Description Managerial Accounting and Cost Concepts Chapter 01 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A.,

Managerial Accounting and
Cost Concepts
Chapter 01
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Classifications of Manufacturing
Costs
Direct
Materials
Direct
Labor
Manufacturing
Overhead
The Product
1-2
Direct Materials
Raw materials that become an integral
part of the product and that can be
conveniently traced directly to it.
Example: A radio installed in an automobile
1-3
Direct Labor
Those labor costs that can be easily
traced to individual units of product.
Example: Wages paid to automobile assembly workers
1-4
Manufacturing Overhead
Manufacturing costs that cannot be easily
traced directly to specific units produced.
Examples: Indirect materials and indirect labor
Materials used to support
the production process.
Examples: lubricants and
cleaning supplies used in the
automobile assembly plant.
Wages paid to employees
who are not directly
involved in production
work.
Examples: maintenance
workers, janitors, and
security guards.
1-5
Nonmanufacturing Costs
Selling
Costs
Administrative
Costs
Costs necessary to
secure the order and
deliver the product.
All executive,
organizational, and
clerical costs.
1-6
Product Costs Versus Period Costs
Product costs include
direct materials, direct
labor, and
manufacturing
overhead.
Inventory
Period costs include all
selling costs and
administrative costs.
Cost of Good Sold
Expense
Income
Statement
Income
Statement
Sale
Balance
Sheet
1-7
Classifications of Costs
Manufacturing costs are often
classified as follows:
Direct
Material
Direct
Labor
Prime
Cost
Manufacturing
Overhead
Conversion
Cost
1-8
Cost Classifications for Predicting Cost
Behavior
Cost behavior refers to
how a cost will react to
changes in the level of
activity. The most
common classifications
are:
▫ Variable costs
▫ Fixed costs
▫ Mixed costs
1-9
Variable Cost
Total Texting Bill
Your total texting bill is based on how
many texts you send.
Number of Texts Sent
1-10
Variable Cost Per Unit
Cost Per Text Sent
The cost per text sent is constant at
5 cents per text message.
Number of Texts Sent
1-11
The Activity Base (Cost Driver)
Machinehours
Units
produced
A measure of what
causes the
incurrence of a
variable cost
Miles
driven
Laborhours
1-12
Fixed Cost
Monthly Cell Phone
Contract Fee
Your monthly contract fee for your cell phone is
fixed for the number of monthly minutes in your
contract. The monthly contract fee does not
change based on the number of calls you make.
Number of Minutes Used
Within Monthly Plan
1-13
Fixed Cost Per Unit
Monthly Cell Phone
Contract Fee
Within the monthly contract allotment, the average
fixed cost per cell phone call made decreases as
more calls are made.
Number of Minutes Used
Within Monthly Plan
1-14
Types of Fixed Costs
Committed
Discretionary
Long term, cannot be
significantly reduced in
the short term.
May be altered in the
short term by current
managerial decisions
Examples
Examples
Depreciation on Buildings
and Equipment and Real
Estate Taxes
Advertising and
Research and
Development
1-15
The Linearity Assumption and the
Relevant Range
Total Cost
Economist’s
Curvilinear Cost
Function
Relevant
Range
A straight line
closely
approximates a
curvilinear
variable cost
line within the
relevant range.
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
Activity
1-16
Fixed Costs and the Relevant Range
For example, assume office space is available at
a rental rate of $30,000 per year in increments of
1,000 square feet.
Fixed costs would increase in a
step fashion at a rate of $30,000 for
each additional 1,000 square feet.
1-17
Rent Cost in Thousands
of Dollars
Fixed Costs and the Relevant Range
90
Relevant
60
Range
30
0
0
The relevant range
of activity for a fixed
cost is the range of
activity over which
the graph of the
cost is flat.
1,000
2,000
3,000
Rented Area (Square Feet)
1-18
Cost Classifications for Predicting Cost
Behavior
Behavior of Cost (within the relevant range)
Cost
In Total
Per Unit
Variable
Total variable cost Increase
and decrease in proportion
to changes in the activity level.
Variable cost per unit
remains constant.
Fixed
Total fixed cost is not affected
by changes in the activity
level within the relevant range.
Fixed cost per unit decreases
as the activity level rises and
increases as the activity level falls.
1-19
Mixed Costs
(also called semivariable costs)
A mixed cost contains both variable and fixed
elements. Consider the example of utility cost.
Total Utility Cost
Y
Variable
Cost per KW
X
Activity (Kilowatt Hours)
Fixed Monthly
Utility Charge
1-20
Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Where:
Y
Y
a
Total Utility Cost
b
X
= The total mixed cost.
= The total fixed cost (the
vertical intercept of the line).
= The variable cost per unit of
activity (the slope of the line).
= The level of activity.
Variable
Cost per KW
X
Activity (Kilowatt Hours)
Fixed Monthly
Utility Charge
1-21
Mixed Costs – An Example
If your fixed monthly utility charge is $40, your
variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours, what is
the amount of your utility bill?
Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100
1-22
Analysis of Mixed Costs
Account Analysis and the Engineering Approach
In account analysis, each account is
classified as either variable or fixed based
on the analyst’s knowledge of how
the account behaves.
The engineering approach classifies
costs based upon an industrial
engineer’s evaluation of production
methods, and material, labor, and
overhead requirements.
1-23
Scattergraph Plots – An Example
Assume the following hours of maintenance work
and the total maintenance costs for six months.
1-24
The Scattergraph Method
Plot the data points on a graph
(Total Cost Y vs. Activity X).
Scattergraph Method
Y
Total Maintenance Cost
$10,000
$9,500
$9,000
$8,500
$8,000
$7,500
X
$7,000
400
500
600
700
Hours of Maintenance
800
900
1-25
The High-Low Method – An Example
The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.
$2,400
= $6.00/hour
400
1-26
The High-Low Method – An Example
Total Fixed Cost = Total Cost – Total Variable Cost
Total Fixed Cost = $9,800 – ($6/hour × 850 hours)
Total Fixed Cost = $9,800 – $5,100
Total Fixed Cost = $4,700
1-27
The High-Low Method – An Example
The Cost Equation for Maintenance
Y = $4,700 + $6.00X
1-28
Least-Squares Regression Method
A method used to analyze mixed costs if a
scattergraph plot reveals an approximately linear
relationship between the X and Y variables.
This method uses all of the
data points to estimate
the fixed and variable
cost components of a
mixed cost. The goal of this method is
to fit a straight line to the
data that minimizes the
sum of the squared errors.
1-29
Least-Squares Regression Method
Software can be used to fit a regression line
through the data points.
