UQ Acct2102 Notes (Midsems)

ACCT2102

Lecture 1: Introduction to Managerial and Cost Accounting 1 The Manager and Management Accounting Financial Accounting, Management Accounting and Cost Accounting 

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Financial accounting: focuses on reporting to external parties and is focused on the past. Measures and records business transactions and provides financial statements that are based on Generally Accepted Accounting Principles (GAAP). Financial accounting affects a manager’s perceived performance and thus their compensation. Management accounting: measures, analyses and reports future orientated financial and nonfinancial information that helps managers (internal users) and other employees make decisions to fulfil the goals of an organization. Managers use management accounting information to develop, communicate and implement strategy and decisions. Management accounting does not follow set rules. Cost accounting: measures, analyses and reports financial and nonfinancial information relating to the costs of acquiring or using resources in an organisation. It provides information for management accounting and financial accounting. Cost accounting can be seen as a part of management accounting.

 Strategic Decisions and the Management Accountant Accountant 

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Management accountants contribute to strategic decisions by providing information about the sources of competitive advantage. Strategy describes how an organization will compete and the opportunities its managers should seek and pursue.  Cost leadership  Product differentiation Strategic cost management: cost management that specifically focuses on strategic issues.  Who are our most important customers, and how can we be competitive and deliver value to them?  What substitute products exist in the marketplace, and how do they differ from out product in terms of price and quality?  What is our most critical capability?  Will adequate cash be available to fund the strategy, or will additional funds need to be raised?

Value Chain and Supply Chain Analysis and Key Suc cess Factors 

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Value chain: the sequence of business functions in which customer usefulness is added to products. 1. Research and Development 2. Design of products and processes 3. Production 4. Marketing 5. Distribution 6. Customer service Customer Relationship Management (CRM): a strategy that integrates people and technology in all business functions to deepen relationships with customers, partners, and distributors. Supply Chain: the flow of goods, services and information from the initial sources of materials and services to the delivery of products to customers, regardless of whether those activities occur in the same organisation or in other organisations. Cost management emphasizes

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integrating and coordination activities across all companies in the supply chain to improve performance and reduce cost.

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Key Success Factors: customers want companies to deliver performance through:  Cost and efficiency : managers must eliminate some activities and reduce the costs of performing activities in all value chain functions to reach a target cost – the cost from subtracting operating income from the target price.  Quality: Total Quality Management (TQM) aims to improve operations throughout the value chain and to deliver products and services that exceed customer expectations. Products are designed with zero defects and waste, with minimal inventory.  Time : Managers ned to understand the cost and benefits of a product over the length of its life cycle to make product and design decisions. Organisations also need to reduce customer response time and deliver goods in a timely fashion.  Innovation: managers rely on management accounting information to evaluate alternative investment and R&D decisions so that it can create a constant flow of innovative products and services.

Decision Making, Planning and Control: Five-Step Decision-Making Process Managers use the Five Step Decision Making Process to implement strategy: 1. Identify the problem and uncertainties 2. Obtain information 3. Make predictions about the future: what would happen in response to actions? 4. Make decisions by choosing among alternatives 5. Implement the decision, evaluate performance and learn 

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Steps 1-4 are referred to as planning. Planning comprises selectiong organisation goals and strategies, predicting results under various alternative ways of achieving those goals, deciding how to attain the desired goals, and communicating the goals and how to achieve them to the entire organisation. Budget is the most important tool when implementing strategy. It is a quantitative expression of a proposed plan of action by management and is an aid to coordinating what needs to be done to execute that plan. Step 5 is control, which comprises taking actions that implement the planning decisions, deciding how to evaluate performance, and providing feedback and learning to help future decision making. Learning is examining past performance and systematically exploring alternative ways to make better informed decisions and plans in the future.

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Key Management Accounting Guidelines 

Three guidelines help management accountants provide the most value in their strategic and operational decision making:  Cost Benefit Approach: managers need to employ the cost benefit approach to making decisions. Resources should be spent only if the expected benefits to the company exceed the expected costs.  Behavioural and Technical Considerations: whenever decisions are made the behavioural aspects as well as technical aspects of the outcomes must be considered for evaluation. Management is not always technical, it involves working with people.  Different Costs for Different Purposes: the different methods of computing cost should be used for the correct purpose, eg. an external reporting of cost may not be useful for internal purposes.

Organisation Structure and the Management Accountant 

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Line management is directly responsible for attaining the goals of the organisation eg. production, marketing and distribution management. Staff management provides advice, support and assistance to line management eg. management accountants, IT and human resources management. Chief Financial Officer (CFO, Finance Director): the executive responsible for overseeing the financial operations of an organisation. Responsibilities include:  Controllership: providing financial information for reports to managers and shareholders, and overseeing the overall operations of the accounting system.  Treasury: banking and financing, investments and cash management.  Risk management: managing the financial risk of interest rate and exchange rate changes and derivatives management.  Taxation  Investor relations  Internal audit Controller (Chief Accounting Officer): financial executive primarily responsible for management accounting and financial accounting. Reports to the CFO. By reporting and interpreting relevant

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data the controller influences the behaviour of all employees and exerts a force that impels line managers toward making better informed decisions as they implement their strategies.

