Cost Accounting

Income Difference – Variable and Absorption Costing

Image Source: http://hoileongchan.blogspot.in/2012/07/absorption-vs-variable-costing-critical.html

Image Source: http://hoileongchan.blogspot.in/2012/07/absorption-vs-variable-costing-critical.html

Variable Costing (CM Approach)

Only variable costs of production are charged to WIP and expensed via COGS when the goods are sold (includes DM, DL, and variable MO).

However, fixed MO is treated as an operating expense and is not charged to WIP.

Instead, it is expensed in the period the cost is incurred. Therefore, all fixed MO is expensed each period regardless of the level of sales.

Absorption Costing (Traditional Approach)

Under this method, all costs of production including fixed MO are charged to WIP and expensed only when the goods are sold via the COGS account. Therefore, the fixed MO relating to units still in ending inventory at the year-end is not expensed until a later period when the goods are sold.

Therefore, net income can differ between the two methods because of the treatment of fixed MO. It is expensed in full under the Variable costing method. However under Absorption Costing, it is split between COGS (which means part ends up on the income statement) and ending inventory (which means part ends up on the Balance Sheet)

Income Effect on Both Methods Relative to the Levels of Sales and Production

If Sales = Production, then net income under both methods is the same.

If inventory levels are rising, (i.e., production is > sales), only part of the fixed MO will be expensed under absorption (relating to the units sold). The fixed MO relating to the unsold units still in ending inventory will remain on the Balance Sheet until a later period when the units are sold. However, under Variable Costing, all the fixed MO is expensed in the period it is incurred regardless of the level of sales. Therefore, total production expenses will be lower and net income higher under Absorption costing.

If inventory levels are falling (i.e., sales are greater than production), all the fixed overhead from the beginning inventory plus a significant portion from current production will be expensed via COGS under absorption costing. However, under variable costing, the most fixed overhead that can be expensed in a period is the amount actually incurred in that period. Therefore, total production costs expensed will be higher under absorption costing and net income will be lower.

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Cost Structure, Op Leverage, and Indifference Points

Cost Structure and Profit Stability
Which cost structure is more stable or more profitable?   A higher proportion of variable costs or a higher proportion of fixed costs?    
A higher proportion of fixed costs implies a lower proportion of variable costs and hence higher CM and CM ratio.     When sales are good, profits will increase faster with a higher CM ratio and higher fixed costs relative to variable costs.   However, in  a downturn, variable costs can be shut off whereas fixed costs cannot.    Therefore a higher proportion of fixed costs will lead to higher financial risk.    As a result, if sales volumes are widely variable from year to year, a lower CM ratio and a higher proportion of  variable costs would lead to lower losses in bad years.     Hence, there is a trade off here between profitability and risk and each business has to look at its own future sales prospects to determine which cost structure is best.
Operating Leverage
Operating leverage is a multiplier tool to measure how sensitive income is to a percentage change in sales. 
It is measured as follows:      Degree of OL  =    CM
                                                                            Op Inc.
                                                                        =  # of times
If  CM = $40,000 and Op Inc. = $10,000,  then the Degree of OL = 4 times
That means that if sales increase by  10%, then Op Inc will increase  4 x 10%  or  40%. or .4 x 10,000 = $4,000.   Since Op Inc was $10,000, that means that the projected Op Inc. would be  $10,000 + $4,000 = $14,000, or $10,000 x 1.40 = $14,000.
 
Companies with higher OL multipliers are companies with a higher proportion of fixed costs (and hence higher CM ratios.    The effect of OL is greatest near the BE pt.   Therefore, near the BE point, a small increase  in sales will have a fairly dramatic increase in  Op. Inc.     Conversely, a small decrease in Sales will lead to a relatively large decrease in Op. Inc.      Therefore, there is always an incentive to increase sales when you are near the BE pt. because results can turn around dramatically.

