CH-1-3 Cost Management and Strategic Decision Making Evaluating Opportunities and Leading Change – Cost Management: Strategies for Business Decisions : Chapter Notes

This Document Contains Chapters 1 to 3 Chapter 1 Cost Management and Strategic Decision Making Evaluating Opportunities and Leading Change Chapter Outline Cost Management Challenges — There are three questions addressed in this chapter. What should a cost manager do when the demands of the job conflict with personal or professional ethical standards? How does the cost-management analyst contribute to strategic decision making? How should a cost-management analyst prepare information for strategic decision making? Learning Objectives — This chapter has four learning objectives. Understand how cost management supports strategic planning and decision making Understand the importance of ethical behavior in decision making Describe and understand the steps in strategic decision making Apply benefit-cost and variance analysis to help evaluate an organization’s strategic plans Cost managers are members of the management team who have responsibility for managing the financial resources. The chief financial officer (CFO) is the top cost manager. This person usually has an educational background in accounting or finance and may be certified as a certified public accountant (CPA), certified financial manager (CFM), or certified management accountant (CMA). The CFO oversees the activities of all cost managers and interacts with many other managers who are responsible for the use of an organization’s resources. Cost managers reporting to the CFO may have training as accountants, finance, engineering, or non-business disciplines. Since a cost manager has a role that extends far beyond that of a cost accountant, the skill set possessed by a cost manager is broad. Cost managers should possess a cost management attitude. They should be vigilant in their pursuit of cost control but not at the expense of product quality or customer needs. They must know their organization and the organization’s goals. They need to possess high ethical standards. Cost management is a philosophy, an attitude, and a set of techniques to create more value at a lower cost. It is a philosophy that encourages continuous improvement. It represents a proactive attitude that all the costs of products and operations result from management decisions. It uses a set of reliable techniques that use diverse measures of performance to assess the impacts of decisions. A cost management system is a set of cost-management techniques that function together to support the organization’s goals and activities. Characteristics of Cost-Management Analysts: Reliability of information is especially important for strategic decision making in a rapidly changing world. Cost-management analysts must maintain high standards of ethical behavior because they can control the information on which strategic decisions are based and justified. Otherwise, ruined reputations can spell disaster for the individuals and for the company. Such outcome is often the result of greed, personal ego, and selfishness on part of the perpetrators without regard to the consequences of their actions. Code of Ethics provides a guideline for the behavior that is acceptable and assists individuals who want to stay ethical in their dealings with others. There are eight very broad management decisions to be made in the arena of cost management. The organization’s long-term strategy must be chosen. The scale of the organization and the scope of operations must be determined. The use of resources must be planned and organized in a way that maximizes the efficiency of operations. Plans and organizational change must be implemented. Results must be measured and reported. Individuals and sub-units in the organization must be motivated and then evaluated. Plans and results must be communicated to appropriate individuals and subunits. Decision making and improvement initiatives must be evaluated. Chapter 1 presents the first four of the broad management decisions listed above. Each is described in more detail below. Choose the organization’s long-term strategy. Identify the organization’s competitive advantage. What can the organization do better than others to provide products or services that customers demand? Is there an underserved market that the organization can satisfy? Strategies are often a product of assumed risk and expected rewards. Lower risks could bring about lower rewards and higher risks could entail higher potential rewards. Identify benchmarks, both external and internal, to measure performance against. Determine where the organization is relative to competitors and relative to prior years’ performance. Benchmarks are standards against which organizations can measure and monitor their own performance. Define the scale of the organization and the scope of operations. This can be accomplished by using the “value chain” approach. Understand the value chain for the organization’s products. The value chain is a way to think about the entire process for a good or service, from its inception to the point at which the consumer receives the product. The value chain begins with research and development, proceeds to product design, supply of inputs, production, marketing, distribution, and customer service. Linked to all of these stages of the value chain is administrative support. Management must decide which potions of the value chain it should handle internally and which parts are better left to outside providers (outsourcing). This decision involves assessing the organization’s competitive advantages and weaknesses. A cost-benefit analysis of the strategic plan should be performed to decide which parts of the value chain should be performed by whom. Cost-benefit analysis consists of identifying as many financial benefits as possible and comparing them to all of the costs that are identifiable. From a purely quantitative standpoint, the financial benefits should outweigh the costs to justify a proposed handling of a value chain process. However, managers must also take into consideration the qualitative aspects of the process before deciding how a process should be performed. A decision to let individuals or organizations from the outside complete portions of the value chain may be the more practical one for two important reasons (among some less important ones). First, some portions of the value chain are best left to experts outside of an organization. If an organization possesses no expertise, then it should defer to others outside of the organization until it does possess the necessary expertise. Second, sometimes the costs of doing something internally far exceeds the costs of having others do it for you. Outsourcing is a term used to describe the decision to have outsiders complete work or a process that an organization might otherwise have to complete itself. There are times when the outsourcing choice is the correct one and times when it is inappropriate. Assessing which parts of the value chain should be completed internally helps managers to define the scope of operations. The scale of operations is defined by the overall goals of the organization. The scale and scope fit together because the scale drives the analysis of the scope. Plan and organize the efficient use of resources. Once the scale and scope have been clearly delineated, the management team can decide how to accomplish the goals of the organization. Determine what the competitive advantage of the organization is. Form a team to analyze the appropriate uses of resources. As a team, formulate a plan to devise the solutions, divide work, and then work on the solutions. Reconvene as a team to assess alternative solutions and choose the best one. For instance, choosing to outsource rather than make a part internally would be one of many pieces of the resource utilization puzzle. Implement plans and organizational change. There is an eight-step process that can be used to successfully implement plans and change. First, identify a need for change (why are you doing all of this anyway?). Create a team to lead and manage the change. Note: This is not the same team that developed the plan. This team will be responsible for leading and managing change. This team needs access to all of the information to implement the change and access to all of the people needed to complete the analysis of the change. Create a vision of and a strategy for the change. This requires input from people who are knowledgeable about the area being changed. Communicate the vision and strategy for change to fellow employees. Solicit additional input from employees. Help co-workers, especially those most affected by the changes, to feel a part of the coming changes. Encourage innovation and remove obstacles to change. Top management should give the implementation team the leeway needed to successfully implement the changes proposed. This means giving them control over the process and authority to make changes. It does not, however, mean they have authority to implement changes to the detriment of the organization. This is why top management has ultimate responsibility and oversees this process. Ensure that short-term achievements are frequent and obvious. Given a major project that results in many changes, the project should be broken down into smaller pieces. This simplifies the work of the implementation teams, makes the setting of deadlines (and meeting them) more realistic, and helps management to see which parts of the plan work and which parts do not. The overall plan of action can be modified in pieces also. This makes it less likely that the entire plan is viewed as a failure. Successes can be promoted as a way to create opportunities for improvement in the entire organization. When a large project is split into pieces, each piece, when successfully implemented, can be used to encourage and motivate employees to make even more suggestions to improve the operations of the organization. By making each success small (relative to the whole project), employees are not afraid to make small suggestions. Reinforce a culture of more improvement, better leadership, and more effective management. If employees believe that management appreciates and will use their suggestions, then the operation of the organization can be continuously improved. Employees feel they are part of the entire “team.” The authors are putting additional emphasis on the question of Ethics in lieu of several ethical lapses in several industries. Ethical lapses could entangle the best of people if they are not careful and use some bad judgment with regard to financial, accounting, or managerial decisions. When it comes to the question of ethics the accountant should be aware of a higher moral law than simply remaining a good team player. Accountants should also be quite cognizant of the implications of the SarbanesOsley Act of 2002 that makes the CEO and CFO personally responsible and requires them to sign off the financial statements. This in turn requires more attention to the question of the adequacy of Internal Controls to protect assets and provide quality information and ascertaining that laws and regulations are strictly complied with. The Internal Audit department within a firm has the direct responsibility of making such reviews and providing the necessary assurances before the financial statements are signed off. It is best for the Internal Audit department to report to top management to minimize possibilities