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UMGC MBA 620: Financial

Decision Making

Project 3: Review and

Practice Guide

Project 3: Review and

Practice Guide

Costing and Cost Allocations

Contents Topic 1: Introduction to Managerial Accounting .......................................................................................... 3

Managerial Accounting ............................................................................................................................. 3

The Process ............................................................................................................................................... 3

Information for Planning ........................................................................................................................... 3

Managerial vs Financial Accounting .......................................................................................................... 4

Topic 2: Cost Terminology ............................................................................................................................ 5

Cost Behavior ............................................................................................................................................ 5

Cost Terminology ...................................................................................................................................... 5

Variable Costs vs Fixed Costs .................................................................................................................... 6

Direct Labor ............................................................................................................................................... 6

Mixed Costs ............................................................................................................................................... 6

Step Costs .................................................................................................................................................. 6

Identifying Types of Costs ......................................................................................................................... 7

Topic 3: Cost-Volume-Profit Analysis ............................................................................................................ 8

Uses for Cost-Volume-Price Analysis ........................................................................................................ 8

Profit Equation & Breakeven .................................................................................................................... 8

Example ..................................................................................................................................................... 8

Margin of Safety ........................................................................................................................................ 8

Contribution Margin ................................................................................................................................. 9

What-If Analysis ........................................................................................................................................ 9

Assumptions in CVP Analysis .................................................................................................................... 9

Topic 4: Cost Allocation............................................................................................................................... 10

The Basics of Cost Allocation .................................................................................................................. 10

1 - Purposes of Cost Allocation ............................................................................................................... 10

2 - Process of Cost Allocation .................................................................................................................. 10

3 – Direct and Indirect Costs ................................................................................................................... 11

Direct Method ......................................................................................................................................... 11

Example: Boise Furniture .................................................................................................................... 11

Example: Boise Furniture (cont'd.) ..................................................................................................... 12

Example: A Banking Organization ....................................................................................................... 12

4 - Problems With Cost Allocation .......................................................................................................... 12

Unitized vs Lump-Sum Allocation ........................................................................................................... 13

Production Volume and Overhead ......................................................................................................... 13

Topic 5: Activity-Based Costing ................................................................................................................... 14

Purpose of Activity-Based Costing .......................................................................................................... 14

The ABC Steps ......................................................................................................................................... 14

Benefits of ABC ....................................................................................................................................... 14

Limitations of ABC ................................................................................................................................... 14

Problems/Exercises ..................................................................................................................................... 15

What to Do .............................................................................................................................................. 15

Chapter 3: Practice Exercises .................................................................................................................. 15

Exercise: Cost-Volume-Profit Analysis .................................................................................................... 15

Solution to Exercise ................................................................................................................................. 16

Chapter 7: Practice Exercises .................................................................................................................. 17

Exercise: Traditional & Activity-Based Costing ....................................................................................... 17

Solution to Exercise ................................................................................................................................. 18

References .............................................................................................................................................. 20

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Topic 1: Introduction to Managerial Accounting

Managerial Accounting Managerial accounting is designed for internal users for planning, control, and decision making.

The Process Decision making, planning, and control are achieved through budgeting.

Information for Planning Budgets for planning

• Profit budget

o Indicates planned income

• Cash flow budget

o Indicates planned cash inflows and outflows

• Production budget

o Indicates the planned quantity of production and expected costs

Plan

•Action taken to implement plan

Results

•Comparison of planned and actual results

Evaluation

•Decisions to reward or punish managers

•Decisions to change operations or revise plans

Based on information from Jiambalvo, 1994

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Managerial vs Financial Accounting Managerial Financial

1. Users Internal External

2. GAAP May deviate Must comply

3. Information

presented

More detailed, emphasis on

segments Summary, emphasis on

total company

4. Nonmonetary

information Emphasized Not emphasized

5. Time focus Future oriented Generally historical

Based on information from Jiambalvo, 1994

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Topic 2: Cost Terminology

Cost Behavior The way costs impact a company and the way they are classified varies by the type of business.

Common types of costs

• Controllable vs. noncontrollable costs

• Sunk costs

• Opportunity costs

• Variable vs fixed costs

• Direct and indirect costs

• Mixed costs

• Step costs

Cost Terminology Controllable & Noncontrollable Costs

• A manager can influence controllable costs but not noncontrollable costs.

