UG802: COST MEASUREMENT AND COST ANALYSIS April 6, 2014 Kanokporn Rienkhemaniyom, Ph.D. Managerial Accounting - Overview Definition: A profession that involves partnering in management decision making, devising planning and performance management systems, and providing expertise in financial reporting and control to assist management in the formulation and implementation of an organization s strategy. (The Institute of Management Accountant, 2013) Managerial accounting supports the decision making process through planning and controlling operations that provide financial and nonfinancial information to an organization s managers and other internal decision makers. 1
The work of management and the need for managerial accounting information Planning Controlling Decision Making Establishing a strategy, objectives, and identifying methods to achieve those objectives Ensuring that the plan is actually carried out and is appropriately adapted as situations change Choosing among competing alternatives The work of management and the need for managerial accounting information In every organization, someone must be responsible for formulating strategy, developing plans, organizing resources, and controlling operations. 2
The work of management and the need for managerial accounting information Planning and Control Cycle Formulating plans (Planning) Comparing actual vs planned (Controlling) Decision Making Implementing plans (Controlling) Measuring Performance (Controlling) Source: Jiambalvo, J. (2010) Current Focus on Management Accounting Customer orientation Create customer value to gain competitive advantage Customer value is the difference between what a customer receives and what the customer gives up when buying products or services Customer value may be increased through two strategies: cost leadership and product differentiation Cost leadership provide the same or better value to customers at a lower cost than competitors Product differentiation provide something, not provided by competitors, to customers Management accounting should track information of all activities in value chain to enhance customer value through the key activities 3
Current Focus on Management Accounting Design Develop Produce Market Deliver Cross-functional perspective Management accountant must understand many functions of the business Current Focus on Management Accounting Time as a competitive element Time is crucial in all phases of the value chain: design, implementation, production cycle, delivery Decreasing non-value-added time implies improving customer responsiveness Short product life cycles force managers to make decision quickly and decisively Total quality management - Continuous improvement - Zero defect work environment 4
Current Focus on Management Accounting Efficiency Quality, time, and efficiency should be considered simultaneously. Cost is a measure of efficiency. Resiliency Ability to return to normal operation after facing any disturbances. Do you know the cost of your products or services? 5
Hands-on exercise for cost analysis Reference: Vinciguerra, B. and Lafond, C. A. Using a hands-on exercise to teach cost accounting concepts. Journal of Business Cases and Applications. 6
Learning Objectives: ² To understand the various functions in a simple manufacturing environment ² To determine product cost in a job cost environment ² To understand different costing systems A Manufacturing Company Product I Paper hat Product II Paper chain 7
Manufacturing Process Paper Hat 1. Paper is delivered by Material Handling to the Assembly Department 2. Paper sheets are folded into a cone shape, taped and stapled in the Assembly Department. Finished hats are moved to the Finishing Department 3. Hats are decorated in the Finishing Department using four stickers per hat 4. Hats are placed on a table for inspection by Quality Control. Quality Control also checks to ensure that the proper items are included in the order. Manufacturing Process Paper Chain 1. Paper is delivered by Material Handling to the Cutting Department 2. Links are cut into 2 by 8.5 strips. Five strips can be made from one sheet of paper. Cut strips are moved to the Assembly Department. 3. Each link is connected to the previous link and then taped and stapled in the Assembly Department. Completed chains are moved to the Finishing Department. 4. Chains are decorated in the Finishing Department using 8 stickers per completed chain 5. Chains are placed on a table for inspection by quality control. Chains are then inspected by Quality Control before being packed for shipment with the completed job 8
Manufacturing Departments Department Description Receiving/Warehouse Storing and distributing raw materials used in the manufacturing process Material handling Requesting materials from Warehouse for the day s job. Also moving items in process between departments and keeping factory clean during downtime Cutting Cutting the paper sheets used in products Assembly Fastening the product parts Finishing Decorating the products Quality control Ensuring that products are made according to specification and checking the accuracy of the final jobs Employees Number of employees Stockroom employee 1 Material handling employees 2 Quality control employee 3 Cutting department employees 3 Assembly department employees 4 Finishing department employees 4 Supervisor 1 9
