Financial Ratios Formuleeee

8/8/2019 Financial Ratios Formuleeee

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Financial Ratios Calculator Ratio Formulae

Ratio Formula

Current Ratio Total Current Assets Total Current Liabilities

Quick (Acid Test) Ratio (Cash + Net Receivables) Total Current Liabilities

Current Liabilities to Net Worth Total Current Liabilities Net Worth

Current Liabilities to Inventory Total Current Liabilities Inventory

Sales to Receivables Net Sales Net Receivables

Days' Receivables 365 (Net Sales Net Receivables)

Cost of Sales to Inventory Cost of Sales Inventory

Days' Inventory 365 (Cost of Sales Inventory)

Cost of Sales to Payables Cost of Sales Accounts Payable

Days' Payables 365 (Cost of Sales Accounts Payable)

Total Liabilities to Net Worth Total Liabilities Net Worth

Total Liabilities to Tangible NetWorth

Total Liabilities (Net Worth - Intangible Assets -Goodwill)

Fixed Assets to Net Worth Fixed Assets Net Worth

Fixed Assets to Tangible Net Worth Fixed Assets (Net Worth - Intangible Assets -Goodwill)

Collection Period (Net Receivables Net Sales) * 365

Sales to Inventory Net Sales Inventory

Sales to Fixed Assets Net Sales Fixed Assets

Sales to Total Assets Net Sales Total Assets

Assets to Sales Total Assets Net Sales

Sales to Net Working Capital Net Sales (Current Assets - Current Liabilities)

Accounts Payable to Sales Accounts Payable Net Sales

% Profits Before Taxes to Tangible Net Worth

(Earnings Before Taxes (Net Worth - IntangibleAssets - Goodwill))*100

% Profit Before Taxes to Total Assets (Earnings Before Taxes Total Assets)*100


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Return on Sales (Profit Margin) Net Profit Net Sales

Return on Assets Net Profit Total Assets

Return on Net Worth (Return onEquity) Net Profit Net Worth

Earnings Before Interest & Taxes(EBIT) to Interest Earnings Before Interest & Taxes Interest Expense

Net Worth is defined as the value of Total Stockholders Equity

We lcom e to M iddl eC ity - F r ee On line A ccou nti ng T utorial

H OME

Fr ee T utorials 1 Introduction

2 Financial

Statements 3 Journals

4 Accruals

5 Reports

6 Merchandising

7 Financial Assets

8 Inventory

9 Plant Assets

10 Liabilities

11 Stockholders'

Equity 12 Income and

Retained Earnings 13 Statement of

Cash Flows 14 Financial

Analysis 16 Management

Accounting 17 Job Costing

18 Process Costing

20 CVP

21 Incremental

Analysis 23 Operational

Ch apt er 20 C ost -Volum e-P rofit An alysis

Ch apt er 19 introduces cost-volume-profit analysis.

CVP Analysis is a way to quickly answer a number of important questions about the profitability of a company's products or services. CVP Analysis can be used with either a product or service. Our examples will usually involve businesses that produce products, since they are often more complexsituations. Service businesses (health care, accounting, barbers & beauty shops, auto repair, etc.) canalso use CVP Analysis.

It involves three elements:

1. Cost - the cost of making the product or providing a service 2. Volume - the number of units of products produced or hours/units of service delivered3. Profit - Selling Price of product/service - Cost to make product/provide service = Operating

Profit

The first two items are information available to business managers, about their own business, products and services. This type of information is not generally available to those outside the business. They constitute important operating information that can help managers asses past performance, plan for the future, and monitor current progress. As for the third item, a business can'tstay in business very long without profits.

It is important to know whether the company is profitable as a whole. It is also important to know if a particular product is profitable. A business that sells 100 or more different products may lose sightof a single product. If that product becomes unprofitable (selling for less than the cost to produce &sell), the company will lose money on each and every sale of that product. The company might raisethe selling price, cut production costs or discontinue the product entirely. Building a business with100 products we know are profitable is good management. CVP & variable costing provide the toolsto make this happen in a real business.

A successful business can be built around a single profitable product. It can also be built aroundhundreds or thousands of profitable products. Many businesses start small and grow over time,


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Budgeting

24 Standard Costs

adding products as they gain experience and are able to identify and/or develop new markets and products. No matter the size of the business or the number of products, the same rules apply. Each product must "carry its own weight" for the business to be profitable.

