COSTING AND PRICING MIDTERMS REVIEWER

CHAPTER 4: PRODUCT COSTING ANG PRICING

-One of the most important roles of managerial accountants is to help determine the cost of the products or services being
produced and sold by a company. Cost information is equally important for manufacturing and service businesses and is used by
managers across the organization.
-Pricing decisions made by marketing managers, manufacturing decisions made by production managers, and finance decisions
made by finance managers are all influenced by the cost of products.

LO1 (Product Costing Systems)

Job costing
-A costing system that accumulates, tracks, and assigns costs for each job produced by a company.
Process costing
-A costing system that accumulates and tracks costs for each process performed and then assigns those costs equally to each unit
produced.
-Companies that produce homogeneous product on a continuous basis like oil refineries, breweries, paint and paper
manufacturers use PROCESS COSTING.
Operations costing
- is a hybrid of job and process costing and is used by companies, such as clothing or automobile manufacturers, that make
products in batches- large numbers of products that are standardized within a batch.

LO2 (Basic Job Costing for Manufacturing and Service Companies)

- Charles' Custom Furniture (CCF) uses job cost- ling to accumulate, track, and assign costs to the cabinets it produces.
CCF builds furniture. based on customer orders so each piece is unique. The direct material, direct labor, and overhead
costs for a specific job are accumulated on a job cost report. This report may be prepared manually or be totally
automated. Regardless, its role is to keep track of the material, labor, and overhead costs that are incurred for a
particular job

Measuring and Tracking Direct Materials

Direct material costs - include the costs of the primary materials used in production. In addition to the cost of the materials
themselves, the cost of direct materials includes shipping costs (if paid by the purchaser), sales tax paid on the purchase (if any),
and other costs incurred in delivering the materials to the factory.
-Measuring direct material cost should be a relatively easy task for CCF. The company has to identify only the amount of
material actually used in each job and attach the proper cost to it. CCF uses a of materials, including variety of wood, fabric, glue,
screws, dowels, and stain, in constructing a finished piece of furniture.

Measuring and Tracking Direct Labor

-The costs of direct labor include the wages earned by production workers for the actual time spent working on a product. The
measurement of direct labor cost also should be a relatively easy task.
-Direct labor cost refers to labor that is directly related to manufacturing a product or providing a service. Assembly-line workers
in a manufacturing setting and CPAs working on tax returns are examples of direct labor.
Fringe benefits
-Payroll costs in addition to the basic hourly wage.
Idle time
-Worker time that is not used in the production of the finished product.
Overtime premium
-An additional amount added to the basic hourly wage owing to overtime worked by the workers.

LO3 (Manufacturing Overhead)

- Overhead is the most difficult product cost to accumulate, track, and assign to products. Unlike direct materials and
direct labor, overhead is made up of several seemingly unrelated costs-rent, depreciation, insurance, repairs and
maintenance, utilities, indirect labor, indirect materials, and so on.
Cost Drivers and Overhead Rate
Understanding what causes overhead costs to be incurred is the key to allocating overhead. The choice of a logical base on which
to allocate overhead depends on finding a cause-and-effect relationship between the base and the overhead. A good allocation
base is one that drives the incurrence of the overhead cost. Therefore, allocation bases are often referred to as cost drivers.

A cost driver for overhead is an activity that causes overhead to be incurred. If we wanted to allocate the cost of utilities incurred
to run machines in the factory to products, we would want to find a cost driver that causes the utility costs to be incurred. In this
case, the time the machines were in use (machine hours) might be an appropriate allocation base. If it takes twice as many
machine hours to make chairs as it does to make tables, chairs would correspondingly be allocated twice as much utility cost. In
more labor-intensive companies, the cost of utilities might be allocated using direct labor hours instead of machine hours as the
cost driver. The choice of cost driver depends on the specific company and the processes it utilizes in manufacturing products and
providing services to customers.

