Accounting I: Costing systems, income statement analysis, and job costing

Weekend update and class plan

  • Athletic highlights mentioned: boys vs Mason in East Lansing; women's soccer beat Michigan in Ann Arbor; there was a light note that they covered the spread.
  • Plan for today: address any questions from last week, use technology to improve the session, in-class assignment to tie concepts together, brief overview of today’s topics, and a look at next week’s agenda.
  • Quick check on chapter 1 questions; none raised, so proceed with in-class exercise.

Core concepts from today

  • Revenue, costs, and profitability snapshots

    • Revenues, cost of goods sold (COGS), and gross profit/gross margin are discussed. Note: gross profit and gross margin are synonyms.
    • Operating loss vs operating profit: numbers given can be stated as either an operating loss or profit depending on whether taxes are included; net would imply after-tax figures.
    • Taxes are not included in this analysis to keep the focus on operating performance.

  • In-class company example: base income statement and a pro forma analysis

    • Base numbers (illustrative):
    • Revenues: 2,600,0002{,}600{,}000
    • COGS: 1,600,0001{,}600{,}000
    • Gross profit: 1,000,0001{,}000{,}000
    • Marketing and distribution costs: 1,150,0001{,}150{,}000
    • Operating loss: 150,000150{,}000
    • Note about numbers: base case uses full-year figures; units sold last year: 200,000extunits200{,}000 ext{ units}.
    • Important distinction discussed: gross profit vs gross margin are interchangeable terms.
    • Homework-style takeaway: teaching students to separate variable vs fixed costs and how costs drive profitability.

  • Derived unit economics from the base case

    • Revenue per unit (from base):
    • Revenue per unit = 2,600,000200,000=13\frac{2{,}600{,}000}{200{,}000} = 13 per unit.
    • COGS breakdown (base):
    • Total COGS = 1,600,0001{,}600{,}000.
    • Fixed manufacturing costs (given later) = 500,000500{,}000 (example in the follow-on footnotes).
    • Therefore, variable COGS = total COGS − fixed COGS = 1,600,000−500,000=1,100,0001{,}600{,}000 − 500{,}000 = 1{,}100{,}000.
    • Variable COGS per unit = 1,100,000200,000=5.50\frac{1{,}100{,}000}{200{,}000} = 5.50 per unit.
    • Marketing costs breakdown (base):
    • Total marketing costs = 1,150,0001{,}150{,}000.
    • Variable marketing costs per unit = 44 per unit (given).
    • For 200,000 units, variable marketing costs = 4×200,000=800,0004 × 200{,}000 = 800{,}000.
    • Fixed marketing costs = Total marketing − Variable marketing = 1,150,000−800,000=350,0001{,}150{,}000 − 800{,}000 = 350{,}000.
    • Summary of base costs:
    • Variable cost per unit (COGS) = 5.505.50
    • Fixed manufacturing costs = 500,000500{,}000
    • Variable marketing per unit = 4.004.00
    • Fixed marketing = 350,000350{,}000

  • Pro forma (what-if) analysis for 230,000 units

    • Assumed unit price: 1313 per unit (unchanged)
    • Revenue: 230,000×13=2,990,000230{,}000 × 13 = 2{,}990{,}000
    • Variable COGS (per unit): 5.50×230,000=1,265,0005.50 × 230{,}000 = 1{,}265{,}000
    • Fixed manufacturing costs: 500,000500{,}000
    • Total COGS: 1,265,000+500,000=1,765,0001{,}265{,}000 + 500{,}000 = 1{,}765{,}000
    • Gross margin / gross profit: 2,990,000−1,765,000=1,225,0002{,}990{,}000 − 1{,}765{,}000 = 1{,}225{,}000
    • Variable marketing costs: 4×230,000=920,0004 × 230{,}000 = 920{,}000
    • Fixed marketing costs: 350,000350{,}000
    • Total marketing costs: 920,000+350,000=1,270,000920{,}000 + 350{,}000 = 1{,}270{,}000
    • Operating income (before taxes): 1,225,000−1,270,000=−45,0001{,}225{,}000 − 1{,}270{,}000 = −45{,}000
    • Conclusion: Selling 230,000 units would still yield an operating loss; hence the idea that 230k units would breakeven is false under these cost assumptions. (Notes about minor transcription: if revenue per unit was mistakenly written as 2,900,000 instead of 2,990,000, the math would not align with the stated results. Correct interpretation uses 2,990,000 revenue for 230k units.)

