Intermediate Management Accounting Primer

Transcription

1 Intermediate Management Accounting Chartered Professional Accountants of Canada, CPA Canada, CPA are trademarks and/or certification marks of the Chartered Professional Accountants of Canada. 2019, Chartered Professional Accountants of Canada. All Rights Reserved

2 Table of Contents INTRODUCTION... 1 PART 1: ROLE OF THE MANAGEMENT ACCOUNTANT... 1 Cost classifications... 1 Cost flows used in manufacturing systems and the schedule of cost of goods manufactured... 2 Cost estimation... 3 Statistical regression approach... 4 Cost-volume-profit analysis... 4 The CVP model... 4 Taxes and the CVP equation... 6 Multi-product CVP analysis... 7 Practice questions... 7 PART 2: CAPACITY Support department cost allocation Allocation methods Job order costing Components and steps of a job order costing system Normal overhead rates and denominator activity Single plant-wide versus multiple overhead cost pools Accounting entries underlying job order costing Joint and by-product costing Joint cost allocation methods Practice questions PART 3: PROCESS COSTING Illustration of a typical process costing system at a soft drink manufacturing plant 22 Spoilage Transferred-in costs Indirect cost allocation systems... 26

3 ABC systems The ABC cost hierarchy Practice questions PART 4: VARIOUS COSTING METHODS AND BUDGETING Variable (direct), absorption (full) and throughput costing Performance evaluation Budgeting The master budget Pricing Cost information and short- and long-term pricing Practice questions PART 5: STANDARDS AND VARIANCES Standards for cost and usage of materials, labour and overhead Illustration of standard costing Static budget versus flexible budget Flexible budget versus actual results Sales price variances Direct materials variances Direct labour variances Fixed manufacturing overhead variances Practice questions PART 6: RELEVANT COSTS Make-or-buy decision Add-or-drop decision Special order decision Scarce resource allocation decisions Transfer pricing Approaches to setting the transfer price A general transfer pricing model Practice questions... 68

4 PRIMER INTRODUCTION Intermediate Management Accounting expands on the introductory course with an emphasis on costs for management decision-making. This will include exploring costvolume-profit analysis, job costing, process costing and activity-based costing. In addition, Intermediate Management Accounting will touch on variable versus absorption costing, budgeting and pricing. Finally, it looks in detail at variance analysis then touches on uncertainty, linear programming and transfer pricing. PART 1: ROLE OF THE MANAGEMENT ACCOUNTANT One of the key roles of the management accountant is to support the decision-making process of the organization. This includes the following tasks: recording and evaluating costs developing information to support planning and control developing, implementing and operating performance measurement systems Cost classifications Management accounting has its own terminology that is used for more effective and concise communication. Knowledge of these terms is also essential in this course, as they are used throughout. Cost terms used in costing system design o Product (or inventoriable) and period costs: A distinction is made between a cost incurred to produce a product (product cost) and all other operating costs (period costs). o Cost object: A cost object is anything to which a cost can be traced, such as a product, a part of the organization (division or department), a project, a client, an event or even the entire organization. o Direct and indirect costs: A direct cost is any cost that can be uniquely and unambiguously traced to a cost object in an economic and convenient way. All other costs are indirect. Cost terms used to describe and predict cost behaviour o Fixed cost: A cost that does not change in total over the relevant range of activity. 1 / 73

5 o Variable cost: A cost that increases in constant proportion with changes in activity level while the cost per unit stays the same within the relevant range of activity. o Relevant range: The normal range of activity in which a company expects to operate. Management accounting decisions are made based on the cost behaviour within this range of activity. Cost terms used in manufacturing costing systems o Prime and conversion costs: Prime costs generally consist of direct material and direct labour. Conversion costs generally consist of direct labour and manufacturing overhead. Cost terms used in planning and control o Controllable versus non-controllable costs: The idea of controllable and uncontrollable costs relates to responsibility accounting where managers are responsible only for those costs they can control. o Discretionary versus engineered costs: Engineered costs, such as materials, labour and equipment costs are driven by a cause-and-effect relationship (materials are driven by production, selling costs are driven by sales). Discretionary costs such as advertising and research and development are, instead, subject to periodic budget allocations. Cost terms used in decision-making o Opportunity cost: The benefit forgone when a resource is used for one purpose instead of another or one course of action is taken over another. o Sunk cost: A cost that has already been incurred and cannot be changed by any decision made now or in the future. o Relevant cost: A relevant cost (or revenue) is a cost (or revenue) that differs among the alternatives being considered and that will be incurred in the future. Cost flows used in manufacturing systems and the schedule of cost of goods manufactured The following diagram illustrates the flows of costs through the various accounts used in a manufacturing system. Note the key accounts used to record these costs and the financial statements on which each account appears. 2 / 73

6 A summary of the activity in the work-in-process (WIP) account is called the schedule of cost of goods manufactured. The following is a simple version of this schedule: Schedule of costs of goods manufactured Direct materials used $1,375,000 Direct labour 750,000 Manufacturing overhead Supervisory labour 595,000 Consumables (lubricants, drill bits and so on) 175,000 Utilities (heat and power) 1,125,000 Depreciation of factory equipment 860,000 2,755,000 Total manufacturing costs 4,880,000 Add: beginning WIP inventory 575,000 Deduct: ending WIP inventory 424,000 Cost of goods manufactured $5,031,000 Cost estimation As discussed above, management accounting consists of using historical costing data to make predictions about the future. The first step is to estimate the cost. This is the basic cost function: Y = a + bx Where: Y = cost to be estimated a = vertical intercept or fixed cost b = slope or variable cost X = level of activity (for example, number of units produced) 3 / 73

