Chapter 17. Objectives PRBA007 TOPIC TWO C. 1of 13. Unit costs for decision-making

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17-0 17-1 Chapter 17 Unit costs for decision-making Objectives 17-2 Once you have completed this part of the topic, you should be able to: 1.

1 Chapter 17 Unit costs for decision-making Objectives 17-2 Once you have completed this part of the topic, you should be able to: 1. Explain the importance of unit costs. 2. Identify the costs that are part of the unit-cost calculation. 3. Explain the difference between actual and normal costing. 1of 13

2 17-3 Objective 1Explain the 1importance of unit costs. The importance of unit costs 17-4 Unit costs play an important role in the strategic and operational decisions of marketing and operating managers. Unit costs assist in determining whether to market a high-priced specialty product, or a low-priced commodity. The importance of unit costs 17-5 Direct labour Raw material Overhead 2of 13

3 The importance of unit costs 17-6 Finished goods Cost of goods sold Unit cost = Total manufacturing cost for a period Number of units produced in that period 17-7 Managers use product cost information to answer questions such as: How should we price a particular product? (Product pricing) Should we continue to offer a particular product? (Market strategy and product life cycle) What is the best way to allocate our limited production resources? (Allocating resources) On which product should marketing focus its efforts to maximise profits? (Unit profit margin) The role of unit costs in business decisions 17-8 Costs are measured and collected in accounts. Costs are assigned to units of products. Individual unit costs are used to make decisions. Company performance is affected by decisions. Work in process Cost/Units = Unit cost 1 Unit cost Product A Unit cost Product B Revenues $ (Cost) $ Profits $ 3of 13

4 Product pricing 17-9 Choosing the right selling price for its products is extremely important to the success of a company. Knowing the cost to make a product is very important when there is no competitive market for a product. Marketing strategy Some companies choose to compete by marketing their products at a low price. Hyundai offers cars priced far below those offered by Mercedes. Timex offers watches at prices far below Rolex. Product life cycle Growth A company introduces a new product; then the company builds a market share in anticipation of future profits. Hold The company focuses on holding the market share of the mature product. Harvest The company maximises the available returns as the sales of the product fall. Divest When profits are no longer adequate, the company eliminates the product. 4of 13

5 Product life cycle Market share is that portion of sales captured by a particular product relative to total t sales of all similar products. Unit profit margin Unit profit margin is the difference between the selling price per unit of a product and the unit cost. Allocating resources Unit costs help managers decide how to allocate limited production and marketing resources. 5of 13

6 17-15 Objective 2 that Identify the costs that are part of the unit-cost calculation. Exhibit 4 The elements of unit cost Direct materials Sugar Product A Product B Direct labour Overhead Exhibit 4 The allocation of costs Product A Product B Direct labour Overhead Allocation Indirect costs Allocation 6of 13

7 17-18 Relationship of Cost Accumulation, Cost Measurement, and Cost Assignment Unit cost is made up of direct materials direct labor overhead traced directly to units Overhead is applied using a predetermined rate based on budgeted overhead costs and budgeted amount of driver. Commonly used drivers include: Units produced Direct labor hours Direct labor dollars Machine hours Direct materials dollars or cost PURPOSES OF COST ACCUMULATION AND COST ALLOCATION Compute costs for EVALUATING Departmental & Managerial Efficiency and Effectiveness Compute costs of various PRODUCTS for the measurement on Income and Inventories Compute costs for decisions relating to; Which products should be produced, continued to be produced or discontinued: Make or buy decisions: Price setting: Manufacturing methods: Capital expenditure (machinery): Expansion or contraction of operating activities for the firm or particular department: Management remuneration, promotion (or demotion) Objective 3 3difference between Explain the difference between actual and normal costing. 7of 13

17-21 Measuring cost Actual costing measures product costs based on the actual costs of direct materials, direct labour, and overhead incurred in producing the product.

