Prentice Hall's one-day MBA in finance & accounting (43 page)

Instead, assume the company fell way short of its sales goals for the year and failed to adjust its production output.

And assume the sales forecast for next year is not all that encouraging. The large inventory overhang at year-end presents all sorts of problems. Where do you store it? Will sales price have to be reduced to move the inventory? And what about the fixed manufacturing overhead cost included in inventory? This last question presents a very troublesome accounting problem.

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E N D T O P I C S

Management Profit Report for Year

Sales Volume = 6,000 Units

Per Unit

Total

Sales revenue

$1,400

$8,400,000

Cost-of-goods-sold expense

($ 685)

($4,110,000)

Gross margin

$ 715

$4,290,000

Variable operating expenses

($ 305)

($1,830,000)

Contribution margin

$ 410

$2,460,000

Fixed operating expenses

($2,300,000)

Operating profit (earnings before

interest and income tax)

$ 160,000

Manufacturing Costs for Year

Annual Production Capacity = 12,000 Units

Actual Output = 12,000 Units

Basic Cost Components

Per Unit

Total

Raw materials

$ 215

$2,580,000

Direct labor

$ 260

$3,120,000

Variable overhead

$

35

$ 420,000

Fixed overhead

$ 175

$2,100,000

Total manufacturing costs

$ 685

$8,220,000

Distribution of Manufacturing Costs

11,000 units sold (see above)

$ 685

$4,110,000

1,000 units inventory increase

$ 685

$4,110,000

Total manufacturing costs

$8,220,000

FIGURE 18.3
Excessive accumulation of inventory.

If only 6,000 units had been produced instead of the 12,000

actual output, the company would have had 50 percent idle capacity—an issue discussed earlier in the chapter. By producing 12,000 units the company seems to be making full use of its production capacity. But is it, really? Producing excessive inventory is a false and illusory use of production capacity.

A good case can be made that no fixed manufacturing overhead costs should be included in excessive quantities of inventory; the amount of fixed overhead cost that usually would be
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M A N U F A C T U R I N G A C C O U N T I N G

allocated to the inventory should be charged off as expense to the period. Unless the company is able to slash its fixed overhead costs, which is very difficult to do in the short run, it will have these fixed overhead costs again next year. It should bite the bullet this year, it is argued.

Assume the company will have to downsize its inventory next year, which means it will have to slash production output next year. Unless it can make substantial cuts in its fixed manufacturing overhead costs, it will have substantial idle capacity next year.

The question is whether the excess quantity of ending inventory should be valued at only variable manufacturing costs and exclude fixed manufacturing overhead costs. As a practical matter, it is very difficult to draw a line between excessive and normal inventory levels. Unless ending inventory was extremely large, the full-cost absorption method is used for ending inventory. The fixed overhead burden rate is included in the unit product cost for all units in ending inventory.*

s

END POINT

Manufacturers must determine their unit product costs; they have to develop relatively complex accounting systems to keep track of all the different costs that go into manufacturing their products. Direct costs of raw materials and labor and variable overhead costs are relatively straightforward. Fixed manufacturing overhead costs are another story. The chapter examines the problems of excess (idle) production capacity, excess manufacturing costs due to inefficiencies, and excess production output. Managers have to stay on top of these situations if they occur and know how their unit product costs are affected by the accounting procedures for dealing with the problems.

*One theory is that
no
fixed manufacturing overhead costs should be included in ending inventory—whether normal or abnormal quantities are held in stock. Only variable manufacturing costs would be included in unit product cost. This is called
direct costing,
though more properly it should be called
variable costing.
It is not acceptable for external financial reporting or for income tax purposes.

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A P P E N D I XA

Glossary for

Managers

accelerated depreciation
(1) The estimated useful life of the fixed asset being depreciated is shorter than a realistic forecast of its probable actual service life; (2) more of the total cost of the fixed asset is allocated to the first half of its useful life than to the second half (i.e., there is a front-end loading of depreciation expense).

accounting
A broad, all-inclusive term that refers to the methods and procedures of financial record keeping by a business (or any entity); it also refers to the main functions and purposes of record keeping, which are to assist in the operations of the entity, to provide necessary information to managers for making decisions and exercising control, to measure profit, to comply with income and other tax laws, and to prepare financial reports.

accounting equation
An equation that reflects the two-sided nature of a business entity, assets on the one side and the sources of assets on the other side (assets = liabilities + owners’ equity). The assets of a business entity are subject to two types of claims that arise from its two basic sources of capital—liabilities and owners’ equity. The accounting equation is the foundation for double-entry bookkeeping, which uses a scheme for recording changes in these basic types of accounts as either debits or credits such that the total of accounts with debit balances equals the total of accounts with credit balances. The accounting equation also serves as the framework for the statement of financial condition, or balance sheet, which is one of the three fundamental financial statements reported by a business.

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A P P E N D I X A

accounts payable
Short-term, non-interest-bearing liabilities of a business that arise in the course of its activities and operations from purchases on credit. A business buys many things on credit, whereby the purchase cost of goods and services are not paid for immediately. This liability account records the amounts owed for credit purchases that will be paid in the short run, which generally means about one month.

accounts receivable
Short-term, non-interest-bearing debts owed to a business by its customers who bought goods and services from the business on credit. Generally, these debts should be collected within a month or so. In a balance sheet, this asset is listed immediately after cash.

