Operations Management

Cost-Volume-Profit Analysis

Cost-Volume-Profit (Break-Even) Analysis A. Break-even is defined as the sales level at which sales revenues exactly offset total costs, both fixed and variable. Note that total costs include period costs (selling and administrative costs) as well as product (manufacturing) costs. The break-even point is usually expressed in sales units or in sales dollars. B. Basic Formula—The following formula helps define a break-even point. All other formulas can be derived from this basic formula. look at section for formulas Using the Contribution Margin Ratio Approach to Calculate Break-Even in Sales Dollars A. Sometimes no unit sales price or unit variable cost information is available. In these cases, it is not possible to calculate the break-even point in units. It is, however, still possible to calculate the break-even point in sales dollars, but a slightly different approach must be used. B. When no unit information is available, but total sales revenue, total variable costs, and total fixed costs are known, the break-even point in sales dollars can be determined by calculating the contribution margin ratio. The contribution margin ratio represents the percentage of each sales dollar that is available to cover fixed costs. C. For example, if total sales are $100 and variable costs are $40, then the contribution margin is $60. This means that for every $100 of sales, $60 is available to cover fixed costs. D. If we express the contribution margin as a ratio (or percentage) of sales dollars, then we can say that 60% ($60/$100) of each sales dollar is available to cover fixed costs. Multiple Product Analysis—Sometimes break-even analysis will require calculations that involve a product mix rather than just one product. In that case we can use either a weighted-average approach or a composite (sometimes called a basket or package) approach to calculate a break-even point for each of the products. As with single-product calculations, we can calculate a break-even in either units or dollars. Perhaps the most intuitive approach is the composite method. This is because we mostly use the same process to solving the problems as we do with single-product scenarios. An Alternative Way of Looking at the Contribution Margin Ratio Although the calculations are the same, many people find that using the common-size income statement format to calculate the contribution margin ratio makes it easier to solve these questions. Exam Tip As mentioned in the introduction to this section, virtually all break-even questions involving calculations can be solved by using one of the two formulas using the contribution margin approach: 1. Break-Even Units = Fixed Costs / Contribution Margin per Unit 2. Break-Even in Sales Dollars = Fixed Costs / Contribution Margin Ratio We expect a significant number of questions on break-even analysis on the exam, so be sure that you know these formulas! Margin of Safety—This indicates the difference between the current sales level and the break-even point. That is, the margin of safety indicates how much revenue can decrease before operating income becomes negative. Similar to break-even or profit, margin of safety can be expressed in either units or dollars. For example, if sales are currently 200,000 units and the break-even point is 150,000 units, the margin of safety would be 50,000 units. Alternatively, where sales are $180,000 and the break-even point is $110,000, the margin of safety would be $70,000. Targeted Profit—When a targeted pretax profit beyond break-even is specified, simply add this amount to the fixed cost in the numerator. You can think about the contribution margin on the denominator as having to cover all items in the numerator. This is exactly the same formula as break-even, but at the break-even level there is no profit (i.e., only fixed costs are covered by CM). Note: If the profit goal is stated in after-tax dollars, one must first determine the amount of pretax profit required to generate the desired after-tax profit. To determine the pretax profit required, simply divide the desired after-tax profit by 1 minus the tax rate. Sales in Units = (Fixed Costs + Targeted Pretax Profit) / Contribution Margin per Unit Underlying Assumptions—In order to perform break-even analysis, certain assumptions must hold true. First of all, for break-even analysis to be relevant and useful, the analysis must be restricted to a relevant range of activity, so that model assumptions are at least approximately satisfied, namely: fixed costs, unit variable costs, and price must behave as constants. In addition: 1. All relationships are linear. 2. When multiple products are sold, the product mix remains constant. (Note: This is not a restrictive assumption of the model, but this condition is widely assumed in practice for problems on the CPA Exam.) 3. There are no changes in inventory levels; that is, the number of units sold equals the number of units produced. a. Total costs can be divided into a fixed component and a component that is variable with respect to the level of output. b. Volume is the only driver of costs and revenues. c. The model applies to operating income (i.e., the CVP model is a before-tax model). Volume-Profit Chart 1. Another variation of the break-even chart graphs profits (revenues less variable costs and fixed costs) instead of separately graphing revenues, fixed costs, variable costs, and total costs. In this graph, the slope of the profit line is equal to the contribution margin: for each unit sold, income increases by the amount of the contribution margin per unit. 2. When no units are sold, the loss is equal to fixed costs. As units are sold, losses decrease by the contribution margin times the number of units sold. At the point where the profit line crosses the x-axis, profits are zero. This is the break-even point. 3. A few additional observations about the volume-profit chart: a. The flatter the line, the smaller the contribution margin per unit. b. When comparing profit lines for multiple years and assuming that the sales price has not changed, variable costs per unit for the steeper line are less than variable costs per unit for the flatter line. Steeper lines indicate larger contribution margins; if the sales price is constant, then variable costs must be relatively smaller. c. Changes in the profit line's y-intercept indicate changes in fixed costs. Note For problems involving taxes and after-tax income, remember: The CVP model is a before-tax or operating income-based model. If you remember this, conversion to after-tax or net income is easy. Merely perform the necessary calculations while using operating income and then convert to after-tax as required. Exam Tip The CPA Exam is likely to test CVP by requiring the candidate to determine the break-even point or income after changing one of the variables involved. We predict that questions will often change something and ask you to determine the effect on those. The effect on income (i.e., increase or decrease) is almost always opposite that of the effect on the break-even point. The only exception to that is where the only change that is made involves an increase or decrease in quantity. In this instance, income will go up or down but the break-even point will remain the same. To calculate the breakeven point, we must first find the fixed cost of the prior year. Fixed costs (FC) / contribution margin (CM) = breakeven point in units. Thus, using prior year data, FC / ($7.50 - $2.25) = 20,000 units. Solving for FC = $105,000. Current year FC = 1.1(prior year FC) = $115,500; thus, breakeven units for the current year = $115,500 / ($9 - $3) = $19,250. Given sales of $5,000,000 and total variable costs of 1,750,000, the contribution margin (CM) is the difference of $3,250,000. Then the CM is divided by the units: $3,250,000 / 250,000 units = $13 CM per unit. From here, the BE point in units is equal to the total fixed costs divided by the CM per unit: $650,000 / $13 = 50,000 units. Solving this problem requires working backwards through the contribution margin (CM) formatted income statement to determing Total CM. The Total CM is then divided by the CM per unit to determine the number of units sold. Two key points: 1. Total Fixed Costs equals the CM at breakeven, thus: 20,000 breakeven units X ($7.50 sales price - $2.25 VC per unit) = $105,000 Fixed Costs. 2. The 40% Income Tax Rate means that Net Income is equal to 60% of Operating Income, calculated as: Operating Income x 60% = $5,040 or Operating Income = $5,040 / 60% = $8,400. Next, adding Fixed Costs to Operating Income = Total CM. Thus, $105,000 + $8,400 = $113,400 Total CM. The calculation of total units sold = Total CM/CM per unit. Thus, $113,400 / $5.25 = $21,600 total units sold. Finally, adding 1,000 units to the units sold in year 1 = 21,600 + 1,000 = 22,600 units expected to be sold in year 2. The margin of safety is the difference between current sales and breakeven sales. Thus, breakeven sales are $120,000 ($200,000 - $80,000). In other words, the firm has breathing room of $80,000 of sales. Sales could fall by this amount before the firm would dip below breakeven. breakeven sales = Fixed cost/contribution margin percentage At the current level of 10,000 units, a contribution margin per unit of $35 = $85 - $50, and fixed costs of $300,000, the contribution margin is $350,000 and the operating income is $50,000. If variable costs increase by 20%, the contribution margin per unit decreases to $25 = $35 - $60, or $300,000 total, resulting in an operating loss of $50,000. Thus, profits would decrease by $100,000. This problem compares the increase in revenue due to the possible increased spending on advertising. The $15,000 for advertising is just another fixed cost. The contribution margin ratio is used to determine 40% of the new revenue of $780,000 = $312,000 resulting in only $12,000 more in contribution margin as compared to a new fixed advertising cost $15,000. The difference between the $15,000 and the $12,000 is a $3,000 decrease in income. Breakeven sales=fixed cost/contribution margin ratio $800,000=$100,000/cmr .125=cmr The margin of safety is the difference between current sales and breakeven sales. Thus, breakeven sales are $120,000 ($200,000 - $80,000). In other words, the firm has breathing room of $80,000 of sales. Sales could fall by this amount before the firm would dip below breakeven. breakeven sales = Fixed cost/contribution margin percentage $120,000= Fixed cost/.20 $24,000= Fixed cost

Cost Behavior Patterns

Costs A. By analyzing the way costs behave when production and/or sales volume changes, we can predict total costs and estimate profit. However, very few costs behave consistently across a wide range of production or sales volumes: At some point, economies or diseconomies of scale will cause the cost behavior to change. Because of this, all discussions of cost behavior must take place within the concept of a relevant range. A relevant range is a range of production volumes where: 1. The range of activity for which the assumptions of cost behavior reasonably hold true; and 2. The range of activity over which the company plans to operate. 3. If (1) is true but (2) is not, then the analysis will not be relevant to the company. If (2) is true but (1) is not, then the assumptions of the model are not satisfied making the analysis invalid. B. All cost behavior patterns are valid only within a relevant range. We will discuss the concept of a relevant range in more detail in conjunction with cost-volume-profit analysis. Fixed costs—Remain constant in total regardless of production volume. Because of this, fixed costs per unit vary—increasing when production decreases and decreasing when production increases. Variable costs—Vary in total, in direct proportion to changes in production volume. Variable costs per unit remain constant regardless of production volume. Total cost—Is the sum of fixed costs and variable costs. As such, total costs take on characteristics from both component costs: total costs per unit vary with changes in production because fixed costs per unit vary with changes in production; total costs in total vary with changes in production because variable costs vary in total with changes in production. Step-Variable Costs—Remain constant in total over a small range of production levels, but vary with larger changes in production volume. Supervisory salaries, utility costs, and shipping costs often behave in this fashion. Mixed Costs (Also Known as Semi-Variable Costs)—Have a fixed component and a variable component. The variable component causes them to vary in total with changes in volume. The fixed component, however, prevents them from varying in direct proportion to the change in volume. The Cost Function When predicting the behavior of a total cost, especially a mixed cost, a cost function can be a useful tool. A cost function is a version of a linear expression. A common version of a linear expression looks like this: Y = b + m(x) where y = dependent variable. b = y-intercept m = slope or rise/run x = independent variable High-Low Method 1. When predicting the behavior of a total cost or a mixed cost, the high-low method provides a rough estimate of the fixed cost and the variable cost components. Although a more precise cost prediction can be obtained using regression analysis, the high-low method provides a quick, easy cost estimate. The high-low method uses the cost function to estimate total costs. 2. The basic concept underlying this method is that when total manufacturing costs change in response to changes in production volume, the changes are, by definition, caused by variable costs. a. By calculating the change in total costs between two production volume extremes (the high value and the low value), the total change in variable costs can be isolated. b. The unit variable cost can then be determined by dividing the change in total costs by the difference in units produced. c. Once the unit variable cost is determined, total fixed costs can be identified by calculating the total variable cost at a specified production volume (e.g., multiply unit variable cost by the number of units produced) and subtracting it from the total cost. Using the High-Low Method—To identify fixed and variable cost components using the high-low method: 1. From the range of production volumes presented, select the period with the highest production and the period with the lowest production. 2. Note—Do not use highest and lowest costs. Always use production volume. 3. Calculate the difference in units produced at the highest and the lowest levels of production. 4. Calculate the difference in costs at the highest and the lowest levels of production. 5. Divide the difference in costs by the difference in units—This is your estimated variable cost per unit. 6. Find total variable costs by multiplying the estimated variable cost per unit by the actual number of units produced at either the high or the low level of production. 7. Subtract the total variable costs from the total cost to determine fixed costs. 8. You can now estimate total costs at any production level by multiplying the production in units times the variable cost per unit and adding it to the total fixed costs. Look at section for high low method example Fixed costs and variable cost per unit must be estimated from the data using the high-low method. Total costs can then be estimated using the following equation: y = a + b(x), where y = total costs, a = fixed costs, b = variable cost per unit, and x = number of kilos. The variable cost per unit (slope of the line) is the change in cost divided by the change in kilos: b = ($160,000 - $132,000)/(80,000 - 60,000) = $1.40. The fixed cost (y intercept point) can be derived from either data point by entering the variable cost per unit and one of the data points into the equation: $160,000 = a + 1.40(80,000)$48,000 = a. Therefore, at 75,000 kilos, an activity within the range of the data, we can expect the following amount of cost: Cost = $48,000 + $1.40(75,000) = $153,000

