Seminar 10 Course Overview

Cost Terminology Variable Costs -Change in proportion to changes in volume or activity Fixed Costs -Do not change in response to changes in volume or activity Sunk Costs - Costs incurred in the past - Not relevant to present decisions Opportunity Costs - Values of benefits foregone when selecting one alternative over another Slide 1-2Learning objective 5: Define cost terms used in planning, control, and decision making

Cost Terminology  Direct and indirect costs - Direct costs are directly traceable to a product, activity, or department, indirect costs are not traceable  Controllable & noncontrollable costs - A manager can influence controllable costs but cannot influence non- controllable costs Slide 1-3Learning objective 5: Define cost terms used in planning, control, and decision making

Relationships Among Cost Categories Learning objective 1: Distinguish between manufacturing and nonmanufacturing costs and between product and period costs Slide 2-4

Job-Order versus Process Costing Job Order Costing  Companies produce goods to a customer’s unique specifications e.g. construction, shipping  Cost of job accumulated on job cost sheet Process Costing  Companies produce large quantities of identical items e.g. producers of paints and plastics  Cost accumulated by each operation  Unit cost of items determined dividing costs of production by number of units produced Learning objective 4: Discuss the types of product costing systems Slide 2-5

Job Costs – Manufacturing Overhead Apply manufacturing overhead to jobs  Choose an allocation base e.g. direct labor hours or direct labor cost  Calculate overhead allocation rate Estimated overhead /estimated quantity of the allocation base  Use rate to apply overhead to jobs based on actual quantity of base used Slide 2-6 Learning objective 6: Describe how direct material, direct labor, and manufacturing overhead are assigned to jobs

Difference Between Job-Order and Process Costing Systems Job-Order Costing  Each unique product or batch is considered a job for which cost information is needed  Necessary to trace manufacturing costs to specific jobs  When completed, cost of job is removed from Work in Process and included in Finished Goods Slide 3-7

Difference Between Job-Order and Process Costing Systems Process Costing  Large quantities produced of homogenous products  Average cost = total costs divided by total number of items produced  When completed, number of units completed times average cost determines cost to be moved from WIP to Finished Goods Slide 3-8

Summarize the flow of physical units Compute output in equivalent units Compute the cost per equivalent unit Assign costs to completed and ending inventory units Steps of Process Costing 9Copyright (c) 2009 Prentice Hall. All rights reserved.

Breakeven Analysis  Break-even point  Sales level at which operating income is zero  Sales above breakeven result in a profit  Two methods:  Income statement approach  Contribution margin approach  Margin of Safety  Excess of expected sales over breakeven sales Slide 1-10

Difference Between Full and Variable Costing Treatment of fixed manufacturing overhead  Under full costing, it is included in inventory and expensed when the product is sold  Under variable costing, it is considered a period cost and expensed in the period incurred. Slide 1-11

Impact of Method Selection on Income Statement  Units produced = units sold No difference in net income  Units produced greater than units sold Full costing yields higher net income  Units Produced less than units sold Variable costing yields higher net income Slide 1-12

Process of Cost Allocation  Determine the cost objective  Form cost pools  Select an allocation base to relate cost pools to the cost objective Slide 6-13Learning objective 2: Describe the cost allocation process

Allocating Budgeted and Actual Service Department Costs  Management should allocate based on budgeted costs rather than actual costs  Allocation of actual amounts allows service department to pass on cost of inefficiencies and waste to production departments Slide 6-14Learning objective 3: Discuss allocation of service department costs

Identify each activity and estimate its total indirect cost Identify the cost driver for each activity and estimate the quantity of each driver Compute the cost allocation rate for each activity Allocate indirect costs to the cost object 15 Activity-Based Costing Copyright (c) 2009 Prentice Hall. All rights reserved.

