COST ACCOUNTING
                 Everything you need to know in three easy pages!!

We begin by defining some terms.

      S = Sales volume p = Price    R = Revenue = pS
      v = unit variable cost V = total variable cost P = Production volume
      f = unit fixed cost    F = total fixed cost

The subscript m indicates a manufacturing cost i.e., a product cost and the
subscript s indicates a period cost. If there is no subscript then we are talking about
total costs i.e., the manufacturing and selling unit variable costs make up unit
variable costs for the company and manufacturing and selling fixed costs make
total fixed costs for the company.

      v m + vs = v         Fm + Fs = F

Unit costs and total costs are connected by volume i.e., total cost = unit cost x
volume. Making things just a little complicated is that you have to figure which
volume from the context. If we are talking about income statements then it is sales
volume; it is a manufacturing statement then it is production volume.

The constants in any problem are little v i.e., unit variable cost and big F i.e., total
fixed cost. Everything else shifts and slides on you. Strictly speaking, big V is a
derived number that we get by multiplying little v by volume and little f is a
derived number that we get by dividing big F by volume.

Happiness in managerial accounting in tests – and in the real world – comes from
always figuring little v and big F!

Full costing versus variable costing

The FASB and the IRS require the use of full costing. They also require that one
distinguish between product (i.e., manufacturing) and period (i.e., selling and
administrative) costs. This means that the inventory cost of a product is its variable
product cost plus a share of the fixed product cost i.e.,
       Unit product cost (upc) = vm + fm where fm = Fm /P.
       Unit selling cost (spc) = vs + fs where fs = Fs/S
       Overall cost of a product (tpc) = upc + spc = v + f
Income statements

Income statements come in two flavors – one is required by the FASB for financial
reporting purposes and by the IRS for tax purposes; the other is used by
management for running a business and making decisions. The first is variously
called a full cost statement because it uses the upc and a functional statement
because it distinguishes between the functions of production and selling. The
second is called a variable cost statement or a behavioral cost statement because it
focuses on the way costs behave i.e., whether they are fixed or variable.

                                         Full                Variable
      1. Revenue                         pS                  pS
      2. Cost of goods sold (full)       (vm + fm )S
      3. Variable costs                                      vS
      4. Gross margin                    1-2
      5. Contribution margin                                 1-3
      6. Selling & admin costs           (vs + fs)S
      7. Fixed costs                                         F
      8. Net income                      4-6                 5-7

The observant will notice where all our problems start. On line 6 we have selling
and administrative costs as (vs + fs)S. Multiplying this out gives us Vs + Fs with
no problems. On line 2 we have (vm + fm )S. This does not multiply out because
Vm is vm P and Fm is fm P. It is this creation of fm by dividing Fm by P and its
reappearance in an income statement where it is multiplied by S, and not P, that
gives us all the headaches. Take this one problem away and we would not need a
course in managerial accounting!

Actual, normal and standard costing

In an actual costing system, all these numbers are actuals i.e., what we actually
experience in a period. In a normal costing system, all the prime manufacturing
costs (i.e., direct labor and direct material) and all the selling and administrative
costs are kept at actual but the manufacturing overhead is based on budgeted
numbers. In a standard costing system, all the costs are based on budgeted
numbers. A series of variances appear in the accounts to track the difference
between what we actually paid for something and what we should have paid.
Manufacturing overhead rates (vm and fm)

This is the departure point for all our troubles. We want to know our unit product
cost when we make something so that we know what to charge when we sell it. We
will not know our total fixed costs until the end of the financial year – a little too
late! So, we compute the unit fixed product cost by using the budget.

      Budgeted or predetermined overhead rate or budgeted fm
           = Budgeted fixed overhead (Fm) / Budgeted production volume (P)

There is no need to compute vm because it is a given.

Assigning, allocating and applying overhead

Prime costs are typically variable and are also direct so there is a straightforward
relationship between a product and its prime costs (direct material and direct
labor). Sadly, this is not true of manufacturing overhead which is defined as all
indirect product costs. By definition, these are indirect and so not directly
traceable. They come from “higher up” in the organization and trickle down onto
products. The process is essentially three-stage.

1.    Overhead costs are assigned i.e., charged to the person, department, division
      who authorized that cost. Some of these costs, such as the salary of a
      departmental supervisor, are assigned to an operating department; many of
      these costs, such as the salary of a cost accountant, are assigned to a service
      department, such as Cost Accounting.

2.    The costs of all the service departments along with the overhead costs of the
      operating departments are then allocated to overhead pools. There may be
      just one of these pools; there may be many. Traditionally accounting
      connected these pools to departments; activity based costing connects these
      pools to activities. Either way, the allocation process uses allocation bases
      e.g., we might allocate all maintenance costs on the basis of the square
      footage occupied by each operating department.

3.    The overhead costs that have been gathered into these pools is then applied
      to the product on using predetermined overhead rates. There might be one or
      more of these overhead rates depending on how many pools we set up – and
      how many pools the product passes through.
                  Everything you need to know in one easy page.

In a manufacturing company, inventory is broken into three (sub) accounts: Raw
material inventory, work-in-process inventory, and finished goods inventory. In
addition, we keep an overhead account.

All period costs are charged to the income statement when incurred – if we stick to
just balance sheet accounts then we charge retained earnings for all period costs
when incurred.

All prime costs are charged to work-in-process inventory when incurred i.e., when
manufacturing takes place.

