Tracy John A. Accounting for Dummies
Подождите немного. Документ загружается.
You submit this budgeted cash flow from operating activities (see Figure 10-3)
to headquarters. Top management expects you to control the increases in your
operating assets and liabilities so that the actual cash flow generated by your
division next year comes in on target. The cash flow of your division (minus,
perhaps, a small amount needed to increase the working cash balance held by
your division) will be transferred to the central treasury of the business.
Headquarters will be planning on you generating about $3.2 million cash flow
during the coming year.
Considering Capital Expenditures
and Other Cash Needs
This chapter focuses on profit budgeting for the coming year and budgeting
the cash flow from that profit. These are the two hardcore components of busi-
ness budgeting, but not the whole story. Another key element of the budgeting
process is to prepare a capital expenditures budget for your division that goes
to top management for review and approval. A business has to take a hard look
at its long-term operating assets — in particular, the capacity, condition, and
efficiency of these resources — and decide whether it needs to expand and
modernize its property, plant, and equipment.
In most cases, a business needs to invest substantial sums of money in pur-
chasing new fixed assets or retrofitting and upgrading its old fixed assets.
These long-term investments require major cash outlays. So, each division of
a business prepares a formal list of the fixed assets to be purchased, con-
structed, and upgraded. The money for these major outlays comes from the
central treasury of the business. Accordingly, the overall capital expenditures
Budgeted profit (See Figure 10-2) $2,856,000
Accounts receivable increase (195,574
Inventory increase (317,095
Prepaid expenses increase (26,226
Depreciation expense 835,000
Accounts payable increase 34,968
Accrued expenses payable increase 52,453
Budgeted cash flow from operating profit $3,239,526
)
)
)
Figure 10-3:
Budgeted
cash flow
from
operating
activities
for the
coming
year.
220
Part III: Accounting in Managing a Business
16_246009 ch10.qxp 4/17/08 12:02 AM Page 220
budget goes to the highest levels in the organization for review and final
approval. The chief financial officer, the CEO, and the board of directors of
the business go over a capital expenditure budget request with a fine-toothed
comb (or at least they should).
At the company-wide level, the financial officers merge the profit and cash
flow budgets of all profit centers and cost centers of the business. (A cost
center is an organizational unit that does not generate revenue, such as the
legal and accounting departments.) The budgets submitted by one or more of
the divisions may be returned for revision before final approval is given. One
main concern is whether the collective cash flow total from all the units pro-
vides enough money for the capital expenditures that will be made during the
coming year — and to meet the other demands for cash, such as for cash dis-
tributions from profit. The business may have to raise more capital from debt
or equity sources during the coming year to close the gap between cash flow
from operating activities and its needs for cash. This is a central topic in the
field of business finance and beyond the coverage of this book.
221
Chapter 10: Financial Planning, Budgeting, and Control
Business budgeting versus government budgeting:
Only the name is the same
Business and government budgeting are more
different than alike. Government budgeting is
preoccupied with allocating scarce resources
among many competing demands. From federal
agencies down to local school districts, govern-
ment entities have only so much revenue avail-
able. They have to make very difficult choices
regarding how to spend their limited tax revenue.
Formal budgeting is legally required for almost
all government entities. First, a budget request
is submitted. After money is appropriated, the
budget document becomes legally binding on
the government agency. Government budgets
are legal straitjackets; the government entity
has to stay within the amounts appropriated for
each expenditure category. Any changes from
the established budgets need formal approval
and are difficult to get through the system.
A business is not legally required to use budget-
ing. A business can implement and use its budget
as it pleases, and it can even abandon its budget
in midstream. Unlike the government, the revenue
of a business is not constrained; a business can
do many things to increase sales revenue. A busi-
ness can pass its costs to its customers in the
sales prices it charges. In contrast, government
has to raise taxes to spend more (except for fed-
eral deficit spending, of course).
