Chapter 1: Introduction to Cost Accounting

Chapter 1: Introduction to Cost Accounting
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Learning Objectives What are the relationships among financial, management, and cost accounting? What are the the sources of authoritative pronouncements for the practice of cost accounting? What are the sources of ethical standards for cost accountants? What is a mission statement, and why is it important to organizational strategy? What must accountants understand about an organization’s structure and business environment in order to perform effectively in that organization? What is a value chain, and what are the major value chain functions? How is a balanced scorecard used to implement an organization’s strategy? Why is ethical behavior so important in organizations? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Accounting is the language of business.
Accountants Financial accountants provide information to external parties Investors Creditors Regulators Managerial accountants provide information to internal users Managers Cost accountants provide information to both internal and external users Product cost information Accounting is the language of business. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Relationship of Financial, Management, and Cost Accounting
Product Costs FINANCIAL ACCOUNTING COST ACCOUNTING MANAGEMENT ACCOUNTING © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Types of Accounting Financial Management
Meet external information needs Comply with GAAP Management Meet internal information needs Does not have to comply with GAAP © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Financial versus Managerial
External focus Whole organization Historical Quantitative Monetary Verifiable GAAP Formal recordkeeping Managerial Internal focus Segments or divisions Current/projected Quantitative/qualitative Monetary and nonmonetary Timely/reasonable estimate Benefits exceed costs Formal and informal recordkeeping © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Product Cost Information
External parties—stockholders, creditors, and regulators For investment and credit decisions Complies with GAAP Enterprise focus Internal parties Planning, controlling, and decision making Evaluating performance Includes upstream and downstream costs Disaggregated © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Accounting Bodies Financial
Public Company Accounting Oversight Board (PCAOB) Securities and Exchange Commission (SEC) Financial Accounting Standards Board (FASB) Management Institute of Management Accountants (IMA) Society of Management Accountants of Canada Cost Accounting Standards Board (CASB) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Management Accounting Organizations
IMA Statements on Management Accounting (not legally binding) Society of Management Accountants of Canada Management Accounting Guidelines Cost Accounting Standards Board (CASB) Government contracting standards (legally binding) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Professional Ethics Earnings management—deliberate accounting adjustments to “hit” profit targets Often adjustments involve cost accounting Product costs Inventory valuations Stretching legitimate accounting techniques Outright fraud © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Ethics and Legislation
Sarbanes-Oxley Act—CEOs and CFOs personally accountable for the accuracy of their organization’s financial reporting False Claims Act—whistle-blower protection and penalties for failure to blow the whistle (disclose known financial frauds) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Ethics and Management Accounting
Standards of Ethical Conduct for Management Accountants Competence Confidentiality Integrity Credibility © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Organizational Strategy
Develop mission statement Implement strategy Deploy resources to create value for customers and shareholders Recognize that each organization is unique—thus unique strategies must be developed © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Organizational Strategy
Develop mission statement Implement strategy Develop, implement, and monitor necessary information systems Establish appropriate measures of accomplishment © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Five Factors in Organizational Strategy
Core competencies Organizational structure Management style and organizational culture Organizational constraints Environmental constraints © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Organizational Strategies
Core competency—critical function or activity providing a competitive advantage Cost leadership strategy—undercut competitor prices Product differentiation strategy—superior quality products or unique services sold at a premium © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Strategy Questions What are your customers’ most important purchase criteria? How do you and your competitors rate on these purchase criteria? What are your main strengths and competencies? Are they appreciated by the market? Which are your priority segments? Where is it most important that you gain market share? What is your competitive advantage? Who are your five most important competitors? Is your firm more or less profitable than these firms? Compare prices for equivalent products/services. Are they higher or lower? Explain the difference. Is it customers, costs, or profit requirements? Are your costs higher or lower than those of main competitors? Where are the differences most pronounced? What segment(s) of your business represents 80% profits? For each business segment above, how large are you relative to the largest competitors? Are you gaining or losing relative market share? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Organizational Structure
Distribution of authority and responsibility in an organization Authority—right to use resources to accomplish a task or achieve an objective Responsibility—obligation to accomplish a task or achieve an objective Line manager works directly toward attaining organizational goals Staff employees give assistance and advice to line managers Treasurer and Controller © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Communicate strategy to all members of the value chain.
A set of value-adding functions and processes that converts inputs into products or services Marketing Distribution Customer Service Research and Development Product Design Supply Production Communicate strategy to all members of the value chain. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Components of the Value Chain

Balanced Scorecard © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Balanced Scorecard Perspectives
Learning and Growth Use the organization’s intellectual capital to adapt to changing customer needs or to influence new customers’ needs and expectations through product or service innovations Internal Business Things to do well to meet customer needs and expectations Customer Value How well the organization is doing relative to important customer criteria Financial Address stockholders/stakeholders concerns about profitability and organizational growth © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Balanced Scorecard Measures
Short-term and long-term Internal and external Financial and nonfinancial © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Ethics in Multinationals
Foreign Corrupt Practices Act—prohibits bribes to obtain/retain business Organization of Economic Cooperation and Development Convention—crime to offer, promise, give bribes to obtain/retain internal business deals © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Questions What is the relationship among financial, management, and cost accounting? How is the balanced scorecard used to implement an organization’s strategy? Where can an accountant find ethical standards for cost accounting? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Potential Ethical Issues
Earnings management Low-cost production at any cost Whistle-blower retaliation Fixing prices Bribery and other corruption Hiding managerial acts © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 2: Cost Terminology and Cost Behaviors

Learning Objectives Why are costs associated with a cost object?
What assumptions do accountants make about cost behavior, and why are such assumptions necessary? How are costs classified on financial statements, and why are such classifications useful? How does the conversion process occur in manufacturing and service companies? What are the product cost categories, and what items comprise those categories? How and why does overhead need to be allocated to products? How is cost of goods manufactured calculated and used in preparing an income statement? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost Monetary measure of resources given up to attain an objective (such as acquiring a good or delivering a service) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost Categories Association with cost object
Cost object is anything for which management wants to collect or accumulate costs Reaction to changes in activity Classification on the financial statements © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Association with a Cost Object
Direct—traceable to a cost object Indirect—not conveniently or practically traceable to a cost object Treated as overhead Allocated © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Reaction to Changes in Activity
Variable Fixed Mixed Step Relevant Range—normal operating range © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost Reaction to Changes in Activity
Variable cost Fixed Cost $ $ # of Units # of Units Within the relevant range © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Variable cost Fixed Cost $ $ Total Total # of Units # of Units $ $ Unit Unit Within the relevant range # of Units # of Units © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Total and Unit Cost Behavior
Varies in direct proportion to changes in activity Remains constant throughout the relevant range throughout the relevant range Varies inversely with changes in activity throughout the relevant range Variable Cost Fixed Total Cost Unit Cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Step Cost (fixed) Mixed Cost $ fixed variable $ # of Units # of Units Within the relevant range © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Determining Cost Behavior
Cost Predictor Activity accompanied by consistent, observable changes in a cost item Predicts but may not cause the cost to change Cost Driver Activity that has a direct cause-effect relationship on cost Directly causes the cost to change © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Classification on the Financial Statements
Unexpired—balance sheet assets Expired—income statement expenses Product—inventoriable costs Prime—direct material and direct labor Conversion—direct labor and overhead Product costs are unexpired before sale Product costs are expired when sold Period—expensed in period incurred © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Product Costs Product costs
Direct material—Measurable part of a product Direct labor—Labor used to manufacture a product or perform a service Overhead—Indirect production cost First appear on the balance sheet in inventory accounts Transferred to the income statement when product is sold © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Period Costs Period costs Appear on the income statement when incurred
Selling and administrative costs Distribution costs Cost to warehouse, transport, and/or deliver a product or service Major impact on managerial decision making Appear on the income statement when incurred Expensed when incurred © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Conversion Process
Change inputs into outputs © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Conversion Process
Input Output Purchase raw materials or supplies Product or Service CONVERSION © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Degrees of Conversion High Low Moderate Manufacturing
Construction Agriculture Architecture Auditing Mining Printing Restaurants Low Department stores Gas stations Jewelry stores Travel agencies Moderate Florists Meat markets Oil-change businesses © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Service Company Input Output
Purchase supplies Significant amount of labor Tangible or intangible output Use supplies, labor, overhead to provide service Output Sell to customer © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Retail Company Input Output
Purchase products for resale Warehouse and/or display Input Output Sell to customer Purchase finished goods Resell to customers © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Manufacturer Input Output
Significant amount of labor and machinery Tangible output Input Output Purchase raw materials and supplies Finished product Production Center add labor and overhead Sell to customer © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Finished Goods Inventory
Cost Accumulation in a Manufacturing Company Materials Inventory Work in Process Inventory Finished Goods Inventory Cost of Goods Sold Income Statement Balance Sheet © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Product Cost—Direct Direct Material Direct Labor
Conveniently and economically traced to cost object Direct Labor To manufacture a product or perform a service Includes wages paid to direct labor employees, production bonuses, payroll taxes May include holiday and vacation pay, insurance, retirement benefits © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Product Cost—Indirect
Overhead—indirect production costs Fringe benefits, if cannot be easily traced to product Overtime, if due to random scheduling Cost of quality Prevention costs Appraisal costs Failure costs © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Product Cost Behavior Direct Material Variable Direct Labor Variable
Overhead Variable, fixed, or mixed © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Overhead Cost Allocation
Assign indirect costs to one or more cost objects To determine full absorption cost (GAAP) To motivate management To compare alternative courses of action for planning, controlling, and decision making Allocation process should be rational and systematic © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Allocating Overhead Actual Cost System
Product Cost Direct Materials Direct Labor Overhead Cost Used Actual © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Allocating Overhead: Actual Cost System
The Actual Cost System is not timely All costs must be known before calculating product cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Allocating Overhead: Actual vs. Normal
Product Cost Direct Materials Direct Labor Overhead Actual Cost System Actual Normal Cost System Actual Predetermined Overhead Rate © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Predetermined Overhead Rate
Allows overhead to be assigned during the period Compensates for fluctuations that are not related to activity level in activity level that do not affect fixed overhead © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Flow of Product Costs Raw Materials Inventory XXX Accounts Payable XXX
Work in Process Inventory XXX Raw Materials Inventory XXX Work in Process Inventory XXX Variable Overhead Control XXX Fixed Overhead Control XXX Salaries/Wages Payable XXX © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Flow of Product Costs Variable Overhead Control XXX
Fixed Overhead Control XXX Utilities Payable XXX Supplies Inventory XXX Accumulated Depreciation–Equipment XXX Other accounts XXX © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Flow of Product Costs Work in Process Inventory XXX
Variable Overhead Control XXX Fixed Overhead Control XXX Finished Goods Inventory XXX Work in Process Inventory XXX © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Matches revenues and expenses on the income statement
Flow of Product Costs Accounts Receivable XXX Sales XXX Cost of Goods Sold XXX Finished Goods Inventory XXX Matches revenues and expenses on the income statement © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Statement of Cost of Goods Manufactured—Raw Materials Used
Beginning balance $ 73,000 Purchases of materials ,000 Raw materials available $353,000 Ending balance <69,000> Total raw materials used $284,000 To Statement of Cost of Goods Manufactured © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Statement of Cost of Goods Manufactured
Beginning work in process $145,000 Raw materials used $284,000 Direct labor ,000 Variable overhead ,200 Fixed overhead ,880 Current period manufacturing costs ,080 Total costs to account for $1,079,080 Ending work in process <20,880> Cost of goods manufactured $1,058,200 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Schedule of Cost of Goods Sold
Beginning Finished Goods $ ,400 Cost of Goods Manufactured 1,058,200 Cost of Goods Available for Sale $1,145,600 Ending Finished Goods <91,600> Cost of Goods Sold $1,054,000 From Schedule of Cost of Goods Manufactured © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Income Statement From Schedule of Cost of Goods Sold Revenue XXXX
Gross Profit XXXX Operating Expenses <XXXX> Operating Income XXXX From Schedule of Cost of Goods Sold © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Questions What is the difference between a fixed and variable cost?
What are the three components of product cost? What are the three inventory accounts for a manufacturing company? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Ethical Issues Expired costs—not on the balance sheet
Period costs—not inventory Product costs—not selling or administrative costs Direct labor—not overstated Ending inventory—not overstated © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing

Learning Objectives Why and how are overhead costs allocated to products and services? What causes underapplied or overapplied overhead, and how is it treated at the end of a period? What impact do different capacity measures have on setting predetermined overhead rates? How are the high-low method and least squares regression analysis used in analyzing mixed costs? How do managers use flexible budgets to set predetermined overhead rates? How do absorption and variable costing differ? How do changes in sales or production levels affect net income computed under absorption and variable costing? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Allocating Overhead Actual vs. Normal
Product Cost Direct Materials Direct Labor Overhead Actual Cost System Actual Normal Cost System Actual Predetermined Overhead Rate © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Predetermined Overhead Rate
Allows overhead to be assigned during the period, fulfilling the matching principle Adjusts for variations not related to activity Compensates for fluctuations in activity level that do not affect fixed overhead Allows managers to be aware of product, product line, customer, and vendor profitability © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

= = Predetermined Overhead Rate Total budgeted overhead Predetermined
A budgeted, constant charge per unit of activity used to assign overhead to production or services Total budgeted overhead Activity level (Volume) (usually for a year) Predetermined Overhead Rate = $100,000 5,000 Direct Labor (DL) Hours = $20 per DL Hour © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Activity Level: The Denominator
Relationship between the overhead cost and the activity Production volume Direct labor hours Direct labor cost Machine hours Number of purchase orders or parts Machine setups Material handling time © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Total budgeted variable overhead
Predetermined Overhead Rate Total budgeted variable overhead Activity level (Volume) $375,000 50,000 machine hours $7.50 per machine hour = Total budgeted fixed overhead Activity level (Volume) $630,000 50,000 machine hours $12.60 per machine hour = © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Applying Variable Overhead
For one month Actual activity level times Predetermined overhead rate equals overhead applied 4,300 actual machine hours times $7.50 Predetermined variable overhead rate equals $32,250 overhead applied Apply Variable Overhead Work in Process Inventory 32,250 Variable Manufacturing Overhead ,250 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4,300 actual machines hours times
Applying Fixed Overhead For one month Actual activity level times Predetermined overhead rate equals overhead applied 4,300 actual machines hours times $12.60 Predetermined fixed overhead rate equals $54,180 overhead applied Apply Fixed Overhead Work in Process Inventory 54,180 Fixed Manufacturing Overhead ,180 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

(Combined Fixed/Variable)
Recording and Applying Overhead For one month Overhead Account (Combined Fixed/Variable) Actual Overhead Applied Overhead Variable ,250 Fixed ,180 Apply Overhead (combined journal entry) Work in Process Inventory ,430 Variable Manufacturing Overhead 32,250 Fixed Manufacturing Overhead ,180 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

(Combined/Fixed/Variable)
Recording Actual Overhead For one month Overhead Account (Combined/Fixed/Variable) Actual Overhead Applied Overhead Variable ,385 Fixed ,970 Variable ,250 Fixed ,180 Record actual overhead Variable Manufacturing Overhead 31,385 Fixed Manufacturing Overhead 55,970 Various Accounts ,355 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

(Combined Fixed/Variable)
Manufacturing Overhead For the entire year Overhead Account (Combined Fixed/Variable) Actual Overhead Applied Overhead Fixed ,000 Fixed ,000 Overhead is $40,000 overapplied $220,000 of actual overhead was incurred $260,000 was applied to Work in Process © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Manufacturing Overhead: Single Account, Variable, and Fixed

