Cost Measurement Systems
➤
Look back
Look at this part
methods. Chapter 7 applies costs
➤
The previous part discussed how
Part Two builds cost management
to continuously produced output
cost management information
tools to promote understanding of
by the methods of process cost-
supports decisions about setting
productive processes. Chapters 4
ing. Chapter 8 describes decision
strategy and using scarce, con-
through 7 develop three key di-
making and allocation of costs to
strained resources. Cost manage-
mensions of costing systems, that
jointly produced products. Chap-
ment helps define strategy by
cost managers evaluate when de-
ter 9 explains decision making us-
predicting and estimating the
signing cost systems. Chapter 4
ing several common methods of
costs and benefits of alternatives.
identifies resources by value chain
allocating service department
The key to using scarce capacity
operation or function (functional
costs.
wisely is to measure the profit or
costing) and distinguishes be-
value contributed by alternative
tween unit-level and higher-level
➤ Look ahead
products and services, and of
costs and among three product
Part Three uses understanding of
course, part of profit is the costs
costing methods. Chapter 5 de-
costs and activities to help im-
used to generate revenues.
scribes five major types or levels
prove the effectiveness and effi-
of activities that drive costs.
ciency of productive processes.
Chapter 6 uses cost categories
and job costing to trace costs to
products, jobs, and projects using
unit-level and full ABC costing
Pa r t Tw o
II
4
Measuring Costs of
Operations
After completing this chapter, you should be able to:
1.
Measure product costs, contributions to profit, and operating expenses using
throughput, variable, and absorption costing.
2.
Compare alternative product costs and their effects on profits.
3.
Understand how different methods for measuring product costs create different
incentives for managing scarce productive resources.
Memorandum
To:
From:
CC:
Subject:
Cost Management
Challenges
1. How can cost managers
measure the financial
results of operations in a
way that reinforces proper
use of resources?
Glenn Penski
Director of Cost Management Systems
Robert Travers
Vice President of Marketing and Sales
Anne Hechman
Vice President of Manufacturing
Congratulations on a job well done
Glenn: I think your analyses and recomendations were exactly on target. We
have all but eliminated our backlog of late customer orders. And our customers
could not be happier. I also will be announcing at our next Executive Committee
meeting that we have added two major customers in Europe because we are
able to meet their on-time delivery requirements. Without our recent changes,
we would not have been able to meet their needs without upsetting our current
customers. Good work, Glenn.
Memorandum
2. How can alternative
methods of calculating
product costs create
different incentives?
To:
3. How should cost
managers measure costs
for internal decision
making?
Subject:
From:
CC:
Glenn Penski
Director of Cost Management Systems
Anne Hechman
Vice President of Manufacturing
Robert Travers
Vice President of Marketing and Sales
Re: Congratulations on a job well done, but...
Glenn (and Robert): I agree that we understand how to schedule our productive
resources much better and that we are much more responsive to customer
orders. Manufacturing operations are much smoother and there is much less
tension in the department now that we rarely have to expedite orders.
However, I do not think that we have completely solved our problems. We
are having limited success in reducing inventories and keeping non-bottleneck
processes idle when their output is not needed. We are still getting reports from
your office, Glenn, that idle capacity is hurting us by creating higher unit costs
and by not converting idle capacity into value-added products. I interpret these
reports to mean that we should keep all of our processes busy all the time. I am
concerned that either the concept of keeping some capacity idle is flawed or you
are measuring costs incorrectly.
I hope you realize that I am grateful for the improvements you have helped
make, but I also think that we can take another step to create cost reports that
reinforce what we should do to use our manufacturing capacity wisely. I hope
that you can sort out what is going on and make some improvements on the
reporting side.
108
Part II Cost Measurement Systems
Introduction
Organizations like Contaminant Measuring Devices (CMD) are formed to manage productive processes efficiently and to generate customer value and profit.1 As discussed
in Chapter 3, any organization’s capacity to do these things is constrained. If an organization provided only one product or service, managing processes would be relatively
easy, though not trivial. Management of resources would entail forecasting total sales,
estimating total costs, and subtracting costs from revenue to get expected profits. If expected profits are too low, managers could either change businesses or find ways to increase sales and/or reduce costs.2 This principle is deceptively simple, however,
because most organizations provide many different products and services, and each
may place different but competing demands on the organization’s resources. In this situation, it can be difficult to know how to use scarce or constrained resources to generate the most value or profit. In order to choose among competing products and
services, managers need to know what resources are needed and how much of the constrained resources each product or service consumes and the profit each can generate.
The purpose of this chapter is to analyze how to measure the costs of resources and
profitability of products and services in ways that reinforce good decision-making.
What Are the
The Resources
Resources of
Ofan
AnOrganization?
Organization?
If you could view CMD from an aerial vantage point, you could observe resources
flowing into the company and finished products flowing out. If the roof were transparent or detachable, you also could see that CMD’s business and production processes
need many resources. These resources include physical resources such as money, parts,
materials, buildings, machinery, and computers. In addition to physical resources,
CMD needs human resources such as the talent, effort, and knowledge of its employees. These resources are not free, and because the resources are not free, they must be
managed wisely.
It is common for organizations to identify resources by at least three dimensions:3
1. The type of resource acquired.
2. How the resource is used.
3. How traceable a resource is to a particular decision.
Distinctions by type, use, and traceability have been used by accountants and financial
analysts for many years because they provide information that is useful for decisionmaking and that communicates how the organization has converted money and human
capital into products and services.
Types of Resources
We will use three general resource types that organizations obtain: materials, conversion, and operating resources. Note that organizations that outsource portions of their
value chains also treat those purchased products or services as material, conversion, or
operating resources, depending on their nature.
Material resources are
physical objects that
may be incorporated
into products or used
to maintain or enhance
the organization’s
productive and
support facilities
Material resources. Material resources are physical objects that may be incorporated into products or used to maintain or enhance the organization’s productive and
1
See the introduction to Chapter 3 for a description of CMD and its products.
Note that accountants refer to the costs of items sold and the costs of using other resources to make
sales possible as expenses. Therefore, accountants and financial managers define profits as sales less
expenses.
3
Chapter 5 introduces a fourth dimension, the level or type of cost driver, in order to measure resource
use more accurately.
2
Chapter 4 Measuring Costs of Operations
109
support facilities. Materials include raw materials and purchased parts, components,
and assemblies, such as the laser instruments that CMD manufactures and assembles
into the devices it sells. Materials also include the maintenance and office supplies that
CMD uses to support production and the general organization.
Conversion resources. Providing products and services usually requires labor,
equipment, and productive facilities; together, these are called conversion resources
because they have the capability to convert other resources into products and services.
CMD’s conversion resources include its manufacturing, technical, and supervisory labor and its manufacturing equipment and buildings.
Conversion resources
include labor,
equipment, and
productive facilities
Other types of physical and human resources are necessary to
create and sustain the organization itself and to enable transactions with parties external to the organization. At CMD, these other operating resources include the corporate
office and the marketing, sales, and customer service departments. Without these elements of the value chain, CMD would not be able to function efficiently or effectively.
Operating resources.
How Resources Are Used
Historically, manufacturing organizations developed accounting systems to support
their primary objective of efficient manufacturing. In many cases, most of these companies’ resources were dedicated to and used in manufacturing processes. Other operating resources were much less important. Since manufacturing efficiency has been
a key element in competing successfully, accountants have distinguished between
production resources used to manufacture products and nonproduction resources
used to support manufacturing processes. Supply, administration, marketing, and distribution resources always have been necessary, but as support for the primary objective of manufacturing. Thus, these other elements of the value chain have not received
as much attention from accountants or accounting systems.
The world of business has changed in many ways since the days when manufacturing was the primary industrial activity. The private and public service sectors are
much larger than the manufacturing sector in many advanced economies including
Canada. Even in most manufacturing companies, support and service resources are
much more extensive and important than they were. However, most accounting systems still separate production resources from nonproduction resources, especially for
financial and tax reporting. Though cost managers now correctly focus on all elements
of the value chain, it is important that they also understand the origins and limitations
of most formal accounting systems that support financial and tax reporting. Analyzing
nonproduction resources, which can be the majority of resources, may require use of
information not normally supplied by the formal accounting system.
CMD’s value chain is shown again in Exhibit 4–1. Recall that physical and human
resources are supplied to and used in all elements of the value chain to deliver the most
customer value at lowest cost.
At CMD, production processes (the middle, shaded element in Exhibit 4–1) use
materials and conversion resources to make its measurement devices. CMD’s other
value chain processes use nonproduction resources to provide support services, research
and development, design, supply, marketing, distribution,
and customer service.
Production resources
are used to manufacture
products
Nonproduction
resources are used to
support manufacturing
processes
In some processes, there is
no substitute for highly
skilled human resources.
110
Part II Cost Measurement Systems
Exhibit 4–1
Physical
resources
CMD’s Value Chain—
Production and
Nonproduction Resources
Human
resources
Support services
• Accounting
• Human resources
• Legal services
• Information systems
• Telecommunications
Research
and
development
Design
Supply
Production
Marketing Distribution
Exhibit 4–2
Categories and Examples
of Resources
Uses
Resources
Material resources
Conversion resources (convert
materials into products,
services, and sales)
Operating resources (provide
operating support)
Used to Produce
Products and Services
Parts, assemblies, protective
coverings, connectors,
supplies
Labor, supervision, maintenance,
utilities, buildings, equipment
Internal business processes
(management, accounting,
information systems, human
resources, etc.), engineering
Customer
service
Measuring
devices
and
services
Used in
Nonproduction Value
Chain Elements
Cleaning supplies, office
supplies, repair items
Labor, equipment, and
facilities in administration,
marketing, sales, distribution,
customer service
Internal business processes
(management, accounting,
information systems, human
resources, etc.), research and
development
A cross-classification by resource type and productive use is displayed with typical examples in Exhibit 4–2. This exhibit shows that classifying operating resources, in
particular, into production or nonproduction uses can be difficult.
Traceability of Resources
A third useful dimension of resources is how easy it is to trace the cost of a resource to
a decision or set of decisions. Cost managers ask, “If we make this particular decision,
what resources must we obtain or use, and what will they cost?” Acquisition and use of
all resources is caused by management decisions, but ease of tracing resource costs to
specific decisions is important to cost managers who are analyzing or planning the cost
effects to the organization of those decisions.
Sometimes, it is easy to see how specific decisions have caused
the acquisition of specific resources. These decisions are directly responsible for those
resources, and the resources are called direct resources of those decisions. For example, a decision to produce laser instruments would cause the acquisition of the materials necessary to make the instruments. Making more instruments obviously causes the
acquisition of more materials. Likewise, the decision to open a sales office in Buenos
Aires obviously causes the acquisition of specific physical and human resources
necessary for the office, and the decision to open and operate that office is directly
Direct resources.
Direct resources are
obtained as the direct
result of certain
decisions; decisions are
directly responsible for
those resources
Chapter 4 Measuring Costs of Operations
111
responsible for acquiring and paying for those resources. Often, however, it is not easy
to trace all resources to all decisions.
Indirect resources. Resources that are difficult to trace to specific management decisions are called indirect resources of those decisions. Other common names for indirect resources are overhead, common costs, and burden, though these sometimes
convey a derogatory image (e.g., unproductive or unnecessary). For example, CMD
hired and retained Robert Travers as vice president of marketing and sales; that hiring
decision is directly responsible for recruiting and paying for this human resource.
Though Mr. Travers manages all of CMD’s sales operations, it is not easy to trace any
of his cost to the decision to open the Buenos Aires sales office. Thus, Mr. Travers
could be classified as an indirect resource of the Buenos Aires office. As another example, Anne Hechman, vice president of manufacturing is paid by CMD to manage its
manufacturing processes, but she does not actually manufacture a single instrument
herself. Thus, though she is necessary to support production, CMD acquired and pays
for this human resource to indirectly support manufacturing of specific instruments.
Thus, Anne Hechman is an indirect manufacturing resource.
The distinction between direct and indirect resources is not restricted to human resources. For example, at its primary location CMD manages the company and manufactures its products in the same large building, using the same computer network.
How much of the building and computer network resources were obtained for administration? How much for manufacturing each instrument? It may not be easy to trace
these resources directly to decisions about either administration or manufacturing, let
alone to manufacturing specific instruments. Thus, the building and computer network
resource would be considered to be an indirect resource for both administration and
manufacturing.
Organizations may acquire some resources to provide the capacity to produce a certain level of products or services. The capacity the organization makes available for use is the resources supplied. For example, CMD has
acquired the human and physical capacity to make more products than they currently
can sell. The supply of skilled technicians who build the instruments, for example, is a
direct cost of the capacity decision, not of specific decisions to use the capacity to
make products, services, or sales. However, the amount of their labor that is used is potentially traceable to products, for example, by maintaining records of who worked on
which products. If we asked, “What resources are used for the Buenos Aires office?”
we would identify the human and physical resources in place in Buenos Aires as well
as a portion, perhaps, of the management resource provided by Mr. Travers. Spending
for Mr. Travers himself, ignoring travel costs, does not depend on how much the
Buenos Aires office uses him. However, knowing how much of his capability is used
by the Buenos Aires office is informative when analyzing how much other work Mr.
Travers is capable of performing. Thus, the capacity used for productive purposes is
the resources used. Confusing the distinction between supply and use of a resource is
potentially misleading because of the different impacts of decisions on spending and
use of resources. As we shall see, organizations use different costing systems depending on their distinctions between supply and use of resources.
Indirect resources are
resources that are
acquired but are
difficult to trace to
some management
decisions
Supply versus use of resources.
Three Dimensions of Resources
In summary, every resource fits into the qualitative dimensions of type of resource, use
in the value chain, and traceability to decisions to supply or use resources. These qualitative dimensions and two example resources are shown in Exhibit 4–3.
