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An Introduction to Cost Terms

and Purposes

Chapter 2

2-1
Basic Cost Terminology
 Cost
 A resource ( does not need to be cash) sacrificed
or foregone to achieve a specific objective

 Cost Object
 Any “object” such as a product, machine, service,
or process for which cost information is
accumulated
 Can vary in size from an entire company, to a
division or program within the company, or down
to a single product or service

2-2
Basic Cost Terminology
 Actual Cost
 A cost that has occurred
 Budgeted Cost
 A predicted / expected cost
 Cost Accumulation
 A collection of cost data in an organized manner

2-3
Basic Cost Terminology
Cost Assignment
 A general term that includes gathering accumulated
costs to a cost object. This includes:
 Tracing accumulated costs with a direct

relationship to the cost object and


 Allocating accumulated costs with an indirect

relationship to a cost object

2-4
Cost Drivers and
Cost Management
 Cost driver (cost generator or cost determinant)
 A factor that causes the amount of cost incurred to change
 Production costs are driven by the number of products
produced, labour costs, number of setups required, and the
number of change orders i.e. there is a causal relationship
 Cost Management
 Doing only value-added activities
 Efficiently managing the use of cost drivers in those
value-added activities

2-5
Characteristics in Defining Costs
 Total cost can be defined in many different
ways
 Various models can be developed using the
various cost definitions
 Understanding of cost definition concepts basis
for “models” used for planning, control and
evaluation

2-6
Major Types of Costs
 Direct vs Indirect
 Variable vs Fixed
 Product vs Period

2-7
Direct and Indirect Costs
Direct Cost
 A cost which is related to a particular cost objective and

can be easily traced to it economically


Indirect Cost
 A cost which is related to a particular cost objective but

cannot be easily traced to it economically


 Indirect costs are allocated to cost objectives

Trace
Direct
Cost Cost
Object
Indirect Cost Allocate
2-8
Factors Affecting Direct/Indirect
Cost Classification
 Materiality
 Availability of Information-gathering
Technology
 Cost of acquiring, analyzing and
communicating of information
 Operational Design

2-9
Direct Cost Examples
 Direct Materials (DM)
 Raw materials – metal, wood
 parts

 Direct Labour (DL)


 Assembly line workers

2-10
Indirect Costs Examples
 Also know as overhead, burden
 Electricity

 Rent

 Property taxes

 Materials - minor parts / material – solder,

washers, grease
 Labour – see following slide

2-11
Indirect Labour Costs
 Forklift truck operators
 Janitors
 Security
 Rework labour (fix defects etc)
 Overtime premium paid to ALL workers
 Idle time (unproductive paid time)
 Manager’s salaries

Payroll fringe benefits (QPP, EI, CSST, etc)

2-12
Manufacturing Overhead
All manufacturing costs except
direct materials and direct labour
Indirect labour and Indirect materials

Wages paid to employees who Materials used to support the


are not directly involved in production process
production work
Examples: maintenance Examples: lubricants,
workers, janitors, and security electricity, solder and cleaning
guards in factory supplies in assembly plant

2-13
Idle Time Defined
Cost of direct labour workers who are unable to
perform their assignments due to machine breakdowns,
materials shortages, power failures, and other
circumstances beyond their control.
Example: For a normal 40 hour work week, a worker is paid $20 per hour.
Due to machine setups the worker is idle for 2 hours per week. The labour
cost would be broken down as follows:
Direct labour (38 hours x $20) $ 760
Manufacturing overhead (2 hrs x $20) 40
Total labour cost for the week $ 800

2-14
Overtime Premium Defined
Overtime premiums paid to all factory
workers are usually considered to be
part of manufacturing overhead.
Example: For a normal 40 hour work week, a worker is paid $20 per
hour. Due to extra orders the worker will need to work 5 overtime
hours in the week. Breakdown of the labour follows:
Direct labour (45 hrs x $20)
$900
Manufacturing overhead OT Premium ( 5 hrs x $10) 50
Total labour cost for the week $950

2-15
Non-manufacturing Costs
Other overheads
Marketing or selling costs
 Costs necessary to get the order and

deliver the product. (order getting &


order filling costs)
Administrative costs
 All executive, organizational, and

clerical costs.

