A306 2ND EXAM!!!

Job Order Costing

- Unique/Custom Products

- Each job is different

- Direct costs traced to a job order (many costs can be directly traced to the job)

Process Costing

- Standard (homogeneous products)

- Each unit of a product is identical

- Costs accumulated and allocated by process (costs are accumulated by stages of production process and allocated evenly to units)

Cost Object

Any item for which we want to measure costs

- In job order costing... is a job

- In process costing is a product (multiple, identical units)

Direct Materials and Direct Labor

Traced directly to jobs and products

Overhead (OH)

Indirect costs... allocated to jobs and products

Allocating Indirect (OH) costs

1. Determine the allocation base (costs driver)... should reflect resources used to produce a product

2. Calculate the POHR

3. Allocation OH to jobs (or products) based on the POHR and the actual value of the allocation base

Timeline of OH estimation and allocation

- Beginning of period: OH costs and the allocation based are estimated, POHR calculated

- Completed: OH applied to jobs

- End of period: Difference between actual and applied OH is calculated

Why do we need product cost information?

- To ensure the selling price is greater than cost

- To determine which products are more profitable

- To evaluate business decisions (managers)

- To determine the value of inventory on the balance sheet (and expenses on the income statement)

Service firms also use cost information

Managers of service firms need cost information to price their services, to budget and control costs, and to determine the profitability of different types of clients

What do cost allocations promote

Cost allocations promote decisions and behaviors that align with the company's objectives. Make managers aware of the cost of resources (ex. IT costs)

When a company spreads (or "allocates") its costs to different departments or products, it helps people make choices that support the company's overall goals.

For example: If a department sees how much its activities actually cost, it might look for ways to save money or use resources more wisely — which helps the whole company do better.

Project bids and markups

Some jobs can be earned by placing a bid:

- A company will allow vendors to place bids for a particular job... often the lowest bid will earn the job

- In this situation, the bidder (company trying to earn the job) will often set a bid based on cost plus a markup

- The markup represents the bidder's profit

Product Costs

Costs that are assigned to the product as it being manufactured... inventorial costs and manufacturing costs (IN THE FACTORY!!!)

Period Costs

Costs that are expensed in the period in which they are incurred... recorded directly as expenses on the income statement (not included in inventory) and NON-MANUFACTURING COSTS!

Balance Sheet Cost Flows

Raw Materials Inventory (DM), Work in Process Inventory (COGM), Finished Goods Inventory (COGS)

Overapplied or underapplied OH

At the end of the period, Total OH will be known and total applied OH will be known (POHR X Actual allocation base)

Because OH is applied base on estimated values, there is likely to be a difference between actual OH and applied OH

Overapplied OH —> Reduce COGS

Underapplied OH —> Increase COGS

Volume-Based Costing vs. Activity Based Costing

Allocate indirect (overhead) costs to products and services

Volume based Costing

A method of assigning indirect costs to products and services based on cost drivers that vary in direct relation to volume

Activity-Based Costing (ABC)

A method of assigning indirect costs to products and services based on the activities (and resources) they require

Allocating Indirect Costs

- We use estimates (POHR x actual value of allocation base)

Allocating indirect OH costs

- Difference between volume-based and activity-based costing is how indirect (OH) costs are allocated to products

- Volume-based cost systems tend to allocate too much OH costs to high-volume, simple products and too little PH cost to low-volume, customized, or complex products... by incorporating both volume and non-volume drivers of costs, ABC provides a more accurate picture of the cost producing diverse products

Two stage OH allocation using ABC

Stage 1 Allocations:

1. Identify and classify activities (costs that are shared among activities can be allocated together)

2. Form activity pools and assign indirect costs to each pool (the goal is to create as few activity pools as possible while capturing the major activities performed)

Stage 2 Allocations:

3. Select a cost driver for each activity pool (the goal is to identify a driver that has a cause-effect relationship with the underlying activity that occurs in each activity pool)

4. Assign indirect costs to products or services based on the cost drivers

Types of Production Activities

Unit-Level, Batch-Level, Product-Level, Facility-Level

Decentralized Performance Evaluation

- Assignment of decision-making authority... decisions should be made at the appropriate level of the organization

