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Summary Accounting 2 TJW

Chapter 1: The accountant’s role in the organization

Management accounting measures and reports financial information as well as other types of information that are intended primarily to assist managers in fulfilling the goals of the organization. Financial accounting focuses on external reporting that is directed by authoritative guidelines. The broad differences between management and financial accounting are in: regulations; range and detail of information; reporting interval; time period.

Cost accounting measures and reports financial and non-financial information related to the organization’s acquisition or consumption of resources. It provides information for both management accounting and financial accounting. Cost management are the actions that managers undertake in the short-run and long-run planning and control of costs that increase value for customers and lower the costs of products and services.

The accounting system is among the most significant quantitative information systems in almost every organization. This system aims to provide information for five broad purposes:

  • - Formulating overall strategic and long-range plans;

  • - Resource allocation decisions such as product and customer emphasis and pricing;

  • - Cost planning and cost control of operations and activities;

  • - Performance measurement and evaluation of people;

  • - Meeting external regulatory and legal reporting requirements where they exist.

Planning: The choosing of goals, predicting results under various ways of achieving those goals, and then deciding how to attain the desired goals. Control: This covers both the action that implements the planning decision and deciding on performance evaluation and the related feedback that will help future decision making. Budget: The quantitative expression of a plan of action and an aid to the coordination and implementation of the plan.

Understanding the reasons for any difference between actual results and budgeted results is an important part of management by exception, which is the practice of concentrating on areas not operating as expected and placing less attention on areas operating as expected. The term variance refers to the difference between the actual results and the budgeted amounts.

Management accountants can be considered to perform three important functions: scorekeeping (data accumulation), attention directing (visualizing opportunities and problems), and problem solving.

Key themes in management decision making are:

  • - Customer focus;

  • - Value-chain and supply-chain analysis;

  • - Key success factors: Cost and efficiency, quality, time, and innovation;

  • - Continuous improvement and benchmarking. These themes are all interrelated.

Important management themes are shaping the design and uses of management accounting systems. A variety of global forces are affecting management accounting thinking and practices, including organizational structure changes, digitization, the need to assess intellectual capital and recognize the significance of knowledge management.

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Summary Accounting 2 TJW Chapter 1: The accountant’s role in the organization Management accounting measures and

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Summary Accounting 2 TJW

Chapter 2: An introduction to cost terms and purposes

Cost: A resource sacrificed or forgone to achieve a specific objective. Most people consider costs as monetary amounts that must be paid to acquire goods and services. A cost object is an item for which cost information is needed.

A costing system typically accounts costs for costs in two basic stages:

  • - Cost accumulation: The collection of costs data in some organized way through an accounting system;

  • - Cost assignment: A general term that encompasses both: tracing accumulated costs to a cost object (such as a new machine, employee, etc.), and allocating accumulated costs to a cost object.

Actual costs: The costs incurred (historical costs), as distinguished from budgeted or forecasted costs; Normal costs: Budgeted rather than actual amounts are used to calculate indirect-cost rates.

Direct costs of a cost object are costs that are related to the particular cost object and that can be traced to it in an economically feasible (cost-effective) way. Indirect costs of a cost object are costs that are related to the particular cost object but cannot be traced to it in an economically feasible (cost-effective) way. Indirect costs are allocated to the cost object using a cost-allocation method. Several factors will affect the classification of a cost as direct or indirect: the materiality of the cost in question; available information-gathering technology; design of operations.

Cost tracing is the assigning of direct costs to the chosen cost object; Cost allocation is the assigning of indirect costs to the chosen object. Cost assignment encompasses both cost tracing and cost allocation.

Cost reduction efforts frequently identify two key areas:

  • - Focusing on value-added activities;

  • - Efficiently managing the use of the cost drivers in those value-added activities.

A cost driver / cost generator / cost determinant is any factor that affects total costs.

Variable cost: A cost that does change in total in proportion to total demand Fixed cost: A cost that does not change in total in proportion to total demand. The definitions of variable costs and fixed costs have important underlying assumptions:

  • - Costs are defined as variable or fixed with respect to a specific cost object;

  • - The time span must be specified;

  • - Total costs are linear;

  • - There is only one cost driver;

  • - Variations in the level of the cost driver are within a relevant range: the range of the cost driver in which a specific relationship between cost and the level of activity or volume is valid

Unit cost / average cost: This is calculated by dividing some amount of total cost by the related number of units, whether this is in monetary terms or not. However, while unit costs are often useful, they must be interpreted with extreme caution if they include fixed costs per unit.

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Summary Accounting 2 TJW

Capitalized costs are first recorded as an asset (capital) when they are incurred. These costs are presumed to provide future benefits to the company. Revenue costs are recorded as expenses of the accounting period when they are incurred.

The capitalized and revenue costs apply to companies in all three sectors of the economy:

  • - Service-sector companies provide services or intangible products to their customers;

  • - Merchandising-sector companies provide tangible products they have previously purchased in the same basic form from suppliers;

  • - Manufacturing-sector companies provide tangible products that have been converted to a different form from that of the products purchased from suppliers.

In the manufacturing sector three main types of costs are used:

  • - Direct material costs are the acquisition costs of all materials that eventually become part of the cost object and that can be traced to the cost object in an economically feasible way;

  • - Direct manufacturing labor costs include the compensation of all manufacturing labor that is specifically identified with the cost object and that can be traced to the cost object in an economically feasible way;

  • - Indirect manufacturing costs / manufacturing overhead costs / factory overhead costs are all manufacturing costs considered to be part of the cost object, but that cannot be individually traced to that cost object in an economically feasible way.

The three categories of stock found in many manufacturing-sector companies depict stages in the conversion process: direct materials, work in progress and finished goods.

Prime costs are all direct manufacturing costs;

Conversion costs are all manufacturing costs other than direct materials costs. Product cost is the sum of the costs assigned to a product for a specific purpose, such as:

  • - Product pricing and product emphasis;

  • - Contracting with government agencies;

  • - Financial statements.

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Summary Accounting 2 TJW Capitalized costs are first recorded as an asset (capital) when they are

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Chapter 3: Job-costing systems

Summary Accounting 2 TJW

Check numerical methods and examples in book!

Cost object: Anything for which a separate measurement of costs is desired; Direct costs of a cost object: Costs that are related to the particular cost object and can be traced to it in an economically feasible (cost-effective) way; Indirect costs of a cost object: Costs that are related to the particular cost object but cannot be traced to it in an economically feasible (cost-effective) way. Indirect costs are allocated to the cost object using a cost-allocation method. Cost pool: A grouping of individual cost items; Cost-allocation base: A factor that is the common denominator for systematically linking an indirect cost or group of indirect costs to a cost object.

These five terms constitute the building blocks that are considered relevant in the design of costing

systems. There are two extremes of costing systems, but note that most companies use a mix:

  • - Job-costing system: Costs are assigned to a distinct unit, batch or lot of a product or service;

  • - Process-costing system: The cost object is masses of identical or similar units.

The general approach to job-costing in service- and manufacturing organizations is:

Step 1: Identify the job that is the chosen cost object; Step 2: Identify the direct costs for the job; Step 3: Identify the indirect-cost pools associated with the job; Step 4: Select the cost-allocation base to use in allocating each indirect-cost pool to the job; Step 5: Develop the rate per unit of the cost-allocation base used to allocate indirect costs to the job; Step 6: Assign the costs to the cost object by adding all direct costs and all indirect costs.

Managers and accountants gather the information that goes into their cost systems through source documents, which are the original records that support journal entries in an accounting system.

Actual costs: The costs incurred (historical costs), as distinguished from budgeted or forecasted costs; Normal costing traces direct costs to a cost object by using the actual direct-cost rate times the actual quantity of the direct-cost input and allocates indirect costs based on the budgeted indirect-cost rate times the actual quantity of the cost-allocation base.

 

Actual costing

Normal costing

Direct-cost rates

Actual rates

Actual rates

Indirect-cost rates

Actual rates

Budgeted rates

Underabsorbed / underapplied / underallocated indirect costs occur when the allocated amount of indirect costs in an accounting period is less than the actual (incurred) amount in that period. Overabsorbed / overapplied / overallocated indirect costs occur when the allocated amount of indirect costs in an accounting period exceeds the actual (incurred) amount in that period.

