acct exam 3

Lucky's Charms is an Irish jewelry company that produces charms for charm bracelets out of 14 karat silver. To produce the bracelets, the company hires skilled labor on an hourly basis (a purely variable cost) and sources silver sheets, the only materials used in the process, that they use to make the charms. On December 31, 20X1, Lucky's reviewed their historical cost information and determined that: They typically paid $20 per hour for their laborers. They paid $1 per gram of silver. Each charm takes 0.5 hours of labor and 6 grams of silver to produce. They typically produce and sell 1,000 charms per month. The charms sell for $19 each. They expect this historical information will be accurate for budgeting the next several months' performance 2. Assume Lucky's only produced and sold 900 units for the month of January. Produce the flexiblebudget for (1) sales revenue, (2) direct labor cost, and (3) direct materials for January 20X2.

(1) Sales Revenue = 19 per unit * 900 units = $17,100 (2) Direct Labor Cost = $20 per hour * 0.5 hours per unit * 900 units = $9,000 (3) Direct Materials Cost = $1 per gram * 6 grams per unit * 900 units = $5,400

Lucky's Charms is an Irish jewelry company that produces charms for charm bracelets out of 14 karat silver. To produce the bracelets, the company hires skilled labor on an hourly basis (a purely variable cost) and sources silver sheets, the only materials used in the process, that they use to make the charms. On December 31, 20X1, Lucky's reviewed their historical cost information and determined that: They typically paid $20 per hour for their laborers. They paid $1 per gram of silver. Each charm takes 0.5 hours of labor and 6 grams of silver to produce. They typically produce and sell 1,000 charms per month. The charms sell for $19 each. They expect this historical information will be accurate for budgeting the next several months' performance 1. Determine the (1) budgeted sales revenue, (2) budgeted direct labor cost, and (3) budgeted direct materials cost for January 20X2

(1) sales revenue = 19 per unit * 1000 units = $19,000 (2) direct labor cost = $20 per hour * 0.5 hours per unit *1,000 units = $10,000 (3) direct material cost = $1 per gram * 6 grams per unit * 1,000 units = $6,000

Example • The hospital purchased 500 boxes of bandages for $2 each • The standard price per box is $1.75

(AQ * AP) - (AQ * SP) =(500 * $2) - (500 * $1.75) = $1,000 - $875 = $125 The hospital paid more than the standard rate, so this is an unfavorable price variance

Example • The hospital should have used 480 boxes of bandages at a standard price of $1.75/box • The hospital actually used 500 boxes

(AQ * SP) - (SQ * SP) = (500 * $1.75) - (480 * $1.75) = $875 - $840 = $35 The hospital used more than the standard rate, so this is an unfavorable quantity variance

Example • You start a company that makes self-driving baby strollers • For the 200th anniversary of WashU, the university bookstore offers to purchase specially modified strollers that say • The normal selling price of a stroller is $699, but the WashU bookstore offers to purchase 100 strollers for $550/stroller Should you accept the order? The Numbers *For internal decision-making this company assigns non manufacturing costs to jobs • The production team gives you the job cost sheet for the special order of 100 strollers, and it shows the following: Direct Materials: $37,200 Direct Labor: $9,000 VMOH: $1,200 FMOH: $7,000 Customer Acquisition Costs: $2,000 Cost Per Unit: $564 The cost per unit would be $564. This implies we should reject the job. But does that seem right?

- If we can already sell everything we produce, we would not consider this offer - But, not all of those things are not fairly assigned to a one time special project + Ex: acquire customers cost and FMOH are incurred regardless if it was a special order (those costs are baked into all of those ordinary sales)- So don't include them since the people approached us, and we did not acquire them Key takeaway: if the incremental revenues from a special order exceed the incremental costs, accept the order costs that don't matter - There aren't any customer acquisition costs for this order (we already have the customer lined up) and the fixed overhead will be incurred regardless of whether we accept this order actual cost per unit - Thus, the cost per unit is really $474. Since WashU is offering $550, you accept the order + We would consider the offer since the cost drops down to $474 (that assumes you have idle capacity, that producing these things doesn't forgo someone else's order)

Distorted Incentives • The purchasing manager for a furniture manufacturer proudly boasts of achieving a $42,000 favorable price variance - She was able to get a better price on lumber by purchasing twenty-five times the typical amount the company orders - Is this a good thing?

- It depends; does the company actually need the lumber or is it simply stockpiling raw materials? • Remember, the goal is to make money, not simply to achieve favorable variances or a low per-unit cost!

Key Takeaway

- Knowing that there is a spending variance is not enough; we need to know why the variance occurred so we can take action • We can decompose a spending variance into two parts: price variance - this measures whether we got a good price quantity variance - this measures how well the resources were used

Example Let's look at 3 companies that sell coffee McDonald's Dunkin Starbucks

- McDonald's looked like it was in trouble, but appears to be making a comeback - Starbucks had very strong growth, but this has leveled off - Dunkin's stores don't appear to be growing

Example • Let's take a company that produces three types of wool: - Coarse - Fine - Superfine • There are joint costs incurred to produce and process the wool - After producing the wool, the firm must decide whether to dye each type of wool

- Now we are going to have incremental revenue problem that is baked into the problem (can't just talk about cost using this method) - All of that is before the split off point for each individual product line (the $40,000 and $200,000) + Before dying coarse, fine, and super fine - Going to get an extra $30,000 in revenue for a cost of $10,000 costs - Do NOT consider the separating process Because we are determining whether to dye each product line (dye or no dye), not whether we should make the product line (coarse, fine, superfine)

Example Let's look at 3 social media companies: Facebook Snapchat Twitter

- Snapchat and Facebook disclose the number of daily active users - Twitter previously disclosed the number of monthly active users This graph is a bit misleading because of the large difference in the number of users between companies. On the next slide, we'll graph the growth rates

Example 4 (No Excess Capacity) • We'll do an example with DeLorean • Assume DeLorean has two departments: Engine Department --Sells engines--> Car Department Example 1 (Excess Capacity) Engine Department Number of engines produced this period (capacity): 70,000 Selling price (to outside customers): $1,600 Variable costs (per unit): $1,200 Fixed costs (per unit): $300 Car Department Cost to buy an engine from a supplier outside the firm: $1,450 Number of engines needed: 40,000

- The Engine Department would need at least $1,400 from the Car Department (the variable cost of $1,000 plus forgone contribution margin of $400) - cost to buy: The Car Department won'tpay more than $1,450 If the Engine Department can sell all 70,000 engines to outside customers, there is no excess capacity But what if the Engine Department avoids $200 in variable costs per unit on transfers within the firm? (maybe it saves money on shipping costs) Thus, any transfer price ranging from $1,400 to $1,450 would be acceptable

Example • To address declining revenues, the University of Phoenix has created a new campus to serve cats

- The online division has the highest ROI ($160m/$800m = 20%) - It has much higher turnover, leading to a higher ROI - While the online division has a lower profit margin than the other two divisions

Key Takeaways in Transfer Pricing

- There is no transfer pricing system that works well in all situations - The goal is always to maximize the total profit of the entire firm

Example • Here is Walmart's consolidated Income Statement • This is total revenue each of the past three years • If you are the CEO of Walmart and are trying to assess total revenue growth, what might you think?

- Total revenue has been fairly stable the past 3 years - But if we only look at total revenue for Walmart as a whole, what types of differences are we missing?

Analyzing Variances

- Variances are inevitable, so investigating every single variance is a waste of resources - Some companies come up with a decision rule (e.g., they only investigate variances that exceed a certain dollar amount)

Use of Residual Income • Why would a company use Residual Income instead of ROI?

- When managers are evaluated based on ROI, they don't have an incentive to take on a project if its ROI is lower than the divisional ROI - When managers are evaluated based on residual income, they have an incentive to take on any project that earns more than the required rate of return

Standard Costing & Product Costing

- unfavorable variance are DEBITED - favorable variances are CREDITED • Standard costs can be integrated into a manufacturer's financial reporting system - e.g., if you pay $800 cash for raw materials, but the standard says you should have paid $650, you would increase the raw materials inventory account by $650. This seems counterintuitive, since you actually paid $800 • You're probably wondering, "What about the other $150?" • The $150 would be recorded in a variance account DM Price Variance is a temporary account - it will be closed to COGS at the end of the period - Instead of closing to COGS, some firms prorate variances among WIP, Finished Goods, and COGS

Disadvantages of Decentralization

1) Lower-level managers might not be aware of the organization's strategy - Does the manager of a McDonald's know the overall corporate strategy? 2) If lower-level managers make their own decisions, it could become difficult to coordinate their activities to achieve organization-wide objectives - What if every McDonald's manager chose how much beef to put in a burger?Standardization of processes makes it easier for top management to ensure quality

Advantages of Decentralization

1. Executives can focus on strategy and delegate less important tasks 2. Lower-level managers have better information 3. Reduces bureaucracy and enables the firm to act more quickly 4. Provides lower-level managers with experience forhigher roles 5. Increases job satisfaction and motivation for lower-level managers

Gymboree case 1. Was Bain Capital's leveraged buyout responsible for Gymboree's demise? 2. What do we learn from Gymboree's key performance indicators? 3. Did Bain Capital make a mistake when it acquired Gymboree? Or was acquiring Gymboree a good decision that resulted in a bad outcome because Bain Capital did a poor job running Gymboree after taking it over? 4. After Gymboree's first bankruptcy in 2017, was it possible to save the company? Or was Gymboree's fate already sealed? 5. Assume you have been asked to analyze J. C. Penney as part of a case competition. Which KPIs would be critical to your analysis?

