SCM Part 1

Primary classification of manufacturing costs

Direct materials, direct labor, manufacturing overhead

Direct materials

Raw materials and other parts that can be traced to a specific product

Direct labor

Payments and benefits for employees who convert direct materials into finished product

Manufacturing overhead

Costs of converting materials into finished product of indirect material, indirect labor, other overhead, indirect pertains to not easy to trace

Indirect material

Not part of finished product but used in its manufacture like repair parts or part of finished product but insignificant in cost like lightbulbs

Indirect labor

Wages of production employees who don’t work directly on product but are required to operate facility like supervisors and cleaners

Other overhead

Set up costs, support departments, overtime

Nonmanufacturing costs

Selling costs and administrtive costs

Cost behavior

Cost response to changes in business activity

Total variable costs

Costs that change in proportion to change in specified cost driver (activity that changes total cost for given cost object like number of batches produced)

Total fixed cost

Costs that don’t vary with small changes in activity levels

Relevant range

Total fixed costs and unit variable costs remain constant within certain range of activity

Marginal cost

Cost of producing additional unit of goods or service

Mixed costs

Cost has both fixed and variable component, ex. electricity bill has base charge plus $2 per shirt produced

Committed costs

Long term obligations that are difficult and costly to change in short term

Discretionary costs

Easier to alter in short term by current managerial decisions, ex. research and development, advertising

Product cost

Cost assigned to goods that’s manufactured or purchased for resale, used to value inventory of manufactured goods until goods are sold, when goods are sold product costs are recognized as COGS

Period cost

Cost of running the business and recorded as expense right away in period it happens, for external financial reporting SG&A and research and development costs are always period costs while this doesn’t have to be true for internal cost management reporting, ex. SG&A costs, research and development

Absorption (Full) costing

Both variable and fixed production costs become part of the product’s cost

Variable costing

Only variable manufacturing costs go into product while fixed manufacturing overhead is a period cost becoming an expense during current period

How to find Net Income for Absorption Costing

Sales

(Less COGS)

Beginning Inventory

+COGM (units produced * unit product cost)

= Goods Available for Sale

- Ending Inventory (amount left * unit product cost)

Gross Margin (Sales - (GAFS - ending inventory))

(Less Selling & Admin Expenses)

Fixed S&A Exp + Variable S&A Exp

= Net Income

How to find Net Income for Variable Costing

Sales

(Less Variable Expenses)

Beginning Inventory

+ COGM (units produced * unit product cost)

= Goods available for Sale

- Ending Inventory (amount left * unit product cost)

= Variable COGS

+ Variable Selling & Admin Exp

Contribution Margin (Sales - (Variable COGS + Variable S&A Exp))

- (Fixed Manufacturing Overhead + Fixed S&A Exp)

= Net Income

If Production > Sales

• Inventory increases

• Absorption Costing > Variable Costing

If Production < Sales

• Inventory decreases

• Absorption Costing < Variable Costing

If Production = Sales

• No change in inventory and is 0

• Absorption Costing = Variable Costing

Fixed Overhead Per Unit

= Fixed manufacturing overhead / Units produced

Basic Cost Volume Profit (CVP) model

Revenue = Variable costs + Fixed costs + Income

Total variable costs

=.Variable cost per unit (V) * Units sold (Q)

Unit contribution margin

= P - V

Number of units sold to break even

Q = F / (P - V)

Break even point in sales dollars

= F / (CM Ratio)

CM Ratio

= CM / Sales

Units sold to earn target income

= (F + Target income) / Unit contribution margin

Income before tax

B = A / (1-T)

Operating leverage

• Reflects risk of missing sales targets

• Operating leverage= CM / operating income

• % change in operating income= (Operating leverage * % change in sales)

Modeling multiple products

1. Find percent of total

2. Weighted contribution: CM times % of total for each, then add each of it up

3. Break even point: F / weighted contribution or F / CM Ratio (using weighted avg sales)

4. Individual sales: (Break even point * % total)

Profit

= (units sold*CM per unit) - F or (sales dollars *CM ratio) - F

Semi variable (mixed) cost structure

• y = mx + b

• m: variable cost per unit (slope)

• x: cost driver

• b: fixed cost component (intercept)

• y: total cost

R square

Measures percentage of variation in dependent variable explained by independent variables, increases when any variable is added, ex. R²= .64 means 64% of variation in dependent variable is explained by independent variable

Adjusted R square

Only increases if new variable truly improves model, better metric for comparing models with different number of variables

Intercept Coefficient

Represents fixed costs

Variable coefficient

Represents slope, variable cost per unit

P value

Less than .05 is statistically significant

Coefficient standard error

Measures uncertainty in estimated coefficients, used to calculate T stat

T statistic

Absolute value greater than 1.96 is statistically significant at 5%

Confidence interval

Shows lower and upper uncertainty around the point estimate with wide interval reflecting high uncertainty

Negative intercept makes sense?

No, intercept is based on predicting salary costs when the variables are both zero which is outside relevant range of the data, linear relationship may not hold zero operations, and model may not capture all baseline fixed costs

Cook’s distance test

• Detects outliers

• Shows if observations were removed would regression result change a lot

• If it does change regression a lot and Cooks D > .1, it’s potentially influential

Standardized residual

• Calculated for each point

• Shows how far actual is from predicted

• = Residual (predicted - actual) / standard error of model

Multicollinearity

• Happens when 2 or more independent variables are strongly related to each other and moving together

• Causes coefficient estimates to become unstable, standard errors to increase, and become harder to determine importance of individual variables

• VIF detects multicollinearity

• To fix this, drop variable, combine variable, ridge regression, or collect more data

VIF

• Detects multicollinearity and how much it effects variable

• 1 shows no multicollinearity, 5 shows moderate concern, >10 shows severe concern

• VIF = 1 / (1 - R²)

Traditional cost system

Created when manufacturing processes were labor intensive, single company wide overhear rate is based on direct labor hours used to allocate overhead to products

Overhead rate for traditional costing

= Total overhead / Total direct labor hours

Overhead allocation for traditional costing method

= Overhead rate * Activity’s total direct labor hours

Activity based costing

Costing method that assigns overhead to products based on activities those products actually use

Cost driver rate for activities (ABC rate)

= Activity cost / Activity volume