COST ACCOUNTING COST MANAGEMENT BASICS 1. Agenda Accounting Overview Financial Accounting Budgetary...

COST ACCOUNTINGCOST MANAGEMENT BASICS

1

Agenda

• Accounting Overview• Financial Accounting• Budgetary Accounting• Management Accounting• Output Costs• Transfer Pricing

2

Accounting Overview

3

“is the production of financial records about an organization. Accountancy generally produces financial statements that show in money terms the economic resources under the control of management; selecting information that is relevant and representing it faithfully. The principles of accountancy are applied to accounting, bookkeeping, and auditing.”

Source Wikipedia

Definition of Accounting

4

Accounting Domains

Financial Accounting – focuses on reporting to external users (e.g. investors, creditors, and governmental agencies) to communicate a financial position

Budgetary Accounting - the process of implementing a budget and the consumption of the budget utilizing special subset of accounts. An additional accounting requirement for State or Federal Government funded entities

Cost Accounting – records, measures, analyzes and reports financial and non-financial information to managers to aide in making decisions to meet objectives. Commonly referred to as managerial accounting

5

Financial Accounting

• Concerned with preparation of financial statements for external users (e.g. investors, creditors, and governmental agencies) to communicate a financial position

• Primary users are external looking to judge the health of the entity and for comparison with other entities

• Not intended for day-to-day running of the company/organization since historical in nature (monthly, quarterly, annual reports)

• Govern by local and international accounting standards; e.g. Financial Accounting Standards Board (FASB)

• Follows Generally Accepted Accounting Principles (GAAP)• Certification/Professionals are CPAs• Has limited influence on employee behavior outside of

employee stock holding

6

Budgetary Accounting

7

• Concerned with preparation of budgetary statements for external users (e.g. governmental agencies) to communicate a budget position

• Primary users are external looking to judge the compliance of a government entity to funded Budgets

• Not intended for day-to-day running of the company/organization since historical in nature (monthly, quarterly, annual reports)

• Govern by oversight entities; e.g. Government Accounting Standards Board (GASB),

• Typically follows Generally Accepted Accounting Principles (GAAP) with some differences

• Certification/Professionals are CGFMs• Has limited influence on employee behavior (influences

when to consume budget)

Cost/Managerial Accounting

8

• Concerned with preparation of statements for internal users (e.g. Product Line or Customer Managers) to communicate a Profit/Loss position

• Primary users are internal management looking to benchmark the management of inputs with corresponding outputs

• Intended for day-to-day running of the company/organization since predictive in nature (daily, monthly, quarterly, annual, forecasts, simulations)

• Not governed to a specific rule or formatting; focus is information to make appropriate decisions

• Typically follows Generally Accepted Accounting Principles (GAAP) with some differences

• Certification/Professionals are any focusing on efficiency/effectiveness or performance improvements (e.g. CMAs, Internal Auditors, PMPs)

• Designed to influence employee behavior (change process to decrease costs, spend $ to increase market-share, etc.)

Summary of Accounting Domains



Managerial Accounting

Purpose Communicate financial position to outsiders

Communicate Budget position to outsiders

Decision making

Primary Users

External users External users Internal managers

Regulating Bodies

SEC, IRS, FASB, IASB OMB, GASB, GAO IMA/IFAC

Focus/ Emphasis

Past-oriented Past-oriented Future-oriented

Rules GAAP compliant; CPA audited

Modified GAAPDo not have to follow

GAAP; cost vs. benefit

Time Span Historical monthly, quarterly reports

Historical monthly, quarterly reports

Ultra current to very long time horizons

Behavioral Impacts

Indirect effects on employee behavior

Indirect effects on employee behavior

Designed to influence employee behavior

4


10

Accounting Methods

• Cash Basis: Record when Pay

• Accrual Basis: Record when receive the Benefit

Plan Order Receive Pay


11

The Accrual Basis of Accounting

• Focuses on exchange of Economic Resources• Records Revenues in the period in which they

are EARNED– Providing a service– Selling a product

PlanTake

Orders

Complete Service or

Ship Product

Collect Cash

Revenue & Non-Cash Asset12

Revenue Comparison

• Cash Basis:

• Accrual Basis:

PlanTake

Orders

Complete Service or

Ship Product

CollectCash

PlanTake

Orders

Complete Service or

Ship Product

CollectCash

Revenue & Non-Cash Asset13

The Accrual Basis of Accounting

• “Matches” Revenues with Expenses • It takes money to make money

• Records Expenses in period INCURRED• Resources Consumed


Asset & Liability Remove Liability Expense

14

What is the Accounting Cycle?

The Accounting Cycle is the systematic process by which accounting information is recorded, compiled, and reported to users.

15

The Financial Accounting Cycle

Record Transactions

Post to Ledger

Prepare Trial

Balance

Adjust AccountsAdjusted

Trial Balance

Prepare Statements

Close Accounts

Post-Closing Trial Balance

16

The Journal

• Accounting events are recorded in the JOURNAL– The Journal is a chronological record of all

transactions• Each transaction requires a journal entry• Each journal entry consists of at least one Debit and

one Credit: “Double Entry” Accounting• Debit amounts must equal Credit amounts• Debit: an entry on the left-hand side of the account• Credit: an entry on the right-hand side of the account

17

Debits and Credits

• Debits and credits are neutral– Debit ≠ decrease – Credit ≠ increase– It depends on the type of account

• Some accounts types record increases with a debit, some record increases with a credit

• The side of the account which records an increase is the account’s NORMAL BALANCE

18

Anatomy of a Journal Entry

19

Amount Debited & CreditedExplanation of

Transaction

2 Basic Types of Adjustments

• Prepayments: Cash is paid before the resource is consumed– When cash is paid in advance, an asset is created– At the end of the period, some of the asset may have

been consumed expense

ConsumePay

Record Asset Reduce Asset, Record Expense

20

2 Basic Types of Adjustments

• Accruals: Resources have been consumed but no cash has been paid– Results in a liability

Consume Pay

Expense & Liability Remove Liability

21

Equipment and Depreciation

• Depreciation is the accounting process of assigning a portion of equipment’s cost to the periods in which it is used

• A portion of the benefit of owning the equipment has been received in the current period expense

• The future benefit is reduced• There is Financial depreciation which tends to

be straight-line (Tank life is expected to be 10 years) and Cost Depreciation which tends to be usage-based (Tank life is 100000 kilometers)

22


23


• Provides a control mechanism to prevent overspending funds

• Does proper budgetary accounting prevent deficits? Why or why not?• It DOES prevent overspending• It does NOT prevent revenue shortfalls• It does NOT prevent over-appropriating by the

legislative body

24

Current Army Focus

• Focused on the “Budget” domain• The “Budget” domain consists of creation of the budget

requests/submissions, determination of the year of execution budget (e.g. availability control and informal budgets), actual execution, and reporting of the status of execution against the budget (e.g. the PPB&E process)

• Primary focus of budget execution is the Obligation (consumption of the budget)

• Budget Accounting focuses on 4 series accounts – status of Budget and consumption

• Budget Management focuses on the status of available funds, which includes both current and prior years funds

25

Budget Terms

• Budget = What Can Be Spent• Commitment = a thought to procure a product/service• Obligation = a promise to procure a product/ service

(e.g. to spend)• Budget Obligations• Budget – Obligations = Availability (e.g. what is left to

spend)• Expenditure is the receipt of the product/service

which was obligated (e.g. what was spent)• Expenditures or collection of expenses/expenditures

determines Costs • Disbursement is the outlay of cash

26

Budgetary Comparison

• Cash Basis:

• Accrual Basis:

• Budgetary Basis:



Commitment Obligation Expenditure Disbursement


27

The Budgetary Accounting Cycle

Obtain Budget Revenue

Distribute to

Allotment

CommitFunds

Obligate FundsExpense

Funds

Disburse Cash

Manage Availability

Close Budget Year

28

The Budgetary Accounts

• Exist solely for the purpose of recording and tracking the budget– Budget = a legally binding spending plan

• Account Titles:– Estimated Revenue = Expected Income– Appropriations = Authorized Spending– Budgetary Fund Balance = Planned Change– Unreserved Fund Balance = Savings

29

Procurement Process

ExpenditureObligationCommitment Liability Payment

30

Budgeting Participation

Encourage bottom-up flow of

information

Encourage bottom-up flow of

information

Encourage top-down flow of information

and plans

Encourage top-down flow of information

and plans

Budgets

attempt to

Budgets

attempt to

31

IMCOM

Jackson Benning Knox

Budget - Color of Money

$

$ BOS$

$

Appropriations Program Elements Fund Centers

ElementsOf Resources

Supplies Training Travel Equipment Labor Etc.

OMA

AFH

SRM$

GFEBS$

RDT&E

32

Cost Vs.Budget

Knowing your obligations is not the same as knowing your costs!

ObligationsA legally binding commitment by the federal government that will result in outlays, immediately or in the future. Budgetary resources must be available before obligations can be incurred legally.

The price or cash value of resources used (expenditures) to produce a program, project or activity. All relevant costs may not appear in the organization’s budget.

Costs

Costs

Obligations

Cost ObligationFull cost can exceed

individual business unit

budget allocations

Cost will contain expenses from different years, source of funds, organizations, etc.

33

Budget Formulation Budget Execution Cost Management

Budget–President’s financial plan

and the priorities for the Federal Government

Cost–Valuation of resources

used to produce outputs, basis for decision making

Budget Authority–Authority to incur

obligations

Focus–requirements

Key Data Elements–appropriation, FTE

Focus–availability, obligations

Key Data Elements–appropriations, EOR’s,

PE, MDEP, projects, BLIN, etc.

Key Data Elements–operational entity (e.g.

cost centers), services, rates, products, projects, etc.

Focus– full costs, Plan vs. Actual

Questions–What do I need?–What will I ask for?

Questions–What funding did I get?–What obligations were

executed?

Questions–What was expensed? –What did I get for it?–How well was it used?

Budget vs Cost Domains

34

Managerial Accounting

35

Three Common Features of Cost Accounting

1. Calculates the cost of products, services, and other cost objects

2. Tracks information for planning & control, and performance evaluation

3. Analyzes relevant information for decision making

36

An Easy Definition of Cost…. “a cost is the value of money that has been used up to produce something”

# Clean Dishes

37

Basic Cost Terms

• Cost: a sacrifice of resources• Cost Object: any item or activity for which a separate

measurement of cost is desired – cost objects are the “something” in a statement

• Cost Driver: any factor whose change ‘causes’ a change in the total cost of a related cost object – cost drivers can be factors other than volume

38

The Many Types of ‘Cost’

• Direct Cost: a cost such as labor, material/supplies that can be directly traced to producing a specific output of organization, product, or service

• Indirect Cost: a cost that cannot be directly traced to a specific organization, product or service output

• Funded Cost: the value of goods or services received because of an obligation of funds (obligation authority), by an organization performing the work

• Unfunded Cost: a cost that is financed by another organization’s or activity’s appropriations

• Variable Cost: a cost that changes with change in the output• Fixed Cost: a cost that remains the same regardless of the

change in output• Recurring Cost: a cost that is incurred repeatedly for each

organization and/or product and service produced• Non-recurring Cost: a cost that is unusual and unlikely to occur

again• Avoidable Cost: a cost incurred on an object that will no longer

be incurred due to a decision to change the output• Unavoidable Cost: a cost incurred on an object that will be

incurred regardless of the decision to change

• Common understanding of different types of costs is necessary for informed decision making

