Review of Basic Cost Accounting Key Topics

1. Review of Basic Cost AccountingKey Topics • Today we will briefly review: • Cost Terms and Purposes • Job & Process Costing • Standard Costing • Activity Based Costing • Alternative Income Calculations

2. COST TERMS & PURPOSES

3. Types of Cost Classification

4. Cost Object [or Objective]: "any activity or item for which a separate measurement of cost is desired." • E.g.: a product, a department a customer [all are activities?] • Purpose: to help in decisions or to prepare financial reports

5. Phases of assigning cost to objectives (1) Accumulation by some "natural" classification (labor, material, etc.) (2) Assignment to the objectives --Tracing --Allocating E.g.: Material costs are accumulated as material is purchased, then typically traced to units of product as they are manufactured. Indirect manufacturing costs (overhead) are allocated to units of product. Direct vs. indirect costs: can they be traced to the cost objective in an economically feasible way? [cost-benefit.] -A matter of judgment

6. Direct/Indirect Examples for Discussion For a sales office as the cost object...... The office space? A receptionist? The sales manager's salary? The company president's salary? Insurance against fire and casualty? Electricity For a manufactured circuit board...... Transistors, integrated circuits, etc., mounted on the boards? Solder used to make the connections? Insulating varnish used to coat it? Labor of the assembly line worker? Supervisor's salary?

7. Cost Behavior: Fixed vs. Variable Cost Driver: Any underlying factor that causes or changes total costs. Example: Cost of an audit engagement? - Client new? - No. of transactions the client has had - Whether and how computerized - Number of branch offices - Volume (units made, sold)

8. Purpose is Prediction:Would we predict based on a driver? • e.g. -The plant manager's salary is "fixed" -- does not depend on volume. Volume But the manager might be laid off at very low volume or a second shift manager hired at very high volume. Many fixed costs are discretionary. Fixed does not mean Unchangeable

9. Cost Reaction to Changes in Activity Need four perspectives! Unit Total • Fixed Cost: • Variable Cost: $ $ Volume Volume $ $ Volume Volume Within the relevant range

10. Separate Dichotomies Think of Examples in a _______________ setting. Cost object is:

11. [Expensed when product sold] All costs to obtain the merchandise: Dir. Material Dir. Labor Factory Overhead [Expensed Immediately] Selling expenses General and Administrative Inventoriable ("Product") Costs vs. Period Costs } "Prime"costs }"Conversion" costs

12. Different Definitions of Costs for Different Applications

13. Job Costing • Managers ask “How much does it cost?” for many purposes • formulating overall strategies • product/service-emphasis decisions • pricing decisions

14. Building Block Conceptsof Costing Systems Direct costs of a cost object are related to the particular cost object and can be traced to it economically. Indirect costs of a cost objectare related to the particular cost object but cannot be traced to economically.

15. Building Blocks of Costing Systems A cost poolis a grouping of individual cost items. A cost allocation baseis the common denominator for systematically linking an indirect cost or group of indirect costs to a cost object.

16. Job-Costing vs. Process-Costing Systems • In a job-costing system, the cost object is an individual unit, batch, or lot of a distinct product or service called a job. • In process costing, the cost object is masses of identical or similar units or a product or service produced during a period. • Uses costs for the period, divided by equivalent units

17. Activity-Based Costing and Activity-Based Management

18. Undercosting and Overcosting • Product undercosting: Occurs when a product consumes a relatively high level of resources but is reported to have a relatively low total cost. • Product overcosting: A product consumes a relatively low level of resources but is reported to have a relatively high total cost.

19. Undercosting and Overcosting • Irene, Roberta, and Nancy are three bank customers. • They require different activities from the bank: • Irene banks exclusively at the ATM or online. • Roberta visits the teller daily to make deposits, withdrawals • Nancy deposits foreign currency as well as calling the branch frequently to ask currency rates.

20. Undercosting and Overcosting • Traditional allocation bases might apply branch overhead to accounts based on account balances or equal amounts per account. • Irene (who never makes any demands on the branch) will be overcosted and appear less profitable than she should. • Roberta and Nancy may be undercosted and appear more profitable than they are.

21. Refining a Costing System • Guidelines for refining a costing system: Direct-cost tracing– Classify as many of the total costs as direct costs as is economically feasible. Indirect-cost pools– Expand the number of cost pools until each of these pools is homogeneous. Cost-allocation basis–Identify the preferred cost-allocation base for each indirect-cost pool.