Professional Ethics 

Management accountants have ethical responsibilities that relate to:  Competence  Confidentiality  Integrity  Credibility

Chapter 2 An Introduction to Cost Terms and Purposes Cost and Cost Terminology    

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Actual cost: the cost incurred (historical or past cost). Budgeted cost: a predicted or forecasted cost (future cost). Cost object: anything for which a measurement of cost is desired. Cost accumulation: the collection of cost data in some organised way by means of an accounting system. These accumulated costs are then assigned to designated cost objects. Cost information is used when making decisions (how to price products, how much to invest in R&D etc.) and implementing decisions (using cost information to inform strategy, eg. rewarding employees for reducing costs).

Direct Costs and Indirect Costs 

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Direct costs of a cost object: related to the particular cost obj ect and can be traced to it in an economically feasible (cost effective) way. Indirect costs of a cost object: related to the particular cost object but cannot be traced to it in an economically feasible (cost effective) way. Cost allocation: the assignment of indirect costs to a particular c ost object. Cost assignment: general term that encompasses both tracing direct costs to a cost o bject and allocating indirect costs to a cost object.

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Challenges in Cost Allocation Factors Affecting Direct/Indirect Cost Classifications 

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The materiality of the cost in question : the smaller the amount of a cost (the more immaterial the cost is), the less likely that it is economically feasible to trace the cost to a particular cost object eg. the cost of tracing invoice paper in mail orders would be considered indirect.  Available information gathering technology : improvements in information gathering technology make it possible to consider more and more costs as direct costs. Design of operations : classifying a cost as direct i s easier if a company’s facility is used exclusively for a specific cost object.  Cost may be both a direct cost of one cost object and an indirect cost of another cost object, eg. salary of a worker is a direct cost to an assembly department but an indirect cost to the products, cars.

Cost-Behaviour Patterns: Variable Costs and Fixed Costs 

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Variable cost changes in total in proportion to changes in the related level of total activity or volume. Fixed cost remains unchanged in total for a given time period, despite wide changes in the related level of total activity or volume. Costs can be both variable and fixed, eg. registration of planes are fixed with regards to each plane, but variable in regards to the number of planes. Cost driver: a variable, such as the level of activity or volume that causally affects costs over a given time span. Relevant range is the band of normal activity level or volume in which there is a specific relationship between the level of activity or volume and the cost in question. Outside the relevant range variable costs may not change proportionately. Relationships of the types of costs:

Total Costs and Unit Costs  

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Total costs can be difficult to interpret alone, so unit cost is used as a tool. Unit cost (average cost): cost per unit of output           Unit costs need to be monitored as changed in the number of units or the manufacturing cost occur often. Using a historical unit cost that is incorrect can be detrimental.

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Business Sectors, Types of Inventory, Inventorial Costs and Period Costs 

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Sectors of the economy:  Manufacturing sector companies purchase materials and components and convert them into various finished goods.  Merchandising sector companies purchase and then sell tangible products without changing their basic form.  Service sector companies provide services (intangible products) Inventory types for manufacturing companies:  Direct materials inventory  Work in process inventory  Finished goods inventory Merchandising companies only hold one type of inventory (products in their  original form), called merchandise inventory . Service sector companies do not have inventories.  Classifications of Manufacturing Costs  Direct materials cost: the acquisition of costs of all materials that eventually become part of the cost object, and can be traced to the cost object in an economically feasible way eg. freight charges, sales tax, cost of tires.  Direct manufacturing labour costs: the compensation of all manufacturing labour that can be traced to the cost object in an economically feasible way eg. wages, fringe benefits.  Indirect manufacturing costs (manufacturing overhead costs): all manufacturing costs that are related to the cost object but cannot be traced to that cost object in an economically feasible way eg. plant maintenance, plant rent. Inventoriable costs: all costs of a product that are considered as assets in the balance sheet when they are incurred and that become cost of goods sold only when the product is sold.  All manufacturing costs are Inventoriable  In merchandising companies Inventoriable costs are the costs of purchasing the goods that are to be resold.  Service sector companies do not have Inventoriable costs. Period costs: costs in the income statement other than cost of goods sold. They are expensed in the accounting period in which they are incurred eg. marketing, distribution and customer service costs.  In manufacturing, period costs are all non-manufacturing costs.  In merchandising, period costs are all costs not related to the cost of goods purchased for resale.  All costs in service sector companies are period costs.

Prime Costs and Conversion Costs 

Prime costs are all direct manufacturing costs           

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The greater the proportion of prime cost in a company’s cost structure, the more confident managers can be about the accuracy of the costs of products. As information technology improve, more costs can be allocated into the direct cost category eg. power costs metered at specific areas of a plant Conversion costs are all manufacturing costs other than direct material costs. Conversion costs represent all manufacturing costs incurred to convert direct materials into finished goods.           

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Direct labour costs are in both prime costs and conversion costs

Measuring Costs Requires Judgement 

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Labour costs classifications can vary significantly among companies, and many use multiple labour cost categories. Special cases of indirect labour:  Overtime premium is the wage rate paid to workers in excess of their straight time wage rates. Although it is easily traceable, it is usually considered an indirect cost as it is not related to any single product. Its cost is regarded as part of overhead, which is borne by both products. However when overtime is not random, it would be regarded as a direct cost.  Idle time: wages paid for unproductive time caused by lack of orders, machine or computer breakdowns, etc. Also considered an overhead. Defining costs associated with labour is very important, as misunderstandings can generate disputes eg. payroll fringe costs as labour cost or overhead – if fringe benefits are classified as labour, then it is taxable. Managers often assign different product costs to the same cost obj ect depending on the purpose:  Pricing and product-mix decisions: for making decisions about pricing and profit, managers are interested in assigning overall costs to products.  Contracting with government agencies: government contracts often reimburse contractors on the basis of the cost of a product plus a pre-specified margin of profit. Government agencies thus provide detailed guidelines for calculating cost.  Preparing financial statements for external reporting under GAAP: under GAAP only manufacturing costs can be assigned to inventories in financial statements.

