example of a direct material cost
cost of hard drive installed in a computer
example of a selling cost
- cost of advertising in the get Sound Computer User newspaper
- sales commissions paid to the company's salespeople
example of a direct labor cost
wages of employees who assemble computers from components
example of a MOH cost
- salary of the assembly shop's supervisors
- depreciation on equipment used to test assembled computers before release to customers
example of a administrative cost
the salary of the company's accountant
Direct Materials
- Primary materials and parts that become physical part of finished goods
- Can readily trace to specific units (direct cost)
- Examples:
>> Flour used in baking bread
>> Engines used in manufacturing trucks
- Direct materials is a "variable cost
Manufacturing Company
- Operates plant that uses machinery to physically transform raw materials into finished goods
- Inventory accounts: Raw materials, WIP, finished goods
- Sells to merchandising company, or to end-consumer
- Examples: PepsiCo, Apple, Boeing, Tesla
Merchandising Company
- Resells tangible goods purchased from suppliers in ready-to-sell form
- Single "merchandise inventory" account
- Examples: Publix, Home Depot, Costco
- Two types: Retailers, Wholesalers
Service Company
- Product is consumed immediately or is intangible service
- Examples >> Hospital, bank, insurance company,
consulting firm, airline, restaurant
- Generally, no inventory
- Still, must determine cost of providing services
Task: preparing financial statements
classifications:
- product cost (capitalize as inventory)
- period cost (expense)
Task: predict cost behavior in response to change in activity
classifications:
- variable cost (proportional to activity)
- fixed cost (stays constant)
- mixed cost (variable and fixed elements)
Task: assign costs to products, projects, or divisions
classifications:
- direct cost (easily traced)
- indirect cost (not easily traced)
Task: account for costs of manufacturing company
classifications:
- manufacturing cost >> DM, DL, and MOH
- non-manufacturing cost >> selling and admin expenses
Task: make decision
classifications:
- differential cost (differs between alternatives)
- sunk cost (not vary)
- opportunity cost (forgone benefit)
Task: evaluate performance
classifications:
- controllable cost (manager can influence)
- uncontrollable cost (cannot influence)
Fixed Costs
total cost stays same as activity increases
Variable Costs
total cost increases as activity increases
Mixed Costs
elements of both fixed and variable costs
Total Cost of Fixed Cost
- Remains constant for a given time period, despite wide
fluctuations in level of activity
- Cannot easily or quickly change to match resources needed
Unit Cost of Fixed Cost
- Varies inversely with changes in activity
- Decreases as activity level increases, and increases as
activity level decreases
Total Cost of Variable Cost
- Equals $0 if no activity
- Changes in direct proportion to changes in activity
>> If activity increases 50% = Total costs increase 50%
>> If activity decreases 50% = Total costs decrease 50%
Unit Cost of Variable Cost
Remains constant at every level of activity (within relevant range)
Relevant Range of Activity
- Predictions are valid only within specified "relevant range"
- Range of activity over which company reasonably expects to operate during period
- Total fixed costs = Remain constant
- Per-unit variable costs = Remain constant
Total Cost of Mixed Costs
- Minimum total cost = Fixed cost component
- Increases as activity increases, due to variable component
Unit Cost of Mixed Costs
Decreases as activity increases, due to fixed costs
Total cost =
Fixed cost component + Variable cost component
Total cost slope equation
y= f + vx
- f = fixed cost over relevant range (line intersects y axis)
- v = variable cost per unit of activity (slope)
- x = volume of activity
Cost Object
Item for which separately measure costs
Direct Costs
- Related to cost object
- Can readily trace to cost
object
>> e.g., cost of 2 tires used to manufacture scooter
- Precise measure
Indirect Costs
- Related to cost object Cannot readily trace to cost
object
>> e.g., cost of insuring plant in which scooters are produced
- Less precise measure because
allocation is somewhat arbitrary
Product Costs
- Costs that are integral to acquiring or making product
- Expense as COGS or COS in period sold (matching principle)
- If unsold at end of period, record as inventory on balance sheet
Period Costs
- Selling and administrative expenses
- Expense in period incurred because benefit realized in current period
Selling Expenses
- Order-getting: Advertising, promotion, compensation of sales force
- Order-filling: Warehousing, shipping
- Period expense because related to sales in current period
Administrative Expenses
- Anything other than produce/acquire product or selling
- Compensation of top executives, rent on headquarters
- Support functions: IT, HR, legal, etc.
