Review of Basic Cost Accounting Key Topics Today we will briefly review: –Cost Terms and Purposes –Job & Process Costing –Standard Costing –Activity Based Costing –Alternative Income Calculations

COST TERMS & PURPOSES

Types of Cost Classification

Cost Object [or Objective]: "any activity or item for which a separate measurement of cost is desired." Example: a product, a department a customer [all are activities?] Purpose: to help in decisions or to prepare financial reports

Phases of assigning cost to objectives (1)Accumulation by some "natural" classification (labor, material, etc.) (2)Assignment to the objectives by either… --Tracing --Allocating E.g.: Material costs are accumulated as material is purchased, then typically traced to units of product as they are manufactured. Indirect manufacturing costs (overhead) are allocated to units of product. Direct vs. indirect costs: can they be traced to the cost objective in an economically feasible way? [cost-benefit.] -A matter of judgment

Direct/Indirect Examples for Discussion For a sales office as the cost object The office space? A receptionist? The sales manager's salary? The company president's salary? Insurance against fire and casualty? Electricity For a manufactured circuit board Transistors, integrated circuits, etc., mounted on the boards? Solder used to make the connections? Insulating varnish used to coat it? Labor of the assembly line worker? Supervisor's salary?

Cost Driver: Any underlying factor that causes or changes total costs. Example: Cost of an audit engagement? - Client new? - No. of transactions the client has had - Whether and how computerized - Number of branch offices - Volume (units made, sold) Cost Behavior: Fixed vs. Variable

Purpose is Prediction: Would we predict based on a driver? e.g. -The plant manager's salary is "fixed" -- does not depend on volume. But the manager might be laid off at very low volume or a second shift manager hired at very high volume. Many fixed costs are discretionary. Fixed does not mean Unchangeable Volume

Fixed Cost: Variable Cost: Unit Total $ Volume $ $ $ Within the relevant range Cost Reaction to Changes in Activity Need four perspectives!

Separate Dichotomies DirectIndirect Fixed Variable Think of Examples in a _______________ setting. Cost object is a _____________ Direct/Indirect means it can be traced to the object. Fixed/Variable concerns whether it increases with volume of activity (define).

Inventoriable ("Product") Costs vs. Period Costs [Expensed when product sold] All costs to obtain the merchandise: –Dir. Material –Dir. Labor –Factory Overhead [Expensed Immediately] –Selling expenses –General and Administrative } "Prime"costs } "Conversion" costs

Different Definitions of Costs for Different Applications

Job Costing Managers ask “How much does it cost?” for many purposes –formulating overall strategies –product/service-emphasis decisions –pricing decisions

Building Block Concepts of Costing Systems Direct costs of a cost object are related to the particular cost object and can be traced to it economically. Indirect costs of a cost object are related to the particular cost object but cannot be traced to economically.

A cost pool is a grouping of individual cost items. A cost allocation base is the common denominator for systematically linking an indirect cost or group of indirect costs to a cost object. Building Blocks of Costing Systems

Job-Costing vs. Process-Costing Systems In a job-costing system, the cost object is an individual unit, batch, or lot of a distinct product or service called a job. In process costing, the cost object is masses of identical or similar units or a product or service produced during a period. Uses costs for the period, divided by equivalent units

Activity-Based Costing and Activity-Based Management

Undercosting and Overcosting Product undercosting : Occurs when a product consumes a relatively high level of resources but is reported to have a relatively low total cost. Product overcosting: A product consumes a relatively low level of resources but is reported to have a relatively high total cost.

Undercosting and Overcosting Irene, Roberta, and Nancy are three bank customers. They require different activities from the bank: –Irene banks exclusively at the ATM or online. –Roberta visits the teller daily to make deposits, withdrawals –Nancy deposits foreign currency as well as calling the branch frequently to ask currency rates.

Undercosting and Overcosting Traditional allocation bases might apply branch overhead to accounts based on account balances or equal amounts per account. Irene (who never makes any demands on the branch) will be over costed and appear less profitable than she should. Roberta and Nancy may be under costed and appear more profitable than they are.

Refining a Costing System Guidelines for refining a costing system: Direct-cost tracing – Classify as many of the total costs as direct costs as is economically feasible. Indirect-cost pools – Expand the number of cost pools until each of these pools is homogeneous. Cost-allocation basis – Identify the preferred cost-allocation base for each indirect-cost pool.

Activity-Based Costing System ABC calculates the costs of individual activities and assigns costs to cost objects such as products, services, or customers based on the activities used to produce a product or service, serve a customer, etc.

