Managerial Accounting and Cost Concepts

Managerial Accounting and Cost Concepts Chapter 01 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Classifications of Manufacturing Costs Direct Materials Direct Labor Manufacturing Overhead The Product 1-2 Direct Materials Raw materials that become an integral part of the product and that can be conveniently traced directly to it. Example: A radio installed in an automobile 1-3 Direct Labor Those labor costs that can be easily traced to individual units of product. Example: Wages paid to automobile assembly workers 1-4 Manufacturing Overhead Manufacturing costs that cannot be easily traced directly to specific units produced. Examples: Indirect materials and indirect labor Materials used to support the production process. Examples: lubricants and cleaning supplies used in the automobile assembly plant. Wages paid to employees who are not directly involved in production work. Examples: maintenance workers, janitors, and security guards. 1-5 Nonmanufacturing Costs Selling Costs Administrative Costs Costs necessary to secure the order and deliver the product. All executive, organizational, and clerical costs. 1-6 Product Costs Versus Period Costs Product costs include direct materials, direct labor, and manufacturing overhead. Inventory Period costs include all selling costs and administrative costs. Cost of Good Sold Expense Income Statement Income Statement Sale Balance Sheet 1-7 Classifications of Costs Manufacturing costs are often classified as follows: Direct Material Direct Labor Prime Cost Manufacturing Overhead Conversion Cost 1-8 Cost Classifications for Predicting Cost Behavior Cost behavior refers to how a cost will react to changes in the level of activity. The most common classifications are: ▫ Variable costs ▫ Fixed costs ▫ Mixed costs 1-9 Variable Cost Total Texting Bill Your total texting bill is based on how many texts you send. Number of Texts Sent 1-10 Variable Cost Per Unit Cost Per Text Sent The cost per text sent is constant at 5 cents per text message. Number of Texts Sent 1-11 The Activity Base (Cost Driver) Machinehours Units produced A measure of what causes the incurrence of a variable cost Miles driven Laborhours 1-12 Fixed Cost Monthly Cell Phone Contract Fee Your monthly contract fee for your cell phone is fixed for the number of monthly minutes in your contract. The monthly contract fee does not change based on the number of calls you make. Number of Minutes Used Within Monthly Plan 1-13 Fixed Cost Per Unit Monthly Cell Phone Contract Fee Within the monthly contract allotment, the average fixed cost per cell phone call made decreases as more calls are made. Number of Minutes Used Within Monthly Plan 1-14 Types of Fixed Costs Committed Discretionary Long term, cannot be significantly reduced in the short term. May be altered in the short term by current managerial decisions Examples Examples Depreciation on Buildings and Equipment and Real Estate Taxes Advertising and Research and Development 1-15 The Linearity Assumption and the Relevant Range Total Cost Economist’s Curvilinear Cost Function Relevant Range A straight line closely approximates a curvilinear variable cost line within the relevant range. Accountant’s Straight-Line Approximation (constant unit variable cost) Activity 1-16 Fixed Costs and the Relevant Range For example, assume office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet. Fixed costs would increase in a step fashion at a rate of $30,000 for each additional 1,000 square feet. 1-17 Rent Cost in Thousands of Dollars Fixed Costs and the Relevant Range 90 Relevant 60 Range 30 0 0 The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat. 1,000 2,000 3,000 Rented Area (Square Feet) 1-18 Cost Classifications for Predicting Cost Behavior Behavior of Cost (within the relevant range) Cost In Total Per Unit Variable Total variable cost Increase and decrease in proportion to changes in the activity level. Variable cost per unit remains constant. Fixed Total fixed cost is not affected by changes in the activity level within the relevant range. Fixed cost per unit decreases as the activity level rises and increases as the activity level falls. 1-19 Mixed Costs (also called semivariable costs) A mixed cost contains both variable and fixed elements. Consider the example of utility cost. Total Utility Cost Y Variable Cost per KW X Activity (Kilowatt Hours) Fixed Monthly Utility Charge 1-20 Mixed Costs The total mixed cost line can be expressed as an equation: Y = a + bX Where: Y Y a Total Utility Cost b X = The total mixed cost. = The total fixed cost (the vertical intercept of the line). = The variable cost per unit of activity (the slope of the line). = The level of activity. Variable Cost per KW X Activity (Kilowatt Hours) Fixed Monthly Utility Charge 1-21 Mixed Costs – An Example If your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, and your monthly activity level is 2,000 kilowatt hours, what is the amount of your utility bill? Y = a + bX Y = $40 + ($0.03 × 2,000) Y = $100 1-22 Analysis of Mixed Costs Account Analysis and the Engineering Approach In account analysis, each account is classified as either variable or fixed based on the analyst’s knowledge of how the account behaves. The engineering approach classifies costs based upon an industrial engineer’s evaluation of production methods, and material, labor, and overhead requirements. 1-23 Scattergraph Plots – An Example Assume the following hours of maintenance work and the total maintenance costs for six months. 1-24 The Scattergraph Method Plot the data points on a graph (Total Cost Y vs. Activity X). Scattergraph Method Y Total Maintenance Cost $10,000 $9,500 $9,000 $8,500 $8,000 $7,500 X $7,000 400 500 600 700 Hours of Maintenance 800 900 1-25 The High-Low Method – An Example The variable cost per hour of maintenance is equal to the change in cost divided by the change in hours. $2,400 = $6.00/hour 400 1-26 The High-Low Method – An Example Total Fixed Cost = Total Cost – Total Variable Cost Total Fixed Cost = $9,800 – ($6/hour × 850 hours) Total Fixed Cost = $9,800 – $5,100 Total Fixed Cost = $4,700 1-27 The High-Low Method – An Example The Cost Equation for Maintenance Y = $4,700 + $6.00X 1-28 Least-Squares Regression Method A method used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship between the X and Y variables. This method uses all of the data points to estimate the fixed and variable cost components of a mixed cost. The goal of this method is to fit a straight line to the data that minimizes the sum of the squared errors. 