Cost Concepts

1
Cost Concepts
2
Life-Cycle Costs

• Life Cycle Cost for an item is the sum of all
  expenditures associated with the items during its
  entire service life.
• Life cycle costs include
• first costs (or initial investment)
• operating and maintenance costs
• disposed costs.

3
Life-Cycle Costs

• First cost is the initial investment required to
  put an asset into service.
• Examples include
• Machine costs
• Training
• Shipping and installation
• Tooling
• Support equipment.

4
Life-Cycle Costs

• Some projects require Working Capital for
• Inventories
• Accounts receivable
• Cash for wages
• Materials
• And more

5
Life-Cycle Costs

• Operating and Maintenance Costs are recurring
  costs that are necessary to operate and maintain
  an item during its useful life.
• Operating and maintenance costs include
• Labor
• Materials
• Overhead
• required for the system to perform its intended
  function.

6
Life-Cycle Costs

• What are typical overhead items?
• 1.Fuel or electric power
• 2.Insurance premiums
• 3.Inventory charges
• 4.Indirect labor
• 5.Administrative and management expenses
• These costs may not be recurring or on a regular
  basis.

7
Life-Cycle Costs

• Disposed costs include
• Labor and material costs for removal of the item
• Shipping costs
• Special costs such as hazardous materials
• Salvage value market value - cost of disposal
• Book value value of a capital asset at the end
  of a given accounting period
• Scrap value refers only to the value of the
  material of which the item is made
• Scrap value example 4 year old car may have a
  scrap value of 500 but a market value of 5,000

8
Past and Sunk Costs

• Past cost are historical costs that have been
  incurred.
• Sunk costs are unrecoverable past costs.
• Why are sunk costs important?
• They may qualify as capital losses and serve to
  offset capital gains or other taxable income and
  thus reduce income taxes paid

9
Sunk Cost Example

• Assume equipment is purchased for 10,000 and the
  salvage value at the end of 5 years of service is
  estimated to be 5000. Assume an annual decrease
  in asset value through physical deterioration, or
  depreciation is 1,000.
• The 1,000 annual cost of depreciation is a cost
  of production that should be allocated to the
  output of the equipment
• Costs for manufacturing, administration,
  marketing and others are added to each unit of
  production to get a total cost
• Profit is added to each unit to get a selling
  price

10
Sunk Cost Example

• When each unit is sold a portion of each sales
  dollar returns a portion of the depreciation
  expense
• We are assuming that the entire depreciation
  expense of 5,000 will be recovered for the five
  year period
• If the equipment has a market value of over
  2,000 at the end of five years, there is a
  3,000 (5000 2000) sunk cost
• The 3,000 represents an error estimating the
  rate of depreciation

11
Future and Opportunity Costs

• Future costs are those costs estimated to be
  incurred in the future.
•  Examples
• Labor
• Materials
• Maintenance
• Overhaul
• Disposal, etc
• These costs are rarely known for sure, thus they
  are estimates.

12
Future and Opportunity Costs

• Opportunity Costs cost of forgoing the
  opportunity to earn interest, or a return, on
  investment funds
• Opportunity cost is really an interest rate or
  rate of return that could have been achieved if
  one does not invest in the project under
  consideration. It is really the rate of return on
  a lost opportunity.

13
Opportunity Costs Example

• You have 1000 stored in a shoe box at home. You
  have decided to forgo the opportunity to earn
  interest on the money in a savings account at a
  local bank.
• Say the bank pays 5 interest compounded
  annually.
• For a 1 year period, you could have earned
  (.05)(1000) 50.
• The 50 amount is thus termed the opportunity
  cost associated with storing the 1000 in your
  shoe box.

14
Future and Opportunity Costs

• Cost of capital (MARR) the cost of obtaining
  funds for financing projects through debt
  obligations (usually from loans or bonds).

15
Direct, Indirect and Overhead Costs

• Cost of Goods Sold is the total cost of
  manufacturing a product
• An amount of profit is added to this total cost
  to arrive at a selling price.
• Direct material and labor costs the costs of
  material and labor that are easily measured and
  can be conveniently allocated to a specific
  operation, product, or project.
• Indirect costs for both labor and material
  difficult to assign directly to a specific
  operation, product, or project.
• Overhead costs all costs of manufacturing other
  than direct material and direct labor.

