Cost Information – Cost information includes all the various types of costs a company may incur in producing or distributing a product or providing a service. Cost information is critical in product mix and product pricing decisions. For example, if a company cannot reduce costs in order to match competitor pricing for the same or similar product, it may decide to eliminate that product from its line.
Cost information includes the variable costs, total manufacturing costs (both fixed and variable) and full costs (which include fixed and variable manufacturing and selling and administrative costs). Variable costs (such as raw material costs, direct labor costs, and selling costs) reveal cost-volume-profit relationships that will be important if different volume levels are possible. With full costing, a per unit cost can be misleading as volume changes. For example, variable costs may be $5 per unit and fixed costs $3 per unit with 1,000 units but $6 per unit with 500 units. Typically in making decisions, multiple costing approaches will generally be used in cost analysis and pricing decisions.
Target costing requires full understanding of cost information. Target costing is the process in which a company tries to achieve a maximum target cost in order to be able to be profitable in the long run. It is used increasingly as companies have less affect on pricing. For example, copper producers must focus almost exclusively on processing costs since the market determines the price of the copper sold. Managing direct and indirect costs to reduce costs and remain competitive is the key to target costing.
Pricing Strategy – One of the major decisions faced by many organizations is pricing, including pricing for new products and pricing for competitive products. A number of factors besides production costs influence pricing including competitors, customer expectations, and legal requirements (for example, the illegality of predatory pricing and discriminatory pricing).
Beyond these factors, however, accountants assist in the pricing strategy decisions by providing information on the costs to produce a product or service. From there a company can decide its pricing approach. Generally a company will either decide upon target costing or a certain margin above price (known as cost-plus pricing, where costs can be defined as variable costs, total direct costs, or full costs). Of course, companies with different types of products may have different price strategies for each. Consider pricing on airlines. Clearly, pricing is a function of covering costs plus some desired margin for many seats. However, in competitive markets the margin is lower, pricing generally must match competitors. If competitors have lower operating costs (such as Southwest Airlines), trying to duplicate pricing often squeezes the margins of competitors. Where demand is higher (such as first class, holidays, last minute tickets), pricing is more a function of what the market will allow.
Return – Return is a measure of income or profit from an investment. The investment might be a passive one such as investing in an equity security of a company or the investment might be part of a plant and equipment investment that will generate revenue and profits. Since investments are outflows of cash and other assets and there is a limited amount of cash and assets, return is a way to measure and prioritize the allocation of these asset resources. For example, assume you have $1,000 to invest. How do you decide where to invest the $1,000? Expected return is one attribute that you will analyze.
Expected return will generally be expressed in terms of future cash inflows. The expected future inflows must be sufficient to justify the investment. Capital budgeting and other types of analyses frequently utilize tools that focus on net returns for a given investment. The result is information about investment and return that facilitate the decision about where to invest.
Time Value of Money - The time value of money refers to the fact that a dollar in hand today is worth more than a dollar promised at some future time. A dollar in hand today can be invested in an interest-bearing account that would grow in value over time. This explains in part why the value of money is related to time. The trade-off between money now and money later depends on, among other things, the rate of interest you can earn by investing. If not invested, the time value of money shrinks by the rate of inflation. At a minimum, money must be invested in order to keep pace with the rate of inflation.
Capital Budgeting - Capital budgeting is the total process of generating, evaluating, selecting and following up on capital expenditures. Capital expenditures can be new equipment, new software, new hardware, new buildings, or any project that is expected to last more than one year. Capital budgeting is an extremely important aspect of a firm's financial management. With limited resources, capital budgeting requires analysis of all potential capital projects and expenditures with decisions regarding which projects will be done first, next, or not at all.
Although capital assets usually comprise a smaller percentage of a firm's total assets than do current assets, capital assets are long-term (at least 12 months but usually much longer). Therefore, a firm that makes a mistake in its capital budgeting process has to live with that mistake for a long period of time.
Sunday, December 17, 2006
Monday, December 11, 2006
Costing Systems
Traditional Manufacturing Costing Systems
Traditional costing systems are one way to estimate cost of a product or customer or job. Cost is direct cost (such as labor and materials) and indirect costs (also known as overhead).Traditional costing uses cost centers or departments to accumulate and allocate overhead costs to products or jobs. Usually, the allocation is based on a volume metric such as labor hours or machine hours. The result may be meaningful where only a few similar products are produced. However, where numerous diverse products are manufactured, the total costs associated with each product are lost through the arbitrary allocation process. Traditional Cost Accounting (or TCA) is unable to calculate the “true” cost of a product when there isn’t a single cost driver for ALL the indirect costs.
Activity-Based Costing Systems
Activity-Based Costing (or ABC) Systems are another method to determine cost of a product or job or customer, etc. ABC is more accurate cost management system than Traditional Cost Accounting (TCA). ABC attempts to determine the true cost for a product, a job, a service, or a customer by focusing on indirect costs and tracing those costs to individual products, services, or customers (rather than simply allocating arbitrarily). Essentially, it makes indirect costs “direct costs” by tracing and assigning them to particular products or jobs, etc. If a product requires certain activities that consume certain resources, that consumption of resources should be included in the total cost.
Information about true costs helps companies identify where they are and are not making money. It assists in computing and evaluating break-even points and in evaluating different options for new improvements and business plans. Strategic decision-making should improve with better cost information.
Sunk Costs
Sunk costs are irrelevant costs to decision-making. Sunk costs are costs that have already occurred. They include expenditures on equipment or inventory. Just because money has been spent on assets or time spent on projects, those asset costs are sunk and are not relevant to the future inflows and outflows. Spending $5 million on a project and abandoning it may not make sense initially, but if the future inflows do not outweigh the future outflows, the $5 million in incurred project costs should not be considered in the decision to keep the project active or discontinue it.
Manufacturing Decisions
Manufacturing decisions relate to product-mix and the relative profitability of products. Manufacturers may make decisions with respect to cost control, such as making a sub-assembly or buying it, going out of the plant for maintenance (outsourcing) or performing maintenance in-house, or replacing old equipment or replacing it with new equipment. Each of these decisions requires information about costs. To the extent the cost information is misleading because of traditional costing systems, the decisions made will not be optimal.
Quality Issues
Quality relates to ensuring that products and services perform to customer or industry standard requirements. Customers have certain expectations as to quality. Automobiles should be reliable, safe, and perform to the expectations of the type of car. Users of audited financial statements also require also quality with respect to reliability and full disclosure.
Regardless of the context, once we understand what quality is, companies still must determine how to maintain and control quality. Accountants in some companies assist in the development of cost of preventing or fixing poor quality. In total quality management systems, accountants focus on controlling production to eliminate poor quality at the earliest stages rather than to detect and fix poor quality.
Traditional costing systems are one way to estimate cost of a product or customer or job. Cost is direct cost (such as labor and materials) and indirect costs (also known as overhead).Traditional costing uses cost centers or departments to accumulate and allocate overhead costs to products or jobs. Usually, the allocation is based on a volume metric such as labor hours or machine hours. The result may be meaningful where only a few similar products are produced. However, where numerous diverse products are manufactured, the total costs associated with each product are lost through the arbitrary allocation process. Traditional Cost Accounting (or TCA) is unable to calculate the “true” cost of a product when there isn’t a single cost driver for ALL the indirect costs.
Activity-Based Costing Systems
Activity-Based Costing (or ABC) Systems are another method to determine cost of a product or job or customer, etc. ABC is more accurate cost management system than Traditional Cost Accounting (TCA). ABC attempts to determine the true cost for a product, a job, a service, or a customer by focusing on indirect costs and tracing those costs to individual products, services, or customers (rather than simply allocating arbitrarily). Essentially, it makes indirect costs “direct costs” by tracing and assigning them to particular products or jobs, etc. If a product requires certain activities that consume certain resources, that consumption of resources should be included in the total cost.
Information about true costs helps companies identify where they are and are not making money. It assists in computing and evaluating break-even points and in evaluating different options for new improvements and business plans. Strategic decision-making should improve with better cost information.
