Accounting For Dummies 4th Edition_10 ppt

Calculating product costThe basic equation for calculating product cost is as follows using the ple of the manufacturer given in Figure 11-1: exam-$91,200,000 total manufacturing costs ÷

Assembling the Product Cost

of Manufacturers

Businesses that manufacture products have several additional cost problems

to deal with, compared with retailers and distributors I use the term ture in the broadest sense: Automobile makers assemble cars, beer companies

manufac-brew beer, automobile gasoline companies refine oil, DuPont makes products

through chemical synthesis, and so on Retailers (also called merchandisers)

and distributors, on the other hand, buy products in a condition ready forresale to the end consumer For example, Levi Strauss manufactures clothing,and Macy’s is a retailer that buys from Levi Strauss and sells the clothes to thepublic The following sections describe costs unique to manufacturers

Minding manufacturing costs

Manufacturing costs consist of four basic types:

 Raw materials (also called direct materials): What a manufacturer buys

from other companies to use in the production of its own products Forexample, General Motors buys tires from Goodyear (or other tire manu-facturers) that then become part of GM’s cars

 Direct labor: The employees who work on the production line.

 Variable overhead: Indirect production costs that increase or decrease as

the quantity produced increases or decreases An example is the cost ofelectricity that runs the production equipment: You pay for the electricityfor the whole plant, not machine by machine, so you can’t attach this cost

to one particular part of the process But if you increase or decrease theuse of those machines, the electricity cost increases or decreases accord-ingly (In contrast, the monthly utility bill for a company’s office and salesspace probably is fixed for all practical purposes.)

 Fixed overhead: Indirect production costs that do not increase or

decrease as the quantity produced increases or decreases These fixedcosts remain the same over a fairly broad range of production outputlevels (see “Fixed versus variable costs,” earlier in this chapter) Threesignificant fixed manufacturing costs are

• Salaries for certain production employees who don’t work directly

on the production line, such as a vice president, safety inspectors,security guards, accountants, and shipping and receiving workers

• Depreciation of production buildings, equipment, and other facturing fixed assets

manu-• Occupancy costs, such as building insurance, property taxes, andheating and lighting charges

Figure 11-1 presents an annual income statement for a manufacturer andincludes information about its manufacturing costs for the year The cost ofgoods sold expense depends directly on the product cost from the summary

of manufacturing costs that appears below the income statement A businessmay manufacture 100 or 1,000 different products, or even more, and the busi-ness must prepare a summary of manufacturing costs for each product Tokeep our example easy to follow (but still realistic), Figure 11-1 presents a sce-nario for a one-product manufacturer The multi-product manufacturer hassome additional accounting problems, but I can’t provide that level of detailhere This example illustrates the fundamental accounting problems andmethods of all manufacturers

Income Statement for Year

Manufacturing Costs for Year

Variable manufacturing overhead costs 70 8,400,000Total variable manufacturing costs $410 $49,200,000Fixed manufacturing overhead costs 350 42,000,000

To 10,000 units inventory increase (7,600,000)

Figure 11-1:

Example fordeterminingthe productcost of

a facturer

manu-The information in the manufacturing costs summary below the incomestatement (see Figure 11-1) is highly confidential and for management eyesonly Competitors would love to know this information A company mayenjoy a significant cost advantage over its competitors and definitely doesnot want its cost data to get into their hands.

Classifying costs properly

Two vexing issues rear their ugly heads in determining product cost for amanufacturer:

 Drawing a bright line between manufacturing costs and manufacturing operating costs: The key difference here is that manufac-

non-turing costs are categorized as product costs, whereas non-manufacnon-turingoperating costs are categorized as period costs (refer to “Product versusperiod costs,” earlier in this chapter) In calculating product costs, youinclude only manufacturing costs and not other costs Period costs arerecorded right away as expenses — either in variable operating expenses

or fixed operating expenses (see Figure 11-1) Here are some examples ofeach type of cost:

• Wages paid to production line workers are a clear-cut example of amanufacturing cost

• Salaries paid to salespeople are a marketing cost and are not part

of product cost; marketing costs are treated as period costs, whichmeans they are recorded immediately to expense of the period

• Depreciation on production equipment is a manufacturing cost,but depreciation on the warehouse in which products are storedafter being manufactured is a period cost

