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

Basic CostManagement Conceptsand Accounting for MassCustomization Operations

Chapter 2

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LearningObjective

1

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Process of Management

DecisionMaking

DirectingControl

PlanningStrategyFormulation

Managers need cost information toperform each of these functions.

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What Do We Mean By a Cost?

A cost

is the measure ofresources givenup to achieve a

particular purpose.

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Basic Cost Terminology

Cost sacrificed resource to achieve aspecific objective

Actual cost a cost that has occurred

Budgeted cost a predicted cost

Cost object anything of interest for which acost is desired or an entity (e.g., a specific

product, service, or department) to which acost is assigned is commonly known as acost object.

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Cost Object Examples at BMW

Cost Object Illustration

Product BMW X 5 sports activity vehicle

Service Dealer-support telephone hotline

Project R&D project on DVD systemenhancement

CustomerHerb Chambers Motors, a dealer thatpurchases a broad range of BMWvehicles

Activity Setting up production machines

Department Environmental, Health & Safety

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How Does a Cost System DetermineThe Costs Of Various Cost Objects?

Cost accumulation a collection of cost datain an organized manner

Cost assignment a general term that

includes gathering accumulated costs to acost object. This includes:Tracing accumulated costs with a direct

relationship to the cost object and

Allocating accumulated costs with an indirectrelationship to a cost object

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LearningObjective

2

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Different Types of Firms

Manufacturing-sector companies createand sell their own products

Merchandising-sector companies product

resellers Service-sector companies provide services

(intangible products)

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Types of Manufacturing Inventories

Direct Materials resources in-stock andavailable for use

Work-in-Process (or progress) products

started but not yet completed. Oftenabbreviated as WIP

Finished Goods products completed and

ready for sale

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Types of Product Costs

Also known as Inventoriable CostsDirect Materials

Direct Labor

Indirect Manufacturing factory costs that arenot traceable to the product. Other commonnames for this type of cost includeManufacturing Overhead costs or Factory

Overhead costs.

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Accounting Distinction Between Costs

Inventoriable costs productmanufacturing costs. These costs arecapitalized as assets (inventory) until theyare sold and transferred to Cost of GoodsSold.

Period costs have no future value andare expensed as incurred.

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Product Costs, Period Costs and Expenses

Product costs are costs associated with goods forsale until the time period during which the productsare sold, at which time the costs become expenses.

Period costs are costs that are expensed during thetime period in which they are incurred.

Expenses are the consumption of assets for thepurpose of generating revenue.

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LearningObjective

3

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Product Costs

Cost of goods sold

Period Costs

Operating expenses

Cost Classifications on FinancialStatements Income Statement

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Merchandiser

Current Assets Cash

Receivables

Prepaid Expenses

MerchandiseInventory

Manufacturer

Current Assets

Cash

Receivables

Prepaid Expenses

InventoriesRaw Materials

Work in Process

Finished Goods

Cost Classifications on FinancialStatements Balance Sheet

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Merchandiser

Current Assets Cash

Receivables

Prepaid Expenses


Manufacturer

Current Assets

Cash

Receivables

Prepaid Expenses

InventoriesRaw MaterialsWork in Process

Finished Goods


Those materialswaiting to beprocessed.

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Merchandiser

Current Assets Cash

Receivables

Prepaid Expenses


Manufacturer

Current Assets

Cash

Receivables

Prepaid Expenses


Finished Goods


Partially complete

products

material towhich some laborand/or overhead has

been added.

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Merchandiser

Current Assets Cash

Receivables

Prepaid Expenses


Manufacturer

Current Assets

Cash

Receivables

Prepaid Expenses


Finished Goods


Completed productsawaiting sale.

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Learning

Objective4

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Types of Production Processes

Type of Production Description of Example ofProcess Process Manufacturer

Job Shop Low volume Disney

Little standardization

Unique products

Batch Multiple products Caterpillar

Low volume

Assembly Line A few major products Ford

Higher volume

Mass Customization High volume Dell

Many standardized components

Customized combination of components

Continuous Flow High volume Exxon

Highly standardized commodity products

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Learning

Objective5

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Manufacturing Costs

TheProduct

DirectLabor

DirectMaterial

ManufacturingOverhead

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Direct Material

Example:Steel used tomanufacture

the automobile.

Cost of raw material that is used tomake, and can be convenientlytraced, to the finished product.

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Cost of salaries, wages, and fringebenefits for personnel who work

directly on manufactured products.