Sunk Costs
Sunk costs are irrelevant costs to decision-making. Sunk costs are costs that have already occurred. They include expenditures on equipment or inventory. Just because money has been spent on assets or time spent on projects, those asset costs are sunk and are not relevant to the future inflows and outflows. Spending $5 million on a project and abandoning it may not make sense initially, but if the future inflows do not outweigh the future outflows, the $5 million in incurred project costs should not be considered in the decision to keep the project active or discontinue it.
Manufacturing Decisions
Manufacturing decisions relate to product-mix and the relative profitability of products. Manufacturers may make decisions with respect to cost control, such as making a sub-assembly or buying it, going out of the plant for maintenance (outsourcing) or performing maintenance in-house, or replacing old equipment or replacing it with new equipment. Each of these decisions requires information about costs. To the extent the cost information is misleading because of traditional costing systems, the decisions made will not be optimal.
Quality Issues
Quality relates to ensuring that products and services perform to customer or industry standard requirements. Customers have certain expectations as to quality. Automobiles should be reliable, safe, and perform to the expectations of the type of car. Users of audited financial statements also require also quality with respect to reliability and full disclosure.
Regardless of the context, once we understand what quality is, companies still must determine how to maintain and control quality. Accountants in some companies assist in the development of cost of preventing or fixing poor quality. In total quality management systems, accountants focus on controlling production to eliminate poor quality at the earliest stages rather than to detect and fix poor quality.
Management accounting -- Chapter 10
Decentralization -- the delegation of freedom to make decisions. The lever in the organization that this freedom exists, the greater decentralization
segment autonomy -- the delegation of decision-making power to managers of segments of an organization
incentives -- those informal and formal performance-based rewards that enhance managerial effort toward organizational goals
agency theory -- a theory that deals with contracting between an organization and the managers that hires to make decisions on its behalf
return on investment (ROI) -- a measure of income or profit divided by the investment required to obtain that income or profit
return on sales -- income divided by revenue
capital turnover -- revenue divided by invested capital
residual income (RI) -- after-tax operating income less a capital charge
capital charge -- Company's cost of capital Times amount of investment
cost of capital -- what a firm must pay to acquire more capital, whether or not it actually has to acquire more capital
economic value added (EVA) -- equals adjusted after-tax operating income minus the cost of invested capital multiplied by the adjusted average invested capital
Gross book value -- the original cost of an asset before deducting accumulated depreciation
net book value -- the original cost of an asset less any accumulated depreciation
transfer price -- the price that one segment of an organization charges another segment of the same organization for product or service
dysfunctional decision -- any decision that is in conflict with organizational goals
management by objectives (MBO) -- the joint formulation by a manager and his or her superior of a set of goals and plans for achieving the goals for a forthcoming period
As companies grow, the ability of managers to effectively plan and control becomes more and more difficult because top managers are further removed from day-to-day operations. One approach to effective planning and control in large companies is to decentralize decision-making. This means that top management gives mid and lower level managers the freedom to make decisions that impact the subunits performance. The more that decision-making is delegated, the greater the decentralization. Often, the subunit manager is most knowledgeable of the factors that management should consider in the decision-making process.
Top management must design and management control system so that it motivates managers to act in the best interests of the company. This is done through the choice of responsibility centers in the appropriate performance measures and rewards. The degree of decentralization does not depend on the type of responsibility center chosen. For example, a cost center manager in one company may have more decision-making authority than does a profit center manager in a highly centralized company.
It is generally a good idea to link managers rewards to responsibility center results. Top management should use performance measures for the responsibility center that promote goal congruence. However, linking rewards to results creates risks for the manager. The greater the influence of uncontrollable factors on a managers reward, the more risk the manager bears.
It is typical to measure the results of investment centers using a set of performance measures that include financial measures such as return on investment (ROI), residual income, or economic value added (EVA). ROI is any income measure divided by the dollar amount invested and is expressed as a percentage. Residual income, or economic value added, is after-tax operating income less a capital charge based on the capital invested (cost of capital). It is an absolute dollar amount.
The way an organization measures invested capital determines the precise motivation provided by ROI, RI, or EVA. Managers will try to reduce assets or increased liabilities that accompany includes in their divisions investment base. They will adopt more conservative assets replacement policies if the company uses net book value rather than Gross book value in measuring the assets.
In large companies with many different segments, one segment often provides products or services to another segment. The siding on the amount the selling division should charge the buying division for these transfers is difficult. Companies use various types of transfer pricing policies. The overall purpose of transfer prices is to motivate managers to act in the best interests of the company, not just the segment.
As a general rule, transfer prices should approximate the outlay cost plus opportunity cost. Each type of transfer price has its own advantages and disadvantages. Each has a situation where it works best, and each can lead to dysfunctional decisions in some instances. Cost based prices are readily available, but if a company uses actual cost, the receding segment manager does not know the cost in advance, which makes cost planning difficult. When a competitive market exists for the product or service, using market-based transfer prices usually leads to goal congruence and optimal decisions. When idle capacity exists in the segment providing the product or service, the use of variable cost as the transfer price usually leads to goal congruence.
Multinational organizations often use transfer prices as a means of minimizing worldwide income taxes, import duties, and tariffs.
Regardless of what measures a management control system uses, when used to evaluate managers they should focus on only the controllable aspects of the measures. MBO can focus attention on performance compared to expectations, which is better than a valuations based on absolute profitability.
segment autonomy -- the delegation of decision-making power to managers of segments of an organization
incentives -- those informal and formal performance-based rewards that enhance managerial effort toward organizational goals
agency theory -- a theory that deals with contracting between an organization and the managers that hires to make decisions on its behalf
return on investment (ROI) -- a measure of income or profit divided by the investment required to obtain that income or profit
return on sales -- income divided by revenue
capital turnover -- revenue divided by invested capital
residual income (RI) -- after-tax operating income less a capital charge
capital charge -- Company's cost of capital Times amount of investment
cost of capital -- what a firm must pay to acquire more capital, whether or not it actually has to acquire more capital
economic value added (EVA) -- equals adjusted after-tax operating income minus the cost of invested capital multiplied by the adjusted average invested capital
Gross book value -- the original cost of an asset before deducting accumulated depreciation
net book value -- the original cost of an asset less any accumulated depreciation
transfer price -- the price that one segment of an organization charges another segment of the same organization for product or service
dysfunctional decision -- any decision that is in conflict with organizational goals
management by objectives (MBO) -- the joint formulation by a manager and his or her superior of a set of goals and plans for achieving the goals for a forthcoming period
As companies grow, the ability of managers to effectively plan and control becomes more and more difficult because top managers are further removed from day-to-day operations. One approach to effective planning and control in large companies is to decentralize decision-making. This means that top management gives mid and lower level managers the freedom to make decisions that impact the subunits performance. The more that decision-making is delegated, the greater the decentralization. Often, the subunit manager is most knowledgeable of the factors that management should consider in the decision-making process.
Top management must design and management control system so that it motivates managers to act in the best interests of the company. This is done through the choice of responsibility centers in the appropriate performance measures and rewards. The degree of decentralization does not depend on the type of responsibility center chosen. For example, a cost center manager in one company may have more decision-making authority than does a profit center manager in a highly centralized company.
It is generally a good idea to link managers rewards to responsibility center results. Top management should use performance measures for the responsibility center that promote goal congruence. However, linking rewards to results creates risks for the manager. The greater the influence of uncontrollable factors on a managers reward, the more risk the manager bears.
It is typical to measure the results of investment centers using a set of performance measures that include financial measures such as return on investment (ROI), residual income, or economic value added (EVA). ROI is any income measure divided by the dollar amount invested and is expressed as a percentage. Residual income, or economic value added, is after-tax operating income less a capital charge based on the capital invested (cost of capital). It is an absolute dollar amount.
The way an organization measures invested capital determines the precise motivation provided by ROI, RI, or EVA. Managers will try to reduce assets or increased liabilities that accompany includes in their divisions investment base. They will adopt more conservative assets replacement policies if the company uses net book value rather than Gross book value in measuring the assets.
