Mang Acc Exam 2

Cost Flows Under Departmental Overhead Rate Method

. Use of multiple overhead rates can result in better overhead cost allocations and improve management decisions. b. The departmental overhead rate method uses a different overhead rate for each production department. This is usually done through a two-stage assignment process where departments are the cost objects in the first stage and products are the cost objects in the second stage. c. Overhead costs are first determined separately for each production department.Then an overhead rate is computed for each production department to allocate the overhead. d. This method allows each department to have its own overhead rate and its own allocation base.

Controlling Costs

1. An effective management control practice is to hold managers responsible only for their controllable costs. 2. Uncontrollable costs are not within the manager's influence. 3. Variable production costs and fixed production costs are controlled at different levels of management. 4. Variable production costs, like direct materials and direct labor, are controllable by the production supervisor. 5. Fixed costs related to production capacity, like depreciation, are controlled by higher-level managers that make decisions to change factory size or add new machines. 6. Income statements that separately report variable and fixed costs, as is done in the contribution formatused in variable costing, are more useful for controlling costs. 7. Absorption costing does not separate variable from fixed costs, so it is less useful in evaluating effectiveness of cost control by different levels of managers.

Converting Income Under Variable Costing to Absorption Costing

1. An income statement using the variable costing method is restated to that under absorption costing by adding the fixed overhead cost in ending inventory and subtracting the fixed overhead cost in beginning inventory. 2. To convert income under variable costing to absorption, add fixed overhead cost deferred in ending inventory and subtract fixed overhead cost in beginning inventory.

Scatter Diagrams

1. Are graphs of unit volume and cost (Exhibit 5-5a). 2. Units are plotted on horizontal axis, cost on the vertical axis. 3. Each point reflects the cost and number of units for a prior period. 4. Estimated line of cost behavior¾drawn with a line that best "fits" the points visually. a. Intersection point of line on cost axis is at fixed cost amount. b. The variable cost per unit of volume equals the slope of the line. i. Select any two levels of units produced. ii. Identify total costs at each of those production levels. iii. Compute the slope of the line as follows: Change in Costs = variable cost per unitChange in volume (units) c. Cost equation (useful to predict future cost levels at different volumes): Total costs = Fixed costs + variable cost per unit x #of units Deficiency of scatter diagram method¾estimates are based on "visual fit" of cost line, subject to interpretation

Units Produced are Less Than Units Sold

1. Beginning inventory under absorption costing is higher than under variable costing. 2. When the beginning inventory is sold, the difference in inventory is included in cost of goods sold under absorption costing. 3. Income under absorption costing is less than income under variable costing.

Break-Even Point

1. Break-even point a. Sales level at which company neither earns a profit nor incurs a loss. b. Can be expressed either in units or dollars of sales. 2. Computation of break-even point a. Break-even units = Fixed costs divided CM per unit b. Break-even sales dollars = Fixed costs divided CM%

Assumptions in Cost-Volume-Profit Analysis

1. CVP analysis relies on several assumptions: a. Costs can be classified as variable or fixed. b. Costs are linear within the relevant range. c. All units produced are sold. Sales mix is constant.

A. Cost-volume-profit analysis is a tool to predict how changes in costs and sales levels affect profit

1. CVP uses four main components including: number of units sold; sales price per unit; variable costs per unit; and fixed costs in total. 2. The concept of relevant rangeis important when classifying costs for CVP analysis. The relevant range is the normal operating range for a business. It excludes extremely high or low operating levels. 3. Conventional CVP analysis requires that all costs must be classified as either fixed or variable with respect to production or sales volume before CVP analysis can be used.

Setting Prices

1. Cost information is a crucial factor in setting prices. 2. Over the long run, the selling price must be high enough to cover all costs and still provide an acceptable return to shareholders. 3. We use a 3-step process to determine product selling prices: a. Determine the product cost per unit using absorption costing. b. Determine the target markup on product cost per unit. Add the target markup to the product cost to find the target selling price

Disadvantages of Activity-Based Costing

1. Costs to Implement and Maintain ABC. Collecting and analyzing cost data are expensive and so is maintaining an ABC system. 2. Some Product Cost Distortion Remains. Even with ABC, product costs can be distorted because some costs cannot be readily classified into ABC cost pools and some cost drivers might not have a strong cause-effect relation with the costs in some pools. Uncertainty with Decisions Remains. Managers must interpret ABC data with caution in making managerial decisions. Managers must examine carefully the controllability of costs before making decisions.

