An Introduction to Cost Terms and Purposes

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Learning Objectives
Understand the strategic role of basic cost concepts Explain cost-driver concepts at the activity, volume, structural, and executional levels Explain the cost concepts used in product and service costing Demonstrate how costs flow through the accounting system Prepare and interpret an income statement for both a manufacturing firm and a merchandising firm

Learning Objective 1 Define and illustrate a cost object.

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Why Cost Terms

Need to understand/interpret costs (from accounting reports)the same way across the entire value chain. Standardised understanding of the terms and concepts

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Basic Definitions
A cost is incurred when a firm uses a resource for some purpose

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Cost and Cost Terminology

Cost is a resource sacrificed or forgone to achieve a specific objective. An actual cost is the cost incurred (a historical cost) as distinguished from budgeted costs. A budgeted cost a predicted cost(estimate to help plan).
A cost object is anything for which a separate measurement of costs is desired.
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Cost continued..
Budgeting the future cost is a major aspect of cost accounting Most important assumption is that the budgeted costs are closest to the real/likely costs All factors taken into account Spending less than budget prima facie , means better efficiency in use of resource

Cost Object
A cost object is any product, service, customer, activity, or organizational unit to which costs are assigned for some management purpose

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Cost Object Examples at BMW

Cost Object Product Service Illustration BMW X 5 sports activity vehicle Dealer-support telephone hotline R&D project on DVD system enhancement Herb Chambers Motors, a dealer that purchases a broad range of BMW vehicles Setting up production machines Environmental, Health & Safety

Project
Customer Activity

Department

Cost system, determination of costs to various cost objects

Cost accumulation a collection of cost data in an organized manner Cost assignment a general term that includes gathering accumulated costs to a cost object. This includes:
Tracing accumulated costs with a direct relationship to the cost object and Allocating accumulated costs with an indirect relationship to a cost object

Cost and Cost Terminology

Cost Object Cost Accumulation

Cost Object
Cost Object

Cost Assignment

Tracing
Allocating
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Learning Objective 2 Distinguish between direct costs and indirect costs.

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Direct & Indirect Costs

Direct costs can be conveniently and economically traced (tracked) to a cost object Indirect costs cannot be conveniently or economically traced (tracked) to a cost object. Instead of being traced, these costs are allocated to a cost object in a rational and systematic manner

Cost Examples
Direct Costs
Parts Assembly line wages

Indirect Costs
Electricity Rent Property taxes

Factors Affecting Direct / Indirect Cost Classification

Cost Materiality Availability of information-gathering technology Operational Design

Direct and Indirect Costs

Direct Costs Example: Paper on which Sports Illustrated magazine is printed Indirect Costs Example: Lease cost for Time-Warner building housing the senior editors of its magazine
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COST OBJECT Example: Sports Illustrated magazine

BMW: Assigning Costs to a Cost Object

Direct and Indirect Costs Example

Direct Costs: Maintenance Department $40,000 Personnel Department $20,600 Assembly Department $75,000 Finishing Department $55,000 Assume that Maintenance Department costs are allocated equally among the production departments. How much is allocated to each department?
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Direct and Indirect Costs Example

Maintenance $40,000

Assembly Direct Costs $75,000 $20,000 Allocated

Finishing Direct Costs $55,000 $20,000

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Learning Objective 3 Explain variable costs and fixed costs.

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Cost Behavior
Variable costs changes in total in proportion to changes in the related level of activity or volume Fixed costs remain unchanged in total regardless of changes in the related level of activity or volume Costs are fixed or variable only with respect to a specific activity or a given time period

Cost Behavior, continued

Variable costs are constant on a per-unit basis. If a product takes 5 pounds of materials each, it stays the same per unit regardless of one, ten or a thousand units are produced Fixed costs change inversely with the level of production. As more units are produced, the same fixed cost is spread over more and more units, reducing the cost per unit

Cost Behavior Summarized

Total Dollars
Variable Costs Variable Costs Fixed Costs Change in proportion with output
More output = More cost

Cost Per Unit

Unchanged in relation to output

Unchanged in relation to output

Change inversely with output

More output = lower cost per unit

Cost Behavior Patterns Example

Bicycles by the Sea buys a handlebar at $52 for each of its bicycles. What is the total handlebar cost when 1,000 bicycles are assembled?

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Cost Behavior Patterns Example

1,000 units $52 = $52,000 What is the total handlebar cost when 3,500 bicycles are assembled? 3,500 units $52 = $182,000

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Cost Behavior Patterns Example

Bicycles by the Sea incurred $94,500 in a given year for the leasing of its plant. This is an example of fixed costs with respect to the number of bicycles assembled.