Resource A in Exhibit 4–3 is a nonproduction, operating resource that is not easily
traced to some particular decision, say the decision to produce one more laser instrument at CMD. This resource might be a computer in the finance department or a human resources specialist in the personnel department. Note that though the computer in
the finance department may not be traceable to a decision to make a laser instrument,
Resources supplied
comprise the capacity
the organization makes
available for use
Resources used
comprise the capacity
used for productive
purposes
Part II Cost Measurement Systems
112
Type of resource
Exhibit 4–3
Three Dimensions of
Resources
Materials
B
A
Ea
sil
(d y tr
ire ac
ct ed
)
Operating
No
te
(in asil
di y t
re ra
ct ce
)
d
Conversion
Traceability to
decisions
Non-production
(period)
Production
(product)
Use in the value chain
it can be directly traced to the decision to have a finance department with its own computers. Thus, this computer is a direct resource of the finance department but an
indirect resource of the manufacture of products. In contrast, resource B is a production, materials resource that is easily traced to a particular decision, perhaps the decision to produce another laser instrument. This resource might be the ruby rod used in
the laser itself. Thus, the ruby rod is a direct resource of manufacturing laser instruments. Many other locations on this three-dimensional resource plot are feasible, too.
How Do Organizations
of Resources?
Measuring
Costs of Resources
A costing system
collects and reports the
costs of resources
supplied and used for
production and
business processes
Technology
Recall the elements of managerial decision-making supported by cost management information that were introduced in Chapter 1 (Exhibit 1–1). Cost managers design and
use costing systems to generate much of the data used to create that information. A
costing system collects and reports the costs of resources supplied and used for production and business processes. Managers use this cost information to support product
and service decisions, enable cost control, and provide historical data for cost management. This cost information may be necessary, for example, for performance evaluations based on comparing plans with actual outcomes of past jobs. By providing
feedback on past outcomes of the uses of resources, costing systems also contribute to
valuable learning about the uses of resources that can be used to plan new jobs or products. Another important purpose of a costing system is to support external financial reporting to investors, regulators, and other interested parties by measuring costs of
goods and services sold and operating expenses.
Some organizations have separate subsystems to support each of these information
activities. To be effective, these subsystems should share common information, such as
accounting, sales, or personnel system information. Many larger organizations develop
or purchase integrated information systems, such as SAP, 4 that provide comprehensive
information services, including costing, from a common database of organizational
data. These integrated systems use common data on sales, acquisition and use of
resources, and other activities to prepare internal cost-management information, external financial and tax information, performance evaluation information, and information as required for regulatory reporting and special projects or problem analyses. As
you might imagine, currently these integrated systems are very expensive but may be
justified on the basis of their providing more consistent information and eliminating
redundant, separate systems throughout large organizations.
4
See SAP’s web site at www.sap.com.
Chapter 4 Measuring Costs of Operations
Design Issues
In designing costing systems, cost managers seek answers to many questions related to
the information they need to present about the acquisition and use of resources for their
organizations’ most important management decisions. They may ask decision-makers
and other members of the cost management team variations of the following questions
about the decision-making of their organization. We consider these types of questions
in this and subsequent chapters.
Importance of resource supply versus resource use (Chapter 4):
䊏 Do we need to make a distinction between costs of supplying versus using
resources?
䊏 Do we need to isolate and report the costs of supplying and using different
resources, or will average costs across types of resources be adequate?
䊏 Do we need expected supply or use, historical supply or use, opportunity costs,
or all of the above?
䊏 Do we need resource costs classified by where the work is performed?
Importance of nature of work versus location of work (Chapter 5):
Is it important to know how the work of the organization is done?
䊏 Do we need costs to provide incentives for improvements, or are other incentives
more appropriate?
䊏
Uniqueness of outputs (Chapters 6 and 7):
Do we need specific costs of each product and service, or will average costs across
products and services be adequate?
䊏 Do we need periodic costs and/or costs for the entire life of projects, products and
services?
䊏
Common to all considerations:
Do we need rapid reporting of costs, or can we tolerate delays in reporting? How
long can the delays be?
䊏 Do we need complex reporting of costs, or is simple, uncomplicated reporting
more useful?
䊏 Do we need flexible data that can be reorganized into unique information by each
decision-maker, or is it better to provide information in a format common to all
decision-makers?
䊏 Do decision-making and financial reporting needs conflict, or can the same information meet both needs?
䊏 Do we have an unlimited budget to develop and maintain the costing system, or
more realistically, do we have a budget limit? Given the budget limit, what tradeoffs of information for the cost of information must we make?
䊏
As Exhibit 4–4 shows, the three discriminating categories of questions (concern
with resource supply or use, nature of work, and uniqueness of output) are associated
in practice with different cost-system designs. Chapter 4 investigates the implications
of resource supply or use for cost-system design and introduces functional costing.
Chapter 5 describes activity-based costing as a system solution to concerns about activities and the nature of work. Chapters 6 and 7 describe cost systems for outputs that
are either unique or undifferentiated, respectively.
Beyond asking and answering these types of questions, there are almost no formulas or recipes that prescribe what a costing system should be. Actually, this is good
news for cost managers. Thoroughly understanding how to match costing information
to decision-making needs is a major way that cost managers use their judgment to add
value to their organizations. This section of the text is devoted to investigating alternative costing systems and how they may be configured to best serve organizations and
113
114
Part II Cost Measurement Systems
Uniqueness
of products
Three Dimensions of
Costing System Designs
in Practice
Chapters 6 and 7
Exhibit 4–4
Job costing
Operation costing
Process costing
Functional
costing
(introduced
in Chapter 4)
Throughput
costing
Variable
costing Absorption
costing
C
ha
pt
er
5
Activitybased
costing
Ch
apt
er 4
Supply
or use of
resources
Nature or
location of
work
decision-makers. Before diving into this topic, we need to develop a common, fundamental understanding of the concept and measurement of “cost.”
Cost Management in
Practice 4.1
Progressive cost managers at Borg-Warner Automotive Diversified Transmission Products Corporation anticipated recent trends toward designing costing systems that serve decision-makers by providing the information they need to improve their products’ competitiveness and value. Cost
managers first learned what decisions had to be made by their internal customers, corporate managers and plant managers, whose needs were very different. They learned, for example, that plant
managers need specialized information about how processes use resources and how that use can
be improved, but not the great amount of detail on past departures from standards that had been
provided. Corporate managers, who had received the same cost reports as plant managers, were
overwhelmed by the accumulated detail of all the plant-level reports and could not find the information they needed to improve their strategic choices. By working closely with decision-makers at both
levels, cost managers were able to design effective costing systems and reports.
Source: G. Hanks, M. Freid, and J. Huber, “Shifting Gears at Borg-Warner.” Also see, P. Drucker, “The
Information Executives Truly Need.” Full citations are in the bibliography.
Visit www.borg-warner.com.
What Do We Really Mean by “Cost”?
LO1 Measure product
costs, contributions to
profit, and operating
expenses using
throughput, variables, and
absorption costing.
Cost is a measure of
the acquisition or
consumption of a
scarce or constrained
resource to achieve a
specific outcome
The measurement of cost is fundamental to managing organizations’ resources because
costs are important measures of resource availability and use. Cost is a measure of the
supply or use of a scarce or constrained resource to achieve a specific outcome.5 An
organization gives up (or “sacrifices”) scarce resources in order to obtain other
resources. The value given up is a measure of the purchase cost of resources. These
5
Usually, costs are expressed in monetary terms, though that is not always necessary or even desirable.
As an alternative, some public and nonprofit organizations use nonmonetary measures of cost, as in measuring the “cost” of a public policy in terms of the incidence of poverty, crime, or disease. Likewise, benefits
may be expressed in nonmonetary terms. Some would argue that the primary justification for political
processes is to make tradeoffs of nonmonetary social costs and benefits that cannot be made easily in traditional markets for products and services.
Chapter 4 Measuring Costs of Operations
acquired resources are subsequently supplied to production and nonproduction
processes and used to produce and sell products and services or to support production
and sales. The value of the resources made available is the cost of resources supplied.
Cost of resources supplied may or may not be the same as cost of resources used because an organization may choose to make available more resources than it uses at any
time, perhaps to take advantage of currently low prices or to accommodate unexpected
needs or shortages. The value of the resources not actually used is the cost of reserve or
excess capacity, as discussed in Chapter 3. The value of resources consumed for productive purposes is the cost of resources used.
Ideally, the value given up to supply or use a resource is measured as an opportunity cost, which is the current value of the forgone, next-best alternative use of whatever is supplied or used. Because opportunity costs can be difficult to measure reliably,
most cost management systems measure actual or expected out-of-pocket costs,
which are the payments (usually cash or obligations to pay cash) made for resources.
Out-of-pocket costs can be the same as opportunity costs, but may not be the same because of imperfect markets and changes in the decision-making environment between
when a resource was acquired and when it is used.6
Actual costs usually are measured as the past payments for currently owned resources, whereas expected costs are the predicted or forecasted payments for future
resources. For example, the actual cost of CMD’s equipment is the money that was
paid to obtain it. As another example, the expected cost of one of CMD’s new products
is the monetary value of the resources that CMD expects to acquire and consume to
complete it.
Traditionally, the costs of resources used to produce products are called product
costs, and these become cost of inventory and cost of goods sold expense when the
products are sold. The costs of resources used in nonproduction value-chain elements
are called period costs and become other income-statement expenses of the period.
Traditionally they have been considered support costs of doing business during the period. Since they are expensed when used, period costs do not become part of the value
of inventories for financial or tax reporting.
Total Cost
CMD’s total cost includes the costs of all resources supplied to the company during a
specified time period. Total cost would include the costs of all production and nonproduction resources, or all material, conversion, and operating resources, or all direct and
indirect resources. It is possible, of course, to create many different subtotals of costs,
such as total production costs, total conversion costs, total direct costs, or total direct
material costs. Organizations would create these subtotals to reflect decision-making
and reporting needs. For example, CMD’s executives receive a report each week from
Glenn Penski that totals weekly costs by type of resource used for the seven types of
CMD’s instruments. Exhibit 4–5 shows an excerpt from a recent week’s report. Anne
Hechman uses this report to monitor how her department is using the company’s scarce
resources. (Note that blank columns B–E will be filled with more detailed cost information about products in subsequent exhibits.)
Exhibit 4–5 shows that during the week CMD completed 380 measuring instruments of all models (cell G2) at a total cost of $5,104,500 (F12). Note that only the
amount of labor traced to production of products is counted as a direct labor cost (F6).
Unused labor is part of indirect production cost (F9). Subtotals of types of resource
costs for all products manufactured also are in column F.
6
An imperfect market does not have reliable prices for all resources. Furthermore, alternative opportunities change because of technology, preferences, and information.
115
Cost of resources
supplied is the value
of the resources made
available
Cost of resources
used is the value of
resources consumed for
productive purposes
Out-of-pocket costs
are the payments
(usually cash or
obligations to pay cash)
made for resources
Actual costs usually
are measured as the
past payments for
currently owned
resources
Expected costs are the
predicted or forecasted
payments for future
resources
Product costs are costs
of resources used to
produce products
Period costs are costs
of resources used in
nonproduction valuechain elements
Total cost includes the
costs of all resources
acquired or used during
a specified time period
Part II Cost Measurement Systems
116
Exhibit 4–5
Weekly Total Cost Information (excerpt)*
A
B
1
Model
2
Quantity
C
D
E
F
G
All Seven Models
380
3
Average
4
Direct costs easily traced to production
5
Material cost (e.g., materials, parts,
assemblies supplied and used for
products)
6
Conversion cost (e.g., labor used to make
Subtotal
per Unit
$ 834,800
$ 2,197
F5/G2
351,200
924
F6/G2
products)
7
Total direct costs ( F5 F6)
8
Indirect costs not easily traced
9
10
1,186,000
3,121
Indirect production cost (e.g., unused
labor, supervision, equipment,
maintenance, facilities used to make
products)
2,200,000
5,790
F9/G2
Indirect operating cost (e.g.
management, support services
facilities used to operate the business)
1,718,500
4,522
F10/G2
11
Total Indirect costs
$3,918,500
$10,312
12
Total costs
$5,104,500
$13,433
*Note: Columns B– E will be used in subsequent exhibits
Average Cost
Average cost per unit
of product is total costs
of a period divided by
the number of units of
product made that
period
One could compute the average cost per unit of product by dividing total costs of a period (F12) by the number of units of product made that period (G2). Exhibit 4–5 computes this figure as $13,433 per unit (G12 $5,104,500 380 units and also equals
G7 G11, or the sum of average direct and indirect costs). Furthermore, the report
calculates the average costs per type of resource. For example, during the week, manufacturing each instrument cost an average of $2,197 in materials (G5) and $924 in conversion (G6). In addition to the easily traced direct costs, each instrument used an
average of $5,790 of indirect production resources (G9) and $4,522 of indirect operating resources (G10).
Appropriate uses of average costs. Average cost may be useful information; for
example, the vice president of manufacturing may compare average costs with historical trends or expectations for the week. Also, the vice president of marketing may compare average costs (which include nonproduction costs) with competitors’ costs and
average prices obtained for these instruments to assess overall profitability and effectiveness of pricing (i.e., average sales prices should exceed average costs).
Dangers of misusing average costs. The average cost usually does not represent
the period’s spending for resources to make products because, as in CMD’s case, only
acquiring material resources can be easily traced to decisions to make more products.
Chapter 4 Measuring Costs of Operations
117
Other resource spending does not change with decisions to make more or fewer units
of product. Thus, a decision to make more “average” products would not cause CMD
to spend $13,433 more for each unit made. If some resources, for example, labor, have
excess capacity, CMD probably would not spend more on labor unless the excess capacity were to be exhausted.
The average product may not exist except as a mathematical computation of average cost. Therefore, if different products use varying amounts of constrained resources,
then some products use more resources than the average, and some use less. In organizations with different products and services, average cost usually is not a meaningful
number for making decisions about the uses of capacity. If CMD only relied on the average cost for all models, the company could fail to improve its use of scarce resources.