2-16
Relevant Range
 The band of normal activity level (or
volume) for a specific time period in
which there is a specific relationship
between the level of activity (or
volume) and a given cost

2-17
Graphical Representation of Activity
Costs and Output in reality

Normal Curvilinear
Total Cost Curve
Total
Dollars
$

Output
Start-up Normal Exceeding
Operations Capacity
2-18
Relevant Range
Total Total
Dollars $ Cost
Relevant
Range
The relevant range is
} the portion of the
curvilinear total cost
curve that covers the
normal operations
area.

Output
Start-up Normal Exceeding
Operations Capacity
2-19
Relevant Range

The portion of the


Total curvilinear cost line
Cost that is in the relevant
Dollars $

range due to flatness


Total

can be approximated
by a straight line

Output
Relevant Range
2-20
Major Assumptions
 Costs defined as variable and fixed
 Time span must be specific
 Total cost relationship is assumed to be
linear
 There is only one cost driver
 Variations in the level of the cost driver
are within the relevant range
2-21
Variable and Fixed Costs
Variable Cost
 A cost that is constant per unit but changes in total $
in proportion to changes in the cost driver
(activity) within the relevant range
 Materials (parts), fuel costs for a trucking
Volume
company, line employee wages
Fixed Cost
$
 A cost which does not change in total as volume

changes but changes on a per-unit basis as the cost


driver increases and decreases within the relevant
range
 Amortization, insurance, real estate taxes,

supervisor salary Volume

2-22
Relevant Range and Cost
Behaviour
 The range of the cost driver in which a specific relationship
between cost and driver is valid
Relevant Relevant
$ Range $ Range

Volume Volume

Variable Cost Fixed Cost


2-23
Total cost
Total cost = Total variable cost + Total fixed costs

Total
Total Dollars $

Cost

Total Variable Cost

Total Fixed Cost

Output
Relevant Range
(Normal Activity)
2-24
Cost Behavior Summarized
within the Relevant Range
TotalTotal
Dollars Cost
Cost per per
Unit
Dollarsin
Change Unit
Change in Unchanged in
Variable proportion
Variable proportion with relation to output
Unchanged in
Costs
Costs with output
output relation to
More
Moreoutput
output= More
= More
cost cost
output

Fixed Unchanged in Change


Change inversely
Fixed
Costs Unchanged
relation inversely
in with
to output output with
Costs relation to output
More output = lower
cost per unit
More output = lower
output cost
2-25
per
A Cost Caveat
 Unit costs are averages and should be
used cautiously
 Since unit costs change with a different
level of output or volume, it is prudent to
base decisions on a total dollar basis
 One should unitize once the total dollar
affect has been determined for a
specific level of activity
2-26
Different Types of Profit Firms
 Merchandising-sector companies
 Product resellers
 Manufacturing-sector companies
 Create and sell their own products
 Service-sector companies
 Provide services / intangible products

2-27
Types of Inventory
Retailer
 Merchandising inventory (FG)

Manufacturer
 Direct material inventory (DM) (raw material / stock
awaiting use in the manufacturing process)
 Work-in-process inventory (WIP) (partially completed
goods in the production facility)
 Finished goods inventory (FG) (completed but not yet
sold)
2-28
Period and Product Costs
Period Costs
 Have no future value and are expensed on the income
statement as they are incurred
 Also called operating costs
 Examples: selling, general and administrative costs

Inventoriable Costs
 Product manufacturing costs are capitalized on the
balance sheet (inventory) and expensed only when the
product is sold and transferred to cost of goods sold
 Also called product Costs
 Examples: materials and labour (manufacturing)

2-29
Inventoriable (Product) Costs
Versus Period (Operating) Costs
Inventoriable costs include Period costs are
direct materials, direct labour, expensed on the
and manufacturing overhead income statement –
which will be capitalized
non-manufacturing
Inventory Cost of Good Sold Expense

Sale

Balance Income Income


Sheet Statement Statement
2-30
Manufacturing Cost Flows
Balance Sheet
Costs Inventories Income
Statement
Material Purchases Raw Materials
Expenses

Direct Labour Work in


Process

Cost of
Manufacturing
Goods
Overhead Finished Sold
Goods
Selling and Period Costs Selling and
Administrative Administrative
2-31
Cost Flows
 The Cost of Goods Manufactured and
the Cost of Goods Sold section of the
income statement are accounting
representations of the actual flow of
costs through a production system.
 Note the importance of inventory accounts
in the following accounting reports, and in
the cost flow chart

2-32
Cost Flowchart
Balance Income
Sheet Statement

Direct Direct
Stored
Materials Materials
Purchases Revenues
Inventory

d ct
ne du
tio De
i si
qu
Re
Inventoriable
Costs Other Direct
Manufacturing Incurred

