Difficulty: Intermediate | Prerequisites: Cost Fundamentals (Doc 1), Budgeting and CVP (Doc 2)
Managerial accounting is ultimately about making better decisions. This document covers the tools for that: identifying which costs matter for a specific decision (and ignoring those that do not), evaluating long-term investments through NPV, measuring performance with the Balanced Scorecard and variance analysis, and handling the accounting for plant assets and depreciation. The unifying idea is relevance: only future costs and revenues that differ between alternatives belong in a decision.
Relevant cost
A future cost that differs between decision alternatives. Only relevant costs belong in a decision analysis. In simple terms, if a cost changes depending on which option you pick, it is relevant.
Sunk cost
A cost that has already been incurred and cannot be recovered or changed by any future decision. Historical depreciation on equipment already purchased is a sunk cost. Sunk costs are always irrelevant to decisions.
Avoidable cost
A cost that can be eliminated if a particular action is taken (e.g. dropping a product line). Avoidable costs are relevant because they differ between the "keep" and "drop" alternatives.
Special order
A one-off order at a price below the normal selling price. The decision rule: accept if the special-order price exceeds the incremental (variable) cost per unit and fixed costs do not change.
Net present value (NPV)
The sum of all discounted future cash flows from an investment minus the initial cost. A positive NPV means the investment earns more than the required rate of return.
Discount factor
The multiplier used to convert a future cash flow to its present value. It equals 1 / (1 + r) raised to the power of n, where r is the discount rate and n is the number of periods. The discount factor decreases as you move further into the future.
Interest coverage ratio
EBITDA divided by Interest Expense. Measures how many times a company can cover its interest obligations from operating earnings.
Balanced Scorecard
A performance measurement framework with four perspectives: Financial, Customer, Internal Business Process, and Learning and Growth. Employee skills and capabilities fall under the Learning and Growth perspective.
Purchase price variance
The difference between the actual price paid for materials and the standard price, multiplied by the actual quantity purchased. Responsibility typically sits with the purchasing manager.
Double declining balance (DDB) depreciation
An accelerated depreciation method. The rate is 2 / useful life. Each year, the rate is applied to the beginning book value (not the depreciable base). Salvage value is not subtracted from the cost before calculating depreciation, but the asset cannot be depreciated below its salvage value.
Plant assets (land account)
The Land account includes the purchase price, closing costs (title fees), real estate commissions, and costs to make the land ready for its intended use (clearing and demolishing old structures). Annual property taxes after the asset is operational are period expenses, not capitalised to the Land account.
A cost is relevant to a decision if and only if it meets both conditions:
It is a future cost (not already incurred).
It differs between the alternatives being considered.
Sunk costs fail condition 1. Costs that remain the same regardless of the decision fail condition 2.
A company receives an offer to buy units at a price below normal. The analysis:
Incremental revenue = Special-order price x Quantity
Incremental cost = Variable cost per unit x Quantity (assuming idle capacity and no change in fixed costs)
If incremental revenue exceeds incremental cost, accept. Fixed costs are irrelevant because they do not change.
Worked example: Special order for 1,000 units at 15 per unit. Variable cost = 12 per unit. Fixed costs = 50,000 (unchanged).
Incremental revenue: 1,000 x 15 = 15,000
Incremental variable cost: 1,000 x 12 = 12,000
Incremental profit: 15,000 minus 12,000 = 3,000
Decision: Accept. Profit increases by 3,000.
When evaluating whether to drop a product line, include:
Contribution margin lost from dropping it (relevant)
Avoidable fixed costs saved by dropping it (relevant)
Direct labour savings (relevant)
Exclude:
Sunk costs such as historical depreciation on existing factory equipment (irrelevant, already incurred)
Allocated common costs that would not disappear if the line is dropped (irrelevant)
NPV discounts all expected future cash flows back to the present using a required rate of return, then subtracts the initial investment.
If NPV > 0, the project earns more than the required return. Accept.
If NPV < 0, the project earns less than the required return. Reject.
If NPV = 0, the project earns exactly the required return.
The discount factor for period n at rate r is 1 / (1 + r) to the power of n. It always decreases as n increases, because a dollar received further in the future is worth less today.
Interest Coverage Ratio = EBITDA / Interest Expense.
This ratio measures a company's ability to meet its interest obligations. A higher ratio indicates greater financial cushion. It is a solvency metric, not a profitability metric.
The Balanced Scorecard translates strategy into measurable objectives across four perspectives:
Financial: Revenue growth, ROI, residual income. How do we look to shareholders?
Customer: Satisfaction, retention, market share. How do customers see us?
Internal Business Process: Cycle time, defect rates, throughput. What must we excel at internally?
Learning and Growth: Employee skills, training hours, information system capabilities. How do we continue to improve and create value?
Employee skills and capabilities sit in the Learning and Growth perspective.
