D = Demand in units for a specified period 

P = Ordering costs per purchase order 

C = Carrying costs of one unit in stock for the time period used for Demand.

Assume, for example, a retail clothing shop carries a line of men’s shoes and the shop sells 1,500 pairs of shoes each year. It costs the company $5 per year to hold a pair of shoes in inventory, and the fixed cost to place an order is $2. The EOQ formula is the square root of: (2 X 1,500 pairs X $2 order cost) / ($5 holding cost), or 34.641 with rounding. The ideal order size to minimize costs and meet customer demand is 35 pairs of shoes.

That should help you out Oliver, let me know if you have any more questions!

For instance, say in a clothing factory and for simplicity sake, the thread used to sew clothing is an example of an overhead cost as with mass production, it would not be economically feasible to calculate how much thread was used spread across multiple clothing styles. 

Typically, managers want to be able to budget ahead of time as this allows for producing budgets and making decisions being made in a timely manner. As a result, they gear more towards trying to make an estimation of how much overhead will be used. Say in this example, the estimated amount of overhead for the whole fiscal period is $500. This $500 is the budgeted overhead and is applied to the credit account “MOH Allocated”.

At the end of the fiscal period, the company can then account for all of the actual overhead costs that have been incurred throughout the year. After accounting for all of the indirect costs for the year, say the actual amount of overhead is $600.

In this case, the actual amount exceeded what was estimated/budgeted, and thus the overhead costs are under allocated. This is similar to saying that the managers have underestimated the actual amount of overhead by estimating that only $500 would be used, but there ends up being $600 of thread being used (see 1).

In contrast, say if the actual overhead costs come out to be $450 when we had anticipated that the overhead costs to be $500 (which we have applied to MOH Applied because this was an estimation), then we over-applied overhead – we over-estimated how much overhead would be applied (see 2).

As stated earlier, the “MOH Allocated” account is a credit. To add onto this, we also have a “MOH Control” account that is a debit. All actual overhead costs that are incurred are applied to this account as once the actual costs are incurred, the balance in “MOH Allocated” gets netted out by the amount in the “MOH Control” account (you can think of this like closing off revenues and expenses into retained earnings at year end where you debit revenues and credit expenses to offset its amounts).

I have included an attachment to show the concept of under- (see 1) and over-applied (see 2) overhead with the use of T accounts.

 

Cost based Transfer Price is a effective policy to use when there’s no market or when there’s not enough information or its too difficult to determine what the market price is. The transfer costs in this case is based on the cost incurred to actually produce the product. Cost based transfer prices can either be in the form of just variable cost, variable cost and fixed costs, full costs and lastly full cost + a markup. 

 

The formula used to calculate transfer price is incremental cost(Variable Cost) + Lost in Contribution Margin(Opportunity costs). I’ve attached a short video that goes through an example of how to calculate min and max transfer price. 

EOQ stands for Economic Order Quantity. It represents the number of units a company should add to inventory in order to minimize the total costs. The optimal quantity of units can be found by using the formula
EOQ = SQRT(2DP/H)

D = Units demanded

P = Order cost

C = Carrying cost

Examples include; order costs, holding costs, and shortage costs. 

I found a simplified example that you can use to better understand: https://www.youtube.com/watch?v=AYpjPWmlyHM

All the best! -Gordon

To build onto April and Jay's response for your chapter 18 question.. I found two helpful sources. 

The first is an article that explains spoilage, and the second link is a real life example. The second link is a video showing how Ford's F150 truck uses spoilage and scrap costs in there production. I think it is valuable as it apply's the content learned from this chapter to a real life example, which helps put the content in perspective!

Link one: https://www.managementstudyguide.com/spoilage-and-rework-in-job-order-costing-system.htm

Link two: https://www.youtube.com/watch?v=Fte2o9_v-T0

Hope this helps!

Gl on the test!

 

Variable Costing 
Under a Variable Cost System only variable manufacturing costs are included as inventorial costs. Meaning that all fixed costs (manufacturing and non manufacturing overhead) are classified as period costs. The costs flow from inventory to Cost of Goods Sold just like in an absorption cost system but within those costs there’s not fixed components whereas in absorption costs system there is. 

Absorption Costing (Also called Full Costing) is a cost method where product costs are capitalized. 

Under Absorption costing, inventorial costs include all variable and fixed manufacturing costs.

Under Variable costing (Also called Direct Costing) product costs are also capitalized as well, however only variable manufacturing costs are included as inventorial costs.

Essentially that is the main difference between the two costing methods, where the fixed manufacturing costs are allocated.

When I learnt this topic seeing the difference on an Income Statement helped, I included one below as well as a link to a video supporting Absorption costing and a mini example which may be beneficial to watch!
-To see the video, please click the link, and then on padlet click "view original".