Building Layout (Number of Employees) Warehouse (1) Cutting Department (3) Factory officers Supervisor, QC, etc. (4) Material handling (2) Assembly Department (4) Finishing Department (4) Jobs to be completed Paper Hats Paper Chains Job order 101 15 10 Job order 102 15 10 10
Assignment Complete the manufacturing of job orders 101 and 102 Identify the various costs involved in making the products Classify the costs as product or period costs Classify the costs as direct material, direct labor, and manufacturing overhead Compute the product cost under various costing system Cost Classification I I. Manufacturing costs (or product costs) are all the costs associated with the production of goods. Product costs usually includes three cost categories: Direct material Direct labor Easy to trace to a product Manufacturing overhead Not easy to trace to a product, cost allocation is required. II. Nonmanufacturing costs (or period costs or selling and administrative costs) Selling costs Administrative costs 11
Manufacturing Costs Direct materials - those that become an integral part of the finished product and whose costs can be traced to the finished product. Indirect materials - those materials that are not directly traced to a product. Their costs are relatively insignificant or not worth to trace. Materials Requisition Form to Trace Direct Materials to a Product or Job Cutting 101 April 6, 2014 12
Manufacturing Costs Direct labor labor that is directly traced to items produced Indirect labor labor that is not traced directly to products produced. Employee Time Ticket Trace Direct Labor to a Product or Job e.g., Cutting, Assembly, Finishing 001 Cutting #1 April 6, 2014 Cutting 13
Manufacturing Costs Manufacturing overhead Involve all manufacturing activities other than direct material and direct labor. Other names: indirect manufacturing, factory overhead Nonmanufacturing Costs Nonmanufacturing costs are divided into two categories 1. Selling costs all costs that are incurred to secure customer orders and get the finished product to the customers. Sometime it is called order-filling costs. For example, shipping, advertising, sales travel, sales salaries, costs of finished goods warehouses. 2. Administrative costs all costs associated with the general management of an organization rather than manufacturing or selling. They are also called as general costs or administrative costs. For example, executive compensation, accounting, secretarial, etc. 14
Cost Classification II Product Costs all costs involved in making a product. For manufacturing, product costs include direct material, direct labor, and manufacturing overhead. Product costs attach to units of product. They are also known as inventoriable costs Period Costs all costs that are not product costs. They are expenses on the income statement in the period in which they are incurred using accrual accounting. For example, selling cost and administrative costs. Cost Classification III Cost behavior refers to how a cost reacts to changes in the level of activity If a cost can be expected to change, a manager must be able to estimate how it will change. Common cost behavior patterns: - Variable costs - Fixed costs - Mixed costs - Step costs 15
Cost Classification III VARIABLE COST a cost that varies in direct proportion to changes in the level of activity such as units produced, units sold, miles traveled, hours worked, etc. Examples of variable cost: direct materials, cost of goods sold, sales commissions, costs of drugs and meals for hospital service to patients FIXED COST a cost that remain constant regardless of changes in the level of activity. Examples of fixed cost: rent, depreciation, supervisor salary, building maintenance MIXED COSTS costs that contain both a variable cost element and a fixed cost element Examples of mixed costs: total compensation of a salesperson (fixed salary + commission), total production cost STEP COSTS costs that are fixed for a range of volume but increase to a higher level when the upper bound of the range is exceeded 16
Calculate a Product Cost: Product cost = Direct material cost + Direct labor cost + Manufacturing overhead cost See the Job Cost Sheet 17
Job Cost Sheet Sheets of paper that was used to produce 15 paper hats Time that the cutting labor spent on making 15 hats of job 101 115% of the product cost 115% of the product cost Cost Allocation: ² To allocate overhead cost to a product using: ² Traditional costing with only one cost pool: If using total units produced as a cost driver: Applied overhead rate = total manufacturing overhead cost in the period number of units produced in the period Hence, Applied overhead cost for a product = applied overhead rate x number of units produced for a specific product 18
