TM 661 Engineering Economics for Managers

1. TM 661Engineering Economics for Managers Managerial and Cost Accounting

2. Learning Objectives • Know the major differences between financial accounting and Managerial Accounting • Given a set of factory overhead data, be able to use the high-low method to compute the fixed and variable factory overhead rates. • Given appropriate cost figures, be able to compute associated cost tables using either the job order costing or the process costing method. • Understand the different pricing strategies

3. Managerial Vs Financial Accounting

4. Managerial Accounting • Different from accounting used for your tax preparation • Tax Accounting: tells you HOW MUCH you sold and What you spent it on • Managerial accounting: tells you Where your income came from and Why you spent it • Two aspects of Managerial Accounting • Getting accurate information • Understanding what that information is telling

5. Cost Classification • For cost accounting purposes: • Product Cost • Period Cost • Relationship to product or activity: • Direct Cost • Indirect Cost • Relationship between total cost and volume of activity • Variable cost • Fixed Cost

6. Cost Classification Continued • Time-Frame perspective • Controllable cost • Non-controllable cost • For other analytical purposes • Differential cost • Allocated cost • Sunk Cost • Opportunity cost

7. Accounting Equation Owner Equity = Assets - Liabilities

13. Cost Behavior & Flexible Budgeting • Mixed costs are a function of fixed & variable costs Cost-Volume formula Y = a + bx where Y = mixed cost to break up x = a measure of activity (machine hrs) a = fixed cost component b = variable rate per unit x

14. High-Low Method Suppose we have the following:

15. High-Low Method X Y High 280 2480 Low 190 2330 Difference 90 150 Variable rate = 150/90 = $1.67 per DLH

16. High-Low Method Fixed Cost Portion Total Mixed - Variable = $2,480 - 1.67(280) = $2,012

17. High-Low Method Fixed Cost Portion Total Mixed - Variable = $2,480 - 1.67(280) = $2,012 Total Mixed Cost = $2,012 + 1.67 X

18. Least Squares

19. Least Squares Y = $1,900.27 + 3.054 x

20. Flexible Budgeting • Geared towards a range of activities • Dynamic rather than static

21. Flexible Budgeting • Geared towards a range of activities • Dynamic rather than static Need to understand rudiments of cost accounting • Job order costing • Process costing • Activity based costing

22. Job Order Costing • K-Corp collects its cost data by the job order cost system. For each job, they know the amount and material costs. Direct labor costs are $9.50 per hour. Factory overhead rate is computed at $4.50 per hour.

24. Process Costing • A Company produces and sells a chemical product. During a given month the company purchases 15,000 gallons of chemicals at a cost of $30,000. 10,000 gallons are completed and transferred to the next department. 5,000 gallons are 20% complete as to conversion. Factory overhead for the month is $20,000.

26. Activity Based Costing • Historically direct labor & material constitute significant elements of cost of goods sold • Current overhead costs dominate the cost of production • Activity-based costing is designed to meet the challenge of a changing cost mix by associating manufacturing costs with activities which drive them

27. ABC Two-Step Process • Define Cost Pools (usually support functions) • Identify Cost Drivers (trace costs to the cost pools)

28. ABC Example • A multinational firm uses traditional accounting to allocate manufacturing and management support costs. However, travel is typically allocated on the basis of employees at plants in France, Germany, Italy, and Greece. Consequently, some plants are likely generating much more management travel than others. The ABC system is chosen to more precisely allocate travel costs to major product lines.

29. ABC Example

30. ABC Example 1. Determine Cost Pool

31. ABC Example 2. Determine Cost Driver

32. ABC Example Driver Distribution

33. ABC Example Allocation of Costs

34. Value Added • Examines the difference between the net operating profit (after tax) and the cost of capital • Four ways to create value for shareholder • increase profit margins without increasing capital • invest in projects that earn more than cost of capital • free-up capital than earns less than cost of capital • use debt to reduce the cost of capital

35. Value Added • Which is the better firm from a shareholder’s point of view?

36. Value Added • Firm B has largest Economic Value Added (EVA)

37. Value Added • Firm B has largest Economic Value Added (EVA) Maximizing ROI is not the right objective!

38. Product Pricing vs Product Cost Product Pricing is different than Product Cost! • Cost-based pricing • Competitive-based pricing • Demand-based pricing

39. Cost Based Pricing • Recognizes a relation ship between pricing and the costs of running a business • The higher your costs…. The higher your prices must be • Pricing = COS * mark-up factor = price Example $10 * 2 = $20 or 100/50 = 2 For 50% COS

40. Competitive-Based Pricing • Recognizes that some products are more price – sensitive to consumers than others, therefore competition is a concern. Groceries Milk, bread, butter Can of Artichokes

41. Demand based pricing • Recognizes the viability of charging as much as the market will bear. • The greater demand, the more you can charge • The fewer providers, the more you can charge • The greater the perceived value, the more you can charge!

42. Benchmarks • Home Studios • 30% cost of goods • 30% general expenses • 40% owner’s compensation + net profit • Different per industry

43. References • Marshall and McManus, Accounting What The Numbers Mean3rd Edition, Irwin, 1994. Page 12-13 • Business Breakthroughs Workshop, Studio Management Services