Chapter 2

Basic Cost Management Concepts and Accounting for Mass Customization Operations

McGraw-Hill/Irwin

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

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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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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.

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Cost Classifications on Financial Statements Income Statement

Product Costs Period Costs

Cost of goods sold

Operating expenses

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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

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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

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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

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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

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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
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Manufacturing Costs
Direct Labor Direct Material Manufacturing 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: Steel used to manufacture the automobile.

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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.

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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.

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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.
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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.
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Classifications of Costs in Manufacturing Companies

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

Prime Cost

Conversion Cost

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Manufacturing Cost Flows

Direct Material Direct Labor Manufacturing Overhead Work in Process Inventory

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Manufacturing Cost Flows

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

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Manufacturing Cost Flows

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

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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

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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
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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

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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

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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

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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
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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
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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

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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

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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.
Per Minute Telephone Charge Minutes Talked
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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
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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 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

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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.
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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 managers 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 Controllable Uncontrollable

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

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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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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.
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Costs and Benefits of Information

Costs

Benefits

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