Galilee Corporate Centre Joe Farrington Road

Galilee College

Cost Accounting I Course No. ACC 214

Galilee Corporate Centre • Joe Farrington Road P.O. Box EE 16507 - Nassau, Bahamas – Tel. (242)364-8202 Fax (242)364-1778 Email: [email protected] www.gcollege.org

Dr. Willis L. Johnson, Galilee College

1 Galilee College Course Outline

COURSE NUMBER: ACC 214 COURSE TITLE: Cost Accounting I DEPARTMENT: Accounting CREDIT VALUE: 3.0

COURSE DURATION: 1 SEMESTER DATE PREPARED: July 2008

PREREQUISITES ACC 112, Principles of Accounting II PROGRAM COORDINATOR ______

REQUIRED TEXTS: COST ACCOUNTING I Author Dr. Willis L.Johnson, Galilee College Description: © Printed Material 2006

SUPPLEMENTAL MATERIALS NONE

COURSE DESCRIPTION A study of cost accounting principles and techniques of assembling data for product cosing and for managerial use in planning and control and decision making cost terminology, cost behavior, job order and process costing, budgeting, cost-volume-profit analysis, standard costs, and relevant costs for decision making are topics covered. COURSE OBJECTIVES Students will be expected to: Demonstrate an understanding of the terms and concepts used in cost/managerial accounting. Demonstrate an ability to solve problems and analyze short case situations involving topics mentioned in the course description. Some problems will require solution using computer spreadsheets. Demonstrate an ability to apply cost/managerial terms, concepts, and procedures to managerial situations, formulate a solution or recommendation, and communicate the results of the application.

2 Program Context: This course is a second year course in the Accounting program. (This course can also be completed in the third year ) Course Learning Outcomes: Learning outcomes identify the knowledge, skills and attitudes that successful students will have developed and reliably demonstrated as a result of the learning experiences and evaluations during this course. Evaluation Strategies and Grading: Class Attendance Full participation and attendance is expected for this course. Students who miss a class are responsible for any information discussed, assigned or distributed in that class period. Six exams are scheduled during the semester. The lowest exam score will be dropped. If an exam is missed for ANY REASON, that will be the exam dropped. If a second exam is missed for ANY REASON, a ZERO will be assigned to the second missed exam. There will be no make-up exams. Everyone is required to take the final exam. Calculators may be used on all exams, but you may NOT share calculators.

ATTENDANCE 10% CLASS TESTS 40% FINAL PROJECT 50% 100% Note that violation of academic honesty can affect the course grade. "Cheating" on an exam (i.e., the giving or receiving of aid) will result in a course grade of "F." Note that classroom behavior (for example, talking to other students during lecture) can negatively affect course grades by as much as three letter grades, e.g., an "A" can become a "D."

GRADING SYSTEM: A 94% - 100% Excellent 4.00 D 68% - 74% Passed 1.00 B 87% - 93% Good 3.00 F 0% - 67% Failed 0.00 C 75% - 86% Average 2.00

COVERAGE X Introduction to Cost Accounting 1. Process Costing 2. Job-Order Costing 3. Standard Costs 4. Variable (Direct) & Absorption (Full) Costing 5. Activity-Based Costing (ABC) 6. Joint Costing & By-Product Costing

3 7. Service Cost Allocations 8. Budgeting 9. Cost- Volume-Profit (CVP) Analysis

COST ACCOUNTING I ACC 214

Professor: Dr. Willis L. Johnson, CPA Course Instructions 1. Review the notes for each chapter 2. Complete all Homework and classwork questions. 3. Upon completion of the above, complete the Final exam which is attached. i. The final exam should be presented in typewritten format 4. Should you require additional information, please contact Dr. Johnson as soon as possible at (242)364-8202 or 364-7386 5. Email any questions that you may have to [email protected], addressed to Professor Johnson. 6. Your “completed” Work must be presented via email to enable you to receive a grade for this course.

Note: Your work should be completed between 6 – 10 weeks. Presentation after 10 weeks will cause the reduction of grade, the maximum time with permission for extension is 12 weeks.

4 Cost Accounting I

TABLE OF CONTENTS

X Introduction to Cost Accounting 1. Process Costing 2. Job-Order Costing 3. Standard Costs 4. Variable (Direct) & Absorption (Full) Costing 5. Activity-Based Costing (ABC) 6. Joint Costing & By-Product Costing 7. Service Cost Allocations 8. Budgeting 9. Cost-Volume-Profit (CVP) Analysis

5 Introduction to Cost Accounting

Accounting is called the language of business. The objective of financial accounting is to provide useful information to external decision makers such as investors and credits. On the other hand, the objective of management accounting is to provide useful financial and non financial information to internal decision makers.

Cost accounting is a specialized form of accounting which measures, analyzes, and reports financial and non-financial information relating to the cost of acquiring or using resources in an organization. Cost accounting provides product cost information used both by external parties and by internal managers who are responsible for planning, controlling, decision making, and evaluating performance within the organization.

Though both management and financial accounting make extensive use of the accounting records of the organization, there are differences between the two fields of accounting in terms of: Management Financial Accounting Accounting Primary users Company managersOutside parties Time focus Present and future Historical Organizational Parts (segmented) Whole (aggregate) focus Time span of Quarterly and As needed reports annually Rules and Need not follow Must follow GAAP regulations GAAP Record-keeping Formal and informal Formal

Managers need reliable information to develop mission statements, implement strategy, devise and control the value chain, and evaluate performance. Cost accountants are charged with the responsibility of providing management with financial and non-financial information so that management's goals are achieved.

One of the keys to a company’s success is in creating value for customers. Value can be defined as the usefulness a customer gains from a company’s product or service. An effective way to evaluate value is through value chain analysis.

6 A value chain can be defined as a set of value-adding functions or processes that convert inputs into products and services for customers. Critical to value chain analysis is a proper determination of costs. Management accountants forecast, identify, and track costs in each function of the value chain. Their goal is to create value while minimizing cost.

Cost accountants act as scorekeepers in assisting management to evaluate performance. In the past companies have used historical financial information to evaluate performance. Today many companies use the balanced scorecard, a combination of financial and non-financial indicators and objectives to evaluate performance.

At the outset of our discussion of cost accounting it is important to consider professional ethics. Though many recent public abuses in accounting reporting have had to do with improperly reporting revenue in external statements; nevertheless, it is important to consider ethical issues relating to both costs (expenses) and revenue.

7 Chapter 1 – Process Costing

Summary 1. Process Costing is accounting for product costs of inventoriable goods or services  Used for continuous process manufacturing of units (homogeneous) a. Costa are accumulated by departments or cost centers b. WIP is stated in terms of equivalent completed units to calculate average cost c. Units are established on a departmental basis i. Period Costs are expensed when incurred. E.g. advertising, officers salaries, depreciation 2. Job-Order Costing accounts for the cost of specific jobs or projects Note: Process & J/O Costing use the same general ledger accounts, and cost flow is the same  WIP for both systems are increased for the application of Material, Labor and FOH 3. Equivalent Units of Production Weighted Average FIFO 1 EUP = (conversion cost: DL & FOH) EWIP Weighted Average EU needed to produce 1 unit of F/G + Completed Units/ - BWIP Transferred  Add normal spoilage or scrap if any 3. Spoilage i. Normal – occurs under normal, efficient operating conditions = product cost ii. Abnormal – not expected under efficient operating conditions – period cost a. (Debit loss & Credit WIP) 4. Scrap – is normal and is a part of cost. When sold (debit cash & credit FOH or Revenue) 5. Waste – no further use for left over material = expense 6. Rework – charge to FOH if normal 7. Product Quality costs – i. Costs of external failure: problems occurring after shipment (e.g. warranty, product liability, customer complaint) ii. Internal failure cost: problems occurring before shipment (e.g. downtime, rework, scrap, tooling changes) iii. Prevention: attempts to avoid defective output (preventive maintenance, employee training, review of equipment design & evaluation of suppliers)

8 iv. Appraisal: Embraces quality control programs (statistical quality control programs, inspecting, testing)

Lecturer Notes

Process costing is a method of allocating manufacturing cost to products to determine an average cost per unit. It is used by companies which mass produce identical or similar products. Since every unit is essentially the same, each unit receives the same manufacturing input as every other unit. Refineries, paper mills, and food processing companies are examples of businesses which use process costing.

