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BEC - Notes Chapter 5 http://www.cpa-cfa.org

Cost Measurement and Cost Measurement Concepts Cost measurement concepts is associated with managerial accounting and internal reporting. - Future orientation and usefulness characterize managerial accounting - Meant for internal users Cost drivers (a factor that has the ability to change total costs) may be based on - Volume (output) - Activity (value added) - other Types of theoretical cost drivers • Executional (short-term) - cost drivers that are helpful to the firm in managing short term costs (relationship with suppliers, improvements to the production process) • Structural (long-term) - cost drivers that have long term effect on cost (experience, available technology, complexity) Types of operational cost drivers • Volume based - associated with traditional cost acctg systems. Based on aggregate volume output (# of direct labor hours used, # of production units) • Activity based - associated with contemporary cost acctg systems. Based on an activity that adds value to output (packaging, inspection) Cost objects - resources or activities that serve as the basis for management decisions. Cost objects require separate cost measurement and may be products, product lines, departments, geographic locations, or any other classification that aids in decision making. A single cost object can have more than one measurement. Inventory (product) costs for financial statements are usually different than costs reported for tax purposes. These costs differ than the inventory (product) costs that management uses to make decisions Prime costs (direct costs) = DM + DL Conversion costs = DL + Factory overhead Product costs = DM + DL + Mfg OH applied. These costs are not expensed until the product is sold (inventoriable) Period costs = non mfg costs (SG&A). Are expensed in the period they are incurred and are not inventoriable. Cost accounting systems are designed to meet the goal of measuring cost objects or objectives. The most frequent objectives include: - Product costing (inventory and COGS) - Efficiency measurements (comparisons to standards) - Income determination (profitability) Examples of indirect costs - not easily traceable to a cost pool or cost object (B5-7) Indirect costs are allocated to a single cost pool called overhead, i.e. manufacturing overhead Indirect costs in mfg OH consist of both fixed and variable components (such as rent and indirect materials). Total overhead cost is a mixed cost because it includes both fixed and variable costs Depreciation is a fixed cost

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BEC - Notes Chapter 5 http://www.cpa-cfa.org

In a standard costing system, standard costs are used for all mfg costs (DM, DL, mfg OH) Joint product costs - costs incurred in production up to the split-off point. Only allocated to the main products. By-products do not receive an allocation of joint costs. Separable costs - costs incurred on a product after the split-off point. 3 methods to allocate joint product costs Method 1: Volume allocation (Volume product A ÷ Total volume) * joint costs = portion of product A joint costs Method 2: Net realizable value (value at split-off point), used for inventory costing only (Sales value of product A at split-off ÷ Total sales value at split-off) * joint costs = portion of product A joint costs Method 3: Sales value not available at split-off, subtract separable costs from final selling price to find net realizable value at split-off Final sales value of product A - Separable costs = sales value of product A at split-off (Sales value of product A at split-off ÷ Total sales value at split-off) * joint costs = portion of product A joint costs *subtract value of byproduct from joint costs when allocating. Because proceeds from by-product reduce costs. The lowest unit price acceptable is the variable cost of the product (DL + DM + Var mfg OH) plus the contribution margin of the alternative use for the production capacity. Accumulating and assigning costs • Full absorption costing - treats fixed manufacturing costs as product costs, while variable costing expenses these as period costs. • Job costing - custom orders • Process costing - mass produced homogeneous product • Operations costing - uses components of both job order costing and process costing • Back flush costing - accounts for certain costs as the end of the process • Life cycle costing - monitors costs throughout the products life cycle and expand on the traditional costing systems. Beg materials + net purchases = available for use Available for use - ending materials = materials used Beg WIP + total mfg costs [DL + DM used + mfg OH applied] - ending WIP = COGM

Application of overhead Overhead rate = Budgeted overhead costs ÷ Estimated cost driver [such as labor hrs or costs, machine hrs] Overhead applied = Actual cost driver * overhead rate [based on actual production] Overhead applied consists of both variable overhead and fixed overhead. The calculation is as follows (with direct labour hours as the cost driver): Variable overhead rate = budgeted variable mfg OH / budgeted direct labor hours 2

BEC - Notes Chapter 5 http://www.cpa-cfa.org

Fixed overhead rate = Budgeted fixed mfg OH / budgeted direct labor hours Total overhead rate = Variable overhead rate + Fixed overhead rate Overhead applied to the job = Total overhead rate x actual direct labor hours = $5,625 Normal spoilage is an inventory cost and is included in the standard cost of the manufactured product Abnormal normal spoilage is a period expense and is charged against income of the period as separate component of cost of goods sold. Weighted Avg method to find equivalent units Equivalent units = Units completed + (Ending WIP * % completed ) Weighted average = (beginning cost + current cost) ÷ equivalent units FIFO method to find equivalent units Equivalent units = (Beginning WIP * % to be completed) + (units completed - beginning WIP) + (ending WIP * % completed) FIFO = current costs only ÷ equivalent units Activity based costing (ABC) uses multiple OH rates to assign indirect costs to products (cost objects) based on the resources a product consumes. An ABC system will apply high amounts of overhead to a product that places high demands on expensive resources Factors affecting productions costs Factors contributing to economies of scale include: - Labor specialization - Managerial specialization - Utilization of by products (or joint products) - Efficient use of capital equipment - Volume discount purchasing Financial models used for operating decisions Revenue Less: Variable Costs (DM + DL + Variable OH + Variable SG&A) Contribution Margin Less: Fixed Costs (Fixed OH + fixed SG&A) Net Income Absorption approach (GAAP) Revenue Less: COGS (DM + DL + Variable OH + Fixed OH) Gross Margin Less: Operating Expenses (Fixed SG&A, Variable SG&A) Net Income Variable costing and absorption costing are the same except that all fixed mfg costs are treated as period costs Under the contribution approach (variable costing), all fixed mfg OH is treated as a period cost and expensed immediately. i.e. COGS includes only variable mfg costs. Not GAAP Under the absorption approach (absorption costing), all fixed mfg OH is treated as a product cost and included in inventory values. i.e. COGS includes both fixed and variable costs. GAAP Net income effect between variable and absorption costing 3

