W. TERRY DANCER

 PROFESSOR OF ACCOUNTING

ARKANSAS STATE UNIVERSITY

COST ACCOUNTING NOTES

COST ACCOUNTING: _____________ accounting whose primary purpose is to ______________ costs for the determination of the ______ _____ cost of the product being manufacturers. FINANCIAL ACCOUNTING: ________ accounting whose primary purpose is to report to owners, creditors, and other outsiders the results of operations and the financial condition of the business in accordance with_____ ( GENERALLY ACCEPTED ACCOUNTING PRINCIPLES).

COST ACCOUNTING AND FINANCIAL ACCOUNTING BOTH RELY ON THE SAME ACCOUNTING ___________ SYSTEM. This system has three purposes: help managers ____ and control operations, help managers ____ decisions, and ______ externally.

MANAGERIAL AND FINANCIAL ACC. OVERLAP:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

COST: WHAT YOU ____ __ IN ORDER TO OBTAIN GOODS AND SERVICES; WHAT YOU ___ FOR WHAT YOU ___; FAIR MARKET VALUE OF CONSIDERATION _____ OR CONSIDERATION ________, WHICHEVER IS MORE _______ DETERMINABLE.
 
 
 
 

THE COST ACCOUNTING PROCESS:

PLANNING: Determine _____, predict results, ______ how to attain desired results.

PRIMARY TOOL: THE BUDGET--A financial ____.

always future oriented.

CONTROL: __________ planning decisions, __________ of results.

PRIMARY TOOL: PERFORMANCE REPORTS-- A __________ of actual and planned . Any difference is called a VARIANCE.

MANAGEMENT CONTROL SYSTEM: Set _____; take ___________: _______ to goal; start the planned _______; generate ________; take any needed ______. PROCESS: Activities aimed at a particular ____. ENVIRONMENT: Our surroundings. FEEDBACK PURPOSES: Change goals?; find _____ means of goal achievement; ___ decision making methodology; make ___________; change a process?;change performance evaluation.

ALWAYS REMEMBER THAT THE CONTROL PHASE IS ______ WORKING WITH ______ AND SHOULD ALWAYS STRIVE TO HELP EVERYONE DO A BETTER JOB.

Everything we do has a ____ and a certain _______, although, measuring one or the other may often be a difficult task. Such is also true for a COST ACCOUNTING SYSTEM. Under __ circumstance should the cost be greater than the benefit. The choice of a particular system will of course be a function of D.O.T.S.( Depends on the situation). This will require a great deal of experience and judgment.
 
 

Within an organization: LINE AUTHORITY- Authority exerted ________ on employees; STAFF AUTHORITY-________ only; FUNCTIONAL AUTHORITY--Command _________ and down.

Cost accounting falls under _____ AUTHORITY.

PERSONS: TREASURER-Manages ____, obtains _______: CONTROLLER-Responsible for both ____ and _________ accounting.

COST ACCOUNTING DUTIES:

1. ____________ AND _______ ACCOUNTING

INFORMATION

2. DIRECT ATTENTION TO _______ AREAS.

3. ASSIST IN _______ PROBLEMS.
 
 
 
 
 
 

COST ACCOUNTING

FUNDAMENTAL CONCEPTS

LEARNING COST

In order to learn cost accounting, you must learn to speak "COST". You must learn the language. This is accomplished by knowing cost terms and appropriate definitions for these terms. Many of these terms will appear in future lessons. Learn them now, and future lessons will be that much easier. If you don't learn to speak cost, you may have a difficult time surviving.

THE LANGUAGE OF "COST"

________ is what you sacrifice to achieve a certain goal. This goal is of course your objective. In cost accounting, we ACCUMULATE COSTS related to our goal for the purpose of determining how must cost went into the meeting or our goal. This process of cost accumulation provides the basis for the COST SYSTEM we may adopt for our particular needs. The ACTUAL COSTS are simply those costs incurred toward the accomplishment of our goal

THE MANY DIFFERENT TYPES OF "COST"

______________ COST--A cost that remains constant per unit, but increases in total as production increases. (CPU,VIT)

FIXED COST--A cost that remains _______________in total, but decreases per unit as production increases.(CIT,VPU)

BOTH OF THE ABOVE DEFINITIONS ARE ONLY TRUE WITHIN WHAT IS CALLED THE "RELEVANT RANGE". THIS RANGE IS THE LEVEL OF ACTIVITY OVER WHICH PRODUCTION IS _______________TO TAKE PLACE. IT IS SIMPLY AN EDUCATED GUESS ABOUT WHERE ONE THINKS PRODUCTION WILL BE. OUTSIDE THE RELEVANT RANGE, THE ABOVE DEFINITIONS DO NOT HAVE ANY MEANING.

AVERAGE COST-Is a fraction. The numerator is some amount of __________ COSTS and the denominator is some unit of measurement, perhaps: hours or units.
 
 
 
 
 
 

DIRECT MATERIALS COST-- The cost of the materials going into your product that are easily and ____________traceable to the finished good. It is probably a DIRECT MATERIAL COST if you can simply look at the product and observe what went into it.

DIRECT LABOR COST--The cost of the labor going into your product that is easily and clearly traceable to the finished good. If the labor is "_______________ THE PRODUCT" then it probably is DIRECT LABOR.

FACTORY OVERHEAD (INDIRECT MANUFACTURING COSTS). Any product cost that is not classified as direct materials or direct labor. Overhead may be either variable factory overhear or fixed factory overhead.

INDIRECT MATERIALS AND INDIRECT LABOR are two of the primary FACTORY OVERHEAD COSTS.

PRIME COSTS--Direct materials _________ direct labor. Thats all.

CONVERSION COSTS--Direct labor __________ factory overhead. Thats all.

PRODUCT COSTS--Costs that attach to the product and reported on the balance sheet as an asset. Product costs are DM, DL, AND FO.

INVENTORIABLE COST--SAME AS PRODUCT COST.

MANUFACTURING COST--SAME AS PRODUCT COST.

PERIOD COSTS--Costs that attach to a certain period of time, __________ to the product. Reported on the income statement as an expense. period costs would include: general, selling, and administrative.

NONINVENTORIABLE COST--SAME AS PERIOD COST

NONMANUFACTURING COST--SAME AS PERIOD COST.

------

REPORTING COSTS IN THE ACCOUNTS AND ON THE FINANCIAL STATEMENTS.

INVENTORIES REPORTED FOR A MANUFACTURER:

DIRECT MATERIALS INVENTORY--On hand for use

WORK IN PROCESS- Inventory of partially completed goods, contains DM, DL, AND FO.

FINISHED GOODS-Completed goods, unsold.

Inventories may be accounted for under the PERPETUAL inventory system or the PERIODIC

SYSTEM. PERPETUAL: ___________ CHANGES RECORDED, COSTLY. PERIODIC: INVENTORY CALCULATIONS MADE ONLY PERIODICALLY, LESS COSTLY THAN A PERPETUAL SYSTEM.
 
 

REPORTING THE RESULTS OF OPERATIONS FOR A MANUFACTURER AND A MERCHANDISER.

FOR A MANUFACTURER: Sales less cost of goods sold equals gross margin. Gross margin less selling and administrative expenses equals operating income. Cost of goods sold equals beginning finished goods plus cost of goods manufactured minus ending finished goods. Cost of goods manufactured equals direct materials
 
 

used plus direct labor plus factory overhead plus beginning work in process minus ending work in process. Direct materials used equals beginning materials inventory plus purchases less ending materials inventory.

FOR A MERCHANDISE: Sales less cost of goods sold equals gross margin. gross margin less selling and administrative expenses equals operating income. cost of goods sold equals beginning merchandise inventory plus purchases less ending merchandise inventory.

---------------
 
 

ANALYSIS OF LABOR COSTS: OVERTIME PREMIUM- Wages in excess of straight time, generally charged to factory overhead. IDLE TIME: Labor cost incurred when people aren't working for some reason, charged to factory overhead. PAYROLL FRINGE COSTS: Health, pension, insurance etc, probably should be considered a part of direct labor rather than a part of overhead.

COST ACCOUNTING SYSTEMS

SYSTEM DEVELOPMENT

In order to accumulate costs for production, the cost accountant needs some type of a ___________. To function properly, the system must do two things: 1. accumulate costs according to various subunits within the company (responsibility centers) and 2. Apply these costs in some manner to the product being manufactured. All systems will accumulate costs by the ______________ center, and then a system for product costing will be chosen. These choices are: Job-order, process, or operation.

JOB ORDER COST SYSTEM.

In this type system, costs are accumulated and applied to specific jobs, rather than a continuous process.

DOCUMENTATION NEEDED FOR A JOB ORDER COST SYSTEM:

Job cost sheet- the primary source document that summarizes all __________ information with respect to the specific job.

Stores Requisitions- Document used to charge the job with direct materials.

Work Tickets- Document used to charge labor to a specific job.

THE FLOW OF COSTS THROUGH A JOB ORDER SYSTEM
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

THE SYSTEM DESCRIBED ABOVE CHARGES ___________ MATERIALS, ____________ LABOR, BUT ____________ OVERHEAD. THIS IS BECAUSE ACTUAL OVERHEAD WILL NOT BE KNOWN UNTIL MUCH LATER AFTER THE PRODUCTS ARE COMPLETED, TRANSFERRED TO FINISHED GOODS, OR PERHAPS EVEN SOLD. SINCE WE DON'T KNOW ACTUAL OVERHEAD, WE HAVE TO MAKE AN ____________.

