Management Accounting Midterm ReviewSmiti Tolani

Chapter 1Introduction to Managerial Accounting

Management Accounting for ManagersProcess of identifying, measuring, accumulating,analyzing, preparing, interpreting andcommunicating information that helps managersfulfill organizational objectives

Problem Solving long range strategic plansAttention-Directing controlling routine

operationsScorekeeping accumulating and classifying

data

Distinctions Between Management Accounting and Financial Accounting

Management Accounting

Organization Managers

Costs versus benefits

Influence on managerial behaviour

Future orientation

Flexible

Detailed

Less sharply defined

FinancialAccounting

External parties

G.A.A.P.

Measurement of economic activity

Past orientation

Less flexible

Summary reports

More sharply defined

Primary Users

Reporting Choices

BehaviouralImplications

Time Focus

Time Span

Reporting Detail

Activities

Management Decision Process1. Identify the problems/issues.

4. Perform the necessary quantitative and qualitative analyses.

3. Identify alternative solutions to the problem.

5. Evaluate the alternative solutions and recommend one.

6. Implement the recommendation.

2. Understand the Key Success Factors of the company.

Key Success Factors (KSF’s)• Factors that must be managed successfully if

the organization is to be successful.

• Many of these factors tie-in to the Value Chain. (for example, timely delivery of product, exceptional customer service, low cost/efficient production, etc.)

• Differ with each industry and organization.

Two major issues to remember when designing Management Accounting systems:

1. The “Cost-Benefit” Philosophy: “The benefits of better decisions should exceed

the cost of the system”

2. The “Behavioural” Philosophy:

▫ Management Accountants should consider behavioural issues (ie. How will Management Accounting systems affect managers and their decisions?)

▫ These behavioural issues may affect the benefit Management Accounting systems

A management accounting system should provide accurate, timely budgets and performance reports in a form useful to

A. ShareholdersB. BankersC. Revenue CanadaD. Managers

Financial Accounting is constrained by GAAP, Managerial Accounting is constrained by:

A) Revenue CanadaB) The ControllerC) Cost BenefitD) GAAS

Chapter 2Cost Behavior and Cost Volume Relationships

Cost BehaviourCost Driver• an activity which influences how a cost is

incurred

Volume

Volume

$

$

Variable Cost• a cost which changes in direct proportion

to changes in the cost driver• is constant per unit as volume changes

Fixed Cost• a cost which is not influenced by changes

in the cost driver over the relevant range• per unit fixed costs change as volume

changes

Cost-Volume-Profit Analysis•the study of the relationships between

revenues, costs, volume and profits

• Break-Even Point- level of sales at which revenue equals expenses, and income is zero

• Margin of Safety- equal to the planned unit sales less the breakeven unit sales; it shows how far sales can fall below planned level before losses occur

▫ Margin of Safety= planned unit sales- break-even unit sales

2 Techniques:▫ Contribution margin approach▫ Income Statement Approach

• EG. Amy Winston is trying to decide whether to rent a line of food vending machines

• She has determined:▫ Selling price/unit $0.50▫ Variable cost of each item $0.40▫ Selling price less variable cost $0.10 (cont. margin)▫ Total fixed per month $6000

▫ Selling price/unit $0.50▫ Variable cost of each item $0.40▫ Selling price less variable cost $0.10 (cont. margin)▫ Total fixed per month $6000

Contribution Margin Approach- CM (per unit) = P – VC

- when enough units have been sold to generate total contribution margin equal to fixed costs, break-even point is reached

- FC/CM = Break even units- 6000/0.1 = 60,000 units

- Break even in Dollars:- CM% = CM/P

- 0.1/0.5 = 20%- FC/CM% = Break even in Dollars

- 6000/0.2 = 30,000

▫ Selling price/unit $0.50▫ Variable cost of each item $0.40▫ Selling price less variable cost $0.10 (cont. margin)▫ Total fixed per month $6000

Income Statement Approach

Sales – VC – FC = Net IncomeX = # of units S = Sales

P(X) – VC(X) – FC = Net Income0.5X-0.4X-6000=00.1X=6000X=6000/0.1 = 60,000 units

S – 0.8S-FC = Net Income

0.2S = 6000

S = 30,000 Dollars

Break-Even Point Summary:

Break-even units = FC/CM

Break-even sales = FC/CM%

Cost-Volume-Profit Graph

Sales

Total Expenses

Relevant Rangeof volume

Volume

$ Break-evenPoint

Net lossarea

Net incomearea

Changes in CVP Model Factors

$

Volume

Sales

Expenses

Basic Model

$

Volume

Sales

Expenses

Decrease Variable Costs

$

Volume

Sales

Expenses

Increase Fixed Costs

$

Volume

Sales

Expenses

Decrease Fixed Costs

Target Net Income and Income Taxes

Target Net Income of $480 :

Target Sales in Units Target Sales in Dollars= (Fixed costs + Target income) = (Fixed costs + Target

income) / CM per unit / CM%= ($6,000 + $480) / $0.10 = ($6,000 + $480) / 20%= 64,800 units = Sales $32,400

Income Taxes• convert desired ‘after-tax’ net income to its ‘before-tax’

equivalent before calculating the target sales formula

Target income before income taxes= Target after-tax net income / (1 - tax rate)= $288 / (1 - .40)= $288 / .6= $480

Cost-Volume-Profit AnalysisMultiple Product SituationsSales Mix- the relative proportions or combinations of quantities of products that comprise total salesEG: Ramos Retail Company sells two products wallets (W) and key cases (K)

Wallets (W) Key Cases (K) Total

Sales in units 300,000 75,000 375,000

Sales @ $30 and $5 9,000,000 375,000 9,375,000

Variable Ex. @ $14 and $3

4,200,000 225,000 4,425,000

Cont Margins @ $16 and $2

4,800,000 150,000 4,950,000

Fixed expenses 198,000

Net Income 4,752,000

IF Constant mix is 4 units of W for every unit of K

What is Break Even?

Operating Leverage

$ Sales

Volume

$

Volume

Sales

TotalExpenses

High Operating LeverageHigh Fixed / Low Variable Costs

Higher CM/Unit

Higher Break-even PointGreater Risk

Greater Potential Returns

Low Operating LeverageLow Fixed / High Variable Costs

Lower CM/Unit

Lower Break-even Point

Reduced RiskLower Potential Returns

TotalExpenses

If fixed expenses are doubled, the break even point in units would be doubled, and break even points in sales would be cut in halfTRUE/FALSE

As the level of activity increases within the relevant range

A. Total variable costs remain unchangedB. Variable costs per unit decreaseC. Total fixed costs increasesD. Fixed costs per unit decrease

Chapter 3Measurement and Cost Behavior

Variations in Cost Behaviour

Step Costs• change abruptly at intervals of

activity because the resources and their costs come in indivisible chunks

• supervisory salaries

Mixed Costs• contain both variable and fixed

cost elements• maintenance costs

Volume

$

Volume

$

Management Influence on Cost Functions Management has influence over 3 general

categories of cost: • Capacity Costs• Committed Fixed Costs• Discretionary Fixed Costs

Capacity Costs:• fixed costs of being able to achieve a desired

level of production or service

• once capacity is set, the company is committed to the fixed costs of that capacity level

• setting capacity is very important if long-run demand fluctuates –> decisions must be made to increase investment in facilities and equipment and, therefore, increase long-term capacity costs, or to pay a premium (outsource or pay overtime) at times of peak demand

Management Influence on Cost Functions II

Committed Fixed Costs:

• arise from the possession of facilities, equipment, and a basic organization

• large, indivisible chunks of cost that the organization is obligated to incur and usually would not consider avoiding

• mortgage payments, lease payments, property taxes, insurance, salaries of key personnel

• committed fixed costs can only be changed by changing the basic philosophy, scale or scope of the organization's operations

Management Influence on Costs Functions III

Discretionary Fixed Costs:• each planning period, management will

determine how much to spend• advertising, promotion, research and

development, employee training• the amount of spending may vary, but only

because management has decided to spend more or less

• management can influence spending on these costs in the short run

Measuring Cost BehaviorCost Function• algebraic equation of the cost and its cost driver• linear cost function is as follows: Y = F + VX

where ▫ Y is the total cost▫ F is the intercept of the vertical axis or the fixed cost▫ V is the slope or the variable cost per unit of activity▫ X is the cost driver (in units)

Example: Total Maintenance Costs per monthGiven: Monthly Maintenance Salaries of $10,000;

Cost Driver is (units are) Mechanic Hours; Cost per Mechanic Hour is $15.00

What is the Monthly Maintenance Cost at 500 Mechanic Hrs.?

