Earnings per share EPS represents the net income earned for each share of outstanding common stock. In a simple capital structure, it is calculated by dividing net income by the number of weighted average common shares outstanding.
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If the number of shares of common stock outstanding changes during the year, the weighted average stock outstanding must be calculated based on shares actually outstanding during the year. The weighted average shares was calculated by 2 because the new shares were issued half way through the year. If preferred stock is outstanding, preferred dividends declared should be subtracted from net income before calculating EPS.
Price-earnings ratio. The payout ratio identifies the percent of net income paid to common stockholders in the form of cash dividends. It is calculated by dividing cash dividends by net income. Many startup companies and companies in some industries do not pay out dividends. It is important to understand the company and its strategy when analyzing the payout ratio.
Another indicator of how a corporation performed is the dividend yield. It is calculated by dividing dividends paid per share by the market price of one common share at the end of the period. It should be investigated so the investor knows the reason it is low.
Solvency ratios Solvency ratios are used to measure long-term risk and are of interest to long-term creditors and stockholders. Debt to total assets ratio. The debt to total assets ratio calculates the percent of assets provided by creditors.
It is calculated by dividing total debt by total assets. Total debt is the same as total liabilities. Times interest earned ratio. It is calculated by dividing earnings before interest and taxes EBIT by interest expense. If the times interest earned ratio is less than two it will be difficult to find a bank to loan money to the business. Limitations on Financial Statement Analysis Many things can impact the calculation of ratios and make comparisons difficult.
The ratios will be as accurate as the estimates. These differences impact ratios and make it difficult to compare companies using different methods. In fact, it usually generates more questions! For example, the balance sheet reports total inventories and the income statement reports cost of goods sold, but the costs of individual products are not disclosed to the public.
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Internal management needs detailed information to make decisions about its business. A comparison of managerial and financial accounting shows the differences between the two sets of information. These include three types of inventory accounts—raw materials, work-in-process, and finished goods—and several long-term fixed asset accounts. The amounts may be shown individually on the face of the balance sheet or disclosed in footnotes. A manufacturer often has patents for its products or processes. The capitalized costs associated with a patent would be included in the intangible asset section of the balance sheet.
The income statement for a manufacturing company is similar to that prepared for a merchandising company. In calculating cost of goods sold, only the finished goods inventory account is used, as shown. Product costs are those costs assigned to an inventory account that eventually become part of cost of goods sold. In a manufacturing company, product costs are also called manufacturing costs. In a service company, product costs are also accumulated as inventory such as the cost of an audit or of a will.
Period costs are those costs recorded as an expense in the period they are incurred. Selling expenses such as sales salaries, sales commissions, and delivery expense, and general and administrative expenses such as office salaries, and depreciation on office equipment, are all considered period costs. In a manufacturing company, these costs are often referred to as nonmanufacturing costs.
There are three categories of manufacturing costs: direct materials, direct labor, and overhead. Some materials used in making a product have a minimal cost, such as screws, nails, and glue, or do not become part of the final product, such as lubricants for machines and tape used when painting. Such materials are called indirect materials and are accounted for as manufacturing overhead.
Direct labor is the cost of the workers who make the product. The cost of supervisory personnel, management, and factory maintenance workers, although they are needed to operate the factory, are classified as indirect labor because these workers do not use the direct materials to build the product. Manufacturing overhead costs include indirect materials, indirect labor, and all other manufacturing costs. Depreciation on factory equipment, factory rent, factory insurance, factory property taxes, and factory utilities are all examples of manufacturing overhead costs.
Together, the direct materials, direct labor, and manufacturing overhead are referred to as manufacturing costs. The costs of selling the product are operating expenses period cost and not part of manufacturing overhead costs because they are not incurred to make a product. The Cost of Goods Manufactured Schedule The cost of goods manufactured schedule is used to calculate the cost of producing products for a period of time. The cost of goods manufactured amount is transferred to the finished goods inventory account during the period and is used in calculating cost of goods sold on the income statement.
