Unit 11-13
Classification of Cost Levels in Manufacturing
Cost Levels Overview: Costs in a manufacturing organization can be categorized based on the operational level at which they are incurred. Identifying the specific cost level is crucial for evaluating whether a cost is avoidable and relevant to managerial decisions.
Unit-Level (UL) Costs:
Definition: Costs that can be avoided by eliminating just a single unit of product.
Direct Materials (DMs): Avoidable because materials directly allocated to that specific unit are no longer required.
Indirect Materials (IMs): Avoidable because indirect materials used for the manufacture of that specific unit are no longer needed.
Direct Labor (DL): May be considered unit-level only if the quantity of direct labor is highly adjustable in response to work demand changes, or if the product is large and requires a substantial amount of direct labor time per individual unit.
Batch-Level (BL) Costs:
Definition: Costs that can only be avoided by eliminating an entire batch of products. Eliminating a batch also avoids all associated unit-level costs.
Direct Labor (DL): Probably avoidable at the batch level (assuming it is not unit-level), as labor schedules can usually be adjusted to eliminate work time for an entire dropped batch.
Machine Setup and Maintenance: Avoidable because equipment adjustments, retooling, and routine maintenance are typically performed between production batches.
Indirect Labor (IL): May be avoidable only if the quantity or scheduling allocation of indirect labor can be adjusted for changes in batch volume.
Utilities: May be avoidable if a batch requires specific equipment usage that consumes substantial electricity or other utility resources.
Product-Level (PL) Costs:
Definition: Costs that can only be avoided by eliminating an entire product line. Eliminating a product line avoids all associated unit-level and batch-level costs.
Indirect Labor (IL): Probably avoidable if indirect labor is tied directly to managing or supporting a specific product line rather than a batch.
Product Design: Avoidable because eliminating a product line removes the necessity for product design effort, updates, and associated costs.
Advertising and Promotion: Probably avoidable if advertising campaigns are managed product-by-product rather than globally for the entire company.
Machine Depreciation: May be avoidable if specific manufacturing equipment is dedicated solely to the eliminated product line and can be disposed of.
Utilities: Probably avoidable for utility costs that were not eliminated at the batch level but are tied to product-line machinery.
Quality Inspection: Avoidable because quality control and defect testing efforts are tailored specifically to individual product lines.
Facility-Level (FL) Costs:
Definition: Costs that can only be avoided by eliminating an entire facility or plant. Eliminating a facility avoids all unit-level, batch-level, and product-level costs associated with that plant.
Factory Depreciation: Probably avoidable upon complete plant elimination.
Factory Insurance: Probably avoidable upon plant closure.
Custodial Services: Probably avoidable as building maintenance for the facility would no longer be required.
Non-Avoidable Higher-Level Corporate Allocations: Allocated overhead costs from corporate headquarters (such as executive salaries for the CEO and CFO) assigned to various departments or facilities are not avoidable, even if an entire facility is shut down.
Framework for General Decision Relevancy
General Relevancy Criteria: To be considered relevant in business decision-making, information must meet two conditions: it must be future-oriented and it must differ between the alternatives being evaluated.
Sunk Costs:
Definition: Costs that have already been incurred in the past.
Relevancy: Sunk costs cannot be changed by any present or future decision; therefore, they are never relevant.
Opportunity Costs:
Definition: The potential benefit or revenue forgone by selecting one alternative over another.
Relevancy: Highly relevant when choosing between competing uses of resources or capacity.
Differential Revenues:
Definition: Future revenue streams that differ depending on which alternative is selected.
Relevancy: Highly relevant in evaluating financial outcomes.
Differential Costs (Incremental Costs):
Definition: Future cost amounts that vary between the alternatives under consideration.
Relevancy: Highly relevant for determining total cost changes.
Qualitative Considerations: Important non-financial factors—such as customer relationships, brand perception, employee morale, and long-term strategic alignment—must always complement quantitative financial analysis.
Time Value of Money (TVM):
When revenues or costs occur at significantly different points in time, future cash flows must be discounted to present value when evaluating alternatives.
For basic operational analysis and short-term decisions, TVM is often simplified or ignored.
Segment Elimination Decisions
Evaluation of Underperforming Segments:
When a business segment reports operating losses, management must evaluate whether eliminating the segment improves total corporate profitability.
Eliminating a segment drops all direct unit-level, batch-level, product-level, and segment-specific facility-level costs.
General corporate overhead costs allocated to the segment will not be eliminated; instead, they will be reallocated to remaining operational segments.
