BUS 315

Chapter 2
FALL 2014
Basic Cost
Management Concepts
and Accounting for
Mass Customization
Operations
McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All

Chapter 2 Learning Objectives

Learn how to Define and Categorize cost measures
Understand where costs appear in Financial Statements for
manufacturing, merchandising, and service organizations
Practice assigning instances of cost to various cost objects
Chart the debit and credit pattern of cost flows through the
organization as production takes place
Prepare a Schedule of Cost of Goods Manufactured
Prepare a Schedule of Cost of Goods Sold & Inc. Statement
Identify appropriate Cost Drivers to explain cost behavior
Comprehend and provide examples of additional cost
classifications germane to management analytical & decision
purposes fixed vs. variable, direct vs. indirect, controllable vs.
uncontrollable, opportunity costs, sunk costs, differential costs,
marginal & average costs
1-2

Process of Management
Decision
Making

Strategy
Formulation

Managers need accurate and timely

cost information to perform each of these
functions described in the first chapter

Control

Planning
Directing
2-3

What Do We Mean By a Cost?

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

2-4

Product Costs, Period Costs

and Expenses
Product costs are costs associated with
goods for sale (Inventoriable) until the time
period during which the products are sold, at
which time these costs become expenses.
Period costs are costs that are expensed
during the time period in which they are
actually incurred.
Expenses are the consumption of assets for
the purpose of generating revenue.
2-5

Cost Classifications on Financial

Statements Income Statement
Product Costs

Period Costs

Included as part of:

Included as part of:

Cost of goods sold

Operating expenses

2-6

Cost Classifications on Financial

Statements Balance Sheet
Manufacturer

Merchandiser
Current Assets

Cash
Receivables
Prepaid Expenses
Merchandise
Inventory

Current Assets

Cash
Receivables
Prepaid Expenses
Inventories
Raw Materials
Work in Process
Finished Goods
2-7

Cost Classifications on Financial

Statements Balance Sheet
Manufacturer

Merchandiser
Current Assets

Cash
Receivables
Prepaid Expenses
Merchandise
Inventory

Current Assets
Cash materials are
Those
waiting to be
Receivables
processed.
Prepaid Expenses
Inventories

Raw Materials
Work in Process
Finished Goods
2-8

Cost Classifications on Financial

Statements Balance Sheet
Merchandiser
Current Assets

Cash
Receivables
Prepaid Expenses
Merchandise
Inventory

Manufacturer

Partially complete
Current
Assets
products material to
Cash
which
some labor
and/or
overhead has
Receivables
been added.
Prepaid Expenses
Inventories

Raw Materials
Work in Process
Finished Goods
2-9

Cost Classifications on Financial

Statements Balance Sheet
Manufacturer

Merchandiser
Current Assets

Cash
Receivables
Prepaid Expenses
Merchandise
Inventory

Current Assets
Cash
Completed
products
Receivables
awaiting sale.
Prepaid Expenses
Inventories

Raw Materials
Work in Process
Finished Goods
2-10

Types of Production Processes

Type of Production
Process

Description of
Process

Example of
Manufacturer

Job Shop

Low volume
Little standardization
Unique products

Disney

Batch

Multiple products
Low volume

Caterpillar

Assembly Line

A few major products

Higher volume

Ford

Mass Customization

High volume
Many standardized components
Customized combination of components

Dell

Continuous Flow

High volume
Highly standardized commodity products

Exxon

Note differing production characteristics (text page 77) for each of these 5
generic types of manufacturing. Ch. 2 = mass customization. Ch. 3 = job
shop and batch. Ch. 4 = continuous flow. Assembly line is a hybrid model
combining some features of the other types of costing in varying proportions.
2-11

Total Manufacturing Costs

Direct
Material

Direct
Labor

Manufacturing
Overhead

The
Product
2-12

Direct Material
Cost of raw materials and purchased parts
that are used to make,
and can be conveniently traced to,
the finished product.
Example:
Example:
Mittal
Mittal Steel
Steel used
used to
to
manufacture
manufacture
the
theauto
auto body,
body,
O.E.
O.E.tires
tirespurchased
purchased
from
from Michelin
Michelin
http://www.imanet.org/PDFs/Public/Research/SMA/Definition%20and%2
0Measurement%20of%20Direct.pdf
2-13

Direct Labor
Cost of salaries, wages, and fringe
benefits for personnel who work
directly on manufactured products.
Accountants may have differing opinions
about what directly means in different
firms.
Example:
Example:
Wages
Wagespaid
paid to
to an
an
automobile
automobileassembly
assembly
worker.
worker.
Didnt waste his time going to college!

