:
▪ We are evaluating the profitability of the entire operation
▪ We need to assign inventory values to joint products
• This could be required due to a cost-based government contract
▪ Thus, we sometimes need to allocate joint costs to joint products
▪ However, we NEVER assign joint costs to byproducts

3 Ways to Allocate Joint Costs

Relative Sales Value Method

• Allocate joint costs based on each joint product’s relative sales value
▪ e.g., if joint product #1 is expected to generate 80% of the total sales of all joint products,
joint product #1 would be assigned 80% of the joint costs

Physical Units Method

• Allocate joint costs using physical measurements (pounds, gallons, etc.)
▪ e.g., if joint product #1 is expected to generate 80% of the total pounds of all joint products,
joint product #1 would be assigned 80% of the joint costs

Net Realizable Value Method

• Allocate joint costs based on each joint product’s relative sales value
▪ e.g., if joint product #1 is expected to generate 80% of the total NRV of all joint products,
joint product #1 would be assigned 80% of the joint costs
• NRV = expected selling price minus any costs that will be occurred going forward in order to
sell that specific joint product

Ways to Account for Byproducts

Production Method - The manufacturing cost of the main products is reduced by the expected
sales value of the byproduct in the period the byproduct is produced

Sales Method- No journal entries are made for the byproduct until it is sold. When the byproduct is
sold, revenue is recognized (usually categorized as nonoperating revenue)

The Income Statement effect of these 2 methods differs on timing and classification
 EDSPIRA 6

Lesson 6: Process Costing

Definitions

• Process Costing is a system for assigning costs to departments

• Usually in the context of manufacturing, but can be used by service companies as well
• A manufacturer may have one production department or multiple production
departments; process costing can be used in either scenario
1. Weighted-average Method (easier; drawback is that it mixes the costs of multiple periods)
2. FIFO Method (more accurate—separates prior period costs from this period’s costs)

Process Costing vs. Job-Order Costing

A manufacturer can’t use FIFO, LIFO, etc. like a retailer because a manufacturer builds its inventory.
Cost of Goods Sold (COGS) for a manufacturer is calculated as follows:
• For purposes of determining Cost of Goods Sold for the Income Statement and Ending Inventory
for the Balance Sheet (i.e., to produce GAAP financial statements):
o A manufacturer that produces large amounts of an identical product (e.g., oil) would
most likely use Process Costing
o A manufacturer that produces a variety of different products (e.g., custom furniture)
would most likely use Job-order Costing

How does Process Costing work?

• Divide a department’s costs by the # of equivalent units produced to find cost per equivalent unit
o Cost per equivalent unit is the # of units worked on by the department, but adjusted for
the fact that some units are still in process (not 100% complete) at the end of the period
1. 200 units that are 40% complete = 80 equivalent units (200 * 40% = 80)
• Then apply the cost per equivalent unit to the units transferred out of the department and to the
units still in process to determine the costs assigned to the units transferred out and to the units
still in process (Work-in-Process Inventory), respectively
Process Costing with Sequential Production Departments
• When a good is manufactured by a series of production departments, the costs transferred out of
one department become work-in-process inventory for the next department
• If Department A transfers a partially completed car to Department B, the costs associated with
the car (incurred in Department A) become the new work-in-process inventory for Department B.
For Department B, these costs are called transferred-in costs
 EDSPIRA 7

Lesson 7: Operation Costing

Definition

Operation Costing is a hybrid cost system that combines features of Job-order

Costing and Process Costing

Why Use Operation Costing?

• Firms that manufacture multiple products using different materials but

identical conversion processes would be most likely to use Operation
Costing
o For example, a company that manufactures salted and unsalted
crackers would have different direct materials costs (the salted
crackers would incur more direct materials costs because salt is being
added) but identical conversion processes (it’s the same process to
make a cracker)

How Does Operation Costing Work?

