Operations Management & Strategic Planning (26%) Flashcards
Indirect Labor and Indirect Materials costs are what type of cost?
Conversion costs (as a component of OH)
Costs on an Income Statement
Net Sales
- COGS ———-> Product Costs
= Gross Profit
- SG&A Expenses ———> Period Costs
= Net Profit (Loss)
Overhead Rate Methodology
- Estimated amounts based on currently attainable capacity are always used for this formula— not historical, ideal, or theoretical amounts. This is likely to be a frequently tested concept on the CPA exam.
An overhead application rate is commonly called a predetermined (“estimated” = “budgeted”) overhead rate and is computed as follows:
Estimated Total Overhead Costs / Estimated Activity Volume
- Direct materials and direct labor are traced to the Work-in-Process (WIP) account, but overhead must be allocated to WIP. Since overhead costs are typically not directly traceable to specific units of production, an estimated overhead amount is applied to production based on a predetermined rate. Actual overhead costs are accumulated separately. At the end of the period, the applied overhead is compared to the actual overhead and an entry is made to adjust any difference.
- The result of this calculation is the overhead allocation rate (or overhead application rate). The overhead allocation rate is normally established prior to the beginning of the period. That is, it is a predetermined rate.
Applied Overhead T-Account Entry
Actual Overhead T-Account Entry
OH Applied - sent to WIP
- DR: Work-in-Process
- CR: Factory Overhead Applied
Actual OH - sent from DM and DL (left side of T-Account)
- DR: Factory Overhead Control Utilities Expense
- CR: Accounts Payable
Closing out the OH Account - T-Account Entry
- DR: Factory Overhead Applied
- CR: Factory Overhead Control
Immaterial deltas are typically allocated to COGS.
Material differences should be allocated PRO-RATA to WIP, FG and COGS based on their respective ending balances. This will be tested on exam.
MFG OH Overapplied to WIP vs. Underapplied MFG OH
Overapplied (allocated) = When more overhead costs are applied to products than are actually incurred, factory overhead is said to be overapplied. When the accounts are closed at the end of the period, overapplied overhead reduces Cost of Goods Sold.
Underapplied (allocated) = When actual OH is > OHA (or budgeted). When the accounts are closed at the end of the period, underapplied overhead increases Cost of Goods Sold. For overhead to be underapplied, either the actual fixed costs must be greater than the budgeted fixed costs or the actual volume must be less than the budgeted volume.
Summary of OH Application (3 steps at 3 time periods during the year)
- At the beginning of the year, we calculate the predetermined overhead allocation rate (POR). For example, estimated overhead is divided by estimated direct labor hours.
- During the year, we periodically allocate overhead by multiplying the overhead allocation rate (POR) by the actual units of the allocation base.
- At the end of the year we dispose of over/underapplied overhead by taking the difference between actual overhead and applied overhead to Cost of Goods Sold.
Conversion Cost
Conversion cost is the sum of direct labor and overhead. It is so named because this is the cost of the efforts that convert raw material into finished goods.
Indirect labor is included in overhead and, thus, is part of conversion cost.
Flow of Inventory Calculation (must know this for multiple sections of CPA exam)
+ Beginning Inventory
+ Purchases
= COG Available for Sale
- Ending Inventory (reported on B/S)
= COGS (appears as line item on I/S)
Direct Materials Formula (Step 1)
BI DM
+ DM Purchased
= DM Available for Use
- EI DM
= DM Used (flows to Total Manufacturing Costs)
Total Manufacturing Costs (Step 2)
DM Used
+ DL
+ MFG OH
= Total MFG Costs (flows to CGM)
CGM (Step 3)
BI WIP
+ Total MFG Costs
= WIP Available
- EI WIP
= CGM (Flows to CGS)
CGS (Final Step in Inventory Flow, hits Income Statement)
BI FG
+ CGM (i.e. Total Production Costs)
= CG Available for Sale
- EI FG
= CGS
What inventory accounts are analyzed for:
CGM
CGS
CGM = Raw Materials and WIP
CGS = Finished Goods
Scrap
Scrap is included in product costs along with normal spoilage.