Similarities between job order and process costing include: Both systems have the same basic purpose—to calculate unit cost Both systems use the same manufacturing accounts The flow of costs through the manufacturing accounts is basically the same

However, there are some important differences between job order and processing costing as described below.

Job Order Costing Process Costing Each job is different All products are identical Costs are accumulated by job Costs are accumulated by department Costs are captured on a job cost sheet Costs are accumulated on a department production report Unit costs are computed by job Unit costs are computed by department

In job costing costs are assigned to specific jobs and then, if necessary, to units within the job. In process costing, however, costs are averaged and then assigned directly to units. Since every unit in process costing is the same, unit cost can be calculated by dividing total product costs by units produced.

In process costing, total production costs are accumulated by department (and by product in each department when multi products are produced). The number of units produced can be complicated by the fact that not all units may be 100% complete at period end. This necessitates the calculation of equivalent units. Equivalent units of production are the number of completed units that could have been obtained from the inputs that went into the partially completed units. For example if 2,000 units are 20% complete at period end, they are equivalent to 400 units (2,000*.2).

There are two methods of accounting for costs in process costing as follows: Weighted average method FIFO method

9 Under the weighted average method, a single average cost per unit is calculated for both the units in beginning inventory and the units started in production during the period. The FIFO method, on the other hand, separates units in beginning inventory from current production so that a current period cost per unit can be calculated.

There is a six step approach to calculating costs. Note that equivalent units are the sum of units transferred to the next department plus the number of equivalent units in ending inventory. Since cost inputs are entered at different times, separate equivalent figures must be calculated for material and for conversion costs.

Again the authors suggest a six step approach to calculating costs. Steps 1 and 2 are the same as used in the weighted average method since they refer to the use of physical units. Note that FIFO number of equivalent units is different from the weighted average number of equivalent units. In the FIFO method equivalent units to be accounted for is the sum of: Equivalent units in beginning Work in Process (100% - percent completed) Units started and completed this period Equivalent units in ending Work in Process

Standard costs rather than actual costs are widely used for inventory valuation. The weighed average and FIFO methods can become complicated for companies which produce a wide variety of very similar products. These companies frequently employ a standard cost system and prepare production reports using standard rather than actual costs. The computation of equivalent units for a standard costing system are identical to those of under the FIFO method.

EXERCISES

Class: PROCESS COSTING: Fife Fiffy uses a process cost system to manufacture laptop computers. The following information summarizes operations related to laptop computer model #KJK20 during the quarter ending March 31. Units Direct Materials WIP Inventory, January 1 100 $70,000 Started during the quarter 500 Completed during the quarter 400 WIP Inventory, March 31 200 Costs added during the quarter $750,000

Beginning work-in-process inventory was 50% complete for direct materials. Ending work-in-process inventory was 75% complete for direct materials. Using the Weighted Average & FIFO methods, Find the following for March:- 1. Equivalent units of production 2. Transfer out cost 3. Cost of Ending Inventory what were the equivalent units of production with regard to materials for March?

10 Home:. PROCESS COSTING: Lint Linty uses a process cost system to manufacture Grape Fruit Juice. The following information summarizes operations related to Grape Fruit Juice the quarter ending June 30, 2007. Units Direct Materials WIP Inventory, April 1 200 $100,000 Started during the quarter 800 Completed during the quarter 400 WIP Inventory, June 31 100 Costs added during the quarter $950,000

Beginning work-in-process inventory was 40% complete for direct materials. Ending work-in-process inventory was 50% complete for direct materials. Using the Weighted Average & FIFO methods, Find the following for June:-1. Equivalent units of production 2. Transfer out cost 3. Cost of Ending Inventory what were the equivalent units of production with regard to materials for June?

11 Chapter 2 – Job-Order Costing

Summary 1. Accumulating cost by specific job Note: Indirect material and indirect labor are FOH (do not overstate FOH) 2. When FOH applied is materially different from FOH incurred, the difference is allocated among: F/G, CGS and EWIP 3. Cost of Good Manufactured BWIP + Direct Materials + Direct Labor + FOH = Cost Accounted for - EWIP = CGM 4. Underapplied FOH: i. If actual fixed cost is greater than expected = underapplied FOH ii. If actual fixed cost is less than expected = Overapplied FOH iii. If actual volume is less than expected (F/C) = Underapplied FOH iv. If actual volume is greater than expected (F/C) = Overapplied FOH 5. Cost Accounting Entries i. Direct Materials Purchased Materials Inventory xx Acct. Pay/Cash xx ii. Materials transferred to WIP WIP xx Materials Inventory xx iii. Factory Salaries WIP (Direct Labor) xx FOH (Indirect Labor) xx Wages Payable/Cash xx Payroll Taxes Payable/Cash xx  t is normal for customers to require early completion and pay an OT premium iv. Manufacturing Expenses (insurance, supplies, plant depreciation, indirect Mat.) FOH xx Expenses xx v. Overhead charged to WIP WIP xx FOH xx vi. Goods are completed(Finished) Finished Goods xx WIP xx vii. Goods are sold

12 Cash/Acct. Rec. xx Sales xx CGS xx Finished Goods xx Note: EWIP/EFG/E Raw Materials = deferred manufacturing costs.

Lecturer Notes

In order to be successful and survive, businesses must employ some type of product costing system. In other words, companies need to track the cost of making a product or furnishing a service. When a service is rendered the customer is given an invoice detailing the material and labor “costs”.

Management needs to cost products for a number of reasons. For financial statements purposes management needs to calculate Cost of Goods Sold on the Income Statement and Inventory on the Balance Sheet. For internal needs management needs product cost information to establish prices, to compare actual with budgeted figures, to properly decide to “make or buy”, etc. Often outsiders such as insurance companies or government agencies require product cost information as well.

Before a product costing system can be implemented, a decision must be made with regard to the following: Which cost accumulation system is appropriate Which valuation method should be used.

There are two broad cost accumulation systems: Job Order and Process Costing. Job Order Costing is used by companies where products or services are identifiable by individual units or batches—auto repair, tax return preparation, case in an attorney’s office, ship construction, etc. The costs attributable to a particular job are assigned directly to it. Process Costing is used in industries where there is mass production of similar or identical products—food products, chemicals, cement, etc. Since each product is identical, product cost can be determined by dividing total manufacturing costs by total units produced. This average cost applies equally to all units produced. At this time, it should be noted that many companies use a hybrid cost accumulation system which incorporates some features of job order costing and other features of a process costing system.

There are three valuation methods which may be used as follows: Actual Costing Actual direct material Actual direct labor

13 Actual overhead (assigned after the end of the period)

Normal Costing Actual direct material Actual direct labor Overhead applied using a predetermined overhead rate

Standard Costing Standard direct material Standard direct labor Overhead applied using predetermined rate times standard input

As mentioned above, in Job Order Costing costs are accumulated individually on a per-job basis. In a manufacturing environment, costs are accumulated on a Job Order Cost Sheet. Note that the direct material cost comes from material requisition forms and the direct labor costs from employee time tickets. In normal costing, manufacturing overhead is charged using a predetermined overhead rate. Actual and budgeted cost data is included so that variances can be examined immediately as the job is in process and as it is completed.

