Galilee College
Managerial Accounting
Course No. ACC 311
Galilee Corporate Centre • Joe Farrington Road
P.O. Box EE 16507 - Nassau, Bahamas –
Tel. (242)324-9466 Fax (242)364-8202
Email: galilee@coralwave.com
www.gcollege.org
Dr. Willis L. Johnson, Galilee College
Contribution by: by Larry Walther
Galilee College © 2008
Galilee College
Course Outline
COURSE NUMBER:
Accounting
ACC 311
COURSE TITLE:
Managerial
DEPARTMENT: Accounting
CREDIT VALUE: 3.0
COURSE DURATION: 1 SEMESTER
DATE PREPARED: July 2002
PREREQUISITES
ACC 112, Principles of Accounting II
PROGRAM COORDINATOR _________________________________
REQUIRED TEXTS:
MANAGEMENT ACCOUNTING
Authors
Cheryl S. McWatters, McGill University
Dale Morse, University of Oregon
Jerold Zimmerman, University of Rochester
ISBN: 0-07-028300-1
Description: © 2001 / Hardcover / 704 pages
SUPPLEMENTAL MATERIALS
Study Guide for use with Management Accounting: Analysis & Interpretation / 007-290854-8
COURSE DESCRIPTION
Further development of financial accounting concepts, interpretation, and
further study of management uses of accounting data. It includes a study of
basic accounting concepts, interpretation of accounting reports, cost control
and analysis, and methods of measuring performance. Not open to
accounting majors.
COURSE OBJECTIVE
Students will be expected to:
Understand that cost analysis is most important to all business and
personal functions.
Demonstrate and understand and have the ability to use all functions and
topics covered in this course.
Program Context:
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This course is a second year course in the Accounting program. (This course can also
be completed in the third year )
Course Learning Outcomes:
Learning outcomes identify the knowledge, skills and attitudes that successful students
will have developed and reliably demonstrated as a result of the learning experiences and
evaluations during this course.
Evaluation Strategies and Grading:
Class Attendance
Full participation and attendance is expected for this course. Students who miss a
class are responsible for any information discussed, assigned or distributed in that
class period.
Exams - Four major exams have been scheduled. Students are expected to
attend on the scheduled date. If an emergency occurs, you should somehow
notify the instructor on the exam date.
To receive a passing grade, the student MUST take the final exam. If any of
the three exams are missed for ANY REASON, the final exam will count
again for each exam missed. In that case, the final exam will be
comprehensive, that is, include all chapters covered in the course.
Homework Homework is assigned for each chapter covered. Due dates will
be assigned. The homework will be graded for neatness, correctness, and
completeness. After the due date, the homework will have NO POINT
VALUE.
Classwork - Some classes will have classwork. This is a time to learn the
material. Use notes, texts, or help each other. This is to develop teamwork. If
you are absent, no grade will be given.
FINAL EXAM
CLASS TESTS
ASSIGNMENTS
40%
50%
10%
100%
Note that violation of academic honesty can affect the course grade.
"Cheating" on an exam (i.e., the giving or receiving of aid) will result in a
course grade of "F."
Note that classroom behavior (for example, talking to other students during
lecture) can negatively affect course grades by as much as three letter
grades, e.g., an "A" can become a "D."
GRADING SYSTEM:
A 94% 100% Excellent
B 87% 93% Good
C 75% 86% Average
4.00
3.00
2.00
F
D 68% - 74% Passed 1.00
0% - 67% Failed 0.00
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COVERAGE
A. Introduction
1. Management Accounting in an Organizational Context
B. Strategy and Planning Decisions
2. Measuring and Analyzing Activity Costs
3. Measuring and Analyzing Product Costs
4. Managing Activities
5. Short-Term Decisions and Constraints
C. Strategy and Control Decisions
6. Managing Organizations
7. Decentralized Organizations
D. Planning and Control Issues
8. Budgeting
9. Cost Allocations
10. Absorption Cost Systems
11. Variable Costing and Capacity Costs
E. Summary
12. Management Accounting in a Dynamic Environment
F. Additional Topics
13. Investment Decisions
14. Standard Costs and Variance Analysis
Additional Information:
1.
MISSED TESTS WILL RESULT IN A ZERO GRADE; SEE YOUR
INSTRUCTOR TO DISCUSS THIS.
2.
Texts, working papers and calculators are to be brought to every class.
3.
Some details of your course schedule may vary by section/teacher or
change as a result of unforeseen circumstances, such as weather,
cancellations, College and student activities and class timetabling.
4
Managerial Accounting
TABLE OF CONTENTS
1. Introduction to Managerial Accounting
2. Process Costing
3. Job-Order Costing
4. Standard Costs
5. Variable (Direct) & Absorption (Full) Costing
6. Activity-Based Costing (ABC)
7. Joint Costing & By-Product Costing
8. Service Cost Allocations
9. Budgeting
10. Cost-Volume-Profit (CVP) Analysis
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Chapter 1 – Introduction to Managerial Accounting
GOALS
Your goals for this "managerial accounting introduction" chapter are to learn about:





The distinguishing characteristics of managerial accounting.
The role of managerial accounting in support of planning, directing, and controlling.
Key production cost components: direct materials, direct labor, and factory overhead.
Product costs versus period costs.
Categories of inventory for manufacturers and related financial statement implications.
DISCUSSION
MANAGERIAL ACCOUNTING
FINANCIAL VS. MANAGERIAL ACCOUNTING: Early portions of this textbook dealt mostly with
financial accounting. Financial accounting is concerned with reporting to external parties such as
owners, analysts, and creditors. These external users rarely have access to the information that
is internal to the organization, nor do they specify the exact information that will be presented.
Instead, they must rely on the general reports presented by the company. Therefore, the
reporting structure is well defined and standardized. The methods of preparation and the reports
presented are governed by rules of various standard-setting organizations. Furthermore, the
external users generally see only the summarized or aggregated data for an entity.
In contrast, managers of a specific business oftentimes need or desire far more detailed
information. This information must be tailored to specific decision-making tasks of managers,
and its structure becomes more "free formed." Such managerial accounting information tends to
be focused on products, departments, and activities. In this context, the management process is
intended to be a broad reference to encompass marketing, finance, and other disciplines. Simply
simply: managerial accounting is about providing information in support of the internal
management processes. Many organizations refer to their internal accounting units as
departments of strategic finance. This title is perhaps more reflective of their wide range and
scope of duties.
Managerial accounting is quite different from financial accounting. External reporting rules are
replaced by internal specifications as to how data are to be accumulated and presented.
Hopefully, these internal specifications are sufficiently logical that they enable good economic
decision making. For example, specific reporting periods may be replaced with access to realtime data that enable quick responses to changing conditions. And, forecasted outcomes
become more critical for planning purposes. Likewise, cost information should be disseminated
in a way that managers can focus on (and be held accountable for!) those business components
("segments") under their locus of control.
In short, the remainder of this book is about the ideas and methods that can be used to provide
accounting information in direct support of the "broadly defined" role of managing a business
organization. If you aspire to work in strategic finance, the remainder of this book is your
introductory primer. But, for most readers -- those who must manage some part of an
organization -- the remainder of this book is your guide to knowing how and when the
management accountant's tools can be used to help you do your job better!
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PROFESSIONAL
CERTIFICATIONS IN
MANAGEMENT
ACCOUNTING: You are
likely familiar with the
CPA (certified public
accountant) designation;
it is widely held and
recognized. The
certification is usually
accompanied by a state
issued license to practice
public accounting.
However, there are also
CMA (certified
management accountant) and CFM (certified financial manager) designations. These are not
"licenses," per se, but do represent significant competency in managerial accounting and financial
management skills. These certifications are sponsored by the Institute of Management
Accountants.
PLANNING, DIRECTING, AND CONTROLLING
THE ROLE OF MANAGEMENT: I once saw a clever sign hanging on the wall of a business
establishment: ''Managers are Paid to Manage -- If There Were No Problems We Wouldn't Need
Managers." This suggested that all organizations have problems, and it is management's
responsibility to deal with them. While there is some truth to this characterization, it is perhaps
more reflective of a "not so impressive" organization that is moving from one crisis to another.
True managerial talent goes beyond just dealing with the problems at hand.
What does it mean to manage? Managing requires numerous skill sets. Among those skills are
vision, leadership, and the ability to procure and mobilize financial and human resources. All of
these tasks must be executed with an understanding of how actions influence human behavior
within, and external to, the organization. Furthermore, good managers must have endurance to
tolerate challenges and setbacks while trying to forge ahead. To successfully manage an
operation also requires follow through and execution. But, each management action is
predicated upon some specific decision. Thus, good decision making is crucial to being a
successful manager.
DECISION MAKING: Some managers seem to have an intuitive sense of good decision
making. The reality is that good decision making is rarely done by intuition. Consistently good
decisions can only result from diligent accumulation and evaluation of information. This is where
managerial accounting comes in -- providing the information needed to fuel the decision-making
process. Managerial decisions can be categorized according to three interrelated business
processes: planning, directing, and controlling. Correct execution of each of these activities
culminates in the creation of business value. Conversely, failure to plan, direct, or control is a
roadmap to business failure.
The central theme to focus on is this: (1) business value results from good management
decisions, (2) decisions
must occur across a
spectrum of activities
(planning, directing,
and controlling), and (3)
quality decision making
can only consistently
occur by reliance on
information. Thus, I
implore you to see the
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relevance of managerial accounting to your success as a business manager. Let's now take a
closer look at the components of planning, directing, and controlling.
PLANNING: A business must plan for success. What does it mean to plan? It is about thinking
ahead -- to decide on a course of action to reach desired outcomes. Planning must occur at all
levels. First, it occurs at the high level of setting strategy. It then moves to broad-based thought
about how to establish an optimum "position" to maximize the potential for realization of goals.
Finally, planning must be undertaken from the perspective of thoughtful consideration of financial
realities/constraints and anticipated monetary outcomes (budgets).
You have perhaps undergone similar planning endeavors. For example, you decided that you
desired more knowledge in business to improve your stake in life, you positioned yourself in a
program of study, and you developed a model of costs (and future benefits). So, you are quite
familiar with the notion of planning! But, you are an individual; you have easily captured and
contained your plan all within your own mind. A business organization is made up of many
individuals. And, these individuals must be orchestrated to work together in harmony. They must
share and understand the organizational plans. In short, "everyone needs to be on the same
page."
Strategy: A business typically invests considerable time and money in developing its strategy.
Employees, harried
with day-to-day tasks,
sometimes fail to see
the need to take on
strategic planning. It is
difficult to see the
linkage between
strategic endeavors
and the day-to-day
corporate activities
associated with
delivering goods and services to customers. But, this strategic planning ultimately defines the
organization. Specific strategy setting can take many forms, but generally includes elements
pertaining to the definition of core values, mission, and objectives.
Core Values -- An entity should clearly consider and define the rules by which it will play. Core
values can cover a broad spectrum involving concepts of fair play, human dignity, ethics,
employment/promotion/compensation, quality, customer service, environmental awareness, and
so forth. If an organization does not cause its members to understand and focus on these
important elements, it will soon find participants becoming solely "profit-centric." This behavior
inevitably leads to a short-term focus and potentially illegal practices that provide the seeds of self
destruction. Remember that management is to build business value by making the right
decisions; and, decisions about core values are essential.
Earlier, reference was made to the CMA and CFM designations that can be earned from the
Institute of Management Accountants (IMA). You might find it interesting to follow this hyperlink
to IMA's standards of ethical conduct for its members.
Mission -- Many companies attempt to prepare a pithy statement about their mission. For
example:
"At IBM, we strive to lead in the creation, development and manufacture of the industry’s
most advanced information technologies, including computer systems, software,
networking systems,
storage devices and
microelectronics.
We translate these
advanced
technologies into
value for our
customers through
our professional
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solutions and services businesses worldwide."
Such mission statements provide a snapshot of the organization and provide a focal point against
which to match ideas and actions. They provide an important planning element because they
define the organization's purpose and direction. Interestingly, some organizations have avoided
"missioning," in fear that it will limit opportunity for expansive thinking. For example, General
Electric specifically states that it does not have a mission statement, per se. Instead, its
operating philosophy and business objectives are clearly articulated each year in the Letter to
Shareowners, Employees and Customers.
In some sense, though, GE’s logo reflects its mission: “imagination at work”. Perhaps the
subliminal mission is to pursue opportunity wherever it can be found. As a result, GE is one of
the world's most diversified entities in terms of the range of products and services it offers.
Objectives -- An organization must also consider its specific objectives. In the case of GE:
"Imagine, solve, build and lead - four bold verbs that express what it is to be part of GE.
Their action-oriented nature says something about who we are - and should serve to
energize ourselves and our teams around leading change and driving performance."
The objective of a business organization must include delivery of goods or services while
providing a return (i.e., driving performance) for its investors. Without this objective, the
organization serves no purpose and and/or will cease to exist.
Overall, then, the strategic structure of an organization is established by how well it defines its
values and purpose. But, how does the managerial accountant help in this process? At first
glance, these strategic issues seem to be broad and without accounting context. But, information
is needed about the "returns" that are being generated for investors; this accounting information
is necessary to determine whether the profit objective is being achieved. Actually, though,
managerial accounting goes much deeper. For example, how are core values policed? Consider
that someone must monitor and provide information on environmental compliance. What is the
most effective method for handling and properly disposing of hazardous waste? Are there
alternative products that may cost more to acquire but cost less to dispose? What system must
be established to record and track such material, etc.? All of these issues require
"accountability." As another example, ethical codes likely deal with bidding procedures to obtain
the best prices from capable suppliers. What controls are needed to monitor the purchasing
process, provide for the best prices, and audit the quality of procured goods? All of these issues
quickly evolve into internal accounting tasks. And, the managerial accountant will be heavily
involved in providing input on all phases of corporate strategy.
Positioning: An important part of the planning process is positioning the organization to achieve
its goals. Positioning is a broad concept and depends on gathering and evaluating accounting
information.
Cost/Volume/Profit Analysis and Scalability -- In a subsequent chapter, you will learn about
cost/volume/profit (CVP) analysis. It is imperative for managers to understand the nature of cost
behavior and how changes in volume impact profitability. You will learn about calculating breakeven points and how to manage to achieve target income levels. You will begin to think about
business models and the ability (or inability) to bring them to profitability via increases in scale.
Managers call upon their internal accounting staff to pull together information and make
appropriate recommendations.
Global Trade and Transfer -- The management accountant frequently
performs significant and complex analysis related to global business
activities. This requires in-depth research into laws about tariffs, taxes,
and shipping. In addition, global enterprises may transfer inventory and
services between affiliated units in alternative countries. These
transactions must be fairly and correctly measured to establish
reasonable transfer prices (or potentially run afoul of tax and other rules
of the various countries involved). Once again, the management
accountant is called to the task.
Branding/Pricing/Sensitivity/Competition -- In positioning a company's
products and services, considerable thought must be given to branding
and its impact on the business. To build a brand requires considerable
investment with an uncertain payback. Frequently, the same product can be "positioned" as an
9
elite brand via a large investment in up-front advertising, or as a basic consumer product that will
depend upon low price to drive sales. What is the correct approach? Information is needed to
make the decision, and management will likely enlist the internal accounting staff to prepare
prospective information based upon alternative scenarios. Likewise, product pricing decisions
must be balanced against costs and competitive market conditions. And, sensitivity analysis is
needed to determine how sales and costs will respond to changes in market conditions.
As you can see, decisions about positioning a company's products and services are quite
complex. The prudent manager will need considerable data to make good decisions.
Management accountants will be directly involved in providing such data. They will usually work
side-by-side with management in helping them correctly interpret and utilize the information. It
behooves a good manager to study the basic principles of managerial accounting in order to
better understand how information can be effectively utilized in the decision process. With these
sorts of topics in play, it is no wonder that the term "strategic finance" is increasingly used to
characterize this profession.
Budgets: A necessary planning component is budgeting. Budgets outline the financial plans for
an organization. There
are are various types of
budgets.
Operating Budgets -- A
plan must provide
definition of the
anticipated revenues
and expenses of an
organization and more.
These operating
budgets can become
fairly detailed, to the level of mapping specific inventory purchases, staffing plans, and so forth.
The budgets, oftentimes, delineate allowable levels of expenditures for various departments.
Capital Budgets -- Operating budgets will also reveal the need for capital expenditures relating to
new facilities and equipment. These longer-term expenditure decisions must be evaluated
logically to determine whether an investment can be justified and what rate and duration of
payback is likely to occur.
Financial Budgets -- A company must assess financing needs, including an evaluation of
potential cash
shortages. These tools
enable companies to
meet with lenders and
demonstrate why and
when additional support
may be needed.
The budget process is
quite important (no
matter how painful the
process may seem) to the viability of an organization. Several of the subsequent chapters are
devoted to helping you better understand the nature and elements of sound budgeting.
DIRECTING: There are many good plans that are never realized. To realize a plan requires the
initiation and direction of numerous actions. Often, these actions must be well coordinated and
timed. Resources must be ready, and authorizations need to be in place to enable persons to act
according to the plan. By analogy, imagine that a composer has written a beautiful score of
music -- the "plan." For it to come to life requires all members of the orchestra, and a conductor
who can bring the orchestra into synchronization and harmony. Likewise, the managerial
accountant has a major role in putting business plans into action. Information systems must be
developed to allow management to orchestrate the organization. Management must know that
inventory is available when needed, productive resources (man and machine) are scheduled
appropriately, transportation systems will be available to deliver output, and on and on. In
addition, management must be ready to demonstrate compliance with contracts and regulations.
10
These are complex tasks. They cannot occur without strong information resources. A major
element of management accounting is to develop information systems to support the ongoing
direction of the business effort.
Managerial accounting supports the "directing" function in many ways. Areas of support include
costing, production management, and special analysis:
Costing:
A strong manager must understand how costs are captured and assigned to goods
and services. This is more complex than most people realize. Costing is such an extensive part
of the management accounting function that many people refer to management accountants as
"cost accountants." But, cost accounting is only a subset of managerial accounting applications.
With that in mind, let's focus on cost accounting.
Cost accounting can be defined as the collection, assignment, and interpretation of cost. In
subsequent chapters, you will learn about alternative costing methods. It is important to know
what products and services cost to produce. The ideal approach to capturing costs is dependent
on what is being produced.
Costing Methods -- In some settings, costs may be captured by the "job costing method." For
example, a custom home builder would likely capture costs for each house constructed. The
actual labor and material that goes into each house would be tracked and assigned to that
specific home (along with some matching amount of overhead), and the cost of each home can
be expected to vary considerably.
Some companies produce homogenous products in continuous processes. For example,
consider the costing issues faced by the companies that produce the lumber, paint, bricks or
other such homogenous components used in building a home. How much does each piece of
lumber, bucket of paint, or stack of bricks cost? These types of items are produced in continuous
processes where costs are pooled together during production, and output is measured in
aggregate quantities. It is difficult to see specific costs attaching to each unit. Yet, it is important
to make a cost assignment. To deal with these types of situations, accountants might utilize
"process costing methods."
Now, let's think about the architectural firms that design homes.
Such organizations need to have a sense of their costs for
purposes of billing clients, but the firm's activities are very
complex. An architectural firm must engage in many activities
that drive costs but do not produce revenues. For example,
substantial effort is required to train staff, develop clients, bill and
collect, maintain the office, print plans, visit job sites, consult on
problems identified during construction, and so forth. The
individual architects are probably involved in multiple tasks and
projects throughout the day; therefore, it becomes difficult to say
exactly how much it costs to develop a set of blueprints for a
specific client! The firm might consider tracing costs and
assigning them to activities (e.g., training, client development,
etc.). Then, an allocation model can be used to attribute activities to jobs, enabling a reasonable
cost assignment. Such "activity-based costing" (ABC) systems can be used in many settings, but
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are particularly well suited to situations where overhead is high, and/or a variety of products and
services are produced.
Costing Concepts -- In addition to alternative methods of costing, a good manager will need to
understand different theories or concepts about costing. In a general sense, the approaches can
be described as "absorption" and "direct" costing concepts. Under the absorption concept, a
product or service would be assigned its full cost, including amounts that are not easily identified
with a particular item. Overhead items (sometimes called "burden") include facilities depreciation,
utilities, maintenance, and many other similar shared costs. With absorption costing, this
overhead is schematically allocated among all units of output. In other words, output absorbs the
full cost of the productive process. Absorption costing is required for external reporting purposes
under generally accepted accounting principles. But, some managers are aware that sole
reliance on absorption costing numbers can lead to bad decisions. As a result, internal cost
accounting processes in some organizations focus on a direct costing approach. With direct
costing, a unit of output will be assigned only its direct cost of production (e.g., direct materials,
direct labor, and overhead that occurs with each unit produced). You will study the differences
