Background Paper:
Management Accounting
Concepts
College of Business and Economics
Master of Business Administration
MBA C604 Accounting and Finance Concepts for Managers
Contents
Topic 1
Introduction and Purpose
Purposes of Accounting Information Systems
Classification and Behavior of Costs
—
—
—
—
—
—
Components of Product Costs
Prime Costs and Conversion Costs
Product Costs and Period Costs
Cost Behavior in Response to Changes in Business Activity Levels (Variable and Fixed Costs)
Relevant Range for Short-term Planning and Control
Committed and Discretionary Fixed Costs
Cost-Volume-Profit Analysis
— Determining Required Production-and-Sales Volume
— Estimating Impact of Sales Changes on Net Income
— Estimating Impact of Contemplated Management Decisions
Presenting and Analyzing Operating Performance: Absorption Costing and Variable Costing Methods
Cost Accounting Systems: Process Cost and Job Order Cost Systems
Standard Costs
— Nature and Purpose of Standard Costs
— Actual-versus-Standard Cost Variances
— Investigation of Unfavorable Usage (Efficiency) Variances
Topic 2
Determining the Costs of Products
— Components of Product Costs and Cost Allocation
— Uses of Product Cost Information
— Measurement Objectives of Determining Product Costs
Traditional Allocation of Manufacturing Overhead Costs
— Manufacturing Overhead Costs
— Allocation of Manufacturing Overhead Costs
— Allocation of Manufacturing Overhead Costs using Multiple Cost Pools
Activity-based Costing (ABC) Method for Allocating Manufacturing Overhead Costs
Comparing the ABC Method to the Traditional Method of MOH Allocation
Cost Allocation for Business Unit Manager Performance Measurement
1
Introduction and Purpose
As a student in this course, you previously completed a managerial (or cost) accounting principles course (in
addition to a financial accounting principles course). Among other topics, that course examined:
Cost terminology and classification
Cost behavior and cost-volume-profit analysis
Cost accounting systems (process cost and job order cost systems)
Standard costs
Product cost determination, including allocation of indirect costs
This background paper reexamines each of these topics from the perspective of managers having
responsibility for planning, controlling, and evaluating the operations of a business. These concepts and
models are useful to managers who seek answers to such common questions as:
Can I improve the business’ profitability by increasing or decreasing product prices, or by investigating
possible reductions in the amounts of material or labor used in making those products?
Will increases in product sales be sufficient to justify the costs of additional expenditures for product
promotion, new-product development, or acquisition of more efficient manufacturing equipment? (The
Topic 6 background paper also examines this question.)
Should I establish standard costs to improve the planning and control of the business’ activities? If so, how
should I set those standards so that they are effective for motivating and evaluating employee and
manager performance?
I may have to reduce the prices of the business’ products to respond to increased competition. How can I
first develop relevant and reliable per-unit cost information for those products, so that I know that they will
still be profitable after the price reductions?
How should I allocate costs to business units so that I can motivate and fairly evaluate the performance of
the managers responsible for them?
2
Topic 1
Purposes of Accounting Information Systems
The accounting information system of a business is the collection of people, policies, procedures, information
technology, and processes that identifies, classifies, processes, summarizes, and distributes economic and
financial information to its various users.1 A business’ management accounting information should describe
its economic performance and resources with respect to its:
Operating units (such as divisions and departments),
Processes,
Products, and
Customers
A business’ accounting information system should provide this information in a manner that permits managers
to plan and control the activities of the business in pursuit of its strategy.2 To be appropriate to a particular
business, managers must tailor its accounting information system to its particular industry characteristics,
organization, products, and requirements for planning and control. In turn, a business’ planning and control
requirements depend on its strategy and objectives. Management accounting information is useful to
managers in examining and reducing the costs of a business’ processes, products, and operating units,
thereby leading to increased market share, profits, or both. Examples of ways businesses reduce costs
include:
Renegotiating terms with suppliers
Outsourcing manufacturing activities to third parties that have lower operating costs
Redesigning products (so that they require fewer or lower-cost components) or manufacturing
processes to shorten production cycle times (by implementing just-in-time manufacturing methods that
reduce excessive production and warehousing of goods and excessive material handling during
manufacturing)3
Pursuing total quality management (TQM) by reducing product defects and the associated costs of
rework and waste
_____
1
The Topic 3-4 background paper examines further the accounting information system, as well as the uses and desired qualities of
accounting information.
2
A business’ strategy is the operational approach by which its managers try to achieve their objectives for the business. Those
objectives relate principally to the interests of the business’ customers and owners.
3
Managerial accounting courses examine target costing, a methodology managers sometimes use to help determine the engineering
design and features of products and production processes, along with their expected costs, in those situations where market factors
primarily determine the prices of the products, rather than a business’ cost-plus-target profit.
3
As examined further below, a business’ management accounting system should provide managers with
information useful for:
Setting the prices of or promotion strategies for its products and services
Determining which products or services it should offer or discontinue
Deciding whether to acquire a competitor or supplier business
Projecting the required level of productive capacity and deciding whether to acquire additional, or close
existing, plants
Evaluating and enhancing the quality or timely delivery of products or customer service4
As described below, a business’ management accounting system may take the form of a process cost
system or a job order cost system (or, in some cases, a combination of both), depending on the nature of its
products and manufacturing processes. In addition, a business may use a standard cost system, which is
compatible with both process cost or job order cost systems.
_____
4
To evaluate the quality or timeliness of product delivery and customer service, managers often use benchmarking. Benchmarking is
a process by which managers examine the economic performance of competing businesses and compare it against the performance of
their own business in order to identify opportunities for enhanced performance and competiveness by their business. Stated broadly,
benchmarking seeks to identify “best practices.” Because manufacturing and product technology, customer requirements, industry
characteristics, and other factors change continuously, many successful businesses practice continuous improvement; that is, they
continuously pursue improvements in product quality and customer service and reductions of product costs, like those listed above.
4
Classification and Behavior of Costs
Cost is the economic value, measured in currency, of resources given in exchange for services or other items
representing potential economic benefits. Examples of these services include those of employees,
contractors, and utilities. Examples of items representing potential economic benefits include raw materials
and machinery used in making products, warehouses used to store materials and finished products, and trucks
used to deliver finished products to customers. Managers commonly refer to the cost of products or services
sold to customers. This reference to the cost of products or services is actually shorthand for the costs of
those activities performed in making and delivering products and services to customers, as examined further,
below.
As examined further below, accountants classify costs in several ways. In a manufacturing business, one cost
classification scheme is manufacturing costs and nonmanufacturing costs.
Manufacturing costs include the costs of materials and labor and other activities used in making products.
Nonmanufacturing costs include all other such costs, such as the costs of administrative, selling and
distribution, and research-and-development (R&D) activities.
Components of Product Costs
In order to determine the cost of products they manufacture, businesses must track and assign to those
products the costs of direct materials and direct labor used in producing them.
Direct materials are materials used directly in producing goods. Examples of direct materials are metals,
plastics and resins, chemicals, coatings, colorants, electronic subassemblies, and computer
semiconductors.
Direct labor refers to the services of production employees directly involved in producing goods.
Examples of direct labor activities are cutting, machining, assembly, and finishing. 5
Costs not comprising direct materials or direct labor are indirect costs. Accountants classify indirect costs as
non-manufacturing overhead costs and manufacturing overhead (MOH) costs. In addition to direct
materials and direct labor, the cost of a business’ products includes allocations of MOH costs.6 MOH costs
include the costs of a manufacturing plant and a variety of supporting services, examined below.
_____
5
Generally, businesses should not include in direct labor the cost of production employees’ services attributable to overtime or idle
time. Instead, they should classify such costs as manufacturing overhead (MOH) because overtime and idle time are usually the result
of decisions or conditions controlled by employees responsible for MOH activities, such as production scheduling or equipment
maintenance, rather than production employees.
6
This background paper examines below (in connection with Topic 2) the process of determining the cost of products a business
manufactures for sale, focusing on the allocation of MOH costs.
5
Prime Costs and Conversion Costs
Collectively, managers and accountants refer to direct materials and direct labor costs as prime costs. They
refer to direct labor and MOH costs as conversion costs. Conversion costs are the costs of activities
necessary to convert direct materials into finished goods ready for sale to a business’ customers.
Prime costs
Direct
materials
Direct labor
MOH
(Indirect)
Conversion costs
Product Costs and Period Costs
As examined in the Topic 3-4 background paper, businesses recognize costs having potential economic
benefits, such as materials and finished goods inventory, manufacturing equipment, and warehouse facilities in
their balance sheets as assets. In contrast, businesses recognize costs no longer having potential economic
benefits, such as the costs of products sold or the cost (salaries) of administrative employees’ services
provided, in their income statements as expenses. Businesses classify costs for financial reporting purposes7
as product costs or period costs.
Product costs have a causal relationship to revenues a business recognizes (reports) in its current
income statement. As defined above, these are the costs of manufacturing products that a business sells
to its customers and include direct material, direct labor, and MOH costs. In general, businesses recognize
product costs as assets (inventory) in their balance sheets until they recognize related revenues from their
sale. When they recognize revenues in their income statement, businesses concurrently recognize the
related product costs as expenses (cost of goods sold, or cost of sales). In general, manufacturing costs
(defined above) represent product costs.
Period costs are those for which a clear causal relationship with specific revenues earned by the business
does not exist. Period costs include R&D, employee training, and advertising costs. Businesses record
period costs as expenses in their income statement as they incur them, rather than as assets in their
balance sheets. Most nonmanufacturing costs represent period costs.
Both product costs and period costs (and both manufacturing costs and non-manufacturing costs) may include
allocated costs. Allocated costs include principally depreciation of long-lived property, plant, and equipment
(PP&E) and amortization of certain long-lived intangible assets (such as the cost of acquired patents or
licenses). For example, a business may depreciate equipment costing $100,000, having an estimated
economic life of 10 years and no estimated end-of-life salvage value, by recording $10,000 of depreciation in
each of those ten years. Depending on whether the business uses the equipment in its manufacturing or nonmanufacturing activities, it will classify the related depreciation in each fiscal year as a manufacturingproduct cost or as nonmanufacturing-period cost.8
_____
7
Recall that you learned about financial reporting in your financial accounting principles course. The Topic 3-4 background paper
examines financial reporting.
