Cram Session Part 1 Jim Clemons, CMA. Cost Management Terminology Financial Accounting – Reporting to external users – Financial statements – Historical.

Cram Session Part 1 Jim Clemons, CMA

Cost Management Terminology Financial Accounting – Reporting to external users – Financial statements – Historical focus Management Accounting – Reporting to internal users – Improve organizational decision making – Future focus Cost Accounting – Supports both financial and management accounting “Information about the cost of resources acquired and consumed by an organization underlies effective reporting for both internal and external users”. 2

Cost Management Terminology IMA Definition of Cost Management Accounting: Measurement in monetary terms of the amount of resources used for some purpose. The term by itself is not operational. It becomes operational when modified by a term that defines the purpose, such as acquisition cost, incremental cost, or fixed cost. 3

Cost Management Terminology Cost Object – Entity to which costs can be attached – Examples: Products Processes Employees Departments Facilities 4

Cost Management Terminology Manufacturing v. Nonmanufacturing – Direct materials – Direct labor – Manufacturing overhead Indirect materials – Tangible inputs unable to trace Indirect labor – Labor that cannot be traced Factory operating costs – Utilities, real estate taxes, insurance, depreciation 5

Cost Management Terminology Manufacturing Costs Prime cost – Direct materials + direct labor – Costs attributable to the product Conversion cost – Direct labor + manufacturing overhead – Costs of converting raw materials into finished product 6

Cost Management Terminology Nonmanufacturing Costs Selling (Marketing) expenses – How much to get the product to the consumer – Sales Personnel Salaries Expensive dinners Fancy sporting events Morale boosting trips to exotic locations – Product Transportation Administrative Expenses Other costs not related to producing or marketing the product Adrien’s salary Adrien’s expensive dinners Fancy sporting events for Adrien to attend Trips to exotic locations to boost Adrien’s morale 7

Cost Management Terminology Product v. Period To capitalize or to expense? – Product Costs – Capitalized as part of finished goods inventory. Become component of cost of goods sold Period Costs – Expensed as incurred – Not capitalized and excluded from cost of goods sold 8

Cost Management Terminology Distinction between product costs and period costs important for external reporting purposes. – GAAP All manufacturing costs must be treated as product costs, and all selling and administrative costs must be treated as period costs. ABSORPTION COSTING – Internal Reporting Capitalize only variable manufacturing costs as product costs, treat all other costs (variable S&A and the fixed portion of both production and S&A expenses) as period costs. VARIABLE COSTING 9

Cost Management Terminology Direct Costs - Can be TRACED Direct materials Direct Labor Indirect Costs - Cannot be associated with a particular cost objective Indirect materials Indirect labor 10

Cost Management Terminology Indirect costs collected in cost pools Cost Pool – Account where similar cost elements are accumulated Example - Manufacturing Overhead 11

Cost Management Terminology Common Costs Indirect cost Shared by two or more users Rationally allocated Examples: Depreciation for HQ building Allocated amongst departments 12

Cost Management Terminology Practice Question 1 A firm calculates that its annual cost to hold excess goods in order to avoid any chance of running out of inventory is $50,000. This $50,000 is an example of a APrime cost. BQuality cost. CCarrying cost. DStockout cost. 13

Cost Management Terminology Practice Question 1 Answer Correct Answer: C The costs of holding or storing inventory are carrying costs. Examples include the costs of capital, insurance, warehousing, breakage, and obsolescence. 14

Cost Behavior and Relevant Range Relevant Range – Limits within which per-unit variable cost remain constant and fixed cost are not changeable. – “In the short-run” (All costs are considered variable in the long-run) – “The efficiency of a company’s current manufacturing plant” “Cost behavior and estimates are valid only within a relevant range, or the normal level of operating activity. Beyond the relevant range, cost relationships are likely to change, and with them, cost estimates”. Ask yourself – “How wide is the relevant range of activity? When does the company leave one relevant range and enter another one with a different cost function? The answer is company specific, and greatly affects the cost estimates used in decision making.” 15

Cost Behavior and Relevant Range Types of Costs and their characteristics Variable cost – Total cost varies in proportion to changes in the level of activity – The cost per unit remains constant, regardless of the level of activity 16

Exhibit 1 - Variable Cost 17

Cost Behavior and Relevant Range Types of Costs and their characteristics Fixed cost – Total cost remains fixed, regardless of changes in the level of activity. – The cost per unit varies inversely with changes in the level of activity. 18

Exhibit 2 – Fixed Cost 19

Cost Behavior and Relevant Range Types of Costs and their characteristics Mixed or semivariable cost – Have both a fixed and variable component. – Both the total cost and unit cost will vary changes in the level of activity. Two methods of estimating mixed: – Regression or scattergraph method – more complex, usually applied using computers and not tested on the exam. – High-low method – less accurate, but quicker. Cost at highest activity level – Cost at lowest activity level Driver at highest activity level – Driver at lowest activity level What is a driver? Machine Hours for examples 20

Exhibit 3 - Mixed Cost High-Low Method Example High Month: May Low Month: July Numerator: $3,400 -$1,900 = $1,500 Denominator: 1,600 –800 = 800 hours Variable Costs: $1,500 / 800 = $1.875 per hour Fixed Costs: $1,900 –(800 x $1.875) = $400 21

Exhibit 3 - Mixed Cost 22

Cost Behavior and Relevant Range Types of Costs and their characteristics (continued) Four of the five cost are linear-costs which change at a constant rate (or remain unchanged) over the short run Fixed cost per unit is an example of a nonlinear-cost function. Another type of nonlinear-cost is a step-cost function. Step cost – Total cost remain constant over the. – Unit cost decrease a usage within the step range. 23

Exhibit 4 – Step Cost 24

Cost Behavior and Relevant Range Types of Costs and their characteristics (continued) Linear vs. Nonlinear Cost Functions – Fixed cost per unit and step cost have non-linear-cost functions – Fixed costs Has asymptotic ( linear asymptote is not parallel to the x- or y-axis, it is called an oblique asymptote or slant asymptote ) character – it will never intersect the X-axis. – Step cost – if steps are relatively narrow, cost are usually treated as variable, but if steps are wide they more similar to fixed costs. 25

Question #1 Ace, Inc. estimates its total materials handling costs at two production levels as follows: CostGallons $160,00080,000 $132,00060,000 What is the estimated total cost for handling 75,000 gallons? (Hint: High/Low Method) 26

Question #3 (continued) 1.Numerator: $160k -$132k = $28k 2.Denominator: 80k gallons –60k gallons = 20k 3.Variable Costs: $28k / 20k gallons = $1.40 per gallon 4.Fixed Costs = Total Cost –Variable Portion $160k –(80k x $1.40) = $48k 5.$48k + (75k x $1.40) = $153,000 27

Cost Behavior and Relevant Range Types of Costs and their characteristics (continued) Relevant Range and Marginal Cost (MC) – Marginal cost is the cost incurred by a one- unit increase in the activity level of a particular cost driver. – Similar to variable cost in the relevant range it stays constant across the relevant range. 28

Which one of the following categories of cost is most likely not considered a component of fixed factory overhead? A.Rent. B.Property taxes. C.Depreciation. D.Power. Cost Behavior and Relevant Range Practice Question 1 29

Cost Behavior and Relevant Range Practice Question 1 Answer Correct Answer: D A fixed cost is one that remains unchanged within the relevant range for a given period despite fluctuations in activity. Such items as rent, property taxes, depreciation, and supervisory salaries are normally fixed costs because they do not vary with changes in production. Power costs, however, are at least partially variable because they increase as usage increases. Incorrect Answers: A: Rent is an example of fixed factory overhead. B: Property taxes are an example of fixed factory overhead. C: Depreciation is an example of fixed factory overhead. 30

Cost of Goods Calculations Cost of Goods Sold – Beginning Balance + Purchases (Costs added during the period) = available – Ending = Used – OrBeginning Balance + Purchases (Costs added during the period) - Costs removed during the period = Ending balance – Straight forward for a retailer but more complex for a manufacturers since they have three distinct classes of inventory: Raw material Work in Process Inventory Finished Goods Inventory 31

Exhibit 5 – Mfg. Cost flow 32

Cost of Goods Calculations Remember: Total manufacturing cost are calculated on a separate statement called a cost of Goods Manufacturing Statement (or Manufacturing Statement, which compiles three major elements of manufacturing costs: New Material Direct Labor Factory overhead Calculations through cost of goods manufactured are found on the Manufacturing Statement. The total and the remainder are found on the income statement. 33

Cost Classifications Controllable VS. Noncontrollable Avoidable Vs. Committed Incremental vs. Differential Engineered s. Discretionary Outlays vs. Opportunity Relevant vs. Sunk 34

Cost Classifications Joined vs. Separable Normal vs. Abnormal Spoilage Rework, Scrap, and Waste Other – Carrying costs – Transferred-in costs – Value-adding costs Manufacturing Capacity – Normal capacity – Practical capacity – Theoretical (ideal) capacity 35

Cost Classifications Practice Question 1 In joint-product costing and analysis, which one of the following costs is relevant when deciding the point at which a product should be sold to maximize profits? A.Separable costs after the split-off point. B.Joint costs to the split-off point. C. Sales salaries for the period when the units were produced. D. Purchase costs of the materials required for the joint products. 36

Cost Classifications Practice Question 1 Answer Correct Answer: A Joint products are created from processing a common input. Joint costs are incurred prior to the split- off point and cannot be identified with a particular joint product. As a result, joint costs are irrelevant to the timing of sale. However, separable costs incurred after the split-off point are relevant because, if incremental revenues exceed the separable costs, products should be processed further, not sold at the split-off point. Incorrect Answers: B: Joint costs have no effect on the decision as to when to sell a product. C: Sales salaries for the production period do not affect the decision. D: Purchase costs are joint costs. 37

Costing Techniques Absorption vs. Variable Costing – Need to understand: Under absorption costing, which costs are considered product costs and which are considered period costs? Under variable costing, which costs are considered products and which are considered period costs? When is income under variable costing higher than income under absorption costing? What formula can be used to calculate the difference between income under variable costing and income under absorption costing? What managerial behavior does variable costing render ineffective? 38

Costing Techniques Absorption vs. Variable Costing (continued) Absorption costing – Also called full costing treats all manufacturing costs as product costs. – Inventoried cost of the product thus includes all prodcution costs, fixed and variable. Required by GAAP. – Gross Margin (gross profit) = Sales revenue and absorption cost of COGS, and covers S, G & A. 39

Costing Techniques Absorption vs. Variable Costing (continued) Variable costing – Also called direct costing considers only variable manufacturing cost as product cost. – Fixed cost are period costs and expensed as incurred. – Simple and easy to calculate. First consideration in determining whether product should be manufactured (does it cover variable production costs). – Contribution margin = net sales revenue minus all variable costs (mfg. & S, G & A). “Contributions toward covering fixed costs”. 40

