Cost Management

Managerial Accounting- Cost Dep 1

 Classifications
Cost
Dimensions

*Direct Material (DM): Materials that are directly put into the finished product (Traceable &
Measurable). The costs included in the direct material cost are all of the costs associated with acquiring the
item itself, shipping-in, insurance and taxes, among others. Ex. Wood, Cloth, Sponge in a chair

*Direct Labor (DL): Costs of labor that can be directly traced to the production of a product. (Traceable
& Measurable) Ex. Assembly line workers are direct labor costs for a manufacturing company.

Managerial Accounting- Cost Dep 2

 Manufacturing overhead costs (FOH): Are the company’s costs related to the production
process that are not direct material or direct labor, but are necessary costs of production.
Ex. are indirect labor, indirect materials, rework
costs, electricity and other utilities,
depreciation of plant equipment, and factory rent.

In-Direct Material: Materials that are not the main components of the finished goods. (Non-
Traceable & Non-Measurable) Ex. glue, screws and nails

In-Direct Labor: Is the labor that is part of the overall production process but does not come
into direct contact with the product. (Non-Traceable & Non-Measurable) Ex. The maintenance
department – Supervisors

Managerial Accounting- Cost Dep 3

Prime Costs: Prime costs are the costs of direct material and direct labor. These are
the direct inputs, or the direct costs of manufacturing.
Prime Costs = Direct Material + Direct Labor

Conversion Costs: Conversion costs include manufacturing overhead (both fixed

and variable) and direct labor. These are the costs that are required to convert the direct
materials into the final product.
Conversion Costs = Direct Labor + Manufacturing Overhead

Managerial Accounting- Cost Dep 4

Total Manufacturing Costs (TMC) Equations:

Managerial Accounting- Cost Dep 5

Cost of Goods Sold Equations: (3 Concepts(

Our Main concern in calculating TMC is Used Material

Managerial Accounting- Cost Dep 6

 Case Study (1)

The ABC Company provides the following data for January:

Beginning of Jan Ending of Jan

DM $50,000 $60,000

WIP $20,000 $15,000

DL $30,000 and FOH $45,000 and Direct Material Purchased during Jan is $120,000
Required: Prepares a cost of goods manufacturing statement.

Managerial Accounting- Cost Dep 7

 Cost Behavior

Production 0 10 20 50 100

Cost Behavior 1 100 100 100 100 100

Cost Behavior 2 0 20 40 100 200

Cost Behavior 3 100 120 140 200 300

Managerial Accounting- Cost Dep 8

 Cost Behavior

Production 0 10 20 50 100

Cost Behavior 1 100 100 100 100 100

Unit Cost 0 10 5 2 1

This cost called fixed cost – decrease by increase in production

( inverse relation) but constant with relevant range

Managerial Accounting- Cost Dep 9

 Cost Behavior

Production 0 10 20 50 100

Cost Behavior 2 0 20 40 100 200

Unit Cost 0 2 2 2 2

This cost called Variable cost – Constant and increase with

production increase (direct relation)
All direct is variable but not all variable is direct

Managerial Accounting- Cost Dep 10

 Cost Behavior

Production 0 10 20 50 100

Fixed cost 100 100 100 100 100

Variable cost 0 20 40 100

200

Cost Behavior 3 100 120 140 200 300

Unit Cost 0 12 7 4 3

This cost called Mixed cost ( semi variable) – decrease by increase in

production per unit ( inverse relation) and increase with production
increase as a total (direct relation)

Managerial Accounting- Cost Dep 11

 Cost Behavior

Variable cost: Are those that are incurred only when a produce is made, such as material or
labor. The total variable cost increase as production increases, but per unit the variable cost will
remain unchanged as production increases or decreases.

Fixed Cost: Do not change within the relevant range of production. The total amount of these
costs does not change with a change in production. However, the cost per unit decreases as
production increases.

Mixed Costs: These are costs that have both a fixed and a variable component. An example
is a mobile phone. You pay a certain fixed amount each month and then a variable amount for
each call that you make

Managerial Accounting- Cost Dep 12

 Cost behavior is studied on the relevant range while on the long run all costs are
variable

Cost function for total manufacturing costs

TC = FC + UVC × Q
Where: Tc = Total Costs

FC = Fixed Costs

UVC = Unit Variable Costs

Q = Total Production

Managerial Accounting- Cost Dep 13

 High & Low Method segregate fixed production costs from variable
production costs
For the High-Low Points Method, we use the highest and lowest observed values of the cost driver within the relevant
range. If, for example, we need to segregate fixed production costs from variable production costs and all we have is a
single total cost amount, we will take the month of the highest level of production or usage and the month of the lowest
level of production or usage. By comparing the differences in production with the differences in total costs between these
two months, we can determine approximately what amount of the costs are variable and what amount are fixed.

The steps to calculate this are the following:

1 .Calculate the Variable Cost Per Unit by dividing the difference between the highest and lowest costs by the
difference between the highest and lowest production volumes:

2. Multiply the Variable Cost per Unit by the unit volume at either the highest or the lowest production
volume to get the total variable cost at that level.
3. Subtract the total variable cost from the total cost at that level to get the fixed cost.

Managerial Accounting- Cost Dep 14

 Case Study (4)

ABC Company wants to estimate a cost function from the following observation :
Machine Hour Cost
.Jan 4,000 30,000 $
.Feb 7,000 39,000 $

Required:
1 Estimate the cost function for maintenance.
2 Compute the estimate maintenance cost for 6000 machine hours.

Managerial Accounting- Cost Dep 15

 Machine Hour Cost
.Jan 4,000 30,000 $

Answer .Feb 7,000 39,000 $

F.C = 30,000 – (4,000 ×3) = $18,000

T.C = F.C + V.C

T.C = 18,000 + $ 3 / Unit

T.C = 18,000 + 3 × 6,000 = $36,000

Managerial Accounting- Cost Dep 16

 Case Study (5)
The following information is for the next four Questions: The estimated unit costs for a company
using absorption (full) costing and planning to produce and sell at a level of 12,000 units per month are
as follows.

