Cpa Business Notes - Chapter 5
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Chapter 5 – Planning, Budgeting, and Cost Management Cost Measurement and Cost Measurement Concepts Cost Measurement Concepts: Cost of goods manufactured and budgeting cost vs. actual cost. Managerial accounting and internal reporting Future orientation: usefulness and future orientation Most accounting reports are for externals (creditors, etc) Managerial accounting reports are for internal users Cost drivers: Cost drivers change total costs Direct causal relationship between change in cost driver and total costs May be based on volume, activity, or other operational characteristic Types of cost driver: executional (short-term) and structural (long-term) o Executional: manage short-term costs o Structure: decisions having long-term effects on cost Type of operational cost driver: volume-based and activity-based o Volume-based: aggregate volume of output. Associated with traditional cost accounting systems o Activity-based: activity that adds value to output. Associated with contemporary cost accounting systems Cost drivers as overhead (OH) allocation bases: o OH costs are indirect and must be applied on some basis. o OH must be added to direct material (DM) and direct labor (DL) to arrive at COGM o Allocation basis cost drivers. Traditional industries use direct labor hours as allocation base for overhead Cost driver = direct labor hours o Activity centers production departments (advertising, inspection, packaging). Are activity bases closely correlated with incurrence of manufacturing OH Contemporary industries accumulate OH with manufacturing and add value to its products Cost drivers = machine hours Cost objects: resources or activities that serve as the basis for management decisions i.e. products, product lines, departments, geographic territories product costing + cost control measurement = maximize effectiveness of management accounting systems Valuation = cost of goods manufactured Cost control = cost comparison to standards and budgets
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Common Flow of Costs Identified by Cost Objects Prime Costs = DM/DL Direct Materials
Conversion Costs = DL/OH Direct Labor
Factory Overhead
Work in Process Finished Goods Cost of Goods Sold Product costs = not expensed until the product is sold (manufacturing costs) They sit on the balance sheet as an asset before being sold Costs attach to the units of output Consist of DM, DL, and mfg OH applied Period costs = non-mfg costs Expensed in the period incurred and are NOT inventorial Expenses include selling and administrative expenses, interest expense Consist of selling the product and administering and managing the operations of the firm Manufacturing costs = treated as product costs Sit as inventory until sold Consist of direct and indirect costs Non-manufacturing costs = treated as period costs Expensed in the period incurred i.e. selling, general, administrative expenses ***Cost accounting systems are designed to meet the goal of measuring cost objects or objectives. The most frequent objectives include: • product costing (inventory and COGM and sold) • efficiency measurements (comparisons to standards) • income determination (profitability) Tracing Costs to Cost Objects (Product) Direct costs Easily traced to cost pool or object direct raw materials used in production or purchased (incl. Freight-in net of any discounts) direct labor directly related to product or performance of a service plus reasonable amount of expected “down time” for labor Becker – 2008 Edition
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Indirect costs in the “factory” – mfg. OH NOT easily traceable to cost pool or cost object Indirect materials not used specifically or could not be easily traced to the completed product Indirect labor supports the manufacturing process but not directly on specific job Other indirect costs in the “factory” (not materials, not labor) = i.e. depreciation of the factory ***Prime Cost = Direct Labor + Direct Material ***Conversion Cost = Direct Labor + Manufacturing Overhead Indirect costs are allocated to benefit cost pools or cost objects using cost drivers that are considered to have a strong relationship to the incurrence of these costs. Allocation basis = cost drivers that are used to allocate indirect costs Accounting = all indirect costs = OH. Cost Behavior (Fixed vs. Variable) DM and DL are variable costs o As volume , Total variable costs (DM & DL) Indirect costs, incl. mfg., are fixed and variable costs o Fixed costs (rent, insurance) are not related to volume o Variable costs (indirect labor, indirect material, utilities) dependent on volume Total costs = FC + VC Variable Costs: Behavior: Changes proportionally with the cost driver Amount: Constant per unit, Total varies o An item costs $25. If produce 10, total cost = $250. If produce 100, total cost = $2500 Long-run characteristics: short-run and long-run impacts of VC are same Fixed Costs: Behavior: In short-term, fixed cost does not change when the cost driver changes Amount: Varies per unit, total remains constant o Rent is $1000. If produce 10 items, unit cost = $100. If produce 100, unit cost = $10. Long-run characteristics: given enough time, any cost can be considered variable Semi-variable Costs: Contain fixed and variable components SEE EXAMPLES ON PAGE B5-9 Relevant Range: Range which the assumptions of cost driver are valid If cost driver activity is no longer in relevant range, the VC and FC assumptions cannot allocate costs to cost objects
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Cost behavior Summary review page B5-11 Keep costs under control! Standard Costs: Based on attainable (realistic) performance Standard cost per unit Lower the better Efficiency (cost) and effectiveness (productivity) Higher the output (volume) the better Standard Costing Systems: Used for all manufacturing costs (raw materials, DL, mfg OH) Direct costs o Standard price x Standard quantity = Standard direct costs Indirect OH costs o Standard (predetermined) application rate x Standard quantity = Standard indirect costs Purpose of standard costing systems o Cost control o Data for performance evaluations (variance analysis) o Ability to learn from standards and improve various processes Joint Product Costing and By-Product Costing (Common Cost Allocation) Allocating the cost of a single process (joint costs) among several final products (or by-products) if two or more final products are produced from the same raw material or input Common (or joint) costs relate to more than one product and cannot be separately identified. Common costs must be allocated in some manner to the benefiting cost object Joint products: “Main” products. 2 or more products that are from a common input By-products: Minor products of relatively small value that incidentally result from the main product Split-off point: point in production where the joint products can be recognized as individual products Joint product cost: costs incurred in producing products up to the split-off point. Generally, allocate to main product only, not by-product. Separable costs: costs incurred on a product after the split-off point Joint products: ∇ Method #1: Allocation by Unit Volume Relationships Example page B5-14 ∇ Method #2: Relative Net Realizable Values at Split-off Point Example page B5-15 o Net realizable values = sales value – cost of completion and disposal o Assuming the sales price quotations are available at split-off point ∇ Method #3: Sales values not available at split-off Example page B5-16 o Work backwards o Identifiable costs incurred after the split-off point must be subtracted from the final selling price to arrive at the net realizable value at split-off Becker – 2008 Edition
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By-products: Very low sales value Cannot even cover their share of common costs (otherwise they would be joint products) Revenue accounting can take one of two forms: o Applied to main product: Proceed from sales of by-products are a reduction to common costs for joint product costing Revenue earned goes to joint costs incurred either at time of production or sale o Miscellaneous income Decisions regarding which method to use (by-product or joint) is based on the demand. Accumulating and Assigning Costs Cost object custom order = job costing Cost object mass-produced (i.e. steel) = process costing Activity based costing may be used to assign costs, regardless of the cost accumulation system used
Operations costing = uses components of both job order costing and process costing Back-flush costing = accounts for certain costs at the end of the process in circumstances where there is little need for in-process inventory valuation Life cycle costing = monitor costs throughout the product’s life cycle and expand on the traditional costing systems that focus only on the manufacturing phase of a product’s life
Costs of goods manufactured: DM, DL, mfg OH Manufacturing costs in a period increase or decrease by the net change in WIP inventory o Beginning WIP – Ending WIP = costs of goods manufactured
o
o
Formula for materials used: Beginning materials + Net purchases Available for use - Ending Inventory Materials Used Cost of goods manufactured: Work in process inventory, beginning Add: Direct material used $30,000 Direct labor $50,000 Manufacturing OH $40,000 Total manufacturing costs incurred Total manufacturing costs available Less: Work-in-process inventory, ending Costs of goods manufactured
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$40,000
$120,000 $160,000 $10,000 $150,000 Page 5 of 26
Cost of goods sold: for a manufacturer, it is similar to retailer, but COGM is used instead of purchases COGS
Retailers add “Purchases”, not COGM.
