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4 4 - 3 Learning Objective 1 Describe the purposes of cost management systems.

5 4 - 4 Cost Management System A cost-management system (CMS) is a collection of tools and techniques that identifies how managements decisions affect costs.

6 4 - 5 What is Cost Accounting? Cost accounting is that part of the accounting system that measures costs for the purposes of management decision making and financial reporting.

7 4 - 6 Learning Objective 2 Explain the relationships among cost, cost objective, cost accumulation, and cost allocation.

8 4 - 7 Cost Accounting System Cost Accumulation Collecting costs by some natural classification such as materials or labor Cost Allocation Tracing costs to one or more cost objectives

9 4 - 8 Cost Accounting System MACHINING DEPARTMENT ACTIVITY FINISHING DEPARTMENT ACTIVITY RAW MATERIAL COSTS (METALS CABINETS DESKS TABLES Cost Accumulation Cost Allocation to Cost Objects: 1. Departments 2. Activities 3. Products

10 4 - 9 Cost A cost may be defined as a sacrifice or giving up of resources for a particular purpose. Costs are frequently measured by the monetary units that must be paid for goods and services.

11 Cost Objective What is a cost object or cost objective? It is anything for which a separate measurement of costs is desired.

12 Learning Objective 3 Distinguish among direct, indirect, and unallocated costs.

13 Direct Costs Direct costs can be identified specifically and exclusively with a given cost objective in an economically feasible way. What are direct costs?

14 Indirect Costs Indirect costs cannot be identified specifically and exclusively with a given cost objective in an economically feasible way. What are indirect costs?

15 What Distinguishes Direct and Indirect Costs? Managers prefer to classify costs as direct rather than indirect whenever it is economically feasible or cost effective. Other factors also influence whether a cost is considered direct or indirect. The key is the particular cost objective.

16 Categories of Manufacturing Costs Any raw material, labor, or other input used by any organization could, in theory, be identified as a direct or indirect cost depending on the cost objective.

17 Categories of Manufacturing Costs All costs which are eventually allocated to products are classified as either… 1direct materials, 2direct labor, or 3indirect manufacturing.

18 Direct Material Costs... –include the acquisition costs of all materials that are physically identified as a part of the manufactured goods and that may be traced to the manufactured goods in an economically feasible way.

19 Direct Labor Costs... –include the wages of all labor that can be traced specifically and exclusively to the manufactured goods in an economically feasible way.

20 Indirect Manufacturing Costs... –or factory overhead, include all costs associated with the manufacturing process that cannot be traced to the manufactured goods in an economically feasible way.

21 Product Costs... –are costs identified with goods produced or purchased for resale. Product costs are initially identified as part of the inventory on hand. These costs, inventoriable costs, become expenses (in the form of cost of goods sold) only when the inventory is sold.

22 Period Costs... –are costs that are deducted as expenses during the current period without going through an inventory stage.

23 Period or Product Costs In merchandising accounting, insurance, depreciation, and wages are period costs (expenses of the current period). In manufacturing accounting, many of these items are related to production activities and thus, as indirect manufacturing, are product costs.

24 Period Costs – Merchandising and Manufacturing In both merchandising and manufacturing accounting, selling and general administrative costs are period costs.

25 Learning Objective 4 Explain how the financial statements of merchandisers and manufacturers differ because of the types of goods they sell.

26 Financial Statement Presentation – Merchandising Companies Merchandise Inventory Merchandise Inventory Sales Cost of Goods Sold (an expense) Cost of Goods Sold (an expense) Selling and Administrative Expenses Selling and Administrative Expenses Balance Sheet Income Statement – Equals Gross Margin Equals Operating Income – Expiration Period Costs

27 Financial Statement Presentation – Manufacturing Companies Finished Goods Inventory Finished Goods Inventory Sales Cost of Goods Sold (an expense) Cost of Goods Sold (an expense) Selling and Administrative Expenses Selling and Administrative Expenses Balance Sheet Income Statement – Equals Gross Margin Equals Operating Income – Expiration Period Costs Direct Material Inventory Direct Material Inventory Work-in- Process Inventory Work-in- Process Inventory

28 Costs and Income Statements On income statements, the detailed reporting of selling and administrative expenses is typically the same for manufacturing and merchandising organizations, but the cost of goods sold is different.