- Scrap is the material left over after making a product. It has minimal or no sales value. Scrap is automatically included in work in process for a product because it is part of the material cost of a product. In many manufacturing settings, it is impossible to use every bit of material input. For example, the circular punch-outs for conduit boxes are scrap.
- Normal spoilage is output that cannot be sold through normal channels. It is an inherent result of production. In many cases, it is not cost effective to attempt to reduce the normal spoilage cost to zero. It is a normal part of the production process and, therefore, its cost is included in the cost of units produced.
- Abnormal spoilage is considered avoidable. It occurs as a result of an unexpected event, such as a machine breakdown or accident. This cost is treated as a loss rather than a normal production cost.
When a flexible budget is used, a decrease in production levels within a relevant range will do what to total costs?
Decrease total costs.
Variable cost per unit is assumed to be constant throughout the relevant range. A decrease in production causes total variable costs to decrease, but not variable cost per unit. Also, variable cost per unit should not increase with lower production.
Cost = FC + VC(vc/unit)
This formula is crucial in calculating many total cost questions. Using the high-low method, remember the Rise/Run to arrive at vc/unit, then solve for FC by plugging in facts from one set of facts given.
Activity Based Costing (ABC) vs. Traditional Cost Systems
ABC shifts costs away from high-volume simple products toward lower volume and more complex products. Cost drivers are used as a basis for cost allocation and activities that are non-value adding are eliminated or reduced to the greatest extent possible.
Adopting ABC will effect:
- more precise cost accuracy
- more cost pools
- more allocation bases
A tradition system tends to over-cost high volume products and undercost low volume products.
- Re-engineering
- Shared Services
- Outsourcing
- Off-shoring
- a process analysis approach that typically results in radical change. This is a different approach from incrementally reducing and eliminating non-value added activities, and otherwise improving processes.
- one part of an organization provides an essential business process where previously it was provided by multiple parts of that same organization
- taking an internal activity and moving it to an external third party service provider
- moving a process outside of the country. Off-shore operations are especially vulnerable to cultural/language issues and difficulty protecting intellectual property rights.
Absorption costing (required by SEC) vs. Direct Costing
- ONLY difference concerns the treatment of Fixed MFG Costs.
- Variable Costing (Direct) treats FC as a period expense and is used only for internal decision making.
Absorption costing: Assigns all three factors of production (direct material, direct labor, and both fixed and variable manufacturing overhead) to inventory. i.e. Fixed Cost = Product Cost
- The absorption model assigns all manufacturing costs to products.
Direct costing: (also known as variable costing) Assigns only variable manufacturing costs (direct material, direct labor, but only variable manufacturing overhead) to inventory.
- The direct model assigns only variable manufacturing costs to products.
Variable (Direct) Costing Method of Arriving at Income = Contribution Margin Format
The contribution margin equals sales minus variable costs. Fixed costs are deducted from the contribution margin to calculate income.
Sales
- Variable MFG
- Variable SGA (these are still NOT product costs!)
= Contribution Margin
- Fixed MFG
- Fixed SGA
= Operating Income
Absorption Costing Method of Arriving at Income = CGS Format
Fixed Mfg. OH is allocated to each item produced. If we produce more than we sell, a portion of the Fixed Mfg. OH is capitalized as inventory (becomes an asset) until it is sold.
Sales
- VC for units sold
- FC for units sold
= Gross Margin
- Variable SGA
- Fixed SGA
= Operating Income
Remember that variable selling and administrative expenses under the Absorption and Direct (Variable) Costing methods are:
NOT Product Costs
Remember also that under both methods it is POSSIBLE to arrive at the same net income total.
Absorption vs. Direct (Variable) Income
If Units Sold = Units Produced
- AC income = VC income
If Units Sold > Units Produced
- AC income < VC Income
If Units Sold < Units Produced
- AC income > VC income
when we produce more than we sell, under the AC method, which capitalizes any remaining FC to inventory as an asset, income will be higher than VC income.
