Cost Behavior Related to Time Resource and Activity


Accounting management deal with the requirements to assess and estimate fixed costs and variable costs. A fixed cost is a cost that remains the same in total as activity usage increases or decreases while a variable cost is a cost that changes in direct proportion to changes in activity output. In economics, it is usually assumed that fixed costs and variable costs are known however in practical assesment requires consideration of

  • Time horizon.
  • Resource usage.
  • Activity output measurement.

Time horizon

In the long run, according to economics, all costs are variable and only at least one cost fixed in the short run. The length of the short run may differ from one cost to another cost. For practical purposes, the firm treats direct materials as variable even though the amount of direct materials already purchased is fixed. In some settings, companies have the ability to hire and lay off its labor, concerning with direct labor in short time intervals, it is fewed as a variable cost. In other cases, circumstances prohibit laying off labor for short term drops in production. In such conditions where lay offs impossible in the short run even when there have been permanent changes in the need for labors, direct labor could be treated as a fixed cost rather than a variable cost.

The same observation can be made for other forms of labor. For example, salaries of moulding production line, supervisors are difficult to adjust as the activity output fluctuates. It could take months, a year or two years to determine whether a drop in production is permanent. According to this situation, this labor cost is seen as a fixed cost rather than a variable cost.

The length of the short run or the long run period depends on management judgment and the purpose of cost is being estimated. Submitting a bid on one time for a special order which span only a month can be used to create a bid and produce the order. Other types of decisions such as product discontinuance or product mix decisions will affect a much longer period of time. In this case the costs including product design and product development, marketing development and marketing penetration that must be considered are long run variable costs.

Short run costs often do not reflect all the costs such as design, produce, market, distribute and support a product.

Resource usage

The ability or capacity to perform activities that must be acquired called Activity Capacity. How much the capacity is needed depends on the level of performance required for each activity. The efficient level of activity performance is called Practical Capacity or Practical Capacity Resources.

Resources are needed to enable activities to be performed. Resources such as capital, labor, energy and materials are simple economic inputs that are consumed in performing activities. Resource Spending is the cost of acquiring capacity to perform an activity.

Resource Usage is the amount of activity capacity used in producing the activity output. Resource usage is equivalent to activity usage. Unused Capacity is the difference between the acquired capacity and the actual activity usage. The relationship between resource spending and resource usage to be used to define variable cost and fixed cost behavior.

Resources supplied in two ways

  1. As used and needed
  2. In advance of usage

Resources supplied as used and needed

Those resources are required from outside sources where the terms of acquisition do not require any long term commitment for any given amount. The firm is free to buy only the quantity of needed or in other words the quantity of supplied equals with the quantity demanded. No unused activity capacity because resource usage equals with resource supplied. For examples materials and energy.

Resources supplied in advance of usage

Those resources acquired by the use of either an explicit or implicit contract to obtain a given quantity of resources, regardless of whether the quantity of the resource is fully used or not. Resources supplied in advance may exceed the demand for their usage. In here, unused capacity is possible. For examples equipment and supervision.

Since the cost of the resources supplied as needed equals with the cost of resources used, the total cost of the resource increases as demand for the resource increases. Generally, we treat the cost of resources supplied as needed as a variable cost. In a manufacturing with Just In Time (JIT) environment, materials are acquired and used as needed for production activities. As the units produced increase, the usage and cost of raw materials would increase proportionately because “units produced” as the activity driver. Similarly, a machining activity will use more power as more machine hours are used, thus the cost of power will increase with an increase in machine hours. Resource supply and usage are measured by an activity driver.

Many resources are acquired before the actual demands for the resource are realized. Organizations acquire many multiperiod service capacities by paying cash up in front or by entering into an explicit contract that requires periodic cash payments. Buying or leasing building and equipment as examples of advance resource acquisition. The annual expense associated with the actual usage of the resources can be defined as fixed expenses. This committed fixed expenses costs incurred provide long term activity capacity.

Organizations that acquire resources in advance through implicit contracts usually with its salaried and hourly employees. The organization will maintain employment levels even though there may be temporary downturns in the quantity of activity used. This expense associated with this category of resources is independent of the quantity used, at least in the short run. Short, the amount of resource expense remains unchanged even though the quantity used may vary in the short run. Resource spending for this category corresponds to discretionary fixed expenses because the costs incurred for the acquisition of short term activity capacity.

Suppose a company hires five receiving clerks for $150,000 to supply the capacity of processing 18000 receiving orders. The activities of receiving orders involve in bringing purchased materials into the plant, include inspecting work, unpacking, creating a receiving order to match to the invoice and moving the materials to the storeroom. Receiving orders is the driver used to measure the receiving activity’s capacity and usage. None of the five receiving clerks would expect to be laid off if only 6000 receiving orders were actually processed unless the downturn in demand is viewed as permanent.
Nowadays, many companies are turning to contingent employment to handle variation in demand for labor services. Suppose the drop is permanent or an activity has too much capacity, resource spending will not be reduced until we reduce the capacity.

The activity based resource can improve on managerial control and decision making. Operational control systems have to pay more attention to control resource usage and spending. If sufficient unused activity capacity does not exist then resource spending must increase, similarly if activity management brings excess activity capacity, managers have to consider what is to be done with the excess capacity, managers must find ways to reduce resource usage. Eliminating excess capacity could decrease resource spending and improve overall profits. Using the excess capacity to increase products produced and sold could increase revenues without increasing in resource spending.

The activity based resource usage allows managers to calculate the changes in resource supply and demand resulting from such decisions as

  • Make or buy a part

  • Accept or reject special orders
  • Keep or drop product lines.

This model increases the power of traditional management accounting decision making because most of decision making models depend on knowledge of cost behavior.

 

Activity output measurement

Describing cost behavior as variable costs and fixed costs, requires measurement of activity output however that activity output is measured by activity drivers. Therefore we must determine the underlying activities and associated drivers that measure activity capacity and usage. To understand cost activity relationship leads to determination of measurement of activity output or activity driver. For examples material handling output measured by number of moves, shipping goods output measured by units sold, laundering hospital bedding output measured by pounds of laundry. Choice of driver not only to the particular firm but also to the particular activity or cost being measured.