Using CVP Analysis we can analyze a single product, a group of products, or evaluate the entire business as a whole. The ability to work across the entire product line in this way gives us a

powerful tool to analyze financial information. It provides us with day-to-day techniques that areeasy to understand and easy to use. The concepts parallel the real world, so they are easy to visualizeand use. The math is very simple - no complex formulae or techniques. Just simple formulae thatcan be easily modified to analyze a large variety of situations.

Q uiz Yours elf CVP Analysis is important because: a. the teacher says so.

b. it sounds cool to say "see vee pee".c. it is a good way to analyze the profitability of a company's products or services. d. I haven't a clue.

Click for answer

CVP R elatio nships Cost - product cost, consisting of materials, labor, overhead, etc. Volume - number of units of product sold in a given period of time Profit - Selling Price minus Cost, per unit or in total

The greater the volume, the greater the TOTAL profit.

Approac he s to product costs F ull Costi ng is used in financial accounting. The full cost of a product includes materials, labor andmanufacturing overhead. Not included: Selling and administrative costs.

Variabl e C osti ng is used in managerial accounting. Costs are classified as either Variable or Fixed,depending on their Cost Beh avior .

Cost Beh avior Costs are classified according to how they behave, in relation to units of production.

CAUTION : Cost behavior can be viewed in terms of total costs or unit costs . Both approaches be used, but they are not interchangeable.

Fixed Costs T otal Fixed Costs - stay essentially the same month to month, regardless of the number of units

produced.

Un it F ixed Costs - goes down as production goes up


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Variabl e C osts T otal Variabl e C osts - go up and down in direct proportion to units produced.

Un it Variabl e C osts - stay the same regardless of how many units are produced.

Accounting information is captured once by the accounting system. In Accounting I you learnedhow to analyze transactions, record journal entries, post to the ledger accounts and prepare financialstatements for use by those outside the company. That is one way to organize accountinginformation, but it is not the only way. That same information can be organized in many differentways. In this section we are going to simplify the process greatly. Our topic is Cost-Volume-Profit,so we will focus on income statement accounts, Revenues and Expenses. For now we can ignore

balance sheet accounts.

Managers focus on income statement accounts because these are the ones affected by day-to-dayoperating activities. Companies produce/purchase and sell products or services. Companies mayuses hundreds of income statement accounts to track all their different types of revenues andexpenses. We are going to simplify the income statement by dividing all expenses into one of twocategories: Variable and Fixed. To master this material you need to master these two concepts.

VA R IABLE COSTING - in gene ral CVP Analysis uses Variable Costing concepts. In this context we will divide ALL costs into one of two categories: Variable or Fixed. We refer to this as "cost behavior." In CVP Analysis cost

behavior will be discussed on BOTH a total cost and per un it basis. The facts will remain the sam but the behavior will appear different, depending on the context. Read carefully, especially onexams and in problems, so you understand the context of the question/problem: total cost or peunit. Since CVP Analysis can answer questions about both, we will switch back and forth frequentlyin our discussion. Tighten you "thinking bolts" and read carefully in this section.

In CVP Analysis we assume that the number of units produced equals the number of units sold. Inother words, we factor out changes in inventory during a production period. In the "real world"managers often include inventory changes & income taxes in CVP Analysis. In this course we willignore both inventory changes and income taxes. Here, you should gain a basic working knowledgeof CVP Analysis fundamentals.

VA R IABLE COSTS (VC) Total Variable Costs increase in direct proportion to production/sales. Unit Variable Costs stay the same as production fluctuates within the relevant range.

EXAMPLE: Mike's Bikes builds the X-Racer from its inventory of parts. Each bicycle is made up of the following parts:

y frame (1) y seat (1) y handlebars (1) y wheels (2) y tires (2) y gears & shifting system (1) y brakes & braking system (1)

Parts prices vary over time. Currently the cost to produce one bicycle is $70.

UNITS of Product : X- Rac er Cost Pe r Un it Total Costs


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1 bicycl e = $70 1 bicycl e @ $70= $70

1 bicycl e = $70 2 bicycl es @ $70= $140

1 bicycl e = $70 3 bicycl es @ $70= $210

Per Unit costs stay the same; total costs increase in direct proportion to the number of units produced or sold (sales or production volume). The R eleva nt Ra nge is the number of units that c be produced or sold under normal circumstances. That might vary due to seasonal demand or factorycapacity. To go beyond the relevant range would generally require the additional of moreequipment, buildings, personnel, etc. and that would cause a change in all costs. We presume thatwe are working within the relevant range when doing CVP Analysis. This makes the task mucheasier. It also helps us understand when we will need to address the need to expand our business.

