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Decision making

A framework

A general approach to decision making

Step 1 Specify the decision problem, including the decision

makers goals

Step 2 Identify options

Step 3 Measure benefits (advantages) and costs

(disadvantages) to determine the value (benefits
reaped less costs incurred) of each option

Step 4 Make the decision, choosing the option with the

highest value

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Goals for class: cost terms and margins

Benefit received
Materials, labor, commissions, travel, advertising
Function supported
Manufacturing, marketing, research
Product versus period costs
Used in financial reporting
Helps figure out gross margin
Variable versus fixed costs
Helps understand how costs change with decisions
Computes contribution margin
Direct versus indirect costs
Helps attach costs to different units of analysis
Associated term is segment margin

Phelps Industries

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Q1: Explain the income statement

Not surprisingly, financial accounting documents are the

primary source for cost data

Underlying transactions are the same

Financial accounting groups these in a particular way to satisfy

its goals determining income, valuation and stewardship
Focus is on reliability and verifiability

Management accounting groups the transactions in a way that

facilitates decision making
Focus is on decision usefulness (relevance)

Costs: financial accounting

Costs in income statement are classified as per GAAP

Product cost All costs required to make a product ready for sale
Period cost Everything else
Product costs include
Materials and components
Labor
Manufacturing overhead (capacity costs)
Rent, depreciation, management costs,
Period costs include
Selling costs
Distribution costs
Administration costs

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Examples
Product or Why?
Period cost?
Raw materials

Factory rent

Sales commissions

Forklift used in distribution

center
Travel expenses for plant
manager
Cost of freight in

Overtime premium for direct

labor
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Connecting resources and inventory values

Cost flow is the generic term used to describe how and

when what we spend on inputs show up in the income
statement (i.e., become product and period costs)

Depends on the nature of the firm

Service firms / Merchandising / Manufacturing

Separate handout (in LMS) has the detail for each kind of firm
Review on your own (also in Chapter 3 of book)

Inventories play a crucial role in determining gross margins

Will discuss in detail later

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Cost flows: an overview

Materials Product costs

Materials
inventory

Labor Inventory of Cost of goods

Labor
control finished goods sold (COGS)

Capacity * Depreciation
Asset
(Machines) (part of mfg. overhead)

Period costs
Commissions
Period costs
Distribution

Administration

*Capacity costs are often termed as overhead

Typical presentation of data

Gross margin is the key term
here Item Amount
Revenue
The gross margin statement COGS*
Carefully distinguishes by whether
cost is manufacturing or marketing Gross margin
Does not care if cost is variable or
fixed Period costs
Net income
Employs allocations to charge
indirect costs to individual units * All product costs are lumped into
of specific products cost of goods sold (COGS)
Fixed manufacturing costs appear
above the line
Allocated to individual units of
each product

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So, for Phelps, we have:

Item Sub-item Amount Total Detail

Sales Revenue $1,800,000 15,000 units @ $120 / unit
- Product costs: Materials 300,000 @ $20 / unit
Labor 375,000 @ $25 / unit
Mfg. overhead 448,750 $1,123,750 Given
= Gross Margin $676,250
- Period costs Selling costs 36,000 @ 2% of revenue
Distribution 30,000 $2.00 per unit
Administration 280,000 346,000 Given
= Profit $330,250

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Overhead: A closer look

Firms typically allocate manufacturing overhead among

products
Attach a bit of overhead to each unit of every product
This procedure unitizes the overhead cost, allowing the cost
system to speak of a cost per unit

Overhead cost $448,750 Given

Machine hours 30,000 = 15,000 units * 2 hours / unit
Rate / Machine hour $ 14.96 = $ 448,750 / 30,000 hours
OH cost per unit $ 29.916 = 2 hrs./ unit * $14.958 / hour
Overhead in COGS $448,750 = 15,000 units * $29.916

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Points to note

The overhead cost reported in COGS and money spent on mfg.

overhead will not be same if there is a change in inventories of
goods
More in class 4 (see also chapter 9)
For product costs, cash outflow and costs depend on production volume
but expenses recognized in income statement depend on sales volume

The allocation also has non-trivial consequences if there are multiple

products
We get to this issue in Class 5 (See also Chapter 10)

In practice, some firms include labor cost in overhead

Typical textbook treatment is to consider labor as separate from overhead
We will consider it as variable and direct (to be defined later)

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Example: Effect of inventory

Suppose Phelps
had no beginning inventory
Produced 15,000 units but sold only 14,000 units
What is the amount in COGS? Value of closing inventory?

