Week 9

INFO 630

Evaluation of Information Systems

Dr. Jennifer Booker

Week 9 – Chapters 13-15

INFO630 Week 9 1 www.ischool.drexel.edu

Inflation and Deflation

Chapter 13



Question

• Think about the last time you bought something you’ve bought before

– How much did you pay?

– How much did you pay the first time it was bought?

– Was it the same price both times?

• Most likely not

• Prices change over time

– Short term

– Long-term



Outline

• Inflation and deflation, defined

• Price indices, Consumer Price Index,

Produce Price Index

• Inflation rate

• Purchasing power and inflation

• Accounting for inflation



• Refer to long-term trends in prices

– Inflation  same things cost more than before

– Deflation  same things cost less than before

• Generally refer to the overall economy, not specific products and services

– Long term changes in the “purchasing power” of money

• Tendency for inflation over last 50+ years but significant deflation has happened

– Note: General trend in 1800’s was deflation

(caused by industrial revolution),


Possible Causes - Inflation and

Deflation

• Inflation

– Government price support polices (subsidies)

– Deficit spending

– Higher production costs

• Wage increase of workers

– Lower availability of resources

• Deflation

– More efficient production methods

• Lowers production cost

– Higher availability of resources


Average Relative Price Level (CPI),

1913-2002

200.0

180.0

160.0

140.0

120.0

100.0

80.0

60.0

40.0

20.0

0.0

1900 1920 1940 1960 1980 2000 2020

NOTE: Shows a substantial change in relative prices over time. Something that sold for about 10 cents in 1910 would go for nearly $2 today .


So what does it mean to us?

• If planning horizon is long or high annual inflation rate

– Can cause noticeable change in value of proposal

– Might need to address during decision

• If planning horizon is short or inflation is weak

– Might be able to just ignore

• Overall it is a judgment call on the decision makers part


Price Indices:

- Measuring Inflation and Deflation

• Ratio (expressed as percentage) of historical price to price at another time

PriceIndex now



Price

Price now then



100

• Example

– Gas in 2005 ($2.00) vs. gas in 1999 ($1.40)

GasPriceIn dex

2005



$2.00

2005

$1.40

1999



100



143 %


Creating a Price Index

• Define a “market basket”

– Reference shopping list with kinds and amounts

• Choose a reference date

• Price the market basket on the reference date

• Price the market basket today

• Price index = ratio of current price to price on reference date


Common Price Indices

• Consumer Price Index (CPI)

– Change from retail purchase’s perspective

• Producer Price Index (PPI)

– Change from sellers perspective

• Complied by Department of Labor and

Department of Commerce


Consumer Price Index (CPI)

• Measures price change from retail purchaser’s perspective

– Based on spending habits of average household consumer

• Market basket of about 400 goods and services

– Housing

– Food and beverage

– Apparel

– Transportation

– Medical care

– Recreation

– Education

– Utilities and fuels, etc.

• Reference date for CPI isn’t a single point in time

– Based on average of three years (1982-1984)


Producer Price Index (PPI)

• Family of price indices

– Measures change in selling prices for domestic goods and services before they reach the retail consumer

– Used for adjusting business-to-business contracts for inflation

(long term)

• Prices to be paid for in the future

• Over 500 industry-level price indices and 10,000+ specific product line and product category sub-indices

– Manufacturing, Agriculture, Forestry, Fisheries, Mining, Scrap, …

– Transportation, Utilities, Finance, Business services, Health,

Legal, Professional services, …


Inflation Rate

• Measures rate of increase of corresponding price index

– Usually stated as an annual percentage

• Deflation rate is negative inflation rate

– 1.4% deflation = -1.4% inflation


Single-Year Annual Inflation Rate

AnnualRate

Year(i)



PriceIndex

Year(i)



PriceIndex

PriceIndex

Year(i 1)

Year(i 1)

• Examples

CPI (1966) = 32.4

CPI (1965) = 31.5

AnnualRate

1966



32.4



31.5

31.5



2 .

9 %

CPI (2000) = 172.26

CPI (1999) = 166

AnnualRate

2000



172.2



166.6

166.6



3 .

