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: 2 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 3 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 5 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! 6 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 7 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 8 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 11 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. 12 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 57 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. 58 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. 60 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 62 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) 63 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? 64 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 71 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 73 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