2

How Time and Interest Affect Money

INTRODUCTION
COST ACCOUNTING
Accounting is the collection and aggregation of information for decision maker- including makermanagers, investor, regulators, lenders, and the public. Accounting system affect behavior and management and have affects across departments, organizations, and even countries.
Information contained within an accounting system has the power to influence actions. Accounting information systems are particularly particularly strong behavioral drivers within the context of a corporation – where profits and the bottom line are daily concerns.

Ir. Haery Sihombing MT.
Pensyarah Pelawat Fakulti Kejuruteraan Pembuatan Universiti Teknologi Malaysia Melaka

BASIC OF A COUNTING RELATED TO COST

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COST ACCOUNTING
There are three type of accounting systems
1. NATIONAL ACCOUNTING SYSTEMS
National accounts are national income and production accounts, such Gross National Product (GNP) and Gross Domestic Product (GDP) which aim to measure and track an economy’s contribution to the well-being of its inhabitants. National income accounts show the national demand or goods and services and are used to track and measure economic growth.
Conventional economic thinking has assumed that the increases in goods and services produced domestically (GDP) and national income (GNP) are adequate yardstick to economic health
Example: The world bank uses per capita GNP as a major criterion for classifying national 3 economies

COST ACCOUNTING
1. NATIONAL ACCOUNTING SYSTEMS

4

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COST ACCOUNTING
2. FINANCIAL ACCOUNTING SYSTEMS
Financial accounts, such as balance sheets and income statements are used to keep track of business incomes and outflows. These financial reports are for use by persons outside the firm – for example: lenders or investors.
There are relevant to the enterprise as a whole and are generally subject to strict government rules The most common financial accounting reports are for external use by are the financial statements in a firm’s annual report to shareholders. In the United States and most developed countries, these reports conform to generally accepted accounting principles developed predominantly by the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC)
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COST ACCOUNTING
The overall objective of a firm’s financial accounting statements
1. The overall objective of a fir’s financial accounting statements are: 2. To provide information useful for making rational investment and credit decisions 3. To allow investors and creditors to assess the amount, timing, and uncertainty of cash flows 4. To provide information about the economic resources of a firm and the claims on those resources 5. To provide information about a firm’s operating performance during period 6. To provide information on how a firm obtains and uses money and other financial resources. 7. To provide information on how management ha discharges its stewardship 6 responsibility to owners and the public.

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COST ACCOUNTING
Type of Financial Accounting Statements

COST ACCOUNTING
3. MANAGEMENT or COST ACCOUNTING SYSTEMS
and CAPITAL BUDGETING Management or cost accounting systems are part of an enterprise’s information system and refer to the internal cost tracking and allocation systems to track costs and expenditures. These are internal rather than external accounting systems. There are no fixed rules governing how an entity should keep track of cash flows internally, although there are many formal methods available for users. Capital budgeting is basically a form of predictive cost accounting over a set time frame which is used to analyze the costs of alternative projects or expenditures over the specified period of time
7 8

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COST ACCOUNTING
The main objectives of managerial/cost accounting are (Hilton, 1998):
Providing managers with information for decision making and planning. Assisting managers in directing and controlling operations. Motivating managers towards the organization’s goals. organization’ Measuring the performance of managers and sub-units within the suborganization.

COST ACCOUNTING

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INTRODUCTION
TIME VALUE OF MONEY :
THE ECONOMIC VALUE OF A SUM DEPENDS ON WHEN IT IS RECEIVED. RECEIVED.

1. Foundations: Overview
1. F/P and P/F Factors 2. P/A and A/P Factors 3. F/A and A/F Factors 4. Interpolate Factor Values

Because money has both EARNING as well as PURCHASING POWER over time (it can be (it put to work, earning more money for its owner) owner)
A Ringgit received today has a gerater value than Ringgit received at some future time
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5. P/G and A/G Factors 6. Geometric Gradient 7. Calculate i 8. Calculate “n” 9. Spreadsheets
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1 Basic Derivations: F/P factor
F/P Factor To find F given P
Fn To Find F given P

F/P and P/F Factors

…………. n P0 Compound forward in time

Section 1

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1 Basic Derivations: F/P factor
F1 = P(1+i) F2 = F1(1+i)…..but: (1+i)… F2 = P(1+i)(1+i) = P(1+i)2 F3 =F2(1+i) =P(1+i)2 (1+i) = P(1+i)3 In general:

1 Present Worth Factor from F/P
Since Fn = P(1+i)n We solve for P in terms of FN P = F{ 1/ (1+i)n} = F(1+i)-n Thus: P = F(P/F,i%,n) where (P/F,i%,n) = (1+i)-n
Thus, the two factors are: 1. F = P(1+i)n finds the future worth of P; 2. P = F(1+i)-n finds the present worth from F

Fn = P(1+i)n Fn = P(F/P,i%,n)
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1 P/F factor –Discounting back in time
Discounting back from the future
Fn

…………. n P P/F factor brings a single future sum back to a specific point in time.
17

P/A and A/P Factors

Section 2

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2 Example- F/P Analysis
Example: P= $1,000;n=3;i=10% What is the future value, F?
F = ??

2 Example – P/F Analysis
Assume F = $100,000, 9 years from now. What is the present worth of this amount now if i =15%?
F9 = $100,000

i = 15%/yr
0 1 2 3

0

1

2

3

…………

8

9

P=$1,000

i=10%/year P= ??

F3 = $1,000[F/P,10%,3] =

$1,000[1.10]3

P0 = $100,000(P/F, 15%,9) = $100,000(1/(1.15)9) = $100,000(0.2843) = $28,430 at time t = 0
19 20

= $1,000[1.3310] = $1,331.00

2 Uniform Series Present Worth and Capital Recovery Factors
Annuity Cash Flow
P = ??

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2 Uniform Series Present Worth and Capital Recovery Factors
Desire an expression for the present worth – P of a stream of equal, end of period cash flows - A

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1
0

2

3

…………..
..

..

n-1

P = ?? n
0 1 2 3 n-1 n

$A per period A = given
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2 Uniform Series Present Worth and Capital Recovery Factors
Write a Present worth expression

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2 Uniform Series Present Worth and Capital Recovery Factors
The second equation

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P 1 i
P A 1 (1 i )1 1 (1 i ) 2 1 .. (1 i ) n
1

A

1 (1 i)2

1 1 .. 3 (1 i) (1 i)n

1 (1 i)n 1

1 (1 i ) n

[2]

[1] To isolate an expression for P in terms of A, subtract Eq [1] from Eq. [2]. Note that numerous terms will drop out.

Term inside the brackets is a geometric progression. Mult. This equation by 1/(1+i) to yield a second equation
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2 Uniform Series Present Worth and Capital Recovery Factors
Setting up the subtraction
P (1 i ) A 1 (1 i ) 2 1 (1 i ) (1 i ) 4
3

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2 Uniform Series Present Worth and Capital Recovery Factors
Simplifying Eq. [3] further

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1

...

1 1 (1 i ) n (1 i ) n

1

[2]

i
[1]

-P
=

A

1 (1 i )1

1 (1 i ) 2

1 .. (1 i )n

1

1 (1 i ) n

1 i

P

A

1 (1 i ) n

1
1

(1 i )

1 1 P A n 1 1 i (1 i) (1 i)

i

P
[3]

A 1 i (1 i ) n

1

1

P

A

(1 i ) n 1 for i i(1 i ) n
26

0

25

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3 F/A and A/F Derivations
Annuity Cash Flow
$F

F/A and A/F Factors

…………..
0

N

Section 3

$A per period

Find $A given the Future amt. - $F
28

3 Sinking Fund and Series Compound amount factors (A/F and F/A)
Take advantage of what we already have Recall:

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3 F/A and A/F Derivations
Annuity Cash Flow
$F

Also:

P F

1 (1 i)n

Substitute “P” and simplify!
0

…………..