4 %


Annual Inflation Rate, 1914 - 2002

20.0%

15.0%

10.0%

5.0%

0.0%

-5.0%

1900

-10.0%

-15.0%

1920 1940 1960 1980 2000 2020


Average Annual Inflation Rate f

 n

CPI t

 n

CPI t



1

• Example

CPI (1999) = 166.6

CPI (1990) = 130.7

f



10

166.6

1999

130.7

1990



1



2 .

46 %

Note: For decisions spanning over 1 year, use Average Inflation Rate applied over entire planning horizon.


Purchasing Power and Inflation

• Inflation means

– Purchasing power if money is going down.

– “Same amount of money later on doesn’t buy as much as it did before”

– Inflation rate – tells how much more is

• Purchasing Power means

– “How much can I buy for a given amount”

• Example

– 1970 candy bar = 25 cents

– 1997 = $1.00

• Purchasing power and inflation are closely related but not equivalent


Purchasing Power

K = PurchasingPower year(1)

= PriceIndex year(0)

------------------

PriceIndex year(1)

K = PurchasingPower

1976

= PriceIndex

(1975)

= 53.8

----------------------- = 0.946

PriceIndex

(1976)

56.9

Means: it would take $1 (end 1976) to buy same goods that could be bought for 94.6 cents (end 1975)



• Average loss in purchasing power over multiple years k



1 n

CPI t

CPI t

 n

 Example k



1 -

10

130.7

1990

166.6

1999

 

2 .

40 %

Average annual loss in purchasing power was 2.4% in the ’90s




(1

 f ) n 

(1



1 k ) n

• E xample

(1



2.46)

10 

(1



1

2.40)

10

Note: fbar (annual inflation rate) thru 1990’s (above) and k-bar (average loss in purchasing power) thru 1990’s (above)


Recap - Purchasing power and inflation


• Use Inflation rate when

– Ask “How much will <x> cost at <time>?”

• Use Purchasing Power when

– Ask “How much can I buy for <amount of money> at <time>?”


Accounting for Inflation

Two Methods

• Actual dollar analysis

– Cash-flow instances represent actual out-ofpocket dollars paid/received at that time

– A.k.a. current dollars, escalated dollars, inflated dollars, …

• Constant dollar analysis

– Cash-flow instances represent hypothetical constant purchasing power amounts

– A.k.a. real dollars, deflated dollars, today’s dollars, …


Actual-Constant Dollar Analogy

Rock on shore

(Beginning of planning horizon)

Ball

River speed

(Inflation)

Boat speed through water

(Interest)

Distance between boat and rock

(Constant dollars)

Distance between boat and ball

(Actual dollars)


Converting Actual Dollars to Constant

Dollars

Constant Dollars



1

(1

 f) n



Actual Dollars

• Example

Constant Dollars

1990



1

(1



0.0246)

5



$ 12.95

1995



$ 11 .

47

Note: Remember we calculated earlier that fbar thru the ’90s was 2.46%.

$12.95 in 1995 was worth the same as $11.47 in 1990.


Converting Constant Dollars to Actual

Dollars

Actual Dollars





1

 f

 n 

Constant Dollars

• Example

Actual Dollars

1995





1



0 .

0246



5 

$ 12.95

1990



$ 14 .

63

Note: Remember we calculated earlier that fbar thru the ’90s was 2.46%. So

$12.95 in 1990 was worth the same as $14.63 in 1995.


Actual Dollar vs. Constant Dollar Analysis

• f is the inflation rate

(speed of current in river)

• i is the market interest rate

(speed of boat through water)

• i ’ is the inflation-free interest rate

(speed of boat relative fixed point) i'







1

1



 f i







1 i'







1

1





0.07

0 .

03







1



3 .

88 %


Relationship Between Actual and Constant

Dollar Analysis

Actual Dollars

P

(1 + i)n

1

(1 + i)n

0 1 2 3

F n-1 n

Constant Dollars

P'

(1 + i') n

1

(1 + i') n

0 1 2 3

F' n-1 n

1

(1 + f)n

(1 + f)n


Simple Example of Actual and Constant

Dollar Analysis

At 7% market interest,

$10k grows to $19,670 after 10 years —this is actual dollars

At 3.88% inflation-free interest, $10k grows to be worth $14,603 base-year dollars in year 10 —this is constant dollars

Note that $19,670 actual dollars in year 10 =

$14,630 constant dollars.