29 Cost of Goods Sold for a Manufacturer The manufacturers cost of goods produced and then sold is usually composed of the three major categories of cost: 1Direct materials 2Direct labor 3Indirect manufacturing

30 Cost of Goods Sold for a Retailer or Wholesaler The merchandisers cost of goods sold is usually composed of the purchase cost of items, including freight-in, that are acquired and then resold.

31 Learning Objective 5 Understand the main differences between traditional and activity-based costing systems and why ABC systems provide value to managers.

32 Traditional Cost System All Unallocated Value Chain Costs Direct Material Resource Direct Labor Resource All Indirect Resources Products Direct Trace Direct Trace Cost Driver Unallocated

33 Two-Stage Activity-Based Cost System All Unallocated Value Chain Costs Direct Material Resource Direct Labor Resource Indirect Resource A Products Direct Trace Direct Trace Activity 1 Unallocated Other Direct Resources Indirect Resource Z Activity 10 %% Cost Driver Cost Driver

34 Activity-Based Costing Understanding the relationships among activities, resources, costs, and cost drivers is the key to understanding ABC and how ABC facilitates managers understanding of operations.

35 Example of Activities and Cost Drivers: Activities: Account billing Bill verification Account iniquity Correspondence Cost Drivers: No. of lines No. of accounts No. of labor hours No. of letters Activity-Based Costing

36 Learning Objective 6 Identify the steps involved in the design and implementation of an activity-based costing system.

37 Designing and Implementing an Activity-Based Costing System Determine cost of activities, resources, and related cost drivers. Develop a process-based map representing the flow of activities, resources, and their interrelationships. Step 1 Step 2

38 Designing and Implementing an Activity-Based Costing System Collect relevant data concerning costs and the physical flow of the cost-driver units among resources and activities. Step 3

39 Designing and Implementing an Activity-Based Costing System Calculate and interpret the new activity-based information. Using an activity-based costing system to improve the operations of an organization is activity-based management (ABM). Step 4

40 Activity-Based Management Activity-based management aims to improve the value received by customers and to improve profits by identifying opportunities for improvements in strategy and operations.

41 Activity-Based Management A value-added cost is the cost of an activity that cannot be eliminated without affecting a products value to the customer. In contrast, non-value-added costs are costs that can be eliminated without affecting a products value to the customer.

42 Learning Objective 7 Use activity-based cost information to improve the operations of an organization.

43 Using ABC Information Activity-based management… provides costs of value-added and non-value-added activities. improves managers understanding of operations.

44 Learning Objective 8 Understand cost accountings role in a companys improvement efforts across the value chain.

45 Cost Accounting and the Value Chain A good cost accounting system is critical to all value-chain functions from research and development through customer service.

46 Activity Based Management

47 Activity-Based Management (ABM) Activity-based management (ABM) is a systemwide, integrated approach that focuses managements attention on activities with the objective of improving customer value and the profit achieved by providing this value. – Activity-based management encompasses both product costing and process value analysis.

48 Cost Dimension Process Dimension Driver AnalysisActivitiesPerformance Measures Resources Products and Customers Why? What? How Well? Activity-Based Management Model

49 Process Value Analysis Process value analysis is fundamental to activity-based responsibility accounting, focuses on accountability for activities rather than costs, and emphasizes the maximization of systemwide performance instead of individual performance. – Process value analysis is concerned with: Driver analysis Activity analysis Performance measurement

50 Activity Analysis Activity analysis should produce four outcomes: What activities are performed? How many people perform the activities? The time and resources required to perform the activities. An assessment of the value of the activities to the organization, including a recommendation to select and keep only those that add value.