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Cost Behavior Patterns Example

What is the leasing (fixed) cost per bicycle when Bicycles assembles 1,000 bicycles? $94,500 1,000 = $94.50 What is the leasing (fixed) cost per bicycle when Bicycles assembles 3,500 bicycles? $94,500 3,500 = $27
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Cost Behavior Visualized

Other Cost Concepts

Cost Driver a variable that causally affects costs over a given time span Relevant Range the band of normal activity level (or volume) in which there is a specific relationship between the level of activity (or volume) and a given cost
For example, fixed costs are considered fixed only within the relevant range.

Contd Cost Drivers

Costs are assembled into meaningful groups called cost pools (e.g., by type of cost or source) Any factor that has the effect of changing the level of total cost is called a cost driver

Product/Service Costing: Cost Assignment

The process of assigning costs to cost pools or from cost pools to cost objects Direct costs can be conveniently and economically traced to a cost pool or a cost object Indirect costs cannot be traced conveniently or economically to a cost pool or a cost object Because indirect costs cannot be traced, assignment is made through the use of cost drivers (cost allocation) These cost drivers are often called allocation bases

Cost Assignment: General Principles

Costs Electric Motor Materials Handling Supervision Packing Materials Final Inspection Packing Washing Machine Cost Drivers and Cost Assignment Cost Pools Cost Objects

Assembly

Dishwasher

Direct and Indirect Product Costs for a Manufacturer

Direct material costs = cost of materials that can be readily traced to outputs = purchase price of materials + freight purchase discounts + reasonable allowance for scrap and defective units
Indirect material costs = cost of materials that cannot readily be traced to outputs (e.g., rags, lubricants, and small tools) Direct labor costs = labor that can be readily traced to outputs = wages paid plus a reasonable allowance for nonproductive time Indirect labor costs = labor costs that cannot be readily traced to outputs (i.e., they are manufacturing support costs)

Direct and Indirect Product Costs: (continued)

All indirect costs for the manufacturer, including indirect materials, indirect labor, and other indirect items are often combined in a cost pool referred to as overhead (or, factory overhead, or indirect manufacturing costs)

The three main types of costs, direct materials, direct labor, and overhead, are often condensed even further:
Direct materials + Direct labor = Prime costs Direct labor + Overhead = Conversion costs

Relevant Range Example

120000 100000 80000 60000 40000 20000 0 0 1000 2000

Fixed Costs

$94,500

3000 Volume

4000

5000

6000

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Relevant Range Example

Assume that fixed (leasing) costs are $94,500 for a year and that they remain the same for a certain volume range (1,000 to 5,000 bicycles). 1,000 to 5,000 bicycles is the relevant range.

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Relevant Range Visualized

Relationships of Types of Costs

Direct

Variable

Fixed

Indirect
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Cost Drivers

The cost driver of variable costs is the level of activity or volume whose change causes the (variable) costs to change proportionately. The number of bicycles assembled is a cost driver of the cost of handlebars.

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Cost Behavior: Cost Drivers

Cost drivers provide two roles for the management accountant
Assigning costs to cost objects Explaining cost behavior, i.e., how total cost changes as the cost driver changes

There are four types of cost drivers:

Activity-based Volume-based Structural Executional

Cost Drivers (continued)

Activity-based cost (ABC) drivers are developed at a detailed level of operations using activity analysisa cost driver is determined for each activity Volume-based cost drivers relate to the amount produced or quantity of service provided: The relationship between the cost driver and total cost is approximately linear within the relevant range

Volume Based Cost Drivers: Classification by Behavior

Fixed cost is the portion of total cost that does not change with changes in output Variable cost is the change in total cost associated with each change in quantity of the cost driver Mixed cost is used to refer to a total cost figure that includes both a fixed and variable component Step costs vary with the cost driver but do so in steps

Cost Drivers (continued)

Structural cost drivers facilitate strategic decision making because they involve plans and decisions that have longterm effects
Scale, experience, technology, and complexity are considered in hopes of improving competitive position

Executional cost drivers facilitate operational decision making by focusing on short-term effects
Workforce involvement, design of the production process, and supplier relationships are considered in an attempt to reduce costs

Learning Objective 4

Interpret unit costs cautiously.