• Moving the raw materials and partially-completed products throughthe production process is a manufacturing cost, but transporting thefinished products from the warehouse to customers is a period cost.The accumulation of direct and indirect production costs starts at thebeginning of the manufacturing process and stops at the end of the produc-tion line In other words, product cost stops at the end of the productionline — every cost up to that point should be included as a manufacturingcost

If you misclassify some manufacturing costs as operating costs, yourproduct cost calculation will be too low (see the following section,

“Calculating product cost”) Also, the Internal Revenue Service may comeknocking at your door if it suspects that you deliberately (or even inno-cently) misclassified manufacturing costs as non-manufacturing costs inorder to minimize your taxable income

 Allocating indirect costs among different products: Indirect

manufac-turing costs must be allocated among the products produced duringthe period The full product cost includes both direct and indirectmanufacturing costs Creating a completely satisfactory allocationmethod is difficult; the process ends up being somewhat arbitrary, but

it must be done to determine product cost Managers should understandhow indirect manufacturing costs are allocated among products (and,for that matter, how indirect non-manufacturing costs are allocatedamong organizational units and profit centers) Managers should alsokeep in mind that every allocation method is arbitrary and that a differentallocation method may be just as convincing (See the sidebar “Allocatingindirect costs is as simple as ABC — not!”)

Allocating indirect costs is

as simple as ABC — not!

Accountants for manufacturers have developedmany methods and schemes for allocating indi-rect overhead costs, most of which are based

on a common denominator of production ity, such as direct labor hours or machine hours

activ-A different method has received a lot of pressrecently: activity-based costing (ABC)

With the ABC method, you identify each porting activity in the production process andcollect costs into a separate pool for each iden-tified activity Then you develop a measure foreach activity — for example, the measure for theengineering department may be hours, and themeasure for the maintenance department may

sup-be square feet You use the activity measures ascost drivers to allocate costs to products

The idea is that the engineering departmentdoesn’t come cheap; including the cost of theirslide rules and pocket protectors, as well as theirsalaries and benefits, the total cost per hour forthose engineers could be $200 or more The logic

of the ABC cost-allocation method is that theengineering cost per hour should be allocated onthe basis of the number of hours (the driver)required by each product So if Product A needs

200 hours of the engineering department’s timeand Product B is a simple product that needs only

20 hours of engineering, you allocate ten times asmuch of the engineering cost to Product A Insimilar fashion, suppose the cost of the mainte-nance department is $20 per square foot per year

If Product C uses twice as much floor space asProduct D, it would be charged with twice asmuch maintenance cost

The ABC method has received much praise forbeing better than traditional allocation methods,especially for management decision making

But keep in mind that this method still requiresrather arbitrary definitions of cost drivers, andhaving too many different cost drivers, eachwith its own pool of costs, is not too practical

Cost allocation always involves arbitrary ods Managers should be aware of which meth-ods are being used and should challenge amethod if they think that it’s misleading andshould be replaced with a better (though stillsomewhat arbitrary) method I don’t mean to puttoo fine a point on this, but cost allocationessentially boils down to a “my arbitrary method

meth-is better than your arbitrary method” argument

Calculating product cost

The basic equation for calculating product cost is as follows (using the ple of the manufacturer given in Figure 11-1):

exam-$91,200,000 total manufacturing costs ÷ 120,000 unitsproduction output = $760 product cost per unitLooks pretty straightforward, doesn’t it? Well, the equation itself may besimple, but the accuracy of the results depends directly on the accuracy ofyour manufacturing cost numbers The business example we’re using in thischapter manufactures just one product Even so, a single manufacturingprocess can be fairly complex, with hundreds or thousands of steps andoperations In the real world, where businesses produce multiple products,your accounting systems must be very complex and extraordinarily detailed

to keep accurate track of all direct and indirect (allocated) manufacturingcosts

In our example, the business manufactured 120,000 units and sold 110,000units during the year, and its product cost per unit is $760 The 110,000 totalunits sold during the year is multiplied by the $760 product cost to computethe $83.6 million cost of goods sold expense, which is deducted against thecompany’s revenue from selling 110,000 units during the year The company’stotal manufacturing costs for the year were $91.2 million, which is $7.6 mil-lion more than the cost of goods sold expense The remainder of the totalannual manufacturing costs is recorded as an increase in the company’sinventory asset account, to recognize that 10,000 units manufactured thisyear are awaiting sale in the future In Figure 11-1, note that the $760 productcost per unit is applied both to the 110,000 units sold and to the 10,000 unitsadded to inventory