For example, though the average price may exceed average cost, which is necessary for
overall profit, some products may be very unprofitable (e.g., cost of resources used exceeds sales revenues) and others may be highly profitable. CMD should stop using its
resources to make the unprofitable products and use the resources to make profitable
ones, but average cost information alone does not identify which products to drop or
expand.7
Tracing versus Allocating Costs
As discussed in detail in Chapters 5 and 6, organizations usually trace direct costs to
products and services. Tracing costs means assigning resource costs to products and
services (or organization subunits) through reliable observations and documentation of
resource use. Therefore, organizations rarely use the overall average cost for decisionmaking because it is cost-effective to trace some costs. That is, the costs of tracing are
less than the costs of production errors based on average costs (e.g., producing the
wrong products). More details of the week’s output and costs of resources used are in
Exhibit 4–6. [Put a place marker or paper clip on this exhibit because we will refer to
it often. Note that some of the numbers are rounded to the nearest dollar. Note also that
for simplicity this exhibit gives details for only two of CMD’s seven product models,
#700A and #900B.]
When managers use the average cost per unit, they act as if each product model
consumes $3,121 in traceable, direct cost (G7 F6 G2 G5 G6). It is apparent
from rows 5, 6, and 7 of Exhibit 4–6, however, that the different product models use
different amounts of direct resources. CMD has traced materials and conversion resources to each product model type. At the low end of resource use, Model #700A uses
$2,200 (C7) of direct material and conversion cost per unit (C7 C5 C6 or B7 C2). Model #900B, at the high end, uses $4,200 (E7) of direct material and conversion
cost per unit, almost twice as much as Model #700A. Most of the difference between
these products is the costs of materials (row 5). Although CMD does not do so, other
organizations may trace use of some marketing and distribution resources directly to
products and services.
These per-unit measures of direct material and conversion costs themselves appear
to be averages. Because CMD has traced these resources to each product line, these
product-line averages (cells C5 to C7 and E5 to E7) should be closer to real (but still
unmeasured) per-unit costs than the overall average cost (cells G5 to G7). Some organizations are able to easily trace direct costs to individual units of product or service
without averaging. This situation is discussed in Chapter 6.
7
Recall that most introductory microeconomic models assume that the firm produces a single product in
a perfectly competitive market. In this simplified setting, the most efficient use of productive resources is to
produce the number of units that minimizes that average cost per unit. The production of multiple products
and the real possibility of imperfect markets complicate this simple situation.
Tracing costs is
assigning direct costs to
products and services
(or organization subunits) through reliable
observations and
documentation of
resource use
Part II Cost Measurement Systems
118
Exhibit 4–6
Weekly Cost and Production Information
A
B
1
Model
2
Quantity
C
#700 A
E
#900 B
F
G
All Seven Models
48
3
4
D
40
380
Subtotal
Average
per Unit
Subtotal
Average
per Unit
Subtotal
Average
per Unit
$ 67,200
$ 1,400
$124,000
$ 3,100
$ 834,800
$ 2,197
38,400
800
44,000
1,100
351,200
924
$105,600
2,200
$168,000
4,200
$1,186,000
3,121
Direct costs
5
Material cost
6
Conversion cost
7
Total direct costs
8
Indirect costs
9
Indirect production cost
277,894
5,790
231,579
5,790
$2,200,000
5,790
10
Indirect operating cost
217,074
4,522
180,895
4,522
1,718,500
4,522
11
Total Indirect costs
$494,968
10,312
$412,474
10,312
$3,918,500
10,312
12
Total costs
$600,568
$12,512
$580,474
$14,512
$5,104,500
$13,433
Exhibit 4–6 shows that CMD allocates costs of indirect
resources to all products by a rough averaging process because it is too costly to trace
those resources more precisely. Cost allocation means attaching or assigning indirect
costs to products, services, or organizational units by some reasonable but imprecise
method of averaging. Note that C9 E9 G9 and C10 E10 G10. These equal,
indirect costs per unit for production and operating costs show that CMD did not attempt to trace these indirect costs to the product-model level. CMD simply averaged
these costs across all units of product. This can be the least accurate way to allocate
costs, but allocating costs in general is less accurate than tracing costs because allocating costs cannot rely on ready observation or documentation of resource use or spending. In fact, at CMD it appears that allocated indirect costs may be unrelated to
resource use.
Cost allocation unrelated to resource use is undesirable if more accurate methods
are cost-effective. There are methods of allocating indirect costs to products and services that can reflect resource use more accurately, and these are discussed in later
chapters. Chapter 5 presents a method (activity-based costing), for example, that may
be able to trace a large proportion of these indirect resources to products and services
in a cost-effective manner. In effect, more accurate cost allocation methods seek to
transform indirect costs into direct costs. If successful, these methods should provide
more accurate measures of resource use.
Allocating indirect costs.
Cost allocation is
attaching or assigning
indirect costs to
products, services, or
organizational units by
some reasonable but
imprecise method of
averaging
Unit-Level Costs and Variable Costs
Unit-level costs are
costs of direct
resources that are
acquired and used on
individual products and
services
As we have seen, it is relatively easy to observe the costs of direct resources such as
parts and materials to make CMD’s devices. Costs of direct resources that are supplied
and used on individual products and services also are called unit-level costs. Unitlevel costs to produce and sell products and services usually include costs of parts and
materials and may include costs of production resources such as labor and energy, and
Chapter 4 Measuring Costs of Operations
Unit-level
costs
Exhibit 4–7
Costs of
direct
resources
supplied and
used to
provide units
of product or
service
+
Costs of
indirect
resources
used to
provide units
of product or
service
119
Unit-Level and
Variable Costs
=
Costs of
direct and
indirect
resources
used to
provide units
of product or
service
Variable
costs
nonproduction resources such as marketing and distribution—if they are acquired to
support specific products or services. In many cases, however, organizations acquire
these latter resources as indirect resources of production. If costs of using these indirect
resources vary with the volume of units of products and services provided, they often
are called variable costs. This term can be misinterpreted unless it is used very carefully. Making or selling more or fewer products and services will cause the costs of using these resources to vary up or down. These are variable costs of the use of indirect
production resources. For example, making more laser instruments will use more
skilled labor at CMD; we know this because the use of skilled labor easily can be
traced to the additional laser instruments manufactured.
However, making or selling more or fewer products and services may not cause
costs of supplying these resources to vary up or down. To repeat, CMD hires skilled
technicians to manufacture its laser instrument assemblies, but the company pays them
for at least 40 hours per week, even if they do not have enough demand for laser instruments to keep them busy for 40 hours per week. Therefore, the costs of using
skilled technicians to make laser instruments may vary with quantities of products
made, but the costs of supplying (paying the wages and benefits for) skilled technicians
will not vary unless CMD decides to hire or lay off technicians.
Failing to make the distinction between the costs of supplying (e.g., spending for)
resources and using resources has caused much confusion and controversy among cost
managers, accountants, financial analysts, and engineers. We need to be clear about
this, and we will identify unit-level costs as those incurred for resources that are both
supplied and used to provide units of products and services. Variable cost refers to the
costs of resource use that vary with the volume of units of product and service provided. As Exhibit 4–7 shows, all unit-level costs are variable costs, but not all variable
costs are unit-level costs.
Variable costs are
costs of resources
whose use varies with
the volume of units of
products and services
provided
Fixed Costs, Committed Costs, and Sunk Costs
For many years, accountants have used the term, fixed costs, for production or nonproduction costs that do not vary with production or sales volumes. These have included such costs as salaries, rent, depreciation, and property taxes. As we have argued
throughout this book, however, decisions cause costs—costs do not just happen—and
there are many more decisions made than just production volume. No resource
Fixed costs are costs
that do not vary with
production or sales
volumes
120
A committed cost is a
cost that is not intended
to vary with production
or sales volume
Discretionary costs
may be changed
quickly and easily
Part II Cost Measurement Systems
decisions are irreversible. All future costs, therefore, are variable with respect to some
decision, so no future cost can be really fixed. It may be costly to change a resource
cost in the future (e.g., renegotiate or nullify a resource contract), but the resource cost
can be changed. A better term to use for costs that are not intended to vary with production or sales volume may be committed cost. This term reflects that the organization has committed to a certain level and type of resource spending, but the
organization also (at some further cost perhaps) can change the commitment.
In most organizations, labor cost is a committed cost and cannot be changed easily
because of contractual obligations, policy, or its critical importance. Other committed
costs may include lease obligations, licenses, and various taxes. In contrast, discretionary costs, such as some advertising costs, remodeling, or charitable giving,
may be changed quickly and easily. This is a difference of degree; that is, both committed and discretionary costs can be changed, but committed costs are more difficult
to change.
When labor is a committed cost, as in many unionized companies or organizations
and countries with strong employment policies, making more or fewer units of product
may not affect the cost to supply labor, positively or negatively. If so, spending for labor resources is not different from spending for other physical capacity resources. In
organizations where this is true of other resources as well, the only unit-level cost of
products and services that varies proportionately with the number of units produced
may be the cost of parts and materials. Under these conditions, spending or costs to
supply all other resources would not vary with the number of units.
Furthermore, the organization may or may not use all of the resources to which it
has committed. For example, as discussed in Chapter 3, an organization may commit
to provide a certain level of production capacity, but may choose to reserve some of
that capacity for unforeseen needs and may have idle capacity that it cannot use.
Many organizations have made payments in the past to acquire resources that they now control. The amounts of these payments usually are recognized
as the costs of resources that are expected to be used in the future (these resources with
future benefits are, of course, assets). These resources often include equipment, buildings, and purchased technology or knowledge. Should you consider the costs of these
resources when making production decisions? That is, should the past payments for
these resources be part of the costs of future products and services? The correct answer
is no; past payments for resources are sunk costs—they cannot be undone. Just as with
any other resource, only the opportunity costs of these already acquired resources
should be counted as part of the cost of future products and services. If these resources
have no alternative use or value (that is, they cannot even be sold to others), it does not
matter how much you paid for them, their opportunity cost is zero.
As a practical matter, however, many companies count the past payments for
resources as part of the cost of current and future products and services. Why? One reason is that measuring opportunity costs of all resources is too difficult, so organizations
assume that past purchase prices approximate current opportunity costs. Also, financial
and tax reporting rules in most countries, including Canada, require that assets be valued at book values, which are their purchase prices, net of accumulated depreciation or
amortization. More precisely: at the lower of book or market value. As those resources
are used, accounting for that use reduces these asset values by the amount of past costs
used. Thus, many organizations count the use, depreciation, depletion, and amortization of existing assets as costs of current and future products and services even though
these costs may be sunk costs or allocations of sunk costs. Another, less justifiable reason may be that managers are unwilling to admit that payments for resources have been
wasted, so they continue to value resources at their book value unless they are required
to write down the assets to a lower value.
Sunk costs.
Sunk costs are past
payments for resources
that cannot be undone
Chapter 4 Measuring Costs of Operations
Cost Classifications and Decision Making
Refer to Exhibit 4–6 and the preceding discussion. Put yourself in Glenn Penski’s position and respond to these comments from co-workers
(Solutions begin on page 135.)
121
You’re the
Decision
Maker 4.1
a. “I don’t see the need to develop complex measures of costs of our devices; average cost is fine.
We know our products are the best in the industry and we have long backlogs of orders. All we
need to do is make as many devices as we can and charge as much as we can for them.”
b. “You say that you have measured direct costs more accurately by tracing them to different
models, but it looks like they are just another average cost at the model level. How is that an
improvement over using overall average cost?”
c. Assume that CMD made 25 more of model 900B, increasing total production to 405 units for
the week. Direct material costs per unit remained as before for all models (e.g., C5, E5), as did
the sum of total conversion cost (F6) and indirect cost (F11). In other words, the only total cost
that increased was direct materials cost. What do these changes and lack of changes in the
various costs indicate about Glenn’s classifications of costs? Would allocated costs change?
Explain.
d. Are there any possible adverse effects of a decision to make 25 more of model #900B?
Alternative Costing Methods
If supplying and using resources result in different measures of costs, which costs
should managers use to solve the problem of how to generate the most profit from constrained capacity? This cost management issue is: Should managers base production
decisions on the profitability of products and services using costs of using resources or
costs of supplying resources?
There is considerable, unresolved controversy among managers, consultants, and
professors about this. Some argue that the answer is always to base production decisions on expected supply of unit-level resources since that mirrors the immediate cash
flow impacts of decisions. Others argue that costs of resource use, which often require
averaging of some past, committed, or indirect costs over units produced, are more effective, long-term measures of the profitability of production decisions because, after
these resources are used, they must be replaced. We will consider implications of both
arguments.
Consider Exhibit 4–8, which Glenn Penski prepared to analyze the costs of different models of CMD’s devices produced during the week. This exhibit uses the basic
cost information from Exhibit 4–6 (rows 1 through 12) but combines it in several different ways to create different measures of product cost—throughput cost, variable
cost, and absorption cost—newly added rows 13 through 15. For simplicity, the exhibit
shows details for only two of CMD’s seven models, #700A and #900B, because they
are most different in their use of resources.
LO2 Compare
alternative product costs
and their effects on
profits.