• Each decision should be focused on ONLY relevant cost that impact the decision

39

Costs may be:• Direct or indirect• Recurring or nonrecurring• Burdened or unburdened• Variable or fixed

Some Characteristics of Costs

40

Direct Cost• Can be easily and conveniently traced to a specific cost

element/objective– Example: The cost of ammunition fired in a training event at the firing

range

Indirect Cost• Cannot be easily and conveniently traced to a specific cost

element/objective– Example: Installation support to the firing range (utilities, upkeep, etc)

Direct vs. Indirect

41

Recurring vs. Non-recurring

Recurring Cost• Cost that is incurred regularly in producing a product or providing a service

– Examples: Civilian and military personnel who conduct the activity, recurring sustainment of facilities, supplies, personnel training, utilities, equipment maintenance, janitorial service, office supplies

Non-Recurring Cost• Cost that only occur once or infrequently.

– Examples: Major items of equipment, major and minor construction, one-time training in new procedures, activities conducted in direct support of individual process improvement efforts

42

Burdened vs. Unburdened

Unburdened Cost• Cost of a product/service that does not consider other related costs necessary

to provide that product/service.– Examples: Direct compensation, cost of a gallon of fuel in a theater of

operations, etc.

Burdened Cost• Cost of a product/service plus an apportioned cost of other related costs

necessary to provide that product/service.– Examples: Salary plus the cost of benefits (health, retirement, etc.),

facilities support cost allocated to an activity or personnel– There are degrees of burden in a CBA. For example:

• Direct compensation for military and civilian personnel is always burdened with the cost of personnel benefits

• Facilities support cost is allocated to a COA only if it can demonstrated that the COA causes the cost to be incurred

43

Variable vs. Fixed

Variable Cost• A cost that varies based on the level of activity or output. This can be either a linear

relationship or a step function.– Examples: Fuel cost for vehicles varies in a linear fashion relative to the number of

miles driven. The number of instructors needed to teach a class can vary in a step function based on the number of students (e.g., 1 instructor for 25 students, 2 instructors for 26-50 students, etc).

Fixed Cost• A cost that does not vary based on the level of activity or output.

– Example: At an Army installation, the cost associated with the commander and his/her immediate staff is unlikely to vary as the installation population or other variables change.

100 200 300 4000

20

40

60

80

100

Fuel Cost as a Func-tion of Miles Traveled

5 11 17 23 29 35 41 47 530

1

2

3

4

5

Instructors as a Func-tion of Class Size

Variable Semi-Variable

5,000 10,000

15,000

20,000

0200400600800

1000

Cost of Cmd Gp ($K) as a Function of Instal-

lation Population

Fixed Cost

Note: Most costs are semi-variable

44

Example: Paul is assembling his new home theatre system. He has spend 5 hours thus far and estimates he will complete the assembly in 2 more hours. Joan informs him he is doing it the hard way and describes a simpler approach which will take one hour to undo his work and re-assemble the system completely

Example: Paul is assembling his new home theatre system. He has spend 5 hours thus far and estimates he will complete the assembly in 2 more hours. Joan informs him he is doing it the hard way and describes a simpler approach which will take one hour to undo his work and re-assemble the system completely

Sunk Costs

Costs that have already been incurred and cannot be changed no matter what action is taken in the future are called Sunk Costs

45

Opportunity Costs

• The size of a foregone opportunity of using a resource is the Opportunity Cost

Example

• The opportunity cost of accepting a job is forgoing the opportunity to do something else with our time

• If our best alternative to working is playing golf the opportunity cost of working is the forgone opportunity of playing golf

46

Marginal Costs

• Marginal Costs are the costs to produce one more additional unit of output

• Marginal costs are highest at very low output rates and at output rates near capacity

• The slope of the ‘Total Cost Curve’ at any given level of production is the marginal cost for one more unit