8
The Topic 3-4 background paper examines the basic accounting principles that guide the financial reporting treatment of costs.
Historically, financial accounting principles and requirements for financial reporting to investors dictated the design of businesses’
accounting systems, including the classification and aggregation of costs for managers’ planning and control purposes. The Topic 5
and Topic 6 background papers examine opportunity costs, which businesses generally do not recognize within their formal
accounting systems.
6
Cost Behavior in Response to Changes in Business Activity Levels (Variable and Fixed Costs)
In order to achieve their planning and control objectives, managers examine the behavior (changes in the
amount) of a business’ costs in response to changes in the level or volume of business activity. Examples of
these activities include (the volume or level of):
Units of a product manufactured for sale or services provided to customers
Hours worked by production or customer services employees
Hours that machinery is in operation
Machine set-ups performed
Production batches run
Vendor invoices processed for payment
Customer orders filled
Managers may measure and report activity volume in any manner that is useful for their planning and control
purposes – in amounts of currency, physical quantities, time (e.g., hours), distance traveled, capacity utilization
rates of productive facilities, and so forth. As examined further below, in connection with Topic 2, an activity
measure is useful for analyzing cost behavior if changes in its volume or level drive changes in the amount of a
cost under analysis. That is, cost drivers generally represent a cause-and-effect relationship between an
activity and a cost.
In order to plan and control costs in the short-term (that is, periods of up to about one year), managers
examine the behavior of individual categories of costs to determine if they are variable or fixed.
Variable costs are those costs whose total amount changes with, and in proportion to, changes in the
volume or level of the selected activity. However, the amounts of such costs per unit of the activity
remain constant. For example, managers assume that the per-unit costs of direct material and direct
labor remain unchanged over the short-term planning period and change in total in proportion to
changes in the number of units of the product manufactured.
Variable costs include those with an engineered or physical relationship to production volume (for
instance, each unit of a final product [output] may consume 1.5 ounces – no more, no less – of
aluminum [input]). However, variable costs do not include discretionary costs that managers budget or
program based on planned or forecasted activity levels or volumes (for instance, managers may set a
policy that total advertising expenditures for each fiscal year will be 5 percent of budgeted total sales
revenue for the corresponding fiscal year. As examined below, discretionary costs are a category of
fixed costs).
Fixed costs are those costs whose total amount remains constant irrespective of changes in the
volume or level of the selected activity. As a result, the amounts of such costs per unit of the activity
change inversely with changes in the activity level. For example, over short-term planning periods, a
business’ manufacturing facilities and related costs (such as property taxes, insurance, and
depreciation) do not change. Similarly, over the short-term, the salaries of employees responsible for
supervisory or essential administrative functions at the manufacturing facility do not change with
changes in number of units of products made. Consequently, the per-unit costs of these facilities and
employees’ services decrease with increases in the number of units of the product manufactured.
7
Relevant Range for Short-term Planning and Control
Variable Costs. The classification of costs as variable or fixed is appropriate only within a relevant range of
the related activity volume or level during a short-term planning period. For example, the per-unit costs of
materials used in making a product may remain at $55 provided production volume falls between 175,000 and
225,000 units during a business’ current fiscal year. Outside the relevant range, a variety of factors, other than
the chosen activity measure, may affect the behavior of costs. In the case of product materials, these other
factors may include:
Upper limits on the ability of suppliers to meet all orders without raising prices,
Supplier rebates or discounts for larger purchase volumes, and
Unexpected changes in material quality that affect the amount of scrap or waste occurring in production
As a result, the linear cost function implied by constant per-unit variable costs is realistic only within a carefully
determined relevant range of activity.
Fixed Costs. Likewise, the assumption that fixed costs remain constant is proper only within the relevant
range. For example, for production volumes above 235,000 units, a business may need additional productive
capacity, requiring it to acquire additional factory floor space, machinery, trucks, and other equipment, and hire
additional employees for material handling, equipment maintenance, and machine-set-up activities. For most
businesses, costs classified as “fixed” do not remain so right up to the point at which the business is operating
“at full capacity.” Most businesses require some amount of “slack” to ensure their uninterrupted, efficient
operation. The relevant range of activity for a business generally corresponds to the normal or typical rate at
which it uses its productive capacity.9
Mixed Costs. Some costs exhibit both fixed and variable characteristics – so-called mixed costs. An example
of a mixed cost is a five-year lease of retail store space that requires the retailer (the lessee) to pay a minimum
amount of rent each month (fixed cost) plus additional (“contingent”) rent based on the value of the sales made
by the store each month (variable cost). To permit their analysis of cost behavior, managers separate mixed
costs into their fixed and variable components, sometimes using statistical methods to facilitate this effort.
_____
9
Courses in microeconomics examine the limits of the relevant range in terms of economies of scale when productive output is below
the relevant range or diseconomies of scale when productive output is above the relevant range. When productive output is below the
relevant range, a business has excess or unused capacity. As a result, total costs increase at a decreasing rate because the marginal
cost of each additional unit produced is below the average per-unit cost. In contrast, when productive output is above the relevant
range, a business is experiencing capacity constraints. Consequently, total costs increase at an increasing rate because the marginal
cost of each additional unit produced exceeds the average per-unit cost.
8
Committed and Discretionary Fixed Costs
The classification of costs as fixed or variable is a simplification made to facilitate short-term planning and
control of a business. Over the long term, all costs are ultimately variable. However, over periods up to about
one year, businesses categorize fixed costs as committed costs or discretionary costs, depending on the
kind of planning and control decisions that drive the related expenditure. Committed costs relate to periods of
several years or more, while discretionary costs correspond to a business’ annual planning period.
Committed Costs. Management’s long-term objectives for increased market share,
expansion into new geographic markets, and product extension are the principal factors
affecting its planning decisions about committed costs. Committed costs relate to periods
beyond the annual planning cycle and largely determine a business’ productive capacity for
an extended period. These costs include principally those for PP&E (also called capital
expenditures or “capex”)10 and for the basic organization needed in order to be ready to
conduct business, such as the labor costs of employees classified as “indirect” (overhead).
For example, a plant must have employees to purchase raw materials and schedule
production before it can manufacture any products. Committed costs also include the costs
of purchased intangible assets (such as licenses of intellectual property developed by
others), and the cost of acquiring a competing business.
Management’s control of committed costs focuses on the business’ return on investment
and asset utilization (turnover), examined in the Topic 8 background paper.
Discretionary Costs. Management’s annual spending plans, reflected in approved
operating budgets, are the principal driver of discretionary costs. Whereas committed costs
generally relate to the amount of productive capacity a business has available, discretionary
costs generally arise from managers’ strategies for generating product demand. These
costs include those for advertising and product promotion, R&D, employee training, and
“special projects” (such as, business process reengineering efforts). In contrast to
committed costs, businesses may reduce or eliminate discretionary costs for a given fiscal
year in response to financial difficulties, to engage in real earnings management 11, or both.
While businesses may augment or reduce discretionary costs over relatively short planning
periods, managers faces challenges in measuring objectively the success of such
expenditures because clear cause-and-effect relationships between such costs and
revenues usually do not exist. For example, the amount a business spends on hightechnology product R&D is only one factor determining sales growth. Other factors include
the rate of success in achieving “technological feasibility” in successive R&D projects, the
size of the potential market demand for new products, the creativity of product promotion,
and the emergence of competing products.
Managers’ difficulty in measuring the effectiveness of such activities highlights the related
difficulty in planning them in the first place.
The operating budget presents managers’ planned sales and operating expenses for the forthcoming fiscal
year of the business.12 Operating expenses include discretionary fixed costs. In contrast, the capital
budget sets forth managers’ approved plans for capital expenditures, which represent committed costs of
assets having long lives, such as PP&E.
_____
10
11
The Topic 6 background paper examines the capital budgeting process.
The Topic 3-4 background paper examines real and cosmetic earnings management.
12
A flexible budget is a dynamic plan for the sales and operating expenses of a business that uses managers’ revised forecast for
sales during a fiscal year and reforecasts the business’ expenses based on the expected relationship between its sales and operating
expenses. Differences between actual sales at an interim date and managers’ originally planned sales for that interim period, adopted
as of the beginning of fiscal year, may prompt them to reforecast sales and operating expenses for the fiscal year.
9
Learning
Objective 1
Cost-Volume-Profit Analysis
Managers routinely use cost-volume-profit (CVP) analysis to help them:
Set the prices of products or services sold by a business, and
Prepare the annual operating budget and production plan of a business, including deciding on the
relative mix of multiple products to be manufactured for sale
Managers also perform CVP analysis (including its special case, “break-even” analysis) together with capital
budgeting analysis (examined in the Topic 6 background paper), to help them make such decisions as
whether to:
Introduce new products or discontinue existing products,
Replace equipment used in production with more efficient or more highly automated equipment, and
Acquire additional plant and equipment in order to expand productive capacity
CVP analysis assumes that a linear function properly describes, for a specified planning period and relevant
range of production (examined above), the relationship between a business’ profits and its:
Product selling prices,
Unit variable costs,
Total fixed costs,
Volume of production and sales13 (measured in number units or another physical attribute, such as
tonnage, lineal feet, or gallons14), and
Selected product mix (relative production volume of alternative products that share production facilities
but have different selling prices and variable costs of production, including direct material and direct
labor costs)
_____
13
However a business measures it, production-and-sales volume represents the single independent variable in the linear CVP
function. Of course, other factors may affect a business’ profitability (such as, changes in economic conditions, tax or other laws and
regulations, intensified competition, and natural disasters). A single independent variable is a simplifying assumption managers use to
facilitate CVP analysis.
14
Service businesses may measure volume in terms of customers or clients (such as hospital patient-days or airline passenger miles).