 A Framework for Cost Accounting and Cost Management 

The features of cost accounting and cost management : 1. Calculating the cost of products, services and other cost objectives. 2. Obtaining information for planning and control and performance evaluation: budgeting is a tool for planning and control, and forces managers to look ahead, formulate strategies, execute and then evaluate. 3. Analysing the relevant information for making decisions.

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Income Statement and Schedule of Cost of Goods Sold

Step 1 (materials) Cost of direct materials

Company Name Schedule of Goods Manufactured For Year Ended December 31, 2009 (000s) Direct Materials: Beginning inventory $11 000 Purchases of direct materials 73 000 Cost of direct materials available for use Less Ending inventory

84 000 (8 000)

Direct materials used

$76 000 9 000

Direct Manufacturing labour Step 2 (overhead + labour) Cost of manufacturing

Manufacturing overhead costs ∑ Indirect manufacturing costs

20 000

Manufacturing overhead cots

Step 3 Cost of goods manufactured

20 000 105 000 6 000 111 000 (7 000) $104 000

Total Manufacturing costs incurred Beginning work in process inventory

Total manufacturing costs to account for Less Ending work in process inventory Cost of goods manufactured Company Name Income Statement For Year Ended December 31, 2009 (000s)

Step 4 Cost of goods sold

Revenues Cost of goods sold: Beginning finished goods inventory Cost of goods manufactured Cost of goods available for sale Ending finished goods inventory Less Cost of goods sold Gross Profit Operating costs: R&D, design, marketing etc. Operating costs Operating income

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$210 000 $22 000 104 000 126 000 18 000 (108 000) 102 000

70 000 70 000 $32 000

Cost of goods manufactured is the sum of direct materials, direct manufacturing labour and manufacturing (indirect) overhead, adjusted for inventory (both materials and WIP inventory) COGS is cost of goods manufactured adjusted for finished goods inventory. Gross Profit = Revenues – COGS Operating income = Gross Profit – Operating Costs

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Lecture 2: Cost Behaviours and CVP Analysis 10 Determining How Costs Behave Basic Assumptions and Examples of Cost Functions 

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Cost function: a mathematical description of how a cost changes with changes in the level of an activity relating to that cost. Assumptions:  Variations in the level of a single activity (cost driver) explain the variations in the related total costs.  Cost behaviour is approximated by a linear cost function within the relevant range. A mixed cost is a cost that has both fixed and variable elements.

Classifying costs as variable or fixed:  Choice of cost object: a particular cost item can be variable with respect to one cost object and fixed with respect to another cost object, eg. Registration for vans is variable with number of vans, but fixed for miles driven for each van.  Time horizon: the longer the time horizon, the more likely that the cost will be variable.  Relevant range

Identifying Cost Drivers 

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Managers use cost estimation to measure a relationship based on data from past costs and the related level of an activity. Managers use past cost behaviour fu nctions to help in cost prediction. Cause and effect relationships need to exist for estimating cost functions. They can arise through:  A physical relationship between the level of activity and costs (units of production affect direct material costs)  A contractual arrangement (costs can be specified in contracts)  Knowledge of operations (eg. number of parts used as the activity measure of ordering costs) Managers must be careful not to interpret a high correlation or connection in the relationship between two variables to mean that either variable causes the other (eg. Using labour costs to predict material costs when certain materials cost more or less compared to labour) Cost drivers and the decision making process (5 step decision making process, ch. 1):  Step 1: identify the problem and uncertainties  Step 2: obtain information  Step 3: make predictions about the future  Step 4: make decisions by choosing among alternatives  Step 5: implement the decision, evaluate and learn

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Cost Estimation Methods Industrial engineering method   (work measurement method) estimates costs functions by analysing the relationship between inputs and outputs in physical terms. Very thorough and detailed but is time consuming and costly. Conference method   estimates cost functions on the basis of analysis and opinions about costs and their drivers gathered from various departments of a company. Encourages interdepartmental cooperation and the pooling of expert knowledge from different business functions of the value chain. 

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 Account analysis method   estimates cost functions by classifying various cost accounts as variable, fixed or mixed with respect to the identified level of activity. This method is rather qualitative, however is widely used because it is reasonably accurate, cost effective and easy to use. Account analysis can be supplemented with conference method to improve credibility. Quantitative analysis method   uses a formal mathematical method to fit cost functions to past data observations.

 Steps in Estimating a Cost Function Using Quantitative Analysis Steps in estimating cost function :  Step 1: Choose the dependent variable:  Step 2: Identify the independent variable, or cost driver. A cost driver should have an economically plausible relationship with the dependent variable (based on a physical relationship, a contract, or knowledge of operations). When there isn’t the same cost driver, cost pools should be allocated for items with the same cost drivers to create more than one function.  Step 3: Collect data on dependent variable and the cost driver. Time-series data pertain to the same entity over successive past periods. Ideally  data should not be affected by economic or technological change. Cross-sectional data pertain to different entities during the same period. Should  be drawn from entities with similar relationships between cost driver and cost.  Step 4: Plot the data.  Step 5: Estimate the cost function (high low method, regression analysis).  Step 6: Evaluate the cost driver of the estimated cost function. 