51 Value-Added Activities A discretionary activity is classified as value- added provided it simultaneously satisfies three conditions: – The activity produces a change of state. – The change of state was not achievable by preceding activities. – The activity enables other activities to be performed.

52 Nonvalue-Added Activities Nonvalue-Added Activities are activities that add cost and impede performance. Scheduling Moving Waiting Inspecting Storing Examples

53 Activity Analysis Activity elimination Activity selection Activity reduction Activity sharing Activity Analysis Can Reduce Costs in Four Ways:

54 Activity Performance Measurement lEfficiency lQuality lTime Three Dimensions of Activity Performance

55 Measures of Activity Performance Financial measures of activity efficiency include: – Value and nonvalue- added activity cost reports – Trends in activity cost reports – Kaizen standard setting – Benchmarking

56 55 Economic Order Quantity, JIT, and the Theory of Contraints INVENTORY MANAGEMENT

57 56 Learning Objectives Describe the traditional inventory management model. Describe JIT inventory management. Explain the basic concepts of constrained optimization. Describe the theory of constraints, and explain how it can be used to manage inventory.

58 57 Managing Inventories Inventory Average Inventory Weeks Inventory, thousands of bricks 60 30

59 58 The Appropriate Inventory Policy Two Basic Questions Must be Addressed n How much should be ordered or produced? n When should the order be placed or the setup be performed?

60 59 Inventories As the firm increases its order size, the number of orders falls and therefore the order costs decline. However, an increase in order size also increases the average amount in inventory, so that the carrying cost of inventory rises. The trick is to strike a balance between these two costs.

61 60 Ordering or Setup Costs Carrying Costs Stockout Costs Inventory Costs Basics of Traditional Inventory Management

62 61 Inventory Costs 1.Ordering Costs: The costs of placing and receiving an order Examples: clerical costs, documents, insurance for shipment, and unloading. 2.Carrying Costs: The costs of carrying inventory Examples: insurance, inventory taxes, obsolescence, opportunity cost of capital tied up in inventory, and storage.

63 62 Inventory Costs (continued) 3.Stock-Out Costs: The costs of not having sufficient inventory Examples:lost sales, costs of expediting (extra setup, transportation, etc.) and the costs of interrupted production. 4.Setup Costs: The costs of preparing equipment and facilities so they can be used to produce a particular product or component Examples: setup labor, lost income (from idled facilities), and test runs. When a firm produces the goods internally, ordering costs are replaced by setup costs.

64 63 Traditional Reasons for Carrying Inventory 1.To balance ordering or setup costs and carrying costs 2.To satisfy customer demand (e.g., meet delivery dates) 3.To avoid shutting down manufacturing facilities because of: a.machine failure b.defective parts c.unavailable parts d.late delivery of parts

65 64 Traditional Reasons for Carrying Inventory (continued) 4.Unreliable production processes 5.To take advantage of discounts 6.To hedge against future price increases

66 65 Inventories Determination of optimal order size Inventory costs, dollars Order size Total costs Carrying costs Total order costs Optimal order size

67 66 Total Costs = Ordering costs + Carrying cost TC = PD/Q + CQ/2 whereTC =The total ordering (or setup) and carrying cost P =The cost of placing and receiving an order (or the cost of setting up a production run) Q =The number of units ordered each time an order is placed (or the lot size for production) D =The known annual demand C =The cost of carrying one unit of stock for one year Economic order quantity (EOQ) = 2PD/C An Inventory Model

68 67 Inventories Economic Order Quantity - Order size that minimizes total inventory costs.