F=$19,670

P=$10,000

Actual Dollars

F/P ,7,10

(1.967)

P /F,7,10

(0.5084)

0 1 2 3

P'=$10,000

Constant Dollars

F/P ,3.88,10

(1.463)

P /F,3.88,10

(0.6835)

0 1 2 3

9 10

F'=$14,630

P /F,3,10

(0.7441)

F/P ,3,10

(1.344)

9 10


Key Points

• Inflation refers to long-term increases in prices

• A price index is the ratio of the price at one time to the price at another

• The inflation rate is the rate of increase in a price index

• Purchasing power and inflation are related but different

• Inflation can be addressed using actual dollar or constant dollar analysis


Depreciation

Chapter 14

INFO630 Week 9

31 www.ischool.drexel.edu

Depreciation

Outline

• Introducing depreciation

• Value-time functions

• Book value

• Depreciation methods

– Before 1981

– 1981 through 1986

– 1987 and beyond

• Units-of-production depreciation


Depreciation

• Depreciation addresses how investments in capital assets are charged off against income over several years

– Important part of calculating after-tax cash flow


Introducing Depreciation

• Two different meanings

– Actual depreciation

• How an asset loses value over time

– Physical depreciation

» Literally means asset is wearing out

» Wear and tear, etc.

– Functional depreciation

» Environment where asset is operating has changed and asset is not well matched to the new environment.

» Obsolescence

– Depreciation accounting

• How the organization accounts for that loss in value

• Note:

– Actual deprecation (real loss in value) is rarely the same as depreciation accounting (how loss accounted for by organization).

– For actual depreciation – need to sell asset and see what someone will pay for it


Key Ideas in Depreciation Accounting

• Corporations are taxed on profit, not income

– Profit = Income - Expenses

• Expenses claimed in a tax year should reflect actual expenses incurred

– Including actual depreciation, as best as it can be estimated

• Tax authorities are trying to force accounting and recognition of an asset’s loss in value to be as close as possible to when that loss actually happens (make each years income tax as realistic as possible)

– Alternatives to depreciation

• Write off in year of acquisition

• Write off in year of disposal


Key Ideas in Depreciation Accounting (cont)

• Depreciation amounts aren’t actual cash-flow instances

– Actual cash flow happened on acquisition

– Depreciation amounts are allocation of actual expense over time

• Force company to spread recognition of original expense over asset’s assumed life

• Depreciable assets (required to be treated as):

– Used in business or trade

– Used for producing income

– Have a known lifespan >1 year


Value-Time Function

• Mathematical function that models how an asset loses value over time

• Two types

– Straight-line

• Simplest

• Asset loses value at a constant rate

– Declining value

• Asset loses value as a fixed percentage of its remaining value over its lifetime.


Value-Time Function

l u

V a e

•

Time

Straight-line

• l u

V a e

•

Time

Declining-balance


Book Value

• Tax authorities’ best estimate—based on depreciation accounting —of an asset’s actual value

– May or may not reflect the true value

Book Value year(t)



Book Value year(t 1)

Depreciati on year(t 1)

Book Value year(t)



Acquision Cost t  i



1

Depreciati on year(i)


Depreciation Methods

Note: Method stays until disposal – doesn't change with laws

• Before 1981

– Straight-line

– Declining-balance

– Declining-balance switching to straight-line

– Sum-of-the-years-digits

• 1981 through 1986

– Accelerated cost recovery system (ACRS)

• 1987 and beyond

– Modified accelerated cost recovery system

(MACRS)


Why Care About Old Methods

• Broad survey of different methods

• Good foundation for today’s method

• When laws change, old method might come back to use

– You never know……


Depreciation Methods

• Before 1981 company could choose

– Straight-line

– Declining-balance

– Declining-balance switching to straight-line

– Sum-of-the-years-digits

• Steps

1.

Choose method

2.

Estimate asset useful life

1.