Three key source documents in a job-costing system are a job cost record, a materials requisition record and a labor time record.

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Summary Accounting 2 TJW

There are two main approaches to dispose of underallocation / overallocation overhead costs:

  • - Adjusted-allocation rate approach: This restates all entries in the general ledger by using actual cost rather than budgeted cost rates. First, the actual indirect-cost rate is calculated at the end of each period. Then, every job to which indirect costs were allocated during the period has its amount recalculated using the actual indirect-cost rate (rather than the budgeted indirect-cost rate). Finally, end-of-period closing entries are made. The result is that every single job cost record – as well as the closing stock and cost of goods sold accounts – accurately represents actual indirect costs incurred;

  • - Proration approach: Spreading of under- or over-allocated overhead among closing stocks and cost of goods sold.

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Summary Accounting 2 TJW There are two main approaches to dispose of underallocation / overallocation overhead

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Chapter 4: Process-costing systems

Summary Accounting 2 TJW

Check numerical methods and examples in book!

Process-costing system: The unit cost of a product or service is obtained by assigning total costs to many identical or similar units. The principal difference between process costing and job costing is the extent of averaging used to calculate unit costs of products or services. In a job-costing system, individuals jobs use different quantities of production resources. Conversion costs: All manufacturing costs other than direct material costs, such as overhead and direct labor.

Often, only two cost classifications, direct materials and conversion costs, are necessary to assign costs to products. Why? Because all direct materials are added to the process at one time and all conversion costs are generally added to the process uniformly through time. If, however, two different direct materials are added to the process at different times, two different direct material categories would be needed to assign these costs in products. We can now illustrate the process costing in three cases:

Case 1: Process costing with zero opening and zero closing work-in-progress stock

This case shows that in a process-costing system, unit costs can be averaged by dividing total costs in a given accounting period by total units produced in that period;

Case 2:Process costing with no opening but a closing work-in-progress stock

For this, we need a five-step procedure to calculate the costs;

  • 1. Summarize the flow of physical units of output;

  • 2. Compute output in terms of equivalent units (focus on quantities);

  • 3. Compute equivalent unit costs (focus on monetary quantities);

  • 4. Summarize total costs to account for;

  • 5. Assign total costs to units completed and to units in closing work in progress.

Equivalent units is a derived amount of output units that takes the quantity of each input (factor of production) in units completed or in work in progress, and converts it into the amount of completed output units that could be made with that quantity of input.

Case 3: Process costing with both some opening and some closing work-in-progress stock

To assign costs to each category, we need to choose a stock cost-flow method. We can use two stock cost- flow methods, namely:

  • - Weighted-average process-costing method: This calculates the equivalent-unit cost of the work done to date and assigns this cost to equivalent units completed and transferred of the process and to equivalent units in closing work-in-progress stock. The weighted-average cost is the total of all costs entering the Work in Progress account divided by total equivalent units of work done to date;

  • - First-in, first-out (FIFO) method: This assigns the cost of the previous period’s equivalent units in opening work-in-progress stock to the first units completed and transferred out of the process, and assigns the cost of equivalent units worked on during the current period first to complete beginning stock, then to start and complete new units, and finally to units in closing work-in- progress. A distinctive feature of the FIFO process-costing method is that work done on opening stock before the current period is kept separate from work done in that current period. The weighted-average method yields higher WIP-closing, but lower finished goods inventory than FIFO.

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Summary Accounting 2 TJW

Standard-costing method separates standard or equivalent-unit costs on the basis of the different technical processing specifications for each product. Identifying standard costs for each product overcomes the disadvantage of costing all products at a single average amount, as under actual costing. Transferred-in costs / Previous department costs are the costs incurred in a previous department that are carried forward as the products’ cost when it moves to a subsequent process in the production cycle.

Transferred-in costs are treated as if they are a separate type of direct material added at the opening of the process. Some points to remember when reviewing transferred-in costs:

  • - Include transferred-in costs from previous departments in your calculations;

  • - In calculating costs to be transferred on a FIFO basis, do not overlook the costs assigned at the opening of the period to units that were in process but are now included in the units transferred;

  • - Unit costs may fluctuate between periods. Therefore, transferred units may contain batches accumulated at different unit costs;

  • - Units may be measured in different terms in different departments. Consider each department separately.

Hybrid-costing system blends characteristics from both job-costing systems and process-costing systems. Job-costing and process-costing systems are best seen as the ends of a continuum.

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Summary Accounting 2 TJW Standard-costing method separates standard or equivalent-unit costs on the basis of the

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Chapter 5: Cost allocation

Summary Accounting 2 TJW

Check numerical methods and examples in book!

Indirect costs of a particular cost object are costs that are related to that cost object but cannot be traced to it in an economically feasible or cost-effective way. There are four purposes for allocating indirect costs to cost objects, namely:

  • - To provide information for economic decisions;

  • - To motivate managers and employees;

  • - To justify costs or calculate reimbursement;

  • - To measure income and assets for reporting to external parties.

It is probable that the cost-allocation practices which exist in companies are not just reflective of

economic-based cost-benefit analysis. Technical design choices are linked to a wide array of institutional, professional, and cultural factors.

A cost pool is a grouping of individual cost items. A homogeneous cost pool is one in which all the activities whose costs are included in the pool have the same or a similar cause-and-effect relationship or benefits-received relationship between the cost allocated and the costs of the activity.

A variety of factors may prompt managers to consider recognizing multiple cost pools where a single cost pool is currently beings used. Such factors are:

  • - Views of line of managers and personnel;

  • - Changes made in plant layout, general operations, such that all products do not use the facility in an equivalent way;

  • - Changes in the diversity of products or services produced or in the way products use the resources in the cost pool.

In many cases, the cost of a department will include costs allocated from other departments. Three key issues that arise when allocating costs from one department to another are:

  • - (1) whether to use a single-rate method or a dual-rate method:

o

Single-rate cost-allocation method pools all costs in one cost pool and allocates them to

o

cost objects using the same rate per unit of the single allocation base. There is no distinction between costs in the cost pool in terms of variability; Dual-rate cost-allocation method first classifies costs in one cost pool into two subpools (fixed and variable). Each subpool has a different allocation rate or a different allocation base.

  • - (2) whether to use budgeted rates or actual rates: Budgeted rates let the user departments know the cost rates they will be charged in advance. In contrast, when actual rates are used, the user department will not know the rates charged until the end of the period.

  • - (3) whether to use budgeted quantities or actual quantities: When budgeted usage is the allocation base, user divisions will know their allocated costs in advance.

Many organizations distinguish between operating departments and support departments. An operating department/product department adds value to a product or service that is observable by a customer. A support department/service department provides the services that maintain other internal departments in the organization.

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We now examine three methods of allocating the costs of support departments:

  • - Direct allocation method / Direct method allocates each support department’s costs directly to the operating departments;

  • - Step-down allocation method / Step-allocation method / Sequential allocation method allows for partial recognition of the services rendered by support departments to other support departments;

  • - Reciprocal allocation method allocates costs by explicitly including the mutual services provided among all support departments. The reciprocal allocation method enables us to incorporate interdepartmental relationships fully into the support department cost allocations.

We next consider two methods used to allocated common costs. A common cost is a cost of operating a facility, operation, activity or other cost object that is shared by two or more users. Two methods of allocating common costs are:

  • - Stand-alone cost-allocation method: This uses information pertaining to each cost object as a separate operating entity to determine the cost-allocation weights;

  • - Incremental cost-allocation method ranks the individual cost objects and then uses this ranking to allocate costs among those cost objects.

Labor-paced operations: Worker dexterity and productivity determine the speed of production; Machine-paced operations: Machines conduct most phases of production, such as movement of materials to the production line, assembly and other activities on the production line and shipment of finished goods to the delivery bay areas.

The use of an inappropriate cost allocation base can cause products to be manufactured less efficiently, management to be misfocused and products to be mispriced in the marketplace. There is growing interest in cost hierarchies, which are categorizations of costs into different cost pools based on either different classes of cost drivers or different degrees of difficulty in determining cause-and-effect relationships.

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Summary Accounting 2 TJW We now examine three methods of allocating the costs of support departments:

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Summary Accounting 2 TJW

Chapter 6: Cost-allocation: joint-cost situations

Check numerical methods and examples in book!

