Managerial Accounting Module-Workbook PDF

MANAGERIAL ACCOUNTING Module-Workbook Catherine Dela Cruz, LPT, Ph.D. NUEVA ECIJA UNIVERSITY OF SCIENCE AND TECHNOLOGY ELECTIVE 8 MANAGERIAL ACCOUNTING First Semester, Academic Year 2022 – 2023 (For Classroom Discussion Only) CATHERINE E. DELA CRUZ, LPT, Ph.D. Author TABLE OF CONTENTS Course Description ………………………………………………………………………….. 1 How to Use the Module? …………………………………………………………………… 1 Unit 1: Nature of Managerial Accounting and Standard Of Ethical Conduct Introduction of Managerial Accounting……………………………………………….2 Functions of Managerial Accounting………………………………………………….3 Tools and Techniques of Management Accounting…………………………………...5 Importance of Management Accounting………………………………………………7 Management Accounting vs. Financial Accounting…………………………………...8 Standards of Ethical Conduct for Management Accountants………………………….9 References Exercises Unit 2: Basic Cost Management Concepts Merchandiser and Manufacturer Accounting: Differences in Cost Concepts………….15 Nature of Costs, Cost Pools, Cost Objects and Cost Drivers…………………….…….15 Classification of Costs …………………………….…………………………………...17 Cost Classification by Relevance to Decision-making and Control……………………21 Characteristics of Managerial Accounting Reports…………………………………….23 Cost of Goods Manufactured vs. Total Manufacturing Cost…………………………...25 Cost of Goods Manufactured vs. Cost of Goods Sold………………………………….27 Cost accounting system…………………………………………………………………29 References Exercises Unit 3: Cost Behavior and Cost Volume-Profit Analysis Cost Behavior ………………………………………………………………………….34 Cost-Volume-Profit Analysis in Planning……………………………………………...37 Sensitivity Analysis of CVP Result…………………………………………………….45 Reference Exercises Unit 4: Absorption and Variable Costing Absorption costing……………………………………………………………………...52 Variable Costing………………………………………………………………………..54 Absorption Costing vs. Variable Costing………………………………………………55 References Exercises Unit 5: Operating and Financial Budgeting Operational budget……………………………………………………………………..67 Financial budget…………………………………………………………………….….67 Some of the advantages for both operating and financial budget……………………..68 Ethical Issues in Budgeting…………………………………………………………....69 Master Budgets………………………………………………………………………...70 Flexible Budgeting…………………………………………………………………….72 References Exercises Unit 6: Accounting Information for Short-Term Decision Making Accounting information and decision making…………………………………………78 Short Term Decision Making…………………………………………………………..81 Types of Decisions……………………………………………………………………..81 Relevant Information for Short-Term Decision-Making………………………………83 References Exercises Unit 7: Responsibility Accounting, Performance, Measurement, & Transfer Pricing Responsibility Accounting……………………………………………………………..86 Responsibility Center…………………………………………………………………..87 Balanced Scorecard…………………………………………………………………….90 Four Perspectives of the Balanced Scorecard………………………………………….91 Transfer Pricing………………………………………………………………………...95 References Exercises Unit 8: Analysis and Interpretation of Financial Statements Introduction of financial analysis………………………………………………………99 Types financial analysis………………………………………………………………..100 Techniques of Analysis and Interpretation……………………………………………..101 Horizontal Analysis…………………………………………………………………….104 Vertical Analysis……………………………………………………………………….105 Financial ratios…………………………………………………………………………106 Financial Ratio Analysis Interpretation………………………………………………...109 References Exercises Unit 9: Capital Budgeting Decisions Capital Budgeting……………………………………………………………………....113 Capital budgeting decision……………………………………………………………..115 Capital investment……………………………………………………………………...124 Types of Capital Investment…………………………………………………………....125 Cash flow analysis……………………………………………………………………...127 References Exercises Course Description The course is designed to prepare the student for effective financial decision-making at a managerial level. This course will introduce students specifically to managerial accounting: the accounting process that uses financial information to organize and govern finances within an organization. How to use this module? This module has eight (9) lessons. Each lesson has the following parts: Learning Outcomes Overview of the Lesson Reference Learning Materials/Resources Self-assessment Tests/Learning Activities To get the most from this module, you need to do the following: 1. Begin by reading and understanding the Learning Outcomes. These will tell you what you should know and be able to do at the end of this module. 2. Study well the given materials and resources for each lesson. If the lesson requires you to watch a video and/or read an article, copy the link provided to your search engine/browser. 3. Do the required self-assessment tests. Test yourself on how much you have learned by means of the self-check tests. This will ensure your mastery of basic information. 4. Demonstrate what you learned by doing what the learning activities directs you to do. 5. You must be able to apply what you have learned in another activity or in a real situation. If you have questions, ask your teacher for assistance. ☺ UNIT I: NATURE OF MANAGERIAL ACCOUNTING AND CONTEMPORARY DEVELOPMENT Learning Objectives: At the end of the unit, I am able to: 1. Define the management accounting. 2. identify the different function of managerial accounting. 3. discuss the objectives, techniques, and importance of management accounting; 4. differentiate financial and managerial accounting; and 5. discuss and apply the standards of ethical conduct of management accountant in resolving ethical conflict.. Introduction: Accountants play a pivotal role in improving their organizations’ financial and operational performance by helping key decision-makers understand the nuances of ongoing business activities. Using both quantitative and qualitative financial information, accountants create detailed reports and recommendations that guide investments, capital management strategies and organizational goals. As accountants advance their career, they often look for new opportunities to leverage their knowledge, skills and experience to greater effect. While being a public accountant might be appealing for some, there are plenty of other career paths available, including managerial accounting. But what is managerial accounting and how can aspiring professionals prepare themselves to take on this role? Managerial Accounting Managerial accounting, also called management accounting, is a method of accounting that creates statements, reports, and documents that help management in making better decisions related to their business’ performance. Managerial accounting is primarily used for internal purposes. It helps the management to perform all its functions, including planning, organizing, staffing, direction, and control. In other words, the field of accounting that provides economic and financial information for managers and other internal users is called management accounting. The Institute of Cost and Management Accountants London has defined, “Management Accounting as the application of professional knowledge and skill in the preparation of accounting information in such a way as to assist management in the formulation of policies and the planning control of the operation of the undertakings.” Similarly, according to the American Accounting Association, “It includes the methods and concepts necessary for effective planning for choosing among alternative business actions and for control through the evaluation and interpretation of performances. 2 What are the functions of Managerial Accounting? The basic function of management accounting is to assist the management in performing its functions effectively. The functions of the management are planning, organizing, directing, and controlling. Management accounting is a part of accounting. It has developed out of the need for making more use of accounting for making managerial decisions. Management accounting helps in the performance of each of these functions in the following ways: ▪ Provides data Management accounting serves as a vital source of data for management planning. The accounts and documents are a repository of a vast quantity of data about the past progress of the enterprise, which is a must for making forecasts for the future. ▪ Modifies data Management accounting modifies the available accounting data rearranging in such a way that it becomes useful for management. The modification of data in similar groups makes the data more useful and understandable. The accounting data required for management decisions is properly compiled and classifies. ▪ Communication Management accounting is an important medium of communication. Different levels of management (top, middle, and lower) need different types of information. The top management needs concise information at relatively long intervals, middle management needs information regularly, and lower management is interested in detailed information at short intervals. Management accounting establishes communication within the organization and with the outside world. ▪ Analyses and interprets data The accounting data is analyzed meaningfully for effective planning and decision- making. For this purpose, the data is presented in a comparative form, Ratios are calculated, and likely trends are projected. ▪ Serves as a means of communicating Management accounting provides a means of communicating management plans upward, downward, and outward through the organization. Initially, it means identifying the feasibility and consistency of the various segments of the plan. The later stages it keeps all parties informed about the plans they have been agreed upon and their roles in these plans. ▪ Facilitates control Management accounting helps in translating given objectives and strategy into specified goals for attainment t by a specified time and secures the effective accomplishment of these goals efficiently. All this is made possible through budgetary control and standard costing, which is an integral part of management accounting. ▪ Uses also qualitative information Management accounting does not restrict itself to financial data for helping the management in decision making but also uses such information that may be capable of being measured in monetary terms. Such information may be collected from special surveys, statistical compilations, engineering records, etc. ▪ To assist in planning. Management Accounting assists the management in planning as well as to formulate policies by making forecasts about the production, selling the inflow and outflow of cash, etc. Not only that, but it may also forecast how much may be needed from alternative courses of action or the expected rate of return from that place and at the same time decides upon the programmed of activities to be undertaken. ▪ To assist in organizing. By preparing budgets and ascertaining specific cost centers, it delivers the resources to each center and delegates the respective responsibilities to ensure their proper utilization. As a result, an interrelationship grows among the different parts of the enterprise. ▪ Decision-Making Management accounting furnishes accounting data and statistical information required for the decision-making process, which vitally affects the survival and the success of the business. Management accounting supplies analytical information regarding various alternatives, and the choice of management is made easy. ▪ To assist in motivation. By setting goals, planning the best and economic courses of action, and also by measuring the performances of the employees, it tries to increase their efficiency and, ultimately, motivate the organization as a whole. ▪ To Coordinate It helps the management in coordination the whole activities of the enterprise, firstly by preparing the functional budgets, then co-coordinating the whole activities of the enterprise, firstly, by preparing the functional budgets, then co-coordinating the whole activities by integrating all functional budgets into one which goes by the name of ‘Master Budget. In this way, it helps the management by con-coordinating the different parts of the enterprise. Besides, overall coordination is not at all possible without budgetary control.’ ▪ To Control ▪ The actual work done can be compared with ‘Standards’ to enable the management to control the performances effectively. Objectives of Management Accounting ▪ Uses of Information The primary functions of management are the uses of information. It presents accounting information in a form that enables the management, investors, and creditors to analyze the financial statements. ▪ Planning and Policy Formulation Planning is deciding in advance what is to be done. It helps the management of ineffective planning. It provides costing and statistical data to be utilized in setting goals and formulating future policies. ▪ Decision Making All management work is accomplished by decision making. Decision making is defined as the selection of a course of action from among alternatives. It helps the management in decision-making. It uses accounting data to solve various management problems. ▪ Motivating Motivation means individuals need, desires, and concepts that cause him or her to act in a particular manner. Delegation serves as a motivation device because it increases the job satisfaction of employees and encourages them to look forward. ▪ Controlling Management accounting helps management in controlling the performance of the organization. Actual performance is compared with operating plans, standards, and budgets, and deviations are reported to the management so that corrective measures may be taken. ▪ Coordinating Operations It helps the management in controlling the performance of the organization. Actual performance is compared with operating plans, standards, and budgets, and deviations are reported to the management so that corrective measures may be taken. ▪ Reporting One of the primary objectives of management accounting is to keep the management fully informed about the latest positions of the concern. The facilitates management to take proper and timely decisions. The object of management accounting is to provide data. It presents the different alternative plans before the management in a comparative manner. The performance of various departments is also regularly communicated to the top management. ▪ Help in Organizing Organizing is the process of allocating and arranging human and non-human resources so that plans can be carried out successfully. Tools or Techniques of Management Accounting Management Accountant applies many of the financial and cost accounting systems, as techniques, to assist the management. Management accounting is concerned with accounting information that is useful to management. Management accounting, like accounting, as an accounting service to management through its various functions, has to employ several tools, techniques, and methods. Now one technique can satisfy managerial needs. These are placed here in brief to have some idea about those. ▪ Financial Planning A business requires finance. Financial planning involves determining both long-term and short-term financing objectives of the firm. Every firm has to decide on the sources of raising funds. ▪ Budgetary Control There are a number of the device which help in controlling. The most widely used device for management control is “Budget.” Budgetary control is a system that resorts to budget as a means of planning and controlling and coordinating different types of activities, like the production and distribution of goods and services as designed. ▪ Marginal Costing Marginal costing is helpful for the measurement of profitability of different lines of production. This technique helps in identifying the nature of costs like marginal costs (variable) and fixed costs. This is a method of costing which is concerned with changes in costs resulting from changes in the volume of production. ▪ Historical Cost Accounting The statement of actual costs after they have been incurred is called Historical cost accounting. Historical cost accounting is a system of accounting that records all transactions at costs incurred as soon as they take place or on a date immediately after their occurrence. ▪ Decision Accounting One of the most important functions of top management is to make decisions. Decision making involves a choice from several alternatives. The decision is taken after studying the alternative data in terms of costs, prices, and profits furnished by management accounting and exercising the best choice after considering other non-financial factors. The objective is to maximize profit using the best alternative method. ▪ Standard Costing Standard costing is an important tool of cost control, which is one of the main objectives of management accounting. Standard costing techniques compare the standard costs of materials, labor, and expenses incidental to production, which is predetermined, with the actual costs that have occurred in the course of carrying out production. It is the most effective technique available for controlling performances and costs. ▪ Analysis of Financial Statement The technique of financial analysis includes comparative financial statements, ratios, fund flow statements, Cash flow statements, and comparative financial statement analysis tools to management for decision making. ▪ Revaluation Accounting This is an important tool for management accounting. Revaluation or Replacement accounting revere to the maintenance of capital in real terms. This term is used to denote the methods employed for overcoming the problems connect with fixed asset replacement in a period of rising prices. ▪ Control Accounting It is not a separate accounting system. It consists of techniques of standard costing, budgetary control, control reports and statement, internal check, internal audit, and reports. ▪ Management Information System It has already been stated that the management accounting of an enterprise is to provide management and other operations as a basis of protective and constructive to management. ▪ Statistical Techniques There is a large number of statistical and graphical techniques that are used in management accounting. Some common examples are the master chart, chart of sales and earnings, investment chart, etc. ▪ Ratio Accounting Ratio accounting signifies the technique and methodology of analysis and interpretation of financial statements using accounting ratios derived from such statements. Ratio accounting included trend analysis, comparative financial statements, ratio analysis, fund flow statements, etc. Importance or Roles of Management Accounting in the Decision-Making Process in a Business Organization The objective of decision making is to maximize profit through the use of the best alternative method. Management accounting helps management in deciding financial affairs. It uses accounting data to solve various management problems. The importance/role of management accounting can be stated as follows: ▪ Efficient Planning Management accounting plays a vital role in taking an efficient plan providing necessary information. Through the capital budget, sales budget, Cost-volume-profit analysis, management accountants provide information for making plans. ▪ Increasing Efficiency to Business Operations Management accounting also plays an important role in increasing efficiency in business operations through budgeting, ratio analysis, variance analysis, standard costing, etc. ▪ Efficient Control Management accounting takes pan inefficient control through JIT philosophy and total quality control system. ▪ Increase Labor Efficiency Management accounting helps to increase labor efficiency through standard labor costing, linking bonus with productivity and budgeting. ▪ Achieve Management Efficiency Management accounting contributes a lot to increase the management efficiency of the organization providing managers with the correct information. ▪ Help Management Function We know that the main functions of management are planning, organizing, leading, and controlling management accounting helps management personnel to perform the functions properly, providing necessary accounting information. ▪ Communicating For performing the functions efficiently and effectively, managers need to communicate with the various parties and parts of the organization. Management accounting helps in this respect preparing various reports. Differences Between Financial and Management Accounting The key difference between financial accounting and management accounting is that financial accounting is the preparation of financial reports for the analysis by the external users interested in knowing the company’s financial position. In contrast, management accounting is the preparation of financial and non-financial information, which helps managers make policies and strategies for the company. Management accounting is much broader than financial accounting in helping management since the subject “management accounting” is created to serve the management (yes, only the management). On the other hand, financial accounting is a niche subject that helps management see how a company is doing financially though financial accounting is created for stakeholders and potential investors who can look at the books of financial accounts and decide for themselves whether they would invest in the company or not. Let’s see the top