Based on organizations past history

2.

Class life asset depreciations range (CLADR)

 See book pg 217, Figure 14.1

 IRS approved useful life range


CLADR System

• “Class Life Asset Depreciation Range”

– Defined lower, recommended, and upper limits on asset life spans

• Business aircraft: 5, 6, 7 years

• Autos & taxis: 2.5, 3, 3.5 years

• Agriculture equipment: 8, 10, 12 years

• Computers: 5, 6, 7 years

• Furniture: 8, 10, 12 years

• …

Note: IRS likes recommended (ADR)


Straight-line Depreciation

• Assumes value of asset decreases at constant rate over its useful life

• Asset loses fixed percentage of original value each year

Depreciati on



Acquisitio nCost



SalvageVal ue

LifetimeIn Years

BookValue year(t)



Acquision Cost -

 t * Depreciati on




Example of Straight-line

Depreciation

• Example asset

– Acquisition cost = $34,000

– Salvage value = $2000

– Useful life = 5 years = n

End of Depreciation Book Value at

Year in that year end of year

0 -$34,000

1 $6400 $27,600

2 $6400 $21,200

3 $6400 $14,800

4 $6400 $8,400

5 $6400 $2,000


Declining-Balance

Depreciation

• Value decreases at fixed percentage of remaining (book) value over useful life

– Depreciation amount is based on fixed percentage of book value ( a a  2/ n, n=years)

• Double declining-balance means a

= 2/n

• 150% declining-balance means a

= 1.5/n

Depreciati on year(t)

 a

* BookValue year ( t



1 )

Book Value year(t)



Acquision Cost *



1 a  t


Example of Declining-balance

Depreciation

• Same asset

– Double declining-balance, a

= 2/5 = 0.40



0 -$34,000

1 0.40 * $34,000 = $13,600 $20,400

2 0.40 * $20,400 = $8160 $12,240

3 0.40 * $12,240 = $4896 $7344

4 0.40 * $7344 = $2938 $4406

5 0.40 * $4406 = $1763 $2644



Depreciation

• Same asset

– 150% declining-balance, a

= 1.5/5 = 0.30



0 -$34,000

1 0.30 * $34,000 = $10,200 $23,800

2 0.30 * $23,800 = $7140 $16,660

3 0.30 * $16,660 = $4998 $11,662

4 0.30 * $11,662 = $3499 $8163

5 0.30 * $8163 = $2449 $5714


Declining-balance Switching to Straight-line

Depreciation

• Declining-balance used initially

– Switch to straight-line when declining-balance amount is less than straight-line amount

– Mathematically – when slope of decliningbalance curve becomes less then slope of straight line.


Declining-balance Switching to Straight-line

Depreciation (cont)

Note: Ignores salvage value l u

V a e

•

Declining Balance

Straight-line

Switch

Time

Depreciati on year(t)

 max



DecliningB alance year ( t )

, StraightLi ne year ( t )



Book Value year(t)



Acquision Cost t  i



1

Depreciati on year(i)



Switching to Straight-line

Depreciation

• Same asset

– 150% declining-balance, a

= 1.5/5 = 0.30

– Straight-line = $6400



0 -$34,000

1 0.30 * $34,000 = $10,200 $23,800

2 0.30 * $23,800 = $7140 $16,660

3 0.30 * $16,660 = $4998, Switch to $6400 $10,260

4 $6400 $3860

5 $3860 $0


Sum-of-the-Years-Digits Depreciation

• Depreciation amount determined by rule:

– List years in order, compute sum

– List years in reverse order

– Depreciation amount is (reverse order / sum)

Year in Depreciation

Year reverse order factor

1 5 5/15

2 4 4/15

3 3 3/15

4 2 2/15

5 1 1/15

Sum = 15

(k/K, K= Sum, k = rev. year)

• Note: Recognizes salvage value


Example of Sum-of-the-Years-

Digits Depreciation

• Same asset



0 -$34,000

1 5/15 * ($34,000 - $2000) = $10,667 $23,333

2 4/15 * ($34,000 - $2000) = $8533 $14,800

3 3/15 * ($34,000 - $2000) = $6400 $8400

4 2/15 * ($34,000 - $2000) = $4267 $4133

5 1/15 * ($34,000 - $2000) = $2133 $2000

Note: Yr 0 = k/K * (acquisition cost – salvage value)