Standard costs may be used in a job order costing system. Costs are entered into Work in Process at the standard rather than the actual rate. When the job is complete standard costs are compared to actual costs incurred on the job so that variances can be examined and analyzed.

14 Job Order Cost Accounting – Supplementary Note

I. COST ACCOUNTIG SYSTEMS A. Cost accounting involves . The measuring . The recording, and . The reporting of product costs

 Accurate product costing is critical to a company’s success

B. Two basic cost accounting systems (Job Order Cost System and Process Cost System)

1. JOB ORDER COST SYSTEM  Costs are assigned to each job or batch

 A job may be for a specific order of inventory May be a unit: ex.

or a Batch of units: ex.

15  A key feature:

 Measures costs for each job completed - not for set time periods 2. PROCESS COST SYSTEM  Used when a large volume of similar products are manufactured. Examples:

 Cost are accumulated for a specific time period (a week or a month)

II. JOB ORDER COST FLOWS A. In general, the cost flow parallels the physical flow of the materials as they are converted into finished goods. . Manufacturing costs are assigned to Work in Process Inventory. . Cost of completed jobs is transferred to Finished Goods Inventory. . When units are sold, the cost is transferred to Cost of Goods Sold.

16 Debit WIP Inventory → FG Inventory → COGS when:

B. Recording Direct Materials, Direct Labor and Overhead costs

 Use a Job cost sheet to record the costs related to a specific job on a daily basis; used to determine the total and unit costs of a completed job.

1. DIRECT MATERIAL COSTS (DM)  Debit Raw Materials Inventory when Purchase direct or indirect materials  Materials requisition slip shows written authorization when used in production  Debit Work-in-Process Inventory when direct materials are Used  Indirect Materials are treated as an overhead cost. (i.e., Debit Manufacturing Overhead Account)

2. DIRECT LABOR COSTS (DL)  Consists of gross earnings of factory workers, employer payroll taxes on such earnings, and fringe benefits incurred by the employer.

17  Debit Work-in-Process Inventory when direct labor is recorded (ie., whether paid or accrued)  Indirect labor is treated as an overhead cost. (i.e., Debit Manufacturing Overhead Account)

Note: Some companies use a Factory Labor account to initially record all factory labor costs (direct and indirect labor). However, factory labor costs are closed out immediately to the Work-in-Process Inventory account for Direct Labor and to the Manufacturing Overhead account for Indirect Labor. Your textbook teaches journal entries using this holding account for Factory Labor, but the account balances are identical whether or not this account is used!

18 3. MANUFACTURING OVERHEAD COSTS (OH)

Manufacturing overhead is a Control Account. It is used to keep track of two things: Actual Overhead costs incurred and Overhead costs assigned to inventory (also known as overhead applied).

DEBIT Manufacturing Overhead Control when actual manufacturing overhead costs are incurred.

Note: The subsidiary ledger consists of individual accounts for each type of overhead cost, but the controlling entry is a debit to Manufacturing OH

CREDIT Manufacturing Overhead Control when Overhead is Applied to production.

 Must be assigned to work in process and to specific jobs on an estimated basis by using a PREDETERMINED OVERHEAD RATE  Based on the relationship between estimated annual overhead costs and expected annual operating activity.  Established at the beginning of the year.

19  Expressed in terms of an activity base such as Direct labor costs, Direct labor hours, Machine hours, or any other activity that is an equitable base for applying overhead costs to jobs.

 Assigning overhead costs to inventory involves a two-step process:

1st: Determine the Predetermined Overhead Rate:

2nd: Overhead is “Applied” or Assigned to work in process inventory during the period based on actual activity.

 At the end of the period determine if manufacturing overhead is UNDERAPPLIED OR OVERAPPLIED

 A debit balance in manufacturing overhead means that overhead is underapplied. (i.e., Overhead assigned to work in process inventory is less than overhead incurred.)  A credit balance in manufacturing overhead means that overhead is overapplied. (i.e., Overhead assigned to work in process inventory is greater than overhead incurred.)

20  If immaterial in amount, any year-end balance in Manufacturing Overhead is eliminated by adjusting cost of goods sold.

. If Underapplied:

. If Overapplied:

Example: Overhead is expected to be $100,000 next year. Management believes the variable portion of overhead varies with direct labor hours, with 40,000 direct labor hours expected next year. 1) Calculate the predetermined OH Rate.

2) Apply overhead to production for January if 3,000 direct labor hours are worked.

3) If actual overhead at the end of January is $8,000, did the company over- or under-apply overhead during the month? Show the adjusting entry to close the overhead account at the end of the month.

22 EXAMPLE #1: JOB ORDER COSTING The Custom Division of Allied Manufacturing had one job in process at the beginning of May (Job #A11 with accumulated costs of $500) and no beginning finished goods inventory.

(1) Record the following journal entries: May 1 Direct materials costing $800 were purchased on account.

May 2 Direct materials were issued to production as follows: Job #A11 $200 Job #A12 $300

May 10 Paid Rent totaling $1,300. Of this amount, $800 was for the factory and $500 was for sales and administrative facilities.

May 15 Paid factory wages for direct labor as follows: Job #A11 (100 hours) $1,000 and Job #A12 (120 hours): $1,200. The company also paid $1,500 for indirect labor in the factory. May 15 Manufacturing Overhead is applied at a rate of $3 per direct labor dollar.

23 May 25 Job #A11 was completed.

May 27 Job #A11 was sold for $8,000 on account.

May 31 Other manufacturing costs incurred during the period include: $2,000 for factory depreciation; $400 for factory insurance; and $200 for factory utilities.

2)Determine the balance in the Work-in-Process and Finished Goods Inventory accounts at the end of May. Also show the journal entry to close out the under- or overapplied overhead at the end of the month.

24 III. COGM and COGS Schedules NOTE: With the information added in this chapter regarding production costs, you should note the following updates regarding the cost of goods manufactured and cost of goods sold schedules:

 The cost of goods manufactured schedule now shows manufacturing overhead applied rather than actual overhead costs. That is, current production costs include: DM Used, DL and OH Applied.  The cost of goods sold schedule will show an adjusting entry for over- or under-applied overhead for the period.

25 DM Used: COGM (completed) Beg. DM Beg. WIP + DM Purchases + Current Production Costs = DM Available DM Used -Ending DM DL = DM Used OH Applied - Ending WIP = COGM

COGS Income Stmt. Beg. FG Sales + COGM -COGS (after adjustment) = Cost of goods Available =Gross Margin - Ending FG -Operating Exp. =COGS = Income +/- Under/Overapplied OH =COGS after adjustment

26 EXAMPLE #2: JOB ORDER COSTING The Custom Division of Allied Manufacturing had one job in process at the beginning of May (Job #A11 with accumulated costs of $400) and no beginning finished goods inventory.

(1) Record the following journal entries: May 1 Direct materials were issued to production as follows: Job #A11 $200 Job #A12 $300

May 10 Paid Rent totaling $350. Of this amount, $200 was for the factory and $150 was for sales and administrative facilities.

May 15 Paid factory wages for direct labor as follows: Job #A11 (100 hours) $1,000 and Job #A12 (120 hours) $1,200

May 15 Manufacturing Overhead is applied at a rate of $3 per direct labor hour.

May 25 Job #A11 was completed and sold for $4,000 cash.

3) Determine the balance in the Work-in-Process Inventory, Finished Goods Inventory and Cost of Goods Sold accounts at the end of May.

27 EXAMPLE 3: Job Order Costing Foster Manufacturing began January with direct materials costing $10,000, work-in-process costing $2,000 and finished goods inventory consisting of Job #500 costing $13,000. All of the costs in work-in-process are associated with Job #501. During January, the following transactions occurred for Foster Manufacturing:

Jan. 1 Issued direct materials costing $8,000 to production ($3,000 to Job #501; $5,000 to Job #502). Also, factory supplies costing $1,000 were issued to production.