of fraud and manipulations at the lower levels. (Appendix A) Ethics for conducting one’s operations in any field particularly in the field of accounting is considered to be very important. Institute of Management Accountants has issued a set of Standards of Ethical Conduct for Management Accountants. These standards deal with the aspects of, Competence – the responsibility of maintaining a level of competence and performing duties assigned competently. Confidentiality – refraining from disclosing confidential information Integrity – avoiding actual or apparent conflicts of interest and refraining from subverting organization’s legitimate objectives. Objectivity – disclosing and communicating information fairly and objectively. L. Appendix B – It is a good idea to review the book’s Table of contents at this point. It helps you get a feel for what you would be studying in this course. Problem 1 – Chapter 1 Objective 2 – Benchmarking Special feature – communication Clemson University is considering outsourcing its bookstore operations. The University Administration has made a presentation to the Faculty Senate as follows: The bookstore has a total revenue of 1.6 million dollars for the current fiscal year. 1.2 million dollars of this budget is for purchase of books. Salaries of the 12 employees plus their benefits amount to $345,000. We figure that the overhead associated with this operation including utilities ($62,000) and allocated overhead from other departments amounts to 15% of the revenue generated. Accordingly, we are losing money running this operation. Barnes & Noble has indicated an interest in running the operation with no cost to us and giving us $100,000 in annual rent. Required: As members of Finance Committee of the Faculty Senate, you are asked to debate the advantages and disadvantages of this proposal and report it to the Faculty Senate. Provide financial as well as qualitative justifications. As a starting point determine the current amount of loss and whether you agree or disagree with the figures provided by the University Administration. Suggested solution: Calculations according to the Administration is as follows: Annual revenue $ 1,600,000 Cost of sales 1,200,000 Salary and benefits 345,000 Utilities 62,000 Allocated overhead 240,000 Annual loss from operations (247,000) Analysis of the above numbers: based on the facts given, the bookstore is losing substantial money. However, it should be noted that allocated overhead may not be an incremental cost; i.e., even if you eliminate the bookstore, those costs which are associated with the cost of the University administration will continue. Subtracting $240,000, it leaves us with a loss of $7,000 or virtually a break-even situation. Alternatively, we should know how much reduction in costs will be experienced by the University Administration in case, the Bookstore is outsourced. On the other hand, the bookstore is not being charged for the space that it occupies. What is the potential rental that we can get from renting that space? Well, we know that it is worth $100,000 to Barnes & Noble. This is an opportunity cost that should be included in the calculations. According to this data, the University will save $107,000 by outsourcing the bookstore. It will forego the direct loss of $7,000 and will pocket $100,000 in rent. Potentially, there will be some savings in administrative costs as well. Other factors to consider: it should also be noted that the University will be relieved from the headaches of the bookstore and can focus on their more important objectives of education and research. On the other hand, university may lose some control with regard to the operations of the bookstore. However, the contractual language plus the good reputation of B & N could alleviate such fears. University may consider to get other offers from interested operators as well before committing to one source. As the university expands and the bookstore’s income grows, a clause could provide giving of a percentage of additional earnings to the University as well. This problem is assigned to help you think about the diversity of questions and problems that a management accountant needs to address and help solve for an organization. Problem 2. Objective 2: Ethical Behavior Suppose that you are the Controller for WorldCON telecommunication services. The CFO has just increased your salary of $190,000 by 20% and has called you in to commend you for your excellent performance. In the general managers’ meeting the same afternoon, the CFO asks you to encourage the marketing people to increase sales through extending credit from 60 days to 120 days in December only if they consider quadrupling their prior period purchases and give them assurance that the company will consider accepting returns of whatever they don’t sell after 120 days. This strategy has the potential of increasing sales by 6.5 million dollars and the current profit of 3.4 million dollars will virtually double as a result of this strategy. Required: How can profit double even though sales would potentially increase by only 20%? Is the CFO’s suggestion unethical or illegal? What would you (should you) do under these circumstances? Suggested answers to the questions: The profit could potentially double even though sales increase by 20% because presumably a lot of fixed costs such as most of the administrative and selling expenses as well as some of the manufacturing costs will remain the same even though sales increase resulting in substantial increase in the company’s net income. The proposition appears to be unethical because the gimmick gives the appearance of higher sales and better performance although the management is just trying to buy time and book next year’s sales into this year’s in order to look better. Investors and potential investors could be fooled as a result of this gimmick. It may very well be illegal too with regards to SEC regulations. The Code of Ethics recommends that the employee first attempt to talk the manager out of this illegal or unethical scheme. If he is not successful, he can then contact the higher level employees or the internal audit and inform them of his dilemma. If he can’t get anywhere with this, then, he should consider resigning. In practice, this could be much harder than the question that we pose here hypothetically. A powerful and unethical boss could cause you all kinds of problems along the way, but a decent and honest accountant must accept the consequences. The next question is what one should do with regard to his various financial commitments and obligations at this level of salary. My recommendation is to live a little less lavishly. Always try to put money aside in a saving account. Don’t overextend yourself, and believe from the bottom of your heart that dishonesty for the sake of a better car and a larger house and a vacation home with a yacht at the cost of the chore of your morality and ethical wellbeing is simply not worth it. Put it another way: You are not for sale Period. Let everyone who works with you know it, and rest assured that you will win in the long-run. Problem 3: Objective: 2 and Appendix A: Ethics Do a computer search on ethics either from a religious, philosophical, political, economic, global, managerial, or accounting perspectives – either in general terms or specific cases, such as the Vietnam War, Watergate Scandal, Monica Lewinsky Scandal, Iran-Contra Affair, Cooked up intelligence leading to the current Iraq War or more specific business scandals such as those of Enron, Worldcom., or Arthur Andersen. Preferably do this exercise in a group with each member selecting a separate sub-topic. Then, compare your notes and find the common threads on what makes a scandal and how it can be avoided on a national, local, or personal level. Sample Quiz Cost management is a philosophy to create more value at lower cost. is an attitude to create more value at lower cost. is a set of techniques to create more value at lower cost. All of the above. None of the above. Answer: d Learning Objective: 1 Rationale: Cost management is not only a series of techniques for controlling and managing costs but it is also an attitude and a philosophy for creating value through best practices and good leadership. Cost accounting focuses on accurate reporting of past costs. relevant information for decision making. preparation of financial statements. All of the above a and b Answer: a Learning Objective: 1 Rationale: Cost accounting delves on accurate reporting of past costs, but cost management although related to cost accounting is future oriented and is more interested in timeliness and relevance of information rather than meticulous accuracy. Cost-management is concerned with creating more value for the customer. being proactive in decision making. continuously assisting organizations in making the right decision. all of the above. a and c Answer: d Learning Objective: 1 Rationale: Cost-management is a philosophy, and a set of techniques to create more value at lower cost and it is future-oriented. Outsourcing is using employees of the organization to provide needed goods or services. using outside parties to obtain needed goods or services. using employees and outside parties to provide needed goods or services. d. b or c e. None of the above. Answer: b Learning Objective: 4 Outsourcing is a means of obtaining needed goods and services if the company finds it more economically feasible to do so. There might be other factors besides economics such as, being relieved to focus on the organization’s main mission, etc. Scale of operations refers to the breadth of operations. size or volume of operations. number off employees in the operation. All of the above. a and b only Answer: b Learning Objective: 3 Scale of operations is obviously the size or volume of operations. Physical resources to achieve company’s long-term strategies include cash and receivables. inventories and supplies. property and equipment. All of the above. None of the above. Answer: d Learning Objective: 3 The company must employ all of its operating assets efficiently and effectively to achieve its longterm objectives. Structural resources of a firm include customer relationships. databases. organizational procedures. All of the above. None of the above. Answer: d Learning Objective: 3 Structural resources of a firm include customer relationships, databases, and organizational procedures. Together, they could lead to long-term stability and success. For motivating employees, intrinsic rewards could include personal satisfaction from work. tangible benefits from work. bonuses, raises, promotions. all of the above. b and c only Answer: a Learning Objective: 3 Intrinsic rewards include personal satisfaction from work aside from other forms of compensation. Benchmarking is comparing one’s performance against the best performers. comparing one’s performance against the budget. comparing one’s performance against the prior year. All of the above. f. a and b Answer: a Learning Objective: 3 Benchmarking is the vehicle through which an organization compares an aspect of its performance in design, production, distribution, or other phases of the value chain to the best competitor. This provides the vehicle for improving performance. The value chain includes the areas of research and development, design, and supply. production and marketing. distribution and customer service All of the above. None of the above. Answer: d Learning Objective: 3 Value chain includes all areas