Introduction To Cost Accounting - MIT OpenCourseWare

Introduction To CostAccounting 15.501/516 AccountingSpring 2004 Professor S. RoychowdhurySloan School of ManagementMassachusetts Institute of Technology April 28, 2004 6Outline¾ Overview of managerial accounting issues Brief discussion of performance evaluation¾ Cost accounting terminology¾ Cost behavior¾ Product costing: traditional method¾ Product costing: activity based costing(ABC)7Managerial AccountingWhat are the Goals?Performance Evaluation(Control)Decision MakingBudgetingVarianceAnalysisProfit andCost CentersCostingPricingFinancial ReportingProductionProductMixMakeor BuyChangeMethodsDiscontinue8Page 1

A few words aboutPerformance Evaluation¾“You get what you pay for”¾Strongly recommended reading: “On the follyof rewarding A, while hoping for B” Doctors and litigation – penalty for type II errors. Where else is this evident? AuditorsLitigation risk induced conservatism Insurance company – reward for attendance buthoping for performance. Financial markets – focus on quarterly earningswhile hoping for long-term growth inprofitability9Basic Cost Terms:Cost Objects and DriversCost¾ A sacrifice of resources. Distinguishfrom “expense.”Cost Object¾ Any activity or item for which a separatemeasurement of costs is desired.Cost Drivere.g. ProcessingSales Order Cost Driver¾ Any factor whose change “causes” achange in the total cost of a related costobject. Note: Cost drivers can be factorsother than volumeCost Objecte.g., Product10Basic Cost Terms:Direct and Indirect CostsDirect Costs¾ Costs that can be traced to a given cost object(product, department, etc.) in aneconomically feasible way.DirectCost AIndirectCost CIndirect Costs¾ Costs that cannot be traced to a given costobject in an economically feasible way.These costs are also known as “overhead”.Cost Assignment¾ Direct costs are traced to a cost object.¾ Indirect costs are allocated or assigned to acost object.DirectCost BObjectXObjectY11Page 2

Basic Cost Terms:Product and Period CostsProduct Costs¾ Costs that “attach” to the units thatare produced (i.e., manufacturingcosts) and are not reported asexpenses until the goods are sold.Product CostsDirectCostPeriod costs¾ Costs that must be charged againstincome in the period incurred andcannot be inventoried (e.g., sellingand administrative expenses).PeriodCostIndirectCostProduct XInventoryUnit Costs¾ Total cost of units divided by unitsproduced.SaleIncomeStatement12Basic Cost Terms:Cost BehaviorVariable Costs¾ Costs that change directly in proportion to changes inthe related cost driverFixed Costs¾ Costs that remain unchanged for a given time periodregardless of changes in the related cost driver.Other Common Functions for Cost Behavior¾ Semi-variable costs (part variable and part fixed)¾ Step costs (aka semi-fixed costs)Main Assumptions Needed to Define Fixed andVariable Costs¾ Cost object, Time span, Linear functional form¾ Relevant range- the band of cost driver activity inwhich a specific relationship between a cost and adriver holds.13Basic Cost Terms¾Product costs can be Direct or Indirect(Overhead)¾Not all Direct costs are variable The depreciation of a special piece of equipmentbought to manufacture a single product line.¾Not all Overheads are fixed Processing of raw material purchase orders Electricity used in operating productionequipment.14Page 3

The “Ins” of Inventory Accounting¾ What costs are assigned to inventory as products aremanufactured?¾ GAAP requires Full Absorption Costing: theproducts fully absorb all manufacturing costs,including: Variable manufacturing costs. e.g., direct material Fixed manufacturing costs. e.g., building depreciation¾ Results in unitizing fixed costs: convert total fixedcosts (TFC) to a unit cost by allocating TFC to theunits produced.15The “Ins” and “Outs”of Inventory AccountingRaw MaterialsDirect LaborRaw MaterialsInventoryWork-in-processInventoryFinished GoodsInventoryTransportation,Set-up, etcIndirect labor,Indirect materials,DepreciationCost ofGoods SoldNon-manufacturing(period) costsI/S,RetainedEarnings16Examples of Product Costing¾ Electron, Inc. produces 10,000 calculators in one month.¾ Variable manufacturing costs are : 6/unit for material, 1/unit for direct labor, and 1/unit for variable overhead.¾ Fixed manufacturing overhead is 50,000/month.¾ Unit costs are 8 (variable) 50,000/10,000 (fixed) or 13/unit.¾ How do these costs flow through Inventory Accounts?17Page 4