Unit Cost Cost Item Estimated

$ 32 Direct materials
20 Direct labor
Variable manufacturing
15
overhead
6 Fixed manufacturing overhead
3 Variable selling
4 Fixed selling

Question 1: Estimated conversion costs per unit are:

A. $35
B. $41
C. $48
D. $67

Managerial Accounting- Cost Dep 17

 Unit Cost Cost Item Estimat
Question 2: Estimated prime costs per unit are:
$ 32 Direct materials
A. $73 20 Direct labor
B. $32
C. $67 15 Variable manufac
D. $52
6 Fixed manufactur
Question 3:Estimated total variable costs per unit are:
3 Variable selling
A. $38
B. $70 4 Fixed selling
C. $52
D. $18

Question 4: Estimated total costs that would be incurred during a month with a
production level of 12,000 units and a sales level of 8,000 units are:
A. $692,000
B. $960,000
C. $948,000
D. $932,000
(32+20+15+6)*12000
+
8000*(3+4)
=932,0000
Managerial Accounting- Cost Dep 18
Cost classified by whether or not inventoriable (Product Vs. Period
Cost(

Period Costs Product Costs

Also Called Non-Inventoriable Costs Also Called Inventoriable Costs
Costs which are expensed as incurred in the Costs which are capitalized as part of finished
Income Statement goods inventory on Balance Sheet
They eventually become a component of cost of
goods sold at sale
Ex. Non- Manufacturing Costs Ex. Manufacturing Costs

The distinction is so crucial for the type of Income statement

reporting

Managerial Accounting- Cost Dep 19

 Full Absorption Costing

Absorption Costing: is a method of inventory costing in which all variable manufacturing costs
and
all fixed manufacturing costs are included as inventoriable costs.

Managerial Accounting- Cost Dep 20

Income Statement under full absorption costing

Managerial Accounting- Cost Dep 21

Variable Costing

Variable costing: is a method of inventory costing in which only variable manufacturing costs
are
included as inventoriable costs

Managerial Accounting- Cost Dep 22

 Income Statement under Variable costing

Managerial Accounting- Cost Dep 23

 Case Study
(6)
VO/ H $ 1000 DL $ 2000 DM $ 5000
FO/ H $ 2000 1000 units Production
Unit sales Price $ 15 800 units Sales
$ 3000 S, G and A
Required: Using these data, Prepare both Absorption and Variable Income statements

Managerial Accounting- Cost Dep 24

 Difference is the FFOH Capitalized for 200 Unit ($2 * 200 Unit) = $400

So Full Absorption fluctuates with the change in Inventory or Production and Sales, While Variable costing
changed with Sales.

Managerial Accounting- Cost Dep 25

 Full Absorption Costing Variable Costing

Requested for external financial Is used only for Internal Reporting

reporting and accepted by the GAAP

All Manufacturing Costs (Direct (Direct All Variable Manufacturing Costs

Product
– Material – Direct Labor Material – Direct Labor – Variable
Costs
(Total Factory Overhead Factory Overhead)
Period Total Selling, General & Fixed Factory overhead Selling,

Costs Administrative General & Administrative

• Operating Income will differ between Absorption and Variable Costing

• The amount of the difference represents the amount of Fixed Product Costs

capitalized as Inventory under Absorption costing, and expensed as a period

costs under Variable Costing

Difference = Δ Inventory X [Link] / Unit

Managerial Accounting- Cost Dep 26
 Case Study (7)

∙ Net income under full absorption is $5,000

∙ Fix O/H in the change in inventory is $1,500
∙ Beg inv. And end inv are $11,000 & 7,000, respectively.
Required: Compute the net income under V.C

Variable Costing net income = 5000 + 1500 = $6,500

Managerial Accounting- Cost Dep 27

Benefits and Limitations of Absorption and Variable Costing

- Absorption costing is required by both the U.S. Internal Revenue Service and GAAP.
However, absorption costing does enable managers to manipulate operating income simply
by increasing production or by producing items that absorb the highest fixed manufacturing
costs.

- Variable costing is used when the emphasis is on what items can be traced to and controlled
by a responsibility center. The method is very effective in supporting internal decision
making and is required for cost-volume-profit analysis (CVP(

Managerial Accounting- Cost Dep 28

 Case Study
(8) Units made 700
Selling Price $200 Units Sold 500
$30 Variable Manufacturing Costs per
Unit
$20 Variable Selling Costs per Unit
$25 Fixed Manufacturing Costs per Unit
$14000 Fixed Selling costs

Required: Prepare Full Absorption & Variable Income Statement

Operating Income Operating Income

Managerial Accounting- Cost Dep 29

 Cost classified by their relevant to decision making

Opportunity Costs: An opportunity cost is a type of implicit cost and considered as economic cost. It is
the maximum benefit forgone by using a scarce resource for a given purpose and not for the next-best
alternative.
Ex: Wages foregone by attending college instead of working fulltime
Carrying Costs: Are the costs the company incurs when it holds inventory. Carrying costs include: Rent
and utilities related to storage - insurance and taxes on the inventory - costs of employees who manage and
protect the inventory - damaged or stolen inventory - the lost opportunity cost of having money invested in
inventory (called cost of capital) - and other storage costs.
Because storage of inventory does not add value to the items themselves, carrying costs are expensed on
the income statement as incurred. They are not included in inventory (in other words, they are not included
on the balance sheet).
Sunk Cost: Are costs that have already been incurred and cannot be recovered. Sunk costs are irrelevant
in any decision-making process because they have already been incurred and no present or future decision
can change that fact.

Managerial Accounting- Cost Dep 30

 Committed Cost: Are costs for the company’s infrastructure. They are costs required to establish and
maintain the readiness to do business.
Ex: Intangible assets such as the purchase of a franchise and the purchase of fixed assets such as property,
plant and equipment.
They are fixed costs that are usually on the balance sheet as assets and become expenses in the form of
amortization and depreciation.
Discretionary Cost: Are costs that may or may not be spent, at the decision of a manager. Discretionary
costs will not cause an adverse effect on the business if they are not incurred, but in the long run they do
need to be spent. These are cost decisions that are made periodically and are not closely related to input or
output decisions. Discretionary costs may be fixed costs, variable costs, or mixed costs.
Advertising, research and development (R&D) and employee training are usually given as examples of
discretionary costs.
Marginal Costs: Marginal costs are the additional costs necessary to produce one more unit
Outlay Cost: Require actual cash disbursements. Also called explicit, accounting, or out-of- pocket costs.
An example is the tuition payment required to attend college.

Managerial Accounting- Cost Dep 31

 Valuation Methods (Factory Overhead Allocation(

How to cost the Product ????

Direct Material Direct Labor Factory O/H

With Actual or Budget ????

Managerial Accounting- Cost Dep 32

 Valuation Methods (Factory Overhead Allocation(

The Main problem of Cost Accounting is that it needs to estimate the costs
while production before receiving of the actual data

One way of estimations is what should be the cost

Different Methods of Cost Valuation

Managerial Accounting- Cost Dep 33

 Cost allocation is a method of applying costs to products, jobs, or services.

