Cost Accounting Test 1- Chapters 1, 2, 3, 5

Target income (units) =

(Fixed expenses + target operating income) / CM per unit

Understanding cost behavior patterns

(i.e., the relationship between cost and activity) is important to managers as they plan, control, and make decisions in the operation of their organizations. (For example, a manager must understand how costs behave across various levels of activity before a budget can be prepared.)

Manufacturing costs:

1. Direct Material (variable) 2. Direct Labor (variable) 3. Variable Manufacturing Overhead (with respect to units produced) 4. Fixed manufacturing Overhead

Indirect costs

1. Do not have an observable cause an effect relationship with the cost object, or 2. Cannot be measured and recorded (traced) to the cost object in an economically feasible way. Indirect costs are allocated to the cost object using a systematic cost allocation method.

Direct costs

1. Have an observable cause and effect relationship with the cost object, and 2. Can be measured and recorded (traced) to the cost object in an economically feasible way. Direct costs are directly assigned to the cost object.

Accounting systems provide information to decision makers. The major purposes of accounting systems are:

1. Routine internal reporting, e.g., for planning and control 2. Non-routine internal reporting, e.g., for "what-if" analysis, legal issues 3. External reporting, e.g., for GAAP reporting to SEC, shareholders, banks

Selling and Administrative costs:

5. Variable Selling and Administrative (with respect to units sold) 6. Fixed Selling and Administrative

you can use the weighted-average contribution margin ratio, which is the weighted-average contribution margin expressed as a percentage of the weighted-average selling price.

= Weighted-average CM / weighted-average sales price

Cost driver

A cost driver is a level of activity or volume that causally affects costs over a given period of time. In other words, there is a cause and effect relationship between the change in level of the cost driver and the level of total costs. The default cost driver in this course is an individual unit of a product.

Cost

A cost is a resource sacrificed or forgone (e.g. money paid) to achieve a specific objective. In financial accounting: A cost generates an asset which may be consumed (used up) immediately (within an accounting period) or over many years (many accounting periods).

Cost object

Anything for which a separate measurement of cost is desired e.g. department, division, customer, activity, project, product line, process, individual product. The default cost object in this course is an individual unit of a product.

Value-added activities:

Are the activities in the chain that customers perceive as adding value to the goods and services.

Break-even point Sales Revenue

Break-even point ($) = Break-even point units x sales price per unit OR Break-even point ($) = Fixed expenses/ CM ratio

Operating leverage factor =

CM / operating income This factor, when multiplied by the percentage change in sales revenue, will equal the percentage change in operating income.

Assumptions of CVP

Changes in the levels of revenues or costs occur because of changes in the level of units sold, i.e., the revenue driver and the cost driver is units sold. In other words, all units produced are sold. Total costs consist of two components: total variable costs total fixed costs The behaviors of total revenues and total costs are linear. Selling price, variable cost per unit, and total fixed costs remain constant (within a relevant range and time period). Sales mix is constant.

Cost accounting & financial accounting users of information

Cost accounting- Internal: Managers of the organization Financial accounting- External: Investors, banks, regulators, suppliers, etc.

Cost accounting and financial accounting behavioral implications

Cost accounting: Designed to influence the behavior of managers and other employees. Financial accounting: Primarily reports economic events but does influence manager behavior because compensation is often based on reported financial results.

Cost accounting and financial accounting types of reports

Cost accounting: Financial and non-financial reports on products, departments, regions, strategy, etc. designed to meet manager needs. Varying degrees of detail from summary to extremely detailed. Financial accounting: Financial reports generally on the company as a whole. Summary information.

Cost accounting & financial accounting purpose of information

Cost accounting: Help managers make decisions to fulfill an organization's goals Financial accounting: Communicate the organization's financial position to outside parties.

Cost accounting & financial accounting important criteria for information

Cost accounting: Decision relevance for managers, timeliness. Financial accounting: Comparability, decision relevance for investors.

Cost accounting & financial accounting focus and emphasis

Cost accounting: Future-oriented Financial accounting: Past-oriented

Cost accounting & financial accounting rules of measurement and reporting

Cost accounting: Internal measures and reporting determined by managers. Do not have to follow GAAP but are based on cost-benefit analysis. Financial accounting: Financial statements prepared in conformance with GAAP and certified by external independent auditors.