Product Costing Events11/ 1: Purchase and receive 60,000 of material (Nov. supply)11/ 2: Requisition ½ of materials to the factory floor ( 30,000)11/ 5: Apply labor to the materials ( 5,000)11/ 7: Recognize depreciation expense for the month ( 50,000)11/ 8: Apply variable OH to the materials ( 5,000)11/ 9: Transfer 5,000 completed calculators from WIP to FGInventory11/10: Ship 2,000 completed calculators to customer18How do Costs Flow through InventoryAccounts?CashRMInvWIPInvFGInvNetWagesPPE PayableREBuy MaterialsRequisition ½Of materialsApply laborApply fixed OH(Depreciation)Applyvariable OHTransfer toFG InvSell 2000 units19How do Costs Flow through InventoryAccounts?Buy MaterialsCash–60RMInv60WIPInvFGInvNetWagesPPE PayableRERequisition ½Of materialsApply laborApply fixed OH(Depreciation)Applyvariable OHTransfer toFG InvSell 2000 units20Page 5

How do Costs Flow through InventoryAccounts?Buy MaterialsCash–60Requisition ½Of materialsApply laborRMInv60WIPInv–3030FGInvNetWagesPPE PayableREApply fixed OH(Depreciation)Applyvariable OHTransfer toFG InvSell 2000 units21How do Costs Flow through InventoryAccounts?Buy MaterialsCash–60Requisition ½Of materialsApply laborRMInv60WIPInv–3030FGInvNetWagesPPE Payable5RE5Apply fixed OH(Depreciation)Applyvariable OHTransfer toFG InvSell 2000 units22How do Costs Flow through InventoryAccounts?Buy MaterialsRequisition ½Of materialsApply laborApply fixed OH(Depreciation)Applyvariable OHTransfer toFG InvSell 2000 unitsCash–60RMInv60WIPInv–3030FGInvNetWagesPPE Payable550RE5–5023Page 6

How do Costs Flow through InventoryAccounts?Buy MaterialsCash–60Requisition ½Of materialsApply laborApply fixed OH(Depreciation)Applyvariable OHTransfer toFG InvSell 2000 unitsRMInv60WIPInv–3030FGInvNetWagesPPE Payable5550–5RE–50524How do Costs Flow through InventoryAccounts?Buy MaterialsCash–60Requisition ½Of materialsApply laborApply fixed OH(Depreciation)Applyvariable OHTransfer toFG InvSell 2000 unitsRMInv60WIPInv–3030FGInvNetWagesPPE Payable5550–5RE–505–656525How do Costs Flow through InventoryAccounts?Buy MaterialsCash–60Requisition ½Of materialsApply laborApply fixed OH(Depreciation)Applyvariable OHTransfer toFG InvSell 2000 unitsRMInv60WIPInv–3030FGInvNetWagesPPE Payable5550–5RE–505–6565–26–2626Page 7

Cost Flow Through Inventories¾ In particular, note the following¾ On direct labor, the accounting entry is Dr WIP5 Cr Wages Payable¾ Not Dr Salaries Expense5 Cr Wages Payable¾ Similarly, on depreciation for manufacturing facility Dr WIP50 Cr Accumulated Depreciation¾ Not Dr Depreciation Expense50 Cr Accumulated Depreciation55505027Traditional Costing SystemDirect CostsDirect LaborDirect MaterialsTraceddirectlyProductCostsOverhead CostsIndirect LaborIndirect MaterialsDepreciationTraced usingallocation baseeg direct labor hrs,machine hrs28Examples of Overhead Activities¾Purchase order processing¾Receiving/Inventorying materials¾Inspecting materials¾Processing accounts payable¾Facility maintenance¾Scheduling production¾Customer complaints¾Quality inspection/testing29Page 8