- Performance evaluation system... performance should be measured... performance measures should reflect the decisions and actions that a manager is responsible for

- Incentive and reward system... performance measures should incentivize decisions and actions that are consistent with organizational goals... managers should be appropriately rewarded on their performance

Decentralized

Decision-making authority is spread through the organization... managers are given more autonomy in making decisions

Centralized

Decision-making authority is primarily at the executive level... lower-level managers implement the decisions

Advantages of Decentralization

- Recognizes that lower-level managers can make quicker and more informed decisions

- Fosters the development of managerial expertise

- Allows top managers to focus on strategic issues

Disadvantages of Decentralization

- Can result in the duplication of resources

- Gives managers the opportunity to make decisions that benefit themselves but are not necessarily in the best interest of the organization

Performance Measures

Effective performance measures have the following characteristics:

- Controllability

- Sensitivity

- Aligned with organizational goals

Controllability

The aspects of performance being measured should be under the control of the manager being evaluated... many aspects of performance are not controllable (mangers cannot control the performance of other units)

Sensitivity

Decisions and actions taken by managers should be reflected in the performance measure... if a performance measure does not change as good performance occurs, then the measure is not sensitive to a manager's actions

Aligned with organizational goals

The performance measures should promote decisions and actions that are consistent with organizational goals... if performance measures can be improved by actions that are inconsistent with organizational goals, this leads to goal incongruence

Balanced Scorecard

A comprehensive performance measurement system that translates an organization's strategic vision into a set of operational performance metrics

- Useful for communicating the company's strategic objectives to managers and employees in an organization

- Measures operational performances on four key dimensions

(A company's incentive and reward system must be redesigned to align with the measures captured by the balanced scorecard... otherwise it may not serve its intended purpose)

A balanced scorecard is a strategic management tool that helps organizations measure performance beyond just financial metrics, using four key perspectives

Balanced Scorecard Sections

- Financial

- Customer (stakeholder)

- Internal business processes

- Organizational Capacity (learning and growth)

Financial Section of Balance Scorecard

- Related to an organization's financial performance and the effective use of financial resources

- ROI, RI, sales growth, NOI, EPS, stock price

Customer (stakeholder) Section of Balance Scorecard

- Takes the view of the customer and other key stakeholders the organization serves

- Market share, customer satisfaction, repeat customers

Internal business processes Section of Balance Scorecard

- Relates To the quality and efficiency of an organization's products, services, or other key business processes

- Defect rates, delivery time, manufacturing cycle time

Organizational capacity (learning and growth) Section of Balance Scorecard

- Captures the organization's most critical capabilities (ex. Human capital, infrastructure, technology, culture, and innovation) that are key to breakthrough performance

- Employee turnover, employee satisfaction, training hours

Cause-Effect relationships of a Balanced Scorecard

The objectives and metrics included in the balanced scorecard should always have a cause-effect relationship where performance in one area of the scorecard ultimately affect performance in the others

ROI

- Measures the percentage return based on an investment in assets

- Components: NOI (earnings before interest and taxes) AND Average operating assets (cash, accounts receivable, inventory, PPE, other operating assets)

Profit Margin

Measures how much profit is earned per dollar of sales... improved by increasing the selling price, decreasing operating expenses, increasing unit sales (lower cost per unit)

Investment turnover

Measures how efficiently operating assets are being used to generate sales... improved by reducing unnecessary assets or increasing sales with the same asset base

Decomposition of ROI (DuPont method)

ROI = Profit margin x investment turnover = net operating income/sales rev x sales rev/average operating assets = net operating income/average operating assets

Residual Income

The amount of net operating income earned over and above the minimum amount needed to meet the required rate of return... (required rate is known as the discount or hurdle rate)

Advantages of ROI

- Easy to calculate and understand

- Widely used and accepted

- Independent of size (scale)

Disadvantages of ROI

- Potential goal incongruence

- Decisions depend on the current ROI

Advantages of residual income

- Avoids underinvestment problems with ROI

- Conceptually leads to better project selection for the company

Disadvantages of residual income

- Sensitive to size (favors large decisions)