Variabl e C osts include any total cost that vari es in dir ect proportio n to volum e. Thesecommonly include:

y component parts, packaging, etc. y production labor y sales commissions (percentage or per unit basis) y other costs allocated on a per unit basis

FIXED COSTS (FC) Total Fixed Costs (FC) do not change as production/sales increases. Unit Fixed Costs decrease as production increases within the relevant range.

Ask yourself this question: Would a cost be zero if production was zero? If the answer is NO, youare looking at a fixed cost. A common example would be rent on a building. The company must pay

rent on the building even if it sells no products in a given month! Some other common costs thatfollow this pattern are:

y managers & executives salaries y insurance y advertising y real estate & property taxes y security service y cleaning & maintenance costs y depreciation expense on buildings, vehicles & equipment

EXAMPLE: Mike's Bikes spends $5,000 per month in fixed costs.

If the y mak e X bicycl es per mo nth.... the ir fixed costs PE R UNIT w ill be...... 1,000 bicycles $5,000 / 1,000 bicycles = $5.00 per bicycle 2,000 bicycles $5,000 / 2,000 bicycles = $2.50 per bicycle 3,000 bicycles $5,000 / 3,000 bicycles = $1.67 per bicycle 4,000 bicycles ????????? Q uick Q uiz try the se on your own 5,000 bicycles ????????? Click for answers

Q uick Q uiz


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Do T otal Fixed Costs change as production goes up? Click for answer

Since Fixed Cost per Unit goes down as sales/production go up, it is always a good idea tosell/produce more units. In the real world, companies try to produce approximately the same number of units they expect to sell in a given period of time. If you think about the computer industry youwill see how important this can be. If a computer company manufactures too many units it may have

a stock of merchandise that is hard to sell as new computer chips are introduced to the market. Itmay have to sell its products at a discount or even at a loss to liquidate its inventory. Chapter 8discusses "Just In Time" (JIT) inventory management, which is used to help reduce inventory costs,

by having parts delivered "just in time" to go into production. JIT inventory systems are commonlyused in automobile assembly plants. Using JIT reduces a company's risk of carrying a stock of partsthat may quickly become obsolete.

MIXED COSTS Mixed costs change somewhat in relation to production, but not proportionately like Variable Costsdo. Mixed costs generally have a fixed portion and a variable portion. We deal with these costs byseparating them into these two parts - so we are back to only 2 types of cost behavior.

A common example of a mixed cost would be a rental car. You might rent a car for a weekend for

$20, for up to a total of 200 miles. You will be charged $ .10 for each additional mile you drive. Theflat rate of $20 represents the fixed component; the $ .10 per mile represents the variablecomponent. If you drive 300 miles you will pay:

Fixed component $20.00 Variable component $10.00 (100 extra miles @ $ .10) Total cost $30.00

We have a couple of simple ways to separate costs into their fixed and variable components. Oneway is called the High-Low Method. It looks at the highest & lowest costs over a period of severalmonths to come up with a simple formula that can be used to calculate the variable & fixed costs.Separating mixed costs into their parts is an in-exact practice. At best it is an estimate, or approximation, that is only as accurate as the method we use. This is not usually a significant issue,since all costs are eventually included in our equations. However, if mixed costs constitute a

percentage of total costs, it is necessary to be as accurate as possible. More sophisticated methodsshould be used when a higher level of accuracy is needed.

Contributio n M ar gin The Contribution Margin (CM) is one of the most essential parts of variable costing and managerialaccounting.

CM = Selling Price - Variable Costs

It can be calculated as either unit CM or total CM.

CM is the profit available to cover fixed costs and provide net income to the owners.

Break Even analysis One of the first uses of variable costing is calculating the break even point. This is the point at whichsales exactly equals total costs. It can be expressed as either units or sales dollars.


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Break Even Units (BE units)- the number of units needed to cover fixed costs for a given period of time.

---------------------------------------------------- BE units exampl e: XYZ Co. has monthly fixed costs of $2,000. They sell a single product for $30 each. Variable costsare $10 per unit. They sell about 200 units per month. Calculate the break even point in units.

1) C alculat e CM

Selling price $ 30 Variable costs 10 Contributio n mar gin (CM) $ 20

2) C alculat e BE units

BE Units = Total Fixed Costs Unit CM =

2000 20 = 100 units to br eak even

proof :

Contribution margin 100 units @ $20 $ 2000 less Total Fixed Costs 2000 Profit (loss) $ 0

When sales are below the Break Even point a company is operating at a loss; Above the BE pointthey will be operating at a profit. The company is selling 200 units per month, well above the break even point, so they are operating at a profit.