of the firm’s operations including research and development, product design, supply, production, marketing, distribution, and customer service. On the value chain, “supply” refers to the management of incoming parts. the collection and assembly of resources. the process that informs customers about the attributes of products. the delivery of products or services to the customers. None of the above. Answer: a Learning Objective: 3 Supply refers to management of incoming parts to be used in the production of goods and services. Customer service refers to the management of incoming parts. the provision of administrative support for operations. the process that informs customers about the attributes of products. the delivery of products or services to the customers. None of the above. Answer: e Learning Objective: 3 Customer service refers to assisting customers with their questions and complaints after delivery of merchandise. A company like IBM thrived for years because of superiority of its customer service. Cost-benefit analysis is a technique for identifying opportunities for improvement. a technique that measures the effects of proposed improvements. a technique that compares the costs and benefit of a proposal. All of the above. a and c only Answer: d Learning Objective: 4 Cost-benefit analysis is a way of identifying opportunities for improvement and a technique that compares the costs and benefit of a proposal. Opportunity cost is the benefit foregone because of choosing another alternative. a real cost like salaries paid to sales people. not explicitly recorded on any accounting statement. All of the above. None of the above. Answer: d Learning Objective: 4 Opportunity cost is the benefit lost because we choose the next best alternative. It is a real cost but is not specifically recorded in the accounting records. For example, you choose to go to school and lose the benefit of working (opportunity cost) for which you would have had an income to show. Cost managers need broad knowledge of the organization’s activities and how those activities interact. to be able to provide information, interpretations, and analyses of alternative courses of action that managers are contemplating. to identify opportunities to improve operational efficiency. All of the above. b and c Answer: d Learning Objective: 1 To be effective, cost managers should have a broad knowledge of the organization’s activities and how those activities interact, be able to provide information, interpretations, and analysis of alternative courses of action, and to identify opportunities to improve operational efficiency. This is a tall order, but the cost manager of today does a lot more than keeping track of company records. Cost managers must understand how changes in the organization’s value chain affect cost. understand how changes in the organization’s value chain affect quality. understand how changes in the organization’s value chain affect customer value. d. All of the above. e. a and b Answer: d Learning Objective: 3 Cost managers are expected to have a good grasp of the value chain and its impact on cost, quality, and customer service. Cost management teams often evaluate alternative uses of resources. use benchmarking in their analysis. use cost-benefit in their analysis. All of the above. a and e Answer: d Learning Objective: 3 Cost management teams are often involved in analysis for finding the best course of action and benchmarking may be a good means to achieve this end. Uptimum Company (U) uses a benchmark (X) for its labor performance. X uses 2 hours of labor at the rate of $8.00 an hour. U uses 2.4 hours at the rate of $8.50 an hour. U can sell what it can produce and works around the clock. What is the cost advantage of the lower labor cost per 5-day (three-shift) week? $60 $48 $34 $12 None of the above. Answer: a Learning Objective: 4 (8.50 – 8) * 5 * 24 = $60. This number is rather misleading. Because not only we are paying more, we also have less productivity. Uptimum Company (U) uses a benchmark (X) for its labor performance. X uses 2 hours of labor at the rate of $8.50 an hour. U uses 2.4 hours at the rate of $8.00 an hour. U can sell what it can produce and works around the clock. Ignoring the labor-rate variance, what is the daily labor inefficiency cost? $60 $48 $34 $12 None of the above. Answer: c Learning Objective: 4 There is a 4 hour daily inefficiency where X makes 12 units per day and U makes 10 units per day per person: (2.0 – 2.4) * 8.50 = $34. This statement is an example of ________________ objective: “Avoid actual or apparent conflicts of interest and advise all appropriate parties.” Competence Confidentiality Integrity Objectivity Answer: c Learning objective: 2 This is an example of the integrity objective from the IMA’s statement of the code of conduct. This statement is an example of ________________ objective: “Disclose fully all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, comments, and recommendations presented.” Competence Confidentiality Integrity Objectivity Answer: d Learning objective: 2 This is an example of the objectivity objective from the IMA’s statement of the code of conduct. Uptimum Company (U) uses a benchmark (X) for its labor performance. X uses 2 hours of labor at the rate of $8.50 an hour. U uses 2.4 hours at the rate of $8.00 an hour. U can sell what it can produce and works around the clock. U has 10 workers for each 8 hour shift. How many more units per week of five-days could U produce if it reaches the efficiency level of X? 6 8 10 12 None of the above. Answer: c Learning Objective: 4 24/2.4 = 10; 24/2 = 12 current daily production in 24 hours per 3-men (three shifts): 2 * 5 = 10 Chapter 2 Product Costing Systems: Concepts and Design Issues Chapter Outline Cost Management Challenges – There are three questions addressed in this chapter: What are the significant inputs to a production process, and how do cost managers track the flow of costs through the process? How can alternative methods to calculate product costs create different incentives? How should cost managers measure costs for internal decision making? Learning objectives: This chapter has nine learning objectives: Explain the role of product costs, period costs, and expenses in financial statements. Prepare an income statement and a schedule of cost of goods manufactured and sold. List the components of manufacturing cost, and diagram their flow through a manufacturing process. Explain how unit-level, variable, and fixed costs differ. Understand the concepts of opportunity costs, sunk costs, committed costs, direct costs, and indirect costs. Prepare income statement using absorption, variable, and throughput costing. Reconcile income under absorption, variable, and throughput costing. Discuss the advantages and disadvantages of absorption, variable, and throughput costing. The role of product costs, period costs, and expenses in the financial statements is explained. At the most basic level, a cost can be defined as the sacrifice made, usually by the resources given up, to achieve a particular purpose. Expense is defined as the cost incurred when an asset is used up or sold for the purpose of generating revenue. Product cost is a cost assigned to goods that were either purchased or manufactured for resale. Product costs are inventoriable. Cost of goods sold is the expense measured by the cost of the units sold during a specific period of time. Period costs are identified with the time period in which they are incurred rather than with units of purchased or produced goods. Preparing income statement and schedule of cost of goods manufactured and sold is explained. Service firms provide customers a product that is consumed as it is produced. Thus, service firms do not carry inventories of produced goods and do not have a line item for cost of goods sold in their income statements. Retail and wholesale companies (merchandising) sell tangible products that can be inventoried. These companies show a separate line item for cost of goods sold in their income statements. Subtracting cost of goods sold from revenues provides the gross margin. Other expenses (selling and administrative) are subtracted to arrive at operation income. At the end of the year, any inventory on hand for merchandising firms is considered an asset which is valued at its product cost. Merchandise bought is valued at cost plus transportation costs. Manufacturing companies carry three kinds of inventory: a) inventory of raw materials for goods bought to be converted, b) work in process inventory for goods which are being converted, and c) finished goods inventory for items completed and ready to be sold. For both merchandising and manufacturing companies, unsold inventories of any type are considered assets until they are sold. All expenses, except inventoriable costs, are considered period costs and are charged to expense and appear in the income statement of the period incurred. The components of a statement of cost of goods manufactured and sold for a manufacturing company are: raw material inventory beginning of the period + purchases – raw materials end of the period = raw material used; raw material used + direct labor + manufacturing overhead = total manufacturing costs (TMC); TMC + work in process (WIP) beginning – WIP end of the period = cost of goods manufactured (CGM); CGM + finished goods inventory beginning = finished goods inventory ending = cost of goods sold. An income statement includes the following items: Sales – cost of goods sold (as illustrated in the above paragraph) = gross profit; gross profit – selling and administrative expenses = operating income; operating income – income tax = net income. Components of manufacturing costs are explained. Direct materials are resources such as raw materials, parts, and components that one can feasibly observe being used to make a specific product. Insignificant items may be classified as indirect costs as part of the overhead accounts. Direct labor is the cost of compensating employees who transform direct materials into finished product. This cost includes the fringe benefits for these workers. Manufacturing overhead includes all costs of transforming materials into a finished product other than direct materials and direct labor. Indirect materials are those that either are not a part of the finished product but are necessary for its manufacture or are part of the finished product but are insignificant in cost. Indirect labor cost consist of the wages of production employees who do not work directly on the product but are required for the manufacturing facility to operate. Support services such as maintenance department do not work directly on the product but are necessary for the production process to operate as such they are part of the overhead cost. Overtime premium is the extra hourly component paid to an employee who works beyond the time normally allowed and is usually classified as part of the overhead cost. Idle time is time not spent productively by employee due to part shortage, waiting time, etc. and is another overhead component. Prime costs include direct material and direct labor. Conversion costs include direct labor and manufacturing overhead. Notice the overlap. Non-manufacturing costs include the costs of selling and administration and are among the period costs for an entity. The cost flow in a manufacturing firm is from raw materials to work in process to finished goods and finally to cost of goods sold. Understanding of costs from different