Summarizing Income Reporting

1. Differences in income are due to timing with which fixed overhead costs are reported in income under the two methods. 2. Income will be different whenever the quantity produced and quantity sold are different. 3. Income under absorption costing is higher when more units are produced than sold, and is lower when fewer units are produced than sold. 4. We normally see differences in income for these two methods extending over several years.

Contribution Margin Income Statement Method

1. Differs from a conventional income statement in two ways: i. Classifies costs and expenses as variable and fixed ii. Reports contribution margin Revenues - Variable Costs = Contribution Margin- Fixed Costs = Net Income

Step-wise costs

1. Fixed within a relevant range of the current production volume. If production volume expands significantly, total costs go up by a lump-sum amount (stair-step cost). 2. Treated as either fixed or variable cost in CVP analysis; depends on width of range, and requires judgment.

Cost-Volume-Profit Chart

1. Horizontal axis¾number of units produced and sold (volume) 2. Vertical axis¾dollars of sales and costs. 3. Three steps: a. Plot fixed costs on vertical axis; draw horizontal line at this level to show that FC remains unchanged regardless of output volume. b. Draw line reflecting total costs (variable costs plus fixed costs) for a relevant range of volume levels. i. Line starts at fixed costs on vertical axis. ii. Slope equals variable cost per unit iii. Compute total costs for any volume level, and connect this point with the vertical axis intercept. iv. Stop line at productive capacity for the planning period. a. Draw sales line. i. Line starts at origin (zero units and zero dollars of sales). ii. Slope of line is equal to selling price per unit; compute total revenues for any volume level, and connect this point with the origin. iii. Stop line at productive capacity for the planning period

Mixed Costs

1. Include both fixed and variable cost components. 2. When volume and cost are graphed, the mixed cost is represented by a straight line with an upward (positive) slope. Start of line is at fixed cost point (or amount of total cost when volume is zero) on cost (vertical) axis. As the volume of activity increases, mixed cost line increases at an amount equal to the variable cost per unit. Mixed costs are often separated into fixed and variablecomponents when included in a CVP analysis.

Curvilinear (or Nonlinear) Costs

1. Increase at a non-constant rate as volume increases. 2. When volume and costs are graphed, curvilinear costs appear as a curved line that starts at intersection point of cost axis and volume axis (total cost is zero when volume is zero) and increases at different rates. 3. Often treated as variable costs in CVP analysis within a relevant range.

Planning Production

1. Many companies link manager bonuses to income computed under absorption costing since this is how income is reported to shareholders per GAAP which can lead such managers to produce excess inventory. 2. Inventory build-up leads to increased costs in storage, financing, and obsolescence. If excess inventory is never sold, it will be disposed of at a loss. 3. Managers cannot increase income under variable costing by merely increasing production without increasing sales. 4. Under absorption costing, fixed overhead per unit is lower when more units are produced so fixed overhead cost is allocated to more units. If these excess units are not sold, the fixed overhead cost allocated to these units is not expensed until a future period when these units are sold. 5. Reported income under variable costing is not affected by production level changes because all fixed production costs are expensed in the year incurred.Under this method, companies increase income by selling more units since it is not by producing excess inventory.

Advantages of Activity Based Costing

1. More Accurate Overhead Cost Allocation - because (1) there are more cost pools and activity rates than other methods. 2. More Effective Overhead Cost Control - can be used to identify activities that can benefit from process improvement by focusing on activities instead of focusing only direct labor or machine hours. 3. Better Production and Pricing Decisions - can reduce cost distortions. 4. Other Uses - ABC has uses beyond determining product costs. ABC can be used to allocate selling and administrative costs expensed by GAAP to activities, and to determine the profitability of various market segments or customers. 5. Activity-based management: Understanding the four levels of overhead costs is a first step toward controlling costs. Activity-based managementis an out-growth of ABC that uses the link between activities and costs for better management. Activity-based management can be useful in distinguishing value-added activities which add value to a product from non-value-added activities, which do not. 6. Costs of quality--costs resulting from manufacturing defective products or providing services that do not meet customer expectations. Costs of quality include prevention, appraisal, internal failure and external failure costs. Can be summarized in a cost of quality report.

Computing Unit Product Cost

1. Product cost per unit under absorption costing consists of direct labor, direct materials, variable overhead, and fixed overhead. 2. Product cost per unit under variable costing consists of direct labor, direct materials and variable overhead. Fixed overhead costs are treated as period costs and expensed in the period incurred. 3. Difference between costing methods is the exclusion of fixed overhead from product cost for variable costing.

