Chapter 2

Basic Cost Management Concepts and Accounting for Mass Customization Operations

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Learning Objective 1

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Process of Management
Strategy Formulation
Planning

Managers need cost information to perform each of these functions.

Control Decision Making

Directing

What Do We Mean By a Cost?

A cost is the measure of resources given up to achieve a particular purpose.

Basic Cost Terminology

Cost sacrificed resource to achieve a specific objective Actual cost a cost that has occurred Budgeted cost a predicted cost Cost object anything of interest for which a cost is desired or an entity (e.g., a specific product, service, or department) to which a cost is assigned is commonly known as a cost object.

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

Project
Customer

Activity
Department

Setting up production machines

Environmental, Health & Safety

How Does a Cost System Determine The Costs Of 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

Learning Objective 2

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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)

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

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.

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.

Product 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.

Learning Objective 3

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Cost Classifications on Financial Statements Income Statement

Product Costs Period Costs

Cost of goods sold

Operating expenses

Cost Classifications on Financial Statements Balance Sheet

Merchandiser
Current Assets
Cash Receivables Prepaid Expenses Merchandise Inventory

Manufacturer
Current Assets
Cash Receivables Prepaid Expenses Inventories
Raw Materials Work in Process Finished Goods

Cost Classifications on Financial Statements Balance Sheet

Merchandiser
Current Assets
Cash Receivables Prepaid Expenses Merchandise Inventory

Manufacturer
Current Assets
Cash materials Those waiting to Receivables be processed. Prepaid Expenses Inventories
Raw Materials Work in Process Finished Goods

Cost Classifications on Financial Statements Balance Sheet

Merchandiser
Current Assets
Cash Receivables Prepaid Expenses Merchandise Inventory

Manufacturer
products material to Cash which some labor Receivables and/or overhead has been added. Prepaid Expenses Inventories
Raw Materials Work in Process Finished Goods

Partially complete Current Assets

Cost Classifications on Financial Statements Balance Sheet

Merchandiser
Current Assets
Cash Receivables Prepaid Expenses Merchandise Inventory

Manufacturer
Current Assets
Cash Receivables Completed products awaiting sale. Prepaid Expenses Inventories
Raw Materials Work in Process Finished Goods

Learning Objective 4

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Types of Production Processes

Type of Production Process Job Shop Description of Process Low volume Little standardization Unique products Multiple products Low volume A few major products Higher volume High volume Many standardized components Customized combination of components High volume Highly standardized commodity products Example of Manufacturer Disney

Batch

Caterpillar

Assembly Line

Ford

Mass Customization

Dell

Continuous Flow

Exxon

Learning Objective 5

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Manufacturing Costs
Direct Labor Direct Material Manufacturing Overhead

The Product

Direct Material
Cost of raw material that is used to make, and can be conveniently traced, to the finished product.
Example: Steel used to manufacture the automobile.

Direct Labor
Cost of salaries, wages, and fringe benefits for personnel who work directly on manufactured products.
Example: Wages paid to an automobile assembly worker.

Manufacturing Overhead
All other manufacturing costs
Indirect Material Indirect Labor Other Costs

Materials used to support the production process. Examples: lubricants and cleaning supplies used in an automobile assembly plant.

Manufacturing Overhead
All other manufacturing costs
Indirect Material Indirect Labor Other Costs

Cost of personnel who do not work directly on the product. Examples: maintenance workers, janitors and security guards.

Manufacturing Overhead
All other manufacturing costs
Indirect Material Indirect Labor Other Costs

Examples: depreciation on plant and equipment, property taxes, insurance, utilities, overtime premium, and unavoidable idle time.

Overtime premium
Is the extra compensation paid to an employee who works beyond the time normally scheduled. For example a technician earns $16 per hour. The technician works 48 hours during a week instead of the scheduled time of 40 hours.

Idle time
Is the time that is not spent productively by an employee due to such events as equipment breakdowns or new setups for production runs. For example, during one 40 hour shift, a machine breakdown resulted in idle time of 11/ 2 hours and a power failure idled workers for an additional hour. Suppose an employee earns $14 per hour, the employee wages for the week will be classified in two categories.