angles is important for effective cost management. An activity is any discrete task that an organization undertakes to make or deliver a good or service. A cost driver is a characteristic of an activity or event that causes costs to be incurred by that activity or event. For example, insurance claims is an activity and the primary cost driver is possibly the number of claims processed. The difference between unit level fixed and variable costs is explained: Variable costs change in direct proportion with a change in the activity volume. We need more material when we produce more of a product. We may also need more workers if we want to produce more products. Fixed costs remain unchanged as the volume of activity changes. For example, we may still have one store manager even if our sales volume doubles. We may still pay the same rent for our plant even if our production volume decreases substantially. The concept of fixed and variable costs is often discussed in terms of a relevant range where these possibilities hold true. The classification is also dependent on the time-frame; i.e., the shorter the time-frame, the more of the costs are fixed, and the longer, the time-frame, the more of the costs are variable; i.e., for more sales, we ultimately need perhaps, a larger space and a larger sales force – everything else being equal. The question of fixed and variable may be partially based on cost driver that we choose. For example, set up costs for machines may be a fixed cost if we consider volume of production as the cost driver. But set up costs may be considered variable if the cost driver in question is the number of set ups needed to produce certain products. Cost hierarchy expands on our initial limitation of fixed and variable costs and classifies costs into unit level, batch level, product level, and facility-related costs. Unit level costs are incurred for every unit of product manufactured or service produced. Example: electricity to run machines. Batch-level costs are incurred for every batch of product or service produced. Example: material handling. Product-level costs are incurred for each line of product or service. Example: product design. Facility or general-operations-level costs are incurred to maintain the overall facility and infrastructure of the organization. The difference between cost of resources used and resources supplied is explained: 1. The distinction is important. Only when resources supplied merge equally with the resources used, we are at an optimum level until other efficiencies are achieved. Otherwise, we would either have a bottleneck where too much is supplied for the next operation to be able to use or there might be not enough supplied for the operation for its normal needs. The management task is to find the optimum between resources supplied and resources used. The terms, committed costs, opportunity costs, sunk costs, direct costs, and indirect costs are explained: Committed cost do not vary with change in production or sales volume. For example, if we have a labor contract that forces us to pay regardless of needs, it becomes a committed cost. Opportunity cost is a foregone benefit that could have been realized from the best alternative use of resources. The money you could have earned instead of going to school is an opportunity cost. Sunk costs are past payments for resources that cannot be changed by any current or future decision. As such, they are irrelevant in managerial decision making. In cost-management decisions, we must look for relevant costs. Costs that make a difference with regard to choosing among certain alternative. If you want to buy a product rather than making it, what costs do you really save if you instead decide to buy the product. Direct costs of a cost object are traceable to that cost object. We can trace material and labor costs (direct portion) to a product but not overhead. On the other hand, we can trace salaries, material, labor, and supplies costs to a department but not the share of costs related to the department as claimed by personnel or facility planning departments. Indirect cost of a cost object are not feasibly traceable to that cost object. For example, we can not trace the supervisor’s cost associated with a particular product. Cost object is any end to which a cost is assigned. Income statements may be prepared using absorption, variable, and throughput costing methods: Absorption or full costing applies all manufacturing overhead costs to manufactured goods. Variable or direct costing applies only variable manufacturing overhead to manufactured goods as a product cost along with direct material and direct labor. Assume that you produced 100 units that cost 20,000 – 75% of which is for fixed costs – and sell for $250 a unit. If you sell 100 units (assume no beginning inventory), your profit would be the same whether you use full costing or variable costing. Full costing income: 25,000 – 20,000 = $5,000. Variable costing income: 25,000 – 5,000 – 15,000 = $5,000. However if you produce 100 and sell, say, 80 units, there will be a difference: Full costing income: (250 * 80) – (200 * 80) = $4,000. Variable costing income: (250 * 80) – (50 * 80) – 15,000 = $1,000. All fixed costs under variable costing is considered period cost whereas, under full costing, the portion of fixed costs attributable to the units not sold remains in inventory until sold. Under variable costing, we use a contribution margin format of income statement where we subtract variable costs from revenue to arrive at contribution margin and then subtract all fixed costs to arrive at operating income. Reconcile income under absorption, variable, and throughput costing: The difference in income between absorption costing and variable costing is the fixed cost portion of cost in inventory that is deferred as asset under full costing and charged to expense under variable costing. Assume that you produced 100 units that cost 20,000 – 75% of which is for fixed costs – and sell for $250 a unit. Sales amounted to 80 units, and there was no beginning inventory. Income under full costing amounts to $4,000 and amounts to $1,000 under variable costing. The difference of $3,000 between the two methods can be reconciled as the fixed cost per unit times the number units in inventory: 20 * 150 = $3,000. In a just-in-time inventory system where inventory is non-existent, there will be no difference in income if either method is used. In throughput costing all costs except material costs are considered period costs. Reconciliation method is similar in terms of approach to the other methods. In situations with increase in inventory, income under full costing would be higher than income under variable costing. Reverse is also true. Advantages and disadvantages of absorption costing, variable costing, and throughput costing are discussed: Absorption costing is non-intuitive, confusing, and subject to manager’s manipulation of income; i.e., produce more to show a higher level of income. Absorption costing, however, is more representative of the long-term cost of the product because it incorporates the fixed cost into the product cost. Many managers prefer to use full costing for their product pricing decisions because it provides a more realistic measure of costs. Variable costing, however, is more helpful for short-term decisions with regard to pricing as well s profitability of the firm. Throughput costing was not adequately discussed in this chapter. It is the extreme in variable costing in that it assigns only the unit-level spending for direct costs as the cost of products or services. Accordingly, with higher production and lower sales, it would show a considerably lower profit as compared to absorption costing or even variable costing. As more costs tend to be considered fixed in the short-run, this methods provides another good short-term measure of performance. Problem 1 – Chapter 2 LO: 6 & 7 Completion time: 40 minutes Variable costing, absorption costing, and throughput costing Group discussion on its merits and computation intricacies. Omid Printing produces two thousand volumes of books in a period. The unit level costs are considered to be material and labor and amount to $25 per book. Other variable costs amount to $25,000 for the period. Fixed costs amount to $64,000 for the period. 1800 of these books were sold in the same time period. The selling is $90 a copy with a 10% paid as sales commission. Required: Prepare income statement under a) absorption costing, b) variable costing, c) throughput costing. Reconcile the difference in income between the three methods. Discuss the advantages and disadvantages of the methods outlined. Solution: Cost per unit under the three method: Material and labor 25.0 Other variable costs 12.5 Fixed costs 32.0 69.5 Throughput cost 25.0 Variable cost 37.5 Full cost 69.5 Sales volume 1800 Selling price 90 Throughput Variable Absorption Sales 162000 162000 162000 Cost of sales 45000 67500 125100 Margin 117000 94500 36900 Sales commission 16200 16200 16200 Fixed costs 89000 64000 Income before taxes 11800 14300 20700 Difference -2500 -8900 Reconciliation 200 * 12.50 200 * 44.50 Diff. (full vs. variable) -6400 Reconciliation 200 * 32 3. In the very short time period, there is not much we can do about fixed costs and even some of the variable costs such as maintenance and part of utility costs. So throughput costing and variable costing provide a more realistic picture of profitability. It is also more conservative. In the sense that if we are unable to sell inventory or sell it at a disposable value equaling to its variable costs, variable costing or throughput costing provides us with a more realistic picture. These methods are also more realistic in the short-run because they do not defer fixed costs as part of inventory costs and write them off to expense. This is more in line with the definition of fixed costs and what it means. Problem 2. LO 5 Assume that Printing Impression has two divisions X & Y with a home office that has a cost of $96,400 for the year. Taxes amount ot 30% of income. Other data for the two divisions for 2008 follow: Sales $675,000 $325,000 Cost of sales 60% 40% Selling and admin. costs $89,500 $67,500 Depreciation (included in CGS) $124,500 $21,700 Number of employees 8 2 Required: a) determine net income for each division assuming that home office charge is allocated to each division based on sales amount, b) determine net income for each division assuming that home office charge is allocated to each division based on number of employees, c) what is each division’s indirect cost and is allocation an accounting or a management decision, d) what is the company’s sunk cost for the year., e) assume that the company has a remaining life of four years anticipating the same level of profits for the remaining years. If division Y can be sold at the end of this year for $225,000, what is the opportunity cost in case the division is sold – assuming that the home office charge will have to be absorbed totally by division X in this case. Solution: Item Division X Division Y Total Sales $ 675,000.00 $ 325,000.00 $ 1,000,000.00 Cost of sales $ 405,000.00 $ 130,000.00 $ 535,000.00 Selling & Admin. Expense $ 89,500.00 $ 67,500.00 $ 157,000.00 Home office charge $ 65,070.00 $ 31,330.00 $ 96,400.00 Income before taxes $ 115,430.00 $ 96,170.00 $ 211,600.00 You can repeat the above exercise, using number of employees as a basis of allocating home office charge (80% to X and 20% to y) and determine the net income