Note: The product cost per unit for our example business is determined for

the entire year In actual practice, manufacturers calculate their productcosts monthly or quarterly The computation process is the same, but the frequency of doing the computation varies from business to business.Product costs likely will vary each successive period the costs are deter-mined Because the product costs vary from period to period, the businessmust choose which cost of goods sold and inventory cost method to use (Ifproduct cost happened to remain absolutely flat and constant period toperiod, the different methods would yield the same results.) Chapter 7explains the alternative accounting methods for determining cost of goodssold expense and inventory cost value

Examining fixed manufacturing costs and production capacity

Product cost consists of two very distinct components: variable manufacturing costs and fixed manufacturing costs In Figure 11-1, note that the company’s

variable manufacturing costs are $410 per unit, and its fixed manufacturingcosts are $350 per unit Now, what if the business had manufactured ten moreunits? Its total variable manufacturing costs would have been $4,100 higher

The actual number of units produced drives variable costs, so even one moreunit would have caused the variable costs to increase But the company’s totalfixed costs would have been the same if it had produced ten more units, or10,000 more units for that matter Variable manufacturing costs are bought on aper-unit basis, as it were, whereas fixed manufacturing costs are bought in bulkfor the whole period

Fixed manufacturing costs are needed to provide production capacity — the

people and physical resources needed to manufacture products — for theperiod After the business has the production plant and people in place forthe year, its fixed manufacturing costs cannot be easily scaled down Thebusiness is stuck with these costs over the short run It has to make the bestuse it can from its production capacity

Production capacity is a critical concept for business managers to stay focused

on You need to plan your production capacity well ahead of time because youneed plenty of lead-time to assemble the right people, equipment, land, andbuildings When you have the necessary production capacity in place, you want

to make sure that you’re making optimal use of that capacity The fixed costs ofproduction capacity remain the same even as production output increases ordecreases, so you may as well make optimal use of the capacity provided bythose fixed costs For example, you’re recording the same depreciation amount

on your machinery regardless of how you actually use those machines, so youshould be sure to optimize the use of those machines (within limits, of course —overworking the machines to the point where they break down won’t do youmuch good)

The burden rate

The fixed cost component of product cost is called the burden rate In our

man-ufacturing example, the burden rate is computed as follows (see Figure 11-1 for data):

$42,000,000 fixed manufacturing costs for period ÷120,000 units production output for period =

$350 burden rateNote that the burden rate depends on the number divided into total fixedmanufacturing costs for the period — that is, the production output for theperiod

Now, here’s a very important twist on my example: Suppose the companyhad manufactured only 110,000 units during the period — equal exactly tothe quantity sold during the year Its variable manufacturing cost per unitwould have been the same, or $410 per unit But its burden rate would havebeen $381.82 per unit (computed by dividing the $42 million total fixed manu-facturing costs by the 110,000 units production output) Each unit sold, there-fore, would have cost $31.82 more simply because the company producedfewer units (The burden rate is $381.82 at the 110,000 output level but only

$350 at the 120,000 output level.)

If only 110,000 units were produced, the company’s product cost would havebeen $791.82 ($410 variable costs plus the $381.82 burden rate) The com-pany’s cost of goods sold, therefore, would have been $3.5 million higher forthe year ($31.82 higher product cost ×110,000 units sold) This rather signifi-cant increase in its cost of goods sold expense is caused by the company pro-ducing fewer units, even though it produced all the units that it needed forsales during the year The same total amount of fixed manufacturing costs isspread over fewer units of production output

Idle capacity

The production capacity of the business example in Figure 11-1 is 150,000 unitsfor the year However, this business produced only 120,000 units during theyear, which is 30,000 units fewer than it could have In other words, it operated

at 80 percent of production capacity, which is 20 percent idle capacity:

120,000 units output ÷ 150,000 units capacity = 80% utilization, or 20% idle capacityThis rate of idle capacity isn’t unusual — the average U.S manufacturingplant normally operates at 80 to 85 percent of its production capacity

The effects of increasing inventory

Looking back at the numbers shown in Figure 11-1, the company’s cost ofgoods sold benefited from the fact that it produced 10,000 more units than itsold during the year These 10,000 units absorbed $3.5 million of its totalfixed manufacturing costs for the year, and until the units are sold this $3.5million stays in the inventory asset account (along with the variable manufac-turing costs, of course) It’s entirely possible that the higher production levelwas justified — to have more units on hand for sales growth next year Butproduction output can get out of hand, as I discuss in the following section,

“Puffing Profit by Excessive Production.”