Costing Techniques Practice Question 1 Which one of the following considers the impact of fixed overhead costs? A.Full absorption costing. B.Marginal costing. C.Direct costing. D.Variable costing. 41

Costing Techniques Practice Question 1 Answer Correct Answer: A Full absorption costing treats fixed factory overhead costs as product costs. Thus, inventory and cost of goods sold include (absorb) fixed factory overhead. Incorrect Answers: B: Marginal costing considers only the incremental costs of producing an additional unit of product. In most cases marginal costs are variable costs. C: Direct (variable) costing treats only variable costs as product costs. D: Direct (variable) costing treats only variable costs as product costs. 42

Overview Cost accounting systems record manufacturing activities using a perpetual inventory system, which continuously update records for cost of materials, goods in process and finished goods inventory. Cost accounting systems accumulate cost and then assign them to products and services. The two basic types of cost accounting systems are job order cost accounting and process cost accounting. 43

Job Costing When companies produce customized products that are separately manufactured, the production is called job order productions or job order manufacturing (also called customized production, which is the production of products in response to special orders). Production activities for a customized product represent a job, which can apply to manufacturing or service companies. 44

Job Costing “A major aim of a job order cost accounting system is to determine the cost of producing each job or job lot, the system also aims to compute the cost per unit” Required: Separate records for each job to accomplish this. 45

Job Costing Steps in Job-Order Costing Receipt of a sales order Predict the cost to complete the job – depends on product design Negotiate price and decide whether to pursue the job – Cost-plus contracts – Customer pays the mfg. for cost incurred on the job plus a negotiated amount or rate of profit – Market factor prices – Target cost Sales order is approved and production order is issued Cost are recorded by classification – Direct Material – Direct Labor – Manufacturing Overhead – Charged is charged using an estimated rate. Remember overhead costs support production of more than one job, and include depreciation, factory supplies, supervision, maintenance, cleaning and utilities. 46

Job Costing Target Costing: Many producers determine a target cost for their jobs. Target cost is determined as follows: Expected selling price – Desired profit = Target Cost If the projected target cost of the job as determined by job costing is too high, the producer can apply value engineering, which is a method of determining ways to reduce job cost until the target cost is met. 47

Job Costing Job Cost Sheet – General ledger accounts usually do not provide the accounting information that managers of job order operations need to plan and control production activities. – Subsidiary records store information about raw materials, overhead costs, jobs in process, finished goods, and other items. – Jobs cost sheets are separate records maintained for each job. It identifies: Customer Job Number Product Key Dates Continued 48

Job Costing – Any costs incurred on the job are immediately recorded on this sheet. – When each job is complete, the supervisor enters the date of completion and records any remarks. – Factory overhead is also allocated (also termed applied, assigned or charged). Factory overhead consists of cost (other than direct materials and direct labor) that ensure the production activities are carried out. 49

Job Costing As a job is being produced, its accumulated cost are kept in Good in Process Inventory. The summation of all cost sheets makes up a subsidiary ledger controlled by the Goods in Process Inventory account in the general ledger. 50

Job Costing Cost Flows: During Production – While a job is being produced, its accumulated costs are kept in Goods in Processed Inventory. The collection of job cost sheets for all jobs in process makes up a subsidiary ledger controlled by the Goods in Process Inventory account in the general ledger. Managers use job cost sheets to monitor costs incurred to date and to predict and control cost for each job. Cost Flow: Job completion – When a job is finished, its job cost sheet is completed and moved from the jobs in process file to the jobs file. This latter file acts as a subsidiary ledger controlled by the Finished Goods Inventory Account. Cost Flows: Job Delivery – When a finished job is delivered to a customer, the job cost sheet is moved to a permanent file supporting the total cost of goods sold. This permanent file contains records from both current and prior periods. 51

Job Costing Material Ledger Cards (files) are perpetual records that are updated each time units are purchased and each time units are issued for use in production. When materials are needed in production, a production manager prepares a material requisition and sends it to the materials manager. 52

Job Costing Labor cost from Factory Payroll account flow to the subsidiary records of the job order cost accounting system. Factory Payroll and Factory Overhead should be considered temporary accounts, which hold various expenses until they are allocated to balance sheep or income statements accounts. 53

Job Costing Factory overhead includes all production costs other than direct materials and direct labor, such as indirect material and indirect labor. They are recorded to the Factory Overhead Control account, and ultimately to the job cost sheets via an allocations. 54

Job Costing Overhead Allocation Bases – Usually based on factors of productions like direct labor or machine hours. – Correct allocation is important and affects accuracy. Overhead Allocation Rates – Predetermined Overhead rate or predetermined overhead allocation (or application) rate. The predetermined overhead rate is computed at the start of the period and is used throughout the period to allocate overhead to jobs. 55

Job Costing Overhead cost are “applied” to (or absorbed” by) each job based on a predetermined overhead application rate for the year. Three step process: 1.Estimate total overhead for the year 2.Divide total overhead by allocation base 3.Apply based on number of allocation base units used per job 56

Job Costing At the end of the period, the overhead control and applied accounts are netted. – If the results (balance) in the overhead control account is a credit, then overhead was overapplied. Actual overhead < applied = Overapplied Continued 57

Job Costing – If the results (balance) in the overhead control account is a debit, the overhead was underapplied. Actual overhead > applied = Underapplied overhead The closer a estimate is to actuals in absolute terms the better the estimates was 58

Job Costing – If the variance is immaterial (with respect to the company), it can be closed (charged off to) cost of goods sold. – If the variance is material, it should be allocated based on the relative “weights” of work in process, finished goods and cost of goods sold. It is important that you and understand the “meaning” of over/under applied with respect to net income and actual job cost. 59

Job Costing Spoilage – Output that does not meet the quality standards for salability is considered spoilage. That amount that is expected is considered normal spoilage in which case it is included as product costs. Spoilage that is over or above normal is considered abnormal and treated as period cost. 60

Job Costing Remember! You are expected to understand the proper accounting for normal and abnormal spoilage under both job- order and process costing: – In job-order costing, normal spoilage is treated as a product cost while abnormal spoilage is treated as a period cost. – Consider what: System is being used, and Whether the product can be sold or not 61

Activity-Based Costing “Activity-based costing (ABC) is a response to the significant increase in the incurrence of indirect costs resulting from the rapid advance of technology” ABC may be used by manufacturing, service, or retailing entities. 62

Activity-based costing Under traditional costing system: OH is simply dumped into a single cost pool Under ABC, indirect costs are attached to activities and then rationally allocated ABC may be used by manufacturing service or retailing 63

Traditional Costing System Peanut-butter costing = product-cost cross-subsidization  inaccurate allocation of indirect costs over products or service units DL + DM are traced to products/services A single pool of indirect costs is allocated based on a single rate (overhead) Indirect costs from the pool are assigned using an allocative (rather than a tracing) procedure, such as using a “single” overhead rate for an entire department. How much resources did I use to product X? 64

Steps in ABC process 1)Activity Analysis: understand the different steps and process from DM to Finished Goods 2)Assign Resource Costs to Activities: first-stage allocation. Identify resource costs: a separate Accounting System may be necessary to track resource costs separately from the GL. Then we need to define resource drivers to allocate it. 3)Allocate Activity Cost Pools to Cost Objects: allocating the activity cost pools to final cost objects = second- stage allocation  What are my activity drivers? 65

Cost Drivers Cause-&-effect relationship Cost object may be a job, product, process, activity, service or anything else for which a cost measure is desired Process value analysis: Organization flow – Value-adding Vs. Non Value-adding – Product costing / continuous improvement ABC used to obtain full-absorption cost (US GAAP) 66

Process Costing Process costing is used in Process Operations, also called process manufacturing or process production, is the mass production of products in a continuous flow of steps. “Products pass through a series of sequential processes” Can you think of any examples? 67

Process Costing Process operations can also extend to services, i.e. mail sorting. Common feature of Process Operations is that it is “sequential” using a series of standardized processes. Series of processes = series of steps 68

Process Costing Understanding processes for companies with process operations is crucial for measuring their costs. Job order costing system the focus is on the individual job or batch. In process costing system focus is on the process itself and the standardized units produced. 69

Process Costing In process operations, each process is identified as a separate production department, workstation, or work center. Every subsequent department, workstation, etc. receives the output of the previous “step” (and is cumulative of all preceding) 70

Process Costing Additional cost added at each “step” can be – Direct Material – Direct Labor – Overhead (labor, material and other) – The last “step” produces the finished goods – Output of one department becomes the input of another department, as is the case with sequential processing – costs transfer with those units from the prior “step” 71

Process Costing Because of the machine-intensive nature of process costing, direct labor tends to form a smaller proportion of overall costs than under job-order costing. Cost accounting under process costing sometimes combines direct labor and manufacturing overhead and treats them as conversion costs. 72

Process Costing Equivalent Units! If a process has no beginning and no ending goods in process inventory, then the unit cost of goods transferred out of a process is: Total cost assigned to the process (direct material, direct labor, and overhead) Total number of units started and finished in the period 73

Process Costing If a process has a beginning or ending inventory of partially processed units (or both), then the total cost assigned to the process must be allocated to all completed and incomplete units worked on during the period. Therefore, the denominator must measure the entire production activity of the process for the period, called equivalent units of production (or EUP). EUP = the number of units that could have started and completed given the cost incurred during a period. 74

Process Costing The goal is to compute the cost per equivalent unit and to assign costs to finished goods and goods in process inventory. What complicates calculations is that material, labor and overhead sometimes are added in unequal increments over the process “steps”. Remember: – First equivalent units are determined and then per-unit cost are calculated. 75

Process Costing Two methods of calculating EUP (both are tested on the exam!) – Weighted-average method – units in beginning work-in- process inventory are treated as if they were started and completed during the current period. – First-in, first-out method – units in beginning work-in- process inventory are part of the EUP calculation. The calculation is thus more complex than weighted-average but tends to be more accurate. 76

Life-cycle costing Estimate revenues & expenses Over the entire sales life cycle Upstream costs (R&D, Design) Manufacturing Downstream costs (Mktg & Distribution, Customer Service)  Great value for Pricing Decision 77

Life-cycle costing Potential Benefits Relationships among costs incurred at different value-chain stages Incurring costs vs. locking in costs (SUNK) Focus on cost control Vs. cost reduction After-purchase costs (operating, support, repair, disposal…) Life-cycle and whole-life cycle  target costing Value engineering: minimize cost without reducing customer satisfaction 78

Life-cycle costing Life-Cycle vs. Other Costing Methods Traditional approaches: – Focus on cost control as opposed cost reduction. – Treat pre- and postproduction costs as period costs largely ignored in determining profitability. – After purchase costs are ignored. Continued 79

Absorption versus Variable Costing You need to be able to answer the following: – Under absorption costing, which cost are considered product cost? Which costs are considered period cost? – In the variable costing, which costs are considered product cost? Which costs are considered period cost? – What income statement format is appropriate for variable cost? – When is income of the variable costing higher than income and absorption costing? – What format can be used to calculate the difference between income under variable costing and income and absorption costing? – What managerial behavior does variable costs were render ineffective?

