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Chapter 2

Basic Cost
Management Concepts
and Accounting for Mass
Customization Operations

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning
Objective
1

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Process of Management
Strategy
Formulation

Planning

Managers need cost information to


perform each of these functions.

Directing

Control
Decision
Making

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What Do We Mean By a Cost?


A cost
is the measure of
resources given
up to achieve a
particular purpose.

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Learning
Objective
2

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Product Costs, Period Costs and Expenses


Product costs are costs associated with goods for
sale until the time period during which the products
are sold, at which time the costs become expenses.
Period costs are costs that are expensed during the
time period in which they are incurred.
Expenses are the consumption of assets for the
purpose of generating revenue.

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Learning
Objective
3

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Cost Classifications on Financial


Statements Income Statement
Product Costs

Cost of goods sold

Period Costs

Operating expenses

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Cost Classifications on Financial


Statements Balance Sheet
Manufacturer

Merchandiser
Current Assets

Cash
Receivables
Prepaid Expenses
Merchandise
Inventory

Current Assets

Cash
Receivables
Prepaid Expenses
Inventories
Raw Materials
Work in Process
Finished Goods
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Cost Classifications on Financial


Statements Balance Sheet
Manufacturer

Merchandiser
Current Assets

Cash
Receivables
Prepaid Expenses
Merchandise
Inventory

Current Assets

Cash
Those materials
waiting to be
Receivables
processed.
Prepaid Expenses
Inventories
Raw Materials
Work in Process
Finished Goods
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Cost Classifications on Financial


Statements Balance Sheet
Merchandiser
Current Assets

Cash
Receivables
Prepaid Expenses
Merchandise
Inventory

Manufacturer

Partially complete
Current
Assets
products material to
Cash
which
some labor
and/or
overhead has
Receivables
been added.
Prepaid Expenses
Inventories

Raw Materials
Work in Process
Finished Goods
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Cost Classifications on Financial


Statements Balance Sheet
Manufacturer

Merchandiser
Current Assets

Cash
Receivables
Prepaid Expenses
Merchandise
Inventory

Current Assets
Cash
Completed
products
Receivables
awaiting sale.
Prepaid Expenses
Inventories

Raw Materials
Work in Process
Finished Goods
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Learning
Objective
4

2-13

Types of Production Processes


Type of Production
Process

Description of
Process

Example of
Manufacturer

Job Shop

Low volume
Little standardization
Unique products

Disney

Batch

Multiple products
Low volume

Caterpillar

Assembly Line

A few major products


Higher volume

Ford

Mass Customization

High volume
Many standardized components
Customized combination of components

Dell

Continuous Flow

High volume
Highly standardized commodity products

Exxon
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Learning
Objective
5

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Manufacturing Costs
Direct
Material

Direct
Labor

Manufacturing
Overhead

The
Product
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Direct Material
Cost of raw material that is used to
make, and can be conveniently
traced, to the finished product.
Example:
Example:
Steel
Steel used
used to
to
manufacture
manufacture
the
theautomobile.
automobile.

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Direct Labor
Cost of salaries, wages, and fringe
benefits for personnel who work
directly on manufactured products.
Example:
Example:
Wages
Wagespaid
paidto
toan
an
automobile
automobileassembly
assembly
worker.
worker.

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Manufacturing Overhead
All other manufacturing costs
Indirect
Material

Indirect
Labor

Other
Costs

Materials used to support


the production process.
Examples: lubricants and
cleaning supplies used in an
automobile assembly plant.
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Manufacturing Overhead
All other manufacturing costs
Indirect
Material

Indirect
Labor

Other
Costs

Cost of personnel who


do not work directly on
the product. Examples:
maintenance workers,
janitors and security
guards.
2-20

Manufacturing Overhead
All other manufacturing costs
Indirect
Material

Indirect
Labor

Other
Costs

Examples: depreciation
on plant and equipment,
property taxes,
insurance, utilities,
overtime premium, and
unavoidable idle time.
2-21

Classifications of Costs in
Manufacturing Companies
Manufacturing costs are often
combined as follows:
Direct
Material

Direct
Labor

Prime
Cost

Manufacturing
Overhead

Conversion
Cost
2-22

Manufacturing Cost Flows


Direct Material
Direct Labor

Work in
Process
Inventory

Manufacturing
Overhead

2-23

Manufacturing Cost Flows


Direct Material
Direct Labor

Work in
Process
Inventory

Manufacturing
Overhead
Finished
Goods
Inventory

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Manufacturing Cost Flows


Direct Material
Direct Labor

Work in
Process
Inventory

Manufacturing
Overhead
Finished
Goods
Inventory

Cost of
Goods
Sold

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Learning
Objective
6

2-26

Schedule of Cost of Goods


Manufactured
Comet Computer Corporation
Schedule of Cost of Goods Manufactured
Raw material used

Direct labor
Total manufacturing overhead

134,980
50,000
230,000

Total manufacturing costs


Add: Work-in-process inventory, January 1

414,980
120

Subtotal
Deduct: Work-in-process inventory, December 31

415,100
100

Cost of goods manufactured

415,000
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Schedule of Cost of Goods