N

A P

i(1 i)n (1 i)n 1
29

$A per period

Find $F given the $A amounts
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3 Example -1
Formosa Plastics has major fabrication plants in Texas and Hong Kong. It is desired to know the future worth of $1,000,000 invested at the end of each year for 8 years, starting one year from now. The interest rate is assumed to be 14% per year.

3 Example-1
•A = $1,000,000/yr; n = 8 yrs, i = 14%/yr •F8 = ??

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3 Example-1
Solution: The cash flow diagram shows the annual payments starting at the end of year 1 and ending in the year the future worth is desired. Cash flows are indicated in $1000 units. The F value in 8 years is

3 Example-1
How much money must Carol deposit every year starting, l year from now at 5.5% per year in order to accumulate $6000 seven years from now?

F = l000(F/A,14%,8) = 1000( 13.23218)
= $13,232.80 = 13.232 million 8 years from now.
33 34

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3 Example -2
Solution The cash How diagram from Carol's perspective fits the A/F factor. A= $6000 (A/F,5.5%,7) = (A/F,5.5%,7) 6000(0.12096) = $725.76 per year 6000(0.12096) The A/F factor Value 0f 0.12096 was computed using the A/F factor formula

Interpolation in Interest Tables

Section 4
35

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4

Interpolation of Factors

4 Interpolation of Factors
Typical Format for Tabulated Interest Tables

All texts on Engineering economy will provide tabulated values of the various interest factors usually at the end of the text in an appendix Refer to the back of your text for those tables.

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4 Interpolation (Estimation Process)
• • • At times, a set of interest tables may not have the exact interest factor needed for an analysis One may be forced to interpolate between two tabulated values Linear Interpolation is not exact because: • • The functional relationships of the interest factors are non-linear functions Hence from 2-5% error may be present with interpolation.
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4 An Example
• • • • Assume you need the value of the A/P factor for i = 7.3% and n = 10 years. 7.3% is most likely not a tabulated value in most interest tables So, one must work with i = 7% and i = 8% for n fixed at 10 Proceed as follows:

40

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4 Basic Setup for Interpolation
•Work with the following basic relationships

4 i = 7.3% using the A/P factor
• For 7% we would observe:
COMPOUND N 10 AMT. FACTOR F/P 1.9672 PRESENT WORTH P/F 0.5083 SINKING FUND A/F 0.0724 COMPOUND AMOUNT F/A 13.8164 CAPITAL RECOVERY A/P 0.14238

A/P,7%,10) = 0.14238

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4 i = 7.3% using the A/P factor
• For i = 8% we observe:
COMPOUND N 10 AMT. FACTOR F/P 2.1589 PRESENT WORTH P/F 0.4632 SINKING FUND A/F 0.0690 COMPOUND AMOUNT F/A 14.4866 CAPITAL RECOVERY A/P 0.14903

4 Estimating for i = 7.3%
• Form the following relationships

(A/P,8%,10) = 0.14903

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4 Final Estimated Factor Value
• • Observe for i increasing from 7% to 8% the A/P factors also increases. One then adds the estimated increment to the 7% known value to yield: •

4. The Exact Value for 7.3%
Using a previously programmed spreadsheet model the exact value for 7.3% is:

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5 Arithmetic Gradient Factors
• In applications, the annuity cash flow pattern is not the only type of pattern encountered •Two other types of end of period patterns are common •The Linear or arithmetic gradient •The geometric (% per period) gradient

P/G and A/G Factors

Section 5

•This section presents the Arithmetic Gradient
48

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5 Arithmetic Gradient Factors
• An arithmetic (linear) Gradient is a cash flow series that either increases or decreases by a constant amount over n time periods. •A linear gradient is always comprised of TWO components:

5 Arithmetic Gradient Factors
•The Two Components are: •The Gradient component •The base annuity component •The objective is to find a closed form expression for the Present Worth of an arithmetic gradient

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5 Linear Gradient Example
A1+(n-1)G A1+(n-2)G

5 Example: Linear Gradient
• Typical Negative, Increasing Gradient: G=$50

Assume the following:
A1+2G A1+G

0

1

2

3

n-1

N

This represents a positive, increasing arithmetic gradient

The Base Annuity = $1500

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5 Example: Linear Gradient
• Desire to find the Present Worth of this cash flow

5 Arithmetic Gradient Factors
• The “G” amount is the constant arithmetic change from one time period to the next. •The “G” amount may be positive or negative! •The present worth point is always one time period to the left of the first cash flow in the series or, •Two periods to the left of the first gradient cash flow!
53 54

The Base Annuity = $1500

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5 Derivation: Gradient Component Only
Focus Only on the gradient Component
(n-1)G (n-2)G

5 Present Worth Point…
The Present worth point of a linear gradient is always:

“0” G

+2G G

2 periods to the left of the “1G” point 1G” or, 1 period to the left of the very first cash flow in the gradient series.

Removed Base annuity
0 1 2 3 n-1 N
55

DO NOT FORGET THIS!
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5 Present Worth Point…
$700 $600 $500 $400 $300 $200 $100

5 Gradient Component
•The Gradient Component
$500 $400 $300 $200 $100 $0 $600

X 0

1

2

3

4

5

6

7

X 0

1

2

3

4

5

6

7

The Present Worth Point of the Gradient
57

The Present Worth Point of the Gradient
58

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5 Present Worth Point…
•PW of the Base Annuity is at t = 0 •PWBASE Annuity=$100(P/A,i%,7)
Base Annuity – A = $100

5 Present Worth: Linear Gradient
The present worth of a linear gradient is the present worth of the two components:
1. The Present Worth of the Gradient Component and, 2. The Present Worth of the Base Annuity flow Requires 2 separate calculations! calculations!

X 0

1

2

3

4

5

6

7

The Present Worth Point of the Gradient
59 60

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5 Present Worth: Gradient Component
The PW of the Base Annuity is simply the Base Annuity –A{P/A, i%, n} factor What is needed is a present worth expression for the gradient component cash flow. We need to derive a closed form expression for the gradient component.

5 Present Worth: Gradient Component
General CF Diagram – Gradient Part Only
(n-1)G (n-2)G 3G 2G 1G
0G We want the PW at time t = 0 (2 periods to the left of 1G) 0 1 2 3 4 ……….. n-1 n
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5 To Begin- Derivation of P/G,i%,n
P G ( P / F , i %, 2) 2G ( P / F , i %,3) ... [(n-2)G](P/F,i%,n-1) + [(n-1)G](P/F,i%,n)
Next Step: Factor out G and re-write as …..

5 Factoring G out….

P/G factor

P=G (P/F,i%,2)+2(P/F,i%,3) +...(n-1)(P/F,i%,n)

What is inside of the { }’s?

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5 Replace (P/F’s) with closed-form
1 (1+i) 2 2 (1+i)3 n-2 (1+i) n-1 n-1 (1+i) n

5 Mult. Both Sides By (n+1)…..
P(1+i)1 =G 1 (1+i)1 2 (1+i)2 ... n-2 (1+i)n-2 n-1 (1+i) n-1

P=G

...

[1]

[2]

Multiply both sides by (1+i)

•We have 2 equations [1] and [2]. •Next, subtract [1] from [2] and work with the resultant equation.

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5 Subtracting [1] from [2]…..
P(1+i)1 =G 1 (1+i)1 2 (1+i) 2 n-2 (1+i) n-2 n-1 (1+i) n-1

5 The P/G factor for i and N
G (1 i ) n 1 n i i (1 i ) n (1 i ) n

...

P

P=G

1 (1+i) 2

2 (1+i)3

...

n-2 (1+i) n-1

n-1 (1+i) n

P

G (1 i ) n 1 n n i i (1 i ) (1 i ) n

( P / G, i %, N ) factor
67 68

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5 Further Simplification on P/G

5 Extension – The A/G factor
Some authors also include the derivation of the A/G factor. A/G converts a linear gradient to an equivalent annuity cash flow. Remember, at this point one is only working with gradient component There still remains the annuity component that you must also handle separately!

( P / G, i %, N )

(1 i ) N iN 1 i 2 (1 i ) N

Remember, the present worth point of any linear gradient is 2 periods to the left of the 1-G cash flow or, 1 period to the left of the “0-G” cash flow.

