Cost terms and concepts case study

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Basic Cost

Management Concepts

Chapter 2

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Chapter 2: Basic Cost Management Concepts

Learning Objective1

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Learning Objective 1. Explain what is meant by the word cost.

Process of Management

Decision Making

Directing Control

Planning Strategy Formulation

Managers need cost information to perform each of these functions.

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The process of management involves formulating strategy, planning, control, decision making and directing operational activities. Management accounting information helps managers perform each of these functions more effectively. (LO1)

What Do We Mean By a Cost?

A cost is the measure of resources given up to achieve a

particular purpose.

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At the most basic level, a cost may be defined as the sacrifice made, usually measured by the resources given up, to achieve a particular purpose. (LO1)

Learning Objective 2

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Learning Objective 2. Distinguish among product costs, period costs, and expenses.

Product Costs, Period Costs, and Expenses

Product costs are costs associated with goods for sale until the time period during which the products are sold, at which time the costs become expenses.

Period costs are costs that are expensed during the time period in which they are incurred.

Expenses are the consumption of assets for the purpose of generating revenue.

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A product cost is a cost assigned to goods that were either purchased or manufactured for resale. Another term for product cost is inventoriable cost, since a product cost is stored as the cost of inventory until the goods are sold. In the period of the sale, the product costs are recognized as an expense called cost of goods sold. Period costs are all costs that are not product costs. They are expensed in the period they are incurred. An expense is the cost incurred when an asset is used up or sold for the purpose of generating revenue. (LO2)

Learning Objective 3

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Learning Objective 3. Describe the role of costs in published financial statements.

Cost Classifications on Financial Statements – Income Statement

Product Costs

Cost of goods sold

Period Costs Operating expenses

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Product costs appear on the income statement as cost of goods sold in the period in which the products were sold. This is true for merchandising and manufacturing companies. Period costs appear on the income statement in the period in which they were incurred. Selling and administrative expenses are an example of period costs. (LO3)

Cost Classifications on Financial Statements – Balance Sheet Merchandiser Current Assets  Cash  Receivables  Prepaid Expenses  Merchandise Inventory

Manufacturer Current Assets

 Cash  Receivables  Prepaid Expenses  Inventories

Raw Materials Work in Process Finished Goods

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Since retailers, wholesalers, and manufacturers sell inventoriable products, their balance sheets are also affected by product costs. Merchandisers, such as Wal-Mart, list the product cost as merchandise inventories on the balance sheet in the current assets section. (LO3)

Cost Classifications on Financial Statements – Balance Sheet Merchandiser Current Assets  Cash  Receivables  Prepaid Expenses  Merchandise Inventory

Manufacturer Current Assets

 Cash  Receivables  Prepaid Expenses  Inventories

Raw Materials Work in Process Finished Goods

Those materials waiting to be processed.

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Manufacturers have three types of inventory. Raw-material inventory includes all materials before they are placed into production. (LO3)

Cost Classifications on Financial Statements – Balance Sheet Merchandiser Current Assets  Cash  Receivables  Prepaid Expenses  Merchandise Inventory

Manufacturer Current Assets

 Cash  Receivables  Prepaid Expenses  Inventories

Raw Materials Work in Process Finished Goods

Partially completed products – material to

which some labor and/or overhead has

been added.

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Work-in-process inventory refers to manufactured products that are only partially completed at the date when the balance sheet is prepared. (LO3)

Cost Classifications on Financial Statements – Balance Sheet Merchandiser Current Assets  Cash  Receivables  Prepaid Expenses  Merchandise Inventory

Manufacturer Current Assets

 Cash  Receivables  Prepaid Expenses  Inventories

Raw Materials Work in Process Finished Goods

Completed products awaiting sale.

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Finished-goods inventory refers to manufactured goods that are complete and ready for sale. The values of the work-in-process and finished-goods inventories are measured by their product costs. (LO3)

Learning Objective 4

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Learning Objective 4. List five types of manufacturing operations and describe mass customization.

