Chapter 3 Flashcards
Cost Objects
Resources or activities that serve as the basis for management decisions
Require separate cost measurements and may be different products, product lines, departments, geographic territories etch
Single cost object can have more than one measurement
Common Cost Objects
- Product Costs
- Period Costs
- Manufacturing Costs
- Nonmanufacturing Costs
Goal of measuring cost objectives include:
- Product costing (inventory and COG manufactured and sold)
- Income determination (Profitability)
- Efficiency Measurements (comparisons to standards)
Product Costs
All cost related to the manufacturing of a product
Are inventoriable
Attach to the unit of output
Inventory, COG Manufactured, and Sold
Components: direct materials, direct labor and manufacturing overhead applied
Period Costs
Expensed in the period in which they are incurred and are not inventoriable
Include selling, general, and administrative expenses as well as interest (financing expense)
Cost of selling product and administering and managing the operation of the firm
Manufacturing Cost
Treated as Product Costs
Including all costs associated with the manufacture of a product
Manufacturing costs are specifically capitalized to the cost of the manufactured product
Consist of both direct and indirect costs
Nonmanufacturing Costs
Treated as Period Costs
Costs that do not related to the manufacture of a product
Selling, General, and administrative expenses
Direct Costs
Can be easily traced to the cost pool or object
Common Examples:
Direct Raw Materials
Direct Labor
Indirect Costs
No easily traceable to a cost pool or object
Typically benefit two or more cost pools or object
Common Examples:
Indirect Materials
Indirect Labor
Other Indirect Costs
Prime Cost
= Direct Labor + Direct Material
Conversion Cost
= Direct Labor + Manufacturing Overhead
Can be used when a customer furnishes the material used in manufacturing a product
Overhead Allocation Using Cost Drivers
- Allocation Bases: cost drivers used to allocate indirect costs
- Accounting for Overhead: When traditional costing is used, all indirect costs are allocated to a single cost pool (or account) called “overhead”
Allocation Using Traditional Costing
Step 1: Overhead Rate = Budgeted Overhead Costs / Estimated Cost Driver
Step 2: Actual Cost Driver * Overhead Rate
Variable Cost
Behavior: changes proportionately with the cost driver
Amount: Constant per Unit, Total Varies
Long-Run Charatertiscs: short and long run effects are the same within relevant ranges
Fixed Costs
Behavior: in short-term and within relevant ranges, fix costs do not change
Amount: Varies per Unit, Total Remains the Same
Long-run characteristics: given enough time, any cost can be considered variable
Semi-Variable Costs (Mixed)
Costs that include components that remain constant over the relevant range and include components that fluctuate in direct relation to production
Relevant Range
Range for which assumptions of the cost driver (linear relationship with the cost incurred) are valid
Cost Behaviors
Cost Accumulation System
Used to assign costs to products
System used is driven by the cost object involved
Most Common = job-order costing and process costing
Others: Operations costing (uses both job and process costing), Backflush Costing, and Life Cycle Costing
Costs of Good Manufactured
Statement that accounts for the manufacturing costs of the products completed during the period
Costs = direct material, direct labor, and manufacturing overhead
COGM = COGS + Ending Finished Goods Inventory - Beginning Finished Goods Inventory
= Total Manufacturing Cost + Beginning WIP - Ending WIP
Where Total Manufacturing Costs = Direct Materials Used + Direct Labor + Applied OH
Where Direct Materials Used = Beginning Inventory of Direct Materials + Purchases - Purchase Returns/ Allowance + Transport In - Ending Inventory of Direct Materials
Manufacturing costs incurred during the period are increased or decreased by the net change in work-in-process inventory (beginning WIP minus ending WIP) to equal cost of good manufactured
Cost of Good Sold
statement for a manufacturer is very similar to one prepared for a retailer expect that cost of goods manufactured is used in place of purchases made during period
WIP Inventory Beginning + Cost of Good Manufactured = Costs of Goods Available for Sale - Finished Goods Inventory Ending = COGS
COGS = COGM + Beginning Finished Goods Inventory - Ending Finished Goods Inventory
Job Order Costing
Identifies the job or individual units or batches as the cost objective and is used when relatively few units are produced and when each unit is UNIQUE or easily identifiable
Cost is allocated to a specific job as it moves through the manufacturing process
Job-Cost Records are maintained for each product, service or batch of products and they serve as the primary record used to accumulate all costs for the job
Internal Documents Use: Materials Requisitions, Labor Time Tickets, Job-Order Costing
Process Costing
Averages costs and applies them to a larger number of homogeneous items
Steps:
- Summarize the flow of physical units (beginning with the production report)