10
Your managerial accounting principles course examined CVP analysis and the related concept of contribution
margin. The following equation summarizes the CVP function:
Net income
(or loss)
=
Income before taxes
– Income taxes
=
[ Total sales
– Total costs, other than income taxes ]
=
[ Total sales
– Total variable costs – Total fixed costs ] – Income taxes
=
[ Total sales
– Total variable costs – Total fixed costs ] – (Income before taxes x Effective tax rate, t)
=
[ Total sales
– Total variable costs – Total fixed costs ] x (1 – Effective income tax rate, t A)
=
=
=
(Unit selling price, SP – (Unit variable cost,
– Total fixed
x Unit volume, Q)
VC x Unit volume, Q)
costs, FC
[ (SP x Q)
– Income taxes
x (1 – t)
– (VC x Q)
–
FC ]
x (1 – t)
[ (Unit contribution margin, CM x Q)
–
FC ]
x (1 – t)
where
Unit CM
=
SP – VC
Total CM
=
(SP – VC) x Q
and
t represents a business’ combined effective income tax rate. “Combined” refers to a business’ income taxes from all applicable
jurisdictions – U.S. federal, states, and any foreign countries. “Effective” refers to combined income taxes as a percentage of total
income before taxes.
A
The graph below illustrates the CVP function (excluding the effect of income taxes):
Dollars
$50 million
Total sales (SP X Q)
Profits
“Break-even” sales dollars
Contribution
Margin
Total costs (FC + VC)
Total FC
Losses
Total VC (Unit VC X Q)
“Break--even” unit volume
$0
200,000
0
Relevant range
Units of production and sales, Q
11
In the above graph, note that:
Total fixed costs, FC, do not change over the relevant range of production and sales13, Q
Total sales (SP x Q) and total variable costs (VC x Q) change in direct proportion to changes in total
production volume, Q. As a result:
The unit contribution margin, Unit CM = SP – VC, remains constant over the relevant range of production,
Q, and
The total contribution margin, Total CM = (SP – VC) x Q = Total sales – Total VC, increases with increases
in production-and-sales volume, Q
Total costs (excluding income taxes) = Total VC + FC = VC x Q + FC
Total production-and-sales volume, Q, does not result in profits until total CM exceeds total fixed costs, FC,
called the “break-even point.” Below the break-even level of production-and-sales, the business
experiences operating losses (that is, FC exceed Total CM). The following algebraic reworking of the CVP
function above restates this important observation:
At break-even,
[ (SP x Q) – (VC x Q) ] x (1 – t) = FC x (1 – t)
(SP x Q) – (VC x Q)
= FC
(SP – VC) x Q
= FC
Unit CM x Q
= FC
Total CM
= FC
and
At break-even, Q = FC / Unit CM
Examination of the CVP function reveals that a company’s profit for a period depends on several factors.
These factors represent a threat (or risk) to, or opportunity for enhancing, a business’ profits. For example:
CVP Function Inputs
Unit selling prices, SP
Threats or Risks
Opportunities
Intensified competition
Product innovations commanding higher prices
Competitor’s introduction of superior
products
Acquisition of competing businesses
Unit variable costs, VC
(including direct material, direct
labor, and certain MOH costs)
Material price increases
More highly automated equipment
“Tightening” labor markets
Consolidation of suppliers for “volume discounts”
Total fixed costs, FC (including
remaining MOH costs)
Overexpansion of productive capacity
leading to underutilization of PP&E
Reorganization of production processes for
increased productivity or reduced MOH costs
Units produced
Production in excess of market
demand, leading to discounting or writeoffs of unsalable products
Production short of market demand,
leading to lost sales (“stock-outs”)
_____
13
For the moment, assume that a business’ sales volume equals its production volume, Q, and therefore the business experiences no
change in the balance of its inventory of finished goods between the beginning and end of the planning period under consideration.
12
Because managers assume the CVP function is linear, they may apply it reliably only over the relevant range,
as discussed above. Consequently, it is important that managers accurately establish this range of productionand-sales output. For example, a poorly defined relevant range may cause a CVP function to be unreliable for
a particular planning period if a business experiences unanticipated material price increases, equipment
breakdowns, or raw material supply interruptions at the upper end of the production range.
The Topic 3-4 background paper examines general-purpose financial statements, including the income (or
operating) statement. However, in order to apply CVP analysis, managers must be familiar with the basic
form and content of the income statement. In brief, a business’ income statement reports, for a specified
period (such as a month or a year), the amounts of its revenues earned, expenses incurred, and net income
(or loss) for the period. The income statement for a simple business might appear as follows:
XYZ Company
Income Statement
For the month ending January 31, 20X5
Notes14
Sales (or, revenue)
$50,000,000
Less: Cost of goods sold (COGS)
40,000,000 Includes all fixed and variable manufacturing costs
Gross profit (GP)
10,000,000
Less: Selling and administrative expenses
7,000,000 Includes both fixed and variable non-manufacturing costs
Research and development expenses
2,000,000 Includes both fixed and variable non-manufacturing costs
Income before taxes
1,000,000
Less: Income taxes
400,000
Net income
$
600,000 Informally, also referred to as “net profit”
Functional classification of expenses. This illustrative income statement follows the format prescribed by
Generally Accepted Accounting Principles in the U.S. (U.S. GAAP)15, examined in the Topic 3-4 background
paper. This form of income statement presents the expenses of a business primarily according to their
function – manufacturing, selling, administrative, and R&D.
_____
14
Notes included here are for instructional purposes only; they do not appear in formally prepared income statements.
15
U.S. GAAP requires that businesses report the cost of “finished goods” inventory held (in the balance sheet) and the cost of inventory
sold (COGS, in the income statement) using the full-absorption (or, absorption costing) method. Under the full-absorption method,
the cost of finished goods held or sold includes all costs that are normal and necessary to making them ready for sale. These costs
include both fixed and variable manufacturing costs, and exclude non-manufacturing costs. As stated above, manufacturing costs
include the costs of direct materials, direct labor, and MOH activities, as discussed below.
13
Behavioral classification of expenses. However, for purposes of CVP analysis, businesses prepare their
income statements using the contribution margin format (variable costing method). Using this method, the
income statement presents a business’ operating expenses according to they way they behave in response to
changes in its activities – as variable or fixed – rather than according to their function. Of course, both
manufacturing and non-manufacturing activities involve both fixed and variable costs. For example, certain
selling and distribution costs, such as sales commissions and shipping costs are variable, while advertising
costs are typically discretionary, fixed costs over periods of up to one year, as stated above. Operations of
both service businesses (such as airlines, hospitals, and banks) and manufacturing businesses involve both
fixed and variable costs.
As indicated above, CVP analysis employs the concept of contribution margin (CM):
The Unit CM for XYZ Company = $250 SP – $150 Unit manufacturing VC – $20 Unit S&A VC = $80 Unit CM
CM measures the contribution to a business’ income before taxes from the production-and-sale of additional
units of its products during the period. Provided total production remains within the relevant range (as
described above) for the period considered, a business’ fixed costs will not change for that period. Therefore,
CM measures the expected increase in the business’ income before taxes from the production-and-sale of
additional units of its products. To illustrate, if XYZ Company sells 1,000 additional units of the product (while
keeping total production within the relevant range), its Total CM will increase by $80,000. Because XYZ
Company’s total FC are unchanged (within the relevant range for 20X5), the $80,000 increase in CM will
increase the business’ income before taxes by this amount, as well.
XYZ Company
Budgeted Income Statement – Contribution Margin Method
For the month ending January 31, 20X5
Budgeted production-and-sales is 200,000 units of a single product
Per unit
Sales (or, revenue)
$50,000,000
$250
30,000,000
150
4,000,000
20
Contribution margin (CM)
16,000,000
80
Less: Fixed cost of goods sold
10,000,000
50
Fixed selling and admin. expenses
3,000,000
15
Fixed research and development exp.
2,000,000
10
1,000,000
5
Less: Variable manufacturing COGS (VC)
Variable selling and admin. expenses
Income before taxes
Less: Income taxes
Net income
Notes16
Per-unit amounts remain unchanged with
changes in volume or quantity of output
Per-unit amounts increase (decrease) with
decreases (increases) in volume or quantity
of output
400,000 Assume company’s effective income tax rate is 40 percent
$
600,000
$ 3
_____
16
Notes included here are for instructional purposes only; they do not appear in formally prepared income statements.
14
Determining Required Production-and-Sales Volume
Once a business has prepared an operating budget for a coming period, managers may use CVP analysis to
estimate quickly the number of units of production-and-sales necessary for the business to achieve
Break-even results (zero net income or loss) or
A targeted level of net income
Break-even volume. To illustrate, assume that XYZ Company’s costs are fixed or variable as indicated in the
budgeted income statement presented above. XYZ Company must produce and sell an estimated 187,500
units in order to break even and must sell an estimated 195,000 units in order to achieve a revised target net
income of (say) $360,000, as explained below.
Recall from the discussion above that,
At break-even,
(SP x Q) – (VC x Q)
Then, for XYZ
$250 x Q – $170 x Q
$80 x Q
Q
and
Break-even sales
= FC
= $15,000,000
= $15,000,000
= 187,500 units
= 187,500 units x $250 SP = $46,875,000
Alternatively,
At break-even,
Q
= FC
/ Unit CM
Then, for XYZ
Q
= $15 million / $80
= 187,500 units
Management based XYZ Company’s budgeted income statement on sales of 200,000 units. As a result, the
company must achieve about 94 percent of its budgeted sales volume (187,500 / 200,000 units) simply to
break even. This minimum break-even sales volume suggests that the company operates with a relatively high
level of operating leverage. Operating leverage refers to the proportion of a business’ total costs that are
fixed, rather than variable.17 The net income of a business having a high level of operating leverage is highly
sensitive to changes in the volume of its sales.18 Outsourcing is a strategy many businesses have used to
reduce operating leverage whereby businesses buy from third-party manufacturers products (or components),
rather than make them directly. This strategy permits a business to disinvest in manufacturing facilities and
related personnel costs, thereby reducing fixed costs. However, the business’ per-unit variable cost of the
products increases because it includes the third-party manufacturer’s MOH costs and profit, and may include
additional shipping costs. If the outsourcing strategy succeeds, the business acquires increased operating
flexibility, reduces the risks associated with operating leverage, and reduces its total per-unit product costs.