What is the Monthly Maintenance Cost at 650 Mechanic Hrs.?

Measuring Cost Behavior

Criteria for Choosing A Cost Function:

• Use activity analysis to determine which cost driver best explains how the cost behaves▫Economic plausibility (it must make sense that

X causes Y)

▫Reliability (the estimates derived by the cost equation must conform with actually observed costs)

Methods of Measuring Cost Functions:Engineering Analysis• systematic review of costs based on past experienceAccount Analysis• review of accounting records and the subjective determination of

cost behavior patternsHigh-Low Analysis• use of simple linear algebra to determine variable and fixed costs• may yield unreliable resultsVisual Fit Analysis• fit a representative line to the data as shown in a scatter diagramRegression Analysis• using mathematical formula, determine the cost equation which

best fits the data• may be simple least squares regression with one X variable or

multiple least squares regression with more than one X variable• enables user to measure the "quality" of the predictive equation

High-Low Approach to Cost AnalysisEquation: Y = F + VX

Variable cost= change in cost / change in volume= $30,000 / 3,700= $8.108 per patient-day

Fixed cost= total mixed cost - variable cost= $40,000 - ($8.108 x 4,900)= $40,000 - $39,730= $270 per month

Maintenance Costs= $270 + $8.108 per square meter

(cost driver)

Month Facilities Mgmt Cost

Square Meter

Jan 10,000 1,200

Feb 15,000 1,600

March 12,000 1,900

April 40,000 4,900

May 22,000 3,400

Regression AnalysisCheck for Economic Plausibility• Does it make sense that X and Y are related?

Plot the data• to see if basic relationship is linear and identify "outliers"

Generate Regression OutputConstant $9,329Std Error of Y Estimate$2,145 Observations 12R-Squared 0.954 Degrees of Freedom 10X Coefficient(s) $6.95 Std Error of Coefficent

0.479

Interpret Regression Output• R-squared (R2) varies between 0 and 1• The closer to R2 is to 1 the more X explains the changes in Y• Standard error of Y estimate and standard error of X

coefficient(s) can be used to set confidence intervals for the cost function estimates and the predicted value of the variable cost per unit

T/F QUESTIONS

•When graphing a cost function, the Total Variable cost is the intercept?

•Plausibility and reliability are 2 important factors to consider to ensure accurate and useful cost functions

Costs that change abruptly at intervals of activity because the resources and their costs come in indivisible chunks are called

A) Step costsB) Intangible costsC) Variable costsD) Mixed costs

A cost function

A. does not explain past cost behaviourB. should be a reliable predictor of future

costsC. should include only personal observations

of costs and activitiesD. need not have a cause-and-effect

relationship

___ is a method in which the analyst would place a straight line through a plot of available data

A) Engineering AnalysisB) Accounting AnalysisC) Visual FitD) Least Square Regression Method

Chapter 4Cost Management Systems

Cost Management SystemsCost Object• a department, service or product for which cost information is

collected

Direct Cost• a cost which can be identified specifically and exclusively with

a given cost objective in an economically feasible way• examples: direct material and direct labour• ASSIGNED

Indirect Cost• a cost which cannot be identified specifically and exclusively

with a given cost objective in an economically feasible way• factory overhead cost (or factory burden) • all factory costs other than direct material and direct labour• power, supplies, indirect labor, supervisory salaries, property

taxes, rent, insurance and depreciation• ALLOCATED

A COST CAN BE BOTH DIRECT AND INDIRECT DEPENDING

ON COST OBJECT

Manufacturing CostsPrime Costs• Direct Material and Direct Labour costs• in many companies direct labour has become

so insignificant that it is simply lumped in with overhead

Conversion Costs• Direct Labour and Factory Overhead costs• cost of converting material into finished

product

DirectMaterials

DirectLabour

FactoryOverhead

Prime Costs

Conversion Costs

Product and Period Costs - RetailerProduct Costs• also called ‘Inventoriable Costs’• all costs involved in the purchase or manufacture of

goods • are expensed only when product is sold

Period Costs• costs which are expensed during the period they are

incurred (without going through an inventory stage)