- Calculate “equivalent unit” output
- Accumulate the total costs to be accounted for (production report)
- Calculate the average unit costs based on total costs and equivalent units
- Apply the average costs to the units completed and the units remaining in the ending work-in-process inventory
Equivalent Units
Costs must be attached to the completed units as well as to the units that are partially completed at the end of each period
Defined: equivalent unit of direct material, direct labor, or conversion costs is equal to the amount of direct material, direct labor or conversion costs necessary to complete one unit of productions
Process Costing Assumptions
- Transfers in are 100% Complete
- Timing of Addition of Direct Material
- Addition at Beginning or During a Process: can be 100% complete or partially complete
- Addition at the End of a Process
- Any material added at the very end of a process will not be in the work-in-process inventory at the month end
Calculating Using FIFO
Ending inventory is priced at the cost of manufacturing during the period, assuming that beginning inventory was completed during the period
Equivalent Unit Components
- Completion of units on hand at the beginning of the period
- Units started and completed during the period (Units Completed - Beginning WIP)
- Units Partially Complete at the End of the Period
Cost Components:
Current Costs incurred during the period are allocated to the equivalent units produced during the period
Formula:
Beginning WIP * % to be Completed XXX
Units Completed - Beginning WIP + XXX
Ending WIP * % Completed + XXX
Equivalent Units XXX
Cost Per Equivalent Units:
= Current Cost Only
Equivalent Units
Calculating Using Weighted Average
Averages the cost of production during the period with the costs in the beginning work-in-process inventory
Equivalent Unit Components:
- Units completed during the month (Beginning WIP + Units stated and completed during the month)
- Units partially complete at the end of the period
Total cost, including both the costs of beginning inventory and current costs, are allocated to equivalent units to arrive at a weighted average unit cost
Formula:
Units Completed XXX
Ending WIP * % Completed +XXX
Equivalent Units XXX
Cost Per Equivalent Unit:
Beginning Cost + Current Cost
Equivalent Units
Comparison of FIFO and Weighted Average
Equivalent unit calculation under FIFO consists of 3 elements representing the current periods production, whereas calculation under the weighted average method consists of only two elements
FIFO represents only cots incurred in the current period. Weighted average includes both current period plus prior period units
Operational Cost Drivers
- Volume-Based:
- Direct Labor Hours or Machine Hours
- Can Distort the amount of costs assigned to various product lines because overall overhead costs do not fluctuate with volume
- Activity Based:
- Assumes that resource-consuming activities with specific purposes cause costs
- Best way to assign indirect costs to product is based on the product’s demand for resource- consuming activities
- Attempts to improve cost allocation by emphasizing long-term product analysis
Activity- Based Costing Terminology
- Activity: any work performed inside a firm
- Resource: an elements that is used to perform ( or applied to perform an activity)
- Cost Drivers: activity bases that are closely correlated with the incurrence of manufacturing overhead costs in an activity center
- Often used as allocation bases for applying overhead costs to cost objects
- Ability to change total costs
- Include nonfinancial, statistical measurements of activities such as sales or production volume
- Resource Cost Driver: amount of resources that will be used by an activity
- Activity Cost Driver: amount of activity that a cost object will use, and it is used to assign the costs to the cost objects
- Activity Centers: operation necessary to produce a product
- Cost Pool: group of costs or specially identified cost center in which costs are grouped, assigned and collected
Characteristics of ABC
- Can be part of a job order system or process cost system
- Can be used for manufacturing or service businesses
- Takes a long-term viewpoint and treats production costs as variable
- Cost driver is often a nonfinancial variable
- May be used for internal but not for external purposes
- Also called Transaction-Based Costing when cost driver is the number of transactions involved in a particular activity
- Focuses management on the cost/benefit of activities
Value Chain (Value-Added Activities)
- Series of activities in which customer usefulness is added to the product
Non-Value Added Activities
- Do not increase product value or service and are targeted for elimination
Steps of ABC
- Identify Cost Drivers
- Accumulate the Costs in Cost Pools
- Trace Indirect Costs to Activity Centers
- Allocate Remaining Indirect Cost Pools
- Costs of each activity are applied to cost objects based on the most appropriate cost drivers
- Divide Assigned Costs by Level of Activity for Cost Center