_____
17
As described below (in connection with Topic 2), computers and other technological advances came into widespread use by
manufacturers in the 1980s and 1990s. These advances lead to increased use of highly automated, costly manufacturing equipment –
representing an important source of fixed costs – and decreased use of direct labor (e.g., factory line workers) – a variable cost.
18
One convenient device managers use to measure the extent of a business’ operating leverage is the operating leverage ratio:
Operating leverage ratio = CM ratio / Net margin ratio, where CM ratio = Unit CM / SP, and Net margin ratio = Net income / Sales. (The
Topic 8 background paper examines the use of financial ratios, including the net margin ratio.)
15
Target net income volume. Assume managers of XYZ Company revised their targeted net income from the
$600,000 included in its budgeted income statement above to $360,000 for the month of January 20X5. The
amount of sales required to meet this revised target is:
Targeted net income19 = [ (SP x Q) – (VC x Q)
$360,000 = [ $250Q – $170Q
$360,000 =
– FC ]
x (1 – t )
– $15,000,000 ]
x (1 – 0.40)
[ $80Q x (1 – 0.40) ] – [ $15,000,000
$360,000 =
$48Q
$9,360,000 =
$48Q
–
x (1 – 0.40) ]
$9,000,000
$48Q = $9,360,000
Q = 195,000 units (this is 5,000 units less than the 200,000 units included in the budget)
Required sales dollars = 195,000 units x $250 SP = $48,750,000
As stated above, CVP analysis relies on a linear function. Implicit in CVP analysis is the assumption that the
per-unit selling price, SP, does not change with changes in unit volume, Q. For example, Company XYZ
managers assumed that they will not need to lower prices in order to increase sales from (say) 190,000 units to
200,000 units in its 20X5 monthly operating budget. (This is analogous to the concept of the relevant range for
analysis of cost behavior.) In addition, a manager’s CVP analysis for a business is static. If industry-wide or
general economic conditions change during the period, managers should revisit their previous CVP analysis to
identify any necessary response. For example, an unexpected change in the prices of direct materials used in
production several months into a business’ fiscal year will affect Unit VC, Unit CM, and the production-andsales volume, Q, necessary to achieve budgeted net income.
_____
19 The Topic 6 background paper examines businesses’ cost of capital (i.e., required return on investment of financial capital)
and the Topic 8 background paper examines financial ratios, including return on investment – i.e., return on assets (ROA) and
return on common equity (ROCE). In relation to CVP analysis, managers may analyze these ratios in the following form:
ROA
=
=
Asset turnover ratio
Sales
X
Net margin ratio
Net income
x
Assets
=
SP x Q
Sales
x
[(SP – VC) x Q – FC] x (1 – t)
Assets
ROCE
=
Net income
Common equity
SP x Q
=
ROA
x
Leverage
=
Net income
Assets
x
Assets
Common equity
16
Managers may also use the CM ratio to estimate the expected effect on a business’ net income of projected
changes in sales dollars, rather than changes in unit volume:
CM ratio = Unit CM / SP
For XYZ Company, CM ratio =
$80
/ $250 = 32 percent
Using XYZ Company to illustrate, a proper interpretation of the CM ratio is that 32 percent of the revenue
earned from each sale of its product remains available to offset its FC and contribute toward income before
income taxes. Accordingly, managers may estimate the company’s break-even monthly sales in dollars using
the CM ratio as:
Total FC, $15,000,000 / CM ratio, 32 percent = $46,875,000
Estimating Impact of Sales Changes on Net Income
Managers may use the CM ratio to estimate the expected effect on a business’ net income in the case where
their latest projections indicate actual sales will vary from budgeted sales. To illustrate, if during 20X5, XYZ
Company’s managers project actual monthly sales will fall $2 million short of its plan, $50 million, they may
estimate the impact this shortfall will have on the company’s net income as follows:
Forecasted sales shortfall
x
CM ratio
x
(1 – Effective tax rate)
=
Shortfall in monthly net income
$2,000,000
x
32 percent
x
(1 – 0.40)
=
$384,000
Estimating Impact of Contemplated Management Decisions
CVP analysis is useful for estimating the effect on financial performance of a variety of management decisions.
To illustrate its usefulness, consider the following two common scenarios:
Scenario 1: Changes in selling prices in response to intensified competition. In early FY 20X5, managers of
XYZ Company learned that a key competitor reduced its product selling prices. They are considering
responding to this development with a 7 percent reduction of the selling price, SP, of its product (from $250 to
$232.50 per unit). Management quickly estimated that the company must produce-and-sell 256,000 units in
order to achieve the company’s budgeted monthly net income of $600,000, above:
Budgeted net income = [ (SP x Q)
– (VC x Q)
– FC ]
$600,000 = [ $232.50Q
– $170Q
– $15,000,000 ] x (1 – 0.40)
$600,000 = [ ($232.50Q
– $170Q) x (1 – 0.40) ] – [ $15,000,000
$600,000 = $37.50Q
–
x (1 – t)
x (1 – 0.40) ]
$9,000,000
$9,600,000 = $37.50Q
$37.50Q = $9,600,000
Q = 256,000 units (this is 56,000 units more than the 200,000 units included in the budget)
Required sales dollars 20 = 256,000 units x $232.50 SP = $59,520,000 (compared to $50,000,000 in the budget)
______
20 Managers may also compute the required sales dollars directly using the contribution margin ratio (i.e., Unit CM / SP):
Fixed costs + Budgeted net income / (1 – t)
Required sales dollars
=
Contribution margin ratio
$15,000,000 + $600,000 / (1 – 0.40)
=
=
$62.50 / $232. 50
$59,250,000
17
Management was understandably concerned by these computations. As a result of a 7 percent reduction in
SP, the company must increase unit sales, Q, by 28 percent (from 200,000 units to 256,000 units) and increase
total sales by 19 percent (from $50,000,000 to $59,520,000) in order to achieve the budgeted net income of
$600,000. These computations prompted management to begin investigating opportunities to reduce both
variable costs and discretionary fixed costs.
Scenario 2: Acquisition of Replacement Manufacturing Equipment. Management of XYZ Company is
considering replacing certain aging manufacturing equipment with new equipment that is more highly
automated and uses materials more efficiently than the existing equipment. The cost of the replacement
equipment is $12 million and its estimated economic life is five years. The existing equipment is fully
depreciated. As a result, monthly depreciation expense will increase by $200,000 ($12 million / 60 months)
and, accordingly, FC will increase from $15,000,000 to $15,200,000. The company’s production engineer has
estimated that the new equipment will use direct labor and direct materials more efficiently, leading to a
reduction in budgeted unit VC (manufacturing and S&A) from $170 to $160. Using this information, managers
quickly estimated that the company must produce-and-sell 180,000 units in order to achieve the company’s
budgeted net income of $600,000, above:
Budgeted net income = [ (SP x Q)
– (VC x Q)
– FC ]
$600,000 = [ $250Q
– $160Q
– $15,200,000 ] x (1 – 0.40)
$600,000 = [ ($250Q
– $160Q) x (1 – 0.40) ] – [ $15,200,000
$600,000 = $54Q
–
x (1 – t)
x (1 – 0.40) ]
$9,120,000
$9,720,000 = $54Q
$54Q = $9,720,000
Q = 180,000 units (this is 20,000 units less than the 200,000 units included in the budget)
Required sales dollars 21 = 180,000 units x $250 SP = $45,000,000 (compared to $50,000,000 in the budget)
Management was understandably pleased with these computations. The new equipment would permit XYZ
Company to meet its original budgeted net income with production-and-sales 10 percent less than the amounts
included in its 20X5 budget.
The Topic 6 background paper further considers CVP concepts within the context of capital budgeting analysis.
______
21 Managers may also compute the required sales dollars directly using the contribution margin ratio (i.e., Unit CM / SP):
Fixed costs + Budgeted net income / (1 – t)
Required sales dollars
=
Contribution margin ratio
$15,200,000 + $600,000 / (1 – 0.40)
=
=
$90 / $250
$45,000,000
18
Learning
Objective 2
Presenting and Analyzing Operating Performance:
Absorption Costing and Variable Costing Methods
U.S. GAAP sets forth the requirements that businesses must follow in preparing general-purpose financial
statements used by parties external to the business. One of these requirements is that businesses apply the
full-absorption (or, absorption costing) method to report the cost of “finished goods” inventory held (in their
balance sheets) and the cost of inventory sold (COGS, in their income statements). Under the full-absorption
method, the cost of finished goods held or sold includes all costs that are normal and necessary to making
them ready for sale. These costs include both fixed and variable manufacturing costs, and exclude nonmanufacturing costs. Manufacturing costs include the costs of direct materials, direct labor, and manufacturing
overhead (MOH) activities, as stated above. However, to facilitate their planning and control of a business’
operations, many managers prefer to analyze operating performance using the variable costing method,
rather the full-absorption method.22 Managers use this alternative method to analyze operating performance
because, over short-term planning periods of a year or less, fixed manufacturing overhead costs are largely
unavoidable costs for which the amounts incurred are unaffected by the volume of production.
For example, consider a business that manufactures a product whose per-unit gross profit (GP) is
negative, but whose unit contribution margin (Unit CM) is positive. That is, the product’s selling price (SP)
exceeds its variable costs, but fixed costs allocated to the product exceed its Unit CM. In the short term,
the business may continue to manufacture and sell the product because it contributes to the recovery of
the business’ fixed costs and total profits.
_____
22
The variable costing method does not comply with U.S. GAAP because it violates a long-standing basic accounting principle – the
matching principle – examined in the Topic 3-4 background paper.
