CHAPTER 3: COST ACCOUNTING CYCLE

MANUFACTURING INVENTORY ACCOUNTS

 Perpetual Inventory Approach

o Used by most manufacturing companies
 Three accounts that must be used in manufacturing inventory accounting:
1. Materials Inventory
2. Work in Process Inventory
3. Finished Goods Inventory

 MATERIALS INVENTORY
 Also Material Inventory Control account
 In manufacturing enterprises, the common practice is to record all materials and supplies in one
control account, Materials
 Made up of balances of materials and supplies on hand
 Maintained much the same way as the Merchandise Inventory account

 WORK IN PROCESS INVENTORY

 All manufacturing costs incurred and assigned to products being produced
 has no counterpart in merchandising accounting
 product costs, including direct labor, direct materials, and overhead costs, enter into accounting for
work in process inventory in issuance for production
 When products are completed, the costs no longer belong to Work in Process Inventory and the
products will be send to the storage area and the costs will be transferred to the Finished Goods
Inventory
 The balance remaining in the Work in Process Inventory account represents the costs assigned to
products partly completed and still in process at the end of the period.

 FINISHED GOODS INVENTORY

 Has also same characteristics of Merchandise Inventory Account
 When goods or products are sold, the costs of those goods are moved from Finished Goods
Inventory to Cost of Goods Sold account
 all costs debited to the Finished Goods Inventory account represents transfers form Work In
Process Inventory Account
 The balance in the Finished Goods Inventory account is made up of the cost of products completed
but unsold as of the date of the end of an accounting period

COST OF GOODS SOLD FORMULA (MANUFACTURING):

Beginning Finished Goods Inventory COST OF GOODS MANUFACTURED STATEMENT

Plus: Cost of Goods Manufactured
Total Goods Available for Sale
Less: Finished Goods Inventory End
Cost of Goods Sold
 Prepared to summarize the manufacturing activity
of period
 CofGM statement for manufacturing firm is
equivalent to purchases for merchandising firm
 is a summary of the direct materials, direct labor,
factory overhead and work in process account

ELEMENTS OF MANUFACTURING COST

 Direct Materials
 Cost of materials which become part of the product being manufactured and which can be readily
identified with a certain product
 Examples: Lumber used in making furniture
Fabric used in clothing
 Direct Labor
 Cost of labor for those employees who work directly on the product manufactured
 Examples: Salary of machine operators
Assembly line workers

 Factory Overhead
 All costs related to manufacturing of a product except direct materials and direct labor, including
other manufacturing expenses such asa depreciation on factory building,
 Indirect Materials – materials that cannot be readily identified with any particular item
manufactured

Examples: sandpaper used in furniture, lubricants in machinery

 Indirect Labor – wages and salaries of employees who are required for manufacturing process
but who do not work directly on the units being manufactured

Examples: wages and salaries of department head, inspectors, supervisors

THE MANUFACTURING STATEMENT

STATEMENT OF COST OF GOODS MANUFACTURED AND SOLD

 Summarize the flow of all manufacturig costs incurred during the year
 The amount for Cost of Goods Manufactured should be the same as the amount transferred from
WIP Inventory account to the FG Inventory account during the year
 The amount of COGS should be the same as the amount transferred from the FGI account to the
COGS account during the year.

Name of Company
Cost of Goods Sold Statement
For the Year ended chuchu
Direct Materials used:
MI, beginning xxxxxx
Add: Purchases xxxxxx
Total Available for Use xxxxx
Less:MI, end xxxxxx xxxxxx
Direct Labor xxxxxxx
FOH xxxxxxx
Total Manufacturing Costs xxxxxx
Add: WIP, beginning xxxxxxx
Cost of Goods put into Process xxxxxxx
Less: WIP, end xxxxxxx
Cost of Goods Manufactured xxxxxxx
Add:FG, beg. xxxxxxx
Total Goods Available for Sale xxxxxxx
Less: FG, end xxxxxxx
Cost of Goods Sold-normal xxxxxxx
Over/Underapplied FOH xxxxxxx
Cost of Goods Sold-actual xxxxxxx