Performance Improvement Tools

his lesson discusses performance improvement in a business environment. Other lessons have discussed how business measure performance. A major metric used to measure performance is return on investment (ROI), wherein we measure operating profit divided by average assets employed. As discussed in the lesson "Ratio Analysis," there are three main ways (which we can call performance improvements) to increase that ROI ratio: 1. Increase revenue by selling more products or raising sales prices. 2. Decrease costs. 3. Decrease average assets. 1. Improve quality—The goal here is to either increase sales or decrease costs. 2. Eliminate or reduce nonvalue-added steps—The goal here is to decrease costs. 3. Reduce quantity of resources used—The goal here is to decrease costs or decrease average assets. Revenue can also be improved by finding ways to relax the constraint. Common methods to relax the constraint (eliminate the bottleneck) include these: 1. Reengineer the production process to make it more efficient. 2. Reengineer the product to make it simpler to produce. 3. Eliminate nonvalue-added activities at the bottleneck operation. 4. Work overtime at the bottleneck operation. 5. Outsource some or all production at the bottleneck operation. Lean Manufacturing Lean manufacturing strives for perfection in quality and removes layers of waste to support continuous improvement. According to the Lean Enterprise Institute, Lean is a business system for organizing and managing product development, operations, suppliers, and customer relations. Businesses and other organizations use lean principles, practices, and tools to create precise customer value—goods and services with higher quality and fewer defects—with less human effort, less space, less capital, and less time than the traditional system of mass production. Comparing and contrasting different types of production processes is helpful to understanding the differences in the lean manufacturing approach: 1. Craft—A small number of a high variety of unique (i.e., customized or one-of-a-kind) products usually with simple tools or technology and highly skilled labor. Traditional cost accounting systems used with this approach typically involve job costing. 2. Mass—Making a large number of standardized or identical products usually with dedicated (i.e., single-purpose), often automated or otherwise sophisticated machinery, and unskilled labor. Traditional cost accounting systems used with this approach typically involve process costing. 3. Lean—Making small batches of a high variety of unique products usually with automated or otherwise sophisticated machinery and highly skilled labor (usually cross-trained). Thus, lean production blends the features of craft and mass production processes. Lean Principles—can be applied to all functions within an organization and include the following: 1. Identify all steps in the value stream for each product family, eliminating steps that do not create value. 2. Make the value-creating steps occur in tight sequence so the product will flow smoothly toward the customer. 3. As flow is introduced, let customers pull value from the next upstream activity. 4. As value is specified, value streams are identified, wasted steps are removed, and flow and pull are introduced: begin the process again and continue it until a state of perfection is reached in which perfect value is created with no waste. Inflexible versus flexible equipment—Mass production typically uses dedicated or single-purpose equipment. Lean production uses flexible multi-use equipment. High versus low setup time—Equipment in mass production typically requires a high setup time. Low versus high labor skill—Mass production typically requires a low labor skill level because of the presence of labor specialization (workers do one task only). This avoids costly training and the need for workers to thoroughly understand the production process. Lean production requires a flexible, skilled work force. Workers usually work in "U" shaped work cells with equipment that can perform a variety of tasks. Cell workers do their own setups, operate all cell equipment, move materials, control quality, and perform routine equipment maintenance. Investment in worker training is significant. Many of the features of lean manufacturing are similar to or share a common philosophy with just-in-time, total quality management, and continuous improvement. For example, in a lean environment: 1. Workers are "empowered." 2. The organization seeks a close relationship with suppliers. 3. The organization maintains a close relationship with customers (i.e., extensive direct contact and information sharing, working with customers to give them what they want—especially in providing greater variety). 4. Product design engineers work "concurrently" with process design engineers, service engineers, production line workers, and others to ensure that products are easy to make, assemble, ship, and repair. Six Sigma Six Sigma is a continuous improvement approach designed to systematically reduce defects by recognizing that (1) the overall yield of a group of related processes is much lower than the yields of the individual processes; and (2) the total cost of a product or service is directly related to the defect rate. Six Sigma involves five steps: 1. Define the business—Business goals, objectives, processes, team responsibilities, resources, scope of operations, and quality definitions 2. Measure the processes—Defects per unit, defects per million opportunities, and production yield. Note that all defects are counted (not just the number of defective units) 3. Analyze the process—Analysis is done to determine the root cause of defects. Tools commonly used with total quality management (TQM) such as Pareto diagrams (histograms) and/or Ishikawa (fishbone) diagrams are used to identify potential causes of defects. 4. Improve the process—This involves (1) design experiments and (2) change management to allow statistical exploration of relationships to reveal how to improve quality levels. Once determined, training, policy, and procedures are adjusted to achieve the desired change. 5. Control—TQM-type quality tools (e.g., control charts, run charts) are used to achieve sustained improvement in operational quality. The demand flow approach, or demand flow technology (DFT), uses mathematical methods to link materials, time, and resources based on continuous flow planning. The objective is to link process flows and manage those flows based on customer demand. 1. According to Wikipedia and other historical archives, DFT was initially used to complement just-in-time, which used a pull-based approach (i.e., driven to actual customer demand) via Kanban (i.e., a visual signal from downstream production to indicate the need for work to a prior work station). 2. DFT was introduced as a way for American manufacturers to adopt Japanese production techniques, while trying to avoid cultural conflicts in applying Japanese business methods in an American context. 3. More recently, DFT has come to be seen as a complementary tool for facilitating lean manufacturing. Demand flow technology is promoted as a method particularly suitable for high-mix, low-volume manufacturing. Six Sigma prescribes the DMAIC roadmap acronym, which provides a detailed list of steps and tools to increase and sustain quality. These include: 1. Define customers and their requirements. 2. Measure defects and other metrics. 3. Analyze to determine root cause of failures and the sources of variation. 4. Improve through experimentation. 5. Control results using TQM statistical process control tools (e.g., control charts). DMAIC

Non-Routine Decisions: Relevant Costs

A. The identification of relevant costs is a critical component in many production decisions: Should we buy a component or make it ourselves? Should we process a product further or sell it now? Should we keep producing a product or drop it? B. Each possibility is characterized by its own set of costs and associated revenues. Which costs do we need to consider? Must we consider all of them? What if the revenues we lose when choosing one option means that we must forgo another option? The answer is that we must consider all future factors that differ among alternatives. Relevant costs and benefits are the future costs and benefits that differ among alternatives. 1. Avoidable costs—Costs that can be eliminated by choosing one alternative over the other—are relevant costs. Opportunity costs—The benefits that are forgone when the selection of one course of action precludes another course of action—are also relevant costs. 2. Unavoidable costs—Costs that will remain the same regardless of which alternative is chosen—are irrelevant to the decision process. Irrelevant costs fall into two general categories: a. Sunk costs—A sunk cost is a cost that has already been incurred and cannot be changed. For example, when deciding whether to buy a new car or keep your current car, the price paid for the current car is irrelevant as it occurred in the past and cannot be changed. On the other hand, the market value of the current car if you sold it is relevant to the decision as it differs between the two alternatives: if you buy the new car, you can sell the current car for its market value; if you keep the current car, you forgo receiving its market value. b. Future costs and benefits that do not differ between alternatives—Future costs that do not differ between alternatives tend to be fixed costs or allocated costs. Types of Decisions Using Relevant Costs A. Several types of decisions involving the identification of relevant costs are frequently encountered. These decisions revolve around: 1. Whether to process a product further or sell it now 2. Whether to keep or drop a product line or company segment 3. Whether to make or buy a product or component 4. Whether to accept or reject a special order Accept or Reject a Special Order A. Special orders, whether for products or for services, require us to think differently about costs and prices specifically because they are "special" orders: one-time opportunities that are not part of the organization's ongoing business. Normally, products are priced to cover "full" costs—not just variable production costs but fixed overhead and selling and administrative costs as well. All costs must be covered if the organization is to survive. Special orders, however, are not subject to this constraint. Since fixed overhead and selling and administrative costs have already been covered by regular product sales, they do not need to be considered when pricing special orders. B. Special-order decisions are usually short-term, profit-maximizing decisions. For these decisions, the only relevant costs are the costs directly attributable to the special order and, if the company is operating at capacity, the opportunity costs associated with production that must be canceled in order to complete the special order. Strategic considerations may also come into play if accepting the special order has the potential to compromise or, alternatively, promote management's objectives outside of profit maximization. For example, a company might be willing to accept a special order from a customer who represented a market segment that the company was trying to penetrate even if the company lost money on the special order. C. Considering a Special Order when There Is Excess Capacity. If the special order can be completed using existing capacity, only sales revenues and the variable costs of producing the order need be considered. D. Considering a Special Order when There Is No Excess Capacity When no excess capacity exists, acceptance of a special order means that other units must be removed from the production schedule to make room for the special order. The forgone profits related to the units that were removed from production represent an opportunity cost and must be included in the profitability analysis of the special order. Take out the unavoidable cost(aka fixed cost)