- Period expense because benefits realized in current period
Merchandiser's Product Costs
- Purchase price paid to supplier + Freight-in costs+ Import duties or tariffs+ Cost to get ready for sale
Manufacturer's Product Costs
- DM + DL = can readily trace costs directly to a unit or batch
- MOH = cannot readily trace costs directly to a unit or batch
Direct Labor
- Compensation of employees who physically convert raw materials into finished goods
- Can readily trace time spent to specific units (direct cost)
- Examples
>> Bottlers who can Coca-Cola
>> Factory workers who assemble furniture
- For simplicity, always
Manufacturing Overhead (MOH)
- Costs related to manufacturing operations as a whole
- Cannot trace to specific jobs
- Allocate to all units using
predetermined overhead rate
- Includes both variable costs and fixed costs
Example of Indirect Labor Costs (MOH costs)
- Plant manager
- Maintenance engineer
- Quality control inspector
- Parts administration
- Materials handling
- Security
Examples of Indirect Labor (MOH costs)
- Inexpensive parts (glues or nails)
- Factory supplies (lubricants)
- Small tools
Examples of "Other MOH
- Depreciation expense and leasing costs on machinery & equipment
- Utilities
- Insurance
- Property taxes
Conventional income statement
- Organized by function
>> Production or purchasing (above)
>> Selling and administration (below)
- Fixed and variable costs are commingled in COGS and S&A
Contribution margin income statement
- Organized by cost behavior
- Contribution margin equals sales
less all variable costs
>> Variable product costs
>> Variable S&A expenses
- Product costs of manufacturer
Contribution margin ratio
- Percentage of each sales dollar available to cover fixed costs and generate a profit
- Also equals 100% minus "variable expense percentage" (variable costs � sales revenues)
= CM / sales revenue
Unit contribution margin
- Increase in contribution margin if sell one more unit
- Variable costs include both:
>> Product costs
>> Selling and administrative costs
= selling price per unit - variable costs per unit
Cost-Volume Profit Analysis
- Decision making tool
- Used to analyze relationships among:
>> C - Fixed and variable
>> V - Unit sales
>> P - Operating income
CVP Analysis: Components
1. Selling price, per unit
2. Volume (unit sales)
3. Variable costs, per unit
4. Fixed costs, total
5. Mix of products sold
6. Operating income
CVP Analysis: Assumptions
- Selling price, per unit
- Variable costs, per unit
- Total fixed costs
- Sales mix
>> remain constant as sales volume changes
Break-Even Point
Sales volume at which operating income is zero
At the Break-Even Point:
- Sales revenue - Total costs = $0
- Contribution margin - Fixed costs = $0
- Contribution margin = Fixed costs
Using unit contribution margin to compute break-even point in UNITS
Sales - Variable costs - Fixed costs = Operating income
BE Point Equation
(fixed costs + operating income) / unit contribution margin
Using contribution margin ratio to compute break-even point in DOLLARS
(fixed costs + operating income) / contribution margin ratio
Methods for calculating sales volume required to achieve target profit
- Same CVP methods used to compute break-even point
- Only change
>> Operating income = Target profit (rather than $0)
- Reminder
>> If required sales volume is outside relevant range, need to re-assess assumptions
Unit sales required to achieve target profit (Unit CM)
(fixed costs + target profit) / Unit CM
Dollar sales required to achieve target profit (CM Ratio)
(fixed costs + target profit) / CM ratio
Margin of Safety
- Excess of budgeted or actual sales
over break-even sales
- How far sales can drop before incur a loss (sales cushion)
Uses of Margin of Safety
- Evaluate risks of existing operations or planned new operations
- Higher MOS means less risk of loss
Margin of Safety (in units)
Budgeted (or actual) sales - break-even sales, in units
Margin of Safety (sales dollars)
Budgeted (or actual) sales - break-even sales, in dollars
Margin of Safety (% of units)