Joint costs are the costs of a production process that yields multiple products simultaneously. The juncture in the process when one or more products in a joint-cost setting become separately identifiable is called the split-off point. Separable costs are costs incurred beyond the split-off point that are assignable to one or more individual products. The joint products produced can be divided into: main products (high value); by-products (low value); scrap (minimal value); and waste (no value).

The purposes for allocating joint costs to produce stock costing for external financial reporting, internal financial reporting, cost reimbursement under contracts, customer profitability analysis, insurance settlements and rate regulation.

There are three basic approaches to allocating joint costs:

  • 1. Allocate costs using market-based data. Three methods that can be used in applying this approach are:

i.

The sales value at split-off method: This allocates joint costs on the basis of the relative sales

ii.

value at the split-off point of the total production in the accounting period of each product; The estimated net realizable value (NRV) method: This allocates joint costs on the basis of the

iii.

relative estimated realizable value (expected final sales value in the ordinary course of business minus the expected separable costs of production and marketing of the total production of the period); The constant gross-margin percentage NRV method: This allocates joint costs in such as way that the overall gross-margin percentage is identical for all the individual products. This method entails three steps:

  • 1. Calculate the overall gross-margin percentage;

  • 2. Use the overall gross-margin percentage and deduct the gross margin from the final sales values to obtain the total costs that each product should bear;

  • 3. Deduct the expected separable costs from the total costs to obtain the joint-cost allocation.

  • 2. Allocate costs using physical measure-based data such as weight or volume: This allocates joint costs on the basis of their relative proportions at the split-off point, using a common physical measure such as weight or volume of the total production of each product.

  • 3. Not allocating joint costs.

The decision to incur additional costs beyond the split-off should be based on the incremental operating profit attainable beyond the split-off point.

There are four ways to account for by-products:

By-product

accounting

When by-products are

Where by-product

Where

by-product

method

recognized

in

the

revenues appear in the

stocks

appear

on

the

general ledger

income statement

balance sheet

A

Production

Reduction of cost

By-product

stock

B

Production

Revenue

or

other

reported at (unrealized)

income item

selling prices

 

C

Sale

Reduction of cost

By-product

stock

not

D

Sale

Revenue

or

other

recognized

income item

 

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Summary Accounting 2 TJW

Chapter 7: Income effects of alternative stock-costing methods

Check numerical methods and examples in book!

The reported profit number of manufacturing companies is affected by cost accounting choices related to

stock. In this chapter we examine two such choices:

  • - Stock-costing choices: The choices here relate which costs are to be recorded as stock when they are incurred;

  • - Denominator-level choices: The choices here relate to the preselected level of the cost allocation base used to set budgeted fixed manufacturing cost rates.

Stock-costing choices

Stock-costing choices can be subdivided into:

  • - Variable costing: A method of stock costing in which all variable manufacturing costs are included as inventoriable costs. All fixed manufacturing costs are excluded from inventoriable costs; they are costs of the period in which they are incurred. The variable costing income statement is based on the contribution margin format;

  • - Absorption costing: A method of stock costing in which all variable manufacturing costs and all fixed manufacturing costs are included as inventoriable costs. That is, stock ‘absorbs’ all manufacturing costs. The absorption costing income statement is based on the gross margin format.

The heart of the difference between variable and absorption costing for financial reporting is accounting for fixed manufacturing costs:

   

Direct

Indirect

Same

under

both

Variable

Direct manufacturing cost

Indirect

manufacturing

methods

cost

Differs

under

both

Fixed

Direct manufacturing cost

Indirect

manufacturing

methods

cost

If the stock level increases during an accounting period, variable costing will generally report less operating profit than absorption costing; when the stock level decreases, variable costing will generally report more operating profit than absorption costing. These differences in operating profit are due solely to moving fixed manufacturing costs into stock increase and out of stock as they decrease.

The difference between operating profit under absorption costing and variable costing can be calculated using the following formula:

(Absorption-costing operating profit) – (variable-costing operating profit) = (fixed manufacturing costs in closing stock) – (fixed manufacturing costs in opening stock)

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Summary Accounting 2 TJW Chapter 7: Income effects of alternative stock-costing methods Check numerical methods and

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Summary Accounting 2 TJW

Two alternative formulae can be used if we assume that all manufacturing variances are written off as

period costs, that no change occurs in work-in-progress stock and that no change occurs in the budgeted fixed manufacturing overhead rate between accounting periods:

(absorption-costing operating income) – (variable-costing operating income) = (units produced – units sold) x (budget fixed manufacturing cost rate) = (closing stock in units – opening stock in units) x (budget fixed manufacturing cost rate)

     

Actual costing

Normal costing

Standard costing

 

Variable

direct

Actual prices x

Actual prices x

Standard

prices

x

conversion costs

actual

inputs

actual

inputs

standard

inputs

used

used

allowed

for

actual

Variable

output achieved

costing

Variable

indirect

Actual variable

Budgeted

Standard

variable

manufacturing

indirect rates x

variable

indirect

rates

x

costs

actual inputs

indirect rates x

standard

inputs

used

actual inputs

allowed

for

actual

Absorption

used

output achieved

costing

 

Fixed

Actual prices x

Actual prices x

Standard

prices

x

manufacturing

actual

inputs

actual

inputs

standard

inputs

costs

used

used

allowed

for

actual

output achieved

Fixed

indirect

Actual variable

Budgeted

Standard

variable

manufacturing

indirect rates x

variable

indirect

rates

x

costs

actual inputs

indirect rates x

standard

inputs

used

actual inputs

allowed

for

actual

used

output achieved

Critics of absorption costing have made a variety of proposals for revising how managers are evaluated. Their proposals include the following:

  • - Change the accounting system;

  • - Change the time period used to evaluate performance;

  • - Careful budgeting and stock planning to reduce management’s freedom to build excess stock;

  • - Include non-financial as well as financial variables in the measure used to evaluate performance.

Denominator-level choices

Denominator-level choices can be narrowed down to:

  • - Theoretical capacity: The denominator-level concept that is based on the product of output at full efficiency for all of the time;

  • - Practical capacity: The denominator-level concepts that reduces theoretical capacity for unavoidable operating interruptions such as scheduled maintenance time, shut-downs for holidays, and so on;

  • - Normal utilization: The denominator-level concept based on the level of capacity utilization that satisfies average customer demand over a period that includes seasonal, cyclical or other trend factors;

  • - Master-budget utilization: The denominator-level concept based on the anticipated level of capacity utilization for the next budget period.

Each denominator-level concept will result in a different production-volume variance:

Production-volume variance = (denominator level in output units – actual output units) x (budget fixed manufacturing overhead rate per output unit)

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Chapter 8: Cost-volume-profit relationships

Cost-volume-profit (CVP) analysis examines the behavior of total revenues, total costs and operating profit as changes occur in the output level, selling price, variable costs or fixed costs.

Revenues are inflows of assets received in exchange for products or services provided to customers. A revenue driver is a factor that affects revenues. Costs are resources sacrificed or forgone to achieve a specific objective. A cost driver is a factor that affect costs. The straightforward relationship between cost and revenue provide an excellent base for understanding the more complex relationships that exist with multiple revenues and multiple cost drivers.

Operating profit is total revenues from operations minus total costs from operations (excluding taxes); Net profit is operating profit plus non-operating revenues minus non-operating costs minus income taxes.

The break-even point is that quantity of output where total revenues and total costs are equal, that is, where the operating profit is zero. We examine three methods for determining the break-even point, and one method for calculating with a budgeted profit:

  • - Equation method: Revenues – variable costs – fixed costs = operating profit;

  • - Contribution margin method: (Fixed costs) / (Unit selling price – Unit variable costs) o Contribution income statement: This lines items by cost behavior pattern to highlight the contribution margin.

  • - Graph method: In the graph method, we plot the total costs line and the total revenues line. Their point of intersection is the breakeven point;

  • - Target operating profit (TOP): Revenues – variable costs – fixed costs = target operating profit. Moreover, (fixed costs + target operating profit) / (Unit selling price – unit variable costs).

A profit-volume (PV) graph shows the impact on operating profit of changes in the output level. We can also introduce income tax effects, which account as follows:

Revenues – variable costs – fixed costs = Operating profit = (target net profit) / (1 – tax rate)

The presence of income taxes will not change the breakeven point, since by definition the operating profit will be zero at the breakeven point.