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High-Low Method uses only the highest and lowest observed values of the cost driver within the relevant range and their respective costs to estimate the slope coefficient and the constant of the cost function. Is easy to compute and gives quick insight, but ignores information from other points. Regression Analysis Method  Regression analysis is a statistical method that measures the average amount of change in the dependent variable associated with a unit change in one or more independent variables.  Simple regression analysis estimates the relationship between the dependent variable and one independent variable  Multiple regression analysis estimates the relationship between the dependent variable and two or more independent variables.  The least squares technique determines the regression line by minimizing the sum of the squared vertical differences from the points to the regression line.  Residual term: the vertical different, measures the distance between actual cost and estimated cost for each observation of the cost driver.  Goodness of fit indicates the strength of the relationship between the cost driver and costs.

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Evaluating Cost Drivers of the Estimated Cost Function 

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Understanding of operations is crucial in determining costs functions. As an example, a company may schedule repairs during periods of low production to minimise taking machines out of service when they are most needed. Thus repair costs will be high during periods of low production –  someone without operations experience may misinterpret the information as an inverse relationship. Repair costs will also lag behind periods of high production, as production wears out machines. Evaluating and choosing cost drivers:  Economic plausibility  Goodness of fit  Significance of independent variable: a flat or slightly slope line indicates a weak relationship between cost and cost driver. Choosing the correct cost driver to estimate indirect manufacturing costs is important because identifying the wrong drivers or misestimating cost functions can lead management to incorrect and costly decisions. Activity based costing (ABC) systems focus on individual activities as the fundamental cost objects. ABC systems have a large number and variety of cost drivers and cost pools, which require many cost relationships to be estimated.

Nonlinear Cost Functions 

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Nonlinear cost function: a cost function for which the graph of total costs is not a straight line within the relevant range. This could be caused by economies of scale or quantity discounts  on direct materials. Step cost function: a cost function in which the cost remains the same over various ranges of the level of activity, but the cost increases by discrete amounts (steps) due to set up costs for each batch of production, or because production inputs (labour, supervision) are acquired in discrete quantities. Step fixed cost function

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Nonlinear functions can also result from learning curves. Learning curves are a function that measures how labour hours per unit decline as units of production increase because workers are learning and becoming better at their jobs. Managers use learning curves to predict how labour hours or lab our costs will increase as more units are produced. Experience curve: a function that measures the decline in cost per unit in various business functions of the value chain as the amount of these activities increases. Broader than simply production as described by the learning curve. Cumulative average-time learning model: cumulative average time per unit declines by a constant percentage each time the cumulative quantity of units produc ed doubles eg. An 80% learning curve means that when quantity is doubled, average time per unit decreases from 100% to 80%. Incremental unit time learning model: incremental time needed to produce the last unit declines by a constant percentage each time the cumulative quantity of unit produced doubles.

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Many companies incorporate learning curve effects when evaluating performance and predicting performance. Other models of learning have been developed that focus on quality.

Data Collection and Adjustment Issues 

An ideal database should: 12

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Contain numerous reliably measured observations of the cost driver and the related costs.  Consider many values spanning a wide range for the cost driver. Too few values grouped together considers a small segment of relevant range and reduces the confidence of estimates. Frequently encountered data problems:  The time period for measuring the dependent variable does not properly match the period for measuring the cost driver. Occurs when accounting records are not kept on an accrual basis.  Fixed costs are allocated as if they are variable, eg. Insurance and depreciation are allocated to products to calculate per unit cost.  Data are either not available for all observations or are not uniformly reliable. This is mitigated through designing data collection reports that regularly and routinely obtain the required data.  Extreme values of observations occur from errors in recording costs, from nonrepresentative periods (random costs eg. Machinery break down), or from observations outside the relevant range. Analysts should adjust or eliminate unusual observations before estimating a cost relationship.  There is no homogenous relationship between the cost driver and the individual cost items in the dependent variable cost pool. A homogenous relationship exists when each activity whose costs are included in the dependent variable has the same cost driver. In this case, a single cost function can be estimated. When this isn’t the case multiple cost functions should be estimated with more than one independent variable using multiple regression.  The relationship between the cost driver and the cost is not stationary – the underlying process that generated the observations has not remained stable over time eg. Due to technology.  Inflation has affected costs, the cost driver or both. Inflation may cause costs to change even when there is no change in the level of the cost driver. Purely inflationary price effects from the data should be removed by dividing each cost by the price index on the date the cost was incurred. There are three types of linear cost functions, variable, fixed and mixed (semi-variable). The most important issue in estimating a cost function is determining whether a cause and effect relationship exists between the level of an activity and the costs related to that level of activity. Only a cause and effect relationship, not merely correlation, establishes an economically plausible relationship between the level of an activity and its costs. Nonlinear cost functions can occur due to quantity discounts, step cost functions and learning curve effects. The most difficult task in cost estimation is collecting high quality, reliably measured data on the costs and the cost driver. Common problems include missing data, extreme values of observations, changes in technology and distortions resulting from inflation. 

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3 Cost-Volume-Profit Analysis 

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Cost-volume-profit (CVP) analysis studies the behaviour and relationship among total revenues, costs and come as changes occur in the units sold, the selling price, the variable cost per unit, or the fixed costs of a product. Contribution margin: indicates why operating income changes as the number of units sold changes          Contribution margin per unit            

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          

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Contribution income statement: groups costs into variable costs and fixed costs to highlight contribution margin. Contribution margin percentage(ratio): contribution margin per dollar of revenue.                   There are 3 ways to model CVP relationships:  Equation method: calculating operating income for different quantities of units sold.          