1-29 Least-Squares Regression Method Software can be used to fit a regression line through the data points. The cost analysis objective is the same: Y = a + bX Least-squares regression also provides a statistic, called the R2, which is a measure of the goodness of fit of the regression line to the data points. 1-30 Comparing Results From the Two Methods The two methods just discussed provide different estimates of the fixed and variable cost components of a mixed cost. This is to be expected because each method uses differing amounts of the data points to provide estimates. Least-squares regression provides the most accurate estimate because it uses all the data points. 1-31 The Traditional and Contribution Formats Used primarily for external reporting. Used primarily by management. 1-32 Uses of the Contribution Format The contribution income statement format is used as an internal planning and decision-making tool. We will use this approach for: 1.Cost-volume-profit analysis (Chapter 5). 2.Budgeting (Chapter 7). 3.Segmented reporting of profit data (Chapter 6). 4.Special decisions such as pricing and make-orbuy analysis (Chapter 10). 1-33 Assigning Costs to Cost Objects Direct costs Indirect costs • Costs that can be easily and conveniently traced to a unit of product or other cost object. • Costs that cannot be easily and conveniently traced to a unit of product or other cost object. • Examples: direct material and direct labor • Example: manufacturing overhead 1-34 Cost Classifications for Decision Making Every decision involves a choice between at least two alternatives. Only those costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits can and should be ignored as irrelevant. 1-35 Differential Cost and Revenue Costs and revenues that differ among alternatives. Example: You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month. Differential revenue is: $2,000 – $1,500 = $500 Differential cost is: $300 1-36 Opportunity Cost The potential benefit that is given up when one alternative is selected over another. Example: If you were not attending college, you could be earning $15,000 per year. Your opportunity cost of attending college for one year is $15,000. 1-37 Sunk Costs Sunk costs have already been incurred and cannot be changed now or in the future. These costs should be ignored when making decisions. Example: Suppose you had purchased gold for $400 an ounce, but now it is selling for $250 an ounce. Should you wait for the gold to reach $400 an ounce before selling it? You may say, “Yes” even though the $400 purchase is a sunk cost. 1-38 Summary of the Types of Cost Classifications Financial Reporting Predicting Cost Behavior Assigning Costs to Cost Objects Making Business Decisions 1-39 End of Chapter 01 1-40 Job-Order Costing Chapter 02 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Job-Order Costing: An Overview Job-order costing systems are used when: 1.Many different products are produced each period. 2.Products are manufactured to order. 3.The unique nature of each order requires tracing or allocating costs to each job, and maintaining cost records for each job. 2-2 Job-Order Costing: An Overview Examples of companies that would use job-order costing include: 1.Boeing (aircraft manufacturing) 2.Bechtel International (large-scale construction) 3.Walt Disney Studios (movie production) 2-3 Job-Order Costing – An Example Direct Materials Job No. 1 Direct Labor Job No. 2 Job No. 3 Charge direct material and direct labor costs to each job as work is performed. 2-4 Job-Order Costing – An Example Direct Materials Job No. 1 Direct Labor Manufacturing Overhead Job No. 2 Job No. 3 Manufacturing Overhead, including indirect materials and indirect labor, are allocated to all jobs rather than directly traced to each job. 2-5 The Job Cost Sheet PearCo Job Cost Sheet Job Number A – 143 Department B3 Item Wooden cargo crate Date Initiated 3-4-11 Date Completed Units Completed Direct Materials Direct Labor Manufacturing Overhead Req. No. Amount Ticket Hours Amount Hours Rate Amount Cost Summary Direct Materials Direct Labor Manufacturing Overhead Total Cost Unit Product Cost Units Shipped Date Number Balance 2-6 Measuring Direct Materials Cost Will E. Delite 2-7 Measuring Direct Materials Cost 2-8 Measuring Direct Labor Costs 2-9 Job-Order Cost Accounting 2-10 Why Use an Allocation Base? An allocation base, such as direct labor-hours, direct labor dollars, or machine-hours, is used to assign manufacturing overhead to individual jobs. We use an allocation base because: a.It is impossible or difficult to trace overhead costs to particular jobs. b.Manufacturing overhead consists of many different items ranging from the grease used in machines to the production manager’s salary. c.Many types of manufacturing overhead costs are fixed even though output fluctuates during the period. 2-11 Manufacturing Overhead Application The predetermined overhead rate (POHR) used to apply overhead to jobs is determined before the period begins. POHR = Estimated total manufacturing overhead cost for the coming period Estimated total units in the allocation base for the coming period Ideally, the allocation base is a cost driver that causes overhead. 2-12 The Need for a POHR Predetermined overhead rates rely upon estimated data because… Actual overhead for the period is not known until the end of the period. Actual overhead costs can fluctuate seasonally, thus misleading decision makers. 2-13 Computing Predetermined Overhead Rates The predetermined overhead rate is computed before the period begins using a four-step process. 1. Estimate the total amount of the allocation base (the denominator) that will be required for next period’s estimated level of production. 