Cost Accounting

Absorption costing is a process of tracing the variable costs of production and the fixed costs of production to the product.-Direct Materials-Direct Labor-Overhead (Both Fixed and Variable)Unlike VARIABLE COSTING this method does account for fixed overhead when determining the cost to manufacture a product, hence, fixed costs will be part of the balance sheet within WIP and FG inventory as soon as value is added to a cost object.GAAP requires full absorption costing for accounting of inventories and product/service costs in financial statements.There are three different types of Absorption Costing Systems: -Job Order Costing -Process Costing -ABC CostingImportant points to take away from how we account for manufacturing costs:1. Initial expenditures on raw materials, direct labor, and overhead are CAPITALIZED (recorded as assets) in Work in process and finished goods inventory.2. They are transferred to expense accounts when the finished goods are sold (they go to cost of goods sold).3. Generally the cost of goods manufactured, (the costs incurred in manufacturing the product) will not equal the cost of goods sold.-This means that in any year some of the costs associated with manufacturing the product will not flow through the income statement as an expense, they will remain in the inventory accounts as assets!

ABC Costing assigns cost from cost centers to the product -Best in a multi product firm, where there are different volumes

In Job Order Costing costs are assigned to the product in Batches or lots. Job order costing is appropriate when the firm makes products in small batches, and each batch consumes different amounts of direct labor, direct materials, and processing time/energy.A survey in “Cost and Management Accounting Practices..” in the Management Accounting Research Centre indicate that job order costing is the primary method of costing in the following industries:-Electorics-Machinery-Computers-Furniture and fixturesWhat happens to the under or over applied overhead?1. Write-off directly to cost of goods sold.2. Write off proportionately to WIP, Finished goods and Cost of goods sold.3. Re-allocate costs to all products to “correctly” allocate overhead to WIP, Finished goods, and Cost of goods sold.

In Process Costing, costs are systematically assigned to the product, since there are no discreet batches to assign costs. A process cost system is used when a manufacturing company makes large volumes of identical products. (pharmaceuticals, bottles of Pepsi, gallons of oil)Each unit consumes the same amount of direct materials, direct labor and indirect costs (overhead)Instead of assigning costs to jobs, then averaged across the job to get a per unit cost, process costing assigns costs to the product through each process the product goes through. -Oil Distilling -Soda ManufacturingSurvey indicates that Process costing is most often used in the following industries:1. Oil refining (100%)2. Chemicals3. Pharmaceuticals4. Food and Beverage

OVERHEADIndirect costs that cannot be directly matched to the production of a finished good or provision of a service. Overhead has to be matched with those by using cost objects (a product or service which cost will be determined) and cost drivers (measurable activities that are closely related to the value being added to a product or service)WHAT COSTS ARE ALLOCATEDIn a single product firm, that has one customer, and only one division there is no need to worry about cost allocations.Most companies are: -Multi Divisional -Offer a variety of Products -Thousands of Customers Divisions, products, and customers consume common costs at different rates, or in different amounts.An effective cost allocation system will more accurately trace the shared costs of production to the divisions, products and customers that consume those costs.WHY ALLOCATE COSTSHow the costs are allocated is going to affect the profits of the entire firm, and the behavior of the manager.-Third Party reimbursements -Rate regulated industries -Governmental subsidies -Cost plus contracts-External Reporting/Taxes -FASB and IRS requires allocation.-Costing products accurately is important. -Decision Making -ControlREFERENCEMIT OpenCourseware: http://ocw.mit.edu/NR/rdonlyres/Sloan-School-of-Management/15-521Management-Accounting-and-ControlSpring2003/006A7DA8-0087-411E-B8D3-7E05A08B7D2F/0/web_class9.pdf

Variable Costing traces only the variable costs of production to the product and the fixed costs of production are treated as period expenses.Variable costing tries to reduce the incentive to over produce by charging fixed overhead costs to expense in the period they are incurred, and allocating only variable costs.Increasing production does not allow a firm to move fixed costs out of COGS and into inventory.

They generously have lecture notes for a lot of their business courses available online. 15-521 Management Accounting and Controlhttp://ocw.mit.edu/OcwWeb/Sloan-School-of-Management/15-521Management-Accounting-and-ControlSpring2003/LectureNotes/index.htm

My beloved graduate institution:http://ellermba.arizona.edu/fulltime/

Operating Leverage represents the ratio of fixed costs to total costs.Firms with higher operating leverage will experience relatively larger changes in income when there are changes in volume.This because firms with more operating leverage have relatively larger per unit contribution margins.SENSITIVITY ANALYSIS should be performed by a wise manager that is implementing a new strategy to evaluate how the new fixed cost structure will be affected by his/her decision.

Margin of Safety = Budgeted Revenues - Break Even Revenues