Jan. 5 Paid salaries as follows: Administrative Salaries:

$3,000; Direct Labor: $12,000 (Job #501 $8,000 and

Job #502 $4,000); Production Manager $2,000.

Jan. 5 Manufacturing overhead costs are applied to production based on direct labor costs at a rate of $2 per direct labor dollar. Jan. 15 Completed Job #501. Jan. 20 Sold Job #500 for $30,000 on account. Jan. 31 Other overhead costs totaled $20,000 and were paid in cash.

Based on the above information, determine the balance in the following accounts at the end of January: Direct Materials Inventory, Work-in-process Inventory, Finished Goods Inventory and Cost of Goods Sold. Prepare a cost of goods manufactured and a cost of goods sold schedule. Also determine the gross profit earned on Job #501.

28 EXAMPLE 4: KA Catering uses a job order costing system to assign costs to its catering jobs. Overhead is applied to each job based on direct labor hours. Listed below is data for the current year:

Budgeted Overhead: $90,000 Actual Overhead: $77,000 Budgeted labor: $100,000 for 10,000 hours Actual Labor: $ 95,000 for 9,000 hours

Required: (1) show the journal entry to record the overhead applied during the period (2) Show the adjusting entry to close the overhead account at the end of the period.

EXERCISES

Class 1 Sim Simmy’s Raw Material cost was $20,000, Direct Labour was $40,000 and FO was 60% of Direct Labour and applied to production. 1. What was the total manufacturing cost applied to production? 2. If the total actual cost was $90,000 how much was FO, 3. FO under or over applied?

Home 1 Glip Glippy’s overhead was applied at a rate of 200% of direct labour. The actual overhead was $270,000. Direct Material was $100,000 and Direct Labour was $150000. 1. What was the applied total cost? 2. What was the FO actual cost. 3. How much as FO over or under applied, 4. Was FO under or over applied?

29 Chapter 3 – Standard Costs

Summary 1. These are budgeted unit costs established to motivate optimal productivity and efficiency  These are predetermined, attainable unit cost. 2. Standard Cost system separates expected cost from actual cost i. Is applicable to: - process and job-order costing, to service and mass production industries ii. Best standards are based on attainable performance (motivate employees) 3. Variances  Accounts with debit balances are unfavorable  Accounts with credit balances are favorable Variance Calculations i. Direct Material Usage/quantity = AQ – SQ x SP Price AP – SP x AQ ii. Direct Labor Efficiency/Hours = AH – SH x SR Rate AR – SR x AH

 Overhead Volume is least controllable by a production supervisor i. Measures effect of not operating at budgeted activity level ii. E.g. insufficient sales, labor strike  Overhead efficiency is wholly attributable to variable overhead  Labor Efficiency measures the efficiency of employees iii. Factory Overhead i. Total Variable Overhead: Spending variance and efficiency variance ii. Spending Variance: Tot. Act. Var. O/H – (Act. Input x S Rate) iii. Efficiency Variance: S. Rate x (Act – Bud. Activity Base ) iv. Two-way variance Volume Variance: Fix O/H Bud. – Fix O/H applied based on standard input allowed for actual output Controllable (budget variance): Tot. Act. O/H – (Fix O/H + Var. O/H based on standard rate & standard input allowed for actual output) v. Three-way efficiency variance  A flexible budget can be adapted for any level of production

30 Spending Variance = A O/H – (Bud. Fix O/H + Bud. Var O/H on Actual input) x SR Volume Variance = (Bud. Fix O/H – Fix O/H applied based on stand. Input allowed for act. Output)  Change in capacity does not affect spending variance because variable unit costs are constant within a relevant range.  Volume variance will decrease or increase depending on the change in capacity. vi. Four – Way efficiency variance Variable: Spending & Efficiency Fixed: Budget (fixed O/H spending) and volume

Lecturer Notes

Performance measurement is essential in a well-run organization. It can provide critical information as to what works and what doesn’t; it is a way to evaluate and motivate employees; and it can provide a means of carrying out the basic strategy of the company. Most companies use some combination of financial and non-financial performance measures (standards) to gauge performance.

Many companies not only use standards to measure performance but they employ a standard cost accounting system which records both standard and actual costs. Standard costs are the budgeted costs incurred to manufacture a product or perform a service. A standard cost system greatly facilitates an analysis of variances, the differences between actual costs and standard costs.

In a manufacturing environment budgeted costs are captured on a standard cost card. In preparing a standard cost card a bill of materials is prepared and an operations flow document establishing labor cost standards may be prepared. Overhead standards are established using predetermined factory overhead rates.

In a standard cost system, then, both cost and quantity standards are established for the cost inputs of direct material, direct labor, and overhead. Actual price paid for a cost input is compared to the standard price and actual quantity used is compared to the standard quantity. Any difference between actual and standard cost creates a variance, either favorable or unfavorable, and may be investigated further. This process facilitates management by exception--depending on the significance of the variance, management takes appropriate action. Insignificant variances are disregarded.

31 The general model of variance analysis takes this form:

The price variance shows the difference between actual price paid and standard price. The quantity variance measures the actual quantity used compared to the standard quantity allowed for the output of the period.

The following illustration is used to present Cost data: Material Price Variance Material Quantity Variance Labor Rate Variance Labor Efficiency Variance Variable Overhead Spending Variance Variable Overhead Efficiency Variance Fixed Overhead Spending (or Budget) Variance Fixed Overhead Volume Variance

In a standard cost system cost inputs are entered at standard cost. Thus when raw material is purchased it is entered at standard not actual cost. Any difference between actual and standard cost is identified immediately and journalized.

Note that all unfavorable variances have debit balances and favorable variances have credit balances. Standard production costs are shown in inventory accounts and thus have debit balances and therefore excess costs are also debits.

At year end standard cost variances are eliminated through the use of adjusting entries. If the variances are in total insignificant they can be closed to Cost of Goods Sold. However, if the variances are significant they should be prorated among ending inventories and Cost of Goods Sold.

Among the many reasons why companies use a standard cost system is that it allows management to plan for expected costs to be incurred in manufacturing a product or providing a service. Additionally, a standard costs system identifies variances at an early point so that appropriate action can be taken at the earliest point possible.

32 There are two broad types of standards--ideal standards and practical standards. An ideal or perfection standard is the absolute minimum cost under ideal conditions. Both total quality management and just-in-time production systems inherently focus on ideal standards by emphasis on zero defects, zero inefficiency, and zero downtime. Both TQM and JIT attempt to eliminate all non- value added activities and therefore all waste. In this respect these management concepts are a type of ideal standard.

Practical standards can be described as a “tight but attainable” standard and they allow for normal downtime and employee rest periods. At one time many U. S. manufacturers utilized practical standards in evaluating performance. More recently they have moved to a type of ideal standard.

In recent years many companies have shifted to an emphasis on conversion cost as an element in standard costing. This is a result of the shift from labor intensive production to machine intensive production.