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Contribution Margin Method

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Graph Method: total costs and total revenues are represented graphically. The total costs line is the sum of fixed costs and variable costs.  Useful for visualising the effect of sales on operating income over a wide range  of quantities sold. Contribution and Equation methods are useful for analysing operating income at  a few specific levels of sales.

Assumptions of CVP analysis:  Changes in the levels of revenues and costs arise only because of changes in the number of product units sold. The number of units sold is the only revenue drier and only cost driver.  Total costs can be separated into two components: a fixed component that does not vary with units sold and a variable component that changes with r espect to units sold.  When represented graphically the behaviours of total revenues and total costs are linear in relation to units sold within a relevant range and time period.  Selling price, variable cost per unit, and total fixed costs are known and constant.

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Breakeven Point and Target Operating Income 

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Breakeven point (BEP): the quantity of output sold at which total revenues equal total costs; the quantity of output sold that results in $0 of operating income. BEP can be calculated by setting operating income to $0.          A PV graph shows how changes in quantity of units sold affect operating income.

Net income: operating income plus non-operating revenues (such as interest revenue) minus non-operating costs (such as interest cost) minus income taxes. When doing CVP analysis it is thus important to account for target net income by looking at tax.

Using CVP Analysis for Decision Making 

Higher contribution margin is better than low for deciding without calculations with the income statement. Contribution margin needs to be greater than fixed costs for positive operating income.

 Sensitivity Analysis and Margin of Safety  

Sensitivity analysis is analysing the effects of changing variables Margin of safety tells us how far the targeted budget can drop. A higher margin is better as it decreases the risk of making a loss.

   () 

      ( )

Cost Planning and CVP 

Alternative Fixed-cost/variable-cost structures  CVP analysis helps managers evaluate fixed/variable cost structures.

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Operating Leverage: the effects that fixed costs have on changes in operating income as changes occur in units sold and contribution margin; the risk return trade off across alternative cost structures.         Companies have high operating leverage if there is a high proportion of fixed costs. Small increases in sales will lead to large increases in operating income, and small decreases in sales causes large decreases in operating come.  Allows companies to evaluate the effects of sales fluctuations on operating income.  Whenever there are fixed costs, the degree of operating leverage decreases as the level of sales increases beyond the breakeven point. If fixed costs is $0, contribution margin equals operating income, and operating leverage is always 1.  It tells the percentage change in operating income when changes are made to contribution margin (sales)  Helps managers calculate the effects of fluctuations in sales on operating income.

Effects of Sales Mix on Income  

Sales mix: the quantities of various products that constitute total unit sales of a company. Sales mix affects the breakeven point.

CVP Analysis in Service and Non-profit Organisations 

CVP analysis can be applied to service organisations by focusing on output: passenger miles for airlines, room-nights occupied (hotels), patient days (hospitals) and student credit-hours (universities).

Contribution Margin Versus Gross Margin   

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Gross Margin = Revenues – COGS (manufacturing costs only) Contribution Margin = Revenues – All variable costs (variable costs only) Gross margin measures how much a company can charge for its products over and above the cost of acquiring or producing them. Contribution margin indicates how much of a company ’s revenues are available to cover fixed costs, and assess risk of loss. Within the manufacturing sector, contribution margin and gross margin differ in two respects: fixed manufacturing costs and variable non-manufacturing costs. Gross margin percentage: gross margin divided by revenue. Gross margin and contribution margin are identical in merchandising companies, since cost of goods sold equals the variable cost of goods purchased.

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CVP analysis assist managers in understanding the behaviour of a product’s or service’s total costs,, total revenues and operating income as changes occur in the output level, selling price, variable costs or fixed costs. The BEP is the quantity of output at which total revenues equal total costs. The 3 methods to compute BEP and the output required to achieve target operating income are the equation method, the contribution margin method and the graph method. BEP is unaffected by taxes as no income tax is paid when operating income is zero. Managers compare how revenues, costs and contribution margins change across alternatives, and choose the option that maximizes operating income. Sensitivity analysis examines how an outcome will change if the original predicted data are not achieved or if an assumption changes. VCP analysis is used to compare contribution margins and fixed costs under different assumptions. Choosing a cost structure is a strategic decision. Proportions of a companies fixed and variable cost structure influence risk and profits. High operating leverage are high risk high reward. CVP analysis can be applied to a company producing multiple products by assuming sales mix of products sold remains constant as the total quantity of units sold changes (or for different levels of revenue).

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Lecture 3: Costing Systems – Job Costing 4 Job Costing Building-Block Concepts of Costing Systems 

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Cost assignment   is a general term for assigning costs, indirect or direct, cost tracing  refers to assigning direct costs, and cost allocation refers to assigning indirect costs.

Cost pool: a grouping of individual indirect cost items. Cost allocation base: a systematic way to link an indirect cost or group of indirect costs. The ideal cost allocation base is the cost driver of the indirect costs, since there is a cause and effect relationship eg. Costs should be allocated to products of a metal cutting machine by machinehours used to produce different products. Can be financial cost or non-financial cost (machine hours). When the cost object is a job, product or customer it is known as cost- application base.

 Job-Costing and Process-Costing Systems 

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Job-costing system: the cost object is a unit or multiple units of a distinct product or service called a job. Because the products and services are distinct, job-costing systems accumulate costs separately for each product or service. Process-costing system: the cost object is masses of identical or similar units of a product or service. In each period total costs of production are divided by the number of units to get an average cost. Companies use a mixture of both job costing and process costing systems.