MerchandiseInventory

Cost ofGoods Sold

Balance Sheet Income Statement

Product Costs

Selling &Administrative

ExpensesPeriodCosts

Product and Period Costs - ManufacturerProduct Costs• also called ‘Inventoriable Costs’• all costs involved in the purchase or manufacture of

goods• are expensed only when product is soldPeriod Costs• costs which are expensed during the period they are

incurred (without going through an inventory stage)

DirectMaterial

Inventory

Work inProcess

Inventory

FinishedGoods

Inventory

Cost ofGoods Sold

Balance Sheet Income Statement

Product Costs

Selling &Administrative

ExpensesPeriodCosts

Product and Period Costs

AbsorptionCosting

Variable Manufacturing

Fixed Manufacturing

Overhead

Variable Selling& Administrative

Fixed Selling& Administrative

Contribution

Costing

Variable Manufacturing

Fixed ManufacturingOverhead

Variable Selling& Administrative

Fixed Selling& Administrative

Product

Costs

Period

Costs

Cost Behaviour and Income Statements

Absorption Income Statement

Sales $20,000Cost of Goods Sold:Direct material $7,000Direct labour 4,000Factory overhead 4,000 15,000

Gross margin 5,000

Selling expenses 3,000Administrative

expenses 1,000Total selling & administrative expenses 4,000

Operating Income $1,000

Contribution Income Statement

Sales $20,000Variable expenses:Direct material $7,000Direct labour 4,000Variable overhead 1,000Variable selling 1,000Variable administrative 100Total variable expenses 13,100Contribution margin 6,900Fixed expenses:Manufacturing $3,000Selling 2,000Administrative 900Total fixed expenses 5,900Operating Income $1,000

Absorption & Variable Costing

Absorption Costing Income Statement• Also called "full" costing• Classify costs by function - selling &

administration versus manufacturing• Inventory comprised of variable and fixed

production costs • Net income is a function of sales and production

Variable Costing Income Statement• Also called "direct" or "variable" • Classify costs based on behaviour • Inventory comprised of only variable

production costs • Net income is a function of sales

Converting Between the Two Models of Income• Difference in net income is equal to the difference in the values

assigned to inventories on the two statements• Absorption’s inventory value will be higher since it includes

an allocation of fixed production costs and Variable’s does not

RevenueVariable Costs

Contribution MarginFixed CostsNet Income

RevenueCost of Goods Sold

Gross MarginSell & Admin Costs

Net Income

Cost Flows: Absorption Costing

Direct material

Direct labour

Variable manufacturingoverhead

Fixed manufacturingoverhead

Costs to Account ForInventoried Costson Balance Sheet

Expense onIncome Statement

Becomeexpenses

when inventoryis sold

Becomeexpenses

immediately

Initially applied

toinventory

asunexpired

costs

As goods

are sold

Expires

immediately

All selling & administrative costs

Cost Flows: Variable Costing

Direct material

Direct labour

Variable manufacturingoverhead

Costs to Account ForInventoried Costson Balance Sheet

Expense onIncome Statement

Becomeexpenses

immediately

Initially applied to

inventory asunexpired

costs

All selling & administrative costs

Fixed manufacturingoverhead

As goods

are sold

Expiresimmediately

Becomeexpenses

when inventoryis sold

Fixed Manufacturing Overhead & Absorption Costing

•Firms use a fixed overhead rate to smooth the application of fixed overhead to ‘work in process’ and to determine "full" product costs

Fixed = Budgeted fixed manufacturing overheadoverhead rate Expected volume of production

