Accountingtools Q&A

What is cost management?

Steven Bragg — Tue, 18 Jun 2013 21:41:54 +0000

Cost management is the control of actual or forecasted costs incurred by a business, using some or all of the following steps:

Collect information about current and projected costs. This typically comes from the general ledger for actual costs, but the information can also be compiled through an activity-based costing system or some less formal collection methodology. Projected costs come from comparisons to similar projects or products, or estimates based on projected bills of material.

Review the collected information to see if costs can be reduced or avoided entirely. This can include the separation of costs into fixed, variable, and mixed costs, reviewing costs on a trend line, analyzing the impact on bottleneck operations, and comparing costs to those of benchmark companies.
Reporting the results of the analysis to management, with recommended actions.
Setting up controls to ensure that changes imposed by management are adhered to in the manner intended.
Monitoring any changes imposed by management as a result of this analysis, to see how the alterations have modified the cost profile of the business.

If a business is trying to manage costs associated with future activities (such as the design of a new product or the construction of a new headquarters building) then the cost management activities are somewhat different. Any of the following activities could be followed:

Using target costing to continually estimate costs as features are added to or subtracted from a project (usually a new product).
Using milestone reviews to compare the costs originally estimated to be incurred to actual costs incurred. These reviews can sometimes result in the outright cancellation of projects.

Cost management can also involve a simple monitoring function, where there is no immediate need to make alterations. In this case, the following approaches to cost management can be followed:

Using variance analysis to highlight any differences between incurred costs and budgeted costs.
Using exception analysis to highlight only those variances from budgeted costs that exceed a certain threshold.
Using trend analysis to note long-term changes in certain costs.

In short, cost management is a broad topic that encompasses a variety of data collection, analysis, reporting, and control activities. Every company wanting to remain profitable over the long term will need to spend a considerable proportion of its time attending to cost management activities.

What is the accounting rate of return?

Steven Bragg — Mon, 17 Jun 2013 21:11:54 +0000

The accounting rate of return is used in capital budgeting to estimate whether you should proceed with an investment. The calculation is the accounting profit from the project, divided by the initial investment in the project. You would then accept a project if the measure yields a percentage that exceeds a certain hurdle rate used by the company as its minimum rate of return.

The formula for the accounting rate of return is:

= Average annual accounting profit / Initial investment

- Where the profit is calculated as the profit related to the project using all accruals and non-cash expenses required under the GAAP or IFRS frameworks (thus, it includes the costs of depreciation and amortization). If the project involves cost reduction instead of earning a profit, then the numerator is the amount of cost savings generated by the project. In essence, then, profit is calculated using the accrual basis of accounting, not the cash basis.
- Where the initial investment is calculated as the fixed asset investment plus any change in working capital caused by the investment.

The result of the calculation is expressed as a percentage. Thus, if a company projects that it will earn an average annual profit of $70,000 on an initial investment of $1,000,000, then the project has an accounting rate of return of 7%.

There are several serious problems with the accounting rate of return, which are:

Time value of money. The measure does not factor in the time value of money. Thus, if there is currently a high market interest rate, the time value of money could completely offset any profit reported by a project - but the accounting rate of return does incorporate this factor, so it clearly overstated the profitability of proposed projects.
Constraint analysis. The measure does not factor in whether or not the capital project under consideration has any impact on the throughput of the company's operations.
System view. The measure does not account for the fact that a company tends to operate as an interrelated system, and so capital expenditures should really be examined in terms of their impact on the entire system, not on a stand-alone basis.
Comparison. The measure is not adequate for comparing one project to another, since there are many other factors than the rate of return that should be considered.
Cash flow. The measure includes all non-cash expenses, such as depreciation and amortization, and so does not reveal the return on actual cash flows.
Time-based risk. There is no consideration of the increased risk in the variability of forecasts that arises over a long period of time.

In short, the accounting rate of return is not by any means a perfect method for evaluating a capital project, and so should be used (if at all) only in concert with a number of other evaluation tools. In particular, you should find another tool to address the time value of money and the risk associated with a long-term investment, since this tool does not provide for it. Possible replacement measurements are net present value, the internal rate of return, and constraint analysis.

