Chap 3

BlocherStoutCokinsChen: Cost Management: A Strategic Emphasis, Fourth Edition
I. Introduction to Cost Management
3. Basic Cost Management Concepts
The McGrawHill Companies, 2008
C H A P T E R
T H R E E
INTRODUCTION TO COST MANAGEMENT
Basic Cost Management Concepts

After studying this chapter, you should be able to . . .
1. Understand the strategic role of basic cost management concepts 2. Explain the cost driver concepts at the activity, volume, structural, and executional levels 3. Explain the cost concepts used in product and service costing 4. Demonstrate how costs ow through the accounts 5. Prepare an income statement for both a manufacturing rm and a merchandising rm 6. Explain the cost concepts related to the use of cost information in planning and decision making 7. Explain the cost concepts related to the use of cost information for management and operational control
PART I
LEARNING OBJECTIVE 1
Understand the strategic role of basic cost management concepts.
As we will see in this chapter, irrespective of their competitive strategy, successful rms nd that they need to apply cost management effectively and, in doing so, to understand the key concepts and terms of cost management. We begin with an example rm that illustrates the importance of understanding the complexity of a rms operationsthe number and diversity of its products, production processes and locations, distribution networks, types of customers, and so on. Complexity on any of these dimensions will have consequences for costs, and the management accountant has developed the necessary vocabulary to identify and describe these effects. A good example of a rm that deals effectively with complexity is Proctor & Gamble (P&G), one of the worlds leading consumer products companies, maker of such well-known products as Tide detergent and Crest toothpaste. P&G has achieved success through product excellence and continuous improvement. One key area of continuous improvement is the rms emphasis on cost reduction through product and process simplication. To accomplish this, P&G uses a concept that we study in this chapter: the inuence of product and process complexity on overall costs. In the early 1990s, P&G had as many as 50 different varieties of some of its brands, including different size containers, avors, and so on. In addition to variety, the number of trade promotions, discounts, rebates, and coupons that affected P&Gs net price were complex. The high complexity in products and pricing increased manufacturing costs, inventory holding costs, selling and distribution costs, customer service costs, administrative and accounting costs, and other operating costs. Over a period of ve years, P&G reduced its product variety by one-half, and its prots surged. At the same time, P&G improved its supply chainthe process of managing its suppliersto reduce supply chain cost and to improve product quality and product innovation. The importance of product simplication to P&G is also reected by its recent strategic decision not to complete a merger with the drug makers American Home Products Corp. and Warner-Lambert Co. At rst glance, the marriage of these three powerful rms might seem to offer a good way to achieve market dominance and economies of scale. On second thought, however, would P&Gs capabilities in developing and marketing consumer brands such as Tide detergent be a competitive advantage in developing and marketing drugs? The technologies and expertise from product development to product marketing and distribution are quite different. Moreover, P&G has established an enviable reputation as a consumer-goods company, but it does not have a reputation as a health-focused company (as, for example, does Johnson
Chapter 3
Basic Cost Management Concepts 55
& Johnson). The rm is not likely to maintain a dual image. In fact, a successful strategy normally requires a single focused image in the marketplace, and the merger would dilute and confuse P&Gs already excellent reputation as a consumer-products company. Again, simplicity and clarity of strategy produce winners. This chapter explains the strategic role of the key cost concepts used throughout the text. Of the four groups of key concepts, the rst group consists of the basic concepts and relationships among cost objects and cost drivers (e.g., complexity as a cost driver and P&Gs products as the cost objects). Each of the remaining three groups includes concepts related to the three management functions: product and service costing, planning and decision making, and management and operational control. The concepts related to strategic management are covered in Chapters 1 and 2.
Cost Drivers, Cost Pools, and Cost Objects

Explain the cost driver concepts at the activity, volume, structural, and executional levels.
A cost is incurred when a resource is used for some purpose. Cost pools are the meaningful groups into which costs are often collected. A cost driver is any factor that causes a change in the cost of an activity.
A cost object is any product, service, customer, activity, or organizational unit to which costs are assigned for some management purpose.
A critical rst step in achieving a competitive advantage is to identify the key costs and cost drivers in the rm or organization. A rm incurs a cost when it uses a resource for some purpose. For example, a company producing kitchen appliances has costs of materials (such as sheet metal and bolts for the enclosure), costs of manufacturing labor, and other costs. Often costs are assigned into meaningful groups called cost pools. Individual costs can be grouped in many different ways, and therefore a cost pool can be dened in many different ways, including by type of cost (labor costs in one pool, material costs in another), by source (department 1, department 2, and so on), or by responsibility (manager 1, manager 2, and so on). For example, an assembly department or a product engineering department might be treated as a cost pool. A cost driver is any factor that has the effect of changing the level of total cost. For a rm that competes on the basis of cost leadership, management of the key cost drivers is essential. For example, to achieve its low-cost leadership in manufacturing, P&G carefully watches the design and manufacturing factors that drive the costs of its products. It makes design improvements when necessary, and the manufacturing plants are designed and automated for the highest efciency in using materials, labor, and equipment. For rms that are not cost leaders, the management of cost drivers may not be so critical, but attention to the key cost drivers contributes directly to the rms success. For example, because an important cost driver for retailers is loss and damage to merchandise, most of them establish careful procedures for handling, displaying, and storing their merchandise. A cost object is any product, service, customer, activity, or organizational unit to which costs are assigned for some management purpose. Products, services, and customers are generally cost objects; manufacturing departments are considered either cost pools or cost objects, depending on whether managements main focus is on the costs for the products or for the manufacturing departments. The concept of cost objects is a broad concept. It also includes groups of products, services, departments, and customers; suppliers; telephone service providers; and so on. Any item to which costs can be traced and that has a key role in management strategy can be considered a cost object.
Cost Assignment and Cost Allocation: Direct and Indirect Costs

Cost assignment is the process of assigning costs to cost pools or from cost pools to cost objects. A direct cost can be conveniently and economically traced directly to a cost pool or a cost object.
Cost assignment is the process of assigning costs to cost pools or from cost pools to cost objects. A direct cost can be conveniently and economically traced directly to a cost pool or a cost object. For example, the cost of materials required for a particular product is a direct cost because it can be traced directly to the product.1 The materials cost is accumulated in cost pools (manufacturing departments) and then is traced to each product manufactured, which is the cost object. Similarly, an airlines cost of preparing a passengers meal is a direct cost that can be traced to each passenger (the cost object). For a direct cost, the cost driver is the number of units of that object, for example, the number of cartons of Tide produced by P&G, or the number of passengers on Flight 617 for
1
We use the expression traced directly to the product to mean that it is economically feasible to identify a direct relationship between the cost and the product, as for example, each dishwasher requires a motor, which can be directly traced to that dishwasher.
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Part One
Introduction to Cost Management
An indirect cost has no convenient or economical trace from the cost to the cost pool or from the cost pool to the cost object.
Cost allocation is the assignment of indirect costs to cost pools and cost objects. Allocation bases are the cost drivers used to allocate costs.
Delta Airlines. Total direct cost increases directly in proportion to the number of cartons or passengers. In contrast, there is no convenient or economical way to trace an indirect cost from the cost to the cost pool or from the cost pool to the cost object. The cost of supervising manufacturing employees and the cost of handling materials are good examples of costs that generally cannot be traced to individual products and therefore are considered indirect costs. Similarly, the cost of fueling an aircraft is an indirect cost when the cost object is the individual airline customer since the aircrafts use of fuel cannot be traced directly to that customer. In contrast, if the cost object for the airline is the ight, the cost of fuel is a direct cost that can be traced directly to the aircrafts use of fuel for that ight. Since indirect costs cannot be traced to the cost pool or cost object, the assignment for indirect costs is made by using cost drivers. For example, if the cost driver for materials handling cost is the number of parts, the total cost of materials handling can be assigned to each product on the basis of its total number of parts relative to the total number of parts in all other products. The result is that costs are assigned to the cost pool or cost object that caused the cost in a manner that is fairly representative of the way the cost is incurred. For example, a product with a large number of parts should bear a larger portion of the cost of materials handling than a product with fewer parts. Similarly, a department with a large number of employees should bear a large portion of the cost of supervision provided for all departments. The assignment of indirect costs to cost pools and cost objects is called cost allocation, a form of cost assignment in which direct tracing is not economically feasible, so cost drivers are used instead. The cost drivers used to allocate costs are often called allocation bases. The relationships between costs, cost pools, cost objects, and cost drivers in appliance manufacturing are illustrated in Exhibit 3.1 and Exhibit 3.2. This simplied example includes two cost objects (dishwasher, washing machine), two cost pools (assembly department, packing department), and ve cost elements (electric motor, materials handling, supervision, packing material, and nal product inspection). The electric motor is traced to the assembly department and from there directly to the two products, assuming for simplicity that the same motor is used in both appliances. Similarly, the packing material is traced directly to the packing department and from there directly to the two products. The cost of nal inspection is traced directly to each of the two products. The two indirect costs, supervision and materials handling, are allocated to the two cost pools (assembly and packing departments) and are then allocated from the cost pools to the products (the allocation bases are shown in Exhibit 3.2). Exhibit 3.2 illustrates the differences between direct and indirect costs and the different types of cost drivers for each. The direct costsmotor, packing material, and nal inspectionsince they are direct and traceable, are traced directly to the nal cost objects, the dishwasher and washing machine. For direct costs, the cost driver is each product produced. In contrast, the indirect costs cannot be traced directly to the products and instead are allocated to the products using an averaging process, based on an allocation base. The details of the allocation of indirect costs are not explained here but are covered in Chapters 4 and 5.
EXHIBIT 3.1
Relationships between Costs, Cost Pools, and Cost Objects, in Appliance Manufacturing
Costs
Cost pools
Cost objects
Electric motor Assembly Materials handling Supervision Packing Packing material Washing machine Final inspection Dishwasher
Chapter 3
EXHIBIT 3.2
Selected Examples of Costs, Cost Pools, Cost Objects, and Cost Drivers in Appliance Manufacturing
The Flow of Cost Assignment