Production Actual - Expected x fixed-overheadvolume = volume volume ratevariance

Flow of Fixed Manufacturing Costs - VariableFixed

ManufacturingOverhead

Incurred

Inventoried Costson Balance Sheet

Expense onIncome Statement

$150,000 $150,000None

Flow of Fixed Manufacturing Costs - Absorption

Fixed Manufacturing

Overhead Incurred

Inventoried Costson Balance Sheet

Expense onIncome Statement

$150,000

Fixed-overhead costs in beginning inventory:

$30,000

Costs added to product: $140,000

Fixed-overhead costs in ending inventory:

$10,000

$140,000 Cost of goods sold:$30,000 + $140,000 - $10,000 = $160,000

$10,000Unfavourable

production volume variance: $10,000

Total expense = $170,000

•When inventory increases, absorption will yield higher income

•When inventory decreases, absorption will yield lower income

•IF amount charged is GREATER than budgeted, favorable variance (subtract from COGS)

T/F Questions• Prime costs consist of direct labor and factory

overhead ▫ FALSE

• In the contribution approach, all factory overhead is considered to be product costs in that they are expensed as incurred▫ FALSE

Only VARIABLE factory overhead is considered to be PRODUCT

Product costs are NOT expensed as incurred- expensed when SOLD!!

Chapter 5Cost Allocation & Activity Based Costing

Cost Accounting System

•technique used to determine the cost of a product or service by collecting and classifying costs and assigning them to cost objects

Cost

Cost Pool

(a group of individual costs that are allocated to

cost objectives using a single cost driver)

Cost Objective

(product, department, division)

Cost Driver

Why Allocate Costs?

•Costs are allocated for 3 main purposes:▫Employee motivation- influence managerial

behavior▫Better compute income and asset

valuations- better measure inventory, COGS, and departmental income

▫Promote fair pricing or obtain reimbursement- prices based on cost, gov’t reimbursement

3 Types of Cost Allocations(based on 3 types of objectives)•Allocation of joint costs to

appropriate responsibility centers

•Allocation of service departments to production department costs

•Allocation of Costs of a particular organizational unit to its outputs of products

Cost Allocation Methods

•Direct Method▫IGNORES other service department costs

•Step-Down Method▫RECOGNIZES some service department

costs•Reciprocal Allocation Method

▫RECOGNIZES all services department costs

Direct Method: Example(Microsoft)

Service Departments Production Departments

Facilities Management

Human Resources

X-Box Office

Direct Dep. Costs

450,000 120,000 178,000 200,000

Sq. meters 20,000 30,000 20,000

# of employees

20 60 40

Outputs 10000

Machine Hours

30,000

1. ALLOCATE FACILITIES MANAGEMENT – account for 450,00030,000 (x box) + 20,000 (office) = 50,000 square units

XBOX = 30,000/50,000 x 450,000 = 270,000

OFFICE = 20/50 x 450,000 = 180,000

2. ALLOCATE HUMAN RESOURCE COSTS – account for 120,000

60 (x box) + 40 (office) = 100 employees

XBOX = 60/100 x 120,000 = 72,000

OFFICE = 40/100 x 120,000 = 48,000

Step-Down Method - ExampleService Departments Production Departments

Facilities Management

Human Resources

X-Box Office

Direct Dep. Costs

450,000 120,000 178,001 200,000

Sq. meters 20,000 30,000 20,000

# of employees

20 60 40

Outputs 10000

Machine Hours

30,000

Service Departments Production Departments

Facilities Management

Human Resources X Box department

Office department

1. Allocate Facilities management

(450,000) 20/70 x 450k= 128,571

30/70 x 450k= 192,857

20/70 x 450k= 128,571

2. Allocate H/R (128,571)+

(120,000)

= (248,571)

60/100 x 248,571

= 149,142

40/100 x 248,571

= 99,429

TOTAL cost after allocation

342,000 228,000

Reciprocal Method

•Recognize that service departments provide services to each other as well as to production departments – ie. Would allocate facilities management to personnel AND personnel to facilities management

Allocating Costs to OutputsStep Down X BOX OFFICE

Direct Dep. Cost 178,001 200,000

Allocated from Facilities Mgmt

192, 857 128,571

Allocated from HR 149,142 99,429

Total 520,000 226,800

Cost Driver – Machine Hours 30,000

Cost Driver – Output 10,000

Summary

•Allocate Costs to Departments (using either Direct or Step-down)

