Managerial Accounting 1

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course classifications, and course behavior. We talked about fixed costs and variable costs, and we said that variable costs are costs that vary with production quantity, which is different from fixed course. Very often students say fixed course are course that are fixed, which of course is true, but...

Fixed costs are costs that don't vary with the production quantity within a certain relevant range. So, costs are fixed if you produce one unit, costs are fixed if you produce a million units, costs are fixed if you produce...

10 million units but at some point you've gone outside the relevant range so if you're producing 10 million units then in that case you could say in that manufacturing facility that the costs are fixed like for example the rent or the interest payments or the property tax but the reason why we say within that relevant range because once you go beyond the relevant range

which it could be 10 million units, it could be 15 million units. Once we go beyond that, then what happens? The reason why I say it's not fixed anymore is because if you start making 15 million units now, maybe your insurance premium is now going to go up. Because the insurance company perceives that there's more risk now that you're producing 50% more units. But otherwise, if you make 5 billion or 10 million units, then...

The course is fixed on your insurance, for example. But once you go beyond that, and it could be 10 million, it could be 20 million, whatever the number is, then... the course might vary. Now the unit fixed course, the unit fixed course will decline as the number of units produced increases. So the total fixed course will stay constant within the relevant range, but the unit fixed course is going to decrease because the more units that you make...

the smaller the amount each unit produced is going to absorb. So if your total fixed costs are $10 million and you make one unit, then that one unit has to absorb the $10 million in fixed costs. If you make 10 million units, then each unit absorbs only $1. If you make 20 million units and each unit only absorbs 50 cents. So the unit fixed course will decrease with the level of production and the total fixed course though is going to remain the same.

So we describe variable course and fixed course as course behavior. That's what we're trying to understand is course behavior so that we can make decisions. We need to understand if we're going to discontinue product line B. or product line C or product line D, what's going to be the benefit? What costs are going to go away and which costs we're going to be stuck with? So in financial accounting,

We spend a lot of time studying past performance. We're looking at how much sales we generate, how much income we generate. But in managerial accounting, we're focusing on... They're gathering information for us as executives to make decisions. So we're not looking at past performance. We're not trying to evaluate past performance. It's helpful to have data from the past.

because like today we're going to talk about calculating the predetermined overhead rate. So we need to make some assumptions about how much overhead a particular product is going to absorb.

Because there's direct materials, direct labor, and manufacturing overhead. Now, manufacturing overhead includes indirect costs. Indirect costs, in this case, are indirect materials and indirect labor. The reason why they're indirect costs is because we can't trace them to a particular product. So direct materials and direct labor, you can trace those to a particular product. So in other words, when we talk about direct materials, we know...

how much plastic we use to make a particular product. That's something that we could easily establish. But what about, for example, indirect labor such as the salary that we pay the plant manager. We know that we have that expense, but how do we capture that? Because it's a shared course right the plant manager is responsible for managing all the production So we need to have an overhead rate to assign

those manufacturing overhead costs. So indirect labor is a good example of a course that is part of manufacturing overhead that we would want to allocate. direct labor or the people who are operating the machines in the factory. So you take this course, you develop your business plan. and you decide that you're going to manufacture a particular product, you need to understand what costs are associated with producing that product. How much are we going to pay laborers in the factory?

Now the salaries that we pay laborers, that's direct labor. The salaries that we pay, and that's a product cost, the salaries that we pay the executives in headquarters. or the salaries that we pay the salespeople, those are period costs. Those are non-manufacturing costs, which are also referred to as selling general and administrative. So we have to make a distinction.

We have to be familiar with these different terms and classifications because they're going to help us make decisions. A classic decision is should we make or should we buy the product? How do we know? There's, I think, an assumption that buying a product or sourcing a product is the right thing to do. That's not always the case.

You have to calculate the numbers and determine whether or not enough variable costs are going to go away that it makes sense to do that. So we need to understand, well, how much are we going to have to... paid to buy the product from somebody else and how much is it costing us now to make the product now you say how much is it costing us now now you think we should know that

You say, what do you mean how much it costs to make the product? We don't know that. I've been in a lot of factories where they have no idea what it costs to make the product. And they price the product at a point. where they think they could sell it and then a marketing organization could turn around and sell that to a retailer and hit a particular price point. But they really have no idea. And why? Because...

