# Dr. Baldwin AC 314 Chapter 2

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1 Dr. Baldwin AC 314 Chapter (15 min.) Computing and interpreting manufacturing unit costs. 1. (in millions) Supreme Deluxe Regular Total Direct material cost \$ \$ \$ \$ Direct manuf. labor costs Indirect manuf. costs Total manuf. costs \$ \$ \$ \$ Fixed costs allocated at a rate of \$20M \$50M (direct mfg. labor) equal to \$0.40 per dir. manuf. labor dollar (0.40 \$14; 28; 8) Variable costs \$ \$ \$ \$ Units produced (millions) Cost per unit (Total manuf. costs units produced) \$ \$ \$ Variable manuf. cost per unit (Variable manuf. costs Units produced) \$ \$ \$ (in millions) Supreme Deluxe Regular Total 2. Based on total manuf. cost per unit (\$ ; \$ ; \$ ) \$ \$ \$ \$ Correct total manuf. costs based on variable manuf. costs plus fixed costs equal Variable costs (\$ ; \$ \$ \$ \$ \$ ; \$ ) Fixed costs Total costs \$ The total manufacturing cost per unit in requirement 1 includes \$20 million of indirect manufacturing costs that are fixed irrespective of changes in the volume of output per month, while the remaining variable indirect manufacturing costs change with the production volume. Given the unit volume changes for August 2007, the use of total manufacturing cost per unit from the past month at a different unit volume level (both in aggregate and at the individual product level) will yield incorrect estimates of total costs of \$ million in August 2007 relative to the correct total manufacturing costs of \$ million calculated using variable manufacturing cost per unit times units produced plus the fixed costs of \$20 million. 2-1

2 2-17 (15 min.) Direct and indirect costs, effect of changing the classification of a cost item (continuation of 2-16). 1. MOP s managers might prefer that energy costs be directly traced to various products because in general, the greater the proportion of economically traceable costs, the more accurate will be the estimated cost of each cost object and hence the better the managerial decisions (like product pricing) based on those cost estimates. Since energy costs were substantial (\$90 million out of \$150 million of manufacturing overhead), tracing them directly to cost objects would significantly increase the accuracy of the cost estimates. 2. (in millions) Supreme Deluxe Regular Direct materials costs \$ 84.0 \$ 54.0 \$62.0 Direct manufacturing labor costs Direct energy costs Other manufacturing overhead costs Total manufacturing costs \$154.6 \$156.3 \$ Units produced (millions) Cost per unit \$ 1.93 \$ 1.30 \$0.89 Cost per unit (before analysis) \$1.75 \$ 1.38 \$0.94 Cost per unit (after analysis) \$1.93 \$ 1.30 \$0.89 Effect of analysis on cost per unit higher lower lower Before Shore s analysis, the Deluxe and Regular product lines were being overcosted and the Supreme line was being undercosted. Shore s analysis resulted in \$60 million of the \$150 million of overhead costs becoming directly traceable to products. It showed that the Supreme line consumes the most energy relative to the volume of production. With more accurate direct costs, and therefore a more accurate allocation of the overheads of \$60 million, Supreme s cost per unit is more than in the old cost system, while the cost per unit of Deluxe and Regular is less than in the old cost system. 2-2

3 2-19 (15 20 min.) Classification of costs, merchandising sector. Cost object: Videos sold in video section of store Cost variability: With respect to changes in the number of videos sold There may be some debate over classifications of individual items, especially with regard to cost variability. Cost Item D or I V or F A D F B I F C D V D D F E I F F I V G I F H D V 2-3

4 2-20 (15 20 min.) Classification of costs, manufacturing sector. Cost object: Type of car assembled (Corolla or Geo Prism) Cost variability: With respect to changes in the number of cars assembled There may be some debate over classifications of individual items, especially with regard to cost variability. Cost Item D or I V or F A D V B I F C D F D D F E D V F I V G D V H I F 2-4

5 2-22 (15 20 min.) Variable costs and fixed costs. 1. Variable cost per ton of beach sand mined Subcontractor Government tax Total \$ 80 per ton 50 per ton \$130 per ton Fixed costs per month 0 to 100 tons of capacity per day = \$150, to 200 tons of capacity per day = \$300, to 300 tons of capacity per day = \$450, Total Variable Costs \$975,000 \$650,000 \$325,000 Total Fixed Costs \$450,000 \$300,000 \$150,000 2,500 5,000 7,500 Tons Mined Tons of Cap acity p er Day The concept of relevant range is potentially relevant for both graphs. However, the question does not place restrictions on the unit variable costs. The relevant range for the total fixed costs is from 0 to 100 tons; 101 to 200 tons; 201 to 300 tons, and so on. Within these ranges, the total fixed costs do not change in total. 3. Tons Mined per Day Tons Mined per Month Fixed Unit Cost per Ton Variable Unit Cost per Ton Total Unit Cost per Ton (1) (2) = (1) 25 (3) = FC (2) (4) (5) = (3) + (4) (a) 180 4,500 \$300,000 4,500 = \$66.67 \$130 \$ (b) 220 5,500 \$450,000 5,500 = \$81.82 \$130 \$ The unit cost for 220 tons mined per day is \$211.82, while for 180 tons it is only \$ This difference is caused by the fixed cost increment from 101 to 200 tons being spread over an increment of 80 tons, while the fixed cost increment from 201 to 300 tons is spread over an increment of only 20 tons. 2-5