Cost Cost Driver Cost Pool Direct Costs Electric motor Packing material Final inspection Direct trace Direct trace Direct trace Assembly department Packing department Not applicable Indirect Costs Supervision Allocation base: Number of employees in the department Allocation base: Number of parts in the product Assembly and packing departments Assembly and packing departments Allocation base: Direct labor-hours for each product Allocation base: Number of parts in the product Dishwasher and washing machine Dishwasher and washing machine Direct trace Direct trace Not applicable Dishwasher and washing machine Dishwasher and washing machine Dishwasher and washing machine Cost Driver Cost Object
Materials handling
Direct and Indirect Materials Costs

Direct materials cost includes the cost of the materials in the product and a reasonable allowance for scrap and defective units. Indirect materials cost refers to the cost of materials used in manufacturing that are not physically part of the nished product. Direct labor cost includes the labor used to manufacture the product or to provide the service. Indirect labor cost includes supervision, quality control, inspection, purchasing and receiving, and other manufacturing support costs.
Direct materials cost includes the cost of materials in the product or other cost object (less purchase discounts but including freight and related charges) and usually a reasonable allowance for scrap and defective units (e.g., if a part is stamped from strip steel, the material lost in the stamping is ordinarily included as part of the products direct materials). On the other hand, the cost of materials used in manufacturing that are not part of the nished product is indirect materials cost. Examples include supplies used by manufacturing employees, such as rags and small tools, or materials required by the machines, such as lubricant.2
Direct and Indirect Labor Costs

Direct labor cost includes the labor used to manufacture the product or to provide the service plus some portion of nonproductive time that is normal and unavoidable, such as coffee breaks and personal time. Other types of nonproductive labor that are discretionary and planned, such as downtime, payroll taxes, fringe benets (pension, vacation, etc.) training, and setup time, usually are included not as direct labor but as indirect labor. Indirect labor costs provide a support role for manufacturing. Examples of indirect labor costs include supervision, quality control, inspection, purchasing and receiving, materials handling, janitorial labor, downtime, training, and cleanup. Note that an element of labor can sometimes be both direct and indirect, depending on the cost object; for example, labor for the maintenance and repair of equipment might be direct to the manufacturing department where the equipment is located but indirect to the products manufactured in that department. Although these examples of direct and indirect costs are from a manufacturing setting, the concepts also apply to service companies. For example, in a restaurant where the cost object is each meal served, the food and food preparation costs are direct costs, but the costs of purchasing, handling, and storing food items are indirect costs. Similarly, in professional services rms such as law rms or accounting rms, the professional labor and materials costs for providing client service are direct costs, but the costs of research materials, nonprofessional support staff, and training professional staff are indirect costs.
Other Indirect Costs

In addition to labor and materials, other types of indirect costs are necessary to manufacture the product or provide the service. They include the costs of facilities, the equipment used to
2
For convenience and economic feasibility, direct materials that are a very small part of materials cost, such as glue and nails, are sometimes not traced to each product but are included instead in indirect materials.
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Part One
All indirect costs are commonly combined into a single cost pool called overhead or, in a manufacturing rm, factory overhead. Prime costs refer to direct materials and direct labor that are combined into a single amount. Conversion cost refers to direct labor and overhead combined into a single amount.
manufacture the product or provide the service, and any other support equipment, such as that used for materials handling. All indirect costsfor indirect materials, indirect labor, and other indirect itemsare commonly combined into a cost pool called overhead. In a manufacturing rm, it is called factory overhead. The three types of costsdirect materials, direct labor, and overheadare sometimes combined for simplicity and convenience. Direct materials and direct labor are sometimes considered together and called prime costs. Similarly, direct labor and overhead are often combined into a single amount called conversion cost. The labor component of total manufacturing costs for many rms that have highly automated operations is relatively low, and these rms often choose to place their strategic focus on materials and facilities/overhead costs by combining labor costs with overhead.
Cost Drivers and Cost Behavior

Cost drivers provide two important roles for the management accountant: (1) enabling the assignment of costs to cost objects, as we saw in the above discussion and in Exhibits 3.1 and 3.2, and (2) explaining cost behavior, how total costs change as the cost driver changes. Generally, the increase in a cost driver will cause an increase in total cost. Occasionally, the relationship is inverse; for example, assume the cost driver is temperature, then in the colder times of the year, increases in this cost driver will decrease total heating cost. Cost drivers can be used to provide both the cost assignment and cost behavior roles at the same time. In the remainder of this section, we focus on the cost behavior role of cost drivers. Most rms, especially those following the cost leadership strategy, use cost management to maintain or improve their competitive position. Cost management requires a good understanding of how the total cost of a cost object changes as the cost drivers change. The four types of cost drivers are activity-based, volume-based, structural, and executional. Activity-based cost drivers are developed at a detailed level of operations and are associated with a given manufacturing activity (or activity in providing a service), such as machine setup, product inspection, materials handling, or packaging. In contrast, volume-based cost drivers are developed at an aggregate level, such as an output level for the number of units produced or the number of direct labor-hours used in manufacturing. Structural and executional cost drivers involve strategic and operational decisions that affect the relationship between these cost drivers and total cost. An example of cost drivers at Pennsylvania Blue Shield is shown in Exhibit 3.3.
Activity-Based Cost Drivers

Activity-based cost drivers are identied by using activity analysisa detailed description of the specic activities performed in the rms operations. The description includes each step in manufacturing the product or in providing the service. For each activity, a cost driver is determined to explain how the costs incurred for that activity change. Example activities and cost drivers for a bank are illustrated in Exhibit 3.4. The total cost to the bank is affected by changes in the cost drivers for each activity. The detailed description of the rms activities helps the rm achieve its strategic objectives by enabling it to develop more accurate costs for its products and/or services. The activity analysis also helps improve operational and management control in the rm since performance at the detailed level can be monitored and evaluated, for example, by (1) identifying which EXHIBIT 3.3
Costs, Cost Pools, Cost Objects, and Cost Drivers at Pennsylvania Blue Shield
Costs
1st-Stage Cost Drivers
Activity Cost Pools
2nd-Stage Cost Drivers
Product Costs
Personnel Facilities & occupancy Data processing Supplies & forms Postage
Number of people Square footage Hours worked Resource usage
Claims processing Beneficiary services Financial services
Volume of output Hours
Podiatry Medical-Surgical Dental Medical-Special Emergency Medicine Radiology Other
Chapter 3
EXHIBIT 3.4
Bank Activities and Cost Drivers
Activity Provide ATM service Provide cashier service Open and close customer accounts Advise customers on banking services Prepare applications for new loans Process loan applications Prepare approved loans and disburse funds Mail customer statements
Cost Drivers Number of ATM transactions; number of customers Number of customers Number of accounts opened or closed Number of customers Number of loan applications prepared Number of loan applications processed Number of loans approved Number of accounts by customer type and size
activities are contributing value to the customer and which are not and (2) focusing attention on those activities that are most costly or that differ from expectations. Activity-based costing and activity-based management are explained in Chapter 5.
Volume-Based Cost Drivers

Many types of costs are volume-based, that is, the cost driver is the amount produced or quantity of service provided. Management accountants commonly call this volume, or volume of output, or simply output. Good examples of volume-based costs are direct materials cost and direct labor costthese costs increase with each unit of the volume of output. Note that the three cost driversthe output of complete units, the quantity (in pounds, etc.) of direct materials, and the hours of direct laborare all volume-based cost drivers and are proportional to each other. The total of a volume-based cost increases at the rate of increase in volume, and over short ranges of output, the relationship is approximately linear. Over a very broad range of output, say, from output of zero up to plant capacity and beyond, the relationship between volume of output and cost tends to be nonlinear. As illustrated in Exhibit 3.5, at low values for the cost driver, costs increase at a decreasing rate, due in part to factors such as more efcient use of resources and higher productivity through learning. The pattern of increasing costs at a decreasing rate is often referred to as increasing marginal productivity, which means that the inputs are used more productively or more efciently as manufacturing output increases. At higher levels of the cost driver, costs begin to increase at an increasing rate, due in part to inefciency associated with operating nearer the limit of capacity; the less efcient resources are now being used, overtime may be required, and so on. This cost behavior in the higher levels of the cost driver is said to satisfy the law of diminishing marginal productivity. The nonlinear cost relationships depicted in Exhibit 3.5 present some difculties in estimating costs and in calculating total costs since linear, algebraic relationships cannot be used. Fortunately, we are often interested in only a relatively small range of activity for the cost driver. For example, we might know in a certain instance that the volume-based cost driver will fall somewhere between 3,500 and 3,600 units of product output. We observe that within this range, the total cost curve is approximately linear. The range of the cost driver in which the actual value of the cost driver is expected to fall and for which the relationship to total cost is assumed to be approximately linear is called the relevant range.
The relevant range is the range of the cost driver in which the actual value of the cost driver is expected to fall and for which the relationship to total cost is assumed to be approximately linear.
EXHIBIT 3.5
Total Cost over a Wide Range of Output
Total Cost Capacity Limit
Volume of Output
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Part One
EXHIBIT 3.6 Total Cost and the Relevant

Range
Relevant range (3,500 to 3,600 units)
EXHIBIT 3.7 Linear Approximation for Actual Cost

Behavior, within the Relevant Range
Relevant range
Total Cost
Total Cost
Total cost line
Linear approximation of actual cost behavior
3,500 3,600 Volume of Output
3,500 3,600 Volume of Output
This simplication process is illustrated in Exhibit 3.6 and Exhibit 3.7. Exhibit 3.6 shows the curved actual total cost line and the relevant range of 3,500 to 3,600 units; Exhibit 3.7 shows the linear approximation of actual total cost; within the relevant range, the behavior of total cost approximates that shown in Exhibit 3.6. Note that the cost line above 3,600 and below 3,500 in Exhibit 3.7 is a dotted line to indicate that this portion of the line is not used to approximate total cost because it is outside the relevant range. Chapter 6 shows the process management accountants use for estimating the cost curves shown in these exhibits.
Fixed and Variable Costs