Computing Sales for a Target Income

1. Sales (in dollars) required for target pretax income equals: (fixed costs + target pretax income) / CM% 2. Sales (in units) required for target income equals (fixed costs + target pretax income) / CM 3. Can also use the contribution margin income statement to compute sales for a target income (exhibit 5.24)

High-low Method

1. Step 1: Identify the highest and lowest volume levels. Note that these may not be the highest or lowest level of costs. 2. Step 2: Compute the slope (variable cost per unit) using the high low volume levels Variable cost = high volume costs - low volume costs per unit high volume units - low volumes units 3. Step #3: Compute the estimated fixed costs by first computing the total variable costs at either the high or low volume level and then subtracting that amount from the total costs at that volume level. Use the cost equation. Total costs = Fixed costs + variable cost per unit x #of units 4. Deficiency of high-low method¾ignores all data points except the highest and lowest resulting in less precision.

Units Produced Equal Units Sold

1. The income statement under variable costing is a contribution margin income statement. Contribution margin is the excess of sales over variable costs. 2. Contribution Margin Report is a performance report that excludes fixed expenses and net income and focuses on revenue minus variable costs. 3. When units produced equals units sold, there is no difference in totalexpenses reported on the income statement, but there is a difference in what categories receive these costs.

Contribution Margin

1. The percent of a unit's selling price that exceeds total unit variable cost. Interpreted as what proportion of each sales dollars remains after deducting total unit variable costs. 2. Contribution margin ratio is computed as: CM % = CM per unit divided by sales price per unit.

Fixed costs

1. Total fixed costs remain unchanged in amount when volume of activity varies from period to period within a relevant range. 2. The fixed cost per unitof output decreases as volume increases (and vice versa). 3. When production volume and cost are graphed, units of product are usually plotted on the horizontalaxis and dollars of cost are plotted on the vertical axis. (Exhibit 5.2) The fixed cost is represented by a horizontal line with no slope (cost remains constant at all levels of volume within the relevant range). 4. Fixed costs per unit decrease as production increases. This drop is known as economies of scale.

Variable costs

1. Variable costs change in proportion to changes in volume of activity. 2. Variable cost per unitremains constant but the totalamount of variable cost changes with the level of production. 3. When production volume and cost are graphed, (Exhibit 5.2) a. Variable cost is represented by a straight line starting at the zero cost level. b. The straight line is upward (positive) sloping. The line rises as volume increases.

Units Produced Exceed Units Sold

1. When units produced exceeds units sold, there is a difference in total expenses. 2. Under absorption costing, cost of goods sold is lower than the total expenses under variable costing. Income and ending finished goods inventory under absorption costing, is greater than under variable costing because of the fixed overhead cost included in ending inventory (asset) under absorption costing.

Sales Mix and Break-Even

A. Modify basic CVP analysis when company produces and sells several products. 1. Important assumption¾Sales mix of the different products is known and remains constant. 2. Sales mix is the ratio (proportion) of the sales volumes for various products. 3. When companies sell more than one product or service, estimate break-even point by using a composite unit. a. Determine sales mix of various products. b. Composite Unit—a specific number of units of each product in proportion to their expected sales mix. Multi-product CVP treats this composite unit as a single product c. Using sales mix, determine the selling price of a composite unit by multiplying the sales mix ratio times the selling price of each product and then adding the totals for all of the products. d. Compute the variable cost of a composite unit in the same manner. e. Determine the CM per composite unit by subtracting the total variable price from the total selling price of the composite unit f. In break-even analysis, a composite unit is treated as a unit of a single product. g. Break-even point in composite units is computed as: Fixed Costs _= Composite Units to break-even CM per composite unit h. To determine how many units of each product must be sold to break even, multiply the number of units of each product in the composite (sales mix) by the break-even point in composite units.

Decision Analysis - Pricing Special Orders

A. Over the long run, prices must cover all fixed and variable costs. B. Over the short run, fixed production costs do not change in production levels. C. With excess capacity, increases in production level will increase variable production costs, but not fixed costs. Managers should, therefore, try to maintain long-run price on existing orders to cover all production costs and should accept special orders as long as the special order price exceeds variable cost.

