Advanced cost accounting

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I-INTRODUCTION This section focuses on managerial accounting which is primarily referred to as advanced cost accounting. Although most of the introductory accounting concepts have been presented in Finance, a review of some of the basics that have the most impact on managerial accounting is in order. While traditional accounting is heavily weighted in the use of ratios, advanced cost accounting uses benchmarks budgets and variances in analyzing the operational cost of a company. In essence, all company activity is measured in dollars, and conclusive cost data is meticulously gathered to aid in planning, control, and decision-making.

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Advance cost accounting I performance and analyzed by high-level management in accounting and other outside departments for key strategic decision-making.
Advance cost accounting is useful in determining what products to keep expand or discontinue, optimal pricing, and accountability for department profitability, as well as many other processes.
A - THE NATURE OF COST
Managerial concern or preoccupation with cost is a necessity that comes from the dictum of the concept summarized in the following equation:
The managerial process of maximizing profit involves increasing revenue or reducing cost, or (more desirably) both. However, the sales element of revenue renders it less susceptible to control by the firm’s management, as compared to cost. Of the two factors of profit, cost is more within the jurisdictional control of management and therefore, readily susceptible to planning or corrective manipulation.
Depending on how a cost value is to be used, cost can be defined correctly in so many ways. For cost analysis and control in business management, it is useful to think of cost as the monetary value of any resource utilized in the provision of goods or services to the firm’s clientele or consumers.
Resources could be physical or non-physical in nature. These include raw materials, worker, energy, supervisory time, plant facilities (i.e. building and yard) storage, floor, floor space and utilities.
In financial accounting, the monetary value is assumed to be stable for a period of one year or more.
B-COST CATEGORIES
In general, cost is categorized into two groupings, namely:
Direct costs – costs that can be identified exclusively with a specific product or service.
Indirect costs – costs that cannot be identified exclusively with s specific product or service.
There are other numerous ways of classifying costs depending on how they are generated and used in the firm’s operations. It is relevant to mention here that, in practice, the term “cost” is given different modifiers to identify precisely the type of cost.
For accounting and management purpose, costs are normally related to specific time periods. It should be noted that all management planning and control decision-making are related to time periods. The cost incurred to produce or acquire finished products within a given period is a product cost. While the cost incurred within that given period that cannot be directly associated with a specific product such as marketing or administrative costs, is a period cost. Period costs are charged against the revenue earned during that period.
Costs are also differentiated according to the principal business operation of an organization – that is, manufacturing, merchandising or service. Figures 1, 2 and 3 reflect the customary cost classification in each type. (Figure 1: Cost classification in manufacturing.)
Direct materials are those used in production that can be physically related to a specific product. Direct material costs include the purchase price of the material plus cost of shipping and sales tax. Other materials used in production, such as glue, thread, or screws are classified as indirect materials and are part of the manufacturing overhead. This is due to the fact that; normally, the cost of keeping cost records would be relatively high compared to the cost of such materials.
Direct labor is the work direct done to produce a specific product. Direct labor costs include salary are wage payments of the production personnel plus the related normal fringe benefits. Work such as those performed by production supervisors, materials handling workers and janitors are considered indirect labor, and the costs are part of the manufacturing overhead.
Taken together, direct material costs and direct labor costs are considered as the prime costs of the manufacturing product costs while direct labor costs plus the manufacturing overhead costs are treated as the conversion costs, i.e. the cost of converting direct materials into finished product.
(Figure 2 Cost Classification in merchandising)
The sum and substance of merchandising is the purchase of goods for resale. The product cost at the end of the period is, therefore, the purchase price of the merchandise sold in that period.
(Figures 3 Cost classification in a service company)
Normally, in a service operation, the services are provided when they are produced. The direct costs are incurred when performing or providing the services. There is no finished product inventory.
Simply stated as “the cost of what”, the cost objective is defined as any business operational activity for which an identifiable measurement of cost is desired by management, e.g. cost of producing a particular product, cost of packaging, and cost of maintenance.
Tracing various costs to cost objects is generally know as cost allocation which, conventionally, is defined as the assignment of a cost or various costs to one or more cost objectives.
It is useful to note here that a cost accounting system a cumulate costs in some organized way and then allocates these costs to cost objectives. Basically, cost accounting is cost accumulation and cost allocation. The quest of management for a more accurate cost data for decision-making increases the complexity of the cost accounting system.
II – COST BEHAVIOR ANALYSIS
Costs differ in response to change in business activity, stated in another way, different measures (or levels) of business activity cause changes in cost. This relationship between cost and the level of business activity is called the cost behavior pattern, there are a variety of cost behavior patterns (or cost functions). Technically, a cost function is the relationship between cost and one or more cost drivers.
A-PATTERNS OF COST BEHAVIOR
In general, cost behavior emulates the following patterns.
1- The total cost fluctuates in direct proportion to aggregate changes in the measure of the related business activity. Cost per unit remains the same as activity changes. This type of costs behavior is known as variable costs. Variable costs include the costs of direct labor, direct materials, and sales commissions. Other variable factory overheads are supplies, overtime, spoilage, defective work, fuel and power.
2- The total cost is not affected by any change in the related total activity. Cost per unit becomes progressively smaller as the measure of the activity increases. This type of cost behavior is known as fixed costs. Fixed costs include advertising expenses salaries and depreciation. Other fixed factory overheads are property taxes, insurance and rent.
3- The total costs fluctuates not indirect proportion to aggregate changes within a range of the measure of related activity. This is due to the fact that the total is a composite of a variable portion and fixed portion. This type of cost behavior is known as mixed costs (or semi-variable costs). For example, a sale person’s compensation includes both salary and commission. Other mixed factory overheads include supervision, inspection, maintenance and repairs, and fringe benefits.
4- The total cost changes abruptly at intervals of the measure of the related activity. Here, the total cost remains the same over a short range of the measure of the activity. It then increases abruptly and remains constant at a higher level on short range. The total cost could either be a variable or fixed cost within a level of range. An example is the cost of supervisors where an increase in the level of production volume will require additional supervisors per number of workers or shifts. Another example is the cost of leasing storage space. A significant increase in inventory would require additional storage space to be leased.
B-FACTORS INFLUENCING COST BEHAVIOR
1-THE NATURE OF THE BUSINESS ACTIVITY
Where the business is labor intensive, the variable cost will usually be high. When it is capital intensive, the fixed costs will be high. An electric company’s high fixed costs could be attributed to its installation requiring heavy investment. A textile manufacturing company which used to be labor intensive is now highly automated with resulting higher fixed costs rather than higher variable costs. The current trend is production towards computer-assisted operations will see increasing fixed cost with decreasing variable costs.
2-THE NATURE OF THE PRODUCT
The quality and durability of a product will dictate the mode of producing it. The product design, materials to be used, and the market price considerations are factors that influence the production process to be used which in turn determines the cost structure of the product. Producing disposable cameras and producing high-price Nikon-type cameras will have distinctive patterns of cost behavior.
3-THE MANAGEMENT’S DISCRETIONARY DECISIONS
At the outset, management decision on target production capacity (in relation to estimated potential demand), in effect, has established the relevant range of the business activity within which a cost behavior pattern can be expected to hold. Moreover, within this range, fixed costs do not change. Also, note that budgeted cost can be changed at management’s discretion. Advertisement or research and development expenses which are fixed costs can be reduced or eliminated during the budget period. Likewise discount allowance (base on units sold) for decreased or increased at management’s discretion.
C- COST – VOLUME RELATIONSHIP
Within a capacity range, variable costs and fixed cost have contrasting behavior patterns. Their relationship to the level of a capacity or volume is best summarized as follows:
It is highly desirable that management tries to obtain the most profitable combination of the variable- cost and fixed-cost factors of the total cost.
The desire to decrease variable cost, particularly direct labor cost, has been with production management from the beginning. The current trend of computer-assisted production processes has led to decreases in variable costs, with increases in related fixed costs. Under such a condition, it is relevant to note that a high ratio of fixed to variable costs decreases the ability of management to respond to short-run changes in the market economic conditions and opportunities.