Variable cost is the change in total cost associated with each change in the quantity of the cost driver. Fixed cost is the portion of the total cost that does not change with a change in the quantity of the cost driver within the relevant range.
Mixed cost is the term used to refer to total cost when total cost includes both variable and xed cost components.
Total cost is made up of variable costs and xed costs. Variable cost is the change in total cost associated with each change in the quantity of the cost driver. The cost driver can be activitybased or volume-based, though typically management accountants in practice use the term variable costs in connection with volume-based cost drivers. Common examples of variable costs are costs of direct materials and direct labor. In contrast, xed cost is that portion of the total cost that does not change with output within the relevant range. Total xed costs and unit variable costs are expected to remain approximately constant within the relevant range. Fixed cost is illustrated as the horizontal dashed line at $3,000 in Exhibit 3.8. Variable cost is $1 per unit, total cost is the upward-sloping line, and total variable cost is the difference between total cost and xed cost. Total cost of $6,500 at 3,500 units is made up of xed cost ($3,000) plus total variable cost (3,500 $1 = $3,500); similarly, total cost at 3,600 units is $6,600 ($3,000 xed cost plus 3,600 $1 = $3,600 variable cost). Fixed costs include many indirect costs, especially facility costs (depreciation or rent, insurance, taxes on the plant building, and so on), production supervisors salaries, and other manufacturing support costs that do not change with the number of units produced. However, some indirect costs are variable since they change with the number of units produced. An example is lubricant for machines. The term mixed cost is used to refer to total cost that includes costs for both variable and xed components as illustrated. The determination of whether a cost is variable depends on the nature of the cost object. In manufacturing rms, the cost object is typically the product. In service rms, however, the cost object is often difcult to dene because the service can have a number of qualitative as well as quantitative dimensions. Lets develop cost objects for one type of service rm, a hospital, which could use a number of measures of output including the number of patients served, the number successfully treated, and so on. However, a common approach in hospitals is to use the number of patient-days since this measure most closely matches the way the hospital incurs costs. It has sometimes been said that all costs are variable in the long run; that is, with enough time, any cost can be changed. While it is true that many xed costs do change over time (for example, the cost of rent might increase from year to year), that does not mean these costs are variable. A variable cost is a cost for which total costs change with changes in the volume of output. Fixed costs are dened for a period of time rather than in relationship to volume of
Chapter 3
EXHIBIT 3.8 Total Cost, Total Variable Cost, and Fixed Cost
EXHIBIT 3.9 A Step Cost
Total Cost
$6,600 6,500 3,000
Total variable cost
Fixed cost 3,500 3,600 Volume of Output 100 200 300 400 500 600 700 Output (number of orders filled)
output, and it is assumed that xed costs will not change during this period of time which is usually taken to be a year. For example, rent is a xed cost that is normally the same amount per year and does not vary with volume. To summarize, when we want to understand the cost behavior of a certain cost object (for example, in order to predict total cost), we have to have clearly in mind the following three questions: (1) what is the cost driver (or cost drivers if there are two or more) for this cost object; (2) what is the relevant range of the cost driver for which we are developing the cost estimate; and (3) what time horizon are we using for xed costs (usually one year is used)?
Step Costs
A cost is said to be a step cost when it varies with the cost driver but in steps.
A cost is said to be a step cost when it varies with the cost driver but does so in steps (Exhibit 3.9). Step costs are characteristic of certain clerical tasks, such as order lling and claims processing. For example, if a warehouse clerk can ll 100 orders in a day, 10 clerks will be needed to process approximately 1,000 orders; as demand exceeds 1,000 orders, an eleventh clerk must be added. The steps correspond to specic levels of the cost driver for which an additional clerk is required; in effect, each step corresponds to one additional clerk. The steps will be relatively narrow if clerks are added for relatively small increases in the cost driver; the steps will be wider for large increases.
Unit Cost and Marginal Cost

Unit cost (or average cost) is the total manufacturing cost (materials, labor, and overhead) divided by units of output.
Marginal cost is the additional cost incurred as the cost driver increases by one unit.
Unit cost (or average cost) is the total manufacturing costs (materials, labor, and overhead) divided by the number of units of output. It is a useful concept in setting prices and in evaluating product protability, but it can be subject to some misleading interpretations. To properly interpret unit cost, we must distinguish unit variable costs, which do not change as output changes, from unit xed costs, which do change as output changes. See Exhibit 3.10. For example, a drivers cost per mile is likely lower for a person who drives a car for 20,000 miles/ year than it is for a person who drives a car for only 5,000 miles/year because the xed costs are spread over more miles. These relationships are illustrated graphically in Exhibit 3.11. The management accountant is careful in using the terms average cost and unit cost because of the potential for misleading interpretations. The term marginal cost is used to describe the additional cost incurred as the cost driver increases by one unit. Under the assumption of linear cost within the relevant range, the concept of marginal cost is equivalent to the concept of unit variable cost.
EXHIBIT 3.10
Illustration of Total Fixed Cost and Variable Cost per Unit Units of output Per unit Total 10,000 $ 10 100,000
Fixed Cost 20,000 $ 5 100,000
Total Cost
Total cost
Variable Cost 10,000 $ 8 80,000 $ 20,000 8 160,000
REAL-WORLD FOCUS
Is It Fixed or Variable: Lincoln Electric and TV Celebrities

TV CELEBRITY PAY BASED ON COST-PER-VIEWER?
TV celebrities such as David Letterman, Conan OBrien, and Paula Zahn negotiate for multimillion dollar salaries based on their viewer drawing ability. These salaries are of course xed in amount. While Letterman is the clear leader with $16 million per year, to OBriens $8 million, and Zahns $2 million, they all have approximately the same amount of pay per viewer. The cost per viewer is $3.68, $3.14, and $3.70 for Letterman, OBrien, and Zahn, respectively. Are these salaries xed or variable? It would appear that the number of viewers is a key driver in the salary negotiations each year for these celebrities. From this perspective, these salaries might be viewed as variable costs. If the networks advertising revenues are also based on number of viewers, then treating celebrities this way makes sense. It also might be used to explain why certain celebrities have higher or lower per-viewer rates, due presumably to different revenue rates for the shows; advertisers might be willing to pay more for a certain type of viewer.
Source: Clare Ansberry, In the Workplace, Jobs Morph to Suit Rapid Pace
of Change, The Wall Street Journal, March 22, 2002, p. 1; Lisa De Moraes, Conan the Cost: NBCs Thrifty Numbers Game, The Washington Post, February 8, 2002, p. C7.
CROSS-TRAINING AT LINCOLN ELECTRIC COMPANY

To retain skilled employees instead of letting them go when demand falls, Lincoln Electric trains employees for other tasks in the company. The Cleveland-based manufacturer of welding and cutting parts has integrated the approach in all its operations, so that it can guarantee employment for all employees who have been with the company for three or more years. This policy has worked for 60 years! The effect of the policy on cost is that labor expense, while xed in total expenditure, is in reality a variable expense. Labor is exible and can be moved from job to job or plant to plant as demand dictates; that is, labor cost at the plant level uctuates with demand at each plant, while total labor cost at the rm stays xed. Other companies such as Nestle and Apex Precision Technology accomplish the same goal of keeping their employees as demand uctuates by using part-time arrangements with the employees. Thus, instead of incurring a xed cost for labor, the companys total labor costs are exible and vary with demand, as part-time labor is added when needed.
EXHIBIT 3.11
Average Variable Cost per Unit and Average Fixed Cost per Unit
Average Cost Average Fixed Cost per Unit
10
Average Variable Cost per Unit
10,000
20,000 Volume of Output
Capacity vs. Usage of Costs

It is important to distinguish between costs that provide capacity for operations (e.g., plant building and equipment) and costs that are consumed during operations (e.g., direct materials and labor). The former are xed costs, while the latter are variable costs. In practice, the management accountant uses care in making the distinctions because sometimes capacity-type costs are treated as variable costs. For example, compare the cost of two types of direct labor employees who work in the assembly of a product: one is a salaried worker who is paid by the month and another a worker paid by the hour. The former is a capacity (xed) cost, while the latter is a variable cost. While both workers might be considered direct labor because they work in product assembly, if volume of output falls and the salaried worker is idle, the total cost of labor does not change, while the total cost of labor would fall for a wage worker who has fewer hours. On the other hand, effective managers try to schedule production and labor carefully by using part-time help and by other means, so that no workers are idle; then, all assembly work can be considered a direct and variable cost. When idle time is present, some management accountants measure the cost of the unused capacity. Note that the cost of unused capacity would potentially apply to many types of xed costs.
Chapter 3
Structural and Executional Cost Drivers

Structural cost drivers are strategic in nature and involve plans and decisions that have a long-term effect with regard to issues such as scale, experience, technology, and complexity.
Structural and executional cost drivers are used to facilitate strategic and operational decision making. Structural cost drivers are strategic in nature because they involve plans and decisions that have long-term effects. Issues such as the following should be considered: 1. Scale. How much should be invested? How large should the rm become? Larger rms have lower overall costs as a result of economies of scale. For example, a retail rm such as Wal-Mart or Target must determine how many new stores to open in a given year to achieve its strategic objectives and compete effectively as a retailer. 2. Experience. How much prior experience does the rm have in its current and planned products and services? The more experience, the lower the development, manufacturing, and distribution costs are likely to be. For example, a manufacturer such as Hewlett-Packard uses existing manufacturing methods as much as possible for new products to reduce the time and cost necessary for workers to become procient at manufacturing the new product. Additionally, health-care management rms such as Hospital Corporation of America (HCA) use their knowledge of experience-related cost drivers to reduce the time and cost necessary to improve the protability of newly acquired hospitals. 3. Technology. What process technologies are used in designing, manufacturing, and distributing the product or service? New technologies can reduce these costs signicantly. For example, manufacturers such as Procter & Gamble use computer technology to monitor the quantities of its products that its customers (typically, large retailers) have on hand so that it can promptly restock these products as needed. Technological innovation at Intel has lowered the cost of computing dramatically by improving the capability of microprocessors used in personal computers. While the capability of the microprocessors has increased exponentially, their manufacturing costs per unit have not changed signicantly. This example of Moores law describes the costs of digital technology falling (by one-half) every 18 to 24 months. 4. Complexity. What is the rms level of complexity? How many different products does the rm have? As noted in the opening discussion of Procter & Gamble, rms with many products have higher costs of scheduling and managing the production process, as well as the upstream costs of product development and the downstream costs of distribution and service. These rms often use activity-based costing to better identify the costs and therefore the profitability of their different products, suppliers, and customers. Strategic analyses using structural cost drivers help the rm improve its competitive position. These analyses include value-chain analysis and activity-based management. Valuechain analysis can help the rm assess the long-term consequences of its current or planned commitment to a structural cost driver. For example, the growth in size and capability of parts manufacturers for automakers should cause the automakers to reassess whether they should outsource the manufacture of certain parts. Executional cost drivers are factors the rm can manage in short-term, operational decision making to reduce costs. They include the following: 1. Workforce involvement. Are the employees dedicated to continual improvement and quality? This workforce commitment will lower costs. Firms with strong employee relationships, such as Federal Express, can reduce operating costs signicantly. 2. Design of the production process. Can the layout of equipment and processes and the scheduling of production be improved? Speeding up the ow of product through the rm can reduce costs. Innovators in manufacturing technology, such as Motorola and Allen-Bradley, can reduce manufacturing costs signicantly. 3. Supplier relationships. Can the cost, quality, or delivery of materials and purchased parts be improved to reduce overall costs? Wal-Mart and Toyota, among other rms, maintain a low-cost advantage partially by agreements with their suppliers that they will provide products or parts that meet the companies explicit requirements as to their quality, timeliness of delivery, and other features. Plant managers study executional cost drivers to nd ways to reduce costs. Such studies are done as a part of operational control, which is covered in Part Four.
Executional cost drivers are factors the rm can manage in the short term to reduce costs, such as workforce involvement, design of the production process, and supplier relationships.
Cost Management in Action

