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