2-14

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.

2-15

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.
2-16

Manufacturing Overhead
All other manufacturing costs
Indirect
Material

Indirect
Labor

Other
Costs

Examples: depreciation
on plant and equipment,
factory property taxes,
insurance, utilities,
overtime premium, and
unavoidable idle time.
2-17

Examples of Direct Material Cost

for XOM and CAKE.
XOM (refinery division to produce automotive gasoline)
Crude oil purchased from parent company
via transfer price mechanism
Additives & catalysts used in chemical
cracking and refining process
CAKE (each store considered as a meal production unit)
Raw flour, dairy, vegetable, meat purchases
Packaged food purchases from Sysco,
whether processed, frozen, or canned
1-18

Examples of Direct Labor Cost

for XOM and CAKE.
XOM (oil exploration & drilling division)
Field Geologists with knowledge of where
and how to drill & ability to evaluate results
Specialized construction crews to assemble
the rigs and initiate drilling process
CAKE (each store considered as a meal production unit)
Kitchen food preparation & cooking crew
Up-front server staff taking orders, delivering
plates & interacting with customers
1-19

Examples of Manufacturing Overhead

(Indirect Material)
for XOM and CAKE.
XOM (pipeline & transport division)
Maintenance & repair materials for tankers
Food & hygiene supplies for tanker crews
Fuel for pipeline inspection vehicles
CAKE (each store considered as a meal production unit)
Condiments, tableware, flatware, glassware
Paper products, cleaning supplies & products
for dining area, kitchen, bathrooms, etc.
1-20

Examples of Manufacturing Overhead

(Indirect Labor)
for XOM and CAKE.
XOM (marketing division)
IT department, art & layout specialists,
secretarial and mailroom staff
Media buyers, agency liaisons, finance and
budgeting staff for marketing campaigns
CAKE (each store considered as a meal production unit)
Cleaning crew, security guard, front cashier
Corporate parent contribution to manager &
staff training, software maintenance, etc.
1-21

Examples of Manufacturing Overhead

(Other Overhead Costs)
for XOM and CAKE.
XOM (retail division both company owned and agents)
Depreciation on delivery trucks, storage
depots and all associated equipment
EPA and other environmental safety
compliance inspection costs
CAKE (each store considered as a meal production unit)
Depreciation on furniture, kitchen equipment
Property taxes, liability insurance, building &
furnishings insurance, heat & electric, rent
1-22

Accepted Cost Terminology in

Manufacturing Contexts
Manufacturing Costs are often combined together
for descriptive convenience as follows:
Direct
Material

Direct
Labor

Prime
Cost

Manufacturing
Overhead

Conversion
Cost

2-23

Manufacturing Cost Flows

Within a Firm
Direct Material
credit inventory, debit WIP

Direct Labor
credit wages payable,
debit WIP

Manufacturing
Overhead
We shall learn about using
a separate total M.O.
costs ledger in chapter 3

Work in
Process
Inventory
Finished
Goods
Inventory

Cost of
Goods
Sold

Remember this simple accounting phrase to apply at each stage of

the ledger-based accumulation of product costs as they flow
through the firm from initial input to final product:

Debit in and then Credit out

2-24

Schedule of
Cost of Goods Manufactured
Lets put all this cost information into a standard internal
accounting report format known as a CGM schedule.
Then lets explain each line in the schedule
Comet Computer Corporation
Schedule of Cost of Goods Manufactured
Raw material used

Direct labor
Total manufacturing overhead

134,980
50,000
230,000

Total manufacturing costs

Add: Work-in-process inventory, January 1

414,980
120

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

415,100
100

Cost of goods manufactured

415,000
2-25

How much material was actually used this period in manufacturing?

Make the pre- & post-inventory comparison, as in Financial Accounting!
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 Comet
used

Computer Corporation

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

$ 134,980

Schedule of Cost of Goods Manufactured

Raw material used

Direct labor
Total manufacturing overhead

134,980
50,000
230,000

Total manufacturing costs

Add: Work-in-process inventory, January 1

414,980
120

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

415,100
100

Cost of goods manufactured

415,000
2-26

Schedule of
Cost of Goods Manufactured
Include all direct labor costs incurred during the
current period.
Known from
timeComputer
cards & Corporation
accounting records
Comet
Schedule of Cost of Goods Manufactured
Raw material used

Direct labor
Total manufacturing overhead

134,980
50,000
230,000

Total manufacturing costs

Add: Work-in-process inventory, January 1

414,980
120

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

415,100
100

Cost of goods manufactured

415,000
2-27

Comet Computer Corporation

Schedule of Cost of Goods Manufactured
Raw material used

Direct labor
Total manufacturing overhead

134,980
50,000
230,000

Total manufacturing costs

Add: Work-in-process inventory, January 1

414,980
120

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

415,100
100

Cost of goods manufactured

415,000

Total of these 3 amounts is Total Manufacturing Costs! As in slide # 12.