7 There are a number of cost estimation methods including judgment and data approaches. Judgment approaches include engineering estimates, account analysis and the conference method, while data approaches include the high-low method, visual fit and statistical regression analysis. You may have covered many of these in your introductory course, so this primer will only touch on the statistical regression approach. Statistical regression approach The statistical regression approach fits an equation to the observed data using the criterion of minimizing the sum of the squared differences between the values predicted by the regression equation and the original data. The data is entered into a software package such as Microsoft Excel. The software then analyzes the data by applying regression analysis. The summary output provided by this tool consists of the following key regression statistics: The adjusted R-square (R 2 ), which is a best-fit criterion also known as a goodnessof-fit measure (called the coefficient of determination). This measures the amount of variability in the dependent variable (Y) that is explained by changes in the independent variable (X). The estimated coefficients consisting of the intercept or fixed cost and the X variable or variable cost. The t-statistic, which is a formal statistical test of the hypothesis. For this course it can be assumed that, if the absolute value of the t-statistic is 2.00 or greater, a statistically significant relationship exists between the independent variable and the dependent variable. There are several limitations of using historical costing data when making cost estimates. These limitations will be covered in the course. Cost-volume-profit analysis Managers use cost-volume-profit (CVP) analysis to assist in making decisions based on the relationship between costs and revenues and how changes in either affect the bottom line. The CVP model The basic CVP model is: (Px) (Vx) F = OI 4 / 73

8 Where: P = selling price per unit V = variable cost per unit F = total fixed cost x = number of units produced and sold OI = operating income This equation allows the decision maker to answer a number of questions relating to profitability. One of these is the ability to identify the number of units (x) that must be made and sold to cover fixed costs (break-even point) and/or provide a target operating income. Contribution margin is the term used to identify how much revenue remains after deducting all variable costs. It is calculated as follows: Contribution margin (CM) per unit = P V Contribution margin ratio = CM/P Example Selling price: $4 per unit Variable costs: $2.50 per unit Fixed costs: $150, How many units must be sold to break even? Using the CVP formula note that at break-even net income is $0. ($4x) ($2.5x) $150,000 = 0 Solve for x: $1.5x $150,000 = 0 $1.5x = $150,000 x = $150,000 / $1.5 x = 100,000 units must be sold to break even. Break-even can also be calculated as follows: Break-even in units = F/CM = $150,000 / $1.5 = 100,000 units 2. How many units must be sold to earn a pre-tax operating income of $100,000? ($4x) ($2.5x) $150,000 = $100,000 5 / 73

9 Solve for x: $1.5x $150,000 = $100,000 $1.5x = $250,000 x = $250,000 / $1.5x x = 166,667 units must be sold to earn a pre-tax operating income of $100,000. Achieving a target pre-tax operating income can also be calculated as follows: Units for target OI = (F + OI)/CM = ($150,000 + $100,000)/$1.5 = 166,667 Additionally, the break-even point or point to achieve desired income can be solved in dollars. Besides simply multiplying the break-even units by the selling price per unit, the CVP formula can be rewritten as follows: Revenues to break even = F/CM ratio For this example, CM ratio = 1.5/4 = 37.5% $150,000 / 37.5% = $400,000 sales revenue is required to break even. Revenues to achieved desired operating income = (F + OI)/CM ratio For this example, ($150,000 +$100,000)/37.5% = $666,667 sales revenue is required to achieve the target operating income. Note that this is an estimate. If 166,667 units are required, then in dollars this would be 166,667 $4 = $666,668. Also, note that you can t sell part units so the number of units to break even must always be rounded up to the nearest whole number. Taxes and the CVP equation If taxes are to be considered, the CVP equation is expressed as follows: Units for target NI = {F + [NI / (1 tax rate)]} / CM Operating income = NI / (1 tax rate) Where after-tax net income = [(Px Vx) F] (1 tax rate) Example Selling price: $4 per unit Variable costs: $2.50 per unit Fixed costs: $150,000 Tax rate: 30% How many units must be sold to earn an after-tax net income of $100,000? {F + [NI / (1 tax rate)]} / CM {$150,000 + [$100,000 / (1 0.3)]} / $1.50 ($150,000 + $142,857.16)/$1.50 = 195,239 units (rounded up) 6 / 73

