An Introduction to Cost terms and Purposes

1. An Introduction to Cost terms and Purposes Session 2

2. Learning Objectives • Define and illustrate a cost object • Distinguish between direct costs and indirect costs • Explain variable costs and fixed costs • Interpret unit costs with caution • Distinguish among manufacturing, merchandising, and service-sector companies • Differentiate between inventoriable costs and period costs • Describe the three categories of inventories commonly found in manufacturing companies • Explain why different ways of computing product costs are appropriate for different purposes

3. Learning Objective 1 Define and illustrate a cost object

4. Cost and Cost Terminology • Costis a resource sacrificed or forgone to achieve a specific objective. • It is usually measured as the monetary amount that must be paid to acquire goods and services. • An actual costis the cost incurred (a historical cost) as distinguished from budgeted costs. • A cost objectis anything for which a separate measurement of costs is desired.

5. Cost and Cost Terminology • There are two basic stages of accounting for costs: • Cost accumulation • Cost assignment to various cost objects Cost Object Cost Accumulation Cost Object Cost Object Cost Assignment

6. Cost and Cost Terminology • Cost accumulation is the collection of cost data in some organized way by means of an accounting system. • Cost assignment is a general term that encompasses... • tracing accumulated costs to a cost object, and • allocating accumulated costs to a cost object.

7. Learning Objective 2 Distinguish between direct costs and indirect costs

8. Direct Costs • Direct costs of a cost object are those that are related to a given cost object (product, department, etc.) and that can be traced to it in an economically feasible way. • Cost-Tracing describes the assignment of direct costs to the particular cost object.

9. Indirect Costs... • are related to the particular cost object but cannot be traced to it in an economically feasible way.

10. Indirect Costs • Cost allocation describes the assigning of indirect costs to the particular cost object. • Ponce, Inc. has two production departments, Assembly and Finishing, and two service departments, Maintenance and Personnel. • Direct Costs: Maintenance Department $30,000 Personnel Department $24,600 Assembly Department $70,000 Finishing Department $50,000 • Assume that Maintenance Department costs are allocated equally among the production departments. • How much is allocated to each department?

11. $15,000 $15,000 Direct and Indirect Costs Maintenance $30,000 Assembly Direct Costs $70,000 Finishing Direct Costs $50,000 Allocated

12. Direct and Indirect Costs • Several factors affect the classification of a cost as direct or indirect: • The materiality of the cost in question • Available information-gathering technology • Design of operations • Contractual arrangements • The direct/indirect classification depends on the choice of the cost object.

13. Learning Objective 3 Explain variable costs and fixed costs

14. Cost Behavior Patterns • Variable costs change in total in proportion to changes in the related level of total activity or volume. • Fixed costs do not change in total for a given time period despite wide changes in the related level of total activity or volume. • Assume that Metairie Bicycles buys a handlebar at $52 for each of its bicycles. • Total handlebar cost is an example of a cost that changes in total in proportion to changes in the number of bicycles assembled (variable cost). • What is the total handlebar cost when 1,000 bicycles are assembled?

15. Cost Behavior Patterns • 1,000 units x $52 = $52,000 • What is the total handlebar cost when 3,500 bicycles are assembled? • 3,500 units x $52 = $182,000

16. Cost Behavior Patterns Total costs ($000) $182 $52 0 1,000 3,500 Units

17. Cost Behavior Patterns • Assume that Metairie Bicycles incurred $94,500 in a given year for the leasing of its plant. • This is an example of fixed costs with respect to the number of bicycles assembled. • These costs are unchanged in total over a designated range of the number of bicycles assembled during a given time span. • What is the leasing (fixed) cost per bicycle when Metairie assembles 1,000 bicycles? • $94,500 ÷ 1,000 = $94.50 • What is the leasing (fixed) cost per bicycle when Metairie assembles 3,500 bicycles? • $94,500 ÷ 3,500 = $27

18. Cost Drivers • A cost driver is a factor, such as the level of activity or volume, that causally affects costs (over a given time span). • The cost driver of variable costs is the level of activity or volume whose change causes the (variable) costs to change proportionately. • The number of bicycles assembled is a cost driver of the cost of handlebars.