In large companies with many different segments, one segment often provides products or services to another segment. The siding on the amount the selling division should charge the buying division for these transfers is difficult. Companies use various types of transfer pricing policies. The overall purpose of transfer prices is to motivate managers to act in the best interests of the company, not just the segment.
As a general rule, transfer prices should approximate the outlay cost plus opportunity cost. Each type of transfer price has its own advantages and disadvantages. Each has a situation where it works best, and each can lead to dysfunctional decisions in some instances. Cost based prices are readily available, but if a company uses actual cost, the receding segment manager does not know the cost in advance, which makes cost planning difficult. When a competitive market exists for the product or service, using market-based transfer prices usually leads to goal congruence and optimal decisions. When idle capacity exists in the segment providing the product or service, the use of variable cost as the transfer price usually leads to goal congruence.
Multinational organizations often use transfer prices as a means of minimizing worldwide income taxes, import duties, and tariffs.
Regardless of what measures a management control system uses, when used to evaluate managers they should focus on only the controllable aspects of the measures. MBO can focus attention on performance compared to expectations, which is better than a valuations based on absolute profitability.
Management accounting -- Chapter 9
Management control system -- a logical integration of techniques for gathering and using information to make planting and control decisions, for motivating employee behavior, and for evaluating performance
Key success factor -- characteristic or attributes that managers must achieve in order to drive the organization toward its goals
responsibility Center -- a set of activities and resources assigned to a manager, a group of managers, or other employees
responsibility accounting -- identifying what parts of the organization have primary responsibility for each action, developing performance measures and targets, and designing reports of these measures by responsibility Center
cost center -- a responsibility Center in which managers are responsible for costs only
profit center -- a responsibility Center in which managers are responsible for revenues as well as costs (or expenses) -- that is, profitability
investment center -- a responsibility Center is success depends on both income and invested capital, perhaps measured by a ratio of income to the value of the capital employed
goal congruence -- a condition where employees, working in their own personal interests, make decisions that help meet the overall goals of the organization
managerial effort -- exertion toward a goal or objective including all conscious actions (such as supervising, planning, and thinking) that result in more efficiency and effectiveness
motivation -- the drive for some selected goal that creates effort and action toward that goal
uncontrollable cost -- any cost that the management of a responsibility Center cannot affect within a given time span
controllable cost -- any cost that a managers decisions and actions can influence
segments -- responsibility centers for which a company develops separate measures of revenue and costs
balanced scorecard -- a performance measurement and reporting system that strikes a balance between financial and operating measures, links performance to rewards, and gives explicit recognition to the diversity of organizational goals
Key performance indicators -- measures that drive the organization to achieve its goals
quality control -- the effort to ensure that products and services performed to customer requirements
cost of quality report -- a report that displays the financial impact of quality
total quality Management (TQM) -- an approach to quality that focuses on prevention of defects and on customer satisfaction
quality control chart -- the statistical plot of measures of various product dimensions or attributes
six Sigma -- an analytical method aimed at achieving near-perfect results on a production line
cycle time (throughput time) -- the time taken to complete a product or service, or any of the components of a product or service
productivity -- a measure of outputs divided by inputs
The starting point for designing and evaluating a management control system is the identification of organizational goals as specified by top management.
Responsibility accounting assigns particular revenue or cost objectives to the management of the subunit that has the greatest influence over them. Cost centers focus on costs only, profit centers on both revenues and costs, and investment centers on profits relative to the amount invested.
A well-designed management control system measures both financial and nonfinancial performance. In fact, nonfinancial performance usually leads to financial performance in time. The performance measures should tell managers how well they are meeting the organization's goals.
The way an organization measures and evaluates performance affects individual's behavior. The more that it ties rewards to performance measures, the more incentive there is to improve the measures. Poorly designed measures may actually work against the organization's goals.
The contribution approach to measuring a segments income aids performance evaluation by separating a segments costs into this controllable by the segment management and those beyond management's control. It allows separate evaluation of a segment as an economic investment in the performance of the segments manager.
The balanced scorecard helps managers monitor actions that are designed to meet the various goals of the organization. It contains key performance indicators that measure how well the organization is meeting its goals.
Measuring performance in areas such as quality, cycle time, and productivity causes employees to direct attention to those areas. Achieving goals in these nonfinancial measures can help meet long-run financial objectives.
Management control in service and nonprofit organizations is difficult because of a number of factors, chief of which is a relative lack of clearly observable outcomes.
Key success factor -- characteristic or attributes that managers must achieve in order to drive the organization toward its goals
responsibility Center -- a set of activities and resources assigned to a manager, a group of managers, or other employees
responsibility accounting -- identifying what parts of the organization have primary responsibility for each action, developing performance measures and targets, and designing reports of these measures by responsibility Center
cost center -- a responsibility Center in which managers are responsible for costs only
profit center -- a responsibility Center in which managers are responsible for revenues as well as costs (or expenses) -- that is, profitability
investment center -- a responsibility Center is success depends on both income and invested capital, perhaps measured by a ratio of income to the value of the capital employed
goal congruence -- a condition where employees, working in their own personal interests, make decisions that help meet the overall goals of the organization
managerial effort -- exertion toward a goal or objective including all conscious actions (such as supervising, planning, and thinking) that result in more efficiency and effectiveness
motivation -- the drive for some selected goal that creates effort and action toward that goal
uncontrollable cost -- any cost that the management of a responsibility Center cannot affect within a given time span
controllable cost -- any cost that a managers decisions and actions can influence
segments -- responsibility centers for which a company develops separate measures of revenue and costs
balanced scorecard -- a performance measurement and reporting system that strikes a balance between financial and operating measures, links performance to rewards, and gives explicit recognition to the diversity of organizational goals
Key performance indicators -- measures that drive the organization to achieve its goals
quality control -- the effort to ensure that products and services performed to customer requirements
cost of quality report -- a report that displays the financial impact of quality
total quality Management (TQM) -- an approach to quality that focuses on prevention of defects and on customer satisfaction
quality control chart -- the statistical plot of measures of various product dimensions or attributes
six Sigma -- an analytical method aimed at achieving near-perfect results on a production line
cycle time (throughput time) -- the time taken to complete a product or service, or any of the components of a product or service
productivity -- a measure of outputs divided by inputs
The starting point for designing and evaluating a management control system is the identification of organizational goals as specified by top management.
Responsibility accounting assigns particular revenue or cost objectives to the management of the subunit that has the greatest influence over them. Cost centers focus on costs only, profit centers on both revenues and costs, and investment centers on profits relative to the amount invested.
A well-designed management control system measures both financial and nonfinancial performance. In fact, nonfinancial performance usually leads to financial performance in time. The performance measures should tell managers how well they are meeting the organization's goals.
The way an organization measures and evaluates performance affects individual's behavior. The more that it ties rewards to performance measures, the more incentive there is to improve the measures. Poorly designed measures may actually work against the organization's goals.
The contribution approach to measuring a segments income aids performance evaluation by separating a segments costs into this controllable by the segment management and those beyond management's control. It allows separate evaluation of a segment as an economic investment in the performance of the segments manager.
The balanced scorecard helps managers monitor actions that are designed to meet the various goals of the organization. It contains key performance indicators that measure how well the organization is meeting its goals.
Measuring performance in areas such as quality, cycle time, and productivity causes employees to direct attention to those areas. Achieving goals in these nonfinancial measures can help meet long-run financial objectives.
Management control in service and nonprofit organizations is difficult because of a number of factors, chief of which is a relative lack of clearly observable outcomes.
