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Summary Intermediate Management Accounting (324223-B-6)
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It is a summary containing the Teacher Notes from topic 1-10, complemented by the lecture slides and the extra explanations given in the lectures.
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Topic 1: Volume-Based Costing (VBC) SystemBasic cost concepts
General cost classification – Costs incurred by firms can be classified as manufacturing costs and non-
manufacturing costs.
- Manufacturing costs (or Product costs)
o Direct materials:
Materials that can be traced to a product.
o Direct Labor:
Labor costs that can be traced to a product.
o Indirect/Overhead costs:
All costs of manufacturing a product other than direct materials and direct labor.
(depreciation of the equipment used, rent paid, water and electricity, etc.)
- Non-manufacturing costs (or Period costs) (not directly involved in de manufacturing process
but are still important to the business)
o Marketing/Selling costs:
All costs incurred to secure customer orders and get the products into the hand of the
customers.
o Administrative costs:
All costs associated with general management of the organization as a whole.
Cost behavior – Based on how they are associated with the volume of products/services, costs can be
classified as fixed costs and variable costs.
- Total costs
o Variable costs: increase with units.
o Fixed costs: do not change with units.
- Costs per unit
o Variable costs: same for each unit.
o Fixed costs: for each unit, the amount of fixed costs allocated decrease with total
number of production.
Cost allocation – firms need to allocate direct and indirect costs to each cost object (e.g., a product, a
product line, a service, etc.), for such purposes as ricing, profitability analysis, and control spending. The
choice of a cost-object can affect if a cost should be classifies as direct or indirect.
- Pricing:
Revenues need to cover all costs so firms can make profit
- Product mix:
Firms with limited capacity need to allocate their capacity in the most profitable way.
- Incentives for production and sales managers to consider all costs, not just the costs under their
control.
- Transfer pricing or government reimbursement
,Implications of cost allocation
- Calculate gross profit and gross margin, which can be used to analyze firm performance
o Gross profit = the profit a firm makes after deducting the costs associated with
making and selling its products
= (Revenue – Direct costs – Allocated overheads)
o Gross margin = (Gross profit ÷ Revenue)
- Cost-Volume-Profit (CVP) relationships
o Examining the behavior of total costs, total revenues and total profits as changes occur
in variables such as the output level, sales price, variable costs, fixed costs, etc.
Profit = Revenue – Variable costs – Fixed costs
Fixed costs + Profit = Revenue – Variable costs
Fixed costs + Profit = N x (Selling price – Variable Cost per unit)
¿ costs+ profit
N=
Selling price−Variable Cost per unit
¿ costs+ profit
N=
Contribution Margin
o Achieve break-even (i.e., making 0 profit or loss) when
(Fixed costs + Profit) = Contribution Margin
o We can use CVP to calculate the number of units that we need to sell to breakeven or
make the amount profit that we desire.
- Planning and budgeting
o Planning:
Developing objectives and preparing various budgets to achieve these objectives.
o Budgeting:
Creating a detailed plan for the acquisition and use of financial and other resources over
a specified time period.
Volume-based costing (VBC), or traditional costing, system
VBC = the assumption that if a product/service is making more variable direct costs (VDC), theoretically
it should also use more resources (overhead).
Using de VBC-system we can allocate more overhead costs to the product(line) that generate higher
revenue and variable direct costs. When the cost allocation rate changes it is going to influence the
product line with more volume to a greater distance.
Features: Allocating indirect costs to a object. A cost object is anything for which cost data are desired
(e.g., amount of direct labor hours, number of products, product lines, customers, jobs, subunits
for organizations, etc.). Allocate overhead/indirect costs evenly on each cost object.
Strengths: Easy to understand and implement. Not expensive.
Weaknesses:
1) It does not recognize that different products may incur indirect costs in different ways. For
example some products may have low production volume and/or machine hours, but it will
incur similar or even more indirect costs than products that have higher volume and/or machine
hours. In other words, volume-based cost allocation is not accurate and may lead to biased
decision of the managers.
, - For example, assume we make two types of products: (1) chocolate bars sold in
supermarkets; (2) gift boxes ordered by 5-star hotels:
Chocolate bars are high volume products – require a lot of machine hours, but
little attention and no special activities.
Gift boxes are low volume products – require less machine hours, but many
special steps and more attentions.
A VBC system allocates overhead based on number of products or machine
hours. It will then allocate more overhead to chocolate bars and less to gift
boxes.
This allocation lack accuracy because gift boxes may incur more overhead costs!
2) It ignores the fact that some indirect costs are fixed and will not change with the volume of the
products (e.g., rent). It may lead managers to wrong perception about the profitability of
different products and undesired decisions about whether to cut a particular product line.
3) It is not possible to analyze and improve the different activities that are required by different
services/products.
Resources spending versus resource consuming
Resource spending ≠ Resource consuming
- Resources spending (amount of money that is actually spend) may be independent from
volumes produces;
o For example, a firm needs to pay for the rent of its warehouse/factory/office regardless
of the volume it sells.
- Resources consuming is usually directly related to production;
o For example, the direct and/or indirect labor and materials used to produce the
products change proportionally with the volume of the production.
When saving costs, managers need to reduce both resource spending and resource consumption to
make the saving work. Managers need to think the following question carefully:
Which costs are avoidable and which are unavoidable?
To answer this questions, managers need to be familiar with the cost behaviors in their firms, as fixed
and variable costs as approximation of what costs are unavoidable or avoidable:
- Variable costs change proportionally with volume;
- Fixed costs remain fixed throughout.
o This may not always be the case. If a firm increases/decreases its capacity (e.g.,
purchased a new machine or sold warehouse), its fixed costs will change. However, even
when fixed costs change, it does not change proportionally with volume of products, but
instead changes with the decisions of the managers.
o Fixed costs can be avoided by managers decisions but not with the change of volume of
products. Variable costs can be avoided by cutting in het volume of products.
Death spiral
The process of death spiral can be summarized as follows:
- A product/product line/customer is dropped;
- Production and sales volumes decrease;
, - Some of the overhead/indirect costs are fixed and do not decrease with the production and
sales volumes;
- Overhead cost allocation rate (=overhead costs/allocation base) increases if the allocation base
(usually volumes or variable costs) decreases significantly more than overhead costs;
- Reported costs of remaining products increase. In some cases, more products will fall under the
minimum profitability criterion;
- More products are dropped from the lineup as their costs are “too high”.
The interactive cycle described above might eventually lead to the elimination of all products from the
lineup, resulting in the death of the firm. More remarks about death spiral:
- There are fixed components to overhead costs. Those fixed components will not go away as a
result of a product drop, which causes the vicious cycle in death spiral;
- In practices, classifying costs as fixed or variable is not always easy;
- In this particular case the death spiral was relatively esy to identify. However, in companies that
produce hundreds of products, such effect might not be easy to isolate;
- Reducing resource consumption is the only effective way to implement successful cost reduction
initiative.
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