between absorption and direct costing, and consider how they influence the management
decision process. It is one of the more useful business decision elements to understand -empowering you to make better decisions. Future chapters will build your understanding of these
concepts.
In review, to properly direct an organization requires a keen sense of the cost of products and
services. Costing can occur under various methods and theories, and a manager must
understand when and how these methods are best utilized to facilitate the decisions that must be
made. Large portions of the following chapters will focus on these cost accounting issues.
Production:
As you would suspect, successfully directing an organization requires prudent
management of production. Because this is a hands-on process, and frequently entails dealing
with the tangible portions of the business (inventory, fabrication, assembly, etc.), some managers
are especially focused on this area of oversight. Managerial accounting provides numerous tools
for managers to use in support of production and production logistics (moving goods through the
production cycle to a customer).
To generalize, production management is about running a "lean" business model. This means
that costs must be minimized and efficiency maximized, while seeking to achieve enhanced
output and quality standards. In the past few decades, advances in technology have greatly
contributed to the ability to run a lean business. Product fabrication and assembly have been
improved through virtually error free robotics. Accountability is handled via comprehensive
software that tracks an array of data on a real-time basis. These enterprise resource packages
(ERP) are extensive in their power to deliver specific query-based information for even the largest
organizations. B2B (business to business) systems enable data interchange with sufficient power
to enable one company's information system to automatically initiate a product order on a
vendor's information system. Looking ahead, much is being said about the potential of RFID
(radio frequency identification). Tiny micro processors are embedded in inventory and emit radio
frequency signals that enable a computer to automatically track the quantity and location of
inventory. M2M (machine to machine) enables connected devices to communicate necessary
information (e.g., electric meters that no longer need to be read for billing, etc.) without requiring
human engagement. These developments are exciting, sometimes frightening, but ultimately
enhance organizational efficiency and the living standards of customers who benefit from better
and cheaper products. But, despite their robust power, they do not replace human decision
making. Managers must pay attention to the information being produced, and be ready to adjust
business processes to respond.
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Production is a complex process requiring constant decision making. It is almost impossible to
completely categorize and cover all of the decisions that will be required. But, many
organizations
will share
similar
production
issues relating
to inventory
management
and
responsibility
assignment
tasks.
Inventory -- For
a
manufacturing
company, managing inventory is vital. Inventory may consist of raw materials, work in process,
and finished goods. The raw materials are the components and parts that are to be processed
into a final product. Work in process consists of goods under production. Finished goods are the
completed units awaiting sale to customers. Each category will require special consideration and
control.
Failure to properly manage any category of inventory can be disastrous to a business.
Overstocking raw materials or overproduction of finished goods will increase costs and
obsolescence. Conversely, out-of-stock situations for raw materials will silence the production
line at potentially great cost. Failure to have finished goods on hand might result in lost sales and
customers. Throughout subsequent chapters, you will learn about methods and goals for
managing inventory. Some of these techniques carry popular acronyms like JIT (just-in-time
inventory management) and EOQ (economic order quantity). It is imperative for a good manager
to understand the techniques that are available to properly manage inventory.
Responsibility Considerations -- Enabling and motivating employees to work at peak performance
is an important managerial role. For this to occur, employees must perceive that their productive
efficiency and quality of output are fairly measured. A good manager
will understand and be able to explain to others how such measures
are determined. Your study of managerial accounting will lead you
through various related measurement topics. For instance, direct
productive processes must be supported by many "service
departments" (maintenance, engineering, accounting, cafeterias,
etc.). These service departments have nothing to sell to outsiders,
but are essential components of operation. The costs of service
departments must be recovered for a business to survive. It is easy
for a production manager to focus solely on the area under direct
control, and ignore the costs of support tasks. Yet, good
management decisions require full consideration of the costs of
support services. You will learn alternative techniques that
managerial accountants use to allocate responsibility for organizational costs. A good manager
will understand the need for such allocations, and be able to explain and justify them to
employees who may not be fully cognizant of why profitability is more difficult to achieve than it
would seem.
In addition, techniques must be utilized to capture the cost of quality -- or perhaps better said, the
cost of a lack of quality. Finished goods that do not function as promised entail substantial
warranty costs, including rework, shipping (back and forth!), and scrap. There is also an extreme
long-run cost associated with a lack of customer satisfaction.
Understanding concepts of responsibility accounting will also require you to think about attaching
inputs and outcomes to those responsible for their ultimate disposition. In other words, a
manager must be held accountable, but to do this requires the ability to monitor costs incurred
and deliverables produced by circumscribed areas of accountability (centers of responsibility) .
13
This does not happen by accident and requires extensive systems development work, as well as
training and
explanation, on the
part of management
accountants.
Analysis: Certain
business decisions
have recurrent
themes: whether to
outsource production
and/or support
functions, what level
of production and pricing to establish, whether to accept special orders with private label branding
or special pricing, and so forth.
Managerial accounting provides theoretical models of calculations that are needed to support
these types of decisions. Although such models are not perfect in every case, they are effective
in stimulating correct thought. The seemingly obvious answer may not always yield the truly
correct or best decision. Therefore, subsequent chapters will provide insight into the logic and
methods that need to be employed to manage these types of business decisions.
CONTROLLING: Things rarely go exactly as planned, and management must make a concerted
effort to monitor and adjust for deviations. The managerial accountant is a major facilitator of this
control process, including exploration of alternative corrective strategies to remedy unfavorable
situations. In addition, a recent trend (brought about in the USA by financial legislation most
commonly known as Sarbanes-Oxley or SOX) is for enhanced internal controls and mandatory
certifications by CEOs and CFOs as to the accuracy of financial reports. These certifications
carry penalties of perjury, and have gotten the attention of corporate executives -- leading to
greatly expanded emphasis on controls of the various internal and external reporting
mechanisms.
Most large organizations have a person designated as "controller" (sometimes termed
"comptroller"). The controller is an important and respected position within most larger
organizations. The corporate control function is of sufficient complexity that a controller may have
hundreds of support personnel to assist with all phases of the management accounting process.
As this person's title suggests, the controller is primarily responsible for the control task; providing
leadership for the entire cost and managerial accounting functions. In contrast, the chief financial
officer (CFO) is usually responsible for external reporting, the treasury function, and general cash
flow and financing management. In some organizations, one person may serve a dual role as
both the CFO and controller. Larger organizations may also have a separate internal audit group
that reviews the work of the accounting and treasury units. Because internal auditors are
14
reporting on the effectiveness and integrity of other units within a business organization, they
usually report directly to the highest levels of corporate leadership. As you
can see, "control" has many dimensions and is a large task!
Monitor: Let's begin by having you think about controlling your car (aka
"driving")! Your steering, acceleration, and braking are not random; they
are careful corrective responses to constant monitoring of many variables - other traffic, road conditions, destination, and so forth. Clearly, each
action on your part is in response to you having monitored conditions and
adopted an adjusting response. Likewise, business managers must rely
on systematic monitoring tools to maintain awareness of where the
business is headed. Managerial accounting provides these monitoring
tools, and establishes a logical basis for making adjustments to business operations.
Standard Costs -- To assist in monitoring productive efficiency and cost control, managerial
accountants may develop "standards." These standards represent benchmarks against which
actual productive activity is compared. Importantly, standards can be developed for labor costs
and efficiency, materials cost and utilization, and more general assessments of the overall
deployment of facilities and equipment (the overhead).
Variances -- Managers will focus on standards, keeping a particularly sharp eye out for significant
deviations from the norm. These deviations, or "variances," may provide warning signs of
situations requiring corrective action by managers. Accountants help managers focus on the
exceptions by providing the results of variance analysis. This process of focusing on variances is
also known as "management by exception."
Flexible tools -- Great care must be taken in monitoring variances. For instance, a business may
have a large increase in customer demand. To meet demand, a manager may prudently
authorize significant overtime. This overtime may result in higher than expected wage rates and
hours. As a result, a variance analysis could result in certain unfavorable variances. However,
this added cost was incurred because of higher customer demand and was perhaps a good
business decision. Therefore, it would be unfortunate to interpret the variances in a negative
light. To compensate for this type of potential misinterpretation of data, management
accountants have developed various flexible budgeting and analysis tools. These evaluative
tools "flex" or compensate for the operating environment in an attempt to sort out confusing
signals. As a business manager, you will want to familiarize yourself with these more robust
flexible tools, and they are covered in depth in subsequent chapters.
Scorecard: The traditional approach to monitoring organizational performance has focused on
financial measures and outcomes. Increasingly, companies are realizing that such measures
alone are not sufficient. For one thing, such measures report on what has occurred and may not
provide timely data to respond aggressively to changing conditions. In addition, lower-level
personnel may be too far removed from an organization's financial outcomes to care. As a result,
many companies have developed more involved scoring systems. These scorecards are custom
tailored to each position, and draw focus on evaluating elements that are important to the
organization and under the control of an employee holding that position. For instance, a fast food
restaurant would want to evaluate response time, cleanliness, waste, and similar elements for the
front- line employees. These are the elements for which the employee would be responsible;
presumably, success on these points translates to eventual profitability.
Balance -- When controlling via a scorecard approach, the process must be carefully balanced.
The goal is to identify and focus on components of performance that can be measured and
improved. In addition to financial outcomes, these components can be categorized as relating to
business processes, customer development, and organizational betterment. Processes relate to
items like delivery time, machinery utilization rates, percent of defect free products, and so forth.
Customer issues include frequency of repeat customers, results of customer satisfaction surveys,
customer referrals, and the like. Betterment pertains to items like employee turnover, hours of
advanced training, mentoring, and other similar items. If these balanced scorecards are carefully
developed and implemented, they can be useful in furthering the goals of an organization.
Conversely, if the elements being evaluated do not lead to enhanced performance, employees
will spend time and energy pursuing tasks that have no linkage to creating value for the business.
15
Improvement -- TQM is the acronym for total quality management. The goal of TQM is
continuous improvement by focusing on customer service and systematic problem solving via
teams made up of front-line employees. These teams will benchmark against successful
competitors and other businesses. Scientific methodology is used to study what works and does
not work, and the best practices are implemented within the
organization. Normally, TQM-based improvements represent
incremental steps in shaping organizational improvement. More
sweeping change can be implemented by a complete process
reengineering. Under this approach, an entire process is mapped
and studied with the goal of identifying any steps that are
unnecessary or that do not add value. In addition, such
comprehensive reevaluations will, oftentimes, identify bottlenecks
that constrain the whole organization. Under the theory of
constraints (TOC), efficiency is improved by seeking out and
eliminating constraints within the organization. For example, an
airport might find that it has adequate runways, security processing,
luggage handling, etc., but it may not have enough gates. The
entire airport could function more effectively with the addition of a
few more gates. Likewise, most businesses will have one or more activities that can cause a
slow down in the entire operation. TOC's goal is to find and eliminate the specific barriers.
So far, this chapter has provided snippets of how managerial accounting supports organizational
planning, directing, and controlling. As you can tell, managerial accounting is surprisingly broad
in its scope of involvement. Before looking at these topics in more detail in subsequent chapters,
become familiar with some key managerial accounting jargon and concepts. The remainder of
this chapter is devoted to that task.
COST COMPONENTS
PRODUCTION COSTS: Companies that manufacture a product face an expanded set of
accounting issues. In addition to the usual accounting matters associated with selling and
administrative activities, a manufacturer must deal with accounting concerns related to acquiring
and processing raw materials into a finished product. Cost accounting for this manufacturing
process entails consideration of three key cost components that are necessary to produce
finished goods:
(1) Direct materials include the costs of all materials that are an integral part of a finished product
and that have a physical presence that is readily traced to that finished product. Examples for a
computer maker include the plastic housing of a computer, the face of the monitor screen, the
circuit boards within the machine, and so forth. Minor materials such as solder, tiny strands of
wire, and the like, while important to the production process, are not cost effective to trace to
individual finished units. The cost of such items is termed "indirect materials." These indirect
materials are included with other components of manufacturing overhead, which is discussed
below.
(2) Direct labor costs consist of gross wages paid to those who physically and directly work on
the goods being produced. For example, wages paid to a welder in a bicycle factory who is
actually fabricating the frames of bicycles would be included in direct labor. On the other hand,
the wages paid to a welder who is building an assembly line that will be used to produce a new
line of bicycles is not direct labor. In general, indirect labor pertains to wages of other factory
employees (e.g., maintenance personnel, supervisors, guards, etc.) who do not work directly on a
product. Indirect labor is rolled into manufacturing overhead.
(3) Manufacturing overhead includes all costs of manufacturing other than direct materials and
direct labor. Examples include indirect materials, indirect labor, and factory related depreciation,
repair, insurance, maintenance, utilities, property taxes, and so forth. Factory overhead is also
known as indirect manufacturing cost, burden, or other synonymous terms. Factory overhead is
difficult to trace to specific finished units, but its cost is important and must be allocated to those
units. Normally, this allocation is applied to ongoing production based on estimated allocation
16
rates, with subsequent adjustment processes for over- or under-applied
overhead. This is quite important to product costing, and will be covered in
depth later.
Importantly, nonmanufacturing costs for selling and general/administrative
purposes (SG&A) are not part of factory overhead. Selling costs relate to
order procurement and fulfillment, and include advertising, commissions,
warehousing, and shipping. Administrative costs arise from general
management of the business, including items like executive salaries,
accounting departments, public and human relations, and the like.
Accountants sometimes use a bit of jargon to describe certain
"combinations" of direct materials, direct labor, and manufacturing overhead:
Prime Costs = Direct Labor + Direct Material
Conversion Costs = Direct Labor + Manufacturing Overhead
Prime costs are the components that are direct in nature. Conversion costs are the components
to change raw materials to finished goods.
PRODUCT VERSUS PERIOD COSTS
PRODUCT COSTS: Now, another way to look at manufacturing costs is to think of them as
attaching to a product. In other words, products result from the manufacturing process and
"product costs" are the summation of direct materials, direct labor, and factory overhead. This is
perhaps easy enough to understand. But, how are such costs handled in the accounting
records?
To build your understanding of the answer to this question, think back to your prior studies about
how a retailer accounts for its inventory costs. When inventory is purchased, it constitutes an
asset on the balance sheet (i.e., "inventory"). This inventory remains as an asset until the goods
are sold, at which point the inventory is gone, and the cost of the inventory is transferred to cost
of goods sold on the income statement (to be matched with the revenue from the sale).
By analogy, a manufacturer pours money into direct materials, direct labor, and manufacturing
overhead. Should this spent money be expensed on the income statement immediately? No!
This collection of costs constitutes an asset on the balance sheet ("inventory"). This inventory
remains as an asset until the goods are sold, at which point the inventory is gone, and the cost of
the inventory is transferred to cost of goods sold on the income statement (to be matched with the
revenue from the sale). There is little difference between a retailer and a manufacturer in this
regard, except that the manufacturer is acquiring its inventory via a series of expenditures (for
material, labor, etc.), rather than in one fell swoop. What is important to note about product costs
is that they attach to inventory and are thus said to be "inventoriable" costs.
PERIOD COSTS: Some terms are hard to define. In one school of thought, period costs are any
costs that are not product costs. But, such a definition is a stretch, because it fails to consider
expenditures that will be of benefit for many years, like the cost of acquiring land, buildings, etc.
It is best to relate period costs to presently incurred expenditures that relate to SG&A activities.
These costs do not logically attach to inventory, and should be expensed in the period incurred.
It is fair to say that product costs are the inventoriable manufacturing costs, and period costs are
the nonmanufacturing costs that should be expensed within the period incurred. This distinction
is important, as it paves the way for relating to the financial statements of a product producing
company. And, the relationship between these costs can vary considerably based upon the
product produced. A soft drink manufacturer might spend very little on producing the product, but
a lot on selling. Conversely, a steel mill may have high inventory costs, but low selling expenses.
Managing a business will require you to be keenly aware of its cost structure.
FINANCIAL STATEMENT ISSUES THAT ARE UNIQUE TO MANUFACTURERS
17
CATEGORIES OF INVENTORY: Unlike retailers, manufacturers have three unique inventory
categories: Raw Materials, Work in Process, and Finished Goods. Below is the inventory section