Throughput Costing
Those who argue that managers should base production decisions on resource supply
and use also argue that costs of products and services should be based on throughput
costing. Throughput costing measures only unit-level costs as the costs of products or
services. Advocates of throughput costing argue that adding any other indirect, past or
committed costs to product cost creates improper incentives to drive down the average
cost per unit by making more parts and assemblies on nonbottleneck processes. Since
these other costs are committed, making more units with the same level of resource
spending arithmetically reduces the average cost per unit and makes the production
Throughput costing
measures only the unitlevel spending for
direct costs as the costs
of products or services
Part II Cost Measurement Systems
122
Exhibit 4–8
Weekly Alternative Product Costs
A
B
1
Model
2
Quantity
D
#700 A
E
#900 B
48
3
4
C
40
Subtotal
Average
per Unit
Subtotal
Average
per Unit
$ 67,200
$ 1,400
$124,000
$ 3,100
38,400
800
44,000
1,100
105,600
2,200
168,000
4,200
Direct (variable) costs
5
Unit-level material cost
6
Variable conversion cost
7
Total direct costs
8
Indirect costs
9
Indirect production cost
277,894
5,790
231,579
5,790
10
Indirect operating cost
217,074
4,522
180,895
4,522
494,968
10,312
412,474
10,312
$600,568
$12,512
$580,474
$14,512
11
Total indirect costs
12
Total costs
13
Throughput cost per unit (C5; E5)
$ 1,400
$ 3,100
14
Variable cost per unit (C7; E7)
$ 2,200
$ 4,200
15
Absorption cost per unit (C7 E9; E7 E9)
$ 7,990
$ 9,990
Balancing production
prevents built-up of excess
inventories of cabinets in
process at all work stations.
process appear to be more efficient. Throughput costing avoids that incentive because
the cost per unit depends only on unit-level spending (e.g., costs of materials), not how
many units are made.8
Using throughput costing means that cost managers must distinguish between
(1) spending for resources that is caused by the decision to produce different levels of
products and services and (2)
use of resources that the organization has committed to supply, regardless of the level of
products and services provided. At CMD, Glenn Penski
determined that only the costs
of materials (row 5 of Exhibit
4–8) qualify as throughput
costs (row 13) because CMD
has committed, at least for the
time being, to supply all other
resources (manufacturing labor, equipment, management,
8
This statement ignores possible effects of gaining or losing quantity discounts on purchases by changing production levels. These effects usually are small, but they would be considered as a benefit or cost of
changing purchasing levels.
Chapter 4 Measuring Costs of Operations
facilities, and so on) regardless of how many measuring devices it makes. Throughput
costing considers all other indirect, discretionary, committed, or past spending for resources to be operating costs of the period. Note that some organizations may pay for
its labor force or other resources such as energy consumption on an hourly or piecerate basis depending on how many units of product are made. Because these resources
are supplied and used on an hourly or piece-rate basis, these would be unit-level costs
and product costs for throughput costing.
Bertch Cabinet Manufacturing, Inc., recently adopted synchronous manufacturing, which is a direct
application of the theory of constraints. The company credits this change with reducing cycle times,
reducing batch sizes, improving material flow, reducing and better-managing inventory, increasing
morale, and improving customer satisfaction. Bertch’s cost managers had developed a very complex costing system but decided to greatly simplify it by converting to throughput costing to be consistent with internal decision-making based on TOC. They defined throughput costs as payments to
external parties for raw materials, components, subcontracted work, sales commissions, transportation, and custom duties on international sales. This allows managers to accurately measure the
profit (or throughput) per unit of bottleneck resource for each product in the Bath Cabinet, Cultured
Marble Top, Kitchen Cabinet, and Semi-Custom divisions.
123
Operating costs of the
period are the total
costs of non-unit-level,
past, or committed
resources for all
products
Cost Management in
Practice 4.2
Source: J. MacArthur, “From Activity-Based Costing to Throughput Accounting.”
Variable Costing
Variable costing measures the cost of a product or service according to the resources
used to provide it. At CMD, Penski measured the variable costs of the company’s products in row 14 of Exhibit 4–8. Variable costs at CMD include the unit-level material
costs (row 5) and the variable conversion costs (row 6) that have been traced to the production of each product-model line. Thus, CMD’s variable costs are unit-level material costs plus variable costs of conversion resources used. At other organizations,
variable costs may include variable costs of production and sales, distribution, and
other used operating resources, the uses of which are traced to products and services.
Note the similarity between variable costing and throughput costing. The only difference is that variable product costs include traced costs of resources used even if additional spending is not required to supply the resource. As shown, CMD’s variable
costs include the (conversion) costs of its skilled laser-manufacturing technicians used
to make instruments even though CMD pays these technicians a salary.
Variable costing
measures the cost of a
product or service
according to the unitlevel resources used to
provide it
Absorption Costing
Absorption costing (full costing or full absorption costing9) allocates indirect production costs to products in addition to unit-level and variable production costs. Note
that because absorption costs conform to financial reporting rules, absorption costs do
not include nonproduction costs that may be unit-level or variable costs. Thus, absorption costs are variable production costs plus allocated indirect production costs. Observe that in some organizations absorption costs may not be a simple addition of
variable costs and allocated indirect costs because absorption costing distinguishes between production and nonproduction resources. Absorption costing counts any variable
costs that are from nonproduction resources as operating expenses. CMD’s situation is
simpler because all indirect, nonproduction costs are committed costs.
9
One cannot observe products consuming indirect resources, but accountants say the products absorb
the costs of indirect resources. Full absorption costing indicates that the full range of production costs is used
to measure the costs of products.
Absorption costing
(full costing or full
absorption costing)
allocates indirect
production costs to
products in addition to
unit-level or variable
production costs
Part II Cost Measurement Systems
124
Exhibit 4–9
Absorption Costs
Variable
Production
Costs
Costs of
direct and
indirect
production
resources
used to
provide units
of product or
service
+
=
Absorption
costs
Allocations of
costs of
indirect
production
resources not
traced to
products or
services
Absorption costing requires judgments or simplifying assumptions about how
products consume indirect production resources. There are many ways to implement
absorption costing. The simplest way would be to divide total indirect production costs
equally across all units of product produced, as CMD did in Exhibit 4–6 and as shown
in C9 and E9 of Exhibit 4–8.
Absorption costs (C15 and E15 of Exhibit 4–8) may be more accurate measures of
the consumption of production resources than either throughput or variable costs (rows
13 and 14) because absorption costs do recognize and contain indirect production
costs. However, just as the overall average cost may misstate product costs, by allocating indirect production costs, absorption costs may misstate consumption of indirect
production resources. It is possible that CMD’s product models use indirect production
resources to a different degree. Absorption costing also ignores products’ use of nonproduction resources. Thus, absorption costing actually may distort the costs to provide
products and services if they have greatly different levels of support from indirect resources. For example, one product may need much more engineering design support
than another, but allocations unrelated to resource use or treating the cost as an operating cost obscure this difference. Exhibit 4–9 shows that absorption costs are variable
production costs plus allocated indirect production costs.
Research
Insight 4.1
Global
Approximately 48 percent of Canadian companies use variable costing in their internal accounting
systems. For financial reporting purposes in Canada, the Canadian Institute of Chartered Accountants (CICA) Handbook advocates, but does not require, absorption costing. The Canada Customs
and Revenue Agency (CCRA) does not explicitly require absorption costing either. However, it does
require that firms be consistent for both financial statements and tax purposes. This results in most
firms using absorption costing for external reporting purposes.
For example, see S. Inoue, “A Comparative Study of Recent Development of Cost Management
Problems in U.S.A., U.K., Canada, and Japan,” C. Drury and M. Tayles, “Product Costing in UK
Manufacturing Organisations,” and E. Shim and E. Sudit, “How Manufacturers Price Products.”
Sources: CICA Handbook, Section 3030 CCRA Interpretation Bulletin No. 473
Chapter 4 Measuring Costs of Operations
Exhibit 4–10
125
Measures of Process Performance per Time Period
Costing Approach
Financial Measure
Throughput Costing
Variable Costing
Absorption Costing
Contribution to profit
Throughput Sales Unit-level cost (spent)
of goods sold
Contribution margin Sales Variable
costs (used) of goods sold
Gross margin Sales Absorption cost of
goods sold
Operating expense
Other costs incurred to
transform inventory
into throughput
Other costs incurred to
transform inputs into
completed products
and goods sold
Nonproduction costs
incurred to transform
inputs into completed
products and goods sold
Inventory
All costs used to acquire
objects for sale
Inventory (asset) turnover
Variable costs of
products in process or
completed but not sold
Inventory turnover
Full costs of products in
process or completed
but not sold
Inventory turnover
Throughput Operating
expense
Contribution margin Operating expense
Gross margin operating
expense
Operating income
Financial Management of Processes
Whether one is an advocate of throughput, variable, or absorption costing, there is general agreement that organizations should manage four financial measures of processes:
contribution to profit (per unit, product, and overall), operating expense, inventory, and
operating income.10 If these measures are designed properly (and this is a source of debate because of alternative ways of measuring costs), they will reinforce the proper
management of constrained resources to generate the most profit.
Exhibit 4–10 outlines the three different approaches to product costing and the corresponding financial measures of process performance. We discuss contribution to
profit, operating expense, and inventory calculations for each costing method separately. Then, we discuss operating income for the methods together because the contrasts are most interesting and demonstrate potential conflicts among the methods.
Exhibits 4–11, 4–12, and 4–13 present the financial measures of performance for
each costing method. To show the effects of different costing methods, these exhibits
assume that:
䊏
䊏
䊏
䊏
CMD produced 65 units of Model #900B but sold 40.
Consequently, twenty-five units of Model #900B were added to inventory.
The only spending increase was for direct cost because this increased production.
All other spending as shown in Exhibit 4–6 was unchanged.
All units of other models produced were sold.
Costs of the other models may be found by subtracting costs for #700A and #900B
from total costs. (Hint: If you have not worked through You’re the Decision Maker
4.1, it would be a good idea to do so now.)
10
CMD, like many other companies, uses nonfinancial measures of performance as well as these financial measures. Other chapters discuss this important aspect of measuring performance.
Part II Cost Measurement Systems
126
Throughput Costing
Throughput is sales
revenue less the
throughput cost of
goods sold, as the
contribution to profit
Exhibit 4–11
Contribution to profit. Throughput costing uses throughput, which is sales revenue
less the unit-level cost of goods sold, as the measure of contribution to profit. Rows 2–
8 of Exhibit 4–11 show the calculation of throughput for the week. Sales revenue in
row 3 had not been given before in this chapter, but this amount is the total revenue
earned from the sale of all products in the week. Information about the costs of products other than models #700A and 900B is given in this exhibit as well. Note that only
the direct material costs of the units that were sold are recognized as throughput cost of
goods sold. Row 5 counts the unit-level material cost of all 48 units of Model #700A
that were made and sold during the week. However, even though CMD made 65 units
of Model #900B, only the cost of the 40 units sold is recognized as cost of goods sold
(row 6). The cost of the other 25 units that were produced but not sold is added to inventory, as shown in subsequent rows of Exhibit 4–11. The unit-level material cost of
the 292 other model units made and sold also count as throughput cost of goods sold.
Subtracting the total cost of goods sold (C7) from sales revenue (C3) yields the week’s
throughput, C8.
Throughput Measures of Process Performance
A
1
(405 units produced, 380 units sold)
2
Contribution to profit
3
Sales revenue (given as additional information)
4
Throughput (unit-level) cost of goods sold
B
$7,600,000
5
Model 700A: 48 units $1,400 per unit (C2 C5, Exhibit 4–6)
6
Model 900B: 40 units $3,100 per unit (E2 E5, Exhibit 4–6)
7
All other models (F5 D5 B5, Exhibit 4–6)
9
$
67,200
124,000
643,600
Throughput (C3 C7)
8
C
834,800
6,765,200
Operating expense
10
Conversion costs (F6, Exhibit 4–6)
351,200
11
Indirect production costs (F9, Exhibit 4–6)
2,200,000
12
Indirect operating costs (F10, Exhibit 4–6)
1,718,500
4,269,700
13
14
15
Operating income Throughput Operating expense
(C8 C12 $6,765,200 $4,269,700)
$2,495,500
Ending assets (Throughput inventory)
Beginning assets, $2,700,000 (given as additional information)
Cost of goods completed, (48 $1,400 65 $3,100 $643,600)
Cost of goods sold, $834,800
$2,777,500
$2,777,500
Note: The increase of $77,500 in inventory is the unit-level cost
of the 25 units of Model #900B that were made but not sold
25$3,100.
16
Asset (Throughput inventory) turnover ratio Sales/Average
total assets $7,600,000 [ ($2,700,000 $2,777,500) 2 ]
2.77
Chapter 4 Measuring Costs of Operations
Managers would make decisions about best uses of capacity by comparing
throughputs of each alternative product mix, which is the relative proportions or numbers of products, for example, the number of Model #700A, Model #900B, and other
models produced. If a different product mix promised a higher total throughput, it
would be preferred to the mix shown in rows 5–7 of Exhibit 4–11. Proponents
of throughput costing say that only this approach is designed to identify the profitmaximizing product mix.
127
The product mix is the
relative proportions or
numbers of products
produced
In general, operating expense is all operating costs of the
period that are not counted in cost of goods sold or inventory. In throughput costing at
CMD, operating expense (C12) is all operating costs of the period other than materials
cost. Because costs of supplying these resources does not vary with levels of production, operating costs include conversion costs (B10), indirect production costs (B11),
and indirect operating costs (B12). If these are past or committed costs, some argue that
they can be ignored for the decision of choosing the best use of capacity. The product
mix that fully utilizes the bottleneck process and generates the highest expected
throughput is the best use of capacity.11 In concept, this approach to management appears to be mechanical and almost error-free. However, this approach also can have
shortcomings if it is applied naïvely or to large organizations as a whole.
Even if costs are correctly identified as throughput or operating expense, failing to
analyze operating costs could lead to treating them as fixed costs that cannot change.
In fact, the organization can and should analyze whether it can manage throughput and
operating costs more efficiently. In addition, choosing the overall product mix implies
centralized management, where a few managers direct the operations of an entire
organization. This may be feasible at a small company like CMD, but it has proved to
be unwieldy and ineffective in most large organizations. Centralized management usually is too slow and inflexible to meet new challenges. In order to compete more effectively, most large organizations have decentralized decision-making authority to
smaller business units or even to individual employees.
Operating expense is
all operating costs of
the period deducted
from revenues that are
not counted in cost of
goods sold or inventory
Centralized
management is the
direction of the
operations of an entire
organization by a few
managers
Inventory, in general, is the cost of materials and products either in
process or completed but not sold. In throughput costing, all costs (other than operating expense) of unsold resources that an organization had acquired are considered inventory (B15). This unusual definition of inventory indicates that all the resources of
the organization (normally termed assets—including land, buildings, and equipment)
are intended to generate goods for sale and are themselves potentially for sale. Note
that throughput costing still only counts unit-level costs as cost of goods sold, however.