Activity-Based Costing SystemDirect CostsDirect LaborDirect MaterialsOverhead CostsIndirect LaborIndirect uctCosts30Typical Activity Cost Drivers¾ Number of alteration notices per product¾ Units produced¾ Number of receipts for materials/parts¾ Stockroom transfers¾ Direct labor hours¾ Set-up hours¾ Inspection hours¾ Facility hours¾ Number of customer complaints31Cost Allocation ExampleDialglow Corporation manufactures travel clocks and watches.Overhead costs are currently allocated using direct labor hours,but the controller has recommended an activity-based costingsystem using the following data:ActivityProduction SetupCost Cost Driver 120,000 No. of setupsMaterial Handling& Requisition30,000 No. of partsPackaging& Shipping60,000 #Units ShippedTotal OverheadDirect labor 0 210,000140,00032Page 9

Using Traditional Costing SystemAllocate Total OH based on labor hours(35,000 hours for travel clocks; 105,000 hours for watches.)OH Rate: 210,000 / 140,000 hours 1.50/hourOH cost per Travel Clock:( 1.50/hr * 35,000 hrs) / 45,000 units 1.167OH cost per Watch:( 1.50/hr * 105,000 hrs) / 75,000 units 2.1033Using ABCAllocation of :Production Setup Costs: 120,000 / (10 15) setups 4,800/setupMaterial Handl’g Costs: 30,000 / (18 36) part numbers 555.56/partPacking/shipping Costs: 60,000 / (45,000 75,000) units 0.50/unit shippedProduct Costs using ABC:Production SetupMaterial yLevelWatchesTotalPer Unit34Using ABCAllocation of :Production Setup Costs: 120,000 / (10 15) setups 4,800/setupMaterial Handl’g Costs: 30,000 / (18 36) part numbers 555.56/partPacking/shipping Costs: 60,000 / (45,000 75,000) units 0.50/unit shippedProduct Costs using ABC:Production SetupMaterial HandlingPacking/ShippingActivityLevel10Clocks 48,000ActivityLevel15Watches 72,000TotalPer Unit35Page 10

Using ABCAllocation of :Production Setup Costs: 120,000 / (10 15) setups 4,800/setupMaterial Handl’g Costs: 30,000 / (18 36) part numbers 555.56/partPacking/shipping Costs: 60,000 / (45,000 75,000) units 0.50/unit shippedProduct Costs using ABC:Production SetupMaterial HandlingPacking/ShippingActivityLevel1018Clocks 48,00010,000ActivityLevel1536Watches 72,00020,000TotalPer Unit36Using ABCAllocation of :Production Setup Costs: 120,000 / (10 15) setups 4,800/setupMaterial Handl’g Costs: 30,000 / (18 36) part numbers 555.56/partPacking/shipping Costs: 60,000 / (45,000 75,000) units 0.50/unit shippedProduct Costs using ABC:Production SetupMaterial ks 48,00010,00022,500ActivityLevel153675000Watches 72,00020,00037,500TotalPer Unit37Using ABCAllocation of :Production Setup Costs: 120,000 / (10 15) setups 4,800/setupMaterial Handl’g Costs: 30,000 / (18 36) part numbers 555.56/partPacking/shipping Costs: 60,000 / (45,000 75,000) units 0.50/unit shippedProduct Costs using ABC:Production SetupMaterial 0Clocks 48,00010,00022,500 80,500ActivityLevel153675000Watches 72,00020,00037,500 129,500Per Unit38Page 11

Using ABCAllocation of :Production Setup Costs: 120,000 / (10 15) setups 4,800/setupMaterial Handl’g Costs: 30,000 / (18 36) part numbers 555.56/partPacking/shipping Costs: 60,000 / (45,000 75,000) units 0.50/unit shippedProduct Costs using ABC:Production SetupMaterial HandlingPacking/ShippingTotalPer UnitActivityLevel101845000Clocks 48,00010,00022,500ActivityLevel153675000Watches 72,00020,00037,500 80,500 129,500 1.79 1.7339Summary¾ Managerial accounting focuses on decision making andcontrol: Decision making: initiating and implementing decisions. Control: ratifying and monitoring decisions. Important: Organizational structure of firm should separate bothfunctions.¾ Characteristics of good internal accounting system: Provide information necessary to identify most profitable products. Provide information necessary to identify production inefficiencies toensure production at minimum cost. Combine measurement of performance with evaluation ofperformance to create incentives for managers that maximize firmvalue.40Page 12

Cost Object Any activity or item for which a separate measurement of costs is desired. Any factor whose change “causes” a change in the total cost of a related cost object. Note: Cost drivers can be factors other than volume Cost Driver e.g. Processing Sales Order Cost Object e.g., Product 11 Ba