P=G(P/G,i,n)
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5 The A/G Factor
Convert G to an equivalent A

5 A/G factor using A/P with P/G
G (1 i ) n 1 n n i i (1 i) (1 i ) n

P

i (1 i ) n (1 i ) n 1
(A/P,i,n)

A G ( P / G , i, n)( A / P, i, n)
The results follow….. How to do it…………

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5 Resultant A/G factor
P G (1 i ) n 1 n n i i (1 i) (1 i ) n

5 Gradient Example
• Consider the following cash flow
$500 $400 $300 $200 $100

i (1 i) n (1 i ) n 1
(A/P,i,n)

(A/G,i,n) =

A G

1 n i (1 i ) n 1
73

0

1

2

3

4

5

Present Worth Point is here! And the G amt. = $100/period

Find the present worth if i = 10%/yr; n = 5 yrs
74

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5 Gradient Example- Base Annuity
• First, The Base Annuity of $100/period

5 Focus on the Gradient Component
$400 $300 $200 $0 $100

A = +$100

0

1

2

3

4

5

0

1

2

3

4

5

•PW(10%) of the base annuity = $100(P/A,10%,5) •PWBase = $100(3.7908)= $379.08 •Not Finished: We need the PW of the gradient component and then add that value to the $379.08 amount

We desire the PW of the Gradient Component at t = 0 PG@t=0 = G( P/G,10%,5 ) = $100( P/G,10%,5 )
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5 The Set Up
$400 $300 $200 $0 $100

5 PW of the Gradient Component
PG@t=0 = G(P/G,10%,5) = $100(P/G,10%,5) P/G,10%,5)
P= G (1 i ) N 1 i i (1 i ) N N (1 i ) N

Sub. G=$100;i=0.10;n=5

0

1

2

3

4

5

6.8618

PG@t=0 = G(P/G,10%,5) = $100(P/G,10%,5)

P=

G (1 i)N 1 N i i(1 i)N (1 i)N

Could substitute n=5, i=10% and G = $100 into the P/G closed form to get the value of the factor.
77

Calculating or looking up the P/G,10%,5 factor yields the following: Pt=0 = $100(6.8618) = $686.18 for the gradient PW
78

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5 Gradient Example: Final Result
• PW(10%)Base Annuity = $379.08 •PW(10%)Gradient Component= $686.18 •Total PW(10%) = $379.08 + $686.18 •Equals $1065.26 •Note: The two sums occur at t =0 and can be added together – concept of equivalence
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5 Example Summarized
This Cash Flow…
$400 $300 $200 $100 $500

0

1

2

3

4

5

Is equivalent to $1065.26 at time 0 if the interest rate is 10% per year!

80

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5 Shifted Gradient Example: i = 10%
• Consider the following Cash Flow
0 1 2 3 4 5 6 7

5 Shifted Gradient Example
• Consider the following Cash Flow
0 1 2 3 4 5 6 7

$450 $500 $550 $600 $600 $550 $500

$450

1. This is a “shifted” negative, decreasing gradient. 2. The PW point in time is at t = 3 (not t = o)
81

•The PW @ t = 0 requires getting the PW @ t =3; •Then using the P/F factor move PW3 back to t=0
82

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5 Shifted Gradient Example
• Consider the following Cash Flow
0 1 2 3 4 5 6 7

5 Shifted Gradient Example: Base Annuity
• PW of the Base Annuity: 2 Steps
0 1 2 3 4 5 6 7

$450 $500 $550 $600
P0=P3(P/F,10%,3)

P3=-600(P/A,10%,4)

P3
39 01 A = -$600 .6 .5 1 7 9 3

•The base annuity is a $600 cash flow for 3 time periods
83

P0

P0= [-600(P/A,10%,4)](P/F,10%,3)
P 0-base annuity = -$1428.93
84

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5 Shifted Gradient Example: Gradient
• PW of Gradient Component: G = -$50
0 1 2 3 4 5 6 7

P3-Grad = +50(P/G,10%,4)

P0=P3(P/F,10%,3)

Geometric Gradient
P3
0G
1G
0 . 7 5 1 3

P0
4 . 3 7 8 1

2G

3G

=-$164.46

P0-grad = {+50(P/G,10%,4)}(P/F,10%,3)
85

Section 6

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6 Geometric Gradients
• An arithmetic (linear) gradient changes by a fixed dollar amount each time period. •A GEOMETRIC gradient changes by a fixed percentage each time period. •We define a UNIFORM RATE OF CHANGE (%) for each time period •Define “g” as the constant rate of change in decimal form by which amounts increase or decrease from one period to the next

6 Geometric Gradients: Derivation
• First Major Point to Remember: •A1 does NOT define a Base Annuity; •There is no BASE ANNUITY for a Geometric Gradient! •The objective is to determine the Present Worth one period to the left of the A1 cash flow point in time •Remember: The PW point in time is one period to the left of the first cash flow – A1!
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6 Geometric Gradients: Derivation
• For a Geometric Gradient the following parameters are required: •The interest rate per period – i •The constant rate of change – g •No. of time periods – n •The starting cash flow – A1

6 Geometric Gradient P/A factor
•Note: If g = i we have a division by “0” – undefined. •For g = i we can derive the closed form PW factor for this special case. •We substitute i for g into the Pg relationship to yield:

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6 Geometric Gradient: Notes
•The geometric gradient requires knowledge of: •A1, i, n, and g •There exist an infinite number of combinations for i, n, and g: Hence one will not find tabulated tables for the (P/A, g,i,n) factor.

6 Geometric Gradient: Notes
•You have to calculated either from the closed form for each problem or apply a preprogrammed spreadsheet model to find the needed factor value •No spreadsheet built-in function for this factor!

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6 Geometric Gradient: Example
•Assume maintenance costs for a particular activity will be $1700 one year from now. •Assume an annual increase of 11% per year over a 6-year time period.

6 Geometric Gradient: Example
•If the interest rate is 8% per year, determine the present worth of the future expenses at time t = 0. •First, draw a cash flow diagram to represent the model.

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6 Geometric Gradient Example (+g)
•g = +11% per period; A1 = $1700; i = 8%/yr

6 Geometric Gradient ( -g )
• Consider the following problem with a negative growth rate – g.
A1 = $1000 $900 $810 $729

0

1
$1700

2

3

4

5

6

7

$1700(1.11)1 $1700(1.11)2 $1700(1.11)3

P0=??

0

1

2

3

4

g = -10%/yr; i = 8%; n = 4

PW(8%) = ??
$1700(1.11)5

We simply apply a “g” value = -0.10
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6 Geometric Gradient (-g value)
• Evaluate:
For a negative g value = -0.10

1 P A 1 g

1 g 1 i i g

n

g i

303: Use "g" 667: use f-bar Geometric Gradients "E" or g or f-bar = -10% i= 8% N= 4 P/A,g,i,n factor is…… 2.87637 First Amt= P. Value = $ $ 1,000.00 2,876.37

Determination of an Unknown Interest Rate

Section 7
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7 When the i – rate is unknown
• A class of problems may deal with all of the parameters know except the interest rate. •For many application-type problems, this can become a difficult task •Termed, “rate of return analysis” •In some cases: •i can easily be determined •In others, trial and error must be used
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7 Example: i unknown
• Assume on can invest $3000 now in a venture in anticipation of gaining $5,000 in five (5) years. •If these amounts are accurate, what interest rate equates these two cash flows?

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7 Example: i unknown
• The Cash Flow Diagram is…
$5,000
0 0 1 2 3 4 5

7 Example: i unknown
• Solution:
1 2 3

$5,000

4

5

$3,000

•F = P(1+i)n •5,000 = 3,000(1+i)5 •(1+i)5 = 5,000/3000 = 1.6667
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$3,000

•(1+i)5 = 5,000/3000 = 1.6667 •(1+i) = 1.66670.20 •i = 1.1076 – 1 = 0.1076 = 10.76%
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7 For “i” unknown
• In general, solving for “i” in a time value formulation is not straight forward. •More often, one will have to resort to some form of trial and error approach as will be shown in future sections. •A sample spreadsheet model for this problem follows.