The following data is provided by the U.S. Department of Agriculture (USDA) regarding the cost of soybean production in the U.S. Heartland (Minnesota, Iowa, South Dakota, Indiana, and Illinois and parts of Ohio,
Cost Per Bushel of Soybeans: U.S. and Brazil

Missouri, Nebraska, and Kentucky) and the Mato Grosso region in western Brazil. The data is used to analyze the cost competitiveness of soybean production in the United States and Brazil.
Cost per Acre and per Bushel of Soybeans U.S. Heartland Variable costs (per acre) Seed Fertilizers Chemicals Machinery Labor Other Total variable costs Fixed costs (per acre) Equipment depreciation Land costs (rental rate) Taxes, insurance Farm overhead Total xed costs Total production cost (per acre) Total cost per bushel Average yield per acre Variable costs Fixed costs Total costs per bushel Required:
1. What can you learn from the information above about the cost competitiveness of the U.S. and Brazil in soybean production? 2. Critically evaluate the cost information.
Brazils Mato Grosso $ 11.23 44.95 39.97 18.22 5.58 12.11 $132.06 $ 8.97 5.84 .55 14.65 $ 30.01 $162.07 41.65 $ 3.17 .72 $ 3.89
$ 19.77 8.22 27.31 20.19 1.29 1.81 $ 78.59 $ 47.99 87.96 6.97 13.40 $156.32 $234.91 46 $ 1.71 3.40 $ 5.11
Source: Data from U.S. Department of Agriculture (USDA), Economic Research

Service
Cost Concepts for Product and Service Costing

Explain the cost concepts used in product and service costing.
Accurate information about the cost of products and services is important in each management function: strategic management, planning and decision making, management and operational control, and nancial statement preparation. The cost accounting systems that provide this information are explained in this section.
Cost Accounting for Products and Services

Cost accounting systems for the rms that manufacture products and for the merchandising rms that resell those products differ signicantly. Merchandising rms include both retailers, which sell the nal product to the consumer, and wholesalers, which distribute the product to retailers. Service rms often have little or no inventory, so their costing systems are relatively simple.
Product Costs and Period Costs

Cost of goods sold is the cost of the product transferred to the income statement when inventory is sold.
Product inventory for both manufacturing and merchandising rms is treated as an asset on their balance sheets. As long as the inventory has market value, it is considered an asset until the inventory is sold; then the cost of the inventory is transferred to the income statement as cost of goods sold. This sequence is the value chain of product costs for a manufacturing rm,
Chapter 3
Product costs for a manufacturing rm include only the costs necessary to complete the product: direct materials, direct labor, and factory overhead.
from the upstream activities of design and marketing research, to manufacture of the product, and nally to the downstream activities of sales and service. Product costs for a manufacturing rm include only the costs necessary to complete the product at the manufacturing step in the value chain: 1. Direct materials. The materials used to manufacture the product, which become a physical part of it. 2. Direct labor. The labor used to manufacture the product. 3. Factory overhead. The indirect costs for materials, labor, and facilities used to support the manufacturing process. Product costs for a merchandising rm include the cost to purchase the product plus the transportation costs paid by the retailer or wholesaler to get the product to the location from which it will be sold or distributed. All other costs for managing the rm and selling the product are expensed in the period in which they are incurred; for that reason, they are called period costs. Period costs primarily include the general, selling, and administrative costs that are necessary for the management of the company but are not involved directly or indirectly in the manufacturing process (or in the purchase of the products for resale). Advertising costs, data processing costs, and executive and staff salaries are good examples of period costs. See Exhibit 3.12. In a manufacturing or a merchandising rm, period costs are also sometimes referred to as operating expenses or selling and administrative expenses. In a service rm, these costs are often referred to as operating expenses.
Period costs are all nonproduct expenditures for managing the rm and selling the product.
Demonstrate how costs ow through the accounts.
Manufacturing, Merchandising, and Service Costing

The cost ows in manufacturing, retail, and service rms are illustrated in Exhibits 3.13, 3.14, 3.15a, and 3.15b. The left-hand side of Exhibit 3.13 presents a graphic representation of the ows of costs for a manufacturing rm. The rst step of the manufacturing process is to purchase materials. The second step involves adding the three cost elementsmaterials used, labor, and overheadto work in process. In the third step, as production is completed, the production costs that have been accumulating in the Work-in-Process account are transferred to the Finished Goods Inventory account and from there to the Cost of Goods Sold account when the products are sold. In the merchandising rm, shown on the right-hand side of Exhibit 3.13, the process is somewhat simpler. It purchases merchandise and places it in the Product Inventory account. When sold, it is transferred to the Cost of Goods Sold account. The merchandising and EXHIBIT 3.12
Furniture Manufacturing Costs: Variable/Fixed, Direct/ Indirect, and Product/Period Costs The manufacture of dining table sets is used to provide examples of costs for each cost concept: variable/xed, direct/indirect, and product/period. The furniture manufacturer for these dining table sets has organized its manufacturing by product line: dining table sets, upholstered chairs, sofas, bedroom furniture, end tables, and outdoor furniture. Each product line has its own manufacturing team although much of the equipment in the plant is shared among product lines (e.g., multiple product lines use the table saws). The company owns its retail sales outlets, each of which offers all of the rms products. The cost object in this illustration is the product line for dining table sets (not each dining set produced). Variable/Fixed, Direct/Indirect, and Product/Period Costs for the Product Line, Dining Table Sets Product Cost Direct Variable Fixed Wood and fabric Salary of manufacturing supervisor for dining table sets Indirect Power for table saws Depreciation on table saws used for all product lines Sales commissions for sales Insurance and depreciation on company-owned sales outlets Period (Nonproduct) Cost
Notes: This illustration is based on the cost object, the product line for dining table sets. The examples would not change if we had chosen instead to have the cost object be each set manufactured except that the manufacturing supervisors salary would no longer be a direct xed product cost. It would become an indirect xed product cost because the salary can be traced to the product line but not to each table set manufactured.
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EXHIBIT 3.13
Cost Flows in Manufacturing and Merchandising Firms
Manufacturing Company First Step Materials Purchases Merchandising Company Merchandise Purchases
Materials Inventory Materials Used Second Step Labor Work-in-Process Inventory Cost of Goods Manufactured Overhead
Finished Goods Inventory Third Step
Product Inventory
Cost of Goods Sold
Cost of Goods Sold
Key:
Beginning Inventory
Ending Inventory
Materials Inventory is the cost of the supply of materials used in the manufacturing process or to provide the service. Work-in-Process Inventory contains all costs put into the manufacture of products that are started but not complete at the nancial statement date. Finished Goods Inventory is the cost of goods that are ready for sale.
manufacturing rms in Exhibit 3.13 are shown side by side to emphasize the difference: The merchandising rm purchases inventory but the manufacturing rm manufactures inventory using materials, labor, and overhead. Manufacturing rms use three inventory accounts: (1) Materials Inventory, where the cost of the supply of materials used in the manufacturing process is kept; (2) Work-in-Process Inventory, which contains all costs put into the manufacture of products that are started but not complete at the nancial statement date; and (3) Finished Goods Inventory, which holds the cost of goods that are ready for sale. Each account has its own beginning and ending balances. An inventory formula relates the inventory accounts, as follows: Beginning inventory + Cost added = Cost transferred out + Ending Inventory The terms cost added and cost transferred out have different meanings, depending on which inventory account is being considered:
Inventory Account Materials Inventory Work-in-Process Inventory Cost Added Purchases of materials 1. Cost of materials used 2. Labor cost 3. Overhead cost Costs of goods manufactured Cost Transferred Out Cost of materials used in production Cost of goods manufactured, for products completed this period Cost of goods sold
Finished Goods Inventory
The inventory formula is a useful concept to show how materials, labor, and overhead costs ow into Work-in-Process Inventory, then into Finished Goods Inventory, and nally into Cost of Goods Sold. Exhibit 3.14 illustrates the effects of the cost ows on the accounts involved when the manufacturing rm converts materials into nished products and then sells them and when the merchandising rm sells merchandise inventory.
Chapter 3
EXHIBIT 3.14
Account Relationships for Manufacturing and Merchandising Companies
Manufacturing Company Labor: Wages Payable 80 Merchandising Company
Materials Inventory BI 10 70 5 75
Overhead 100
EI Cost of Materials Used ($75)
Work-in-Process Inventory BI 10 75 80 100 EI 50
215
Cost of Goods Manufactured ($215)
Finished Goods Inventory BI 20 215 EI 25 210
Merchandise Inventory BI 40 250 EI 60 230
Cost of Goods Sold ($210)
Cost of Goods Sold 210
Cost of Goods Sold 230
Key: BI: Beginning Inventory EI: Ending Inventory
Prepare an income statement for both a manufacturing rm and a merchandising rm.
Cost of Goods Manufactured is the cost of goods nished and transferred out of the Work-inProcess Inventory account this period.
The illustration in Exhibit 3.14 shows the accounts for a manufacturing company that begins the period with $10 in Materials Inventory, $10 in Work-in-Process Inventory, and $20 in Finished Goods Inventory. During the period, it purchases $70 of materials, uses $75 of materials and $80 of direct labor, and spends $100 for factory overhead. Also during the period, $215 of goods are completed and transferred from the Work-in-Process Inventory account to the Finished Goods Inventory account, and $210 of goods are sold. These events leave ending inventories of $5 in the materials account, $50 in the work-in-process account, and $25 in the nished goods account. The merchandising company purchased merchandise of $250 and made sales of $230, and its Merchandise Inventory account increases from $40 to $60. Exhibit 3.15a shows how the accounting relationships are nally represented in the income statements for the two types of rms. Note that the manufacturing rm requires a twopart calculation for cost of goods sold: the rst part combines the cost ows affecting the Work-in-Process Inventory account to determine the amount of Cost of Goods Manufactured, that is, the cost of the goods nished and transferred out of work in process during this period. The second part combines the cost ows for the Finished Goods Inventory account to determine the amount of the cost of the goods sold and operating income, assuming $50 of selling expense for the manufacturing rm and $40 of operating expense for the merchandising rm. Operating expenses for a merchandising company include all the nonproduct costsfacilities cost, advertising, stafng, and so on. Exhibit 3.15b shows the relatively simple income statement for a service rm with $300 in sales, $10 in materials costs, $90 in labor costs, and $100 in other operating expenses for an operating income of $100. This provides an introduction to costs ows in the three types of rms. The process is shown in greater detail in Chapter 4.
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EXHIBIT 3.15a Income Statements for Manufacturing and Merchandising Firms