∙ Actual costing: Material, Labor, and Overhead are charged at actual cost and then
allocated to Units of production. It is not widely used because actual overhead costs are
generally not available immediately.

∙ Normal costing: materials and labor are charged at actual cost; overhead is charged
using a predetermined rate. Multiplying the overhead-predetermined rate by actual number
of the allocation base that was used in producing the product. It allows current calculation
of product costs and, by normalizing the fluctuations in overhead rates, enables
comparisons between periods

∙ Standard Costing: expected or target costs used for material, labor, and overhead costs.
Multiplying the standard manufacturing overhead rate by the standard number of the
allocation base that should be used in producing one unit of product. It is designed to point
out where variances occur so that the company can achieve a better operating result.

Managerial Accounting- Cost Dep 34

 Cost Flow Equation

Managerial Accounting- Cost Dep 35

 The Difference between FOH Control and FOH Applied results in over-applied or under- applied.
Over-Applied and Under-Applied Manufacturing Overhead. Chances are very likely that the actual costs
incurred and/or the actual level of activity during the period will be different from the estimates made at the
beginning of the year.

The amount of over- or under-applied factory overhead is calculated as follows:

Actual Costs Incurred − Factory Overhead Applied During the Period = Under (Over) Applied Factory
Overhead

Over-applied Under-applied
FOH Applied > Actual FOH FOH Applied < Actual FOH
Over applied is credited balance Over applied is Debit balance

:Entry :Entry

Dr. Overhead Applied 1,200 Dr. Overhead Applied 1,000 Dr.

Cr. Over applied Balance 200 Under applied Balance 200
Cr. Overhead Control 1,000 Cr. Overhead Control 1,200

Managerial Accounting- Cost Dep 36

 Closing Over/Under Applied
The way we transfer out this remaining over- or under-applied balance depends on whether the
balance is immaterial or material.

• Distributed among the WIP Inventory, Finished Goods Inventory and Cost of Goods Sold
accounts in proportion to their balances.

XX Dr. FOH Applied

XX Cr. Cost of Goods Sold
XX Cr. Ending WIP Inventory
Over Applied
XX Cr. Ending FG Inventory
XX .Cr. FOH Control

XX Dr. FOH Applied

XX Dr. Ending WIP Inventory
XX Dr. Ending FG Inventory
Under Applied
XX Dr. Cost of Goods Sold
XX FOH Control

Managerial Accounting- Cost Dep 37

 • Allocated to COGS if not Material. This will increase (Decrease) the COGS amount and
decrease (Increase) the profit for the period.

XX Dr. FOH Applied

XX Cr. Cost of Goods Sold
Over Applied
XX .Cr. FOH Control

XX Dr. FOH Applied

XX Dr. Cost of Goods Sold
Under Applied
XX FOH Control

It is always given whether it is material or immaterial. If it is not

given work as if it is material

Managerial Accounting- Cost Dep 38

How are you going to
Estimate FOH for the
production ?????

Managerial Accounting- Cost Dep 39

1- Estimate production level 5000 units

2- As production Manger estimation O/H was 10000 $

3- Detect the cost driver‫ ( ﻣﺳﺑب اﻟﺗﻛﻠﻔﺔ‬M/H or L/H )

Production
Manger
4- It was 3 M/H per unit

5- That mean the 5000 units will take ( 5000*3) 15000 M/H

6- O/H rate is 10000$/15000= 0.67$/ unit

Overheard Pre-dirtied Allocation Rate
Equation

Managerial Accounting- Cost Dep 40

Overheard Pre-dirtied Allocation Rate
Equation

Plant-Wide overhead rate (single rate used for all overhead cost (.

Total Plant Overhead

= Plant-Wide Overhead Rate
Cost Driver common to all jobs

Departmental overhead rate (single overhead rate calculated a particular department).

Total Department Overhead

Departmental Overhead Rate =
Cost driver common to all jobs for the department

Managerial Accounting- Cost Dep 41

 The Denominator of overhead is Manufacturing
Capacity

∙ When overtime must be worked, the overtime premium (this is the amount that the wage
increases for overtime work) that is paid to the workers is factory overhead.
∙ However, if the need to work overtime is the result of a specific job or customer request,
the premium should be charged to that specific job and not included in the overall
amount to allocate.

Managerial Accounting- Cost Dep 42

 Overhead cost should either be allocated to products and / or departments on the relative benefit received by
production or allocated according to the cause – and - effect relationship existing between the O/H cost and
other objective. Allocation bases include direct labor hours, Machine hours, direct material cost and unit of
production. If a company does not take overhead costs into account when it determines the selling price for a
product, there is significant risk that it will price the product so that it is actually selling at a loss if the price
that a company charges covers the direct costs of production but not the indirect costs of production.

A cost basis, or basis of cost allocation is a measure of activity such as direct labor-hours or machine-hours
that is used to assign costs to cost objects.
A cost object: is a function, organizational subdivision, contract, or other work unit for which cost
information is desired and for which provision is made to accumulate and measure the cost of processes,
products, jobs, capitalized projects, and so forth.

∙ Units of Production cannot be used since FOH can’t be traced to any specific
product Units.
∙ Units of Production is only used as a production base when the factory produces
only one product

Managerial Accounting- Cost Dep 43

 Joint Cost &By product

Joint products :are products that share a portion of the production process and have relatively the
same sales value. Ex. Petroleum products like crude oil and natural gas - Coco beans extract Coco
butter – Coco powder

Managerial Accounting- Cost Dep 44

 By-products are products that share the same production process with a product or joint product such as
diesel, gasoline, motor oil, and plastic. A lumber mill may have finished boards and the scrap that could be
used in plywood (a joint product), whereas the sawdust is used in other products (by-products)..
Both joint products and by-products share at least some of the same raw materials and initial processing costs.
The Split-off point is the point at which products diverge and become separately identifiable. The split-off
point is not necessarily the point at which the products become finished goods.
Costing for joint products and by- products includes all
manufacturing costs incurred before and after the split-off point. For
the financial reporting, joint costs incurred before the split-off point
are allocated among the joint
products. Additional processing costs (separable costs)
are any costs that can be specifically identified with a product because the cost
occurs after the split- off point where the costs are assigned to the separate
products.
Costing for joint products and by- products includes all
manufacturing costs incurred before and after the split-off
point. For the financial reporting, joint costs incurred before
the split-off point are allocated among the joint
products.
Additional processing costs (separable costs)
are any costs that can be specifically identified with a product because
the cost occurs after the split- off point where the costs are assigned to
the separate products.

