Ch 2 Introduction to Cost Terms

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McGraw-Hill/Irwin

Introduction to Cost Terms

And Purposes

2 Chapter Chapter TwoTwo

1-2

Process of ManagementProcess of Management

DecisionMaking

DirectingControl

PlanningStrategy Formulation

Managers need cost information toperform each of these functions.

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What Do We Mean By a Cost?What Do We Mean By a Cost?

A costis the measure ofresources givenup to achieve a

particular purpose.

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Product Costs, Period Costs and ExpensesProduct Costs, Period Costs and Expenses

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

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

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

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Product CostsProduct Costs

Cost of goods sold

Period CostsPeriod Costs

Operating expenses

Cost Classifications on Financial Cost Classifications on Financial Statements – Income StatementStatements – Income Statement

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MerchandiserMerchandiser Current Assets

– Cash

– Receivables

– Prepaid Expenses

– Merchandise Merchandise InventoryInventory

ManufacturerManufacturer Current Assets

CashCash ReceivablesReceivables Prepaid ExpensesPrepaid Expenses InventoriesInventories

Raw MaterialsRaw Materials

Work in ProcessWork in Process

Finished GoodsFinished Goods

Cost Classifications on Financial Cost Classifications on Financial Statements – Balance SheetStatements – Balance Sheet

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– Cash

– Receivables









Those materials waiting to be processed.

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– Cash

– Receivables









Partially complete products – material to

which some labor and/or overhead has

been added.

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– Cash

– Receivables









Completed products awaiting sale.

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Manufacturing CostsManufacturing Costs

TheProduct

DirectLabor

DirectMaterial

Manufacturing Overhead

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Direct MaterialDirect Material

Example:Steel used tomanufacture

the automobile.

Example:Steel used tomanufacture

the automobile.

Cost of raw material that is used tomake, and can be convenientlytraced, to the finished product.

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Cost of salaries, wages, and fringebenefits for personnel who work

directly on manufactured products.

Direct LaborDirect Labor

Example:Wages paid to an

automobile assemblyworker.

Example:Wages paid to an

automobile assemblyworker.

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All other manufacturing costs

Manufacturing OverheadManufacturing Overhead

Materials used to support the production process. Examples: lubricants and

cleaning supplies used in an automobile assembly plant.

IndirectLabor

IndirectMaterial

OtherCosts

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Cost of personnel who do not work directly on

the product. Examples: maintenance workers, janitors and security

guards.

IndirectLabor

IndirectMaterial

OtherCosts

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Examples: depreciation on plant and equipment,

property taxes, insurance, utilities,

overtime premium, and unavoidable idle time.

IndirectLabor

IndirectMaterial

OtherCosts

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Classifications of Costs in Classifications of Costs in Manufacturing CompaniesManufacturing Companies

PrimeCost

ConversionCost

Manufacturing costs are oftencombined as follows:

DirectMaterial

DirectLabor

ManufacturingOverhead

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Manufacturing Cost FlowsManufacturing Cost Flows


Direct Material

Direct Labor Work in Process Inventory

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Direct Material

Direct Labor

FinishedGoods

Inventory

Work in Process Inventory

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Direct Material

Direct Labor

FinishedGoods

Inventory

Cost of GoodsSold

Work in Process Inventory

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Comet Computer Corporation

Schedule of Cost of Goods Manufactured

Raw material used 134,980$

Direct labor 50,000

Total manufacturing overhead 230,000

Total manufacturing costs 414,980$

Add: Work-in-process inventory, January 1 120

Subtotal 415,100$

Deduct: Work-in-process inventory, December 31 100

Cost of goods manufactured 415,000$

Schedule of Cost of Goods Schedule of Cost of Goods ManufacturedManufactured

Exh. 2-7

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Direct labor 50,000




Subtotal 415,100$




Computation of Cost of Raw Material Used

Raw-material inventory, January 1 6,000$

Add: Purchases of raw materials 134,000

Raw material available for use 140,000

Deduct: Raw material inventory, December 31 5,020


Exh. 2-7

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Direct labor 50,000




Subtotal 415,100$



Schedule of Cost of Goods Schedule of Cost of Goods ManufacturedManufacturedInclude all direct labor

costs incurred during the current period.

Exh. 2-7

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Direct labor 50,000




Subtotal 415,100$



Schedule of Cost of Goods ManufacturedSchedule of Cost of Goods Manufactured

Computation of Total Manufacturing Overhead

Indirect material 10,000$

Indirect labor 40,000

Depreciation on factory 90,000

Depreciation on equipment 70,000

Utilities 15,000

Insurance 5,000

Total manufacturing overhead 230,000$

Exh. 2-7

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Direct labor 50,000




Subtotal 415,100$




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

prior period.