The cost analysis objective is the same:
Y = a + bX
Least-squares regression also provides a statistic,
called the R2, which is a measure of the goodness
of fit of the regression line to the data points.
1-30
Comparing Results From
the Two Methods
The two methods just discussed provide
different estimates of the fixed and variable cost
components of a mixed cost.
This is to be expected because each method
uses differing amounts of the data points to
provide estimates.
Least-squares regression provides the most
accurate estimate because it uses all the data
points.
1-31
The Traditional and Contribution Formats
Used primarily for
external reporting.
Used primarily by
management.
1-32
Uses of the Contribution Format
The contribution income statement format is used
as an internal planning and decision-making tool.
We will use this approach for:
1.Cost-volume-profit analysis (Chapter 5).
2.Budgeting (Chapter 7).
3.Segmented reporting of profit data (Chapter 6).
4.Special decisions such as pricing and make-orbuy analysis (Chapter 10).
1-33
Assigning Costs to Cost Objects
Direct costs
Indirect costs
• Costs that can be
easily and
conveniently traced
to a unit of product
or other cost object.
• Costs that cannot
be easily and
conveniently traced
to a unit of product
or other cost object.
• Examples: direct
material and direct
labor
• Example:
manufacturing
overhead
1-34
Cost Classifications for Decision Making
Every decision involves a choice
between at least two alternatives.
Only those costs and benefits that
differ between alternatives are relevant
in a decision. All other costs and
benefits can and should be ignored as
irrelevant.
1-35
Differential Cost and Revenue
Costs and revenues that differ among alternatives.
Example: You have a job paying $1,500 per month in
your hometown. You have a job offer in a neighboring
city that pays $2,000 per month. The commuting cost
to the city is $300 per month.
Differential revenue is:
$2,000 – $1,500 = $500
Differential cost is:
$300
1-36
Opportunity Cost
The potential benefit that is
given up when one alternative
is selected over another.
Example: If you were
not attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college for
one year is $15,000.
1-37
Sunk Costs
Sunk costs have already been incurred and cannot
be changed now or in the future. These costs
should be ignored when making decisions.
Example: Suppose you had purchased gold for
$400 an ounce, but now it is selling for $250 an
ounce. Should you wait for the gold to reach $400 an
ounce before selling it? You may say, “Yes” even
though the $400 purchase is a sunk cost.
1-38
Summary of the Types of Cost
Classifications
Financial
Reporting
Predicting Cost
Behavior
Assigning Costs
to Cost Objects
Making Business
Decisions
1-39
End of Chapter 01
1-40
Job-Order Costing
Chapter 02
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Job-Order Costing: An Overview
Job-order costing systems are
used when:
1.Many different products are produced each
period.
2.Products are manufactured to order.
3.The unique nature of each order requires
tracing or allocating costs to each job, and
maintaining cost records for each job.
2-2
Job-Order Costing: An Overview
Examples of companies that
would use job-order costing include:
1.Boeing (aircraft manufacturing)
2.Bechtel International (large-scale construction)
3.Walt Disney Studios (movie production)
2-3
Job-Order Costing – An Example
Direct Materials
Job No. 1
Direct Labor
Job No. 2
Job No. 3
Charge
direct
material and
direct labor
costs to
each job as
work is
performed.
2-4
Job-Order Costing – An Example
Direct Materials
Job No. 1
Direct Labor
Manufacturing
Overhead
Job No. 2
Job No. 3
Manufacturing
Overhead,
including
indirect
materials and
indirect labor,
are allocated
to all jobs
rather than
directly traced
to each job.
2-5
The Job Cost Sheet
PearCo Job Cost Sheet
Job Number A – 143
Department B3
Item Wooden cargo crate
Date Initiated 3-4-11
Date Completed
Units Completed
Direct Materials
Direct Labor
Manufacturing Overhead
Req. No. Amount Ticket Hours Amount Hours
Rate
Amount
Cost Summary
Direct Materials
Direct Labor
Manufacturing Overhead
Total Cost
Unit Product Cost
Units Shipped
Date Number Balance
2-6
Measuring Direct Materials Cost
Will E. Delite
2-7
Measuring Direct Materials Cost
2-8
Measuring Direct Labor Costs
2-9
Job-Order Cost Accounting
2-10
Why Use an Allocation Base?
An allocation base, such as direct labor-hours,
direct labor dollars, or machine-hours, is used to
assign manufacturing overhead to individual jobs.
We use an allocation base because:
a.It is impossible or difficult to trace overhead costs to particular
jobs.
b.Manufacturing overhead consists of many different items ranging
from the grease used in machines to the production manager’s
salary.
c.Many types of manufacturing overhead costs are fixed even
though output fluctuates during the period.
2-11
Manufacturing Overhead Application
The predetermined overhead rate (POHR) used to apply
overhead to jobs is determined before the period begins.
POHR =
Estimated total manufacturing
overhead cost for the coming period
Estimated total units in the
allocation base for the coming period
Ideally, the allocation base
is a cost driver that causes
overhead.
2-12
The Need for a POHR
Predetermined overhead rates rely upon
estimated data because…
Actual
overhead for
the period is
not known until
the end of the
period.
Actual
overhead costs
can fluctuate
seasonally,
thus misleading
decision
makers.
2-13
Computing Predetermined Overhead
Rates
The predetermined overhead rate is computed before the period begins
using a four-step process.
1. Estimate the total amount of the allocation base (the denominator)
that will be required for next period’s estimated level of production.
2. Estimate the total fixed manufacturing overhead cost for the coming
period and the variable manufacturing overhead cost per unit of the
allocation base.
3. Use the following equation to estimate the total amount of
manufacturing overhead: Y = a + bX
Where,
Y = The estimated total manufacturing overhead cost
a = The estimated total fixed manufacturing overhead cost
b = The estimated variable manufacturing overhead cost
per unit of the allocation base
X = The estimated total amount of the allocation base.
4. Compute the predetermined overhead rate.
2-14
Overhead Application Rate
PearCo estimates that it will require 160,000 direct labor-hours to meet the
coming period’s estimated production level. In addition, the company
estimates total fixed manufacturing overhead at $200,000, and variable
manufacturing overhead costs of $2.75 per direct labor-hour.
Y = a + bX
Y = $200,000 + ($2.75 per direct labor-hour × 160,000 direct laborhours)
Y = $200,000 + $440,000
Y = $640,000
POHR =
$640,000 estimated total manufacturing overhead
160,000 estimated direct labor-hours (DLH)
POHR = $4.00 per direct labor-hour
2-15
Job-Order Cost Accounting
2-16
Job-Order Cost Accounting
2-17
Job-Order Cost Accounting
2-18
Learning Objectives 4 and 5
Learning Objective 4 is to
understand the flow of costs in
the job-order costing system and
prepare appropriate journal
entries to record costs.