 

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D- LONG-RUN AND SHORT-RUN COSTS RELATIONSHIP

Managerial decision-making requires an understanding of the relationship between the firm’s cost and output-which is called the firm’s cost function. The two basic cost functions used are:

1-LONG-RUN FUNCTIONS

A long run is a period during which the firm’s management can change any of its production facilities by addition, subtraction or modification of assets. There is no fixed (or unchangeable) production function long run costs are all variable. Normally, long-run cost functions are used for long-range planning decisions.

2-SHORT-RUN FUNCTIONS

A short run is a period during which some production inputs are fixed or cannot be altered. Decisions are restricted by prior capital investments and other commitments. The total cost at each level of production is the sum of the total variable costs and the total fixed costs. The short-run cost functions are, there fore, affected by the variable and fixed costs. Normally, short-run cost functions are use for operating decisions.

It is noteworthy that long run cost functions, specifically the long run average costs of production are influenced by the following:
1- Technological improvements in production process there by increasing productivity
2- Higher input prices.
3- The effects of economies of scale, such as those that lead to –
a- Specialization and the consequential production efficiency
b- Large scale purchasing of raw materials and suppliers and other inputs.
c- Large business operations having greater access to capital markets and acquires funds at lower rates.
4- The learning curve (cong queo) phenomenon (hien tuong)

Through cumulative production expensive, process workers increasingly became more proficient in their jobs resulting in decrease average costs. The learning (or experience) rate is taken as the percentage by which the average cost declines as output increases Thus

Where: AC1 is the original average cost
AC2 is the reduces average cost

E- ANALYSIS OF MIXED COSTS AND TOOL OF COST BEHAVIOR ANALYSIS

Mixed cost are separated into their variable and fixed elements using the high-low method or regression analysis. The high-low method can be easier and quicker to use. However, it has the disadvantage of utilizing two extreme data points. This may not give an accurate picture of normal conditions. The regression method has the advantage of including all the observed data and tries to find a line of best fit.

Today, there are computer programs available to help with regression analysis.

Note: See Managerial Economics for details on regression analysis.

The high low method uses two extreme data points to calculate the values of (a) (the fixed of cost part) and (b) (the variable rate).

The equation used is
Y = a + bx

Fixed cost portion = Total semi-variable cost – Variable cost

Example: Using the high – Low Method

Superior Development Company wants to develop an equation which can predict the factory overhead cost of any given job with a certain number of labor hours required. This was difficult for them in the past because of a fixed element in the overhead costs.

The high-low method for dealing with mixed cost will solve their problem.

Table:
Month Direct Labor Hours Factory Overhead
Jan 5 10
Feb 8 15
Mar 14 22
April 19 24
May 16 23
June 11 19
X Y
High $19 $24
Low 5 10
Difference $14 $14

Variable rate b = $14/14 = $1 per direct labor hour.

High Low
Factory Overhead 24 10
Variable Expense ($1/DLH) (19) (5)
5 5

The cost volume formula for factory overhead is $5 fixed, plus $1per direct labor hour (DLH).
y= $5+$1x
y: estimated factory overhead’ x = #DLH
The company can now use this formula to determine the factory overhead when the costs are mixed including both fixed and variable component.

III – COST PROFIT VOLUME ANALYSIS FOR PLANNING AND CONTROL

A- DETERMINING COST-PROFIT-VOLUME RELATIONSHIPS

The cost-profit-volume (CPV) analysis, the term for the study of costs and net profit in relation to sales volume, is a necessary preoccupation of management in any profit or non-profit business operation.

In nearly all cases, business decisions are made taking into account their impact on the company’s profits. In a hospital setting for example, administrators are confronted with questions such as:
+ If an additional wing is built to accommodate more patients, how much additional revenue must it bring into meet the increased operating expenses?
+ If it offers a senior citizen discount, how will it affect revenues, costs, and operating income?
+ How many beds should be filled to break event?

Essentially, the CPV analysis examines how changes in sales volume (production volume), unit sales price, unit variable costs, fixed costs, and product mix will affect profit.

The CPV analysis is done through the use of either the basic profit equation, or the concept of contribution margin.

1- USING THE PROFIT EQUATION

Profit = Sales Revenue – Total Costs

Profit = Sales Revenue – (Variable Costs – Fixed Costs)

Profit = [(Unit Sales Price)(Sales Volume in Units)] – [(Unit Variable Costs)(Sales Volume in Units) – Fixed Costs]

Profit = (Unit Sales Price – Unit Variable Cost)(Sales Volume in Units) – Fixed Costs)

For an estimated expected sales volume, the expected profit could be calculated. Note that with sales volume remaining the same, an increase in fixed costs will lower profit.
The equation is used to determine an essential point of reference applied in business operations i.e. the break-even-point (or more descriptively, the break-even volume). The break-even-point is defined as the level of sales volume at which the total sales revenues equal total costs. There is neither profit nor loss. Thus.

0 = (Unit Sales Price)(Sales Volume in Units) – (Unit Variable Costs)(Sales Volume in Units) – Fixed Cost

Or = (Unit Sales Price – Unit Variable Costs)(Sale Volume in Units) – Fixed Costs

Or (Unit Sales Price – Unit Variable Costs)(Sales Volume in Units) = Fixed Costs)

Or Sales Volume in Units = Fixed Costs(Unit Sales Price – Unit Variable Costs)

This is the break-even volume. Multiplying this with the unit sales price will provide the break-even sales dollars.
Reading the Break –Event Chart

Target income sales volume equation

Cash break-even-point The budgeted values for unit sales and revenues should fall on the right side of the break-even-point

 

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TOUCHSTONES IN COST-PROFIT-VOLUME ANALYSIS
Companies anticipate a return on their investment. This expected amount of profit is generally known as target profit. Cost-volume-profit analysis can estimate the number of product units to be sold to ensure its target profit.
The formula for calculating the sales necessary for achieving a particular income is as follows:
Target income sales volume =
The quantity of sales that will cover all cash expenditures for a particular time is known the cash cost-volume-profit point.
Cash break-even-point =
Depreciation is subtracted because it is a non-cash fixed charge.
2- USING THE CONCEPT OF CONTRIBUTION MARGIN (CM)
Contribution margin is the difference between sales revenue and variable costs. Thus
CM = Sales Revenue – Variable Costs
The difference can be applied to cover fixed costs and then to provide profits. Hence, CM is also known as profit contribution.
The concept is applied either as unit CM or CM ratio, that is:
a- Unit CM (or contribution margin per unit) is the monetary amount contributed by the sales of me unit to fixed costs and, after covering fixed costs, to the firm’s profit. It is determined by subtracting the variable cost per unit from the sales price per unit. Thus
Unit CM = Unit Sales Price – Unit Variable Cost
For Example
If sales price per unit is $5 This mean that for every with sold, $2 is contributed to fixed cost and operating income
And variable costs per units is $3
The CM per unit is $2
To determine how many units mush be sold to cover fixed costs, the fixed costs individual by the unit CM as follows:
Break-even Sales Volume =
For example, with a fixed cost of $200.000 = 200.000/$2 = 100.000 units.
This indicates that 100.000 units must be sold to cover fixed costs and to break even.
b- CM Ratio is the percentage of each dollar sales contributed to fixed costs and, after covering fixed costs to the firm’s profit. It is calculated by dividing the CM by sales revenue, or expressed as follows:
CM Ratio = =
CM Ratio = 1-
Note that is the variable cost ratio, i.e. the
variable costs multiplied by present of sales it follows that (1- x percent of sales) is the CM ratio.
The CM ratio can also be calculated by using unit CM as follows:
CM Ratio = =
CM Ratio = 1-
For example, where the variable cost is 65 percent of sales, then 35 percent of sales is the contribution margin. This means that for every sales dollar $0,65 goes to cover the variable costs and $0,35 to fixed costs and income.
Using the CM ratio, the required sales revenue and the break-even sales in dollars to provide for a target profit can be determined by using the following equations:
Sales Revenue needed =
Break-even sales in dollars=
From the preceding explanations of the contribution concept, it is clear that contribution margin (CM) is expressed and applied as a total amount, as a per unit amount or as a ratio (percentage). It is evident that, by its nature, the total contribution margin determines the firm’s profitability not the sales revenues.
Summing up: Break-Event Point And The Contribution Margin
The break-even point is the monetary crossover point when revenues precisely match cost, resulting is no profit or loss
Break-even point in units=
Break-even point in dollars =
The contribution margin (CM) is the surplus of sales over the variable costs of the goods or service. The contribution margin is also the amount of money available to cover fixed costs and generate profits, thus also calling it the margin income.
The contribution margin ratio is the contribution margin as a portion of sales
• Contribution approach
Selling price $1,000
Variable $400
(1)
Fixed Cost $30,000
(2)
Example:
A mountain bike Company can provide 1,000 Titanium bicycles at full capacity in one production cycle. They charge $1,000 per bike and are shouldered with a $30,000 fixed cost.
The $1,000 charge (i.e. sale) of each bicycle is broken down into a $400 variable cost and a $600 contribution factor. The amount of contribution margin of $60,000 ($600 x 1000 units) is expected to first recoup the fixed cost of $30,000 (i.e. the break-even point is reached) and any surplus is income or profit.

