An Introduction to Cost terms and Purposes

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An Introduction to Cost terms and Purposes

• Session 2

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Learning Objectives

• Define and illustrate a cost object
• Distinguish between direct costs and indirect
  costs
• Explain variable costs and fixed costs
• Interpret unit costs with caution
• Distinguish among manufacturing, merchandising,
  and service-sector companies
• Differentiate between inventoriable costs and
  period costs
• Describe the three categories of inventories
  commonly found in manufacturing companies
• Explain why different ways of computing product
  costs are appropriate for different purposes

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Learning Objective 1

• Define and illustrate a cost object

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Cost and Cost Terminology

• Cost is a resource sacrificed or forgone to
  achieve a specific objective.
• It is usually measured as the monetary amount
  that must be paid to acquire goods and services.
• An actual cost is the cost incurred (a historical
  cost) as distinguished from budgeted costs.
• A cost object is anything for which a separate
  measurement of costs is desired.

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Cost and Cost Terminology

• There are two basic stages of accounting for
  costs
• Cost accumulation
• Cost assignment to various cost objects

Cost Object
Cost Accumulation
Cost Object
Cost Object
Cost Assignment
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Cost and Cost Terminology

• Cost accumulation is the collection of cost data
  in some organized way by means of an accounting
  system.
• Cost assignment is a general term that
  encompasses...
• tracing accumulated costs to a cost object, and
• allocating accumulated costs to a cost object.

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Learning Objective 2

• Distinguish between direct costs and indirect
  costs

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Direct Costs

• Direct costs of a cost object are those that are
  related to a given cost object (product,
  department, etc.) and that can be traced to it in
  an economically feasible way.
• Cost-Tracing describes the assignment of direct
  costs to the particular cost object.

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Indirect Costs...

• are related to the particular cost object but
  cannot be traced to it in an economically
  feasible way.

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Indirect Costs

• Cost allocation describes the assigning of
  indirect costs to the particular cost object.
• Ponce, Inc. has two production departments,
  Assembly and Finishing, and two service
  departments, Maintenance and Personnel.
• Direct Costs Maintenance
  Department 30,000 Personnel
  Department 24,600 Assembly
  Department 70,000 Finishing
  Department 50,000
• Assume that Maintenance Department costs are
  allocated equally among the production
  departments.
• How much is allocated to each department?

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Direct and Indirect Costs
Maintenance 30,000

Assembly Direct Costs 70,000
Finishing Direct Costs 50,000
Allocated
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Direct and Indirect Costs

• Several factors affect the classification of a
  cost as direct or indirect
• The materiality of the cost in question
• Available information-gathering technology
• Design of operations
• Contractual arrangements
• The direct/indirect classification depends on the
  choice of the cost object.

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Learning Objective 3

• Explain variable costs and fixed costs

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Cost Behavior Patterns

• Variable costs change in total in proportion to
  changes in the related level of total activity or
  volume.
• Fixed costs do not change in total for a given
  time period despite wide changes in the related
  level of total activity or volume.
• Assume that Metairie Bicycles buys a handlebar at
  52 for each of its bicycles.
• Total handlebar cost is an example of a cost that
  changes in total in proportion to changes in the
  number of bicycles assembled (variable cost).
• What is the total handlebar cost when 1,000
  bicycles are assembled?

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Cost Behavior Patterns

• 1,000 units x 52 52,000
• What is the total handlebar cost when 3,500
  bicycles are assembled?
• 3,500 units x 52 182,000

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Cost Behavior Patterns

• Total costs (000)
  
  
  
  
  
  
  
  

182
52
0 1,000 3,500 Units
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Cost Behavior Patterns

• Assume that Metairie Bicycles incurred 94,500 in
  a given year for the leasing of its plant.
• This is an example of fixed costs with respect to
  the number of bicycles assembled.
• These costs are unchanged in total over a
  designated range of the number of bicycles
  assembled during a given time span.
• What is the leasing (fixed) cost per bicycle when
  Metairie assembles 1,000 bicycles?
• 94,500 1,000 94.50
• What is the leasing (fixed) cost per bicycle when
  Metairie assembles 3,500 bicycles?
• 94,500 3,500 27

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Cost Drivers

• A cost driver is a factor, such as the level of
  activity or volume, that causally affects costs
  (over a given time span).
• The cost driver of variable costs is the level
  of activity or volume whose change causes the
  (variable) costs to change proportionately.
• The number of bicycles assembled is a cost driver
  of the cost of handlebars.

