Managerial Accounting

9.1 Managerial Accounting—Discussion Guide

Performance Indicator: Explain the nature of managerial accounting

THINK ABOUT IT

Although it is not a mandatory business function, managerial accounting plays a crucial role in assuring a company’s success.

• Managerial accountants provide management with tailored accounting information and deliver valuable assistance by helping businesses plan, control, and make well-informed decisions.

KEY CONCEPTS

Slide #1 What Is Managerial Accounting?

• Managerial accounting, also called management accounting or cost accounting, is an internal process that centers about three main functions within the business: planning, controlling, and decision-making.

• Managerial accounting communicates financial information in a way that empowers management to measure, analyze, and interpret the results of their decisions.

• The purpose of managerial accounting is to provide managers with the information necessary to improve an organization’s financial performance, efficiency, and productivity, and ultimately reach the business’s goals.

• Managerial accountants help create budgets, analyses, metrics, and forecasts to optimize organizational decision-making.

• Since managerial accounting is not a required business function, companies that take advantage of its benefits enjoy the flexibility of segmented reporting (i.e., a single product or line of service) in whichever method and preparation format is most helpful for managerial decision-making.

Slide #2 Managerial vs. Financial Accounting

• Managerial accounting is different from financial accounting in several ways.

  • Managerial accounting reports are prepared for individuals within the organization, or internal users, while financial accounting reports are prepared for parties outside the business, or external users.

  • Financial accounting is a requirement for all companies, and as such, must conform to standards like generally accepted accounting principles (GAAP).

    • Since managerial accounting is not mandatory, it does not need to conform to specific accounting standards or formats.

  • Financial accounting provides more general results, while managerial accounting delivers specific data which can be modified by department, product, presentation, or information format.

  • Financial accounting reviews historical data, while managerial accounting takes a future approach.

  • Overall, managerial accounting is intended to provide managers within the company with accounting information tailored to their specific needs, and help management make the business more profitable.

Slide #3 Sources & Types of Managerial Accounting Reports

• Employees who conduct managerial accounting rely on the business’s historical data and financial accounting records as sources for their information.

  • These individuals work directly with the financial accounting team to prepare accurate reports, compare data with projections, strategize successfully, and enhance business profitability.

• Managerial accounting reports cover planning, controlling, and decision-making for the business, which can include some of the following reports:

• Product costing and valuation

• Cash-flow analysis

• Inventory turnover analysis

• Margin analysis

• Constraint analysis

• Job cost reports

• Inventory and manufacturing reports

• Performance reports

• Financial leverage metrics

• Accounts Receivable management

• Budget reports

• Trend analysis and forecasting

Slide #4 How Managerial Accountants Can Help

• Managerial accountants provide valuable assistance and information to management.

  • They help with preparing budgets and developing standards, accumulating data on costs and profits, comparing actual activity with plans or budgets, and advising management about non-routine decisions.

  • Managerial accounting information can help marketing, manufacturing, human resources, and top management all with planning, controlling, managing risk, measuring performance, and making decisions.

  • The information in these internal reports enables managers to set competitive product and/or service prices, control costs, save money, and ultimately increase the business’s profitability.

9.2 Overhead/Operating Costs—Discussion Guide

Performance Indicator: Explain the nature of overhead/operating costs

THINK ABOUT IT

The expenses that keep your life running on a day-to-day basis—housing, food, clothing, etc.—might be considered your personal “operating” costs.

• Businesses have operating costs as well.

• These expenses don’t directly relate to the business’s product(s), but they are still essential for success.

KEY CONCEPTS

Slide #1 What Are Operating Costs?

• Every business has operating costs, sometimes called operating expenses or overhead.

  • Operating expenses are ongoing, day-to-day expenses of running a business that are not directly related to production.

  • These can relate to maintaining a company building (e.g., janitorial services) or running a piece of equipment (e.g., electricity).

• Business owners and managers must keep operating costs in mind every time they engage in important business activities, such as setting organizational goals, determining whether or not to launch new products, setting budgets, etc.

• Though most businesses try to keep operating costs as low as possible so they can focus on production, these expenses are still vital for success.

• A realistic budget, for example, plans for operating costs (both fixed and variable) appropriately.

Slide #2 Fixed vs. Variable Costs

• The two main types of operating costs are fixed and variable.

  • Operating costs that do not increase or decrease with changes in production are called fixed costs.

    • In other words, these are the expenses that must be paid no matter what. Examples of fixed costs include:

      • Facility maintenance and repairs

      • Utilities (electricity, water, sewage, etc.)

      • Insurance

      • Rent/Mortgage

      • Wages/Salaries

      • Office supplies

  • Operating costs that fluctuate with changes in production are called variable costs.

    • When a company produces more of a product, variable expenses go up.

    • When a company produces less of a product, variable expenses go down.

    • There are several variable operating costs, such as:

      • Advertising and promotion

      • Travel expenses

      • Sales commissions

      • Employee bonuses

      • Certain permits and fees

      • Shipping, delivery, or installation costs

Slide #3 Semi-Variable Costs

• Some operating costs may be considered partially variable and partially fixed.

• These are known as semi-variable costs.

• Semi-variable costs are fixed until the company reaches a certain level of production; after that, they become variable.

  • For example, a manufacturer has a fixed cost for its employees’ wages, but when it decides to produce a greater number of products this month, its employees work more hours and earn overtime.

  • The employees’ base wages are still fixed, but the cost of paying this overtime is variable, depending on how many extra hours are worked.

• Certain costs may be considered either fixed or variable, depending on how you look at them.

  • For instance, one business may consider pest-control costs to be fixed, since it spends the same amount of money each year ridding its facility of spiders and ants.

  • Another business, however, may consider the costs to be variable, since it only spends money for pest control as needed.

• The decision of whether to categorize an expense as fixed or variable is ultimately up to the individual business.

