Chapter 2: Cost Terms, Concepts, and Classifications Manufacturing Costs: Direct Material: materials that become an integral part

of the product. Direct Labor: labor that transforms the materials into a finished product and can traced to the product. Manufacturing Overhead: all other manufacturing costs that cannot be classified as direct materials or direct labor. a. b. c. Indirect materials: manufacturing supplies, lubricants, cleaning materials, etc. Indirect labor: factory supervision, janitorial, security, factory management., etc Other: factory taxes, insurance, depreciation, etc

1. 2. 3.

1. 2. 3.

Nonmanufacturing Costs Selling: any cost that is necessary to obtain customer orders or get the product to the customers. Administrative: general administrative costs. Research and Development: all costs incurred to develop new products.

Product Costs: the cost to manufacture or purchase a product. These costs are charged to the product in inventory and are expensed as cost of goods sold when the product is sold. Period Costs: selling, administrative, and research and development costs. These costs are immediately expensed when incurred.

Financial Statements: key differences in the financial statements of merchandisers and manufacturers. Balance Sheet: Merchandiser Merchandise Inventory: completed products purchased from suppliers.

Manufacturer Raw Materials Inv.: raw inputs into production. Work In Process Inv.: partially completed goods. Finished Goods Inv.: completed products.

Income Statement: Merchandiser Sales less Cost of Goods Sold Gross Margin less Selling, Adm., R&D Operating Income less Other Expense less Income Tax Net Income

Manufacturer Sales less Cost of Goods Sold Gross Margin less Selling, Adm., R&D Operating Income less Other Expense less Income Tax Net Income

Cost of Goods Sold Schedule: Merchandiser Beg. Merchandise Inv. plus Purchases Cost of Goods Available less End. Merchandise Inv. Cost of Goods Sold

Manufacturer Beg. Fin. Goods Inv. plus Cost of Goods Mfd. Cost of Goods Available less End. Fin. Goods Inv. Cost of Goods Sold

Cost of Goods Manufactured: the cost of the units completed during the period. Total Manufacturing Costs: the total cost of material, labor, and manufacturing overhead that was place into production during the period.

The Flow of Costs: Direct Materials Direct Labor Mfg. Overhead Production (WIP Inventory) Fin. Goods Warehouse (Finished Goods Inventory) Customer (Cost of Goods Sold)

Cost Behavior: how total costs react to changes in activity levels. Variable Cost: total cost changes directly with changes in activity. Fixed Cost: total cost does not change with changes in activity.

Direct (Traceable) Cost: a cost that can be directly traced to a unit of product (direct materials and direct labor) or a cost that can be directly traced to some segment or division of the organization. Indirect (Common) Cost: a cost that cannot be directly traced to a unit of product (manufacturing overhead) or a cost that cannot be traced to some segment or division of the organization. Differential Cost: a cost that changes from one decision alternative to another decision alternative. (these costs are relevant for decision-making.) Opportunity Cost: the benefit that is forgone when choosing one alternative precludes choosing another alternative. (these benefits/costs are differential and are therefore relevant for decision-making.) Sunk Cost: a cost that has already been incurred and cannot be changed by any decision alternative. (these costs are not differential and therefore are not relevant for decision-making.)

Chapter 5: Cost Behavior Analysis and Use Cost Behavior: how total costs react to changes in activity levels. Cost Structure: the relative proportion of fixed and variable costs employed by a firm. Mixed Costs: contain both fixed and variable cost components. Mixed Cost Analysis: the purpose is to separate mixed costs into their fixed and variable components so that future costs can be predicted. Mixed Cost Analysis: High-Low Method: separates mixed costs into their fixed and variable components by examining the change in cost between the high and low levels of activity. VC/unit of activity = High Cost* - Low Cost* High Act. Low Act. *Cost at highest (lowest) level of activity Ex. 1 2 3 4 Month Machine Hrs 500 200 1,000 700 (here, you are simply calculating the slope of the line that connects the high and low levels of activity.)