accordingly. The indirect cost is the cost to be allocated; i.e., the home office charge. Indirect costs cannot be directly associated with the cost objective. Cost allocation is strictly an accounting rather than a management decision. It does not affect the total income for the firm regardless of how the home office charge is allocated. The sunk cost is the depreciation amount. It is the money already spent and does not affect the cash flow of the firm. The opportunity cost for the firm is the benefit lost because of selling the division; i.e., (96,170 * 4 = 384,580) versus the amount of $225,000 to be received now. Of course, this comparison does not account for a) time value of money (the money to be received now rather than in the course of four years. Neither does it address the tax implication for the sale of division Y. Problem 3. LO: 2 Ariana Design Company’s financial data for 2008 appears as follows: Item 1/1/2008 12/31/2008 Raw material inventory $48,500 $93,600 Finished goods inventory $144,600 $121,700 Work in process inventory $27,400 $38,300 The company purchased $295,000 of raw materials, incurred $128,000 in direct labor costs and overhead amounted to 200% of direct labor. Prepare a cost of goods produced and sold report for 2008 based on the above data. Solution: Item Amount Raw material inventory beginning 48,500.00 Purchases 295,000.00 Less: Raw material inventory ending (93,600.00) Raw maerials used 249,900.00 Direct labor 128,000.00 Manufacturing overhead 256,000.00 Costs to manufacture 633,900.00 Work in process inventory beginning 27,400.00 Less: Work in process inventory ending (38,300.00) Costs of goods manufactured 623,000.00 Finished goods inventory beginning 144,600.00 Less: Finished goods inventory ending (121,700.00) Cost of goods sold 645,900.00 3. Sample Quiz 1. Product cost is a cost that is identified with the period in which they are incurred. is either purchased or manufactured for resale. is manufactured as a tooling for the plant. is incurred when as asset is used up or sold for the purpose of generating revenue. Answer: b LO: 1 A product cost is a cost that is either purchased or manufactured for resale. 2. A period cost is a cost that is identified with the period in which it is incurred. is either purchased or manufactured for resale. is manufactured as a tooling for the plant. is incurred when as asset is used up or sold for the purpose of generating revenue. Answer: a LO: 1 A period cost is a cost that is identified with the period in which they are incurred such as, a sales commission paid for revenue generated in the period. Inventoriable cost is a cost that is identified with the period in which they are incurred. is either purchased or manufactured for resale. is manufactured as a tooling for the plant. is incurred when as asset is used up or sold for the purpose of generating revenue. Answer: b LO: 1 Inventoriable cost is another term for product cost. ABC company has used 210 lbs of material X. Inventory of X at the beginning of the period was 150 lbs and 180 lbs were purchased. Inventory at the end of the period should have been a. 100 lbs. b. 120 lbs. c. 140 lbs. d. 160 lbs. Answer: b LO: 3 5. [150 + 180 – 210] = 120 lbs. ABC Company used 210 lbs of x at $5 a lb. direct labor amounted to 130 hours at $8 an hour. Overhead is approximately 200% of labor, and total manufacturing cost amounted to $4,090. Actual overhead amounted to a. $2,080 b. $2,040 c. $2,020 d. $2,000 Answer: d LO: 3 6. 4,090 – [(210 * 5) + (130 * 8)] = $2,000. ABC Company sold 200 units of a product at $32 a unit that cost $21 a unit. Sales commission amounted to 10% of sales and administrative costs amounted to $1,640. Operating income amounts to a. $100 b. –100 c. $80 d. –80 Answer: d LO: 2 (200 * 32) – [(200 * 21) + (6,400 * .10) + 1,640)] = - $80. 7. ABC Company sold 200 units of a product at $32 a unit that cost $21 a unit. Sales commission amounted to 10% of sales and administrative costs amounted to $1,480. Taxes are at 25% of income. Net income amounts to a. $60 b. –60 c. $80 d. –80 Answer: a LO: 2 8. (200 * 32) – [(200 * 21) + (6,400 *. 10) + 1,480)] = $80; 80 – (80 * .25) = $60. NBC Company had a total material cost of $,1050, total direct labor of $1,040, and overhead amounting to 200% of direct labor. Prime cost amounts to $2,090 $2,080 $3,120 $4,170 Answer: a LO: 3 Prime cost: 1,050 + 1,040 = $2,090. NBC Company had a total material cost of $ 1,050, total direct labor of $1,040, and overhead amounting to 200% of direct labor. Conversion costs amount to a. $2,090 b. $2,080 c. $3,120 d. $4,170 Answer: c LO: 3 9. Conversion cost: 1,040 + 2,080 = $3,120. NHI Company had a total direct labor of 120 hours for the period at the rate of $8 an hour. Ten percent of this time was on an exceptional overtime basis with a pay premium of 50% of regular rate. Total direct labor cost amounts to $960 $1,008 $1,056 $1,104 Answer: a LO: 3 Direct labor: 120 hours * 8 = $960 NHI Company had a total direct labor of 120 hours for the period at the rate of $8 an hour. Ten percent of this time was on an exceptional overtime basis with a pay premium of 50% of regular rate. Overtime premium amounts to a. $144 and should be charged to direct labor b. $144 and should be charged to indirect labor c. $48 and should be charged to direct labor d. $48 and should be charged to indirect labor. Answer: d LO: 3 10. Overtime premium: 120 hours * 10% * $8 * 50% = $48. Overtime premium which is not part of the normal work routine is charged to indirect labor as part of manufacturing overhead. ABC Company’s current manufacturing costs amount to $4,090 and work in process at the end of the period amounted to $1,120. A total of 100 units at the cost of $41.80 were completed. Work in process at the beginning of the period amounts to a. $1,110 b. $1,120 c. $1,210 d. $1,220 Answer: c LO: 3 11. Work in process beginning: 4,180 + 1,120 – 4,090 = $1,210 where $4,180 = 41.80 * 100 units. A cost driver is any discrete task that an organization undertakes any task results in delivery of goods or services a characteristic of an activity or event that causes costs to be incurred by that activity or event none of the above Answer: c LO: 4 Answer (c) is the definition of a cost driver. Answer (a ) is the definition of an activity. Material handling cost is an example of a. unit level costs b. batch level costs c. product level costs d. facility related costs Answer: b LO: 4 12. Material handling costs are usually related to a batch of a product Machinery maintenance cost is an example of a. unit level costs b. batch level costs c. product level costs d. facility related costs Answer: a LO: 4 13. Machinery maintenance can be related to each unit of a product manufactured. Product design cost is an example of a. unit level costs b. batch level costs c. product level costs d. facility related costs Answer: c LO: 4 14. Product design depends on type of product and is a product level cost Ryan decided to buy a car that cost him $18,000. His dad could not convince him to save the money and earn an interest of 10% on it for the life of the car which is probably five years. No interest is paid on the interest earned. Opportunity cost of this decision amounts to a. $1,800 b. $9,000 c. $13,500 d. $18,000 Answer: b LO: 5 15. Opportunity cost is the benefit lost because of choosing another alternative: 18,000 * 10% * 5 = $9,000. Saba Company decided to make part A at a cost of $12 a unit which includes $6 in material and labor plus an overhead of 100% on direct cost. One half of overhead is fixed overhead that will continue regardless of making the goods or buying it from outside. The relevant cost of A for this decision is $6 $9 $12 $15 Answer: b LO: 4 Relevant cost: 6 + (6 * 50%) = $9. The fixed costs would remain regardless of this decision. With regard to fixed and variable costs, we can say that fixed cost per unit remains the same regardless of output total variable costs remain the same regardless of output unit cost which includes a small amount of variable cost remains constant regardless of volume variable cost per unit remains the same regardless of output Answer: d LO: 7 Variable cost per unit stays the same while unit cost and fixed cost per unit would be lower at higher volumes. If inventory ending in a manufacturing firm is higher than inventory beginning, income under absorption costing income is higher than income under variable costing throughput costing is higher than income under variable costing variable costing income is higher than absorption costing income none of the above Answer: a LO: 8 When inventory ending is higher, it means that production was higher than the quantity sold. Under these conditions, absorption costing income is higher than income under variable costing or throughput costing. Income under variable costing would also be higher than income under throughput costing. This is due to absorption of more fixed costs by inventory which would otherwise be written off to period costs. Absorption costing is intuitive straight-forward reports fixed versus variable manufacturing cost separately on the income statement none of the above Answer: d LO: 8 Absorption costing is non-intuitive, confusing, and considers both fixed and variable costs as part of the product cost. Identify the incorrect response. Variable costing is more helpful for long-term decisions b. is more intuitive c. separates fixed and variable costs d. considers all fixed costs as period costs. Answer: a LO: 8 While variable costing is more intuitive and separates costs into fixed and variable, reporting the former as period cost, but full cost is more of a long-term measure of costs. Anderson decided to produce 600 units more than it otherwise would have because the profit reported would be 950,000 more of which Anderson receives 10% as part of his bonus: a. this action is illegal. b. this action is unethical. c. this action is unethical and illegal d. an opinion can not be reached based on the above. Answer b LO: 9 Under the present rules, this action is not illegal. However, it is some sort of data and action manipulation for personal gain and must be discouraged, or methods must be devised (such as variable costing method of preparing income statement) so that the manager would not have such an incentive for manipulating the system. Chapter 3 Cost Accumulation for Job-Shop and Batch Production Operations Chapter Outline Cost Management Challenges — There are three questions addressed in this chapter. What factors should a cost manager consider when designing a cost system? What features should a job-cost system have, and how can they be developed? How can cost managers use job-cost information to support planning and decisionmaking activities? Learning Objectives — This chapter has eight learning objectives. Explain the difference in job-order, process, and operation costing systems. Explain how costs flow through the manufacturing accounts. Assign costs to production jobs or projects using a job-order costing system. Prepare accounting journal entries to record job costs. Use a predetermined overhead rate to assign indirect resource costs to production jobs. Explain how to measure production costs under actual, normal, and standard costing systems. Discuss the role of job-order costing in service organizations. Understand how companies manage long-term projects and their costs. Organizations choose among costing systems by considering two things. First, how detailed and specialized must costs of each product be? Second, must periodic costs be accumulated from the beginning of the life of a product until it is sold? Answering these questions helps managers to choose from three different types of costing systems. They are job costing, process costing, and operation costing. 