CHAP 1 – AN INTRODUCTION TO COST TERMS AND PURPOSES

1. Cost and cost terminology

Actual cost: cost incurred

Budgeted cost: predicted or forecasted cost

Cost object: anything for which a measurement of costs is desired

2. Direct cost and Indirect cost

The direct cost of a cost object can be traced in an economically feasible way

The indirect cost of a cost object can not be traced

Cost allocation: the assignment of indirect costs to a particular object

Cost assignment: encompasses tracing direct costs to a cost object and Cost allocation

Direct costs of cost objects are easier to measure

Indirect costs are harder to measure

Managers basically want to assign costs accurately to cost objects since this affects decisions

Depending on cost objects, a specific cost may be either direct or indirect cost

3. Variable costs and Fixed costs

A variable cost changes in proportion to a level of volume

(most direct costs are variable cost)

A fixed cost remains unchanged regardless of the level of volume

(the higher the units the lower the fixed cost per unit)

Unlike variable cost, fixed cost cannot be easily changed in the short-run. However, in the long-run it can be changed to match with the resources needed

(firing workers or switch them to another department)

Labor cost can be classified as fixed cost to enhance employee’s dedication and loyalty but can also be variable cost if workers are paid on a piece-unit basis.

Mixed or Semivariable cost

A cost driver is a variable that affects costs over a given time span

Relevant range

4. Total costs and Unit costs: focus on total costs instead of unit costs

5. Types of sectors

Manufacturing: purchase materials and components and then convert them into various finished goods

Merchandising: sell tangible products without changing their basic forms (retailers)

Service: provide services or intangible products

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Summary Pg. 76

Exercises: 2-17/ 27/ 39

CHAP 2 – COST VOLUME PROFIT (CVP) ANALYSIS

1. Basic formula

Operating income = contribution margin – fixed cost

Contribution margin = total revenues – total variable costs

Contribution margin per unit = contribution margin / number of units sold

= contribution margin percentage x revenues

Contribution margin percentage = contribution margin per unit / selling price per unit

2. Cost-Volume graph (pg. 91)

3. BEP

Break-even point = Q = FC / Contribution margin per unit

Quantity required = Q = (TOI + FC) / Contribution margin per unit

= {TNI ÷ (1−tax rate ) }+FC

Contributionmargin perunit

Break-even revenue = FC / Contribution margin percentage

4. Other formula

Margin of safety (in dollar) = Budgeted revenues – breakeven revenues

Margin of safety (in units) = Budgeted sales – breakeven sales

Margin of safety percentage = margin of safety / budgeted revenues

5. Operating leverage

Degree of operating leverage = contribution margin / operating income

= (R – VC) / operating income

= (FC + OI) / OI

= FC / OI + 1

If Degree of OL = 2.67 => FC / OI = 1.67, which means $1 of operating income requires $1.67 investment in fixed cost. Therefore, the lower the degree of OL the better because investing in fixed cost is dangerous; we are all trying to reduce fixed cost.

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Summary Pg. 106

Exercises: 3- 19/ 23/ 28/ 40

CHAP 3 – JOB COSTING

1. Terms

Cost pool: a grouping of individual indirect cost items

Cost-allocation base: a systematic way to link an indirect cost or group of indiect costs (cost pool) to a cost object

Job-costing: the cost object is a unit or multiple units of a distinct product or service called a job. Job-costing systems accumulate costs seperately for each product or service.

Process-costing: the cost object is masses of identical or similar units of a product or service. This per-unit cost is the average unit cost that applies to each of the identical or similar units produced in that period.

Eg: ABC Corp. uses job-costing to calculate the total cost to manufacture each of the 3 distinct types of products- Corn Flakes, Crispix and Froot Loops. But use process costing to calculate the per-unit cost of producing each identical box of Corn Flakes.

