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chapter 4 Costing Methods istockphoto Learning Objectives Understand the ethical duty of managerial accountants to provide proper costing information. Apply concepts and techniques that are used to fairly measure and report job costs. Be able to track job costs, including overhead, through a typical accounting system. Understand alternative costing concepts, such as process costing and activity-based costing. waL80281_04_c04_083-112.indd 1 9/25/12 1:02 PM CHAPTER 4 Chapter Outline Chapter Outline 4.1 Job Costing Job Costing and the Ledger Actual Overhead Differences Between Actual and Applied Overhead Mandatory Reporting of Overhead Job Costing Is Not Only for Manufacturing 4.2 Process Costing Environments Cost of Production Report Case Study in Process Costing 4.3 Activity-Based Costing ABC Modeling ABC Example W hat is the cost of producing a product or service? To the untrained accountant, this question seems simple enough. But, the more you learn about accounting, the more difficult this question becomes to answer. How does one identify all of the necessary elements that are needed to produce an output? The answer to this question necessarily includes direct material and direct labor. But you are also very familiar with other factory and nonfactory-related costs that must be incurred before a product may be produced. Typically, accountants will devise schemes by which costs are captured and assigned to products. When an accountant reports on the cost of a product or service, he or she is really reporting on measurements based on systematic processes for cost assignment. Accountants should not be flippant in developing their costing procedures. Key business decisions that impact the allocation of business resources, and ultimately peoples' livelihoods, are at stake. As such, accountants have a high ethical duty to develop and correctly deploy fair and defensible models for product costing. This chapter provides insight into costing techniques that offer general acceptability in arriving at an answer to the all-important question about the cost of a product or service. Several methods can be used for costing purposes. They are somewhat dependent on the nature of the product that is being produced and/or the process by which production occurs. One such method is job costing, which is best suited to those situations in which goods and services are produced upon receipt of a customer order, according to customer specifications, or in separate batches. For example, a home builder would likely accumulate costs for each unique house that it produces. Materials and labor can be readily identified with each house, and the costing method will accumulate costs accordingly. In contrast, process costing captures costs for each process or department. It is applicable to homogenous goods that are produced in batches or continuous processes. An example is the production of candy. Candy might be produced in stages such as mixing, cutting, and cooking. Within the mixing department, the cost of all ingredients and labor is accumulated and divided across the total pounds of finished goods to find a per-pound (or other measure) cost for the mixed material. Similar cost assignment processes are followed within each department to arrive at the cost of a final box of candy. The bulk of the remainder of this chapter will introduce you to the key components in job and process costing techniques. 84 waL80281_04_c04_083-112.indd 2 9/25/12 1:02 PM CHAPTER 4 Section 4.1 Job Costing Accountants have long thought about costing methods and have challenged the basic assumptions on which costing decisions are made. There is considerable literature on this subject, and alternative models have been proposed. One model that has a strong group of proponents is activity-based costing. This chapter will close with a brief introduction to this alternative approach to answering questions about what a product or service costs. 4.1 Job Costing J ob costing entails the development of a tracking system or database by which costs are matched to jobs. This generally entails specifically identifying the amount of direct labor and direct material that is used on a specific job. The other overhead costs are then assigned to a job by reliance on a predetermined overhead allocation formula. One common approach is to take the period's total anticipated overhead and divide it by the anticipated labor hours to arrive at an amount of overhead that is expected to be incurred \"per labor\" (overhead can be applied on other application bases, such as material usage; the goal is to try to closely associate overhead to jobs based on consumption of overhead). A logical starting point for costing a job is to determine the amount of direct labor that is attributable to a specific job. Employees typically complete reports (via a time card, electronic clock, spreadsheet, etc.) indicating the amount of time they worked. From the employees' perspective, these time reports are important because they may be used to establish how much they are owed (i.e., how many hours they worked). However, in addition to hours worked, time reports usually have codes to identify the work performed. These codes can be matched to specific tasks on specific jobs, but they will also include time spent on travel, breaks, job setups, and other work-related tasks that do not track to a specific product that is being produced. By querying the company's accounting system, it then becomes possible to determine all of the direct labor time that was spent on a specific job. The indirect labor costs not traced to a specific job become part of the overhead cost pool, which is allocated across all jobs using the overhead application rate. Direct materials are assigned to jobs in a manner very similar to direct labor. It is very important that material that is used on a specific job be matched to the job. Just as employees are expected to maintain time records, they should also complete materials requisition forms. These forms are used to pull raw materials from inventory and transfer them into work in process. A very detailed coding system must be established that allows tracking of material from inventory into a specific job. Sometimes, a materials requisition form will only show inventory by part number and not identify the cost of the material. When this is the case, additional systems must be put in place to subsequently allow the company to identify the cost of the materials. Great care must always be taken to match the right cost to the right item and the right item to the right job. Indirect materials, such as tape, screws, and touch-up paint, are not traced to a specific job. These costs should instead be contemplated in the overhead cost pool that is allocated among all jobs. Previously, it was mentioned that a predetermined overhead rate is used to assign overhead to a particular job. It has likely already occurred to you that there can be differences between the actual overhead incurred and the amount applied to production via the predetermined overhead application rate. This difference cannot be ignored indefinitely, and you will soon see how it is to be processed. For the moment, let's not be concerned with those potential differences and instead focus on a job cost sheet (Exhibit 4.1) that summarizes direct labor, direct material, and overhead cost that is applied to a particular job: 85 waL80281_04_c04_083-112.indd 3 9/25/12 1:02 PM waL80281_04_c04_083-112.indd 4 Time Card #6998 Materials Req. A56 Materials Req. B17 Susan Markey Steel Wheels Time Card #7002 Ravi Rajnar Materials Req. B24 Glass Totals Time Card #6998 Susan Markey Applied Overhead Time Card #6573 Bob Thurman Nov. 17, 20X7 Time Card #6573 Bob Thurman Nov. 16, 20X7 Time Card #6573 Bob Thurman Nov. 15, 20X7 Source Code 38.00 8.00 2.00 8.00 6.00 6.00 8.00 Hours $18 $12 $15 $12 $18 $12 Rate Direct Labor 96.00 72.00 24.00 $ 564.00 $ 144.00 $ $ 120.00 $ $ 108.00 $ Total $ 3.00 $15.00 25 sq ft $ 2.00 6 units Cost Per Unit 400 lbs Qty Direct Material JOB COST