10 Multi-product CVP analysis CVP analysis can be used where a company produces and sells more than one product. In those situations, the units are combined in a bundle based on the projected sales mix. The contribution margin of the bundle is the denominator of the break-even equation while the numerator is the total fixed costs. As with calculating unit break-even point, bundle break-even is always rounded up to the nearest complete bundle. Once the break-even in sales mix bundles has been determined, the bundles are broken apart and each product in the mix is multiplied by the number of bundles. Example Product A (200 units) Product B (100 units) Per unit Total Per unit Total Firm total Revenue $100 $20,000 $ 250 $ 25,000 $ 45,000 Variable cost 40 8, ,000 18,000 Contribution $ 60 $12,000 $ 150 $ 15,000 $ 27,000 margin Fixed cost 21,600 Operating income $ 5,400 The sales mix based on the sales volume is: two units of Product A are sold for every unit of Product B. 200:100 = 2:1 The contribution margin using the sales mix is: (2 $60) + (1 $150) = $270 per bundle of product Then use the F/CM equation to arrive at the break-even bundles: $21,600 / $270 = 80 bundles. Each bundle consists of two units of Product A and one unit of Product B. (2 80) = 160 units of Product A (1 80) = 80 units of Product B Practice questions 1. Multiple-choice questions: i. The following selected data from April were taken from Elfin Inc. s financial statements: Cost of goods available for sale $ 79,000 Manufacturing overhead 20,000 Cost of goods manufactured 69,000 Finished goods inventory beginning 10,000 Direct materials used 16,000 Sales 130,000 Direct labour 23,000 7 / 73

11 WIP inventory beginning 15,000 Cost of goods sold 71,000 What was the WIP inventory at the end of April? a) $5,000 b) $10,000 c) $15,000 d) $44,000 Solution Option a) is correct. Cost of goods manufactured is calculated as follows: Direct materials used $16,000 Direct labour 23,000 Manufacturing overhead 20,000 Total manufacturing costs $59,000 Beginning WIP inventory 15,000 Less: ending WIP inventory 5,000* Cost of goods manufactured $69,000 *59, ,000 69,000 = 5,000 Option b) is incorrect. This is the difference between cost of goods manufactured and the sum of direct material used, direct labour and manufacturing overhead costs. Opening WIP inventory was not taken into account. Option c) is incorrect. This is beginning WIP. Option d) is incorrect. This is the sum of direct materials used, direct labour and manufacturing overhead less the beginning WIP inventory. Cost of goods manufactured was not taken into account. ii. In which of the following lists of costs would all costs be classified as direct costs when manufacturing ice cream? a) Supplies to clean the mixing tanks, wages of shift supervisor, cream b) Chocolate flavouring, plant utilities costs, powdered milk c) Plastic pails for the finished product, wages of the worker who runs the assembly line, vanilla flavouring d) Equipment maintenance costs, janitorial costs, marshmallow sauce 8 / 73

12 Solution Option c) is correct. Plastic pails and vanilla flavouring are direct ingredients and the wages of the worker who runs the assembly line is direct labour. Option a) is incorrect. Both the supplies to clean the mixing tanks and the wages of the shift supervisor are manufacturing overhead costs. Option b) is incorrect. The plant utilities costs are a manufacturing overhead cost. Option d) is incorrect. Both equipment maintenance and janitorial costs are manufacturing overhead costs. 2. ALF Inc. is starting to manufacture metal desks. It has been determined that the market demand can be 7,000, 8,000 or 9,000 units. To start up, ALF obtained a $3 million term loan at 6%. Other information is as follows: Selling price per desk $200 Variable cost per desk $50 Total fixed costs $1,000,000 (includes interest on the term loan) Required: a) What is ALF s break-even point in units and in dollars? b) There is a risk that ALF may have to take out an additional loan for $1,500,000 at the same rate as its current loan. If so, what is the minimum level of demand (7,000, 8,000 or 9,000 units) at which ALF must operate? Solution a) CPA Way step: Assess the Situation Break-even in units = $1,000,000 ($200 $50) = 6,667 units Break-even in sales dollars = $1,000,000 [($200 $50) $200] = $1,333,333 Or 6,667 units $200 = $1,333,400 b) CPA Way steps: Analyze Major Issue(s) and Conclude and Advise An additional loan of $1,500,000 at 6% annual interest will require $1,500, = $90,000 in additional profits to pay the interest. ($1,000,000 + $90,000) / ($200 $50) = 7,267 units Thus ALF must operate at a minimum level of 8,000 units to pay the loan interest. 9 / 73

13 3. Shirley owns a small factory that manufactures hot tubs. Shirley sells two distinctive hot tubs: the Great Little Spa and the Majestic. She sells most of her products to one discount retailer and ships the products by truck to the stores. She is planning for the coming quarter and has the following data on revenues and costs per product: The Great Little Spa The Majestic Sales mix 3 1 Shipping weight (kilograms) Selling price $1,500 $2,850 Unit costs: Direct materials $385 $705 Direct labour Variable overhead (excluding shipping costs) Monthly fixed overhead costs (excluding shipping costs) $53,990 To make more accurate predictions of profits, Shirley needs to focus on shipping costs, which vary by month. She knows that the cost is mixed, and she would like to be able to determine the fixed and variable portions, which she believes vary by shipping weight. She gathers the information and prepares a regression analysis which generates an Adjusted R 2 of and a cost function of 0.976x + $9,466 where x is the shipping weight. Required: a) What would be the estimated cost if the expected shipping weight was 5,100 kg? b) Does the Adjusted R 2 indicate a good fit? c) Calculate the break-even point in units for the two hot tubs for the coming quarter assuming no change in the sales mix. 10 / 73