The cost of goods manufactured schedule reports the total manufacturing costs for the period that were added to work-in-process, and adjusts these costs for the change in the work-in-process inventory account to calculate the cost of goods manufactured. Journal entries are used to record transactions, adjusting journal entries are used to recognize costs and revenues in the appropriate period, financial statements are prepared, and closing entries are recorded. Raw material purchases are recorded in the raw material inventory account if the perpetual inventory method is used, or the raw materials purchases account if the periodic inventory method is used.
Debit Credit Credit Union Payable It is recorded with an increase debit to factory depreciation and an increase credit to accumulated depreciation—building. Debit Credit 20X0 May 31 Factory Depreciation Expense Accumulated Depreciation— Building 9, 9, Record factory building depreciation Some companies use one account, factory overhead, to record all costs classified as factory overhead. If one overhead account is used, factory overhead would be debited in the previous entry instead of factory depreciation.
At the end of the cycle, the closing entries are prepared. For a manufacturing company that uses the periodic inventory method, closing entries update retained earnings for net income or loss and adjust each inventory account to its period end balance. A special account called manufacturing summary is used to close all the accounts whose amounts are used to calculate cost of goods manufactured.
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The manufacturing summary account is closed to income summary. Income summary is eventually closed to retained earnings. The manufacturing accounts are closed first. The closing entries that follow are based on the accounts included in the cost of goods manufactured schedule and income statement for Red Car, Inc. Debit Credit Insurance Expense 9, Office Supplies Expense 2, Income Tax Expense 10, Close operating expense accounts and adjust inventory C6 Income Summary 19, Retained Earnings 19, Close income summary The following T-accounts illustrate the impact of the closing entries on the special closing accounts and retained earnings.
To accompany these procedures are the two traditional types of cost accounting systems: job order cost system and process cost system. The information captured by these cost accounting systems aids managers in determining total production costs. Job Order Cost System The job order cost system is used when products are made based on specific customer orders. Each product produced is considered a job. Costs are tracked by job.
Services rendered can also be considered a job. For example, service companies consider the creation of a financial plan by a certified financial planner, or of an estate plan by an attorney, unique jobs. The job order cost system must capture and track by job the costs of producing each job, which includes materials, labor, and overhead in a manufacturing environment. This is used to track the job number; customer information; job information date started, completed, and shipped ; individual cost information for materials used, labor, and overhead; and a total job cost summary.
See Figure To assure that materials costs are properly allocated to jobs in process, a materials requisition form see Figure is usually completed as materials are taken from the raw materials inventory and added to work-inprocess. Labor costs are allocated to work-in-process inventory based on the completion of time tickets see Figure identifying what job a worker spent time on. Predetermined overhead rate Factory overhead costs are allocated to jobs in process using a predetermined overhead rate.
The predetermined overhead rate is determined by estimating during the budget process total factory overhead costs and dividing these total costs by direct labor hours or direct labor dollars. Once the job is sold and delivered, the job costs are transferred from finished goods inventory to cost of goods sold.
Figure summarizes the flow of costs in a job order cost system and Figure summarizes the journal entries required given the flow of costs in Figure The ending balances in the three inventory accounts would be reported as inventories on the balance sheet and cost of goods sold would be reported on the income statement. The factory overhead account see Figure has a balance which indicates the amount of overhead applied to work-in-process inventory is different from the actual overhead incurred.
When there is a debit balance in the factory overhead account, it is called underapplied overhead meaning not enough overhead was allocated to jobs. If the balance in the factory overhead account was a credit, the overhead would be over-applied, meaning too much overhead was allocated to jobs. Factory overhead must be zero at the end of the year.
Most companies transfer the balance in factory overhead to cost of goods sold. An alternative method, although more complex, is to allocate the under- or over-applied balance among the work-in-process inventory, finished goods inventory, and cost of goods sold accounts. To zero out the account balance and transfer it to cost of goods sold, the entry would be: Date General Journal Account Title and Description Ref. Excludes portion of entry to recognize revenue on sale. They continually process their product, moving it from one function to the next until it is completed. In these companies, the manufacturing costs incurred are allocated to the proper functions or departments within the factory process rather than to specific products.
Examples of products that companies produce continuously are cereal, bread, candy, steel, automotive parts, chips, and computers. Companies that refine oil or bottle drinks and companies that provide services such as mail sorting and catalog order are also examples of continuous, homogeneous processing. To illustrate, assume the Best Chips company manufactures potato chips.