Intersegment Revenue Effects:
Substitute Revenues: Occur when customers choose between products offered by different segments of the same company. Discontinuing an unprofitable segment may cause customers to shift purchases to surviving internal segments, offsetting lost revenue.
Corporate Example: When General Motors (GM) discontinued the Pontiac brand in 2008, management anticipated that a portion of potential Pontiac buyers would purchase Chevrolet, GMC, Cadillac, or Buick vehicles instead.
Complementary Revenues: Occur when customers purchase products from different segments as a set or bundle. Discontinuing one segment can negatively impact sales in related segments.
Corporate Example: Appliance manufacturer Whirlpool produces washers, dryers, refrigerators, dishwashers, and ranges. Because consumers often buy appliances in matching brand sets, eliminating the refrigerator line could cause customers to buy their dishwashers or ranges from competitors. (Whirlpool's ownership of Maytag also creates substitute revenue dynamics).
Qualitative Factors: Laying off workforce members can cause severe reputational damage, disrupt community relations, and degrade remaining employee loyalty. Customer trust may also erode if product lines are suddenly abandoned.
Segment Reporting Case Analysis (HP, Inc. 2023 Form 10-K):
Segment Operating Earnings:
Personal Systems:
Printing:
Corporate Investments: $-\$142\text{ million}$
Total Segment Earnings from Operations: $5,386\text{ million}$
Unallocated Corporate Items:
Corporate and unallocated costs and other: $-\
Stock-based compensation expense: $-\$438\text{ million}$
Restructuring and other charges: $-\
Acquisition and divestiture charges: $-\$240\text{ million}$
Amortization of intangible assets: $-\
Russia exit charges:
Interest and other, net: $-\$519\text{ million}$
Total Earnings Before Taxes: $2,937\text{ million}$
Decision Implication: The $375 million listed under "corporate and unallocated costs and other" contains higher-level expenses that cannot be separated by segment. Furthermore, any allocated portions contained within segment reports are non-avoidable and would simply be reallocated to surviving segments if Corporate Investments or another segment were eliminated.
Outsourcing and Make-or-Buy Decisions
Decision Mechanics: A make-or-buy analysis determines whether a company should manufacture a component part (or perform a service) internally or outsource it to an external supplier.
Cost Avoidability in Outsourcing:
Avoidable Costs: Direct materials, direct labor, and variable manufacturing overhead tied directly to producing the outsourced component (unit-level and batch-level costs).
Non-Avoidable Costs: Product-level costs, facility-level costs, plant depreciation, and general allocated administrative overhead persist.
Sunk Costs: Historical costs of manufacturing equipment previously used for the component must be ignored.
Capacity Utilization: Vacated production space may create opportunity costs if it can be leased to third parties or repurposed for other profitable operations.
Qualitative Considerations in Outsourcing:
Supplier reliability regarding delivery schedules and volume capabilities.
Quality control consistency of outsourced parts compared to internal production.
Reputational fallout and morale degradation associated with employee layoffs.
Loss of internal expertise and technical capabilities, creating extreme vulnerability if the supplier subsequently raises prices.
Economic Drivers for Supplier Cost Advantages:
Economies of Scale: External suppliers specializing in a single component achieve high production volumes, drastically lowering unit overhead costs.
Resource Cost Differentials: External suppliers may operate in regions or foreign countries with significantly cheaper labor or raw materials.
Core Competency: Specialized external vendors focus entirely on component production, whereas the primary company may lack efficiency in that specific manufacturing process.
Lease-or-Sell Decisions:
Option to Sell: Generates immediate current sales proceeds (differential revenue). If standard sales commissions apply, they represent differential costs.
Option to Lease: Generates a recurring series of future lease payments (differential revenue). Ongoing asset maintenance, repairs, and insurance obligations represent differential costs.
Asset Book Value: The original purchase cost of the asset is sunk and entirely non-relevant.
Equipment Replacement Decisions
Decision Drivers: Equipment replacement is typically driven by technological innovations that allow new machinery to operate faster, produce higher output volume, or manufacture higher quality products.
Relevant Differential Items:
Differential Costs: Purchase price of the new equipment; operational cost savings or maintenance expense differentials between old and new machines.
Differential Revenues: Current salvage or trade-in value of the old equipment; incremental contribution margin earned from producing additional or higher-quality units; net salvage value of the new equipment at the end of its useful life.
Irrelevant Sunk Items: Original historical cost of the old machinery and its accumulated accounting depreciation are sunk and completely irrelevant to the replacement choice.
Special Order Decisions
Decision Parameters: Evaluates whether to accept a one-time, large-volume order from a customer at a discounted price when the firm possesses excess, unutilized manufacturing capacity.