6 2-26 (15 min.) Total costs and unit costs. 1. (a) \$100,000 2,000 = \$50.00 per package (b) \$100,000 6,000 = \$16.67 per package (c) \$100,000 10,000 = \$10.00 per package (d)[\$100,000 + (10,000 \$8)] 20,000 = \$180,000 20,000 = \$9.00 per package The unit cost to ECG decreases on a per-unit base due to the first \$100,000 payment being a fixed cost. The \$8 amount per package beyond 10,000 units is a variable cost. The cost function is \$300,000 \$260,000 Total Costs \$200,000 \$100,000 \$180,000 \$100,000 10,000 20,000 30,000 Packages Sold ECG should not use any of the unit costs in requirement 1 when predicting total costs. Up to 10,000 units, the total cost is a fixed amount. Beyond 10,000 units, the total cost is a combination of a fixed amount plus a per-unit (beyond 10,000 unit) variable amount. The total costs at different volume levels cannot be predicted by using the unit cost at a specific volume level. The total cost should be predicted by combining the total fixed costs and total variable costs rather than multiplying a unit cost amount by the predicted number of packages sold. End Day One of Chapter 2 (day 2 of class) 2-6

7 Chapter 2: day 2 (day 3 of class) 2-27 (20 30 min.) Inventoriable costs versus period costs. 1. Manufacturing-sector companies purchase materials and components and convert them into different finished goods. Merchandising-sector companies purchase and then sell tangible products without changing their basic form. Service-sector companies provide services or intangible products to their customers for example, legal advice or audits. Only manufacturing and merchandising companies have inventories of goods for sale. 2. Inventoriable costs are all costs of a product that are regarded as an asset when they are incurred and then become cost of goods sold when the product is sold. These costs for a manufacturing company are included in work-in-process and finished goods inventory (they are inventoried ) to build up the costs of creating these assets. Period costs are all costs in the income statement other than cost of goods sold. These costs are treated as expenses of the period in which they are incurred because they are presumed not to benefit future periods (or because there is not sufficient evidence to conclude that such benefit exists). Expensing these costs immediately best matches expenses to revenues. 3. (a) Mineral water purchased for resale by Safeway inventoriable cost of a merchandising company. It becomes part of cost of goods sold when the mineral water is sold. (b) Electricity used at GE assembly plant inventoriable cost of a manufacturing company. It is part of the manufacturing overhead that is included in the manufacturing cost of a refrigerator finished good. (c) Depreciation on Google s computer equipment period cost of a service company. Google has no inventory of goods for sale and, hence, no inventoriable cost. (d) Electricity for Safeway s store aisles period cost of a merchandising company. It is a cost that benefits the current period and it is not traceable to goods purchased for resale. (e) Depreciation on GE s assembly testing equipment inventoriable cost of a manufacturing company. It is part of the manufacturing overhead that is included in the manufacturing cost of a refrigerator finished good. (f) Salaries of Safeway s marketing personnel period cost of a merchandising company. It is a cost that is not traceable to goods purchased for resale. It is presumed not to benefit future periods (or at least not to have sufficiently reliable evidence to estimate such future benefits). (g) Bottled water consumed by Google s engineers period cost of a service company. Google has no inventory of goods for sale and, hence, no inventoriable cost. (h) Salaries of Google s marketing personnel period cost of a service company. Google has no inventory of goods for sale and, hence, no inventoriable cost. 2-7

8 2-28 (20 min.) Flow of Inventoriable Costs. (All numbers below are in millions). 1. Direct materials inventory 8/1/2007 \$ 90 Direct materials purchased 360 Direct materials available for production 450 Direct materials used 375 Direct materials inventory 8/31/2007 \$ Total manufacturing overhead costs \$ 480 Subtract: Variable manufacturing overhead costs (250) Fixed manufacturing overhead costs \$ Total manufacturing costs \$ 1,600 Subtract: Direct materials used (from requirement 1) (375) Total manufacturing overhead costs (480) Direct manufacturing labor costs \$ Work-in-process inventory 8/1/2007 \$ 200 Total manufacturing costs 1,600 Work-in-process available for production 1,800 Subtract: Cost of goods manufactured (moved into FG) (1,650) Work-in-process inventory 8/31/2007 \$ Finished goods inventory 8/1/2007 \$ 125 Cost of goods manufactured (moved from WIP) 1,650 Finished goods available for sale in August \$ 1, Finished goods available for sale in August (from requirement 5) \$ 1,775 Subtract: Cost of goods sold (1,700) Finished goods inventory 8/31/2007 \$

