Unformatted text preview: Conversion Process and Inventory Accounts Full Costs Full Costs = Direct Costs + Indirect Costs Direct Costs
– Direct materials – raw materials used in production or Direct in the delivery of a service in – Direct labor – wages earned in converting direct Direct materials to finished goods or in delivery of a service materials Indirect Costs
– Manufacturing Overhead – all other production costs Manufacturing that are not direct materials or direct labor that Labor Costs Direct labor includes the labor used to Direct manufacture the product or to provide the service the Indirect labor includes supervision, Indirect quality control, inspection, purchasing and receiving, and other manufacturing support costs manufacturing Prime Cost or Conversion Cost
Manufacturing costs may be combined either as : Direct Materials Direct Labor Overhead Prime Cost Conversion Cost Cost Behaviors Y = Total Costs X = Total Activity Do total costs (Y) vary proportionately with Do (X)? (X)? – Costs that vary in proportion to activity are Costs called “variable” costs called – Costs that don’t vary with activity are called Costs “fixed” costs “fixed” – Costs that vary with activity, but not Costs proportionately, are a mixture of the two proportionately Variable Costs
Total variable costs increase in proportion to increases in unit level cost drivers. Total variable costs (Y) 0 0 Total activity (X) Variable Costs
Notice the intercept is always zero Costs vary proportionately with Costs production production The slope of the line (b) is the variable The rate/unit rate/unit – Formula: Y = bX – Examples: direct labor, direct materials Consider the following data for Beverage Of Your Choice Corporation:
Last Month 400,000 bottles $120,000 32,000 12,000 24,000 $188,000 Current Month 480,000 bottles $144,000 38,400 14,400 28,800 $225,600 Production Variable Costs: Cost of Bottles Ingredient Cost Water Labor Cost Total Var. Cost Per Unit $0.30 0.08 0.03 0.06 $0.47 Per Unit $0.30 0.08 0.03 0.06 $0.47 Fixed Costs
Total fixed costs do not respond to changes in unit-level cost drivers. Total fixed costs (Y) 0 0 Total activity (X) Fixed Costs
The intercept is the amount of fixed cost The (a) The slope of the line is zero – Formula: Y = a (notice that X does not enter Formula: the equation) the – Examples: fixed-rate debt, property taxes, Examples: corporate salaries and insurance (fixed in the short run) the Consider the following data for Beverage Of Your Choice Corporation:
Notice the unit cost of a fixed cost varies with production, but not the total. Production Fixed Costs: Rent Depreciation Other Total Fix. Cost Last Month 400,000 bottles $5,000 6,667 8,333 $20,000 Per Unit $0.0125 0.0167 0.0208 $0.0500 Current Month 480,000 bottles $5,000 6,667 8,333 $20,000 Per Unit $0.0104 0.0139 0.0174 $0.0417 Mixed Costs
Total mixed costs contain fixed and variable cost elements. They increase, but not in direct proportion to increases in unit level cost drivers.
Total mixed costs (Y) 0 Sometimes called semivariable costs 0 Total activity (X) Mixed Costs
The intercept is the fixed portion of cost The The slope is the variable rate/unit The – Formula: Y = a + bX (note that this is the Formula: mathematical equation of a straight line) mathematical – Examples: utility bills, salesperson Examples: compensation (usually base plus commission) commission) Step Costs
Total step costs are constant over a range of activity for a unit-level cost driver but move to a different amount at different ranges.
Total step costs (Y) 0 0 Total activity (X) Step Costs Costs are fixed for a narrow range of Costs production, but the fixed levels vary with overall production Can identify the fixed cost over a relevant Can range of production.
– – – Note: most fixed costs are actually step costs in the Note: long run. Formula: Y = ai where i is the current level of activity Examples: Shipping Examples: Relevant Range If you sufficiently expand your time If expand horizon, there are no fixed costs (contracts expire, facilities can be constructed, etc.).