T. Maint. Cost 700 500 1,100 750

VC/Mach. Hour = 1,100 500 = 600 = 0.75/Mach. Hour 1,000 200 800 TC = TFC + TVC TFC = TC TVC TFC = TC (VC/unit of act. * Units of activity) TFC = 1,100 (0.75/Mach hour * 1,000 Mach. Hours) = 1,100 750 = 350 (using high level of activity) TFC = 500 (0.75/Mach hour * 200 Mach. Hours) = 500 150 = 350 (using low level of activity) Cost Function: Total Maint. Cost = 350 + (0.75/ Mach hour * # of Mach hours) Estimate the Total Maintenance Cost for month 5 if total machine hours is expected to be 800. Total Maint. Cost = 350 + (0.75/ Mach hour * 800 Mach hours) = 350 + 600 = 950 Income Statement Format: Traditional (Functional) Format: costs are organized by their function (product and period) Contribution Format: costs are organized by their behavior (variable and fixed). Traditional Sales Cost of Goods Sold Gross Margin Selling &Adm. Exp Net Income Contribution Sales Total Variable Costs Contribution Margin Total Fixed Costs Net Income

Chapter 6: Cost-Volume-Profit Relationships Contribution Margin (CM) = Sales Total Variable Costs Defn: the amount of sales that are left to cover fixed costs and profit.

CM per unit = CM/# units sold or Price VC/unit Defn: the amount that each unit of sales contributes toward covering fixed costs and profit. CM Ratio = CM/Total Sales or CM per unit/Price Defn: the percentage of each sales dollar that contributes toward covering fixed costs and profit. Cost-Volume-Profit Applications Price = 25 VC/unit = 10 Ex1. TFC = 9,000 Current Sales = 800 units

Suppose the company can buy an ad in the Post Gazette for $5,000. This ad is expected to increase sales by 300 units. By how much will income change if we buy the ad? Without the Ad Total Per Unit 20,000 25 8,000 10 12,000 15 9,000 3,000 With the Ad Total Per Unit 27,500 25 11,000 10 16,500 15 14,000 2,500

Sales Var. Costs CM Fixed Costs Net Income

% 100 40 60

Sales Var. Costs CM Fixed Costs Net Income

% 100 40 60

**Income would decrease by $500 if we buy the ad. Ex2. Refer to the original information. Suppose the company can buy higher quality materials, which will increase the Direct Material cost per unit by $5. This increase in quality is also expected to increase sales to 1,300 units. By how much will income change if we buy the higher quality materials? With the Old Materials % Total Per Unit 20,000 25 100 10 40 8,000 12,000 15 60 9,000 3,000 With the New Materials Total Per Unit % 32,500 25 100 19,500 15 60 13,000 10 40 9,000 4,000

Sales Var. Costs CM Fixed Costs Net Income

Sales Var. Costs CM Fixed Costs Net Income

**Income would increase by $1,000 if we buy the higher quality materials.

Break-Even : What level of Sales do I need to earn zero profit? -break even implies that Sales = Total Costs and CM = TFC Break even calculated in units: XBE = TFC CM/unit Break even calculated in Sales Dollars: BESales$ = TFC CM Ratio

and

Ex. Given the following information, how many units do I need to sell to break even? How many Sales $ to Break-even? Price = 25 VC/unit = 10 XBE = TFC = 9,000 = 600 units CM/unit 15 **Check: 600 units * $25/unit = $15,000 TFC = 9,000 Current Sales = 800 units BESales$ = TFC = 9,000 = $15,000 CM Ratio .60

Target Profit Analysis: What level of Sales do I need to achieve a given level of profit? Target Profit calculated in units: XTP = TFC + T. Profit CM/unit Target Profit calculated in Sales Dollars: Target Profit$ = TFC + T. Profit CM Ratio

and

Ex. Given the following information, how many units do I need to sell to earn a target profit of $21,000? How many Sales $ to earn a target profit of $21,000? Price = 25 VC/unit = 10 TFC = 9,000 Current Sales = 800 units Target Profit$ = 9,000 + 21,000 = $50,000 .60

XTP = TFC + T. Profit = 9,000 + 21,000 = 2,000 units CM/unit 15 **Check: 2,000 units * $25/unit = $50,000

Chapter 12: Segment Reporting and Decentralization Segment Reporting: financial reports for individual segments of an organization. Segment: examples include products, product lines, divisions, territories, stores, departments, customers etc Responsibility Centers (Levels) 1. Cost Center: segments that have control over costs, but do not control the generation of revenue or investments in assets. Evaluation of Cost Center Performance: budgeted versus actual costs and cost variances. : 2. Profit Center: segments that have control over the generation of both costs and revenues, but do not control investments in assets. Evaluation of Profit Center Performance: budgeted versus actual income. 3. Investment Center: segments that have control over the generation of both costs and revenues and also control investments in assets. Evaluation of Cost Center Performance: rate of return. Direct (Traceable) Cost: a cost that can be directly traced to a unit of product (direct materials and direct labor) or a cost that can be directly traced to some segment or division of the organization. -segments may have some variable costs and some fixed costs that are traceable to that segment. Indirect (Common) Cost: a cost that cannot be directly traced to a unit of product (manufacturing overhead) or a cost that cannot be traced to some segment or division of the organization. -costs that are not traceable to a segment are always fixed costs. Evaluating Profit Centers: Segmented Income Statements (in contribution format) Total Company 1,500,000 810,000 690,000 400,000 290,000 240,000 50,000 Segments Meats 900,000 460,000 440,000 230,000 210,000 Produce* 600,000 350,000 250,000 170,000 80,000