Managerial Accounting- Cost Dep 45

 The main purpose of Joint Costs and By Product is to determine Inventory Costs

Product Cost= Share of Joint Costs + Separable Costs

Product Cost = Cost Before Split of Point + Costs after Split of point

Managerial Accounting- Cost Dep 46

 Key terms:
∙ Common (Joint) Cost: Cannot be identified with a particular joint product.
∙ Spilt – off point: At this stage, the joint products have separate identities.
∙ Separable cost: Identified with particular joint product and allocated to specific units of output.
They are the cost incurred for a specific product after the spilt – off point.
∙ Joint products: Share a portion of their production process with other joint products
∙ By-products: Share their production process but have minimal sales value
∙ Joint costs mechanism:

1. Cost incurred up to the split-off point

2. After the split-off point, products become separately identifiable.
3. After the split-off point, additional processing costs can be identified with a product.

Methods of Allocating Joint Costs

1- Physical Unit Method: Allocates joint costs to each product base on their relative proportions.

Managerial Accounting- Cost Dep 47

 Case Study (18)

Joint cost $ 60,000 given for joint product A,B & C:

Total Price/Unit Separable Costs

A Kg 2,000 $25 $20,000

B Kg 1,000 $30 $15,000

C Kg 3,000 $40 $65,000

Required: Allocate the joint cost using Physical method

Managerial Accounting- Cost Dep 48

 A 2,000 Kg
B 1,000 Kg
C 3,000 Kg
Total Method 6,000 Kg

60,000
= Joint Cost of A X 2,000 20,000 $ =
6,000
60,000
= Joint Cost of B X 1,000 10,000 $ = 60,000 $
6,000
60,000
= Joint Cost of C X 3,000 30,000 $ =
6,000

Benefits and Limitation of Physical Unit

Method

• Easy to use • It treats low-value products that are large in

size as if they were valuable. As a result , a
• The allocation is objective
large, low- value product might always
• The method is useful when rates or
show loss, whereas small, high-vale
prices are regulated
products will always show a profit.
• Physical measures are not always
comparable for products. For example
some products may be in liquid form
(Petroleum) while some might be in
gaseous form (Natural gas).
Managerial Accounting- Cost Dep 49
2- Sales Value at Split off Point: Allocates joint costs to each product base on their relative
proportional amounts of Sales at split off.

Case Study (19)

Using the sales value at spilt-off method, what is the cost for two products have total joint costs of
$50,000 with product A sales at split off of $100,000 and product B sales of $400,000.

Total Sales Value at Split off point = $100,000 + $400,000= $500,000

= Joint Cost of A 50.000 X 100,000

10,000 $ =
500.000 50,000 $
= Joint Cost of B 50.000 X 400,000
40,000 $=
500.000
Managerial Accounting- Cost Dep 50
 Benefits and Limitation of Sales Value At Split off Method

• Costs are allocated to • To use this method, selling prices at

products in proportion to the split off point must exist for all
their expected revenues, of the products. If they don’t, this
which is in proportion to method cannot be used
their individual ability to
absorb costs. • Market prices of joint products may
vary frequently, but sales value at
• The method is easy to split off method uses a single set
calculate, simple and straight of selling prices throughout an
forward accounting period, this can
introduce inaccuracies into the
allocations.

Managerial Accounting- Cost Dep 51

 3- The estimated net realizable value (NRV) : Allocates joint costs to each product based on their
relative proportional amounts of NRV.

Case Study (20)

Company has $50,000 joint cost. Sales Value for product A =$100,000 and B =$400,000 knowing
that B has $30,000 as additional processing costs.

∙ Determine NRV: Final sales value less additional processing costs $30,000
Product A: $100,000-$0 = $ 100,000
Product B: $400,000-$30,000 = $ 370,000
Total Method 6,000 Kg

50.000
= Joint Cost of A X 100,000 10,638 $ =
470,000
50,000 $
50.000
= Joint Cost of B X 370,000 39,362 $=
470,000

Managerial Accounting- Cost Dep 52

 Benefits and Limitation of
NRV

• This method can be used • Method is complex, it require

instead of Sales value at split more information about further
off when selling prices for one processing and separable costs
or more products at split off
don’t exist, because it provides
• Market prices of joint products
a better measure of the
benefits received than other may vary frequently, but NRV
methods that could be used in method uses a single set of selling
this situations prices throughout an accounting
period, this can introduce
inaccuracies into the allocations.
• The allocation results in
comparable profitability.

4- The Constant Gross Margin Percentage: Allocates joint costs to each product based on using the same gross margin
for all products.

Managerial Accounting- Cost Dep 53

 Case Study (21)

Joint cost $ 60,000 given for joint product A, B & C:

Total Price/Unit Sales Separable
Costs
A 2,000 Kg $25 $50,000 $20,000
B 1,000 Kg $30 $30,000 $15,000
C 3,000 Kg $40 $120,000 $65,000

$200,000 $100,000
Required: Allocate the joint costs using Constant gross margin percentage

Joint Cost = $60,000 Separable Cost = $100,000 Total Cost = $160,000

Gross profit =$200,000 - $$ 160,000 = $40,000

Gross Margin % =$40,000 / $200,000 = 20% GM

Sales – Separable cost – Gross profit = Joint cost

A 50,000 - 20,000 - 10,000 $20,000 =

B 30,000 - 15,000 - 6,000 $9,000 = 60,000 $
C 120000 - 65000 - 24000 $31000 =

Sales X 20% = Sales X Gross profit

Managerial Accounting- Cost Dep 54

 Benefits and Limitation of Constant Gross Margin Percentage

• Easier to implement than • This method assume

the complexity of the NRV that all products have
the same ratio of margin
• This is the only method for is probably not the case
allocating joint costs under
which product may receive
negative allocations in order
to reserve the profitability of
the products.

• This method allocates both

joint cost and gross profit

Managerial Accounting- Cost Dep 55

 By Product
Are product of joint process that have minor sales value as compared with that of the major product Examples are mill ends
of cloth and carpets, cotton meal , tar, and kerosene.

There are two methods of accounting for byproducts

1- The Production Method: Inventory the Byproduct Costs (By-product Recognized at
Production)
In the Production Method, the costs that are allocated to the byproducts are inventoried, and the sales
revenue received from the sale of the byproduct is treated as a reduction of the costs of production of
the main product.