THE FOLLOWING DISCUSSION WILL DEMONSTRATE HOW OVERHEAD IS FIRST ESTIMATED AND THEN APPLIED TO THE JOBS.
 
 

STEPS IN APPLYING FACTORY OVERHEAD TO THE JOB

1. Select an activity base, perhaps direct labor hours.

2. Estimate the amount of overhead you expect to incur, relative to the base chosen in step one.

3. Divide ESTIMATED OVERHEAD by ACTIVITY BASE.

4. Apply overhead to the jobs based on the rate calculated in step 3.

At some point in time when the actual amounts of overhear are known, the accountant must compare actual to what was applied. If actual is more, then the system is underapplied, if actual is less, then the system is overapplied.

In general, an annualized overhead rate, as opposed to a daily, weekly, or monthly rate, might be better incorporated into the system.

WHAT TO DO WITH OVER OR UNDER APPLIED OVERHEAD.

At some point in time, perhaps the end of an accounting period, a comparison must be made of actual and applied overhead. This is done by noting the credits to Factory Overhead, the applied side, and comparing this to the debits to Factory Overhead, the actual side.

1. If the amounts are the same, no additional accounting is needed.

2. If the credit side is greater than the debit side, then overhead is over applied. If this happens, then it means that the amount of overhead charged to work in process is more than it should have been. For accounting purposes, factory overhead must be debited and cost of goods sold must be credited for an amount that will make the balance in factory overhead zero.

3. If the debit side is greater than the credit side, then overhead is underapplied. This means that not enough overhead was charged into work in process. For accounting purposes, factory overhead must be credited and cost of goods sold debited for an amount that will make the balance in factory overhead zero.

Charging off over or under applied overhead in the manner described above is generally accepted and widely used. Conceptually, a more accurate method of allocation would be to prorate the amount of over or under applied overhead to the various elements where this amount is located. This would be the work in process account, finished goods account, and cost of goods sold. The amount would be allocated to these three accounts in total, proportional to the relative amounts in each of the three accounts. For example:

work in process: balance of 20

finished goods: balance of 45

cost of goods sold: balance 35

total 100

calculate the percent each is to the total. work in process is 20%, finished goods is 45%, and cost of goods sold is 35%. The allocation process would be to multiply this percent times the over/under amount.

*******

A NORMAL COSTING SYSTEM IS ONE THAT CHARGES ACTUAL MATERIALS, ACTUAL LABOR, AND APPLIED OVERHEAD.

Companies that manufacture a product on a ______________ basis, and all finished goods look alike, may use a process cost system.

COSTS ARE ACCUMULATED IN THE ____________ RATHER THAN BY THE JOB. THIS SYSTEM WILL AVERAGE THE TOTAL COSTS OF PRODUCTION OVER ALL THE GOODS COMPLETED.

STEPS IN THE PROCESS COST SYSTEM( THE STEPS NOTED BELOW ARE ONLY THE VERY BASIC ELEMENTS, A FUTURE CHAPTER WILL BE DEVOTED ENTIRELY TO PROCESS COST ACCOUNTING)

1. CALCULATE ________________ UNITS OF PRODUCTION (EPU'S). An equivalent unit is measured as being the amount of whole units that could have been completed if they had been worked to completion. The concept notes that if you have 10 units that are each 60% complete, then you have worked on 10 units, you have completed zero units, but you have done 6 equivalent units. A formula would be that epu's = units worked on X % of completion.

2. DETERMINE YOUR COSTS FOR DM,DL, AND FO.

3. DIVIDE THE COSTS BY THE EPU'S CALCULATED IN STEP ONE AND FIND THE COST PER EPU.

4. ALLOCATE THE TOTAL COST BETWEEN THE GOODS COMPLETED AND TRANSFERRED OUT AND THOSE THAT REMAIN IN THE ENDING INVENTORY.
 
 

OPERATION COSTING SYSTEM -- THIS IS A SYSTEM DESIGNED TO HANDLE YOUR SPECIFIC NEEDS FROM A COST STANDPOINT. MAY COMBINE ELEMENTS OF JOB ORDER AND PROCESS. MIGHT SAY THAT IT IS "CONSTRUCTED" TO MEET YOUR NEEDS

Process costing is one of the methods that might be utilized for product costing. Some important aspects of this method are:

It is used primarily for __________ production of homogenous products.

Product costs are determined at the end of the cost __________.

Costs are accumulated in departments as opposed to the jobs.

There will be __________work in process account for each department.

Assumes a continuous flow of costs from one department to the next until the product is finished, this means that work in process might be debited and credited at the same time, only for different departments.

Requires the calculation of EQUIVALENT PRODUCTION UNITS (EPU). At the end of the costing period, in order to correctly calculate product costs for the period, those units which are partially complete must be restated to equivalent whole units. To correctly do this, multiply the number of units in the inventory times the percentage of work done on the unit this period. EPU = %CTP X U. In order to properly account for EPU's, the rates at which materials, labor, and overhead are added to the product must be thoroughly analyzed.

At the end of the costing period, the objective of process costing is to restate the costing activities of the period through the use of a COST OF PRODUCTION REPORT. A properly prepared cost of production report doesn't have to look like those presented in the text, however, a proper report will show five items. These are: a quantity schedule, a schedule of EPU's and cost per EPU, total costs to account for, a proper accounting for all costs, and proof of costing.

JOURNAL ENTRIES IN PROCESS COSTING.

The entries are very similar to job order costing. One difference from job order costing is that under process costing, it may be possible to use actual as opposed to applied overhead, such a system will require the judgment of the accountant. Actual factory overhead must be assigned to the departments.
 
 
 
 

TWO METHODS FOR PROCESS COSTING

The weighted average method or the FIFO method are the two methods that might be used in process costing. The ________ method is the theoretically superior method because this method separates costs in the beginning inventory from costs incurred in the current period. Under the ___________ average method, the units and costs for those units are assumed to have been started and completed in the current period.

The easy way to calculate EPU's under the two methods is as follows

1. Completed and transferred out

Add: EPU's, ending inventory

Equals: EPU's, weighted average

Minus: EPU's, beginning inventory

Equals: EPU's, FIFO method

WHEN CALCULATION, ALWAYS ASK YOURSELF THE QUESTION: HOW MUCH DID WE DO THIS PERIOD? If the beginning inventory is 20% complete, How much did we do this period? If the ending inventory is 20% complete, how much did we do this period?

ADDITION OF MATERIALS

Materials added __________ a unit is started in process has the potential to increase the units to account for or simply increase the per unit cost.

The procedure for added materials is almost identical to that previously shown. The only accounting problem is to be sure to consider the impact that the added materials has on units and unit cost.

LOSS OF UNITS DURING PRODUCTION

In many manufacturing processes, the number of units of output will not equal the number of units of input. SCRAP represents materials that cannot be used in the process, ______________ UNITS are units that will require additional cost before they can be a first quality unit, and SPOILED GOODS are those units that are so bad that additional costs will not make them a first quality unit.

There are two types of losses, normal and abnormal. ____________ losses are expected losses and _______________ losses are unexpected. Costs must be separately determined for normal and abnormal losses.

QUALITY CONTROL/ZERO DEFECTS PROGRAM

The zero defects program is one that is intended to stress that all work must be done right the first time. Such a program may change the way manufacturing looks at normal and abnormal spoilage. Such a program will require the total commitment of all workers within the organization. This program may result in all spoilage being considered abnormal spoilage.

TIMING OF INSPECTIONS

An important aspect of a process cost system is the point in the manufacturing process where units are inspected in order to determine the quality of the unit. If the inspection takes place at the end of operations, then all units have 100% of the materials, labor, and overhead, and must be included in the calculation of equivalent units.

The abnormal cost must be kept separate and will be treated as a period cost. The normal cost is simply added to the cost of the good units transferred out. If units are inspected at the beginning of the process, normal and abnormal units will be added to determine the equivalent units from the prior department, but since they were never put into process in the inspecting department, no equivalent units for normal and abnormal spoilage will be added in the inspecting department.

ALLOCATION OF THE NORMAL LOSS

The cost for normal units lost is spread over the good units completed and still in process. To do this, multiply the total amount of the normal loss times the %of total units transferred out to obtain the amount to transfer to the next department, and then times the % of units still in inventory to obtain the cost that will remain in ending inventory.

The point of inspection may take place anywhere between the beginning and end of the process. Be sure to remember that once a unit is inspected and found to be a lost unit, no additional costs will be added to this unit. Costs for normal loss will not be allocated to the ending inventory unless the ending inventory has passed the point of inspection.

JUST-IN-TIME (JIT) MANUFACTURING SYSTEM

JIT is a manufacturing system that functions based on the demand for the product being manufactured. Materials are purchased, labor is incurred, and overhead is added to the product at a pace that is JUST-IN-TIME to meet demand.

**JIT manufacturing results in a lowering of inventory levels because materials arrive just as they are needed, thus lowering inventory.

**Labor in a JIT system is based on the use of manufacturing cells where machines are grouped together to provide for efficient flow of the product and such that workers in each cell don't specialize in only one machine, but rather know how to work with all. Each cell might be called a factory within the factory.

**JIT relies heavily on the concept of total quality control as opposed to acceptable quality levels. JIT also mandates that control

over the manufacturing process must be decentralized.

Because of the cell arrangement, interdisciplinary labor, and decentralized service activities, most costs are more clearly traceable to a particular finished product.