Direct Labor

Example:Wages paid to an

automobile assemblyworker.

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All other manufacturing costs

Manufacturing Overhead

Materials used to support

the production process.Examples: lubricants andcleaning supplies used in anautomobile assembly plant.

IndirectLabor

IndirectMaterial

OtherCosts

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Cost of personnel who

do not work directly onthe product. Examples:maintenance workers,janitors and security

guards.

IndirectLabor

IndirectMaterial

OtherCosts

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Examples: depreciation

on plant and equipment,property taxes,insurance, utilities,

overtime premium, andunavoidable idle time.

IndirectLabor

IndirectMaterial

OtherCosts

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Overtime premium

Is the extra compensation paid to anemployee who works beyond the timenormally scheduled. For example a

technician earns $16 per hour. Thetechnician works 48 hours during a weekinstead of the scheduled time of 40 hours.

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Idle time

Is the time that is not spent productivelyby an employee due to such events asequipment breakdowns or new setups

for production runs. For example, duringone 40 hour shift, a machine breakdownresulted in idle time of 11/ 2 hours and apower failure idled workers for an additional hour. Suppose an employee earns $14per hour, the employee wages for the weekwill be classified in two categories.

Cl ifi ti f C t i

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Classifications of Costs inManufacturing Companies

PrimeCost

ConversionCost

Manufacturing costs are oftencombined as follows:

DirectMaterial

DirectLabor


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Other Cost Considerations

Prime cost is a term referring to all directmanufacturing 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

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Manufacturing Cost Flows


Direct Material

Direct LaborWork inProcess

Inventory

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Direct Material

Direct Labor

FinishedGoods

Inventory

Work inProcess

Inventory

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Direct Material

Direct Labor

FinishedGoods

Inventory

Cost ofGoods

Sold

Work inProcess

Inventory

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Learning

Objective6

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Cost Flows

The Cost of Goods Manufactured and theCost of Goods Sold section of the IncomeStatement are accounting

representations of the actual flow ofcosts through a production system.

Note the importance of inventory accounts in thefollowing accounting reports, and in the cost flow

chart

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Cost Flows Visualized

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Cost of Goods Manufactured

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Multiple-Step Income Statement

S h d l f C t f G d

Exh.

2 9

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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$

Schedule of Cost of GoodsManufactured

Beginning work-in-process inventory iscarried over from the

prior period.

2-9

Sched le of Cost of GoodsExh.

2 7

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Direct labor 50,000




Subtotal 415,100$




2-7

Schedule of Cost of Goods

Exh.

2 7

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Direct labor 50,000




Subtotal 415,100$




Computation of Cost of Raw Material Used

Raw-material inventory, January 1 6,000$

Add: Purchases of raw materials 134,000

Raw material available for use 140,000

Deduct: Raw material inventory, December 31 5,020


2-7


Exh.

2 7

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Direct labor 50,000




Subtotal 415,100$




Include all direct laborcosts incurred during the

current period.

2-7


Exh.

2 7

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Direct labor 50,000




Subtotal 415,100$



Schedule of Cost of GoodsManufacturedComputation of Total Manufacturing Overhead

Indirect material 10,000$

Indirect labor 40,000Depreciation on factory 90,000

Depreciation on equipment 70,000

Utilities 15,000

Insurance 5,000

Total manufacturing overhead 230,000$

2-7


Exh.

2 9

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Direct labor 50,000




Subtotal 415,100$




Ending work-in-process inventorycontains the cost of unfinished goods,and is reported in the current assets

section of the balance sheet.

2-9

Income Statement for aExh.

2-7

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Income Statement for aManufacturer


Income StatementFor 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$

2-7

Income Statement for a

Exh.

2-7

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Income StatementFor 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$

Income Statement for aManufacturerComet 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 for sale 415,200

Deduct Finished-goods inventory, Dec. 31 190

Cost of goods sold 415,010$

2-7

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Learning

Objective7

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Learning

Objective8

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Cost Classifications

Cost behavior meanshow a cost will reactto changes in the

level of businessactivity.

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Cost behavior meanshow a cost will reactto changes in the

level of businessactivity.

Total variable costschange when activitychanges.

Total fixed costs remainunchanged whenactivity changes.

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2009 Pearson Prentice Hall. All rights reserved.