14 Solution a) CPA Way step: Assess the Situation Cost estimate: $9, , = $14, which would be rounded to $14,444 b) An Adjusted R 2 value of means that 99% of the variability in the dependent variable is explained by changes in the independent variable. This is considered to be a good representation of the explanation of change in cost. c) CPA Way steps: Analyze Major Issue(s) and Conclude and Advise Contribution margin calculation: The Great Little Spa The Majestic Selling price $1,500 $2,850 Variable unit cost Direct materials Direct labour Variable overhead Shipping cost $ (100 kg $0.976) $ (400 kg $0.976) Total variable cost $ $1, Contribution margin $ $ Break-even analysis: Contribution margin per bundle: (3 $607.40) + (1 $984.60) = $2, Fixed costs $ 63,456 ($53,990 + $9,466) Product bundle CM $ 2, Fixed costs / bundle CM 23 Bundles (rounded) per month Breakdown by individual product: The Great Little Spa 23 hot tubs per bundle 3 Total hot tubs per month 3 months The Majestic 23 hot tub per bundle 1 Total hot tubs per month 3 months To break even for the quarter, 207 Great Little Spa and 69 Majestic hot tubs must be sold. 11 / 73

15 PART 2: CAPACITY Manufacturing capacity is the constraint on the amount of resources that are available to manufacture a product or provide a service. Actual, normal, theoretical and practical capacity are some of the ways of valuing capacity. Typically, the greater the capacity, the greater the related fixed costs. Managing the use of capacity, therefore, allows companies to manage related fixed costs. Support department cost allocation Support (or service) departments assist production departments by providing resources that the production departments need to complete their work. The main reason that the costs of these departments are allocated to the production departments is to help organizations have a better understanding of the costs of all resources needed to produce a good (product or service). Common examples of support departments include accounting, legal, administrative and human resources. Three different methods can be used to allocate support department costs to production departments. Allocation methods The simplest of the three, the direct method, writes off the support departments costs directly to each of the production departments. Example The Janitorial and Human Resources departments provide a service to the Machining and Assembly departments. Janitorial costs are allocated based on the square metres of each of the production departments, and Human Resources costs are allocated based on the number of employees working in each of the production departments. Janitorial Human Resources Machining Assembly Total Costs incurred by department $250,000 $750,000 Service units provided from ,500 2,750 Janitorial (square metres) Service units provided from Human Resources (employees) Under the direct method, costs are allocated to each of the production departments directly without taking into consideration service that these support departments also give to other support departments. 12 / 73

16 Total costs to allocate Machining Assembly Total Allocate Janitorial costs $250,000 $93,750 $156,250 $250, / ( ,500) $240,000 1,500 / ( ,500) $240,000 Allocate Human Resources costs $750,000 $250,000 $500,000 $750, / ( ) $750, / ( ) $750,000 Total allocated $343,750 $656,250 $1,000,000 The other two methods are the step method and the reciprocal method. They will be covered in detail in the Intermediate Management Accounting course. Job order costing Management accountants use job order costing to accumulate costs associated with a unique cost object. Examples of organizations that would use a job order costing system are dental practices, automobile repair shops and print shops. Components and steps of a job order costing system A typical job order costing system would have a job cost sheet for each job in production. That job cost sheet records the direct materials, direct labour and manufacturing overhead incurred (applied) for the job. The steps in a job order costing system are as follows: Identify the cost object or job (a unique order or service). Assign direct materials and direct labour costs to the cost object. Allocate manufacturing or service-related overhead to the cost object. Normal overhead rates and denominator activity Because manufacturing overhead is not directly assignable to a job, a manufacturing overhead application rate is calculated usually based on beginning-of-year estimates. This rate is applied to each job based on an activity driver. Common activity drivers used in a manufacturing business are direct labour hours, direct labour costs or machine hours. A costing system that uses an estimated rate to apply overhead is called a normal costing system. The formula for determining the predetermined overhead rate is as follows: Manufacturing overhead rate = Budgeted manufacturing overhead costs / Budgeted denominator activity The denominator activity chosen is one that attempts to reflect the underlying cost behaviour of manufacturing overhead cost. In a labour-intensive company, the direct labour hours are often chosen as the denominator-level activity, whereas in an 13 / 73

17 automated company, machine hours are usually chosen. Common choices for activity level are historic actual, estimated, average, and practical capacity of the cost driver. The amount of manufacturing overhead applied to a job will equal the manufacturing overhead rate multiplied by the actual denominator activity specific to the job. Single plant-wide versus multiple overhead cost pools Management accountants must make decisions as to what drives the cost of manufacturing overhead. In some situations, where there is little variability in the cost driver between processes or departments, a single plant-wide rate may be used to allocate manufacturing overhead. In other cases, especially where one department s costs are primarily driven by manual labour and another department s costs by machine operations, it makes more sense to set different cost drivers for each department. Example Consider the following job that records the costs for manufacturing a chair: Chair Item Cutting department Assembly department Finishing department Job 2945 Materials costs $95.00 $3.00 $6.00 Labour hourly rate $18.00 $12.00 $15.00 Labour hours Machine hours Using a plant-wide rate of $39.22 per direct labour hour results in the following costs: Chair Item Cutting dept. Assembly dept. Finishing dept. Total Job 2945 Materials costs $ $ 3.00 $ 6.00 $ Direct labour costs: Labour hourly rate $ $ $15.00 Direct labour hours Direct labour costs $ $ $ 7.50 $ Manufacturing overhead allocation: Cost driver quantity DLH Cost driver rate $ $ $39.22 Overhead allocation $ $ $19.61 $ Total manufacturing costs $ / 73

