Cost Management

Session 1 Introduction

Learning Goals
Need for Cost Management

Course Overview
Cost Accounting and Financial Accounting Basic Cost Terms, Cost Classifications Flow of Manufacturing Costs Estimating Cost Behaviour Scatter Graph, High Low Method, Least Square Regression Preparing Income Statement using Contribution Format

Planning and Control Cycle

Formulating plans (Planning - Budgeting) Begin

Comparing actual to planned performance (Controlling)

Decision Making

Implementing plans

(Directing and Motivating)

Measuring performance
(Controlling)
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Need
Mrs Barua opens a boutique. She doesnt know how to price her products. Mr Raheja, the manager of XYZ Ltd needs to decide whether it should drop a product line which is reporting losses. A Ltd is wondering if it should manufacture a component D or outsource it. N Ltd needs to decide whether it should expand its manufacturing unit to China. Cost Accounting system provides cost, revenue & other information to managers to support them in decision making within an organization towards achieving organizational goals Decisions which : Improve products/services, Improve allocation of resources within a company, Reduce and Control costs, Support strategies adopted by the company Create Value: through Cost minimization and /or Revenue maximization
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Course Overview
Introduction Basic Cost concepts and cost classifications Cost-Volume-Profit Analysis and Marginal Costing Product costing methods based on Absorption costing : Job costing, Process costing Activity Based Costing (ABC) Relevant costs for decision making Budgeting Standard costing and variance analysis Transfer Pricing Responsibility Accounting, Target Costing

Cost Accounting & Financial Accounting

Similarities : Information for decision making Based on common documents or records Differences :
Areas of difference Users Time Focus Data Emphasis Subject GAAP Financial Accounting External Past Verifiability Precise Organisation Must follow Cost Accounting Internal Future Relevance Timely Segments Need not Not mandatory
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Preparing Reports Mandatory

Basic Terms
Cost Amount of resources consumed to achieve an objective Cost Object Anything for which separate measurement of costs is desired

Product, Customers, Departments, Jobs

Cost Centre Segment of the enterprise for which costs are accumulated

- Production centre, Service centre

Cost Unit Form of measurement of volume of production or service
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Cost Classification
Based on Element: Material, Labour and Overheads

Based on Function: Manufacturing and Non-manufacturing costs

For Preparing external Financial Statements: Product and Period Costs For Assigning costs to cost objects Direct and Indirect Costs For Predicting cost behaviour i.e. changes in cost due to changes in activity Fixed and Variable Costs For decision making : Differential, Opportunity, Sunk
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Cost Classification : By Element and Function

Costs Manufacturing Costs Non-Manufacturing Costs

Direct Material

Direct Labour

Manufacturing/Factory Overhead Administrative costs

Indirect Material Indirect Labour

Prime Cost
Indirect Expenses Marketing or Selling Costs

Flow of Manufacturing Costs

Raw Material : Opening RM + RM Purchases
(+ Freight in, if any)

Direct Material + Direct Labour + Manufacturing OH

Total Manufacturing Costs

+ Opening WIP - Closing WIP

= Cost of goods manufactured + Opening FG = Cost of goods available for sale

- Closing RM = Raw Material Consumed in production

= Total Manufacturing Costs

Direct Material

Conversion Costs

- Closing FG = Cost of Goods Sold (COGS)

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Exercise 2-4
Lompac Products Schedule of Cost of Goods Manufactured
Direct materials: Beginning raw materials inventory Add: Purchases of raw materials Raw materials available for use Deduct: Ending raw materials inventory Raw materials used in production Direct labor Manufacturing overhead Total manufacturing costs Add: Beginning work in process inventory $ 60,000 690,000 750,000 45,000 $ 705,000 135,000 370,000 1,210,000 120,000 1,330,000 Deduct: Ending work in process inventory Cost of goods manufactured 130,000 $1,200,000 11

Cost Classification Inventoriable: Expense or Asset

Product (inventoriable) Costs Connected with the manufacture of products Includes : Direct materials, direct labour, manufacturing overhead Expensed to Income Statement on sale as Cost of goods sold Capitalized on Balance Sheet till sold as Inventory For Manufacturing Company : Raw Materials, Work in process, Finished Goods For Merchandising Company : Merchandise Inventory Period Costs General costs of being in the business Not involved in making a product and cant be traced to any revenue transaction during the period Expensed to Income Statement in the period in which incurred Includes: Selling, General and Administrative Expenses

Period cost or Product cost for a manufacturing company? Manufacturing equipment depreciation, Property taxes on corporate headquarters, Direct materials costs, Electrical costs to light the production facility.
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Product Costs or Period Costs ?