Finished goods inventory, beginning Add: COGM COG available for sale Less: Finished goods inventory, ending COGS
$20,000 $150,000 $170,000 ($50,000) $120,000
JOB-COSTING Job order costing (cost accumulation system): Method of product costing that identifies the job as the cost objective Used when there are few units produced and when each unit is unique or easily identifiable Cost allocated to specific job as it moves through the manufacturing process “sequential” Job cost records: Maintained for products, services, or batch of products Serve as primary records used to accumulate all costs for the job Also known as job-cost sheets or job orders Include data from: o Materials requisitions: docs that show materials requested for use on the job o Labor time tickets (time cards): docs that show the labor hours and labor rate for the time applied to the job o Overview of job order costing: require a limited number of W-I-P accounts. (a new job cost account will be added every time there is a new job) RM + DL + OH WIP FG (when sold) COGS is expensed INVENTORY (Balance Sheet) MUST SEE CHART ON PAGE B5-19 ***Application of OH is accomplished in two ways: Step #1: Calculate OH Rate = Budgeted OH Costs / Estimated Cost Driver Step #2: Apply OH = Actual Cost Driver x Overhead Rate (from step #1)
Labor Hours Machine Hours Labor Costs
Based on actual production
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PROCESS COSTING Process Costing (Cost Accumulation System): Method of product costing that averages costs and applies them to a large number of homogeneous items. ***Computation of how each segment of the process should compute COG transferred out and the COG remaining in WIP (inventory) is the central product costing issue in process cost environments. Five steps are normally followed to resolve this issue: 1. Summarize the flow of physical unites (beginning with the Production Report) 2. Calculate “equivalent unit” output 3. Accumulate the total costs to be accounted for (Production Report) 4. Calculate the unit costs based on total costs and equivalent units 5. Apply the average costs to the units completed and the units remaining in ending WIP inventory Production Report Keep track of physical flow of units and costs incl. beginning inventory, # of units started, # of units completed, # of units remaining in inventory Unit (quantity) Accounting: # of units accounted equal the # of units charged to department Cost accounting: amount of costs accounted for must also equal the amount of costs charged to the department ***Accounting for the physical flow of units is an important first step in process costing. The pure physical flow of units will be different than the equivalent units of production. Inventory: Raw Materials
Inventory: Work-In-Process
Inventory: Finished Goods
B Beginning inventory of raw materials A Add: Purchases of raw materials Raw materials available for use S Subtract: Raw materials used E Ending Inventory of raw materials
B Beginning inventory of WIP A Add: Raw materials used + DL +OH used WIP inventory available to be finished S Subtract: Inventory transferred to finished goods E Ending inventory of WIP
B Beginning inventory of finished goods A Add: Inventory transferred from WIP Finished goods inventory available for sale S Subtract: COGS E Ending inventory of finished goods
Equivalent unit: An equivalent unit of DM, DL, or conversion costs (DL+OH) = to the amount of DM, DL, or conversion costs necessary to complete one unit of production Any material added at the very end of a process will not be in WIP inventory at month end Calculations of average unit costs: Averaging of costs from prior month’s WIP: costs from previous month’s WIP inventory are different from costs of current month. Costs must be averaged. Cost averaging computations depend upon FIFO and/or weighted (or moving) average cost flow assumptions. Normal Spoilage (or shrinkage) Inventory cost Lost or spoiled units reduce the denominator and raise the cost per unit Occurs under regular operating conditions and is included in the standard cost of manufactured product Is capitalized as part of inventory cost. Becker – 2008 Edition
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o If accounted for separately, are allocated to good units produced Abnormal spoilage Period expense Per unit cost is based on actual units. Equivalent units of production include spoiled units Expensed separately on the income statement as a period cost Is charged against income of the period as a separate components of COGS Specific Cost Flow Assumptions: Calculation with FIFO: o Ending inventory is priced at cost of mfg during the period, assuming that beginning inventory was completed during the period o Equivalent units are composed of three separate elements: completion of units on hand at the beginning of the period, units started and completed, and units partially complete at the end of the period o Cost components: current costs incurred during the period are allocated to the equivalent units produced during the period Calculation using weighted-average o Averages the cost of production during the period with the costs in the beginning WIP inventory o Equivalent unit components: output divisor. Units completed during the month + equivalent units of work done on the WIP at the end of the period o Total costs include the costs of beginning inventory and current costs are allocated to equivalent units FIFO method: Equivalent units of production: FIFO consists of 3 elements FIFO represents only costs incurred in the current period Beginning WIP x % to be completed XXX Units completed – Beginning WIP + XXX Ending WIP x % completed + XXX Equivalent units XXX Cost per equivalent unit: FIFO = Current costs ONLY Equivalent units Weighted-average method: Equivalent units of production: Weighted-average consists of only 2 elements Weighted-average consists current period and prior period units Units completed XXX Ending WIP x % completed + XXX Equivalent units XXX
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Cost per equivalent unit: Weighted-average = Beginning cost + Current cost Equivalent units SEE EXAMPLE PAGE B5-24 & B5-25 Record-keeping for process-costing is less costly than job-order costing system since individual units produced are not identified. Increased accounts: Focuses on processes and typically requires more WIP accounts than job order costing Record sequence: follow sequential pattern of production process ACTIVITY-BASED COSTING (ABC) Activity-based costing = cost-assigning system Traditional cost systems assign overhead as a single cost pool with a single plant-wide overhead application rate using a single allocation base. These rates are volume-based and use an application basis (i.e. DL hours or machine hours). ABC = uses multiple OH rates Assigns indirect costs to products (cost objects) is based on the product’s demand for resourceconsuming activities (costs assigned based on consumption of resources). Activity = work performed inside a firm. Identified for ABC Resource = element that is used to perform an activity Cost drivers = “multiple” Denominator Causes cost to be incurred. Closely correlated with the incurrence of mfg OH costs Has ability to change the total cost Resource cost driver = amount of resources used Activity cost driver = amount of activity that a cost object will use. Used to assign costs to cost objects Activity centers = “multiple” OH incurred in that department Operation necessary to produce a product Cost pool = group of costs Characteristics of ABC: More focused and detailed approach Focuses on multiple causes and effects and then assigns cost to them. “build-up” Job order system or process cost system Used for manufacturing or service business Long-term view point Becker – 2008 Edition
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Production costs = variable Cost driver is a non-financial variable Used for internal purposes, not external
ABC = transaction-based costing cost driver is # of transactions in an activity Focuses on cost/benefit of activities: Value-added activities Value chain (value-added activities): add value to the product. Support activities directly support value-added activities o i.e. direct costs, mfg costs Non-value added activities: do not increase product value o Eliminate costs – warehousing, overproduction, insurance Effects of activity based costing: High OH to products that have high demands on expensive resources Removes cost distortion EXAMPLE PAGE B5-29 AND B5-30
Factors Affecting Production Costs Types of costs: Explicit Costs: out-of-pocket expenses (wages, materials, and utilities) Implicit Costs: opportunity costs by owners (entrepreneurship, equity, capital) Opportunity costs: value of the next best alternative foregone Analysis of costs: Accounting costs: explicit costs of operating a business. Do not consider opportunity costs. Economic costs: sum of both accounting (explicit) and opportunity (implicit) costs. (rent, wages) Production costs in the short run and long run: Short-run: period of time in which some of the inputs used for production are fixed Period of time in which all of the inputs used for production are variable Accounting profits = Total revenue - total accounting costs Economic profits = Total revenue - total economic costs (implicit and explicit) *Accounting profits are higher because economic profits reduce revenue by explicit and implicit costs. Economies of Scale: Produce more = lower fixed cost per unit = increase in profit per unit Economies of scale will eventually be lost, and diseconomies of scale will result Factors: o Opportunity for specialization o Utilization of advanced technology o Ability to use by-products o Volume purchases and discounts Becker – 2008 Edition
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o o
Proportionately lower costs of purchasing and installing larger pieces of equipment Lower capital costs per unit spreading FC over more units
Diseconomies of Scale: Large firms become inefficient and are not cost effective Increase in average operational costs because of problems in managing large-scale enterprise Factors: o Bottlenecks and costs of transporting materials o Difficulty of supervising and managing a large bureaucracy Sunk Costs: Costs that have been incurred and are unavoidable. Will not vary with the course of action taken NOT relevant in decision-making Opportunity Costs: Potential benefit lost by selecting a particular course of action Relevant Do not represent actual cash outlays Not recorded in the accounting records, but must be considered in every decision (economics) Time Value of Money: Cash flow over a # of years represents consideration of opportunity costs Cash flows devoted to a particular project are expected to yield amounts that equal or exceed the returns associated with alternative investments Financial Models Used for Operating Decisions Cost-Volume-Profit (CVP) Analysis for Decision Making: Breakeven Analysis Revenues and costs in an economic model that allows managers to anticipate profits at different levels of sales and production volume All costs can be separated into either VC or FC, depending on their behavior Volume is the only relevant factor affecting cost TC = FC + VC(volume) Contribution Approach (Direct Costing): NON-GAAP Approach to income statement uses FC Extremely useful for internal decision making The contribution of each transaction to covering FC and in computing breakeven in revenue $$ Revenue Less: Variable Costs DM + DL + Var. OH + Var. Selling, General & Admin. Contribution Margin Less: Fixed Costs Fixed OH + Fixed Selling, General & Admin. Net Income
Variable costs include DL, DM, var. Mfg OH, shipping and packaging, and var. selling & admin.