Activity drivers explain changes in activity costs by measuring changes in activity usage or output. There are two categories of activity drivers

  1. Unit level drivers
  2. Nonunit level drivers

Unit Level Drivers, explain changes in cost as units produced change. For examples pounds of direct materials and kilowatt hours used to run production machinery. Direct labor hours are examples of unit based activity drivers.

Nonunit Level Drivers, explain changes in costs as factors other than units change. Examples of nonunit based cost driver such as setups costs, work orders, engineering change orders, inspection hours, material moves. There are three kinds of nonunit level drivers

  • Batch level
  • Product level
  • Facility level

Batch Level Costs tends to vary as the number of batches changes, Product Level Costs tends to change as number of different products changes, Facility Level Costs tends to stay constant and can be viewed as fixed costs at least for the short run.

In a traditional management accounting system, cost behavior is assumed to be described by unit based drivers only however in a contemporary management accounting system both unit and nonunit based drivers are used.

Managerial judgment is critically important in determining cost behavior. Many managers simply use their experience and past observation of cost relationships to determine fixed and variable costs. Some managers assign particular activity costs to the fixed and variable category, they ignore the possibility of mixed costs. Management should do well to make sure that each cost is predominantly fixed or variable and that decisions being made are not sensitive to errors in classifying costs.

The advantage of using managerial judgment to separate fixed and variable costs is its simplicity. In situations in which the manager has a deep understanding of the firm and its cost patterns, this kind of method (managerial judgment) can give good results. However, if the manager does not have a good judgment, errors will occur. Therefore, it is important to consider the experience of the manager to minimize or avoid the potential for errors and the effects have on related decisions.

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Kinds of Income Statement and Closing Entries


The operations of a company determines the shape of its income statement, an income statement presented of a trading or merchandising company is different  with the income statement of a manufacturing company. There would be raw materials, work in process and finished goods with an income statement of a manufacturing company.

To find direct material available to use, add beginning inventory of direct material with purchasing direct material. Deduct direct material available to use with ending inventory of direct material to find direct material used.

Total manufacturing cost by adding direct material used with direct labor and manufacturing overhead. To find cost of goods manufactured by adding total manufacturing cost with beginning inventory of work in process and deduct with ending inventory of work in process.

Add cost of goods manufactured with beginning inventory of finished goods and deduct with ending inventory of finished goods, to find cost of goods sold. Sales deduct with cost of goods sold to find gross profit and net income before taxes result from gross profit deduct with operating expenses.

Those steps use within an income statement of a manufacturing company. The income statement of a trading or merchandising company looks more simplier because there is no raw materials and work in process. To find cost of goods sold of a trading or a merchandising company, add beginning inventory of merchandise with net purchase of merchandise and deduct with ending inventory of merchandise. Net sales deduct with cost of goods sold to find gross profit. Net income before taxes result from gross profit deduct with operating expenses.  

No matter you work with an income statement of a trading or a merchandising company nor a manufacturing company, you have to prepare the accounts for the next period’s transactions which is known as the CLOSING PROCESS.
In the closing process, all of the revenue and expense account balances are transferred to an account called INCOME SUMMARY to clear. This process is used only at the end of yearly accounting period.

On closing process, all revenues and expenses are matched in the income summary account to get the net result of this matching which represents the net income or net loss for the period. The net income or net loss then be transferred to an owners’ equity account called retained earning for a corporation and capital account for proprietorship and partnerships.

A shop with the following balances at the end of the year
Revenue of sales $560,000
Rental revenue $50,000
Interest revenue $30,000
Cost of goods sold $309,000
Selling expenses $45,000
Administrative expenses $50,000
Interest expense $15,000
Income tax expense $25,000

 Those revenue accounts would be closed with debit on
revenue of sales $560,000
rental revenue $50,000
interest revenue $30,000.
Credit with income summary $640,000 ($560,000 + $50,000 + $30,000)

Cost of goods sold account and those expense accounts should be closed with debit income summary $444,000 ($309,000 + $45,000 + $50,000 + $15,000 + $25,000) and credit on
cost of goods sold $309,000
selling expenses $45,000
administrative expenses $50,000
interest expense $15,000
income tax expense $25,000

Now, you have income summary from revenue $640,000 credit and income summary from cost of goods sold and expense $444,000 debit, as a result the income summary has a credit balance $196,000 ($640,000 credit minus $444,000 debit) which is the net income. This net income then be transferred to owners’ equity by closing the income summary account with debit on income summary $196,000 and credit $196,000 on retained earnings, if it is a corporation. Debit on income summary $196,000 and credit $196,000 on capital, if it is a proprietorship or patnership.

If the dividends $10,000 were declared and distributed during the year, the closing journal entry debit retained earning $10,000 and credit dividends $10,000

After the financial statement have been prepared and the books have been closed, it is often helpful to reverse some of the adjusting entries before recording the regular transactions of the next period. It is called REVERSING ENTRIES.
A reversing entries is made at the beginning of the next accounting period and is opposite of the related adjusting entry made in the previous period.
The purpose of reversing entries is to simplify the recording of transactions in the next accounting period. The use of reversing entries does not change the amounts reported in the financial statements for the previous period.

Expenses related to reversing entries
However there are conditions whether or not reversing entries are used, the entries are same. For example on date 24th Nov, a company pays salaries $18,000 incurred between 1st Nov till 24th Nov. The journal entry on date 24th Nov debit salaries expense $18,000 and credit cash $18,000
If salaries between 25th Nov till the end of Nov will be paid on 10th Dec, the adjusting journal entry for accrued expense on date 30th Nov debit salaries expense $4,500 (6 days / 24 days x $18,000) and credit salaries payable $4,500

Suppose the closing entries is applied on date 30th Nov, debit income summary $22,500 ($18,000 + $4,500) credit salaries expense $22,500

The entries on date 24th Nov and 30th Nov still same whether or not reversing entries are used by a company.

