NINJA BOOK
BUSINESS ENVIRONMENT AND CONCEPTS IV
O P E R AT I O N S M A N AG E M E N T
I
COST ACCOUNTING & MEASUREMENT
1
A.
Cost Measurement Methods and Techniques
01
Management Accounting is the process of measuring and using information for the following purposes:
a.
Management planning, decision making, and control
b.
Reporting assets and cost of goods sold for financial statements and income taxes
c.
Reporting of costs under cost-based contracts
Because management accounting information is used for many purposes, the accounting systems need to be sufficiently
flexible to allow measuring and combining costs in different ways.
02
Assignment of costs to cost objects: Cost assignment is the process of tracing direct costs and allocating
indirect/common costs to cost objects. A cost object (or cost objective) is an item or activity for which a separate and
discrete measurement of costs is desired, such as a product, function, department, division, contract, or service.
03
Costs for external reporting is the financial accounting purpose of reporting the value of inventory so that the
cost of goods sold and income can be determined. Costs are classified based on their attachability to inventory.
a.
Product costs: Direct costs can be attached to inventory based on associating cause and effect. Indirect costs are
attached by systematic and rational allocation.
b.
Period costs: These costs are not attached to inventory, but are recognized immediately.
04
Manufacturing costs:
a.
Direct materials: Raw material costs that can be reasonably traced to a product on a per-unit basis.
b.
Direct labor: Wages relating to employees who work directly on the product (i.e., hands-on) that can be
reasonably traced to a product on a per-unit basis.
c.
Indirect materials: These are costs incurred in the manufacturing process, but either they do not become part of
the product (e.g., machine oil) or they are not reasonably traceable to the product (e.g., paint, varnish, glue). Such costs
become part of factory overhead and are attached to the product through an allocation process.
d.
Indirect labor: This incorporates factory labor costs for personnel who do not work directly on the product and
whose costs cannot be reasonably traced on a per-unit basis. This category includes salaries of peripheral production
employees, notably production supervisors/managers, factory janitors, and factory security personnel. Like indirect
materials, these costs become part of factory overhead and are attached to the product through an allocation process.
e.
Factory overhead: This is also called manufacturing overhead, factory burden, or simply overhead. It includes all
costs except direct labor and direct materials that are part of making the product, but which are not directly traced to a
specific product. Costs are accumulated in factory overhead accounts. They may either vary with production (variable
costs) or not (fixed costs). The costs are traditionally allocated to each unit produced on some basis such as $ per direct
labor hour, per direct labor cost, or per machine hour.
f.
Prime costs: Direct materials and direct labor together are called prime costs.
g.
Conversion costs: All factory costs other than direct materials are called conversion costs; they are required to
convert materials into a finished product. Conversion costs include direct labor and factory overhead.
2
Application: Which of the following is assigned to goods that were either purchased or manufactured for resale?
Relevant cost
Period cost
Opportunity cost
Product cost
D - Product costs are “attached” or assigned to units produced in a manufacturing process. Product costs are direct
materials, direct labor, and manufacturing overhead.
Relevant costs are those expected to differ among alternative future courses of action. They are also known as
incremental costs or differential costs.
Period costs are not associated with the manufacturing process. They are expensed in the period incurred. Period costs
are selling, general, or administrative expenses.
Opportunity costs are those revenues that will be lost if one action is chosen over another.
05
Manufacturing inventories: Traditional manufacturing environment
a.
Raw materials: This inventory includes anything tangible that becomes part of the product or its packaging. Raw
materials are held in inventory until requisitioned by the production department. In the just-in-time (JIT) production system,
raw materials are not stored in inventory, because they are not delivered to the factory until they are needed in production.
+
–
=
Beginning raw materials inventory
Purchases
Ending raw materials inventory
Raw materials used
b.
Work-in-process: Once production is begun, manufacturing costs are accumulated in the work-in-process (WIP)
account until the product is finished and transferred to the finished goods inventory.
+
+
+
–
=
c.
+
–
=
Beginning WIP
Raw materials used (from a.)
Direct labor
Overhead applied
Ending WIP
Cost of goods manufactured
Finished goods: These items are ready to be sold.
Beginning finished goods
Cost of goods manufactured (from b.)
Ending finished goods
Cost of goods sold
3
Application: JacKue Co. plans to produce 200,000 pairs of roller skates during January of next year. Planned
production for February is 250,000 pairs. Sales are forecasted at 180,000 pairs for January and 240,000 pairs for
February. Each pair of roller skates has eight wheels. JacKue's policy is to maintain 10% of the next month's production
in inventory at the end of a month. How many wheels should JacKue purchase during January?
195,000
205,000
1,560,000
1,640,000
D - The general inventory reconciliation formula is useful here:
Beginning inventory + Purchases - Uses = Ending inventory
This formula can be restated as:
Purchases = Ending inventory - Beginning inventory + Uses
The beginning and ending inventory will be 10% of the next month's purchases and can be calculated as follows:
Beginning inventory = 10% of January's planned production
= 0.10 x (200,000 pairs of skates x 8 wheels per pair)
= 160,000 wheels
Ending inventory = 10% of February's planned production
= 0.10 x (250,000 pairs of skates x 8 wheels per pair)
= 200,000 wheels
Production uses for January = 200,000 pairs of skates x 8 wheels per pair = 1,600,000 wheels
The necessary January purchases can then be calculated:
Purchases = Ending inventory - Beginning inventory + Uses
= 200,000 wheels - 160,000 wheels + 1,600,000 wheels
= 1,640,000 wheels
4
06
Sequence of manufacturing cost flows
Costs are accumulated and flow with the physical inventory from one inventory account to the next, as shown in the
following T-accounts illustration:
Inventory Cost Flows in Traditional Manufacturing Environment
07
Schedule of cost of goods manufactured: This schedule summarizes the costs assigned to the manufacturing
process during the period. A condensed example follows:
Schedule of Cost of Goods Manufactured
Beginning direct materials inventory
$10
+ Purchases of direct materials
80
– Ending direct materials inventory
-30
Raw materials used
60
+ Direct labor
70
+ Overhead (supplies, utilities, indirect labor, etc.)
40
Total manufacturing costs for the period
170
+ Beginning WIP inventory
50
Total manufacturing costs
220
– Ending WIP inventory
-140
Cost of goods manufactured
$80
5
Assigning Costs to Inventory
08
Introduction: Assigning Costs to Inventory
A determination of unit cost is needed for product pricing, cost control, GAAP reporting (inventory valuation, cost of goods
sold), and income tax reporting. There are several methods of attaching production costs to each unit produced. Within
each method, inputs can be valued using actual, normal, or standard costs.
The choice of method is influenced by the production process. Production processes range from making products
individually or in identifiable batches, to making a continuous stream of indistinguishable goods. Therefore, job costing
can be viewed as existing at one end and process costing at the other end of a cost-tracking continuum. There are hybrid
methods in between that have been known by various names, such as operation costing.
Application: Companies in what type of industry may use a standard cost system for cost control?
Mass production industry
Service industry
Both mass production and service industries
Neither mass production nor service industries
C - Historically, standard cost systems have been mainly used by companies involved in mass production of products.
Cost categorization by materials, labor, and overhead fits in well with cost standards and variance analysis.
There is no inherent reason why standard cost systems would not work equally well for service-oriented companies. In
fact, the number of service companies using standard cost systems has increased rapidly in the last decade.
In summary, both the mass production and service industries use standard cost systems.
09
Job costing, also called job order costing, is a tracking system used for customized products or services.
a.
Job cost records (or sheets): Costs are accumulated by the job, or job lot, and are recorded on job cost records
as work progresses. Entries are made into the WIP ledger account for manufacturing inputs from the job cost records. The
job cost records make up a subsidiary ledger that supports the control account Work in Process.
b.
Direct materials: Most raw materials will be traceable to the units produced through the requisition forms used to
issue materials from the raw materials inventory storeroom to the production department. Indirect materials are charged to
manufacturing overhead and are attached to the product through the allocation process.
c.
Direct labor: This cost is recorded by the employee on a detailed time record listing the job number, operation
performed, hours used, etc. Indirect labor is charged to manufacturing overhead and attached to the product through the
allocation process.
d.
Overhead: This is applied to jobs using the predetermined rate applied on the selected allocation base or cost
driver. If this is a normal costing system, actual driver units experienced are used as the input quantity. If a standard
costing system, the number of driver units that should have been used to complete the related activity is used.
e.
Job completion and sale of goods: As jobs are completed and moved to the Finished Goods warehouse, entries
are made to transfer the completed cost from WIP to Finished Goods and the job cost records become a subsidiary ledger
for the Finished Goods account. Ultimately, as sales occur, the job cost records become supporting documents for Cost of
Goods Sold.
6
Application: Gram Co. develops computer programs to meet customers' special requirements. How should Gram
categorize payments to employees who develop these programs?
By direct costs and value-adding costs
By direct costs only
By value-adding costs only
By neither direct costs nor value-adding costs
A - Direct costs are costs that relate directly to and are traceable to products. The payments Gram makes to employee
programmers can be traced to the programs so they are direct costs. Value-adding costs are those costs that are
necessary to production and add value to the product. Clearly, the employee programmers' efforts are value-added
costs.
Some production costs such as manufacturing machine set-up or administrative work related to licensing of programs is
necessary but does not add value per se to the product.
10
Process costing is used for products whose individual units are indistinguishable from other units (e.g., sugar,
corn flakes, textiles, paint). Such products are continuously produced through a series of uniform production steps called
processes. Costs are accumulated by process, then applied to the units processed using an average cost for input units.
There is a separate Work-in-Process account for each department or process through which the units flow.
At the end of each period, costs are allocated between the units completed and transferred to the next department and
the unfinished units remaining in ending inventory based on equivalent finished units.
Application: In computing the current period's manufacturing cost per equivalent unit, the first-in, first-out (FIFO)
method of process costing considers current period costs:
only.
plus cost of beginning work-in-process inventory.
less cost of beginning work-in-process inventory.
plus cost of ending work-in-process inventory.
A - 1. The FIFO method of process costing uses an equivalent unit computation that includes only work done in the
current period (i.e., Equivalent units work = Work done to complete beginning work-in-process + Work on units started
and completed + Work done on units left in ending work-in-process).
2. In order to be consistent with 1., only current period costs are used in calculating cost(s) per equivalent unit.
Another method, the weighted-average method, averages some previous period costs with current period costs.
7
11
Computation of unit costs and assigning costs to inventories: To compute costs relating to completed units
transferred out of the department and costs of unfinished units that remain in ending inventory, both physical units and
total costs must be accounted for in a five-step process. This process comprises a process costing report. The steps are
listed below. Note that Steps 2 and 3 are interchangeable.
Step 1: Account for all physical units.
Step 2: Compute the equivalent finished units (EFU or EU) for each element of manufacturing cost that is incurred at a
separate rate. Usually two computations are needed: one for materials units and one for conversion units.
Step 3: Determine the total dollars to be accounted for.
Step 4: Compute the per-unit cost for each separately identified manufacturing element. This will usually be materials
and conversion.
Step 5: Use the per-unit cost to assign the dollars to the units transferred out and to the units remaining in the ending
inventory. The sum of the dollars transferred out to the next department or to finished goods and the dollars remaining in
ending WIP must be equal to the total dollars identified in Step 3.
12
Equivalent finished units (EFU)
a.
Work done: There are three categories of physical units being worked on during a period:
(1)
Units in beginning inventory that need to be completed
(2)
Units received into the department during the month that are started and completed during the month
(3)
Units started but not finished (ending inventory units)
Obviously, the same amount of work is not applied to these three different categories during the period.
b.