Byproducts are inventoried in a separate inventory account at

their estimated net realizable value. Inventoried costs allocated
to the main product or joint products are reduced by the NRV
allocated to the byproduct. When the byproduct is sold, the
company recognizes no revenue or cost of goods sold but
simply debits cash or accounts receivable and credits
Byproduct Inventory.

Managerial Accounting- Cost Dep 56

 2-The Sales Method: Revenue from the Byproduct (By-product Recognized at Time of
Sale).
In the Sales Method, the byproduct costs are not put into inventory separately from the main product or
joint products. Instead, all of the costs of production are allocated to the main product or joint products
in inventory. When the main product or joint products are sold, their COGS will be higher than it would
have been under the Production Method. Since the byproduct is not put into inventory at all, when it is
sold the sale is recorded the way service revenue would be recorded, with no associated COGS. So the
company debits cash or accounts receivable and credits revenue for the amount of the sale.

Managerial Accounting- Cost Dep 57

 Service Cost Allocation – Methods of Allocation

Direct Method: All costs are allocated directly to the production departments. The direct method
ignores the cost drivers that are related to the service departments and concentrates only on the cost
drivers attributable to the production departments.
It is the most widely used Method. Its benefit is it simplicity. There is no need to predict the usage of
support-department services by other support department. A disadvantage is that it ignores information
about reciprocal services provided among support departments and can therefore lead to inaccurate
estimates of cost of operating departments.
Step Down Method: In this Method it is partially recognize the services provided among supporting
departments.
Under this method once the first or the base supporting department cost is allocated, no subsequent support
department cost are allocated back to it. Once the plant maintenance department costs are allocated, it
receives no further allocation from other (lower ranked) support departments.

Managerial Accounting- Cost Dep 58

 The result is that the step-down method does not recognize the total services that support
departments provide to one another. The reciprocal method fully recognizes all such services.

Reciprocal Method: This method is the most complicated and advanced of these methods
because it recognizes all of the services that are provided by the service departments to the
other service departments. Because of this detailed allocation between the service departments,
the reciprocal method is the most theoretically correct method to use. However, a company will
need to balance the additional costs required in doing this against the benefits that are received

Managerial Accounting- Cost Dep 59

 Case Study (24)

Consider Castleford Engineering, which operates at practical capacity to manufacture engines used in
electric-power generating plants.
Castleford has two support departments and two operating departments in its manufacturing facility:

Allocate the FO/H of the service departments to production departments using:

- Direct method - Step Down Method (Starting with S1) -Reciprocal method

Direct Method

Managerial Accounting- Cost Dep 60

 Step Down Method

Managerial Accounting- Cost Dep 61

 PM = $6,300,000 + 0.1 IS
IS = $1,452,150 + 0.2 PM
IS = $1,452,150 + [0.2 ($6,300,000 + 0.02 IS)]
IS = $1,452,150 + $1,260,000 + 0.02 IS
0.98 IS = $2,712,150
IS = $2,767,500
PM = $6,300,000 + 0.1 ($1,2767,500)
PM = $6,300,000 + $276,750 = $6,576,750

Managerial Accounting- Cost Dep 62

 Cost classified by cost system

Process costing is used for multiple, Job – order costing is used when the
nearly identical units that can be organized product or service has costs that can be,
into a flow. A process costing system would and often need to be, tracked and assigned
be suitable for products and a service such to a specific job or service. For example,
as newspapers, books, and soft drinks in the job costing is used for capital asset
manufacturing sector, check processing and construction (buildings, ships) in the
postal delivery in the service sector, and manufacturing sector; advertising
magazine subscription receipts in the campaigns, research and development,
merchandising sector. These products tend and repair jobs in the service sector, and
to be homogeneous in nature, meaning
costume mail- order items and special
they are all alike or very similar, and
promotions in the merchandising sector.
therefore it is not necessary to track costs to
a specific unit of product or service Costs for the products, projects, or
services can be easily tracked to the
product, project, or service.
Cost classified by cost system

Operation costing (hybrid system) is a costing system that combines job costing with process costing.
Similar to job costing, operation costing assigns direct materials to each job or batch, but direct labor and
overhead (conversion costs) are assigned similarly to process costing. This hybrid system is most suitable for
manufactures that have similar processes for high-volume activities but who need to use different materials for
different jobs. Clothing manufacturers, for example, have standard operations choosing patterns, cutting and
sewing, but the fabric used vary by item, size and color and price, among other factors. Other industries that are
suitable for operation costing include textiles, metalworking, furniture, shoes, and electronic equipment.

For example: a metalworking company produces handrails that are either unfinished (for painting) or chrome
plated. The company has one department create all of the metal rails and then transfers some to the
chrome-plating department.
 Job Order Costing System

Used by industries whose products or services can be easily identified by units or groups of
units, or by customers requiring different types of resources and skills (e.g., aircraft, ship,
furniture, hospital, account firm, and repair shops). Here, the unit of activity is the job and all
costs are accumulated by jobs. A subsidiary ledger tracks costs for each job.
 Question
Lucy Sportswear manufactures a line of T-shirts using a job-order cost system. During
March, the following costs were incurred completing Job ICU2 direct materials $13,700;
direct labor, $4,800; administrative Expenses $1,400; and selling, $5,600. Factory
overhead was applied at the rate of $25 per machine hour, and Job ICU2 required 800
machine hours. If Job ICU2 resulted in 7,000 good shirts, the cost of goods sold per unit
would be?
A. $6.50 Total Cost = DM + DL + FOH
B. $6.30
C. $5.70 Total Cost = 13700+4800+ ( 800*25) = 38500
D. $5.50
Total Cost / unit = 38500 / 7000 = 5.5 $
 Process Costing System

Process costing is used to allocate costs to individual products when the products are all
relatively similar and are mass-produced. “homogeneous” Ex. Assembly Lines – Drinks
Industries – Oil Refining
In process costing all of the costs incurred by a process (a process is often referred to as a
department)
 Spoilage
Spoilage is the term used for defective units that are not transferred to the next
process.

Normal spoilage Abnormal spoilage

is included in the cost of the good units is allocated to a loss from the abnormal
sold, as a direct cost or allocated to spoilage account
factory overhead. (any spoilage over the amount considered
normal)
Uncontrollable Controllable
 Cost classified by cost system

The treatment of spoilage costs will depend on the type of spoilage.

Normal Spoilage
If the spoilage is normal spoilage, the costs that have been allocated to the normally spoiled
units are added to the costs of the good units that are transferred out to finished goods (or the
next department). This will cause the cost per unit transferred in to the next department to be
higher than the cost of producing a good unit in the current department.