Learning Objective 5 is to use
T-accounts to show the flow of
costs in a job-order costing
system.
2-19
Key Definitions
1. Raw materials include any materials that go
into the final product.
2. Work in process consists of units of production
that are only partially complete and will require
further work before they are ready for sale to
customers.
3. Finished goods consist of completed units of
product that have not been sold to customers.
4. Cost of goods manufactured include the
manufacturing costs associated with the goods
that were finished during the period.
2-20
Flow of Costs: A Conceptual Overview
Costs
Balance Sheet
Inventories
Material Purchases
Raw Materials
Direct Labor
Work in
Process
Manufacturing
Overhead
Selling and
Administrative
Finished
Goods
Period Costs
Income
Statement
Expenses
Cost of
Goods
Sold
Selling and
Administrative
2-21
Job-Order Costing: The Flow of Costs
The transactions
(in T-account and
journal entry form)
that capture the
flow of costs in a
job-order costing
system are
illustrated on the
following slides.
2-22
The Purchase and Issue of Raw
Materials: T-Account Form
Raw Materials
Material ⚫Direct
Purchases Materials
⚫Indirect
Materials
⚫
Work in Process
(Job Cost Sheet)
Direct
Materials
⚫
Mfg. Overhead
Actual Applied
⚫Indirect
Materials
2-23
Cost Flows – Material Purchases
On October 1, Smith Corporation had $5,000 in raw
materials on hand. During the month, the company
purchased $45,000 in raw materials.
(1)
Raw Materials
Accounts Payable
45,000
45,000
2-24
Issue of Direct and Indirect Materials
On October 3, Smith had $43,000 in raw materials
requisitioned from the storeroom for use in production.
These raw materials included $40,000 of direct and $3,000
of indirect materials.
(2)
Work in Process
Manufacturing Overhead
Raw Materials
40,000
3,000
43,000
2-25
Labor Costs
Salaries and
Wages Payable
Direct
Labor
⚫Indirect
Labor
⚫
Work in Process
(Job Cost Sheet)
Direct
Materials
⚫Direct
Labor
⚫
Mfg. Overhead
Actual
⚫Indirect
Materials
⚫Indirect
Labor
Applied
2-26
Labor Costs
During the month the employee time tickets included
$35,000 of direct labor and $12,000 for indirect labor.
(3)
Work in Process
Manufacturing Overhead
Salaries and Wages Payable
35,000
12,000
47,000
2-27
Recording Actual Manufacturing Overhead
Salaries and
Wages Payable
Direct
Labor
⚫Indirect
Labor
⚫
Work in Process
(Job Cost Sheet)
Direct
Materials
⚫Direct
Labor
⚫
Mfg. Overhead
Actual Applied
⚫Indirect
Materials
⚫Indirect
Labor
⚫Other
Overhead
2-28
Recording Actual Manufacturing Overhead
During the month the company incurred the following
actual overhead costs:
1. Utilities (heat, water, and power) $1,700
2. Depreciation of factory equipment $2,900
3. Property taxes payable on factory $1,000
(4)
Manufacturing Overhead
Utilities Payable
Accumulated Depreciation
Property Taxes Payable
5,600
1,700
2,900
1,000
2-29
Applying Manufacturing Overhead
Salaries and
Wages Payable
Direct
Labor
⚫Indirect
Labor
⚫
Mfg. Overhead
Actual Applied
⚫Indirect
Materials ⚫Overhead
⚫Indirect
Applied to
Labor
Work in
⚫Other
Process
Overhead
Work in Process
(Job Cost Sheet)
Direct
Materials
⚫Direct
Labor
⚫Overhead
Applied
⚫
If actual and applied
manufacturing overhead
are not equal, a year-end
adjustment is required.
2-30
Applying Manufacturing Overhead
Smith uses a predetermined overhead rate of $3.50 per
machine-hour. During the month, 5,000 machine-hours
were worked on jobs.
(5)
Work in Process
Manufacturing Overhead
17,500
17,500
(5,000 machine-hours × $3.50 = $17,500)
2-31
Accounting for Nonmanufacturing Cost
Nonmanufacturing costs are not assigned to
individual jobs, rather they are expensed in the
period incurred.
Examples:
1.
Salary expense of employees
who work in a marketing, selling,
or administrative capacity.
2.
Advertising expenses are expensed
in the period incurred.
2-32
Accounting for Nonmanufacturing Cost
During the month, Smith incurred but has not paid sales
salaries of $2,000, and advertising expense of $750.
(6)
Salaries Expense
Advertising Expense
Salaries Payable
Accounts Payable
2,000
750
2,000
750
2-33
Transferring Completed Units
Work in Process
(Job Cost Sheet)
Direct
Materials
⚫Direct
Labor
⚫Overhead
Applied
⚫
Finished Goods
Cost of
Goods
Mfd.
⚫
Cost of
Goods
Mfd.
⚫
2-34
Transferring Completed Units
During the period, Smith completed jobs with a total cost of
$27,000.
(9)
Finished Goods
Work in Process
27,000
27,000
2-35
Transferring Units Sold
Work in Process
(Job Cost Sheet)
Direct
Materials
⚫Direct
Labor
⚫Overhead
Applied
⚫
Finished Goods
Cost of
Goods
Mfd.
⚫
Cost of
Goods
Mfd.
⚫
Cost of
Goods
Sold
⚫
Cost of Goods Sold
Cost of
Goods
Sold
⚫
2-36
Transferring Units Sold
Smith sold the $27,000 in finished goods inventory to
customers for $43,500 on account.
(10)
Accounts Receivable
Sales
43,500
Cost of Goods Sold
Finished Goods
27,000
43,500
27,000
2-37
Schedule of Cost of Goods Manufactured:
Key Concepts
This schedule contains three
types of costs, namely direct
materials, direct labor, and
manufacturing overhead.
It calculates the cost of raw
material and direct labor used in
production and the amount of
manufacturing overhead
applied to production.
It calculates the
manufacturing
costs associated
with goods that
were finished
during the
period.
2-38
Product Cost Flows
Raw Materials
Beginning raw
materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production
– Ending raw materials
inventory
= Raw materials used
in production
Manufacturing
Costs
Work
In Process
Direct materials
As items are removed from raw
materials inventory and placed into
the production process, they are
called direct materials.