• However, for accounting purposes, the business’s decision must remain consistent over time.

Slide #4 Operating Expenses, Selling Price, & Profit

• Operating costs have a great influence on a product’s final selling price.

• The total cost of a product is the sum of the overhead and direct costs required to produce it.

  • Let’s say the total cost of producing a pair of basketball shoes is $25 ($5 in operating costs and $20 in materials).

  • To make a profit, then, the company must set a selling price that is higher than $25.

• Operating costs also have a major impact on a business’s profits.

• As costs go up or down, profits fluctuate as well.

• More costs equal less profit, and fewer costs equal greater profit.

• A company’s gross profit is the revenue it makes after subtracting the costs of the products it has sold.

  • For example, if a company made $1 million last quarter and spent $200,000 producing its goods, its gross profit is $800,000.

• Gross profit is a good indicator of how well a company keeps its costs under control.

• A company reaches its break-even point when total expenses equal total sales.

  • At this point, the business has covered its costs but has not yet made a profit.

  • The formula for calculating the break-even point is: Fixed costs / (Price per unit – Variable costs per unit) = Break-even point

• Operating costs are just “a part of life” for every business and organization.

• Operating costs can mean the difference between profit and loss, failure and success.

• Prosperous businesses are mindful of operating costs and work to keep them in line.

9.3 Managerial Accounting Costs—Discussion Guide

Performance Indicator: Describe types of costs used in managerial accounting (e.g., direct cost, indirect cost, sunk cost, differential cost, etc.)

THINK ABOUT IT

Managerial accounting costs play a vital role in determining a business’s profitability and overall viability.

• By gathering accurate cost information in various fields, managers can then use the information to plan, perform, evaluate, and communicate decisions for the business.

KEY CONCEPTS

Slide #1 Classifying Managerial Accounting Costs

• Managerial accounting costs can be classified several ways, and certain costs can fall into multiple categories depending on the circumstances.

• Some ways in which costs can be classified are by:

  • Behavior:

    • How will this cost respond to changes in the level of a related activity or cost object? Does the cost rise, fall, or remain constant?

  • Function:

    • Is this cost integral to the production of a product?

  • Relevance:

    • Does this cost vary among multiple alternatives?

  • Traceability:

    • Can this cost be easily traced to one specific product or cost object?

  • Controllability:

    • Can we choose whether to pay this cost or not?

Slide #2 Basic Manufacturing Costs

• Manufacturing costs (a.k.a. product costs or inventoriable costs) consist of the expenses involved in transforming raw materials into finished products.

• These costs include the cost of materials, the human resources, and the overhead involved in production.

• Basic manufacturing cost categories include the following:

  • Direct materials costs:

    • These are the costs of components and raw materials that are combined and/or transformed to create a finished product.

    • They can be easily traced to the finished product and are a significant portion of the total product cost.

  • Direct labor costs:

    • These are sometimes called touch labor and consist of the monies paid to employees to produce the product.

    • They are a significant portion of the total product cost.

  • Manufacturing/Production overhead costs (a.k.a. factory overhead or factory burden):

    • These consist of factory-/production-related costs (excluding direct materials costs and direct labor costs) required to produce a finished product.

Slide #3 Common Managerial Accounting Costs

• Product vs. period costs:

  • Product costs (a.k.a. manufacturing costs or inventoriable costs):

    • These can be associated with the production of a good or service and are treated as expenses when the resulting products are sold.

    • They appear as cost of goods sold on income statements and as inventory on balance sheets.

  • Period costs:

    • These are non-manufacturing/non-product costs, and they consist of all costs except for product costs.

    • They are not associated with a particular good or service, but they can be associated with a particular time period.

    • They are treated as expenses when they are incurred, and they appear as operating expenses on the income statement.

• Selling vs. general administrative costs:

  • Selling costs (a.k.a. order-getting or order-filling costs):

    • These are associated with marketing a good or service.

  • General and administrative costs:

    • These pertain to the administration of the business, and they are all the executive, organizational, and clerical costs associated with the general management of a business.

• Direct vs. indirect costs:

  • Direct costs:

    • These can be easily associated and traced to a particular product, process, department, etc.

  • Indirect costs:

    • These are associated with multiple products, processes, departments, etc., and they cannot be conveniently traced to a particular product, process, department, etc.

• Controllable vs. uncontrollable costs:

  • Controllable costs:

    • These can be regulated and controlled by certain individuals or departments within a business, and they can be incurred or not, based on responsible parties’ decisions.

  • Uncontrollable costs:

    • These cannot be regulated or controlled by certain individuals or departments within a business, and they are beyond the scope of employees’ power.

• Avoidable vs. unavoidable costs:

  • Avoidable costs:

    • These can be avoided and eliminated by doing or not doing an activity.

  • Unavoidable costs:

    • These cannot be avoided or eliminated, no matter whether you initiate a certain activity or not.

• Out-of-pocket vs. sunk costs:

  • Out-of-pocket costs:

    • These are associated with current expenses.

  • Sunk costs:

    • These are the costs of items that were purchased in the past and cannot be recovered.

    • These often pertain to discontinued products or processes that have been eliminated and should not influence future decisions.

• Differential, incremental, opportunity, and imputed costs:

  • Differential costs (a.k.a. incremental or relevant costs):

    • These are the differences in costs among alternative actions or decisions being considered.

    • They are useful when evaluating multiple options.

  • Opportunity costs (a.k.a. imputed costs):

    • These are the benefits that are lost when you decide to use scarce resources for one purpose rather than for another.

    • These are useful when evaluating multiple options.

• Relevant vs. irrelevant costs:

  • Relevant costs (a.k.a. differential or incremental costs):

    • These are the differences in costs among alternative actions or decisions being considered.

    • They can be eliminated and/or reduced by choosing one alternative over others and are avoidable costs.

  • Irrelevant costs:

    • These are the costs that are the same among alternative actions or decisions being considered.