Accelerated Cost Recovery

System (ACRS) Depreciation

• Used from 1981 to 1986

• Two variants

– Prescribed method

• All depreciable assets are assigned to 1 of 4 separate classes of property

– Alternative method

• Organization chooses 1 of 3 possible periods


ACRS Prescribed method

• Depreciable assets assigned to classes:

– 3-year property

– 5-year property

– 10-year property

– 15-year property

– (see text for property class descriptions)

• Note: uses half-year conversion

– Assume asset start service midyear (Jul 1) and ends service midyear (Jun 1)


ACRS Prescribed Method

Depreciation Schedule

Recovery year 3-Year 5-Year 10-Year 15-Year

1 0.25 0.15 0.08 0.05

2 0.38 0.22 0.14 0.10

3 0.37 0.21 0.12 0.09

4 0.21 0.10 0.08

5 0.21 0.10 0.07

6 0.10 0.07

7 0.09 0.06

8 0.09 0.06

9 0.09 0.06

10 0.09 0.06

11 0.06

12

Each year’s depreciation amount = 0.06

13 0.06

15 0.06


Example of ACRS Depreciation Prescribed

• Same asset



0 -$34,000

1 0.15 * $34,000 = $5100 $28,900

2 0.22 * $34,000 = $7480 $21,420

3 0.21 * $34,000 = $7140 $14,280

4 0.21 * $34,000 = $7140 $7140

5 0.21 * $34,000 = $7140 $0


Modified Accelerated Cost Recovery

System (MACRS) Depreciation

• Used since 1987

– Derived from ACRS

– Two new classes, 7- and 20-year property

– 3-, 5-, 7-, and 10-year classes use 200% declining-balance

– 15- and 20-year use 150% declining-balance

– No distinction between new and used property

• See text for MACRS Prescribed Method depreciation schedule

– Table 14.11 on page 227

– Also half year convention but this time entire depreciation shifted right (6 months in 1 st yr, 6 months in last year)


Example of MACRS

Depreciation

• Same asset



0 -$34,000

1 0.2000 * $34,000 = $6800 $27,200

2 0.3200 * $34,000 = $10,880 $16,320

3 0.1920 * $34,000 = $6528 $9792

4 0.1152 * $34,000 = $3917 $5875

5 0.1152 * $34,000 = $3917 $1958

6 0.0576 * $34,000 = $1958 $0


Units-of-Production Depreciation

• Not allowed under current US tax code

• Depreciation is based on use, not time

Depreciati onPerUse



Acquisitio nCost



SalvageVal ue

LifetimeCa pacityforU se


Key Points

• Actual depreciation refers to how assets lose value over time

• Depreciation accounting refers to how the organization estimates that loss

• Value-time functions model the rate of loss

• Book value is the estimated remaining value of an asset due to depreciation

• A number of depreciation methods have been used,

MACRS is used today


General Accounting and

Cost Accounting

Chapter 15

INFO630 Week 9


General Accounting and Cost Accounting

Outline

• Balance sheet

• Profit and loss statement

• Cash-flow statement

• Cost accounting

• Cost of goods sold statement

• Determining unit cost


Balance Sheet

• Shows the financial position of a company at a moment in time

– “Snap shot” or “freeze frame”

– “How much is the company worth right now?”

• Assets

– Things of value the company owns or is owed by others

• Liabilities

– Opposite of assets, what the company owes others

• Owner’s equity

– The company’s net worth

Assets = Liabilities + Owner’s Equity


Acme Corp Balance Sheet

Assets 20x5 20x4

Cass & equivalents $198 $161

Accounts receivable 28 14

Inventory 53 36

Property 52 47

Plant & Equipment

Investments

Total Assets

46 66

26 16

403 340

Note: Assets = Liabilities

+ Owner’s equity

Liabilities

Accounts payable

Debt

Declared dividends

Total liabilities

73 50

36 41

0 0

109 91

Owner’s Equity

Stock

Retained earnings

Total equity

121 121

173 128

294 249

Total liabilities and equity 403 340


Profit and Loss Statement

• Summarizes income and expenses between balance sheets

– “How quickly is the company gaining or losing value?”