But now, we must convert mfg. costs to cost of goods manufactured.
2-28

How do we make that conversion? Same method as

before, except now we reference the change in WIP
inventory instead of the change in raw materials.
Beginning work-inprocess inventory is
carried over from Bal.
Sheet of prior period.
Ending work-in-process inventory contains
the inventoriable cost of unfinished
goods, as reported in the current assets
section of the year-end balance sheet.

2-29

 This makes total sense for XOM

But Wait! Theres no such thing as WIP Goods
Inventory for CAKE!
You cant store a partially completed meal in WIP
inventory, & plan to sell it in a future period, can you?
Such items are simply not Inventoriable
This is generally true for all service firms (seats on a
flight?, haircuts?), and specifically true for CAKE
which combines elements of Manufacturing and
Services Provision within its business model
Important accounting implication for CAKE:
Total Mfg Costs are = Cost of Goods Manufactured
1-30

Income Statement for a Manufacturer

To get to the bottom line, we need to convert
the computed CGM into Cost of Goods Sold
Comet Computer Corporation
Income Statement
For the Year Ended December 31, 20X2
Sales revenue
Less: Cost of goods sold

700,000
415,010

Gross margin
Selling and administrative expenses

284,990
174,490

Income before taxes

Income tax expense

110,500
30,000

Net income

80,500
2-31

How do we make that conversion? Once again, the

same method as the first time, except now we reference
the change in Finished Goods inventory instead of the
change in raw materials.
Comet Computer Corporation
Schedule of Cost of Goods Sold
For the Year Ended December 31, 20X2
Finished-goods inventory, Jan. 1
Comet Computer
Add: Cost of goods manufactured

Cost of goods available for sale

Income Statement
Deduct Finished-goods inventory, Dec. 31

For
Cost of goods sold

200

Corporation 415,000

415,200
190

the Year Ended December 31,

$ 20X2
415,010

Sales revenue
Less: Cost of goods sold

700,000
415,010

Gross margin
Selling and administrative expenses

284,990
174,490

Income before taxes

Income tax expense

110,500
30,000

Net income

80,500
2-32

 Once again, this makes total sense for XOM

But Wait! Theres no such thing as Finished
Goods Inventory for CAKE!
What you cant do to a partially completed meal (carry it
over to the next period), is even less possible for the
finished goods category
Such items are just not Inventoriable
Service firms create products simultaneously with
selling them. Hence, primarily operating expenses
But as weve seen, its still very useful for CAKE &
XOM to accumulate costs by cost object or activity
Accounting implication for CAKE:
Mfg Cost = CGM = COGS = operating expenses
1-33

Examples of Period Costs

for XOM and CAKE.
XOM (the corporate entity)
D.C. lobbying expenses to maintain current
depletion drilling allowances and tax rates
Geologist training and laboratory expenses
Charity donations & artistic events support

CAKE (the corporate entity)

National media advertising and couponing
Strategic planning team the guys deciding
about expansion to Czech Republic & Poland
Financial statement preparation and auditing
1-34

Activities that cause costs to be

incurred are called COST DRIVERS:

A cost driver is a characteristic of an activity or event

that causes costs to be incurred by that activity or
event. Identifying the best driver is often quite 2-35

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.

Just what IS this guys problem?

He needs a rest home visit.

Total fixed costs remain

unchanged when activity
changes, at least within a
relevant range of activity.
2-36

Total Variable Cost Example

Total Pay-Per-View
Bill

Your total cable pay-per-view bill is based on

how many movies you watch.

Pay-Per-View
Movies Watched
2-37

Variable Cost Per Unit Example

Per Movie Charge

The cost per movie watched is constant. For

example, $4.00 per movie.

Movies Watched
2-38

Total Fixed Cost Example

Monthly Charge for

HBO Bill

Your monthly cable bill probably does not change (at

least within the relevant range) when you watch
movies on channels that you have elected to be paid
on a monthly basis (HBO).

Number of HBO Movies

Watched
2-39

Fixed Cost Per Unit Example

Monthly HBO Bill per Movie

Watched

The average cost per HBO movie decreases

as more HBO movies are watched.

Number of HBO
Movies Watched
2-40

Cost Classifications
Summary of Variable and Fixed Cost Behavior
Cost

In Total

Per Unit

Variable

Total variable cost changes

as activity level changes.

