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Chapter 4

Chapter 4. Cost Terminology and Cost Flows. C4. Learning Objectives. 1. What is the relationship between cost objects and direct costs? 2. How do you classify product costs into direct materials, direct labor, and factory overhead categories?. C4. Continuing . . . Learning Objectives.

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Chapter 4

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  1. Chapter 4 Cost Terminology and Cost Flows

  2. C4 Learning Objectives 1. What is the relationship between cost objects and direct costs? 2. How do you classify product costs into direct materials, direct labor, and factory overhead categories?

  3. C4 Continuing . . . Learning Objectives 3. How does the conversion process work in manufacturing and service companies? 4. What are the assumptions accountants make about cost behavior and why are these assumptions necessary?

  4. C4 Continuing . . . Learning Objectives 5. How can mixed costs be analyzed using the high-low method and (Appendix) least-squares regression analysis? 6. What is the usefulness of flexible budgeting to managers?

  5. C4 Continuing . . . Learning Objectives 7. How are predetermined factory overhead rates developed and how does the selection of a capacity measure affect factory overhead application? 8. How is underapplied or overapplied factory overhead accounted for at year-end and why are these accounting techniques appropriate?

  6. C4 Continuing . . . Learning Objectives 9. Why are separate predetermined overhead rates generally more useful than combined rates? 10. How is cost of goods manufactured calculated?

  7. Cost Classification Categories • Time of incurrence • Reaction to changes in activity • Classification on the financial statements • Impact on decision making • Type of sacrifice

  8. Continuing . . . Cost Classification Categories Cost Classification Types of Costs Associated with time of incurrence Historical (past) Replacement (present) Budgeted (future)

  9. Continuing . . . Cost Classification Categories Cost Classification Types of Costs Cost behavior: reaction to changes in activity Variable (fluctuates in total) Fixed (constant in total) Mixed (part variable; part fixed)

  10. Continuing . . . Cost Classification Categories Cost Classification Types of Costs Unexpired (balance sheet) Expired (income statement) Product (inventoriable) Direct (traceable) Indirect (nontraceable) Prime Conversion Period (expensed) Classification on the financial statements

  11. Continuing . . . Cost Classification Categories Cost Classification Types of Costs Relevant (important) Quality (conformity) Prevention Appraisal Failure Impact on decision making

  12. Continuing . . . Cost Classification Categories Cost Classification Types of Costs Out-of-pocket (cash) Sunk (historical) Opportunity (foregone benefit) Type of sacrifice

  13. Components of Product Cost Product costs relate to the products or services that generate an entity’s revenues. These costs are either direct or indirect in relation to a particular cost object. Costs that are clearly traceable to the cost object are called direct costs. Costs that cannot be traced to the cost object are indirect (or common) costs.

  14. Direct Material • Readily identifiable, physical part of a product • Clearly, conveniently, and economically traceable to a product

  15. Direct Labor • Individuals who work on product or perform service • Basic compensation • Production efficiency bonuses • Employer’s share of Social Security and Medicare taxes • Employer-paid insurance costs, holiday and vacation pay, and retirement benefits — only if operations are relatively stable

  16. Factory Overhead Any factory or production cost that is not directly or conveniently traceable to manufacturing a product or providing a service

  17. Behavior of Product Costs • Direct Material • Variable • Direct Labor • Generally variable • Factory Overhead • Some variable • Some fixed

  18. Prime Cost Prime Cost = Direct Material + Direct Labor

  19. Conversion Cost Conversion Cost = Direct Labor + Factory Overhead

  20. Stages of Production Production processing or conversion can be viewed as existing in three stages: 1. Work not started (raw materials) 2. Work in process 3. Finished work

  21. Determining Cost Behavior • Cost driver • Activity has a direct cause-effect relationship with a cost • Cost predictor • Activity is accompanied by consistent, observable changes in a cost.