What we consider in accounting to be indirect and direct costs, costs that are easily traceable, even direct costs are challenging for some organizations to attract. So we need to understand that. We need to be able to say, I know that this is how much my direct materials are for product A, and this is the direct labor, and this is the manufacturing overhead.

These are my product costs, and you have to know that, okay, this is what it costs to make the product, and this is what it's going to cost to buy the product. And so we need to understand all these terms and classifications because if we don't know how to classify the course, then how are we going to, if we can't even classify them, then how are we going to determine what our course are?

Because remember the fixed costs are not going to go away So you might think well if we discontinued this line Then we're gonna the company overall is going to benefit well sales are gonna decrease because of that. And we say well, but our expenses are also going to decrease. But by how much? Because we're still going to have those fixed costs. And some course we consider to be sunk. Sunk course are those course that we've already incurred.

should not impact our decision to make or buy the product. So in other words, we've already spent a million dollars on equipment. That money, no matter what we do, if we continue to make the product, Or if we decide to buy the product from, let's say we're going to source the product from Albania or Turkey, then those course... are still expensed. We can't hide from them. We're stuck with those costs. We shouldn't consider that. Oh, we spent a million dollars on equipment.

Whether we discontinue the lie or we continue to make the lie, the million dollars is spent. So those costs are referred to as sunk costs. They shouldn't affect our future decisions. And it's challenging as managers because you keep thinking, we spent a million dollars. I know, you spend a million dollars, but there's nothing you can do to change that at this point. So continuing to make the product.

That doesn't necessarily help us. And if we don't make the product anymore, the fact that we spend a million dollars, that's irrelevant. That's irrelevant.

So we need to understand those costs. But now what I want to talk to you about is the difference between process costing and job costing. Because they're not the same. So process forcing, for example, is when a company produces many units of a single product. And they're basically the same. In fact, you could say that... These products are identical. So process costing is when you're producing large quantities of a single product that's identical.

So what that means is that we know what the costs are. We have a process. We know very well how much direct materials we're using, how much direct labor. What the manufacturing overhead costs are why because we're making them? 24 hours a day seven days a week. We've already made 50 million of them. We know what our costs are

So, I don't want to spend a lot of time talking about process forcing because we have that information. That's what we talked about last time is what are the direct materials. What is the direct labor? What is the manufacturing overhead? And that's what tells us our total manufacturing force. So that's assuming there's any reason why we could talk about that and those numbers.

And we kind of take that for granted is because we have a process costing system in place. So we're making millions and millions of the same unit. But job order costing is when we're making products. that are unique so that means each job essentially we need to course out each job so for example every job is made to order what would be a good example for example a wedding dress so if you're gonna if you have a business and this is what um

Even though we're talking about accounting and we're talking about it from an accountant's perspective, this is what small business people do even if they don't realize that it's job order costing. What happens if you go to a seamstress? And you say, I'm getting married and I want a dress. But you're not going to buy your dress at Macy's. Macy's is a very successful company and it's a nice place to shop but you decided that you want to have your dress made for you.

components and aspects about the dress that you wanted to have. So we saw the royal wedding. and you've got some ideas in your head and so you go to a seamstress and you say this is what i want and this is what i want the neckline to be and this is how much lace and so on well How does the seamstress know what to charge you? So what the seamstress is going to do is basically job order costing.

Now, probably, unless the psychiatrist took this course, probably the psychiatrist doesn't realize that that's what she's doing. But in reality, every job she's costing out. Each dress is unique because Christina has certain aspects of the dress that she wants. Matilda has certain aspects of the dress that she wants, and each dress is unique. That's the key about job order coursing. You say, well, how do I know if we're doing job order coursing? Well, if each job is unique.

Then it's job order costing. Now we still need to find out the same information. We still got to make the same decisions and assumptions around basically what are we trying to figure out? The total manufacturing cost. Which means what? We need to know what is the direct materials. So that means how much cotton are we using? How much lace are we using? How much linen are we using? So how many yards of linen are we using to make the dress?