Since most costs are determined to be direct costs, as opposed to indirect, product costing is enhanced. Thus, the unit cost for the product produced by each cell may reflect more clearly the actual costs incurred to finish each unit.

Under JIT, many service department costs are directly traced to a particular cell, thus eliminating the need to allocate service department costs using some basis for allocation.

In a JIT manufacturing process, where emphasis is on automation and decentralization, the role of direct labor may change from that of traditional manufacturing systems. Two possible results are: 1) direct labor may decrease as a % of total cost, and 2) direct labor

may change from a variable to a fixed cost.

JIT manufacturing may eliminate the need to cost the product for the purpose of valuation of inventory on the financial statements. If everything happens just-in-time, there will be no inventory to be reported.

If a JIT system is installed in a manufacturing environment that was previously a job order system, after implementation of the manufacturing cell to handle repetitive orders, the system will perhaps take on more characteristics of a process system.

If a JIT system is installed in a manufacturing environment that was previously a process cost system, the JIT system will lead to simplification of the costing process. Since everything happens just-in-time, there will be no need to account for equivalent units of production, or prior period costs.

Under a JIT system, all inventories are reduced to insignificant levels, which means that less attention has to be paid to costs that are specifically product costs; DM, DL, and FO. The emphasis shifts from costing for materials, labor, and overhead, to costing for all costs incurred, both product costs and period costs.

COST ESTIMATION

Cost accountants are keenly interested in the relationship between changes in various costs given changes in levels ofa Activity(production, volume, units, hours of input, etc.).

Such changes are a function of what is termed COST _______________.

Knowledge of cost behavior is vitally important so that accountants can properly budget costs at various levels of

activity and managers can make decisions based on the budget information.

A given cost will behave in one of three ways. If the total cost is ________________ of activity, the cost is a FIXED COST.

If the total cost is dependent on the level of activity, the cost is a VARIABLE COST. A cost that is part variable and part fixed is called a mixed or semivariable cost. In the short run, variable costs may be assumed to cease when activity ceases, however, fixed costs may not be so easily eliminated. In the long run, one may conclude that all costs are variable (that is, dependent upon production).

Costs are incurred as a result of activity levels. Some books refer to various activity levels as COST ____________. That is to say that costs are driven by various levels of activity. The formula for estimating costs is as follows:

Y = A +bX

where Y equals TOTAL COST, A equals the FIXED COST component, b equals the variable rate per unit of activity, and X equals some unit of activity. Even though some costs might behave in a nonlinear manner, in accounting, we focus on the relevant range of activity, and conclude that cost behavior is linear.

METHODS FOR ESTIMATION OF COSTS

In industry, there are five methods that are commonly used to estimate costs. These methods are

1. ENGINEERING ESTIMATES-- Under this method, engineers will perform various studies, for example, time-and-motion studies, to determine what a particular cost ought to be. Cost estimations are then made by the accountant based upon information supplied by the engineers.

2. THE ACCOUNT METHOD-- The accountant, based on ______________, will classify all accounts in the ledger as fixed, variable, or mixed. A subsequent listing of the accounts and the amounts associated with each account will be prepared and then an estimate of the appropriate cost function will be determined. This method requires a great deal of judgment on the part of the accountant.

3. SCATTER GRAPH (SHOTGUN) METHOD.

In reality, this is a poor method for cost estimation.

Under this method, costs are plotted on a graph at various levels of activity. Then the accountant will visually plot a straight line that best fits the points plotted. The intersection of the line with the y axis represents the fixed portion of the cost and the slope of the line represents the variable rate. However, no two people might draw the same line.

4. THE HIGH-LOW METHOD. This method is widely used and easily applied. Given costs at various levels of activity, the accountant will choose two points for comparison, normally the highest and lowest levels of activity. The variable rate is then determined as follows:

variable rate = the change in cost/the change in activity.

The fixed component of the cost is then determined by choosing either the high or low level of activity and subtracting the total variable cost from the total cost.

5. REGRESSION ANALYSIS-- This method for cost estimation is the most ____________ and exacting. Whereas the SCATTER GRAPH method finds the line of best fit visually, this method finds the line of best fit mathematically. While most applications of regression analysis are best done on the computer, manual calculations are also possible, especially when there is only one independent variable.

Once the cost formula is established using regression analysis, a further analysis may be used to determine the correlation between the independent and dependent variable. The CORRELATION COEFFICIENT is the most widely used statistic to measure correlation. The closer this coefficient is to positive one, the stronger the relationship, the closer to negative one, the stronger is the inverse relationship. The correlation coefficient squared is called the COEFFICIENT OF DETERMINATION. This measure will tell you the percent of change in a particular cost that may be explained by the change in a given level of activity.

ASSUMPTIONS ASSOCIATED WITH REGRESSION ANALYSIS

1. REPRESENTATIVE OBSERVATIONS- model assumes that the points plotted are representative of all possible points.

2. LINEARITY AND RELEVANT RANGE- model assumes that all costs and activities are within the relevant range and that all cost functions are straight line.

3. CONSTANT VARIANCE- model assumes that the variance that exists among the plotted points is constant.

4. INDEPENDENCE- model assumes that the sequence of observations is independent of the associated cost.

5. NORMALITY- model assumes that the points around the regression line are normally distributed. This must be assumed to make calculations in regards to the STANDARD ERROR OF THE ESTIMATE, which measures how far actual costs deviate from the estimated.

6. ABSENCE OF MULTICOLINEARITY- model assumes that when one has more than one independent variable that the independent variables are not highly correlated with each other.
 
 

UTILIZATION OF COST ESTIMATES.

Given all of the above, be sure not to lose sight of your objective. Your objective was to estimate costs for planning purposes. Once your costs are estimated, you will use these cost estimations in the preparation of your primary planning tool, the budget.

A ____________ BUDGET- is one based on only one level of activity.

A ______________ BUDGET- is one based on various levels of activity and depends upon the cost estimates that were made utilizing one of the above methods. A more complete discussion of flexible budgeting will be presented at a later time.
 
 
 
 

LEARNING CURVE THEORY

The learning curve theory may have a significant impact on labor costs. This theory states that the more a person

performs a given task, the more proficient they become, and thus the less time will be required for completion of the

task. For example, an 80% learning curve assumes that each

doubling of output will require only 80% of the work associated with the prior level.

DEFERRED LEARNING CURVE COSTS- An interesting concept.
 
 

This is a study of:

COST: WHAT YOU_____TO OBTAIN GOODS AND

SERVICES; VOLUME: YOUR ___________OF GOODS AND SERVICES; AND PROFIT: HOW MUCH YOU ARE________ --- AND THE INTERRELATIONSHIP AMONG THESE THREE ELEMENTS.

THE BREAK-EVEN POINT.

This is an excellent ______________ for doing cvp analysis. BREAK-EVEN POINT: Where net income is ____, where total cost ______ total revenue, the point where there is no profit or loss.

CALCULATION OF THE BREAK EVEN POINT

SALES-VAR COST-FIXED COST=___________, SO THE BREAK-EVEN POINT IS WHERE SALES-VAR COST-FIXED COST =_____.

SALES - VAR COST = CONTRIBUTION MARGIN, THEN BREAK-EVEN POINT = FIXED COST/CONTRIBUTION MARGIN ________. BREAK-EVEN POINT = FIXED COST/ CONTRIBUTION MARGIN _____.

GRAPHING THE BREAK-EVEN POINT:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

CALCULATION OF A TARGET NET INCOME:

USE THE EQUATIONS ABOVE, AND RATHER THAN SETTING THE EQUATION EQUAL TO ZERO, SET IT EQUAL TO THE _______ LEVEL OF NET INCOME.

LEARNING TO CALCULATE BREAK-EVEN:

Your ability to calculate break-even will be greatly enhanced if you will learn the ____________ format to the income statement. This is as follows:

SALES

- VARIABLE COSTS

__________________

CONTRIBUTION MARGIN

-FIXED COSTS

________________________

PROFIT BEFORE TAX

-TAX

_____________________

NET INCOME
 
 

COST VOLUME PROFIT ASSUMPTIONS

ACCOUNTANTS MAKE THE FOLLOWING ASSUMPTIONS FOR CVP ANALYSIS:

1. All costs are ______ (not curvilinear)

2. all costs are either _____ or ________

3. costs are analyzed within the ________ range.

4. selling price is ________

5. cost for production needs are ________

6. Productive __________ remains constant

7. Either a ______ product or constant sales mix

8. cost comparisons based on a CONSTANT ____

9. ______ is the only factor affecting cost.

10. Inventory changes are _____________.

INTERRELATIONSHIP AMONG C-V-P ELEMENTS

UNCERTAINTY: THE CHANCE THAT ______ AMOUNTS WILL DIFFER FROM ________ AMOUNTS

SENSITIVITY ANALYSIS: A "WHAT IF" TYPE OF ANALYSIS. YOU MEASURE HOW _________ NET INCOME AND OTHER COSTS IS TO A CHANGE IN VOLUME.

MARGIN OF SAFETY: BUDGETED SALES _____ BREAK-EVEN SALES.

A CHANGE IF VARIABLE COST WILL ______ THE CONTRIBUTION MARGIN, THE CONTRIBUTION MARGIN RATIO, AND NET INCOME.