The company has three work areas they call preparation, baking, and packaging. The preparation area includes cutting potatoes and adding flavorings. Conveyor belts are used to move the product from one function to the next. In this company, raw materials are added in two of the functions: the preparation function and the packaging function. Labor and overhead are incurred in each function.
The journal entries to record these transactions are made prior to the period end entries that transfer the amounts from one work-in-process inventory account to another, from work-in-process inventory to finished goods inventory, and from finished goods inventory to cost of goods sold.
The letters of the journal entries used to illustrate the accounting for process cost systems see Key to Figure correspond to the letters in Figure Best Chips uses the perpetual inventory method see Chapter 8 , so raw materials purchased are added to the raw material inventory account when they are received. Raw materials requisitioned that become part of the final product or are used by a specific function are considered direct materials used. Raw materials requisitioned that are used for general production purposes are added to factory overhead.
Raw Materials Inventory beginning balance A ending balance 5, 4, 1, 6, 9, 7, C F 2, Factory labor As the factory labor payroll is prepared and recorded, the payroll costs are split between those employees who work in specific functions departments and those involved in the general functions of the factory. The specific function costs are called direct labor and are assigned to work-in-process inventory. The general factory labor costs are indirect labor costs that are added to factory overhead. If a specific maintenance worker or supervisor is assigned to the preparation function, their wages are allocated to that function even though these workers are not directly involved in preparing the chips to be baked.
The accounting for the labor costs for June includes the following journal entries, shown in the following table.
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Factory Labor B 7, 1, 5, 7, 7, D G 0 Factory overhead In a process company, factory overhead represents those costs not directly assigned to one function. For example, the depreciation expense of a machine used solely by the preparation function would be assigned to work-in-process inventory for the preparation department while depreciation expense for the plant the factory building would be assigned to factory overhead as all functions occupy the plant. The journal entries that follow illustrate the accounting for general overhead costs.
This is called overapplied overhead and an entry would be made at the end of the period to move it to cost of goods sold, or alternatively, to allocate the difference to work-in-process inventories, finished goods inventory, and cost of goods sold. After recording this entry, the balance in the factory overhead account is zero.
In this example, costs are moved from work-in-process inventory-preparation to work-in-process inventory-baking and from work-in-process inventory-baking to work-in-process inventory-packaging. The costs of the completed products are then transferred from work-in-process inventory-packaging to finished goods inventory. This transfer also requires a journal entry. The number of units is determined separately for each function using the actual number of units completed and transferred out of the function adjusted for partially completed units that were not transferred.
This calculated number of units used is called equivalent units. If there are no in-process units at the beginning or end of the period, the per unit cost is calculated by dividing the total costs assigned to a function department by the total number of units that were started and completed during the period. The total costs include materials, labor, and overhead. For example, if two employees each work 20 hours a week, this is the equivalent of one full-time employee one equivalent unit. This calculation assumes that the materials, labor, and overhead are all added evenly throughout the time the units are in process in the function.
In many companies, the materials are all added at the beginning of the process while the labor and overhead costs are incurred throughout the process. If materials, labor, and overhead are added at different times in the production process, two separate calculations of equivalent units are necessary, one for the materials and one for conversion costs.
The equivalent units for materials would be the number of units times the percent complete. The total materials costs are divided by 1, to calculate the materials cost per unit. Unlike materials, more labor and overhead will be needed before these units are transferred to another function or to finished goods. The total conversion costs are divided by to calculate the conversion costs per unit.
To calculate total cost per unit, the materials cost per unit is added to the conversion cost per unit. Assume a company has two functions in its production process called Department 1 and Department 2. The beginning units and those started and completed are not separately identified in the calculation of equivalent units.
When calculating the per unit cost using the weighted average method, the beginning work-in-process costs for the function are added to those costs incurred during the period and then divided by the equivalent units. Equivalent units may also be calculated using the first-in, firstout FIFO method. Under the FIFO method of calculating equivalent units, the beginning units would be identified separately from those started and completed. Assume the following facts and costs for Department 1 for August. Overhead costs are based on direct labor hours.