Disposing of Overhead Differences
If overhead is underapplied, the adjusting entry increases Cost of Goods Sold decreases Net Income If overhead is overapplied, the adjusting entry decreases Cost of Goods Sold increases Net Income © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Immaterial Cost of Goods Sold Material— Prorate to Work in Process Finished Goods Cost of Goods Sold © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Immaterial Cost of Goods Sold Material Prorate to Work in Process Finished Goods Cost of Goods Sold © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Alternative Capacity Levels (The Denominator Level)
Capacity measure of volume or some other activity base Alternative measures Theoretical Practical Normal Expected Choice of capacity level affects product cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Theoretical Capacity Machinery breakdown Holiday downtime
All production factors are operating perfectly Disregards Machinery breakdown Holiday downtime Results in Significant underapplied overhead Lowest product cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Practical Capacity Theoretical capacity reduced by ongoing, regular operating interruptions (holidays, downtime, and start-up time) Usually results in Underapplied overhead Low product cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Normal Capacity Considers Attainable level of activity
Historical production level Estimated future production level Cyclical fluctuations Attainable level of activity When normal capacity is greater than expected capacity, may result in Underapplied overhead Higher product cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Expected Capacity Anticipated activity level for the upcoming period based on projected product demand Determined during the budget process Should closely reflect actual costs Results in Immaterial overapplied or underapplied overhead Highest product cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Alternative Capacity Levels (The Denominator Level)
Theoretical lowest product cost Practical low product cost Normal higher product cost * Expected highest product cost *assuming normal exceeds expected capacity © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Analyzing Mixed Costs $ Mixed Cost # of Units
A mixed cost contains both a variable and fixed component Mixed Cost variable $ fixed # of Units © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Separating Mixed Costs
To determine variable and fixed predetermined overhead rates, separate mixed costs into variable and fixed components Use formula for a straight line: y = a + bX y = total cost a = fixed portion of total cost b = variable cost X = activity base to which y is related © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Methods for Separating Mixed Costs
High-Low Method Actual cost observations Considers only two data points Highest and lowest levels of activity Disregard outliers when analyzing mixed costs Least Squares Regression Analysis Statistical technique that analyzes the relationship between dependent and independent variables Dependent variable—Cost Independent variables—Activities Regression line provides line of best fit for the data © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Using the High–Low Method
Machine Hours Cost High 9,000 $3,500 Low 4,600 2,180 Difference 4,400 $1,320 $1,320 4,400 = $0.30/unit Variable cost per unit 3,500 = a + ($0.30)(9,000) a = 800 Fixed cost Y = $800 + $0.30X (X = machine hours) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Regression Analysis Assumptions
Independent variable must be a valid predictor of the dependent variable Coefficient of correlation Reliable only within the relevant range Useful only as long as circumstances existing at the time of its development remain constant © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

better estimate of total costs
Estimated Total Costs High—Low Method $ $0.30X Regression Analysis $ $0.35X More data points mean a better estimate of total costs (X = machine hours) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Flexible Budgets Separate overhead costs into fixed and variable components in order to estimate the amount of overhead at various levels of the denominator activity Shows manufacturing overhead costs and cost behavior Separates costs into fixed and variable elements Provides budgeted costs at various activity levels Shows impact of a change in the denominator level of activity © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Preparing a Flexible Budget
Separate mixed costs into variable and fixed elements Determine the a + bX cost formula Select several potential levels of activity within the relevant range Determine total cost expected at each of the activity levels © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Flexible Budgets © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Absorption vs. Variable Costing
Absorption or Full Costing External use GAAP Classify by Function Cost of goods sold Selling expense Administrative expense Variable or Direct Costing Internal use Not GAAP Classify by Behavior Variable Fixed © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Absorption vs. Variable Costing
Absorption or Full Product costs Direct material Direct labor Variable mfg. overhead Fixed mfg. overhead Period costs Selling General Administrative Variable or Direct Product costs Direct material Direct labor Variable mfg. overhead Period costs Fixed mfg. overhead Selling General Administrative © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Differences Between Absorption and Variable Costing
Absorption Costing Fixed manufacturing overhead is a product cost Variable Costing Fixed manufacturing overhead is a period cost Variable operating expenses are subtracted from product contribution margin to equal contribution margin © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Income Statement Absorption Costing
Sales Less: Cost of Goods Sold Gross Profit Less: Operating Expenses Net Income Product Costs Direct Material Direct Labor Fixed and Variable Mfg. Overhead Period Costs Selling, General, Administrative © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Variable Costing or Contribution Margin Income Statement
Sales Less: Variable Cost of Goods Sold Product Contribution Margin Less: Variable Operating Expenses Contribution Margin Less: Fixed Mfg. Overhead Less: Fixed Operating Expenses Net Income Direct Material Direct Labor Variable Mfg. Overhead Selling, General, Administration Selling General Administrative © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Difference in Income Absorption vs. Variable
No change in inventory level Absorption Income = Variable Income Increase in inventory level Absorption Income > Variable Income Phantom Profits Decrease in inventory level Absorption Income < Variable Income © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Questions How does underapplied overhead affect cost of goods sold and net income? What two methods are used to separate mixed costs into variable and fixed costs? What is the difference between absorption and variable costing? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Using high activity level for overhead application rate resulting in lower overhead rate, lower product cost, and higher operating income Using high production estimate resulting in lower overhead rate, lower product cost, and higher operating income Treating period costs as product costs resulting in higher inventory and net income Manipulating sales reporting at the end of an accounting period Choosing overhead allocation methods that distort cost and profit of certain products or subunits © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 4: Activity-Based Management and Activity-Based Costing

Learning Objectives In an activity-based management system, what are value-added and non-value-added activities? How do value-added and non-value-added activities affect manufacturing cycle efficiency? Why is it important to analyze the drivers of costs? How are product costs computed using an activity-based costing system? Under what conditions is activity-based costing useful in an organization and what information do activity-based costing systems provide to management? What criticisms have been directed at activity-based costing? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Activity-Based Management
Focuses on activities during production and performance process An activity is a repetitive action performed in fulfillment of a business function Improves the value received by customers Enhances profitability © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Activity-Based Management
Activity analysis Cost driver analysis Activity-based costing Continuous improvement Operational control Quality management Business process improvement Performance measurement © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Benefits of Activity-Based Management
Internal benefits More efficient production More accurate cost determination More effective performance evaluation External benefits Increased customer value Enhanced profitability © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Activity Analysis Non-value-added activity Value-added activity
Increases time spent on product or service but does not increase worth Unnecessary from customer perspective Can be reduced, redesigned or eliminated without affecting market value or quality Business-value-added activities are essential Value-added activity Increases worth of product or service to a customer Customer is willing to pay for it © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 113

Process Production Distribution Selling Administration
A process is a series of activities that, when performed together, satisfy a specific objective Production Distribution Selling Administration © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 114

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 115

Activity Analysis Create a Process Map (detailed flowchart) for each process Identify each step Create Value Chart Identify stages and time spent in stages from beginning to end of process Value-Added Processing Time Service Time Non-Value-Added Inspection Time Transfer Time Idle Time © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cycle Time Eliminate or minimize activities that add the most time and cost and the least value Cycle Value- Non- Time = Added + Value-Added Time Time © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Manufacturing Cycle Efficiency
Cycle Efficiency (MCE) Value-Added Processing Time Total Cycle Time = 100% efficiency unrealistic Reducing non-value-added activities will increase MCE Value-added activity usually represents about 10% of total cycle time Just-in-time (JIT) increases MCE © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Non-Value-Added Activities
Attributed to following factors Systemic Physical Human Eliminating or reducing non-value-added activities that create the most costs will Increase product/service quality Decrease cycle time and cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost Driver Analysis Cost drivers are factors that have a direct cause–effect relationship to a cost Limit the number of cost drivers Cost of measurement should not exceed benefit of using the cost driver Easy to understand Directly related to the activity being performed Appropriate for measurement © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A Management Tool Combine: What activities are non-value-added?
Activity analysis What activities are non-value-added? Cost driver analysis What causes costs to be incurred? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost Drivers Unit-level costs Batch-level costs
direct material, direct labor Batch-level costs setup, inspection Product/process-level costs engineering changes, product development Organizational or facility costs building depreciation, plant manager’s salary © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Product Cost Behavior Unit-level costs are variable in relation to change in production volume Batch, product/process, and organizational level costs are variable for reasons other than changes in production volume © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Product Cost Unit-Level Allocate over number Cost per unit Costs
of units produced Cost per unit Batch-Level Costs Cost per unit in batch Allocate over number of units in batch Product/Process- Level Costs Allocate over number of units produced in related product line Cost per unit in product line © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 125

Product and Company Profitability Unit Batch Total product revenue
<Total product cost> Net product margin +/– All other net product margins Total margin provided by products <Organizational/facility-level costs> Company profit or loss Unit Batch Product Not GAAP © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 127

Activity-Based Costing
Recognizes several levels of costs Accumulates costs into related cost pools Uses multiple cost drivers to assign costs to products and services © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 128

When to Use ABC Companies use ABC when:
They have a wide variety of products or services High overhead costs are not proportional to the unit volume of individual products Automation makes it difficult to assign overhead to products using direct labor or machine hours Profit margins are difficult to explain Hard-to-make products show big profits and easy-to-make products show losses © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 129

Two-Step Allocation Collect costs in general ledger and subsidiary accounts Identify activity centers Choosing an activity center Geographical proximity of equipment Centers of managerial responsibility Magnitude of product costs Choose a manageable number of activity centers Accumulate costs into activity center cost pools Identify cost drivers Costs in each cost pool are Driven by homogenous activities Strictly proportional to the activity Allocate costs to products and services Activity driver measures demands placed on activities, thus, the resources consumed by products/services © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 130

Activity Drivers Reports requested Job change actions Hiring actions
Training hours Transactions processed Engineering changes Defects discovered Repair hours Material requisitions Purchase requisitions Space occupied Set-ups Moves Employees © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 131

Activity-Based Costing
Record Costs in GL Activity Driver Accumulate in Activity Center Cost Pools Cost Driver Cost Objects © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 132

Traditional vs. ABC Costing
When ABC is implemented Cost is reduced for high-volume, standard products Cost is increased for low-volume, complex specialty products © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 133

Long-Term Variable Costs
Cost drivers Product variety—number of different types of products Product complexity—number of processes through which a product flows © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ABC Costing Considerations
Number and diversity of products/services produced Diversity and differential degree of support services used for different products Extent to which common processes are used Effectiveness of current cost allocation methods Rate of growth of period costs © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 135

Use ABC Costing for… Product Variety and Process Complexity
Lack of Commonality in Overhead Costs Problems with Current Cost Allocations Changes in Business Environment © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 136

Use ABC Costing for… Product Variety and Process Complexity
Caused by mass customization Too many choices, opportunity for errors Pareto Principle Commonality of parts Reduced by Simultaneous (or Concurrent) Engineering Design for Manufacturability © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 137

Use ABC Costing when… Lack of Commonality in Overhead Costs
Some products/services use substantially more overhead than others Problems with Current Cost Allocations Significant changes in process with no change in cost allocations Expense majority of period costs when incurred Changes in Business Environment Increase in competition or change in management strategy © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 138

Continuous Improvement
Eliminates non-value-added activities to reduce cycle time Makes products/performs services with zero defects Reduces product costs on an ongoing basis Simplifies products and processes ABC Costing Supports Continuous Improvement © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 139

Criticisms of ABC Significant amount of time and cost to implement
Must overcome barriers to change Does not conform to GAAP © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 140

Advantages of ABC and ABM
Identify and monitor significant technology costs Trace technology costs directly to products Increase market share Identify the cost drivers that create or influence cost Identify activities that do not contribute to perceived customer value Understand the impact of new technologies on all elements of performance Translate company goals into activity goals Analyze the performance of activities across business functions Analyze performance problems Promote standards of excellence © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Questions What are the differences between activity-based costing and traditional cost accounting? What are cost drivers and activity drivers? What are two advantages and two criticisms of activity-based costing? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 143

Ignoring non-value-added activities Using non-value label to eliminate jobs Misclassifying activities to allocate costs away from lower volume products to justify lower selling prices Selecting an inappropriate cost driver to distort cost calculations Using ABC to eliminate a vendor or customer Using ABC to eliminate funding of social or environmental causes Using ABC to transfer cost from fixed price contracts to cost-plus contracts © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 144

Chapter 5: Job Order Costing

Learning Objectives How do job order and process costing systems, as well as their related valuation methods, differ? What are the fundamental characteristics of a job order costing system? What are the primary documents supporting a job order costing system and what purposes are served by each of them? How are costs accumulated in a job order costing system? How are standard costs used in a job order costing system? How does information from a job order costing support management decision making? How are losses treated in a job order costing system? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Job Order or Process Costing
Small quantities Batches of identifiable, tailor-made products User-specific services Tracks costs by job Process Large quantities Homogeneous goods Tracks costs by batch of goods by department © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Job Order Costing A job is a single unit or group of units identifiable as being produced to distinct customer specifications A job can be a Client Engagement Project Contract © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 148

Product Costing Cost identification Cost measurement
Product cost assignment Methods of product costing: Cost Accumulation System defines Cost object Method of assigning costs to production Valuation Method specifies How product costs will be measured © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Six Possibilities COST ACCUMULATION SYSTEM V A L M U E A T T H I O O D
Job Order Actual Normal Standard Process Actual Normal Standard © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Valuation Methods Actual Standard Normal The Difference
Actual direct material Actual direct labor Actual overhead Normal Predetermined overhead Standard Standard direct material Standard direct labor Standard overhead The Difference © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 151

Job Order Costing System
Each job is a cost object Costs are accumulated for each job A job can consist of one or more units of output There is a subsidiary ledger for each job © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 153

Job Order Costing System
WIP Subsidiary Ledger Job 2 Job 1 Job 3 WIP Control = 100 200 500 Job Job Job Total 800 Job 1 + Job 2 + Job = WIP Control © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 154

Material Requisition Form
Tracks who is responsible for materials Verifies flow of materials from warehouse to department to job Journal entry Work in Process Inventory (direct material) Manufacturing Overhead (indirect material) Raw Material Inventory © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Materials Requisition Form
Date ___________________ No. 341 Job No. _________________ Department _______________ Issued by _________________ Authorized by ___________ Inspected by _______________ Received by _____________ Item Part Unit of Quantity Quantity Unit Total No. No. Descrip. Measure Required Issued Cost Cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 156

Job Order Cost Sheet All financial information about a job
Direct material (from material requisitions) Direct labor (from time sheets or labor tickets) Applied overhead Budgeted cost information When job is complete, use job order cost sheet to analyze actual costs compared with budgeted costs © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Job Order Cost Sheet Materials Date Ref# Amount Direct Labor
Customer ____________ Job No. 315 Starting Date _________ Job Description ____________ Completion Date ______ Contract Price _____________ Materials Date Ref# Amount Direct Labor Date Ref # Amount Overhead Applied Date Ref# Amount Total Materials _________ Total Labor _________ Total Cost of Job Total OH Applied _________ ======== © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 158

Employee Time Sheet Time worked on each job Journal entry
Work in Process Inventory (direct labor) Manufacturing Overhead (indirect labor) Salaries and Wages Payable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 160

Employee Time Sheet For week ending _______ Start Stop Total
Employee Name _______________ Employee No. _______________ Department _______________ For week ending _______ Start Stop Total Type of Work Job No. Time Time Day Hours Employee Signature Supervisor’s Signature © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 161

Manufacturing Overhead
Overhead Account Actual Overhead Applied Overhead Journal Entry Work in Process Inventory Manufacturing Overhead (applied) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 162

Completion of a Job Move job cost sheet from WIP subsidiary to Finished Goods subsidiary Journal entry Finished Goods Inventory Work in Process Inventory © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Matches revenues and expenses on the income statement
Sale Journal entry Accounts Receivable Sale Cost of Goods Sold Finished Goods Inventory Matches revenues and expenses on the income statement © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 164

Job Order Costing and Technology
Automate data collection and data entry Accounting software includes job costing modules Share information using intranet Intranet: Restricted network for sharing information and delivering data from corporate databases to local-area network (LAN) desktops © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Journal Entries WIP consists of job cost sheets W & Sal Pay Materials
WIP-Job 1 FG Accts Pay WIP-Job 2 Overhead CGS WIP consists of job cost sheets © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 166

Purchase Materials on Account (a)
W & Sal Pay Materials WIP-Job 1 FG a Accts Pay WIP-Job 2 Overhead CGS a © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 167

Use Materials Requisition to Request Materials for Jobs (b)
W & Sal Pay Materials WIP-Job 1 FG a b b Accts Pay WIP-Job 2 Overhead CGS a b b Direct materials to WIP Indirect materials to Overhead © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 168

Apply Overhead (d) c b a b c d b a b d c c d W & Sal Pay Materials
WIP-Job 1 FG c b a b c d Accts Pay WIP-Job 2 Overhead CGS b a b d c c d © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 169

Complete Job 1 (e) c b e e a b c d b a b d c c d W & Sal Pay Materials
WIP-Job 1 FG c b e e a b c d Accts Pay WIP-Job 2 Overhead CGS b a b d c c d © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 170

Sell Job (f, g) b e e c f a b c d b f a b d c c d g g W & Sal Pay
Materials WIP-Job 1 FG b e e c f a b c d Accts Pay WIP-Job 2 CGS Overhead b f a b d c c d Accts Rec Sales g g © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 171