SHEET Turnkey Enterprises $965.00 $ 75.00 $ 90.00 $800.00 Total Labor Hours Basis 38.00 Qty $11 Rate Applied Overhead $418.00 $418.00 Total 96.00 72.00 90.00 24.00 75.00 $1,947.00 $ 418.00 $ $ 144.00 $ $ 120.00 $ $ $ 800.00 $ 108.00 $ Total Section 4.1 Job Costing CHAPTER 4 Exhibit 4.1 86 9/25/12 1:02 PM CHAPTER 4 Section 4.1 Job Costing Exhibit 4.1 is quite typical. The direct labor hours are drawn from the employee time cards and associated with each employee's wage rate. The direct materials are drawn from the materials requisition forms (or similar documents) and associated with the cost of specific inventory items, and the overhead is applied based on the predetermined rates. Be aware that technology can greatly facilitate preparation of job cost sheets. For instance, materials can be automatically tracked to jobs by scanners and radio frequency identification chips. Furthermore, the job cost sheet is really just a compilation of data into a useful report format. The data may be mined from within a sophisticated database. Beyond this summarized data, you also need to recognize that information must be captured by a company's general ledger system and lead to the preparation of aggregated data for reporting purposes. Job Costing and the Ledger The data, which are foundational for the preceding job cost sheet, must also be transferred to a company's general ledger system. A robust information system will do this quite easily and automatically. However, it is necessary for you to see the debit/credit process to fully comprehend the cost flow through an accounting system and into the resulting financial statements. Let's begin by considering the cost flows for the various factors of production. The typical sequence of steps for direct materials entails the purchase of raw materials from a supplier, a transfer of raw materials into work in process as production occurs, the transfer of the cost of completed goods into finished goods inventory, and finally the transfer of inventory to cost of goods sold when products are sold and delivered to a customer. Direct labor is slightly simpler because the first step is essentially not applicable. As wages are incurred, those costs are accumulated straight into Work in Process. Upon completion, the labor cost is transferred to Finished Goods Inventory and then on to Cost of Goods Sold at the time of sale. The factory overhead items, such as factory depreciation, maintenance, supplies, indirect labor, and indirect material, are not directly added to Work in Process. Instead, these costs are introduced into Work in Process based on the predetermined application base; if overhead is applied based on labor hours, it may well be that overhead is attached concurrent with direct labor costs. The following entries illustrate the full process for assigning job costs. Carefully review each entry, taking special note of the related journal entry description: 10-1-X2 Raw Materials Inventory 965 Accounts Payable 965 To record purchase of materials, placing costs into raw materials inventory 10-15-X2 Work in Process Inventory 1,947 Raw Materials Inventory 965 Salaries Payable 564 Factory Overhead 418 To transfer raw materials to production, record direct labor costs on job, and apply overhead at the predetermined rate of $11 per direct labor hour 87 waL80281_04_c04_083-112.indd 5 9/25/12 1:02 PM CHAPTER 4 Section 4.1 Job Costing 10-24-X2 Finished Goods Inventory 1,947 Work in Process Inventory 1,947 To transfer total cost of a completed unit to finished goods inventory 10-28-X2 Accounts Receivable 2,500 Sales 2,500 To record sale of finished for $2,500 Cost of Goods Sold 1,947 Finished Goods Inventory 1,947 To remove cost of sold unit from the finished goods inventory Actual Overhead Students are sometimes slightly confused by their first exposure to the accounting for factory overhead. In previous chapters, you saw how salaries, utilities, depreciation, the consumption of supplies, and similar costs were charged (i.e., debited) directly to various expense accounts. The accounting for these types of costs in a manufacturing environment now gets a slight twist. In the preceding entries, we credited an account titled \"Factory Overhead\" for the allocated amount of overhead cost. What is the nature of this overhead account? It clearly is not Cash, Accounts Payable, or some other familiar account that would ordinarily be related to an expenditure. Instead, it is a unique account that is used to accumulate and allocate the actual overhead costs. The credit you witnessed was the allocation effect. The accumulation of the actual costs results in a debit to Factory Overhead as follows: 10-XX-X2 Factory Overhead 450 Salaries Payable 150 Supplies 75 Accumulated Depreciation 100 Utilities Payable 125 To record actual factory overhead costs The previous credits are those customarily associated with incurring salaries, using supplies, recording depreciation, and utilizing utilities. However, instead of debiting the customary expense accounts, the costs are charged to Factory Overhead. The net result of this process is to debit Factory Overhead for the actual costs incurred and credit Factory Overhead as these costs are allocated to Work in Process (which eventually gets transferred to expense as Cost of Goods Sold as shown via the preceding entries). You may be wondering what happens if the amount of overhead actually incurred differs from the amount allocated, and that question is answered in the following discussion. 88 waL80281_04_c04_083-112.indd 6 9/25/12 1:03 PM CHAPTER 4 Section 4.1 Job Costing Differences Between Actual and Applied Overhead An actual company would, of course, have many jobs in process, so the preceding journal entries for only one job present a very simple picture of costs flows within the organization. Nevertheless, it is a realistic portrait. Notice that assigned costs totaled $1,947 (producing a $553 profit: $2,500 sales price 2 $1,947 of goods sold), including allocated overhead of $418. However, the actual overhead was $450. The fact that actual overhead was more than the amount assigned to production represents underapplied overhead. This is indicative of an unfavorable outcome. More was actually spent than was anticipated based on the application rate. This amount cannot be ignored. Based on the previous journal entries, the Factory Overhead account contains a net debit of $32 ($450 in debits and $418 in credits). Accountants dispose of this balance by one of several processes. A popular approach is to adjust cost of goods sold as follows: 10-31-X2 Cost of Goods Sold 32 Factory Overhead 32 To transfer underapplied overhead to cost of goods sold This entry causes an increase in cost of goods sold for the excess overhead spending. Alternative methods for clearing the Factory Overhead account are usually covered in advanced accounting classes. What is most important for you to note at this time is that the Factory Overhead is indeed zeroed out. It is not a financial statement account. Rather, it is a temporary account for accumulating and transferring overhead costs into production. If applied overhead had exceeded the actual amount, overhead would have been overapplied. Overapplied overhead would be cleared in just the opposite manner of that illustrated for underapplied overhead. Mandatory Reporting of Overhead Although managerial accounting information is generally viewed as for internal use only, be mindful that many manufacturing companies do prepare external financial statements. Also, generally accepted accounting principles (GAAP) dictate the form and content of those reports. GAAP requires that underapplied overhead relating to idle facilities, wasted material, the allocation of fixed production overhead, and so forth be charged to current period income by means similar to those just illustrated. Job Costing Is Not Only for Manufacturing Most textbook illustrations tend to demonstrate job costing in the context of a productmanufacturing scenario. However, at least in the United States, most employees now work in the service sector. This