Bookkeeping & Accounting All-in-One For Dummies (2015)

Book V

Accountants: Managing the Business

Chapter 4

In This Chapter

Determining costs: The second most important thing accountants do

Comprehending the different needs for cost information

Contrasting costs to understand them better

Determining product cost for manufacturers

Padding profit by manufacturing too many products

Measuring costs is the second most important thing accountants do, right after measuring profit. But really, can measuring a cost be very complicated? You just take numbers off a purchase invoice and call it a day, right? Not if your business manufactures the products you sell - that’s for sure! Businesses must carefully record all their costs correctly so that profit can be determined each period, and so that managers have the information they need to make decisions and to control profit performance.

Previewing What’s Coming Down the Road

One main function of accounting for a manufacturing business is measuring product cost. Examples are the cost of a new car just rolling off the assembly line or the cost of this book, Bookkeeping & Accounting For Dummies, All-in-One. Most production (manufacturing) processes are fairly complex, so measuring product cost is also fairly complex in most cases. Every step in the production process has to be tracked very carefully from start to finish. One major problem is that many manufacturing costs can’t be directly matched with particular products; these are called indirect costs. To arrive at the full cost of each separate product manufactured, accountants devise methods for allocating the indirect production costs to specific products. Different accountants use different allocation methods. In other respects as well, product cost accounting is characterised by a diversity of methods. Generally accepted accounting principles (GAAP) provide very little guidance for measuring product cost. Manufacturing businesses have a lot of leeway in how their product costs are determined; even businesses in the same industry use different product cost accounting methods.

In addition to measuring product costs of manufacturers, accountants in all businesses determine many other costs: the costs of the departments and other organisational units of the business; the cost of pensions for the company’s employees; the cost of marketing initiatives and advertising campaigns; and, on occasion, the cost of restructuring the business or the cost of a major recall of products sold by the business. A common refrain among accountants is ‘different costs for different purposes’. True enough, but at its core cost accounting serves two broad purposes - measuring profit and providing relevant information to managers.

This chapter covers cost concepts and cost measurement methods that are used by both retail and manufacturing businesses, along with additional stuff for manufacturers to worry about. We also discuss how having a good handle on cost issues can help you recognise when a business is monkeying around with product cost to deliberately manipulate its profit figure. Service businesses - which sell a service such as transportation or entertainment - have a break here. They don’t encounter the cost-accounting problems of manufacturers, but they have plenty of cost allocation issues to deal with in assessing the profitability of each of their separate sales revenue sources.

What Makes Cost So Important?

Without good cost information, a business operates in the dark. Cost data is needed for different purposes in business, including the following:

· Setting sales prices: The common method for setting sales prices (known as cost-plus or mark-up on cost) starts with cost and then adds a certain percentage.

· Measuring gross margin: Investors and managers judge business performance by the bottom-line profit figure. This profit figure depends on the gross margin figure that you get when you subtract your cost of goods sold expense from your sales revenue. Gross margin (also called gross profit) is the first profit line in the Profit and Loss statement (see Figure 4-2).

· Valuing assets: The Balance Sheet reports cost values for many assets, and these values are, of course, included in the overall financial position of your business.

· Making optimal choices: You often must choose one alternative over others in making business decisions. The best alternative depends heavily on cost factors, and you have to be careful to distinguish relevant costs from irrelevant costs, as described in the section ‘Relevant versus irrelevant (sunk) costs’, later in this chapter.

In most situations, the book value of a fixed asset is an irrelevant cost. Say the book value is £35,000 for a machine used in the manufacturing operations of the business. This is the amount of original cost that hasn’t yet been charged to depreciation expense since it was acquired, and it may seem quite relevant. However, in deciding between keeping the old machine or replacing it with a newer, more efficient machine, the disposable value of the old machine is the relevant amount, not the non-depreciated cost balance of the asset. Suppose the old machine has only a £20,000 salvage value at this time. This is the relevant cost for the alternative of keeping it for use in the future - not the £35,000 that hasn’t been depreciated yet. In order to keep using it, the business forgoes the £20,000 it could get by selling the asset, and this £20,000 is the relevant cost in the decision situation. Making decisions involves looking at the future cash flows of each alternative - not looking back at historical-based cost values.