Abnormal Spoilage
The costs that have been allocated to the abnormally spoiled units will be expensed on the
income statement in that period as a loss from abnormal spoilage. It is generally considered
that production management can control abnormal spoilage. Normal spoilage is expected to
occur and generally cannot be prevented. However, abnormal spoilage, by definition, should
not occur and should therefore be preventable
Cost / Unit = $2,200 / 5,500 = $0.4/Unit
Abnormal Spoilage = $0.4 × 200 = $80 Loss on Spoilage
Normal Spoilage= $2,200 - $80 = $2,120
$2,120 / 5,000 = $0.424 / Unit Allocated on COGS
Rework

When spoiled goods are fixed and prepared for sale, this is called rework. The costs
incurred in rework of normally spoiled goods should be charged to the factory overhead
account and allocated to all good units as part of factory overhead. Costs incurred in rework
of abnormally spoiled units should be expensed.
Scrape

Scrap related to a specific job is charged to the job’s work-in-process inventory account.
Scrap that is common to all jobs is charged to factory overhead. Scrap costs are not
separately accounted for, but if scrap is sold, either work-in-process inventory or overhead
is credited by the price received for the scrap
Waste

Waste is the material that is left over after production is complete. It is simply unused and is
now unusable materials.

Shrinkage
Shrinkage occurs when a product simply evaporates or losses some of its quantity through time.
We account for it in the same manner as spoilage – if it is normal it is charged to good units
produced and if it is abnormal it is charged to the income statement.
 Cost classified by cost system

Comparison between Job Order and Process Costing

Similarities
1. The manufacturing cost elements. Both costing systems track three manufacturing cost
elements (direct materials, direct labor, and manufacturing overhead)
2. Both systems then assign these costs to the same accounts (Work in Process, Finished
Goods Inventory, and Cost of Goods Sold)

Differences
 Life Cycle Costing

Life-cycle costing is used when a longer-term perspective is needed. This method

considers the entire life cycle of a product or service, from concept through sales and
warranty service, and is sometimes used on a strategic basis for cost planning and
product pricing, to enable the firm to focus on the overall costs for the product or
service.
 Case Study (43)

Business Soft Co. is about to launch a new product. The company expects a 6-year life cycle from the
moment it starts developing this product through its last sale and installation of the product. However, it also
expects to provide after-purchase services as part of the contract within and beyond this period. The
company's cost estimates are:

R&D $750,000
Design $500,000
Manufacturing costs $300,000
Marketing $200,000
$100,000
Distribution
$250,000
Customer service
$60,000
After-purchase
support

The company planes to produce and sell 1,500 installations of the product and would like to earn a 40%
mark-up over its life-cycle cost relating to this product. Also, the Company envisages that an average client
would incur around $500 of installation, training, operating, maintaining and disposal costs relating to usage
of this product. What is the expected total life- cycle cost per installation for Business Soft? And how much
do they need to charge per installation?
Answer:

The life-cycle costs to Business Software includes all of the upstream, manufacturing and
downstream related to this product (750,000 + 500,000 + 300,000 + 610,000) in total the life
cycle costs are $2,160,000.

With a required 40% mark-up (2,160,000 * 40%) $864,000. this mean that the total amount
that Business Soft need to charge for 1500 installation is $3,024,000 or $2,016 per
installation.

If the company charges $2016 per installation, it will be able to recover all of the life cycle
costs associated with this product and have s 40% mark-up on this cost.
R&D $750,000
Design $500,000
Manufacturing costs $300,000
Marketing $200,000
$100,000
Distribution
$250,000
Customer service
$60,000
After-purchase
support
Life Cycle Costing introduces the following terms:
1. Target Costing & Target Pricing

2. Term of Value Engineering

Is a mean of reducing targeted cost levels. Its purpose is to minimize costs without reducing
customer satisfaction by assessing all aspect of value chain cost

Value engineering seeks to

• Minimize non-value-added activities and their costs by reducing the cost drivers of these activities
• Minimize the costs of value-added activities by improving their efficiency
 Comparison between Traditional Costing System & Life Cycle *

Traditional Costing Life Cycle Costing

Is not a costing system but used for cost planning

Is a costing System
and product pricing
It sum up all revenues of a products upon many
Upstream and downstream costs are considered
periods and all the expenses including the upstream
to be period cost incurred and expensed in the
and downstream to give an overview of the
period.
profitability of the product
Is not approved by the GAAP but used for internal
Approved by the GAAP
management reporting

Consider after purchase costs paid by the customer

Does not consider any costs paid by the customer
(Repair) which is called Whole life cost

Whole life cost = Life cycle + After

purchase Cost by Customer
 Supply Chain Management

Supply chain management is the active management of

supply chain activities by the members of a supply chain with
the goals of maximizing customer value and achieving a
sustainable competitive advantage.

The supply chain firms endeavor to develop and run their

supply chains in the most effective and efficient ways
possible.
Supply chain activities cover product development, sourcing,
production, logistics, and the information systems needed to
coordinate the supply chain activities.
 Supply Chain Management

Some supply chain management goes so

far as the retailer allowing the distributor or
the distributor allowing the manufacturer to
manage its inventories, shipping product to
it automatically whenever its inventory of
an item gets low. Such a practice is called
supplier- managed or vendor-managed
inventory.
Lean resource management technique was developed from lean
manufacturing, that was developed in the late 1980s. This newer technique
can be applied to every process within a business organization, as well as
to service providers and government.

It is not just for manufacturing anymore. The focus is on resource

optimization. Some examples of resources include capital, human skills,
inventory, information, and production capabilities.
 Method Central Purpose Operational Benefits
The goal is to maximize customer value
while minimizing waste. Any
resource used for any goal other than
creating customer value is considered
waste and should be eliminated.
Created the idea of value-added from the
customer perspective. Five key steps are
in the process: Resource optimization
Lean Resource
1. Identify what creates value from the • Reduced waste
Management • Improved process flow
customer’s perspective
Techniques • Reduced costs
2. Identify all steps in the value stream
(Developed 2000s) • Increased customer value
(process) eliminate those that do not
create value
3. Make the value-creating steps flow
smoothly
4. Make only what is “pulled” by the
customer
5. Strive for perfection by continually
removing waste.
 Materials MRP requires production management ∙ Less coordination required between
Requirement to plan for what is needed, then “push” functional areas because
Planning (MRP) the product through production to reach everyone
(Developed 1960– a market. This process ensures that raw follows the master production
1970s) materials are available for production schedule and the bill of materials
and finished goods are available to the ∙ Reduce idle time and machine setup
customer, regardless of whether there is costs due to scheduling
demand or not improvements
∙ Predictable raw material needs allow
purchasing to take
advantage of bulk purchasing and
other price breaks
∙ More efficient inventory control may
reduce raw materials and/ or
finished goods, which
reduces inventorycarrying costs
 A comprehensive production and inventory
control methodology in which materials arrive
exactly as they are needed for each stage in
the production process.
Need is created by demand for the product.
So, demand “pulls” a product through the ∙ Creates obvious production
system. priorities
Just-in-Time Production organized in work cells that ∙ Reduced setup and
group related processes to create the final manufacturing lead time
Manufacturing
product. ∙ No overproduction Improved quality
(JIT)
(In US late 1970s) This organization creates multi- skilled control leads to fewer materials
workers. wasted
It requires strong relationships with ∙ Easier inventory control due to
reliable suppliers to ensure on-time lower or zero inventory levels
deliveries of high quality goods. ∙ Less paperwork