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Fixed costs include fixed OH, fixed selling, and most general and administrative expenses Allows to be calculated either as a total or per unit Unit contribution margin = unit sales price – unit variable cost Contribution margin ratio = contribution margin expressed as a % of revenue Contribution margin ratio = contribution margin / revenue
Absorption Approach: GAAP Does not segregate FC and FC Equation: Revenue Less: COGS DM + DL + Var. OH + Fixed OH Gross Margin Less: Operating Expenses Fixed & Var. Selling, General, & Admin Net Income
Approach to income statement is required by GAAP for external reporting Comparison of Costs Included in Product Cost
Absorption Costing 1. Direct materials 2. Direct labor 3. Manufacturing OH, both variable and fixed
Variable (Direct) Costing 1. Direct materials 2. Direct labor 3. Variable mfg overhead ONLY All fixed manufacturing costs are treated as period costs
The difference between contribution and absorption approaches is the treatment of fixed factory OH. Selling, general, and administrative expenses are period costs under both methods. Fixed Factory OH: Contribution approach: Period Cost NOT GAAP Expense immediately Absorption approach: Product Cost GAAP Expense when sold Selling, General, & Administrative: Are period costs used in the determination of net income under both methods Steps to compute differences between contribution and absorption method: 1. Compute fixed cost per unit (fixed manufacturing OH/units produced) 2. Compute the change in income (change in inventory units x fixed cost per unit) 3. Determine the impact of the change in income: No change in inventory: Increase in inventory: Decrease in inventory:
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Absorption Net Income = Variable Net Income Absorption Net Income > Variable Income (Less fixed OH expensed under absorption) Absorption Net Income < Variable Net Income (More fixed OH expensed under absorption)
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Breakeven Computation Breakeven for units: Breakeven points in units = Total fixed costs / Contribution margin per unit Contribution margin per unit: Unit price x Breakeven point in units = Breakeven point in dollars Contribution margin ratio: Total fixed costs / Contribution margin ratio = Breakeven point in dollars Required sales volume for target profit: Sales = Variable Costs + (Fixed Costs 9 Net Income Before Taxes) Sales =
Fixed Cost + Profit Contribution Margin Ratio (or per unit)
Calculate target profit before tax: Target profit before tax = Target profit after tax + Tax Target profit before tax = Target profit after tax / (1 – tax rate) Calculate the breakeven point in sales: Sales = Variable costs + Fixed costs + Target profit before taxes A company’s profit after breakeven = units sold after breakeven x the CM per unit Margin of safety in dollars = Total sales in dollars – Breakeven sales in dollars Margin of safety in percentage = Margin of safety in dollars Total sales SEE EXAMPLE ON PAGE B5-43... Step 1: TC = FC + VC per unit (units produced) Step 2: FC = y intercept = $150,000 – not dependent on volume Step 3: VC per unit – slope = ∇DV = 280,000 – 150,000 = $50 ∇IV 2600 - 0 Step 4: TC = 150,000 + 50 (2,600) = 280,000 Target Costing = technique to establish the product cost allowed to ensure both profitability per unit and total sales volume Requires the selling price of the product to determine the production costs to be allowed Competition sets prices, any change in price could easily cause a customer defection Cost control, ongoing profitability Becker – 2008 Edition
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Target Cost = Market price – Required profit May have to compromise on quality (by reducing costs) = loss of sales due to the poor quality Increase downstream cost (differentiate their products, create brand loyalty, competitive advantage) Advanced cost management techniques to attain a higher productivity level Redesign product to reduce costs throughout the life cycle of a product (The Kaizen Method)
Economic Value Added (EVA) Similar to residual income method (computes required rate of return based on hurdle rate) Measures the excess of income after taxes earned by an investment over the return rate defined by the company’s cost of capital Step 1: Calculate the required amount of return and income after taxes Investment x Cost of Capital Required Return
1,000,000 x 12% 120,000
Step 2: Compare income to the required return Income after taxes - Required return Economic Value Added
150,000 120,000 30,000
Positive EVA: performance is meeting standards Negative EVA: performance is not meeting standards Refined using any number of investment or income adjustments to produce more accurate analysis of economic profit Organization will capitalize research and development costs as part of its asset base Balance sheet accounts are re-valued to represent current cost Adjustments to the balance sheet impact the income statement (Deferred taxes are ignored) Forecasting and Projection Techniques
Budget Policies: technique for developing forecasts and budgets. ∇ Involves a budget committee, which includes members of senior management ∇ Resolve dispute and make final decisions for major budget changes ∇ Management give guidelines based on strategic goals and long-term plan. Include: o Evaluation of current conditions: consideration of the changes to the environment since the adoption of the strategic plan, organizational goals for the coming period & operating results year-to-date o Management instructions: setting the tone for the budget, corporate policies Standards and benchmarking manufacturing, service Standards set below expectations to motivate productivity and efficiency revised at least once a year Becker – 2008 Edition
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Ideal standards perfect efficiency and effectiveness. Not historical, but future. Unrealistic because no provision for normal spoilage or down time. o Advantage: emphasis on continuous quality improvement (CQI) to meet ideal o Disadvantage: de-motivation b/c unrealistic standards Currently attainable standards used with flexible budgets. Costs that result from work performed by employees with appropriate training and experience but without extraordinary effort. Provision for normal spoilage and down time. o Advantage: reasonable standards o Disadvantage: use of judgment and potential manipulation Authoritative standards set by management o Advantage: implemented quickly and will include all costs o Disadvantage: workers might not accept Participative standards by managers and individuals held accountable o Advantage: works will accept o Disadvantage: slower to implement Benchmark best practices of different firms to establish standards o Purpose: promotes achievement of competitive advantage Data-driven Techniques for Forecasting and Projection Sensitivity analysis: experimenting with different parameters (i.e. size of FC, size of VC per unit, volume) and assumptions regarding a model and cataloguing the range of results to view the possible consequences of a decision Forecasting analysis: risk analysis. Extension of sensitivity analysis: o Predicting future values of depending variables (total cost) using information from previous time periods (FC, VC per unit, volume) Regression analysis: predict total costs. o Studying the relationship between two or more variables. o Predict the dependent variable (y) given independent variable (x) o Simple regression = one independent variable (volume) o Multiple regression = two or more independent variables o One type of goal: predict total costs based on output o y = A + Bx DV TC VC Total + Cost FC Quantity Becker – 2008 Edition
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IV
o o o o
y = dependent variable x = independent variable (regressor) A = y-intercept for regression line B = slope of regression line → Variable cost per unit ∇DV = cost ∇IV = volume Page 15 of 26
The coefficient of correlation (r): - Measures the strength of the linear relationship between independent (volume) and dependent (total cost) variables - Range of r is from -1.0 to +1.0: o -1.0 = perfect inverse relationship o 0 = no relationship o +1.0 = perfect direct relationship The coefficient of determination (R): - Proportion of the total variation in the dependent variable (total cost) explained by the independent variable (volume) - Range from 0 to +1.0 - The higher the R2, the greater is the proportion of the total variation in y that is explained by the variation in x. The higher the R2, the better fit of the regression line ***How much of the ∇TC (DV) is explained by ∇output (IV)? ***When selection cost drivers, choose the one with the highest r/R2 Learning curve: method of logically projecting costs when learning is a variable, often for repetitive tasks Learning rate: percentage expression of the decrease in avg time (or total time) as production doubles High-low method: used to estimate the fixed and variable portions of cost, usually production costs - Enables preparation of flexible/performance budget by identifying total fixed costs and variable costs per unit - Can estimate total costs at any volume Flexible budget formula: - Series of budgets for a range of activity level o
o
Total Cost = Fixed Cost + (Variable cost per unit x Number of units) (y-intercept) + slope: ∇DV = cost x IV ∇IV = volume Really helpful example on page B5-54 Planning/Budgeting Overview and Planning/Budgeting Techniques
Tactical planning short-term up to 18 months Single use plans: Tactical plans are also called single use plans because they are developed to apply to specific circumstances during a specific timeframe Annual budget: type of single-use tactical plan. Place responsibility for achievement of strategic goals in the hands of managers promotes routine accomplishment of strategy as part of the manager’s job function Becker – 2008 Edition
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Master budget (annual budget): short-term operating performance goals for up to one year’s time - Includes operating budget and financial budget for a single level of sales volume - Comprehensive and coordinated budget guidance for an organization consistent with overall strategic objectives - Control objective criteria for performance - known as static budgets, annual business plans, profit planning, targeting budgets - useful specifically in manufacturing industry because of coordination of financial and operating budgets - Limitations: o Master budget confined to one year at a single level of activity. o Budget may differ from actual results, even though the relationship between expenses and revenues is consistent NOT flexible o Product: Pro forma financial statements Don`t provide management information useful for decision making - Driven by sales budget o Unit sales drive unit production o Sales volume drives support cost - Operating budget include: o Sales budgets o Production budgets (begins with sales budget) o Selling and administrative budgets Support Cast o Personnel budgets - Financial budgets: detail sources and uses of funds to be used in operations o Pro forma financial statements o Cash budgets - Annual plan overview: for relationships between annual plan components, SEE PAGE B5-57
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Flexible budgeting: - Used with most budgets & in most industries - Focus on substantive variances from standards rather than simple changes in volume or activity - Adjustable economic models designed to predict outcomes and accommodate changes in actual activity - Consider revenue per unit, variable costs per unit, and fixed costs over the relevant range where the relationship between revenues and variable costs will remain unchanged and fixed costs will remain stable - Flexible budgets derive the expenses and revenues allowed from the output achieved for comparison to actual activity and performance evaluation - Limitation: dependent on accurate identification of fixed and variable costs and determination of the relevant range - Uses standard cost Standard cost flexible budget. Zero-budget starts with zero, and all cost is justified. Static budget is opposite of flexible budget, and is used only for one specific volume. Strategic budget is long-term and does not use standard cost. Becker – 2008 Edition
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Budget Variance Analysis Variance analysis: comparison of actual results to the annual business plan = 1st and basic level of control and evaluation of operations (performance). Standard cost system: realistic budgeted cost for use in planning and decision-making. Variance from standard could have been prevented controllable variance VC (i.e. DM, DL) - If not preventive uncontrollable FC Variances calculated for the following elements: - DM - DL - VOH (variable mfg overhead) - FOH (fixed mfg overhead) Direct Materials and direct labor variance two variances are typically calculated: 1. Price or rate variance 2.