7 Example of the IRR function

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=IRR($D7:$D12)

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8 Unknown Number of Years
• Some problems require knowing the number of time periods required given the other parameters

Determination of Unknown Number of Years

•Example: •How long will it take for $1,000 to double in value if the discount rate is 5% per year? •Draw the cash flow diagram as….
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Section 8

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8 Unknown Number of Years
Fn = $2000

8 Unknown Number of Years
• Solving we have…..
Fn = $2000

0

1 P = $1,000

2

...

. . . …….

n

0

1

2

...

. . . …….

n

P = $1,000

i = 5%/year; n is unknown!

•Fn=? = 1000(F/P,5%,x): 2000 = 1000(1.05)x •Solve for “x” in closed form……
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8 Unknown Number of Years
• Solving we have….. •(1.05)x = 2000/1000

8 No. of Years – NPER function
• From Excel one can formulate as:

•Xln(1.05) =ln(2.000) •X = ln(1.05)/ln(2.000) •X = 0.6931/0.0488 = 14.2057 yrs •With discrete compounding it will take 15 years to amass $2,000 (have a little more that $2,000)
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=NPER(C23,C22,C20,C21)
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9 Basic Sensitivity Analysis
• Sensitivity analysis is a procedure applied to a formulated problem whereby one can assess the impact of each input parameter relating to the output variable.

Spreadsheet Application – Basic Sensitivity Analysis

•Sensitivity analysis is best performed using a spreadsheet model. •The procedure is to vary the input parameters within certain ranges and observe the change on the output variable.
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Section 9

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9 Basic Sensitivity Analysis
• By proper modeling, one can perform “what-if” analysis on one or more of the input parameters and observe any changes in a targeted output (response) variable •Commercial add-in packages are available that can be linked to Excel to perform such an analysis •Specifically: Palisade Corporation’s TopRank Excel add-in is most appropriate.
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9 Basic Sensitivity Analysis
• When you build your own models, devise an approach to permit varying at least one of the input parameters and store the results of each change in the output variable…then plot the results. •If a small change in one of the input parameters represents a significant change in the output variable then… •That input variable is “sensitive”
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9 Basic Sensitivity Analysis
• If an input parameter is deemed “sensitive” then some effort should go into the estimation of that parameter •Because it does influence the response (output) variable. •Less sensitive input parameters may not have as much effort required to estimate as those input parameters do not have that much impact on the targeted response variable. 115

9 Basic Sensitivity Analysis
• When you build your own models, devise an approach to permit varying at least one of the input parameters and store the results of each change in the output variable…then plot the results. •If a small change in one of the input parameters represents a significant change in the output variable then… •That input variable is “sensitive”
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Summary
• This chapter presents the fundamental time value of money relationships common to most engineering economic analysis calculations •Derivations have been presented for: •Present and Future Worth- P/F and F/P •Annuity Cash flows – P/A, A/P, F/A and A/F •Gradients – P/G, A,G and P/A,g,i,n
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Summary
• One must master these basic time value of money relationships in order to proceed with more meaningful analysis that can impact decision making. •These relationships are important to you professionally and in your personal lives. •Master these concepts!!!

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Ir. HaerySihombing MT. (additional)
Pensyarah Pelawat Fakulti Kejuruteraan Pembuatan Universiti Teknologi Malaysia Melaka

INTRODUCTION
Consumer and Producer Goods and Services

Producer goods and services are used to produce consumer goods and services or other producer goods
Machine tools Factory Building Buses Farm Machinery, etc. In the log run, producer goods serve to satisfy human wants, but only means to that end. Thus, the amount of producer goods needed is determined indirectly by the amount of consumer goods or services that are demanded by people

Cost Management Systems
and

Activity-Based Costing

Consumer and Producer Goods and Services
Goods and Services are produced and desired because directly or indirectly they have utility – the power to satisfy human wants and needs Utility is most commonly measured in terms of value, expressed in some medium of exchange as the price that must paid to obtain the particular item.

Consumer and Producer Goods and Services
Much of our business activity, including engineering, focuses on increasing the utility (value) of materials and products by changing their form or location
Goods and Services divided into two types: Necessities Luxuries

Consumer and Producer Goods and Services
GENERAL PRICE - DEMAND RELATIONSHIP For all goods and services, there is relation-ship between relationthe price that must be paid and the quantity that will be demanded or purchased p
p = a - bD

Consumer and Producer Goods and Services
TOTAL REVENUE (TR) FUNCTION

Most business would not obtain maximum profits by maximizing revenue
TR = Process x Demand = p . D

P = a – bD
For 0 D

If the relationship between price and demand is used: Price

a/b, and a>0, b>0 D Units of Demand

TR =(a-bD)D = aD-bD 2 =(aaDfor 0 D a/b and a>0, b>0

Consumer and Producer Goods and Services
Maximum TR = a -b
2

INTRODUCTION
COST ACCOUNTING

= a2/2b – a2/4b = a2/4b

price = a - bD Total revenue

A cost-management system (CMS) is a collection of tools and techniques that identifies how management’s decisions affect costs. Cost accounting is that part of the accounting system that measures costs for the purposes of management decision making and financial reporting.

= a/2b

dTR/dD = a-2bD =0 = a/2b

Demand

Cost Accounting System
Collecting costs by some “natural” classification such as materials or labor

Cost Accounting System
Direct Material Job (work in progress) Finished Goods Inventory

Cost Accumulation

Direct Labor Factory Overhead

Selling Expense

Cost Allocation

Tracing costs to one or more cost objectives

TOTAL EXPENSE

Cost of Goods Sold

Administrative Expense

Cost Accounting System
Cost Accumulation Cost Allocation to Cost Objects: 1. Departments 2. Activities RAW MATERIAL COSTS (METALS FINISHING DEPARTMENT
ACTIVITY ACTIVITY

Cost
A cost may be defined as a sacrifice or giving up of resources for a particular purpose. Costs are frequently measured by the monetary units that must be paid for goods and services.

MACHINING DEPARTMENT
ACTIVITY ACTIVITY

CABINETS

CABINETS DESKS TABLES DESKS TABLES

3. Products

Cost Objective

Direct Costs
What are direct costs?
Direct costs can be identified specifically and exclusively with a given cost objective in an economically feasible way.

What is a cost object or cost objective? It is anything for which a separate measurement of costs is desired.

Indirect Costs
What are indirect costs?
Indirect costs cannot be identified specifically and exclusively with a given cost objective in an economically feasible way.

What Distinguishes Direct and Indirect Costs?
Managers prefer to classify costs as direct rather than indirect whenever it is “economically feasible” or “cost feasible” effective.” effective.” Other factors also influence whether a cost is considered direct or indirect. The key is the particular cost objective.

Categories of Manufacturing Costs

Categories of Manufacturing Costs
All costs which are eventually allocated to products are classified as either… either… direct materials, direct labor, or indirect manufacturing.

Any raw material, labor, or other input used by any organization could, in theory, be identified as a direct or indirect cost depending on the cost objective.

1 2 3

Direct Material Costs...

Direct Labor Costs...

include the acquisition costs of all materials that are physically identified as a part of the manufactured goods and that may be traced to the manufactured goods in an economically feasible way.

include the wages of all labor that can be traced specifically and exclusively to the manufactured goods in an economically feasible way.

Indirect Manufacturing Costs...

Product Costs...

or factory overhead, include all costs overhead, associated with the manufacturing process that cannot be traced to the manufactured goods in an economically feasible way.

are costs identified with goods produced or purchased for resale. Product costs are initially identified as part of the inventory on hand. These costs, inventoriable costs, become expenses (in the form of cost of goods sold) only when the inventory is sold.

Period Costs...

Period or Product Costs
In merchandising accounting, insurance, depreciation, and wages are period costs (expenses of the current period). In manufacturing accounting, many of these items are related to production activities and thus, as indirect manufacturing, are product costs.

are costs that are deducted as expenses during the current period without going through an inventory stage.