Standard Cost System Actual cost Normal cost Standard cost
Predetermined norms (or standards) for materials, labor, and overhead Compare actual costs to standard costs— difference is a variance © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 172

Management Use of Job Order Costing Systems
Estimate future job costs Establish realistic bids and selling prices Develop budgets and standards Compare actual costs to estimated costs Furnish performance evaluation information based on profitability of jobs © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 173

Product and Material Losses
Shrinkage Evaporation Leakage Oxidation Production errors Defects can be economically reworked Spoilage cannot be economically reworked © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 174

Normal vs. Abnormal Loss
Normal Loss—expected during production Anticipated on all jobs Include cost when calculating predetermined overhead application rate Include cost less the estimated disposal value Specific to a job Applied to the specific job Abnormal Loss—exceeds what is expected during production Abnormal spoilage Period cost—includes cost of abnormal loss less any disposal value © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Product and Material Losses
Normal Loss Abnormal Loss Loss for most jobs In overhead rate Period cost Loss identified with a specific job Charge to specific job Period cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 176

Questions What is the difference between job order and process costing systems? How do actual, normal, and standard costing valuation methods differ? How is the job order cost sheet used? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 177

Inflating costs assigned to cost-plus contracts Assigning costs from a fixed-fee contract to a cost-plus contract Substituting materials with inferior quality Overstating costs included in Work in Process Using methods or materials that violate intellectual property rights of other firms Recording sales value of defective work as “Other Revenue” © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 178

Chapter 6: Process Costing

Learning Objectives Why are equivalent units of production used in process costing? How are equivalent units of production, unit costs, and inventory values determined using the weighted average (WA) method of process costing? How are equivalent units of production, unit costs, and inventory values determined using the first-in, first-out (FIFO) method of process costing? How are transferred-in costs and units accounted for in a multidepartment production setting? How are equivalent units of production, unit costs, and inventory values determined using the standard costing method of process costing? Why would a company use a hybrid costing system? (Appendix 1) What alternative methods can be used to calculate equivalent units of production? (Appendix 2) How are normal and abnormal spoilage losses treated in an EUP schedule? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Job Order vs. Process Costing
Small quantities of distinct products or services Assign costs to job and then to units within the job Process Costing Large quantities of homogeneous products or services Using an averaging technique, assign costs directly to units produced during the period © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 181

Process Costing Unit Cost = Production Costs Production Quantity
Averaging technique to assign costs to units produced Unit Cost = Production Costs Production Quantity © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Production Costs The Numerator—Production Costs
Accumulate costs by department Accumulate costs by product Direct material from material requisitions Direct labor from time sheets and wage rates Overhead Actual Predetermined application rates Unit Cost = Production Costs Production Quantity © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Materials Requisition Form
Date ___________________ No. 341 Job No. _________________ Department _______________ Issued by _________________ Authorized by ___________ Inspected by _______________ Received by _____________ Item Part Unit of Quantity Quantity Unit Total No. No. Descrip. Measure Required Issued Cost Cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 185

Employee Time Sheet For week ending _______ Start Stop Total
Employee Name _______________ Employee No. _______________ Department _______________ For week ending _______ Start Stop Total Type of Work Job No. Time Time Day Hours Employee Signature Supervisor’s Signature © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 186

Units Produced The Denominator—Units Produced
Complicated by work in process Units started last period and completed this period Units started this period and not completed Convert partially completed units to equivalent whole units Unit Cost = Production Costs Production Quantity © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Equivalent Units of Production
Approximation of the number of whole units of output that could have been produced from the actual effort expended Includes units Started last period and finished this period Started and finished this period Started this period and not finished Assumes FIFO physical flow through the production department © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 188

Two Process Costing Methods
Weighted Average (WA) Method Combines beginning work in process current period production First-in, First-Out (FIFO) Method Separates © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 190

Process Costing Methods
WA Beginning WIP % Started and finished % Ending WIP % completed FIFO Beginning WIP % completed Started and finished 100% Ending WIP % completed The Difference © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 191

Process Costing Direct material Direct labor Overhead
Added at the beginning, during, and/or at the end of process Direct labor Added throughout the process Overhead Based on direct labor Based on other, multiple cost drivers © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 192

Process Costing Steps Units Costs Units to account for
Units accounted for Determine equivalent units Costs to account for Compute cost per equivalent unit Assign costs to inventories Costs © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 194

Cost of Production Report
Name of Department for the period --- Production Data: Units to account for Units accounted for EUP for each cost Cost Data: Costs to account for Cost per EUP Cost Assignment: Transferred Out Ending Work in Process Inventory   * Numbers correlate to the process costing steps in the previous slide     © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 195

Step 1—Units to Account For
Beginning WIP ,000 Started ,700 Units to account for 205,700 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 196

Step 2—Units Accounted For
Beginning WIP ,000 Started ,700 Units to account for 205,700 must be equal Finished and transferred 203,000 Ending WIP ,700 Units accounted for 205,700 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 197

Step 3—Compute Equivalent Units
DM Conversion Beginning WIP inventory , ,000 Started and completed , ,000 Ending WIP inventory , ,160* Equivalent units , ,160 * ending units * % complete 2,700 * 80% = 2,160 WA Method © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 198

Step 4—Costs to Account For
DM Conversion Total Beginning WIP $ 5, $ 16, $ 22,701 Current costs , , ,390 To account for $327, $677,028 $1,004,091 WA Method © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 199

Step 5—Cost per Equivalent Unit
DM Conversion Total Beginning WIP $ 5, $ 16, $ 22,701 Current costs , , ,390 To account for $327, $677,028 $1,004,091 Divide by EUP , ,160 Cost per EUP $ $ = $4.89 WA Method © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 200

Step 6—Assign Costs to Inventories
Transferred (203,000 * $4.89) $992,670 Ending WIP Inventory Direct Materials (2,700 * $1.59) $4,293 Conversion Costs (2,700 * 80% * $3.30) 7, ,421 Cost accounted for $1,004,091* *must agree with costs to account for Transferred Out Ending WIP WA Method © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 201

Process Costing—FIFO Emphasizes current period costs and production
Steps 1, 2, and 4 are the same © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 202

Step 3—Compute Equivalent Units
DM Conversion Beginning WIP/completed ,000* Started and completed 198, ,000 Ending WIP Inventory 2, ,160 Equivalent units , ,160 * beginning units * % complete in current period 5,000 * 60% = 3,000 FIFO Method © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 203

Step 5—Cost per Equivalent Unit
DM Conversion Total Current costs $321, $660, $981,390 Divide by EUP , ,160 Cost per EUP $ $ = $4.85 * Recall that Step 4 is the same as used for the WA method FIFO Method © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 204

Step 6—Assign Costs to Inventories
Transferred Beginning WIP Inventory $22,701 Cost to complete Conversion (3,000 * $3.25) , $ 32,451 Started and completed (198,000 * $4.85) ,300 Total cost transferred $992,751 Ending inventory Direct Materials (2,700 * $1.60) $4,320 Conversion Costs (2,7000 * 80% * $3.25) , ,340 Cost accounted for $1,004,091* *must agree with costs to account for Transferred Out Ending WIP FIFO Method © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 205

Process Costing Comparison
WA EUP DM ,700 EUP Conversion 205,160 Cost per unit DM $1.59 Cost per unit Conv Total $4.89 Transferred Out $992,670 Ending WIP ,421 Total $1,004,091 FIFO EUP DM ,700 EUP Conversion 203,160 Cost per unit DM $1.60 Cost per unit Conv Total $4.85 Transferred Out $992,751 Ending WIP ,340 Total $1,004,091 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 206

Process Costing The purpose of the six steps
Assign a value to ending work in process Assign a value to items transferred out Prepare this journal entry Finished Goods Work in Process or Transferred-In Cost (successor department) Work in Process (current department) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 207

Multidepartment Processing
Wait Materials Transferred-In Cost Process 2 Wait Finished Product Process 3 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 208

Process Costing with Standard Costs
Simplify costing process Eliminate periodic cost recomputations Same as FIFO computations Emphasize current period costs and production Inventories are stated at standard cost Variances are calculated for material, labor, and overhead Assigns a “normal” production cost to the equivalent units of output each period Allows managers to quickly recognize and investigate significant deviations from expected production costs Allows benchmarking with other firms © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Hybrid Costing Systems
Characteristics of job order and process costing systems Various product lines Different direct material—job order costing Different direct labor—job order costing Same process—process costing Hybrid costing used for furniture, clothing, jam © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 210

Appendix 1— Alternative Cost Computation
There are two alternative methods to calculate WA and FIFO EUP Use alternative methods To confirm standard computation As a simplified computation © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Appendix 1— Traditional Cost Computation
Conversion Costs WA FIFO Beginning WIP inventory 5, ,000 Started and completed 198, ,000 Ending WIP inventory , ,160 Equivalent units , ,160 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 212

Appendix 1— Alternative Cost Computation 1
Units transferred out (whole units) Plus: Ending work in process (equivalent units) WA EUP Less: Beginning work in process (equivalent units) FIFO EUP © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 213

Conversion Costs Candles transferred 203,000 Ending WIP EUP ,160 WA EUP 205,160 Beginning WIP EUP (2,000) FIFO EUP ,160 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 214

Total units to account for Less: EUP to be completed next period WA EUP Less : EUP completed in prior period FIFO EUP © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 215

Conversion Costs Total units to account for ,700 EUP to be completed next period (540) WA EUP ,160 EUP completed in prior period (2,000) FIFO EUP ,160 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 216

Appendix 2—Spoilage Continuous loss—Loss occurs fairly uniformly through the process Discrete loss—Loss occurs at a specific point and is detectable only when a quality check is performed © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 217

Appendix 2—Spoilage Normal shrinkage and continuous losses
Assign costs only to units that have passed the inspection point Use Method of Neglect Excludes spoiled units in the equivalent units schedule Spreads cost of lost units proportionately over the good units transferred and those remaining in WIP inventory Abnormal losses Period expense Accounted for on an equivalent unit basis © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 218

Loss in all ending inventory and transferred-out units on an EUP basis
Appendix 2—Spoilage Normal Spoilage Abnormal Spoilage Loss in all ending inventory and transferred-out units on an EUP basis Continuous Loss Period expense in EUP Loss in all units past inspection point in ending inventory and transferred out on an EUP basis Discrete Loss Period expense in EUP © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 219

Questions What is an EUP?
What is the difference between the WA and FIFO methods of calculating equivalent units? Why would a company use a hybrid costing system? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 220

Over- or underestimating completion % for ending WIP inventory to distort results Using outdated standard costs Ignoring the assignment of significant direct costs to specific jobs Treating abnormal spoilage as normal spoilage © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 221

Chapter 7: Standard Costing and Variance Analysis

Learning Objectives How are material, labor, and overhead standards set? How are material, labor, and overhead variances calculated and recorded? Why are standard cost systems used? How have the setting and use of standards changed over time? How does the use of a single conversion element (rather than the traditional labor and overhead elements) affect standard costing? (Appendix) How are variances affected by multiple material and labor categories? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Standard Cost Systems Manufacturing Service Not-for-Profit
Record standard and actual costs in the accounting records © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Standards Standard costs are budgeted costs to
Manufacture a single unit of product or Perform a single service To develop standards, identify Material and labor types, quantities, and prices Overhead types and behavior © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Manufacturing Objective
Minimize unit cost while achieving certain quality specifications. Input Resources Output Quality © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 226

Material Standards Materials used From
Types Quantity Quality Price From Product specifications, observation, inquiry Bill of materials Balance cost, quality, and projected sales price Standard Material = Unit Purchase Price * quantity Cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 227

Labor Standards Labor used From Types Quantity Cost
Production, setup, cleanup, and rework Quantity Cost Include wages, payroll taxes, and fringe benefits From Industrial engineering studies including methods-time measurement (MTM), time and motion studies, historical data Operations flow document Standard Labor = Hours * Wage Rate Cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 229

Overhead Standards Variable and fixed manufacturing overhead
Estimated level of activity Estimated costs Predetermined factory overhead application rates © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 231

Standard Cost Card For one unit of output (a bike)
Standard Direct Material Components Standard Direct Labor Components Manufacturing Overhead Variable Overhead Fixed Overhead © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 232

Variance Variance is the difference between
an actual cost and a standard cost. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 234

Total Variance Actual price of actual production input
Total actual cost incurred minus total standard cost applied to output produced Standard cost of actual production output Actual price of actual production input Total Variance* *Favorable or unfavorable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 235

Total Variance SP x SQ AP x AQ Total Variance Inputs Outputs
AP = actual cost/price per unit of materials or hours of labor AQ = actual quantity of materials or hours of labor SP = standard cost/price per unit of materials or hours of labor SQ = standard quantity of materials or hours of labor © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 236

Price Variance AP x AQ SP x SQ Total Variance SP x AQ (AP – SP) x AQ*
Price/Rate Variance What was paid What should have been paid (AP – SP) x AQ* *Favorable or unfavorable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 237

Usage Variance AP x AQ SP x SQ Total Variance SP x AQ Usage Variance
What was used What should have been used for the level of output (AQ – SQ) x SP* *Favorable or unfavorable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 238

Material Price Variance (MPV)
AP x AQ SP x SQ Total Variance SP x AQ MPV What was paid What should have been paid (AP – SP) x AQ* *Favorable or unfavorable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 239

MPV Calculations Point of purchase or When materials used
Calculate MPV at Point of purchase or When materials used © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Material Quantity Variance (MQV)
AP x AQ SP x SQ Total Variance SP x AQ MQV What was used What should have been used for level of output (AQ – SQ) x SP* *Favorable or unfavorable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 241

Labor Rate Variance (LRV)
AP x AQ SP x SQ Total Variance SP x AQ LRV What was paid What should have been paid (AP – SP) x AQ* *Favorable or unfavorable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 242

Labor Efficiency Variance (LEV)
AP x AQ SP x SQ Total Variance SP x AQ LEV What was used What should have been used for level of output (AQ – SQ) x SP* *Favorable or unfavorable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 243

Overhead Variances Variable Overhead
Actual variable overhead is total of various ledger accounts SP = Predetermined variable overhead rate Fixed Overhead Actual fixed overhead is total of various ledger accounts SP = Predetermined fixed overhead rate © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 244

VOH Efficiency Variance
Variable Overhead Variances VOH Spending Variance VOH Efficiency Variance Total VOH Variance SP x SQ SP x AQ Actual VOH Budgeted VOH Applied VOH Actual For actual hours used What should have been used for level of output © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 245

VOH Spending Variance Caused by price differences
Managers have little control over prices Caused by shrinkage or waste Managers should be held accountable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 246

Fixed Overhead Variances
SP x SQ Actual FOH Budgeted FOH Applied FOH FOH Spending Variance FOH Volume Variance Total FOH Variance Constant Amount What should have been used for level of output © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 247

FOH Spending and Volume Variance
FOH Spending Variance Calculate variance for each component Caused by price differences May reflect mismanagement of resources FOH Volume Variance Measures capacity utilization Caused by producing at a level that differs from the capacity level used to compute the predetermined overhead rate Also called the noncontrollable variance © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Alternative Overhead Variance Approaches
One variance Two variance Three variance Four variance © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 249

One Variance Approach Standard Cost of OH Actual OH SP x SQ
Total OH Variance Applied Overhead © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 250

Two Variance Approach SP x SQ Actual OH Budgeted OH based on SQ
Standard Cost of OH Budget Variance Volume Variance Total OH Variance Applied Overhead © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 251

OH Efficiency Variance
Three Variance Approach Budgeted OH Actual OH Standard OH based on Actual Inputs based on Actual Output SP x SQ OH Spending Variance OH Efficiency Variance Volume Variance Total OH Variance Applied Overhead © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 252

Standard Cost Journal Entries
Variances recorded in accounting system Favorable variances Credits Represent savings in production costs Unfavorable variances Debits Represent excess production costs Inventories are recorded at standard cost during the period © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 253

(Point of Purchase Method)
Purchase of Materials (Point of Purchase Method) At Standard Cost Materials Price Variance Materials Accts Pay SP x AQ purchased U F AP x AQ purchased Debit—Unfavorable Credit—Favorable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 254

Use of Materials Materials Quantity Variance Materials WIP
Standard Cost Materials Quantity Variance WIP Materials SP x SQ allowed SP x AQ used U F Debit—Unfavorable Credit—Favorable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 255

Record Labor LEV LRV U F U F Wages Pay WIP SP x SQ allowed AP x AQ
At Standard Cost LRV U F U F WIP Wages Pay SP x SQ allowed AP x AQ Debit—Unfavorable Credit—Favorable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 256