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Direct, Indirect and Overhead Costs
Direct materials
Prime Costs
Direct labor
Cost of goods manufactured
Indirect materials
Factory Overhead Costs
Conversation Costs
Indirect labor
Cost of Goods Sold
Fixed and miscellaneous
General and Administrative
Selling Price
Selling
Profit
17
Direct, Indirect and Overhead Costs

• Overhead cost examples
• Indirect materials
• Indirect labor
• Taxes
• Insurance premiums Rent
• Maintenance and repairs
• Supervisory and administrative personnel
• Utilities
• For a description direct labor and material
  costs, indirect labor and material costs, fixed
  and miscellaneous costs, general and
  administration costs, selling costs, conversion
  costs, prime costs, factory overhead costs, cost
  of good manufactured and costs of goods sold see
  pages 365 367 and Figure 8.1.

18
Fixed and Variable Costs

• Fixed Costs costs which remains relatively
  constant regardless of the volume of output.
• The symbol for fixed cost is FC.
•  Fixed Cost Examples
• General administrative expenses
• Taxes
• Insurance
• Rent building and equipment depreciation
• Utilities
• Variable Costs costs that vary in the
  proportion to the volume of output.
• Variable costs are VC(x) where v is the variable
  cost per unit and x is the number of units.

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Fixed and Variable Costs
Variable Cost Examples 1.      Direct
labor 2.      Direct materials Total Costs are
fixed costs plus variable costs. TC(x) FC
VC(x) The Breakeven point is the volume at which
the Total Revenue equals the Total Costs. TR(x)
TC(x) FC VC(x)   See example 8.1 and 8.2 on
pages 370 372 for illustrations of these
concepts.
20
Fixed and Variable Costs Example

• Total annual cost for operating a personal
  automobile
• Fixed costs
• Insurance
• License tags
• Depreciation
• Maintenance
• Interest borrowed on money
• Variable costs depends on the number of miles
  driven
• Gas
• Oil
• Tires
• Maintenance proportional to miles driven

21
Fixed and Variable Costs Example
Assume that the costs could be represented
as TC(x) 950 .15x
Dollars
Variable costs
Total annual costs
Fixed costs
Annual Mileage, x
22
Fixed and Variable Costs
Total Revenue
Annual Net Profit
Total costs
Dollars
A
Fixed costs
Annual Production Volume, x
23
Fixed and Variable Costs
Dollars
A
Annual Production Volume, x
24
Fixed and Variable Costs
B
Dollars
C
A
Annual Production Volume, x
25
Fixed and Variable Costs

• We want a low break even value
• We can accomplish a low break even in three ways
• Increase the slope of the revenue line
• Decrease the slope of the variable cost line
• Decrease the magnitude of the fixed cost line
• Which of these is the most feasible?
• Increasing the price will not be popular with
  customers and may be risky in a competitive
  environment
• Fixed costs are often difficult to reduce
• Reducing variable costs for direct material and
  labor usually offer the greatest opportunity for
  improvement

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Example 8.1
The cost of tooling and direct labor required to
set up for a machining job on a turret lathe is
300. Once set up, the variable cost to produce
one finished unit consists of 2.50 for material
and 1 for labor to operate the lathe. For
simplicity, it is assumed these are the only
relevant fixed and variable costs. If each
finished unit can be sold for 5, determine the
production quantity required to break even and he
net profit (or loss) of the lot size is 1000
units. X production volume in units TR(x)
TC(x) FC VC(x) 5x 300 (2.50 1.00)x x
300/1.50 200 units For 1000 units Net profit
P 5(1000) (2.50 1.00)(1000) 300 1200
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Average Costs
Average Cost is the total cost divided by the
number of units   AC(x) TC(x) / x AC(x)
average cost per unit of x TC(x) total cost for
x units of output x output quantity   Average
cost is a variable function of the output
quantity and normally decreases with an
increasing quantity of output (often referred to
as the economies of scale).
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Average Cost Example
Say that the Total Cost for operating a car is
950 .15x
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Economies of Scale

• Say that the Total Cost for operating a car is
  950 .15x
• As the output quantity x increases, the
  proportion of the fixed cost allocated to each
  unit of output decreases.
• This economic principle is referred to as the
  economies of scale.
• Economies of scale assumptions
• The variable cost coefficient remains constant
  over the range of output variable x
• Whats the problem with this assumption?
• It is very likely that the variable cost
  coefficient will increase as the production
  volume increases beyond a given point. Why?