differences between financial vs. management accounting Key Differences ▪ The scope of financial accounting is narrower than management accounting. The scope of management accounting is more pervasive. ▪ The purpose of financial accounting is to showcase an accurate and fair picture of the company’s financial affairs to potential investors, government, and existing shareholders. The purpose of management accounting, on the other hand, is to facilitate the management in making effective decisions on behalf of the shareholders. ▪ Financial accounting is independent of management accounting. Management accounting gathers data and information from financial accounting. ▪ Financial accounting only talks about quantitative data, and management accounting deals with quantitative and qualitative data. ▪ Financial accounting needs to be reported by maintaining certain formats. Management accounting is represented via informal formats or structures. ▪ Financial accounting is based on historical information. On the other hand, management accounting is based on both historical and predictive information. Standards of Ethical Conduct for Management Accountants Management accountants have an obligation to the organizations they serve, their profession, the public, and themselves to maintain the highest standards of ethical conduct. In recognition of this obligation, the Institute of Management Accountants (IMA) has published and promoted the following standards of ethical conduct for management accountants. The IMA Code of Conduct for Management Accountants Practitioners of management accounting and financial management have an obligation to the public, their profession, the organization they serve, and themselves, to maintain the highest standards of ethical conduct. In recognition of this obligation, the Institute of Management Accountants (IMA) has promulgated the following standards of ethical conduct for practitioners of management accounting and financial management. Adherence to these standards internationally is integral to achieving the objective of management accounting. Competence ▪ Maintain an appropriate level of professional competence through the ongoing development of their knowledge and skills. ▪ Perform their professional duties following relevant laws, regulations, and technical standards. ▪ Prepare complete and clear reports and recommendations after appropriate analyses of relevant and reliable information. Confidentiality ▪ Refrain from disclosing confidential information acquired in the course of their work except when authorized, unless legally obligated to do so. ▪ Inform subordinates as appropriate regarding the confidentiality of information acquired in the course of their work and monitor their activities to assure the maintenance of that confidentiality. ▪ Refrain from using or appearing to use confidential information acquired in the course of their work for unethical or illegal advantage either personally or through third parties. Integrity ▪ Avoid actual or apparent conflicts of interest and advise all appropriate parties of a potential conflict. ▪ Refrain from engaging in any activity that would prejudice their ability to carry out their duties ethically. ▪ Refuse any gift, favor, or hospitality that would influence or would appear to influence their actions. ▪ Refrain from either actively or passively subverting the attainment of the organization s legitimate and ethical objectives. ▪ Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity. ▪ Communicate unfavorable as well as favorable information and professional judgments or opinions. ▪ Refrain from engaging in or supporting any activity that would discredit the profession. Credibility ▪ Communicate information fairly and objectively. ▪ Disclose fully all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, comments, and recommendations presented. Resolution of Ethical Conflicts In applying the standards of ethical conduct, practitioners of management accounting and financial management may encounter problems in identifying unethical behavior or in resolving an ethical conflict. When faced with significant ethical issues practitioners of management accounting and financial management should follow the established policies of the organization bearing on the resolution of such conflict. If these policies do not resolve the ethical conflict, such practitioner should consider the following course of action. ✓ Discuss such problems with the immediate superior except when it appears that superior is involved, in which case the problem should be presented to the next higher managerial level. If a satisfactory resolution cannot be achieved when the problem is initially presented, submit the issue to the next higher managerial level. ✓ If the immediate superior is the chief executive officer or equivalent, the acceptable reviewing authority may be a group such as the audit committee, executive committee, board of directors, board of trustees, or owners. Contact with a level above the immediate superior should be initiated only with the superior’ s knowledge, assuming the superior is not involved. Except where legally prescribed, communication of such problems to authorities or individuals not employed or engaged by the organization is not considered appropriate. ✓ Clarify relevant ethical issues by confidential discussion with an objective adviser to obtain a better understanding of possible course of action. ✓ Consult your own attorney as to legal obligations and rights concerning the ethical conflict. If the ethical conflict still exists after exhausting all levels of internal review, there may be no other recourse on significant matters than to resign from the organization and to submit an informative memorandum to an appropriate representative of the organization. After resignation, depending on the nature of the ethical conflict, it may also be appropriate to notify other parties. ---------------------------------- END OF CHAPTER------------------------------------------------- References Webpage Managerial Accounting – Definition, Objective, Techniques & Limitations - https://www.zoho.com/books/guides/management-accounting.html Functions of Managerial Accounting: https://www.wallstreetmojo.com/functions-of-managerial- accounting/ Management Accounting: Definition, Functions, Objectives, Roles https://www.iedunote.com/management-accounting The IMA Code of Conduct for Management Accountants https://onlinelibrary.wiley.com/doi/pdf/10.1002/9781444395907.app2 Assessing Learning Activity 1 Name: ______________________________________ Date: ___________________________ Course and Section: ______________________ Score: _________________________ Direction: Briefly answer the following questions. 1. Describe and explain the major functions of management accounting and give examples. ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ _______________________________________________________________________ ________________________________________________________________________ _______________________ 2. “Planning is really more vital than control”. Do you agree? Why? ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________ 3. What roles do management accountants perform? ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________ 4. What are the ethical responsibilities of management accountants? ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________ 5. Compare and contrast financial and managerial accounting. ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ _____________________________________________________ UNIT II: BASIC COST MANAGEMENT CONCEPT Learning Objectives: At the end of the unit, I am able to: 1. Identify the cost allocation. 2. Enumerate and explain the classification of cost and relevance to decision making and control. 3. Analyze the managerial accounting report. Introduction: Cost Classifications for Preparing External Financial Statements. This section of the unit focuses on the problem of valuing inventories and determining cost of goods sold for external financial reports. Before beginning this discussion, you may want to explain the difference between a manufacturing and a merchandising company. Manufacturing companies convert raw materials into a product. The company then sells that product either to other companies or, less commonly, directly to individuals. “Manufacturing” includes restaurants, movie studios, and other service- type companies as well as the more obvious examples of manufacturing such as automobile and clothing production. Merchandising companies, by contrast, buy finished products and resell the products to customers. Valuing inventories and determining cost of goods sold is simple in a merchandising company but is difficult in a manufacturing company. Cost Allocation Cost allocation is the process of identifying, accumulating, and assigning costs to costs objects such as departments, products, programs, or a branch of a company. It involves identifying the cost objects in a company, identifying the costs incurred by the cost objects, and then assigning the costs to the cost objects based on specific criteria. When costs are allocated in the right way, the business is able to trace the specific cost objects that are making profits or losses for the company. If costs are allocated to the wrong cost objects, the company may be assigning resources to cost objects that do not yield as much profits as expected. Cost Allocation Mechanism Typical cost allocation mechanism involves: ▪ Identifying the object to which the costs have to be assigned, ▪ Accumulating the costs in different pools, ▪ Identifying the most appropriate basis/method for allocating the cost Cost Object Cost object is an item for which a business need to separately estimate cost. Examples of cost object include a branch, a product line, a service line, a customer, a department, a brand, a project, etc. Cost Pool Cost pool is the account head in which costs are accumulated for further assignment to cost objects. Examples of cost pools include factory rent, insurance, machine maintenance cost, factory fuel, etc. Selection of cost pool depends on the cost allocation base used. For example if a company uses just one allocation base say direct labor hours, it might use a broad cost pool such as fixed manufacturing overheads. However, if it uses more specific cost allocation bases, for example labor hours, machine hours, etc. it might define narrower cost pools. Cost Driver Cost driver is any variable that ‘drives’ some cost. If increase or decrease in a variable causes an increase or decrease is a cost that variable is a cost driver for that cost. Examples of cost driver include: ▪ Number of payments processed can