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Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 4
Relevant Information for Decision Making
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Q1: Nonroutine Operating Decisions
• Routine operating decisions are those made on a
regular schedule. Examples include:
• annual budgets and resource allocation decisions
• monthly production planning
• weekly work scheduling issues
• Nonroutine operating decisions are not made on a
regular schedule. Examples include:
• accept or reject a customer’s special order
• keep or drop business segments
• insource or outsource a business activity
• constrained (scarce) resource allocation issues
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q1: Process for Making Nonroutine
Operating Decisions
1. Identify the type of decision to be made.
2. Identify the relevant quantitative analysis
technique(s).
3. Identify and analyze the qualitative factors.
4. Perform quantitative and/or qualitative analyses
5. Prioritize issues and arrive at a decision.
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 5
Q1: Identify the Type of Decision
•
•
Special order decisions
•
determine the pricing
•
accept or reject a customer’s proposal for order quantity
and pricing
•
identify if there is sufficient available capacity
Keep or drop business segment decisions
•
•
examples of business segments include product lines,
divisions, services, geographic regions, or other distinct
segments of the business
eliminating segments with operating losses will not
always improve profits
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 6
Q1: Identify the Type of Decision
•
•
•
Outsourcing decisions
•
make or buy production components
•
perform business activities “in-house” or pay another
business to perform the activity
Constrained resource allocation decisions
•
determine which products (or business segments)
should receive allocations of scarce resources
•
examples include allocating scarce machine hours or
limited supplies of materials to products
Other decisions may use similar analyses
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 7
Q2-Q5 : Identify and Analyze Qualitative Factors
•
Qualitative information cannot easily be valued in
dollars.
•
•
•
can be difficult to identify
can be every bit as important as the quantitative
information
Examples of qualitative information that may be
relevant in some nonroutine decisions include:
•
quality of inputs available from a supplier
•
effects of decision on regular customers
•
effects of decision on employee morale
•
effects of production on the environment or the
community
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 9
Q1: Consider All Information and Make a Decision
•
Before making a decision:
•
Consider all quantitative and qualitative information.
• Judgment is required when interpreting the effects of
qualitative information.
•
Consider the quality of the information.
• Judgment is also required when user lower-quality
information.
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 10
Q2: Special Order Decisions
•
•
A new customer (or an existing customer) may
sometimes request a special order with a lower
selling price per unit.
The general rule for special order decisions is:
•
•
accept the order if incremental revenues exceed
incremental costs,
subject to qualitative considerations.
Price >=
•
Relevant
Variable Costs +
Relevant
Fixed Costs +
Opportunity
Cost
If the special order replaces a portion of normal
operations, then the opportunity cost of accepting
the order must be included in incremental costs.
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 11
Q2: Special Order Decisions
RobotBits, Inc. makes sensory input devices for robot manufacturers.
The normal selling price is $38.00 per unit. RobotBits was approached
by a large robot manufacturer, U.S. Robots, Inc. USR wants to buy
8,000 units at $24, and USR will pay the shipping costs. The per-unit
costs traceable to the product (based on normal capacity of 94,000
units) are listed below. Which costs are relevant to this decision?
yes$6.20 Relevant?
Direct materials
yes 8.00 Relevant?
Direct labor
Variable mfg. overhead yes 5.80 Relevant?
no 3.50 Relevant?
Fixed mfg. overhead
yes
Shipping/handling
no 2.50 Relevant?
Fixed administrative costs no 0.88 Relevant?
no 0.36 Relevant?
Fixed selling costs
$27.24
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
$20.00
Slide # 12
Q2: Special Order Decisions
Suppose that the capacity of RobotBits is 107,000 units and projected
sales to regular customers this year total 94,000 units. Does the
quantitative analysis suggest that the company should accept the
special order?
First determine if there is sufficient idle capacity to accept this
order without disrupting normal operations:
Projected sales to regular customers
Special order
94,000 units
8,000 units
102,000 units
RobotBits still has 5,000 units of idle capacity if the order is
accepted. Compare incremental revenue to incremental cost:
Incremental profit if accept special order =
($24 selling price – $20 relevant costs) x 8,000 units = $32,000
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 13
Q2: Qualitative Factors in
Special Order Decisions
What qualitative issues, in general, might RobotBits consider before
finalizing its decision?
• Will USR expect the same selling price per unit on future
orders?
• Will other regular customers be upset if they discover the
lower selling price to one of their competitors?
• Will employee productivity change with the increase in
production?
• Given the increase in production, will the incremental costs
remain as predicted for this special order?
• Are materials available from its supplier to meet the increase
in production?
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 14
Q2: Special Order Decisions and Capacity Issues
Suppose instead that the capacity of RobotBits is 100,000 units and
projected sales to regular customers this year totals 94,000 units.
Should the company accept the special order?
Here the company does not have enough idle
capacity to accept the order:
Projected sales to regular customers
Special order
94,000 units
8,000 units
102,000 units
If USR will not agree to a reduction of the order to 6,000
units, then the offer can only be accepted by denying sales
of 2,000 units to regular customers.
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 15
Q2: Special Order Decisions and Capacity Issues
Suppose instead that the capacity of RobotBits is 100,000 units and
projected sales to regular customers this year total 94,000 units. Does
the quantitative analysis suggest that the company should accept the
special order?
Direct materials
Direct labor
Variable mfg. overhead
Fixed mfg. overhead
Shipping/handling
Fixed administrative costs
Fixed selling costs
$6.20
8.00
5.80
3.50
2.50
0.88
0.36
$27.24
Variable cost/unit for
regular sales = $22.50.
CM/unit on regular sales
= $38.00 – $22.50 = $15.50.
The opportunity cost of accepting this
order is the lost contribution margin
on 2,000 units of regular sales.
Incremental profit if accept special order =
$32,000 incremental profit under idle capacity – opportunity cost =
$32,000 – $15.50 x 2,000 = $1,000
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 16
Q3: Keep or Drop Decisions
•
Managers must determine whether to keep or
eliminate business segments that appear to be
unprofitable.
•
The general rule for keep or drop decisions is:
•
•
keep the business segment if its contribution margin
covers its avoidable fixed costs,
subject to qualitative considerations.