Sensitivity analysis is a what-if technique that examines how a result will change if the original predicted data are not achieved or if an underlying assumption changes. One aspect of sensitivity analysis is the margin of safety, which is the excess of budgeted revenues over the breakeven revenues. Sensitivity analysis is one approach to recognizing uncertainty, which is the possibility that an actual amount will deviate from an expected amount. Another approach is to calculate expected values using probability distributions.

The risk-return trade-off across alternative cost structures is usefully summarized in a measure called operating leverage. Operating leverage describes the effects that fixed costs have on changes in operating profit as changes occur in units sold and hence in contribution margin. At any given level of sales, the degree of operating leverage equals the contribution margin divided by operating profit. In brief, whether costs really are fixed depends heavily on the relevant range, the length of the time horizon in question, and the specific decision situation.

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Summary Accounting 2 TJW Chapter 8: Cost-volume-profit relationships Cost-volume-profit (CVP) analysis examines the behavior of total

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Summary Accounting 2 TJW

Revenue mix / sales mix is the relative combination of quantities of products or services that constitutes total revenues.

Some formulas to remember:

Contribution margin = revenues – all variable costs Gross margin = revenues in cost of goods sold Contribution margin percentage = (total contribution margin) / (revenues) Variable-cost percentage = (total variable costs) / (revenues) Gross-margin percentage = (gross margin) / (revenues)

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Chapter 9: Determining how costs behave

A cost function is a mathematical function describing cost behavior patterns – how cost change with changes in the cost driver. Costs are either linear or non-linear. CVP-analysis requires linear cost functions. We write the linear cost function as:

Y = constant / intercept + slope x variable = a + bX

There are several types of linear cost functions:

  • - Variable cost function: = 0, ≠ 0

  • - Fixed cost function: ≠ 0, = 0

  • - Mixed / semivariable cost function: ≠ 0, ≠ 0

Cost estimation is the attempt to measure past cost relationships between total costs and the drivers of those costs. Managers are interested in estimating past cost-behavior patterns primarily because these estimates can help them make more accurate cost predictions, or forecasts, about future costs. Chapter 2 outlined three other specifications necessary to classify costs into their fixed and variable cost components: choice of cost object; time span; relevant range.

The most important issue in estimating a cost function is to determine whether a cause-and-effect relationships exists between the cost driver and the resulting costs. Be careful not to interpret a high correlation, between two variables to mean that either variable causes the other.

There are four approaches to cost estimation. These approaches differ in the costs of conducting the

analysis, the assumptions they make, and the evidence they provide about the accuracy of the estimated cost function. They are not mutually exclusive. Many organizations use a combination of the approaches:

  • - Industrial engineering method / Work-measurement method: This estimates cost functions by analyzing the relationship between inputs and outputs in physical terms;

  • - The conference method: This estimates cost functions on the basis of analysis and opinions about costs and their drivers gathered from various departments of an organization;

  • - The account analysis method: This estimates cost functions by classifying cost accounts in the ledger as variable, fixed, or mixed with respect to the identified cost driver.

  • - Quantitative analysis of current or past cost relationships: There are six steps in estimating a cost function on the basis of an analysis of current or past cost relationships:

o

Step 1: Choose the dependent variable (the cost variable to be predicted);

o

Step 2: Identify the independent variable (level of activity or cost driver);

o

Step 3: Collect data on the dependent variable and the cost driver;

o

Step 4: Plot the data in a graph;

o

Step 5: Estimate the cost function;

o

Step 6: Evaluate the estimated cost function.

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Summary Accounting 2 TJW Chapter 9: Determining how costs behave A cost function is a mathematical

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Managers at times, use very simple methods to estimate cost functions, such as:

  • - The high-low method, which entails using only the highest and lowest observed values of the cost driver within the relevant range. The line connection these two points becomes the estimated cost function. Since the slope coefficient b = (difference between costs associated with highest and lowest observations of the cost driver) / (difference between highest and lowest observations of the cost driver), we can solve for a = y – bX;

  • - Regression analysis is a statistical method that measures the average amount of change in the dependent variable that is associated with a unit change in one or more independent variable. Simple regression analysis estimates the relationship between the dependent variable and one independent variable. Multiple regression analysis estimates the relationship between the dependent variable and multiple independent variables.

Three criteria for evaluating and choosing cost drivers are: (a) economic plausibility, (b) goodness of fit, and (c) the slope of the regression line.

So far we have assumed linear cost functions. In practice, cost functions are not always linear:

  • - Non-linear cost functions are cost functions where, within the relevant range, the graph of total costs versus the level of a single activity is not a straight line;

  • - A step-cost function is a cost function in which the cost is constant over various ranges of the cost driver, but the cost increases by discrete amounts as the cost driver moves from one range to the next, such as the step-variable cost function and the step-fixed cost function.

Learning curves also result in cost functions being non-linear. A learning curve is a function that shows

how labor-hours per unit decline as units of production increase and workers learn and become better at what they do. An experience curve is a function that shows how full product costs per unit decline as unit of output increase. We now describe two learning-curve models:

  • - Cumulative average-time learning model: The cumulative average time per unit declines by a constant percentage each time the cumulative quantity of units produced doubles;

  • - Incremental unit-time learning model: The incremental unit time (the time needed to produce the last unit) declines by a constant percentage each time the cumulative quantity of units produced doubles.

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Chapter 10: Relevant information for decision making

A decision model is a formal method for making a choice, frequently involving quantitative and qualitative analyses. Relevant costs are those expected future costs that differ among alternative courses of action. The two key aspects to this definition are that the costs must occur in the future and that they must differ among the alternative courses of action. Relevant revenues are those expected future revenues that differ among alternative courses of action. The difference in total cost between two alternatives is a differential cost.

We divide the consequences of alternatives into two broad categories:

  • - Quantitative factors are outcomes that are measured in numerical terms;

  • - Qualitative factors are outcomes that cannot be measured in numerical terms.

Managers often make decisions that affect output levels. When changes in the output level occur, managers are interested in the effect it has on the organization and on operating profit. Why? Because maximizing organizational objectives also increase managers’ rewards. Management is sometimes faced with the decision of accepting or rejecting one-off special orders when there is idle production capacity and where the order has no long-run implications.

Incremental costs are additional costs to obtain an additional quantity, over and above existing or planned quantities, of a cost object. There are two common problems in relevant-cost analysis: (a) assuming all variable costs are relevant, and (b) assuming all fixed costs are irrelevant.

Outsourcing is the process of purchasing goods and services from outside vendors rather than producing the same goods or providing the same services within the organization, which is called insourcing. Decisions about whether a producer of goods or services will insource or outsource are also called make- or-buy decisions.

Opportunity cost is the maximum available contribution to income that is forgone (rejected) by not using a limited resource in its next-best alternative use. The idea of an opportunity cost arises when there are multiple uses for resources and some alternatives are not selected. Opportunity cost is often included in decision making because it represents the best alternative way in which an organization may have used it resources had it not made the decision it did.

When a multiple-product plant operates at full capacity, managers must often make decisions regarding which products to emphasize. These decisions frequently have short-run focus. Managers should aim for the highest contribution margin per unit of the constraining factor – that is, the scarce, limiting or critical factor. The constraining factor restricts or limits the production or sale of a given product.

Expected future revenues and costs are the only revenues and costs relevant in any decision model. The book value of existing equipment in equipment-replacement decisions represents past (historical) cost and therefore is irrelevant.

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Summary Accounting 2 TJW Chapter 10: Relevant information for decision making A decision model is a

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Chapter 11: Activity-based costing

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Check numerical methods and examples in book!

Cost smoothing is a costing approach that uses broad averages to uniformly assign the cost of resources

to cost objects when the individual products, services or customers in fact use those resources in a non- uniform way. Cost smoothing can lead to:

  • - Product undercosting: A product consumer a relatively high level of resources but is reported to have a relatively low total cost;

  • - Product overcosting: A product consumers a relatively low level of resources but is reported to have a relatively high total cost.

Product-cost cross-subsidization means that at least one miscosted product is resulting in the miscosting of other products in the organization.

