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Section C Cost ManagementThis section is 25% of the Part 1 ExamThis section focuses on the process of determining how much it costs to produce a product and how to control this expense.Major topics include:Classification of costsVariable and absorption costingProcess costing and other types of costing methodsOverhead allocationService cost allocationOperational efficiencyBusiness process performance2010 CMA Part 1 Section C Cost Management #Classification of Costs 2010 CMA Part 1 Section C Cost Management #Classifications of CostsThe various costs that a company incurs can be classified in different ways. These different terms and classifications are important because they will be the basis for a number of other topics that will be discussed later.These terms may be tested directly (simple definition or classification) or indirectly (as part of a larger question).2010 CMA Part 1 Section C Cost Management #Costs Based on the Level of ProductionFixed Costs do not change as the level of production changes (example, rent) as long as the production level remains within the relevant range.Total fixed costs do not change, but the fixed cost per unit decreases as production increases.Variable Costs change in total as the level of production changes (example, labor)Total variable costs will change, but the variable cost per unit will not change as production increases, as long as the production level remains within the relevant range.Mixed Costs have a component that is fixed and a component that is variable. May be semi-fixed or semi-variable.2010 CMA Part 1 Section C Cost Management #Variable CostsVariable costs are costs that are incurred only when the company produces something. If the company produces no units, no variable costs will be incurred.Direct material and direct labor are usually variable costs.As the production level increases, the total amount of variable costs will increase, but the cost per unit will remain the same.2010 CMA Part 1 Section C Cost Management #Fixed CostsA fixed cost is a cost that does not change as the production level changes, over the relevant range.The relevant range is the level of production in which fixed costs do not change.For example, factory rent is a fixed cost as long as the production level is within the capacity of the factory. Once production exceeds the capacity of the factory, a bigger factory will be needed. The rent cost will increase in order to cover the increased factory space.As we will cover, in most situations, fixed costs are not relevant in the decision making process, because they do not differ between alternatives.2010 CMA Part 1 Section C Cost Management #Mixed CostsMixed costs may be semi-variable costs or semi-fixed costs.A semi-variable cost has a fixed component and a variable component. It has a basic fixed amount that must be paid regardless of activity, even if there is no activity. Added to that fixed amount is an amount which varies with activity. Example: utilities.A semi-fixed cost is fixed over a given, small range of activity, and above that level of activity, the cost suddenly jumps. A semi-fixed cost moves upward in a step fashion, staying at a certain level over a small range and then moving to the next level quickly. The range over which it is fixed is smaller than that for a fixed cost.2010 CMA Part 1 Section C Cost Management #Product (or Inventoriable) CostsProduct costs are the costs of producing the product. The costs treated as product costs are inventoried and carried on the balance sheet until sold. They are called inventoriable costs.Product costs include (with examples):Direct labor (assembly line labor)Direct materials (components of the product)Manufacturing overheadIndirect labor (maintenance costs)Indirect materials (glues, nails)Overhead costs (rent, electricity, utilities)2010 CMA Part 1 Section C Cost Management #Classifications of Product CostsThe main types of product costs in the previous slide can be further combined to create different cost classifications. The three classifications that you need to be aware of are listed below:Prime costs include direct materials and direct labor.Manufacturing costs include prime costs and manufacturing costs applied.Conversion costs are manufacturing overhead and direct labor. Conversion costs are the costs that are required to convert the materials into the finished product.2010 CMA Part 1 Section C Cost Management #Period CostsPeriod costs are costs that are not involved in the production of the product.Period costs are expensed as they are incurred.Examples include: general and administrative, legal fees, marketing, accounting departmentIt is also possible that a company may choose to allocate period costs to the production depts.Period costs must be reported as period costs for external reporting. However, for internal reporting, companies may choose to allocate them to units produced.This is covered later in the topic Service Cost Allocation.2010 CMA Part 1 Section C Cost Management #Other Costs and Cost ClassificationsOpportunity costs are the contribution to income that is lost because a different option was selected.Carrying costs are the costs of carrying a unit of inventory.Sunk costs are costs that have already been spent. Because they have already been spent, they are not relevant to the decision making process.Committed costs are costs that have not yet been spent, but have been promised to be spent (example, future lease payments that are owed under an existing lease contract).Marginal costs are the costs necessary to produce one more unit.2010 CMA Part 1 Section C Cost Management #Other Costs and Cost Classifications contdDiscretionary costs are costs that do not need to be spent in the short-term and there will be no negative impact on the company. If they are not spent in the long-term, however, the company may face detrimental results. Training and advertising are often classified as discretionary costs.Engineered costs are costs that have a direct relationship between the activity base and the incurring of costs.Imputed costs are costs that are not actually paid but are necessary for decision making (interest is often imputed in decision making, even when it is not actually paid).2010 CMA Part 1 Section C Cost Management #Cost of Goods Sold (COGS)The costs that were paid in order to produce (or purchase) the goods that were sold during the period.It is calculated as:Beginning finished goods inventory+Purchases (for a reseller) or +Cost of goods manufactured (for a manufacturer)Ending finished goods inventory=Cost of goods soldThis ignores goods that are lost or stolen, but is sufficient for our purposes here.2010 CMA Part 1 Section C Cost Management #Cost of Goods Manufactured (COGM)This is the cost to manufacture the goods completed during the period and transferred to finished goods.For a manufacturing company, this is part of the COGS formula.The formula is:Direct materials used* +Direct labor used+Manufacturing overhead applied = Manufacturing Costs Incurred During the Period+Beginning work-in-process inventory Ending work-in-process inventory=Cost of goods manufactured* Calculation on next slide2010 CMA Part 1 Section C Cost Management #Direct Materials UsedDirect materials used is calculated as:

Beginning direct materials inventory+Purchases+Transportation-in ReturnsEnding direct materials inventoryDirect materials used2010 CMA Part 1 Section C Cost Management #Variable and Absorption Costing 2010 CMA Part 1 Section C Cost Management #Variable and Absorption CostingVariable and absorption costing are two methods of costing that are different in only two ways:The treatment of fixed factory overhead (such as factory rent), andThe presentation on the income statement of different costs.Variable costing is also called direct costing.US GAAP requires the use of absorption costing for the financial statements.However, many accountants feel that variable costing is a better tool to use for analysis, and therefore variable costing is often used internally. 2010 CMA Part 1 Section C Cost Management #Fixed Factory CostsUnder variable costing, fixed factory overheads are treated as a period cost and are expensed as they are incurred.Under absorption costing, fixed factory overheads are allocated to the units that were produced during the period.This means that the fixed factory overhead costs will go first to the balance sheet as inventory and then flow to the income statement as cost of goods sold as the units they are attached to are soldOver the long-term, both methods will provide the same total net income. The difference between the methods is a timing difference.2010 CMA Part 1 Section C Cost Management #Effect of Changing Inventory LevelsWhen inventory increases during the period (production > sales), the absorption method provides a higher net income because under the absorption method, some of the fixed factory overheads are carried on the balance sheet in inventory and have not yet been expensed.When inventory decreases during the period (production < sales), the absorption method provides a lower net income because under the absorption method, all of the current periods fixed factory overheads are expensed on the income statement as well as some of the fixed factory overheads from the previous period.2010 CMA Part 1 Section C Cost Management #Effect of Changing Inventory Levels contdNote that under absorption costing, a company can manipulate income by increasing production which will cause more of the fixed factory overheads to be on the balance sheet as inventory.2010 CMA Part 1 Section C Cost Management #Presentation Under Absorption CostingUnder absorption costing, the income statement is broken down into components based on whether the costs are manufacturing or nonmanufacturing

Sales revenue COGS (incl. variable and fixed mfg. costs)=Gross margin Variable nonmanufacturing costs Fixed nonmanufacturing costs=Operating income2010 CMA Part 1 Section C Cost Management #Presentation Under Variable CostingUnder variable costing, the income statement is broken down based on whether the costs are variable or fixed

Sales revenue Variable manufacturing costs=Manufacturing contribution margin Variable nonmanufacturing costs=Contribution margin Fixed costs (mfg. and nonmanufacturing)=Operating income2010 CMA Part 1 Section C Cost Management #Variable vs. Absorption CostingThough absorption costing is required by US GAAP, variable costing is generally considered to be better for decision making by management.Fixed costs are usually not relevant in decision making, and by excluding them from the cost of production, companies are able to make better decisions.Under variable costing, operating income is influenced by the level of sales only and not based on changes in inventory levels.Variance analysis under absorption costing is difficult.The impact on income of fixed costs is visible under variable costing, because fixed costs are listed on the income statement as expenses.It is easier to calculate contribution for a division or product when variable costing is used.2010 CMA Part 1 Section C Cost Management #Calculation of the Difference in IncomeIf there is (1) no beginning inventory, or if (2) the LIFO inventory cost flow assumption is used and ending inventory is higher than beginning inventory, or if (3) under other cost flow assumptions, the beginning inventory is valued at the same per unit manufacturing cost as the current years planned per unit manufacturing cost, the difference in net income between the variable and absorption costing methods is:Fixed overhead cost per unitNumber of units of change in inventory=Difference in incomeRemember, this works only in the above situations.

2010 CMA Part 1 Section C Cost Management #Joint Products and Byproducts 2010 CMA Part 1 Section C Cost Management #Joint ProductsJoint products are two or more products that are produced sharing the same production process up to what is called the split-off point.

The joint costs that are incurred prior to the split-off point need to be allocated between or among the joint products.

The method that should be used will be given in the problem.2010 CMA Part 1 Section C Cost Management #Methods of Allocating Joint CostsThe different methods to allocate joint costs are:Physical-unit method uses weight, volume, the number of units or other physical measure.Relative Sales Value method uses relative sales value of the different products to allocate the joint costs.Estimated Net Realizable Value (NRV) method uses the estimated NRV of the different products.For a product that needs additional processing before it can be sold, NRV is calculated as the sales price minus the costs to complete and dispose of the unit.Constant Gross-Margin percentage NRV allocates the joint costs so that all of the joint products have the same gross margin percentage.

2010 CMA Part 1 Section C Cost Management #ByproductsA byproduct is an immaterial product that is produced as the result of the production of the main product.Byproducts are by nature immaterial and are not intentionally produced.An example would be sawdust produced by a lumber mill. One use for sawdust is to bond it with resins and mold it into furniture parts, containers and various other products. Companies that manufacture those products buy the sawdust from the lumber mill; so the lumber mill can make a little money from its waste product and also avoid sending it to a landfill.2010 CMA Part 1 Section C Cost Management #Byproducts contdByproducts are usually sold, generating some amount of revenue. There are two ways to account for byproducts.Production method. Byproducts are inventoried in a separate inventory account at their estimated net realizable value. Inventoried costs allocated to the main product are reduced by the amount allocated to the byproduct. When the byproduct is sold, the company recognizes no revenue or cost of goods sold but simply debits Cash or A/R and credits Byproduct Inventory.Sale method. All costs are allocated to the main product (none to the byproduct). When the byproduct is sold, the company debits Cash or A/R and credits Revenue for the amount of the sale.2010 CMA Part 1 Section C Cost Management #Process Costing 2010 CMA Part 1 Section C Cost Management #Process CostingProcess costing is used in a situation in which the company produces a product in an assembly line type of structure. Within each department, the company must allocate the costs of that department to the units produced.Again, remember that this is a mathematical allocation in which the costs of the department are allocated to the units that were produced.2010 CMA Part 1 Section C Cost Management #Types of CostsIn process costing, there are two classification of costs that are added during the period:Direct Materials, andConversion costs these are the costs of direct labor and manufacturing overhead that are combined into one classification (the cost to convert the raw materials into the finished product).There is another source of costs that must be included in the costing process and those are the costs that are already in the products when they are transferred into the department. 2010 CMA Part 1 Section C Cost Management #Steps in Process CostingThere are seven steps in process costing:1) Determine the physical flow of goods,2) Calculate how many units were started and completed during the period,3)Determine when materials are added to the process,4) Calculate the equivalent units produced for materials and conversion costs,5) Calculate the costs incurred during the period for materials and conversion costs,6) Calculate the cost per equivalent unit for materials and conversion costs, and7) Allocate the costs to EWIP and transferred out2010 CMA Part 1 Section C Cost Management #1. Determine the Physical Flow of GoodsThis is not going to be a question on the exam, but it is a starting point to just determine what specifically needs to be accounted for. This equation keeps track of the number of units during the period.There are two places the units can come from and two places that they can be at the end of the period. This is the basis of the equation.# units in Beginning Inventory + # of units Transferred In = # units in Ending WIP + # of units Completed2010 CMA Part 1 Section C Cost Management #2. Calculate # of Units Started and CompletedThis is also not going to be a specific question, but it will be used in later calculations.This is the number of units for which 100% of the work was done during the period. Thus the name, the number of units that were started and completed during the period.