 Job Costing: Evaluation and Implementation 

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Actual costing: a costing system that traces direct costs to a cost object by using the actual direct cost rates times the actual quantities of the direct-cost inputs. Actual costs are not commonly used as they cannot b e computed in a timely manner. Actual direct costs are easy to compute for direct materials and direct manufacturing labour, however actual indirect costs are difficult to calculate. Reasons for longer periods in calculating indirect cost rates:  The numerator reason (indirect-cost pool): the shorter the period, the greater the influence of seasonal patterns on the amount of costs (and non-seasonal erratic costs). Pooling costs over a year helps smooth erratic bumps associated with shorter periods.  The denominator reason (quantity of the cost-allocation base): to avoid spreading monthly fixed indirect costs over fluctuating levels of monthly output and fluctuating quantities of the allocation base. Fixed costs should be spread evenly over a longer period, as if it is charged for one period, costs will be inflated. Also, the number of work weeks varies from 20-23 a month, which again alters unit costs of jobs.

Normal Costing 

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Managers can’t   calculate actual costs of jobs as they are completed because of the difficulty in calculating actual indirect-cost rates on a weekly or monthly basis. Because of the need for immediate access to job costs, a predetermined (budgeted) indirect-cost rate is calculated for each cost pool at the beginning of the fiscal year, and overhead costs are allocated to jobs as work progresses. Budgeted indirect-cost rate:                   Normal costing: a costing system that (1) traces direct costs to a cost object by using the actual direct cost rates times the actual quantities of the direct-cost inputs and (2) allocates indirect costs based on the budgeted indirect-cost rates times the actual quantities of the cost-allocation bases. 18

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Steps in job costing (normal costing): 1. Identify the job that is the chosen cost object. Source document: an original record that supports journal entries in an  accounting system. Job-cost record: records and accumulates all the costs assigned to a specific job,  starting when work begins. 2. Identify the actual direct costs of the job (for manufacturing, direct materials  and direct manufacturing labour ).  Materials-requisition record contains information about the cost of direct materials used on a specific job and in a specific department. Labour-time sheet contains information about the amount of labour time used  for a specific job in a specific department. 3. Select the budgeted cost-allocation bases  to use for allocating indirect costs to the job. Indirect manufacturing costs are costs that are necessary to do a job but that  cannot be traced to a specific job (supervision, manufacturing engineering, repairs etc.). Since they cannot be traced they must be allocated. Companies use cost-allocation bases to allocate indirect costs because different  indirect costs have different cost drivers. 4. Identify the budgeted indirect costs pools associated with each cost-allocation base. Eg. Direct manufacturing labour-hours. Put into a cost pool.  5. Compute the budgeted cost-allocation base rate used to allocate indirect costs to the job Budgeted total quantity of the cost-allocation base (step 3)  Total indirect costs in the pool (step 4)                  6. Compute the allocated indirect costs allocated to the job.  The indirect costs of a job are calculated by multiplying the actual quantity of each different allocation base associated with the job by the budgeted indirect cost rate of each allocation base (step 5). 7. Compute the total cost  of the job by adding all direct and indirect costs  assigned to the job.

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 Actual Costing 

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Actual costing uses actual indirect-cost rates calculated annually at the end of the year, whereas normal costing uses budgeted indirect cost rates frequently. Actual costing method is exactly the same as normal costing steps, except that actual indirect costs are used rather than budgeted.

 A Normal Job-Costing System in Manufacturing

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Manufacturing overhead costs are first accumulated in a manufacturing overhead account, and later allocated to individual jobs. As manufacturing overhead costs are allocated, they become part of work in process inventory. Period costs (marketing and customer service) do not create any assets in the balance sheet as they are not incurred while transforming materials into a finished product, so they are expensed in the income statement as they are incurred. 20

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Overheads can only be added to work-in-process control when they are allocated.

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Subsidiary ledgers contain the underlying details of the general ledger. Pg. 114-117 MUST REVIEW  Materials Records is the subsidiary ledger for materials, and keeps a continuous record of quantity received, quantity issued to jobs and inventory balances for each type of material.  Labour Records by employee are used to trace direct manufacturing labour to individual jobs and to accumulate the indirect manufacturing labour in manufacturing department overhead records.  Manufacturing department overhead records are the subsidiary for manufacturing overhead control and show details of different categories of overhead costs such as indirect materials, indirect manufacturing labour, supervision and engineering, plant insurance and utilities, and plant depreciation.  Work in Process Inventory Records by jobs  Finished goods inventory records by jobs

Budgeted Indirect Costs and End-of-Accounting-Year Adjustments 

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Adjustments are needed when at the end of the fiscal year, indirect costs allocated differ from actual indirect costs incurred. Under-allocated indirect costs occur when the allocated amount of indirect costs in an accounting period is less than the actual (incurred) amount. Over-allocated indirect costs occur when the allocated amount of indirect costs in an accounting period is greater than the actual (incurred) amount.  ()            AKA under-applied/under-absorbed There are two indirect-cost accounts in the general ledger that have to do with manufacturing overhead:  Manufacturing overhead control; the record of the actual costs in all the individual overhead categories (indirect materials, indirect manufacturing labour, supervision, engineering, utilities, plant depreciation etc.)  Manufacturing overhead allocated; the record of the manufacturing overhead allocated to individual jobs on the basis of the budgeted rate multiplied by actual direct manufacturing labour-hours. Under allocation and over allocation occur because of inaccuracies in the indirect-cost pool (incorrect cost, numerator reason) or in the quantity of allocation base (incorrect quantity, denominator reason). There are 3 methods to accounting for under/over allocation:

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1.