Activities of a Milk Truck Delivery Person ActivityCost Driver DrivingTime; miles; area of town ShelvingTime; number of packages; categories of products PaperworkTime; types of customer WaitingType of customer?

Cost Hierarchies Different cost pools basis on of the different types of cost drivers (used as the cost-allocation bases) ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases: 1Output unit-level cost 2Batch level costs 3Product-sustaining costs 4Facility-sustaining costs

Output Unit-Level Costs... are resources consumed for activities performed as a function of individual units of product or service. –Energy –Machine maintenance, repairs (depreciation?) –Labor

Batch-Level Costs... are resources used on activities that are related to a group of units of product or service –Setup hours to run a batch –Procurement costs of placing an order

Product-Sustaining... or service-sustaining, costs are incurred on activities to support individual products or services. –Design costs –Engineering costs –Equipment dedicated to the product or service

Facility-Sustaining Costs... are resources used on activities that cannot be traced to individual products or services but support the organization as a whole. –General administration –Rent or depreciation for headquarters, etc. –Building security

Usefulness of Cost Hierarchies Different levels of cost drivers: Level Useful for Decisions Such As… Output-unitShall we increase production, and at what price? BatchHow often should we produce batches? What base amount must we charge to set up a “run,” regardless of the number a customer wants made? Product/Service-Sustaining Should we continue to offer this service/product? Facility-Sustaining Shall we continue in business or dissolve it?

Activity-based Management Supervisors & managers typically oversee activities rather than products. ABC pinpoints opportunities for cost reduction. Improved information technology facilitates ABC.

Activity-Based Management ABM describes management decisions that use activity-based costing information to satisfy customers and improve profits. –Product pricing and mix decisions –Cost reduction and process improvement decisions –Design decisions

Product Pricing and Mix Decisions ABC gives management insight into the cost structures for making and selling diverse products. It provides more accurate product cost information and more detailed information on costs of activities and the drivers of those costs.

Cost Reduction and Process Improvement Decisions Manufacturing and distribution personnel use ABC systems to focus on cost reduction efforts. Managers set cost-reduction targets in terms of reducing the cost per unit of the cost-allocation base.

Design Decisions Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs. Companies can work with their customers to evaluate the costs and prices of alternative design choices.

Major Differences, Traditional Costing vs. ABC Typical System ABC One or a few indirect Many pools cost pools Application base may Base more likely a be a true cost driver true cost driver Application base often Bases likely to be financial (direct labor cost, non-financial (# of parts, direct material cost, etc) number of operations, hours of testing, etc.)

Indicators of Need for ABC Systems... significant amounts of indirect costs are now allocated using only one or two cost pools. all or most costs are identified as output unit- level costs. products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.

Indicators of Need for ABC Systems... products that a company is well-suited to make and sell report small profits while products for which a company is less suited report large profits. complex products appear to be very profitable and simple products appear to be losing money. operations staff have significant disagreements with the accounting staff about the costs.

Limitations of ABC Systems The main limitations of ABC are the effort & measurements necessary to implement the system. ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools.

Limitations of ABC Systems Activity-cost rates also need to be updated regularly. Very detailed ABC systems are costly to operate and difficult to understand.

Standard Costing Basic Concept: Only the standard cost will be applied to the product for inventory valuation and income determination. –Any difference from std. is called a "variance.“ –Variances are calculated and investigated (if large). – Management by exception

Standard Cost Variances Variable OH: Like DM, DL Fixed OH: Prod’n volume, Spending components

Criticisms of Standard Costing A static target? –Can avoid this Emphasis on efficiency –Encourages buildup of inventory, keeping workers & machines busy Emphasis on price of inputs –Can undermine quality

Absorption Costing Sales - CGS =Gross Margin - Selling Expenses - Gen & Admin Expns =Operating Income Sales -Variable Mfg. Costs [= Manufacturing Margin possible subtotal] -Variable Selling & Admin = Contribution Margin -Fixed Costs: Manufacturing Selling Administrative =Operating Income Alternative Income Calculations Variable Costing

Change in Inventory Effect on FC Expensed Effect on Incomes IncreaseSome FC deferred under Absorption that would be expensed under Variable ACI higher than VCI DecreaseSome FC carried forward from last year; this year’s FC also expensed ACI less than VCI No ChangeAmounts expensed are the sameACI = VCI If fixed OH/unit is not constant across time, we must trace the difference in fixed overhead that gets expensed (or the amount that gets carried forward – the same difference in amounts). Differences in Reported Income