Absorption and Variable Costing Theory Overview Product cost consist of all the costs incurred the production of a product: direct materials, direct labor, and manufacturing overhead. The process to classified all these costs as part of product costs is referred to as absorption costing (or full costing). Absorption costing is the cost accumulation method required by generally accepted accounting principles (GAAP) for external reporting, and by regulatory body such as the Internal Revenue Service. continued

Absorption and Variable Costing Theory Overview The main reason is that absorption costing satisfies the matching principle, which states that expenses should be matched with revenues they generate. Based on the matching principle, our product cost flow through raw materials inventory, work in process inventory, and finished goods inventory until the goods are sold.

Absorption and Variable Costing Theory Overview One thing you have to ask yourself is, if inventory unit costs combined variable cost (typically direct materials, direct labor, and overhead) with fixed cost (typically overhead), how can managers make sound decisions? One way is to use variable costing (or direct costing) in which only variable product costs are accumulated in the inventory accounts. In variable costing, fixed manufacturing overhead is treated as a period expense rather than product cost, meaning it is expensed in the period in which it is incurred.

Absorption and Variable Costing Theory Overview The main advantage other variable costing method is that income cannot be manipulated by management action, whereas management can manipulated income when using absorption method.

Absorption Costing Sales - Product Costs (incl. fixed and variable) = Gross Margin - Total S, G & A (fixed and Variable)

Variable Costing Sales - Product Cost (only variable cost) = Contribution Margin (portion available to cover fixed costs -Fixed Costs (both mfg. and S, G & A) -Under variable costing, fixed overhead is considered a cost of maintaining capacity, not a cost of producing a product. -Contribution margin will tell you if you are covering at least the direct product costs

Absorption and Variable Costing Theory Impact on Operating Income – Produced = Sold = no difference in income – Produced > Sold > income When production exceeds sales, fewer fixed cost are expensed under the absorption basis, and operating income always increases. A production manager can thus increase absorption-based operating income by increasing production, whether there is any customer demand for the additional product or not. This practice, called producing for inventory, can be effectively discouraged by using variable costing for performance reporting and consequent bonus calculation.

Absorption and Variable Costing Theory – Produced < Sold < income Variable costing will show a higher income in periods when inventories decline because absorption method forces the subtraction of all of the current fixed costs, plus some fixed costs incurred (and capitalized) in prior periods. Most importantly, in using variable costing, profits always move in the same direction as sales volume. Profits reported on absorption costing behave erratically and sometimes move in the opposite direction from sales trends.

Absorption and Variable Costing Theory Other benefits of variable costing: – Variable costing is better suited for management's needs which requires a knowledge of cost behavior under various operating conditions. For planning and control, management is more concerned with treating fixed and variable costs separately than with calculating full cost. – Full costs are usually dubious value because they contain arbitrary allocation of fixed cost. – The production manager cannot manipulate income levels over overproducing. continued

Absorption and Variable Costing Theory The cost data for profit planning and decision-making are readily available from accounting records and statements under variable costing. For example cost profit relationships and the effects of changes in sales volume on that income can easily be computed from income statement prepared under the variable costing concept, but not from the conventional absorption costing income statement based on the same data. Absorption cost income statements may show decreases in profits from sales and rising and increases in profits from sales or decreasing, which may be confusing to management. A favorable margin in the variable costing justifies a higher production level. Variable costing is also preferred over absorption costing for studies of relative profitability of products, territories, and other segments of a business. A concentrate on the contribution of each segment makes to the recovery of fixed costs that will not be altered by decisions to make and sell. continued

Absorption and Variable Costing Theory Inventory changes have no effect on the breakeven computation. Disinvestment decisions are facilitated because were their product or department is recouping its variable cost can be determined. If the variable costs are being covered operating a department at apparent loss may be profitable. Cost figures are guided by the sales figures. Under variable costing cost of goods sold very directly with sales volume, and the influence of production of gross profit is avoided. There will costing also eliminates a possible difficulties have explain over and under applied factory overhead to higher management.

Joint Product and By-Product Joint processing and the split off point – Joint (common) cost are those costs incurred up to the point where products become separately identifiable, called the split off point. They can include direct materials direct labor and manufacturing overhead, and must be allocated to the individual joint products. – Separable cost and be identified with a particular joint product and allocated to a specific unit of output.

Joint Product and By-Product Since joint cost cannot be traced to individual products, they must be allocated. There essentially four methods of doing so: – Physical-measure-based approach – Market-based approach Sales value at split off method Estimated net realizable value method – Constant gross margin percentage NRV method

Joint Product and By-Product By-products - Are products of relatively small total value that are produced simultaneously from a common manufacturing process with products of greater value and quantity. – If additional processing and selling cost exceed the selling price they should be scrapped. – If they can be processed further at a gain than the question becomes are the byproduct material, and if so they should be capitalized in a separate inventory account, which essentially reduces the cost of goods sold. – If the byproducts are immaterial after further processing their not recognize until the time of sale.

6.4 OH and Normal Costing All manufacturing costs that are not DM/DL MOH = Factory OH = Indirect Pdt Cost (Indirect Materials, Indirect Labor, Supplies, Utilities, Insurance, Taxes, Depreciation) Costs outside the product cost (G&A, Selling) are not inventoriable in COGS = P&L DL and DM are purely variable costs OH contains both Variable and Fixed costs

What is Normal Costing? Normal costing is used to derive the cost of a product. It includes the following components:cost – Actual cost of materialsmaterials – Actual cost of laborlabor A standard overhead rate that is applied using the product's actual usage of whatever allocation base is being used (such as direct labor hours or machine time)overheadallocation base If there is a difference between the standard overhead cost and the actual overhead cost, then you can either charge the difference to the cost of goods sold (for smaller variances) or prorate the difference between the cost of goods sold and inventory.cost of goods soldinventory

What is Normal Costing? Normal costing is designed to yield product costs that do not contain the sudden cost spikes that can occur when you use actual overhead costs; instead, it uses a smoother long-term estimated overhead rate. It is acceptable under generally accepted accounting principles and international financial reporting standards to use normal costing to derive the cost of a product.generally accepted accounting principles international financial reporting standards Normal costing varies from standard costing, in that standard costing uses entirely predetermined costs for all aspects of a product, while normal costing uses actual costs for the materials and labor components.standard costing

Other Definitions Normal costing uses a predetermined annual overhead rate to assign manufacturing overhead to products. In other words, the overhead rate under normal costing is based on the expected overhead costs for the entire accounting year and the expected production volume for the entire year. Under actual costing each month’s actual costs and each month’s actual production volume are used to assign overhead costs. Since most companies will experience month to month fluctuations in activity, the actual monthly overhead rates will likely vary from month to month. Normal costing will result in an overhead rate that is more uniform and realistic for all of the units manufactured during an accounting year.

MOH = definition Manufacturing overhead (also referred to as factory overhead, factory burden, and manufacturing support costs) refers to indirect factory-related costs that are incurred when a product is manufactured. Along with costs such as direct material and direct labor, the cost of manufacturing overhead must be assigned to each unit produced so that Inventory and Cost of Goods Sold are valued and reported according to generally accepted accounting principles (GAAP).InventoryCost of Goods Soldgenerally accepted accounting principles (GAAP) Manufacturing overhead includes such things as the electricity used to operate the factory equipment, depreciation on the factory equipment and building, factory supplies and factory personnel (other than direct labor). How these costs are assigned to products has an impact on the measurement of an individual product's profitability.

MOH = definition Nonmanufacturing costs (sometimes referred to as “administrative overhead”) represent a manufacturer’s expenses that occur apart from the actual manufacturing function. In accounting and financial terminology, the nonmanufacturing costs include Selling, General and Administrative (SG&A) expenses, and Interest Expense. Since accounting principles do not consider these expenses as product costs, they are not assigned to inventory or to the cost of goods sold. Instead, nonmanufacturing costs are simply reported as expenses on the income statement at the time they are incurred.Selling, General and Administrative (SG&A)Interest Expenseincurred

Manufacturing Overhead On financial statements, each product must include the costs of the following: Direct material Direct labor Manufacturing (or factory) overhead According to generally accepted accounting principles (GAAP), manufacturing overhead must be included in the cost of Work in Process Inventory and Finished Goods Inventory on a manufacturer’s balance sheet, as well as in the Cost of Goods Sold on its income statementWork in Process InventoryFinished Goods Inventory

Manufacturing Overhead As their names indicate, direct material and direct labor costs are directly traceable to the products being manufactured. Manufacturing overhead, however, consists of indirect factory- related costs and as such must be divided up and allocated to each unit produced. For example, the property tax on a factory building is part of manufacturing overhead. Although the property tax covers an entire year and appears as one large amount on just one tax bill, GAAP requires that a portion of this amount be allocated or assigned to each product manufactured during that year.

Steps for Analysis Cost Driver  allocation base (cause-and- effect relationship) It can be direct machine or labor hours Calculating the application rate Recording Actual Overhead Costs Allocating OH to WIP Over and Under applied Overhead

Over – Under applied: If variance is immaterial: directly allocated to COGS If variance is material: allocated based on relative values of WIP, Finished goods, COGS

Activity-Based Costing Indirect costs are attached to activities rather than simply dumped in one or two indirect cost pools More accuracy and greater detail regarding OH More complex and costly to implement

Variance Analysis A budget communicates to employees the organization’s operational and strategic objectives Considerations: – Evaluations system must be used to monitor progress – Feedback must be timely

Variance Analysis Variance analysis is the basis of any performance evaluation system. – On the cost side, a favorable variance occurs when actual costs are less than standard costs. An unfavorable variance occurs when actual costs are greater than standard costs. – On the revenue side, a favorable variance occurs when actual revenues are greater than budgeted revenues. An unfavorable variance occurs when actual revenues are less than budgeted revenues.

Variance Analysis The significance of variances depends not only on their amount but also on their direction, frequency, and trend. It enables management by exception – the practice of giving attention primarily to significant deviations from expectations. – Assignment of responsibility = Budget owner – Cost centers = cost drivers = controllable costs – Allocation / indirect costs Crucial part of variance analysis is the assignment of responsibility to those most likely to have information that will help find solutions. – Constructive approach is to promote learning and continuous in manufacturing, not to assign blame.