30
Marginal Costs

• Marginal Cost is the cost to provide one
  additional unit.
• For total cost functions that are continuous in
  the output (or independent) variable, marginal
  cost is defined as the derivative of the total
  cost function (dependent variable) with respect
  to x, or dTC/dx
• This is true for continuous functions that are
  linear or nonlinear in the output variable x.

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Marginal Costs Example
Consider a continuous function that is
linear TC(x) 950 .15x dTC(x)/dx .15 In
this case, the marginal cost is the constant
value .15 and is the constant required to
increase the output quantity x by one unit.
32
Marginal Costs Example
Consider a discontinuous function that is defined
only for discrete values of x (say x 1, 2, 3,
) Must use difference equations to determine
marginal costs TC(6) TC(5) marginal cost of
increasing the output quantity from x 5 to x
6 Thus, for discrete, marginal cost is always the
cost required to increase the output quantity x
by one unit at a specified level of output true
for linear and nonlinear functions
33
Marginal Costs Example 8.3
Production process fixed costs are 60,000.
Variable costs are 30 per unit of production.
Total cost equation TC(x) 60000 30x What is
the marginal cost at X 10 and x 20? Using
difference equations Marginal cost at 10 Total
cost at 11 total cost at 10 MC(10) TC(11)
TC(10) MC(10) 60000 30(11) 60000
30(10) MC(10) 60330 60300 30
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Marginal Costs Example 8.3
Production process fixed costs are 60,000.
Variable costs are 30 per unit of production.
Total cost equation TC(x) 60000 30x What is
the marginal cost at X 10 and x 20? Using
differentiation Marginal cost at 10 first
derivative of the total cost function evaluated
at 10 MC(x) d/dx TC(x) MC(x) d/dx 60000
30(x) MC(x) 30 Thus, MC(10) 30 and MC(20)
30
35
Marginal Costs Example 8.4
A small firm blends and bags chemicals for home
gardening purposes. For one pesticide duct
product, sales and production cost records over
the past 10 seasons have been reviewed and
analyzed. The following equations approximate the
relationships among selling price, sales volume,
production costs and profit become income taxes.
Let t number of tons per season SP(t)
selling price in order to sell t tons (800 -
.8t) TR(t) total revenue when t tons are sold
at a particular selling price TR(t) (800 -
.8t)t (800t - .8t2)
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Marginal Costs Example 8.4
MR(t) marginal revenue at a sales volume of t
tons MR(t) dTR(t)/dt (800 1.6t) TC(t) the
total production cost for t tons TC(t) (10000
400t) TP(t) total profit when t tons are
sold TP(t) TR(t) - TC(t) TP(t) (800 - .8t2)
(10000 400t) TP(t) (-.8t2 400t
10000 AP(t) average profit per ton when t tons
are sold AP(t) TP(t)/t AP(t) (-.8t 400
10000/t) The equations apply for the range 0 lt t
lt 1000
37
Marginal Costs Example 8.4
Consider total revenue dTR(t)/dt 800 2(.8)t
0 800 1.6t 500 t amount when the total
revenue will be maximized TR(t) TR(500)
800(500) - .8(500)2 200,000 Consider Marginal
Revenue MR(500) 800 1.6(500) 0
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Marginal Costs Example 8.4
Consider total Profit dTP(t)/dt 2(-.8)t 400
0 400 1.6t 250 t amount when the total
profit will be maximized TP(250) (-.8)(250)2
400(250) -10000 40,000 Consider Average
Profit AP(250) -.8(250) 400 10000/250
160/ton
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Marginal Costs Example 8.4
Find the break-even point TR(t) TC(t) 800t -
.8t2 10000 400t -.8t2 400t - 10000 0
solve using quadratic formula T 26.39,
473.61 For a sales volume in the range of 26.39 lt
t lt 473.61, the firm will make a profit, Sale
volume outside this range will result in total
costs exceeding total revenues and a net loss to
this firm.
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Estimation

• Cost estimating can be done using 2 different
  approaches
• Top-down or parametric
• Bottom-up or detailed
• The parametric approach utilizes historical data
  from prior work and determines the new cost
  estimate based on the differences between the new
  product or project and the new one.
• The detailed approach requires estimates of costs
  for each element and sub-element of a product or
  project and then applies appropriate pricing
  parameters (allowances for overhead and profit)
  to accumulate a total cost estimate.

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Estimation

• When should each approach be used?
• Use parametric in the early stages when several
  projects are under consideration.
• The objective is often only to reduce the field
  of choices down rather than making an ultimate
  choice.
• Use the detailed approach when the options are
  narrowed to only 2 or 3 projects.
• At this stage, details could make a difference.