18 Alternatively, if the overhead costs in each of the departments had different cost drivers, the overhead costs could be applied as follows: Department Cost driver Cost driver average activity level Estimated manufacturing overhead Manufacturing overhead rate Cutting Machine hours 5,000 $400,000 $80.00/MH Assembly Direct labour hours 12,000 $250,000 $20.83/DLH Finishing Number of chairs 7,000 $150,000 $21.43/unit $800,000 The application of overhead costs above would have the following effect on costs: Chair Item Cutting dept. Assembly dept. Finishing dept. Total Job 2945 Materials costs $ $ 3.00 $ 6.00 $ Direct labour costs: Labour hourly rate $ $ $15.00 Direct labour costs $ $ $ 7.50 $ Manufacturing overhead allocation: Cost driver quantity Cost driver rate $ $ $21.43 Overhead allocation $ $ $21.43 $ Total manufacturing costs $ Recording manufacturing overhead and writing off year-end residual Manufacturing overhead Actual manufacturing overhead Applied (allocated) manufacturing overhead To WIP Underapplied Overapplied The manufacturing overhead account is a clearing account. Under normal costing, actual manufacturing costs are accumulated in the clearing account and then applied to jobs in WIP using a predetermined overhead allocation rate multiplied by the actual denominator activity. As the rate is usually based on estimates, a residual balance is common at year end. A debit balance means insufficient overhead was applied during the year, while a credit balance means too much overhead was applied to the jobs. Two methods used to write 15 / 73

19 off this amount are the direct charge to cost of goods sold method and the prorating based on ending balances method. Accounting entries underlying job order costing The following diagram illustrates the flow of costs through a typical manufacturing job order costing system: Job order costing the flow of costs Direct materials Finished goods COGS Direct labour Work-in-process Mfg. costs COGM Mfg. overhead Cost of goods sold Job cost sheets Joint and by-product costing In some production environments such as forestry, a single raw material produces multiple products. For example, a single log can produce a variety of products, such as two-by-fours or two-by-sixes, or it can be processed further into plywood or flooring. These products are called joint products. Additional products of lesser value, such as sawdust or bark mulch, are classified as by-products. The split-off point is where the joint and by-products become separately identifiable, and the cost incurred up to the split-off point is called the joint cost. Some of the practical reasons to allocate joint costs include external reporting, transfer pricing, and costing the product for insurance-related purposes. Joint cost allocation methods Four basic methods are used to allocate joint costs to joint products: physical output, sales value at split-off, net realizable value and constant gross margin percentage. These methods will be covered in the Intermediate Management Accounting course in detail. 16 / 73

20 Practice questions 1. Multiple-choice questions: i. When are departmental overhead rates generally preferred to plant-wide overhead rates? a) When activities of each of the various departments in the plant are not homogenous b) When all products passing through various departments require the same manufacturing effort in each department c) When most of the overhead costs are fixed d) When all products passing through the various departments require a different amount of direct materials in each department Solution Option a) is correct. A unique rate should be established for each department to better reflect the level of activity and consumption when activities across departments are different. Option b) is incorrect. If the same effort is required throughout, then a plantwide rate would be preferred. Option c) is incorrect. If the overhead costs are fixed, they will not vary based on the different drivers used by departmental overhead rates. Option d) is incorrect. The amount of direct materials is unlikely to be a driver of the overhead cost allocation, so it is irrelevant in deciding between departmental and plant-wide rates. ii. The following is an excerpt from DellCo s accounting information system: Indirect factory materials $ 48,000 Direct manufacturing materials 114,000 Indirect office wages 14,000 Manufacturing overhead applied 182,000 Factory depreciation 86,000 Office depreciation 14,000 Direct office wages 32,000 Factory supervisors salaries 36,000 Factory supplies 7, / 73

21 Based on the information above, what value will be debited to the WIP account regarding manufacturing overhead? a) $177,000 b) $182,000 c) $191,000 d) $205,000 Solution Option b) is correct. Manufacturing overhead is applied to WIP by crediting the manufacturing overhead account and debiting WIP. Option a) is incorrect. This is the total of indirect factory materials, factory depreciation, factory supervisors salaries and factory supplies costs, not the amount applied. The manufacturing overhead is applied using a predetermined rate. Option c) is incorrect. This is the total of indirect factory materials, indirect office wages, factory depreciation, factory supervisors salaries and factory supplies costs, not the amount applied. In addition, indirect office wages would not be part of the manufacturing overhead. Option d) is incorrect. This is the total of indirect factory materials, indirect office wages, factory depreciation, office depreciation, factory supervisors salaries and factory supplies costs, not the amount applied. In addition, indirect office wages and office depreciation would not be part of the manufacturing overhead. 18 / 73

22 2. Renaissance Wood Products Ltd. manufactures wooden knife blocks. The marketing manager wants to set the selling price of these blocks. There are two distinct designs. The simpler design is the curve block, which holds four knives. The more complicated design is the square block, which holds eight knives. The production manager has just completed a production run of 350 of the curve blocks. The following data pertain to this run of curve blocks: Opening inventory, direct materials $500 Purchases of direct materials $1,000 Ending inventory, direct materials $625 Direct labour to make the blocks was hours at $25/hour Budgeted indirect costs for the year (for all jobs) Supplies such as glue and stain $ 840 Hydro 1,230 Machine maintenance 1,250 Machine depreciation 3,000 Indirect labour 16,630 Total budgeted indirect costs $22,950 Machine hours is the cost driver for the indirect costs. The budgeted machine hours for the year are based on the production of 4,200 curve blocks at 0.30 hours each and 3,600 square blocks at 0.50 hours each. The machine hours used to produce the 350 curve blocks are the same as the budgeted level. Renaissance s pricing policy is to mark up its products by 50% of product cost. Required: a) CPA Way step: Assess the Situation i) Calculate the total cost for 350 curve blocks. ii) Calculate a unit cost per block. b) CPA Way steps: Analyze Major Issue(s) and Conclude and Advise Advise management on the appropriate selling price for the curve block product. 19 / 73