EXERCISES

4. These are budgeted unit costs established to motivate optimal productivity and efficiency  These are predetermined, attainable unit cost. iii. Best standards are based on attainable performance (motivate employees) 5. Variances  Accounts with debit balances are unfavorable  Accounts with credit balances are favorable Variance Calculations vii. Direct Material `Direct Labor Usage/quantity = AQ – SQ x SP Efficiency/Hours = AH – SH x SR Price AP – SP x AQ Rate AR – SR x AH Class 1 George Georgy cost analysis showed the following:- Standard Actual Purchases of Raw Material $30,000 $33,000 Units Purchased 10,000 9,000 Labour Cost $90,000 $86,000 Hours Worked 20,000 22,000

Find the following variances and indicate whether they are favourable or unfavourable:-

1, Material price 2. Material quantity 3. Labour rate 4. Labour efficiency

33 Home 1 Peorge Peorgy cost analysis showed the following:- Standard Actual Purchases of Raw Material $39,000 $36,000 Units Purchased 13,000 12,000 Labour Cost $86,000 $89,000 Hours Worked 24,000 26,000

Find the following variances and indicate whether they are favourable or unfavourable:-

1, Material price 2. Material quantity 3. Labour rate 4. Labour efficiency

Chapter 4 – Variable (Direct) and Absorption (Full) Costing

Summary 1. Absorption(Full) costing is required for external reporting purposes (GAAP)

34  Includes fixed and variable FOH in product cost i. these are included in Finished Goods 2. Variable (Direct) costing treats variable FOH as a product cost, but fixed FOH as an expense. Similar to fixed & variable selling, general & administrative expenses)  Direct Labor, Direct Materials, Variable FOH are handled just like absorption costing.  REMEMBER: Fixed FOH is expenses.  Sales – Var. Expenses = Contribution Margin – fixed expenses = operation income.

Lecturer Notes

Earlier we discussed actual cost systems which costs products and/or services using actual direct material cost, actual direct labor cost, and actual overhead cost (may not be available until the end of the period). We have also considered normal costing system which costs products and/or services using actual direct material cost, actual direct labor cost, and allocated overhead cost based on a predetermined overhead rate.

Many companies use normal rather than actual costing for the following reasons: Overhead cost can be assigned as the production occurs or the service is rendered. Predetermined overhead rates adjust for variations in actual overhead costs that are unrelated to activity Predetermined overhead rates adjust for problems of fluctuation in activity levels that have no impact on actual fixed overhead costs Predetermined overhead rates allow managers to be more aware of product and customer profitability

As mentioned above, normal costing uses a predetermined rate to allocate overhead. The predetermined rate is calculated as follows: Total Estimated Overhead Cost Total Estimated Activity Base

Since overhead consists of numerous costs some of which are not immediately available, in normal costing overhead is charged on an allocated basis. At the beginning of the year the company calculates a predetermined overhead rate by dividing estimated total overhead cost by estimated total units of the allocation base. Overhead is charged to Work In Process by multiplying the predetermined overhead rate by the number of actual units of allocation base used during the period.

Since budgeted amounts are used to calculate the predetermined overhead rate there will typically be a balance remaining in Manufacturing Overhead at the end

35 of the period. Note that Manufacturing Overhead is a temporary account and must be closed out at year end. The difference between the overhead cost applied to Work in Process and the actual overhead costs of the period is called either under-applied or over-applied overhead. When overhead is underapplied, manufacturing costs have been understated and when overhead is overapplied, overhead costs have been overstated. In the Manufacturing Overhead Account actual costs are recorded on the debit side and applied costs are recorded on the credit side. If the amount of under-applied or over-applied overhead is immaterial, the balance can be closed out to Cost of Goods Sold. However, if the amount of under-applied or over-applied overhead is material, it should be pro-rated among the accounts in which applied overhead is recorded-- Work in Process, Finished Goods, and Cost of Goods Sold.

Mixed costs are costs which contain both a variable and a fixed element. The fixed element is the basic charge for having the service ready and available for use. The variable element is the actual consumption charge. An example of a mixed cost is the cost of a large capacity copier leased at $1,000 per month plus $.01 per copy. Mixed costs can be represented by the equation Y = a + bX where Y = Total Cost a = Total Fixed Cost b = Unit Variable Cost

X = Activity Level

In order to predict mixed cost behavior it is necessary for the accountant to separate the mixed cost into its fixed and variable elements. As you are probably aware, a number of methods are available to compute the total fixed cost component and the variable cost per unit component in a mixed cost including the following: High low method Least squares method Excel or other software applications

By means of the least squares method and Excel, the value of b (and of a) can be calculated using all data observations. We'll do an Excel exercise where we create a regression line of averages and compute the values of a and b.

Next we discuss flexible budgets. A flexible budget is a plan which provides estimates of what costs should be for any level of activity within a specified range. By using a flexible budget the manager can compare actual costs to what costs should have been for that actual level of activity.

A plant-wide overhead rate is inappropriate for companies which product different kinds of products with different input requirements.

36 Costs can be accumulated and presented in various ways. Cost accumulation refers to which costs are recorded as product costs and which costs are recorded as period costs. Cost presentation refers to how costs are shown on external financial statements or internal management reports. Accumulation and presentation of costs is accomplished using one of two methods, absorption costing or variable costing.

Absorption costing (also known as full costing) treats all manufacturing costs as product (inventoriable) costs in accordance with GAAP. Thus Direct Material, Direct Labor, Variable Overhead, and Fixed Overhead are all charged into the Work in Process Account. When products are completed, Finished Goods is Debited and Work in Process credited. Only when finished units are sold are they charged as expense (COGS) on the income statement. In absorption costing only selling expenses and administrative expenses are treated as period costs and charged off as expense immediately.

In variable costing only variable product costs (Direct Material, Direct Labor, and Variable Overhead) are charged to Work in Process. In variable costing Fixed Manufacturing Overhead is charged as a period cost. Variable product costs are charged to Work in Process and all other expenses including variable selling and administrative expense, fixed manufacturing overhead, and fixed non- manufacturing expense are charged as expenses immediately. Using variable costing a contribution income statement can be prepared in the following format: Sales Revenue - Variable Expense = Product Contribution Margin - Variable Non-manufacturing Expense = Total Contribution Margin - Total Fixed Cost = Income Before Income Tax

Note that absorption costing treats classifies expenses by function whereas variable costing classifies expenses by cost behavior.

EXERCISES

Class I: Bick Bicky’s 2005 manufacturing costs for its new plant were as follows: Direct Materials $900,000, Other Variable Manufacturing Cost $200,000, and Depreciation of Factory building and manufacturing equipment $60,000, Other

37 Fixed Manufacturing Overhead cost $25,000. During 2005 Bick Bicky manufactured 50,000 units and 20,000 were on hand at year end. What amount should be considered product cost for (a) internal reporting purposes? and (b) external reporting purposes? What is the value of ending inventory under both (c) absorption costing and (d) direct costing?

Home I: Rick Ricky’s 2005 manufacturing costs for its plant were as follows: Direct Materials $1,100,000, Other Variable Manufacturing Cost $450,000, Additional Raw Material put into production $60,000 and Depreciation of Factory building and manufacturing equipment $100,000, Other Fixed Manufacturing Overhead cost $40,000. During 2005 Rick Ricky manufactured 100,000 units and 30,000 were on hand at year end. What amount should be considered product cost for (a) internal reporting purposes? and (b) external reporting purposes? What is the value of ending inventory under both (c) absorption costing and (d) direct costing? (e) under variable costing, what is the period cost?

Chapter 5 - Activity-Based Costing (ABC)

Summary

1. Identifies activities needed to provide products or services, and i. assign cost to those activities, then

38 ii. reassigns costs to the products or service based on their consumption of activities  ABC helps manage cost by providing more detailed analyses of cost than traditional methods  ABC facilitates cost reduction by determining what activities do and do not add value to the product or service.  ABC defines cost objects as activities rather than functions or departments 2. Cost Objects: Intermediate and final dispositions of cost pools 3. Cost Pool: an account in which a variety of similar costs are accumulated prior to allocation to cost objects. 4. Cost Driver is a factor that causes a change in the cost pool for a particular activity  These are used as a basis for cost allocation. i. Cost assignment/allocation is based on a multiple cause-and-effect relationship Note: 1. ABC system uses more cost pools and allocation bases than a traditional system. 2. Activities that are unnecessary are nonvalue-adding (raw material & storage) 3. Value-adding (design engineering, heat treatment and drill press)

Lecturer Notes

Activity based management (ABM) is a management system which focuses on analyzing and controlling activities incurred in the production or performance process in an attempt to improve customer value and enhance profitability. The term "ABM" focuses on pricing and product mix decisions, cost reduction and process improvement decisions, design decisions, and planning and managing activity decisions.