 

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B- APPLYING COST-PROFIT-VOLUME ANALYSIS
1- TO MULTI PRODUCT OPERATIONS
In a multi product firm, as with a firm with a single product, management must also consider the variable costs, fixed costs, sales price and sales volume of each product. However, in a multi product situation, the overall profitability of the firm also depends on the product mix or sales mix-that is, the relative proportions or combinations of quantities of the different products that constitute total sales volume.
Taking into consideration the sales mix is important because each product has a different contribution margin. In as much as total contribution margin determines the profitability of the business, the sales mix effectively influences the firm’s profit.
If the proportion of the sales mixes changes, the cost profit volume relationships also change. The break-even point and expected income at various sales levels will be altered. Based on these considerations, management’s goal is to develop the most profitable sales mix.
It is axiomatic to maximize the sales of all products. However, resource limitations could force decisions to emphasize or de-emphasize certain products. The higher the proportion of the more profitable products, the higher the profit. Moreover, management would prefer selling the products with higher contribution margin per unit.
The following example illustrates how sales mix influences profits.
ABZ incorporated produces and sells two products, X and Y. The firm expects to sell 50,000 units of product X and 40.000 units of product Y at total fixed costs $ 350.000. The respective product price, cost and contribution margin are:
Product X Product Y
Sales price per unit $10 $15
Variable costs per unit 4 10
CM per unit 6 4
Overall
Sales volume in units 50.000 40.000 90.000
Sales revenue $500.000 $600.000 $1.100.000
Total variable cost 200.000 440.000 640.000
Contribution margin $300.000 $160.000 $460.000
Fixed costs 350.000
Operating income $110.000
2- TO ARCHIVE EXPECTED PROFIT
To determine the number of units (X) that must be sold to earn the expected profit, the amount of the expected profit s substituted into the CPV equation:
Sales Revenue = Profit + Variable Costs + Fixed Costs
(Sales price / unit) = Profit + (Variable Cost / Unit) + Fixed Costs
Solve for
Amore direct method is the use of CM per unit in the equation.
Sales Volume =
3- DETERMINE THE MARGIN OF SAFETY
How far actual sales volume can decline before a firm loses income is a normal concern of management. A margin of safety is needed to provide management a chance to take corrective actions when possibly needed. It could be taken as a danger-flagging measure.
The margin of safety is the difference between the actual sales and the break-even sales volume. A relevant break-even point is used as the point of reference. Thus, the margin of safety is the amount by which actual sales may decline before a loss is incurred. It is computed as follows:
Margin of safety = x 100
Hence, the margin of safety is expressed as a percentage of the expected sales volume.
Example: An electric game manufacturer expects to sell 15.000 units of its new model. The calculated break-even sales volume foe the model is 9000 units. Substituting values into the equation gives a margin of safety drop to 40 percent below the expected sales volume, the manufacture will just break even, at a drop of more than 40 percent, and the firm loses money on the model.
The margin of safety is used as a measure of the risk inherent in a sales plan. The higher the margin of safety, the lesser the risk. A significantly low margin would necessitate corrective management actions by way of lowering costs or increasing sales, or both.
4- TO MAXIMIZE THE PROFIT CONTRIBUTION OF SCARCE RESOURCES
When a resource used in production or contribution is in short supply, it is necessary to consider the contribution margin per unit of the scarce resources – which is computed by dividing the unit contribution margin by the amount of the scarce resource required to produce or distribute are unit of product.
Scarce resources in production are normally materials, direct labor hours, and machine-hours. In merchandising, they are qualified sales personnel, display space in the store, and even warehouse space.
In deciding which product to produce or sell within a situation of scarce resources, management decision must be based on the amount of the resources needed for each product or sale.
When labor hours are the scarce resources for example product A’s unit CM is $3 and takes one hour to produce. Product B’s unit CM is $5 and takes three hours to produce.
Product A’s CM per labor hour = $3 per unit/1labor hrs per unit
= $3 per labor hour
Product B’s CM per labor hour = $5 per unit/3lobors per unit
= $1.67 per labor hour
Product A has a higher contribution margin per labor hour and, therefore, is preferred for production.
An alternative: if only 3000 labor hours are available for the period 3000 units of product A can be produced and only 1000 units of product B. The contribution margin for each product would be.
Contribution margin for 3000 units of product A
= 3000 units x $3 CM per units = $9000
Contribution margin for 1000 units of product B
= 1000 units x $5 CM per unit = $5000
The total contribution margin of product A is higher and, therefore the choice for production.
Where more than one scarce resource is involved, linear programming is used in determine the combination of products that will maximize the total contribution margin. The objective of the linear programming is to maximize the total contribution margin. The constrains are the scarce resource. These objective and constrains are formulated as algebraic equations. Then the problem is solved by using a computer.

 