includes the fields of accounting, sales, law, food service, electronic information, and transportation. In addition, the not-for-profit and governmental sectors are significant components of the economy. Activities relate to education, health care, fire protection, law enforcement, transportation, human services, and the like. The idea of a \"job\" can easily be expanded from a tangible product to a particular activity. In health care, a job could be a surgical procedure. In accounting, a job could be preparation 89 waL80281_04_c04_083-112.indd 7 9/25/12 1:03 PM CHAPTER 4 Section 4.2 Process Costing Environments of a tax return. In education, a job could be a particular course. Measuring the cost of this output is equally important, and the job costing techniques remain fully applicable. For example, an architectural firm would likely track time (direct labor) devoted to each design. Direct materials can relate to printing of blueprints. Overhead allocations can become substantial, including the office costs, computers, software, and so forth. Successful management of a service-related entity requires careful attention to costing information. As you can imagine, it is easy to underestimate the full cost of providing services to customers; it is ultimately necessary to recover not only direct labor but also the other significant costs of operations. 4.2 Process Costing Environments S ometimes job costing techniques simply do not apply. Production may instead involve a continuous flow of raw materials through production departments. The output is not identifiable as discrete jobs. Rather, output consists of a homogenous product. Paint, petroleum distillates, paper products, steel, glass, and many other products display such attributes. It becomes virtually impossible to match direct labor and direct material to a particular gallon, pound, square foot, or other measure of final output. Nevertheless, it is vitally important for management to be able to assess the cost of production. Companies facing this challenge often turn to process costing. Process costing allocates the total cost of production across all units of output. This usually entails accumulation of costs for each stage (or department) of production and assigning those costs to all output from that stage. Process costing has certain attributes in common with job costing. Material, labor, and factory overhead are all still assigned to work in process, and they are eventually transferred on to finished goods and then to cost of goods sold. In this respect, the journal entries are quite like those applicable to job costing. The main difference between job costing and process costing is that process costing captures costs by process or department rather than by specific job. If you consider a candy factory, three departments define the basic processes: mixing ingredients, cutting the ingredients into bite-sized pieces, and cooking. A separate Work in Process account will likely be used for each department. The Work in Process account for the mixing department will capture (i.e., be debited) the aggregate amount of direct material, direct labor, and allocated factory overhead incurred during a period. The accounts utilized in this entry would appear like the October 15 entry that was used for the job costing illustration. Assuming a weighted-average cost assumption (in contrast to FIFO or some other technique), the total dollar amount accumulated in this account would be divided by the total production (this could be pounds or some other measure) to find per-unit cost (e.g., dollars per pound). The per-unit cost can then be used to allocate cost between goods still in process and those that were completed and transferred to the cutting department. The journal entry to reflect a transfer out of cost from the mixing department to the cutting department would appear as follows: 90 waL80281_04_c04_083-112.indd 8 9/25/12 1:03 PM CHAPTER 4 Section 4.2 Process Costing Environments 10-30-X2 Work in Process Inventory 2 Cutting 50,000 50,000 Work in Process Inv. 2 Mixing To transfer cost assigned to completed pounds of mixed candy to the cutting department The cutting department's Work in Process account would therefore include the direct material, direct labor, and factory overhead generated directly within that department and also the carried forward cost from the preceding mixing department. A similar process would be used to transfer work completed by the cutting department to the cooking department. At the end of the production process, the Work in Process account of the final stage (cooking) would be cleared of the accumulated costs by a transfer of those costs to finished goods inventory. This entry would be just as the October 24 entry for the job costing example. By carefully following this approach, the finished goods inventory will have completely captured the costs of production generated within each department. Cost of Production Report When process costing methods are used, management of each department will likely receive a cost of production report for each period. This report is very similar in purpose to a job cost sheet. It details the amount of direct material, direct labor, and factory overhead incurred by the department (rather than by job as with a job cost sheet). It then shows how those costs were allocated to total production and provides supporting documentation for the journal entries that were used to transfer costs to successive departments. To understand a cost of production report requires the introduction of one new dimension, that of equivalent units. An equivalent unit is a physical unit expressed in terms of a finished unit. This is a relatively simple concept. As an example, assume that 100 pounds of candy was 40% complete within a particular department. This is assumed to be equivalent to the production of 40 pounds (100 pounds 3 40% complete). Although none of the 100 pounds is complete, we can abstractly say that we produced the equivalent of 40 pounds. The concept of equivalent units is exceedingly important to grasp. It is rare that a company will not have goods in production at the end of an accounting period. Accounting periods end on regular intervals, but there is no compelling business reason to cease production with the flip of a page on a calendar. Indeed, many production processes are difficult to stop and restart effectively (e.g., heating a kiln). It is better to keep the production flow going. Thus, it is frequently necessary for managerial accountants to estimate the equivalent units under production. As you examine the example cost of production report that follows, you will see how this concept comes into play. The following example shows a simplified cost of production report for one department for 1 month. As you inspect this report, take special note that the ending work in process was assumed to be 40% complete. This report shows that of the total cost of $1,500,000, $1,250,000 was transferred to the next department, and $250,000 remained in work in process at the end of the month. 91 waL80281_04_c04_083-112.indd 9 9/25/12 1:03 PM CHAPTER 4 Section 4.2 Process Costing Environments SWEET CANDY COMPANY Cost of Production Report for Mixing Department for the Month of October 20XX Total Pounds Percent Complete Equivalent Units Transferred to Cutting Department 500,000 100% 500,000 In production at end of month 250,000 40% 100,000 600,000 Total equivalent units for the month Cost Calculations Cost of beginning inventory $ 400,000 1,100,000 Additional costs during the month Total costs to account for $1,500,000 600,000 Equivalent units from above $ Per unit cost 2.50 Equivalent Units Per Unit Cost Total pounds transferred to Cutting Department 500,000 $2.50 $1,250,000 Equivalent units in ending work in process 100,000 $2.50 250,000 600,000 Cost Assignment $1,500,000 The preceding cost of production report was simplified by an assumption that materials, labor, and overhead were all introduced into production uniformly. If you study more advanced cost accounting courses, you will learn how to account for scenarios where that assumption is violated. Essentially, it becomes necessary to separate the cost of materials, labor, and overhead so that you derive separate costs per equivalent for each component. 