MANUFACTURING, Inc.
Statement of Cost of Goods Manufactured For the Year Ended December 31, 2007 Direct Materials Beginning Inventory Purchases Direct Materials Available Ending Direct Materials Inventory Direct Materials Used Direct Labor Factory Overhead Total Manufacturing Cost Add: Beginning Work-in-Process Inventory Total Manufacturing Cost to Account for Less: Ending Work-in-Process Inventory Cost of Goods Manufactured $ 10 70 $ 80 5 $ 75 80 100 $255 10 265 50 $215 (No need for a Cost of Goods Manufactured Statement for Merchandising Inc.)
MANUFACTURING, Inc.
Income Statement For the Year Ended December 31, 2007 Sales Cost of Goods Sold Beginning Finished Goods Inventory Cost of Goods Manufactured Cost of Goods Available for Sale Ending Finished Goods Inventory Gross Margin Selling and Administrative expenses Operating Income $300 $ 20 215 235 25
MERCHANDISING, Inc.
Income Statement For the Year Ended December 31, 2007 Sales Cost of Goods Sold Beginning Finished Goods Inventory Purchases Cost of Goods Available for Sale Ending Finished Goods Inventory Gross Margin Operating expenses Operating Income $300 $ 40 250 $290 60
210 90 50 $ 40
230 $ 70 40 $ 30
EXHIBIT 3.15b
Income Statement for a Service Firm
Revenues Operating Expenses Materials Labor Other Operating Expenses Operating Income
SERVICE, Inc.
Income Statement For the Year Ended December 31, 2007 $300 $ 10 90 100 200 $100
Cost Concepts for Planning and Decision Making

Explain the cost concepts related to the use of cost information in planning and decision making.
To facilitate management decision making and planning, the management accountant provides relevant, timely, and accurate information at a reasonable cost. Relevance is the most critical of the decision-making concepts; timeliness, accuracy, and cost are unimportant if the information is irrelevant.
Relevant Cost
The concept of relevant cost arises when the decision maker must choose between two or more options. To determine which option is best, the decision maker must determine which option
Chapter 3
A relevant cost has two properties: (1) it differs for each decision option and (2) it will be incurred in the future.
offers the highest benet, usually in dollars. Thus, the decision maker needs information on relevant costs. A relevant cost has two properties: (1) it differs for each decision option and (2) it will be incurred in the future. If a cost is the same for each option, including it in the decision only wastes time and increases the possibility for simple errors. Costs that have already been incurred or committed are irrelevant because there is no longer any discretion about them.
Opportunity Cost
Opportunity cost is the benet lost when choosing one option precludes receiving the benets from an alternative option.
Opportunity cost is the benet lost when choosing one option precludes receiving the benets from an alternative option. For example, if a sales manager chooses to forgo an order from a new customer to ensure that a current customers order is lled on time, the potential prot from the lost order is the managers opportunity cost for this decision. Ensuring the loyalty of an existing customer has a difcult-to-quantify but signicant long-term value, but the shortterm loss of the new order, while quantiable, is not so important.
Sunk Cost
Sunk costs are costs that have been incurred or committed in the past and are therefore irrelevant.
Sunk costs are costs that have been incurred or committed in the past and are therefore irrelevant for decision making because the decision maker no longer has discretion over them. For example, if a company purchased a new machine without warranty that failed the next day, the purchase price is irrelevant for the present decision to replace or to repair the machine. Only future costs are relevant, and the purchase price of the recently acquired machine has no effect on future costs. An important additional issue related to sunk costs must be considered. There is apparently an inherent bias for decision makers to include sunk costs as relevant to the analysis. Research has shown that decision makers are more willing to invest money to recover sunk costs than to invest the money to earn the same net return. Other studies show that decision makers tend to escalate commitments to sunk costs. The practical implication of these ndings is that the management accountants must be particularly careful to develop information for decision makers that separates sunk costs from differential future costs.
Attributes of Cost Information for Decision Making

Accuracy
The experienced decision maker does not use accounting information without considering the potential for inaccuracy. Inaccurate data can mislead, resulting in potentially costly mistakes. A primary way to ensure accurate data for decision making is to design and monitor an effective system of internal accounting controls. The system of internal accounting controls is a set of policies and procedures that restrict and guide activities in the processing of nancial data with the objective to prevent or detect errors and fraudulent acts. The emphasis on effective internal controls has increased signicantly in recent years in response to new Securities and Exchange Commission (SEC) requirements imposed by the Sarbanes-Oxley Act of 2002 (see Chapter 1).
The system of internal accounting controls is a set of policies and procedures that restrict and guide activities in the processing of nancial data with the objective to prevent or detect errors and fraudulent acts.
Timeliness
Cost management information must be available to the decision maker in a timely manner to facilitate effective decision making. The cost of delay can be signicant in many decisions, such as in lling rush orders that may be lost if the necessary information is not timely. The cost of identifying quality defects early in a manufacturing process can be far less than the cost of materials and labor wasted until the defect is detected later in the process.
Cost and Value of Cost Information

Thinking of cost management information as having a certain cost and value emphasizes that the management accountant is an information specialist, very much like other nancial professionals, such as tax advisers, nancial planners, and consultants. The management accountant provides an information service that has both a preparation cost and a value to the user. The preparation costs for cost management information should be controlled as should any other service provided within the rm. These preparation costs are likely inuenced by the desired accuracy, timeliness, and level of aggregation; when increased accuracy, timeliness, and detail are desired, the preparation costs are higher.
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Part One
Cost Concepts for Management and Operational Control

Explain the cost concepts related to the use of cost information for management and operational control.
A crucial role for cost management information is to provide a basis for motivating and rewarding managers and employees efforts and effectiveness. Key cost concepts applicable for this management function include controllability and risk preferences.
Controllability
A cost is said to be controllable if the manager or employee has discretion in choosing to incur it or can signicantly inuence its amount within a given, usually short, period of time. For example, the shop supervisor ordinarily cannot control rent expense and insurance on the plant facility nor would the division manager ordinarily have discretion over the amount of corporate-level administrative costs. In contrast, employees typically have control over the labor and materials used in their work area. Costs such as advertising and maintenance ordinarily are within the scope of the product or division managers control. There are two views of the importance of controllability in the context of employee and manager motivation. One view holds that the manager or employee should be responsible only for the costs that he or she controls. This view is consistent with the argument that to hold managers responsible for changes in costs beyond their control is unfair and unmotivating. The second view is that many uncontrollable costs, such as corporate-level administrative costs, are in fact controllable by all managers taken as a whole; thus, to include these costs on the managers costs reports sends a clear message that the rm benets when managers manage these costs properly.
A cost is said to be controllable if the manager or employee has discretion in choosing to incur it or can signicantly inuence its amount within a given, usually short, period of time.
Summary
There are several important concepts for the management accountant, which Chapter 3 presents in four groups: (1) cost objects, cost drivers, and cost pools, (2) product and service costing for the preparation of nancial statements, (3) planning and decision making, and (4) operational and management control. Group 1 includes concepts that are important in all management functions, while groups 2, 3, and 4 are three of the four management functions. Concepts for the fourth management function, strategic management, are covered in Chapters 1 and 2. The rst group of concepts includes the four types of cost drivers: activity-based, volume-based, structural, and executional. Activity-based cost drivers are at the detail level of operations: equipment setup, materials handling, and clerical or other tasks. In contrast, volume-based cost drivers are at the aggregate level: usually the number of units produced. Structural cost drivers involve plans and decisions having long-term effects; executional cost drivers have short-term decision frames. The most important volume-based concepts are variable costs, which change according to a change in the level of output, and xed costs, which do not. Direct costs are dened as costs that can be traced directly to a cost object in contrast to indirect costs, which cannot. The important concepts in product costing are product costs, which are the costs of direct materials, direct labor, and indirect manufacturing (called overhead) required for the product and production process. Nonproduct costs (also called period costs) are the selling, administrative, and other costs not involved in manufacturing. The inventory formula is used to determine the cost of materials used in production, the cost of goods manufactured, and the cost of goods sold for a given period. The most important concept in planning and decision making is relevant costa cost that differs for each option and will occur in the future. When considering options, the management accountant considers relevant costs. All past costs (also called sunk costs) are irrelevant because they will not change regardless of the option chosen. The key concept in management and operational control is controllability. Distinguishing controllable costs from other costs is important because evaluation, even in part, on the basis of costs a manager cannot control can be negatively motivating.
Chapter 3
Key Terms
allocation bases, 56 average cost, 61 controllable cost, 70 conversion cost, 58 cost, 55 cost allocation, 56 cost assignment, 55 cost driver, 55 cost object, 55 cost of goods manufactured, 67 cost of goods sold, 64 cost pools, 55 direct cost, 55
direct labor cost, 57 direct materials cost, 57 executional cost drivers, 63 factory overhead, 58 nished goods inventory, 66 xed cost, 60 indirect cost, 56 indirect labor cost, 57 indirect materials cost, 57 internal accounting controls, 69 marginal cost, 61 materials inventory, 66 mixed cost, 60
opportunity cost, 69 overhead, 58 period costs, 65 prime costs, 58 product costs, 65 relevant cost, 69 relevant range, 59 step cost, 61 structural cost drivers, 63 sunk costs, 69 unit cost, 61 variable cost, 60 work-in-process inventory, 66
Comments on Cost Management in Action
Cost per Bushel of Soybeans: U.S. and Brazil