Physical units divisor: When dividing costs by a physical units denominator to arrive at a cost per unit, the
denominator must be one which has “evened out” the inequality of work done as described above. The denominator used
is the equivalent finished units. This is the number of units that would have been completed during the period if all work
performed had been done only on units that were both started and finished during the period.
c.
Equivalent units computation methods: There are two different methods used for computing the equivalent
finished units:
(1)
Weighted average: In this method, no attempt is made to separate the work done to complete the beginning
inventory units and costs from the work performed on units started and finished. It is as though the beginning inventory
data were “pulled into” the current period and a simplifying assumption is made that all units completed during the current
period were started during the current period. Thus, all the costs incurred, including the beginning inventory costs, are
averaged over all the equivalent units. This method is appropriate when costs and production remain relatively stable from
period to period. It is not appropriate in a standard costing system.
All costs
All E.units
OR
Beginning inventory costs + Started costs
All units completed + (EI × Completion %)
8
(2)
First In, First Out (FIFO): In this method, the beginning inventory units and costs are kept separate from the
current period units and costs. The units transferred out are made up of two “layers”─the beginning inventory units
finished up during the period plus units started and finished. The ending inventory is valued using the most recent costs.
This method is preferred when costs fluctuate from period to period and is required if a standard cost system is in use.
Current-period costs
Current-period E. units
OR
Total costs Beg. inventory costs
Completed units + (EI × %) (BI × %)
Application: A company uses process costing to assign product costs. Available inventory information for a period is as
follows:
Inventory Material
Conversion
(in Units) Cost
Cost
Beginning
0
Started during the period
15,000
$75,000
$55,500
Transferred out
13,500
End of period
1,500
The ending inventory was 25% complete as to the conversion cost. 100% of direct material was added at the beginning
of the process. What was the total cost transferred out?
$130,500
$126,973
$121,500
$117,450
C - Equivalent units (EU) for material were 15,000 (including 13,500 in units completed and 1,500 in ending work in
process). The equivalent units of conversion cost in ending inventory equaled 1,500 units times 25%, or 375. Adding the
375 equivalent units in ending inventory to the 13,500 units completed gives 13,875 total equivalent units of conversion
cost.
Dividing $75,000 of material cost by 15,000 EU for material gives $5 as the unit cost for material. Dividing conversion
cost of $55,500 by 13,875 EU for conversion cost gives $4 as unit cost for conversion costs. Adding the $5 to the $4
gives $9 as total cost per unit completed. Multiplying the 13,500 units completed by $9 gives total cost transferred out of
$121,500.
13
Materials costs: Materials are added to the manufacturing process at different points in time. For example,
Material A could be added as processing begins in the department and Material B added at the 60% conversion phase. In
CPA Examination problems, materials are generally added at either the beginning of the process or at the end; therefore,
units will be either 0% or 100% complete as to materials costs.
9
14
Conversion costs: It is assumed that conversion occurs uniformly during the process; therefore, the CPA
Examination question fact pattern will indicate the percentage of completion as to these costs for both the beginning and
ending inventories. Note that conversion includes both labor and overhead costs.
Application: If a product required a great deal of electricity to produce, and crude oil prices increased, which of the
following costs most likely increased?
Direct materials
Direct labor
Prime costs
Conversion costs
D - Direct material and direct labor are prime costs that would not change due to an increase in crude oil prices (unless
crude oil is a material used directly in the product). Conversion cost is the cost of converting the material to finished
goods, including direct labor and manufacturing overhead. Electricity used by the factory is part of overhead cost, so an
increase in electricity cost would increase overhead and conversion cost.
It is possible that direct material cost would increase as well if electricity is a major cost incurred by the supplier of that
material or if crude oil is part of the material used in the product, but that is not indicated in the problem. This factory will
certainly see an increase in overhead cost.
15
Process costing report procedure
The five steps required to produce a process costing report are listed in section 11.
Step 1: Account for all units.
+ Units in beginning inventory
+ Completed units transferred out
+ Units started during period
= + Ending WIP units
Total physical units to account for
Total physical units accounted for
Step 2: Compute equivalent finished units (EFU). The example in section 16 assumes that the department is the first
processing stage. If this were for a second or subsequent department, the equivalent unit computation would need to
include a third column, “Transferred-in Costs.” All cost elements in a “Transferred-in” column would be computed at 100%
because units transferred in to subsequent departments come 100% complete as to costs incurred in previous
departments.
a.
Weighted-average method:
Completed Units Transferred Out
Materials
Conversion
X
X
Add Ending Inventory:
Materials - % added during period
X
Conversion - % added during period
X
Equivalent Finished Units, WA (EFU/WA)
X
10
X
b.
FIFO method:
Completed Units Transferred Out
Materials
Conversion
X
X
Add Ending Inventory:
Materials - % added during period
X
Conversion - % added during period
X
Less Beginning Inventory:
Materials - % completed at beginning of period
(X)
Conversion - % completed at beginning of period
X
(X)
Equivalent Finished Units, FIFO (EFU/FIFO)
X
X
Step 3: Determine total costs to account for:
Beginning costs
Add period costs:
Transferred in
Direct materials
Direct labor
Overhead
$
$
$
$
$
Total costs to account for $
Step 4: Compute per-unit cost for materials and conversion. (Where EFU is the same for both materials and
conversion, only one computation needs to be done.)
a.
Weighted-average method:
Total materials costs
EFU/WA - Materials
b.
FIFO method:
Total conversion costs
EFU/WA - Conversion
Current-period materials costs
EFU/FIFO - Materials
Current-period conversion costs
EFU/FIFO - Conversion
Step 5: Total costs accounted for:
Transferred-out costs
+ Ending WIP costs
Total costs accounted for (must equal total costs to account for in Step 3)
11
Application: Weighted-average and first-in, first-out (FIFO) equivalent units would be the same in a period when which
of the following occurs?
No beginning inventory exists.
No ending inventory exists.
Beginning inventory units equal ending inventory units.
Both a beginning and an ending inventory exist but are not necessarily equal.
A - The basic difference between the weighted-average and the first-in, first-out (FIFO) method equivalent unit methods
is the handling of the prior-period costs. The FIFO method separates product units and costs into two groups:
1. Costs related to the prior period
2. Costs related to the current period
In contrast, the weighted-average method blends the units and costs from both periods as if they were all part of the
current period. The following chart compares the two methods:
Weighted-Average Method
FIFO Method
Units in the beginning are
Only the work needed to complete the
treated as if they were started
units in the beginning inventory is
and completed in the current
period.
included in the calculation of equivalent units for the period.
Costs related to the beginning
Only costs related to the current
inventory are added to the costs period are included in the computations
added during the current period
of the costs per equivalent unit for
when determining the costs per
equivalent unit for the period.
All units transferred out are
treated in a like fashion whether
they were part of the beginning
inventory or were started and
completed during the current
period.
the period.
The units transferred out are divided
into two groups: (1) units in the beginning inventory and (2) units started
and completed during the current period.
The costs to be accounted for are The costs to be accounted for are the same using both methods.
the same using both methods.
Since the differences related to the cost assignment of the costs to be accounted for relate to the handling of the
beginning inventory, the weighted-average and FIFO equivalent units would be the same under a condition when the
difference is nonexistent—in other words, when there is no beginning inventory.
12
16
Process costing report example: Levittown Company employs a process cost system for its manufacturing
operations. All direct materials are added at the beginning of the process and conversion costs are added uniformly.
Levittown’s production quantity schedule and costs for November are reproduced below for the first stage of processing:
Beginning WIP (60% complete as to conversion costs)
Units started during period
Ending WIP (20% complete as to conversion costs)
1,000
5,000
2,000
Materials
Conversion
Total
Beginning inventory costs
$2,000
$6,000
$8,000
Current-period costs
5,500
38,000
43,500
$7,500
$44,000
$51,500
A process cost report for Levittown Company for this process stage would require the following steps (sections 17 and
18).
17
Process costing report example: Weighted-average method
Step 1: Determine physical units to account for.
Units in beginning inventory
1,000
Completed units transferred out
4,000
+ Units started during period
5,000
+ Ending inventory units
2,000
Physical units
6,000
6,000
Step 2: Compute equivalent finished units.
Materials
Conversion
Completed Units Transferred Out
4,000
+ Ending Inventory, Materials (2,000 × 100%)
2,000
4,000
Conversion (2,000 × 20%)
400
EFU (Weighted Average)
6,000
4,400
Step 3: Determine total costs to be accounted for.
Materials
Beginning inventory costs
Period costs
Total costs to account for
Conversion
Total
$2,000
$6,000
$8,000
5,500
38,000
43,500
$7,500
$44,000
$51,500
Step 4: Compute unit costs based on EFU denominators computed in Step 3. (Use total costs.)
Materials
$7,500 ÷ 6,000 units = $1.25 per unit
Conversion $44,000 ÷ 4,400 units = 10.00 per unit
Total unit cost (weighted average) $11.25
13
Step 5: Use unit costs computed in Step 4 to allocate costs between units completed and transferred out and units in
ending inventory.
Units Transferred Out:
(4,000 × $11.25)
$45,000
Ending WIP Inventory
Materials (2,000 × $1.25)
$2,500
Conversion (2,000 × 20% × $10.00)
4,000
Total Costs in Ending WIP
6,500
Total Costs Accounted For
$51,500
18
Process costing report example: FIFO method
Step 1: Determine physical units to be accounted for. (Note that this is the same under both weighted-average and FIFO
methods.)
Units in beginning inventory 1,000
+ Units started during period 5,000
Physical units
6,000
Completed units transferred out 4,000
+ Ending inventory units
2,000
6,000
Step 2: Compute equivalent finished units.
Materials
Conversion
Completed Units Transferred Out
4,000
+ Ending Inventory, Materials (2,000 × 100%)
2,000
4,000
Conversion (2,000 × 20%)
400
Less Beginning Inventory, Materials (100%)
-1,000
400
Conversion (60%)
-600
EFU (FIFO)
5,000
3,800
Step 3: Determine total costs to be accounted for. (Note that this also is the same under both weighted-average and FIFO
methods.)
Materials
Conversion
Total
Beginning inventory costs
$2,000
$6,000
$8,000
Period costs
5,500
38,000
43,500
$7,500
$44,000
$51,500
Total costs to account for
Step 4: Compute unit costs based on EFU denominators computed in Step 3. (Use current-period costs.)
Materials
$5,500 ÷ 5,000 units
=
$1.10
per unit
Conversion
$38,000 ÷ 3,800 units
=
10.00
per unit
Total unit cost (FIFO)
$11.10
14
Step 5: Use unit costs computed in Step 4 to allocate costs between units completed and transferred out and units in
ending inventory.
Units Transferred Out:
1. From Beginning Inventory
Beginning Costs
$8,000
Costs to Complete Beginning Inventory
Materials added during period
-0-
Conversion added to complete during period
(1,000 units × 40%* added × $10.00)
4,000
2. Started and Completed (3,000 × $11.10)
33,300
Total Costs Transferred Out (4,000 units)
$45,300
Ending WIP
Materials (2,000 × $1.10)
$2,200
Conversion (2,000 × 20% × $10.00)
4,000
Total Costs of 2,000 units in WIP
6,200
Total Costs Accounted For
$51,500
* Beginning inventory was 60% complete as of the beginning of the month and all materials had been added in the
previous period at the beginning of the process. Therefore, 40% conversion costs were added during the period and no
additional materials costs were incurred for these units.
19
Spoilage consists of units that are lost, broken or otherwise defective and cannot be sold with regular good units.
a.
Normal spoilage: A certain amount of spoilage is expected as part of the manufacturing process. The amount
expected spoilage is often expressed as a percent relative to the good units produced. It is considered to be a cost of
producing the good units and is classified as a product cost.
b.
