2 Basic Concepts of

Cost Management
and
Accounting for
Mass Customized Operations

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All

 Process of Management
Strategy Planning
Formulation

Managers need cost information to

perform each of these functions.

Control Directing
Decision
Making

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What Do We Mean By a Cost?

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

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 Expense:

Expense is the cost incurred when an asset is

used up or is sold for the purpose of
generating revenue
An Asset used up
Depreciation treated as expense for using an
asset
When goods are sold
Cost of goods sold is treated as expense
against revenue

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 Cost Classifications on Financial
Statements – Income Statement
The term product cost and period cost are used to
describe the timing with which various expenses are
recognised in the books of accounts.

Product costs are costs associated with goods for

sale until the products are sold, at which time the
costs are recognised as expenses.

Product Costs

Cost of goods sold

(Material, Labour, Mfg Exp)
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Product Costs, Period Costs and Expenses

Period costs are costs that are expensed during

the time period in which they are incurred.

Period Costs
(Other than product costs)

Operating expenses
(other than cost cost of goods sold
(Selling, Admin, Distribn. R&D)

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 Product Costs, Period Costs and Expenses

Period Costs
Product Costs (Other than product costs)

Cost of goods sold

Operating expenses
(Material, Labour, Mfg Exp) (Selling, Admin, Distribn. R&D)

Recognised as expense Treated as expenses on

expiry of accounting
when goods are sold period

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Cost Classifications on Financial
Statements – Balance Sheet
Current assets Current Assets
Merchandiser Manufacturer
Current Assets
Current Asset
– Cash
● Cash
– Receivables
● Receivables
– Prepaid Expensesid
Expenses ● Prepaid Expenses
Expenses ● Inventories
– Merchandise Raw Materials
Inventory Work in Process
Finished Goods

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Cost Classifications on Financial
Statements – Balance Sheet

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

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Cost Classifications on Financial
Statements – Balance Sheet

Merchandiser Manufacturer
PartiallyAssets
Current complete
Current Assets products – material to
● Cash
– Cash which some labor
– Receivables and/or overhead has
● Receivables
been added.
● Prepaid Expenses
– Prepaid Expenses
● Inventories
– Merchandise
Inventory Raw Materials
Work in Process
Finished Goods

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Cost Classifications on Financial
Statements – Balance Sheet

Merchandiser Manufacturer
Current Assets Current Assets
– Cash ● Cash
– Receivables Completed products
● Receivables

● awaiting sale.
Prepaid Expenses
– Prepaid Expenses
● Inventories
– Merchandise
Inventory Raw Materials
Work in Process
Finished Goods

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 Manufacturing Costs

Direct Direct
Material Manufacturing
Labor Overhead

The
Product

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 Direct Material

Cost of raw material that is used to

make, and can be conveniently
traced, to the finished product.
Example:
Example:
Steel
Steel used
used to
to
manufacture
manufacture
the
theautomobile.
automobile.

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 Direct Material
Direct materials (used at factory)
All materials or components specifically purchased,
produced or taken from stores
Primary packing material like carton, wrapping,
cardboards boxes
process materials, production materials,
stores materials, construction materials
e.g Silicon chip for computer system
Tyres, gear assembly, window glasses, steering
wheels for a car
Wood for furniture
Plastic for plastic toys,
Bricks, marble, cement, steel, for a construction project
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 Direct Labor

Cost of salaries, wages, and fringe

benefits for personnel who work
directly on manufactured products.

Example:
Example:
Wages
Wagespaid
paidto
toan
an
automobile
automobileassembly
assembly
worker.
worker.

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

Materials used to support

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

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 Indirect materials
That may be part of product but can be traced at
great cost and inconvenience are called indirect
materials
e.g. Glue, nails, Welding material

Or like repair material that can not be identified with

any one unit of product because it is used for
benefit of all products rather than any specific
product
• lubricants, oil, consumable stores

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

Cost of personnel who

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

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 Indirect labour: (factory)
cost that can not be traced physically to
the creation of the product i.e wages of all
employees who assist in mfg. process
e.g.
• Maintenance people,
• production supervisors,
• canteen workers,
• medical staff,
• engineers,
• security guards
who are essential to production process but it is
impractical to accurately relate their cost to specific
product

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

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

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 Other overheads

Indirect mfg. expenses

Taxes, Power, water , lighting,

employee fringe benefits like
health and insurance, pension benefits,
inventory handling costs

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 Non Manufacturing costs
period costs
• Selling and distribution costs
Costs to market and sell finished products
Or Order getting and order filling costs
Advertisement.
Salesmen salary and commission,
costs for warehousing the finished goods
Shipping, transportation charges to deliver
goods,

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 Non Manufacturing costs
period costs
Administrative costs
Costs for general management of the Firm
Top management expenses,
Accounting expenses,
General secretarial services,
Public relations
Stationery expenses
Telephone and General expenses etc.