92 waL80281_04_c04_083-112.indd 10 9/25/12 1:03 PM CHAPTER 4 Section 4.2 Process Costing Environments Case Study in Process Costing To further illustrate process costing, let's focus on a comprehensive case study. Yum Gum produces chewing gum in a three-step process consisting of (a) blending ingredients, (b) cooking, and (c) cutting and packing. Each process involves a uniform incurrence and introduction of materials, labor, and overhead. Following are cost of production reports for each of the three departments for August. The amounts are all assumed, but do take note of how costs transferred out of one department are received into the next department. YUM GUM Cost of Production Report for Blending Department for the Month of August Total Pounds Percent Complete Equivalent Units Transferred to Cooking Department 300,000 100% 300,000 In production at end of month 100,000 25% 25,000 325,000 Total equivalent units for the month Cost Calculations Cost of beginning inventory $ 80,000 570,000 Additional costs during the month $650,000 Total costs to account for 325,000 Equivalent units from above $2.00 Per unit cost Total pounds transferred to Cooking Department Equivalent units in ending work in process Equivalent Units Per Unit Cost Cost Assignment 300,000 $ 2.00 $600,000 25,000 $ 2.00 50,000 325,000 $ 650,000 93 waL80281_04_c04_083-112.indd 11 9/25/12 1:03 PM CHAPTER 4 Section 4.2 Process Costing Environments YUM GUM Cost of Production Report for Cooking Department for the Month of August Transferred to Cutting Department In production at end of month Total Pounds Percent Complete Equivalent Units 250,000 100% 250,000 60,000 30% 18,000 268,000 Total equivalent units for the month Cost Calculations Cost of beginning inventory $ 35,000 Costs transferred in from Blending Department 600,000 Additional costs during the month 236,000 $ Total costs to account for 871,000 268,000 Equivalent units from above $ Per unit cost 3.25 Equivalent Units Per Unit Cost Cost Assignment Total pounds transferred to Cutting Department 250,000 $3.25 $812,500 Equivalent units in ending work in process 18,000 $3.25 58,500 268,000 $871,000 94 waL80281_04_c04_083-112.indd 12 9/25/12 1:03 PM CHAPTER 4 Section 4.2 Process Costing Environments YUM GUM Cost of Production Report for Cutting Department for the Month of August Total Pounds Percent Complete Equivalent Units Transferred to Finished Goods 275,000 100% 275,000 In production at end of month 40,000 60% 24,000 299,000 Total equivalent units for the month Cost Calculations $ 260,000 Cost of beginning inventory Additional costs during the month 123,500 Costs transferred in from Cooking Department 812,500 $1,196,000 Total costs to account for 299,000 Equivalent units from above $ Per unit cost Total pounds transferred to Finished Goods Equivalent units in ending work in process 4.00 Equivalent Units Per Unit Cost 275,000 $4.00 $1,100,000 24,000 $4.00 96,000 299,000 Cost Assignment $1,196,000 The cost of production report for each department triggers information necessary to support the following journal entries. Be sure to observe the unique entries where costs are handed off from one department to the next. 95 waL80281_04_c04_083-112.indd 13 9/25/12 1:03 PM CHAPTER 4 Section 4.2 Process Costing Environments Journal entries related to blending: 8-31-XX Work in Process Inventory 2 Blending 570,000 Raw Materials Inventory 190,000 Salaries Payable 190,000 Factory Overhead 190,000 To transfer raw materials to production, record direct labor costs for blending, and apply overhead at the predetermined rate 8-31-XX Work in Process Inventory 2 Cooking 600,000 600,000 Work in Process Inventory 2 Blending To transfer cost assigned to completed pounds of blended gum to cooking department Journal entries related to cooking: 8-31-XX Work in Process Inventory 2 Cooking 236,000 Raw Materials Inventory 78,667 Salaries Payable 78,667 Factory Overhead 78,666 To transfer raw materials to production, record direct labor costs for cooking, and apply overhead at the predetermined rate 8-31-XX Work in Process Inventory 2 Cutting 812,500 812,500 Work in Process Inventory 2 Cooking To transfer cost assigned to completed pounds of cooked gum to cutting department Journal entries related to cutting: 8-31-XX Work in Process Inventory 2 Cutting 123,500 Raw Materials Inventory 41,167 Salaries Payable 41,167 Factory Overhead 41,166 To transfer raw materials to production, record direct labor costs for cutting, and apply overhead at the predetermined rate 8-31-XX Finished Goods Inventory 1,100,000 Work in Process Inventory 2 Cutting 1,100,000 To transfer cost assigned to completed pounds of cut gum to finished goods 96 waL80281_04_c04_083-112.indd 14 9/25/12 1:03 PM CHAPTER 4 Section 4.3 Activity-Based Costing This comprehensive example shows how costs are monitored, accumulated, and assigned to finished goods. Bear in mind that the comingling of ingredients and involvement of numerous steps makes it exceedingly difficult to have an intuitive awareness of costs for goods that are produced via continuous processes. Process costing is essential for controlling costs and setting pricing in such environments. 4.3 Activity-Based Costing B oth job costing and process costing methods divide costs between product and period costs. As you know, period costs are charged against income as they occur, and they generally relate to selling, general, and administrative (SG&A) activities. In contrast, direct materials, direct labor, and factory overhead are assigned to inventory. One conceptual shortcoming is that it becomes difficult to fully contemplate the true cost of a finished product. Arguably, the cost of producing a product should sometimes take into account a portion of the organization's SG&A. For instance, buying raw materials is an administrative task: Why is the cost of this activity not assigned to inventory? Conversely, lawn maintenance for a factory is usually part of factory overhead: Why does the cost of that activity become assigned to inventory when the cost will be incurred no matter how many units are produced? Activity-based costing (ABC) attempts to overcome deficiencies such as those cited in the preceding paragraph. ABC requires a new mind-set as compared to traditional costing methods. Some companies have embraced ABC, and others see it as too radical of a departure from traditional costing methods. Indeed, ABC is not acceptable for external reporting under GAAP. Thus, companies that implement aspects of ABC typically do so to supplement traditional costing information. ABC is normally for internal use only and is intended to facilitate internal decision-making processes by pinpointing actual (full) production costs more precisely. ABC requires one to abandon attempts to distinguish product and period costs. Instead, ABC is a costing model that divides production into core cost objects and activities, defines the costs for each, and then allocates activity costs to cost objects based on how much of a particular activity is consumed by the cost object. This results in products absorbing costs of manufacturing and nonmanufacturing activities alike. Conversely, some manufacturing costs may not attach to any products. The driving principle of ABC is that a product's cost is based only on the cost of capacity utilized in producing the product. Unused capacity is not assessed or allocated to production. Remember that traditional costing approaches usually allocate all manufacturing costs (via the overhead application rate), whether related to excess capacity or not, to the inventory actually produced. This has the potential to distort the measured cost of production, thereby limiting a manager's ability to make decisions about pricing and production. As you might suspect, important business decisions are based on assessment of product profitability. To the extent a product's