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Period Costs – Merchandising and Manufacturing
In both merchandising and manufacturing accounting, selling and general administrative costs are period costs.

Financial Statement Presentation – Merchandising Companies
Balance Sheet Income Statement Sales Sales


Merchandise Merchandise Inventory Inventory
Expiration

Cost of Goods Sold Cost of Goods Sold (an expense) (an expense) Equals Gross Margin

Period Costs

Selling and Selling and Administrative Administrative Expenses Expenses Equals Operating Income

Financial Statement Presentation – Merchandising Companies
Balance Sheet Direct Direct Material Material Inventory Inventory Work-inWork-inProcess Process Inventory Inventory Income Statement Sales Sales

Costs and Income Statements
On income statements, the detailed reporting of selling and administrative expenses is typically the same for manufacturing and merchandising organizations, but the cost of goods sold


Expiration

Cost of Goods Sold Cost of Goods Sold (an expense) (an expense) Equals Gross Margin

is different.

Finished Finished Period Goods Goods Inventory Costs Inventory

Selling and Selling and Administrative Administrative Expenses Expenses Equals Operating Income

Cost of Goods Sold for a Manufacturer
The manufacturer’s cost of goods manufacturer’ produced and then sold is usually composed of the three major categories of cost: Direct materials Direct labor Indirect manufacturing

Cost of Goods Sold for a Retailer or Wholesaler
The merchandiser’s cost of goods sold is merchandiser’ usually composed of the purchase cost of items, including freight-in, that are freightacquired and then resold.

1 2 3

Traditional Cost System
Direct Material Resource Direct Labor Resource All Indirect Resources All Unallocated Value Chain Costs

Two-Stage Activity-Based Cost System
Direct Material Resource Direct Labor Resource Other Direct Resources Indirect Resource A Indirect Resource Z All Unallocated Value Chain Costs

Direct Trace

Direct Trace

Cost Driver

Direct Trace

Direct Trace

%

%

%

%

Activity Activity 1 10 Cost Cost Driver Driver

Products

Unallocated

Products

Unallocated

Traditional vs. Activity-Based Costing ActivityTraditional Costing There is one predetermined overhead rate for everything Activity-Based Costing ActivityThere are two or more activities each with its own overhead cost pool and cost driver

Traditional vs. Activity-Based Costing Activity-

Traditional vs. Activity-Based Costing Activity-

ACTIVY BASED COSTING
Understanding the relationships among activities, resources, costs, and cost drivers is the key to understanding ABC and how ABC facilitates managers’ understanding of operations.
Activity-based costing: is a costing approach that Activityassigns resource costs to a cost object based on activities performed for the cost object

ACTIVY BASED COSTING
Activity-Based Costing (ABC) is a method of assigning the Activityorganization's resource costs through activities to the and services services provided to its customers. Activity-Based Costing (ABC) is used to identify, describe, Activityassign costs to, and report on agency operations. A more accurate accurate cost management system than traditional cost accounting, ABC identifies opportunities to improve business process effectiveness effectiveness and efficiency by determining the "true" cost of a product or service.

It is generally used as a tool for understanding product and customer cost and profitability. ABC has predominately been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives.

ACTIVY BASED COSTING
(1)

ACTIVY BASED COSTING
The Four Steps to ABC Implementation Identify activities—perform an in-depth analysis of inthe operating processes of each responsibility segment. Each process may consist of one or more activities required by outputs.
An analysis of the factory process determines that there are 2 activities with the following overhead costs identified to them
OVERHEAD COSTS
Re-Tooling Machines Machining Total RM 300,000 RM 700,000 RM 1,000,000

(2)

ABC principles are used: to focus management attention on the total cost to produce a product or service as the basis for full cost recovery.

Activity-Based Costing uses cost drivers to assign the Activitycosts of resources to activities and unit cost as a way of measuring an output. Unit cost is the "average total cost " of producing one unit of output. It is calculated by dividing the total cost of production by the total number of units of output produced.

Identify Activities & Allocate Overhead Costs to Cost Pools

ACTIVY BASED COSTING
The Four Steps to ABC Implementation Assign resource costs to activities—this is sometimes called "tracing." Traceability refers to tracing costs to cost objects to determine why costs were incurred. DoD categorizes costs in three ways: Direct
The Drivers have been identified as # of Re-Toolings and Machine Hours ReProduct-A # of Re-Toolings Machine Hours

The Four Steps to ABC Implementation
Direct—costs that can be traced directly to one output. Example: the material costs (varnish, wood, paint) to build a chair. Indirect—costs that cannot be allocated to an individual output; in other words, they benefit two or more outputs, but not all outputs. Examples: maintenance costs for the saws that cut the wood, storage costs, other construction materials, and quality assurance.) General & Administrative—costs that cannot reasonably be associated with any particular product or service produced (overhead). These costs would remain the same no matter what output the activity produced. Examples: salaries of personnel in purchasing department, depreciation on equipment, and plant security.

ACTIVY BASED COSTING

Indirect General and Administrative
Product-B TOTAL

50 500 Identify Drivers

10 1,500

60 2,000

The Four Steps to ABC Implementation

ACTIVY BASED COSTING

Identify outputs—identify all of the outputs for which an activity segment performs activities and consumes resources. Outputs can be products, services, or customers (persons or entities to whom a federal agency is required to provide goods or services).
Overhead Cost Drivers Overhead Rate

The Four Steps to ABC Implementation Assign activity costs to outputs—assign activity
costs to outputs using activity drivers. Activity drivers assign activity costs to outputs based on individual outputs’ outputs’ consumption or demand for activities. For example, a driver may be the number of times an activity is performed (transaction driver) or the length of time an activity is performed (duration driver). Costs are assigned to each product by multi- Re-Toolings multiplying the activity Machines overhead Machining rate by the activity TOTAL driver
Product-A
(RM 5,000 X 50)

ACTIVY BASED COSTING

Product-B
(RM 5,000 X 10)

TOTAL

# of Re-Toolings Machining TOTAL

RM 300,000 RM 700,000 RM 1,000,000

60 2,000

RM 5,000 RM 350

250,000
(RM 350 X 500)

50,000
(RM 350 X 1,500)

300,000 700,000 1,000,000

175,000 425,000

525,000 575,000

Compute Overhead Rate for Each Activity

Assign Overhead Costs to Products

ACTIVY BASED COSTING
Activity-Based Costing encourages managers to identify which activities are value-added— those that will best accomplish a mission, deliver a service, or meet a customer demand. It improves operational efficiency and enhances decision-making through better, more meaningful cost information.

ACTIVY BASED COSTING

Example of Activities and Cost Drivers: Activities: Account billing Bill verification Account iniquity Correspondence Cost Drivers: No. of lines No. of accounts No. of labor hours No. of letters

Designing and Implementing an Activity-Based Costing System
Step 1 Determine cost of activities, resources, and related cost drivers. Step 2 Develop a process-based map representing the flow of activities, resources, and their interrelationships.

Designing and Implementing an Activity-Based Costing System
Step 3 Collect relevant data concerning costs and the physical flow of the cost-driver units among resources and activities.

Designing and Implementing an Activity-Based Costing System
Step 4 Calculate and interpret the new activity-based information. Using an activity-based costing system to improve the operations of an organization is activity-based management (ABM).

ACTIVITY-BASED MANAGEMENT
Activity-based management aims to improve the value received by customers and to improve profits by identifying opportunities for improvements in strategy and operations.

ACTIVITY-BASED MANAGEMENT
A value-added cost is the cost of an activity valuethat cannot be eliminated without affecting a product’s value to the customer. product’ In contrast, non-value-added costs are costs non- valuethat can be eliminated without affecting a product’s value to the customer. product’

Using ABC Information
Activity-based management… provides costs of value-added and non-value-added activities. improves managers’ understanding of operations.

Cost Accounting and the Value Chain

A good cost accounting system is critical to all value-chain functions from research and development through customer service.