A job/ABC costing system with a single indirect-cost rate goes as follows:

Step 1: Identify the chosen cost objects; Step 2: Identify the direct costs of the products; Step 3: Select the cost-allocation bases to use for allocating indirect costs to the products; Step 4: Identify the indirect costs associated with each cost-allocation base; Step 5: Compute the rate per unit each cost-allocation base uses to allocate indirect costs to the products; Step 6: Compute the indirect costs allocated to the products; Step 7: Compute the total cost of the products by adding all direct and indirect costs assigned to them.

A refined costing system reduces the use of broad averages for assigning the cost of resources to cost objects and provides better measurement of the costs of indirect resources used by different cost objects – no matter how differently the different cost objects use indirect resources. There are four principal reasons to refine a costing system: increase in product diversity; increase in indirect costs; advances in information technology; competition in product markets.

This chapter describes three guidelines for refining a costing system:

  • - Direct-cost tracing: Classify as many of the total costs as direct costs of the cost object as is economically feasible;

  • - Indirect-cost pools: Expand the number of indirect-cost pools until each of these pools is more homogeneous;

  • - Cost-allocation bases: Use the cause-and-effect criterion, when possible, to identify the cost- allocation base (the cause) for each indirect-cost pool (the effect).

One often-used approach for refining a costing system is activity-based costing. Activity-based costing (ABC) systems refine costing systems by focusing on individual activities as the fundamental cost objects. By defining activities and identifying the costs of performing each activity, ABC systems seek a greater

level of detail in understanding how an organization uses its resources. As we describe the ABC-system, keep in mind three features:

  • - ABC systems create smaller cost pools linked to different activities;

  • - For each activity-cost pool, a measure of the activity performed serves as the cost-allocation base;

  • - In some cases, costs in a cost pool can be traced directly to products.

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A cost hierarchy categorizes costs into different cost pools on the basis of the different types of cost driver or different degrees of difficulty in determining cause-and-effect relationships. ABC systems commonly use a four-part cost hierarchy, namely:

  • - Output-unit-level costs are resources sacrificed on activities performed on each individual unit of a product or service;

  • - Batch-level costs are resources sacrificed on activities that are related to a group of units of products or services rather than to each individual unit of product or service;

  • - Product-sustaining / service-sustaining costs are resources sacrificed on activities undertaken to support individual products or services;

  • - Facility-sustaining costs are resources sacrificed on activities that cannot be traced to individual products or services but which support the organization as a whole.

Activity-based management (ABM) describes management decisions that use activity-based costing information to satisfy customers and manage profitability. Although ABM has many definitions, we define it broadly to include pricing and product-mix decisions, cost reduction and process improvement decisions, and product design decisions.

Using department indirect-cost rates to allocate costs to products results in the same product costs as activity-cost rates if:

  • - A single activity accounts for a sizeable fraction of the department’s costs;

  • - Significant costs are incurred on different activities within a department but each activity has the same cost-allocation base;

  • - Significant costs are incurred on different activities with different cost-allocation bases within a department but different products use resources from the different activity areas in the same proportions. Where any one of these three conditions holds, using department indirect-cost rates rather than activity rates is often adequate. In companies where none of these conditions hold, department costing systems can be refined using ABC systems.

Organizational context influences the decision to adopt ABC as well as its consequences. National contextual factors are also likely to have an effect.

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Summary Accounting 2 TJW A cost hierarchy categorizes costs into different cost pools on the basis

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Chapter 12: Pricing, target costing and customer profitability analysis

There are three major influences on pricing decisions: customers, competitors and costs. Most pricing decisions are either short run (less than one year) or long run (more than one year). Short-run decisions include (1) pricing for a one-off special order with no long-term implications, and (2) adjusting product mix and output volume in a competitive market. Long-run decisions include pricing a product in a major market where price setting has considerable leeway.

Short-run pricing decisions

  • - One-off special order: Existing fixed manufacturing overhead costs are irrelevant, since these costs do not change if the special one-off order is accepted. Only relevant costs should be taken into account.

Long-run pricing decisions

Many pricing decisions are made for the long run. Buyers prefer stable prices over an extended time

horizon. A stable price reduces the need for continuous monitoring of suppliers’ prices. Greater prices stability also improves planning and build long-run buyer-seller relationships. Short-run pricing focuses on covering variable costs, while long-run pricing focuses on covering both variable and fixed costs. Obtaining appropriate product-cost information is useful to a manager making a pricing decision.

The starting point for pricing decisions can be:

  • - Market-based: Given what our customers want and how our competitors will react to what we do, what price should we charge?

  • - Cost-based / Cost-plus: What does it cost us to make this product, and hence what price should we charge that will recoup our costs and produce a desired profit?

Market-based approach: Target costing and target pricing

An important form of market-based price is the target price. A target price is the estimated price for a product or service that potential customers will be willing to pay. A target operating profit per unit is the operating profit that a company wants to earn each unit of a product or service sold. The target price

leads to a target cost. A target cost per unit is the estimated long-run cost per unit of a product or service that, when sold at the target price, enables the company to achieve the target operating profit per unit. We need to include all costs in the target cost calculations, both fixed and variable. Developing target prices and target costs typically entails the following steps:

  • - Step 1: Develop a product that satisfies the needs of potential customers;

  • - Step 2: Choose a target price based on customers’ perceived value for the product and the prices competitors charge, and a target operating profit per unit;

  • - Step 3: Derive a target cost per unit by subtracting the target operating profit per unit from the target price;

  • - Step 4: Perform value engineering to achieve target costs.

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Value engineering is a systematic evaluation of all aspects of the value-chain business function, with the objective of reducing costs while satisfying customer needs. Value engineering can result in improvements in product designs, changes in materials specifications or modifications in process methods. Two key concepts in value engineering and in managing value-added and non-value-added costs are cost incurrence and locked-in costs. Cost incurrence occurs when a resource is sacrificed or used up. Locked-in costs / Designed-in costs are those costs that have not yet been incurred but that will be incurred in the future on the basis of decisions that have already been made.

The best way to evaluate the effect of alternative design decisions on the target cost per unit is to organize a cross-functional value-engineering team, because only a cross-functional team can evaluate the impact of design decisions on all value-chain functions. Unless managed properly, value engineering and target costing can have undesired consequences:

  • - The cross-functional team may add too many features in an attempt to accommodate the different wishes of team members;

  • - Long development times may result as alternative designs are evaluated endlessly;

  • - Organizational conflicts may develop as the burden of cutting costs falls unequally on different parts of the organization. To avoid these pitfalls, target-costing efforts should always focus on the customer, pay attention to schedules, and build a culture of teamwork and cooperation across business functions.

Cost-plus approach: Cost-plus costing, life-cycle costing

The general formula for setting a price adds a mark-up to the cost base, but how is the mark-up

percentage determined? One approach is to choose a mark-up to earn a target rate of return on investment (= the target operating profit that an organization must earn divided by invested capital). Many different costs can serve as the cost base in applying the cost-plus formula. Prices are then modified on the basis of customers’ reactions and competitors’ responses.

The product life cycle spans the time from initial R&D to the time at which support to customers is withdrawn. Using life-cycle budgeting, managers estimate the revenues and costs attributable to each product from its initial R&D to its final customer servicing and support in the marketplace. Life-cycle costing tracks and accumulates the actual costs attributable to each product from start to finish. A product life-cycle reporting format offers at least three important benefits:

  • - The full set of revenues and costs associated with each product becomes visible;

  • - Differences among products in the percentage of their total costs incurred at early stages in the life cycle are highlighted;

  • - Interrelationships among business function cost categories are highlighted.

Price discrimination is charging different prices to different customers. Peak-load pricing is charging a higher price when demand approaches physical capacity.

Customer-profitability analysis refers to the reporting and analysis of customer revenues and customer costs. The revenues of customers purchasing the same product can differ due to differences in the quantity of units purchased and discounts from list price. Customer-cost hierarchies highlight how some costs can be reliably assigned to individual customers while other costs can be reliably assigned only to distribution channels or to corporate-wide efforts. Customer-profitability reports, shown in a cumulative form, often reveal that a small percentage of customers contribute a large percentage of profits. It is important that companies devote sufficient resources to maintaining and expanding relationships with these key contributors to profitability.