Types of Production Processes Type of Production Description of Example of

Process Process Manufacturer

Job Shop Low volume Disney Little standardization

Unique products

Batch Multiple products Caterpillar Low volume

Assembly Line A few major products Ford Higher volume

Continuous Flow High volume Exxon Highly standardized commodity products

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Production processes can be classified into five generic types. The nature of the manufacturing process can affect the manufacturing costs incurred. The management team is in a better position to control these costs if the relationship of the production process to the types of costs incurred is understood. (LO4)

Learning Objective 5

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Learning Objective 5. Give examples of three types of manufacturing costs.

Manufacturing Costs

The Product

Direct Labor

Manufacturing Overhead

Direct Material

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Managerial accountants classify costs by the functional area of the organization to which costs relate. Some examples of functional areas are manufacturing, marketing, administration, and research and development. Manufacturing costs are further classified into the following three categories: direct material, direct labor, and manufacturing overhead. (LO5)

Direct Material

Example: Steel used to manufacture

the automobile.

Cost of raw material that is used to make, and can be conveniently traced, to the finished product.

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Raw material that is consumed in the manufacturing process, is physically incorporated in the finished product, and can be traced to products conveniently is called direct material. (LO5)

Cost of salaries, wages, and fringe

benefits for personnel who work directly on manufactured products.

Direct Labor

Example: Wages paid to an

automobile assembly worker.

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The cost of salaries, wages, and fringe benefits for personnel who work directly on the manufactured products is classified as direct-labor cost. (LO5)

Manufacturing Overhead All other manufacturing costs

Materials used to support the production process.

Examples: lubricants and cleaning supplies used in an automobile assembly plant.

Indirect Labor

Indirect Material

Other Costs

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All other costs of manufacturing are classified as manufacturing overhead, which includes three types of costs: indirect material, indirect labor, and other manufacturing costs. The cost of materials that are required for the production process but do not become an integral part of the finished product are classified as indirect material costs. Materials that do become an integral part of the finished product but are insignificant in cost are also often classified as indirect material. (LO5)

Manufacturing Overhead All other manufacturing costs

Cost of personnel who do not work directly on the product. Examples: maintenance workers, janitors, and security

guards.

Indirect Labor

Indirect Material

Other Costs

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The costs of personnel who do not work directly on the product, but whose services are necessary for the manufacturing process, are classified as indirect labor. (LO5)

Manufacturing Overhead All other manufacturing costs

Examples: depreciation on plant and equipment,

property taxes, insurance, utilities,

overtime premium, and unavoidable idle time.

Indirect Labor

Indirect Material

Other Costs

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All other manufacturing costs that are neither material nor labor costs are classified as manufacturing overhead. (LO5)

Classifications of Costs in Manufacturing Companies

Manufacturing costs are often combined as follows:

Prime Cost

Conversion Cost

Direct Material

Direct Labor

Manufacturing Overhead

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Direct material and direct labor are often referred to as prime costs. Direct labor and overhead are often called conversion costs, since they are the costs of “converting” raw material into finished products. (LO5)

Manufacturing Cost Flows

Manufacturing Overhead

Direct Material

Direct Labor Work in Process Inventory

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As direct material is consumed in production, its cost is added to work-in-process inventory. Similarly, the costs of direct labor and manufacturing overhead are accumulated in work in process. (LO5)

Manufacturing Cost Flows

Manufacturing Overhead

Direct Material

Direct Labor

Finished Goods

Inventory

Work in Process Inventory

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When products are finished, their costs are transferred from work-in-process inventory to finished-goods inventory. The total cost of direct material, direct labor, and manufacturing overhead transferred from work-in-process inventory to finished-goods inventory is called the cost of goods manufactured. (LO5)

Manufacturing Cost Flows

Manufacturing Overhead

Direct Material

Direct Labor

Finished Goods

Inventory

Cost of Goods Sold

Work in Process Inventory

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The costs then are stored in finished goods until the time period when the products are sold. At that time, the product costs are transferred from finished goods to cost of goods sold, which is an expense of the period when the sale is made. (LO5)

Learning Objective 6

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Learning Objective 6. Prepare a schedule of cost goods manufactured, a schedule of cost of goods sold, and an income statement for a manufacturer.