– Accumulation over a period of time

• Operating income

– Gross income minus cost of goods sold

• Operating expenses

– Costs to run the company

• Investment-related expenses

– Costs to finance the company

• Income taxes

– Federal, state, and local taxes

• Net earnings after taxes


Acme Corp

Profit & Loss Statement

Operating Income 20x5 20x4

Sales & operating income $784 $721

Cost of goods sold

Net operating income (loss)

470 423

314 298

Operating Expenses

Selling expenses 36 34

General & administrative expenses 62 60

Research & development

Investment Related Expenses

99 115

Interest expense

Investment expense

7 14

1 3

Depreciation 36 35

Net earnings before income taxes (loss) 73 37

Income Taxes

Federal, state, and local 28 14

Net Earnings After Taxes (loss) 45 23


Cash-Flow Statement

• Details actual flow of cash

– Some P&L isn’t real cash, some real cash isn’t P&L

– “How much more or less cash does the company have now?”

• Cash from operating activities

• Cash from investing activities

• Cash from financing activities

• Net change in cash


Acme Corp

Cash-Flow

Statement

Cash from Operating Activities 20x5 20x4

Net earnings $45 $23

Depreciation 36 35

Changes in accounts receivable (14) 8

Changes in accounts payable 23 (4)

Changes in inventory

Net cash from operating activities 73 69

(17) 7

Cash from Investing Activities

Capital expenditures (24) (17)

Acquisitions (11) 0

Proceeds from dispositions 4 26

Net cash from investing activities (31) 9

Cash from Financing Activities

New borrowing

Debt repayment

Net stock

Dividends paid

8 4

(13) (14)

0 0

Net cash from financing activities (5) (10)

Net change in cash

Cash at beginning

Cash at end

0 0

37 68

161 93

198 161


Relating the Three Statements

•Balance Sheet - company’s financial position at a give point in time

•P&L Statement –shows company financial position changed over time

•Cash-Flow Statement - shows how the company’s cash position changed over time

Balance

Sheet for time

T

Balance

Sheet for time

T+1

Balance

Sheet for time

T+2

T

Profit &

Loss

Statement for time

T to T+1

Cash Flow

Statement for time

T to T+1

T+1

Profit &

Loss

Statement for time

T+1 to T+2

Cash Flow

Statement for time

T+1 to T+2

T+2


Cost Accounting

• Production cost has a major influence on profit

– Cost accounting helps manage that cost

– Find out how much it costs to provide product or service

– Show in Cost of Goods statement


Direct

Material

Cost Accounting

Indirect

Material

Direct Labor

Work in Process

Indirect Labor

Finished

Goods


Cost of Goods Sold Statement

• Details cost of producing goods and services

– “How much did it cost to provide the goods and services sold during a reporting period?”

– Forwards to Cash-flow Statement

• Direct Material

– Cost of material that can be directly allocated to units of production

• Direct Labor

– Cost of labor that can be directly allocated to units of production

• Manufacturing Overhead

– Cost of material and labor that can’t be directly allocated to units of production

• Cost of Goods Made

– Total cost of good produced during this period

• Cost of Goods Sold

– Total cost of goods sold during this period


Acme Corp

Cost of Goods Sold Statement

Direct Material

In process Jan. 1, 20x5 $5

Applied during year

Total

In process Dec 31, 20x5

59

64

7 57

Cost of Goods Made

Finished goods Jan. 1, 20x5

457

49

Total 506

Finished goods Dec. 31, 20x5 36

Direct Labor

In process Jan. 1, 20x5 6

Applied during year 129

Total

In process Dec 31, 20x5

135

8 127

Cost of Goods Sold 470

Manufacturing Overhead

In process Jan. 1, 20x5 23

Applied during year 282

Total 305

In process Dec 31, 20x5 32 273


Determining Unit Cost

• “How much does it cost to produce each unit?”