Similar Terms

The accounting rate of return is also known as the average rate of return or the simple rate of return.

What is called up share capital?

Steven Bragg — Sun, 16 Jun 2013 16:45:24 +0000

A company may issue shares to investors, under the understanding that the shares will be paid for at a later date, or in installments. The amount of these shares for which the company has not yet been paid, and for which the company has demanded payment, is referred to as called up share capital. The reference to "called up" means that the company has issued a request for a portion or all of the unpaid balance. Technically, the demand for payment comes from the board of directors of the issuing company.

Once a shareholder has paid the issuing entity the full amount owed for issued shares, these shares are considered to be called up, issued, and fully paid. However, this does not mean that the shares are registered, which would allow the shareholder to sell the shares to a third party. The registration process requires the issuer to register the shares with the applicable government oversight entity, which involves a lengthy application process and ongoing public reporting of financial results.

What is the scattergraph method?

Steven Bragg — Sat, 15 Jun 2013 20:28:30 +0000

The scattergraph method is a visual representation of the cost and activity data associated with an expense, which is used to identify and separate the fixed and variable components of a cost. A cost that has both fixed and variable components is considered a mixed cost. Use the following steps to create a scattergraph and glean costing information from it:

Plot a collection of data points on a chart, showing the amount of cost incurred for a given level of activity. The horizontal x axis shows the activity level, while the vertical y axis shows the amount of cost incurred.
Plot on the scattergraph a regression line that represents the relationship between the various data points. A typical regression line has a upward slant, indicating that costs increase with unit volume. The regression line may also intercept the y axis above the zero cost level, indicating the presence of fixed costs that must be incurred even in the absence of any unit activity.
Determine from the scattergraph that component of the cost data that indicates the presence of a fixed cost. This is the point at which the regression line intercepts the y axis.
After subtracting the impact of fixed costs from the scattergraph, determine the remaining cost per unit of activity, which is the variable cost per unit.
Apply these separated fixed and variable costs to the projection of costs to be incurred in the future.

Ideally, the result of a scattergraph analysis should be a formula that states the total amount of fixed cost and the variable cost per unit of activity. Thus, if an analyst finds that the fixed cost associated with a mixed cost is $1,000 per month and the variable cost component is $3.00 per unit, then it is easy to project that an activity level of 500 units in an accounting period will result in a total mixed cost of $2,500 (calculated ast $1,000 fixed cost + ($3.00/unit x 500 units)).

The scattergraph method is most useful for gaining insight into the nature of mixed costs, which can then be used to project costs in a company forecast, based on expected activity levels.

The scattergraph method is not an overly precise method for determining cost levels, since it does not factor in the impact of step costing points, where costs change dramatically at certain activity levels. For example, reaching a certain number of units produced might require outsourcing some work or opening a new production shift, either of which will alter the variable cost incurred per unit and/or the fixed cost level.

The scattergraph method is also not useful in situations where there is little correlation between the cost incurred and the related activity level, since this makes it difficult to project costs into the future. Actual costs incurred in future periods might vary substantially from what the scattergraph method projects will happen.

Operating cash flow ratio definition and usage

Steven Bragg — Sat, 15 Jun 2013 19:32:03 +0000

Ideally, the bulk of the cash flow generated by a business should come from its core operations. The cash flows from ancillary activities should be quite minor. Otherwise, the entity is relying on non-core activities to support its core activities.

The calculation of the operating cash flow ratio first calls for the derivation of cash flow from operations, which requires the following calculation:

+ Income from operations
+ Non-cash expenses
- Non-cash revenue
= Cash flow from operations

An example of non-cash revenue is deferred revenue that is being recognized over time, such as an advance payment on services that will be provided over several months.

Once cash flow from operations has been derived, we then divide it by the total net income for the entity. The calculation is:

Cash flow from operations
Net income

Ideally, the ratio should be fairly close to 1:1. A much smaller ratio indicates that a business is deriving much of its cash flow from sources other than its core operating capabilities.