Comet Computer Corporation Schedule of Cost of Goods Manufactured

Raw material used 134,980$ Direct labor 50,000 Total manufacturing overhead 230,000 Total manufacturing costs 414,980$ Add: Work-in-process inventory, January 1 120 Subtotal 415,100$ Deduct: Work-in-process inventory, December 31 100 Cost of goods manufactured 415,000$

Schedule of Cost of Goods Manufactured

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Manufacturers generally prepare a schedule of cost of goods manufactured and a schedule of cost of goods sold to summarize the flow of manufacturing costs during an accounting period. Let’s take a look at the schedule of cost of goods manufactured for Comet Computer Corporation. (LO6)

Comet Computer Corporation Schedule of Cost of Goods Manufactured

Schedule of Cost of Goods Manufactured

Computation of Cost of Raw Material Used

Raw-material inventory, January 1 6,000$ Add: Purchases of raw materials 134,000 Raw material available for use 140,000 Deduct: Raw material inventory, December 31 5,020 Raw material used 134,980$

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Raw materials used in production is calculated by adding raw materials purchases for the period to the beginning raw materials inventory. This is the value of the raw materials that were available for use during the period. The raw materials at the end of the period is subtracted from raw materials available to arrive at the raw materials used in production during the period. (LO6)

Comet Computer Corporation Schedule of Cost of Goods Manufactured

Schedule of Cost of Goods Manufactured

Include all direct labor costs incurred during the

current period.

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All direct labor costs incurred during the period is added to raw materials used. (LO6)

Comet Computer Corporation Schedule of Cost of Goods Manufactured

Computation of Total Manufacturing Overhead

Indirect material 10,000$ Indirect labor 40,000 Depreciation on factory 90,000 Depreciation on equipment 70,000 Utilities 15,000 Insurance 5,000 Total manufacturing overhead 230,000$

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Costs incurred during the period that fall into the category of manufacturing overhead are totaled and then added to raw materials used and direct labor to arrive at total manufacturing costs. (LO6)

Comet Computer Corporation Schedule of Cost of Goods Manufactured

Schedule of Cost of Goods Manufactured

Beginning work-in- process inventory is carried over from the

prior period.

Ending work-in-process inventory contains the cost of unfinished goods, and is reported in the current assets section of the balance sheet.

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The value of the work-in-process inventory at the beginning of the period is added to the total manufacturing costs. The value of the ending work-in-process inventory is subtracted from the subtotal to arrive at cost of goods manufactured for the period. (LO6)

Income Statement for a Manufacturer

Comet Computer Corporation Income Statement

For the Year Ended December 31, 20X2 Sales revenue 700,000$ Less: Cost of goods sold 415,010 Gross margin 284,990$ Selling and administrative expenses 174,490 Income before taxes 110,500$ Income tax expense 30,000 Net income 80,500$

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Now let’s look at the income statement for Comet. Remember, cost of goods sold is the expense measured by the cost of the finished goods sold during a period of time. (LO6)

Comet Computer Corporation Income Statement

Comet Computer Corporation Schedule of Cost of Goods Sold

For the Year Ended December 31, 20X2

Finished-goods inventory, Jan. 1 200$ Add: Cost of goods manufactured 415,000 Cost of goods available for sale 415,200 Deduct Finished-goods inventory, Dec. 31 190 Cost of goods sold 415,010$

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The cost of goods sold amount can be obtained from the cost of goods sold schedule. This schedule starts with the finished goods inventory value at the beginning of the period. Cost of goods manufactured from the cost of goods manufactured schedule is added to arrive at cost of goods available for sale. The value of the finished goods inventory at the end of the period is deducted to determine the cost of goods sold amount for the period. (LO6)

Learning Objective7

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Learning Objective 7. Understand the importance of identifying an organization’s cost drivers.