sales price is set by market conditions, and profit is seen as the sales price minus product cost, the determination of a product's cost becomes critical in deciding on its fate. 97 waL80281_04_c04_083-112.indd 15 9/25/12 1:03 PM CHAPTER 4 Section 4.3 Activity-Based Costing ABC Modeling If you think about traditional costing, you will quickly conclude that the cost object is normally a product or service. With ABC, the concept of a cost object is far more expansive. Cost objects expand to also include customers, markets, and similarly identifiable items or events that require activity to support. For example, a customer may receive a quarterly visit from a sales representative, no matter the level of purchasing activity. The customer would be a cost object, and activities to support the customer might include an airline ticket, hotel bill, and so forth. These activities have a clear cost that is traceable to the customer (i.e., the cost object) rather than the products produced/sold or period incurred. A business is apt to have many cost objects and hundreds of activities in support thereof. Therefore, the first step in ABC implementation entails a detailed study of processes and costs. This study is usually supported by flowcharts and diagrams, and it may resemble something that looks more like it was developed by an engineer than a managerial accountant. In linking activities to cost objects, it is important to consider that activities occur at many levels. Some activities occur at the unit level. There is a one-to-one correspondence with a unit of output. Final inspection of each car for an automobile manufacturer is an example. Other activities occur at a batch level. Global shipping of containers is an example; the same amount of effort must be expended to clear customs, regardless of the quantity of individual products within a container. Thus, shipping a container would be a batch-level activity. Other activities occur at much higher levels. Product-level activities include designing a new product. Customer-level activities include developing catalogs and sales calls; in other words, the amount of activity is dependent on the number of customers. Some businesses even identify market-level activities (Asia, Europe, North America, etc.). At the highest level are entity-sustaining activities, such as the cost of a corporate audit. The identification of activities is unique to each company, and considerable study and thought is needed to properly map a company's activities. Once all activities and cost objects have been identified, it next becomes necessary to study how the organization's costs align with activities and objects. Basically, each cost is identified as one of three types. First, some costs are directly traceable to a specific cost object. Direct material is a clear example of a cost that is attributable to the \"product\" cost object. You are quite familiar with this concept because this piece is the same under traditional costing and ABC. Moving to a less familiar concept, the cost of printing a catalog would be traced to a \"customer\" cost object. Once all costs that can be directly traced are determined, the second step is to attempt to allocate remaining costs to specific activities. For some costs, this is very logical. The cost of a new product design team would be allocated to the product-level design activity. At other times, considerable judgment must be applied to make the allocation. Consider the light bill for the office space; perhaps 10% of this amount is for electricity usage within the design department's space. You can see that ABC quickly entails a degree of complexity. Finally, some costs do not seem to match with any cost object or activity. This third grouping of costs is not assigned to any activity or cost object. The fact that a cost is not assigned to a cost object or activity does not mean that it is to be ignored; it is expensed but should be closely monitored by management. The final step in ABC requires that the cost of activities be allocated to cost objects. For example, the accumulated cost of the design activity must finally be allocated to cost objects. If three new products were developed, it might be appropriate that the design activity's total cost be shared one-third by each new product. 98 waL80281_04_c04_083-112.indd 16 9/25/12 1:03 PM CHAPTER 4 Section 4.3 Activity-Based Costing Exhibit 4.2 is an attempt to recap the overall design of an ABC system: Exhibit 4.2 STUDY COSTS AND PROCESSES DETERMINE COSTS TRACE COSTS TO COST OBJECTS WHEN POSSIBLE COSTS THAT ARE NOT TRACEABLE OR ASSIGNABLE ASSIGN COSTS TO ACTIVITIES WHEN NOT TRACEABLE TO COST OBJECT FINAL COST DETERMINATION FOR COST OBJECTS ADOPT ALLOCATION SCHEME TO TRANSFER ACTIVITY COSTS TO COST OBJECTS CHARGED TO EXPENSE BUT MONITORED CLOSELY AS PART OF OVERALL FINANCIAL MANAGEMENT ABC Example Because of its complexity, it is easy to quickly lose sight of the purpose of ABC. ABC is intended to improve measures of cost. By introducing activity cost pools as an intermediate step for selected costs (rather than allocating every cost directly to a product or period), we are much better able to allocate the costs to end objects (products, customers, etc.). Without activity cost pools, it becomes difficult to connect each cost with final cost objects. A simplified example should prove quite helpful in clarifying how ABC works. Hong sells three products. Each product generates exactly $1,750,000 in total sales. Two products (A and B) are manufactured internally, and one (C) is outsourced. A and C are sold via direct sales efforts, and B is sold only via a website. For simplicity, assume Hong has only four identifiable activities: manufacturing, direct sales, administration, and web support. The cost of manufacturing ($1,000,000, excluding direct materials and direct labor) is allocated 50% to A and 50% to B. The study of the cost of direct sales ($800,000) revealed that it is attributable 70% to A and 30% to C. Administrative activities ($1,200,000) are found to be consumed 20% by A, 30% by B, and 50% by C. Finally, web support ($100,000) is 100% attributable to B. Let's assume that there are no costs that cannot be traced to a particular cost object or activity. 99 waL80281_04_c04_083-112.indd 17 9/25/12 1:03 PM CHAPTER 4 Section 4.3 Activity-Based Costing Table 4.1 reveals the ABC approach to assessing costs for each final product. Table 4.1: The ABC approach to assessing costs Product A Direct materials and labor (traceable) Product B $500,000 Product C $750,000 Purchase of outsourced product (traceable) $900,000 Manufacturing activity (allocated activity) 500,000 Direct sales (allocated activity) 560,000 Administration (allocated activity) 240,000 360,000 600,000 - 100,000 - $1,800,000 $1,710,000 $1,740,000 Web support (allocated activity) Total cost assignment 500,000 240,000 The costs in the preceding table were either directly traceable to cost object A, B, and C or allocated based on the given percentages. The resulting total cost assignment shows that only products B and C are profitable (remember that each product had total sales of $1,750,000). A traditional costing model would not pinpoint these facts nearly so precisely. Why? The answer is that each product would have a high gross profit (sales minus cost of sales, based only on the traceable and allocated manufacturing costs). Furthermore, selling and administrative costs would be deducted in the aggregate as follows: Product A Product B Product C Total Sales $1,750,000 $1,750,000 $1,750,000 $5,250,000 Cost of sales 1,000,000 1,250,000 900,000 3,150,000 Gross profit $750,000 $500,000 $850,000 $2,100,000 Sales (800,000) Administration (1,200,000) Web support (100,000) - Net income This quite simplified example of ABC is intended to show how alternative costing models can shed additional light on business operations and enable much better decision making. More advanced managerial accounting courses frequently go into ABC in much greater depth. The allocation tables are similar to those given here but will potentially