Materials and Labor cost per unit

Cost of units sold
Value of units in
inventory
Allocated Fixed overhead costs per unit
Cost of units sold
Units in inventory

COGS
Inventory 14

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Pictorially (GM Statement)

Panel A: Physical flow In Income Statement In Balance Sheet

Units Units into

produced Units sold
= 14,000 inventory
=15,000 = 1,000

Panel B: Variable costs

Spend
$675,000 on
COGS: $630,000 Inventory: $45,000
materials and
= 14,000 units * $45/unit = 1,000 units * $45/unit
labor

Panel C: Capacity (Manufacturing overhead) costs

Spend
$448,750 on COGS: $418,833
capacity costs Inventory = $29,917
= 14,000 units * 1,000 units * $29.916/
(fixed) $29.916/unit unit

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Why does GAAP unitize fixed costs?

Matching of revenues and costs is a core aim for GAAP

To make a product, we need
Materials and labor, which costs are proportional to production volume.
There are termed variable costs
Capacity resources. The cost of these resources is not proportional.
These are often termed fixed costs
When there is inventory, all of these cost apply to units in
inventory and units in COGS
Variable costs will split nicely in proportion to units
Fixed costs do not
So, we split the fixed cost between inventory and COGS by unitizing it
This process makes a FIXED cost look like a VARIABLE cost!

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Application to service firms

Distinction between product and period costs important for

manufacturing firms
Determines gross margin %, a measure of profitability
Classification determines inventory values

Distinction less important in service firms

There is minimal inventory of finished goods
All expenses flow directly to income statement!
Expenses mirror cash outflows for the most part
Many firms do not even break out gross margin
Profit = Revenue ALL expenses
Product versus period classification has limited use

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Cost flows: service firms

Labor
Labor
control Cost of Goods
sold (COGS)
Capacity * Depreciation
Asset
(Buildings) (overhead)

Commissions
Period costs
Distribution

Administration

*Capacity costs are often termed as overhead

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Q2: Income if we sell 20,000 units?

This exercise is useful for profit planning

How should we make this estimation?
This is the data we have (for 15,000 units; from earlier slides)
15,000 units
Sales Revenue $1,800,000
- Product costs: Materials 300,000
Labor 375,000
Mfg. overhead 448,750 $1,123,750
= Gross Margin $676,250
- Period costs Selling costs 36,000
Distribution 30,000
Administration 280,000 346,000
= Profit $330,250
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Q2: Income if we sell 20,000 units?

The key is to recognize that some costs will change and others
will not with volume

Usual classification
Variable costs change proportionately with volume
Fixed costs do not change as volume changes

We need to model cost behavior to get a good estimate!

We need to cut the data on a different dimension
Product and period cost is useful for accounting but not economics

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Variable and fixed costs

Variable costs Fixed costs
Product costs Materials Machine depreciation
Labor Supervisor salary
Other factory salaries
Power Maintenance
Oils and lubricants Utilities

Period costs Sales commissions Sales staff salaries

Distribution costs General administration

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Visualizing cost behavior

Cost TOTAL FIXED & VARIABLE Cost PER UNIT COSTS

Activity (units) Activity (units)

SCALE EFFECT Cost STEP COSTS
Cost

Activity
Activity (units)

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Presentation of data - Economic

Capture cost structure Item Amount
Contribution margin is the Revenue
key term here Variable costs
The contribution margin Contribution margin
statement
Fixed costs
Groups costs by fixed and
variable costs Net income
Does not care about type of
cost (mfg. vs. mktg.)
Treats indirect capacity
costs as being fixed
Suitable for economic
analysis of short-run decision
problems

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Classifying costs

Item Sub-item Amount 15,000 units Variable /

fixed?
Sales Revenue $1,800,000
- Product costs: Materials 300,000
Labor 375,000
Mfg. overhead 448,750 $1,123,750
= Gross Margin $676,250
- Period costs Selling costs 36,000
Distribution 30,000
Administration 280,000 346,000
= Profit $330,250

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Classifying overhead* (fixed and variable)