19
The illustrations below compare and contrast the full-absorption and variable costing methods. The following
table summarizes important points evident from this comparative presentation of XYZ Company’s income
statement for the month of January 20X5:
Full-absorption Method
Variable costing method
Gross Profit
versus
Contribution
Margin
measurements
Income statement presents a business’ gross
profit (GP) as:
Sales less cost of goods sold (COGS), where
COGS includes all:
Fixed manufacturing expenses, and
Variable manufacturing expenses
Income statement presents a business’
contribution margin (CM) as:
Sales less all variable expenses, including:
Variable manufacturing expenses, and
Variable selling and administrative (S&A)
expenses
Functional versus
Behavioral
Classification of
Expenses
Income statement deducts from GP all nonmanufacturing expenses, such as:
S&A expenses, and
R&D expenses
whether fixed or variable in nature
Income statement deducts from CM all fixed
expenses, including:
Fixed manufacturing,
Fixed S&A, and
Other fixed costs
Presentation of
COGS or Variable
COGS
Using either method, the income statement shows the computation of COGS (full-absorption
method) or variable COGS (variable costing method), respectively, as:
Beginning-of-period inventory balance, plus
Costs of goods manufactured, equals
Costs of goods available for sale, less
End-of-period inventory balance, equals
COGS (full-absorption method) or variable COGS (variable costing method)
The sole difference between the two methods is the amount of the per-unit cost used:
Uses the total manufacturing (fixed and variable) Uses the variable (only) manufacturing cost per
cost per unit
unit
Reported net
income when
inventory balance
does not change
during period
Provided the business begins and ends the reporting period (for example, the month of January
20X5) with no inventory on hand (or the inventory balance is unchanged at the beginning and the
end of the period), the full-absorption method and variable costing method will both result in
reporting the same amounts of net income.
Scenario 1, below, illustrates this situation.
Reported net
income when
inventory balance
changes during
period
If the business’ beginning-of-period and end-of-period inventory balances are different from each
other, the number of units produced does not equal the number of units sold. In that case, using the
full-absorption method, a business’ income statement does not recognize MOH costs as expenses
(in COGS) until the business sells the related goods. Prior to their sale, the cost of goods – including
fixed MOH costs – remains in the balance sheet as inventory.
An increase in a business’ inventory balance from the beginning of the period to the end of the
period will result in the deferral of fixed MOH costs incurred during the period and a decrease in
COGS by an amount equal to the deferred fixed MOH costs.
Scenario 2, below, illustrates this situation.
A decrease in a business’ inventory balance from the beginning of the period to the end of the
period will result in the expensing of fixed MOH costs incurred during a previous period and an
increase in COGS by an amount equal to the additional expensed fixed MOH costs.
20
Scenario 1: Business’ inventory balance at beginning and end of period is unchanged.
XYZ Company
Income Statement
For the month ended January 31, 20X5
Full-Absorption (or, Absorption Costing) Method (U.S. GAAP)
Units
Sales (or, Revenue)
200,000
Variable Costing Method (Contribution Margin Format)
Per unit
$ 250.00
SP
$ 50,000,000
Sales (or, Revenue)
Units
Per unit
200,000
$ 250.00
SP
$ 50,000,000
12,000
$ 150.00
(1)
$ 1,800,000
150.00
(1)
30,000,000
150.00
(1)
Variable expenses
Cost of goods sold (COGS)
Variable cost of goods sold
Inventory, January 1
12,000
Cost of goods manufactured
200,000
Cost of goods available for sale
212,000
12,000
Less: Inventory, January 31
Cost of goods sold
$ 200.00
(1)
200.00
(1)
200.00
(1)
$
200,000
2,400,000
Inventory, January 1
40,000,000
Variable manufacturing costs
200,000
42,400,000
Cost of goods available for sale
212,000
2,400,000
Less: Inventory, January 31
12,000
40,000,000
Variable cost of goods sold
200,000
Variable selling and adm in. expenses
200,000
31,800,000
20.00
(2)
10,000,000
Contribution margin (CM)
4,000,000
34,000,000
Total variable expenses
Gross profit (GP)
1,800,000
30,000,000
200,000
80.00
16,000,000
Fixed expenses
Fixed manufacturing overhead
(4)
10,000,000
7,000,000
Selling and admin. expenses
(2)
3,000,000
Research and development expenses
2,000,000
Research and development expenses
Income before taxes
1,000,000
(2)
Selling and admin. expenses
(5)
Income taxes
Net income
Units
(1) Unit costs of production:
400,000
Income taxes
600,000
Net income
Per unit
(2) Selling and administrative expenses
Variable:
2,000,000
Income before taxes
Variable
1,000,000
(5)
400,000
600,000
Units
Per unit
200,000
$ 20.00
(3)
4,000,000
$ 55.00
Fixed
3,000,000
Direct labor
50.00
Total
7,000,000
Manufacturing overhead (MOH) costs
45.00
Direct materials
Total variable cost per unit
Fixed MOH costs
2,400,000
Total (fully absorbed) cost per unit
150.00
(4)
50.00
(4)
(3) Variable S&A costs include sales commissions and customer shipping
120,000,000
200.00
(5) Company's combined (U.S. federal and state) effective income tax rate is
40 percent
(4) For purposes of this illustration, assume that:
– The company's unit variable costs, VC, are stable at the amounts indicated
above in both the current and preceding fiscal years of the company
– The company's annual normal, expected fixed MOH costs (obtained from its
20X5 budget) are $120 million and corresponding output, Q, is 2.4 million units
21
Scenario 2: Business’ inventory balance increases from beginning of period to end of period.
XYZ Company
Income Statement
For the month ended January 31, 20X5
Full-Absorption (or, Absorption Costing) Method (U.S. GAAP)
Units
Sales (or, Revenue)
200,000
Variable Costing Method (Contribution Margin Format)
Per unit
$ 250.00
SP
$ 50,000,000
Sales (or, Revenue)
Units
Per unit
200,000
$ 250.00
SP
$ 50,000,000
Variable expenses
Cost of goods sold (COGS)
Variable cost of goods sold
12,000
$ 200.00
(1)
$ 2,400,000
12,000
$ 150.00
(1)
$ 1,800,000
Cost of goods manufactured
206,000
200.00
(1)
41,200,000
Variable manufacturing costs
206,000
150.00
(1)
30,900,000
Cost of goods available for sale
218,000
43,600,000
Cost of goods available for sale
218,000
150.00
(1)
Inventory, January 1
Less: Inventory, January 31
Cost of goods sold
18,000
200.00
(1)
200,000
Inventory, January 1
3,600,000
Less: Inventory, January 31
18,000
40,000,000
Variable cost of goods sold
200,000
Variable selling and adm in. expenses
200,000
32,700,000
20.00
(1)
10,000,000
Contribution margin (CM)
4,000,000
34,000,000
Total variable expenses
Gross profit (GP)
2,700,000
30,000,000
200,000
80.00
16,000,000
Fixed expenses
Fixed manufacturing overhead
(2)
Selling and admin. expenses
Research and development expenses
7,000,000
Selling and admin. expenses
2,000,000
Research and development expenses
10,300,000
(2)
3,000,000
2,000,000
Income before taxes
(5)
1,000,000
Income before taxes
(5)
700,000
Income taxes
(6)
400,000
Income taxes
(6)
280,000
600,000
Net income
Net income
(1) Unit costs of production:
Units
Per unit
(2) Selling and administrative expenses
Variable:
Variable
420,000
Units
200,000
Per unit
$
20.00
(3)
4,000,000
55.00
Fixed
3,000,000
Direct labor
50.00
Total
7,000,000
Manufacturing overhead (MOH) costs
45.00
Direct materials
$
Total variable cost per unit
Fixed MOH costs
Total (fully absorbed) cost per unit
2,400,000
(3) Variable S&A costs include sales commissions and customer shipping
150.00
(4)
50.00
(4)
(5) Reconciliation of difference in income before taxes between the two methods:
Units
120,000,000
200.00
Increase (decrease) in inventory
(4) For purposes of this illustration, assume that:
– The company's unit variable costs, VC, are stable at the amounts indicated
above in both the current and preceding fiscal years of the company
– The company's annual normal, expected fixed MOH costs (obtained from its
Per unit
Income before taxes - full absorption
Fixed MOH cost per unit
1,000,000
6,000
$
50.00
(1)
Fixed MOH cost expensed (deferred)
under full absorption method
Income before taxes - variable costing
(300,000)
700,000
20X5 budget) are $120 million and corresponding output, Q, is 2.4 million units
(6) Company's combined (U.S. federal and state) effective income tax rate is
40 percent
Of course, a decrease in a business’ inventory balance from the beginning of the period to the end of the
period (rather than an increase, as illustrated above) will result in the expensing of fixed MOH costs incurredand-deferred during a previous period leading to an increase in COGS equal to the additional fixed MOH costs
expensed.
22
Cost Accounting Systems:
Process Cost and Job Order Cost Systems
As noted above, a business’ management accounting system may adopt a process cost system or a job
order cost system (or, in some cases, a combination of both systems), depending on the nature of its
products and manufacturing processes. Your managerial or cost accounting principles course text examined
each of these system in detail. In addition, a business may use a standard cost system, which is compatible
with both process cost or job order cost systems. The following table summarizes and compares process cost
and job order cost systems.
Process cost system
Job order cost system
How business
accumulates
costs of products
Business assigns direct labor, direct materials,
and MOH costs to a series of production
departments or processes for regular reporting
periods, such as a month, and reports
summarized costs in this manner for each
period. (Managers analyze actual-vs.-standard
cost variances for each department or process,
for each period.)
Business assigns direct labor, direct materials,
and MOH costs to each job (customer-specific
order) or to each batch of a product
manufactured. Business accumulates the total
cost of each job or batch during its production
using separate job cost worksheets. (Managers
analyze actual-vs.-standard cost variances for
each job or batch.)
How business
decides which
kind of cost
system to adopt
System is suited to continuous production of
uniform or homogenous products through
several stages, generally in significant volumes
or quantities
System is suited to discrete production of
customer-specific orders or batches of unique
products
How business
computes per-unit
product costs
Business computes per-unit product costs as
total manufacturing costs for the period in all
production departments divided by the volume or
quantity of production during such period
Business computes per-unit product costs as the
total manufacturing costs for the job or batch
divided by the number of completed units of
production comprising the job or batch.