1. Perhaps not, as Gymboree was in trouble before Bain Capital got involved. Gymboree was known for its complete outfits, and consumers began to prefer mix-and-match styles instead. Gymboree might have been able to recover, but the Bain Capital acquisition burdened Gymboree with so much debt that it was difficult for Gymboree to execute a turnaround strategy. The large interest payments prevented Gymboree from updating its stores and rolling out an app, which meant Gymboree had no chance to keep up with The Children's Place 2. Sales per square foot, sales per store, and same-store sales were all declining prior to Bain Capital's acquisitor, which suggests Gymboree was in trouble prior to the acquisition. However, the decline in these sales KPIs may have been attributable to the recession and not to Gymboree-specific issues. To drill down on this further, it would be helpful to look at these same KPIs for The Children's Place over the same time period. Several KPIs related to liquidity were actually improving prior to the Bain Capital acquisition, however. For example, Gymboree's working capital and cash position were on an upward trend prior to 2010, but this trend reversed after Bain Capital took over. This supports the argument that Bain Capital's takeover was at least partly responsible for the demise of Gymboree 3. Bain Capital failed to anticipate the shift in consumer preferences away fromcomplete outfits, so this was a mistake on its part. However, Bain Capital failed toadd value to Gymboree following the takeover. It restricted Gymboree's ability tomake capital investments (due to the high debt load), which resulted in Gymboreenot rolling out an app until years after its competitors had apps 4. It's difficult to say since we don't have Gymboree's financial data for that time period, but it seems that Gymboree had difficult overcoming the shift in consumer preferences. It tried to pivot away from its image as the place for a matching outfit and began targeting older children, but this only served to alienate its remaining customers. At that point, Gymboree was probably done 5. Same-store sales would probably be the most important KPI. This isolates the company's organic growth; changes in total revenue, on the other hand, are affected by increases (or decreases) in the number of retail stores. You'd rather know whether sales went up or down at an established location to make predictions about the direction in which sales are headed. Sales per square foot is helpful for assessing the company's efficiency in using its space, and increases might be indicative of better management and corporate strategy. However, sales per square foot may also go up due to more foot traffic, so it's tough to know precisely why this metric improved or declined Since J. C. Penney has experienced financial difficulties (to a greater extent than most retailers - the company shuffled through several CEOs over just a few years), you'd also want to take a close look at its liquidity ratios (e.g., quick ratio), level of debt (e.g., debt-to-equity ratio), interest coverage, and operating cash flow. Also, you should check out the cash flow to CAPX ratio to know whether the company is generating enough cash from its core operations to update its stores and make other capital improvements without having to borrow more money

Lucky's Charms is an Irish jewelry company that produces charms for charm bracelets out of 14 karat silver. To produce the bracelets, the company hires skilled labor on an hourly basis (a purely variable cost) and sources silver sheets, the only materials used in the process, that they use to make the charms. On December 31, 20X1, Lucky's reviewed their historical cost information and determined that: They typically paid $20 per hour for their laborers. They paid $1 per gram of silver. Each charm takes 0.5 hours of labor and 6 grams of silver to produce. They typically produce and sell 1,000 charms per month. The charms sell for $19 each. They expect this historical information will be accurate for budgeting the next several months' performance At the end of January 20X2, Lucky's determined that they spent $7,920 on direct labor and $4,725 on direct materials. Additionally, they earned $17,500 in sales revenue from their 900 units in sales. 6. Based on your findings, who should be rewarded/punished within the organization? 7. Given the information you've been provided, what are the limitations on your ability to answerpart 6?

6) Looking at our variances, we can see that labor is being used much more efficiently but that we're paying slightly more for that labor. This means that we might reward the scheduling manager and the individual employees for their performance, but punish HR who is poorly negotiating pay for new hires. For materials, the opposite pattern emerges: we're less efficient with the materials (we use 7 materials per unit) and so we may punish the employees for being careless with the materials. Those materials are also cheaper per unit of material, however, so it may be that the materials are poor quality. Accordingly, we should talk to the purchasing manager and determine whether they're getting a better deal on price but only because of the lower quality and thus inefficient materials. 7) Variance analysis doesn't tell us any of the answers as to why these have arisen, just where to go start looking for answers. So, we can't punish or reward anyone purely on the basis of these variances until we know why things are turning out the way they are.

Lucky's Charms is an Irish jewelry company that produces charms for charm bracelets out of 14 karat silver. To produce the bracelets, the company hires skilled labor on an hourly basis (a purely variable cost) and sources silver sheets, the only materials used in the process, that they use to make the charms. On December 31, 20X1, Lucky's reviewed their historical cost information and determined that: They typically paid $20 per hour for their laborers. They paid $1 per gram of silver. Each charm takes 0.5 hours of labor and 6 grams of silver to produce. They typically produce and sell 1,000 charms per month. The charms sell for $19 each. They expect this historical information will be accurate for budgeting the next several months' performance At the end of January 20X2, Lucky's determined that they spent $7,920 on direct labor and $4,725 on direct materials. Additionally, they earned $17,500 in sales revenue from their 900 units in sales. After computing these variances, Lucky's wanted a more thorough analysis of these differences. They determined that only used 6,300 grams of silver and 360 labor hours 5. Using this information, determine the price/rate and efficiency variances for direct materials and direct labor for January 20X2

Actual Efficiency Rate for Materials = 6,300 grams of silver / 900 units = 7 materials per unit Actual Efficiency Rate for Labor = 360 hours / 900 units produced = 0.4 hours per unit Actual price of materials = Actual cost of materials / materials used = $4,725 / 6300 gram = $0.75 per gram Actual price of labor = Actual cost of labor / labor used = $7,920 / 360 hours = $22 per hour We can calculate the price/rate and efficiency variances now that we have these. For example, the total direct materials variance was $1,275 favorable. This has been decomposed to $600 favorable activity variance and $675 favorable spending variance. We will now decompose this $675 into two pieces. Price variance = Actual Quantity * (Actual Price - Standard Price) = (7 materials per unit (actual) * 900 units actually produced) * ($0.75 per material actual - $1 per material budgeted) = $(1,575) favorable variance (comes out negative, meaning reduced cost) Efficiency variance = Standard Price * (Actual Quantity - Standard Quantity) = $1 per material budgeted * [(7 materials per unit actual - 6 materials per unit budgeted) * 900units actual] = $900 unfavorable variance. *As noted above, we can combine these to arrive back at the $675 favorable variance that is the composite of the two effects. Repeating the same process for direct labor: Price variance = Actual Quantity * (Actual Price - Standard Price) = (0.4 hours per unit (actual) * 900 units actually produced) * ($22 per hour actual - $20 perhour budgeted) = $ 720 unfavorable variance Efficiency variance = Standard Price * (Actual Quantity - Standard Quantity) = $20 per hour budgeted * [(0.4 hours per unit actual - 0.5 hours per unit budgeted) * 900 units actual] = $(1,800) favorable variance. *Combining the two, we arrive back at the $1,080 favorable spending variance on labor

Amazon's Segment Reporting 1) Which segment do you think has the highest sales growth? 2) Which segment do you think has the highest profit?