Apply Overhead WIP VOH FOH SP x SQ Allowed SP x SQ Allowed SP x SQ

Enter a debit or credit to bring balance to zero
Year-End Treatment for VOH VOH Efficiency Variance VOH Spending Variance VOH Actual Applied Enter a debit or credit to bring balance to zero Debit—Unfavorable Credit—Favorable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 258

Enter a debit or credit to bring balance to zero
Year-End Treatment for FOH FOH Spending Variance Volume Variance FOH Actual Applied Enter a debit or credit to bring balance to zero Debit—Unfavorable Credit—Favorable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 259

Year-End Treatment of Variances
Immaterial—Adjust Cost of Goods Sold Material—Prorate variances to: Material Price Variances Raw Materials WIP Finished Goods Cost of Goods Sold All other variances WIP Finished Goods Cost of Goods Sold © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Why Use Standard Cost Systems
Motivation Planning Controlling—variance analysis Decision making Performance evaluation © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Setting Standards and Trends
Appropriateness Attainability Expected standards Practical standards Ideal standards Trends in Standards Ideal Standards and Theoretical Capacity Adjusting standards Price variance on purchase versus usage Decline in direct labor content © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Conversion Costs Combine direct labor and manufacturing overhead
Variances Spending variance for overhead Efficiency variances for machinery and production costs Volume variances for production © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Material Price, Mix, and Yield Variances
AM x AQ x AP SM x AQ x SP SM x SQ x SP AM x AQ x SP Material Price Variance Material Mix Variance Material Yield Variance What should have been used for level of output? AM—Actual Mix SM—Standard Mix © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 264

Labor Rate, Mix, and Yield Variances
AM x AH x AR SM x SH x SR AM x AH x SR SM x AH x SR Labor Rate Variance Labor Mix Variance Labor Yield Variance What should have been used for level of output? M—Mix H—Hours R—Rate © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 265

Questions How are standards set for material, labor, and overhead?
How is variance analysis used for control and performance evaluation? Why are labor and overhead elements sometimes combined into a single conversion element? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Setting high standards to create favorable variances Ignoring effects of one production area on another Setting overhead rates too low based on high production levels to distort inventory cost and operating income Producing inventory only to create a favorable volume variance Not updating standards so that favorable variances are created Using low quality materials or labor to create favorable variances and low quality products © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 8: The Master Budget

Learning Objectives How are strategic planning and tactical planning related to budgeting? What is the starting point of a master budget and why? What are the various components of a master budget and how are they prepared? Why is the cash budget so important in the master budgeting process? How and why are budgeted financial statements prepared at the end of the budgeting process? What benefits are provided by a budget? (Appendix) How does a budget manual facilitate the budgeting process? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Management and Planning
Planning is the cornerstone of effective management. Budgeting—Formalizes plans and translates qualitative narratives into a documented, quantitative format Budget—Expresses a commitment to planned activities and resource acquisition and use © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Planning Process Strategic Planning Tactical Planning Budget 271

Strategic Planning Long term (5 to 10 years) Top-level management
Long-range goals, strategies, and policies Foundation for short-term planning Identify and gather information on key variables, both internal and external © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 272

Strategic Planning Strategic Planning Effective strategic planning requires that managers build plans and budgets that integrate external considerations and influences with internal factors Core competencies Product development Product life cycles © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 273

External Key Variables
Strategic Planning Competitor actions Local and global market conditions Political/regulatory climates Current and emerging technology issues Outsourcing opportunities Consumer trends and attitudes Demographics © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 274

Tactical Plans Short term (1 to 18 months) Top and middle management
Planning Short term (1 to 18 months) Top and middle management Specific objectives and means to achieve strategic plans Basis against which results can be measured © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 275

Budgets Communicate objectives, constraints, and expectations
Provide financial predictions Provide nonfinancial performance goals and objectives Identify potential difficulties Determine resource allocation and constraints Permit control through budget-to-actual comparisons © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 276

Budget Budgeting Short term Top, middle, and operational management involvement Usable guidelines to implement strategic and tactical plans Allocates resources Standard against which performance can be measured © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 277

Top, Middle, and Operational
Planning Relationships Top Management Strategic Planning Top, Middle, and Operational Management Tactical Planning Budget Top and Middle Management © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 278

The Control Phase Actual-to-budget comparisons
Determining and investigating variances Corrective action Feedback to operating managers © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Master Budget Budget A comprehensive set of budgets, budgetary schedules, and pro forma organizational financial statements For a specific period of time Static—based on a single level of output demand Interactive—departments generate and consume information © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 281

The Master Budget Operating Budgets Financial Budgets Cash Budget
Sales Budget Cash Budget Production Budget Capital Expenditures Budget Purchases Budget Balance Sheet Direct Labor Budget Income Statement Overhead Budget Statement of Cash Flows Selling & Administrative Budget Statement of Retained Earnings © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 283

Sales Budget Sales forecast Ask sales personnel
Extrapolate past trends Use market research Employ statistical models and simulation Units to be sold * Selling price per unit = Dollars of sales © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Operating Budget Sales Budget Production Budget 285

Production Budget Production manager combines
Sales estimates Beginning inventory targets Ending inventory targets Determines the types, quantities, and timing of products to be manufactured © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 286

Ending Inventory Policy
Percentage of next period’s projected sales Constant amount Buildup of inventory for high-demand periods Near zero in just-in-time systems Cost of holding inventory includes storage, insurance, obsolescence, shrinkage, damage © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 287

Operating Budget Sales Budget Production Budget Purchases Budget
Direct Labor Budget © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 288

Direct Labor Budget Total number of people Specific types of workers
Production hours needed Costs Union contracts Minimum wage laws Fringe benefit costs Payroll taxes Units to be produced (or DM components) * Standard time allowed per unit = Standard labor time allowed * Per hour direct labor cost = Total direct labor cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Operating Budget Sales Budget Production Budget Overhead Budget
Purchases Budget Direct Labor Budget © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 290

Overhead Budget Identify activity base Estimate overhead costs
Separate costs as fixed or variable Show total costs for operating budgets Show costs without depreciation for cash budgets Predicted activity base * Variable overhead rate per unit of activity = Total variable overhead cost + Fixed overhead cost = Total overhead cost = Total cost without depreciation © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Operating Budget Sales Budget Selling & Admin Budget Production Budget
Purchases Budget Overhead Budget Direct Labor Budget © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 292

Selling and Administrative Budget
Predicted sales dollars (or other measure) * Variable S&A rate per dollar = Total variable overhead cost + Fixed S&A cost = Total S&A cost = Total cost without depreciation © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Financial Budget Cash Budget Operating Budget 294

Cash Budget Highlights importance of cash for organization’s continued existence Translates accrual-based information into cash flows Indicates effectiveness of credit practices Allows for planned cash borrowing or investing Used to prepare pro forma Cash Flow Statement Beginning cash balance + Cash receipts (collections) = Cash available for disbursements – Cash disbursements = Cash excess or deficiency – Minimum desired cash balance = Cash needed/available for investment or loan repayment +/– Various financing measures = Ending cash balance © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cash Collections/Disbursements
Sales Cash Accounts Receivable Disbursements Purchases Accounts Payable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 297

Cash Collections/Disbursements
Receipts/Disbursements From Jan Feb Mar Total Nov Dec Jan Feb Mar Total Percentage of cash received/paid during the month Reduced by discounts and estimated uncollectible accounts © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 298

How to Improve Cash Flow
Establish sound credit practices Expedite fulfillment and shipping Bill promptly and accurately Offer discounts for prompt payments Aggressively follow up on past due accounts Deposit payments promptly Seek better payment terms from suppliers/banks Keep tight control of inventory Review and reduce expenses Pay bills on time but never before they are due © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Financial Budget Cash Budget Capital Budget Operating Budget 300

Capital Budget Long-term fixed asset needs Payment points Plant
Equipment Payment points © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Financial Budget Cash Budget Capital Budget Operating Budget
Income Statement/ Cost of Goods Manufactured © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 302

The Financial Budget Cash Budget Capital Budget Income Statement/
Cost of Goods Manufactured Operating Budget Statement of Retained Earnings © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 303

Budgets Provide Budget Guide to align activities and resources with organizational goals Vehicle to promote employee participation, cooperation, and departmental coordination Tool to enhance planning, controlling, problem solving, and evaluating © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Budgeting Provides Budget Basis to sharpen responsiveness to internal and external factors Model to view future performance and consider alternative measures © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Budgeting Terms Continuous budgeting Budget slack Participatory budget
12-month rolling budget Budget slack Intentional underestimation of revenue Intentional overestimation of expenses Participatory budget Developed by top management and operating personnel Imposed budgets Developed by top management Imposed on operating personnel © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Activity Budget Connect line items in budget to list of activities
Raise awareness of non-value-added activities Question and reduce non-value-added costs © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Budget Manual (Appendix)
Statements of budgetary purpose and its desired results Listing of specific budgetary activities to be performed Calendar of scheduled budgetary activities Sample of budgetary forms Original, revised, and approved budgets © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Questions How are strategic and tactical planning related to budgeting? In what order are the master budget schedules prepared? Why is the cash budget important in the master budgeting process? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 309

Potential Ethical Issues (1 of 2)
Using a single budget system globally that may conflict with national cultures Permitting budget slack Distorting budgeting process by treating short-term conditions as long-term conditions Using fraudulent accounting techniques to meet budget goals Ignoring employee input in budgeting Justifying management decisions by using “backwards budgeting” © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 310

Potential Ethical Issues (2 of 2)
Disregarding contingencies in budgeting Ignoring external performance measures and benchmarks Failure to communicate “big picture” assumptions to all managers participating in the budget process Promoting “spend-it-or-lose-it” attitudes to punish cost savings and reward spending Mandating “across-the-board” budget cuts without considering alternative cost reductions © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 311

Chapter 9: Break-Even Point and Cost-Volume-Profit Analysis

Learning Objectives What is the break-even point (BEP) and why is it important? How is the BEP determined and what methods are used to determine BEP? What is cost-volume-profit (CVP) analysis and how do companies use CVP information in decision making? How do BEP and CVP analyses differ for single-product and multiproduct firms? How are margin of safety and operating leverage concepts used in business? What are the underlying assumptions of CVP analysis? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost-Volume-Profit Analysis
Relationship of Revenue Costs Volume changes Taxes Profits Applies to Manufacturers Wholesalers Retailers Service industries © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Variable Costing and CVP
Separates costs into fixed and variable components Shows fixed costs in lump-sum amounts, not on a per-unit basis Does not allow for deferral/release of fixed costs from/to inventory when production and sales volumes differ © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Use CVP Analysis to… Compute the BEP Study interrelationships of
Prices Volumes Fixed and variable costs Contribution margins Profits Calculate the level of sales necessary to achieve a target profit Set sales price Answer “what-if” questions to influence current operations and predict future operations © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

CVP Assumptions Company is operating within the relevant range
Revenue per unit remains constant Variable costs per unit remain constant Total fixed costs remain constant Mixed costs are separated into variable and fixed elements © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Important Equations Break-even point Contribution Margin (CM)
Total Revenues = Total Costs Total Revenues – Total Costs = Zero Profit Contribution Margin (CM) Sales Price – Variable Cost per unit = CM per unit Revenue – Total Variable Costs = CM in total Contribution Margin Ratio (CM%) Sales Price – Variable Cost Sales Price © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Break-Even Formula—Units
Total Fixed Costs Sales Price (per unit) – Variable Cost (per unit) Contribution Margin $100,000 $12 – $ = 12,500 units If fixed costs are $100,000, unit sales price is $12, and unit variable cost is $4, the BEP is 12,500 units. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Break-Even Formula—Dollars
Total Fixed Costs Sales Price (per unit) – Variable Cost (per unit) Sales Price (per unit) $100,000 $12 – $ = $150,000 $12 Contribution Margin Ratio If fixed costs are $100,000, unit sales price is $12, and unit variable cost is $4, the BEP is $150,000. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Income Statement Proof
Sales Less Total variable costs Contribution Margin Less Total fixed costs Profit before taxes $ 150, (12,500 * 12) (50,000) (12,500 * 4) $ 100,000 (100,000) -0- If fixed costs are $100,000, unit sales price is $12, and unit variable cost is $4, the BEP is 12,500 units. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Using CVP Analysis $100,000 + $30,000 12 – 4 = $195,000 12
Setting a target profit Enter before-tax profit in numerator $100,000 + $30,000 12 – = $195,000 12 If fixed costs are $100,000, unit sales price is $12, unit variable cost is $4, and the desired before-tax profit is $30,000, the required sales are $195,000. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Using CVP Analysis Setting a target profit $48,000 = 1 – 20% $60,000
Convert after-tax profit to before-tax profit Before-tax profit = After-tax profit 1 – tax rate $48,000 = 1 – 20% $60,000 At a 20% tax rate, an after-tax profit of $48,000 equals a before-tax profit of $60,000. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Using CVP Analysis $100,000 + $60,000 $12 – $4 = $240,000 $12
Setting a target profit Convert after-tax profit to before-tax profit Enter before-tax profit in numerator $100,000 + $60,000 $12 – $ = $240,000 $12 If fixed costs are $100,000, unit sales price is $12, unit variable cost is $4, and the desired after-tax profit is $48,000, the required sales are $240,000. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Sales Less Total variable costs Contribution Margin Less Total fixed costs Profit before taxes Income taxes Profit after taxes $ 240, (20,000 * 12) (80,000) (20,000 * 4) $ 160,000 (100,000) $ ,000 (12,000) (60,000 * 20%) $ ,000 If fixed costs are $100,000, unit sales price is $12, unit variable cost is $4, and the desired after-tax profit is $48,000, the required sales are $240,000. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Using CVP Analysis Set profit per unit X = FC/(CMu - PuBT) Profit
Before Tax Sales Volume Total Fixed Cost Contribution Margin © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Graph Approach to Breakeven
Break-even chart illustrates relationships among Revenue Volume Costs © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Traditional CVP Graph Total Costs Total Costs Total Total $
Activity Level Total Costs Variable Costs Total $ Activity Level Fixed Costs Total Costs Loss Total $ Activity Level Total Costs Total Revenues Profit Total $ Activity Level Total Costs Total Revenues © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Profit-Volume Graph $ BEP Activity Level Fixed Costs Profit Loss

Income Statement Approach
B/E $ 150,000 (50,000) $ 100,000 (100,000) -0- Target Profit $ 240,000 (80,000) $ 160,000 (100,000) 60,000 (24,000) $ ,000 Sales Less Total variable costs Contribution Margin Less Total fixed costs Profit before taxes Income taxes Profit after taxes Proof of CVP and/or graph solutions © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Incremental Analysis Focuses only on factors that change from one option to another Changes in revenues, costs, and/or volume BEP increases when Fixed costs increase Sales price decreases Variable costs increase © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Multiproduct CVP Analysis
Assumes a constant product sales mix Contribution margin is weighted on the quantities of each product included in the “bag” of products Contribution margin of the product making up the largest proportion of the bag has the greatest impact on the average contribution margin of the product mix © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

“Bag”—three units of first product for every two units second product.
Multiproduct CVP Analysis $8000 3($2) + 2($1) = 1,000 “bags” Sales mix 3 2 $2 $1 Contribution margin per unit Breakeven FC = $8,000 “Bag”—three units of first product for every two units second product. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

To break even, sell 3,000 of first product
Multiproduct CVP Analysis Sales mix 3 2 Breakeven “bag” x 1,000 3,000 x 1,000 2,000 Breakeven units To break even, sell 3,000 of first product and 2,000 of second product. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Product 1 3,000 X 2 $6,000 Product 2 2,000 X 1 $2,000 Total $8,000 (8,000) -0- Sales (units) CM per unit Total CM Less Total fixed costs Profit before taxes © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Margin of Safety How far the company is operating from its BEP
Budgeted (or actual) sales after the BEP The amount that sales can drop before reaching the BEP Measure of the amount of “cushion” against losses Indication of risk The lower the margin of safety, the more carefully management must watch sales and control costs. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Margin of Safety Units Actual units—break-even units Dollars
Actual sales dollars—break-even sales dollars Percentage Margin of Safety in units or dollars Actual unit sales or dollar sales © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Operating Leverage Relationship of variable and fixed costs
Effect on profits when volume changes Cost structure strongly influences the impact that a change in volume has on profits © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Operating Leverage High Operating Leverage Low Operating Leverage
Low variable costs High fixed costs High contribution margin High BEP Sales after break-even have greater impact on profits Low Operating Leverage High variable costs Low fixed costs Low contribution margin Low BEP Sales after break-even have lesser impact on profits © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Degree of Operating Leverage
Measures how a percentage change in sales will affect profits Degree of Operating Leverage Contribution Margin Profit Before Taxes © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Degree of Operating Leverage and Margin of Safety
When margin of safety is small, the degree of operating leverage is large Margin of Safety % = 1/Degree of Operating Leverage Degree of Operating Leverage = 1/Margin of Safety % © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Actual sales 200,000 units Break-even sales 90,000 units Contribution margin $408,000 Profit before tax $224,400 Margin of Safety % = Actual sales – Break-even sales Actual sales = 200,000 – 90,000 200,000 55% © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Actual sales 200,000 units Break-even sales 90,000 units Contribution margin $408,000 Profit before tax $224,400 Degree of Operating = Contribution margin Leverage = Profit before taxes = $408,000 $224,400 1.818 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