•Select cost drivers for each production department (ie. Machine hours and output)

•Allocate total costs to products based on cost driver($17.33 machine hour & 22.68/output)

Traditional Cost SystemDirect

MaterialCosts

DirectLabourCosts

OverheadCosts

DirectTrace

DirectTrace

Direct Labour Hour

Allocation

Products

ABC Cost System

DirectMaterialCosts

DirectLabourCosts

Overhead Costs

DirectTrace

DirectTrace

Products

Machiningactivitycosts

Assemblyactivitycosts

Inspectionactivitycosts

# of partsProcessing

Hours# of

inspections

Activity Based Costing

•Activity Based Costing- a system that first accumulates overhead costs for each of the activities of an organization, and then assigns the costs of activities to the products, services, or other cost objects that caused that activity

Steps in ABC Costing

Step 1 Determine cost objectives, key activity centres, resources, and related cost drivers

Step 2 Develop a process-based map representing the flow of activities, resources, and their relationships

Step 3 Collect relevant data concerning costs and the physical flow of cost-driver units among resources and activities

Step 4 Calculate and interpret the new ABC information

Activity-Based Costing

Product Line A1,000 MHs25 setups

Product Line B1,750 MHs70 setups

Product Line C1,050 MHs130 setups

$251,739Setup Costs225 setups

$1,118.84 per setup

$835,830Molding process

3,800 machine hours$219.96 per machine hour

Traceable costsPhysical flowof cost driver

units

Cost objectsPhysical flowof cost driver

for each object

Molding Department Activity CentreTraceable overhead cost = $1,087,569

Activity-Based Costing (ABC)

Direct material $1,050,000 $575,000 $240,000Direct labour 346,480 303,170 124,730Overhead:Setup $1,118.84 25 27,971 70 78,319 130 145,449Molding $219.96 1,000 219,960 1,750 384,930 1,050 230,958Total costs $1,644,411 $1,341,419 $741,137Production volume 1,000,000 500,000 150,000

Product Line A Product Line B Product Line C

Cost per Driver Driver Driver Driver Units Cost Units Cost Units Cost

Cost per unit $1.64 $2.68 $4.94

Traditional and ABC Costing Systems

Traditional System

Allocation Based on DL

Product A $486,608Product B 425,782Product C 175,179

$1,087,569

ABC Costing System

Allocation Based on MH and SU

Product A $247,931Product B 463,249Product C 376,407

$1,087,569

Product A45%

Product B39%

Product C16%

Product A23%

Product B42%

Product C35%

EXAMPLE:ABC Toy manufacturing company – makes Dolls and Cars3 main activities that comprise Overhead Costs consist of:

Dolls Cars

# of units 200 400

Surface Area 540 870

Minutes of Testing

40 90

If DM costs are 50,000 for dolls and 70,000 for cars, and DL is 25,000 and 40,000 respectively, what is the total cost per unit if I produce 100,000 units of each

Activity Cost Driver Cost of Activity

Assembling Units # of units $15

Painting Surface area $10/cm squared

Quality Assurance Minutes of testing $16/minute

Cost Management SystemsCost Management System• identifies how management’s decisions affect costs

Activity-Based Management (ABM)• distinguish between value-added and non-value-added costs• reduce or eliminate non-value-added costs. i.e. costs that

can be eliminated without affecting the value of the product to the customer.

Just-In-Time (JIT Systems)• focus on eliminating waste and improving quality• purchase material and produce products when needed

▫ focus on quality▫ shorter production cycle times▫ smooth the flow of production▫ adopt more flexibility with facilities and employees

Which of the following is NOT an acceptable type of cost allocationA) Allocation of costs to the appropriate

organizational unitB) Allocation of Costs of a particular

organizational unit to products/servicesC) Reallocation of costs from production

departments to service departmentsD) Rellocation of costs from service

departments to production departments

Chapter 6Job Order Costing and Accounting for Overhead

Product CostingJob Order

Allocates costs to products

that are readily identifiable

Common in construction,print shops, unique goods

Accumulate costs forspecific jobs

Produce for sale

Process Costing

Average costs over large number of nearly identical units

Common in chemical, textiles, lumber, glass, food processing

Accumulate costs by departments

Produce for inventory

Job-Order Costing

Job Cost SheetJob #963 12 units

Direct materials $460.00Direct labour 267.50Applied factory overhead 180.00Total cost $907.50Unit cost ($907.50 / 12 )

