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Administrative Studies
ADMS 2510
John Parkinson

Chapter 4: Systems Designs: Process Costing  Process Costing – used for industries that produce generic products and are all uniform e.g. bricks, corn flakes, pop, paper etc. o Used when industries take raw materials and make them into homogeneous products o Also mostly used with assembly lined industries (e.g. Toyota (automobiles), Sony (DVD Players) etc.) Comparison of Job-Order And Process Costing Similarities:  Both systems have same basic purpose – assign materials, labour and overhead costs to products to provide a mechanism for computing unit costs  Both systems use the same basic manufacturing accounts, manufacturing overhead, raw materials, work in process, and finished goods  Flow of costs through manufacturing accounts is basically the same in both systems Differences:  The flow of units in a process costing system is more or less continuous  Units are not distinguishable from another in process costing system  Under process costing we accumulate costs by department, rather than by order and assign these costs equally to all units that pass through the department during a period o No point in identifying the materials, labour and overhead costs since all products are identical  Use something called production report instead of job cost sheets o A report that summarizes all activity in a department`s Work in Process accounts during a period that contains 3 parts: provides summary of the number of units moving through a department during a period, it also provides a computation of unit costs, it shows what costs were charged to the department and what disposition was made of these costs Processing Departments  Is part of an organization where work is performed on a product and where materials, labor or overhead costs are added to the product o Activity performed in the processing department must be performed uniformly on all of the units passing through it o Second, the output of the processing department must be identical The Flow of Materials, Labour and Overhead Costs  Costs are traced from only a few processing departments. An average unit cost is computed by dividing total production costs for the period by the number of units produced during the same period  A separate Work in Progress account maintained for each processing department  After the first processing department is completed it is transferred into the work in process account of the second processing department and continues its work . Once the two jobs are finished it goes to Finished Goods  Materials, labour and overhead costs can be added in any processing department not just first. o Costs in department B`s Work in Process account would consist of materials, labour, and overhead costs incurred in department B + the costs attached to partially completed units transferred in from Department A (called transferred-in Costs) Material Costs  Materials are drawn from the storeroom using a materials requisition form  Materials can be added in any processing department, although it`s not unusual for materials to be added only in the first department, with subsequent departments only adding labour and overhead costs as the partially completed units move along toward completion E.g. journal entry for placing materials into process in the first department is as follows: Work in Process – Mixing ………XXX Raw Materials……………………….XXX E.g. journal entry to record the material used in the second processing department, the filling department: Work in Process – Filling……….XXX Raw Materials……………..XXX Labour Costs  Labour costs are traced to departments, not to individual jobs E.g. Labour costs in the mixing department at standard products co. Work in Process – Mixing………….XXX Salaries and Wages Payable…………XXX Overhead Costs  If overhead costs are incurred uniformly over the year, overhead costs can be charged to departments  If production levels fluctuate or if not incurred uniformly, charging products with actual overhead costs will result in unit produc costs that vary randomly from one period to the next. => predetermined overhead rates should be used to charge for overhead cost to products e.g. ised to apply overhead costs to units of product for mixing department: Work in Process – Mixing ……………XXX Manufacturing Overhead………………….XXX Completing the Costs Flows  Product units are transferred to the next department for further processing, following journal entry is used to transfer the costs of partially completed units from the mixing department to the filling department Work In Process – Filling………XXX Work in Process – Mixing……….XXX  After processing has been completed in final department, the cost of the completed units are then transferred to the Finish Goods inventory account: Finished Goods…………..XXX Work in Process – Filling………….XXX  Lastly, when a customer’s order is filled and units are sold, the cost of the unit is transferred to the cost of goods sold: Cost of Goods Sold…………….XXX Finished Goods………………..XXX Equivalent Units of Production:  Equivalent units = #number of partially completed units X percentage completion  The product of the number of partially completed units and the percentage completion of those units => basically it is the number of complete units that could have been obtained from the materials and effort that went into the partially complete units  E.g. if have 500 partially completed units at 60% completion it equals to 300 units (500x60% =300)  FIFO Method of costing is a method inn which equivalent units and unit costs relate to work done during the current period  Weighted-Average Method blends together units and costs from current period with units and costs from the prior period  Equivalent units of production: for a department are the number f units transferred to the next department (or to finished goods) plus the equivalent units in the department’s ending work in process inventory. Weighted Average Method Equivalent Units transferred to Equivalent units in Units of = the next department + ending work in production or to finished goods process inventory  The computation of the equivalent units of production involves adding the number of units transferred out of the department to the equivalent units