Uses a Kanban system that is a visual

record or card to signal the need for a specified
quantity of materials or parts to move from one
work cell to another, in sequence.
 ERP evolved from MRP to give ∙ Integrates many business processes to save
organizations an information time and expense
technology tool to combine and integrate ∙ Improved business effectiveness and
Enterprise
the various systems it uses into one efficiency
Resource ∙ Better and timelier decisions
comprehensive system to
Planning (ERP) ∙ More flexible and agile organization that can
(Developed 1990s) manage operations.
better adapt to change
Often includes modules for
accounting, human resources, supply chain, ∙ Improved data integrity and Security
and inventory. ∙ Improved collaboration between
organizational functions
Lean thinking is a new way of thinking about the roles of firms and functions in managing the
flow of value creation—called the “value stream”—from concept to the final customer. The
emphasis in lean thinking is on adding value to the customer while cutting out waste, or muda
in Japanese.

✔ “Adding value to the customer” is not the same thing as adding value to the product or
service. If extra options added to a product or service are not things the customer wants or is
willing to pay for, they may well add value to the product, but they do not add value to the
customer.

✔ “Muda” or “waste” is anything that does not add value to the customer or anything the
customer is not willing to pay for.

Identifying and eliminating waste is a primary focus of lean resource management. For example,
in manufacturing, the primary wasteful activities addressed by lean production include:
1. Over-production, that is, producing more items than can customers want.
2. Delay, or waiting for processing, and parts sitting in storage.
3. Transporting parts and materials from process to process or to various storage locations.
4. Over-processing, or doing more work on a part or product than is necessary.
5. Inventory, as in committing too much money and storage space to unsold parts or products.
6. Motion, or moving parts more than the minimum amount required to complete and ship them.
7. Making defective parts, that is, creating parts or products that are not sellable due to defects and
that must be discarded or reworked.
The five principles of lean manufacturing are described below. The phrases
“lean resource management” or “the lean process” are sometimes used to
imply that many of the techniques can be used by non-manufacturers.

1. Value involves identifying the features of the

product or service that are valuable for the customer.

2. Value stream requires

i. Examining every process within the production of a product,
ii. identifying processes that add value, and
iii. removing processes (if possible) that do not add value.
3- Flow and pull incorporates designing the
production process to be capable of maximizing the
flow of the product initiated by the pull of customer
demand (i.e., only produce what the customer wants).
This is where lean manufacturing and JIT principles
coincide.

4- Empowerment provides each employee with the knowledge and authority to

make valuable and timely decisions in order to
i. add customer value and
ii. eliminate waste from the process.

5- Perfection focuses on making incremental improvement in each

process with perfection as the goal.
Benefits of Lean Resource Management
•Quality performance, fewer defects, and rework.
•Fewer machine and process breakdowns.
•Lower levels of inventory.
•Less space required for manufacturing and storage.
•Greater efficiency and increased output per person-hour.
•Improved delivery performance.
•Greater customer satisfaction.
•Improved employee morale and involvement.
•Improved supplier relations.
•Lower costs due to elimination of waste leading to higher operating
income.
•Increased business because of increased customer responsiveness.
Kanban is a Japanese term for the visual
record or card initially used for this purpose.
E-Kanban applications provide an
automated approach that can be integrated
with communications and enterprise
resource planning systems.
Benefits Limitations
▪ JIT permits reductions in the cost of carrying
inventory,
▪ Because inventories are low, workers can trace
problems and defects to their source
and resolve them at the point where they ▪ defects caused at one workstation very quickly affect
originated. Because problems with quality are other workstations, so problems and defects must be
resolved quickly, the causes of rework, scrap, solved as quickly as possible.
and waste are eliminated, leading to improved ▪ Since inventory levels are kept low, raw materials received
quality. must be of the required quality and delivered on time
▪ Batch setup time is reduced, making ▪ The reduced inventory carries an increased risk of stockout
production of smaller batches more costs.
economical and leading to lower ▪ If the products produced have large or unpredictable market
manufacturing lead times. The fluctuations, a JIT system may not be able to reduce or
smaller batches and lower manufacturing lead eliminate overproduction and associated waste.
times enable inventory reductions and enable the ▪ JIT is not appropriate for high-mix manufacturing
company to respond quickly to changes in
environments, which may have thousands of products and
customer demand.
▪ JIT systems typically require less floor space
dozens of work centers.
than traditional factories do, leading to
reduced
facility costs.
Introduction to MRP, MRPII, and ERP

MRP, MRPII, and ERP systems are all integrated information systems that have evolved from early database
management systems.
•MRP stands for Material Requirements Planning
•MRPII refers to Manufacturing Resource Planning
•ERP stands for Enterprise Resource Planning

Material Requirements Planning (MRP) systems help determine what raw materials to order for
production, when to order them, and how much to order.

Manufacturing Resource Planning (MRPII)systemsfollowed MRPand added integration with finance and
personnel resources.

Enterprise Resource Planning (ERP) takes integration further by including all the systems of the
organization, not just the manufacturing systems. ERP systems address the problem of paper-based tasks that
cause information in organizations to be entered into systems that do not “talk” to one another.
Enterprise Resource Planning integrates all departments and functions across a company onto
a single computer system with a single database so that the information needed by all areas of the
company will be available to the people who need it for planning, manufacturing, order fulfillment, and
other purposes.
2. Material Requirement Planning MRP

The system of production traditionally used in manufacturing is materials requirements

planning (MRP), in which a product is "pushed" from the raw material stage through
to delivery. The premises underlying MRP Push- though systems include:
• Demand forecasts
- A production order specifying the quantities of materials, components, subunits, and
product inventories needed to meet the demand forecast.
- A materials order specifying the materials, components, and subunit tasks required to
produce a final product.