Abnormal spoilage: This is spoilage in excess of the expected level. It is treated as a period cost. Cost relating to
abnormal spoilage units is transferred out of the WIP account into a loss account.
c.
Treatment in EFU calculation: Abnormal spoilage units are generally always included in the computation of
equivalent units, because their cost must be calculated and recorded as a separate loss. However, the inclusion of normal
spoiled units depends on whether a company wishes to separately identify and report the extent to which normal spoilage
costs impact the cost of good units. There are, therefore, two treatments for normal spoilage:
(1)
Include the units and add their cost to only the cost of good units passing the inspection point (separate
identification of costs), or
(2)
Exclude the units, thereby increasing the manufacturing cost per equivalent unit, and spreading normal spoilage
cost over not only good units completed, but also over abnormal spoilage units and equivalent units in ending inventory
(hidden cost method).
15
Application: Which of the following choices shows the proper treatment of sales commissions and abnormal spoilage
charges when calculating a manufactured good's inventoriable cost?
Include both sales commissions and abnormal spoilage
Include sales commissions and exclude abnormal spoilage
Exclude sales commissions and include abnormal spoilage
Exclude both sales commissions and abnormal spoilage
D - Abnormal spoilage is spoilage in excess of the expected level. It is a period cost (a loss recognized in the income
statement of the period incurred) rather than being included in the inventory asset account.
Sales commissions are a selling cost, not a manufacturing cost. Selling costs are expensed in the period incurred, not
included in the inventory asset account.
20
Separately reported normal spoilage costs: Spoiled units are identified at an inspection point. The inspection
point usually occurs upon completion of departmental processing. Therefore, normal spoilage costs should be identified
and added to the costs of good units completed. No normal spoilage costs should be attached to the incomplete units in
ending inventory. To accomplish this, all spoilage units are included in the equivalent unit computation to arrive at a
manufacturing cost per equivalent unit. The cost of normal spoilage is added to the cost of good units produced. The cost
of abnormal spoilage is removed from work in process and is charged as an expense of the period.
21
Example of separately reported normal spoilage costs: For cost control purposes, Hamilton Company requires
separate identification of all spoilage costs. Normal spoilage costs are added to the cost of good units produced up to the
point of inspection. The cost of abnormal spoilage is written off as a period loss. Inspection occurs upon completion of
departmental processing, before units are transferred to the next department.
The extracting department processed 14,000 units during the month of January.
Of these, 10,000 were completed and 4,000 units remained 60% converted in the ending inventory on January 31.
Of the 10,000 units completed, 1,000 were spoiled. Spoilage of 10% of good units is considered normal.
No materials are added in the department. Conversion costs to account for are $59,520.
The weighted-average method is used for EFU computation.
Identify (1) the loss due to abnormal spoilage, and (2) the cost of good units transferred out, including that portion of cost
attributable to normal spoilage.
1.
Identify normal and abnormal spoilage.
Total units completed
10,000
Less total spoilage
<1,000>
Good units completed 9,000
16
2.
Compute the equivalent units of production using the weighted-average method (only conversion element
involved).
Good units completed
9,000
Abnormal spoilage units
100
Normal spoilage units
900
Ending inventory (4,000 × 60% converted) 2,400
Equivalent finished units
12,400
3.
Compute unit conversion cost.
$59,520 / 12,400 equivalent units = $4.80 per equivalent unit
4.
Assign costs to abnormal spoilage and inventories.
Abnormal spoilage, 100 units at $4.80 (to loss account)
$480
Good units transferred out:
Good units, 9,000 at $4.80
$43,200
Normal spoilage units, 900 at $4.80
4,320
Total cost of good units transferred out
47,520
Ending inventory, 2,400 equivalent units at $4.80
11,520
Total product costs
59,040
Total costs accounted for
$59,520
Note: (1) The normal spoilage costs are separately identified so that (2) the impact of those costs is seen on the unit cost
of good units transferred out ($47,520 total costs ÷ 9,000 good units transferred = $5.28, as opposed to $4.80/unit overall
manufacturing cost), and (3) no normal spoilage cost is included in ending inventory. Any spoilage in those 4,000 units will
be identified upon their completion and allocated to those units at that time.
17
Application: During the current year, the following manufacturing activity took place for a company's products:
Beginning work-in-process, 70% complete
Units started into production during the year
10,000 units
150,000 units
Units completed during the year
140,000 units
Ending work-in-process, 25% complete
20,000 units
What was the number of equivalent units produced using the first-in, first-out method?
138,000
140,000
145,000
150,000
A - Equivalent units is the number of units that would have been completed had the same production effort been
devoted to starting and finishing a smaller number of units (the number of complete units).
On a FIFO (first-in, first-out) method, the equivalent units are calculated as follows:
Units completed during the period
XX
Plus equivalent units in-process at end of period
XX
Less equivalent units in-process at beginning of period XX
---
Total equivalent units for FIFO method
XXX
Units completed during the year
= 140,000 units
Equivalent units in-process at end of period = 25% of 20,000
= 5,000 units
Equivalent units in-process at end of period = 70% of 10,000
= 7,000 units
140,000 + 5,000 - 7,000 = 138,000 equivalent units
22
Hidden normal spoilage costs: (Use this method when no information is given about spoilage inspection point or
when not told to attach cost to only good units produced.)
Some companies choose not to separately identify normal spoilage costs. This is appropriate when such costs are
relatively small.
In this procedure, abnormal spoilage is included in the equivalent unit computation, but normal spoilage is excluded.
Thus, the per-unit manufacturing cost is proportionately higher.
The normal spoilage cost is absorbed into the cost of all remaining equivalent units (including abnormal spoilage and
ending inventory).
18
23
Example of hidden normal spoilage costs: Assume the same facts for Hamilton Company as described in
section 21, but that normal spoilage costs are not separately identified.
1.
Computation of spoilage units would be the same as with separately reported normal spoilage costs.
Total units completed
10,000
Less total spoilage
1,000
Good units completed
9,000
Total spoilage
1,000
Less normal spoilage (9,000 good × 10%)
900
Abnormal spoilage
2.
100
Compute equivalent units.
Good units completed
9,000
Abnormal spoilage units
100
Ending inventory (4,000 × 60%)
2,400
Equivalent finished units
3.
11,500
Compute unit conversion cost.
$59,520 / 11,500 equivalent units = $5.18 (rounded)
4.
Assign costs to abnormal spoilage and inventories.
Abnormal spoilage, 100 units at $5.18 (to loss account)
$518
Good units transferred out, 9,000 at $5.18
46,620
Ending inventory, 2,400 equivalent units at $5.18
12,432
Total product costs
59,052
Total costs accounted for ($50 difference due to rounding)
$59,520
Note: (1) The normal spoilage costs are not separately identified; rather, (2) they are hidden in the unit manufacturing cost
of $5.18, and (3) both the abnormal spoilage units and ending inventory include some normal spoilage costs. For this
reason, some authorities believe this method is not theoretically correct and do not advocate its use.
24
Spoilage in job costing: The net cost (cost less any disposal value) related to normal spoilage that is not
attributable to a particular job is charged to factory overhead. It is thus allocated to all jobs worked on through the normal
overhead application procedure. The net cost of spoilage attributable to the characteristics of a particular job or job lot is
charged to that particular job. The cost of abnormal spoilage not attributable to a particular job is treated as a period cost
and charged to a special loss account.
25
Scrap: Normally, no cost is assigned to scrap. Its disposal value is most commonly credited to factory overhead.
Where feasible, it may be used to reduce the cost of a particular job or type of job.
26
Rework costs: Costs of reworking defective units are generally charged to factory overhead and are spread
among all units produced through the overhead application process. Special circumstances may cause such costs to be
charged to a particular job.
19
27
Costing methods: Inputs into the production process can be accounted for by three different costing methods:
actual, normal, and standard costing.
Input
Actual Costing
Normal Costing
Standard Costing
Direct Materials
Actual
Actual
Standard Input at Budgeted Rate
Direct Labor
Actual
Actual
Standard Input at Budgeted Rate
Factory Overhead
Actual
Actual Input at
Budgeted Rate
Standard Input at Budgeted Rate
28
Actual costing: The inputs to production are valued at their actual cost, the actual number of dollars paid for direct
materials, direct labor, and overhead. All factory overhead costs incurred (debit to Factory Overhead Control) would be
applied to Work-in-Process (credit Factory Overhead Control). The problem is that the total actual costs of overhead are
not known until the end of the period. It may not be practical to wait until the end of the year to cost products, particularly if
cost is a factor in setting prices. If monthly overhead costs are used, unit costs could vary widely.
29
Normal costing: The inputs of direct materials and direct labor are valued at their actual cost, but overhead is
applied on a budgeted or “normalized” basis. Estimated overhead costs are divided by estimated production for the year
to determine an application rate. If overhead is applied on a direct labor hour basis, then the overhead rate would be
applied to actual direct labor hours.
20
Application: Merry Co. has two major categories of factory overhead: material handling and quality control. The costs
expected for these categories for the coming year are as follows:
Material handling $120,000
Quality inspection 200,000
The plant currently applies overhead based on direct labor hours. The estimated direct labor hours are 80,000 per year.
The plant manager is asked to submit a bid and assembles the following data on a proposed job:
Direct materials
$4,000
Direct labor (2,000 hours) 6,000
What amount is the estimated product cost on the proposed job?
$8,000
$10,000
$14,000
$18,000
D - The first step in this problem is to calculate the two factory overhead rates:
1. Material handling
2. Quality control
This is accomplished by dividing the expected annual costs by the estimated direct labor hours (DLH) for the coming
year.
Material handling overhead rate = $120,000 ÷ 80,000 DLH hours = $1.50 per DLH
Quality control overhead rate = $200,000 ÷ 80,000 DLH hours = $2.50 per DLH
The estimated cost of the proposed job can then be determined assuming that 2,000 hours of direct labor will be
needed to complete the job.
Direct materials
Direct labor
$ 4,000
6,000
Applied material handling (2,000 hours x $1.50 per DLH)
Applied quality inspection (2,000 hours x $2.50 per DLH)
Estimated product cost for proposed job
3,000
5,000
$18,000
30
Standard costing: In a standard costing system, standard costs are developed for all inputs per unit of production.
For example, if overhead is applied on direct labor hours, it would be applied according to the number of hours that should
have been used to make that unit, not the actual number of direct labor hours used. Standard costs are designed to
control the two components of the cost of producing something: the price paid and the quantity used. Price and quantity
standards are set for materials, labor and overhead. Standard cost is a unit concept. It represents the budget to produce
one unit. Standard costs are often used to develop a master budget and flexible budget, and variances from standard
costs are then analyzed.
a.
Ideal standards: These are standards that can be attained only under perfect conditions. There is no allowance for
machinery to break down, or to wait for materials, or for other delays that can be expected in a normal world. Ideal
standards require at all times a level of effort and skill that would be expected from the very best employees at their peak
performance. Ideal standards are generally not used in practice, because they discourage the efforts of ordinary
21
employees who know they can’t make the standard, so “why bother?” Variances are often viewed as useless because
part of the variance is “normal.” Expected differences from the standard obscure the actual variances that need to be
investigated. However, advocates of TQM (total quality management) and continuous improvement are often in favor of
the use of ideal standards because such standards can encourage greater efficiency over time.
b.
Attainable standards: Practical standards are tight, but attainable. They can be achieved by normal workers
working with reasonable, efficient effort, with a reasonable allowance for breakdowns, etc. Variances provide useful
information because they represent abnormal conditions that need to be investigated. Attainable standards are also useful
in the planning and budget process when calculating the production budget, etc.
Applying Overhead
31
Applying overhead: In both normal and standard costing systems, a process must be developed for calculating
and applying a budgeted overhead allocation rate.