Exercise 1 Calculate the product cost by allocating overhead cost using the total units produced as a cost driver. Given that: The cost of paper is $0.05 per sheet The cost of sticker is $0.01 each Labor cost (Cutting, Finishing, and Assembly) is $15 per hour The total overhead cost and the total number of units produced during the month are $66,550 and 240,000 units, respectively. Job Cost Sheet 101 15 0.05 0.75 60 0.01 0.60 1.35 10 0.05 0.5 80 0.01 0.8 1.3 15 10 0 0.25 15 3.75 0.25 15 3.75 0.5 7.5 0.15 15 2.25 0.30 15 4.5 0.15 15 2.25 0.6 9.00 Cost per unit of cost driver = Total overhead cost per month Total units produced per month = 66,550 240,000 = $0.28 15 0.28 4.16 115% of the product cost 4.16 13.01 0.87 1.00 10 0.28 2.8 115% of the product cost 2.8 13.11 1.31 1.50 19
Exercise 2 Calculate the product cost by allocating overhead cost using the total direct labor hours as a cost driver. Given that: The cost of paper is $0.05 per sheet The cost of sticker is $0.01 each Labor cost (Cutting, Finishing, and Assembly) is $15 per hour The total overhead cost and the total direct labor hours during the month are $66,550 and 11,000 hours, respectively. Job Cost Sheet 101 15 0.05 0.75 60 0.01 0.60 1.35 10 0.05 0.5 80 0.01 0.8 1.3 15 10 0 0.25 15 3.75 0.25 15 3.75 0.5 7.5 0.15 15 2.25 0.30 15 4.5 0.15 15 2.25 0.6 9.00 Cost per unit of cost driver = Total overhead cost per month Total direct labor hours per month = 66,550 11,000 = $6.06 0.5 6.05 3.03 115% of the product cost 3.03 11.88 0.79 0.91 0.6 6.05 3.63 115% of the product cost 3.63 13.93 1.39 1.60 20
Cost Allocation: ² To allocate overhead cost to a product using: ² Activity-based costing: Form overhead cost into several cost pools based on activities (cost drivers), such as labor hours, space, level of activity, etc. The overhead from each cost pool is allocated to a product based on its cost driver. Applied overhead rate of a cost pool = Overhead cost of a cost pool Number of cost driver for the cost pool Therefore, Applied overhead cost of a cost pool to a product = Applied overhead rate of a cost pool x number of the cost driver used in the product Exercise 3 Calculate the product cost by allocating overhead cost using Activity-Based Costing. There are 4 cost pools as follows: Cost pool Cost driver 1. Cutting dept cutting dept labor hrs 2. Assembly dept assembly dept labor hrs 3. Finishing dept finishing dept labor hrs 4. General cost pool total labor hours 21
What are the overhead costs associated with the cutting department? (Given that the total cutting labor hour during the month is 1,500 hours) - Depreciation on cutting machine 3,000 - Depreciation and taxes on building (16.67%) 1,667 overhead cost cost driver cost / unit of cost driver Total cutting overhead 4,667 1,500 4,667/1,500 = 3.11 Cutting overhead is $3.11 per cutting labor hour What are the overhead costs associated with the assembly department? (Given that the total assembly labor hour during the month is 5,500 hours) - Depreciation on stapling machine 2,000 - Depreciation on tape equipment 1,000 - Tape 100 - Staples 150 - Depreciation and taxes on building (25%) 2,500 overhead cost cost driver cost / unit of cost driver Total assembly overhead 5,750 5,500 5,750/5,500 = 1.05 Assembly overhead is $1.05 per assembly labor hour 22
What are the overhead costs associated with the finishing department? (Given that the total finishing labor hour during the month is 4,000 hours) - Depreciation and taxes on building (25%) 2,500 overhead cost cost driver cost / unit of cost driver Total finishing overhead 2,500 4,000 2,500/4,000 = 0.63 Finishing overhead is $0.63 per assembly labor hour What are the general overhead costs? overhead cost cost driver cost / unit of cost driver - Depreciation on building (33.33%) 3,333 - Utilities 1,500 - Indirect labor 14,400 - Quality control 12,800 - Supervisor 21,600 Total general overhead 53,633 11,000 53,633/11,000 = 4.88 General overhead is $4.88 per labor hour 23
Job Cost Sheet 101 15 10 15 0.05 0.75 60 0.01 0.60 1.35 0 0.25 15 3.75 0.25 15 3.75 0.5 7.5 10 0.05 0.5 80 0.01 0.8 1.3 0.15 15 2.25 0.30 15 4.5 0.15 15 2.25 0.6 9.00 Cutting 0 3.11 0 Assembly 0.25 1.05 0.26 Finishing 0.25 0.63 0.16 General OH 0.5 4.88 2.44 2.86 Cutting 0.15 3.11 0.47 Assembly 0.30 1.05 0.31 Finishing 0.15 0.63 0.09 General OH 0.6 4.88 2.93 2.86 115% of the product cost 11.71 0.78 0.90 115% of the product cost 14.10 1.41 1.62 Final thoughts ² It is obvious that each product uses different amount of materials, but they are also use different amount of manufacturing overhead ² The traditional costing method, which uses only one cost pool, is easy to do. However, it does not reflect the way the products cause overhead costs ² The Activity-base costing provides more precise cost information, but it is complicated and requires more work ² Getting cost right has a significant impact on pricing and product mix decisions 24
Summary ² Understand the various functions in a simple manufacturing environment ² Understand the costs associated with making each of product and different cost types ² Understand different costing systems ² Getting the cost right will support a good planning, controlling, and decision making 25