Drop if: Contribution < Relevant Margin Fixed Costs • + Opportunity Cost If the business segment’s elimination will affect continuing operations, the opportunity costs of its discontinuation must be included in the analysis. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 18 Q3: Keep or Drop Decisions Starz, Inc. has 3 divisions. The Gibson and Quaid Divisions have recently been operating at a loss. Management is considering the elimination of these divisions. Divisional income statements (in 1000s of dollars) are given below. According to the quantitative analysis, should Starz eliminate Gibson or Quaid or both? Revenues Variable costs Contribution margin Traceable fixed costs Division operating income Unallocated fixed costs Operating income Gibson Quaid Russell $390 $433 $837 247 335 472 143 98 365 166 114 175 ($23) ($16) $190 Breakdown of traceable fixed costs: Avoidable $154 Unavoidable 12 $166 © John Wiley & Sons, 2011 $96 18 $114 Total $1,660 1,054 606 455 151 81 $70 $139 36 $175 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 19 Q3: Keep or Drop Decisions Revenues Variable costs Contribution margin Traceable fixed costs Division operating income Unallocated fixed costs Operating income Gibson Quaid Russell $390 $433 $837 247 335 472 143 98 365 166 114 175 ($23) ($16) $190 Breakdown of traceable fixed costs: Avoidable $154 Unavoidable 12 $166 $96 18 $114 Total $1,660 1,054 606 455 151 81 $70 $139 36 $175 Contribution margin Avoidable fixed costs Effect on profit if keep Use the general rule to determine if Gibson and/or Quaid should be eliminated. Gibson Quaid $143 $98 154 96 ($11) $2 The general rule shows that we should keep Quaid and drop Gibson. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 20 Q3: Keep or Drop Decisions Revenues Variable costs Contribution margin Traceable fixed costs Division operating income Unallocated fixed costs Operating income Gibson Quaid Russell $390 $433 $837 247 335 472 143 98 365 166 114 175 ($23) ($16) $190 Breakdown of traceable fixed costs: Avoidable $154 Unavoidable 12 $166 $96 18 $114 Total $1,660 1,054 606 455 151 81 $70 $139 36 $175 Using the general rule is easier than recasting the income statements: Gibson Quaid Russell Total Revenues $390 $433 $837 $1,270 Variable costs 247 335 472 807 Contribution margin 143 98 365 $463 Traceable fixed costs 166 114 175 289 Division operating income ($23) ($16) $190 $174 Unallocated fixed costs 81 Gibson's unavoidable fixed costs 12 Operating income $81 Quaid & Russell only Profits increase by $11 when Gibson is eliminated. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 21 Q3: Keep or Drop Decisions Suppose that the Gibson & Quaid Divisions use the same supplier for a particular production input. If the Gibson Division is dropped, the decrease in purchases from this supplier means that Quaid will no longer receive volume discounts on this input. This will increase the costs of production for Quaid by $14,000 per year. In this scenario, should Starz still eliminate the Gibson Division? Effect on profit if drop Gibson before considering impact on Quaid's production costs Opportunity cost of eliminating Gibson Revised effect on profit if drop Gibson $11 (14) ($3) Profits decrease by $3 when Gibson is eliminated. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 22 • Q4: Insource or Outsource (Make or Buy) Decisions Managers often must determine whether to • • • make or buy a production input keep a business activity in house or outsource the activity The general rule for make or buy decisions is: • • choose the alternative with the lowest relevant (incremental cost), subject to qualitative considerations If the decision will affect other aspects of operations, these costs (or lost revenues) must be included in the analysis. Outsource if: Cost to Outsource < Cost to Insource Where: © John Wiley & Sons, 2011 Cost to Relevant Relevant Opportunity Insource = FC + VC + Cost Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 24 Q4: Make or Buy Decisions Graham Co. currently of our main product manufactures a part called a gasker used in the manufacture of its main product. Graham makes and uses 60,000 gaskers per year. The production costs are detailed below. An outside supplier has offered to supply Graham 60,000 gaskers per year at $1.55 each. Fixed production costs of $30,000 associated with the gaskers are unavoidable. Should Graham make or buy the gaskers? The production costs per unit for manufacturing a gasker are: yes $0.65 Relevant? Direct materials yes 0.45 Relevant? Direct labor Variable manufacturing overhead yes 0.40 Relevant? no 0.50 Relevant? Fixed manufacturing overhead* $2.00 *$30,000/60,000 units = $0.50/unit $1.50 Advantage of “make” over “buy” = [$1.55 - $1.50] x 60,000 = $3,000 © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 25 Q3: Make or Buy Decisions Suppose the potential supplier of the gasker offers Graham a discount for a different sub-unit required to manufacture Graham’s main product if Graham purchases 60,000 gaskers annually. This discount is expected to save Graham $15,000 per year. Should Graham consider purchasing the gaskers? Advantage of “make” over “buy” before considering discount (slide 23) $3,000 Discount Advantage of “buy” over “make” 15,000 $12,000 Profits increase by $12,000 when the gasker is purchased instead of manufactured. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 27 Q5: Constrained Resource (Product Emphasis) Decisions • Managers often face constraints such as • • production capacity constraints such as machine hours or limits on availability of material inputs limits on the quantities of outputs that customers demand • Managers need to determine which products should first be allocated the scarce resources. • The general rule for constrained resource allocation decisions with only one constraint is: • allocate scarce resources to products with the highest contribution margin per unit of the constrained resource, • subject to qualitative considerations. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 28 Q5: Constrained Resource Decisions (Two Products; One Scarce Resource) Urban’s Umbrellas makes two types of patio umbrellas, regular and deluxe. Suppose there is unlimited customer demand for each product. The selling prices and variable costs of each product are listed below. Selling price per unit Variable cost per unit Contribution margin per unit Regular $40 20 $20 Deluxe $110 44 $ 66 Contribution margin ratio 50% 60% Required machine hours/unit 0.4 2.0 Urban has only 160,000 machine hours available per year. Write Urban’s machine hour constraint as an inequality. 0.4R + 2D  160,000 machine hours © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 29 Q5: Constrained Resource Decisions (Two Products; One Scarce Resource) Suppose that Urban decides to make all Regular umbrellas. What is the total contribution margin? Recall that the CM/unit for R is $20. The machine hour constraint is: 0.4R + 2D  160,000 machine hours If D=0, this constraint becomes 0.4R  160,000 machine hours, or R  400,000 units Total contribution margin = $20*400,000 = $8 million Suppose that Urban decides to make all Deluxe umbrellas. What is the total contribution margin? Recall that the CM/unit for D is $66. If R=0, this constraint becomes 2D  160,000 machine hours, or D  80,000 units Total contribution margin = $66*80,000 = $5.28 million © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 30 Cost Management Measuring, Monitoring, and Motivating Performance Chapter 7 Activity-Based Costing and Management © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2e Slide # 1 Q1: Activity-Based Costing (ABC) • ABC is a method of cost system refinement. • Indirect costs are divided into “sub-pools” of costs of activities. • Activity costs are then allocated to the final cost objects using a cost allocation base (more commonly called cost drivers in ABC). • Activities are measurable, making it more likely that cost drivers can be found so that a final cost object will absorb indirect costs in proportion to its use of the activity. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2e Slide # 3 Q1: Traditional Costing vs. ABC Traditional costing systems: Indirect Costs Indirect costs are grouped into one (or a small number) of cost pools; a cost allocation base assigns costs to the individual products © John Wiley & Sons, 2011 Product A Direct Costs Product B Direct Costs Product C Direct Costs The individual products are the final cost objects. Direct costs are traced to the individual products. Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2e Slide # 4 Q1: Traditional Costing Systems © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2e Slide # 5 Q1: Traditional Costing vs. ABC Activity-based costing systems: Activity 1 Indirect Costs Activity 2 Product A Direct Costs Product B Direct Costs Product C Direct Costs Activity 3 Indirect costs are assigned (traced & allocated) to various pools of activity costs. © John Wiley & Sons, 2011 Activity costs are allocated to products Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2e The individual products are the final cost objects & direct costs are traced to the individual products. Slide # 6 Q1: ABC Costing Systems © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2e Slide # 7 Q2: What are Activities and How are They Identified? The ABC cost hierarchy includes the following activities: • organization-sustaining – associated with overall organization • facility-sustaining – associated with single manufacturing plant or service facility • customer-sustaining – associated with a single customer • product-sustaining – associated with product lien or single product • batch-level – associated with each batch of product • unit-level – associated with each unit produced © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2e Slide # 8 Q2: ABC Cost Hierarchy Example Some of the costs incurred by the Dewey Chargem law firm are listed below. This firm specializes in immigration issues and family law. For each cost, identify whether the cost most likely relates to a(n) (1) organiz-ationsustaining, (2) facility-sustaining, (3) customer-sustaining, (4) productsustaining, (5) batch-level, or (6) unit-level activity and explain your choice. Cost Cost Hierarchy Level Bookkeeping software Salary for partner in charge of family law Office supplies Subscription to family law update journal Telephone charges for local calls Long distance telephone charges Window washing service Salary of receptionist © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2e Slide # 9 Q3: What Process is Used to Assign Costs in an ABC system? 1. Identify the relevant cost object. 2. Identify activities and group homogeneous activities. 3. Assign costs to the activity cost pools. 4. Choose a cost driver for each activity cost pool. 5. Calculate an allocation rate for each activity cost pool. 6. Allocate activity costs to the final cost object. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2e Slide # 10 Q3: How Are Cost Drivers Selected for Activities? • For each activity, determine its place in the ABC cost hierarchy. • Look for drivers that have a good cause-and-effect relationship with the activities’ costs. • Use a reasonable driver when there is no cause-and-effect relationship. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2e Slide # 11 Q3: ABC in Manufacturing Example Alphabet Co. makes products A & B. Product A is a low-volume specialty item and B is a high-volume item. Estimated factory- wide overhead is $800,000, and the number of DL hours for the year is estimated to be 50,000 hours. DL costs are $10/hour. Each product uses 2 DL hours. Compute the traditional cost of each product if Products A & B use $25 and $10 in direct materials, respectively. First, compute the estimated overhead rate: Estimated overhead rate = $800,000/50,000 hours = $16/hour. Direct materials Direct labor (2hrs @ $10) Overhead (2 hrs @ $16) © John Wiley & Sons, 2011 Product A $25 20 32 $77 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2e Product B $10 20 32 $62 Slide # 12 Q3: ABC in Manufacturing Example Alphabet Co. is implementing an ABC system. It estimated the costs and activity levels for the upcoming year shown below. Estimated Estimated Activity Levels Costs Prod. A Prod. B Total Machine set-ups $200,000 3,000 2,000 5,000 Inspections 140,000 500 300 800 Materials handling 80,000 400 400 800 Machining dep't 320,000 12,000 28,000 40,000 Quality control dep't 60,000 600 150 750 $800,000 Cost Driver # set-ups # inspections # mat'l requistions # machine hours # tests First, compute the estimated overhead rate for each activity: © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2e Slide # 13 Q3: ABC in Manufacturing Example Estimated Costs Estimated Activity Overhead Rate $40 Machine set-ups $200,000 5,000 set-ups $40/setup /setup $175 Inspections 140,000 800 inspections $175/inspection /inspection Materials handling 80,000 800 mat'l requistions $100 $100/requisition /requisition $8 Machining dep't 320,000 40,000 machine hours $8/mach /machhrhr $80 Quality control dep't 60,000 750 tests $80/test /test $800,000 © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2e Slide # 14 Q3: ABC in Manufacturing Example Alphabet recently completed a batch of 100 As and a batch of 100 Bs. Direct material and labor costs were as budgeted. Information about each batch’s use of the cost drivers is given below. Compute the overhead allocated to each unit of A and B. 100 As 100 Bs Machine set-ups 60 10 Inspections 10 2 Overhead allocated: 100 As 100 Bs Materials handling 4 2 Machine set-ups $2,400 $400 Machining dep't 240 120 Inspections 1,750 350 Quality control dep't 3 1 Materials handling 400 200 Machining dep't 1,920 960 Quality control dep't 240 80 Overhead for batch $6,710 $1,990 Overhead per unit © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2e $67.10 $19.90 Slide # 15 Q3: ABC in Manufacturing Example Compute the total cost of each product and compare it to the costs computed under traditional costing. Prod A Prod B Direct material $25.00 $10.00 Direct labor 20.00 20.00 Overhead 67.10 19.90 $112.10 $49.90 Total Traditional costing assigned $77 to a unit of Product A and $62 to a unit of Product B. • The only difference between the two costing systems is that Product A is assigned more overhead costs under ABC. • The additional overhead assigned to Product A reflects Product A’s consumption of resources. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2e Slide # 16 Cost Management Measuring, Monitoring, and Motivating Performance Chapter 8 Measuring and Assigning Support Department Costs © John Wiley & Sons, 2011 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 1 Q1: Support versus Operating Departments • The operating departments of an organization produce products or services that generate revenue. • The support departments of an organization produce products or provide services to the operating and other support departments. • The support department costs are common costs that are shared between two or more other departments. © John Wiley & Sons, 2011 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 3 Q1: Reasons for Allocating Support Department Costs • External reporting • Motivation • appropriate consumption of support department resources • efficiency of support department • monitor consumption of support department services • Decision making • product pricing • make or buy decisions © John Wiley & Sons, 2011 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 4 Q2: Process for Allocating Support Department Costs 1. Clarify allocation purpose 2. Identify cost pools 3. Assign costs to cost pools 4. Choose allocation bases for each cost pool 5. Choose allocation method; allocate support department costs 6. Allocate updated operating department costs to units of goods or services, if relevant © John Wiley & Sons, 2011 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 6 Q3: The Direct Method of Allocating Support Department Costs • The direct method ignores the fact that support departments use each others’ services. • Each support department’s costs are allocated only to operating departments. • This method is the easiest computationally and the easiest to explain. © John Wiley & Sons, 2011 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 13 Q3: The Direct Method Example Philco Toys makes metal and plastic toys in separate departments. It has two support departments, Accounting and Information Systems. Philco has decided to allocate Accounting department costs based on the number of employees in each department and Information Systems costs based on the number of computers in each department. Given the information below, use the direct method to allocate support department costs. Support Dep'ts Total department costs Number of employees Number of computers Operating Departments AccInfo Plastic Metal ounting Systems Products Products Total $48,000 $72,000 $386,000 $182,000 $688,000 3 4 22 16 45 4 6 3 3 16 Allocate costs: Accounting (48,000) Information Systems Totals © John Wiley & Sons, 2011 $0 27,789 20,211 $0 (72,000) 36,000 36,000 $0 $0 $449,789 $238,211 $688,000 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 14 Q3: The Direct Method Example Plastic Products is allocated Plastic and Metal Product share 22/(22+16) of Accounting Info Systems costs equally department costs, and Metal because they have the same Products is allocated number of computers in each 16/(22+16). Notice that the department. Notice that the number of employees in the number of computers in the support departments is ignored departments is ignored Support Dep'ts support Operating Departments under the direct method. under the direct method. Total department costs Number of employees Number of computers AccInfo Plastic Metal ounting Systems Products Products Total $48,000 $72,000 $386,000 $182,000 $688,000 3 4 22 16 45 4 6 3 3 16 Allocate costs: Accounting (48,000) Information Systems Totals © John Wiley & Sons, 2011 $0 27,789 20,211 $0 (72,000) 36,000 36,000 $0 $0 $449,789 $238,211 $688,000 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 15 Q4: The Step-Down Method of Allocating Support Department Costs • The step-down method allocates some (but not all) support department costs to other support departments. • The first support department’s costs are allocated to all operating and support departments that use its services. • Each subsequent support department’s costs are allocated to all operating and support departments that use its services, except any support department whose costs were already allocated. • Allocation order must be determined. © John Wiley & Sons, 2011 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 16 Q4: The Step-Down Method Example Given the information for Philco, use the step-down method to allocate support department costs. Allocate the costs of the support department that provides the largest percentage of its services to the other support department first. First determine allocation order: Accounting provided 4/(4+22+16) = 4/42 = 9.5% of its services to Info Systems. Information Systems provided 4/(4+3+3) = 4/10 = 40% of its services to Accounting, so Information Systems goes first. Support Dep'ts Total department costs Number of employees Number of computers © John Wiley & Sons, 2011 Operating Departments AccInfo Plastic Metal ounting Systems Products Products Total $48,000 $72,000 $386,000 $182,000 $688,000 3 4 22 16 45 4 6 3 3 16 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 17 Q4: The Step-Down Method Example Given the information for Philco, use the step-down method to allocate support department costs. Now perform the allocation: Support Dep'ts Total department costs Number of employees Number of computers Operating Departments Metal Plastic Info AccTotal Products ounting Systems Products $48,000 $72,000 $386,000 $182,000 $688,000 45 16 22 4 3 16 3 3 6 4 Allocate costs: Accounting (76,800) (48,000) Information Systems 28,800 $0 Totals © John Wiley & Sons, 2011 44,463 27,789 32,337 20,211 $0 $0 (72,000) 21,600 21,600 21,600 $0 $0 $0 $435,389 $452,063 $223,811 $235,937 $659,200 $688,000 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 18 Q4: The Step-Down Method Example Info Systems costs are allocated to Accounting, Plastic, & Metal based on each department’s number of computers compared to total non-Info Systems Support Dep'ts computers: 4+3+3=10. Total department costs Number of employees Number of computers Accounting costs are allocated only to Plastic & Metal based on each department’s number of employees compared to total non-Accounting and non-Info Operatingemployees: Departments Systems 22+16=38 AccInfo Plastic Metal ounting Systems Products Products Total $48,000 $72,000 $386,000 $182,000 $688,000 3 4 22 16 45 4 6 3 3 16 Allocate costs: Accounting (76,800) Information Systems 28,800 $0 Totals 44,463 32,337 $0 (72,000) 21,600 21,600 $0 $0 $452,063 $235,937 $688,000 Total costs allocated out of Accounting are now higher because of the Info Systems costs allocated to Accounting. © John Wiley & Sons, 2011 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 19 Q4: The Step-Down Method Example (22/38) x $76,800 (4/10) x $72,000 (16/38) x $76,800 (3/10) x $72,000 Support Dep'ts Total department costs Number of employees Number of computers (3/10) x $72,000 Operating Departments AccInfo Plastic Metal ounting Systems Products Products Total $48,000 $72,000 $386,000 $182,000 $688,000 3 4 22 16 45 4 6 3 3 16 Allocate costs: Accounting (76,800) Information Systems 28,800 $0 Totals © John Wiley & Sons, 2011 44,463 32,337 $0 (72,000) 21,600 21,600 $0 $0 $452,063 $235,937 $688,000 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 20 Q5: The Reciprocal Method of Allocating Support Department Costs • The reciprocal method allocates all support department costs to other support departments. • The first step is to compute the total costs of each support department when its usage of other support department services is taken into consideration. • Support department costs are then allocated to all other operating and support departments that consume its services. © John Wiley & Sons, 2011 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 21 Q5: The Reciprocal Method Example Given the information for Philco, use the reciprocal method to allocate support department costs. First determine total costs for each support department by writing an equation for its costs (use A and IS as abbreviations). A = $48,000 + [4/(4+3+3)] x IS; IS = $72,000 + [4/(4+22+16)] x A Then solve: A = $48,000 + (4/10) x [$72,000 + (4/42) x A] A = $48,000 + $28,800 + (16/420) x A] (404/420) x A = $76,800 A = $76,800 x (420/404) = $79,842 IS = $72,000 + (4/42) x $79,842 = $79,604 Support Dep'ts Total department costs Number of employees Number of computers © John Wiley & Sons, 2011 Operating Departments AccInfo Plastic Metal ounting Systems Products Products