encompass far more cost objectives, activities, and allocation steps. In business, ABC would become almost impossible to implement without modern information systems and software that tracks and allocates complex cost arrays with relative ease. For now, your coverage of ABC is intended to make you aware of the limitations of traditional costing models and show an alternative thoughtful approach. Even ABC has its critics. It is no better than the processes used to identify activities and allocation 100 waL80281_04_c04_083-112.indd 18 9/25/12 1:03 PM CHAPTER 4 Concept Check percentages, and these are inherently judgmental. Indeed, this facet of ABC underscores that an ethical manager must provide strong leadership to be sure that whatever costing model is used, it must be thoughtfully designed and implemented. Without strong knowledge and leadership in costing, poor signals will be produced. Poor signals lead to bad decisions and wasted resources. This can be viewed as unethical from the perspective of failing to discharge appropriate stewardship over company resources. Concept Check The five questions that follow relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The correct answers can be found at the end of your text.) 1. Which of the following businesses would be least likely to use a job costing system? a.\tAutomobile repair shop b.\tCustom home builder c.\tCrude oil refinery d.\tMotion picture producer 2. The journal entry to record the use of indirect materials in production activities is a.\tdebit Work in Process; credit Raw Materials. b.\tdebit Factory Overhead; credit Raw Materials. c.\tdebit Raw Materials; credit Work in Process. d.\tdebit Work in Process; credit Factory Overhead. 3.\t\u0007Direct materials, direct labor, and factory overhead applied are initially brought together in which of the following accounts? a.\tWork in Process b.\tFinished Goods c.\tCost of Goods Sold d.\tIncome Summary 4.\t\u0007SRT Inc. applies factory overhead on the basis of direct labor cost. The company's accountant has forecast $180,000 of factory overhead and $200,000 of direct labor for 20X5. Actual factory overhead and direct labor for 20X5 amounted to $185,000 and $210,000, respectively. Overhead for 20X5 is a.\tunderapplied by $4,000. b.\tunderapplied by $9,000. c.\toverapplied by $4,000. d.\toverapplied by $9,000. 5. In today's modern manufacturing environment, many companies: a.\tare experiencing a decrease in overhead application rates. b.\tare experiencing a decrease in factory overhead and an increase in direct labor cost. c.\t\u0007can ignore cost drivers because of a recent pronouncement from the Financial Accounting Standards Board. d.\thave a labor component that may be as low as 5% of total product cost. 101 waL80281_04_c04_083-112.indd 19 9/25/12 1:03 PM CHAPTER 4 Critical Thinking Questions Key Terms activity-based costing (ABC) A costing method typically reserved for internal use only, which is intended to facilitate internal decision-making processes by pinpointing actual (full) production costs more precisely. job cost sheet A form that summarizes direct labor, direct material, and overhead cost that is applied to a particular job. job costing Used in situations in which goods and services are produced upon receipt of a customer order, according to customer specifications, or in separate batches. batch level Represents activity regarding a number of similar units. cost of production report A report that details the amount of direct material, direct labor, and factory overhead incurred by the department and then shows how those costs were allocated to total production and provides supporting documentation for the journal entries that were used to transfer costs to successive departments. customer-level Represents activity at the customer level, such as developing catalogs or sales calls. entity-sustaining Represent the highest level of activities, such as the cost of a corporate audit. equivalent unit A physical unit expressed in terms of a finished unit. market-level Market-level activities represent market-oriented actions. materials requisition A form that is used to pull raw materials from inventory and transfer them into work in process. process costing Allocates the total cost of production across all units of output and is applicable to homogenous goods that are produced in batches or continuous processes. product-level Represents high levels of activity, such as designing a new product. underapplied overhead A figure that results when the actual overhead is more than the amount assigned to production. unit level Represents a one-to-one correspondence with a unit of output. Critical Thinking Questions 1.\t\u0007Briefly explain several of the problems encountered when trying to compute the actual cost of a good or service. 2.\t\u0007Discuss the general features associated with a job order costing system. In what types of applications are job order systems used? 3.\t\u0007Explain how the flow of costs through an accounting system parallels the flow of goods and materials through a manufacturing plant. 4. Contrast the proper accounting treatments of direct materials and indirect materials. 5.\t\u0007How does the use of a predetermined overhead rate smooth product costs over a period of time? 6.\t\u0007Explain how an overhead application rate is developed and used to apply overhead to specific jobs. 102 waL80281_04_c04_083-112.indd 20 9/25/12 1:03 PM CHAPTER 4 Exercises 7. List the characteristics of a good overhead application base. 8.\t\u0007Ritten Company's factory depreciation for the year just ended totaled $40,000 and was recorded as follows: Depreciation Expense 40,000 Accumulated Depreciation: Factory 40,000 Comment on the appropriateness of Ritten's journal entry. 9.\t\u0007Discuss the relationship between the Work in Process account and individual job cost sheets. 10.\t\u0007If overhead is underapplied, will the Factory Overhead account contain a debit or credit balance? What is the probable effect of the underapplication on the Work in Process balance (before adjustment) at the end of the accounting period? 11.\t\u0007What is probably the most popular application base for overhead? Can this base be criticized in light of today's manufacturing environment? Briefly explain. 12. List several possible applications of job costing systems by service enterprises. 13. Distinguish between a direct cost and an indirect cost. Exercises 1. Manufacturing journal entries The following selected transactions and events occurred at Pipeline Manufacturing during March: Mar. 3 Purchased $10,000 of direct materials and $7,300 of indirect materials on account from Sunbelt Distributors. 7 Issued $3,100 of direct materials and $700 of indirect materials from the storeroom. 14 Incurred $5,600 of direct labor and $3,400 of indirect labor. 17 Recorded $1,300 of overhead incurred on account. Mar. 20 Applied $2,800 of overhead to production. 23 Noted that $6,200 of production had been completed. 26 Sold goods on account at a profit of 30% of cost. The goods cost $5,000. Prepare journal entries to record the preceding transactions and events. 103 waL80281_04_c04_083-112.indd 21 9/25/12 1:03 PM CHAPTER 4 Exercises 2. Analysis of job cost sheet Sumpter Manufacturing began job No. 587 in December 20X6 and recorded material, labor, and overhead charges of $38,800 through year-end. The bottom portion of page 2 of the job's cost sheet is reproduced here: Summary of January charges Direct materials used $ 12,600 Direct labor (580 hours) 4,350 Factory overhead applied 6,728 Total $ 23,678 Job No. 587 was completed on January 30, 20X7. a.\t\u0007Determine Sumpter's overhead application rate, assuming the company uses direct labor hours for an application base. b.\tWhat is the total cost of job No. 587? c.\tPrepare the journal entries recorded in January related to job No. 587. 