Quantity or efficiency variance
o o o o o o
DM price variance = Actual quantity purchased * (Actual price - Standard price) DM quantity variance = Standard price * (Actual quantity used - Standard quantity allowed) DL rate variance = Actual hours works * (Actual rate - Standard rate) DL efficiency variance = Standard rate * (Actual hours worked - Standard hours allowed) Standard quantity allowed (SQA) = actual output * standard allowed output Tabular method: B5-63 variance chart
To calculate the difference in variance analysis Remember S-A-D: Standard – Actual = Difference S -A D
Standard - Actual Difference
Four main types of variances for RM and DL (not OH): P Price variance (DM) U Usage (quantity) variance (DM) R Rate variance (DL) E Efficiency variance (DL) Memorizing the variance formula, apply “DADS” twice!! P U R E
Price variance (DM) Usage (quantity) variance (DM) Rate variance (DL) Efficiency variance (DL)
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DA DS DA DS
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Difference Difference Difference Difference
x x x x
Actual Standard Actual Standard
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Example page B5-66 Manufacturing Overhead Variance o Net overhead variance (one-way variance): (debit) under vs. (credit) over applied o Two-way variance consisting of: o Budget (controllable) variance variable OH o Volume (uncontrollable) variance fixed OH o Three-way variance consisting of: o Spending variance the less we spend on OH, the better o Efficiency variance the less hours worked, the better o Volume (uncontrollable) variance the more units produced, the better o Production volume variance: OH variances = applied OH – budgeted OH based on standard hours Applied OH = (Std VOH rate x Std DLH allowed) + (Std FOH rate x actual production) Budgeted OH on std hours = (Std VOH rate x Std DLH allowed) + (Std FOH rate x standard production)
o
MUST PRACTICE example page B5-69 (listen to the lecture item 13 of 20)
Target Market Analysis - Essential to development of consistent strategy for the success of a company Selling price x Volume = Sales (high price, low volume OR low price, high volume) (ex. Hyundai vs. Mercedes) -
Sales volume variance: flexible budget variance that distils volume activity from other sales performance components
Sales volume variance = (Actual sold units – Budgeted sales units) x Std contribution margin per unit -
Sales mix variance: impact of company’s departure from planned mix products in budget
Sales mix variance = (actual product sales mix ratio - budgeted product sales mix ratio) * actual sold units * budgeted contribution margin per unit of that product -
Sales quantity variance: difference of actual sold units and budgeted, incl. market size and share of target market
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Sales quantity variance = (actual units sold - budgeted unit sales) * budgeted sales mix ratio * budgeted contribution margin per unit -
Market size variance: the effect the size of the entire market for the product has on the contribution margin for the firm
Market size variance = (actual market size in units - expected market size in units) * budgeted market share * budgeted contribution margin per unit weighted avg -
Market share variance: effect of firm`s market share on the firm`s contribution margin
Market share variance (actual market share - budgeted market share) * actual industry units * budgeted contribution margin per unit weighted avg -
Selling price variance: aggregate impact of selling price different from budget o Lower price cost leadership strategy o Higher price product differentiation strategy
Selling price variance = (actual SP per unit - budgeted selling price per unit) * actual units sold
Organizational Performance Measures Responsibility accounting: dependent on proper delegation & authority Responsibility segments strategic business units (SBUs). - Classified around four financial measures (performance objectives) managers are responsible for - SBUs effective in organizing performance requirements and financial responsibility 1. Cost SBU managers responsible for controlling costs (materials, labor, OH) – has least responsibility 2. Revenue SBU managers responsible for generating revenues (# units sold x SP per unit) – has more responsibility than cost SBU 3. Profit SBU managers responsible for producing target profit (revenue and costs) – More responsibility than Cost and Revenue SBUs 4. Investment SBU managers responsible for return on the assets invested (highest level: board of directors) – line an independent business – has the most responsibility Financial scorecards: feedback function links planning, control, and performance evaluations and is integral to evaluating and reporting performance 1. Accurate and timely 2. Understandable 3. Specific accountability (each SBU is subdivided into additional categories) a. Product lines Becker – 2008 Edition
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b. Geographic linesc. Customer Allocation of common costs: managers have control over variable costs and over controllable fixed costs (i.e. insurance). Common costs are NOT controllable (i.e. rent on factory, long term lease) Contribution margin: Controllable the excess of revenues over FC. Controllable margin: Refinement of contribution margin reporting and represents the difference between contribution margin and controllable fixed costs - Controllable fixed costs = costs that managers can impact in less than one year (i.e. advertising) Non-financial scorecards: 1. Qualitative: measurements that may be difficult or imprecise and are not numerical. a. Employee morale, customer satisfaction 2. Quantitative: numerical measurements, but not in dollars a. Reduction in travel time, distance displayed in hours or miles Balanced scorecard: gathers information on multiple dimensions of an organization’s performance defined by critical success factors necessary to accomplish firm strategy. - Critical success factors are: o F – Financial Profit o I – Internal business processes Efficient production o C – Customer satisfaction Market share o A – Advancement of innovation and human resource development (learning & growth) employee moral, retaining key employees - No one dimension of operations will accomplish an organization’s business objectives Benchmarking Techniques and Best Practices Benchmark: identifies standards defining success factors, used for comparison to actual performance (or gaps in performance), and implementation of improvements to meet or exceed the benchmark. External benchmarks: Productivity Measures -
Measure efficiency Compare actual performance to similar organizations
Objective: 1. Determine whether more inputs have been used than necessary to obtain the actual output. 2. Determine whether the best mix of inputs has been used.
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Two types of productivity ratios: 1. Total productivity ratios (TPR): value of all output relative to the value of all input Quantity of output produced / Cost of inputs 2. Partial productivity ratios (PPRs): value of all outputs as compared to the value of major categories of input Quantity of output produced / Quantity of the single input used Internal benchmarks: Techniques to find and analyze problems -
Monitoring and investigative techniques
Control Charts: “Determine zero defects” - Graphically display the impact of measuring goalpost conformance - Show if there is a trend toward improved quality conformance or deteriorating quality conformance - “Statistical control”: where n one of the actual measures fall outside of boundaries Pareto Diagrams: frequency diagram - histogram of quality control issues displayed in order of most to least frequent with a line graph that displays the cumulative occurrence of the problems - managers use this to determine the quality control issues that are most frequent and demand the greatest attention - 6 types. - Type 1, 2, and 3 are 75% of all defects. Cause and effect fishbone diagram: - Analyze the source/location of problems - Managers analyze the problems that contribute to the occurrence of defects - Trace defects back to source - Diagram on PAGE B5-80 - Elements of manufacturing process include: o Machinery o Method o Materials o Manpower Continuous Improvement (Kaizen) - Continuous improvement efforts that improve the efficiency and effectiveness of organizations through greater operational control - Manufacturing stage (where it is ensured that resource uses stay within target costs)
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Process improvements / Activity-based Management (ABM) - ABC and ABM are highly compatible with process improvements and total quality management (TQM) - Availability of cost data by activity make the identification of costs of quality and value-added activities more obvious - Process management has many of the attributes of ABC, TQM, and value chain analysis Quality control principles Goalpost conformance: - Compliance within an acceptable range - Zero-defects conformance because management has the full expectation that production will conform to the range of quality standards with no exception - Goalpost is not absolute conformance o Absolute conformance = higher quality products Quality control principles: Costs of Quality 1. Conformance costs: conformance with quality standards prevention and appraisal costs a. Prevention costs: incurred to prevent the production of defective units i. Employee training ii. Inspection expenses iii. Preventive maintenance iv. Redesign of product v. Redesign of processes vi. Search for higher quality suppliers b. Appraisal costs: incurred to discover and remove defective parts i. Statistical quality checks ii. Testing iii. Inspection iv. Maintenance of the laboratory 2. Non-conformance costs: Cost of “failure” a. Internal failure: costs to cure a defect discovered before the product is sent to customer i. Rework costs ii. Scrap iii. Tooling changes iv. Costs to dispose v. Cost of the lost unit vi. Downtime b. External failure: costs to cure a defect discovered after the product is sent to customer i. Warranty costs ii. Cost of returning the good iii. Liability claims iv. Lost customers v. Re-engineering an external failure 3. Quality reporting: financial impact of quality in four categories Becker – 2008 Edition
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a. Inverse relationship between conforming and non-conforming costs A – Appraisal – costs to identify defective products – conforming P – Prevention – costs to prevent the production of defective products - conforming I – Internal failure – cost of defective parts or lost production time – non-conforming E – External failure – cost of returns and lost customer loyalty – non-conforming Total Quality Management (TQM): - Commitment to customer-focused performance – quality and continuous improvement - Seven factors: o Customer focus: External customers Internal customers (each link in value chain) o Continuous improvement o Workforce involvement: Quality circles o Top management support: delegation and empowerment o Objective measures o Timely recognition o Ongoing training
Regression analysis: - Statistical model that can estimate the dependent cost variable based on changes in the independent variable - Independent variable is assumed (not estimated) in regression analysis and is based on activity, not costs - separate costs into fixed and variable components - Estimates the dependent cost variable - No probabilities are used!! - The coefficient of determination is a statistical measure used to evaluate the results of regression analysis Trend analysis: project costs (expenses) out into the future.