Sunday, December 10, 2006
Management accounting -- Chapter 6
Differential cost (revenue) -- the difference in total cost or revenue between two alternatives
incremental cost -- another term for differential cost when one alternative includes all the costs of the other plus some additional costs
outlay cost -- a cost and requires a future cash disbursement
opportunity cost -- the maximum available contribution to profit forgone (or passed up) by using limited resources for particular purpose
joint products -- 2 or more manufactured products that: have relatively significant sales values and are not separately identifiable as individual products until they're split off point
split off point -- the juncture of manufacturing or the joint products become individually identifiable
separable costs -- any cost beyond the split off point
joint costs -- the costs of manufacturing joint products prior to split off point
depreciation -- the periodic cost of equipment that accompany spreads over the future periods in which the company will use the equipment
book value (net book value) -- the original cost of equipment less accumulated depreciation
accumulated depreciation -- the sum of all depreciation charge to pass periods
sunk cost -- a historical or passed cost, that is, a cost that the company has already incurred and, therefore, is irrelevant to the decision-making process
absorption approach -- a cost of approach that considers all indirect manufacturing costs (both variable and fixed) to be product costs that become an expense in the form of manufacturing cost of goods sold only as sales occur
contribution approach -- a method of internal reporting that emphasizes the distinction between variable and fixed costs for the purpose of better decision-making
One should always consider opportunity costs when deciding on the use of limited resources. The opportunity cost of a course of action is the maximum profit forgone from other alternative actions. Decision-makers may fail to consider opportunity costs because accountants do not report them in the financial accounting system.
One of the most important production decisions is the make or buy decision. Should a company make its own parts or products or should they buy them from outside sources? Both qualitative and quantitative factors affect this decision. In applying relevant cost analysis to make or buy situation, he key factor to consider is the use of facilities.
Another typical production situation is deciding whether to process further a joint product or sell it at the split off point. The relevant information for this decision includes the costs that differ beyond the split off point. Joint costs that occur before split off are irrelevant.
In certain production decisions, it is important to recognize and identify irrelevant costs. In the decision to dispose of obsolete inventory, the original cost of the inventory is irrelevant because there is no way to restore the resources used to buy or produce that inventory.
And the decision to keep or replace equipment, the book value of old equipment is irrelevant. This sunk cost is a past or historical cost that a company has are ready incurred. Relevant costs normally include the disposal value of old equipment, the cost of new equipment, and the difference in the annual operating costs.
Unit fixed costs can be misleading because of the differences in the assumed level of volume on which they are based. The more units a company makes, the lower the unit fixed cost will be. If a salesperson assumes a company will produce 100,000 units and actually produces only 30,000 units, the unit costs will be understated. You can avoid being misled by unit costs by always using total fixed costs.
If companies evaluate managers using performance measures that are not in line with relevant decision criteria, there could be a conflict of interest. Managers often make decisions based on how the decision affects their performance measures. Thus, performance measures work best when they are consistent with the long-term good of the company.
The major difference between the absorption and contribution formats for the income statement is that the contribution format focuses on cost behavior (fixed and variable), whereas the absorption format reports cost by business functions. The contribution approach makes it easier for managers to evaluate the effects of changes in volume on income and dust it is better for decision-making.
incremental cost -- another term for differential cost when one alternative includes all the costs of the other plus some additional costs
outlay cost -- a cost and requires a future cash disbursement
opportunity cost -- the maximum available contribution to profit forgone (or passed up) by using limited resources for particular purpose
joint products -- 2 or more manufactured products that: have relatively significant sales values and are not separately identifiable as individual products until they're split off point
split off point -- the juncture of manufacturing or the joint products become individually identifiable
separable costs -- any cost beyond the split off point
joint costs -- the costs of manufacturing joint products prior to split off point
depreciation -- the periodic cost of equipment that accompany spreads over the future periods in which the company will use the equipment
book value (net book value) -- the original cost of equipment less accumulated depreciation
accumulated depreciation -- the sum of all depreciation charge to pass periods
sunk cost -- a historical or passed cost, that is, a cost that the company has already incurred and, therefore, is irrelevant to the decision-making process
absorption approach -- a cost of approach that considers all indirect manufacturing costs (both variable and fixed) to be product costs that become an expense in the form of manufacturing cost of goods sold only as sales occur
contribution approach -- a method of internal reporting that emphasizes the distinction between variable and fixed costs for the purpose of better decision-making
One should always consider opportunity costs when deciding on the use of limited resources. The opportunity cost of a course of action is the maximum profit forgone from other alternative actions. Decision-makers may fail to consider opportunity costs because accountants do not report them in the financial accounting system.
One of the most important production decisions is the make or buy decision. Should a company make its own parts or products or should they buy them from outside sources? Both qualitative and quantitative factors affect this decision. In applying relevant cost analysis to make or buy situation, he key factor to consider is the use of facilities.
Another typical production situation is deciding whether to process further a joint product or sell it at the split off point. The relevant information for this decision includes the costs that differ beyond the split off point. Joint costs that occur before split off are irrelevant.
In certain production decisions, it is important to recognize and identify irrelevant costs. In the decision to dispose of obsolete inventory, the original cost of the inventory is irrelevant because there is no way to restore the resources used to buy or produce that inventory.
And the decision to keep or replace equipment, the book value of old equipment is irrelevant. This sunk cost is a past or historical cost that a company has are ready incurred. Relevant costs normally include the disposal value of old equipment, the cost of new equipment, and the difference in the annual operating costs.
Unit fixed costs can be misleading because of the differences in the assumed level of volume on which they are based. The more units a company makes, the lower the unit fixed cost will be. If a salesperson assumes a company will produce 100,000 units and actually produces only 30,000 units, the unit costs will be understated. You can avoid being misled by unit costs by always using total fixed costs.
If companies evaluate managers using performance measures that are not in line with relevant decision criteria, there could be a conflict of interest. Managers often make decisions based on how the decision affects their performance measures. Thus, performance measures work best when they are consistent with the long-term good of the company.
The major difference between the absorption and contribution formats for the income statement is that the contribution format focuses on cost behavior (fixed and variable), whereas the absorption format reports cost by business functions. The contribution approach makes it easier for managers to evaluate the effects of changes in volume on income and dust it is better for decision-making.
Management accounting -- Chapter 5
Relevant information -- the predicted future costs and revenues that will do for a mall alternative courses of action
decision model -- any method for making a choice, sometimes requiring elaborate quantitative procedures
avoidable costs -- costs that will not continue to fund ongoing operation is changed or deleted
unavoidable costs -- costs that continue even if a company discontinues in operation
common costs -- those costs of facilities and services that are shared by users
limiting factor (scarce resource) -- the item that restricts or constrains the production or sale of a product or service
inventory turnover -- the number of times the average inventory is sold per year
perfect competition -- a market in which a firm can sell as much of a product as it can produce, all at a single market price
marginal cost -- the additional cost resulting from producing and selling one additional unit
marginal revenue -- the additional revenue resulting from the sale of an additional unit
imperfect competition -- a market in which the price a firm charges for a unit will influence the quantity of units it sells
Price elasticity -- the effect of price changes on sales volume
predatory pricing -- establishing prices so low that they drive competitors out of the market. The predatory price or then has no significant competition and can raise prices dramatically
discriminatory pricing -- charging different prices to different customers for the same product or service
markup -- the amount by which price exceeds cost
full cost (fully allocated cost) -- the total of all manufacturing cost plus the total of all selling and administrative costs
target costing -- a cost management hole for making cost reduction a key focus throughout the life of a product
value engineering -- a cost reduction technique, used primarily during design, that uses information about all value chain functions to satisfy customer needs while reducing costs
kaizen costing -- the Japanese term for continuous improvement during manufacturing
To be relevant to a particular decision, a cost (or revenue) must meet to criteria:
1.it must be unexpected future cost (or revenue)
2.it must have an element of difference among the alternative courses of action.
All managers make business decisions based on some decision process. The best processes help decision-making by focusing the manager's attention on relevant information.
Decisions to accept or reject a special sales order should use the contribution margin technique and focus on the additional revenues and additional costs of the order.
Relevant information also plays an important role in decisions about adding or deleting products, services, or departments. Decisions on whether to delete a department or product line require analysis of the revenues forgone and the costs saved from the deletion.
When production is constrained by limiting resource, the key to obtaining the maximum profit from a given capacity is to obtain the greatest possible contribution to profit per unit of the limiting or scarce resource.
Market conditions, the law, customers, competitors, and costs influence pricing decisions. The degree that management actions can affect price and cost determines the most effective approach to use for pricing and cost management purposes.