• Manager should not be evaluated against noncontrollable costs.

Sunk Costs

• Costs incurred in the past

• Not relevant to present decisions

Opportunity Costs

• Values of benefits foregone when selecting one alternative over another

Variable vs Fixed Costs

• Variable costs change proportionately with changes in volume or activity; fixed costs do not.

Direct and Indirect Costs

• Direct costs are directly traceable to a product, activity, or department; indirect costs are not.

Based on information from Jiambalvo, 1994

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Variable Costs vs Fixed Costs Fixed costs too high? Make them variable!

Examples:

• Incentive compensation

• Outsourcing

Direct Labor Questions to consider

Is direct labor always a variable cost?

Are you willing to lay off workers when production declines?

• What if the decline is temporary?

• What if the decline is permanent?

Does the degree of automation make a difference in whether direct labor is fixed or variable?

Mixed Costs Mixed costs include both variable and fixed elements.

Examples:

Salesperson with base salary (fixed) and commission on sales (variable)

• Base salary included with fixed costs

• Commission included with variable costs

Step Costs Step costs are fixed for a range of output but increase when the upper bound of a range is exceeded.

• When budgeting for a specific range, be sure to use the correct cost

Example:

A company adds third production shift. The cost increase includes a production supervisor's salary.

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Identifying Types of Costs Which type of cost is this?

Fixed cost of a production facility: As the number of

units produced increases, the fixed production cost

remains constant.

As the number of units produced increases, so

does the variable production cost.

Mixed cost: The total cost line intersects the y-

axis at $100,000, representing the fixed

component of the mixed cost

Step costs are fixed over only a small range of

activity.

Based on information from Jiambalvo, 1994

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Topic 3: Cost-Volume-Profit Analysis

Uses for Cost-Volume-Price Analysis CVP is the analysis of how costs and profit change when volume changes.

It is used for:

• Planning for next year—How much should be produced? What are the projected cost and

profit?

• Control—A production cost has increased unexpectedly. Why? Who should be responsible for

controlling it?

• Decision making—If the price of the product were decreased or increased, what would the

profit be?

Profit Equation & Breakeven The Profit Equation

profit = (selling price × Q) − (variable cost × Q) − total fixed cost = (selling price − variable cost)

× Q − total fixed cost

Breakeven—the point at which costs and income are equal

• Number of units (QBEP) sold allows a company to neither earn a profit nor incur a loss

•

$0 = selling price × QBEP − variable cost × QBEP − total fixed cost

Example Here are the price and costs related to a wedding cake business (Jiambalvo, 1994):

• Each cake sells for $500.

• The variable cost of baking the cakes is $200.

• The fixed cost per month is $6,000.

1. How many cakes must be sold to break even?

number of cakes × $500 − (number of cakes × $200 + $6,000) = $0

number of cakes = $6,000 / ($500 − $200) = 20 cakes

2. How many cakes must be sold to earn a profit of $9,000?

number of cakes × $500 − (number of cakes × $200 + $6,000) = $9,000

number of cakes = ($9,000 + $6,000) / ($500 − $200) = 50 cakes

Margin of Safety Margin of safety is a measurement of how close expected revenue is to the breakeven level.

margin of safety = expected revenue − breakeven revenue

Example:

If the wedding cake business expects to sell 35 cakes per month, what is the margin of safety?

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Answer:

Expected revenue: $500 × 35 = $17,500

Break-even revenue: $500 × 20 = $10,000

Margin of safety: $17,500 − $10,000 = $7,500

Contribution Margin The contribution margin is the incremental profit generated by selling one additional unit.

• unit contribution margin = sales price per unit − variable cost per unit

• total contribution margin = contribution margin per unit × quantity

• contribution margin ratio = contribution margin per unit / sales price per unit

The contribution margin ratio measures the amount of incremental profit generated by an additional

dollar of sales.