in the department’s ending inventory  Conversion costs is direct labour cost plus manufacturing overhead cost Cost per Equivalent unit =  This takes costs from prior and current periods  Costs per equivalent unit are value units in ending inventory and units that are transferred to the next department Chapter 5: Activity-Based Costing: A Tool To Aid Decision Making  Activity-Based Costing (ABC) is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore “fixed” as well as variable o Used for internal decision making Treatment of Costs under the Activity-Based Costing Model  In ABC: 1. Non-manufacturing/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. Overhead cost pools are used, each is allocated to products and other cost objects using its own unique measure of activity 4. Overhead rates or activity rates may be based on the level of activity at capacity rather than on the budgeted level of activity  Traditional absorption costing is designed to provide data for external financial reports Non-Manufacturing Costs and Activity-Based Costing  Selling, general and administrative expenses are treated as period expenses  Non-manufacturing costs are also part of the costs of producing, selling, distributing and servicing products o E.g. commissions paid to salespeople, shipping costs and warranty repair costs can easily be traced to individual products  Determining the products entire cost not just its manufacturing cost Manufacturing Costs and Activity-Based Costing  All manufacturing costs are assigned to products – even manufacturing costs that are not caused by the products o E.g. portion of the factory security guard’s wages would be allocated to each product even though the guard’s wages are totally unaffected by which products are made or not during a period  In activity-based costing cost is assigned to a product only if believed that 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 based Costing:  Activity is an event that causes the consumption of overhead resources  Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system  Activity Measure a measure of the amount of activity that drives the costs in an activity cost pool also called (costing driver)  Transaction Drivers are simple counts of the number of times an activity occurs  Duration Drivers measure the amount of time required to perform an activity o Duration drivers better than transaction drivers => easier to record and more accurate  If plantwide overhead costs do not move in tandem with plantwide direct labour-hours, product costs will be distorted o Activity-Based costing addresses this by the 5 Levels of Activity 1. Unit- Level Activities are performed every time a unit is produced => should be proportional to the number of units produced e.g. providing power to run processing equipment should be proportional to amount of units produced since it will take more power to create more units 2. Batch-level Activities are performed each time a batch is handled or processed, regardless of how many units are in the batch e.g. a batch-level activities could be placing an order, setting up equipment, arranging for shipments to customers 3. Product-level Activities relate to specific products and typically must be carried out regardless of how many batches are run or units of products are produced or sold. E.g. designing, advertising, maintaining product manager and staff = product level activities 4. Customer-level activities relate to specific customers and include activities such as sales calls, catalogue mailings, and general tech support that aren’t tied to specific products 5. Organization-sustaining Activities are carried out no matter what. They include activities such as heating the factory, cleaning executive offices, providing a computer network, arranging for loans, preparing annual reports to shareholders and etc. The Costs of Idle Capacity in Activity-Based Costing  This practice results in applying the cost of unused or idle, capacity to products and it results in unstable unit product costs  If budgeted activity falls, overhead rate increases because fixed components of overhead are spread over a smaller base, resulting in increased unit product costs  Charged for the costs of capacity they use – not for the costs of capacity they do not use => cost of idle capacity are not charged to products o Idle capacity costs are considered to be period costs 3 Essential Characteristics of Successful Activity Based Costing 1. Top managers must strongly support the implementation a. They must motivate all workers to accept the need for change 2. Top managers should ensure that ABC is linked to how people are evaluated and rewarded 3. Cross-functional team should be created to design and implement the ABC system 5 Basic Steps to Implementation Process 1. Identify and Define Activities, Activity Cost Pools, and Activity Measures a. Don’t want a huge list so we combined activities i. Activities that are combined into a single activity are called materials handling ii. They should be combined at right level, ones that are highly correlated=> batch level activities should not be combined with unit level activities and etc. 2. Assign Overhead Costs to Activity Cost Pools a. First-stage allocation is the process of assigning functionally organized overhead costs derived from a company’s general ledger to the activity cost pools (usually asked employees with first-hand knowledge and ask them what percentage of available machine capacity is consumed by each activity such as number of customer orders or number of units processed, and etc.) 3. Calculate Activity Rates a. Activity rates are computed by dividing Total Cost for each activity by its Total Activity b. Page 181 Exhibit 5-8 IMPORTANT c. Second-stage allocation, activity rates are used to apply overhead costs to products and customers 4. Assign Overhead Costs to Cost Objects 5. Prepare Management Reports a. To compute a product’s profit (profit margin), the design team needed to gather each product’s sales and direct costs in addition to the overhead costs previously computed Targeting Process Improvements  Activity-based Management (ABM) is used in conjunction with activity-based costing to improve processes and reduce costs  Benchmarking is a systematic approach to