Example of the Operating Cash Flow Ratio

Blitz Communications recently raised $50 million through an initial public offering, and promptly parked all of the cash in investments. In the following quarter, the company’s net income rose from $400,000 to $900,000. Further investigation reveals the following cash flow from operations ratio:

	Preceding Quarter	Current Quarter
Cash flow from operations	$390,000	$375,000
Net income	$400,000	$900,000
Cash flow from operations ratio	98%	42%

The ratio reveals that the core operations of the business have generated less cash than had been the case before the company went public. The entire source of the increased net income has been the investment income generated by the cash the company obtained from investors when it went public.

Total Shareholder Return Definition and Usage

Steven Bragg — Fri, 14 Jun 2013 17:02:34 +0000

When an investor buys the shares of a company, the return generated by the purchase will be derived from a combination of the change in the share price over the measurement period, plus any dividends paid by the company in the interim.

The formula for this total shareholder return (on an annual basis) is:

(Ending stock price - Beginning stock price)
+ Sum of all dividends received during the measurement period
= Total shareholder return

The total return can then be divided by the initial purchase price to arrive at a total shareholder return percentage.

This measurement can be skewed to a considerable extent if a shareholder has control over a business. If this is the case and the company is sold, then the shareholder will likely be paid a control premium in exchange for giving up control over the entity.

Example of Total Shareholder Return

An investor purchases shares of Albatross Flight Systems for $15.00 per share. One year later, the market value of the shares is $17.00, and the investor has received several dividends totaling $1.50. Based on this information, the total shareholder return is:

($17.00 Ending stock price - $15.00 Beginning stock price)
+ $1.50 Dividends received
= $3.50 Total shareholder return

Based on the initial $15.00 purchase price, this represents a 23.3% total shareholder return.

What is manufacturing overhead?

Steven Bragg — Fri, 14 Jun 2013 16:58:04 +0000

Manufacturing overhead is all of the costs that a factory incurs, other than the variable costs required to build products, such as direct materials and direct labor.

Examples of costs that are included in the manufacturing overhead category are:

Depreciation on equipment used in the production process
Rent on the factory building
Salaries of maintenance personnel
Salaries of manufacturing managers
Salaries of the materials management staff
Salaries of the quality control staff
Supplies not directly associated with products (such as manufacturing forms)
Utilities for the factory
Wages of building janitorial staff

Since direct materials and direct labor are usually considered to be the only costs that directly apply to a unit of production, manufacturing overhead is (by default) all of the indirect costs of a factory.

Manufacturing overhead does not include any of the selling or administrative functions of a business. Thus, the costs of such items as corporate salaries, audit fees, and bad debts are not included in manufacturing overhead.

When you create financial statements, both generally accepted accounting principles and international financial reporting standards require that you assign manufacturing overhead to the cost of products, both for reporting their cost of goods sold (as reported on the income statement), and their cost within the inventory asset account (as reported on the balance sheet). The method of cost allocation is up to the individual company - common allocation methods are based on the labor content of a product or the square footage used by production equipment. Whatever allocation method used should be used on a consistent basis from period to period.

Related Terms

Manufacturing overhead is also known as factory overhead, production overhead, and factory burden.

Related Questions

What is a burden rate?
What is a plantwide overhead rate?
What is fixed overhead?
What is variable overhead?

What is the direct material price variance?

Steven Bragg — Thu, 13 Jun 2013 17:01:05 +0000

The direct material price variance is the difference between the actual price paid to acquire a direct materials item and its budgeted price, multiplied by the actual number of units acquired. The formula follows:

(Actual price - Budgeted price) x Actual quantity = Direct material price variance

The direct material price variance is one of two variances used to monitor direct materials. The other variance is the direct material yield (or usage) variance. Thus, the price variance tracks differences in raw material prices, and yield variance tracks differences in the amount of raw materials used.

The budgeted price is the price that the company's purchasing staff believes it should pay for a direct materials item, given a predetermined level of quality, speed of delivery, and standard purchasing quantity. Thus, the presence of a direct material price variance may indicate that one of the underlying assumptions used to construct the budgeted price is no longer valid.

Here are several possible causes of a direct material price variance:

Materials shortage. There is a raw material shortage, which drives up its cost.
New supplier. The company has changed vendors, and the replacement vendor charges a different price.
Rush basis. The company needed the materials on short notice and paid overnight freight charges to obtain them.
Volume assumption. The company now buys in different volumes than it originally planned. This may be caused by an incorrect initial sales assumption regarding the number of units that will be sold.