Classifications of Costs in Manufacturing Companies

Manufacturing costs are often combined as follows:
Direct Material Direct Labor Manufacturing Overhead

Prime Cost

Conversion Cost

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

Manufacturing Cost Flows

Direct Material Direct Labor Manufacturing Overhead Work in Process Inventory

Manufacturing Cost Flows

Direct Material Direct Labor Manufacturing Overhead Finished Goods Inventory Work in Process Inventory

Manufacturing Cost Flows

Direct Material Direct Labor Manufacturing Overhead Finished Goods Inventory Cost of Goods Sold Work in Process Inventory

Learning Objective 6

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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

Cost Flows Visualized

Cost of Goods Manufactured

Multiple-Step Income Statement

Schedule of Cost of Goods Manufactured

Beginning work-inprocess inventory is carried over from the Comet Computer Corporation prior period. Schedule of Cost of Goods Manufactured
Raw material used Direct labor Total manufacturing overhead Total manufacturing costs Add: Work-in-process inventory, January 1 Subtotal Deduct: Work-in-process inventory, December 31 Cost of goods manufactured $ $ $ $ 134,980 50,000 230,000 414,980 120 415,100 100 415,000

Exh. 2-9

Schedule of Cost of Goods Manufactured

Comet Computer Corporation Schedule of Cost of Goods Manufactured Raw material used Direct labor Total manufacturing overhead Total manufacturing costs Add: Work-in-process inventory, January 1 Subtotal Deduct: Work-in-process inventory, December 31 Cost of goods manufactured $ $ $ $ 134,980 50,000 230,000 414,980 120 415,100 100 415,000

Exh. 2-7

Schedule of Cost of Goods Manufactured

Computation of Cost of Raw Material Used Raw-material inventory, January 1 Add: Purchases of raw materials $ Raw material available for use Deduct: Raw material inventory, December 31 Raw material used

Exh. 2-7

6,000 134,000 140,000 5,020

Comet Computer Corporation

$ 134,980

Schedule of Cost of Goods Manufactured Raw material used Direct labor Total manufacturing overhead Total manufacturing costs Add: Work-in-process inventory, January 1 Subtotal Deduct: Work-in-process inventory, December 31 Cost of goods manufactured $ $ $ $ 134,980 50,000 230,000 414,980 120 415,100 100 415,000

Schedule of Cost of Goods Manufactured

Include all direct labor costs incurred during the current period. Comet Computer Corporation
Schedule of Cost of Goods Manufactured Raw material used Direct labor Total manufacturing overhead Total manufacturing costs Add: Work-in-process inventory, January 1 Subtotal Deduct: Work-in-process inventory, December 31 Cost of goods manufactured $ $ $ $ 134,980 50,000 230,000 414,980 120 415,100 100 415,000

Exh. 2-7

Schedule of Cost of Goods Manufactured

Computation of Total Manufacturing Overhead $ Indirect material Indirect labor Depreciation on factory Depreciation on equipment

Exh. 2-7

10,000 40,000 90,000 70,000

Utilities 15,000 Comet Computer Corporation Insurance 5,000 Schedule of Cost of Goods Manufactured Total manufacturing overhead $ 230,000

Raw material used Direct labor Total manufacturing overhead Total manufacturing costs Add: Work-in-process inventory, January 1 Subtotal Deduct: Work-in-process inventory, December 31 Cost of goods manufactured

134,980 50,000 230,000

$ $ $

414,980 120 415,100 100 415,000

Schedule of Cost of Goods Manufactured

Exh. 2-9

Ending work-in-process inventory contains the cost of unfinished goods, and is reported in the Comet Computer Corporation current assets section of Manufactured Schedule of Cost of Goods the balance sheet.
Raw material used Direct labor Total manufacturing overhead Total manufacturing costs Add: Work-in-process inventory, January 1 Subtotal Deduct: Work-in-process inventory, December 31 Cost of goods manufactured $ $ $ $ 134,980 50,000 230,000 414,980 120 415,100 100 415,000

Income Statement for a Manufacturer

Exh. 2-7

Comet Computer Corporation Income Statement For the Year Ended December 31, 20X2 Sales revenue Less: Cost of goods sold Gross margin Selling and administrative expenses Income before taxes Income tax expense Net income $ $ $ $ 700,000 415,010 284,990 174,490 110,500 30,000 80,500

Income Statement for a Manufacturer

Comet Computer Corporation Schedule of Cost of Goods Sold For the Year Ended December 31, 20X2 Finished-goods inventory, Jan. 1 Add: Cost of goods manufactured $ 200 415,000 415,200 190 Cost of goods available for sale Comet Computer Corporation Deduct Finished-goods inventory, Dec. 31 Cost of goods sold

Exh. 2-7

Income Statement $ 415,010 For the Year Ended December 31, 20X2 $ $ $ $

Sales revenue Less: Cost of goods sold Gross margin Selling and administrative expenses Income before taxes Income tax expense Net income

700,000 415,010 284,990 174,490 110,500 30,000 80,500

Learning Objective 7

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Learning Objective 8

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

Cost Classifications
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.