from the balance sheet of an actual company:
INVENTORIES
RAW MATERIAL
11,736,735
WORK-IN-PROCESS
7,196,938
FINISHED GOODS
2,161,627
For this company, observe that finished goods is just a small piece of the overall inventory.
Finished goods represent the cost of completed products awaiting sale to a customer. But, this
company has a more significant amount of raw materials (the components that will be used in
manufacturing units that are not yet started) and work in process. Work in process is the account
most in need of clarification. This account is for goods that are in production but not yet
complete; it contains an accumulation of monies spent on direct material (i.e., the raw materials
that have been put into production), direct labor, and applied manufacturing overhead.
Your earlier studies should have ingrained these formulations: Beginning Inventory + Purchases
= Cost of Goods Available for Sale, and Cost of Goods Available for Sale - Ending Inventory =
Cost of Goods Sold. If you need a refresher, look at Chapter 5. Of course, these relations were
necessary to calculate the cost of goods sold for a company with only one category of inventory.
For a manufacturer with three inventory categories, these "logical" formulations must take on a
repetitive nature for each category of inventory. Typically, this entails a detailed set of
calculations/schedule for each of the respective inventory categories. Don't be intimidated by the
number of schedules, as they are all based on the same concept.
SCHEDULE OF RAW MATERIALS: Focusing first on raw material, a company must determine
how much of the available supply was transferred into production during the period. The
schedule at right illustrates this process for Katrina's Trinkets, a fictitious manufacturer of
inexpensive jewelry.
The amounts in the schedule are all "made up" to support the example, but in a real world
scenario, the beginning and ending inventory amounts would be supported by a physical
inventory and the purchases determined from accounting records. Or, Katrina might utilize a
sophisticated perpetual system that tracks the raw material as it is placed into production. Either
way, the schedule summarizes the activity for the period and concludes with the dollar amount
attributed to direct materials that have flowed into the production cycle. This material transferred
to production appears in the schedule of work in process that follows.
SCHEDULE OF WORK IN PROCESS: The following schedule presents calculations that pertain
to work in process. Pay attention to its details, noting that (1) direct materials flow in from the
schedule of raw materials, (2) the conversion costs (direct labor and overhead) are added into the
mix, and (3) the cost of completed units to be transferred into finished goods is called cost of
goods manufactured. The amounts are assumed, but would be derived from accounting records
and/or by a physical counting process.
18
SCHEDULE OF COST OF GOODS MANUFACTURED: The schedules of raw materials and
work in process are often combined into a single schedule of cost of goods manufactured. This
schedule contains no new information from that presented above; it is just a combination and
slight rearrangement of the separate schedules.
SCHEDULE OF COST OF GOODS SOLD: The determination of cost of goods sold is made via
an examination of changes in finished goods:
19
THE INCOME STATEMENT: An income statement for a manufacturer will appear quite similar to
that of a merchandising
company. The cost of goods
sold number within the
income statement is taken
from the preceding schedules,
and is found in the income
statement at right.
All of the supporting
schedules that were
presented leading up to the
income statement are
ordinarily "internal use only"
type documents. The details
are rarely needed by external
financial statement users who
focus on the income
statement. In fact, some
trade secrets could be lost by
publicly revealing the level of detail found in the schedules. For example, a competitor may be
curious to know the labor cost incurred in producing a product, or a customer may think that the
finished product price is too high relative to the raw material cost (e.g., have you ever wondered
how much it really costs to produce a pair of $100+ shoes?).
REVIEWING COST FLOW CONCEPTS FOR A MANUFACTURER: Review the following
diagram that summarizes the discussion thus far. Notice that costs are listed on the left -- the
"product costs" have a blue drop shadow and the "period costs" have a pink drop shadow.
Further, the "prime costs" of production have a back slash in the blue shadow, while the
"conversion costs" have a forward slash in the blue shadow. Yes, the direct labor shadow has
both forward and back slashes; remember that it is considered to be be both a prime and a
conversion cost!
20
CRITICAL THINKING ABOUT COST FLOW: It is easy to overlook an important aspect of cost
flow within a manufacturing operation. Let's see if you have taken note of an important concept!
Try to answer this seemingly simple question: Is depreciation an expense? You are probably
inclined to say yes. But, the fact of the matter is that the answer depends!
Let's think through this with an example. Suppose that Altec Corporation calculated deprecation
of $500,000 for 20X1. 60% of this depreciation pertained to the manufacturing plant, and 40%
related to the corporate offices. Further, Altec sold 75% of the goods put into production during
the year. One third of the remaining goods placed in production were in finished goods awaiting
resale, and the other portion was still being processed in the factory. So, what is the accounting
implication? Let's reexamine the above diagram -- this time with the flow of the $500,000 of
depreciation superimposed (for this illustration, we are ignoring all other costs and looking only at
the depreciation piece):
21
First, notice that the $500,000 of depreciation cost enters the cost pool on the left; $300,000
attributable to manufacturing ($500,000 X 60%) and $200,000 to nonmanufacturing ($500,000 X
40%). The nonmanufacturing depreciation is a period cost and totally makes its way to expense
on the right side of the graphic. But, the manufacturing depreciation follows a more protracted
journey. It is assigned to work in process, and 75% of the goods put in process end up being
completed and sold by the end of the year. Therefore, $225,000 of the $300,000 ($300,000 X
75%) is charged against income as cost of goods sold. The other $75,000 ($300,000 - $225,000
cost of goods sold) remains somewhere in inventory. In our fact situation, 1/3 of the $75,000
($25,000) is attributable to completed goods and becomes part of finished goods inventory. The
other $50,000 ($75,000 x 2/3) stays in work in process inventory since it is attributable to units
still in production.
Confusing enough? The bottom line here is that only $425,000 of the depreciation was charged
against income. The other $75,000 was assigned to work in process and finished goods
inventory. In short, $500,000 ($300,000 + $200,000) entered on the left, and $500,000 can be
found on the right ($50,000 + $25,000 + $225,000 + $200,000). Returning to the seemingly
simple question, we see that a cost is not always an expense in the same period. In a
manufacturing business, much of the direct material, direct labor, and factory overhead can end
up in inventory -- at least until that inventory is disposed.
How important are these cost flow concepts? Well, they are important enough that the FASB has
specified external reporting rules requiring the allocation of production overhead to inventory.
And, for tax purposes, the IRS has specific "uniform capitalization" rules. Under these rules,
inventory must absorb direct labor, direct materials, and indirect costs including indirect labor,
pensions, employee benefits, indirect materials, purchasing, handling, storage, depreciation, rent,
taxes, insurance, utilities, repairs, design cost, tools, and a long list of other factory overhead
items. A company's results of operations are sensitive to proper cost assignment, and
management accountants are focused on processes for correctly measuring and capturing this
information. Subsequent chapters will better acquaint you with this aspect of accounting.
22
Chapter 1: Introduction to Management Accounting
Class & Home Exercise
The following information relates to Droke Drokey Corp. and Groke Grokey Corp:Droke Drokey Corp. (2007)
Beg. Year
End. Year
Groke Grokey Corp. (2007)
Beg. Year
End. Year
Materials inventory
$ 52,000
$ 66,000
$
31,000
$
40,000
Work in process inventory
$ 63,000
$ 77,000
$
42,000
$
51,000
Finished goods inventory
$ 74,000
$ 88,000
$
53,000
$
68,000
$ 130,000
$ 108,000
$
$
102,000
95,000
$ 41,000
$ 27,000
$ 38,000
$ 10,000
$ 85,000
$ 100,000
$
$
$
$
$
$
27,000
21.000
25,000
15,000
99,000
105,000
Purchases of raw materials
Direct labor
Factory Overhead
Indirect labor
Insurance on plant
Depreciation of plant building & equipment
Repairs and maintenance expense
Selling Expenses
General and administrative expenses
Units Produce
Units of Product Sold
Unit Selling Price
Income Tax Rate
70,000
45,000
$35
30%
85,000
60,000
$40
32%
Class Work 1– Droke Drokey Corp.
Required: for Droke Drokey Corp. that produces Hair Weaves:1. Complete the Cost of Goods Manufactured Statement for Droke Drokey Corp.
2. What is the cost to produce one unit
3. How much of the production is Prime cost?
4. How much of the production is Conversion cost?
5. Complete the Cost of Goods Sold Statement for Droke Drokey Corp.
6. Prepare an Income Statement for Droke Drokey Corp.
a. Record all information on Page 1 of the General Journal
b. Post all journal entries to the T Accounts
Home Work 1 – Groke Grokey Corp.
Required: For Groke Grokey Corp. that produces Golden Grills
1. Complete the Cost of Goods Manufactured Statement for Groke Grokey Corp.
2. What is the cost to produce one unit
3. How much of the production is Prime cost?
4. How much of the production is Conversion cost?
5. Complete the Cost of Goods Sold Statement for Groke Grokey Corp.
6. Prepare an Income Statement for Groke Grokey Corp.
a. Record all information on Page 1 of the General Journal
b. Post all journal entries to the T Accounts
23
Chapter 2 – Process Costing
Summary
1. Process Costing is accounting for product costs of inventoriable goods or
services
 Used for continuous process manufacturing of units (homogeneous)
a. Costa are accumulated by departments or cost centers
b. WIP is stated in terms of equivalent completed units to calculate
average cost
c. Units are established on a departmental basis
i.
Period Costs are expensed when incurred. E.g. advertising, officers
salaries, depreciation
2. Job-Order Costing accounts for the cost of specific jobs or projects
Note: Process & J/O Costing use the same general ledger accounts, and cost
flow is the same
 WIP for both systems are increased for the application of Material, Labor
and FOH
3. Equivalent Units of Production
Weighted Average
1 EUP = (conversion cost: DL & FOH) EWIP
Average EU
needed to produce 1 unit of F/G
+ Completed Units/
Transferred
 Add normal spoilage or scrap if any
FIFO
Weighted
- BWIP
3. Spoilage
i.
Normal – occurs under normal, efficient operating conditions = product
cost
ii.
Abnormal – not expected under efficient operating conditions – period
cost
a. (Debit loss & Credit WIP)
4. Scrap – is normal and is a part of cost. When sold (debit cash & credit FOH
or Revenue)
5. Waste – no further use for left over material = expense
6. Rework – charge to FOH if normal
7. Product Quality costs –
i.
Costs of external failure: problems occurring after shipment (e.g.
warranty, product liability, customer complaint)
ii.
Internal failure cost: problems occurring before shipment (e.g.
downtime, rework, scrap, tooling changes)
iii.
Prevention: attempts to avoid defective output (preventive
maintenance, employee training, review of equipment design &
evaluation of suppliers)
iv.
Appraisal: Embraces quality control programs (statistical quality
control programs, inspecting, testing)
24
Lecturer Notes
Process costing is a method of allocating manufacturing cost to products to
determine an average cost per unit. It is used by companies which mass
produce identical or similar products. Since every unit is essentially the same,
each unit receives the same manufacturing input as every other unit. Refineries,
paper mills, and food processing companies are examples of businesses which
use process costing.
Similarities between job order and process costing include:
Both systems have the same basic purpose—to calculate unit cost
Both systems use the same manufacturing accounts
The flow of costs through the manufacturing accounts is basically the same
However, there are some important differences between job order and
processing costing as described below.
Job Order Costing
Process Costing
Each job is different
Costs are accumulated by job
Costs are captured on a job cost sheet
All products are identical
Costs are accumulated by department
Costs are accumulated on a department
production report
Unit costs are computed by department
Unit costs are computed by job
In job costing costs are assigned to specific jobs and then, if necessary, to units
within the job. In process costing, however, costs are averaged and then
assigned directly to units. Since every unit in process costing is the same, unit
cost can be calculated by dividing total product costs by units produced.
In process costing, total production costs are accumulated by department (and
by product in each department when multi products are produced). The number
of units produced can be complicated by the fact that not all units may be 100%
complete at period end. This necessitates the calculation of equivalent units.
Equivalent units of production are the number of completed units that could have
been obtained from the inputs that went into the partially completed units. For
example if 2,000 units are 20% complete at period end, they are equivalent to
400 units (2,000*.2).
There are two methods of accounting for costs in process costing as follows:
Weighted average method
FIFO method
Under the weighted average method, a single average cost per unit is calculated
for both the units in beginning inventory and the units started in production during
the period. The FIFO method, on the other hand, separates units in beginning
25
inventory from current production so that a current period cost per unit can be
calculated.
There is a six step approach to calculating costs. Note that equivalent units are
the sum of units transferred to the next department plus the number of equivalent
units in ending inventory. Since cost inputs are entered at different times,
separate equivalent figures must be calculated for material and for conversion
costs.
Again the authors suggest a six step approach to calculating costs. Steps 1 and
2 are the same as used in the weighted average method since they refer to the
use of physical units. Note that FIFO number of equivalent units is different from
the weighted average number of equivalent units. In the FIFO method equivalent
units to be accounted for is the sum of:
Equivalent units in beginning Work in Process (100% - percent completed)
Units started and completed this period
Equivalent units in ending Work in Process
Standard costs rather than actual costs are widely used for inventory valuation.
The weighed average and FIFO methods can become complicated for
companies which produce a wide variety of very similar products. These
companies frequently employ a standard cost system and prepare production
reports using standard rather than actual costs. The computation of equivalent
units for a standard costing system are identical to those of under the FIFO
method.
26
Chapter 2 EXERCISES
Class: PROCESS COSTING: Fife Fiffy uses a process cost system to manufacture
laptop computers. The following information summarizes operations related to laptop
computer model #KJK20 during the quarter ending March 31.
Units
Direct Materials
WIP Inventory, January 1
100
$70,000
Started during the quarter
500
Completed during the quarter
400
WIP Inventory, March 31
200
Costs added during the quarter
$750,000
Beginning work-in-process inventory was 50% complete for direct materials. Ending
work-in-process inventory was 75% complete for direct materials. Using the Weighted
Average & FIFO methods, Find the following for March:1. Equivalent units of production 2. Transfer out cost 3. Cost of Ending Inventory
what were the equivalent units of production with regard to materials for March?
Home:. PROCESS COSTING: Lint Linty uses a process cost system to manufacture
Grape Fruit Juice. The following information summarizes operations related to Grape
Fruit Juice the quarter ending June 30, 2007.
Units
Direct Materials
WIP Inventory, April 1
200
$100,000
Started during the quarter
800
Completed during the quarter
400
WIP Inventory, June 31
100
Costs added during the quarter
$950,000
Beginning work-in-process inventory was 40% complete for direct materials. Ending
work-in-process inventory was 50% complete for direct materials. Using the Weighted
Average & FIFO methods, Find the following for June:-1. Equivalent units of production
2. Transfer out cost 3. Cost of Ending Inventory what were the equivalent units of
production with regard to materials for June?
27
Chapter 3 – Job-Order Costing
Summary
1. Accumulating cost by specific job
Note: Indirect material and indirect labor are FOH (do not overstate FOH)
2. When FOH applied is materially different from FOH incurred, the difference is
allocated among: F/G, CGS and EWIP
3. Cost of Good Manufactured
BWIP + Direct Materials + Direct Labor + FOH = Cost Accounted for
- EWIP
= CGM
4. Underapplied FOH:
i.
If actual fixed cost is greater than expected = underapplied FOH
ii.
If actual fixed cost is less than expected = Overapplied FOH
iii.
If actual volume is less than expected (F/C) = Underapplied FOH
iv.
If actual volume is greater than expected (F/C) = Overapplied FOH
5. Cost Accounting Entries
i.
Direct Materials Purchased
Materials Inventory
Acct. Pay/Cash
ii.
Materials transferred to WIP
WIP
Materials Inventory
xx
xx
xx
xx
iii.
Factory Salaries
WIP (Direct Labor)
xx
FOH (Indirect Labor)
xx
Wages Payable/Cash
xx
Payroll Taxes Payable/Cash
xx
 t is normal for customers to require early completion and pay an
OT premium
iv.
Manufacturing Expenses (insurance, supplies, plant depreciation,
indirect Mat.)
FOH
xx
Expenses
xx
v.
Overhead charged to WIP
WIP
FOH
xx
Goods are completed(Finished)
Finished Goods
WIP
xx
Goods are sold
Cash/Acct. Rec.
Sales
xx
vi.
vii.
xx
xx
xx
28
CGS
Finished Goods
xx
xx
Note: EWIP/EFG/E Raw Materials = deferred manufacturing costs.
Lecturer Notes
In order to be successful and survive, businesses must employ some type of
product costing system. In other words, companies need to track the cost of
making a product or furnishing a service.
When a service is rendered the
customer is given an invoice detailing the material and labor “costs”.
Management needs to cost products for a number of reasons. For financial
statements purposes management needs to calculate Cost of Goods Sold on
the Income Statement and Inventory on the Balance Sheet. For internal needs
management needs product cost information to establish prices, to compare
actual with budgeted figures, to properly decide to “make or buy”, etc. Often
outsiders such as insurance companies or government agencies require product
cost information as well.
Before a product costing system can be implemented, a decision must be made
with regard to the following:
Which cost accumulation system is appropriate
Which valuation method should be used.
There are two broad cost accumulation systems: Job Order and Process
Costing. Job Order Costing is used by companies where products or services
are identifiable by individual units or batches—auto repair, tax return preparation,
case in an attorney’s office, ship construction, etc. The costs attributable to a
particular job are assigned directly to it. Process Costing is used in industries
where there is mass production of similar or identical products—food products,
chemicals, cement, etc. Since each product is identical, product cost can be
determined by dividing total manufacturing costs by total units produced. This
average cost applies equally to all units produced. At this time, it should be
noted that many companies use a hybrid cost accumulation system which
incorporates some features of job order costing and other features of a process
costing system.
There are three valuation methods which may be used as follows:
Actual Costing
Actual direct material
Actual direct labor
Actual overhead (assigned after the end of the period)
Normal Costing
Actual direct material
Actual direct labor
29
Overhead applied using a predetermined overhead rate
Standard Costing
Standard direct material
Standard direct labor
Overhead applied using predetermined rate times
standard input
As mentioned above, in Job Order Costing costs are accumulated individually on
a per-job basis. In a manufacturing environment, costs are accumulated on a
Job Order Cost Sheet. Note that the direct material cost comes from material
requisition forms and the direct labor costs from employee time tickets. In normal
costing, manufacturing overhead is charged using a predetermined overhead
rate. Actual and budgeted cost data is included so that variances can be
examined immediately as the job is in process and as it is completed.
Standard costs may be used in a job order costing system. Costs are entered
into Work in Process at the standard rather than the actual rate. When the job is
complete standard costs are compared to actual costs incurred on the job so that
variances can be examined and analyzed.
30
Job Order Cost Accounting – Supplementary Note
I. COST ACCOUNTIG SYSTEMS
A. Cost accounting involves
 The measuring
 The recording, and
 The reporting of product costs