1. Job costing (or job-order costing) treats each job as a unit of product. Costs are allocated based on resource use in each job. Job costing helps managers to identify jobs that will be profitable, so organizations can more clearly define the scope and scale of its operations. Job costing provides data that is useful for predicting costs of future jobs. Job costing allows costs of current jobs to be better managed and controlled. It facilitates re-negotiation of job contracts if changes in jobs occur. Job costing provides information that allows comparison between actual and expected outcomes. Throughput time is the average time required to convert raw materials into finished goods. Many firms are getting away from direct labor cost identification, but understanding throughput is still considered significant. Process costing treats all units of product the same. Process costing is useful when all units of product use virtually the same resources in the same way. A producer of sunflower seeds is not likely to keep track of each pound of seeds as a separate job. Operation costing is a hybrid of the two extremes. Job order costing assumes each job is a unique, distinct unit of product. Process costing assumes each unit of product is virtually the same. Hybrid costing is most commonly used when batches of similar products are made that are virtually the same within the batch but each batch is a unique, distinct job. Garment and shoe industries use a variety of styles and qualities of fabric and leather but virtually the same labor and overhead for various products. The basic cost-flow model in accounting for inventory can be used for job costing. The model is as follows. 1. Beginning balance + costs transferred in – costs transferred out = ending balance. Costs in the beginning balance are from prior periods, and represent costs of resources used so far. They may be unit, batch, product, customer, and facility- level costs assigned using cost-driver rates. Resources used, or transferred-in, in a subsequent period are assigned in the same way. Transfers out reflect costs of goods or services that are either completed and ready for sale or are partially completed goods being transferred to another department for additional production activities. Transferred-out may also represent defective or scrapped products. The ending balance is the amount of cost that remains on a job. In job costing, an ending balance is an indication that the job has not been completed. 2. Because reporting of business activity occurs periodically but completion of jobs generally does not occur at the end of a reporting period, job cost reporting must reflect the value of jobs at interim points before they are completed. There are two inventory accounts in which costs of jobs are accumulated. They are Work-in Process (WIP) inventory and Finished-goods inventory (FGI). Work-in-Process inventory accumulates all costs of resources used on jobs that have not been completed. Each job has its own subsidiary account, where costs specific to the job are recorded. Finished-goods inventory is an account where costs of all completed jobs are recorded. These costs are transferred from WIP inventory when a job is completed. The costs remain in FGI until the job is sold. Once sold, the costs of a job are transferred to an expense account called cost of goods sold. Tracing and assigning costs to jobs requires (1) choosing methods for tracing costs to jobs; (2) setting predetermined cost-driver rates; and (3) using the predetermined cost-driver rates. 1. There are four methods for tracing and assigning costs to jobs. Actual costing assigns actual costs as they occur. Although accurate, only unit and batch-level costs can be assigned immediately. Higher-level costs must be assigned later. In addition to the inability to assign higher-level costs immediately, they also cannot be traced directly to a particular job. Normal costing uses actual costs for lower-level resources and average costs for higher-level resources. Budget costing uses expected costs of resource use. It is useful when it is likely that costs will change in the future. Standard costing is a widely used approach, where standard costs and rates are used to assign costs to products. 2 Predetermined cost-driver rates are developed for resources above unit-level, and these rates are used to apply costs to jobs. If a traditional costing system other than ABC is used, the predetermined cost-driver rate may be referred to as a predetermined overhead rate or a burden rate. Developing predetermined cost-driver rates requires a lot of estimation, described below. For estimating cost-driver rates for higher-level activities, all activities must be defined and categorized by level. Then the costs of all of these levels must be estimated. These cost estimates are usually based on past experience, current conditions, and expected changes. Next, cost-driver bases must be chosen. Sometimes a cost-driver base is obvious for a facility-level resource. At other times, a valid cost-driver base cannot be identified. After choosing the cost-driver base, the quantity of the base must be estimated. Finally, the predetermined cost-driver rate can be calculated by dividing the estimated cost of a resource by the estimated quantity of the chosen cost-driver base. These rates are then used to apply costs to jobs based on the actual amount of use of the cost driver. 3. Predetermined cost-driver rates are used to assign higher-level resource costs. Actual unit or batch-level costs can be assigned without a predetermined cost-driver rate. Some higher-level resources in a job-costing environment may be grouped together as general and administrative costs. Companies using job costing usually have many jobs being worked on at the same time. An accounting system must allow the organization to keep track of all jobs separately and must maintain records of all jobs in progress, completed, and sold. It must also record activity for WIP inventory, FGI, and cost of goods sold. 1. A job cost accounting system records information in a journal, usually maintained on a computer system. This information is summarized, and the totals are recorded in general ledger accounts. The general ledger accounts contain balances of all accumulated effects of transactions. Three general ledger accounts important in a job costing system are Work-in-Process inventory, Finished-goods inventory, and cost of goods sold. The general ledger account, Work-in-Process inventory, is a control account containing total costs for all incomplete jobs. There is also a subsidiary ledger account that contains details for each job. General ledger accounts are depicted in textbooks as “T” accounts. The left-hand side of a T-account for inventory, like WIP or FGI, or for an expense account, like cost of goods sold (CGS), is called the “debit” side. The right-hand side of an inventory or expense account is called the “credit” side. Increasing an inventory or expense account is accomplished by “debiting” the account. Decreasing an account like WIP, FGI, or CGS occurs by “crediting” the account. Inventory accounts cannot have a credit balance. That is like saying that you have a negative amount of materials on hand. A T-account for WIP inventory, for one job, is shown below. JOB 598 BB $5,000 TI $ 500 $5,500 TO EB $0 BB is the beginning balance, TI is costs transferred in during the period, TO is for costs transferred out of Job 598. In this example, the job is completed, and costs are transferred to FGI. c. The simplest job costing system used to assign higher-level resource costs to jobs is one that uses one predetermined rate, called the overhead rate. Job costs are summarized for three reasons. (1) A job is completed, and costs must be summarized to determine the total cost of the job. (2) A job is sold. (3) The end of an accounting period makes it necessary to report the status of all jobs. When jobs are completed, amounts are transferred from WIP inventory to FGI. When jobs are sold, balances are transferred from FGI to CGS. Price minus CGS = Gross Profit. At month-end or year-end, a company’s books are closed and financial statements are prepared. Since it is not likely that every job will be complete at the end of an accounting period and every completed job will not have been sold, it is necessary to update the balances in the inventory accounts. Cost of goods sold must be closed at the end of each accounting period. Adjustments must be made to the overhead account at the end of a period. Higher-level resource costs, which collectively are called overheads, are expenses, and expense accounts must be closed at the end of an accounting period. The overhead control account is a summary total of all higher-level resource costs. Subsidiary ledger accounts contain detail of the overhead control account. The detail is based on the type of cost. Actual costs are accumulated in the control and subsidiary ledgers by debiting these expense accounts. These higher-level costs are assigned to jobs using the predetermined overhead (or cost-driver) rate. Since the rate is derived using estimated costs and activity but costs are assigned to jobs based on the rate and actual activity, there is usually a mismatch between the amount assigned and the amount that actually occurs. The difference between the amount applied to jobs and the amount of actual overhead expense incurred is called an overhead variance. There are two reasons an overhead variance occurs. Either actual spending differed from budgeted spending, or actual activity was different from budgeted activity. The first difference results in an overhead spending or budget variance. The second difference results in an overhead activity or volume variance. Overhead costs can be over-applied to jobs, meaning that more overhead costs were assigned than actually occurred. Overhead costs may also be under-applied, meaning that less cost was assigned to jobs than occurred. Since the overhead control account is an expense account, the amount of overhead over-applied or under-applied needs to be disposed of. There are two ways to dispose of overhead variances. One way is to assign them to cost of goods sold. The other way is to prorate them among WIP, FGI, and CGS. The latter method is necessary only if the amount of variance is considered to be material. The flow of overhead costs through the accounting system is as described below. Actual overhead costs are accumulated in the overhead control (and subsidiary) accounts. At the end of an accounting period, overhead costs are assigned to jobs in WIP inventory, based on predetermined overhead (or cost-driver) rates and actual activity for the jobs receiving the overhead costs. If more costs are assigned to jobs than actually occurred, then the overhead control account and corresponding subsidiary accounts must be closed by debiting them by amounts equal to the credit balance. If fewer costs are assigned than actually incurred, then the overhead accounts must be credited by amounts equal to the debit balances. Some organizations set up separate accounts to reflect spending and activity variances in order to separate them from the overhead account. In that case, it is the variance accounts that must be closed. the