Sharpening Your Sensitivity to Costs

The following sections explain important distinctions between costs that managers should understand in making decisions and exercising control. Also, these cost distinctions help managers better appreciate the cost figures that accountants attach to products that are manufactured or purchased by the business. In a later section we focus on the special accounting methods and problems of computing product costs of manufacturers. Retailers purchase products in a condition ready for sale to their customers - although the products have to be removed from shipping containers and a retailer does a little work making the products presentable for sale and putting the products on display.

Manufacturers don’t have it so easy; their product costs have to be ‘manufactured’ in the sense that the accountants have to compile production costs and compute the cost per unit for every product manufactured. We can’t exaggerate the importance of correct product costs (for businesses that sell products, of course). The total cost of goods (products) sold is the first, and usually the largest, expense deducted from sales revenue in measuring profit. The bottom-line profit amount reported in the Profit and Loss statement of a business for the period depends heavily on whether its product costs have been measured properly. Also, keep in mind that product cost is the value for the stock asset reported in the Balance Sheet of a business.

Direct versus indirect costs

What’s the difference between these costs? Well:

· Direct costs can be clearly attributed to one product or product line, or one source of sales revenue, or one organisational unit of the business, or one specific operation in a process. An example of a direct cost in the book publishing industry is the cost of the paper that a book is printed on; this cost can be squarely attached to one particular phase of the book production process.

· Indirect costs are far removed from and can’t be obviously attributed to specific products, organisational units or activities. A book publisher’s phone bill is a cost of doing business but can’t be tied down to just one step in the book’s editorial and production process. The salary of the purchasing officer who selects the paper for all the books is another example of a cost that’s indirect to the production of particular books.

Indirect costs are allocated according to some methods to different products, sources of sales revenue, organisational units and so on. Most allocation methods are far from perfect, and in the last analysis end up being rather arbitrary. Business managers should always keep an eye on the allocation methods used for indirect costs, and take the cost figures produced by these methods with a grain of salt.

The cost of filling the fuel tank in driving your car from London to Bristol and back is a direct cost of making the trip. The annual road tax that the government charges you is an indirect cost of the trip, although it’s a direct cost of having the car available during the year.

Fixed versus variable costs

Two other costs you need to know about are as follows:

· Fixed costs remain the same over a relatively broad range of sales volume or production output. For example, the cost of renting office space doesn’t change regardless of how much a business’s sales volume increases or decreases. Fixed costs are like a dead weight on the business. Its total fixed costs form the hurdle that the business must overcome by selling enough units at high enough profit margins per unit in order to avoid a loss and move into the profit zone. (Book V, Chapter 3 explains the break-even point, which is the level of sales needed to cover fixed costs for the period.)

· Variable costs increase and decrease in proportion to changes in sales or production level. If you increase the number of books that your business produces, the cost of the paper and ink also goes up.

Breaking even

The saying goes that every picture is worth a thousand words. Well, ‘finance’ and ‘pictures’ are words that don’t come together too often, but they certainly do when you look at costings.

Take a look at Figure 4-1. The bottom horizontal axis represents volume, starting at 0 and rising as the company produces more product. The vertical axis represents value, starting at 0 and rising, as you’d expect, with any increase in volume. The horizontal line in the middle of the chart represents fixed costs - those costs that remain broadly unchanged with increases in volume, rents and so on. The line angling upwards from the fixed cost line represents the variable cost - the more we produce, the higher the cost. We arrive at the total costs by adding the fixed and variable costs together.

Figure 4-1: A break-even chart.

On the hopeful assumption that our sales team has been hard at work, we should then see sales revenue kicking in. The line representing those sales starts at 0 (no sales means no money is coming in) and then rises as sales grow. The crucial information this chart shows is the break-even point, when total costs have been covered by the value of sales revenue and the business has started to make profit. The picture makes it easier to appreciate why lowering cost, either fixed or variable, or increasing selling prices helps a business to break even at lower volumes and hence start making profit sooner and be able to make even more profit from any given amount of assets.

Conversely, a business that only reaches break-even when sales are so high that there’s virtually no spare capacity is shown as being vulnerable, because that business has a small margin of safety if events don’t turn out as planned.

Relevant versus irrelevant (sunk) costs

Is there such a thing as an irrelevant cost in business accounting? Sure:

· Relevant costs: Costs that should be considered when deciding on a future course of action. Relevant costs are future costs - costs that you would incur, or bring upon yourself, depending on which course of action you take. For example, say that you want to increase the number of books that your business produces next year in order to increase your sales revenue, but the cost of paper has just shot up. Should you take the cost of paper into consideration? Absolutely: that cost will affect your bottom-line profit and may negate any increases in sales volume that you experience (unless you increase the sales price). The cost of paper is a relevant cost.

