Managerial Accounting and Cost Concepts

Chapter 2

2010 The McGraw-Hill Companies, Inc.

Work of Management

Planning

Directing and Motivating

Controlling

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Planning

Identify alternatives.

Select alternative that does the best job of furthering organizations objectives.
Develop budgets to guide progress toward the selected alternative.
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Directing and Motivating

Directing and motivating involves managing day-to-day activities to keep the organization running smoothly.

Employee work assignments. Routine problem solving. Conflict resolution. Effective communications.

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Controlling
The control function ensures that plans are being followed. Feedback in the form of performance reports that compare actual results with the budget are an essential part of the control function.

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Planning and Control Cycle

Formulating longand short-term plans (Planning) Comparing actual to planned performance (Controlling)

Begin

Decision Making

Implementing plans (Directing and Motivating)

Measuring performance (Controlling)

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Learning Objective 1

Identify the major differences and similarities between financial and managerial accounting.

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Comparison of Financial and Managerial Accounting

Financial Accounting
1. Users 2. Time focus 3. Verifiability versus relevance 4. Precision versus timeliness 5. Subject 6. GAAP 7. Requirement External persons who make financial decisions Historical perspective Emphasis on verifiability Emphasis on precision Primary focus is on the whole organization Must follow GAAP and prescribed formats Mandatory for external reports

Managerial Accounting
Managers who plan for and control an organization Future emphasis Emphasis on relevance for planning and control Emphasis on timeliness Focuses on segments of an organization Need not follow GAAP or any prescribed format Not Mandatory
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Learning Objective 2

Identify and give examples of each of the three basic manufacturing cost categories.

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Manufacturing Costs
Direct Materials Direct Labor Manufacturing Overhead

The Product

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Direct Materials
Raw materials that become an integral part of the product and that can be conveniently traced directly to it.

Example: A radio installed in an automobile

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Direct Labor
Those labor costs that can be easily traced to individual units of product.

Example: Wages paid to automobile assembly workers

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Manufacturing Overhead
Manufacturing costs that cannot be traced directly to specific units produced.
Examples: Indirect materials and indirect labor
Materials used to support the production process.
Examples: lubricants and cleaning supplies used in the automobile assembly plant.

Wages paid to employees who are not directly involved in production work.
Examples: maintenance workers, janitors and security guards.
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Nonmanufacturing Costs

Selling Costs

Administrative Costs

Costs necessary to secure the order and deliver the product.

All executive, organizational, and clerical costs.

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Learning Objective 3

Distinguish between product costs and period costs and give examples of each.

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Product Costs Versus Period Costs

Product costs include direct materials, direct labor, and manufacturing overhead.
Inventory Sale
Cost of Good Sold

Period costs include all selling costs and administrative costs.

Expense

Balance Sheet
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Income Statement

Income Statement
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Quick Check
Which of the following costs would be considered a period rather than a product cost in a manufacturing company?
A. Manufacturing equipment depreciation. B. Property taxes on corporate headquarters. C. Direct materials costs. D. Electrical costs to light the production facility. E. Sales commissions.

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Quick Check
Which of the following costs would be considered a period rather than a product cost in a manufacturing company?
A. Manufacturing equipment depreciation. B. Property taxes on corporate headquarters. C. Direct materials costs. D. Electrical costs to light the production facility. E. Sales commissions.

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Classifications of Costs

Manufacturing costs are often classified as follows:

Direct Material Direct Labor Manufacturing Overhead

Prime Cost

Conversion Cost

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Comparing Merchandising and Manufacturing Companies Merchandisers . . .

Buy

Manufacturers . . .
Buy

finished goods. Sell finished goods.

MegaLoMart

raw materials. Produce and sell finished goods.

Balance Sheet Merchandiser

Current assets
Cash Receivables Merchandise Inventory

Manufacturer
Current Assets
Cash
Receivables Inventories Raw Materials Work in Process Finished Goods

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Balance Sheet Merchandiser

Current assets
Cash Receivables Merchandise Inventory

Manufacturer
Current Assets
Cash

Partially complete products some material, labor, or overhead has been added.

Materials waiting to Receivables be processed. Inventories

Raw Materials Work in Process Finished Goods

Completed products awaiting sale.

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Learning Objective 4

Prepare an income statement including calculation of the cost of goods sold.