55% = 1.818 Degree of Operating = 1 Leverage Margin of Safety% = .55 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Additional CVP Assumptions
Total contribution margin increases proportionally with increases in unit sales No change in inventory (production equals sales) No change in capacity Sales mix remains constant Anticipated price level changes included in formulas Labor productivity, production technology, and market conditions remain constant Are fixed costs fixed or long-term variable costs? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Questions What is the difference between absorption and variable costing? How do companies use CVP analysis? What are the underlying assumptions of CVP analysis? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Ignoring relevant range in setting assumptions about cost behavior Using absorption (fixed manufacturing) costs as part of variable costs for CVP analysis Using improper assumptions about cost and volume relationships to manipulate results Assuming constant sales mix while ignoring demand for individual products Using CVP analysis to improperly support long-term cost management strategies Visually distorting break-even graphs Using irrelevant information in incremental analysis © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 10: Relevant Information for Decision Making

Learning Objectives What factors determine the relevance of information to decision making? What are sunk costs, and why are they not relevant in making decisions? What information is relevant in an outsourcing decision? How can management achieve the highest return from use of a scarce resource? What variables do managers use to manipulate sales mix? How are special prices set, and when are they used? How do managers determine whether a product line should be retained or discontinued? (Appendix) How is linear programming used to optimally manage multiple resource constraints? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 349

Relevant Costing Relevant Costing focuses managerial attention on a decision’s relevant facts Relevance Associated with the decision under consideration Important to the decision maker Connected to or bearing on some future endeavor Most variable costs are relevant Most fixed costs are not relevant © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Incremental Revenue, Cost, & Profit/Loss
Incremental Revenue—the amount of revenue that differs across decision choices Incremental Cost or Differential Cost—the amount of cost that varies across decision choices Incremental Profit or Loss—the difference between incremental revenue and incremental cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 351

Opportunity & Sunk Costs
Opportunity Costs—benefits foregone because one course of action is chosen over another Sunk Costs—costs incurred in the past to acquire an asset or a resource Not relevant because they cannot be changed regardless of future actions Not recoverable SUNK COSTS ARE IRRELEVANT. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Relevant Costing & Business Decisions
Outsourcing a product or part Allocating scarce resources Accepting special orders Determining the sales/production mix © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Outsourcing & Make-or-Buy Decions
Outsourcing—having work performed for one company by an off-site non-affiliated supplier Offshoring—sending a job formerly performed in the home country to a foreign country Make-or-Buy decisions compare internal production and opportunity costs with purchase cost Relevant information: Strategic Economic Technological Management and human resources Most outsourcing relates to operating costs not to strategic core competencies © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Make-or-Buy—Quantitative Factors
Incremental production costs per unit Cost to purchase outside Number of available suppliers Production capacity available Opportunity costs of production facilities Space available for storage Inventory carrying costs Increase in throughput from buying components © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Make-or-Buy—Qualitative Factors
Reliability of supply sources Ability to control quality of items purchased outside Nature/importance of the work to be subcontracted Impact on customers and markets Future bargaining position with supplier(s) Perceptions about future price changes Perceptions about current product prices © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Outsourcing Risk Pyramid
Strategic Direction, Unique Core Competencies Tax, Audit, Legal Information Technology Help Desk, Call Centers Data Centers, Logistics Facility, Network, Supply-Chain Management, Temporary Staffing, Payroll, Security Services, Food Services Never Outsource Outsource under Tight Control Service Levels Low-Risk Outsourcing © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 358

Services Often Outsourced
Accounting and legal services School bus programs Medical—blood testing Process design activities Utilities Engineering services Employee health services © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Scare Resources Essential to production activity but available only in limited quantity Machine hours Skilled labor hours Raw materials Production capacity Choose product or service with highest contribution margin per unit of scarce resource When there are several limiting factors, use linear programming to choose product or service Before eliminating products or services, consider qualitative factors Company reputation Impact on customer base Market saturation Company stagnation © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Low CM on razors may be required to obtain high CM on razor blades
Production Choices Production and sale of some less profitable products may be necessary to maintain either customer satisfaction or sales of other products Low CM on razors may be required to obtain high CM on razor blades © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Sales Mix Decisions Sales Mix—relative quantities of the products that make up the total sales of a company Factors affecting sales mix: Product selling prices Sales force compensation Advertising expenditures © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Impact of Change in Sales Price
Quantitative Factors New contribution margin per unit of each product Changes in product demand and production volume Best use of scarce resources Qualitative Factors Customer goodwill Customer loyalty Response of competitors Production of new products © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Pricing New Products Consider the product’s entire life cycle (long run) To set prices at various stages in the product’s life cycle, make assumptions about: Consumer behavior Competitor behavior Pace of technology changes Government posture Environmental concerns Size of potential market Demographic changes © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Impact of Change in Compensation
Commission based on fixed percentage of gross sales dollar Sell highest priced product Commission based on product contribution margin Sell most profitable product When considering compensation structure Ignore fixed costs unless the fixed costs are incremental relative to the new policy or to changes in sales volume © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Impact of Change in Advertising
Increase in advertising costs may cause Change in sales mix Change in sales volume Advertising budget changes Relevant costs Increased sales revenue Increased variable costs Increased fixed costs Irrelevant costs include Original fixed costs Contribution margin generated by the current sales levels Incremental Revenues Less: Incremental Variable Costs equals Incremental Contribution Margin Less: Incremental Fixed Costs equals Incremental Benefit (or Loss) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Special Order Decisions
Special order decisions involve management computing a reasonable sales price for products or services not part of normal operations. Sales price should cover: Variable production and selling costs Incremental fixed costs Profit Special prices can be considered for: Unusual quantity, delivery, packaging, or customization of product One-time job such as an overseas order that will not affect the domestic market © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Private-Label Orders, Low-Ball Bids & Ad Hoc Discounts
Buyer’s name (not producer’s) attached to the product Accept during slack periods to use available capacity Fixed costs usually not allocated Variable selling costs often reduced/eliminated Sales price set to generate a positive contribution margin Low-ball bid To introduce product or service to particular market Sales price at or below cost Cannot be continued over the long run Ad Hoc Discounts Price concessions related to real (or imagined) competitive pressures rather than to the location of the merchandising chain or volume purchased © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Special Order Decisions – Qualitative Factors
Impact on future prices and sales Sufficient contribution margin to justify the additional burden on workers and management Impact on scarce resources and throughput Keep workforce employed during slow times Consider Robinson-Patman Act Prohibits companies from pricing the same product at different levels when those amounts do not reflect related cost differences Requires that cost differences result from actual variations in the cost to manufacture, sell, or distribute because of different methods of production or quantities sold © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Product Line and Segment Decisions
Multiproduct Environments Costs by product lines Costs of divisions Distinguish between relevant and irrelevant information Commingling relevant and irrelevant information may suggest a product line/ segment is operating at a loss when it is actually operating at a profit Separate costs by Product Line Revenue Variable costs Avoidable direct fixed costs Unavoidable direct fixed costs Common Costs Unavoidable Direct Fixed Costs and Common Costs Will continue even if a product line or segment is eliminated Are irrelevant costs when deciding to eliminate a product line or segment © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Segment Margin Income Statement Sales <Variable Expenses>
Contribution Margin <Avoidable/Attributable Fixed Expenses> <Unavoidable Fixed Expenses> Product Line Result <Allocated Common Expenses> Net Income (Loss) Use segment margin to decide to continue or eliminate a segment © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 371

Product Line Decisions – Beware
Proceeds from sale of equipment are relevant Costs that appear to be avoidable may not be Depreciation on equipment is irrelevant Eliminating a product may affect customers Customers seek products elsewhere due to shrinking market assortment © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Appendix—Linear Programming
Used to find the optimal allocation of scarce resources in a situation involving one objective and multiple limiting factors Resource constraints Demand or marketing constraints Technical product constraints Nonnegativity constraints Whole number constraints Helps managers allocate scarce resources among competing uses One objective Maximize contribution margin Minimize product cost Optimal solution—provides best answer to allocation problem © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Questions What are some relevant financial considerations when making an outsourcing decision? How are prices set for special orders? What types of decisions require segment margin income statements? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 374

Ignoring qualitative factors in decisions Going offshore to exploit lax environmental and labor standards Making decisions based on financial earnings impact Using bait-and-switch advertising techniques Setting prices that violate the Robinson-Patman Act or other pricing regulations Substituting materials that pose health or environmental risks in a scarce resource situation © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 375

Chapter 11: Allocation of Joint Costs and Accounting for By-Product/Scrap

Learning Objectives How are the outputs of a joint process classified?
What management decisions must be made before beginning a joint process? How is the joint cost of production allocated to joint products? How are by-product and scrap accounted for? How should not-for-profit organizations account for the cost of a joint activity? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Joint Process Joint process—single process in which one product cannot be manufactured without producing others Extractive industries Agriculture industries Food industries Chemical industries Industries that produce both first-quality and factory seconds merchandise in a single operation When the process is unstable and is unable to maintain output at a uniform quality level or The output quality varies © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Joint Costs Joint costs—material, labor, and overhead incurred during a joint process Allocate to primary products of a joint process using Physical measures Monetary measures Interpret costs allocated to joint products carefully Product profitability is determined largely by the allocation method © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Joint Process Products
A joint process produces Joint products—primary outputs of a joint process; substantial revenue-generating ability By-products—incidental output of a joint process with a higher sales value than scrap but less than joint products Scrap—incidental output of a joint process with a low sales value Waste—residual output with no sales value © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost at Various Stages of Production
Separate cost—incurred in later states of production; assignable to specific primary products Split-off point—when joint products are first identifiable as individual products At split-off, joint costs are allocated to joint products Joint costs are sunk costs once the split-off point is reached Joint costs may be reduced by the sales value of by-products and/or scrap © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Illustration of a Joint Process
D’s Chicken Soup Company Chicken Noodle Chicken & Dumplings Chicken Rice Chicken, water, spices and vegetables are joint inputs Cook vegetables and chicken in water Chicken Water Spices Prepare vegetables, discard waste © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Illustration of a Joint Process
Cooked, canned, and into FG inventory split off point add Chicken Noodle Noodles Basic chicken soup Rice Chicken Rice Dumplings Chicken & Dumplings © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 384

To Process or Not to Process?
Decide before the joint-process is started Will revenues exceed total costs? Revenue from sale of joint process outputs Costs Joint costs Processing costs after split-off Selling costs What is the opportunity cost? Is income from the joint process greater than income from other uses? Is the joint production process the best use of capacity? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

To Process or Not to Process?
Decide at the split-off point How to classify outputs Primary By-product Scrap Waste Joint costs, reduced by the value of by-products and scrap, are assigned to primary products only Sell at split-off or process further? If primary products are marketable at split-off, process further only if value added to the product (incremental revenue) exceeds incremental cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Allocating Joint Costs
Each method may allocate a different cost to joint products Physical measure Common physical characteristic Monetary measure © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Physical Measures Physical Measures Examples of Physical Measures
Treats each unit as equally desirable Assigns same cost to each unit Provides an unchanging yardstick of output over time Use for products with unstable selling prices Use in rate-regulated industries Ignores revenue-generating ability of joint product Examples of Physical Measures Tons of meat, bone, and hide in meat packing and chicken processing Tons of ore in mining Linear board feet in lumber milling Barrels of oil in petroleum refining Number of computer chips in semiconductors Joint Cost Pounds $150 300 lbs $0.50 per lb = © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monetary Measures Monetary Measure Choices
Recognizes the revenue—generating ability of joint products The base is not constant— unchanging Choices Sales value at split-off Net realizable value (NRV) at split-off Approximated NRV at split-off © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monetary Measure Allocation Steps
Choose a monetary allocation base List values that comprise the base for each joint product Sum the values Divide each individual value by the total value; this is the numerical proportion for each value Multiply joint costs by each proportion; this is the amount to allocate to each product Divide allocated joint cost for each product by the number of equivalent units to obtain a cost per equivalent unit © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monetary Measure Allocation Example (slide 1 of 3)
Choose a monetary allocation base Sales value at split-off List values that comprise the base for each joint product Product Revenue (at split-off) A $ 1,000 B $ 4,000 C $ 5,000 Sum the values $1,000 + $4,000 + $5,000 = $10,000 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Divide each individual value by the total value; this is the numerical proportion for each value Product Revenue A $ 1,000 1,000/10,000 = 10% B $ 4,000 4,000/10,000 = 40% C $ 5,000 5,000/10,000 = 50% $10, % Multiply joint costs ($3,000) by each proportion; this is the amount to allocate to each product Joint Cost Product Joint Costs Proportion Per Product A $3, * 10% $ 300 B $3, * 40% $1,200 C $3, * 50% $1,500 $3,000 $3,000 of joint costs are allocated to Products A, B and C © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Divide allocated joint cost for each product by the number of equivalent units to obtain a cost per EUP Joint Cost Equivalent Cost Product Per Product Units Per EU A $ / $3.00 B $1, / $2.00 C $1, / $ $3,000 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monetary Measure: Sales Value at Split-Off
Uses relative sales value at split-off point All joint products must be marketable at split-off Uses a weighting technique based on both Quantity produced Selling price of production © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monetary Measure: NRV at Split-Off
Sales revenue at split-off less product disposal costs equals NRV NRV at split-off Assigns joint costs based on the proportional NRVs of the joint products at the split-off point All joint products must be marketable at split-off Approximated NRV at split-off Some or all joint products are not marketable at split-off Uses simulated NRV at split-off in place of actual NRV at split-off Incremental separate cost equals all processing and disposal costs incurred between split-of point and point of sale Assumes that incremental revenue from further processing is equal to or greater than the incremental costs of further processing and selling Final sales price less incremental separate costs equals simulated NRV at split-off © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Choosing Monetary Measures
Which monetary measure method to use? Sales value at split-off NRV at split-off Approximated NRV at split-off Superior method of measuring benefits Matches costs of joint processing with its benefits Provides expected contribution of each product line to the coverage of joint costs More complex due to required estimates © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Accounting for By-Products and Scrap (slide 1 of 3)
By-products, scrap, and waste may provide substantial revenue Companies are devoting time, attention, and creativity to developing innovative revenue sources from by-products, scrap, and waste Sales value of by-products/scrap is recorded using NRV Method or Realized Value Method Choose method based on Magnitude of NRV Need for additional processing after split-off Decide before joint costs are allocated to the joint products © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Selling Price Less Process, Storage, Disposal Costs equals NRV of By-Product/Scrap NRV Use this method when NRV is significant Scrap or by-product recorded at NRV NRV reduces joint cost of main products Any loss is added to cost of the main products Indirect method NRV reduces cost of goods sold for joint products Conservative; joint cost is reduced when the product/scrap is sold Direct method NRV reduces work in process for joint products Joint cost is reduced when by-product/scrap is produced © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

NRV is the traditional method, not necessarily best method By-products have either no assignable costs or costs equal to their net sales value Difficult for management to Monitor production and further processing of by-products Make effective decisions for by-products © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

By-Products & Scrap: Realized Value (slide 1 of 2)
First option Proceeds recorded as Other Revenue Costs of additional processing or disposal added to costs of primary products Provides little information to management as it does not match revenues and expenses Second option Proceeds less related costs shown as Other Income Matches revenues and related expenses for storage, further processing, transportation, and disposal costs Highlights the revenue enhancement provided by managing the costs and revenues related to by-products/scrap Allows for better control and improved performance By-product/scrap value is recognized when items sold © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