The data is taken from an October 2001 Report of the Economic Research Service of the U.S. Department of Agriculture, based on 19981999 data. The report can be viewed at the following Web site: http://www .ers.usda.gov/Brieng/SoybeansOilcrops/pdf/SBProdExpCompOCS2001.pdf 1. What can you learn from this information about the cost competitiveness of the United States and Brazil in soybean production? Of particular value here is that the report distinguishes variable and xed costs, which is not common in reports of this type. The distinction gives the reader an opportunity to better understand how cost production costs behave in the two countries. A wide number of observations are possible. In particular, we see the relatively high cost of land and equipment in the United States, partly balanced by relatively high labor and fertilizer and chemical costs in Brazil. Is the high labor cost a result of a substitution of labor for equipment or does it represent poorly trained or supervised workers? Similarly, does the high cost of chemicals and fertilizer in Brazil indicate that U.S. farmers have superior land use practices, or are the fertilizers and chemicals more expensive in Brazil for other reasons? While the gures clearly show that Brazil has a total cost advantage over the United States in the production of soybeans, other nonproduction, downstream costs are likely to be higher in Braziltransportation (including fuel costs), marketing, and salesbecause of its more remote location from world markets. Also, the United States has a cost advantage in variable costs, showing clearly the importance of the cost of land and farm equipment in the United States. Since the signicance of the data is for understanding international competitiveness in global soybean production, it is also important to note that the above analysis does not include data on uctuations in currency exchange rates, import restrictions, government subsidies, taxes, and other factors that are critical in global trade. Some of the strongest controversies among the World Trade Organization (WTO) countries at this time are the restrictions and subsidies involved in agricultural trade. 2. Critically evaluate the cost information. A number of potential questions arise about the way the data is collected and presented. Here are some ideas to start with. First, what about the size of the farm: should this affect the xed cost-per-acre calculations, since xed costs are driven in part by the number of acres farmed but also by the fact that certain pieces of equipment are necessary for a farm of any size. Farm equipment might be more of a step cost than a xed cost. If this is the case, the relatively low equipment cost per acre might simply be due to the fact that farm sizes are larger in Brazil. Are the xed costs computed annually or monthly? And if land can be rented by the acre, is it not a variable cost?
Self-Study Problem
(For solution, please turn to the end of the chapter.)
The following data pertain to Spartan Products Company: Sales revenue Direct materials inventory, Jan. 1, 2007 Direct laborWages Depreciation expensePlant and equipment Indirect laborWages Heat, light, and powerPlant Supervisors salaryPlant $1,000,000 20,000 350,000 80,000 5,000 12,000 40,000 (Continued)
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Finished goods inventory, Jan. 1, 2007 Work-in-Process inventory, Dec. 31, 2007 SuppliesAdministrative ofce Property taxesPlant Finished goods inventory, Dec. 31, 2007 Direct materials inventory, Dec. 31, 2007 Sales representatives salaries Work-in-Process inventory, Jan. 1, 2007 Direct materials purchases SuppliesPlant DepreciationAdministrative ofce
35,000 25,000 6,000 13,000 40,000 30,000 190,000 35,000 100,000 4,000 30,000
Required Prepare a statement of cost of goods manufactured and an income statement for Spartan Products Company for the year ended December 31, 2007, similar to the one in Exhibit 3.15a.
Questions
3-1 3-2 3-3 3-4 3-5 3-6 3-7 3-8 3-9 3-10 3-11 3-12 3-13 3-14 3-15 3-16 3-17 3-18 3-19
For what particular management function is relevant cost information needed? Distinguish between direct and indirect costs and give several examples of each. Are all direct costs variable? Explain. Are all xed costs indirect? Explain. Dene cost driver. What is the difference between variable and xed costs? Explain step costs and give an example. Dene relevant range and explain its use. What is a conversion cost? What are prime costs? Why might the term average cost be misleading? How do total variable costs, total xed costs, average variable costs, and average xed costs react to changes in the cost driver? What does the term marginal cost mean? Distinguish between product costs and period costs. Explain the difference between cost of goods sold and cost of goods manufactured. What are the three types of inventory in a manufacturing rm? Cost management information should be relevant, timely, and accurate. Which of these attributes is most important? Why? What is a relevant cost? Dene opportunity cost and sunk cost. Should managers be responsible for the costs they cannot control directly? Why or why not? Identify what are likely to be variable costs for an airline such as Southwest Air. Also, what are the xed costs likely to be? Identify what are likely to be variable costs for a discount retailer such as Target. Also, what are the xed costs likely to be? Identify what are likely to be variable costs for a movie theater. Also, what are the xed costs likely to be? Identify what are likely to be variable costs for a brewery such as Molson or Budweiser. Also, what are the xed costs likely to be? Identify what variable costs are likely to be for a company that provides personal trainers. The personal trainers are paid a small salary plus a commission for each lesson. Also, what are the companys xed costs? Jason can buy a new motorcycle for $13,500 or have his own repaired for $2,000. The trade-in value of his current cycle, which he paid $9,995 for, is about $6,000. His insurance for the motorcycle is $1,000 per year. What are the relevant costs in his decision to repair or replace the motorcycle? Toby Jackson is assistant manager for an International House of Pancakes located in Greensboro, North Carolina. His performance is evaluated quarterly, and he has the opportunity for a quarterly bonus, if his performance ranks well relative to other managers. Which of the following do you think is least likely to be a controllable cost in his evaluation: cost of pancake syrup; cost of wasted food
Brief Exercises
3-20 3-21 3-22 3-23 3-24
3-25
3-26
Chapter 3
3-27 3-28
3-29
3-30
items due to spoilage, overstocking, or errors in customers orders; cost of heat and lights for the restaurant; cost of cleaning supplies; or cost of waitresses/waiters? Clay Armstrong misses a week of work and pay because of a family emergency. Is the lost pay best called a relevant cost, opportunity cost, or controllable cost? If a merchandising company has a beginning nished goods inventory of $400,000 and a nished goods ending inventory of $200,000, and the company purchased $1,600,000 of inventory during the month, what is the companys cost of goods sold? The Walden Manufacturing Corp. has interest expense of $4,000, factory supplies of $1,000, indirect labor of $6,000, direct materials of $16,000, advertising expense of $2,500, ofce expense of $14,000, and direct labor of $20,000. What is the total period cost? Kristin Dawson has a great idea to start a new business, but as a student, decides to focus on her studies. Is the loss of the potential prot from the new business best described as a controllable cost, a relevant cost, or an opportunity cost? Classication of Costs The following costs were taken from the accounting records of the Barnwell Manufacturing Company: 1. State income taxes 2. Insurance on the manufacturing facilities 3. Supplies used in manufacturing 4. Wages for employees in the assembly department 5. Wages for employees who deliver the product 6. Interest on notes payable 7. Materials used in the production process 8. Rent for the sales outlet in Sacramento 9. Electricity for manufacturing equipment 10. Depreciation expense on delivery trucks 11. Wages for the sales staff 12. Factory supervisors salaries 13. Company presidents salary 14. Advertising expense
Exercises
3-31
Required Classify each item as either a product cost or a period cost. Classify all product costs as direct or indirect, assuming that the cost object is each unit of product manufactured. 3-32 Classication of Costs Following is a list of costs from Oakland Company, a furniture manufacturer: 1. Wood used in chairs 2. Salaries of inspectors 3. Lubricant used in machinery 4. Factory rent 5. Wages of assembly workers 6. Factory workers compensation insurance 7. Sandpaper 8. Fabric used for upholstery 9. Property taxes on manufacturing plant 10. Depreciation on machinery
Required Classify each cost as direct or indirect assuming that the cost object is each item manufactured. Also indicate whether each cost is a variable or xed cost. 3-33 Classication of Costs The following is a list of costs from the accounting records of Sunshine Pool Management, Inc. Each of Sunshines 77 customers owns a pool. Sunshine maintains each customers pool by providing supplies, cleaning, and repairs. 1. Lifesaving supplies 2. Salaries of Sunshines managers
74
Part One
3. 4. 5. 6. 7. 8. 9. 10. Required 3-34
Pool chemicals Sunshines ofce rental expense Wages of lifeguards Workers compensation insurance Training for lifeguards pH testing supplies Ofce expense, including bookkeeping and clerical Depreciation on cleaning and testing equipment Classify each item as direct or indirect assuming that the cost objects are each of 77 pools.
Activity Levels and Cost Drivers Tartan Manufacturing Company produces four lines of highquality lighting xtures in a single manufacturing plant. Products are built to specic customer specications. All products are made-to-order. Management of the plant lists the following as the key activities at the plant: a. Product design b. Production scheduling c. Cost of purchasing department d. Receipt and inspection of materials e. Machine set-ups f. Product inspection, done for each product g. Plant security h. Customer credit check i. Machine operation j. Machine maintenance Identify a cost object and a cost driver for each activity.
Required 3-35
Application of the Direct Cost Concept in the Fashion Industry Jane Wilson is the production manager for a company that produces high-fashion designer clothing for women. The product is made in small batches that are presold to high-end retailers, based on specic orders. The product is completed in batches, which consist of a single item of clothing being made for a single or small number of retail customers. In effect, Jane manages the ow of small batches of product through the companys design/production shop in New York. The materials and labor for each batch are purchased and scheduled well in advance of the time of production. The materials are unique to the job, and the employees assigned to the job will work on it till the job is done. The company has found that dedicating specic employees to each batch improves employee satisfaction, and most important, product quality.
Required Evaluate the role of the direct cost concept in this unique company. 3-36 Complexity of Operations and the Effect on Cost In the mid-1990s, a large consumer goods manufacturer moved its customer-based department and specialty stores to mass merchandising in a a variety of retail stores, large and small. The strategic change required it to increase signicantly the complexity of its operationsthe number of products, prices, discounts, patterns, colors, and sizes. After noticing the rms expense beginning to rise, the company hired a consultant to study the rms cost structure. The ndings: As many as 10 different wvendors provided certain purchased items. Of the rms customers after the strategic shift, 98% were responsible for only 7% of total sales volume. The wide variety of prices and discounts and promotional programs added complexity to the accounts receivable collection process because of increased disputes over pricing and customer balances. Seventy-ve percent of the company sales involved products with ve or more color combinations Customer demands for fast delivery of new orders had caused a shift in manufacturing to smaller batch sizes and more frequent equipment setups. Thus, total setup-related costs increased.
Required What would you advise the company to do?
Chapter 3
3-37
Average and Total Costs The Accounting Students Association wants to have a Christmas dance for its members. The cost of renting a nightclub is $1,500, and the cost of refreshments will be $12 per person.
Required 1. What is the total cost if 100 people attend? What is the average cost? 2. What is the total cost if 200 people attend? What is the average cost? 3. Explain why average total cost differs with changes in total attendance. 3-38 Classification of Costs Fran McPhair Dance Studios is a chain of 45 wholly owned dance studios that offer private lessons in ballroom dancing. The studios are located in various cities throughout the southern and southeastern states. McPhair offers a set of 12 private lessons; students may pay for the lessons one at a time, but each student is required to enroll for at least a 12-lesson plan. The 20-, 40-, and 100-lesson plans offer savings. Each dance instructor is paid a small salary plus a commission based on the number of dance lessons provided.
Required 1. McPhairs owner is interested in a strategic analysis of the business. The owner wants to understand why overall protability has declined slightly in the most recent year while other studios in the area seem to be doing well. What is the proper cost object to begin this analysis? Explain your choice. 2. For each of the cost elements determine the cost classication from the following list for the cost object you chose in requirement 1. (In some cases, two or more classications may apply.)
Cost Elements 1. 2. 3. 4. 5. 6. 7. 8. Each dancing instructors salary. Managers salary. Music tapes used in instruction. Utilities for the studio. Part-time studio receptionist. Planning and development materials sent from the home ofce. Free lessons given by each studio as a promotion. Regional TV and radio advertisements placed several times a year.
Cost Classications a. b. c. d. e. f. Direct Indirect Variable Fixed Controllable by studio manager Uncontrollable by studio manager Activities and Cost Drivers in a Hospital Greenbelt Hospital has the following activities in its value chain of providing service to each inpatient admission: 1. Schedule patient. 2. Verify insurance. 3. Admit patient. 4. Prepare patients room. 5. Review doctors report. 6. Feed patient. 7. Order tests. 8. Move to/from laboratory. 9. Administer lab tests. 10. Order pharmaceuticals.
3-39
76
Part One
11. 12. 13. 14. 15. 16. 17. 18.
Complete patient report. Check patients vital signs. Prepare patient for operation. Move to/from operating room. Operate. Collect charges. Discharge patient. Bill insurance.