· Irrelevant (or sunk) costs: Costs that should be disregarded when deciding on a future course of action. If brought into the analysis, these costs could cause you to make the wrong decision. An irrelevant cost is a vestige of the past; that money is gone, so get over it. For example, suppose that your supervisor tells you to expect a load of new recruits next week. All your staff members use computers now, but you have loads of typewriters gathering dust in the cupboard. Should you consider the cost paid for those typewriters in your decision to buy computers for all the new staff? Absolutely not: that cost should have been written off and is no match for the cost you’d pay in productivity (and morale) for new employees who are forced to use typewriters.

Generally speaking, fixed costs are irrelevant when deciding on a future course of action, assuming that they’re truly fixed and can’t be increased or decreased over the short term. Most variable costs are relevant because they depend on which alternative is decided on.

Fixed costs are usually irrelevant in decision-making because these costs will be the same no matter which course of action you decide upon. Looking behind these costs, you usually find that the costs provide capacity of one sort or another - so much building space, so many machine-hours available for use, so many hours of labour that will be worked and so on. Managers have to figure out the best overall way to utilise these capacities.

Separating between actual, budgeted and standard costs

Other costs to know about are:

· Actual costs: Historical costs, based on actual transactions and operations for the period just ended, or going back to earlier periods. Financial statement accounting is based on a business’s actual transactions and operations; the basic approach to determining annual profit is to record the financial effects of actual transactions and allocate historical costs to the periods benefited by the costs.

· Budgeted costs: Future costs, for transactions and operations expected to take place over the coming period, based on forecasts and established goals. Note that fixed costs are budgeted differently than variable costs - for example, if sales volume is forecast to increase by 10 per cent, variable costs will definitely increase accordingly, but fixed costs may or may not need to be increased to accommodate the volume increase (see ‘Fixed versus variable costs’, earlier in this chapter). Book V, Chapter 5 explains the budgeting process and budgeted financial statements.

· Standard costs: Costs, primarily in manufacturing, that are carefully engineered based on detailed analysis of operations and forecast costs for each component or step in an operation. Developing standard costs for variable production costs is relatively straightforward because many of these are direct costs, whereas most fixed costs are indirect, and standard costs for fixed costs are necessarily based on more arbitrary methods (see ‘Direct versus indirect costs’, earlier in this chapter). Note: Some variable costs are indirect and have to be allocated to specific products in order to come up with a full (total) standard cost of the product.

Product versus period costs

Product costs differ from period costs:

· Product costs: Costs attached to particular products. The cost is recorded in the stock asset account until the product is sold, at which time the cost goes into the cost of goods sold expense account. One key point to keep in mind is that product cost is deferred and not recorded to expense until the product is sold.

The cost of a new car sitting on a dealer’s showroom floor is a product cost. The dealer keeps the cost in the stock asset account until you buy the car, at which point the dealer charges the cost to the cost of goods sold expense.

· Period costs: Costs that are not attached to particular products. These costs don’t spend time in the ‘waiting room’ of stock. Period costs are recorded as expenses immediately; unlike product costs, period costs don’t pass through the stock account first. Advertising costs, for example, are accounted for as period costs and recorded immediately in an expense account. Also, research and development costs are treated as period costs.

Separating between product costs and period costs is particularly important for manufacturing businesses, as you find out in the following section.

Putting Together the Pieces of Product Cost for Manufacturers

Businesses that manufacture products have several additional cost problems to deal with. We use the term manufacture in the broadest sense: car makers assemble cars, beer companies brew beer, oil companies refine oil, ICI makes products through chemical synthesis and so on. Retailers, on the other hand, buy products in a condition ready for resale to the end consumer. For example, Levi Strauss manufactures clothing, and Selfridges is a retailer that buys from Levi Strauss and sells the clothes to the public.

The following sections describe costs that are unique to manufacturers and address the issue of determining the cost of products that are manufactured.

Minding manufacturing costs

Manufacturing costs consist of four basic types:

· Raw materials: What a manufacturer buys from other companies to use in the production of its own products. For example, The Ford Motor Company buys tyres from Goodyear (and other tyre manufacturers) that then become part of Ford’s cars.

· Direct labour: 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 of electricity that runs the production equipment: you pay for the electricity for 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 the use of those machines, the electricity cost increases or decreases accordingly.