As you can see from the list of variance causes, different people may be responsible for an adverse variance. For example, a rush order is probably caused by an incorrect inventory record that is the responsibility of the warehouse manager. As another example, the decision to buy in different volumes may be caused by an incorrect sales estimate, which is the responsibility of the sales manager. In most other cases, the purchasing manager is considered to be responsible.

The direct material price variance can be meaningless or even harmful in some circumstances. For example, the purchasing manager might have engaged in heavy political maneuvering to have the standard price set unusually high, which makes it easier to generate a favorable variance by purchasing at prices below the standard. Also, the variance can cause incorrect behavior by creating an incentive to purchase in bulk in order to obtain the lowest price, even though this means burdening the company with an inordinate amount of inventory that it does not immediately need.

Direct Material Price Variance Example

The purchasing staff of ABC International estimates that the budgeted cost of a chromium component should be set at $10.00 per pound, which is based on an estimated purchasing volume of 50,000 pounds per year. During the year that follows, ABC only buys 25,000 pounds, which drives up the price to $12.50 per pound. This creates a direct material price variance of $2.50 per pound, and a variance of $62,500 for all of the 25,000 pounds that ABC purchases.

Related Topics

The direct material price variance is also known as the purchase price variance.

What is direct material cost?

Steven Bragg — Thu, 13 Jun 2013 16:55:45 +0000

Direct material cost is the cost of the raw materials and components used to create a product. The materials must be easily identifiable with the resulting product (otherwise they are considered to be joint costs). The direct material cost is one of the few variable costs involved in the production process; as such, it is used in the derivation of throughput from production processes. Throughput is sales minus all totally variable expenses.

Examples of direct materials are:

The timber used to construct a house
The steel included in an automobile
The circuit board included in a radio
The fabric used to assemble clothing

Some costs are for materials that are not considered direct materials, and so are instead classified as indirect material costs. These materials are so immaterial as not to be worth tracing to a specific product, or cannot be clearly associated with a specific product. Examples of indirect materials are:

Rags and solvents used during the construction of a house
The grease used on machines that manufacture products
The thread used in clothing

A company may buy direct materials from suppliers or create them on-site.

To determine the amount of direct materials cost in a product, work with the engineering staff to create a bill of materials, which specifies the quantity of each raw material item and component included in a product. Then assign a standard cost to each item, based on recent prices paid for them (including freight and sales taxes), and add a reasonable allowance for scrap and spoilage. The total is the direct material cost of the product.

Related Questions

What are direct costs?
What is direct labor cost?

Period order quantity definition and usage

Steven Bragg — Wed, 12 Jun 2013 20:34:03 +0000

The period order quantity is the standard number of units to be ordered over a fixed period of time. This approach is used when the amount of raw materials or supplies usage is very consistent from period to period; the purchasing staff can simply arrange for certain quantities to be delivered at regular intervals under a master purchase order agreement. When received, the purchasing staff logs in the number of units delivered against the grand total authorized under the related master purchase order, and may also track the ability of the supplier to deliver as of a designated date. This is one of the easiest ways in which to order goods in an efficient manner.

The problems with the period order quantity concept are as follows:

Investment size. A single delivery is usually planned for a fairly long period of time, such as a month or a quarter of usage, which can result in an excessively large amount of inventory on hand. If management wants to reduce the investment in inventory, it will need to use a more precise ordering system, such as a material requirements planning or just-in-time system.
Demand variation. If the level of demand for an item increases unexpectedly near the end of a usage period, there is an increased risk of a stockout. This issue can be resolved by employing some amount of safety stock, though doing so also increases the investment in inventory.
Demand termination. The method can result in continuing supplier deliveries even when usage has declined or been terminated. The problem is the lack of a tracking system for these goods. The issue can be resolved by instituting a periodic visual check of on-hand stocks by the purchasing staff.

In short, the period order quantity method is a simple way to ensure that approximately correct quantities are ordered on a regular basis, with minimal supporting systems. Its use should be limited to those items for which there is a high degree of confidence that demand will be consistent over a fairly long period of time.