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A Cost Caveat
Unit costs should be used cautiously. Since unit costs change with a different level of output or volume, it may be more prudent to base decisions on a total dollar basis.
Unit costs that include fixed costs should always reference a given level of output or activity Unit Costs are also called Average Costs

Multiple Classification of Costs

Costs may be classified as:
Direct / Indirect, and Variable / Fixed

These multiple classifications give rise to important cost combinations:

Direct & Variable Direct & Fixed Indirect & Variable Indirect & Fixed

Multiple Classification of Costs, Visualized

Total Costs and Unit Costs Example

What is the unit cost (leasing and handlebars) when Bicycles assembles 1,000 bicycles? Total fixed cost $94,500 + Total variable cost $52,000 = $146,500 $146,500 1,000 = $146.50

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Total Costs and Unit Costs Example

$146,500
200000

Total Costs

150000 100000 50000 0 0 500 Volume

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$94,500

1000

1500

Use Unit Costs Cautiously

Assume that Bicycles management uses a unit cost of $146.50 (leasing and wheels). Management is budgeting costs for different levels of production. What is their budgeted cost for an estimated production of 600 bicycles? 600 $146.50 = $87,900
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Use Unit Costs Cautiously

What is their budgeted cost for an estimated production of 3,500 bicycles? 3,500 $146.50 = $512,750
What should the budgeted cost be for an estimated production of 600 bicycles?

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Use Unit Costs Cautiously

Total fixed cost $ 94,500 Total variable cost ($52 600) 31,200 Total $125,700 $125,700 600 = $209.50
Using a cost of $146.50 per unit would underestimate actual total costs if output is below 1,000 units.
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Use Unit Costs Cautiously

What should the budgeted cost be for an estimated production of 3,500 bicycles? Total fixed cost $ 94,500 Total variable cost (52 3,500) 182,000 Total $276,500 $276,500 3,500 = $79.00

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Learning Objective 5 Distinguish among manufacturing companies, merchandising companies, and service-sector companies.
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Manufacturing

Manufacturing companies purchase materials and components and convert them into finished goods.
A manufacturing company must also develop, design, market, and distribute its products.
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Merchandising

Merchandising companies purchase and then sell tangible products without changing their basic form.

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Merchandising

Service companies provide services or intangible products to their customers. Labor is the most significant cost category.

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Different Types of Firms

Manufacturing-sector companies create and sell their own products Merchandising-sector companies product resellers Service-sector companies provide services (intangible products)

Learning Objective 6 Differentiate between inventoriable costs and period costs.

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Types of Inventory
Manufacturing-sector companies typically have one or more of the following three types of inventories: 1. Direct materials inventory
2. Work in process inventory (work in progress) 3. Finished goods inventory
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Types of Inventory
Merchandising-sector companies hold only one type of inventory the product in its original purchased form. Service-sector companies do not hold inventories of tangible products.

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Types of Manufacturing Inventories

Direct Materials resources in-stock and available for use Work-in-Process (or progress) products started but not yet completed. Often abbreviated as WIP Finished Goods products completed and ready for sale

Classification of Manufacturing Costs

Direct materials costs Direct manufacturing labor costs

Indirect manufacturing costs

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Types of Product Costs

Also known as Inventoriable Costs
Direct Materials Direct Labor Indirect Manufacturing factory costs that are not traceable to the product. Other common names for this type of cost include Manufacturing Overhead costs or Factory Overhead costs.

Learning Objective 7 Describe the three categories of inventories commonly found in manufacturing companies.

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Inventoriable Costs

Inventoriable costs (assets) become cost of goods sold

after a sale takes place.

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Accounting Distinction Between Costs

Inventoriable costs product manufacturing costs. These costs are capitalized as assets (inventory) until they are sold and transferred to Cost of Goods Sold.
Period costs have no future value and are expensed as incurred.

Period Costs
Period costs are all costs in the income statement other than cost of goods sold. Period costs are recorded as expenses of the accounting period in which they are incurred.

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Multiple Classification of Period Costs, Visualized

Cost Object: Number of Mortgage Loans Example: fees paid to property appraisal company for each mortgage loan Cost Object: Number of Mortgage Loans Example: Salary paid to executives in mortgage loan department to develop new mortgage loan products Cost Object: Number of Mortgage Loans Example: Postage paid to deliver mortgage loan documents to lawyers/ homeowners Cost Object: Number of Mortgage Loans Example: cost to the bank of sponsoring annual golf tournament

Cost Flows
The Cost of Goods Manufactured and the Cost of Goods Sold section of the Income Statement are accounting representations of the actual flow of costs through a production system.
Note the importance of inventory accounts in the following accounting reports, and in the cost flow chart

Flow of Costs Example

Bicycles by the Sea had $50,000 of direct materials inventory at the beginning of the period. Purchases during the period amounted to $180,000 and ending inventory was $30,000. How much direct materials were used?

$50,000 + $180,000 $30,000 = $200,000

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Flow of Costs Example

Direct labor costs incurred were $105,500.
Indirect manufacturing costs were $194,500.

What are the total manufacturing costs incurred?