Absorption and Direct Costing

Absorption Costing (also known as full costing): Assigns all three factors of production (direct material, direct labor, and both fixed and variable manufacturing overhead) to inventory. Direct Costing (also known as variable costing): Assigns only variable manufacturing costs (direct material, direct labor, but only variable manufacturing overhead) to inventory. 1.Absorption costing is required for external reporting purposes. This is currently true for both external financial reporting and reporting to the IRS. 2. Direct costing is frequently used for internal decision-making but cannot be used for external reporting. 1. Variable manufacturing costs a. Direct material—Materials that are feasibly traceable to the final product b. Direct labor—Wages paid to employees involved in the primary conversion of direct materials to finished goods c. Variable factory overhead—Variable manufacturing costs other than direct material and direct labor (e.g., supplies, utilities, repairs, etc.) 2. Fixed manufacturing costs a. Fixed factory overhead—Fixed manufacturing costs (e.g., depreciation on factory buildings and equipment, manufacturing supervisory salaries and wages, property taxes and insurance on the factory, etc.) 3. Variable selling and administrative costs a. Selling costs—Variable costs associated with selling the good or service (e.g., freight out, sales commissions, etc.) b. Administrative costs—Variable costs associated with the administrative functions of an organization (e.g., office supplies, office utilities, etc.) 4. Fixed selling and administrative costs a. Selling costs—Fixed costs associated with selling the good or service (e.g., sales representatives' salaries, depreciation on sales-related equipment, etc.) b. Administrative costs—Fixed costs associated with the administrative functions of an organization (e.g., officers' salaries; depreciation, property taxes, and insurance on office building, advertising, etc.) B. The principal difference between the absorption model and the direct costing model rests on which costs are assigned to products: 1. The absorption model assigns all manufacturing costs to products. 2. The direct model assigns only variable manufacturing costs to products. Absorption Costing Income Statement—The absorption costing income statement lists its product costs, including the fixed manufacturing costs, "above the line" and subtracts the product costs from Sales to calculate Gross Margin. The absorption costing income statement lists costs by whether they are manufacturing or not. All manufacturing costs are listed together and are subtracted from Sales to calculate Gross Margin. All non-manufacturing costs (operating expenses) are then listed together and are subtracted from Gross Margin to get Operating Income. Direct Costing Income Statement—The direct costing income statement lists costs by behavior (variable or fixed). All variable costs are listed together and are subtracted from Sales to calculate Contribution Margin. All fixed costs are then listed together and are subtracted from Contribution Margin to get Operating Income. Note Although variable selling and administrative costs are listed along with the variable manufacturing costs (direct material, direct labor, variable manufacturing overhead) and are subtracted from sales to arrive at the contribution margin, the variable selling and administrative costs are not product costs and are not considered part of Cost of Goods Sold. Instead, they are always recognized as a period cost and are completely expensed each period. Fixed Manufacturing Costs are treated as period costs. All selling and administrative costs are treated as period costs regardless of whether the absorption or variable costing method is used. Effect of Product Costing Model on Operating Income—Absorption costing and direct costing assign different costs to inventory. Since direct costing does not include fixed manufacturing costs as part of product cost, the inventory valuation under absorption costing will always be greater than the inventory valuation under direct costing. From an external reporting point of view, direct costing understates assets on the balance sheet. Income Reconciliation—Explaining the difference in income between absorption costing and variable costing. 1. Because absorption costing and direct costing assign different costs to products, there may be a difference in income reported under the two methods. However, absorption costing and direct costing do not always produce different incomes. When the number of units sold equals the number of units produced, absorption costing and direct costing produce identical incomes. (Note: This assumes that fixed cost per unit remains the same from one period to the next.) 2. The difference between the two measures of income is due to the different treatment of fixed manufacturing costs. Direct costing deducts all fixed manufacturing costs as a lump-sum period cost when calculating income. Absorption costing assigns fixed manufacturing costs to products and therefore only deducts fixed manufacturing costs when the units are sold. 3. Depending on whether the units sold are greater than or less than the units produced, the fixed manufacturing overhead deducted under absorption costing may be greater or less than the fixed manufacturing overhead deducted under direct costing. Look at examples on this section Absorption costing includes both variable and fixed manufacturing costs as product costs. Direct costing includes only variable manufacturing costs as product cost and expenses fixed manufacturing costs as a period expense. In this case, absorption costing includes $20,000 of fixed manufacturing costs (1,000 x $20) in ending inventory while direct costing expenses the full amount of fixed manufacturing costs. Pretax income is consequently $20,000 higher for absorption costing. Current ratio = current assets/current liabilities. Return on stockholders' equity = net income/average owners' equity. Absorption costing allocates both variable and fixed manufacturing costs to inventory. Variable costing assigns only variable manufacturing cost to inventory and expenses fixed manufacturing overhead as a period cost. Therefore, ending inventory, and thus, current assets, are higher under absorption costing by the amount of fixed overhead allocated to ending inventory. The current ratio under absorption costing is, therefore, higher than under variable costing. Income in the current period is the same under both absorption costing and variable costings because the fixed overhead allocation rate has not changed, and ending inventory quantities have not changed. Therefore, total expenses recognized for the life of the firm for absorption costing are less than for variable costing by the amount of fixed overhead remaining in those 5,000 units at the end of Year 2. Thus, retained earnings are higher for absorption costing, causing the denominator of return on stockholders' equity to be greater, and finally causing the ratio to be smaller for absorption costing. Absorption costing includes fixed manufacturing costs as part of product costs; direct costing expenses fixed manufacturing costs as a period expense. Because of this, inventory valuation under absorption costing is more than inventory valuation under direct costing. When a firm sells more than it produces, it must use some of its existing inventory. Since absorption costing has a higher inventory valuation, the cost of goods sold under absorption costing will be higher (and income lower) than under direct costing.

Benchmarking, Best Practices, and the Balanced Scorecard

Benchmarking is a technique of organizational self-assessment via internal and external comparison to sources of excellence in performance. In other words, you try to find someone who is doing it better than you and attempt to emulate their performance. Benchmarking can be done for many dimensions of life. Our concern here is to benchmark business processes. Examples of business processes that may be benchmarked include production, shipping, customer service, accounts payable, payroll, and many, many more. In theory, any process that a business uses is a candidate for benchmarking. A. Benchmarking is a process. These are the typical steps: i. Decide WHAT or WHY—Identify the dimensions of the business to benchmark. Usually, these are "problem" areas or "problem" business processes. Examples of things to benchmark: i. Order fulfillment time 1. Defect rates 2. Employee turnover 3. Employee absenteeism 4. Returned products ii. Determine WHO or WHERE—Identify organizations or parts of the organization that are best-in-class performers. Hence, the label "external" or "internal" benchmarking. If external, be aware that not all organizations care to share data of this type. Some organizations will share only if they are promised the results of the survey. This is a major decision to make in the benchmarking process: Is the organization willing to share the results of its benchmarking efforts with all the participants? Firms may not be willing to take this step, as doing so may reveal that the benchmarking firm may be weak in certain areas and/or dissemination of the data to outside participants will increase the benchmarking workload. iii. Determine HOW—Organizations can and do use surveys, informal conversations, or personal visits. Some firms are in the business of writing benchmarking surveys. Hiring a company to develop a benchmarking survey may result in a more professional survey that may be better received than a home-grown survey, but doing so will increase the cost of the benchmarking effort. iv. GET the data. This may take several weeks, depending on the answers to steps 2 and 3. v. COMPARE the data to the organization's own performance. Identify best practices. Look for gaps. vi. DETERMINE how the gaps can be corrected: a. Change the process b.Change the product or service c.Train the people vii. TAKE necessary steps to CLOSE the gaps. Important Points and Features of Benchmarking 1. A company can't be the best at everything. Benchmarking should be done in the key areas that create a unique competitive advantage as determined by the company's distinctive competencies. 2. Because best practices change over time, benchmarking should be an ongoing process within the organization. In this way, benchmarking supports continuous learning and improvement. Priorities for benchmarking can change over time; expect this. 3. Don't try to focus on improving in every benchmark all the time. 4. Benchmarking is one tool that can be used to help create an atmosphere that supports a learning organization. Learning organizations can remain competitive in volatile business environments because of their ability to evaluate and interpret information and their willingness to embrace change. Learning organizations are characterized by flexibility—a willingness to adopt new ideas and new processes—and efficiency in the acquisition and distribution of information. Human capital is especially important in learning organizations, as it is the source of their creativity and vitality. The balanced scorecard is a best practice. A. What is a balanced scorecard (BSC)? Let's understand what isn't a BSC. Typical measures of business success, as discussed in other lessons, include earnings per share, return on investment, free cash flow, and other financial ratios. These measures are all financial measures. Some people believe that too much emphasis on financial measures is unbalanced, so they invented the BSC. 1. The BSC translates an organization's mission and strategy into a comprehensive set of performance metrics. 2. The BSC does not focus solely on financial metrics. 3. The BSC highlights both financial and nonfinancial metrics that an organization can use to measure strategic progress. B. Four Perspectives of a Typical BSC 1. Financial—Specific measures of financial performance 2. Customer—Performance related to targeted customer and market segments 3. Internal business processes—Performance of the internal operations that create value (i.e., new product development, production, distribution, and after-the-sale customer service) 4. Learning, innovation, and growth—Performance characteristics of the company's personnel and abilities to adapt and respond to change (e.g., employee skills, employee training and certification, employee morale, and employee empowerment) Note Note: The BSC can and should be tailored by industry and company. Some companies may want to add other perspectives, such as environmental impact, community involvement, vendor relations, or other areas of critical importance to those firms. Exam Note: The most common questions regarding a BSC focus on the four perspectives listed above. Candidates should be able to explain one or two performance measures appropriate for each perspective. C. Lead and Lag 1. The theory behind BSC includes an understanding of all four of the common perspectives of the scorecard from a timing perspective. Customer, internal process, and learning perspectives are often measured in real time; these measures will not be audited. These measures can be acted on quickly. As such, these dimensions of a BSC are called LEAD measures. 2. Financial measures, on the other hand, tend to be recorded after the fact. These numbers are audited and typically cannot be changed quickly, if at all. The financial measures are labeled as LAG measures. The theory then says that if the LEAD measures indicate positive performance, this will LEAD to positive financial performance. D. Sharing the BSC—Organizations don't typically publish their BSCs. They could, if they wanted to convince investors that they are using innovation management tools to continuously improve their business. Use of a BSC is completely voluntary. E. The process of building a BSC starts with the organization identifying, for each of the four dimensions of the scorecard, its -Strategic goals -Critical success factors. -Operational tactics -Performance measures Exam Tip Most balanced scorecard questions on the CPA Exam are expected to ask the candidate to identify performance measures associated with one of the four classifications or, conversely, to identify the classification in which a particular performance measure would be found. Definitions of the manufacturing performance measures listed in the Internal Business Processes section (delivery cycle time, manufacturing cycle time, and manufacturing cycle efficiency) sometimes may appear in CPA Exam questions.