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The Income Statement

Cost of goods sold for manufacturers differs only slightly from cost of goods sold for merchandisers.
Merchandising Company
Cost of goods sold: Beg. merchandise inventory $ 14,200 + Purchases 234,150 Goods available for sale $ 248,350 - Ending merchandise inventory (12,100) = Cost of goods sold $ 236,250

Manufacturing Company
Cost of goods sold: Beg. finished goods inv. $ 14,200 + Cost of goods manufactured 234,150 Goods available for sale $ 248,350 - Ending finished goods inventory (12,100) = Cost of goods sold $ 236,250
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Basic Equation for Inventory Accounts

Beginning balance

Additions to inventory

Ending balance

Withdrawals from inventory

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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.

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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 $1,100 - $300 = $800

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Learning Objective 5

Prepare a schedule of cost of goods manufactured.

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Schedule of Cost of Goods Manufactured

Calculates the cost of raw material, direct labor, and manufacturing overhead used in production.

Calculates the manufacturing costs associated with goods that were finished during the period.
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Product Cost Flows

Raw Materials
Beginning raw materials inventory Raw materials purchased Raw materials available for use in production Ending raw materials inventory Raw materials used in production

Manufacturing Costs
Direct materials

Work In Process

+ =

As items are removed from raw materials inventory and placed into the production process, they are called direct materials.
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McGraw-Hill/Irwin

Product Cost Flows

Raw Materials
Beginning raw materials inventory Raw materials purchased Raw materials available for use in production Ending raw materials inventory Raw materials used in production

Manufacturing Costs
Direct materials + Direct labor + Mfg. overhead = Total manufacturing costs

+ =

Conversion costs are costs incurred to convert the direct material into a finished product.

Work In Process

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Product Cost Flows

Raw Materials
Beginning raw materials inventory Raw materials purchased Raw materials available for use in production Ending raw materials inventory Raw materials used in production

Manufacturing Costs
Direct materials + Direct labor + Mfg. overhead = Total manufacturing costs

Work In Process
Beginning work in process inventory + Total manufacturing costs = Total work in process for the period

+ =

All manufacturing costs incurred during the period are added to the beginning balance of work in process.
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McGraw-Hill/Irwin

Product Cost Flows

Raw Materials Manufacturing Costs Work In Process
Beginning work in process inventory Total manufacturing costs Total work in process for the period Ending work in process inventory Cost of goods manufactured

Beginning raw Direct materials materials inventory + Direct labor + Raw materials + Mfg. overhead purchased = Total manufacturing = Raw materials costs available for use in production Ending raw materials inventory Costs associated with the goods that = Raw materials used arein completed during the period are production

+ =

transferred to finished goods inventory.

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Product Cost Flows

Work In Process
Beginning work in process inventory Manufacturing costs for the period Total work in process for the period Ending work in process inventory Cost of goods manufactured

Finished Goods
Beginning finished goods inventory + Cost of goods manufactured = Cost of goods available for sale - Ending finished goods inventory Cost of goods sold

+ = =

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Manufacturing Cost Flows

Costs
Material Purchases Direct Labor Manufacturing Overhead

Balance Sheet Inventories

Raw Materials Work in Process

Income Statement Expenses

Finished Goods

Cost of Goods Sold Selling and Administrative

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Selling and Administrative

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Period Costs

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. $276,000 B. $272,000 C. $280,000 D. $ 2,000
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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 Beg. raw materials present. What is the cost of direct material $ 32,000 + Raw materials used? purchased 276,000 A. $276,000 = Raw materials available for use in production $ 308,000 B. $272,000 Ending raw materials inventory 28,000 C. $280,000 = Raw materials used D. $ 2,000 in production $ 280,000
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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.

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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 Direct Materials $ 280,000 Direct Labor 375,000 D. Cannot be+determined.
+ Mfg. Overhead = Mfg. Costs Incurred for the Month 180,000 $ 835,000

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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.
McGraw-Hill/Irwin
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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 Beginning workmonth. in process inventory at the end of the process inventory $ 125,000 What was the cost of goods manufactured + Mfg. costs incurred for the period 835,000 during the month? work in process A. $1,160,000 = Total during the period $ 960,000 B. $ 910,000 Ending work in process inventory 200,000 C. $ 760,000 = Cost of goods manufactured $ 760,000 D. Cannot be determined.
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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.

