Economics for Engineering Prof. Andrea Sianesi academical year 2008/2009

1. Economics for Engineering Prof. Andrea Sianesiacademical year 2008/2009 Introduction to Cost Accounting

2. The Accounting System Financial Accounting System Periodic financial statements and related disclosures Managerial Accounting System Detailed plans and continuous performance reports External Decision Makers Investors, creditors, suppliers, customers, etc. Internal Decision Makers Managers throughout the organization Accounting System

3. Accounting Disciplines • Financial Accounting • Focus on external users • Generally Accepted Accounting Principles (GAAP rules) • Managerial Accounting • Focus on internal users and is not necessarily GAAP-driven. • Also provides data for financial accounting. • This includes: • Cost Accounting • Cost Management

4. Fin vs Man Accounting Managerial Financial Help Managers Make Decisions Communicate Financial Position Purpose External Stakeholders Internal Managers Primary Users Future Oriented Focus Past Oriented Rules GAAP Cost-benefit Time Span Varies Annual/Quarter EE – Introduction to Cost Accounting

5. Strategy and Management Accounting • Strategy – specifies how an organization matches its own capabilities with the opportunities in the marketplace to accomplish its objectives • Strategic Cost Management – focuses specifically on the cost dimension within the overall strategy

6. Strategy and Management Accounting • Management accounting helps answer questions such as: • Who are our most important customers? • What substitute products exist? • What is our critical resource? • Will we have enough cash to support our strategy?

7. Management Accounting and Value • Creating value is an important part of planning and implementing strategy • Value is the usefulness a customer gains from a company’s product or service • Value Chain is the sequence of business functions in which customer usefulness is added to products or services

8. Management Accounting and Value • The Value Chain: • Research and Development • Design • Production • Marketing • Distribution • Customer Service • Management accounting can provide information in each of these areas • Analysis can also include the supply chain

9. Key Success Factors • The dimensions of performance that customers expect, and that are key to the success of a company include: • Cost and efficiency • Quality • Time • Innovation

10. Planning and Control Systems • Planning selects goals, predicts results, decides how to attain goals, and communicates this to the organization • Budget – the most important planning tool • Control takes actions that implement the planning decision, decides how to evaluate performance, and provides feedback to the organization

11. Organizational Structure and the Management Accountant • A typical structure might include: • Chief Executive Officer (CEO) • Chief Financial Officer (CFO) • Controller – responsible for managerial and financial accounting • Treasury (Cash) • Risk Management • Taxation • Internal Audit

12. Definition • Cost • Monetary equivalent measuring the consumption of resources to obtain a product or a service • Several classifications can be adopted: • Cost source (industrial, commercial, administrative, etc.) • Relationship with volume (fixed, variabile, semifixed) • Type of measurement (total, unit) • Kind (product, period) • Type of attribution (direct, indirect) • Type of cash flow (true, figurative) • Cost accounting is the discipline aiming to help companies in using the cost information in the correct way EE – Introduction to Cost Accounting

13. Example of costs If a company manufactures , distributes and sells different kind of products in different volumes, which is the correct cost of every product sold ? EE – Introduction to Cost Accounting

14. Why cost accounting is relevant? • Different cost concepts and terms are often used in accounting reports. • Managers who are comfortable with these concepts and terms are able • to make best use of the information provided, and • to avoid misuse of that information. EE – Introduction to Cost Accounting

15. Cost accounting: scope and objectives • Cost accounting systems • Which set of resources are considered? • How resources are accounted? • How costs of resources are assigned to organizational units? • How costs of resources are assigned to products and services? • Cost Accounting mainly deals with the “Internal” (or (“Analytical”) Accounting • On the other hand, the External Accounting looks at the cost as a measure to rule an exchange with other companies EE – Introduction to Cost Accounting

16. Cost accounting: scope and objectives • The cost accounting system aims at assigning costs to: • Organizational units, • Products, • Services. • Information produced by the cost accounting system are therefore used for: • Financial reporting • Management accounting EE – Introduction to Cost Accounting

17. The cost accounting system’s structure EE – Introduction to Cost Accounting

18. The phases • Costs of resources are included in the resources’ ledger • Each ledger is a database where costs of resources are accounted, when resources are purchased • Each ledger follows a hierarchical model and resources are categorized according to their nature • When resources are consumed, their costs are moved from the resources’ ledger to the organizational units where they are used • Costs of each organizational unit are then allocated to products and services EE – Introduction to Cost Accounting