Allocation
-The process of finding a logical method of assigning overhead costs to the products or services a company produces or provides.
Cost drivers
-Factors that cause, or drive, the incurrence of costs.
Cost pools
-Groups of overhead costs that are similar; used to simplify the task of assigning costs to products using ABC costing.

Plantwide Overhead Rates

-In labor-intensive manufacturing companies and service industries, direct labor hours or direct labor cost have often served as
cost drivers. In automated manufacturing environments, machine hours historically have been used as the cost driver.
-Direct labor hours and machine hours are both volume-based cost drivers-that is, they are directly related to the volume or
number of units produced.

Predetermined Overhead Rates

-Companies that estimate the amount of overhead cost incurred in costing products allocate overhead by using predetermined
overhead rates. Predetermined overhead rates are calculated using a slight modification of the basic overhead rate formula

Predetermined overhead rate (for a cost pool) =

Estimated overhead for the cost pool/Estimated units of the cost driver.
- Predetermined overhead rates are typically calculated using annual estimates of overhead and cost drivers, although
some companies do more frequent calculations.

LO4 (The Use of Estimates)

-It is not unusual for managers to want to estimate the cost of a product before it is actually produced or before the actual costs
are known with certainty. Having timely cost information is useful for pricing decisions as well as for production decisions.
However, because the actual amount of many overhead items will not be known until the end of a period (perhaps when an
invoice is received), companies often estimate the amount of overhead that will be incurred in the coming period.
- Using estimates smoothes out, or normalizes, seasonal and random fluctuations in overhead costs. Thus, this method of costing
is often called normal costing.

Normal costing
-A method of costing using an estimate of overhead and predetermined overhead rates instead of the actual amount of overhead.

LO5 (The Problem of Over- and Underapplied Overhead)

-Because overhead is applied to products using predetermined overhead rates based on estimates, it is likely that actual overhead
costs (when they be- come known) will differ from those applied. If applied overhead is greater than actual overhead, the
company overapplied overhead. If the applied overhead is less than actual overhead, the company underapplied overhead
for the period. Over- and underapplied over- head can occur for a couple of reasons-estimating the overhead incorrectly or
estimating the cost driver incorrectly.

LO6 (Basic Process Costing)

Companies that produce beverages or other products (paint, paper, oil, and textiles) in a continuous flow production process
typically use process costing. As mentioned previously, instead of accumulating, tracking, and assigning direct material and
direct labor costs directly to each job, process costing systems accumulate and track direct material and direct labor costs by
department and then assign the costs evenly to the products that pass through each department. Likewise, instead of applying
overhead to each specific job, overhead is applied to each department and then assigned evenly to each product that passes
through. Although the application to job or department differs, the amount of overhead applied is calculated in exactly the same
way. After predetermined overhead rates are developed, overhead is applied by multiplying the predetermined overhead rate by
the actual units of cost driver incurred in each department. A comparison of the cost flows in job costing and process costing is
shown in Exhibit 4-7.

Materials, Labor, and Overhead Cost Journal Entries

The use of multiple WIP accounts in process costing introduces some peculiarities in recording the flow of costs using journal
entries. While the journal entries to record the flow of costs through a process costing system are similar to those in job costing,
there are a few key differences.

Material Costs
-As materials are drawn from the raw materials inventory storeroom, the costs are traced to processing departments rather than
individual jobs.

Equivalent units
-The number of finished units that can be made from the materials, labor, and overhead included in partially completed units.

Labor Costs
-Likewise, labor costs are traced directly to a processing department rather than to individual jobs. As labor costs are incurred in
processing department A, the journal entry to record the labor costs is as follows:

Overhead Costs
-Predetermined overhead rates are typically used in process costing to apply overhead. However, instead of applying overhead to
a particular job, overhead is applied to units of product as they move through each processing department as follows:

Transferring Costs from Process to Process

-As work is completed within a processing department, the accumulated costs of materials, labor, and overhead must be
transferred to the next processing department. For example, once processing is complete in process A, the accumulated costs in
the WIP account would be transferred to the WIP account in process B as follows:
Transferring Costs to Finished Goods
-As work is completed in process C, the product is ready to transfer to finished goods. The journal entry to transfer the costs of
the completed units to finished goods inventory is as follows:

Recording the Cost of Goods Sold

- As the finished goods are sold, the cost of the goods is transferred out of finished goods inventory and recognized as the cost of
goods sold:

LO7 (Additional Topics in Process Costing)

When a company has both beginning and ending inventories of WIP, process costing becomes more complicated. In this
situation, it is useful to view process costing in four steps.