The 5-step decision-making process: Identify – Obtain info – Make predictions – Make decision – Implement & Learn

2. Actual costing VS Normal costing

General approach to job costing: 1. Identify cost object

2. Identify the direct costs: DM & DML

3. Select the cost-allocation bases

4. Identify cost pool

5. Compute the rate per unit: <4/3>

6. Compute the indirect cost allocated to the job

7. Compute the total cost <6 + 2>

Actual costing Normal costing

Direct costs Actual direct cost rate X

Actual quantities of direct-cost input

Actual direct cost rate X

Actual quantities of direct-cost input

Indirect costs Actual indirect cost rate X

Actual quantities of cost-allo bases

Budgeted indirect cost rate X

Actual quantities of cost-allo bases

Pros and Cons Able to report a job cost as soon as the job is completed, assuming that both the DM and DML costs are also known at the time of use.

Have to wait until the end of the year to compute the job cost.

3. Accounting adjustment

Underallocated indirect costs occur when the allocated amount of indirect costs in an accounting period is less than the actual amount. And vice versa for overallocated indirect costs.

Manufacturing overhead control: the record of actual costs

Manufacturing overhead allocated: the record of budgeted cost based on the basis of the budgeted rate multiplied by actual quantities of cost driver

A. Adjusted Allocation-rate approach

Restate and recompute using actual statistics.

Although this is a strenuous work, the widespread adoption of computerized accounting systems has greatly reduced the cost and workload.

This approach yields the benefits of both the timeliness and convinience of normal costing during the year and the allocation of actual manufacturing overhead costs at year-end.

B. Proration approach (pg. 144 + 158 – 2 kinds of proration)

More complex compared with the write-off to COGS approach

Appropriate to use when the amount of under- or overallocated is material (significant). In so doing, this method will bring about more detail and even more accurate statistics

C. Write-off to cost of goods sold approach (pg. 145)

This is the simplest approach among the three

Appropriate to use when the amount of under- or overallocated is immaterial (small).

Many companies normally make use of the combination of the two approaches B&C to yield the most benefits and accuracy.

Job costing in a service firm?

Very similar to job costing at a manufacturing company

The main difference is that the company is allocating indirect period costs (marketing and customer service costs) to each client, rather than to manufacturing costs

Since there is no inventory, no journal entries are needed

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Summary Pg. 149

Exercises: 4- 18/ 19/ 34/ 36

 

CHAP 4: ACTIVITY-BASED COSTING AND AB-MANAGEMENT

1. Simple costing

Broad averaging can lead to undercosting or over costing of products or services. Product undercosting occurs when a product consumes a high level of resources but is reported to have a low cost per unit.

Product-cost cross-subsidization means that if a company undercosts one of its products, then it will overcost at least one of its other products.

2. Refined costing system

A refined costing system reduces the use of broad averages and provides better measurement of the costs of indirect resources.

Demands for using a refined costing system: 1. Increase in prodcuct diversity

2. Increase in competition

3. Increase in indirect cost

3. Activity-based costing systems

Cost hierarchies:

Output unit-level: costs of activities performed on each individual unit of a product or service

Batch-level: costs of activities related to a group of units of products or services rather than to each individual unit of product or service

Product-sustaining: costs of activities undertaken to support individual products or services regardless of the number of units or batches in which the units are produced. Such kinds of cost are Product Research and Development costs, Marketing costs.

Facility-sustaining: costs of activities that cannot be traced to individual products or services but that support the organization as a whole. For instance, Administration costs.

ABC system provides more accurate information to make better decisions. But this benefit must be weighed against the measurement and implementation costs of an ABC system.

4. The use of ABC systems

Pricing and product-mix decisions

Cost reduction and process improvement decisions (idle capacity)

Design decisions

Planning and managing activities (compare and adjust at the end of the year; eliminate non-added value activities)

5. Activity-based costing system VS Department costing system

Department costing system uses only one cost pool and an appropriate allocation base

Department costing system yields the same information as ABC and should be used only if: (1) a single activity accounts for a sizeable proportion of the department’s costs; (2) significant costs are incurred on different activities within a department but each activity has the same cost driver and hence the same cost-allocation base.

6. ABC in Service and Merchandising companies

ABC has many applications in service and merchadising companies. These companies have used ABC system to identify profitable product mixes, improve efficiency and satisfy customers.

ABC systems should be used for strategic decisions by managers rather than for inventory evaluation. Therefore, it’s suitable for service companies which don’t have inventory as well.

