Accounting Ch4-6

Structuring Sales Commissions

Companies generally compensate salespeople by: 1. commission based on sales or 2. salary plus a sales commission Commissions based on sales dollars can lead to lower profits in a company

Profit Stability cont.

Companies with low fixed cost structures enjoy greater stability in income across good and bad years

Degree of Operating Leverage Equation

Contribution Margin / Net Operating Income a measure at a given level of sales of how a percentage change in sales volume will affect profits

In process costing, manufacturing overhead costs are

generally applied using a predetermined overhead rate

Product-level

relate to specific products and typically must be carried out regardless of how many batches or units of the product are manufactured

Cost structure

relative proportion of fixed and variable costs in an organization. Managers often have some latitude in determining their organization's cost structure

Contribution Income Statement

sales - variable expenses = contribution margin - fixed expenses = net operating income

Batch-level

tasks performed each time a batch is processed. Costs depend on number of batches done

Target Profit Analysis in dollar sales

(target profit + fixed expenses) / CM ratio

Target Profit Analysis in unit sales

(target profit + fixed expenses) / unit CM

Similarities between Process Costing & Job-Order Costing

- Both assign material, labor and OH to products and provide a mechanism for computing unit product costs - Both use the same Manuf. Accounts (MOH, R/M, WIP, and F/G) - The flow of costs is basically the same

Journal Entry Views of Process Cost Flows

- Cost flow same as in a process costing system - Only difference at this point is that in a process costing system each department has a separate WIP account

Designing an Activity-Based Costing (ABC)

- The challenge is to select a reasonably small number of activities that explain the bulk of variation in overhead costs - Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the resources - Related activities are often combined to reduce the amount of detail and record-keeping costs

Degree of operating leverage does what?

- decreases as sales and profits rise - is not a constant - is greatest at sales levels near the break-even point

Facility-level activities

- general factory administration - plant building and grounds [direct labor hours]

Batch-level examples

- processing purchase orders - processing production orders - setting up equipment - handling materials [purchase orders processed, production orders processed, number of setups, pounds of material handled]

Unit level examples

- processing units on machines - processing units by hand - consuming factory supplies - completed goods [machine hours, direct-labor hours, units produced]

Product-level examples

- testing new products - administering parts inventories - designing products [hours of testing time, number of part types, hours of design time]

CVP (Cost Volume Profit)

1. Prices of products 2. Volume or level of activity 3. Per unit variable costs 4. Total fixed costs 5. Mix of products sold

Limitations of ABC

1. Products differ substantially in volume, batch size, and in activities required 2. Conditions have changed substantially since the existing cost system was established 3. Overhead costs are high and increasing and no one seems to understand why 4. Management does not trust the existing cost system and it ignores data from it when making decisions the product costs computed will most likely be overstated for purposes of decision making

Step 2

Calculate cost per equivalent unit

Contribution Margin (CM)

= sales revenue - variable expenses

Benefits of ABC

ABC improves the accuracy of product costing by: 1. Increasing the number of cost pools used to accumulate overhead costs 2. Using activity cost pools that are more homogeneous than departmental cost pools 3. Assigning overhead costs using activity measures that cause those costs, rather than relying solely on direct labor-hours 4. Activity-based costing also highlights activities that could benefit most from process improvement efforts, such as Six Sigma

Targeting Process Improvements

ABC system helps identify where the company can benefit from improving its current processes: Activity rates: used to target areas where costs seem excessively high Benchmarking: used to compare activity cost information with world-class standards of performance achieved by other organizations

Margin of Safety

Amount by which sales can drop before losses are incurred. The higher the m.o.s the lower the risk of incurring a loss.

Cost Structure and Profit Stability

An advantage of a high fixed cost structure is that income will be higher in good years compared to companies with lower proportion of fixed costs A disadvantage of a high fixed cost structure is that income will be lower in bad years compared to companies with lower proportion of fixed costs

CM is first used to cover fixed expenses

Any remaining CM = net operating income.

Degree of Operating Leverage

At a given level of sales, measures how a percentage change in sales volume will affect profits

Step 1

Calculate Equivalent Units of Production

Step 3

Calculate cost of ending WIP inventory and units transferred/completed

Step 4

Cost reconciliation report

How cost structures impact D of OL

Dependent on cost structure (assuming revenue and total expenses are equal): • Higher CM (low variable/high fixed) = higher operating leverage • Lower CM (high variable/low fixed) = lower operating leverage **Degree of operating leverage is not a constant

Conversion Costs

Direct labor and manufacturing overhead may be combined into one classification of product cost

What happens to overhead costs when a company implements an ABC System (shifting of overhead)?

Low-volume product: when implements ABC, overhead cost shifts from high-volume to low-volume products because of the fixed costs

Differences between Process Costing & Job-Order Costing

Process Costing: - Used when a single product is produced for a long period of time - Accumulate costs by department - Compute unit costs by department

Margin of safety in dollars

Total Sales - Break Even Sales dollars

Calculating Equivalent Units

The Weighted-Average Method- Makes no distinction between work done in prior or current periods Blends together units and costs from prior and current period

Contribution Margin

The amount remaining from sales revenues after all variable expenses have been deducted. Used for internal decision making

Process Costing

Used in industries that convert raw materials into homogeneous products - products that are similar and produced continuously

activity

an event that causes the consumption of overhead resources in an organization

Facility-level

carried out regardless of products or output (overhead costs, management salaries) - cannot be traced on a cause-and-effect basis to individual products

Unit level

done each time a unit is produced. Costs should be proportional to number of units produced

Once the break-even point is reached, the sale of an additional unit increases contribution margin by an amount that is ______ the increase in net operating income.

equal to

activity rate is computed by dividing

estimated OH total cost in the activity cost pool/expected activity level in the activity cost pool

Break even point in dollar sales

fixed expense/ cm ratio

Break even point in units sales

fixed expense/ unit cm

A company with a high ratio of fixed costs

is more likely to experience greater profits when sales are up than a company with mostly variable costs. is more likely to experience a loss when sales are down than a company with mostly variable costs.

Margin of safety in units

margin of safety in dollars / selling price per unit

Margin of safety percentage

margin of safety in dollars / total sales

Profit Equation

profit = (sales-variable exp.) - fixed exp. profit= ((Q*P)-(Q*V))- fixed exp.

Hierarchy of Activities

unit level, batch level, product level, facility level

Operating Leverage Illustrated

• Dependent on level of sales • Highest at sales levels near the break-even point • Decreases as sales and profits rise

Equivalent units of production

• Equivalent units are the product of the number of partially completed units AND the percentage completion of those units. • These partially completed units complicate the determination of a department's output for a given period and the unit cost that should be assigned to that input

Assumptions of CVP Analysis

• Selling price is constant • Costs are linear and can be accurately divided into variable and fixed • Sales mix is constant • Inventories do not change