2-39
Product Cost Flows
Raw Materials
Beginning raw
materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production
– Ending raw materials
inventory
= Raw materials used
in production
Manufacturing
Costs
Work
In Process
Direct materials
+ Direct labor
+ Mfg. overhead applied
= Total manufacturing
costs
Conversion
costs are costs
incurred to
convert the
direct material
into a finished
product.
2-40
Product Cost Flows
Raw Materials
Beginning raw
materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production
– Ending raw materials
inventory
= Raw materials used
in production
Manufacturing
Costs
Work
In Process
Direct materials
+ Direct labor
+ Mfg. overhead applied
= Total manufacturing
costs
Beginning work in
process inventory
+ Total manufacturing
costs
= Total work in
process for the
period
All manufacturing costs added to
production during the period are
added to the beginning balance of
work in process.
2-41
Product Cost Flows
Raw Materials
Manufacturing
Costs
Beginning raw
Direct materials
materials inventory
+ Direct labor
+ Raw materials
+ Mfg. overhead applied
purchased
= Total manufacturing
= Raw materials
costs
available for use
in production
– Ending raw materials
inventory
= Raw materials used
in production
Costs
associated with the goods that
are completed during the period are
transferred to finished goods
inventory.
Work
In Process
Beginning work in
process inventory
+ Total manufacturing
costs
= Total work in
process for the
period
– Ending work in
process inventory
= Cost of goods
manufactured
2-42
Product Cost Flows
Work
In Process
Beginning work in
process inventory
+ Manufacturing costs
for the period
= Total work in process
for the period
– Ending work in
process inventory
= Cost of goods
manufactured
Finished Goods
Beginning finished
goods inventory
+ Cost of goods
manufactured
= Cost of goods
available for sale
– Ending finished
goods inventory
Cost of goods
sold
2-43
Underapplied and Overapplied
Overhead―A Closer Look
The difference between the overhead cost applied to
Work in Process and the actual overhead costs of a
period is referred to as either underapplied or
overapplied overhead.
Underapplied overhead
exists when the amount of
overhead applied to jobs
during the period using the
predetermined overhead
rate is less than the total
amount of overhead actually
incurred during the period.
Overapplied overhead
exists when the amount of
overhead applied to jobs
during the period using the
predetermined overhead
rate is greater than the total
amount of overhead actually
incurred during the period.
2-44
Overhead Application Example
PearCo’s actual overhead for the year was
$650,000 with a total of 170,000 direct labor-hours
worked on jobs.
How much total overhead was applied to PearCo’s
jobs during the year? Use PearCo’s
predetermined overhead rate of $4.00 per direct
labor-hour.
Overhead Applied During the Period
Applied Overhead = POHR × Actual Direct Labor-Hours
Applied Overhead = $4.00 per DLH × 170,000 DLH = $680,000
2-45
Overhead Application Example
PearCo’s actual overhead for the year was
$650,000 with a total of 170,000 direct labor-hours
worked on jobs.
How much
overhead was applied to PearCo’s
PearCo
hastotal
overapplied
jobsforduring
the year? Use PearCo’s
overhead
the year
overhead
rate of $4.00 per direct
bypredetermined
$30,000. What
will
PearCo do? labor-hour.
Overhead Applied During the Period
Applied Overhead = POHR × Actual Direct Labor-Hours
Applied Overhead = $4.00 per DLH × 170,000 DLH = $680,000
2-46
Disposition of Under- or Overapplied
Overhead
PearCo’s Cost
of Goods Sold
Actual Overhead
overhead applied
costs
to jobs
Unadjusted
Balance
$30,000
Adjusted
Balance
PearCo’s
Mfg. Overhead
$650,000
$680,000
$30,000
$30,000
overapplied
2-47
Multiple Predetermined Overhead Rates
To this point, we have assumed that there is a single
predetermined overhead rate called a plantwide
overhead rate.
Large companies
often use multiple
predetermined
overhead rates.
May be more complex
but . . .
May be more accurate because
it reflects differences across
departments.
2-48
Job-Order Costing in Service Companies
Job-order costing is used in many different
types of service companies.
2-49
End of Chapter 02
2-50
Activity-Based Costing
Chapter 03
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Assigning Overhead Costs to Products
When cost systems were developed in the 1800s, the
emphasis was on simplicity because:
1. Cost and activity data had to be collected by
hand and all calculations were done with paper
and pencil.
2. Most companies produced a limited variety of
similar products, so there was little difference
in the overhead costs consumed by each
product.
3-2
Plantwide Overhead Rate
Plantwide Overhead Rate
A single overhead rate used
throughout an entire factory.
Direct labor has often been used as the allocation
base for overhead because:
1.
Direct labor information was already being recorded.
2.
Direct labor was a large component of product costs.
3.
Managers believed direct labor and overhead costs
were highly correlated.
3-3
Plantwide Overhead Rate
Today, direct labor may no longer be a satisfactory base
for allocation of overhead.
1. Most companies sell a large variety of products that
consume differing amounts of overhead.
2. As a percentage of total costs, direct labor has been
shrinking and overhead has been increasing. Many of
these growing overhead costs may not be correlated
with direct labor.
3. Technology advancements have reduced the cost and
complexity of gathering diverse sources of data.
A plantwide overhead allocation system may not be optimal
for many companies in today’s business environment.
3-4
Departmental Overhead Rates
Many companies have a system in which each
department has its own overhead rate.
Machining Department
Assembly Department
Shipping Department
The allocation base depends
on the nature of the work
performed in each department.
In the machining department,
overhead may be based on
machine-hours, but in the
assembly department,
overhead may be based on
labor-hours.
3-5
Departmental Overhead Rates
Departmental rates will not correctly assign overhead
in situations where a company has a range of
products and complex overhead costs.
The departmental approach relies
exclusively on volume-related allocation bases while
some overhead costs may be caused by factors
that are not related to the volume of production.
Activity-based costing is required to account for
these other factors.
3-6
Activity-Based Costing (ABC)
A number of allocation bases are used
for assigning costs to products.
3-7
Activity-Based Costing (ABC)
Cost Objects
(e.g., products and customers)
Activities
Consumption of Resources
Cost
3-8
Activity-Based Costing (ABC)
An event that causes
the consumption of
overhead resources
Activity
Examples of Activities
Setting up
machines
Admitting
hospital
patients
Billing
customers
Opening a
bank account
3-9
Activity-Based Costing (ABC)
Activity
Cost Pool
A “cost bucket” in which
costs related to a particular
activity are accumulated.
Activity
Measure
Expresses how much of the
activity is carried out and is
used as the allocation base
for applying overhead costs.
Activity
Rate
A predetermined overhead
rate for each activity
cost pool.