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3.

Adjusted Allocation-Rate Approach: restates all overhead entries in the general ledger and subsidiary ledgers using actual cost rates rather than budgeted cost rates. Actual manufacturing overhead is computed, and the actual manufacturing  overhead rate is used to job cost every job. Yields the benefits of the timeliness and convenience of normal costing during  the year and allocation of actual manufacturing overhead costs at the year-end. Due to computerized accounting systems this approach is very easy to apply.  Proration Approach: spreads under-allocated overhead and over-allocated overhead among ending work-in-process inventory, finished goods inventory and cost of goods sold (no materials inventory because there are no manufacturing overhead costs associated with it). Pg. 120 REVIEW Write Off to COGS Approach: the total under/over allocated manufacturing overhead is included in COGS.

Variations from Normal Costing: A Service-Sector Example Pg. 122-123  

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A major challenge of job costing is estimating the actual cost of jobs in a timely manner. A job costing system in manufacturing records the flow of inventoriable costs in the general and subsidiary ledger for (a) acquisition of materials and other manufacturing inputs, (b) their conversion into work in process, (c) their conversion into finished goods, and (d) the sale of finished goods. The job costing system also expenses period costs, such as marketing costs, as they are incurred. There are two theoretically correct approaches for disposing of under/over allocated manufacturing overhead costs at the end of the fiscal year for correctly stating balance sheet and income amounts: to adjust the allocation rate, or to prorate on the basis of the total amount of the allocated manufacturing overhead cost in the ending balances of work in process control, finished goods control and COGS. Many companies simply write off amounts of under/over allocated manufacturing overhead to COGS when amounts are insignificant. In some variations from normal costing, organisations use budgeted rates to assign direct costs,  as well as indirect costs, to jobs.

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Lecture 4: Cost Allocation – Support Department Costs 14 Cost Allocation, Customer-Profitability Analysis, and Sales-Variance Analysis Purposes of Cost Allocation 

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Indirect costs of a particular cost object are costs that are related to that cost object b ut cannot be traced to it in an economically feasible (cost-effective) way and form a large proportion of overall costs assigned. Costs in different business functions of the value chain:

Purposes of Cost Allocation:  Information for economic decisions  Motivating managers and employees  Justifying costs or computing reimbursement amounts  Measuring income and assets For economic-decision purposes (long run product pricing), the costs in all six functions are relevant, for short run economic decisions, costs from only one or two functions might be relevant. For reimbursement, a particular contract will stipulate what costs are relevant for reimbursement. For measuring income and assets for reporting to external parties under GAAP, only manufacturing costs and in some cases product design costs are inventoriable and allocated to products.

Criteria to Guide Cost-Allocation Decisions 

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After identifying the purposes of cost allocation, managers and management accountants must decide how to allocate costs. Criteria for cost-allocation decisions: 1. Cause and effect : managers identify the variables that cause resources to be consumed. Costs under this criterion are usually the most credible to operating personnel. 2. Benefits received: managers identify the beneficiaries of the outputs of the cost object. The costs are allocated among the beneficiaries in proportion to the benefits each receives. Divisions with higher revenues thus usually take on more costs. 3. Fairness/Equity: often cited in government contracts when cost allocations are the basis for establishing a price satisfactory to the government and its suppliers. Based on “fairness”, a matter of subjective judgement. 4.  Ability to bear: allocates costs in prop ortion to the cost object’s ability to bear costs allocated to it. Cause and effect and the benefits received criteria are superior, especially when the purpose of cost allocation is to provide information for economic decisions or to motivate managers and employees. Fairness and ability to bear are less frequently used and are problematic. Ability to bear distorts the perceived profitability of products. Cross subsidising invites regulatory scrutiny and competitors attempting to undercut artificially higher-priced services.

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15 Allocation of Support-Department Costs, Common Costs, and Revenues  Allocating Support Department Costs using the Single-Rate and Dual-Rate Methods  

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Operating department (production department): directly adds value to a product or service. Support department (service department): provides the services that assist other internal departments in the company eg. Information systems, plant maintenance. Most companies believe that fixed costs of support departments should be allocated because the support department needs to incur fixed costs to provide operating divisions with the services they require. There are two approaches to allocating ongoing support department costs: the single rate cost allocation method, and the dual rate cost allocation method. Single-rate method: makes no distinction between fixed and variable costs. Divisions are charged the budgeted rate for each hour of actual use.           Benefits: Low cost to implement, avoids expensive analysis necessary to classify the  individual cost. Offers users operational control over the charges they bear because they  condition the final allocations on the actual usage of central facilities, rather than basing them solely on uncertain forecasts of expected demand.  Costs: Makes the allocated fixed costs of the support department appear as variable  costs to the operating divisions. Thus it may lead division managers to make outsourcing decisions that are in their own best interest but may be inefficient from the standpoint of the organisation as a whole (because fixed costs look seem variable, managers may look for outsourcing which is cheaper than this variable rate, without noticing fixed costs will still be incurred).  This divergence in interests may be lessened when allocation is done on the basis of practical capacity. Dual-rate method: partitions the cost of each support division into two pools, a variable cost pool and a fixed cost pool. Fixed costs are based on budgeted hours, whilst variable costs are based on actual hours. Fixed cost is allocated in advance in a pre-set lump sum charge.                           Benefits: Signals to division managers how variable costs and fixed costs behave  differently. Guides division managers to make decisions that benefit the organisation as a whole, as well as each division. If costs can be easily separated into variable and fixed, the dual rate method should be used as it provides better information for decision making. Under the two methods, managers can allocate support-department costs to operating divisions based on either a budgeted rate (preferred) or the eventual actual cost rate. Under the two methods, the same amount is charged for variable costs, however the overall assignment of costs differ because the single-rate method allocates fixed costs of the support department based on actual usage, whereas the dual-rate method allocates fixed costs based on budgeted use .