For example, the same that we would in process Boston. Except for that, we know, because we make the same dress. We make a million dresses. And the only difference is some are small, some are medium, some are large. But we know that. Because why? Because we're making 500,000 small and 500,000 medium.

and 500,000 large. And so we know how much direct materials we're using. We know the direct labor. So we know how long the people are at the sewing machines, how long it takes them to... make address and we know because we're an ongoing concern we know what is the manufacturing overhead associated which remember the manufacturing overhead is the indirect materials and labor

Because remember, indirect costs are those that are difficult to trace back to a particular product. So in that factory, we might be making things other than dresses. Maybe we're making also shirts. but we still have one plant manager. So we need to somehow account for that. But that situation where we're making a large quantity of a single item, which is pretty much identical, that's process crossing. But you could make, if you're making dresses that are unique, that are custom order,

That's job order costing. You see the difference? So you don't know. You don't know beforehand how much direct materials is going to be used to make Christina's dress. You don't know how much direct materials are going to be used to make Bonita's dress. That's something that we gotta, when the person comes in, we gotta do some estimates. based on what they tell us their requirements are. So if it's a custom job, then that's job order costing. And so we need to have a...

what we refer to as a course sheet, a job course sheet. And the job course sheet is one that lists and a space for us to list how much direct materials we're going to use. how long it's going to take us to make the dress. Now, to make Christina's dress, it might be $25,000. To make Matilda's dress... It might be $35,000. So I'm assuming that we were gonna have it made by Vera Wang. No?

So, but you know, bear in mind, they sell her dresses, her clothes at Target, not Target, Kohl's. So you have to be careful because, you know, when you go to your wedding... And you say, let me tell you something about jaw board of course thing. My professor explained that to me and I, you know, even on my wedding day, I'm still thinking about this. You know that my dress. My dress is an example of job order forcing. My dress is a Vera Wang and they say I shop at Coles too!

and so so you need to you need to think of that what about another example of where you would do the job or the costing is for example if you're painting You're hiring a painter. Painters use job order forcing because let's say they're going to paint the inside of your house. You tell them you want to paint the bedrooms.

So in one house they go in there and there's two bedrooms. Another house, there's three bedrooms. Somebody else's house, there's four bedrooms. Some houses have five bedrooms. Some have six, seven. eight bedrooms So they want people ask them how much is it going to force to paint my bedrooms, but they can't say $1,500 they need to

do a job or a Porsche. And so they look at the square footage. Well, one person has two bedrooms, but the square footage is less. Another person we said has six bedrooms. The square footage is a lot more. And then, so you say, well, why? I don't get it. Like, why do we care? Why? The reason why we care is because in order for us to set price at which we could be profitable we need to know how much it's costing us and we can't just think about how much how much living

we're using to make the dress. Certainly direct materials could be a significant portion of the product cost. But how many hours is it going to take us? How much labor is involved? And what about the manufacturing overhead? Because we need to think about that. Because we might be able to cover the variable course, but then we forgot to take into account the fixed course. So...

Keep in mind that period course, which are the selling general and administrative, and product course can be both variable and fixed. That's just course behavior. So a period course can be fixed or it could be variable. And the same applies for product course. So if we're going to price out a dress, we need to understand... What are our non-manufacturing costs, if you will? What are our period costs? What are our selling general administrative? Because if we price it just enough to cover...

the direct materials and direct labor, but then we don't take into account the fact that we have rent that we have to pay. Suppose we have a dress shop. We have to make sure that we're taking that into account and that each dress that we sell is going to cover a portion of the rent. So that's why cost is so important, especially as entrepreneurs and small business people.

You need to know how much it costs you. You say, oh, I want to make sandwiches. Great. We're going to open up a sandwich shop. We're going to open up the... That's our sandwich shop and you guys we're gonna we're gonna form a Sub chapter s corporation and you're gonna all be shareholders in that corporation I'm going to give you all shares and in the corporation so I'm going to divide up the shares amongst myself and everybody on our team

So all of you, you're gonna get 45% and I'm gonna get 55%. Okay? So I'm not gonna give up control over the company. Right, Khalil? Come on, come on. I was born at night, but not last night, right? Come on. So we can open up this sandwich shop. Why not? Why not open up the sandwich shop? But then when you start to think about it, right, it's never as simple as it seems. Each sandwich is unique.