Exercise 2-2
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Depreciation on salespersons cars Rent on equipment used in the factory Lubricants used for maintenance of machines Salaries of finished goods warehouse personnel Soap and paper towels used by factory workers at the end of a shift Factory supervisors salaries Heat, water, and power consumed in the factory Materials used for boxing products for shipment overseas (units are not normally boxed) Advertising costs Workers compensation insurance on factory employees Depreciation on chairs and tables in the factory lunchroom The wages of the receptionist in the administrative offices Lease cost of the corporate jet used by the company's executives Rent on rooms at a Florida resort for holding the annual sales conference Attractively designed box for packaging the companys productbreakfast cereal X X X X X X X X X X X X X X Product Cost Period Cost X

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Cost Classification based on Assignment

Direct Costs Easily and conveniently traceable to cost object (say, to a unit of product) Example: Direct Material like raw cotton in textile manufacturing plant Indirect Costs Not easily and conveniently traceable to cost object Must be allocated to a product or department Example: Manufacturing Overhead like lubricants for the machines used for production Factory managers salary in a company producing products A and B, when the cost object is A: common costs for A & B A cost may be direct or indirect cost depending on whether the cost is caused by the cost object under consideration Factory managers salary when the cost object is manufacturing division Direct Cost
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Direct Costs or Indirect Costs ?

Exercise 2-6
Cost 1 2 3 4 5 6 7 8 The wages of pediatric nurses Prescription drugs Heating the hospital The salary of the head of pediatrics The salary of the head of pediatrics Hospital chaplains salary Lab tests by outside contractor Lab tests by outside contractor Costing object The pediatric department A particular patient The pediatric department The pediatric department A particular pediatric patient A particular patient A particular patient A particular department X X 15 X X X Direct Cost X X X Indirect Cost

Cost Classification - Behaviour

Based on Behaviour: Variable Costs (V) Fixed Costs (F) Relevant Range & R. Period Variable cost in an ice cream shop? Wages of shop manager Lighting costs Cost of ice cream Manufacturing Overhead: F/V ? Period Costs: F/V? Is Direct Labour always variable ? Cost Structure Linear Approximation
Costs Behaviour w ith increase in level of activity Costs Fixed Costs Variable Costs Total Constant Increases Per Unit Decreases Constant
Variable Costs 300 250 200
Costs

Total Variable Costs Variable cost per unit

150 100 50 0 1 2 3 Units 4 5

Fixed Costs 1200 1000 800

Costs

600 400 200 0 1 2 3

Total Fixed Costs Fixed cost per unit

Units

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Other cost behaviours

Step costs Maintenance workers Supervisory Salary

Y
Costs

X
Units

Mixed costs (Semi-Variable Costs) Cost of electric power Compensation to a sales personnel

Y
Variable Fixed Units

Fixed salary Commission based on units sold Costs

X
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Estimating Cost Behaviour

Total mixed cost can be expressed as: Y= a + bX where, Y= Total Mixed cost, a = Total Fixed cost (intercept), b = Variable cost per unit (slope), X= level of activity in units

Diagnosing Mixed Costs 1. Scatter graph method

Intercept : TFC Slope: VC Rs 1200 Rs1000

2. The High-Low Method

Total Costs Units 1400 400 High 1300 300 1200 200 1100 100 Low Varaible cost p.u. = (1400 - 1100)/ (400-100) = 1 Total variable cost at 400 units = 1 *400 =400 Total Fixed Cost = Total Cost Total Variable Cost 1000 '=> 1400 - 400

X
200 units

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Estimating Cost Behaviour

3. Least Squares Regression Method
Uses all data points Most accurate estimate of fixed and variable portion of the mixed costs Can be used for estimating costs at a given level of activity.

Meaning of Contribution = Sales Variable Cost = Fixed Costs + Profit Income statement :
Traditional Approach (Rs) Contribution Approach (Rs) Sales 100000 Sales 100000 Less: COGS 70000 Less: Variable Costs 60000 Gross Margin 30000 Contribution 40000 Less: Operating exp 20000 Less: Fixed Costs 30000 Net Operating Income 10000 Net Operating Income 10000
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Thank You

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