· Fixed overhead: Indirect production costs that do not increase or decrease as the quantity produced increases or decreases. These fixed costs remain the same over a fairly broad range of production output levels (see ‘Fixed versus variable costs’, earlier in this chapter). Here are three significant fixed manufacturing costs:

· Salaries for certain production employees who don’t work directly on the production line, such as department managers, safety inspectors, security guards, accountants, and shipping and receiving workers.

· Depreciation of production buildings, equipment and other manufacturing fixed assets.

· Occupancy costs, such as building insurance, property rental, and heating and lighting charges.

Figure 4-2 shows a sample management Profit and Loss statement for a manufacturer, including supplementary information about its manufacturing costs. Notice that the cost of goods sold expense depends directly on the product cost from the manufacturing cost summary that appears below the management profit and loss statement. A business may manufacture 100 or 1,000 different products, or even more. To keep the example easy to follow, Figure 4-2 presents a scenario for a one-product manufacturer. The example is realistic yet avoids the clutter of too much detail. The multi-product manufacturer has some additional accounting problems, but these are too technical for a book like this. The fundamental accounting problems and methods of all manufacturers are illustrated in the example.

Figure 4-2: Example for determining product cost of a manufacturer.

The information in the manufacturing cost summary schedule below the profit and loss statement (see Figure 4-2) is highly confidential and for management eyes only. Competitors would love to know this information. A company may enjoy a significant cost advantage over its competitors and definitely would not want its cost data to get into the hands of its competitors.

Unlike a retailer, a manufacturer doesn’t purchase products but begins by buying the raw materials needed in the production process. Then the manufacturer pays workers to operate the machines and equipment and to move the products into warehouses after they’ve been produced. All this is done in a sprawling plant that has many indirect overhead costs. All these different production costs have to be funnelled into the product cost so that the product cost can be entered in the stock account, and then to the cost of goods sold expense when products are sold.

Allocating costs properly: Not easy!

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

· Drawing a defining line between manufacturing costs and non-manufacturing operating costs: The key difference here is that manufacturing costs are categorised as product costs, whereas non-manufacturing operating costs are categorised as period costs (refer to ‘Product versus period costs’, earlier in this chapter). In calculating product cost, you factor in only manufacturing costs and not other costs. Period costs are recorded right away as an expense - either in variable operating expenses or fixed operating expenses for the example shown in Figure 4-2.

Wages paid to production-line workers are a clear-cut example of a manufacturing cost. Salaries paid to salespeople are a marketing cost and aren’t part of product cost; marketing costs are treated as period costs, which means these costs are recorded immediately to the expenses of the period. Depreciation on production equipment is a manufacturing cost, but depreciation on the warehouse in which products are stored after being manufactured is a period cost. Moving the raw materials and works-in-progress through the production process is a manufacturing cost, but transporting the finished products from the warehouse to customers is a period cost. In short, product cost stops at the end of the production line - but every cost up to that point should be included as a manufacturing cost. The accumulation of direct and variable production costs starts at the beginning of the manufacturing process and stops at the end of the production line. All fixed and indirect manufacturing costs during the year are allocated to the actual production output during the year.

If you mis-classify some manufacturing costs as operating costs, your product cost calculation will be too low (refer to ‘Calculating product cost’, later in this chapter).

· Whether to allocate indirect costs among different products, organisational units or assets: Indirect manufacturing costs must be allocated among the products produced during the period. The full product cost includes both direct and indirect manufacturing costs. Coming up with a completely satisfactory allocation method is difficult and ends up being somewhat arbitrary - but must be done to determine product cost. For non-manufacturing operating costs, the basic test of whether to allocate indirect costs is whether allocation helps managers make better decisions and exercise better control. Maybe; maybe not. In any case, managers should understand how manufacturing indirect costs are allocated to products and how indirect non-manufacturing costs are allocated, keeping in mind that every allocation method is arbitrary and that a different allocation method may be just as convincing. (See the sidebar ‘Allocating indirect costs is as simple as ABC - not!’)

Allocating indirect costs is as simple as ABC - not!

Accountants for manufacturers have developed loads of different methods and schemes for allocating indirect overhead costs, many based on some common denominator of production activity such as direct labour hours. The latest method to get a lot of press is called activity-based costing (ABC).