Isn't this job order course thing? Each sandwich is unique. How do you know how much to charge for a sandwich? Now at the end of the day, we could have a whole pile of money in the register. Maybe we're selling sandwiches for $5 or maybe even $10. But how do we know if that's enough to cover our costs? And that's why I want to take the time to talk to you about costs because...

It's not as simple as it sounds to say, well, what are my costs? Tell me. That's what we need to know. How much are our costs? Because we need to cover all of our costs. Ultimately, we want to be profitable. So if we're going to be profitable, that means we need to cover all of our costs. The direct course and the indirect course. The period course and the product course. So the rent, we have to pay the rent. So maybe $5 is not enough for a sandwich.

And you say well, maybe nobody would buy sandwiches for ten dollars. Well, maybe Maybe that means that we can't have a sandwich shop so that's why it's important well a lot of times we focus in the marketing class spend a lot of time talking about the price We talk a lot about price, about penetration pricing strategies and skimming pricing strategies and prestige pricing strategies, but the net effect is actually $5,000.

of work in process inventory. So in effect what we're doing is from the total manufacturing course, we're subtracting the $5,000 of work in process inventory. which leaves us with $310,000 of cost of goods manufacturing. Does that make sense? So we have to subtract the work in process because... The cost of goods manufactured is finished goods. Because remember we said that product costs are inventoryable costs. That means that we're not going to record those.

cost those expenses until at the time that it's sold. So what we're trying to do is to get the cost of goods manufactured total. so that we could calculate the cost of goods sold, which is a line item. This is just a schedule. This is our schedule. This is our worksheet, so that we could determine what is the cost of goods sold for our income statement.

And that's what we're going to do now. We're going to look at an abbreviated version of the income statement for this company. So now that we have the cost of goods manufactured, what we could do is calculate...

the course of goods sold based on the information that we're given. Let's see, we're going to the other side of this port here. Let's see, are we still able to... You can focus the camera over here. So we're looking at Swift Company and... No, I mean... This is their income statement. And this is for... month ending August 31st.

that we put on our income statement is the amount of sales. In this case, we're told in this scenario for Swift Company that for the month of August they had sales of $450,000. 450,000 US dollars. That's not too bad You wouldn't mind as an entrepreneur having a business that was generating sales of $450,000. But sales are not everything. We need to understand what are our expenses. So we're going to look at the product costs and we're also going to look at the period costs as well.

So we have the product course information that we need to calculate the cost of goods sold. Now, in this scenario, we're told that the value of the finished goods inventory is $40,000. So the finished goods inventory... as of August 1st, at the beginning of the month, is $40,000. So we have some product on hand, some finished goods that is in the warehouse.

and that's valued at forty thousand dollars but now we add in the cost of goods manufactured so we took the trouble to prepare that schedule And we need to add in the course of goods manufactured, which we calculated to be $310,000. This gives us the value of the goods available for sale. which is $350,000. So remember, what we're trying to calculate here is the cost of goods sold.

Let's go back here for a second. We found out what the total manufacturing costs were, which includes the direct material, the direct labor and the manufacturing overhead. We said that we need to net out the work and process inventory because those are partially completed products what we're trying to find out is the cost of goods sold well Presumably, you can't sell a product that's partially completed. So in this case, we've taken out the value of the working process inventory.

and therefore the course of goods manufactured is accurate and we record that here and we add that to the finished goods inventory. So we have finished goods inventory at the beginning of the month on August 1st. That's $40,000. That's the value of the finished goods. But we add to that, we add to that... The cost of goods manufactured. That's at the beginning of the month. This is the cost of goods manufactured for the entire month of August.

So we started with finished goods inventory. The prior month, whatever we produced, we didn't sell everything in this scenario. We were left with some inventory. In this case, it's valued at $40,000. Then we went on and introduced product this month. Remember we said that we bought $165,000 worth of plastic. We produced a lot of units. And at the end of the month... even after starting with $8,000 worth of plastic and purchasing $165,000 worth of plastic and having at that point

Raw materials available for use of $173,000. So $173,000 worth of plastic at the end of the month. we still had $13,000 worth of plastic, which means that we used $160,000 worth of plastic to make product. And that's what we're... We're capturing here, in part, that's the direct materials. And we've also captured direct labor and manufacturing overhead. So that total is $310,000.