be a good cost driver for salaries of Accounts Payable section of accounting department, ▪ Number of purchase orders can be a good cost driver for cost of purchasing department, ▪ Number of invoices sent can be a good cost driver for cost of billing department, ▪ Number of units shipped can be a good cost driver for cost of distribution department, etc. While direct costs are easily traced to cost objects, indirect costs are allocated using some systematic approach. Cost allocation base Cost allocation base is the variable that is used for allocating/assigning costs in different cost pools to different cost objects. A good cost allocation base is something which is an appropriate cost driver for a particular cost pool. Classification of Costs Classification of Costs essentially means the grouping of costs according to their similar characteristics. Now, in costing there are a dozen ways to classify costs as per their nature, functions, traceability etc. Here we will be focusing on such classifications. Let us learn this in detail. Classification of Cost by Element In this class, costs are categorized based on the factors they are incurred for. Based on their elements, costs may be grouped as:. ▪ Material Costs refers to the cost of commodities supplied to an undertaking (e.g., in the case of a textile mill, the cost of cotton or yarn, the cost of cotton waste to clean the machinery, the cost of dyes, the cost of finishing material, and so on). ▪ Labor Costs: Labor costs consists of the salary and wages paid to permanent and temporary employees in the pursuit of the manufacturing of the goods ▪ Expenses: All other expenses associated with making and selling the goods or services (e.g., rent for a building, telephone expenses, depreciation of the owned factory building, depreciation of delivery van, and so on). Classification of Cost by Nature In this class, costs are classified based on their identifiability with cost centers or cost units. Costs can be grouped as follows based on their nature: ▪ Direct costs are costs that can be directly and easily traced to (or identified with) a product, process, or department. Common examples of direct costs include the materials used and labor employed in manufacturing an article or in a production process. ▪ Indirect costs, on the other hand, are costs that are not traceable to any particular product, process, or department, but which are common in a number of products, processes, or departments. Examples of indirect costs are factory rent, factory insurance, and the salary of the factory manager. Classification of Cost by Variability or Behavior Costs (both direct and indirect) can also be classified into the following groups based on their behavior relative to changes in the volume of activity: ▪ Variable costs are costs that vary in a directly proportional way to changes in the volume of output or sales. These costs tend to increase or decrease with the rise and fall in production or sales. Variable costs vary in total but their per-unit cost stays the same. Examples of variable costs are direct material cost, direct wages, direct expenses, consumable stores, and commission on sales. ▪ Fixed costs are costs that generally remain unaffected by changes in sales volume/output. Fixed costs remain unchanged when output or sales increase or decrease. These costs remain fixed in total but their per-unit cost changes with output or sales. These costs depend mainly on the passage of time and do not vary directly with the changes in the volume of output or sales. Typical examples of fixed costs include rent, rates, taxes, insurance charges, and salaries for managers. It is worth remembering that fixed costs are not absolutely fixed for all of time. In fact, fixed costs are fixed only in relation to a particular level of production capacity. ▪ Semi-variable costs are costs that tend to vary with changes in the volume of output or sales, but which do not vary in a directly proportional way relative to such changes. These costs have the characteristics of both fixed and variable costs. One part of semi-variable costs remains constant irrespective of changes in the volume of output or sales. By contrast, the other part varies in proportion to changes in the volume of output or sales. Typical examples of semi-variable costs include repairs and maintenance costs for plants, machinery, and buildings and supervisor salaries. Cost Classification by Controllability Under this category, costs are classified based on whether or not they are influenced by the action of a given member of an undertaking. The classes of costs are: ▪ Controllable costs are costs that an entity in an undertaking can influence through their action. An undertaking is usually divided into several departments or cost centers that are placed under the direct control and supervision of specified persons. The person in charge of a particular department or cost center can control only those costs that come directly under their control. ▪ Uncontrollable costs, on the other hand, are costs that cannot be influenced by the action of a specified member of an undertaking. Costs that are controllable for one person may be uncontrollable for another person. Therefore, the issue of whether a cost is controllable or uncontrollable is determined by the individual or level of management in question. Cost Classification by Normality In this category, costs are classified based on whether they are normally incurred at a particular level of output under the conditions for which that level of output is normally attained. Based on normality, costs may be classified as: ▪ Normal or unavoidable costs are normally incurred at a given level of output under the conditions for which that level of output is normally attained. Costs of this kind cannot be avoided at all. The cost of normal spoilage of materials and the cost of normal idle time are typical examples of normal costs. ▪ Abnormal or avoidable costs are costs that are not normally incurred at a given level of output under the conditions for which that level of output is attained. It is possible to avoid such costs if proper care is taken. The cost of spoilage of material over and above the normal limit is an example of an abnormal cost. Cost Classification by Function Costs can also be classified based on their perceived function. The following types of cost exist by function: ▪ Production costs refer to costs that arise in the course of acquiring, processing, and using raw materials. Production costs include the cost of materials, cost of labor, other factory expenses, and the cost of primary packing. ▪ Administration costs are the costs incurred in formulating business policies, directing the organization, and controlling the operations of an undertaking. Administration costs are not related to research, development, production, distribution, or selling activities. ▪ Selling costs are incurred to create and stimulate demand and secure orders. As such, these costs are incurred in connection with the marketing of products. ▪ Distribution costs are associated with the sequence of operations. This sequence starts with dispatch preparations for the packed product and ends by facilitating the availability of the reconditioned, returned, and empty packages for re-use. Classification by Time From the view of time, costs can be classified as: Historical costs are costs that are identified after they have been incurred. They are determined after goods have been manufactured or services have been rendered. Historical costs simply represent a post-mortem of past events, and they are useful in ascertaining profitability but not in exercising cost control. Predetermined costs are computed in advance of production based on a specification of all the factors affecting them. Predetermined costs can be further divided into: a. Estimated costs are costs that, according to investigation and analysis, are most likely to be incurred. They are estimated in advance based on the following assumptions: firstly, that costs are more or less free to move; and secondly, that what is made is the best estimate of the cost conditions that will apply when the cost is incurred. b. Standard costs refer to a predetermined cost that is calculated from the management’s standards of efficient operation and the relevant necessary expenditure. Standard cost is established based on the assumption that costs will not be allowed to move freely but will be controlled as far as possible. This ensures that the actual cost will be as close to the standard cost as possible, and that any disparity between actual and standard cost can be reasonably explained. Cost Classification by Relevance to Decision-making and Control In this category, costs are classified based on whether they are relevant to managerial decisions. These costs are as follows: Marginal Cost: Marginal cost is defined as “the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit.” Marginal cost refers to the increase in total cost that results from an increase in output by one unit. Marginal cost is denoted by variable cost, and it consists of direct material cost, direct labor cost, direct expenses, and variable overheads. Sunk Costs: Sunk costs refer to costs that have already been incurred and cannot be changed by a future decision. These costs become irrelevant costs for later decisions. For example, if a manager decides to replace an existing machine with a new one, the amount of capital invested in the existing machine (less scrap value) will be irrecoverable and, as a result, is known as a ‘sunk cost’. Let’s assume that you bought an automobile that cost ₱ 600,000 two years ago. The ₱600,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the ₱ 600,000cost. Out-of-pocket Costs: These costs represent the present or future case expenditure regarding decisions, which vary based on the nature of the decision. Management decisions are directly affected by such costs because they give rise to cash expenditure. For example, consider a firm that has its own fleet for transporting raw materials and finished goods from one place to another. It seeks to replace these vehicles by employing public carriers. In making this decision, the depreciation of the vehicles is not to be considered but the management must take into account the present expenditure on fuel, maintenance, and driver salaries. Such costs are treated as out-of-pocket costs. Opportunity Costs: The opportunity cost of a product or service is measured in terms of revenue that could have been earned by applying the resources to some other use. Opportunity cost can be defined as the cost of foregoing the best alternative. Thus, the opportunity cost of yarn produced by a composite spinning and weaving mill, which is used in the weaving section, would be the price that could have been obtained by selling the yarn in the market. 