2. Estimate the total fixed manufacturing overhead cost for the coming period and the variable manufacturing overhead cost per unit of the allocation base. 3. Use the following equation to estimate the total amount of manufacturing overhead: Y = a + bX Where, Y = The estimated total manufacturing overhead cost a = The estimated total fixed manufacturing overhead cost b = The estimated variable manufacturing overhead cost per unit of the allocation base X = The estimated total amount of the allocation base. 4. Compute the predetermined overhead rate. 2-14 Overhead Application Rate PearCo estimates that it will require 160,000 direct labor-hours to meet the coming period’s estimated production level. In addition, the company estimates total fixed manufacturing overhead at $200,000, and variable manufacturing overhead costs of $2.75 per direct labor-hour. Y = a + bX Y = $200,000 + ($2.75 per direct labor-hour × 160,000 direct laborhours) Y = $200,000 + $440,000 Y = $640,000 POHR = $640,000 estimated total manufacturing overhead 160,000 estimated direct labor-hours (DLH) POHR = $4.00 per direct labor-hour 2-15 Job-Order Cost Accounting 2-16 Job-Order Cost Accounting 2-17 Job-Order Cost Accounting 2-18 Learning Objectives 4 and 5 Learning Objective 4 is to understand the flow of costs in the job-order costing system and prepare appropriate journal entries to record costs. Learning Objective 5 is to use T-accounts to show the flow of costs in a job-order costing system. 2-19 Key Definitions 1. Raw materials include any materials that go into the final product. 2. Work in process consists of units of production that are only partially complete and will require further work before they are ready for sale to customers. 3. Finished goods consist of completed units of product that have not been sold to customers. 4. Cost of goods manufactured include the manufacturing costs associated with the goods that were finished during the period. 2-20 Flow of Costs: A Conceptual Overview Costs Balance Sheet Inventories Material Purchases Raw Materials Direct Labor Work in Process Manufacturing Overhead Selling and Administrative Finished Goods Period Costs Income Statement Expenses Cost of Goods Sold Selling and Administrative 2-21 Job-Order Costing: The Flow of Costs The transactions (in T-account and journal entry form) that capture the flow of costs in a job-order costing system are illustrated on the following slides. 2-22 The Purchase and Issue of Raw Materials: T-Account Form Raw Materials Material ⚫Direct Purchases Materials ⚫Indirect Materials ⚫ Work in Process (Job Cost Sheet) Direct Materials ⚫ Mfg. Overhead Actual Applied ⚫Indirect Materials 2-23 Cost Flows – Material Purchases On October 1, Smith Corporation had $5,000 in raw materials on hand. During the month, the company purchased $45,000 in raw materials. (1) Raw Materials Accounts Payable 45,000 45,000 2-24 Issue of Direct and Indirect Materials On October 3, Smith had $43,000 in raw materials requisitioned from the storeroom for use in production. These raw materials included $40,000 of direct and $3,000 of indirect materials. (2) Work in Process Manufacturing Overhead Raw Materials 40,000 3,000 43,000 2-25 Labor Costs Salaries and Wages Payable Direct Labor ⚫Indirect Labor ⚫ Work in Process (Job Cost Sheet) Direct Materials ⚫Direct Labor ⚫ Mfg. Overhead Actual ⚫Indirect Materials ⚫Indirect Labor Applied 2-26 Labor Costs During the month the employee time tickets included $35,000 of direct labor and $12,000 for indirect labor. (3) Work in Process Manufacturing Overhead Salaries and Wages Payable 35,000 12,000 47,000 2-27 Recording Actual Manufacturing Overhead Salaries and Wages Payable Direct Labor ⚫Indirect Labor ⚫ Work in Process (Job Cost Sheet) Direct Materials ⚫Direct Labor ⚫ Mfg. Overhead Actual Applied ⚫Indirect Materials ⚫Indirect Labor ⚫Other Overhead 2-28 Recording Actual Manufacturing Overhead During the month the company incurred the following actual overhead costs: 1. Utilities (heat, water, and power) $1,700 2. Depreciation of factory equipment $2,900 3. Property taxes payable on factory $1,000 (4) Manufacturing Overhead Utilities Payable Accumulated Depreciation Property Taxes Payable 5,600 1,700 2,900 1,000 2-29 Applying Manufacturing Overhead Salaries and Wages Payable Direct Labor ⚫Indirect Labor ⚫ Mfg. Overhead Actual Applied ⚫Indirect Materials ⚫Overhead ⚫Indirect Applied to Labor Work in ⚫Other Process Overhead Work in Process (Job Cost Sheet) Direct Materials ⚫Direct Labor ⚫Overhead Applied ⚫ If actual and applied manufacturing overhead are not equal, a year-end adjustment is required. 2-30 Applying Manufacturing Overhead Smith uses a predetermined overhead rate of $3.50 per machine-hour. During the month, 5,000 machine-hours were worked on jobs. (5) Work in Process Manufacturing Overhead 17,500 17,500 (5,000 machine-hours × $3.50 = $17,500) 2-31 Accounting for Nonmanufacturing Cost Nonmanufacturing costs are not assigned to individual jobs, rather they are expensed in the period incurred. Examples: 1. Salary expense of employees who work in a marketing, selling, or administrative capacity. 2. Advertising expenses are expensed in the period incurred. 2-32 Accounting for Nonmanufacturing Cost During the month, Smith incurred but has not paid sales salaries of $2,000, and advertising expense of $750. (6) Salaries Expense Advertising Expense Salaries Payable Accounts Payable 2,000 750 2,000 750 2-33 Transferring Completed Units Work in Process (Job Cost Sheet) Direct Materials ⚫Direct Labor ⚫Overhead Applied ⚫ Finished Goods Cost of Goods Mfd. ⚫ Cost of Goods Mfd. ⚫ 2-34 Transferring Completed Units During the period, Smith completed jobs with a total cost of $27,000. (9) Finished Goods Work in Process 27,000 27,000 2-35 Transferring Units Sold Work in Process (Job Cost Sheet) Direct Materials ⚫Direct Labor ⚫Overhead Applied ⚫ Finished Goods Cost of Goods Mfd. ⚫ Cost of Goods Mfd. ⚫ Cost of Goods Sold ⚫ Cost of Goods Sold Cost of Goods Sold ⚫ 2-36 Transferring Units Sold Smith sold the $27,000 in finished goods inventory to customers for $43,500 on account. (10) Accounts Receivable Sales 43,500 Cost of Goods Sold Finished Goods 27,000 43,500 27,000 2-37 Schedule of Cost of Goods Manufactured: Key Concepts This schedule contains three types of costs, namely direct materials, direct labor, and manufacturing overhead. It calculates the cost of raw material and direct labor used in production and the amount of manufacturing overhead applied to production. It calculates the manufacturing costs associated with goods that were finished during the period. 2-38 Product Cost Flows Raw Materials Beginning raw materials inventory + Raw materials purchased = Raw materials available for use in production – Ending raw materials inventory = Raw materials used in production Manufacturing Costs Work In Process Direct materials As items are removed from raw materials inventory and placed into the production process, they are called direct materials. 