23 Solution a) i) Direct materials $ ($ $1, $625.00) Direct labour 1, (52.50 $25.00) Manufacturing overhead Total cost $2, To calculate the manufacturing overhead, the first step is to determine the predetermined rate by dividing the total budgeted indirect costs by the total machine hours for the year. Total machine hours = 4, = 1,260 hours = 3, = 1,800 hours Total 3,060 hours $22,950 3,060 = $7.50 per hour Next, determine how many machine hours were used to manufacture the 350 curve blocks: = 105 hours The overhead applied to the production of curve blocks was 105 hours $7.50/hour = $ ii) Unit cost for each curve block = $2,975/350 = $8.50 b) Based on Renaissance s pricing policy, the selling price of each curve block should be $ = $ / 73

24 3. Steppe Co. has two production departments, Stamping and Painting. There are three support departments: Administration, Maintenance and Cafeteria. The Administration costs are allocated based on direct labour hours. The Maintenance costs are allocated based on square metres. The Cafeteria costs are allocated based on number of employees. The following data describe the costs incurred in each department and the cost driver consumption: Production Support Stamping Painting Admin. Maintenance Cafeteria Direct labour costs $1,950 $2,050 $90 $80 $87 (in 000s) Direct materials costs $3,130 $950 $0 $65 $91 (in 000s) Overhead costs $1,650 $1,850 $70 $55 $62 (in 000s) Total (in 000s) $160 $200 $240 Direct labour hours (in 000s) Number of employees Square metres (in 000s) Cost driver Direct labour hours Square metres Number of employees Required: Applying the direct method, allocate the support department costs to the production departments. Solution CPA Way step: Assess the Situation Allocated costs Costs Driver Stamping Painting Total Administration $160 Direct labour hours Maintenance $200 Square metres Cafeteria $240 Number of employees 562.5/1,000 $160 = $90 88/160 $200 = $ /480 $240 = $ /1,000 $160 = $70 72/160 $200 = $90 200/480 $240 = $100 $160 $200 $240 Total allocation received $340 $260 $ / 73

25 PART 3: PROCESS COSTING Process costing is a costing system suitable for costing the mass production of identical products (for example, packaging soft drinks and manufacturing plastic bottles). Instead of costing individual units or jobs as is done in job costing, total costs are simply divided by the number of units produced to compute the cost per unit. The purpose of job and process costing is to cost products and services. However, some of the differences are as follows: Job order costing Process costing Products Each product is unique. Each product is the same as all others. Cost accumulation Reporting of costs Unit costs Costs are collected and recorded for each job. Costs are accumulated and reported on the job cost sheet. Unit costs are calculated for each job. Costs are collected and recorded by department/process. Costs are reported on the department production report. Unit costs are calculated for each department. Illustration of a typical process costing system at a soft drink manufacturing plant It would not be practical to cost each can of soft drink individually, and it is not necessary because each can should contain the same ingredients as all the other cans. However, it is still necessary to know the cost of producing the soft drink. The following highlights three basic processing steps taken to produce soft drinks: Each step takes place in a separate division or department. Because each can of soft drink is homogeneous, costs are assigned by department instead of job. As the diagram below illustrates, each department has its own WIP account to accumulate the product cost. When the product is complete in one department, the costs are transferred to the next department, where more direct materials and conversion costs are added as required. 22 / 73

26 The two most widely used process costing approaches in Canada are the weighted average method and the first-in, first-out (FIFO) method. The main difference between the two is that the weighted average method does not separate the cost of the work done in the previous period from the work done in the current period, whereas FIFO separates the costs and units of each period. Using the soft drink example and focusing on the Syrup Production department, four steps are required to determine how the following costs in that department are assigned. This illustration uses the weighted average method of allocating costs. The second method, called first-in, first-out (FIFO), will be discussed in the Intermediate Management Accounting course. First, note that in this example there are two cost pools: one is the direct materials (direct ingredients) costs; the second is the conversion costs pool comprising all direct labour and manufacturing overhead costs. Item Units Percentage complete Cans in beginning inventory 1,000 80% Cans of soft drink started during the month 50,000 Cans of soft drink completed in the month 49,500 Cans in ending inventory 1,500 40% Item Costs Cost of ingredients in beginning inventory $1,500 Conversion costs in beginning inventory $200 Cost of ingredients added this month $6,150 Conversion costs added this month $12, / 73