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. Imputed Costs: Imputed costs are costs that are not included in costs but are considered for making management decisions. These costs are hypothetical in character. For example, interest on capital, though not actually payable, must often be included to judge the relative profitability of two products involving unequal outlays of cash. Differential Costs: Differential costs refer to the difference in total costs between two alternatives. When choosing an alternative increases total cost, such increased costs are known as incremental costs. On the other hand, if the choice results in a decrease in total costs, such decreased costs are called decremental costs. Assume you have a job paying ₱ 2,500 per month in your hometown. You have a job offer in a neighboring city that pays ₱ 3,000 per month. The commuting cost to the city is ₱ 300 per month. Differential revenue = P 3,000 – P 2,500 = P 500 Differential cost is P 300. Shut-down Costs: Shut-down costs are costs that will still be incurred when a plant is shut down temporarily. Sometimes, the normal operations of a business must be suspended temporarily due to unfavorable market conditions, strikes, or other forces. During the suspension of production or other activities, certain costs may still need to be incurred, and these are considered ‘shut-down costs’. Examples of shut-down costs include rent for factory premises, salaries of top management, and so on. Postponable Costs: These are the costs that can be postponed or shifted to the future with little or no effect on the efficiency of current operations. These costs are postponable but not avoidable and must be incurred at a later stage. The concept of a postponable cost is highly significant in the railway and transport business, where it’s possible to delay the cost of repairs and maintenance for a certain period. In manufacturing, economic crises can also be averted by postponing certain costs. This strategy was used during the depression period. Replacement Cost: Replacement cost is the cost of replacing an asset in the current market or at the current price. Thus, the replacement cost of an asset is the cost that would be incurred if the asset were purchased at the current market price and not at the original purchase price. Abandonment Costs: Abandonment refers to the complete retirement or withdrawal of a fixed asset from service or use. Fixed assets are abandoned when they are no longer serviceable. Abandonment cost refers to the cost incurred in abandoning a fixed asset (i.e., the cost that cannot be recovered or salvaged from the abandoned asset). It is also known as abandonment loss. Other Types of Cost Research Cost: This refers to the cost of searching for new or improved products, new applications of materials, or new or improved methods of production. Development Cost: This refers to the cost of the process that begins with making the decision to produce a new/improved product/method and ends with the commencement of formal production of that product/method. Pre-production Cost: This refers to the part of the overall development cost that is incurred in making a trial production run before beginning formal production. Conversion Cost: This refers to the costs incurred to convert raw materials into finished goods, and it consists of direct labor cost, direct expenses, and factory overhead. Characteristics of Managerial Accounting Reports While a merchandiser has only one type of inventory—merchandise available for sale—a manufacturer has three types—raw materials, partially complete work in process, and ready-for- sale finished goods. Instead of one inventory account, three different inventory accounts are necessary to show the cost of inventory in various stages of production. Looking at Figure 2.8, you cans see how the inventory cost flows differ between manufacturing and merchandising companies. You compare a manufacturer’s cost of goods sold section of the Statement of Comprehensive Income (also known as the income statement) to that same section of the merchandiser’s income statement in the chart below. There are two major differences in these cost of goods sold sections: (1) goods ready to be sold are referred to as merchandise inventory by a merchandiser and finished goods inventory by a manufacturer, and (2) the net cost of purchases for a merchandiser is equivalent to the cost of goods manufactured by a manufacturer. Unlike a merchandiser’s statement of financial position (commonly known as the balance sheet) that reports a single inventory amount, the balance sheet for manufacturer typically shows raw materials, work in process, and finished goods inventories separately. Figure 2.9 Income Statements of Merchandising and Manufacturing Company Source: The McGraw-Hill Companies, Inc., 2003 Figure 2.10 Balance Sheets of Merchandising and Manufacturing Company Source: The McGraw-Hill Companies, Inc., 2003 Figure 2.11Product and Period Cost Flows As summary, manufacturing cost incurred in producing products that are not yet finished, and finished goods that are not yet sold will be presented in the balance sheet. The cost of finished goods already sold is shown in the income statement under the Cost of Goods Sold account. Period costs is presented as expenses in the income statement as they are incurred and will not appear in the balance sheet. The Statement of Cost of Goods Manufactured The statement of cost of goods manufactured shows the total production costs for a company during a specific period of time. The Cost of Goods Manufactured (or COGM) is an accounting term that signifies the total expense incurred from turning raw materials inventory into finished goods inventory over a set time-period. It gives a broad understanding of the costs of manufacturing, making COGM an invaluable KPI for analyzing the profitability of companies. COGM includes all expenses related to the manufacturing process from inventory and factory overhead to labor. It is calculated by adding together the total costs of manufacturing and beginning work in process (or WIP) inventory and subtracting the ending WIP inventory from their sum. Cost of Goods Manufactured vs. Total Manufacturing Cost The Cost of Goods Manufactured and the Total Manufacturing Cost are similar and related terms. However, if the Total Manufacturing Cost is comprised of the direct material costs, direct labor costs, and the firm overhead costs, the Cost of Goods Manufactured also accounts for the change in Work-in-Process Inventory. The Total Manufacturing Cost is, however, a part of the Cost of Goods Manufactured. How to calculate the Cost of Goods Manufactured? COGM is comprised of all costs related to making the finished products, including: – Direct materials used. You can calculate the direct material costs by taking the beginning raw materials inventory, adding the cost of the raw materials purchased, and subtracting the ending raw materials inventory. – Direct labor used. This means only the salaries of the employees directly dealing with production activities, i.e. the shop floor workers. – Manufacturing overhead assigned to the production of the goods. This includes indirect materials that are used in production but are not necessarily part of the product (e.g. glue, sandpaper, lubricant, etc.); indirect labor such as supervision, quality control, materials management, and others that are not directly responsible for the production of goods but without whom production would not happen; depreciation of the premises and of the production equipment; rent or property taxes; and insurance. All of the abovementioned costs make up the Total Manufacturing Cost The COGM also accounts for the Beginning WIP Inventory, i.e. the cost of the goods that are unfinished in the production process during the accounting period. In order to calculate COGM, just add the Beginning WIP Inventory to the Total Manufacturing Cost, and subtract the Ending WIP Inventory. This will give you the total cost of the goods that were finished during the specified period. Example At the start of a quarter, a furniture manufacturer has $12,000 worth of furniture in the making. This is the Beginning WIP Inventory. Beginning WIP Inventory = $12,000 Furthermore, the company has $8,000 worth of raw materials in stock, waiting to be made into furniture. Within the quarter, the raw material inventory is replenished with $5,000 worth of stock altogether. At the end of the period, $3,000 worth of stock remains as raw materials. Using these figures, we can calculate the Direct Materials used. Direct Materials = $8,000 + $5,000 – $3,000 = $10,000 The company employs eight shop floor workers that are directly responsible for the execution of production processes. Four of them have seniority or special skills and make $2,600 a month, the other four make $2,200 a month. The sum of their three-month salaries (as we decided that the accounting period for the calculations is a quarter, i.e. three months) is the Direct Labor Costs. Direct Labor = [($2,600 x 4) + ($2,200 x 4)] x 3 = ($10,400 + $8,800) x 3 = $19,200 x 3 = $57,600 The Manufacturing Overhead is $28,600 altogether, comprising indirect labor costs for maintenance (wages $9,000 in a quarter) and warehouse (wages $12,000 in a quarter), additional materials such as glue and sandpaper ($800), rent ($6,000 per quarter), insurance ($200 per quarter), and an equipment depreciation of $2,400 a year, i.e. $600 per quarter. Manufacturing Overhead = $28,600 So, the Total Manufacturing Cost for the quarter is the sum of the direct material and labor costs, plus manufacturing overhead. Total Manufacturing Cost = $10,000 + $57,600 + $28,600 = $96,200 At the end of the quarter, $11,000 worth of furniture was still in the production process. This is the Ending WIP Inventory. Ending WIP Inventory = $11,000 And finally, we get the Cost of Goods Manufactured by adding the Beginning WIP Inventory to the Total Manufacturing Cost and subtracting the Ending WIP Inventory. COGM = $12,000 + 96,200 – $11,000 = $97,200 According to these basic calculations, the quarterly COGM of the furniture company is 97,200 dollars. Cost of Goods Manufactured vs. Cost of Goods Sold The COGM and the COGS are also very similar terms, but they are not to be confused with each other. While the Cost of Goods Manufactured accounts for both those finished products that have already been sold and those that remain in inventory waiting to be sold, the Cost of Goods Sold includes only the costs of making the products that have been sold during the accounting