19. Designing a cost accounting system • There are four main choices related to the cost accounting system’s model • Set of resources included in the general ledger • Method used for resources evaluation (actual or standard costs) • Resources allocation to organizational units (direct or step-down method) • Resources allocation to products and services (Process Costing, Job Order Costing, Operations Costing or Activity Based Costing) EE – Introduction to Cost Accounting

20. Set of resources included in the general ledger • Set of resources to be assigned to products and services • There are different categorization of costs • Direct and indirect costs; • Period and product costs; • Fixed and variable costs; • Avoidable and unavoidable costs. EE – Introduction to Cost Accounting

21. Direct and Indirect costs • Direct costs are those costs that can be specifically and exclusively identified with a particular cost object • Indirect costs are those costs that cannot be identified specifically and exclusively with a given cost object. • The distinction between direct and indirect costs depends on the cost object: • Example: supervisor’s salary of a maintenance department • Cost object = department  salary is a direct cost • Cost object = product  salary is a indirect cost If we want to define a relation between the supervisor’s salary and the product we have a problem of allocation EE – Introduction to Cost Accounting

22. Cost assignment Cost Tracing Direct Costs Cost Object Indirect Costs Cost Allocation EE – Introduction to Cost Accounting

23. Direct and Indirect costs • The steps for allocating resources are: • Defining the cost object and the resources (indirect costs) to be allocated; • Group together homogenous group of resources (cost pools); • Choosing the allocation basis (a measure for dividing the costs) for each cost pool; • Calculating different overhead rates for each cost pool; • Allocating resources to the different products; EE – Introduction to Cost Accounting

24. Manufacturing Costs Manufacturing consists of activities and processes that convert raw materials into finished goods.

25. Manufacturing Costs - Materials • Raw Materials • Basic materials and parts used in manufacturing process. • Direct Materials • Raw materials and parts/components that can be physically and directly associated with the finished product during the manufacturing process.

26. Manufacturing Costs - Materials • Indirect Materials • Raw materials that cannot be easily associated with the finished product. • Not physically part of the finished product or they are an insignificant part of finished product in terms of cost. • Considered part of manufacturing overhead

27. Manufacturing Costs - Labor • Direct Labor • Work of factory employees that can be physically and directly associated with converting raw materials into finished goods. • Indirect Labor • Work of factory employees that has no physical association with the finished product or for which it is impractical to trace costs to the goods produced.

28. Manufacturing Costs - Overhead • Costs that are indirectly associated with manufacturing the finished product. • Includes all manufacturing costs except direct materials and direct labor. • Also called factory overhead, indirect manufacturing costs, or burden. • Includesdepreciation of fixed manufacturing assets (e.g. toolingmachines)

29. The depreciation (introduction) • Depreciation is an artificial (non-cash) accounting entry intended to capture the consumption of a capital asset over its economic life • Depreciation increases “after tax profit” (it’s a cost !), so firms desire to depreciate assets as fast as possible (depreciation schedule has major tax implications) • Depreciation basis is that part of the asset’s purchase price that is spread over the depreciation period (service life). • Depreciation basis is cost minus expected salvage value at the end of the service period • Depreciation methods • Constant percentage • Accelerated cost recovery schedules (ACRS) EE – Introduction to Cost Accounting

30. The depreciation (introduction) • When businesses buy fixed assets (those that will last longer than one year) the value of the asset will change • Depreciation seeks to take account of such changes in the accounts • An imprecise science allows different interpretations • Take a tooling machine: • What is its life span? • How much did it cost originally? • How much will it be worth at the end of its useful life? • What will be its value after 1 year? • After 2 years, 4 years, 15 years? • Would anyone else want to buy it? • How specialised is it? • What would it cost to replace after 5 years? • …. EE – Introduction to Cost Accounting

31. The depreciation (introduction) • Key terms: • Historical Value - initial purchase price • Value at the end of the life of the asset - the Residual Value (RV) • Life span of the asset • Straight Line Method (Constant) • (Historic cost – RV)/Useful life • Declining Balance Method (Accelerated) • Depreciating assets at a changing rate each year (e.g.: 50%-20%-15%-10%-5%) EE – Introduction to Cost Accounting