A company which does not use reversing entries need not to make any entry on date 1st Dec however on 10th Dec when a company pays the salaries, a company has to make journal entry debit salaries payable $4,500 and salaries expense for salaries incurred between 1st Dec till 10th Dec $7,500 (10 days / 24 days x $18,000). Credit cash $12,000 ($4,500 + $7,500)

If a company uses reversing entries, the journal entry on date 1st Dec as a reversing entry debit salaries payable $4,500 and credit salaries expense $4,500

Since a company uses reversing entries, the journal entry on 10th Dec debit salaries expense $12,000 ($4,500 + $7,500) credit cash $12,000

Prepayments related to reversing entries
The situation differs when a company buys some office supplies $25,000 on 10th Dec in cash, the journal entry whether or not using reversing entries are debit office supplies $25,000 and credit cash $25,000

On 31st Dec when office supplies on hand $10,000 the journal adjusting entry for a company without reversing entries are debit office supplies expense $15,000 ($25,000 – $10,000) and credit office supplies $15,000 to record the use of office supplies.
If a company use reversing entries, the adjusting journal debit office supplies $10,000 to record the rest of office supplies on hand, credit office supplies expense $10,000  

Suppose the closing entries is applied on date 31st Dec, whether or not using reversing entries, the jounal for closing entries debit income summary $15,000 ($25,000 – $10,000) credit office supplies expense $15,000

A company which does not use reversing entries need not to make any entry on date 1st Jan however for a company which use reversing entries has to make journal reversing entry on date 1st Jan with debit office supplies expense $10,000 and credit office supplies $10,000 to reverse adjusting journal entry which is done on 31st Dec before closing entries.

Sometimes this practice is followed for items such as supplies and parts inventories that need to be apportioned over several periods. For items that do not follow this regular pattern and that may or may not involve two or more periods are ordinarily entered in revenue accounts or expense accounts. The revenue accounts and expense accounts may not require adjusting and systematically closed to Income Summary.

As guidelines for reversing entries

  • All accrued items should be reversed.
  • All prepaid items for which the cash was debited or credited to an expense account or revenue account should be reversed.
  • Adjusting entries for depreciation and bad debts are not reversed.

You may know that some accountants avoid to use these reversing entries because the reversing entries do not have to be used.

Accrual basis of accounting
Most of companies use accrual basis to recognizing revenue when it is earned and recognizing expenses in the period incurred without regard to the time of receipt or payment of cash.

Cash basis of accounting
Some small enterprises and individual taxpayer use Modified Cash Basis Approach. Under cash basis, revenue is recorded when the cash is received and expenses are recorded when the cash is paid. The determination of income on cash basis rests upon the collection of revenue and the payment of expenses. Revenue recognition and the matching principle are ignored in cash basis. As a result, cash basis financial statement are not in conformity with General Accepted Accounting Principles (GAAP).

Today’s economy is lubricated by credit than by cash, accrual basis recognizes all aspects of the credit phenomenon. Investors, creditors and others seek timely information about enterprise’s future cash flows. Accrual basis provides this information by reporting cash inflows and outflows associated with earnings activities as soon as the cash flows can be estimated with an acceptable degree of certainty. Accrual basis aids in predicting future cash flows rather than when the cash is received and paid.

Modified Cash Basis Approach
The modified cash basis approach is a mixture of cash basis and accrual basis. This method often uses by service enterprises such as lawyers, doctors, architects, advertising agencies and public accountants. With this approach, expenditures having economic life of more than one year are capitalized as assets and depreciated over future years. Prepayments of expenses are deferred and deducted only in the year to which they apply, expenses paid after the year of incurrence or accrued expenses are deducted only in the year paid. Revenue is reported in the year of receipt, for tax purposes, individuals and personal businesses may use modified cash basis but this approach is prohibited to be used by corporations and any business in which inventory is a significant factor.

Any business in which inventory is a significant factor must use accrual basis accounting in reporting revenue from sales and cost of goods sold.

The aim of writing about income statement, process of closing and reversing entries to  tell us that accounting is a recording process that must follow on specific rules and basis which is often using in an accounting processs report.

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The Use of Accounting System in Reality


Talking about accounting systems, accounting systems vary widely from one business to another, it depends on

  • Nature of the business
  • The size of the firm
  • The volume of data
  • The informational demands.

Accounting systems include all of the activities required to provide management with the information for planning, controlling and reporting the financial condition and operations of an enterprise.

If we look at a balance sheet with “T” account format, the terms DEBIT mean left side and the terms CREDIT mean right side. These terms do not mean increase or decrease. The equality of debits on the left side and credits on the right side provides the basis for the DOUBLE – ENTRY SYSTEM or DOUBLE – ENTRY BOOK KEEPING of recording transactions. The used double entry accounting system or the dual or two sided effect of each transaction in appropriate accounts. This system provides a logical method for recording transactions and proving the accuracy of the recorded amounts. If every transaction is recorded with equal debits and credits, then the sum of all the debits to the accounts must equal with the sum of all the credits or total debits must equal with total credits. In a double system every debit there must be follow with a credit and vice-versa.

There are three basic guidelines for an accounting system

  1. All asset and expense accounts are increased on debit or the left side and decreased on credit or the right side.

  1. All liability and revenue accounts are increased on credit or the right side and decreased on debit or the left side.

  1. Stockholders’ equity accounts like common stock and retained earnings are increased on credit or right side whereas dividends is increased on debit or the left side.

Balance sheet and Income statement as Financial statement related to ownership structures

Investments by stockholders called common stock and retained earnings comes from net income retained in business are reported in the stockholders’ equity section of the balance sheet.

Dividends are reported on the statement of retained earnings. Revenue and expenses are reported on the income statement.

Dividends, revenues and expenses are eventually transferred to retained earnings at the end of the period. It means dividends and net income or net loss are eventually transferred to retained earnings at the end of the period.

The type of ownership structure employed by a business enterprise affect the equity section. In a corporation there are accounts commonly used such as

  • Common stock
  • Additional Paid – in Capital
  • Dividends
  • Retained Earnings

In a proprietorship or patnership, a “Capital Account” is used to indicate the owner’s investment in the company. A “Drawing Account” is used to indicate with drawals by the owner.

