Cost Analysis Control costs and expenses Improve cost structure – problems show up Cost structure – relative proportion of each type of cost – fixed, variable, mixed Improve effectiveness of firm Which costs eroding profit margin What first? – earnings decrease Analyze situation, target problem areas Prime costs – direct labor, direct materials Conversion costs – direct labor, overhead

–Cost behavior – important for making decisions –Understand how expenses react to production – improve management Fixed – remain constant – i.e. rent Fixed – remain constant – i.e. rent Variable – dollar amount varies in direct proportion to changes in activity level – i.e. Battery in car Variable – dollar amount varies in direct proportion to changes in activity level – i.e. Battery in car Mixed – contains both variable and fixed elements – license fee of $25,000/year and $3/dinner party Mixed – contains both variable and fixed elements – license fee of $25,000/year and $3/dinner party Stepped costs – variable but increases in big chunks – i.e. Wages of maintenance workers Stepped costs – variable but increases in big chunks – i.e. Wages of maintenance workers

Make sure that costing done correctly, reduce costs Direct costs – easy to trace to product Indirect costs – overhead – hard to trace, control – estimate, calculate cost per unit Standard costing – assigning overhead costs based upon one predetermined rate based on volume Easier, less accurate Works best with one product Could be misleading

Activity based costing - designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore affect fixed as well as variable costs. Most organizations maintain two costing systems – internal – most useful information Apply overhead - most accurate way possible Uses numerous activity cost drivers at various levels – unit, batch, customer

Standard costing – steps 1.Accumulate total overhead costs 2.Identify base 3.Calculate application base rate (total overhead/total physical base) 4.Multiply rate by base for each product – overhead cost per unit 5.Add overhead cost per unit to direct labor cost per unit and direct material cost per unit = total cost per unit

ABC costing – steps 1.Re-categorize overhead costs into activity pools 2.Calculate total costs and total physical base for each activity 3.Calculate application base rate for each category (total overhead/total physical base) 4.Calculate proportion of physical base for each category 5.Multiply rate by base for each product 6.Calculate total overhead for each product 7.Divide total cost for each product by product manufactured = overhead cost per unit 8.Add overhead cost per unit to direct labor cost per unit and direct material cost per unit = total cost per unit

Activity Based Costing Two stage allocation process Two stage allocation process –Assign costs to pools, then assign to products using cost drivers I.e. Sell 50,000 units – Product A, 200,000 units – Product B = 250,000 units total I.e. Sell 50,000 units – Product A, 200,000 units – Product B = 250,000 units total –Both require two direct labor hours to complete = 500,000 direct labor-hours –Total manufacturing overhead = $10,000,000

Standard Costing Method 10,000,000/50,000 = $20/labor hour $20 * 2 = $40 overhead cost Product A = manufacturing overhead cost/unit - $40 Product B = manufacturing overhead cost/unit - $40 Product A = total manufacturing cost/unit - $150 Product B = total manufacturing cost/unit - $110

Standard Costing Method Direct Costs A B Direct Materials $90 $50 Direct $10/hr $20 $20 Manufacturing OH $40 $40 Total per unit cost$150$110 Total manufacturing overhead$10,000,000 Direct labor hours 500,000

ABC Costing

Product A - manufacturing overhead costs = $93.20 Product B - manufacturing overhead costs = $26.70

Direct Costs A B Direct Materials $90 $50 Direct $10/hr $20 $20 Manufacturing OH $93.20 $26.70 Total per unit cost$ $ 96.70

Assign #5 – Standard/ABC Costing problem, ½ page – what do you think? Why is the ABC Costing method better? Assign #6 – ABC Cost Case – download, print, read – ½ page – What is going on? What is the problem? How can ABC help?