16_246009 ch10.qxp 4/17/08 12:02 AM Page 221
222
Part III: Accounting in Managing a Business
16_246009 ch10.qxp 4/17/08 12:02 AM Page 222
Chapter 11
Cost Concepts and Conundrums
In This Chapter
Determining costs: The second most important thing accountants do
Appreciating the different needs for cost information
Contrasting costs for understanding them better
Determining product cost for manufacturers
Padding profit by manufacturing too many products
M
easuring costs is the second most important thing accountants do,
right after measuring profit. (Well, the Internal Revenue Service might
think that measuring taxable income is the most important.) But really, can
measuring a cost be very complicated? You just take numbers off a purchase
invoice and call it a day, right? Not if your business manufactures the products
you sell — that’s for sure! In this chapter, I demonstrate that a cost, any cost,
is not as obvious and clear-cut as you may think. Yet, obviously, costs are
extremely important to businesses and other organizations.
Consider an example close to home: Suppose you just returned from the gro-
cery store with several items in the bag. What’s the cost of the loaf of bread you
bought? Should you include the sales tax? Should you include the cost of gas
you used driving to the store? Should you include some amount of depreciation
expense on your car? Suppose you returned some aluminum cans for recycling
while you were at the grocery store, and you were paid a small amount for the
cans. Should you subtract this amount against the total cost of your purchases?
Or should you subtract the amount directly against the cost of only the sodas in
aluminum cans that you bought? And, is cost the before-tax cost? In other
words, is your cost equal to the amount of income you had to earn before
income tax so that you had enough after-tax income to buy the items?
These questions about the cost of your groceries are interesting (well, to me
at least). But you don’t really have to come up with definite answers for such
questions in managing your personal financial affairs. Individuals don’t have
to keep cost records of their personal expenditures, other than what’s needed
for their annual income tax returns. In contrast, businesses must carefully record
all their costs correctly so that profit can be determined each period, and so that
managers have the information they need to make decisions and to make a
profit.
17_246009 ch11.qxp 4/17/08 12:50 AM Page 223
224
Part III: Accounting in Managing a Business
Looking down the Road to
the Destination of Costs
All businesses that sell products must know their product costs — in other
words, the costs of each and every item they sell. Companies that manufac-
ture the products they sell — as opposed to distributors and retailers of
products — have many problems in figuring out their product costs. Two
examples of manufactured products are a new Cadillac just rolling off the
assembly line at General Motors and a copy of my book, Accounting For
Dummies, 4th Edition, hot off the printing presses.
Most production (manufacturing) processes are fairly complex, so product cost
accounting for manufacturers is fairly complex; every step in the production
process has to be tracked carefully from start to finish. Many manufacturing
costs cannot be directly matched with particular products; these are called indi-
rect costs. To arrive at the full cost of each product manufactured, accountants
devise methods for allocating indirect production costs to specific products.
Surprisingly, generally accepted accounting principles (GAAP) provide very
little authoritative guidance for measuring product cost. Therefore, manufactur-
ing businesses have more than a little leeway regarding how to determine their
product costs. Even businesses in the same industry — Ford versus General
Motors, for example — may use different product cost accounting methods.
Accountants determine many other costs, in addition to product costs:
The costs of departments, regional distribution centers, and other
organizational units of the business
The cost of the retirement plan for the company’s employees
The cost of marketing programs and advertising campaigns
The cost of restructuring the business or the cost of a major recall of
products sold by the business, when necessary
A common refrain among accountants is “different costs for different purposes.”
True enough, but at its core, cost accounting serves two broad purposes: mea-
suring profit and providing relevant information to managers for planning,
control, and decision-making.
In my experience, people are inclined to take cost numbers for granted, as if
they were handed down on stone tablets. The phrase actual cost often gets
tossed around without a clear definition. An actual cost depends entirely on
the particular methods used to measure the cost. I can assure you that these
cost measurement methods have more in common with the scores from
judges in an ice skating competition than the times clocked in a Formula One
auto race. Many arbitrary choices are behind every cost number you see.
17_246009 ch11.qxp 4/17/08 12:50 AM Page 224
There’s no one-size-fits-all definition of cost, and there’s no one correct and
“best-in-all-circumstances” method of measuring cost.