    • These are sunk costs and future costs that do not differ among alternatives being considered, and they are unavoidable costs.

Slide #4 How Cost Information Is Used

• In general, costs consist of the expenses involved in manufacturing, promoting, and distributing a product—in other words, the costs of various resources needed to produce revenue.

• In managerial accounting, managers utilize many different types of costs, and the specific costs they study and use depend on the tasks they are completing.

• These tasks fall into four main categories:

  • Planning:

    • Managers estimate operating costs and sales volume, set prices, and prepare budgets.

  • Performing:

    • Managers monitor the profitability of products, make decisions concerning products, and compute the unit cost of a product.

  • Evaluating:

    • Managers compute variances between estimated and actual costs, and analyze variance, address causes of variances, and revise future plans.

  • Communicating:

    • Managers prepare internal reports for management and prepare external reports for stakeholders.

FI:719 Discuss cost accounting systems (e.g., job costing, process costing, standard costing, activity-based costing

9.4 Cost Accounting Systems—Discussion Guide

Performance Indicator: Discuss cost accounting systems (e.g., job costing, process costing, standard costing, activity-based costing [ABC])

THINK ABOUT IT

How do businesses set and keep track of product prices, highlight production efficiencies, identify areas for improvement, and accurately distribute manufacturing costs?

• They make the most of cost accounting systems and overhead allocation to enhance profitability and optimize operations.

KEY CONCEPTS

Slide #1 Purposes of Cost Accounting Systems

• Businesses use cost accounting systems to track production activities, assess profitability, enhance budgeting, measure cash flow, and fine-tune operations.

• Unlike financial accounting, which is subject to reporting standards, cost accounting is an internal process where reports are tailored to management’s needs.

• Cost accounting systems let businesses check inventory at each production stage and maintain just-in-time inventory systems.

  • Tracking costs increases efficiency by identifying areas to streamline, which improves strategic planning capabilities.

  • Businesses assess variable and fixed production costs to select the system that will serve them best in allocating costs.

Slide #2 Cost Accounting Systems

• There are four main types of cost accounting systems, and businesses can use a hybrid approach that mixes pieces of each system to create a unique method.

  • Job order costing, often called job costing, in which the company assigns costs from labor, materials, and overhead to each job.

    • This method is best suited to unique or customized products, as it is more precise and accurate than process costing; however, it is labor-intensive due to large amounts of data entry.

    • The flow of costs follows the physical flow of materials: manufacturing costs are assigned to one general Work In Process Inventory account, then after a job is completed, the costs transfer to Finished Goods Inventory.

    • As the goods are sold, costs are transferred to Cost of Goods Sold.

  • Process costing, in which product costs are tracked by department or process instead of job.

    • Costs are compiled for a total production process, then distributed to individual units.

    • This method is generally used for large volumes of identical products, and it is efficient and simple to operate.

    • This method uses a Work In Process account for each process, which results in each unit receiving an average production cost.

    • The flow of costs is similar to job-order costing, except product costs are assigned to each process or production department.

  • Standard costing, where companies assign expected costs to a product instead of the actual costs of materials, labor, and overhead.

    • The differences between standard and actual costs are called variances, which management analyzes to control costs.

    • Costs are recorded as standard costs, then the actual amounts are logged and applied as they occur.

    • Companies often use standard costing to create budgets and set prices, but it can be time-consuming.

  • Activity-based costing (ABC), where all costs are organized by activity, then allocated to cost pools and divided by cost drivers (e.g., machine hours, units, etc.).

    • This method identifies every cost, then allocates costs based on how much the product uses the activity.

    • This lets businesses identify which tasks add the most value or cost the most.

    • Businesses can accurately allocate costs in complex production processes, but it can be difficult to operate.

    • The flow of costs considers direct and indirect costs involved in creating every product.

Slide #3 Importance of Overhead Cost Allocation

• Overhead allocation is the required process of distributing indirect costs to finished products.

  • Responsible overhead allocation helps businesses keep accurate financial records, set reasonable prices, cut manufacturing costs, and improve efficiency.

  • By allocating overhead costs to all goods a company produces and incorporating these costs into product prices, that company is better able to cover costs and enhance their profitability.

Slide #4 Overhead Cost Allocation Methods

• There are two types of overhead: manufacturing and nonmanufacturing (or administrative) overhead.

  • Manufacturing overhead includes all costs a business sustains; nonmanufacturing overhead includes all costs that aren’t involved in production, like sales and general administration.

• To allocate overhead costs, businesses calculate an overhead rate by collecting all relevant costs, then selecting a cost driver.

  • Cost drivers include direct labor, machine hours, sales, miles, orders completed, etc.

  • To calculate overhead, gather manufacturing costs into cost pools, or individual cost groupings that are often split by department or service center.

  • Divide the cost pool by the cost drivers to calculate overhead allocation per unit, or the overhead rate.

• Businesses generally use either the traditional method, using a single cost driver, or the ABC method, using multiple cost drivers.

  • ABC involves determining the costs of all activities required to produce an item, then assigning costs of those activities to those items.

  • While businesses can allocate based on any cost driver in the traditional method, they typically allocate manufacturing overhead by direct labor hours or machine hours.

    • Labor-intensive activities are suited to direct labor hours, while automated factories are best for machine hours.

  • ABC’s numerous cost pools improve accuracy with diverse products and complicated processes; however, it can be expensive and time-consuming.

  • The traditional method is simple and less expensive, but does not distribute overhead as accurately as utilizing multiple cost drivers.

9.5 Apply Cost Accounting Techniques—Discussion Guide

Performance Indicator: Apply cost accounting techniques (e.g., job costing, process costing, standard costing, activity-based costing [ABC])

THINK ABOUT IT

An ice cream manufacturing company notices that its production process isn’t as efficient as it should be, and the company is losing money.

• What should they do?

