ACG 4341 Intermediate Cost Accounting

1. ACG 4341Intermediate Cost Accounting • Website: http://business2.fiu.edu/1400473/www • E-mail address: schlacht@fiu.edu • Office hours: before and after class • Final Exam: Date and Place to be determined.

2. Write on cards: Your name Your preferred e-mail address # other courses being taken now Expected date of graduation # minutes it takes you to get to class Your day job (in accounting?) ACG 4341Intermediate Cost Accounting

3. CLASS ROUTINE • 5:00-5:40 Discuss cases in groups and then with whole class • 5:40-6:00 Review homework problems assigned the previous class (and due next week) • 6:10-7:10 Cover chapter material for day • 7:10-7:40 Present essay topics (due next week, about one full page, 2 strong points)

4. TAKE HOME ESSAYS They are scored as follows: 5 (thorough and convincing arguments on at least two points) 4 (nearly but not quite, because the argument is incomplete or off track) 3 (something very important is missing, or the essay is just too short) 2 (only one point, or points poorly argued) 1 (the argument is completely off track)

5. TAKE-HOME ESSAYS • No title pages! Put just your name and number of critical analysis on first page. • Credit is given for your best 9 essays. You may submit more than 9. You may resubmit essays once to try for higher scores. • Do your essays on assigned topics. • If you wish to do another topic, clear it with the instructor. • One full page is usually enough.

6. Chap. 1 TAKE-HOME ESSAYS 1.15 Cost AccountingCost Management 1. Historical focus Planning and intervention focus 2. Specialists do it Cross functional teams 3. Ongoing operations Strategic focus

7. COST MANAGEMENT Philosophy: Improvement Attitude: Take charge! Measurement System PAST PRESENT FUTURE It is not the “cost accounting” approach. Is it just another catchword used by consultants? Or is it a way for accountants to regain their relevance? (You can tell me in August)

8. REPORTING, YES!BUT FIRST, DO: EXECUTION Process Improvement Cost Control Feedback Product Improvement Evaluation Initial Design PLANNING REPORTING

9. STRATEGYTWO KEY QUESTIONS GET IN, BUILD HOLD HARVEST or GET OUT 1. Where to go?

10. STRATEGYTWO KEY QUESTIONS HOLD (mid-range risk) HARVEST or GET OUT (lower risk) GET IN, BUILD (high risk) 2. How to get there? 1. Where to go?

11. Ch. 2 WE ALSO PREPARE FINANCIALS • Product costs (materials, labor, production overhead – accumulated until the products are sold) • Period expenses (general and administrative – charged) BUT WHAT ARE COSTS? • * Costs are the usage of a scarce resource (usually • measured in some monetary unit like $) • Kinds of cost: Direct materials and labor (traceable) • Indirect materials (supplies, fuel) • Indirect labor (maintenance) • Machine depreciation

12. MANUFACTURING COST FLOW MaterialsWork in ProcessFinished Goods Direct [used] materials Add Direct labor Add Production overhead [storage] [unfinished work] [unsold goods] [finished] ? * The three inventories that remain at the end of the period: Materials, Work in Process and Finished Goods. * Finished Goods are taken out of inventory when they are … ? * Cost of Goods Manufactured: Beginning Work in Process + Materials used, Direct Labor, Production Overhead - Ending Work in Process * Cost of Goods Sold = ?

13. THE NEW COST PARADIGM • Costs just don’t “happen.” • Observe the activities that lead to consumption of resources. • Something about the activities causes costs to be incurred (cost driver). OTHER CLASSIFICATIONS In a process: Fixed costs (if they stay the same) Variable costs (if they rise with production) Mixed costs (if we have some of both) In an investment: Committed cost (hard to change) Opportunity cost (alternative benefits) Discretionary cost (open to change) Sunk cost (already incurred – irrelevant)

14. Ch. 3 SYSTEMS OF COSTING Job-order costing (tracking unique batches, orders, clients) Process costing (homogeneous and continuous production) Operation costing (hybrid: features of unique and continuous production)

15. METHODS OF COSTING • Actual costing (recording what we actually use, including overhead) • Normal costing (recording actual prime costs and estimating overhead) • Standard costing (estimating all costs based on predetermined standards, and tracking any deviations from them)

16. IF COSTS INDICATE THE WORK DONE $ BUDGET Overrun? ACTUAL Amount of cost incurred to date on job NOW, IF THE WORK DONE IS MEASURED IN TIME MONTHS BUDGET Ahead of schedule? ACTUAL Amount of time spent to date on job IT LOOKS AS IF A TRADE-OFF IS GOING ON.