Managers (and investors as well) should understand the inventory increaseeffects caused by manufacturing more units than are sold during the year In theexample shown in Figure 11-1, the cost of goods sold expense escaped $3.5 million

of fixed manufacturing costs because the company produced 10,000 moreunits than it sold during the year, thus pushing down the burden rate Thecompany’s cost of goods sold expense would have been $3.5 million higher if

it had produced just the number of units it sold during the year The loweroutput level would have increased cost of goods sold expense and wouldhave caused a $3.5 million drop in gross margin and earnings before incometax Indeed, earnings before income tax would have been 27 percent lower($3.5 million ÷ $13.2 million = 27 percent decrease)

The actual costs/actual output method

and when not to use it

The product cost calculation for the businessexample shown in Figure 11-1 is based on theactual cost/actual output method, in which youtake your actual costs — which may have beenhigher or lower than the budgeted costs for theyear — and divide by the actual output for the year

The actual costs/actual output method is priate in most situations However, this method

appro-is not appropriate and would have to be fied in two extreme situations:

modi- Manufacturing costs are grossly excessive

or wasteful due to inefficient production operations: For example, suppose that the

business represented in Figure 11-1 had tothrow away $1.2 million of raw materialsduring the year The $1.2 million should beremoved from the calculation of the rawmaterial cost per unit Instead, you treat it as

a period cost — meaning that you take itdirectly into expense Then the cost of goods

sold expense would be based on $750 perunit instead of $760, which lowers thisexpense by $1.1 million (based on the 110,000units sold) But you still have to record the

$1.2 million expense for wasted raw als, so EBIT would be $100,000 lower

materi- Production output is significantly less than normal capacity utilization: Suppose that the

Figure 11-1 business produced only 75,000units during the year but still sold 110,000units because it was working off a largeinventory carryover from the year before

Then its production output would be 50 cent instead of 80 percent of capacity In asense, the business wasted half of its pro-duction capacity, and you can argue that half

per-of its fixed manufacturing costs should becharged directly to expense on the incomestatement and not included in the calculation

of product cost

Puffing Profit by Excessive Production

Whenever production output is higher than sales volume, be on guard

Excessive production can puff up the profit figure How? Until a product is sold,the product cost goes in the inventory asset account rather than the cost ofgoods sold expense account, meaning that the product cost is counted as a

positive number (an asset) rather than a negative number (an expense) Fixed

manufacturing overhead cost is included in product cost, which means thatthis cost component goes into inventory and is held there until the productsare sold later In short, when you overproduce, more of your total of fixed man-ufacturing costs for the period is moved to the inventory asset account andless is moved into cost of goods sold expense for the year

You need to judge whether an inventory increase is justified Be aware that

an unjustified increase may be evidence of profit manipulation or just goodold-fashioned management bungling Either way, the day of reckoning willcome when the products are sold and the cost of inventory becomes cost ofgoods sold expense — at which point the cost impacts the bottom line

Shifting fixed manufacturing costs to the future

The business represented in Figure 11-1 manufactured 10,000 more units than

it sold during the year With variable manufacturing costs at $410 per unit,the business expended $4.1 million more in variable manufacturing coststhan it would have if it had produced only the 110,000 units needed for itssales volume In other words, if the business had produced 10,000 fewerunits, its variable manufacturing costs would have been $4.1 million less —that’s the nature of variable costs In contrast, if the company had manufac-

tured 10,000 fewer units, its fixed manufacturing costs would not have been

any less — that’s the nature of fixed costs

Of its $42 million total fixed manufacturing costs for the year, only $38.5 lion ended up in the cost of goods sold expense for the year ($350 burdenrate ×110,000 units sold) The other $3.5 million ended up in the inventoryasset account ($350 burden rate ×10,000 units inventory increase) The $3.5million of fixed manufacturing costs that are absorbed by inventory is shifted

mil-to the future This amount will not be expensed (charged mil-to cost of goodssold expense) until the products are sold sometime in the future

Shifting part of the fixed manufacturing cost for the year to the future mayseem to be accounting slight of hand It has been argued that the entireamount of fixed manufacturing costs should be expensed in the year that

these costs are recorded (Only variable manufacturing costs would beincluded in product cost for units going into the increase in inventory.)