$75.625OverheadApplication

Rate

LabourTime

Ticket

Direct MaterialRequisition

Sheet

Job-Costing Cost Flows• Apply material, labour and overhead costs to work in process • As goods are produced, costs flow to finished goods inventory • When sold, costs shift to cost of goods sold

DirectMaterial

Inventory

BuyMaterial

Work inProcess

Inventory

FinishedGoods

Inventory

Cost ofGoods Sold

Use

Material

Labour Costs

OverheadCosts

Production Sales

OverheadControl Account Over / under

applied overhead

(at year end)

Accounting for Factory Overhead

Overhead Application (Overhead Absorption) • Allocation of overhead costs to products

Budgeted Factory Overhead Rate• Calculated at the beginning of the year and

used to apply overhead to products throughout the year

this is known as a ‘normalized’ overhead rate or ‘normal’ costing approach --> i.e. one average overhead rate is consistently used throughout the year

Accounting for Factory Overhead

Budgeted Factory Overhead Rate:

Six Steps in Applying Overhead1. Choose a cost driver for overhead2. Prepare a budget for yearly overhead costs (est’d. total

$’s) and yearly volume of the chosen cost driver (est’d. total qty.)

3. Calculate the Budgeted Factory Overhead Rate = Budgeted yearly overhead ($’s)

Budgeted yearly cost driver volume (qty.)4. Obtain data on the actual cost driver volume used by the

job5. Apply overhead to jobs: (actual cost driver volume used x

budgeted factory overhead rate) 6. At year end, account for difference between actual

overhead costs and applied overhead costs

Over / Under Application of Overhead

Actual overhead• a mixed cost function with variable and fixed costs• Y = F + VXApplied overhead• a variable cost function• Applied overhead = actual driver x overhead rate

• Overapplied: Applied > Actual • Underapplied: Applied < Actual • Dispose of over/under applied

overhead at year end

$

Volume

Applied Overhead

Actual Overhead

Volume

Volume

$

$

Fixed Manufacturing Overhead & Absorption Costing• Firms use a overhead rate to smooth the application of

overhead to work in process and determine "full" product costs

Budgeted overhead =Budgeted total factory overhead $’sapplication rate Budgeted total units of cost driver

• difference between actual and applied fixed overhead relates to:• spending more or less than expected• producing more or less than expected

ActualFixed

Overhead

Budgeted FixedOverhead

Rate x Budgeted Volume

Applied FixedOverhead

Rate x Actual Volume

Fixed Overhead Spending Variance Production-Volume Variance

Over / Under Applied Overhead

Disposition of Underapplied and Overapplied Overhead•Immediate Write Off

▫Use when you have low EI▫Apply directly to COGS and NI

•Proration among Inventories▫Prorates over/under applied overhead

among WIP, finished goods, and COGS▫Used when inventory valuations would be

materially affected

Overhead M/CBudgeted direct-labour hours 50,000

Actual direct-labour hours 70,000

Budgeted factory overhead $250,000

Actual factory overhead $315,000

Cost driver Direct-labour hours

What is the budgeted factory overhead rate?A. $6.00B. $5.50C. $5.00D. $3.50

What is the amount of over/under applied overhead?A. $35,000 under appliedB. $35,000 over appliedC. $65,000 under applied

D.$65,000 over applied

In the immediate write-off approach, over applied overhead is regarded asA. A decrease in current incomeB. A decrease in cost of goods soldC. An addition to the cost of inventoryD. A reduction in inventory

