Chapter 1

L.O. 1 Describe the way managers use accounting information to create value in organizations. L.O. 2 Distinguish between the uses and users of cost accounting and financial accounting information. L.O. 3 Explain how cost accounting information is used for decision making and performance evaluation in organizations. L.O. 4 Identify current trends in cost accounting. L.O. 5 Understand ethical issues faced by accountants and ways to deal with ethical problems that you face in your career. 1-2

– Value added activities – Non value added activities The Value Chain describes a set of activities that transforms raw materials and resources into the goods and services end users purchase and consume. L.O. 1 Describe the way managers use accounting information to create value in organizations. 1-3

Research & Development DesignPurchasing MarketingDistribution Customer Service Production LO1 1-4

Managerial AccountingFinancial Accounting PurposeDecision making Communicate financial position to outsiders Primary UsersInternal managersExternal users Focus/EmphasisFuture-orientedPast-oriented Rules Little GAAP guidence; cost vs. benefit GAAP compliant; CPA audited Time Span Current to very long time horizons Historical monthly, quarterly reports Behavioral Issues Designed to influence employee behavior Indirect effects on employee behavior © 2009 Pearson Prentice Hall. All rights reserved. L.O. 2 Distinguish between the uses and users of cost accounting and financial accounting information.

Individuals make decisions. Decisions determine the performance of the organization. Managers use information from the accounting system to make decisions. Owners evaluate organizational and managerial performance with accounting information. L.O. 3 Explain how cost accounting information is used for decision making and performance evaluation in organizations. 1-6

Carmen’s Cookies has been making and selling cookies through a small store downtown. One of her customers suggests that she expand operations and sell to wholesalers and retailers. Should Carmen expand operations? LO3 1-7

DriverCost Rent Insurance Labor Ingredients Number of stores Number of cookies LO3 1-8

Costs that change in response to a particular course of action Differential costs change (differ) between actions. LO3 1-9

Revenues that change in response to a particular course of action. Differential revenues change (differ) between actions. LO3 1-10

Sales revenue Costs: Food Labor Utilities Rent Other Total costs Operating profits $6,300 1,800 1, ,250 1,000 $5,450 $ 850 $8,505 a 2,700 b 1,500 b 600 b 1,250 1,200 c $7,250 $1,255 $2, $1,800 $ 405 (1) Status Quo Original Shop Sales Only (2) Alternative Wholesale & Retail Distribution(3) Difference Carmen’s Cookies Projected Income Statement for One Week (a) 35 percent higher than status quo (b) 50 percent higher than status quo (c) 20 percent higher than status quo LO3 1-11

1. Research and development 2. Design 3. Purchasing 4. Production 5. Marketing 6. Distribution 7. Customer service 8. ERP – Enterprise resource planning 9. Creating value in the organization L.O. 4 Identify current trends in cost accounting. 1-12

LO4 Lean manufacturing techniques are not simply about production. Companies partner with suppliers in the development stage to ensure cost-effective deigns for products Being lean is based on three concepts: a) eliminate waste b) continuous improvement c) respect for people.

Product designers must write detailed specifications on a product’s design. ABC assigns costs of activities needed to make a product, then sums the cost of those activities to compute the total cost of the product. This is often referred to as design for manufacturing (DFM). LO4 1-14

Performance measurement indicates how well a process is working. It minimizes unnecessary transaction processes. LO4 Benchmarking methods measure products, services, and activities against the best performance. Benchmarking is an ongoing process resulting in continuous improvement. 1-15

From IMA Standard 67 A lean accounting system provides measures at a work cell or process level. LO4 JIT is an inventory system designed to lower the cost of maintaining excess inventory 1-16 A work cell is a group of dissimilar operations formed to produce a product. “As the organization changes structure, the information used to guide decisions and evaluate performance also needs to change. The content, format, and frequency of management accounting information need to change to support a system that is now customer-focused.” Lean accounting challenges many traditional cost account techniques

Cost relationship management (CRM) is a system that allows firms to target profitable customers by assessing customerrevenues and costs. Casinos provides complimentary” services to some customers. (known as comping”). LO4 1-17

Outsourcing occurs when a firm’s activities are performed by another organization or individual in the supply or distribution chain. Nikon, for example, relies on UPS for distribution. LO4 1-18

TQM is a management method which focuses on excelling in all dimensions. Cost of quality is a system that identifies the cost of producing low quality items. The emphasis is placed on quality. Quality is defined by the customer. LO4 1-19