• Management should consider cost accounting!

• Read on to learn about applying four major cost accounting techniques.

KEY CONCEPTS

Slide #1 Cost Accounting Techniques

• Cost accounting enables businesses to make better financial decisions.

• Since it is an internal process that is used by management, cost accounting is not required to meet specific reporting standards, which means it can be more flexible.

• Businesses use cost accounting to measure, report, and analyze costs in production or separate projects or processes, then reduce these expenses to boost efficiency and profitability.

• Costs involved in cost accounting include direct, indirect, fixed, variable, and operating costs.

• While there are many cost accounting techniques, four of the most widely used are job costing, process costing, standard costing, and activity-based costing (ABC).

Slide #2 Job Costing

• Job costing helps businesses track costs for individual jobs or projects.

• To track direct labor, employees record their time, then management calculates the labor cost to assign to each job.

• Indirect labor is recorded in an overhead cost pool, then allocated to jobs.

• To track overhead, costs are accumulated in cost pools, then allocated to jobs based on usage.

• Here’s how job costing works:

  • Step 1: Calculate direct material.

    • This involves totaling all materials used in creating the product.

    • However, this isn’t always a practical process, so you can estimate these costs by using an inventory costing method (e.g., First In, First Out [FIFO]; Last In, First Out [LIFO]; Weighted Average Cost [WAC], Specific Identification).

  • Step 2: Calculate direct labor.

    • Multiply the payroll day rate for those working on the product by the amount of time needed to complete the job.

  • Step 3: Determine overhead rate.

    • Overhead costs include the indirect costs that make the project possible, like rent and utilities.

    • This calculation splits indirect costs among jobs by using an activity cost driver (e.g., labor or machine hours).

    • The overhead rate formula is

      • Predetermined Overhead Rate = Estimated Overhead Cost / Estimated Level of Activity

  • Step 4: Allocate overhead.

    • After calculating the overhead rate, apply it to your job by using

      • Applied Overhead = Predetermined Overhead Rate X Actual Level of Activity

  • Step 5: Calculate job cost.

    • The final job cost formula is

      • Total Job Cost = Direct Material + Direct Labor + Applied Overhead

Slide #3 Process Costing

• Process costing accumulates the production costs for a large quantity of identical products, then allocates those costs proportionally to the entire batch.

• Since the units are identical, businesses don’t need to track individual unit information.

• With process costing, costs are recorded for each process, which makes it the opposite of job costing, where costs are accumulated individually for each product.

• There are three main types of process costing:

  • Standard cost, where businesses use standardized costs based on historical cost data, then charge the difference between actual costs to a variance account at the end of the period.

  • FIFO, where companies create separate layers of costs by assigning costs based on the order items were produced.

  • WAC, where businesses disregard time period and simply assign all costs to produced units.

• Here’s how process costing works:

  • Step 1: Analyze inventory.

    • Evaluate the inventory cost flow to determine the costs of each process in the production cycle.

    • Calculate the inventory opening balance, the amount produced during the period, and how much was left as Work in Process (WIP).

  • Step 2: Convert inventory costs.

    • Convert the WIP inventory to a number of equivalent units.

    • For example, 100 items in-process at 75% completion would equal 75 produced units.

  • Step 3: Calculate total costs.

    • Calculate the total indirect and direct costs accumulated in the manufacturing process.

    • Apply these costs to completed inventory and equivalent units.

  • Step 4: Calculate cost per unit.

    • Divide the total costs of production over the complete and equivalent units.

  • Step 5: Assign costs to complete and in-process units.

    • Split the costs by allocating amounts based on cost per unit and number of completed units to Finished Goods and WIP.

Slide #4 Standard Costing

• Standard costing assigns “standard” costs to inventory based on expected production operating conditions.

• Standard costing involves estimating the cost of a production process.

• The difference between the standard efficient cost and the actual cost to produce the items is called a variance, and businesses compare them with variance analysis.

• A favorable variance exists when actual costs are lower than expected, and an unfavorable variance exists when actual costs are higher than the standard costs.

• Rate variance includes the cost of the input (e.g., labor, materials) while volume variance includes the quantity or efficiency of the input.

• Here’s how standard costing works:

  • Step 1: Create standard cost.

    • Determine the cost of direct materials, direct labor, and overhead.

    • Multiply the rate by the quantity.

    • The standard cost formula is

      • Standard Cost = Direct Labor + Direct Materials + Manufacturing Overhead

  • Step 2: Establish standards.

    • Review past data, future trends, and business production plan.

    • Compare to the estimated standard cost and set the production standards.

  • Step 3: Determine actual costs.

    • Establish the actual costs for materials, labor, and overhead.

  • Step 4: Compare actual costs and standard costs.

    • Compare the costs to determine variance.

  • Step 5: Determine causes.

    • Decide the reasons for the variances to take corrective action.

  • Step 6: Dispose of variances.

    • Transfer the variances to the profit and loss account.

Slide #5 Activity-Based Costing (ABC)

• Activity-based costing (ABC) assigns overhead and indirect costs to specific cost objects.

• This system is based on activities, which is any unit of work, event, or task with a goal.

• These activities are known as cost drivers and help calculate the cost driver rate, which is then used to allocate overhead costs.

• Here’s how ABC costing works:

  • Step 1: Identify activities and assign costs.

    • Identify all the activities that contribute to producing an item.

    • These include unit-level, batch-level, product-level, and customer-level activities.

    • Then assign costs to all the activities.

  • Step 2: Divide into cost pools.

    • Separate the activities into cost pools, then calculate the total overhead of each cost pool.

  • Step 3: Assign cost drivers.

    • Assign activity cost drivers (e.g., hours, units) to each cost pool.

  • Step 4: Calculate cost driver rate.

    • To calculate the rate for each cost pool, use this formula (which is the same formula for calculating predetermined overhead rate)

      • Cost Driver Rate = Overhead / Activity Cost Drivers

  • Step 5: Assign costs to products.