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

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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

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Cost Behavior Summarized

Variable Costs Variable Costs

Total Dollars Total Dollars Change in Change in proportion with proportion with output output
More output = More cost More output = More cost

Cost per Unit Per Unit

Unchanged in relation to output

Fixed Costs Fixed Costs

Change Change inversely inversely with Unchanged in with output Unchanged in output relation to output More output = lower cost relation to output More output = lower cost per unit
per unit
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Total Variable Cost Example

Your total long distance telephone bill is based on how many minutes you talk.
Total Long Distance Telephone Bill Minutes Talked

Variable Cost Per Unit Example

The cost per long distance minute talked is constant. For example, 5 cents per minute.
Per Minute Telephone Charge Minutes Talked

Total Fixed Cost Example

Your monthly basic telephone bill probably does not change when you make more local calls.
Monthly Basic Telephone Bill Number of Local Calls

Fixed Cost Per Unit Example

The average cost per local call decreases as more local calls are made.
Monthly Basic Telephone Bill per Local Call Number of Local Calls

Cost Behavior Visualized

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Cost Classifications
Summary of Variable and Fixed Cost Behavior
Cost Variable In Total Total variable cost changes as activity level changes. Total fixed cost remains the same even when the activity level changes. Per Unit Variable cost per unit remains the same over wide ranges of activity. Fixed cost per unit goes down as activity level goes up.

Fixed

Other Cost Concepts

Cost Driver a variable that causally affects costs over

a given time span. A cost driver is any event or activity that causes costs to be incurred. Possible examples include labor hours in manual assembly work and machine hours in automated production settings or cost of petrol is determined largely by the number of miles driven.

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Identifying Cost Drivers

Cost Driver Examples

Activities that Machining operations Machine hours cause costs Setup hours to be Setup incurred are called Production scheduling Manufacturing orders Inspection Pieces inspected cost drivers.
Purchasing Shop order handling Valve assembly support Purchase orders Shop orders Customer requisitions

Activity

Cost Driver

Other Cost Concepts

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.

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Relevant Range Visualized

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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

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Learning Objective 9

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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

Direct and Indirect Costs

Direct costs
Costs that can be easily 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.

Direct and Indirect Costs

A cost can be direct to the department, but indirect to units of product produced in the department.
Example: department managers salary.

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

Factors Affecting Direct / Indirect Cost Classification

Cost Materiality : The smaller the amount of the cost, the less likely that it is economically feasible to trace that cost to a particular cost object. Availability of information-gathering technology: For example bar-code technology has made it possible to trace just about any material used in the manufacturing process. Operational Design: A cost used for a specific cost object can be readily traced.

BMW: Assigning Costs to a Cost Object

Cost Examples
Direct Costs
Parts Assembly line wages

Indirect Costs
Electricity Rent Property taxes

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
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Multiple Classification of Costs, Visualized

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Learning Objective 10

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Controllable and Uncontrollable Costs

A cost that can be significantly influenced by a manager is a controllable cost.
Cost item Manager Classificaton Controllable Uncontrollable

Cost of food used Restaurant in a restaurant manager Cost of national advertising by a restaurant chain Restaurant manager

Opportunity 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 cost of attending college for one year is $20,000.

Sunk 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.

Differential Costs
Costs that differ between alternatives.
Example: You can earn $1,500 per month in your hometown or $2,000 per month 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

Marginal Costs and Average Costs

The extra cost incurred to produce one additional unit. The total cost to produce a quantity divided by the quantity produced.

Marginal and average costs are largely a function of cost behavior -- variable and fixed costs.

Costs and Benefits of Information

Costs

Benefits

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

 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

Different Definitions of Costs for Different Applications

Different Definitions of Costs for Different Applications

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