Chapter two: finacial management for managers.pptx

cost management for managers for manufucturing business

1. Chapter Two: Cost 1

2. What is Cost? Cost is the measurement of resources that must be expended in order to obtain an object or complete an activity . Cost is usually expressed in monetary terms . Cost has four essential purposes . It is used for planning for future activities or budgets. It is used for decision making throughout an organization. It is used to compare actual results with budgets and determine why there are variances. It is used to calculate income from the company’s operations and projects. 2

3. C ost c lassifications Financial Statements Product Cost Period Cost Cost Behavior Variable Fixed Assigning Costs Direct Indirect Cost Decisions Differential Costs Sunk Costs Cost of Quality Prevention Correction Warranty 3

4. Product and Period Cost Period and product costs provide information to create financial statements for external use. Product cost is the sum of all costs that are directly linked to the production or acquisition of a product or service to be sold later. Product costs might include direct materials and direct labor for a product. Period costs are all costs that are not related directly to creating the product. For example , the cost of administration of a company or for marketing and sales cannot be directly linked to the production of an individual product . In addition, the cost of administration, such as human resources services, salaries, or insurance and rent cannot be linked directly to a product or service. These are period costs that are recognized as expenses when the benefit occurs. 4

5. Variable and Fixed costs VARIABLE COSTS Variable costs are those that change in direct relationship to changes in the activity that triggers the cost. For example, the cost of the material needed to manufacture a bolt increases in direct proportion to the number of bolts that are manufactured. A grocery retailer will incur increased cost as more containers of milk are sold . A consulting company will incur increased cost for each hour of service provided by hourly consultants . FIXED COSTS In contrast to variable costs, fixed costs remain the same despite increases or decreases in business activity. For example, a manufacturing plant must heat the plant during the winter whether production increases or decreases. The grocery retailer that rents its building must pay the rent no matter how many containers of milk are sold, and the service company must pay the rent for its offices, whether billable hours increase or decrease. 5

6. Direct and Indirect costs DIRECT COSTS A direct cost is the measure of resources that must be given in order to obtain an object or complete an activity that can be directly related to that object or activity. In a manufacturing setting, direct materials and labor would be direct costs. In a retail industry, the cost of acquiring goods for sale would be a direct cost. In a service industry, the cost of paying the employee to do consulting is a direct cost . INDIRECT COSTS Indirect costs are those costs that are not related directly to the object or activity that produce a project or service. Examples , the cost of heating a factory is an indirect cost, as are the salaries of administrators not directly working on the production of goods or services. 6

7. Differential and sunk cost Differential Cost Differential cost is simply the difference in the cost of two alternatives. The other side of differential cost is differential revenue. When considering the different options to pursue , the differential cost and revenue of each option is reviewed, and the option that presents the higher income usually is chosen . SUNK COSTS A sunk cost is any cost that is already incurred or sunk into a project . Sunk costs should never have a place in deciding future activities or operations . 7

8. Cost of Quality The three costs associated with quality are prevention costs, correction costs, and warranty costs. As indicated, quality costs are a balance between preventing mistakes and discovering and correcting them . Prevention The best place to ensure quality in a product or service is at the time that the product or service is created . In the case of a new product, this may be engineering tests . Correction The cost of correction includes all of the activities that take place to find and correct problems . Warranty The cost of warranty includes all of those activities that correct problems that occur after the product or service has been sold. Normally, this is the most expensive quality cost. It can involve return, repair, or replacement of merchandise and rework of services. 8

9. Cost allocation Cost allocation is the process of: identifying , aggregating , and assigning costs to cost objects. Cost allocation is used for: financial reporting purposes, to spread costs among departments or inventory items. To track and allocate costs, the cost needs to first be associated with a specific cost object .

10. Cont.… Allocating an employee’s salary between two departments, allocating a utility bill between administrative and manufacturing facilities, or a nonprofit that needs to allocate costs between various programs are just a few reasons almost any business may need to regularly allocate costs . When allocating costs, there are four allocation methods to choose from ; Labor Machine time used Square footage Units produced

11. Example 1 Abebe owns a small manufacturing plant, with administrative offices housed on the second floor. The square footage of the plant is 5,000 square feet, while the administrative offices are 2,500 square feet, with rent for the entire facility $15,000 per month. Rent must be allocated between the two departments.