ABM divides activities into two categories--value added and non-value added. Value added activities are those which increase the worth of a product or service. Non-value added activities, on the other hand, are those which add nothing to the worth of a product or service. Examples of non-value activities include wait time, inspection time, move time, etc. Value added versus non- value added time can be compared using the manufacturing cycle efficiency (MCE), computed as follows: MCE = Value added time Total throughput time

39 Of course, a company operating in a perfect environment would have no non- value costs and would have an MCE of 1.

An important component of activity based management is activity based costing (ABC). Activity based costing is a costing method which analyzes and attempts to accurately cost specific resources which are consumed to deliver a product or perform a service. In ABC, the calculation of direct material and direct labor is usually uncomplicated. Emphasis is on accurately calculating overhead.

Earlier we calculated product costs using a broad averaging technique such as direct labor hours to allocate indirect (manufacturing overhead) costs. In the historic past when direct costs were a large percentage and indirect costs were a small percentage of total product cost this method provided a sufficiently adequate approximation of product cost. Changes in the economy though and changes in the needs of management require that a new, more accurate, costing system be implemented to supplement the traditional financial accounting costing system.

Modern companies produce a greater and greater variety of products and services. Broad averaging can lead to under or over costing of products or services. This is especially true when the mix of products includes some products which consume relatively few resources and other products which consume relatively many resources. Activity based costing is a costing system which focuses on all the individual resources consumed in providing a product or service. ABC first traces costs to activities and then to products and services.

In ABC, the assignment of overhead costs first involves the division of activities into indirect cost pools and on identification of respective cost drivers for each activity pool. One method to accomplish this is to use a cost hierarchy and separate activities into four general levels as follows:

Unit level costs Costs of activities performed on each individual unit Batch level costs Costs of activities related to a group of products Product/process Costs of activities undertaken to support individual products level costs Costs of activities that cannot be traced to individual Organization or products but that support the facility costs organization as a whole

Note that in both the averaging method and the activity based costing method, direct material and direct labor costs were the same. Also note that all costs (both product and period) that relate to a product are computed when using activity based costing.

40 Activity based costing involves a two step process. Overhead costs are first accumulated in activity cost centers using an appropriate cost drive and second costs are assigned out of the activity cost centers to products.

EXERCISES

Class 1: Bill Billy, entire electricity bill for the entire company was $500,000. Bill Billy had the following departments (a) Computer (b) Plant (c) Sales & Marketing and (d) Administration. The following information was generated from Bill Billy cost sheet:- Square Actual Electrical Department Feet Meters (used) Maintenance Computer 3,000 30,000 $10,000 Plant 4,500 40.000 $25,000 Sales & Marketing 2,500 20,000 $15,000 Administration 6,000 25,000 $20,000

In using Activity-Based Costing, what is the cost allocated to each department?

Home 1: During 2005 Based Basedy, incurred $300,000 in fuel for its manufacturing division. The following factors relate to its activity:- Fuel (tons) Actual Other Facility Consumed Weight (lbs) Fuel Cost Bottling Plant 3,000 20,000 $30,000 Processing Plant 4,500 15.000 $45,000 Filling Plant 2,500 25,000 $25,000

In using Activity-Based Costing, what is the total cost of fuel for each department?

Chapter 6 - Joint and By-Product Costing

Summary

41 1. Joint Products – two or more separate products are produced by a common manufacturing process  Value allocated at point at which joint products become separate. 2. By-products – smaller value products are produced simultaneously from a common manufacturing process with products of greater value and quantity (joint products)  By Products do not usually receive an allocation of joint cost. 3. Joint Cost – incurred prior to split-off point to produce two or more goods manufactured simultaneously by a single process or series of processes.  To assign joint cost, use NRV of products x joint cost 4. Separable cost can be identified with a particular joint product and allocated to a specific unit of output.  Cost incurred after split-off point.

Lecturer Notes

1. Definitions a. Joint Cost: the cost of a single process that yield multiple products simultaneously. Includes DM, DL, and mfg. Ohd up to the split-off point b. Split-off Point: the point in the process at which the products become separately identifiable. c. Separable Costs: those costs incurred beyond the split-off point that are identifiable with individual products d. Main Product: the product with the highest sales value relative to other products beyond split-off e. Joint Products: other products with a relative high sales value that are not identifiable as individual products until the split-off point f. Byproduct: a product beyond the split-off point with a relatively low sales value in comparison with main and joint products g. Scrap: products beyond split-off with minimal value (May have a negative sales value if must be hauled away to a landfill)

2. Reasons for Allocating Joint Costs to Individual Products a. To value inventory and COGS for external reports b. To value inventory and COGS for internal reports (including profitability analysis and performance evaluation) c. For cost reimbursement under contracts where not all the separable products go to a single customer so that allocation of the joint costs is necessary. d. For settlement of insurance claims involving separable products at or beyond split-off.

42 e. For rate regulation when one or more jointly produced products or services are subject to rate regulation based on cost. E.g. services using telephone lines

3. Methods of Allocating Joint Costs

a. Methods where a measure is available at the Split-off point for each separable product. i. Sales Value at Split-off: This method allocates joint costs to the separable products based on the relative slaves value of each product at the split-off point Includes the sales value of the entire production----not just actual sales Simple to apply because it provides a common measure applicable to all products if sales value is readily available Also, relates cost allocated to the revenue-generating power of individual products. Demo 15-16

ii. Physical Measures Method: This method uses some measure of weight of volume common to all separable products at the split-off point. The problem with this method is that the physical measure may bear no relationship to the revenue producing power of the separable products. For example, if a company mines gold and lead, an ounce of gold will be much more valuable than an ounce of lead but both would get the same allocation when ounces is used as the measure. This causes high value items per unit of the physical measure to show high profits and low value items per unit of the physical measure to show low profits. Demo 15-16

b. Methods where there isn’t a market for all of the separable products at split-off. Therefore, some other method has to be used that approximates the situation at the split-off point. (The allocation must relate to the situation at split-off because joint costs cease to have meaning beyong the splitoff point). There are two methods that can approximate the situation at split-off. i. Estimated Net Realizable Value Method (NRV) The NRV for each product as a % of the total NRV of all products, is the basis for the allocation. Est’d NRV = Final sales value of production – Separable Costs (to get an estimated NRV for all products combined that is approximately equal to joint costs, you would also need to deduct selling and admin expenses and gross profit. This is not usually done in practice just to keep things simple)

43 iii. Constant Gross Profit % NRV Method This method assumes every separable product earns the same GP% (this may not be very realistic) It starts with the final sales value of production and subtracts the Gross Profit (which is equal to Sales x constant GP%), and then subtracts the Separable Costs. The result is an approximation of the Joint Costs for each separable product at split-off. Steps: 1. Compute the overall GP% (called the constant GP%) for all products combined (i.e., GP = FSVP – JC – SC 2. Calculate the GP in $ for each product (i.e., FSVP x constant GP% determined in part 1.) 3. Calculate the Joint Costs for each product as follows: FSVP xx Less: GP in $ (xx) Less Sep. Costs (xx) = Joint Costs allocated xx Note: Some products may end up with a negative allocation of Joint costs;

Accounting for By-products

A by-product is a product having a relatively low sales value compared with the main or joint products; by-products can be sold at split-off or processed further; also, if sales increase, a by-product may be re-classified as a joint product at some point.

There are several methods of accounting for by-products in terms or recognizing when to record the cost of the by-product. We will recognize the cost of the by- product only when production is completed.