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Cost of Increasing Detail - Figure 8.5 p.378
CT C(M) C(E) CT the total cost of making
the estimate, dollars C(M) the functional cost
of making the estimate C(E) the functional cost
of errors in the estimate
CT
C(M)
Cost
C(E)
D1
Amount of Detail
43
Project Estimation

• All engineering economic analyses are based on
  estimates. Therefore, some estimation terminology
  is important to know. There are three types of
  estimates as follows
• Order of magnitude estimates are estimates that
  are based on judgment and experience. Their
  accuracy is 50 .
• Preliminary estimates are estimates based on some
  preliminary analyses. Their accuracy is 20. 
• Detailed estimates are estimates based on each
  detailed items cost estimate. A detailed design
  of each part is necessary. Their accuracy is
  5.
• You should read Section 8.3.2 on page 380 to
  obtain a listing of the sources of data on which
  the above estimate could be based.

44
General Accounting Principles

• Accounting is the language of business just like
  mathematics is the language of science.
• How well you communicate with the decision makers
  often will determine whether or not the
  alternative is funded.
• How do you increase your chances of getting your
  idea approved?
• Speak the language of the listeners
• Understand what motivates them
• See the world as they see it
• Understand what rules and criteria they use.

45
General Accounting Principles

• The four primary functions accounting systems
  perform with financial data are
• Recording
• Classifying
• Summarizing
• Interpreting
• The two primary financial statements of a general
  accounting system are
• Balance Sheet
• Income Statement.

46
Balance Sheet

• Provides a statement of the financial condition
  of a firm at a point in time by providing a
  summarizing listing of the values of the assets
• Reflects the financial condition as a result of
  the activities reported in the income statement

47
Income Statement

• Provides a statement of the revenues and expenses
  incurred by a firm during a period of time
  (usually a month, quarter, or year)
• Summarizes the financial activities that occur
  between two balance sheets

Income Statement
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Balance Sheet

• The Balance Sheet lists
• Assets properties owned by the firm
• Liabilities debts owed by the firm against
  these assets
• Net worth dollar difference between assets and
  liabilities
• Net worth is also referred to as owners equity
  measures the investment made by the owners or
  stockholders plus accumulated profits
• Data is usually prepared quarterly.

49
Balance Sheet

• The basic financial Equation is
• Assets Liabilities Net worth
• This Equation can be solved for Net Worth to
  obtain Equation 8.6 below.
• Net Worth Assets Liabilities . . . EQ. 8.6
• Assets can be purchased by Ownership money
  (equity) or by borrowing (debt / Liabilities).  

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Balance Sheet

• Current assets are those that will be converted
  to cash within one year.
• Examples include
• Cash
• Accounts receivable
• Notes receivable
• Raw material inventory
• Work in process
• Finished goods inventory
• Prepaid expenses
• Current assets are listed so that the most liquid
  are listed first

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Balance Sheet

• Current liabilities debts that are due an
  payable within 1 year from the date of the
  balance sheet in question
• Examples include
• Accounts payable
• Notes payable
• Interest payable
• Taxes payable
• Prepaid income
• Dividends payable

52
Balance Sheet

• Fixed assets properties owned by the firm that
  are not readily converted into cash within a
  1-year period
• Examples include
• Land
• Buildings
• Equipment
• Furniture
• Fixtures

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Balance Sheet

• Fixed liabilities long term debts due and
  payable after 1 year from the date of the balance
  sheet
• Examples include
• Notes payable
• Bonds payable
• Mortgages payable

54
Balance Sheet

• Net Worth depend on the size of business but
  typically include
• Capital stock
• Retained earnings
• Capital surplus
• Earned surplus

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Balance Sheet

• Liquidity is a term which measures how easy it
  is to convert an asset to cash.
• The more liquid an asset the more easy it is to
  convert it to cash.
• Cash is therefore the most liquid asset and is
  listed first.
• Accounts receivable are payments due by
  customers.
• In most cases these will be received and
  therefore converted to cash within 30 days.