margin of safety / budgeted (or actual) sales, in units
Margin of Safety (% of sales dollars)
margin of safety / budgeted (or actual) sales, in dollars
Sales mix
Combination of products or segments that make up total sales revenues
Importance of sales mix
- Different products or segments have different contribution margins
- Need to compute "weighted-average contribution margin"(or "overall contribution margin") of all products or segments in mix
Weighted-average contribution margin steps:
1. Compute unit contribution margin for each product
2. Determine sales mix percentage for each product
3. Compute weighted-average unit contribution margin
Weighted-average contribution margin equation
[Product A Unit CM x Product A Sales Mix %] + [Product B Unit CM x Product B Sales Mix %]
CVP graphs
- Helps us visualize how changes in elements of CVP analysis impact profits
- X-axis > Sales volume (units)
- Y-axis > Sales revenues and total costs ($)
Break-Even Point on a graph
point where sales revenue line intersects total costs line
operating leverage
- How sensitive profits are to changes in sales
- Determined by relative proportions of fixed and variable costs
Cost Structure: High operating leverage
- Higher fixed costs
- Lower variable costs
Cost Structure: Low operating leverage
- Lower fixed costs
- Higher variable costs
Contribution Margin Ratio: High operating leverage
Higher due to lower variable costs
Contribution Margin Ratio: Low operating leverage
Lower due to higher variable costs
Impact of increase in sales volume: High operating leverage
- Profits rise rapidly
- Higher potential rewards
Impact of increase in sales volume: Low operating leverage
- Profits rise slowly
- Lower potential rewards
Impact of decrease in sales volume: High operating leverage
- Profits drop quickly, and fixed costs remain high
- Higher risk of loss
Impact of decrease in sales volume: Low operating leverage
- Profits decline slowly, and less fixed costs to cover
- Lower risk of loss
Examples of high operating leverage firms
Theme park or resort, airline, railroad
Examples of low operating leverage firms
Retailer, fast-food restaurant
Degree of Operating Leverage
- Type of multiplier used to gauge earnings volatility
- Percentage increase in profits resulting from percentage increase in sales
Degree of Operating Leverage equation
Contribution Margin / Operating Income
Budget
- Management's plan
- For specified time
period
- Expressed in financial terms
Benefits of Budgeting
- Planning
- Benchmarking
- Communication and coordination
Planning
forces managers to plan for future
benchmarking
- creates targets to evaluate performance and award bonuses
- provides early warning system for identifying problems
Communication and coordination
- facilities coordination of activities within company
- greater awareness of company's overall operations
Zero-Based Budgeting
- All business segments begin with $0, and must justify every dollar
- Very time consuming, so used infrequently
Participative Budgeting
- Involves managers at all levels
- Process
> 1. Top management specifies targets
> 2. Lower-level managers prepare budgets that meet targets
> 3. Budget committee makes final decisions
- Goal: Fair and achievable budget that meets corporate goals
Advantages of Participative Budgeting
- Lower level managers provide more accurate estimates
- Employees more motivated when help set goals
- Process is viewed as more fair
- Treats all managers as valuable members of team
Disadvantages of Participative Budgeting
- More complex and time consuming
- Lower-level managers have incentive to build in "slack"
>> e.g., inflate expense budget to guard against uncertainty
Importance of Sales Budget
- Starting place for budgeting
- Provides basis for estimating:
>> Number of units that must produce or purchase to meet budgeted sales
>> Cash collections related to sales
>> Timing of cash collections
Sales Budget
- Projected sales revenue
- Accuracy is critical because
forecast impacts all other budgets
- Key estimates
>> Unit sales?
>> Selling price per unit?