69 68 Economic-Order-Quantity Decision Model The formula for the EOQ model is: EOQ = D = Demand in units for a specified time period P = Relevant ordering costs per purchase order C = Relevant carrying costs of one unit in stock for the time period used for D

70 69 An EOQ Illustration EOQ = 2PD/C D = 1,000 units Q = 500 units P = $200 per order C = $40 per unit EOQ = (2 x 200 x 10,000) / 40 EOQ = 10,000 EOQ = 100 units

71 70 Economic-Order-Quantity Decision Model What are the relevant total costs? The formula for relevant total costs (RTC) is: RTC = Annual relevant ordering costs + Annual relevant carrying costs RTC = ( ) × P + ( ) × C = + Q can be any order quantity, not just EOQ. DQDQ Q2Q2 DP Q QC 2

72 71 Economic-Order-Quantity Decision Model Relevant Total Costs (Dollars) 2,000 4,000 6,000 8,000 10,000 5, ,2001,8002, EOQ Annual relevant carrying costs Annual relevant total costs Annual relevant ordering costs Order Quantity (Units)

73 72 Considerations in Obtaining Estimates of Relevant Costs Obtaining accurate estimates of the cost parameters used in the EOQ decision model is a challenging task. What are the relevant incremental costs of carrying inventory? –Only those costs of the purchasing company that change with the quantity of inventory held

74 73 Considerations in Obtaining Estimates of Relevant Costs What is the relevant opportunity cost of capital? –It is the return forgone by investing capital in inventory rather than elsewhere. –It is calculated as the required rate of return multiplied by those costs per unit that vary with the number of units purchased and that are incurred at the time the units are received.

75 74 Costs Associated with Goods for Sale Five categories of costs associated with goods for sale are: 1. Purchasing costs 2. Ordering costs 3. Carrying costs 4. Stockout costs 5. Quality costs

76 75 Reorder Point When Demand is Certain Reorder point = Rate of usage x Lead time Example: Assume that the average rate of usage is 4 units per day for a component. Assume also that the time required to place and receive an order is 10 days. What is the reorder point? Reorder point = 4 x 10 = 40 units Thus, an order should be placed when inventory drops to 40 units.

77 76 Reorder Point When Demand is Uncertain Reorder point = (Ave. rate of usage x Lead time) + Safety stock where: Safety stock = (Maximum usage - Average usage) x Lead time

78 77 Reorder Point (continued) Example: Suppose that the maximum usage is 6 units per day and the average usage is 4 units per day. The lead time is 10 days. What is the reorder point? Safety stock=(6 - 4) x 10 = 20 units Reorder point=(4 x 10) + 20 = 60 units

79 78 Reorder Point Weeks Reorder Point Lead Time 2 weeks

80 79 Reorder Point (no safety stock) Reorder point = Rate of usage x Lead time Time ROP

81 80 Safety Stock Safety stock is inventory held at all times regardless of the quantity of inventory ordered using the EOQ model. Safety stock is used as a buffer against unexpected increases in demand or lead time and unavailability of stock from suppliers.

82 81 Evaluating Managers and Goal- Congruence Issues Goal-congruence issues can arise when there is an inconsistency between the EOQ decision model and the model used to evaluate the performance of the manager implementing the inventory management decisions.

83 82 Traditional versus JIT Inventory Procedures Inventory Control System 1.Balance setup and carrying costs 2.Satisfy customer demand 3. Avoid manufacturing shutdowns 4. Take advantage of discounts 5. Hedge against future price increases 1. Drive setup and carrying costs to zero 2. Use due-date performance *3. Total preventive maintenance *4. Total quality control *5. The Kanban system Traditional SystemsJIT Systems *Rather than holding inventories as a hedge against plant-shutdowns, JIT attacks the plant-shutdown problem by addressing these issues.

84 83 Just-In-Time Production Systems Just-in-time (JIT) production systems take ademand pull approach in which goods are only manufactured to satisfy customer orders. Demand triggers each step of the production process, starting with customer demand for a finished product at the end of the process, to the demand for direct materials at the beginning of the process.

85 84 Materials Requirement Planning (MRP) Materials requirements planning (MRP) systems take a push-through approach that manufactures finished goods for inventory on the basis of demand forecasts. MRP predetermines the necessary outputs at each stage of production. Inventory management is a key challenge in an MRP system.