3-10
Activity-Based Costing (ABC)
For each activity in
isolation, this system works exactly
like the job-order costing system
described in Chapter 2.
A predetermined overhead rate is computed for
each activity and then applied to jobs and
products based on the amount of activity
consumed by the job or product.
3-11
Designing an Activity-Based
Costing System
The challenge is to select a reasonably
small number of activities that explain the
bulk of the variation in overhead costs.
Activities are usually chosen by interviewing a
broad range of managers to find out what
activities they think consume most of the
organization’s resources.
3-12
Designing an Activity-Based
Costing System
Related activities are
frequently combined to reduce
the amount of detail and
record-keeping costs.
For example, several actions may
be involved in handling and moving
raw materials, but these may be
combined into a single activity
titled material handling.
An activity dictionary defines each of the activities
that will be included in the activity-based costing
system and how the activities will be measured.
3-13
Hierarchy of Activities
Level
Activities
Activity Measure
Unit-level
Processing units on machines
Processing units by hand
Consuming factory supplies
Machine-hours
Direct labor-hours
Units produced
Batch-level
Processing purchase orders
Processing production orders
Setting up equipment
Handling materials
Purchase orders processed
Production orders processed
Number of setups
Pounds of material handled
Product-level
Testing new products
Administering parts inventories
Designing products
Hours of testing time
Number of part types
Hours of design time
Facility-level
General factory administration
Plant building and grounds
Direct labor-hours
Direct labor-hours
3-14
Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs
First-Stage Cost Assignment
Labor
Related Pool
Machine
Related Pool
Setup
Pool
Production
Order Pool
Parts
Admin. Pool
General
Factory Pool
3-15
Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs
First-Stage Cost Assignment
Labor
Related Pool
Machine
Related Pool
Setup
Pool
Production
Order Pool
Parts
Admin. Pool
General
Factory Pool
Second-Stage Allocations
$/DLH
$/MH
$/Setup
$/Order
$/Part Type
$/MH
Products
Unit-Level
Activity
Batch-Level
Activity
Product-Level Facility-Level
Activity
Activity 3-16
Using Activity-Based Costing
Comtek Sound, Inc.
 Comtek Sound, Inc., makes two products: CD players
and DVD players.
 The company has been losing bids to supply CD
players to lower-priced competitors.
 The company has been winning all bids to supply
DVD players.
3-17
Using Activity-Based Costing
Comtek Sound, Inc.
 For the current year, Comtek has budgeted sales
of 50,000 DVD units and 200,000 CD units.
 Comtek’s traditional cost system applies
manufacturing overhead to products based on directlabor hours.
 Both products require two direct labor-hours to
complete, for a total of 500,000 direct labor-hours.
Hours
DVDs: 50,000 units @ 2 hours per unit = 100,000
CDs: 200,00 units @ 2 hours per unit = 400,000
Total direct labor-hours
500,000
3-18
Using Activity-Based Costing
Comtek Sound, Inc.
 Unit costs for materials and labor are:
Direct materials
Direct labor
DVD
Units
$ 90
$ 20
CD
Units
$ 50
$ 20
3-19
Direct Labor-Hours as a Base
Total manufacturing overhead costs for the
current year are estimated to be $10,000,000.
The company develops the following overhead
rate based upon labor-hours:
Predetermined
$10,000,000
=
overhead rate
500,000 DLHs
= $20 per DLH
3-20
Direct Labor-Hours as a Base
Since each product requires two hours of
direct labor, $40 of overhead is assigned to
each product.
Direct materials
Direct labor
Manufacturing overhead
DVD Unit
$
90
20
40
CD Unit
$
50
20
40
$
$
(2 DLHs x $20 per DLH)
Unit product cost
150
110
3-21
Computing Activity Rates
The ABC project team at Comtek has
developed the following basic information.
Activity and Activity Measures
Estimated
Overhead
Cost
Labor-related (DLH)
$ 800,000
Machine-related (MH)
2,100,000
Machine setups (setups)
1,600,000
Production orders (orders)
3,150,000
Parts administration (part types)
350,000
General factory (MH)
2,000,000
$ 10,000,000
Total
500,000
1,000,000
4,000
1,200
700
1,000,000
Expected Activity
DVD
100,000
300,000
3,000
800
400
300,000
CD
400,000
700,000
1,000
400
300
700,000
3-22
Computing Activity Rates
Activity and Activity Measures
Labor-related (DLHs)
Machine-related (MHs)
Machine setups (setups)
Production orders (orders)
Parts administration (part types)
General factory (MHs)
Estimated
Overhead
Cost
$
800,000
2,100,000
1,600,000
3,150,000
350,000
2,000,000
$ 10,000,000
÷
÷
÷
÷
÷
÷
Total
Expected
Activity
Activity Rate
500,000 = $
1.60 per DLH
1,000,000 =
2.10 per MH
4,000 =
400.00 per setup
1,200 = 2,625.00 per order
700 =
500.00 per part type
1,000,000 =
2.00 per MH
We can calculate an activity rate for each of the six activities
by dividing the estimated overheard for an activity by the
total expected activity.
3-23
Computing Overhead Cost per Unit
DVD Units
Expected
Activity
Activity and Activity Measures
Activity
Rate
Amount
Labor-related (DLHs)
100,000 × $ 1.60 = $ 160,000
Machine-related (MHs)
300,000 ×
2.10 =
630,000
Machine setups (setups)
3,000 ×
400.00 = 1,200,000
Production orders (orders)
800 × 2,625.00 = 2,100,000
Parts administration (part types)
400 ×
500.00 =
200,000
General factory (MHs)
300,000 ×
2.00 =
600,000
Total overhead cost assigned
$ 4,890,000
Number of units produced
50,000
Overhead cost per unit
$
97.80
3-24
Computing Overhead Cost per Unit
CD Units
Expected
Activity
Activity and Activity Measures
Activity
Rate
Amount
Labor-related (DLHs)
400,000 × $
1.60 = $ 640,000
Machine-related (MHs)
700,000 ×
2.10 = 1,470,000
Machine setups (setups)
1,000 ×
400.00 =
400,000
Production orders (orders)
400 × 2,625.00 = 1,050,000
Parts administration (part types)
300 ×
500.00 =
150,000
General factory (MHs)
700,000 ×
2.00 = 1,400,000
Total overhead cost assigned
$ 5,110,000
Number of units produced
200,000
Overhead cost per unit
$
25.55
3-25
Comparing the Two Approaches
Activity-Based Costing
DVD Unit
CD Unit
Direct material
$ 90.00 $
50.00
Direct labor
20.00
20.00
Manufacturing overhead
97.80
25.55
Unit product cost
$ 207.80 $
95.55
Direct Labor Costing
DVD Unit
CD Unit
$ 90.00 $
50.00
20.00
20.00
40.00
40.00
$ 150.00 $
110.00
Note that the unit product cost of a CD
unit decreased from $110 to $95.55 . . . .