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Balance Sheet Table 8.5 p. 383
57
Balance Sheet - Assets

• Fixed Assets
• Building originally cost 200,000
• Building depreciation to date 50,000
  depreciation reserve
• Depreciation reserve - accumulated amount of
  funds held to repurchase the asset when its
  functionally useful life ends
• Book value first cost depreciation reserve

58
Balance Sheet Table 8.5 p. 383
59
Balance Sheet Liabilities and Net Worth

• Common stock contributed capital reflects the
  ownership position of the stockholders
• Retained earnings summarizes the surplus of
  deficit of earnings over expenses
• Earned surplus net profit on the income
  statement

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Balance Sheet Table 8.8 p. 387
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Balance Sheet Table 8.8 p. 387
62
Income Statement

• The Income Statement is also called a Profit and
  Loss Statement.
• It is a listing of revenues, expenses and profit
  over a fixed period of time.
• It summarizes the financial activities that occur
  between two balance sheets.
• Revenues are primarily the result of sales of
  goods or services.
• Expenses include direct materials, direct labor,
  indirect materials and labor, overhead costs,
  depreciation, and taxes

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Income Statement Table 8.9 p.388
64
Ratio Analysis

• A common method for analyzing a company is to
  compare the value of certain important accounting
  ratios with industry averages for their type of
  company.
• The value of this year's ratio can be compared
  with that of previous years to get a sense of
  direction in which the company is going.
• There are three categories of ratios
• Profitability Ratios
• Short Term Debt Ratios
• Long Term Debt Ratios.

65
Ratio Analysis

• Analysis of financial statements focus on three
  primary areas
• Earning power of the company
• Short-term liability
• Long term liability

66
Ratio Analysis

• The two commonly used profitability ratios are
• Return on assets
• (2) Return on equity.
• Return on Assets Net income / Total average
  assets
• Return on Equity Net income / Average owners
  Equity
• Total average assets is the average of last
  periods ending assets and this periods ending
  assets.
• Average owners equity is the average of last
  periods ending owners equity and this periods
  ending owners equity.
• Net income is taken form the Income Statement
  while assets and equity are taken from the
  Balance Sheet.

67
Ratio Analysis

• Short term liability liquidity ratios measure
  a companys ability to meet its current
  obligations
• Current Ratio Current Assets / Current
  Liabilities
• We want this ratio to be greater than 1, because
  we want more assets than liabilities.
• Is a ratio of 5 better than 3?
• Not necessarily because if we have that much cash
  on hand, why are we not putting that cash to work
  for us in investments?

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Acid Test Ratio

• Short term liability liquidity ratios
• Acid Test Ratio (Cash Receivables Short
  term marketable securities)/Current liabilities
• Basically this is the current assets minus
  inventory
• Acid Test (Current Assets - Inventory)/ Current
  liabilities
• The question is "can you still pay your bills?"
• Sometimes your inventory is not any good. If the
  inventory is out of date, who is going to buy it?
• With the acid test, the question is "Could you
  pay your bills even if you could not sell your
  inventory?"

69
Ratio Analysis

• Accounts receivable Turnover Net sales/Average
  accounts receivable
• Net sales comes from the income statement
• Average accounts receivable comes from the
  balance sheet
• Inventory Turnover Cost of goods sold/Average
  inventory
• Debt to Equity Ratio Total Liabilities / Total
  Capital Worth
• The more debt a company carries, the more a risk
  they are.

70
Ratio Analysis
Long term Liability Times interest earned ratio
net income before taxes and interest / Interest
charges Operating Income to total Assets ratio
net operating income / Total Assets
71
Cost Accounting Principles

• Cost Allocation Methods
• The total cost of producing any job order
  consists of
• Direct material
• Direct labor
• Overhead costs.
• An additional item of cost could be special
  tooling or equipment purchases strictly for the
  job order in question.
• This definition of total cost does not detail the
  overhead cost into factory overhead, general
  overhead, and marketing expenses in order to
  simplify the presentation

72
Cost Accounting Principles

• Materials for a given job order may include
• Purchased parts and in-house fabricated parts
• Cost for direct materials is determined primarily
  from purchase invoices.  
• Direct labor time spent on job order
• Normally recorded by operators on labor time
  cards
• Direct labor cost is determined by applying the
  appropriate labor cost rates.

73
Cost Accounting Principles

• Labor rates (as determined by the accounting
  system) will normally include
• Cost of employee fringe benefits
• Basic hourly rate.
• Although accurately determining the direct labor
  cost for a given job is a major accounting
  problem, it is more readily determined than the
  overhead cost.