How much profit will they make by selling 200 units per month?

Contribution margin 200 units @ $20 $ 4000 less Total Fixed Costs 2000 Profit at 200 units per month $ 2000

---------------------------------------------------- E xampl e 2: XYZ is facing fierce competition from a new company, and management decides to lower theselling price of their product to $20 per unit. They also decide to take out advertising at a cost of $400 per month. Recalculate their Break Even point given the new information:

1) Calculate CM

Selling price $ 20


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Variable costs 10 Contribution margin $ 10

2) Calculate BE units The $400 advertising costs will increase total fixed costs; add it to the numerator (top number).


2400 10 = 240 units at break even

This will be a problem for the company. Their new break even point is higher than their normalmonthly sales. They will be operating at a loss under these conditions, and must re-evaluate thedecision.

proof :

Contribution margin 200 units @ $10 $ 2000less Total Fixed Costs 2400Profit (loss) ($ 600)

---------------------------------------------------- E xampl e 3 : We can work the formula in reverse. Assume they include the advertising costs of $400 per month,and sell 200 units. What selling price will put them at the break even point?

CM Unit at BE = $2400 200

= $12 CM

They must reverse the calculation, and add variable costs to CM to arrive at the new selling price.

Contribution margin $ 12 Variable costs + 10 Selling price $ 22

Proof :

Selling price $ 22



2400 12 = 200 units at break even


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proof :

Contribution margin 200 units @ $12 $ 2400 less Total Fixed Costs 2400 Profit (loss) $ 0

CM Ratio and BE sal es volum e The CM can also be viewed as a percentage or ratio. To calculate the CM ratio, divide CM by theSelling Price (SP).

ABC Co. has monthly fixed costs of $2,400. They sell a single product for $40 each. Variable costsare $24 per unit. They sell about 250 units per month. Calculate their break even point in salesdollars (also called sales volume).

Selling price $ 40


The ir CM Ratio is CM/SP = 16/40 = .40 or 40%

(In accounting we usually carry calculations out to 4 decimal places).

Break Even Sales Volume

Total Fixed Costs / CM Ratio = 2400/.40 = $6000 in sales per month

proof: $6000 / $40 SP per unit = 150 units to break even, or:

BE Units = 2400 16 = 150 units at break even

When do we use CM Ratio and BE sal es volum e? We can use these calculations anytime. They are especially useful when the company sells a largenumber of different products - in other words a large sales mix. Take for example a conveniencestore. They might sell 200 different items, or more. Each item carries its own selling price, andcontribution margin per unit.

Calculating all those contribution margins would be a huge job. And with a sales mix, the companywould have to carefully track each and every product. It is much easier to consider the merchandiseas a large group, and use the CM Ratio.

QuikMart operates a convenience store, and their CM Ratio is approximately 42%. Their monthlyoverhead (fixed costs) is $2604. What sales volume is needed to break even?

BE volume = TFC / CM Ratio = $2604 / .42 = $6200 per month in sales volume


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It is not necessary for the owner to know exactly how many Snickers bars, Milky Way, cans of Cokeetc. will be sold each month. That will depend on the what the customers want to buy. The owner will stock a variety of products. By using CM Ratio we don't need to know each item individually.

Of course, in the real world not all products will earn the same CM Ratio. Some products face stiff competition, and the company will charge accordingly. For instance, they will sell milk at a price

similar to grocery stores, earning a rather small CM. But the neat trinkets that adorn the frontcounter will be sold for twice, three, four times or more their cost, greatly improving the company'soverall profit margin. A few high profit items can make up for the "loss leaders" in a company's

product mix.

[Loss leaders are products sold at a low price, sometimes at a loss, to attract customers, and get themto shop in your store. Free items, 2-fer sales, 1 cent sales, etc. are all examples of the loss leader strategy used by grocery stores to get your business. They hope you will buy some of the high profititems while you are shopping in their store. Sometimes they will require a minimum purchase, or limit the number of loss leader items a customer can buy.]

CVP G rap hs CVP relationships and the break even formula can all be illustrated with a simple graph. CVP graphs

are a great way to convey information. They are especially useful in presenting alternatives todecision makers, many of whom may more easily grasp the concepts with a visual presentation,rather than page full of numbers.