. . . . while the unit cost of a DVD unit
increased from $150 to $207.80.
3-26
Comparing the Two Approaches
Activity-Based Costing
DVD Unit
CD Unit
Direct material
$ 90.00 $
50.00
Direct labor
20.00
20.00
Manufacturing overhead
97.80
25.55
Unit product cost
$ 207.80 $
95.55
Direct Labor Costing
DVD Unit
CD Unit
$ 90.00 $
50.00
20.00
20.00
40.00
40.00
$ 150.00 $
110.00
The ABC system assigns $14.45
less overhead than the traditional
system to each CD player.
3-27
Comparing the Two Approaches
Activity-Based Costing
DVD Unit
CD Unit
Direct material
$ 90.00 $
50.00
Direct labor
20.00
20.00
Manufacturing overhead
97.80
25.55
Unit product cost
$ 207.80 $
95.55
Direct Labor Costing
DVD Unit
CD Unit
$ 90.00 $
50.00
20.00
20.00
40.00
40.00
$ 150.00 $
110.00
The ABC system assigns $57.80
more overhead than the traditional
system to each DVD player.
3-28
Shifting of Overhead Cost
Activity-Based Costing
DVD Unit
CD Unit
Direct material
$ 90.00 $
50.00
Direct labor
20.00
20.00
Manufacturing overhead
97.80
25.55
Unit product cost
$ 207.80 $
95.55
Direct Labor Costing
DVD Unit
CD Unit
$ 90.00 $
50.00
20.00
20.00
40.00
40.00
$ 150.00 $
110.00
Low-volume product
When a company implements activity-based costing,
overhead cost often shifts from high-volume to lowvolume products with a higher unit product cost
resulting for the low-volume products.
3-29
Shifting of Overhead Cost
Activity-Based Costing
DVD Unit
CD Unit
Direct material
$ 90.00 $
50.00
Direct labor
20.00
20.00
Manufacturing overhead
97.80
25.55
Unit product cost
$ 207.80 $
95.55
Direct Labor Costing
DVD Unit
CD Unit
$ 90.00 $
50.00
20.00
20.00
40.00
40.00
$ 150.00 $
110.00
High-volume product
The traditional system assigns the same amount
of all overhead costs to each CD or DVD player
($40 per unit).
3-30
Shifting of Overhead Cost
Production Orders Activity Cost Pool
(a batch-level cost pool)
The ABC system assigns different amounts of
Production Order-related overhead costs to each product.
This fact can be illustrated in a two-step process.
1. Compute the number of units processed
per production order for each product.
Number of units produced per year
Number of production orders issued per year
Number of units processed per production order
DVD Units
50,000
800
62.5
CD Units
200,000
400
500
3-31
Shifting of Overhead Cost
2. Compute production order cost per unit for each product.
Cost to issue a production order
Average number of units processed per
production order
Production order cost per unit
DVD Units CD Units
$
2,625 $
2,625
$
62.5
42.00 $
500
5.25
Notice, the costs are being shifted from the highvolume CD players to the low-volume DVD players.
3-32
Targeting Process Improvements
An ABC system can help identify
areas where the company can benefit
from improving its current processes.
Activity-Based Management
Focuses on managing activities to eliminate
waste and reduce delays and defects.
3-33
Targeting Process Improvements
The first step in any improvement
program is deciding what to improve.
The Theory of Constraints
approach targets the
highest impact
improvement opportunities.
Activity rates can be
used to target areas
where costs seem
excessively high.
Benchmarking can be used to compare activity cost
information with world-class standards of performance
achieved by other organizations.
3-34
Benefits of Activity-Based Costing
ABC improves the accuracy of product costing by:
1. Increasing the number of cost pools used to accumulate
overhead costs.
2. Using activity cost pools that are more homogeneous
than departmental cost pools.
3. Assigning overhead costs using activity measures that
cause those costs, rather than relying solely on direct
labor hours.
Activity-based costing also highlights activities
that could benefit most from process
improvement efforts, such as Six Sigma.
3-35
Limitations of Activity-Based Costing
Costs of implementing an ABC system may outweigh
the benefits. However, the benefits are more likely to be
worth the costs when:
1. Products differ substantially in volume, batch size, and in
activities required.
2. Conditions have changed substantially since the existing
cost system was established.
3. Overhead costs are high and increasing and no one seems
to understand why.
4. Management does not trust the existing cost system and it
ignores data from it when making decisions.
3-36
Activity-Based Costing
Critical Assumption
The cost in each activity pool is strictly
proportional to its activity measure. When this
assumption is violated, the accuracy of ABC
data can be called into question.
For example, managers should be particularly
alert to product costs that contain allocated
facility-level costs.
3-37
Modifying the ABC Model
The illustrations in the chapter assume
that ABC is being used for external reporting
purposes. If the system is used for internal
decision-making purposes, two important
modifications should be made:
1. Selling and administrative costs should be
assigned to products, where appropriate.
2. Facility-level costs should be removed
from product costs.
3-38
End of Chapter 03
3-39
Process Costing
Chapter 04
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Processing Departments
Any unit in an organization where materials, labor,
or overhead are added to the product.
The activities performed in a processing
department are performed uniformly on all
units of production. Furthermore, the output of
a processing department must be homogeneous.
Products in a process costing environment
typically flow in a sequence from one department
to another.
4-2
Comparing Job-Order and Process
Costing
Direct
Materials
Direct Labor
Manufacturing
Overhead
Costs are traced and
applied to departments
in a process cost
system.
Processing
Department
Finished
Goods
Cost of
Goods
Sold
4-3
Process Cost Flows: The Flow of
Raw Materials (in T-account form)
Raw Materials
•Direct
Materials
Work in Process
Department A
•Direct
Materials
Work in Process
Department B
•Direct
Materials
4-4
Process Cost Flows: The Flow of
Labor Costs (in T-account form)
Salaries and
Wages Payable
•Direct
Labor
Work in Process
Department A
•Direct
Materials
•Direct
Labor
Work in Process
Department B
•Direct
Materials
•Direct
Labor
4-5
Process Cost Flows: The Flow of Manufacturing
Overhead Costs (in T-account form)
Work in Process
Department A
Manufacturing
Overhead
•Actual
Overhead
•Overhead
Applied to
Work in
Process
•Direct
Materials
•Direct
Labor
•Applied
Overhead
Work in Process
Department B
•Direct
Materials
•Direct
Labor
•Applied
Overhead
4-6
Process Cost Flows: Transfers from WIP-Dept.