– This means that all costs are variable in the This variable long run. long Nonlinearity The previous graphs were all linear (with The the exception of the step costs). the Is that descriptive of reality? Law of diminishing marginal returns Law states that as more of something becomes available, the less it will be in demand. – This induces curvature into the This mathematical function and this curvature is prevalent in almost every revenue or cost function. function. Relevant Range If you sufficiently contract your time If contract horizon, the segment of the nonlinear graph will be linear graph Components of Costs Overhead Manufacturing overhead – all other costs Manufacturing associated with production that are not direct materials or direct labor. direct
– Variable manufacturing overhead – Variable overhead costs that vary with the level of production (i.e., supplies, electricity, materials handling) – Fixed manufacturing overhead – overhead Fixed costs that do not vary with the level of production (i.e., depreciation on facilities, property taxes, (i.e., insurance, salaries of supervisors, fixed portion of utilities) Applying what we’ve learned:
Labor – fixed or variable? Depends on where you are: – U.S. culture – treat labor as a variable cost – Some countries like Japan and Korea, labor Some is considered a fixed cost. Japanese and Korean companies are hesitant to Japanese lay off workers when business decreases (just as they are hesitant to increase labor when business increases). business Cost Estimation Techniques:
Relatively easy to identify strictly fixed Relatively and strictly variable costs. Mixed costs present a challenge: – – – High-Low Estimation High-Low Scatter Diagrams Scatter Least Squares Regression Analysis Least HighLow High-Low Estimation – estimates the fixed and High-Low variable components in a mixed cost: variable – Organize observations in order of activity Organize level (production, etc.) level – Choose a representative high and low Choose activity point and gather the associated costs for each point Absolute highest and lowest may not be representative Absolute due to extreme events such as equipment breakdowns, materials outages, labor strikes, interruption of production due to natural or manmade disasters, etc. due HighLow High-Low Estimation – Continued
– Estimate the variable portion of the mixed Estimate cost as: cost Variable cost per unit = (High activity cost – low Variable activity cost)/(High activity level – low activity level) level) – Compute fixed costs based on the Compute estimation of variable cost: estimation Fixed costs = Total costs – (variable cost per unit Fixed * activity level) activity You can apply this formula to either the high or You low point (assuming fixed costs are constant at both activity levels) both Suppose you have the following monthly production information: January February March April Units 6,000 9,000 12,000 10,000 Cost $17,000 26,000 32,000 20,000 High Low Example If you wanted to predict future costs, you could form an equation to predict future costs. The high-low method is one estimation approach (the others being scatterplot and regression). This method is based upon separating out the fixed cost component from the variable cost per unit. To begin, we choose which observation (month) has the highest and lowest X (units). January is the low month and March is the high month. Then we use the following formula to estimate the variable cost per unit, b (the slope of the function): b = (High Cost – Low Cost)/(High Activity – Low Activity) = (32,000 – 17,000)/(12,000 – 6,000) = $2.50 per unit Next we choose either the high or low observation and solve for fixed costs (a). I will illustrate using the high point: a = Total costs – Variable Costs = High Cost – (b * High Activity) = 32,000 – (2.50 * 12,000) = 2,000 Now we have an equation we can use to predict total future costs: Y = $2,000 + $2.50X If we think we may produce 20,000 units in the next month, we can predict that total costs will be: Y = $2,000 + ($2.50*20,000) = $2,000 + $50,000 = $52,000 Scatter Diagrams Graph of historical data (cost versus Graph activity level) activity
– Graph points – Fit a straight line (visually) – Choose two points on the line and perform Choose high-low cost analysis high-low Regression Analysis Least Squares Regression Analysis – Least produces a mathematically-derived line (not visual line-fitting) that minimizes the distance between the line and the data points.
– – Uses more data points to produce the line (model Uses will perform better if outliers are eliminated). The intercept of the line is the total fixed cost The amount, and the slope of the line is the variable cost per unit. Coefficient of determination (R2) iindicates the explanatory ndicates power of the fitted line (would like an R2 close to 1.00) power Can extend simple regression to several activity drivers to Can arrive a more complex cost and product function. arrive Inventory In manufacturing concerns, inventory is In comprised of several subcategories: comprised
– – Raw materials – direct materials used in production Work-in-process – includes direct materials, direct Work-in-process labor, and manufacturing overhead (direct labor and manufacturing overhead are referred to as conversion costs) conversion Remember that manufacturing overhead is any production Remember cost that is not direct materials or direct labor (i.e., depreciation on plant and equipment, production supervisors’ salaries, plant maintenance, custodial services, plant insurance, plant property taxes, plant security, plant utilities, etc.) security, – Finished goods – once sold, finished goods are Finished transferred to cost of goods sold transferred How do we allocate production costs to individual products? – – Direct materials – we can track them because Direct they have physical substance.