In the weighted average example see Figure , the calculation of number of units accounted for does not differentiate between units in beginning inventory and those units started and completed during the period because the costs are averaged for all these units. The per unit costs are based on the equivalent units completed and the total costs incurred on those units. Per unit costs are current period unit costs and calculated based on equivalent units completed and costs incurred for the current period.
For the units in the beginning inventory, once the current period costs are calculated, they are added to the costs incurred in prior periods to determine the total costs for these units. However, in some companies, new technologies have changed the manufacturing environment such that the number of hours worked or dollars earned by employees are no longer good indicators of how much overhead will be needed to complete a job or process products through a particular function.
In such companies, activity-based costing ABC is used to allocate overhead costs to jobs or functions.
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Activity-Based Costing Activities Activity-based costing assumes that the steps or activities that must be followed to manufacture a product are what determine the overhead costs incurred. Each overhead cost, whether variable or fixed, is assigned to a category of costs. These cost categories are called activity cost pools. Cost drivers are the actual activities that cause the total cost in an activity cost pool to increase.
The number of times materials are ordered, the number of production lines in a factory, and the number of shipments made to customers are all examples of activities that impact the costs a company incurs. When using ABC, the total cost of each activity pool is divided by the total number of units of the activity to determine the cost per unit.
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Assume Lady Trekkers, Inc. As an example to calculate the per unit cost for the purchasing department, the total costs of the purchasing department are divided by the number of purchase orders. Lady Trekkers, Inc. Once the per unit costs are all calculated, they are added together, and the total cost per unit is multiplied by the number of units to assign the overhead costs to the units. Activity categories While using cost drivers to assign overhead costs to individual units works well for some activities, for some activities such as setup costs, the costs are not incurred to produce an individual unit but rather to produce a batch of the same units.
For other costs, the costs incurred might be based on the number of product lines or simply because there is a manufacturing facility. The costs of direct materials, direct labor, and machine maintenance are examples of unit-level activities. Purchase orders, machine setup, and quality tests are examples of batch-level activities. Examples of product-line activities are engineering changes made in the assembly line, product design changes, and warehousing and storage costs for each product line.
In contrast, the facility-level costs are kept separate from product costs and are not allocated to individual units because the allocation would have to be made on an arbitrary basis such as square feet, number of divisions or products, and so on. Comparison of Activity-Based Costing and Traditional Cost System Assume the Busy Ball Company makes two types of bouncing balls; one has a hollow center and the other has a solid center.
The same equipment is used to produce the balls in different runs. Between batches, the equipment is cleaned, maintained, and set up in the proper configuration for the next batch. The hollow center balls are packaged with two balls per package, and the solid center balls are packaged one per package. During the year, Busy Ball expects to make 1,, hollow center balls and 2,, solid center balls. The per unit cost to produce balls is calculated in two steps: 1.
Calculate the predetermined overhead rate by dividing total overhead costs by total direct labor dollars. Allocate overhead to each type of product by multiplying the overhead cost per direct labor dollar by the per unit direct labor dollars for hollow center balls and for solid center balls. The reason for the differences is the traditional method determines the cost allocation using direct labor dollars only, so a product with high direct labor dollars gets allocated more of the overhead costs than a product with low direct labor dollars.
The number of orders, setups, or tests the product actually uses does not impact the allocation of overhead costs when direct labor dollars are used to allocate overhead. The more activities identified, the more complex the costing system becomes. Computer systems are needed for complex ABC systems. Some companies limit the number of activities used in the costing system to keep the system manageable. While this approach may result in some allocations being arbitrary, using ABC does provide a more accurate estimate of costs for use in making management decisions.
Fundamental to this understanding is learning about cost behavior. Cost Behavior The way a specific cost reacts to changes in activity levels is called cost behavior. Costs may stay the same or may change proportionately in response to a change in activity. Knowing how a cost reacts to a change in the level of activity makes it easier to create a budget, prepare a forecast, determine how much profit a new product will generate, and determine which of two alternatives should be selected. Fixed costs Fixed costs are those that stay the same in total regardless of the number of units produced or sold.