A to WIP-Dept. B (in T-account form)
Work in Process
Department A
•Direct
Transferred
Materials
to Dept. B
•Direct
Labor
•Applied
Overhead
Department
A
Work in Process
Department B
•Direct
Materials
•Direct
Labor
•Applied
Overhead
•Transferred
from Dept. A
Department
B
4-7
Process Cost Flows: Transfers from WIP-Dept.
B to Finished Goods (in T-account form)
Work in Process
Department B
•Direct
•Cost of
Materials
Goods
•Direct
Manufactured
Labor
•Applied
Overhead
•Transferred
from Dept. A
Finished Goods
•Cost of
Goods
Manufactured
4-8
Process Cost Flows: Transfers from Finished
Goods to COGS (in T-account form)
Work in Process
Department B
Finished Goods
•Direct
•Cost of
•Cost of
•Cost of
Materials
Goods
Goods
Goods
•Direct
Manufactured
Manufactured
Sold
Labor
•Applied
Overhead
•Transferred
Cost of Goods Sold
from Dept. A
•Cost of
Goods
Sold
4-9
Equivalent Units of Production
Equivalent units are the
product of the number
of partially completed
units and the
percentage completion
of those units.
These partially completed units complicate the
determination of a department’s output for a given
period and the unit cost that should be assigned to
that output.
4-10
Equivalent Units – The Basic Idea
Two half-completed products are
equivalent to one complete product.
+
=
1
So, 10,000 units 70% complete
are equivalent to 7,000 complete units.
4-11
Equivalent Units of Production
Weighted-Average Method
The weighted-average method . . .
1. Makes no distinction between work done in prior
or current periods.
2. Blends together units and costs from prior and
current periods.
3. Determines equivalent units of production for a
department by adding together the number of
units transferred out plus the equivalent units in
ending Work in Process Inventory.
4-12
Treatment of Direct Labor
Dollar Amount
Direct
Materials
Conversion
Direct
Labor
Direct
Labor
Manufacturing
Overhead
Direct labor and
manufacturing
overhead may be
combined into
one classification
of product
cost called
conversion costs.
Type of Product Cost
4-13
Compute and Apply Costs
The formula for computing the cost per
equivalent unit is:
Cost per
equivalent =
unit
Cost of beginning
Work in Process + Cost added during
Inventory
the period
Equivalent units of production
4-14
Process Costing Using the
FIFO Method
Appendix 4A
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
FIFO vs. Weighted-Average Method
The FIFO method (generally considered more
accurate than the weighted-average method) differs
from the weighted-average method in two ways:
1. The computation of equivalent units.
2. The way in which the costs of beginning
inventory are treated.
4-16
Cost per Equivalent Unit – FIFO
The formula for computing the cost per
equivalent unit under FIFO method is:
Cost per
equivalent =
unit
Cost added during the period
Equivalent units of production
4-17
A Comparison of Costing Methods
In a lean production environment, FIFO and
weighted-average methods yield similar
unit costs.
When considering cost control, FIFO is
superior to weighted-average because it
does not mix costs of the current period with
costs of the prior period.
4-18
End of Chapter 04
4-19
Cost-Volume-Profit
Relationships
Chapter 05
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Basics of Cost-Volume-Profit Analysis
The contribution income statement is helpful to managers
in judging the impact on profits of changes in selling price,
cost, or volume. The emphasis is on cost behavior.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Sales (500 bicycles)
$
250,000
Less: Variable expenses
150,000
Contribution margin
100,000
Less: Fixed expenses
80,000
Net operating income
$
20,000
Contribution Margin (CM) is the amount remaining from
sales revenue after variable expenses have been deducted.
5-2
Basics of Cost-Volume-Profit Analysis
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Sales (500 bicycles)
$
250,000
Less: Variable expenses
150,000
Contribution margin
100,000
Less: Fixed expenses
80,000
Net operating income
$
20,000
CM is used first to cover fixed expenses. Any
remaining CM contributes to net operating income.
5-3
The Contribution Approach
If RBC sells 400 units in a month, it will be
operating at the break-even point.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (400 bicycles)
$
200,000
$
500
Less: Variable expenses
120,000
300
Contribution margin
80,000
$
200
Less: Fixed expenses
80,000
Net operating income
$
–
5-4
CVP Relationships in Equation Form
This equation can be used to show the profit
RBC earns if it sells 401. Notice, the answer of
$200 mirrors our earlier solution.
Profit = (Sales – Variable expenses) – Fixed expenses
$80,000
401 units × $500
401 units × $300
Profit = ($200,500 – $120,300) – $80,000
$200 = ($200,500 – $120,300) – $80,000
5-5
Preparing the CVP Graph
Break-even point
(400 units or $200,000 in sales)
$350,000
Profit Area
$300,000
$250,000
$200,000
Sales
Total expenses
Fixed expenses
$150,000
$100,000
$50,000
$0
0
Loss Area
100
200
300
400
500
600
Units
5-6
Contribution Margin Ratio (CM Ratio)
The CM ratio is calculated by dividing the total
contribution margin by total sales.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bicycles)
$ 250,000
$ 500
Less: Variable expenses
150,000
300
Contribution margin
100,000
$ 200
Less: Fixed expenses
80,000
Net operating income
$
20,000
CM Ratio
100%
60%
40%
$100,000 ÷ $250,000 = 40%
5-7
Contribution Margin Ratio (CM Ratio)
If Racing Bicycle increases sales from 400 to 500 bikes ($50,000),
contribution margin will increase by $20,000 ($50,000 × 40%).
Here is the proof:
400 Units
Sales
$ 200,000
Less: variable expenses 120,000
Contribution margin
80,000
Less: fixed expenses
80,000
Net operating income
$
–
500 Units
$ 250,000
150,000
100,000
80,000
$ 20,000
A $50,000 increase in sales revenue results in a $20,000
increase in CM ($50,000 × 40% = $20,000).
5-8
Break-Even in Unit Sales:
Equation Method
Profits = Unit CM × Q – Fixed expenses
Suppose RBC wants to know how many
bikes must be sold to break-even
(earn a target profit of $0).
$0 = $200 × Q + $80,000
Profits are zero at the break-even point.
5-9
Break-Even in Unit Sales:
Formula Method
Let’s apply the formula method to solve for
the break-even point.