2-39 Product Cost Flows Raw Materials Beginning raw materials inventory + Raw materials purchased = Raw materials available for use in production – Ending raw materials inventory = Raw materials used in production Manufacturing Costs Work In Process Direct materials + Direct labor + Mfg. overhead applied = Total manufacturing costs Conversion costs are costs incurred to convert the direct material into a finished product. 2-40 Product Cost Flows Raw Materials Beginning raw materials inventory + Raw materials purchased = Raw materials available for use in production – Ending raw materials inventory = Raw materials used in production Manufacturing Costs Work In Process Direct materials + Direct labor + Mfg. overhead applied = Total manufacturing costs Beginning work in process inventory + Total manufacturing costs = Total work in process for the period All manufacturing costs added to production during the period are added to the beginning balance of work in process. 2-41 Product Cost Flows Raw Materials Manufacturing Costs Beginning raw Direct materials materials inventory + Direct labor + Raw materials + Mfg. overhead applied purchased = Total manufacturing = Raw materials costs available for use in production – Ending raw materials inventory = Raw materials used in production Costs associated with the goods that are completed during the period are transferred to finished goods inventory. Work In Process Beginning work in process inventory + Total manufacturing costs = Total work in process for the period – Ending work in process inventory = Cost of goods manufactured 2-42 Product Cost Flows Work In Process Beginning work in process inventory + Manufacturing costs for the period = Total work in process for the period – Ending work in process inventory = Cost of goods manufactured Finished Goods Beginning finished goods inventory + Cost of goods manufactured = Cost of goods available for sale – Ending finished goods inventory Cost of goods sold 2-43 Underapplied and Overapplied Overhead―A Closer Look The difference between the overhead cost applied to Work in Process and the actual overhead costs of a period is referred to as either underapplied or overapplied overhead. Underapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is less than the total amount of overhead actually incurred during the period. Overapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is greater than the total amount of overhead actually incurred during the period. 2-44 Overhead Application Example PearCo’s actual overhead for the year was $650,000 with a total of 170,000 direct labor-hours worked on jobs. How much total overhead was applied to PearCo’s jobs during the year? Use PearCo’s predetermined overhead rate of $4.00 per direct labor-hour. Overhead Applied During the Period Applied Overhead = POHR × Actual Direct Labor-Hours Applied Overhead = $4.00 per DLH × 170,000 DLH = $680,000 2-45 Overhead Application Example PearCo’s actual overhead for the year was $650,000 with a total of 170,000 direct labor-hours worked on jobs. How much overhead was applied to PearCo’s PearCo hastotal overapplied jobsforduring the year? Use PearCo’s overhead the year overhead rate of $4.00 per direct bypredetermined $30,000. What will PearCo do? labor-hour. Overhead Applied During the Period Applied Overhead = POHR × Actual Direct Labor-Hours Applied Overhead = $4.00 per DLH × 170,000 DLH = $680,000 2-46 Disposition of Under- or Overapplied Overhead PearCo’s Cost of Goods Sold Actual Overhead overhead applied costs to jobs Unadjusted Balance $30,000 Adjusted Balance PearCo’s Mfg. Overhead $650,000 $680,000 $30,000 $30,000 overapplied 2-47 Multiple Predetermined Overhead Rates To this point, we have assumed that there is a single predetermined overhead rate called a plantwide overhead rate. Large companies often use multiple predetermined overhead rates. May be more complex but . . . May be more accurate because it reflects differences across departments. 2-48 Job-Order Costing in Service Companies Job-order costing is used in many different types of service companies. 2-49 End of Chapter 02 2-50 Activity-Based Costing Chapter 03 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Assigning Overhead Costs to Products When cost systems were developed in the 1800s, the emphasis was on simplicity because: 1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil. 2. Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product. 3-2 Plantwide Overhead Rate Plantwide Overhead Rate A single overhead rate used throughout an entire factory. Direct labor has often been used as the allocation base for overhead because: 1. Direct labor information was already being recorded. 2. Direct labor was a large component of product costs. 3. Managers believed direct labor and overhead costs were highly correlated. 3-3 Plantwide Overhead Rate Today, direct labor may no longer be a satisfactory base for allocation of overhead. 1. Most companies sell a large variety of products that consume differing amounts of overhead. 2. As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of these growing overhead costs may not be correlated with direct labor. 3. Technology advancements have reduced the cost and complexity of gathering diverse sources of data. A plantwide overhead allocation system may not be optimal for many companies in today’s business environment. 3-4 Departmental Overhead Rates Many companies have a system in which each department has its own overhead rate. Machining Department Assembly Department Shipping Department The allocation base depends on the nature of the work performed in each department. In the machining department, overhead may be based on machine-hours, but in the assembly department, overhead may be based on labor-hours. 3-5 Departmental Overhead Rates Departmental rates will not correctly assign overhead in situations where a company has a range of products and complex overhead costs. The departmental approach relies exclusively on volume-related allocation bases while some overhead costs may be caused by factors that are not related to the volume of production. Activity-based costing is required to account for these other factors. 3-6 Activity-Based Costing (ABC) A number of allocation bases are used for assigning costs to products. 