Monte Carlo simulation: generate individual values for a random variable. Dynamic programming: make a series of interrelated decisions. Learning curve analysis: determine increases in efficiency or production as experience is gained. Expected value analysis: long-term average of repeated trials and is found by multiplying the probability of each outcome by its payoff and then summing the results Continuous probability simulation: procedure that studies a problem by creating a model of the process and then, through trial and error solutions, attempts to improve the problem solution Becker – 2008 Edition
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Common Flow of Costs Identified by Cost Objects Prime Costs = DM/DL Direct Materials
Conversion Costs = DL/OH Direct Labor
Factory Overhead
Work in Process Finished Goods Cost of Goods Sold Product costs = not expensed until the product is sold (manufacturing costs) They sit on the balance sheet as an asset before being sold Costs attach to the units of output Consist of DM, DL, and mfg OH applied Period costs = non-mfg costs Expensed in the period incurred and are NOT inventorial Expenses include selling and administrative expenses, interest expense Consist of selling the product and administering and managing the operations of the firm Manufacturing costs = treated as product costs Sit as inventory until sold Consist of direct and indirect costs Non-manufacturing costs = treated as period costs Expensed in the period incurred i.e. selling, general, administrative expenses ***Cost accounting systems are designed to meet the goal of measuring cost objects or objectives. The most frequent objectives include: • product costing (inventory and COGM and sold) • efficiency measurements (comparisons to standards) • income determination (profitability) Tracing Costs to Cost Objects (Product) Direct costs Easily traced to cost pool or object direct raw materials used in production or purchased (incl. Freight-in net of any discounts) direct labor directly related to product or performance of a service plus reasonable amount of expected “down time” for labor Becker – 2008 Edition
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Indirect costs in the “factory” – mfg. OH NOT easily traceable to cost pool or cost object Indirect materials not used specifically or could not be easily traced to the completed product Indirect labor supports the manufacturing process but not directly on specific job Other indirect costs in the “factory” (not materials, not labor) = i.e. depreciation of the factory ***Prime Cost = Direct Labor + Direct Material ***Conversion Cost = Direct Labor + Manufacturing Overhead Indirect costs are allocated to benefit cost pools or cost objects using cost drivers that are considered to have a strong relationship to the incurrence of these costs. Allocation basis = cost drivers that are used to allocate indirect costs Accounting = all indirect costs = OH. Cost Behavior (Fixed vs. Variable) DM and DL are variable costs o As volume , Total variable costs (DM & DL) Indirect costs, incl. mfg., are fixed and variable costs o Fixed costs (rent, insurance) are not related to volume o Variable costs (indirect labor, indirect material, utilities) dependent on volume Total costs = FC + VC Variable Costs: Behavior: Changes proportionally with the cost driver Amount: Constant per unit, Total varies o An item costs $25. If produce 10, total cost = $250. If produce 100, total cost = $2500 Long-run characteristics: short-run and long-run impacts of VC are same Fixed Costs: Behavior: In short-term, fixed cost does not change when the cost driver changes Amount: Varies per unit, total remains constant o Rent is $1000. If produce 10 items, unit cost = $100. If produce 100, unit cost = $10. Long-run characteristics: given enough time, any cost can be considered variable Semi-variable Costs: Contain fixed and variable components SEE EXAMPLES ON PAGE B5-9 Relevant Range: Range which the assumptions of cost driver are valid If cost driver activity is no longer in relevant range, the VC and FC assumptions cannot allocate costs to cost objects
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Cost behavior Summary review page B5-11 Keep costs under control! Standard Costs: Based on attainable (realistic) performance Standard cost per unit Lower the better Efficiency (cost) and effectiveness (productivity) Higher the output (volume) the better Standard Costing Systems: Used for all manufacturing costs (raw materials, DL, mfg OH) Direct costs o Standard price x Standard quantity = Standard direct costs Indirect OH costs o Standard (predetermined) application rate x Standard quantity = Standard indirect costs Purpose of standard costing systems o Cost control o Data for performance evaluations (variance analysis) o Ability to learn from standards and improve various processes Joint Product Costing and By-Product Costing (Common Cost Allocation) Allocating the cost of a single process (joint costs) among several final products (or by-products) if two or more final products are produced from the same raw material or input Common (or joint) costs relate to more than one product and cannot be separately identified. Common costs must be allocated in some manner to the benefiting cost object Joint products: “Main” products. 2 or more products that are from a common input By-products: Minor products of relatively small value that incidentally result from the main product Split-off point: point in production where the joint products can be recognized as individual products Joint product cost: costs incurred in producing products up to the split-off point. Generally, allocate to main product only, not by-product. Separable costs: costs incurred on a product after the split-off point Joint products: ∇ Method #1: Allocation by Unit Volume Relationships Example page B5-14 ∇ Method #2: Relative Net Realizable Values at Split-off Point Example page B5-15 o Net realizable values = sales value – cost of completion and disposal o Assuming the sales price quotations are available at split-off point ∇ Method #3: Sales values not available at split-off Example page B5-16 o Work backwards o Identifiable costs incurred after the split-off point must be subtracted from the final selling price to arrive at the net realizable value at split-off Becker – 2008 Edition
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By-products: Very low sales value Cannot even cover their share of common costs (otherwise they would be joint products) Revenue accounting can take one of two forms: o Applied to main product: Proceed from sales of by-products are a reduction to common costs for joint product costing Revenue earned goes to joint costs incurred either at time of production or sale o Miscellaneous income Decisions regarding which method to use (by-product or joint) is based on the demand. Accumulating and Assigning Costs Cost object custom order = job costing Cost object mass-produced (i.e. steel) = process costing Activity based costing may be used to assign costs, regardless of the cost accumulation system used
Operations costing = uses components of both job order costing and process costing Back-flush costing = accounts for certain costs at the end of the process in circumstances where there is little need for in-process inventory valuation Life cycle costing = monitor costs throughout the product’s life cycle and expand on the traditional costing systems that focus only on the manufacturing phase of a product’s life
Costs of goods manufactured: DM, DL, mfg OH Manufacturing costs in a period increase or decrease by the net change in WIP inventory o Beginning WIP – Ending WIP = costs of goods manufactured
o
o
Formula for materials used: Beginning materials + Net purchases Available for use - Ending Inventory Materials Used Cost of goods manufactured: Work in process inventory, beginning Add: Direct material used $30,000 Direct labor $50,000 Manufacturing OH $40,000 Total manufacturing costs incurred Total manufacturing costs available Less: Work-in-process inventory, ending Costs of goods manufactured
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$120,000 $160,000 $10,000 $150,000 Page 5 of 26
Cost of goods sold: for a manufacturer, it is similar to retailer, but COGM is used instead of purchases COGS
Retailers add “Purchases”, not COGM.