Sales TVC CM Traceable Fixed Costs Segment Margin Common Fixed Costs Net Income

*We can now break down the Produce division into its segments. Segments Sales TVC CM Traceable Fixed Costs Segment Margin Common Fixed Costs Net Income *Produce 600,000 350,000 250,000 100,000 150,000 70,000 80,000 Fresh 400,000 200,000 200,000 40,000 160,000 Packaged 200,000 150,000 50,000 60,000 (10,000)

Segment Margin: the amount of income generated by a specific segment.

Evaluating Investment Centers: Rate of Return 1. Return on Investment (ROI) = Margin * Turnover

Margin = Net Operating Income/Sales Turnover = Sales/Avg. Operating Assets ROI = (Net Operating Income/Sales) * (Sales/Avg. Operating Assets) Net Operating Income/Avg. Operating Assets

Therefore: ROI = 2.

Residual Income = Net Operating Income Minimum Acceptable Return**

**Minimum Acceptable Return = Avg. Operating Assets * Minimum ROI Ex. Net Operating Income Avg. Operating Assets Minimum ROI Minimum Acc. Return Residual Income Current Operations 8,500 50,000 10% 5,000 3,500 Proposed Operations 1,400 10,000 10% 1,000 400 Total Operations 9,900 60,000 10% 6,000 3,900

Chapter 9: Profit Planning Budget: a plan outlining the acquisition and use of resources. Capital Budget: budgets for the acquisition of property, plant and equipment Operating Budget: budgets that coordinate the daily operations. Master Budget: a summary of all of the individual department budgets including budgeted financial statements. Alternative Budget Methods The Starting Point Zero-Based Budget: all budgets start at zero with estimates then made of the resources needed to achieve the firms objectives. Minimum Level Budget: a budgetary base is established for committed costs with expenditures above that base requiring justification. Incremental Budget: costs are budgeted as a dollar or percentage change from the prior period. Activity Level and Time Period Covered Static Budget: once the budget is determined, all budgeted amounts remain fixed. Flexible Budget: a series of budgets that reflect various levels of possible activity. Perpetual (Continuous, Rolling, Revolving) Budget: as one month or quarter expires in the budget, a new month or quarter is added in order to keep a 12 month planning horizon. Life Cycle (Project, Program) Budget: expenditures are organized into a package with a focus of achieving a specific objective. (examples include the stadiums, convention center, Penguins new arena, etc) Ownership Top-Down Budget: budgets are prepared by top management and handed down to lower levels of management. Participative (Self-Imposed, Bottom-Up) Budget: managers participate in the preparation of their own budgets.

Budgeting Example (Note: This example data will also be used in chapter 10):
Estimated Operating Figures Std. Price Selling Price $40.00 Direct Material $25.00 Direct Labor $10.00 Variable Overhead $5.50 Fixed Overhead Per unit pound labor hour labor hour Std. Quantity 0.5 lbs./unit 0.6 hrs./unit 0.6 hrs./unit Sales Forecast Jan. 94 Feb 88 March 92 April 96

$250 per month

Planned Ending Inventories Finished Goods 50% of next months unit sales Work-In-Process 20% of this months Budgeted Mfg. Cost Raw Materials 50% of material used this month

Sales Budget Sales Forecast-Units Selling Price Budgeted Sales-$

Quarter Ending March 31, 2007 Jan. Feb. 94 40 3,760 88 40 3,520

March 92 40 3,680

Quarter 274 40 10,960

Production Budget Sales Forecast-Units

06 QTR 4

Jan. 94

Feb. 88 46 134 44 90

March 92 48 140 46 94

Quarter 274 48 322 40 282

Finished Goods End. Inv-Units Total Units Needed Finished Goods Beg. Inv-Units Budgeted Production-Units

40

44 138 40 98

Material Purchases Budget 06 QTR 4 Budgeted Production-Units Pounds Per Unit (Standard) Budgeted Mat. Usage-pounds Raw Mat. End. Inv.-pounds Total Pounds Needed Raw Mat. Beg. Inv.-pounds Pounds to be Purchased Cost per Pound Budgeted Material Purchases 14