Activities that cause costs to be incurred are called COST DRIVERS:

Cost Driver Examples Activity Cost Driver

Machining operations Machine hours Setup Setup hours Production scheduling Manufacturing orders Inspection Pieces inspected Purchasing Purchase orders Shop order handling Shop orders Valve assembly support Customer requisitions

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The phrase different costs for different purposes is often used to convey the notion that different characteristics of costs can be important to understand in a variety of managerial situations. One of the most important cost classifications involves the way a cost changes in relation to changes in the activity of the organization. Activity refers to a measure of the organization’s output of products or services. The activities that cause costs to be incurred are also called cost drivers. (LO7)

Learning Objective 8

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Learning Objective 8. Describe the behavior of variable and fixed costs, in total and on a per-unit basis.

Cost Classifications

Cost behavior means how a cost will react to changes in the level of business activity.  Total variable costs change

when activity changes.

 Total fixed costs remain unchanged when activity changes.

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After identifying costs and cost drivers, management should examine the relationship of various costs to the activities performed. Such a relationship is referred to as cost behavior. Costs are classified into two types of cost behavior: variable and fixed costs. A variable cost changes in total in direct proportion to a change in the level of activity (or cost driver). A fixed cost remains unchanged in total as the level of activity (or cost driver) varies. (LO8)

Total Variable Cost Example Your total cable pay-per-view bill is based on how many movies you

watch.

Pay-Per-View Movies Watched

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-P er

-V ie

B ill

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For example, assume your pay-per-view movie costs are classified as variable costs. If you watch zero movies, your pay-per-view movie cost will be zero. (LO8)

Variable Cost Per Unit Example The cost per movie watched is constant. For example, $4.00 per

movie.

Movies Watched

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The cost per movie is constant, regardless of the number of movies watched. (LO8)

Total Fixed Cost Example Your monthly cable bill probably does not change when you watch movies on channels that you have elected to be paid on a

monthly basis (HBO).

Number of HBO Movies Watched

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fo r

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Your monthly cable bill (in which you have elected to include HBO) is the same every month, regardless of the number of HBO movies that you watch. This is classified as a fixed cost. It does not change when activity changes. (LO8)

Fixed Cost Per Unit Example The average cost per HBO movie decreases as more HBO movies are

watched.

Number of HBO Movies Watched

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H B

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ov ie

at ch

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The cost of your HBO cable bill can be divided by the number of HBO movies watched to arrive at the average cost per HBO movie. The more HBO movies that you watch, the average cost per HBO movie decreases. (LO8)

Cost Classifications

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Total variable cost changes Variable cost per unit Variable as activity level changes. remains the same over

wide ranges of activity.

Total fixed cost remains Fixed cost per unit Fixed the same even when the goes down as activity

activity level changes. level goes up.

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In summary, the total variable cost changes as activity changes. But the cost per unit of variable costs stays the same, regardless of the level of activity. On the other hand, total fixed costs stay the same, regardless of the level of activity. The fixed cost per unit changes as the level of activity changes. (LO8)

Learning Objective 9

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Learning Objective 9. Distinguish among direct, indirect, controllable, and uncontrollable costs.

Direct and Indirect Costs Direct costs  Costs that can be

easily and conveniently traced to a product or department.

 Example: cost of paint in the paint department of an automobile assembly plant.

Indirect costs  Costs that must be allocated

in order to be assigned to a product or department.

 Example: cost of national advertising for an airline is indirect to a particular flight.

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An entity, such as a particular product, service, or department, to which a cost is assigned is called a cost object. A cost that can be traced to a particular cost object is called a direct cost of that cost object. A cost that is not directly traceable to a particular cost object is called an indirect cost of that cost object. Whether a cost is a direct cost or an indirect cost of a department often depends on which department is under consideration. A cost can be a direct cost of one department or subunit in the organization but an indirect cost of other departments. While the salary of a General Electric Company plant manager is an indirect cost of the plant’s departments, the manager’s salary is a direct cost of the plant. An important objective of a cost management system is to trace as many costs as possible directly to the activities that cause them to be incurred. Sometimes called activity accounting, this process is vital to management’s objective of eliminating non-value-added costs. These are costs of activities that can be eliminated without deterioration of product quality, performance, or perceived value. (LO9)

Controllable and Uncontrollable Costs

A cost that can be significantly influenced by a manager is a controllable cost.