Companies used cost plus pricing for product management actions can influence the market price. They can add profit markups to a variety of cost basis including variable manufacturing costs, all variable costs, full manufacturing costs, or all costs. The contribution margin approach to pricing has the advantage of providing detailed cost behavior information that is consistent with cost value profit analysis.
When market conditions are such that management cannot influence prices, companies must focus on cost control and reduction. They use target costing primarily for new products, especially during the design phase of the value chain. They deduct a desired target margin from the market established price to determine the target cost. Cost management and focuses on controlling in reducing costs over the product's life cycle to achieve that target cost.
decision model -- any method for making a choice, sometimes requiring elaborate quantitative procedures
avoidable costs -- costs that will not continue to fund ongoing operation is changed or deleted
unavoidable costs -- costs that continue even if a company discontinues in operation
common costs -- those costs of facilities and services that are shared by users
limiting factor (scarce resource) -- the item that restricts or constrains the production or sale of a product or service
inventory turnover -- the number of times the average inventory is sold per year
perfect competition -- a market in which a firm can sell as much of a product as it can produce, all at a single market price
marginal cost -- the additional cost resulting from producing and selling one additional unit
marginal revenue -- the additional revenue resulting from the sale of an additional unit
imperfect competition -- a market in which the price a firm charges for a unit will influence the quantity of units it sells
Price elasticity -- the effect of price changes on sales volume
predatory pricing -- establishing prices so low that they drive competitors out of the market. The predatory price or then has no significant competition and can raise prices dramatically
discriminatory pricing -- charging different prices to different customers for the same product or service
markup -- the amount by which price exceeds cost
full cost (fully allocated cost) -- the total of all manufacturing cost plus the total of all selling and administrative costs
target costing -- a cost management hole for making cost reduction a key focus throughout the life of a product
value engineering -- a cost reduction technique, used primarily during design, that uses information about all value chain functions to satisfy customer needs while reducing costs
kaizen costing -- the Japanese term for continuous improvement during manufacturing
To be relevant to a particular decision, a cost (or revenue) must meet to criteria:
1.it must be unexpected future cost (or revenue)
2.it must have an element of difference among the alternative courses of action.
All managers make business decisions based on some decision process. The best processes help decision-making by focusing the manager's attention on relevant information.
Decisions to accept or reject a special sales order should use the contribution margin technique and focus on the additional revenues and additional costs of the order.
Relevant information also plays an important role in decisions about adding or deleting products, services, or departments. Decisions on whether to delete a department or product line require analysis of the revenues forgone and the costs saved from the deletion.
When production is constrained by limiting resource, the key to obtaining the maximum profit from a given capacity is to obtain the greatest possible contribution to profit per unit of the limiting or scarce resource.
Market conditions, the law, customers, competitors, and costs influence pricing decisions. The degree that management actions can affect price and cost determines the most effective approach to use for pricing and cost management purposes.
Companies used cost plus pricing for product management actions can influence the market price. They can add profit markups to a variety of cost basis including variable manufacturing costs, all variable costs, full manufacturing costs, or all costs. The contribution margin approach to pricing has the advantage of providing detailed cost behavior information that is consistent with cost value profit analysis.
When market conditions are such that management cannot influence prices, companies must focus on cost control and reduction. They use target costing primarily for new products, especially during the design phase of the value chain. They deduct a desired target margin from the market established price to determine the target cost. Cost management and focuses on controlling in reducing costs over the product's life cycle to achieve that target cost.
Friday, December 08, 2006
Cost Overview
Cost information is used in deciding whether to introduce a new product or discontinue an existing product, assessing the efficiency of a particular operation, and budgeting. Cost information is also used for the valuation of inventory and cost of goods sold.
Different types of cost information are needed for different managerial purposes and decisions. For example, product cost information is used for produce mix and pricing decisions. The cost of serving customer segments will include the cost of activities that support customer service. For management control purposes, an organization may compare actual costs to budgeted costs.
Inside the organization, costs serve two broad purposes: planning and evaluation.
Cost calculations can be tailored to specific purposes. For example, for planning purposes, cost might serve as a reference point for determining the selling price of a prospective product, or might be used in a budgeting model to forecast costs under different levels of production and selling activities. Evaluation purposes occur, for example, when comparing actual costs to budgeted costs or when judging whether a process is efficient compared with the costs of similar internal or external processes.
Multistage process costing systems have the same objective as job order costing systems. Both types of systems assign material, labor, and manufacturing support activity costs to products.
The two types of systems differ on some dimensions. In a job order environment, production requirements vary across different jobs, so production occurs job by job and costs are measured for individual jobs. In addition, cost reports that compare actual to estimated costs may be determined for individual jobs.
In a multistage process environment, production requirements are homogeneous across products or jobs, so production occurs continuously, semi-continuously, or in large batches, and costs are measured for individual process stages. Because of the homogeneous production, cost reports that compare actual to estimated costs are likely to be determined only for individual process stages.
Different types of cost information are needed for different managerial purposes and decisions. For example, product cost information is used for produce mix and pricing decisions. The cost of serving customer segments will include the cost of activities that support customer service. For management control purposes, an organization may compare actual costs to budgeted costs.
Inside the organization, costs serve two broad purposes: planning and evaluation.
Cost calculations can be tailored to specific purposes. For example, for planning purposes, cost might serve as a reference point for determining the selling price of a prospective product, or might be used in a budgeting model to forecast costs under different levels of production and selling activities. Evaluation purposes occur, for example, when comparing actual costs to budgeted costs or when judging whether a process is efficient compared with the costs of similar internal or external processes.
Multistage process costing systems have the same objective as job order costing systems. Both types of systems assign material, labor, and manufacturing support activity costs to products.
The two types of systems differ on some dimensions. In a job order environment, production requirements vary across different jobs, so production occurs job by job and costs are measured for individual jobs. In addition, cost reports that compare actual to estimated costs may be determined for individual jobs.
In a multistage process environment, production requirements are homogeneous across products or jobs, so production occurs continuously, semi-continuously, or in large batches, and costs are measured for individual process stages. Because of the homogeneous production, cost reports that compare actual to estimated costs are likely to be determined only for individual process stages.
Management accounting -- Chapter 4
Cost management system (CMS) -- a collection of tolls and techniques that identify how management's decisions affect costs, by first measuring the resources used in performing the organization's activities and then assessing the effects on costs of changes in those activities
cost accounting systems -- the techniques used to determine the cost of the product, service, customer, or other cost objective
cost accounting -- the part of the cost management system that measures costs for the purposes of management decision-making and financial reporting
cost accumulation -- collecting costs by some natural classification such as activities performed, labor, or materials
cost assignment -- tracing or allocating costs to one or more cost objectives such as activities, departments, customers, or products
cost -- a sacrifice or giving up of resources for a particular purpose, frequently measured by the monetary units that organization must pay for goods and services
cost objective -- anything for which decision-makers desire a separate measurement of costs. Example include departments, products, activities, and territories
direct costs -- costs that can be identified specifically and exclusively with a given cost objective in an economically feasible way
indirect costs -- costs that cannot be identified specifically and exclusively with a given cost objective and economically feasible way
cost allocation -- assigning indirect costs to cost objects using plausible and reliable cost drivers
unallocated costs -- costs for which we can identify new relationship to a cost objective
direct material costs -- the acquisition costs of all materials that a company identifies as part of the manufactured goods and traces to the manufactured goods in an economically feasible way
direct labor costs -- the wages of all labor and a company can trace specifically in exclusively to the manufactured goods
indirect production costs -- all costs other than direct material or direct labor that are associated with the manufacturing process. Such as indirect manufacturing costs, factory burden, factory overhead, manufacturing overhead
product costs -- costs identified with goods produced or purchased for resale
period costs -- costs that become expenses during the current period without going through an inventory stage
traditional costing systems -- one that does not accumulate or report costs of activities or processes
cost pool -- a group of individual costs that a company allocates to cost objectives using a single cost driver
activity based costing (ABC) systems -- a system that first accumulates overhead costs for each of the activities of the area being caustic, and then assigns the costs of activities to the products, services, or other cost objectives that require that activity
two stage ABC system -- a costing system with two stages of allocation to get from the original cost to the final product or service cost. The first stage allocates resource costs to activity cost pools. The second stage allocates activity costs to products or services
activity based management (ABM) -- using an activity based costing system to improve the operations of an organization
value added cost -- the necessary cost of an activity that cannot be eliminated without affecting a product's value to the consumer
non-value added costs -- costs that a company can eliminate without affecting a product's value to the consumer
benchmarking -- the continuous process of comparing products, services, and activities against the best industry standards
process map -- a schematic diagram capturing interrelationships between cost objects, activities, and resources
multistage ABC (MSABC) systems -- costing systems with more than two stages of allocations and cost drivers other than percentages
Cost management systems provide cost information for external financial reporting, for strategic decision-making, and for operational cost control.