Amazon has three segments 1) North America (33% sales growth) 2) International (23% sales growth) - actually losing money 3) AWS (43% sales growth) - contributes the most profit

Tom's Thumb Corporation operates two grade supply stores: A and B. The following information relates to store A: A's segment profit margin is: A. $105,000 B. $225,000 C. $380,000 D. $500,000 E. $505,000

D. $500,000 CM = sales revenue - variable operating expenses = $900,000 - $400,000 = $500,000 traceable fixed costs: 275,000 500,000 - 395,000 = 225,000

Example • Assume that Apple makes and sells iPhones using 3 divisions: - Division 1 manufactures the components - Division 2 assembles the components - Division 3 sells the iPhone in Apple stores Division 3's manager will say this outcome is unfair; the other divisions are each showing a profit, having foisted their costs downstream

Division 3's manager will say this outcome is unfair; the other divisions are each showing a profit, having foisted their costs downstream • If Division 3 were to mark up its costs by 50%, it would sell iPhones for $1,080/unit - But let's say the market price is $1,000/unit - Division 3 will lose $5 on each iPhone sold $1,000 revenue - $1,005 costs = $5 loss per unit - Yet, the company as a whole makes $280/unit! • $1,000 - $370 - $200 - $150 = $280

Analyzing a spending variance Let's say we're analyzing a hospital. We'll focus on the cost driver "patient days." This is the total number of days spent in the hospital for each patient who was admitted during the period and left the hospital during the period - e.g., if Tom was in the hospital for 10 days and Rachel was in the hospital for 37 days, total patient days would be 47

Given the actual activity level of 27,000 patient days, the cost of supplies should have been $189,000... however, it was $300,000 - variable cost increased doesn't exceed our fixed costs - those additional patients broke our averages and increased cost per person

Example • Let's look at three retailers Walmart Target Costco

Here is the sales per square foot. Thoughts? - Costco is getting better - Walmart is getting worse - something bad happened to Target in 2016 - Costco's sales per square foot is substantially higher than that of its competitors

Cost to Acquire a Customer

Here's the formula to calculate CAC costs spent to acquire new customer / number of new customer acquired costs are typically marketing and sales costs

Joint Costs

Joint costs are allocated to products for purposes of determining the ending inventory balance and COGS - However, joint costs are irrelevant in decisions regarding what to do with a product after the split-off point - Everything that brought us up towards the inflection point of us being on fire is not relevant, we only consider the incremental benefit • Once the split-off point is reached, joint costs are sunk - After we reach the split off cost (when we are on fire), joint costs are irrelevant - We still need to reflect those joint costs, but we are not going to use that as a factor when deciding what to do after a split off point - This is critical to remember when deciding whether to: 1. Sell a product as-is 2. Process the product further and sell it for a higher price This decision is referred to as "Sell or Process Further" Easiest way to think: sell a product (cut down tree and just sell the lumber) as is or you can process the product further (turn it into furniture) and sell it for a higher price - What costs are relevant for making the furniture (additional processing costs to make it into lumber)

LTV to CAC Ratio

LTV:CAC <1 -> you're spending too much to acquire customers LTV: CAC > 5 -> perhaps you're not spending enough to acquire customers

Segmented Income Statement

Let's pretend this is the segmented Income Statement for a toy company that has 2 segments: Nerf & Play-Doh - What would happen if the company allocated 50% of the common fixed costs to each division? - But ask yourself this: would the common fixed expenses decrease if the Nerf division went away? - Allocating fixed costs can have a big effect. Now it appears that the Nerf division is losing money

Using the Market Price

Market prices are generally regarded as the best basis for transfer pricing - The market price most closely approximates the opportunity cost of the resource - However: • We don't always know the market price • The market price might not work well if the selling division has excess capacity

Comparison • Let's pretend there is an oil company with two divisions: transportation and refining- The transportation division purchases crude oil and transports it to the refining division - The refining division uses the crude oil to create and sell gasoline transportation division --crude oil--> refining division • The price charged to the buying division (the refinery) could be: - Market ($85) - Full cost, plus a 5% markup ($79.80) - Negotiated ($82)

Production and Sales Data Barrels of crude oil transferred to downstream division: 100 Barrels of gasoline sold: 50 Market price of crude oil: $85.00 Full cost of transportation division: $76.00 Full cost, plus 5% markup: $79.80 Negotiated price: $82.00 Market price of gasoline: $190 - each column corresponds to a different transfer pricing method

The DuPont Method

ROI can be decomposed into 2 components: income/invested capital = income/revenue * revenue/invested capital income/revenue = This is sometimes called "Return on Sales" or "Profit Margin" revenue/invested capital = This is sometimes called "Investment Turnover" or "Capital Turnover" or "Asset Turnover" - measures the efficiency of a company's use of its assets in generating sales revenue

Residual Income

Residual Income shows the amount of profit a division (or project) earns, over and above the required return - It is a dollar amount, not a percentage like ROI residual income = income - (required return * investment) income: The profit earned by the division (or the project) required return: The required rate of return (this is a threshold set by the company's management) - You could also think of this as each division being charged interest for the capital it uses investment: The money that was invested in the division (or the project)

Example • Let's say Plurk spends $500,000 on digital advertising to acquire 500 new customers what is the CAC?

The CAC is: $500,000/500 = $1,000

Example • The Geoffrey case and "nowhere income"

The Geoffrey Tax Case • To avoid paying state income tax in South Carolina, Toys R Us set up a subsidiary in Delaware called "Geoffrey" - Toys R Us then had to pay licensing fees to Geoffrey to use its trademarks - The licensing fees were a deductible expense that reduced the taxable income of Toys R Us in South Carolina - Royalty income is not taxed in Delaware, so Geoffrey paid no tax on the royalties received - Thus, Toys R Us created "nowhere income." The money it paid to Geoffrey wasn't taxed anywhere

price variance

The price variance is calculated as follows: (AQ * AP) - (AQ * SP) this is equivalent to: AQ * (AP - SP)

Quantity Variance

The quantity variance is calculated as follows: (AQ * SP) - (SQ * SP) this is equivalent to: SP * (AQ - SQ)

Segment Margin

The terms segment margin, segment profit margin, and segment profit can be used interchangeably We can calculate the profit margin for each segment segment contribution margin - segment traceable fixed costs = segment margin - This is the general formula, but in the real world some firms do it differently

Favorable vs. Unfavorable • A regional manager at St. Louis Breadco noticed a $9,000 favorable quantity variance for the ingredients to make soup at one of its stores - Tom, the store manager, says, "The corporate office told me to reduce costs, so that's what I did" - What might Tom be doing, and how might this affect customers?

Tom might be watering down the soup. This would result in a favorable quantity variance for the soup ingredients, but it will decrease the quality of the soup and potentially drive customers away

• The battery division raises its price for batteries to the automotive division from $100 to $150 .• How does this effect the profitability for the entire company?

Transfer pricing's effect on company profit No effect! - A higher transfer price increases the profit of the selling (battery) division. - A higher transfer price decreases the profit of the buying (automotive) division. - The increase exactly offsets the decrease. So, why does transfer price matter?

Economic Value Added (EVA)

Two primary differences between residual income and EVA are: 1. EVA subtracts current liabilities from total assets 2. EVA uses WACC as the charge for capital EVA = after-tax operating income - [WACC * (total assets - current liabilities)] WACC: This is the companywide weighted-average cost of capital total assets: some firms deviate from GAAP here (e.g., counting R&D spending as an asset)

Methods of Allocation

We will discuss three ways of allocating jointcosts: - Relative Sales Value Method - Physical Units Method - Net Realizable Value Method + The Net Realizable Value is the expected selling price minus any costs incurred after the split-off point *realistically, this isn't about which one should we make or make one or the other, it is about how we can allocate costs to determine profitability

Amazon by Product Type

Whole Foods is included in the physical stores, but only from the date of acquisition (8/28/17) through the Balanced Sheet date (12/31/17)

Example Let's look at 3 social media companies: Facebook Snapchat Twitter Q/Q User Growth

Year-over-year growth is more appropriate when the company's business is seasonal (think Walmart and the holiday season) - We can also examine the percentage growth of active users from one quarter to the next - Snapchat was initially growing very fast, but has slowed down. Facebook's growth has been fairly stable. Twitter no longer appears to be growing

WACC

[(after tax cost of debt * market value of debt) + (cost of equity * market value of equity)] / (market value of debt + market value of equity) Here's the formula for calculating the weighted-average cost of capital I won't test you on WACC,I'm just providing the formula in case you find it helpful

example with beers static budget 10 people 3 beers/person $1 per beer flex budget 12 people 3 beers/person $1 per beer actual 12 people 6 beers/person $2 per beer

activity variance - more people (increase) (unfavorable) - this type of variance is specifically for more or fewer people showing up for something than anticipated spending - total cost per person increased (unfavorable) - more beer/person (U) - more $/beer (U)

Lucky's Charms is an Irish jewelry company that produces charms for charm bracelets out of 14 karat silver. To produce the bracelets, the company hires skilled labor on an hourly basis (a purely variable cost) and sources silver sheets, the only materials used in the process, that they use to make the charms. On December 31, 20X1, Lucky's reviewed their historical cost information and determined that: They typically paid $20 per hour for their laborers. They paid $1 per gram of silver. Each charm takes 0.5 hours of labor and 6 grams of silver to produce. They typically produce and sell 1,000 charms per month. The charms sell for $19 each. They expect this historical information will be accurate for budgeting the next several months' performance At the end of January 20X2, Lucky's determined that they spent $7,920 on direct labor and $4,725 on direct materials. Additionally, they earned $17,500 in sales revenue from their 900 units in sales. 4. Determine the activity variance and the spending/revenue variance for each of (1) sales revenue, (2) direct labor cost, and (3) direct materials for January 20X2. Be sure to identifywhether they are favorable or unfavorable.