Relevancy Structure:
Relevant Factors: Discounted revenue generated by the special order; variable unit-level costs (direct materials, direct labor); batch-level setup costs; opportunity costs (e.g., lost rental income from utilizing idle plant space).
Irrelevant Factors: Fixed product-level and facility-level overhead costs, as overall factory capacity is already established and paid for.
Qualitative Risks: Existing regular customers might discover the discounted price, leading to demands for matching discounts or severe dissatisfaction, customer loss, and brand erosion.
Strategic Capacity Reserves: Companies frequently maintain deliberate excess capacity to preserve operational flexibility for unexpected demand surges at full retail price, rather than locking up capacity with low-margin special orders.
Joint Products Costing and Allocation Methodologies
Joint Products Fundamentals:
Joint Products: Two or more distinct products generated from a single, common raw material input or manufacturing process up to a specific separation point.
Split-Off Point (SPLIT-OFF POINT): The stage in the common manufacturing process where individual joint products become separately identifiable.
Industry Example: Dairy processing converts raw milk into distinct joint products including cream, butter, yogurt, and cheese at the split-off point.
Cost Classifications:
Separable Costs: Production costs incurred after the split-off point that are tied exclusively to individual joint products.
Non-Separable Costs (Joint Costs): Common processing costs incurred prior to the split-off point. These costs must be allocated across joint products to establish accurate product costs and prevent product mispricing.
Allocation Method 1: Physical Units Method:
Allocates pre-split-off joint costs based on a physical measure (such as weight, volume, or unit count) at the split-off point.
Service Sector Application: A public accounting firm allocates shared Human Resource (HR) department costs across Audit, Tax, and Consulting service divisions based on the number of active partners in each division. Alternatively, universities allocate central administrative costs based on department headcounts or enrolled student credit hours.
Mathematical Example (Illustration 11-3: Toothpaste):
Joint Cost: $700,000 incurred to produce 1,000,000 total tubes (100-gram size) before adding flavor additives.
Mint Flavor Output: 200,000 units
Strawberry Flavor Output: 300,000 units
Watermelon Flavor Output: 500,000 units
Allocation Calculations: \text{Mint Joint Cost Allocation} = 20\% \times \$700,000 = \$140,000\text{Strawberry Joint Cost Allocation} = 30\% \times \$700,000 = \$210,000\text{Watermelon Joint Cost Allocation} = 50\% \times \$700,000 = \$350,000\n\n* **Allocation Method 2: Sales Value at Split-Off Point Method**:\n * Allocates joint costs based on each joint product's relative sales value computed directly at the split-off point. Applicable when products require no further processing and can be sold immediately at split-off.\n * *Mathematical Example (Illustration 11-4: Wood Cutting Boards)*:\n * Joint Processing Cost: 200,000\n * Big Cutting Boards: 5,000 units sold at 20/unit\n * Small Cutting Boards: 25,000 units sold at $15/unit\n * *Sales Value Calculations*:\n \text{Big Boards Sales Value} = 5,000 \text{ units} \times \$20 = \$100,000\text{Combined Sales Value at Split-Off} = \$100,000 + \$375,000 = \$475,000\n * *Joint Cost Allocations*:\n \text{Big Boards Allocation} = \frac{\$100,000}{\$475,000} \times \$200,000 = \$42,105
Allocation Method 3: Net Realizable Value (NRV) Method:
Applicable when joint products cannot be sold at split-off and must undergo further processing. Joint costs are allocated relative to each product's total net realizable value.
Formulas: \text{Total Product Line NRV} = \text{NRV per Unit} \times \text{Units Produced}\n * *Mathematical Example (Illustration 11-5: Leather Goods)*:\n * Joint Processing Cost: 250,000\n * Handbags: 5,000 units produced; selling price = 75/unit\n * Wallets: 10,000 units produced; selling price = 50/unit; separable cost = $10/unit\n * *NRV Calculations*:\n \text{Handbag NRV per Unit} = \$200 - \$75 = \$125\text{Wallet NRV per Unit} = \$50 - \$10 = \$40\text{Combined Total NRV} = \$625,000 + \$400,000 = \$1,025,000\n * *Joint Cost Allocations*:\n \text{Handbag Joint Cost Allocation} = \frac{\$625,000}{\$1,025,000} \times \$250,000 = \$152,439
Standard Costing Fundamentals and Variance Analysis
Purpose of Standard Costing: Standard costs are predetermined expectation benchmarks established for quantity and price across direct materials, direct labor, and manufacturing overhead. They serve as targets to measure efficiency, control operations, and assign operational responsibility.