LO8 (Allocation of Service Department Costs to Production Department)

- Many large organizations have both production departments and service departments. The production departments are
involved in the direct manufacturing of the company's product or provision of a service to external customers. On the
other hand, service departments provide various services to other departments within the organization.
- Allocation of service department costs to production departments that consume the services is one of the first steps in
the overall product-costing process. Costs must be allocated using an allocation base or cost driver that is related to the
particular costs incurred. For example, a cafeteria's costs would typically be allocated on the basis of the number of
meals served to a production department. Other common cost drivers for various service departments are listed in the
second column of Exhibit 4-19.
Companies allocate service department costs to production for various reasons, such as:
 To provide more accurate product cost information
 To improve decisions concerning scarce resources
 To hold service departments accountable for the costs they incur
 To hold production departments accountable for the services they consume

Service department costs can be allocated on the basis of actual or budgeted costs.
In general, budgeted costs should be allocated to production departments because allocating actual costs would allow the service
department to pass cost inefficiencies in their departments to the production departments that consume their services. There are
three methods of allocating service depart gent costs. The direct method is the most widely used. It allocates each service
department's costs directly to the department.
Direct method
-A method of allocating service department costs that allocates costs directly to production departments.
Step-down or sequential method
-Recognizes that service departments consume resources of other service departments and allocates those costs to other service
departments and then to production departments in a sequential fashion.

CHAPTER 6: Cost Volume Profit Analysis

Introduction
Some of the more important decisions managers make involve analyzing the relationships among the cost, volume, and
profitability of products produced and services provided by a company.
Cost-volume-profit (CVP) analysis focuses on the relationships among the following five factors and the overall profitability of a
company:

1. The prices of products or services

2. The volume of products or services produced and sold
3. The per unit variable costs
4. The total fixed costs
5. The mix of products or services produced

As in any form of analysis involving projections of the future, certain assumptions must be considered. The major assumptions
are as follows:
1. The selling price is constant throughout the entire relevant range. In other words, we assume that the sales price of the product
will not change as volume changes.
2. Costs are linear throughout the relevant range. As discussed in Chapter 3, although costs may bchave in a curvilinear fashion,
they can often be approximated by a linear relationship between cost and volume within the relevant range.
3. The sales mix used to calculate the weighted-average contribution margin is constant.
4. The amount of inventory is constant. In other words, the number of units produced is equal to the number of units sold.

Although some of these assumptions are often violated in real business settings, the violations are usually minor and have little or
no impact on management deci sions. CVP analysis can still be considered valid and very useful in decision making.

LO1. The Contribution Margin and Its Uses

As mentioned in Chapter 3, the traditional income statement required for external financial reporting focuses on function (product
costs versus period costs) in calculating cost of goods sold and a company's gross profit. Gross profit is the difference between
sales and cost of goods sold. However, because cost of goods sold includes both fixed costs
(facility-level costs, such as rent) and variable costs (tumit-level costs, such as direct materials), the behavior of cost of goods
sold and gross profit is difficult to predict when production increases or decreases.

The difference between sales and cost of goods sold is Gross Profit.

The contribution margin income statement is structured to emphasize cost behavior as opposed to cost function.

Contribution Margin Ratio

The contribution margin income statement can also be presented using percentages, as shown in the following income statement.
The contribution margin ratio is calculated by dividing the contribution margin in dollars by sales dollars.

The contribution margin per unit and the contribution margin ratio will remain constant as long as sales vary in direct proportion
to volume.