– Trivial for direct costs

– Difficult for indirect costs

• Traditional unit-costing methods

– Direct-material-cost method

– Direct-labor-hour method

– Direct-labor-cost method

• Activity-based costing


Acme Corp

Cost Allocation Case Study

• Direct costs

Gizmo

Whatzit

Direct-material dollars per unit

$65.35

$82.21

Direct-labor hours per unit

6.6

7.0

Direct-labor cost per hour

$21.75

$25.50

Direct-labor dollars per unit

$143.55

$178.50

• Indirect costs

Manufacturing overhead $273

Selling expenses 36

General and administrative expenses 62

Research & development 99

Interest

Investments

Depreciation

Total overhead

17

1

36

524


Direct-Material-Cost Method

• Overhead is allocated in proportion to the cost of direct materials

DirectMate rialCostRa te



TotalOverh

TotalDirec ead tMaterialC ost

• For Acme Corp

DirectMate rialCostRa te



$524K

$57K



9 .

19

Gizmo

Direct material $65.35

Direct labor 143.55

Overhead, $65.35 * 9.19 600.57

809.47

INFO630 Week 9

Whatzit


Direct labor 178.50

Overhead, $82.21 * 9.19 755.51

1016.22


Direct-Labor-Hour Method

• Overhead is allocated in proportion to the number of direct labor hours

DirectLabo rHourRate



TotalOverh

TotalDirec ead tLaborHour s

• For Acme Corp

DirectLabo rHourRate



$524K

5581hrs



$ 93 .

89 / hr

Gizmo


Direct labor 143.55

Overhead, 6.6 * $93.89 619.67

828.10

Whatzit


Direct labor 178.50

Overhead, 7.0 * $93.89 657.23

917.94


Direct-Labor-Cost Method

• Overhead is allocated in proportion to the cost of direct labor

DirectLabo rCostRate



TotalOverh

TotalDirec ead tLaborCost

• For Acme Corp

DirectLabo rCostRate



$524K

$127K



4 .

13

Gizmo


Direct labor 143.55

Overhead, 143.55 * 4.13 592.86

801.76

Whatzit


Direct labor 178.50

Overhead, 178.50 * 4.13 737.21

997.92


Activity-Based Costing (ABC)

• Traditional cost

– Gather all overhead cost in a single large pool then allocate across company’s products and services

• ABC

– Entire cost of each activity is averaged out across all occurrences of that activity and is then allocated to individual products based on how much that activity occurs for that product


Activity-Based Costing

Overhead pool

Overhead

1

Direct material

1

Overhead

Direct material

2

2

Activity

1

Activity

2

...

Overhead n

Direct material n

Activity n

Product

Direct labor

1

Direct labor

2

Direct labor n

Overhead

1

Direct material

1

Overhead

Direct material

2

2

Activity

1

Activity

2

...

Overhead n

Direct material n

Activity n

Product

Direct labor

1

INFO630 Week 9

Direct labor

2

Direct labor n


Activity-Based Costing (cont)

1. Identify the activities

2. Determine total cost for each activity

3. Define a measure and quantity for each activity

4. Calculate the average cost per output for each activity

5. Specify the activity quantities for each product

6. Calculate unit costs


Caution on Unit Costing

• Might seem reasonable to use unit cost to calculate total cost for any arbitrary production rate

• Not that simple

– Variable costs

• proportional to the rate of production (raw materials, direct labor, …)

– Fixed costs

• Independent of the rate of production (facilities rental, loan interest, property tax, …)

– Unit cost = slope of dotted line.

• Doubling production rate will probably not double total cost!, therefore not unit cost either


Caution on Unit Costing

•

Sl op e =

U nit

co st

Vari able

Cos t

Total cost

Fixed Cost

Production rate


Key Points

• Balance Sheet shows financial position of a company at a point in time

• Profit & Loss Statement explains how financial position changed over time

• Cash Flow Statement shows details actual flow of cash between company and outside

• Cost accounting finds cost to provide products and services that were sold

• Unit cost shows cost to produce one instance of each product or service

– Direct-material-cost method

– Direct-labor-hour method

– Direct-labor-cost method

– Activity-Based Costing (ABC)

• Be careful to not misinterpret unit costs