Variance Analysis Objectives of the budget: performance? Budget vs. Actual, evaluate the trend, and develop a rolling Forecast

Flexible budget and sales-volume variance Static budget = flexible budget and sales volume variance Flexible budget variance – Diff. between the actual results and the budgeted amount for the actual activity level. The costs that should have been incurred given the actual level of production. The actual level of production is based on the actual output while still using the standard level of inputs. Variance could be due to: – Selling Price – Input costs – Input quantities

Flexible budget and sales-volume variance The sales-volume variance is the difference between the flexible budget and static budget amounts if selling prices and costs are constant.

Flexible budget and sales-volume variance ACTUAL RESULTS = ACTUAL INPUTS x ACTUAL PRICE FLEXIBLE BUDGET = ACTUAL INPUTS x STANDARD PRICE STATIC BUDGET = BUDGETED INPUTS x STANDARD PRICE

Remember Flexible budget = Actual level of production x standard costs

Components of the flexible Budget DM variance Price variance Quantity or usage variance Materials mix variance / yield variance DL variance Rate variance Efficiency variance Labor mix variance / yield variance MOH variance (By Jim Clemons) 4 way analysis VOH spending variance VOH efficiency variance FOH spending variance (budget variance) FOH production-volume variance

Flexible budget Remember a flexible budget adjusts for changes in the volume of activity. It can be adapted to any level of production. Flexible budget variances result from variations in the efficiency and effectiveness of producing actual output. They are the differences between actual results and flexible budget amounts.

DM / DL variances DL rate variance AQ x (AP – SP) DL efficiency variance SP x (AQ – SQ) Mix and yield variances Substitutable products Weighted average standard price Standard mix of inputs (SPSM) Actual mix of inputs (SPAM) Mix variance = ATQ x (SPSM – SPAM) Yield variance = (STQ – ATQ) x SPSM MIX + YIELD variances = EFFICIENCY variance

Cram Session Part 2 Ronald Schmidt, CMA, CFM

Concepts in Financial Accounting Objective of General-Purpose Reporting –Usefulness in decision making –Information relates to economic resources and claims (Statement of Financial Positions) & changes in those (Income Statement) –Used for evaluating Liquidity Solvency Financial needs Obtaining financing

Concepts in Financial Accounting Financial Accounting vs. Managerial Accounting –Management Accounting: Used primarily for internal users Helps management in decision making, planning and control Can be “prospective” Does not have to conform to GAAP Direct interest users invest or manage the business Indirect interest users advise, influence, or represent direct interests.

Concepts in Financial Accounting Financial Statements are the primary means of communicating financial information. –Financial statement notes – are there to enhance not make corrections or improper reporting, but rather “amplify” –MD&A – –Other disclosures –Full set of Financial Statements Statement of Financial Position (Balance sheet) Income Statement Statement of Comprehensive Income Statement of changes in equity Statement of Cash Flows

Concepts in Financial Accounting Financial Statement must be: –Relevant –Faithfully represented –Comparable (past and others) –Based on going-concern assumption (1 yr.)

Concepts in Financial Accounting Accrual vs cash basis accounting –Accrual accounting records the financial effects of transactions and other events and circumstances when they occur rather than when their associated cash is paid or received. –For the CMA exam assume that all is on an accrual basis Revenues are recognized in the period in which they are earned –Accrual –Deferral Expenses are recognized in the period in which they were incurred –Accrual –Deferral

Concepts in Financial Accounting Practice question 2 An entity that sprays chemicals in residences to eliminate or prevent infestation of insects requires that customers prepay for 3 months’ service at the beginning of each new quarter. Select the term that appropriately describes this situation from the viewpoint of the entity. ADeferred income. BEarned income. CAccrued income. DPrepaid expense.

Concepts in Financial Accounting Practice question 2 answer Correct Answer: A The future inflow of economic benefits is not sufficiently certain given that the entity has not done what is required to be entitled to those benefits. Thus, the receipt of cash in anticipation of goods to be delivered or services to be performed must be recognized as a liability, usually called deferred (or unearned) revenue or deferred (or unearned) income.

Statement of Financial Position (Balance Sheet) Statement of Financial Position, AKA Balance Sheet Reports the amounts of assets, liabilities, and their relationships at a “moment in time”. Elements include: –Assets – resources controlled by the entity, and represent probably future economic benefits to the entity. –Liabilities – present obligations from past events. –Equity – residual interest in assets after liabilities are subtracted, also ref. to as “net assets”. continued

Statement of Financial Position (Balance Sheet) Equity can be affected by operations but also by: –Investment by owners –Distribution to owners –Ref. accounts on page 14

Statement of Financial Position (Balance Sheet) Assets –Classified as Current and Noncurrent based on whether they will be converted into cash or sold or consumed within the entities operating cycle or 1 year, whichever is longer. –Major current asset categories incl.: Cash and Cash equivalents Trading, Available-for-sale, and Held-to-maturity securities Receivables Inventories Pre-paid expenses continued

Statement of Financial Position (Balance Sheet) Practice Question 1 A statement of financial position allows investors to assess all of the following except the AEfficiency with which enterprise assets are used. BLiquidity and financial flexibility of the enterprise. CCapital structure of the enterprise. DNet realizable value of enterprise assets.

Statement of Financial Position (Balance Sheet) Practice Question 1 Answer Correct Answer: D Assets are usually measured at original historical cost in a statement of financial position, although some exceptions exist. For example, some short-term receivables are reported at their net realizable value. Thus, the statement of financial position cannot be relied upon to assess NRV.

Income Statement and Statement of Comprehensive Income Income Statement Elements –Income Statement reports results over a “period” of time –Revenues – Inflows or other enhancements of assets or settlements of liabilities (or both) from delivering goods and/or providing services from operations. –Gains – Increases in equity (or net assets) other than from revenues or investments by owners. –Expenses – Outflows or other usage of assets or incurrences of liabilities (or both) from delivering or producing goods and/or services from operations. –Losses – Decreases in equity (or net assets) other than from expenses or distributions to owners. continued

Income Statement and Statement of Comprehensive Income Income Statement Elements –Income = net change in equity except: Transactions with owners Prior-period adjustments Items reported in Other Comprehensive Income (OCI) Transfers to and from appropriated retained earnings Accounts are temporary or “nominal”

Income Statement and Statement of Comprehensive Income Typical Items of Cost and Expense –Accrual based accounting attempts to “match” income with the expenses that were incurred because of them, i.e. COGS is recognized in the same period as the revenue from the sale of the goods. –SG & A – Selling, General and Administrative are incurred for the benefit of the organization and therefore also recognized in the period incurred (Period Cost vs. Product Cost). They can be both variable and fixed. –Some expenses are recognized because of the passage of time, i.e. interest, insurance.

Income Statement and Statement of Comprehensive Income Income Statement Formats –Single-step income statement –Multi-step income statement Irregular Items –Discontinued Operations Income/Loss from operations is classified as held for sale from the first day of the reporting period until the date of disposal Gain/Loss on the disposal of other assets, such PP&E, etc. continued

Income Statement and Statement of Comprehensive Income Irregular Items –Extraordinary items Unusual in nature “and” Infrequent in occurrence (in the environment in which the entity operates) Limitations –Some items are shown on OCI and not on the Income Statement –Accrual base Income Statement does not identify liquidity

Income Statement and Statement of Comprehensive Income Statement of Comprehensive Income –Includes all changes in equity except investments and distributions by/to owners Net Income Other Comprehensive Income

Income Statement and Statement of Comprehensive Income Practice Question 2 Which one of the following items is included in the determination of income from continuing operations? ADiscontinued operations. BExtraordinary loss. CCumulative effect of a change in an accounting principle. DUnusual loss from a write-down of inventory.

Income Statement and Statement of Comprehensive Income Practice Question 2 Answer Correct Answer: D Certain items ordinarily are not to be treated as extraordinary gains and losses. Rather, they are included in the determination of income from continuing operations. These gains and losses include those from write-downs of receivables and inventories, translation of foreign currency amounts, disposal of a business segment, sale of productive assets, strikes, and accruals on long-term contracts. A write-down of inventory is therefore included in the computation of income from continuing operations. Incorrect Answers: ADiscontinued operations are reported separately from income from continuing operations. BExtraordinary loss is reported separately from income from continuing operations. C A cumulative effect of a change in an accounting principle is not reported in the income statement.

Statement of Changes in Equity and Equity Transactions Statement of Changes in Equity –Presents a reconciliation of changes in equity for the accounting period. –Each change shown separately Net Income Distributions Increases of Common Stock (CS) Total change in Other Comprehensive Income (OCI)

Statement of Changes in Equity and Equity Transactions Statement of Retained Earnings –Reconciles Retained Earnings (RE) for the period See format on page 21 –Prior period adjustments include Cumulative effects in accounting principles Corrections of prior financial statements Beginning balance of Retained Earnings is adjusted continued

Statement of Changes in Equity and Equity Transactions Statement of Retained Earnings –Appropriated for special purposes including: Compliance with bond indenture (bond contract) Retention of assets of internally financed expansion Anticipated losses Legal restrictions Only limits availability of dividends

Statement of Changes in Equity and Equity Transactions Statement of Retained Earnings –Common and Preferred Stock Authorized Issued Outstanding Common Stockholders –Vote –Select Board of Directors (BOD) –Liquidating Distributions (last in line) –Preemptive Rights Continued

Statement of Changes in Equity and Equity Transactions Statement of Retained Earnings –Preferred Stock – Hybrid, but still considered an equity instrument Dividends are not considered an obligation No voting rights Features include: –Cumulative –Convertible –Participating

Statement of Changes in Equity and Equity Transactions Practice Question 3 When treasury stock is accounted for at cost, the cost is reported on the balance sheet as a(n) AAsset. BReduction of retained earnings. CReduction of additional paid-in-capital. DUnallocated reduction of equity.