• Direct material costs are assigned by • Conversion costs are assigned by

batch
o This is similar to Job-order Costing
- In the cracker example, direct
materials costs would be assigned
separately to the salted cracker
batch and to the unsalted cracker
batch
department
o This is similar to Process Costing
- In the cracker example,
conversion costs would be
assigned using a cost per unit
that is calculated at the
departmental level (if both the
salted and unsalted crackers pass
through the same packaging
department and are packaged the
same way, they would be
assigned costs from the
packaging department using the
same rate)
 EDSPIRA 8

Lesson 8: Activity-based Costing

Definitions

• Activity-based Costing is a cost system that provides more accurate information for
internal decision-making purposes than traditional cost systems (Job-order Costing,
Process Costing, or a hybrid of the two like Operation Costing)
How is Activity-based Costing different?
• Not consistent with GAAP -- a manufacturer can’t use ABC to calculate Cost of Goods Sold
or ending inventory for GAAP financial statements, because:
o With ABC, nonmanufacturing costs may be assigned to products
o With ABC, some manufacturing costs may be excluded from products
• ABC allocates overhead costs using multiple cost pools and activity rates, whereas
traditional cost systems typically used a single cost pool and MOH rate.

How does Activity-based Costing work?

• Define the cost pools and activity measures

• Assign overhead costs to cost pools
• Calculate activity rates
• Assign overhead to cost objects using the activity rates and activity measures
• Prepare a report for management

Applications Drawbacks

Activity-based Costing can be used • Time-consuming to interview employees

to determine:
• Cost of producing a unit
• Cost to provide a service
• Profitability of a product
line
• Profitability of a customer
• Employees overstate the amount of time they
spend on activities
• It results in a massive amount of data
• The payoff is not immediate
• Employees may resist the new system
• Manufacturers must maintain 2 separate cost
systems: ABC for internal decision-making, and a
traditional cost system to compute Cost of Goods
Sold and ending inventory for the financial
statements

Note: Time-driven Activity-based Costing was created to

address some of these drawbacks
 EDSPIRA 9

Lesson 9: Cost Behavior

Cost Behavior
• When we say we want to know how a cost behaves, this means we want to figure out how the
cost will change if the activity level changes. For example…
o What happens to foods costs at a restaurant if the number of customers increases?
o What happens to sales commissions as a car dealership sells more cars?
• Why do we care how a cost behaves?
o We want to predict how costs will change under various scenarios
• Note: a cost might behave differently outside of its relevant range
o The relevant range is the band of normal activity level for the cost in question
o e.g., the cost of rent for Happy Restaurant is fixed, assuming it does not have more
than 1 million customers in a year. If it has more than 1 million customers the cost of
rent will increase because it will need to open a second location

Cost Classifications
• Variable cost • Fixed cost • Mixed cost (aka
o The total cost changes in o The total cost does not semivariable cost)
response to changes in change in response to o Mixed costs are a
the activity level changes in the activity combination of fixed and
o Variable costs can be level variable costs
subcategorized as: o Fixed costs can be o Mixed costs are also
- True variable cost subcategorized as: known as semivariable
- Step-variable cost - Committed fixed cost costs
• Discretionary fixed cost • Mixed costs are typically
analyzed using one of three
techniques

3 Techniques for Analyzing Mixed Costs

1. Visual Fit Method
o Create a scatter plot and look for patterns
2. High-Low Method
Cost at high activity level − Cost at low activity level
o Variable cost per unit =
High activity level − Low activity level
o High-Low Method is easy to use, but only uses 2 data points
3. Regression Method
o Regress the total cost on the activity level
▪ The y-intercept is the total fixed cost
▪ The coefficient for the activity measure is the variable cost per unit
o This is the most accurate method for analyzing mixed costs
 EDSPIRA 10

Lesson 10: Cost Volume Profit Analysis

Definitions

• Cost Volume Profit (CVP) analysis focuses on calculating how many units a
company needs to sell in order to break even or reach certain profit levels
• To perform CVP analysis, you need to know a company’s contribution margin
• Contribution Margin = Revenues – Variable Costs
• Contribution Margin can also be expressed on a per-unit basis or as a ratio:
• Unit Contribution Margin = selling price – variable cost per unit
Contribution Margin
• CM Ratio =
Sales Revenue

Break-even Analysis Achieving a Target Profit Level

When the company sells one product with one
price point, use these formulas:
• Break-even Point (in units) =
Total Fixed Costs
Unit Contribution Margin
Break-even analysis is great, but the company
wants to earn a profit:
• # of Units to Achieve Before-tax Profit =
Total Fixed Costs + Target Before−tax Profit
Unit Contribution Margin

