This chapter compares managerial accounting with financial accounting and identifies the basic components of a product’s cost, distinguishing product costs from period costs. It compares financial reporting by a merchandiser with that of a manufacturer, traces cost flows through a job costing system, and explains predetermined overhead rates.
Managerial versus financial accounting, and product cost
Managerial accounting serves internal decision makers with detailed, forward-looking information prepared as needed, while financial accounting serves external users through general-purpose statements prepared under set standards; the two draw on much of the same underlying data but for different audiences. A manufactured product’s cost consists of direct materials, direct labor, and manufacturing overhead, and only these product costs attach to inventory, while period costs, such as selling and administrative expenses, are expensed as incurred regardless of production volume.
Reporting for a manufacturer
A manufacturer’s financial statements differ from a merchandiser’s mainly in the cost of goods sold section: rather than simply purchasing finished goods for resale, a manufacturer prepares a statement of cost of goods manufactured that tracks materials, labor, and overhead through work in process into finished goods. The resulting cost of goods manufactured then flows into the income statement, and unsold inventory at each stage of production appears among the assets on the balance sheet.
Job costing and overhead rates
A job cost system accumulates the materials, labor, and overhead costs of production according to individual jobs, which suits companies that produce distinct, identifiable units or batches, such as a construction project or a custom order. Because actual overhead costs are not known until a period ends, companies apply overhead to jobs using a predetermined overhead rate, calculated in advance by dividing estimated overhead by an estimated activity base, so job costs can be determined as work is completed.
This chapter describes the features of bonds and how they differ from stock, and the advantages and disadvantages of financing with long-term debt, including financial leverage. It covers pricing a bond using present value, recording bonds issued at face value, at a discount, or at a premium, bond redemptions and conversions, and bond ratings.
Bonds compared with stock
A bond is a formal promise to pay a stated amount at a future maturity date plus periodic interest, which makes it fundamentally different from stock: interest is a fixed, tax-deductible obligation regardless of company earnings, while dividends are discretionary and paid only after taxes. Financing with long-term debt can amplify returns to shareholders through financial leverage when the return earned on borrowed funds exceeds their interest cost, but it also raises fixed obligations the company must meet even in a poor year.
Pricing and recording bonds
A bond’s issue price is found by applying the concept of present value to its future interest payments and maturity amount, discounted at the market rate of interest; when the market rate differs from the bond’s stated rate, the bond sells at a discount or a premium rather than at face value. The chapter shows the journal entries required in each case, at issuance and as interest is recorded, as well as the entries for bonds issued exactly at face value.
Redemptions, conversions, and ratings
Bonds can be redeemed before maturity or converted into shares of stock under terms set when they were issued, each requiring its own set of journal entries to remove the bond liability and recognize any resulting gain or loss. Independent rating agencies assign bond ratings that signal a company’s creditworthiness to investors, and the times interest earned ratio, which relates income before interest and taxes to interest expense, measures how comfortably a company can meet its interest obligations.
This chapter explains cost behavior patterns and how to separate mixed costs into fixed and variable components using the scatter diagram and high-low method. It covers the relationship among costs, volume, revenue, and profits, finding the break-even point and margin of safety, applying cost-volume-profit analysis, and the assumptions and limitations that underlie it.
Cost behavior and separating mixed costs
Costs behave differently as volume changes: fixed costs stay constant in total regardless of activity level, while variable costs change in direct proportion to it, and many real costs are mixed, containing both a fixed and a variable element. The scatter diagram plots cost against activity to visualize this relationship, while the high-low method uses the highest and lowest activity levels observed to estimate the fixed and variable components mathematically.
Break-even point and margin of safety
The break-even point is the sales volume, in units or dollars, at which total revenue exactly equals total costs and profit is zero, found by relating the contribution margin, the amount each unit contributes toward fixed costs after covering its variable cost, to total fixed costs. The margin of safety measures how far actual or expected sales can fall before the company reaches that break-even point, giving managers a sense of how much cushion exists against a downturn.
Applying and questioning the analysis
Cost-volume-profit analysis can be applied to decisions such as setting sales targets for a desired profit or evaluating the effect of a change in price or cost structure, and computer spreadsheets make it practical to test many such scenarios quickly. The analysis rests on assumptions, including that costs and revenues behave in a straight-line manner within a relevant range and that sales mix stays constant, and automation’s tendency to convert variable costs into fixed costs is changing how these relationships play out in practice.
This chapter identifies the different sources of paid-in capital and how to present them on a balance sheet, and explains accounting for a cash dividend, a stock dividend, a stock split, and a retained earnings appropriation. It covers acquiring and reissuing treasury stock, discontinued operations and extraordinary items, prior period adjustments, and earnings per share.
Sources of paid-in capital
Paid-in capital comes from more than the sale of common and preferred stock at par or stated value; it can also arise from amounts received above par, from donations to the corporation, and from other capital transactions, and each source is presented separately in the paid-in capital section of the balance sheet. Together with retained earnings, these accounts make up total stockholders’ equity.
Dividends, stock splits, and treasury stock
A cash dividend reduces both cash and retained earnings once declared, while a stock dividend distributes additional shares and transfers an amount from retained earnings to paid-in capital without changing total stockholders’ equity; a stock split, by contrast, only increases the number of shares outstanding and reduces par value per share, leaving all equity accounts unchanged. Treasury stock, a corporation’s own shares reacquired but not retired, reduces total stockholders’ equity when purchased and is accounted for separately from unissued shares.
Unusual items and analyzing results
Discontinued operations, extraordinary items, and changes in accounting principle each receive specific, separate treatment in the financial statements so a reader can distinguish continuing operating performance from one-time or accounting-driven effects, and prior period adjustments correct errors from earlier years directly through retained earnings rather than through current income. Analysts use earnings per share and the price-earnings ratio to relate a corporation’s profitability and market price to its shares outstanding.
This chapter discusses the nature of standard costs and how they are set, and the advantages and disadvantages of using a standard cost system alongside budgets. It explains how to calculate the six cost variances and determine whether each is favorable or unfavorable, and prepare the journal entries that record them.
Standards, budgets, and their trade-offs
A standard cost represents what a unit of product should cost under efficient operating conditions, set in advance for materials, labor, and overhead, and it works alongside a company’s budgets to plan and control operations. Using standard costs offers advantages such as simplifying inventory valuation and highlighting inefficiencies quickly, but it also carries disadvantages, including the cost of setting and revising standards and the risk that outdated standards mislead managers about current performance.
Computing and recording the six variances
Comparing actual costs to standard costs produces six variances covering materials, labor, and overhead, each of which can be favorable, when actual cost is less than standard, or unfavorable, when it is more. The chapter shows how to calculate each variance and prepare the journal entries needed to record it, isolating the difference between actual and standard cost directly in the accounts rather than leaving it buried in a single actual-cost figure.
Investigating and disposing of variances
Not every variance is worth investigating, so managers apply selection guidelines, generally based on the size of the variance and whether it appears to be a recurring or one-time deviation, to decide where to spend their limited investigative time. Once a period ends, the accumulated variances must also be disposed of in the accounting records, using either a theoretical approach that allocates them to inventory and cost of goods sold or a more practical approach that closes them directly to cost of goods sold.