Finished goods inventory, beginning Add: COGM COG available for sale Less: Finished goods inventory, ending COGS
$20,000 $150,000 $170,000 ($50,000) $120,000
JOB-COSTING Job order costing (cost accumulation system): Method of product costing that identifies the job as the cost objective Used when there are few units produced and when each unit is unique or easily identifiable Cost allocated to specific job as it moves through the manufacturing process “sequential” Job cost records: Maintained for products, services, or batch of products Serve as primary records used to accumulate all costs for the job Also known as job-cost sheets or job orders Include data from: o Materials requisitions: docs that show materials requested for use on the job o Labor time tickets (time cards): docs that show the labor hours and labor rate for the time applied to the job o Overview of job order costing: require a limited number of W-I-P accounts. (a new job cost account will be added every time there is a new job) RM + DL + OH WIP FG (when sold) COGS is expensed INVENTORY (Balance Sheet) MUST SEE CHART ON PAGE B5-19 ***Application of OH is accomplished in two ways: Step #1: Calculate OH Rate = Budgeted OH Costs / Estimated Cost Driver Step #2: Apply OH = Actual Cost Driver x Overhead Rate (from step #1)
Labor Hours Machine Hours Labor Costs
Based on actual production
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PROCESS COSTING Process Costing (Cost Accumulation System): Method of product costing that averages costs and applies them to a large number of homogeneous items. ***Computation of how each segment of the process should compute COG transferred out and the COG remaining in WIP (inventory) is the central product costing issue in process cost environments. Five steps are normally followed to resolve this issue: 1. Summarize the flow of physical unites (beginning with the Production Report) 2. Calculate “equivalent unit” output 3. Accumulate the total costs to be accounted for (Production Report) 4. Calculate the unit costs based on total costs and equivalent units 5. Apply the average costs to the units completed and the units remaining in ending WIP inventory Production Report Keep track of physical flow of units and costs incl. beginning inventory, # of units started, # of units completed, # of units remaining in inventory Unit (quantity) Accounting: # of units accounted equal the # of units charged to department Cost accounting: amount of costs accounted for must also equal the amount of costs charged to the department ***Accounting for the physical flow of units is an important first step in process costing. The pure physical flow of units will be different than the equivalent units of production. Inventory: Raw Materials
Inventory: Work-In-Process
Inventory: Finished Goods
B Beginning inventory of raw materials A Add: Purchases of raw materials Raw materials available for use S Subtract: Raw materials used E Ending Inventory of raw materials
B Beginning inventory of WIP A Add: Raw materials used + DL +OH used WIP inventory available to be finished S Subtract: Inventory transferred to finished goods E Ending inventory of WIP
B Beginning inventory of finished goods A Add: Inventory transferred from WIP Finished goods inventory available for sale S Subtract: COGS E Ending inventory of finished goods
Equivalent unit: An equivalent unit of DM, DL, or conversion costs (DL+OH) = to the amount of DM, DL, or conversion costs necessary to complete one unit of production Any material added at the very end of a process will not be in WIP inventory at month end Calculations of average unit costs: Averaging of costs from prior month’s WIP: costs from previous month’s WIP inventory are different from costs of current month. Costs must be averaged. Cost averaging computations depend upon FIFO and/or weighted (or moving) average cost flow assumptions. Normal Spoilage (or shrinkage) Inventory cost Lost or spoiled units reduce the denominator and raise the cost per unit Occurs under regular operating conditions and is included in the standard cost of manufactured product Is capitalized as part of inventory cost. Becker – 2008 Edition
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o If accounted for separately, are allocated to good units produced Abnormal spoilage Period expense Per unit cost is based on actual units. Equivalent units of production include spoiled units Expensed separately on the income statement as a period cost Is charged against income of the period as a separate components of COGS Specific Cost Flow Assumptions: Calculation with FIFO: o Ending inventory is priced at cost of mfg during the period, assuming that beginning inventory was completed during the period o Equivalent units are composed of three separate elements: completion of units on hand at the beginning of the period, units started and completed, and units partially complete at the end of the period o Cost components: current costs incurred during the period are allocated to the equivalent units produced during the period Calculation using weighted-average o Averages the cost of production during the period with the costs in the beginning WIP inventory o Equivalent unit components: output divisor. Units completed during the month + equivalent units of work done on the WIP at the end of the period o Total costs include the costs of beginning inventory and current costs are allocated to equivalent units FIFO method: Equivalent units of production: FIFO consists of 3 elements FIFO represents only costs incurred in the current period Beginning WIP x % to be completed XXX Units completed – Beginning WIP + XXX Ending WIP x % completed + XXX Equivalent units XXX Cost per equivalent unit: FIFO = Current costs ONLY Equivalent units Weighted-average method: Equivalent units of production: Weighted-average consists of only 2 elements Weighted-average consists current period and prior period units Units completed XXX Ending WIP x % completed + XXX Equivalent units XXX
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Cost per equivalent unit: Weighted-average = Beginning cost + Current cost Equivalent units SEE EXAMPLE PAGE B5-24 & B5-25 Record-keeping for process-costing is less costly than job-order costing system since individual units produced are not identified. Increased accounts: Focuses on processes and typically requires more WIP accounts than job order costing Record sequence: follow sequential pattern of production process ACTIVITY-BASED COSTING (ABC) Activity-based costing = cost-assigning system Traditional cost systems assign overhead as a single cost pool with a single plant-wide overhead application rate using a single allocation base. These rates are volume-based and use an application basis (i.e. DL hours or machine hours). ABC = uses multiple OH rates Assigns indirect costs to products (cost objects) is based on the product’s demand for resourceconsuming activities (costs assigned based on consumption of resources). Activity = work performed inside a firm. Identified for ABC Resource = element that is used to perform an activity Cost drivers = “multiple” Denominator Causes cost to be incurred. Closely correlated with the incurrence of mfg OH costs Has ability to change the total cost Resource cost driver = amount of resources used Activity cost driver = amount of activity that a cost object will use. Used to assign costs to cost objects Activity centers = “multiple” OH incurred in that department Operation necessary to produce a product Cost pool = group of costs Characteristics of ABC: More focused and detailed approach Focuses on multiple causes and effects and then assigns cost to them. “build-up” Job order system or process cost system Used for manufacturing or service business Long-term view point Becker – 2008 Edition
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Production costs = variable Cost driver is a non-financial variable Used for internal purposes, not external
ABC = transaction-based costing cost driver is # of transactions in an activity Focuses on cost/benefit of activities: Value-added activities Value chain (value-added activities): add value to the product. Support activities directly support value-added activities o i.e. direct costs, mfg costs Non-value added activities: do not increase product value o Eliminate costs – warehousing, overproduction, insurance Effects of activity based costing: High OH to products that have high demands on expensive resources Removes cost distortion EXAMPLE PAGE B5-29 AND B5-30
Factors Affecting Production Costs Types of costs: Explicit Costs: out-of-pocket expenses (wages, materials, and utilities) Implicit Costs: opportunity costs by owners (entrepreneurship, equity, capital) Opportunity costs: value of the next best alternative foregone Analysis of costs: Accounting costs: explicit costs of operating a business. Do not consider opportunity costs. Economic costs: sum of both accounting (explicit) and opportunity (implicit) costs. (rent, wages) Production costs in the short run and long run: Short-run: period of time in which some of the inputs used for production are fixed Period of time in which all of the inputs used for production are variable Accounting profits = Total revenue - total accounting costs Economic profits = Total revenue - total economic costs (implicit and explicit) *Accounting profits are higher because economic profits reduce revenue by explicit and implicit costs. Economies of Scale: Produce more = lower fixed cost per unit = increase in profit per unit Economies of scale will eventually be lost, and diseconomies of scale will result Factors: o Opportunity for specialization o Utilization of advanced technology o Ability to use by-products o Volume purchases and discounts Becker – 2008 Edition
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o o
Proportionately lower costs of purchasing and installing larger pieces of equipment Lower capital costs per unit spreading FC over more units
Diseconomies of Scale: Large firms become inefficient and are not cost effective Increase in average operational costs because of problems in managing large-scale enterprise Factors: o Bottlenecks and costs of transporting materials o Difficulty of supervising and managing a large bureaucracy Sunk Costs: Costs that have been incurred and are unavoidable. Will not vary with the course of action taken NOT relevant in decision-making Opportunity Costs: Potential benefit lost by selecting a particular course of action Relevant Do not represent actual cash outlays Not recorded in the accounting records, but must be considered in every decision (economics) Time Value of Money: Cash flow over a # of years represents consideration of opportunity costs Cash flows devoted to a particular project are expected to yield amounts that equal or exceed the returns associated with alternative investments Financial Models Used for Operating Decisions Cost-Volume-Profit (CVP) Analysis for Decision Making: Breakeven Analysis Revenues and costs in an economic model that allows managers to anticipate profits at different levels of sales and production volume All costs can be separated into either VC or FC, depending on their behavior Volume is the only relevant factor affecting cost TC = FC + VC(volume) Contribution Approach (Direct Costing): NON-GAAP Approach to income statement uses FC Extremely useful for internal decision making The contribution of each transaction to covering FC and in computing breakeven in revenue $$ Revenue Less: Variable Costs DM + DL + Var. OH + Var. Selling, General & Admin. Contribution Margin Less: Fixed Costs Fixed OH + Fixed Selling, General & Admin. Net Income
Variable costs include DL, DM, var. Mfg OH, shipping and packaging, and var. selling & admin.