• Break-even Point (in sales dollars) = • # of Units to Achieve After-tax Profit =

Total Fixed Costs Target After−tax Profit
Total Fixed Costs +( )
Contribution Margin Ratio 1 − tax rate
Unit Contribution Margin
Multiple products at different price points:
• Break-even Point (in units) =
Total Fixed Costs
Weighted−average Unit Contribution Margin

Degree of Operating Leverage Margin of Safety

The DOL is a tool that tells you how much • Margin of Safety = Forecasted Sales
operating profit changes if sales revenue Revenue – Break-even Sales Revenue
changes: • Margin of Safety Percentage =
• Degree of Operating Leverage = Margin of Safety
Contribution Margin Forecasted Sales Revenue
Operating Profit
• If the DOL is 4, this means 10%
increase in sales would increase profit
by 40%
• It is highest near the break-even point
 EDSPIRA 11

Lesson 11: Variable Costing

Definition
• Manufacturers are required to use Absorption Costing when preparing financial
statements according to GAAP
• Absorption Costing means product (inventoriable) costs are (1) direct materials
used, (2) direct labor, and (3) manufacturing overhead (both variable and fixed)
• Thus, a traditional Job-order Costing or Process Costing system used by a
manufacturer would adhere to Absorption Costing
• Absorption Costing is problematic because fluctuations in the company’s inventory level
affect the company’s profit
• If the company produces more units than it sells in a period, some of the fixed
MOH incurred that period will go to that period’s ending inventory. A dishonest
manager could increase profit in the current period by ramping up production
• To address this, some manufacturers treat fixed MOH as a period cost, expensing it in
the period in which it was incurred. This is known as “Variable Costing”

Absorption Costing vs. Variable Costing

Product costs include: Product costs include:
• Direct Materials Used • Direct Materials Used
• Direct Labor • Direct Labor
• Variable MOH • Variable MOH
• Fixed MOH

Absorption Costing vs. Variable Costing

Units Produced > Units Sold
Units Produced < Units Sold
Units Produced = Units Sold
Inventory Increases Profit per Absorption Costing is
HIGHER than Variable Costing
Inventory Decreases Profit per Absorption Costing is
LOWER than Variable Costing
Inventory Stays the Profit per Absorption Costing is
Same THE SAME AS Variable Costing

Advantages of Variable Costing Disadvantages of Variable Costing

• Profit is not affected by changes in inventory
– this improves internal decision-making
• Easier for managers to understand; if you
sell more units, you become more profitable
• More closely approximates cash flow
• A Variable Costing Income Statement
provides the data needed to perform CVP
analysis
• Not consistent with GAAP – can only be
used for internal decision-making
• Assumes constant per-unit variable costs
• Not necessary if the firm uses a Just-in
Time Inventory system
• Need to educate employees when
implementing (so the sales staff don’t
reduce the price)
 EDSPIRA 12

Lesson 12: Budgeting

Definitions

• A budget is a quantitative forecast that shows how a company plans to acquire and use
resources over one or more future periods. A budget helps with planning and control.
• The master budget includes all of an organization’s budgets, including budgeted financial
statements. The master budget can be divided into 2 parts:
• The Operating Budget
▪ Includes the Budgeted Income Statement and all budgets used to create it
• The Financial Budget
▪ Includes the Cash Budget, the CAPX Budget, the Budgeted Balance Sheet,
and the Budgeted Statement of Cash Flows
• The Sales Budget is the most important and is prepared first, based on a sales forecast. If
the Sales Budget is inaccurate, many other budgets will be inaccurate.
• For example, the Production Budget of a manufacturer is based on its Sales
Budget. Their Raw Materials Budget is based on its Production Budget. Thus, if the
Sales Budget is wrong, there is a domino effect.
• Manufacturers, retailers, and service providers do not use the same set of budgets.
• A manufacturer has a Production Budget, whereas the others do not
• A retailer has a Merchandise Purchases Budget, whereas the others do not