27 Step 1: Determine physical flow of goods Goods in beginning WIP plus all units started during the period end up in one of three places: units completed and transferred to the next department, units in ending inventory or spoiled units. 1 Physical flow Syrup Production department Physical units Opening WIP 1,000 Started this period 50,000 Units to account for 51,000 Units completed and transferred out 49,500 Units in ending WIP 1,500 Units accounted for 51,000 It is also important to understand the flow of costs in each department (that is, when the costs are incurred in the process). For example, in the Syrup Production department, direct materials are added at the beginning of the production process, and conversion costs are added evenly throughout. Understanding when costs are added in the process will be vital in calculating the equivalent units in Step 2. Step 2: Calculate the equivalent units of production for the period The second step in process costing is to identify the equivalent units of production for materials and conversion costs. The equivalent unit concept is used when there is partially completed WIP at the end of an accounting period. The equivalent unit is used to quantify the amount of work that has been done on the unit. Equivalent units for ingredients are 1,500 because all ingredients (direct materials) are added at the beginning of the process; therefore, the amount of work completed is 100% of the ingredients for both units completed and units in the ending WIP. In contrast, the amount of conversion effort is added evenly throughout the production process; therefore, the conversion costs put into the ending inventory would be equivalent to the effort expended to complete, that is, 40% 1,500 = 600 units. 1 Note that where inspection takes place, units that do not pass inspection are classified as spoiled units and are also considered in this step. This will be covered in detail in the Intermediate Management Accounting course. 24 / 73

28 Physical units Equivalent units Direct materials Conversion costs Units transferred out 49,500 49,500 49,500 Ending inventory 1,500 1, Total 51,000 51,000 50,100 Step 3: Calculate the cost per equivalent unit for each cost category The equivalent units calculated in Step 2 are then used to calculate the cost per equivalent unit. Under the weighted average method, costs incurred from the previous period, which accumulated in the beginning WIP, are not separated from the costs incurred in the current period. The total costs incurred to date would be assigned to the units based on the work completed to date that is, the equivalent units. Direct materials Conversion costs Total costs Costs in beginning inventory $ 1,500 $ 200 $ 1,700 Costs incurred this period 6,150 12,325 18,475 Total costs to date $ 7,650 $12,525 $20,175 Divide by equivalent units 51,000 50,100 Cost per equivalent unit $ 0.15 $ 0.25 Step 4: Assign costs to appropriate accounts The cost per equivalent unit is then used to assign costs to those units transferred to the next department and those left in the Syrup Production department. Direct materials Costs assigned Conversion costs Total costs Units transferred out: 49,500 $0.15; 49,500 $0.25 $7,425 $12,375 $19,800 DR WIP of Bottling/Canning dept. CR WIP of Syrup Production dept. Units in ending inventory: 1,500 $0.15; 600 $ Amount left in WIP $7,650 $12,525 $20,175 The journal entry to record this would be a debit to the WIP account of the next department (Bottling/Canning) and a credit to the WIP account of the Syrup Production department. 25 / 73

29 Spoilage Spoilage is identified at a point of inspection and can be classified as either abnormal or normal. Abnormal spoilage is spoiled units above the number that is expected or normal for the process. Normal spoilage contributes to the cost of the good units produced, whereas abnormal spoilage is reported as a period cost in the period incurred. The cost of spoiled units is based on the percentage of completion at the point where the units were inspected. Transferred-in costs When production is complete in one department, the direct materials and conversion costs incurred in that department are transferred with the units to the next department. Thus, in subsequent departments, costs will consist of the costs accumulated in all previous departments and the addition of conversion and direct materials costs in the current department. Indirect cost allocation systems A major focus of management accounting is how to allocate indirect costs effectively. Various factors, including inaccurate pricing, may indicate that a cost allocation system is producing inaccurate information. This may result in inappropriate decision-making or even loss of competitive advantage. For example, if the costs of indirect resources are grouped together into a single indirect cost pool and allocated in proportion to one single quantity measure (such as units produced, machine hours or labour hours), the high-volume products tend to pick up more than their fair share of costs if resources used are not proportional to the single volume measure. It would lead to product cost cross-subsidization: one product is under-costed and the other over-costed. To improve the accuracy of assigning indirect costs, a cost allocation system for indirect costs can be designed by identifying activities as the fundamental cost objects. Under this approach, the indirect cost pool is expanded into groups of activities each carrying the same cost driver. The cost drivers are selected based on a causal relationship with the costs in the cost pool. Each cost pool will then have an individual cost driver rate to apply the costs to the products. This approach to cost allocation recognizes that it is the activities the organization undertakes to produce goods and services that create costs. This focus on using 26 / 73

30 activities as the cost driver for indirect costs is called activity-based costing (ABC). Under a carefully constructed ABC system, the actual use of the resources will be reflected, thus improving the accuracy of cost allocation. ABC systems In ABC, an activity is any event that causes overhead costs to be incurred. The costs of performing these activities are accumulated in an activity cost pool. There must be a cause-and-effect relationship between the activity measures and the costs of the activities. Any of the cost estimation methods discussed in Part 1 can be used to establish and measure the relationship between the costs of an activity and the activity measure. The ABC cost hierarchy Activity-based costs can be classified into one of the following ABC cost hierarchy elements: Unit-level costs vary directly with the level of production. They are often called variable costs. Batch-level costs are incurred whenever a batch or group of units is processed, regardless of the number of units. An example is setting up machines for a production run. Product-sustaining costs are incurred without regard to the number of batches or units produced. Examples include costs of developing and advertising a product line. Customer-sustaining costs are incurred to provide a service to specific customers. Examples include the cost of sales representative visits to a customer or of sending out catalogues. Facility-sustaining costs benefit all business functions. They are incurred to enable an organization to continue, regardless of customers, products, batches or units. An example is head office administrative costs. These costs are not usually allocated, because there is no apparent cause-and-effect relationship with activity levels. Consider an example of an organization that produces Product 1 and Product 2. A total of $140,000 of indirect costs must be allocated to these two products. Using a single rate based on direct labour hours ($1.60/DLH), the costs are allocated as follows: Units Direct labour hours Cost allocated Cost per unit Product 1 (0.50 DLH/unit) 100,000 50,000 $ 80,000 $0.80 Product 2 (0.50 DLH/unit) 75,000 37,500 60,000 $ ,000 87,500 $140,000 In this case, indirect costs per unit are the same for Product 1 and Product / 73