Indifference Analysis
CVP analysis can be used to compare the profitability of alternative products or methods of production.    A product with a high level of fixed cost and relatively low variable costs (high CM %)  will require a higher sales level to break even and earn profits, than a product with low fixed costs a relatively high variable costs (low CM%).   Therefore, two similar products with different cost structures will have different break even points.
However,  there is some level of activity at which the profits on the two  products will become the same.    This level of activity is called the indifference point—–that is, the activity level  at which you are indifferent between the two cost structures.    This indifference point can be determined by stating the cost structure for each product in algebraic terms, equating them, and solving for the quantity (indifference point volume).   
See example, p. 241.    If selling prices between the two products are different, then selling prices and costs should be built into the equation for each product. 
At points above the indifference point, the product with the higher CM% and a relatively higher proportion of fixed costs, will always be more profitable.    At volumes below the indifference point, the product with the lower CM% and relatively higher proportion of variable costs, will always be more profitable. 
Example
A company is looking at replacing its current  labour-intensive manufacturing line with a more machine-intensive line.   This will change the cost structure by replacing variable costs (labour) with fixed costs (machine maintenance and  depreciation).
The selling price for the product is $50
Current System:    VC/unit  = $30    TFC = $11,000
Proposed System:    VC/unit = $15    TFC = $20,000
At what level of sales (in units) would the company be indifferent between the two manufacturing approaches?
30n + $11,000  =   15n  +  $20,000
15n    =      $9,000
n      =     $9,000/15    =    600 units
At 600 units, the company is indifferent between the two manufacturing approaches.   Below 600 units, the current system with its higher VC/unit, lower  TFC, and lower CM%, will be more profitable
Above 600 units, the  proposed system with its higher TFC, lower VC/unit, and higher CM%, will be more profitable.

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Four Primary Ethical Issues Relating to Management Accountants

1. Competence: Management accountants have a responsibility to perform their professional duties in accordance with relevant laws and regulations and to keep abreast of current developments or changes affecting the practice of accounting.

2. Confidentiality: Management accountants must refrain from disclosing confidential information unless legally obligated to do so.

3. Integrity: Management accountants have a responsibility to refrain from either actively or passively subverting the attainment of the organizations legitimate and ethical objectives. And to communicate favourable as well as unfavourable information and professional judgments or opinions.

4. Objectivity: Management accountants must fully disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, comments, and recommendations.

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Practical Considerations in Resolving an Ethical Conflict

• The first step is to discuss the problem with your immediate superior unless it appears this individual is involved in the conflict.

• Communication of confidential information to anyone outside the organization (e.g. a newspaper) is inappropriate unless there is a legal obligation to do so (such as a law being broken.

• If the conflict is not resolved after exhausting all of the courses of review within the organization (i.e., the accountant gets no satisfaction resolving his/her ethical concerns), then he should fully document the steps he has taken, or, if the matter is serious enough, he should resign.

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Use of Multiple Overhead Rates

If all production departments in a manufacturing business have the same mix of labour and machines, and all jobs require the same amount of work in a given department, then it is appropriate to use a single, plant-wide overhead rate.
However, if some departments are machine intensive and some are labour intensive, then the amount of overhead applied will not approximate the overhead used in all departments. If we use DLH’s as the activity base in a labour intensive department, this will give a good result but if we use DLH’s in a machine intensive environment that has few labour hours actually worked, the result will be very unsatisfactory. Machine-intensive departments typically use a lot of overhead cost but if there are few labour hours and the rate is applied on the basis of DLH’s, little overhead will be applied.
Even if all departments are labour intensive, the amount of labour time required for each job might vary from one department to another. This could still result in imprecise application of overhead costs to a given job if a single labour based plant-wide rate was used for all departments..
To overcome these problems companies use multiple overhead rates. Machine intensive departments have their own overhead cost pool and the rate is based on Machine hours. Labour intensive departments likewise have their own cost pool based on DLH’s or Direct Labour $. If the labour time varies from job to job in an given labour-intensive department, then each department should still have its own overhead cost pool and MO rate based on a labour activity base just for that department.
By using separate departmental overhead rates, the overhead applied can be tailored to the specific needs of a particular job. This will lead to more precise costing of products, which can be critical if the business has to bid for jobs.

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Disposal of Under/Over Applied Overhead

There are two methods of closing out the under or over applied balance in the MO account at the year-end.
1.         Close the balance out to COGS.     This causes the full amount of the adjustment to affect the income statement.     Under applied overhead would increase COGS and reduce net income and over applied overhead would reduce COGS and increase net income.
            Sample entry:  (assuming under applied by $4,200)
            COGS                          $4,200
                  MO                                                $4,200
2.         Close out the under/over applied balance by allocating it to all the accounts that contain MO-applied, namely WIP, FG, and COGS.    The allocation is done on the basis of the % of MO-applied in each of the ending balances of the three accounts relative to the total MO-applied in all three accounts.   If the MO applied component is not readily available, the full cost (DM, DL, and MO applied) in each of the three balances is used instead and the method is the same.
            Example:     Assume under applied overhead is $4,200
The MO-applied component in the ending balances of WIP, FG and    COGS are as follows:
                                          Ending Balances
                        WIP                 $15,000
                        FG                    25,000
                        COGS                60,000
                        Total                $100,000
The allocation is done on a small schedule as follows:
Account
Ending Bal.
% of total
 x under/over applied
= amount allocated
WIP
$15,000
.15
x  $4,200
$   630
FG
 25,000
.25
x  $4,200
$1,050
COGS
 60,000
.60
x  $4,200
$2,520
Total
$100,000
1.00
$4,200
Entry:               WIP                 $   630
                        FG                     1,050
                        COGS                2,520
                                    MO                  $4,200
Under this method part of the adjustment (the part relating to WIP and FG) goes to the Balance Sheet and does not affect the income statement.    In this example, Net Income would be $630 +$1,050 = $1,680  higher using this method (rather than sending it all to COGS) since $1,680 of additional cost is kept out of the income statement.

