Chapter 3

Basic Cost Management Concepts Learning Objectives

1. 2. 3. 4. 5. Understand the strategic role of basic cost concepts. Explain the cost driver concepts at the activity, volume, structural, and executional levels. Explain the cost concepts used in product and service costing. Demonstrate how costs flow through the accounts. Prepare an income statement for both a manufacturing firm and a merchandising firm.

Teaching Suggestions
This chapter covers a very traditional topic, but in a very non-traditional way. The cost terms and concepts are organized relative to the management function for which they are used. For example, the concepts of relevant cost, opportunity cost, and sunk cost are covered under the heading of costs terms and concepts for planning and decision making. Similarly, the cost terms for strategic management include the concepts of the different types of costs drivers volume- and activity-based, executional and structural. Another unique aspect of the chapter is the coverage of risk aversion as an important concept with management control. Additionally, the supplementary materials section for this chapter includes advanced material related to decision making under uncertainty and the role of risk aversion in decision making, for those who would like to cover this topic in further detail.

New in this Edition

1. Clarification of the discussion on cost drivers 2. New exercises and problems 3. Coverage of risk preferences removed from chapter 3 and now enhanced in chapter 17, including related exercises 4. New real world focus examples, including an extensive example of cost terms used in agriculture

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Assignment Matrix
Learning Objectives Cost drivers at different levels Product and service cost concepts Flow of costs through the accounts Preparing income statements Planning and decision cost concepts Cost concepts related to control Text Features Strategy Service International Ethics X X X X X X X X X X X X X X X X X X X X X X X X X Spreadsheet

Problem E3-31 E3-32 E3-33 E3-34 E3-35 E3-36 E3-37 E3-38 E3-39 E3-40 E3-41 E3-42 E3-43 E3-44 E3-45 E3-46 E3-47 E3-48 E3-49 P3-50 P3-51 P3-52 P3-53 P3-54 P3-55 P3-56 P3-57

Time 10 min. 10 min. 10 min. 10 min. 15 min. 10 min. 15 min. 15 min. 15 min. 15 min. 5 min. 5 min. 20 min. 10 min. 10 min. 15 min. 15 min. 15 min. 20 min. 20 min. 25 min. 30 min. 30 min. 20 min. 20 min. 40 min. 40 min. X X X X X X X X X X X X X X X X X X X X X X

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Lecture Notes
A. Cost Drivers, Cost Pools, and Cost Objects. A cost driver is any factor that has the effect of
changing the level of total cost. In cost leadership, managing cost drivers is essential. A firm incurs a cost when it uses a resource for some purpose. Often costs are collected into meaningful groups called cost pools. Since individual costs can be group in several different ways, cost pools can be defined in several different ways as well (by cost type, source, or responsibility). A cost object is any product, service, customer, activity, or organizational unit to which costs are assigned for management purposes. Any item to which costs can be traced and that has a key role in management strategy can be considered a cost object.

1. Cost Assignment and Cost Allocation: Direct and Indirect Costs. Cost assignment is the
process of assigning costs to cost pools or from cost pools to cost objects. A direct cost can be conveniently and economically traced to a cost object or pool. In contrast, there is no convenient or economical way to trace indirect costs from cost or cost pool to the cost pool or cost object. Indirect costs are caused by two or more cost pools or objects, but cannot be directly traced to either one. Because of this difficulty, indirect costs are traced using cost drivers. The result is that indirect costs are assigned to the cost pool or object that caused the costs in the manner that is fairly representative of the way the cost was incurred. This assignment of indirect costs is known as cost allocation, which is a form of cost assignment used when direct tracing is not possible. The cost drivers used in the allocation are called allocation bases.

2. Direct and Indirect Materials Costs. Direct materials cost includes the cost of materials in the
product or other cost object (less purchase discounts but including freight and related charges) and usually a reasonable allowance for scrap and defective units. Conversely, indirect materials costs include the cost of materials that are not part of the finished product.

3. Direct and Indirect Labor Costs. Direct labor cost includes the labor used to manufacture the
product or to provide the service plus some portion of nonproductive time that is normal and unavoidable. Indirect labor costs provide a support role for manufacturing. Note that an element of labor can sometimes be both direct and indirect, depending on the cost object.

4. Other Indirect Costs. In addition to labor and materials, other types of indirect costs are necessary
to manufacture a product or provide a service. They include the cost of facilities and equipment. All indirect costs are commonly combined into a single cost pool called overhead (factory overhead in manufacturing firms). The three types of costs are sometimes combined for simplicity. Direct labor and materials are considered prime costs, while direct labor and overhead are also called conversion costs.

5. Types of Cost Drivers. The four types of cost drivers are activity-based, volume-based, structural,
and executional. Activity-based drivers are developed at a detailed level of operations and are associated with a given manufacturing activity. Volume-based cost drivers are developed at an aggregate level. Structural and executional drivers involve strategic and operational decisions that affect the relationship between these cost drivers and total cost.