Examples of
products or
services for which
system is well
suited
Processed foods and beverages, as well as
the cans, jars, or other packaging used with
them
Chemicals
Coatings
Paints
Natural gas production
Metals
Pharmaceuticals
Computer hard drive memory devices
Television production company’s production of
awards show, such as “the Oscars,” for a
broadcast network
Building contractor’s construction of high-rise
office building, airport, or bridge
IT consulting firm’s design and installation of
enterprise resource planning (ERP) system for
a client
A publisher’s production of a “first printing” of a
Stephen King novel
Aerospace firm’s manufacture of 10 rocket
engines for NASA
Both process cost systems and job order cost systems have similar overall purposes, including providing
information for determining the unit cost of products made and sold, as examined later in this background
paper (in connection with Topic 2).
23
Learning
Objective 3
Standard Costs
Nature and Purpose of Standard Costs
Managerial (or cost) accounting courses examine standard cost systems in detail. However, managers
should understand the purposes and potential limitations of standards, and the typical causes of variances
between actual costs and standard costs.
Standard costs represent agreed-upon targets or objectives. Standard costs and budgeted costs are related to
each other because managers construct a business’ operating budget using standards for:
Physical quantities of materials used in manufacturing products,
Activity times for labor and machinery used in producing goods or services,
Prices of material, labor, and other services, and
Utilization rate of productive capacity
Consequently, managers use both standards and budgets to plan and control a business’ operations and
performance. However, they distinguish standards from budgets in the sense that standard costs are a “unit”
concept, while budgets are a “total” concept. In the illustrative budgeted income statement of XYZ Company,
above, managers may have determined the per-unit fixed and variable costs shown using a standard cost
system. Businesses in both manufacturing and service industries may use standard cost systems.
A business may base its standard costs on its:
Normal, expected conditions and experience (a “deductive-indirectly inferred” approach), or
Product engineers’ physical measurements of quantities – such as, weight, volume, etc. – of required
materials and industrial engineers’ estimates of the time required to perform manufacturing activities –
such as, time-and-motion studies (an “inductive-directly observed” approach)
Engineers may make their measurements and estimates under controlled or ideal conditions, using statistical
or non-statistical sampling plans, observation of employees performing production processes, and analysis of
production data that records previous years’ consumption of materials, labor time, and machine time.23
_____
23
Businesses formalize material usage (efficiency) standards for each of their products in a “bill of materials” (BoM). Employees in the
purchasing, production scheduling, materials storage-and-handling, and production departments refer to the BoM when performing their
respective responsibilities.
24
Standard cost systems generate information about actual costs incurred during the period, standard costs set
before the start of the period, and variances between actual and standard costs. Managers use standard cost
systems to:
Estimate total costs included in budgets, as indicated above24
Control costs by investigating and responding to price and usage (efficiency) variances, as described
below, and provide a basis for motivating, evaluating, and rewarding managers having control over costs
Determine standard per-unit product costs based on standard quantities and prices for direct material,
direct labor, and each element of manufacturing overhead (MOH)
Facilitate the setting of prices for a business’ products or services based on per-unit costs
Support a business’ treasury operations (management of liquidity and achieving working capital objectives,
as examined in the Topic 7 background paper)
While they serve these useful purposes, establishing and maintaining a standard cost system is costly,
complex, and time-consuming. Standard cost systems require the participation of many people throughout a
business, including managers of business divisions, production and service departments, finance and
accounting staff, product engineers, and industrial engineers. In a business experiencing frequent changes in
product specifications or production methods, standards may become out-of-date, thereby necessitating their
frequent review and revision.
Actual-versus-Standard Cost Variances
Businesses that use standard cost systems prepare periodic (typically, monthly) reports of cost variances.
Variances are the differences between actual costs and standard costs. A favorable variance occurs when
actual costs are less than standard costs. An unfavorable variance occurs when actual costs exceed
standard costs. To determine the amount of these variances, managers first compute the total standard cost
for each of direct materials, direct labor, and MOH for the period by multiplying the per-unit standard costs of
each of these product cost elements by the actual volume or quantity (units) of production, Q, for the period:
Total Standard Cost = Per-unit standard cost x Actual volume or quantity (units) of production
Most business experience differences between the volume or quantity of finished products completed during a
period and the volume or quantity initially planned, as set forth in their budgets for the period. Differences
between actual and budgeted production volume are especially common over brief periods, such as one
month, that comprise a small portion of the full-year period to which the budget relates. Therefore, to facilitate
their analysis of variances, managers compute the standard cost of each product cost element – direct
materials, direct labor, and MOH – based on the actual, rather than budgeted, volume or quantity of
production.
_____
24
Managerial accounting courses examine businesses’ use of master (static) budgets and flexible budgets to plan and control a
business.
25
Direct Materials Variances
Total material variance. The total material variance is the difference between the actual cost of direct materials
used in production during the period and the standard cost of materials allowed for the volume or quantity of
products actually completed.
Total Material Variance
=
=
Actual cost of direct materials used in
production during period
Actual Quantity
x
Actual Price
–
Standard cost of materials allowed for the
volume or quantity of actual production25
–
Standard Quantity
x
Standard Price
Material price variance. The material price variance represents the portion of the total material variance
caused by the difference between actual material prices and standard material prices.
Material Price Variance
=
=
Actual cost of direct materials used in
production during period
Actual Quantity
x
Actual Price
–
–
Standard cost of materials actually used in
production
Actual Quantity
x
Standard Price
Material usage (efficiency) variance. The material usage (efficiency) variance represents the portion of the
total material variance caused by the difference between the actual quantity of materials used during the period
and standard quantity of materials allowed to manufacture the actual volume or quantity of finished products
completed during the period.
Material Usage Variance
=
Standard cost of direct materials actually
used in production during period
–
Standard cost of materials allowed for the
volume or quantity of actual production25
=
Actual Quantity
–
Standard Quantity
x
Standard Price
x
Standard Price
Direct Labor Variances
Total labor variance. The total labor variance is the difference between the actual cost of direct labor hours
(DLHs) used in production during the period and the standard cost of DLHs allowed for the volume or quantity
of products actually completed.
Total Labor Variance
=
Actual cost of DLHs used in production
during period
–
Standard cost of DLHs allowed for volume
or quantity of actual production25
=
Actual Hours
–
Standard Hours
x
Actual Rate
x
Standard Rate
Labor rate variance. The labor rate variance represents the portion of the total labor variance caused by the
difference between actual labor rates and standard labor rates.
Labor Rate Variance
=
Actual cost of DLHs used in production
during period
–
Standard cost of DLHs actually used in
production
=
Actual Hours
–
Actual Hours
x
Actual Rate
x
Standard Rate
Labor usage (efficiency) variance. The labor usage (efficiency) variance represents the portion of the total
labor variance caused by the difference between the actual number of DLHs worked during the period and
standard number of DLHs allowed to manufacture the actual volume or quantity of finished products completed
during the period.
Labor Usage Variance
=
=
Standard cost of DLHs actually used in
production during period
Actual Hours
x
Standard Rate
–
Standard cost of DLHs allowed for volume
or quantity of actual production25
–
Standard Hours
x
Standard Rate
Usage (or efficiency) variances are particularly important to managers, as examined further, below.
_____
25
Accountants typically refer to the standard cost of material or labor inputs allowed for the volume or quantity of actual production as
the flexible budget cost.
26
Manufacturing (MOH) Variances
Total MOH variance. The total MOH variance is the difference between the actual MOH costs incurred during
the period and the amount of MOH cost allocated (i.e., applied) to products completed during the period. This
background paper examines the allocation of MOH costs to products below, in connection with Topic 2. 27
Total MOH variance
=
Actual MOH costs
–
MOH costs applied to completed products
Controllable MOH variance. In general, the controllable MOH variance relates to variable, rather than fixed,
MOH costs.
Controllable MOH
variance
=
=
Actual MOH costs
Actual variable
MOH costs
incurred
+
Actual fixed
MOH costs
incurred
–
–
Standard variable MOH cost for
actual volume or quantity of
production
Standard
variable MOH
cost per unit
x
+
Budgeted
fixed MOH
cost
Standard
+
DLHs allowed
for actual
volume or
quantity of
production
Budgeted
fixed MOH
cost
If a business’s actual fixed MOH costs incurred equals its budgeted fixed MOH costs, the computation of its
controllable MOH variance is simpler:
Controllable MOH
Variance
=
Actual variable MOH costs incurred
–
Standard variable MOH cost for actual
volume or quantity of production
_____
27
To illustrate, most businesses that adopt the traditional method for allocating MOH costs to completed units of production (examined
below) allocate MOH cost to products based on DLHs used in production. In that case, managers determine the amount of MOH cost
to allocate (i.e., “apply”) to products completed during the period (say, a month) as:
Total MOH cost allocated (applied) to
products completed during the period
=
Standard MOH cost per DLH
x
Standard DLHs allowed for the number of units
completed during the period
where,
Standard MOH cost
per DLH
=
Budgeted (fixed and variable) MOH costs for the fiscal year
Total standard DLHs allowed for the budgeted total volume or quantity of production for the fiscal year
Most businesses using the traditional MOH cost allocation method (discussed below in connection with Topic 2) determine the standard
MOH cost application rate by dividing (i) total budgeted MOH costs for the coming fiscal year by (ii) the total budgeted direct labor hours
(cost per direct labor hour approach), illustrated above, or by the total budgeted direct labor cost (percent of direct labor cost approach).
For this purpose, managers determine the business’ budgeted total MOH costs and budgeted total direct labor hours (or direct labor
costs) based on the same budgeted total number of units of planned production. However, as described later in this background paper,
standard per-unit costs of MOH based on direct labor hours (or machine hours) generally do not correspond to the drivers of productrelated, plant-related, and some batch-related MOH activities and related costs (such as engineering department, materials handling,
and machine setup activities). The result is often distortion of per-unit product cost information that can lead to improper management
decisions.