Effects of transactions on owners’ equity accounts

A. In corporations

A1. Investment by owners

When owners invest in exchange for common stocks, this transaction impact on increasing owners’ equity called “Common Stock” in a balance sheet.
For example, owners invest $130,000 in exchange for common stocks to use for buying some equipments. Debit or the left side of assets (equipment account) will increase $130,000 and credit or the right side of owners’ equity (common stock account) will increase $130,000

A2. Revenue earned

When a company gets revenue, this transaction impact on increasing owners’ equity called “Retained Earnings” in a balance sheet, at the end of the period. However at the time when a company receives the revenue in cash, assets (cash account) on the left side or debit will increase and credit or the right side of owners’ equity (a temporary account called revenue account) will increase. At the end of the period, total amounts in temporary account called revenue account will be transferred to Retained Earnings to increase owners’ equity called Retained Earnings in a balance sheet.
For example, at the time when a company gets revenue $4,000 in cash, cash account will be debited $4,000 and a temporary account called revenue account will be credited $4,000. At the end of the period $4,000 on revenue account will be transferred to owners’ equity – retained earnings on a balance sheet to increase owners’ equity.

A3. Expenses incurred

When a company pays wages, this transaction impact on decreasing owners’ equity called “Retained Earnings” in a balace sheet, at the end of the period. However at the time when a company pays wages in cash, a temporary account called expense account on the left side or debit will increase and credit or the right side of cash account will decrease. At the end of the period, total amounts in temporary account called expense account will be transferred to Retained Earnings to decrease owners’ equity called Retained Earnings in a balance sheet.
For example, at the time when a company pays wages $1,600 in cash, a temporary account called expenses account will be debited $1,600 and cash account will be credited $1,600. At the end of the period $1,600 on expenses account will be transferred to owners’ equity – retained earnings on a balance sheet to decrease owners’ equity.

A4. Withdrawal by owners

Withdrawal by owners in corporations called “Dividends”. This transaction impact on decreasing owners’ equity called “Retained Earnings” in a balance sheet, at the end of the period. However at the time when a company pays dividends in cash, a temporary account called dividends account on the left side or debit will increase and credit or the right side of cash account will decrease. At the end of the period, total amounts in temporary account called dividends account will be transferred to Retained Earnings to decrease owners’ equity called Retained Earnings in a balance sheet.
For example, at the time when a company pays dividends $5,500 in cash, a temporary account called dividends account will be debited $5,500 and cash account will be credited $5,500. At the end of the period $5,500 on dividends account will be transferred to owners’ equity – retained earnings on a balance sheet to decrease owners’ equity.

When a company declare to pay dividends, a temporary account called dividends account on the left side or debit will increase and credit or the right side of liability account  will increase. At the end of the period, total amounts in temporary account called dividends account will be transferred to Retained Earnings to decrease owners’ equity called Retained Earnings in a balance sheet. At the time when a company pays dividends in cash, liability account will be debited and cash account will be credited.

B. In proprietorships and patnerships

B1. Investment by owners

When owners invest, this transaction impact on increasing owners’ equity called “Capital” in a balance sheet.
For example, owners invest $130,000 to use for buying some equipments. Debit or the left side of assets (equipment account) will increase $130,000 and credit or the right side of owners’ equity (capital account) will increase $130,000

B2. Revenue earned

When a company gets revenue, this transaction impact on increasing owners’ equity called “Capital” in a balance sheet. However at the time when a company receives the revenue in cash, assets (cash account) on the left side or debit will increase and credit or the right side of owners’ equity (a temporary account called revenue account) will increase. At the end of the period, total amounts in temporary account called revenue account will be transferred to Capital in a balance sheet to increase owners’ equity.
For example, at the time when a company gets revenue $4,000 in cash, cash account will be debited $4,000 and a temporary account called revenue account will be credited $4,000. At the end of the period $4,000 on revenue account will be transferred to owners’ equity – capital on a balance sheet to increase owners’ equity.

B3. Expenses incurred

When a company pays wages, this transaction impact on decreasing owners’ equity called “Capital” in a balace sheet. However at the time when a company pays wages in cash, a temporary account called expense account on the left side or debit will increase and credit or the right side of cash account will decrease. At the end of the period, total amounts in temporary account called expense account will be transferred to Capital in a balance sheet to decrease owners’ equity.
For example, at the time when a company pays wages $1,600 in cash, a temporary account called expenses account will be debited $1,600 and cash account will be credited $1,600. At the end of the period $1,600 on expenses account will be transferred to owners’ equity – capital on a balance sheet to decrease owners’ equity.

B4. Withdrawal by owners

The impact of withdrawal by owners will decrease owners’ equity called “Capital” in a balance sheet. However at the time when owners drawing in cash, a temporary account called drawing account on the left side or debit will increase and credit or the right side of cash account will decrease. At the end of the period, total amounts in temporary account called drawing account will be transferred to Capital in a balance sheet to decrease owners’ equity.
For example, at the time when owners witdraw $5,500 in cash, a temporary account called drawing account will be debited $5,500 and cash account will be credited $5,500. At the end of the period $5,500 on drawing account will be transferred to owners’ equity – capital on a balance sheet to decrease owners’ equity.

The first step in accounting cycle is analysis of each sale or purchase transaction, no matter how small it is, it should be recorded. The transactions and events that affect a business enterprise is used to describe th source of changes in an entity’s assets, liabilities and equity. There are many events that have both external and internal elements however there are only two types of events

A.  External events

Involve interaction between an entity and its environment such as a transaction with another entity or a change in the price of a good or service that an entity buys or sells or an improvement in technology by a competitor.

B.  Internal events

Occur within an entity, such as using buildings and machinery in its operations or consuming raw materials in production processes.

Transactions as particular kind of external events, may be an exchange in which each entity receives and sacrifices value such as purchases and sales of goods or services. Transactions may be transfers in one direction to another entity without directly receiving or giving value in exchange, such as investments by owners, distributions to owners, payment of taxes, etc.