identifying the activities with the greatest room for improvement o Based on comparing the performance of some aspect of an organization’s operations (e.g. quality control) with the performance of other, similar organizations known for their outstanding performance o Using outside organizations as the basis for comparing is called external benchmarking o Internal benchmarking when one division’s operations performance is compared to another division’s performance Product Margins Computed Using the Traditional Cost System Traditional Cost Systems assigns only manufacturing costs to products – includes direct materials/labour and manufacturing overhead 1. Sales and direct materials/ labour cost data are the same numbers used by the ABC team 2. Traditional cost system uses a plantwide overhead rate to assign manufacturing overhead costs to products Plantwide Overhead Rate =  Action Analysis Report shows what costs have been assigned to a cost object such as a product or customer, and how difficult it would be to adjust the cost given a change in activity Reasons why traditional and activity-based costing systems report different product margins: 1. Traditional cost system allocates all manufacturing costs to products regardless of whether they consumed those costs. ABC system doesn’t assign manufacturing overhead costs to products for either customer relations activities or other activities because they are not caused by a product 2. Traditional cost system allocates all manufacturing overhead costs using machine hours, whereas ABC system uses unique activity measures to allocate the costs of each activity cost pool selected on the basis of management’s assessment of the driver of overhead costs for that activity a. Traditional cost system over costs high volume products (custom compass housings) and under cost low-volume products (standard stanchions) because they assign batch- level and product-level costs using volume-related allocation bases ( e.g. machine hours) 3. ABC system assigns nonmanufacturing overhead costs such as shipping to products on a cause- and-effect basis. Traditional cost system excludes these costs because they are classified as period costs  ABC System is more accurate than Traditional cost system and is used more in external reports because they are less detailed than internal reports and individual product costs are not reported Chapter 6: Cost Behaviour: Analysis and Use  Cost Behaviour refers to how a cost will react or change as changes take place in the level of business activity  Contribution format costs are organized by behaviour rather than traditional functions of production, sales and administration  Cost structure is the relative proportion of fixed, variable, and mixed costs found in an organization Types of Cost Behaviour Patterns  Variable costs is a cost whose total dollar amount varies in direct proportion to changes in the activity level =) however if on a unit basis the variable cost will not change doesn’t matter about the activity level  Activity Base is a measure of whatever causes the incurrence of a variable cost (also a cost driver)  True Variable Costs: Direct materials is a true variable cost because the amount used during a period will vary in direct proportion to the level of production activity  Step-Variable Costs – the cost of a resource that is obtainable only in large chucks (e.g. maintenance workers) and that increases/decreases only in response to fairly wide changes in activity The Linearity Assumption and the Relevant Range  Curvilinear Costs a relationship between cost and activity that is a curve rather than a straight line o Relevant range is that range of activity within which the assumptions made about cost behaviour are valid Fixed Costs  Remain constant within the relevant range of activity Types of Fixed Costs:  Committed Fixed Costs are those investments in facilities, equipment and basic organizational structure that can’t be significantly reduced even for short time periods, without making fundamental changes that would impair a firm’s long-run goals or profitability o E.g. depreciation of buildings/equipment, property taxes, insurance expenses and salaries of top management and operating personnel  Discretionary Fixed Costs (managed fixed costs) are costs that arise from annual decisions by management to spend in certain fixed costs areas o E.g. advertising, research & development and management training programs  Unless otherwise stated assumed that direct labour is a variable cost Mixed Costs  Mixed costs (semi-variable costs) contains both variable and fixed cost elements  Y= a+bX o Y= mixed costs o A= the total fixed costs(the vertical intercept) o B= the variable cost per unit of activity (the slope) o X= the level of activity  Fixed portion of mixed costs is the minimum cost of having a service ready and available for use  Variable portion of a mixed costs represents the costs incurred for actual consumption of the service  Account analysis is 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 is a detailed analysis of cost behaviour based on an industrial engineer’s evaluation of the inputs that are required to carry out a particular activity and of the prices of those inputs  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 o Variable Cost = The Contribution Format  Contribution Approach an income statement format that is geared to cost behaviour in that costs are separated into variable and fixed categories o Contribution margin the amount remaining from sales revenues after all variable expenses have been deducted Chapter 7: Cost-Volume-Profit Relationships  Cost-Volume-Profit (CVP) Analysis is a tool that helps managers understand the relationship among cost, volume, profit o Focuses on how profit is affected by 5 elements:  Prices of products  Volume or level of activity  Per unit variable costs  Total fixed costs  Mix of products sold  Contribution margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted  Break-Even Point is where the level of sales at which profit is not at a loss or a gain it is at 0 CVP Relationships in Graphic Form  Cost-Volume-Profit Graph (CVP) highlights the CVP relationships over wide ranges of activity  Contribution Margin (CM) Ratio is the contribution margin as a