Services companies find great value from ABC because a vast majority of their cost structure comprises indirect costs. This kind of system will provide greater insight than the traditional system.

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Summary Pg. 189

Exercises: 5-27/ 31/ 32/ 33/ 37

CHAP 5 – COST ALLOCATION: JOINT PRODUCTS AND BYPRODUCTS

1. Basic terms

Joint costs: costs of a production process that yields multiple products simultaneously

Splitoff point: the juncture in a joint production process when two or more products become seperately indentifiable

Seperable costs: any costs incurred beyond the splitoff point that are assignable to each of the specific products identified at the splitoff point

Product: describes any output that has a positive total sales value

Main product: a product with high total sales value compared with other products

Joint products: two or more products with high total sales value compared with the rest

Byproducts: products with low total sales value

Distinction among main product, joint products, byproducts are not so definite

The classification can be changed over time

2. Approaches to allocating joint costs

Using market-based data: 1. Sales value at splitoff

2. Net realizable value (NRV)

3. Constant gross-margin percentage NRV

Using physical measures: this is the simplest method yet least accurate. For this method to be effective, all products must have the same unit measurement and be of the same value – which are unlikely to happen in reality. Besides, byproducts must be excluded from computation because their low sale revenues will distort the results.

COMPARISONS:

Sales value at splitoff should be used since it provides accurate results – costs are allocated in proportion to sales value of total production. Besides, this method does not require much information on the processing steps after splitoff; therefore, it’s pretty simple to conduct. However, were selling prices for all products at the splitoff point not available, we could not use this approach.

If we cannot use sales value at splitoff method, NRV and constant gross-margin percentage NRV will be picked as substitutes. Among the two methods left, NRV is more complex yet provides a better measure of benefits received compared with the constant gross-margin percentage NRV or physical measure method. Nevertheless, if the profit brought about from the further-processing decision is large enough, it will distort the results because NRV at splitoff point comprises this amount of profit (beside the joint cost and profit at stage 1; and we know that the joint cost allocation shall have nothing to do with profits occurred at the latter stage).

As mentioned above, if the profit at stage 2 is considerable, we should use constant gross-margin percentage NRV method. However, this approach is not without its problems. This method applies the assumption that all products have the same ratio of costs (or profit) to sales value. Such a situation is very uncommon in the real world context.

3. Sell-or-process-further decisions

If (Incremental revenues – incremental processing cost) is positive, we should further process the product.

In making such decision, joint cost is irrelevant because this cost is the same regardless of the sell-or-process-further decision. It’s already occurred; we cannot change this amount whatsoever.

4. Accounting for Byproducts (pg. 611)

COMPARISON between Production method & Sales method. (pg. 612-613)

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Summary Pg. 616

Exercises: 16-16/ 17/ 21/ 23/ 25/ 26/ 30/ 32

CHAP 6: DECISION MAKING AND RELEVANT INFORMATION

1. One-time-only special orders

Absorption-costing basis: both variable and fixed manufacturing costs are included in inventoriable costs and cost of goods sold (full cost)

We should consider only relevant costs in this case (such as variable cost). All irrelevant costs such as fixed cost are unchangeable in the short run so we do not count them in costing the order.

Pay attention to total revenues and total costs rather than unit revenue or unit cost to avoid misled information. For example, the fixed cost is $135,000 whether the company produces 30,000 or 35,000 units. By mentioning a fixed cost of $4.5 per unit would lead to an assumption that the fixed cost in producing 35,000 units is larger than one in producing 30,000 units.

2. Insourcing VS Outsourcing (Make VS Buy Decision)

Outsourcing: purchasing goods and services from outside vendors

Insourcing: producing the same goods or providing the same services within the organization

Outsourcing is not without risks. A company outsourcing turns out to be dependent on its supplier and may face lots of uncertainties. To solve the problem, normally a company will enter into long-run contract with its supplier. Intelligent managers build close partnerships or alliances with a few key suppliers.

Offshoring: outsourcing services to lower-cost countries

Total-alternatives approach VS Opportunity-cost approach (pg. 423): using the former approach when more than 2 alternatives are being consider simultaneously.