27
MOH usage (efficiency) variance. The MOH usage (efficiency) variance relates only to fixed MOH costs. It
represents the portion of the total MOH variance that relates to over-applied or under-applied fixed MOH costs.
Over-applied fixed MOH results when a business’ actual production volume or quantity exceeds its normalcapacity (budgeted) volume or quantity of output, resulting in a favorable variance. In contrast, under-applied
fixed MOH results when a business’ actual production volume or quantity is less than its normal-capacity
(budgeted) volume or quantity of output, resulting in an unfavorable variance.28
Investigation of Unfavorable Usage (Efficiency) Variances
Direct material and direct labor. Unfavorable direct material or direct labor usage (efficiency) variances may
arise from several causes, including the use of:
Inexperienced, inadequately trained, inattentive, or fatigued production employees
Materials whose quality is below that assumed in developing the standards, and
Machinery that is operating poorly or was not set up properly in advance of a production batch
Of course, some of these factors may yield favorable direct material or direct labor price variances. For
example, the labor rate of less experienced (lower seniority) production employees may be less than that of
more experienced workers. Similarly, the price of low-quality materials is likely to be less than the price of
high-quality materials. Depending on the particular circumstances of a business, favorable price variances
may lead to – and offset – the unfavorable usage (efficiency) variances, or vice versa.
Manufacturing overhead. Unfavorable overhead variances may result from a variety of factors, such as:
Excessive spending on activities that give rise to these costs (examined below, in connection with Topic 2)
Under-utilization of productive capacity compared to the level of production and sales assumed in a
business’ operating budget
Improper machine setup or inadequate maintenance of equipment and facilities
As indicated above, an important purpose of using a standard cost system is to control costs. A business
achieves cost control by investigating timely variances between standard costs and actual costs, and by
requiring that managers responsible for variances take corrective action. Businesses are likely to experience
and report many variances – for each month, each product, and for each category of material, labor, and MOH.
Some of these variances may be significant; however, many of them are likely to be insignificant. Because
investigating variances is time-consuming, managers will prefer to investigate only the significant variances.
Consequently, a business’ managers must determine, in advance, the criteria or thresholds for “significant”
variances. Accountants discuss significance in terms of materiality and the cost-benefit constraint. The
Topic 3-4 background paper discusses these concepts. In the context of standard cost systems, a variance is
material if, by understanding the reason for it, managers are better able to control costs. However, according
to the cost-benefit constraint, the cost of investigating a particular variance and taking corrective action must
not exceed the resulting future savings, as indicated by smaller unfavorable variances in the future. While
materiality and the cost-benefit constraint provide a rational framework for variance analysis, they provide
limited guidance in setting specific criteria and threshold for investigating variances. As a result, most
businesses set criteria and thresholds that are somewhat arbitrary. To illustrate,
“The machining department manager shall investigate, for Product X, all monthly material usage
(efficiency) variances that exceed 5 percent of standard cost or $1,000, whichever is less.”
_____
28
If a business uses DLHs to develop its standard MOH cost per unit of output and to allocate MOH costs to determine product unit
costs, as illustrated above, it would compute the MOH usage (or, efficiency) variance as:
MOH Usage
(Efficiency) Variance
=
Standard fixed
MOH cost per
unit
x
Standard DLHs allowed for budgeted-normal
volume or quantity of output
Budgeted-normal
volume or quantity
of output
x
Standard DLHs
allowed per unit of
output
–
Standard DLHs allowed for actual volume
or quantity of output
Actual volume
or quantity of
output
x
Standard DLHs
allowed per unit of
output
28
Topic 2
Determining the Cost of Products
Components of Product Costs and Cost Allocation
This background paper examines below the process of determining the cost of products a business
manufactures for sale, focusing on the allocation of manufacturing overhead costs.
As described earlier in this background paper, in order to determine the cost of products they manufacture,
businesses must track and assign to those products the costs of direct materials and direct labor used in
producing them.
Direct materials are materials used directly in producing goods. Examples of direct materials are metals,
plastics and resins, chemicals, coatings, colorants, electronic subassemblies, and computer
semiconductors.
Direct labor refers to the services of production employees directly involved in producing goods.
Examples of direct labor activities are cutting, machining, assembly, and finishing.
Businesses must also allocate to (include in the cost of) products those indirect costs called manufacturing
overhead (MOH) costs. Recall that businesses classify indirect costs as:
Manufacturing overhead (MOH) costs, and
Non-manufacturing overhead costs
MOH costs include the costs of a manufacturing plant and a variety of supporting services, examined below.
The basic categories of non-manufacturing costs are selling, administrative, and research and development
(R&D) costs.
Stated broadly, cost allocation is the process of assigning indirect costs to business units (such as,
production or service departments), products, or processes by using methods and assumptions consistent with
manager-specified measurement objectives.29
Uses of Product Cost Information
Accurate and timely cost determinations are critical to achieving several objectives, including:
Establishing the prices of products or services sold by a business and determining their profitability
Identifying opportunities for reducing costs, and concomitant opportunities to reduce prices in pursuit of
increased market share, improved profitability, or both
Determining whether to introduce new products or discontinue existing products
Determining the cost of inventory held (reported in a business’ balance sheet) and the cost of inventory
sold during a period (reported in the business’ income statement), examined in the Topic 3-4 background
paper
The discussion in this background paper adopts the perspective of a manufacturing business. However, many
businesses in services industries (such as health care, airlines, and financial services) apply these concepts
and methods, as well.
_____
29
Cost allocation is pervasive in accounting. Unless you’re very lucky in your career as a manager, you will have the misfortune of
either (i) being responsible for “fairly” allocating costs to units of a business (such as departments or divisions) for which your fellow
managers are responsible, or (ii) worse, being one those business unit managers who must “live with” (if not accept as fair) someone
else’s cost allocations.
29
Learning
Objective 1
Traditional Allocation of Manufacturing Overhead Costs
The traditional method for allocating MOH costs reflects the long-standing emphasis on designing accounting
systems that enable businesses to prepare general-purpose financial statements that comply with Generally
Accepted Accounting Principles (GAAP), examined in the Topic 3-4 background paper. As described
previously in this background paper, in the U.S., GAAP requires businesses to present the balance of inventory
(in the balance sheet) and the cost of goods sold (in the income statement) using the full-absorption method.
Under the full-absorption method, businesses include in the cost of inventory (on hand or sold) all costs normal
and necessary to make those goods ready for sale, including MOH (or indirect) costs, as well as the cost of
direct materials and direct labor used to produce such goods.
Manufacturing Overhead Costs
MOH includes the costs of the following items (this is not necessarily an exhaustive list):
Nature or Function of Manufacturing Overhead (MOH)
Form of Overhead Costs
Depreciation (i.e., allocations) of the cost of
PP&E owned
Rental cost of leased PP&E
Cost of replacement parts and materials used to
refurbish, repair, and maintain PP&E
Property taxes on PP&E
Property insurance premiums related to PP&E
Property, plant, and equipment (PP&E) used in the manufacture of
products, including:
Buildings
Machinery and equipment (M&E)
Vehicles
Computers
Managers and employees (or independent contractors) responsible
for:
Plant supervision
Production process engineering
Production scheduling
Setting up M&E in anticipation of scheduled production
PP&E refurbishment, repair, and maintenance
Purchasing and receiving materials
Materials handling
Materials warehousing
Product quality inspection
Plant janitorial services
Plant-level human resource, payroll, and accounting services
Salaries, wages, and bonuses
Payroll taxes * [* elements of employee “fringe”]
Retirement benefit expenditures (defined
contribution plans, such as IRC § 401(k) plans,
or defined benefit plans, such as traditional
pension plans, and other post-retirement
benefits) *
Insurance premiums for (or expenditures of selffunded) employee health care plans, workers
compensation and other benefits *
Employee training expenditures
Expenditures for independent contractors
performing these services
Water and power (electricity, gas) for lighting, heating, and cooling
used by PP&E; telecommunication services used by plant and its
employees
Expenditures for water, power, telecommunication,
and other similar services
Indirect materials used in manufacturing goods, such as lubricants
and supplies; and pallets, containers and materials used for moving
or warehousing products prior to shipment to customers
Expenditures for supplies and other indirect
materials
30
Allocation of Manufacturing Overhead Costs
Many companies allocate MOH costs to products they manufacture using a single MOH cost application rate
based on:
A single, combined cost “pool” comprised of all MOH costs, and
A single, “unit-related” allocation base. The most commonly used allocation bases are direct labor hours,
direct labor dollars, or machine hours, because businesses implicitly assume that, as they increase the
number of units of goods they produce, their total MOH costs also increase.
The MOH cost allocation base provides the device for identifying MOH costs with products manufactured.
The most appropriate allocation base is one that presents the strongest cause-and-effect
relationship between the products manufactured and the category of MOH costs allocated.
For example, managers may determine that the primary driver of plant-level human resource
and payroll service costs is direct labor hours or direct labor costs (payroll and related “fringe”
costs of all plant employees) incurred in the plant.
However, as examined further below, identifying allocation bases that present such strong
cause-and-effect relationships is often challenging. Using allocation bases that represent a
weak relationship between MOH costs and the products (or departments) to which managers
allocate them may be unavoidable, leading to challenges in (i) achieving goal congruence
among business unit managers and corporate senior managers and (ii) providing sufficient
performance incentives for business unit managers.
The table below illustrates this simplistic approach to the traditional method of allocating MOH costs using a
single MOH cost “pool” and a single allocation base – direct labor hours – for a business manufacturing three
products:
Normal or expected unit cost computation for coming fiscal year (FY)
Product
Gloves
Direct materials
Bats
.