Cost accounting systems provide cost information for various types of objectives -- products, customers, activities, and so on. A system first accumulates resource costs by natural classifications such as materials, labor, and energy. Then it assigns these costs to cost objectives, either tracing them directly or signing them indirectly through allocation.
Accountants can specifically in exclusively identify direct costs with a cost objective in an economically feasible way. When this is not possible, accountants may allocate costs to cost objectives using a cost driver. Such costs are called indirect costs. The greater the proportion of direct costs, the greater the accuracy of the cost system. When the proportion of indirect costs is significant, accountants must take care to find the most appropriate cost drivers. Some costs are unallocated because the accountants can determine no plausible and reliable relationship between resource costs of cost objectives.
The primary difference between the financial statements of a merchandiser and the manufacturer is the reporting of inventories. A merchandiser has only one type of inventory whereas a manufacturer has three types of inventory -- raw materials, work in process, and finished goods.
Traditional systems usually allocate only the indirect costs of the production function. ABC systems allocate many of the costs of the value chain functions. Traditional costing accumulates costs using categories such as direct material, direct labor, and production overhead. ABC systems accumulate costs by activities required to produce a product or service. The key value of ABC systems is in their increased costing accuracy and better information provided that can lead to process improvements.
Designing and implementing an activity based costing system involves four steps.
Activity based management is using ABC information to improve operations. A key advantage of an activity based costing system is its ability to aid managers in decision-making. ABC improves the accuracy of cost estimates, including product and customer costs and the costs of value added versus non-value-added activities. ABC also improves managers understanding of operations. Managers can focus their attention on making strategic decisions, such as product mix, pricing, and process improvements.
For some organizations that have operations that are highly complex, two stage ABC systems do not offer enough costing accuracy or decision-making information. The three key attributes of MSABC systems that lead to more value for these organizations include more than two stages of allocation, cost behavior of resources, and much more operational information.
cost accounting systems -- the techniques used to determine the cost of the product, service, customer, or other cost objective
cost accounting -- the part of the cost management system that measures costs for the purposes of management decision-making and financial reporting
cost accumulation -- collecting costs by some natural classification such as activities performed, labor, or materials
cost assignment -- tracing or allocating costs to one or more cost objectives such as activities, departments, customers, or products
cost -- a sacrifice or giving up of resources for a particular purpose, frequently measured by the monetary units that organization must pay for goods and services
cost objective -- anything for which decision-makers desire a separate measurement of costs. Example include departments, products, activities, and territories
direct costs -- costs that can be identified specifically and exclusively with a given cost objective in an economically feasible way
indirect costs -- costs that cannot be identified specifically and exclusively with a given cost objective and economically feasible way
cost allocation -- assigning indirect costs to cost objects using plausible and reliable cost drivers
unallocated costs -- costs for which we can identify new relationship to a cost objective
direct material costs -- the acquisition costs of all materials that a company identifies as part of the manufactured goods and traces to the manufactured goods in an economically feasible way
direct labor costs -- the wages of all labor and a company can trace specifically in exclusively to the manufactured goods
indirect production costs -- all costs other than direct material or direct labor that are associated with the manufacturing process. Such as indirect manufacturing costs, factory burden, factory overhead, manufacturing overhead
product costs -- costs identified with goods produced or purchased for resale
period costs -- costs that become expenses during the current period without going through an inventory stage
traditional costing systems -- one that does not accumulate or report costs of activities or processes
cost pool -- a group of individual costs that a company allocates to cost objectives using a single cost driver
activity based costing (ABC) systems -- a system that first accumulates overhead costs for each of the activities of the area being caustic, and then assigns the costs of activities to the products, services, or other cost objectives that require that activity
two stage ABC system -- a costing system with two stages of allocation to get from the original cost to the final product or service cost. The first stage allocates resource costs to activity cost pools. The second stage allocates activity costs to products or services
activity based management (ABM) -- using an activity based costing system to improve the operations of an organization
value added cost -- the necessary cost of an activity that cannot be eliminated without affecting a product's value to the consumer
non-value added costs -- costs that a company can eliminate without affecting a product's value to the consumer
benchmarking -- the continuous process of comparing products, services, and activities against the best industry standards
process map -- a schematic diagram capturing interrelationships between cost objects, activities, and resources
multistage ABC (MSABC) systems -- costing systems with more than two stages of allocations and cost drivers other than percentages
Cost management systems provide cost information for external financial reporting, for strategic decision-making, and for operational cost control.
Cost accounting systems provide cost information for various types of objectives -- products, customers, activities, and so on. A system first accumulates resource costs by natural classifications such as materials, labor, and energy. Then it assigns these costs to cost objectives, either tracing them directly or signing them indirectly through allocation.
Accountants can specifically in exclusively identify direct costs with a cost objective in an economically feasible way. When this is not possible, accountants may allocate costs to cost objectives using a cost driver. Such costs are called indirect costs. The greater the proportion of direct costs, the greater the accuracy of the cost system. When the proportion of indirect costs is significant, accountants must take care to find the most appropriate cost drivers. Some costs are unallocated because the accountants can determine no plausible and reliable relationship between resource costs of cost objectives.
The primary difference between the financial statements of a merchandiser and the manufacturer is the reporting of inventories. A merchandiser has only one type of inventory whereas a manufacturer has three types of inventory -- raw materials, work in process, and finished goods.
Traditional systems usually allocate only the indirect costs of the production function. ABC systems allocate many of the costs of the value chain functions. Traditional costing accumulates costs using categories such as direct material, direct labor, and production overhead. ABC systems accumulate costs by activities required to produce a product or service. The key value of ABC systems is in their increased costing accuracy and better information provided that can lead to process improvements.
Designing and implementing an activity based costing system involves four steps.
- First, managers determine the cost objectives, key activities, and resources used, and they identify cost drivers for each resource and activity.
- Second, they determine the relationship among cost objectives, activities, and resources.
- The third step is collecting costs and operating data.
- The last up is to calculate and interpret the new activity based information.
Activity based management is using ABC information to improve operations. A key advantage of an activity based costing system is its ability to aid managers in decision-making. ABC improves the accuracy of cost estimates, including product and customer costs and the costs of value added versus non-value-added activities. ABC also improves managers understanding of operations. Managers can focus their attention on making strategic decisions, such as product mix, pricing, and process improvements.
For some organizations that have operations that are highly complex, two stage ABC systems do not offer enough costing accuracy or decision-making information. The three key attributes of MSABC systems that lead to more value for these organizations include more than two stages of allocation, cost behavior of resources, and much more operational information.
