CHAPTER 6

Traditional Cost
Management
 Learning Objective 1

Outline the different

cost flow patterns in
manufacturing,
merchandising, and
service organizations
and understand how
these costs are
reflected in the
income statement
and balance sheet.
 What are Cost Flow Patterns of Manufacturing,
Merchandising, and Service Organizations?
Manufacturing
Direct Materials
Work-in- Finished
Direct Labor Cost of
Process Goods
Manufacturing Goods Sold
Inventory Inventory
Overhead
Merchandising

Inventory Purchase Cost Merchandise Cost of

Inventory Shipping Cost Inventory Goods Sold

Service
Supplies Work-in- Cost of
Wages & Salaries Process Services Sold
Overhead Services
 Learning Objective 2

Interpret a cost of
goods manufactured
schedule and analyze
the levels of raw
materials, work-in-
process, and finished
goods inventories in a
manufacturing
organization.
Cost of Goods Manufactured Schedule
 Shows specific costs incurred to manufacture goods.
 Provides calculations that support flow of costs.
 Total costs of goods manufactured should include only those
costs that have gone through work-in-process during the
period.
 Underapplied MOH is subtracted from actual MOH costs.
Overapplied MOH is added to actual MOH costs.
 Cost of goods available for sale = beginning finished goods
inventory (adjusted for over- or underapplied MOH) + total cost
of goods manufactured.
 Analyzing COGS

 COGS is not useful for internal decision making.

 Management wants to determine cost of goods
manufactured
 on a product-by-product basis;
 on a department-by-department basis;
 on a period-by-period basis.
 Other criteria examined besides
cost:
 product quality.
 speed of production.
 Learning Objective 3

Understand how
merchants
manage cost
information in
their organization.
 Inventory Management Issues
Carrying Too Much Inventory Carrying Too Little Inventory
 Increased overhead costs  Increased risk of lost
 Increased financial holding sales
costs  Increased ordering costs
 Increased risk of loss of  Increased risk of supplier
market value price increases
 Decreased inventory  Increased exposure to
flexibility nondelivery
 Increased inventory  Decreased bulk order
shrinkage discounts
 Return on Investment
 It is just as important to manage the money outflow for
asset investment as it is to manage the money inflow from
profits.
 Good management accounting can provide real value in the
management effort to improve a merchandising operation.

ROI = Profit margin X Asset turnover

Profit
Profit margin =
Revenue
Revenue
Asset turnover =
Total assets
 Define Net Operating Profit

The difference
between normal
business sales and
normal business
expenses.
Learning Objective 4

Measure
profitability and
personnel
utilization in a
service
organization.
Describe the Characteristics of Service
Organizations
Professional Service Mass
Services Shops Services

People Equipment

Process Product

High Low
Customization Customization
 What Two Concepts Are Used to
Develop Cost Management Evaluation
Tools for Service Organizations?

1) Profitability
2) Efficiency
- While management of materials inventories,
equipment, and building space are important in a
service organization, where must the emphasis be
placed?
- Management of the people and their related cost to
obtain the most efficient use of this critical
resource.
 What is the Formula for Profit
Percentage from Professionals (PPP)?

Revenue – Professional compensation cost

PPP =
Revenue

What is a Personnel Utilization Report

(PUR)?

Actual billable hours

PUR =
Budgeted billable hours
 Learning Objective 5

Calculate and
interpret holding
costs in
merchandising
and service
businesses.
Match These Terms with Their Correct
Formula or Definition

Economic
Profit The Cost of Using Money

Cost of Average Investment x Annual

Capital Rate x Number of Periods

Financial Net Operating Profit – Holding

Holding Cost Cost of Inventory and Other
Asset Investments
Match These Terms with Their Correct
Formula or Definition

Economic Net Operating Profit – Holding

Profit Cost of Inventory and Other
Asset Investments

Cost of
Capital The Cost of Using Money

Financial Average Investment x Annual

Holding Cost Rate x Number of Periods
 Define Segment and Economic
Value Added
Segment is a part of a business
__________
that requires separate reports by
management for evaluation purposes.

_____________________
Economic Value Added is a
commercialized performance
measurement system emphasizing
incremental profits above the profit
necessary to meet cost of capital
requirements.
 Expanded Material
Learning Objective 6

Use classic
quantitative tools in
inventory

%
management
(economic order
quantity, reorder
point, and safety
stock).
 Economic Order Quantity
What must firms balance?
costs
costs of carrying too
of carrying little inventory
too much
inventory

EOQ attempts to balance these costs:

overhead costs, holding costs,
risk of lost market values, shrinkage, etc.

EOQ attempts to answer what questions?

How much inventory should we order?
When do we place the inventory order?
 Calculating EOQ
How much inventory should we order?
What is the formula for EOQ?
What do the terms mean?

2QP
EOQ 
C
Q = The market demand in units for the period
P = The overhead cost of placing one order
C = The total carrying cost for one unit for the period
 Reorder Point
When do we place the inventory order?
What is the formula?

Reorder point = Average lead time in days

x Average daily sales

Define Lead Time:

time lag between initiating a
purchase order and when
inventory is delivered and
ready for sale.
 Safety Stock
Why does a business want to hold safety
stock?

Because a surge in customer demand

or problems in order processing or
shipping may cause fulfillment
problems, a manager may see the
need for a little cushion in reorder
point.

Safety stock — calculation has two parts:

1. To handle possible problems in the reorder process.
2. To handle an unexpected spike in sales demand.
 Define Safety Stock
The minimal level of inventory required to ensure against
the organization running out of inventory in the case of
unforeseen problems in receiving its next purchase
order.

Reorder point = (Average lead time in days

x Average daily sales)
+ Safety stock
Combining the two calculations is acceptable,
assuming management is not interested in knowing the
specific level for safety stock. However, management
usually wants to know when sales are eating into the
safety stock.
 EOQ, Reorder Points, and Safety Stock
Inventory Levels
Inventory
(Units)
Reorder
Point with
Safety E
Stock O
Reorder Q
Point
Safety
Stock

0 3 6 9 12
units days days days days
Average Lead Time (3 days)