Wedding cake business example:

• Unit Contribution Margin

sales price per unit − variable cost per unit = unit contribution margin

$500 − $200 = $300

• Total Contribution Margin

contribution margin per unit × quantity = total contribution margin

$300 × Q = total contribution margin

• Contribution Margin Ratio contribution margin per unit / sales price per unit = contribution margin ratio $300 / $500 = contribution margin ratio

What-If Analysis Use this equation to determine the impact of managerial decisions on profit:

• profit = (selling price − variable cost) × Q − total fixed cost

o Change in fixed and variable costs

o Change in selling price

Assumptions in CVP Analysis Assumptions affect the validity of the analysis:

1. Costs can be separated into fixed and variable components

2. Within a specific range of cost-driver activity, variable cost per unit and total fixed cost

do not change (relevant range) (Lumen, n.d.)

3. Multiproduct analysis assumes the product mix does not change

With correct assumptions, CVP is useful.

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Topic 4: Cost Allocation

The Basics of Cost Allocation 1. Purpose of Cost Allocation

2. Process of Cost Allocation

3. Allocating Service Department Costs

4. Problems with Cost Allocation

1 - Purposes of Cost Allocation Companies allocate costs to

• provide information for decision making

• reduce frivolous use of common resources

• encourage evaluation of internally provided services

• calculate the "full cost" of products for GAAP reporting

(Jiambalvo, 1994)

Provide full-cost information:

• GAAP requires full costing for external reporting purposes.

• Full-cost information is needed when the company has an agreement whereby revenue received

depends upon the cost incurred, as in cost-plus contracts.

2 - Process of Cost Allocation

1. Identify the cost objectives.

2. Form cost pools so that individual costs in the same cost pool are allocated using one allocation

base.

3. Select an allocation base to relate cost pools to the cost objective

Ideally, allocated cost should

measure the opportunity cost.

Allocated costs serve as charges or fees for use

of internal resources or services.

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Example of the cost-allocation process in action:

UMGC Europe has several graduate programs. Imagine that you want to allocate costs to these

programs to determine if

1. Non-profitable programs should be shut down

2. Resources are being used efficiently

Cost pool Allocation base Cost objectives

Salaries of the professors

Salaries of the administrative staff

Photocopying

Computer lab

Rent for the building

Marketing

Online course pages

IT

Number of students enrolled

Number of hits per web page

Number of Trouble Tickets

fixed + variable × face-to-face

hours

MBA

Cybersecurity

Social Work

Management

3 – Direct and Indirect Costs • Organizational units of manufacturing firms are classified as one of the following:

o production department (direct)

o service department (indirect)

• Cost pools

o formed by service departments

o allocated to production departments

Direct Method

Example: Boise Furniture Service department costs are allocated to production departments but not to other service departments

Chair

Table

Assembly of chair

Finishing of table

Janitorial costs

Personnel costs

Products Production Departments Service Departments

Based on information from Jiambalvo, 1994

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Example: Boise Furniture (cont'd.) Allocate the janitorial cost of $100,000 as follows:

• Allocation base: square feet

o Assembly department: 20,000 square feet

o Finishing department: 30,000 square feet

• Calculate the allocation rate:

o $100,000 / (20,000 + 30,000) = $2 / sq. ft.

The resulting allocation to the production departments is as follows:

o Assembly Dept: 20,000 sq. ft. x $2 = $40,000

o Finishing Dept: 30,000 sq. ft. x $2 = $60,000

Example: A Banking Organization Assume that a banking organization has these service departments:

• Human Resources—hires employees and manages benefits

• Duplicating—performs copy services

• Janitorial—provides routine cleaning services

• Accounting—provides accounting services

• Graphic Design—designs forms)

• Food Services—provides free breakfast and lunch to employees

The services are used by the company’s two subsidiaries, Commercial Banking and Investment Banking.

Suggest ways to allocate the service department costs to the two subsidiaries.

Food Services are used by employees in the Human Resources department.

Would a share of food service costs be allocated to Human Resources under the direct method of

allocation?

Use the following as the basis for allocating service department costs:

• Human Resources—number of employees

• Duplicating—number of pages copied

• Janitorial—floor space

• Accounting—number of sales transactions

• Graphic Design—time spent on design work

• Food Services—number of employees

4 - Problems With Cost Allocation • Allocation of costs that are not controllable

• Arbitrary allocations

• Allocation of fixed costs that make the fixed costs appear to be variable costs

• Allocation of manufacturing overhead to products using too few overhead cost pools

• Use of only volume-related allocation bases

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Unitized vs Lump-Sum Allocation • Unitized fixed costs

o Fixed costs are stated on a per-unit basis and allocated as a variable cost.

o The perception that costs are variable could alter decision making.