Accurate product costing is critical to a company’s
success
B. Two basic cost accounting systems
(Job Order Cost System and Process Cost System)

1. JOB ORDER COST SYSTEM
Costs are assigned to each job or batch

A job may be for a specific order of inventory
May be a unit: ex.
or a Batch of units: ex.

A key feature:
31

Measures costs for each job completed - not for set
time periods
2. PROCESS COST SYSTEM
 Used when a large volume of similar products are
manufactured. Examples:
 Cost are accumulated for a specific time period
(a week or a month)
II. JOB ORDER COST FLOWS



A. In general, the cost flow parallels the physical flow
of the materials as they are converted into finished
goods.
Manufacturing costs are assigned to Work in Process
Inventory.
Cost of completed jobs is transferred to Finished Goods
Inventory.
When units are sold, the cost is transferred to Cost of
Goods Sold.
Debit WIP Inventory → FG Inventory → COGS
when:
32
B. Recording Direct Materials, Direct Labor and
Overhead costs

Use a Job cost sheet to record the costs related to a
specific job on a daily basis; used to determine the
total and unit costs of a completed job.
1. DIRECT MATERIAL COSTS (DM)
 Debit Raw Materials Inventory when Purchase
direct or indirect materials
 Materials requisition slip shows written
authorization when used in production
 Debit Work-in-Process Inventory when direct
materials are Used
 Indirect Materials are treated as an overhead cost.
(i.e., Debit Manufacturing Overhead Account)
2. DIRECT LABOR COSTS (DL)
 Consists of gross earnings of factory workers,
employer payroll taxes on such earnings, and fringe
benefits incurred by the employer.
 Debit Work-in-Process Inventory when direct labor is recorded
(ie., whether paid or accrued)
 Indirect labor is treated as an overhead cost. (i.e., Debit
Manufacturing Overhead Account)
Note: Some companies use a Factory Labor account to initially record all
factory labor costs (direct and indirect labor). However, factory labor costs
33
are closed out immediately to the Work-in-Process Inventory account for
Direct Labor and to the Manufacturing Overhead account for Indirect Labor.
Your textbook teaches journal entries using this holding account for Factory
Labor, but the account balances are identical whether or not this account is
used!
34
3. MANUFACTURING OVERHEAD COSTS (OH)
Manufacturing overhead is a Control Account. It is
used to keep track of two things: Actual Overhead
costs incurred and Overhead costs assigned to
inventory (also known as overhead applied).
DEBIT Manufacturing Overhead Control when
actual manufacturing overhead costs are incurred.
Note: The subsidiary ledger consists of individual
accounts for each type of overhead cost, but the
controlling entry is a debit to Manufacturing OH
CREDIT Manufacturing Overhead Control when
Overhead is Applied to production.
Must be assigned to work in process and to specific
jobs on an estimated basis by using a
PREDETERMINED OVERHEAD RATE
Based on the relationship between estimated annual
overhead costs and expected annual operating activity.
Established at the beginning of the year.



35

Expressed in terms of an activity base such as
Direct labor costs, Direct labor hours,
Machine hours, or any other activity that is
an equitable base for applying overhead
costs to jobs.
 Assigning overhead costs to inventory involves a
two-step process:
1st: Determine the Predetermined Overhead Rate:
2nd: Overhead is “Applied” or Assigned to work in process
inventory during the period based on actual activity.
 At the end of the period determine if manufacturing overhead
is UNDERAPPLIED OR OVERAPPLIED


A debit balance in manufacturing overhead means that
overhead is underapplied. (i.e., Overhead assigned to work in
process inventory is less than overhead incurred.)
A credit balance in manufacturing overhead means that
overhead is overapplied. (i.e., Overhead assigned to work in
process inventory is greater than overhead incurred.)
36

If immaterial in amount, any year-end balance in
Manufacturing Overhead is eliminated by adjusting
cost of goods sold.

If Underapplied:

If Overapplied:
Example: Overhead is expected to be $100,000 next
year. Management believes the variable portion of
overhead varies with direct labor hours, with 40,000
direct labor hours expected next year.
1) Calculate the predetermined OH Rate.
2) Apply overhead to production for January if 3,000
direct labor hours are worked.
3) If actual overhead at the end of January is $8,000,
did the company over- or under-apply overhead
during the month? Show the adjusting entry to
close the overhead account at the end of the month.
37
38
EXAMPLE #1: JOB ORDER COSTING
The Custom Division of Allied Manufacturing had
one job in process at the beginning of May (Job #A11
with accumulated costs of $500) and no beginning
finished goods inventory.
(1) Record the following journal entries:
May 1 Direct materials costing $800 were purchased
on account.
May 2 Direct materials were issued to production as
follows: Job #A11 $200
Job #A12 $300
May 10 Paid Rent totaling $1,300. Of this amount,
$800 was for the factory and $500 was for sales and
administrative facilities.
May 15 Paid factory wages for direct labor as follows: Job #A11 (100 hours) $1,000
and Job #A12 (120 hours): $1,200. The company also paid $1,500 for indirect labor in
the factory.
May 15 Manufacturing Overhead is applied at a rate
of $3 per direct labor dollar.
39
May 25 Job #A11 was completed.
May 27 Job #A11 was sold for $8,000 on account.
May 31 Other manufacturing costs incurred during
the period include: $2,000 for factory depreciation;
$400 for factory insurance; and $200 for factory
utilities.
2) Determine the balance in the Work-in-Process and
Finished Goods Inventory accounts at the end of May.
Also show the journal entry to close out the under- or
overapplied overhead at the end of the month.
40
III. COGM and COGS Schedules
NOTE: With the information added in this chapter
regarding production costs, you should note the
following updates regarding the cost of goods
manufactured and cost of goods sold schedules:

The cost of goods manufactured schedule now
shows manufacturing overhead applied rather than
actual overhead costs. That is, current production
costs include: DM Used, DL and OH Applied.
 The cost of goods sold schedule will show an
adjusting entry for over- or under-applied overhead for
the period.
41
DM Used:
COGM (completed)
Beg. DM
Beg. WIP
+ DM Purchases
+ Current Production Costs
= DM Available
DM Used
-Ending DM
DL
= DM Used
OH Applied
- Ending WIP
= COGM
COGS
Income Stmt.
Beg. FG
Sales
+ COGM
-COGS (after adjustment)
= Cost of goods Available
- Ending FG
=COGS
+/- Under/Overapplied OH
=COGS after adjustment
=Gross Margin
-Operating Exp.
= Income
42
EXAMPLE #2: JOB ORDER COSTING
The Custom Division of Allied Manufacturing had one job in process at the
beginning of May (Job #A11 with accumulated costs of $400) and no
beginning finished goods inventory.
(1) Record the following journal entries:
May 1 Direct materials were issued to production as follows:
Job #A11 $200
Job #A12 $300
May 10 Paid Rent totaling $350. Of this amount, $200 was for the factory
and $150 was for sales and administrative facilities.
May 15 Paid factory wages for direct labor as follows:
Job #A11 (100 hours) $1,000 and Job #A12 (120 hours) $1,200
May 15 Manufacturing Overhead is applied at a rate of $3 per direct labor
hour.
May 25 Job #A11 was completed and sold for $4,000 cash.
3) Determine the balance in the Work-in-Process Inventory, Finished Goods
Inventory and Cost of Goods Sold accounts at the end of May.
43
EXAMPLE 3: Job Order Costing
Foster Manufacturing began January with direct materials costing $10,000,
work-in-process costing $2,000 and finished goods inventory consisting of Job
#500 costing $13,000. All of the costs in work-in-process are associated with
Job #501. During January, the following transactions occurred for Foster
Manufacturing:
Jan. 1 Issued direct materials costing $8,000 to production
($3,000 to Job #501; $5,000 to Job #502). Also, factory supplies
costing $1,000 were issued to production.
Jan. 5 Paid salaries as follows: Administrative Salaries:
$3,000; Direct Labor: $12,000 (Job #501 $8,000 and
Job #502 $4,000); Production Manager $2,000.
Jan. 5 Manufacturing overhead costs are applied to
production based on direct labor costs at a rate of $2
per direct labor dollar.
Jan. 15 Completed Job #501.
Jan. 20 Sold Job #500 for $30,000 on account.
Jan. 31 Other overhead costs totaled $20,000 and were paid in cash.
Based on the above information, determine the balance in the following
accounts at the end of January: Direct Materials Inventory, Work-in-process
Inventory, Finished Goods Inventory and Cost of Goods Sold. Prepare a cost of
goods manufactured and a cost of goods sold schedule. Also determine the
gross profit earned on Job #501.
44
EXAMPLE 4:
KA Catering uses a job order costing system to assign costs to its catering
jobs. Overhead is applied to each job based on direct labor hours. Listed
below is data for the current year:
Budgeted Overhead: $90,000
Actual Overhead:
$77,000
Budgeted labor:
$100,000 for 10,000 hours
Actual Labor:
$ 95,000 for 9,000 hours
Required:
(1) show the journal entry to record the overhead
applied during the period
(2) Show the adjusting entry to close the overhead
account at the end of the period.
45
Chapter 3 EXERCISES
Class 1
Sim Simmy’s Raw Material cost was $20,000, Direct Labour was $40,000 and
FO was 60% of Direct Labour and applied to production. 1. What was the total
manufacturing cost applied to production? 2. If the total actual cost was $90,000
how much was FO, 3. FO under or over applied?
Home 1
Glip Glippy’s overhead was applied at a rate of 200% of direct labour. The actual
overhead was $270,000. Direct Material was $100,000 and Direct Labour was
$150000. 1. What was the applied total cost? 2. What was the FO actual cost.
3. How much as FO over or under applied, 4. Was FO under or over applied?
46
Chapter 4 – Standard Costs
Summary
1. These are budgeted unit costs established to motivate optimal productivity
and efficiency
 These are predetermined, attainable unit cost.
2. Standard Cost system separates expected cost from actual cost
i.
Is applicable to:
- process and job-order costing, to service and mass production
industries
ii.
Best standards are based on attainable performance (motivate
employees)
3. Variances
 Accounts with debit balances are unfavorable
 Accounts with credit balances are favorable
Variance Calculations
i.
Direct Material
Usage/quantity =
AQ – SQ x SP
Price
AP – SP x AQ
ii.
Direct Labor
Efficiency/Hours =
Rate



iii.
AH – SH x SR
AR – SR x AH
Overhead Volume is least controllable by a production supervisor
i.
Measures effect of not operating at budgeted activity level
ii.
E.g. insufficient sales, labor strike
Overhead efficiency is wholly attributable to variable overhead
Labor Efficiency measures the efficiency of employees
Factory Overhead
i.
Total Variable Overhead: Spending variance and efficiency
variance
ii.
Spending Variance: Tot. Act. Var. O/H – (Act. Input x S Rate)
iii.
Efficiency Variance: S. Rate x (Act – Bud. Activity Base )
iv.
Two-way variance
Volume Variance: Fix O/H Bud. – Fix O/H applied based on standard
input allowed for
actual output
Controllable (budget variance): Tot. Act. O/H – (Fix O/H + Var. O/H based
on standard
rate & standard input allowed for actual output)
v.
Three-way efficiency variance
 A flexible budget can be adapted for any level of production
47
Spending Variance =
Actual input) x SR
Volume Variance =