    • Multiply the cost driver rate (or the predetermined overhead rate) by the level of cost driver activity used to create the product.

    • This is also known as applied overhead.

9.6 Maintain Job Order Cost Sheets—Discussion Guide

Performance Indicator: Maintain job order cost sheets

THINK ABOUT IT

Imagine you own a large manufacturing company that produces different sized boats, from small rowboats to double-decker houseboats.

• You know the rowboat costs less to produce than the houseboat, but how much less?

• If you want to determine the exact amount it costs to create each boat in your inventory, your company should prepare job order cost sheets.

• Read on to learn more.

KEY CONCEPTS

Slide #1 Importance of Job Order Cost Sheets

• Think back to job order costing, in which companies or organizations assign costs from labor, materials, and overhead to each individual job.

  • These businesses use job order cost sheets, sometimes called job cost sheets, to accurately record and track all job cost information.

  • Job order cost sheets compile and assign all costs to a particular job.

  • Businesses use them to organize costs for each job, which helps them streamline production processes and optimize expenditures.

  • By maintaining accurate job order cost sheets, management can track performance to improve efficiency and productivity, and compare profitability among jobs.

• Job order cost sheets are also important for a business’s accounting records.

  • These documents act as a supplementary ledger, or record, to the work in process (WIP) account since it includes everything about jobs in process.

  • Although job order costing is popular with manufacturing, service businesses like law firms, hospitals, and accounting firms also use it to invoice individual customers.

Slide #2 Costs Recorded on Job Order Cost Sheets

• Three types of costs are recorded on job order cost sheets:

  • Direct materials costs, which are authorized by the materials requisition form.

    • It’s important that only direct materials for the specific job are charged to this category.

  • Direct labor costs, which are recorded on a time ticket or time sheet.

    • It’s vital that only time recorded working on the specific job is included in this category.

  • Manufacturing overhead costs, which include all indirect costs.

    • Management calculates the predetermined overhead rate by dividing estimated overhead costs by estimated allocation base (e.g., labor hours, machine hours, etc.).

    • Then, they calculate the applied overhead for a particular job by multiplying the predetermined overhead rate by the actual activity.

• In addition to these costs, job order cost sheets also contain the job number, job name, start date, completion date, and the quantity of items or units completed.

Slide #3 Determining the Cost of a Job

• To record resources for each job, businesses utilize source documents for accuracy.

  • They employ materials requisition forms, which record the job number and the type, quantity, and unit price of the direct materials for the job.

  • Management then uses time tickets, which employees use to clock in and out of specific jobs, to apply direct labor to the job.

  • To determine the final cost of a completed job, total the direct labor costs, direct materials costs, and the overhead allocation.

• Under the job order cost system, all unfinished jobs fall under the WIP category.

  • Direct material costs are assigned to specific jobs when inventory releases the supplies.

  • Direct labor costs are documented by employees then linked to the job.

  • Overhead is allocated using the predetermined overhead rate.

  • At the end of the month, the WIP balance is the total of all job order cost sheets for the unfinished jobs.

  • This means all completed job order cost sheets that have yet to be sold can act as the supplementary ledger for finished goods inventory.

    • As the company sells and ships its finished goods, it pulls the cost records from the finished goods inventory file.

      • These records are then used to calculate a specific time period’s cost of goods sold.

Slide #4 Preparing Job Order Cost Sheets

• Each time a business starts a new job, it needs to create a new job order cost sheet where all costs for the specific job will accumulate.

  • Depending on the product, the job order cost sheet may be brief, with a few lines of costs, or complex, with pages of data.

  • Companies often find it useful to specifically name the job, either with a customer’s name or a uniquely identifiable number.

  • It’s crucial for employees to accurately track and record all costs for the specific job, as forgetting even a few hours can have a massive impact of the job’s total cost.

• For companies that use job order costing, a product’s price is typically based on its cost to create, which makes it vital for businesses to engage in ethical cost accounting.

  • If a company decides to simply transfer the costs from one job order cost sheet to a different job, ethical problems can develop.

  • Companies must exercise integrity and professionalism in their recordkeeping.

9.7 Calculate Cost of Goods Sold—Discussion Guide

Performance Indicator: Calculate the cost of goods sold

THINK ABOUT IT

If your business has inventory, you’re responsible for determining the costs involved in selling your products.

• Performing cost of goods sold calculations enables you to optimize your company’s profitability and determine how efficiently you’re using resources in production processes.

• Read on to learn more about calculating cost of goods sold.

KEY CONCEPTS

Slide #1 Importance of Calculating COGS

• Cost of goods sold (COGS) is the cost of creating a company’s products during a period, often a year.

  • It includes all costs that are directly related to the production of a business’s goods.

  • Fixed costs, like marketing, salaries, and utilities, are not included in COGS calculations.

  • Simply put, it is the expense needed to produce the items a company sells.

  • Cost of goods sold can be referred to as cost of sales.

• Cost of goods sold is an important metric that provides insight into the financial health of a company.

  • Businesses calculate COGS to determine taxable income, review profitability, and enhance strategic decision-making.

  • It is also used to calculate other metrics like net income, which is revenue minus COGS and expenses, and gross profit, which is a profitability measure that reflects a company’s efficiency in managing materials and labor in its production process.

Slide #2 Relationship to Inventory Costing Method

• The value of COGS is directly dependent on a company’s inventory costing method.

  • Each inventory costing method produces a different effect on the expense charged to COGS and therefore impacts the amount of earned income.

  • There are three main ways to account for inventory sold:

    • First In, First Out (FIFO), where oldest goods are sold first.

      • Since prices generally go up over time, the company sells its least expensive items first.

      • This means COGS is lower because it’s built on cheaper costs, which results in higher gross profit and higher taxable income.

    • Last In, First Out (LIFO), where the newest goods are sold first.