Job Order Costing
Job order costing is used to accumulate costs related to the production of large, relatively expensive, heterogeneous (custom-ordered) items. Costing follows the general rules for manufacturing cost flows and is relatively straightforward.
As with traditional costing methods, estimated amounts based on currently attainable capacity are always used for this formula.
- Immaterial differences between the two amounts are usually allocated to COGS.
- If the difference is material, it should be prorated to WIP, finished goods, and COGSbased on their respective ending balances.
Applied OH
Applied Overhead = (bud. FOH/bud. volume) X (actual volume)
Process Costing
Process costing is used to accumulate costs for mass-produced, continuous, homogeneous items, which are often small and inexpensive. Job Order Costing is exactly the opposite.
Since costs are not accumulated for individual items, the accounting problem becomes one of tracking the number of units moving through the work-in-process (WIP) into finished goods (FG) and allocating the costs incurred to these units on a rational basis. The cost allocation process is complicated because:
- There may be partially completed items in beginning and ending inventories.
- Each of the three factors of production (labor, material, and overhead) may be at different levels of completion, making it necessary to perform separate calculations for each factor.
- Some costs do not occur uniformly across the process; this is particularly true for direct materials (DMs). This is why the two categories of the factors of production indicated are typically DMs and conversion costs (i.e., direct labor [DL] and overhead [OH]). DL and OH are normally included together because they are typically uniformly incurred.
CGS is called what in Process Costing?
The term “cost of goods transferred out” is often used in process costing rather than the “cost of goods finished” since the units could be transferred through several departments prior to going to FG inventory. Cost of goods finished would only accurately apply to the last department in the sequence.
Which of the following types of budgets is the last budget to be produced during the budgeting process?
- Cash
- Capital
- Cost of Goods Sold
- Marketing
Cash
The cash budget is the last budget to be prepared and includes a plan for earning and financing all of the strategic action plans of the enterprise and other incidental issues earning and requiring cash flow.
Define Static Budget
Budgeted Costs for Budgeted Output
A static budget is a comprehensive financial plan produced at the beginning of the year for the entire enterprise and does not change (or flex) during the year. Thus, it uses budgeted costs based on budgeted output.
The Master Budget is a static budget.
Regression Equation and Graph
y = A + Bx
- y = dependent variable
- A = the y-intercept
- B = the slope of the line
- x = independent variable
Correlation Coefficient (R)
The correlation coefficient (R) measures the strength of the relationship between the dependent and independent variables. The correlation coefficient can have values from −1 to 1 where:
- 1 indicates perfect positive correlation (as x increases, so does y),
- −1 indicates perfect negative correlation (as x increases, y decreases), and
- 0 indicates no correlation (you cannot predict the value of y from the value of x).
Coefficient of Determination (R2 or R-squared)
The coefficient of determination, identified as R2 (R-squared), indicates the degree to which the behavior of the independent variable predicts the dependent variable. The coefficient of determination is calculated by squaring the correlation coefficient. R2 can take on values from 0 to 1.
- The closer R2 is to 1, the better the independent variable predicts the behavior of the dependent variable.
Transfer Pricing Methodologies
- Market price - Market price is the “theoretically correct” transfer price. The price the purchasing unit would have to pay on the open market.
- Cost-based price - one of several variations on the selling units’ cost of production: variable cost, full cost, cost “plus” (a percentage or a fixed amount).
- Negotiated price - a price that is mutually agreeable to both the selling and purchasing unit.
Transfer Pricing:
- Goal Congruence
- Suboptimization
- Goal Incongruence
- Goal Congruence - Senior management establishes the methodology for setting internal TP’s in such a way as to promote goal congruence. Goal congruence occurs when the department and division managers make decisions that are consistent with the goals and objectives of the organization as a whole.
- Suboptimization - when both managers act in their individual best interests, the organization as a whole may suffer resulting in suboptimization. Typically occurs in decentralized organizations.
- Goal Incongruence - exists when actions encouraged by the reward structure of a department conflict with goals for other departments or the organization as a whole.