With the ABC method, you identify each necessary, supporting activity in the production process and collect costs into a separate pool for each identified activity. Then you develop a measure for each activity - for example, the measure for the engineering department may be hours, and the measure for the maintenance department may be square feet. You use the activity measures as cost drivers to allocate cost to products. So if Product A needs 200 hours of the engineering department’s time and Product B is a simple product that needs only 20 hours of engineering, you allocate ten times as much of the engineering cost to Product A.

The idea is that the engineering department doesn’t come cheap - including the cost of their computers and equipment as well as their salaries and benefits, the total cost per hour for those engineers could be £100 to £200. The logic of the ABC cost-allocation method is that the engineering cost per hour should be allocated on the basis of the number of hours (the driver) required by each product. In similar fashion, suppose the cost of the maintenance department is £10 per square foot per year. If Product C uses twice as much floor space as Product D, it will be charged with twice as much maintenance cost.

The ABC method has received much praise for being better than traditional allocation methods, especially for management decision-making, but keep in mind that it still requires rather arbitrary definitions of cost drivers - and having too many different cost drivers, each with its own pool of costs, isn’t too practical. Cost allocation always involves arbitrary methods. Managers should be aware of which methods are being used and should challenge a method if they think that it’s misleading and should be replaced with a better (though still somewhat arbitrary) method. We don’t mean to put too fine a point on this, but to a large extent cost allocation boils down to a ‘my arbitrary method is better than your arbitrary method’ argument.

Note: Cost allocation methods should be transparent to managers who use the cost data provided to them by accountants. Managers should never have to guess about what methods are being used, or have to call upon the accountants to explain the allocation methods.

Calculating product cost

The basic equation for calculating product cost is as follows (using the example of the manufacturer from Figure 4-2):

· £91.2 million total manufacturing costs ÷ 120,000 units production output = £760 product cost per unit

Looks pretty straightforward, doesn’t it? Well, the equation itself may be simple, but the accuracy of the results depends directly on the accuracy of your manufacturing cost numbers. And because manufacturing processes are fairly complex, with hundreds or thousands of steps and operations, your accounting systems must be very complex and detailed to keep accurate track of all the manufacturing costs.

As we explain earlier, when introducing the example, this business manufactures just one product. Also, its product cost per unit is determined for the entire year. In actual practice, manufacturers calculate their product costs monthly or quarterly. The computation process is the same, but the frequency of doing the computation varies from business to business.

In this example the business manufactured 120,000 units and sold 110,000 units during the year. As just computed, its product cost per unit is £760. The 110,000 total units sold during the year is multiplied by the £760 product cost to compute the £83.6 million cost of goods sold expense, which is deducted against the company’s revenue from selling 110,000 units during the year. The company’s total manufacturing costs for the year were £91.2 million, which is £7.6 million more than the cost of goods sold expense. This remainder of the total annual manufacturing costs is recorded as an increase in the company’s stock asset account, to recognise the 10,000-unit increase of units awaiting sale in the future. In Figure 4-2, note that the £760 product cost per unit is applied both to the 110,000 units sold and to the 10,000 units added to stock.

Note: As just mentioned, most manufacturers determine their product costs monthly or quarterly rather than once a year (as in the example). Product costs likely will vary in each successive period the costs are determined. Because the product costs vary from period to period, the business must choose which cost of goods sold and stock cost method to use - unless product cost remains absolutely flat and constant period to period, in which case the different methods yield the same results. Book V, Chapter 2 explains the alternative accounting methods for determining cost of goods sold expense and stock cost value.

Fixed manufacturing costs and production capacity

Product cost consists of two very distinct components: variable manufacturing costs and fixed manufacturing costs. In Figure 4-2 note that the company’s variable manufacturing costs are £410 per unit and that its fixed manufacturing costs are £350 per unit. Now, what if the business had manufactured just one more unit? Its total variable manufacturing costs would have been £410 higher; these costs are driven by the actual number of units produced, so even one more unit would have caused the variable costs to increase. But the company’s total fixed costs would have been the same if it had produced one more unit, or 10,000 more units for that matter. Variable manufacturing costs are bought on a per unit basis, as it were, whereas fixed manufacturing costs are bought in bulk for the whole period.

Fixed manufacturing costs are needed to provide production capacity - the people and physical resources needed to manufacture products - for the period. After the business has the production plant and people in place for the year, its fixed manufacturing costs can’t be easily scaled down. The business is stuck with these costs over the short run. It has to make the best use it can from its production capacity.