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When practical capacity   is used to allocate costs, the single-rate method allocates only the actual fixed-cost resources used by the divisions, while the dual-rate method allocates the budgeted fixed-cost resources to be used by the operating divisions.            Same as single rate, BUT also allocate costs for the remaining unused supply capacity.  Same as dual rate, BUT only fixed costs are allocated to unused supply capacity.  Focuses manager’s atten tion on unused capacity, and avoids burdening the user divisions with the cost of unused capacity. When costs are allocated on the basis of the demand, all of the budgeted fixed costs, including unused capacity are allocated to user divisions.

Budgeted Versus Actual Fixed Costs, and the Choice of Allocation Base 

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Budgeted rates:  Gives managers decision making information in advance as they know costs to be allocated, and can thus plan the amount of service and whether to use internal source or external vendor.  Helps motivate managers of the support department to improve efficiency, as the support department bears the risk of cost variances. User divisions do not pay for the costs or inefficiencies of the support department.  Some organisations try to identify uncontrollable factors that cause cost variances and relieve support department managers of responsibilities of c hanges in costs compared to budgeted rates. In other organisations, the supplier department and the user division agree to share the risk. Fixed cost allocation based on budgeted rates and budgeted usage (dual -rate method)  Helps user divisions with both short run and long run planning.  May tempt managers to underestimate planned usage, resulting in their divisions bearing a lower percentage of fixed costs. Firms either give rewards for accurate estimates, or penalties for underestimates. Fixed cost allocation based on budgeted rates and actual usage (single-rate method)? Allocating budgeted fixed costs based on actual usage? The use of budgeted rates enables managers of user departments to have certainty about the costs allocated to them, and insulates users from inefficiencies in the supplier department. Changing budgeted variable cost rates to users based on actual usage is causally appropriate and promotes control of resource consumption.

 Allocating Costs of Multiple Support Departments 

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Departments can provide reciprocal support to each other as well as to operating departments eg. Costs of training and recruitment for all departments. Costs need to be allocated accurately for this problem. Direct Method:  Allocates each support department’s costs to operating departments only. Does not allocate support costs to other departments.  Allocation is done proportionately (hours of department/total hours worked by operating departments * total cost) Step-Down Method (sequential allocation method):  Allocates support department costs to other support departments and to operating departments in a sequential manner that partially recognises the mutual services provided among all support departments.  Requires support departments to be ranked in the order that the step-down allocation is to proceed. Support costs are distributed to the other support divisions and operating

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divisions. Added together, and the next department’s costs are distributed again until all support costs are distributed. Usually the  first support department   is the one that  renders the highest percentage of its total services to other support departments.   Continues with the department with next highest percentage and so on.

Step Down Diagram: Support 1 costs Support 2 costs

Support 2 + a* Support 1 = x

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Operating 1 costs

Operating 2 costs

Operating 1+ b*Support1 = y

Operating 2+ c*Support1 = z

 y+d*x

z+ex

Once a support department’s costs have been allocated, no subsequent support department costs are allocated back to it. The result is that the step down method does not recognise the total services that support departments provide on e another.

Reciprocal Method:  Allocates support department costs to operating departments by fully recognising the mutual services provided among all support departments. Fully incorporates interdepartmental relationships into the support-department cost allocation.  Is similar to the step down method, except that the allocated support costs are reallocated back to the original support department, and done back and forth until no support costs are left to be allocated, since they have all been allocated to operating.  Gives a more accurate distribution of costs allocated to operating departments.  Sometimes called matrix method due to required inverse of matrix when solving algebraically.  Reciprocal diagram:

Support 1 costs

Support 2 costs

Operating 1 costs

Operating 2 costs

$0

$0

$0

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Can be solved through linear equations 1. Express support department costs and reciprocal relationships           

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ACCT2102

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Where 100 and 150 represent department costs, coefficients are the reciprocal relationship, A and B are the complete reciprocated costs. 0.1 is proportion of B used by A (A = cost of A + cost of B used by A) 2. Solve the linear equations 3. Allocate the complete reciprocated costs of each support department to all other departments based on percentages of usage. For each operation department: Cos t = existing cost + ∑(proportion × o department reciprocal cost) Differences among the three methods’ allocations increase: 1. As the magnitude of the reciprocal allocations increases 2. As the differences across operating departments’ usage of each support department’s services increase. Summary: Direct method allocates each support department’s costs to operating departments without allocating a support department’s   cost to other support departments. The step down method allocates support department costs to other support departments and to operating departments in a sequential manner that partially recognises the mutual services provided among all support departments. The reciprocal method fully recognises mutual services provided among all support departments. Managers need to clarify the method used for cost allocation to avoid disputes in costreimbursement contracts that require the allocation of support department costs. Reciprocal method is the most accurate, but the direct and step down methods are easiest to use. However computing power is increasing making it easier to compute repeated iterations or multiple simultaneous equations. Another advantage of the reciprocal method highlights the complete reciprocated costs of support departments and how they differ from budgeted or actual costs of departments, and assist in deciding whether to outsource cheaper support department services. A department’s complete rec iprocal cost should be looked at when comparing outsourcing prices, as the costs from other departments will be saved as well.

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