- Divide costs assigned to activity center by the estimated level of activity for the center to derive an application rate for that center
- Cost the Product
- Multiplying its demand for the resources of an activity center by the rate for that activity center
Effects of ABC
- Apply high amounts of overhead to a product that places high demands on expensive resources
- Removes distortion caused by traditional, volume-based overhead system
Standard Costing System
- natural extension of ABC
- Standards are set at activity levels based on cost drivers
- Variations are calculated by comparing actual and standard costs that consider levels of activities
- Due to price (labor), usage (efficiency), or others
- Normal and abnormal scrap or spoilage is estimated for activity levels
- Standards may be difficult to set on a per unit basis
- Per unit costs are often inversely proportional to volume
- Assumption of a relevant range may be necessary to set a per unit standard
Service Costs Allocation Using ABC
- Direct Method: most widely used and least complex
- Step-Down Method (sequential method)
- used in more complex situations
- service department costs are also allocated to other service departments as well as production departments
- assumes that once a service department’s costs have been allocated to another service department, there can be no subsequent costs allocated back to the other service department
Joint Products
two or more products that are generated from a common input
By-Products
minor products of relatively small value that incidentally results from the manufacture of the main product
have relatively low sales values that are not sufficient to cover their share of common costs
Revenue Accounting:
- Applied to Main Product: any proceeds from the sale of a by-products are a reduction to common costs for joint product costing
- sales credited to joint costs incurred either at the time of production or time of sale
- Miscellaneous Income: revenue from the sale of by-products may be credited to misc. income
Split-Off Point
point in the production process at which the joint products can be recognized as individual products
Joint Product Costs (Joint Costs)
costs incurred in producing products up to the split-off point
Separable Costs
costs incurred on a product after the split-off point
Relative Net Realizable Values
Equals sales value loss cost of completion and disposal
At split-off point is used purely for inventory costing and is of little use for cost planning and control purposes
Sales Value at Split-Off
Used if split-off values are not available
= Final Selling Pricing - Identifiable Costs Incurred After Split-Off
Service Department Cost Allocation to Joint Products
Can be accomplished by using the joint products unit-volume relationship
Financial Performance Measures
Include Financial Scorecards, Costs of Quality, ROI, ROA, ROE, Residual Income and Economic Value Added
Nonfinancial Performance Measures
Productivity Measures: measures of ratio of the outputs achieved to the inputs of production
Measure of efficiency
Uses relationships derived from actual performance in comparison to similar organizations over time
Types:
- Total Factor Productivity Ratios: (TFP)
- Reflect the quantity of all output produced relative to the costs of all inputs used
- Used to compare actual costs per unit production levels to budgeted ( or prior year’s) production levels
- Partial Productivity Ratios: (PPRs)
- Reflect the quantity of output produced relative to the quantity of individual input(s) used
- Ratio can be used to compare actual levels of production input needed to produce a given output
- Used for comparison with a budgeted (or prior year’s) input level
- Most frequently used productivity measure
Control Chart
Important tools used in statistical quality control (SQC)
Graphical tool used to plot a comparison of actual results by batch or other suitable constant interval to an acceptable range
Shows whether there is a trend toward improved quality conformance or deteriorating quality conformance
Pareto Diagrams
Used to determine the quality-control issues that are most frequent and often demand greatest attention
Demonstrates the frequency of defects from highest to lowest frequency
Cause-and-Effect Diagram (Fishbone)
Once the most frequently recurring and costly defects/problems are identified by Pareto Diagram, cause-and-effect can be used to further analyze the defect
Provide framework for managers to analyze the problems that contribute to the occurrence of defects
Types of Responsible Segments
Sometimes referred to as Strategic Business Units (SBUs)
Highly effective in organizing performance requirements and in establishing accountability for financial responsibility
- Cost SBUs: managers held responsible for controlling costs
- Revenue SBU: managers are held responsible for generating revenues
- Profit SBU: managers are held responsible for producing a target profit (both revenues and costs)
- Investment SBU: managers are held responsible for return on the assets invested to product the earnings generating by the SBU
Areas of Accountability in Financial Scorecards
- Product Lines:
- some SBUs involve multiple products
- Costs, Sales, Profits or Returns associated with each of these products can be further analyzes
- Geographic Areas
- performance can generally be traced by geographic location or market to provide additional insight into results
- Customers
- one of the most significant classifications
Contribution Reporting
- Contribution Margin: measures the excess of revenues over variable costs (or contribution to fixed costs) for a company or division
- Controllable Margin: represents the difference between contribution margin and controllable fixed costs
- Controllable fixed costs can be influenced by managers in les than one year (sales promotion and advertising)
- Allocation of Common Costs: Managers have control over variable costs and controllable fixed costs
- Common costs are not controllable
- must be fair and logical
Balanced Scorecard
Gathers information on multiple dimensions of an organization’s performance by defined by critical success factors necessary to accomplish the firm’s strategy
Critical Success Factors: Financial, Internal Business Processes, Customer Satisfaction, and Advancement of innovation and human resources development (learning and growth)
Cost of Quality
Includes costs associated with activities related to conformance with quality standards and opportunity costs or activities associated with correcting nonconformance with quality standards
An inverse relationship between conformance and nonconformance costs exists
Conformance Costs
- Prevention Costs:
- incurred to prevent the production of defective units
- Examples:
- Employee training
- Inspection expenses (raw materials coming in)
- Preventative Maintenance
- Redesign of Product
- Redesign of Processes
- Search for higher quality suppliers
- Appraisal Costs: incurred to discover and removed defective parts before they are shipped to customer or the nest department
- Examples:
- Statistical quality checks
- Testing
- Inspection (completed products before they ship)
- Maintenance of the laboratory
- Examples:
Non Conformance Costs
Classified as either internal or external costs
Often difficult to compute because most are in the form of opportunity costs
Types:
- Internal Failure: costs to cure a defect discovered before the product is sent to the customer
- Examples:
- Rework costs
- Scrap
- Tooling Change
- Costs to Dispose
- Cost of the lost unit
- Downtime
- Examples:
- External Failure: costs to cure a defect discovered after the product is sent to the customer
- Examples:
- Warranty Costs
- Cost of Returning the Good
- Liability Claims
- Lost Customers
- Reengineering an external failure
- Examples:
Non Conformance Costs
Classified as either internal or external costs
Often difficult to compute because most are in the form of opportunity costs
Types:
- Internal Failure: costs to cure a defect discovered before the product is sent to the customer
- Examples:
- Rework costs
- Scrap
- Tooling Change
- Costs to Dispose
- Cost of the lost unit
- Downtime
- Examples:
- External Failure: costs to cure a defect discovered after the product is sent to the customer
- Examples:
- Warranty Costs
- Cost of Returning the Good
- Liability Claims
- Lost Customers
- Reengineering an external failure
- Examples:
Return on Investment (ROI)
ROI = Income / Investment Capital
or
ROI = Profit Margin * Investment Turnover
Ideal performance measure for investment SBUs
Profit Margin = Income / Sales
Investment Turnover = Sales / Invested Capital
Higher Percentage Return, the BETTER
Limitations:
- Short-Term Focus: investment myopia
- Disincentive to Invest: profitable units are reluctant to invest in additional productive resources because they could reduce their ROI
Facts:
- Use of ROI can make it undesirable for a skillful manager to take on trouble-shooting assignments such as those involving turning about unprofitable divisions
- The use of ROI may lead managers to reject capital investment projects that can be justified used discounted cash flow models
- When the average age of assets differs substantially across segments of a business, the use of ROI is appropriate
Return on Assets (ROA)
ROA = Net Income
Average Total Assets
** Can be used to compare profitability of companies that differ in size
** Profitability measure that can be used to evaluate the efficiency of asset usage and managements, and the effectiveness of the business strategies to create profit
ROI/ ROA Issues
Variations on Asset Valuation: appropriate asset valuation depends on the strategic objectives of the company and the direction that leadership wants to give its manager
Types:
- Net Book Value: represent historical costs less accumulated depreciation
- Gross Book Value: represents historical cost prior to the reduction for accumulated depreciation
- Replacement Cost: represents the cost to replace assets at their current level of utility
- Liquidation Value: represents the selling price of the productive asset
Return on Equity (ROE)
ROE = Net Income
Equity
or
= Net Income * Sale * Assets
Sales Assets Equity
Simple to compute
Additional breakouts of the components of ROE provide management with a much clearer picture of the efficiencies and leverage of a given company’s operations