Production capacity is a critical concept for business managers to grasp. You need to plan your production capacity well ahead of time because you need plenty of lead time to assemble the right people, equipment, land and buildings. 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 of production capacity remain the same even as production output increases or decreases, so you may as well make optimal use of the capacity provided by those fixed costs.

The fixed cost component of product cost is called the burden rate. In our manufacturing example the burden rate is computed as follows (see Figure 4-2 for data):

· £42.0 million total fixed manufacturing costs for period ÷ 120,000 units production output for period = £350 burden rate

Note that the burden rate depends on the number divided into total fixed manufacturing costs for the period; that is, the production output for the period. Now, here’s a very important twist on our example: suppose the company had manufactured only 110,000 units during the period - equal exactly to the quantity sold during the year. Its variable manufacturing cost per unit would have been the same, or £410 per unit. But its burden rate would have been £381.82 per unit (computed by dividing the £42 million total fixed manufacturing costs by the 110,000 units production output). Each unit sold, therefore, would have cost £31.82 more, simply because the company produced fewer units (£381.82 burden rate at the 110,000 output level compared with the £350 burden rate at the 120,000 output level).

In this alternative scenario (in which only 110,000 units were produced), the company’s product cost would have been £791.82 (£410 variable costs plus the £381.82 burden rate). The company’s cost of goods sold, therefore, would have been £3.5 million higher for the year (£31.82 higher product cost × 110,000 units sold). This rather significant increase in its cost of goods sold expense is caused by the company producing fewer units, although it did produce all the units that it needed for sales during the year. The same total amount of fixed manufacturing costs would be spread over fewer units of production output.

Shifting the focus back to the example shown in Figure 4-2, the company’s cost of goods sold benefited from the fact that it produced 10,000 more units than it sold during the year. These 10,000 units absorbed £3.5 million of its total fixed manufacturing costs for the year, and until the units are sold this £3.5 million stays in the stock asset account. It’s entirely possible that the higher production level was justified - to have more stock on hand for sales growth next year. But production output can get out of hand - see the following section, ‘Excessive production output for puffing up profit’.

For the example illustrated in Figure 4-2, the business’s production capacity for the year is 150,000 units. However, this business produced only 120,000 units during the year, which is 30,000 units fewer than it could have produced. In other words, it operated at 80 per cent of production capacity, which is 20 per cent idle capacity (which isn’t unusual):

· 120,000 units output ÷ 150,000 units capacity = 80% utilisation

Running at 80 per cent of production capacity, this business’s burden rate for the year is £350 per unit (£42 million total fixed manufacturing costs ÷ 120,000 units output). The burden rate would have been higher if the company had produced, say, only 110,000 units during the year. The burden rate, in other words, is sensitive to the number of units produced. This can lead to all kinds of mischief, as explained next.

Excessive production output for puffing up profit

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 stock asset account rather than the cost of goods sold expense account, meaning that the product cost is counted as a positive number (an asset) rather than a negative number (an expense). The burden rate is included in product cost, which means that this cost component goes into stock and is held there until the products are sold later. In short, when you overproduce, more of your fixed manufacturing costs for the period are moved to the stock asset account and less are moved into cost of goods sold expense, which is based on the number of units sold.

The actual costs / actual output method and when not to use it

To determine its product cost, the business in the Figure 4-2 example uses the actual cost / actual output method in which you take your actual costs - which may have been higher or lower than the budgeted costs for the year - and divide by the actual output for the year.

The actual costs / actual output method is appropriate in most situations. However, this method isn’t appropriate and would have to be modified in two extreme situations:

· Manufacturing costs are grossly excessive or wasteful due to inefficient production operations. For example, suppose that the business represented in Figure 4-2 had to throw away £1.2 million of raw materials during the year. The £1.2 million is included in the total raw materials cost, but should be removed from the calculation of the raw material cost per unit. Instead, you treat it as a period cost - meaning that you take it directly into expense. Then the cost of goods sold expense would be based on £750 per unit instead of £760, which lowers this expense by £1.1 million (based on the 110,000 units sold). But you still have to record the £1.2 million expense for wasted raw materials, so earnings before interest and taxes (EBIT) would be £100,000 lower.

· Production output is significantly less than normal capacity utilisation. Suppose that the Figure 4-2 business produced only 75,000 units during the year but still sold 110,000 units because it was working off a large stock carryover from the year before. Then its production capacity would be 50 per cent instead of 80 per cent. In a sense, the business wasted half of its production capacity, and you can argue that half of its fixed manufacturing costs should be charged directly to expense on the Profit and Loss statement and not included in the calculation of product cost.