3-7 Activity-Based Costing (ABC) Cost Objects (e.g., products and customers) Activities Consumption of Resources Cost 3-8 Activity-Based Costing (ABC) An event that causes the consumption of overhead resources Activity Examples of Activities Setting up machines Admitting hospital patients Billing customers Opening a bank account 3-9 Activity-Based Costing (ABC) Activity Cost Pool A “cost bucket” in which costs related to a particular activity are accumulated. Activity Measure Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs. Activity Rate A predetermined overhead rate for each activity cost pool. 3-10 Activity-Based Costing (ABC) For each activity in isolation, this system works exactly like the job-order costing system described in Chapter 2. A predetermined overhead rate is computed for each activity and then applied to jobs and products based on the amount of activity consumed by the job or product. 3-11 Designing an Activity-Based Costing System The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs. Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization’s resources. 3-12 Designing an Activity-Based Costing System Related activities are frequently combined to reduce the amount of detail and record-keeping costs. For example, several actions may be involved in handling and moving raw materials, but these may be combined into a single activity titled material handling. An activity dictionary defines each of the activities that will be included in the activity-based costing system and how the activities will be measured. 3-13 Hierarchy of Activities Level Activities Activity Measure Unit-level Processing units on machines Processing units by hand Consuming factory supplies Machine-hours Direct labor-hours Units produced Batch-level Processing purchase orders Processing production orders Setting up equipment Handling materials Purchase orders processed Production orders processed Number of setups Pounds of material handled Product-level Testing new products Administering parts inventories Designing products Hours of testing time Number of part types Hours of design time Facility-level General factory administration Plant building and grounds Direct labor-hours Direct labor-hours 3-14 Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs First-Stage Cost Assignment Labor Related Pool Machine Related Pool Setup Pool Production Order Pool Parts Admin. Pool General Factory Pool 3-15 Graphic Example of Activity-Based Costing Various Manufacturing Overhead Costs First-Stage Cost Assignment Labor Related Pool Machine Related Pool Setup Pool Production Order Pool Parts Admin. Pool General Factory Pool Second-Stage Allocations $/DLH $/MH $/Setup $/Order $/Part Type $/MH Products Unit-Level Activity Batch-Level Activity Product-Level Facility-Level Activity Activity 3-16 Using Activity-Based Costing Comtek Sound, Inc.  Comtek Sound, Inc., makes two products: CD players and DVD players.  The company has been losing bids to supply CD players to lower-priced competitors.  The company has been winning all bids to supply DVD players. 3-17 Using Activity-Based Costing Comtek Sound, Inc.  For the current year, Comtek has budgeted sales of 50,000 DVD units and 200,000 CD units.  Comtek’s traditional cost system applies manufacturing overhead to products based on directlabor hours.  Both products require two direct labor-hours to complete, for a total of 500,000 direct labor-hours. Hours DVDs: 50,000 units @ 2 hours per unit = 100,000 CDs: 200,00 units @ 2 hours per unit = 400,000 Total direct labor-hours 500,000 3-18 Using Activity-Based Costing Comtek Sound, Inc.  Unit costs for materials and labor are: Direct materials Direct labor DVD Units $ 90 $ 20 CD Units $ 50 $ 20 3-19 Direct Labor-Hours as a Base Total manufacturing overhead costs for the current year are estimated to be $10,000,000. The company develops the following overhead rate based upon labor-hours: Predetermined $10,000,000 = overhead rate 500,000 DLHs = $20 per DLH 3-20 Direct Labor-Hours as a Base Since each product requires two hours of direct labor, $40 of overhead is assigned to each product. Direct materials Direct labor Manufacturing overhead DVD Unit $ 90 20 40 CD Unit $ 50 20 40 $ $ (2 DLHs x $20 per DLH) Unit product cost 150 110 3-21 Computing Activity Rates The ABC project team at Comtek has developed the following basic information. Activity and Activity Measures Estimated Overhead Cost Labor-related (DLH) $ 800,000 Machine-related (MH) 2,100,000 Machine setups (setups) 1,600,000 Production orders (orders) 3,150,000 Parts administration (part types) 350,000 General factory (MH) 2,000,000 $ 10,000,000 Total 500,000 1,000,000 4,000 1,200 700 1,000,000 Expected Activity DVD 100,000 300,000 3,000 800 400 300,000 CD 400,000 700,000 1,000 400 300 700,000 3-22 Computing Activity Rates Activity and Activity Measures Labor-related (DLHs) Machine-related (MHs) Machine setups (setups) Production orders (orders) Parts administration (part types) General factory (MHs) Estimated Overhead Cost $ 800,000 2,100,000 1,600,000 3,150,000 350,000 2,000,000 $ 10,000,000 ÷ ÷ ÷ ÷ ÷ ÷ Total Expected Activity Activity Rate 500,000 = $ 1.60 per DLH 1,000,000 = 2.10 per MH 4,000 = 400.00 per setup 1,200 = 2,625.00 per order 700 = 500.00 per part type 1,000,000 = 2.00 per MH We can calculate an activity rate for each of the six activities by dividing the estimated overheard for an activity by the total expected activity. 3-23 Computing Overhead Cost per Unit DVD Units Expected Activity Activity and Activity Measures Activity Rate Amount Labor-related (DLHs) 100,000 × $ 1.60 = $ 160,000 Machine-related (MHs) 300,000 × 2.10 = 630,000 Machine setups (setups) 3,000 × 400.00 = 1,200,000 Production orders (orders) 800 × 2,625.00 = 2,100,000 Parts administration (part types) 400 × 500.00 = 200,000 General factory (MHs) 300,000 × 2.00 = 600,000 Total overhead cost assigned $ 4,890,000 Number of units produced 50,000 Overhead cost per unit $ 97.80 3-24 Computing Overhead Cost per Unit CD Units Expected Activity Activity and Activity Measures Activity Rate Amount Labor-related (DLHs) 400,000 × $ 1.60 = $ 640,000 Machine-related (MHs) 700,000 × 2.10 = 1,470,000 Machine setups (setups) 1,000 × 400.00 = 400,000 Production orders (orders) 400 × 2,625.00 = 1,050,000 Parts administration (part types) 300 × 500.00 = 150,000 General factory (MHs) 700,000 × 2.00 = 1,400,000 Total overhead cost assigned $ 5,110,000 Number of units produced 200,000 Overhead cost per unit $ 25.55 3-25 Comparing the Two Approaches Activity-Based Costing DVD Unit CD Unit Direct material $ 90.00 $ 50.00 Direct labor 20.00 20.00 Manufacturing overhead 97.80 25.55 Unit product cost $ 207.80 $ 95.55 Direct Labor Costing DVD Unit CD Unit $ 90.00 $ 50.00 20.00 20.00 40.00 40.00 $ 150.00 $ 110.00 Note that the unit product cost of a CD unit decreased from $110 to $95.55 . . . . . . . . while the unit cost of a DVD unit increased from $150 to $207.80. 