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Summary Accounting 2 TJW Value engineering is a systematic evaluation of all aspects of the value-chain

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Chapter 14: Motivation, budgets, and responsibility accounting

A budget is a quantitative expression of a proposed plan of action by management for a future time period and is an aid to the coordination and implementation of the plan. Many companies adopt the following budgeting cycle:

Summary Accounting 2 TJW Chapter 14: Motivation, budgets, and responsibility accounting A budget is a quantitative
Summary Accounting 2 TJW Chapter 14: Motivation, budgets, and responsibility accounting A budget is a quantitative

Organizations use budgets, because budgets can:

  • - Compel strategic planning including the implementation of plans:

o

Short-run planning short-run budgets;

o

Long-run planning long-run budgets;

o

Forward-looking budgets

  • - Provide performance criteria:

o

Actual versus budgeted results;

o

Feedback to managers;

o

Performance evaluation attached to budgets

  • - Promote communication and coordination within the organization:

o

A budget puts all the employees in the same direction;

o

Department-goals are derived from the firm-goal;

o

A budget makes the links between departments salient and instigates communication

  • - Affect motivating and wider organizational processes:

o

A budget provides people with a specific target;

o

Targets should be challenging but attainable;

o

Process in which the target is established should be considered as fair by the employee

Rolling budget: A budget or plan that is always available for a specified future period by adding a month, quarter or year in the future as the month, quarter or year just ended is dropped. Fixed budget: A budget or plan that is available per year, from January until December.

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Top-down budgeting: A budget in which the targets are set by the top management. In this case, the dangers are that targets are either too difficult or too easy, and targets are perceived as more unfair; Bottom-up budgeting: A budget in which the targets are set in accordance with lower management. The danger is that lower-level management may propose a target that is too low, but that can easily be met.

Various alternatives of budgeting are:

  • - Computer-based budgeting: Mathematical statements of the relationships among operating activities, financial activities and other factors that affect the budget. These models allow management to conduct what-if (sensitivity) analyses of the effects on the master budget of changes in the original predicted data or changes in budget assumptions;

  • - Kaizen budgeting: This captures the continuous improvement notion that is a key management concern. Costs in kaizen budgeting are based on future improvement that are yet to be implemented rather than on current practices or methods;

  • - Activity-based budgeting: This focuses on the costs of activities necessary to produce and sell products and services. It is inherently linked to activity-based costing, but differs in its emphases on future costs and future usage of activity areas.

Organizational structure is an arrangement of lines of responsibility within the entity. To attain the goals described in the master budget, an organization must coordinate the efforts of all its employees – from

the top executive through all levels of management to every supervised worker. Each manager, regardless of level, is in charge of a responsibility centre. A responsibility centre is a part, segment or subunit of an organization whose manager is accountable for a specified set of activities. Responsibility accounting is a system that measures the plans (by budgets) and actions (by actual results) of each responsibility centre. Four major types of responsibility center are:

  • - Cost centre: Manager accountable for costs only;

  • - Revenue centre: Manager accountable for revenues only;

  • - Profit centre: Manager accountable for revenues and costs;

  • - Investment centre: Manager accountable for investments, revenues and costs.

The responsibility accounting approach traces costs to either the individual who has the best knowledge

about why the costs arose, or the activity that caused the costs.

Controllability is the degree of influence that a specific manager has over costs, revenues or other items in question. A controllable cost is any cost that is primarily subject to the influence of a given manager of a given responsibility centre for a given time span.

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Summary Accounting 2 TJW Top-down budgeting: A budget in which the targets are set by the

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Chapter 15: Flexible budget, variances and management control: I

A static budget is a budget that is based on one level of output; it is not adjusted or altered after it is set, regardless of ensuing changes in actual output (or actual revenue and cost drivers), it is calculated at the start of the budget period.

Static-budget variance = Actual results – static-budget amount of operating profit

A flexible budget is adjusted in accordance with ensuing changes in actual output (or actual revenue and cost drivers), it is calculated at the end of the period.

  • - Step 1: Determine the budgeted selling price per unit, the budgeted variable costs per unit and the budgeted fixed costs;

  • - Step 2: Determine the actual quantity of the revenue driver;

  • - Step 3: Determine the flexible budget for revenue based on the budgeted unit revenue and the actual quantity of the revenue driver;

  • - Step 4: Determine the actual quantity of the cost drivers;

  • - Step 5: Determine the flexible budget for costs based on the budgeted unit variable costs and fixed costs and the actual quantity of the cost drivers

A favorable variance (F) is a variance that increases operating income relative to the budgeted amount. An unfavorable variance (U) is a variance that decreases operating income relative to the budgeted amount.

Static-budget

variance

Summary Accounting 2 TJW Chapter 15: Flexible budget, variances and management control: I A static budget

Flexible-budget

Sales-Volume

variance variance Efficiency Price variance variance
variance
variance
Efficiency
Price variance
variance

Flexible-budget variance = actual results – flexible-budget amount = price variance + efficiency variance

Sales-volume

variance

=

Flexible-

budget

amount

static-budget

amount

Static-budget

variance

=

flexible-

budget

variance

+

sales-volume

variance

Price variance / Input-price variance / Rate variances = (actual price of input – budgeted price of input) x actual quantity of input Efficiency variance / Input-efficiency variance / Usage variances = (actual quantity of input used – budgeted quantity of input allowed for actual output units achieved) x budgeted price of input

A standard input is a carefully predetermined quantity of input required for one unit of output. A standard cost is a carefully predetermined cost. We determine the standard quantities and prices with help of; past experience; observation; benchmarking, either internal or external; continuous improvement by lowering standards continuously.

We use variance analysis: to promote organizational learning; performance evaluation; and management by exception: focus on areas that do not operate as expected.

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Chapter 16: Flexible budgets, variances and management control: II

This chapter focuses on understanding flexible-budget variances for overhead costs and their causes:

  • - Planning variable-overhead costs: Effective planning of variable overhead costs involves undertaking only value-added variable-overhead activities and then managing the cost drivers of those activities in the most efficient way. A value-added cost is one that, if eliminated, would reduce the value customers obtain from using the product or service. A non-value-added cost is on that, if eliminated, would not reduce the value customers obtain from using the product or service;

  • - Planning fixed-overhead costs: Effective planning of fixed-overhead costs includes undertaking only value-added fixed-overhead activities and then determining the appropriate level for those activities.

Variable-overhead costs

Static-budget

variance

Flexible-budget Sales-Volume variance variance
Flexible-budget
Sales-Volume
variance
variance

Spending variance

Summary Accounting 2 TJW Chapter 16: Flexible budgets, variances and management control: II This chapter focuses

Efficiency variance

Static-budget

variance

=

actual

results – static-budget amount = flexible-budget variance + sales- volume variance

Sales-volume variance = flexible- budget amount – static-budget amount

Flexible-budget variance = actual results – flexible budget amount = spending variance + efficiency variance

Spending variance = (actual overhead rate – standard overhead rate) x actual units of cost driver used

Efficiency variance = (actual units of cost driver used – budgeted units of cost driver) x standard overhead rate

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Fixed-overhead costs

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Static-budget

variance

Flexible-budget variance No sales-Volume variance No efficiency Spending variance variance
Flexible-budget
variance
No sales-Volume
variance
No efficiency
Spending variance
variance

Static-budget variance = actual results – static-budget amount

Sales-volume variance = flexible-budget amount – static-budget amount = 0

Flexible-budget variance = actual results – flexible-budget amount = spending variance + efficiency variance

Spending variance = (actual overhead rate – standard overhead rate) x actual units of cost driver used

Efficiency variance = (actual units of cost driver used – budgeted units of cost driver) x standard overhead rate = 0

The production-volume variance / denominator-level variance / output-level overhead variance is the difference between budgeted fixed overhead and the fixed overhead allocated. Fixed overhead is

allocated based on the budgeted fixed overhead rate times the budgeted quantity of the fixed-overhead allocation base for the actual output units achieved.

Production-volume variance = budgeted fixed overhead – (fixed overhead allocated using budgeted input allowed for actual output units achieved x budgeted fixed overhead rate)

A 4-variance analysis measures the spending, efficiency and production-volume variance in relation to the variable and fixed manufacturing overhead. A 3-variance analysis / combined variance analysis measures the spending, efficiency and production- volume variance in relation to the total manufacturing overhead A 2-variance analysis measures the flexible-budget variance and production-volume variance in relation to the total manufacturing overhead. A 1-variance analysis measures the total overhead variance in relation to the total manufacturing overhead.