  • Key takeaways from the exercise

    • Fixed vs variable costs: understanding how changes in volume affect operating income.
    • The importance of accurate categorization and how it drives decision-making for pricing, volume targets, and profitability projections.

Cost systems: job order costing vs process costing

  • Two broad cost systems:
    • Process costing: high-volume, homogeneous products; costs tracked per process/product line.
    • Job order costing: low-volume, customized products/services; costs tracked per job.
  • Intended use examples:
    • Process costing: mass production (examples not explicitly stated in transcript).
    • Job order costing: homebuilding, custom manufacturing, professional services (e.g., accounting firm engagements).
  • Real-world tie-in: accounting firms use job order costing by client/project; each project has a distinct job code to track costs.

Key components of a job order costing system (from the in-class example)

  • Direct costs vs overhead:
    • Direct costs: costs that can be traced to a specific cost object (e.g., a job). Includes direct materials and direct labor.
    • Indirect costs: costs that cannot be traced to a single cost object; allocated to cost objects via cost pools and allocation bases.
  • Example setup (three jobs):
    • Materials flow: direct materials used by each job (e.g., Job 1 uses 50 lb, Job 2 uses 30 lb, Job 3 uses 20 lb; total 100 lb).
    • Direct labor: total direct labor hours and rate (e.g., 200 hours at 10/hr=10/hr =2{,}000 in direct labor across all jobs).
    • Cost accounting flow uses source documents: material requisition forms and payroll/payroll timekeeping linking time to specific jobs.
    • Job costing without overhead yet: direct costs per job are tracked; overhead is ignored in this step.
  • Definition recap (five steps):
    • Indirect costs are traced to cost pools.
    • Costs in cost pools are allocated to cost objects using a cost allocation base.
    • A common indirect cost example: plant manager compensation.
    • Cost pools are an intermediate step in the allocation of indirect costs.
    • Cost pools are assigned to cost objects using a cost allocation basis; the allocation method should reflect the cause-and-effect relationship between cost pools and cost objects.
  • Cost object and cost pool definitions:
    • Cost object: anything we want to know the cost of (e.g., a specific job or project).
    • Cost pool: a grouping of similar indirect costs (e.g., administration, quality control) used to allocate overhead.
  • Common allocation bases and overhead drivers:
    • Labor hours is the most common base for applying overhead.
    • Machine hours is the second common base.
    • The selection of the base should reflect the cause-and-effect relationship between overhead costs and the cost object.
  • Takeaway on overhead allocation:
    • Overhead must be allocated to ensure the product/service cost reflects all costs incurred, not just direct costs; this aligns with the broader goal of absorption costing and accurate profitability analysis.