CHAPTER 4: COST-VOLUME-PROFIT RELATIONSHIPS

Cost-volume-profit (CVP) analysis

 helps managers understand the interrelationships among cost, volume, and profit by focusing their
attention on the interactions among the prices of products, volume of activity, per unit variable
costs, total fixed costs, and mix of products sold.
 is a vital tool used in many business decisions such as deciding what products to manufacture or
sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive
facilities to acquire.
Basics of Cost-Volume-Profit Analysis

CONTRIBUTION INCOME STATEMENT

 helpful to managers in judging the impact on profits of changes in selling price, cost, or volume. The
emphasis is on cost behavior
 For example:
Let's look at a hypothetical contribution income statement for Racing Bicycle Company (RBC).
Notice the emphasis on cost behavior. Variable costs are separate from fixed costs. The
contribution margin is defined as the amount remaining from sales revenue after variable
expenses have been deducted.

Racing Bicycle Company Contribution Margin (CM)

Contribution Income Statement  is the amount remaining from sales revenue
For the Month of June after variable expenses have been deducted.
Sales (500 bicycles) $ 250,000
 used first to cover fixed expenses. Any
Less: Variable expenses 150,000
remaining CM contributes to net operating
Contribution margin 100,000
income.
Less: Fixed expenses 80,000
Net operating income $ 20,000

CVP Relationships in Equation Form

The contribution format income statement can be expressed in the following equation:

Profit = (Sales – Variable expenses) – Fixed expenses

Sales = Variable cost =
(Quantity or Units sold) (Quantity or Units sold)
x (Selling price per unit) x (Variable cost per unit)

Profit = (CM per Unit x Quantity Sold) – Fixed expenses

CM per Unit =
Selling price per unit
Less: Variable cost per unit

CVP Relationships in Graphic Form

The relationships among revenue, cost, profit, and volume can be expressed graphically by preparing a CVP
graph. Racing Bicycle developed contribution margin income statements at 0, 200, 400, and 600 units
sold. We will use this information to prepare the CVP graph.
Units Sold
0 200 400 600
Sales $ - $ 100,000 $ 200,000 $ 300,000
Total variable expenses - 60,000 120,000 180,000
Contribution margin - 40,000 80,000 120,000
Fixed expenses 80,000 80,000 80,000 80,000
Net operating income (loss) $ (80,000) $ (40,000) $ - $ 40,000

Preparing the CVP Graph

In a CVP graph, unit volume is usually represented on the
horizontal (X) axis and dollars on the vertical (Y) axis.
Using this convention, a CVP graph can be prepared in
three steps.
The first step begins by drawing a line parallel to the volume axis to represent total fixed expenses of
$80,000.

Second Step, choose some sales volume (for example, 400 units) and plot the point representing total
expenses (e.g., fixed and variable) at that sales volume. Draw a line through the data point back to where
the fixed expenses line intersects the dollar axis.

Third Step, choose some sales volume (for example, 400 units) and plot the point representing total sales
dollars at the chosen activity level. Draw a line through the data point back to the origin.
The break-even point is where the total revenue and total expenses lines intersect. In the case of Racing
Bicycle, break-even is 400 bikes sold, or sales revenue of $200,000.

PROFIT GRAPH
 An even simpler form of the CVP graph
 based on the equation – profit equals Unit Contribution Margin times quantity sold less total fixed
costs
 To build the graph, plot two profit or loss points (in our case 300 units and 500 units sold) and
connect them with a straight line.

CONTRIBUTION MARGIN RATIO (CM RATIO)

 calculated by dividing the total contribution margin by total sales
 can also be calculated by dividing the contribution margin per unit by the selling price per unit
 FORMULAS:
CM RATIO = Contribution Margin / Sales
CM RATIO = Contribution Margin per Unit / Selling Price per Unit

THE VARIABLE EXPENSE RATIO

 is the ratio of variable expenses to sales
 can be computed by dividing the total variable expenses by the total sales
 in a single product analysis, it can be computed by dividing the variable expenses per unit by the
unit selling price.
 FORMULAS:
VARIABLE COST RATIO = Variable Cost / Sales
VARIABLE COST RATIO = Variable cost per Unit / Selling Price per Unit
TARGET PROFIT ANALYSIS
 We can compute the number of units that must be sold to attain a target profit using either:
o Equation method,
o Formula method.
 FORMULAS:

Unit sales to attain the target profit = (Desired Profit + Fixed Costs) / CM per Unit

Sales with Target Profit = (Fixed Costs + Desired Profit) / CM Ratio

BREAK-EVEN ANALYSIS

Break-even in Unit Sales: Equation Method

To find the break-even point, we set profits equal to zero, and solve for the unknown quantity, Q.