All indirect manufacturing costs are charged to overhead when incurred and then
applied to work-in-process inventory using an overhead rate.

The total cost of goods manufactured is transferred from work-in-process
inventory to finished goods inventory when the goods are complete. If we divide
this dollar number by the number of items produced we arrive at the unit product

Cost of goods sold is the unit product cost multiplied by the number of units sold.
It reduces the finished goods inventory.

Raw material inventory
      A: Purchase of raw material – credit to cash or accounts payable
      S: Use of raw material – debit to work-in-process inventory
Work-in-process inventory
      A: Use of raw material – credit to raw material inventory
      A: Use of direct labor – credit to wages payable
      A: Manufacturing overhead applied – credit to overhead account
      S: Cost of goods manufactured – debit to finished goods inventory
Overhead account
      A: Actual overhead incurred – credit to cash, various payable accounts, ppe
      S: Overhead applied – debit to work-in-process inventory
Finished goods inventory
      A: Cost of goods manufactured – credit to work-in-process inventory
      S: Cost of goods sold – debit to cost of goods sold account
                          COST-BASED DECISIONS
                   Everything you need to know in one easy page

All cost-based decision problems, whether in textbooks or in the real world, begin
by trying to trick you. You are typically given, especially in the real world, a unit
product cost and then asked to make a decision based on that cost. Wisdom comes
when you realize that upc is a rubber ruler and that you must immediately derive
little v and big F. Once you do that, the rest of the problem is a cinch. In all cases,
we can focus on just the costs that are relevant or one can do a complete analysis
of all costs.

Decision problems come two fundamentally different flavors and then a half-
dozen sub-flavors for each. They all resolve themselves very easily if one derives
little v and big F and does a before and after analysis.

Decisions involving changes in volume aka CVP analysis
      What’s our breakeven point?
      How many do we need to sell to arrive at a target profit?
      At what price do we need to sell to achieve a target profit?
      What is our operating leverage and does that affect our profitability?

Decisions that do not involve volume changes aka incremental cost analysis
      Should we add a product or service?
      Should we drop a product or service?
      Should we make a product or buy it from outside?
      Should we sell it now or process it further?

Two related complications make these problems a little more interesting. If one has
a limited amount of a resource one often arrives at the best solution by making the
best use of that particular resource. If we have an unlimited amount of material,
say, but just one worker, then we need to focus on the best that worker can do for
us. The fact that we might have been able to spin all that lead into gold is irrelevant
if our one worker is unable to spin!

The other half of that problem is that sometimes we are dealing with limited
capacity. When we have slack in the system one can focus purely on the
contribution that a product makes. When one is at capacity one has to add
opportunity costs into the decision i.e., what else could we do with our capacity if
we did not do “this.”
                         MANAGEMENT CONTROL
                  Everything you need to know in two easy pages

Management control is a system in which a business tries to persuade people to act
in the interest of the business through the use of accounting numbers. The most
obvious example of financial control in action is to give a manager a bonus if they
raise the net income of the company.

Companies are divided up by departments to facilitate the processing of work.
These departments may be measured by the revenue they generate and are called
revenue centers, by the costs they incur when they are called cost centers, or by the
profit they generate when they are called profit centers. When we know the assets
that a profit center is using it becomes an investment center. Typically cost and
revenue centers are controlled through the use of budgets; profit centers and
investment centers also use budgets but we can also begin to analyze their
profitability more directly.


Many companies begin their management control system by setting up a budget
that provides targets for employees to shoot for in the upcoming year. The budget
is built by setting standard prices (i.e., the price that one should pay for an input),
standard usages (i.e., the amount of input that one should use to produce on unit of
output), and a budgeted output volume. For variable costs we can write:

      Master budget = Standard price x standard usage x budgeted output volume

At the end of a period when the output volume is known, it is typical practice to
revise the budget to take into consideration the know volume. So for variable costs:

      Flexible budget = Standard price x standard usage x actual output volume

The difference between actual and budget is called a variance. A cost variance is
unfavorable if actual cost exceeds budgeted cost; it is favorable if budgeted cost
exceeds actual cost. Revenue budgets are reversed.

Fixed costs are independent of volume so there is no equation that describes them.
All we have is F – budgeted and actual – and the difference between them.

Variance analysis is the process of determining why a variance occurred. There is
no real analysis to do in the case of fixed costs. There may be good reasons for a
fixed cost variance but it is not mathematically derived – try words!

Variances of variable costs (and revenues) are most easily explained by simply
dividing the actual variable cost by the master (or flexible) budget and tracking the
percentage (or ratio) changes of each component.

      Actual variable cost/Budgeted variable cost
            = (Actual price/standard price)
                  x (Actual usage per unit/standard usage per unit)
                         x (Actual output volume/budgeted output volume)

That is all the explanation that we need at this point.


Investment centers (typically the division of a company) are often evaluated using
ROA i.e., the return on the assets at their disposal measured by the operating
income generated by the division divided by the assets they are using. The duPont
company suggested that ROA could be usefully broken into two components:
Profitability and turnover. (At the company level we can add financial leverage but
divisions seldom control their financing activities.)

      ROA = OI/TA = OI/S x S/TA

A manager is rewarded if the ROA is greater than some predetermined rate that we
will label rho ( ). Some companies like to rework the equation slightly and
creating something called residual income.

      OI/TA >      ==> OI -     TA > 0

The relationship OI - TA, which was known for years as residual income, has
been popularized in recent years (and copyrighted) under the name EVA
(economic value added.)

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