Companies have set policies in place that dictate how they do things, how they make money, and how they produce products and services through the help of the employees who make up their workforce. These policies can stay stagnant for decades, causing many companies to fall behind as a result. One common example of this is a Motorola factory in the 1970's that was considered to be one of the worst factories in the company in terms of productivity. The factory was sold to a Japanese firm, and quickly became a highly productive factory for the company, even rising to be one of the company's best. Did the Japanese firm fire all the staff and replace them with new employees? Not at all. Not one person lost their job in the transition. So how could a company go from being one of the worst to one of the best? The answer comes in the managerial accounting techniques that the Japanese firm implemented in the factory. By looking at how the processes worked together, not as a whole but in segments, the firm was able to use the same employees but use different processes to gain excellent results.
This is what managerial accountants need to do in the companies they work for. They need to help the managers make the right decisions to improve the efficiency of the company so that everyone can benefit. To do this, the managerial accountant needs to look at the policies of the company to determine where the changes can be made. In this chapter, we will look at the various things in a company that can affect the overall cost of a product, and the productivity of the employees.
To understand how the financial system in a company works, so that we can use it to make the company more efficient and help managers find a direction, we need to look at the accounting cycles.
- Purchases and Payments Cycle. This is the cycle where there is a purchase of raw materials and supplies. As well, bills are paid by the company at this point when they come due. In this cycle, there are many ways that managerial accountants can look at a company to improve it. Finding raw materials that are cheaper is one way. For example, instead of buying a product out of Kenya for half the price it would be in Mexico, the company should take into account transportation costs and the stability of the Kenya government to determine if Mexico is a more efficient option.
- Payroll Cycle. This is the cycle where the scheduling of employees for production and their pay happens. Managerial accountants can look at this and perhaps find employees who are better suited for other tasks, rather than what they are doing presently. Doing up reports on employee performance in various tasks can help managers determine who should go where.
- Production Cycle. This includes collecting of materials and the costs relating to labor and inventory. A managerial accountant can look at this cycle to determine how production processes can be improved upon so that they can provide detailed cost-benefit reports to the managers.
- Sales-Receipt Cycle. This is where the goods are transferred from finished goods to goods sold. Customers are billed at this point. Managerial accountants can use financial data relating to customer purchases, repeat purchases, and customer satisfaction to help managers determine if the product is hitting the mark with customers or if changes are needed in the future.
Managerial accountants study manufacturing environments so that they can determine where the company can save money and become more efficient to help the managers determine a new and better direction for the company. Manufacturing costs come in three categories Direct Materials, Direct Labor, and Factory Overhead.
- Direct Materials. These are the raw materials and parts that are traceable to the product. These materials must become a part of the finished product, making them a direct part of the manufacturing of the product, thereby influencing the future cost of the product. If managers want to lower the cost of the product, they should start looking at alternative or lower cost direct materials.
- Direct Labor. This is the payroll costs of the employees who convert the direct materials into the finished product. These costs are traceable to the product and managers should create higher efficiency through managerial accounting reports by allocating the right employees to the right areas to increase productivity.
- Manufacturing Overhead. This is all the other costs that are related to producing the product. These costs do not translate as direct materials or direct labor costs. Essentially, when managerial accountants are looking at a factory, they subtract the direct material and direct labor costs to determine the overhead. Lowering the overhead increases profits and can affect the future direction of the company. Manufacturing overhead costs are not directly traceable to the finished product.
These are the costs that are not related to the creation of the product, and thereby not related to the manufacturing costs like direct materials, direct labor, and manufacturing overhead.
The three categories of non-manufacturing costs are selling costs, general and administrative costs, and period costs.
- Selling Costs. These are the costs related to selling the company's product and can include sales commissions as well as sales salaries. In addition, costs like advertising, stores, and equipment also factor into this category. Managerial accountants will look at things like determining the best advertising method for the highest return on investment to help managers make decisions on the future advertising of the product.
- General and Administrative Costs. These are the costs that come from the management and home office of the company. Costs such as buildings, offices, equipment, salaries, and more all factor into this category. Detailed financial reports of these costs and how they affect the product can be invaluable for a manager.
- Period Costs. These are costs that have no future value and are only applicable to the current period, which includes sales costs, general administration costs, income taxes, and interest.
Inventories are an important part of the process for managerial accountants. Determining how the company can deal with its inventories, which the managerial accountants translate into statistics and financial reports for managers, can help companies save money and improve efficiency. There are three categories of inventories:
- Materials Inventory. These are the raw materials and parts that are used in producing goods.
- Work in Process Inventory. This is all the partially completed items that are not ready for sale.
- Finished Goods Inventory. These are all the completed goods that are ready for sale.
Costs move through a company where they collect in the company's accounting books. Financial accountants look at those costs as a whole, rather than in segments like managerial accounting. By looking at cost flow in segments, managerial accountants gain an interesting view of the processes and they learn where managers can save money to shape the future of the company.
Cost flow moves through the company as such:
Direct materials, direct labor, and manufacturing overhead all transition into works in process, which translates into finished goods, which then translates into goods sold. Putting it like this may be a bit confusing, so we will use an example to give you a better understanding of how this works.