activity variance flex - stat (1) sales revenue = $17,100 - $19,000 = ($1,900) U (2) direct labor = ($9,000) - ($10,000) = $1,000 F (3) direct materials = ($5,400) - ($6,000) = $600 F spending/revenue variance actual - flex (1) sales revenue = $17,500 - $17,100 = $400 F (2) direct labor = ($7,920) - ($9,000) = $1,080 F (3) direct materials = ($4,725) - ($5,400) = $675 Here, notice that the total variance from the previous question is the composite of the activity and spending/revenue variance. For example, while there is a $1,500 unfavorable variance for sales revenue, that decomposes into $1,900 of unfavorable (activity) and $400 of favorable (revenue). This means that, while we sold fewer units, we did so at a higher price. That higher price did not fully compensate for the decrease in volume but did offset some of the decreased volume. Total Variance = Activity Variance + Spending (or Revenue) Variance 1500 Unfavorable = 1900 Unfavorable + 400 Favorable

guy on fire example

before: guy fully on fire with $20 in his pocket split into 2 after alternatives: (A) extinguish right side of body; costs $20 (B) keep $20 and remain on fire - in exchange for $20, can have only half of body on fire - or, can keep $20 and still be on fire + it is not up for debate whether that part stays burning, not a relevant factor because going to happen either way - the question is not how do we solve entire problem, but rather should we spend this money to solve half of our problem + all of the costs of producing inventory up to the date are not relevant - just the increase if we sold it immediately and didn't do anything - what kind of change is up for discussion, not the whole issue

Example • Hennessy sells hammocks for camping - With each hammock sold, they include a free tarp - Hennessy is trying to determine whether they should make the tarps themselves or simply buy them from a third-party supplier • Note: assume that cost is the only consideration Here are the numbers... Internal Information - If Hennessy manufactures the 8,000 tarps, it must purchase and use $48,000 of raw materials, incur $32,000 of direct labor, and incur $8,000 of variable manufacturing overhead - There is a supervisor of tarp production who makes $24,000/year - Equipment purchased last year that is used strictly to make the tarps incurs $20,000 of depreciation expense annually - $30,000 of corporate-level costs (not traceable to tarps) are allocated to the tarp department annually - If the company decides not to make the tarps, then all of its silnylon(which it paid $10,000 for last year) will become worthless External information: - Hennessy can simply buy 8,000 tarps for $152,000 If cost is the only consideration, shouldHennessy make or buy the tarps?

costs that don't matter - Not having tarps is not an option - Who makes $24,000 a year if we make the tarps - Depreciation is a non-cash expense, so we are generally not going to think of it as a relevant cost - The $30,000 of corporate level costs are not relevant - Sinylon not relevant because we are not talking about not making tarps - allocated overhead: these costs won't disappear if we outsource, so they're irrelevant - Have make column and buy column and then list everything out + Outside purchase price is only thing for buy column + Under make side, have direct materials, direct labor, variable overhead, supervisor (assume we only need them if we make the tarps) + Depreciation is a sunk cost BECAUSE we did NOT have to buy the machine ~ If we had to buy the machine to make the tarps then we would include it in the costs of make ~ But, since we bought the machine last year (depreciation is unavoidable since we already bought it) + Raw material already on hand was already there so we don't consider it + A salvage value would be a potential positive thing for the make side (if the equipment had a salvage value) - Unavoidable costs are irrelevant (paying corporate level costs regardless) costs that matter - The only raw materials costs that matter are the $48,000 we'd pay going forward - costs $112,000 to make the tarps - it costs $152,000 buy the tarps

Lucky's Charms is an Irish jewelry company that produces charms for charm bracelets out of 14 karat silver. To produce the bracelets, the company hires skilled labor on an hourly basis (a purely variable cost) and sources silver sheets, the only materials used in the process, that they use to make the charms. On December 31, 20X1, Lucky's reviewed their historical cost information and determined that: They typically paid $20 per hour for their laborers. They paid $1 per gram of silver. Each charm takes 0.5 hours of labor and 6 grams of silver to produce. They typically produce and sell 1,000 charms per month. The charms sell for $19 each. They expect this historical information will be accurate for budgeting the next several months' performance At the end of January 20X2, Lucky's determined that they spent $7,920 on direct labor and $4,725 on direct materials. Additionally, they earned $17,500 in sales revenue from their 900 units in sales. 3. Determine the total variances for (1) sales revenue, (2) direct labor cost, and (3) direct materials for January 20X2. Be sure to identify whether they are Favorable or Unfavorable.

difference between static budget and actual (actual - static) (1) sales revenue = $17,500 - $19,000 = ($1,500) U (2) direct labor = ($7,920) - ($10,000) = $2,080 F (3) direct materials = ($4,725) - ($6,000) = $1,275 F

Let's say Tesla has: - An automotive division that produces cars - A battery division that produces batteries • A battery is an intermediate product that is installed in cars • When Tesla's Battery Division sells a battery to Tesla's Automotive Division, what price should the Battery Division charge?

general battery division - This is called the "upstream" or "selling" division --sells batteries--> automative division - this is called the "downstream" or "buying" division - the price charged by one division to another is called a transfer price batter division --charges a transfer price--> automative division

Example • Assume that Apple makes and sells iPhones using 3 divisions: - Division 1 manufactures the components - Division 2 assembles the components - Division 3 sells the iPhone in Apple stores

manufacturing -> assembly -> retail • The transfer price is cost-based - Each division marks up additional costs incurred by 50% - Thus, Division 3 pays $855 to Division 2 + Each division has an incentive to state as high a cost as possible, because higher costs means higher revenue for the selling division!

Net Realizable Value Method

production of raw milk $300,000 cost -> separation process $100,000 cost (split off point) -> whole milk $220,000 NRV or -> cream $180,000 NRV Whole Milk is 55% of the total NRV ($220k/$400k), so it is allocated 55% of the joint costs whole milk: cost= $220,000 ($300K + $100K) * 55% By the same logic, Cream gets allocated 45% of the joint costs cream: cost=$180,000 ($300K + $100K)*45% + Not going to test on how to calculate net realizable value (going to give us the NRV), specifically not the production costs of the inventory (not COGS), thinking about reduction in sales profits (If there is some sort of meaningful distinction in the selling price of the products) + Basic idea: once you've allocated the costs, this just becomes part of the inventory in income statement (expensed as part of the whole milk segment or the cream segment)

Relative Sales Value Method

production of raw milk $300,000 cost -> separation process $100,000 cost (split off point) -> whole milk $240,000 sales value or -> cream $360,000 sales value Whole Milk is 40% of the total sales value ($240k/$600k), so it is allocated 40% of the joint costs whole milk: cost= $160,000 ($300K + $100K)*40% By the same logic, Cream gets allocated 60% of the joint costs Cost = $240,000($300k + $100k) * 60% cream: cost = $240,000 ($300K + $100k)*60%

Whole Milk

production of raw milk $300,000 cost -> separation process $100,000 cost (split off point) -> whole milk $240,000 sales value or -> cream $360,000 sales value Joint cost allocation is about finding a way to split the $400,000 of joint costs among the whole milk and the cream - Remember, when you are deciding (for internal decision-making) whether to sell a joint product or process it further, you ignore any costs that occurred before the split off point (you only look at incremental revenues and incremental costs) - trying to determine the relative benefit milk or cream bring to the firm after what is necessary to produce the products - If there were costs incurred after the split off, we wouldn't include them in joint cost allocation, they would be 100% allocated to the branch it is relevant to (ex: pasteurization of whole milk would only apply to whole milk branch)

Physical Units Method

production of raw milk $300,000 cost -> separation process $100,000 cost (split off point) -> whole milk 70,000 gallons or -> cream 30,000 gallons + Physical units: if we say it has 100,000 gallons of output, then 70% costs allocated to whole milk and 30% costs allocated to cream (logic: units somehow better trace through the firm) Whole Milk accounts for 70% of the total gallons (70k/100k), so it is allocated 70% of the $400,000 in joint costs whole milk: cost = $280,000 ($300K + $100K) * 70% By the same logic, Cream gets allocated 30% of the joint costs cream: cost = $120,000 ($300K + $100K) * 30%

Example A division is given $2,000,000 of capital - The company charges its divisions 12% for the capital they employ - The division earns a $300,000 profit

residual income = income - (required return * investment) residual income = $300,000 - (12% * $2,000,000) residual income = $60,000

Example 3 (No Excess Capacity) • We'll do an example with DeLorean • Assume DeLorean has two departments: Engine Department --Sells engines--> Car Department Example 1 (Excess Capacity) Engine Department Number of engines produced this period (capacity): 70,000 Selling price (to outside customers): $1,600 Variable costs (per unit): $1,200 Fixed costs (per unit): $300 Car Department Cost to buy an engine from a supplier outside the firm: $1,450 Number of engines needed: 40,000

selling price: The Engine Department would need at least $1,600 from the Car Department cost to buy: However, the Car Department won't pay more than $1,450. Thus, no transfer takes place If the Engine Department can sell all 70,000 engines to outside customers, there is no excess capacity Thus, any transfers made will cause the Engine Department to forgo some contribution margin