17. Ch. 4 ASSIGNING COSTS TO JOBS:ART OR SCIENCE?(PROPER OR IMPROPER?) • Did we complete that much work? • Did we spend resources on that? • How much did we really spend? • What does the contract allow?

18. ACTIVITY-BASED COSTINGWhat’s the fuss all about? Materials Labor JOB A JOB B JOB C Cleaning Maintenance Set-up Inspection R & D Purchasing Receiving Storage Production Overhead: on what basis to allocate these costs to jobs?

19. ACTIVITY-BASED COSTING OPEN UP THE BOX STUDY AND MEASURE THE ACTIVITIES R & D Cleaning Maintenance Purchasing Set-ups • Identify activities. • Determine cost. • What drives the cost of each activity? • Calculate driver rate and assign it to products and services.

20. WHY USE ABC? We want to know if: * a given customer is really profitable * a given product is really profitable Customer profitability: Revenues – Direct costs (materials, labor) - Customer specific costs (servicing, order fulfillment) = Operating profit for this customer Product profitability: Revenues – Direct costs (materials, labor) - Indirect costs (calculated with ABC) = Operating profit from this product

21. HOW IS ABC USED? • Primarily for internal decision making (not for financial reporting) • To track support activities in general (service sector, too) • BENEFITS OF ABC • Improves understanding of costs • Helps uncover extreme cost distortions • Improves competitiveness in pricing DRAWBACKS OF ABC *Cost tracking becomes more complex *Expensive to implement and maintain *ABC in itself only shifts costs from one product to another *Complete the process with Activity-based Management

22. COST DRIVER RATE Total cost in the activity pool / number of events that occurred Events can be measured in time or just counted. They can be units of output. Examples: In customer service: $80,000 in telephone call usage Number of calls: 8,000 ($10.00 per call) Number of minutes: 120,000 ($0.67 per minute) In designing of manufacturing molds: $125,000 total cost Number of molds completed: 50 Cost driver rate: $2,500 per mold WITH THIS COST INFORMATION, WE CAN ASSIGN EACH COST MORE RATIONALLY TO THE CUSTOMERS, PRODUCTS, AND DEPARTMENTS THAT “DROVE” EACH ACTIVITY.

23. ABC vis-a-vis ABM Ch. 5 ACTIVITY-BASED COSTING Technique for measuring and analyzing costs at a particular point in time Ongoing philosophy for managing and optimizing costs in every period ACTIVITY-BASED MANAGEMENT

24. HOW TARGET COSTING COULD WORK (example of ABM) • ABC analysis says: cost now = $315,000 • Process review says: It will cost $321,400 to make • the product work the way it should work. • 3. Market research says: Selling price must <= $340,000 • 4. Projected gross profit margin must >= 20% • 5. So, costs cannot exceed 80% of $340,000, or $272,000 • 6. Well, that means a reduction of $49,600 (15.4%) in costs • is necessary to meet our desired profit margin. • 7. Back to the drawing board! In this case, we started with cost information. We could also start with the selling price and the desired margin.

25. DO OUR PRODUCTION ACTIVITIESADD VALUE? (example of ABM) Rework Storage Waiting Moving Inspection • Would this activity lead to more satisfied customers? • Would it help the organization achieve its goals • (efficiency, effectiveness)? • Prioritize each activity using a customer satisfaction scale (from 1 to 5). • Some activities are inescapable (payment of taxes). • If a given activity does not add value, drop it or re-design the product. Under-utilization of company resources: another non-value cost. Only 5 of 6 spaces in this building are in use. When we apply overhead to this building, by counting all the square feet, we could take out 1/6 of the cost as under-utilization.