Costs Work-in- Finished Cost of


Process
Completed Goods Sold Goods
Manufacturing Inventory Inventory Sold
Overhead Applied
Costs in
arg
ss M ct
r o du
ls G d e
ua he n
Eq T

R&D Costs
Design Costs
Marketing Costs Period
Distribution Costs Costs
Customer-Service
Costs

Equals Operating
Income

2-33
Schedule of Cost of Goods
Manufactured
Cellular Products
Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 2007 (in thousands)
Direct Materials:
Beginning Inventory, January 1 $ 11,000 Calculates the cost of
Add: Purchases
Cost of Direct Materials Available for Use
73,000
84,000
Direct Materials Used
Less: Ending Inventory, December 31 8,000
Direct Materials Used 76,000
Direct Labor 9,000 Accumulates the three
Manufacturing Overhead:
Indirect Labor 7,000 product costs for the
Supplies 2,000
Heat, Light & Power 5,000 current period
Depreciation - plant building 2,000
Depreciation - plant equipment 3,000
Miscellaneous 1,000
Total Manufacturing Overhead Costs 20,000
Manufacturing costs incurred during 2007 105,000 Adjusts the current period
Add: Beginning WIP, January 1
Total Manufacturing Costs to account for
6,000
111,000
manufacturing costs to
Less: Ending WIP, December 31 7,000 account for units actually
Cost of Goods Manufactured $ 104,000
completed
2-34
Income Statement Encompassing
the Cost of Goods Sold Schedule

Cellular Products
Income Statement
Figure carries
For the Year Ended December 31, 2007 (in thousands) forward from the
Revenues $210,000
Cost of Goods Sold Schedule of Cost
Beginning Finished Goods, January 1 22,000 of Goods
Cost of Goods Manufactured 104,000
Cost of Goods Available for sale 126,000 Manufactured
Ending Finished Goods, December 31 18,000
Cost of Goods Sold 108,000
Gross Profit 102,000 Period Costs are
Operating Costs:
Marketing, distribution, and customer-service 70,000 expensed as
Total operating costs 70,000 incurred
Operating Income $32,000

2-35
Other Classification of Costs
Manufacturing costs are often
combined as follows:
Direct Direct Manufacturing
Materials Labour Overhead

Prime Conversion
Cost Cost

2-36
Inventory & Cost of goods sold
Relationship
 Inventory + purchases – inventory = CGS
begin end

CGS = cost of goods sold

COS = cost of sales = CGS

2-37
Costs in a Merchandising
Retail / Wholesale Company
Balance Sheet Income Statement
Revenue
Merchandise Merchandise Cost of Goods Sold
Purchases Inventory
Gross Margin

Inventoriable Period Marketing and


(Product) Costs Administrative
Costs Costs
Operating Income

2-38
Costs in a
Manufacturing Company
Direct Balance Sheet Income Statement
Material Materials
Purchases Inventory Revenue
Direct Cost of Goods Sold
Labour Work-in- Finished
Process Goods
Gross Margin
Indirect Inventory Inventory
Marketing and
Manufacturing
Period Administrative
Costs
Costs Costs
Inventoriable
(Product) Operating Income
Costs 2-39
The Many Meanings of
Product Costs
 Important theme of this book is “different costs for different
purposes”
Three examples of “product cost”
3. Product pricing and product emphasis
 Include all costs incurred
4. Contracting with government agencies
 May exclude marketing costs and include only a portion of
R&D costs (Cost plus % basis)
5. Financial Statements
 Under GAAP, only manufacturing costs are included in
inventory

2-40
Framework
Cost Accounting and Cost
Management
 Calculating the cost of products, services and other cost
objects
 Traceability & identification

 Obtaining information for planning, control and


performance evaluation
 Budgeting as a tool
 Forward looking and quantification to allow planning and control

 Analyzing the relevant information for decision making


 Distinguishes between relevant & irrelevant data

2-41
Alternative Classifications of
Costs
1. Business function 1. Behaviour pattern
a. R&D a. Variable costs
b. Fixed costs
b. Design
c. Production 2. Aggregate or average
d. Marketing a. Total costs
e. Distribution b. Unit costs
f. Customer service
3. Assets or expenses
a. Inventoriable costs
2. Assignment to a cost b. Period costs
object
a. Direct costs
b. Indirect costs
2-42

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