Transfer Pricing - rule that helps to ensure goal congruence is achieved.
Transfer Price per Unit = Additional Outlay Cost per Unit + Opportunity Cost per Unit
Opportunity Cost per Unit = Selling Price per Unit - Additional Outlay Cost per Unit
General rule is that the minimum transfer price (floor) is equal to the avoidable outlay costs, while the maximum transfer price (ceiling) is equal to the market price. However, this is only true where idle capacity exists to make the transfer.
Breakeven Point (BEP) Decrease Rationale
The breakeven point is the ratio of fixed costs to the contribution margin ratio (or contribution margin per unit for the unit breakeven point). If the fixed costs are decreased (numerator), and the contribution margin is increased (increasing the denominator of either breakeven formula), then the ratio and, therefore, the breakeven point decrease. Decreasing the fixed costs causes the numerator of the ratio to decrease, and increasing the contribution margin causes the denominator to increase. Both changes have the effect of decreasing the ratio. This also makes real-world sense. If fixed costs have decreased, it is easier for the firm to break even because there are less fixed costs to cover. Likewise, if the contribution margin increases, each unit provides a greater contribution to covering fixed costs, thus requiring the sale of fewer units to break even.
Break-even Point (BEP)
In the linear Cost-Volume-Profit Analysis model (where marginal costs and marginal revenues are constant, among other assumptions), thebreak-even point (BEP) (in terms of Unit Sales (X)) can be directly computed in terms of Total Revenue (TR) and Total Costs (TC) as:
- TR = TC
- P x Units = TFC + VC x Units
- P x Units - VC x Units = TFC
- (P - VC) x Units = TFC
- BE Units = TFC / (P - VC)
Contribution Margin
CM focuses on cost behavior whereas Gross Margin is used for traditional external reporting
CM = Revenue (or Sales) - Variable Costs
For breakeven analysis:
- Total Contribution Margin = Total Fixed Costs
- Unit CM x Units = TFC
- BE Units = TFC / Unit CM
- BE Sales = TFC / (CM/P)
CM is the selling price per unit minus the variable cost per unit. “Contribution” represents the portion of sales revenue that is not consumed by variable costs and so contributes to the coverage of fixed costs.
Margin of Safety
MoS = Current Output - Break-even Output
or Current Sales - Break-even Sales
Standards vs. Budget
Standards are developed for each factor of production (materials, labor and overhead) and may be used to value inventory (raw materials, WIP, FG) and CoGS.
Standard costs are budgeted amounts, but are actually entered into the General Ledger.
- Cost (Price or Rate) Variances
- remember for cost variances always calculate using S - A, it results in proper signage for favorable (unfavorable)
- Quantity (Usage or Efficiency) Variances
Price Variances (responsibility of purchasing department)
- Price/Rate = (Difference in Prices) x Actual Units
- Usage/Efficiency = (Difference in Quantities) x Standard Rate
For purposes of allocating joint costs to joint products, the sales price at point of sale reduced by cost to complete after split-off is assumed to be equal to the…
Relative sales value at split-off.
Joint Costs Allocation - Net Realizable Value Method
Remember you must subtract the separable costs from the Sales Value for each product and then compute the weight for each product. Example attached, Product A carries an 80% weight based on 72/90.
Balanced Scorecard
The balanced scorecard is a strategic performance measurement and management framework for implementing strategy by translating an organization’s mission and strategy into a set of performance measures. These performance measures are generally in four primary perspectives:
- Financial - investment focused
- Customer - customer centric
- Internal business processes - operations
- Learning and growth - employees
An increase in production levels within a relevant range most likely would result in?
Increasing Total Cost.
Relevant Costs
Relevant costs and benefits
- future costs and benefits that differ among alternatives
- avoidable costs are those that can be eliminated by choosing one alternative over the the other - they are always considered relevant.