You need to judge whether a stock increase is justified. Be aware that an unjustified increase may be evidence of profit manipulation or just good old-fashioned management bungling. Either way, the day of reckoning will come when the products are sold and the cost of stock becomes cost of goods sold expense - at which point the cost subtracts from the bottom line.

Recapping the example shown in Figure 4-2: The business manufactured 10,000 more units than it sold during the year. With variable manufacturing costs at £410 per unit, the business took on £4.1 million more in manufacturing costs than it would have if it had produced only the 110,000 units needed for its sales volume. In other words, if the business had produced 10,000 fewer units, its variable manufacturing costs would have been £4.1 million less. That’s the nature of variable costs. In contrast, if the company had manufactured 10,000 fewer units, its fixed manufacturing costs wouldn’t 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 million ended up in the cost of goods sold expense for the year (£350 burden rate × 110,000 units sold). The other £3.5 million ended up in the stock asset account (£350 burden rate × 10,000 units stock increase). Let us be very clear here: we’re not suggesting any malpractice. But the business did help its pre-tax 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 volume for the year, then all the fixed manufacturing costs would have gone into cost of goods sold expense. As explained earlier, the expense would have been £3.5 million higher, and EBIT would have been that much lower.

Now suppose that the business manufactured 150,000 units during the year and increased its stock by 40,000 units. This may be a legitimate move if the business is anticipating a big jump in sales next year. But on the other hand, a stock increase of 40,000 units in a year in which only 110,000 units were sold may be the result of a serious overproduction mistake, and the larger stock may not be needed next year. In any case, Figure 4-3 shows what happens to production costs and - more importantly - what happens to profit at the higher production output level.

Figure 4-3: Example in which production output greatly exceeds sales volume, thereby boosting profit for the period.

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 cost may be a little higher than £410 per unit because as you start crowding your production capacity some variable costs may increase a little.) The business would need about £12.3 million more for the additional 30,000 units of production output:

· £410 variable manufacturing cost per unit × 30,000 additional units produced = £12,300,000 additional variable manufacturing costs invested in stock

But check out the business’s EBIT in Figure 4-3: £23.65 million, compared with £15.95 million in Figure 4-2 - a £7.7 million increase, even though sales volume, sales prices and operating costs all remain the same. Whoa! What’s going on here? The simple answer is that the cost of goods sold expense is £7.7 million less than before. But how can cost of goods sold expense be less? The business sells 110,000 units in both scenarios and variable manufacturing costs are £410 per unit in both cases.

The burden rate component of product cost in the first case is £350 (see Figure 4-2). In the second case the burden rate is only £280 (see Figure 4-3). Recall that the burden rate is computed by dividing total fixed manufacturing costs for the period by the production output during the period. Dividing by 150,000 units compared with 120,000 units reduces the burden rate from £350 to £280. The £70 lower burden rate multiplied by the 110,000 units sold results in a £7.7 million smaller cost of goods sold expense for the period, and a higher pre-tax profit of the same amount.

In the first case the business puts £3.5 million of its total annual fixed manufacturing costs into the increase in stock (10,000 units increase × £350 burden rate). In the second case, in which the production output is at capacity, the business puts £11.2 million of its total fixed manufacturing costs into the increase in stock (40,000 units increase × £280 burden rate). Thus, £7.7 million more of its fixed manufacturing costs go into stock rather than cost of goods sold expense. But don’t forget that stock increased 40,000 units, which is quite a large increase compared with the annual sales of 110,000 during the year just ended.

Who was responsible for the decision to go full blast and produce up to production capacity? Do the managers really expect sales to jump up enough next period to justify the much larger stock level? If they prove to be right, they’ll look brilliant. But if the output level was a mistake and sales don’t go up next year, they’ll have you-know-what to pay next year, even though profit looks good this year. An experienced business manager knows to be on guard when stock takes such a big jump.

A View from the Top Regarding Costs

The CEO of a business gets paid to take the big-picture point of view. Using the business example in the chapter (refer to Figure 4-2 again), a typical CEO would study the management Profit and Loss statement and say something like the following:

Not a bad year. Total costs were just about 90 per cent of sales revenue. EBIT per unit was a little more than 10 per cent of sales price (£145 per unit ÷ £1,400 sales price). I was able to spread my fixed operating expenses over 110,000 units of sales for an average of £195 per unit. Compared with the £340 contribution margin per unit, this yielded £145 EBIT per unit. I can live with this.