26. IMPLEMENTATION OF ABM • Make careful plans for: • The scope of ABM • (allow some early payoffs) • 2. The commitment inside the organization • (using inter-departmental committees) • Organizational resistance to anything new • (What is the culture?)

27. CUSTOMER PROFITABILITY(another application of ABM) Ch. 6 For individual customers: Start with gross sales to each customer. Subtract the cost of the products and services sold to the customer. Subtract the cost of servicing each customer *Calls attended (# minuites, $ per minute) *Visits made (# hours, $ per hour) *Hands-on work (# hours or days, $ per) The result is customer profit (or is it a loss?) [At the individual customer level, disregard general and administrative expenses.]

28. PRODUCT LINE PROFITABILITY(grouping by customer) • Sales of product • Cost of goods sold (variable cost only) • = Contribution margin • Operating expenses • = Operating income • For a product line, include all product-related expenses. • General and administrative expenses may be more difficult to break down. • Components of operating expenses for customers: • Selling (order taking, customer administration) • Marketing (research, strategy, advertising) • Distribution (packing, shipping, delivery)

29. EXAMPLES OF ACTIVITIES DesignOrder, Receive, StoreSet-upCustomer contact ACTIVITIES OCCUR (AND CAN BE ANALYZED WITH ABC) AT MANY LEVELS IN AN ORGANIZATION • * Attention can be focused on individual units of production or service • (individual contracts, films, clients, patients) • * Attention can be focused on a batch of identical goods • (mass production, assembly line) • * Attention can be focused on an entire product line • (special equipment, design, advertising campaign) • Attention can be focused on specific customers (special orders) • * Attention can be focused on an entire service facility • (brand name, R & D department, general manager)

30. REASONS WE MIGHT WANT TO KEEP UNPROFITABLE CUSTOMERS • It gives a certain prestige to count them as customers. • There is some potential to make the account profitable. • Having this customer gives us an entrée into new markets. • These customers provide us access to valuable information. We might reconsider a marginally profitable account for these reasons. BENEFITS OF STUDYING CUSTOMER PROFITABILITY • We identify effective customer-related activities: • Customers are more satisfied. • Customers are willing to pay more for a specific service. • Customers prefer personal calls to using a chat room.

31. PURPOSE OF COMMON SIZE STATEMENTS • The statement is created by converting monetary • amounts into percentages: • On the balance sheet: percentage of total assets. • On the income statement: percentage of gross revenue. • This standardization allows us to make easy comparisons • between products, customers and business units. • Example: • Gross revenue $150,000 100.0% • Variable COGS 105,00070.0% • Contribution margin $ 45,000 30.0% • Operating expenses 30,00020.0% • Operating profit $ 15,000 10.0%

32. SO WHAT DO WE DO WITHALL THIS PRODUCT AND CUSTOMER INFORMATION? *Just collect it for the fun of it? (only if everything is perfect) *Drop the poor performers? (be careful, because downsizing may not lead to greater profits) *Become more efficient? (if we can come up with alternative delivery systems) *Find company-wide savings? (This is not so easy.)

33. Ch. 7 DIMENSIONS OF QUALITY (FOR PRODUCTS) Performance How strongly or smoothly it operates Features SupplementsReliability Performs with no malfunctions Conformance It meets industry standards Durability Long useful life Serviceability Speed and ease of repair Esthetics Its appearance to the senses Perceived quality The customer’s voice (FOR SERVICES) Timeliness When the customer wants it Accuracy Exactly what the customer needs Resolution, Satisfaction How the customer perceives it Follow-up Prompt and thorough response Courtesy How the customer is treated Convenience Ease of contact Prestige Perception of world-class provider

34. TOTAL QUALITY MANAGEMENT RETURN ON QUALITY “Optimize quality. Our under- standing of the process, and our technology, do not yield perfect quality yet. There are diminishing returns.” “Maximize quality, Whatever it costs. We will more than make it up in additional sales.” $ $ SALES SALES COST COST Q Q “TQM is a process of continuous improvement.” “ROQ tells us what we can accomplish right now.”