32
Overhead application/allocation rate: Overhead is allocated to cost objects (e.g., units or jobs) using an
application rate (also called an allocation rate), which may be calculated in several different ways:
a.
Actual overhead application rate: This rate is calculated by dividing the overhead costs by the actual volume of
the allocation base. An actual rate is useful when the goal is to measure actual costs; however, actual data may not be
available on a timely basis.
b.
Budgeted (or predetermined) overhead application rate: This rate is calculated by dividing estimated (or
budgeted) overhead cost by the estimated (or budgeted) volume of the allocation base. A standard overhead application
rate is an example of a predetermined rate.
Application: The accountant for Champion Brake, Inc., applies overhead based on machine hours. The budgeted
overhead and machine hours for the year are $260,000 and 16,000, respectively. The actual overhead and machine
hours incurred were $275,000 and 20,000. The cost of goods sold (COGS) and inventory data compiled for the year is
as follows:
Direct materials
$50,000
COGS
450,000
Work-in-process (WIP) (units) 100,000
Finished goods (units)
150,000
What is the amount of over/underapplied overhead for the year?
$15,000
$50,000
$65,000
$67,000
B - The overhead application rate is $16.25 per machine hour (budgeted overhead of $260,000 divided by budgeted
machine hours of 16,000). Multiplying that rate by actual hours of 20,000 gives $325,000 for overhead applied.
Subtracting that from the $275,000 actual overhead gives a variance of $50,000. The overhead is over-applied since
more overhead was applied to work-in-process than the actual overhead.
22
33
Example of overhead application/allocation rate: XYZ Company is a highly automated machinery manufacturer.
The company estimated its manufacturing overhead expenses as follows. All of these costs are classified as fixed.
Depreciation
$100,000
Rent
50,000
Utilities
35,000
Supervision
10,000
$195,000
Expected Material Cost
$390,000
Expected Machine Hours (normal capacity)
1.
19,500
Calculate the overhead application rate using (a) material cost and (b) machine hours as the allocation base.
2.
Calculate the overhead charged to Job A if 900 hours of machine time and $20,000 of materials were used,
assuming that the allocation base is (a) material cost and (b) machine hours.
Solutions:
1.
Calculation of application rate:
a.
Overhead application rate based on material cost (overhead cost divided by material cost):
$195,000 = $0.50 per dollar of material cost (or 50% of material cost)
$390,000
b.
Overhead rate based on machine hours (overhead cost divided by machine hours):
$195,000 = $10 per machine hour
19,500 hours
2.
Allocation of overhead to Job A:
a.
Assuming that overhead is based on material costs:
$20,000 × $0.50 = $10,000
b.
Assuming that overhead is based on machine hours:
900 hours × $10 = $9,000
34
Under/over-applied overhead: In a normal costing system, overhead is allocated using a predetermined
application rate and actual volume of the allocation base. In a standard costing system, overhead is allocated using a
standard overhead rate per unit of output. In these costing systems, there will always be some amount of underapplied or
over-applied overhead caused by deviations from budgeted or standard amounts in either the numerator or the
denominator of the application rate:
23
a.
Inaccurate cost budget: Even if actual production is equal to the anticipated levels at which the application rate is
set, actual costs are likely to differ from budgeted. This affects the numerator of the ratio, resulting in an inappropriate
application rate.
b.
Inaccurate allocation base budget: If actual volume of the allocation base (labor hours, materials dollars, etc.) is
different than the budgeted volume, the denominator in the application rate is incorrect relative to actual activities. This
difference can be caused by a difference between budgeted and actual production volumes or deviations from budgeted
efficiency.
35
Disposition of under/overapplied overhead: The amount of underapplied or overapplied overhead must be
periodically closed.
a.
Fixed overhead allocated based on normal capacity: In the past, any material over/underapplied overhead was
prorated among work in process, finished goods, and cost of goods sold. Now, however, FASB ASC 330-10-30 requires
fixed factory overhead to be allocated to inventory using normal capacity, or the typical volume of production. The new
accounting standard prevents the overstatement of inventory values when production volumes fall below normal.
Assuming that normal capacity is used to establish the predetermined overhead rate, any over/underapplied overhead
caused by differences between actual and normal capacity should be recorded in cost of goods sold.
The new accounting standard is likely to increase the number of companies that account for fixed and variable
overhead separately. In addition, more companies are likely to use normal capacity as the budgeted volume when
establishing predetermined overhead rates.
b.
Adjustment for fixed overhead: In general, over/underapplied fixed overhead should be assigned to cost of goods
sold. However, any material amounts of over/underapplied fixed overhead caused by an inaccurate cost budget should be
prorated among ending units in work in process, finished goods, and cost of goods sold.
c.
Adjustment for variable overhead: By definition, variable overhead is expected to vary with the volume of
production. This means that over/underapplied variable overhead is caused by error in the budgeting process.
Accordingly, any material amounts of over/underapplied variable overhead should be prorated among ending units in work
in process, finished goods, and cost of goods sold. If the over/underapplied amount is not material, it may be adjusted to
cost of goods sold alone.
36
Example of disposition of under/overapplied overhead: Continue with the information from section 33. Assume
that XYZ Company incurred $180,000 of manufacturing expenses and that actual machine hours were 17,000. Before any
adjustment is made, the amounts of fixed overhead applied units in work-in-process, finished goods, and cost of goods
sold are $17,000, $34,000, and $119,000, respectively.
1.
Calculate the actual fixed overhead rate based on (a) actual machine hours and (b) normal capacity.
2.
Calculate the amount of over/underapplied fixed overhead, then calculate the amount attributable to (a) inaccurate
cost budget and (b) difference between actual and normal capacity.
3.
What adjustments should be made if the fixed overhead spending variance is considered immaterial?
4.
What adjustments should be made if the fixed overhead spending variance is considered material?
24
Solutions:
1a.
Actual fixed overhead rate based on actual machine hours:
$180,000 = $10.59 per machine hour
17,000
1b.
Actual fixed overhead rate based on normal capacity:
$180,000 = $9.2308 per machine hour
19,500
Note: The rate of $9.2308 should be used to assign fixed overhead to inventory.
2.
Over/underapplied fixed overhead:
Actual fixed overhead
Fixed overhead applied (17,000 hours × $10 per hour)
a.
$180,000
<170,000>
$10,000
Amount attributable to inaccurate cost budget:
Actual volume × (Predetermined rate – Actual rate based on normal capacity)
= 17,000 hours × ($10.00 - $9.2308) = $13,077 Overapplied
b.
Amount attributable to difference between actual and normal capacity:
Actual rate based on normal capacity × (Normal capacity – Actual volume)
= $9.2308 × (19,500 – 17,000) = $23,077 Underapplied
Math check: $13,077 + $(23,077) = $(10,000) Underapplied overhead
25
3.
If the $13,077 amount is considered material, then it should be prorated among WIP, finished goods, and COGS.
However, the $23,077 amount should be assigned only to COGS.
Overhead in WIP account ending balance
$17,000
10%
of total
Overhead in Finished Goods ending balance
34,000
20%
of total
Overhead in Cost of Goods Sold
119,000
70%
of total
Total – Actual Fixed Overhead
$170,000
100%
Adjustment: Dr. (Cr.)
Allocation of over/underapplied overhead:
WIP
Fin. Goods
COGS
Inaccurate cost budget:
$13,077 overapplied × 10%
-$1,308
$13,077 overapplied × 20%
-$2,615
$13,077 overapplied × 70%
-$9,154
Diff. between actual and normal capacity:
$23,077 underapplied
23,077
Total adjustment
-$1,308
-$2,615
$13,923
Journal Entry:
Cost of goods sold
13,923
Work in process
1,308
Finished goods
2,615
Overhead control
10,000
4.
If the $13,077 amount is considered immaterial, then it may be netted against the $23,077 amount and assigned
directly to COGS:
Journal Entry:
COGS (23,077 – 13,077) 10,000
Overhead control
10,000
37
Cost allocation is the process of assigning indirect costs (also called overhead, common costs, or joint costs) to
cost objects. The focus in financial accounting is primarily on the allocation of factory overhead to inventories and cost of
goods sold. However, indirect costs may also be allocated to help management plan and control operations. It is a
controversial topic because, by its very nature, allocation is an arbitrary process.
38
Cost allocation terms
a.
Cost pool: Because indirect costs cannot be traced to the cost object, it is efficient to accumulate indirect costs in
one or more cost pools. The dollars in the cost pool are then allocated to cost objects.
b.
Allocation base versus cost driver: The allocation base is an activity measure used to allocate cost pool dollars to
cost objects. Any logical allocation base may be used; however, the allocation base should ideally have a cause-and-
26
effect relationship to the variability of costs in the cost pool. In other words, the ideal allocation base is a cost driver, which
is an activity that causes costs to increase.
Application: A manufacturing company has several product lines. Traditionally, it has allocated manufacturing
overhead costs between product lines based on total machine hours for each product line. Under a new activity-based
costing system, which of the following overhead costs would be most likely to have a new cost driver assigned to it?
Electricity expense
Repair and maintenance expense
Employee benefits expense
Depreciation expense
C - The allocation base is an activity measure used to allocate costs. The allocation base should have a cause-andeffect relationship to the variability of that cost.
The company has been assigning overhead costs in all four categories using machine hours as the cost driver. The
more a machine is used, the more cost is allocated to that product line. Assuming that machines are powered by
electricity, more machine hours result in increased electricity cost, so this seems an appropriate cost driver for
electricity. The more a machine is used, the greater the repair and maintenance cost incurred, so machine hours would
be the appropriate cost driver.
Similarly, it seems appropriate to use machine hours to allocate depreciation on machinery. However, it is likely some
machines will use many more employee hours than other machines, so machine hours seem inappropriate as the cost
driver for employee benefit expense. It is likely the cost driver for employee benefit expense will be changed to direct
labor hours or direct labor dollars, both of which would be more directly related to changes in employee benefit cost
incurred.
39
Traditional overhead cost allocation systems
a.
Traditional overhead cost pools: Traditionally, production overhead costs have been accumulated in either one
single cost pool or in two cost pools for fixed and variable overhead.
b.
Plant-wide versus departmental overhead cost pools: In a traditional system, organizations may accumulate
overhead costs on a plant-wide or departmental basis. The choice depends on (a) whether production is divided into
activities performed in separate departments, (b) whether different managers are responsible for controlling overhead
costs in different departments, and (c) whether allocation bases are likely to vary across departments. Departmental cost
pools are generally preferred to plant-wide pools when there are several departments involved in the manufacturing
process and the activities in each department are different. Furthermore, it may be desirable to break overhead cost pools
down even further based on underlying drivers of activities within departments.
c.
Problems with traditional allocation systems: Traditional allocation systems are plagued by three major
problems:
(1)
Small number of cost pools: Traditional systems use a very small number of indirect cost pools, limiting the ability
of managers to analyze cost behavior, adequately control costs, and identify relevant information for decisions. In addition,
manufacturing processes have become less labor-intensive over time, with overhead costs becoming increasingly
important.
(2)
Traditional allocation bases: Commonly used allocation bases in a traditional product costing system include labor
hours, labor dollars, materials dollars, and machine hours. Traditional allocation bases are reasonable if they are likely to
27
have a cause-and-effect relationship with overhead costs. For example, labor hours or labor dollars may be reasonable
for a labor-intensive production system. Similarly, machine hours may be reasonable for a machine-intensive production
system.
However, these allocation bases are inappropriate in many settings. In an automated manufacturing environment, direct
labor is a smaller and overhead a larger part of production costs. In such an environment, the allocation of overhead
based on direct labor can produce significant distortions in product costs. A relatively small increase in labor input to a
product can cause an enormous increase in the amount of overhead allocated to that product; products which are more
labor intensive than others receive a larger burden of overhead allocation. In these situations, labor-intensive products
subsidize other products by carrying more than their proper share of overhead, leading to inappropriate decisions such as
which products to emphasize.
