IMSE 577 Accounting Notes – L.T. Moore and modified by R.C. Creese-revised 01/09, 02/10, 1/27/03, 12/23/03, 1/26/04, 1/8/05
ACCOUNTING AND COSTING FUNDAMENTALS
By
L. T. Moore
for
IMSE 577- Advanced Engineering Economics
Instructor:
Dr. R. C. Creese
Editing has been done by Ashutosh Nandeshwar, January 2003
Table of Contents
ACCOUNTING AND COSTING FUNDAMENTALS 4
Purpose 4
Imputed Costs 4
Observed Costs 5
Overhead Costs 7
Accounting Costs and the I.E. 11
Accounting 12
Accounting Categories 12
Tracking Account Values 15
Account Tracking 16
Accounting Statements 23
Interpretation of the Financial Statements 25
Assets Analysis and Variation 28
Liabilities and Equities 29
Debt Justification and ROI 30
Income Statement 31
Financial Flows 32
Analysis of Flows of Funds 35
Supplier Flows 36
Inventory Flows 36
Budgeting 40
Summary 42
PROBLEMS 43
List of Tables
Table A.1 Glop Resource Standards 6
Table A.2 Glop Standard Costs 6
Table A.3 Rolb Resource Standards 9
Table A.4 Balance Sheet Template 23
Table A.5 Income Statement Template 23
Table A.6 GHK Balance Sheets at Start and End of Year 20xx 24
Table A.7 GHK Income Statement for Year 20xx 25
Table A.8 Common Accounting Depreciation Schedule 29
Table A.9 Ending Balance Sheet Derived From Figure A.4 40
Table A.10 Cash Budget for Lemohr Corporation (units $1,000) 41
List of Figures
Figure A.1 Manufacturing Cost Transactions 16
Figure A.2 Numerical Example of Transactions 18
Figure A.3 Financial Flows for Lemohr Corporation (in $1,000) 33
Figure A.4. Before/ After Balances for Lemohr Corporation (in $1,000) 39
Figure A.5. Financial Flows for Snarko, Inc (in $1,000) 46
Figure 1. Transactions Template with Starting Balances 49
ACCOUNTING AND COSTING FUNDAMENTALS
Purpose
Industrial engineers deal with costs throughout their working lives. They find themselves faced with choices between candidate procedures for accomplishing desired ends, and they must make intelligent decisions based upon objective criteria. The usual reason for making a choice is that it costs less or produces higher profit. Since profit is defined as
Profit = Revenues - Costs
both increasing profits and decreasing costs require well-understood costs. Thus, I.E.’s need a background in what costs are and how they are obtained, along with the terminologies and procedures used by disciplines that deal with costs.
Unfortunately, it has been found that some of the common approaches to cost-related topics, such as asset valuation and product costing, may require revision before they can be used in decision making by I.E.’s. This limitation of common procedures, especially those employed by accountants, requires a knowledge of the way accountants do their work. For this reason, basic accounting ideas and costing methods are explained in this chapter, as will other approaches I.E.’s will find more compatible to their decision making.
There is yet another important reason for studying accounting lore; the basic terminologies of money and investment are based in accounting. Financial decision making is rooted in the numbers produced by standard accounting procedures, as are the financial ratios used to describe the health or viability of a firm. Accounting procedures are also the basis of depreciation and tax calculations. Thus, a basic knowledge of accounting is indispensable, even ignoring its relation to cost assessment.
Part of the understanding of costs and, therefore, profits is based on a knowledge of tax law and budgeting. In this chapter, taxes will not be stressed; this topic will be left for coverage by other text materials. However, budgeting will be discussed, along with its relation to cost planning and to accounting categories.
From this chapter the student should obtain a background in accounting and costing sufficient for application to financial decisions, taxes, product mix analysis, and production/inventory scheduling.