Criteria for Standards: Standards must be realistic—reflecting normal, attainable operating efficiency rather than ideal best-case or worst-case scenarios.
Sign Conventions and Terminology:
Cost Variances:
Unfavorable (U): Actual usage or price exceeds standard expectation (negative financial impact).
Favorable (F): Actual usage or price is less than standard expectation (positive financial impact).
Sales Variances:
Favorable (F): Actual revenue or selling price exceeds standard expectation.
Unfavorable (U): Actual revenue or selling price falls below standard expectation.
Budgetary Framework for Variances:
Master Budget: Static budget based on planned production volume.
Flexible Budget: Dynamic budget calculated by applying standard prices and rates to the actual volume of activity achieved.
Usage / Quantity / Volume Variances: Differences between the Master Budget and the Flexible Budget.
Price / Rate / Spending Variances: Differences between the Flexible Budget and Actual Results.
Direct Materials Variance Analysis
Direct Materials Quantity Variance (Usage Variance):
Compares actual physical quantity of direct materials used against standard quantity expected for actual production volume.
Organizational Responsibility: Assigned primarily to the Manufacturing Manager.
Direct Materials Price Variance:
Compares actual price per unit of material against standard price expected per unit.
Organizational Responsibility: Assigned primarily to the Purchasing Manager.
Total Direct Materials Cost Variance:
Combine individual quantity and price variances, or compare total standard materials cost for actual production against total actual materials cost incurred.
Graphical Overview of Direct Materials Variances:
Managerial Trade-Offs and Interdependence:
If a purchasing manager buys cheap, low-quality materials to secure a favorable price variance, the inferior materials can cause higher scrap rates, excessive waste, and machine jams, resulting in a large unfavorable quantity variance for the manufacturing manager.
Materials price and quantity variances must be evaluated in tandem rather than in isolation.
Detailed Example (Illustration 12-2):
Standard Expectations: of material at a price of $\$8.60\text{/lb}$.
Planned Production: $1,800\text{ units}$.
Actual Results: $1,900\text{ units}$ produced using $3,097\text{ lbs}$ of material at a total actual cost of $\.
Actual Unit Metrics: \text{Actual DMs price per pound} = \frac{\26,479.35}{3,097\text{ lbs}} = \8.55\text{/lb}\n * *Variance Computations*:\n \text{DMs Quantity Variance} = [(1.6\text{ lbs} - 1.63\text{ lbs}) \times 1,900\text{ units}] \times \$8.60 = -\$490.20\text{ U}\text{Total DMs Cost Variance} = -\$490.20 + \$154.85 = -\$335.35\text{ U}\n * *Alternative Total Variance Verification*:\n \text{Standard Total Cost} = 1.6\text{ lbs} \times 1,900\text{ units} \times \$8.60 = \$26,144.00
Direct Labor Variance Analysis
Direct Labor Usage Variance (Efficiency / Time Variance):
Compares actual direct labor hours worked against standard labor hours expected for actual volume produced.
Organizational Responsibility: Assigned primarily to the Manufacturing Manager (or Service Manager).
Direct Labor Rate Variance:
Compares actual hourly labor rate paid against standard expected hourly labor rate.
Organizational Responsibility: Assigned primarily to the Human Resources Manager.
Total Direct Labor Cost Variance:
Combine labor usage and rate variances, or subtract actual total direct labor cost from standard total direct labor cost for actual output.
Graphical Overview of Direct Labor Variances:
Managerial Trade-Offs and Interdependence:
If HR hires lower-skilled or under-qualified labor at low pay rates (favorable rate variance), production efficiency may drop, requiring excess labor hours to complete tasks (unfavorable usage variance).
Labor rate and usage variances must be evaluated together.
Detailed Example (Illustration 12-4):
Standard Expectations: at a labor rate of $\$13.40\text{/hour}$.
Planned Production: $1,800\text{ units}$.
Actual Results: $1,900\text{ units}$ produced using $399\text{ total labor hours}$ at a total labor cost of $\.
Actual Unit Metrics: \text{Actual hourly wage rate} = \frac{\5,362.56}{399\text{ hours}} = \13.44\text{/hour}\n * *Variance Computations*:\n \text{DL Usage Variance} = [(0.22\text{ hrs} - 0.21\text{ hrs}) \times 1,900\text{ units}] \times \$13.40 = \$254.60\text{ F}\text{Total DL Cost Variance} = \$254.60 + (-\$15.96) = \$238.64\text{ F}\n * *Alternative Total Variance Verification*:\n \text{Standard Total DL Cost} = 0.22\text{ hrs} \times 1,900\text{ units} \times \$13.40 = \$5,601.20
Comprehensive Variance Analysis: Healthy Juices Co.