Decision Analysis--Degree of Operating Leverage

A. Useful tool in assessing the effect of changes in the level of sales on income is the degree of operating leverage computation. B. Operating leverage is the extent, or relative size, of fixed costs in the total cost structure. C. Degree of operating leverage (DOL) is computed as: Total Contribution margin (dollars) / pretax income D. Use DOL to measure the effect of changes in the level of sales on pretax income by multiplying DOL by the percentage change in sales.

Margin of safety

A. can be expressed in units, dollars, or as a percent of predicted level of sales. It is the excess of expected sales over break-even sale. It is the amount that sales can drop before the company incurs a loss. 1. Expected Unit Sales - Break-even Unit sales = Margin of safety (units) Expected Sales Dollars- Break-even Sales Dollars = Margin of Safety (dollars) 2. Margin of Safety Rate (%) = Margin of Safety divided by Expected Sales

Lean Operations

A. focusing on activities is common in lean manufacturing which strives to eliminate waste while satisfying customers. Common features include: 1. Just-in-time (JIT) inventory systems to reduce costs of moving and storing inventory. 2. Cellular manufacturing where products are made by teams of employees in small workstations called cells. 3. Building quality into products by focusing on costs of good quality. Lean accounting includes eliminating waste; alternative performance measures; and simplified product costing.

Applying Activity-Based Costing

Activity-based costing accumulates overhead costs into activity cost pools and then allocates those costs to products using activity rates. A. Step 1: Identify Activities and the Costs They Cause B. Step 2: Assign activities and their overhead costs to activity cost pools. C. Step 3: Compute activity overhead (cost pool) rates used to assign overhead costs to find cost objects such as products. Proper determination of activity rates depends on: 1. Proper identification of the factor that drives the cost in each activity cost pool and 2. Proper measures of activities. D. Step 4: Assign overhead costs in each activity cost pool to cost objects using activity rates. Overhead costs are allocated to products based on the actual levels of activities used. E. Differences between ABC and Multiple Departmental Rates. 1. ABC recognizes that overhead costs are complex and emphasizes activities and costs of these activities. 2. ABC better reflects the complex nature of overhead costs and how these costs are used in making products

Measuring Cost Behavior

After establishing that cost data are reliable and useful in predicting future costs, three methods are commonly used to analyze past cost behavior. Goal is to develop a cost equation.

Decision Analysis: Customer Profitability

Companies cause the ABC method to analyze their customer profitability. ABC encourages management to consider all resources consumed to serve a customer, not just manufacturing costs that are the focus of traditional costing methods.

Activity-Based Costing

Cost Flows Under Activity-Based Costing Method. Activity-based costing (ABC) attempts to more accurately assign overhead costs by focusing on activities. a. Basic principle is that activities, which are tasks, operations, or procedures, cause costs to be incurred. b. All activities of an organization can be linked to use of resources. c.Activity cost pool is a collection of costs that are related to the same or similar activity. d. The first step of ABC is to identify activities (cost objects) involved in manufacturing products and match those activities with the costs they cause (drive). e. To reduce the number of activities, the homogenous activities (those caused by the same factor) are grouped into activity cost pools. f. The second step is to trace overhead costs to activity cost pools. g. The third step is to compute overhead allocation rates for each activity. h. The fourth step is to use the activity overhead rates to assign overhead costs to cost objects (products). g. ABC is similar to the departmental method in that it uses more than one overhead rate. It differs from the departmental method in that it focuses on activities rather than departments.

Assigning Overhead Costs

I. Product pricing, product mix decisions, and cost control depend on accurate product cost information. Product costs consist of direct labor, direct materials and overhead (indirect costs). Overhead costs cannot be traced directly to units of product in the same way that direct labor and direct materials can. Therefore, we must assign such overhead costs using an allocation system.

CVP Analysis

If the income statement is prepared under variable costing and presented in the contribution format, the data for CVP analysis are available. If the income statement is prepared under absorption costing, the data needed for CVP analysis are not readily available.

Computing Income from Sales and Costs

Sales (# units sold x unit selling price)- Variable Costs (# units sold x unit variable cost) = Contribution Margin- Fixed Costs = Income (pretax)

Applying Cost-Volume-Profit Analysis

Useful in helping managers forecast future sales or income.

Advantages of assessing the plant wide and departmental overhead rate methods

a. Based on readily available information. b. Easy to implement. c. Consistent with GAAP and can be used for external reporting needs.

Usefulness of the single plantwide overhead rate depends on two assumptions

a. Overhead costs change with the allocation base. b. All products use overhead costs in the same proportions. c. For companies that manufacture few products or are labor-intensive, the single plantwide method can yield reasonably useful information. d. For companies with many different products or ones that use overhead costs in very different ways, the assumptions of the single plantwide rate are not reasonable.