3. Product-mix decisions

Make decisions regarding which products to sell and in what quantities in order to maximize operating income, given constraints suh as capacity and demand.

Normally, we only produce the minimum required amount of unprofitable products. The rest of the capacity should be used to produce one with highest contribution margin per unit.

4. Adding or dropping a customer/ department

Information A customer A department

Rent Irrelevant Relevant

General administration Irrelevant Relevant

Corporate-office costs Irrelevant Irrelevant

Depreciation Depreciation cost is irrelevant in deciding whether to drop or a customer or a department because it is a sunk cost (past cost). But the cost of purchasing new equipment (when adding a customer or a department) that will then be written off as depreciation in the future is relevant.

5. Replacement decisions

Book value: original cost minus accumulated depreciation. Book value is irrelevant in decision making.

For example, go to pg. 432

Normally, when deciding to keep or replace, managers will focus on their benefits first. For instance, replacing can be better for the company (from the view of the whole process) but not for the managers at some point in the future; therefore, they tend to keep instead of replacing (pg. 433). We call this the problem of inconsistency – telling managers to take a multiple-year view in their decision making but then to judge their performance only on the basis of the current year’s operating income.

BEFORE MAKING ANY DECISIONS, CONSIDERING BOTH THE QUANTITATIVE AND QUALITATIVE FACTORS.

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Summary Pg. 435

Exercises: 11-19/ 21/ 25/ 28/ 31/ 33/ 36/ 39

CHAP 7: MASTER BUDGET AND VARIANCES

1. Basic termsStrategic plan: expressed through long-run budgetsOperating plan: expressed through short-run budgetsOperating decision: deal with how to best use the limited resources of the organizationFinancing decision: deal with how to obtain the funds to acquire those resourcesAdvantages of budgets: 1. Coordination and communication

2. Framework for judging performance and facilitating learning3. Motivation

Budgets is not without its problems such as time-consuming and costly.Budgets should not be implemented rigidly. The usual period for budget is one year yet many firms use rolling budget (continuous budget).Sensitivity analysis: a series of what-if questions

CHAP 8: PRICING DECISIONS AND COST MANAGEMENT

1. Major influences on pricing decisions

Customers: affect demand

Competitors

Costs: affect supply

Inelastic demand curve Elastic demand curve

P

D

P

D

The curve is steep, which means a large increase in price just slightly reduce the demand for the product.

In other words, there are not many substitutes for the product in the market. The power lies in the hand of the product manufacturer.

We say, the demand for the product is insensitive to price.

The curve is much flatter, which means a large increase in price will dramatically reduce the demand for the product.

In other words, if the price increases, customers will switch toward available substitute products in the market. The customers hold power in this context.

The demand for the product is sensitive to price.

2. Short-run pricing

Set price a bit lower than market’s bid but still be able to make profit.

Fixed cost remains unchanged in the short-run.

To decide whether to accept a special order or not, we just need to see if the price is larger than the variable cost. In this case, we accept the order (if we have idle capacity).

3. Long-run pricing

Market-based: if operating in a competitive market

Cost-based: if operating in a less competitive market

Market-based approach Cost-based approach

The price is determined by the market. We have to take the following steps:

Analyze customers and competitor → Set target price → Minus target operating income → Come up with target cost → Compare with full cost → Do cost analysis/ Value engineering.

Price = full cost + markup

The markup rate is based on:

Rate of return on investment

Alternative cost bases

These two approaches are different only at the beginning of the process.

In the end, price based on cost-based approach will be driven by the market forces.

In the final step, we have to reduce cost incurred by identifying value-added and nonvalue-added cost. We have to eliminate as many nonvalue-added cost as possible.

Other terms include: peak-load pricing/ time-and-material method/ grey area/ locked-in cost/ cost incurrence (pg. 464 for graph)

4. Other considerations

Antitrust laws

Price discrimination: is allowed as long as not hinder competition.

Predatory pricing: reduce price temporarily to kick other competitors out of business.

Dumping: set price lower than the whole market.

Collusive pricing: collude with suppliers to adjust price.

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Summary Pg. 477

Exercises: 12-36