Statement of Changes in Equity and Equity Transactions Practice Question 3 Answer Correct Answer: D Treasury stock is a corporation’s own stock that has been reacquired but not retired. In the balance sheet, treasury stock recorded at cost is subtracted from the total of the capital stock balances, additional paid-in capital, retained earnings, and accumulated other comprehensive income. Incorrect Answers: ATreasury stock is not an asset. A corporation cannot own itself. BTreasury stock accounted for at cost is subtracted from the total of the other equity accounts. C

Statement of Cash Flows Purpose – Provide relevant information about the cash receipts and cash payments of an entity during the period. It helps assess the entity’s ability to generate positive future net cash flows (liquidity), meet obligations (solvency) and its financial flexibility. –Three sections: Cash flow from Operations Cash flow from Investing Cash flow from Financing continued

Statement of Cash Flows –Cash flow from Operations – everything that is not financing or investing activities. Usually changes to Balance Sheet current items, and adjusting for certain accruals and deferrals (non-cash, i.e. depreciation expense). There are two methods – Direct and Indirect method, of which you need to know the indirect method for the exam. Under the indirect method of presenting the statement of cash flows, the presentation of this statement begins with net income or loss, with subsequent additions to or deductions from that amount for non-cash revenue and expense items, resulting in net income provided by operating activities. continued

Statement of Cash Flows –Cash flow from Investing Activities – An item on the cash flow statement belongs in the investing activities section if it results from any gains (or losses) from investments in financial markets and operating subsidiaries. An investing activity refers to cash spent on investments in capital assets such as plant and equipment, which is collectively referred to as capital expenditure, or capex.capital assetscapital expenditure continued

Statement of Cash Flows –Cash flow from Investing Activities Examples of Inflows: – Proceeds from disposal of property, plant and equipment – Cash receipts from disposal of debt instruments of other entities – Receipts from sale of equity instruments of other entities Examples of Outflows: – Payments for acquisition of property, plant and equipment – Payments for purchase of debt instruments of other entities – Payments for purchase of equity instruments of other entities – Sales/maturities of investments – Includes purchasing and selling long- term assets and other investments. continued

Statement of Cash Flows –Cash flow from Financing Activities - external activities that allow a firm to raise capital and repay investors, such as issuing cash dividends, adding or changing loans or issuing more stock. Cash flow from financing activities shows investors the company’s financial strength. A company that frequently turns to new debt or equity for cash, for example, could have problems if the capital markets become less liquid. Items included: – Sale of stock (positive cash flow) – Repurchase of company stock (negative cash flow) – Issuance of debt, such as bonds (positive cash flow) – Repayment of debt (negative cash flow) – Payment of dividends (negative cash flow) continued

Statement of Cash Flows – Noncash Investing and Financing Activities – Anything that affect assets or liabilities but not cash flows must be disclosed in the notes. Include: – Conversion of debt to equity – Acquisition of assets via debt – Exchange of a noncash or liability for another Any “paper for paper” transaction

Statement of Cash Flows Practice question 1 Depreciation expense is added to net income under the indirect method of preparing a statement of cash flows in order to AReport all assets at gross carrying amount. BEnsure depreciation has been properly reported. CReverse noncash charges deducted from net income. DCalculate net carrying amount.

Statement of Cash Flows Practice question 1 answer Correct Answer: C The indirect method begins with net income and then removes the effects of past deferrals of operating cash receipts and payments, accruals of expected future operating cash receipts and payments, and net income items not affecting operating cash flows (e.g., depreciation). Incorrect Answers: AAssets other than cash are not shown on the statement of cash flows. B Depreciation is recorded on the income statement. On the statement of cash flows, depreciation is added back to net income because it was previously deducted on the income statement. DNet carrying amount of assets is reported on the balance sheet, not the statement of cash flows.

Revenue Recognition – After Delivery Revenues and gains should be recognized when: –Realized or realizable – Goods and/or services have been exchanged for cash or claims to cash. They are realizable when exchanged for assets (other than cash) that are readily convertible to cash or claims to cash. –And earned when earnings process has been substantially completed. Read IFRS difference on page 30

Revenue Recognition – After Delivery Installment Method – only acceptable when: –Receivables are collectible over an extended period, and –No reasonable basis exists for estimating collectability –Recognizes “partial” profit (gross profit) on each installment Cost-Recover Method – Same as Installment Method, except: –No profit recognized until collections exceed the cost of the item sold. –Everything thereafter is recognized as revenues. continued

Revenue Recognition – After Delivery Deposit Method – The deposit method is used when a company receives cash before transfer of ownership occurs. Revenue is not recognized when cash is received because the risks and rewards of ownership have not transferred to the buyer. The seller records the cash deposit as a deferred revenue, which is reported as a liability on the balance sheet until the revenue is earned.balance sheet

Revenue Recognition – Before Delivery Completed Contract Method – Used when Percentage-of-Completion is inappropriate. –Defers contract cost until project is completed. –Revenue and gross profit recognized when project completed.

Revenue Recognition – Before Delivery Percentage-of-Completion Method - work-in-progress evaluation (and billings) for recording long-term contracts, used wherein the revenues are determined based on the costs incurred so far. The percentage of completion method is used when:contracts Collections are assured The accounting system can: – Estimate profitability – Measure progress toward completion. Losses are recognized in the year when they are discovered, the same way as for the completed contract method. The balance sheet presentation is the same as in the completed contract method.

Accounts Receivable Allowances for Uncollectible Accounts and Bad Debt Expense –Percentage of Sales (Income Statement approach) – Based on percentage of “credit” sales. –Percentage of Receivables (Balance Sheet approach) – Based on “ending gross” accounts receivables. Could be based on total A/R account balance, but more likely to be based on an “Aging Schedule” continued

Accounts Receivable Allowances for Uncollectible Accounts and Bad Debt Expense –Write-off of bad debt has no effect on expenses/income statement –Write-off has no effect on carrying amount of net accounts receivable or working capital –Recovery of written-off bad debt has no effect on expenses See reconciliation of allowance for uncollectible accounts page 50

Accounts Receivable Factoring of Accounts Receivables –Transfer of receivables to a third party (factor) who accepts responsibility of collections. They are “more” than just “servicing” the collection process, they have rights to the funds. –Factoring can be done: With recourse – Transferor may be required to make payments for receivables that can’t be collected. Without recourse – Transferee assumes the risks of collection Example on bottom of page 50 –Transferor receives immediate cash as opposed to having to wait on payment, but pays a high price to the factor.

Accounts Receivable Practice question 1 An analysis of an entity’s $150,000 accounts receivable at year end resulted in a $5,000 ending balance for its allowance for uncollectible accounts and a bad debt expense of $2,000. During the past year, recoveries on bad debts previously written off were correctly recorded at $500. If the beginning balance in the allowance for uncollectible accounts was $4,700, what was the amount of accounts receivable written off as uncollectible during the year? A$1,200 B$1,800 C$2,200 D$2,800

Accounts Receivable Practice question 1 answer Under the allowance method, uncollectible accounts are written off by a debit to the allowance and a credit to accounts receivable. The $500 of recovered bad debts is accounted for by a debit to accounts receivable and a credit to the allowance. The $2,000 bad debt expense is also credited to the allowance. The amount of accounts receivable written off can be calculated as follows: Beginning allowance $4,700 Bad debt expense 2,000 Recoveries 500 Ending allowance (5,000) A/R written off $2,200

Inventory –Cost of manufactured inventories includes: Direct labor costs, and Manufacturing overhead costs –Accounting systems include Perpetual inventory system –Probably most common today, which updates inventory accounts after each purchase or sale. –Important when inventory expensive and heterogeneous items. –Purchases charged to inventory and COGS are adjusted as sales occur. –Benefits include that the amount of inventory is always available, but can be more complex to implement continued

Inventory –Periodic inventory system Inventory and COGS sold are updated at specific intervals, based on a physical count. Purchases are booked to a temporary account like Purchases. Changes in inventory of cost of goods sold are recorded only at the end of the period, based on the physical count at the end of the period. See example on bottom of page XX and the difference between periodic and perpetual on the top of page 53 continued

Inventory Inventory Errors may affect: –Current Assets, working capital, COGS, Net Income and Equity. –Common error is inappropriate timing of recognition of transaction. –Understand the effects of overstating and understanding inventory. –Will have no effect in the long-term but can cause two years to be incorrect.

Inventory Practice question 1 A physical inventory count showed an entity had inventory costing $1,000,000 on hand at December 31, Year 1. Excluded from this amount were the following: Goods costing $82,000, shipped to a customer free on board (FOB) shipping point on December 28, Year 1. They were expected to be received by the customer on January 4, Year 2. Goods costing $122,000, shipped to a customer free on board (FOB) destination December 30, Year 1. They were expected to be received by the customer on January 5, Year 2. Compute the correct ending inventory to be reported on the shipper’s statement of financial position at December 31, Year 1. A$1,000,000 B$1,082,000 C$1,122,000 D$1,204,000

Inventory Practice question 1 answer Correct Answer: C The goods shipped FOB shipping point should be counted in the buyer’s, not the seller’s, inventory because title and risk of loss pass at the time and place of shipment. These goods were properly excluded from ending inventory. The goods shipped FOB destination were improperly excluded from the seller’s ending inventory. The title and risk of loss did not pass until the time and place where the goods reached their destination and were duly tendered. Thus, the correct ending inventory is $1,122,000 ($1,000,000 beginning balance + $122,000 goods shipped FOB destination). Incorrect Answers: AThe amount of $1,000,000 results from excluding the goods shipped FOB destination. B The amount of $1,082,000 results from excluding the goods shipped FOB destination and from including the goods shipped FOB shipping point. DThe amount of $1,204,000 results from including the goods shipped FOB shipping point.

Inventory – Cost Flow Methods First-in, First-out (FIFO) –Ending inventory consists of latest purchases and therefore will result in the highest inventory balance and the lowest COGS. –Year-end inventory and COGS for the period are the same, regardless of perpetual or periodic inventory accounting. Last-in, First-out (LIFO) –Newest items are sold first and ending inventory is the oldest and usually lowest “cost” inventory, which will create lowest inventory balance and highest COGS. –Calculation of inventory and COGS are made at the end of the period for the Periodic Inventory method. continued

Inventory – Cost Flow Methods Cost Flow Methods – Comparison\ –Objective is to most clearly reflect periodic income. –FIFO better approximates replacement costs, but matches old cost against current revenues. –Management can affect Net Income under LIFO with an end-of-period purchase which alters COGS. –In times of rising prices (large inflation), LIFO results in the Lowest ending inventory (lower Balance Sheet) Highest COGS (lower Net Income)

Concepts in Financial Accounting Practice question 1 An entity has 8,000 units in inventory on January 1, valued at $10 per unit. During the year, the entity sold 25,000 units and purchased inventory as follows DateQuantity PurchasedUnit Price 1 Apr15,000 units$8 1 Jul10,000 units$9 1 Oct12,500 units$10

Concepts in Financial Accounting Practice question 1 continued If the entity uses the weighted-average method of inventory valuation, cost of goods sold for the period will be A$186,978 B$197,000 C$228,023 D$235,000

Concepts in Financial Accounting Practice question 1 answer Correct Answer: C Under the weighted-average method, the weighted-average cost per unit is multiplied by the number of units sold to determine the cost of goods sold for the period. The total units available for sale equaled 45,500 (8,000 + 15,000 + 10,000 + 12,500). The total cost of all units available for sale was $415,000 [(8,000 × $10) + (15,000 × $8) + (10,000 × $9) + (12,500 × $10)]. Thus, the weighted-average cost per unit of inventory was $9.1209 ($415,000 ÷ 45,500), and cost of goods sold was $228,023 (25,000 × $9.1209).