Budgeting Strategies

Situation Pro Con

Continuous Budgeting Saves time More time-consuming

Participative Budgeting Improves morale Leads to budgetary slack

Zero-based Budgeting Reduces costs More time-consuming

Advantages of Budgeting Disadvantages of Budgeting

• Forces people to think about the future
• Allows firms to model how different
scenarios would play out
• Predicts cash flows so the company can
take steps to avoid running out of cash
• Reduce costs with cost reduction targets
• Provides forecasted earnings that can be
shared with investors
• It takes a lot of time to make budgets, and
they can be inaccurate and biased
• Budgets create a use-it-or-lose-it
mentality that often leads to rigid decision-
making
• If the targets are too ambitious, workers
might become demoralized
 EDSPIRA 13

Lesson 13: Flexible Budgeting

Actual Activity Level
• You should never compare a company’s operating results to its original budget
o This is because the static planning budget was made assuming a certain activity
level (e.g., that the firm would sell 20,000 units). But the actual activity level will
probably turn out to be higher (or lower) than the activity level that was planned
o To address this, you should adjust the numbers in the budget once you know the
actual activity level. In so doing, you are creating the budget that should have
existed (had you known the actual activity level when you made the budget)

Flexible Budgeting
• The adjusted budget (based on the actual activity level) is called the flexible budget
• Once you’ve created the flexible budget, you compare the numbers in the flexible budget
to the company’s actual operating results
o Differences between the revenues in the flexible budget and the actual results are
called revenue variances (marked “F” for favorable, “U” for unfavorable)
o Differences between the expenses in the flexible budget and the actual results are
called spending variances (marked “F” for favorable, “U” for unfavorable)

Planning Budget vs. Flexible Budget vs. Actual Results

Here’s an example for a consulting firm, where the activity level is the number of consulting
projects:
Static Activity Flexible Revenue & Actual
Planning Variance Budget Spending Results
Budget Variances
Consulting Projects 100 130 130
Sales Revenue $250,000 $75,000 F $325,000 $7,000 U $318,000
Expenses:
Entertainment $20,000 $6,000 U $26,000 $23,000 U $49,000
Wages $70,000 $12,000 U $82,000 $3,000 F $79,000
Supplies $10,000 $3,000 U $13,000 $200 U $13,200
Utilities $3,005 $2 U $3,007 $94 U $3,100
Rent $18,000 $0 $18,000 $0 $18,000
Insurance $2,400 $0 $2,400 $0 $2,400
Business License $5,000 $0 $5,000 $0 $5,000
Company Car $13,500 $2,250 U $15,750 $6,250 U $22,000
Operating Profit $108,095 $51,749 F $159,844 $33,544 U $126,300
 EDSPIRA 14

Lesson 14: Standard Costing

Definitions

• Some companies establish standards regarding the price they should pay for a resource
or the amount of the resource they should use. This practice is known as standard
costing.
o Differences between actual amounts and standard amounts are called variances
o Variances are marked “F” for favorable or “U” for unfavorable
- Favorable means the firm paid less or used less than the standard
- Unfavorable means the firm paid more or used more than the standard

List of Variances

Type Formula Explanation

Materials Price AQ * (AP – SP) Actual Quantity * (Actual Price – Standard Price)
Variance

Materials Quantity SP * (AQ – SQ) Standard Price * (Actual Quantity – Standard

Variance Quantity)

Labor Rate Variance AH * (AR – SR) Actual Hours * (Actual Rate – Standard Rate)

Labor Efficiency SR * (AH – SH) Standard Rate * (Actual Hours – Standard

Variance Hours)

VMOH Rate Variance AQ * (AR – SR) Actual Quantity * (Actual Rate – Standard Rate)

VMOH Efficiency SR * (AQ – SQ) Standard Rate * (Actual Quantity – Standard

Variance Quantity)

FMOH Spending Actual FMOH – Budgeted FMOH

Variance

FMOH Volume Budgeted FMOH – FMOH Applied to WIP

Variance Inventory
 EDSPIRA 15

Lesson 15: Capital Budgeting

Time Value of Money
• A dollar received today is worth more than a dollar received tomorrow
o This is because dollar received today could be invested to earn a return
Cash Flow
o Present Value of a Single Cash Flow =
(1 + r)n
1−(1+ r)−n
o Present Value of an Ordinary Annuity = Cash Flow *
r
Cash Flow
• Present Value of a Perpetuity =
r