Thursday, December 07, 2006
Management accounting - chapter 3
Measurement of cost behavior -- understanding and quantifying how activities of an organization affect its levels of costs
linear cost behavior -- activity that can be graphed with a straight line because costs are soon to be either fixed or variable
step costs -- costs that changed abruptly at intervals of activity because the resources and their cost come in indivisible chunks
mixed costs -- cost that contained elements of both fixed and variable cost behavior
capacity costs -- the fixed costs of being able to achieve a desired level of production or to provide a desired level of service while maintaining product or service attributes, such as quality
committed fixed costs -- costs arising from possession of facilities, equipment, and a basic organization
discretionary fixed costs -- cost determined by management as part of the periodic planning process in order to meet the organization's goals. They have no obvious relationship with levels of capacity or output activity
cost measurement -- estimating or predicting costs as a function of appropriate cost drivers
cost function -- an algebraic equation used by managers to describe the relationship between a cost and its drivers
activity analysis -- the process of identifying appropriate cost drivers and their effects on the costs of making a product or providing a service
engineering analysis -- the systematic review of materials, supplies, labor, support services, and facilities needed for products and services; measuring cost behavior according to what costs should be, not by what costs have been
account analysis -- selecting a plausible cost driver and classifying each account as a variable cost or as a fixed costs
high-low method -- a simple method for measuring a linear cost function from past cost data, focusing on the highest activity and lowest activity points and fitting a line through these two points
visual fit method -- a method in which the cost analyst visually fits a straight line through a plot of all the available data
least squares regression (regression analysis) -- measuring a cost function objectively by using statistics to fit a cost function to all the data
coefficient of determination -- a measurement of how much of the fluctuation of a cost is explained by changes in the cost driver
Step and mixed cost behaviors.
Cost behavior refers to how cost changed as levels of an organization's activities change. Costs can behave as the fixed, variable, step, or mixed costs. Step and mixed costs both combine aspects of variable and fixed cost behavior. Step costs for graphs that look like stats. Costs will remain fixed within a given range of activity or cost driver level, but then will rise or fall abruptly when the cost driver level is outside this range. Mixed costs involved a fixed element and a variable element of cost behavior. Unlike step costs, mix costs have a single fixed costs at all levels of activity, and in addition have a variable cost element that increases proportionately with activity.
Management influences on cost behavior.
Managers can affect the costs and cost behavior patterns of their companies through the decisions they make. Decisions on product and service features, capacity, technology, and cost control incentives, for example, can all affect cost behavior.
Cost functions, prediction costs.
The first step in estimating or predicting costs is measuring cost behavior. This is done by finding a cost function. This is an algebraic equation that describes the relationship between a cost in its drivers. To be useful for decision-making purposes, cost functions should be plausible and reliable.
Activity analysis for measuring cost functions.
Activity analysis is the process of identifying the best cost drivers to use for cost estimation and prediction in determining how they affect the costs of making a product or service. This is an essential step in understanding and predicting costs.
Once analysts have identified cost drivers, they can use one of several methods to determine the cost function. Engineering analysis focuses on what the costs should be by systematically reviewing the materials, supplies, labor, support services, and facilities needed for a given level of production. Account analysis involves examining all accounts in terms of an appropriate cost driver and classifying each account as either fixed or variable with respect to the driver. The cost function consists of the variable cost per cost driver unit multiplied by the amount of the cost driver plus the total fixed cost. The high-low, visual-fit, and least-squares methods all use historical costs to determine cost functions. Of these three methods, high-low is the easiest, although least-squares is the most reliable.
linear cost behavior -- activity that can be graphed with a straight line because costs are soon to be either fixed or variable
step costs -- costs that changed abruptly at intervals of activity because the resources and their cost come in indivisible chunks
mixed costs -- cost that contained elements of both fixed and variable cost behavior
capacity costs -- the fixed costs of being able to achieve a desired level of production or to provide a desired level of service while maintaining product or service attributes, such as quality
committed fixed costs -- costs arising from possession of facilities, equipment, and a basic organization
discretionary fixed costs -- cost determined by management as part of the periodic planning process in order to meet the organization's goals. They have no obvious relationship with levels of capacity or output activity
cost measurement -- estimating or predicting costs as a function of appropriate cost drivers
cost function -- an algebraic equation used by managers to describe the relationship between a cost and its drivers
activity analysis -- the process of identifying appropriate cost drivers and their effects on the costs of making a product or providing a service
engineering analysis -- the systematic review of materials, supplies, labor, support services, and facilities needed for products and services; measuring cost behavior according to what costs should be, not by what costs have been
account analysis -- selecting a plausible cost driver and classifying each account as a variable cost or as a fixed costs
high-low method -- a simple method for measuring a linear cost function from past cost data, focusing on the highest activity and lowest activity points and fitting a line through these two points
visual fit method -- a method in which the cost analyst visually fits a straight line through a plot of all the available data
least squares regression (regression analysis) -- measuring a cost function objectively by using statistics to fit a cost function to all the data
coefficient of determination -- a measurement of how much of the fluctuation of a cost is explained by changes in the cost driver
Step and mixed cost behaviors.
Cost behavior refers to how cost changed as levels of an organization's activities change. Costs can behave as the fixed, variable, step, or mixed costs. Step and mixed costs both combine aspects of variable and fixed cost behavior. Step costs for graphs that look like stats. Costs will remain fixed within a given range of activity or cost driver level, but then will rise or fall abruptly when the cost driver level is outside this range. Mixed costs involved a fixed element and a variable element of cost behavior. Unlike step costs, mix costs have a single fixed costs at all levels of activity, and in addition have a variable cost element that increases proportionately with activity.
Management influences on cost behavior.
Managers can affect the costs and cost behavior patterns of their companies through the decisions they make. Decisions on product and service features, capacity, technology, and cost control incentives, for example, can all affect cost behavior.
Cost functions, prediction costs.
The first step in estimating or predicting costs is measuring cost behavior. This is done by finding a cost function. This is an algebraic equation that describes the relationship between a cost in its drivers. To be useful for decision-making purposes, cost functions should be plausible and reliable.
Activity analysis for measuring cost functions.
Activity analysis is the process of identifying the best cost drivers to use for cost estimation and prediction in determining how they affect the costs of making a product or service. This is an essential step in understanding and predicting costs.
Once analysts have identified cost drivers, they can use one of several methods to determine the cost function. Engineering analysis focuses on what the costs should be by systematically reviewing the materials, supplies, labor, support services, and facilities needed for a given level of production. Account analysis involves examining all accounts in terms of an appropriate cost driver and classifying each account as either fixed or variable with respect to the driver. The cost function consists of the variable cost per cost driver unit multiplied by the amount of the cost driver plus the total fixed cost. The high-low, visual-fit, and least-squares methods all use historical costs to determine cost functions. Of these three methods, high-low is the easiest, although least-squares is the most reliable.
Accounting Fundamentals - 1
Great ideas and passions often lead to the formation of businesses, which, in turn may lead to great rewards for those involved; not only for those who originate the ideas, but also for those who help them become realized. Bill Gates had a great idea: making computers user-friendly. His business – Microsoft is the realization of that great idea and passion.
These great ideas can take the form of making something (we call this type of business manufacturing), selling something (this would be considered retailing), or doing something (which is known as service). Ford’s great idea was manufacturing cars, Sam Walton’s great idea was selling lots of items for less, and Henry and Richard Block came up with a great idea to help people file their income taxes. None of these individuals would have been able to build the successful businesses that exist today without help.
Business Operations Resources
Business resources include creditors (who make loans to the business) and investors (who provide financial support to the business and in turn receive partial ownership in that business). There are risks and rewards associated with providing these resources. Creditors risk non-repayment of the loans, whereas investors risk losing their entire investment. Creditors are rewarded by interest they receive; investors are rewarded by sharing in the company’s earnings or by seeing the value of their investment increase. These two groups of resources (creditors and investors) must evaluate the risk that they will be incurring and will need useful information on which to base their economic decisions. The ultimate purpose of financial accounting is to provide that information.
Financial Statements
This information takes the form of specialized reports, which communicate specific information about the business. The income statement provides information on how effectively the company used resources to generate income. The balance sheet presents how company resources are financed (by either creditors or investors). Finally, the cash flow statement describes how cash is provided by and used by operating, financing, and investing activities. These specialized reports are collectively known as the financial statements, which must be prepared based on what is known as ‘generally accepted accounting principles’ (or GAAP). These principles originated as unregulated best practices used by accountants with open interpretations. It was not until the 1929 market crash that the government intervened, issuing acts creating and empowering the Securities Exchange Commission, (the SEC) to regulate publicly traded companies (including the financial statements these companies issue).