Joint and By-Product Costing

I. Joint Products and By-Products are Similar—They are both the result of a single manufacturing process that yields multiple products. They both face the accounting problem of allocation of the shared costs of production. Two or more products of significant sales value are said to be joint products when they: A. Are produced from the same set of raw materials; and B. Are not separately identifiable until a split-off point. II. Joint Products Frequently Receive Further Processing After the Split-Off Point A. Split-Off—Is the point at which products manufactured through a common process are differentiated and processed separately. B. Separable Costs—Are additional processing costs incurred beyond the split-off point. Separable costs are attributable to individual products and can be assigned directly. C. Cost Allocation—Joint costs may be allocated to the joint products in several ways: 1. Relative physical volume—Costs are allocated based on the quantity of products produced. The total volume of all products is established (pounds, feet, gallons, etc.), each product's pro rata share is determined, and the joint costs are allocated based on that proportion. Note: This method can be used only if the unit of measure for all joint products is the same. 2. Relative sales value at split-off—Costs are allocated based on the relative sales values of the products either at split-off or after additional processing. When significant markets exist for the products at the split-off point, the relative sales value of each product at the split-off point can be used to allocate costs. Note: A joint process question regarding relative sales value at split-off may provide the relative value for each product, or the question may provide the quantity of units and the individual selling prices. One must multiply the units by the selling price to determine the total sales value of each product. Do not simply use the individual selling prices to allocate the joint cost. III. By-Products—By-products differ from joint products in that they have relatively insignificant sales value when compared to the main product(s). A. Costing—Because of their relatively insignificant sales value, by-products usually are not allocated a share of the joint costs of production. However, when by-products are processed beyond split-off, the additional processing costs are assigned to the by-product. These costs reduce the proceeds ultimately recognized from the sale of the by-product. B. Net Proceeds from the Sale of By-Products—Are sometimes used to reduce the cost of the main products. C. Proceeds—May be recognized in several ways: 1. Recognize when produced—The ultimate sales value of the by-product (less any additional costs necessary to sell the by-product) is deducted from the joint cost of the main products produced when the by-product is produced. This method is used when the saleability of the by-product is relatively certain. In this case, the NRV of the by-product is kept in ending inventory until sold. As such, the by-product must be counted, stored and treated like any other asset. When the by-product is sold, ending inventory is reduced; there is no gain or loss on the sale. 2. Recognize when sold—When the by-product value is recognized at the time of sale, the net proceeds can be recorded as other revenue, other income, or as a reduction in cost of goods sold. This method is used when the saleabillity of the by-product is uncertain. In this case, the joint cost of the main products is not reduced by the NRV of the by-product. There is no need to track the by-product, as its value is not added to ending inventory. If and when the by-product is sold, either Other Income is recorded or Cost of Goods Sold is reduced. The current method of accounting for May is to reduce the cost of goods sold of the major product by net sales of $3 per unit of May. The effect of this method of accounting is to increase gross margin by $3 per unit of May sold. If the method of accounting were changed to joint product accounting, then sales would increase to $4 per unit of May sold, without any addition to variable cost. The $1 cost associated with each unit of May would be classified as a sales expense, which is subtracted below gross margin. The $1 expense would no longer affect gross margin. Therefore, by changing the method of accounting, the gross margin increases by $1, while expenses below gross margin in the income statement increase by $1. Gross margin would reflect the full $4 gross sales of May, rather than only the net reduction in the cost of goods sold of $3. Using NRV, the final revenue for L is $8 (10,000 units produced) = $80,000; the final revenue for M is $20 (5,000 units produced) = $100,000; Sales less separable costs is $80,000 - $20,000 = $60,000 for L, while sales less separable costs for M is $100,000 - $40,000 = $60,000 for M also. Accordingly, both products have the same net realizable value, so the $36,000 in joint costs would be split 50/50 providing each with an allocation of $18,000. The value of the by-product, being insignificant in relation to the cost of the primary product, is treated as a reduction in the cost of the primary product at production. The separable costs associated with the by-product reduce the amount by which the cost of sales of gasoline is decreased. In this question, the value of the by-products is recognized at production (not sale). In this case, the net realizable value of the by-product at production is subtracted from the cost of the primary product (gasoline). None of the joint production cost is allocated to the by-product. Thus, the cost of sales for the by-product is zero. The $25,000 of costs associated with the by-product ($10,000 + $15,000) reduces the net realizable value of the by-product. For the primary product: Net Realizable Value of the By-product: +Sales value. $30,000 -Less separable by-product costs. (25,000) =Equals net realizable value $5,000 Cost of Goods Sold for Main Product: +Joint production cost $120,000 -Less net realizable value of by-product (5,000) =Adjusted production cost for main product. $115,000 -Less ending inventory of gasoline. (15,000) =Equals cost of goods sold for gasoline $100,000

Sales and Direct Cost Variance Analysis

Ideal/theoretical standards—Ideal standards presume perfect efficiency and 100% capacity.Not useful for control purposes as they are not practically attainable Currently attainable standards—Currently attainable standards are based on higher than average levels of efficiency, but are clearly achievable a. Typically used for employee motivation, product costing, and budgeting Variance Calculations A. Variance analysis analyzes the difference between standard costs and actual costs. When standard costs are used to value inventories, the variance must be written off: 1. Non-significant variances—Write off to cost of goods sold. 2. Significant variances—Allocate to ending work-in-process, finished goods, and cost of goods sold. B. Variance analysis segregates the difference between actual costs and standard costs into two parts: 1. Differences due to the cost of the resource (price per pound, labor rate per hour, etc.) 2. Differences due to the quantity used (gallons, pounds, feet, labor hours, etc.) Variance calculation is a multistep process. Step 1. Review the data. Determine what was expected to happen by determining the standard quantity allowed, based on what was actually produced. Step 2. Review the data. Determine what actually happened by isolating the actual dollars spent, rates used, and activity used. Step 3. Calculate the differences in rates, quantities, and total cost (Rate × Quantity). Step 4. Use the differences in rates and quantities to calculate the variances. Step 3: Calculating the Differences—When calculating cost variances, it is best to use the following format: look at image 1.When cost variances are calculated in this manner, negative numbers indicate unfavorable variances and positive numbers indicate favorable variances. Exam Note: While the discussion above, referencing negative numbers in a variance calculation, is technically correct, CPA candidates should avoid using the terns "negative" and "positive" in any written communication regarding cost variances. In a written communication, the prepared CPA candidate will want to clearly indicate their understanding of the variance. It is important to explain what happened to create the variance. Explanations for variances should include the terms "Favorable" when the variance positively impacts the business and "Unfavorable" when the business is negatively impacted. Explanations for variances should include reasons, such as "Materials were purchased at a higher price than the standard price" or "The direct laborers used less time than the standard allowed." 2. A Note about the Standard Quantity—The "standard quantity" is the "standard quantity allowed for actual production." For example, if the standard amount of aluminum required to produce a sheet of siding is 2 lbs. and 50 pieces of siding are produced, then the "standard quantity allowed for actual production" is 100 lbs. B. Step 4: Calculating the Variances—The differences in rate and quantity are used to calculate the price/rate variance and the usage/efficiency variance as follows: Price/rate variance=differences in rates x Actual Quantity Usage/Efficiency Variance=Difference in Quantities x Standard Rate Complicating Factors—Multiple choice questions on the CPA Exam will sometimes complicate these calculations by providing partial information about the standard and actual figures and the related variances. You must use your knowledge of the relationships among these figures to work backwards and provide the answer to the question. Using the format suggested above simplifies these calculations substantially. Analyzing Sales Variances A. Although we predict this will not be frequently tested on the exam, questions about sales variances may sometimes appear. Analysis of sales variances can be handled in the same manner as cost variances as long as the following points are observed: 1. Budgeted or planned sales—Quantities and prices are used instead of "standard" quantities and prices. 2. Sales variances work backwards—When compared to cost variances, that is: a. When actual prices are greater than planned prices, favorable variances result (e.g., it is good for people to pay more than you had planned). b. When actual quantities sold are greater than planned quantities sold, favorable variances result (e.g., it is good to sell more than you had planned). 3. Sales variances—Use slightly different names: a. Sales price variance—Difference in prices × actual quantity sold. b. Sales quantity variance—Difference in units × planned unit price.

Inventory Flow, Cost, Spoilage, Scrap

Inventory Flow and Cost—Organizations use one of several cost flow assumptions (LIFO, FIFO, weighted average) to assign costs to ending inventory and cost of goods sold. For retailers, wholesalers, and distributors, which buy products for resale, this is a fairly straightforward process. For manufacturing companies, however, the addition of raw materials inventory and work-in-process inventory makes the process more complex. Wholesale and Retail Organizations—These organizations purchase the items that they sell, so their inventory calculations are relatively simple. Under the periodic inventory method, inventory is counted at the end of the period and valued, typically using FIFO, LIFO, or weighted average cost flow assumptions. The ending inventory valuation is then subtracted from Goods Available for Sale (the value of the beginning inventory plus purchases) to determine Cost of Goods Sold:look at section for this schedule(inventory fornula) Manufacturing Organizations 1. Manufacturing organizations maintain three categories inventories instead of one: a. Raw Materials b.Work-in-Process c.Finished Goods 2. Costs flow from Raw Materials Inventory through Work-in-Process Inventory and into Finished Goods Inventory. As items are sold, costs flow from Finished Goods Inventory into Cost of Goods Sold. The ending balances of the three inventories are added together and reported as a single line item on the Balance Sheet. Cost of Goods Sold appears as a line item on the Income Statement. Schedule of Cost of Goods Manufactured—This schedule calculates the dollar value of the goods that were completed during the period and transferred to finished goods. It is primarily an analysis of the Work-In-Process account (Beginning Balance + Total Manufacturing Costs − Ending Balance = Cost of Goods Manufactured), but it is sometimes complicated by calculations related to the Direct Materials Inventory. Look at section for schedule Schedule of Cost of Goods Sold—This schedule is produced by analyzing the Finished Goods Inventory. Exam Tip Be sure that you thoroughly understand the account analysis formats used in this example. The examiners are likely to make these questions more difficult by giving you the Cost of Goods Sold or Cost of Goods Manufactured and asking you for one of the intermediate amounts (e.g., the Ending WIP Inventory value or the Direct Labor added during the period). If you understand the format of the analysis, these types of questions are easy to answer by simply filling in the blanks and solving for the unknowns. The complete CGS/CGM format is shown below. Also, as the arrows show, you should notice how something from each of the sections sends something to the next section. For example, the first section for direct materials moves direct materials used to the next section. You should also notice that sections 1, 3, and 4 are all essentially the same format. This should make it easier to memorize the format. look at section for format Scrap, Spoilage and Rework The manufacturing cost flow discussed in the previous section implies that all direct material usage creates unblemished finished products; this is simply not the case. Scrap, spoilage, and rework are very real elements of any manufacturing process A. "Scrap" is defined as bits and pieces of leftover, unused direct material. Scrap may be: 1. Normal: Uncontrollable, unavoidable, and expected, or 2. Abnormal: Not expected; sometimes avoidable. B. The accounting for scrap is determined not by the cause of the scrap but rather by what happens to these bits and pieces of leftover, unused direct material. Sometimes scrap is salable; other times, an organization may be required to pay for scrap removal. 1. Accounting treatment of scrap: Recognize value at time of production. If the scrapped direct material is salable: a. Scrap is recognized at the time of production. b. Cost of the main product is reduced by the net realizable value (NRV) of the scrap, even if the scrap is not yet sold. c. NRV of the scrap is kept in ending inventory until sold (treated like an asset). d. When the scrap is sold, ending inventory of scrap is reduced; there is no gain/loss on sale. 2. Accounting treatment of scrap: Recognize value at time of sale. If the sale of the scrapped direct material is not certain: a. Scrap value is recognized at the time of sale. b. Cost of the main product is not reduced by the NRV of the scrap. c. There is no need to keep NRV of the scrap in ending inventory until sold. d. If and when the scrap is sold, either Other Income is recorded or Cost of Goods Sold is reduced. C. "Spoilage" is defined as units of product that are unacceptable, discarded, reworked, or sold at a reduced price. Spoilage may be: 1. Normal: Uncontrollable, unavoidable, and expected, or 2. Abnormal: Not expected; sometimes avoidable. D. "Rework" is defined as spoiled units that are repaired. If abnormal defects, charge as a loss. If defect from specific product, charge to product. If defect occurs periodically as a regular part of manufacturing, charge to overhead. CORRECT! Two steps are required to solve this problem: Step 1: Determine the number of units the company must produce to meet the sales requirements, adjusting for beginning and ending finished goods inventory. Step 2: Determine the amount of raw material required to produce these units, adjusting for beginning and ending raw materials inventory. Given this process, we have: Step 1: +Sales + 100,000 units -Beg. FG inventory - 10,000 units +End. FG Inventory + 9,000 units =Units to Produce = 99,000 units Step 2: +RM req'd for Production + 495,000 ft. raw material* -Beg. RM Inventory - 40,000 ft. +End RM Inventory + 42,000 ft. =RM to purchase = 497,000 * 99,000 FG units x 5 ft. per unit = 495,000 ft. raw material

