Cost Concepts Terms Behavior and Classification Unit 2

Cost Concepts, Terms, Behavior and Classification Unit 2

Learning Objectives 1. 2. 3. 4. Explain the basic concept of “cost. ” Explain how costs are presented in financial statements Explain the process of cost allocation. Understand how material, labor, and overhead costs are added to a product at each stage of the production process. 5. Define basic cost behaviors, including fixed, variable, semivariable, and step costs. 6. Identify the components of a product’s costs. 7. Understand the distinction between financial and contribution margin income statements.

Cost Accounting • • Cost accounting systems provide information to help managers make better decisions. Managers who use cost accounting information to make decisions need to understand the cost terms used in their organizations. Because cost accounting systems are tailored to the needs of individual companies, several terms are used in practice to describe the same or similar cost concepts, depending on the use or the audience. Therefore, before we discuss the design of cost systems to aid decision making, we introduce a set of terms that will be used throughout the course. These terms are important to the discussion because they will be the “language” we use to communicate for the remainder of the lessons. Mc. Graw-Hill/Irwin Copyright © 2008 The Mc. Graw-Hill Companies, Inc. All rights reserved.

Cost Concept • A cost is a sacrifice of resources. Every day, we buy many different things: clothing, food, books, music, perhaps an automobile, and so on. When we buy one thing, we give up (sacrifice) the ability to use these resources (typically cash or a line of credit) to buy something else. The price of each item measures the sacrifice we must make to acquire it. • Whether we pay cash or use another asset, whether we pay now or later (by using a credit card), the cost of the item acquired is represented by what we forgo as a result.

Cost versus Expenses • It is important to distinguish cost from expense. An expense is a cost charged against • revenue in an accounting period; hence, expenses are deducted from revenue in that • accounting period. We incur costs whenever we give up (sacrifi ce) resources, regardless • of whether we account for it as an asset or Mc. Graw-Hill/Irwin Copyright © 2008 an expense. (We may. The Mc. Graw-Hill Companies, Inc. Alleven incur costs that rights reserved.

What is Cost? LO 1 Explain the basic concept of “cost”. Cost Outlay Cost Past, present, or future cash outflow Opportunity Costs Forgone benefit from the best alternative course of action Expense Cost charged against revenue in an accounting period

Cost Example Serra wants to go out with her friends for a night of fun and adventure. Cost of the outing? Outlay Cost Opportunity Cost $50 to pay for dinner and drinks Passing her accounting exam and a new pair of shoes!

Cost Example Your education costs? Outlay Cost The cost of tuition, books, and all other educational expenses Opportunity Cost The interest on the money you would save by not attending college and the income you will forgo while in college

Recording Costs in Financial Statements LO 2 Explain how costs are presented in financial statements. Income Statements Service Company Merchandising Company Cost incurred Service Revenues Sales Revenues - Cost of Services Sold = Gross Margin - General Selling and Administrative Costs = Operating Profit to purchase the goods sold Cost of billable hours - Cost of Goods Sold = Gross Margin - General Selling and Administrative Costs = Operating Profit The excess of operating revenue over costs necessary to generate those revenues

Manufacturing Company Costs Two types of manufacturing company costs: 1. Product Costs: Costs relating to inventory 2. Period Costs: Non-manufacturing costs related to the firm All Costs Product Costs: Costs incurred to product the product Recorded as an asset “inventory” when cost is incurred Recognized as an expense when the product is sold Period Costs: Costs incurred to sell a product and operate the business Recognized as an expense when the cost is incurred

A Manufacturing Company’s Income Statement Cost incurred to manufacture the product sold Product costs recorded as “inventory” when cost is incurred Sales Revenue - Cost of Goods Sold = Gross Margin - General Selling & Administrative Costs Period costs recorded as an expense in the period the cost is incurred = Operating Profit Expensed when sold

Product vs. Period Costs Product Costs: Costs that are recorded as an asset in inventory when incurred and expensed as Cost of Goods Sold when sold. Period Costs: Costs that are expensed under General Selling and Administrative Costs when incurred.

Product Costs: Direct vs. Indirect Direct Costs: Costs that, for a reasonable cost, can be directly traced to the product. Indirect Costs: Cost that cannot reasonably be directly traced to the product. Direct Materials: Materials directly traceable to the product. Direct Labor: Work directly traceable to transforming materials into the finished product. Manufacturing Overhead: All production costs except direct materials and direct labor. Indirect Materials Indirect Labor Other Indirect Costs

Tracing Costs Sara decides to go out with friends to a nice dinner and a movie. Identify the object A night on the town Direct Costs Indirect Cost The cost of the dinner and the movie The cost of Sara’s dress, shoes, and car. Mc. Graw-Hill/Irwin Copyright © 2008 The Mc. Graw-Hill Companies, Inc. All rights reserved.