Total $48,000 $72,000 $386,000 $182,000 $688,000 3 4 22 16 45 4 6 3 3 16 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 22 Q5: The Reciprocal Method Example Given the information for Philco, use the reciprocal method to allocate support department costs. Now perform the allocation: Support Dep'ts Total department costs Number of employees Number of computers Operating Departments AccInfo Plastic Metal ounting Systems Products Products Total $48,000 $72,000 $386,000 $182,000 $688,000 3 4 22 16 45 4 6 3 3 16 Allocate costs: Accounting Information Systems Totals © John Wiley & Sons, 2011 (79,842) 7,604 41,822 (79,842) 7,604 41,822 31,842 (79,604) (79,604) 23,881 31,842 23,881 $0 $0 $451,703 $451,703 $0 $0 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e 30,416 30,416 23,881 23,881 $0 $0 $236,297 $236,297 $688,000 Slide # 23 Q5: The Reciprocal Method Example These numbers are the solutions to the simultaneous equations. (4/42) x $79,842 (22/42) x $79,842 (16/42) x $79,842 Support Dep'ts Total department costs Number of employees Number of computers Operating Departments AccInfo Plastic Metal ounting Systems Products Products Total $48,000 $72,000 $386,000 $182,000 $688,000 3 4 22 16 45 4 6 3 3 16 Allocate costs: Accounting Information Systems Totals © John Wiley & Sons, 2011 (79,842) 7,604 41,822 (79,842) 7,604 41,822 31,842 (79,604) (79,604) 23,881 31,842 23,881 $0 $0 $451,703 $451,703 $0 $0 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e 30,416 30,416 23,881 23,881 $0 $0 $236,297 $236,297 $688,000 Slide # 24 Q5: The Reciprocal Method Example (4/10) x $79,604 (3/10) x $79,604 (3/10) x $79,604 Support Dep'ts Total department costs Number of employees Number of computers Operating Departments AccInfo Plastic Metal ounting Systems Products Products Total $48,000 $72,000 $386,000 $182,000 $688,000 3 4 22 16 45 4 6 3 3 16 Allocate costs: Accounting Information Systems Totals © John Wiley & Sons, 2011 (79,842) 7,604 41,822 (79,842) 7,604 41,822 31,842 (79,604) (79,604) 23,881 31,842 23,881 $0 $0 $451,703 $451,703 $0 $0 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e 30,416 30,416 23,881 23,881 $0 $0 $236,297 $236,297 $688,000 Slide # 25 Q6: Single- versus Dual-Rate Allocation • In single-rate allocation, each cost pool includes fixed and variable costs. • In dual-rate allocation, fixed and variable costs are in separate cost pools. • Both methods can be employed with the direct, step-down, or reciprocal methods. • The prior three examples used the singlerate allocation method. © John Wiley & Sons, 2011 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 26 Q6: Single- versus Dual-Rate Example Philco has decided to use the direct method and allocate variable Accounting costs based on the number of transactions and fixed Accounting costs based on the number of employees. The Info Systems variable costs will be allocated based on the number of service requests and fixed costs will be allocated based on the number of computers. The required information is presented below. Support Dep'ts Total department variable costs Total department fixed costs Number of transactions Number of employees Number of service requests Number of computers Operating Departments AccInfo Plastic Metal ounting Systems Products Products $20,000 $22,000 $186,000 $100,000 $28,000 $50,000 $200,000 $82,000 20 32 140 86 3 4 22 16 18 5 12 8 4 6 3 3 Now perform the allocation… © John Wiley & Sons, 2011 Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 27 Q6: Single- versus Dual-Rate Example Total department variable costs Total department fixed costs Number of transactions Number of employees Number of service requests Number of computers Support Dep'ts Operating Departments AccInfo Plastic Metal ounting Systems Products Products $20,000 $22,000 $186,000 $100,000 $28,000 $50,000 $200,000 $82,000 20 32 140 86 3 4 22 16 18 5 12 8 4 6 3 3 Allocate variable costs: Accounting (20,000) 12,389 7,611 (22,000) 13,200 8,800 $0 $211,589 $116,411 $0 (50,000) $0 16,211 25,000 $241,211 11,789 25,000 $118,789 $0 $0 $452,800 $235,200 Information Systems Total variable costs Allocate fixed costs: Accounting Information Systems Total fixed costs Total fixed and variable costs © John Wiley & Sons, 2011 $0 (28,000) Chapter 8: Measuring and Assigning Support Department Costs Eldenburg & Wolcott’s Cost Management, 2e Slide # 28 Cost Management Measuring, Monitoring, and Motivating Performance Chapter 9 JOINT PRODUCT AND BY-PRODUCT COSTING © John Wiley & Sons, 2011 Chapter 9: Joint Product and By-Product Costing Eldenburg & Wolcott’s Cost Management, 2e Slide # 1 Q1: Joint Processes and Costs • A process that yields one or more products is called a joint process. • The products are called joint products. • The costs of the process are called joint costs. • The split-off point is the stage in the joint process where the separate products become identifiable. • Joints costs are incurred prior to the split-off point. • Costs incurred past split-off are separable costs. • Joint products that have minimal sales value compared to the main product are called byproducts. © John Wiley & Sons, 2011 Chapter 9: Joint Product and By-Product Costing Eldenburg & Wolcott’s Cost Management, 2e Slide # 3 Q1: Joint Processes and Costs Sawdust Bark Joint costs include DM, DL & Overhead. © John Wiley & Sons, 2011 Planks If sawdust sells for a relatively minimal amount, it is a byproduct. The costs of processing planks further are separable costs. Wall paneling Joint products Chapter 9: Joint Product and By-Product Costing Eldenburg & Wolcott’s Cost Management, 2e Slide # 4 Q2: Methods of Allocating Joint Costs • Physical output methods • Can be used only when joint products are measured the same way (e.g. pounds or feet). • Market-based methods • Sales value at split-off method • Often used when all products sold at split-off. • Net realizable value (NRV) method • NRV = Final selling price – Separable costs. • Constant gross margin (GM) NRV method • The two NRV methods can be used when some products are processed past split-off. © John Wiley & Sons, 2011 Chapter 9: Joint Product and By-Product Costing Eldenburg & Wolcott’s Cost Management, 2e Slide # 5 Q2: Physical Volume Method Example Pleasing Peaches grows peaches and processes three different peach products that are sold to a canning company. The pounds produced for each product, and the selling price per pound, is given below. The joint costs of processing the 280,000 pounds of products were $70,000. Allocate the joint costs to each product using the physical volume method. Pounds Product Produced Peach halves 160,000 Peach slices 80,000 Peach purée 40,000 280,000 © John Wiley & Sons, 2011 Selling Total Sales Price per Value at Pound Split-Off $0.50 $80,000 $0.40 $32,000 $0.30 $12,000 $124,000 Chapter 9: Joint Product and By-Product Costing Eldenburg & Wolcott’s Cost Management, 2e Relative Allocated Weight Joint Costs 57.1% $40,000 28.6% $20,000 14.3% $10,000 100.0% $70,000 Slide # 6 Q2: Sales Value at Split-Off Method Example Allocate the joint costs of $70,000 to each of Pleasing Peaches products using the sales value at split-off method. Product Peach halves Peach slices Peach purée © John Wiley & Sons, 2011 Pounds Produced 160,000 80,000 40,000 280,000 Selling Total Sales Price per Value at Pound Split-Off $0.50 $0.40 $0.30 $80,000 $32,000 $12,000 $124,000 Chapter 9: Joint Product and By-Product Costing Eldenburg & Wolcott’s Cost Management, 2e Relative Sales Allocated Value Joint Costs 64.5% 25.8% 9.7% 100.0% $45,161 $18,065 $6,774 $70,000 Slide # 7 Q2, 6: Compare the Physical Volume and Sales Value at Split-Off Methods Compute the gross margin for each