1999-2010 Copyright Malcolm E. White, Fulton, Missouri, USA For personal educational use only. All rights reserved. No part of this tutorial may be reproduced or stored in any way without permission. Contact webmaster at [email protected]


H OME


2 Financial


4 Accruals

5 Reports

6 Merchandising

7 Financial Assets

8 Inventory

9 Plant Assets

10 Liabilities

11 Stockholders'

Ch apt er 13 Stat emen t of Cas h F lows

The terms " C as h F low S tat emen t" and " Stat emen t of C as h F lows" areinterchangeable.

The Cash Flow Statement is relatively easy to prepare. It is better to use logic and

"common sense" to understand what is happening and how information should be presented in this statement.

The Income Statement and Balance Sheet are both prepared using AccrualAccounting. This involves making a combination of adjustments to the books,including accruals, deferrals, apportioning costs such as depreciation, and chargingIncome with future expenditure such as warranty claims and post-retirement

benefits. Every time we make an adjustment in the books and records, the resulting


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Cash Flows

14 Financial Analysis 16 Management

Accounting 17 Job Costing

18 Process Costing

20 CVP

21 Incremental

Analysis 23 OperationalBudgeting

24 Standard Costs

financial statements comply with accrual accounting, but are also farther away fromcash accounting.

Before 1987 we prepared a third financial statement called the Stat emen t of Ch ange s in F inancial Positio n . This was generally prepared on a Working Capita

basis, but could also be prepared on a Cash Flow basis.

In 1987 FASB mandated the use of the Cash Flow Statement, in place of theStatement of Changes. The Statement of Cash Flows removes all accruals, deferralsand other non-cash adjustments, and provide investors and creditors withinformation about a company's Sources and Uses of Cash. An Income Statementmight show a Profit or a Loss, but that says nothing about how the company'sManagement managed the company's money.

Today this is more important than every. Managers are frequently caught "cookingthe books," hiding losses and liabilities, overstating or understating Income, all for

the purpose of influencing the market price of company stock. Managers frequently benefit personally from increases in company stock prices, so there is a highincentive for these people to manipulate information.

The Cash Flow Statement is fairly simple.There are only 3 sections, which reportIncreases and Decreases in Cash. The sections are always presented in thefollowing order.

O perati ng C as h F lows -In flows - Money received from customers for sales of products or services.O utflo ws - Money paid to suppliers, employees, etc. for normal business expenses.

In vesti ng C as h F lows -In flows - Money received from selling assets, including land, buildings equipment,stocks, bonds. Money received from loans made to others, such as NotesReceivable.O utflo ws - Money paid to purchase assets; and money paid out to make loans toothers.

Financing C as h F lows -In flows - Money received from stockholders purchasing company stock, from

bondholders for bonds payable, and money borrowed from banks and other creditors.O utflo ws - Money paid to stockholders for dividends, to bondholders, banks andother creditors.

The Statement of Cash Flows also reconciles the Cash balance from the beginningto end of the year. The beginning and ending Cash balances can be found on theBalance Sheet.


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Dir ect and In dir ect Me th od There are 2 ways to present the Statement of Cash Flows - Direct and Indirect.Your textbook presents the Direct Method. The Indirect Method is illustrated in the

appendix at the end of the chapter. FASB recommends the use of the DirectMethod. A recent survey of company shows the following:

Companies using the Direct Method 5%

Companies using the Indirect Method 95%

Despite these statistics, most accounting textbooks teach the Direct Method.Youshould also note that when the Direct Method is used, the statement must alsoinclude a supplemental calculation of Operating Cash Flows using the IndirectMethod. Accountants should be able to do both methods.

P r epari ng the S tat emen t of C as h F lows I generally include the cash flow worksheet as part of my 13-column trial balanceworksheet. I use the space in the far right side of the trial balance worksheet toanalyze cash flows for all accounts. Calculate the difference between the beginningand ending balances for all accounts, and determine if the change reflects anincrease or decrease in cash flow. Mark each account with and O for Operatingcash flows, I for Investing cash flows and F for Financing cash flows.

Next lay out the general format of the statement on a piece of paper or spreadsheet.I generally identify the Investing and Financing activites first, and put them in theappropriate place. There should only be a few items that fall in these categories.Most of the accounts will be Operating activities. These include all Income andExpense accounts - the majority of accounts on the trial balance.

You may need to look at a few Ledger accounts. For instance, the company mayhave purchased Land and also sold Land in the same year. The purchases would beoutflows of cash, and recorded as Debits in the Land account. Sales would beinflows of cash, and recorded as Credits in the Land account.