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Relevant Range...

• is the band of the level of activity or volume
  in which a specific relationship between the
  level of activity or volume and the cost in
  question is valid.
• Assume that fixed (leasing) costs are 94,500 for
  a year and that they remain the same for a
  certain volume range (1,000 to 5,000 bicycles).
• 1,000 to 5,000 bicycles is the relevant range.
• If annual demand for Metairies bicycles
  increases, and the company needs to assemble more
  than 5,000 bicycles, it would need to lease
  additional space which would increase its fixed
  costs.

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Relevant Range

• Total fixed costs (000)
  
  
  
  
  
  
  
  
  

Relevant range
94.5
0 1,000 5,000
Volume
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Relationships of Types of Costs

• Costs may be simultaneously
• variable and direct, variable and indirect,
• fixed and direct, fixed and indirect

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Learning Objective 4

• Interpret unit costs with caution

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Total Costs and Unit Costs

• A unit cost (also called an average cost) is
  computed by dividing some amount of cost total by
  some number of units.
• The units may be expressed in various ways
• Hours worked
• Packages delivered
• Bicycles assembled
• What is the unit cost (leasing and handlebars)
  when Metairie Bicycles assembles 1,000 bicycles?
• Total fixed cost 94,500 Total variable cost
  52,000 146,500
• 146,500 1,000 146.50

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Total Costs and Unit Costs

• Total costs (000)
  
  
  
  
  
  
  
  
  
  
  
  
  
  

146.5
94.5
0 1,000 Volume
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Use Unit Costs Cautiously

• Assume that Metairie Bicycles management uses a
  unit cost of 146.50 (leasing and handlebars).
• Management is budgeting costs for different
  levels of production.
• What is their budgeted cost for an estimated
  production of 600 bicycles?
• 600 146.50 87,900
• What is their budgeted cost for an estimated
  production of 3,500 bicycles?
• 3,500 146.50 512,750

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Use Unit Costs Cautiously

• What should the budgeted cost be for an estimated
  production of 600 bicycles?
• Total fixed cost 94,500
  Total variable cost (52
  600) 31,200 Total 125,700
• 125,700 600 209.50
• Using a cost of 146.50 per unit would
  underestimate actual total costs if output is
  below 1,000 units.

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Use Unit Costs Cautiously

• What should the budgeted cost be for an estimated
  production of 3,500 bicycles?
• Total fixed cost 94,500
  Total variable cost (52
  3,500) 182,000
• Total 276,500
• 276,500 3,500 79.00
• Using a cost of 146.50 per unit instead of
  79.00 would overestimate actual total costs if
  output is above 1,000 units.
• For decision making, managers should think in
  terms of total costs rather than unit costs.

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Learning Objective 5

• Distinguish among manufacturing, merchandising,
  and service-sector companies

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Manufacturing

• Manufacturing-sector companies purchase materials
  and components and convert them into finished
  goods.
• A manufacturing company must also develop,
  design, market, and distribute its products.

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Merchandising

• Merchandising-sector companies purchase and then
  sell tangible products without changing their
  basic form.

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Service Companies...

• provide services or intangible products to their
  customers.
• Labor is the most significant cost category.

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Learning Objective 6

• Differentiate between inventoriable costs and
  period costs

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Types of Inventory

• Manufacturing-sector companies typically have one
  or more of the following three types of
  inventories
• Direct materials inventory
• direct materials in stock and awaiting use in the
  manufacturing process
• Work-in-process inventory (work in progress)
• goods partially worked on but not yet fully
  completed.
• Finished goods inventory
• goods fully completed but not sold.

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Types of Inventory

• Merchandising-sector companies hold only one type
  of inventory the product in its original
  purchased form.
• Service-sector companies usually do not hold
  inventories of tangible products.

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Classification of Manufacturing Costs

• Direct materials costs
• Direct materials costs are the acquisition costs
  of all materials that eventually become part of
  the cost object.
• Direct materials costs can be traced
  economically.
• Acquisition costs include freight-in (inward
  delivery) charges, sales taxes, and customs
  duties.