product for each of the two allocation methods. Discuss the differences between the two methods. Allocated Joint Costs Total Sales Sales Physical Value at Value at Volume Split-Off Product Split-Off Method Method Peach halves $80,000 $40,000 $45,161 Peach slices $32,000 $20,000 $18,065 Peach purée $12,000 $10,000 $6,774 $124,000 $70,000 $70,000 © John Wiley & Sons, 2011 Gross Margin Sales Physical Value at Volume Split-Off Method Method $40,000 $34,839 $12,000 $13,935 $2,000 $5,226 $54,000 $54,000 Chapter 9: Joint Product and By-Product Costing Eldenburg & Wolcott’s Cost Management, 2e Slide # 8 Q2, 6: Compare the Physical Volume and Sales Value at Split-Off Methods Compute the gross margin ratio (GM/Sales) for each product under both of the methods and discuss. Product Peach halves Peach slices Peach purée © John Wiley & Sons, 2011 Total Sales Value at Split-Off $80,000 $32,000 $12,000 $124,000 Gross Margin Sales Physical Value at Volume Split-Off Method Method $40,000 $34,839 $12,000 $13,935 $2,000 $5,226 $54,000 $54,000 Chapter 9: Joint Product and By-Product Costing Eldenburg & Wolcott’s Cost Management, 2e Gross Margin Ratio Sales Physical Value at Volume Split-Off Method Method 50.0% 43.5% 37.5% 43.5% 16.7% 43.5% 43.5% 43.5% Slide # 9 Q2: Net Realizable Value (NRV) Method Example Pleasing Peaches could process each of its three products beyond split off. It could can the peach halves itself, make the peach slices into frozen peach pie, and make juice out of the peach purée. The retail value of the new products and the separable costs for the additional processing are given below. Compute the joint costs allocated to each of the products using the NRV method. Final Allocated Sales Separable Relative Joint Product Value Costs NRV NRV Costs Canned peaches $180,000 $60,000 $120,000 64.2% $44,920 Peach pie $120,000 $70,000 $50,000 26.7% $18,717 Peach juice $50,000 $33,000 $17,000 9.1% $6,364 $350,000 $163,000 $187,000 100.0% $70,000 © John Wiley & Sons, 2011 Chapter 9: Joint Product and By-Product Costing Eldenburg & Wolcott’s Cost Management, 2e Slide # 10 Cost Management Measuring, Monitoring, and Motivating Performance Chapter 10 Static and Flexible Budgets © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 1 Q1: Budgets & Strategic Management Process • A budget is • A formalized financial plan. • A translation of an organization’s strategies. • A method of communicating. • A way to define areas of responsibility and decision rights. • The budget cycle is the series of sequential steps followed to create and use budgets. © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 3 Q1: Budgets & Strategic Management Process • Budgeting process begins with the organizational vision, core competencies, and risk appetite • Organizational strategies designed to achieve the vision will drive the capital expenditures and long term financing plans • Operating plans are then created in line with the organizational strategies • Actual results must be monitored, measured, and analyzed compared to budgeted plans © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 4 Q1: Budgets & Levers of Control Belief Systems • Communicates organizational strategies and goals • Motivates managers to plan in advance and coordinate activities © John Wiley & Sons, 2011 Boundary Systems Interactive Control Systems Diagnostic Control Systems • Authorizes employees to engage in planned activities and spend within budget limits • Ensures sufficient cash flow for financial viability • Utilize variances to identify opportunities and threats to the business • Revaluate strategies and operating plans as conditions changes • Assign responsibility and reward employees for achieving budget targets • Motivate managers to provide good estimates and use resources appropriately Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 5 Q2: Master Budgets • A master budget is • A comprehensive plan for the upcoming accounting period. • Usually prepared for a one-year period. • Is based on a series of budget assumptions. • The master budget consists of several subsidiary budgets, in two categories: • Operating budgets. • Financial budgets. © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 6 Q2: Operating Budgets © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 7 Q2: Operating Budget Example Stanley J, Inc., makes a tool used by auto mechanics that sells for $68/unit. It expects to sell 6,000 units in April and 7,000 units in May. Stanley J prefers to end each period with a finished goods inventory equal to 10% of the next period’s sales in units and a direct materials inventory equal to 20% of the direct materials required for the next period’s production. The company never has any beginning or ending work-in-process inventories. There were 400 units in finished goods inventory on April 1. Prepare the revenue and production budgets for April. Production budget Revenue budget Budgeted sales in units in April 6,000 Budgeted sales in units in April Budgeted selling price per unit $68.00 Desired ending FG inventory Budgeted revenues $408,000 Total units required Less: beginning FG inventory Required production in units © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e 6,000 700 6,700 (400) 6,300 Slide # 10 Q2: Operating Budget Example Stanley J’s product uses 0.3 pounds of direct material per unit, at a cost of $4/lb. There were 220 lbs. of direct material on hand on April 1. Assume that budgeted production for May is 6,500 units. Prepare the direct materials purchases and usage budget for April. Direct materials budget Required production in units DM required per unit, in pounds Total DM required, in pounds Less: Beginning DM inventory Plus: Desired ending DM inventory Required DM purchases in pounds Budgeted DM cost per pound Budgeted cost of DM 6,300 0.3 1,890 (220) 390 2,060 $4.00 $8,240 Usage Budget = 1,890 pounds * $4 per pound = $7,560 © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 11 Q2: Operating Budget Example Stanley J’s product uses 0.2 hours of direct labor at a cost of $12/hr. Prepare the direct labor budget for April. Direct labor budget Required production in units DL required per unit, in hours Total DL hours required Budgeted cost per DL hour Budgeted cost of DL © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e 6,300 0.2 1,260 $12.00 $15,120 Slide # 12 Q2: Operating Budget Example Stanley J’s budgeted fixed manufacturing overhead for April is $167,000, and variable manufacturing overhead is budgeted at $6 per direct labor hour. Prepare the manufacturing overhead budget for April. Manufacturing overhead budget Total DL hours required Budgeted variable overhead per DL hour Total budgeted variable overhead Budgeted fixed overhead Total budgeted overhead © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e 1,260 $6.00 $7,560 $167,000 $174,560 Slide # 13 Q2: Operating Budget Example Assume that Stanley J’s April 1 direct materials inventory had a cost of $1,560. Prepare the April ending inventories budget for direct materials. Ending inventories budgets Budgeted cost of DM purchases $8,240 Beginning DM inventory $854 DM available for use $9,094 Budgeted cost of desired ending DM inventory: [6,500 units x 0.3 lbs/unit] x 20% x $4/lb $1,560 Budgeted cost of DM to be used $7,534 © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 14 Q2: Operating Budget Example Prepare the April ending inventories budget for finished goods. Budgeted cost of DM to be used Budgeted cost of DL Total budgeted overhead Total budgeted manufacturing costs Required production in units Budgeted manufacturing cost per unit Budgeted ending FG inventory in units Budgeted cost of ending