The ending assets (throughput inventory in C15) for the week are computed as
shown in row 15 by adding changes in assets to the beginning assets. For simplicity, we
assume CMD made no net purchases or sales of other assets, so the only change in assets is the change in product inventory. That change is the cost of goods completed less
the cost of goods sold. CMD made 25 more units of Model #900B than it sold, so the
throughput cost of those units is the net increase to inventory.
A throughput measure of the use of inventories is the asset turnover ratio (C16),
which is sales revenue divided by average asset level. Since high levels of inventories
tie up scarce monetary and physical resources, low inventory levels are desirable.
However, there should be enough inventories on hand to allow for unforeseen variations in needs. Otherwise, bottleneck processes may not have parts and assemblies to
work with, and irreplaceable bottleneck time would be lost. These ratios are most useful as performance benchmarks. Increasing inventory turnover ratios over time indicates improved use of inventories, and vice versa. Comparing inventory turnover ratios
across organizations that use the same costing method indicates relative efficiencies of
Inventory is the cost of
materials and products
either in process or
completed but not sold
Operating expense.
Inventory.
11
Linear programming is a mathematical technique consistent with throughput costing that can be used
to select the mix of products that maximizes the contribution to profit subject to constrained resources.
Decentralized
decision-making is the
freedom of managers
at various levels of the
organization to make
decisions without
intervention from
corporate head office
The asset turnover
ratio is sales revenue
divided by average
asset level
128
Saturn’s “ski-lift” system
enables smooth flow of
automobiles through
processes.
Part II Cost Measurement Systems
the use of inventories. Inventory turnover ratios are not
comparable across different
costing methods since the
methods value inventories
differently.
Variable Costing
Contribution margin
is sales revenue less
variable costs of goods
sold
Work-in-Process
Inventory is measured
as the cost of materials,
labor, and other
production resources
added to products that
are not yet completed
Finished-Goods
Inventory is measured
as the production costs
used to make products
that have been fully
completed but not yet
sold
Exhibit 4–12 presents the variable-cost financial measures
of performance, also assuming
that CMD produced 65 units
of Model #900B but sold 40.
As before, only material-cost
spending increased with this increased production. All other spending as shown previously in Exhibit 4–6 was unchanged, and all other model units produced were sold.
Variable costing uses the contribution margin (C14), which is sales revenue (C3)
less variable costs of goods sold (C13), as the measure of contribution to profit. Variable cost of goods sold is calculated in rows 4 to 13 and includes unit-level materials
and variable conversion costs (and in other organizations any variable support and
marketing/distribution costs). The variable cost of goods sold (C13) is computed by
adding the unit-level material costs (C8), which are the same as in Exhibit 4–11, to the
variable conversion costs of Models #700A and #900B from Exhibit 4–6. These calculations appear in rows 10 and 11. To these we also add the variable conversion costs of
the other 292 units made and sold (B12) to obtain the total variable conversion cost
(C12). Note that the variable costs of the additional 25 units of Model #900B made but
not sold are added to inventory, as discussed later.
Using variable costs and the financial criterion of maximizing the contribution to
profit, managers would select the product mix that they expect to generate the highest
contribution margin (C14).
Operating expense. In variable costing, operating expense (C18) is all indirect costs
of the period, including both indirect production (B17) and indirect operating
costs (B18).
Note that the total amount of indirect production cost (B17) is $27,500 less than in
Exhibit 4–11. All costs must be accounted for. What happened to this amount of cost?
It is now part of cost of goods completed but not sold—added to inventory. The additional 25 units used an additional $27,500 of conversion resources ( 25 $1,100)
used and traced to the production of Model #900B. Previously for throughput costing
in Exhibit 4–11, the total amount of conversion cost is part of operating expense; none
of it was counted as a product cost. In contrast, for variable costing any variable cost
used is traced to units produced and counted as product cost, and only the unused portion of conversion cost is part of operating expense.
Inventory. In manufacturing organizations like CMD, variable (and absorption) costing methods measure three types of inventory resources or assets: materials, work-inprocess, and finished-goods inventories. Materials Inventory is measured at the
acquisition price of the materials (including purchase cost, transportation, etc.) available for use. Work-in-Process Inventory is measured as the cost of materials, labor,
and other production resources added thus far to products that are not yet completed.
Finished-Goods Inventory is measured as the production costs used to make products
that have been fully completed but not yet sold. All production costs first are accumulated in Work-in-Process Inventory. As items are completed, they are then transferred
to Finished-Goods Inventory. All beginning and ending inventories are related similarly as shown in the following equations:
Chapter 4 Measuring Costs of Operations
129
Ending Materials Beginning Materials Inventory Purchases
Inventory Materials used
Ending Work-in-Process Beginning Work-in-Process Inventory Inventory Costs added (materials, labor, etc.) Cost of
goods completed
Ending Finished-Goods Beginning Finished-Goods Inventory Cost
Inventory of goods completed Cost of goods sold.
Exhibit 4–12
Variable-Cost Measures of Process Performance
A
B
1
(405 units produced, 380 units sold)
2
Contribution to profit
3
Sales revenue (given as additional information; same as Exhibit 4–11)
4
Variable cost of goods sold
5
$7,600,000
Unit-level material costs (same as Exhibit 4–11)
6
Model 700A: 48 units $1,400 per unit (C2 C5, Exhibit 4–6)
7
Model 900B: 40 units $3,100 per unit (E2 E5, Exhibit 4–6)
124,000
8
All other models (F5 D5 B5, Exhibit 4–6)
643,600
9
$
67,200
834,800
Variable conversion costs
10
Model 700A: 48 units $800 per unit (C2 C6 in Exhibit 4–6)
38,400
11
Model 900B: 40 units $1,100 per unit (E2 E6 in Exhibit 4–6)
44,000
12
All other models (F6 D6 B6, Exhibit 4–6)
13
C
268,800
Total variable cost of goods sold (C8 C12)
1,186,000
Contribution margin (C3 C13)
14
351,200
6,414,000
15
16
Operating expense
17
Indirect production costs used (F9, Exhibit 4–6 less additional direct
conversion cost traced to #900B 25 $1,100 $27,500)
2,172,500
18
Indirect operating costs used (F10, Exhibit 4–6)
1,718,500
3,891,000
19
20
21
22
Operating income Contribution margin Operating expense C14 C18 $6,414,000 $3,891,000
$2,523,000
Ending inventory
Beginning inventory, $100,000 (given as additional information)
Cost of goods completed, [ 48 ($1,400 $800) ] [ 65 ($3,100 $1,100) ] [ $643,600 $268,800 ]
Cost of goods sold, $1,186,000
$205,000
Note: the increase in inventory of $105,000 is the variable cost
of the 25 units of Model #900B produced but not sold 25 ($3,100 $1,100).
$ 205,000
Inventory turnover ratio Cost of goods sold/Average inventory
$1,186,000 [ ($100,000 $205,000) 2 ]
7.78
130
The inventory
turnover ratio is the
cost of goods sold of
the period divided by
average total inventory
cost
Part II Cost Measurement Systems
In our example using CMD, we are assuming that all units begun during the week
are completed that week, so we can focus on Finished-Goods Inventory. Otherwise, we
would also compute ending Work-in-Process Inventory in a similar manner (this topic
is covered in a later chapter). The ending Finished-Goods Inventory is computed in
row 21 of Exhibit 4–12. To compute the inventory value, we add the variable conversion costs of the units made as well as the unit-level material cost. The increase in inventory value is the variable cost of the 25 units of Model #900B made but not sold
($105,000 25 $4,200).
In variable (and absorption) costing, the measure of efficient use of inventories is
the inventory turnover ratio, which is the cost of goods sold of the period divided by
average total inventory cost (C22). The inventory turnover ratio is most useful when
used as a benchmark over time, and against other organizations that use the same costing method. A higher or increasing level of this ratio indicates improved use of inventory resources.
Absorption Costing
Exhibit 4–13 presents the financial measures of performance for CMD during the week
using absorption costing. As before, CMD made 25 more units of Model #900B than it
sold that week. Only material cost spending increased, and all other units produced
were sold.
The gross margin is
sales revenue less
absorption cost of
goods sold
Absorption costing uses gross margin (C15), which is sales
revenue (C3) less absorption cost of goods sold (C14), as the contribution to profit. As
shown in Exhibit 4–13 (rows 4–14), absorption cost of goods sold is composed of variable and indirect production costs of units sold. In this example, the variable costs of
goods sold (C8 C13) are identical to the costs recognized in variable costing (Exhibit 4–12). To these variable costs CMD adds the indirect production costs allocated
to the units that were sold (C13). For simplicity, CMD allocates an equal amount of indirect production cost to each unit made. Row 13 of Exhibit 4–13 computes the average indirect cost per unit made ($2,172,500 405) and multiplies this amount by the
units sold to obtain indirect costs of units sold (C13). The total absorption cost of units
sold is in row 14. Subtracting the absorption cost of goods sold (C14) from sales revenue (C3) yields the gross margin (C15). Using this financial criterion, the product mix
with the highest expected gross margin is the best use of scarce resources.
Similar to the other costing methods, the product costs of the additional 25 units of
Model #900B that were made but not sold are added to inventory costs.
Contribution to profit.
In absorption costing, operating expense (C16) is all indirect,
nonproduction costs of the period. These typically include all costs of sales, marketing,
and administration.
Operating expense.
Absorption-costing inventories include all production costs (direct and indirect) that have been added to products that have not been sold. Row 18 of Exhibit
4–13 computes ending Finished-Goods Inventory by adding beginning inventory and
the cost of goods completed, then subtracting cost of goods sold. Cost of goods completed includes the variable material and conversion costs and indirect production cost
of all units produced. Cost of goods sold, however, is the absorption cost of only the
units sold. The increase in inventory is the absorption cost of the 25 units of Model
#900B that were produced but not sold. The inventory turnover ratio is computed in
row 19 by dividing sales revenue by the average, absorption cost inventory level.
Inventory.
Operating income is
the contribution to
profit less operating
expense, each defined
appropriately for the
costing method used
Comparing Operating Incomes
Operating income is the contribution to profit less operating expense, each defined
appropriately for the costing method used. It is instructive to see that differences in operating incomes across the methods are caused by whether conversion and indirect
production costs are counted as part of operating expense or as costs of the products.
Chapter 4 Measuring Costs of Operations
Exhibit 4–13
Absorption-Cost Measures of Process Performance
A
1
(405 units produced, 380 units sold)
2
Contribution to profit
3
Sales revenue (given as additional information)
4
Absorption cost of goods sold
5
B
Unit-level material costs (same as Exhibit 4–11 and 4–12)
Model 700A: 48 units $1,400 per unit (C2 C5, Exhibit 4–6)
7
Model 900B: 40 units $3,100 per unit (E2 E5, Exhibit 4–6)
124,000
8
All other models (292 units, F5 D5 B5, Exhibit 4–6)
643,600
$
67,200
Model 700A: 48 units $800 per unit (C2 C6 in Exhibit 4–6)
38,400
11
Model 900B: 40 units $1,100 per unit (E2 E6 in Exhibit 4–6)
44,000
12
All other models (292 units, F6 D6 B6, Exhibit 4–6)
13
Indirect production costs Indirect production cost per unit
produced units sold ($2,172,500 405) 380
15
268,800
Total absorption cost of goods sold
351,200
2,038,395
3,224,395
Gross margin (C3 C14)
16
Operating expense Indirect operating costs (F10, Exhibit 4–6)
17
Operating income Gross margin Operating expense C15 C16 $4,375,605 $1,718,500
18
834,800
Variable conversion costs (same as Exhibit 4–12)
10
14
C
$7,600,000
6
9
131
Ending inventory
Beginning inventory, $180,000 (given as additional information)
Cost of goods completed, [48 ($1,400 $800) ] [ 65 ($3,100 $1,100) ] $643,600 $268,800 2,172,500
Cost of goods sold, $3,224,395
$419,105
4,375,605
1,718,500
$2,657,105
$419,105
Note: the increase in inventory of $239,105 is the variable material
and conversion cost plus allocated indirect production cost of the
25 units of Model #900B produced but not sold
25 ($3,100 $1,100) ($2,172,500 405).
19
Inventory turnover ratio Cost of goods sold/Average inventory
$3,224,395 [ ($180,000 $419,105) 2]
These differences are at the heart of arguments in favor of using throughput costing because, with either variable or absorption costing, managers can increase operating income just by increasing production, without increasing sales, and by costing products
at more than spending for direct cost. Sounds strange? Read on.
Advocates of throughput costing argue that including costs of resources used that
already have been acquired or committed as costs of products distorts the cash flow of
production decisions. This can create an incentive to make more parts, assemblies, and
finished units than can be sold in order to spread these past, or committed, costs over
more output. This reduces the average cost per unit and, as will be shown, allows
managers to “hide” costs in inventory that otherwise would be charged as operating expense. Study how this works in Exhibit 4–14.
10.8
Part II Cost Measurement Systems
132
Exhibit 4–14
Reconciling Alternative Operating Income Measures
A
B
C
D
Conversion and Indirect
Cost Added to Inventory
1
Costing Method
Operating Income
Total Expense Recognized
(Costs of goods sold +
Operating expense)
2
Throughput
(Exhibit 4–11)
$2,495,500
(C14)
$5,104,500
(C7 C12)
0
3
Difference between
Throughput and Variable
$27,500
$(27,500)
$27,500
4
Variable
(Exhibit 4–12)
$2,523,000
(C20)
$5,077,000
(C13 C18)
$27,500 25 ($1,100)
5
Difference between
Variable and Absorption
$134,105
$(134,105)
$134,105
6
Absorption Costing
(Exhibit 4–13)
$2,657,105
(C17)
$4,942,895
( C14 C16)
$161,605 25 ($1,100 $2,172,500/405)
Operating income using each costing method is shown in the nonshaded rows of
column B of Exhibit 4–14. Observe that operating income for throughput costing is
$27,500 (B3) less than operating income with variable costing (compare B2 and B4).
Revenues are the same in each case, so to have higher operating income, variable costing must recognize $27,500 less total expense (C3) than throughput costing, as shown
in the comparison of C2 and C4. All costs must be accounted for, so what happened to
this $27,500 of cost in variable costing? Hint: It did not disappear; it’s only hiding.