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5- TO MAXIMIZE THE CASH BREAK-EVEN POINT
When available cash is limited to carry out business operations at a comfortable level it is useful to know the volume of sales that could generate cash money to cover all cash expenses during a period. This volume of sales is known as the cash break even point.
The equation for the conventional break-even point sales volume is as follows:
Break even sales volume =
(in units)
Break even sales volume =
(in units)
To calculate the cash break-even point, all the non-cash expenses, such as depreciation are deducted from fixed costs. Hence,
Cash break-even point =
If the computed cash break-even point is to be 1000 units, this means that the firm must sell 1000 units to cover only the fixed costs requiring cash payments and to break-even.
6- TO MAXIMIZE THE DEGREE OF OPERATING LEVERAGE (DOL)
Fixed costs have leverage quality in that the presence of fixed operating costs cause a percentage change in sales volume to generate a magnified percentage change in operating profit (or loss).
The effect of the operating leverage is that a change in the volume of sales produces a more than proportional change in operating net income (i.e. profit or loss). The measurement of this sensitivity of operating profit to a change in sales is known as the degree of operating leverage (DOL). The DOL varies at each level of sales or output.
The DOL is calculated as follows:
DOL at Q units = =
Where: Q: the sales volume in units
Qbe: the break-even sales volume
p: the price per unit
v: the variable cost per unit
For example, the DOL of a firm with 8000 units of sales volume and an estimated break-even sales volume of 6000 will be:
DOL at 8000 units = = 4
This indicates that with me percent increase in sales, profit will increase four times that amount.
If the sales volume increase to 9000 units
DOL at 9000 units = =3
Note that an increase of the sales volume to 9000 units generates a decrease in the value of DOL to 3 from 4. It is evident that the greater the distance of the level of sales volume or output from the break-even point, the lower the degree of operating leverage. In other words, how close the firm operates to its break-even point will determine the sensitivity of its profit to any change in sales volume.
Leverage is the part of the fixed costs which represent a risk to the corporation.
Operation leverage is a determinant of operating risk and describes the fixed operating costs located in the corporation’s income statement.
In the provided graphs, a company with a high operating leverage is one which possesses high fixed cost and low unit variable cost. Notice that the total cost line starts a little higher than its counterpart. Further, the total cost line intersects total revenue line at a wide angle (light blue) suggesting that profit increases rapidly to the right of the break-even point.
On the downside, the proportionally wide angle on the left side of the break-even point suggests that the company incurs heavy losses as production decreases.
A company with a low operating leverage has a lower fixed cost but a higher variable cost. Again, notice that the total revenue line producing a smaller angle. This suggests that the company’s profit and loses grow slowly on either side of the break-even point.
Note: a working example is given in the Marketing Economic portion of the Marketing section.
7- TO ANALYSIS THE EFFECT OF
a- A change in sales price
b- A change in variable costs
c- A change in fixed costs
d- Simultaneous changes in price and cost
The analysis will be useful for profit planning and to a certain extent, for short-term decision-making. The analytical methods, applying the CPV and CM equations, are essentially the same.
For multi-production operations, the analysis is done for each product and the results are summed up for the over-all picture. Note that in this case, the overall profitability also depends on the product mix (or sales mix).
The use of computer spreadsheet program facilitates the analysis involved in studying the effects of the changes referred to in (a) to (d) above.
In summing up cost-profit –volume analysis is a useful profit planning tool in many ways, such as:
1- Having a high margin of safety (like compiling reserved assets) translates into less operating risk because a substantial decline in sales may happen prior to the occurrence of losses.
2- As sales go beyond the break-even point, a large unit contribution margin (CM) or CM ratio will create more substantial profits than a low unit CM or CM ratio.
3- An alteration in either the selling price or the variable cost per unit changes contribution margin or the CM ratio and, therefore, ultimately the break-even point.
4- The lower the break-even sales level the less risky the project and in general the safer the investment.

 

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IV – PRODUCT COSTING
Cost accounting system are assigned to (a) allocate costs for planning and control purposes; and (b) apply cost to units of product for product costing. At this point, the presentation deals mainly with product costing.
There are two basic types of product costing, namely:
(a)-Job order costing; and
(b)-Process costing
In practice, most products are allocated costs by blend of the two, applying both at various phases of the production process, or by hybrid systems of:
(c)-Activity-based costing; and
(d)-Just-in-time (JIT) inventory system (using its philosophy)
A-JOB ORDER COSTING
Job order costing is commonly used in aircraft manufacturing, housing construction, printing, special purpose machinery, auto repairs, management consultancy, and accounting services.
Job order costing is used to collect and assign costs to units of product produce in distinct batches or produced accounting to customers’ order and specifications. Each job or batch is distinctive from other jobs and has definite staring and completion points. Costs are accumulated for specific jobs through a system of cost sheets created for each job.
Determine the cost of a job consists of the cost of direct materials plus, labor hours worked times the rate per hour plus the total labor or machine hours times the overhead rate per hour.
Cost of job = $direct materials + #labor hours ($per hour) + #labor (or machine) hours ($overhead per hour)
Direct material and direct labor costs are directly accumulated and attached to each specific job, or batch. Direct materials and labor used in each job are readily distinguished from those used in others.
Company
Job-cost sheet Job No 2345
Direct material Direct labor Factory overhead
Summary
Direct material xx
Direct labor costs xx
A-Job order costing
Material Requisition Invoice No.DRF8975
Material Type AA
Received Issued Balance
Materials ordered and received
Materials issued for the job
Received issued
Direct labor
Company work ticket
Employee ID# …………………………Job Number………………..
Date …………………………………….
Operation……………………………….
Stop date………………………………. Star date……………………
Union contact………………………….. Date………………………..
Amount…………………….
Production overhead
Company
Job-cost sheet Job No 2345
Direct labor Factory Overhead
Known only at the end of the fiscal year
Summary
Direct material cost xx
Direct labor costs xx
Factory overhead cost xx
Indirect costs, or production overhead costs, are applied for each job using a predetermined overhead rate. Note that the predetermined overhead rate is applied to a job or process, i.e. regardless of the costing system used (job order or process costing).
Actual overhead costs commonly be known at the end of fiscal year and, therefore, are not available at the time of production during that year. To set prices for completed jobs or products during the year, it is necessary to use a predetermined (or more descriptively, budgeted) overhead rate. Such as rate is calculated at the beginning of that year and is applied during that year’s production activities.
Briefly, the predetermined overhead rate is calculated as follows:
(1)-Select a cost driver (overhead cost base) that because the major categories of indirect costs, e.g. direct labor hours or costs or machine-hours. There must be a strong cause – and – effect relationship between the indirect or overhead cots (the effect) and the base chosen (the cause).
(2)-Estimate (usually based on experience and/or historical records) the expected total overhead cost and the expected total measure of the chosen base.
The actual data of a chosen base, generated during the year, is multiplied by the predetermined overhead rate to obtain the overhead cost for application to the completed job or finished product.
For example: based on the previous year’s production, with some adjustments for expected increase in job orders, ABZ company budgeted for production with.
Total production overhead $108,000
Direct labor cost $216,000
The budgeted overhead rate per unit of labor cost = $108.000/$216.000 = 50%.
(For every dollar of labor cost, the overhead cost is $0.50)
If actual labor cost for the year is = $300.000
The applied overhead cost will be = $300.000 x 0.50 = $150.000
(this exceeds the budgeted production overhead cost of $108.000 by $42.000)
Overhead costs are aggregated into cost pools along functional categorization, such as indirect labor (labor-related overhead costs), material-handling (usually material-related), repairs and maintenance (usually machine-hours related). The costs are calculated for each pool.
Overhead costing variance
During the production year and at the end of the year, the applied overhead is rarely equal to the actual overhead. If the applied overhead for the period exceeds the actual or incurred overhead, the overhead has been overapplied. If the applied is less than the incurred, the overhead has been underapplied.
This variance between applied and incurred overhead costs can be attributed to me or more of the following.
1-The volume of production usually varies seasonally.
2-The overhead costs incurred also vary seasonally.
3-Parts of overhead costs are irregularly incurred.
4-Annual estimates of total production volume and the related overhead are incorrect.
The variance due to seasonal costs and incurred exceptional costs (as in repairs and maintenance) are common and normally expected by management. Such characteristics of overhead are complied in the annual overhead cost pool and the resultant annual overhead rate is used regardless of the variations during the period.
A significant variance usually indicates incorrect estimate of production volume and the related overhead for the year. This could be the result of an important change in the production process. Production output would be at a difference level of volume than the value used as the chosen base for calculating the overhead rate. The predetermined overhead rate needs to be recalculated based on the revised estimates of production volume and overhead. Note that for the practical reason of cost of revising entries to change the applied overhead, the predetermined overhead rate is revised only as a result of a substantial change in annual estimates of production volume and overhead. The estimates of production are directly related to sales estimate.
A significant variable, particularly where actual exceeds applied overhead, may also suggest that actual overhead is out of control and needs close scrutiny and monitoring.
With predetermined overhead rate unchanged, the difference between the applied and incurred overhead is usually accumulated during the year. At year-end the difference is disposed of by:
1-Procating the amount of under applied variance to account of the work in process, finished goods, and the cost of goods sold. Using the actual incurred overhead to recalculated the overhead cost of all individual jobs worked on could be ideal. However, it is rarely useful:
2-Direct write-off the overhead variance is added to (incase of under applied overhead) or deducted (for over applied overhead) the cost pf goods sold.