(3)
Focus on manufacturing alone: Non-manufacturing activities such as customer support, delivery processes, and
information technology have become highly important for many businesses. These activities can be quite costly, and
managers want to ensure that they are managed efficiently. In addition, managers want accounting systems to provide
them with useful information, such as the relative profitability of different customers. Traditional allocation systems do not
address these types of management information needs.
40
Activity-Based Costing (ABC) addresses several of the concerns about traditional overhead costing systems.
Instead of using a small number of overhead cost pools and arbitrary allocation bases, overhead costs are accumulated in
cost pools related to separately identified activities that are allocated based on cost drivers.
Application: A basic assumption of activity-based costing (ABC) is that:
all manufacturing costs vary directly with units of production.
products or services require the performance of activities, and activities consume resources.
only costs that respond to unit-level drivers are product costs.
only variable costs are included in activity cost pools.
B - Activity-based costing (1) identifies activities (i.e., things that are done), (2) determines the cost of those activities,
and (3) assigns costs to products/services based on their consumption of activities. In order for ABC to be used,
therefore, those “products or services require the performance of activities, and activities consume resources.”
41
Activities and cost hierarchy: Activities are the separately identifiable tasks required to produce a product or
provide a service. They can be referred to as the work to be done. In an ABC system, activities are grouped into cost
pools, which could be a machine, a group of machines, a department, or a function.
The following hierarchy of activity levels is useful in helping accountants and managers identify activities for their
organization:
a.
Unit level: These activities are done a certain number of times per unit of output, and are thus volume-related. For
example, assembly of parts into a subassembly unit is a unit-level activity.
b.
Batch level: These activities are performed once for each batch, or group, of units. An example is machine setup
that has to be done for each production run no matter how many units are in a batch.
c.
Customer level: These activities support specific customers or groups of customers. They cannot be specifically
correlated to a particular product, batch, or unit. Examples include sales calls, service and support, and advertising aimed
at particular customers.
28
d.
Product level: These activities support specific product types or services. They cannot be specifically correlated to
a particular unit or batch on a cause-and-effect basis. They are incurred regardless of the number of units produced, and
include such items as product advertising, research and development, engineering specifications, and design costs.
e.
Plant (facility) level: These activities and resources are not traceable to specific products, customers, or services,
but they support an individual plant or facility. Examples include building (facility) maintenance, security, and plant
manager’s salary.
f.
Organization level: These activities are not traceable to specific products or services or to specific facilities; they
support the organization as a whole. Examples include headquarters building maintenance and depreciation, CEO and
CFO compensation, and centralized accounting functions.
42
Cost driver: One of the major differences between activity-based costing (ABC) and traditional costing systems is
that greater effort is made to identify cost allocation bases that are cost drivers. For example, in an assembly activity, the
more parts that have to be put together, the more the cost of that activity increases. Therefore, the cost driver for an
assembly activity would be the number of parts. Increased activity of the cost driver causes the total costs related to that
activity to increase.
43
Steps in activity-based costing: Activity-based costing applies the accumulated costs of identified activities to
cost objects using a separate driver for each activity, using the following series of steps:
a.
Identify causal relationship: Identify the causal relationship between cost incurrence and activities.
b.
Determine driver: Determine the underlying driver of overhead costs for activities.
c.
Establish cost pools: Establish homogeneous cost pools related to individual drivers.
d.
Determine cost ratio: Develop a predetermined cost ratio for each activity cost pool.
e.
Apply costs: Apply the accumulated costs in the cost pools to the cost objects on the basis of resources
consumed as determined by the amount (units) of cost driver used. Costs may be assigned to any type of cost object
depending on the information management wants. For example, costs may be assigned to units of product, groups of
customers, or product lines.
44
Example of activity-based costing: Glide-Free, Inc., manufactures two models of patio swings: Deluxe
(upholstered with a woven-vinyl material) and Standard (with stained-wood finish). The following data relate to the
company’s production activities and costs:
Manufacturing Activity
Budgeted
Activity Costs
for Year
Cost Driver Used as
Allocation Base
Cost per Unit of
Allocation Base
Materials handling
$300,000 Number of parts
$0.40
Cutting
1,500,000 Number of parts
2.00
Assembly
4,500,000 Number of parts
6.00
Upholstery
1,200,000 Direct labor hours
20.00
Wood refinishing
3,000,000 Direct labor hours
15.00
29
Actual production data for the month of April is as follows:
Model
# of Units
Direct
Material
Total #
of
Produced
Costs
Parts
Stand
ard
8,000
$100,000
64,000
Delux
e
2,500
62,500
30,000
Direct Labor Hours
Upholstery
-5,100
Wood
Refin.
16,200
--
1.
Compute the total manufacturing costs and manufacturing cost per unit for each product.
2.
In addition, various product design and research costs (also called “upstream” costs) have been identified and
applied to the Standard model at $15 per unit and to the Deluxe model at $25 per unit. Also, marketing, distribution, and
customer service costs (also called “downstream” costs) of $120 and $180 have been applied to each unit of the Standard
and Deluxe models, respectively. Compute the full product cost per unit of each model.
Solutions:
Standard Model:
Direct Materials
$100,000
Conversion Costs:
Materials Handling: 64,000 × $0.40
$25,600
Cutting: 64,000 × $2.00
128,000
Assembly: 64,000 × $6.00
384,000
Wood Refinishing: 16,200 × $15.00
243,000
780,600
Total Manufacturing Costs
$880,600
Manufacturing Cost per Unit: $880,600 ÷ 8,000 units
$110.075
Deluxe Model:
Direct Materials
$62,500
Conversion Costs:
Materials Handling: 30,000 × $0.40
$12,000
Cutting: 30,000 × $2.00
60,000
Assembly: 30,000 × $6.00
180,000
Upholstery: 5,100 × $20.00
102,000
354,000
Total Manufacturing Costs
$416,500
Manufacturing Cost per Unit: $416,500 ÷ 2,500 units
$166.60
Standard
Deluxe
$110.075
$166.60
Upstream costs
15.000
25.00
Downstream costs
120.000
180.00
Total unit cost
$245.075
$371.60
Manufacturing cost per unit
30
45
Value-added and non-value-added activities: Identification and analysis of activities is central to activity-based
costing (ABC). When managers and accountants develop an ABC system, they have an opportunity to classify each
activity as either value-added or non-value-added. A value-added activity enhances the product or satisfies an
organizational need. For example, production processing activities typically add value. Non-value-added activities do not
enhance the product. In the manufacturing department, waiting time, move time, and inspection time are all classified as
non-value-added activities. Non-value-added activities should be reduced to a minimum. Thus, ABC systems help
managers identify ways to reduce inefficiencies.
46
Applicability and benefits of ABC: Activity-based costing (ABC) procedures are most applicable in settings
where overhead costs other than organization-level are a relatively large component of costs. Benefits of implementation
include the following:
a.
Provides an understanding of complex product costs and product profitability for improved resource management
b.
Allows management to focus on the nature of activities performed so that non-value-added activities can be
controlled or eliminated, thus streamlining the production process
c.
Highlights the interrelationship of costs and activities and thus provides opportunities to reduce costs
d.
Provides a more appropriate means of charging overhead costs to products
47
Allocation of Support Department Costs: Costs incurred by support (or service) departments, such as Human
Resources, Purchasing, Building Maintenance, and Power Plant, that directly assist the production process can be a large
part of the overhead to be allocated to user departments, which use the support services.
48
Allocation bases: Support costs are allocated to user departments using an allocation base, preferably a cost
driver. Typical allocation bases are as follows:
a.
Human Resources: Number of employees served
b.
Purchasing: Number of purchase requisitions processed
c.
Building Maintenance: Square feet serviced
49
Cost allocation methods: Three major methods are used to assign support costs to user departments:
1.
Direct method: Service department costs are allocated directly to the production departments without any
allocation to other service departments for which work might have been performed.
2.
Step-down (or sequential) method: Since service departments often provide services to the other service
departments as well as to the production departments, service department costs are allocated to other service
departments and to production departments in a predetermined sequence. Generally, the service department allocated
first is the one that provides the most service to other service departments. Where there is no determinable difference in
service levels, total costs in each service department are used, starting with the department that has the most costs, and
then moving down. Once a service department’s costs have been allocated, no further costs are allocated to that service
department.
3.
Reciprocal method: Service department costs may also be allocated using a method that fully incorporates the
interdepartmental support provided among the service departments. This method requires simultaneous equations and,
where there are more than two service departments involved, a computer program is generally used. It is theoretically the
most accurate method; however, the added precision resulting from its use may not exceed the cost of using it.
31
50
Single- versus dual-rate allocation systems: Regardless of which of the allocation methods is used (see section
49), support costs may be allocated from a single pool (single-rate method) or from separate pools fixed and variable cost
pools (dual-rate method). A dual-rate system for fixed and variable costs is a more correct procedure, especially if the
actual volume of support activity can vary significantly from the budgeted volume.
51
Example of allocation of support department costs: Spalding Enterprises has two support departments,
Maintenance and Receiving, whose costs are allocated to two production functions, Machining and Assembly. During the
current year, Maintenance and Receiving incurred the following costs and budgeted volume of activity:
Costs/Departments
Maintenance
Receiving
Totals
Fixed costs
$10,000
$15,000
$25,000
Variable costs
30,000
20,000
50,000
$40,000
$35,000
$75,000
Total costs to be allocated
Allocation base
Hours of
Maintenance
Deliveries Received
and Processed
Budgeted volumes of activity are as follows:
Budgeted Support Activity
Support
provided by:
Maintenance
Maintenance
(hours)
XXX
Receiving
(deliveries)
500
Receiving
Machining
3,000
XXX
Assembly
Totals
12,000
15,000
30,000
1,500
4,000
6,000
Using a single-rate system, the calculations shown below demonstrate allocation of support costs to the Machining and
Assembly departments using the (a) direct method and (b) step-down method.
a.
Direct Method: First, determine the ratio of support activity supplied among the user departments. Disregard any
support provided by one service department to another (ratios rounded to whole percents).
Maintenance Support:
Machining function
12,000/27,000 hours
44%
Assembly function
15,000/27,000 hours
56%
Machining function
1,500/5,500 deliveries
27%
Assembly function
4,000/5,500 deliveries
73%
Receiving Support:
32
Next, use ratios to allocate support department costs directly to user departments.
Maintenance
Costs to be
allocated:
$40,000
Maintenance
(44%, 56%)
-40,000
Receiving
Machining
Assembly
Totals
$35,000
$17,600
$22,400
$40,000
$0
Receiving
(27%, 73%)
-35,000
9,450
25,550
35,000
Totals
$0
$27,050
$47,950
$75,000
b.
Step-Down Method: The following steps are taken:
Step 1: Determine the ranking (order) for the support department allocation. Maintenance is budgeted to provide 3,000
hours or 10% (3,000/30,000) of its total support activities to Receiving. Receiving is budgeted to process 500 deliveries or
8% (500/6,000) of its total support activities to Maintenance. Thus, Maintenance provides more support to the other
support function than does Receiving, so the ranking is Maintenance costs allocated first, followed by Receiving. Note:
Had each support department provided the other one with equal levels of support, then Maintenance would still have been
selected first because it has more dollars to be allocated than does Receiving.
Step 2: Determine the allocation ratios to be used for each of the support departments. For the first-ranked department,
ratios need to be developed relating to all user departments, including the other support department. Ratios for remaining
support departments are based on the activity to be done for only the support departments not yet allocated and the other
user departments.
