McGraw-Hill/Irwin

Chapter 17

Full Costs and Their Uses

Copyright © 2011. The McGraw-Hill Companies. All Rights Reserved.

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Cost

• A measurement,• In monetary terms,• Of the amount of resources used for

some purpose.

Cost Object

Product, project, organizational unit, or other activity or purpose for which costs are measured.

Can be defined broadly or narrowly. E.g., an entire production run of jeans vs.

one pair of jeans.

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Full Cost

All the resources used for a cost object. Includes:

Direct production costs. Indirect production costs. Selling cost. General and administrative cost.

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Direct Costs

Costs specifically traced to (caused by) the cost object.

E.g., denim cloth used in jean manufacturing.

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Indirect Costs

Costs associated with (or caused by) two or more cost objects jointly.

Not possible or feasible to trace directly to a single cost object.

Terms “direct” and “indirect” are only meaningful in context of a specific cost object (i.e., can change as cost object(s) change).

Allocation of Indirect Costs

Indirect costs are allocated to departments or organizational units using the following steps:

1. Choose an allocation base for the indirect cost.

2. Compute an indirect cost allocation rate.3. Allocate the indirect cost.

Choose an Allocation Base

Cost or Expense BasisIndirect labour Time spentBuilding amortization Square metresHeat, lights, etc. Square metresJanitorial services Square metresPayroll and personnel # of employeesPurchasing # of purchase orders placed

Choose an Allocation Base• Lets consider a medical clinic which has 2 tenants,

a doctor and dentist • Rent for the year is $120,000.• Total square metres occupied by the clinic is 1200.• What is the rent per square metre?• $120,000 ÷ 1,200 = $100• The rent would be allocated to the doctor and

dentist bases on how much space they use in the clinic

Allocate the Indirect CostThe doctor occupies 900 square metres.

How much rent is allocated to the doctor?

• 900 × $100 = $90,000 How much rent is allocated to the dentist?• 1,200 – 900 = 300 square metres• 300 × $100 = $30,000

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What is GAAP Cost?

Limited guidance. Any “systematic and rational” method

of cost assignment is allowed.

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Elements of product cost

Cost organized into categories (i.e., materials, labor, overhead, etc.).

Collected in a product costing system. Accumulates and reports costs of product

cost objects. Cost object can be a physical product or a

service.

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Direct Material Cost

Quantities of material that can be specifically identified with a cost object in an economically feasible manner.

Also know as raw materials. Usually priced at unit price of material.

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Direct Labor Cost

Quantities of labor that can be specifically identified with a cost object in an economically feasible manner.

Usually priced at unit price of labor.

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Overhead Costs All other production costs. Indirect production costs.

Indirect materials. Indirect labor. Utilities. Maintenance. Depreciation. Insurance. Taxes. Etc.

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Other Cost Terminology

Conversion costs. All production costs needed to convert

direct material into finished goods. Direct labor cost + overhead cost.

Full production cost. Also called inventory cost, product cost. Direct materials + direct labor +

overhead.

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Nonproduction Costs

Also known as period costs. Includes:

Selling costs. Marketing (order-getting) costs. Logistics (order-filling) costs.

General and administrative costs. Research and development costs. Interest costs.

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Summary

• Full cost: Production costs.

Direct materials. Direct labor. Overhead.

Nonproduction costs. Selling cost. General and administrative cost. Research and development costs. Interest costs.

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Product Costing Systems

• Involves accounting for the:1. Acquisition of resources needed for

production.2. Production process.3. Sale of completed products.

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Production Inventory Accounts

• Materials inventory.– Increased by acquisition of materials.– Decreased when materials are used in production.

• Work in process inventory.– Collects all costs of production– Increased when material, labor, and overhead are added

to (used in) the production process.– Decreased when product is completed.

• Finished goods inventory.– Increased when product is completed.– Decreased when product is sold.

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Overhead Account

Clearing account (i.e., temporary holding account). Increased (debit) by incurrence of overhead costs

(e.g., usage of indirect materials, incurrence of indirect labor costs, factory utilities cost, depreciation cost on factory assets, etc.).

Decreased (credit) when costs are applied to the product(s) being produced (i.e., placed into Work in Process Inventory).

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Product Costing Systems: Visual Representation

Materials Inventory

Work in Process

Inventory

Wages Payable

Overhead

Finished Goods

Inventory

Cost of Sales

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Nonmanufacturing Companies• Merchandising companies.

• Since cost of goods sold is invoice cost, only requires simple system (relative to manufacturing company).

Service organizations. Cost object is “job” (e.g., “patient” in a

hospital, “vehicle” in a auto repair shop, “client” for an law office.

Job cost record kept for each job. Cost record serves as work in process

inventory account.

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Nonprofit Organizations

• E.g., healthcare, educational, performing arts, government.

• Cost object is programs not products.• Similar cost accounting practices to profit

organizations.

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Life Cycle Costing

• Cost system considers all of a product’s costs from “birth to abandonment.”– Birthing costs.

• Necessary to develop product and bring it to market.

• Includes research and development, product testing, initial market creation, salesperson training.

– Abandonment costs.• Incurred after product is discontinued and doesn’t

produce significant revenues.• Disposal of plant and equipment, severance costs,

restoring polluted land.

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Uses of Full Costs

Financial reporting. Determine cost of inventory and cost of

sales. Analysis of profitability.

Entire business and parts of the business (e.g., product, product line, plant, division, sales territory, etc.).

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Uses of Full Costs

Product pricing. Cost plus contracts.• Contribution pricing.

• Price set below full cost, but above variable costs.

Setting regulated prices (e.g., utilities, cable).

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Uses of Full Costs

Product pricing. Normal pricing.

Recover direct costs, recover applicable indirect costs, make a satisfactory profit.

Applicable for differentiated products (i.e., has distinct characteristics.

For undifferentiated products (i.e., commodities), price set by market.

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Uses of Full Costs Product pricing.

• Time and material pricing.• Price material cost and labor cost separately (i.e.,

material loading charge, billing rate).• Used by repair shops, physicians, lawyers,

consultants, etc.

• Target pricing (costing).• Price set first (based on competitive strategy).• Then product is designed to cover full cost and

profit.

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Uses of Full Costs

Strategic positioning. Strategic cost management.

Use of cost management to help better understand one’s advantages and disadvantages relative to competitors.

Covers entire value chain.