CHAPTER
6
Traditional Cost
Management
Learning Objective 1
Outline the different
cost flow patterns in
manufacturing,
merchandising, and
service organizations
and understand how
these costs are
reflected in the
income statement
and balance sheet.
What are Cost Flow Patterns of Manufacturing,
Merchandising, and Service Organizations?
Manufacturing
Direct Materials
Direct Labor
Manufacturing
Overhead
Work-inProcess
Inventory
Finished
Goods
Inventory
Cost of
Goods Sold
Merchandising
Inventory Purchase Cost
Inventory Shipping Cost
Supplies
Wages & Salaries
Overhead
Merchandise
Inventory
Service
Work-inProcess
Services
Cost of
Goods Sold
Cost of
Services Sold
Learning Objective 2
Interpret a cost of
goods manufactured
schedule and analyze
the levels of raw
materials, work-inprocess, and finished
goods inventories in
a manufacturing
organization.
Cost of Goods Manufactured Schedule

Shows specific costs incurred to manufacture goods.

Provides calculations that support flow of costs.

Total costs of goods manufactured should include only
those costs that have gone through work-in-process
during the period.

Underapplied MOH is subtracted from actual MOH costs.
Overapplied MOH is added to actual MOH costs.

Cost of goods available for sale = beginning finished
goods inventory (adjusted for over- or underapplied
MOH) + total cost of goods manufactured.
Analyzing COGS



COGS is not useful for internal decision making.
Management wants to determine cost of goods
manufactured
 on a product-by-product basis;
 on a department-by-department basis;
 on a period-by-period basis.
Other criteria examined
besides cost:
 product quality.
 speed of production.
Learning Objective 3
Understand how
merchants
manage cost
information in
their organization.
Inventory Management Issues
Carrying Too Much Inventory Carrying Too Little Inventory
 Increased overhead costs
 Increased risk of lost
sales
 Increased financial holding
costs
 Increased ordering costs
 Increased risk of loss of
 Increased risk of supplier
market value
price increases
 Decreased inventory
 Increased exposure to
flexibility
nondelivery
 Increased inventory
 Decreased bulk order
shrinkage
discounts
Return on Investment


It is just as important to manage the money
outflow for asset investment as it is to manage the
money inflow from profits.
Good management accounting can provide real
value in the management effort to improve a
merchandising operation.
ROI =
Profit margin X Asset turnover
Profit
Profit margin =
Revenue
Revenue
Asset turnover =
Total assets
Define Net Operating Profit
The difference
between normal
business sales and
normal business
expenses.
Learning Objective 4
Measure
profitability and
personnel
utilization in a
service
organization.
Describe the Characteristics of Service
Organizations
Professional
Services
People
Service
Shops
Mass
Services
Equipment
Process
Product
High
Customization
Low
Customization
What Two Concepts Are Used to Develop
Cost Management Evaluation Tools for
Service Organizations?
1) Profitability
2) Efficiency
- While management of materials inventories,
equipment, and building space are important in a
service organization, where must the emphasis be
placed?
- Management of the people and their related cost to
obtain the most efficient use of this critical
resource.
What is the Formula for Profit
Percentage from Professionals (PPP)?
Revenue – Professional compensation cost
PPP =
Revenue
What is a Personnel Utilization Report
(PUR)?
Actual billable hours
PUR =
Budgeted billable hours
Learning Objective 5
Calculate and
interpret holding
costs in
merchandising
and service
businesses.
Match These Terms with Their Correct
Formula or Definition
Economic
Profit
Cost of
Capital
Financial
Holding Cost
The Cost of Using Money
Average Investment x Annual
Rate x Number of Periods
Net Operating Profit – Holding
Cost of Inventory and Other
Asset Investments
Match These Terms with Their Correct
Formula or Definition
Economic
Profit
Cost of
Capital
Financial
Holding Cost
Net Operating Profit – Holding
Cost of Inventory and Other
Asset Investments
The Cost of Using Money
Average Investment x Annual
Rate x Number of Periods
Define Segment and Economic
Value Added
Segment is a part of a business
__________
that requires separate reports by
management for evaluation purposes.
_____________________
Economic Value Added is a
commercialized performance
measurement system emphasizing
incremental profits above the profit
necessary to meet cost of capital
requirements.
Expanded Material
Learning Objective 6
Use classic
quantitative tools in
inventory
management
(economic order
quantity, reorder
point, and safety
stock).
%
Economic Order Quantity
What must firms balance?
costs
of carrying
too much
inventory
costs
of carrying too
little inventory
EOQ attempts to balance these costs:
overhead costs, holding costs,
risk of lost market values, shrinkage, etc.
EOQ attempts to answer what questions?
How much inventory should we order?
When do we place the inventory order?
Calculating EOQ
How much inventory should we order?
What is the formula for EOQ?
What do the terms mean?
2QP
EOQ =
C
Q = The market demand in units for the period
P = The overhead cost of placing one order
C = The total carrying cost for one unit for the period
Reorder Point
When do we place the inventory order?
What is the formula?
Reorder point = Average lead time in days
x Average daily sales
Define Lead Time:
time lag between initiating a
purchase order and when
inventory is delivered and
ready for sale.
Safety Stock
Why does a business want to hold safety
stock?
Because a surge in customer
demand or problems in order
processing or shipping may cause
fulfillment problems, a manager
may see the need for a little
cushion in reorder point.
Safety stock — calculation has two parts:
1. To handle possible problems in the reorder process.
2. To handle an unexpected spike in sales demand.
Define Safety Stock
The minimal level of inventory required to ensure
against the organization running out of inventory in the
case of unforeseen problems in receiving its next
purchase order.
Reorder point = (Average lead time in days
x Average daily sales)
+ Safety stock
Combining the two calculations is acceptable,
assuming management is not interested in knowing the
specific level for safety stock. However, management
usually wants to know when sales are eating into the
safety stock.
EOQ, Reorder Points, and Safety Stock
Inventory Levels
Inventory
(Units)
Reorder
Point with
Safety
Stock
Reorder
Point
E
O
Q
Safety
Stock
0
units
3
days
6
days
Average Lead Time (3 days)
9
days
12
days