In short, accountants record as many events as possible that affect the financial position of enterprise. Some events are omitted because the problem of measuring them are too complex. To have a complete record of each transaction concern with asset, liability, equity, revenue and expense items in one place, a journal called GENERAL JOURNAL as the book of original entry is employed. General journal is a simplest journal form as a chronological listing of transactions and events expressed in terms of debits and credits to particular accounts.

Most businesses use SPECIAL JOURNALS such as

  • Cash receipts journal
  • Sales journal
  • Purchases journal (Voucher register)
  • Cash payments journal (Check register)

in addition to the GENERAL JOURNAL.  

Using general journal nor special journal is kind of  the most fundamental  process of recording that must be done carefully before posting process to the ledger, trial balance, adjustment process until reversing entries.  Any error on recording process with journal have impact on the subsequent process however the good result of recording with journal does not guarantee free of errors in the subsequent processes. This process must be taken when you follow on accounting system in reality.  

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How to Deal with Product Costing


Product costing is needed at the time of producing goods or services, the calculation of product costing will be used as the basic information and to find out the cost of production or cost of goods manufactured. Improper of product costing will effect on  cost of goods sold, selling price and failure in business competition. To avoid these errors we need to understand how to deal with product costing and what the elements of product costing are that we should understand.

Direct materials 

Direct materials are those materials that are traceable to the goods or services being produced. By using physical observation on all of materials can be directly charged to products and the quantity consumed by each product can be measured. Some several kinds of direct materials such as steel in automobile industry, wood in furniture, anesthesia for an surgery operation, food on an airline, etc.

Direct materials that form an “ insignificant part of the final product “ are lumped into overhead category as INDIRECT MATERIAL because the cost of tracing is greater than the benefit of increased accuracy. The glue used in furniture industry or toys is an example of indirect material.

Direct labor

Direct labor is the labor that is traceable to the goods or services being produced. Physical observation can be used to measure the quantity of labor used to produce a product or service. Employees who convert raw materials into a product or who provide a service to customer are classified as direct labor. Some examples of direct labor such as workers on assembly line at a plant, a chef in a restaurant, a pilot, etc.

The cost of overtime for direct labor is assigned to overhead category as INDIRECT MANUFACTURING COST because no particular production run can be identified as the cause of the overtime. For example if workers are paid at regular rate $50 and $25 for overtime, then only $25 overtime is assigned to overhead. The $50 still regarded as a direct labor cost. However if a special order is taken when production is at 100% capacity, in these cases it is appropriate to treat overtime as a direct labor cost.

Overhead

All about production costs other than direct materials and direct labor called overhead. Overhead is also known as factory burden or manufacturing overhead. It contains a wide variety of items. There are many inputs other than direct material and direct labor are needed to produce products or services. Samples of overhead costs such as depreciation on building and equipment, maintenance costs, supplies, supervision, material handling, power, etc.

Those materials necessary for production that do not become part of the finished product or which do not used in providing a service, called “ Supplies “. Dishwasher detergent in a fast food restaurant and oil for production equipment are examples of supplies.

Other than direct materials, direct labor and overhead ; Selling or marketing costs and administrative costs are categories of non production costs. They are noninventoriable or period costs because selling or marketing costs and administrative costs are expensed in the period in which they are incurred. None of these costs can be assigned to products or appear as part of inventories on the balance sheet.

In a manufacturing organization, these costs can be significant because these costs often run greater than 25% of sales revenue. Controlling on these costs may bring greater cost savings results than the same effort exercised in controlling production costs.

Salaries and commissions of sales personnel, advertising, warehousing, shipping or freight out, customer service, royalties paid and rent are examples of selling or marketing costs.

Administrative costs are costs that cannot be reasonably assigned to either marketing or production. Top executive salaries, office salaries, loss from bad debts, legal fees, printing and annual report, general accounting, R&D with designing and developing of the new products, are examples of administrative costs.

Another term used in product costing is the Prime cost and Conversion cost. Prime cost is the sum of direct materials cost and direct labor cost while conversion cost is the sum of direct labor cost and overhead cost. For a manufacturing firm, conversion cost can be interpreted as the cost of converting raw materials into a final product. To meet external reporting requirements, costs must be classified according to its function. In preparing an income statement production costs, selling and administrative costs are viewed as period costs. Thus, production costs attached to the products sold are recognized as an expense called “ COST OF SALES “ on the income statement.

Production costs that are attached to products that are not sold are reported as inventory on the balace sheet. Selling and administrative expenses as costs of the period must be deducted as expenses and not appear on the balance sheet.

Income stament of a manufacturing company

After reading those information element of production costs, we have to prepare an income statement for a manufacturing company on end of each year as steps below

Step 1

Beginning inventory of Direct materials add with Purchases of direct materials to get Direct materials available for use.

Diret materials available for use deducted with Ending inventory of direct materials to get Direct materials used.

Step 2

Direct labor.

Step 3

The sum of Manufacturing overhead or Factory overhead ; Such as indirect labor, power and light, heat, insurance, tool expenses, supplies, machine and factory building depreciation, rent, utilities, property taxes, repairs and maintenance, etc

Step 4

Get a Total manufacturing cost by summing Direct materials used in step 1 with Direct labor in step 2 plus the sum of Manufacturing overhead or Factory overhead in step 3

Step 5

Total manufacturing costs as result of step 4 plus Beginning inventory of work in process, then deducted with Ending inventory of work in process to find the Cost of goods manufactured

Step 6

The Cost of goods manufactured in step 5 plus Beginning inventory of finished goods to find Cost of goods available for sale

Step 7 

Deducted the Cost of goods available for sale in step 6 with Ending inventory of finished goods to find Cost of goods sold

Step 8

To find Gross profit, deducted Sales with Cost of goods sold in step 7

Step 9

To know Net income before taxes, deducted Gross profit in step 8 with the sum of Operating expenses. Operating expenses consist of marketing expenses and administrative expenses.