Required Assume that the cost object is the individual patient. Determine the appropriate cost driver(s) for each activity. 3-40 Fixed, Variable, and Mixed Costs Adams Manufacturings ve manufacturing departments had the following operating and cost information for the two most recent months of activity: May 2007 Units produced Costs in each department Department A Department B Department C Department D Department E 10,000 $10,000 25,000 35,000 18,000 22,000 June 2007 20,000 $10,000 50,000 45,000 64,000 44,000
Required Identify whether the cost in each department is xed, variable, or mixed. 3-41 Fixed, Variable, and Mixed Costs Habib Manufacturing has ve manufacturing departments and operating and cost information for the most recent two years of activity. 2006 Units produced Costs in each department: Department 1 Department 2 Department 3 Department 4 Department 5 Required 3-42 4,000 $11,000 10,000 20,000 33,000 16,000 2007 6,000 $12,000 15,000 25,000 33,000 24,000
Identify whether the cost in each department is xed, variable, or mixed.
Military Contracts and Direct vs. Indirect Costs In contracts with the U.S. government, direct costs are reimbursable. Indirect costs can be a problem however, when a contract is terminated because the approved cost assignment procedures are no longer appropriate. The determination of whether a cost is direct or indirect can be critical in some situations. To understand the problem, consider this typical case. A contractor enters into a multiyear, xed-price development contract with the military. The job requires a signicant investment in inspection equipment that the contractor uses only for the military contract. Equipment cost is not treated as a direct cost, however, because governmental cost standards require depreciation costs of all similar assets to be treated consistently, either as direct or indirect costs. Thus, the inspection equipment must be treated as an indirect cost. Because the equipment is an indirect cost, its cost cannot be fully recovered until the project is completed. If the contract is terminated early, only a portion of the cost of the inspection equipment can be recovered. How do you think this issue should be resolved?
Required
Chapter 3
3-43
Interpreting Average Cost Concern for gas emissions and depletion of nonrenewable resources has caused environmentalists and others to push for higher fuel-efciency standards for new cars. The current corporate automotive fuel efciency (CAFE) standards require automakers to produce an overall fuel efciency of 26.2 miles per gallon for all autos produced. Currently the U.S. government supports the development of hybrid autos that combine gas and electric power as the solution to the problem. Others propose simply raising the CAFE standards for auto manufacturers. To study the issue, the American Council for an Energy-Efcient Economy (ACEEE) conducted research to determine the cost for raising fuel efciency for the different proposals. Their ndings are as follows: Cost for each Gallon of Gas Saved $0.57 $0.60 $1.38 $1.80
Option to reduce emissions and provide better fuel economy Current mileage standards Moderate increase in CAFE Signicant increase in CAFE Partial hybrid (15% of power from electricity) Full hybrid (40% of power from electricity)
Fuel Efciency (mpg) 26.2 40.8 45.8 52.6 59.3
The increase in fuel economy required by higher CAFE standards would require automakers to use conventional technology to improve engines and transmissions. The hybrid vehicles require newer technology and electric motors. Required Give a brief critical review of the ACEEEs research results. What questions would you have for the researchers who presented these results? 3-44 Interpreting Average Cost Recently the American Institute of CPAs (AICPA) and the Hackett Group, a consulting rm, partnered to study the trends in the nature and amount spent on the accounting function in corporations. A key nding was that the worlds best accounting departments were able to function effectively at relatively low cost; these departments total costs were only about 1 percent of their rms total revenues. In contrast, less efcient accounting departments required on the average 1.4 percent of total revenue, 40 percent higher. The world-class accounting departments were also faster in preparing regular nancial reports (less than two days for the best departments, compared to ve to eight days for the others). The study also found that larger rms spent less on accounting: Manufacturing Firms Firms with less than $1 billion in revenues $1 billion to $5 billion More than $5 billion Service Firms Less than $1 billion in revenues More than $1 billion 2.1% 1.6% Finance Cost as a Percent of Total Revenue 1.6% 1.4% 1%
Required Give a brief critical review of these research results. What questions would you have for the researchers who presented these results? 3-45 Cost of Goods Manufactured The following information pertains to the Petrie Company: Prime costs Conversion costs Direct materials used Beginning work in process Ending work in process Required Determine the cost of goods manufactured. $180,000 215,000 95,000 75,000 65,000
78
Part One
Problems
3-46
Product Costs and Period Costs Galletas Americanas is a cookie company in Guadalajara, Mexico, that produces and sells high-quality American-style cookies. The owner wants to identify the various costs incurred each year to be able to plan and control the business costs. Galletas Americanass costs are the following (in thousands of pesos): Utilities for the bakery Paper used in packaging product Salaries and wages in the bakery Cookie ingredients Bakery labor and fringe benets Administrative costs Bakery equipment maintenance Depreciation of bakery plant and equipment Uniforms Insurance for the bakery Rent for administrative ofces Advertising Boxes, bags, and cups used in the bakery Managers salary Overtime premiums Idle time 1,600 70 15,000 27,000 1,000 800 600 1,500 300 600 13,200 1,500 700 10,000 2,000 400
Required 1. What is the total amount of product and period costs? 2. Assume that Galletas is planning to expand its business into the United States and Canada, initially targeting the United States. This expansion will not require additional baking facilities, but labor and materials costs will increase, and advertising costs and packaging costs will increase substantially. Also, U.S. authorities will require certain documentation and inspections that will be an added cost for Galletas. a. Which of the additional costs are product costs? b. Which costs are relevant for the decision whether to expand into the United States? 3-47 Executional Cost Drivers, Internet Retailer Assume that you are a consultant for a start-up Internet retailer, Bikes.com, which provides a variety of bicycle parts and accessories in a convenient and effective customer service approach. The rm operates from an ofce building and nearby warehouse located in Danville, Virginia. Currently, the rm has 10 permanent administrative staff, 6 customer service representatives who respond to customer inquiries, and 12 employees who pick, pack, and ship customer orders. All orders are placed over the rms Web site. An 800 telephone number is available for customer service. The rms sales increased at about 20 percent per year in the last two years, a decline from the 50 percent rate in its rst three years of operation. Management is concerned that the decline will delay the rms rst expected prot, which had been projected to occur in the next two years. The rm is privately held and has been nanced with a combination of bank loans, personal investments of top managers, and venture capital funding.
Required What specic executional cost drivers are important in this business? How should the rm use them to improve its sales rate? 3-48 Structural Cost Drivers Case A. Food Fare is a small chain of restaurants that has developed a loyal customer base by providing fast-food items with more choices (e.g., how the hamburger should be cooked; self-serve toppings) and a more comfortable atmosphere. The menu has a small number of popular items, including several different hamburgers, grilled chicken sandwiches, and salads. Recently, to broaden its appeal, Food Fare added barbecue, seafood, and steak to its menu. Case B. Gilman Heating and Air Conditioning, Inc., provides a broad range of services to commercial and residential customers, including installation and repair of several different brands of heating and air conditioning systems. Gilman has a eet of 28 trucks, each operated by one or more service technicians, depending on the size of a job. A recurrent problem for Gilman has been coordinating the service teams during the day to determine the status of a job and the need for parts not kept in the service vehicle as well as to identify which team to send on emergency calls. Gilmans service area is spread over an urban/rural area of approximately 20 square miles. The company has developed cost and price sheets so that the service technicians accurately and consistently price the service work they perform.
Chapter 3
Required For each case, identify the important structural cost drivers for the company and the related strategic issues that it should address to be competitive. 3-49 Cost of Goods Manufactured and Sold Benvanides Company produces womens clothing. During 2007, the company incurred the following costs: Factory rent Direct labor UtilitiesFactory Purchases of direct materials Indirect materials Indirect labor Inventories for the year were as follows: January 1 Direct materials Work in process Finished goods $ 30,000 40,000 115,000 December 31 $50,000 85,000 95,000 $425,000 325,000 75,000 465,000 70,000 35,000
Required 1. Prepare a statement of cost of goods manufactured. 2. Calculate cost of goods sold. 3-50 Cost of Goods Manufactured The following data pertain to Duvernoy Company for the year ended December 31, 2008: December 31, 2006 Purchases of direct materials Direct labor Indirect labor Factory insurance DepreciationFactory Repairs and maintenanceFactory Marketing expenses General and administrative expenses Direct materials inventory Work-in-process inventory Finished goods inventory Sales in 2007 were $500,000. Required Prepare a schedule of cost of goods manufactured and an income statement for 2007 for Duvernoy Company similar to those in Exhibit 3.15a. 3-51 Cost of Goods Manufactured, Income Statement Consider the following information for Household Furnishings, Inc. for the year ended December 31, 2007: December 31, 2007 $60,000 45,000 25,000 12,000 80,000 15,000 66,000 55,000 35,000 35,000 20,000
$20,000 33,000 23,000
Depreciation expenseAdministrative ofce Depreciation expensePlant and equipment Direct laborWages Direct materials inventory, Dec. 31, 2007 Direct materials inventory, Jan. 1, 2007 Direct materials purchases Finished goods inventory, Dec. 31, 2007 Finished goods inventory, Jan. 1, 2007 Heat, light, & powerPlant
33,000 88,000 487,000 25,000 18,000 155,000 38,000 15,000 44,000
(Continued)
80
Part One
Indirect labor Property taxesPlant Sales representatives salaries Sales revenue Factory Supervisors salary SuppliesAdministrative ofce SuppliesPlant Work-in-Process inventory, Dec. 31, 2007 Work-in-Process inventory, Jan. 1, 2007
25,000 34,000 145,000 1,500,000 66,000 16,000 29,000 9,000 23,000
Required Prepare a statement of cost of goods manufactured and an income statement for Household Furnishings for the year ended December 31, 2007, similar to the one in Exhibit 3.15a. 3-52 Cost of Goods Manufactured; Income Statement Consider the following information for Blue Water Equipment, Inc., a manufacturer of sailboat rigging, blocks, and cordage. Advertising expenses Depreciation expenseadmin. ofce Depreciation expenseplant Depreciation expensedelivery trucks Direct materials inventory, beginning Direct materials inventory, ending Direct materials purchases Direct labor Indirect labor Finished goods inventory, beginning Finished goods inventory, ending Insurance on plant Heat and light for plant Repairs on plant building Supervisors salaryplant Suppliesplant Suppliesadministrative ofce Work-in-process inventory, beginning Work-in-process inventory, ending Sales representatives salaries Sales revenue $ 16,000 73,000 197,000 34,000 33,000 28,000 190,000 345,000 128,000 66,000 43,000 44,000 23,000 34,000 85,000 21,000 42,000 14,000 11,000 216,000 1,675,000
Required Prepare a statement of cost of goods manufactured and an income statement for Blue Water Equipment, Inc. for the year ended December 31, 2007. 3-53 Cost of Goods Manufactured, Calculating Unknowns The following information was taken from the accounting records of Blazek Manufacturing Company. Unfortunately, some of the data were destroyed by a computer malfunction. Case A Sales Finished goods inventory, Jan. 1, 2007 Finished goods inventory, Dec. 31, 2007 Cost of goods sold Gross margin Selling and administrative expenses Operating income Work in process, Jan. 1, 2007 Direct material used Direct labor Factory overhead Total manufacturing costs Work in process, Dec. 31, 2007 Cost of goods manufactured Required $100,000 15,000 16,000 ? 25,000 ? 10,000 ? 18,000 15,000 20,000 ? 7,000 ? Case B $ ? 8,000 ? 43,000 3,000 1,000 2,000 14,000 8,000 9,000 ? 35,000 ? 45,000
Calculate the unknowns indicated by question marks.
Chapter 3
3-54
Cost of Goods Manufactured, Income Statement Norton Industries, a manufacturer of cable for the heavy construction industry, closes its books and prepares nancial statements at the end of each month. The statement of cost of goods sold for April 2007 follows:
NORTON INDUSTRIES
Statement of Cost of Goods Sold For the Month Ended April 30, 2007 ($000 omitted)
Inventory of nished goods, March 31 Cost of goods manufactured Cost of goods available for sale Less inventory of nished goods, April 30 Cost of goods sold
$ 50 790 $840 247 $593
Additional Information
Of the utilities, 80 percent relates to manufacturing the cable; the remaining 20 percent relates to the sales and administrative functions. All rent is for the ofce building. Property taxes are assessed on the manufacturing plant. Of the insurance, 60 percent is related to manufacturing the cable; the remaining 40 percent is related to the sales and administrative functions. Depreciation expense includes the following: Manufacturing plant Manufacturing equipment Ofce equipment $20,000 30,000 4,000 $54,000
The company manufactured 7,825 tons of cable during May 2007. The inventory balances at May 31, 2007, follow: Direct materials inventory $23,000 Work-in-process inventory $220,000 Finished goods inventory $175,000
NORTON INDUSTRIES
Preclosing Account Balances May 31, 2007 ($000 omitted)
Cash and marketable securities Accounts and notes receivable Direct materials inventory (4/30/07) Work-in-process inventory (4/30/07) Finished goods inventory (4/30/07) Property, plant, and equipment (net) Accounts, notes, and taxes payable Bonds payable Paid-in capital Retained earnings Sales Sales discounts Other revenue
54 210 28 150 247 1,140 70 600 100 930 1,488 20 2
(Continued)
82
Part One
Purchases of direct materials Direct labor Indirect factory labor Ofce salaries Sales salaries Utilities Rent Property tax Insurance Depreciation Interest expense Freight-in for materials purchases
510 260 90 122 42 135 9 60 20 54 6 15
Required Based on Exhibit 3.15, prepare the following: 1. Statement of cost of goods manufactured for Norton Industries for May 2007. 2. Income statement for Norton Industries for May 2007. (CMA Adapted)
Solution to SelfStudy Problem
SPARTAN PRODUCTS COMPANY