8 17-21 Measuring cost Actual costing measures product costs based on the actual costs of direct materials, direct labour, and overhead incurred in producing the product. Normal costing measures product costs by adding the actual costs of direct materials and direct labour to an estimated overhead cost incurred in producing the product. MEASURES OF ACTIVITY Activity level must be predicted for the coming year to calculate the predetermined overhead rate. FOUR DIFFERENT MEASURES OF ACTIVITY LEVEL: Actual versus normal costing Actual overhead costs Actual costing Unit cost Actual direct labour cost Actual direct materials costs 8of 13

9 17-24 Actual versus normal costing Amount of activity required by the unit times a predetermined rate Normal costing Unit cost Actual direct labour cost Actual direct materials costs Measuring cost A predetermined overhead rate is an estimate of the amount of overhead assigned to a product for each unit of activity. An activity base is a production activity or a measure of the cost of production activity Measuring cost Rogers Company, a valve manufacturer, purchases raw materials costing $ Statement of Financial Position Accounts Account Cash + Other assets = Liabilities + Equity Raw Mat. Inventory Accts. pay of 13

10 17-27 Measuring cost During the period, $ of the material is placed into production as part of the manufacturing process. Statement of Financial Position Accounts Account Cash + Inv + Inv = Liabilities+Equity mats WIP Raw mat. inventory WIP inv Measuring cost Direct labour costs totaling $ are incurred in the production process Statement of Financial Position Accounts Account Cash + Inv + Inv = Liabilities + Equity mats WIP WIP inventory Wages pay Measuring cost Actual manufacturing overhead costs incurred totaled $ Statement of Financial Position Accounts Account Cash + Inv + Man = Liabilities + Equity mats o/h Manufact overhead Wages pay of 13

11 17-30 Assignment of overhead costs in a normal costing system Summary of procedures: Establishing the predetermined overhead rate At the beginning of the financial year: 1. Estimate the total costs of manufacturing overhead for the period. 2. Choose a relevant activity or cost base, and estimate the amount of that activity or cost for the cost. 3. Calculate the predetermined overhead rate by dividing the estimate of total manufacturing overhead costs by the estimated amount of the activity or cost base Assignment of overhead costs Norman Carpets Assigning overhead costs using the predetermined overhead rate At the end of each accounting gperiod: 1. Determine the actual amount of the activity base used during the period. 2. Multiply that amount by the predetermined overhead rate. 3. Estimated overhead costs = actual activity base x predetermined overhead rate Assignment of overhead costs Norman Carpets Norman Carpets expects to produce 1 million rolls of carpet next year and to incur manufacturing overhead in this period of $25 million. Norman uses 5 labour hours to produce one carpet. 11 of 13

12 Assignment of overhead costs Norman Carpets Management decides to use direct labour hours as the activity base. Five direct labour hours are generally needed to produce one roll. Thus, the activity base is direct labour hours. $ The predetermined overhead rate is $5 per direct labour hour Assignment of overhead costs Roger Company Roger Company actually used 3,600 direct labour hours in At $5 per hour, the applied overhead is $ (3,600 x $5). Statement of Financial Position Accounts Account Cash + Inv + Man = Liabilities + Equity WIP o/h WIP inventory Man O/h Assignment of overhead costs Roger Company The actual overhead cost was $ and the applied (or estimated) When the estimated overhead is greater than overhead was calculated to the actual overhead, the be $ company overapplied its In the Rogers overhead Company cost. example, the overhead is overapplied by $ of 13

13 Assignment of overhead costs Roger Company The Manufacturing overhead account is closed to Cost of goods sold. Statement of Financial Position Accounts Account Cash + Inv + Man = Liabilities + Equity WIP o/h CoGS Manf O/h Assignment of overhead costs Roger Company If the actual overhead had been $20 000, then the firm s overhead would have been underapplied by $ of 13

ACCT Professor Johnson Lecture Notes Chapter 16: PROCESS COSTING AND ANALYSIS

ACCT Professor Johnson Lecture Notes Chapter 16: PROCESS COSTING AND ANALYSIS PROCESS OPERATIONS ACCT 102 - Professor Johnson Lecture Notes Chapter 16: PROCESS COSTING AND ANALYSIS In Chapter 15, we studied the job order cost accounting system used when a company manufactures products