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Fixed costs include fixed OH, fixed selling, and most general and administrative expenses Allows to be calculated either as a total or per unit Unit contribution margin = unit sales price – unit variable cost Contribution margin ratio = contribution margin expressed as a % of revenue Contribution margin ratio = contribution margin / revenue
Absorption Approach: GAAP Does not segregate FC and FC Equation: Revenue Less: COGS DM + DL + Var. OH + Fixed OH Gross Margin Less: Operating Expenses Fixed & Var. Selling, General, & Admin Net Income
Approach to income statement is required by GAAP for external reporting Comparison of Costs Included in Product Cost
Absorption Costing 1. Direct materials 2. Direct labor 3. Manufacturing OH, both variable and fixed
Variable (Direct) Costing 1. Direct materials 2. Direct labor 3. Variable mfg overhead ONLY All fixed manufacturing costs are treated as period costs
The difference between contribution and absorption approaches is the treatment of fixed factory OH. Selling, general, and administrative expenses are period costs under both methods. Fixed Factory OH: Contribution approach: Period Cost NOT GAAP Expense immediately Absorption approach: Product Cost GAAP Expense when sold Selling, General, & Administrative: Are period costs used in the determination of net income under both methods Steps to compute differences between contribution and absorption method: 1. Compute fixed cost per unit (fixed manufacturing OH/units produced) 2. Compute the change in income (change in inventory units x fixed cost per unit) 3. Determine the impact of the change in income: No change in inventory: Increase in inventory: Decrease in inventory:
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Absorption Net Income = Variable Net Income Absorption Net Income > Variable Income (Less fixed OH expensed under absorption) Absorption Net Income < Variable Net Income (More fixed OH expensed under absorption)
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Breakeven Computation Breakeven for units: Breakeven points in units = Total fixed costs / Contribution margin per unit Contribution margin per unit: Unit price x Breakeven point in units = Breakeven point in dollars Contribution margin ratio: Total fixed costs / Contribution margin ratio = Breakeven point in dollars Required sales volume for target profit: Sales = Variable Costs + (Fixed Costs 9 Net Income Before Taxes) Sales =
Fixed Cost + Profit Contribution Margin Ratio (or per unit)
Calculate target profit before tax: Target profit before tax = Target profit after tax + Tax Target profit before tax = Target profit after tax / (1 – tax rate) Calculate the breakeven point in sales: Sales = Variable costs + Fixed costs + Target profit before taxes A company’s profit after breakeven = units sold after breakeven x the CM per unit Margin of safety in dollars = Total sales in dollars – Breakeven sales in dollars Margin of safety in percentage = Margin of safety in dollars Total sales SEE EXAMPLE ON PAGE B5-43... Step 1: TC = FC + VC per unit (units produced) Step 2: FC = y intercept = $150,000 – not dependent on volume Step 3: VC per unit – slope = ∇DV = 280,000 – 150,000 = $50 ∇IV 2600 - 0 Step 4: TC = 150,000 + 50 (2,600) = 280,000 Target Costing = technique to establish the product cost allowed to ensure both profitability per unit and total sales volume Requires the selling price of the product to determine the production costs to be allowed Competition sets prices, any change in price could easily cause a customer defection Cost control, ongoing profitability Becker – 2008 Edition
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Target Cost = Market price – Required profit May have to compromise on quality (by reducing costs) = loss of sales due to the poor quality Increase downstream cost (differentiate their products, create brand loyalty, competitive advantage) Advanced cost management techniques to attain a higher productivity level Redesign product to reduce costs throughout the life cycle of a product (The Kaizen Method)
Economic Value Added (EVA) Similar to residual income method (computes required rate of return based on hurdle rate) Measures the excess of income after taxes earned by an investment over the return rate defined by the company’s cost of capital Step 1: Calculate the required amount of return and income after taxes Investment x Cost of Capital Required Return
1,000,000 x 12% 120,000
Step 2: Compare income to the required return Income after taxes - Required return Economic Value Added
150,000 120,000 30,000
Positive EVA: performance is meeting standards Negative EVA: performance is not meeting standards Refined using any number of investment or income adjustments to produce more accurate analysis of economic profit Organization will capitalize research and development costs as part of its asset base Balance sheet accounts are re-valued to represent current cost Adjustments to the balance sheet impact the income statement (Deferred taxes are ignored) Forecasting and Projection Techniques
Budget Policies: technique for developing forecasts and budgets. ∇ Involves a budget committee, which includes members of senior management ∇ Resolve dispute and make final decisions for major budget changes ∇ Management give guidelines based on strategic goals and long-term plan. Include: o Evaluation of current conditions: consideration of the changes to the environment since the adoption of the strategic plan, organizational goals for the coming period & operating results year-to-date o Management instructions: setting the tone for the budget, corporate policies Standards and benchmarking manufacturing, service Standards set below expectations to motivate productivity and efficiency revised at least once a year Becker – 2008 Edition
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Ideal standards perfect efficiency and effectiveness. Not historical, but future. Unrealistic because no provision for normal spoilage or down time. o Advantage: emphasis on continuous quality improvement (CQI) to meet ideal o Disadvantage: de-motivation b/c unrealistic standards Currently attainable standards used with flexible budgets. Costs that result from work performed by employees with appropriate training and experience but without extraordinary effort. Provision for normal spoilage and down time. o Advantage: reasonable standards o Disadvantage: use of judgment and potential manipulation Authoritative standards set by management o Advantage: implemented quickly and will include all costs o Disadvantage: workers might not accept Participative standards by managers and individuals held accountable o Advantage: works will accept o Disadvantage: slower to implement Benchmark best practices of different firms to establish standards o Purpose: promotes achievement of competitive advantage Data-driven Techniques for Forecasting and Projection Sensitivity analysis: experimenting with different parameters (i.e. size of FC, size of VC per unit, volume) and assumptions regarding a model and cataloguing the range of results to view the possible consequences of a decision Forecasting analysis: risk analysis. Extension of sensitivity analysis: o Predicting future values of depending variables (total cost) using information from previous time periods (FC, VC per unit, volume) Regression analysis: predict total costs. o Studying the relationship between two or more variables. o Predict the dependent variable (y) given independent variable (x) o Simple regression = one independent variable (volume) o Multiple regression = two or more independent variables o One type of goal: predict total costs based on output o y = A + Bx DV TC VC Total + Cost FC Quantity Becker – 2008 Edition
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IV
o o o o
y = dependent variable x = independent variable (regressor) A = y-intercept for regression line B = slope of regression line → Variable cost per unit ∇DV = cost ∇IV = volume Page 15 of 26
The coefficient of correlation (r): - Measures the strength of the linear relationship between independent (volume) and dependent (total cost) variables - Range of r is from -1.0 to +1.0: o -1.0 = perfect inverse relationship o 0 = no relationship o +1.0 = perfect direct relationship The coefficient of determination (R): - Proportion of the total variation in the dependent variable (total cost) explained by the independent variable (volume) - Range from 0 to +1.0 - The higher the R2, the greater is the proportion of the total variation in y that is explained by the variation in x. The higher the R2, the better fit of the regression line ***How much of the ∇TC (DV) is explained by ∇output (IV)? ***When selection cost drivers, choose the one with the highest r/R2 Learning curve: method of logically projecting costs when learning is a variable, often for repetitive tasks Learning rate: percentage expression of the decrease in avg time (or total time) as production doubles High-low method: used to estimate the fixed and variable portions of cost, usually production costs - Enables preparation of flexible/performance budget by identifying total fixed costs and variable costs per unit - Can estimate total costs at any volume Flexible budget formula: - Series of budgets for a range of activity level o
o
Total Cost = Fixed Cost + (Variable cost per unit x Number of units) (y-intercept) + slope: ∇DV = cost x IV ∇IV = volume Really helpful example on page B5-54 Planning/Budgeting Overview and Planning/Budgeting Techniques
Tactical planning short-term up to 18 months Single use plans: Tactical plans are also called single use plans because they are developed to apply to specific circumstances during a specific timeframe Annual budget: type of single-use tactical plan. Place responsibility for achievement of strategic goals in the hands of managers promotes routine accomplishment of strategy as part of the manager’s job function Becker – 2008 Edition
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Master budget (annual budget): short-term operating performance goals for up to one year’s time - Includes operating budget and financial budget for a single level of sales volume - Comprehensive and coordinated budget guidance for an organization consistent with overall strategic objectives - Control objective criteria for performance - known as static budgets, annual business plans, profit planning, targeting budgets - useful specifically in manufacturing industry because of coordination of financial and operating budgets - Limitations: o Master budget confined to one year at a single level of activity. o Budget may differ from actual results, even though the relationship between expenses and revenues is consistent NOT flexible o Product: Pro forma financial statements Don`t provide management information useful for decision making - Driven by sales budget o Unit sales drive unit production o Sales volume drives support cost - Operating budget include: o Sales budgets o Production budgets (begins with sales budget) o Selling and administrative budgets Support Cast o Personnel budgets - Financial budgets: detail sources and uses of funds to be used in operations o Pro forma financial statements o Cash budgets - Annual plan overview: for relationships between annual plan components, SEE PAGE B5-57
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Flexible budgeting: - Used with most budgets & in most industries - Focus on substantive variances from standards rather than simple changes in volume or activity - Adjustable economic models designed to predict outcomes and accommodate changes in actual activity - Consider revenue per unit, variable costs per unit, and fixed costs over the relevant range where the relationship between revenues and variable costs will remain unchanged and fixed costs will remain stable - Flexible budgets derive the expenses and revenues allowed from the output achieved for comparison to actual activity and performance evaluation - Limitation: dependent on accurate identification of fixed and variable costs and determination of the relevant range - Uses standard cost Standard cost flexible budget. Zero-budget starts with zero, and all cost is justified. Static budget is opposite of flexible budget, and is used only for one specific volume. Strategic budget is long-term and does not use standard cost. Becker – 2008 Edition
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Budget Variance Analysis Variance analysis: comparison of actual results to the annual business plan = 1st and basic level of control and evaluation of operations (performance). Standard cost system: realistic budgeted cost for use in planning and decision-making. Variance from standard could have been prevented controllable variance VC (i.e. DM, DL) - If not preventive uncontrollable FC Variances calculated for the following elements: - DM - DL - VOH (variable mfg overhead) - FOH (fixed mfg overhead) Direct Materials and direct labor variance two variances are typically calculated: 1. Price or rate variance 2.