percentage of total sales o CM RATIO = Contribution Margin divided by Sales o E.g. if CM ratio is 40% that means contribution margin will increase by 40 cents for every dollar increase in operating income  Incremental Analysis – an analytical approach that focuses only on those items of revenue, cost and volume that will change as a result of a decision Break-Even Analysis  Break-Even Computation designed to answer questions such as how far sales could drop before the company begins to lose money  The Equation Method - Profits = (Sales – Variable Expenses) – Fixed Expenses o Rearrange => Sales = Variable Expenses + Fixed Expenses + Profits  Variable Expense Ratio is the ratio of variable expenses to sales dollars o Computed by dividing the total variable expenses by the total sales dollar  Contribution Margin Method – a method of computing the break-even point where the fixed expenses are divided by the contribution margin per unit o Break-even point in units sold = o Or can use Break-even point in units sold = The contribution Margin Approach Units sold to attain the target profit = After-Tax Analysis  Profit after taxes = Before-tax profit – taxes o Becomes B = t= taxes  Margin of Safety = Total budgeted(or actual) sales – Break-even Sales  Margin of Safety Percentage = CVP Considerations in Choosing a Cost Structure  Cost structure refers to the relative proportion of fixed and variable costs in an organization Operating Leverage  Operating leverage is a measure of how sensitive operating income is to percentage changes in sales o If operating leverage is high, a small percentage in sales can produce a much larger percentage increase in operating income  Degree of operating leverage is a measure, of how a percentage change in sales volume will affect profits o Degree of operating leverage =  % Operating Income Before Taxes (OIBT) = % Sales x Degree of operating Leverage Chapter 8: Variable Costing: A Tool For Management Absorption Costing  Treats all manufacturing costs as product costs, regardless on whether they are fixed or variable  Cost of a unit product under this method consists of direct materials, direct labour and both variable and fixed manufacturing overhead Variable Costing  Only manufacturing costs that vary with output are treated as product costs o Includes direct materials/labour, and variable portion of manufacturing overhead o Fixed product cost is not treated as a product cost in this method => fixed manufacturing overhead is treated as a period cost and it is expenses in its entirety against revenue each period Selling and Administrative Expense  These expenses are rarely treated as product costs => doesn’t matter about the cost method used  They are always treated as period costs (expenses) and deducted from revenues as incurred Under Absorption Costing Method/ Variable Costing Method  Fixed manufacturing overhead cost deferred in inventory – the portion of the fixed manufacturing overhead cost of a period that goes into inventory under the absorption costing method as a result of production exceeding sales  Absorption costing method does not go well with the CVP computations because you would have to rework and reclassify costs on the absorption statement  The Contribution approach to the income statement works well with the variable costing approach to costing units because both are based on the idea of classifying costs by behaviour  When production exceeds sales, the operating income under absorption costing will generally be greater than the operating income reported under variable costing. o Because under absorption costing, part of the fixed manufacturing overhead costs of the current period is deferred in inventory  When production is less than sales, the operating income reported under the absorption costing approach will generally be less than the operating income reported under the variable costing approach o Because as inventories are drawn down, fixed manufacturing overhead costs that were previously deferred in inventory under absorption costing are released and charged against income (which is fixed manufacturing overhead cost released from inventory)  Operating income is not influenced by changes in inventories when variable costing is used o Because variable costing released variable costs from inventory to COGS in amounts that are based on the volume of sales => thus production doesn’t influence COGS because fixed manufacturing overhead is fixed and not released as COGS Effect of Changes in production on Operating Income Variable Costing  Operating income is not affected by changes in production under this method  A change I production has no effect on operating income when variable costing is used Absorption Costing  Operating income is affected by changes in production under this method  Operating income goes up => in response to an increase in production Choosing a Costing Method: The Impact on the Manager  Under absorption costing, if there is an increase in inventories, fixed manufacturing overhead costs are deferred in inventories and operating incomes is increased o Decrease in inventories, fixed manufacturing overhead costs are released from inventories and operating income decreases Chapter 9: Budgeting  Master Budget is a summary of a company’s plans that sets specific targets for sales, production, distribution and financing activities. o Usually a cash budget, a budgeted income statement, budgeted balance sheet  Budgeting serves as both a planning tool and a control tool in organizations: o Planning involves developing objectives and preparing various budgets to achieve these objectives o Control involves the steps taken by management to increase the likelihood that the objectives developed at the planning stage are attained and to ensure that all parts of the organization function in a manner consistent with organizational policies Advantages of Budgeting 1. Budgets communicate management’s plans throughout the organization => causes better understanding to employees of organizational goals/objectives 2. Forces managers to think and plan about the future 3. Provides a means of allocating resources to those parts of the organization where they can be used most effectively and most needed
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