19. Relevant Range... • is the band of the level of activity or volume in which a specific relationship between the level of activity or volume and the cost in question is valid. • Assume that fixed (leasing) costs are $94,500 for a year and that they remain the same for a certain volume range (1,000 to 5,000 bicycles). • 1,000 to 5,000 bicycles is the relevant range. • If annual demand for Metairie’s bicycles increases, and the company needs to assemble more than 5,000 bicycles, it would need to lease additional space which would increase its fixed costs.

20. Relevant Range Total fixed costs ($000) Relevant range $ 94.5 0 1,000 5,000 Volume

21. Direct Variable Fixed Indirect Relationships of Types of Costs • Costs may be simultaneously: variable and direct, variable and indirect, fixed and direct, fixed and indirect

22. Learning Objective 4 Interpret unit costs with caution

23. Total Costs and Unit Costs • A unit cost (also called an average cost) is computed by dividing some amount of cost total by some number of units. • The “units” may be expressed in various ways: • Hoursworked • Packages delivered • Bicycles assembled • What is the unit cost (leasing and handlebars) when Metairie Bicycles assembles 1,000 bicycles? • Total fixed cost $94,500 + Total variable cost $52,000 = $146,500 • $146,500 ÷ 1,000 = $146.50

24. Total Costs and Unit Costs Total costs ($000) $146.5 $ 94.5 0 1,000 Volume

25. Use Unit Costs Cautiously • Assume that Metairie Bicycles management uses a unit cost of $146.50 (leasing and handlebars). • Management is budgeting costs for different levels of production. • What is their budgeted cost for an estimated production of 600 bicycles? • 600 × $146.50 = $87,900 • What is their budgeted cost for an estimated production of 3,500 bicycles? • 3,500 × $146.50 = $512,750

26. Use Unit Costs Cautiously • What should the budgeted cost be for an estimated production of 600 bicycles? • Total fixed cost $ 94,500 Total variable cost ($52 × 600) = 31,200 Total $125,700 • $125,700 ÷ 600 = $209.50 • Using a cost of $146.50 per unit would underestimate actual total costs if output is below 1,000 units.

27. Use Unit Costs Cautiously • What should the budgeted cost be for an estimated production of 3,500 bicycles? • Total fixed cost $ 94,500 Total variable cost (52 × 3,500) = 182,000 Total $276,500 • $276,500 ÷ 3,500 = $79.00 • Using a cost of $146.50 per unit instead of $79.00 would overestimate actual total costs if output is above 1,000 units. • For decision making, managers should think in terms of total costs rather than unit costs.

28. Learning Objective 5 • Distinguish among manufacturing, merchandising, and service-sector companies

29. Manufacturing • Manufacturing-sector companies purchase materials and components and convert them into finished goods. • A manufacturing company must also develop, design, market, and distribute its products.

30. Merchandising • Merchandising-sector companies purchase and then sell tangible products without changing their basic form.

31. Service Companies... • provide services or intangible products to their customers. • Labor is the most significant cost category.

32. Learning Objective 6 Differentiate between inventoriable costs and period costs

33. Types of Inventory • Manufacturing-sector companies typically have one or more of the following three types of inventories: • Direct materials inventory • direct materials in stock and awaiting use in the manufacturing process • Work-in-process inventory (work in progress) • goods partially worked on but not yet fully completed. • Finished goods inventory • goods fully completed but not sold.

34. Types of Inventory • Merchandising-sector companies hold only one type of inventory – the product in its original purchased form. • Service-sector companies usually do not hold inventories of tangible products.

35. Classification of Manufacturing Costs • Direct materials costs • Direct materials costs are the acquisition costs of all materials that eventually become part of the cost object. • Direct materials costs can be traced economically. • Acquisition costs include freight-in (inward delivery) charges, sales taxes, and customs duties.