Jan. 98 .5 49 24.5 73.5 14 59.5 25 1,487.5

Feb. 90 .5 45 22.5 67.5 24.5 43 25 1,075

March 94 .5 47 23.5 70.5 22.5 48 25 1,200

Quarter 282 .5 141 23.5 164.5 14 150.5 25 3,762.5

Labor Budget Budgeted Production-Units DLH per Unit (Standard) Budgeted Total DLHs Labor Rate Per Hour Budgeted Direct Labor Cost

Jan. 98 .6 58.8 10 588

Feb. 90 .6 54 10 540

March 94 .6 56.4 10 564

Quarter 282 .6 169.2 10 1,692

Manufacturing Overhead Budget Budgeted Total Direct Labor Hours Var. OH Rate per Labor Hour Budgeted Variable Mfg. Overhead Budgeted Fixed Mfg. Overhead Budgeted Total Mfg. Overhead

Jan. 58.8 5.5 323.4 250 573.4

Feb. 54 5.5 297 250 547

March 56.4 5.5 310.2 250 560.2

Quarter 169.2 5.5 930.6 750 1,680.6

Chapter 10: Standard Costs and the Balanced Scorecard Standard: are used to construct budgets and serve as a benchmark for performance evaluation. ***(For illustrative purposes, all of the examples that follow will use the standards that are incorporated in the estimated operating figures of the preceding budgeting example.) Two Primary Standard Classifications 1. Quantity Standard: how much of a given resource should be used for each unit of product. ex. Materials: .5 pounds per unit, Labor: .6 hours per unit, Mfg. Overhead: .6 hours per unit 2. Price Standard: how much each unit of resource should cost. ex. Materials: $25 per pound, Labor: $10 per hour, Mfg. Overhead: $5.50 per hour Standard Cost = Quantity Standard * Price Standard Defn: how much should be spent on a given resource for one unit of finished product. Ex. Materials: Labor: Mfg. OH: Standard Cost = .5lbs/unit * $25/lb = $12.50/unit Standard Cost = .6hrs/unit * $10/hr = $6.00/unit Standard Cost = .6hrs/unit * $5.5/hr = $5.50/unit

Variance: the difference between standard (expected) and actual results. Two Primary Variance Classifications 1. Quantity Variance: how much of a resource was used compared to how much should have been used. 2. Price Variance: how much was paid for a resource compared to how much should have been paid.

Material Variances ex. In January, the company purchased 60 pounds of material at a cost of $1,470. Production of 100 units required 55 pounds of material. 1. Material Price Variance (MPV): AQP(AP SP) = 60lbs. * (24.5/lb 25/lb) = $30 favorable

-the variance is favorable because the price paid for the materials ($24.5/lb) is less than the standard price ($25/lb.)

AQP = the actual quantity of materials purchased AQU = the actual quantity of material used. 2. Material Quantity Variance (MQV): SP(AQU - SQ) = $25/lb * (55lbs. 50lbs.) = $125 unfavorable
-the variance is unfavorable because the pounds of materials used (55) is greater than the pounds that should have been used given production (50 = 100 units produced * .5lbs./unit)

Labor Variances ex. January production of 100 units required 58 direct labor hours at a cost of $609.

1. 2.

Labor Rate Variance (LRV): Labor Efficiency Variance (LEV):

AQ(AP SP) = 58hrs. * (10.5/hr 10/hr) = $29 unfavorable SP(AQ - SQ) = $10/hr. * (58hrs. 60hrs.) = $20 favorable

-the variance is unfavorable because the price paid for labor ($10.5/hr) is less than the standard price ($10/lb.)

-the variance is favorable because the hours of labor used (58) is less than the hours that should have been used given production (60 = 100 units produced * .6hrs./unit)

Variable Overhead Variances ex. For January, Variable Mfg. Overhead was estimated to be $323.4 and total direct labor hours for January was estimated to be 58.8. January production of 100 units required 58 direct labor hours. Actual VOH in January was $330.60.

1.

Var. OH Spending Variance (OSV):

AQ(AP SP) = 58hrs. * (5.7/hr 5.5/hr) = $11.6 unfavorable

-the variance is unfavorable because variable overhead increased at a rate of $5.70 per labor is greater than the expected increase of $5.50 per labor hour.

2.

Var. OH Efficiency Variance (OEV):

SP(AQ - SQ) = $5.50/hr * (58hrs. 60hrs.) = $11 favorable

-the variance is favorable because the hours of labor used (58) is less than the hours that should have been used given production (60 = 100 units produced * .6hrs./unit)

For Variable Overhead: SP = Estimated VOH $323.4/58.8 hours = $5.70/hour Estimated Activity AP = Actual VOH Actual Activity $330.60/58 hours = $5.50/hour