Job Costing

Job order costing is used to accumulate costs related to the production of items that are custom-made and can be distinguished from each other. Costing follows the general rules for manufacturing cost flows and is relatively straightforward: job costing is also used in service industries, such as accounting firms, law offices, and event planners. Note Job costing is compatible with the use of normal costing, standard costing, and variance analysis Overhead (OH) is applied based on a predetermined OH rate. Manufacturing overhead is the third component of product cost, but because it is not DIRECTLY incurred in the manufacture of products, no "transaction" triggers a journal entry. Instead, manufacturing overhead is recorded periodically on the job cost sheet. Two common events that lead to manufacturing overhead being recorded are: Preparing financial statements for which work-in-process inventory needs to be valued or measured. Completing a job for which costs need to be recorded Overhead Allocation—Direct materials and direct labor are traced to the WIP account, but OH must be allocated to WIP. Since overhead costs are typically not directly traceable to specific units of production, an estimated overhead amount is applied to production based on a predetermined rate. Some organizations use one "manufacturing overhead control" account to record both actual and applied expenses, while other organizations may use separate accounts. In either case, these are temporary accounts that must be "zeroed out" at the end of the accounting period. Organizations are not allowed to use estimated numbers to value inventory or cost of goods sold. The primary reason for using estimated, predetermined overhead rates is timeliness. Overhead costs are often of a varied nature, and payment for these expenses does not mirror production or service work patterns. Property taxes, for example, an overhead cost, may be incurred a year or more after the production process. Organizations simply cannot wait until all actual overhead costs are incurred to have a reasonable estimate of cost and profitability. As such, estimated overhead costs are developed and used as a surrogate for actual cost data. Actual OH costs are accumulated separately. At the end of the period, the applied OH is compared to the actual OH and an entry is made to adjust any difference. A. Predetermined OH Application Rate—The first step in applying OH to WIP is to calculate the rate that will be used to apply overhead to production. The rate is based on an estimated OH amount divided by an estimated allocation base amount (e.g., machine hours or [DLH]). The measure of activity or volume should have some plausible relationship to the OH charges. For example, if production were highly automated, then machine hours would be a likely choice. Where production is more labor paced, DLH might be a reasonable allocation base. Exam Tip Estimated amounts based on currently attainable capacity are always used for this formula, not historical, ideal, or theoretical amounts. This is likely to be a frequently tested concept on the CPA exam. Applied OH—The amount of estimated OH charged to production. Applied OH is calculated by multiplying the POROH by the actual number of units used in production (e.g., DLH or machine hours). Actual OH—The amount actually paid for OH expenses. These costs are initially charged to the specific expense account (i.e., supplies inventory, utilities, maintenance, supervision, etc.) and to the factory OH control account. Closing Out the OH Accounts—At the end of the period the factory OH control account (which contains the actual OH costs) and the factory OH applied account (which contains the OH costs that were applied to production using the POROH) are closed out. Exam Tip The treatment of material differences between actual and applied OH is likely to be tested on the CPA Exam. Overapplied Factory OH—When more OH costs are applied to products than are actually incurred, factory OH is said to be overapplied. When the accounts are closed at the end of the period, overapplied OH reduces COGS and, as such, increases gross margin. Underapplied Factory OH—When more OH costs are actually incurred during the period than are applied to products, factory OH is said to be underapplied. When the accounts are closed at the end of the period, underapplied OH increases COGS and reduces gross margin. Summary of OH Application—There are three steps to allocation of OH and they take place at different times during the year. 1. At the beginning of the year, we calculate the POR. For example, estimated OH is divided by estimated DLH. 2. During the year, we periodically allocate OH by multiplying the POR by the actual units of the allocation base. 3. At the end of the year we dispose of over-/underapplied OH by taking the difference between actual OH and applied OH to COGS. Additional Points 1. Make sure that you know which type of OH to use in these calculations and when to use them. There are three different types: estimated, applied, and actual. 2. Make sure that you multiply the POR by "ACTUAL" units in Step 2. 3. Make sure you know what happens during the different times of the year and which OH amounts are relevant. 4. The terms budgeted and estimated mean the same thing. Also, the terms allocated and applied mean the same thing. 5. Be sure to memorize this three-step process. It is one of the most widely used calculations you are likely to see on the CPA Exam. Correct. The $6,800 ending balance contains $1,800 of direct material charges and $2,000 of direct labor charges. As such, the amount of overhead cost in the ending balance is $3,000. $3,000/$2,000 = 150%, so the predetermined rate, as a percentage of direct labor costs, is 150%. Underapplied overhead occurs when actual overhead was greater than applied overhead. Applied Overhead = (bud. FOH/bud. volume) X (actual volume) For overhead to be underapplied, either the actual fixed costs must be greater than the budgeted fixed costs or the actual volume must be less than the budgeted volume. Another term for overhead is indirect cost. Indirect costs cannot be traced to specific jobs. In other words, overhead is not directly attributable to specific jobs. All manufacturing cost is, by definition, a necessary ingredient of the total production cost. All jobs consume some overhead or receive the services of an overhead department or cost center. Both types of systems use standard cost systems. Standards are reasonable expectations of input quantity per unit of output and input cost per unit of input. Both systems can specify reasonable expectations for both of these types of standards. $4,000 + $24,000 + $16,000 + $12,800 - $48,000 (all attributable to Job No. 5, the only remaining job) = $8,800 Less direct labor charged to Job No. 5: (2,000) Less overhead charged to Job No. 5: .80($2,000). (1,600) Equals materials charged to Job No. 5: $5,200