6. Activity-Based Cost Drivers. Activity-based cost drivers are identified by using activity analysis,
a detailed description of the specific activities performed in the firms operations. For each activity, a cost driver is developed to explain how the costs incurred for that activity change. The activity analysis allows the firm to achieve its strategic objectives by enabling the firm to develop more accurate costs for

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its products. Furthermore, the analysis improves operational and management control since performance at the detailed level can be monitored closely.

7. Volume-Based Cost Drivers. Total cost for a volume-based cost has a nonlinear relationship with
the volume-based cost driver, which is the number of units of output for the product or service. At low values of the cost driver, costs increase at a low rate. This increasing marginal productivity stops, however, at higher levels of the cost driver (the law of diminishing marginal productivity). This nonlinear relationship presents a problem when estimating costs using linear, algebraic relationships. However, we are often interested only in a small range of activity, thus we are able to assume that the cost relationship is linear for the small relevant range that we are concerned about. a. Fixed and variable costs. Variable cost is the change in total cost associated with each change in the quantity of the cost driver. Conversely, fixed cost is that portion of the total cost that does not change with a change in the quantity of the cost driver within the relevant range. Total fixed costs and unit variable costs are expected to remain approximately constant within the relevant range. When the total cost includes both variable and fixed components, its referred to as a mixed cost. Deciding whether a cost is variable depends on the nature of the cost object (i.e. the product). b. Step costs. A cost is said to be a step cost when it varies with the cost driver, but does so in discrete steps. Each step corresponds to specific levels of the cost driver for which an additional unit of resource is required. c. Unit cost and marginal cost. Unit cost (or average cost) is the total manufacturing costs divided by the units of output. To properly interpret unit cost, we must distinguish unit variable costs, which do not change as output changes, from unit fixed costs, which do change as output changes. The term marginal cost is used to describe the additional cost incurred as the cost driver increases by one unit. Under the assumption of linear costs within the relevant range, the concept of marginal cost is equivalent to the concept of unit variable cost.

8. Structural and Executional Cost Drivers. Structural cost drivers are strategic in nature because
they involve plans and decisions that have a long-term effect. There are several issues that should be considered when determining structural cost drivers: scale (firm size, amount invested), experience, technology, and complexity. Strategic analysis, such as value-chain analysis, using structural cost drivers help the firm improve its competitive position. Executional cost drivers are factors the firm can manage in short-term, operational decisions making. Executional decision-making involves: workforce involvement (employee dedication), design of the production process (speed and throughout issues), and supplier relations. Executional cost drivers are studied in order to reduce costs.

B. Cost Concepts for Product and Service Costing. Accurate information about the cost of
products and services is important in each management function.

1. Cost Accounting for Products and Services. Cost accounting systems can vary widely among
different types of firms. Specifically, the system for manufacturers is quite different from that of merchandisers, while service firms have relatively simple costing systems.

2. Product Costs and Period Costs. Product inventory for both manufacturing and merchandising
firms is treated as an asset of their balance sheets. Assuming the inventory has market value, it is considered an asset until it is sold; then the cost of the inventory is transferred to the income statement as cost of goods sold, an expense. Product costs for a manufacturing firm include only the costs necessary to complete the product (direct labor, direct materials, and factory overhead). Product costs for a

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merchandising firm include the cost to purchase the product plus the transportation costs. All other expenditures for managing the firm and selling the product (general, selling, and administrative costs) are expensed in the period in which they are incurred; thus they are called period costs.

3. Manufacturing, Merchandising, and Service Costing. The cost flow for a manufacturing firm
involves three steps. The first step is to purchase materials. Next, materials used, labor, and factory overhead added to work in process. Finally, upon the completion of production, the production costs are transferred to the Finished Goods Inventory account and from there to the Cost of Goods Sold account. For a merchandising firm, it purchases goods and places them in the Product Inventory account. When the items are sold, they are transferred to Cost of Goods Sold. Manufacturing firms use three inventory accounts: Materials Inventory, Process Inventory, and Finished Goods Inventory. The following is a formula that relates the inventory accounts: Beginning inventory + Costs added = Cost transferred out + Ending inventory Please note that the terms cost added and cost transferred out can have different meanings, depending on which inventory account is being used. Also note that the manufacturing firm requires a two-part calculation for cost of goods sold. The first part combines the cost flows affecting the Work-in-Process Inventory account to determine the amount in the costs of Goods Manufactured account (the cost of goods that were finished and transferred out of work in process). The second part combines the cost flows for the Finished Goods Inventory account o determine the amount of the cost of the goods sold.

4. Attributes of Cost Information for Decision Making.

a. Accuracy. A primary way to ensure accurate data for decision-making is to design and monitor an effective system of internal accounting controls. This is a set of policies and procedures that restrict and guide activities in the processing of financial data with the objective to prevent or detect errors and fraudulent acts. b. Timeliness. Cost management information must be available to the decision maker in a timely manner to facilitate effective decision-making. c. Cost and value of cost information. The management accountant provides an information service that has both a preparation cost and a value to the user. These preparation costs are influenced by the desired accuracy, timeliness, and level of detail, with increased accuracy, timeliness, and detail costing more.

Blocher, Stout, Cokins: Cost Management 5e

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