Although total fixed costs are the same, fixed costs per unit changes as fewer or more units are produced. Straight-line depreciation is an example of a fixed cost. It does not matter whether the machine is used to produce 1, units or 10,, units in a month, the depreciation expense is the same because it is based on the number of years the machine will be in service.
With a variable cost, the per unit cost stays the same, but the more units produced or sold, the higher the total cost. Direct materials is a variable cost. Graphically, the total fixed cost looks like a straight horizontal line while the total variable cost line slopes upward. Total Fixed Costs Total Variable Costs 30, 20, 10, 50 0 10 20 Units 30 40 0 10 20 30 40 Units The graphs for the fixed cost per unit and variable cost per unit look exactly opposite the total fixed costs and total variable costs graphs.
Although total fixed costs are constant, the fixed cost per unit changes with the number of units. The variable cost per unit is constant. At certain levels of activity, new machines might be needed, which results in more depreciation, or overtime may be required of existing employees, resulting in higher per hour direct labor costs.
The definitions of fixed cost and variable cost assumes the company is operating or selling within the relevant range the shaded area in the graphs so additional costs will not be incurred. During March, a company made 2, local calls. Several methods, including scatter diagrams, the high-low method, and least-square regression, are used to identify the variable and fixed portions of a mixed cost, which are based on the past experience of the company.
Scatter diagram. In a scatter diagram, all parts would be plotted on a graph with activity gallons of water used, in the example graph later in this section on the horizontal axis and cost on the vertical axis. A line is drawn through the points and an estimate made for total fixed costs at the point where the line intersects the vertical axis at zero units of activity. To compute the variable cost per unit, the slope of the line is determined by choosing two points and dividing the change in their cost by the change in the units of activity for the two points selected.
See the graph to illustrate the point. The high point of activity is 75, gallons and the low point is 32, gallons. Least-squares regression analysis. The least-squares regression analysis is a statistical method used to calculate variable costs. It requires a computer spreadsheet program for example, Excel or calculator and uses all points of data instead of just two points like the high-low method.
The contribution margin represents the amount of income or profit the company made before deducting its fixed costs. Said another way, it is the amount of sales dollars available to cover or contribute to fixed costs. When calculated as a ratio, it is the percent of sales dollars available to cover fixed costs.
Once fixed costs are covered, the next dollar of sales results in the company having income. The contribution margin is sales revenue minus all variable costs. It may be calculated using dollars or on a per unit basis. It can be calculated using either the contribution margin in dollars or the contribution margin per unit. To calculate the contribution margin ratio, the contribution margin is divided by the sales or revenues amount. In other words, the point where sales revenue equals total variable costs plus total fixed costs, and contribution margin equals fixed costs.
Similarly, the fixed costs represent total manufacturing, selling, and administrative fixed costs. Break-even point in dollars. Break-even point in units. Once the break-even point in units has been calculated, the break-even point in sales dollars may be calculated by multiplying the number of breakeven units by the selling price per unit. This also works in reverse. If the break-even point in sales dollars is known, it can be divided by the selling price per unit to determine the break-even point in units.
To calculate the required sales level, the targeted income is added to fixed costs, and the total is divided by the contribution margin ratio to determine required sales dollars, or the total is divided by contribution margin per unit to determine the required sales level in units. Remember that there are additional variable costs incurred every time an additional unit is sold, and these costs reduce the extra revenues when calculating income.
If a targeted net income income after taxes is being calculated, then income taxes would also be added to fixed costs along with targeted net income. It is computed by subtracting break-even sales from budgeted or forecasted sales. To state the margin of safety as a percent, the difference is divided by budgeted sales. CVP analysis using the break-even formula is often used for this analysis. While some portions of a long-range plan are concerned with the organization in five to ten years, the budget is the short-range portion of the plan.
Most budgets are prepared for a twelve-month period, sometimes on a rolling basis. Rolling budgets require management to keep looking forward and to anticipate changes. Although different textbooks group the budgets differently, the main components of a budget are operating budgets for revenues and expenses, capital expenditures budget, cash budget, and finally the budgeted financial statements, which include the income statement, balance sheet, and cash flow statement. Operating Budgets The operating budgets include the budgets for sales, manufacturing costs materials, labor, and overhead or merchandise purchases, selling expenses, and general and administrative expenses.