FOR CVP ANALYSIS, ALWAYS REMEMBER THAT CHANGES IN THE LEVEL OF SALES IS ALWAYS ____________ TO A CHANGE IN VARIABLE COSTS. AN 8 PERCENT INCREASE IN SALES WILL CAUSE AN 8 PERCENT INCREASE IN TOTAL VARIABLE COSTS (PER UNIT WILL REMAIN UNCHANGED)

A CHANGE IN FIXED COSTS WILL CHANGE THE _________ AND THE ___ INCOME, THE AMOUNT OF CHANGE DEPENDENT ON THE AMOUNT OF CHANGE IN FIXED COSTS.
 
 
 
 

ABSORPTION VERSUS VARIABLE (DIRECT) COSTING

________ COSTING, AKA, FULL COSTING, FOLLOWS THE FORMAT PRESENTED ABOVE. ALL PRODUCTION COSTS, DM, DL, VFO, AND FFO, ARE CONSIDERED A COST OF THE _______.

ABSORPTION COSTING FOLLOWS THE TRADITIONAL FORMAT FOR THE INCOME STATEMENT:

SALES

-COST OF GOODS SOLD

______________________

GROSS PROFIT (MARGIN)

-SELLING AND ADMINISTRATIVE COSTS

___________________________________

OPERATING INCOME

-INTEREST AND TAXES

________________________

NET INCOME.
 
 
 
 
 
 

UNDER VARIABLE COSTING, ONLY THE COSTS FOR DM, DL, AND VFO, ARE CONSIDERED A _______ COST. FFO IS CONSIDERED A PERIOD COST.

FOR INTERNAL COST ACCOUNTING PURPOSES, THE VARIABLE APPROACH PROVIDES ________ INFORMATION FOR DECISION

MAKING PURPOSES. KNOWING THE CONTRIBUTION MARGIN IS MORE ________ THAN KNOWING GROSS PROFIT.

FOR EXTERNAL FINANCIAL ACCOUNTING PURPOSES, THE ABSORPTION METHOD MUST BE USED IN ORDER TO CONFORM TO ____.

KNOWING THE CONTRIBUTION MARGIN HELPS MANAGEMENT TO

1. MAKE _______ DECISIONS

2. EVALUATE ____________ FOR PRODUCTION

3. CALCULATE SALES TO PRODUCE A DESIRED INCOME

4. HELPS ACCOUNTANTS TO BETTER UNDERSTAND THE INTERRELATIONSHIP THAT EXISTS AMONG COSTS, VOLUME AND PROFIT.

VARIABLE AND ABSORPTION COSTING
 
 

The method chosen for determining product costs will always have an impact on reported income. Two possibilities are the variable costing (direct) method and the absorption costing method.

Differences in income between the two methods is quite simple: Fixed factory overhead is expenses under variable costing and inventoried under absorption. Therefore, some amounts of fixed factory overhead will be reported as assets under the absorption method.

Variable costing - Product cost= DM+DL+VFO

Absorption costing - Product cost=DM+DL+VFO+FFO

Variable costing is used widely in practice, because of the usefulness of the information produced, however, it is not acceptable for GAAP. Absorption costing must be used if the statements are to conform to GAAP.

The choice of costing method will produce a difference in operating income between the two methods. The difference can always be explained as follows|

DIFFERENCE IN INCOME = CHANGE IN INVENTORY UNITS TIMES FIXED FACTORY OVERHEAD RATE
 
 

IF PRODUCTION = SALES, BOTH METHODS PRODUCE THE SAME INCOME

IF PRODUCTION IS > SALES, ABSORPTION INCOME IS HIGHER THAN VARIABLE INCOME

IF PRODUCTION IS < SALES, ABSORPTION INCOME IS LOWER THAN VARIABLE INCOME.
 
 

------------------------------------

Under variable costing, the break-even point is calculated in the usual manner:

BEP= FIXED COSTS DIVIDED BY CONTRIBUTION MARGIN PER UNIT

THERE IS ONLY ONE UNIQUE ZERO POINT FOR INCOME.

However, under absorption costing, income depends on both sales and production. This produces a number of points of break-even, I. e., points where income is zero.

In order to determine break-even under absorption, the formula above must be adjusted so that the numerator takes into account the difference between sales and production multiplied times the fixed factory overhead rate per unit.

The formula then becomes

BEP, ABSORPTION COSTING = FIXED OVERHEAD PLUS (FIXED FACTORY OVERHEAD RATE TIMES [BREAK EVEN SALES MINUS PRODUCTION] DIVIDED BY THE CONTRIBUTION MARGIN PER UNIT.
 
 

----------------------------------------------
 
 
 
 

The DENOMINATOR level of activity was defined earlier as the expected level of activity that was to be used in order to set the rates for application of factory overhead. Hopefully, the above discussion pointed out that this chosen level of production can have an impact on reported income.

Because of this impact on income, the choice of an appropriate level becomes very important.

Possible choices for a denominator level would include:

a. THEORETICAL CAPACITY- assumes maximum output all the time

b. PRACTICAL CAPACITY- Takes into account items such as down time, idle time, and non working days and hours.

This capacity allows for less than 100% output all the time.

c. NORMAL VOLUME - The level of capacity that will meet expected demand over some period of time.

d. MASTER-BUDGET VOLUME - The expected level of capacity utilization for the upcoming year..

SURVEYS HAVE SHOWN THAT THE DENOMINATOR LEVEL MOST OFTEN USED IN INDUSTRY IS THE MASTER-BUDGET VOLUME.

A BUDGET is simply a ____ . In accounting we speak of a budget as being a _________ plan as it shows amounts of dollars that we expect to receive and pay out. It is a __________ of the future. However, we don't gaze into our crystal ball to make our guesses, we must find a better way.

MASTER BUDGET - This is simply a budget that is made up of all the other budgets. This total budget will show __________ from budgeted sales to cash flow.

STEPS IN MASTER BUDGETING:

1. Formulate overall organizational __________.

2. Formulate your ____ (your budget)

3. Compare ______ to budgeted

4. Plan _____, responding to any need perceptions from step

three.

ADVANTAGES OF BUDGETING

1. The majority of small businesses never prosper, and soon ____. The primary reason is that they fail to plan, meaning that they fail to ______. Always remember that people seldom plan to fail, but often fail to plan.

2. Budgeting ______ business people to plan.

3. Budgets provide yardsticks against which ___________ might be evaluated.

4. A budget is useful in ____________ of overall organizational strategies. Different levels of the organization working toward specific goals.

5. In short, budgets force you to look 1,2,even 5 years ahead and see what the ______ holds.

TYPES OF BUDGETS:

1. ANNUAL- One that is set up on your ______ year.

2. CONTINUOUS- one that always forecasts __ months ahead. as one month is finished, a month 12 months from now is added to the budget.

3. OPERATING BUDGET - These show business __________, buying, selling, producing, and earning a profit

4. FINANCIAL BUDGET - These are the capital budget, cash budget, budgeted balance sheet, and budgeted cash flow.

MASTER BUDGET COMPONENTS.

1. Always start with the _____ BUDGET - This shows the number of units and the total dollar value of the units that are expected to be sold.

2. PRODUCTION BUDGET - Once you decide how many you expect to sell, you must set your __________ budget so that you produce enough to meet your sales plus any desired ____________. Take expected sales and add your desired inventory, this tells you how many you will need. Then subtract how many you already have, and this will give your production needs.

3. DIRECT MATERIALS, DIRECT LABOR, AND FACTORY OVERHEAD BUDGETS - Once you determine how many units to _______, you must understand you will have to purchase enough _________, pay for enough _____ and incur enough items of factory overhead to meet your production needs. You have to buy enough materials to meet your production needs and provide for any desired inventory. You have to buy enough labor at a certain rate per unit to meet production needs. And lastly, you must determine the amount of factory overhead that will be incurred in the production of the units determined from your production budget.

4. ENDING INVENTORY BUDGET - Simply shows the value of your ending inventory based on units times unit costs for _______________________________.

5. COST OF GOODS SOLD BUDGET - This shows the _________ cost of the goods that are expected to be sold by your company.

6. SELLING AND ADMINISTRATIVE BUDGET - An estimate of your ______ costs.

7. BUDGETED INCOME STATEMENT - An income statement based solely on the _______ above.
 
 

SALES FORECASTING

The forecasting of sales for a particular company is not an easy task, and is ______ the scope of this text. We will take the sales budget as a given. Three possible methods for forecasting sales are : 1. The ______ opinion of your sales staff, 2. ___________ analysis such as regression, and 3. Let top management _____, sometimes called executive judgment.

Establishment of the sales forecast is the most ________ aspect of the budgeting process. As you can hopefully see from the discussion above, everything in your budget is based upon your guess as to the amount of sales. If you guess _____ on sales, everything that follows will also be _____. Remember also that the budget is not carved in stone, if conditions warrant, ______ the budget in order that it might be a better reflection of reality.
 
 
 
 
 
 

RESPONSIBILITY ACCOUNTING

This aspect of accounting is a system that places ___ and only ___ individual in charge of a particular function and then determines whether a ____________ or ______________ job has been done.

There are four types of responsibility centers. Each should have one individual responsible for maintaining and controlling the actions of their center.

1. COST CENTER - One that accounts for _____ only. Therefore the manager in this responsibility center is held responsible only for cost control.

2. REVENUE CENTER - ONE that is accountable for ________ only.

3. PROFIT CENTER - accountable for _____ and ________.

4. INVESTMENT CENTER - Accountable for costs, revenues, and ___________.

RESPONSIBILITY ACCOUNTING allows for an evaluation of all areas, and the use of management by _________, whereby the attention of upper levels of management will be directed toward those areas that ______ to be having the most trouble.