86 85 JIT And Inventory Management Setup and Carrying Costs: The JIT Approach JIT reduces the costs of acquiring inventory to insignificant levels by: 1. Drastically reducing setup time 2. Using long-term contracts for outside purchases Carrying costs are reduced to insignificant levels by reducing inventories to insignificant levels

87 86 JIT And Inventory Management Due-Date Performance: The JIT Solution Lead times are reduced so that the company can meet requested delivery dates and to respond quickly to customer demand. Lead times are reduced by: – reducing setup times – improving quality – using cellular manufacturing

88 87 JIT And Inventory Management Avoidance of Shutdown: The JIT Approach Total preventive maintenance to reduce machine failures Total quality control to reduce defective parts Cultivation of supplier relationships to ensure availability of quality raw materials and subassemblies The use of the Kanban system is also essential

89 88 JIT And Inventory Management Discounts and Price Increases: JIT Purchasing Versus Holding Inventories Careful vendor selection Long-term contracts with vendors – Prices are stipulated (usually producing a significant savings) – Quality is stipulated – The number of orders placed are reduced

90 89 Major Features of a JIT System The five major features of a JIT system are: Organizing production in manufacturing cells Hiring and retaining multi-skilled workers Emphasizing total quality management Reducing manufacturing lead time and setup Time Building strong supplier relationships

91 90 Benefits of JIT Systems Benefits of JIT production: –Lower carrying costs of inventory –Eliminating the root causes of rework, scrap, waste, and manufacturing lead time.

92 91 Performance Measures and Control in JIT Production To manage and reduce inventories, the management accountant must design performance measures to control and evaluate JIT production. What information may management accountants use? – Personal observation by production line workers and managers – Financial performance measures, such as inventory turnover ratios

93 92 Performance Measures and Control in JIT Production What are nonfinancial performance measures of time, inventory, and quality? – Manufacturing lead time – Units produced per hour – Days inventory on hand – Total setup time for machines/Total manufacturing time – Number of units requiring rework or scrap/Total number of units started and completed

94 93 Backflush Costing A unique production system such as JIT often leads to its own unique costing system. Organizing manufacturing in cells, reducing defects and manufacturing lead time, and ensuring timely delivery of materials enables purchasing, production, and sales to occur in quick succession with minimal inventories.

95 94 Backflush Costing Where journal entries for one or more stages in the cycle are omitted, the journal entries for a subsequent stage use normal or standard costs to work backward to flush out the costs in the cycle for which journal entries were not made.

96 95 Trigger Points Stage A: Purchase of direct materials Stage B: Production resulting in work in process Stage C: Completion of a good finished unit or product Stage D: Sale of finished goods

97 96 Trigger Points Assume trigger points A, C, and D. This company would have two inventory accounts: Type Account Title 1. Combined materialsInventory: Material and materials in work-in-and In-Process process inventoryControl 2. Finished goodsFinished Goods Control

98 97 Trigger Points Assume trigger points A and D. This company would have one inventory account: Type Account Title Combines direct materials Inventory inventory and any direct Control materials in work-in-process and finished goods inventories

99 98 Special Considerations in Backflush Costing Backflush costing does not necessarily comply with GAAP – However, inventory levels may be immaterial, negating the necessity for compliance Backflush costing does not leave a good audit trail – the ability of the accounting system to pinpoint the uses of resources at each step of the production process

100 99 What is the Kanban System? A Card System is used to monitor work-in- process A withdrawal Kanban A production Kanban A vendor Kanban

101 100 The Withdrawal Kanban Item No. TVD-114 Preceding Process Item Name LCD Screen Computer Assembly Computer Type Compaq 4/25 Box Capacity 12 Subsequent Process Box Type AD-1942 Final Assembly

102 101 The Production Kanban Item No. TVD-114 Process Item Name LCD Screen Computer Assembly Computer Type Compaq 4/25 Box Capacity 12 Box Type ___AD-1942