Exh. 2-9

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Direct labor 50,000




Subtotal 415,100$




Ending work-in-process inventory contains the cost of unfinished

goods, and is reported in the current assets section of the balance sheet.

Exh. 2-9

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Income Statement for a Income Statement for a ManufacturerManufacturer


Income Statement

For the Year Ended December 31, 20X2

Sales revenue 700,000$

Less: Cost of goods sold 415,010

Gross margin 284,990$

Selling and administrative expenses 174,490

Income before taxes 110,500$

Income tax expense 30,000

Net income 80,500$

Exh. 2-7

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Income Statement


Sales revenue 700,000$

Less: Cost of goods sold 415,010

Gross margin 284,990$

Selling and administrative expenses 174,490

Income before taxes 110,500$

Income tax expense 30,000

Net income 80,500$

Income Statement for a ManufacturerIncome Statement for a ManufacturerComet Computer Corporation

Schedule of Cost of Goods Sold


Finished-goods inventory, Jan. 1 200$

Add: Cost of goods manufactured 415,000

Cost of goods available for sale 415,200

Deduct Finished-goods inventory, Dec. 31 190

Cost of goods sold 415,010$

Exh. 2-7

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Identifying Cost DriversIdentifying Cost Drivers

Cost Driver Examples

Activity Cost Driver

Machining operations Machine hoursSetup Setup hoursProduction scheduling Manufacturing ordersInspection Pieces inspectedPurchasing Purchase ordersShop order handling Shop ordersValve assembly support Customer requisitions

Activities thatcause costs to be

incurred are calledcost drivers.

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Cost ClassificationsCost Classifications

Cost behavior means how a cost will react to changes in the level of business activity.

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

change when activity changes.

– Total fixed costs remain unchanged when activity changes.

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Total Variable Cost ExampleTotal Variable Cost Example

Your total long distance telephone bill is based on how many minutes you talk.

Minutes Talked

Tot

al L

ong

Dis

tanc

eT

elep

hone

Bill

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Variable Cost Per Unit ExampleVariable Cost Per Unit Example

Minutes Talked

Per

Min

ute

Tel

eph

on

e C

har

ge

The cost per long distance minute talked is constant. For example, 5 cents per minute.

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Total Fixed Cost ExampleTotal Fixed Cost Example

Your monthly basic telephone bill probably does not change when you make more local

calls.

Number of Local Calls

Mo

nth

ly B

asic

T

elep

ho

ne

Bill

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Fixed Cost Per Unit ExampleFixed Cost Per Unit Example

Number of Local Calls

Mo

nth

ly B

asic

Tel

eph

on

e B

ill p

er L

oca

l Cal

l

The average cost per local call decreases as more local calls are made.

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Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

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

wide ranges of activity.

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

activity level changes. level goes up.

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Direct and Indirect CostsDirect and Indirect CostsDirect costs

• Costs that can beeasily and conveniently traced to a product or department.

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

Indirect costs

• Costs that must be allocated in order to be assigned to a product or department.

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

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• A cost can be direct to the department, but indirect to units of product produced in the department.– Example: department manager’s salary.

• Tracing costs directly to departments or products helps to identify and eliminate non-value added costs.

Direct and Indirect CostsDirect and Indirect Costs

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A cost that can be significantly influencedby a manager is a controllable cost.

Controllable andControllable andUncontrollable CostsUncontrollable Costs

Cost item Manager Classificaton

Cost of food used Restaurant Controllablein a restaurant manager

Cost of national Restaurant Uncontrollableadvertising by a managerrestaurant chain

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Opportunity CostOpportunity Cost

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

not attending college,you could be earning$20,000 per year. Your opportunity costof attending college for one year is $20,000.

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Sunk CostsSunk Costs

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

– Example: You bought an automobile that cost $12,000 two years ago. The $12,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $12,000 cost.

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Differential CostsDifferential Costs

Costs that differ between alternatives.

Example: You can work in your home town or in a nearby city.Your commuting costs are $50 per month in your

hometown and $300 per month to the city.

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

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Marginal Costs and Average Marginal Costs and Average CostsCosts

The extra costincurred to produceone additional unit.

The total cost toproduce a quantity

divided by thequantity produced.

Marginal and average costs arelargely a function of cost behavior

-- variable and fixed costs.

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Costs and Benefits of InformationCosts and Benefits of Information

Costs Benefits

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

Documents

Ch 2 Introduction to Cost Terms