Accounting Regulation
The Financial Accounting Standards Board (the FASB), is the current organization empowered to create financial accounting standards. Formed in 1975, the FASB began its mission, by evaluating the objectives of financial reporting. They determined that the most critical objective is to provide ‘useful’ information on which economic decisions may be based. Since the term ‘useful’ is not clear-cut, the FASB then determined what characteristics of information would make that information ‘useful’ and described those characteristics in their Statements of Financial Accounting Concepts. All of the financial accounting rules that you will be learning in this course are based on those concepts. The SEC mandates that the financial reports are audited to provide some assurance to creditors and investors that their risk assessments are valid. Obviously, both the preparers and auditors of these statements must uphold the highest ethical standards so that those who rely upon them may make viable economic decisions.
These great ideas can take the form of making something (we call this type of business manufacturing), selling something (this would be considered retailing), or doing something (which is known as service). Ford’s great idea was manufacturing cars, Sam Walton’s great idea was selling lots of items for less, and Henry and Richard Block came up with a great idea to help people file their income taxes. None of these individuals would have been able to build the successful businesses that exist today without help.
Business Operations Resources
Business resources include creditors (who make loans to the business) and investors (who provide financial support to the business and in turn receive partial ownership in that business). There are risks and rewards associated with providing these resources. Creditors risk non-repayment of the loans, whereas investors risk losing their entire investment. Creditors are rewarded by interest they receive; investors are rewarded by sharing in the company’s earnings or by seeing the value of their investment increase. These two groups of resources (creditors and investors) must evaluate the risk that they will be incurring and will need useful information on which to base their economic decisions. The ultimate purpose of financial accounting is to provide that information.
Financial Statements
This information takes the form of specialized reports, which communicate specific information about the business. The income statement provides information on how effectively the company used resources to generate income. The balance sheet presents how company resources are financed (by either creditors or investors). Finally, the cash flow statement describes how cash is provided by and used by operating, financing, and investing activities. These specialized reports are collectively known as the financial statements, which must be prepared based on what is known as ‘generally accepted accounting principles’ (or GAAP). These principles originated as unregulated best practices used by accountants with open interpretations. It was not until the 1929 market crash that the government intervened, issuing acts creating and empowering the Securities Exchange Commission, (the SEC) to regulate publicly traded companies (including the financial statements these companies issue).
Accounting Regulation
The Financial Accounting Standards Board (the FASB), is the current organization empowered to create financial accounting standards. Formed in 1975, the FASB began its mission, by evaluating the objectives of financial reporting. They determined that the most critical objective is to provide ‘useful’ information on which economic decisions may be based. Since the term ‘useful’ is not clear-cut, the FASB then determined what characteristics of information would make that information ‘useful’ and described those characteristics in their Statements of Financial Accounting Concepts. All of the financial accounting rules that you will be learning in this course are based on those concepts. The SEC mandates that the financial reports are audited to provide some assurance to creditors and investors that their risk assessments are valid. Obviously, both the preparers and auditors of these statements must uphold the highest ethical standards so that those who rely upon them may make viable economic decisions.
Management accounting - Chapter 2
Cost behavior -- how the activities of an organization affect its costs
cost driver -- any output measure that causes costs
variable cost -- a cost that changes in direct proportion to changes in the cost driver level
fixed cost -- a cost that is not immediately affected by changes in the cost driver level
relevant range -- the limit of cost driver activity level within which a specific relationship between costs and the cost driver is valid
cost value profit (CVP) analysis -- the study of the effects of output valume on revenue (sales), expenses (costs), and net income (net profit)
breakeven point -- the level of sales at which revenue equals expenses and net income is zero
unit contribution margin (marginal income) -- the sales price minus the variable cost per unit
contribution margin -- a term used for either unit contribution margin or total contribution margin
variable cost percentage -- total variable costs divided by total sales
contribution margin percentage -- total contribution margin divided by sales or 100% minus the variable cost percentage
variable cost ratio -- variable cost percentage expressed as a ratio
contribution margin ratio -- contribution margin percentage expressed as a ratio
sales mix -- the relative proportions or combinations of quantities of products that constitute total sales
incremental effect -- the change in total results (such as revenue, expenses, or income) under a new condition in comparison with some given or known condition
operating leverage -- a firm's ratio of fixed to variable costs
margin of safety -- the planned unit sales less than break even unit sales; it shows how far sales can fall below the planned level before losses occur
Gross margin (Gross profit) -- the excess of sales over the total cost of goods sold
cost of goods sold -- the cost of the merchandise at a company acquires or produces and then sells
How cost drivers affect cost behavior.
A cost driver is an output measure that causes the use of costly resources. When the level of an activity changes, the level of the cost driver or output measure will also change, causing changes in costs.
Changes and cost driver activity levels affect variable and fixed costs.
Different types of costs behave in different ways. If the cost of the resource used changes in proportion to changes in the cost driver level, the resource is a veritable cost resource. If the cost of the resource used does not change because of cost driver level changes, the resource is a fixed cost resource.
Calculate breakeven sales volume in total dollars and total units.
We can approach CVP analysis (sometimes called break even analysis) graphically or with equations. To calculate the breakeven point in total units, divide the fixed costs by the unit contribution margin. To calculate the break even point in total dollars (sales dollars), divide the fixed costs by the contribution margin ratio.
Cost volume profit graph.
We can create a cost volume profit graph by drawling revenue and total cost lines as functions of the cost driver level. Be sure to recognize the limitations of CVP analysis and that it assumes constant efficiency, sales mix, and inventory levels.
Contribution margin and gross margin.
The contribution margin -- the difference between sales price and variable costs. The gross margin is the difference between the sales price and cost of goods sold.
cost driver -- any output measure that causes costs
variable cost -- a cost that changes in direct proportion to changes in the cost driver level
fixed cost -- a cost that is not immediately affected by changes in the cost driver level
relevant range -- the limit of cost driver activity level within which a specific relationship between costs and the cost driver is valid
cost value profit (CVP) analysis -- the study of the effects of output valume on revenue (sales), expenses (costs), and net income (net profit)
breakeven point -- the level of sales at which revenue equals expenses and net income is zero
unit contribution margin (marginal income) -- the sales price minus the variable cost per unit
contribution margin -- a term used for either unit contribution margin or total contribution margin
variable cost percentage -- total variable costs divided by total sales
contribution margin percentage -- total contribution margin divided by sales or 100% minus the variable cost percentage
variable cost ratio -- variable cost percentage expressed as a ratio
contribution margin ratio -- contribution margin percentage expressed as a ratio
sales mix -- the relative proportions or combinations of quantities of products that constitute total sales
incremental effect -- the change in total results (such as revenue, expenses, or income) under a new condition in comparison with some given or known condition
operating leverage -- a firm's ratio of fixed to variable costs
margin of safety -- the planned unit sales less than break even unit sales; it shows how far sales can fall below the planned level before losses occur
Gross margin (Gross profit) -- the excess of sales over the total cost of goods sold
cost of goods sold -- the cost of the merchandise at a company acquires or produces and then sells
How cost drivers affect cost behavior.
A cost driver is an output measure that causes the use of costly resources. When the level of an activity changes, the level of the cost driver or output measure will also change, causing changes in costs.
Changes and cost driver activity levels affect variable and fixed costs.
Different types of costs behave in different ways. If the cost of the resource used changes in proportion to changes in the cost driver level, the resource is a veritable cost resource. If the cost of the resource used does not change because of cost driver level changes, the resource is a fixed cost resource.
Calculate breakeven sales volume in total dollars and total units.
We can approach CVP analysis (sometimes called break even analysis) graphically or with equations. To calculate the breakeven point in total units, divide the fixed costs by the unit contribution margin. To calculate the break even point in total dollars (sales dollars), divide the fixed costs by the contribution margin ratio.
Cost volume profit graph.
We can create a cost volume profit graph by drawling revenue and total cost lines as functions of the cost driver level. Be sure to recognize the limitations of CVP analysis and that it assumes constant efficiency, sales mix, and inventory levels.
Contribution margin and gross margin.
The contribution margin -- the difference between sales price and variable costs. The gross margin is the difference between the sales price and cost of goods sold.
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