32. Product and Period costs • Product costs : value of resources used for producing a product or delivering a service; • Direct materials • Direct labour • Energy • Other manufacturing Overhead (moulds, tools, fixtures, etc.) • Period costs: value of resources used in activities that cannot be associated to the product production or service delivery with a cause-effect relation. • Administrative and general expenses • Selling expenses • R&D • Information system • Every period cost is an indirect cost EE – Introduction to Cost Accounting

33. CostClassification - Summary

34. Variable and fix costs • Variable costs change in total in proportion to changes in the related level of total activity or volume. Variable vary directly with the amount produced, e.g., raw material costs, some direct labour costs, some direct energy costs • Fixed costs do not change in total for a given time period despite wide changes in the related level of total activity or volume. Fixed are not influenced by the amount produced but can change in the long run e.g., insurance costs, administration, rent, some types of labour costs (salaries), some types of energy costs, equipment and machinery, buildings, advertising and promotion costs • Semi-fixed – where costs not directly attributable to either of the above, for example, some types of energy and labour costs EE – Introduction to Cost Accounting

35. Variable vs. Fixed costs • Indirect material is a • variable cost because it increases in total directly and proportionately with the change in the activity level. • Supervisory salaries is a • fixed cost because it remains the same in total regardless of changes in the activity level. • Maintenance is a • mixed cost because it increases in total but not proportionately with changes in the activity level. • Typicallycomprises a fixedportion and a variableportion

36. Variable and fix costs Costs VariableCosts FixedCosts Production Volume EE – Introduction to Cost Accounting

37. Total, average and marginal • Total Costs (TC) = Fixed Costs (FC)+ Variable Costs (VC) • Average Costs (AC) = TC/Output (Q) • AC (unit costs) show the amount it costs to produce one unit of output on average • Marginal Costs (MC) – the cost of producing one extra or one fewer units of production • MC = TCn – TCn-1 EE – Introduction to Cost Accounting

38. total/averagecost totalfixedcost totalvariable (linear) cost Total, average and fixed, variable Total Average K K/Q n° units n° units Total Average mQ m n° units n° units EE – Introduction to Cost Accounting

39. Fix – var / Total – per unit Total Cost Cost per Unit Change in proportion with output More output = More cost Unchanged in relation to output Variable Costs Fixed Costs Unchanged in relation to output Change inversely with output More output = lower cost per unit EE – Introduction to Cost Accounting

40. Cost configurations • There are different cost configurations • The most frequent distinction is between: • Direct costing • Costs allocated to products include only those items which can be directly associated to products (direct material and direct labour) • Full costing • Costs of both direct and indirect resources are attributed to products and services EE – Introduction to Cost Accounting

41. Cost configurations Direct cost Full cost EE – Introduction to Cost Accounting

42. Cost configurations Raw materials + Direct Labour cost = Prime (Direct) Product Cost Prime cost + Product Indirect Cost = Full Industrial Cost Direct Labour Cost + Product Indirect Cost = Tranformation Cost Full Industrial Cost + Indirect Period Costs = Full Company Cost EE – Introduction to Cost Accounting

43. Cost of GoodsSold / Manufactured • It's the Financial Management perspective: • Work In Progress (WIP) = productsthat are onlypartiallycompletedattime "t" EE – Introduction to Cost Accounting

44. Cost of GoodsSold / Manufactured • CGM = Cost of GoodsManufactured • CGS = Cost of GoodsSold • Value of WIP "t-1" + Manufacturing Cost"t-1"-"t" – Value of WIP "t" = Cost of GoodsManufactured "t" • Value of FinishedGoods Inventory "t-1" + CGM "t" - Value of FinishedGoods Inventory "t" = CGS EE – Introduction to Cost Accounting

45. Cost of GoodsSold / Manufactured EE – Introduction to Cost Accounting

46. Cost of GoodsSold / Manufactured EE – Introduction to Cost Accounting

47. Cost of GoodsSold / Manufactured EE – Introduction to Cost Accounting

48. Cost of GoodsSold / Manufactured • Whichis the annual manufacturing costif the company produces 10.000 boards ? • And whichis the cost of oneboard ? EE – Introduction to Cost Accounting