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Types of Relevant Cost Decisions

1.      Accept/Reject a Special Order
Special orders are one-time orders from non-regular customers usually at a price below normal selling price.   They may be orders for “generic” or no-name products.
The business would normally only consider accepting the special order if the following conditions are met:
·         The incremental (relevant) revenue on the order exceeds the incremental (relevant) cost.
·         Accepting the order will not disrupt regular markets or customers.
·         Also, the business should normally have excess capacity available;   otherwise, they would have to give up regular business at normal selling prices in order to accept the special order.      (Any margin given up on regular business in order to accept the special order would be considered an opportunity cost.)
The minimum acceptable price for a special order = the total relevant costs of the                          order per unit plus any opportunity cost (if applicable),  divided by the number of units in the order.   
2.      Make v. Buy a Part or Component
For this type of problem, we usually list the relevant cost of making the part (DM, DL, variable overhead, and any additional fixed costs), and then we list the relevant cost of buying outside  (total purchase cost).     The business should make the part as long as the relevant cost of making the part is < the cost of buying outside.    Qualitative factors affecting the decision include a desire to have better control over the quality of the part  and more control over the delivery to the production area when the part is made “in-house”.   
Sometimes, if the part is purchased outside, part of the plant facility can be freed-up for other uses.     This freed-up space could be sublet to others to earn rental income, or could be used to make another product on which product margin is earned.    Such amounts are considered to be “opportunity costs” and can be regarded either as a reduction in the relevant cost of buying outside, or as an additional cost of making in-house.
The maximum price per unit you would be willing to pay to purchase outside = the total relevant cost of making the part plus any opportunity cost (if applicable) divided by the number of units required.
3.      Keep vs. Drop a Product Line
This type of decision relates to product lines, divisions, retail outlets, etc. that appear to be losing money.    The question is, should the company keep or drop such “marginal” segments.    There are two main considerations:
·         The CM given up if the segment is dropped   (i.e., Sales – TVC)   —the “bad news”
·         The avoidable fixed costs that would be saved if the segment is dropped   —-the “good news”.
These two amounts offset one another.    If there is net CM given up, then more is to be gained by keeping the segment going.    If there are net avoidable fixed costs saved, then there are greater savings in closing the segment down.    It is not a question of profitability but whether the business is better off or worse off to keep the segment going or to shut it down.
Sometimes a segment is retained for qualitative reasons.    For example, a “marginal” product line may be maintained because all major competitors have a similar product.   Also, sometimes, loss of a given segment may cause sales and hence CM of other segments to increase or decrease.   The effect on the CM of other segments should be built into the analysis in these cases (either as a “good news” effect or a “bad news” effect
4.      Keep vs. Replace a Piece of Equipment (supplemental, not in text)
When a contemplating the disposal of an older piece of equipment with a newer machine, there are both relevant and irrelevant items, but only the relevant items affect the decision.  
In this type of decision, the relevant items are regarded as cash inflows or outflows over the life of the new equipment.
Items to consider:
Purchase cost of new equipment:    ——–relevant (outflow of cash)
Salvage value of old equipment      ———relevant  (inflow of cash)
Book value of old equipment   ————this is a combination of purchase cost of old equipment (a sunk cost and therefore irrelevant) and accumulated amortization  (also in effect a sunk cost).   Therefore, book value is always irrelevant
Gains and losses on disposal—-this is a combination of salvage value (proceeds of disposal) which is relevant, and book value, which is irrelevant;   therefore, gains and losses on disposal must be broken down into these two components and be treated separately.
Operating Savings by using the new equipment (over the life of the new equipment)  ———relevant  (in effect, an inflow of cash)
So only three items are relevant:   purchase cost of new equipment (outflow), salvage value or proceeds from selling old equipment (inflow); and annual operating savings over the life of the new machine  (inflow).    These are the only three items you need to include in the analysis.
It is sometimes difficult to persuade management to buy a new machine based on the above relevant cost analysis because the books may show an accounting loss on disposal.    However, as noted above, gains and losses are a mixture of relevant and irrelevant items and should not in themselves affect the decision.
5.      Sell as is or Process Further:
Some products are derived from an initial  joint process that can be separated in to separate products at a “split off point” .    A decision than has to be made as to whether to sell the separate products at the split off point (assuming there is a market for them), or process them further and then sell them.    The costs of the joint process up to the split-off point (called “joint costs”) are irrelevant because they are “sunk costs”.   The decision as to the best option is based on the following relevant costs and revenues which in this instance are called “incremental (or additional)  revenues” and “incremental (or additional) costs”
Incremental revenues   =    Sales value if processed further   minus  Sales value if sold at split off
Incremental costs  =   the additional processing costs
If the incremental revenues are > the incremental costs, then process further
If the incremental revenues are < the incremental costs, then sell at split off without further processing      
There is a variation of this type of decision where you have a machine and need to make a decision whether to sell it “as is”and buy a new machine, or rebuild the existing machine.    In these instances you compare any cash inflows and outflows of selling “as is” and buying a new machine, vs. cost of rebuilding the old machine.
6.      Which products to produce when there is a constraining factor
There is often a “constraining factor that affects how much a company can produce of its products.    The most common constraining factors are available labour time or machine time; or raw materials.    If the company makes several products, they need to decide which products to produce (assuming the demand is there).
Instead of producing the products with highest CM/unit (the normal situation), they should produce the products with the highest CM per unit of the constraining factor such as CM per direct labour hour.
Steps in this kind of analysis:  (assume the constraining factor is hours of labour time)
i)                    Determine the CM per unit for each product
ii)                  Determine the time in hrs required to make each type of product
iii)                Convert this to the inverse (by dividing into 1) to get the units per hour
iv)                Multiply CM per unit x # of units per hour    to get the CM per hour
v)                  Rank the products from highest to lowest CM per hour produce the product with the highest CM per hour.
If demand for the products is limited, determine how many hours are needed to satisfy demand for each product;    then start with the highest ranked product and use up the hours to satisfy demand (and calculate the number of units this involves);   then move to the second highest ranked product, and the third highest etc., until you have used up all the available hours.   The last product usually will have the hours and quantities as a plug amount (so as to not exceed the total amount of the constraint available.
Maximum price that would be paid for the constrained resource  =   normal price of the constrained resource  +   CM earned/unit of the constrained resource on the product available to be produced.