Intangible Assets Intangible Assets – Identifiable, nonmonetary assets lacking physical substance. –Initial Recognition – Either externally acquired or internally developed Externally acquired recorded at cost plus any additional cost Internally developed (other than goodwill) are recorded initially at the additional costs other those for R&D R&D expensed as incurred

Intangible Assets –Finite useful live – Total cost minus residual valued amortized over useful life Carrying amounts Impairment test –Indefinite useful live – Not amortized, but instead periodically tested for impairment (all except goodwill) Qualitative assessment – 1st Quantitative assessment – only if findings from qualitative testing deems so Nonreversible continued

Intangible Assets Impairment test for indefinite useful life –Reviewed (tested) at least annually –Qualitative – If potential impairment is found quantitative test must be performed –Quantitative – Carrying amount is compared with fair value –Nonreversible

Intangible Assets Intangible Assets - Goodwill –Not finite –Tested at the reported-unit level –Similar that qualitative test is performed first If fair value is greater then carrying amount, then no impairment If fair value is less, recognize at reported-unit level; non-reversible

Intangible Assets Intangible Assets - Patents –Lesser of the useful life or legal life –Treatment of the cost associated with the legal defense of a patent depends on the outcome Successful litigation are capitalized to the cost of the patent because they will benefit future use of the patent. Unsuccessful litigation are expensed as incurred, and could actually lead to impairment recognition.

Intangible Assets Practice question 1 On July 1, Broadstreet Corporation acquired a patent on its new manufacturing process, which streamlines its production operation. The cost of the patent was $17,000, and Broadstreet expects that the useful life of the new process will be 10 years, although the legal life of the patent is 17 years. Broadstreet is a calendar-year corporation and is preparing its December 31 Statement of Financial Position. At which amount should the patent be reported at December 31 of the year of acquisition? A$15,300 B$16,000 C$16,150 D$16,500

Intangible Assets Practice question 1 answer Correct Answer: C A patent is amortized over the shorter of its useful life or legal life, so annual amortization on this patent is $1,700 ($17,000 ÷ 10 years). The depreciation expense for the year of acquisition is $850 [$1,700 × (6 ÷ 12 months)]. The patent should therefore be reported at December 31 at $16,150 ($17,000 – $850). Incorrect Answers: AThe amount of $15,300 results from improperly taking a full year of depreciation. B The amount of $16,000 results from improperly using the legal life of the patent rather than its useful life and improperly taking a full year of depreciation. D The amount of $16,500 results from improperly using the legal life of the patent rather than its useful life.

Leases Leases – Any long-term contract in which the owner of property (the lessor) allows another party (the lessee) to use the property for a stated period in exchange for a stated payment. – The question that must be answered is, who will substantially gain the benefits and risk of ownership? – If yes, then it is a capital lease, and should include: Transfer of ownership. Bargain purchase option Provides 75% or more of the estimated economic life of the leased property PV of min. lease payments equals 90% of the fair value of the leased property. Lease is a purchase-and-financing agreement. Both assets and liabilities are recognized at the present value (implicit rate or lessor’s incremental borrowing rate) of the minimum lease payments, which includes rental payments plus the amount of residual value. continued

Leases Leases - Operating leases – If no, then an operating lease and the lessor retains substantially all the benefits and risks. – Lessee reports period rental expense. – Off-balance sheet financing – Consider why there may be a motivation to consider a lease an operating lease in lieu of a capital lease.

Leases Leases –Capital leases - Lessee: – Periodic payments have two components: Interest expense, and a reduction of the lease liability. Interest expense is calculated using the effective-interest method. Lessee must depreciate the asset either over the: – Estimated economic life, or – Term of the lease. continued

Leases Leases –Capital leases - Lessor: – Lessor removes asset from financial statement and books receivable for the present value of minimum lease payments to be received. – Does not depreciate. – Each payment has two components: Interest revenue Reduction of the lease receivables – Classifies lease as either a: Direct financing lease – Economic interest is in financing; no dealer’s profit or loss. Sales-type lease – Recognizes dealer’s profit – Subsequent to the inception of the lease, the accounting is the same. continued

Leases Leases – Capital leases - Lessor: – No depreciation is recognized. – Each payment has two components: Interest revenue Reduction of the lease receivables – Debit gross lease receivable – Credit to unearned interest income See example on page 95

Leases Practice question 1 Which one of the following statements with respect to leases is correct? AAn operating lease is treated like a rental contract between the lessor and lessee. B A lease that does not transfer ownership from the lessor to the lessee by the end of the lease is automatically an operating lease. CSales and direct financing leases pertain more to lessees than lessors. D Unpredictability of lease revenues or expenses can transform what would otherwise be a capital lease for the lessee into an operating lease for the lessee.

Leases Practice question 1 answer Correct Answer: A An operating lease is a transaction in which the lessee rents the right to use the lessor’s assets without acquiring a substantial portion of the benefits and risks of ownership. Thus, an operating lease is treated like a rental contract between the lessor and lessee. Incorrect Answers: B The transfer of ownership test is only one of four tests that are used to determined whether a lease is classified as a capital lease. CSales-type leases and direct financing leases are reported by lessors, not lessees. D The degree of unpredictability of lease revenues or expenses is not a factor for the lessee in the classification of the lease as a capital or operating lease.

Accounting for Bonds and Noncurrent Notes Payable A bond is a formal contract to pay an amount of money (face amount) at the maturity date plus interest at the stated rate at specific intervals. The proceeds received from the investors on the day the bonds are sold equal the present value of the sum of the future cash flows expected to be received from the bonds. These proceeds equal a.The present value of the face amount plus b.The present value of the annuity of interest payments

Accounting for Bonds and Noncurrent Notes Payable The bonds are recognized in the financial statements as the amount of proceeds paid for them, i.e., the face amount of the bonds plus any premium or minus any discount. a.They are recorded as a debt in the issuer’s financial statements and as an investment in the investors’ financial statements.

Accounting for Bonds and Noncurrent Notes Payable Bond Issuance - The cash proceeds from the sale of bonds can be equal to, less than, or greater than the face amount of the bonds depending on the relationship of the bonds’ stated rate of interest to the market rate of interest on the date the bonds are sold. a.If the stated rate is equal to the market rate, the cash proceeds equal the face amount of the bonds. b.If the stated rate is greater than the current market rate, the cash proceeds are greater than the face amount, and the bonds are sold at a premium. c.If the stated rate is lower than the current market rate, the cash proceeds are lower than the face amount, and the bonds are sold at a discount. continued

Accounting for Bonds and Noncurrent Notes Payable The current market rate of interest is used to discount the cash flows expected to be received by the investor (paid by the issuer) from the bonds.

Accounting for Bonds and Noncurrent Notes Payable Amortization of Premium or Discount - Bond premium or discount must be amortized over the life of the bonds using the effective-interest method (the market interest rate on the date the bond was sold). Under this method, interest expense changes every period and equals the following: Annual interest expense = Carrying amount of the bond at the beginning of the period x Effective interest rate The annual interest expense consists of the cash interest paid plus the effect of amortization of premium or discount. a.When the bond is issued at a premium, annual interest expense equals cash interest paid minus the amount of premium amortized.

Accounting for Bonds and Noncurrent Notes Payable b.When the bond is issued at a discount, annual interest expense equals cash interest paid plus the amount of discount amortized. c.The carrying amount of bonds as they are present in the financial statements equals the face amount plus the premium (or minus the discount). d.At the maturity date, the discount or premium is fully amortized, and the carrying amount of bonds equals the face amount.

Accounting for Bonds and Noncurrent Notes Payable Different Types of Bonds – Maturity Pattern a.A term bond has a single maturity date at the end of its term. The examples in this study unit are regular term bond. b.A serial bond matures in stated amounts at regular intervals. – Repayment Provisions a.Income bonds pay interest contingent on the debtor’s profitability. b.Revenue bonds are issued by governments and are payable from specific revenue sources. – Securitization a.Mortgage bonds are backed by specific assets, usually real estate.

Accounting for Bonds and Noncurrent Notes Payable b.Debentures are backed by the borrower’s general credit but not by specific collateral. c.Guaranty bonds are guaranteed by a third party, e.g., the parent of the subsidiary that issued the bonds. d.Collateral trust bonds are secured by a financial asset, such as stock or other bonds. e.Equipment trust bonds are secured by a mortgage on movable equipment, such as airplanes or railroad cars.

Accounting for Bonds and Noncurrent Notes Payable Valuation a.Variable (or floating) rate bonds pay interest that is dependent on market conditions. b.Zero-coupon or deep-discount bonds bear no stated rate of interest and thus involve no periodic cash payments; the interest component consists entirely of the bond’s discount. c.Commodity-backed bonds are payable at prices related to a commodity such as gold.

Accounting for Bonds and Noncurrent Notes Payable Redemption provisions a.Callable bonds (also called redeemable bonds) may be repurchased (redeemed) by the issuer at a specified price before maturity. i.During a period of failing interest rates, the issuer can replace high-interest debt with low-interest debt. b.Convertible bonds may be converted into equity securities of the issuer at the option of the holder (buyer) under specified conditions. Convertible bonds generally pay a lower yield than comparable nonconvertible bonds.

Just-In Time Inventory and Lean Operation Many companies have traditionally built parts and components for subsequent operation on a preset schedule. Such a schedule provides a cushion of inventory so that the next operation will always have parts to work with-they just in case method. Just-in-time Model (in contrast) – Limits output to the demand of the subsequent operation. – Reduction in inventory Less money invested in idle assets Less storage space Less inventory taxes Less pilferage – Identify defects in parts due to limited supply – QC is focuses on prevention of quality problems.

Just-In Time Inventory and Lean Operation Just-in-time Model Objectives – Higher productivity – Reduced order costs / carrying costs – Faster & cheaper setups – Shorter manufacturing cycle times – Improved quality – Flexible processes – Increased competitiveness and higher profits!

Just-In Time Inventory and Lean Operation JIT originated from a Japanese philosophy that combines purchasing, production, and inventory control. It is a reaction to the trends of global competition and rapid technological progress that have resulted in shorter product life-cycles in greater consumer demand for product diversity. JIT strives to minimize inventory due to many of the inventory-related activities do not add value. Symptom of problems: – Poor quality – Long cycle times – Lack of coordination JIT is a pull system – Items are pulled through production by current demand, not pushed by anticipated demand. – Examples???