3-26 Comparing the Two Approaches Activity-Based Costing DVD Unit CD Unit Direct material $ 90.00 $ 50.00 Direct labor 20.00 20.00 Manufacturing overhead 97.80 25.55 Unit product cost $ 207.80 $ 95.55 Direct Labor Costing DVD Unit CD Unit $ 90.00 $ 50.00 20.00 20.00 40.00 40.00 $ 150.00 $ 110.00 The ABC system assigns $14.45 less overhead than the traditional system to each CD player. 3-27 Comparing the Two Approaches Activity-Based Costing DVD Unit CD Unit Direct material $ 90.00 $ 50.00 Direct labor 20.00 20.00 Manufacturing overhead 97.80 25.55 Unit product cost $ 207.80 $ 95.55 Direct Labor Costing DVD Unit CD Unit $ 90.00 $ 50.00 20.00 20.00 40.00 40.00 $ 150.00 $ 110.00 The ABC system assigns $57.80 more overhead than the traditional system to each DVD player. 3-28 Shifting of Overhead Cost Activity-Based Costing DVD Unit CD Unit Direct material $ 90.00 $ 50.00 Direct labor 20.00 20.00 Manufacturing overhead 97.80 25.55 Unit product cost $ 207.80 $ 95.55 Direct Labor Costing DVD Unit CD Unit $ 90.00 $ 50.00 20.00 20.00 40.00 40.00 $ 150.00 $ 110.00 Low-volume product When a company implements activity-based costing, overhead cost often shifts from high-volume to lowvolume products with a higher unit product cost resulting for the low-volume products. 3-29 Shifting of Overhead Cost Activity-Based Costing DVD Unit CD Unit Direct material $ 90.00 $ 50.00 Direct labor 20.00 20.00 Manufacturing overhead 97.80 25.55 Unit product cost $ 207.80 $ 95.55 Direct Labor Costing DVD Unit CD Unit $ 90.00 $ 50.00 20.00 20.00 40.00 40.00 $ 150.00 $ 110.00 High-volume product The traditional system assigns the same amount of all overhead costs to each CD or DVD player ($40 per unit). 3-30 Shifting of Overhead Cost Production Orders Activity Cost Pool (a batch-level cost pool) The ABC system assigns different amounts of Production Order-related overhead costs to each product. This fact can be illustrated in a two-step process. 1. Compute the number of units processed per production order for each product. Number of units produced per year Number of production orders issued per year Number of units processed per production order DVD Units 50,000 800 62.5 CD Units 200,000 400 500 3-31 Shifting of Overhead Cost 2. Compute production order cost per unit for each product. Cost to issue a production order Average number of units processed per production order Production order cost per unit DVD Units CD Units $ 2,625 $ 2,625 $ 62.5 42.00 $ 500 5.25 Notice, the costs are being shifted from the highvolume CD players to the low-volume DVD players. 3-32 Targeting Process Improvements An ABC system can help identify areas where the company can benefit from improving its current processes. Activity-Based Management Focuses on managing activities to eliminate waste and reduce delays and defects. 3-33 Targeting Process Improvements The first step in any improvement program is deciding what to improve. The Theory of Constraints approach targets the highest impact improvement opportunities. Activity rates can be used to target areas where costs seem excessively high. Benchmarking can be used to compare activity cost information with world-class standards of performance achieved by other organizations. 3-34 Benefits of Activity-Based Costing ABC improves the accuracy of product costing by: 1. Increasing the number of cost pools used to accumulate overhead costs. 2. Using activity cost pools that are more homogeneous than departmental cost pools. 3. Assigning overhead costs using activity measures that cause those costs, rather than relying solely on direct labor hours. Activity-based costing also highlights activities that could benefit most from process improvement efforts, such as Six Sigma. 3-35 Limitations of Activity-Based Costing Costs of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when: 1. Products differ substantially in volume, batch size, and in activities required. 2. Conditions have changed substantially since the existing cost system was established. 3. Overhead costs are high and increasing and no one seems to understand why. 4. Management does not trust the existing cost system and it ignores data from it when making decisions. 3-36 Activity-Based Costing Critical Assumption The cost in each activity pool is strictly proportional to its activity measure. When this assumption is violated, the accuracy of ABC data can be called into question. For example, managers should be particularly alert to product costs that contain allocated facility-level costs. 3-37 Modifying the ABC Model The illustrations in the chapter assume that ABC is being used for external reporting purposes. If the system is used for internal decision-making purposes, two important modifications should be made: 1. Selling and administrative costs should be assigned to products, where appropriate. 2. Facility-level costs should be removed from product costs. 3-38 End of Chapter 03 3-39 Process Costing Chapter 04 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Processing Departments Any unit in an organization where materials, labor, or overhead are added to the product. The activities performed in a processing department are performed uniformly on all units of production. Furthermore, the output of a processing department must be homogeneous. Products in a process costing environment typically flow in a sequence from one department to another. 4-2 Comparing Job-Order and Process Costing Direct Materials Direct Labor Manufacturing Overhead Costs are traced and applied to departments in a process cost system. Processing Department Finished Goods Cost of Goods Sold 4-3 Process Cost Flows: The Flow of Raw Materials (in T-account form) Raw Materials •Direct Materials Work in Process Department A •Direct Materials Work in Process Department B •Direct Materials 4-4 Process Cost Flows: The Flow of Labor Costs (in T-account form) Salaries and Wages Payable •Direct Labor Work in Process Department A •Direct Materials •Direct Labor Work in Process Department B •Direct Materials •Direct Labor 4-5 Process Cost Flows: The Flow of Manufacturing Overhead Costs (in T-account form) Work in Process Department A Manufacturing Overhead •Actual Overhead •Overhead Applied to Work in Process •Direct Materials •Direct Labor •Applied Overhead Work in Process Department B •Direct Materials •Direct Labor •Applied Overhead 4-6 Process Cost Flows: Transfers from WIP-Dept. A to WIP-Dept. B (in T-account form) Work in Process Department A •Direct Transferred