74
Cost Accounting Principles

• Overhead costs typically cannot be allocated as
  direct charges to any single job order and must,
  therefore, be prorated among all the job orders
  on some rational basis.
• Three popular methods of allocating overhead
  costs to manufacturing jobs are in wide use
  today. They are
• Allocation based on direct labor hours
• Allocation based on direct labor dollars
• Allocation based on direct labor dollars plus
  direct material dollars (prime costs)

75
Cost Accounting Principles

• Allocate Overhead Based on Direct Labor Hours
• 1. Determine (or estimate) values for previous
  period direct labor hours and overhead cost for
  the manufacturing unit
• 2. Calculate the rate per direct labor hour
• Rate overhead cost / direct labor hours
• 3. Determine (or estimate) the number of direct
  labor hours required by the particular job for
  which overhead cost is being estimated.
• 4. Calculate the overhead cost for the job
• Estimated overhead rate X estimated direct
  labor hours

76
Cost Accounting Principles

• Allocate Overhead Based on Direct Labor Dollars
• 1. Determine (or estimate) values for previous
  period direct labor dollars and overhead cost for
  the manufacturing unit
• 2. Calculate the percentage ratio of overhead
  cost to direct labor dollars
•  
• ratio overhead cost / direct labor dollars x
  100
•  
• 3. Determine (or estimate) the direct labor
  dollars required by the particular job for which
  overhead cost is being estimated.
• 4. Calculate the overhead cost for the job
• Estimated overhead ratio X estimated direct
  labor dollars

77
Cost Accounting Principles

• Allocate Overhead Based on Direct Labor Dollars
  and Direct Material Dollars
• 1. Determine (or estimate) values for previous
  period direct labor dollars, direct material
  dollars, and overhead cost for the manufacturing
  unit
• 2. Calculate the percentage ratio of overhead
  cost to direct labor dollars plus direct material
  dollars
• ratio overhead cost / (direct labor dollars
  direct material dollars) x 100
• 3. Determine (or estimate) the direct labor
  dollars and direct material dollars required by
  the particular job for which overhead cost is
  being estimated.
• 4. Calculate the overhead cost for the job
• estimated overhead ratio x (estimated direct
  labor dollars estimated direct material
  dollars)

78
Cost Accounting Principles Example 8.5

• The overhead allocation for a job is to be
  estimated. Assume the direct labor hours for the
  job are estimated to be 40 hours at a rate of
  12.50 per hour. Direct materials costs are
  estimated at 850. The overhead calculations are
  to be based on the following previous period cost
  totals
• Total direct labor hours 48,000
• Total direct labor dollars 480,000
• Total direct material dollars 600,000
• Total overhead costs 360,000

79
Cost Accounting Principles Example 8.5

• Direct labor hours
• Step 1
• Previous period direct labor hours 48,000
• Previous period overhead costs 360,000
• Step 2
• Rate per direct labor hour 360,000/48,000
  7.50/hour
• Step 3
• Estimate direct labor hours for job 40
• Step 4
• Estimate overhead 7.50/hour (40 hours)
  300

80
Activity-Based Costing

• Activity-based costing (ABC) has emerged due to
  the dramatic changes occurring in the nature and
  characteristics of manufacturing costs.
•  
• Historically, direct labor and direct material
  constituted the most significant elements of the
  cost of goods.
•  
• Overhead was the smallest element and hence was
  allocated based on direct labor or prime costs
  (see Section 8.5.1).
•  
• In many cases today, it is no longer accurate to
  assume that direct labor is the largest element
  in the cost pool and overhead the smallest.
•  
• With the introduction and implementation of
  computer controlled and automated manufacturing
  systems, it is not unusual for overhead costs to
  dominate the cost of producing items. Frequently
  in fact, direct labor is the least significant in
  the cost pool and overhead the largest.

81
Activity-Based Costing

• Activity-based costing is designed to meet the
  challenge of a changing cost mix by associating
  manufacturing costs with activities which drive
  them.
•  
• First, costs must be identified by categories.
  Categories need not (and probably should not) be
  associated with products or organizational units,
  rather, they are associated with clearly defined
  elements or cost categories. Typical examples
  might include material handling costs, energy
  costs, tooling costs, or maintenance costs.
•  
• Next the activities which drive the significant
  cost categories must be identified. These are the
  activities which are to be monitored and
  controlled under activity- based costing.
•  
• This task is difficult and complex. Many
  companies have never considered their processes
  from the cost driver and/or value-adding
  viewpoint. The newness of this approach as well
  as the implicit challenge of considering
  activities from a new perspective make this task
  a significant undertaking. Examples of
  cost-driving activities include machine hours for
  energy costs, material moves or truck hours for
  material handling costs, and machine hours or
  production volume for tooling and maintenance
  costs.