36. Classification of Manufacturing Costs Direct materials costs Direct manufacturing labor costs • Direct manufacturing labor costs include the compensation of all manufacturing labor that can be traced to the cost object in an economically feasible way. • Wages and fringe benefits paid to: • Machine operators • Assembly-line workers

37. Classification of Manufacturing Costs Direct materials costs Direct manufacturing labor costs Indirect manufacturing costs • Indirect manufacturing costs are all manufacturing costs that are considered to be part of the cost object, but that cannot be traced to that cost object in an economically feasible way. • Other terms for this cost category include manufacturing overhead costsand factory overhead costs.

38. Inventoriable Costs • Inventoriable costsare all costs of a product that are regarded as an asset when they are incurred and then become cost of goods sold when the product is sold. • For manufacturing-sector companies, almost all manufacturing costs are inventoriable costs. • Inventoriable costs (direct materials, direct labor and indirect manufacturing costs) are included in work-in-process and finished goods inventory. • For merchandising-sector companies, inventoriable costsare the costs of purchasing the goods which are resold in their same form. • For service-sector companies, the absence of inventories means there are no inventoriable costs.

39. Period Costs • Period costs are all costs in the income statement other than cost of goods sold. • Period costs are recorded as expenses of the accounting period in which they are incurred. • For manufacturing-sector companies, period costs include all non-manufacturing costs (research and development, distribution, etc.). • For merchandising-sector companies, period costs include all costs not related to the cost of goods purchased for resale. • For service-sector companies, all of their costs are period costs.

40. Learning Objective 7 Describe the three categories of inventories commonly found in manufacturing companies

41. Categories of Inventory • The three categories of inventory found in many manufacturing companies depict stages in the conversion process: • materials • Direct materials inventory costs are used to compute the cost of materials used. • Beginning direct materials inventory • + Purchases of direct materials •  Ending direct materials inventory • = Direct materials used

42. Categories of Inventory • The three categories of inventory found in many manufacturing companies depict stages in the conversion process: • materials • work-in-process • Work-in-process inventory costs are used to compute the cost of goods manufactured. • Beginning work-in-process inventory • + Manufacturing costs incurred during the period •  Ending work-in-process inventory • = Cost of goods manufactured

43. Categories of Inventory • The three categories of inventory found in many manufacturing companies depict stages in the conversion process: • materials • work-in-process • finished goods • Finished goods inventory costs are used to compute the cost of goods sold. • Beginning finished goods inventory • + Cost of goods manufactured • - Ending finished goods inventory • = Cost of goods sold

44. Learning Objective 8 Explain why different ways of computing product costs are appropriate for different purposes

45. Measuring Costs Requires Judgment • Judgment is frequently required when measuring costs. • Differences can exist in the way accounting terms are defined.

46. Measuring Costs Requires Judgment • Manufacturing labor-cost classifications vary among companies. • The following distinctions are generally found: • Direct manufacturing labor • Manufacturing overhead • Indirect labor • Managers’ salaries • Payroll fringe costs

47. Measuring Costs Requires Judgment • Overtime premium consists of the wages paid to all workers (for both direct labor and indirect labor) in excess of their straight-time wage rates. • Overtime premium is usually considered part of overhead. • Why is overtime premium of direct labor usually considered an indirect rather than a direct cost? • Because it does not “penalize” (add to) the cost of a particular batch of work solely because it happened to be worked on during the overtime hours. • Sometimes overtime is not random; for instance a rush job may clearly be the sole source of the overtime. • In this case the overtime premium is regarded as a direct cost of the services on that job.

48. Many Meanings of Product Cost • A product cost is the sum of the costs assigned to a product for a specific purpose. • Pricing and product emphasis decisions • Contracting with government agencies • Preparing financial statements for external reporting under generally accepted accounting principles

49. Many Meanings of Product Cost • For pricing and product emphasis decisions, the costs included are all areas of the value chain. • When contracting with government agencies, companies must follow the guidelines provided on the allowable and nonallowable items in a product-cost amount.

50. Many Meanings of Product Cost • Whenpreparing financial statements for external reporting, the focus is on inventoriable costs. • Usually under generally accepted accounting principles, only manufacturing costs are assigned to inventories in the financial statements.