The formula for units started and completed is:

# of units Completed # of units in Beginning WIP2010 CMA Part 1 Section C Cost Management #3. Determine When Materials are AddedAgain, this is not going to be a specific question, but it will be used in a later step.You need to identify if the materials are added at the start of the process, the end of the process, or at a specific point during the process.Materials may be added at the beginning of the process, at the end, at some point in the middle, or evenly throughout the process.2010 CMA Part 1 Section C Cost Management #4. Calculate Equivalent Units of Production (EUPs)This is the basis of Process Costing and it is critical that you understand this concept and how to calculate the number of EUPs during the period.This calculation determines how many units would have been completed if the company had started and completed each unit before starting the next.Usually companies have a number of units that are in the process at any point in time. This leads to some units being only partially finished at the end of the period.In the EUP calculation, 100 units that are 25% complete will be considered to be 25 equivalent units.2010 CMA Part 1 Section C Cost Management #4. EUP Calculation contdThere are two methods of calculating the EUPs for the period. The difference is based on the assumption that is made regarding the units in beginning inventory.Under the FIFO method, it is assumed that all of the units in beginning inventory were completed during the period and transferred to the next process.Therefore, the costs in beginning inventory are automatically transferred to the next department or to finished goods.Under the weighted average method, we do not assume that the units in beginning inventory were finished.Therefore, the costs and the EUPs in beginning inventory are considered to have been spent and worked this period.2010 CMA Part 1 Section C Cost Management #4. EUP for Materials and Conversion CostsThere are also two calculations that will be made for EUPs.EUP for materials, andEUP for conversion costs.If materials are added evenly throughout the process, the EUPs for materials and conversion costs are the same.If materials are added when the process is 50% complete as to conversion costs and ending WIP is only 40% complete, then 0% of the materials have been added to the units in ending WIP. But if ending WIP is 60% complete, then 100% of the materials have been added to ending WIP.2010 CMA Part 1 Section C Cost Management #4. EUP Calculation - FIFOUnder FIFO, calculating EUPs involves three steps:EUP needed to complete beginning WIP1+Number of units started and completed+EUP needed to start ending WIP2=EUP under the FIFO method

1 the number of units in beginning inventory (1 - % complete)2 the number of units in ending inventory (% complete)

Remember that this needs to be done for both materials and conversion costs. 2010 CMA Part 1 Section C Cost Management #4. EUP Calculation FIFO MaterialsIf the materials are added at the beginning of the process, the EUPs for materials will be equal to the number of units started during the period.

If the materials are added at the end of the process, the EUPs for materials will be equal to the number of units that were completed during the period (WIP completed + units started and completed). There will be no EUPs in materials in ending WIP inventory, since those units have not reached the end of the process yet.2010 CMA Part 1 Section C Cost Management #4. EUP Calculation Weighted AverageUnder the Weighted Average method, the calculation of EUPs involves two steps:Number of units completed during the period+EUPs needed to start ending WIP1=EUPs under the Weighted Average method

1 the number of units in ending inventory (% complete)2010 CMA Part 1 Section C Cost Management #4. EUP Calculation CommentsOver a long period of time, the EUPs under the FIFO method will equal the actual number of units completed.However, over the same period of time, the total EUPs under the weighted average method will be larger than the actual number of units completed.This is because under the weighted average method, the EUPs in ending inventory each period are included in the next periods calculation.For the same period, EUPs under the Weighted Average method will never be lower than EUPs under FIFO.If there is no beginning inventory they will be equal.2010 CMA Part 1 Section C Cost Management #5. Calculation of Costs IncurredLike the calculation of EUPs, the costs that are included in the process for the period depends on the method used.Under FIFO, the costs that are included are only the costs that were actually incurred during the period.Under the Weighted Average method, there are two costs to be included:The costs actually incurred during the period, andThe costs that were associated with the units in beginning inventory.2010 CMA Part 1 Section C Cost Management #6. Cost per EUPTo calculate the cost per equivalent unit, we simply need to divide the costs for the period by the number of equivalent units:Cost for the Period (step #5)Number of Equivalent Units (step #4)2010 CMA Part 1 Section C Cost Management #7. Allocation of Costs to the ProductsOnce the cost per EUP is known, it is simply a process of multiplying the number of equivalent units in Ending WIP by the cost per EUP.This calculation needs to be done for both materials and conversion costsHowever, when FIFO is used, do not forget to include the costs of BWIP along with the allocated costs in the costs that are transferred out, either to finished goods or to the next department.2010 CMA Part 1 Section C Cost Management #Spoilage in Process CostingSpoiled units are units that are in some way defective and not able to be transferred to the next department.Spoiled units are included in the calculation of EUPs, and the cost per EUP.Costs are then assigned to the spoiled units based on the number of EUPs that were in the spoiled units.The way the costs allocated to the spoiled units will be treated depends upon the type of spoilage for the particular units that were spoiled whether it is normal or abnormal spoilage.2010 CMA Part 1 Section C Cost Management #Treatment of Costs of Spoiled UnitsThere are two classifications of spoiled units:Normal spoilage these are the units that are expected to spoiled in the production process. The costs assigned to normal spoilage are transferred to the next department as part of the costs of the good units produced.Abnormal spoilage these are the spoiled units that are in excess of the level of normal spoilage. The costs assigned to abnormal spoilage are expensed on the income statement.2010 CMA Part 1 Section C Cost Management #Additional Classifications of SpoilageBelow are additional terms similar to spoilage:Shrinkage occurs when a product evaporates or losses some quantity over time. We account for it like spoilage: if it is normal it is charged to good units produced. If it is abnormal it is charged to the income statement.Rework occurs when spoiled goods are fixed and prepared for sale. The costs incurred in rework of normally spoiled goods should be charged to the factory overhead account and allocated to all good units as part of factory overhead. Costs incurred in rework of abnormally spoiled units should be expensed.Waste is the material that is left over after production is complete. It is simply unused and is now unusable materials.