  22. Basic Cost Graph y Total Cost x 0 Activity Level

  23. Relevant Range Total Cost Activity Level

  24. Variable Cost y = bx b = slope of line Total Cost Activity Level

  25. Fixed Cost y = a a = y intercept Total Cost 0 Activity Level

  26. Total Cost y = a + bx Total Cost 0 Activity Level

  27. Mixed Cost Total Cost 0 Activity Level

  28. Step Cost Total Cost 0 Activity Level

  29. Step Variable Cost Total Cost 0 Activity Level

  30. Step Fixed Cost Total Cost 0 Activity Level

  31. High-Low Method • Cost estimation technique for separating mixed cost into variable and fixed components • Uses activity and cost information • Select highest and lowest activity levels--if within relevant range • Used to develop y = a + bx

  32. High-Low Analysisof Utility Cost: Step 1 LEVEL OF ACTIVITY UTILITY COST MONTH $1,712 1,716 1,469 1,719 1,698 1,691 1,989 January February March April May June July 11,300 11,400 9,000 11,500 11,200 10,100 12,200

  33. High-Low Analysisof Utility Cost: Step 2 Cups of Coffee Associated Utility Cost $1,719 High activity — April 11,500 Low activity — March 1,469 9,000 2,500 ==== Changes $ 250 =====

  34. High-Low Analysisof Utility Cost: Step 3 $ 250 Change in total cost b = = = $.10 per cup 2,500 Change in activity volume

  35. High-Low Analysisof Utility Cost: Step 4 High level of activity: TVC = $.10 (11,500) = $1,150 OR Low level of activity: TVC = $.10 (9,000) = $ 900

  36. High-Low Analysisof Utility Cost: Step 5 High level of activity: a = $1,719 - $1,150 = $569 ==== OR Low level of activity: a = $1,469 - $900 = $569 ====

  37. High-Low Analysisof Utility Cost: Step 6 y = $569 + $.10x where x = number of cups of coffee

  38. Preparing a Flexible Budget • Analyze overhead as to cost behavior • Find variable, fixed, and mixed costs • Separate each mixed cost into variable and fixed components • Use cost formula (y = a + bx) for each mixed cost • Prepare a series of individual financial plans that detail the individual costs at different levels of activity

  39. Flexible Budget # of Units 5,000 7,000 9,000 Variable Cost $1.85 $1.85 $1.75 Fixed Cost $3,500 $5,200 $5,200 Variable Cost $8,750 $12,950 $15,750 Fixed Cost 3,500 5,200 5,200 Total Cost $12,250 $18,150 $20,950 ====== ====== ======

  40. Variable Overhead Rate • Computed for each variable overhead cost pool • Activity measure should provide a logical relationship between activity and cost • Direct labor hours, direct labor dollars, machine hours, production orders, production-related physical measures Budgeted VOH cost for coming year Budgeted activity measure for coming year

  41. Fixed Overhead Rate • Select a specific activity level • Expected capacity • Theoretical capacity • Practical capacity • Normal capacity Budgeted FOH cost for coming year Budgeted activity measure for coming year

  42. Disposition of Underappliedand Overapplied Overhead • If immaterial: amount closed to Cost of Goods Sold • Cost of Goods Sold increased if underapplied OH • Cost of Goods Sold decreased if overapplied OH • If material: amount allocated to • Work in Process Inventory • Finished Goods Inventory • Cost of Goods Sold Year-end disposition depends on materiality of the amount.

  43. Combined Overhead Rate Advantages • Clerical ease • Clerical cost savings • No formal requirement to separate overhead costs by behavior

  44. Continuing . . . Combined Overhead Rate Disadvantages • Reduces manager’s ability to determine the causes of underapplied or overapplied overhead • Underlying cause-effect relationships between activities and costs are blurred • Contributes to inability to reduce costs • Limits attempts to improve productivity • Hinders ability to plan operations, control costs, and make decisions

  45. Inventory Methods Periodic • Inventory account balances stay the same throughout period • Inventory account adjusted to new balance at end of period Perpetual • Inventory accounts are adjusted as the product flows through the company

  46. Exhibit 4-15:Purchase Materials Raw Materials Inventory 85,000 Accounts Payable 85,000 To record cost of direct materials purchased on account.

  47. Exhibit 4-15:Use Materials Work in Process Inventory 69,000 Variable Factory Overhead 12,600 Raw Materials Inventory 81,600 To record direct materials transferred to production.

  48. Exhibit 4-15: Record Labor Costs Work in Process Inventory 5,000 Variable Factory Overhead 13,800 Salaries and Wages Payable 18,800 To accrue factory wages for direct and indirect labor.

  49. Exhibit 4-15: Record Labor Costs Fixed Factory Overhead 7,500 Salaries and Wages Payable 7,500 To accrue production supervisors’ salaries.

  50. Exhibit 4-15: Record Other Overhead Variable Factory Overhead 1,200 Fixed Factory Overhead 670 Utilities Payable 1,870 To record mixed factory utility cost in its variable and fixed proportions.

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