3 Decision Rules for Evaluating Projects

Each company establishes criteria for how it decides to accept or reject a project. Here
are the 3 most popular decision rules for choosing projects
1. Net Present Value (NPV)
a. The NPV is the sum of discounted cash inflows and discounted cash outflows
b. If the NPV is greater than zero, accept the project
2. Internal Rate of Return (IRR)
a. The IRR is the required return that results in a zero NPV when it is used as
the discount rate
b. Thus, the IRR is the time-adjusted economic return
c. If the IRR is greater than the company’s hurdle rate, accept the project
3. The Payback Method
a. You calculate the time it takes to recoup the upfront investment, then
compare this to the company’s required payback period
b. If the investment pays back faster than the required period, accept the project

Advanced
• NPV is better than IRR – people like IRR because it’s easier to interpret and you
don’t need to know the cost of capital to compute it
• When there are mutually exclusive investments, disregard IRR and choose the
project with the highest NPV. IRR also fails when:
1. There is a delayed investment, or positive and negative cash flows alternate
2. There are multiple IRR’s
3. The IRR is nonexistent
• When capital is constrained, you may not be able to accept all positive-NPV
projects
• In such cases, you can rank positive-NPV projects using the Profitability Index:
Present Value of Cash Inflows
Profitability Index =
Initial Investment
 EDSPIRA 16

Lesson 16: Key Performance Indicators

Definitions

Many different key performance indicators (KPIs) are used to evaluate the performance of
companies and divisions within those companies. We’ll cover the most popular KPIs:
𝐈𝐧𝐜𝐨𝐦𝐞 𝐈𝐧𝐜𝐨𝐦𝐞 𝐑𝐞𝐯𝐞𝐧𝐮𝐞
1. Return on Investment (ROI) = = *
𝐈𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐑𝐞𝐯𝐞𝐧𝐮𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐂𝐚𝐩𝐢𝐭𝐚𝐥
ROI is the product of Profit Margin and Capital Turnover
2. Residual Income = Income – (required return * investment)
3. Economic Value Added (EVA) = after-tax operating income – [WACC * (TA – CL)]
WACC = weighted-average cost of capital
TA = total assets
CL = current liabilities

Customer-related KPIs

Compare the cost to acquire a customer (CAC) to the lifetime value of a customer (LTV).
Customers should be worth more than the cost to acquire them
• The cost to acquire a customer is calculated as follows:
𝐂𝐨𝐬𝐭𝐬 𝐬𝐩𝐞𝐧𝐭 𝐭𝐨 𝐚𝐜𝐪𝐮𝐢𝐫𝐞 𝐧𝐞𝐰 𝐜𝐮𝐬𝐭𝐨𝐦𝐞𝐫𝐬
o CAC =
𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐧𝐞𝐰 𝐜𝐮𝐬𝐭𝐨𝐦𝐞𝐫𝐬 𝐚𝐜𝐪𝐮𝐢𝐫𝐞𝐝
• The lifetime value of a customer is calculated as follows:
o LTV = CM Ratio * # of months a customer * monthly revenue per customer
• You want the ratio of CAC to LTV to be at least three, four, or five to one because…
o Customer acquisition costs aren’t the only costs the company needs to cover!

Industry-specific KPIs

• Sales Per Square Foot tells you how well a retailer uses its space
• Same-store Sales tells you a company’s organic growth rate
• Active Users tells you how many people are using a social media website
 EDSPIRA 17

Lesson 17: The Balanced Scorecard

Definition
• A Balanced Scorecard shows how the company will create long-term value by identifying
financial and nonfinancial goals and measures
• It provides a clear picture of the firm’s strategy and how to execute that strategy
• It focuses attention on the most critical measures
• It is based on cause-and-effect relationships

The 4 Perspectives of the Balanced Scorecard

1. Learning and growth: are we innovating and improving as a company?
2. Internal process: are we becoming better at executing our processes?
3. Customer: are we increasing customer satisfaction?
4. Financial: are we improving sales growth, profitability, and cash flow?
Summary: if we learn and grow, we will improve our internal processes. If we improve our
processes, customers will be happier. If we make customers happier, we will make more money.