2010 CMA Part 1 Section C Cost Management #Overhead Allocation 2010 CMA Part 1 Section C Cost Management #Introduction to OverheadsThere are two broad classifications of overheadsManufacturing overheads are necessary for the production of the goods or services of the company.Nonmanufacturing overheads are not associated with the production process. These are essentially the period costs of the company that may be expensed as corporate costs or allocated to the production departments.2010 CMA Part 1 Section C Cost Management #Manufacturing Overhead AllocationBecause there is no direct connection between the production of a unit and the incurrence of these costs, the manufacturing overhead costs of the company must be allocated to the units that are produced.No matter what method is being used to do the allocation, you must remember that we are simply taking all of the overhead costs and somehow dividing them amongst the units that were produced during the period.2010 CMA Part 1 Section C Cost Management #Manufacturing Overhead Allocation continuedThe categories of costs included in manufacturing overhead are:Indirect materials - materials not identifiable with a specific product or job, such as cleaning supplies, disposable tools, etc.,Indirect labor - wages not directly attributable to production, such as the plant superintendent, janitorial services, andGeneral manufacturing overheads - factory rent, electricity and utilities.Overheads may be either fixed, variable, or mixed costs.Fixed overheads are costs that do not change in total over the relevant range of activity or production.Variable overheads are costs that change in total as the level of production changes.2010 CMA Part 1 Section C Cost Management #Traditional Allocation MethodUnder the traditional method, the overhead costs are allocated to individual products based on one allocation basis.The allocation basis is the measure that will be used to divide the costs amongst the units.Examples are direct labor hours, machine hours, kilograms, componentsThe measure is called the activity base or allocation basis.At the start of the period, the company determines an allocation rate based on the allocation basis.2010 CMA Part 1 Section C Cost Management #Determining the Allocation BasisThe basis that the company uses should be one that reflects the production costs and the way overhead costs are actually incurred.If the company has a very automated process, machine hours may be the allocation base.If the production process requires a lot of manual labor, direct labor hours may be the best allocation base.If the different products produced vary significantly in the number of components that go into them, number of component parts may be the best base.Usually a company will divide their overhead into groups (or pools) and have a different basis for each pool, but under the traditional method, there is only one allocation base for each pool.2010 CMA Part 1 Section C Cost Management #Predetermined RateAn estimated rate needs to be used during the period so that the company will know how much it costs them to produce their product so that they can set the appropriate price.Though this is only an estimate, if the allocation is done reasonably, the estimate will be very close to the actual costs.This predetermined rate will be used throughout the period to allocate overhead to the units that are produced. Any differences between the estimates used and the actual costs will be adjusted for at the end of the period.2010 CMA Part 1 Section C Cost Management #Calculating the Predetermined RateThe predetermined overhead rate is calculated as follows:Budgeted Dollar Amount of Manufacturing OverheadBudgeted Activity Level of the Allocation Base

Both of these amounts are estimates that are made at the beginning of the period.These budgeted amounts come from the financial budget.The budgeted activity level is also called the denominator level.2010 CMA Part 1 Section C Cost Management #Determining the Level of Activity to UseMore difficult than the estimated costs, the company must carefully determine the estimated level of activity.If the company is too optimistic and estimates that they will produce a large number of units, the predetermined rate will be incorrectly low per unit and their selling price will be too low. They will sell a lot of units, but not make much money.If the company is too pessimistic and estimates that they will produce a small number of units, the predetermined rate will be incorrectly high per unit and their price will be too high. They will not sell many units, but will make a lot of money on each unit they sell.2010 CMA Part 1 Section C Cost Management #Determining the Level of Activity contdFour options for the activity level to use in calculating the predetermined manufacturing overhead allocation rate:Theoretical, or ideal, capacity the level if the company produces at its most efficient level.Practical, or currently attainable, capacity the theoretical level reduced for idle and downtime.Expected actual capacity, or master budget capacity the level actually expected during the next budget period based on actual demand.Normal capacity the average level that will be achieved over 2-3 years, including seasonal and cyclical changes.2010 CMA Part 1 Section C Cost Management #Determining the Level of Activity contdAt the end of the accounting period, variances that result from differences between the actual overhead incurred and the overhead applied must be resolved as part of the closing activities. Three ways this can be done:Prorated among ending work in process, ending finished goods, and cost of goods sold for the period, or 100% closed out to cost of goods sold, or Less commonly, all amounts restated using actual cost allocation rates rather than the budgeted cost application rates.2010 CMA Part 1 Section C Cost Management #Determining the Level of Activity contdIf 100% of the variances are closed out to cost of goods sold, the use of master budget capacity or normal capacity will lead to the highest net income of these choices. If variances are prorated among inventories and cost of goods sold or if the amounts are restated using actual rates, the choice of the denominator level for allocating manufacturing costs during the period will have no effect on the end-of-period financial statements.2010 CMA Part 1 Section C Cost Management #Allocating the Costs to the UnitsOnce the predetermined rate has been calculated, the process of allocating overhead to the units is relatively simple.This is done by multiplying the predetermined rate by a given number of units of the allocation basis that were either actually used or that were supposed to be used in the production of each unit.There are 3 different ways of determining how many units of the allocation base were used in each unit, i.e. 3 different costing systems.2010 CMA Part 1 Section C Cost Management #Types of Costing SystemThe amount of manufacturing overhead allocated to each unit of product depends upon the costing system that the company uses. Standard costing system predetermined overhead rate is multiplied by the standard number of the allocation base that should be used in producing one unit of product.Normal or extended normal costing system predetermined overhead rate is multiplied by the actual number of the allocation base that was used in producing one unit of product.Actual costing system actual manufacturing overhead costs are allocated to the units. This costing system does not use predetermined rates.2010 CMA Part 1 Section C Cost Management #Comparison of the Three Costing SystemsThe following points should be noted when comparing the three costing systems:All three costing systems record the cost of inventory based on actual output.Direct labor and direct materials are treated the same under normal and actual costing.Normal and standard costing use the same overhead rate.Standard costing is typically used with a flexible budget system. Standard costing is based on the inputs (i.e., direct materials, direct labor and factory overhead) that should have been used for the actual output produced.