      • Since higher priced items are sold first, ending inventory is valued lower at the older costs.

      • This means COGS is higher and both gross profit and taxable income are lower.

    • Weighted Average Cost (WAC), where goods are valued at the average cost.

      • This levels out COGS by preventing extreme fluctuations from skewing costs.

Slide #3 Limitations of COGS Calculations

• There are several potential limitations of COGS calculations.

  • Accountants or management can manipulate COGS by overvaluing inventory, altering the ending inventory amount, overstating discounts, and more.

  • Artificially inflating inventory results in lower COGS and an inflated net income.

  • Another issue with the COGS formula is that it’s very broad, meaning companies can calculate their direct inventory costs different ways.

  • Inventory accounting methods also vary by company, and one business can have multiple COGS results depending on inventory calculations.

Slide #4 Information Needed To Calculate COGS

• To determine COGS, businesses need to know the following information:

  • Accounting method, whether cash or accrual accounting

  • Inventory costing method

  • Beginning inventory, which is the value of all items in inventory at the start of the period

  • Cost of purchases for inventory

  • Costs of labor, supplies, and other costs (shipping, rent, utilities, etc.)

  • Ending inventory, which is the value of all items in inventory at the end of the period

Slide #5 Techniques for Calculating & Recording COGS

• To calculate COGS, businesses follow these steps:

  • Step 1: Determine direct costs and indirect costs

  • Step 2: Determine facilities costs

  • Step 3: Determine beginning inventory

  • Step 4: Add purchases of inventory items

  • Step 5: Determine ending inventory

  • Step 6: Perform COGS calculation

• The formula for calculating COGS is:

  • Cost of Goods Sold = Beginning Inventory + Purchases – Closing Inventory

• When calculating COGS, inventory amounts are found on the balance sheet.

• Cost of goods sold is recorded as an expense on the income statement, typically beneath sales revenue and before gross profit.

• It’s important to keep regular, accurate records of a company’s COGS calculations.

  • Detailed records help ensure taxes are filed correctly, and they are especially useful in case of an audit.

9.8 Standard Cost Accounting—Discussion Guide

Performance Indicator: Develop costs per unit of product

THINK ABOUT IT

A lot of business is about knowing how much money is being spent developing goods and services, and how much money is being brought in from customers who are purchasing those products.

• Below you’ll read about how businesses plan for their own manufacturing costs and compare it to the money spent on their goods and services.

KEY CONCEPTS

Slide #1 Businesses use standard cost accounting to estimate the cost of manufacturing a product or developing a service.

• In other words, standard cost is a way to make sure production of a good or service is financially on track.

• Standard costs are used to plan out how much it costs to develop a product.

• Managers will compare the standard cost per unit with the actual cost of a good or service to determine whether modifications to the standard cost need to be made.

• The final cost of making a product is the actual cost.

  • Unlike standard cost, actual cost is not an estimate because all of the costs have been taken on by the business to make the product.

Slide #2 Three categories are needed to solve for standard cost: direct material, direct labor, and manufacturing overhead. Read more about them below:

• Direct material: This is the material used to make a product. To solve for direct material, multiply quantity of materials used to make the product by the price of the materials.

• Direct labor: This is the work involved in product development. Direct labor is made up as labor hours multiplied by labor rate (wages).

• Manufacturing overhead: This is the combination of all other expenses involved in the building of the good or service. To solve for manufacturing overhead, add up all of the costs that are incurred during the production of a product that do not include direct labor.

• The sum of direct material, direct labor, and manufacturing overhead is the standard cost.

• The total of the three is the standard cost per unit.

  • For example, if the direct material to make a guitar is $500, the direct labor is $200, and the manufacturing overhead is $200, the standard cost to produce the guitar is $900.

Slide #3 A variety of factors can go into developing the standard cost of a product.

• There could be changes in efficiency of labor after employees go through more training, or maybe experienced workers have been replaced with more inexperienced labor.

• The former could make labor more efficient and faster, while the latter could be cheaper but take longer to complete work.

• The prices of direct materials for a product can also rise and fall year to year.

• The age and condition of equipment could affect overhead costs, too.

• Some equipment could need repairs, which would make manufacturing overhead go up and cause production volume to go down.

Slide #4 Business administrators or managers will typically review the standard cost estimates on a yearly basis.

• There are a few reasons for that.

• As discussed above, direct labor, direct material, and overhead costs can change frequently year over year.

• Remember that standard cost is used for planning and anticipating the costs for a product.

  • If the actual cost is above the standard cost, it means that the profit will be less than anticipated.

  • If the actual cost is below the standard cost, the profit from the sale of a product will be above what was anticipated, which is generally good for business.

• Businesses will adjust the standard cost to get closer to the actual cost of the product after the review is conducted.

• Some business administrators will even review the standard cost per unit on a quarterly basis to make sure their estimates for product development are correct, and then adjust their estimates as needed.

• These differences between the actual cost and standard cost are called variances.

• The following list includes examples of what could be a variance between actual costs and standard costs:

  • Production cost

  • Production output

  • Change in labor production

  • Cost of materials

  • The price of paid labor

  • Equipment updates or repairs

  • Amount of materials used for a product

9.9 Cost-Volume-Profit Analysis—Discussion Guide

Performance Indicator: Discuss the use of cost-volume-profit analysis

THINK ABOUT IT

Which products are most profitable?

• How far can you drop prices and still hit your goals?

• What sales volume is necessary to hit your target income?

• Cost-volume-profit analysis, which measures the interdependent relationship among production costs, output volume, and profit gained, can help you answer these questions and more.

KEY CONCEPTS

Slide #1 Objectives of Cost-Volume-Profit Analysis

• Businesses use cost-volume-profit analysis to measure how changes in levels of costs and volume affect the business’s operating income (or operating profit).