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Classification of Manufacturing Costs
Direct materials costs Direct manufacturing labor
costs

• Direct manufacturing labor costs include the
  compensation of all manufacturing labor that can
  be traced to the cost object in an economically
  feasible way.
• Wages and fringe benefits paid to
• Machine operators
• Assembly-line workers

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Classification of Manufacturing Costs
Direct materials costs Direct manufacturing labor
costs Indirect manufacturing costs

• Indirect manufacturing costs are all
  manufacturing costs that are considered to be
  part of the cost object, but that cannot be
  traced to that cost object in an economically
  feasible way.
• Other terms for this cost category include
  manufacturing overhead costs and factory overhead
  costs.

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Inventoriable Costs

• Inventoriable costs are all costs of a product
  that are regarded as an asset when they are
  incurred and then become cost of goods sold when
  the product is sold.
• For manufacturing-sector companies, almost all
  manufacturing costs are inventoriable costs.
• Inventoriable costs (direct materials, direct
  labor and indirect manufacturing costs) are
  included in work-in-process and finished goods
  inventory.
• For merchandising-sector companies, inventoriable
  costs are the costs of purchasing the goods which
  are resold in their same form.
• For service-sector companies, the absence of
  inventories means there are no inventoriable
  costs.

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Period Costs

• Period costs are all costs in the income
  statement other than cost of goods sold.
• Period costs are recorded as expenses of the
  accounting period in which they are incurred.
• For manufacturing-sector companies, period costs
  include all non-manufacturing costs (research and
  development, distribution, etc.).
• For merchandising-sector companies, period costs
  include all costs not related to the cost of
  goods purchased for resale.
• For service-sector companies, all of their costs
  are period costs.

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Learning Objective 7

• Describe the three categories of inventories
  commonly found in manufacturing companies

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Categories of Inventory

• The three categories of inventory found in many
  manufacturing companies depict stages in the
  conversion process
• materials
• Direct materials inventory costs are used to
  compute the cost of materials used.
• Beginning direct materials inventory
• Purchases of direct materials
  
• ? Ending direct materials inventory
• Direct materials used

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Categories of Inventory

• The three categories of inventory found in many
  manufacturing companies depict stages in the
  conversion process
• materials

• work-in-process
• Work-in-process inventory costs are used to
  compute the cost of goods manufactured.
• Beginning work-in-process inventory
• Manufacturing costs incurred during the period
• ? Ending work-in-process inventory
• Cost of goods manufactured

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Categories of Inventory

• The three categories of inventory found in many
  manufacturing companies depict stages in the
  conversion process
• materials
• work-in-process

• finished goods
• Finished goods inventory costs are used to
  compute the cost of goods sold.
• Beginning finished goods inventory
• Cost of goods manufactured
• - Ending finished goods inventory
• Cost of goods sold

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Learning Objective 8

• Explain why different ways of computing product
  costs are appropriate for different purposes

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Measuring Costs Requires Judgment

• Judgment is frequently required when measuring
  costs.
• Differences can exist in the way accounting terms
  are defined.

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Measuring Costs Requires Judgment

• Manufacturing labor-cost classifications vary
  among companies.
• The following distinctions are generally found
• Direct manufacturing labor
• Manufacturing overhead
• Indirect labor
• Managers salaries
• Payroll fringe costs

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Measuring Costs Requires Judgment

• Overtime premium consists of the wages paid to
  all workers (for both direct labor and indirect
  labor) in excess of their straight-time wage
  rates.
• Overtime premium is usually considered part of
  overhead.
• Why is overtime premium of direct labor usually
  considered an indirect rather than a direct cost?
• Because it does not penalize (add to) the cost
  of a particular batch of work solely because it
  happened to be worked on during the overtime
  hours.
• Sometimes overtime is not random for instance a
  rush job may clearly be the sole source of the
  overtime.
• In this case the overtime premium is regarded as
  a direct cost of the services on that job.

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Many Meanings of Product Cost

• A product cost is the sum of the costs assigned
  to a product for a specific purpose.
• Pricing and product emphasis decisions
• Contracting with government agencies
• Preparing financial statements for external
  reporting under generally accepted accounting
  principles

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Many Meanings of Product Cost

• For pricing and product emphasis decisions, the
  costs included are all areas of the value chain.
• When contracting with government agencies,
  companies must follow the guidelines provided on
  the allowable and nonallowable items in a
  product-cost amount.

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Many Meanings of Product Cost

• When preparing financial statements for external
  reporting, the focus is on inventoriable costs.
• Usually under generally accepted accounting
  principles, only manufacturing costs are assigned
  to inventories in the financial statements.