2010 CMA Part 1 Section C Cost Management #The Process of Accounting for OverheadWhen monies are actually spent for overheads, the journal entry isDr Factory overhead controlXCr Cash (or accounts payable)X

When the overhead is allocated, the journal entry isDr Work-in-process inventoryXCr Factory overhead control X2010 CMA Part 1 Section C Cost Management #Over and Underapplied OverheadThe factory overhead control account has actual amounts going into it (debits) and budgeted amounts coming out and being applied to production (credits).The difference between these two amounts is the amount of overhead that was underapplied or overapplied.A debit ending balance in the factory overhead control account means overhead was underapplied (credits were less than debits).A credit ending balance in the factory overhead control account means overhead was overapplied. (credits were greater than debits).2010 CMA Part 1 Section C Cost Management #Over and Underapplied Overhead contdThis is the difference between the amount of overhead applied and the actual costs incurred.The formula to determine this isActual costs incurred Factory overhead applied during the period= Under (over) applied factory overheadIf it is immaterial, the difference can be cleared to cost of goods sold.If it is material, it should be allocated to work-in-process, finished goods and cost of goods sold.2010 CMA Part 1 Section C Cost Management #Multiple Allocation BasesIt is very unlikely that there will be one allocation basis for a company that will accurately reflect how overhead is incurred.Therefore, most companies will use multiple allocation bases.When there are multiple allocation bases, the process of allocating overhead is exactly the same as we have done it will just be done a number of times.Activity-based costing (covered next) is an example of the use of multiple allocation bases.2010 CMA Part 1 Section C Cost Management #Activity Based Costing (ABC)In ABC the allocation bases that are used are determined by looking at what are the activities that cause costs to be incurred (called cost drivers). Examples of these activities are:Moving the goods from one point in the factory to another.A machine breaking.Performing a quality inspection.The costs that are associated with each of these activities are allocated to that activity and a rate (cost) per activity is calculated in the same way as the predetermined rate was calculated earlier.2010 CMA Part 1 Section C Cost Management #Activity-Based Costing (ABC) contdABC allocates indirect and fixed costs to individual products or product lines based on the value-added activities that go into each product.ABC provides an appropriate allocation of indirect costs and overhead, compared to traditional volume-based cost driven systems which understate the costs per unit of products with low sales volumes or high degrees of complexity.ABC is most useful when overhead accounts for the majority of manufacturing costs.ABC is frequently used with TOC production planning.2010 CMA Part 1 Section C Cost Management #Non-value Adding ActivitiesAfter all of the activities that cause costs to be incurred are identified, they can be divided into two categories:Value adding activities add value to the end product that a customer is willing to pay for.Non-value adding activities cause costs to be incurred but do not provide anything of value that the customer would be willing to pay for.Non-value adding activities should be reduced and eliminated if possible because this will reduce costs without the company having to reduce the selling price (since it has not reduced the value of the product by reducing or eliminating them).2010 CMA Part 1 Section C Cost Management #Categories of ActivitiesAnother breakdown of the activities is based on how specific the activity is to a specific unit or to the factory as a whole:Unit-level activities are performed for each unit produced examples, hours of work or inspection.Batch-level activities occur each time a batch is produced examples, machine setup, purchasing, scheduling, materials handling and batch inspection.Product-sustaining activities are incurred in order to support the production of a different product from what is currently produced examples, product design, engineering changes.Facility-sustaining activities are incurred to support production in general examples, security, maintenance, plant management and depreciation of the factory.2010 CMA Part 1 Section C Cost Management #Advantages and Disadvantages of ABCSome of the advantages of ABC are:ABC provides a more accurate product cost, which is useful in pricing and strategic decisions.By identifying the activities that cause costs to be incurred, ABC enables management to identify activities that do not add value to the final product.Some of the disadvantages of ABC are:Not everything can be allocated strictly on a cost driver basis. This is particularly true in respect to facility-sustaining costs.It is expensive and time consuming to implement and maintain.2010 CMA Part 1 Section C Cost Management #ABC QuestionsA common form of question is to require you to calculate the cost per unit under a traditional method and under ABC.You need to remember that ABC is exactly the same as the traditional method in the way you calculate your answer. What is different is that under ABC you will need to do the mathematical process 3 or 4 times instead of just once.Therefore, the key to an ABC problem is to go slowly and carefully and not to rush through the calculations, as a mistake in any one of the calculations will give you an incorrect answer.2010 CMA Part 1 Section C Cost Management #Job-Order CostingJob-order costing is used when each item the company produces is unique and identifiable from all others. Examples of companies that use job-order costing are:Audit firms, law firms, ship-building companies, and companies that produce something that is large and/or hand-made, such as a custom furniture maker.A job-order costing question is no different from a standard overhead allocation question.This is because direct materials and labor are assigned directly to each project. But, in order to price properly, the company must allocate overhead to each project.2010 CMA Part 1 Section C Cost Management #Life-Cycle CostingIn life-cycle costing a company does not determine the production cost in the short-term sense of the production of one unit. The company takes a much longer view to the cost of production and attempts to allocate all of the research and development, marketing, development, after-sale service costs and any other cost that is associated with this product during its entire life cycle. This longer-term view is of particular importance when the product has significant R&D costs (or other nonproduction costs such as after sale service costs). For the product to be profitable over its life, these costs also need to be covered by the sales revenue. 2010 CMA Part 1 Section C Cost Management #Life-Cycle Costing contdLife-cycle costing is different versus costing methods because it treats pre-production and after-sale costs as product costs. Other methods treat these costs as period expenses that are expensed as incurred.Under other methods, these pre-production and after-sale costs are not taken into account to determine the profitability of a product or product line.All of the costs in the life cycle of the company can be broken down into three categories:Upstream costs (before production)Manufacturing costsDownstream costs (after production)2010 CMA Part 1 Section C Cost Management #Service Cost AllocationIf a company chooses to allocate the costs of one service department (accounting, finance, etc) to multiple users, there are two methods that can be used to allocate the costs:Single-rate method: does not separate fixed costs of the service department from the variable costs. All costs It puts all of the costs into one cost pool and allocates the costs using one rate per unit of single allocation base.Dual-rate method: breaks the cost of each service department into two pools, a variable cost pool and a fixed cost pool. It allocates each cost pool using a different cost allocation base.2010 CMA Part 1 Section C Cost Management #Service Cost Allocation contdIf a company chooses to allocate the costs of multiple service departments (accounting, finance, general administration) there are three methods that can be used to allocate the costs to the production departments:Direct method,Step methodReciprocal method.The differences among these methods is how they treat the services that are provided from one service department to the other service departments.2010 CMA Part 1 Section C Cost Management #The Direct MethodUnder the Direct method, we ignore any services that are provided between the service departments.The costs of the service departments are allocated directly and only to the production departments.No service costs are allocated to other service departments.The costs of the different service departments may be allocated to the production departments using different allocation bases.The cafeteria costs may be allocated based on number of people.The advertising department costs may be allocated based on level of sales.2010 CMA Part 1 Section C Cost Management #The Step MethodUnder the Step method, we take into account some of the services that are provided to other service departments. There must be an order in which we allocate the costs of the service departments. A popular way (but not the only way) is to determine the order according to the percentage of each departments services that are provided to other service departments.The department that provides the highest percentage of its services to other service departments is allocated first.The costs of this service department are allocated to the other service departments and the production departments2010 CMA Part 1 Section C Cost Management #The Step Method contdThe costs of the service department that provides the second highest % of its services to other service departments are then allocated to the remaining service departments and the production departments.The costs that are allocated for the second department include the second service departments share of the costs allocated to it by the first service department.No costs are allocated back to the first service department.Once a service department has had its costs allocated, no costs will be allocated to it from other service departments.2010 CMA Part 1 Section C Cost Management #The Reciprocal MethodUnder the Reciprocal method, we recognize all of the services that are provided to the other service departments.This process uses multiple equations, with one equation for each service department.When the equations are solved, the answer is the amount of money that needs to be allocated to all of the other departments, including the other service departments.The reciprocal method is the most theoretically correct method to use. However, a company will need to balance the additional costs required in doing this against the benefits that are received. 2010 CMA Part 1 Section C Cost Management #Estimating Fixed CostsSometimes costs are mixed costs or the fixed costs are not segregated from the variable costs in the historical information available. When we need to separate fixed costs from variable costs for analysis, budgeting or costing purposes, there are two methods that can be used: The High-Low points methodRegression Analysis