I’d like to improve our margins, of course, but even if we don’t, we should be able to increase sales volume next year. In fact, I notice that we produced 10,000 units more than we sold this year. So, I’ll put pressure on the sales manager to give me her plan for increasing sales volume next year.

I realise that cost numbers can be pushed around by my sharp-pencil accountants. They keep reminding me about cost classification problems between manufacturing and non-manufacturing costs - but what the heck: it all comes out in the wash sooner or later. I watch the three major cost lines in my profit and loss statement - cost of goods sold, variable operating expenses and fixed operating expenses.

I realise that some costs can be classified in one or another of these groupings. So, I expect my accountants to be consistent period to period, and I have instructed them not to make any changes without my approval. Without consistency of accounting methods, I can’t reliably compare my expense numbers from period to period. In my view, it’s better to be arbitrary in the same way, period after period, rather than changing cost methods to keep up with the latest cost allocation fads.

Have a Go

1. You can see in Table 4-1 that Firm X records £42 million fixed manufacturing overhead costs in the year.

Table 4-1 Internal Profit and Loss Statement for Firm X

Suppose, instead, that its fixed manufacturing overhead costs are £45.6 million for the year, which is an increase of £3.6 million. Would the business’s operating profit be £3.6 million lower? (Assume that variable manufacturing costs per unit and operating expenses remain the same.)

2. Please use the information found in Table 4-2 to answer the following:

Table 4-2 Internal Profit and Loss Statement for Firm Y

Towards the end of the year, the managing director (MD) of Firm Y looks at the preliminary numbers for operating profit and doesn’t like what she sees. She promised the board of directors that operating profit for the year would come in at £4.85 million. In fact, her bonus depends on hitting that operating profit target. Time is still left before the end of the year to crank up production output for the year. Therefore, she orders that production output be stepped up. The MD asks you, as the chief accountant, to determine what the production output level for the year would have to be in order to report £4.85 million operating profit for the year. Of course, you have ethical qualms about doing so, but you need the job. Therefore, you reluctantly decide to do the calculation. Determine the production output level that would yield £4.85 million operating profit for the year.

Answering the Have a Go Questions

1. No, operating profit wouldn’t be £3.6 million lower.

Table 4-3 Internal Profit and Loss Statement for Firm X

Table 4-3 shows that operating profit would be £3.3 million lower. The higher fixed manufacturing overhead costs drive up the product cost per unit, from £760 to £790, or £30 per unit. However, the business sells only 110,000 units, and so the £30 higher product cost per unit increases the cost of goods sold expense by only £3.3 million (£30 increase in product cost × 110,000 units sales volume = £3,300,000). Therefore, operating profit decreases by £3.3 million.

The operating profit decrease still leaves £300,000 of the total £3.6 million fixed manufacturing overhead costs increase to explain. The 10,000 units increase in stock absorbs this additional amount of fixed manufacturing overhead costs; including fixed manufacturing overhead costs in product cost is called absorption costing. Some accountants argue that product cost should include only variable manufacturing costs and not include any fixed manufacturing overhead costs. This practice is called direct costing, or variable costing, and it isn’t generally accepted. GAAP require that the fixed manufacturing overhead cost must be included in product cost.

2. In answer to question 2. The accountant has calculated that in order for the operating profit of Company Y to be £4.85Million, the business must manufacture at least 625,000 units. See Table 4-4 which shows that if the business manufactures 625,000 units, its operating profit becomes £4.85 million.

Table 4-4 Internal Profit and Loss Report for Firm Y

The MD wants £1.6 million more profit than shown in Table 4-2 (£4,850,000 profit target - £3,250,000 profit at 500,000 units production level = £1,600,000 additional profit). The only profit driver that changes with a higher production level is the burden rate, which has to decline £3.20 per unit in order to achieve the additional profit (£1,600,000 additional profit wanted ÷ 500,000 units sales volume = £3.20 decrease needed in burden rate). The burden rate has to decrease £3.20, from £16 (see Table 4-2) to £12.80. The production output level has to be 625,000 units to get the burden rate down to £12.80 (£8,000,000 fixed manufacturing overhead costs ÷ £12.80 burden rate = 625,000 units).

Whether jacking up production to 625,000 units is ethical when sales are only 500,000 units for the year is a serious question. The members of Firm Y’s board of directors should definitely challenge the MD on why such a large stock increase is needed. We certainly would!