103 102 The Vendor Kanban Item No. TVD-114 Name of Receiving Company Item Name Computer Chassis Type Black Plastic Box Capacity 12 Box Type Cardboard--Type Receiving Gate North Receiving Gate Time to Deliver 8:30 A.M., 12:30 P.M., 2:30 P.M. Name of Vendor Hovey Supply Company

104 103 The Kanban Process Withdrawal Store LCD Screen Withdrawal Lot with P-Kanban Production Ordering Post (6) Signal LCD Assembly Remove (4) P-Kanban Attach to Post (5) Attach W-Kanban (1) Remove W-Kanban Attach to Post Withdrawal Post (2), (3) (7) Final Assembly (1)

105 104 Multiple Constrained Resource To the Thurman Company example for a one constrained resource, add the following additional constraint: the market limits sales of the economy disk player to 3,000 units. Formulate the linear programming problem and solve using the graphical method Let X 1 = deluxe models and X 2 = economy models Formulation:Max CM = 40X X 2 Subject to:4X + 2X 2 < 20,000 X 2 < 3,000

106 105 Multiple Constrained Resource (continued) 10,000 3,000 A 5,000 DC B X X 4X +2X < 20,000 X < 3,

107 106 Multiple Constrained Resource (continued) Corner PointX 1 X 2 CM = 40X X 2 A000 B5,0000$200,000 C*3,5003,000$215,000 D03,000$75,000 * Point C is optimal The X 1 value of point c is found by substituting the second equation into the first one like so: $X (3,000) = 20,000 4X 1 + 6,000 = 20,000 4X 1 =14,000 X 1 = 3,500

108 107 Throughput Inventory Operating expenses Three Measures of Systems Performance Theory of Constraints

109 108 The Theory of Constraints (continued) Five steps to improve performance: 1. Identify an organizations constraints. 2. Exploit the binding constraints. 3. Subordinate everything else to the decisions made in Step Elevate the organizations binding constraints. 5. Repeat the process as a new constraint emerges to limit output.

110 109 Theory of Constraints A sequential process of identifying and removing constraints in a system. Restrictions or barriers that impede progress toward an objective

111 110 Theory of Constraints The theory of constraints emphasizes the management of bottlenecks as the key to improving the performance of the production system as a whole.

112 111 Methods to Relieve Bottlenecks Eliminate idle time at the bottleneck operation Process only those parts or products that increase throughput contribution, not parts or products that will remain in finished goods or spare parts inventories Shift products that do not have to be made on the bottleneck operation to nonbottleneck processes, or to outside processing facilities

113 112 Methods to Relieve Bottlenecks Reduce setup time and processing time at bottleneck operations Improve the quality of parts or products manufactured at the bottleneck operation

114 113 Theory of Constraints The objective of TOC is to increase throughput contribution while decreasing investments and operating costs. TOC considers a short-run time horizon and assumes operating costs to be fixed costs.

115 114 The Drum-Buffer-Rope System Initial Process Process A Process B Drummer Process Raw Materials Process C Final Process Rope Time Buffer Finished Goods

116 115 The Management of Capacity Managers can reduce capacity-based fixed costs by measuring and managing unused capacity Unused Capacity is the amount of productive capacity available over and above the productive capacity employed to meet consumer demand in the current period

117 116 Analysis of Unused Capacity Two Important Features: 1.Engineered Costs result from a cause-and-effect relationship between output and the resources used to produce that output 2.Discretionary Costs have two parts: 1.They arise from periodic (annual) decisions regarding the maximum amount to be incurred 2.They have no measurable cause-and-effect relationship between output and resources used

118 117 Managing Unused Capacity Downsizing (Rightsizing) is an integrated approach of configuring processes, products, and people to match costs to the activities that need to be performed to operate effectively and efficiently in the present and future Because identifying unused capacity for discretionary costs is difficult, downsizing, or otherwise managing this unused capacity, is also difficult.

119 118 End of Week


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