A primary focus of Responsibility accounting should be _______________. If the system is functioning as planned, managers at all levels are held responsible only for those items that they can _______. If a manager has the ability to _________ a particular item over a particular time period, they have control. No one should ever be held responsible for that which they ______ control.
 
 

***

RESPONSIBILITY ACCOUNTING IS THE _____ ASPECT OF BUDGETING. A BUDGET IS SIMPLY A BUNCH OF NUMBERS ON A PIECE OF PAPER. THESE NUMBERS ARE MEANINGLESS WITHOUT THE __________ ELEMENT. ALWAYS REMEMBER THAT THE BUDGETING PROCESS IS PEOPLE WORKING WITH OTHER PEOPLE. A CAREFULLY CONSTRUCTED AND MAINTAINED BUDGET SHOULD ALWAYS ADD TO AND NEVER DETRACT FROM THE OVERALL ORGANIZATIONAL STRATEGIES OF THE BUSINESS.
 
 
 
 

BUDGETING: FLEXIBLE BUDGETS AND

STANDARDS

A BUDGET is simply a financial ____.

A STATIC BUDGET is a budget that is geared toward ___ level of activity, static budgets are of course better than no budgeting at all, but beyond this, they have very _______ use.

A FLEXIBLE BUDGET is a budget that is __________ to any level or activity or production. A FLEXIBLE BUDGET is far ________ to one that is static.

FLEXIBLE BUDGETING

A flexible budget adjusts to ___ level of activity you want it to. You could use it for doing some sensitivity analysis or more importantly, use it to adjust to what ________ happened with respect to __________.

In the process of flexible budgeting, start with the ____________ format to the income statement. Determine the expected sales price, the variable costs for each unit of production, and the expected fixed costs. By combining the revenues and costs, you can then determine _________ income at any level of production in the relevant range. Ordinarily, a flexible budget will be formatted based upon _______ levels of production, perhaps in increment of 500 or 1000 units

Once you have the flexible budget established, you can now begin the process of __________. You will compare the amounts on your flexible budget with ______ results. Any difference between the flexible budget and actual amounts is called a ________.

SALES VOLUME VARIANCE-- The difference between the flexible - budget amount and the static (master) budget amount. The ______ of the variance is simply the difference in actual and expected unit sales times the unit contribution margin.

The sales volume variance is a measure of _____________ - the degree to which your goal was achieved.

FLEXIBLE - BUDGET VARIANCE: This compares the actual operating income with the flexible budget income adjusted to the ______ level achieved. The first thing you do is to prepare your flexible budget based on ______ results. This will enable you to determine an operating income that ______ have been achieved. The compare this to your actual operation income based on actual revenues and actual costs. Any __________ in your Flexible budget variance.

A PRICE VARIANCE is a more ________ variance. Price variances are determined by taking the difference between the budgeted price and the

actual price and ___________this times the actual quantity. This provided management with a more detailed summary of variances.
 
 

STANDARD COST - A predetermined ____________of what a particular cost ought to be. Companies need standards for _________ ______, and _____. Stated simply, a STANDARD IS A ______ PER UNIT. Whereas a budget is directed toward the overall organization, a standard is directed toward ___ and only ___ unit of your finished product.
 
 

The real difficulty with respect to a standard is the process of ____________ the standard in the first place. Much of what we will do will take the standard as given, which bypasses the more difficult aspect. The process of setting standards should be very carefully done with attention toward a ____ _______ approach. The cost of setting the standard should not outweigh the benefits.

Standard costing involves an analysis of what went ____ the manufacturing process and what came ___. The standard cost allowed is simply an indication of the amounts of money that ______ have been spent in order to achieve the level of production that was ________ met. A KEY TO UNDERSTANDING STANDARD COSTING IS TO ALWAYS REMEMBER THAT TOTAL STANDARD COST _______ IS BASED ON ______ PRODUCTION. YOU SET THE STANDARD PER UNIT, AND THEN THE TOTAL STANDARD ALLOWED IS BASED ON THIS STANDARD PER UNIT TIMES YOUR ACTUAL PRODUCTION.

VARIANCES FOR DIRECT MATERIALS:

Direct materials price variance: DMPV

Direct materials efficiency variance: DMEV

CALCULATION DIRECT MATERIALS VARIANCES

PRICE: AQMPXAP AQMPX SP
 
 
 
 
 
 

WHERE AQMP EQUALS ACTUAL QUANTITY OF MATERIALS PURCHASED.

EFFICIENCY : AQMUXSP SQMUXSP
 
 
 
 

WHERE AQMU IS ACTUAL QUANTITY USED, AND SQMP IS THE STANDARD QUANTITY THAT ______ HAVE BEEN USED

THE ACTUAL QUANTITY WILL BE KNOWN, AND THE STANDARD QUANTITY IS BASED UPON ______ PRODUCTION.
 
 

DIRECT LABOR VARIANCES:`

PRICE VARIANCE compares actual labor costs with standard labor costs for wages

EFFICIENCY VARIANCE compares actual hours used to standard hours that should have been used.
 
 
 
 
 
 
 
 
 
 
 
 

CALCULATION OF DIRECT LABOR VARIANCES

The following format can be used for both:

AQ X AP AQ X SP SQ X SP

PRICE EFFICIENCY

ACTUAL QUANTITIES WILL BE KNOWN, THE STANDARD PRICE WILL BE KNOWN, AND THE STANDARD QUANTITY IS BASED ON THE ACTUAL LEVEL OF PRODUCTION THAT WAS ACHIEVED DURING THE PERIOD.

---------------------------

WHEN VARIANCES SHOULD BE DETERMINED.

The direct materials price variance is usually determined at the time of ________. The direct materials efficiency is usually determined once production has been _________. Variances for labor are also usually determined once production has been _________.

ENTERING VARIANCES INTO THE ACCOUNTS.

UNFAVORABLE variances are always entered into the accounts as ______. FAVORABLE variances are always entered into the accounts as _______. You will have one ledger account for each possible variance, this account is debited if ___________ and credited if _________. All variances are closed out to _____________ sold or prorated among inventories and cost of goods sold ( the same treatment we give over or under applied overhead).

-----------------------------

ANALYSIS OF STANDARD SETTING

Of major concern with setting standards is the _____ at which standards are established. Should the be real high, reflecting perfect conditions, should they be real low, considering all possible interruptions, or should they be somewhere in between. PERFECTION, IDEAL, MAXIMUM, OR THEORETICAL STANDARDS REPRESENT THE BEST THAT IS HUMANLY POSSIBLE. _________ _________ STANDARDS are those that ought to be reached under normal operating conditions. In practice, currently attainable standards are perhaps the best to use.

RESPONSIBILITY FOR VARIANCES

DIRECT MATERIALS PRICE VARIANCE - ORDINARILY THE __________ AGENT.

DIRECT MATERIALS EFFICIENCY VARIANCE - ORDINARILY THE PRODUCTION _______ (FOREMAN).

HOWEVER, SOMETIMES, A FAVORABLE PRICE VARIANCE MAY LEAD TO AN UNFAVORABLE EFFICIENCY VARIANCE IF SUB STANDARD MATERIALS ARE PURCHASED.
 
 

DIRECT LABOR PRICE AND EFFICIENCY. Labor cannot be put in inventory. The purchase and use of labor happens at the same instant. Therefore, the production _______ is usually held responsible for both of these variances. However, if a labor contract changes, the manager should ___ be held responsible for an unfavorable price variance.

___________________________________________

INVESTIGATION OF VARIANCES

When should a variance be investigated? Randomly? Only when it is unfavorable? only when it is unfavorable by a certain amount? When it is favorable? THE ANSWER IS ____________________ IN OUR INVESTIGATION OF VARIANCES, THE QUESTION OF "WHEN" SHOULD BE ANSWERED BY OUR APPROACH TO COST BENEFIT ANALYSIS, AND REMEMBERING THAT OUR MOST SCARCE RESOURCE IS OUR "____".

There are two kinds of overhead: Fixed and Variable. Remember the definitions for these two items. Fixed overhead is expected to remain __________ throughout the relevant range, but Variable overhead is expected to increase in total as production increases..

The part of overhead analysis that is not easy is establishing the standards that are to apply. This is accomplished in various ways by various companies. The standard is of course based on some estimate of the total overhead to be incurred and some type of activity base, such as direct labor hours.

Once the rates (standards) are established, you then need only compare the standards to the actual amounts spent for the various overhead items, and the difference is of course your variance.

-----The model that Is presented below is different from any that you will see in a text. It is easier. Once you work with it some, you will be able to clearly see just how easy that calculation of overhead variances really is.-----

The six variances that need to be determined with respect to fixed and variable overhead may be determined as follows:

Set up a model with three items across the top: ACTUAL, BUDGETED, AND STANDARD(APPLIED). On the left hand side you will have two items: VARIABLE and FIXED. In rough form, the model will look like this:
 
 

ACTUAL BUDGETED STANDARD

VARIABLE

FIXED
 
 

As presented, the model will develop six different amounts that are needed for the calculation of the different overhead variances. The six amounts would be: actual variable overhead, budgeted variable overhead, standard variable overhead, actual fixed overhead, budgeted fixed overhead, and standard variable overhead.
 
 
 
 
 
 
 
 

In abbreviated form the model would then look like this:
 
 

A B S

V (1) (2) (3)

F (4) (5) (6)

Once these six variables are determined, then you can proceed to calculate the overhead variances.