Activity-Based Management

What is the objective of Activitybased management?
Activity-Based management: is a method of Activitybusiness analysis that utilizes ABC information
improving competitiveness, cost reduction, increasing productivity and augmenting flexibility in meeting customers needs Focuses on changing the way the work is carried out or on the reasons why the work is performed Operational ABM: doing things right and performing activities more efficiently Strategic ABM: Choosing appropriate activities for the operation

How would you describe strategic ABM?
Strategic ABM: Choosing appropriate activities for the operation, „doing the right things” things” Encompasses actions that shift the mix of activities away from unprofitable applications

Under which circumstances would you recommend to consider introducing strategic ABM? Highly recommended for service sector organisations, organisations, and companies with complex production processes and a wide portfolio ABC is not a quick fix: requires patience and participation to see the results cultures that reward only short-term results are not fertile grounds for ABC shortMost common characteristics of successful systems: High level of top management support and commitment Technical competence of the implementation team Effective change management

What is a difference, if any, in decision making between companies adopted and not adopted strategic ABM?

Using also non-financial information nonTime-consumption ime- consumption Division of accounting activities Ethical problems and sub-optimization sub-

How is strategic ABM related to strategy implementation?

How would you calculate the costs of introducing ABM in a company and potential benefits?

ABC can be used as a basis for strategic decision making
E.g. regarding changes in the supply chain and changes in target customers

Predictable costs: Consultancy hours, ABC software, Education Unpredictable costs: Use of employees in the development process, Organizational changes Benefits: More efficent processes, Easier to make rational decisions

The ABC Approach

Activity-Based Costing
Better Costing for Better Decisions

BENEFIT Vs. COST
The larger the number of overhead cost pools used, the more accurate a cost estimate you can calculate leading to better decisions

BENEFIT Vs. COST
Use ABC when:
Overhead costs are large proportion of total costs Product lines :
Differ in volume and manufacturing complexity Are numerous, diverse, and require differing degrees of support

BUT
The larger the number of overhead cost pools used, the greater the burden to set-up setand maintain. Also, one or more costs may still need to be arbitrarily allocated

The manufacturing process or the number of product has changes significantly Decision makers ignore the current cost estimates

4 CLASSIFICATIONS OF ACTIVITY LEVELS
1.UNIT
Examples: Machining, Assembling

VALUE-ADDED Vs. NON-VALUEADDED ACTIVITIES
Vale-Added Activities ValeIncrease the worth of a product or service.
Examples: Engineering, design, manufacturing

2. –BATCH
Examples: Equipment Set-Ups, Purchase Orders Set-

3. PRODUCT
Examples: Design, Engineering Change

Non-Value Added Activities NonOnly add costs to the product or service
Examples: Purchasing, Bookkeeping, Machine Set-Up Set-

4. FACILITY
Examples: Management Salaries, Plant Depreciation

VALUE-ADDED Vs. NON-VALUE-ADDED ACTIVITIES
Rule-of-Thumb: If you as a consumer care Rule- ofabout it when you buy the good or service, then it is a Value-Added Activity ValueOtherwise, it is a Non-Value Added Activity NonSo What…? What… As a manager you should seek to improve your process to minimize non-value added nonactivities

Examples of Activities
1. Processing purchase orders. 2. Handling materials and parts. 3. Inspecting incoming material and parts. 4. Setting up equipment. 5. Producing goods using manufacturing equipment. 6. Supervising assembly workers. 7. Inspecting finished goods. 8. Packing customer orders.

Indirect Costs
Not easily and conveniently traceable to cost objects
Cost element is shared among cost objects Physically impossible to trace Not cost effective to trace

Indirect Costs
Need for allocation
Estimate product or activity cost
What does it really cost?

Increase awareness of indirect costs
Activities are not free

Plan more cost efficient operations
Now that we know what it costs, what should we do?

Allocation of Indirect Costs
Typical allocation methods
Ability to bear Fairness or equity Benefits received Cause and effect

Traditional Allocation Method
Indirect costs allocated to cost object based on the cost object’s consumption object’ of some measure of activity, usually labor hours
$10,000,000 total indirect cost 400,000 total labor hours = $25 per hour rate

A product consuming 6 labor hours would be charged $150 of indirect costs

Criticisms of Traditional Overhead Allocation
Assumes all overhead is volume-related volumeFactory-wide or departmental rates FactoryAll related to single activity measure

Activity-Based Costing
Purpose
Allocation of indirect costs based on causal activities
Attempts to identify “direct” link between cost direct” and cost object

Departmental focus, not process focus Focus on costs incurred, not cause of costs

Results in better allocation Does not provide “true” cost true”

Activity-Based Costing
Traditional allocation method
Costs Products

Overview of ABC
Identifies activities required to produce the product or service Determines the cost of the activities Allocates costs to the cost object based on the object’s consumption of activities object’

Activity-based allocation method Activity-

Costs First stage

Activities

Products Second stage

Levels of Cost Incurrence
Not all costs are volume-related volumeUnit level Batch level Product level Facility level

Operation of an ABC System
Assign costs to activity pools
First stage allocation Identify the costs incurred to perform various activities

Determine the measure of activity best related to each cost pool
Cost drivers

Operation of an ABC System
Determine rate per unit of activity Assign costs to products/services based on consumption of activities
Second stage allocation

Implementing ABC
Step 1 – Plan the system
What are the goals?
Inventory valuation Process improvement

Indirect costs are converted to direct costs

Foster active involvement Assemble cross-functional team crossFunctional specialists

Implementing ABC
Step 2 – Define, analyze activities and resources
Decompose organization into elemental activities
Who does what, and why?
Interview employees Determine resources Determine inputs and outputs

Implementing ABC
Gather statistics on activities
Inputs and outputs Transaction, duration, intensity For possible use as second-stage cost drivers second-

Implementing ABC
Step 3 – Establish activity cost pools and determine first stage allocation
First stage allocations assign costs to cost pools
Requires costs to be re-categorized reaccording to why they are incurred, not by type Drivers may be employee time, square footage, etc.

Implementing ABC
Step 4 – Determine second stage drivers and assign costs to cost objects
Outputs of activity analysis may be second stage drivers
Distance moved, times handled, machine hours, units, etc.

Amount assigned to the cost object is the amount of activity consumed times the rate per unit of the activity

When is ABC Most Useful?
High amounts of overhead cost Multiple products Complex products Complex production system Significant variation in volume between high and low volume products

When is ABC Most Useful?
Different products place different demands on resources Problems with current cost allocations due to changes in products or processes Better cost information is needed

Activity-Based Management Natural extension of ABC
Why are activities performed?
Are they necessary? Are they consistent with organizational goals?

ABM for Process Improvement
Focus on problems, opportunities Prioritize opportunities for improvement
Most critical Greatest potential for cost savings

How are they performed?
Are they performed efficiently? Can they be redesigned or eliminated?

ABM for Process Improvement
Determine and explain causes for problems and opportunities
Cannot improve the system without first understanding it

ABM for Process Improvement
Use ABC/ABM data to test potential impact of changes Make changes Iterate
Process of continual improvement

Select specific improvement projects

Implications of ABC/ABM
Shifts focus from managing costs to managing activities Aids in recognizing, measuring and controlling complexity Promotes understanding of why costs are incurred Provides better cost allocation information

Implications of ABC/ABM
Useful for planning future operations Fosters continuous improvement Likely to meet with substantial resistance
Analysis of why and how activities are performed

Requirement of Cost Systems
• Valuation of inventory and measurement of the cost of goods sold for financial reporting. • Estimation of the costs of activities, products, services, and customers. • Providing economic feedback to managers and operators about process efficiency.

Today’s businesses are working in an increasingly complex environment.
Use of Advanced Technology Product Life Cycle Product Complexity Channels of Distribution Quality Requirements Product Diversity

Conventional Costing
Composition of Cost
100

• Total Cost = Material + Labour+ Overheads
• Overheads are allocated to the products on volume based measures e.g. labour hours, machine hours, units produced Will this not distort the costing in the new environment?