By-Products & Scrap: Realized Value (slide 2 of 2)
Other clerically efficient options Proceeds added to gross margin Proceeds reduce cost of goods manufactured Proceeds reduce cost of goods sold © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Impact of Realized Value and NRV
If most jobs create by-products or scrap Proceeds reduce the manufacturing overhead account The journal entry using the realized value approach is: Cash Manufacturing Overhead If only specific jobs create by-products or scrap Proceeds reduce work in process for the specific job The journal entries using the NRV approach are: Scrap Inventory Work in Process Cash © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Joint Costs in Service Organizations
Joint costs include Advertising for multiple products Printing for multipurpose documents Events held for multiple purposes Not required to allocate joint costs Allocation base Physical (number of locations) Monetary (sales volume) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Joint Costs in Not-for-Profit Organizations
Joint costs related to Fund-raising Organizational programs (program activities) Conducting an administrative function Joint costs must be allocated for NPFs and state and local government entities Method must be rational and systematic Clearly show the amount spent for various activities Three tests for allocation—purpose, audience, and content If tests not met, the costs are fund-raising Compensation tied to contributions is automatically fund-raising Purpose is to ensure that users of financial statements can identify fund-raising costs © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Questions What is a joint product?
How are costs allocated to joint products? What accounting methods are used to record the proceeds from the sale of by-products? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Product decisions based on sum of joint and separate processing costs Misclassifying a joint product as by-product or scrap Misclassifying products as waste and selling “off the books” Manipulating joint costs in ending inventory Using sales values of by-products and scrap to manipulate overhead allocation rates Disposing of hazardous waste in a harmful way Misallocating costs to programs or management activities to reduce fund-raising costs reported by a not-for-profit organization © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 12: Introduction to Cost Management Systems

Learning Objectives Why do organizations have management control systems? What is a cost management system? What are the organizational roles of a cost management system? What factors influence the design of a cost management system? What are the three groups of elements that comprise a cost management system, and what are the purposes of these elements? What is gap analysis, and how is it used in the evolution of a cost management system? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Relationship of Financial, Management, and Cost Accounting

Cost Accounting Financial accounting Management accounting
Uses cost accounting information for external reporting Conforms to GAAP Highly aggregated Historical Management accounting Uses cost accounting information for internal purposes Planning Controlling Decision making Performance evaluation Segmented Current Relevant for specific purposes © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost Management Systems
When cost accounting is shaped and dominated by financial accounting needs, the information generated may be of limited value to managers A Cost Management System (CMS): May provide information that is more relevant to internal users A CMS is part of the Management Information System (MIS) A structure of interrelated elements that collects, organizes, and communicates data so managers may plan, control, make decisions, and evaluate performance Emphasizes satisfying internal demands for information rather than external demands A CMS offers formal methods to plan and control an organization’s cost-generating activities with major challenges of Achieving profitability in the short run Maintaining a competitive position in the long run © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Internal Information Flows
Planning Control Decision Performance © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

External Information Flows
Intelligence Competition Organization Suppliers Government Creditors Clients Organizational communications © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Management Control Systems
Management Control Systems (MCS) help to Implement strategic and operating plans Provide a means for comparison of actual to planned results for control purposes The MCS is part of the MIS An MCS Is not a mechanical process Requires judgment Is a black box—An operation whose exact nature cannot be observed Guides the organization in designing and implementing strategies to achieve organizational goals and objectives © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

MCS Components Detector or sensor Assessor Effector
Measuring device that identifies what is actually happening in the process being controlled Assessor Device for determining the significance of what is happening Comparing the information on what is actually happening with some standard or expectation of what should be happening Effector Device that alters behavior if the assessor indicates the need for doing so Feedback Communications network Transmits information between the detector and the assessor and the assessor and the effector © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Entity being controlled
MCS Overview Control device Assessor Effector Detector Entity being controlled © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

MCS Processes Information gathered Comparisons made
Source documents (detectors) gather information about sales Comparisons made Comparisons are made to budget (assessor) Communication occurs A variance report (effector) is issued (communications network) Changes made when necessary Encourages sales staff to increase sales volume © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Information Characteristics
CMS Overview Short Run Long Run Objective Organizational Efficiency Survival Focus Specific costs: manufacturing, service, marketing, administration Cost categories: customers, suppliers, products, distribution channels Information Characteristics Timely, accurate, highly specific, short term Periodic, reasonably accurate, broad focus, long term © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

CMS Goals Develop product costs
Assess product/service life-cycle performance Improve understanding of processes and activities Control costs Measure performance Allow pursuit of organizational strategies © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

CMS Goals: Develop Product Costs
Use cost drivers (activities that have a direct cause-and-effect relationship with costs) Trace costs when possible using Bar coding RFID (radio frequency identification) Use product costs to Plan Prepare financial statements Assess individual product/service profitability Assess period profitability Establish prices for cost-plus contracts Create a basis for performance measurements © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

CMS Goals: Assess Performance
Assess product/service life-cycle performance Provides basis to relate costs incurred in one stage of the life cycle to costs and profitability of other stages Strong investment in development and design stages might reduce engineering changes and quality costs in later stages Inability to trace development and design costs to related product/services might camouflage “disasters” © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

CMS Goals: Improve Understanding
Improve understanding of processes and activities Understanding the process and reasons for cost incurrence allows managers to make cost-beneficial improvements in the production and processing systems © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

CMS Goals: Control Costs
CMS provides information on activities and cost drivers In the case of spoilage, the CMS provides Number of spoiled units Cost of spoiled units Information to determine the cause of spoilage © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

CMS Goals: Assess Performance
Measure performance CMS allows managers to measure and evaluate performance Human performance Equipment performance Future investment opportunities © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

CMS Goals: Organizational Strategies
Allow pursuit of organizational strategies CMS allows managers to Effectively manage strategic resources Determine core competences and organizational constraints Assess positive and negative financial and nonfinancial factors of strategic and operational plans © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Designing a CMS ANALYZE DETERMINE desired outputs PERFORM gap analysis
Improve ASSESS gap reduction © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

CMS Design Influences The design of the CMS is influenced by
Organizational form, structure, and culture Organizational mission and core competencies Operations and competitive environment and strategies © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Organizational Form and Structure
Choice of form affects Cost of raising capital Cost of operating business Cost of litigating Statutory authority to make decisions Forms of the business include Corporations Partnerships LLPs LLCs Organizational structure Distribute authority and responsibility Centralized or decentralized decision making Group subunits Geographically By similar missions (build, harvest, or hold) By natural product clusters Determine accountability for cost management and organizational control Determine the information needed by the decision maker © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Organizational Culture
Underlying set of assumptions about the entity and the goals, processes, practices, and values that are shared by its members How people interact with each other Extent to which individuals take authority and assume responsibility for organizational outcomes © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Organizational Mission and Core Competencies
Business mission provides a long-term goal toward which the organization wishes to move Business mission regarding competition Avoid competition Product Differentiation Cost Leadership Confront competition by identifying and exploiting temporary opportunities Business mission in relation to product life cycle Core competencies Timeliness Quality Customer service Efficiency and cost control Responsiveness to change The CMS gathers data and reports about core competencies © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Operations and Competitive Environment
Management needs to assess: Cost structure, including the proportion of fixed and variable costs Level of technology costs, which tend to be fixed and not susceptible to short-run control Production capacity Flexibility to respond to a change in short-term conditions © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Strategies Supplier relations Integration of entire information system
Strategies include: Being first to market Allows pricing flexibility Increases market share Large per-unit profit Substantial reduction in product costs Develop new production processes Capture learning curve effects Increase capacity utilization Create a focused factory arrangement Design for manufacturability, logistical support, reliability, maintainability Supplier relations Form strategic alliances Involve suppliers in product design and development Link electronically Integration of entire information system Payroll Inventory valuation Budgeting Costing © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

CMS Purposes A better CMS is essential to long-run organizational survival and short-run profitability More sophisticated CMS are required as Cost of gathering, processing, and communicating information decreases Quantity and intensity of competition increases © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

CMS Elements: Motivational and Reporting
Motivational elements Performance measurements Quantitative or nonquantitative Financial or nonfinancial Short term or long term Reward structure Profit sharing Support of organizational mission and competitive strategy Reporting elements Prepare financial statements Implement responsibility accounting system Performance reports for subunits focusing on costs and activities © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

CMS Elements: Information
Information elements Support budgeting process Disclose cost drivers of activities Reduce/eliminate non-value-added activities Emphasize managing costs throughout the product life cycle Adapt to changing competitive conditions Support of cost reduction initiatives Focus on cost control Assess core competencies Analyze make-or-outsource decisions Relate cost to product/process design Focus on capital spending Minimize cost distortions © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

<Information Available>
Implementing CMS Gap Analysis Identify gap to overcome Prioritize differences Develop and deploy improvements Repeat process to ensure continuous improvement Information Needs <Information Available> Gap to Overcome © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Enterprise Resource Planning
For a truly integrated CMS Standardize information systems/replace legacy systems Automate and integrate transfer of data among systems Improve the quality of information Improve timeliness of information Real-time, on-line reporting Oracle SAP PeopleSoft © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Questions Why do companies have MCS?
How does the external operating environment affect the CMS? What is gap analysis? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Using the financial accounting system rather than a CMS to support management functions Not balancing long and short-run concerns in the design of the CMS Using motivational elements to create high payoffs for fraudulent behavior Designing motivational elements that don’t align with manager’s authority © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 13: Responsibility Accounting, Support Department Allocations, and Transfer Pricing

Learning Objectives Which factors determine whether a firm should be decentralized or centralized? How are decentralization and responsibility accounting related? What are the four primary types of responsibility centers, and what distinguishes them from each other? How are revenue variances computed? Why and how are support department costs allocated to operating departments? What types of transfer prices are used in organizations, and why are such prices used? What difficulties can be encountered by multinational companies using transfer prices? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Organizational Structure
Centralization Top management retains the major portion of authority Decentralization Top management delegates decision-making authority to subunit managers © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Decentralization Continuum (slide 1 of 2)
Factor Centralized Decentralized Age of firm Young Mature Size of firm Small Large Stage of product development Stable Growth Growth rate Slow Rapid Impact on profits of incorrect decisions High Low Management’s confidence in subordinates Low High Degree of control Tight Moderate/loose © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 444

Decentralization Continuum (slide 2 of 2)
Factor Centralized Decentralized Geographic diversity Local Widespread Cost of communications Low High Ability to resolve conflicts Easy Difficult Level of employee motivation Low Moderate to high Level of organizational flexibility Low High Response time to changes Slow Rapid © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 445

Advantages and Disadvantages of Decentralization
Personnel Train and screen aspiring managers Develop leadership qualities, problem-solving abilities, and decision-making skills Compare managers’ results Increase job satisfaction and job enrichment Effective means of achieving organizational goals Reduces decision-making time Allows management by exception Disadvantages Lack of goal congruence Suboptimization Pursuing the subunit manager’s goals instead of the company’s goals Requires more effective communication skills Managers must relinquish control Expensive Train managers in decision-making skills Absorb cost of poor decisions Requires a sophisticated planning and reporting system © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Responsibility Accounting
Managers delegate decision-making authority but retain responsibility for outcomes. Reporting system Provides information about subunits Allows management to measure subunit performance Consistent with Standard costing Activity-based costing Monetary and nonmonetary Adjusted for the planning, controlling, and decision-making needs of each unit manager Separates costs as controllable or noncontrollable by the unit manager © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Responsibility Report
Budgeted Costs Actual Variance Itemized Costs Controllable Noncontrollable Nonmonetary items DEPARTMENT MANAGER © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Nonmonetary Measures Capacity measures Target ROI
Desired/actual market share Throughput Defects Backorders Complaints On-time delivery Manufacturing cycle efficiency Reduction of non-value-added time Employee suggestions received/implemented Unplanned production interruptions Schedule changes Engineering changes Safety violations Absenteeism © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Control Process Steps Prepare a plan using budgets and standards and use it to communicate output expectations and delegate authority Use responsibility accounting system to record and summarize data for each organizational unit Monitor the differences between planned and actual data at scheduled intervals Exert influence in response to significant differences Continue comparing data and responding and then begin the process again © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Responsibility Reporting
Upward flow of information From operations to top management Unit level reports are detailed Upper-level reports are summarized Encourages management by exception Major deviations are highlighted © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Responsibility Reporting System
Dept R Costs Itemized Total for Dept Dept Q Costs Division A Dept Q Totals Dept R Totals Total for Division Division B Dept X Totals Dept Y Totals To CEO Division A Total Division B Total Total for Company Department data are reported to the Division Division data are reported to the CEO © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Disadvantages of Responsibility Accounting
Disadvantages of responsibility accounting include Important details may not be visible at upper management levels Managers might “promote” their unit while “blaming” their competitor units Departmental interdependencies might not be visible © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Responsibility Centers
Responsibility accounting systems identify, measure, and report on activities in responsibility centers Cost center Revenue center Profit center Investment center © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost Centers Authority to incur costs
Evaluated on how well costs are controlled Revenues Do not exist Example: equipment maintenance center Exist but are not under manager’s control Example: community libraries Exist but cannot be measured Example: R&D center Focus on variances outside acceptable range © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Revenue Centers Responsible for generating revenue
No control of selling price or costs Example: Individual sales departments in retail stores Revenue and Limited Cost Center Some involvement in planning and controlling costs © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Profit Centers Responsible for generating revenues—set selling prices
Responsible for controlling expenses—allowed to purchase at most economical price Goal is to maximize the center’s profit Independent units Examples: Bank branches Educational divisions 18-wheelers Evaluate on profit variance © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Investment Centers Responsible for generating revenues and planning and controlling expenses Responsible for plant assets Goal is maximize rate of return on assets Evaluate on rate of return on assets and other performance measures Example: Divisions or subsidiaries © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Responsibility Centers
To control cost center performance, management may: Assign costs incurred in cost centers to revenue-producing areas through service department cost allocation “Create” revenue through a system of internal charges (charge-backs) for the center’s tangible or intangible output used by other company units © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Service Department Cost Allocation
Service departments provide functional tasks for other internal units Purchasing Maintenance Engineering Security Warehousing Administrative departments provide management activities for the organization Human resources Accounting Legal Insurance © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 460

Allocating Service Costs: Full Cost Objective
Reasons for: Cost recovery Awareness of support costs “Fair share” of costs Regulations for some pricing instances Reasons against: Managers cannot control costs Arbitrary costs not useful in decision making Confuses costing and pricing issues © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Allocating Service Costs: Motivation for Managers Objective
Reasons for: Awareness of support costs in production managers Relates unit’s profit to total company profits Reflects usage of services Encourages cost control Encourages usage of certain services Reasons against: Distorts profits with subjective allocations Managers cannot control costs Not material to profits Creates interdivisional ill will Not cost beneficial © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Allocating Service Costs: Compare Alternate Courses of Action Objective
Reasons for: Relevant information helps compare alternatives Provides best cost estimates when comparing alternatives Reasons against: Unnecessary if costs do not change among alternatives Arbitrary allocations distort cash flow and profits for alternatives © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Allocation Bases for Service Department Costs
Rational and systematic base Benefit received by revenue-producing department Causal relationship Fairness or equity of the allocations Ability of revenue-producing department to bear the allocated cost Methods Direct method Step method Benefits-provided ranking Algebraic method Simultaneous equations © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Direct Method Service Revenue 1 2 A B C Step 1 $ Step 2 $
Assigns costs straight to revenue-producing areas Service Revenue A B C $ Step 1 $ Step 2 Does not recognize service provided to other service departments © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 465

Service Method Service Revenue 1 2 A B C Step 1 $ Step 2 $
Partially recognizes relationships among service departments Service Revenue A B C $ Step 1 $ Step 2 Does not recognize the two-way exchange of services between service departments © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 466

Algebraic Method Service Revenue 1 2 A B C At the same time $ $
Provides the best allocation information Service Revenue A B C $ At the same time $ Recognizes all interrelationships among departments © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 467