Information technology linking various processes of the enterprise into a single comprehensive information system Technology Purchasing Human Resources Marketing Production Finance LO4 1-20

Institute of Management Accountants’ (IMA) Code of Ethics: Standards 1.Competence 2.Confidentiality 3.Integrity 4.Credibility 1-21

Members have a responsibility to: 1.Maintain an appropriate level of professional expertise by continually developing knowledge and skills. 2.Perform professional duties in accordance with relevant laws, regulations, and technical standards. 3.Provide decision support information and recommendations that are accurate, clear, concise, and timely. 4.Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of activity. 1-22

Members have a responsibility to: 1.Keep information confidential except when disclosure is authorized or legally required. 2.Inform all relevant parties regarding appropriate use of confidential information. 3.Refrain from using confidential information for unethical or illegal advantage. 4.Monitor subordinates’ activities to ensure compliance. 1-23

Members have a responsibility to: 1.Mitigate actual conflicts of interest, regularly communicate with business associates to avoid apparent conflicts of interest. Advise all parties of any potential conflicts. 2.Refrain from engaging in any conduct that wouldprejudice carrying out duties ethically. 3.Abstain from engaging in or supporting any activity that might discredit the profession. 1-24

Members have a responsibility to: 1.Communicate information fairly and objectively. 2. Disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations. 3.Disclose delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization policy and/or applicable law. 1-25

Chapter 2

L.O. 1 Explain the basic concept of “cost.” L.O. 2 Explain how costs are presented in financial statements. L.O. 3 Explain the process of cost allocation. L.O. 4 Understand how material, labor, and overhead costs are added to a product at each stage of the production process. L.O. 5 Define basic cost behaviors, including fixed, variable, semivariable, and step costs. L.O. 6 Identify the components of a product’s costs. L.O. 7 Understand the distinction between financial and contribution margin income statements. 2-27

Cost is a sacrifice of resources. All Expenses are costs Not all costs are expenses when sacrifice is made L.O. 1 Explain the basic concept of “cost.” 2-28

Cost Outlay Cost Past, present, or future cash outflow Opportunity Costs Forgone benefit from the best alternative course of action Expense Cost charged against revenue in an accounting period LO1 2-29

L.O. 2 Explain how costs are presented in financial statements. Income Statements Service company Revenues –Cost of services sold =Gross margin –Marketing and administrative costs =Operating profit The excess of operating revenue over costs necessary to generate those revenues Cost of billable hours 2-30

Income Statements Merchandising company Revenues –Cost of goods sold =Gross margin –Marketing and administrative costs =Operating profit The excess of operating revenue over costs necessary to generate those revenues Expense assigned to products sold during a period LO2 2-31

Sales revenue –Cost of goods sold =Gross margin –Marketing and administrative costs =Operating profit Cost incurred to manufacture the product sold Product costs recorded as “inventory” when cost is incurred Period costs recorded as an expense in the period the cost is incurred Expensed when sold Income Statements Manufacturing company LO2 2-32

Two types of manufacturing costs: Product costs: Costs related to inventory Period costs: Non-manufacturing costs related to the firm LO2 2-33

Product costs: Costs that are recorded as an asset in inventory when incurred and expensed as Cost of Goods Sold when sold Period costs: Costs recognized for financial reporting when incurred LO2 2-34

Direct costs: Costs that, for a reasonable cost, can be directly traced to the product. Direct materials: Materials directly traceable to the product Direct labor: Work directly traceable to transforming materials into the finished product LO2 2-35

Indirect costs: Costs that cannot reasonably be directly traced to the product. Manufacturing overhead: All production costs except direct materials and direct labor. Indirect materialsOther indirect costs Indirect labor LO2 2-36

Prime costs: The “primary” costs of the product Conversion costs: Costs necessary to “convert” materials into a product Direct materials Direct labor Direct labor Manufacturing overhead LO2 2-37

Recognized as expenses when the costs are incurred Marketing: Costs necessary to sell the products Administrative: Costs necessary to operate the business Advertising Sales commissions Shipping costs Executive salaries Data processing Legal costs LO2 2-38

L.O. 3 Explain the process of cost allocation. It is the process of assigning indirect costs to products, services, business units, etc. 2-39

1.Define the cost pool: The collection of costs to be assigned to cost objects 2.Determine the cost allocation rule: The method used to assign costs in the cost pool to cost objects 3.Assign the costs in the cost pool to the cost object: Any end to which a cost is assigned – product, product line, department, customer, etc. LO3 2-40