The contribution margin ratio can be viewed as the amount of each sales dollar contributing to the payment of fixed costs and
increasing net profit-that is, 28 cents of cach sales dollar contributes to the payment of fixed costs or increases net income. Like
the contribution margin per unit, the contribution margin ratio will remain constant as long as sales vary in direct proportion to
volume.

Contribution margin ratio

The contribution margin divided by sales; used to calculate the change in contribution margin resulting from a dollar change in
sales.

LO2: What-If Decisions Using CVP

Continuing with our example, Happy Daze had
a net loss of $7,000 when 8,000 units were sold. At that level of sales, the total contribution margin of $28,000 is not sufficient to
cover fixed costsof $35,000. The CEO of the company would like to consider options to increase net income while maintaining
the high quality of the company's products. After consultation with marketing, operations, and accounting managers, the CEO
identifies three options that she would like to consider in more depth:
1. Reducing the variable costs of manufacturing the product
2. Increasing sales through a change in the sales incentive structure or commissions (which would also increase variable costs)
3. Increasing sales through improved features and increased advertising

LO3: Break-Even Analysis

In addition to what-if analysis, it is useful for managers to know the number of units sold or the dollar amount of sales that is
necessary for a company to break even. The break-even point is the level of sales at which contribution margin just covers fixed
costs and, consequently, net income is equal to zero. Break-even analysis is really just a variation of CVP analysis in which
volume is increased or decreased in an effort to find the point at which net income is equal to zero.
Break-even analysis is facilitated through the use of a mathematical equation derived directly from the contribution margin
income statement. Another way to look at these relationships is to put the income statement into equation form:

Sales - Variable Costs - Fixed Costs = Net Income SP(x) - VC(x) - FC = NI

where:
SP = Sales price per unit
VC = Variable costs per unit
FC = Total fixed costs
NI = Net income
x = Number of units sold

Break-Even Calculations with

Multiple Products
Break-even calculations become more difficult when more than one product is produced and sold. In a multiproduct environment,
a manager calculating the break-even point is concerned not so much with the unit sales or the dollar sales of a single product but
with the amount of total sales necessary to break even. This requires the calculation of an "average" contribution margin for all
the products produced and sold. This in turn requires an estimate of the sales mix-the relative percentage of total units or total
sales dollars expected from each product. However, customers (and sales volume) will not always behave in the manner that we
predict.

A thorough understanding of fixed and variable costs is necessary before a manager can calculate and understand a break-even
analysis.

LO4: Target Profit Analysis (Before and After Tax)

The goal of most businesses is not to break even but to earn a profit. Luckily, we can easily modify the break-even formula to
compute the amount of sales needed to earn a target profit (before tax). Instead of solving for the sales necessary to earn a net
income of zero, we simply solve for the sales necessary to reach a target profit.

Sales - Variable Costs - Fixed Costs = Target Profit (before tax)

SP(x) - VC(x) - FC = TP

where:
SP = Sales price per unit
VC = Variable costs per unit
FC = Total fixed costs
TP = Target profit (before tax)
x = Number of units sold

The payment of income taxes is an important variable in target profit and other CVP decisions if managers are to understand the
bottom line effect of their decisions.

LO5: Cost Structure and Operating Leverage

As mentioned in Chapter 3, cost structure refers to the relative proportion of fixed and variable costs in a company. Highly
automated manufacturing companies with large investments in property, plant, and equipment are likely to have cost structures
dominated by fixed costs. On the other hand, labor-intensive companies such as home builders are likely to have cost structures
dominated by variable costs. Even companies in the same industry can have very different cost structures. A company's cost
structure is important because it directly affects the sensitivity of that company's profits to changes in sales volume. Consider, for
example, two companies that make the same product (furniture), with the same sales and same net income.