9 2-29 (20 min.) Computing cost of goods purchased and cost of goods sold. (a) Marvin Department Store Schedule of Cost of Goods Purchased For the Year Ended December 31, 2007 (in thousands) Purchases \$155,000 Add transportation-in 7, ,000 Deduct: Purchase return and allowances \$4,000 Purchase discounts 6,000 10,000 Cost of goods purchased \$152,000 (b) Marvin Department Store Schedule of Cost of Goods Sold For the Year Ended December 31, 2007 (in thousands) Beginning merchandise inventory 1/1/2007 \$ 27,000 Cost of goods purchased (above) 152,000 Cost of goods available for sale 179,000 Ending merchandise inventory 12/31/ ,000 Cost of goods sold \$145,

10 2-31 (25 30 min.) Income statement and schedule of cost of goods manufactured. Howell Corporation Income Statement for the Year Ended December 31, 2007 (in millions) Revenues \$950 Cost of goods sold: Beginning finished goods, Jan. 1, 2007 \$ 70 Cost of goods manufactured (below) 645 Cost of goods available for sale 715 Ending finished goods, Dec. 31, Gross margin 290 Marketing, distribution, and customer-service costs 240 Operating income \$ 50 Howell Corporation Schedule of Cost of Goods Manufactured for the Year Ended December 31, 2007 (in millions) Direct materials costs: Beginning inventory, Jan. 1, 2007 \$ 15 Purchases of direct materials 325 Cost of direct materials available for use 340 Ending inventory, Dec. 31, Direct materials used \$320 Direct manufacturing labor costs 100 Indirect manufacturing costs: Indirect manufacturing labor 60 Plant supplies used 10 Plant utilities 30 Depreciation plant, building, and equipment 80 Plant supervisory salaries 5 Miscellaneous plant overhead Manufacturing costs incurred during Add beginning work-in-process inventory, Jan. 1, Total manufacturing costs to account for 650 Deduct ending work-in-process, Dec. 31, Cost of goods manufactured \$

11 2-32 (15 20 min.) Interpretation of statements (continuation of 2-31). 1. The schedule in 2-31 can become a Schedule of Cost of Goods Manufactured and Sold simply by including the beginning and ending finished goods inventory figures in the supporting schedule, rather than directly in the body of the income statement. Note that the term cost of goods manufactured refers to the cost of goods brought to completion (finished) during the accounting period, whether they were started before or during the current accounting period. Some of the manufacturing costs incurred are held back as costs of the ending work in process; similarly, the costs of the beginning work in process inventory become a part of the cost of goods manufactured for The sales manager s salary would be charged as a marketing cost as incurred by both manufacturing and merchandising companies. It is basically an operating cost that appears below the gross margin line on an income statement. In contrast, an assembler s wages would be assigned to the products worked on. Thus, the wages cost would be charged to Work in process and would not be expensed until the product is transferred through Finished Goods Inventory to Cost of Goods Sold as the product is sold. 3. The direct-indirect distinction can be resolved only with respect to a particular cost object. For example, in defense contracting, the cost object may be defined as a contract. Then, a plant supervisor working only on that contract will have his or her salary charged directly and wholly to that single contract. 4. Direct materials used = \$320,000,000 1,000,000 units = \$320 per unit Depreciation = \$ 80,000,000 1,000,000 units = \$ 80 per unit 5. Direct materials unit cost would be unchanged at \$320 per unit. Depreciation cost per unit would be \$80,000,000 1,200,000 = \$66.67 per unit. Total direct materials costs would rise by 20% to \$384,000,000 (\$320 per unit 1,200,000 units), whereas total depreciation would be unaffected at \$80,000, Unit costs are averages, and they must be interpreted with caution. The \$320 direct materials unit cost is valid for predicting total costs because direct materials is a variable cost; total direct materials costs indeed change as output levels change. However, fixed costs like depreciation must be interpreted quite differently from variable costs. A common error in cost analysis is to regard all unit costs as one as if all the total costs to which they are related are variable costs. Changes in output levels (the denominator) will affect total variable costs, but not total fixed costs. Graphs of the two costs may clarify this point; it is safer to think in terms of total costs rather than in terms of unit costs. 2-11

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