Support provided by Maintenance to:
Receiving function
3,000/30,000 hours
10%
Machining function
12,000/30,000 hours
40%
Assembly function
15,000/30,000 hours
50%
Support provided by Receiving (without considering support to Maintenance):
Machining function
1,500/5,500
27%
Assembly function
4,000/5,500
73%
Step 3: Use ratios to allocate support department costs in sequence, determined by ranking in Step 1.
Maintenance
Receiving
Costs to be
allocated:
$40,000
$35,000
Maint. (10%,
40%, 50%)
-40,000
4,000
$0
39,000
Receiving
(27%, 73%)
Machining
-39,000
Assembly
Totals to
Prod.
$16,000
$20,000
$36,000
10,530
28,470
39,000
$26,530
$48,470
$75,000
$0
Totals
33
52
Joint products are two or more products whose total resale value is significant and which are produced
simultaneously in the same processing operation. The joint (or common) processing costs must be allocated to the joint
products using estimates. The allocations are typically based on the relative sales value or relative measures (i.e., units or
pounds) of the products.
53
Byproducts are a product of a process having a relatively small total resale value in relation to the sales value(s)
of the main or joint products. The recovery value may be treated either as other income or a reduction of main product
joint cost.
Application: For which type of product is it appropriate for the seller to accept any price that exceeds the storage and
delivery costs for the product?
Byproduct
Optional product
Captive product
Product bundle
A - Any amount received above the storage and delivery costs for a byproduct allows the seller to reduce the main
product's cost and price to make it more competitive.
Optional products are those offered for sale along with the main product. They are unlikely to have a zero production
cost so the seller must receive a price above the storage and delivery costs for such products.
Captive products are those that must be used along with the main product, such as film for use with a camera. Sellers
often make their money on the captive products, rather than on the main product which is sold at a low price. The
captive products therefore will be priced well above the storage and delivery costs.
Product bundles are combinations of products sold together at a reduced price, such as season tickets for a theater.
Products are bundled in order to promote the sale of certain items that consumers might not otherwise purchase. The
combined price of the bundle must be low enough to encourage consumers to buy the bundle, but must recover
production costs and provide some profit for the seller, so the price must exceed storage and delivery costs.
54
1.
2.
3.
4.
Allocation methods: Four methods are commonly used for allocating joint costs:
Relative sales value at split-off
Physical output
Net realizable value (NRV)
Constant gross margin NRV
34
Application: For purposes of allocating joint costs to joint products, the sales price at point of sale, reduced by cost to
complete after split-off, is assumed to be equal to the:
joint costs.
total costs.
net sales value at split-off.
sales price less a normal profit margin at point of sale.
C - When allocating joint costs to joint products using a sales value or market value approach, the “sales or market
value” of each joint product must be derived in a similar fashion. If all products can be sold at split-off and the respective
prices are known, there is no problem. But, what if one or more of the joint products requires some cost to complete
(such as special packaging) after split-off? It is generally assumed that cost to complete can be subtracted from the final
product sales price to arrive at net sales value at split-off and further, that this value is comparable to sales values at
split-off of product(s) which require no completion cost beyond split-off.
55
Relative sales value at split-off: Split-off is the point at which separately identifiable main products emerge from
the joint processing phase. Where sales values at split-off are known, they are usually used to determine the allocation
percentage of joint costs to each product. This method cannot be used in cases where no market exists for one of more
products at the split-off point (i.e., some products require further processing before they are marketable).
Application: LM Enterprises produces two products in a common production process, each of which is processed
further after the split-off point. Joint costs incurred for the current month are $36,000. The following information for the
current month was also gathered:
Units
Product
Units
Produced
Separable
Sold
Selling
Costs
Price
per Unit
L
10,000
9,500
$20,000
$ 8
M
5,000
4,000
40,000
20
What amount would be the joint cost allocated to Product M, assuming that LM Enterprises uses the estimated net
realizable value method to allocate costs?
$20,000
$12,000
$15,000
$18,000
D - Net realizable value equals eventual sales price less separable costs. For Product L, this is $80,000 (10,000 units
produced × $8 selling price per unit) less $20,000, or $60,000. For Product M, it is $100,000 (5,000 units × $20) less
$40,000, or $60,000.
Net realizable value of the two products together is $120,000, so Product M is allocated 60/120 or 50% of joint costs.
Multiplying joint costs of $36,000 by 50% gives $18,000.
56
Physical output: The joint product cost is allocated based on each product’s percentage of the total physical
quantity of all the products. This method is the least preferred because it does not consider a product’s ability to generate
enough revenue to cover the costs allocated (ability-to-bear concept). In addition, this method requires all joint products to
be measured in the same physical output, which is not always possible.
35
57
Example of joint product cost: Gyro Company produces 15,000 pounds of Product A and 10,000 pounds of
Product B in a joint production process at a total cost of $150,000. The aggregate sales values of the Products A and B at
split-off are $180,000 and $90,000, respectively. Calculate the joint cost allocable to each product using both the relative
sales value and the unit of measure approaches.
Relative sales value approach: This method will result in the same gross profit percentage for each joint product at the
point of split-off. Each product receives part of the joint costs in proportion to its sales value in relation to the total sales
value of all the products. In this case, the total sales value is $180,000 + $90,000 = $270,000.
Product A
$180,000
$270,000
× $150,000 joint cost = $100,000
Product B
$90,000
$270,000
× $150,000 joint cost = $500,000
Physical output method: This approach will result in the same cost per unit of physical output (in this example, pounds)
for each joint product.
Product A
15,000
(15,000/25,000 = 60%)
Product B
+ 10,000
(10,000/25,000 = 40%)
25,000 pounds
Joint Cost $150,000/25,000 pounds = $6 per pound
Total cost allocated to:
Product A
Product B
15,000 × $6 = $90,000 (= $150,000 × 60%)
10,000 × $6 = 60,000 (= $150,000 × 40%)
$150,000
58
Net Realizable Value (NRV): This is a variation of the relative sales value method and can be used in situations
where no market value exists for one or more joint products at the split-off point. The ultimate sales value of each product
is reduced dollar for dollar by any additional processing costs after split-off (i.e., its separable costs) to arrive at its NRV at
the time of split-off. The NRV is then used to allocate joint costs.
59
Example of NRV: Products A and B are produced in Department 1 at a joint cost of $45,000. Product A is further
processed in Department 2 at a cost of $15,000, and Product B is further processed in Department 3 at a cost of $10,000.
Products A and B are not in salable form after Department 1 processing. Their sales values, after all production has been
completed, are $60,000 and $40,000, respectively. Using the net realizable values at split-off, calculate the Department 1
joint cost allocable to each product.
Product A
Product B
Sales value
$60,000
$40,000
Less separable costs
15,000
10,000
NRV at split-off
$45,000
$30,000
Joint cost assigned to A
$45,000
$75,000
× $45,000 = $27,000
Joint cost assigned to B
$30,000
$75,000
× $45,000 = $18,000
36
Total
$75,000
60
Constant Gross Margin NRV: Under this method, joint costs are allocated so that the gross margin percentage
(after further processing, if any) for each main product is identical. Because this method requires simultaneous equations,
calculations are not likely to be tested on the CPA Examination. However, this method is theoretically superior to the other
methods because it avoids making some joint products appear to be more profitable than other joint products. In other
words, it preserves the idea that one joint product cannot be produced without also producing the other joint product(s).
By ensuring that the gross margin for all joint products is identical, this method reduces the likelihood that managers will
make inappropriate joint product decisions; managers will be encouraged to consider the entire group of joint products
when making decisions to keep or drop the joint products, process a joint product further, or emphasize one joint product
versus another.
61
Backflush Costing:
a.
JIT and cost tracking: Some people call just-in-time (JIT) a costing technique; however, it is an inventory control
method that could be used with any costing method. It does facilitate costing, in that very little inventory is on hand at the
end of the period to complicate calculations.
b.
Little or no inventory: Because inventory on hand is (ideally) eliminated or at least minimized under JIT production,
it is not necessary to use an accounting system that tracks the details for each element of manufacturing costs and
physical flows through inventory accounts. Instead, some form of backflush costing (also called delayed, JIT, or postdeduct costing) may be used. These systems reflect the concept of stockless production that results from the “demandpull” concept of JIT production, and relatively few cost accounting transactions are recorded.
(1)
Trigger points: Instead of recording every detail of the manufacturing process from acquisition of raw materials
through completion of manufacturing, a triggering event or events (sometimes called a pay point or points), such as
purchase of materials, completion of manufacturing, or point of sale causes accounting entries to be made that reflect
(i.e., “look back” on) what has happened. There are several different versions of backflush costing, each of which uses a
different trigger point or combination of points.
(2)
True JIT cost tracking: Where a true JIT system is in operation (zero or very low inventories and fast throughput),
only one trigger point, the completion of manufacturing, is recognized. Entries are made to finished goods, payables, and
conversion costs applied accounts when manufacturing is completed. Costs are then transferred to cost of goods sold at
the time the sale is made. Under this version, no inventory records are kept for raw materials or work in process because
no inventories are kept on hand.
(3)
Two trigger points: Other versions use two trigger points: (1) purchase of materials and completion of product or
purchase of materials and (2) point of sale. In none of the versions is a Work-in-Process account used. An account called
Raw and In Process (RIP) is used in one of the two-trigger point methods to account for all materials that are either in
process or in the materials warehouse. An account called Inventory is used in the other two-trigger point methods to
account for all materials that are either in the warehouse or in unsold finished goods.
Cost Reporting
62
Cost Reporting: Operating statements are prepared for both external and internal purposes. For external
purposes, GAAP must be followed. The matching principle requires that an absorption (full costing) statement be
presented so that product costs (both variable and fixed) are deducted when sold, and period costs are deducted when
incurred. For internal purposes, management is more interested in the progress it is making toward making a profit for the
period. A profit cannot be made until and unless all fixed costs for the period are covered. Therefore, an internal report is
focused on cost behavior, not on the distinction between product and period costs.
63
Absorption Costing: This is the traditionally prepared income statement. Cost of Goods Sold is deducted from
sales to arrive at Gross Margin. The cost of goods sold is made up of all manufacturing costs attached to the product,
including fixed manufacturing overhead per unit. Fixed costs attached to units not sold are on the balance sheet in the
ending inventory. A major problem with absorption costing is that managers have an incentive to produce more units,
37
which allows them to defer more fixed costs in ending inventory. This method discourages managers from rapidly reducing
production volumes if sales drop.
64
Variable/Direct/Contribution costing: In this reporting approach, only variable manufacturing costs are deducted
for cost of goods sold. Fixed manufacturing is regarded as a period cost and is deducted in full, regardless of the number
of units sold. This approach is not acceptable for public reporting (GAAP) or for reporting to the SEC or IRS. However,
variable costing can be useful for managerial decision making because it separates variable and fixed costs, regardless of
whether they are product or period costs. Thus, this method helps managers analyze the effects of fluctuations in volume
on profits. In addition, this method does not encourage managers to overproduce inventory.
65
Operating income: absorption versus variable costing: Because fixed manufacturing costs are treated differently
between these two reporting approaches, operating income will be different if sales and production are not equal during
the period. The amount of the difference is the change in inventory units times fixed overhead per unit.
a.
Production greater than sales: In this scenario, inventory increases. Absorption costing operating income will be
greater than variable costing net income because some of the current period’s fixed costs are held in inventory until the
next period. On the variable statement, all fixed costs are deducted regardless of unit sales.
b.
Production less than sales: If sales are greater than production, inventory decreases. Absorption costing operating
income will be less than variable costing because, in addition to deducting all fixed costs relating to this period’s
production, some fixed costs from the previous period will also be in cost of goods sold (beginning inventory), thus
reducing the current period’s income. However, the variable costing statement will still include only this period’s fixed
costs.
Application: Which of the following statements is correct regarding the difference between the absorption costing and
variable costing methods?