 

[cayman]

cont.

B-PROCESS COSTING
Definition
In process costing, every cost, direct and indirect is compiled by company departments (not by job) for various lengths time. Then a mean cost for the time is calculated and is used for costing of the product.
It is designed for manufactures whose goods are generated on a non-stop basis with units getting equal treatment in every individual processing center. It is an appropriate costing procedure for mass production of like products as those generated in assembly line.
Types of Processes
Dept.1 Dept.2 Completed product
Parallel to convergence
Steps in Process costing
The five steps in process costing are:
1-Summarize costs by category or by company departments.
2-Examine physical flow
3-Estimate output in equivalent units
4-Estimated unit cost
5-Calculated cost of goods finished is the final work in progress.
Salient (adj- noi bat) features of the Process Costing System
- Production flows through a series of steps called processes. These processes are usually organized as separate departments. A department may over more than on process.
- As material being worked on move from process to process, the accumulated cots are transferred accordingly.
- The unit cost for inventory purpose is calculated by accumulating the cost of processing in each department and dividing the total by the magnitude of that department’s output.
- Costs are divided into two categories only-direct materials and conversion costs-this includes direct labor costs.
- At the end of an according period, a processing department has completed and partially completed units. The total product cost for the department for the period is the sum of the cost of completed units and the cost of partially completed units.
Product flow in a department within a period is schematically illustrated below:
Completed units Partially completed units
Note that the work in process at the end of the current period will be the work in process at the beginning of the next period.
- The cost of partially completed units is the cost of products remaining in the work-in-process inventory in the department at the end of the period. Thus, the costing system distinguishes the cost of completed units from the cost of partially completed units.
- To be able to calculate the cost of partially completed units, the concept of equivalent units is used. An equivalent unit is the collection of inputs necessary to produce one complete unit of product. It is used to measure the output (both fully of the factors of production (i.e. direct materials and conversion costs) already applied to the product.
If the partially completed units are, on the average, 40 percent complete, it is assumed that one, one such unit contains 40% of the factors of production (direct materials, direct labor and overhead) applied to fully completed it. If it is 60% complete then it is assumed to contain 60% of the effort and cost of a fully complete unit.
To illustrate: let us say that at the end of November 1996 (the end of the accounting period). Processing Center A has 30.000 units completed and stacked and 1000 units that are only 75% complete. This mean that at period end, processing Center A has 30.000+1000 in indirect material cost and has 30.000+(1000×75%) in conversion cost.
- In process production, the resource (i.e. direct materials, direct labor, and applied production overhead) are introduced into the process either (a) in lumps at specific points of the process, or (b) uniformly throughout the process. In general direct materials are introduced in lumps while direct labor and production overhead are added uniformly or gradually throughout the process. This mode of using resources makes it difficult to calculate equivalent units. Equivalent units and correlatively unit costs are calculated for each resource added in different ways. Direct materials costs are determined separately from the conversion cost.
- Where a resource of production (like materials) is introduced in a lump or all at one time, the equivalent units will be equal to the number of physical units of work in process pissing the point at which the resources is introduced or added.
Thus:
For example, required materials are normally added at the beginning of a production process, hence, the number of equivalent units for materials will be equal to the number of physical units of production started.
- For direct labor and production overhead which are introduced or applied uniformly throughout the process, the equivalent units will be dependent on the degree of completion of the physical units of production. Thus, at 100 percent completion, the equivalent units will be equal to the physical units completed. For partially completed units of x percent degree of completion, the equivalent units will be equal to the number of partially completed units multiplied by the percentage of completion.
For example, 1000 partially completed units at 40 percent completion will have equivalent units of 400, (1000×0.4). This means that the 1000 partially completed units have utilized effort and overhead cost as 400 fully completed units.
- Product cost varies from period to period. To calculate the cost/unit of the work-in-process inventory at the beginning, there is a need to correlate the cost from one period to another. To do this, two primary methods are-used-weighted average cost flow and the FIFO cost flow.
Under the weighted average costing method, the cost of the beginning inventory is added to costing method, the cost of beginning inventory is added to costs incurred during the period. And the equivalent units of the work still in process at period and is added to the total units completed during the period. Then the total cost is divided by the total equivalent units resulting in an average cost per equivalent unit. This average unit cost is then used for costing the completed units transferred out of the department and the work still in process at period end.
In essence, the averaging of the cost of the beginning inventory with the cost of other units worked on during the period will give one average cost for costing products worked on in a department where equivalent units vary in cost category (i.e. direct materials, or conversion cost) separate equivalent units and unit costs are calculated for each cost category. This applies to both the weighted overage and the FIFO costing methods. Thus
Unit Cost (materials cost) =
Unit Cost (conversion cost) =
- With the first in, first out (FIFO) concept, the assumption is that the beginning inventory of work on process will be worked on, complete and transferred first. This approach implies a distinct batch of production each time period.
If follows that under the FIFO costing method, the cost of the beginning inventory is segregate from the cost incurred during the period. That is the previous work done on the beginning inventory is distinguished from the current work. Therefore, the work done at period end minus work done before the period is equals the work done during the period. Thus, the equivalent units are calculated as follows:
Equivalent units = units completed + (ending work in process x percent completion) – (beginning work in process x percent completion)
Dividing the work done during the period by the calculated equivalent units will provide the unit cost which will be used for costing the products worked on in the department.

 

[cayman]

cont.