Process Costing

Process Costing—Process costing is used to accumulate costs for mass-produced, continuous, homogeneous items, which are often small and inexpensive. Since costs are not accumulated for individual items, the accounting problem becomes one of tracking the number of units moving through the work-in-process (WIP) into finished goods (FG) and allocating the costs incurred to these units on a rational basis. Note Process costing is compatible with the use of normal costing, standard costing, and variance analysis. Three-Step Solution Process TA. he following steps walk you all the way through the process of allocating costs to WIP and FG for a single factor of production. Since the three factors of production—raw materials, labor, and OH—do not usually accumulate evenly across the production process, the process must be repeated for each of the three factors of production. The three steps are: B. Step 1—Determine equivalent units 1. Clearly identify the physical flow of units. As units move through the production process, each processing department adds material and conversion costs (i.e., labor, and OH) to WIP. As goods move from department to department through the manufacturing process, these costs accumulate. 2. At the beginning of each period, the units in beginning WIP are, by definition, only partially complete. The completion rate for beginning WIP inventory reflects the work done "to date," meaning during the prior period. A different percentage of completion is normally associated with each factor of production. During the period, fully completed units are transferred to the next department or to FG. At the end of the period, the units remaining in ending WIP are, by definition, at various stages of completion for each factor of production (i.e., DM and conversion costs). 3. The next chart summarizes the flow of physical units through a single department's manufacturing process and identifies the percentage of completion of the beginning and ending WIP inventory. Note This analysis follows the same "account analysis" format used to create the Schedule of COGS and the schedule of cost of goods manufactured (see the "Manufacturing Costs" lesson in the Operations Management section.). You should provide a column to calculate physical units as shown above and a separate column to calculate EU for each of the two types of factors of production (i.e., DM and conversion costs). The following illustrations use only one factor of production since the approach is the same for both. 4. The first task is to calculate the physical units to account for. Here they are given, but often you will have limited information. For example, sometimes you will be given only one of the inventories (either beginning or ending) and have you work backward to figure out total units to account for. Use the logical setup in the chart in Section II.B.3 above to help you do that. To make this easy, you should remember that total units to account for will involve two pieces of information: either (units started + units not started) or (units finished + units not finished). a. Beginning inventory represents units not started this period, while units added to production are units started. Adding those two sets of units will always give you total units to account for. b. Conversely, if you are given ending inventory, you should understand that "units completed and transferred out" provides units finished, while ending inventory provides units not finished, again providing the total units to account for. c. Taking this logical approach will always ensure that you know how many physical units to account for. 5. Calculate EU. The term equivalent units (EU) refers to the number of whole units that could have been produced during the period in terms of cost incurred. For example, the cost associated with six units that are 50% complete is equivalent to the cost associated with three units that are 100% complete. 6. Because the units in beginning and ending WIP inventory can be at different percentages of completion in terms of cost, the number of physical units remaining in ending WIP inventory plus the units transferred to FG does not reflect the actual work done. The fraction of work done on the partially completed units in beginning and ending WIP must be taken into account. 7. Solving for the EU of production will depend on which method is being used: weighted average or first in, first out (FIFO). a. Weighted average uses only two categories: goods completed and ending inventory. The format will differ in that weighted average combines prior period work (i.e., beginning inventory) with current period work (units finished this period not in [BI]) to determine "goods completed." b. The FIFO method uses three categories, separating (1) beginning inventory from (2) the new or current period completed work (called "units started and finished"), while (3) ending inventory (at least for EU) is treated the same as with weighted average. 8. You should notice several things about the format presented just above. a. Physical units are the same (in total) regardless of the EU method used. b. Exam questions stating percentage of completion for the ending inventory EU calculation are likely to be communicated in terms of how much dollar-equivalent work was completed in the current period. However, the percentage of completion for beginning inventory is typically stated in terms of how much dollar-equivalent work was completed in the prior period. This is often confusing to candidates. To make this easier to understand, think about the fact that the FIFO method is interested in calculating current-period information separately from prior-period information. As such, FIFO wants to know the EU of work done on the beginning inventory this current period. That is why you are required to use the complement (100% - 10%) in the calculation of beginning inventory EU. c. Regarding the percentage of completion multiplier: For the weighted average method, the goods completed amount will always be 100% complete. For the FIFO method, the units started and finished will always be 100% complete. Ending inventory will be the same equivalent units amount for both methods. Physical units will, of course, be the same regardless of the method used to calculate equivalent units. d. The ultimate goal in calculating equivalent units is to segregate the WIP inventory account between (1) work finished and transferred out and (2) ending WIP inventory. e. A T-account can be used to check your work and to help display how these two pieces of WIP are relevant. The following T-account provides an example. We know how the physical units are divided from the 50,000 units available shown on the left below, and we will use the EU concept to determine (1) the cost of units transferred out and (2) the value of the ending WIP inventory shown in the T-account. Note The term "cost of goods transferred out" is often used in process costing rather than the "cost of goods finished" since the units could be transferred through several departments prior to going to FG inventory. Cost of goods finished would only accurately apply to the last department in the sequence. C. Step 2—Determine the cost per equivalent unit. 1. First determine the total costs to account for; the following costs are usually accumulated during the period: a. Beginning WIP costs—The total costs of production (material, labor, and overhead) that were allocated to the production units during previous periods. Exam Tip Costs of units transferred in from a previous department are significant complications that are not likely to be tested on the exam. b. Transferred-in costs—The costs of production (material, labor, and overhead) from previous departments that flow with the production items from department to department. c. Current-period costs—The transfer costs and costs of production (material, labor, and OH) added to the WIP during the current period. d. Total costs to account for—The total of the beginning WIP costs, the transfer-in costs, and the current period costs. Total costs must be allocated to ending WIP inventory and to FG inventory at the end of the period. 2. The type of cost flow assumption used impacts which costs are used to determine the unit price. Note Regardless of the cost flow assumption, all costs must be allocated either to ending WIP inventory or to FG. a. Weighted average cost flow—Under the weighted-average cost flow assumption, the beginning WIP inventory costs are added to the current period costs (including transfer-in costs, if any) before dividing by the EU figure. This process averages the two cost pools together. b. FIFO cost flow—Under the FIFO cost flow assumption, the costs associated with prior period work on beginning WIP inventory are transferred to FG in their entirety. The current period (equivalent) unit cost is determined by dividing the current period costs (including transfer-in costs, if any) by the EU added to production during the current period. 3. Calculate the cost per EU. Once the correct EU number and total costs to allocate have been determined (based on the specified cost flow assumption), calculation of the EU cost is straightforward: simply divide the cost to be allocated by the EU. D. Step 3—Determine (a) cost of goods transferred out of WIP and (b) ending WIP inventory. 1. Use the cost per EU to value the ending WIP inventory and the cost of goods transferred out (recall that this is the ultimate purpose of the two methods). a. Note that although the number of ending WIP inventory equivalent units (1,200 EU) are the same regardless of whether weighted average or FIFO is used, the dollar amounts will be different due to the difference in the cost per equivalent unit between the methods. 2. To value the cost of goods transferred out for each of the methods, weighted-average is considerably different from FIFO. This is because weighted average averages the two periods' work together while FIFO separately values the cost of goods transferred out by period. For weighted average, using the table from step 1, we simply multiply the cost per EU by the goods completed and transferred out (5,000) to provide the final valuation of cost of goods completed. 3. The calculation for FIFO is similar in that EU are multiplied by the cost per EU for the remaining categories shown in bold in the table below, but we must remember that this EU total accounts for the work done in the current period only. Because of this, we must calculate the current period work and add this to the prior period work (beginning inventory amount given to us) to compute the cost of goods transferred out. Study Tip After calculating these amounts, it is useful to check your work (if you have time) by adding the ending inventory valuation amount to the cost of goods transferred out to determine whether that amount is equal to the total costs to account for. This amount will, in total, be the same for the two methods: FIFO considers only the current period cost and effort in computing cost per equivalent unit. The cost of the work performed during the previous period, embodied in beginning inventory work in process, is assumed to be the first transferred out (first-in, first-out). Goods transferred out will reflect the earlier cost and effort applied to beginning inventory at the cost per equivalent unit in the previous period. But it will also reflect the remaining work to complete the inventory during this period, at the cost per equivalent unit for the current period. This also means that the goods started and completed during the period, and the ending inventory work in process, will reflect only the current period costs. The FIFO assumption does not mix the costs and effort of two periods when computing cost per equivalent unit. Under the weighted average method, the cost per equivalent unit includes all the work done through the end of the current period, including the work performed on beginning inventory during the previous period. This is why the method is called the weighted average method. In this situation, material is added at the beginning of the process. Therefore, all units are considered complete with respect to materials. The costs associated with this effort form the numerator of the calculation. The sum of units completed plus units in ending inventory equals 55,000 (42,500 + 12,500). The total cost incurred on material equals $23,500 ($5,500 + $18,000). Thus, the cost per equivalent unit for materials is $.43 ($23,500/55,000). Beginning work in process: 10,000 units, 70% complete Units started into production during the year: 150,000 units Units completed during the year: 140,000 units Ending work in process: 20,000 units, 25% complete What was the number of equivalent units produced using the first-in, first-out method? 138,000. 140,000. 145,000. 150,000.\" I have already read your explanation to other students saying the 130,000 is calculated one of two ways: \"Units started into production during the year: 150,000 units Units completed during the year: 140,000 units Which is, I believe, why students get confused about the calculation. Using 'Units Started into Production During the Year:' + 150,000 Units Started into Production During the Year -__20,000 Units remaining in Ending WIP Inventory = 130,000 Units Started and Completed During the Year Using 'Units Completed During the Year:' + 140,000 'Units Completed During the Year:' - __10,000 Units in Beginning WIP Inventory = 130,000 Units Started and Completed During the Year \"

Ratio Analysis

Profitability and Return Metrics—These metrics are derived from income statements and are measuring financial results for a period of time. Many of these metrics can be calculated with data found on externally published financial statements. A. Gross Margin or Gross Profit—This metric is heavily used by organizations that sell physical goods. The calculation is: Revenue less Cost of goods sold = Gross margin. This commonly used metric reflects profitability prior to the recognition of period expenses, such as selling, general, and administrative expenses. Gross margin is typically found on a GAAP-compliant "absorption" or "full cost" income statement. B. Contribution Margin—This metric requires an organization to segregate costs by behavior, meaning that costs are identified as either fixed or variable. The calculation is: Revenue - All variable costs = Contribution margin. This approach to measuring financial success is not GAAP-compliant and is used by many organizations for internal purposes. The types of income statements that feature contribution margin are often called variable cost P&Ls or direct costing P&Ls. Contribution Margin Ratio = Contribution Margin / Sales Revenue Operating Profit Margin = Operating Income / Sales Revenue Profit Margin or Return on Sales = Net Income / Net Sales Return on Investment = Net Income / Investment or Net Income / Total Assets The DuPont formula for ROI: Return on Sales (ROS) × Asset Turnover Where Profit Margin or ROS = Net Income / SalesCapital or Asset Turnover = Sales / Total Assets The DuPont approach to ROI separates ROI into two other metrics for analysis. The two metrics offer a separate measure of profitability as a percentage of sales and the efficiency with which assets were utilized to generate those sales. Multiplying the two metrics together results in ROI. Residual Income = Operating Income - Required Rate of Return (Invested Capital). Residual income (RI) measures the dollar amount of operating income that exceeds an internal capital charge. This metric is often used to evaluate different segments or a business or different capital expenditures. This metric provides a sense of scale when comparing segments of different sizes; return metrics do not provide this sense of scale. Asset Utilization Receivables Turnover = Sales on Account / Average Accounts Receivable Days' Sales in Receivables or Average Collection Period = Average Accounts Receivable / Average Sales per Day Inventory Turnover = Cost of Goods Sold / Average Inventory Fixed Asset Turnover = Sales / Average Net Fixed Asset Liquidity Current Ratio = Current Assets / Current Liabilities Quick Ratio or Acid Test Ratio = (Current Assets − Inventory) / Current Liabilities Solvency—Solvency ratios measure an organization's ability to survive in the long run. They do this by comparing a company's level of debt against earnings, assets, and equity. Solvency ratios are commonly used by lenders or investors to determine the ability of a company to pay back its debts. The most common measure of solvency is: (Net after-tax income + Noncash expenses) / (Short-term liabilities + Long-term liabilities) Debt Utilization (risk) Debt to Total Assets = Total Debt / Total Assets Debt to Equity = Total Debt / Total Owners' Equity Times Interest Earned—Operating Income / Interest Expense. Market Value Ratios Price Earnings (PE) Ratio—Market Price per Share / Earnings per Share Market-to-Book Ratio—Market Value per Share / Book Value per Share Additional Ratios Return on C/S Equity = Net Income - Preferred Dividend (obligation for the period only)/Average Common Stockholders' Equity (e.g., Beginning + Ending/2) EPS (Basic) = Net Income − Preferred Dividends (obligation for the period only) / Weighted Average Number of Shares Outstanding P/E Ratio (the "Multiple") = Market Price for a Common Share / Earnings per (Common) Share (EPS) C/S Dividend Payout Rate = Cash Dividends to Common Shareholders / Net Income to Common Shareholder C/S Dividend Payout Rate = Cash Dividends per Common Share / Earnings per Common Share Common Stock Dividend Yield = Dividend per Common Share / Market Price per Common Share