82
Activity-Based Costing

• Next, the expected (or actual) rate of activity
  for each of the cost drivers is used to predict
  (or monitor) the costs associated with each cost
  category. Such activity-based accounting of costs
  can be used as a basis to eliminate high cost
  activities, particularly if they generate low
  value added.
•  
• Similarly, ABC analysis can be used to focus the
  attention of process improvement activities
  toward those activities that drive high costs.
  Better still, product and process redesign can
  focus on changes which ultimately eliminate the
  activation of high-cost driver activities.
•  
• Many companies are employing ABC to make
  activity-based decisions which result from a more
  realistic allocation of costs than was previously
  possible. In many cases, ABC-generated process
  and product redesigns have been impressive when
  measured in terms of cost reduction and profit
  improvement. ABC does, however, require
  information sharing and a cross-functional
  perspective that is new to most companies.
  Additional information regarding activity-based
  costing can be found in 2, 3, 6, 9.

83
Standard Costs

• Another major purpose of cost accounting is to
  interpret financial data so that management can
• measure changes in production efficiency
• judge the adequacy of production performance.
•  
• Establishing cost standards can be of great
  assistance in achieving these objectives.
•  
• A standard-cost system involves, in advance of
  manufacture,
• the preparation of standard rates for material,
  labor, and overhead
• the application of these rates to the standard
  quantities of material and labor required for a
  job order, or for each production operation
  required to complete the job order.
•  
• Since a process-type manufacturing firm such as
  an oil refinery outputs the same product (or a
  few products) over a long time period, cost
  standards are more readily determined for process
  firms than for job-shop firms where the variety
  of output is large and varies with customer
  order.
•  

84
Standard Costs

• Thus, a standard amount of material can be
  determined for each unit, and standard labor
  times and machine times can be determined for
  each unit.
•  
• It is usually the responsibility of the work
  measurement function within the firm to determine
  these standard quantities. Then, by applying
  standard unit material costs and standard labor
  rates, standard unit costs for material, labor,
  and overhead can be determined.
• The standard costs then serve as a basis for
  measuring production efficiency and performance
  over time.
•  
• Deviations from standard costs may be caused by
  several factors, especially (1) raw material
  price variations and (2) actual quantities of
  material and labor used versus the standard
  amounts of these items. This latter factor is the
  one of primary concern in determining production
  efficiency and performance, measures of which
  provide information to management to aid in cost
  control.

85
ECONOMIC VALUE ADDED

• Economic value added focuses management's
  attention on an important objective adding value
  for the share- holders.
•  
• What are the uses of EVA?
• EVA is used to facilitate decisions regarding
  major capital investment, as well as acquisitions
  and divestitures.
•  
• It has also been used to analyze products and
  operating units to determine the economic dogs
  and cash cows within the firm's portfolio of
  products and businesses.
•  
• EVA is a management tool that examines the
  difference between the net operating profit after
  taxes and the cost of capital, which includes the
  cost of both debt and equity capital.
•  
• Thus, the interest charges and bond rates that
  contribute to the cost of debt capital are
  combined with the cost to the shareholders of
  providing the firm with equity capital (by
  purchasing its stock) 24.

86
ECONOMIC VALUE ADDED

• Many firms that adopted EVA found that few of
  their managers knew how much capital was tied up
  in their business units.
•  
• Moreover, the managers did not have the foggiest
  notion about the true cost of capital.
•  
• EVA seeks to remedy this by focusing attention on
  adding value for the shareholder through more
  effective use of capital. The result of an
  increased emphasis on effective use of capital
  will result in lower inventories, fewer
  warehouses, etc. 24.
• Stern Stewart argues that there are four ways to
  create value for the shareholder
• Increase profitability without using additional
  capital, e.g., increase profit margins and
  increase sales without using additional capital.
•  Invest in projects that earn more than the cost
  of capital.
•  Free-up capital that earns less than the cost of
  capital.
•  Use debt to reduce the cost of capital 211.

87
ECONOMIC VALUE ADDED

• Real estate, equipment, facilities, working
  capital, and inventories are examples of capital
  being used within the firm.
•  
• Other, not so obvious examples of capital are
  investments in training and in research and
  development.
•  
• The investments in training result in increased
  value of the firm's human capital. While it is
  not easy to quantify the value of capital in RD
  and in training, they should not be completely
  overlooked in the quest for value.