• We'll do an example with DeLorean • Assume DeLorean has two departments: Engine Department --Sells engines--> Car Department Example 1 (Excess Capacity) Engine Department Number of engines produced this period (capacity): 70,000 Selling price (to outside customers): $1,600 Variable costs (per unit): $1,200 Fixed costs (per unit): $300 Car Department Cost to buy an engine from a supplier outside the firm: $1,450 Number of engines needed: 40,000 Example 2 (Excess Capacity)

variable cost + fixed cost = The Engine Department would need $1,500 from the Car Department cost to buy an engine: However, the Car Department won't pay more than $1,450. Thus, no transfer takes place If the Engine Department can only sell 30,000 engines to outside customers, there is excess capacity (because it makes 70,000 engines) But what if company policy dictated that the transfer price be full cost? This is suboptimal, because the company ends up paying $1,450 for engines that were readily available at a cost of just $1,200

• We'll do an example with DeLorean • Assume DeLorean has two departments: Engine Department --Sells engines--> Car Department Example 1 (Excess Capacity) Engine Department Number of engines produced this period (capacity): 70,000 Selling price (to outside customers): $1,600 Variable costs (per unit): $1,200 Fixed costs (per unit): $300 Car Department Cost to buy an engine from a supplier outside the firm: $1,450 Number of engines needed: 40,000

variable costs: The Engine Department would be happy with receiving at least $1,200 from the Car Department cost to buy an engine: The Car Department won't pay more than $1,450 If the Engine Department can only sell 30,000 engines to outside customers, there is excess capacity (because it makes 70,000 engines) Thus, any transfer price ranging from $1,200 to $1,450 would be acceptable

Segment Reporting

• A segment is any component of an organization for which a manager seeks cost, revenue, or profit data - The financial statements are prepared on a consolidated basis, but can also be prepared on a segmented basis • Disaggregated information is more informative because it tells you which organizational subunits are doing well • Analysts are able to create better forecasts when they have access to disaggregated information

Accept or Reject a Special Order

• A special order is a one-time order that is not considered part of the company's normal business

Traceable vs. Common Fixed Costs

• A traceable fixed cost of a segment would disappear if the segment was eliminated • A common fixed cost supports one or more segments, but would not disappear if one particular segment was eliminated

KPIs

• All companies track and monitor several key performance indicators (KPIs) - There are thousands of KPIs - Some KPIs are specific to certain industries • e.g., WashU closely watches its "melt rate"

Same-store Sales

• Any company can increase total sales by opening new stores - Thus, we shouldn't just examine sales growth, but should also look at the sales growth of existing stores

what is capital budgeting?

• Capital budgeting is the process of making long-run planning decisions for investments in projects. • In much of accounting, income is calculated on a period-by-period basis. - Think GAAP income reporting quarterly or annually - We make several assumptions about how to spread expenses and revenues in order to effectively present information over that horizon • In choosing investments, managers make selections among multiple projects, each of which may span several periods. - This can make comparison challenging • To make capital budgeting decisions, managers analyze each project by considering all the life-span cash flows from its initial investment through its termination.

Churn Rate

• Churn is the number of customers who stop being a customer in any given week/month/year - e.g., if Plurk has 1,000 customers and every month 20 decide to cancel, the monthly churn is 2% • If you invert the churn rate (1/monthly churn rate), this tells you the average number of months a customer will remain a customer - e.g., a 2% monthly churn implies the average customer sticks around 50 months

Tax Avoidance

• Companies artificially set transfer prices to shift income to low-tax jurisdictions - FYI: many companies use different transfer prices for tax purposes than they use for internal accounting purposes; this practice is called "decoupling"

Transfer Pricing Methods

• Companies generally set transfer prices based on: - Market prices - Cost - Negotiation (between the divisional managers) *"Cost" could mean variable cost, full cost, or cost plus a markup

Types of Segment Reporting

• Companies may disaggregate their financial information by: - geographic region: United States, International - product line: cars, trucks - customer type: personal clients, corporate clients CliftonLarsonAllen is a CPA firm that organizes its operations by industry(e.g., healthcare)

Make or Buy Decision

• Companies must determine whether to make an inputinternally or to outsource it from another firm - e.g., a CPA firm must decide whether to: • Develop its own tax preparation software in-house • Purchase the right to use tax preparation software from another firm - All of costs of being a CPA firm are irrelevant and not up for a debate (going to be a CPA firm anyway) - If it's going to be the same, it is irrelevant - Only relevant part is if they need more training for outside or inside software + Which one is going to cost us more? + How does it benefit us? + If the employee training cost is the same, it's going to be about how fast they can work, and if the inside software saves us half an hour, is that extra efficiency going to benefit us enough so that the cost of the software engineer salary is going to offset the cost of other thing

Discounted Cash Flows (DCF)

• Discounted cash flow (DCF) methods measure all expected future cash inflows and outflows of a project discounted back to the present point in time • The key feature of DCF methods is the time value of money, which means that a dollar received today is worth more than a dollar received at any future time. • The reason is that $1 received today could be invested at, say, 10% per year so that it grows to $1.10 at the end of one year. - Accordingly, you would prefer money earlier (even if the future quantity is larger) depending on the interest rates • The time value of money is the opportunity cost from nothaving the money today. - I can't invest money I do not have into projects • DCF methods use the required rate of return (RRR), which isthe minimum acceptable annual rate of return on aninvestment. • RRR is internally set, usually by upper management, and typically represents the return that an organization could expect to receive elsewhere for an investment of comparable risk. - RRR is also called the discount rate, hurdle rate, cost of capital, oropportunity cost of capital. - This is because the firm has obligations to its shareholders and debt holders to use their capital wisely. If they owe debt holders 9% and equity holders 12% returns, they cannot make 5% returns with the invested capital

Obtain Information

• Enterprise resource planning (ERP) systems typically provide most of the cost and production information within the firm • Here, we need both internal (cost) and external (marketing) information about the costs and consumer demand [potential revenues] associated with the potential project • This is NOT the analysis stage - this is just gatheringinformation • Still mostly strategy people but also includes marketing and lower-level managers to help validate the data and explain key assumptions. - Projects may be rejected at this stage for broad reasons - For example, Honda may realize a new car cannot be created using existing facilities and so may be too capital intensive - At AkzoNobel (a paints and coatings manufacturer), the chief sustainability officer reviews projects against a set of environmental criteria and can veto projects that do not meet the company's standards

Transfer Pricing & Taxation

• Everything we've discussed thus far pertains to internal transfer pricing for decision-making • However, transfer pricing is also a significant tax issue

AARR Advantages and Disadvantages

• Firms vary in how they calculate AARR - Super problematic because managers can't be expected to have experience with the specific assumptions • It is easy to understand and uses numbers reported in financial statements. - "Easy" is relative • Cash flows are not tracked. - Super problematic if the company has significant accruals • Time value of money is ignored. - Getting the theme of problematic yet? • When different methods lead to different rankings of projects, more weight should be given to the NPV method because the assumptions made by the NPV method are most consistent with making decisions that maximize a company's value.

Flexible Budgeting variances

• Flexible Budgeting shows us revenue and spending variances - A revenue variance occurs when you generate more (or less) revenue than expected - A spending variance occurs when you spend more (or less) on a cost than expected

Debt vs. Equity vs. Retained Earnings

• Given the previous decision rules related to capital budgeting, we decide whether we should undertake the project or not. • Part of this decision-making process is how to finance the initial investment related to the project. - We can finance it using debt, equity or cash on hand - Each of these has its own required rate of return, which should be used to consider whether the project satisfies that expected return - For example, if we borrow at 8% but the project is only NPV positive at 7%, the project is insufficiently profitable to justify the debt capital.

Terminology

• Here are the definitions of some terms we will be using: - Two or more products made from a common input are called joint products - The point in the manufacturing process where joint products can be recognized as separate products is known as the split-off point - Any costs incurred before the split-off point are known as joint costs

Make Decisions

• Here, managers are choosing among the various projects available to them using the information produced in the previous step • This is also the point where qualitative information (which can be reasoned judgement or arbitrary bias) is introduced into the process. - For example, Honda may decide not to pursue a new line of gas-guzzlers if their strategy is to enter the electric and green-energy space • Considerations of environmental sustainability may LOOK unprofitable - However, there is a significant body of academic research that shows that long term investments in sustainability result in superior cash flows in the long run. - Accordingly, UPS (freight and logistics) relaxes the company's minimum required rateof return on projects that result in lower fuel usage - Similarly, Sealed Air (packaging company) targets their greenhouse gas emissions and waste production • There are two components to calculating the feasibility of a project: - Future expected cash flows/cash savings - Risk of the project (this includes the uncertainty of the cash flows, as well as theinherent risks of the project to the firm) • Garbage in, garbage out - These decisions are usually only as good astheir data + the bias of the interpreter of the data • Sometimes the best choice is to do nothing

Standard Costing

• How do we know whether we got a good price, or used too many resources? - We compare the price paid (or the amount of resources used) to a standard formulas price variance Actual Quantity x Actual Price Actual Quantity x Standard Price quantity variance Actual Quantity x Standard Price Standard Quantity x Standard Price AQ(AP - SP) AQ = Actual Quantity AP = Actual Price SP(AQ - SQ) SP = Standard Price SQ = Standard Quantity *quantity refers to 6 beers/person or 3 beers/person

Five Broad Stages in Capital Budgeting

• Identify projects—identify potential capital investments that agree with the organization's strategy. - Sell or process decision (Make it small or make it large, but you MAKE it so that portion of it is a sunk cost. Then think about marginal cash flow, what is the extra cash flow we would get from making it larger) • Obtain information—gather information from all parts of the value chain to evaluate alternative projects. • Make predictions—forecast all potential cash flows attributable to the alternative projects. • Make decisions by choosing among alternatives—determine which investment yields the greatest benefit and the least cost to the organization. • Implement the decision, evaluate performance, and learn (generally separated into two phases): - Obtain funding and make the investment selected in stage 4. - Track realized cash flows, compare against estimated numbers, and revise plans if necessary.