>> Credit sales versus cash sales? (impacts timing of cash flows)
Importance of Production Budget
- Provides estimate of number of units to produce
Provides basis for budgeting manufacturing costs
>> Direct materials
>> Direct labor
>> Manufacturing overhead
Production Budget
- Number of units that company must produce to:
>> Meet budgeted sales, and
>> Provide desired ending finished goods inventory ("safety stock")
Finding Units Need to Produce =
(units needed to cover sales + desired ending inventory) - units in beginning of inventory
Merchandise Purchases Budget
- Provides estimate of cost of merchandise need to purchase
- Same format as production budget, except in dollars
inventory need to purchase (aka budgeted purchases)=
(budgeted COGS + desired ending inventory) - beginning inventory, in dollars
Direct Materials Budget
Quantity and cost of DM to be purchased
DM costs, in dollars =
Quantity to purchase x price per unit
Quantity of DM to purchase =
[quantity of DM needed for production (note: this is based on production budget) + desired ending inventory of DM] - beginning inventory of DM
Direct Labor Budget
Quantity (hours) and cost of DL needed for production
Quantity of DL to purchase =
[units to be produced (note: this is based on production budget) + desired hours per unit] x DL cost per hour
Manufacturing Overhead Budget
- Projected MOH costs for period
- Distinguishes between fixed and variable costs
>> Cost driver for variable costs < Units produced (not units sold)
S&A Expenses Budget
- Projected selling and administrative expenses for period
- Distinguishes between fixed and variable costs
>> Cost driver for variable costs < Units sold(not units produced)
- Compilation of many smaller, departmental budgets
>> Marketing, HR, R&D, Shipp
Cash Budget
- Reflects effect of operating budgets
- Contains three sections
1. Cash receipts
2. Cash payments
3. Financing
- Provides information regarding:
>> Expected cash inflows and outflows
>> Whether need to borrow funds during budget period
>> Beginning and e
Cash Receipts Budget
- Includes: Virtually all expected cash receipts
>> Revenues from product sales
>> Interest income
>> Proceeds from sales of old equipment
- Key Issue: TIMING of receipts from product sales
Cash Payments Budget
- Includes: virtually all expected cash payments
>> Product costs
>> Selling and administrative expenses
>> Capital expenditures, income taxes, dividends
- Key Issue: TIMING of cash payments
Importance of a Budgeted Income Statement
- Key schedule in budget process
- End-product of operating budgets
- Benefits:
>> Know in advance if plan results in acceptable profit
>> Benchmark for evaluating overall company performance
>> Lenders often require profit forecast
How to Create a Budgeted Balance Sheet:
1. Balance sheet at
beginning of year
2. Operating and financial budgets for year
gross profit=
sales - COGS
COGS=
BI + Purchases - EI
(# of units [DM + DL]) + total MOH
Total Product Cost=
DM + DL + fixed MOH + variable MOH
Total Period Costs include
depreciation, sales commission, any not considered to be a product cost (includes S&A costs)
total conversion cost=
DL + MOH costs
total MOH=
fixed MOH + variable MOH
% change=
(current year - last year) / last year x 100
y= mx + b
y= total cost
m= variable price per unit
x= number of units
b= fixed expense
Monthly gross profit=
([selling price - unit cost] x # of units)
ch. 1 operating income equation
sales - COGS + GP - S&A expenses
unit CM=
selling price - variables costs per unit
contribution margin=
revenues - variable costs
OR
operating income + fixed costs
CM ratio=
CM/total sales
OR
unit CM/ selling price
sales rev needed for target profit=
(fixed costs +target profit) / CM ratio
*
CM ratio when looking for sales rev
*
if variable costs are 75% of sales, then
CM ratio is 25% of sales
changes in sales revenue required =
change in fixed costs / CM ratio
break-even point in sales=
(fixed costs + sales rev. required)
OR
fixed costs / avg. total CM ratio
break-even point in units=
fixed costs / unit CM
units needed for target profit =
(fixed costs + target profit) / unit CM
*
looking for an answer in units so you must use unit CM
*
weighted-average CM=
(CM x sales mix) + (second CM x sales mix) + etc.,
break-even point in units (when there are more than one product)=
fixed costs / weighted-average CM per boat
Margin of Safety, in Dollars=
expected sales rev. - BE pt in sales rev.
degree of operating leverage=
CM / operating income
margin of safety, in %
MOS, dollars / expected sales
if sales changes, how will that effect operating income (this is if you have degree of operating leverage)
%change in sales x degree of operating leverage
change in per unit selling price =
change in fixed costs / # of units
budgeted sales, in units =
sales rev / per-unit selling price
units needed to produce=
(current month unit sales + ending inventory units) - beginning inventory units
sales needed to purchase=
COGS of current month + ending inventory + beginning inventory
cash amount at end of month=
cash on 1st of month + cash receipts - cash payments
when 5% of credit sales are not collected, then
you take 5% away from the % of cash received for the month
total direct manufacturing cost=
(DM + DL) x # of units
total indirect manufacturing cost=
var. MOH + fixed MOH
variable cost per unit=
DM + DL + var. MOH + var. admin. + sales commission
CM per unit=
CM / total # of units sold
net operating income=
gross profit - selling + admin
operating income=
service revenue - operating expenses
prime cost=
DM + DL
sales mix=
# sold / total