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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. $130,000 + $760,000 = $890,000 C. $780,000. $890,000 - $150,000 = $740,000 D. $760,000.

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Learning Objective 6

Understand the differences between variable costs and fixed costs.

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Cost Classifications for Predicting Cost Behavior

How a cost will react to changes in the level of activity within the relevant range.

Total variable costs change when activity changes. Total fixed costs remain unchanged when activity changes.

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Variable Cost
Your total texting bill is based on how many texts you send.
Total Texting Bill Number of Texts Sent
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Variable Cost Per Unit

The cost per text sent is constant at 5 cents per text.
Cost Per Text Sent Number of Texts Sent
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Fixed Cost
Your monthly contract fee for your cell phone is fixed for the number of monthly minutes in your contract. The monthly contract fee does not change based on the number of calls you make.
Monthly Cell Phone Contract Fee Number of Minutes Used Within Monthly Plan
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Fixed Cost Per Unit

Within the monthly contract allotment, the average fixed cost per cell phone call made decreases as more calls are made.
Monthly Cell Phone Contract Fee Number of Minutes Used Within Monthly Plan
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Cost Classifications for Predicting Cost Behavior

Behavior of Cost (within the relevant range)

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. Average fixed cost per unit goes down as activity level goes up.

Fixed

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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.

McGraw-Hill/Irwin

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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.

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Learning Objective 7

Understand the differences between direct and indirect costs.

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Assigning Costs to Cost Objects Indirect costs Direct costs

Costs that can be easily and conveniently traced to a unit of product or other cost object.

Costs that cannot be easily and conveniently traced to a unit of product or other cost object. Example: manufacturing overhead

Examples: direct material and direct labor

Learning Objective 8

Define and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.

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Cost Classifications for Decision Making

Every decision involves a choice between at least two alternatives.

Only those costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits can and should be ignored.
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Differential Cost and Revenue

Costs and revenues that differ among alternatives.

Example: You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month.

Differential revenue is: $2,000 $1,500 = $500

Differential cost is: $300

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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 $15,000 per year. Your opportunity cost of attending college for one year is $15,000.

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Sunk Costs
Sunk costs have already been incurred and cannot be changed now or in the future. These costs should be ignored when making decisions. Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.

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Quick Check
Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you dont want to waste money needlessly. Is the cost of the train ticket relevant in this decision? In other words, should the cost of the train ticket affect the decision of whether you drive or take the train to Portland? A. Yes, the cost of the train ticket is relevant. B. No, the cost of the train ticket is not relevant.
McGraw-Hill/Irwin
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Quick Check
Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you dont want to waste money needlessly. Is the cost of the train ticket relevant in this decision? In other words, should the cost of the train ticket affect the decision of whether you drive or take the train to Portland? A. Yes, the cost of the train ticket is relevant. B. No, the cost of the train ticket is not relevant.
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Quick Check
Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you dont want to waste money needlessly. Is the annual cost of licensing your car relevant in this decision? A. Yes, the licensing cost is relevant. B. No, the licensing cost is not relevant.

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Quick Check
Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you dont want to waste money needlessly. Is the annual cost of licensing your car relevant in this decision? A. Yes, the licensing cost is relevant. B. No, the licensing cost is not relevant.

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Quick Check
Suppose that your car could be sold now for $5,000. Is this a sunk cost? A. Yes, it is a sunk cost. B. No, it is not a sunk cost.

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Quick Check
Suppose that your car could be sold now for $5,000. Is this a sunk cost? A. Yes, it is a sunk cost. B. No, it is not a sunk cost.

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Summary of the Types of Cost Classifications

Financial Reporting

Predicting Cost Behavior

Assigning Costs to Cost Objects

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Making Business Decisions

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Further Classification of Labor Costs

Appendix 2A

2010 The McGraw-Hill Companies, Inc.

Learning Objective 9

(Appendix 2A)

Properly account for labor costs associated with idle time, overtime, and fringe benefits.

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Idle Time
Machine Breakdowns Power Failures Material Shortages

The labor costs incurred during idle time are ordinarily treated as manufacturing overhead.
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Overtime The overtime premiums for all factory workers are usually considered to be part of manufacturing overhead.