Service Cost Allocation
Allocated service department costs are included in the overhead application rate for the revenue-producing areas Service department costs are allocated to products or jobs through normal overhead assignment procedures © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Transfer Pricing Advantages
Internal charges for the exchange of goods or services within the organization Promote goal congruence Make performance evaluation among segments more comparable Transform a cost center into a pseudo-profit center Encourages managers to be entrepreneurial Advantages Encourage development of beneficial services Promote cost consciousness of services provided Promote making a service department a profit center Transfer prices are for internal use only. They are eliminated on external financial reports. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Setting the Transfer Price
Maximum—no higher than the lowest market price Minimum—no less than the sum of Selling segment’s incremental costs plus The opportunity cost of the facilities used Ease of determining the transfer price Managers should understand how to compute and evaluate the transfer price © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost-Based Transfer Prices
Definition of cost Variable cost vs. absorption cost Actual vs. standard Standard cost is superior to actual cost Actual costs vary according to season and production volume Standard costs are stable measures of production costs Variances are attributed to selling division © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Market-Based Transfer Prices
Objective, arm’s-length measure Potential problems when the market determines the transfer price No exact counterpart in the external market Ignores internal cost savings Market price varies Current depressed price vs. long-run market price Different prices, discounts, and credit terms for different buyers © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Negotiated Transfer Prices
Below market purchase price Above the incremental and opportunity costs of the selling unit If negotiation fails Managers can purchase on the market Arbitration by top management © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Dual Pricing Seller transfers at market or negotiated price
Buyer records transfer at cost-based amount Eliminates need to divide profits artificially Provides relevant information for decision making and performance evaluation Requires internal reconciliation © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Advantages and Disadvantages of Transfer Pricing Systems
Permit evaluation of segment performance Allow for rational acquisition of goods and services between corporate divisions Provide flexibility to respond to changes Encourage and reward goal congruence Disadvantages May cause disagreement among managers Adds costs and takes time May not work for all departments May cause underutilization or overutilization of services May cause dysfunctional organizational behavior Causes a need for year-end entries to eliminate transfer prices © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Multinational Transfer Pricing
Differences in Tax systems Customs duties Freight and insurance costs Import/export regulations Foreign-exchange controls Develop guidelines that are followed on a consistent basis Set transfer prices that reflect an arm’s-length transaction Be prepared for transfer pricing audits Consider Advance Pricing Agreements—binding contracts between a company and taxing authorities that set an acceptable transfer pricing methodology © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Transfer Pricing Audit

Multinational Transfer Pricing Objectives
Internal Better goal congruence Better performance evaluations More motivated managers Better cash management External Less taxes and tariffs Less foreign exchange risks Better competitive positions Better relations with government © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Questions What are some advantages and disadvantages of decentralization? What are the four types of responsibility centers? Why are transfer prices used? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managers who make decisions to benefit themselves but not always the firm Burying important details in responsibility reports Allocating costs using “ability-to-bear” criterion Shifting support department costs to inappropriate departments Not allowing managers to buy or sell externally in a transfer pricing situation Using transfer pricing to shift costs to low- or no-tax locations © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 14: Performance Measurement, Balanced Scorecards, and Performance Rewards

Learning Objectives Why is a mission statement important to an organization? What roles do performance measures serve in organizations? What guidelines or criteria apply to the design of performance measures? What are the common short-term financial performance measures, and how are they calculated and used? Why should company management focus on long-run performance? What factors should managers consider when selecting nonfinancial performance measures? Why is it necessary to use multiple performance measures? How can a balanced scorecard be used to measure performance? What is compensation strategy, and what factors must be considered in designing the compensation strategy? What difficulties are encountered in trying to measure performance and design compensation plans for multinational firms? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Mission and Values Statements
Underlies organizational goals and objectives Mission statement Expresses the organization’s purposes Identifies how the organization will meet its customers’ needs through products or services Communicates organizational purpose and intentions to external parties and to employees Provides a basis for setting organizational strategy Values statement Reflects the organization’s culture Identifies fundamental beliefs about what is important to the organization Without short-run success, there will be no long-run success. Without long-run planning, short-run success will probably fade rapidly. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Performance Measures User performance measures to:
Implement strategies that apply resources to activities Gauge the effective and efficient use of organizational resources Provide proof of a firm’s competitive advantages Enhance organizational communication Motivate managers Implement organizational control over activities Evaluate comparative managerial performance © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Designing a Performance Measurement System
Assess progress toward goals and objectives Awareness of and participation in developing measures Appropriate skills, equipment, resources, information, and authority to achieve goals and objectives Timely and useful feedback Flexible system for new conditions © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Assess Progress Use multiple performance measures
Financial performance measures Customer satisfaction Zero defects Minimal lead time to market Social responsibility for environment © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Awareness and Participation
Communicate standards to those being measured Workers act specifically in accordance with how they are measured Participation in setting standards forms a “social contract” Workers understand and accept the standards © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Tools for Performance and Feedback
Adequate equipment, resources, information, and authority Performance measures needed in decentralized firms Monetary and nonmonetary benchmarks Feedback Positive and negative feedback Given on continuing basis to avoid surprises Ultimate feedback provided by short-run financial measures © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Short-Term Financial Performance Measures
Divisional profits Achievement of budget objectives Variances from budget or standard Cash flow—Statement of Cash Flows shows Sources and uses of cash Quality of earnings © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Evaluating Responsibility Centers
Cost Center Variances from budgeted costs Revenue Center Compare budget to actual revenue Profit and Investment Centers Revenue and expense variances Net cash flow Return on investment Residual income Economic value added © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Return on Investment (ROI) (slide 1 of 2)
Return on = Income Investment Assets Invested Income Segment or operating Before tax or after tax Assets Total assets utilized, total assets available or net assets Plant assets at original cost, book value, current value Beginning, ending, or average assets © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Return on Investment (ROI) (slide 2 of 2)
Dupont Formula Return on = Income Sales Investment Sales * Assets Invested Profit Margin Asset Turnover Increase ROI Increase sales price (if it does not impact demand) Decrease expenses Decrease dollars invested in assets © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 495

Residual Income (RI) Residual Income = Income – (Target Rate * Asset Base) RI is the profit earned that exceeds an amount “charged” for funds committed to the center Make additional investments in assets as long as RI is a positive number © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Residual Income (RI) Illustration
Top management establishes a minimum rate of return 12% Multiply the asset base ($100,000) by the minimum rate of return $100,000 * 12% = $12,000 (required return) RI is income ($30,000) minus the required return $30,000 – $12,000 = $18,000 (RI) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Economic Value Added (EVA) ™
After-Tax Profits – ( Cost of Capital %*Invested Capital) Measure of profit above the cost of capital Capital is market value of total equity and interest-bearing debt EVA provides a better measure than ROI if market value is much greater than book value Short-term measure may discourage investment in long-term projects Invested capital increases before profits © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ROI, RI, EVA Limitations Income Asset Investment Base
Income can be manipulated on short-run basis To compare, all segments must use the same accounting methods Income is based on accrual accounting; cash flows and time value of money are not considered Asset Investment Base Assets may be understated (R&D expensed) Current management may be judged on decisions of previous managers Assets not restated for changing (rising) price levels (older assets will report higher ROI) ROI, RI, EVA do not measure performance relative to company-wide objectives Can lead to suboptimization of resources © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Short-Term versus Long-Term Objectives
Short-run objectives Effective and efficient management of Operating activities Financing activities Investing activities Long-term objectives Investments in resources Enhance competitive position through customer satisfaction © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Nonfinancial Measurements
Can be clearly articulated and defined Are relevant to the objective Can trace responsibility Rely on valid data Have target objectives Have established internal and/or external benchmarks © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Advantages of Nonfinancial over Financial Performance Measures
Relevant to nonmanagement employees Timely; more apt to identify problems and potential benefits Reflect leading indicators of activities that create shareholder wealth Cause goal-congruent behavior rather than suboptimization Integrated with organizational effectiveness; focus on processes rather than outputs Indicate productive activity and future cash flows Appropriate measure of teamwork; focus on processes not outputs Cross-functional performance measures Comparable for benchmarking externally Aligned with reward systems; measures under control of lower-level employees © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Selecting Nonfinancial Performance Measures
Identify critical success factors Direct causes of achievement of organizational goals and objectives Choose some short and long-run attribute measures of critical success factors Use qualitative and quantitative measures Limit the number of measures © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Throughput Nonfinancial Performance Measures
Number of good units or quantity of services that are produced and sold within a specified time Increase throughput in time and in quality Decrease non-value-added activities Increase total unit production and sales Decrease per-unit processing time Increase the process quality yield © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Throughput Formula Manufacturing Cycle Efficiency Process Quality
Good Units Total Time Manufacturing Cycle Efficiency Process Quality Yield Process Productivity X X Total Units Value-Added Processing Time Value-Added Processing Time Total Time Good Units Total Units © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 506

Comparison Bases Establish benchmark Assign specific responsibility
Monitor and report at appropriate intervals © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Multiple Measures Measures Areas Nonfinancial Financial
Internal and external Short run and long run Qualitative Quantitative Nonfinancial Financial Areas Human resources Market Costs Returns (Profitability) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Internal Business Financial Learning and Growth Customer
Balanced Scorecard Financial Internal Business Customer Learning and Growth © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Balanced Scorecard Measures
Financial Shareholder-relevant issues Profitability Organizational growth Market price of stock Customer Lead time Quality Service Price Internal Business Process quality yield Cycle efficiency Time to market On-time delivery Cost variances Learning and Growth Number of patents or copyrights Percentage of R&D projects that are patentable Time of R&D from conception to commercialization Percentage of capital invested in “high-tech” projects © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Multinational Performance Measures
Flexible performance measures should: Recognize differences in Sales volumes Accounting standards Economic conditions Risks Use qualitative measures Market share Quality improvements Inventory management improvements New product development © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Plan Performance Reward Model
Set strategic goals Identify critical success factors, set operational targets and compensation strategy Identify performance measures Set performance rewards Employee or employee group performs tasks Measure/monitor performance Determine rewards © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Traditional Compensation Strategy
Top managers Salary and significant financial incentives Middle managers Salary and raises based on performance and bonuses Workers Wages and small bonuses © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Pay-for-Performance Plans
Correlation with organization targets Maximization of shareholder wealth Appropriate time horizon Long-run perspective Reward with stock or stock options Subunit mission Employee perspective relative to commitment Balance of group and individual benefits © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Setting Performance Measures
Minimize risk to worker of random effects Incentives Relative to Organization Level Worker Pay and Performance Links Worker Specific, short-run measures Weighted toward monetary and short-term measures Rely more on results-based evaluations; rely less on direct supervision Upper Management Less specific, longer-time horizon, organization longevity measures Weighted toward nonmonetary and long-term measures © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Profit Sharing Contingent on organizational success
Current and/or deferred incentives in form of cash or stock Allocated among employees based on Personal performance measures Seniority Team performance Managerial judgment Specified formulas © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Employee Stock Ownership Plan (ESOP) and Nonfinancial Incentives
Profit-sharing compensation invested in company stock More valuable as company stock price increases Employees lose some or all benefits if company goes bankrupt Nonfinancial incentives Recognition of efforts Participation in decision making © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Tax Treatments of Compensation Elements
Full and immediate taxation Tax deferral—pay tax at a future date Tax exempt—pay no tax © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Global Compensation Expatriate compensation
Domestic base salary and fringe benefits plus adjustments for: Cost of living—housing, education, security, spouse’s loss of employment Currency fluctuations Tax implications Retirement benefits in home currency © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Questions What are some short-term financial performance measures for investment centers? What factors should be considered when selecting nonfinancial performance measures? How is the balanced scorecard used to measure performance? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Excessive emphasis on short-term measures Excessive pressure on managers to hit earnings targets Manipulating profits to create higher bonuses Evaluation of managers using uncontrollable criteria Backdating managerial stock options Hiding performance criteria in evaluations Not providing timely feedback Ignoring nonfinancial performance criteria Suboptimization by managers Compensating foreign workers in inappropriate ways © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 15: Capital Budgeting

Learning Objectives Why do most capital budgeting methods focus on cash flows? How is payback period computed, and what does it measure? How are the net present value (NPV) and profitability index (PI) of a project computed, and what do they measure? How is the internal rate of return (IRR) on a project computed, and what does that rate measure? How do taxation and depreciation affect cash flows? What are the underlying assumptions and limitations of each capital project evaluation method? How do managers rank investment projects? How is risk considered in capital budgeting analyses? How and why should management conduct a post-investment audit of a capital project? (Appendix 1) How are present values (PV) calculated? (Appendix 2) What are the advantages and disadvantages of the accounting rate of return method? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Assets Capital assets are long-term assets used to:
Generate future revenues or cost savings Provide distribution, service, or production capacity Tangible fixed assets Land, building, machinery, etc. Intangible assets Capital lease, patent, etc. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Budgeting Capital budgeting is the process for evaluating and ranking alternative long-range projects for the purpose of allocating limited resources Plan and prepare the capital budget Review past investments to assess success of past decisions and enhance the decision process in the future Compare and evaluate alternative projects Financial and nonfinancial criteria Short- and long-term benefits Usually multiple criteria Consider all significant stakeholders © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Budgeting as Part of the Financial Budget
Statement of Cash Flows Cash Budget Capital Budget Income Statement Operating Budget Statement of Retained Earnings Balance Sheet © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Budgeting: Quantitative versus Qualitative
Accounting rate of return Payback period Discounted payback period NPV IRR PI Qualitative Employee morale, safety, and responsibility Corporate image Social responsibility Market share Growth Strategic planning Sustainability © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Budgeting: Financial Analysis
Payback period NPV PI IRR Accounting rate of return Cash Flow Focus © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cash Flow Cash Receipts Cash Disbursements
Revenues earned and collected Savings generated by reducing operating costs Proceeds from sale of assets Cash Disbursements Expenditures for asset acquisition Working capital investments Costs for direct material, direct labor, and overhead © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Investment vs. Financing
Investment decision Which assets to acquire Made by divisional managers and top management Financing decision How to raise capital (debt/equity) to fund an investment Made by treasurer and top management Interest is a financing decision Interest cost Cash flow associated with debt financing Not part of the project selection process First justify the acquisition. Then justify how to finance it. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Payback Period Time required for project’s cash inflows to equal the original investment The longer it takes to recover the original investment, the greater the risk The faster capital is returned, the more rapidly it can be invested in other projects Management sets a maximum payback period Ignores Cash inflows that occur after payback has been reached Desired rate of return Time value of money © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Payback Period Illustration
Original Investment Annual Cash Inflows (assuming equal cash flows) Payback Period = Example: Original Investment $25,000 Annual Cash Inflows $10,000 Payback Period years © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Discounting Future Cash Flows
Reduce the future value (FV) of cash flows by the portion that represents interest Variables are Length of time until the cash flow is received or paid Required rate of return on capital—discount rate PV is stated in a common base of current dollars © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Discount Rate and Returns
Discount rate should equal or exceed the cost of capital Cost of Capital—weighted average cost for the debt and equity that comprise a firm’s financial structure Return OF Capital Recovery of the initial investment Return ON Capital Represents income Original investment multiplied by the discount rate $100,000 * 12% = $12,000 return on capital © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Discounted Cash Flow Methods
Net Present Value (NPV) Profitability Index (PI) Internal Rate of Return (IRR) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Net Present Value Evaluates if project rate of return is greater than, equal to, or less than the desired rate of return PV equals the cash flows discounted using the desired rate of return NPV equals PV of cash inflows minus PV of cash outflows Does not calculate the rate of return Minus Investment made currently Plus PV of future cash inflows or cost savings Minus PV of future cash outflows Equals NPV © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Interpreting NPV NPV = 0 NPV > 0 NPV < 0
Actual rate of return equals desired rate of return NPV > 0 Actual rate of return is greater than desired rate of return NPV < 0 Actual rate of return is less than desired © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Net Present Value Function of two factors
Discount rate Amount and timing of cash flows Useful to select best project among investments that can perform the same task or achieve the same objective When comparing independent projects requiring different initial investments, use the PI © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Profitability Index Compares PV of net cash flows to net investment
Measures efficiency of the use of capital Should be greater than or equal to 1 Does not calculate the rate of return Profitability = PV of Net Cash Flows Index Net Investment © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Profitability Index Illustration
Project PV of net cash flows $900, $580,000 Net investment $720, $425,000 NPV $180, $155,000 PI $900,000/$720, $580,000/$425, Assuming limited funds, which project would you choose? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Internal Rate of Return
Discount rate where PV of cash inflows = PV of cash outflows NPV = 0 Hurdle rate is the lowest acceptable return on investment (at least equal to the cost of capital) If IRR = Hurdle Rate; Accept If IRR > Hurdle Rate; Accept If IRR < Hurdle Rate; Reject Computed using Financial calculators Computers Annuity tables (assuming equal cash flows) Trial and error © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Income Taxes An integral part of the business planning and decision-making process Operating income is taxed, which reduces the cash inflows from projects Depreciation reduces operating income, which reduces the taxes paid © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