Land

Dat e De scriptio n De bit Cr edit Bala1/1/04 Beginning balance forward 100,003/17/04 Purchase of Land 30,000 130,009/12/04 Sale of Land 20,000 110,00


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Le t's analyz e the L and accou nt

Beginning balance 100,000

Ending balance 110,000Increase in Land 10,000

If the Land was sold and purchased for Cash, there would be a net decrease in Cashof $10,000, but really we have an Outflow of $30,000 for the purchase of Land, andan Inflow of $20,000 from the sale of Land.

Let's assume the Cash account looks like this for these transactions....

Cas h

Dat e Descriptio n De bit Cr edit Bal-

3/17/04 Purchase of Land (cash outflow) 30,000 -9/12/04 Sale of Land (cash inflow) 20,000 -[Cash balance is irrelevant]

The Investing section of the Cash Flow statement would look like this:

In vesti ng C as h F lows

C as h In flows:

Sale of Land $20,000

C as h O utflo ws:

Purchase of Land (30,000)

Net Cas h us ed for In vesti ng activiti es $(10,000)

An alyzi ng the C as h F low S tat em en t Analyzing cash flows is an important part of financial statement analysis. Here aresome important things to look for:

1. There should be a net Increase in Cash from O perati ng Activities. If operationdon't produce positive cash flows, the business will soon be in trouble. Withoutadequate operating cash flows, the company may have to dip into cash reserves or


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sell investments to meet regular payment of expenses.

2. If a company shows net Increase in In vesti ng Cash Flows, it means they areselling off assets. That is generally not a good sign. I would also look to see if tehcompany was posting losses and had negative cash flows from Operating activities.

This might indicate that Management is selling off assets to pay bills. Moreanalysis is needed in this case.



H OME


2 Financial


4 Accruals

5 Reports

6 Merchandising

7 Financial Assets

8 Inventory

9 Plant Assets

10 Liabilities

11 Stockholders'



Cash Flows 14 Financial Analysis

16 Management Accounting

17 Job Costing

18 Process Costing

20 CVP

Ch apt er 16 M anagem en t Accou nting

Management Accounting Manufacturing Costs

Non-Manufacturing Costs Inventories Unit Product Costs Applying Overhead

Overhead allocation methods

Ch apt er 16 introduces you to some of the basic managerial accounting conceptsyou will use for the remainder of the course. The introduction to managementaccounting begins with an overview of the design requirements of a managerialaccounting system. The system must allocate decision-making authority over acompany's resources. Second, it must furnish the information to support decision-making by managers. Finally, the system must generate the information needed toevaluate and reward performance.

Managers deal with the op eratio ns of the business, and with information that isinternal to the business. We call this op erati ng informatio n . It involves things li

product costing information, payroll information and other sensitive or confidentialinformation. For this reason, operating information is not released to the public, butis used by managers to improve business performance, and ensure the objectives of the company.

Manufacturing costs are first classified into direct material, direct labor and


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21 Incremental

Analysis 23 OperationalBudgeting

24 Standard Costs

manufacturing overhead. With these definitions established, we introduce thecritical distinction between product and period costs. This discussion in turn laysthe foundation for introducing the manufacturing inventory accounts: raw materials,work-in-process, and finished goods.

The flow of costs through the inventory accounts is explained with the help of anextended illustration. The example includes a detailed analysis of the process of applying overhead using a predetermined rate. The text explains both the mechanicsand the rationale underlying overhead application at this point, and calls attention tothe potential weaknesses of volume based applications that will be addressed inlater chapters.

The chapter closes with the development of financial statements for amanufacturing company. The schedule of cost of goods manufactured is introducedas a supplement to the financial statements intended to assist managers inevaluating the overall costs of manufactured products.

M anagemen t Accou nting Management (or managerial) accounting is intended to fulfill a large number of requirements. Financial accounting is intended to meet the needs of outside users of financial information, and follows GAAP. Management accounting is intended tosatisfy the various needs of a large group of decision-makers inside the business,and does not follow GAAP.

A single set of financial statements satisfies the requirements of GAAP, butmanagement accounting reports can be tailored for any situation and user. The form

and format can vary widely, depending on the type of decision being analyzed.You first need to learn to use a few basic concepts. After that, those concepts can bemodified in an almost infinite number of ways to analyze business information, andmake operating decisions.

A company's audited financial statements look backwards in to the prior year or years. But managers have to make decisions today, that affect the present and thefuture. Financial statements that are a year or more old are not very useful for thedaily decisions managers have to make. They are more interested in currentoperating information, and projections about the future. They are also concernedwith setting goals, measuring progress and achievement, eliminating waste,complying with government regulations, and a much, much more.