Throughput costing treats only unit-level cost (e.g., material cost at CMD) as the
cost of a product, and all indirect conversion and other production costs are operating
expenses. With variable costing, however, the cost of each unit produced is measured
as material cost plus directly traced conversion cost. Therefore, the 25 unsold units of
Model #900B that are in inventory waiting to be sold add $27,500 of conversion cost
beyond the material cost of those unsold units to inventory cost (see D4). The mystery
of the missing cost is solved! Using variable costing rather than throughput costing,
CMD could “store” $27,500 of conversion cost in inventory. This reduces total expenses and increases operating income by that same amount. But wait. For a more dramatic effect, consider what happens if CMD uses absorption costing.
Exhibit 4–14 demonstrates that variable-costing operating income (B4) is
$134,105 less (B5) than absorption-costing operating income (B6). Comparing total
expenses in column C shows that absorption costing (C6) recognizes $134,105 less
(C5) total expense than variable costing (C4), as you would expect since revenues are
the same. Is it coincidental that these differences (B5 and C5) between the operating incomes and expenses of variable and absorption costing are the exactly the same as the
additional inventory cost (D5) between the two methods? Not at all.
How absorption costing treats indirect conversion and other production costs also
explains the difference between the operating incomes of variable costing (B4) and absorption costing (B6). In this case, absorption costing adds a total of $161,605 of conversion and indirect cost (D6) to inventory for the 25 unsold units, which is $134,105
more indirect cost beyond the conversion cost added by variable costing (D4). Adding
the 25 unsold units to inventory stores an additional $134,105 (D5) of indirect production cost [ 25 ($2,172,500/405) ] that variable costing recognized as an expense of
the period [ and $161,605 more ($27,500 $134,105) compared to throughput costing]. Therefore, absorption-costing operating income is $134,105 higher (B5) than
variable-costing operating income and $161,605 higher than throughput-costing operating income (B5 B3).
Chapter 4 Measuring Costs of Operations
133
What is more, that amount of conversion and indirect cost (D6) (plus the unit-level
material cost, too) will stay in inventory until the units are sold or discarded as obsolete, at which time the entire cost of the units will be an expense or loss. In the meantime, valuable resources will be tied up in inventory and incentives to overuse capacity
will be reinforced. This is why proponents of throughput costing argue so strongly
against traditional accounting methods, which count more than the cost of unit-level
spending (e.g., materials) as product cost. If only unit-level cost is counted as product
cost, managers cannot reduce average costs of committed or past resource spending by
increasing production, and they cannot “hide” these costs in inventory by making more
than they can sell.12
Analyses of Alternative Production Decisions
Refer to Exhibits 4–11 through 4–14 and the preceding discussions.
Exhibits 4–11 through 4–14 assume that 405 units were made in the week, but only 380 were
sold. The unsold products were 25 units of Model #900B. Respond to the following assuming that
430 units were produced but still only 380 were sold. Also and as before, only material cost spending increased. The unsold 50 units were again Model #900B.
(Solutions begin on page 136.)
a. Recalculate throughput (C8) in Exhibit 4–11.
b. Recalculate operating expense (C12) and operating income (C14) in Exhibit 4–11.
c. Recalculate inventory (C15) and the asset turnover ratio (C16) in Exhibit 4–11.
d. Recalculate contribution margin (C14) in Exhibit 4–12.
e. Recalculate operating expense (C18) and operating income (C20) in Exhibit 4–12.
f.
Explain the difference between these two revised measures of operating income as in
Exhibit 4–14.
g. Without computing the elements of operating income in Exhibit 4–13, compute the difference
between operating income using variable costing and absorption costing. (Hint: What is the
difference in how indirect costs are treated?)
Chapter Summary
Some organizations use only full, absorption costs per unit for decision-making for several reasons:
䊏
䊏
Most organizations already prepare absorption cost information because it is used for financial
and tax reporting in most countries. Canadian companies tend to follow this practice. It may
be difficult to justify the cost of yet another set of information based on unit-level costs, when
everyone is pressured to reduce costs of all kinds.
Managers may be evaluated on the financial performance that is reported publicly (using absorption costing under generally accepted accounting principles), and they may prefer to make
decisions that will be compatible with reported performance.
Some managers, consultants, and professors also feel that absorption costs per unit are better
measures of the long-term use of all resources than throughput or variable costs because absorption
costs explicitly recognize that indirect resources are needed to provide products and services. Particularly in decentralized organizations, they fear that indirect resources will “fall through the
cracks” if they are not allocated to products in a visible way. If nothing else, managers can complain that the organization must be spending too much on indirect resources if they perceive that allocations make absorption costs per unit too high.
Proponents of throughput costing argue that, not only are other methods inaccurate and misleading, they encourage managers, who want to avoid idle capacity, to fully use all the capacity in
every process in order to drive down the average cost per unit. The result could be similar to what
Glenn Penski found early in his analysis of CMD’s production processes—stacks and shelves of
12
Substantial additional coverage of the income-reporting effects of variable and absorption costing is
provided in Section 3 of Chapter 18 (pp. 788–797), which may be studied now. The appendix to Chapter 18
(pp. 800–802), which covers the effect of the fixed-overhead volume variance on reported income under
variable and absorption costing, should be read after completing Chapters 16, 17 and 18.
You’re the
Decision
Maker 4.2
Part II Cost Measurement Systems
134
unneeded and probably obsolete parts and assemblies that filled every available space in the production area and warehouse.
Making more products with the same level of spending for capacity does reduce the average
cost of resources supplied per unit. However, if these additional products could not be sold, this
apparent cost reduction per unit is an illusion because scarce resources were wasted and tied up in
inventory. Furthermore, if salespeople believe they can drop prices because absorption costs per
unit are lower, the organization may lose doubly if overall profits decline. If using absorption costs
per unit motivates employees to make more product than can be sold, and many argue that it does,
absorption costing works directly against the objective to use nonbottleneck processes only as
much as needed to keep the bottleneck fully employed. Critics of absorption costing argue that,
even though it is required for external reporting, it should be avoided completely for decisions
about the uses of constrained capacity.
Absorption costing produces per-unit production costs that look like (but are not) unit-level
costs. These total production costs per unit will drop as more units are produced and indirect costs
are spread more thinly across them. If managers or production supervisors are evaluated in part on
reducing unit costs, absorption costing creates incentives to build as many parts, subassemblies, or
products as possible every day by increasing capacity utilization, regardless of whether additional
final products can be sold. To reduce incentives that build up inventories or reduce unit costs,
throughput costing advocates argue that products should be valued at only their unit-level costs. All
other costs are treated as inventories or operating costs.
Key Terms
Key Terms
absorption costing (full or
full absorption costing, 123
actual costs, 115
asset turnover ratio, 127
average cost, 116
centralized
management, 127
committed cost, 120
contribution margin, 128
conversion resources, 109
cost, 114
cost allocation, 118
cost of resources
supplied, 115
cost of resources used, 115
costing system, 112
decentralized decisionmaking, 127
direct resources, 110
discretionary cost, 120
expected costs, 115
finished-goods
inventory, 128
fixed cost, 119
gross margin, 130
indirect resources, 111
inventory, 127
Meeting the Cost Management
1.
inventory turnover
ratio, 130
materials resources, 108
nonproduction
resources, 109
operating costs, 123
operating expense, 127
operating income, 130
out-of-pocket costs, 115
period costs, 115
product costs, 115
production resources, 109
product mix, 127
resources supplied, 111
resources used, 111
sunk cost, 120
throughput, 126
throughput costs,
throughput costing, 121
total cost, 115
tracing costs, 117
unit-level cost, 118
variable cost, 118
variable costing, 123
work-in-process
inventory, 128
Challenges
How can cost managers measure the financial results
of operations in a way that reinforces proper use of
resources?
Organizations should strive to use their resources wisely to
achieve their goals. For profit-seeking firms, that means managing scarce resources to produce a competitive level of
profit. For manufacturing firms this also means not wasting
resources by building up inventories that cannot be sold in a
reasonable amount of time. How financial results are measured can affect the management of resources. For example, if
managers are rewarded for reducing average costs and increasing short-term profits, then they may have incentives to
overuse capacity and build up inventories, which could increase the current period’s profit. This also could affect future
periods’ profit adversely, however, by requiring a write-down
of obsolete inventory.
2.
How can alternative methods of calculating product
costs create different incentives?
Again, if managers of manufacturing companies are rewarded
on the basis of profits (this is very common), how product
costs are calculated can affect incentives to produce more
parts, assemblies, and products than can be sold. Specifically,
variable costing and absorption costing add costs of resources
used to products without considering whether spending to
supply resources is affected. Levels of spending for some resources may be unaffected by how those resources are used
(e.g., salaries or rent). Making more units with the same capacity reduces the average cost of products produced. Since
the costs of products are held in inventory until the products
are sold, these costs also can be “hidden” in inventory. Using
throughput costing, only spending for resources is counted as
costs of products, and all other costs are expensed. Average
product costs cannot be reduced and profits increased merely
Chapter 4 Measuring Costs of Operations
by making more products than can be sold. Therefore, proponents argue, throughput costing alone aligns financial incentives of managers with the objective of using resources wisely.
3. How should cost managers measure costs for internal
decision making?
Though the previous discussion indicates that the answer should
be straightforward (i.e., use throughput costing), this actually is
a difficult question to answer outside the context of a specific
organization. Most organizations are required to use absorption
costing for financial and tax reporting. Therefore, whether to
use a different costing method internally depends on whether
the benefits (i.e., making better productive decisions) outweigh
the costs of an additional costing system. Though it may seem
Solutions to
4.1
a.
intuitively obvious that managers should make better productive decisions using throughput costing, there is remarkably little reliable research that indicates that better decisions really
result. The lack of research might be attributed to the newness
of throughput costing and the reluctance of organizations that
have successfully employed it to give away a source of competitive advantage. But it also may be that using absorption costing
is beneficial in complex organizations because it makes sure
that indirect costs are not forgotten in production and pricing
decisions. It also may be that the costs of using additional internal information are greater than the benefits. Though improvements in costing practices are always possible and should be
explored, it is a bit arrogant to assert that all firms using absorption costing for internal purposes are making a mistake.
You’re the Decision Maker
Cost Classification and Decision
Making, p. 121
c.
There are several problems with relying on average costs.
First, if there is great variety among products, it is difficult to determine how to use scarce capacity without reliable measures of profitability. Second, if prices are based
on costs, CMD may be charging too much for devices
whose costs are lower than average, and charging too little for devices with costs above average. Customers probably would demand more of the high-cost devices, but
their low prices mean that profits would be low (or negative). Likewise, customers would not buy the low cost devices, perceiving that they are overpriced.
It is true that most cost systems measure model costs in
total and then divide by the number of units of each
model. This makes the calculation of unit cost an average. However, the natural variation in cost within product
models is probably much less than the production cost
across all models. Therefore, the unit-level costs by
model should be more accurate than an overall average
cost.
b.
135
A
1
Model
2
Quantity
3
Direct costs
4
Direct material cost
5
Direct conversion cost
B
C
It is important to observe that total conversion and operating costs did not vary when production levels changed.
This indicates that they are not caused by changes in production, and they are likely to be indirect resources with
excess capacity.
The most likely change in the cost table would be
that some indirect production cost would be allocated to
Model #900B to reflect the additional conversion capacity used, as shown in the spreadsheet at the bottom of the
page.
The changes caused by increasing production of
Model #900B ripple through the costs of all the other
products made. Let’s consider them in turn.
1. Increasing production of #900B to 65 units for the
week causes $71,500 conversion cost to be traced
to the production of #900B (D5 E2 E5 65
$1,100). Compare this to the $44,000 traced to
this product when 40 units are made (Exhibit 4–6).
The additional conversion cost of $27,500 ($71,500
$44,000) traced to the product reduces the indirect production cost, which includes the cost of
D
#700A
Per Unit
F
#900B
48
Total
E
All Models
65
Total
Per Unit
G
405
Total
Per Unit
$67,200
$1,400
$201,500
$3,100
$912,300
$2,253
38,400
800
71,500
1,100
378,700
935
6
Total direct costs
105,600
2,200
273,000
4,200
1,291,000
3,188
7
8
9
Indirect costs
Indirect production cost
Indirect operating cost
257,481
203,674
5,364
4,243
348,673
275,809
5,364
4,243
2,172,500
1,718,500
5,364
4,243
10
Total indirect costs
461,155
9,607
624,482
9,607
3,891,000
9,607
11
Total costs
$566,755
$11,807
$897,482
$13,807
$5,182,000
$12,795
136
d.
4.2
a.
Part II Cost Measurement Systems
reserve and excess capacity, by the same amount:
F8 $2,172,500, which is $27,500 less than the
corresponding figure in Exhibit 4–6.
2. This change does not affect the direct costs per unit
of any of the products, but, of course, the total direct cost increases to reflect the increased direct
costs used to make more Model #900B. That is, F6
is higher than the corresponding figure in Exhibit
4–6 by the amount of direct cost to make 25 units
more of Model #900B [ 25 $4,200(E6) $105,000 $1,291,000 (F6) $1,186,000 (from
Exhibit 4–6) ].
3. The reduced total indirect production cost (F8) is
divided by the increased total number of units produced (G2 405) and results in a lower average
indirect cost per unit (G8 F8/G2). The overall increase in units produced also reduces the average
indirect operating cost per unit (G9 F9/G2) allocated to all units made.
4. The net effect of making 25 more units of Model
#900B is to reduce the average cost of all units
made (G11 $12,795) by $638 [ $13,433 (from
Exhibit 4–6) $12,795 ].
There are several adverse effects to expect. First, because
resources have been tied up by building products that
may not be sold, fewer resources are available for other,
more productive purposes. Second, if Model #900B is
subject to rapid obsolescence, the 25 extra units may
never be sold, or must be sold at steep discounts. Third, if
this is overuse of capacity, it sets bad precedent for the
rest of the company, and it will be difficult to prevent
other product teams from doing the same.
Analyses of Alternative Production
Decisions, p. 133
b.
c.
d.
e.