Relevant Costs & Decision-making

• In this lesson we will discuss three types of decisions which hinge on your ability to correctly identify which costs are relevant 1) The decision to produce something in-house or buy it from a supplier ("Make or Buy") 2) The decision to accept or reject a special order + if I'm producing 70,000 units and if someone wants to pay a premium for it, etc. 3) The decision to sell a product as-is or process it further + Is it worth it for me to take that version of the supply chain to vertically integrate and add those costs? Or should I sell it to a firm to process it further?

Capital Budgeting and Working Capital

• Investing in new projects involves gathering funding for multiple expenses, usually bucketed into two groups - Capital expenditures + Machines, equipment, etc. necessary to run the business - Working capital + Inventory, day to day expenses, wages, etc. • Typically, working capital is referred to as the differencebetween current assets and current liabilities. This is because we can offset some of these expenses with credit (accounts payable). • Any additional investment, whether capex or working capital, required for a project will be included in that project's cash flows as expenses or outflows.

Responsibility Accounting for Variance

• Is the person who purchases the supplies responsible for the unfavorable variance? - Perhaps the purchasing manager isn't buying supplies at the best price. If so, we should speak with the purchasing manager • Are the people who use the supplies responsible for the unfavorable variance? - Perhaps the staff are using more supplies than they should (so we're having to purchase more supplies than would otherwise be necessary). If so, we should speak with the head nurse

Sell or Process Further

• It is profitable to continue processing a joint product after the split-off point if: incremental revenue > incremental cost

Responsibility Centers

• Large organizations create responsibility centers to hold people accountable - Cost Center • The manager has responsibility for costs (e.g., an IT department) - Revenue Center • The manager has responsibility for revenues (e.g., a sales office) - Profit Center • The manager has responsibility for costs and revenues (e.g., a Panera store) - Investment Center • The manager has responsibility for costs, revenues, and investments in operating assets (e.g., Walmart Mexico)

Accrual Accounting Rate of Return (AARR)

• Literally used by no one outside of publicly traded companies (because it determines the performance reflected on financial statements), and even then, it's like finding sum-of-years-digits depreciation in practice. - You're more likely to win the lottery • The AARR method divides the average annual [accrual accounting] income of a project by a measure of the investment in it. • That "measure of the investment" in the project can vary company by company. • Also called the accounting rate of return. • The AARR method is similar to the IRR method in that both calculate a rate-of-return percentage - However, the IRR method is generally regarded as better than the AARR. AARR Method Formula Accrual Accounting Rate of Return = (Increase in Expected Average Annual After-Tax Operating Income) / Net Initial Investment • Remember that the value used for the denominator can vary, so be sure you understand how the AARR is defined in each individual situation. AARR Method Formula

Decentralized Decision-Making Structure

• Many critical decisions are pushed down to lower-level managers • Lower-level managers gain more authority

Centralized Decision-Making Structure

• Most critical decisions are made by top management

Comparing NPV vs. IRR

• NPV is generally preferred because its use leads to share holder value maximization. - Knowing that a project exceeds the hurdle rate is not as valuable as knowing the amount of profit that is generated • NPV measures capture the value, in today's dollars, of the surplus generated by the project for the firm's share holders over and above the required rate of return. - Note: The "hurdle" rate is often the cost of the financing used to invest in the project. Any amount in excess of the hurdle rate is added to firm value and thus is the profit to shareholders. • The NPV amount for each project can be summed to calculate an NPV of a combination or portfolio of projects. - In theory, you can do the same with IRR but it's more complicated • NPV method can be used when the RRR varies over the lifeof the project. - IRR just gives you the average RRR for the entire life of the project • If the IRR is less than the RRR, the NPV is negative (favoring rejection). Obviously, managers prefer projects with higher IRRs to projects with lower IRRs, if all other things are equal • For example, if a company has an RRR of 12% and the IRR of the project is 12%, it means the cash inflows from the project are adequate to - (1) recover the net initial investment in the project - and (2) earn a return of exactly 12% on the investment tied up in the project over its useful life. • IRR is more prone than NPV to indicate erroneous decisions. - It is a single quantity and both the explicit and implicit assumptions are harder to see • IRR implicitly assumes that project cash flows can be reinvested at the project's rate of return. - This is a huge assumption that cannot be guaranteed. This may bea one-time special rate project. • NPV accurately assumes that project cash flows can only be reinvested at the company's required rate of return. - This assumption is still an assumption, but is more reasonable: if the company cannot find new projects at the required rate of return, it should distribute all excess profits to shareholders so they can get the return elsewhere. • Still, the IRR method is widely used. - Why? • Managers find the percentage return computed under the IRR method easy to understand and compare.

Four Capital Budgeting Analysis Methods

• Net present value (NPV) • Internal rate of return (IRR) • Payback period • Accrual accounting rate of return (AARR) Methods 1 and 2 (NPV and IRR) are discounted cash flow (DCF) methods.

Lifetime Value of a Customer

• Now let's calculate the LTV for Plurk: LTV = CM Ratio * average number of months a customer * monthly revenue per customer LTV = 75% * 50 * $40 LTV = $1,500 - 75% is the Number of months is calculated by dividing one by the churn rate (2%) CM ratio: This is the Contribution Margin Ratio, which we computed earlier in the course. Customer retention costs and other variable costs are used to derive this average number of months a customer: This is avg. time people remain a customer Plurk's LTV is $1,500 but the CAC is $1,000. Thus, Plurk is generating more value from a customer than it costs to acquire the customer, but not by much. Remember, Plurk needs to cover its other costs too! This is avg. time people remain a customer.

Make Predictions

• Now that we have information about future expected demand and the costs associated with the project, we can forecast expected cash flows - This includes both cash inflows, in the form of sales and future disposition of assets (salvage value) - And outflows (expenses, initial purchase of machinery, etc.) • This is usually the economists and accounting people in the firm • For example, BMW estimates yearly cash flows and sets its investment budgets using a 12-year planning horizon. - Spoiler alert: 12 year forecasts are essentially hot garbage • Second spoiler alert: 12-month forecasts are essentially luke warm garbage (see February 2020's projections of record growth) • In BMW, this is still the task of the marketing people - They are asked to construct a 90% confidence interval of sales figures • "Moral Hazard" refers to the problem of individuals making choices that are better for themselves than for their employer - Imagine a 58-year-old manager at BMW making a 12 year forecast. They know the early years will look good and the future years will result in net losses. Their bonuses are calculated yearly and they plan to retire at 65 years old.

Implement & Learn

• Obtain funding and make the investment selected in stage 4. - This is the finance group - For example, Honda opting to make a new car will need to order the steel, aluminum, paint, computer chips, etc. + May need to examine the feasibility of ordering at scale and evaluate alternatives (which starts the process over again) • Track realized cash flows, compare against estimated numbers, and revise plans if necessary - This is also the accounting group, especially with respect to budgeted numbers versus actuals - This is where abandonment options come in. If the project is underperforming as it progresses, it is sometimes better to cut your losses + See: Practically every project Google has tried in the last decade - For example, in July of 2017, a natural gas liquefaction and export facility in British Columbia was cancelled despite it costing the project leader, Petronas (a Malaysian energy company) $800M in losses. + They made this choice due to changes in the energy industry that saw the project losing more in the long run. - Important: This is where we worry about sunk costs, as well. That $800M in invested capital is gone - it isn't coming back

Relevant Cash Flows in DCF Analysis

• One of the biggest challenges in capital budgeting, particularly DCF analysis, is determining which cash flows are relevant in making an investment selection. • Relevant cash flows are the differences in expected future cash flows as a result of making the investment. • A capital investment project typically has three categories of cash flows: - Net initial investment - After-tax cash flow from operations. - After-tax cash flow from terminal disposal of an asset and recovery of working capital

Can a Firm Achieve Sustained Growth?

• One way is to compare two things: Lifetime Value of a Customer (LTV) Cost to Acquire a Customer (CAC) - The LTV should be several times higher than the CAC!