Imputed Costs
First, let us examine some basic concepts that underlie both the accounting and engineering viewpoints. Costs are observed or imputed expenditures incurred by financial entities. Our primary concern is with costs of operating companies, especially manufacturing companies. Observed costs are simply monies paid out or promised, such as salaries. Imputed costs are attached to money and monetary equivalents to indicate implicit cost of doing business. Such costs include the time value of money (TVM), the minimum attractive rate of return (MARR), and the opportunity cost associated with tying up funds instead of leaving them available for investment.
The TVM and MARR concepts are treated elsewhere within this course. Opportunity
cost is the rate of return funds could earn a company, were they available. This rate is commonly determined by a firm to be that of the best segment of its business, so the number may be very high, say 45%. Any of these implicit values of money may be used to assign finance costs to capital-intensive activities, as may yet additional rates.
The best example of the use of such an implicit cost in business it its application to inventories. Inventories are simply materials, supplies, partially finished products, and finished goods. All of these inventories represent money that has been spent to acquire or to work on these items, so they represent capital that could have been invested otherwise. People commonly attach holding costs to inventories to weigh their effect on costs of operations.
Holding costs should logically include the costs of warehousing and handling inventories along with the imputed cost of capital. Since the holding costs assumed at most firms are high, there is considerable motivation to hold inventories to a minimum. For example, it a firm believes its holding cost rate is 20%, this means that a $100 item costs $20 to be held for a year. Few products net a profit of 20%, so the firm would be under pressure to avoid holding items in inventory for long.
Observed Costs
It is clear that a prerequisite for the calculation of holding costs is the assignment of the value of the inventories. There are several possible components of the value assigned to inventories and diverse ways to calculate the value. Accountants often use procedures that may make their inventory valuations inappropriate for decisions made by engineers. To provide a basis for deciding how to value inventories, the likely cost components are discussed below. Since finished goods make up one category of inventory, this discussion will also show how to calculate the cost base of a finished product.
One costs of doing business that may be very important is called a setup (or order) cost. This is a direct cost incurred each time a new lot of items is ordered or produced. For instance, if a men’s store orders 100 suits, it will require the time and effort of personnel to place the order, do the paperwork, and the handle the order when it arrives. These order costs must be added to the purchase cost of the lot of 100 suits to obtain an accurate picture of their total costs.
Similarly, when a manufacturer produces a lot of some product, money must be spent to find and queue materials and to tool up the production line for that specific product. Again, these setup costs must be added to all the other product expenses to obtain an accurate total cost per unit of the product.
The remaining direct cost incurred by a product is dominated by materials, labor, and equipment expenses. Since these costs commonly vary as the number of units produced varies, they are called variable costs. Let one consider a short list of such costs:
direct labor
direct materials
machine time
Example A.1 Product Cost Calculations
If a product is well understood, its requirements of these costly inputs will be expressed as standards. A brief example has been concocted where a firm makes glops. Our firm makes glops. The developed standards are shown below. The numbers represent predictions of average resource consumption by production.
Table A.1 Glop Resource Standards
Input / StandardLabor / 3 hours/unit
Material / 2 pounds/unit
Machine time / 1 hour/unit
The standards are in physical units, not dollars. There are two reasons for this fact: 1) production people must plan and track physical quantities; and 2) costs of resources may vary. To find dollar cost estimates, one simply multiply current costs times their respective standards.
In preparing dollar cost of variable resources, one must include only the costs that clearly vary with production level. Therefore, fixed costs and unexpected costs are logically excluded from costs of variable resources. For instance, machine time costs might include costs of electricity usage and maintenance that vary as production but would not include the fixed cost of leasing equipment. In this case the costs and standard costs are as follows.
Labor costs / $ 8.00/hourMaterial costs / $ 1.00/pound
Machine time costs / $ 4.00/hour
Thus, standard variable costs are
Table A.2 Glop Standard Costs
Input / Standard CostLabor / $ 24.00
Material / $ 2.00
Machine time / $ 4.00
Unit Standard Variable Cost / $ 30.00
If one was to make glops at an actual variable cost of $30.00 per unit, that would be operating at standard, i.e., as predicted. If one was making a new product and was trying to guess how much it might cost, one would have to develop an estimating procedure, and then our predicted costs would not be a standard cost but an estimated cost. Estimates work just like standard cost but is considerable less certain, which is more variable.