The conundrum is that, in spite of the inherent ambiguity in determining
costs, we need exact amounts for costs. In order to understand the income
statement and balance sheet that managers use in making their decisions, they
need to understand a little bit about the choices an accountant has to make in
measuring costs. Some cost accounting methods result in conservative profit
numbers; other methods boost profit, at least in the short run.
This chapter covers cost concepts and cost measurement methods that apply to
all businesses, as well as basic product cost accounting of manufacturers. I dis-
cuss how a manufacturer could be fooling around with its production output to
manipulate product cost for the purpose of artificially boosting its profit figure.
(Service businesses encounter their own problems in allocating their operating
costs for assessing the profitability of their separate sales revenue sources.)
Are Costs Really That Important?
Without good cost information, a business operates in the dark. Cost data is
needed for the following purposes:
Setting sales prices: The common method for setting sales prices (known
as cost-plus or markup on cost) starts with cost and then adds a certain
percentage. If you don’t know exactly how much a product costs, you
can’t be as shrewd and competitive in your pricing as you need to be.
Even if sales prices are dictated by other forces and not set by managers,
managers need to compare sales prices against product costs and other
costs that should be matched against each sales revenue source.
Formulating a legal defense against charges of predatory pricing prac-
tices: Many states have laws prohibiting businesses from selling below
cost except in certain circumstances. And a business can be sued under
federal law for charging artificially low prices intended to drive its com-
petitors out of business. Be prepared to prove that your lower pricing is
based on lower costs and not on some illegitimate purpose.
Measuring gross margin: Investors and managers judge business perfor-
mance by the bottom-line profit figure. This profit figure depends on the
gross margin figure you get when you subtract your cost of goods sold
expense from your sales revenue. Gross margin (also called gross profit) is
the first profit line in the income statement (see Figures 4-1 and 9-1, as
well as Figure 11-1 later in this chapter, for examples). If gross margin is
wrong, bottom-line net income is wrong — no two ways about it. The cost
of goods sold expense depends on having correct product costs (see
“Assembling the Product Cost of Manufacturers” later in this chapter).
225
Chapter 11: Cost Concepts and Conundrums
17_246009 ch11.qxp 4/17/08 12:50 AM Page 225
Valuing assets: The balance sheet reports cost values for many (though
not all) assets. To understand the balance sheet you should understand
the cost basis of its inventory and certain other assets. See Chapter 5 for
more about assets and how asset values are reported in the balance
sheet (also called the statement of financial condition).
Making optimal choices: You often must choose one alternative over
others in making business decisions. The best alternative depends heav-
ily on cost factors, and you have to be careful to distinguish relevant
costs from irrelevant costs, as I describe in the section “Relevant versus
irrelevant costs,” later in this chapter.
In most situations, the book value of a fixed asset is an irrelevant cost. Say
book value is $35,000 for a machine used in the manufacturing operations
of the business. This is the amount of original cost that has not yet been
charged to depreciation expense since it was acquired, and it may seem
quite relevant. However, in deciding between keeping the old machine or
replacing it with a newer, more efficient machine, the disposable value of
the old machine is the relevant amount, not the undepreciated cost bal-
ance of the asset. Suppose the old machine has only a $20,000 salvage
value at this time; this is the relevant cost for the alternative of keeping it
for use in the future — not the $35,000 that hasn’t been depreciated yet. In
order to keep using it, the business forgoes the $20,000 it could get by sell-
ing the asset, and this $20,000 is the relevant cost in this decision situation.
Making decisions involves looking forward at the future cash flows of each
alternative — not looking backward at historical-based cost values.
Becoming More Familiar with Costs
The following sections explain important cost distinctions that managers
should understand in making decisions and exercising control. Also, these cost
distinctions help managers better appreciate the cost figures that accountants
attach to products that are manufactured or purchased by the business.