  • Cost-volume-profit analysis assesses how changes in fixed and variable costs, sales volume, and price impact the company’s profit.

  • This tool helps managers gain insight into profitability in various outcomes and ultimately make better strategic decisions.

• Cost-volume-profit analysis helps in forecasting profits, preparing budgets, formulating pricing policies, evaluating performance, controlling costs, increasing efficiency, determining expansion plans, and more.

  • The information derived from cost-volume-profit analysis enables businesses to set costs at various volume levels, analyze the impact of changes in prices and product mix, and help solve financial and production challenges.

Slide #2 Components of Cost-Volume-Profit Analysis

• There are five main components of cost-volume-profit analysis:

  • Volume or level of activity

  • Unit selling price

  • Variable cost per unit

  • Total fixed costs

  • Sales mix

• These components are then combined and analyzed to generate the contribution-format income statement, break-even analysis, margin of safety, and targeted income.

  • Businesses use contribution-format income statements, which are reformatted income statements that show the business’s fixed and variable expenses as well as net profit or net loss for the time period.

  • Targeted income, which is also known as target profit, involves calculating the number of sales necessary to generate a desired profit.

    • Businesses can analyze this amount by incorporating their goal amount into the break-even formula.

Slide #3 Assumptions and Limitations

• Cost-volume-profit analysis features several assumptions, including that sales price per unit, variable costs per unit, and total fixed costs are all known and constant.

  • When drawn on a graph, total revenues and total costs are linear, or straight lines, in relation to the number of units sold.

  • Another assumption is that everything that is produced is sold.

  • In addition, the only reason costs are affected or change is because activity changes; in other words, changes in revenues and costs only occur due to changes in the number of products or units sold.

• Cost-volume-profit analysis has the following limitations: it is not recommended for a multiproduct business, it ignores how other factors can influence cost and profit, it does not account for inventory, there can be issues with identifying variable and fixed costs, and it is a short-term tool.

Slide #4 Cost-Volume-Profit Analysis Tools

• Cost-volume-profit analysis offers three main tools:

  • Contribution margin analysis, which involves computing the profitability of various products.

    • The contribution margin is the amount of profit the business makes after deducting variable expenses.

    • The contribution margin ratio is the percentage of sales dollars that are available to cover fixed costs.

      • The contribution margin ratio, which can be calculated with dollars or per unit, is calculated by dividing the contribution margin by sales amount.

  • Break-even analysis, which shows the quantity of products or sales needed to cover all costs and break even financially.

    • After determining the break-even point, businesses can use it to view the effects of increasing or decreasing fixed costs to improve overall profitability.

  • Operating leverage analysis, which analyzes how changes in both products sold and contribution margin affect operating income as fixed costs change.

    • How a business uses fixed costs compared to variable costs in operations is known as operating leverage.

      • The degree to which a business uses fixed costs enhances profits as sales go up but increases losses as sales decrease.

      • Operating leverage is the risk-return tradeoff among different cost structures (i.e., sales commissions as variable costs instead of salaries as fixed costs).

Slide #5 Sensitivity Analysis

• Sensitivity analysis is used to show the changes that will occur with changes in fixed costs, variable costs per unit, sales price, units sold, and/or sales mix.

  • Sensitivity analysis shows how the break-even point changes as the predicted data changes.

  • One part of sensitivity analysis is margin of safety, which is the amount by which sales can drop and the company can still break even.

    • It is the amount which revenues exceed break-even quantity, or a company’s “wiggle room.”

FI:454 Conduct cost-volume-profit analysis

9.10 Conducting Cost-Volume Profit Analysis—Discussion Guide

Performance Indicator: Conduct cost-volume-profit analysis

THINK ABOUT IT

Cost-volume-profit (CVP) analysis is a powerful tool that businesses use to optimize profitability.

• CVP analysis is comprised of numerous components that all contribute to its usefulness.

KEY CONCEPTS

Slide #1 Conducting Cost-Volume-Profit Analysis

• Businesses use CVP analysis any time they want to see how changes in fixed and variable costs, price, and sales volume will impact profitability.

  • CVP analysis helps determine selling price and reveals the number of products needed to cover costs, break even, and reach target profit.

• CVP analysis aims to establish the business’s break-even point and subsequent target income.

  • The first step involves viewing a contribution margin format income statement to review all revenue and expenses.

  • Total the business’s fixed costs, including rent, utilities, insurance, etc.

  • Then, determine the product’s selling price, which you may need to calculate multiple times to set the optimal price.

  • Next, calculate the variable cost per unit.

  • The next step is to calculate the contribution margin and contribution margin ratio, outlined below.

  • Finally, plug all values into the following formulas to determine break-even sales:

    • Break-Even Point in Dollars = Total Fixed Costs / Contribution Margin Ratio

    • Break-Even Point in Units = Total Fixed Costs / Contribution Margin

  • Businesses often plot the break-even point on a graph to view its impact on profit.

    • After calculating break-even sales, companies use these calculations to determine target income, also outlined below.

    • For a step-by-step guide to conducting CVP analysis, visit https://www.fool.com/the-blueprint/cost-volume-profit-analysis/.

Slide #2 Contribution Margin

• The contribution margin is the difference between the sales price and the variable costs involved with production.

  • A business’s contribution margin is money it has to cover fixed costs and contribute to profit.

  • Calculating contribution margin enables businesses to determine break-even point and set ideal prices for products.

  • The formula for calculating contribution margin is as follows:

    • Contribution Margin = Net Sales Revenue – Total Variable Costs

• The contribution margin ratio (or percentage) is the fraction of each sales dollar that is used to cover fixed costs.

  • The formula for calculating the contribution margin ratio is as follows:

    • Contribution Margin Ratio = Contribution Margin / Net Sales Revenue

Slide #3 Operating Leverage

• Operating leverage is a financial efficiency ratio that refers to how well a business uses its fixed costs to create profits.