Quantity or efficiency variance
o o o o o o
DM price variance = Actual quantity purchased * (Actual price - Standard price) DM quantity variance = Standard price * (Actual quantity used - Standard quantity allowed) DL rate variance = Actual hours works * (Actual rate - Standard rate) DL efficiency variance = Standard rate * (Actual hours worked - Standard hours allowed) Standard quantity allowed (SQA) = actual output * standard allowed output Tabular method: B5-63 variance chart
To calculate the difference in variance analysis Remember S-A-D: Standard – Actual = Difference S -A D
Standard - Actual Difference
Four main types of variances for RM and DL (not OH): P Price variance (DM) U Usage (quantity) variance (DM) R Rate variance (DL) E Efficiency variance (DL) Memorizing the variance formula, apply “DADS” twice!! P U R E
Price variance (DM) Usage (quantity) variance (DM) Rate variance (DL) Efficiency variance (DL)
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DA DS DA DS
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Difference Difference Difference Difference
x x x x
Actual Standard Actual Standard
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Example page B5-66 Manufacturing Overhead Variance o Net overhead variance (one-way variance): (debit) under vs. (credit) over applied o Two-way variance consisting of: o Budget (controllable) variance variable OH o Volume (uncontrollable) variance fixed OH o Three-way variance consisting of: o Spending variance the less we spend on OH, the better o Efficiency variance the less hours worked, the better o Volume (uncontrollable) variance the more units produced, the better o Production volume variance: OH variances = applied OH – budgeted OH based on standard hours Applied OH = (Std VOH rate x Std DLH allowed) + (Std FOH rate x actual production) Budgeted OH on std hours = (Std VOH rate x Std DLH allowed) + (Std FOH rate x standard production)
o
MUST PRACTICE example page B5-69 (listen to the lecture item 13 of 20)
Target Market Analysis - Essential to development of consistent strategy for the success of a company Selling price x Volume = Sales (high price, low volume OR low price, high volume) (ex. Hyundai vs. Mercedes) -
Sales volume variance: flexible budget variance that distils volume activity from other sales performance components
Sales volume variance = (Actual sold units – Budgeted sales units) x Std contribution margin per unit -
Sales mix variance: impact of company’s departure from planned mix products in budget
Sales mix variance = (actual product sales mix ratio - budgeted product sales mix ratio) * actual sold units * budgeted contribution margin per unit of that product -
Sales quantity variance: difference of actual sold units and budgeted, incl. market size and share of target market
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Sales quantity variance = (actual units sold - budgeted unit sales) * budgeted sales mix ratio * budgeted contribution margin per unit -
Market size variance: the effect the size of the entire market for the product has on the contribution margin for the firm
Market size variance = (actual market size in units - expected market size in units) * budgeted market share * budgeted contribution margin per unit weighted avg -
Market share variance: effect of firm`s market share on the firm`s contribution margin
Market share variance (actual market share - budgeted market share) * actual industry units * budgeted contribution margin per unit weighted avg -
Selling price variance: aggregate impact of selling price different from budget o Lower price cost leadership strategy o Higher price product differentiation strategy
Selling price variance = (actual SP per unit - budgeted selling price per unit) * actual units sold
Organizational Performance Measures Responsibility accounting: dependent on proper delegation & authority Responsibility segments strategic business units (SBUs). - Classified around four financial measures (performance objectives) managers are responsible for - SBUs effective in organizing performance requirements and financial responsibility 1. Cost SBU managers responsible for controlling costs (materials, labor, OH) – has least responsibility 2. Revenue SBU managers responsible for generating revenues (# units sold x SP per unit) – has more responsibility than cost SBU 3. Profit SBU managers responsible for producing target profit (revenue and costs) – More responsibility than Cost and Revenue SBUs 4. Investment SBU managers responsible for return on the assets invested (highest level: board of directors) – line an independent business – has the most responsibility Financial scorecards: feedback function links planning, control, and performance evaluations and is integral to evaluating and reporting performance 1. Accurate and timely 2. Understandable 3. Specific accountability (each SBU is subdivided into additional categories) a. Product lines Becker – 2008 Edition
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b. Geographic linesc. Customer Allocation of common costs: managers have control over variable costs and over controllable fixed costs (i.e. insurance). Common costs are NOT controllable (i.e. rent on factory, long term lease) Contribution margin: Controllable the excess of revenues over FC. Controllable margin: Refinement of contribution margin reporting and represents the difference between contribution margin and controllable fixed costs - Controllable fixed costs = costs that managers can impact in less than one year (i.e. advertising) Non-financial scorecards: 1. Qualitative: measurements that may be difficult or imprecise and are not numerical. a. Employee morale, customer satisfaction 2. Quantitative: numerical measurements, but not in dollars a. Reduction in travel time, distance displayed in hours or miles Balanced scorecard: gathers information on multiple dimensions of an organization’s performance defined by critical success factors necessary to accomplish firm strategy. - Critical success factors are: o F – Financial Profit o I – Internal business processes Efficient production o C – Customer satisfaction Market share o A – Advancement of innovation and human resource development (learning & growth) employee moral, retaining key employees - No one dimension of operations will accomplish an organization’s business objectives Benchmarking Techniques and Best Practices Benchmark: identifies standards defining success factors, used for comparison to actual performance (or gaps in performance), and implementation of improvements to meet or exceed the benchmark. External benchmarks: Productivity Measures -
Measure efficiency Compare actual performance to similar organizations
Objective: 1. Determine whether more inputs have been used than necessary to obtain the actual output. 2. Determine whether the best mix of inputs has been used.
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Two types of productivity ratios: 1. Total productivity ratios (TPR): value of all output relative to the value of all input Quantity of output produced / Cost of inputs 2. Partial productivity ratios (PPRs): value of all outputs as compared to the value of major categories of input Quantity of output produced / Quantity of the single input used Internal benchmarks: Techniques to find and analyze problems -
Monitoring and investigative techniques
Control Charts: “Determine zero defects” - Graphically display the impact of measuring goalpost conformance - Show if there is a trend toward improved quality conformance or deteriorating quality conformance - “Statistical control”: where n one of the actual measures fall outside of boundaries Pareto Diagrams: frequency diagram - histogram of quality control issues displayed in order of most to least frequent with a line graph that displays the cumulative occurrence of the problems - managers use this to determine the quality control issues that are most frequent and demand the greatest attention - 6 types. - Type 1, 2, and 3 are 75% of all defects. Cause and effect fishbone diagram: - Analyze the source/location of problems - Managers analyze the problems that contribute to the occurrence of defects - Trace defects back to source - Diagram on PAGE B5-80 - Elements of manufacturing process include: o Machinery o Method o Materials o Manpower Continuous Improvement (Kaizen) - Continuous improvement efforts that improve the efficiency and effectiveness of organizations through greater operational control - Manufacturing stage (where it is ensured that resource uses stay within target costs)
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Process improvements / Activity-based Management (ABM) - ABC and ABM are highly compatible with process improvements and total quality management (TQM) - Availability of cost data by activity make the identification of costs of quality and value-added activities more obvious - Process management has many of the attributes of ABC, TQM, and value chain analysis Quality control principles Goalpost conformance: - Compliance within an acceptable range - Zero-defects conformance because management has the full expectation that production will conform to the range of quality standards with no exception - Goalpost is not absolute conformance o Absolute conformance = higher quality products Quality control principles: Costs of Quality 1. Conformance costs: conformance with quality standards prevention and appraisal costs a. Prevention costs: incurred to prevent the production of defective units i. Employee training ii. Inspection expenses iii. Preventive maintenance iv. Redesign of product v. Redesign of processes vi. Search for higher quality suppliers b. Appraisal costs: incurred to discover and remove defective parts i. Statistical quality checks ii. Testing iii. Inspection iv. Maintenance of the laboratory 2. Non-conformance costs: Cost of “failure” a. Internal failure: costs to cure a defect discovered before the product is sent to customer i. Rework costs ii. Scrap iii. Tooling changes iv. Costs to dispose v. Cost of the lost unit vi. Downtime b. External failure: costs to cure a defect discovered after the product is sent to customer i. Warranty costs ii. Cost of returning the good iii. Liability claims iv. Lost customers v. Re-engineering an external failure 3. Quality reporting: financial impact of quality in four categories Becker – 2008 Edition
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a. Inverse relationship between conforming and non-conforming costs A – Appraisal – costs to identify defective products – conforming P – Prevention – costs to prevent the production of defective products - conforming I – Internal failure – cost of defective parts or lost production time – non-conforming E – External failure – cost of returns and lost customer loyalty – non-conforming Total Quality Management (TQM): - Commitment to customer-focused performance – quality and continuous improvement - Seven factors: o Customer focus: External customers Internal customers (each link in value chain) o Continuous improvement o Workforce involvement: Quality circles o Top management support: delegation and empowerment o Objective measures o Timely recognition o Ongoing training
Regression analysis: - Statistical model that can estimate the dependent cost variable based on changes in the independent variable - Independent variable is assumed (not estimated) in regression analysis and is based on activity, not costs - separate costs into fixed and variable components - Estimates the dependent cost variable - No probabilities are used!! - The coefficient of determination is a statistical measure used to evaluate the results of regression analysis Trend analysis: project costs (expenses) out into the future.
Monte Carlo simulation: generate individual values for a random variable. Dynamic programming: make a series of interrelated decisions. Learning curve analysis: determine increases in efficiency or production as experience is gained. Expected value analysis: long-term average of repeated trials and is found by multiplying the probability of each outcome by its payoff and then summing the results Continuous probability simulation: procedure that studies a problem by creating a model of the process and then, through trial and error solutions, attempts to improve the problem solution Becker – 2008 Edition
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