vi.
A O/H – (Bud. Fix O/H + Bud. Var O/H on
(Bud. Fix O/H – Fix O/H applied based on
stand. Input allowed for act. Output)
Change in capacity does not affect spending variance because
variable unit costs are constant within a relevant range.
Volume variance will decrease or increase depending on the change in
capacity.
Four – Way efficiency variance
Variable:
Spending & Efficiency
Fixed:
Budget (fixed O/H spending) and volume
Lecturer Notes
Performance measurement is essential in a well-run organization. It can provide
critical information as to what works and what doesn’t; it is a way to evaluate and
motivate employees; and it can provide a means of carrying out the basic
strategy of the company. Most companies use some combination of financial
and non-financial performance measures (standards) to gauge performance.
Many companies not only use standards to measure performance but they
employ a standard cost accounting system which records both standard and
actual costs. Standard costs are the budgeted costs incurred to manufacture a
product or perform a service. A standard cost system greatly facilitates an
analysis of variances, the differences between actual costs and standard costs.
In a manufacturing environment budgeted costs are captured on a standard cost
card. In preparing a standard cost card a bill of materials is prepared and an
operations flow document establishing labor cost standards may be prepared.
Overhead standards are established using predetermined factory overhead
rates.
In a standard cost system, then, both cost and quantity standards are established
for the cost inputs of direct material, direct labor, and overhead. Actual price paid
for a cost input is compared to the standard price and actual quantity used is
compared to the standard quantity. Any difference between actual and standard
cost creates a variance, either favorable or unfavorable, and may be investigated
further. This process facilitates management by exception--depending on the
significance of the variance, management takes appropriate action. Insignificant
variances are disregarded.
48
The
form:
general
model
of
variance
analysis
takes
this
The price variance shows the difference between actual price paid and standard
price. The quantity variance measures the actual quantity used compared to the
standard quantity allowed for the output of the period.
The following illustration is used to present Cost data:
Material Price Variance
Material Quantity Variance
Labor Rate Variance
Labor Efficiency Variance
Variable Overhead Spending Variance
Variable Overhead Efficiency Variance
Fixed Overhead Spending (or Budget) Variance
Fixed Overhead Volume Variance
In a standard cost system cost inputs are entered at standard cost. Thus when
raw material is purchased it is entered at standard not actual cost. Any
difference between actual and standard cost is identified immediately and
journalized.
Note that all unfavorable variances have debit balances and favorable variances
have credit balances. Standard production costs are shown in inventory
accounts and thus have debit balances and therefore excess costs are also
debits.
At year end standard cost variances are eliminated through the use of adjusting
entries. If the variances are in total insignificant they can be closed to Cost of
Goods Sold. However, if the variances are significant they should be prorated
among ending inventories and Cost of Goods Sold.
Among the many reasons why companies use a standard cost system is that it
allows management to plan for expected costs to be incurred in manufacturing a
product or providing a service. Additionally, a standard costs system identifies
49
variances at an early point so that appropriate action can be taken at the earliest
point possible.
There are two broad types of standards--ideal standards and practical standards.
An ideal or perfection standard is the absolute minimum cost under ideal
conditions. Both total quality management and just-in-time production systems
inherently focus on ideal standards by emphasis on zero defects, zero
inefficiency, and zero downtime. Both TQM and JIT attempt to eliminate all nonvalue added activities and therefore all waste. In this respect these management
concepts are a type of ideal standard.
Practical standards can be described as a “tight but attainable” standard and
they allow for normal downtime and employee rest periods. At one time many U.
S. manufacturers utilized practical standards in evaluating performance. More
recently they have moved to a type of ideal standard.
In recent years many companies have shifted to an emphasis on conversion cost
as an element in standard costing. This is a result of the shift from labor
intensive production to machine intensive production.
50
Chapter 4 EXERCISES
4. These are budgeted unit costs established to motivate optimal productivity
and efficiency
 These are predetermined, attainable unit cost.
iii.
Best standards are based on attainable performance (motivate
employees)
5. Variances
 Accounts with debit balances are unfavorable
 Accounts with credit balances are favorable
Variance Calculations
vii.
Direct Material
`Direct Labor
Usage/quantity =
AQ – SQ x SP
Efficiency/Hours =
AH – SH x SR
Price
AP – SP x AQ
Rate
AR – SR x AH
Class 1
George Georgy cost analysis showed the following:Standard
Actual
Purchases of Raw Material
$30,000
$33,000
Units Purchased
10,000
9,000
Labour Cost
$90,000
$86,000
Hours Worked
20,000
22,000
Find the following variances and indicate whether they are favourable or
unfavourable:1, Material price 2. Material quantity 3. Labour rate 4. Labour efficiency
Home 1
Peorge Peorgy cost analysis showed the following:Standard
Actual
Purchases of Raw Material
$39,000
$36,000
Units Purchased
13,000
12,000
Labour Cost
$86,000
$89,000
Hours Worked
24,000
26,000
Find the following variances and indicate whether they are favourable or
unfavourable:1, Material price 2. Material quantity 3. Labour rate 4. Labour efficiency
51
Chapter 5 – Variable (Direct) and Absorption (Full) Costing
Summary
1. Absorption(Full) costing is required for external reporting purposes (GAAP)
 Includes fixed and variable FOH in product cost
i. these are included in Finished Goods
2. Variable (Direct) costing treats variable FOH as a product cost, but fixed
FOH as an expense. Similar to fixed & variable selling, general &
administrative expenses)
 Direct Labor, Direct Materials, Variable FOH are handled just like
absorption costing.
 REMEMBER: Fixed FOH is expenses.
 Sales – Var. Expenses = Contribution Margin – fixed expenses =
operation income.
Lecturer Notes
Earlier we discussed actual cost systems which costs products and/or services
using actual direct material cost, actual direct labor cost, and actual overhead
cost (may not be available until the end of the period). We have also considered
normal costing system which costs products and/or services using actual direct
material cost, actual direct labor cost, and allocated overhead cost based on a
predetermined overhead rate.
Many companies use normal rather than actual costing for the following reasons:
Overhead cost can be assigned as the production occurs or the service is
rendered.
Predetermined overhead rates adjust for variations in actual overhead costs
that are unrelated to activity
Predetermined overhead rates adjust for problems of fluctuation in activity
levels that have no impact on actual fixed
overhead costs
Predetermined overhead rates allow managers to be more aware of product
and customer profitability
As mentioned above, normal costing uses a predetermined rate to allocate
overhead. The predetermined rate is calculated as follows:
Total Estimated Overhead Cost
Total Estimated Activity Base
Since overhead consists of numerous costs some of which are not immediately
available, in normal costing overhead is charged on an allocated basis. At the
beginning of the year the company calculates a predetermined overhead rate by
dividing estimated total overhead cost by estimated total units of the allocation
base. Overhead is charged to Work In Process by multiplying the predetermined
52
overhead rate by the number of actual units of allocation base used during the
period.
Since budgeted amounts are used to calculate the predetermined overhead rate
there will typically be a balance remaining in Manufacturing Overhead at the end
of the period. Note that Manufacturing Overhead is a temporary account and
must be closed out at year end. The difference between the overhead cost
applied to Work in Process and the actual overhead costs of the period is called
either under-applied or over-applied overhead.
When overhead is underapplied, manufacturing costs have been understated and when overhead is overapplied, overhead costs have been overstated. In the Manufacturing Overhead
Account actual costs are recorded on the debit side and applied costs are
recorded on the credit side. If the amount of under-applied or over-applied
overhead is immaterial, the balance can be closed out to Cost of Goods Sold.
However, if the amount of under-applied or over-applied overhead is material, it
should be pro-rated among the accounts in which applied overhead is recorded-Work in Process, Finished Goods, and Cost of Goods Sold.
Mixed costs are costs which contain both a variable and a fixed element. The
fixed element is the basic charge for having the service ready and available for
use. The variable element is the actual consumption charge. An example of a
mixed cost is the cost of a large capacity copier leased at $1,000 per month plus
$.01 per copy. Mixed costs can be represented by the equation Y = a + bX
where
Y = Total Cost
a = Total Fixed Cost
b = Unit Variable Cost
X = Activity Level
In order to predict mixed cost behavior it is necessary for the accountant to
separate the mixed cost into its fixed and variable elements. As you are probably
aware, a number of methods are available to compute the total fixed cost
component and the variable cost per unit component in a mixed cost including
the following:
High low method
Least squares method
Excel or other software applications
By means of the least squares method and Excel, the value of b (and of a) can
be calculated using all data observations. We'll do an Excel exercise where we
create a regression line of averages and compute the values of a and b.
Next we discuss flexible budgets. A flexible budget is a plan which provides
estimates of what costs should be for any level of activity within a specified
53
range. By using a flexible budget the manager can compare actual costs to what
costs should have been for that actual level of activity.
A plant-wide overhead rate is inappropriate for companies which product different
kinds of products with different input requirements.
Costs can be accumulated and presented in various ways. Cost accumulation
refers to which costs are recorded as product costs and which costs are recorded
as period costs. Cost presentation refers to how costs are shown on external
financial statements or internal management reports. Accumulation and
presentation of costs is accomplished using one of two methods, absorption
costing or variable costing.
Absorption costing (also known as full costing) treats all manufacturing costs as
product (inventoriable) costs in accordance with GAAP. Thus Direct Material,
Direct Labor, Variable Overhead, and Fixed Overhead are all charged into the
Work in Process Account. When products are completed, Finished Goods is
Debited and Work in Process credited. Only when finished units are sold are
they charged as expense (COGS) on the income statement. In absorption
costing only selling expenses and administrative expenses are treated as period
costs and charged off as expense immediately.
In variable costing only variable product costs (Direct Material, Direct Labor, and
Variable Overhead) are charged to Work in Process. In variable costing Fixed
Manufacturing Overhead is charged as a period cost. Variable product costs are
charged to Work in Process and all other expenses including variable selling and
administrative expense, fixed manufacturing overhead, and fixed nonmanufacturing expense are charged as expenses immediately. Using variable
costing a contribution income statement can be prepared in the following format:
Sales Revenue
- Variable Expense
= Product Contribution Margin
- Variable Non-manufacturing Expense
= Total Contribution Margin
- Total Fixed Cost
= Income Before Income Tax
Note that absorption costing treats classifies expenses by function whereas
variable costing classifies expenses by cost behavior.
54
Chapter 5 EXERCISES
Class I:
Bick Bicky’s 2005 manufacturing costs for its new plant were as follows: Direct
Materials $900,000, Other Variable Manufacturing Cost $200,000, and
Depreciation of Factory building and manufacturing equipment $60,000, Other
Fixed Manufacturing Overhead cost $25,000. During 2005 Bick Bicky
manufactured 50,000 units and 20,000 were on hand at year end. What amount
should be considered product cost for (a) internal reporting purposes? and (b)
external reporting purposes? What is the value of ending inventory under both
(c) absorption costing and (d) direct costing?
Home I:
Rick Ricky’s 2005 manufacturing costs for its plant were as follows: Direct
Materials $1,100,000, Other Variable Manufacturing Cost $450,000, Additional
Raw Material put into production $60,000 and Depreciation of Factory building
and manufacturing equipment $100,000, Other Fixed Manufacturing Overhead
cost $40,000. During 2005 Rick Ricky manufactured 100,000 units and 30,000
were on hand at year end. What amount should be considered product cost for
(a) internal reporting purposes? and (b) external reporting purposes? What is the
value of ending inventory under both (c) absorption costing and (d) direct
costing? (e) under variable costing, what is the period cost?
55
Chapter 6 - Activity-Based Costing (ABC)
Summary
1. Identifies activities needed to provide products or services, and
i.
assign cost to those activities, then
ii.
reassigns costs to the products or service based on their consumption
of activities
 ABC helps manage cost by providing more detailed analyses of cost than
traditional methods
 ABC facilitates cost reduction by determining what activities do and do not
add value to the product or service.
 ABC defines cost objects as activities rather than functions or
departments
2. Cost Objects: Intermediate and final dispositions of cost pools
3. Cost Pool: an account in which a variety of similar costs are accumulated
prior to allocation to cost objects.
4. Cost Driver is a factor that causes a change in the cost pool for a particular
activity
 These are used as a basis for cost allocation.
i.
Cost assignment/allocation is based on a multiple cause-and-effect
relationship
Note:
1. ABC system uses more cost pools and allocation bases than a
traditional system.
2. Activities that are unnecessary are nonvalue-adding (raw
material & storage)
3. Value-adding (design engineering, heat treatment and drill
press)
Lecturer Notes
Activity based management (ABM) is a management system which focuses on
analyzing and controlling activities incurred in the production or performance
process in an attempt to improve customer value and enhance profitability. The
term "ABM" focuses on pricing and product mix decisions, cost reduction and
process improvement decisions, design decisions, and planning and managing
activity decisions.
ABM divides activities into two categories--value added and non-value added.
Value added activities are those which increase the worth of a product or
service. Non-value added activities, on the other hand, are those which add
nothing to the worth of a product or service. Examples of non-value activities
include wait time, inspection time, move time, etc. Value added versus non-
56
value added time can be compared using the manufacturing cycle efficiency
(MCE), computed as follows:
MCE =
Value added time
Total throughput time
Of course, a company operating in a perfect environment would have no nonvalue costs and would have an MCE of 1.
An important component of activity based management is activity based costing
(ABC). Activity based costing is a costing method which analyzes and attempts
to accurately cost specific resources which are consumed to deliver a product or
perform a service. In ABC, the calculation of direct material and direct labor is
usually uncomplicated. Emphasis is on accurately calculating overhead.
Earlier we calculated product costs using a broad averaging technique such as
direct labor hours to allocate indirect (manufacturing overhead) costs. In the
historic past when direct costs were a large percentage and indirect costs were a
small percentage of total product cost this method provided a sufficiently
adequate approximation of product cost. Changes in the economy though and
changes in the needs of management require that a new, more accurate, costing
system be implemented to supplement the traditional financial accounting costing
system.
Modern companies produce a greater and greater variety of products and
services. Broad averaging can lead to under or over costing of products or
services. This is especially true when the mix of products includes some
products which consume relatively few resources and other products which
consume relatively many resources. Activity based costing is a costing system
which focuses on all the individual resources consumed in providing a product or
service. ABC first traces costs to activities and then to products and services.
In ABC, the assignment of overhead costs first involves the division of activities
into indirect cost pools and on identification of respective cost drivers for each
activity pool. One method to accomplish this is to use a cost hierarchy and
separate activities into four general levels as follows:
Unit level costs
Batch level costs
Product/process
level costs
Organization or
facility costs
Costs of activities performed on each individual unit
Costs of activities related to a group of products
Costs of activities undertaken to support individual products
Costs of activities that cannot be traced to individual
products but that support the
organization as a whole
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Note that in both the averaging method and the activity based costing method,
direct material and direct labor costs were the same. Also note that all costs
(both product and period) that relate to a product are computed when using
activity based costing.
Activity based costing involves a two step process. Overhead costs are first
accumulated in activity cost centers using an appropriate cost drive and second
costs are assigned out of the activity cost centers to products.
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Chapter 6 EXERCISES
Class 1: Bill Billy, entire electricity bill for the entire company was $500,000. Bill Billy had the following
departments (a) Computer (b) Plant (c) Sales & Marketing and (d) Administration. The following
information was generated from Bill Billy cost sheet:Square Actual
Electrical
Department
Feet
Meters (used) Maintenance
Computer
3,000
30,000
$10,000
Plant
4,500
40.000
$25,000
Sales & Marketing
2,500
20,000
$15,000
Administration
6,000
25,000
$20,000
In using Activity-Based Costing, what is the cost allocated to each department?
Home 1: During 2005 Based Basedy, incurred $300,000 in fuel for its manufacturing division. The
following factors relate to its activity:Fuel (tons)
Actual
Other
Facility
Consumed
Weight (lbs)
Fuel Cost
Bottling Plant
3,000
20,000
$30,000
Processing Plant
4,500
15.000
$45,000
Filling Plant
2,500
25,000
$25,000
In using Activity-Based Costing, what is the total cost of fuel for each department?
59
Chapter 7 - Joint and By-Product Costing
Summary
1. Joint Products – two or more separate products are produced by a common
manufacturing process
 Value allocated at point at which joint products become separate.
2. By-products – smaller value products are produced simultaneously from a
common manufacturing process with products of greater value and quantity
(joint products)
 By Products do not usually receive an allocation of joint cost.
3. Joint Cost – incurred prior to split-off point to produce two or more goods
manufactured simultaneously by a single process or series of processes.
 To assign joint cost, use NRV of products x joint cost
4. Separable cost can be identified with a particular joint product and allocated
to a specific unit of output.
 Cost incurred after split-off point.
Lecturer Notes
1. Definitions
a. Joint Cost: the cost of a single process that yield multiple products
simultaneously. Includes DM, DL, and mfg. Ohd up to the split-off
point
b. Split-off Point:
the point in the process at which the products
become separately identifiable.
c. Separable Costs: those costs incurred beyond the split-off point that
are identifiable with individual products
d. Main Product: the product with the highest sales value relative to
other products beyond split-off
e. Joint Products:
other products with a relative high sales value that
are not identifiable as individual products until the split-off point
f. Byproduct:
a product beyond the split-off point with a relatively low
sales value in comparison with main and joint products
g. Scrap:
products beyond split-off with minimal value (May have a
negative sales value if must be hauled away to a landfill)
2. Reasons for Allocating Joint Costs to Individual Products
a. To value inventory and COGS for external reports
b. To value inventory and COGS for internal reports (including profitability
analysis and performance evaluation)
c. For cost reimbursement under contracts where not all the separable
products go to a single customer so that allocation of the joint costs is
necessary.
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d. For settlement of insurance claims involving separable products at or
beyond split-off.
e. For rate regulation when one or more jointly produced products or
services are subject to rate regulation based on cost. E.g. services
using telephone lines
3. Methods of Allocating Joint Costs
a. Methods where a measure is available at the Split-off point for each
separable product.
i. Sales Value at Split-off: This method allocates joint costs to
the separable products based on the relative slaves value of
each product at the split-off point
Includes the sales value of the entire production----not just
actual sales
Simple to apply because it provides a common measure
applicable to all products if sales value is readily available
Also, relates cost allocated to the revenue-generating power
of individual products. Demo 15-16
ii. Physical Measures Method:
This method uses some
measure of weight of volume common to all separable
products at the split-off point.
The problem with this method is that the physical measure
may bear no relationship to the revenue producing power of
the separable products.
For example, if a company mines
gold and lead, an ounce of gold will be much more valuable
than an ounce of lead but both would get the same allocation
when ounces is used as the measure. This causes high
value items per unit of the physical measure to show high
profits and low value items per unit of the physical measure
to show low profits. Demo 15-16
b. Methods where there isn’t a market for all of the separable products
at split-off. Therefore, some other method has to be used that
approximates the situation at the split-off point. (The allocation
must relate to the situation at split-off because joint costs cease to
have meaning beyong the splitoff point). There are two methods
that can approximate the situation at split-off.
i. Estimated Net Realizable Value Method (NRV)
The NRV for each product as a % of the total NRV of all
products, is the basis for the allocation.
Est’d NRV = Final sales value of production – Separable
Costs
(to get an estimated NRV for all products combined that is
approximately equal to joint costs, you would also need to
61
deduct selling and admin expenses and gross profit. This is
not usually done in practice just to keep things simple)
iii. Constant Gross Profit % NRV Method
This method assumes every separable product earns the
same GP% (this may not be very realistic) It starts with the
final sales value of production and subtracts the Gross Profit
(which is equal to Sales x constant GP%), and then
subtracts the Separable Costs. The result is an
approximation of the Joint Costs for each separable product
at split-off.
Steps:
1. Compute the overall GP% (called the constant GP%)
for all products combined (i.e., GP = FSVP – JC – SC
2. Calculate the GP in $ for each product (i.e., FSVP x
constant GP% determined in part 1.)
3. Calculate the Joint Costs for each product as follows:
FSVP
xx
Less: GP in $
(xx)
Less Sep. Costs
(xx)
= Joint Costs allocated xx
Note: Some products may end up with a negative
allocation of Joint costs;
Accounting for By-products
A by-product is a product having a relatively low sales value compared with the
main or joint products; by-products can be sold at split-off or processed further;
also, if sales increase, a by-product may be re-classified as a joint product at
some point.
There are several methods of accounting for by-products in terms or recognizing
when to record the cost of the by-product. We will recognize the cost of the byproduct only when production is completed.
Steps:
1. Calculate the NRV of the by product (i.e., FSVP – SC, or sometimes if
specified, FSVP – SC – normal GP).
2. Subtract this NRV of the by-product from the total joint cost and set the
amount up as by-product inventory.
By-product inventory
Joint costs
xxx
xxx
3. Allocate the revised joint cost in the usual way to the joint products using
one of the four methods
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4. Record any sales of the by-product as follows:
A/R
xxx
By product inventory
xxx
Note: Because the NRV of the by-product is treated as a reduction in the
total joint cost allocation and because the by-product is given no status as
a separate product, there is no Sales a/c and no COGS a/c for the byproduct itself------only Balance Sheet accounts.
The sales of the by-product are either added to the sales of the other joint
products or deducted from the COGS of the other joint products.
These
Sales or COGS adjustments are done on the financial statement and not
in the accounting records. (This procedure assumes that the selling price
and inventory cost per unit of the by-product are both valued at the NRV
per unit of the by-product)
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Chapter 7 EXERCISES
Class 1: Clent Clenty produces joint products GLUE and CLUE, and a by-product
BLUE, each of which incurs separable production cost after split-off. Information
concerning a batch produced at a $600,000 joint cost before split-off follows:Separable
Product
Costs
Sales Value
GLUE
$8,000
$80,000
CLUE
22,000
40,000
BLUE
30,000
What is the joint cost assigned to GLUE and CLUE if cost are assigned using the relative
net realizable value?
Home 1: Blent Blenty produces joint products LED and PAINT, and a by-product INK,
each of which incurs separable production cost after split-off. Information concerning a
batch produced at a $600,000 joint cost before split-off follows:Separable
Product
Costs
Sales Value
LED
$20,000
$100,000
PAINT
30,000
90,000
INK
(produced 1,000 gallons with a sales price of $50 per gallon after further
processing at a total cost of $20,000)
What is the joint cost assigned to LED and PAINT if costs are assigned using the relative
net realizable value?
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Chapter 8 - Service Cost Allocations
Summary
1. Fixed cost of service departments should be allocated to production
departments in lumps-sum mounts on the basis of the service departments
budgeted cost of long-term capacity to serve.
Criteria: Cause & effect, Benefits Received, Fairness and Ability to bear
2. Direct Method (most common) – allocates service department cost directly to
the producing departments without recognition of services provided among
the service departments
3. Step Method (Step-down Method) – allocates service cost to other
departments as well as to production departments
 Does not provide for reciprocal allocations
4. Reciprocal Method – allows reflection of all reciprocal services among service
departments using simultaneous equations
Lecturer Notes
A common cost is the cost of operating a facility, operation or activity that is
shared by
two or more users. There are two methods of allocating common costs.
1. Stand Alone Method
This method emphasizes equity or fairness in that each user bears a
proportionate share of stand alone cost based on their individual stand alone
cost. That is, each user is treated as if they were a stand alone entity.
Share of common cost =
cost for user #1
stand alone cost of user #1 x actual total common
sum of stand alone
costs for all users
2. Incremental Method
This method ranks the individual user cost objects and then uses this ranking to
allocate the common costs among the various users.
The first ranked user object is call the primary party. This user is allocated costs
up to the amount of the costs that would be incurred if the cost object were
operated as a stand-alone entity and this was the only user.
The second ranked user is called the incremental party. It is allocated the extra
costs that result from there being two users rather than one.
If there are more than two users, than all the users need to be ranked in a
sequence.
Under this method, the primary user always receives the highest allocation of the
65
common cost.
Primary user -----> allocate the stand alone cost that would exist if this user was
the only user
Incremental user -----> allocate the remainder of the common cost to this user
(total common cost – stand alone cost for primary user)
66
Chapter 8 EXERCISES
CLASS:
Serve Servey Photocopying Department provides photocopy services for both Departments A and
B and has prepared its total budget using the following information for the next year:Fixed Costs
$100,000
Budgeted Usage:Variable Costs
$0.03 per page
Dept. A
1,200,000
pages
Available capacity
4,000,000 pages
Dept. B
2,400,000
pages
Instructions: Assuming that the single-rate method is used and the allocation base is budgeted
usage. How much photocopying cost will be allocated to Dept. A and Dept. B in the budget year?
HOME:
Food Foody Restaurant provides meal for all of its staff in its 4 chains. Chain 1, Chain 2, Chain 3
and Chain 4. Food Foody has prepared its total budget using the following information for the next
year:Fixed Costs
$300,000
Budgeted Number of Plates:Variable Costs
$1.20 per plate
Chain 1: 250,000 Plates Chain 2:
350,000 plates
Available capacity
2,000,000 plates
Chain 3: 450,000 Plates Chain 4:
550.000 plates
Instructions: Assuming that the single-rate method is used and the allocation base is budgeted
number of plates. How much meal cost will be allocated to Chain 1, Chain 2, Chain 3 and Chain 4.
67
Chapter 9 – Budgeting
Summary
1. A flexible budget is designed to allow adjustment of the budget to the actual
level of activity before comparing the budgeted activity with actual results.
 A set of static budgets prepared in anticipation of varying levels of activity
 It permits evaluation of actual results when actual and expected
production differ
 A flexible budget can be prepared for any production level within a
relevant range
i. When production levels decrease within a range, total cost will decrease
 These are adjusted during the budgeted period
 Applicable for the entire production facility Cash, Marketing, Sales, Cost,
etc.,
Note: setting standard costing facilitates preparation of a flexible budget
2. A static budget is prepared for just one level of activity
 Total variable cost varies with the activity level
 Fixed cost is fixed within a relevant range
 Not useful for evaluating variance if expected sales are not reached.
 When sales are less than budget: variable cost = favorable. fixed
cost = unfavorable
3. The Master Budget contains estimates by management from all functional
areas based on one specific level of production.
 A master budget is based on one level of production.
 Recognize organizations goals and objectives
4. In budget calculations, REMEMBER: fixed cost will not change. Therefore,
variable cost will change as activity is change.
5. Zero-base budgeting is a budget and planning process in which each
manager must justify a department’s entire budget every year, or period.
 Objective is to encourage periodic reexamination of all costs
i.
to reduce or eliminate costs
Lecturer Notes
Effective planning, both long term and short term, is crucial to the success of any
business organization. Budgeting is the process of formalizing plans and
translating them into financial and non-financial goals and expectations. The
budget, the end result of budgeting, is a detailed plan for the acquisition and use
of financial and other resources over a specified time period.
68
There are many advantages of budgeting including:
It requires managers to set goals and objectives and allocate the means
to achieve the goals and objectives
It is a means of communicating and coordinating plans and objectives
throughout the organization
It provides a means by which performance can be evaluated
The master budget is an overall budget of an organization and includes and
incorporates the budgets of all sub-units of the business.. It consists of both
operating and financial budgets. An operating budget is expressed in both units
and dollars. A financial budget is a budget that aggregates the detail in the
operating budgets.
The master budget begins with a sales forecast and once the sales expectation
is formalized, the production budgets can be prepared.
Production budgets are prepared in the following format:
Budgeted unit sales
Add: Desired ending inventory
Total units needed
Less: Beginning inventory
Required production
The operating budgets for include:
Sales Budget
Production Budget
Purchases Budget
Direct Labor Budget
Overhead Budget
Selling and Administrative Budget
Any capital expenditures in the current period need to be incorporated in the
master budget.
Once the operating budgets have been prepared, a cash budget can be
developed. Note that the cash budget takes the following form:
Beginning cash balance
Add:
Cash collections
Equals:
Cash available
Less:
Cash disbursements
Equals:
Excess (deficiency) of cash
Less:
Minimum desired ending cash balance
Equals:
Financing borrowings or repayments
69
If credit is extended to customers, then cash receipts will tail cash sales.
Pro forma financial statements are prepared as part of the master budget
process and they include:
Cost of Goods Sold Schedule
Income Statement
Ending Balance Sheet
Statement of Cash Flows
70
Chapter 9 EXERCISES
Both CLASS 1 and HOME 1 problems are based on the Following:Bud Budy company is formulating its plans for the coming year, including the preparation of its cash budget.
Historically, 20% of the company’s sales are cash sales. Except for its 5% bad debt, the remaining credit
sales are collected as follows:-.
Sales
$
$
Collections on Account Percentage
January
3,900,000
May
6,500,000
In 1st Month
30%
February
4,200,000
June 6,900,000
In 2nd Month
40%
March
5,000,000
July
7,200,000
In 3rd Month
25%
April
6,100,000
August 8,000,000
CLASS 1: Prepare a schedule to show the total cash receipts from sales and collections on account for the
month of April.
HOME 1: Prepare a schedule to show the total cash receipts from sales and collections on account for the
month of August.
Class & Home 2
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Chapter 10 - Cost-Volume-Profit (CVP) Analysis
Summary
1.
2.
3.
4.
5.
Break-Even-Point: The sales volume at which total revenue equals total cost
Breakeven = Variable cost + Fixed Cost
Breakeven = Sales – Variable Cost = Contribution Margin – Fixed Cost
Breakeven Sales = (Fixed Cost / Contribution Margin Ratio)
Breakeven Sales in Unit = (Fixed cost / unit contribution margin)
 Breakeven analysis assumes that over the relevant range unit variable
cost remains constant within the relevant range.
 It also assumes that cost and revenues are linear. (one straight line)
6. Contribution Margin = (Fixed Cost / BEP sales) or Sales – Variable Cost
i. Margin of safety: Budget Sales – Breakeven Volume
 An increase in cost will increase BEP and decrease the margin of
safety
7. High-low method: estimates variable cost by dividing the difference in cost
incurred at the highest and lowest observed levels of activity by the difference
in activity.
 Once the variable cost is found, the fixed portion is determinable.
Lecturer Notes
CVP analysis is an examination of the relationships of prices, costs, volume, and
mix of products. It involves the separation of costs into their variable and fixed
categories at the outset of the analysis. Once variable and fixed costs are
isolated, a contribution margin income statement can be prepared in which total
and per unit contribution margin can be analyzed. Then meaningful "what if"
analysis can be done such as trading off variable costs for fixed costs, increasing
fixed costs and expected volume, reducing price and studying the impact on
sales volume and profits, etc.
Break-even analysis is an important aspect of CVP analysis. The break-even
point is that level of sales where total revenue exactly equals total expenses.
Calculation of BEP is demonstrated in the following example.
Sample BEP Problem
Per Bike
Percentage
Sales Price
Less Variable Cost
Contribution Margin $200
$500
100%
300
60%
40%
72
Fixed Cost totals $80,000 per month
Equation Method
1.
1.
Using dollars
$500X - $300X - $80,000 = 0
$200X = $80,000
X = 400 bikes
2.
Using percentages X - .6X - $80,000 = 0
.4X = $80,000
X = $200,000
Unit Contribution Method
1.
1.
Using dollars - Fixed Cost $80,000 = 400 bikes
Unit CM
2.
2.
$200
Using percentages - Fixed Cost $80,000 = $200,000
Unit CM
.4
Of course, companies do not wish to just break even. We can expand our break-even calculations
to include a computation of Target Net Income. For example, let’s assume the above company
wants to earn of profit of $40,000. What level of revenue would generate profits of $40,000?
Equation Method
X - .6X -$80,000 = $40,000
.4X = $120,000
X = $300,000
Unit Contribution Method
Fixed Costs + Target Net Income
Unit CM
$80,000 + $40,000 = $300,000
.4
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The Margin of Safety is the excess of budgeted sales over the break-even
volume of sales.
Margin of safety = Total budgeted (or actual) sales – Break-even Sales. The
margin of safety shows the amount by which sales can decrease before losses
are incurred. It can be computed in dollars or in a percentage as follows:
Margin of safety percentage =Margin of Safety in $/Total Budgeted (or actual)
Sales
Cost structure refers to the relative proportion of fixed and variable costs existing
in an organization.
An automated manufacturing plant would have a high
proportion of fixed costs whereas a direct labor intensive plant would have a high
proportion of variable costs. Any organization has some choice as to its cost
structure.
A company’s cost structure has a significant effect on the way in which profits
fluctuate in response to changes in sales volume. The greater the proportion of
fixed costs in a firm’s structure, the greater will be the impact on profit from a
given percentage change in sales revenue. This results from the fact that firm
with relatively higher fixed costs (and relatively lower variable costs) will have a
higher contribution margin ratio.
Operating leverage is a measure of how sensitive net income is to percentage
changes in sales. Operating leverage is greatest in companies which have a
high proportion of fixed costs relative to variable costs. A firm with high fixed
costs and low variable costs has high operating leverage, the ability to highly
increase net income from an increase in sales revenue. In other words, after the
break-even point has been reached, a larger amount of contribution margin will
fall to the bottom line in a high fixed cost structure than if the cost structure had
been comprised mostly of continuing high variable costs, which continue to eat
away at net income after the break-even point is reached. Of course, the risk is
also greater because if the break-even point is not reached, losses will be greater
in the firm with high operating leverage.
The degree of operating leverage at a given level of sales is computed as
follows:
Degree of Operating Leverage
=
Contribution Margin
Net Income
So far in our discussion of CVP relationships we have focused on a firm selling a
single product. Of course, most businesses sell more than one product and thus
we need to discuss CVP analysis involving more than one product. Sales mix
refers to the relative proportions in which a company’s products are sold.
Managers try to achieve that product mix which will maximize profits.
74
Chapter 19 EXERCISES
Both CLASS and HOME problems are based on the Following:Prof Proffy sells its single product at a price of $60.00 per unit and incurs the following variable cost per unit
of product:Direct Material
$16.00
Fixed costs are $880,000
Direct Labour
12.00
Income Tax Rate 30%
Manufacturing Overhead
7.00
Total Variable Man. Cost $35.00
Selling expenses
5.00
Total variable costs
$40.00
CLASS: 1. If production and sales volume is 4,000 units of product per month, what is the annual after-tax
income or loss?
2. What is Prof Proffy Contribution Margin?
3. How many units must Prof Proffy sell to break even?
HOME: Fixed Cost is now $1,000,000, selling price is now $75.00 per unit, direct material and direct labour
have increased by 20% and 10% respectively, and the income tax rate is now 40%.
1. If production and sales volume is 7,500 units of product per month, what is the annual after-tax
income or loss?
2. What is Prof Proffy Contribution Margin?
3. How many units must Prof Proffy sell to break even?
75