3. Cost flows and overhead application Cleveland Metals uses a job cost system and applies factory overhead to production at a predetermined rate of 180% of direct labor cost. Data pertaining to recent operations follow: J\u0007 ob No. 636 was the only job in process on January 1 of the current year. The Work in Process account contained a $24,600 balance on this date. \u0007Job Nos. 637, 638, and 639 were started during January. T \u0007 otal direct material requisitions and direct labor incurred during January amounted to $89,200 and $114,500, respectively. \u0007 he only job that remained in process on January 31 was job No. 638, with costs T of $15,000 for direct materials and $20,000 for direct labor. a.\tCompute the total cost of the work in process inventory on January 31. b.\t\u0007Compute the cost of jobs completed during January, and present the proper journal entry to reflect job completion. 4. Job costing and overhead application Uniflex applies overhead on the basis of direct labor cost. In December 20X4, the company's cost accountant made the following predictions for 20X5 operations: direct labor cost, $620,000; factory overhead, $961,000. Uniflex worked on job Nos. 241 and 242 in January. The costs incurred and production status of these two jobs appear in the table that follows. 104 waL80281_04_c04_083-112.indd 22 9/25/12 1:03 PM CHAPTER 4 Exercises Job No. 241 Direct materials Direct labor Production status Job No. 242 $26,000 $47,000 18,000 24,000 In process In process By the end of 20X5, actual direct labor cost amounted to $612,500, and factory overhead incurred totaled $967,500. There was no work in process on January 1, 20X5. Compute the following: a.\tUniflex's overhead application rate. b.\tThe balance of the Work in Process account on January 31, 20X5. c.\t\u0007The amount of over- or underapplied overhead for 20X5. Be sure to indicate whether overhead was overapplied or underapplied. 5. Job costing and overhead application Oxford Enterprises uses a job costing system to accumulate manufacturing costs. Overhead is applied to products on the basis of machine hours in the machining department and direct labor cost in the assembly department. The following estimates pertain to 20X4: Machining Machine hours Assembly 40,000 5,000 Direct labor cost $270,000 $800,000 Factory overhead 810,000 960,000 Job No. 328 was the only job in process at the end of 20X4. Its cost sheet revealed the data that follow: Machining Machine hours Direct labor cost Direct materials cost Assembly 100 10 $1,100 $3,500 1,900 3,400 a.\t\u0007Compute Oxford's overhead application rates in the machining department and the assembly department. b.\tCalculate the total amount of overhead applied to job No. 328. c.\tDetermine the total cost of job No. 328. 105 waL80281_04_c04_083-112.indd 23 9/25/12 1:03 PM CHAPTER 4 Exercises 6. Overview of job costing and overhead application Evaluate the comments that follow as being true or false. If the comment is false, briefly explain why. a.\t\u0007A materials requisition forms the basis for the following journal entry: debit Work in Process, credit Raw Materials. b.\t\u0007The Work in Process account normally contains the following costs for the jobs in production at year-end: direct materials used, direct labor, and actual factory overhead. c.\t\u0007Direct labor cost is a good overhead application base to use if a company is highly automated. d.\t\u0007The amount of over- or underapplied overhead at year-end is normally closed to the Work in Process account. e.\t\u0007An overhead application rate is derived by the following computation: estimated factory overhead divided by an estimated application base. 7. Overhead application: Working backward The Towson Manufacturing Corporation applies overhead on the basis of machine hours. The following divisional information is presented for your review: Division A Division B Actual machine hours 22,500 ? Estimated machine hours 20,000 ? Overhead application rate $ 4.50 Actual overhead $110,000 $ 5.00 ? Estimated overhead ? $90,000 Applied overhead ? $86,000 Over- (under-)applied overhead ? $ 6,500 Find the unknowns for each of the divisions. 8. Direct costs and indirect costs Executive Airlines is studying whether to begin flight service from Chicago to St. Louis. Identify the following costs as a direct cost or an indirect cost of the Chicago/St. Louis flight segment, assuming the route would be serviced by aircraft that would continue to be flown throughout Executive's extensive route system: a.\tPassenger beverage service b.\tAirport landing fees c.\tMonthly engine maintenance service d.\tFuel consumed e.\tCommissions paid to travel agents on tickets sold f.\tSalary of Executive's director of route planning 106 waL80281_04_c04_083-112.indd 24 9/25/12 1:03 PM CHAPTER 4 Problems 9. Cost drivers, service business Don't Bug Me treats insect-infested homes and trees in Omaha, Nebraska. The company utilizes many liquid pesticides that are purchased in 55-gallon drums and later divided into 10-gallon containers for crew use. The pesticides are accounted for as indirect materials (i.e., supplies) in the firm's job cost system. a.\t\u0007Why do you think the company treats pesticides as indirect materials (as opposed to direct costs) of servicing a client? b.\tWhat is a cost driver? c.\t\u0007Management insists that crews estimate square footage and tree height, respectively, for homes and trees serviced. Why is this procedure necessary? Problems 1. Preparation of job cost sheet and journal entries Nycom Inc. manufactures items that are used in the electronics industry. The company, which uses a job costing system, has two departments: machining and finishing. The machining department applies overhead to products at the rate of $15 per machine hour. Finishing, in contrast, uses an application rate of 250% of direct labor cost. On March 19, 20X3, Nycom received an order from Sensormatic for 225 photons, Model No. 116. Production began immediately, and the order (known as job No. 4155) was completed on March 31. Paperwork supporting the order revealed the following: Document* Date Department Hours Amount MR 1165 3/19 Machining $5,600 MR 1169 3/21 Machining 3,500 TT 1450-52 3/23 Machining 45 400 MUR 46 3/23 Machining 105 MR 4330 3/27 Finishing 700 TT 1475-76 3/31 Machining 30 300 MUR 47 3/31 Machining 50 TT 6608-13 3/31 Finishing 200 2,000 *MR, materials requisition; MUR, machine usage report; TT, time ticket. 107 waL80281_04_c04_083-112.indd 25 9/25/12 1:03 PM CHAPTER 4 Problems Instructions a.\t\u0007Prepare a job cost sheet for the Sensormatic order as of March 31. Use the following column headings: Direct Materials Date Requisition Direct Labor Amount Ticket Hours Amount Machine Usage Report Hours Factory Overhead Amount b.\t\u0007Prepare journal entries to record (1) the issuance of direct materials, (2) direct labor incurred on the order, and (3) the application of factory overhead. All materials requisitions should be combined in one entry, all time tickets in another, and so forth. c.\t\u0007If company policy is to sell goods at a profit of 80% of total job cost, present the journal entries necessary to recognize completion and sale of the photons. 2. Computations using a job order system General Corporation employs a job order cost system. On May 1, the following balances were extracted from the general ledger: Work in process $ 35,200 Finished goods 86,900 Cost of goods sold 128,700 Work in Process consisted of two jobs, No. 101 ($20,400) and No. 103 ($14,800). During May, direct materials requisitioned from the storeroom amounted to $96,500, and direct labor incurred totaled $114,500. These figures are subdivided as follows: Direct Materials Direct Labor Job No. Amount Job No. Amount 101 $ 5,000 101 $ 7,800 115 19,500 103 20,800 116 36,200 115 42,000 Other 35,800 116 18,000 $96,500 Other 25,900 $114,500 Job No. 115 was the only job in process at the end of the month. Job No. 101 and three \"other\" jobs were sold during May at a profit of 20% of cost. The \"other\" jobs contained material and labor charges of $21,000 and $17,400, respectively. 108 waL80281_04_c04_083-112.indd 26 9/25/12 1:03 PM CHAPTER 4 Problems General applies overhead daily at the rate of 150% of direct labor cost as labor summaries are posted to job orders. The firm's fiscal year ends on May 31. Instructions a.