Income statement of a service organization

An income statement for a service firm is computed differently with a manufactured firm. In a service organization, there are no beginning or ending finished goods inventories. The service firm has no finished goods inventories because it is not possible to store services. However it is still possible to have work in process for services, for example an architect may have drawing in process. Cost of services sold in a service organization would correspond to Cost of goods manufactured in a manufacturing company. Cost of services sold in a service organization consist of

* Direct materials plus direct labor and overhead or manufacturing overhead

* Add: Beginning of work in process

* Less: Ending of work in process

 To find Gross profit, deducted Sales with Cost of services sold

To know Net income before taxes, deducted Gross profit with the sum of Operating expenses. Operating expenses consist of marketing expenses and administrative expenses.

An income statement provides information on how sales are generated, gross profit and net income before taxes. Through the income statement, we may know how much the cost of goods manufactured, cost of goods sold and operating expenses. All information submitted by the income statement can be used as a basis to determine what corrective action should be undertaken by management because there are direct materials, direct labor and overhead component as a determinant of total manufacturing costs.

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Contemporary Management Accounting (part 2)


5. Total Quality Management Continuous improvement is crusial to establish a state of manufacturing excellence. Making products with little waste are the two objectives of world class firms. Manufacturing excellence is the key to survival in today’s world class competitive environment.

A philosophy of Total Quality Management in which manufacturers strive to create an environment that will enable workers to manufacture perfect products with zero defect, is replacing the “ Acceptable Quality “ of the past. This increased emphasis on quality has also create a demand for a management accounting system that provides financial and non financial information about quality.

Service industries also have to improve their quality in bringing their service. Service firms are emphasizing consistency through the development of systems to support employee efforts. Many financial services companies invested heavily in information technology for incoming documents such as applications, checks and appraisal are scanned electronically and stored on optional disks. When a customer calls, a service representative can check the customer’s file on the computer and answer the question immediately. This is in contrast to the old system which required a process that could take up to several days or weeks.

Quality cost measurement and reporting are the key features of the contemporary management accounting system for both manufacturing and service industries. The management accounting system should be able to provide operational and financial information about quality, including number of defects, cost reports and performance reports.

6. Time as a Competitive Element In all phases of the value chain, time is a crucial element. World class firms reduce time to market by compressing design, implementation and production cycles. These firms deliver products or services more quickly by eliminating non value added time and time of no value to the customers such as time a product spends on the loading dock. Decreasing non value added time appears to go hand in hand with inreasing quality. The overall objective of improvement in service quality that resulted from the management time, of course is to increase customer responsiveness.

The rate of technological innovation has increased for many industries and the life of a particular product can be quite short. Managers must be able to respond quickly and decisively to changing market conditions. The correlation between cost and time is the kind of information that should be available from a management accounting information system.

While quality and time are important, improving efficiency is a vital concern too. Both financial and non financial measures of efficiency are needed. Cost is a critical measure of efficiency. Trends in costs overtime and measures of productivity changes can provide important measures of the efficiency of continuous improvement decisions. For these efficiency measures, costs must be properly defined, measured and assigned. Production of output must be related to the inputs required and the overall financial effect of productivity should be calculated.

7. Advances in Information Technology Two significant advances information technology, automated manufacturing connected with computer and supplies tools such as personal computers, spread-sheet software and graphic packages.

With automated manufacturing connected with computers to monitor and control operations, a considerable amount of useful information can be collected and reported to managers about what is happening on the floor. It is possible to track products continuously as they move through the factory and report on the real time basis such as units produced, material used, scrap and product cost. The outcome information system that fully integrates between manufacturing, marketing and accounting. Managers can access the data, extract and analyze it quickly and efficiently.

Personal computer (PC) serves as a communication link to

  • Company’s information system
  • Spreadsheet
  • Graphics

It gives managers with informations to be analyzed and used by all types of organizations. PCs and user friendly software allow managers to do with their own analysis and to decrease their dependence on a centralized information system.

Managers can access information more quickly and prepare many reports. Management accountants have the flexibility to respond the managerial need for more complex product costing. The increased responsiveness of a contemporary management accounting system results cost savings by eliminating the huge volume of internally monthly reports.

 8. Advances in The Manufacturing Environment Improving technology and process is having effect on the manufacturing environment. These changes are effecting on

  • Product costing system
  • Control system
  • Cost behavior and traceability
  • Capital budgeting
  • Others

Traditional manufacturing systems are “ Push Through Systems “, it means that production is pushed through the system and efforts are made to sell as many units as are produced. If production greater than demand, the inventories of finished goods are created or increase. By using Demand Pull System such as Just In Time (JIT) to produce a product only when it is needed or demanded by customers. Demand pulls product through the manufacturing process, no production takes place until a signal from a succeeding process indicates the need to produce.

These might happen with JIT environment

  1. In JIT system, parts and materials arrive just in time to be used in production.
  2. JIT manufacturing reduces inventories to lower levels than in conventional systems.
  3. JIT also increases the emphasis on quality control and produces fundamental changes in the way production is organized and carried out.
  4. JIT manufacturing focus on continual improvement by reducing inventory costs and other economic problems.
  5. By reducing inventories capital, it can be used for more productive investment.
  6. By increasing quality enhances the competitive ability of the firm.

Changing a traditional manufacturing setup to JIT manufacturing allows the firm to focus on quality, productivity and more accurate assessment of what is costs to produce products. Increasing costing accuracy occurs because the ability to trace products in JIT system increases.

Along with JIT, automation of the manufacturing environment can produce a competitive advantage for a firm since automation of the manufacturing allow firms to

  • Reduce inventory
  • Increase productive capacity
  • Improve quality and service
  • Decrease processing time
  • Increase output

Implementation of automated manufacturing typically follows JIT to increase quality and shorter response times. As more firms automate will force other firms to do likewise to survival. There are three levels of automation

  1. Stand alone piece of equipment
  2. Cell
  3. Completely integrated factory

Any level of automation should produce a more focused and simplified manufacturing process. If automation is justified, installation of a computer integrated manufacturing (CIM) system must be implemented. The capabilities of CIM

  • Products designed by CAD (Computer Assisted Design)
  • Test to design by CAE (Computer Assisted Engineering)
  • Products manufacturing by robots or CAM (Computer Assisted Manufacturing)
  • Information system connects the various of automated components

A particular type of CAM is flexible manufacturing system, it is used to produce a variety kind of family products from start to finish using robots and other automated equipment under control by a mainstream computer.