• Master production schedule “Bill of Material” dictates the quantities and timing of each part
to be produced. Once the scheduled production run begins, departments push output through a
system.
 Case Study (44)

Using MRP system, here is how a company might calculate subunits (parts) to
produce product P and offsets lead time. If 100 Units of product P are required.
Answer: Number of Raw material units to be purchased in order to produce 100 Unit of P

Once the data for product P deli every is known, a schedule can be created, specifying when all
parts must be ordered and received to meet the demand for product P.
 Advantages Disadvantages
• Predictable raw material needs
• Efficient inventory control
• Less coordination required
between • Potential inventory accumulation,
functional areas, everyone follow the bill
workstations may receive materials
of material
before they are ready to process them
• Scheduling improvements • Quality control problems may not be
• Quickresponse to new customer identified until items are shipped and
demand reach the end user.
• Less Raw Material Inventory
Accumulation and carrying costs
• Less Set up Costs
3. Manufacturing Resource Planning (MRPII)

An MRPII system is designed to centralize, integrate, and process information for effective decision
making in scheduling, design engineering, inventory management and cost control in manufacturing.
4. Enterprise Resource Planning (ERP)
Enterprise Resource Planning (ERP) is a successor to
Manufacturing Resource Planning. An ERP system is usually a
suite of integrated applications that is used to collect, store,
manage, and interpret data across the organization. Often the
information is available in real- time. The applications share data,
facilitating information flow among business functions.

ERP systems integrate the logistics, distribution, sales, marketing, customer service, human
resources, and all accounting and finance functions into a single system.

The main focus of an ERP system is tracking all business resources and commitments
regardless of where, when, or by whom they were entered into the system.
For example, a customer support representative using an ERP system would be able
to look up a customer’s order, see that the product the customer ordered is on
backorder due to a production delay, and provide an estimate for the delivery based on
the expected arrival of the required raw materials. Without the sales, support, and
production systems being tightly integrated through an ERP system, such a level of
customer service would be very difficult if not impossible to achieve.
Note: The major components of an ERP system are:
✔ Production planning
✔ Integrated logistics
✔ Accounting and finance
✔ Human resources
✔ Sales, distribution, and order management
Any subdivision of any of the above components is, by itself, not a component of an
ERP system.
Generally, separate financial and nonfinancial systems have the increased
potential to experience:
1. Different reporting results (requiring personnel to research discrepancies
instead of enhancing operations)
2. Inefficiencies

3. A lack of standardized purchasing among departments (i.e., departments not

taking advantage of quantity discounts)
 Benefits of ERP Systems
✔ Integrated back-office systems result in better customer service and
production and distribution efficiencies.
✔ Centralizing computing resources and IT staff reduces IT costs versus every department maintaining its own systems and
IT staff.
✔ Day-to-day operations are facilitated..
✔ Business processes can be monitored in new and different ways, such as with dashboards.
✔ Communication and coordination are improved across departments,
✔ Data duplication is reduced, and labor required to create, distribute, and use system outputs is reduced.
✔ Expenses can be better managed and controlled.
✔ Inventory management is facilitated. Detailed inventory
✔ The efficiency of financial reporting can be increased.
✔ Resource planning as a part of strategic planning is simplified. Senior management has access to the information it needs
to do strategic planning.

The disadvantages of traditional ERP

✔ Its extent and complexity, which make customization of the software difficult and costly.
 Current generation of ERP software (ERP II) has added front-office functions, which provide
the capability for smooth (and instant) interaction with the business processes of external parties
such as customers, suppliers, shareholders or other owners, creditors, and strategic allies (e.g., the
members of a trading community or other business association).

Accordingly, an ERP II system has the following interfaces with its back-office functions:
1. Supply-chain management applications for an organization focus on relationships extending from
its suppliers to its final customers. Issues addressed include distribution channels,
warehousing and other logistical matters, routing of shipments, and sales forecasting.
2. Customer relationship management applications extend to customer service, finance- related matters,
sales, and database creation and maintenance.

3. Partner relationship management applications connect the organization not only with such partners as
customers and suppliers but also with owners, creditors, and strategic allies (for example, other
members of a joint venture).
 Advantages of a Current ERPII System
1. Lower inventory costs
2. Better management of liquid assets
3. Reduced labor costs and greater productivity
4. Enhanced decision making
5. Elimination of data redundancy, centralization of data, and protection of data integrity
6. Avoidance of the costs of other means of addressing needed IT changes
7. Increased customer satisfaction
8. More rapid and flexible responses to changed circumstances
9. More effective supply chain management
10. Integration of global operations
11. Standardization and simplification of the decision-making process

Disadvantages of a Current ERP II System

1. Losses from an unsuccessful implementation, e.g., sales declines
2. Purchasing hardware, software, and services
3. Data conversion from legacy systems to the new integrated system (although
conversion software may help)
4. Training
5. Design of interfaces and customization
6. Software maintenance and upgrades
7. Salaries of employees working on the implementation
5. Outsourcing

Outsourcing allows a firm to capitalize on the expertise of another

company that is more efficient, effective, or knowledgeable at performing
a specialized task that is peripheral to the firm's core business
competencies. Common examples include information technology
services, human resources (such as benefit plan administration), and
customer service functions.

A “make versus buy” analysis examines the relevant costs of keeping activities in-
house versus outsourcing.

Some firms have extended the idea of outsourcing to contract manufacturing, in which
another company manufactures a portion of the first firm’s products. This can be successful
for both organizations if one has excess capacity or specific capabilities the other lacks.
Advantages Disadvantages

• Allows management and employees to • May cost more to go outside for specific
focus on core competencies and strategic expertise
revenue- generating activities • Can result in a loss of in-house expertise
• Improves efficiency and effectiveness by and capabilities
gaining outside expertise or economies of • Can reduce process control
• May reduce control over quality
scale
• May lead to less scheduling flexibility
• Provides access to current technologies
(depending on the external supplier)
at reasonable cost without the risk of • May result in less personalized service
obsolescence • Creates privacy and confidentiality issues
• Reduces expenses by gaining capabilities • Can result in giving knowledge away and lead
without incurring overhead costs (staffing, to competitors obtaining expertise, scale,
benefits, space) customers,
• Improves the quality and/or timeliness of • Potential for decreased employee morale and
products or services loyalty
Managerial Accounting- Cost Dep 110