Sample Balanced Scorecard for a Donut Shop

 EDSPIRA 18

Lesson 18: Segment Reporting

Segment Reporting, Profit, and Disclosures

• We can break a large organization into parts and evaluate the performance of each part, known
as segment reporting
• Firms report segment financial data by geographic region, product line, or customer type
• A segment’s profit is equal to its contribution margin minus its traceable fixed costs
o A traceable fixed cost is a fixed cost that would disappear without the segment
o A common fixed cost, on the other hand, stays even if the segment is shut down
• The segment profit is the best indicator of the segment’s long-run success
o Unprofitable segments cause cross-subsidization
• Companies may allocate corporate-level costs to segments to remind managers these costs
exist and must be covered. However, this can lead to bad decisions when shutting down a
segment.

Decentralization

• A decentralized organization encourages lower-level managers to make decisions

o At centralized organizations, the decision-making is concentrated among a small group of
people at the top of the organization
• Decentralization provides several advantages:
1. Executives can focus on strategy and delegate less important tasks
2. It takes advantages of lower-level managers’ information
3. It reduces bureaucracy and enables the firm to act more quickly
4. It provides lower-level managers with experience for higher roles
5. It increases job satisfaction and motivation for lower-level managers
• Decentralization isn’t perfect, and it has disadvantages:
o Lower-level managers might not understand the organization’s overall strategy, and might
make decisions that go against that strategy
o It can be difficult for large organizations to coordinate the activities of all their lower-level
managers (which could number in the thousands – think of Walmart)

Responsibility Centers

All large organizations have various responsibility centers. Here are the 4 main types:
1. Cost Center – the manager is held responsible solely for managing costs
a. e.g., the human resources department of a manufacturing firm
2. Revenue Center – the manager is held responsible solely for generating revenues
a. e.g., a sales office
3. Profit Center – the manager is held responsible for costs and revenues (profits)
a. e.g., a single McDonald’s store
4. Investment Center – the manager is held responsible for profits and investments
a. e.g., McDonald’s Japan
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Lesson 19: Relevant Costs

Irrelevant vs. Relevant Costs
• When making decisions, managers are
often distracted by irrelevant costs
o Sunk costs are irrelevant—they have
already been incurred and can’t be
recovered
o Future costs that do not differ
between alternatives should be
ignored— they will be incurred
regardless of which alternative is
chosen
• Managers should therefore focus only on
relevant costs
• The concept of relevant costs is
illustrated by examining 3 decisions
made by managers:
1. Make or Buy
2. Accept or Reject a Special Order
3. Sell or Process Further

Make or Buy
• A manager must decide whether to determine whether to make a component
internally or outsource it from another firm
o e.g., should General Motors manufacture its own engines, or purchase engines
from a supplier?
• When deciding whether to make or buy a component, companies consider:
o Quality: Will quality decrease if the company outsources the component?
o Speed: Will it take too long if the company outsources the component?
o Cost: Is it cheaper to make the component in-house or to simply outsource it?
• When comparing the costs of making the component to the costs to purchasing it:
o Ignore any sunk costs, such as the cost of equipment that was purchased at
some point in the past to make the component)
o Consider any opportunity costs of making the component in-house, such as
any profits that could be earned by using the space that would otherwise be
used to manufacture the component

Accept or Reject a Special Order

• If the incremental revenues exceed the incremental costs, accept the order
• Be sure to ignore sunk costs, but do consider opportunity costs of accepting the
order

Sell or Process Further

• When deciding whether to sell a joint product as is or process it further to achieve a
higher selling price, only compare the incremental revenues to the incremental costs
• Joint costs are sunk costs (irrelevant!) when deciding whether to sell or process
further
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Lesson 20: Transfer Pricing

Definitions

• A transfer price is the price charged by a division to another division of the same
company
o Assume an automobile manufacturer has one division that assembles cars and
another division that makes car batteries. The price charged by the battery
division to the assembly division is called the transfer price.
• Transfer prices are prevalent in vertically integrated firms, a company that owns
some or all of its supply chain
o If a car manufacturer owns the various companies that produce the
components that go into the car (e.g., battery, tires) the manufacturer is
vertically integrated
o Some companies vertically integrate so they have more control over the speed
with which they receive components, as well as the price of those components