Balls
$ 22.50
$12.25
$17.50
Direct labor ($25 per hour, including “fringe”)
37.50
18.75
12.50
Manufacturing overhead (MOH) (1) (2)
75.00
37.50
25.00
$135.00
$68.50
$55.00
Total
Conversion costs:
Total manufacturing costs (“normal” cost per unit)
(1) MOH cost application rate computation
All amounts are planned (expected) values for coming FY:
A. Total MOH costs
B. Total units of production
C. Direct labor hours (DLH) per unit produced
D. Total DLHs for planned units of production (B x C)
$9,250,000
50,000
80,000
100,000
1.50
0.75
0.50
75,000
60,000
50,000
E. MOH cost per DLH (A / D)
F. MOH cost per unit produced (C x E)
G. Total MOH cost for planned units (B x F)
185,000
$50.00
$75.00
$3,750,000
$37.50
$25.00
$3,000,000 $2,500,000
$9,250,000
(2) A business experiences normal average per-unit costs when its actual volume of production-and-sales represents a normal
capacity utilization rate for its available MOH resources.
31
MOH Cost Allocation Rates Determined Annually in Advance during Planning
and Budgeting. As indicated in the illustration, above, businesses determine MOH
cost application rates as of the beginning of the fiscal year, based on amounts
included in an approved production plan and operating budget. Businesses may
determine MOH cost application rates in conjunction with adopting standard costs,
as described earlier in this background paper.
To permit timely determination of product costs for pricing-setting, financial reporting, and other purposes,
businesses must determine MOH cost application rates at the outset of the fiscal year for which they are to be
applied, rather than wait until the end of the fiscal year to make final determinations of actual overhead costs
incurred, units produced, and direct labor hours worked. Businesses generally determine MOH cost
application rates annually, rather than monthly or quarterly, in order to avoid the volatility in such rates that
would result from seasonal or other month-to-month fluctuations (i) in direct manufacturing activity
(represented by, for example, direct labor hours incurred) or (ii) in indirect manufacturing activity (and the
related incurrence of overhead costs). Annual determination of MOH cost application rates also corresponds
with the typical business planning and budgeting interval.
Potential Distortion of Product Costs. In the illustration above, the business followed the
full-absorption method and allocated the total of all costs comprising the MOH cost pool ($9.25
million) to planned units of production of its three products based on planned total direct labor
hours (DLH) for each product. Because the business allocated all MOH costs, any distortion of
the unit cost of one of its products resulting from the use of this method will also result in
distortion of unit costs of one or both of the business’ other products. For example, if the DLH
used to manufacture any of its products overstates the actual consumption by that product of
resources comprising MOH costs, then the MOH cost and total cost per unit of that product is
overstated. Consequently, the MOH cost and total cost per unit of one or both of the business’
other products is understated. Such distortions may lead to poor management decisions,
including failure to accomplish the product cost measurement objectives listed above.
Relative Significance of MOH to Total Product Costs. In the illustration above, MOH
represents a significant portion of the total cost of the business’ products:
Relative distribution of total unit costs
Direct materials
Conversion costs:
Direct labor
MOH
Total manufacturing costs
Gloves
Bats
Balls
16.7%
$17.9%
31.8%
27.8%
55.5%
100.0%
27.4%
54.7%
100.0%
22.7%
45.5%
100.0%
As the significance of MOH costs increases relative to total product costs, any distortion of a product’s total unit
cost caused by an inappropriate allocation method also increases. In deed, the traditional method for
allocating MOH costs (illustrated above) was already in use for many decades when computers and other
technological advances came into widespread use by manufacturers in the 1980s and 1990s. These
advances lead to increased use of highly automated, but costly, manufacturing equipment capable of greater
productive output and decreased use of direct labor (e.g., factory line workers). Advances in this technology
and related production processes lead to a significant change in the relative mix of direct material, direct labor,
and MOH costs comprising manufacturers’ total product costs. As direct labor costs declined as a percentage
of total product costs, MOH costs increased as a percentage of total product costs. This shift in the relative
mix of product costs prompted the demand for better approaches to allocating MOH costs.
32
Before the early 1980s
Beginning in the early 1980s
Increased investment in more highly automated manufacturing equipment requiring less direct labor
Direct materials
Direct materials
Direct
labor
Direct
labor
MOH
Relatively low
MOH
Relatively high
Extent of distortion of product costs resulting from MOH cost allocation using a single base, such as direct labor hours
In light of the potential distortion of product costs resulting from the simplistic use of a single MOH cost pool
and allocation base, the argument for this approach is that it is easy to understand (even for a manager who
did not complete a course such as this one) and requires relatively little time to apply to each month’s
production data. If this simplistic approach results in materially accurate product unit cost information, it is by
coincidence, and managers will be unable to demonstrate this accuracy without applying a more sophisticated
approach, as well.
Allocation of Manufacturing Overhead Costs using Multiple Cost Pools
A somewhat more sophisticated approach to this traditional method uses
Multiple MOH cost pools, summarized by department, and
Separate allocation bases (for each MOH cost pool) more closely related to the drivers of MOH costs in
each department
For this purpose, businesses classify their departments as production departments or service departments:
Production departments are those departments (physical areas) within a plant in which
the actual manufacturing of products occurs. Direct labor activities occur in production
departments. In automated plants, the activities of machinery and equipment (M&E),
(measured using machine hours) convert direct materials to finished goods. In addition to
the activities of M&E (represented by PP&E-related MOH costs), production departments
may also include activities of indirect labor, such as plant supervision (represented by
indirect labor costs).
Service departments are those departments within a plant in which actual manufacturing
of goods does not occur, but whose activities provide support that is essential to effective
and efficient operation of production departments and possibly to other service
departments.
33
The allocation base used in each department is a measurable factor (such as machine hours or DLH) that
identifies a functional relationship between a manufactured product and the department’s resources used in
producing that product. The resources used in manufacturing a product include principally the PP&E and
commitment of employee and other services for this purpose, as examined above. The costs of these
resources comprise a business’ MOH costs. To illustrate, consider a business’ machining department (a
production department):
Department: Machining
Allocation base:
Resources: M&E and
supervisory (indirect) labor
Machine hours, which have an engineered
relationship to each unit of product manufactured
Cost
objective:
Product A
Allocation of MOH costs using multiple cost pools follows these steps:
34
Traditional MOH Cost Allocation Steps
Abbreviated Illustration*
1. As of the beginning of the fiscal year, determine (from the annual production
plan and operating budget) the normal, expected total MOH costs for
each production department and service department for the coming fiscal
year
Machining Dept’s (a production
department), annual (normal) machine
depreciation, property taxes, insurance,
and refurbishment costs: $200,000
2. Identify the most appropriate bases for allocating the MOH costs of each
service department and each production department.30 The table below
lists illustrative service departments and production departments, indicating
the form that MOH cost take in each department and possible allocation
bases for each. The most appropriate allocation base is one that presents a
causal relationship between the products manufactured and the MOH costs
allocated. The most commonly used allocation bases for production
department costs relate primarily to units of products, rather than production
runs or batches, particular products, or the overall plant.
Machine hours (a “unit-related” allocation
base; machine hours have an
“engineered” or physical relationship to
each unit produced, even though the
costs of PP&E are largely fixed, rather
than variable, over short-term planning
periods of up to one year)
3. Determine the normal, expected level or volume of each allocation base
Number of machine hours (MH) normally
expected to be provided annually by
machines in Machining Dept. (production
department): 50,000
4. Allocate the normal, expected MOH costs of service departments to
production departments. Most businesses allocate service department
MOH costs directly to production departments, ignoring any services
provided by service departments to other service departments. The direct
allocation method (used in the complete illustration below) leads to
materially correct (rather than precisely accurate) product costs, assuming
the level of services consumed by service departments is not significant
relative to the level of services consumed by production departments.31
MOH costs accumulated within (directly
traceable to) Machining Dept., $200,000,
plus MOH costs of service departments
allocated to Machining Dept., $50,000,
equals total Machining Dept. MOH costs:
$250,000
5. Determine the MOH cost application rates for each production department
by dividing (i) normal, expected MOH costs of each production department,
including its allocated share of service department MOH costs (step 4) by
(ii) normal, expected level or volume of the related allocation base (step 3)32
Total Machining Dept. MOH costs,
$250,000 divided by 50,000 machine
hours equal $5 per MH (MOH cost
application rate)
6. Apply MOH costs of each production department to individual units of each
product by multiplying (i) the MOH cost application rate (step 5) by (ii) the
normal, expected amount of each allocation base consumed by a unit of the
product.
The total per-unit cost of a product is the sum of the per-unit costs of direct
materials, direct labor, and MOH costs for each production department
Product A: Machining Dept. MOH cost
application rate, $5 per MH, times 0.5
MHs required in Machining Dept. for
each unit of Product A equals $2.50 per
unit. To determine Product A’s total unit
cost, combine the per-unit costs of
Machining and all other production
departments, as well as direct materials,
and direct labor.
* Complete illustration set forth below
30
In order to facilitate planning and control of costs, businesses typically budget and accumulate actual costs in individual departments.
31
When a business’ service departments provide significant levels of service to other service departments, as well as production
departments, businesses should allocate the MOH costs of each service department to other service and production departments, until
they have fully allocated the costs of all service departments to production departments. In such cases, businesses generally allocate
the MOH costs of each service department in a step-wise (or sequential) manner, allocating the MOH costs of service departments
one-at-a-time to other consuming service and production departments. Using this method, once managers have allocated the MOH
costs of a given service department, they do not allocate any costs back to the given department. Instead, they allocate the costs of
successive service department only to the remaining service departments and producing departments. Following this step-wise
method, businesses generally allocate first the MOH costs of those service departments that provide services to the largest number of
other service departments. Consequently, the total MOH of succeeding service departments allocated to remaining service
departments and production departments includes part of the MOH costs of other service departments previously allocated to them.
The step-wise allocation of service department MOH costs is actually an approximation of the theoretically correct, but more
complicated, reciprocal allocation method of allocating service department MOH costs. The reciprocal allocation method applies matrix
algebra, including multiple simultaneous equations, to determine the correct allocations of service department MOH costs. Managerial
(or cost) accounting textbooks illustrate the step-wise (sequential) and reciprocal allocation ...
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