When production equals sales, absorption costing income is greater than variable costing income.
When production equals sales, absorption costing income is less than variable costing income.
When production is greater than sales, absorption costing income is greater than variable costing income.
When production is less than sales, absorption costing income is greater than variable costing income.
C - Variable (direct) costing includes only variable production costs in inventory, while absorption costing includes both
variable and fixed production costs in inventory. Fixed overhead costs are expensed in the period incurred when using
variable costing.
Since production is greater than sales this period, the ending inventory is greater than the beginning inventory. The
fixed costs allocated to those additional units will increase ending inventory cost under absorption costing, while those
same fixed costs will be expensed under variable costing. Since variable costing has greater expense during the period
than absorption costing, net income will be higher under absorption costing than under variable costing.
38
66
Example of Variable and Absorption Costing: Smith Company manufactures and sells one product. The
following is information about its operations for the first two months of the current year.
Selling price per unit
$11
Variable manufacturing cost per unit
4
Variable selling cost per unit sold
2
Monthly fixed manufacturing costs (normal production
capacity of 10,000 units)
30,000
Fixed manufacturing cost per unit (based on normal
production capacity of 10,000 units)
3
Monthly fixed selling costs
10,000
January
Beginning inventory
February
-0-
Production
$1,000
$10,000
10,000
Sales
9,000
10,500
Ending inventory
1,000
500
Variable and absorption costing reports for the first two months of the year are presented below:
JANUARY – Variable Costing Report
Sales – 9,000 units × $11
JANUARY – Absorption Costing Report
$99,000
Variable Cost of Goods Sold
Beginning Inventory
$99,000
Full Cost of Goods Sold
$0
Plus Production (10,000
units × $4 per unit)
40,000
Less Ending Inventory
(1,000 units × $4)
4,000
Beginning Inventory
36,000
Manufacturing Margin
$63,000
Less Variable Selling
Expenses (9,000 units × $2
per unit)
18,000
Contribution Margin
$45,000
Less Fixed Costs:
$0
Plus Production (10,000
units × $7 per unit)
70,000
Less Ending Inventory
(1,000 units × $7)
7,000
Gross Profit
63,000
$36,000
Less Period Costs:
Fixed manufacturing costs
$30,000
Fixed selling expenses
10,000
Operating Income
Sales – 9,000 units at
$11
Variable selling costs
(9,000 units x $2 per unit)
40,000
Fixed selling costs
$5,000
Operating Income
$18,000
10,000
28,000
$8,000
Inventory increased from 0 to 1,000 units. Therefore, absorption income as reported is higher than variable
income. The difference in dollars is the change in inventory units × fixed manufacturing costs per unit
(1,000 units × $3 per unit), or $3,000.
39
FEBRUARY – Variable Costing Report
Sales – 10,500 units × $11
FEBRUARY – Absorption Costing Report
$115,500
Variable Cost of Goods Sold
Sales – 10,500 units ×
$11
$115,500
Full Cost of Goods Sold
Beginning Inventory
$4,000
Beginning Inventory
$7,000
Plus Production (10,000 units
× $4 per unit)
40,000
Plus Production
(10,000
units × $7 per unit)
70,000
Less Ending Inventory
(500 units × $4)
2,000
42,000
Manufacturing Margin
$73,500
Less Variable Selling Expenses
(10,500 units × $2 per unit)
21,000
Contribution Margin
$52,500
Less Fixed Costs:
3,500
Gross Profit
73,500
$42,000
Less Period Costs:
Fixed manufacturing costs
$30,000
Fixed selling costs
10,000
Operating Income
Less Ending Inventory
(500 units × $7)
Variable selling costs
(10,500 units × $2 per
unit)
40,000
$12,500
Fixed selling costs
$21,000
10,000
Operating Income
Inventory decreased from 1,000 to 500 units. Therefore, absorption income as reported is lower than
variable income. The difference in dollars is the change in inventory units × fixed manufacturing costs per
unit (500 units × $3 per unit) or $1,500.
40
31,000
$11,000
II
PROCESS & PROJECT MANAGEMENT
41
A.
Process-Management-Driven Businesses
01
Business process management includes approaches, techniques, and measures that support the organization
design and administer and analyze the business process. The business process needs to be analyzed throughout the
lifetime of the organization, no matter what process. These processes are put into place manually by knowledgeable
personnel under strict control of the organization’s regulations and procedures.
Application: Which of the following does not support business process management?
Approaches
Systems
Techniques
Measures
B - Business process management is supported by the approaches, techniques, and measures of the organization (not
the systems). These processes are analyzed throughout the life of the organization.
02
A few business process modeling tools follow:
a.
Use case diagrams present an overview of functionality provided by system drivers, their goals, and any
dependencies.
b.
Activity diagrams represent the step-by-step workflow of a process.
c.
Business process modeling notation is a graphical representation that identifies the business processes in
business process modeling.
d.
Extended business modeling language (xBML) answers the questions Who, What, When, Where, and Which.
e.
Unified Modeling Language is a general-purpose, standardized modeling language.
Application: Which of the following is not a business process modeling tool?
Use case diagrams
Activity diagrams
Unified modeling language
Activity modeling diagram
D - Use case diagrams, activity diagrams, business process modeling notation, extended business modeling language,
and unified modeling language are all business process modeling tools
42
B.
Roles of Shared Services, Outsourcing, and Off-Shore Operations
01
Shared services means that the service is internal; it is the exact opposite of outsourcing. For example, two
hospitals might decide to merge their HR functions.
Application: What is the definition of shared services?
Sharing personnel to cut back on costs
Combining two companies who share the same vendor
Creating an external service provider
Combining the efforts of two departments that share the same resources
D - Shared services is combining efforts of two departments that share the same resources. Why have two internal
departments working on one common goal and spending twice the money? Shared services combines the two internal
departments that can then share in the resources and costs.
02
Outsourcing Advantages
a.
Cost savings: the lowering of overall costs of the services to the business.
b.
Focus on core business: A company may outsource a service such as their information technology so that they can
concentrate on developing their core (profit center) business and have a specialized company oversee the service.
c.
Improve quality: achieve increased quality by contracting out the service to a specialist.
d.
Capacity management: The risk in providing excess capacity is borne by the service supplier, not the firm, which
improves the methods of capacity management of the services and technology provided.
Application: What is the main purpose of outsourcing?
To improve management
Better training
To reduce costs
To increase personnel
C - Outsourcing to other countries helps reduce costs. A corporation in the United States will outsource to Japan
because Japan will pay employees much less wages for the same work.
03
Off-shore operations means that the organization is incorporated outside the jurisdiction of the primary
operations. For example, a U.S. citizen may use a Swiss company for a certain portion of his or her business. Competitive
pressure and cost reduction are the main goals of off-shoring. Call centers and IT seem to be the best off-shoring costcutters.
43
Application: Which of the following describes an off-shore operation?
A U.S. company incorporates in Japan.
A Japanese company produces right off the Japanese shore.
It is an internal department.
It is a cost-saving process.
A - “Off-shore operations” describes an organization incorporating outside of the original jurisdiction of the primary
operations. The organization will be considered off-shore if it:
incorporates under offshore company laws.
incorporates as a nonresident.
does not trade within the offshore jurisdiction.
meets nominal tax expenses.
C.
Selecting and Implementing Improvement Initiatives
01
To ensure stakeholder satisfaction, organizations have to come up with an effective strategy for selecting and
implementing improvements.
02
Following are the six main improvement approaches:
1.
Total Quality Management (TQM) is a set of management practices utilized throughout the organization that focus
on process measurement and controls to facilitate continuous improvement. TQM is designed to ensure the organization
consistently meets or exceeds customer satisfaction requirements.
2.
Six Sigma is a methodological approach to eliminating defects with the goal to achieve six standard deviations
from the desired target of quality (e.g., 3.4 defects per million).
3.
Business Process Re-engineering (BPR) is a systematic approach or methodology for analyzing business
activities or processes with a view to improving the organization's alignment with strategic goals and/or its effectiveness,
efficiency, competitiveness, etc.
4.
ISO 9001 contains a set of standards that companies can implement for continual improvement. It contains quality
improvement standards that have been adopted by firms worldwide. Among other things, it helps organizations improve
customer satisfaction and employee morale and productivity.
5.
The Business Excellence (BE) Framework is a set of eight fundamental concepts to manage the organization
and achieve better performance: results orientation; customer focus; leadership and constancy of purpose; management
by processes and facts; people development and involvement; continuous learning, innovation and improvement;
partnership development; and public responsibility.
03
Lean Production or Lean Manufacturing is the set of "tools" that assist in the identification and elimination of
waste to improve quality while reducing production costs.
44
Application: R Beck, Inc., has learned that 4,971 of 310,000 of its commercial DVDs over the past 12 months have
arrived to the customer as blank discs with no data contained on them. Which improvement initiative would R Beck
most likely adapt to reduce or eliminate the blank discs?
Lean production
Business excellence framework
Six Sigma
Business process re-engineering
C - While each answer choice represents a quality improvement initiative, Six Sigma is an improvement initiative
specifically designed to address errors in defects. If R Beck were to achieve Six Sigma on 92,000 units, it would
represent a defect rate of one DVD per year per 310,000 DVDs produced.
04
Improvement Initiatives: The process for choosing an improvement initiative begins with identifying company
needs, which can be done through a SWOT analysis (strengths, weaknesses, opportunities, tactics), gap analysis, or
even using a business excellence framework to identify organizational needs. Using one of these techniques, the
organization can establish a baseline for where it currently stands, establish its objectives for moving forward, and then
establish if it has the capabilities and resources to begin a specific initiative.
Application: When is data collection most critical in the implementation of an improvement initiative for a hospital
attempting to improve emergency-room care patient satisfaction?
Before the initiative begins
During the initiative
After completion of the initiative
All of the answer choices are correct.
D - Organizations must collect data before, during, and after the implementation to reach a desired target. By
performing a SWOT or gap analysis, the organization can first establish a baseline of where it stands and where it
needs to go, and also determine if the initiative will fit into the organization as a whole. However, once an initiative has
been chosen and launched, ongoing data collection and analysis is critical to determine if the initiative is on target or
whether changes need to be made. Once the initiative is fully implemented, additional data is collected and analyzed to
determine a cost benefit analysis.
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D.
Business Process Reengineering
01
Business Process Re-engineering (BPR) is the search for, and implementation of, radical change in business
processes to achieve breakthrough results. It reexamines how a company performs basic business processes in
fundamentally different ways to radically improve efficiency. Most change efforts start with what exists and fixes it. Reengineering starts with the future and works backwards, unconstrained by existing methods, people, or departments.
Application: What does business process re-engineering do within an organization?
Only analyzes design workflows
Only designs work processes
Analyzes and designs workflows and processes
Tests and implements processes
C - Business process re-engineering (BPR) identifies processes and workflows, analyzes processes and workflows,
and designs processes and workflows
02
Three tests can be used to determine if a company is doing BPR:
1.
Is the effort focused on critical business processes that, if they are changed, can have a major impact on
performance? A company’s processes can be classified into critical processes (those that are central to providing goods
and services to customers) and support processes (those that support critical business processes). BPR focuses on
critical business processes.
2.
How ambitious is the desired improvement? A company looking for a 10%–20% improvement would not be
considered to be using BPR, which generally looks to improve the process by 100%–150%.
3.
How receptive is senior management to change? Because BPR requires fundamental changes in critical
business processes, senior management must be committed to change.
Application: Which of the following is not a test to determine if an organization is using business process reengineering (BPR)?
The effort focused on critical business processes
The receptiveness of senior management.
The desired improvement's ambition
The effort focused on project management
D - There are three questions that need to be answered to see if an organization is implementing BPR:
1. Is the effort focused on critical business processes that, if they are changed, can have a major impact on
performance?