47

Marginal Costs

Output

Cost Total cost

High marginal costs

A

CHigh marginal costs

BLowest marginal costs

48

Average Costs

Average Cost is very high at low levels of output

Average Cost is very high at low levels of output

Average Cost is calculated by dividing the total cost by the total

units produced

Average Cost is calculated by dividing the total cost by the total

units produced

49

Cost Behavior

• Variable costs: changes in total in proportion to changes in the related level of activity or volume– Variable costs are constant on a per-unit basis– If a product takes 5 pounds of materials each, it stays the same per unit

regardless of number of units produced

• Fixed costs: remain unchanged in total regardless of changes in the related level of activity or volume– Fixed costs change inversely with the level of production – As more units are produced, the same fixed cost is spread over more units,

reducing the cost per unit

• Costs are fixed or variable only with respect to a specific activity or a given time period

50

Cost Behavior Summarized

Total Dollars Cost per Unit

Variable Costs

Change in proportion with

outputMore output = More cost

Fixed CostsUnchanged in

relation to output

Change inversely with output

More output = lower cost per unit

Total Dollars Cost Per Unit

Variable Costs

Change in proportion with output

More output = More cost

Unchanged in relation to output

Fixed CostsUnchanged in

relation to output

Change inversely with output

More output = lower cost per unit

51

Cost in More Detail

“Cost” is a monetary measure of the sacrifice associated with:• expending resource functionality to achieve a specific objective, or• utilizing resource output required to achieve a specific objective, or• the provision of resource functionality or resource output while not

using it

Resources ResourcesConsumed

52

Cost = Converting and Measurement of Work

Cost Center

Asset / Equipment

Project / Program

Internal Order

WBS / Work Order

Organization - Labor, Materials, Supplies

Res

ourc

es/I

nput

sO

utpu

ts

Plant, Property & Equipment

Building Project, Weapon System

Services, Events (SSP, Course)

Job (Set of Tasks) – Maint & Repair

53

Problems in Identifying and Measuring Costs

Planning DecisionsPlanning Decisions

What is the cost of a dissatisfied customer? What is the cost of a

dissatisfied customer?

How do I measure the cost of setting my

price too high?

How do I measure the cost of setting my

price too high?

How do I measure the cost of poor quality?

How do I measure the cost of poor quality?

What is the cost of postponing this year’s

training program?

What is the cost of postponing this year’s

training program? What is the cost of using current

facilities?

What is the cost of using current

facilities?

What is the cost of requiring employees to

work overtime?

What is the cost of requiring employees to

work overtime?

What is the cost of using raw materials in

inventory?

What is the cost of using raw materials in

inventory?

54

Costing Philosophies

55

Costing Philosophies

When determining how to develop the cost model to be utilized to generate the Cost Accounting data there are multiple Costing Philosophies to be considered:

• Standard Costing• Traditional Costing• Activity-based Costing• Grenzplankostenrechnung (GPK)• Resource Consumption Accounting (RCA)

56

Standard Costing

• Traces direct costs to output by multiplying the standard prices or rate by the standard quantities of inputs allowed for actual outputs produced

• Allocates overhead costs on the basis of the standard overhead-cost rates time the standard quantities of the allocation bases allowed for the actual outputs produced

• Replaced by Traditional Costing once actual data collection was automated

57

Activities Based Costing

• “ABC as an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attach activity costs to outputs1”

• ABC seeks to improve the tracing of indirect costs to products/customer by recognizing the different levels of activities that lead to indirect product/customer costs

• ABC is useful to provide visibility into support activities required to address complexities in products or customers

• Typically Full-absorption (all costs associated to the product) which caused inappropriate product/customer decisions