Competitive Analysis REVISIT

Return on Investment—This is the primary external financial ratio. There is not a GAAP Statement regarding ratios. Different businesses may use different measures to reflect ROI. Generally, ROI is calculated as operating income over average operating assets. The word "operating" is what causes some confusion. Commonly, a firm would calculate its ROI on an annual basis, using a year's worth of operating income and the average of the beginning balance of operating assets and the ending balance of operating assets. However, a firm may also report ROI for a month, a quarter, or another time period. This might be used if a business is new. For example, if a business has a fiscal year starting on April 1 or February 1, it may measure ROI for a partial year. Remember to carefully read any question (or any financial statement) to understand the time period being measured. The degree of uniformity for ROI metrics will vary because of the word "operating." Some firms use after-tax income, some use EBITDA. Be sure to read the entire problem for context on what numbers to use. ROI is used by external analysts to value companies for potential investors or bondholders. ROI is also used to reflect the profitability of capital projects. Organizations that invest in capital projects and/or other financial instruments often use ROI to measure the profitability of various projects and proposals. Companies may use ROI to compare products, channels, physical locations, and/or product lines. The DuPont analysis is a method to break down, or dissect, the ROI calculation into two parts: investment turnover, also called asset turnover, and return on sales, which is often called margin. These two ratios, multiplied together, create ROI. A. The DuPont method can help an organization better determine how to improve ROI. There are really only three ways to improve, or increase, ROI: increase revenue, decrease costs, or decrease assets. Residual Income (RI) = Operating Income - Required Rate of Return (Invested Capital) Residual income (RI) is a general form of economic profit. Economic profit differs from accounting income in that it recognizes the cost of capital. RI has often been used as an alternative to ROI to preclude the diluted hurdle rate problem by expressing the return on investment in terms of dollars rather than a rate. Note There are multiple ways of calculating residual income in the sense that some sources suggest using net income or net operating profit after tax (NOPAT) instead of operating income as shown above. The required rate of return is also referred to as the minimum required rate of return but can be equal to whatever management decides. Invested capital is usually total assets, but again can be modified to suit the needs of the user. This is why RI is referred to as a "general" form of economic profit. Exam Tip Economic value added is perhaps especially important because it is mentioned more than once in the detailed content specification outline. EVA = NOPAT − WACC (Total Assets − Current Liabilities) 1. NOPAT = net operating profit after tax; WACC = weighted average cost of capital 2. EVA is an economic profit (EP) metric and a specific form of residual income. Like other forms of residual income, EVA is stated in dollars. 3. EVA is often used for incentive compensation and investor relations. This is likely due to the emphasis on the use of income (first part of the equation) exceeding the cost of capital (second part of the equation) in measuring wealth creation. 4. EVA suffers from its origins in accrual-based NOPAT and the difficulty in defining the nature of economic profit (i.e., economic profit is not cash-based, but it is often adjusted such that it is not strictly accrual-based either). Definition WACC: Summarizes the overall cost of capital based on the weighted proportion of debt versus equity after reducing the cost of debt by the marginal tax rate. CFROI = (CFO − ED) / Cash Invested 1. For CFROI, economic depreciation (ED) is defined as the annual cash investment required to replace fixed assets; CFO is cash flow from operations. 2. CFROI is a cash-based metric that is designed to compute the real internal rate of return on a company's assets and is stated as a rate. 3. CFO − ED is designed to approximate free cash flow (FCF), which is approximately equal to cash flow from operations (CFO) less net investment in fixed assets. This amount represents cash that is potentially distributable to shareholders. 4. CFROI is often used for incentive compensation, valuation, and capital budgeting. This is likely due to the emphasis on cash flow and the wide acceptance of cash flow for these purposes. 5. CFROI suffers from the weaknesses inherent in rate-based metrics (i.e., diluted hurdle rate problem and the potential difficulty in applying rates to analysis where negative cash flows are involved). Prevalent VBM Themes and Concepts 1. Accrual-based metrics are discredited—This is because accrual-based concepts are designed to fulfill external reporting goals (e.g., consistency, conservatism, and matching) rather than provide economic substance. 2. Cost of capital is increasingly emphasized—This emphasizes the economic income view that cost of capital is important in the evaluation of wealth creation. 3. Shareholders and shareholder value as the primary element of interest is common—This is about the importance of enhancing and protecting shareholder wealth. 4. Relating VBM to strategy and making linkages to drivers of success are important—This recognizes the importance of causality and value drivers as related to strategic planning and execution (i.e., understanding causal performance linkages). Price Elasticity Analysis By definition, the price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price A price is considered elastic if the price elasticity of demand is greater than 1 and inelastic if the elasticity of demand is less than 1. To solve for residual income (RI), you must first solve for assets (investment) and income. Since an asset turnover of 1.5 is sales/investment and sales is $750,000, we use $750,000 / x = 1.5, where x = investment. Thus, investment is $500,000. Since a return on sales of 8% is profit/sales and sales is $750,000, we use x / $750,000 = 8%, where x = income. Thus, income is $60,000. Now, RI = income less the rate given at 12% multiplied by the investment. Thus, RI is 0 = $60,000 - .12 ($500,000). The calculation of the weighted average cost of capital (WACC) involves proportional weighting for debt and equity with the debt figure reduced for deductible taxes. Thus, the cost of debt is 1.8% = 50% (6%) (1 - .4); the cost of owners' equity is split for the preferred 0.7% = 10% (7%); and the common 4.6% = 40% (11.5%). Thus, the WACC is 7.1% = 1.8% + 0.7% + 4.6%. Residual income is calculated as operating income less the investment (total assets here) multiplied by the required rate of return. Thus, Division B's residual income is $400 - .1($1,600) = $240. CORRECT! Cost of debt is equal to 8%, and the debt ratio = debt/equity (40%). stock is to be issued at 10% and debt is weighted at 40% while stock is 60%. Therefore, cost of debt is 8% (.40) = 3.2%; equity is 10% (.60) = 6.0% and 3.2% + 6% = 9.2%.

Quality Management

The concept of quality as used in total quality management (TQM) often differs from the traditional concept of quality. "Quality" is most commonly used to refer to "grade." For example, a platinum bracelet is usually considered to be of higher quality than a silver bracelet, and a Mercedes is usually considered to be a higher-quality vehicle than a Ford. Quality of Conformance: Refers to the degree to which a product meets its design specifications and/or customer expectations. Exam Tip There is likely to be at least one question about TQM in Operations Management, and it is likely to ask the candidate to match a cost of quality (e.g., cost of using better-quality materials, cost of scrap, cost of sales returns, etc.) with its appropriate category (i.e., prevention costs, appraisal costs, internal failure costs, or external failure costs). Cost of Quality A. The costs incurred by an organization to ensure that its products and/or services have a high quality of conformance are known as costs of quality. B. Cost of quality is based on the philosophy that failures have an underlying cause, prevention is cheaper than failures, and cost of quality performance can be measured. Cost of quality consists of four components—(1) prevention cost, (2) appraisal cost, (3) internal failure cost, and (4) external failure cost. Each of these categories is explained in detail below. 1. Prevention cost—The cost of prevention is the cost of any quality activity designed to help do the job right the first time. 2. Appraisal cost—The cost of quality control including testing and inspection. It involves any activity designed to appraise, test, or check for defective products. 3. Internal failure cost—The costs incurred when substandard products are produced but discovered before shipment to the customer. 4. External failure cost. The cost incurred for products that do not meet requirements of the customer and have reached the customer. Total Cost of Quality and Quality Cost Behavior A. An organization's total cost of quality is the sum of its prevention, appraisal, internal failure, and external failure costs. There is inverse trade-off between the cost of failure (internal or external), and the cost of prevention and appraisal in determining the total quality of conformance: 1. When the overall quality of conformance is low, more of the total cost of quality is typically related to cost of failure. For example, a manufacturer substitutes a lower-quality power cord connection on one of its products with the result that, after a short period of use, the power cords break, rendering the product unusable. This problem causes the quality of conformance for the product to be lower and the cost of external failure to be higher. 2. Increases in the cost of prevention and the cost of appraisal are usually accompanied by decreases in the cost of failure and increases in the quality of conformance. Continuing with the power cord example, if the manufacturer increased the amount of testing completed before the product was shipped, more defective products would be discovered. This would increase the cost of internal failure but decrease the cost of external failure. Since the cost of an external failure is normally greater per unit than the cost of an internal failure (i.e., it is less expensive to identify a faulty product before it has left the factory than to replace or refund a faulty product in the hands of a consumer or distributor), the overall cost of failure decreases. Six-Sigma Quality—What Is Six-Sigma? Six Sigma:A statistical measure expressing how close a product comes to its quality goal. One-sigma means 68% of products are acceptable; three-sigma means 99.7% of products are acceptable. Six-sigma is 99.999997% perfect: 3.4 defects per million parts. A. Six-Sigma Black Belts must attend a minimum of four months of training in statistical and other quality improvement methods. Six-Sigma black belts are experts in the Six-Sigma methodology. They learn and demonstrate proficiency in the DMAIC methodology and statistical process control (SPC) techniques within that methodology. DMAIC is the structured methodology for process improvement within the Six-Sigma framework. It stands for Define, Measure, Analyze, Improve, and Control. Quality Tools and Methods A. Total Quality Control (TQC)—The application of quality principles to all company activities. Also known as total quality management (TQM). B. Continuous Improvement and Kaizen Continuous Improvement (CI) seeks continual improvement of machinery, materials, labor, and production methods, through various means including suggestions and ideas from employees and customers. Kaizen:The Japanese art of continuous improvement. It is a philosophy of continuous improvement of working practices that underlies total quality management and just-in-time business techniques. PDCA (Plan-Do-Check-Act) also called the Deming Wheel: Focuses on the sequential and continual nature of the CI process. Cause-and-effect (fishbone or Ishikawa) diagrams: Identify the potential causes of defects. Four categories of potential causes of failure are: human factors, methods and design factors, machine-related factors, and materials and components factors. Cause-and-effect diagrams are used to systematically list the different causes that can be attributed to a problem (or an effect). Such diagrams can aid in identifying the reasons why a process goes out of control. Pareto chart:A bar graph that ranks causes of process variations by the degree of impact on quality. The Pareto chart is a specialized version of a histogram that ranks the categories in the chart from most frequent to least frequent. A related concept, the Pareto Principle,states that 80% of the problems come from 20% of the causes. The Pareto Principle states: "Not all of the causes of a particular phenomenon occur with the same frequency or with the same impact." Control charts: Statistical plots derived from measuring factory processes; they help detect "process drift," or deviation, before it generates defects. Control charts also help spot inherent variations in manufacturing processes that designers must account for to achieve "robust design." Robust design: A discipline for making designs "production-proof" by building in tolerances for manufacturing variables that are known to be unavoidable. Poka-yoke (mistake-proofing): Poka-yoke involves making the workplace mistake-proof. For example, a machine fitted with guide rails permits a part to be worked on in just one way.

Overhead Variance Analysis

The process of analyzing overhead variances is substantially more difficult than analyzing variances related to direct materials and direct labor because: 1. Some overhead varies with production volume while other overhead is fixed; because of this, separate variances must be calculated for variable overhead and for fixed overhead. 2. Fixed overhead is applied to production based on a specified cost driver; if actual usage of the cost driver differs from planned, applied overhead costs will change solely as a result of changes in cost driver consumption (i.e., the variance does not represent true changes in overhead). 3. While some overhead costs are controllable by the production manager, other overhead costs are uncontrollable except in the very long run (e.g., depreciation on factory buildings). Exam Tip Overhead variances are likely to be a fairly light area on the CPA Exam. When questions do appear, they are expected to be conceptual questions about controllability (e.g., which variances is the supervisor actually responsible for) rather than computational questions. Recall that both variable and fixed overhead are applied to production based on a single predetermined overhead application rate: Overhead Application Rate = (Budgeted Variable Overhead + Budgeted Fixed Overhead) / (Budgeted Units of the Allocation Base) Fixed Overhead A. Fixed Overhead Volume Variance 1. Since fixed overhead does not change with changes in production volume, yet is applied to production based on a unit rate, anytime actual production differs from planned production, a fixed overhead variance results. This variance is known as the volume variance and, since it is merely an artifact of the way that we assign fixed overhead to production, it is considered an uncontrollable variance. 2. The fixed overhead volume variance is calculated as: look at image Fixed Overhead Budget Variance 1. Even when actual production is exactly equal to planned production, it is still possible to have fixed overhead variances. The difference between the actual fixed overhead and the budgeted (or planned) fixed overhead is known as the budget variance. 2. The fixed overhead budget variance is calculated as: Actual Fixed Overhead − Budgeted Fixed Overhead Overhead Variances Can Be Difficult to Interpret 1. Because of this difficulty, some companies choose to combine the four basic overhead variances into subtotals that make the numbers easier to evaluate over time. Three combinations are generally found in practice and on the CPA Exam: a. Four-way analysis b. Three-way analysis c. Two-way analysis 2. Four-way analysis—Four-way analysis comprises the four variances shown above: the two variable overhead variances (spending variance and efficiency variance) and the two fixed overhead variances (budget variance and volume variance). Four-way analysis provides the most detailed variance information, but it is less commonly used than two-way and three-way analyses because of the difficulty of interpreting the information. 3. Three-way analysis—Three-way analysis combines the variable overhead spending variance and the fixed overhead budget (spending) variance into a single variance referred to as the total spending variance. 4. Two-way analysis—Two-way analysis separates the overhead variances into a controllable and an uncontrollable variance. The two variable overhead variances are combined with the fixed overhead spending variance to create the controllable variance (often referred to as the flexible budget variance). The fixed overhead volume variance is isolated in the uncontrollable variance. Note Remember that although the efficiency variance is often controllable, it only reflects variation in units of the allocation base, not variance due to overhead itself. The overhead volume variance equals the difference between the master budget for fixed overhead and applied fixed overhead. The variance has one cause only: producing a number of units different from that specified in the master budget. The variance can be broken down into the following: (master budget production volume - actual production volume)(PF)(SQ), where PF is the predetermined overhead rate for fixed overhead based on direct labor hours, and SQ is the standard quantity of direct labor hours per unit. The production supervisor has less control over the actual production volume than the factors underlying the other variances listed, because actual production is strongly influenced by sales demand, a factor not under the control of the production supervisor. The supervisor has some responsibility for the volume level, however, when the volume falls below required levels due to maintenance and other internal problems. But typically, the volume variance is not one of the variances that is considered controllable by the production supervisor. The spending variance is unaffected by the volume used for allocating the fixed overhead. The spending variance for the variable overhead is the difference between the actual overhead and the budgeted overhead based on actual direct labor hours. The spending variance for the fixed overhead is the difference between the actual overhead and the master budget for the fixed overhead. Neither variance is affected by the denominator used for allocating the fixed overhead. However, the volume variance (computed for fixed overhead only) is the difference between the master budgeted fixed overhead and the allocated fixed overhead. The allocated fixed overhead is the product of the predetermined overhead rate per direct labor hour, and standard direct labor hours. An increase in the denominator of the predetermined fixed overhead rate from 80% to 100% of capacity would cause the predetermined overhead rate to decline, along with the allocated fixed overhead. This would increase the volume variance because the master budgeted fixed overhead would remain unchanged.