Machinedepreciation $115,000 Fixed

Supervisorsalary 80,000 Fixed
Factorysalaries 60,000 Fixed
Factorymaintenance 62,500 Fixed
Propertytaxesandutilities 15,000 Fixed $332,500
Powertooperatemachines 56,250 Variable
Oilsandlubricants 60,000 Variable $116,250
Totaloverheadcost* $448,750 $448,750

*Recall that overhead is the term for capacity costs

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A revised income statement (15,000 units)

Sales Revenue $1,800,000

- Variable costs Materials 300,000
Labor 375,000
Variable mfg. overhead 116,250
Commissions 36,000
Distribution 30,000 $857,250
= Contribution margin $942,750
- Fixed costs Manufacturing overhead 332,500
Selling & administration 280,000 612,500
= Profit $330,250

Variable cost per unit = $857,250 / 15,000 = $57.15

Variable cost ratio (VCR) = 47.625%
Contribution margin per unit = $942,750/15,000 = $62.85
Contribution margin ratio (CMR) = 52.375%
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Now, we are in business!

15,000 20,000 25,000

Sales Revenue $1,800,000 $2,400,000 $3,000,000
- Variable costs ($57.15/ unit) $857,250 1,143,000 $1,428,750
= Contribution margin $942,750 $1,257,000 $1,571,250
- Fixed costs 612,500 612,500 612,500
= Profit $330,250 $644,500 $958,750

Can express this relation as:

Profit = Unit CM * # of units Fixed cost
Can make the estimation more precise
Allow for step-fixed costs
Allow for curvature in costs

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Projecting income: Dont do this!

Current income = $330,250 / 15,000 units = $22.01 / unit

Units Income
15,000 $330,250
20,000 440,333
25,000 550,416

Current gross margin = $45.0833 / unit = $676,250 / 15,000 units

Units GM Period Profit

costs
15,000 $ 676,250 $346,000 $330,250
20,000 901,666 368,000 533,666
25,000 1,127,083 390,000 737,083

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Inventory & CM statements

Suppose Phelps
had no beginning inventory
Produced 15,000 units but sold only 14,000 units
What is the amount in closing inventory (under a CM statement)?
Variable mfg. costs
To units sold
To units in inventory

Fixed mfg. overhead costs (Not allocated)

To units sold
To units in inventory

Variable COGS
Inventory value
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Pictorially (CM Statement)

Panel A: Physical flow In Income Statement In Balance Sheet

Units
produced Units sold Units into inventory
=15,000 = 14,000 = 1,000

Panel B: Variable costs (materials + labor + variable mfg. OH)

Spend
$791,250 on COGS: $738,500 Inventory = $52,750
materials, = 14,000 units * $52.75 = 1,000 units * $52.75
labor and VOH per unit per unit

Panel C: Capacity (fixed manufacturing overhead) costs

Spend
$332,500 on Expensed $332,500 in
capacity costs Inventory = 0
income statement Not allocated to units
(fixed) (below CM line)

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Extension: general cost structure

The fixed / variable cut is a crude partition

Gets us most of the way in many situations

Often, we think of cost as occurring at levels of activity

Unit Proportional to volume of activity

Materials, fuel cost, commissions,

Batch Incurred once per batch.

Set up of OR. Check in guests. Account statements

Product / Associated with a particular product or process

Process Design, special equipment, patents, advertising

Facility Cost of doing business.

Property taxes, registration fees
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Q3: Adding a new product

Suppose adding a new product (sprockets) is expected to

trigger the following costs. Should we add this product?
Gears Sprockets Total (for
(12,000 units) the firm)
Price per sprocket $73.00
Materials cost / sprocket 25.00
Labor cost / sprocket 30.00
Variable overhead (1.5 machine hours per sprocket)
Power (15% of labor cost) $56,250
Oils ($2 per M. hr.) 60,000
Total 116,250
Fixed costs 332,500 67,500 $400,000

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The correct economic analysis

Consider incremental revenues and costs!
Relevance is the key concept at work
Will look at in detail in class #2 and #3

Change in () Detail Sprockets

Revenue
Materials
Labor
Variable power
Oils and lubricants
Selling commission
Distribution cost
Incremental CM
Additional fixed cost
Incremental profit
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Looking at gross margin is not OK

Let us first look at the GM for each product
Overhead rate = ($206,250 + $400,000) / (30,000 + 18,000 hours) = $12.63/hour
To each gear = 2 hours * $12.63 /hr.; To each sprocket: 1.5 hours * $12.63 / hr.
Gears Sprockets
(15,000 units @ (12,000 units @
2 hrs. per unit) 1.5 hrs. per unit )
Price (per unit) $120.00 $73.00
Materials 20.00 25.00
Labor 25.00 30.00
Overhead 25.26 18.95
Gross margin (GM) $ 49.74 ($0.95)

Gross margin (GM) of gears has gone up because we are now spreading the
(same amount of) fixed overhead over a larger base
Same idea as when we increased the volume of operations

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So, why is this not quite right?