Irrelevant Costs
- Sunk costs—A sunk cost is a cost that has already been incurred and cannot be changed. For example, when deciding whether to buy a new car or keep your current car, the price paid for the current car is irrelevant as it occurred in the past and cannot be changed. On the other hand, the market value of the current car if you sold it is relevant to the decision as it differs between the two alternatives: if you buy the new car, you can sell the current car for its market value; if you keep the current car, you forgo receiving its market value.
- Future costs and benefits that do not differ between alternatives—Future costs that do not differ between alternatives tend to be fixed costs or allocated costs.
Unavoidable Costs compared to Fixed Costs
Fixed costs are not equivalent to unavoidable costs. Unavoidable costs cannot be changed while fixed costs can change. Remember that fixed costs are fixed with respect to output. For example, utility costs of heating fluctuate constantly with weather conditions and the commodity price per unit of natural gas—but this does not make them variable. Fixed costs are always fixed with regard to the volume of units produced/sold.
High Low Method of calculating estimated variable cost
- Remember most questions might not give you FC and you will have to solve for FC. Do this by plugging in one of the total costs from either end of the range and using the VC per unit that you found with high/low and plug that into the cost equation of y = Mx + B
Relationship between Product Production Budget and Purchases Budget
Production
Sales
ADD Desired End FG Inv.
= Total Needs
SUBTRACT Beg. FG Inv.
= Units to be produced—–>
Units to be produced x DM/unit = Production Needs
Direct Materials Budget
Production needs
ADD Desired End DM Inv.
= Total needs
SUBTRACT Beg. DM Inv.
= DM to be purchased in units
x Price/unit = DM purchased in dollars
Critical Path Network Diagram
The critical path is the longest path in the network and indicates that if any activity on the critical path is delayed, then the project will not be accomplished according to the original schedule.
Prime Costs vs. Conversion Costs
Prime Costs = Direct Materials and Direct Labor
Conversion Costs = Direct Labor and MFG. OH
Equivalent Units
- Weighted Average
- FIFO
Weighted Average -
- Weighted average uses only two categories: goods completed and ending inventory. The format will differ in that weighted average combines prior period work (i.e., beginning inventory) with current period work (units finished this period not in [BI]) to determine “goods completed.”
FIFO -
- The FIFO method uses three categories, separating (1) beginning inventory from (2) the new or current period completed work (called “units started and finished”), while (3) ending inventory (at least for EU) is treated the same as with weighted average.
Direct Costs vs. Indirect Costs
Direct - costs that are easily traceable to final product.
- Direct Material - The cost of significant raw materials and components that are directly incorporated in the finished product. For example, direct material costs of a leather briefcase include cost of leather (raw material) as well as buckles and zippers (purchased components).
- Direct Labor - The wages and salaries paid for work that directly converts raw materials into a finished product. Continuing with our leather briefcase example, the direct labor costs associated with the manufacture of a leather briefcase include wages paid to workers who cut the leather, finish the leather, and sew the briefcase.
Indirect - costs that are not directly traceable to final product and must be allocated.
- Factory Overhead - The cost of indirect labor, indirect materials, and other manufacturing costs other than direct material and direct labor that are necessary to support the production process but are not easily traceable to the finished product. For example, factory overhead associated with production of a leather briefcase includes salaries paid to the production line supervisors, wages paid to mechanics who maintain the equipment, wages paid to custodians who maintain the factory, thread used to sew the briefcase together, electricity used to power the equipment and provide lighting to the factory, and depreciation on the factory building and equipment.
Overhead Rate Steps Example
Absorption vs. Direct Costing Example
Absorption vs. Direct Costing Income a.k.a…
The Income Reconciliation Rule
Sales Variance Analysis
- Budgeted or planned sales – Quantities and prices are used instead of “standard” quantities and prices.
- Sales variances work backwards – When compared to cost variances, that is:
- When actual prices are greater than planned prices, favorable variances result (e.g. it is good for people to pay more than you had planned).
- When actual quantities sold are greater than planned quantities sold, favorable variances result (e.g., it is good to sell more than you had planned).
- Sales variances – Use slightly different names:
- Sales price variance – Difference in prices × actual quantity sold.
- Sales quantity variance – Difference in units × planned unit price.