22. Activity-Based Costing System • ABC calculates the costs of individual activities and assigns costs to cost objects such as products, services, or customers based on the activities used to produce a product or service, serve a customer, etc.

23. Activities of a Milk Truck Delivery Person ActivityCost Driver Driving Time; miles; area of town Shelving Time; number of packages; categories of products Paperwork Time; types of customer Waiting Type of customer?

24. Cost Hierarchies • Different cost pools basis on of the different types of cost drivers (used as the cost-allocation bases) • ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases: • Output unit-level cost • Batch level costs • Product-sustaining costs • Facility-sustaining costs

25. Output Unit-Level Costs... • are resources consumed for activities performed on each individual unit of product or service. • Energy • Machine maintenance, repairs (depreciation?) • Labor

26. Batch-Level Costs... • are resources used on activities that are related to a group of units of product or service • Setup hours to run a batch • Procurement costs of placing an order

27. Product-Sustaining... • or service-sustaining, costs are incurred on activities to support individual products or services. • Design costs • Engineering costs • Equipment dedicated to the product or service

28. Facility-Sustaining Costs... • are resources used on activities that cannot be traced to individual products or services but support the organization as a whole. • General administration • Rent or depreciation for headquarters, etc. • Building security

29. Usefulness of Cost Hierarchies • Different levels of cost drivers: LevelUseful for Decisions Such As… Output-unit Shall we increase production, and at what price? Batch How often should we produce batches? What base amount must we charge to set up a “run,” regardless of the number a customer wants made? Product/Service-Sustaining Should we continue to offer this service/product? Facility-Sustaining Shall we continue in business or dissolve it?

30. Activity-based Management • Supervisors & managers typically oversee activities rather than products. • ABC pinpoints opportunities for cost reduction. • Improved information technology facilitates ABC.

31. Activity-Based Management • ABM describes management decisions that use activity-based costing information to satisfy customers and improve profits. • Product pricing and mix decisions • Cost reduction and process improvement decisions • Design decisions

32. Product Pricing and Mix Decisions • ABC gives management insight into the cost structures for making and selling diverse products. • It provides more accurate product cost information and more detailed information on costs of activities and the drivers of those costs.

33. Cost Reduction and Process Improvement Decisions • Manufacturing and distribution personnel use ABC systems to focus on cost reduction efforts. • Managers set cost-reduction targets in terms of reducing the cost per unit of the cost-allocation base.

34. Design Decisions • Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs. • Companies can work with their customers to evaluate the costs and prices of alternative design choices.

35. Major Differences,Traditional Costing vs. ABC Typical SystemABC One or a few indirect Many pools cost pools Application base may Base more likely a be a true cost driver true cost driver Application base often Bases likely to be financial (direct labor cost, non-financial (# of parts, direct material cost, etc) number of operations, hours of testing, etc.)

36. Indicators of Need for ABC Systems... • significant amounts of indirect costs are now allocated using only one or two cost pools. • all or most costs are identified as output unit-level costs. • products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.

37. Indicators of Need for ABC Systems... • products that a company is well-suited to make and sell report small profits while products for which a company is less suited report large profits. • complex products appear to be very profitable and simple products appear to be losing money. • operations staff have significant disagreements with the accounting staff about the costs.

38. Limitations of ABC Systems • The main limitations of ABC are the effort & measurements necessary to implement the system. • ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools.

39. Limitations of ABC Systems • Activity-cost rates also need to be updated regularly. • Very detailed ABC systems are costly to operate and difficult to understand.

40. Standard Costing • Basic Concept: Only the standard cost will be applied to the product for inventory valuation and income determination. • Any difference from std. is called a "variance.“ • Variances are calculated and investigated (if large). • Management by exception

41. Standard Cost Variances Variable OH: Like DM, DL Fixed OH: Prod’n volume, Spending components

42. Implications of Standard Costing? • A static target? • Can avoid this • Emphasis on efficiency • Encourages buildup of inventory, keeping workers & machines busy • Emphasis on price of inputs • Can undermine quality

43. Absorption Costing Sales - CGS =Gross Margin - Selling Expenses - Gen & Admin Expns =Operating Income Sales -Variable Mfg. Costs [= Manufacturing Margin possible subtotal] -Variable Selling & Admin = Contribution Margin -Fixed Costs: Manufacturing Selling Administrative =Operating Income Alternative Income Calculations Variable Costing

44. Differences in Reported Income If fixed OH/unit is notconstant across time, we must trace the difference in fixed overhead that gets expensed (or the amount that gets carried forward – the same difference in amounts).