Generally accepted accounting principles require that full product cost (variable

plus fixed manufacturing costs) be used for recording an increase in inventory

However, as the example in Figure 11-1 shows, producing more than you selldoes boost profit

Let me be very clear here: I’m not suggesting any hanky-panky in the exampleshown in Figure 11-1 Producing 10,000 more units than sales volume duringthe year looks — on the face of it — to be reasonable and not out of the ordi-nary Yet at the same time, it is nạve to ignore that the business did help itspretax profit to the amount of $3.5 million by producing 10,000 more units than

it sold If the business had produced only 110,000 units, equal to its sales volumefor the year, all its fixed manufacturing costs for the year would have gone intocost of goods sold expense The expense would have been $3.5 million higher,and EBIT would have been that much lower

Cranking up production output

Now let’s consider a more suspicious example Suppose that the businessmanufactured 150,000 units during the year and increased its inventory by40,000 units It may be a legitimate move if the business is anticipating a bigjump in sales next year On the other hand, an inventory increase of 40,000units in a year in which only 110,000 units were sold may be the result of aserious overproduction mistake, and the larger inventory may not be needednext year In any case, Figure 11-2 shows what happens to production costsand — more importantly — what happens to the profit lines at the higherproduction output level

The additional 30,000 units (over and above the 120,000 units manufactured

by the business in the original example) cost $410 per unit (The precise costmay be a little higher than $410 per unit because as you start crowding pro-duction capacity, some variable costs per unit may increase a little.) Thebusiness would need $12.3 million more for the additional 30,000 units of pro-duction output:

$410 variable manufacturing cost per unit × 30,000additional units produced = $12,300,000 additionalvariable manufacturing costs invested in inventoryAgain, its fixed manufacturing costs would not have increased, given thenature of fixed costs Fixed costs stay put until capacity is increased Salesvolume, in this scenario, also remains the same

But check out the business’s EBIT in Figure 11-2: $23.65 million, compared with

$15.95 million in Figure 11-1 — a $7.7 million higher amount, even though salesvolume, sales prices, and operating costs all remain the same Whoa! What’sgoing on here? The simple answer is that the cost of goods sold expense is $7.7million less than before But how can cost of goods sold expense be less? Thebusiness sells 110,000 units in both scenarios And variable manufacturingcosts are $410 per unit in both cases

Income Statement for Year

Manufacturing Costs for Year

To 40,000 units inventory increase (27,600,000)

Figure 11-2:

Example inwhichproductionoutputgreatlyexceedssalesvolume forthe year,therebyboostingprofit for theperiod

The culprit is the burden rate component of product cost In the Figure 11-1example, total fixed manufacturing costs are spread over 120,000 units ofoutput, giving a $350 burden rate per unit In the Figure 11-2 example, totalfixed manufacturing costs are spread over 150,000 units of output, giving amuch lower $280 burden rate, or $70 per unit less The $70 lower burden ratemultiplied by the 110,000 units sold results in a $7.7 million lower cost ofgoods sold expense for the period, a higher pretax profit of the same amount,and a much improved bottom-line net income.

Being careful when production output

is out of kilter with sales volume

In the example shown in Figure 11-2, the business produced 150,000 units (fullcapacity); therefore, its inventory asset absorbed $7.7 million of the company’sfixed manufacturing costs for the year, and its cost of goods sold expense forthe year escaped this cost But get this: Its inventory increased 40,000 units,which is quite a large increase compared with the annual sales of 110,000 duringthe year just ended Who was responsible for the decision to go full blast andproduce up to production capacity? Do the managers really expect sales to jump

up enough next year to justify the much larger inventory level? If they prove to

be right, they’ll look brilliant But if the output level was a mistake and sales donot go up next year they’ll have you-know-what to pay next year, even thoughprofit looks good this year An experienced business manager knows to be onguard when inventory takes such a big jump

Summing up, the cost of goods sold expense of a manufacturer, and thus itsoperating profit, is sensitive to a difference between its sales volume and pro-duction output during the year Manufacturing businesses do not generallydiscuss or explain in their external financial reports to creditors and ownerswhy production output is different than sales volume for the year Financialreport readers are pretty much on their own in interpreting the reasons forand the effects of under- or over-producing products relative to actual salesvolume for the year All I can tell you is to keep alert and keep in mind theprofit impact caused by a major disparity between a manufacturer’s produc-tion output and sale levels for the year

Part IV

Preparing and Using Financial

Reports