35. INDICATORS OF QUALITY Response time frequencies (histogram) 20 min. 5 min. 2 min. 14 min. min. Average response time (trend over time) 1 2 3 4 5 6 7 8 week min. Acceptable range Average response time (control chart) 1 2 3 4 5 6 7 8 week

36. INDICATORS OF QUALITY:DIAGNOSTIC INFORMATION PHYSICAL RESOURCES HUMAN RESOURCES PROCEDURES Fishbone diagram DEFECT COMMUNICATION PRODUCT INFORMATION Response time * * Scatter diagram: The data suggest a causal relationship. * * * * * * frequency of errors

37. ACTIVITY: Passing through toll plaza Approach Toll Plaza No No Veer toward Center, Fumble in pocket Have SunPass? Have Change? Yes Yes Go to Exact Change Lane Change Lane Go into Left Lane Leave Toll Plaza Drop Change (ANY FLAWS?)

38. COST OF QUALITY APPROACH FAILURE COSTS CONTROL COSTS • Prevention • * Suppliers • * Training • * Better process • 2. Appraisal • * Inspection • * Sampling • * Testing • Internal Failure • * Scrap, rework • * Delay processes • External Failure • * Warranty repairs • * Replacements • * Lost sales • * Government audit ADVANTAGES OF THIS APPROACH: * It exposes costs that are often hidden in overhead or dispersed throughout the organization. * It suggests that a dollar spent on prevention can save the organization much more than that in failures.

39. TIME MANAGEMENT Development of new product / service * Quality management helps shorten time needed. * Target costing has greater impact here. * Communication is essential. Response to customer need * Electronic inputs reduce simple error and shorten time. * Value-added activities can be maximized. * Schedule our scarce resources carefully. Complete the product cycle efficiently. PROCESS EFFICIENCY MEASURES Productivity Value of output(s) / Value of input(s) Cycle Time Time elapsed / Number of good units Throughput Value-added time / Total time spent (close to 100%?) efficiency

40. JUST-IN-TIME PHILOSOPHY • Timing of inventory (minimizing inventory cost) implies: • Quality processes • Shorter cycle time • Less “product pushing” (sales driven, building inventory) • More “product pulling” (order driven, satisfying customers)

41. COST ESTIMATION Ch. 11 COSTS ACTIVITIES What is the relationship? How accurately can we know it? Is the relationship simple (one driver) or complex (many drivers)? Simple linear relationship: Semi-variable cost (Fixed cost + (unit cost * driver)) $ Activity More complex relationships: Step costs Mixed costs Scale economy Scarce resource

42. COST ESTIMATION TECHNIQUE Regression (least squares) Analysis TOTAL = FIXED + UNIT * COST COSTS COSTS VARIABLE DRIVER COSTS Intercept Slope Independent Variable Dependent Variable • Does that relationship make sense? (plausible cost driver) • 2. Does it hold within the range of activity? (relevant range) • 3. Are the historical data comparable? (no other intervening events) • 4. Were the data gathered without error? (any outliers?) $ * * * * * * outlier * * Cost Driver

43. REGRESSION (one cost driver) EXCEL FUNCTION LINEST Estimate of slope (variable cost per cost driver unit) INTERCEPT Estimate of “fixed cost” RSQUARE Percentage of data variability explained by regression $ COSTS DRIVER (units) Costs = dependent or “y” variable Driver = independent or “x” variable LINEST = $2.89 per activity INTERCEPT = $2,153 estimated fixed cost RSQUARE = 0.78 of variability is accounted for by this driver.