Unit sales to
=
break even
Fixed expenses
CM per unit
$80,000
Unit sales =
$200
Unit sales = 400
5-10
Break-Even in Dollar Sales:
Equation Method
Suppose Racing Bicycle wants to compute
the sales dollars required to break-even (earn
a target profit of $0). Let’s use the equation
method to solve this problem.
Profit = CM ratio × Sales – Fixed expenses
Solve for the unknown “Sales.”
5-11
Break-Even in Dollar Sales:
Formula Method
Now, let’s use the formula method to calculate the
dollar sales at the break-even point.
Dollar sales to
Fixed expenses
=
break even
CM ratio
$80,000
Dollar sales =
40%
Dollar sales = $200,000
5-12
The Margin of Safety in Dollars
The margin of safety in dollars is the excess
of budgeted (or actual) sales over the
break-even volume of sales.
Margin of safety in dollars = Total sales – Break-even sales
Let’s look at Racing Bicycle Company and
determine the margin of safety.
5-13
The Margin of Safety in Dollars
If we assume that RBC has actual sales of
$250,000, given that we have already determined
the break-even sales to be $200,000, the margin
of safety is $50,000 as shown.
Break-even
sales
400 units
Sales
$ 200,000
Less: variable expenses
120,000
Contribution margin
80,000
Less: fixed expenses
80,000
Net operating income
$
–
Actual sales
500 units
$ 250,000
150,000
100,000
80,000
$
20,000
5-14
Cost Structure and Profit Stability
There are advantages and disadvantages to high fixed cost
(or low variable cost) and low fixed cost (or high variable
cost) structures.
An advantage of a high fixed
cost structure is that income A disadvantage of a high fixed
will be higher in good years cost structure is that income
compared to companies
will be lower in bad years
with lower proportion of
compared to companies
fixed costs.
with lower proportion of
fixed costs.
Companies with low fixed cost structures enjoy greater
stability in income across good and bad years.
5-15
Operating Leverage
Operating leverage is a measure of how
sensitive net operating income is to percentage
changes in sales. It is a measure, at any given
level of sales, of how a percentage change in
sales volume will affect profits.
Degree of
operating leverage
Contribution margin
= Net operating income
5-16
End of Chapter 05
5-17
Variable Costing and
Segment Reporting: Tools
for Management
Chapter 06
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Overview of Variable and Absorption
Costing
Variable
Costing
Absorption
Costing
Direct Materials
Product
Costs
Direct Labor
Variable Manufacturing Overhead
Product
Costs
Fixed Manufacturing Overhead
Period
Costs
Variable Selling and Administrative Expenses
Fixed Selling and Administrative Expenses
Period
Costs
6-2
Unit Cost Computations
Harvey Company produces a single product with the
following information available:
6-3
Unit Cost Computations
Unit product cost is determined as follows:
Under absorption costing, all production costs, variable
and fixed, are included when determining unit product
cost. Under variable costing, only the variable
production costs are included in product costs.
6-4
Variable and Absorption Costing
Income Statements
Let’s assume the following additional information
for Harvey Company.
• 20,000 units were sold during the year at a price
of $30 each.
• There is no beginning inventory.
Now, let’s compute net operating
income using both absorption
and variable costing.
6-5
Variable Costing Contribution Format
All fixed
Income Statement
Variable
manufacturing
costs only.
manufacturing
overhead is
expensed.
Variable Costing
Sales (20,000 × $30)
Less variable expenses:
Variable cost of goods sold (20,000 × $10) $ 200,000
Variable selling & administrative
expenses (20,000 × $3)
60,000
Total variable expenses
Contribution margin
Less fixed expenses:
Fixed manufacturing overhead
$ 150,000
Fixed selling & administrative expenses 100,000
Net operating income
$ 600,000
260,000
340,000
250,000
$ 90,000
6-6
Absorption Costing Income
Statement
Unit product
cost.
Fixed manufacturing overhead deferred in
inventory is 5,000 units × $6 = $30,000.
6-7
Extended Comparisons of Income
Data Harvey Company – Year Two
6-8
Variable Costing Contribution Format
Income Statement
All fixed
Variable
manufacturing
costs only.
manufacturing
overhead is
expensed.
Variable Costing
Sales (30,000 × $30)
Less variable expenses:
Variable cost of goods sold (30,000 × $10)
Variable selling & administrative
expenses (30,000 × $3)
Total variable expenses
Contribution margin
Less fixed expenses:
Fixed manufacturing overhead
Fixed selling & administrative expenses
Net operating income
$ 900,000
$ 300,000
90,000
390,000
510,000
$ 150,000
100,000
250,000
$ 260,000
6-9
Absorption Costing Income
Statement
Unit product
cost.
Fixed manufacturing overhead released from
inventory is 5,000 units × $6 = $30,000.
6-10
Summary of Key Insights
6-11
Explaining Changes in Net Operating
Income
Variable costing income is only affected by
changes in unit sales. It is not affected by
the number of units produced. As a general
rule, when sales go up, net operating
income goes up, and vice versa.
Absorption costing income is influenced by
changes in unit sales and units of
production. Net operating income can be
increased simply by producing more units
even if those units are not sold.
6-12
Keys to Segmented Income
Statements
There are two keys to building
segmented income statements:
A contribution format should be used
because it separates fixed from variable
costs and it enables the calculation of a
contribution margin.
Traceable fixed costs should be separated
from common fixed costs to enable the
calculation of a segment margin.
6-13
Identifying Traceable Fixed Costs
Traceable fixed costs arise because of the existence of
a particular segment and would disappear over time if
the segment itself disappeared.
No computer
division means . . .
No computer
division manager.
6-14
Identifying Common Fixed Costs
Common fixed costs arise because of the
overall operation of the company and would
not disappear if any particular segment were
eliminated.
No computer
division but . . .
We still have a
company president.
6-15
Traceable Costs Can Become
Common Costs
It is important to realize that the traceable
fixed costs of one segment may be a
common fixed cost of another segment.
For example, the landing fee
paid to land an airplane at an
airport is traceable to the
particular flight, but it is not
traceable to first-class,
business-class, and
economy-class passengers.
6-16
Segment Margin
Profits
The segment margin, which is computed by subtracting the
traceable fixed costs of a segment from its contribution
margin, is the best gauge of the long-run profitability of a
segment.
Time
6-17
Common Costs and Segments
Common costs should not be arbitrarily allocated to segments
based on the rationale that “someone has to cover the
common costs” for two reasons:
1. This practice may make a profitable business segment appear
to be unprofitable.
2. Allocating common fixed costs forces managers to be held
accountable for costs they cannot control.
Segment
1
Segment
2
Segment
3
Segment
4
6-18
End of Chapter 06
6-19

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