Benefits of ABC  Provide more accurate costing -Less likely to undercost/overcost due to cost driver usage  May lead to improvements in cost control - Costs broken out into a number of activities rather than into one or two overhead cost pools Slide 6-16 Learning objective 5: Discuss activity- based costing (ABC) and cost drivers

Limitations of ABC  More costly to develop and maintain than a traditional costing system  Used to develops full cost of products - Includes fixed costs - Lacks incremental information necessary for decision making Slide 6-17 Learning objective 5: Discuss activity- based costing (ABC) and cost drivers

 If product has a negative contribution margin  DROP  Unavoidable fixed costs are irrelevant  Avoidable, direct fixed costs are relevant  If direct fixed costs decrease more than the decrease in revenues  DROP  Other considerations:  Lost contribution margins from other products  Will more profitable products be made with excess capacity? Copyright (c) 2009 Prentice Hall. All rights reserved. 18 Dropping a Product

19 Capital Budgeting Process Copyright (c) 2009 Prentice Hall. All rights reserved. Identify potential investments Project net cash inflows Analyze using one or more of the methods Capital rationing Post-audits

Methods that Ignore the Time Value of Money Payback PeriodAccounting rate of return Simple to computeUses accrual accounting Focuses on time it takes to recover cost of asset Shows how investment will impact operating income, which is important to investors Ignores cash flows after the payback period Highlights risks of assets with longer cash recovery periods Measures the profitability over the asset’s life Ignores time value of money Comparing Capital Budgeting Methods 20 Copyright (c) 2009 Prentice Hall. All rights reserved.

Methods that Incorporate the Time Value of Money Net present valueInternal rate of return Uses time value of money and asset’s cash flows over its entire life Indicates whether the asset will earn the minimum required rate of return Computes the project’s unique rate of return Shows excess or deficiency of asset’s present value of net cash flows over its initial cost Profitability index should be computed when assets have differing investment amounts No additional steps needed for capital rationing decisions Comparing Capital Budgeting Methods 21 Copyright (c) 2009 Prentice Hall. All rights reserved.

 Set of budgeted financial statements and supporting schedules  Three types:  Operating  Capital expenditures  Financial Copyright 2009 Prentice Hall. All rights reserved. 22 Master Budget

Operating Budget Sales budget Operating expenses budget Purchases and cost of goods sold budget Inventory budget Budgeted income statement Copyright 2009 Prentice Hall. All rights reserved. 23

Capital Expenditures and Financial Budgets 24 Budgeted income statement Cash budget Budgeted balance sheet Budgeted statement of cash flows Capital expenditures budget Financial budget Copyright 2009 Prentice Hall. All rights reserved.

 Forecast of sales revenues  Cornerstone of master budget  Level of sales affects all elements 25 Sales Budget Copyright 2009 Prentice Hall. All rights reserved. Budgeted total sales Sales price Expected number of units sold

26 Inventory, Purchases, and Cost of Goods Sold Budget Purchases = Cost of goods sold + Ending inventory – Beginning inventory Copyright 2009 Prentice Hall. All rights reserved. Cost of goods sold = Beginning inventory + Purchases – Ending inventory

Copyright 2009 Prentice Hall. All rights reserved. 27 Financial Budget Cash Budget Budgeted Balance Sheet Budgeted Statement of Cash Flows

Advantages and Disadvantages of Decentralization Advantages Disadvantages  Frees top management time  Supports use of expert knowledge  Improves customer relations  Provides training  Improves motivation and retention  Duplication of costs  Problems achieving goal congruence Copyright (c) 2009 Prentice Hall. All rights reserved. 28

 When companies decentralize, top management needs a system to communicate goals to subunit managers  Primary goals:  Promoting goal congruence and coordination  Communicating expectations  Motivating unit managers  Providing feedback  Benchmarking Performance Measurement Copyright (c) 2009 Prentice Hall. All rights reserved. 29

 Management must consider both financial and operational performance measures  Measures should be linked with company goals and strategy  Financial measures are only one measure among many  Uses key performance indicators Balanced Scorecard Copyright (c) 2009 Prentice Hall. All rights reserved. 30

Return on investments Provides information on profitability & efficiency Can compare across divisions & companies Useful for resource allocation Residual income Promotes goal congruence Uses management’s minimum rate of return Can use different rates for divisions based on risk Economic value added Considers income earned for investors and long-term creditors Promotes goal congruence Advantages of Performance Measures Copyright (c) 2009 Prentice Hall. All rights reserved. 31

 Measurement issues  Total asset figure in equation  Nonproductive assets  Gross book value vs. net book value  Depreciation may artificially inflate measures  Short-term focus  Figures are for a one-year time frame  Incentive to management to cut essential spending to increase measurement Limitations of Performance Measures Copyright (c) 2009 Prentice Hall. All rights reserved. 32