  • Managers use operating leverage to calculate break-even point and measure the effectiveness of the company’s pricing structure.

  • The more money a business can generate from its fixed assets, the higher its operating leverage, the more profit it generates from each sale, and the more effective its pricing strategy.

  • The formula for calculating operating leverage is as follows:

    • Degree of Operating Leverage = Contribution Margin / Operating Income

Slide #4 Target Income

• Target income, which is also known as target profit, involves calculating the number of sales necessary to generate a desired profit.

  • Businesses analyze this amount by incorporating their goal amount into the break-even formula.

  • Target income can be calculated using the following formulas:

    • Target Income in Dollars = (Total Fixed Costs + Target Income) / Contribution Margin Ratio

    • Target Income in Units = (Total Fixed Costs + Target Income) / Contribution Margin per Unit

Slide #5 Margin of Safety and Sensitivity Analysis

• The margin of safety is the degree to which a business’s sales exceed its break-even point.

  • It is the number of sales a business can lose before it stops being profitable.

  • The margin of safety acts as a buffer between profit and loss.

  • The formula for calculating margin of safety is as follows:

    • Margin of Safety in Dollars = Current (or Actual) Sales – Break-Even Sales

    • Margin of Safety in Units = Current (or Actual) Sales Units – Break-Even Point

• Along the same lines, businesses use sensitivity analysis to predict what will happen with changes in fixed costs, variable costs, sales price, units sold, and sales mix.

  • Managers perform sensitivity analysis on different scenarios to determine how changes in variables will impact profitability.

9.11 Conduct Break-Even Analysis—Discussion Guide

Performance Indicator: Conduct break-even analysis

THINK ABOUT IT

Wouldn’t it be convenient if there was a formula to determine the exact number of products a business needed to sell to make a profit?

• Well, luckily there is!

• Break-even analysis enables businesses to determine the number of sales necessary to break even, which happens when total cost and total revenue are equal.

• Any sales past the break-even point are the business’s profit.

KEY CONCEPTS

Slide #1 Importance of Break-Even Analysis

• Businesses conduct break-even analyses to determine the number of units or products they must sell to cover all costs and financially break even.

  • This calculation represents the minimum number of products or sales volume necessary to cover all expenses before the business can make a profit.

  • Any units sold above the break-even point increase the business’s profitability.

  • Break-even analyses help companies set targets for units/revenue and are helpful in the pricing and promotion process.

• Conducting break-even analyses enables businesses to monitor and regulate costs by setting cost control points, determine pricing strategies for sales volume/profitability, and determine margin of safety.

  • They help businesses set budgets and targets by clarifying the effects of changes in variable/fixed costs and motivate sales staff by highlighting the potential for greater commissions.

Slide #2 Limitations of Break-Even Analysis

• Break-even analyses have several limitations.

  • Sales prices are not constant at all levels of output.

    • This means fixed costs vary when output changes and products are sold at different prices at different output levels.

  • In addition, variable costs can change as businesses wield more buying power.

  • Break-even charts can also be time-consuming to prepare.

  • They can only apply to a single product, which makes it more difficult for businesses that sell multiple products.

  • As such, it’s helpful to use break-even analyses as planning support instead of a tool for making decisions.

Slide #3 Correcting High Break-Even Points

• Businesses can lower their break-even points a few different ways.

  • They can increase selling prices to lower the number of products necessary to break even.

  • Businesses can reduce fixed costs through outsourcing.

  • They can also reduce variable costs per unit by streamlining production.

  • Businesses can introduce upselling and cross-selling to increase profitability.

  • Additionally, businesses can improve their sales mix by selling products with larger contribution margins.

• Some of the benefits of lowering break-even points include targeting smaller niches, then tailoring products and providing greater customer value, which builds brand equity and positively affects price and margin.

  • When businesses reach higher margins, they can reduce their break-even points.

Slide #4 Conducting Break-Even Analysis

• The formula for calculating the break-even point is as follows:

  • Break-Even Point = Fixed Costs / (Selling Price per Unit – Variable Cost per Unit)

    • Fixed costs:

      • These costs don’t fluctuate with production or sales of units.

      • They include startup costs, rent, insurance, utilities, and administration costs.

      • Fixed costs occur on a regular basis.

    • Selling price per unit:

      • This is the price at which a business sells its product.

    • Variable costs per unit:

      • These costs are directly associated with number of units produced and are calculated on a per unit basis.

      • Variable costs include material, labor, direct sales, commission, promotion, storage, and shipping.

      • Variable costs increase/decrease with production volume.

• Businesses should construct break-even tables for both sales volumes and unit prices for each product.

• To conduct a break-even analysis, follow these steps:

  • Determine variable unit costs, fixed costs, selling price per unit, sales volume, and unit price

  • Calculate contribution margin:

    • Selling price per unit – Variable costs

  • Calculate contribution margin ratio:

    • Contribution margin per unit / Selling price per unit

  • Determine break-even points:

    • Calculate units to break even:

      • Fixed costs / Contribution margin per unit

    • Calculate sales revenue to break even:

      • Fixed costs / Contribution margin ratio

  • Adjust costs, prices, and volume to change results and increase profitability

  • Create a spreadsheet to plot the break-even point for each level of sales and item price

Slide #5 Impact of Adjusted Sales Revenue and Expenses

• When businesses understand the relationships between sales and volume, they can better plan pricing strategies and marketing campaigns.

  • As fixed costs rise, break-even analysis calculates the increase in sales or amount to raise prices needed to account for increased costs.

  • By calculating break-even prices at various sales volumes, businesses can glean insights about product profitability and sales techniques.

  • Pricing at break-even points is one way businesses can try to drive competitors out of the market.

  • Often, break-even sales prices decline as production volume increases; this occurs when fixed costs are spread over a greater number of products while variable costs remain the same.

  • These variations affect pricing strategies and anticipated demand at different price points.