• Lump-sum allocations

o A predetermined amount of fixed costs not affected by level of activity is allocated.

o The allocation must appear to be fixed to managers of departments that receive the

charge.

Production Volume and Overhead Problem: Using measures of production volume to allocate overhead

• Typical allocation basis includes direct labor hours and machine hours

• Assumes all overhead costs are proportional to production volume

• What happens when overhead costs are not proportional to production volume?

o High-volume products are over-costed

o Low-volume products are under-costed

ABC solves these problems.

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Topic 5: Activity-Based Costing

Purpose of Activity-Based Costing • Identifies major activities that cause overhead costs to be incurred

• Costs of resources consumed performing these activities are grouped into cost pools

• Costs are assigned to products using a measure of activity, i.e., cost driver

The ABC Steps

Benefits of ABC • Provides more accurate costing

o Costs are allocated to products based on the amount of each resource used for the

activities involved in producing the product.

• May lead to improvements in cost control

o Understanding each activity that contributes to a product and the resources each one

consumes enables a company to focus on those areas where efficiency could be

improved.

Limitations of ABC • More costly to develop and maintain than a traditional costing system

• Used to develop full costs of products

o Includes fixed costs

o Lacks incremental information necessary for decision making

Identify major activities

• Processing orders, packaging, delivery, customer service

Group costs of activities into cost pools

• Salary, vehicles, equipment, packaging materials

Identify measures of activities—the cost drivers

• Number of orders, number of phone calls, miles per day, labor hours

Relate costs to products using the cost drivers

• One-day service, same-day service, standard service

Step 1

Step 2

Step 3

Step 4

Based on information from Jiambalvo, 1994

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Problems/Exercises

What to Do You are encouraged to complete all the practice exercises listed below. They will help you gain the

knowledge and skills needed to fully participate in the group assignment in Step 3 and complete the

final Project 2 deliverable. The answers are provided, so you can check your own work.

Chapter 3: Practice Exercises (in Webster, 2015)

• Unit 3.1 Practice Exercise

• Unit 3.2 Practice Exercise

• Unit 3.3 Practice Exercise

• Unit 3.4 Practice Exercise

(Practice exercises follow the Self Study questions.)

Exercise: Cost-Volume-Profit Analysis Your company's CEO is planning for next year. Prepare a contribution format income statement showing

anticipated operating income. Consider each scenario independently. Last year's income statement is as

follows:

Total Per Unit

Sales $600,000 $15.00

Variable expenses 320,000 8.00

Contribution margin 280,000 7.00

Fixed expenses 175,000

Operating income $105,000

Required

A. The sales price increases by 12% and sales volume decreases by 4%. B. The sales price increases by 8% and variable cost per unit increases by 6%. C. The sales price decreases by 5% and sales volume increases by 15%. D. Fixed expenses increase by $40,000. E. The sales price increases by 12%, variable cost per unit increases by 15%, fixed expenses

increase by $30,000, and sales volume decreases by 15%.

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Solution to Exercise A. Current sales volume: $600,00/$15 = 40,000 units

New sales volume: 40,000 × .96 = 38,400 units

New sales price: $15.00 × 1.12 = $16.80

Total Per Unit

Sales $645,120 $16.80

Less variable expenses 307,200 8.00

Contribution margin 337,920 $ 8.80

Less fixed expenses 175,000

Operating income $162,920

B. New sales price: $15.00 × 1.08 = $16.20 per unit

New variable cost per unit: $8.00 × 1.06 = $8.48 per unit

Total Per Unit

Sales $648,000 $16.20

Less variable expenses 339,200 8.48

Contribution margin 308,800 $ 7.72

Less fixed expenses 175,000

Operating income $133,800

C. New sales price: $15.00 × .95 = $14.25 per unit

New sales volume: 40,000 × 1.15 = 46,000 units

Total Per Unit

Sales $655,500 $14.25

Less variable expenses 368,000 8.00

Contribution margin 287,500 $ 6.25

Less fixed expenses 175,000

Operating income $112,500

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D. New fixed expenses: $175,000 + $40,000 = $215,000

