Managerial Accounting

1. Managerial Accounting Week 4 Notes David B. Hamm, MBA, CPA June, 2002 Revised Nov. 2003

2. Cost Classification • Direct costs—Materials & Labor • Materials (if not highly perishable) are generally inventoried until put into production • Direct labor can not be inventoried, but may be controllable by scheduling to meet production as required • Accurate and timely scheduling is needed to minimize costs of idle inventories or wasted labor (motivation behind JIT and bottleneck management) • Only those costs directly traceable to production

3. Cost Classification (cont.) • Indirect costs—overhead • Will include indirect materials & labor (not specifically identified with production, such as general supplies, manager’s salary, janitorial services, etc.) • Since these costs are not directly traceable, major problem is how to allocate overhead costs to production

4. Overhead Cost Allocation • Identify cost pools—examples • Engineering, supervision, facility costs, maintenance/janitorial, etc. • Needed for production but not directly part of the finished product. • Many of these costs are not “value-added” • Estimate costs (budgeting process) • Establish an allocation base • This will be a “cost driver” for the pool (machine hours for machine-intensive production, labor hours for labor-intensive production, etc.)

5. Overhead Cost Allocation (cont.) • Estimate quantity for allocation base • How many labor hours budgeted, etc. • Calculate cost allocation rate: Budgeted cost (pool) ------------------------ = Overhead Allocation Rate Budgeted Quantity

6. Overhead cost illustration Estimated direct labor hours= 8,000 hours

7. Overhead cost illustration (cont.) Budgeted cost $100,000 ----------------------------- = $12.50 /direct labor hr. Budgeted hours 8,000 A project during the year that required 100 hours of direct labor would therefore be assigned $1,250 in overhead costs (100 hours x $12.50 per hour) in addition to the actual materials and direct labor costs used.

8. Overhead cost illustration (cont.) • Since this is a budget estimate, assigned overhead costs must be reconciled with actual costs at the conclusion of the budgeted period • Underapplied OV costs (actual costs exceed applied), or • Overapplied OV costs (actual costs less than applied) • Difference usually “plugged” as an adjustment to cost of goods sold (if not material) or allocated among cost of goods sold, finished goods inventory and work in process inventory if significant difference (if we blew our budget!)

9. Cost Assignment Methods • Job order costing • Costs are assigned to specific “jobs” or orders (common in specialized production or service industries) • Process costing • Costs are assigned “per equivalent unit” -- batch or continuous production • Activity Based Costing • Costs are accumulated in cost pools and assigned to production using either of above methods (particularly applicable to overhead costs)

10. Job Order Cost Illustration Pause for class work on job order cost example.

11. Other Cost Accounting Issues • Joint processing: • Some production processes may be used to “spin off” multiple products from a “joint” activity • Example: Carl’s Chemical Co. process C79 develops a liquid that is then split for further processing into C79A (a fertilizer) and C79B (a pest repellant). How do we allocate the joint processing costs?

12. Joint Processing Costs (cont.) • Alternatives for cost allocation— • Physical measurement—number of barrels or pounds, etc. Easy to calculate but may not reflect true value of the respective products. • Sales value—if the fertilizer (C79A) can sell at a higher price than the insect repellant (C79B), more joint cost is allocated appropriately • No allocation—the joint costs are simply expensed as overhead, and only costs directly related to finishing C79 A and B are allocated to each.

13. Other Cost Accounting Issues (cont.) • By-products, scrap, waste— • Some processes generate “by-products” or scrap that may be sold at a reduced value, or waste, that must be disposed of • Can allocate cost to by-products or scrap based on their sales values, if any • Or make no allocation and book sales of by-products/scrap only as misc. revenue. • Waste disposal costs should be allocated as a proper cost of producing the product that generated it.

14. Pause for Class Example

15. Budgeting (Overview) • Critical tool for management planning and control • Compare actual results to budget, identify “variances”, evaluate and re-work in future budgets • The Master Budget • Sales Budget (volume levels targeted) • Production Budgets (what is needed to achive sales target) • Other Operating Budgets (to support above activity)

16. Budgeting (continued) • Master Budget (continued) • Cash Budget (cash resources needed to achieve budgeted operations) • Pro-forma Financial Statements (what are the projected financial results of this budget?) • Budgets help answer the following: • Where are we going? (future plans, strategies) • Where are we now? (benchmark for current performance) • Where have we been? (historical comparison with previous budgets and results)

17. Approaches to Budgeting • “Top down”—management sets most budget parameters and staff must implement • “Bottom up”/Participative—management may set general goals but all staff are involved in setting department and individual objectives (“ownership”)--MBO • Zero Based—all budgets are “zeroed out” and each department must justify all activities for the new budget cycle (vs. incremental budgets)

18. Approaches to Budgeting (cont.) • Time frames: • Single period budget—fixed period (often one calendar or fiscal year) • Rolling / continuous budget—budgets are updated frequently (quarterly or monthly) with actual results and forecasts are added to the budget for the next quarter or month with adjustments as needed

19. Budget—Wally’s Widget Works Pause to examine Wally’s Widget Works Master Budget Template in class. This is a manufacturing budget for a continuous product (process-type costing). But it is adaptable to other production or service-type organizations.