Direct materials used Direct labor Indirect manufacturing costs Total manufacturing costs $200,000 105,500 194,500 $500,000
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Flow of Costs Example

Assume that the work in process inventory at the beginning of the period was $30,000, and $35,000 at the end of the period. What is the cost of goods manufactured? Beginning work in process Total manufacturing costs Ending work in process Cost of goods manufactured $ 30,000 500,000 35,000 $495,000
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Flow of Costs Example

Assume that the finished goods inventory at the beginning of the period was $10,000, and $15,000 at the end of the period. What is the cost of goods sold? Beginning finished goods Cost of goods manufactured Ending finished goods Cost of goods sold $ 10,000 495,000 15,000 $490,000
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Flow of Costs Example

Work in Process 30,000 495,000 200,000 105,500 194,500 35,000

Beg. Balance Direct mtls. used Direct labor Indirect mfg. costs Ending Balance

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Flow of Costs Example

Finished Goods 10,000 490,000 495,000 15,000 Cost of Goods Sold 490,000
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Work in Process 495,000

Cost Flows Visualized

Manufacturing Company
BALANCE SHEET
Inventoriable Costs

INCOME STATEMENT

Revenues
Finished Goods Inventory
when sales occur deduct

Materials Inventory

Cost of Goods Sold

Equals Gross Margin deduct

Work in Process Inventory

Period Costs
Equals Operating Income
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Merchandising Company
BALANCE SHEET
Inventoriable Costs

INCOME STATEMENT

Revenues
Inventory
when sales occur deduct

Merchandise Purchases

Cost of Goods Sold

Equals Gross Margin deduct

Period Costs
Equals Operating Income
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Prime Costs

Direct Materials

Direct Labor

Prime Costs

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Prime Costs
What are the prime costs for Bicycles by the Sea? Direct materials used + Direct labor = $200,000 105,500 $305,000

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Conversion Costs

Direct Labor

Manufacturing Overhead

Conversion Costs

Indirect Labor

Indirect Materials

Other
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Conversion Costs
What are the conversion costs for Bicycles by the Sea? Direct labor $105,500 + Indirect manufacturing costs 194,500 = $300,000

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Multiple-Step Income Statement

Cost of Goods Manufactured

Recap of Inventoriable Costs and Period Costs

BALANCE SHEET INCOME STATEMENT Revenues Beginning Inventory When sales occur

deduct
Cost of Goods Sold (an expense) Equals Gross Margin Deduct Design Cost Purchasing Dept. Cost Marketing cost Distribution cost Customer service cost

Inventoriable Merchandise Costs Purchases

Merchandise Inventory

Ending Inventory

Period Cost

Equals Operating Income

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Other Cost Considerations

Prime cost is a term referring to all direct manufacturing costs (labor and materials) Conversion cost is a term referring to direct labor and factory overhead costs, collectively Overtime labor costs are considered part of overhead due to the inability to precisely know the true cause of these costs

Different Definitions of Costs for Different Applications

Pricing and product-mix decisions may use a super cost approach (comprehensive) Contracting with government agencies very specific definitions of cost for cost plus profit contracts Preparing external-use financial statements GAAP-driven product costs only

Measuring Costs Requires Judgment

Manufacturing labor-cost classifications vary among companies. The following distinctions are generally found: Direct manufacturing labor Manufacturing overhead

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Measuring Costs Requires Judgment

Manufacturing overhead
Indirect labor Managers salaries Payroll fringe costs

Forklift truck operators (internal handling of materials)

Janitors Overtime premium Rework labor Idle time

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Measuring Costs Requires Judgment

Overtime premium is usually considered part of overhead. Assume that a worker gets $18/hour for straight time and gets time and one-half for overtime.

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Measuring Costs Requires Judgment

How much is the overtime premium?
$18 50% = $9 per overtime hour

If this worker works 44 hours on a given week, how much are his gross earnings? Direct labor 44 hours $18 = $792 Overtime premium 4 hours $ 9 = 36 Total gross earnings $828
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Learning Objective 8 Explain why product costs are computed in different ways for different purposes.

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Many Meanings of Product Cost

A product cost is the sum of the costs assigned to a product for a specific purpose. 1. Pricing and product emphasis decisions
2. Contracting with government agencies 3. Preparing financial statements for external reporting under generally accepted accounting principles
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Different Definitions of Costs for Different Applications

Learning Objective 9 Present key features of cost accounting and cost management.

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A Framework for Cost Management

Three features of cost accounting and cost management: 1. Calculating the costs of products 2. Obtaining information 3. Analyzing information

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Three Common Features of Cost Accounting & Cost Management

1. Calculating the cost of products, services, and other cost objects 2. Obtaining information for planning & control, and performance evaluation 3. Analyzing the relevant information for making decisions