Just-In Time Inventory and Lean Operation JIT and Kanban are often confused. – JIT is a total system. – Kanban is an element within the JIT system. Kanban = ticket Tickets control the flow of production or parts so that they are produced or obtained in the needed amounts at the needed times. Withdrawal kanban – Qty that a later process should withdraw from its predecessor

Just-In Time Inventory and Lean Operation Production kanban – States the output of the preceding process Vendor kanban – Tells a vendor what, how much, where and when to deliver. US companies have integrated their existing computer systems with the JIT systems.

Question 4 Which of the following internal controls is not one typically eliminated when a just- in-time inventory system is introduced? A. Sophisticated inventory tracking system. B. Central receiving dock. C. Statistical methods for quality assurance. D. Hard copy receiving report.

Question 4 Answer A. Frequent receipt of deliveries from suppliers often means less need for a sophisticated inventory control system and for control personnel. B. Under JIT, a central receiving area and central warehouse are not needed because deliveries are made by suppliers directly to the area of production. C. *Correct Answer* Under a JIT system, the quality of parts provided by suppliers is verified by use of statistical controls rather than inspection of incoming goods. Storage, counting, and inspection are eliminated in an effort to perform only value- adding work. D. With the elimination of central receiving areas and central warehouses that typically accompanies the institution of a JIT system, hard copy receiving reports are unnecessary.

Material Requirements Planning and Outsourcing Short-range plans must be converted into specific production targets for finished goods. Raw material deliveries carefully planned. Master Production Schedule (MPS) Develops specific dates for completion and availability based on the numbers of finished goods called for in demand forecasts. Materials Requirements Planning (MRP) Coordinates both the manufacture of component parts for finished goods and the arrival of raw materials. Combines production scheduling and inventory control. Right part, right quantity, right time.

Material Requirements Planning and Outsourcing MRP is a Push System Demand for raw materials is driven by the forecasted demand for the final product. Computer Program MRP system utilizes bill of materials (BOM), which and how many subassemblies go into the finished product.

Material Requirements Planning and Outsourcing MRP creates schedules identifying when inventory items will be needed in the production departments. – Purchase orders are automatically generated based on inventory levels. – Timing of deliveries is vital. MRP benefits – Reduced idle time – Lower setup costs – Lower inventory carrying costs – Increased flexibility

Material Requirements Planning and Outsourcing Manufacturing Resource Planning (MRP II) Closed-loop manufacturing system that integrates all facets of production, sales, inventories, schedules, and cash flows. – The same system is used for both the financial reporting managing operations (both use the same transactions and numbers). – Because manufacturing resource planning encompasses materials requirements planning, MRP is a component of an MRP II system.

Material Requirements Planning and Outsourcing Outsourcing – Management / execution of day-to-day operations by a 3 rd party. – Allows focus on core competency and have less concern on marginal activities. Business Process Outsourcing – Back office and front office functions. Insourcing – Transfer of an outsourced function to an internal department. Cosourcing – Internal and external resources.

Material Requirements Planning and Outsourcing Outsourcing Advantages – Reliable service – Reduced costs – Technological access – Leverage experts Outsourcing Disadvantages – Dependence on outsiders – Loss of control – Costs

Theory of Constraints and Throughput Costing The theory of constraints developed in 1948, as a system to improve human thinking about problems. It has been greatly extended to include manufacturing operations. The basic premise of TOC as applied to the business is that improving any process is best done not by trying to maximize efficiency in every part of the process, but by focusing on the slowest part of the process, call the constraint. 1.Identify the Constraint. Bottleneck operation is where the work-in-process backs up the most. Determine which phase has slack time – phase w/o enough resources to keep up with input. Continued

Theory of Constraints and Throughput Costing 2.Determine most Profitable Product mix given the constraint. Max contribution margin through the constraint – Throughput margin. Throughput costing (aka Supervariable costing) uses only direct materials costs. Throughput margin = Sales – Direct Materials 3.Maximize the flow through the constraint. 4.Increase capacity at the constraint. Redesign the manufacturing process for greater flexibility and speed.

Theory of Constraints and Throughput Costing Most profitable use of bottleneck operation – calculate throughput margin per unit of time spent in the constraint. – Profit maximized when bottleneck is busy with the product that has the highest throughput margin per unit of time.

Theory of Constraints and Throughput Costing Increase Capacity at the Constraint While making the best use of the bottleneck is encouraged in the short-run, the next best step would be to increase the bottleneck’s capacity. Redesign the Process Gain greater flexibility and speed. Long-term solution is to redesign the process Value engineering – balances product cost and the needs of potential customers

Theory of Constraints and Throughput Costing TOC Analysis complements activity-based costing – focus on different aspects of improvement process – TOC is short-term – ABC is long-term

Allocation of Service Department Costs Overview Historically, there have been three alternative methods for allocating service department costs. These methods differ in the extent to which they account for the fact that service departments provide services to other service departments as they will as to production departments: Direct Method Step-down Method Reciprocal Method

Allocation of Service Department Costs Direct Method The Direct Method is the most widely-used method. This method allocates each service department’s total costs directly to the production departments, and ignores the fact that service departments may also provide services to other service departments. Example: Machining and Assembly are the only production departments that used the services of the Human Resources Department in March. Costs from Human Resources are allocated based on the number of new hires. Machining hired seven employees in March and Assembly hired three employees. Human Resources incurred total costs of $93,000 in March. Allocation of H.R. Department costs to Machining: 70% of $93,000 = $65,100 Allocation of H.R. Department costs to Assembly: 30% of $93,000 = $27,900 The characteristic feature of the direct method is that no information is necessary about whether any service departments utilized services of the Human Resources Department. It does not matter whether no other service department hired anybody, or whether three other service departments each hired five employees (implying that more than 50% of the hiring occurred in the service departments). Under the direct method, service department to service department services are ignored, and no costs are allocated from one service department to another.

Allocation of Service Department Costs Step-down Method The Step-down Method is also called the Sequential Method. This method allocates the costs of some service departments to other service departments, but once a service department’s costs have been allocated, no subsequent costs are allocated back to it. The choice of which department to start with is important. The sequence in which the service departments are allocated usually effects the ultimate allocation of costs to the production departments, in that some production departments gain and some lose when the sequence is changed. Hence, production department managers usually have preferences over the sequence. The most defensible sequence is to start with the service department that provides the highest percentage of its total services to other service departments, or the service department that provides services to the most number of service departments, or the service department with the highest costs, or some similar criterion.

Allocation of Service Department Costs Step-down Method Example: Human Resources (H.R.), Data Processing (D.P.), and Risk Management (R.M.) provide services to the Machining and Assembly production departments, and in some cases, the service departments also provide services to each other: Total Cost Service Dept % of services provided by the service department listed at left to: H.R.D.P.R.M. Machinin g Assembly $ 80,000H.R.--20%10%40%30% 120,000D.P.8%--7%30%55% 40,000R.M.-- 50% $240,000

Allocation of Service Department Costs Step-down Method The amounts in the far left column are the costs incurred by each service department. Any services that a department provides to itself are ignored, so the intersection of the row and column for each service department shows zero. The rows sum to 100%, so that all services provided by each service department are charged out. The company decides to allocate the costs of Human Resources first, because it provides services to two other service departments, and provides a greater percentage of its services to other service departments. However, a case could be made to allocate Data Processing first, because it has greater total costs than either of the other two service departments. In any case, the company decides to allocate Data Processing second.

Allocation of Service Department Costs Step-down Method In the table below, the row for each service department allocates the total costs in that department (the original costs incurred by the department plus any costs allocated to it from the previous allocation of other service departments) to the production departments as well as to any service departments that have not yet been allocated. H.R.D.P.R.M.Machining Assembl y Costs prior to allocation $ 80,000$120,000$40,000-- Allocation of H.R. ($ 80,000 ) 16,0008,000$32,000$24,000 Allocation of D.P. (136,000)10,34844,34881,304 Allocation of R.M. (58,348)29,174 000$105,522$134,478

Allocation of Service Department Costs Step-down Method After the first service department has been allocated, in order to derive the percentages to apply to the production departments and any remaining service departments, it is necessary to “normalize” these percentages so that they sum to 100%. For example, after H.R. has been allocated, no costs from D.P. can be allocated back to H.R. The percentages for the remaining service and production departments sum to 92% (7% + 30% + 55%), not 100%. Therefore, these percentages are normalized as follows: Risk Management: 7% ÷ 92% = 7.61% Machining: 30% ÷ 92% = 32.61% Assembly: 55% ÷ 92% = 59.78% Total: 100.00% For example, in the table above, 59.78% of $136,000 (= $81,304) is allocated to Assembly, not 55%.

Allocation of Service Department Costs Step-down Method The characteristic feature of the step-down method is that once the costs of a service department have been allocated, no costs are allocated back to that service department. As can be seen by adding $105,522 and $134,478, all $240,000 incurred by the service departments are ultimately allocated to the two production departments. The intermediate allocations from service department to service department improve the accuracy of those final allocations.

Allocation of Service Department Costs Reciprocal Method The Reciprocal Method is the most accurate of the three methods for allocating service department costs, because it recognizes reciprocal services among service departments. It is also the most complicated method, because it requires solving a set of simultaneous linear equations. Using the data from the step-down method example, the simultaneous equations are: H.R. = $ 80,000 + (0.08 x D.P.) D.P. = $120,000 + (0.20 x H.R.) R.M. = $ 40,000 + (0.10 x H.R.) + (0.07 x D.P.) Where the variables H.R., D.P. and R.M. represent the total costs to allocate from each of these service departments. For example, Human Resources receives services from Data Processing, but not from Risk Management. 8% of the services that Data Processing provides, it provides to Human Resources. Therefore, the total costs allocated from Human Resources should include not only the $80,000 incurred in that department, but also 8% of the costs incurred by Data Processing. Solving for the three unknowns (which can be performed using spreadsheet software): H.R. = $ 91,057 D.P. = $138,211 R.M. = $ 58,781

Allocation of Service Department Costs Step-down Method Example: Human Resources (H.R.), Data Processing (D.P.), and Risk Management (R.M.) provide services to the Machining and Assembly production departments, and in some cases, the service departments also provide services to each other: Total Cost Service Dept % of services provided by the service department listed at left to: H.R.D.P.R.M. Machinin g Assembly $ 80,000H.R.--20%10%40%30% 120,000D.P.8%--7%30%55% 40,000R.M.-- 50% $240,000

Allocation of Service Department Costs Reciprocal Method Hence, costs are allocated as follows: To illustrate the derivation of the amounts in this table, the $36,423 that is allocated from Human Resources to Machining is 40% of H.R.’s total cost of $91,057. H.R.D.P.R.M. Machin ing Assembl y Costs prior to allocation$80,000$120,000$40,000-- Allocation of H.R.($91,057) 18,211 9,106$36,423 $ 27,31 7 Allocation of D.P. 11,05 7 (138,211 ) 9,675 41,463 76,016 Allocation of R.M. (58,781 ) 29,390 $ 0 $107,27 6 $132,72 3

Allocation of Service Department Costs Summary The direct method and step-down method have no advantages over the reciprocal method except for their simplicity, and the step-down method is sometimes not very simple. Nevertheless, the reciprocal method is not widely used. Given advances in computing power, the reciprocal method would seem to be accessible to many companies that are not using it. Presumably, these companies believe that the benefits obtained from more accurate service department cost allocations do not justify the costs required to implement the reciprocal method. In fact, many companies do not allocate service department costs at all, either because they do not think these allocations are beneficial, or because they do not believe that the benefits justify the costs.