Variable cost per unit

remains the same over
wide ranges of activity.

Total fixed cost remains

the same even when the
activity level changes.

Fixed cost per unit

goes down as activity
level goes up.

Fixed

1-41

Direct and Indirect Costs

Direct costs

Indirect costs

Costs that can be

easily and conveniently
traced to a product or
department.

Costs that must be

allocated in order to
be assigned to a
product or department.

Example: cost of paint

in the paint department
of an automobile
assembly plant.

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

Only Ferraris or Lamborghinis should be this color!

2-42

Direct and Indirect Costs

Ideally, managerial accountants would like to
describe cost objects in such a manner that all
costs associated with object were direct costs
Thats not possible for cost/benefit reasons
Designation often depends on your perspective
Hotel managers salary is direct to the hotel site, but
indirect for the portion allocated to concierge or
restaurant or housekeeping or security, etc.
But its still part of the budget for each
of the relevant departments of the
hotel and must be considered when
measuring performance.
Edgewater Beach Hotel Chicago, c. 1928

1-43

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

Manager

Classificaton

Cost of food used Restaurant Controllable

in a restaurant
manager
Cost of national Restaurant Uncontrollable
advertising by a manager
restaurant chain
2-44

Controllable vs. Uncontrollable costs

In principle, every cost ought to be controllable by
someone in the organization.
Who can best influence a cost at the moment? Time
and prior commitments often matter.
5 years ago, the Board & CEO approved a new plant. As long as
the plant remains on the balance sheet, the annual depreciation
expense is beyond anyones immediate control once the
estimated lifetime & a proper depreciation method were selected.

Designation often depends on your perspective

Manager of an individual CAKE restaurant treats her accounting
allocated share of national advertising as uncontrollable
For the national marketing director, its a perfectly controllable
amount subject to analysis and cost/benefit thinking
In contrast, local manager may have local promotion discretion
which cannot be overruled, short of her failure to reach other
more general performance targets. Remember Empowerment?
1-45

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
CHF 50,000 per year.
Your opportunity cost
of attending college for
one year is CHF 50,000.

Opportunity costs are just as real as are out-ofpocket costs when considering resource
allocation decisions. Equivalent amounts, cash
paid or not!

Is this you in May 2014? Or 15? Or 16?

(Read text page 90 ticket example carefully.)

2-46

Sunk Costs
Definition: All costs incurred in the past that cannot
be changed by any decision made now or in the
future are sunk costs.
Sunk costs irrelevant and should not ever
be considered in making current decisions.

You Wish!

Example: You bought an automobile that cost CHF

190,000 two years ago. Your driving license has been
suspended. The CHF 190,000 cost is sunk because
whether you drive it, park it, trade it, or sell it, you
cannot change the CHF 190,000 cost.
Nonetheless, psychology experiments verify that
people violate this all the time. Still, its always bad
management behavior and not at all resource
effective to let sunk costs influence decisions.
2-47

Differential Costs
Costs that differ between alternatives.
Example: You can earn CHF 3,500 per month in
your hometown or CHF 4,000 per month in a
distant city. Your commuting costs are estimated
to be CHF 50 per month in your hometown and
CHF 400 per month to the city.
What is your differential cost?
CHF 400 CHF 50 = CHF 350

Is the job worth that?

2-48

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.
2-49

Costs and Benefits of Information

Costs

Benefits

More information does not always mean greater

decision-making benefits if information overload results.
Now that you understand costs, it would be a good idea
to once again review slides 27 - 29 from chapter 1.
2-50

Chapter 2 Focus on Ethics Case, WorldCom, Inc.

If you are not already familiar with the sad and sordid tale of Bernie Ebbers &
the WorldCom bankruptcy case from a bit more than a decade ago, you
should read about it. A first-rate tale of stupidity, greed and corruption in the
late 90s fast-growing Telecoms industry, aided and abetted on Wall Street by
Shearson Lehman, Andersen auditing, hedge funds, & a host of characters.
It started with the deliberate mis-classification of period costs within the
reported financial statements. Hence the relationship to chapter 2 of the text.
If you wrongly classify period expenses as capital expenditures, then you (1)
overstate your assets and (2) ignore/delay expenses with the result of
overstating net income. No wonder everyone loved the stock! Later to cover
tracks, the CEO & CFO began to invent revenues over late night pizza.
An internal audit began the downfall and the outside auditors should have
known better, but claimed they were duped. Billions of $$ of wealth were
destroyed. If you wonder why managerial accountants seem so obsessive
about measuring costs correctly, just be thankful that not all corporate types
behave like Bernie Ebbers & Scott Sullivan did!

1-51