C-ACTIVITY-BASED COSTING (ABC)
What is ABC?
Activity-base costing is a product costing system that is primarily based on the activities or operations undertaken (dam nhan, dam trach) to produce the finished product.
Carrying out these activities or operations consume resources. Hence, costs are incurred as a direct result of these an activities or operations. This costing system is also known as activity costing or operation costing.
An activity is a standardized technique or method the application of which induces or effects changes in work in process during production. The activities for a finished product are identified through process-flow mapping usually done in converting product-design for production. Sides from the needed materials, the series of activities or operations to produce the desired product are specified in the work or production order. Some example are cutting, sewing, assembling, sanding, painting, special chemical treatment (e.g. fire proofing, waterproofing), packing, and materials handling.
There are two essential characteristics of ABC namely:
a-Only products using an activity or operation are charged for its use; and
b-Cost traceable (vach ra, chi ra) to an activity or operation can be measure rather than allocated.
These characteristics make product costing, particularly overhead costing, more accurate than in the traditional systems. However, activity-based costing is more expensive to administer. Managerial decision has to be made on the matter of accuracy against cost.
Activity-based costing is a relatively new accounting phenomenon (hien tuong) that can accurately depict cost when more than one product is manufactured at a particular processing center. This costing method picks up the ball where previous accounting methodologies have floundered.
The usefulness of ABC for multiple-product manufacturing is based on the fact that-
a- Multiple products do not always have the same overhead costs because certain products may take more or less to produce than others, and
b- Products consume resources at different rates.
The costing scheme
Briefly, the costing scheme is a follows:
a- Direct materials and run-hours (direct labor) are specified for each work order. Costing is straight forward and normally poses no problem.
b- The production overhead cost early on involves development of an activity-based predetermined overhead rate for each for each activity or operation. This is largely based on historical data and experience.
c- The total units output using an activity is multiplied by the predetermined overhead rate for that activity to give the overhead cost for utilizing that activity on the product worked on.
d- Summing up all the calculated overhead costs for each activity in the series of activities to produce the finished product will provide the total production overhead cost for the product.
e- Adding the direct materials and labor cots to the total product overhead will result in the product cost.
f- At the end of the accounting cycle, any under application or over application of overhead costs is disposed of as in the job order costing system.
An alternative approach often used is to aggregate direct labor costs and production overhead into a single conversion cost. Conversion cost data are complied for each activity or operation. An average conversion cost for that activity or operation is developed which is the predetermined or budgeted conversion rate. The total units output using an activity is multiplied by the relevant predetermined or budgeted rate to give the conversion cost for that activity for the period.
Overhead costs in ABC
As mentioned earlier, the ABC system is more accurate but more expensive than the traditional job order and process costing systems. The accuracy is due to the way production overhead costing is done. It is therefore, useful to delve in more detail on activity-based overhead costing.
In ABC, a predetermined overhead rate for each production activity is determined and used to allocate or a sign overhead cost for that activity.
Unlike the traditional systems which used only one or two cost drivers usually volume-based, ABC involves more cost drivers.
A useful feature of activity-based costing is that the cost drivers that directly measure the utilization of an activity could be replaced with a cost driver that indirectly measures that utilization. This replacement is often made necessary when the information for the initial cost driver is not available. A correlated cost driver with readily available information is used to avoid the need to produce new additional information and its corresponding added expenses. The initial accuracy is maintained as long as the quantity of activities utilized in the work in process remains reasonably constant for each product. Regression analysis is often used to determine the degree of correlation of the indirect cost driver used.
Overhead costs are generally common costs. Productions overhead are in essence, pools of these common costs which must be allocated or assigned to a product for its costing. In ABC, this is done through the use of cost pools of homogenous overhead costs. It is usual for these overhead costs to have similar consumption ratios for all products. The consumption ratio is the proportion of an activity utilized by a product in its progression through a series of production activities.
Dividing the cost pool by the measure (i.e. based on historical data or experience) of the related cost driver will give the overhead cost per unit of the cost driver. This is the pool rate. It is an activity-based predetermined overhead rate. In this manner, a predetermined overhead rate for a specific production activity is established.
To allocate or assign an activity overhead cost to each product that was processed through the activity, the pool rate for that activity is multiplied by the magnitude of the amount of resource consumed in undertaking that activity- that is, the quantity of the related cost driver used. The result is the applied overhead cost for undertaking an activity on a product.
A summation of all the applied overhead costs from each of the cost pool will provide the production overhead cost for that product. Adding the pertinent prime costs gives the total product cost.
Overhead costs from service activities
So far, considerations have been given to overhead cost incurred for production activities. However, in the process of producing goods or products, there are some activities that produce noting but services to support other activities. These are services activities. Some common examples include janitorial, human resources management, cost accounting, data processing, and production administration.
The cost of operating each service activity is an indirect cost and part of the overhead cost. Hence, there are two types of activities that incur overhead costs-production activities do not work directly on products. The activities provide services so that production activities could function at a target level of productivity. The cost of providing each type of service cannot be allocated directly to products. The cost is first assigned to production activities for inclusion in their respective predetermined overhead rates. The rates are used to allocate the predetermined overhead costs to products.
Service activity costs are assigned to production activities according to the amount of service used. The basic equitable concept is that a production activity that received or used more service than others should bear a larger portion of the service’s costs. The amount of service used is determined in the normal way of using the measure of pertinent cost drives.
Service activity costs are usually assigned by either the direct method or the step method.
In the direct method, service activity costs are assigned only to production activities. The costs of services done by one service activity for another service activity are completely disregarded. Hence, this is a simpler method.
To illustrated: XYZ Production has 100 workers, 25 of whom are in an assembly activity. The cost of production administration at period end is $80.000. The identified cost driver is the number of workers. The service cost of production administration assigned to production assembly activity is $80.000 x (25/100) = $20.000. Parts of the cost of production administration are not assigned to the other service activities, such as cost accounting and building maintenance.
In the step method, service activity costs are assigned to production activities as well as other service activities. Only major services rendered to other service activities, not all, are considered in the step method. Consideration of all services rendered would entail the use of the more complex method of reciprocal assignment. The step method produces results close enough to that of me reciprocal method.
It is useful to follow a sequence of assigning activity costs to wit:
a- Start with assigning the costs of their service activity that serves the largest number of other activities.
b- Assign the costs of the service activity that serves the next largest number of activities, and so forth.
c- Assign the costs of the activity with the highest cost first whenever two service activities serve an equal number of other activities.
Following the preceding sequence, the costs of services provided by one service activity to another service are assigned as follows
:
a- The cost of the first service activity are assigned to production activities and other service activities.
b- The costs of the second service activity (which then include the cost assigned from the first service activity) are assigned to the production activities and the remaining service activities.
c- The process is continued until all service activity costs are assigned to the production activities.
It is desirable that this process of assigning service activity costs be in accordance with the sequencing of which service activity is first and which second, and so on…
Determining Applied Overhead in Processing Multiple Products.
In activity-based costing, overhead costs are separated into homogeneous cost pools. A homogeneous cost pool is an accumulation of overhead costs for which cost differences can be accounted for by one cost driver.
The cost per unit of the cost driver is then calculated for each pool. This is termed the pool rate.
The overhead allocated for the cost pool is thus:
Applied overhead = Pool rate x Cost driver units used
(Cost per unit x number of units)
Let us examine a graphical representation of the process involved in activity-based costing in a manufacturing setting.
Step 1: Identify all cost drivers
Step 2: Group all cost drivers into related cost pools. Hence, a company’s quality control effort is tied into the step cost of each production run. This is grouped as cost pool 1.
In cost pool 2, machine utilities are grouped with another related cost driver; machine maintenance.
Step 3: Establishing the pool rate. The pool rate is determined by the combined total of all related cost drivers in a particular cost pool divided by a processing center overhead category (i.e. manufacturing run, machine hours or direct center labor hours) depending on what you are intending to measure.
Pool rate 1 would be interpreted as “cost per run” and Pool rate 2 as “cost per machine hours”
The end result can be a pool rate which describes the cost per production run, cost per machine hour or the cost per direct labor hour.
Step 4: Calculating the unit costs
Unit cost = (Prime cost + (Pool rate 1 x Production run) + … + (Pool rate n x production run)) / Units produced.
The end result is an accounting data accurately depicts the cost of product for the individual products that can serve as a:
a- Benchmark for production
b- Gouge for pricing; and
c- Measurement of process efficiency
In retrospect, activity-based costing has been the latest craze in corporate America and has emerged as the leading instrument in carrying-out the process of reengineering or TQM.
Activity-based costing has transformed itself from a mere accounting tool to managerial way of life. The full impact of ABC can be seen as companies decentralize their products into separate and bottom-line cost. The one-site for a mix of products is being replaced by separate, high quality-controlled processing centers.

 

[cayman]

cont.