31 Now consider that indirect costs consist of costs for setting up machines and for materials handling. Cost pools are set up for both activities with the following costs, cost drivers and usage of cost driver for each product: Activity Cost driver Product 1 usage Product 2 usage Total activity driver Total cost Cost per unit of activity driver Machine setups Setup $120,000 $ Materials handling Kilogram 50,000 50, ,000 20,000 $0.20 $140,000 Note the differences in activity for both products. Product 1 s batch size is 1,000 units (100,000 units / 100 batches), while Product 2 s batch size is only 375 units (75,000 units / 200 batches). Setup costs are not dependent on batch size. The smaller the batch size, the higher the number of batches for setup to produce the same number of units. Therefore, higher setup costs are absorbed by Product 2. Then consider materials handling costs. Each unit of Product 1 requires the handling of 0.5 kilograms of materials (50,000 kilograms of materials / 100,000 units), whereas each unit of Product 2 requires the handling of kilograms of materials (50,000 kilograms of materials / 75,000 units). As a result, Product 2 will absorb more materials handling resources and costs. These differences in indirect cost consumption result in the following unit product costs: Apply costs to products Product 1 Product 2 Machine setups 100 $400 $ 40, $400 $80,000 Materials handling 50, ,000 50, ,000 Total cost $ 50,000 $90,000 Units produced 100,000 75,000 Cost per unit $ 0.50 $ 1.20 The following is a comparison of the differences in unit cost using a single allocation rate and using ABC: Comparison Using single rate Difference in unit cost Using ABC Difference Product 1 $0.80 $0.50 $0.30 Product 2 $0.80 $1.20 ($0.40) Using a single rate method would result in over-costing Product 1 and under-costing Product 2. Companies setting selling price based on a markup of cost would have overpriced Product 1 and could have potentially sold Product 2 at a loss. 28 / 73

32 Practice questions 1. Multiple-choice questions: i. Which of the following best describes the calculation of equivalent units for a period? a) The number of units actually finished for the period b) The number of units that the direct materials and/or conversion expended would have completed to 100% c) The number of units actually finished plus the unfinished units in WIP at the end of the period d) The number of units started in the period less the unfinished units in WIP at the end of the period Solution Option b) is correct. Equivalent units represent the efforts and resources to start and complete a unit. Thus, the time and resources put into two units that are 50% complete represent the time and resources to start and complete one unit (2 50% = 100%). Option a) is incorrect. This only covers the units of the finished products. Partially completed units should be converted into equivalent units based on the amount of work that has been done. Option c) is incorrect. This describes the physical units of the finished units and the units in WIP. Partially completed units should be converted into equivalent units based on the amount of work that has been done. Option d) is incorrect. This calculates the physical units started and finished. ii. Using ABC, how would the costs of inspecting the quality of the product be accounted for? a) As an organization-sustaining activity b) As a product-level activity c) As a batch-level activity d) As a unit-level activity 29 / 73

33 Solution Option c) is correct. A batch-level cost is incurred whenever a batch or group of units is processed. The cost of inspecting is the same. A batch of product is inspected before being moved forward to the next step in the process. Option a) is incorrect. An organization-sustaining activity, such as general administration costs, supports the entire organization. Inspection of product quality supports activities at a lower level. Option b) is incorrect. A product-level activity, such as design, supports individual products or services regardless of the number of units or batches produced. Therefore, it is not limited to one batch, whereas inspecting a batch of products for quality would be. Option d) is incorrect. Inspection is done on a number of units, but the cost is not driven by the unit. The cost is driven by the number of batches, not by the number of units in the batch. 2. Clyde s Cleaning Supplies makes a liquid industrial cleaner for the shipbuilding industry. The ingredients for the liquid cleaner pass through the Mixing department and the Finishing department, where the cleaner is put into containers. The information for the Mixing department for March is as follows: Beginning WIP Units started Units completed 4,000 litres 18,000 litres 19,000 litres Beginning WIP direct ingredients $7,400 Beginning WIP conversion $1,200 Direct ingredients added during the month $33,300 Conversion costs added during the month $30,832 The company uses the weighted average method of process costing. Beginning WIP was 20% complete as to conversion. Direct ingredients are added at the beginning of the process. All conversion costs are incurred evenly throughout the process. Ending WIP was 60% complete. Before the cost accountant had a chance to prepare the production report, the company president added up all of the costs for the month and divided by the units transferred. This resulted in a unit cost of $3.828 for the month. The president is concerned about rising costs because the original budget for the month was a unit cost of $ / 73