DuPont Analysis
Breaks ROE into three distinct components (Net Profit Margin, Asset Turnover, Financial Leverage)
Net Profit Margin (Measures Operating Efficiency)
= Net Income
Sales
Asset Turnover (Efficiency of Asset Usage)
= Sales
Assets
Financial leverage (Measures Extent of Debt in Capital Structure)
= Assets
Equity
DuPont ROE = Net Profit Margin * Assets Turnover * Financial Leverage
or
ROA * Financial Leverage
Extended DuPont Model
Breaks out Net Profit Margin into three components (Tax Burden, Interest Burden, and Operating Income Margin)
Tax Burden = Net Income
Pretax Income
Extend to which a company retains profits after paying taxes
Interest Burden = Pretax Income
Earning Before Interest and Taxes (EBIT)
Reflects how much in pretax income a company retains after paying interest to debt holders
EBIT Margin = EBIT
Sales
Measures company profits earned on sales after paying operating and nonoperating costs (other than interest & tax)
Extended DuPont ROE = Tax Burden * Interest Burden * EBIT Margin * Asset Turnover * Financial Leverage
Both DuPont and Extended DuPont produce the same number. Breaking them down allows for better analysis by management
Residual Income
Method that measures the excess of actual income earned by an investment over the return required by the company
Rate of Return might be the WACC, Cost of Equity, or Return Established by Management
Provides an amount in $$$
Like ROI, is a performance measure for investment SBUs
Formula:
Residual Income = Net Income (from IS) - Required Return
Where:
Required Return = Net Book Value (Equity) * Hurdle Rate
Positive indicates performance is meeting standards
** Imputed interest rate used in the Historical Weighted Average Cost of Capital for the Company or Target Return on Investment set by company’s management
Benefits:
- Ease of measurement of actual dollars earned by an investment above its required amount
- Encourage management to invest in projects that generate income in excess of the target or calculated rate
- Better than ROI because desirable investment decisions will not be neglected by high-return divisions
- Better than ROI because goal congruence is more likely to be promoted
Weaknesses:
- Distorts comparison of units with unequal size
- Computing target rate of return may sometimes be difficult
Economic Value Added Method
Similar to Residual Income Method
Measures the excess of income after taxes (not counting interest expense) earned by an investment of the return rate defined by company’s overall cost of capital (WACC)
NOPAT = Net Operating Profit After Tax
Ensures performance is measured in comparison to changes associated with al capital, debt and equity
Expressed as an amount and considered a form of economic profit
Formula:
EVA = NOPAT - Required Return
where:
Required Return = Investment * WACC
Positive EVA = performance is meeting standards
Negative EVA = Performance is not meeting standards
Investment Valuation Issues for EVA
- Capitalization of Research & Development:
- can capitalize as part of its asset base along with other value-adding investments in advertising and training
- Current Valuation of the Balance Sheet:
- generally revalued to represent current costs
Income Determination in EVA Method
NOPAT may be adjusted to eliminate the effect of certain transactions and thereby create a nearly cash basis income statement
Adjustments to balance sheet affect the income statement
Deferred taxes are ignored
Cost of Goods Sold- Manufacturing
= Cost of Goods Sold - Ending Finished Goods + Beginning Finished Goods
- Beginning Inventory of Finished Goods
- Add: Cost of Goods Manufactured
- Equals: Finished Goods Available for Sale
- Subtract: Ending Inventory of Finished Goods
- Equals: Cost of Goods Sold
Gross Profit
Gross Margin = Revenue - COGS
Revenue
Sales 1,000,000
Beginning Inventory of Finished Goods 100,000
+ Cost of Goods Manufactured 800,000
- Ending Finished Goods Inventory -500,000
- 400,000
Gross Profit 600,000
Gross Profit Formula
GP = Revenue - COGS
Where COGS = COGM + Beginning Finished Goods Inventory - Ending Finished Goods Inventory
Weighted Average Method for Equivalent Units Formula
= Total Costs / Equivalent Units
Where:
Total Costs = Beginning Costs + Current Costs
Total Units = Units Completed + Ending WIP * % Completed
Ending Inventory Calculation
Beginning inventory + net purchases – COGS = ending inventory
Cost of Goods Transferred to Finished Goods Inventory
Beginning Balance in WIP XXX
Plus Total Manufacturing Costs XXX
Equals Goods Available to Transfer XXX
Minus Goods Transferred to Finished Goods XXX ← Squeeze
Ending Balance of WIP XXX
Where :
Total Manufacturing Costs = Direct Materials + Direct Labor + % Applied from Overhead
Direct Materials Costs = Beginning Balance Direct Materials + Purchases + Transportation In - Purchase Returns/ Allowances
Spoilage Calculation
= Normal Spoilage * Percent Sold + Abnormal Spoilage
Asset Turnover Formula
= Sales / Assets
Capital Turnover
Total Sales / Shareholder’s Equity
Investment Turnover
= Sales / Average Investment