44. IF THIS IS THE WAY OUR COSTS BUILD UP, THEN WHAT PRICE MUST WE HAVE? Estimated fixed cost = $2,153 Estimated variable cost per unit = $2.89 Units produced = 4,000 Then--- the total cost would be $2,153 + 11,560 = $13,713 A selling price of $4.00 would give a profit of $2,287. USE REGRESSION TECHNIQUES WITH CAUTION: Have sufficient data in the analysis. Make sure the data are complete and consistent. Watch for outliers. Make sure costs are truly either fixed or variable within the range. Control for price inflation. Control for time lag in the data.

45. ALTERNATIVE COST ESTIMATION METHODS • ACCOUNT ANALYSIS: • Identify the activity accounts (what is the level of analysis?) • Calculate the average cost driver rate (forget fixed vs. variable) • This method is accurate only if the data are reliable. • ENGINEERING METHOD (Projection) • Measure the amount of work done in each activity. • Assign a cost based on the work done and on industry standards. • It does not require historical data, but does require much effort. • HYBRID METHOD (use a little of each method) • Human judgment is used to adjust the figures. • The past is not a perfect predictor of the future.

46. Ch. 12 WHAT IS A FINANCIAL MODEL? *Accurate, reliable simulation of relations between costs and benefits, adaptable to many settings. *Adaptable to one or many products and their revenue-cost streams. *Allows advance study of the impact of financial decisions, before we commit to a course of action. MOST WELL-KNOWN FINANCIAL MODEL: COST-VOLUME-PROFIT (CVP) *It assumes that sales volume alone drives costs and profit. *It can be extended to include more complex impacts: other activities, demand, taxation, change of product mix. *It provides decision support for a number of decisions: various levels of sales, additional resources, outsourcing *It assumes stability in our cost patterns over a relevant range.

47. TO USE COST-VOLUME-PROFIT Estimate: facility costs (committed), variable costs and price per unit. THE BASIS CVP APPLICATION: BREAK-EVEN (where revenues = costs) “Contribution margin” approach: Break-even volume = Fixed costs / Unit contribution margin “Equation” approach: Profit = Sales – Total variable costs – Total fixed costs (Of course, profit = 0) Break-even volume = Fixed costs / Unit sales price – Unit variable cost OTHER PRODUCTION AND SALES VOLUMES WILL RESULT IN PROFITS (OR LOSSES). Use the same equation approach. OR START WITH THE DESIRED AMOUNT OF PROFIT. (Use the equation approach again.)

48. OPERATING LEVERAGE(the risk of missing our sales target) Total Contribution Margin / Operating Income A high operating leverage means risk is high. A high fixed cost also means risk is high. When setting up a spreadsheet: Keep parameters (price, volume and cost) at the top where they can be changed more easily. Put formulas next, where they will remain unchanged. EXAMPLE: Production volume: Unit variable cost: Unit price: Total fixed cost: Total contribution margin: Unit contribution margin: Operating income: Operating leverage: Break-even point:

49. MORE COMPLEX FINANCIAL MODELS • EFFECT OF TAXES: • After-tax income = Before-tax income * (1 – income tax rate) • Example: $97,500 = $150,000 * (1 – 0.35) • WHAT SALES MUST WE HAVE TO OBTAIN A GIVEN PROFIT • AFTER TAXES? • Before-tax income = After-tax income / (1 – income tax rate) • Sales volume = (Fixed costs + Before-tax income) / Unit CM • So, if I want a profit after taxes of $350,000, • my fixed costs are $500,000 and my unit contribution margin is $20, • and the income tax rate is 35%, • Before-tax income equals $350,000 / 0.65 = $538,462 • Sales volume equals ($500,000 + 538,462) / $20 = 51,923 units.

50. FOR MULTIPLE PRODUCTS Use the weighted-average unit contribution margin. Example: Product A has CM of $4 and represents 80% of our sales. Product B has CM of $13 and represents 20% of our sales. The weighted-average unit CM = ($4 * 0.80) + ($13 * 0.20) = $5.80. The break-even point would equal the fixed costs / $5.80, as long as we make and sell the same product mix. If the sales mix changes, so do the other parameters. If there are other cost drivers, they will add to the financial model’s complexity.