Accou nti ng cycl es

An accou nti ng syst em is oft en or gan ized in to accou n ti ng cycl es. The se cycl ear e conne ct ed and in terr elat ed . C osts flow the product costi ng syst em as illustrat ed in your text , an d as describ ed below.


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The P urc has e/P aym en ts cycl e includ es purc hasi ng ra w mat erials and suppli es as nee ded , and payi ng the bills when the y com e du e.

The P ayroll cycl e includ es sche duli ngemploy ees for productio n and payi ng the mon r egular in tervals .

The P roductio n cycl e includ es coll ecti ngmat erials , labor and over he ad costs in to aninven tory cost pool call ed W ork in P roc ess.On ce compl eted the product costs ar etra nsf err ed to F in ishe d G oods inven tory u n til the g oods ar e sold .

Finally in the S ales/R eceipts cycl e sal es ar er ecord ed when g oods ar e sold , and Fin ishe dG oods costs ar e tra nsf err ed to C ost of

G oods Sold . C ustom ers ar e bill ed and r eceipts ar e r ecord ed when r eceived .

Separati ng the accou n ting proc ess lets us assi gn diff er en t peopl e to diff er entasks . M any compa n ies hav e lar ge A ccou n ts Payabl e, A ccou nts R eceivabl ePayroll departm en ts , n ot to m en tio n h uge P roductio n departm en ts and masal es peopl e. Se parati ng activiti es in to accou nting cycl es he lps us understa nand apply ma nagerial con trols to the se activiti es.

Accou nti ng C ycles ar e conne ct ed and in terr elat ed .


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M anufacturi ng C osts We study manufacturing environments because they are some of the most complex

business environments. What we learn here can easily be transferred to other, lesscomplex, situations. Management accounting is really much easier than financialaccounting. We classify all costs as either manufacturing or non-manufacturing.

We separat e ma nufacturi ng costs in to th r ee cat egori es: Manufacturing costs relate to making a product.

Dir ect M at erials (DM) - raw materials and parts, dir ectly trac eabl e to the product. Materials must attach themselves to, and become part of, the finished product to be considered Direct Materials.


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Dir ect Labor (DL) - wages and other payroll costs of the employees that directlywork to convert Direct Materials into finished products. These costs are dir ectlytrac eabl e to the product.

M anufacturi ng O ver he ad (O H D) - all the other costs related to producing

products that don't qualify as Direct Materials or Direct Labor. Picture amanufacturing plant and all the costs of the plant. Now subtract DM and DL.Everything that's left is Overhead. These costs are in dir ectly trac eabl e to the

product.

Non-M anufacturi ng C osts Some costs are specifically not manufacturing costs, and therefore not DM, DL or OHD. These are costs not related to the manufacturing plant or producing the

product. The include the following two categories:

Selling C osts The costs associated with selling the product are Selling C osts . These include sasalaries and commissions, advertising, stores and their related fixtures andequipment.

Gene ral an d Admi nistrativ e C osts The costs associated with the central management and home office of a company,and general costs of being incorporated, are classified as General andAdministrative (GA) costs. This includes buildings, offices, equipment, salaries,etc. that are part of the administrative arm of the business, provided these costs can't

be traced directly or indirectly to the manufacturing function.

Pe riod C osts Some costs don't have any future value, and only relate to the current period. Theseinclude Selling costs and GA costs. Other period costs include income taxes andinterest expense.

In ven tori es There are th r ee classificatio n s of inven tory .

M at erials inven tory - raw materials and parts used in producing goods

W ork in proc ess inven tory (WIP)- all partially completed goods, not ready for sale

Fin ishe d goods inven tory - all completed goods ready for sale

Cost Flow


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We say that costs "flow" though a company. This means that we collect costs in the books in certain accounts, and transfer those costs to other accounts, in a way thatresembles how those costs are actually incurred in the manufacturing process.

In gene ral he r e is the w ay costs flow th rou gh an accou nti ng syst em:

Direct Materials >Direct Labor ==>Mfg Overhead =>

Work in Process => Finished Goods=> Cost of Goods Sold

These are the actual accou nts that will be debited and credited in a way thatapproximates the way costs are actually incurred in the production process. Theseaccounts are all debited to increase the account, and credited to decrease theaccount.