If a company manufacturers toy trucks, then the first stage of the cost flow will look like this:
Direct Materials: Plastics for toys, stickers for toys
Direct Labor: Individuals to put together the toys
Manufacturing Overhead: Any other costs related to the initial process
Laborers need to work to put the plastic together so that it resembles the toy, while other laborers will put the stickers on the toys so that the product looks like something resembling a full functional (although miniaturized) toy truck. As the product is assembled, it moves into the work in process stage. If there is a backlog on stickers, then the toy trucks will sit in the work in process stage accumulating costs, especially from labor.
Once the toy trucks are completely assembled, they move into the finished goods phase. Costs here will relate to the cost of housing the toy trucks in the warehouse while the company looks for stores to stock the toy trucks. If too many toy trucks sit in the warehouse, the return on investment for the company is going to go down.
However, once the toy trucks start moving out into the goods sold stage, the company begins to look at the costs of advertising the toy trucks and hiring sales staff to sell the toy trucks.
As we can see, the total cost of the product is going to increase as it moves along, growing in size as the cost flow picks up related costs along the way. Naturally, the cost flow is minimal at the beginning, but by the end the cost of the product's manufacturing, storage, and selling can get quite large. As any managerial accountant will tell you, the longer and more complex a process is to make a product, the more it is going to cost over the course of the production process. Cost flow increases as do complexity and production length.
To determine total costs, we have to look at unit product costs, overhead costs, and labor to determine the total cost of the product.
Unit Product Costs
When companies look at the product going out, they usually look at it in terms of thousands of units put together. This is common in financial accounting but as we have learned with managerial accounting, detail is better so that better decisions can be made. Precision is more important than relevance for managers who need to make decisions based on the information that they have in front of them.
A unit cost is the cost of producing one unit of product broken down into its various parts, labor, materials, and overhead. Often, this is done in great detail by managerial accountants.
Typically, companies will make large quantities at once for a product along an assembly line, comprising thousands of units. When this is done, there is little done to look at the differences between the departments.
The unit cost controls the selling price of the product and since a company usually sells one product at a time, they need to know the total cost of making that one unit so they can determine the cost and selling price.
For example, if the cost of producing one toy truck amounts to $10.32, then the company may charge $19.99 to provide a profit of just over $9.00 for the toy truck. Multiplied by 10,000 units, that amounts to a lot of profit. However, that can be deceiving. It is possible to get thousands of dollars of extra profit out of those toy trucks by looking at the production cycle of the product. Managerial accountants will do this and present their reports to managers, who may change how the product is made to capitalize on those savings.
Many small costs can come together to create a great deal of overhead costs during the manufacturing process. These costs can range from the rent of the factory that is producing the product, the cost of the energy to power the machines to make the product, and even the elements needed (fire, water) to help put the product together.
All of these costs are collected together in a single account under the term of overhead application rate.
The overhead application rate takes in all the costs for one year in the manufacturing of all the products made in that year. To determine the overhead application rate, we use the simple rate of:
Total Annual Overhead Cost / Overhead Cost Driver
The overhead cost driver relates to the production of the product and it can be used to spread the total cost evenly to individual units of the product. Usually, this will come in the form of the number of units produced over the course of the entire year.
We will do an example of this formula to help you determine the overhead application rate.
If the company makes 50 toy trucks per day, and operates 365 days of the year, then over the course of the year, they will make 18,250 toy trucks per year. Now, the overhead costs are electricity, heat, and water to make the toys. Each month electricity costs $200, water costs $75, and heat costs $450. Therefore, the overhead costs amount to $725 per month. Over the course of the year, that amounts to $8,700.
Therefore, the overhead application rate comes to:
$8,700 / 18,250 = 48 cents per product.
Now we know that the overhead costs per product are 48 cents. Therefore, a managerial accountant could look at the overhead costs of using water, electricity, and heat and recommend putting in items that will save energy costs by 20 percent. By doing that, the costs of those items go down to $160, $60 and $360 and the overall cost goes down to $580. Therefore, the new formula is:
$6,960 / 18,250 = 38 cents per product.
That 20 percent savings on heat, electricity, and water saves 10 cents for every product made. If the company makes 18,250 products a year, that amounts to an extra income of $1,825 for the company.
Overhead as Labor
Labor hours are a cost driver that applies to overhead and total overhead costs are often divided by the estimated labor hours, which brings a dollar rate per labor hour. This allows companies to see that whenever a labor hour is recorded by an employee, the overhead can be allocated to the labor hour.
There are several advantages to use labor hours to determine the cost of a product.
First, the labor hours tend to be very predictable and in a steady amount.
Second, it makes no difference with the different pay rates among employees.
Lastly, labor hours are related to production, which means it is a very accurate measurement of costs.
For example, if a company estimates 100,000 labor hours and $200,000 in overhead costs, and they record 8,300 labor hours in a month, then the overhead allocation comes to:
$200,000 / 100,000 = 2
That corresponds to $2 per labor hour, which is then multiplied by 8,300 hours to give us a result of $16,600. This means that the company would then transfer $16,600 from the overhead costs account to the work in process for the production that month.
If a company has a very large workforce, then they will allocate overhead using labor hours, which give them a total labor dollar amount that is very predictable. This would also be done if the company operates under a labor contract.
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