58 1 Source Wikipedia

Cost Allocation & Assignments

59

Accounting for Overhead

• Actual costs will almost never equal budgeted/planned costs

• Accordingly, an imbalance situation exists between the two overhead accounts– If Overhead Control > Overhead Allocated, this is

called Under-allocated Overhead– If Overhead Control < Overhead Allocated, this is

called Over-allocated Overhead

60

Accounting for Overhead

• This difference will be eliminated in the end-of-period adjusting entry process, using one of three possible methods

• The choice of method should be based on such issues as materiality, consistency and industry practice

61

Cost Allocation

• Assigning indirect costs to cost objects• These costs are not traced• Indirect costs often comprise a large percentage

of Total Overall Costs

62

Purposes of Cost Allocation

63

Criteria for Cost-Allocation Decisions

• Cause and Effect: variables are identified that cause resources to be consumed– Most credible to operating managers– Integral part of ABC

• Benefits Received: the beneficiaries of the outputs of the cost object are charged with costs in proportion to the benefits received

64

Criteria for Cost-Allocation Decisions

• Fairness (Equity): the basis for establishing a price satisfactory to the government and its suppliers– Cost allocation here is viewed as a “reasonable” or “fair”

means of establishing selling price

• Ability to Bear: costs are allocated in proportion to the cost object’s ability to bear them– Generally, larger or more profitable objects receive

proportionally more of the allocated costs

65

Cost Allocation Illustrated

66

GFEBS Manual Cost Allocation

67

Allocating Costs of a Supporting Department to Operating Departments

• Supporting (Service) Department: provides the services that assist other internal departments in the company

• Operating (Production) Department: directly adds value to a product or service

68

Methods to Allocate Support Department Costs

• Single-rate method: allocates costs in each cost pool (service department) to cost objects (production departments) using the same rate per unit of a single allocation base– No distinction is made between fixed and variable

costs in this method

69

Methods to Allocate Support Department Costs

• Dual-Rate method: segregates costs within each cost pool into two segments: a variable-cost pool and a fixed-cost pool

• Each pool uses a different cost-allocation base

70

Allocation Method Tradeoffs

• Single-Rate method is simple to implement, but treats fixed costs in a manner similar to variable costs

• Dual-Rate method treats fixed and variable costs more realistically, but is more complex to implement

71

Allocation Bases

• Under either method, allocation of support costs can be based on one of the three following scenarios:

1. Budgeted overhead rate and budgeted hours2. Budgeted overhead rate and actual hours3. Actual overhead rate and actual hours

• Choosing between actual and budgeted rates: budgeted is known at the beginning of the period, while actual will not be known with certainty until the end of the period

72

Allocating Common Costs

• Common Cost: the cost of operating a facility, activity, or cost object that is shared by two or more users at a lower cost than the individual cost of the activity to each user

73

Title IX

• Unequal aggregate expenditures for members of each sex or unequal expenditures for male and female teams if a recipient operates or sponsors separate teams will not constitute noncompliance with this section, but the Assistant Secretary [of Education for Civil Rights] may consider the failure to provide necessary funds for teams for one sex in assessing equality of opportunity for members of each sex.

3 Prong Test:• Providing athletic participation opportunities that are substantially proportionate to

the student enrollment. This prong of the test is satisfied when participation opportunities for men and women are "substantially proportionate" to their respective undergraduate enrollment.

• Demonstrating a continual expansion of athletic opportunities for the underrepresented sex. This prong of the test is satisfied when an institution has a history and continuing practice of program expansion that is responsive to the developing interests and abilities of the underrepresented sex (typically female).

• Accommodating the interest and ability of underrepresented sex. This prong of the test is satisfied when an institution is meeting the interests and abilities of its female students even where there are disproportionately fewer females than males participating in sports.

74

Output Costs

75

Capture Output CostsOverview

In addition to capturing cost, non-financial quantity information is necessary to support Cost Management

Non-financial quantity information can be:Quantitative, e.g. # of helpdesk tickets, # studentsQualitative, e.g. average # days to close helpdesk ticket, % Completion Rate

76

Capture Output Costs Decisions

Does the output quantity support the cost by BCT/ARFORGEN? HQ Need? or Field product/services?