Cost accounting and financial accounting time span

Cost accounting: Varying time horizons from minutes to decades. Financial accounting: Annual and quarterly

CVP analysis

Cost-volume-profit (CVP) analysis often referred to as break-even analysis, examines the interrelationship of sales activity, prices, costs, and profits in planning and decision-making situations.

Cost accounting is utilized to determine the cost of the product for each of these three company types including valuation for external reporting purposes. Under the traditional (absorption) methods of accounting (GAAP compliant) the cost to manufacture a product consists of three categories of inputs:

Direct Material, Direct Labor, and Manufacturing Overhead.

On the balance sheet, product costs are found in three inventory accounts:

Direct materials - materials that await production -Work in process - partially completed production -Finished goods - completed production that awaits sale

Manufacturing Costs:

Direct materials, direct labor, manufacturing overhead (includes indirect materials, indirect labor, and other manufacturing costs).

Cost estimation methods

Engineering method Account analysis method Visual-fit method/scattergraph High-low method Least-squares regression method

Fixed costs

Fixed costs remain constant in total as the level of activity changes. Within the relevant range, total fixed costs remain constant with changes of cost driver activity but fluctuate on a per unit basis. For instance, straight-line depreciation of a bicycle plant remains the same whether 100 bicycles or 1,000 bicycles are produced. However, the depreciation cost per unit fluctuates because this constant total is spread over a smaller or greater volume. stay constant in total but fluctuate on a per-unit basis across ranges of activity. Example: a professor's salary is fixed, and more students enrolled in his or her course will not affect salary. However, the salary cost per student will vary depending on class size.

Break-even point in units =

Fixed expenses + 0 / CM per unit

Break-even point number of units (multiple products):

Fixed expenses/ weighted average contribution margin

Break-even point ($) =

Fixed expenses/ weighted-average contribution margin ratio

Financial Accounting:

Focuses on external reporting guided by GAAP (external use; past-oriented).

Contribution income statement

For internal reporting purposes costs are often split into purely variable or fixed components for ease of analysis to aid decision-making. The contribution income statement allows for an easier analysis of the effects of changes in projected sales because as sales increase: total variable costs will increase but total fixed costs will remain constant.

Visual-fit method/scattergraph

For the visual-fit method, the manager examines a cost by plotting points on a graph called a scatter diagram, or scattergraph, and placing a line through the points to yield a cost function. The line is fitted to the points visually versus statistically. The fixed cost is where the line crosses the Y-axis. The slope of the line is the variable cost rate which is used to calculate the variable cost. Advantages: Includes all of the points observed. Outliers (non-representative points) are visibly apparent. Easy to apply. Disadvantages: Lack of objectivity. Two different people may draw two different lines.

Cost-Benefit Approach:

If the cost of collecting information is more than the benefits gained from its use, then it does not make sense to collect the information.

Income before taxes =

Income after taxes / (1 - tax rate)

Manufacturing overhead - all other manufacturing costs such as:

Indirect materials, indirect labor, other manufacturing costs.

Behavioral and Technical Considerations:

Information is provided both to assist in decision-making and to motivate employees to act in the best interests of the organization.

Cost assignment

Is the association of accumulated costs to a cost object. Cost assignment is achieved through 1. Cost tracing of direct costs. 2. Cost allocation of indirect costs. When a cost object is an individual unit of a product then cost assignment is synonymous with product costing.

Cost allocation

Is the process of assigning indirect costs to cost objects. Indirect costs are accumulated in a cost pool and assigned to the cost objects using a systematic cost allocation method.

Merchandising Costs:

Merchandise purchases including freight-in, insurance, and handling -merchandise purchased for resale (e.g. clothes for a department store). On the balance sheet, product costs are found in one inventory account: -Merchandise Inventory —purchased merchandise that has not yet sold (e.g. clothes on the department store floor)

Mixed (semi-variable) costs

Mixed costs have both a fixed and a variable component. For example a utility bill will include a: (a.) fixed minimum charge for providing a service that is ready and available for use (b.) variable charge for actual consumption of the service. or semi-variable costs, change in total and on a per-unit basis in response to changes in cost driver activity, but not proportionately. Mixed costs have both variable and fixed elements. Example: a printer's fee for brochures, which includes an initial set-up fee (fixed) and a per-copy (variable) charge for running the total copies needed.

Percentage Change in Operating Income

Percentage change in sales revenue x operating leverage factor

Period costs

Period costs are all non-product costs in an organization (e.g. selling and administrative expense). Period costs are not inventoried but are expensed as incurred. Period costs benefit revenues in the period incurred rather than future periods.