Manufacturing Costs: Product Costs Inventory Costs Prime Costs: The “primary” costs of the product Direct Materials Conversion Costs: Cost necessary to “convert” materials into a product Direct Labor Manufacturing Overhead

Product Cost Review Direct Materials Direct Labor • Given the following data → Direct cost? $8. 00 $7. 00 Manufacturing Overhead DM + DL = $15. 00 $14. 00 Prime cost? Conversion cost? DL + MOH = $21. 00 DM + DL = $15. 00 Indirect Cost? Total Product Cost? DM + DL + MOH = $29. 00 MOH $14. 00

Period Costs: Non-manufacturing Cost Recognized as an expense when the cost is incurred. Marketing: Costs necessary to sell the products. Advertising Sales Commissions Shipping Costs Administrative: Costs necessary to operate the business. Executive Salaries Data Processing Legal Costs

Cost Allocation LO 3 Explain the process of cost allocation. Assigning indirect cost to a cost object 1. Define the cost pool: The collection of costs to be assigned to cost objects. 2. Determine the cost allocation rule: The method used to assign costs in the cost pool to cost objects. 3. Assign the cost object: Any end to which a cost is assigned – product, product line, department, customer, etc.

Example: Cost Allocation Rockford Company Situation: Rockford has two divisions, East Coast and West Coast. Both divisions are supported by the IT Department. East Coast Revenues West Coast Total $80 million $20 million $100 million 1. Define Cost Pool: IT Department’s Costs of $1, 000 2. Determine the Cost Allocation Rule: IT costs are allocated based on divisional revenue. (% of Revenue) 3. Assign the Cost Object: East Coast: 80% of cost = $800, 000 West Coast: 20% of cost = $200, 000

Manufacturing Cost Flows LO 4 Understand how material, labor, and overhead costs are added to a product at each stage of the production process. Product costs are recorded in inventory when cost is incurred. A manufacturing company has three inventory accounts: 1. Raw Materials Inventory: Materials purchased to make a product. 2. Work-in-Process Inventory: Products currently in the production process, but not yet completed. 3. Finished Goods Inventory: Completed products that have not yet been sold.

Inventory Accounts – The Balance Sheet Raw Materials Inventory Beg. RM Inventory + Purchases = Raw Materials Available for Production Work-in-Process Inventory Beg. WIP Inventory Finished Goods Inventory Beg. FG Inventory + Direct Materials Transferred from Raw Materials + Cost of Goods Completed & Transferred from WIP + Direct Labor - Raw Materials Transferred to WIP + Manufacturing Overhead = Goods Available for Sale = Total Manufacturing Costs - Cost of Good Sold = Ending RM Inventory - Cost of Good Completed & Transferred to Finished Goods = Ending FG Inventory = Ending WIP Inventory To the Income Statement

Jackson Gears Cost of Goods Manufactured Statement For the Year Ending December 31, 200 X Beginning WIP Inventory, January 1 $ 270, 000 Manufacturing Cost During the Year: Direct Materials: Beginning Raw Materials Inventory, Jan. 1 $ 95, 000 Add: Purchases 5, 627, 000 Direct Materials Available Less: Ending RM Inventory, Dec. 31 Direct Materials put into Production $ 5, 722, 000 72, 000 $5, 650, 000 Direct Labor 1, 220, 000 Manufacturing Overhead 6, 780, 000 Total Manufacturing Costs Incurred 13, 650, 000 Total Work-in-Process During the Year 13, 920, 000 Less: Ending Work-in-Process Inv, Dec. 31 Cost of Goods Manufactured 310, 000 $ 13, 610, 000 =====

Jackson Gears Cost of Good Sold Statement For the Year Ending December 31, 200 X Beginning Finished Goods Inventory, Jan. 1 $ 420, 000 Cost of Goods Manufactured 13, 610, 000 Finished Goods Available for Sale 14, 030, 000 Less: Ending Finished Goods Inventory, Dec. 31 Cost of Goods Sold 930, 000 $ 13, 100, 000 =====

Jackson Gears Income Statement For the Year Ending December 31, 200 X Sales Less: Cost of Goods Sold $ 20, 450, 000 13, 100, 000 Gross Margin 7, 350, 000 Less: Marketing & Administrative Expenses 3, 850, 000 Operating Profit $ 3, 500, 000 =====

Cost Behavior LO 5 Define basic cost behaviors including fixed, variable, semi-variable, and step costs. Cost Behavior? How costs respond to a change in activity level within the relevant range Relevant Range? Activity levels within which a given total fixed cost or unit variable cost will be unchanged

Fixed Costs Fixed costs remain unchanged as volume changes within the relevant range. Fixed costs per unit varies inversely to a change in activity. Fixed costs are “fixed” in “total” as activity changes. Costs ($) Activity Level

Sara’s Night on the Town Fixed Costs Fixed costs are “fixed” in “total” as activity changes Fixed cost per unit varies inversely with a change in activity. Cost of a dress ($) Number of times the dress is worn

Variable Costs that change in direct proportion with a change in the volume within the relevant range. Variable costs “vary” in “total” as activity changes. Cost ($) Variable cost per unit stays constant when activity changes within the relevant range. Activity Level

Sara’s Entertainment Expenses Variable Costs Variable costs “vary” in “total” as activity changes over the relevant range. Drink Cost ($) Variable cost per unit remains constant when activity changes over the relevant range. Number of drinks

Semi-variable Costs that have both fixed and variable components. Also known as MIXED COSTS.