The six variances for overhead are:

1. VARIABLE OVERHEAD SPENDING VARIANCE

2. VARIABLE OVERHEAD EFFICIENCY VARIANCE

3. FIXED OVERHEAD SPENDING VARIANCE

4. VOLUME VARIANCE

5. FLEXIBLE BUDGET OVERHEAD VARIANCE: VARIABLE

6. FLEXIBLE BUDGET OVERHEAD VARIANCE: FIXED
 
 
 
 
 
 
 
 

The six variances are calculated as follows:
 
 

A B S

VOSV VOEV

V B-A S-B

FOSV VV

F B-A S-B
 
 

The process is straightforward. Once you determine the six unknown amounts of variable and fixed overhead, simply subtract as indicated and determine the amount of the variance. If you will subtract as shown, any time you calculate a negative amount, the variance will always be unfavorable. Otherwise, the variance is favorable.

------------------------------------------

The above model is useful for only one purpose. That purpose being the ability to simply calculate the amounts for the different variances. The model is simple recall and does nothing with respect to your ability to understand and analyze and evaluate the six variances. For these purposes, you need a much deeper understanding.

Establishing and maintaining standard costs for fixed and variable overhead allows for planning, control, and product costing (topics that have been covered in previous materials).

The planning phase involves identification of those costs that fall into each category. For variable costs, we look for those product costs that can be expected to vary in total with changes in production, but are not direct materials or direct labor. examples would include indirect labor, indirect materials, fringe benefits, repairs and maintenance, etc. The planning process would include a detail analysis of and identification of the costs that should be included in the category of variable overhead. The same planning process is necessary for identification of the fixed costs that are relevant to your particular company. Once the planning phase has determined the costs that are to be included as fixed and variable overhead, This information would be used to establish an appropriate rate to be used for applying overhead costs to the product. Establishing this rate is still a part of the planning process.

--An important aspect of the planning process is to determine what is called the DENOMINATOR LEVEL of activity. The _______________level is simply an educated guess of the expected level of production. Once the denominator level is chosen, this level is then used to establish the standard rates for variable and fixed overhead.--

Once the planning phase is completed, the ____________ phase will begin. This phase is putting your plan into action. During this control phase, your plan is compared to what actually happened, and any Variances from your plan are identified. The control phase may lead to a review of the planning process, and adjustment to your plan as necessary. The necessary numbers for the control phase will be provided by the model presented earlier.

In the product costing phase, variable and fixed overhead are applied to the product based upon your plan so that a per unit cost for the product being manufactured can be determined. Using your plan is superior to waiting until all actual costs for the various overhead items are know.

------------

EVALUATION overhead VARIANCES

AN UNFAVORABLE VARIABLE OVERHEAD SPENDING VARIANCE will occur when actual variable overhead is more than budgeted variable overhead. There are two possible explanations for this unfavorable variance. 1) The prices paid for variable overhead costs were higher than planned, or 2) or the unfavorable variance could be explained by poor usage of various items, such as supplies, which would cause your actual costs to be higher than necessary.

AN UNFAVORABLE VARIABLE OVERHEAD EFFICIENCY VARIANCE will result when the actual hours taken to produce a certain level of units is greater than the standard hours called for in your original plan. An assumption is made that if the use of labor is inefficient, where actual hours are greater than standard hours, then this inefficiency will also carry over into the use of items considered variable overhead. Remember that the standard rate is the constant in the calculation and the variance is then attributable only to the difference in actual and standard hours times the standard rate.

THE FLEXIBLE BUDGET VARIANCE FOR VARIABLE OVERHEAD will combine the above variances and the resulting variance will show the total variance due to all possible explanations: poor use of the variable items, price changes in your plan, and inefficient use of labor when the goods are being manufactured.

An UNFAVORABLE FIXED OVERHEAD SPENDING VARIANCE will occur when actual fixed overhead is more than budgeted. This type of variance tends to be relatively small, because in the planning phase, costs that were identified as truly constant over wide ranges of production (FIXED) were placed into this category. An unfavorable variance for fixed overhead may simply necessitate a change in your plan.

AN unfavorable VOLUME VARIANCE is the easiest variance of all to explain. It is when your budgeted fixed overhead is in excess of your standard (applied) overhead. Stated simply, an unfavorable volume variance is when the actual level of production achieved is less than the denominator level. If you produce fewer than you expected, your volume is unfavorable, and therefore your volume variance will always be unfavorable.

AN UNFAVORABLE FIXED OVERHEAD BUDGET VARIANCE is the same as the spending variance for fixed overhead.

To make a long story short, a favorable variance will occur when the opposite of what is presented above happens.

When reality sets in, you will find that variance analysis for overhead items will be done on an item-by-item, line-by-line basis. Such an analysis will allow for a much better analysis of the resulting variances.
 
 

1. DESCRIBE THE NATURE OF CENTRALIZED AND DECENTRALIZED OPERATIONS: CENTRALIZED means that all major decisions are made by the head hogs at the trough, without any involvement from anyone else in the pen. DECENTRALIZED means that everyone in the pen has a say so in the day to day activities and operations.

Advantages of Decentralization: 1) Allows management to concentrate on STRATEGIC (long term) operations as opposed to day-to-day operations, 2) Excellent training for managers at all levels, 3) provided managers at all levels with some positive reinforcement. Disadvantages of decentralization: 1) duplication of efforts, and 2) sub-optimization of profits.

2. DESCRIBE THE THREE TYPES OF DECENTRALIZED OPERATIONS:

A) A COST CENTER is a type that incurs costs only and should be evaluated based on the ability to control these costs, B) A PROFIT CENTER is a type that incurs costs and generates revenues and should be evaluated on the ability to generate segment (departmental) margin, and c) AN INVESTMENT CENTER is a type that incurs cost, generates revenues, and has the responsibility to maintain and control some volume of assets. An investment center should be evaluated based on what is called RETURN ON INVESTMENT or ROI

3. COST CENTER ANALYSIS: Use a budget performance report. This report will show the amount of cost budgeted at certain levels of operations, and then compare these budgeted costs to actual costs. The budget report will show whether costs were over budget or underbudget

4. PROFIT CENTER ANALYSIS: Evaluation of profit centers on the ability to generate Net Income will often provide poor information. This is because some of the expenses that are charged to a particular segment or department may be allocated from general operations of the company, and the particular center may have zero control over these costs. Therefore, it is far more relevant to judge performance of a profit center on the basis of segment or departmental margin, because calculation of this amount will only take into consideration those costs and revenues that the center has control over.

5. INVESTMENT CENTER ANALYSIS: Use ROI

Operating income

ROI = ----------------- or

INVESTED ASSETS

ROI = Margin x turnover

where Margin = Operating income divided by sales

and turnover= sales divided by invested assets

BOTH OF THE ABOVE ARE EXTREMELY IMPORTANT IN YOUR UNDERSTANDING OF WHAT RETURN ON INVESTMENT ACTUALLY REPRESENTS. LEARN BOTH..

6. EXPLAIN THE CONCEPT OF RESIDUAL INCOME: ____________ income is the excess of operating income over some predetermined minimum level desired.

RESIDUAL INCOME = OPERATING INCOME-DESIRED INCOME

COULD BE POSITIVE, NEGATIVE, OR ZERO.

The most important function of management is to make decisions. Accountants do not make decisions. This is done by management. However, more often then not, the decisions made by management is based on information provided by accountants through the accounting information system. This being the case, management will depend very strongly on the accountant to provide information that is timely and relevant to the alternatives being considered.

Accountants should never provide management with irrelevant information. This only complicates the decision that has to be made. All information must be RELEVANT.

RELEVANT information must: 1) Be different among the alternatives, and 2) have the capacity to influence the decision. Anything else is irrelevant.

The most common irrelevant cost is a past cost. Any cost that has already been incurred is a past cost (sunk) and is ALWAYS, FROM NOW UNTIL THE END OF TIME, IRRELEVANT. What was paid for something yesterday, last week, last month, or last year is always irrelevant.

So RELEVANT COSTS would then be ANY FUTURE COST THAT VARIES AMONG THE ALTERNATIVES BEING CONSIDERED.

RELEVANT costs allow for accountants to do what is called DIFFERENTIAL ANALYSIS, which will show management the differences that exist among the alternatives.

LEASE OR SELL DECISION

Carefully analyze differential revenues and differential costs between the alternatives and choose the one that provides for a net advantage.

KEEP OR DROP A PARTICULAR SEGMENT OR PRODUCT

Carefully analyze the costs that will remain, and the costs that will be eliminated if a segment or product is dropped. In general, one might expect variable costs to be eliminated and fixed costs to remain. Analyze carefully however, this is not always the case. Sometimes a product or segment that generates a net loss will actually generate a certain level of segment margin which, if lost, will reduce overall company profits.

MAKE OR BUY DECISION

First, determine the cost to buy the product. Second, determine the cost to make the product with particular emphasis on fixed costs. Some fixed costs may be eliminated if a product is bought and not made, however, some fixed costs, such as rent, will remain the same whether a product is made internally or purchased externally.
 
 
 
 

EQUIPMENT REPLACEMENT

The most common mistake made with this decision is to try and make the cost of the equipment to be replaced a relevant cost. The cost of the old equipment is NEVER RELEVANT to the decision to keep or replace. However, the cost of the new equipment is ALWAYS RELEVANT, because it is a future cost. This decision may require careful consideration of OPPORTUNITY COSTS. Opportunity cost is the sacrifice made from choosing the best alternative. In other words, it represents what you give up in order to make the best decision. If you spend $500,000 to buy a new machine, you can't invest the $500,000 in the stock market or a CD.