period. However, COGM is part of the COGS formula in periodic inventory accounting. cost-of-goods-sold-formula According to the previous example, if the company had a $10,000 beginning and a $20,000 ending finished goods inventory for the quarter, the COGS was: COGS = $10,000 + $97,200 – $20,000 = $87,200 The COGM and the COGS can differ for various reasons, such as: – more items were produced than sold during the accounting period (i.e. some items that were produced remain in stock, waiting to be sold). – more items were sold than produced during the accounting period (i.e. some items were sold from the last period’s remaining finished goods inventory). – some finished goods or WIP inventory have become obsolete (i.e. there is no demand for those products in the marketplace anymore). Example 1 Format of Cost of Good Sold Example 2 Format of Cost of Goods Manufactured Example Format of Manufacturing of Income Statement ---------------------------------- END OF CHAPTER------------------------------------------------- References Managerial Accounting Chapter 1: Nature of Managerial Accounting and Costs. (2017, September 25). Retrieved from https://courses.lumenlearning.com/managacct/chapter/characteristics-of-managerial-accounting- reports/ Managerial Accounting Chapter 1: Nature of Managerial Accounting and Costs. (2017, September 25). Retrieved from https://courses.lumenlearning.com/managacct/chapter/costs-and- expenses/ Managerial Accounting Chapter 1: Nature of Managerial Accounting and Costs. (2017, September 25). Retrieved from https://courses.lumenlearning.com/managacct/chapter/cost- classifications-used-for-planning-and-control/ Managerial Accounting Chapter 1: Nature of Managerial Accounting and Costs. (2017, September 25). Retrieved fromhttps://courses.lumenlearning.com/managacct/chapter/the- statement-of-cost-of-goods-manufactured/ Classification of Cost - https://learn.financestrategists.com/explanation/cost-accounting/analysis- of-cost/classification-of-cost/ Cost Allocation - https://corporatefinanceinstitute.com/resources/knowledge/accounting/cost- allocation/ How to Calculate the Cost of Goods Manufactured (COGM)?: https://manufacturing-software- blog.mrpeasy.com/cost-of-goods-manufactured-cogm/ Assessing Learning Activity 2 Name: ______________________________________ Date: ___________________________ Course and Section: ______________________ Score: _________________________ For the month of October, Durian Corporation had the following information: Inventories October 1 October 31 Materials P 58,000 P 50,000 Work in Process 34,000 26,000 Finished Goods 82,000 90,000 Materials purchased P 122,000 Direct Labor (at a uniform rate of P 6.40 per hour) 90,000 Factory overhead (120% of direct labor) Marketing and administrative expenses 10% of sales Sales P 410,000 Direction: You are required to compute the following items listed below. Show your computations. 1. Prime Cost 2. Conversion Cost 3. Total Manufacturing cost 4. Cost of goods manufactured 5. Cost of Goods Sold 6. Period Costs 7. Gross Profit 8. Net Income Assessing Learning Activity 3 Name: ______________________________________ Date: ___________________________ Course and Section: ______________________ Score: _________________________ Direction: Briefly answer the following questions. 1. Define the terms sunk cost and differential cost. ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ___ 2. Identify the three elements of cost incurred in manufacturing a product and indicate the distinguishing characteristics of each. ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ___ ________________________________________________________________________ _________________________ 3. Distinguish fixed costs from variable costs. ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ___ ________________________________________________________________________ _________________________ 4. Why are certain costs referred to as period costs? What are the major types of period costs incurred by a manufacturer? ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________ 5. Explain why the income statement of a manufacturing company differs from the income statement of a merchandising company. ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ___________________________ UNIT III: COST BEHAVIOR AND COST-VOLUME-PROFIT ANALYSIS Learning Objectives_ At the end of the unit, I am able to: 1. Explain how changes in activity affect contribution margin and net operating income. 2. Show the effects on contribution margin of changes in variable costs, fixed costs, selling price, and volume. 3. Compute the break-even point in unit sales and sales dollars. 4. Determine the level of sales needed to achieve a desired target profit. 5. Compute the margin of safety and explain its significance. Introduction: This chapter describes different types of costs and shows how changes in a company’s operating volume affect these costs. The chapter also analyzes a company’s costs and sales to explain how different operating strategies affect profit or loss. Managers use this type of analysis to forecast what will happen if changes are made to costs, sales volume, selling prices, or product mix. They then use these forecasts to select the best business strategy for the company Cost Behavior Cost Behavior is the change in the behavior of a cost (or costs) due to a change in business activity. The study of this change is the cost behavior analysis. For example, the electricity cost will move up if a business extends the working hours. However, not all costs change with business activity. And, some costs may remain stagnant despite a change in business activity. For instance, a company needs to pay insurance whether or not it is operating. Some costs do not change in proportion to the change in business operations. A company usually uses mathematical cost functions to study the behavior of costs. Before analyzing the behavior of costs, a manager needs to understand the crucial business activities that may impact the costs. Usually, a manager can define activity levels in terms of dollars, units, miles were driven, and more. Moreover, the manager should try to determine the correlation between activity levels and costs. Types of Cost Behavior 1. Variable cost is an expenditure directly correlated with the sale or manufacture of goods or services. For each sale of a unit of product or service, one unit of variable cost is incurred. 2. Fixed costs remain the same in terms of their total dollar amount, regardless of the number of units manufactured or sold. These are general expenditures that cannot be traced to any one item sold and may include electricity, insurance, depreciation, salary, and rent expenses. 3. Mixed costs have both a fixed and a variable component. There is typically a base amount that is incurred even if there are no sales at all. There is also an incremental amount assigned to each unit sold. Examples of Cost Behavior An example of a variable cost is the cost of flour for a bakery that produces artisan breads. The greater the number of loaves produced, the greater the total cost of the flour used by the bakery. An example of a fixed cost is the depreciation and insurance on the bakery facility and equipment. Regardless of the quantity of artisan breads produced in a month, the total amount of depreciation and insurance cost for the month will remain the same. An example of a mixed cost or semivariable cost is the bakery's cost of natural gas. Some of the monthly gas bill is a flat fee charged by the utility and some of the gas bill is the cost of heating the building. These two components of the gas bill are fixed since they will not change when the bakery produces more or less loaves of its bread. However, a third component of the gas bill is the cost of operating the ovens. This component is a variable cost since it will increase when the ovens must operate for a longer time in order to produce additional loaves of bread. Cost Behavior Patterns There are four basic cost behavior patterns: fixed, variable, mixed (semi variable), and step which graphically would appear as below. The relevant range is the range of production or sales volume over which the assumptions about cost behavior are valid. Often, we describe them as time-related costs. Source: https://courses.lumenlearning.com/sac-managacct/chapter/cost-behavior-vs-cost- estimation/ Figure 3.1 Cost Behavioral Patterns Managers usually separate mixed costs into their fixed and variable components for decision- making purposes. They include the fixed portion of mixed costs with other fixed costs, while assuming the variable part changes with volume. You will look at ways to separate fixed and variable components of a mixed cost later in the chapter. A step cost remains constant at a certain fixed amount over a range of output (or sales). Then, at certain points, the step costs increase to higher amounts. Visually, step costs appear like stair steps. Although we have described four different cost patterns (fixed, variable, mixed, and step), we simplify our discussions in this chapter by assuming managers can separate mixed and step costs into fixed and variable components using cost estimation techniques. Figure 3.3 Stair-Step Cost Cost-Volume-Profit Analysis in Planning Cost Volume Profit Analysis (CVP) looks at the impact on the operating profit due to the varying levels of volume and the costs and determines a break-even point for cost structures with different sales volumes that will help managers in making economic decisions for short term. Cost-volume-profit (CVP) analysis is a key step in many decisions. CVP analysis involves specifying a model of the relations among the prices of products, the volume or level of activity, unit variable costs, total fixed costs, and the sales mix. This model is used to predict the impact on profits of changes in those parameters. Explanation Cost Volume Profit Analysis includes the analysis of sales price, fixed costs, variable costs, the number of goods sold, and how it affects the profit of the business. The aim of a company is to earn a profit, and profit depends upon a large number of factors, most notable among them is the cost of manufacturing and the volume of sales. These factors are largely interdependent. The volume of sales is dependent upon production volume, which in turn is related to costs that are affected by the volume of production, product mix, internal efficiency of the business, production method used, etc. CVP analysis helps management in finding out the relationship between cost and revenue to generate profit. CVP Analysis helps them to BEP Formula for different sales volume and cost structures. With CVP Analysis information, the management can better understand the overall performance and determine what units it should sell to break even or to reach a certain level of profit. Contribution Margin. Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. It contributes towards covering fixed costs and then towards profit. Unit Contribution Margin. The unit contribution margin can be used to predict changes in total contribution margin as a result of changes in the unit sales of a product. To do this, the unit contribution margin is simply multiplied by the change in unit sales. Assuming no change in fixed costs, the change in total contribution margin falls directly to the bottom line as a change in profits. Contribution Margin Ratio. The contribution margin (CM) ratio is the ratio of the contribution margin to total sales. It shows how the contribution margin is affected by a given dollar change in total sales. The contribution margin ratio is often easier to work with than the unit contribution margin, particularly when a company has many products. This is because the contribution margin ratio is denominated in sales dollars, which is a convenient way to express activity multi product firms. CVP Relationships in Graphic Form. CVP graphs can be used to gain insight into the behavior of expenses and profits. The basic CVP graph is drawn with dollars on the vertical axis and unit sales on the horizontal axis. Total fixed expense is drawn first and then variable expense is added to the fixed expense to draw the total expense line. Finally, the total revenue line is drawn. The total profit (or loss) is the vertical difference between the total revenue and total expense lines. The break-even occurs at the point where the total revenue and total expenses lines cross. Break-Even Analysis and Target Profit Analysis. Target profit analysis is concerned with estimating the level of sales required to attain a specified target profit. Break-even analysis is a special case of target profit analysis in which the target profit is zero. Basic CVP equations. Both the equation and contribution (formula) methods of break-even and target profit analysis are based on the contribution approach to the income statement. The format of this statement can be expressed in equation form as: Profits = Sales - Variable expenses - Fixed expenses In CVP analysis this equation is commonly rearranged and expressed as: Sales = Variable expenses + Fixed expenses + Profits a. The above equation can be expressed in terms of unit sales as follows: Price x Unit sales = Unit variable cost x Unit sales + Fixed expenses + Profits Unit contribution margin x Unit sales = Fixed expenses + Profits Unit sales = b. The basic equation can also be expressed in terms of sales dollars using the variable expense ratio: Sales = Variable expense ratio x Sales + Fixed expenses + Profits (1 - Variable expense ratio) x Sales = Fixed expenses + Profits Contribution margin ratio* x Sales = Fixed expenses + Profits Sales = * 1 - Variable expense ratio = 1 - *1 - Variable expense ratio = 1 - = =Contribution margin/Sales =Contribution margin ratio Break-even point using the equation method. The break-even point is the level of sales at which profit is zero. It can also be defined as the point where total sales equals total expenses or as the point where total contribution margin equals total fixed expenses. Break-even analysis can be approached either by the equation method or by the contribution margin method. The two methods are logically equivalent. a. The Equation Method—Solving for the Break-Even Unit Sales. This method involves following the steps in section (1a) above. Substitute the selling price, unit variable cost and fixed expense in the first equation and set profits equal to zero. Then solve for the unit sales. Break-even point using the contribution method. This is a short-cut method that jumps directly to the solution, bypassing the intermediate algebraic steps. a. The Contribution Method—Solving for the Break-Even Unit Sales. This method involves using the final formula for unit sales in section (1a) above. Set profits equal to zero in the formula. Break-even unit sales = b. The Contribution Method—Solving for the Break-Even Sales in Dollars. This method involves using the final formula for sales in section (1b) above. Set profits equal to zero in the formula. Break-even sales = Target profit analysis. Either the equation method or the contribution margin method can be used to find the number of units that must be sold to attain a target profit. In the case of the contribution margin method, the formulas are : Unit sales to attain target profits = Dollar sales to attain target profits = Note that these formulas are the same as the break-even formulas if the target profit is zero. Margin of Safety. The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales. It is the amount by which sales can drop before losses begin to be incurred. The margin of safety can be computed in terms of dollars: Margin of safety in dollars = Total sales – Break-even sales or in percentage form: Margin of safety percentage = Sales Mix. Sales mix is the relative proportions in which a company’s products are sold. Most companies have a number of products with differing contribution margins. Thus, changes in the sales mix can cause variations in a company’s profits. As a result, the break-even point in a multi-product company is dependent on the sales mix. 1. Constant sales mix assumption. In CVP analysis, it is usually assumed that the sales mix will not change. Under this assumption, the break-even level of sales dollars can be computed using the overall contribution margin (CM) ratio. In essence, it is assumed that the company has only one product that consists of a basket of its various products in a specified proportion. The contribution margin ratio of this basket can be easily computed by dividing the total contribution margin of all products by total sales. Overall CM ratio = 2. Use of the overall CM ratio. The overall contribution margin ratio can be used in CVP analysis exactly like the contribution margin ratio for a single product company. For a multi-product company the formulas for break-even sales dollars and the sales required to attain a target profit are: Break-even sales = Sales to achieve target profits = Note that these formulas are really the same as for the single product case. The constant sales mix assumption allows us to use the same simple formulas. Changes in sales mix. If the proportions in which products are sold change, then the overall contribution margin ratio will change. Since the sales mix is not in reality constant, the results of CVP analysis should be viewed with more caution in multi-product companies than in single product companies. Assumptions in CVP Analysis. Simple CVP analysis relies on simplifying assumptions. However, if a manager knows that one of the assumptions is violated, the CVP analysis can often be easily modified to make it more realistic. 1. Selling price is constant. The assumption is that the selling price of a product will not change as the unit volume changes. This is not wholly realistic since unit sales and the selling price are usually inversely related. In order to increase volume it is often necessary to drop the price. However, CVP analysis can easily accommodate more realistic assumptions. A number of examples and problems in the text show how to use CVP analysis to investigate situations in which prices are changed. 2. Costs are linear and can be accurately divided into variable and fixed elements. It is assumed that the variable element is constant per unit and the fixed element is constant in total. This implies that operating conditions are stable. It also implies that the fixed costs are really fixed. When volume changes dramatically, this assumption becomes tenuous. Nevertheless, if the effects of a decision on fixed costs can be estimated, this can be explicitly taken into account in CVP analysis. A number of examples and problems in the text show how to use CVP analysis when fixed costs are affected. 3. The sales mix is constant in multi-product companies. This assumption is invoked so as to use the simple break-even and target profit formulas in multi-product companies. If unit contribution margins are fairly uniform across products, violations of this assumption will not be important. However, if unit contribution margins differ a great deal, then changes in the sales mix can have a big impact on the overall contribution margin ratio and hence on the results of CVP analysis. If a manager can predict how the sales mix will change, then a more refined CVP analysis can be performed in which the individual contribution margins of products are computed. 4. In manufacturing companies, inventories do not change. It is assumed that everything the company produces is sold in the same period. Violations of this assumption result in discrepancies between financial accounting net operating income and the profits calculated using the contribution approach. This topic is covered in detail in the chapter on variable costing. Benefits ▪ CVP analysis provides a clear and simple understanding of the level of sales that are required for a business to break even (No profit, No loss), level of sales required to achieve targeted profit. ▪ CVP analysis helps management to understand the different costs at different levels of production/sales volume. CVP analysis helps decision-makers in forecasting cost and profit on account of change in volume. ▪ CVP Analysis helps businesses analyze during recessionary times the comparative effects of shutting down a business or continuing business at a loss, as it clearly bifurcates the Direct and Indirect cost. ▪ The effects of changes in fixed and variable cost help management decide the optimum level of production. Limitations of Cost-Volume Analysis (CVP) ▪ CVP analysis assumes fixed cost is constant, which is not the case always; beyond a certain level, fixed cost also changes. ▪ Variable cost is assumed to vary proportionately, which doesn’t happen in reality. ▪ Cost volume profit analysis assumes costs are either fixed or variable; however, in reality, some costs are semi-fixed in nature. For example, Telephone expenses comprise a fixed monthly charge and a variable charge based on the number of calls made. Examples of Cost Volume Profit Analysis Let’s understand examples of Cost volume profit analysis with the help of a few examples: Examples #1 XYZ wishes to make an annual profit of $100000 from the sale of appliances. Details of manufacturing and annual capacity are as follows: Based on the above information, let’s plug the numbers in the CVP equation: 10000*p= (10000*30) +$30000+$100000 