2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics85Estimating Fixed Costs ContdThe high-low points method uses the highest and lowest values of the cost driver within the range of values. The steps to calculate the fixed costs are:Calculate the Variable Cost Per Unit: divide the difference between the highest and lowest costs by the difference between the highest and lowest production volumes:

Difference in Costs/Difference in Units = Variable Cost per Unit

Multiply the variable cost per unit by the unit volume at either the highest or lowest production level to get the total variable cost at that level.Subtract the total variable cost from the total cost at that level to get the fixed cost.

2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics86Estimating Fixed Costs ContdSimple regression analysis can be used to find the fixed cost and the variable cost per unit when you have:an independent variable such as production in unitsa dependent variable such as total production costs.the relationship between the two variables is consistentrefer to the forecasting section of the text book for further details regarding regression analysis

2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics87Operational Efficiency 2010 CMA Part 1 Section C Cost Management #Just-In Time SystemsJust-in-time (JIT) inventory systems are based on a manufacturing philosophy that combines purchasing, production and inventory control into one function. This reduces the level of inventory that is held within the company at all stages of production, and lowers the cost of carrying the inventory. The main idea of JIT is that nothing is produced until the next process in the assembly line needs it. JIT is a pull system rather than a push system. Since nothing is produced until it is needed, nothing is produced until a customer orders it. 2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics89Implementing JITTo implement the JIT approach and minimize inventory storage, the factory must be reorganized to permit what is known as lean productionEach worker knows how to operate all machines and can perform supporting tasks within that cell, which lessens downtime resulting from breakdowns or employee absences.