Chapter 7Process-Costing Systems

Process Costing

• Accumulate costs by departments and allocate costs to

products based on broad, average costs

• Process costing systems are usually simpler and less

expensive than job-order costing systems

Process Costing - Overview

DirectMaterial

DirectMaterialTransferred-In

Costs

Conversion Costs Conversion Costs

Cooking Department Freezing Department

Direct materials• Materials applied to the production process at specific points in

time Conversion costs• Labour and overhead costs which are assumed to be applied

uniformly throughout the production process Transferred-In costs• Value of materials and conversion costs carried forward to

subsequent departments

To FinishedGoods Inventory

PECUA

•Step 1: Calculate number of physical units•Step 2: Calculate output in terms of

equivalent units•Step 3: Calculate total Costs•Step 4: Calculate Unit Costs•Step 5: Apply unit costs to units

completed and to units in the WIP inventory

Equivalent Units

•Basic unit of measurement to convert work on

•"units started in previous period" and "units not completed" to equivalent whole units

•Example: 100 units 40% complete = 40 units 100% complete

Example: ABC Produces Back packs. They purchase polyester as DM for the Stitching department. Once the back packs are done at the stitching department, they go to the finishing department, where the zippers and extra features are added.

-Stitching department produced 50,000 units

-DM costs were 100,000

-DL costs were 12,000

-Factory Overhead was 18,000

Flow of Production Physical Units Direct Materials Conversion Costs

Started and completed 40,000 40,000 40,000

WIP, ending inventory 10,000 10,000 10,000*65% =6,500

Units account for 50,000

Work done to date 50,000 46,500

Work in Process – Forming

1. Direct Materials $100,0002. Direct Labor 12,0003. Factory OH 18,000Costs to Account For 130,000

Balance 24,225

4. Transferred to Finishing 105,800

Backflush Costing• As companies achieve JIT inventory control and Total Quality

Management, less cost is carried in inventory• Less attention is given to systems which sequentially track the

flow of product costs from material inventory to work in process and finished goods

• Use backflush costing when Levels of inventory are minimal Production process / technology is relatively stable Standard costs/unit are clear

• When finished goods inventory is minimal, it is possible to eliminate this account and transfer costs directly to cost of goods sold

MaterialsAccount

Cost ofGoods Sold

Finished GoodsInventory

Conversion CostsAccount

The System that applies costs to like products that are usually mass produced in a continuous fashion through a series of production processes is known as:

A) JIT CostingB) Job Order CostingC) Process CostingD) Variable Costing

Chapter 8

Relevant Information and Decision Making:

Marketing Decisions

Relevant Costs and Revenues

Meet 2 criteria. They are:(1) predicted future costs or future

revenues that

(2) differ among the alternatives being considered

Avoidable and Unavoidable CostsAvoidable Costs:

Costs that will not continue if an ongoing operation is changed or deleted

These costs are relevant. (are affected by a decision)

Unavoidable Costs: Costs that continue even if an operation is

halted Include many common costs: - costs of

facilities and services that are shared by users (e.g. building depreciation, heating/air conditioning, general management expenses)

These costs are not relevant. (not affected by a decision)

Optimal Use of Limited Resources• when something constrains or limits operations (e.g. labour hours, machine hours, raw material, space)• determine contribution margin per the limiting factor• allocate usage to maximum profit

Plain Fancy

• Contribution margin per unit $4.00 $9.00• Units of production per hour 3 1• Contribution margin per hour $12.00 $9.00

• allocate capacity to “Plain” up to expected demand, and then allocate remaining capacity to “Fancy”

Mark-Up and MarginMark-up:

% increase based on a cost or costs Margin:

Profit or Contribution % based on sales $’s or revenue

Example: Sales $100,000 Costs 80,000 Profit $ 20,000

Mark-up is ($100,000 - 80,000)/ $80,000 = 25%

Profit Margin is $20,000/ $100,000 = 20%

Target Pricing &Target CostingTraditional Approach• Determine costs and add on a mark-up to set selling

prices

Target Costing and Target Pricing• First determine the price at which the product will

sell• Then design a product to be produced at a low

enough cost to provide an adequate profit margin over target cost

+Costs

Mark-Up = Price

TargetPrice

Target Costs

_ Margin =

Maximizing Total ContributionMarginal Cost: The additional cost of producing

and selling one more unit

Marginal Revenue: The additional revenue from the sale of one more unit

The question is: How many items to produce? The decision point is where Marginal Cost = Marginal Revenue

As long as marginal cost < marginal revenue, additional production is profitable