AFM 102 Review Notes chapter 5.doc

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University of Waterloo
Accounting & Financial Management
AFM 102
Tom Vance

AFM 102 Review Notes Chapter 5: Activity-based costing - A costing method based on activities that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore fixed costs - Used for internal decision making How costs are treated under activity-based costing 1. Non-manufacturing as well as manufacturing costs may be assigned to products, but only on a cause-and-effect basis 2. Some manufacturing costs may be excluded from product costs 3. Numerous overhead cost pools are used, each of which is allocated to products and other cost objects using its own unique measure of activity 4. Overhead rates may be based on the level of activity at capacity rather than on the budgeted level of activity - Overhead refers to all costs including non-manufacturing costs - In activity-based costing, a cost is assigned to a product only if there is good reason to believe that the cost would be affected by decisions concerning the product - Costs that are unaffected by product-related decisions are treated as period expenses instead of product costs - Activity: any event that causes the consumption of overhead resources - Activity cost pool: a “bucket” in which costs are accumulated that relate to a single activity measure in the activity-based costing system - Activity measure: an allocation base in an activity-based costing system; ideally a measure of the amount of activity that drives the costs in an activity cost - Transaction driver: a simple count of the number of times an activity occurs - Duration driver: A measure of the amount of time required to perform an activity ABC defines five levels of activity: unit-level, batch-level, product-level, customer-level, and organization-sustaining activities - in ABC, products are charged for the costs of capacity they use (excluding idle times), therefore resulting in a more stable unit costs - idle capacity is considered period costs for ABC - cost object: the specific product or service to be costed The implementation of ABC takes five steps 1. identify and define activities, activity cost pools and activity measures 2. assign overhead costs to activity cost pools (FSA) 3. Calculate activity rates (different activity rates for different activities for ABC) 4. Assign overhead costs to cost objects using the activity rates and activity measures (SSA) 5. Prepare management reports First-stage allocation: the process by which overhead costs are assigned to activity cost pools in an activity-based costing system Second-stage allocation: the process by which activity rates are used to apply costs to products and customers in activity-based costing - Customer Relations are not included in the product profitability report because the costs are not caused by products. Chapter 6: Cost Behaviour Variable costs- total dollar amount varies in direct proportion to changes in the activity level, but is constant on a per unit basis Activity base: a measure of whatever causes the incurrence of a variable cost True variable cost: cost varies in direct proportion to the level of production activity Step-variable cost: A cost (such as the cost of a maintenance worker) that is obtainable only in large chunks and that increases and decreases only in response to fairly wide changes in the activity level Curvilinear costs: A relationship between cost and activity that is a curve rather than a straight line Relevant range: The range of activity within which assumptions about variable and fixed cost behaviour are valid Types of Fixed costs Committed fixed costs: those fixed costs that are difficult to adjust and that relate to the investment in facilities, equipment, and the basic organizational structure of a firm. Discretionary fixed costs: those fixed costs that arise from annual decisions by management to spend in certain fixed cost areas, such as advertising and research. Once the total discretionary fixed costs have been budgeted, they are unaffected by the actual level of activity Mixed cost: a cost that contains both variable and fixed cost elements Account analysis: a method for analyzing cost behaviour in which each account under consideration is classified as either variable or fixed based on the analyst’s prior knowledge of how the cost in the account behaves Engineering approach: a detailed analysis of cost behaviour based on an industrial engineer’s evaluation of the inputs that are required to carry a particular activity and of the prices of those inputs Linear cost behaviour: cost behaviour is linear when a straight line is a reasonable approximation for the relationship between cost and activity High-low method: a method of separating a mixed cost into its fixed and variable elements by analyzing the change in cost between the high and low levels of activity Variable cost = cost at the high activity level – cost at the low activity level High activity level – low activity level Least-squares regression method: a method of separating a mixed cost into its fixed and variable elements by fitting a regression line that minimizes the sum of the squared errors Multiple regressions: An analytical method required in those situations where variations in a dependent variable are caused by more than one factor Contribution margin: The amount remaining from sales revenues after all variable expense have been deducted Example: Contribution Approach Sales ---------------------------------------------------------------- $12000 Less variable expenses: ----------------------------2000 Variable production -------------------------------600 Variable selling -------------------------------------400 3000 Contribution margin ----------------------------------------------9000 Less fixed expenses: Fixed production ----------------------------------4000 Fixed selling -----------------------------------------2500 Fixed administrative ------------------------------1500 8000 Operating income ------------------------------------------------$1000 Chapter 7: Cost-volume profit relationships Cost-volume profit analysis focuses on how profits are affected by the following five elements: 1. Prices of products 2. Volume or level of activity 3. Per unit variable costs 4. Total fixed costs 5. Mix of products sold Acoustic Concepts, Inc. Contribution income statement For the month of June Total Per Unit Sales (400 speakers) ---------------------------$100,000 $250 Less variable expenses --------------------------60,000 150 Contribution margin ----------------------------$40,000 $100 Less fixed expenses -------------------------------35,000 Operating income ---------------------------------$5,000 Break-event point – the level of sales at which profit is zero. The break-even point can also be defined as the point where total sales equals total expenses or as the point where total contribution margin equals total fixed expenses - Once the break-event point has been reached, operating income will increase by the unit contribution margin for each additional unit sold Contribution Margin (CM) Ratio - The contribution margin as a percentage of total sales CM Ratio = contribution margin/ sales - If contribution is 0.4, it means that for every dollar increase in sales, contribution margin will increase by 40 cents. Some applications of CVP Concepts - Acoustic Concepts is currently selling 400 speakers per month at $250 per speaker for total monthly sales of $100,000. The sales manager feels that a $10,000 increase in the monthly advertising budget would increase monthly sales by $30,000 to a total of $130,000. Should the advertising budget be increased? Solution 1: Expected total contribution margin: $130,000 x 40% CM Ratio ----------------------------------$52,000 Presented total contribution margin: $100,000 x 40% CM Ratio
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