Disadvantages of Standard Costing

• Political issues- Creating the standards can be a political process. Managers want to look good, and they will lobby to have the standards set accordingly. If standards are set based on politics, variances are meaningless • Time lag- The accounting department calculates variances after the period has ended, so there is a delay • Root cause- Variances tell you the problem (e.g., we used too much material) but they don't tell you precisely why the problem occurred (e.g., there was spoilage)

Improving ROI

• ROI can be increased in 3 ways: 1. increasing revenues - this is the hardest one to do- it's easier said than done 2. decreasing expenses - i.e., cost cutting 3. decreasing capital invested - if you maintain the same profit while using less capital, ROI will go up

Use of ROI

• ROI can be used to determine which divisions made the best use of their capital • It can also be used to evaluate a project

Return on Investment (ROI)

• ROI is the most popular measure of performance. It is calculated as follows: ROI = Income/Invested Capital Income: This is the profit of the investment center (the division or department) Invested Capital: This is the capital that was given to the investment center companies calculate ROI differently income: Some firms use operating profit in the numerator, some firms use Net Income, etc. invested capital: Some firms use total assets in the denominator, some firms use total assets minus current liabilities, etc. ROI is also called the "accounting rate of return"

Drawback to ROI

• ROI may lead to suboptimal behavior if managers are evaluated strictly based on ROI - Assume that Tom's division has an ROI of 40% - Tom would reject all projects with an ROI of less than 40% because they would lower his division's ROI

Ideal transfer price

• Set the price such that decisions that maximize division's profit also maximize company's profit • Ideal transfer price is the opportunity cost of a unit to the selling division transfer price = additional outlay cost per unit incurred because goods are transferred + opportunity cost per unit to the selling division because of the transfer Selling division manager has incentive to overstate opportunity cost per unit

Active Users

• Social media firms closely track the # of active users - There are high fixed costs (but low variable costs) in building an app or website. This creates a strong incentive to add users because: • It doesn't cost very much to serve an additional user • The company needs to cover its high fixed costs or it will run out of cash and go bankrupt

Cost Allocation

• Some companies allocate nontraceable corporate HQ costs to segments - Companies do this to remind lower-level managers that HQ costs must be covered • This is problematic for two reasons: - It's not fair - It could lead to bad decisions You are holding lower-level managers responsible for costs they don't control - The allocation could make a segment appear unprofitable; if you then eliminate that segment, however, the HQ costs will simply be allocated to the remaining segments, making them appear less profitable in turn

Using the Cost

• Some companies have the selling division use the intermediate product's cost (or cost plus a markup) as the transfer price - People like this because it's easier to determine the cost than the market price - However, this can lead to bad behavior • The selling division has less incentive to control costs and may even try to shift non-product costs to the product to pass them on to the next division Full-cost transfer prices, which incorporate variable and fixed costs, result in suboptimal decisions and are NOT recommended. If you are going to use cost-based transfer pricing, you want to focus on variable costs

Using Negotiated Prices

• Some firms allow the managers of the buying division and selling division to negotiate the price - This preserves divisional autonomy - However, there are two significant drawbacks: • The managers waste time arguing about the price • A division may appear to be performing well simply because its manager is a good negotiator, not because the division is actually doing well

Vertical Integration

• Some firms are vertically integrated - This means the company produces not just the final product, but also makes the components that go into the final product "vertical integration is the merging together of two businesses that are at different stages of production" (The Economist) ex: - A car company that produces not just cars, but also the engines that go into its cars, would be vertically integrated

Advantages of Standard Costing

• Standard costing allows you to perform variance analysis, which raises red flags about potential problems - A manager can review a list of variances and quickly identify areas of concern. The manager can then take corrective action • This is called "Management by Exception"

Common Fixed Costs

• The CEO of Walmart is Doug McMillon - His salary is a fixed cost - Yet, we can't directly trace it to Sam's Club, Walmart International, and Walmart U.S.

Net Present Value (NPV)

• The NPV method calculates the expected monetary gain or loss from a project by discounting all expected future cash inflows and outflows back to the present point in time, using the Required Rate of Return (RRR). • Based on financial factors alone, only projects with a zero or positive NPV are acceptable. • We'll use three steps for the NPV method. 1) draw a sketch of the relevant cash inflows and outflows 2) Discount the cash flows using the correct compound interest table or formula and sum the discounted cash flows 3) Make the project decision on the basis of the calculated NPV (zero or positive should be accepted because the expected rate of return equals or exceeds the required rate of return). Why accept a zero NPV project? 0 NPV does NOT mean 0 profit. It simply means that the profit from the project is equal to the required rate of return (the hurdle or discount rate).

Benefits of Vertical Integration

• The company gains greater control over its supply chain - This can reduce transaction costs - It can also eliminate the hold-up problem Transaction Cost Economics "All complex contracts will be incomplete- there will be gaps, errors, omissions, and the like." Williamson was awarded the Nobel Prize in 2009

Project Management, Performance Evaluation and Strategic Considerations

• The final stage (stage 5) of capital budgeting begins with implementing the decision and managing the project. - A post-investment audit provides managers with feedback about the performance of a project so that they can compare the actual results to the costs and benefits expected at the time the project was selected. + This helps with the calculation of future project payoffs, plus revisions of the existing estimates (for abandonment considerations) • Suppose for example, that actual results are less than expected. Managers must determine if this result occurred because the original estimates were overly optimistic or because of implementation problems. Either explanation is a concern • Companies should perform post investment audits with thought and care and only after the outcomes of the projects are fully known. • Ideally, managers should be evaluated on a project-by-project basis (so that controllable factors are more easily identified); however, in practice, the evaluation is often based on aggregate information • Ensure that the method of evaluation does not conflict with the use of the chosen method to evaluate capital budgeting decisions. - In other words, make sure managers are evaluated on the actual method of decision making, not on a hypothetical perfect model. • A post investment audit may prevent managers from overstating the expected cash inflows from projects and accepting projects they should reject. - Hopefully corrects moral hazard - Creates a unique situation where the audit, if perfect, is useless because the manager complies in expectation • There is an inconsistency between using the NPV method as best for capital budgeting decisions and then using a different method to evaluate performance (many companies use IRR). - Even though NPV is the best for capital budgeting decisions, managers will be tempted to make the decisions based on the method on which they will be evaluated. • A company's strategic goals are the source of its strategic capital budgeting decisions. - Should not let NPV positive, one-off projects dictate strategy - Brand dilution, customer confusion, quality issues all may arise • Some firms regard R&D projects as important strategic investments; however, the distant payoffs from R&D investments are more uncertain than other investments, such as new equipment purchases. - Being able to communicate the long-run benefits of high quality R&D is crucial to the success of most firms, yet many do not prioritize it. • For any strategic capital budgeting decision, managers mustuse good judgment and intuition to make a good decision. - Easier said than done - it is important to gather as much data and asmany different perspectives as possible - There is significant research that shows diverse teams do a better job of avoiding biases (especially when projects concern demographics that are not represented in the team)

Responsibility Accounting

• The idea behind responsibility accounting is that managers should only be held accountable for those items that they can actually control to some extent - Each line item (revenue or cost) is the responsibility of some manager - If we don't hold managers responsible for costs, they will spiral out of control - If no one is responsible for keeping costs down, then no one will take action to keep costs down

Payback Method

• The payback method measures the time it will take to recoup, in the form of expected future cash flows, the net initial investment in a project. • Like the NPV and IRR methods, the payback method does not distinguish among the sources of cash flows. • The payback method highlights liquidity, a factor that often plays a role in capital budgeting decisions, particularly when the investments are large. - Managers prefer projects with shorter payback periods (projects that are more liquid) to projects with longer payback periods, if all other things are equal. • Organizations choose an acceptable project payback period(much like setting a hurdle rate). - Generally, the greater the risk, the shorter the payback period should be. - This may be counter intuitive. The logic here is that high risk projects should have high rewards. - In other words, if we invest in pharmaceuticals (say, a 2% success rate on average for literal billions of investment of capital), we expect that a successful drug will print money. Venture capital too. • Shorter payback periods are preferred because managers are less confident about cash flow predictions that stretch far into the future. - This is solid skepticism because again - long-run predictions are hot garbage. • The payback method is easy to understand. • Two weaknesses: - Fails to recognize the time value of money + For this reason, it is NOT a decision making tool by itself - Says nothing about when the investment is recaptured in terms of the required rate of return. - Doesn't consider cash flow beyond the payback pointPayback Method CALCULATIONS • With uniform cash flows payback period = net initial investment / uniform increase in annual future cash flows • With nonuniform cash flows - Add cash flows period-by-period until the initial investment is recovered; count the number of periods included for payback period. • It is relatively simple to adjust the payback method to incorporate the time value of money by discounting the expected future cash flows before performing the calculations. - I highly recommend adjusting payback period in this way.