D-JUST-IN-TIME (JIT) INVENTORY SYSTEM
As originally developed in Japanese companies such as Toyota, it is refreshed to as just-in-time inventory system. The idea is to minimize inventories by arranging for materials and subcomponents to be acquired and inserted in production just as they are needed-just in time. The increasing adoption of the concept and its ramifications by VS companies has provided the cornerstone of a broad new management philosophy resulting in anew production environment. The philosophy is currently referred to as JIT philosophy or JIT for short.
At this point, what is important to understand is that for production or manufacturing operation, the cost structure changes with the adoption of the JIT philosophy.
The focus of the JIT philosophy is for operating a production process with emphasis on higher quality products and shorter process time with minimal inventories (including in-process inventories). The essence of the philosophy is the elimination of wasted and therefore, the reduction of cost.
Consider the following implications:
a- Higher quality products necessitate a high degree of quality from both the production process and the suppliers. As a result quality control and inspection costs are lower. Quality dependability is the key factor in the selection of supplies with possible elimination of defect rework or wastage costs.
b- Shorter process time requires redesigning and simplifying the production process. This is facilitated by computer-aided design (CAD) and computer-aided manufacturing (CAM). Small changes in design often lead to substantial cost savings. Products, equipment and produces are modified to reduce time and cost. CAM usually results in a more efficient processing with minimal, if not zero, defective products. Machine-time utilization is significantly improved.
c- Minimal inventory will require.
1- Drawing materials and parts into each operation only as needed suppliers are required to deliver quality materials or parts as needed.
2- Producing to order or producing in batch. A tighter coordination of sales and production planning and operation is a must. Budgeting and planning need to be more accurate.
3- Resorting to out-sourcing whenever it is significantly cheaper to do so. Out-sourcing is the practice of purchasing parts or components rather than making them in-house.
It is obvious from the preceding expositions that the implementation of JIT in a production firm will necessitate.
a- A tighter and more accurate planning and budgeting process, with broader coverage and reorientation where needed. For example, under the JIT, the control of direct materials cost is accomplished before the cost is incurred. This is done by long0term direct materials contracts with suppliers that specify the price quality and delivery schedules.
b- Major changes in most firms’ production concepts and practices. An example. Is the notion of maintaining “sufficient” inventory stocks as buffets against uncertainties? Another concept that will require rethinking is the provision of production floats in the process operations. The normal drive for assembly-line type of production needs evaluation in the face of the flexibility required by the JIT philosophy.
c- A greater emphasis on quality not only in production but also in management. Total quality management (TQM) is an inherent component of the implementation of the JIT total quality control (TQC), which aims to achieve a zero production environment is a major factor in this implementation.
Under the JIT, other cost drivers will increasingly replace the traditional direct labor hours and machine-hours as overhead cost drivers. Overhead could be expected to become more equitable and realistic.
In the face of increasing consumer demands for quality and global competition, the JIT philosophy could be the answer to most American firms. Note that the result in higher quality, more efficient production, and lower inventory of the JIT lead to an ultimate effect of higher profits.
V-CONTROLLING COST
A-STANDARD COSTS
To be able to control the variables that affect the cost of producing a product management must apply the concept of standard cost. Standard cost serves as the yard stick with which actual cost is compared and thus provides management with the knowledge of whether or not operations are proceeding as expected or planned and if corrective actions are necessary.
Essential, a standard cost represents the expected cost of producing one unit of product. Hence, standard cost per unit of output is calculated by adding the material cost, labor costs, and production overhead. The standard cost per unit of output is determines for a level of production that has been decided on. For example, if the firm normally produces 100.000 units, standard cost is determine on the basis of this normal level of production. In practical terms, the standard cost gives an idea of what it costs to produce a unit of output at normal production.
Ideal Standard VS Attainable Standards.
Depending on the management philosophy in developed the standard costs measures, these standards are either one of the following categories:
a- Ideal standards which represent the minimum costs attainable under ideal conditions, using existing specifications and equipment. These standards are essentially based on engineering estimates. There is no allowance for normal spoilage, waste, normal inefficiencies, machine breakdowns, and the like.
Under these standards production must use the most minimal amount of materials and labor, acquired at the lowest price and utilized in the most efficient way. Ideal standards are considered as ideal targets. These targets are not commonly used for planning and control purpose particularly in the area of labor. However, under a production or manufacturing environment of the JIT philosophy, it is thinkable and expected that standard costs would be closer or approach the ideal standards.
b- Currently attainable standards represent the costs that con be achieved with current efficient operations. As with ideal standards attainable standards are normally based on engineering specifications and standards. However, there is an allowance for normal spoilage waste machine breakdowns and the like. An allowance is also made for normal inefficiencies to the extent that they can be anticipated and quantified. In essence, these standards represent predictions of what will occur in the operations. Therefore, compared to that of ideal standards, the variances tend to be minimal.
These standards are usually used for managerial and cost accounting. It is also commonly utilized for planning and control purposes. In common usage, the term “standard costs” implies currently attainable standards.
SETTING THE STANDARD COSTS
As a predetermined cost, a standard cost per unit is composed of two elements:
a- Quantity standard, which is the quantity of input used to produce a standard unit of finished product. This standard is expressed in terms of the unit of measurement of the input, e.g. pounds, broad feet, direct labor hours.
b- Price standard, which is the price per unit of measurement of the quantity of input. This standard is expressed in monetary terms per unit of measurement of input e.g. dollars per pound, per board feet, or per direct labor hour. The price includes shipping and handling charges, fringe benefits and payroll taxes.
The standard cost is calculated as follows:
Standard cost = Quantity standard x Price standard.
Quantity standards for direct materials are normally specified in the bill of materials of the product design. The quantity standard for a material is the required quantity or measure of the material input to produce one unit of acceptable finished product. Allowance for expected normal spoilage, waste, and normal loss of material in the process of production, are quantified and include in the setting of a quantity standard.
To illustrate:
Gallons of solution 2.0
Allowance for evaporation 0.1 per gallon 0.2
Quantity standard for the solution 2.2
This means that 2.2 gallons of units is needed to produce a 2.0 gallon unit of output.
Note that the specifications of quantity standards for direct materials are also used for panning the purchase and handling of the materials.
The price standard of a material is the price that management expects to pay per unit of that material during the current budget period. This is established with the purchasing staffs that are more familiar with market conditions about the material. The price includes shipping and handling charges and discount on bulk purchases which is quantified on per unit basis.
To illustrate:
Established price of material per gallon $1.50
Shipping and handling 0.5
Price standard of the material per gallon $1.55
A price standard is normally established and used over a budget period while actual price tends to fluctuate during that period. This is the underlying cause of price variances. Unless there is a binding contractual provision for a constant price on a material delivered at least during the budget period, price variances will happen. Note that this type of arrangement under the JIT philosophy.
Quantity standard for direct labor is the number of direct labor hours need to produce one unit of finished product. Labor quantity standards are determines through industrial engineering analyses (most accurate but expensive), analyses of historical data/or intuitive judgments of experienced workers and supervisors. In the engineering approach, all factors that will influence completion time are identified, quantified, and specified for each labor quantity standard. Allowances for “normal ideal time” are also made.
Price standard for direct labor is the hourly rate which a firm is expected to pay a given skill category of workers for the budget year. The labor price standards are based on the prevailing market rate for each type of worker, or on a negotiated union contract. Allowance for fringe benefits and environment taxes are included in setting the price standards. The price standard for direct labor is in practice commonly refreshed to as the labor rate standard.
The difference between the actual direct labor hours used and the standard hours allowed per unit of output, multiplied by the standard rate per direct labor hour will determine the direct labor efficiency variance. This variance is of particular interest in the controlling of cost.
Illustration of the structuring of a standard cost
DEVIATIONS FROM STANDARD COSTS
Deviations from standard cost happen when:
a- Material cost or labor cost has change between the time the standard cost was estimated and the time of actual production; and
b- The firm operates at a greater or lesser capacity than normal.
For example: ABZ company produced 100.000 units at normal capacity with an assigned overhead cost of $300.000. Material cost is at $5 per unit, labor cost &7per unit, and overhead $3 per unit ($300.000/100.000).
The standard cost is $15 (5+7+3)
Assuming there was no variance in material and labor cost:
- If only 75.000 units were purchased
Overhead will be $4 per unit ($300.000/75.000)
The cost per unit is $16 (5+7+4)
- If 150.000 units were produced
Overhead will be $2 per unit ($300.000/150.000)
The cost per unit is $14 (5+7+2)
It is noteworthy to mention at this point that standard cost is cost per unit, while budgeted cost is total cost.
Besides its use in planning and control, standard cost is employed to determine selling price and expected profit per unit. It is also useful in deciding whether or not to accept a special order job or in bidding on jobs.

