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An Introduction to Cost Terms ,cost classification and Purposes
© 2009 Pearson Prentice Hall. All rights reserved.
© 2009 Pearson Prentice Hall. All rights reserved.
What is cost?All businesses have costs. A cost is any spending on goods and services for the business. Or
'the resources consumed or used up to achieve a certain objective' or
Cost – sacrificed resource to achieve a specific objective or
A cost is incurred when a firm uses a resource for some purpose.
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Basic Cost TerminologyActual cost – a cost that has occurred
Budgeted cost – a predicted cost
Cost object – anything of interest for which a cost is desired
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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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
Basic Definitions
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There are four main ways to classify costs (“different costs for different purposes”):
For product and service costing (GAAP) For strategic decision-making (cost-driver
analysis)For planning and decision-making For control/feedback
Cost Concepts: Overview
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Direct cost‘expenditure that can be attributed to a
specific cost unit’ CIMA Official Terminology
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Indirect cost‘expenditure on labour, materials or
services that cannot be economically identified with a specific saleable cost
unit’. CIMA Official Terminology
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The process of assigning costs to cost pools or from cost pools to cost objectsDirect 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
Product/Service Costing: Cost Assignment
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Cost Assignment: General Principles
Costs
Electric Motor
Materials Handling
Supervision
PackingMaterials
Cost Pools
AssemblyAssembly
PackingPacking
Cost Objects
Dishwasher
Washing Machine
FinalInspection
Cost Drivers and Cost Assignment
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Period CostPeriod costs are not manufacturing cost. However,
they are incurred and paid based on the periodThey are deductible from revenue.Example: Rent, salaries, telephone etc.
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Product CostsProduct costs are manufacturing costs They are incurred for the manufacturing of goodsThey include direct material, direct labour, and
manufacturing overheads. Example: direct material, labour cost,
manufacturing overhead etc.
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Product costs include only the costs necessary to complete the product at the manufacturing step in the value chain (manufacturing) or to purchase and transport the product to the location of sale (merchandising)
Period costs include all other costs incurred by the firm in managing or selling the product (indirect costs outside the manufacturing step of the value chain)
Product and Service Costing Concepts (GAAP)
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Types of Manufacturing InventoriesDirect 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
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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., 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 for a Manufacturer
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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:
Prime cost is a term referring to all direct manufacturing costs (labor and materials)Direct materials + Direct labor = “Prime costs”
Direct and Indirect Product Costs: Further Comments
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Other Cost Considerations
Direct labor + Overhead = “Conversion costs”
Conversion cost is a term referring to direct labor and factory overhead costs, collectively or
cost of converting raw material to finished goods = Production cost- direct material.
Conversion cost which converts the direct material into finished goods
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Costs for Strategic Decision-Making
Inventory valuation (GAAP) vs. strategic costing?
Cost drivers provide two roles for the management accountantAssigning costs to cost objectsExplaining cost behavior, i.e., how total cost
changes as the cost driver changesThere are four types of cost drivers:
Activity-basedVolume-basedStructuralExecutional
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Cost Drivers
Activity-based cost (ABC) drivers are developed at a detailed level of operations using activity analysis–a 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
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Structural cost drivers facilitate strategic decision making because they involve plans and decisions that have long-term effectsScale, experience, technology, and complexity are
considered in hopes of improving competitive position
Executional cost drivers facilitate operational decision making by focusing on short-term effectsWorkforce involvement, design of the production
process, and supplier relationships are considered in an attempt to reduce costs
Cost Drivers (continued)
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Cost classification by behaviour'the way in which cost per unit of output is
affected by fluctuations in the level of activity'.