Rockford Corporation has two divisions, East Coast and West Coast. Both divisions are supported by the IT Group. East CoastWest CoastTotal Revenues$80 million$20 million$100 million 1. Define the cost pool:IT department’s costs of $1,000, Determine the cost allocation rule:IT costs are allocated based on divisional revenue. (% of revenue) 3. Assign to the cost object:East Coast:80% of cost West Coast:20% of cost LO3 2-41

Corporate IT Group $1,000,000 East Coast $800,000 West Coast $200,000 Allocated 2-42

L.O. 4 Understand how material, labor, and overhead costs are added to a product at each stage of the production process. Product costs are recorded in inventory when costs are incurred. A manufacturing company has three inventory accounts: 1.Raw Materials Inventory: Materials purchased to make a product 2.Work-in-Process Inventory: Products currently in the production process, but not yet completed 3. Finished Goods Inventory: Completed products that have not yet been sold 2-43

Beg. RM inventory +Purchases =Raw materials available for production – Ending RM inventory =Raw materials transferred to WIP Direct Materials Inventory Beg. WIP inventory +Direct materials transferred from raw materials +Direct labor =Total manufacturing costs –Costs of goods completed and transferred to finished goods (or cost of goods manufactured) +Manufacturing overhead =Ending WIP inventory Work-in-Process Inventory Beg. FG inventory +Cost of goods completed and transferred from WIP =Goods available for sale –Cost of goods sold =Ending FG inventory Finished Goods Inventory To the Income Statement LO4 2-44

JACKSON GEARS Income Statement For the Year Ending December 31, Year 200X Sales$20,450,000 Less: Cost of goods sold 13,100,000 Gross margin$ 7,350,000 Less: Marketing and administrative expenses 3,850,000 Operating profit$ 3,500,000 LO4 2-45

JACKSON GEARS Cost of Goods Manufactured Statement For the Year Ending December 31, Year 200X ($000) Beginning work-in-process inventory, January 1$ 270 Manufacturing costs during the year: Direct materials: Beginning inventory, January 1$ 95 Add: Purchases 5,627 Direct materials available$5,722 Less: Ending inventory, December Direct material put into production$5,650 Direct labor 1,220 Manufacturing overhead 6,780 Total manufacturing costs incurred 13,650 Total work in process during the year$13,920 Less: Ending work-in-process inventory, December Cost of goods manufactured$13,610 LO4 2-46

JACKSON GEARS Cost of Goods Sold Statement For the Year Ending December 31, Year 200X ($000) Beginning finished goods inventory, January 1$ 420 Cost of goods manufactured 13,610 Finished goods available for sale$14,030 Less: Ending Finished Goods Inventory, December Cost of goods sold$13,100 LO4 2-47

L.O. 5 Define basic cost behaviors, including fixed, variable, semivariable, and step costs. Cost behavior: How costs respond to a change in activity level within the relevant range Relevant range: Activity levels within which a given total fixed cost or unit variable cost will be unchanged 2-48

Cost ($) Activity Level Fixed costs remain unchanged as volume changes within the relevant range. Fixed costs per unit varies inversely to a change in activity. Fixed costs are “fixed” in “total” as activity changes. LO5 2-49

Costs that change in direct proportion with a change in the volume within the relevant range Variable costs “vary” in “total” as activity changes. Variable cost per unit stays constant when activity changes within the relevant range. Cost ($) Activity Level LO5 2-50

LO5 2-51

Cost ($) Activity Level Costs that have both fixed and variable components Also known as mixed costs LO5 2-52

Costs that increase in total with steps when the volume changes to a particular level Step costs are also known as semifixed costs. Cost ($) Activity Level LO5 2-53

L.O. 6 Identify the components of a product’s costs. Full cost: The sum of all costs of manufacturing and selling a unit of the product Full absorption cost: The sum of all variable and fixed costs of manufacturing a unit of the product Variable cost: The sum of all variable costs of manufacturing and selling a unit of the product 2-54

Direct materials = $8 Direct labor = $7 Variable manufacturing overhead = $8 Fixed manufacturing overhead = $6 Variable marketing and administrative costs = $4 Fixed marketing and administrative costs = $7 Full cost per unit = $40 Full absorption cost per unit = $29 Variable manufacturing cost = $23 Unit variable cost = $27 Variable marketing and administrative costs = $4 LO6 2-55