FG inventory © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e $7,534 $15,120 $174,560 $197,214 6,300 $31.3037 700 $21,913 Slide # 15 Q2: Operating Budget Example Assume that Stanley J’s April 1 finished goods inventory had a cost of $12,146. Prepare the cost of goods sold budget for April. Cost of goods sold budget Beginning FG inventory Total budgeted manufacturing costs Cost of goods available for sale Less: budgeted ending FG inventory Budgeted cost of goods sold © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e $12,146 $197,214 $209,359 $21,913 $187,447 Slide # 16 Q2: Operating Budget Example Stanley J’s budget for April includes $22,000 for administrative costs, $34,000 for fixed distribution costs, $18,000 for research and development, and $13,000 for fixed marketing costs. Additionally, the budgeted variable costs for distribution are $0.75/unit sold and the budgeted variable costs for marketing are 4% of sales revenue. Prepare the support department budget for April. Support department budget Administration $22,000 Distribution: Fixed costs $34,000 Variable costs $4,500 $38,500 Research & development $18,000 Marketing: Fixed costs $13,000 Variable costs $16,320 $29,320 Total budgeted support department costs $107,820 © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 17 Q2: Operating Budget Example Suppose that Stanley J’s income tax rate is 28%. Prepare the budgeted income statement for April. Budgeted income statement Sales revenue Cost of goods sold Gross margin Operating costs: Administration Distribution Research & development Marketing Net income before taxes Income taxes Net income © John Wiley & Sons, 2011 $408,000 $187,447 $220,553 $22,000 $38,500 $18,000 $29,320 $107,820 $112,733 $31,565 $81,168 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 18 Q4: Budget Variances • Managers compare actual results to budgeted results in order to • Monitor operations, and • Motivate appropriate performance. • Differences between budgeted and actual results are called budget variances. • Variances are stated in absolute value terms, and labeled as Favorable or Unfavorable. © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 19 Q4: Budget Variances • Reasons for budget variances are investigated. • The investigation may find: • Inefficiencies in actual operations that can be corrected. • Efficiencies in actual operations that can be replicated in other areas of the organization. • Uncontrollable outside factors that require changes to the budgeting process. © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 20 Q3: Static Budgets • A budget prepared for a single level of sales volume is called a static budget. • Static budgets are prepared at the beginning of the year. • Differences between actual results and the static budget are called static budget variances. © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 21 Q3, Q4: Flexible Budget Example Tina’s Trinkets is preparing a budget for 2006. The budgeted selling price per unit is $10, and total fixed costs for 2006 are estimated to be $5,000. Variable costs are budgeted at $3/unit. Prepare a flexible budget for the volume levels 1,000, 1,100, and 1,200 units. Sales in units Revenues Variable costs Contribution margin Fixed costs Operating income © John Wiley & Sons, 2011 Volume Levels 1,000 1,100 1,200 $10,000 $11,000 $12,000 $3,000 $3,300 $3,600 $7,000 $7,700 $8,400 $5,000 $5,000 $5,000 $2,000 $2,700 $3,400 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 23 Q3, Q4: Static Budget Variances Example Suppose that Tina’s 2006 static budget was for 1,100 units of sales. The actual results are given below. Compute the static budget variances for each row and discuss. Static Budget Sales in units 1,100 Revenues $11,000 $3,300 Variable costs Contribution margin $7,700 Fixed costs $5,000 $2,700 Operating income © John Wiley & Sons, 2011 Static Actual Budget Results Variance 980 $9,604 $1,396 Unfavorable $311 Favorable $2,989 $6,615 $1,085 Unfavorable $4,520 $480 Favorable $605 Unfavorable $2,095 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 24 Q3, Q4: Flexible Budget Variances Example Compute the flexible budget variances for Tina and discuss the results. Compare the flexible budget variances to the static budget variances on the prior page. Year-end Flexible Flexible Actual Budget Budget Results Variance Sales in units 980 980 Revenues $9,800 $9,604 $196 Unfavorable Variable costs $2,940 $2,989 $49 Unfavorable Contribution margin $6,860 $6,615 $245 Unfavorable Fixed costs $5,000 $4,520 $480 Favorable Operating income $1,860 $2,095 $235 Unfavorable © John Wiley & Sons, 2011 Chapter 10: Static and Flexible Budgets Eldenburg & Wolcott’s Cost Management, 2e Slide # 25 Cost Management Measuring, Monitoring, and Motivating Performance Chapter 11 Standard Costs and Variance Analysis © John Wiley & Sons, 2011 Chapter 11: Standard Costs and Variance Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 1 Q2: Standard Costs • Organizations set standards to help plan operations. • A standard cost is the expected cost of providing a good or service. • In manufacturing, the standard cost of a unit of output is comprised of: • the standard price (SP) of the input, and • the standard quantity of the input expected to be consumed in the production of one output unit. © John Wiley & Sons, 2011 Chapter 11: Standard Costs and Variance Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 3 Q2: Standard Costs © John Wiley & Sons, 2011 Chapter 11: Standard Costs and Variance Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 4 Q2: Standard Costing Systems Advantages Disadvantages • Information can be used to quickly estimate job or project costs • Monitor resources to measure efficiency • Communicates targets (goals) to employeess • Provides information to analyze operations • May reduce employee motivation if the standards are too high or low • Time involved in setting standards and analyzing variances • Incorrect standards could result in inappropriate employee rewards or penalties © John Wiley & Sons, 2011 Chapter 11: Standard Costs and Variance Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 6 Q1: Variance Analysis • The difference between an actual cost and the standard cost of producing goods or services at the actual volume level is called a standard cost variance. • Managers investigate the reasons for standard cost variances so that: • efficiencies can be rewarded and replicated, • inefficiencies can be minimized, and • the validity of the standards can be assessed. © John Wiley & Sons, 2011 Chapter 11: Standard Costs and Variance Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 7 Q3: Direct Cost Variances • A price variance is the difference between the standard cost of resources purchased (or that should have been consumed) and the actual cost. • An efficiency variance measures whether inputs were used efficiently. • It is the difference between the inputs used and the inputs that should have been used, times the standard price of the input © John Wiley & Sons, 2011 Chapter 11: Standard Costs and Variance Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 9 Q3: Direct Cost Variances © John Wiley & Sons, 2011 Chapter 11: Standard Costs and Variance Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 10 Q3: Direct Labor Cost Variances • The direct labor price and efficiency variances are a decomposition of the direct labor flexible budget variance. • The year-end flexible budget direct labor cost is based on the standard direct labor hours for the actual output, or standard quantity allowed (SQA). • Other abbreviations used: • SP = standard price of the input • AP = actual price of the input • AQ = actual quantity of the input used © John Wiley & Sons, 2011 Chapter 11: Standard Costs and Variance Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 11 Q3: Direct Labor Cost Variances Example Matthews Manufacturing makes a product that is expected to use ¼ hour of direct labor to produce. At the beginning of the year Matthews expected to produce 10,000 units. Actual production, however, was 9,800 units. The standard price of direct labor is $10/hour. Actual direct labor costs were $24,696 for the 2,520 labor hours used. Compute the direct labor cost variances. First compute SQA for direct labor: SQA = 9,800 units x ¼ hour/unit = 2,450 hours Then compute AP for direct labor: AP = $24,696/2,520 hours = $9.80/hour DLPV = [SP – AP] x AQ = [$10/hour - $9.80/hour] x 2,520 hours = $504F DLEV = [SQA – AQ] x SP = [2,450 hours - 2,520 hours] x $10/hour = $700U Note that the DL FBV = $504F + $700U = $196U © John Wiley & Sons, 2011 Chapter 11: Standard Costs and Variance Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 13 Q3: Direct Material Cost Variances Example Matthews Manufacturing makes a product that is expected to use 2 pounds of direct material to produce. At the beginning of the year Matthews expected to produce 10,000 units. Actual production, however, was 9,800 units. The standard price of direct materials is $3/pound. Matthews purchased 20,500 pounds of direct material at $3.10/pound, and used 19,400 pounds. Compute the direct material cost variances. First compute SQA for direct materials: SQA = 9,800 units x 2 pounds/unit = 19,600 pounds DMPV = [SP – AP] x Actual Quantity Purchased = [$3/pound - $3.10/pound] x 20,500 pounds = $2,050U DMEV = [SQA – AQ] x SP = [19,600 pounds - 19,400 pounds] x $3/pound = $600F © John Wiley & Sons, 2011 Chapter 11: Standard Costs and Variance Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 17 Cost Management Measuring, Monitoring, and Motivating Performance Chapter 15 Performance Evaluation and Compensation © John Wiley & Sons, 2011 Chapter 15: Performance Evaluation and Compensation Eldenburg & Wolcott’s Cost Management, 2e Slide # 1 Q1: Agency Theory • In agency theory, a principal contracts with an agent to act on his or her behalf. • The principal can observe the outcome of the agent’s actions, but cannot observe the agent’s behavior or effort level. • The costs or lost benefits the principal suffers when the agent does not act in the best interests of the principal are called agency costs. © John Wiley & Sons, 2011 Chapter 15: Performance Evaluation and Compensation Eldenburg & Wolcott’s Cost Management, 2e Slide # 3 Q1: Agency Costs • Agency Costs include: • Losses from poor decisions • Losses from incongruent goals • Monitoring costs • Goal alignment costs • Contracting costs • The principal must design plan to minimize agency costs. • Utilize well designed compensation schemes • Assign responsibility for decision making • Establish appropriate transfer prices © John Wiley & Sons, 2011 Chapter 15: Performance Evaluation and Compensation Eldenburg & Wolcott’s Cost Management, 2e Slide # 4 Q2: Decision Making Responsibility • In a centralized organization, decision making authority and responsibility resides with top management. • In a decentralized organization, decision making authority and responsibility is given to lower levels of management. • Usually, top management has general knowledge about the operations of business segments and the business segment managers have specific knowledge. © John Wiley & Sons, 2011 Chapter 15: Performance Evaluation and Compensation Eldenburg & Wolcott’s Cost Management, 2e Slide # 5 Q4: Performance Evaluation of Investment Centers • Return on investment (ROI) shows the percentage return the center made on the investment level chosen. • Residual income (RI) shows the dollar amount the center earned above the minimum required for the center’s investment level. • Economic value added (EVA®) is a specific type of residual income calculation. • ROI can be used to compare the performance of different-sized business segments, but RI and EVA® can not. © John Wiley & Sons, 2011 Chapter 15: Performance Evaluation and Compensation Eldenburg & Wolcott’s Cost Management, 2e ® Stern Stewart & Co. Slide # 13 Q4: Return on Investment (ROI) • ROI is simply calculated as “earnings” over “investment”. • “Earnings” and “investment” must be defined; often, earnings is defined as operating income and investment is defined as average operating assets, so that Operating income ROI = Average operating assets • Operating assets include cash, A/R, inventory, and the property and equipment used in producing the revenue. © John Wiley & Sons, 2011 Chapter 15: Performance Evaluation and Compensation Eldenburg & Wolcott’s Cost Management, 2e Slide # 14 Q4: ROI Example Altus Industries has two divisions, North and South. Given the information below, compute the ROI for each division. Operating income After-tax operating income Average operating assets Average current liabilities Net sales North South $180,000 $40,000 120,000 24,000 2,000,000 200,000 400,000 36,000 2,600,000 100,000 North ROI = $180,000/$2,000,000 = 9% South ROI = $40,000/$200,000 = 20% © John Wiley & Sons, 2011 Chapter 15: Performance Evaluation and Compensation Eldenburg & Wolcott’s Cost Management, 2e Slide # 16 Q4: ROI and DuPont Analysis Example Altus Industries has two divisions, North and South. Use DuPont analysis to decompose the ROI for each divisions and discuss. Operating income After-tax operating income Average operating assets Average current liabilities Net sales Return on sales (ROS) Investment turnover (ITO) ROI (ROS x ITO) North South $180,000 $40,000 120,000 24,000 2,000,000 200,000 400,000 36,000 2,600,000 100,000 North 6.92% 1.30 9.0% South 40.00% 0.50 20.0% North does a better job of using its asset base to generate sales than does South. However, South does a better job of turning sales dollars into operating income than does North. © John Wiley & Sons, 2011 Chapter 15: Performance Evaluation and Compensation Eldenburg & Wolcott’s Cost Management, 2e Slide # 17 Q4: ROI and New Projects Example Suppose that Altus has a minimum required rate of return for all investments of 10%. Each division is considering a new project. The expected return and initial investment of each project is shown below. If ROI is used to evaluate division performance, will each division accept or reject the new project? Are these decisions in line with the best interests of Altus? Project income Project investment Project ROI North South $7,500 $2,250 $80,000 $15,000 9.38% 15.00% North will decide to accept the project because it will increase division ROI. However, this is not in line with the organization’s best interests because investments with an ROI less than 10% should not be accepted. South will decide to reject the project because it will decrease division ROI. However, this is not in line with the organization’s best interests because investments with an ROI exceeding 10% should be accepted. © John Wiley & Sons, 2011 Chapter 15: Performance Evaluation and Compensation Eldenburg & Wolcott’s Cost Management, 2e Slide # 18 Q4: Residual Income (RI) • RI is operating income less the minimum required operating income given the segment’s investment in assets. RI = Operating income - Required rate of return X Average operating assets • RI removes the incentive for business segment managers to make project investment decisions based on a comparison of segment ROI and project ROI. © John Wiley & Sons, 2011 Chapter 15: Performance Evaluation and Compensation Eldenburg & Wolcott’s Cost Management, 2e Slide # 19