Revenue

(COGS- including fixed manufacturing OH)

=Gross Profit

(Operation Expense)

=Operating Income

Revenue

(Variable costs)

=CM

(FC- including fixed manufacturing OH)

=Operating Income

Static budget is basically using forecasted data to create a budget.

Where the Flexible budget uses all the same data as the static budget, but replaces the budgeted amount produced for the ACTUAL output produced to create its figures.

An example would be if at the beginning of the year you thought you would produce 5 units @ a sales price of $10, but at the end of the year you find out you actually produce 8 units.

Under Static budget, you would record 5x$10= $50

Under Flexible budget, you would record 8x$10=$80

2. Standard costing vs. Normal costing

Standard costing uses target amounts (predetermined figures) for the companies DL and DM. If the company is following standard costing they will use these targeted amounts for recording purposes. 

However when time goes on, and when we know the ACTUAL amounts, we can find our variances.

So in standard costing, basically the variances are going to be a comparison of the actual amounts and the standards (targets) set at the beginning of the year. The variances allow the managers' how their predictions panned out, and using standard costing also helps managers see where they need to improve.

Relating standard costing to normal costing, the main difference between the two is that normal costing uses the actual figures right away, and does not set standards. 

For your trouble with variances, I found this short video which explains conceptually why we use variances, I think it will help if you check it out:

The reason why there’s always an over or under applied over head is due to the fact that when we are calculating total cost using normal costing system we are using an budgeted overhead rate to calculate the estimated manufacturing Overhead. We have to use the Normal costing system because we don’t know what the actual overhead amount will be till year end. Once we do know the actual overhead amount we would recalculating total cost under the actual costing system. The concept of over and under applied comes from the difference between the total budgeted over head cost applied (total manufactured overhead under normal costing) and the actual overhead cost incurred. When overhead incurred > overhead applied à under allocated overhead. When overhead incurred < overhead applied à over allocated overhead.

 

The difference between Activity based costing and traditional costing 

·      Traditional Costing: Uses the estimated allocation rate to budget total Manufacturing Over head cost. 

·      Activity based costing: allocates overhead to specific activities in the manufacturing process instead of to the whole product its self. Therefore, each activity has its own activity cost rate that is based on a cost driver 

o   Activity cost rate: total cost related to the activity/activity cost driver 

·      Under both methods total cost will be the same the only thing that’s different is the amount of manufacturing over head.

 

 

We have to first realize that we are using estimates when applying costs to overhead because you will never know the actual costs until they are incurred, and that is where over or under applied overhead comes into play. Over or under applied overhead refers to the difference between manufacturing overhead cost applied and manufacturing overhead cost incurred. When the estimated costs applied to manufacturing overhead ends up being greater than the manufacturing overhead cost we actually incurred then that's where over-applied overhead appears. Vice versa, when the manufacturing overhead cost applied is less than the actual manufacturing overhead cost incurred then that's where under-applied overhead appears. Therefore, in the normal costing system we must make periodic adjustments to reconcile the amount of Overhead we applied to the actual amount of overhead used.

 

Traditional vs ABC

 

 

Traditional Based Costing uses one average rate to allocate company's overhead to jobs relating to the product, this treats overhead costs as a single pool of indirect costs. Activity Based Costing however assigns overhead costs to each specific activity associated with a cost driver to, each at a different rate.

 

Traditional Based Costing

 

Pro:

Con:

 

Activity Based Costing

 

Pro:

Con:

Activity Based Costing assigns a cost to each specific activity associated with creating a product, then determines the cost of the product by calculating the sum of these activities. Traditional based Costing uses an average rate to assign costs to a product. Management uses activity based costing because it allocates resources based on actual consumption therefore they find it more accurate. Although activity based costing seems like more work, it helps make better pricing and product mix decisions. For example, Chrysler uses activity based costing to reduce costs and eliminate inefficient activities.

A pro of Activity based costing is that it helps identify wasteful activities and products

A con of Activity based costing it that it is expensive and time-consuming to implement

A pro of traditional based costing is its easiness to apply 

A con of traditional based costing is that it can lead to poor management decisions since an average rate is being used 

Chapter 4
Under normal costing we use budgeted overhead rates to try and forecast the future costs to help make decisions assess profitability. 

When allocating overhead using the budgeted rate we basically have an estimate of the amount of indirect materials used in each specific job. But at year end, when we have the actual amount of overhead (specific indirect labour hours, Indirect materials used etc.), we want to compare and see how well we predicted the allocation of overhead. That is why when calculating Over/Under applied OH we take the Actual MOH costs- Allocated MOH, to find the difference between our OH forecast and the OH actual balance at year end. The difference is either the under/over applied OH. 

That’s basically how I would sum up conceptually why we have under and over applied overhead for Oliver! 

-Each method (Traditional vs. ABC) provide different OH amounts.