And we add that to the finished good, the value of the finished goods from the prior month, which in this case is $40,000. And that gives us goods available for sale of $350,000. But we're not done. Because we need to look at the net remember this is the finished good at the beginning of the month so now we need to subtract the finished goods inventory at from the end of the month So we deduct the finished goods inventory That we had on August 31st and in this case

We're told that it's $60,000. And that means that our cost of goods sold is... $290,000. So we finally got to a point where these inventoryable product costs... These are all product costs, direct material, direct labor, manufacturing overhead. They're not period costs. That's going to be one of the following line items. So that's our cost of goods sold which is $290,000. And so we subtract the cost of goods sold from our sales. And that gives us a gross margin.

of $160,000. But then we got some period costs. These are non-manufacturing costs. So what we've talked about so far is the manufacturing cost, the direct materials, the direct labor and manufacturing overhead. And we've captured that here. in our course of goods manufacture, but now we need to address our period course, which are also known as selling, general, and administrative. Those are the non-manufactured course.

In this case, the selling general and administrative are $142,000. So that means for the month of August, We have net operating income of $18,000.

What are we capturing here in selling general and administrative? Those are all the period course, all the non-manufacturing course that we're incurring. So that's the money that we spent on advertising. the money that we paid our managers in corporate headquarters. We said, that's not what we paid the plant manager. The plant manager is part of manufacturing overhead.

Because that's a product course. But we don't capture that as direct labor. Direct labor is the course that we pay the people on the manufacturing line. The people that are tightening the bolts on the cars. That's direct labor and then those course we could tie back to the four tourists or the four expedition

So we're able to effectively allocate those costs to particular products. But we said that with the plant manager, well, the plant manager owns the entire plant. And the plant manager is responsible for not just the poor tourists. and the Ford Expedition, but the Ford Focus and other products in their portfolio. So the manager of the plant, that salary...

expense is captured as manufacturing overhead. And that's part of the cost of goods manufacturing. Selling general and administrative are all those non-manufacturing costs. We have to operate the corporate headquarters. That's where we're capturing what we pay the president and the CEO and the accountants. We gotta pay the accountants. They've gotta get paid. So their salary is part of selling general and administrative. So you see what we've done is.

We started off by talking about the different types of manufacturing costs, which we said we refer to them as product costs, the direct materials, direct labor, and manufacturing overhead. The manufacturing overhead we said includes indirect materials and indirect labor. The difference is that direct costs, like direct material or direct labor,

a course that we could easily trace to a particular product. Indirect materials and indirect labor are difficult to trace to a particular product. So indirect labor... would be, like you said, the manufacturing supervisor. It was a supervisor for the entire plant, or the plant manager. We don't want to lose sight of those. Those costs are important, but we capture that as manufacturing overhead. And those three combined are the total manufacturing costs.

And ultimately what we're trying to do by completing the schedule is to determine what is the cost of goods sold. So once we know the cost of goods manufactured. Right you see the difference so what what is actually happening here? What does this tell us? That we made right we made $18,000 for the month But what is the difference between the course of goods manufactured and the course of goods sold? So what does this tell us here? Here we said that the course of goods manufactured is $310,000.

But it says that the cost of goods sold, which is this, is $290,000. So the cost of goods sold. is 290,000. So let's see what does that actually indicate. The cost of the goods manufactured. So we manufacture a certain amount of product. That's $310,000. But the cost of goods not manufactured but sold is $290,000. So what happened there? How come those numbers are not the same? Absolutely. So we have some excess inventory. We have at the end of the month.

we have some finished good inventory and presumably that we have some work in progress, some partially completed goods. which is that's already reflected the net amount we subtracted from the course of goods manufacturing but so that's already been addressed but this suggests that as you're saying everything that we produced we didn't sell

That's not bad, per se. You don't want to make a lot more than what you're going to sell in a given month, but you have to hold some inventory because what happens very often is you're not able to produce the quantity that you need. for a given period in let's say a month so you have certain capacity limitations so you may need to build inventory for several months

So for example, let's say you're a company that sells giftable items. And in the fourth quarter, during the holiday season, you do a significant percentage of your business. Maybe even two-thirds or 75% of your business is done in the fourth quarter of the year. So what happens is that throughout the year, you're going to be... Yeah, you're going to be selling but you're also going to be creating inventory That's more than the amount that you're selling So you have to be able to hold inventory

Because when you reach October, November, and you get that huge demand for product, there's very often capacity limitations that's going to... There's just only so many items that you can make in a given month.