9. Growth and Deregulation in The Service Industry Deregulation of many services such as airlines, financial services, telecomunications, etc, has increased competition in the service industry. Many service organizations are scrambling to survive. In deregulated environment, many of the same issues facing manufacturers began to emerge quality, productivity, cost efficiency, customer satisfaction and time based competition. These competitive issues have made managers of service companies more conscious of the need to use management accounting information for planning, controlling and decision making. The service sector will increase its demand for management accounting information to get better information and productivity.

The aim of description above to tell us that accounting continues to follow the demands of the information needs and development of management needs. It is also a proof that the accounting is always trying to present information that is accurate and reliable for planning, controlling and decision making process which done by managers in all levels of organizations.

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Contemporary Management Accounting (part 1)


The economic environment has forced many firms to develop more relevant management accounting in practices. Many manufacturers have to change their way in doing businesses. These changes not only create a new environment for management accounting to do with many aspects but the focus of management accounting systems has been broadened to enable managers to bring better serve the needs of customers and keep managing the firm’s value chain. To secure and maintain a competitive advantage, managers must emphasize on time, quality and efficiency. Accounting information must be used to support the organizational goals. The factors that are bringing these changes on a traditional cost accounting to become a contemporary management accounting as follow

1. Activity Based Management (ABM)
It is a systemwide, integrated approach that focuses management’s attention on activities with the objective of improving customer value and the resulting profit. The demand for more accurate and relevant management accounting information has led to the development of activity based management.

Activity Based Management (ABM) or Activity Based Costing (ABC) improves the accuracy of assigning costs by first tracing costs to activities and then to products or customers that consume these activities. Process value analysis is talking about emphasis activity analysis, trying to determine why activities are performed and how well they are performed. The objective is to find ways to perform necessary activities more efficiently and to eliminate those that do not create customer value. Traditional cost accounting does not record the cost of nonproducing in manufacturing such as

a. The cost of faulty quality
b. The cost of a machine being out of order
c. The cost needed parts not being on hand

These unrecorded and uncontrolled costs in some plants run as high as the traditional accounting cost does record. A new method of cost accounting called “ACTIVITY BASED” accounting records all costs. The transition from traditional management accounting to activity based management accounting not instantaneous. Time is required for firms to adopt new procedures.

2. Customer Orientation
Activity Based Management (ABM) has the objective of increasing customer value by managing activities. Most of firms are focusing on creating a competitive advantage by creating better customer value for the same cost or with lower cost than that of competitors.

Custormer value is the difference between what a customer receives in realization and what the customer gives up or sacrifice. What is customer received is called The Total Product, so the total product is the complete range of tangible and intangible benefits that a customer receives from the product what he or she purchased. Customer realization includes product features, service and after sales service, quality of a product, instruction for users, product reputation and brand name, other factors deemed important to customers.

Customer sacrifice includes the cost of purchasing the product, delivery time and any other effort to acquire and learn about how to use the product or services. The cost of using, maintaining and disposing of the product called Postpurchase Costs.

Increasing customer value means increasing customer realization or decreasing customer sacrifice or both.

To create a sustainable competitive advantage, a firm must select and decide upon several strategies which to be used. Cost information called STRATEGIC COST MANAGEMENT plays a critical role in this process because the use of cost data to develop and identify strategies to produce a sustainable competitive advantage. There are two strategies in strategic cost management which often be used by many firms.

I. Cost Leadership
The effective of the cost leadership strategy is to provide the same or better value to customers at a lower cost then competitors, to increase customer value by reducing sacrifice such as reducing the cost of making a product by improving a process will reduce the product’s selling price, this effort will reduce customer sarifice.

II. Superior product through differentiation
A differentiation strategy to increase customer value by increasing realization will provide customers with something which not provided by competitors. After sales service for a computer with on-site repair service is a kind of differentiation strategy. The firm must ensure that the value added to the customer by differentiation strategy exceeds the firm’s cost of providing the differentiation. Each differentiation strategies require different cost information, according to the strategy adopted by a firm.

Concern with customer orientation or focus on customer value means the management accounting system should produce information about customer realization and customer sacrifice. Collecting information about customer sacrifice means gathering information outside the firm, a practice not usually found within traditional management accounting system. Successful pursuit of cost leadership or differentiation strategies requires of a firm’s internal and industrial value chain.

Effective management of the value chain is very important to increase customer value especially if a goal of the firm is maximizing customer realization at the lowest possible cost.

Value chain is a set of activities required to
* Design
* Develop
* Produce
* Market and deliver products or services to customer

Emphasizing customer value forces managers to determine which activities in the value chain is important to customers. Management accounting system should track information about a wide variety of activities that span the value chain. Timely delivery of a product or service is part of the total product, so it has a value to the customer. By increasing the speed of delivery can increase customer value. It means that a good response of accounting management system ought to be developed and use to measure a customer satisfaction.

The industrial value chain is critical for strategic cost management. The industrial value chain is the linked set of value, creating activities from basic raw materials to the disposal of the final product by end-use customers.

A firm operating within the industry may not span the entire value chain. Different firms have to participate in different segments of the chain. Breaking down a firm’s value chain into its strategically important activities is a basic to successful implementation of cost leadership and differentiation strategies. Fundamental to a value chain framework is the complex linkages and interrelationships among activities. There are two type of linkages.

I. Internal linkages
Are relationships among activities that are performed within a firm’s portion of the industrial value chain or internal value chain.

II. External linkages
Are activity relationships between the firm and firm’s suppliers and customers.

These linkages bring about win-win outcome for the firm, suppliers and customers. Managing the material flow beginning with suppliers and their upstream suppliers, moving to the transformation of materials into finished goods and finishing with the distribution of finished goods to customers and their downstream customers, called SUPPLY CHAIN MANAGEMENT.

Undestanding the industrial value chain, suppliers and customers may reveal hidden benefits. The firm’s objective is to manage these linkages better than its competitors to create a competitive advantage.