 

[cayman]

cont.

B-COSTS AND THEIR VARIANCES
Variances analysis is the comparison of standard performance to actual performance. Variance is the difference between the standard cost and the actual cost. A variance is unfavorable if the actual price or actual quantity exceeds the standard price or standard quantity. In this section, variance will be used to determine the cost of a change due to arise or decline in material use, purchasing price or labor or machine hour input.
Type of variance
Price variance = Actual quantity x (Actual Price – Standard Price)
Price variance appraises purchasing efforts and the weighted impact of the changing cost of raw materials.
Example:
Select soda is troubled by the increase in the price of the syrup it uses to manufacture its cola. The actual quantity is 1000 units. The actual price is $55 per unit. The standard price is $50. The variance is calculated to be $5,000
Price variance = 1000 x ($55 -$50) = $5,000
Analysis:
According to this calculation, the cola company is paying an extra $5,000 to manufacture 1,000 units which it deems unfavorable.
Quantity variance = (Actual quantity – Standard quantity) x Standard price
Quantity variance estimated cost consequences of excess or deficit usage of material or labor production.
Example:
BNC normally uses four widget sub-assembly parts for each widget it produces. Due to quality control problems the company used an average of six sub-assembly parts for each widget. Each sub-assembly part cost $1.50. This occurred on one production run of 10,000 units. The company wants to know the quantity variance. It is $30,000
Quantity variance = (6×10,000)-(4×10,000)x$1.50 = $30,000
Analysis:
The addition of the two sub-assembly parts will cost BNC $30,000 more than the usual operating procedure of four sub-assembly parts. This is an unfavorable variance.
Cost Reduction Techniques to Offset Unfavorable Variances.
- Implement a cost-reduction program
- Reengineer to stay lean and mean
o Inspect production methods
o Inspect departmental handling
o Look for bottlenecks
o Consolidate departments
- Make volume purchase to get a better discount
- Useless expensive material.
C-BUDGETING
A budget is a comprehensive financial plan describing the acquisition and use of financial and other resources of a company during a particular time period. A budget is a tool for planning and is helpful as a control device.
A budget in the initial phase of planning servers as a standard and at the end of an accounting cycle servers as a control mechanism to aid mangers in measuring performance.
Producing a master budget stars with the creation of a sales budget and continues through several steps that finally lead to the cash budget the budgeted income statement and the budgeted balance sheet.
A master budget is simply the overall budget which includes many smaller component budgets.
ZERO BASED BUDGETING
An important new budgeting technique used in businesses to control costs and justify expenditures is zero-based budgeting.
In the past, many companies stared with the previous year’s budget and added to it new expenses and adjusted for inflation. Expenses may have been budgeted for items which were no longer relevant adding value to the company.
Zero-based budgeting is a process which demands every company department management to justify the department’s budget in detail from the starting point of zero and requires an examination of the output values of every activity of a specific cost / responsibility center. The objective is to pinpoint and eliminate up productive activities within the company. It greatly reduces wasteful spending.
Zero-based budgeting is an approach to budgeting used especially in on-profit, government, and service organizations.
SALES BUDGET
The sales budget often includes a computation of expected cash collections from credit sales. (see the cash budget for example)
Quarter 1 2 3 4 Total
Expect sales units 4,000 6,000 5,000 6,000 21,000
Unit sales price X $50 X $450 X $50 X $50 X $50
Total sales (thousands) $200 $300 $250 $300 $1,050
The cash budget presents the expected cash inflow and outflow for a given time period.
Quarter 1 2 3 4 Total
Beginning Cash 20,000 15,000 25,000 30,000 90,000
Additional Receipts 60,500 70,100 78,000 85,000 293,600
Cash available 80,500 85100 103,000 115,000 383,600
Less payments:
Quarter 1 2 3 4 Total
Materials 7,000 8,000 7,500 9,000 31,500
Labor 30,500 31,000 30,000 32,000 123,500
Overhead 19,000 20,500 18,000 20,000 77,500
Sell & Administrative 25,300 24,000 22,000 22,500 93,800
Machinery 25,000 ———— ———— ———— 25,000
Income tax 6,000 6,700 7,000 7,500 27,200
Total payments 112,800 90,200 84,500 91,000 387,500
Cash surplus (deficit) (32,300) (5,100) 18,500 24,000 5,100
A financing section the follows which provides an account of the borrowings interest and repayments expected during the budgeted period.
The additional receipts are the “cash” collections from sales. They are either in the form of cash from current sales or receipt of payment for previous and current quarter on credit.
Components of the Cost of Goods Sold Budget
D-COMPANY PERFORMANCE
Returns on Investment and residual income are the two most highly used methods of measuring divisional performance.
Return on Investment (ROI) =
In the Dupont Formula, the ROI is broken down as follows:
ROI = x
ROI = Margin x Asset Turnover
Important points:
Profit margin: earning from each dollar of sales reflecting cost control and pricing strategy.
Asset Turnover: sales generated from the left side of the balance sheet bench marking how well assets are used to generate revenues for the company.
There appears to be inverse relationship between profit margin and asset turnover. High profit margins (originating from high price ticked items) move less quickly than a lower price ticketed item earning s lower profit margin. Think of asset turnover comparison between Kmart or a sales way, to that of an Ethan Allen Furniture Store.
RETURN ON INVESTMENT
Increasing performance
1- ROI, a measure of performance, can be enhanced by improving margin, improving turnover both.
Margin may be increased by decreasing expenses, raising selling prices, or increasing sales quicker than expenses.
Turnover may be increasing sales while keeping the investment in assets constant or by decreasing assets.
Assets may be reduced by getting rid of a\obsolete and redundant inventory; speeding up collection of receivables; and utilizing assets to repay outstanding debts or buy back out standing issues of stock.
2- Residual Income (RI) is the operating income which an investment center is capable of generating beyond a given minimum rate of return on its operating assets. This value is an actual dollar amount that is used to pace departmental performance. This calculation is more effective in gauging departments of similar size, otherwise keep in mind that larger budgeted departments tend to produce bigger RI values.
RI = Operating Income - (Minimum Required rate of return x Operating Assets)
Ex: BNC has operating assets valued at 4,000,000 and possesses an operating income of $1,750,000. The minimum required rate of return is 20%.
RI = $1,750,000 – (20% x $4,000,000) = $950,000
BNC can earn an extra $950,000 beyond the 20% minimum rate of return based on their operating income or budget.

E-TRANSFER PRICING
Transfer pricing is the price to be charged in an exchange of products and services between two investment centers or independent divisions (responsible for their own profit-making) within a company.
The preferred transfer price to utilize is the negotiated market price (the best attainable from an outside supplier). When that is not available the following can be used.
Transfer price = Variance cost per unit + Opportunity costs per unit for the firm as a whole.
The motivation behind this formula is that the selling division should be allowed to recover its variable and opportunity costs (in our case, revenue that would be earned by selling aluminum to outsiders), without suffering a loss of income when selling inter-departmentally.
Note. The buying division should never be charged price that is greater than the external market price.
A company with subsidiaries may utilize transfer pricing to undermine non-integrated competitors by a price squeeze. Also, a multinational company may engage in transfer pricing to increase its profits so that the larger position of it resides in a country with low taxes.
Ex: A cola company contains two independent divisions, an aluminum plant and a bottling plant. The bottling plant purchases aluminum from their sister aluminum processing plant and some from an out side supplier when huge material requisitions are needed what is the price that the aluminum plant should charge the bottling plant?