Scenario Parameters (Illustration 12-5):
Healthy Juices Co. produces bottles of Apple Juice and Apple-Strawberry Juice.
Standard Selling Prices: Apple Juice = $\$10\text{/bottle}$; Apple-Strawberry Juice = $\.
Standard Material Requirements:
Apple Juice: organic apples, organic strawberries.
Apple-Strawberry Juice: organic apples, organic strawberries.
Standard Direct Labor Requirements:
Apple Juice: () technician time per bottle.
Apple-Strawberry Juice: ( or ) technician time per bottle.
Standard Input Costs:
Organic Apples: $\$1.00\text{/lb}$
Organic Strawberries: $\
Fruit Processing Technicians: $\$10.00\text{/hour}$
Actual Production and Sales in 20XX:
Apple Juice: $16,000\text{ bottles}$ produced and sold (Revenue = $\).
Apple-Strawberry Juice: produced and sold (Revenue = $\$250,000$).
Actual Input Costs Incurred:
Organic Apples: $\ for (Actual Price = \frac{\150,000}{175,000\text{ lbs}} = \).
Organic Strawberries: $\$100,000$ for $40,000\text{ lbs}$ (Actual Price = $\frac{\100,000}{40,000\text{ lbs}} = \2.50\text{/lb}$).
Fruit Processing Technicians: $\ for (Actual Rate = \frac{\154,000}{14,000\text{ hrs}} = \).
Direct Materials Variances for Organic Apples:
Standard Quantity Allowed:
Variance Calculations: \text{DMs Price Variance} = (\$1.00 - \$0.8571) \times 175,000\text{ lbs} = \$25,000\text{ F}
Verification: (155,000\text{ lbs} \times \1.00) - \$150,000 = \$155,000 - \$150,000 = \$5,000\text{ F}$. Overall apples variance is favorable.
Direct Materials Variances for Organic Strawberries:
Standard Quantity Allowed:
Variance Calculations: \text{DMs Price Variance} = (\$2.00 - \$2.50) \times 40,000\text{ lbs} = -\$20,000\text{ U}
Verification: (50,000\text{ lbs} \times \2.00) - \$100,000 = \$100,000 - \$100,000 = \$0$. Overall strawberry variance is zero, though individual price and quantity variances offsets suggest higher-quality strawberries were purchased at a higher price, reducing material waste.
Direct Labor Variances for Fruit Processing Technicians:
Standard Hours Allowed:
Variance Calculations: \text{DL Usage Variance} = (12,333\text{ hrs} - 14,000\text{ hrs}) \times \10.00 = -1,667 \times \\text{DL Rate Variance} = (\$10.00 - \$11.00) \times 14,000\text{ hrs} = -\1.00 \times 14,000 = -\14,000\text{ U}
Verification: (12,333\text{ hrs} \times \10.00) - \$154,000 = \$123,330 - \$154,000 = -\$30,670\text{ U}$. Overall labor variance is highly unfavorable.
Manufacturing Overhead Variance Analysis
Variable Overhead (OH) Variances:
Variable OH Efficiency Variance: Measures whether actual activity quantity of cost drivers (e.g., direct labor hours, machine hours) was higher or lower than budgeted expectations for production volume.
Variable OH Spending Variance: Measures whether actual variable overhead expenditure per unit of cost driver activity was higher or lower than expected.
Fixed Overhead (OH) Variances:
Fixed OH Volume Variance: Compares total budgeted fixed overhead against fixed overhead applied to production based on standard driver rates.
Fixed OH Spending Variance: Compares actual fixed overhead costs incurred against budgeted fixed overhead costs.
Graphical Overview of Overhead Variances:
Sales Revenue Variance Analysis
Formula Directionality: Because higher sales revenue is favorable for business performance, standard values are subtracted from actual values .
Sales Volume Variance:
Compares actual volume of units sold against standard planned sales volume, priced at standard selling price.
Organizational Responsibility: Assigned primarily to the Sales Manager.
Sales Price Variance:
Compares actual average selling price per unit against standard expected selling price per unit.
Organizational Responsibility: Assigned primarily to the Marketing Manager.
Total Sales Variance:
Detailed Example (Illustration 12-6):
Standard Expectations: Planned sales of at a standard price of $\$3.45\text{/unit}$.
Actual Results: Actual sales of $17,550\text{ units}$ generating $\$59