Practical job costing example (Dalton’s mowing service) and absorption costing

  • Scenario elements to define variable vs fixed costs:
    • Variable costs: costs that vary with the number of hours or jobs.
    • Fixed costs: costs that do not vary with the level of activity within the relevant range.
  • Dalton’s inputs:
    • Gasoline: 2.002.00 per hour.
    • Gatorade: 2 bottles per day, 1.301.30 per bottle → 2.602.60 per day.
    • Mower: replacement cost 4,0004{,}000; expected life 3{,}000 hours; depreciation per hour = 40003000≈1.33\frac{4000}{3000} ≈ 1.33 per hour.
    • Annual mower insurance: 500.00500.00 (fixed).
    • Location: Plano, Michigan (context for seasonal work).
    • Operating season: May to August (approximately 4 months) with a schedule described as roughly 6 hours per day and several days per week; the exact schedule is stated unclearly in the transcript, but the key drivers are hours of use and days worked.
  • Core questions posed for the Kalamazoo Valley Community College (KBCC) campus mowing job:
    • What is the lowest price Dalton could charge KBCC and still cover costs (minimum to avoid a loss)?
    • What should Dalton actually charge (target price including profit considerations)?
  • Conceptual approach and calculations to illustrate absorption costing:
    • Define cost object: the mowing job (KBCC campus).
    • Identify unique job identifier: e.g., KBCC address or campus job code.
    • Determine direct costs for the job: direct labor and direct materials (in this case, direct labor may be Dalton’s time; direct materials may include fuel and consumables if tracked).
    • Allocate overhead to the job using an allocation base (hours are used as the primary driver):
    • Overhead rate base example (per hour): use the fixed and variable components of overhead.
    • Depreciation per hour: 1.331.33 per hour; for an 8-hour mowing session that would be 1.33×8≈10.641.33 × 8 ≈ 10.64.
    • Insurance: fixed 500$ per year; allocation would depend on the number of jobs; if Dalton has only one KBCC job, allocate the full 500 to that job; if multiple jobs, allocate a share equal to the proportion of jobs.
    • Variable costs per hour for the KBCC job:
    • Gas: 2.00 imes 8 = 16.00
    • Gatorade: since it is per day, assume one day of work → 2.60
    • Total variable costs for the KBCC job (excluding direct labor): 16.00 + 2.60 = 18.60
    • Total overhead allocation for the KBCC job (example with one job per year):
    • Depreciation: 10.64
    • Insurance: 500.00
    • Total overhead per 8-hour KBCC job: 10.64 + 500.00 = 510.64
    • Therefore, total estimated cost for the 8-hour KBCC mowing job (excluding Dalton’s direct labor if not separately charged): roughly 18.60 + 510.64 = 529.24 per 8-hour session, plus any direct labor cost if tracked separately.
    • Important note: If multiple jobs exist, fixed overhead per job would be lower (shared across jobs), altering the minimum price per job. The key point is to use absorption costing so all costs (fixed and variable) are allocated to each job.
  • Absorption costing takeaway
    • Absorption costing ensures all costs are allocated to the product/service; otherwise, pricing may under-recover costs and the business could fail over time as fixed costs accumulate.
    • The short-run focus on covering variable costs is not sufficient for long-run viability; fixed costs (e.g., depreciation and insurance) must also be recovered through pricing and volume.

Practical takeaways for exam prep

  • Distinguish clearly between:
    • Direct costs vs indirect costs.
    • Variable costs vs fixed costs.
    • Cost pools, cost objects, and allocation bases.
  • Be able to:
    • Compute per-unit costs from given base data (including separating fixed vs variable components).
    • Build a pro forma income statement under different volume scenarios (e.g., 230,000 units) and determine the impact on gross profit and operating income.
    • Identify the break-even point using the formula:
    • Break-even in units: BE_{units} = rac{FC}{P - VC}wherewherePispriceperunit,andis price per unit, andVC is variable cost per unit.
  • Understand the two cost systems well enough to explain when each would be used and how overhead is allocated:
    • Job order costing: used for customized, low-volume work; overhead allocated via cost pools to each job using an allocation base (e.g., labor hours).
    • Process costing: used for high-volume homogeneous products; costs allocated per process rather than per job.
  • Key five-step framework for cost allocation (verbatim checkpoints):
    • 1) Indirect costs are traced to cost pools.
    • 2) Costs in cost pools are allocated to cost objects using a cost allocation base.
    • 3) A common indirect cost is plant manager compensation (example of a pool).
    • 4) Cost pools are an intermediate step in the allocation of indirect costs.
    • 5) Cost pools are assigned to cost objects using a cost allocation basis; the basis should reflect the cause-and-effect relationship between the pool and the cost object.
  • Next week’s plan:
    • Terms and definitions for weeks 1 and 2.
    • Slides to be posted tonight or tomorrow; chapter 3 materials and Connect/McGraw Hill resources available.
    • Sample problems to practice; office hours mainly Monday and Wednesday (early morning options available).

Quick formulas to remember (for quick reference)

  • Gross profit / gross margin: ext{Gross Margin} = ext{Revenue} - ext{COGS}
  • Contribution margin per unit: ext{CM} = P - VC_{ ext{per unit}}
  • Break-even units: BE{units} = rac{FC}{CM} = rac{FC}{P - VC{ ext{per unit}}}
  • Variable COGS per unit (from base): VC_{ ext{COGS}} = rac{ ext{Total Variable COGS}}{ ext{Units}}
  • Variable marketing per unit (given): VC_{MK} = ext{unit-level variable MK}
  • Fixed marketing: FC{MK} = ext{Total MK} - ( ext{VC}{MK} imes ext{Units})
  • Depreciation per hour (capital cost):
    • ext{Dep per hour} = rac{ ext{Replacement cost}}{ ext{Estimated life (hours)}} = rac{4000}{3000} \approx 1.33 ext{ per hour}$$
  • Absorption costing principle: allocate both fixed and variable costs to cost objects using an appropriate base (e.g., hours).