Total Per Unit

Sales $600,000 $15.00

Variable expenses 320,000 8.00

Contribution margin 280,000 $ 7.00

Fixed expenses 215,000

Operating income $ 65,000

E. New sales price: $15.00 × 1.12 = $16.80

New variable cost per unit: $8.00 × 1.15 = $9.20

New fixed expenses: $175,000 + $30,000 = $205,000

New sales volume: 40,000 × .85 = 34,000 units

Total Per Unit

Sales $571,200 $16.80

Variable expenses 312,800 9.20

Contribution margin 258,400 $ 7.60

Fixed expenses 205,000

Operating income $ 53,400

Chapter 7: Practice Exercises (in Webster, 2015)

• Unit 7.1 Practice Exercise

• Unit 7.2 Practice Exercise

• Unit 7.3 Practice Exercise

(Practice exercises follow the Self Study questions.)

Exercise: Traditional & Activity-Based Costing Determining Product Costs

Your company produces Product A and Product B. Total overhead costs traditionally have been allocated

based on direct labor hours. Here are the cost pools and cost drivers based on ABC. From now on,

general costs will not be allocated to products.

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Activity Pool Department Cost Cost Driver

Binding 297,000 Number of units

Printing 955,500 Machine hours

Design 234,000 Change orders

General 727,500 None

Total overhead costs $2,214,000

Other information is as follows:

Produce A Product B

Units 62,500 20,000

Direct materials cost per unit 3.00 10.00

Direct labor cost per unit 4.00 8.00

Direct labor hours 30,000 19,200

Machine hours 150,000 144,000

Change orders 1,500 2,400

Required

A. Determine the unit product cost for Product A and Product B using the traditional costing

system.

B. Determine the unit product cost for Product A and Product B using the ABC system.

C. Show that general cost is the difference between the total overhead costs allocated to products

under the traditional system and the total cost allocated to products under ABC.

Solution to Exercise

A.

Predetermined OH rate = $2,214,00 = $45/DLH

(30,000 DLH + 19,200 DLH)

Product A Product B

Direct Materials $3.00 $10.00

Direct Labor 4.00 8.00

Overhead 30,000DLH × $45/DLH= 21.60 19,200DLH × $45/DLH= 43.20 62,500 Product A 20,000 Product B

Total Unit Cost $28.60 $61.20

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B. ABC Rates

Binding: $297,000 = $3.60/unit (62,500 + 20,000 Product A) Printing: $955,500 = $3.25/machine hour (150,000 + 144,000) machine hours Design: $234,000 = $60/change order (1,500 + 2,400) change orders

ABC overhead allocation

Products A

Binding 62,500 tablet × $3.60/unit $225,500

Printing 150,000 MH × $3.25/MH 487,500

Design 1,500 change orders × $60/change order 90,000

Total overhead 802,500

Units produce  62,500

Overhead per unit $12.84

Products B

Binding 20,000 books × $3.60/unit $72,000

Printing 144,000 MH × $3.25/MH 468,000

Design 2,499 change orders × $60/change order 144,000

Total overhead 684,000

Units produced  20,000

Overhead per unit $34.20

ABC unit cost

Product A Product B

Direct Materials $ 3.00 $ 10.00

Direct Labor $ 4.00 8.00

Overhead 12.84 34.20

Total Unit Cost $19.84 $ 52.20

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C.

OH allocated to Product A using traditional DLH

(30,000 DLH × $45/DLH)

$1,350,000

OH allocated to Product B using traditional DLH

(19,200 DLH × $45/DLH)

864,000

Total allocated OH using traditional DLH $2,214,000

OH allocated to Product A using ABC 802,500

OH allocated to Product B using ABC 684,000

Total allocated OH using ABC 1,486,500

Difference in allocated overhead $ 727,500

References Jiambalvo, J. (1994). Managerial accounting 4th ed. Wiley.

Lumen Learning. (n.d.). Relevant range. Module 6: cost behavior patterns. Accounting for managers.

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Now that you have read this Review and Practice Guide and completed the exercises, you are ready to participate in the group assignment in Step 3.