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 Classifications of Costs in
Manufacturing Companies
Manufacturing costs are often
combined as follows:

Direct Direct Manufacturing

Material Labor Overhead

Prime Conversion
Cost Cost

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 Manufacturing Cost Flows
Direct Material
Work in
Direct Labor Process
Inventory
Manufacturing
Overhead

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

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

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 Exh.

Schedule of Cost of Goods 2-7

Manufactured

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

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 Exh.

Schedule of Cost of Goods

2-7

Computation of Cost of Raw Material Used

Manufactured
Raw-material inventory, January 1
Add: Purchases of raw materials
$ 6,000
134,000
Raw material available for use 140,000
Deduct: Raw material inventory, December 31 5,020
Raw material used $ 134,980
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

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 Exh.

Schedule of Cost of Goods 2-7

Manufactured
Include all direct labor
costs incurred during the
Cometcurrent
Computerperiod.
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

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 Schedule of Cost of Goods Manufactured Exh.
2-7

Computation of Total Manufacturing Overhead

Indirect material $ 10,000

Indirect labor 40,000
Depreciation on factory 90,000
Depreciation on equipment 70,000
Comet Computer Corporation
Utilities 15,000
Insuranceof Cost of Goods Manufactured
Schedule 5,000
Total manufacturing overhead $ 230,000
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

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 Exh.

Schedule of Cost of Goods 2-9

Manufactured
Beginning work-in-
process inventory is
carried over from the
Comet Computer Corporation
prior period.
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

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 Exh.

Schedule of Cost of Goods 2-9

Manufactured
Ending work-in-process inventory
contains the cost of unfinished
Cometgoods,
ComputerandCorporation
is reported in the current
Schedule ofassets
Cost of section of the balance sheet.
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

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 Exh.

Income Statement for a 2-7

Manufacturer

Comet Computer Corporation

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

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 Exh.

Income Statement for a Manufacturer 2-7

Comet Computer Corporation

Schedule of Cost of Goods Sold
For the Year Ended December 31, 20X2

Finished-goods inventory, Jan. 1 $ 200

Add: Cost of goods manufactured 415,000
Cost of goods available
Cometfor sale
Computer Corporation 415,200
Deduct Finished-goods inventory, Dec. 31 190
Income Statement
Cost of goods sold $ 415,010
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

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 Identifying Cost Drivers

Cost Driver Examples

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

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Cost Classifications

Cost behavior means

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

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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.

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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

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Variable Cost Per Unit Example
The cost per long distance minute talked is
constant. For example, 5 cents per minute.

Telephone Charge
Per Minute

Minutes Talked

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 Total Fixed Cost Example
Your monthly basic telephone bill probably
does not change even if you do not make
any calls
Telephone Bill
Monthly Basic

Number of Local Calls

upto 100 per month
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 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
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 Cost Classifications

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Total variable cost changes Variable cost per unit

Variable as activity level changes. remains the same over
wide ranges of activity.
Total fixed cost remains Fixed cost per unit
Fixed the same even when the goes down as activity
activity level changes. level goes up.

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 Direct and Indirect Costs
Direct costs Indirect costs
• Costs that can be • Costs that must be
easily and allocated in order to
conveniently traced to be assigned to a
a product or product or
department. department.
• Example: cost of • Example: cost of
paint in the paint national advertising
department of an for an airline is
automobile assembly indirect to a particular
plant. flight.

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 Direct and Indirect Costs
• 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.

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

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 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.

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 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

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Cost unit
a unit or quantity of product for which costs may be
ascertained or with which costs may be identified
e.G Brick work- per 1000 bricks
Collieries- per tonne of coal
Textile mills- per yard / lb. of cloth or yarn
Electricity companies –per unit of elec. Watt hour unit
Transport co.- per tonne, per passenger
Steel mills- per tonne of steel mass Weight-
Dairy products- kilogram, litre, tonne,
Length/dimension- metre, yard, M3
Number - number of pieces / units
Hotel- per room per day,
nursing home- per bed per day
Gas- per cft / m3 ,
timber - per m3

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Marginal Costs and Average
Costs

The total cost to

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

Marginal and average costs are

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

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AND, NOW…

???????
We believe
that it’s more
than
enough!!!!
Do you feel happy
at the end?
End of Chapter 1

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