amounts of the variance are written off to cost of goods sold, then whatever amount is taken from the overhead (or variance) account is assigned to cost of goods sold. If the amounts are prorated among WIP inventory, FGI, and CGS, then they are usually prorated based on the existing balances in each of the three accounts. Complex jobs that take a long time (months or even years) to complete are called projects. Unlike some jobs, which may be completed before a customer is identified, projects normally are not initiated unless a customer has requested that the work be performed. In most cases, organizations must submit bids for projects. Bids are based on estimated costs and estimated uses of resources and time. Profits are also estimated and factored into the bid. If an organization submits a low bid with unrealistically low cost estimates, any cost overruns come directly out of profits. There are two control issues for the manager of a project. They are related to control and management of project cost and to proper budgeting and use of project time. Project cost is estimated before the project begins and usually is developed from the estimates used in the bidding process. The project manager spreads the cost budget over the expected time to complete the project. As the project progresses, the manager periodically evaluates the budgeted cost of work completed versus the actual cost of work completed. Also evaluated is the budgeted percentage of work completed versus the actual percentage of work completed. If actual costs are greater than budgeted costs for the percentage of work done, then the project has “cost overruns.” The manager must also see whether a project is on schedule, so periodically checks to see what percentage of the project is actually complete compared to what percentage should have been completed by pre-specified points in time. Project scheduling can be depicted using a Gantt chart, which shows the timing and sequencing of major project activities. All activities of a project are displayed on the chart month by month (or week by week). Both planned and actual times are shown. A Gantt chart allows a project manager to anticipate delays and bottlenecks, so that scheduling of subsequent activities can be revised accordingly. 3. Job and project costs can, at times, far exceed estimates or may be incorrectly reported or charged. The most common improprieties are (1) misstating the stage of completion; (2) charging costs to the wrong job intentionally to reduce cost overruns on a job; and (3) misrepresenting costs on jobs in order to receive a larger payment for a job. Job costing systems are indispensable for reporting and controlling the costs of jobs. Profitability can be easily assessed job by job if job costing is used. Overhead variance may be prorated among cost of goods sold, finished goods inventory, and work in process inventory based on the balances in those accounts. If the variance is significant, this approach is preferable to writing all the variance off directly to cost of sales. In this manner, the accounts are adjusted to be closer to what the actual costs would have been. Problem 1 – Chapter 3 JVC Company has three jobs outstanding. The company uses normal costing and the overhead rate which is based on machine hours amounts to $96 per machine hour based on a forecast of 4000 hours. Job A with a direct cost of $94,300 has used 1290 machine hours. Job B with a direct cost of $74,700 has used 1,760 machine hours. Job C with a direct cost of $87,470 has used 789 hours. Actual overhead amounted to $449,700. Job A is completed and sold for $276,500. Job B is completed and not yet delivered. Job C is still in process. Over/underapplied overhead is prorated to cost of sales and inventory accounts based on the amount of overhead charged to each job. Required: a) determine the amount of overhead applied, b) determine the over/underapplied overhead amount, c) prorate the overhead to the cost of sales and inventory accounts, d) prepare the necessary journal entries for the disposition of variance. Solution: Overhead applied: Job A – 1,290 * 96 = $123,840. This job is completed and charged to cost of goods sold. Job B – 1,760 * 96 = $243,660. This job is completed and charged to finished goods inventory. Job C – 789 * 96 = $75,744. This job is still in process. 123,840 + 243,660 + 75,744 = $443,244. This is the amount of overhead applied. 443,244 – 449,700 = -$6,456. Overhead is underapplied by this sum. Proration to cost of sales and inventory accounts: Job A – (123,840 / 443,244) * 6,456 = $1,803.77 Job B – (243,660 / 443,244) * 6,456 = $3,548.99 Job C – (75,744 / 443,244) * 6,456 = $1,103.24 Journal entry: Cost of goods sold 2,169.22 Finished goods inventory 2,960.08 Work in process inventory 1,326.70 Manufacturing overhead 6,456.00 To account for underapplied overhead for the period. Problem 2. LO: 3 and 4 Refer to problem 1 and prepare the necessary journal entries for same: Solution: Dr. Work in process $443,244 Cr. Manufacturing overhead $443,244 To account for manufacturing overhead applied Dr. Cost of goods sold $218,140 Cr. Work in process $218,140 To account for completion and delivery of Job A Dr. Finished goods inventory $536,500 Cr. Work in process $536,500 To account for completion of Job B Dr. Manufacturing overhead $449,700 Cr. Various accounts $449,700 For manufacturing overhead costs incurred Dr. Work in process $443,244 Cr. Manufacturing overhead $443,244 For manufacturing overhead applied Note that direct cost entries are assumed to have already been made. Also note that overhead applied could be charged to an account by that name and then offset against the actual manufacturing overhead account when disposing of over/underapplied overhead balance per item (d) above in problem 1. Problem 3. LO: 6 Ryan Arman, the CFO, is considering an overhead application method for the firm. Actual overhead amounted to $347,100 for 8,900 machine hours whereas, the budget was based on 10,000 machine hours for a forecasted budget of 395,000. Other data for the year is provided in the following table: Item Direct cost of the job Related machine hours Job A $1,274,600 Actual = 2,650; Std. = 2,600 Job B $679,450 Actual = 1,745, Std. = 1,790 Job C $397,960 Actual = 3,175, Std. = 3,050 Job D $448,580 Actual = 1,330, Std. = 1,290 Required: Use the above data to determine the amount of overhead applied using a) actual costing, b) normal costing, and c) standard costing. D) prepare the necessary journal entries for the overhead amount applied. Solution: Actual overhead rate per hour: 347,100 / 8,900 = $39.00 per hour Standard overhead rate per hour: 395,000/10,000 = 39.50 per hour Item Actual hours Std. hours Actual costing Normal Costing Std. Costing Job A 2,650 2,600 103350 104675 102700 Job B 1,745 1,790 68055 68927.5 70705 Job C 3,175 3,050 123825 125412.5 120475 Job D 1,330 1,290 51870 52535 50955 Totals 8,900 8,730 347,100 351,550 344,835 Dr. Work in process $347,100 Cr. Manufacturing overhead $347,100 Overhead applied under actual costing Dr. Work in process $351,550 Cr. Manufacturing overhead $351,550 Overhead applied under normal costing Dr. Work in process $344,835 Cr. Manufacturing overhead $344,835 Overhead applied under standard costing Note that over or underapplied overhead needs to be disposed of to cost of goods sold (if insignificant) or prorated to work in process, finished goods inventory, and cost of goods sold (if significant). Problem 4. LO: 8 Arman Omid wants to prepare a projection for his activities for the month of March 2008 for a major job. He expects to secure the major job on March 3. The job will be immediately assigned to Saba to prepare all the technical detail. This is expected to take five days. The job will then be turned over to production who needs seven days to complete the job. After production, the work needs to be turned over to binders who need 10 days for binding. After the work is completed, it will need to be shipped to California which should take four days to get there. The contract is for $375,000 and is to be completed by March 31. For every day of delay, there will be a penalty of $5,000. If the delay is in excess of 15 days, all the down payment needs to be refunded. The job was turned over to Saba on March 4th and took him seven days to complete. It took production ten days, and the binders 15 days to do their part, and it took another five days for the completed work to reach the customer. Required: Prepare a Gantt chart to view the forecasted versus actual completion of the job and compute the amount of penalty if any. How could Omid protect himself in order not to have to pay penalties? You can prepare the Gantt chart by reviewing the appropriate section in the textbook. Ideally the job must be completed in 29 days (counting from March 1st) which provides two days of leeway until March 31st. Unfortunately, it took Omid 34 days to get the work delivered. There is the possibility that he has to pay $15,000 in penalty if the customer is too strict with regard to this transaction. Omid can protect himself against paying penalties by having the employees involved in this process, making sure that they are given enough time. He should also give them proper incentives for meeting deadline, and possibly reasonable penalties for missing deadlines. If the shipment is subcontracted, he should ask for similar assurances or insurance for timely delivery of the merchandise. In addition, Omid may also be able to get some leeway from the customer to accept delays of 2 or 3 days which must be considered delays within reason. Sample Quiz Operation costing assigns costs to each job as resources are used. treats all the units processed as the output to be costed. is used when large batches of similar products are made which use different materials. d. None of the above. e. a and b Answer: c Learning Objective: 1 Operation costing is used when large batches of similar products are made which use different materials such as, garment industry. As examples for job order costing we can name H & R Block’s tax returns. Dell’s computers. a heart transplant surgery. Quaker Oats’ oatmeal. None of the above. Answer: c Learning Objective: 1 A heart transplant surgery needs a job costing system to be able to keep track of costs associated with that specific operation. Note also that if H & R Block uses significantly different tax returns requiring different amounts of time and resources, a job order costing may be used for same. Assume work in process beginning of $16,000, added costs of $95,000. Cost of goods completed amounts to $89,000, and there is an additional cost of defective goods amounting to $3,650. The work in process ending amounts to a. $32,000 $28,350 $22,000 $18,350 None of the above. Answer: d Learning Objective: 3 WIP ending: 16,000 + 95,000 – 89,000 – 3,650 = $18,350 Budgeted cost uses expected costs of resource use. is more appropriate when conditions are expected to be different from the past. uses average past spending for higher-level resources. None of the above. a and b Answer: e Learning Objective: 2 Budgeted cost uses expected costs of resource use and is more appropriate when conditions are expected to be different from the past. ABC Company’s overhead amounts to $300,000 per period based on an output of 200 units of A, 300 units of B, and 500 units of C. Direct labor costs of A, B, and C per unit amount to $75, 50, and 40 respectively. Each unit also requires 7, 12, and 20 machine hours per unit of production. Using direct