Product costs

Product costs are the costs of goods manufactured or the cost of goods purchased for resale. These costs are inventoried until the goods are sold. In other words, these costs are considered as assets on the balance sheet when they are incurred, and are expensed as cost of sold on the income statement when they are sold. As such, product costs can also be called inventoriable costs.

the sales-mix percentages are multiplied by the number of "total units" to calculate individual product units to break even.

ProductA break-even units = sales mixA % x break-even point (units) ProductB break-even units = sales mixB % x break-even point (units)

Contribution margin per unit =

Sales price -variable cost per unit

Profit=

Sales- total variable expenses -total fixed expenses (Sales price x # of units) - (Variable cost per unit x # of units) - Total fixed expense = profit

Companies can be generally be categorized into one of three major types depending on the product sold:

Sell an intangible product: 1. Service companies - perform and sell a service (an intangible product). For example: banks, attorneys, accountants, hairdressers. Sell a tangible product: 2. Merchandising companies (wholesalers, distributors, retailers) - acquire tangible products in finished form from a manufacturer or other outside source and then sell the product without changing the product's basic form. Just selling; not making. For example: Albertson's, Staples, Macy's, Target, Best Buy. 3. Manufacturing companies - acquire raw materials and components and convert them into finished form tangible products through the efforts of manufacturing labor and equipment. For example: General Motors, General Electric, Dell Computer, Campbell Soup.

Different Costs for Different Purposes:

Since cost accounting information (used for internal purposes) does not need to be GAAP compliant (external reporting rules), the information provided to managers can be more useful (tailored to better facilitate decision-making) for implementing strategy, evaluating performance, and fulfilling company-specific goals. For example: -GAAP-compliant product costing information only includes manufacturing costs, but the company will want to include all costs for pricing decisions. -GAAP-compliant product costing information includes an allocation of fixed manufacturing overhead costs, but many of these costs may be irrelevant for decision-making between future alternative courses of action.

Target operating income sales revenue =

Target income units x sales price per unit OR (Fixed expenses + target operating income) / CM ratio

Safety Margin in Dollars:

The amount in dollars by which sales revenues can fall before losses begin to occur is computed as follows: = Budgeted sales ($) - Break-even sales ($)

cost structure

The cost structure of an organization is the relative proportion of fixed and variable costs to total costs. An automated manufacturing plant has a high proportion of fixed costs while a labor-intensive plant has a high proportion of variable costs. A firm's cost structure has a significant effect on the way that profits fluctuate in response to changes in sales volume. The greater the proportion of fixed costs, the greater the impact on profit from a given percentage change in sales volume.

operating leverage

The extent to which an organization uses fixed costs in its cost structure is called operating leverage A firm with a higher proportion of fixed costs and a lower proportion of variable costs has high operating leverage and the ability to greatly increase operating income from an increase in sales revenue. However, firms with higher operating leverage also have higher levels of risk. For the firm with the relatively higher fixed cost structure: After the break-even point has been reached, the relatively larger contribution margin of each additional unit sold will fall to the bottom line. If the break-even point is not reached, losses will be larger.

The greater the degree of operating leverage:

The greater the change in operating income i.e. profits are more sensitive to changes in sales activity - higher level of risk

Sensitivity analysis

The impact of changes in: fixed expenses, variable expenses, selling prices, and volume on profit can be determined by using CVP analysis. Therefore, CVP is also useful tool in answering "what-if" questions.

Safety Margin as a Percentage:

The percentage by which sales revenues can fall before a firm starts losing money is computed as follows: =(Budgeted sales ($) - Break-even sales ($)) / Budgeted sales ($) OR Safety margin in dollars / budgeted sales ($)

Target operating income

The preceding break-even point equations can be modified to determine the level of sales needed to produce a particular target operating income. Each unit now contributes toward covering fixed expenses and generating profit (some amount greater than zero).

Relevant range

The relevant range is the band of normal activity within which there is a specific relationship between the level of activity and cost. It is the range of activity within which managers expect a company to operate and within which managers can predict cost behavior with some certainty. For example, once a machine reaches its maximum production output capacity, the company can only increase output by purchasing/leasing another machine. Within the relevant range, even curvilinear costs may behave in a linear fashion.