2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics90Implementing JIT contdBecause inventory levels are kept low in a JIT system, the company must have a relationship with its suppliers to make certain that they make frequent deliveries of smaller amounts of inventory. It is also critical that inventory be of the required quality, because there are no extras to use in place of defective units. Although a cost reduction strategy focused on the elimination of waste is universally applicable, JIT implementation is not appropriate for high-mix manufacturing environments, which often have thousands of products and dozens of work centers. 2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics91KanbanKanban, a Japanese term for visual record, is a simple parts movement system or an inventory system in which cards or tickets are used to keep track of inventory and its movement. Originally developed at Toyota in the 1960s, Kanban is part of a JIT system and its purpose is to manage the flow on a manufacturing assembly line. At the core of the Kanban concept is that the supplier delivers components to the production line on an as needed basis, signaled by receipt of a card and empty container, eliminating storage in the production area. 2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics92Kanban contdThis is a chain process where orders flow from one process to another, so production of components is pulled to the production line, rather than the pushed (as is done in the traditional forecast-oriented system).It should be mentioned that Kanban can go beyond being a simple JIT technique because it can also support industrial reengineering and HR management. 2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics93Materials Requirements Planning (MRP)MRP is an approach that uses computer software to help manage a manufacturing process. It is a system for ordering and scheduling of dependent demand inventories.Dependent demand is demand for items that are components, or subassemblies, used in the production of a finished good. The demand for them is dependent upon the demand for the finished good.MRP is a push inventory management system. Finished goods are manufactured for inventory on the basis of demand forecasts. MRP makes it possible to have the needed materials available when they are needed and where they are needed. 2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics94MRP contdWhen demand forecasts are made by the sales group, the MRP software breaks out the finished products to be produced into the required components and determines total quantities to be ordered of each component. It is also determined when each component should be ordered, based upon information about inventory of each component already on hand, vendor lead times and other parameters that are input into the software.Once the quantities and the timing have been worked out, the required cash to pay for the parts can be planned for. MRP can be used to reduce cash needed by the organization, which in turn improves profitability and ROI. 2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics95MRP CalculationsMRP uses the following information in order to determine what outputs will be necessary at each stage of production and when to place orders for each needed component:Demand forecasts for finished goods;A Bill of Materials for each finished product. The Bill of Materials gives all the materials, components, and subassemblies that are required for the product;The quantities of the materials, components, and finished products inventory presently on hand.Although MRP is done by computers, it is important to know how the software does its work in order to be certain that the output from the MRP software is correct and to troubleshoot problems.2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics96OutsourcingWhen a company outsources, an external company performs one or some of its internal functions. By outsourcing certain functions to a specialist, management can free up resources within the company in order to focus on the primary operations of the company. It may also be cheaper to outsource a function to a company that specializes in an area than it is to run and support that function internally. The disadvantage of outsourcing is that the company loses direct control over these functions. 2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics97Theory of ConstraintsTheory of Constraints says that there are only a few areas in which changes in one units performance will bring about a meaningful change in overall profitability. Those areas where changes can impact overall profitability are called constraints. If you want to improve profitability, you need to identify the constraints and focus on them. Theory of Constraints focuses on local measurements that are linked directly to performance measures such as net profit, return on investment, and cash flow. A technique that improves speed in manufacturing by increasing throughput contribution, decreasing investments and decreasing operating costs.2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics98TOC Terms and ConceptsSome important concepts in TOC are listed below: Throughput is product produced and shipped. Throughput time is the time that elapses between the receipt of a customers order and the shipment of the order. Throughput contribution is revenue minus totally variable (i.e., direct materials) cost for a given period of time.The rate at which contribution dollars are being earned the amount earned for product produced and shipped during one hour, one day, one month, etc. Theory of Constraints assumes that operating costs are fixed costs because it regards them as difficult to change in the short run.

2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics99TOC Terms and Concepts contdSome important concepts in TOC are listed below (contd): Operating costs are equal to all operating costs other than direct materials or any other strictly variable costs incurred to earn throughput contribution margin. Operating costs include salaries and wages, rent, utilities, and depreciation.Inventory costs are limited to costs that are strictly variable, called super-variable and these are usually only direct materials. All other costs, even direct labor, are considered operating, or fixed, costs.Investments equal the sum of costs in direct materials, work-in-process and finished goods inventories, R&D, and costs of equipment and buildings. 2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics100Bottlenecks and Drum-Buffer-Rope SystemsThe application of TOC to production is called Drum-Buffer-Rope.The bottleneck is the part of the process that has the smallest amount of capacity relative to its load and is therefore the slowest part. The Drum-Buffer-Rope system is used to resolve the conflict between having enough work in the system to make sure the bottleneck keeps running while at the same time limiting the amount of work-in-process inventory buildup.2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics101The Drum-Buffer-Rope SystemIn DBR terminology, the drum is the bottleneck or the constraint, because it provides the beat that the entire operation must march to. In order to protect the throughput of the entire factory, the bottleneck, or drum, must be protected from running out of material to process. The buffer is a minimum level of work-in-process inventory provided as protection against delays that would delay the drum. The buffer protects the drum resource from problems that might occur upstream that might delay materials from reaching the drum.

2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics102The Drum-Buffer-Rope System contdThe rope is the schedule for releasing materials to the floor to begin processing, so that they will reach the drum at just the right time. The rope limits the amount of inventory in the system. Material is released only at the rate that the drum can consume, and the rope keeps it from being released too soon. 2010 CMA Part 1 Section C Cost Management #Managing the Bottleneck in TOCThe steps that can followed to manage the bottleneck are:Recognize that the bottleneck operation determines throughput contribution of the system as a whole, and identify the bottleneck by determining where requirements exceed availability.Calculate the best use of the bottleneck to maximize contribution. Maximize the flow through the bottleneck by using the drum-buffer-rope (DBR) system.Increase the production capabilities of the bottleneck by adding capacity.Analyze the system to see if there are improvements to make through redesigning or reordering.2010 CMA Part 1 Section C Cost Management #Revised CMA Part 1Section AMicroeconomics104Business Process Performance 2010 CMA Part 1 Section C Cost Management #The Value ChainThe value chain describes the companys chain of activities for transforming inputs into the outputs that customers value.Primary activities (business functions) that add value to a product or service are:R & DProductionMarketing, Sales and DistributionCustomer ServiceSupport activities are:InfrastructureInformation SystemsMaterials ManagementHuman Resources2010 CMA Part 1 Section C Cost Management #Value Chain AnalysisValue chain analysis helps an organization gain competitive advantage by identifying what activities add value to customers.The organization can increase the related benefits of value-added activities and reduce non-value added activities.Three steps in value chain analysis:Identify activities that add value to the end product.Identify the cost driver(s) for each activity.Build competitive advantage by either increasing value to the customer or reducing the costs of production.2010 CMA Part 1 Section C Cost Management #Business Process ReengineeringManagement disassembles its business processes and, starting from scratch, redesigns its entire processes to achieve company objectives. The steps in business process reengineering are:The organization identifies what it does better than the competition. These are its distinctive competencies. By identifying them, the organization understands what activities are vital to its success.Management determines what processes it uses in its efforts to generate a product or service that have value. Thereafter management is enabled to determine the degree of value for each process. This effort can uncover low value processes to discard.2010 CMA Part 1 Section C Cost Management #Benchmarking Process PerformanceOne of the best ways to achieve superior performance and competitive advantages for a firm is to identify and adopt best practices. This can be done through benchmarking.Benchmarking is the process of measuring the organization against the products, practices and services of its most efficient global competitors. This process involves continuously striving to imitate the performance of the best companies in the world. By meeting these higher standards, the organization is able to create a competitive advantage over its competitors.