Materials to Dept. B •Direct Labor •Applied Overhead Department A Work in Process Department B •Direct Materials •Direct Labor •Applied Overhead •Transferred from Dept. A Department B 4-7 Process Cost Flows: Transfers from WIP-Dept. B to Finished Goods (in T-account form) Work in Process Department B •Direct •Cost of Materials Goods •Direct Manufactured Labor •Applied Overhead •Transferred from Dept. A Finished Goods •Cost of Goods Manufactured 4-8 Process Cost Flows: Transfers from Finished Goods to COGS (in T-account form) Work in Process Department B Finished Goods •Direct •Cost of •Cost of •Cost of Materials Goods Goods Goods •Direct Manufactured Manufactured Sold Labor •Applied Overhead •Transferred Cost of Goods Sold from Dept. A •Cost of Goods Sold 4-9 Equivalent Units of Production Equivalent units are the product of the number of partially completed units and the percentage completion of those units. These partially completed units complicate the determination of a department’s output for a given period and the unit cost that should be assigned to that output. 4-10 Equivalent Units – The Basic Idea Two half-completed products are equivalent to one complete product. + = 1 So, 10,000 units 70% complete are equivalent to 7,000 complete units. 4-11 Equivalent Units of Production Weighted-Average Method The weighted-average method . . . 1. Makes no distinction between work done in prior or current periods. 2. Blends together units and costs from prior and current periods. 3. Determines equivalent units of production for a department by adding together the number of units transferred out plus the equivalent units in ending Work in Process Inventory. 4-12 Treatment of Direct Labor Dollar Amount Direct Materials Conversion Direct Labor Direct Labor Manufacturing Overhead Direct labor and manufacturing overhead may be combined into one classification of product cost called conversion costs. Type of Product Cost 4-13 Compute and Apply Costs The formula for computing the cost per equivalent unit is: Cost per equivalent = unit Cost of beginning Work in Process + Cost added during Inventory the period Equivalent units of production 4-14 Process Costing Using the FIFO Method Appendix 4A PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. FIFO vs. Weighted-Average Method The FIFO method (generally considered more accurate than the weighted-average method) differs from the weighted-average method in two ways: 1. The computation of equivalent units. 2. The way in which the costs of beginning inventory are treated. 4-16 Cost per Equivalent Unit – FIFO The formula for computing the cost per equivalent unit under FIFO method is: Cost per equivalent = unit Cost added during the period Equivalent units of production 4-17 A Comparison of Costing Methods In a lean production environment, FIFO and weighted-average methods yield similar unit costs. When considering cost control, FIFO is superior to weighted-average because it does not mix costs of the current period with costs of the prior period. 4-18 End of Chapter 04 4-19 Cost-Volume-Profit Relationships Chapter 05 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Basics of Cost-Volume-Profit Analysis The contribution income statement is helpful to managers in judging the impact on profits of changes in selling price, cost, or volume. The emphasis is on cost behavior. Racing Bicycle Company Contribution Income Statement For the Month of June Sales (500 bicycles) $ 250,000 Less: Variable expenses 150,000 Contribution margin 100,000 Less: Fixed expenses 80,000 Net operating income $ 20,000 Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted. 5-2 Basics of Cost-Volume-Profit Analysis Racing Bicycle Company Contribution Income Statement For the Month of June Sales (500 bicycles) $ 250,000 Less: Variable expenses 150,000 Contribution margin 100,000 Less: Fixed expenses 80,000 Net operating income $ 20,000 CM is used first to cover fixed expenses. Any remaining CM contributes to net operating income. 5-3 The Contribution Approach If RBC sells 400 units in a month, it will be operating at the break-even point. Racing Bicycle Company Contribution Income Statement For the Month of June Total Per Unit Sales (400 bicycles) $ 200,000 $ 500 Less: Variable expenses 120,000 300 Contribution margin 80,000 $ 200 Less: Fixed expenses 80,000 Net operating income $ – 5-4 CVP Relationships in Equation Form This equation can be used to show the profit RBC earns if it sells 401. Notice, the answer of $200 mirrors our earlier solution. Profit = (Sales – Variable expenses) – Fixed expenses $80,000 401 units × $500 401 units × $300 Profit = ($200,500 – $120,300) – $80,000 $200 = ($200,500 – $120,300) – $80,000 5-5 Preparing the CVP Graph Break-even point (400 units or $200,000 in sales) $350,000 Profit Area $300,000 $250,000 $200,000 Sales Total expenses Fixed expenses $150,000 $100,000 $50,000 $0 0 Loss Area 100 200 300 400 500 600 Units 5-6 Contribution Margin Ratio (CM Ratio) The CM ratio is calculated by dividing the total contribution margin by total sales. Racing Bicycle Company Contribution Income Statement For the Month of June Total Per Unit Sales (500 bicycles) $ 250,000 $ 500 Less: Variable expenses 150,000 300 Contribution margin 100,000 $ 200 Less: Fixed expenses 80,000 Net operating income $ 20,000 CM Ratio 100% 60% 40% $100,000 ÷ $250,000 = 40% 5-7 Contribution Margin Ratio (CM Ratio) If Racing Bicycle increases sales from 400 to 500 bikes ($50,000), contribution margin will increase by $20,000 ($50,000 × 40%). Here is the proof: 400 Units Sales $ 200,000 Less: variable expenses 120,000 Contribution margin 80,000 Less: fixed expenses 80,000 Net operating income $ – 500 Units $ 250,000 150,000 100,000 80,000 $ 20,000 A $50,000 increase in sales revenue results in a $20,000 increase in CM ($50,000 × 40% = $20,000). 5-8 Break-Even in Unit Sales: Equation Method Profits = Unit CM × Q – Fixed expenses Suppose RBC wants to know how many bikes must be sold to break-even (earn a target profit of $0). $0 = $200 × Q + $80,000 Profits are zero at the break-even point. 5-9 Break-Even in Unit Sales: Formula Method Let’s apply the formula method to solve for the break-even point. Unit sales to = break even Fixed expenses CM per unit $80,000 Unit sales = $200 Unit sales = 400 5-10 Break-Even in Dollar Sales: Equation Method Suppose Racing Bicycle wants to compute the sales dollars required to break-even (earn a target profit of $0). Let’s use the equation method to solve this problem. Profit = CM ratio × Sales – Fixed expenses Solve for the unknown “Sales.” 