Operating Leverage
Operating leverage is a measure of the proportion of fixed costs ina company's cost structure and is used as an indicator of how
sensitive profit is to changes in sales volume. A company with high fixed costs in relation to variable costs will have a high level
of operating leverage. In this case, net income will be very sensitive to changes in sales volume. In other words, a small
percentage increase in sales dollars will result in a large percentage increase in net income. On the other hand, a company with
high variable costs in relation to fixed costs will have a low level of operating leverage, and income will not be as sensitive to
changes in sales volume. Operating leverage is computed using the following formula:

Operating leverage = contribution margin / net income

A company operating near the break-even point will have a high level of operating leverage, and income will be very sensitive to
changes in sales volume.

CHAPTER 7- Relevant Costs and Product Planning Decisions.

Introduction

Relevant costs are costs that differ among alternatives, that is, costs that are avoidable or can be eliminated by choosing one
alternative over another. Because sunk costs have already been incurred and cannot be avoided, they are not relevant in decisions.
Likewise, future costs that do not differ among alternatives are not relevant because they cannot be eliminated by choosing one
alterna- tive over another. On the other hand, opportunity costs are relevant in decision making. In this chapter, we discuss the
tools that managers use to make these short-term tactical decisions

LO1 Special Orders

Special-order decisions - Short-run pricing decisions in which management must decide which sales price is appropriate when
customers place orders that are different from those placed in the regular course of business (onetime sale to a foreign customer,
etc.).

Many of the costs of flying an airliner are fixed and don't vary with the number of passengers on the plane. Understanding cost
behavior is critical for companies making everyday decisions such as those discussed in this chapter.

A special order would almost never be accepted if a company does not have excess capacity. If a company does not have excess
capacity, it will have to turn away current customers in order to fill a special order.

If a special order is profitable from a quantitative perspective, the impact on customer relations should be considered before
deciding whether to accept or reject the order.

LO2 Outsourcing and Other Make-or-Buy Decision

The decision to outsource labor or to purchase components used in manu- facturing from another company rather than to provide
the services to produce the or components internally affects a wide range of manufacturing, merchandising, and service
organizations. For example, a university can contract with an outside company to provide janitorial and repair services-for on-
campus dormitories, or it can provide those services by using university employees. A local florist can provide payroll processing
internally, or it can hire a CPA to provide those services. Hewlett-Packard can make carrying cases for its calculators internally.

Strategic Aspects of Outsourcing and Make-or-Buy Decisions

An analysis of outsourcing and make-or-buy decisions requires an in-depth analysis of relevant quantitative and qualitative
factors and a consideration of the costs and benefits of outsourcing and vertical integration. Forexample, Sunset Airlines might
consider outsourcing the

Make-or-buy decisions Short-term decisions

- to outsource labor or to purchase components used in manufacturing from another company rather than to provide
services or produce components internally.

Vertical integration- is accomplished when a com pany is involved in multiple steps of the value chain. In an extreme example,
the same company might own a gold mine, a manufacturing facility to produce gold jewelry, and a retail jewelry store.

Advantages of making components internally

Vertically integrated companies are not dependent on suppliers for timely delivery of services or components needed in the
production process or for the quality of those services and components.

There are disadvantages to making parts internally. The supplier may be able to provide a higher-quality Vertical integration
Accomplished when a part for less cost.

A product should continue to be made internally if the avoidable costs are less than the additional costs that will be
incurred by buying or outsourcing.

LO3 The Decision to Drop a Product or a Service

The decision to drop a product or a service is among the most difficult that a manager can make. Like other decisions discussed
in this chapter, deciding whether to drop an old product or product line hinges on an analysis of the relevant costs and qualitative
factors affecting the decision. Qualitative factors are sometimes more important than focusing solely on income.

A product should be dropped when the fixed costs that are avoided exceed the contribution margin that is lost.

