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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