-ABC uses multiple allocation rates, Traditional costing uses only one.

-Goal is to assign OH costs in a cost pool directly to a product.

-Detailed analysis of looking at a companies activity costs, seeing how those costs are individually allocated to the job and finding a rate to assign to each product. 

 

Traditional
-Uses averages to allocate OH costs to jobs, and doesn’t look at the actual OH costs incurred for the job. 

-Companies should use this type of costing when their indirect costs are minimal in comparison to the total costs.

EOQ

EOQ stands for “economic order quantity”.  It’s a decision model represented by the equation EOQ = sqrt (2DP/C).  Solving the equation will give the optimal quantity of inventory that a company should order given a set of assumptions.  The assumptions are:

·The same quantity is ordered at each re-order point.  

·Demand, lead times, ordering costs, and carrying costs are certain.  

·Quantity ordered does not affect the purchasing costs per unit

·No stockouts (situations where inventory has been exhausted)

·Costs of quality and shrinkage are only considered if they affect the ordering or carrying costs

Example:  Oliver runs a stall in the Byward market during the summer, selling gourmet olives.  He sells 10,000 Olives per summer (D) and the costs to hold one olive is $0.12 (C).  It costs him $80 per purchase order (P) from his supplier in Europe.  What is his EOQ?

EOQ = sqrt (2*10,000*80/.12)

EOQ = 3651 olives

Transfer Pricing

1. Market based:

The transfer price is set at the market price (i.e. the cost of a similar product or service that is also on the open market.  This method is best used when the selling division does not have idle capacity.

2. Cost based:

Transfer price is determined based on the costs of producing the intermediate product.  Transferring at full cost means the price will contain an allocation of fixed overhead; this might lead to suboptimal decisions in de-centralized organizations. Transferring at variable cost might lead divisions to record large losses and income due to the transfer pricing decision.

3. Negotiated transfer price (NTP):

An NTP comes from discussions between the selling and buying parties.  This method is generally used when the market is more volatile, and it allows managers autonomy, as they will often have the most accurate information about what is going on in their respective divisions.  

To calculate the minimum transfer price (MTP):

Use MTP = Variable cost + lost contribution margin

Example: 

A T-shirt company has two divisions. P Division makes printed T-shirts and buys 30,000 (plain t-shirts) a month from an outside supplier for $11 each.  C Division makes t-shirts with slogans on them.  C Division sells 40,000 T-shirts each month; VC per shirt is $2 and CM is $28. Idle capacity is 5,000.

If P Division wants to transfer their 30,000 shirts to C Division, what is the MinTP and MaxTP?   

MTP = 2 + (28* (40000-30000)/40000) = $9

Hope that helps

My group members did a good job explaining units-transferred-in and spoilage, so I’ll go over rework and how it applies to a job costing system.

-Normal rework attributable to a specific job refers to rework that is not out of the ordinary for the manufacturing process of a specific job and can therefore be charged to the work in process for that job. 

Example: Say a mining equipment company is building some excavators with diamond tipped teeth for a customer.  Unfortunately, the excavators are accidentally fitted with regular steel teeth.  The teeth can be switched out but it will cost the company in terms of direct labour and overhead.  The extra costs of doing this would be charged to the WIP for that specific job.    

-Normal rework common to all jobs refers to rework that is not out of the ordinary for the manufacturing process of all jobs currently being undertaken, and therefor can be charged to MOH in order to spread the cost over all the jobs.   

Example: The mining company installs plexiglass shields on the cabs of all its excavators.  Unfortunately these were slightly scratched during the manufacturing process and now must be cleaned off in order to be brought up to safety standards.  The rework costs associated with doing this for all the excavators are charged to MOH and spread across all the different jobs.     

-Abnormal rework refers to rework that is out of the ordinary for the manufacturing process, and is therefore charged to a loss account:  

Example:  The company is installing transmissions on the excavators.  Unfortunately the crane installing the transmission malfunctions and the transmission falls to the ground, cracking all the gears.  The rework costs of doing this are abnormal for the company and the costs associated with doing so are charged to the Loss from Abnormal Rework account.

Hope that helps!

Hi Oliver, to build onto Kimberley and Jay's response, I can tell you about Negotiated TP.

This is where both parties (buyer and seller) can negotiate a transfer price, there are no conditions that have to be met, its commonly used when there is no market price.

With this method of transfer pricing, you want to look at the relevant range of pricing that both the buyer and seller can agree between.

The Max TP is equal to what the buyer can go buy from an external supplier. While the Min TP is the minimum amount that the supplier is willing to sell the item for, making sure they cover all there costs incurred for production. 

Therefore it makes sense that Min TP= VC + CM per unit lost.

Some advantages of Negotiated TP are:

-Give managers power to decide on price

-Divisional managers probably have the best information on the costs incurred for each product, and can help when setting the TP.

Hope this helps!