Manufactured
Computation of Cost of Raw Material Used

Raw-material inventory, January 1


Add: Purchases of raw materials

Raw material available for use


Deduct: Raw material inventory, December 31
Raw material used

Comet Computer Corporation

6,000
134,000
140,000
5,020

$ 134,980

Schedule of Cost of Goods Manufactured


Raw material used

Direct labor
Total manufacturing overhead

134,980
50,000
230,000

Total manufacturing costs


Add: Work-in-process inventory, January 1

414,980
120

Subtotal
Deduct: Work-in-process inventory, December 31

415,100
100

Cost of goods manufactured

415,000
2-28

Schedule of Cost of Goods


Manufactured
Include all direct labor
costs incurred during the
Cometcurrent
Computer
Corporation
period.
Schedule of Cost of Goods Manufactured
Raw material used

Direct labor
Total manufacturing overhead

134,980
50,000
230,000

Total manufacturing costs


Add: Work-in-process inventory, January 1

414,980
120

Subtotal
Deduct: Work-in-process inventory, December 31

415,100
100

Cost of goods manufactured

415,000
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Computation of Total Manufacturing Overhead


Indirect material

10,000

Indirect labor

40,000

Depreciation on factory

90,000

Depreciation on equipment

70,000

Utilities
15,000
Comet Computer Corporation
Insuranceof Cost of Goods Manufactured
5,000
Schedule
Total manufacturing overhead
$ 230,000

Raw material used

Direct labor
Total manufacturing overhead

134,980
50,000
230,000

Total manufacturing costs


Add: Work-in-process inventory, January 1

414,980
120

Subtotal
Deduct: Work-in-process inventory, December 31

415,100
100

Cost of goods manufactured

415,000
2-30

Schedule of Cost of Goods


Manufactured
Beginning work-inprocess inventory is
carried over from the
prior period.

Ending work-in-process
inventory contains the cost of
unfinished goods, and is
reported in the current assets
section of the balance sheet.
2-31

Income Statement for a


Manufacturer
Comet Computer Corporation
Income Statement
For the Year Ended December 31, 20X2
Sales revenue
Less: Cost of goods sold

700,000
415,010

Gross margin
Selling and administrative expenses

284,990
174,490

Income before taxes


Income tax expense

110,500
30,000

Net income

80,500
2-32

Comet Computer Corporation


Schedule of Cost of Goods Sold
For the Year Ended December 31, 20X2
Finished-goods inventory, Jan. 1
Add: Cost of goods manufactured

Cost of goods available for sale


Comet Computer Corporation
Deduct Finished-goods inventory, Dec. 31

200
415,000
415,200
190

Income Statement
$ 415,010
For the Year Ended December 31, 20X2

Cost of goods sold

Sales revenue
Less: Cost of goods sold

700,000
415,010

Gross margin
Selling and administrative expenses

284,990
174,490

Income before taxes


Income tax expense

110,500
30,000

Net income

80,500
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Learning
Objective
7

2-34

Activities that cause costs to be


incurred are called COST DRIVERS:

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Learning
Objective
8

2-36

Cost Classifications
Cost behavior means
how a cost will react
to changes in the level
of business activity.
Total variable costs
change when activity
changes.
Total fixed costs remain
unchanged when activity
changes.
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Total Variable Cost Example

Total Pay-Per-View
Bill

Your total cable pay-per-view bill is based on


how many movies you watch.

Pay-Per-View
Movies Watched

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Variable Cost Per Unit Example

Per Movie Charge

The cost per movie watched is constant. For


example, $4.00 per movie.

Movies Watched
2-39

Total Fixed Cost Example

Monthly Charge for


HBO Bill

Your monthly cable bill probably does not change


when you watch movies on channels that you have
elected to be paid on a monthly basis (HBO).

Number of HBO Movies


Watched

2-40

Fixed Cost Per Unit Example

Monthly HBO Bill per Movie


Watched

The average cost per HBO movie decreases


as more HBO movies are watched.

Number of HBO
Movies Watched

2-41

Cost Classifications
Summary of Variable and Fixed Cost Behavior
Cost

In Total

Per Unit

Variable

Total variable cost changes


as activity level changes.

Variable cost per unit


remains the same over
wide ranges of activity.

Total fixed cost remains


the same even when the
activity level changes.

Fixed cost per unit


goes down as activity
level goes up.

Fixed

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Learning
Objective
9

2-43

Direct and Indirect Costs


Direct costs

Indirect costs

Costs that can be


easily and
conveniently traced to
a product or
department.

Costs that must be


allocated in order to
be assigned to a
product or
department.

Example: cost of
paint in the paint
department of an
automobile assembly
plant.

Example: cost of
national advertising
for an airline is
indirect to a particular
flight.
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Controllable and
Uncontrollable Costs
A cost that can be significantly influenced
by a manager is a controllable cost.
Cost item

Manager

Classificaton

Cost of food used Restaurant


in a restaurant
manager

Controllable

Cost of national
advertising by a
restaurant chain

Uncontrollable

Restaurant
manager

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Learning
Objective
10

2-46

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
$20,000 per year.
Your opportunity cost
of attending college for one year
is $20,000.

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Sunk Costs
All costs incurred in the past that cannot be
changed by any decision made now or in the
future are sunk costs. Sunk costs should not be
considered in decisions.
Example: You bought an automobile that cost
$12,000 two years ago. The $12,000 cost is
sunk because whether you drive it, park it, trade
it, or sell it, you cannot change the $12,000 cost.

2-48

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

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Marginal Costs and Average


Costs
The extra cost
incurred to produce
one additional unit.

The total cost to


produce a quantity
divided by the
quantity produced.

Marginal and average costs are


largely a function of cost behavior
-- variable and fixed costs.
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Costs and Benefits of Information

Costs

Benefits

More information does not mean more


benefits if information overload results.
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End of Chapter 2

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