Does the cost of tracking specific materials ever Does outweigh the benefits? outweigh Yes, especially when they are commodity-based Yes, goods or homogeneous in nature. goods Direct labor – we can require employees to Direct record which products they work on or organize them by product line (still have to devise a way to allocate their time among individual units) individual Manufacturing overhead – how can we Manufacturing possibly allocate overhead to individual units? possibly We don’t use actual costs to assign overhead What happens if you use actual manufacturing What costs to assign overhead to units? costs – Actual costs are not timely – must wait to be billed for Actual things like utilities, supplies, etc. things – Cost do not occur uniformly (i.e., property taxes and Cost insurance are paid for periodically). This would cause extreme volatility in unit costs. extreme – If production volume varies from month-to-month, this If presents an allocation problem for assigning fixed overhead costs. overhead For these reasons, firms usually developed For predetermined manufacturing overhead rates. rates Predetermined Overhead Rates: This rate is established at the beginning of This the production period (usually annually) and is based on the predicted overhead costs and predicted production volume for the upcoming period: the
Predetermined overhead rate = Predicted overhead cost Predicted Predicted overhead cost driver activity Predicted . Cost driver activity could be labor hours, Cost machine hours, labor dollars, etc. machine Cost Pools Cost pools – collections of similar costs Cost that are assigned to one or more cost objectives. The use of cost pools is more efficient The than assigning individual costs to cost objectives. objectives. The costs should be homogeneous and The affected by the same activity or driver. affected Allocation Bases: Cost allocation base is the driver (activity, Cost factor, etc.) that determines how much of the cost pool should be allocated to each cost objective. A logical association must exist between logical the costs incurred and the basis (allocation base) by which they are assigned. assigned. Simplest Scenario: All costs are accumulated in one cost pool and All allocated to products based on a plantwide overhead rate.
– The allocation base may be direct labor hours, The machine hours, units produced, etc. machine This scenario is appropriate when the firm This manufactures a single product. manufactures However, multiple products (or production However, processes) will demand a more involved allocation system. allocation Applying the Overhead Once the actual production takes place, Once then manufacturing overhead is applied applied for the period using the predetermined overhead rate. This is the amount of overhead that will be This reflected in work-in-process (and ultimately finished goods) inventory. ultimately Applied manufacturing overhead = Applied Actual activity (i.e., labor hours, machine hours, etc.) x Predetermined overhead rate overhead Overhead Variance The overhead costs applied will not match the The actual overhead costs (once known). The difference is called a variance and is used to variance control and evaluate production operations. control However, if the amount over- or under-applied However, accumulates to excessive amounts during the year, then managers should revise the predetermined overhead rate to make sure the applied overhead costs better reflect the eventual, actual costs that will be incurred. Timeline Predetermined Rate is computed Production Takes Place; Overhead is assigned based on actual production using PD rate Actual costs become known Overhead variance is computed and becomes adjustment to COGS Over or underapplied manufacturing overhead: The accumulated amount is removed at The the end of the production period with the over- or under-applied amount treated as an adjustment to cost of goods sold (in the next period when the actual costs are known): known): Over-applied Under-applied Reduces COGS Increases COGS Which activity should we use for an overhead cost driver? In the early part of the 20th century, labor In was the predominant input into manufactured goods. For that reason, labor-hours were historically the most labor-hours popular activity driver. However, as production processes However, became more automated, machine-hours machine-hours gained in popularity as an activity driver. gained Reconciliation to Cost of Good Sold:
What is COGS really comprised of, now that we understand What that inventory is not a single account? Finished Goods Finished Finished Goods Beg. Bal. + Cost of Goods Manufactured Cost of Goods Available for Sale Less Finished Goods End. Bal. Cost of Goods Sold XXX XXX XXX XXX XXX Cost of Goods Manufactured:
Cost of Goods Manufactured: Cost Work-in-Process Beg. Bal. + Current Manufacturing Costs Total Costs-in-Process Less Work-in-Process End. Bal. Cost of Goods Manufactured XXX XXX XXX XXX XXX Current manufacturing costs are comprised of direct Current materials, direct labor, and manufacturing overhead. materials, Direct (or Raw) Materials Inventory: Raw material inventory is treated in a way similar to Raw regular inventory: regular Raw materials Beg. Bal. + Raw materials purchased Raw materials available for prod. Less raw materials End. Bal. Direct material used XXX XXX XXX XXX XXX Cost of Goods Manufactured
Cellular Products Schedule of Cost of Goods Manufactured For the Year Ended December 31, 2007 (in thousands) Direct Materials: Beginning Inventory, January 1 $ 11,000 Add: Purchases 73,000 Cost of Direct Materials Available for Use 84,000 Less: Ending Inventory, December 31 8,000 Direct Materials Used 76,000 Direct Labor 9,000 Manufacturing Overhead: Indirect Labor 7,000 Supplies 2,000 Heat, Light & Power 5,000 Depreciation - plant building 2,000 Depreciation - plant equipment 3,000 Miscellaneous 1,000 Total Manufacturing Overhead Costs 20,000 Manufacturing costs incurred during 2007 105,000 Add: Beginning WIP, January 1 6,000 Total Manufacturing Costs to account for 111,000 Less: Ending WIP, December 31 7,000 Cost of Goods Manufactured $ 104,000 Calculates the cost of Direct Materials Used Accumulates the three product costs for the current period Adjusts the current period manufacturing costs to account for units actually completed Income Statement
Cellular Products Income Statement For the Year Ended December 31, 2007 (in thousands) Revenues Cost of Goods Sold Beginning Finished Goods, January 1 Cost of Goods Manufactured Cost of Goods Available for sale Ending Finished Goods, December 31 Cost of Goods Sold Gross Profit Operating Costs: Marketing, distribution, and customer-service Total operating costs Operating Income $210,000 22,000 104,000 126,000 18,000 108,000 102,000 70,000 70,000 $32,000 Figure carries forward from the Schedule of Cost of Goods Manufactured Period Costs are expensed as incurred COST P240 Need to find the mission amounts Case 1: – Cost of Goods Sold – Ending Finished Goods Inventory Case 2: – Gross Margin – Overhead Costs Case 1 Which Formula?
Beginning Finished Goods Plus Cost of Goods Manufactured = Goods Available for Sale Less Ending Finished Goods Less Ending = COGS COGS What is another way to get COGS?
Sales Less COGS Less COGS = Gross Margin Sales $32,000 Less COGS X Less = Gross Margin $11,300 So COGS = $32,000 - $11,300 = $20,700 So $20,700 Now solve for ending F/G
Beginning Finished Goods + Cost of Goods Manufactured = Goods Available for Sale Less COGS = Ending F/G Ending $4,000 ? Solving for COGM
Beginning WIP + Current Mfg Costs = Costs of Production - Ending WIP = COGM $ 0 18,000** 18,000** $18,000 0 $18,000 **What are Current Manufacturing Costs? Direct materials used + Direct labor + Overhead = $8,000 + $3,000 + $7,000 = $18,000 $8,000 $18,000 Now solve for ending F/G
Beginning Finished Goods + Cost of Goods Manufactured = Goods Available for Sale Less COGS = Ending F/G Ending $4,000 18,000** 22,000 (20,700) (20,700) $1,300 $1,300 COST P240 Need to find the mission amounts Case 1: – Cost of Goods Sold – Ending Finished Goods Inventory Case 2: – Gross Margin – Overhead Costs Case 2 Which Formula?
Sales Less COGS = Gross Margin Gross Sales Less COGS = Gross Margin $31,800 20,000 $11,800 Now solve for Overhead
Beginning Finished Goods + Cost of Goods Manufactured = Goods Available for Sale Goods Less COGS = Ending F/G Ending $4,000 ? ?** (20,000) (20,000) $5,300 $5,300 **What is Cost of Goods Available for Sale? Ending F/G + COGS Ending = $5,300 + 20,000 = $25,300 $25,300 Solving for COGM
Beginning WIP + Current Mfg Costs = Costs of Production - Ending WIP = COGM $ 800 ?** $ ? (3,000) (3,000) $21,300 **What are Costs of production? COGM + Ending WIP = $24,300 COGM $24,300 Solving for COGM
Beginning WIP + Current Mfg Costs = Costs of Production - Ending WIP = COGM $ 800 ?** $ 24,300 (3,000) (3,000) $21,300 **What are Current Manufacturing Costs? Costs of Production – Beginning WIP = $24,300 – 800 = $23,500 $24,300 $23,500 Cost of Goods Manufactured
Direct materials used Direct labor Overhead Current Mfg Costs $12,000 5,000 ?** $23,500 ** Overhead = Current Manufacturing Costs ** – Direct materials used – Direct labor Direct = $23,500 - $12,000 - $5,000 = $6,500 $23,500 $6,500 ...
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