Retailers (such as Wal-Mart or Costco) purchase products in a condition ready
for sale to their customers — although the products have to be removed from
shipping containers, and a retailer does a little work making the products
presentable for sale and putting the products on display. Manufacturers don’t
have it so easy; their product costs have to be “manufactured” in the sense that
the accountants have to accumulate various production costs and compute
the cost per unit for every product manufactured. I focus on the special cost
concerns of manufacturers in the upcoming section “Assembling the Product
Cost of Manufacturers.”
226
Part III: Accounting in Managing a Business
17_246009 ch11.qxp 4/17/08 12:50 AM Page 226
227
Chapter 11: Cost Concepts and Conundrums
Accounting versus economic costs
Accountants focus mainly on
actual costs
(though they disagree regarding how exactly to
measure these costs). Actual costs are rooted
in the actual, or historical, transactions and
operations of a business. Accountants also
determine
budgeted costs
for businesses that
prepare budgets (see Chapter 10), and they
develop
standard costs
that serve as yardsticks
to compare with the actual costs of a business.
Other concepts of cost are found in economic
theory
.
You encounter a variety of economic
cost terms when reading
The Wall Street
Journal,
as well as in many business discus-
sions and deliberations. Don’t reveal your igno-
rance of the following cost terms:
Opportunity cost: The amount of income (or
other measurable benefit) given up when
you follow a better course of action. For
example, say that you quit your $50,000 job,
invest $200,000 to start a new business, and
end up netting $80,000 in your new business
for the year. Suppose also that you would
have earned 5 percent on the $200,000 (a
total of $10,000) if you’d kept the money in
whatever investment you took it from. So
you gave up a $50,000 salary and $10,000 in
investment income with your course of
action; your opportunity cost is $60,000.
Subtract that figure from what your actual
course of action netted you — $80,000 —
and you end up with a “real” economic
profit of $20,000. Your income is $20,000
better by starting your new business
according to economic theory.
Marginal cost: The
incremental,
out-of-
pocket outlay required for taking a particu-
lar course of action. Generally speaking, it’s
the same thing as a
variable
cost (see
“Fixed versus variable costs,” later in this
chapter). Marginal costs are important, but
in actual practice managers must recover
fixed (or nonmarginal) costs as well as mar-
ginal costs through sales revenue in order
to remain in business for any extent of time.
Marginal costs are most relevant for ana-
lyzing one-time ventures, which don’t last
over the long-term.
Replacement cost: The estimated amount it
would take today to purchase an asset that
the business already owns. The longer ago
an asset was acquired, the more likely its
current replacement cost is higher than its
original cost. Economists are of the opinion
that current replacement costs are relevant
in making rational economic decisions. For
insuring assets against fire, theft, and nat-
ural catastrophes, the current replacement
costs of the assets are clearly relevant.
Other than for insurance, however, replace-
ment costs are not on the front burners of
decision-making — except in situations in
which one alternative being seriously con-
sidered actually involves replacing assets.
Imputed cost: An ideal, or hypothetical, cost
number that is used as a benchmark or yard-
stick against which actual costs are com-
pared. Two examples are
standard costs
and
the
cost of capital.
Standard costs are set in
advance for the manufacture of products
during the coming period, and then actual
costs are compared against standard costs
to identify significant variances. The cost of
capital is the weighted average of the inter-
est rate on debt capital and a target rate of
return that should be earned on equity capi-
tal. The
economic value added
(EVA) method
compares a business’s cost of capital
against its actual return on capital, to deter-
mine whether the business did better or
worse than the benchmark.
For the most part, these types of cost aren’t
reflected in financial reports. I’ve included them
here to familiarize you with terms you’re likely
to see in the financial press and hear on finan-
cial talk shows. Business managers toss these
terms around a lot.
17_246009 ch11.qxp 4/17/08 12:50 AM Page 227
I cannot exaggerate the importance of correct product costs (for businesses
that sell products, of course). The total cost of goods (products) sold is the first,
and usually the largest, expense deducted from sales revenue in measur
ing profit.