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Accounting for Costs Relating to Idle Time, Overtime Premium, and Employee Benefits

Idle Time

Idle time represents the labour cost of direct labour employees who are unable to perform their assigned duties due to machine breakdowns, material shortages, power failures, etc.
The labour costs for idle time hours are charged to Mfg. Overhead at normal wage rates. regardless of when the hours were worked.

Overtime Premium

Any premium paid for labour time in excess of normal work times for direct labour employees is treated as part of MO. We are dealing only with the premium. The regular wage even for excess hours over and above normal work times is still charged to Direct Labour.

Example: Employee works 44 hours and earns an hourly rate of $16/hr. Any hours worked over 40 hours are paid at time and one half ($24/hr).


Steps:

1. Calculate Gross Wages paid

Total Gross Wages paid:
Wages paid: (regular hours)                          40 x $16 = $640
                   (overtime hrs)                            4 x $24 = 96
                                                                    $736


2. Allocate Gross Wages Paid between DL (WIP) and MO

Allocation of labour cost:
Direct Labour (total hrs worked x regular rate) 44 x $16 = $704 (charged to WIP)
Overtime premium (overtime hrs x premium over regular rate) 4 x $8) = $32
Total labour cost recorded $736

If there was idle time incurred during the overtime period, the normal rate will be charged to idle time and the premium will be charged to overtime premium (i.e., both end up charged to MO).

If the overtime was worked specifically at the request of a customer (to speed up the completion of a order), then the overtime premium should be charged to direct labour (WIP).

Cost of Labour Fringe Benefits and Payroll Taxes (EI, CPP) Paid by the Employer

These costs include employer share of EI, CPP, supplementary health plans, long-term disablility plans, etc. While such costs usually arise from the existence of wages paid, they are normally charged to MO, even for direct labour employees.

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