10000p = ($300000+$30000+$100000) 10000p=$430000 Price per unit= ($430000/10000) = $43 Thus, price per unit comes out to $43, which implies that XYZ will have to price its product $43 and need to sell 10000 units to achieve its targeted profit of $100000. Further, we can see that the fixed cost remains constant ($30000) irrespective of the level of sales. Examples #2 ABC Limited has entered into the business of making Electrical fans. The management of the company is interested in knowing the breakeven point at which there will be no profit/loss. Below are the details pertaining to the cost incurred: No. of units sold by ABC limited: ($300000/$300) = 1000 units Variable cost per unit = ($240000/1000)= $240 Contribution per unit= Selling price per unit-Variable cost per unit = ($300-$240) = $60 per unit Break-Even Point= (Fixed Cost/Contribution per unit) = ($60000/$60) =10000 units Thus, ABC limited the need to sell 10000 units of electric fans to break even at the current cost structure Sensitivity Analysis of CVP Results What Is Sensitivity Analysis? Sensitivity analysis determines how different values of an independent variable affect a particular dependent variable under a given set of assumptions. In other words, sensitivity analyses study how various sources of uncertainty in a mathematical model contribute to the model's overall uncertainty. This technique is used within specific boundaries that depend on one or more input variables. Sensitivity analysis is used in the business world and in the field of economics. It is commonly used by financial analysts and economists and is also known as a what-if analysis. Sensitivity Analysis: An Example To illustrate sensitivity analysis, let’s go back to Snowboard Company, a company that produces one snowboard model. The assumptions for Snowboard were as follows: Sales price per unit $ 250 Variable cost per unit 150 Fixed costs per month 50,000 Target profit 30,000 Recall from earlier calculations that the break-even point is 500 units, and Snowboard must sell 800 units to achieve a target profit of $30,000. Management believes a goal of 800 units is overly optimistic and settles on a best guess of 700 units in monthly sales. This is called the “base case.” The base case is summarized as follows in contribution margin income statement format: Question: Although management believes the base case is reasonably accurate, it is concerned about what will happen if certain variables change. As a result, you are asked to address the following questions from management (you are now performing sensitivity analysis!). Each scenario is independent of the others. Unless told otherwise, assume that the variables used in the base case remain the same. How do you answer the following questions for management? 1. How will profit change if the sales price increases by $25 per unit (10 percent)? 2. How will profit change if sales volume decreases by 70 units (10 percent)? 3. How will profit change if fixed costs decrease by $15,000 (30 percent) and variable cost increases $15 per unit (10 percent)? Answer: The CVP model shown in Figure 6.6 "Sensitivity Analysis for Snowboard Company" answers these questions. Each column represents a different scenario, with the first column showing the base case and the remaining columns providing answers to the three questions posed by management. The top part of Figure 6.6 "Sensitivity Analysis for Snowboard Company" shows the value of each variable based on the scenarios presented previously, and the bottom part presents the results in contribution margin income statement format. Figure 6.6 Sensitivity Analysis for Snowboard Company ---------------------------------- END OF CHAPTER------------------------------------------------- References Webpage Accounting Cost-Volume-Profit Analysis. (2016). Retrieved from http://simplestudies.com/accounting-cost-volume-profit-analysis.html/page/9 Managerial Accounting Chapter 5: Cost Behavior and Cost-Volume-Profit Analysis. (2017, September 25). Retrieved from https://courses.lumenlearning.com/managacct/chapter/cost-behavior-vs-cost-estimation/ Managerial Accounting Chapter 5: Cost Behavior and Cost-Volume-Profit Analysis. (2017, September 25). Retrieved from https://courses.lumenlearning.com/managacct/chapter/variable-costs/ Managerial Accounting Chapter 5: Cost Behavior and Cost-Volume-Profit Analysis. (2017, September 25). Retrieved from https://courses.lumenlearning.com/managacct/chapter/mixed-costs/ Managerial Accounting Chapter 5: Cost Behavior and Cost-Volume-Profit Analysis. (2017, September 25). Retrieved from https://courses.lumenlearning.com/managacct/chapter/cost-volume-profit-analysis-in- planning/ Managerial Accounting Chapter 5: Cost Behavior and Cost-Volume-Profit Analysis. (2017, September 25). Retrieved from https://courses.lumenlearning.com/managacct/chapter/break-even-point/ https://www.accountingcoach.com/blog/what-is-cost-behavior https://saylordotorg.github.io/text_managerial-accounting/s10-03-using-cost-volume- profit-model.html Assessing Learning Activity 4 Name: ______________________________________ Date: ___________________________ Course and Section: ______________________ Score: _________________________ Direction: Briefly answer the following questions. 1. Define cost behavior and relevant range. ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ___ 2. Enumerate and describe the four cost behavior patterns. ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ______ 3. What effect does and increase in volume have on a. unit fixed costs? ________________________________________________________________________ ________________________________________________________________________ __________________________________________________ b. unit variable costs? ________________________________________________________________________ ________________________________________________________________________ __________________________________________________ c. total fixed costs? ________________________________________________________________________ ________________________________________________________________________ __________________________________________________ d. total variable costs? ________________________________________________________________________ ________________________________________________________________________ __________________________________________________ 4. What is the meaning of the term contribution margin? ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ___ Assessing Learning Activity 5 Name: ______________________________________Date: ___________________________ Course and Section: ______________________ Score: _________________________ King and Queen Company’s most recent income statement is shown below: Total Per unit Sales (30,000 units) P 150,000 P5 Less: Variable expenses 90,000 3 Contribution margin 60,000 2 Less: fixed expenses 50,000 Net operating income P 10,000 Direction: Prepare a new income statement under each of the following conditions. (Consider each case independently). Support your answers by showing your computations. 1. The sales volume increases by 25%. 2. The sales price decreases by 50 cents per unit, and the sale volume increases by 30%. 3. The selling price increases by 50 cents per unit, fixed expenses increase by P 10,000 and the sales volume decreases by 5%. 4. Variable expenses increase by 20 cents per unit, the selling price increases by 12% and the sales volume decreases by 5%. UNIT IV: ABSORPTION AND VARIABLE COSTING Learning Objectives_ At the end of the unit, I am able to: 1. Understand the absorption and variable costing 2. Identify the different steps of absorption costing 3. Differentiate the absorption and variable costing Introduction: Absorption costing refers to a method of costing to account for all the costs of manufacturing. The management uses this method to absorb the costs incurred on a product. The costs include direct costs and indirect costs. Direct costs include materials, labour used in production. Indirect costs include factory rent, administration costs, compliance, and insurance. Understanding Absorption Costing The costs observed under absorption costing include variable costs, fixed costs, and semi-variable costs. Variable costs increase or decrease in the proportion of the goods produced. Fixed costs do not alter irrespective of the quantity of production. Semi-variable costs increase or decrease in batches. Absorption costing is part of accounting methods and procedures. Absorption costing determines the cost of the inventory at the end of an accounting period. The closing inventory also consists of fixed costs, thus increasing the value of the inventory. This method of inventory valuation increases the profit of the company. Absorption costing is also known as full costing since it includes all the costs associated with production. Variable costs are direct labour and material costs. Fixed costs include rent, security, and insurance expenses. Semi-variable costs include electricity charges for the factory. Thus, under full costing, all the expense are absorbed by the product irrespective of the product being sold. Absorption costing enables precise accounting for the overall cost of production, unlike in variable costing, which considers only variable costs. The method of absorption costing enables reporting of high profit with a high value of closing inventory. This is because the cost of production is completely absorbed. What is absorption costing? Absorption costing—also referred to as “full absorption costing" or "full costing"—is an accounting method designed to capture all of the costs that go into manufacturing a specific product. Absorption costing is necessary to file taxes and issue other official reports. Regardless of whether every manufactured good is sold, every manufacturing expense is allocated to all products. In other words, the company’s products absorb all the company’s costs. Some of these costs include: Labor: The direct factory labor used to manufacture a product. This cost is directly associated with wages paid during production. Raw materials: The materials used to construct a finished product are calculated as well. Variable manufacturing overhead: The costs necessary to run a production facility. They are variable costs because they vary with the volume of production. Examples of variable manufacturing overhead are electricity, utilities and supplies used by the manufacturing equipment. Fixed manufacturing overhead: The costs associated with operating a production facility that remain fixed, regard

Managerial Accounting Module-Workbook PDF

Document Details

Tags

Related

Summary

Full Transcript

Upgrade to continue