Sara’s Entertainment Semi-variable costs The fixed component is “fixed” in total as activity changes over the relevant range. The variable component “varies in total as activity changes over the relevant range. Cost ($) Number of movies

Step Costs that increase in total with steps when the volume changes to a particular level. Step costs are also known as semi-fixed costs. Example: If a factory can produce 100, 000 units a month and the firm needs to produce 120, 000 units then more factory space must be procured. The additional space will only be purchased if 100, 000 units are exceeded. Costs ($) Cost of 2 nd rented space Cost of 1 st rented space Cost of original factory Activity Level

Product Cost Components LO 6 Identify the components of a product’s costs. Full Cost: The sum of all costs of manufacturing and selling a unit of the product. (GAAP) Full Absorption Cost: The sum of all variable and fixed costs of manufacturing a unit of the product. Variable Cost: The sum of all variable costs of manufacturing and selling a unit of the product.

Costs: An Example Given the following: Direct Materials = $8 Direct Labor = $7 1. What is the full cost per unit? DM + DL + VMOH + FMOH + VMA + FMA = $40 Variable Manufacturing Overhead = $8 Fixed Manufacturing Overhead = $6 Variable Marketing & Admin = $4 2. What is the full absorption cost per unit? DM + DL + VMOH + FMOH = $29 Fixed Marketing & Admin = $7 3. What is the variable cost per unit? DM + DL + VMOH + VMA = $27

Making Costs Information Useful LO 7 Understand the distinction between financial and contribution margin income statements. Full Absorption Costing: • Required by GAAP Used for: • Financial purposes • External reporting Variable Costing Used for: • Managerial purposes • Internal decision-making Sales Revenue - Cost of Goods Sold - Variable Costs = Gross Margin = Contribution Margin

Making Cost Information Useful, Continued… Financial Income Statement Full Absorption Costing Contribution Margin Income Statement Variable Costing Sales Price - Full Absorption Cost Sales Price - Variable Cost = Gross Margin = Contribution Margin

Product vs. Period Full Absorption Costing Variable Manufacturing Costs Fixed Manufacturing Costs Variable Costing Product Costs Variable Manufacturing Overhead Fixed Manufacturing Costs Variable Marketing & Admin Costs Fixed Marketing & Admin Costs Period Costs Variable Marketing & Admin Costs Fixed Marketing & Admin Costs

Income Statement: Full Absorption Costing Full Absorption Sales Revenue - Cost of Goods Sold = Gross Margin Variable and Fixed Manufacturing Costs Period Costs - Marketing & Admin Cost = Operating Profit Variable and Fixed Marketing & Admin Costs

Income Statement: Variable Costing Sales Revenue -Variable Costs = Contribution Margin - Fixed Costs = Operating Profit Variable Manufacturing Costs and Variable Marketing & Admin Costs Fixed Manufacturing Costs and Fixed Marketing & Admin Costs

Quick Check If your inventory balance at the beginning of the month was $1, 000, you bought $100 during the month, and sold $300 during the month, what would be the balance at the end of the month? A. $1, 000. B. $ 800. C. $1, 200. D. $ 200.

Quick Check If your inventory balance at the beginning of the month was $1, 000, you bought $100 during the month, and sold $300 during the month, what would be the balance at the end of the month? A. $1, 000. B. $ 800. C. $1, 200. D. $ 200. $1, 000 + $100 = $1, 100 - $300 = $800

Quick Check Beginning raw materials inventory was $32, 000. During the month, $276, 000 of raw material was purchased. A count at the end of the month revealed that $28, 000 of raw material was still present. What is the cost of direct material used? A. B. C. D. $276, 000 $272, 000 $280, 000 $ 2, 000

Quick Check Direct materials used in production totaled $280, 000. Direct labor was $375, 000 and factory overhead was $180, 000. What were total manufacturing costs incurred for the month? A. $555, 000 B. $835, 000 C. $655, 000 D. Cannot be determined.

Quick Check Beginning work in process was $125, 000. Manufacturing costs incurred for the month were $835, 000. There were $200, 000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month? A. $1, 160, 000 B. $ 910, 000 C. $ 760, 000 D. Cannot be determined.

Quick Check Beginning finished goods inventory was $130, 000. The cost of goods manufactured for the month was $760, 000. And the ending finished goods inventory was $150, 000. What was the cost of goods sold for the month? A. $ 20, 000. B. $740, 000. C. $780, 000. D. $760, 000.

Quick Check Beginning finished goods inventory was $130, 000. The cost of goods manufactured for the month was $760, 000. And the ending finished goods inventory was $150, 000. What was the cost of goods sold for the month? A. $ 20, 000. B. $740, 000. C. $780, 000. D. $760, 000. $130, 000 + $760, 000 = $890, 000 - $150, 000 = $740, 000

Quick Check Which of the following costs would be variable with respect to the number of cones sold at a Baskins & Robbins shop? (There may be more than one correct answer. ) A. The cost of lighting the store. B. The wages of the store manager. C. The cost of ice cream. D. The cost of napkins for customers.

UNIT 2: END!!