From a planning and control standpoint, managers often find it useful to classify costs in general, and overhead costs in particular, into three main categories:

  • - Engineered costs result specifically from clear cause-and-effect relationship between costs and output;

  • - Discretionary costs arise from period decisions regarding the maximum outlay to be incurred, and they have no clearly measurable cause-and-effect relationship between costs and the outputs;

  • - Infrastructure costs arise from having property, plant and equipment, and a functioning organization.

The separate analysis of variable- and fixed-overhead costs requires the use of separate variable- and fixed-overhead control accounts and separate variable- and fixed-overhead allocated accounts. At the end of each accounting period, any variances for variable- or fixed-overhead costs can be disposed. Flexible budgeting in ABC-systems enables insight into why activity costs differ from those budgeted.

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Chapter 17: Measuring yield, mix, and quantity effects

This chapter focuses on variance analysis with multiple inputs, as well as substitutable inputs. When inputs are substitutable, mix refers to the relative proportion or combination of the different inputs used within an input category such as direct materials or direct manufacturing labor to produce a quantity of finished output. Yield refers to the quantity of finished output units produced from a budgeted or standard mix of inputs within an input category.

Static-budget variance

Summary Accounting 2 TJW Chapter 17: Measuring yield, mix, and quantity effects This chapter focuses on

Flexible-budget

Sales-Volume variance

 

variance

Sales-mix
 

Sales-mix

Price variance

Efficiency

variance

 

variance

Yield

Yield Mix

Mix

variance

variance

Sales-quantity variance Market-share Market-size variance
Sales-quantity
variance
Market-share
Market-size
variance

variance

Static-budget variance = flexible-budget variance + sales-volume variance = actual results – static-budget amount

Flexible-budget variance = actual results – flexible-budget amount = price variance + efficiency variance Price variance = (actual price of input – budgeted price of input) x actual quantity of input Efficiency variance = (actual units of cost driver used – budgeted units of cost driver) x standard overhead rate = yield variance + mix variance Yield variance = (actual total output – budgeted total output) x budgeted mix % x budgeted price Mix variance = (actual mix % - budgeted mix %) x actual total output x budgeted price

Sales-volume variance = flexible-budget amount – static-budget amount = sales-mix variance + sales- quantity variance Sales-mix variance = total actual output x (actual mix % - budgeted mix %) x budgeted price Sales-quantity variance = (total actual output – budgeted actual output) x budgeted mix % x budgeted price = market-share variance + market-size variance Market-share variance = actual market output x (actual market % - budgeted market %) x budgeted price Market-size variance = (actual market output – budgeted market output) x budgeted market share x budgeted average selling price per unit

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Chapter 18: Control systems and transfer pricing

A management control system is a means of gathering and using information to aid and coordinate the process of making planning and control decisions throughout the organization and to guide employee behavior. The goal of the system is to improve the collective decisions within an organization. Information for management control is gathered and reported at various levels:

  • - Total-organization level;

  • - Customer/market level;

  • - Individual-facility level;

  • - Individual-activity level.

Management control systems use: financial; non-financial; formal; and informal measures.

To be effective, management control systems should be closely aligned to an organization’s strategy and goals. It should also be designed to fit the organization’s structure and the decision-making responsibility of individual managers. Finally, it should motivate managers and employees.

The essence of decentralization is the freedom for managers at lower levels of the organization to make decisions. Total decentralization means minimum constraints and maximum freedom, whereas total centralization means maximum constraints and minimum freedom for managers.

Benefits of decentralization

Costs of decentralization

Creates greater responsiveness to local needs Leads to quicker decision making Increases motivation Aids management development and learning Sharpens the focus of managers

Leads to suboptimal/ incongruent decision making Results in duplication of activities Focuses managers’ attention on the subunit rather than the organization as a whole Increases costs of gathering information

A transfer price is the price one subunit of an organization charges for a product or service supplied to another subunit of the same organization. There are three methods for determining transfer prices:

  • - Market-based transfer prices: Transferring products or services at market prices generally leads to optimal decisions when three conditions are satisfied: (1) the intermediate market is perfectly competitive, (2) interdependencies of subunits are minimal, and (3) there are no additional costs or benefits to the corporation as a whole in using the market instead of transacting internally.

  • - Cost-based transfer prices: Cost-based transfer prices are helpful when market prices are unavailable, inappropriate, or too costly to obtain. We can use dual pricing, which uses a fixed price and a variable mark-up, to obtain these prices.

  • - Negotiated transfer prices: When there is excess capacity, the transfer price range for negotiations generally lies between the minimum price at which the selling division is willing to sell (its variable costs) and the maximum price the buying divisions is willing to pay (the price at which the product is available from outside suppliers).

The general guideline for transfer pricing states that the minimum transfer price equals the incremental costs per unit incurred up to the point of transfer plus the opportunity costs per unit to the supplying division resulting from transferring products or services internally. Transfer prices can reduce income tax payments by recognizing higher profits in low-tax-rate countries and lower profits in high-tax-countries.

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Chapter 19: Control systems and performance measurement

Increasingly, companies are supplementing internal financial measures with measures based on external financial information, internal non-financial information, and external non-financial information. Some companies present financial and non-financial performance measures for various organization subunits in a single report called the balanced scorecard. Most scorecards include (1) profitability measures; (2) customer-satisfaction measures; (3) internal measures of efficiency; (4) innovation measures.

The design of an accounting-based performance measure might entail the following general steps:

  • - Step 1: Choosing the variable(s) that represents top management’s financial goal(s):

o Return on investment (ROI) = income / investment Residual income = income – (require rate of return in % x investment) Economic value added (EVA) = after-tax operating profit – [WACC x (total assets – current liabilities)] Return on sales (ROS) = operating profit / revenues

o

o

o

  • - Step 2: Choosing definitions of the items included in the variables in step 1, such as: total assets available; total assets employed; working capital (current assets minus current liabilities) plus long-term assets; shareholders’ equity;

  • - Step 3: Choosing measures for the items included in the variables in step 1:

o Current cost is the cost of purchasing an asset today identical to the one currently held. Because historical-cost investment measures are used often in practice, there has been much discussion about the relative merits of using gross book value or net book value.

  • - Step 4: Choosing a target against which to gauge performance: We need to create a budget that is carefully negotiated with full knowledge of historical-cost accounting pitfalls. The desirability of tailoring a budget to a particular subunit and a particular accounting system cannot be overemphasized.

  • - Step 5: Choosing the timing feedback: Timing of feedback depends largely on how critical the information is for the success of the organization, the specific level of management that is receiving the feedback, and the sophistication of the organization’s information technology.

Organizations create incentives by rewarding managers on the basis of performance. But managers may face risks because random factors beyond their control may also affect performance. Owners choose a mix of salary and incentive compensation to trade off the incentive benefit against the cost of imposing risk. Obtaining measures of employee performance that are superior is critical for implementing strong incentives. Many management accounting practices, such as the design of responsibility centers and the establishment of financial and non-financial measures, have as their goal better performance evaluation. Most employees perform multiple tasks as part of their jobs. In some situations, one aspect of a job is easily measures, while another aspect is not. Creating incentives to promote the quantitative aspect may cause a worker to ignore an qualitative aspect of the job.

To avoid unethical behavior, companies need to balance the push for performance resulting from diagnostic control systems, the first of four levers of control, with three other levers:

  • - Boundary systems describe standards of behavior and codes of conduct expected of all employees, especially action that are off-limits;

  • - Belief systems articulate the mission, purpose and core values of a company;

  • - Interactive control systems are formal information systems that managers use to focus organization attention and learning on key strategic issues.

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Summary Accounting 2 TJW Chapter 19: Control systems and performance measurement Increasingly, companies are supplementing internal

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Chapter 20: Quality and throughput concerns in managing costs

Many companies throughout the world view total quality management as providing an important competitive edge. This is because quality focus reduces costs and increases customer satisfaction. International quality standards have emerged, such that certification and an emphasis on quality has rapidly become conditions for competing in the global market. Quality improvement also has non- financial and qualitative effects, such as environmental aspects, that improve a company’s long-run

performance. In this chapter we discuss two basic aspects of quality:

  • - Quality of design: This measures how closely the characteristics of products or services match the needs and wants of customers;

  • - Conformance quality: The performance of a product or service according to design and product specifications.