5-11 Break-Even in Dollar Sales: Formula Method Now, let’s use the formula method to calculate the dollar sales at the break-even point. Dollar sales to Fixed expenses = break even CM ratio $80,000 Dollar sales = 40% Dollar sales = $200,000 5-12 The Margin of Safety in Dollars The margin of safety in dollars is the excess of budgeted (or actual) sales over the break-even volume of sales. Margin of safety in dollars = Total sales – Break-even sales Let’s look at Racing Bicycle Company and determine the margin of safety. 5-13 The Margin of Safety in Dollars If we assume that RBC has actual sales of $250,000, given that we have already determined the break-even sales to be $200,000, the margin of safety is $50,000 as shown. Break-even sales 400 units Sales $ 200,000 Less: variable expenses 120,000 Contribution margin 80,000 Less: fixed expenses 80,000 Net operating income $ – Actual sales 500 units $ 250,000 150,000 100,000 80,000 $ 20,000 5-14 Cost Structure and Profit Stability There are advantages and disadvantages to high fixed cost (or low variable cost) and low fixed cost (or high variable cost) structures. An advantage of a high fixed cost structure is that income A disadvantage of a high fixed will be higher in good years cost structure is that income compared to companies will be lower in bad years with lower proportion of compared to companies fixed costs. with lower proportion of fixed costs. Companies with low fixed cost structures enjoy greater stability in income across good and bad years. 5-15 Operating Leverage Operating leverage is a measure of how sensitive net operating income is to percentage changes in sales. It is a measure, at any given level of sales, of how a percentage change in sales volume will affect profits. Degree of operating leverage Contribution margin = Net operating income 5-16 End of Chapter 05 5-17 Variable Costing and Segment Reporting: Tools for Management Chapter 06 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Overview of Variable and Absorption Costing Variable Costing Absorption Costing Direct Materials Product Costs Direct Labor Variable Manufacturing Overhead Product Costs Fixed Manufacturing Overhead Period Costs Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Period Costs 6-2 Unit Cost Computations Harvey Company produces a single product with the following information available: 6-3 Unit Cost Computations Unit product cost is determined as follows: Under absorption costing, all production costs, variable and fixed, are included when determining unit product cost. Under variable costing, only the variable production costs are included in product costs. 6-4 Variable and Absorption Costing Income Statements Let’s assume the following additional information for Harvey Company. • 20,000 units were sold during the year at a price of $30 each. • There is no beginning inventory. Now, let’s compute net operating income using both absorption and variable costing. 6-5 Variable Costing Contribution Format All fixed Income Statement Variable manufacturing costs only. manufacturing overhead is expensed. Variable Costing Sales (20,000 × $30) Less variable expenses: Variable cost of goods sold (20,000 × $10) $ 200,000 Variable selling & administrative expenses (20,000 × $3) 60,000 Total variable expenses Contribution margin Less fixed expenses: Fixed manufacturing overhead $ 150,000 Fixed selling & administrative expenses 100,000 Net operating income $ 600,000 260,000 340,000 250,000 $ 90,000 6-6 Absorption Costing Income Statement Unit product cost. Fixed manufacturing overhead deferred in inventory is 5,000 units × $6 = $30,000. 6-7 Extended Comparisons of Income Data Harvey Company – Year Two 6-8 Variable Costing Contribution Format Income Statement All fixed Variable manufacturing costs only. manufacturing overhead is expensed. Variable Costing Sales (30,000 × $30) Less variable expenses: Variable cost of goods sold (30,000 × $10) Variable selling & administrative expenses (30,000 × $3) Total variable expenses Contribution margin Less fixed expenses: Fixed manufacturing overhead Fixed selling & administrative expenses Net operating income $ 900,000 $ 300,000 90,000 390,000 510,000 $ 150,000 100,000 250,000 $ 260,000 6-9 Absorption Costing Income Statement Unit product cost. Fixed manufacturing overhead released from inventory is 5,000 units × $6 = $30,000. 6-10 Summary of Key Insights 6-11 Explaining Changes in Net Operating Income Variable costing income is only affected by changes in unit sales. It is not affected by the number of units produced. As a general rule, when sales go up, net operating income goes up, and vice versa. Absorption costing income is influenced by changes in unit sales and units of production. Net operating income can be increased simply by producing more units even if those units are not sold. 6-12 Keys to Segmented Income Statements There are two keys to building segmented income statements: A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin. 6-13 Identifying Traceable Fixed Costs Traceable fixed costs arise because of the existence of a particular segment and would disappear over time if the segment itself disappeared. No computer division means . . . No computer division manager. 6-14 Identifying Common Fixed Costs Common fixed costs arise because of the overall operation of the company and would not disappear if any particular segment were eliminated. No computer division but . . . We still have a company president. 6-15 Traceable Costs Can Become Common Costs It is important to realize that the traceable fixed costs of one segment may be a common fixed cost of another segment. For example, the landing fee paid to land an airplane at an airport is traceable to the particular flight, but it is not traceable to first-class, business-class, and economy-class passengers. 6-16 Segment Margin Profits The segment margin, which is computed by subtracting the traceable fixed costs of a segment from its contribution margin, is the best gauge of the long-run profitability of a segment. Time 6-17 Common Costs and Segments Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons: 1. This practice may make a profitable business segment appear to be unprofitable. 2. Allocating common fixed costs forces managers to be held accountable for costs they cannot control. Segment 1 Segment 2 Segment 3 Segment 4 6-18 End of Chapter 06 6-19

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