2. How ambitious is the desired improvement?
3. How receptive is senior management to change?
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03
Information Technology (IT) is usually at the heart of business process re-engineering (BPR). IT is the engine
that allows BPR to take place. Intelligent workstations allow the company to decentralize control throughout the
organization. Groupware software helps coordinate a variety of activities performed by many individuals, and all of this is
tied together with communication networks in a client-server environment.
Application: What is the role of IT in business process re-engineering?
It is the major facilitator for new ways of sharing information within a specific organization and outside of the
organization.
It only creates the systems that work the processes and workflows.
It is the minor facilitator for creating the systems that work the process and workflows.
It maintains the process management piece of the project.
A - IT is the major facilitator for coming up with new forms of working and sharing information within a specific
organization, and also with organizations outside of the original organization. They are a key department to keep
processes, workflows, and communications working.
E.
Management Philosophies and Techniques for Performance Improvement
01
Just-in-Time (JIT) refers to systems in which items are delivered where and when needed.
Application: The benefits of a just-in-time system for raw materials usually include:
elimination of nonvalue-adding operations.
increase in the number of suppliers, thereby ensuring competitive bidding.
maximization of the standard delivery quantity, thereby lessening the paperwork for each delivery.
decrease in the number of deliveries required to maintain production.
A - A just-in-time (JIT) system for raw materials provides for delivery of materials to the workplace just in time (hence the
name!) for use. If things go as planned, the materials will not be moved back and forth into and out of storage. Since
material handling is not an activity that adds value to the finished goods, a major benefit of the just-in-time system is
elimination of nonvalue-adding operations.
A JIT inventory system will generally:
decrease the number of suppliers,
minimize the standard delivery quantity, and
increase the number of deliveries required.
02
A JIT inventory system is one in which the company develops a group of reliable local vendors who can supply
the inventory with minimum lead time just before the item is required in the manufacturing process.
a.
Quality Control: Little or no inventory is kept on hand, so production is interrupted if parts do not arrive as needed
or are defective. Quality control is critical, as is a good relationship with vendors to obtain high-quality materials with
frequent deliveries. If quality control procedures are not in place, the entire process breaks down.
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b.
Kanban: The basic principle of just-in-time production is not to produce anything until the next stage in the
production process is ready to work on it. The procedure originated in Japan and is based on the “kanban” concept. A
kanban is a communication device, which may be a card, sign, or production bin. When work is completed in one area,
the card, sign, or empty bin is returned to the preceding work area to signal that additional materials/products are
demanded. This demand triggers production at the previous station, hence the name “demand-pull.” The ultimate demand
is the customer’s order or anticipated orders.
c.
JIT Characteristics and Objectives: Just-in-time production has the following characteristics and objectives:
(1)
Smooth production flow: Smooth, uninterrupted flow of material is needed from suppliers through the production
process and finally to customers, as completed goods without fluctuations that can lead to excess inventories and/or
delays. Raw material must arrive when needed for each subassembly so that the production process functions smoothly.
(2)
Pull method of production: The pull production method is utilized, whereby goods are produced at each step of
the manufacturing process only when required by the subsequent step.
(3)
Small lot sizes: Purchasing materials and producing subassemblies in small lot sizes reduces inventory buildup
and associated costs.
(4)
Reduced setup time: Reduction in setup time is necessitated by production in small lot sizes.
(5)
High quality standards: High quality standards for direct materials and finished products are required to avoid
production line shutdowns and waiting-time costs.
(6)
Preventive routine equipment maintenance: Routine preventive maintenance avoids downtime from
malfunctions and associated waiting time costs from resultant delays in the production process.
(7)
Effective employee teamwork: Employee teamwork generates ideas to improve product quality and production
efficiency, and to reduce costs.
(8)
Versatile workers and equipment: In order to produce a variety of products as needed to avoid bottlenecks and
resultant higher costs, both workers and equipment must be versatile.
(9)
Work/manufacturing cells: In a JIT production system, work is often broken down into sets of tasks that are
performed in different work or manufacturing cells. Each cell is a work area that performs a particular set of tasks.
Application: Kanban is:
a technique for managing a just-in-time (JIT) inventory system developed by the Japanese.
a method of evaluating alternative credit policies developed by the Japanese.
a method of determining the economic order quantity expressed in mathematical terms.
a method of developing a relationship between sales and inventory used in forecasting.
A - Kanban is a technique for managing a just-in-time inventory system. The kanban is a tag attached to the storage
container where component parts are kept. As a component is used, a kanban is placed in a box. Managers determine
the number of kanbans needed to be in the box of the component part before a reorder of that part is necessary.
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03
Lean is a concept closely related to the notion of efficiency that focuses on maximizing customer value and
minimizing costs. It fundamentally means to operate with little waste.
Application: Just-in-time production is also called:
kaizen.
lean manufacturing.
activity-based management.
backflush costing.
B - Lean manufacturing is another term for just-in-time (JIT) production system, in which a company develops a group
of vendors who can supply the inventory with minimum lead time just before the item is required in the manufacturing
process. The goal is to maximize customer value and minimize costs.
04
Throughput is the output relative to input of a system. In TOC (theory of constraints), throughput is defined as the
rate at which the system generates money based on sales. Thus, the focus is on producing goods that are sold, rather
than simply producing goods.
Application: A newly introduced costing method that has recently been adopted at some firms is called ________
costing.
absorption
standard
throughput
variable
C - Throughput costing relegates all product costs except direct materials to period cost (expense) status. It is a newly
proposed costing method.
Absorption, standard, and variable costing have been used for several decades.
05
Drum-Buffer-Rope System: a tool for managing product flow, inspired by the theory of constraints (TOC). The
system focuses on maximizing throughput around the constraint as follows:
a.
Drum: The constraint in the system sets the pace (i.e., the “drum”) for production. Production cannot exceed the
slowest path through the system.
b.
Buffer: Protective inventory is built into the system to provide slack around the constraint. Unlike JIT (just-in-time
production), in which desirable inventory is zero, TOC builds an allowance for problems into the system. Such problems
might include last-minute customer orders, delays in vendor shipments, employee absenteeism, and equipment failure. An
inventory buffer is needed to reduce risks to throughput.
c.
Rope: a “pull” system such as Kanban to trigger product flow.
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Application: Which one of the following statements relating to the drum-buffer-rope (DBR) theory developed by Dr.
Eliyahu Goldratt is incorrect?
DBR assumes that within a manufacturing system, there is at least one (or a limited number) of constraints created by
scarce resources.
In order to best protect the throughput of a manufacturing operation, the limiting factor of the manufacturing process
must be protected.
It is important to focus on the queuing throughout the entire manufacturing system in order to provide for a smooth
transition from one area to another.
It is important to protect against inflationary inventory levels (inventory build ups) that can occur at bottlenecks.
C - The drum-buffer-rope theory:
assumes that within a manufacturing system there is at least one (or a limited number) of constraints created by scarce
resources.
states that in order to best protect the throughput of a manufacturing operation, the limiting factor of the manufacturing
process must be protected.
states that it is important to protect against inflationary inventory levels (inventory build ups) and the associated carrying
costs which can occur at bottlenecks (constraints).
focuses on only the queuing area within a manufacturing firm that is in front of the constraint (bottleneck).
F.
Project Planning, Implementation, and Monitoring
01
Project management is the key to planning, implementing, and monitoring a successful project. When a project is
needed, a group is put together to initiate the whole process. In this process, there are certain steps to proceed with in
order to complete the project in a timely and accurate manner. The three main steps are:
1.
planning,
2.
implementing, and
3.
monitoring.
Application: Project management is the key to:
planning, implementing, and monitoring.
planning only.
implementing and monitoring only.
None of the answer choices are correct.
A - Project management is the key to planning, implementing, and monitoring. It does not stop with only planning, but
encompasses all three processes of the project.
02
The planning stage consists of many steps:
a.
Create the project plan: Explain the goals, objectives, scope, and deliverables.
b.
Create a schedule: Examine date constraints and create timelines for specific portions of the project.
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c.
Create a control plan: Specify how changes to the plan will be handled, how changes will be accepted or rejected,
and how the accepted or rejected plans will be communicated to the project creators.
d.
Create a quality control plan: Determine how issues of quality will be addressed and how quality will be
monitored.
e.
Create a risk management plan: Create a procedure on how to deal with the identified problem areas, what the
major assumptions are, what other risks may occur, and how they will be handled.
f.
Create a communications plan: Figure out what, when, and how to communicate.
g.
Create a procurement plan: Decide on how to purchase goods or services for the project.
h.
Create a completion plan: Consider if this is even needed. This portion of the planning will answer a couple of
questions: Are we done with the project, and has everyone been contacted about completion?
Application: Which of the following is not considered a step in the planning stage?
Create a communications plan
Create a schedule
Create a quality control plan
Monitor the project
D - The planning stage is the planning of the project and does not go beyond planning. As a result, the planning stage
of a project includes the following:
Creating the project plan
Creating a schedule
Creating a control plan
Creating a quality control plan
Creating a risk management plan
Creating a communications plan
Creating a completion plan
Monitoring the project occurs at a later stage.
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03
The implementation stage coincides with the planning stage. In some cases, the project manager will have an
issue arise and will have to go back to the risk management plan to find the appropriate procedure. Other parts of the
planning stage coincide with the implementation stage as well.
Application: The implementation stage is the second step in project management. What does the implementation
stage entail?
Creating a schedule
Creating the plan
Holding meetings, monitoring progress, and tracking costs
Releasing the final project
C - The implementation stage includes holding meetings, monitoring the progress of the project, updating the project
plan, tracking costs, and communicating the progress of the project. Remember that the implementation stage
coincides with the planning stage.
04
The monitoring stage is more than simply monitoring the results, but includes ensuring the quality of the project,
finalizing records, and communicating the results to the stakeholders of the project.
G.
Project Risks, Including Resource, Scope, Cost, and Deliverables
01
Internal risks are considered risks that may be within the control of the project manager. These risks may emerge
when the scope of the project is not understood or if there are not enough funds for the project. The internal risks may
result in being over budget, schedule delays, and inexperienced personnel.
Application: A project manager's activities include all of the following, except:
establishing policies for IT.
managing costs.
planning the project.
risk analysis.
A - The project manager's activities include, but are not limited to:
planning the project,
developing schedules,
defining the scope,
risk analysis and management,
quality control, and
cost management.
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02
External risks are considered factors that are out of the control of the project manager. These risks may include
stock market changes, policies affecting currency, taxes, or inflation. These risks will generally be considered threats,
while internal risks may generally be categorized as threats or opportunities.
03
Delphi method - To help identify risks, the project manager may perform brainstorming sessions. One example of
brainstorming is the Delphi method, a technique for decision making and problem solving. The Delphi method attempts to
develop a forecast through a group consensus. Individual experts are asked to respond to an initial questionnaire followed
by a second one prepared using the information and opinions gathered through the first questionnaire. In this process,
each expert is asked to reconsider and revise his or her initial answers to the various questions. This process continues
until some type (or range) of consensus is reached.
Application: Information systems steering committees:
should consist of systems specialists and end users who plan and direct projects through the system's life cycle.
should consist of systems management, the controller, and other management personnel, and should establish policies
with regard to an organization's information system.
are found in organizations that have had a history of information system problems, with the focus of the committee
being the overseeing of information systems development.
consist of a top management team that oversees the information systems department.
B - An information systems steering committee is a managing or directing committee and, as such, should establish
overall policy and direction for an organization's information system. Such a committee should not be involved in the
actual design, development, coordination, and direction of projects, or the resolution of specific operational problems
within the information system. Consequently, the steering committee should consist of systems management, the
controller, and other management personnel.
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