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Review of Basic Cost Accounting Key Topics Today we will briefly review: – – – – – Cost Terms and Purposes Job & Process Costing Standard Costing Activity Based Costing Alternative Income Calculations COST TERMS & PURPOSES Types of Cost Classification Classification Example Object of Expenditure Heat, light, xerox paper, salaries, etc. (Common in state budgets. Says nothing about purpose; hard to evaluate!) Functional Sales, administration, Cost of Goods Sold (used under GAAP. shows purpose.) Behavior as volume of activity changes variable, fixed (useful internally for decisions.) Others: Not really “classifications” since they are so situation-specific. Controllable /noncontrollable (useful concept in budgeting) Direct (traceable to cost object) or Indirect (can’t trace) Cost Object [or Objective]: "any activity or item for which a separate measurement of cost is desired." Example: a product, a department a customer [all are activities?] Purpose: to help in decisions or to prepare financial reports Phases of assigning cost to objectives (1) Accumulation by some "natural" classification (labor, material, etc.) (2) Assignment to the objectives by either… --Tracing --Allocating E.g.: Material costs are accumulated as material is purchased, then typically traced to units of product as they are manufactured. Indirect manufacturing costs (overhead) are allocated to units of product. Direct vs. indirect costs: can they be traced to the cost objective in an economically feasible way? [cost-benefit.] -A matter of judgment Direct/Indirect Examples for Discussion For a sales office as the cost object...... The office space? A receptionist? The sales manager's salary? The company president's salary? Insurance against fire and casualty? Electricity For a manufactured circuit board...... Transistors, integrated circuits, etc., mounted on the boards? Solder used to make the connections? Insulating varnish used to coat it? Labor of the assembly line worker? Supervisor's salary? Cost Behavior: Fixed vs. Variable Cost Driver: Any underlying factor that causes or changes total costs. Example: Cost of an audit engagement? - Client new? - No. of transactions the client has had - Whether and how computerized - Number of branch offices - Volume (units made, sold) Purpose is Prediction: Would we predict based on a driver? e.g. -The plant manager's salary is "fixed" -- does not depend on volume. Volume But the manager might be laid off at very low volume or a second shift manager hired at very high volume. Many fixed costs are discretionary. Fixed does not mean Unchangeable Cost Reaction to Changes in Activity Need four perspectives! Unit Fixed Cost: $ Total $ Volume Variable Cost: $ Volume $ Volume Within the relevant range Volume Separate Dichotomies Think of Examples in a _______________ setting. Cost object is a _____________ Direct/Indirect means it can be traced to the object. Fixed/Variable concerns whether it increases with volume of activity (define). Direct Fixed Variable Indirect Inventoriable ("Product") Costs vs. Period Costs [Expensed when product sold] [Expensed Immediately] – Selling expenses – General and Administrative All costs to obtain the merchandise: – Dir. Material "Prime"costs – Dir. Labor – Factory Overhead "Conversion" costs } } Different Definitions of Costs for Different Applications Activity-Based Costing and Activity-Based Management Undercosting and Overcosting Product undercosting: Occurs when a product consumes a relatively high level of resources but is reported to have a relatively low total cost. Product overcosting: A product consumes a relatively low level of resources but is reported to have a relatively high total cost. Undercosting and Overcosting Irene, Roberta, and Nancy are three bank customers. They require different activities from the bank: – Irene banks exclusively at the ATM or online. – Roberta visits the teller daily to make deposits, withdrawals – Nancy deposits foreign currency as well as calling the branch frequently to ask currency rates. Undercosting and Overcosting Traditional allocation bases might apply branch overhead to accounts based on account balances or equal amounts per account. Irene (who never makes any demands on the branch) will be overcosted and appear less profitable than she should. Roberta and Nancy may be undercosted and appear more profitable than they are. Refining a Costing System Guidelines for refining a costing system: Direct-cost tracing – Classify as many of the total costs as direct costs as is economically feasible. Indirect-cost pools – Expand the number of cost pools until each of these pools is homogeneous. Cost-allocation basis – Identify the preferred cost-allocation base for each indirect-cost pool. Activity-Based Costing System ABC calculates the costs of individual activities and assigns costs to cost objects such as products, services, or customers based on the activities used to produce a product or service, serve a customer, etc. Activities of a Milk Truck Delivery Person Activity Driving Shelving Paperwork Waiting Cost Driver Time; miles; area of town Time; number of packages; categories of products Time; types of customer Type of customer? Cost Hierarchies 1 2 3 4 Different cost pools basis on of the different types of cost drivers (used as the cost-allocation bases) ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases: Output unit-level cost Batch level costs Product-sustaining costs Facility-sustaining costs Output Unit-Level Costs... are resources consumed for activities performed as a function of individual units of product or service. – Energy – Machine maintenance, repairs (depreciation?) – Labor Batch-Level Costs... are resources used on activities that are related to a group of units of product or service – Setup hours to run a batch – Procurement costs of placing an order Product-Sustaining... or service-sustaining, costs are incurred on activities to support individual products or services. – Design costs – Engineering costs – Equipment dedicated to the product or service Facility-Sustaining Costs... are resources used on activities that cannot be traced to individual products or services but support the organization as a whole. – General administration – Rent or depreciation for headquarters, etc. – Building security Usefulness of Cost Hierarchies Different levels of cost drivers: Level Output-unit Batch Useful for Decisions Such As… Shall we increase production, and at what price? How often should we produce batches? What base amount must we charge to set up a “run,” regardless of the number a customer wants made? Product/Service-Sustaining Should we continue to offer this service/product? Facility-Sustaining Shall we continue in business or dissolve it? Activity-based Management Supervisors & managers typically oversee activities rather than products. ABC pinpoints opportunities for cost reduction. Improved information technology facilitates ABC. Activity-Based Management ABM describes management decisions that use activity-based costing information to satisfy customers and improve profits. – Product pricing and mix decisions – Cost reduction and process improvement decisions – Design decisions Product Pricing and Mix Decisions ABC gives management insight into the cost structures for making and selling diverse products. It provides more accurate product cost information and more detailed information on costs of activities and the drivers of those costs. Cost Reduction and Process Improvement Decisions Manufacturing and distribution personnel use ABC systems to focus on cost reduction efforts. Managers set cost-reduction targets in terms of reducing the cost per unit of the cost-allocation base. Design Decisions Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs. Companies can work with their customers to evaluate the costs and prices of alternative design choices. Major Differences, Traditional Costing vs. ABC Typical System One or a few indirect cost pools Application base may be a true cost driver Application base often financial (direct labor cost, direct material cost, etc) ABC Many pools Base more likely a true cost driver Bases likely to be non-financial (# of parts, number of operations, hours of testing, etc.) Indicators of Need for ABC Systems... significant amounts of indirect costs are now allocated using only one or two cost pools. all or most costs are identified as output unitlevel costs. products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity. Indicators of Need for ABC Systems... products that a company is well-suited to make and sell report small profits while products for which a company is less suited report large profits. complex products appear to be very profitable and simple products appear to be losing money. operations staff have significant disagreements with the accounting staff about the costs. Limitations of ABC Systems The main limitations of ABC are the effort & measurements necessary to implement the system. ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools. Limitations of ABC Systems Activity-cost rates also need to be updated regularly. Very detailed ABC systems are costly to operate and difficult to understand. Standard Costing Basic Concept: Only the standard cost will be applied to the product for inventory valuation and income determination. – Any difference from std. is called a "variance.“ – Variances are calculated and investigated (if large). – Management by exception Standard Cost Variances Variable OH: Like DM, DL Fixed OH: Prod’n volume, Spending components Criticisms of Standard Costing A static target? – Can avoid this Emphasis on efficiency – Encourages buildup of inventory, keeping workers & machines busy Emphasis on price of inputs – Can undermine quality Alternative Income Calculations Absorption Costing Sales - CGS =Gross Margin - Selling Expenses - Gen & Admin Expns =Operating Income Variable Costing Sales -Variable Mfg. Costs [= Manufacturing Margin possible subtotal] -Variable Selling & Admin = Contribution Margin -Fixed Costs: Manufacturing Selling Administrative =Operating Income Differences in Reported Income Change in Effect on FC Inventory Expensed Effect on Incomes Increase Some FC deferred under Absorption that ACI higher than VCI would be expensed under Variable Decrease Some FC carried forward from last year; this year’s FC also expensed ACI less than VCI No Change Amounts expensed are the same ACI = VCI If fixed OH/unit is not constant across time, we must trace the difference in fixed overhead that gets expensed (or the amount that gets carried forward – the same difference in amounts).