Cost item Manager Classificaton Cost of food used Restaurant Controllable in a restaurant manager Cost of national Restaurant Uncontrollable advertising by a manager restaurant chain

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If a manager can control or heavily influence the level of a cost, then that cost is classified as a controllable cost of that manager. Costs that a manager cannot influence significantly are classified as uncontrollable costs of that manager. Many costs are not completely under the control of any individual. In classifying costs as controllable or uncontrollable, managerial accountants generally focus on a manager’s ability to influence costs. The question is not, Who controls the cost? but, Who is in the best position to influence the level of a cost item? (LO9)

Learning Objective10

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Learning Objective 10. Define and give examples of an opportunity cost, an out-of-pocket cost, a sunk cost, a differential cost, a marginal cost, and an average cost.

Opportunity Cost

The potential benefit that is given up when one alternative is selected over another.  Example: If you were

not attending college, you could be earning $30,000 per year. Your opportunity cost of attending college for one year is $30,000.

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An opportunity cost is defined as the benefit that is sacrificed when the choice of one action precludes taking an alternative course of action. (LO10)

Sunk Costs All costs incurred in the past that cannot be changed by any decision made now or in the future are sunk costs. Sunk costs should not be considered in decisions.

 Example: You bought an automobile that cost $22,000 two years ago. The $22,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $22,000 cost.

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Sunk costs are costs that have been incurred in the past. Consequently, they do not affect future costs and cannot be changed by any current or future action. (LO10)

Differential Costs Costs that differ between alternatives.

Example: You can earn $1,500 per month in your hometown or $2,000 per month in a nearby city.

Your commuting costs are $50 per month in your hometown and $300 per month to the city.

What is your differential cost? $300 - $50 = $250

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A differential cost is the amount by which the cost differs under two alternative actions. (LO10)

Marginal Costs and Average Costs

The extra cost incurred to produce one additional unit.

The total cost to produce a quantity

divided by the quantity produced.

Marginal and average costs are largely a function of cost behavior

-- variable and fixed costs.

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A special case of the differential-cost concept is the marginal cost, which is the extra cost incurred when one additional unit is produced. Marginal costs typically differ across different ranges of production quantities because the efficiency of the production process changes. (LO10)

Costs and Benefits of Information

Costs Benefits

More information does not mean more benefits if information overload results.

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Another important task of the managerial accountant is to weigh the benefits of providing information against the costs of generating, communicating, and using that information. When managers receive more data than they can utilize effectively, information overload occurs. In deciding how much and what type of information to provide, managerial accountants should consider these human limitations. (LO10)

End of Chapter 2

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Chapter 2
Learning Objective1
Process of Management
What Do We Mean By a Cost?
Learning Objective 2
Product Costs, Period Costs, and Expenses
Learning Objective 3
Cost Classifications on Financial Statements – Income Statement
Cost Classifications on Financial Statements – Balance Sheet
Cost Classifications on Financial Statements – Balance Sheet
Cost Classifications on Financial Statements – Balance Sheet
Cost Classifications on Financial Statements – Balance Sheet
Learning Objective 4
Types of Production Processes
Learning Objective 5
Manufacturing Costs
Direct Material
Direct Labor
Manufacturing Overhead
Manufacturing Overhead
Manufacturing Overhead
Classifications of Costs in Manufacturing Companies
Manufacturing Cost Flows
Manufacturing Cost Flows
Manufacturing Cost Flows
Learning Objective 6
Schedule of Cost of Goods Manufactured
Schedule of Cost of Goods Manufactured
Schedule of Cost of Goods Manufactured
Slide Number 30
Schedule of Cost of Goods Manufactured
Income Statement for a Manufacturer
Slide Number 33
Learning Objective7
Activities that cause costs to be incurred are called COST DRIVERS:
Learning Objective 8
Cost Classifications
Total Variable Cost Example
Variable Cost Per Unit Example
Total Fixed Cost Example
Fixed Cost Per Unit Example
Cost Classifications
Learning Objective 9
Direct and Indirect Costs
Controllable and�Uncontrollable Costs
Learning Objective10
Opportunity Cost
Sunk Costs
Differential Costs
Marginal Costs and Average Costs
Costs and Benefits of Information
End of Chapter 2