Gears are using 30,000 hours and sprockets 18,000

62.5% of hours are in gears and 37.5% in sprockets
We will therefore charge 62.5% of the capacity cost to gears
and 37.5% to sprockets
$8.33 * 30,000 hours $250,000 62.5%
$8.33 * 18,000 hours $150,000 37.5%

But, the increase in overhead cost due to sprockets is NOT

37.5% of the revised overhead cost
The accountants allocation is just a way to spread the cost
Does not capture the economic reality

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More on relevance

A fixed cost may be relevant

Supervisor salary (a fixed cost) can be relevant if we are deciding whether
to keep or drop the entire product line

A variable cost need not be relevant

Commissions (a variable cost) can be the same and not relevant whether we
ship to market using trucks or by rail

A direct cost may not be relevant

Materials cost not relevant for outsourcing if we supply the materials

An indirect cost might be relevant

Utilities, laundry relevant for calculating cost of guest stay

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Q3: What is the profit from each line?

We can partition costs into traceable (direct) and non-

traceable (indirect) costs
Define traceability with respect to a particular cost object. Here, it is
products

From a decision making perspective,

High degree of confidence that traceable costs will change with
decisions that affect product
Lower degree of confidence about non-traceable or indirect costs

The associated term is segment margin

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Examples
Product or Direct or Indirect to a
Period cost? product?
Raw materials
Product
Factory rent
Product
Sales commissions
Period
Forklift used in distribution
center Period
Travel expenses for plant
manager Depends
Cost of freight in
Product
Overtime premium for direct Product
labor
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Traceable costs and segment margins

Costs differ in their traceability

Some variable costs are directly related to the product
Direct variable costs; Indirect variable costs also exist
Many fixed costs are indirect to the product
Some fixed costs are directly related to the product or sub-unit

Makes sense to capture this attribution in the presentation

Allows evaluation of segment contribution or divisional performance

Common fixed costs still exist

Might be a large item in a product context
Might be relatively small proportion when considering divisional
profitability

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Analysis of (fixed) overhead costs

Gears Sprockets Common Total
Depreciation $115,000 $115,000
Supervisor 80,000 40,000 120,000
Factory salaries 60,000 60,000
Maintenance 62,500 62,500
Utilities 5,000 5,000 10,000 20,000
Jigs and fixtures 22,500 22,500
Total $85,000 $67,500 $247,500 $400,000

Variable power (mfg. overhead) proportion to direct labor cost

Variable oils (mfg. overhead) proportional to # of hours
Variable selling expenses proportion to revenue
Variable distribution proportion to # of units

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Segment reporting
Gears Sprockets Total
(30,000 hrs.) (18,000 hours)
Revenue $1,800,000 $876,000 2,676,000
Variable Mfg. costs 791,250 750,000 1,541,250
Variable SGA costs 66,000 41,250 107,520
Contribution margin $942,750 $84,480 $1,027,230
Traceable fixed costs 85,000 67,500 152,500
Segment margin $857,750 $ 16,980 $ 874,730
Common fixed costs (Mfg.) 247,500
Common fixed costs (SGA) 280,000
Profit margin $ 347,230

Overall profit has gone up by $16,980

Segment margin for sprockets = incremental profit!
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Should we allocate common costs?

So, should we just ignore common fixed costs for decisions?

No!
Cannot restrict all decisions to contribution or segment margins
This focus is appropriate only for short-term decisions

Even the common fixed cost will change over time in

proportion to level of activity
Relevant for long-term decisions!

We use allocations to model this change

Details to come later (Class 4 and 5)

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What is coming down the road?