PROCESS FURTHER OR SELL

Very often, a single manufacturing process will produce more than one product. At the SPLIT-OFF-POINT each product will establish a separate identity. The decision has to be made to sell the product at this point or process the unit further. If the increase in revenue exceeds the increase in cost beyond split-off, the unit should be processed further.

ACCEPTANCE OF A SPECIAL PRICE (OFFER)

If your regular price is $5.00 per unit and someone offers you $4.80 per unit, should you sell at the lower price. The most important items to consider are the level of excess capacity, and the level of variable costs. If the special offer covers variable costs and you have excess capacity, you may decide to sell at the lower price. BE CAREFUL, in doing so, you may alienate some present customers, and you may violate anti-trust laws.
 
 

2. ESTABLISHING PRODUCT PRICES:

A common approach to setting the price of a particular product is the cost-plus approach. Under this approach, total costs are determined, after which, a MARKUP is added

Under the TOTAL COST APPROACH all costs are included in the cost to markup. The markup percentage would then equal the desired profit divided by the total cost.

Under the PRODUCT COST APPROACH, the markup percentage is equal to Desired profit plus total selling and admin expenses divided by total manufacturing costs.

Under the VARIABLE COST APPROACH, the markup is equal to the desired profit plus total fixed cost divided by total variable costs.
 
 

JOINT PRODUCTS- When a manufacturing process produces two or more products with a significant value.

BY PRODUCTS- Incidental products resulting from processing of main products. Very often, these products cannot be distinguished from scrap, and the accounting is very similar.

ACCOUNTING FOR JOINT COSTS: WHY??

Costs incurred in the production of joint and by products are called common costs, or more specifically, joint costs. The accounting problem with joint costs is to determine the amount of cost to be charged to each product. Joint costs must be allocated in order to 1) determine cost of goods sold and ending inventory values for financial statement presentation, 2) Value inventory for insurance purposes, and 3) Determine cost of goods sold and ending inventory for internal purposes.

ALLOCATION OF JOINT COSTS: WHEN??

Joint costs should be allocated at the point where the products attain their separate identity. This is called the split off point. At this point, joint products and by products are easily identifiable.

ALLOCATION OF JOINT COSTS: HOW??

For by-products, generally, subtract the net realizable value of the by products from the joint costs. The net realizable value equals the market value at split off minus any additional processing costs beyond split off for the by product. These costs are termed SEPARABLE COSTS. Another acceptable method is to recognize the sale price of the by product as OTHER INCOME without any cost allocation.

For joint products: Two ways: 1) some type of physical measure (quantities, average unit costs, or weighted factors) or 2) a market or sales value method (gross or net).

There is really no magic formula for either method. The procedure is one of determining the amount of joint costs to be allocated, determining the method for allocation, and allocation of costs.

Under the physical measure method, determine the percentage that each joint product is to the total and multiply this percentage times the joint cost.

Under the market value method, determine the percentage of value that each joint product is to the total and multiply this percentage times the amount of joint cost.
 
 

SEPARABLE COSTS are any costs incurred after the split off point. They have no effect on the total joint cost to be allocated but will effect the net market value for the products.

DIFFERENTIAL COSTS are the extra cost incurred from different alternatives.

DIFFERENTIAL REVENUES are the additional revenues generated from different alternatives. When deciding to sell or progress further a joint product, the decision must be made without regard to joint costs. The company must compare any separable cost with any additional revenue.
 
 
 
 
 
 
 
 
 
 

SUMMARY OF CAPITAL BUDGETING METHODS

1. THE PAYBACK METHOD - Net cash outlay

Net cash flow

a) The most popular and simplest method to calculate.

b) It only indicates the length of time to recover the original cost.

c) Can be deceptive as a yardstick of profitability, and can give wrong decisions.

d) Major shortcomings of the method are that

1. It fails to consider cash flows after the payback period.

2. Does not take account of the magnitude or timing of cash flows during the payback period.

3. Considers only the recovery period as a whole.

e) Actually is a better measure of risk than of profitability

2. THE INTERNAL RATE OF RETURN - The time-adjusted rate of return

a) Is the discount rate that equates the present value of the expected cash flows with the present value of project cost.

b) Means that the present value of the net cash flows, computed at the IRR, will be exactly equal to the net cost of the project.

c) We are given the cash flows and solve for the rate of discount. (Sometimes involves a trial-and-error procedure using present value tables.)

d) The IRR is then compared with the required rate of return to determine whether the proposal should be accepted.

e) Implies that the inflows are reinvested at the rate equivalent to the IRR over the remaining life of the proposal.

3. THE PROFITABILITY INDEX - Present value of cash flows

Net cash outlay

a) Takes account of both magnitude and timing of expected cash

flows in each period of a project's life.

b) As long as the profitability index is equal to or greater

than 1.0 - the proposal is acceptable.

c) For any given project the PI and the NPV give the same

accept-reject signals.

d) The major shortcoming is that it expresses only relative profitability.

e) When different cash outlays are involved in mutually

exclusive projects the NPV method is the better of the two

methods.
 
 
 
 
 
 
 
 

4. THE NET PRESENT VALUE METHOD - Total PV of cash flows

- Net cash outlay

= Net present value

a) All cash flows are discounted to present value using the

required rate of return (cost of capital).

b) We are given the cash flows and the required rate of return

and solve for the net present value.

c) The acceptability of the proposal is determined by whether

the NPV is equal to, or greater than zero.

d) Implies a reinvestment rate equal to the required rate of

return used, as the discount factor.
 
 
 
 

QUALITY COSTS

Consumers have come to demand quality products. Many consumers feel that products from Japan and other foreign countries are often of higher quality than comparable domestic products. Thus, to effectively compete in international markets, United States companies must become more quality conscious. Ironically, United States firms spend a much higher percentage of sales on quality costs compared to Japanese firms. Control of quality costs is an area of opportunity for improving profits.

Quality costs can be divided into four categories:

(1) Prevention. Prevention costs include costs for redesigning the product to decrease the number of parts and thus reduce the probability of manufacturing error. Other prevention costs include employee training costs, supplier training costs to achieve purchase of better-quality materials, and costs of quality circles to identify problems and propose solutions.

(2) Appraisal. Appraisal costs are incurred to ensure that products meet quality standards during manufacture. The emphasis should be on inspection by each worker on the line. Each worker is responsible for his own workmanship. Thus, fewer quality control inspectors are needed. When a worker detects a problem in materials, his own work, or a co-worker's work from a previous station in the line, the worker should have the power to shut down the line until the problem is solved. In addition, workers suggest solutions to ensure that the problem does not recur.

(3) Internal Failure. Internal failure costs are the costs of scrapped products and the costs of reworking defective products prior to shipment.

(4) External Failure. External failure costs are due to defective products having been shipped to customers. These costs include handling customer complaints, repair or replacement of defective products covered by warranty, and loss of customer goodwill.

Perhaps one reason that United States firms spend a much higher percentage of sales on quality costs than do their Japanese competitors is that United States firms likely spend much more on external failure costs. The traditional approach to quality control is that there is a tradeoff between the other types of quality costs and external failure costs. The new approach is that the firm should strive to eliminate external failure costs completely. Internal failure costs and appraisal costs should be minimized. The firm should concentrate its quality control efforts at the prevention stage in order to reduce total quality costs to two to four percent of sales.

FLEXIBLE MANUFACTURING SYSTEMS

A flexible manufacturing system (FMS) is a hybrid of a job order cost system and a process cost system. FMS allows a wide variety of products to be produced similar to a job order cost system. In a FMS there is a continuous flow of production just as in a process cost system.

The objective of a FMS is to be able to produce a wide variety of products while giving rapid service to customers. The keys to a successful FMS are (1) minimizing setup time, (2) eliminating production bottlenecks, and (3) measuring cycle time--the time between receipt of an order and its shipment.

Continuous flow is achieved by quick setup time and an efficient layout of the plant. Equipment that can produce a family of products may be setup on a U shape. A single worker may operate several machines simultaneously under such a setup.

Also, the product can quickly be moved from one machine to another which reduces idle time.

In a FMS operations are monitored continually to prevent problems from occurring. When a problem is discovered, the production line is stopped and the problem is solved. This differs from a traditional cost control system in which variances from standards are determined and investigated.
 
 
 
 
 
 

ACCT 4003 Managerial Accounting

Return on Investment (ROI)

What is ROI?

Return on Investment (ROI) is net operating income divided by average operating assets. Net operating income is earnings before interest and taxes (EBIT) excluding any non-operating gains and losses. Operating assets are those assets such as cash, accounts receivable, inventory, and property and equipment that are used in the firm's ongoing operations. Operating assets do not include such assets as land held for future plant site. Although it would be best to use the weighted average of operating assets, usually a simple average is used. To determine the average operating assets, add the beginning operating assets and the ending operating assets and divide the sum by two.

The Dupont Formula for Calculating ROI

ROI can also be determined by use of the Dupont formula. According to this formula, ROI is equal to margin times turnover. Margin is equal to net operating income divided by sales. Turnover is equal to sales divided by average operating assets. Thus, when margin is multiplied by turnover sales cancels out leaving net operating income divided by average operating assets. The Dupont formula is used to focus on the causes of ROI and how to improve ROI.
 