Variable costFixed cost
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Factors Affecting Direct / Indirect Cost ClassificationCost MaterialityAvailability of information-gathering
technologyOperational Design
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Cost Information for Short-term Planning: Classification by Behavior
What is meant by “cost behavior”?Common classifications of cost behavior:
Fixed (capacity) 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
Applications:BudgetingCost-Volume-Profit analysis (profit planning)
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Fixed Costs
$6,600
$6,500
$3,000
3,500 3,600Units of the Cost Driver
Total Cost
Total Fixed Cost
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Variable Costs
Total Variable Cost
$6,600
$6,500
$3,000
Units of the Cost Driver
Total Cost Total CostTotal Cost
3,500 3,600
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Relevance is the most important characteristic for information used in decision makingRelevant costs have two properties: they differ for
each decision option and they will be incurred in the future
Opportunity cost is the benefit lost when choosing one option precludes receiving the benefits from the alternative option
Sunk costs are costs that have been incurred or committed in the past and are therefore irrelevant in current decision making
Short-Run Decision-Making Cost Concepts
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There are three other characteristics that are important for planning and decision making
Accuracy (and the need to monitor internal accounting controls)
Cost and value of cost information (the cost of information should be monitored by the management accountant to ensure that costs do not outweigh the associated benefits)
Timeliness (often involves sacrificing in the other two areas)
Qualitative Characteristics of Cost Information for Planning
and Decision-Making
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Controllability is a basic consideration in evaluating managers and providing feedbackA cost is considered “controllable” if the
manager or employee has discretion in choosing to incur it or can influence the amount in a short period of time
The controllability of some costs is subject to debate, for example, changes in interest rates, foreign exchange fluctuations, or changes in state or local taxes; should the manager be responsible for these changes?
Cost Information for Control/Feedback Purposes
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There are different ways to classify (or categorize) cost information, depending on the information needs of management (“different costs for different purposes”):To prepare financial statements (GAAP)For strategic decision-makingFor short-term planningFor short-term decision-makingFor control/feedback purposes
Product and service costing (GAAP) focuses on differentiating product costs from period costs
Costs flow through three inventory accounts in a manufacturing firm; merchandising firms have one inventory account
Chapter Summary
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Chapter Summary (continued)
• For strategic decision-making, we think about costs in terms of the following types of drivers: activity-based, volume-based, structural, and executional
• Cost concepts used in short-term planning relate to the behavior of costs (i.e., how they change in response to one or more activities)
• For decision-making we generally classify costs into one of the following categories: relevant, opportunity, or sunk– Relevance, accuracy, timeliness, and value that exceeds cost
are important information characteristics
• Controllability and risk preferences must be assessed when using cost information for management and operational control
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Different Types of FirmsManufacturing-sector companies – create and
sell their own productsMerchandising-sector companies – product
resellersService-sector companies – provide services
(intangible products)
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Cost FlowsThe 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
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Cost FlowsDemonstrate how costs flow through the formal accounting system?
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Opportunity CostNot recordable in the books of account but are
considered in every decisions of managers.It is the amount of benefit that is sacrificed
when one alternative is selected.
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The economic problemThe basic economic problem is the scarcity of
social resources to satisfy human wants and needs.
An economic system must make choices about the allocation of resources among the many possible uses.
The economic system also chooses how the goods and services are distributed -- who gets what.
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Cost and the necessity of choice, even in health care
When a high percentage of all spending in our economy is for health care, we wonder if some of the resources going into health care could be better used elsewhere, as
other kinds of health care, that might give more benefit for the same resources
other kinds of health-enhancing investments besides health care, such as education
consumption goods and services that might enhance our lives more than spending on certain kinds of health care would,
or as investments outside of health care that might improve our future ability to produce goods and services more than some investments in health do.
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Opportunity cost Opportunity cost is the most fundamental
cost concept. The opportunity cost of doing or getting
something is: what you could have done or gotten instead
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Opportunity cost is what you forgo.Example: The opportunity cost of buying a
box of Cracklin Oat Bran is one-and-a half boxes of Wheat Chex, if that's your second favorite cereal.
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Opportunity cost is what you forgo.Example: Your opportunity cost for taking
this class includes: Whatever else you could have bought with
your tuition and fee moneyplus
the work, family participation, and recreation that you are not doing because you are here.
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Opportunity cost is not resources usedStrictly speaking, the cost of something is not
the resources used up to get it. Instead, the cost is what else you could have
done with those resources. Resources have value only because you can
use them to make goods and services that have value.
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Sunk costsCosts are the cost incurred a result of past
decisions.Cost can not be changed by taking operating
decisionSunk costs are irrelevant from decision making.Sunk costs are depreciation of assets, lease rent
etc.
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