2010 CMA Part 1 Section C Cost Management #Benchmarking Process Performance ContdThe steps to follow to benchmark a companys business processes are:Identify the critical success factors for the business and the processes to benchmark. Critical success factors are the aspects of the companys business that are essential to its competitive advantage.Set up a team to do best practice analysis and document the best practices for the processes that are used in performing the firms critical success factor activities. The team will need to identify what areas need improvement and how they will accomplish this improvement by utilizing the experience of the benchmarked company.

2010 CMA Part 1 Section C Cost Management #Activity Based Management (ABM)Activity-based management is a means of performing value chain analysis and business process engineering. Activity-based management uses activity analysis and activity-based costing data to improve the value of the companys products and services.Activity-based management is divided into operational ABM and strategic ABM.Operational ABM uses ABC data to improve efficiency. Strategic ABM uses ABC data to make strategic decisions about what products or services to offer and what activities to use to provide those products and services. 2010 CMA Part 1 Section C Cost Management #KaizenThe term Kaizen is a Japanese work that means improvement. As used in business, it implies continuous improvement, or slow but consistent incremental improvements in all areas of operations. Kaizen says that improvement is always possible. The goal is to attain the ideal standard, even when practical standards are being attained. Implementing ideal standards and quality improvements is the heart of the kaizen concept. Kaizen challenges people to imagine the ideal condition and strive to make the necessary improvements to achieve that ideal. . 2010 CMA Part 1 Section C Cost Management #The Costs of QualityThere are two main difference in the classifications of the costs of quality.Each of these two classifications can be broken down into two further classifications of the cost of quality.Cost of ConformancePrevention CostsAppraisal CostsCosts of NonconformanceInternal FailureExternal Failure2010 CMA Part 1 Section C Cost Management #Costs of ConformanceThese are the costs of making sure that the unit is produced properly and according to all design specifications.Prevention costs are the costs of trying to prevent a defect from occurring. Include quality training and planning costs, equipment maintenance costs, supplier training and confirmation costs, and information systems costs.Appraisal costs are the costs of assessing whether a unit was produced properly or not. Include testing and inspections, quality audits and internal quality programs.2010 CMA Part 1 Section C Cost Management #Costs of NonconformanceThese are the costs that are incurred after a defective unit has been produced. These costs are further classified based on who finds the defect the company or the customer.Internal failure costs are the costs of fixing the defect when the defect is discovered by the company. Include rework, scrap, tooling and downtime and expediting costs.External failure costs are the costs of fixing the defects when the defect is discovered by the customer. Include warranty costs, product liability costs, the loss of customer goodwill and, potentially, environmental costs.2010 CMA Part 1 Section C Cost Management #Opportunity Cost of QualityThere may also be a large cost associated with not producing a product of quality.Money and time must be spent fixing the initial product,More customer service is necessary after the sale to fix defective products. These resources could be used elsewhere in the company.Customers are less likely to repurchase from the company, andCustomers are less likely to recommend the company.2010 CMA Part 1 Section C Cost Management #Quality of DesignQuality of design refers to how well a product or service meets the needs and wants of its customers. If there is a demand for a particular feature on a product, or a particular service, and a manufacturer or service company is supplying its product without that feature, there is a problem. Not providing what the customer wants is a quality-of-design failure.2010 CMA Part 1 Section C Cost Management #Total Quality Management (TQM)Total Quality Management (TQM) an approach committed to customer satisfaction and continuous improvement.TQMs goals are to both reduce costs and improve quality.Objectives of TQM:Enhanced and consistent quality of the product or serviceTimely and consistent responses to customer needsElimination of non-value adding work or processes to lower costsQuick adaptation and flexibility in response to customers shifting requirements.2010 CMA Part 1 Section C Cost Management #Core Principles of TQMCertain core principles, or critical factors, are common to all TQM systems:They have the support and active involvement of top management. They have clear and measurable objectives. They recognize quality achievements in a timely manner. They continuously provide training in TQM. They strive for continuous improvement (Kaizen). They focus on satisfying their customers expectations and requirements. They involve all employees.2010 CMA Part 1 Section C Cost Management #TQM is Not a Short-Term ProjectTQM is something that requires the commitment of top management and implementation throughout an organization.Part of this pursuit of excellence is a focus on continuing education. Employees at all levels participate regularly in continuing education and training in order to promote and maintain a culture of quality.In TQM, the role of quality manager is not limited to a special department; instead, every person in the organization is responsible for finding errors and correcting any problems as soon as possible. 2010 CMA Part 1 Section C Cost Management #Methods of Analyzing Quality ProblemsControl chart records observations of an operation taken at regular intervals. The sample is used to determine whether all the observations fall within the specified range to determine whether the process is in statistical control or out of control.Histogram a bar graph that represents the frequency of events in a set of data to help see patterns in it.Pareto diagram a type of histogram illustrating the Pareto Principle: 20% of the causes account for 80% of the problems.2010 CMA Part 1 Section C Cost Management #Methods of Analyzing Quality Problems contdCause-and-effect diagram, or Ishikawa diagram organizes causes and effects visually to sort out root causes and identify relationships between causes.2010 CMA Part 1 Section C Cost Management #TQM and Activity Based CostingA TQM system is most compatible with an Activity Based Costing (ABC) system.An ABC system identifies costs with activities and makes the costs of quality, such as costs to correct poor quality, more apparent.If an ABC system is in place, most of the cost information needed for TQM is already being captured.A company that uses ABC will continuously identify non-value added activities that can be reduced or eliminated and ensure that necessary activities value added activities are carried out efficiently.2010 CMA Part 1 Section C Cost Management #Quality Management and ProductivityWhile it may seem that producing a quality product is more difficult and time consuming, in fact, companies that focus on quality are more productive than other companies.This is because the company will have:A reduction in the number of defective units. This in turn reduces the amount of time, material and effort wasted on unusable output as well as time spent fixing salvageable defective units. A more efficient manufacturing process. A commitment to doing it right the first time. 2010 CMA Part 1 Section C Cost Management #