0 1 Direct Material 2 Labour 3 Overheads 4

ABC provides an Alternative.

Conventional Costing

BASIC of A B C
AB Costing Resources Economic Element

Expenses

Activities Cost Objects

Work Performed

Cost Objects

Product or service

• Cost of a product is the sum of the costs of all activities required to manufacture and deliver the product. • Products do not consume costs directly • Money is spent on activities • Activities are consumed by product/services • ABC assigns Costs to Products by tracing expenses to “activities”. Each Product is charged based on the extent to which it used an activity

BASIC of A B C
• The primary objective of ABC is to assign costs that reflect/mirror the physical dynamics of the business • Provides ways of assigning the costs of indirect support resources to activities, business processes, customers, products. • It recognises that many organisational resources are required not for physical production of units of product but to provide a broad array of support activities.

ABC systems addresses the following Questions:
What activities are being performed by the organisational resources? How much does it cost to perform activities? Why does the oranisation need to perform those activities? How much of each activity is required for the organisation’s products, services, and organisation’ customers?

Basics of A B C : How?
Cost pools are groups or categories of Steps: individual expense 1. Form cost pools items 2. Identify activities 3. Map resource costs to activities 4. Define activity cost drivers 5. Calculate cost

Identify Activities
In developing an ABC system, the organisation identifies the activities being performed: Activity Dictionary
•Move material •Schedule production •Purchase material •Inspect items •Respond to customers •Improve products •Introduce new products •Explore new markets

Map resource costs to activities
Financial accounting categorises expenses by spending code; salaries, fringe benefits, utilities, travel, communication, computing, depreciation etc. •ABC collects expenses from this financial system and drive them to the activities performed.
Accounting Records Salaries 313,000 Depreciation Electricity Supplies Travel Total 155,000 132,000 25,000 100,000 725,000

Mapping
Activities Business Development ABC Records Salaries DepreciatioElectricity Supplies Travel 20,000 25000 60000 50000 10000 10000 5000 50000 20000 2000 50000 5000 5000 20000 Total

5000 55,000 10000 205,000 60000 275,000 37,000 110,000 25000 43,000 25000 100000 725,000

Maintianing Present Business 80,000 Purhcasing Material Set up Machines Running Machines Resolve Quality Problems Total 125,000 25,000 50,000 13,000

313,000 155000 132000

Activities: Types
• Unit level: Performed each time a unit is produced • Batch level: Performed each time a batch is produced • Product level: Performed to support production of different type of product • Customer Level: Performed to support servicing customers • Facility level:Residuary head

Define activity drivers
The linkage between activities and cost objects, such as products, customers,, is accomplished by using activity drivers. An activity driver is a quantitative measure of the output of an activity. The selection of an activity driver reflects a subjective trade-off between accuracy and tradecost of measurement.

Activities Drivers Unit Level Acquire and Use material for containers No. of Containers Acquire and Use material for baby-care p No. of products Batch Level Set up manually controlled machines Set up computer controlled machines Product Level Design and manufacture moulds Use manually controlled machines Use conputer controlled machines Customer Level Consult customers Provide warehousing for customers

Activities Drivers Unit Level Acquire and Use material for containers No. of Containers Acquire and Use material for baby-care products No. of products Batch Level Set up manually controlled machines No. of batches of containers Set up computer controlled machines No. of batches of B. Produst Product Level Design and manufacture moulds No.of moulds required Use manually controlled machines Product type (containers) Use conputer controlled machines Product type (B.Products) Customer Level Consult customers No. of consultations Provide warehousing for customers No. of cubit feet

Activity Cost Activity Volum Activity Ra 40,000 80,000 1,000,000 8,000 0.04 10

No. of batches of con No. of batches of B. P

3,000 12,000

10 20

300 600

No.of moulds required Product type (contain Product type (B.Produ

5,000 15,000 40,000

5 1 1

1000 15000 40000

4,000 2,000

40 10,000

100 0.2

No. of consultations No. of cubit feet
Faciltiy Level Manage workers Salaries Use main building Square feet 3,000 48,000 15,000 16,000 0.2 3

Faciltiy Level Manage workers

Salaries

Ascertaining Cost
Containers Baby Product Activities A. Rate A.Volume Unit Level Acquire and Use material for containers 0.04 1,200,000 48,000 Acquire and Use material for baby-care products 10 7,000 70000 Batch Level Set up manually controlled machines Set up computer controlled machines Product Level Design and manufacture moulds 1000 1 4 1 1 1,000 4000 15,000 40000

Building an ABC Model
Identify Resources Identify Activities Identify Cost Objects

300 600

12 16

3,600 9600

Use manually controlled machines Use conputer controlled machines Customer Level Consult customers Containers B.products Provide warehousing for customers Containers B.products Faciltiy Level Manage workers Containers B.products Use main building Containers B.products Total Cost

15000 40000

100 2 40 0.2 8,000 2,000 0.2 4,000 10,000 3 5,000 7,000 15,000 85,200 21000 151,000 800 2000 1,600 400 200 4000

Define Activity Drivers

Define Resource Drivers

Enter Resource Costs

Enter Resource Driver Qty.

Enter Activity Driver Qty.

Calculate Costs

ABC: Where to Use?
High Overheads Product Diversity or Multiple Products Customer Diversity Service Diversity Stiff Competition

Traditional, Volume-Based Product-Costing System
Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III. The following information is obtained from company records:
Mode I Production: Units Runs 10,000 1 run of 10,000 units Mode II 20,000 4 runs of 5,000 units Mode III 4,000 10 runs of 400 units

Traditional, Volume-Based Product-Costing System
Direct materials Direct labor Manufacturing overhead Total $ Mode I 50.00 60.00 99.00 209.00 $ Mode II 90.00 80.00 132.00 $ 302.00 $ Mode III 20.00 40.00 66.00 $ 126.00

Traditional, Volume-Based Product-Costing System
Units produced Direct labor (hr/unit) Total hours Total hours required Mode I 10,000 3 30,000 Mode II 20,000 4 80,000 118,000 Mode III 4,000 2 8,000

$

Additional information includes:
Direct materials Direct labor (hr/board) Setup time (hr/run) Machine time (hr/board) $ Mode I 50.00 3 10 1 $ Mode II 90.00 4 10 1.25 $ Mode III 20.00 2 10 2

Budgeted manufacturing overhead Budgeted direct-labor hours directMode I Direct labor (hr/unit) Overhead rate per hour Overhead per unit $ $

$3,894,000 118,000
Mode II 3 33 99 $ $

= $33 per hour

Mode III 4 33 132 $ $ 2 33 66

Manufacturing overhead is determined as follows

Traditional, Volume-Based Product-Costing System
With these product costs, Aerotech established target selling prices (Cost × 125%).
Direct materials Direct labor Manufacturing overhead Total $ Mode I Mode II Mode III 50.00 $ 90.00 $ 20.00 60.00 80.00 40.00 99.00 132.00 66.00 209.00 $ 302.00 $ 126.00

Activity Based Costing System

(ABC)
ABC systems follow a two-stage twoprocedure to assign overhead costs to products.
Assigning overhead to products is a difficult process.

I agree!

$

Cost per unit Target selling price

$

Mode I 209.00 261.25

$

Mode II Mode III 302.00 $ 126.00 377.50 157.50

209.00 x 1.25

Activity Based Costing System
(ABC)
ABC systems follow a

Activity Based Costing System
(ABC)
ABC systems follow a two-stage procedure twoto assign overhead costs to products.

two-stage twoprocedure to assign overhead costs to products.
Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used.

Let’s begin by identifying our major activities.

Overhead assigned to activities are called “activity cost pools.”

Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products.

Overhead Costs
Activity must be done on each unit produced. Total budgeted cost = $3,894,000

Activity Cost Pools

Identification Identification of Activity of Activity Cost Pools Cost Pools

Unit Level Machinery cost pool $1,212,600

Batch Level Setup cost pool $3,000 Receiving/Inspection cost pool $200,000 Material-Handling Materialcost pool $600,000 Quality-Assurance Qualitycost pool $421,000 Packaging/Shipping cost pool $250,000

ProductSustaining Level Engineering cost pool $700,000

Facility Level Facility cost pool $507,400

Unit Level
Machinery cost pool $1,212,600
Activity performed on each batch produced.