Risk Management

Uncertainty and Risk Management—There are multiple approaches to managing risk, and there are multiple types of risk to be managed. Items in each of these categories should be adequately understood and married together to provide a comprehensive approach to risk management. A. Management must identify the different types of risk and uncertainty that are relevant and determine their impact as a first step in determining the appropriate approach to risk management. B. Management should then identify the different methods that are available for mitigating or eliminating risk to the organization given the types of risk and uncertainty present. Types of Risk Strategic Risk—This type of risk occurs as a consequence of the specific and overall action plans to achieve the organization's mission. This includes general market approaches (e.g., cost leadership versus differentiation) and the changing nature of the competitive environment. Strategic and market risk is relatively long-term and can be managed by continually assessing the competitive space in which the organization operates. This includes employing SWOT analysis (i.e., strengths, weaknesses, opportunities, and threats) with an emphasis on weaknesses and threats. Externally, this could include assessing the state of the economy, analyzing the competitive landscape, and determining and optimizing organizational structure. Internally, assessment might include threats to safeguarding assets, ensuring business continuity, and maintaining operational flexibility. Operational Risk—This type of risk is more short-term in nature and involves daily implementation issues. Specific aspects of operational risk include process risk, shared services risk, foreign/off-shore operations risk, and credit/default risk. Market Risk—This type of risk is associated with large-scale economic events or natural disasters that, to some extent, influence all companies. This is often discussed in the context of volatility. Market risk is considered systematic or nondiversifiable risk. Various Financial or Non-Operational Risk—There are many different types of risk included here such as interest rate risk (including price and reinvestment risk), portfolio risk, credit/default risk (note: both financial and operational), liquidity risk, and exchange rate risk. Definitions of these risk types and approaches to mitigating them are covered in more detail in the "Operations Management" section. Methods for Dealing with Risk—Although controlling for strategic and operational risk has been explained in general, there are several systematic ways to reduce risk within an organization's operational and strategic structure as shown below. 1. Increasing the proportion of fixed costs increases potential for both higher returns and higher risk due to increased leverage. Thus, using operational leverage involves effectively making a trade-off between risk and return. 2. The enhanced risk of having too much fixed costs is based on the risk of not being able to reach the break-even point. The more fixed costs, the harder it is to break even. 3. The enhanced return aspect of high leverage is that given low variable costs, the contribution margin per unit is higher. Thus, once the fixed costs are covered (i.e., the break-even point is reached) each unit sold delivers a relatively higher amount of contribution margin per unit. 4. Operating leverage can often be reduced by leasing assets rather than buying them or by considering outsourcing arrangements to minimize fixed costs. Provide contingency planning for disaster recovery and business continuity. This type of risk is covered in more detail in part four of the planning and measurement section. Often these issues are addressed by safeguarding equipment, building in redundancy and backup procedures, and using insurance. Use hedging and diversification to overcome defined levels of excessive exposure Use insurance contracts to provide for risk mitigation or elimination of risk in some cases. 1. Insurance is used to deal with peril and hazard. Peril is something specific that causes a loss, while hazard is a condition that may lead to a loss. Evaluate uncertainty involved with estimating future costs and revenues. Cost and revenue planning and control can also be included as an important part of a comprehensive risk management plan. Cost and Revenue Control—Wherever items are within the control of management and excessive risk levels are impinging on important areas of the enterprise, cost and revenue control become extremely important. A. Cost avoidance is the most common way to avoid unnecessary costs and involves finding acceptable alternatives to managing spending for high-cost items and/or not spending for unnecessary goods and services. Cost avoidance is a quicker way to increase profitability than enhancing revenue (but maybe not better) since increasing revenue typically involves at least some increases in proportional costs as well. B. Attempts to increase revenue are often closely linked to strategic objectives and present a longer-term consideration than most cost reduction efforts. For example, companies can try to increase revenue by increasing the quality of the goods/services provided, but this can take a considerable amount of time. C. Distinguishing between committed and discretionary costs is one way to determine which costs are considered essential and which costs are considered perhaps beneficial but not absolutely necessary. The terms committed and discretionary costs are subject to definition, and this issue is vulnerable to multiple perspectives. The more objectively management behaves toward approaching these definitions, the more likely they are to achieve important distinctions. D. The distinction between committed and discretionary costs should be related to conformance with organizational strategy. The importance of funding specific activities should be related to the achievement of the organization's goals. E. Often included in the discretionary category are costs related to maintenance, training, advertising, and research and development. The committed cost category is typically related to costs of clearly defined input-output relationships that cannot be omitted without threatening the strategic objectives of the organization. Generally, essential cost initiatives should be determined based on committed costs. F. One way to control discretionary costs is to establish authority for approval to spend up to a specified amount. Another way to control spending is to require that the spending demonstrate that it supports defined organizational objectives.

Manufacturing Costs

Understanding the costs involved in manufacturing products is an important element of operations management. Manufacturers must record the cost of producing goods as either Inventory or Cost of Goods Sold. Both these accounts are major factors in a manufacturer's financial and business success. CPA candidates are expected to have a solid understanding of manufacturing cost terminology and practices. Product costs—Can be associated with the production of specific goods. These costs generally attach to physical product units and are expensed in the period in which the goods are sold. Prior to being sold, these costs are reflected in Inventory accounts on the Balance Sheet. Product costs are also known as inventoriable costs or manufacturing costs. Period costs—Cannot be matched with specific revenues (i.e., accountant's salary) and are expensed in the period incurred. These costs are also called selling and administrative costs. Selling, general and adminstrative (SG&A)costs do not add value to products or product inventory. Direct Material—The cost of significant raw materials and components that are directly incorporated in the finished product. For example, direct material costs of a leather briefcase include cost of leather (raw material) as well as buckles and zippers (purchased components). Direct Labor—The wages and salaries paid for work that directly converts raw materials into a finished product. Continuing with our leather briefcase example, the direct labor costs associated with the manufacture of a leather briefcase include wages paid to workers who cut the leather, finish the leather, and sew the briefcase. Factory Overhead—The cost of indirect labor, indirect materials, and manufacturing costs other than direct material and direct labor that are necessary to support the production process but are not easily traceable to the finished product. For example, factory overhead associated with production of a leather briefcase includes salaries paid to the production line supervisors, wages paid to mechanics who maintain the equipment, wages paid to custodians who maintain the factory, thread used to sew the briefcase together, electricity used to power the equipment and provide lighting to the factory, and depreciation on the factory building and equipment. Direct Costs—Costs that can be traced to specific units of production. Direct materials are actually incorporated into the product. Direct labor is comprised of the wages of workers who fabricate the product. Indirect Costs—(Note: the term "indirect costs" is often treated synonymously with the term "manufacturing overhead.") Necessary costs of the manufacturing process that cannot be easily associated with specific units. These include all manufacturing costs other than direct material and direct labor. Indirect materials such as custodial and maintenance supplies, depreciation, and scrap are also overhead. Indirect labor including salaries for supervisors, custodians, and maintenance and repair personnel are overhead as well. Indirect costs can be either variable (e.g., supplies) or fixed (e.g., depreciation). Exam Tip Direct labor is included as a prime cost and as a conversion cost. This overlap in classifications is likely to be tested on the exam. Prime Costs and Conversion Costs—Prime costs are direct labor and direct materials, while conversion costs are direct labor and manufacturing overhead. You can think of prime costs as being the "primary" costs (i.e., direct materials and direct labor) of the product. You can think of conversion costs as the "costs of converting" direct materials into a product by using direct labor and overhead. Value-added costs—Product costs that enhance the value of the product in the eyes of the consumer. Most direct costs are value-added costs. Continuing with the briefcase example, the leather that the briefcase is made of and the labor required to cut the pieces and sew them together are value-added costs. Nonvalue-added costs—Costs that could be eliminated without deterioration of product quality, performance, or perceived value to the consumer. Many nonvalue-added costs are essential to production and cannot be completely eliminated. For example, oiling the machine that is used to sew the briefcase together is a nonvalue-added cost from the customer's viewpoint. However, if the machine wasn't oiled, sooner or later it would stop sewing. Oiling the machine is an essential, but nonvalue-added, cost. Some overhead costs might be viewed as non-value-added costs, but this is a subjective topic. Exam questions regarding nonvalue-added costs should have clear examples, such as inventory storage costs, rework, excess material movement and/or defects. For example, the thread used to sew the briefcase together is usually an overhead cost, but most consumers would see it as a value-added cost. Marginal cost or revenue—Additional cost or revenue resulting from one more unit of output Accounting cost—Explicit costs that are "accounted for," typically as evidenced by an entry in a fundamental book or accounting record (e.g., the general ledger) Average fixed cost per unit—Decreases as volume increases (subject to the relevant range). Average variable cost—Remains constant as volume increases (subject to the relevant range). Committed cost—Cannot be avoided in the current accounting time period (the opposite of discretionary costs). Discretionary cost—May or may not be included in the budget and can be considered avoidable as determined by a decision maker with the authority to do so (opposite of committed cost). Variable costs are presumed to be avoidable and fixed costs are presumed to be unavoidable. Thus, the cost to make versus buy is calculated as follows: Make: variable cost (10,000 units x ($4 + 3)) = $70,000 + fixed plant facility cost = $20,000 = $90,000 total cost Buy: variable cost ($10,000 x $8) = $80,000 + fixed plant facility costs = $20,000 - $5,000 rent revenue = $95,000 total cost Thus the decision to buy, rather than to make the part, results in a cost increase of $5,000. Journal entries to record the manufacturing cost are similar for job-order and process costing. When overhead is applied, it is debited to work in process. The credit is to factory overhead applied. Work in process receives only applied overhead, unless some underapplied factory overhead is allocated to work in process at the end of the period.