Cost BehaviorVariable 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, continuedVariable costs are constant on a per-unit basis. If

a product takes 5 pounds of materials each, it staysthe same per unit regardless of one, ten or a

thousand units are produced

Fixed costs change inversely with the level ofproduction. 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 SummarizedTotal Dollars Cost per Unit

Variable Costs

Change in

proportion withoutputMore output = More cost

Fixed CostsUnchanged in

relation to output

Change inversely

with outputMore output = lower cost

per unit

Total Dollars Cost Per Unit

Variable Costs

Change in

proportion withoutput

More output = More cost

Unchanged in

relation to output

Fixed Costs Unchanged inrelation to output

Change

inversely withoutputMore output = lower cost

per unit

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Total Variable Cost Example

Your total long distance telephone bill isbased on how many minutes you talk.

Minutes Talked

TotalLongDistance

TelephoneBill

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Total Fixed Cost Example

Your monthly basic telephone bill probablydoes not change when you make more local

calls.

Number of Local Calls

MonthlyBasic

TelephoneBill

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Fixed Cost Per Unit Example

Number of Local Calls

Monthly

BasicTeleph

one

Billp

erLocalCall

The average cost per local call decreases asmore local calls are made.

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Cost Behavior Visualized

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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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Other Cost Concepts Cost Driver a variable that causally affects costs over

a given time span. Acost driver is any event oractivity that causes costs to be incurred. Possible

examples include labor hours in manual assemblywork and machine hours in automated productionsettings or cost of petrol is determined largely by thenumber of miles driven.

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Identifying Cost Drivers

Cost Driver Examples

Activity Cost Driver

Machining operations Machine hoursSetup Setup hours

Production scheduling Manufacturing orders

Inspection Pieces inspected

Purchasing Purchase ordersShop order handling Shop orders

Valve assembly support Customer requisitions

Activities that

cause costs to beincurred are called

cost drivers.

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Other Cost Concepts Relevant Range the band of normal activity level (or

volume) in which there is a specific relationshipbetween 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, itmay 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

Objective9

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Direct & Indirect Costs

Direct costs can be conveniently andeconomically traced (tracked) to a costobject

Indirect costs cannot be conveniently oreconomically traced (tracked) to a costobject. Instead of being traced, these costsare allocated to a cost object in a rationaland systematic manner

Di d I di C

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Direct and Indirect Costs

Direct costs Costs that can be

easily andconveniently traced to

a product ordepartment.

Example: cost ofpaint in the paint

department of anautomobile assemblyplant.

Indirect costs Costs that must be

allocated in order tobe assigned to a

product ordepartment.

Example: cost ofnational advertising

for an airline isindirect to a particularflight.

Di t d I di t C t

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A cost can be direct to the department,but indirect to units of product producedin the department.

Example: department managers salary.

Tracing costs directly to departments orproducts helps to identify and eliminate

non-value added costs.

Direct and Indirect Costs

Factors Affecting Direct / Indirect Cost

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Factors Affecting Direct / Indirect CostClassification

Cost Materiality : The smaller the amountof the cost, the less likely that it iseconomically feasible to trace that cost to aparticular cost object.

Availability of information-gatheringtechnology: For example bar-codetechnology has made it possible to trace

just about any material used in themanufacturing process.

Operational Design: A cost used for a

specific cost object can be readily traced.

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BMW: Assigning Costs to a Cost

Object

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Cost Examples

Direct CostsParts

Assembly line wages

Indirect CostsElectricity

Rent

Property taxes

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Multiple Classification of Costs,

Visualized

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Learning

Objective10

Controllable and

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A cost that can be significantly influencedby a manager is a controllable cost.

Uncontrollable Costs

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

O t it C t

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Opportunity Cost

The potential benefit that isgiven up when onealternative is selected

over another. Example: If you were

not attending college,you could be earning

$20,000 per year.Your opportunity costof attending college for oneyear is $20,000.

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Diff ti l C t

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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

Marginal Costs and Average

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g gCosts

The extra costincurred to produce

one additional unit.

The total cost toproduce a quantity

divided by thequantity produced.

Marginal and average costs arelargely a function of cost behavior

-- variable and fixed costs.

Costs and Benefits of Information

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Costs and Benefits of Information

Costs Benefits

More information does not mean morebenefits if information overload results.

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Different Definitions of Costs

for Different Applications Pricing and product-mix decisions may use

a super cost approach (comprehensive)

Contracting with government agenciesvery specific definitions of cost for cost plusprofit contracts

Preparing external-use financial statements GAAP-driven product costs only

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Different Definitions of Costs

for Different Applications

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Three Common Features ofCost 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 formaking decisions

Chap two

Documents

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