Steps: 1. Calculate the NRV of the by product (i.e., FSVP – SC, or sometimes if specified, FSVP – SC – normal GP). 2. Subtract this NRV of the by-product from the total joint cost and set the amount up as by-product inventory.

By-product inventory xxx Joint costs xxx

3. Allocate the revised joint cost in the usual way to the joint products using one of the four methods 4. Record any sales of the by-product as follows:

44 A/R xxx By product inventory xxx

Note: Because the NRV of the by-product is treated as a reduction in the total joint cost allocation and because the by-product is given no status as a separate product, there is no Sales a/c and no COGS a/c for the by- product itself------only Balance Sheet accounts.

The sales of the by-product are either added to the sales of the other joint products or deducted from the COGS of the other joint products. These Sales or COGS adjustments are done on the financial statement and not in the accounting records. (This procedure assumes that the selling price and inventory cost per unit of the by-product are both valued at the NRV per unit of the by-product)

EXERCISE

Class 1: Clent Clenty produces joint products GLUE and CLUE, and a by-product BLUE, each of which incurs separable production cost after split-off. Information concerning a batch produced at a $600,000 joint cost before split-off follows:- Separable Product Costs Sales Value GLUE $8,000 $80,000 CLUE 22,000 40,000 BLUE 30,000

What is the joint cost assigned to GLUE and CLUE if cost are assigned using the relative net realizable value?

Home 1: Blent Blenty produces joint products LED and PAINT, and a by-product INK, each of which incurs separable production cost after split-off. Information concerning a batch produced at a $600,000 joint cost before split-off follows:- Separable Product Costs Sales Value LED $20,000 $100,000 PAINT 30,000 90,000 INK (produced 1,000 gallons with a sales price of $50 per gallon after further processing at a total cost of $20,000)

What is the joint cost assigned to LED and PAINT if costs are assigned using the relative net realizable value?

Chapter 7 - Service Cost Allocations

45 Summary

1. Fixed cost of service departments should be allocated to production departments in lumps-sum mounts on the basis of the service departments budgeted cost of long-term capacity to serve. Criteria: Cause & effect, Benefits Received, Fairness and Ability to bear 2. Direct Method (most common) – allocates service department cost directly to the producing departments without recognition of services provided among the service departments 3. Step Method (Step-down Method) – allocates service cost to other departments as well as to production departments  Does not provide for reciprocal allocations 4. Reciprocal Method – allows reflection of all reciprocal services among service departments using simultaneous equations

Lecturer Notes

A common cost is the cost of operating a facility, operation or activity that is shared by two or more users. There are two methods of allocating common costs.

1. Stand Alone Method This method emphasizes equity or fairness in that each user bears a proportionate share of stand alone cost based on their individual stand alone cost. That is, each user is treated as if they were a stand alone entity.

Share of common cost = stand alone cost of user #1 x actual total common cost for user #1 sum of stand alone costs for all users

2. Incremental Method This method ranks the individual user cost objects and then uses this ranking to allocate the common costs among the various users. The first ranked user object is call the primary party. This user is allocated costs up to the amount of the costs that would be incurred if the cost object were operated as a stand-alone entity and this was the only user.

The second ranked user is called the incremental party. It is allocated the extra costs that result from there being two users rather than one. If there are more than two users, than all the users need to be ranked in a sequence. Under this method, the primary user always receives the highest allocation of the common cost.

46 Primary user -----> allocate the stand alone cost that would exist if this user was the only user Incremental user -----> allocate the remainder of the common cost to this user (total common cost – stand alone cost for primary user)

EXERCISES

CLASS: Serve Servey Photocopying Department provides photocopy services for both Departments A and B and has prepared its total budget using the following information for the next year:- Fixed Costs $100,000 Budgeted Usage:- Variable Costs $0.03 per page Dept. A 1,200,000 pages Available capacity 4,000,000 pages Dept. B 2,400,000 pages Instructions: Assuming that the single-rate method is used and the allocation base is budgeted usage. How much photocopying cost will be allocated to Dept. A and Dept. B in the budget year?

HOME: Food Foody Restaurant provides meal for all of its staff in its 4 chains. Chain 1, Chain 2, Chain 3 and Chain 4. Food Foody has prepared its total budget using the following information for the next year:- Fixed Costs $300,000 Budgeted Number of Plates:- Variable Costs $1.20 per plate Chain 1: 250,000 Plates Chain 2: 350,000 plates Available capacity 2,000,000 plates Chain 3: 450,000 Plates Chain 4: 550.000 plates Instructions: Assuming that the single-rate method is used and the allocation base is budgeted number of plates. How much meal cost will be allocated to Chain 1, Chain 2, Chain 3 and Chain 4.

47 Chapter 8 – Budgeting

Summary

1. A flexible budget is designed to allow adjustment of the budget to the actual level of activity before comparing the budgeted activity with actual results.  A set of static budgets prepared in anticipation of varying levels of activity  It permits evaluation of actual results when actual and expected production differ  A flexible budget can be prepared for any production level within a relevant range i. When production levels decrease within a range, total cost will decrease  These are adjusted during the budgeted period  Applicable for the entire production facility Cash, Marketing, Sales, Cost, etc., Note: setting standard costing facilitates preparation of a flexible budget 2. A static budget is prepared for just one level of activity  Total variable cost varies with the activity level  Fixed cost is fixed within a relevant range  Not useful for evaluating variance if expected sales are not reached.  When sales are less than budget: variable cost = favorable. fixed cost = unfavorable 3. The Master Budget contains estimates by management from all functional areas based on one specific level of production.  A master budget is based on one level of production.  Recognize organizations goals and objectives 4. In budget calculations, REMEMBER: fixed cost will not change. Therefore, variable cost will change as activity is change. 5. Zero-base budgeting is a budget and planning process in which each manager must justify a department’s entire budget every year, or period.  Objective is to encourage periodic reexamination of all costs i. to reduce or eliminate costs

Lecturer Notes

Effective planning, both long term and short term, is crucial to the success of any business organization. Budgeting is the process of formalizing plans and translating them into financial and non-financial goals and expectations. The budget, the end result of budgeting, is a detailed plan for the acquisition and use of financial and other resources over a specified time period.

48 There are many advantages of budgeting including: It requires managers to set goals and objectives and allocate the means to achieve the goals and objectives It is a means of communicating and coordinating plans and objectives throughout the organization It provides a means by which performance can be evaluated

The master budget is an overall budget of an organization and includes and incorporates the budgets of all sub-units of the business.. It consists of both operating and financial budgets. An operating budget is expressed in both units and dollars. A financial budget is a budget that aggregates the detail in the operating budgets.

The master budget begins with a sales forecast and once the sales expectation is formalized, the production budgets can be prepared.

Production budgets are prepared in the following format: Budgeted unit sales Add: Desired ending inventory Total units needed Less: Beginning inventory Required production

The operating budgets for include: Sales Budget Production Budget Purchases Budget Direct Labor Budget Overhead Budget Selling and Administrative Budget

Any capital expenditures in the current period need to be incorporated in the master budget.

Once the operating budgets have been prepared, a cash budget can be developed. Note that the cash budget takes the following form: Beginning cash balance Add: Cash collections Equals: Cash available Less: Cash disbursements Equals: Excess (deficiency) of cash Less: Minimum desired ending cash balance Equals: Financing borrowings or repayments

49 If credit is extended to customers, then cash receipts will tail cash sales.

Pro forma financial statements are prepared as part of the master budget process and they include: Cost of Goods Sold Schedule Income Statement Ending Balance Sheet Statement of Cash Flows

EXERCISES

Both CLASS and HOME problems are based on the Following:-

Bud Budy company is formulating its plans for the coming year, including the preparation of its cash budget. Historically, 20% of the company’s sales are cash sales. Except for its 5% bad debt, the remaining credit sales are collected as follows:-.