After-Tax Cash Flows Depreciation is not a cash flow item
Depreciation on capital assets affects cash flows by reducing the tax obligation Depreciation is a tax shield that provides a tax benefit Depreciation tax benefit = Depreciation expense * Tax rate © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Tax Depreciation Deprecation tax shield is affected by
Changes in tax laws Different depreciation methods Changes in tax rates © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Budgeting Methods
Understand similarities and differences of capital budgeting methods Use several techniques Limitations of all methods Management preferences regarding timing of cash flows are not included Single, deterministic measures of cash flow are used rather than probabilities © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Payback Assumptions Limitations Speedy recovery of investment is key
Cash flows can be accurately predicted Risk is lower for the shorter payback project Limitations Ignores cash flows after payback Cash flow and project life are deterministic, not subject to probabilities Ignores time value of money Does not consider recognized cash flow pattern preferences © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Net Present Value Assumptions Limitations Discount rate is valid
Timing and size of cash flows can be predicted Life of project can be predicted If shorter-lived project is selected, proceeds of shorter project will earn the discount rate through theoretical completion of longer project Limitations Cash flow and project life are deterministic, not subject to probabilities Alternative project rates of return are not known Does not consider recognized cash flow pattern preferences IRR on project is not reflected © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Profitability Index Assumptions Limitations
Measures efficient use of capital Discount rate is valid Timing and size of cash flows can be predicted Life of project can be predicted If shorter project selected, proceeds of shorter project will earn the discount rate through theoretical completion of longer project Limitations A relative answer is given but dollars of NPV are not reflected Cash flow and project life are deterministic, not subject to probabilities Alternative project rates of return are not known Does not consider cash flow pattern preferences IRR on project is not reflected N P V N P V © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Internal Rate of Return
Assumptions Hurdle rate is valid Timing and size of cash flows can be predicted Project life can be predicted If shorter project selected, proceeds of shorter project will continue to earn the IRR through theoretical completion of longer project Limitations Projects are ranked by IRR and not dollar size NPV dollars are not reflected Cash flow and project life are deterministic, not subject to probabilities Does not consider cash flow pattern preferences Multiple rates of return can be calculated on the same project © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Comparing Techniques Pay-back NPV PI IRR Uses time value money N Y
Provides specific rate of return Uses cash flows Considers returns during life of project Uses discount rate N* *often used as a hurdle rate © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Investment Decision
Is the activity worthy of an investment? Which assets can be used for the activity? Of the available assets for each activity, which is the best investment? Of the “best investments” for all worthwhile activities, in which ones should the company invest? Consider Quantitative and Qualitative Factors © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Budgeting Terms
Screening decision Preference decision Mutually exclusive projects Independent projects Mutually inclusive projects © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Ranking Capital Projects
For the projects under consideration NPV is nonnegative PI of 1 or more IRR equals or exceeds hurdle rate Selection ranking of multiple projects Results can vary depending on evaluation techniques and whether dollars or percentages are used © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Reinvestment Assumptions
NPV and PI assume that released cash flows are reinvested at the discount rate At least the cost of capital IRR assumes that released cash flows are reinvested at the expected IRR Could be substantially different than the cost of capital © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

? NPV Compared to IRR More realistic reinvestment assumption
Results measured in dollars not rates Do you prefer a 100% return on $1, or a 10% return on $100? ? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Compensating for Risk (slide 1 of 2)
Judgmental method Use logic and reasoning to decide if acceptable rate of return will be achieved Risk-adjusted discount rate method Higher discount/hurdle rate for riskier projects and/or cash flows Shorter payback period for riskier projects Higher IRR for riskier projects Sensitivity analysis © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Compensating for Risk (slide 2 of 2)
Sensitivity Analysis—the amount of change that must occur in a variable before a different decision would be made Discount rate—What increases could occur in the cost of capital and related discount rate before a project becomes unacceptable? Cash flows—How small can the net cash inflows be before a project becomes undesirable? Asset life—What is the minimum time the cash flows must be received for the project to remain acceptable? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Post-Investment Audit
Complete after project has stabilized Compare actual results to expected results Use same analysis techniques Identify areas where results differ from expectation Evaluate capital budgeting process, particularly original projections, problems with implementation, sponsor credibility © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Time Value of Money (Appendix 1)
Future value (FV) and present value (PV) depend on Amount of cash flow Rate of interest Timing of cash flow Simple vs. compound interest Single cash flow Annuity Ordinary annuity or annuity due © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Accounting Rate of Return
Measures rate of return on earnings for average capital investment over project’s life Consistent with accounting model Uses profits shown on accrual-based financial statements Not based on cash flows Accounting = Average Annual Profits Rate of Return Average Investment © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Questions Why do most capital budgeting methods focus on cash flows?
What is the relationship between the NPV and the PI? What are the assumptions and limitations of the various capital project evaluation methods? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Ignoring enhanced safety or detrimental environmental impact for project decisions Changing assumptions or estimates to meet criteria for approval Using a discount rate that is inappropriately low Not conducting a post-investment audit to hold decision makers accountable Choosing projects based on accounting earnings only rather than including discounted cash flow methods © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 16: Managing Costs and Uncertainty

Learning Objectives What are the functions of a cost control system?
What factors cause costs to change from period to period or to deviate from expectations? What are the generic approaches to cost control? What are the two primary types of fixed costs, and what are the characteristics of each? What are the typical approaches to controlling discretionary fixed costs? What are the objectives managers strive to accomplish in managing cash? How is technology reducing costs of supply-chain transactions? Why is uncertainty greater in dealing with future events than with past events? What are the four generic approaches to managing uncertainty? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost Control Systems Provide information for planning and for determining the efficiency of activities while they are being planned and after they are performed © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Functions of an Effective Cost Control System (slide 1 of 2)
Before an event Preventive Reflects planning Examples: Budgets Standards Policies Objectives Ethical guidelines During an event Corrective Ensure event is happening as planned Examples: Periodic monitoring Compare budgets to actual results Avoid excess expenditures © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Functions of an Effective Cost Control System (slide 2 of 2)
After an event Diagnostic Guides future actions Examples: Feedback Variance analysis Responsibility reports © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Planning and Control Model
RESPOND EXECUTE CONTROL EVALUATE © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 569

Stages of Planning Plan Execute Evaluate Respond
Where do we want to go? How do we compare to peers? What is the impact of these decisions? Execute What do we have to do? Can we achieve the targets? How do we allocate resources? Evaluate Where are we? How are we doing compared to plan? What actually happened? Respond What decisions do we make? What are the alternatives? Why did it happen? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost Consciousness A companywide employee attitude toward the topics of: Understanding cost changes Cost containment Cost avoidance Cost reduction © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

COST CONSCIOUSNESS ATTITUDE
Before During After ACTIVITY COST CONSCIOUSNESS ATTITUDE Budgeting, Standard setting Monitoring, Correcting Providing feedback Cost understanding Cost containment, Cost avoidance reduction © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 572

Why Costs Change Cost behavior Inflation/deflation Quantity purchased
Reaction of variable and mixed costs to changes in activity level Inflation/deflation General price-level changes Consumer price index (CPI) Quantity purchased Quantity discounts and group purchases Higher taxes Additional regulations Supply/supplier cost adjustments Supply/demand adjustments Specific price-level changes Advances in technology may decrease cost Additional production or performance costs may increase product or service cost Number of suppliers As the number of suppliers decreases, costs may rise © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost Containment Cannot contain Use cost containment for
An approach to minimize cost increases Cannot contain Inflation Tax Regulatory changes Supply and demand adjustments Use cost containment for Reduced supplier competition Seasonality Quantities purchased Develop interorganizational arrangements Arrange long-term or single-source contracts © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost Avoidance and Reduction
Avoidance—finding acceptable alternatives; substituting lower cost inputs Reduction—lowering current costs Benchmarks Outsourcing Consultants Operation redesign © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fixed Costs Committed costs Discretionary Costs
Plant assets and personnel structure Depreciation Lease rentals Property taxes Staff salaries Cannot easily be reduced Discretionary Costs Important but optional activities Employee travel Repairs and maintenance Advertising Research and development Employee training and development Can be reduced © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Controlling Committed Costs
Compare expected benefits to expected costs Perform post-investment audit; compare actual to expected results © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Budgeting Discretionary Costs
Vary in type and magnitude Vary in quality of performance Not easy to measure benefits in terms of money Consider: Perceived significance to the achievement of objectives and goals Expected level of operations Managerial negotiations Spend all of the appropriation Do not reduce preventive maintenance budget Spend less than the appropriation Reduce travel and entertainment budget, as long as desired results are achieved © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Measuring Benefits from Discretionary Costs
Use nonmonetary surrogate measures Compare discretionary costs to benefits to measure efficiency and effectiveness © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Nonmonetary Measures (slide 1 of 2)
Preventative Maintenance Reduction in number of equipment failures Reduction in unplanned downtime Reduction in frequency of production interruptions caused by preventable maintenance activities Advertising Increase in unit sales after an advertising effort Number of customers referring to the ad Number of coupons clipped and redeemed Example: University admissions recruiting trip Percentage of students met who requested an application Number of students who sent ACT/SAT scores to university Number of admissions from the area © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Nonmonetary Measures (slide 2 of 2)
Prevention and appraisal quality activities Reduction in number of Customer complaints Warranty claims Product defects discovered by customers Example: Executive retreat Proportion of participants still there at end of retreat Number of useful suggestions made Values tabulated from an exit survey © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Discretionary Cost Measures (slide 1 of 2)
Actual Result Compared to Desired Result Efficiency = Actual Output Actual Input Planned Output Planned Input OR Efficiency = Actual Input Actual Output Planned Input Planned Output Meaningful when: Inputs and outputs can be matched in the same period A credible causal relationship exists between inputs and outputs © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 583

Discretionary Cost Measures (slide 2 of 2)
Actual Result Compared to Desired Result Effectiveness = Actual Output Planned Output Preestablished Standard Measures how well the activity's objectives were achieved © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 584

Controlling Discretionary Costs
To determine variances, compare actual to standards or budgeted amounts Prevent managers from overspending budgets Use engineered costs for repetitive activities Costs that bear an observable and known relationship to a quantifiable activity base Compute fixed or variable variances © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cash Management Issues
Cash level Sufficient to cover all needs Low enough to allow for alternative uses of cash What variables influence the optimal level of cash? Uncertainty of amount and timing of cash inflows and outflows Variability in cash requirements throughout the year Ability to arrange short-term financing Bond ratings and bond/loan covenants What are the sources of cash? Sale of equity or debt instruments Sale of unneeded or unproductive assets Normal operations Reduce inventory Increase A/R turnover Decelerate payments What variables influence the cost of carrying cash? Cost of borrowing and cost of issuing equity capital Opportunity costs of holding cash © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cash Collection Cycle Balance Sheet—Current Assets Cash
Inflow Balance Sheet—Current Assets Outflow Cash Materials Inventory Work in Process Inventory Finished Goods Inventory Accounts Receivable © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 587

Banking Relationships
Accurate, conservative accounting and cash flow information affects Loan eligibility Loan limits Credit terms Bank assets Credit history Ability to generate cash flow Quality of collateral Character of senior officers Operational plans and strategies © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Supply Chain Management
Supply chain management—A set of processes that convert inputs into products and services for the firm’s customers Firms and their Internal Processes Suppliers Final Customers Flow of Material Flow of Customer Information Flow of Payments © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Supply Chain Relationships
Information Technology Electronic exchanges of information to reduce purchasing transaction costs Electronic Data Interchange (EDI) E-procurement systems © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Uncertainty Uncertainty—doubt or lack of precision in specifying future outcomes Causes of cost management uncertainty Lack of identification or understanding of cost drivers Random—some portion of the cost is not predictable based on the cost driver Unforeseen events © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Dealing with Uncertainty (slide 1 of 2)
Explicitly factor uncertainty into estimates of future costs—reduce prediction error Regression analysis—single or multiple Coefficient of determination—the portion of the variance in the dependent variable explained by the variance in the independent variable Range is 0 to 1 Closer to 1 provides a better predictor of total cost Computer simulations Sensitivity analysis—range of estimated costs Structure costs to automatically adjust to uncertain outcomes Operating leverage—Adjust the proportion of fixed and variable costs © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Dealing with Uncertainty (slide 2 of 2)
Use options and forward contracts to mitigate uncertainty—hedging Options and forward contracts are agreements that give the holder the right to purchase a given quantity of a specific input at a specific price Common hedges include: energy, metals, currencies, interest rates, agricultural products Purchase insurance to cover unexpected, specific occurrences Fire, theft, vandalism insurance Acts of nature (tornados, floods, earthquakes) Key employee insurance Business interruption insurance © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Questions What are committed costs and discretionary costs?
What are three approaches to cost control? How can a firm reduce uncertainties associated with business activities? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Refusing to grant sales price decreases when costs decline Artificially contracting with suppliers to force price increases to customers Acquiring excessive quantities of inputs to generate favorable price variances Acquiring counterfeit goods to obtain lower prices Outsourcing production or procurement to companies with unacceptable labor or environmental practices Slowing payments to creditors to generate more investment returns Manipulating or falsifying financial statements to obtain credit or lower interest rates on borrowed funds © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 17: Implementing Quality Concepts
Cost Accounting Principles, 8e Raiborn and Kinney © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Learning Objectives What is quality, and from whose viewpoint should it be evaluated? What is benchmarking, and why do companies engage in it? What constitutes the total quality management philosophy? How is the Baldrige Award related to quality? What are the types of quality costs, and how are those types related? How is cost of quality measured? How are the balanced scorecard and a cost management system used to provide information on quality in an organization? How is quality instilled as part of an organization’s culture? (Appendix) What international quality standards exist?

Quality The sum of all of the characteristics of a product or service that influence its ability to meet the stated or implied needs of the person acquiring it Totality of internal processes that generate a product or service Customer satisfaction with that product or service

Quality Control Quality control—all attempts to reduce variability and product defects Six Sigma Statistical Process Control

Statistical Process Control
Analyze where fluctuations occur in processes Use control charts SPC charts require workers to respond when there are Occurrences outside the control limits Nonrandom patterns Workers can prevent product defects and process malfunctions

Characteristics of Product Quality
Objective Performance Features Reliability Conformance Durability Serviceability and responsiveness Subjective Aesthetics Perceived value Sloan Management Review

Characteristics of Service Quality
All the characteristics of product quality plus: Assurance Tangibles Empathy

Evaluating Quality Grade Value It’s too expensive
One of the many quality levels that a product or service has relative to the inclusion or exclusion of characteristics to satisfy customer needs, especially price Value Meet the highest number of needs at the lowest possible cost (purchase price plus operating, maintenance, and disposal costs) It’s too expensive

Reasons to Benchmark (slide 1 of 2)
Increase awareness of the competition Understand competitors’ production and performance methods Identify areas of competitors’ internal strengths and weaknesses Identify external and internal threats and opportunities Justify and accelerate a plan for continuous process improvement and change

Reasons to Benchmark (slide 2 of 2)
Create a framework for program and process assessment and evaluation Establish a focus for mission, goals, and objectives Establish performance improvement targets Understand customers’ needs and expectations Encourage creative thinking Identify state-of-the-art business practices and new technologies

Total Quality Management (TQM)
Management approach of an organization, centered on quality, based on the participation of all its members and aiming at long-term success through customer satisfaction, and benefits to all members of the organization and to society

TQM Tenets Dictate continuous improvement to the internal managerial system (plan, control, make decisions) Require participation by everyone in the organization Focus on improving goods and services from the customer’s point of view Value long-term partnerships with suppliers

The Quality System Moves from after-the-fact inspection to proactive quality assurance Emphasizes planning for quality in every process and product prevention building quality into the process or product Results ability to set goals and methods for improvements system for measuring quality encouragement of teamwork change from product inspection and defect correction to proactive quality assurance

Malcolm Baldrige National Quality Award
Focuses on Management systems Processes Consumer satisfaction Business results Types of entrants Business and not-for-profit Education Health care Represents Excellence

Types of Quality Costs Cost of Compliance Cost of Noncompliance
Preventive costs—prevent product defects Appraisal costs—monitor and compensate when prevention fails Cost of Noncompliance Failure costs Internal losses—scrap, rework External losses—warranty work, customer complaint departments, litigation, product recalls

Calculating the Total Quality Cost
Prevention Cost Appraisal Cost Failure Cost = + + T = K + A + F

Organizational Culture of Quality
Committed and consistent top leadership Employees who are eager to meet and exceed customer expectations Work environment that cares about employees and rewards efforts to achieve high quality Empowered employees Job and quality training Pursuit of quality awards

Questions What is quality?
How is benchmarking used to improve quality? What are the different measures of the cost of quality?

Ignoring acceptable variation limits and therefore accepting defect levels that are excessive Using lower grade raw material and components than specified Using benchmarking to illegally gain information from competitors Discriminating against minority supplies Choosing to ignore internal information about defects and failures Minimizing estimates of internal and external failure costs Not supporting total quality management initiatives in company practices Selling products at low prices and attempting to recover revenue with exorbitant repair charges after warranty time period

Chapter 1: Introduction to Cost Accounting

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