Sales budget The sales budget is the starting point in putting together a comprehensive budget for a business. It includes the number of units to be sold and the selling price per unit. It is important to agree to the sales budget first because many other budgets are based on this data. Although its components are simple, getting a management team to agree on the number of units to be sold and the selling price per unit, the two items needed to prepare the budget, is often difficult and timeconsuming.
The Pickup Trucks Company, which makes toy trucks, has just completed its budgeting process for next year. Manufacturing costs Before preparing the direct materials, direct labor, and manufacturing overhead budgets, the production budget must be completed. Production budget. The production budget shows the number of units that must be produced. To budget for annual production, three things must be known: the number of units to be sold, the required level of inventory at the end of the year, and the number of units, if any, in the beginning inventory.
If quarterly budgets are required, this same information is needed on a quarterly basis. The end of one quarter is the same as the beginning of the next quarter. So the ending inventory for quarter one March 31 is the same as the beginning inventory for quarter two April 1 ; the ending inventory for quarter two is the beginning inventory for quarter three, and so on.
The 2, ending inventory at the end of quarter four is also the end of the year inventory. The 2, represents the inventory at the beginning of the year see quarter one. Direct materials budget. The direct materials budget determines the number of units of raw materials to be purchased.
It uses the number of units to be produced from the production budget, the required level of ending inventory for raw materials, and the number of units in beginning inventory. Once the number of units to be purchased is determined, it is multiplied by the cost per unit to determine the budgeted amount for raw materials purchases. Units to be produced from the production budget. Number of units of raw material for one unit produced. The ending inventory is also used as the beginning inventory for the following quarter.
This process is repeated for all the other raw material components used in producing a toy pickup truck. Direct labor budget. The direct labor budget shows the number of direct labor hours and the cost of the labor to determine the total cost of direct labor. The break out by quarter is shown in the following table. The manufacturing overhead budget identifies the expected variable and fixed overhead costs for the year or other period being budgeted.
The separation between fixed and variable costs is important because the Pickup Trucks Company uses a predetermined overhead rate for applying overhead to units produced. The variable expenses in the selling expenses budget are usually based on sales dollars.
The calculations for sales commissions and delivery expense, followed by the selling expenses budget, are shown in the following tables. The Pickup Trucks Company has no variable administrative expenses. Although funds for expenditures may be identified and approved in total during the budget process, most companies have a separate process for approving funds for the specific items included in a capital expenditures budget.
Many companies include long-term assets, such as joint ventures, purchases of other companies, and purchases or leases of fixed assets, as well as new products, new markets, research and development, significant marketing programs, and information technology items in their capital expenditures budgets. Cash Budget The cash budget is prepared after the operating budgets sales, manufacturing expenses or merchandise purchases, selling expenses, and general and administrative expenses and the capital expenditures budget are prepared.
The cash budget starts with the beginning cash balance to which is added the cash inflows to get cash available. Cash outflows for the period are then subtracted to calculate the cash balance before financing. The financing section also includes debt repayments, including interest payments. The cash balance before financing is adjusted by the financing activity to calculate the ending cash balance. The ending cash balance is the cash balance in the budgeted or pro forma balance sheet. In addition to the information in the budgets previously prepared, the following information is needed to complete the cash budget.
All other cash expenses are paid for in the quarter they are incurred. Income taxes for the current year are paid quarterly with the final payment being made in the first quarter of the following year. Assume all borrowings are made at the beginning of the quarter. B Depreciation expense is not a cost outlay and is not included in the cash budget for manufacturing overhead. The Pickup Trucks Company does not have any long-term liabilities.
See production budget and cost of goods sold calculation for further information. See direct materials budget and cash budget for units and costs. See cash payments for raw materials in cash budget and its calculation spread sheet. Difference between estimated taxes paid per cash budget for quarters two, three, and four and the expense per budgeted income statement. The company did not make a payment of its 20X1 taxes in quarter one of 20X0; the payment in the cash budget quarter one is for 20X0 taxes. Add more categories. Review This Product. Welcome to Loot. Checkout Your Cart Price.
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Accounting At Your Fingertips, 2e. George R. Murray, CPA.