12. Solution Cost per square foot would be: $15,000 ÷ 7,500 = $2 per square foot Next , Abebe , will calculate the rental cost for the plant : $ 2 x 5,000 = $ 10,000 That means that Abebe can allocate $10,000 to overhead expenses for the factory. Next , Abebe will calculate the rental cost for the administrative offices : $ 2 x 2,500 = $ 5,000 The balance of the rent, $5,000, will be allocated to the administrative offices.

13. Example 2 Chala’s manufacturing company manufactures backpacks. In July, Chala produced 2,000 backpacks with direct material costs of ETB 5.50 per backpack, and ETB 2.25 direct labor costs per backpack. He also had ETB 7,250 in overhead costs for the month of July. Using the number of units produced as the allocation method, we can calculate overhead costs using the following overhead cost formula:

14. Solution ETB 7,250 ÷ 2,000 = ETB 3.63 per backpack The cost to produce each backpack is ETB 11.38 , calculated as follows: Direct Materials: ETB 5.50 per backpack Direct Labor: ETB 2.25 per backpack Overhead : ETB 3.63 per backpack Total Cost: ETB 11.38 per backpack

15. Example 3 Company XYZ has its own building. There are ten projects running in that building . The company is trying to find the overhead cost of the pantry and administrative support for project A . The pantry supplies to all the ten projects, and the total cost of pantry service is ETB 500,000 for a year . The support service is also shared by all the projects. The administrative support service is ETB 20,000 and is being shared by all the projects.

16. Solution The Overhead Cost of Pantry for Project A = Total Cost of Pantry / Number of Projects The overhead cost of the pantry for project A = ETB500,000 / 10 = ETB50,000 The Overhead Cost of Administrative Support for Project A = Total Cost of Administrative Support / Number of Projects Administrative Support for Project A= ETB20,000 / 10 = ETB2,000 Total Overhead Cost of Project A = Overhead Cost of Pantry for Project A + Overhead Cost of Administrative Support for Project A ETB50,000 + $ETB= ETB52,000

17. Example 4 Consider a warehouse that is rented to produce cars. In a month, 100 cars are produced in the warehouse. Rent of the warehouse is ETB10,000 monthly. If 100 cars are produced in a month, then each car will share an overhead rent cost of = Monthly Rent /Number of Cars . Car will Share an Overhead Rent Cost = 10,000 / 100 = ETB100 So ETB100 is the Allocation rate. Each car is using ETB100 of warehouse rent to finish itself.

18. Example 5 A company produces two products, namely “A” and “B” on the premises of the same factory. Factory Rent = ETB100,000 Units Produced of “A” = 30,000 Units Produced of “B” = 20,000 Total no. of units produced = 50,000 Let us see how can the cost allocation of factory rent be done for the two products .

19. Cont.….. Here; Cost Object = Product “A” and “B” Cost Pool = Factory Rent Cost Driver = No. of Units Produced Product A = ETB 100,000*30,000/50,000= ETB60,000 Product B = ETB 100,000*20,000/50,000= ETB 40,000

20. Exercises A company makes two products: A and B. The company uses a plant wide allocation method to allocate manufacturing overhead costs of ETB 90,000. Product A Product B Direct material per unit ETB 20 ETB25 Direct labor per unit 20 15 Units Produced 1000 2000 Direct labor hours per unit 2 1.5 Machine hours per unit 0.5 1

21. Cont … How much manufacturing overhead per unit is allocated to each product if the company uses the following as the allocation base? Units Produced Direct labor Machine hours

22. SOLUTION Units Produced Allocation rate = Total OH cost/ Total units produced; ETB90,000/3,000= ETB30/unit So, Product A 1,000*30 = ETB 30,000 Product B 2,000*30 = ETB 60,000 Direct Labour Direct labour for A= 20*1000 =20,000 LHRS For B= 15*2,000= 30,000 LHRS Total DLHR = 20,000+30,000 = 50,000 DLH Allocation rate = Total OH cost/ Total DLH =90,000/50,000 = ETB 1.8/DLH

23. Cont.…. Allocated OHC: Product A = 20,000DLH * ETB 1.8 = ETB 36,000 Product B = 30,000DLH * ETB 1.8= ETB 54,000 Machine Hours MHR for product A = 0.5 *1000= 500MHRS MHR for Product B = 1*2000 = 2,000 MHR Total MHR = 500+2,000 =2,500 MHR Allocation rate = Total OH cost/ Total MHR =ETB 90,000/2,500 = ETB 36/MHR Product A = 500*36 = ETB18,000 Product B = 2,000*36 = ETB 72,000

24. reading assignment Meaning of cost estimation project cost estimation