Batch Level
Setup cost pool $3,000

ProductSustaining Level
Engineering cost pool $700,000

Facility Level
Facility cost pool $507,400

Activities needed to support an entire product line

Activity required in order for the production process to occur.

STAGE ONE
Various overhead costs related to machinery
Maintenance Depreciation Computer Support Lubrication Electricity Calibration

STAGE TWO
Calculate the pool rate
Budgeted Machinery Costs = $1,212,600 Budgeted Machine Hours 43,000 = $28.20/hour

Activity cost pool

Machinery Cost Pool
Total budgeted cost = $1,212,600

Cost Assignment

Mode I: $28.20 per hr. 1 hr. per unit $28.20 per unit

Mode II: $28.20 per hr. 1.25 hr. per unit $35.25 per unit

Mode III: $28.20 per hr. 2 hr. per unit $56.40 per unit

STAGE ONE
Calculation of total setup cost
Total budgeted setup cost $20 per hour 10 hr. per setup $200 cost per setup 15 production runs $ 3,000 Total

STAGE TWO
Calculate the pool rate
Budgeted Setup Costs Planned Production Runs = $3,000 15 runs = $200 per run

Activity cost pool

Setup Cost Pool
Total budgeted cost = $3,000

Cost Assignment

Mode I: (1 Run) $200 per run 10,000 units per run = $.02 per unit

Mode II: (4 Runs) $200 per run 5,000 units per run = $.04 per unit

Mode III: (10 Runs) $200 per run 400 units per run = $.50 per unit

STAGE ONE
Various overhead costs related to engineering
Engineering salaries Engineering supplies Engineering software Depreciation

STAGE TWO
Allocate based on engineering transactions

Engineering Cost Pool
Total budgeted cost = $700,000

Activity cost pool

Engineering Cost Pool
Total budgeted cost = $700,000

Cost Assignment

Mode I: 25% × $700,000 10,000 units = $17.50 per unit

Mode II: 45% × $700,000 20,000 units = $15.75 per unit

Mode III: 30% × $700,000 4,000 units = $52.50 per unit

STAGE ONE
Various overhead costs related to general operations
Plant depr. Plant mgmt. Plant maint. Property taxes Insurance Security

Exh. 5-9

STAGE TWO
Calculate the pool rate
Budgeted Facilities Cost = $507,400 Budgeted Direct-Labor Hours 118,000 = $4.30/hour

Exh. 5-9

Activity cost pool

Facility Cost Pool
Total budgeted cost = $507,400

Cost Assignment

Mode I: $4.30 per hr. × 3 hr. per unit $12.90 per unit

Mode II: $4.30 per hr. × 4 hr. per unit $17.20 per unit

Mode III: $4.30 per hr. × 2 hr. per unit $8.60 per unit

Other Overhead Costs
Receiving and Inspection Cost Pool
Board Overhead Mode I $ 200,000 Mode II 200,000 Mode III 200,000 × × × × % 6% 24% 70% ÷ ÷ ÷ ÷ Units 10,000 20,000 4,000 = Cost/Unit = $ 1.20 = 2.40 = 35.00

Other Overhead Costs
Receiving and Inspection Cost Pool
Board Overhead Mode I $ 200,000 Mode II 200,000 Mode III 200,000 × × × × % 6% 24% 70% ÷ ÷ ÷ ÷ Units 10,000 20,000 4,000 = Cost/Unit = $ 1.20 = 2.40 = 35.00

Material-Handling Cost Pool
Board Overhead Mode I $ 600,000 Mode II 600,000 Mode III 600,000 × × × × % 7% 30% 63% ÷ ÷ ÷ ÷ Units 10,000 20,000 4,000 = Cost/Unit = $ 4.20 = 9.00 = 94.50

Material-Handling Cost Pool

$14.82

Board Overhead Mode I $ 600,000 Mode II 600,000 Mode III 600,000

× × × ×

% 7% 30% 63%

÷ ÷ ÷ ÷

Units 10,000 20,000 4,000

= Cost/Unit = $ 4.20 = 9.00 = 94.50

Quality-Assurance Cost Pool
Board Overhead Mode I $ 421,000 Mode II 421,000 Mode III 421,000 × × × × % 20% 40% 40% ÷ ÷ ÷ ÷ Units 10,000 20,000 4,000 = Cost/Unit = $ 8.42 = 8.42 = 42.10

Quality-Assurance Cost Pool
Board Overhead Mode I $ 421,000 Mode II 421,000 Mode III 421,000 × × × × % 20% 40% 40% ÷ ÷ ÷ ÷ Units 10,000 20,000 4,000 = Cost/Unit = $ 8.42 = 8.42 = 42.10

Packaging and Shipping Cost Pool
Board Overhead Mode I $ 250,000 Mode II 250,000 Mode III 250,000 × × × × % 4% 30% 66% ÷ ÷ ÷ ÷ Units 10,000 20,000 4,000 = Cost/Unit = $ 1.00 = 3.75 = 41.25

Packaging and Shipping Cost Pool
Board Overhead Mode I $ 250,000 Mode II 250,000 Mode III 250,000 × × × × % 4% 30% 66% ÷ ÷ ÷ ÷ Units 10,000 20,000 4,000 = Cost/Unit = $ 1.00 = 3.75 = 41.25

Product Cost from ABC
These are the new product costs when Aerotech uses ABC.
Mode I Direct materials $ 50.00 Direct labor 60.00 Machinery 28.20 Setup 0.02 Engineering 17.50 Facilities 12.90 Other 14.82 Total $ 183.44 $ Mode II 90.00 80.00 35.25 0.04 15.75 17.20 23.57 $ 261.81 Mode III $ 20.00 40.00 56.40 0.50 52.50 8.60 212.85 $ 390.85

Distorted Product Costs
Both original and ABC target selling prices are based on (Cost × 125%).
Traditional costing ABC costing Original target selling price ABC target selling price $ Mode I 209.00 183.44 261.25 229.30 $ Mode II 302.00 261.81 377.50 327.26 Mode III $ 126.00 390.85 157.50 488.56

The selling price of Mode I and II are reduced and the selling price for Mode III is increased.
[$209.00 × 1.25] [$183.44 × 1.25]

Distorted Product Costs
Can you identify any problems Aerotech is likely to face as a result of this distortion?
Mode I Traditional costing $ 209.00 ABC costing 183.44 Cost distortion per unit 25.56 Units produced 10,000 Total cost distortion 255,600 Mode II $ 302.00 261.81 40.19 20,000 803,800 Mode III $ 126.00 390.85 (264.85) 4,000 (1,059,400)

Two Key Points
A large proportion of A large proportion of non-unit-level activities non- unitnon-unit-level activities
A unit-level cost driver, such A unitunit-level cost driver, such as direct labor, machine as direct labor, machine hours, or throughput, will not hours, or throughput, will not be able to assign the costs of be able to assign the costs of non-unit-level activities non- unitnon-unit-level activities accurately. accurately.

Product diversity Product diversity
When the consumption When the consumption ratios differ widely ratios differ widely between activities, no between activities, no single cost driver will single cost driver will accurately assign the accurately assign the resulting overhead costs. resulting overhead costs.

Traditional costing understates the cost of complex, low volume products.

Cost Drivers
A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . .
Degree of Correlation Cost of Measurement Behavioral Effects

Indicators of Need for ABC
Direct labor is a Direct labor is a small percentage small percentage of total costs of total costs Sales are increasing, Sales are increasing, but profits are declining. but profits are declining. Product-line profit Product-line profit margins are hard margins are hard to explain to explain Line managers do not Line managers do not believe the product believe the product costs reports costs reports Some products that Some products that have reported high have reported high profit margins are not profit margins are not sold by competitors sold by competitors

Marketing does not Marketing does not use costs reports for use costs reports for pricing decisions pricing decisions