Sales $ $ Collections on Account Percentage January 3,900,000 May 6,500,000 In 1st Month 30% February 4,200,000 June 6,900,000 In 2nd Month 40% March 5,000,000 July 7,200,000 In 3rd Month 25% April 6,100,000 August8,000,000

CLASS: Prepare a schedule to show the total cash receipts from sales and collections on account for the month of April. HOME: Prepare a schedule to show the total cash receipts from sales and collections on account for the month of August.

50 Chapter 9 - Cost-Volume-Profit (CVP) Analysis

Summary

1. Break-Even-Point: The sales volume at which total revenue equals total cost 2. Breakeven = Variable cost + Fixed Cost 3. Breakeven = Sales – Variable Cost = Contribution Margin – Fixed Cost 4. Breakeven Sales = (Fixed Cost / Contribution Margin Ratio) 5. Breakeven Sales in Unit = (Fixed cost / unit contribution margin)  Breakeven analysis assumes that over the relevant range unit variable cost remains constant within the relevant range.  It also assumes that cost and revenues are linear. (one straight line) 6. Contribution Margin = (Fixed Cost / BEP sales) or Sales – Variable Cost i. Margin of safety: Budget Sales – Breakeven Volume  An increase in cost will increase BEP and decrease the margin of safety 7. High-low method: estimates variable cost by dividing the difference in cost incurred at the highest and lowest observed levels of activity by the difference in activity.  Once the variable cost is found, the fixed portion is determinable.

Lecturer Notes

CVP analysis is an examination of the relationships of prices, costs, volume, and mix of products. It involves the separation of costs into their variable and fixed categories at the outset of the analysis. Once variable and fixed costs are isolated, a contribution margin income statement can be prepared in which total and per unit contribution margin can be analyzed. Then meaningful "what if" analysis can be done such as trading off variable costs for fixed costs, increasing fixed costs and expected volume, reducing price and studying the impact on sales volume and profits, etc.

Break-even analysis is an important aspect of CVP analysis. The break-even point is that level of sales where total revenue exactly equals total expenses. Calculation of BEP is demonstrated in the following example.

Sample BEP Problem Per Bike Percentage

Sales Price $500 100%

Less Variable Cost 300 60%

51 Contribution Margin $200 40%

Fixed Cost totals $80,000 per month

Equation Method

1. 1. Using dollars $500X - $300X - $80,000 = 0

$200X = $80,000

X = 400 bikes

2. Using percentages X - .6X - $80,000 = 0

.4X = $80,000

X = $200,000

Unit Contribution Method

1. 1. Using dollars - Fixed Cost $80,000 = 400 bikes

Unit CM $200

2. 2. Using percentages - Fixed Cost $80,000 = $200,000

Unit CM .4

Of course, companies do not wish to just break even. We can expand our break-even calculations to include a computation of Target Net Income. For example, let’s assume the above company wants to earn of profit of $40,000. What level of revenue would generate profits of $40,000?

Equation Method

X - .6X -$80,000 = $40,000

.4X = $120,000

X = $300,000

Unit Contribution Method

Fixed Costs + Target Net Income

Unit CM

52 $80,000 + $40,000 = $300,000

The Margin of Safety is the excess of budgeted sales over the break-even volume of sales. Margin of safety = Total budgeted (or actual) sales – Break-even Sales. The margin of safety shows the amount by which sales can decrease before losses are incurred. It can be computed in dollars or in a percentage as follows: Margin of safety percentage =Margin of Safety in $/Total Budgeted (or actual) Sales

Cost structure refers to the relative proportion of fixed and variable costs existing in an organization. An automated manufacturing plant would have a high proportion of fixed costs whereas a direct labor intensive plant would have a high proportion of variable costs. Any organization has some choice as to its cost structure.

A company’s cost structure has a significant effect on the way in which profits fluctuate in response to changes in sales volume. The greater the proportion of fixed costs in a firm’s structure, the greater will be the impact on profit from a given percentage change in sales revenue. This results from the fact that firm with relatively higher fixed costs (and relatively lower variable costs) will have a higher contribution margin ratio.

Operating leverage is a measure of how sensitive net income is to percentage changes in sales. Operating leverage is greatest in companies which have a high proportion of fixed costs relative to variable costs. A firm with high fixed costs and low variable costs has high operating leverage, the ability to highly increase net income from an increase in sales revenue. In other words, after the break-even point has been reached, a larger amount of contribution margin will fall to the bottom line in a high fixed cost structure than if the cost structure had been comprised mostly of continuing high variable costs, which continue to eat away at net income after the break-even point is reached. Of course, the risk is also greater because if the break-even point is not reached, losses will be greater in the firm with high operating leverage. The degree of operating leverage at a given level of sales is computed as follows: Degree of Operating Leverage = Contribution Margin Net Income So far in our discussion of CVP relationships we have focused on a firm selling a single product. Of course, most businesses sell more than one product and thus we need to discuss CVP analysis involving more than one product. Sales mix

53 refers to the relative proportions in which a company’s products are sold. Managers try to achieve that product mix which will maximize profits.

EXERCISES

Both CLASS and HOME problems are based on the Following:-

Prof Proffy sells its single product at a price of $60.00 per unit and incurs the following variable cost per unit of product:- Direct Material $16.00 Fixed costs are $880,000 Direct Labour 12.00 Income Tax Rate 30% Manufacturing Overhead 7.00 Total Variable Man. Cost $35.00 Selling expenses 5.00 Total variable costs $40.00

CLASS: 1. If production and sales volume is 4,000 units of product per month, what is the annual after-tax income or loss? 2. What is Prof Proffy Contribution Margin? 3. How many units must Prof Proffy sell to break even?

HOME: Fixed Cost is now $1,000,000, selling price is now $75.00 per unit, direct material and direct labour have increased by 20% and 10% respectively, and the income tax rate is now 40%. 1. If production and sales volume is 7,500 units of product per month, what is the annual after-tax income or loss? 2. What is Prof Proffy Contribution Margin? 3. How many units must Prof Proffy sell to break even?

54 Galilee College Costing I Final Exam

Instructions A. Complete all problems

1. Service Cost Allocations

CLASS: Teck Tecky Water Services provides water for Departments A,B and C and has prepared its total budget using the following information for the next year:- Fixed Costs $300,000 Budgeted Gallon Usage:- Variable Costs $0.10 per gallon Dept. A 2,500,000 gallons Available capacity 10,000,000 gallons Dept. B 2,000,000 gallons Dept C 1,500,000 gallons

Instructions: Assuming that the single-rate method is used and the allocation base is budgeted usage. How much water cost will be allocated to Dept. A, B and C in the budget year?

2. Budgeting

Fost Fosty company is formulating its plans for the coming year, including the preparation of its cash budget. Historically, 10% of the company’s sales are cash sales. Except for its 5% bad debt, the remaining credit sales are collected as follows:-.

Sales $ $ Collections on Account Percentage June 3,900,000 October 6,500,000 In 1st Month 25% July 4,200,000 November 6,900,000 In 2nd Month 35% August 5,000,000 December 7,200,000 In 3rd Month 20% September 6,100,000 In 4th Month 15%

CLASS: Prepare a schedule to show the total cash receipts from sales and collections on account for the month of December 2007.

55 3. Cost-Volume-Profit (CVP) Analysis

Sport Sporty sells its single product at a price of $75.00 per unit and incurs the following variable cost per unit of product:- Direct Material $20.00 Fixed costs are $1,000.000 Direct Labour 15.00 Income Tax Rate 25% Manufacturing Overhead 10.00 Total Variable Man. Cost $45.00 Selling expenses 10.00 Total variable costs $55.00

CLASS: 1. If production and sales volume is 10,000 units of product per month, what is the annual after-tax income or loss? 4. What is Sport Sporty Contribution Margin? 5. How many units must Sport Sporty sell to break even?