88
Example

• Example 8.7
•  
• Two firms (A and B) are being considered for
  acquisition. The assets of the firms are 100
  million and 200 million, respectively.
•  
• Both are debt free hence, the equity equals the
  assets.
•  
• The annual operating profits for the firms are
  40 million and 70 million, respectively.
•  
• Taxes equal 40 of operating profit.
  Consequently, the annual net incomes for the
  firms are 24 million and 42 million,
  respectively.
•  
• Dividing the net income by equity yields return
  on equity of 24 and 21, respectively.
•  
• The cost of capital is 12.

89
Example

• Which firm is best from a shareholder value point
  of view?
•  
• Some would choose A because it has the greatest
  ROE (return on equity) or ROA (return on assets).
  
•  
• However, B maximizes value for shareholders.
•  
• To determine the EVA, subtract the cost of
  capital from net operating profit after taxes.
•  
• For A, this yields 24 million - 0.12(100
  million) 12 million.
•  
• For B, the EVA equals 42 million - 0.12(200
  million) 18 million.
•  
• (As was the case with the IRR method, one cannot
  choose the alternative that has the greatest
  return on equity instead, incremental net
  operating profits should be compared with the
  cost of capital.)

90
Example

• Example 8.8
• Consider two firms, C and D, each with a 12 cost
  of capital.
•  
• The financial data for the two firms (in M's)
  are
• On the basis of net income generated, one might
  conclude that D is the better performing company.
  
•  
• However, for C there is a capital cost of 12 and
  an EVA of 3 whereas, for D there is a capital
  cost of 24 and an EVA of -3.
•  
• Therefore, firm C is superior to firm D in adding
  value for the shareholder.
•  
• There are several ways to compute EVA.

91
Example

• Example 8.9
• The method used in the previous examples was

92
ECONOMIC VALUE ADDED

• Analysis of Financial Statements
•  
• The financial position of a firm is important to
  understand because it determines to a large
  extent the availability of capital and the
  desirability of future investment in new plants
  and equipment.
•  
• Basic Financial Statements
•  
• The two basic financial statements of a firm are
  the balance sheet and the income statement or the
  statement of profit and loss. The balance sheet
  is a statement of the financial position of a
  firm as of a specific point in time. The basic
  balance sheet equation is
•  
• Assets Liabilities Net Worth.

93
ECONOMIC VALUE ADDED

• The assets are generally listed on the left side
  of a balance sheet.
• Assets are listed in decreasing order of
  liquidity, where liquidity refers to an
  assets capability for being converted to
  cash.
• For example, cash the most liquid asset is
  generally listed at the top of the assets
  column on a balance sheet. Other assets in
  order of decreasing liquidity would be
  marketable securities, accounts receivable
  and inventories.
• These assets are listed under current
  assets in Figure 1 because they are
  convertible to cash in less than one year.
  Other assets include investments not
  convertible to cash within one year, plant
  and equipment, prepaid expenses and deferred
  charges.
• Prepaid expenses might include prepaid
  insured premiums whereas deferred charges
  refer to expenses to be recovered over an
  extended business period. An example of a
  deferred charge might be the cost to set
  up the organization which might be
  recovered over the life of the firm.

94
ECONOMIC VALUE ADDED

• The claims on the assets of a firm
  include the liabilities and the net worth.
  
•  
• Liabilities are claims of creditors and
  have precedence on rights to the assets
  before the owners.
•  
• Net worth refers to the portion of the
  assets of a firm, which are paid for by
  the owners.
•  
• Liabilities are separated into current and
  other liabilities.
•  
• Current liabilities are those debts which
  are payable within one year.
•  
• Examples of current liabilities include
  accounts and notes payable within one year
  and taxes and other expenses which have
  accured and are payable within one year

95
ECONOMIC VALUE ADDED

• Net Working capital is defined as the
  current assets minus current liabilities.
•  
• The Owner's Equity or Net Worth is
  generally made up of preferred and common
  stock, capital surplus and retained
  earnings.
•  
• Capital surplus is the amount of money
  received from the sale of stock in excess
  of the face value of the stock.
•  
• Retained earnings are the accumulated net
  operating income after taxes less the
  dividends paid to stockholders.

96
ECONOMIC VALUE ADDED

• Manhan Manufacturing Company Balance Sheet
  as of