This is another trick question since operating expense in
throughput costing also does not change if material cost
is the only cost that changes.
Inventory does change because 25 more unsold units, a
total of 50, were produced and placed in inventory. Inventory will increase by another 25 $3,100 $77,500
to a total of $2,777,500 $77,500 $2,855,000. The inventory turnover ratio will be $7,600,000/[ ($2,700,000
$2,855,000)/2 ] 2.73, a decline that reflects the increase in inventory without an increase in sales. Recall
that in throughput costing the numerator is sales revenue,
but in the other costing methods the numerator is cost of
goods sold.
This is yet another trick question, because contribution
margin depends on the cost of goods sold. As long as
variable costs per unit do not change, the contribution
margin will remain the same because the units sold remain the same.
Finally, a change because some of the indirect production
cost has been traced to the additional units produced.
Operating expense Indirect conversion
($2,200,000 50 1,100) Operating costs
(unchanged) $2,145,000 $1,718,500
$3,863,500
Operating income Contribution margin
operating expense $6,414,000 $3,863,500
$2,550,500
f.
Costing
Method
Throughput Costing
Difference
Variable Costing
g.
This is a trick question; throughput does not change with
production. It only changes with sales.
Operating
Income
Conversion Cost
Added to Inventory
$2,495,500
$55,000
$2,550,500
$0
$55,000
$55,000 50 ($1,100)
The difference is the amount of additional indirect cost
added to inventory using full costing. The difference 50 ($2,145,000/430) $249,419, and absorption-cost
operating income will be $249,419 higher because that
much additional cost is hidden in inventory using absorption costing rather than expensed as in variable costing.
Review Questions
4.1
4.2
4.3
4.4
4.5
Distinguish among material resources, conversion
resources, and operating resources.
Distinguish between production and nonproduction
resources. Give examples of each.
Explain the concept of traceability and how it is used to
classify resources as direct or indirect.
Is a resource always either direct or indirect? Explain.
Define and give an example of each of the following
costs:
a. Opportunity cost
b. Out-of-pocket cost
c. Product cost
d. Period cost
e. Direct cost
f. Indirect cost
4.6
4.7
4.8
4.9
4.10
4.11
4.12
What is a unit-level cost? How does it differ from
average cost? How does it differ from variable cost?
How is tracing costs different from allocating costs?
Are committed or discretionary costs the same as
fixed or sunk costs? Explain.
How does throughput costing differ from variable or
absorption costing?
What are the four measures commonly used for the
financial management of processes? Describe each
briefly.
What are the differences among throughput,
contribution margin, and gross margin?
Explain how absorption costing can create an
incentive to make more products than can be sold.
Chapter 4 Measuring Costs of Operations
137
Critical Analysis
4.13 Evaluate this statement: “Issues of product costing are
irrelevant for service organizations, since they cannot
build up inventories of services, and all costs of
providing services are expensed in the period they are
used. Service firms effectively use throughput
costing.”
4.14 Evaluate this statement: “Issues of product costing are
unimportant for virtual organizations that outsource
production operations.”
4.15 Prepare a diagram that illustrates how the following
resources—headquarters, facilities, division managers,
information systems personnel—can be considered
both direct and indirect in a company that has four
operating divisions, which each provide multiple
services.
4.16 Respond to this comment from an economist friend:
“You cost managers use an overabundance of cost
terms to cover up the fact that you really do not
understand opportunity costs and to create jobs for
yourselves based on unintelligible jargon. Not that
that’s a bad thing.”
4.17 Respond to this observation: “So, there really is no
fundamental difference between tracing costs and
allocating costs. The only difference is the degree of
accuracy with which you want to trace costs.”
4.18 Help a friend develop an answer to his questions:
“Help me out. It seems that the difference between
throughput costing and variable costing depends on the
difference between when resources are paid for and
when they are used. Isn’t throughput costing just
another tactic for replacing accrual accounting with
cash-flow accounting? Accrual accounting has been
used for centuries; how can it suddenly be bad for
business?”
4.19 A colleague challenges you: “What do you mean there
is no such thing as a fixed cost? Pick up any
microeconomics or cost accounting book, and you will
see the term used all the time. We have lots of fixed
costs in our organization, don’t we? What about your
salary and the depreciation of your computer? Why do
you want to replace fixed cost with committed cost?”
4.20 Individually or as a group, develop written arguments
for and against the following proposition: “The
company needs to use absorption costing for financial
and tax reporting. We make so many products in so
many places that it would be too expensive to develop
a separate accounting system based on throughput
costing in addition to the system we are required to
have. The way to keep divisions from making more
than they can sell is to charge them interest on any
inventories they maintain. If divisions want to tie up
the company’s resources in inventory, then they should
pay the company at least the interest it could be
earning if the treasurer had the same amount of cash.”
Be prepared to present your arguments.
4.21 Explain how making more products than can be sold in
a period can increase the operating income of the
organization. Is this a sustainable tactic to increase
operating income? Would this happen in a service
company, or is it only an issue in manufacturing
companies? Explain.
[CMA Adapted]
4.22 Respond to this comment: “Your analysis of last
month’s financial performance demonstrates that it
really doesn’t matter whether we use throughput,
variable, or full costing. All the costs are accounted
for; you have just put them in different places. I cannot
see what real difference this analysis makes. Isn’t this
just a bean-counting exercise?”
4.23 Evaluate this criticism of financial management of
processes: “All this emphasis on operating income,
regardless of how you measure it, contributes to our
continuing, short-term outlook. If we only focus on
operating income, managers will do whatever they can
to increase that measure, regardless of long-term
impacts. This is what is wrong with modern business.
We need to look beyond this period’s operating income
and focus on the long-term.”
Exercises
Compute throughput product cost of goods sold, throughput, and operating income from the following data for each month. Note the relationship between variable and indirect conversion costs.
Beginning inventory units . . . . . . . .
Units produced . . . . . . . . . . . . . . . .
Units sold . . . . . . . . . . . . . . . . . . . .
Sales . . . . . . . . . . . . . . . . . . . . . . .
Material cost . . . . . . . . . . . . . . . . . .
Direct conversion cost used . . . . . .
Indirect conversion cost . . . . . . . . .
Indirect operating cost . . . . . . . . . .
Month 1
Month 2
Month 3
0
500
500
$50,000
$10,000
$12,000
$ 8,000
$16,000
0
600
500
$50,000
$12,000
$14,400
$ 5,600
$16,000
100
400
500
$50,000
$ 8,000
$ 9,600
$10,400
$16,000
Exercise 4.24
Throughput Costing
(LO 1)
138
Part II Cost Measurement Systems
Exercise 4.25
Variable Costing
(LO 2)
Refer to the data in exercise 4.24. Compute variable cost of goods sold, contribution margin, and
operating income. Why is operating income different from one month to the next?
Exercise 4.26
Absorption Costing
(LO 2)
Refer to the data in exercise 4.24. Compute absorption cost of goods sold, gross margin, and operating income. Why is operating income different from one month to the next?
Exercise 4.27
Throughput Costing
(LO 2)
Compute throughput cost of goods sold, throughput, and operating income from the following data
for each month. Note the relations between variable and indirect conversion and operating costs.
Month 1
Beginning inventory units . . . . . . . . . . . . .
—
Units produced . . . . . . . . . . . . . . . . . . . . .
1,750
Units sold . . . . . . . . . . . . . . . . . . . . . . . . .
1,750
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $220,500
Material cost . . . . . . . . . . . . . . . . . . . . . . .
57,750
Direct conversion cost used . . . . . . . . . . .
49,000
Direct operating cost used . . . . . . . . . . . .
12,250
Indirect conversion costs . . . . . . . . . . . . . .
23,000
Indirect operating costs . . . . . . . . . . . . . . .
67,750
Month 2
—
1,900
1,750
$220,500
62,700
53,200
12,250
18,800
67,750
Month 3
150
1,600
1,750
$220,500
52,800
44,800
12,250
27,200
67,750
Exercise 4.28
Variable Costing
(LO 3)
Refer to the data in exercise 4.27. Compute variable cost of goods sold, contribution margin, and
operating income. Why is operating income different from one month to the next?
Exercise 4.29
Absorption Costing
(LO 4)
Refer to the data in exercise 4.27. Compute absorption cost of goods sold, gross margin, and operating income. Why is operating income different from one month to the next?
Exercise 4.30
Throughput Costing
(LO 1)
Compute throughput cost of goods sold, throughput, and operating income from the following data
for each month. Note the relation between variable and indirect conversion and operating costs.
Month 1
Beginning inventory units . . . . . . . . . . . . .
—
Units produced . . . . . . . . . . . . . . . . . . . . .
1,725
Units sold . . . . . . . . . . . . . . . . . . . . . . . . .
1,725
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $232,875
Material cost . . . . . . . . . . . . . . . . . . . . . . .
82,800
Direct conversion cost used . . . . . . . . . . .
36,225
Direct operating cost used . . . . . . . . . . . .
18,975
Indirect conversion costs . . . . . . . . . . . . . .
32,775
Indirect operating costs . . . . . . . . . . . . . . .
36,225
Month 2
Month 3
—
2,070
1,725
$232,875
99,360
43,470
18,975
25,530
36,225
345
1,380
1,725
$232,875
66,240
28,980
18,975
40,020
36,225
Exercise 4.31
Variable Costing
LO 2
Refer to the data in exercise 4.30. Compute variable cost of goods sold, contribution margin, and
operating income. Why is operating income different from one month to the next?
Exercise 4.32
Absorption Costing
LO 3
Refer to the data in exercise 4.30. Compute absorption cost of goods sold, gross margin, and operating income. Why is operating income different from one month to the next?
Problems
Problem 4.33
Production Costs
(LO 1)
Integer Peripherals, Inc. is a manufacturer of computer data storage devices. Its Atlantic division
designs and assembles the MicroDrive, designed for laptop computers. You have gathered the following data for the MicroDrive for a recently completed month.
Chapter 4 Measuring Costs of Operations
139
INTEGER PERIPHERALS, INC.
Summary of Operations
MicroDrive Division
February
($000)
Account balances
Inventories (all), Feb. 1 . . . . . . . . . . $225
Other assets, Feb. 1 . . . . . . . . . . . . 550
Total assets, Feb. 1 . . . . . . . . . . . . . $775
Inventories (all), Feb. 28 . . . . . . . . . $290
Other assets, Feb. 28 . . . . . . . . . . . 540
Total assets, Feb. 28 . . . . . . . . . . . . $830
Transactions
Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Materials purchased . . . . . . . . . . . . . . . . . . . . . . . . .
480
Materials used . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
445
Variable manufacturing labor used . . . . . . . . . . . . . .
200
Indirect production costs
Depreciation on manufacturing building
and equipment . . . . . . . . . . . . . . . . . . . . . . . .
180
Manufacturing supervisory salaries . . . . . . . . . . . .
50
Manufacturing overhead . . . . . . . . . . . . . . . . . . .
525
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,750
Indirect operating costs
Marketing costs . . . . . . . . . . . . . . . . . . . . . . . . . . .
440
Administrative costs . . . . . . . . . . . . . . . . . . . . . . . .
570
Required
a.
Compute the cost of goods sold using:
(1) Throughput costing
(2) Variable costing
(3) Absorption costing
Compute contribution to profit, operating expense, and operating income using each costing
method.
Demonstrate why operating income is different using each costing method.
Compute the inventory turnover ratio using each costing method. Are these ratios
comparable? Explain.
b.
c.
d.
CMD, Inc. has collected the following production information.
A
1
Model
2
Quantity
B
C
#700 A
E
F
#900 B
60
3
4
D
Problem 4.34
Product Costs
(LO 1)
G
All Seven Models
28
380
Subtotal
Average
per Unit
Subtotal
Average
per Unit
Subtotal
Average
per Unit
$ 84,000
$ 1,400
$ 86,800
$ 3,100
$ 814,400
$ 2,143
48,000
800
30,800
1,100
347,600
915
132,000
2,200
117,600
4,200
1,162,000
3,058
Direct costs
5
Direct material cost
6
Direct conversion cost
7
Total direct costs
8
Indirect costs
9
Indirect production cost
347,937
5,799
162,371
5,799
2,203,600
5,799
10
Indirect operating cost
271,342
4,522
126,626
4,522
1,718,500
4,522
619,279
10,321
288,997
10,321
3,922,100
10,321
$751,279
$12,521
$406,597
$14,521
$5,084,100
$13,379
11
Total Indirect costs
12
Total costs
Part II Cost Measurement Systems
140
Required
a.
Explain how changing the product mix (C2 and E2) from that in Exhibit 4–6 changes the
highlighted numbers in this spreadsheet from the corresponding numbers in Exhibit 4–6.
Calculate throughput cost, variable cost, and absorption cost for models #700A and #900B.
Compare the costs in part “b” with those computed in Exhibit 4–6. Explain any differences.
b.
c.
Problem 4.35
Operating Income
(LO 2)
Refer to the production information in the table for the previous problem and the additional sales
information below.
Sales revenue . . . . . . . . . . . . . . . . . . . $6,400,000
Sales of Model 700A . . . . . . . . . . . . .
50 units
Sales of Model 900B . . . . . . . . . . . . .
20 units
Sales of five other models . . . . . . . . . .
270 units
Total . . . . . . . . . . . . . . . . . . . . . . . .
340 units
Required
a.
Compute contribution to profit, operating expense, and operating income using
(1) Throughput costing
(2) Variable costing
(3) Absorption costing
Explain the differences between each pair of operating income measures.
b.
GPS, Inc., has collected the following information for production of its two products for a recent
year.