Profits = Unit CM × Q – Fixed expenses

Suppose RBC wants to know how many bikes must be sold to break-even (earn a target profit of $0).

$0 = $200 × Q + $80,000

Racing Bicycle has a unit contribution margin of $200, and total fixed expenses of $80,000. Take a second
and solve this equation.

$0 = $200 × Q + $80,000
$200 × Q = $80,000
Q = 400 bikes

Break-even in Unit Sales: Formula Method

Break-even Point (Units) = Fixed Costs / CM per Unit

or
Break-even Point (Units) = Fixed Costs / (Selling Price per Unit – Variable Cost per Unit)

Break-even in Dollar Sales: Equation Method

Suppose Racing Bicycle wants to compute the sales dollars required to break-even (earn a target profit of
$0). Let’s use the equation method to solve this problem. We must setup the equation and solve for the
unknown value of sales.

Profit = CM ratio × Sales – Fixed expenses

Here is the equation that will always be used to calculate the break-even point in a single product company.
Remember, we solve for the unknown “Sales.”

$ 0 = 40% × Sales – $80,000

40% × Sales = $80,000
Sales = $80,000 ÷ 40%
Sales = $200,000

In the case of Racing Bicycle dollar sales must be $200,000 for the company to break-even.

Break-even in Dollar Sales: Formula Method

Break-even Point (Sales) = Fixed Costs / CM Ratio

or
Break-even Point (Sales) = Break-even Point (Units) x Selling Price
THE MARGIN OF SAFETY IN DOLLARS
 is the excess of budgeted (or actual) sales over the break-even volume of sales
 helps management assess how far above or below the break-even point the company is currently
operating
 FORMULA:
Margin of safety = Total Sales - Break-even sales
Margin of Safety = Margin of Safety in Units x Selling Price per Unit
THE MARGIN OF SAFETY PERCENTAGE/RATIO
 percentage is equal to the margin of safety in dollars divided by the total budgeted (or actual) sales
in dollars
 FORMULA:
Margin of Safety Ratio = Margin of Safety / Total Sales

THE MARGIN OF SAFETY IN UNITS

 FORMULA:
Margin of Safety in Units = Margin of Safety / Selling Price

COST STRUCTURE AND PROFIT STABILITY

COST STRUCTURE
 refers to the relative proportion of fixed and variable costs in an organization.
 Managers often have some latitude in determining their organization’s cost structure.

ADVANTAGE OF A HIGH FIXED COST STRUCTURE

 Income will be higher in good years compared to companies with lower proportion of fixed costs.

DISADVANTAGE OF A HIGH FIXED COST STRUCTURE

 Income will be lower in bad years compared to companies with lower proportion of fixed costs.

ADVANTAGE OF A LOW FIXED COST STRUCTURE

 enjoy greater stability in income across good and bad years.

OPERATING LEVERAGE

DEGREE OPERATING LEVERAGE

 is a measure of how sensitive net operating income is to percentage changes in sales
 is a measure, at any given level of sales, of how a percentage change in sales volume will affect
profits
 computed by dividing contribution margin by net operating income
 FORMULAS:
Degree of Operating Leverage = Contribution Margin / Net Operating Income
Percent Increase in Profit = Percent Increase in Sales / Degree of Operating Leverage

BREAK—EVEN POINT FOR A MULTIPRODUCT COMPANY

The Concept of Sales Mix

 Sales mix is the relative proportion in which a company’s products are sold.
 Different products have different selling prices, cost structures, and contribution margins.
 When a company sells more than one product, break-even analysis becomes more complex as the
following example illustrates.
FORMULAS:
BEP in Total Units = Fixed Cost / Weighted Average Contriution Margin

BEP in Total Units = Fixed Cost / Weighted Average Contriution Margin per Unit

BEP in Sales per Model/product= BEP in Total Units x Sales Mix