(Actually the amount of short-term marketable investments, if the business has any, is listed after cash and before accounts receivable.) Accounts receivable are viewed as a near-cash type of asset that will be turned into cash in the short run. A business may not collect all of its accounts receivable. See also
bad debts.

accounts receivable turnover ratio
A ratio computed by dividing annual sales revenue by the year-end balance of accounts receivable. Technically speaking, to calculate this ratio the amount of annual
credit
sales should be divided by the
average
accounts receivable balance, but this information is not readily available from external financial statements. For reporting internally to managers, this ratio should be refined and fine-tuned to be as accurate as possible.

accrual-basis accounting
Well, frankly,
accrual
is not a good descriptive term. Perhaps the best way to begin is to mention that accrual-basis accounting is much more than cash-basis accounting. Recording only the cash receipts and cash disbursement of a business would be grossly inadequate. A business has many assets other than cash, as well as many liabilities, that must be recorded. Measuring profit for a period as the difference between cash inflows from sales and cash outflows for expenses would be wrong, and in fact is not allowed for most businesses by the income tax law. For management, income tax, and financial reporting purposes, a business needs a comprehensive record-keeping system—one that recognizes, records, and reports all the assets and liabilities of a business. This all-inclusive scope of financial record keeping is referred to as
accrual-basis accounting.
Accrual-basis accounting records sales revenue when sales are made (though cash is received before or after the sales) and records expenses when costs are incurred (though cash is paid before or after expenses are recorded). Established financial reporting standards require that profit for a period must be recorded using accrual-basis accounting methods. Also, these
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A P P E N D I X A

authoritative standards require that in reporting its financial condition a business must use accrual-basis accounting.

accrued expenses payable
The account that records the short-term, non-interest-bearing liabilities of a business that accumulate over time, such as vacation pay owed to employees. This liability is different than
accounts payable,
which is the liability account for bills that have been received by a business from purchases on credit.

accumulated depreciation
A contra, or offset, account that is coupled with the property, plant, and equipment asset account in which the original costs of the long-term operating assets of a business are recorded.

The accumulated depreciation contra account accumulates the amount of depreciation expense that is recorded period by period. So the balance in this account is the cumulative amount of depreciation that has been recorded since the assets were acquired. The balance in the accumulated depreciation account is deducted from the original cost of the assets recorded in the property, plant, and equipment asset account. The remainder, called the
book value
of the assets, is the amount included on the asset side of a business.

acid test ratio
(also called the
quick ratio
) The sum of cash, accounts receivable, and short-term marketable investments (if any) is divided by total current liabilities to compute this ratio. Suppose that the short-term creditors were to pounce on a business and not agree to roll over the debts owed to them by the business. In this rather extreme scenario, the acid test ratio reveals whether its cash and near-cash assets are enough to pay its short-term current liabilities. This ratio is an extreme test that is not likely to be imposed on a business unless it is in financial straits.

This ratio is quite relevant when a business is in a liquidation situation or bankruptcy proceedings.

activity based costing (ABC)
A relatively new method advocated for the allocation of indirect costs. The key idea is to classify indirect costs, many of which are fixed in amount for a period of time, into separate activities and to develop a measure for each activity called a
cost driver.

The products or other functions in the business that benefit from the activity are allocated shares of the total indirect cost for the period based on their usage as measured by the cost driver.

amortization
This term has two quite different meanings. First, it may refer to the allocation to expense each period of the total cost of an intangible asset (such as the cost of a patent purchased from the inventor) over its useful economic life. In this sense amortization is equivalent
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A P P E N D I X A

to depreciation, which allocates the cost of a tangible long-term operating asset (such as a machine) over its useful economic life. Second, amortiza-

tion may refer to the gradual paydown of the principal amount of a debt.

Principal
refers to the amount borrowed that has to be paid back to the lender as opposed to interest that has to be paid for use of the principal.

Each period, a business may pay interest and also make a payment on the principal of the loan, which reduces the principal amount of the loan, of course. In this situation the loan is
amortized,
or gradually paid down.

asset turnover ratio
A broad-gauge ratio computed by dividing annual sales revenue by total assets. It is a rough measure of the sales-generating power of assets. The idea is that assets are used to make sales, and the sales should lead to profit. The ultimate test is not sales revenue on assets, but the profit earned on assets as measured by the
return on
assets
(ROA) ratio.

bad debts
Refers to accounts receivable from credit sales to customers that a business will not be able to collect (or not collect in full). In hind-

sight, the business shouldn’t have extended credit to these particular customers. Since these amounts owed to the business will not be col-

lected, they are written off. The accounts receivable asset account is decreased by the estimated amount of uncollectible receivables, and the bad debts expense account is increased this amount. These write-offs can be done by the
direct write-off method,
which means that no expense is recorded until specific accounts receivable are identified as uncollectible. Or the
allowance method
can be used, which is based on an estimated percent of bad debts from credit sales during the period.

TEAMFLY

Under this method, a contra asset account is created (called
allowance
for bad debts
) and the balance of this account is deducted from the accounts receivable asset account.