Absolutely. So think about, are you familiar with Tickle Me Elmo? It's like some sort of teddy bear or something, right? Stuffed animal. They start making Tickle Me Elmo for the next year in November. So everything that they're making in November in China of these stuffed animals are going to be sold in the next year. Why is that because it takes 45 days on a ship for the product to be shipped from China to the United States Well, if you ship that in November

You're not going to get the merchandise until the beginning of January. What are you going to do with that then? They ship your 50,000, you know, they ship Macy's 50,000 Tickle Me Yamo and you get that January 10th? What are you going to do with all of those? You miss the season. But what they do is they build the inventory, not Macy's, the manufacturer, and they hold it because they know once it reaches August.

They're going to get an order for 30 million Tickle Me Elmo. Well, you can't make that in a weekend. You have to make it in advance. Now, there's certain trade-offs. You could have, you could increase your manufacturing. capability so you can have more equipment. But let's say you've already reached what you consider to be the maximum. Maybe you already have a thousand sewing machines.

and you have over a thousand workers stitching these stuffed animals all day long. Does it make sense to open up another facility and hire another thousand people and buy another? thousand sewing machines. That's what we would need to decide. And that's what managerial accounting is all about, is about getting information to make decisions. about the future performance of the company. We said financial accounting is focused on the past performance.

When you're preparing the income statement, it's about what happened last month or last year. That's the focus of financial accounting and to analyze those results.

a variety of different ways certainly the financial statements are one way but then there's we could calculate financial ratios as well and do financial statement analysis but all of that is based on historical performance managerial accounting and what we're talking about today is about how managers are going to make decisions and the information

that they need to make those decisions. So that was the focus of today's lecture. Any questions? Are you good? Yeah. Are you great? Yeah. Because this stuff is directed in accounting. So I didn't know I was going to do it. All right. So as entrepreneurs, we need to... be the accountant, we need to be the sales manager, we need to be responsible, we need to be responsible for advertising.

Because early on, unless we have significant funding, we're not going to be able to hire all these people. So we need to be able to understand how to capture the information that we need. the cost in particular, we're talking a lot about the cost, we need to know what costs are we incurring so that we could minimize those costs where possible and make the company

more profitable. Because it's not just about sales. $450,000. Wow, we're going to be so excited, right? At first I said, yeah, I want that business. Then after everything... What are we left with? $18,000. No, $18,000 is not insignificant either. That's not, you know, that's not, remember, that's on net income. So presumably,

In the SG&A, the Selling General Administrative, you already paid yourself a salary for the month, but we're left with $18,000. But that's not as impressive as that $450,000 in sales. So what we want to understand is, for example, in another scenario, what would happen if one of the product lines would discontinue? had sales of $150,000. We need to ask ourselves, should we continue to make that product or should we discontinue making that product?

How is it going to impact the profit of the company? And if we do continue to sell that product, should we make it or should we buy it? In other words, should we outsource it? And we said that, well, it depends what percentage of the course are fixed and what percentage are variable. Because the fixed course are not going to go away.

So what's going to go away is that $150,000 in sales if we discontinue the line, but the fixed costs are still there. The variable costs are going to go away, but... for that particular product line, but not the fixed course. So we need to evaluate that scenario and similar scenarios so that we can make the right decisions.

Just like with the case that we looked at with Su Chen, the grocery store. You need to consider the shelf space productivity of the grocery store. So what items do you keep on the shelf? And if you have an item on the shelf that's delivering $5,000 in sales per month, then we have to ask ourselves, well, what if we took that item off and we put a different item there? impact the profitability of the company. So we'll talk more about cost and profit relationships within an organization.

Anything else?