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Types of decisions

Two broad roles for management accounting in organizations:

planning and control

Goal of planning decisions is to effectively acquire and

efficiently use organizational resources

Goal of control decisions is to ensure the effectiveness and

efficiency of resource use

Effectiveness usually is more of a long-term concern, while

efficiency is more of a short-term concern

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Short- and long-term decisions

The controllability (the ability to change via a decision) of a cost or

benefit is time dependent

Capacity costs are of particular importance

Lumpy and indirect

Short-term
Capacity costs are not controllable. Not relevant for decisions

Long-term
Capacity costs are controllable. Relevant for decisions.

Accounting data tend to confuse the issue

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Transforming data
Short-run decisions
Period over which we cannot change capacity
The opportunity cost of capacity is still relevant
The link between historical and opportunity cost is broken
Historical capacity costs are not relevant for decision making
Decisions require that we strip out historical costs and put in opportunity
costs

Long-term decisions
Period over which we can change capacity
OC of capacity is relevant for decision making
We use accounting data on allocated costs to estimate OC
There is a link between historical and opportunity cost
But, the validity of this link is not always strong
Decisions require that we validate the link and, even then, use the data with
caution

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C = Chapter

Howdowematchthe Areweusing
supplyanddemandfor C11 resources
Long
Long resources?Class4,5 effectively?Class9,10
term (C9,C10) (C12,C13)
term

Short Howcanwegetthe Areweusing

Short mostfromavailable
Term
term C7
resources
resources?Class2,3 efficiently?Class6,7,8
(C4,C5,C6) (C8)

Planning Control

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A detour

Service Industries

Billing in consulting
JLR Enterprises provides the following data re its budget, the % of each cost traceable
to clients directly, and the detail for one client. The firm desires a total profit of
$640,000 before tax. The firm allocates overhead based on direct costs and tacks on a
markup for profit. (See last sheet in handout for problem)

Budgeted % traceable Detail for

cost to clients Martin Mfg.
(sample client)
Professional salaries $2,500,000 80% $41,000
Admin support staff 300,000 60% 2,600
Travel 250,000 90% 4,500
Photocopying 50,000 90% 500
Other operating costs 100,000 50% 1,400
Total $3,200,000 n/a $50,000

Question: How much should it bill Martin Manufacturing?

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Billing in consulting: Solution

First, let us separate the costs into traceable and non-traceable portions (using
clients as the cost object)

Budget Percent Traceable Non-traceable

traceable
Prof. salaries $2,500,000 80% 2,000,000 500,000
Admin staff 300,000 60% 180,000 120,000
Travel 250,000 90% 225,000 25,000
Photocopying 50,000 90% 45,000 5,000
Other costs 100,000 50% 50,000 50,000
Total $3,200,000 n/a 2,500,000 700,000

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Bill to Martin Manufacturing

Total direct/traceable costs $2,500,000

Indirect/non-traceable costs $700,000

Overhead rate (indirect / traceable) 28% of traceable costs

Mark up percentage (= $640/$3200) 20% of total costs

Billing for Martin Manufacturing

Traceable costs = $50,000
Overhead charge @ 28% = 14,000
Total costs = 64,000
Mark-up @ 20% = 12,800
Bill amount = $76,800

Notice that OH rates are being used to determine cost

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Example: JLR Enterprises

JLR Enterprises provides consulting services throughout California and uses job-order
costing system to accumulate the cost of client projects. In contrast, other costs incurred
by JLT, but not identifiable with specific clients are charged to jobs using a
predetermined overhead application rate. Clients are billed directly for chargeable costs,
overhead, and a markup. JLRs director of cost management, Brent Dean, anticipates the
following costs for the upcoming year:

Percentage of cost
Directly Traceable to
Cost Clients
Professional staff salaries $2,500,000 80%
Administrative support
staff 300,000 60%
Travel 250,000 90%
Photocopying 50,000 90%
Other operating costs 100,000 50%
Total $3,200,000

The firm desires to make a $640,000 profit for the firm and adds a percentage markup on
total cost to achieve that figure.

During the year, JLR received a proposal from Martin Inc. for a project. The following
costs are expected for this project: professional staff salaries, $41,000; administrative
support staff, $2,600; travel, $4,500; photocopying, $500; and other operating costs,
$1,400.

Required:

1. Determine JLRs total traceable costs for the upcoming year and the firms total
anticipated overhead
2. Calculate the predetermined overhead rate. The rate is based on total costs
traceable to client jobs.
3. What percentage of cost will JLR add to each job to achieve its profit target?
4. Determine the total cost of the Martin project. How much would Martin be quoted
for the project for the company?