Let us assume that 80 glops are made in a single production run and that the setup cost for that run is $80.00. Then the total direct cost per unit would be
setup cost/unit + standard cost = $80/80 + $30
= $1 + $30
= $31
In addition, assume a 20% per annum holding cost. Then each glop held in stock for a year would cost
0.2 x $31 = $6.20
in holding costs.
Variable costs will rarely adhere to standard exactly. Each similar production run will actually cost a little more or less. These divergences from standard are called variances. As long as variances average to about zero over time, they are not worrisome, but, if resource utilizations continue to exceed standards, an I.E. must investigate to discover why the process has changed. This is because standards should predict average consumption of resources by production, and, if they no longer do so, they must be adjusted until they do.
In many cases the direct costs cited above are considered the primary costs of interest to a decision maker because they represent the main “controllable” costs. That is, if fewer units are produced, total variable costs decline. However, the setup cost per unit become important if lot sizes are too small, and total holding costs may be oppressive if inventories are too large.
One important exceptional instance should be cited. In some cases, production lot sizes are so constant in size, or so numerous, that management feels the setup cost can be absorbed into variable costs as an average setup cost per unit. In this case, no separate setup cost would be employed. For instance, if glops are always made in 80-unit lots, the setup cost could be abandoned while revising the standard variable cost to $31/unit.
Using the direct costs alone to represent product costs is called direct costing. It lends itself well to certain decision making instances. However, there are other commonly used methods of product costing, and these will be discussed within the context of accounting procedures.
The costs discussed so far provide a manager with a method for attaching a dollar cost figure to a unit of production. Knowledge of meaningful product costs is essential to intelligent product mix decisions. However, even more important is an understanding of overall corporate profit, and direct costs alone may not provide a clear picture of corporate costs because of the role of overhead.
Overhead Costs
Many expenses in a business are difficult to relate directly to variable levels of activity. Such expenses include staff salaries, advertising, outside services, stockroom purchases, and rent. Most of these costs are period costs, that is, they are about the same each accounting period. Others are simply unexpected. All such nonvariable and nondirect costs are generically referred to as overhead.
Some overhead costs are clearly incurred by specific activities, especially manufacturing. For instance, costs of maintaining production equipment should be classes as manufacturing overhead. All other overhead is nonmanufacturing overhead by default.
The logical problem presented by overhead costs is how and whether to associate them with the cost of making products. One method for doing this that is common among accountants is to allow manufacturing overhead to be “absorbed” by products. This method presents a number of difficulties in accurately costing products, but, if overhead costs are a large percentage of total costs, it seems reasonable to allocate some of these costs to production. The most common method for allocating manufacturing overhead to products is through the use of a predetermined overhead rate.
Example A.2 One-Product Overhead Allocation
This approach to cost absorption can be demonstrated in the example of the production of glops. Assume the following breakdown of overhead costs for the upcoming planning year:
Manufacturing overhead / $ 600,000Nonmanufacturing overhead / $ 400,000
Total overhead / $ 1,000,000
Further assume that 60,000 glops are expected to be produced over the planning year. Then the manufacturing overhead each glop needs to absorb is
$600,000/60,000 = $10
One could logically assign the $10 to each unit, or $3.33 to each labor hour, or $5 to each pound of material, or $10 to each hour of machine time. Each procedure gives the same result under the assumption of standard production of 60,000 glops and the expenditure of the assumed overhead.
Now visualize the cost per unit as having become
setup/unit + standard cost + allocated over head =
$1 + $30 + $10 = $41
The effect on holding cost can be seen in that now a unit held in inventory for a year costs
0.2 x $41 = $8.20
in holding costs. The higher the cost base of an item, the higher its holding cost, thus the choice of cost base must be chosen carefully in order to avoid distortions of holding cost calculations.