Types of Transfer Prices

There is no transfer-pricing scheme that works in all situations. Here are 3 types of transfer
prices:
1. Market-based: The market price is regarded as the best basis for transfer pricing
because it most closely approximates the opportunity cost of the resource, however…
• We don’t always know the market price
• Might not work well if the selling division has excess capacity, meaning the selling
division can produce more units than it can sell to entities outside the firm
2. Cost-based: Some firms have transfers take place at cost, or cost plus a markup
• Full-cost transfer prices are not recommended because they don’t give the selling
division an incentive to control costs
3. Negotiated: Allowing divisional managers to negotiate the price preserves their
autonomy
• However, managers waste time arguing about the price
• Moreover, a division may appear to be performing well simply because its manager
is a good negotiator, not because the division is actually doing well

Tax Issues Related to Transfer Pricing

• Firms are allowed to “decouple” their transfer prices – this means a company can use
one transfer price for internal decision-making, but report a different price to tax
authorities
• Firms thus use transfer prices to shift profits from high-tax to low-tax jurisdictions
 EDSPIRA 21

Lesson 21: Product Pricing

The 3 Approaches to Pricing
1. Economic Approach
o Choose the price at which marginal revenue equals marginal cost. This is the
profit-maximizing price

2. Cost-based Approach
o Apply a percentage markup to the cost of providing a product or service

3. Target Costing
o Set the price first. Then design the product in such a way that the costs will be
low enough to achieve the target profit

Key Terms
• The Law of Demand says that price and quantity demanded are inversely related
• We can measure how sensitive consumers are to a change in price by calculating the price
elasticity of demand.
Percentage Change in Quantity Demanded
Price Elasticity of Demand =
Percentage Change in Price
• We can also measure the change in quantity demanded in response to a chance in the price
of a related good. This is called the cross elasticity of demand.
Percentage Change in Quantity Demanded
Cross Elasticity of Demand =
Percentage Change in Price of Related Good
• Many firms don’t know their marginal revenue or marginal cost, so they determine the price
of a product or service by marking up the variable cost or total cost. (Cost-plus pricing is
easy, but it ignores customers’ willingness-to-pay.)
o With Target Costing, you determine the maximum allowable cost for a new product
and then develop a prototype that can be profitably made for that cost figure
Target Cost = Expected Selling Price – Target Profit

Price Elasticity of Demand

If Price Elasticity of Demand is… Then Demand for the Good is…
0 Perfectly Inelastic
0<1 Inelastic
1 Unit Elastic
1<∞ Elastic
∞ Perfectly Elastic

Cross Elasticity of Demand

If Cross Elasticity of Demand is… Then the Goods are…
Positive Substitutes
Negative Complements
 EDSPIRA 22

Lesson 22: Inventory Management

Definitions

Inventory is a significant cost for companies that sell products, so it is imperative they
manage inventory well to keep costs down. There are 3 types of inventory-related costs:

1. Ordering Costs
a. Costs of preparing purchase orders, finding suppliers, inspecting shipments.
This is not the price you pay for the inventory, it’s the cost of placing an order
2. Carrying Costs
a. Costs of insurance, security, shrinkage, obsolescence, taxes
b. This also includes the forgone interest on working capital
i. You could have earned a return on money tied up in inventory
3. Stockout Costs
a. Lost sales from dissatisfied customers who won’t be coming back because the
inventory wasn’t available when they wanted to purchase it

Decision Rules for Inventory

• The following formula tells you the optimal amount of inventory to order:
2 * Demand * Cost Per Order
Economic Order Quantity = √
Carry Cost of One Unit
o This Economic Order Quantity balances ordering against carrying costs
▪ The “Demand” is the quantity of inventory demanded for the time period
▪ The “Carrying Cost of One Unit” is for the same time period as demand
• The following formula tells you the point when you should reorder inventory:
Reorder Point = (Average Daily Usage * Lead Time) + Safety Stock

Inventory Management Systems

• Firms initially adopted Material Requirements Planning (MRP) software systems

o MRP is a “push-through” system that plans the manufacturing of inventory based
on demand forecasts. A master production schedule specifies the quantity and
timing of each good to be produced
o Once production begins, the output of each department is pushed through the
production line whether it is needed or not
• Japanese firms noticed that carrying costs were higher than had been assumed
o At the same time, purchasing costs came down due to advances in technology
o Thus, some firms shifted to a Just-in Time Inventory (JIT) system
▪ With JIT, inventory is produced as needed (low or zero inventory)