Capital Budgeting

The process of evaluating and making decisions about investments in major capital assets... examples of capital assets include property, facilities, equipment, new product lines, R&D, etc... these represent significant investments

Cost Capital

Cost of financing a company's operations

- Calculated based on the cost of obtaining capital from debt and equity

- Known as the required rate of return or the discount rate

Capital Budgeting Areas

- Screening decisions

- Preference decisions

- Independent projects

- Mutually exclusive projects

Screening decisions

Determining whether a proposed investment meets some minimum (return) criteria

Preference Decisions

Evaluating and comparing alternative investment opportunities

Independent Projects

- Projects that are unrelated to one another... investing in one project does not preclude investment in other projects

Mutually Exclusive projects

Projects are competing alternatives, where managers would invest in one alternative or another, but not both

Cash flows at the start of a project

- Initial investment, including installation costs

- Working capital required: investment in current assets (cash, accounts receivable, inventory) minus current liabilities (accounts payable) required to support the investment

Cash flows During the project

- Cash revenues (inflows)

- Cash expenses (outflows)

(All non-cash amounts should be excluded in most capital budgeting methods such as depreciation)

Cash Flows at the end of a project

- Disposal (salvage value) of certain assets

- Working capital release: reduction in current assets minus current liabilities that were required during the project

Capital budgeting methods

- Measure of returns

- Incorporation of the time value of money

Measure of returns

Cash flows (recorded when cash is received and paid out) vs. Net income (accrual-based accounting measure... income statement, revenues are recognized when earned, expenses are recognized when incurred)

Incorporation of the time value of money

Discounted methods (discounts future returns to the present value) Vs. Non-discounted methods (does not discount future returns to present value)

The main difference is that discount methods factor in the time value of money, while non-discount methods (like payback period) do not. Discount methods are more accurate for long-term investments because they adjust future cash flows to their present value, while non-discount methods are simpler and quicker but can be inaccurate.

Accounting rate of return (Capital investment evaluation method)

The rate of return on a capital investment, measured by net income (annual net income as a percentage of the initial investment in assets)... called annual rate of return, simple rate of return, or unadjusted rate of return... a project would be acceptable if the ARR exceeded the minimum required rate of return

- Weakness: Does not incorporate the time values of money

(ARR is the only capital budgeting methods that uses net income rather than cash flows)

Payback Period (Capital investment evaluation method)

The amount of time it will take for a capital investment to earn back the cost of the original investment... in general, projects with shorter payback periods are considered safer investments than those with longer payback periods

Weakness: Does not incorporate the time value of money; does not incorporate any cash flows that occur after the end of the payback period

Net Present Value - NPV (Capital investment evaluation method)

The present value of future cash flows from a capital investment (including the cash outflows from the initial investment)... can be used to compare capital investment projects

- All cash flows need to be discounted to present value (stated in their value today)

- Compare the present value of cash inflows and outflows to determine the net present value

- If the NPV is zero, the project is acceptable

Internal Rate of Return (Capital investment evaluation method)

The rate of return that will yield a zero NPV... if the IRR is higher than the required rate of return, the NPV will be positive, indicating that the project is acceptable

Profitability Index

The ratio of the present value of cash flows to the initial investment (indicates how much benefit is generated for each dollar of initial investment)... a profitability index higher than one shows that the project has a positive NPB... can be used to compare capital investment projects

Capital investment evaluation methods summary

- The NPV method is the best for evaluating mutually exclusive projects or deciding between two competing alternatives

- The profitability index is best for prioritizing independent projects when investment funds are limited (because it started as a ratio rather than a dollar value, the profitability index allows managers to easily compare projects that vary in size)

Unit-level

- Performed for each unit

- Machining, assembling, packaging

Batch-level

- Performed for a batch of units

- Machine setup, calibration, quality testing, purchasing, materials handling

Product-level

- Performed to support a specific product line or service offering

- Product design, R&D, advertising a product line, purchasing product-specific equipment

Facility-level

- Performed to support the entire company

- Factory supervision/administration, depreciation on the factory building, factory IT systems, human resources