Safety Margin in Units:

The safety margin can also be expressed in units i.e. The amount by which sales quantity in units can fall before losses begin to occur is computed as follows: Budgeted sales (units) - break-even sales (units)

Gross Margin versus Contribution Margin Formats:

The traditional income statement required by GAAP for a manufacturer includes a cost-of-goods-sold figure that combines variable costs and fixed manufacturing overhead. The statement's format does not group costs by behavior but rather by function which makes analysis difficult. Gross margin (sales revenue less cost of goods sold) is a measure of competitiveness - it indicates how much a company can charge over and above the cost to acquire or produce the product sold. The contribution income statement is presented in a format that highlights cost behavior - costs that vary and costs that are fixed with changes in activity within the relevant range. Variable expenses (variable product and variable period) are subtracted from sales to produce a total contribution margin. Next, fixed expenses (fixed product and fixed period) are subtracted from the contribution margin to yield the period's operating income. Contribution Margin (sales revenue less total variable costs) is a measure of risk - it indicates how much of company's revenues are available to cover fixed costs.

Break-even point Sales Revenue (multiple products):

To find the break-even point in dollars when more than one unit is being sold, simply multiply the break-even point in units for each product by the selling price for each product. =Σ (Producti break-even units * Sales price per uniti)

Variable costs

Variable costs in total move in direct proportion to a change in activity. Within the relevant range, total variable costs fluctuate in direct response to cost driver changes but remain constant on a per unit basis. For example, in the manufacture of bicycles, the total cost of bicycle seats goes up in proportion to the number of bicycles produced. However, the cost per unit (i.e., per seat) remains constant. are costs that remain constant on a per-unit basis but fluctuate proportionately in total in response to changes in cost-driver activity. Example: the paper cost in giving exams varies with the number of students in a class.

The cost function (formula) for a mixed cost is:

Y = mx + b Where: Y = Total mixed cost m = Variable cost rate per unit of activity x = Activity level b = Total fixed cost Note: mx is the total variable cost

a change in a firm's sales mix will

alter the company's break-even point.

Expense

an expired cost. When the benefits of the acquisition expire the cost becomes an expense or a loss.

Prime costs

are all direct manufacturing costs i.e. Direct Material and Direct Labor

Conversion Costs

are all manufacturing costs to convert direct material into finished goods i.e. Direct Labor and Manufacturing Overhead.

Differences between a cost and an expense

are generally due to timing differences e.g. the cost of acquiring a building versus the expense of depreciating the cost of the equipment over its useful life.

curvilinear cost function

cannot be represented with a straight line but instead is represented with a curve that reflects either increasing or decreasing marginal costs.

High-low method

considers only two points of data within the relevant range: The cost associated with the highest activity level and The cost associated with the lowest activity level. 1. The method first focuses on the cost changes allowing the manager to determine the presence of any variable cost: Variable Cost Rate = Cost associated with highest activity level - Cost associated with lowest activity level Highest activity level - Lowest activity level 2. Next, fixed costs are determined by subtracting total variable costs from total cost at either of the two data points: Total Fixed Costs = Total Costsª - (Variable Cost Rate x Activity Level)ª ªImportant: Total Costs and the related activity level must be one of the two activity levels used to calculate the Variable Cost Rate 3. Finally, deriving the Variable Cost Rate and Total Fixed Cost allows the manager to calculate estimated total costs for different activities within the relevant range: Total Cost = Total Fixed Cost + (Variable Cost Rate x Activity Level) Advantages: Objective. Two different people will derive the same cost function. Easy to apply. Disadvantages: Only uses two data points in determining the cost function. This method is only accurate if the highest and lowest activity points are representative of all the points in cost and activity.

CVP analysis is based on a variable costing, or

contribution margin income statement approach: Sales revenue (#units x sales price) Less: Total variable costs (#units x variable cost per unit) Total contribution margin Less: Total fixed cost Operating income

In the presence of Fixed Costs, the degree of operating leverage will be

different at different levels of sales.

Direct labor

human labor that can be easily (economically feasible) traced to a finished product - generally the wages of anyone who works directly on the product (e.g., the assembly-line wages of the bicycle manufacturer).

Distribution chain

individuals and firms that buy, distribute, and sell goods and services from the organization.

Supply chain

individuals and firms that sell goods and services to the organization.

At the Breakeven point, taxes and tax rates are

irrelevant. This is because at the breakeven point, profits are $0; therefore there are no taxes.

Cost pool

is a collection of costs to be assigned to the cost objects.