The costs of quality (COQ) are costs incurred to prevent, or costs arising as a result of the production of a low-quality product. Costs of quality are classified into four categories:

  • - Prevention costs: Costs incurred in precluding the production of products that do not conform to specifications;

  • - Appraisal costs: Costs incurred in detecting which of the individual units of products do not conform to specifications;

  • - Internal failure costs: Costs incurred when a non-confirming product is detected before it is shipped to customers;

  • - External failure costs: Costs incurred when a non-confirming product is detected after it is shipped to customers.

There are several techniques to identify quality problems, such as:

  • - Control charts: A graph of a series of successive observations of a particular step, procedure or operation taken at regular intervals of time. Each observation is plotted relative to specified ranges that represent the expected distribution. Only those observations outside the specific limits are ordinarily regarded as non-random and worth investigating;

  • - Pareto diagrams: This indicates how frequently each type of failure (defect) occurs;

  • - Cause-and-effect diagrams / Fishbone diagrams: This identifies potential causes of failures or defects.

The relevant costs of quality improvement are the incremental costs incurred to implement the quality program. The relevant benefits are the savings in total costs and the estimated increase in contribution margin from the higher sales that will result from the quality improvements.

Non-financial measures of quality and customer satisfaction

Customer satisfaction

Internal performance

Market research information Defective units shipped / total units shipped Number of customer complaints On time delivery rate

Number of defects Employee turnover Employee satisfaction

Financial measures are helpful to evaluate trade-offs among prevention and failure costs. They focus attention on how costly poor quality can be. Non-financial measures help focus attention on the precise problem areas that need attention.

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The theory of constraints (TOC) describes methods to maximize operating profit when faced with some bottlenecks and some non-bottleneck operations. It defines three measurements:

  • - Throughput contribution, equal to sales revenue minus direct materials costs;

  • - Investment (stock), equal to the sum of materials of direct materials stock, work-in-progress stock and finished goods stock; R&D costs; and costs of equipment and buildings;

  • - Operating costs, equal to all operating costs (other than direct materials) incurred to earn throughput contribution. Operating costs include salaries and wages, rent, utilities and depreciation. The objective of TOC is to increase throughput contribution while decreasing investments and operating costs. The theory of constraints considers short-run time horizons and assumes other current operating

costs to be fixed costs. The key steps in managing bottleneck resources are as follows:

  • - Step 1: Recognize that the bottleneck resource determines throughput contribution of the plant as whole;

  • - Step 2: Search and find the bottleneck resource by identifying resources with large quantities of stock waiting to be worked on;

  • - Step 3: Keep the bottleneck operation busy and subordinate all non-bottleneck resources to the bottleneck resource. That is, the needs of the bottleneck resource determine the production schedule of non-bottleneck resources;

  • - Step 4: Take actions to increase bottleneck efficiency and capacity – the objective is to increase throughput contribution minus the incremental costs of taking such actions. These actions can be:

o

Eliminating idle time;

o

Processing only those parts or products that increase sales and throughput contribution;

o

Shifts products that do not have to be made on the bottleneck machine to non-

o

bottleneck machines or to outside facilities; Reduce set-up times and processing time at bottleneck operations;

o

Improve the quality of parts or products manufactured at the bottleneck operation.

Throughput accounting (TA) is a management tool which is partly informed by the theory of constraints. The primary concern of TA is the rate at which a business can generate profits. A key point of focus is return per bottleneck, which underscores an important management accounting concern to maximize contribution per unit of a given limiting factor.

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Summary Accounting 2 TJW The theory of constraints (TOC) describes methods to maximize operating profit when

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Chapter 21: Accounting for just-in-time (JIT) systems

Just-in-time (JIT) refers to a system in which materials arrive exactly as they are needed. Just-in-time

production is a system in which each component on a production line is produced immediately as needed by the next step in the production line. There five main features in a JIT-production system:

  • - Production is organized in manufacturing cells;

  • - Multi-skilled workers;

  • - Total quality management (TQM);

  • - Reducing manufacturing lead time and set-up time;

  • - Strong supplier relationships.

The financial benefits of JIT include: lower investment in stocks; reductions in paperwork; reductions in

risk of obsolescence of stocks, etc.

A unique production system such as JIT leads to its own unique costing system. Traditional normal and standard costing systems use sequential tracking / synchronous tracking, which is any product-costing method in which the accounting system entries occur in the same order as actual purchases and production. The term backflush costing / delayed costing / endpoint costing / post-deduct costing describes a costing system that delays recording changes in the status of a product being produced until good finished units appear; it then uses budgeted or standard costs to work backwards to flush out manufacturing costs for the units produced.

Accounting information can play a key role in stock management. The following costs are important when

managing stocks and goods for sale:

  • - Purchasing costs consists of the costs of goods acquired from suppliers including incoming freight or transportation costs;

  • - Ordering costs consist of the costs of preparing and issuing a purchase order;

  • - Carrying costs arise when a business holds stocks of goods for sale;

  • - Stock-out costs or no-sales-costs;

  • - Quality costs: The quality of a product or service is its conformance with a preannounced or pre- specified standard. Quality costs include: prevention, appraisal, internal failure and external failure costs.

The economic order quantity (EOQ) decision model calculates the optimal quantity of stock to order. The reorder point is the quantity level of the stock on hand that triggers a new order. It is calculated by multiplying numbers of units sold per unit of time with the purchase-order lead time. Safety stock is stock held at all times regardless of stock ordered using EOQ. It is used as a buffer against unexpected increases in demand or lead time and unavailability of stock from suppliers.

JIT-purchasing is the purchase of goods or materials such that delivery immediately precedes demand or use. EOQ models support smaller and more frequent purchase orders as relevant carrying costs increase and relevant ordering costs per order decrease. A relevant cost-benefit analysis of JIT purchasing includes relevant costs of purchasing, carrying stock, ordering and stock-out, quality-related costs of inspection and customer returns and lost contribution margins due to late deliveries. The relevant benefits and relevant costs of JIT production include relevant costs of set-up and carrying stock, better quality and faster delivery. Performance measurement and control in JIT production systems emphasize personal observation and non-financial performance measures.

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Chapter 22: Strategic management accounting and emerging issues

Strategy is an elusive concept. Many definitions and notions of strategy exist in the management literature. Most popular are Porters five forces model and the notions of product differentiation and cost leadership. Product differentiation refers to offering products and services that are perceived by customers as being superior and unique. Cost leadership refers to the pursuit of low costs relative to those of competitors.

Strategic management accounting (SMA) places particular emphasis on blending external with internal organizational information. SMA encompasses both financial and non-financial information.

The balanced scorecard translates an organization’s mission and strategy into a comprehensive set of performance measures that provides the framework for implementing its strategy. The balanced scorecard measures an organization’s performance from four key perspectives:

  • - Financial perspective: This perspective evaluates the profitability of strategy;

  • - Customer perspective: This perspective identifies the targeted market segments and measures the company’s success in these segments;

  • - Internal business process perspective: This perspective focuses on internal operations that further both the customer perspective by creating value for customers and the financial perspective by increasing shareholder wealth. The internal business process perspective comprises three principal sub processes:

o

The innovation process – creating products, services and processes that will meet the

o

needs of customers; The operations process – producing and delivering existing products and services to

o

customers; After-sales service – providing service and support to the customer after the sale or delivery of a product or service.

  • - Learning and growth perspective: This perspective identifies the capabilities in which the organization must excel in order to achieve superior internal processes that create value for customers and shareholders.

Features of a good balanced scorecard

Pitfalls when creating a balanced scorecard

Shows cause-and-effect relationships Communicates strategy throughout the company Places strong emphasis on financial objectives Only identifies the most critical measures Highlights suboptimal trade-offs

Cause-and-effect linkages are not precise Seeking improvement of measures all the time Using only objective measures Failing to consider both costs and benefits Ignoring non-financial measures when evaluating managers and employees

A tableau de bord (TdB) is a customized multidimensional control system encompassing both financial and non-financial information to identify and measure organizational objectives and key variables. Enterprise governance is about both corporate governance and business governance. The strategic scorecard aims to assist boards of directors achieve effective business governance. A variety of emerging issues has recently made a growing impact on management accounting systems. Environmental management accounting and knowledge management and intellectual capital value creation practices are discussed for the future.

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Summary Accounting 2 TJW Chapter 22: Strategic management accounting and emerging issues Strategy is an elusive

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