 
 
 
 
 
 
 

Illustration of the Dupont Formula

ROI = Margin X Turnover

Margin = Net Operating Income Turnover = Sales Sales Average Operating Assets

ROI = Net Operating Income X Sales

Sales Average Operating Assets

Assume the following amounts:

Net Operating Income $10,000

Sales $200,000

Average Operating Assets $50,000

Margin = $10,000 / $200,000 = 5%

Turnover = $200,000 / $50,000 = 4

ROI = 5% X 4 = 20%

Undesirable Consequences of Using ROI for Performance Evaluation

If ROI is used to evaluate a manager's performance, the manager will select projects that improve the ROI. Thus, the manager would invest in a project if the project's ROI is expected to be

greater than the ROI that is currently being realized by the manager. The manager would not invest in projects that were expected to achieve a ROI less than the current ROI. This would be the case even if the expected ROI of the new project is greater than the firm's required rate of return. However, managers should invest in projects which promise a ROI greater than the required rate of return. Also, if a manager's current ROI is less than the required ROI, the manager would be motivated to invest in projects which promised a ROI greater than the current ROI even if such projects had an expected ROI which was

less than the required ROI. These undesirable problems can be

solved by using residual income (discussed below) rather than ROI as a performance measure.

Another problem with using ROI as a performance measure is that it encourages the manager to make decisions that improve ROI in the short term. Decisions that improve ROI in the short term may not be in the firm's long term interest. For example, a manager could improve his ROI by reducing maintenance expense. The long term consequences of such a decision could be disastrous. This problem cannot be solved by using residual income as a performance measure. Residual income suffers from the same short term bias.

Residual Income

Residual income is the net operating income that is left after subtracting the product of the required rate of return and the average operating assets. Residual income can be improved only when an investment yields a ROI that is greater than the required ROI. Thus, a manager will be motivated to invest only in projects whose expected ROI is greater than the required ROI. However, residual income has a limitation. When comparing the residual incomes of two or more divisions, there is an inherent bias in favor of large divisions. Thus, one could not necessarily conclude that a large division is better managed than a small one solely on the basis of residual income.
 
 
 
 
 
 

How to Improve ROI and Residual Income

Increase Sales

This strategy works because an increase in sales will lead to an increase in net operating income (as long as the sales are made at a profit). Notice that sales cancels out in the Dupont formula. It is the resulting increase in net operating income that can increase ROI.

Almost all businesses want an increase in sales. The problem is that costs usually must be incurred to increase sales. These costs could come in the form of increased investment, more advertising, and incentive compensation for salespeople. Additional investment increases average operating assets and higher expenses decrease net operating income. Therefore, the manager must analyze any strategy to increase sales to determine if the expected increase in contribution margin is greater than the increase in expenses. Also, the expected increase in income must be great enough to achieve a rate of return on any new investment that is greater than the required rate of return. The manager must keep these aspects in mind no matter which strategy he decides to implement.

The following are some of the strategies that may be used to increase sales:

1. Increase advertising and promotion

2. Increase price if demand is inelastic and competition allows

3. Decrease price if demand is elastic and competition allows
 
 

4. Find a new market for the product without finding a new use for the product--different geographic market, mail order, trade shows, different age group, delivery service, etc.

5. Find a new use for the product--baking soda is a classic example

6. Provide incentives for salespeople--bonuses, commissions, prizes, etc.

7. Improve customer service. Concentrate on increasing the number of satisfied customers rather than just increasing the volume of sales. A satisfied customer is your best advertisement. He will tell others about your firm and products. On the other hand, an angry customer can more than undo the benefits of advertising.

8. Improve product quality to attract more customers

9. Suggestive selling--ask the customer as he makes a purchase if he could also use an additional product that the firm sells. McDonald's asks if you want any french fries when you buy a hamburger. Be specific and positive in your suggestions. Do not just ask the customer if he wants anything else. This will sometimes receive a positive response, but the customer is often predisposed to say no. It is more difficult for the customer to say no if you make a specific suggestion and sell the benefits of the additional product.

10. Give quantity discounts

11. Improve the location of the product in a retail store. Place complementary products together as much as possible. Place impulse items near the cash register. Place items that customers

deliberately plan to buy past other items. They must walk past these other items to reach the items that they planned to purchase. Occasionally, change the location of products within the store.

12. Find a better location for the store.

13. Provide more liberal credit terms.

14. Provide training and motivational seminars for salespeople.

Help your salespeople to set goals.

15. For retail stores, maintain attractive, well stocked shelves.

16. Improve the packaging of the product.

17. Survey current customers. Find out what their needs are and how well you are satisfying them. Consider their preferences and also the strength or intensity of those preferences.

Reduce Expenses

Reducing wasteful expenses improves ROI because net operating income increases. The manager must make sure that the expenses are truly unnecessary. The behavioral consequences must also be considered. For example, the manager might reduce the time for coffee breaks but in the process destroy employee morale. Reducing research and development may temporarily increase ROI. However, the long term consequences may be disastrous. Manufacturing companies may implement computer aided design (CAD), computer assisted manufacturing (CAM), or a combination
 
 

known as computer integrated manufacturing (CIM) to reduce labor costs and increase quality. Expenses may be reduced by locating plants in low cost areas including foreign countries.

Reduce Average Operating Assets

Operating assets can be reduced in a number of ways. Accounts receivable can be decreased by offering cash discounts for prompt payment. The discounts, however, are an additional cost. For manufacturing companies, inventories can be drastically reduced by implementing a just in time (JIT) inventory system. This will also reduce operating expenses because carrying costs are reduced. For merchandising companies the use of the economic order quantity will determine the optimal quantity of each order.

THE BASIC OBJECTIVE OF FINANCIAL STATEMENTS IS TO PROVIDE INFORMATION USEFUL FOR MAKING ECONOMIC DECISIONS.

1. Users of financial statements seek to predict, compare, and evaluate the cash consequences of their economic decisions.

2. Information about the cash consequences of decisions made by the enterprise is useful for predicting, comparing, and evaluating cash flows to users. (If the value of the unit of measure is unstable, that is, if inflation or deflation is so great that direct cash consequences are no longer comparable, such circumstances should be recognized in the financial statements.)

3. Financial statements are more useful if they include but distinguish information that is primarily factual, and therefore can be measured objectively, from information that is primarily interpretive.

OBJECTIVES OF FINANCIAL STATEMENTS ARE:

1. To serve primarily those users who have limited authority, ability, or resources to obtain information and who rely on financial statements as their principal source of information about an enterprise's economic activities.

2. To provide information useful to investors and creditors for predicting, comparing, and evaluating potential cash flows to them in terms of amount, timing, and related uncertainty.

3. To provide users with information for predicting, comparing, and evaluating enterprise earning power.

4. To supply information useful in judging management's ability to utilize enterprise resources effectively in achieving the primary enterprise goal.

5. To provide a statement of periodic earnings useful for predicting, comparing, and evaluating enterprise earning power. The net result of completed earnings cycles and enterprise activities resulting in recognizable progress toward completion of incomplete cycles should be reported. Changes in the values reflected in successive statements of financial position should also be reported, but separately, since they differ in terms of their certainty of realization.

6. To provide a statement of financial activities useful for predicting, comparing, and evaluating enterprise earning power. This statement should report mainly on factual aspects of enterprise transactions having or expected to have significant cash consequences. This statement should report data that require minimal judgment and interpretation by the preparer.

DESIRABLE FEATURES OF ALL FINANCIAL STATEMENTS:

Each of the financial statements should be structured to enhance the user's ability to assess the following:

1. The extent to which sacrifices and benefits vary over time and among themselves, such as differentiation between fixed and variable expenses.

2. The extent to which sacrifices and benefits vary in relation to changes in the industry and the economy.

3. The extent to which the occurrence of sacrifices and benefits, or their allocation to time periods, is discretionary or arbitrary. Examples are contribution, unusual research expenditures, or the recognition of gains or losses whose timing can be controlled.

4. The extent to which sacrifices and benefits are unusual or infrequent and therefore require special consideration for predicting, comparing, and evaluating.

5. The extent to which sacrifices and benefits pertain to various lines of activity of the enterprise.
 
 

ACCOUNTING

DAILY WORKSHEET

2 PTS

NAME____________________________

DATE:_______________________

CHECK ONE:

WORKSHEET COMPLETED_____

WORKSHEET PARTIALLY COMPLETED_____

THIS WORKSHEET WILL BE TAKEN UP AT THE BEGINNING OF CLASS. ALL WORK MUST BE DONE ON THE FRONT AND/OR BACK OF THIS SHEET. WORKSHEETS WILL NOT BE ACCEPTED LATE. NO ONE MAY TURN IN THIS SHEET FOR YOU. YOU AND ONLY YOU MUST BE PRESENT TO HAND IN THIS WORK.

THIS SHEET WILL ALSO BE USED TO RECORD ATTENDANCE. IF YOU DO NOT HAVE THIS WORKSHEET, I WILL ASK THAT YOU TURN IN A SHEET WITH YOUR NAME ON IT FOR ATTENDANCE PURPOSES.

REQUIRED:

1. Write a summary of the five most important items you learned in the previous class. If the previous class was a test, write about the test and how you think you scored.

2. Provide a detailed solution to one end of chapter exercise or problem for a chapter we have already covered and one that has not been assigned or worked elsewhere.

3. Write two multiple choice questions. One must be quantitative and the other qualitative. Provide solutions for each question.