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Labor Fringe Benefits

Fringe benefits include employer paid costs for insurance programs, retirement plans, supplemental unemployment programs, Social Security, Medicare, workers compensation, and unemployment taxes.
Some companies include all of these costs in manufacturing overhead.
McGraw-Hill/Irwin

Other companies treat fringe benefit expenses of direct laborers as additional direct labor costs.
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Cost of Quality
Appendix 2B

2010 The McGraw-Hill Companies, Inc.

Learning Objective 10

(Appendix 2B)

Identify the four types of quality costs and explain how they interact.

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Quality of Conformance

When the overwhelming majority of products produced conform to design specifications and are free from defects.

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Prevention and Appraisal Costs

Prevention Costs
Support activities whose purpose is to reduce the number of defects

Appraisal Costs

Incurred to identify defective products before the products are shipped to customers

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Internal and External Failure Costs

Internal Failure Costs
Incurred as a result of identifying defects before they are shipped

External Failure Costs

Incurred as a result of defective products being delivered to customers

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Examples of Quality Costs

Prevention Costs
Quality training Quality circles Statistical process control activities

Appraisal Costs
Testing and inspecting incoming materials Final product testing Depreciation of testing equipment

Internal Failure Costs

Scrap Spoilage Rework

External Failure Costs

Cost of field servicing and handling complaints Warranty repairs Lost sales

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Distribution of Quality Costs

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Learning Objective 11

(Appendix 2B)

Prepare and interpret a quality cost report.

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Quality Cost Report For Years 1 and 2 Year 2 Amount Percent* Prevention costs: Systems development Quality training Supervision of prevention activities Quality improvement Total prevention cost Appraisal costs: Inspection Reliability testing Supervision of testing and inspection Depreciation of test equipment Total appraisal cost Internal failure costs: Net cost of scrap Rework labor and overhead Downtime due to defects in quality Disposal of defective products Total internal failure cost External failure costs: Warranty repairs Warranty replacements Allowances Cost of field servicing Total external failure cost Total quality cost $ 400,000 210,000 70,000 320,000 1,000,000 0.80% $ 0.42% 0.14% 0.64% 2.00%

Year 1 Amount Percent* 270,000 130,000 40,000 210,000 650,000 0.54% 0.26% 0.08% 0.42% 1.30%

600,000 580,000 120,000 200,000 1,500,000

1.20% 1.16% 0.24% 0.40% 3.00%

560,000 420,000 80,000 140,000 1,200,000

1.12% 0.84% 0.16% 0.28% 2.40%

900,000 1,430,000 170,000 500,000 3,000,000

1.80% 2.86% 0.34% 1.00% 6.00%

750,000 810,000 100,000 340,000 2,000,000

1.50% 1.62% 0.20% 0.68% 4.00%

400,000 870,000 130,000 600,000 2,000,000 7,500,000

0.80% 1.74% 0.26% 1.20% 4.00% 15.00% $

900,000 2,300,000 630,000 1,320,000 5,150,000 9,000,000

1.80% 4.60% 1.26% 2.64% 10.30% 18.00%

Quality cost reports provide an estimate of the financial consequences of the companys current defect rate.

* As a percentage of total sales. In each year sales totaled $50,000,000.

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Quality Cost Reports in Graphic Form

$10 9 8
Quality Cost (in millions)

20

7 6 5 4 3 2 1 0 Appraisal Prevention 1 Year Prevention 2 Internal Failure Appraisal Internal Failure External Failure External Failure

Quality reports can also be prepared in graphic form.

18
Quality Cost as a Percentage of Sales

16 14 12 10 8 6 4 2 0 Appraisal Prevention 1 Year

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External Failure

External Failure

Internal Failure Internal Failure Appraisal

Prevention 2

McGraw-Hill/Irwin

Uses of Quality Cost Information

Help managers see the financial significance of defects. Help managers identify the relative importance of the quality problems. Help managers see whether their quality costs are poorly distributed.
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Limitations of Quality Cost Information

Simply measuring and reporting quality cost problems does not solve quality problems. Results usually lag behind quality improvement programs.

The most important quality cost, lost sales, is often omitted from quality cost reports.
McGraw-Hill/Irwin
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ISO 9000 Standards

ISO 9000 standards have become international measures of quality.

To become ISO 9000 certified, a company must demonstrate:

1. A quality control system is in use, and the system clearly defines an expected level of quality. 2. The system is fully operational and is backed up with detailed documentation of quality control procedures. 3. The intended level of quality is being achieved on a sustained basis.
McGraw-Hill/Irwin
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End of Chapter 2

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