Lecture II

Basic Cost Management Concepts

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Process of Management
Strategy Planning
Formulation

Managers need cost information to

perform each of these functions.

Control Directing
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.

1-3
 Product Costs and Period Costs

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.

1-4
Cost Classifications on Financial
Statements – Balance Sheet

Merchandiser Manufacturer
Current Assets Current Assets
– Cash  Cash
– Receivables  Receivables
– Prepaid Expenses  Prepaid Expenses
– Merchandise  Inventories
Inventory Raw Materials
Work in Process
Finished Goods

1-5
Cost Classifications on Financial
Statements – Balance Sheet

Merchandiser Manufacturer
Current Assets Current Assets
– Cash  Cash
Those materials
– Receivables  waiting to be
Receivables
processed.
Prepaid Expenses
– Prepaid Expenses 

– Merchandise  Inventories
Inventory Raw Materials
Work in Process
Finished Goods

1-6
Cost Classifications on Financial
Statements – Balance Sheet

Merchandiser Manufacturer
PartiallyAssets
Current complete
Current Assets products – material to
 Cash
– Cash which some labor
 Receivables
and/or overhead has
– Receivables
been added.
 Prepaid Expenses
– Prepaid Expenses
 Inventories
– Merchandise
Inventory Raw Materials
Work in Process
Finished Goods

1-7
Cost Classifications on Financial
Statements – Balance Sheet

Merchandiser Manufacturer
Current Assets Current Assets
– Cash  Cash
 Receivables
Completed products
– Receivables
awaiting sale.
 Prepaid Expenses
– Prepaid Expenses
 Inventories
– Merchandise
Inventory Raw Materials
Work in Process
Finished Goods

1-8
 Types of Production Processes
Type of Production Description of Example of
Process 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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 Product Cost

Direct Direct Manufacturing

Labor Material 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:
Steel used to
manufacture
the automobile.

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 Direct Labor

Cost of salaries, wages, and fringe

benefits for personnel who work
directly on manufactured products.

Example:
Wages paid to an
automobile assembly
worker.

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 Manufacturing Overhead
All other manufacturing costs
Indirect Indirect Other
Material Labor 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 Indirect Other
Material Labor Costs

Cost of personnel who

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

1-14
 Manufacturing Overhead
All other manufacturing costs
Indirect Indirect Other
Material Labor Costs

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

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

Prime Conversion
Cost Cost

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 Manufacturing Cost Flows
Direct Material
Work in
Direct Labor Process
Inventory
Manufacturing
Overhead

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 Manufacturing Cost Flows
Direct Material
Work in
Direct Labor Process
Inventory
Manufacturing
Overhead
Finished
Goods
Inventory

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 Manufacturing Cost Flows
Direct Material
Work in
Direct Labor Process
Inventory
Manufacturing
Overhead
Finished Cost of
Goods Goods
Inventory Sold

1-19
Myrtle beach Golf Equipment Inc. incurs several costs as listed below. For each
cost, indicate which of the following classifications best describe the cost. (More
than one classification may apply)

Cost Items:
Metal used in golf clubs
Salary of plant manager
Cost of air-conditioning in the factory
Commissions paid to Sales Personnel
Depreciation of Personal Computer used by Company President

Cost Classifications
Variable cost
Fixed cost
Period cost
Product Cost
Direct Material
Direct labour
Manufacturing overhead
Selling and Administrative Overhead

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 Exh.

Schedule of Cost of Goods 2-7

Manufactured

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

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 Exh.

Schedule of Cost of Goods

Computation of Cost of Raw Material Used
2-7

Manufactured
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
Raw material used $ 134,980
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

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 Exh.

Schedule of Cost of Goods 2-7

Manufactured
Include all direct labor
costs incurred during the
Cometcurrent period.
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

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 Schedule of Cost of Goods Manufactured Exh.
2-7

Computation of Total Manufacturing Overhead

Indirect material $ 10,000
Indirect labor 40,000
Depreciation on factory 90,000
Depreciation on equipment 70,000
Comet Computer Corporation
Utilities 15,000
Insuranceof Cost of Goods Manufactured
Schedule 5,000
Total manufacturing overhead $ 230,000
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

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 Exh.

Schedule of Cost of Goods 2-9

Manufactured
Beginning work-in-
process inventory is
carried over from the
Comet Computer Corporation
prior period.
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

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 Exh.

Schedule of Cost of Goods 2-9

Manufactured
Ending work-in-process inventory
contains the cost of unfinished goods,
Cometand is reported
Computer in the current assets
Corporation
section
Schedule of Cost of the
of Goods balance sheet.
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

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 Exh.

Income Statement for a 2-7

Manufacturer

Comet Computer Corporation

Income Statement
For 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

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 Exh.

Income Statement for a Manufacturer 2-7

Comet 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
Comet Computer Corporation
Deduct Finished-goods inventory, Dec. 31 190
Income Statement
Cost of goods sold $ 415,010
For 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

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 Bodin Company manufactures finger splints for teenagers who get tendonitis
from playing games on mobile phones. With the data given below, find answers
to questions given below:

January 1 January 31
Raw material 125,000 117,000
WIP 235,000 251,000
Finished Goods 134,000 124,000

Following Additional data pertains to January operations:

Raw material purchased Rs. 191,000
Direct Labour Rs. 300,000
Actual Mfg. overhead Rs. 175,000
Actual Selling and Admin expenses Rs. 115,000

The company applies manufacturing overhead @60% of direct labour cost. Any
underapplied or overapplied overhead is accumulated until the end of the year.

Compute the following amounts as on January 31:

Prime Cost, Manufacturing Cost, Cost of Goods Manufactured, Cost of Goods
Sold

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 Identifying Cost Drivers

Cost Driver Examples

Activity Cost Driver
Machining operations Machine hours
Setup Setup hours
Production scheduling Manufacturing orders
Inspection Pieces inspected
Purchasing Purchase orders
Shop order handling Shop orders
Valve assembly support Customer requisitions
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Cost Classifications

Cost behavior means

how a cost will react
to changes in the
level of business
activity.

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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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 Cost Classifications

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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 Direct and Indirect Costs
Direct costs Indirect costs
• Costs that can be • Costs that must be
easily and allocated in order to
conveniently traced to be assigned to a
a product or product or
department. department.
• Example: cost of • Example: cost of
paint in the paint national advertising
department of an for an airline is
automobile assembly indirect to a particular
plant. flight.

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 Direct and Indirect Costs
• A cost can be direct to the department,
but indirect to units of product produced
in the department.
– Example: department manager’s salary.

• Tracing costs directly to departments or

products helps to identify and eliminate
non-value added costs.

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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 Controllable
in a restaurant manager
Cost of national Restaurant Uncontrollable
advertising by a manager
restaurant chain
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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
$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.

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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

1-39
Marginal Costs and Average
Costs

The total cost to

The extra cost
produce a quantity
incurred to produce
divided by the
one additional unit.
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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