L.O. 7 Understand the distinction between financial and contribution margin income statements. Full absorption costing: Required by GAAP Used for: – Financial purposes – External reporting Variable costing: Used for: – Managerial purposes – Internal decision making Sales revenue –Cost of goods sold =Gross margin Sales revenue –Variable costs =Contribution margin 2-56

Financial income statement Full absorption costing Sales price –Full absorption cost =Gross margin Variable costing Contribution margin income statement Sales price –Variable costs =Contribution margin LO7 2-57

Sales revenue –Cost of goods sold =Gross margin –Marketing and administrative costs =Operating profit Full absorption Variable and fixed manufacturing costs Period costs Variable and fixed marketing and administrative costs LO7 2-58

Sales revenue –Variable costs =Contribution margin –Fixed costs =Operating profit Variable manufacturing costs and variable marketing and administrative costs Fixed manufacturing costs and fixed marketing and administrative costs LO7 2-59

Consider the following concert example where Sheryl Crow will be paid $48,000 regardless of the number of tickets sold. When activity.. i.e. # units

$48,000 ÷ 3,000 Tickets = $16.00 per Ticket

When activity... Let’s see what happens to the concert example if the band receives $16 per ticket instead of $48,000.

The total variable cost increases in direct proportion to the number of tickets sold. Variable unit cost per ticket remains at $16 regardless of the number of tickets sold.

Example: Office space is available at a fixed rental rate of $30,000 per year in increments of 1,000 square feet. As the business grows more space is rented, increasing the total cost. Continue

Rent Cost in Thousands of Dollars 0 1,000 2,000 3,000 Rented Area (Square Feet) Relevant Range Total fixed cost doesn’t change for a range of activity, and then jumps to a new higher cost for the next higher range of activity.

A measure of the extent to which fixed costs are being used in an organization. Operating leverage is greatest in companies that have a high proportion of fixed costs in relation to variable costs. Consider the following concert example where all costs are fixed.

When all costs are fixed, every additional sales dollar contributes one dollar to gross profit. 10% Revenue Increase 90% Gross Profit Increase

Risk refers to the possibility that sacrifices may exceed benefits. Risk may be reduced by converting fixed costs into variable costs. Let’s see what happens to the concert example if the band receives $16 per ticket instead of $48,000.

Shifting the cost structure from fixed to variable not only reduces risk but also the potential for profits. 10% Revenue Increase 10% Gross Profit Increase

Fixed Cost Structure $ Units Revenue Fixed Cost Profit Loss  

Variable Cost Structure Variable Cost Revenue Profit $ Units

Variable Costs Fixed Costs Do companies with higher levels of fixed costs experience more earnings volatility?

Now Let’s see what happens when the number of units sold increases.

The income increase is greater in the All Fixed Company. +10% +25%

Variable Costs Fixed Costs If sales decrease, will the income decrease be greater in the All Fixed Company?

Yes, the income decrease is greater in the All Fixed Company. -10% -25%

Variable Costs Fixed Costs

The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income.

Contribution margin Net income Operating Leverage = Show me an example.

$20,000 $5,000 Operating Leverage == 4 A measure of how a percentage change in sales will effect profits.

A 10 percent increase in sales results in a 40 percent increase in net income.

Your monthly basic telephone bill is probably fixed and does not change when you make more local calls. Number of Local Calls Monthly Basic Telephone Bill Total Fixed Cost

Number of Local Calls Monthly Basic Telephone Bill per Local Call The fixed cost per local call decreases as more local calls are made.

Your total long distance telephone bill is based on how many minutes you talk. Minutes Talked Total Long Distance Telephone Bill Total Variable Cost

Minutes Talked Per Minute Telephone Charge The cost per minute talked is constant. For example, 10 cents per minute. Variable Cost Per Unit

When activity level changes...

Example: Office space is available at a fixed rental rate of $30,000 per year in increments of 1,000 square feet. As the business grows more space is rented, increasing the total cost. Continue

Rent Cost in Thousands of Dollars 0 1,000 2,000 3,000 Rented Area (Square Feet) Relevant Range Total fixed cost doesn’t change for a range of activity, and then jumps to a new higher cost for the next higher range of activity.

Activity Total Cost Relevant Range Our variable cost assumption (constant unit variable cost) applies within the relevant range. Possible Variable Cost Behavior Our Variable Cost Assumption