Statement of Cost of Goods Manufactured For the Year Ended December 31, 2007
Direct materials Direct materials inventory, Jan. 1, 2007 Purchases of direct materials Total direct materials available Direct materials inventory, Dec. 31, 2007 Direct materials used Direct labor Factory overhead Heat, light, and powerPlant SuppliesPlant Property taxesPlant Depreciation expensePlant and equipment Indirect labor Supervisors salaryPlant Total factory overhead Total manufacturing costs Add: Beginning work-in-process inventory, Jan. 1, 2007 Total manufacturing costs to account for Less: Ending work-in-process, Dec. 31, 2007 Cost of goods manufactured
$ 20,000 100,000 $120,000 30,000 $ 90,000 350,000 12,000 4,000 13,000 80,000 5,000 40,000 154,000 $594,000 35,000 $629,000 25,000 $604,000
Chapter 3
SPARTAN PRODUCTS COMPANY

Income Statement For the Year Ended December 31, 2007
Sales revenue Cost of goods sold Finished goods inventory, Jan. 1, 2007 Cost of goods manufactured Total goods available for sale Finished goods inventory, Dec. 31, 2007 Cost of goods sold Gross margin Selling and administrative expenses Sales representatives salaries SuppliesAdministrative ofce Depreciation expenseAdministrative ofce Total selling and administrative expenses Net income
$1,000,000 $ 35,000 604,000 $639,000 40,000 599,000 $ 401,000 190,000 6,000 30,000 226,000 $ 175,000

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BlocherStoutCokinsChen: Cost Management: A Strategic Emphasis, Fourth Edition

I. Introduction to Cost Management

3. Basic Cost Management Concepts

The McGrawHill Companies, 2008

INTRODUCTION TO COST MANAGEMENT

Basic Cost Management Concepts

BlocherStoutCokinsChen: Cost Management: A Strategic Emphasis, Fourth Edition

I. Introduction to Cost Management

3. Basic Cost Management Concepts

The McGrawHill Companies, 2008

Basic Cost Management Concepts 55

Cost Drivers, Cost Pools, and Cost Objects

Cost Assignment and Cost Allocation: Direct and Indirect Costs

BlocherStoutCokinsChen: Cost Management: A Strategic Emphasis, Fourth Edition

I. Introduction to Cost Management

3. Basic Cost Management Concepts

The McGrawHill Companies, 2008

Introduction to Cost Management

BlocherStoutCokinsChen: Cost Management: A Strategic Emphasis, Fourth Edition

I. Introduction to Cost Management

3. Basic Cost Management Concepts

The McGrawHill Companies, 2008

Basic Cost Management Concepts 57

The Flow of Cost Assignment

Direct and Indirect Materials Costs

Direct and Indirect Labor Costs

Other Indirect Costs

BlocherStoutCokinsChen: Cost Management: A Strategic Emphasis, Fourth Edition

I. Introduction to Cost Management

3. Basic Cost Management Concepts

The McGrawHill Companies, 2008

Introduction to Cost Management

Cost Drivers and Cost Behavior

Activity-Based Cost Drivers

1st-Stage Cost Drivers

Activity Cost Pools

2nd-Stage Cost Drivers

Number of people Square footage Hours worked Resource usage

Claims processing Beneficiary services Financial services

Volume of output Hours

Podiatry Medical-Surgical Dental Medical-Special Emergency Medicine Radiology Other

BlocherStoutCokinsChen: Cost Management: A Strategic Emphasis, Fourth Edition

I. Introduction to Cost Management

3. Basic Cost Management Concepts

The McGrawHill Companies, 2008

Basic Cost Management Concepts 59

Volume-Based Cost Drivers

BlocherStoutCokinsChen: Cost Management: A Strategic Emphasis, Fourth Edition

I. Introduction to Cost Management

3. Basic Cost Management Concepts

The McGrawHill Companies, 2008

Introduction to Cost Management

EXHIBIT 3.6 Total Cost and the Relevant

EXHIBIT 3.7 Linear Approximation for Actual Cost

Total cost line

Linear approximation of actual cost behavior

3,500 3,600 Volume of Output

3,500 3,600 Volume of Output

Fixed and Variable Costs