labor as cost driver, total overhead chargeable to job/product A amounts to a. 90,000 100,000 110,000 20,000 None of the above. Answer: a Learning Objective: 2 Overhead for A: DL = [(200 * 75) + (300 * 50) + (500 * 40)] = $50,000; 300,000 / 50,000 = 6 times 15,000 * 6 = $90,000. ABC Company’s overhead amounts to $300,000 per period based on an output of 200 units of A, 300 units of B, and 500 units of C. Direct labor costs of A, B, and C per unit amount to $75, 50, and 40 respectively. Each unit also requires 7, 12, and 20 machine hours per unit of production. Using direct labor as cost driver, overhead chargeable per unit of C amounts to a. 240 300 360 450 None of the above. Answer: a Learning Objective: 2 Overhead per unit of C: DL = [(200 * 75) + (300 * 50) + (500 * 40)] = $50,000; 300,000 / 50,000 = 6 times; 20,000 * 6 = $120,000; 120,000 / 500 = $240. ABC Company’s overhead amounts to $300,000 per period based on an output of 200 units of A, 300 units of B, and 500 units of C. Direct labor costs of A, B, and C per unit amount to $75, 50, and 40 respectively. Each unit also requires 7, 12, and 20 machine hours per unit of production. Using machine hours as cost driver, overhead chargeable per unit of B amounts to a. 140 240 340 400 None of the above. Answer: b Learning Objective: 2 Overhead per unit of B: [(200 * 7) + (300 * 12) + (500 * 20)] = [1,400 + 3,600 + 10,000] = 15,000; 300,000 / 15,000 = $20; 12 * 20 = $240. ABC Company’s overhead amounts to $300,000 per period based on an output of 200 units of A, 300 units of B, and 500 units of C. Direct labor costs of A, B, and C per unit amount to $75, 50, and 40 respectively. Each unit also requires 7, 12, and 20 machine hours per unit of production. Using machine hours as cost driver, overhead chargeable in total for C amounts to a. 28,000 72,000 144,000 200,000 None of the above. Answer: d Learning Objective: 2 Overhead for C: [(200 * 7) + (300 * 12) + (500 * 20)] = [1,400 + 3,600 + 10,000] = 15,000; 300,000 / 15,000 = $20; 500 * 20 * 20 = $200,000. ABC Company’s overhead amounts to $300,000 per period based on an output of 200 units of A, 300 units of B, and 500 units of C. Direct labor costs of A, B, and C per unit amount to $75, 50, and 40 respectively. Each unit also requires 7, 12, and 20 machine hours per unit of production. Assuming that 40% of overhead relates to labor and 60% relate to machine hours, the overhead chargeable per unit of A amounts to a. 234 264 296 336 None of the above. Answer: b Learning Objective: 2 Overhead for A: DL = [(200 * 75) + (300 * 50) + (500 * 40)] = $50,000; OH/DL$ = [300,000 * 40%] / 50,000 = $2.4; M hrs = [(200 * 7) + (300 * 12) + (500 * 20)] = [1,400 + 3,600 + 10,000] = 15,000; OH per M hr = (300,000 * 60%) / 15,000 = $12; (2.4 * 75) + (7 * 12) = $264. JVC Company has three jobs outstanding. The company uses normal costing and the overhead rate which is based on machine hours amounts to $96 per machine hour based on a forecast of 4000 hours. Job 1 with a direct cost of $94,300 has used 1290 machine hours. Job 2 with a direct cost of $74,700 has used 1,760 machine hours. Job 3 with a direct cost of $87,470 has used 789 hours. Actual overhead amounted to $375,000. Budgeted overhead amounts to a. 368,544 375,000 384,000 394,000 None of the above. Answer: c Learning Objective: 3 Budgeted overhead: 4,000 * 96 = $384,000. JVC Company has three jobs outstanding. The company uses normal costing and the overhead rate which is based on machine hours amounts to $96 per machine hour based on a forecast of 4000 hours. Job 1 with a direct cost of $94,300 has used 1290 machine hours. Job 2 with a direct cost of $74,700 has used 1,760 machine hours. Job 3 with a direct cost of $87,470 has used 789 hours. Actual overhead amounted to $375,000. Job 1 is completed and sold for $276,500. Job 2 is completed and not yet delivered. Job 3 is still in process. Job 1’s total cost amounts to a. 163,214 218,140 243,660 262,164 None of the above. Answer: b Learning Objective: 3 Job 1: 94,300 + (1,290 * 96) = $218,140 JVC Company has three jobs outstanding. The company uses normal costing and the overhead rate which is based on machine hours amounts to $96 per machine hour based on a forecast of 4000 hours. Job 1 with a direct cost of $94,300 has used 1290 machine hours. Job 2 with a direct cost of $74,700 has used 1,760 machine hours. Job 3 with a direct cost of $87,470 has used 789 hours. Actual overhead amounted to $375,000. Job 1 is completed and sold for $276,500. Job 2 is completed and not yet delivered. Job 3 is still in process. The entry for job 2 is a. Dr. accounts receivable, Cr. Sales. Dr. cost of sales, Cr. Work in process. Dr. finished goods inventory, Cr. Work in process. Dr. work in process, Cr. finished goods inventory. None of the above. Answer: c Learning Objective: 3 Job 2 is completed and not yet sold so we take it out of WIP and store it as FG. JVC Company has three jobs outstanding. The company uses normal costing and the overhead rate which is based on machine hours amounts to $96 per machine hour based on a forecast of 4000 hours. Job 1 with a direct cost of $94,300 has used 1290 machine hours. Job 2 with a direct cost of $74,700 has used 1,760 machine hours. Job 3 with a direct cost of $87,470 has used 789 hours. Actual overhead amounted to $375,000. Overhead spending variance amounts to a. 6456 unfavorable 9000 favorable 15456 favorable 15456 unfavorable None of the above . Answer: a Learning Objective: 3 Overhead spending variance: 375,000 – (4,000 * 96) = $9,000; actual minus budgeted amount JVC Company has three jobs outstanding. The company uses normal costing and the overhead rate which is based on machine hours amounts to $96 per machine hour based on a forecast of 4000 hours. Job 1 with a direct cost of $94,300 has used 1290 machine hours. Job 2 with a direct cost of $74,700 has used 1,760 machine hours. Job 3 with a direct cost of $87,470 has used 789 hours. Actual overhead amounted to $375,000. The under/overapplied overhead is a. 6456 underapplied 6456 overapplied 15456 underapplied 15456 overapplied None of the above. Answer: a Learning Objective: 3 Underapplied overhead: [(1290 + 1760 + 789) * 96] – 375,000 = $6,456 JVC Company has three jobs outstanding. The company uses normal costing and the overhead rate which is based on machine hours amounts to $96 per machine hour based on a forecast of 4000 hours. Job 1 with a direct cost of $94,300 has used 1290 machine hours. Job 2 with a direct cost of $74,700 has used 1,760 machine hours. Job 3 with a direct cost of $87,470 has used 789 hours. Actual overhead amounted to $375,000. Job 1 is completed and sold for $276,500. Job 2 is completed and not yet delivered. Job 3 is still in process. Assume that spending variance amounts to $9,000 favorable. If over/underapplied overhead is prorated to cost of sales and inventory accounts based on total costs in each job, cost of sales will be a. debited by 3141 credited by 3141 debited by 3508 credited by 3508 None of the above. Answer: b Learning Objective: 3 The favorable variance credited to cost of sales should be based on determining the total cost first: [94,300 + (1290 * 96)] + [74,700 + (1760 * 96)] + [87,470 + (789 * 96)] = $625,014; Job A is sold its ratio to total is 218,140 / 625,014 = 34.9%; 9,000 * 34.9% = $3,141 favorable. JVC Company has three jobs outstanding. The company uses normal costing and the overhead rate which is based on machine hours amounts to $96 per machine hour based on a forecast of 4000 hours. Job 1 with a direct cost of $94,300 has used 1290 machine hours. Job 2 with a direct cost of $74,700 has used 1,760 machine hours. Job 3 with a direct cost of $87,470 has used 789 hours. Actual overhead amounted to $375,000. Job 1 is completed and sold for $276,500. Job 2 is completed and not yet delivered. Job 3 is still in process. Assume that spending variance amounts to $9,000 favorable. If over/underapplied overhead is prorated to cost of sales and inventory accounts based on the amount of overhead charged to each job, work in process will be a. debited for 4126 credited for 4126 debited for 1850 credited for 1850 None of the above. Answer: d Learning Objective: 3 The favorable variance credited to cost of sales should be based on determining the total overhead: (1290 * 96) + (1760 * 96) + (789 * 96)] = $368,544; % for WIP = 75,744 / 368,544 = 20.55%; 9,000 * 20.55% = $1,850. Roxanne Company has concluded a contract with the Defense Department for $495,000 with a forecasted cost of $375,000. It is estimated at this time that 60% of the job is complete with a cost-todate amount of $276,000 and a draw of $276,000 as well. How much does the Defense Department owe Roxanne at this point? a. $219,000 $99,000 $51,000 $21,000 None of the above. Answer: d Learning Objective: 4 Balance of draw should be: (495,000 * 60) – 276,000 = $21,000. Roxanne Company has concluded a contract with the Defense Department for $495,000 with a forecasted cost of $375,000. It is estimated at this time that 60% of the job is complete with a cost-todate amount of $276,000 and a draw of $276,000 as well. What should be the entry(s) for costs incurred to-date? Dr. WIP 276,000; Cr. material inventory, payroll, and other accounts 276,000 Dr. Finished goods inventory 276,000; Cr. WIP 276,000 Dr. Cost of goods sold 276,000; Cr. WIP 276,000 Dr. Receivable or cash 276,000; sales 276,000 None of the above. Answer: a Learning Objective: 4 Answer (a) explains the entry for charging work in process and crediting various related accounts. Roxanne Company has concluded a contract with the Defense Department for $495,000 with a forecasted cost of $375,000. It is estimated at this time that 60% of the job is complete with a cost-todate amount of $276,000 and a draw of $276,000 as well. At this rate, the completed job cost will amount to 375,000 460,000 495,000 520,000 None of the above. Answer: b Learning Objective: 4 Estimated completed cost: 276,000 / .60 = $460,000. The ultimate measure of accountability in job order costing is to identify and charge directly to the job as much of the production cost as possible. identify and charge directly to the job as much of the non-production cost as possible. identify and charge directly to the job as much of production and non-production cost as possible. allocate overhead to jobs to the extent that you find a reasonable association between a cost driver and a cost item. c and d Answer: e Learning Objective: 4 The ultimate measure of accountability in job order costing is to identify and charge directly to the job as much of production and non-production cost as possible and allocate overhead to jobs to the extent that you find a reasonable association between a cost driver and a cost item. Job order costing is used in manufacturing companies only service companies only. manufacturing or service companies none of the above. Answer: d LO: 7 Job order costing is used in both manufacturing and service oriented firms. Gantt chart is used for comparing job order costing to operational costing comparing time frame of forecast to actual assessing progress of work toward completion a and b b and c. Answer: e LO: 8 Gantt chart depicts the stages required to complete a project and the sequence in which the tasks are to be performed. Instructor Manual for Cost Management: Strategies for Business Decisions Ronald W. Hilton, Michael W. Maher, Frank H. Selto 9780073526805, 9780072430332, 9780072830088, 9780072299021, 9780072881820, 9780072882551, 9780070874664, 9780072388404, 9780072343533