To move costs along we debit the accou nt the cost is movi ng into , and cr editaccou n t the cost is movi ng from . Total cost increases as it moves along, just like snowball gets bigger as you roll it around in the snow. As goods move through themanufacturing process they pick up all the related costs along the way. Materialsand labor are added as the goods are worked on, and overhead is added along theway.

Let's look at how one unit of product picks up costs in its journey through the production process. Amalgamated Widget, Inc. produces a variety of widgets for home and commercial use. The production manager requisitions raw materials,from the Materials inventory. Materials inventory account is credited and the costs

are transferred to the Work in Process inventory account.

Work is started in the shaping and forming department. Labor is added at this point by crediting Direct Labor and debiting Work in Process inventory. After thewidgets are formed, they go to the finishing department. The appropriate finish isapplied and the finished widget is sent to the packing department, where it is

prepared for shipment. Additional Materials and Direct Labor costs are added toWork in Process in the finishing and packing departments.

Overhead is added to the product cost at each stage of the operation by debitingWork in Process inventory and crediting the Overhead account. We will discuss

Overhead allocation more in a moment.

At this point the product is complete and ready for sale. The final cost is transferredto the Finished Goods inventory account. When the item is sold the cost will then

be transferred to the Cost of Goods Sold account.

The total cost of producing a widget accumulates as the widget moves along thoughthe production process.


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Un it Product C osts The word "unit" comes from the Latin unus, meaning one. The Spanishword uno comes from the same Latin root, and also means one. A Unit Cost is the

cost of producing one unit of product. We might break that down into itscomponent parts - labor, materials & overhead - perhaps in great detail.

Manufacturing companies usually make a large quantity of products at a time. Each batch of product may be thousands of units. In some cases production is done on anassembly line, and there is little distinction between departments, aside from thosearbitrarily determined by management.

Ultimately the company must set a selling price for its goods. Since goods are soldone at a time, the company must determine the total cost of produci ng a sing leun it of goods. Unit costs are tracked throughout the production cycle in some

accounting systems. In other cases, unit costs are determined at the end of production, after all costs of production have been accumulated and the finishedunits have been counted.

It is important that you clearly distinguish between unit costs and total costs, inyour mind, at all times in this class.

Applyi ng O ver he ad Overhead consists of a large number of separate costs related to the manufacturing

process. They are collected in a single account and allocated to the product cost

using what is called an over he ad applicatio n rat e.The overhead application rate is simply a way to divide the total overhead costs for a year, across all the units of goods produced that year. Here's the formula:

Total Annual Overhead CostsOverhead Cost Driver

The overhead cost driver, is something related to production that can be used tohelp spread the total cost evenly to individual units of product. Sometimes that issimply the number of units of products produced in a given year. At other times

that's not the best measure to use. For instance, hot dogs are produced by the tens-of-thousands per day, packed into boxes and sold by the palette load. The overheadcost applied to one hot dog would be a very small amount, and not very relevant tomanagers. They will apply overhead costs in a way relevant to the decisions theyneed to make.

Allocati ng over he ad usi ng labor hours


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Labor hours are often used as a cost driver, to apply overhead. Total overhead costsare divided by total estimated labor hours to come up with a dollar rate per labor hour. Each time labor is recorded, a corresponding amount of overhead can also beallocated and recorded (transferred to WIP).

Advantages of using labor hours:Tends to be a predictable & steady amountDifferent pay rates among employees is irrelevantLabor hours are closely related to production, so should be an accurate measure

Let's look at an example. The company estimates it will have 100,000 labor hoursand spend $200,000 in overhead costs. The company records 8,300 labor hours thismonth. Their overhead allocation is:

$200,000 / 100,000 hours = $2 per labor hour x 8,300 hours = $16,600

The company would transfer $16,600 from the Overhead account to Work inProcess for the month's production.

Allocati ng over he ad usi ng labor dollars Some very large companies allocate overhead using labor dollars, because theyhave a large work force, and their total labor dollars tends to be a predictableamount. They may be operating under a labor contract. They may have a large andwide-spread work force.

Overhead costs are allocated in much the same manner as above, except that labor dollars would be used, instead of labor hours.

O the r O ver he ad Allocatio n Me thods Some companies use other allocation methods for overhead. Whatever method isused should be a reliable and predictable method, where a cost driv er or reasoncause and effect relationship can be found between costs and production.

Overhead costs are allocated using journal entries, which means that thesemanagerial accounting entries will also affect the audited financial statements

released to outsiders. The allocation method will come under the scrutiny of thecompany's auditors, so it should be a reasonable method that complies with GAAP.


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Documents

Financial Ratios Formuleeee