BEC - Notes Chapter 5 http://www.cpa-cfa.org

Fixed cost per unit = fixed mfg OH ÷ units produced Change in net income = change in inventory units * fixed cost per unit No change in inventory: absorption NI = Variable NI Increase in inventory: Absorption NI > Variable NI [because less fixed OH expensed under absorption] Decrease in inventory: Absorption NI < Variable NI [because more fixed OH expensed under absorption] Contribution margin ratio = contribution margin ÷ revenue Breakeven in units = total fixed costs ÷ contribution margin per unit Break even in dollars = total fixed costs ÷ contribution margin ratio Break even in dollars = unit price * break even point in units Required sales volume for target profit Sales = (Fixed cost + target profit) ÷ contribution margin ratio Target profit before tax = target profit after tax ÷ (1 - tax rate) Margin of safety = total sales in dollars - breakeven in dollars Margin of safety % = margin of safety in dollars ÷ total sales Target costing - the selling price of the product determines the production costs allowed Economic value added (EVA) - measures the excess of income after taxes earned by an investment over the return rate defined by the company's cost of capital. Investment * cost of capital = required rate of return Income after taxes - required return = economic value added When considering alternatives, such as discontinuation of a product line, management should consider relevant costs. Relevant costs are those costs that will change under different alternatives.

Forecasting and projection techniques Regression analysis - statistical model that can estimate the dependent cost variable based on changes in the independent variable. Learning curve analysis - used to determine increases in efficiency or production as experience is gained. Both products have long production runs, making learning curve analysis the best method for estimating the cost of the competitive bid. Attainable standards are used with flexible budgets Authoritative standards are set exclusively by management, while participative standards are set by both managers and employees Planning/budgeting overview and planning/budget techniques A master budget - an overall budget, consisting of many smaller budgets, that is based on one specific level of production (usually begins with sales budget) A flexible budget - a series of budgets based on different activity levels within the relevant range. The production budget - begins with sales budget and then adds in the effect of any changes in inventory levels 4

BEC - Notes Chapter 5 http://www.cpa-cfa.org

Standard costs usually means that a flexible budget is being used. Standard costs per unit can be used to adjust the flexible budget to the actual volume.

Budget Variance Analysis DM price variance = actual quantity purchased * (actual price - standard price) DM quantity variance = standard price * (actual quantity used - standard quantity allowed) DL rate variance = actual hours works * (actual rate - standard rate) DL efficiency variance = standard rate * (actual hours worked - standard hours allowed) Standard quantity allowed (SQA) = actual output * standard allowed output B5-63 variance chart Sales volume variance = (actual units sold - budgeted unit sales) * standard contribution margin per unit Sales mix variance = (actual product sales mix ratio - budgeted product sales mix ratio) * actual sold units * budgeted contribution margin per unit of that product Sales quantity variance = (actual units sold - budgeted unit sales) * budgeted sales mix ratio * budgeted contribution margin per unit Market size variance = (actual market size in units - expected market size in units) * budgeted market share * budgeted contribution margin per unit weighted avg Market share variance (actual market share - budgeted market share) * actual industry units * budgeted contribution margin per unit weighted avg Selling price variance = (actual SP per unit - budgeted selling price per unit) * actual units sold Variable overhead efficiency variance - computed as budgeted variable overhead based on standard hours minus budgeted variable overhead based on actual hours. Budgeted variable OH = standard direct labor hours allowed x standard variable overhead rate Budgeted variable OH = actual direct labor hours x standard variable overhead rate Production volume variance component for overhead variances is computed as applied overhead minus budgeted overhead based on standard hours Applied Overhead (Std Var OH Rate x Std DLH Allowed) + (Std Fixed OH Rate x Actual Production) Budgeted overhead based on standard hours (Std Var OH Rate x Std DLH Allowed) + (Std Fixed OH Rate x Standard Production) The fixed overhead rate is $5 per machine hour [$1,200,000 / 240,000 = $5]. • The amount of FIXED manufacturing overhead planned for November is $100,000. • Therefore, the standard production for FIXED overhead is 20,000 machine hours [$100,000/$5 = 20,000.]

Organizational performance measures Strategic business units (SBU), are generally classified around 4 financial measures - Cost SBU - Revenue SBU - Profit SBU - Investment SBU (most like and independent business) (highest level) 5

BEC - Notes Chapter 5 http://www.cpa-cfa.org

Critical success factors to accomplish a firm strategy are FICA: - Financial - Internal business processes - Customer Satisfaction - Advancement of innovation and human resource development Benchmarking Techniques and best practices Control chart - determine zero defects, shows quality performance trends Pareto diagrams (histogram) - used to determine frequency of quality control issues Cause and effect (fishbone) - analyze the source and location of a problem Conformance costs - costs to ensure products conform to quality standards - Prevention costs - incurred to prevent production of defects (employee training, engineering) - Appraisal costs - remove defects before they reach customer (testing, inspections) Non-conformance costs - costs that result from lost sales or reputation damage - Internal failure - cost of defective parts or lost production time (scrap, rework) - External failure - cost of returns and lost customer loyalty (warranty, liability)

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