The companies have internal customer too. The support of staff function to serve the line function such as the procurement department process acquires and delivers materials and parts to producing department is just as vital as it is for a company to provide high quality goods to external customers.

3. Cross Functional Perspective
Emphasis on the value chain means the management accountant must understand functions of the business, from marketing distribution to customer service. This need is magnified when the company is involved in international trade. Contemporary management accounting has moved beyond the traditional manufacturing cost definition of product cost to more inclusive definitions. In contemporary approaches, the product costing include
a. Initial design and engineering costs as well as manufacturing     costs.
b. The costs of distribution, sales and service.

Concerning with determining which information is relevant to use for decision making process. Strategic decisions require a product cost of all value chain activities, whereas a short run decision that is occurred with a special order should be accepted or rejected.

When a value chain approach is taken and customer value is emphasized, we see that these disciplines are interrelated. Many manufacturing encourage wholesalers and retailers to buy more product than they can quickly resell by offering huge discounts. As a result, inventory become bloated and the wholesalers and retailers stop purchasing for a time. When selling activity stops, so does production. As a result the factories were idle and workers were laid off. In effect, the sales were costing the companies with more amount of production cost as additional. By using this cross functional perspective, we see the forest, not just one or two of the trees. This broader vision allows managers to increase quality, reduce the time required to serve internal and external customers and improve efficiency.

4. Global Competition and E-Business
Several decades ago, firms did not care about what similar firms in Japan, Taiwan, Korea, China were making. These foreign firms were not competitors since the markets were separated by large geographic distances. However vastly improved transport action and communications have led to a global market for many manufacturing and service firms. Modernizations in transportation and communication have led to increased global competition. Cars made in Japan can be in United States in two weeks. Investment bankers and management consultants can communicate with foreign offices instantly. Because of these intense competitive pressures, the cost of making bad decisions based on low quality information has increased significantly. Thus, global competition has created a demand for improved management accounting information.

Many firms has forced to know and use of electronic business called “ e – business “ in doing their transaction or information exchange. E-business provides opportunities for a company to expand their sales throughout the world and lower costs significantly relative to paper based transactions. It also facilities the value chain to management, however management accountants need to understand the benefit and risks of e-business as well as its opportunities. The e-business plays a vital role in providing relevant cost information. Managers may need to know the cost per electronic transaction versus the cost per paper transaction.

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Financial Accounting and Its Nature


To whom want to know about Financial Accounting, this article will give you something that you should know. The nature of Accounting is commonly can be divided into the following areas

  • Financial Accounting
  • Managerial or Cost Accounting
  • Tax Accounting
  • Nonprofit or Fund Accounting

What is Financial Accounting
Financial accounting is the process that culminates the preparation of financial reports on the enterprise for internal and external of the enterprise. Investors, creditors, managers, union and government agencies are the users of these financial reports.

How with Managerial or Cost Accounting
Managerial or Cost Accounting is the process of identifying, measuring, analyzing and communicating financial information needed by management to plan, evaluate and control an organization’s operations.

Financial statements provide

  • Balance sheet
  • Income statement
  • Statement of cash flows
  • Statement of owner’s / stock holder’s equity

There are several objectives of financial reporting used by business enterprises

  1. To investors, creditors and other users in making rational investment, credit and similar decisions.
  2. To help the investors, creditors and other users in assesing the amounts, timing and uncertainty of prospective cash receipts from dividens or interest, proceeds from the sale, redemption or maturity of securities or loans.
  3. Economic resources of an enterprise claims to obligations of the enterprise to transfer to other entities and owners’ equity as jotted down on their financial reporting.

The objectives of financial reporting to provide

  • Informations for investment and credit decisions.
  • Informations in assessing cash flow prospects.
  • Informations about enterprise resources.

To provide informations they used accrual basis instead of cash basis. What is the difference between Cash Basis and Accrual Basis of accounting.

Accrual basis of accounting provides a better indication of an enterprise’s present and continuing ability to generate favorable cash flows. Cash flow means cash generated and used in operations. Cash flow is frequently used also to include cash obtained by borrowing and used to repay borrowing, cash used for investments in resources and obtained from the disposal of investments and cash contributed by or distributed to owners. Objective of accrual basis accounting is to ensure that events that change an entity’s financial statements are recorded in the periods in which the events occur, rather than only in the periods in which the entity receives or pays cash. Using accrual basis to determine net income means recognizing revenues when earned rather than when cash is received and recognizing expenses when incurred rather than when paid.

Under accrual accounting, revenues for the most part are recognized when sales are made so they can be related to the economic environment of the period in which they occurred. Over the long run, trends in revenues are generally more meaningful than trends in cash receipts.

Cash basis of accounting is used very rare, the events that change an entity’s financial statement are recorded not in the periods in which the events occur but recorded in the periods in which the entity receives or pays cash. Under cash basis accounting, revenues are recognized when sales are made along with cash receives.

Accounting plays an important role in obtaining a higher standard of living because it helps investors and lenders to identify efficient and inefficient users of resources. Investors and lenders can compare the income, earned and assets employed, they can assess the relative return and risks associated with investment opportunities and resources more effectively.

Business enterprises consist of

  • Economic resources called assets
  • Economic obligations called liabilities
  • Residual interests called owners’ equity

which are increased or decreased by economic activities.

Accounting accumulates and reports economic activity as it effects the elements of each business enterprise. In large organizations, the corporate form of organization tends to divorce ownership from management. The owners in most large organizations are the stockholders who directly and indirectly hire managers to run the firm.

To provide standards that ensure the relevance, reliability and comparability of information reported to absentee owners, accounting need a standard measuring called Accounting Standards. To meet these needs and to satisfy them, accountants prepare a single set of general purpose financial statements to present fairly, clearly and completely the economic facts of the existence and operations of the enterprise in order to minimize the potential dangers of bias, misinterpretation, inexactness and ambiguity. The accounting profession has attemted to develop a set of standards that is generally accepted and universally practiced called Generally Accepted Accounting Principles (GAAP). That is why the preparation of financial statements must follow all rules set by GAAP.

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