\tCompute the total overhead applied to production during May. b.\tCompute the cost of the ending work in process inventory. c.\tCompute the cost of jobs completed during May. d.\tCompute the cost of goods sold for the year ended May 31. 3. Job order costing, overhead emphasis Toledo Company uses a job order system to accumulate manufacturing costs. On December 31, 20X1, the work in process inventory consisted of job No. 764, costed as follows: Direct materials $ 4,800 Direct labor 12,500 Applied overhead 10,000 $27,300 Because of changing plant conditions and labor markets, the cost accounting department calculated a new overhead application rate for use throughout 20X2. Estimated totals for direct labor cost and factory overhead for 20X2 amounted to $300,000 and $270,000, respectively. Actual results follow: Direct materials used Direct labor Indirect materials Indirect labor $259,600 316,000 23,700 144,900 Factory depreciation 55,300 Factory taxes 12,700 Factory utilities 55,200 $867,400 All jobs were completed and sold by December 31, 20X2, except for job no. 821, which contained direct material costs of $10,900 and direct labor charges of $22,500. This job was still in production and was anticipated to be completed in early January. The company charges any under- or overapplied overhead to Cost of Goods Sold. 109 waL80281_04_c04_083-112.indd 27 9/25/12 1:03 PM CHAPTER 4 Problems Instructions a.\t\u0007Determine the 20X2 overhead application rate, using direct labor cost as the application base. b.\t\u0007Determine the total cost of the company's work in process inventory as of December 31, 20X2. Determine the amount of under- or overapplied overhead for the year. Be sure to indicate whether overhead was underapplied or overapplied. c.\t\u0007Compute the company's cost of goods sold. Toledo had no finished goods inventory on January 1, 20X2. 4. Job costing in a service business Diego, Hyatt, and Stevens, a prestigious law firm located in San Antonio, uses a job order system to monitor the cost of servicing clientele. The office manager has prepared the following budget for 20X7: Client billings $11,520,000 Less: Professional staff costs (85%) Administrative staff costs (75%) $6,000,000 2,000,000 Computer time (80%) 500,000 Photocopying (70%) 200,000 Other office costs (20%) 300,000 9,000,000 $ 2,520,000 Net income The numbers in parentheses indicate the percentage of cost that is directly traceable to client jobs. The remaining, nontraceable portion is charged to clients by using a predetermined overhead application rate. The office manager feels that total direct cost is the most appropriate overhead application base. In March, the firm completed work on a suit for Picante Foods. The following costs were directly chargeable to Picante: Professional staff $25,000 Administrative staff 6,400 Computer time 2,500 Photocopying 3,700 Other office costs 400 110 waL80281_04_c04_083-112.indd 28 9/25/12 1:03 PM CHAPTER 4 Problems Instructions a.\t\u0007Determine the firm's total budgeted traceable and nontraceable costs and the overhead application rate. b.\tCalculate the firm's estimated income for the year as a percentage of traceable costs. c.\t\u0007Compute the total cost of the Picante job and the amount that Diego, Hyatt, and Stevens would bill the client. d.\t\u0007The office manager can acquire new software that would allow the firm to increase the percentage of direct (as opposed to indirect) costs. Briefly explain why Diego, Hyatt, and Stevens would be interested in this software. 111 waL80281_04_c04_083-112.indd 29 9/25/12 1:03 PM waL80281_04_c04_083-112.indd 30 9/25/12 1:03 PM chapter 5 Cost-Volume-Profit Analysis istockphoto Learning Objectives Extend your knowledge of fixed and variable costs, and be able to perform cost behavior analysis. Understand the contribution margin, contribution margin ratio, and how knowledge of these concepts can be used to calculate breakeven and other performance measures. Know the critical assumptions of cost-volume-profit analysis. Understand variable versus absorption costing. Be able to calculate residual income. waL80281_05_c05_113-140.indd 1 9/25/12 1:03 PM CHAPTER 5 Section 5.1 Mixed Costs Chapter Outline 5.1 Mixed Costs 5.2 Cost-Volume-Profit Analysis The Algebra of Break-Even and Targeted Income Analysis Influence of Taxes Changing Costs Changing Revenues Multiple Products 5.3 CVP Assumptions Direct Costing Comprehensive Income Statements Under Variable and Absorption Costing Fluctuating Inventory 5.4 Evaluating Residual Income Y ou have previously learned about fixed and variable costs. Fixed costs are the same over the relevant range of expected production. Variable costs fluctuate in direct proportion to volume. You have seen how cost behavior influences measures of income, flexible budgeting, standard costing models, and so forth. Management must understand cost behavior to operate a successful business organization effectively. In this chapter, your knowledge of cost behavior will be extended to encompass techniques useful in studying a business's break-even point and similar concepts. These techniques are commonly referred to as cost-volume-profit analysis or just CVP. You will also apply your knowledge of cost behavior to understand alternative costing methods that are useful in managing business decisions. 5.1 Mixed Costs B efore diving into CVP and alternative costing models, one must give consideration to the prospect of a mixed cost. Mixed costs entail a fixed component and a variable component. They are actually quite common. If you have ever committed to a cell phone contract, it is very possible that you have some hands-on experience with mixed costs. Your monthly cellular bill may include both fixed and variable amounts. Perhaps there is a fixed charge for basic monthly service and variable charges related to Internet access, texting, and so forth. Mixed costs change in response to fluctuations in volume, but not in a way that is immediately apparent. Before a manager can study the effects of volume fluctuation on a business, it is first necessary to develop a model that separates mixed costs into their fixed and variable components. Assume that Charlie's Restaurant receives a monthly electric bill. Charlie's electricity use fluctuates significantly each month. The cause of the fluctuation relates mostly to seasonal differences in utility consumption, based on heating and air-conditioning needs. Charlie's provides data about its monthly electric bill in Table 5.1. 114 waL80281_05_c05_113-140.indd 2 9/25/12 1:03 PM CHAPTER 5 Section 5.1 Mixed Costs Table 5.1: Charlie's electric bill data Total cost Kilowatts used January $1,950 15,000 February 1,750 13,000 March 1,650 12,000 April 1,350 9,000 May 1,450 10,000 June 1,750 13,000 July 2,150 17,000 August 2,050 16,000 September 1,850 14,000 October 1,350 9,000 November 1,550 11,000 December 1,750 13,000 At first glance, it may not be at all apparent how the total cost relates to the total usage. However, a graphical representation of this cost is quite revealing. Exhibit 5.1 is a chart with the total cost indicated along the vertical axis and the total usage along the horizontal axis. From this chart, you are able to see that fixed cost is the same, at $450, no matter the electricity consumed. Variable cost is rising at $0.10 per kilowatt hour. Exhibit 5.1 TOTAL ELECTRICITY COST $2,500 $2,000 $1,500 $1,000 Variable cost area $500 Fixed cost area $0 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 KILOWATTS USED 115 waL80281_05_c05_113-140.indd 3 9/25/12 1:03 PM CHAPTER 5 Section 5.1 Mixed Costs Perhaps you are able to \"eyeball\" the data in the table and make a determination of the fixed and variable portions in the electric bill. However, what if the data set is much larger and more cryptic? How can you estimate the fixed and variable amounts? This problem is frequently encountered because many expenses contain both fixed and variable components. A simple (and sometimes imprecise) approach is the high-low method. With this