As we discussed earlier, qualitative factors are sometimes more important than quantitative factors in these decisions. For
example, what impact will discontinuing the sale of mud and snow tires have on sales of the remaining product lines? Tire
retailers are likely to prefer purchasing tires from a company offering a full line of tires. Retailers that cannot offer mud and snow
tires may have difficulty selling tires to individuals in the winter

LO4 Resource Utilization Decisions

A company faces a constraint when the capacity to manufacture a product or to provide a service is limited in some manner. A
resource utilization decision requires an analysis of how best to use a resource that is available in limited supply. The limited
resource may be a rare material or component used in manufacturing a product, but more likely is related to the time required to
make a product or provide a service or to the space required to store a product. For example, build- ing custom furniture requires
skilled craftspeople, who
Constraint- A restriction that occurs when the capacity to manufacture a product or to provide a service is limited in some
manner.

Resource utilization decision - A decision requiring an analysis of how best to use a resource that is available in limited supply.

Deciding how best to utilize the limited labor time available is a resource utilization decision.

● Grocery stores and other retail stores have limited shelf space. The resource utilization decision involves an analysis of
how best to use this limited re- source.
● A decision concerning how much of each product to have on hand must also consider the impact of qualitative factors,
such as customer reaction if a product is not carried, the impact on sales of other products, and so on.

Resource utilization decisions are typically short- rerm decisions. In the short run, such resources as ma- chine time, labor hours,
and shelf space are fixed and cannot be increased. However, in the long run, new machines can be purchased, additional skilled
laborers can be hired, and stores can be expanded. When faced with short-run constraints, managers must focus on the
contribution margin provided by each product per unit of limited resource rather than on the profitability of each product.

Decisions valving limited resources or constraints often include multiple constraints, such as storage space, machine time, labor
hours, and yen dollars available to invest. When we have more than one constraining factor, the decision-making process
becomes more complicated and is facilitated by the use of computerized near programming models. A discussion of linear
pgramming is beyond the scope of this text

LO5 The Theory of Constraints

The theory of constraints- is a management tool for dealing with constraints. The theory of constraints identifies bottlenecks in
the production process.

Bottlenecks- limit throughout, which can be thought of as the amount of finished goods that result from the production process.
In the previous example, machine time is a bottleneck that limits the amount of throughput. In the airline industry, certain tasks
performed while the aircraft is on the ground may delay departure and increase the turnaround time for the plane.

Bottlenecks must be identified and managed if a business is to be successful in overcoming constraints.

In Exhibit 7-7, Birdie Maker has discovered that delays in delivery of golf clubs to customers result from the extra time it takes to
order and receive putters from Ace Putters. Options for relieving this bottleneck in- clude requiring Ace Putters to reduce its
delivery time. If Ace cannot speed up delivery, Birdie Maker might consider using another supplier or perhaps making thetime
spent manufacturing irons or woods, will not re- duce overall delivery time until the bottleneck with the putters is relieved.

LO6 Decisions to Sell or Process Further

The decision whether to sell a product as is or process it further LO generare additional revenue is another common management
decision. For example, furniture manufacturers may sell fur- niture unassembled and unfinished, assembled and finished (see
Exhibic 7-8). The key in deciding whether to sell or process further is that all costs that are incurred up to the point where the
decision is made are sunk costs and therefore not relevant.

A product should be processed further if the additional revenue exceeds the additional.

The relevant costs are the incremental or additional processing costs. Managers should compare the addi- tional sales revenue that
can be earned from processing the product further to the additional processing costs. If the additional revenue is greater than the
additional costs, the product should be processed further. If the additional costs exceed the revenues, the product should be sold
as is.

Unassembled and unfinished furniture- Assembled but unfinished furniture

- Compare costs to assemble with additional revenue from selling assembled furniture
Assembled but unfinished furniture- Assembled and finished furnitures
- Compare costs to finish with additional revenue from selling assembled and finished by

For example, assume that unassembled and unfinished tables cost $100 to produce and can be sold for $150. The company is
considering selling assembled and finished tables for $225 each. Additional as- sembly and finishing costs of $45 per table would
be required. the additional (incremental) revenue from selling assembled and finished furniture is $75 per unit. As long as the ad-
ditional (incremental) costs of assembly and finishing are less than $75, the company will