Applying the Departmental Overhead Rate Method - 4 step process.

a. Step 1: Assign overhead costs to departmental cost pools. b. Step 2: Select an allocation base for each department. If overhead costs are common to several departments, companies must allocate overhead to departments applying reasonable allocation bases. Each department determines an allocation base for its operations. c. Step 3: Compute overhead allocation rates for each department. d. Step 4: Use departmental overhead rates to assign overhead costs to each product. e. This method allows each department to have its own overhead rate and its own allocation base which usually results in more accurate overhead allocations as compared to the plantwide rate method.When analysts are able to logically trace costs to cost objects, costing accuracy is improved.

Cost Flows Under Plantwide Overhead Rate Method. This method is also referred to as the single plantwide overhead rate methodor the plantwide overhead rate method.

a. Target of the cost objectis the unit of product. b. The rate is determined using a volume-related measure such as direct labor hours or machine hours. c. For industries where overhead costs are closely related to these volume-related measures, it is logical to use this method to allocate indirect manufacturing costs to products.

Applying the Plantwide Overhead Rate Method

a. Total budgeted overhead costs are divided by the chosen allocation base to arrive at a single plantwide overhead rate. b. This rate is then applied to assign overhead costs to all products based on the allocation base such as direct labor hours required to manufacture each product.

On either side of break-even point, the area between sales line and total cost line at any specific sales volume reflects the profit or loss expected at that point.

a. Volume levels to left of break-even point¾area is amount of loss expected because the total costs line is above the total sales line. b. Volume levels to right of break-even point¾area is amount of profit expected because the total salesline is above the total costs line.

The departmental overhead rate method assumes that

a.Different products are similar in volume, complexity, and batch size, and b. Departmental overhead costs are directly proportional to the department allocation base.

Introducing Variable Costing and Absorption Costing

absorption costing, or full costing, products include direct materials, direct labor, and both variableand fixedoverhead. This method is required for external financial reporting under GAAP, but can result in misleading product cost information and poor managerial decisions. Under variable costing only direct materials, direct labor and variableoverhead costs are included in product costs. Useful for managerial decisions but cannot be used for external financial reporting. A. Both methods include direct materials, direct labor and variable overhead in product costs. B. Key difference is in treatment of fixed overhead. C. Fixed overhead is included in product costs under absorption costs and included in period expenses under variable costing. D. Computing Unit Product Cost 1. Product cost per unit under absorption costing consists of direct labor, direct materials, variable overhead, and fixed overhead. 2. Product cost per unit under variable costing consists of direct labor, direct materials and variable overhead. Fixed overhead costs are treated as period costs and expensed in the period incurred. 3. Difference between costing methods is the exclusion of fixed overhead from product cost for variable costing.

Variable Costing and Performance Reporting

contribution margin income statement also known as a variable costing income statement. A. Variable costing - only costs that change in total with changes in production levels are included in product costs. B. Includes direct materials, direct labor and variable overhead costs. C. Fixed overhead costs are excluded from product costs. D. GAAP (external reporting) requires absorption costs whereby product costs includes direct materials, direct labor and all overhead (fixed and variable).

Evaluating Strategies

knowing the effects of changing some estimates used in CVP analysis by substituting new estimated amounts (in total or per unit as appropriate) in the related formula can be helpful in making predictions. Can also use the contribution margin income statement.

The break-even point is at the intersection

of total cost line and sales line.

Disadvantages of assessing the plant wide and departmental overhead rate methods

overhead costs are too complex to be explained by one factor like direct labor or machine hours.

Product level activities

performed on each product line and are not affected by either the number of units or batches. Costs do not vary with the number of units or batches.

Unit-level activities

performed on each product unit. Costs tend to change with the number of units produced

Batch level activities

performed only on each batch or group of units. Costs do not vary with the number of units, but with the number of batches.

Facility level activities

performed to sustain facility capacity as a whole and are not caused by any specific product. Costs do not vary with what is manufactured, number of batches, or the output quantity.

ABC for Service Providers

the only requirements are the existence of costs and demand for reliable cost information.

Departmental Overhead Rate Method

use of a single plantwide overhead rate can produce cost assignments that do not reflect the cost to manufacture products.

Variable Costing for Service Firms

variable costing also applies to service companies. Service companies do not have inventory but a focus on variable costs is still useful for managerial decisions