(e.g. ammo used for training, # soldiers)Is the output quantity currently used by scheduling/operational managers on a timely basis?Can an output change the behavior of an organization/individual to be more efficient and effective (e.g. # cancelled course registrations in ATAARS)Are output quantities used for justifications and/or requests for funding?If it supports cost management – efficiently & effectively - then it is considered

77

Capturing Output CostsAnalysis

Understanding the dollar amount of unit provided, based on number delivered Cost/Per

Understanding the relationship between Resource Capacity to Output generation (e.g. 3 Hrs: 1 Output)

0%

20%

40%

60%

80%

100%

Month 1 Month 2 Month 3 Month 4 Month 5 Month N

Capacity

Actual Output

78

Capturing Output CostsAnalysis

Cost of Closing Tickets

Num

ber

of T

icke

ts

• Visibility across the Army as to what tasks should costs

– Supports comparative analysis between sites, tasks, types of work, and groups of resources to identify best practice vs. inefficiencies

– Allows for realization of trade-offs between delivery and resource consumption

79

2ABM0014: LEGAL (ILO)

Name Cost Element

Amount Quantity

Perm 6100.11B1 $5,000 100 hrs

Capture Output Costs Analysis

Training Event (UIC)10 roundsat $50

Qty is valuated with rate

2ABM0065: AMMO SUPPLY

Name Cost Element Amount Quantity

Ammo 9400.AMMO 10 EA

Name Cost Element

Amount

Quantity

Ammo 9400.AMMO $500 10 EA

AMMO FIRED

WARS

AMOUNT AND QUANTITY ARE THE OUTPUTS OF THIS PROCESS

80

Agency Problems

81

Various Types of Agency Problems

• Moral Hazard– Tendency to take risks because the costs that could incur will not

be felt by the party taking the risk. In other words, a tendency to be more willing to take a risk, knowing that the potential costs or burdens of taking such risk will be borne, in whole or in part, by others.

• Free rider– Benefiting from resources, goods, or services without paying for

the cost of the benefit.

• Adverse Selection– The buyer of a good (or the seller) attracts potential sellers (or

borrowers) that offer low quality goods (have a high probability of default). The quality of the goods is not readily observable.

Output Manipulation

• Managers may seek to manipulate income by producing too many units

• Production beyond demand will increase the amount of inventory on hand

• This will result in more fixed costs being capitalized as inventory

• This will leave a smaller amount of fixed costs to be expensed during the period

• Profit increases, and potentially so does a manger’s bonus

83

Countermeasures for Output Manipulation

• Careful budgeting and inventory planning• Incorporate an internal carrying charge for

inventory• Change (lengthen) the period used to evaluate

performance• Include non-financial as well as financial

variables in the measures to evaluate performance

84

Transfer Pricing

85

Transfer Pricing

• The amount charged when one division sells goods or services to another division

• The transfer price affects the profit measure for the selling division and the buying division

86

The External and Internal Transfer of Products

ExternalSupplier

Division A

Division B

ExternalCustomer

Intermediate

Product

Finished Product

Raw Materials

87

Reasons for Transfer Pricing

1. Control (incentives and performance measures)

2. Decentralized planning decisions3. International/tax reasons

88

Summary of Transfer Pricing Methods

Method Advantages Disadvantages

Market-Based •Approximates opportunity cost if competitive market exists •Excludes effects of internal transaction costs on transfer price

•May not have external market for intermediate goods•Excludes effects of internal transaction costs of transfer price

Variable Cost •Approximates opportunity cost if fixed costs are sunk

•Does not allow selling division to recover fixed costs•Provides incentive for selling division to convert fixed costs to variable costs

Full Cost •Reduces disputes as the figure is objective •Simple to compute as it parallels accounting system figures•Approximates opportunity cost if division is operating at capacity