Correlation and regression Forecasting Methods – Qualitative – Manager’s experience and intuition Can you think of some methods – Quantitative – Mathematical models and graphs Regression Trend analysis

Correlation and regression Correlation Analysis – Foundation of any quantitative method of forecasting – Strength of the linear relationship between two variables – Value ranges from 1 to -1 – The more a straight line the greater correlation (r)

SU 8.1 - Correlation and regression Qualitative methods: forecast based on manager’s experience and knowledge Quantitative methods use mathematical models – Correlation analysis: strength of a linear relationship between 2 variables  coefficient of correlation (r) – r = [ -1 ; +1]

SU 8.1 - Correlation and regression Coefficient of determination (r2) – Also coefficient of correlation squared – Is a measure of how good fit between the two variables – Total variation in the dependent variable that is accounted for by the independent variables

Statistic Definitions (to know and remember) Correlation coefficient may refer to: – Pearson product-moment correlation coefficient, also known as r, R, or Pearson's r, a measure of the strength and direction of the linear relationship between two variables that is defined as the (sample) covariance of the variables divided by the product of their (sample) standard deviations. Pearson product-moment correlation coefficient Related concepts: – Correlation and dependence, a broad class of statistical relationships between two or more random variables or observed data values Correlation and dependence – Goodness of fit, any of several measures that measure how well a statistical model fits observations by summarizing the discrepancy between observed values and the values expected under the model in question Goodness of fit – Coefficient of determination, a measure of the proportion of variability in a data set that is accounted for by a statistical model; often called R 2 ; equal in a single-variable linear regression to the square of Pearson's product-moment correlation coefficient. Coefficient of determination

Statistic Definitions Coefficient of determination (r^2) This is a measure of how good the fit between 2 variables is – Regression Analysis : y = a + bx y = dependent variable a = the y intercept b = slope of the regression line x = independent variable

Learning curve analysis Increased rate at which people perform tasks as they gain experience % of reduced time to complete a task for each doubling of cumulative production 2 methods: - cumulative average-time learning model - incremental unit-time learning model

Question 1 The average labor cost per unit for the first batch produced by a new process is $120. The cumulative average labor cost after the second batch is $72 per product. Using a batch size of 100 and assuming the learning curve continues, the total labor cost of four batches will be A. $4,320 B. $10,368 C. $2,592 D. $17,280

Question 1 Answer A. The cost of the items in the fourth batch equals $4,320. B. The amount of $10,368 is based on the assumption that the cumulative average unit labor cost is reduced by the learning curve percentage with each batch, not each doubling of output. C. The amount of $2,592 represents the labor cost of 100 units at the unit rate expected after another doubling of production to eight batches. D. *Correct Answer* The learning curve reflects the increased rate at which people perform tasks as they gain experience. The time required to perform a given task becomes progressively shorter. Ordinarily, the curve is expressed in a percentage of reduced time to complete a task for each doubling of cumulative production. One common assumption in a learning curve model is that the cumulative average time (and labor cost) per unit is reduced by a certain percentage each time production doubles. Given a $120 cost per unit for the first 100 units and a $72 cost per unit when cumulative production doubled to 200 units, the learning curve percentage must be 60% ($72 ÷ $120). If production is again doubled to 400 units (four batches), the average unit labor cost should be $43.20 ($72 × 60%). Hence, total labor cost for 400 units is estimated to be $17,280 (400 units × $43.20).

The Master Budget Annual Profit Plan Operating Budget – emphasis is on current resources – Sales budget – Production budget – Direct material budget – Manufacturing overhead budget – Ending finished goods inventory budget – Cost of goods sold budget Continued

The Master Budget – Nonmanufacturing budget Research and development budget Design budget Marketing budget Distribution budget Customer service budget Administrative budget – Pro forma income statement

The Master Budget Financial Budget – emphasis on funds needed to purchase operating assets. Sales Budget Production Budget Purchase Budget Expense Budget Continued

The Master Budget Capital budget Cash budget – Projected cash disbursement – Projected cash collection schedule Pro forma income statement Pro forma balance sheet Pro forma statement of cash flows

The Master Budget Also called comprehensive budget or annual profit plan (operating + financial) Operating Budget (Sales, Production, DM, DL, MOH, COGS, R&D, Marketing…) Financial Budget (Capital or CAPEX, Cash flows, Pro- Forma B/S, Pro-Forma CF)

Budget Methodologies Project Budget Activity-Based Budget Zero-Based Budget (Manager must justify the entire budget every year/cycle) Continuous budgeting – More accurate and keep Managers thinking ahead – time consuming

Budget Methodologies Remember Static & Flexible Budgeting: – Static Budget = based on only one level of sales or production – Flexible Budget = series of budgets prepared for many levels of activity

Question 1 An advantage of incremental budgeting when compared with zero-based budgeting is that incremental budgeting A. Encourages adopting new projects quickly. B. Accepts the existing base as being satisfactory. C. Eliminates functions and duties that have outlived their usefulness. D. Eliminates the need to review all functions periodically to obtain optimum use of resources.

Question 1 Answer Answer Explanations for Question 2: A. Both types of budgets treat new projects in the same manner. B. *Correct Answer* Incremental budgeting simply adjusts the current year’s budget to allow for changes planned for the coming year; a manager is not asked to justify the base portion of the budget. ZBB, however, requires a manager to justify the entire budget for each year. Incremental budgeting offers to managers the advantage of requiring less managerial effort to justify changes in the budget. C. Reexamining functions and duties that may have outlived their usefulness is an advantage of ZBB. D. Periodic review of functions is essential regardless of the budgetary system used.

Operating Budget Calculation Sales Budget: Sales forecast x Selling Price Production Budget: concerned with Units only (no impact from Pricing strategy) – Projected Units (Volume) – Desired Ending Inventory (Safety Stock) – Projection on BGN Inventory –  Units to be produced (include % spoilage)

Operating Budget Calculation Direct Materials Budget – Follow directly from the production budget – Concerned with units and input prices – Objective is to minimize raw inventory carrying cost, obsolesces – Closely

Operating Budget Calculations Direct Labor Budget Employee Fringe Benefits Variable OH: Manufacturing OH budget reflects the nature of OH as a mixed cost (VC + FC) VOH contains elements that vary with level of production: indirect materials, indirect labor, variable factory operating costs Fixed OH: real estate taxes, insurance, depreciations = easy to project

Operating Budget Calculations Ending Finished Goods Inventory Budget COGS Budget (materials, labor, overhead) Variable Costing & Contribution Margin Nonmanufacturing Budget Pro Forma Operating Income

Cash Budget Cash budget projects cash receipts and disbursements for planning and control purposes. It helps prevent not only cash emergencies but also identifies excessive idle cash. – Part of the financial budget cycle that ties together all the schedules from the operating budget. – Vital because an organization must have adequate cash. Particularly important for seasonal organizations Must consider collection policies, bad debt est., changes in the economy, etc.

Sales Forecast and Pro Forma Financial Statements Sales Forecast – Begin by looking at historical trends Using regression analysis to forecast next year’s sales Determining the AAGR (Average Annual Growth Rate)

Sales Forecasts Percent of sales method – After sales are forecasted, future financial statements must be forecasted – Common method is the percent of sales method Items on the income statement and balance sheets assumed to increase proportionately to sales Other items based off historical data and forecasted net sales

Pro Forma Financial Statements Pro forma: Latin phrase meaning “according to form.” – Referred to when financial statements reflect projected, rather than actual, results – Used to decide whether budget activities will result in acceptable level of income – Also observed is target gross margin percentage and the interest coverage ratio

Pro Forma Financial Statements Pro Forma Balance Sheet: – Using cash and capital budgets – And the pro forma income statement – Beginning-of-the-period balance sheet

Pro Forma Financial Statements Pro Forma Statement of Cash Flow – Normally last statement prepared – Classifies cash receipts and disbursements – Direct presentation reports the major classes of gross cash operating receipts, payments, and difference between them – Indirect presentation reconciles net income with net operating cash flow

Pro Forma Financial Statements Financial Projections and Ratio Analysis – Help the bank asses debt covenants – To see whether company anticipates satisfying requirements – Typically debt ratio < than a certain threshold – Coverage ratio > than a threshold – Satisfactory levels of these ratios provide the bank assurance

Question 1 In November, a company finalized its budget for the upcoming calendar year. In December, the decision was made to acquire new equipment in January by trading in old equipment and financing the amount due by a loan with principal and interest due at the end of 3 years. Out-of-pocket costs to operate the machinery would not change. This decision would change which of the company’s budgeted financial statements for the upcoming year? A. The budgeted balance sheet only. B. Both the budgeted balance sheet and the income statement. C. The budgeted balance sheet, the income statement, and the statement of cash flows. D. Both the budgeted income statement and the statement of cash flows.

Question 1 Answer A. The budgeted balance sheet is not the only statement that would change. B. The budgeted balance sheet and the income statement are not the only statements that would change. C. *Correct Answer* The budgeted balance sheet, the income statement, and the statement of cash flows would all change. D. The budgeted income statement and the statement of cash flows are not the only statements that would change.

Question 2 A production plan should be based on A. A sales forecast adjusted for projected inventory levels. B. Economic order quantities and reorder points. C. Exponential smoothing. D. Linear regression.

Question 2 Answer A. *Correct Answer* A production plan depends on the sales budget and anticipated inventory levels. Inventory serves to balance seasonal fluctuations in sales with the need for stable and efficient use of productive resources. B. EOQs and reorder points are considered only after it has decided how many units are needed. C. Exponential smoothing is a technique used to level or smooth variations encountered in a forecast. A production plan should be based on the variations expected. D. Regression analysis explains the correlation of a dependent variable with one or more independent variables. It is based on linearity of costs.

Cram Session Part 1 Jim Clemons, CMA. Cost Management Terminology Financial Accounting – Reporting to external users – Financial statements – Historical.

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Cram Session Part 1 Jim Clemons, CMA. Cost Management Terminology Financial Accounting – Reporting to external users – Financial statements – Historical.

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