The least-squares regression method

is a statistical approach that both is objective and considers all data points. The regression line is in the form: y = α + βx where: y is the dependent variable (total cost) α is the intercept (total fixed cost) x is the independent variable (activity level) β is the coefficient (variable cost per unit of activity) Advantages: Utilizes all data points. Objective. Two different people will derive the same cost function. By using mathematical formulas to arrive at the best possible cost line (i.e., the regression line), the method is more accurate than the other methods. The coefficient of determination, R2, can be used to judge the line's goodness of fit, or how well the line fits the data on which it is based. If the goodness of fit is relatively high (close to 1 or 100%), a large proportion of the variation in the dependent variable is explained by changes in the independent variable. The t-statistic can be used to determine the significance of the coefficient, β, or how much effect the independent variable has on the dependent variable. If the t-statistic is greater than 2.0 it is generally considered significant. Multiple regression can be used to estimate a cost function when there is more than one independent variable. For example, the fuel cost for an airline is determined by the number of miles flown and by other variables such as wind speed and load. Disadvantages: In the past, using regression to estimate a line was time-consuming and usually not economically feasible. However, with advances in computer technology, this method is now as easy as the other methods.

weighted-average unit contribution margin

is calculated by multiplying a product's contribution margin by its sales mix percentage, and then summing the results for individual products.

Cost allocation rule

is the method used to assign costs in the cost pool to the cost objects.

Sales mix

is the number of units sold of a given product relative to the total units sold. For example, if a company sells 8,000 units of product A and 2,000 units of product B, the sales mix is 80% A and 20% B.

Value chain

is the set of activities required to provide goods and services that the customer values (purchases and consumes). It also includes externalities (disposal and waste generated by the process and the end user).

Traditional costing or absorption costing (compliant with GAAP)

is used for external reporting purposes. Under absorption costing, the traditional income statement splits all costs into: Manufacturing (product) costs Selling and Administrative (period) costs.

Indirect materials

materials and supplies other than those classified as direct materials - generally insignificant costs (too costly to track e.g. glue in furniture).

Direct materials

materials easily (economically feasible) traced to a finished product (e.g., the seat on a bicycle).

In management accounting: A cost is a monetary

measurement of the amount of resources used for some purpose. To become operational, the cost must also include a term that defines its purpose e.g. acquisition cost, fixed cost, incremental cost, opportunity cost.

Managerial Accounting:

measures and reports financial and non-financial information that assists management in fulfilling the goals of the organization (internal use; future-oriented).

Cost Accounting:

measures and reports information related to the acquisition and consumption of resources (internal and external use). Note: the terms "cost accounting" and "managerial accounting" are often used interchangeably.

Other manufacturing costs

not easily traceable to a finished good (insurance, property taxes, depreciation, utilities, and service/support department costs).

In both formats (CM income statement and traditional absorption income statement),

operating income is the same (assuming no inventory). However managers typically prefer the contribution income statement because it enhances the statement's usefulness as an aid for making operational decisions. Decisions like: -How income will be affected if sales volume changes by a given percentage -The sales volume and sales revenue required to breakeven -The margin of safety for budgeted sales.

Companies with zero fixed costs have an

operating leverage factor of 1.

Account analysis method

or account-classification method, requires the study of the accounts in the general ledger that make up the total costs being analyzed. The experienced analyst uses the account information as well as his or her own judgment to determine future cost behavior.

Step costs

or semi-fixed costs, stay constant in total within a relatively narrow range of activity but jump (step) to a new level outside of that range. Example: if one exam proctor is needed for every ten students, then: one proctor is needed for one to ten students; two proctors for eleven to twenty students, etc. In other words, the fixed cost jumps in steps within the relevant range.

Indirect labor

personnel who do not work directly on the product (e.g., manufacturing supervisors), overtime premiums, idle time, fringe benefits.

The break-even point is the

point where revenues and expenses are equal i.e. where operating income is $0.00.

Engineering method

requires a detailed analysis of the steps required to complete a task. Cost estimates are based on measurement and pricing of the work involved in the task.

The safety margin (or margin of safety)

shows the amount by which sales revenues can fall before a firm starts losing money.

Contribution margin ratio

which is the contribution margin expressed as a percentage of the selling price. The contribution margin ratio represents the percentage of each sales dollar that contributes towards covering fixed costs and generating profit. CM ratio = total CM/ Total sales revenue CM ratio = CM per unit / sales price per unit