•Overstates opportunity cost if excess capacity exists

Negotiated •Maintains managerial autonomy •Preserves upper-management time

•Is time consuming and relies on negotiation skills of divisional managers •May not be the optimal transfer price for the firm as a whole •Can lead to conflicts between responsibility centers

89

Control Issues

Transfer prices can be used as inputs to the performance measurement system

Transfer prices can be used as inputs to the performance measurement system

Transfer pricing assigns costs to managers who are responsible for the costs

Transfer pricing assigns costs to managers who are responsible for the costs

90

Transfer Pricing

Parts Division £ Assembly Division £

Revenue per unit 12 Revenue per unit 23

Parts cost per unit 10 Parts cost per unit 12

Profit per unit 2 Assembly costs 4

Profit per unit 7

The ‘Parts’ division manufactures parts that it sells to the ‘Assembly’ division

The ‘Parts’ division manufactures parts that it sells to the ‘Assembly’ division

The cost to the ‘Parts’ division is £10 per unit.

The ‘Assembly division’ assembles the part at a cost of £4 per unit and sells the product to another organization for £23 per unit.

What is the profit per unit if the transfer price is £12 each

The cost to the ‘Parts’ division is £10 per unit.

The ‘Assembly division’ assembles the part at a cost of £4 per unit and sells the product to another organization for £23 per unit.

What is the profit per unit if the transfer price is £12 each

What is the profit per unit if the transfer price is £10 eachWhat is the profit per unit if the transfer price is £10 each

Parts Division £ Assembly Division £

Revenue per unit 10 Revenue per unit 23

Parts cost per unit 10 Parts cost per unit 10

Profit per unit 0 Assembly costs 4

Profit per unit 9

91

Transfer Pricing for Decentralized Planning Purposes

• Some divisions are required to buy internally produced items

• The internal producer may not have an incentive to keep costs down

• When managers have the choice to buy “outside,” the internal producer must stay competitive on both quality and cost

• Some divisions are required to buy internally produced items

• The internal producer may not have an incentive to keep costs down

• When managers have the choice to buy “outside,” the internal producer must stay competitive on both quality and cost

92

Transfer Prices for Decentralized Planning Decisions

Circumstance Transfer Price

Market price exists Market price

No market price exists; supplying division has no alternative use of capacity

Variable cost

No market price exists; supplying division has alternative use of capacity

Full Cost*

*The full cost is intended to be a rough approximation of the forgone opportunity of using the facilities of the supplying division to do something else

93

Choosing Transfer Prices

A transfer price that maximizes firm value (a planning issue) may not maximize a manager’s

performance measure (a control issue)

A transfer price that maximizes firm value (a planning issue) may not maximize a manager’s

performance measure (a control issue)

Negotiated transfer prices are more effective when there is an external market alternative

Negotiated transfer prices are more effective when there is an external market alternative

94

Globalization and Transfer Pricing

Tax Minimization: if a multi-national transfers products between two countries with different tax rates the company will try to set a transfer price to minimize its total tax liability in the two countries

Tax Minimization: if a multi-national transfers products between two countries with different tax rates the company will try to set a transfer price to minimize its total tax liability in the two countries

Political Considerations can affect the transfer-pricing decision, if there is a risk of

expropriation of assets the company may use high transfer prices to reduce the apparent

profitability of their foreign subsidiaries

Political Considerations can affect the transfer-pricing decision, if there is a risk of

expropriation of assets the company may use high transfer prices to reduce the apparent

profitability of their foreign subsidiaries

95

Conclusion

96

COST ACCOUNTING COST MANAGEMENT BASICS 1. Agenda Accounting Overview Financial Accounting Budgetary...

Documents

Transcript of COST ACCOUNTING COST MANAGEMENT BASICS 1. Agenda Accounting Overview Financial Accounting Budgetary...