Idle Capacity

• The preceding analysis assumes you have idle capacity (i.e., accepting the special order isn't displacing another activity) - If you are giving up an action (e.g., selling 100 strollers at the regular price of $699) by accepting the special order, then the forgone profit of the action you gave up is an opportunity cost of accepting the special order

One more wrinkle...

• The prior analysis assumed the spaced used to make the tarps inside Hennessy's factory was idle (it would not be used if the tarps weren't made) • But what if NOT making the tarps in-house means we could use that space to make additional hammocks, which would yield an extra $60,000 of profit? - The production of the tarps in-house would cause the companyto forgo $60,000 of profit - This is an opportunity cost and it is relevant to our decision

Traceable Fixed Costs

• The rent for Walmart's corporate office in France - This is a fixed cost, but it is directly traceable to the Walmart International division

Interpreting the Segment Margin

• The segment margin is the best indicator of the long-run profitability of the segment because it only includes costs that are caused by the segment - If a segment can't cover its own costs and is supported by other segments, it may have difficulty in the long-run • This is called "cross-subsidization" and is a common problem

Why is transfer pricing important?

• The transfer price affects whether the transfer takes place. • The transfer price affects the income of the buying and selling units and therefore affects: (1) the performance evaluations of both managers (2) the operating decisions that the managers make • If division managers maximize profit, they may not transact at some prices

Sales Per Square Foot

• This is a popular metric in the retail industry - It tells you how well the company is using its space to generate sales • Sales per square foot can be improved by: - Increasing the number of customers - Increasing the average transaction value (ATV) If you have $800 in sales revenue from 16 customers, the ATV is $50

Identify Projects

• This is usually the realm of the strategy people and top management in the firm, but requires detailed information on resources and capacity (which we have discussed at length) • Projects here can be anything: entering a new market, purchasing a new machine, designing a new product, etc. • Projects can also be abandoning existing lines of business, if those lines are unprofitable - Having organic produce to get people to buy slurpies? • For example, Nike is a classic example of product differentiation. - They make significant investments in product innovation, engineering and design (with the hopes of developing the next generation of sportswear) - Project wasn't make this shoe, it was making shoes that people want - The idea of coming up with people want is the objective not creating the shoe • Alternatively, a cost leadership strategy could also lead to project discovery: Lenovo follows a cost leadership strategy - May include outsourcing components to lower-cost contracts with manufacturing facilities overseas

Relevant Cash Flows: Net Initial Investment

• Three components of net-initial investment cashflows - Initial machine investment - Initial working capital investment - After-tax cash flow from current disposal of old machine + Feel free to assume that the gain from the sale of the machine is taxable and that the depreciation is deductible/acts a reduction in the book value of the asset + For example, assume you buy a machine worth $1000 with a 10 year expected life and depreciate straight line (0 salvage value). Then, at the end of year 7, you sell the asset for $500. You have again of $200 ($500 inflow - $300 remaining book value [$1000 asset - $700 accumulated depreciation]) + You have an after-tax gain of $120 [$200 * (1 - 40% tax rate)]

Sensitivity Analysis

• To present the basics of the NPV and IRR methods, we have assumed that the expected values of cashflows will occur for certain. • To manage the uncertainties that are likely to exist, managers use sensitivity analysis (essentially multiple calculations over "what if" scenarios) • A common way to apply sensitivity analysis for capital budgeting decisions is to vary each of the inputs to the NPV calculation by a certain percentage and assess the effect on the project's NPV.

Capital Budgeting—Introduction

• Top executives have to figure out how and when to best allocate the firm's financial resources among alternative opportunities to create future value for the company. - Because it is hard to know what the future holds and how much projects will ultimately cost, this can be a challenging task, but it is one that managers must constantly confront. • This deck explains the different methods organizations use to get the "biggest bang for their buck" in terms of the projects they invest in or undertake.

Relevant Cash Flows: Cash Flow from Operations

• Two components of cash flow from operations - Annual after-tax cash flow from operations (excluding the depreciation effect) - Income tax cash savings from annual depreciation deductions + Again, remember: we're calculating cash flows so depreciation does not factor in EXCEPT as a reduction to the tax bill. For economic-policy reasons, tax laws specify which depreciation methods and which depreciable lives are permitted. When there is a legal choice, take the depreciation sooner rather than later because this will increase a project's NPV.

Relevant Cash Flows: Terminal Disposal of Investment

• Two components of terminal disposal ofinvestment - After-tax cash flow from terminal disposal of asset (investment) - After-tax cash flow from recovery of working capital (liquidating receivables and inventory that was needed to support the project)

Efficiency Variance (Labor) - quantity variance equivalent

• Unfavorable efficiency variances might becaused by: - Employees who have been poorly trained (and thus require more time to perform tasks) or did not receive any instruction (and thus are figuring things out on their own)

Price Variance (Materials)

• Unfavorable price variances might be caused by: - An industry shortage, which is driving up the price - The use of a new supplier, who is charging a higher price - The use of rush shipping - Purchases being made in a lower volume than usual, which means the company isn't getting a volume discount - A purchasing manager who isn't negotiating well

Quantity Variance (Materials)

• Unfavorable quantity variances might be causedby: - High amounts of spoilage, scrap, and shrinkage - Switching to a lower quality of material, which can lead to more rejections for quality control reasons

Rate Variance (Labor) - price variance equivalent

• Unfavorable rate variances might be caused by: - Not factoring the effects of a pay raise into the standard rate - Overtime wages - Staffing issues (e.g., someone quit, and an employee who makes more money is doing the work of the person who quit)

Walmart's Segment Reporting

• Walmart tracks financial data by 3 segments: - Walmart U.S. (2.8% sales growth) - Walmart International (no change in sales) - Sam's Club (1.6% sales growth) all three segments are profitable

Relevant Costs

• We want to focus on costs that are relevant (avoidable) • 2 types of costs are NOT relevant when makingdecisions: 1. Sunk costs 2. Future costs that do not differ between alternatives - When just examining current state and one change, just have to analyze the things that are up for debate (it's not up for debate that you are on fire, everything that happened before it already happened) - Future costs that do not differ between alternatives (shouldn't consider because not dependent on the decision you are making)

Decision Factors

• When deciding whether to make or buy something, companies consider: - Quality (will it decrease if we outsource?) + Will the quality of the thing increase or decrease? - Speed (will it take too long if we outsource?) + a potential cost, opportunity cost of doing business, if I don't have software yet, I can't start doing business with clients - Cost There are other factors. Coca-Cola doesn't outsource the production of concentrate because it wants to protect the secrecy of its formula - Other factors are harder to quantify (people pretend this doesn't exist)

Allocating Joint Costs

• When deciding whether to sell a joint product or process it further, we ignore joint costs because they occurred before the split-off point and are sunk - All of these costs will still be baked into the inventory either way • However, we may need to allocate joint costs tojoint products in order to: - Calculate ending inventory and COGS - Determine the product cost so we know what to charge for cost-plus government contracts + Cost-plus contracts are what we engage in when we're unsure what the market price would be (ex: no fair market value for nuclear weapon), so can't really determine the right price to charge so instead we determine: What is the minimum margin we need to run a defensive firm, so take the cost and then add a 10% markup. - Submit a defensible insurance claim if our inventory is destroyed in a fire or natural disaster + Defensible insurance claim, what we want to reimbursed for what is Joint costs are also relevant when you're evaluating the profitability of the entire firm

Byproducts

• When the production process creates two or more products (from the same input) that have high sales values, they are known as joint products - If there is an additional product produced that has a relatively low sales value, it is known as a byproduct - We NEVER assign joint costs to byproducts! - Something like scrap, or when making gasoline, byproduct is the other petroleum product using the extra parts that aren't used to make the finished gasoline - Extra product produced, ex: sawdust of the lumber manufacture - Not the purpose of the manufacturing firm and not main source of revenue - Can't assign joint costs into the product because you didn't incur the cost to produce that product, because you incurred cost for lumber, but got sawdust as an effect

What is decentralization?

• When we say that an organization is "decentralized" we mean the authority to make decisions is spread throughout the organization rather than being confined to a few top executives • Example (of centralization): - The price of a Dairy Queen sundae is $3 • A customer tastes a free sample • The customer tries to bargain with the manager, offering $1 • The manager tells the customer to leave - The manager of a Dairy Queen does not have the authority to change the price; this decision can only be made by senior executives • Example (decentralization) - Bed Bath & Beyond allows its local store managers to choose 70% of their store's merchandise - This allows managers to respond to local tastes

Internal Rate of Return (IRR) Method

• Whereas NPV is determining whether the cashflows of a potential project result in net profit when discounted using the required rate of return, IRR does the opposite. • The IRR method calculates the discount rate at which an investment's present value of all expected cash inflows equals the present value of its expected cash outflows. - The IRR is the discount rate that makes NPV = 0. - A project is accepted only if the IRR equals or exceeds the firm's RRR (required rate of return). • If you calculate the IRR and then use the IRR as the discount rate for the NPV method, you should get an NPV of exactly 0.