Problem 4.36
Product Costs
(LO 1)
A
B
1
Models
2
Quantities produced and sold
3
Direct costs
Direct materials costs
5
6
E
3000 XL
12,000
Total
G
Total
9,000
Per Unit
F
21,000
Per Unit
Total
Per Unit
$589,740
$36.91
Direct conversion costs
45,200
148,500
9.22
Direct operating costs
39,600
41,200
3.85
270,244
779,440
$50.00*
Total direct costs
8
Indirect costs
Indirect conversion costs
10
D
$185,444
7
9
1500 XS
Total
4
C
Indirect operating costs
11
Total indirect costs
12
Total cost
$3,568,000
2,789,000
6,357,000
$7,406,684
*rounded
GPS, Inc., traces direct material to products produced. Though GPS pays its highly skilled workforce
on a salary basis, the company traces direct conversion costs to products produced. GPS also traces
direct operating costs, which is 40 percent packaging materials and 60 percent distribution labor to
products sold. Conversion and operating costs in total (direct plus indirect) do not vary with units produced. For financial reporting purposes, GPS allocates indirect conversion costs to products on an
equal, per-unit basis. Untraced conversion and operating costs are expensed in the period.
Chapter 4 Measuring Costs of Operations
141
Required
a.
b.
c.
d.
Fill in the highlighted, blank cells (Hint: Create a computer spreadsheet to solve this
problem. Another hint: When you complete the spreadsheet, the highlighted cells should
contain formulas that reference appropriate numbers but should not contain any number
themselves. For example, C4 B4/B2).
Compute the following costs per unit for each product model:
(1) Throughput cost
(2) Variable cost
(3) Absorption cost
Compute the effects on product costs in part “b” of changing the product mix to 12,000 units
of each product produced and sold.
Is there anything wrong with the attitude, “The board of directors sets the incentive plan, and
I am just playing by the rules. The rules don’t say anything about how many units I should
produce.” If managers are evaluated on annual, externally reported operating profit, as
computed in part b(3) above, comment on the ethics of knowingly producing more units than
can be sold in a period.
Refer to the previous problem and the additional information below.
Model 1500XS
Model 3000XL
Total
9,000
8,000
21,000
19,000
$8,400,000
Units produced . . . . . . . . . . . 12,000
Units sold . . . . . . . . . . . . . . . 11,000
Sales revenue . . . . . . . . . . . .
Problem 4.37
Operating Income
(LO 2)
Required
a.
b.
Compute contribution to profit, operating expense, and operating income using:
(1) Throughput costing
(2) Variable costing
(3) Absorption costing
Explain the differences between each pair of operating income measures.
Hathaway Company uses variable costing for internal management purposes and absorption costing for external reporting purposes. Thus, at the end of each year, financial information must be
converted from variable costing to absorption costing for external reports. At the end of last year,
management anticipated that sales would rise 20 percent this year. Therefore, production was increased from 20,000 units to 24,000 units. However, economic conditions kept sales volume at
20,000 units for both years.
The following data pertain to the two years:
Last Year
This Year
Selling price per unit . . . . . . . . . . . . . . . . . . . $
60
Sales (units) . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Beginning inventory (units) . . . . . . . . . . . . . .
2,000
Production (units) . . . . . . . . . . . . . . . . . . . . . 20,000
Ending inventory (units) . . . . . . . . . . . . . . . .
2,000
Unapplied variable overhead . . . . . . . . . . . . $10,000
$ 60
20,000
2,000
24,000
6,000
$8,000
Variable cost per unit for both years was composed of the following:
Conversion . . . . . . . . . . . . . . . . .
Materials . . . . . . . . . . . . . . . . . . .
$21
9
Total . . . . . . . . . . . . . . . . . . . .
$30
Indirect costs for each year follow:
Production . . . . . . . . . . . . . . . . . $600,000
Selling and administrative . . . . . . 200,000
Total . . . . . . . . . . . . . . . . . . . . $800,000
Problem 4.38
Conversion of Variable
to Absorption Costing
(LO 2)
Communication
142
Part II Cost Measurement Systems
Conversion costs are production costs that are traced directly to products as resources are used.
Untraced indirect cost is expensed in the period. Absorption costing allocates indirect production
costs per unit based on a denominator volume of 20,000 units for each year.
Required
Use the preceding data to complete the following:
a.
b.
c.
Present the income statement for this year based on variable costing for this year.
Present the income statement for this year based on absorption costing for this year.
Write a short report to management that explains the difference, if any, in the operating
profit figures.
[CMA Adapted]
Problem 4.39
Effect of Changes in
Production and Costing
Method on Operating
Profit
(LO 3)
Communication
(This classic problem is based on an actual company’s experience.) Brassinni Company uses an actual cost system to apply all production costs to units produced. The plant has a maximum production capacity of 40 million units, but only 10 million units were produced and sold during year 1.
There were no beginning or ending inventories. Brassinni Company’s income statement for year 1
follows:
BRASSINNI COMPANY
Income Statement
For the Year Ending December 31, Year 1
Sales (10,000,000 units at $6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,000,000
Cost of goods sold
Direct (10,000,000 at $2) . . . . . . . . . . . . . . . . $20,000,000
Indirect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,000,000
68,000,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (8,000,000)
Marketing and administrative costs . . . . . . . . . . . . . . . . . . . . . . . . . .
10,000,000
Operating profit (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(18,000,000)
The board of directors is concerned about the $18 million loss. A consultant approached the
board with the following offer: “I agree to become president for no fixed salary. But I insist on a
year-end bonus of 10 percent of operating profit (before considering the bonus).” The board of directors agreed to these terms and hired the consultant.
The new president promptly stepped up production to an annual rate of 30 million units. Sales
for year 2 remained at 10 million units. The resulting Brassinni Company absorption costing income statement for year 2 follows:
BRASSINNI COMPANY
Income Statement
For the Year Ending December 31, Year 2
Sales (10,000,000 units at $6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold
Cost of goods manufactured
Direct (30,000,000 at $2) . . . . . . . . . . . . . . . . . . . $60,000,000
Indirect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
48,000,000
Total cost of goods manufactured . . . . . . . . . . . .
Less ending inventory
Variable (20,000,000 at $2) . . . . . . . . . . . . . . .
Indirect (20/30 $48,000,000) . . . . . . . . . . . .
$60,000,000
108,000,000
$40,000,000
32,000,000
Total inventory . . . . . . . . . . . . . . . . . . . . . . . . .
72,000,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
36,000,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Marketing and administrative costs . . . . . . . . . . . . . . . . . . . . . . . . . .
24,000,000
10,000,000
Operating profit before bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
14,000,000
1,400,000
Operating profit after bonus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$12,600,000
Chapter 4 Measuring Costs of Operations
143
The day after the statement was verified, the president took his check for $1,400,000 and resigned to take a job with another corporation. He remarked, “I enjoy challenges. Now that
Brassinni Company is in the black, I’d prefer tackling another challenging situation.” (His contract
with his new employer is similar to the one he had with Brassinni Company.)
Required
a.
b.
Write a report to Brassinni’s board of directors evaluating the year 2 performance.
Using variable costing, what would operating profit be for year 1? For year 2? What are the
inventory values? (Assume that all marketing and administrative costs are committed and
unchanged.) Compare those results with the preceding absorption statements.
Refer to the facts for problem 4.39. What would year 2’s operating profit (loss) be if Brassinni used
absorption costing with an indirect manufacturing overhead rate of $4.80 ($48,000,000 indirect
manufacturing costs 10,000,000 estimated unit sales)?
Problem 4.40
Effect of Overhead Rate
(LO 2)
Required
Communication
a.
b.
Prepare income statement using absorption costing and the $4.80 indirect cost per unit for
year 2
Prepare a chart to show how this income differs from that in the income statement of
problem 4.39.
Tammari Enterprises released the following figures from its records for year 1 and year 2:
Sales units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Production units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling price per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable manufacturing cost per unit . . . . . . . . . . . . . . . . . . . . . . . . .
Annual committed manufacturing cost . . . . . . . . . . . . . . . . . . . . . . .
Variable marketing and administrative costs per unit sold . . . . . . . . .
Committed marketing and administrative costs . . . . . . . . . . . . . . . .
Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Year 1
Year 2
250,000
250,000
$40
$24
$860,000
$2.40
$840,000
$0
250,000
344,000
$40
$24
$860,000
$2.40
$840,000
?
Problem 4.41
Comparison of Variable
and Full-Absorption
Costing: Analyzing Profit
Performance
(LO 3)
Communication
Required
a.
b.
c.
Prepare income statements for both years using absorption costing.
Prepare income statements for both years using variable costing.
Comment on the different operating profit figures. Write a brief report explaining why the
operating profits are different, if they are.
Search the Internet for at least one example of an actual organization that uses throughput or variable costing (preferably not a university class or consultant’s homepage). (Hint: Begin by using a
search engine to find sites with the key words “variable cost,” “throughput,” “theory of constraints,” or “goldratt,”) Prepare a memorandum to your instructor that describes:
a.
b.
c.
The organization—its name, industry, size, profitability, strategy, etc.
How the organization uses variable or throughput costing
Any costs or benefits the organization discloses about using variable or throughput costing
The following questions are based on Larue Corporation, which produces a single product it sells
for $12 per unit. Of the 100,000 units produced, 80,000 were sold during year 1; all ending inventory was in finished goods inventory. Larue had no inventory at the beginning of the year.
Direct materials (unit-level cost) . . . . . . . . . . . . . . . . . . . . . . . . $240,000
Direct labor (unit-level cost) . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000
Factory overhead (unit-level cost) . . . . . . . . . . . . . . . . . . . . . .
80,000
Factory overhead (capacity cost) . . . . . . . . . . . . . . . . . . . . . . . 240,000
Marketing and administrative (unit-level cost) . . . . . . . . . . . . .
80,000
Marketing and administrative (capacity cost) . . . . . . . . . . . . . . 128,000
Problem 4.42
Internet Search
(LO 1)
Technology
Problem 4.43
Comparison of Variable
and Absorption Costing
(LO 1)
Part II Cost Measurement Systems
144
Required
a.
b.
c.
d.
e.
f.
In presenting inventory on the balance sheet at December 31, what is the unit cost under
absorption costing?
In presenting inventory on a variable costing balance sheet, what is the unit cost?
What is the operating profit using variable costing?
What is the operating profit using absorption costing?
What is the ending inventory using absorption costing?
What is the ending inventory under variable costing?
[CPA Adapted]
Cases
Cases
Case 4.44
Inventory Turnover
(LO 1)
The New & Used Bookstore* is located near campus. Martha Williams, a part-time student employee, noticed that the managers at the bookstore seemed unconcerned about the costs of carrying
large inventories. For example, several times a year the manager of the general merchandise department (one of six departments) would buy large quantities of merchandise (clothing, gift items,
etc.) with the university and sports team logos in order to get quantity discounts. The general merchandise manager also had argued successfully for more warehouse space for his merchandise, for
which the bookstore pays rent. Inevitably several months later, the manager would mark down the
unsold merchandise to purchase cost or less in order to make room for the next purchase. This
seemed very inefficient to Martha, and she began to analyze the bookstore’s purchases and sales for
the past year. Martha gathered the following data.
Ethics
Department
Cost of Goods
Sold
Average
Inventory
Percent of
Warehouse
Space
Average Number
of Days Items
Were Purchased
in Advance
of Sale
New books . . . . . . . . . . . . $ 5,730,972
Used books . . . . . . . . . . . .
1,258,007
Reference books . . . . . . . .
563,686
Supplies . . . . . . . . . . . . . .
662,560
General merchandise . . . . .
883,251
Computers . . . . . . . . . . . .
2,246,600
$ 840,475
180,600
370,500
251,700
640,600
402,000
25%
12
10
8
25
20
63
37
86
71
94
28
Total store . . . . . . . . . . . . . $11,345,076
$2,585,275
100%
66.3
Required
a.
b.
c.
d.
e.
Compute inventory turnover ratios for each department and the bookstore as a whole. What
would these ratios tell Williams about the management of inventories at the New & Used
Bookstore? Is it reasonable to compare these ratios across departments? Why or why not?
Another store in the university area sells licensed (general) merchandise with the university’s
logo and reported to Williams that its inventory turnover ratio for the past year was 5.30. Is
that a legitimate benchmark for the New & Used Bookstore? Why or why not?
What are the benefits and costs to the New & Used Bookstore of its current methods for
purchasing and inventory?
What information would Williams need to place a dollar figure on all of those costs?
Williams has learned that the manager of the General Merchandise Department is a close
personal friend of the bookstore manager and receives incentive prizes from suppliers for
ordering large quantities of merchandise. What are Martha’s ethical responsibilities?
*This is a more complex version of Problem 3.29.
Chapter 4 Measuring Costs of Operations
Cotierre imports designer clothing that subcontractors in Mexico manufacture. Clothing is a seasonal product. The goods must be ready for sale prior to the start of the season. Any goods left over
at the end of the season must usually be sold at steep discounts. The company prepares a dress design and selects fabrics approximately six months before a given season. It receives these goods
and distributes them at the start of the season. Based on past experience, the company estimates
that 60 percent of a particular lot of dresses will be unsold at the end of the season and are marked
down to one-half of the initial retail price. Even with the markdown, a substantial number of
dresses remain unsold. They are returned to Cotierre and destroyed. Even though a large number of
dresses must be discounted or destroyed, the company needs to place a minimum order of 1,000
dresses to have a sufficient selection of styles and sizes to market the design.
Recently, the company placed an order for 1,000 dresses of a particular design for $25,000
plus import duties of $5,000 and a $7 commission for each dress sold at retail, regardless of the
price. Return mailing and disposing of each unsold dress cost $3 after the end of the markdown
period.
Required
a.
b.
c.
d.
Use absorption costing to compute the cost of each dress in this lot of dresses.
Suppose that the company sells 30 percent of the dresses in this lot for $75 each during the
first accounting period. Using absorption costing, what is the value of the ending inventory?
What is the operating profit or loss for the period, assuming no other transactions and that
the season has not ended, so that the number of dresses subject to markdown or to be
returned is unknown?
During the second period, 10 percent of the 1,000 dresses were sold at full price and 30
percent were sold at the half-price markdown. The remaining dresses were returned and
disposed of. Using absorption costing, what is the operating profit or loss for the period,
assuming no other transactions?
Suggest a method of accounting for these dresses that would more closely relate revenues
and costs.
145
Case 4.45
Absorption and Variable
Costing Importing
Decisions
(LO 3)