A variance is the difference between a budgeted (standard) amount and an actual amount.
Purchase price variance for direct materials: (Actual price minus Standard price) x Actual quantity purchased. Responsibility: the purchasing manager, who negotiates supplier contracts and selects vendors.
Efficiency (quantity) variance for direct materials: (Actual quantity used minus Standard quantity allowed) x Standard price. Responsibility: typically the production supervisor, who controls material usage on the factory floor.
Assigning responsibility matters because it drives accountability. The person who controls the cost should own the variance.
The Land account is debited for all costs necessary to acquire the land and make it ready for its intended use:
Purchase price
Closing costs (title fees, legal fees)
Real estate commissions
Costs of clearing or demolishing old structures on the land
Costs that do not go into the Land account:
Annual property taxes after the building is operational (these are period expenses)
Costs of constructing a building on the land (these go into the Building account)
DDB is an accelerated method. Key rules:
DDB rate = 2 / Useful life.
Each year, multiply the rate by the beginning book value (cost minus accumulated depreciation). Do not subtract salvage value before applying the rate.
Stop depreciating when book value reaches salvage value.
Worked example:
Truck cost: 50,000. Salvage value: 10,000. Useful life: 5 years.
DDB rate = 2 / 5 = 40%.
Year 1 depreciation = 50,000 x 0.40 = 20,000. End-of-year book value = 30,000.
Year 2 depreciation = 30,000 x 0.40 = 12,000. End-of-year book value = 18,000.
The Year 2 depreciation expense is 12,000.
Students often treat depreciation on existing equipment as relevant to a keep-or-drop decision. It is a sunk cost. The money was spent when the equipment was bought, and no future decision can undo that.
Students sometimes subtract salvage value from cost before applying the DDB rate. Under DDB, you apply the rate to the full beginning book value. Salvage value only acts as a floor: you stop depreciating once book value reaches it.
Students confuse the discount factor direction. The discount factor always decreases as you move further into the future, because money received later is worth less today.
Students mix up who is responsible for the purchase price variance. The purchasing manager controls supplier selection and contract terms. The production supervisor controls how efficiently materials are used (the efficiency variance).
Special-order questions are a staple. The key insight: when idle capacity exists and fixed costs do not change, compare the offer price to variable cost only.
The Balanced Scorecard question almost always asks which perspective covers employee skills. The answer is Learning and Growth.
DDB depreciation is a common calculation question. Write out Year 1 and Year 2 step by step. Show the rate, the beginning book value, and the depreciation amount for each year.
Sunk cost questions test whether you can identify irrelevant information. If a cost is described as "historical" or "already incurred," it is sunk and irrelevant.
The Land account question tests whether annual property taxes go into the asset cost. They do not. They are period expenses.
True or False: Historical depreciation on factory equipment is relevant when deciding whether to drop a product line.
False. It is a sunk cost.
Fill in the blank: The DDB rate for an asset with a 5-year useful life is ______.
40% (2/5).
True or False: Under DDB, you subtract salvage value from cost before applying the depreciation rate.
False. You apply the rate to beginning book value. Salvage value is only a floor.
Fill in the blank: Employee skills and training are measured under the ______ perspective of the Balanced Scorecard.
Learning and Growth.
True or False: Annual property taxes on land after a building is operational should be debited to the Land account.
False. They are period expenses.
Q: A company receives a special order for 1,000 units at 15 per unit. Normal price is 25, variable cost is 12, fixed costs are 50,000 and will not change. Should it accept?
A: Yes. Incremental revenue (15,000) exceeds incremental variable cost (12,000) by 3,000. Fixed costs are irrelevant because they do not change. Profit increases by 3,000.
Q: When deciding whether to drop a product line, which of the following is irrelevant: avoidable fixed costs, sunk costs (historical depreciation), contribution margin lost, or direct labour savings?
A: Sunk costs (historical depreciation). They have already been incurred and cannot be changed.
Q: A truck costs 50,000, salvage value 10,000, useful life 5 years. What is Year 2 DDB depreciation?
A: Rate = 40%. Year 1: 50,000 x 0.40 = 20,000. Book value = 30,000. Year 2: 30,000 x 0.40 = 12,000.
Q: Which Balanced Scorecard perspective includes employee skills and capabilities?
A: Learning and Growth.
Q: Which manager is typically responsible for the purchase price variance on direct materials?
A: The purchasing manager.
Relevant cost analysis builds on the cost classification from Doc 1. You need to know which costs are variable (and therefore avoidable with idle capacity) before you can evaluate a special order.
The Balanced Scorecard connects to budgeting (Doc 2) because budgets set the financial targets that appear in the Financial perspective, while non-financial measures (customer satisfaction, process efficiency, learning) fill the other three perspectives.
Variance analysis ties back to standard costing and budgeting (Doc 2). The predetermined overhead rate set in the budget creates the standard against which actual performance is measured.
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