The bottom-line profit amount reported in a business’s income statement depends
heavily on whether its product costs have been measured properly during that
period. Also, keep in mind that product cost is the value for the inventory asset
reported in the balance sheet of a business. (For a balance sheet example see
Figure 5-2.)
Direct versus indirect costs
You might say that the starting point for any sort of cost analysis, and particu-
larly for accounting for the product costs of manufacturers, is to clearly distin-
guish between direct and indirect costs. Direct costs are easy to match with a
process or product, whereas indirect costs are more distant and have to be
allocated to a process or product. Here are more details:
Direct costs: Can be clearly attributed to one product or product line, or
one source of sales revenue, or one organizational unit of the business,
or one specific operation in a process. An example of a direct cost in the
book publishing industry is the cost of the paper that a book is printed
on; this cost can be squarely attached to one particular phase of the
book production process.
Indirect costs: Are far removed from and cannot be naturally attached
to specific products, organizational units, or activities. A book pub-
lisher’s phone bill is a cost of doing business but can’t be tied down to
just one step in the book editorial and production process. The salary of
the purchasing officer who selects the paper for all the books is another
example of a cost that is indirect to the production of particular books.
Each business must determine a method of allocating indirect costs to dif-
ferent products, sources of sales revenue, organizational units, and so on.
Most allocation methods are far from perfect and, in the final analysis, end
up being arbitrary to one degree or another. Business managers should
always keep an eye on the allocation methods used for indirect costs and
take the cost figures produced by these methods with a grain of salt. If I
were called in as an expert witness in a court trial involving costs, the first
thing I’d do is critically analyze the allocation methods used by the busi-
ness for its indirect costs. If I were on the side of the defendant, I’d do my
best to defend the allocation methods. If I were on the side of the plaintiff,
I’d do my best to discredit the allocation methods — there are always
grounds for criticism.
228
Part III: Accounting in Managing a Business
17_246009 ch11.qxp 4/17/08 12:50 AM Page 228
The cost of filling the gas tank as I drive from Denver to San Diego and back
to consult with my coauthor and son, Tage, about the book we wrote
together, Small Business Financial Management Kit For Dummies (Wiley), is a
direct cost of making the trip. The annual auto license plate fee that I pay to
the state of Colorado is an indirect cost of the trip, although it is a direct cost
of having the car available during the year.
Fixed versus variable costs
If your business sells 100 more units of a certain item, some of your costs
increase accordingly, but others don’t budge one bit. This distinction
between variable and fixed costs is crucial:
Variable costs: Increase and decrease in proportion to changes in sales
or production level. Variable costs generally remain the same per unit of
product, or per unit of activity. Additional units manufactured or sold
cause variable costs to increase in concert. Fewer units manufactured or
sold result in variable costs going down in concert.
Fixed costs: Remain the same over a relatively broad range of sales volume
or production output. Fixed costs are like a dead weight on the business.
Its total fixed costs for the period are a hurdle it must overcome by selling
enough units at high enough margins per unit in order to avoid a loss and
move into the profit zone. (Chapter 9 explains the break-even point, which
is the level of sales needed to cover fixed costs for the period.)
Note: The distinction between variable and fixed costs is essential for under-
standing and analyzing profit behavior, which I explain in Chapter 9.
Relevant versus irrelevant costs
Not every cost is important to every decision a manager needs to make.
Hence the distinction between relevant and irrelevant costs:
Relevant costs: Costs that should be considered and included in your
analysis when deciding on a future course of action. Relevant costs are
future costs — costs that you would incur, or bring upon yourself, depend-
ing on which course of action you take. For example, say that you want to
increase the number of books that your business produces next year in
order to increase your sales revenue, but the cost of paper has just shot
up. Should you take the cost of paper into consideration? Absolutely —
that cost will affect your bottom-line profit and may negate any increase
in sales volume that you experience (unless you increase the sales
price). The cost of paper is a relevant cost.
229
Chapter 11: Cost Concepts and Conundrums
17_246009 ch11.qxp 4/17/08 12:50 AM Page 229