November 10, 2015

1. November 10, 2015 • Types of Costs • Starting to Build the Income Statement • To build the Income Statement, we must know COGS • To know COGS for a manufacturing company, we must know Cost of Goods Manufactured • Build up and calculation of Cost of Goods Manufactured • Fixed versus Variable Costs • Other cost distinctions

2. Purpose of Cost Classifications • We have seen there are many ways of classifying costs • Each type falls into one or more of the following purposes: • Financial Reporting • Inventory on Balance Sheet • COGS and S&A on Income Statement • Predicting Cost Behaviour • Fixed and variable costs • Assigning Costs to Objects • Product costs • Decision Making • Differential costs and revenues

3. Classifying Costs • A good Managerial Accountant thinks and uses judgment to arrive at or develop the best approach to support decision making • This requires a deep understanding of costs and when to use the many classifications there are: • Period versus Product • Prime versus Conversion • Fixed versus Variable • Direct versus Indirect • Sunk Costs • Opportunity Costs • Differential Costs and Differential Revenue • Of course any cost item can fit into a number of these categories

4. Summary of the Types of Cost Classifications Financial Reporting Predicting Cost Behavior Assigning Costs to Cost Objects Making Business Decisions

5. 1. Manufacturing Costs • Manufacturing Costs are Product Costs (flow through balance sheet) • Direct Materials • Raw materials that become an integral part of the product and that can be conveniently traced directly to it • Direct Labour • Those labor costs that can be easily traced to individual units of product • Manufacturing Overhead • Manufacturing costs cannot be traced directly to specific units produced. • Indirect materials, indirect labour, other indirect costs related to manufacture • What are examples of each type of cost?

6. DirectMaterials DirectLabor ManufacturingOverhead Classifications of Manufacturing Costs The Product

7. Raw materials that become an integral part of the product and that can be conveniently traced directly to it. Direct Materials Example:A radio installed in an automobile

8. Those labor costs that can be easily traced to individual units of product. Direct Labor Example:Wages paid to automobile assembly workers

9. Manufacturing costs that cannot be easily traced directly to specific units produced. Wages paid to employees who are not directly involved in production work. Examples: maintenance workers, janitors, and security guards. Materials used to support the production process. Examples: lubricants and cleaning supplies used in the automobile assembly plant. Manufacturing Overhead Examples:Indirect materials and indirect labor

10. 2. Non-Manufacturing Costs • Non Manufacturing Costs are Period Costs (through I/S) • Selling Costs • All costs associated with selling • Administrative Costs • All other costs which cannot be attributed to production or selling • What are examples of each type of cost?

11. 2. Non-Manufacturing Costs • Non Manufacturing Costs are Period Costs (through I/S) • Selling Costs • All costs associated with selling • Marketing • Selling • Delivering • Customer satisfaction • Administrative Costs • All other costs which cannot be attributed to production or selling • Executive salaries • Clerical support • What are examples of each type of cost?

12. Costs for a Manufacturing Company – An Example • Pick a manufacturing company • Cost • Direct Labour • Direct Materials • Manufacturing Overhead • Selling • Administration Examples

13. Selling Costs Administrative Costs Costs necessary to secure the order and deliver the product. All executive, organizational, and clerical costs. Nonmanufacturing Costs

14. Manufacturing costs are oftenclassified as follows: PrimeCost ConversionCost Classifications of Costs DirectMaterial DirectLabor ManufacturingOverhead

15. Cost behavior refers to how a cost will react to changes in the level of activity. The most common classifications are: Variable costs Fixed costs Mixed costs Cost Classifications for Predicting Cost Behavior

16. Your total texting bill is based on how many texts you send. Total Texting Bill Number of Texts Sent Variable Cost

17. The cost per text sent is constant at 5 cents per text message. Cost Per Text Sent Number of Texts Sent Variable Cost Per Unit

18. The Activity Base (Cost Driver) Unitsproduced Machine- hours A measure of what causes the incurrence of a variable cost Miles driven Labor- hours

19. Your monthly contract fee for your cell phone is fixed for the number of monthly minutes in your contract. The monthly contract fee does not change based on the number of calls you make. Monthly Cell Phone Contract Fee Number of Minutes UsedWithin Monthly Plan Fixed Cost

20. Within the monthly contract allotment, the average fixed cost per cell phone call made decreases as more calls are made. Monthly Cell Phone Contract Fee Number of Minutes UsedWithin Monthly Plan Fixed Cost Per Unit

21. Types of Fixed Costs Committed Long term, cannot be significantly reduced in the short term. Discretionary May be altered in the short term by current managerial decisions Examples Depreciation on Buildings and Equipment and Real Estate Taxes Examples Advertising and Research and Development

22. A straight line closely approximates a curvilinear variable cost line within the relevant range. RelevantRange Accountant’s Straight-Line Approximation (constant unit variable cost) The Linearity Assumption and the Relevant Range Economist’sCurvilinear Cost Function Total Cost Activity

23. Fixed costs would increase in a step fashion at a rate of RMB 30,000 for each additional 1,000 square feet. Fixed Costs and the Relevant Range For example, assume office space is available at a rental rate of RMB 30,000 per year in increments of 1,000 square feet.

24. Fixed Costs and the Relevant Range 90 The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat. Relevant Range 60 Rent Cost in Thousands of RMB 30 0 0 1,000 2,000 3,000 Rented Area (Square Feet)

25. Cost Classifications for Predicting Cost Behavior

26. Y X Mixed Costs(also called semivariable costs) A mixed cost contains both variable and fixed elements. Consider the example of utility cost. Total mixed cost Total Utility Cost Variable Cost per KW Fixed MonthlyUtility Charge Activity (Kilowatt Hours)

27. Y X Mixed Costs Total mixed cost Total Utility Cost Variable Cost per KW Fixed MonthlyUtility Charge Activity (Kilowatt Hours)

28. Y = a +bX Y = RMB400 + (RMB 0.30 × 2,000) Y = RMB 1000 Mixed Costs – An Example If your fixed monthly utility charge is RMB400, your variable cost is RMB0.30 per kilowatt hour, and your monthly activity level is 2,000 kilowatt hours, what is the amount of your utility bill?

29. Analysis of Mixed Costs Account Analysis and the Engineering Approach In account analysis, each account is classified as either variable or fixed based on the analyst’s knowledge of how the account behaves. The engineering approachclassifies costs based upon an industrial engineer’s evaluation of production methods, and material, labor, and overhead requirements.

30. Used primarily forexternal reporting. Used primarily bymanagement. The Traditional and Contribution Formats

31. Assigning Costs to Cost Objects Indirect costs • Costs that cannot be easily and conveniently traced to a unit of product or other cost object. • Example: manufacturing overhead Direct costs • Costs that can beeasily and conveniently traced to a unit of product or other cost object. • Examples: direct material and direct labor

32. Setting up the Income Statement • Revenues – • Relatively straight forward, from your Financial Accounting • Less Cost of Goods Sold (COGS)

33. Inventory Flows • Calculating inventory balances • Beginning inventory, plus • Additions to inventory, less • Withdrawals from inventory, equals • Ending balance • This straight forward formula holds true • For a simple merchandising situation where inventory is in a single account, • For each inventory account of a manufacturing company • Raw Materials, Work in Progress and Finished Goods

34. Inventory Flow - Example • Pick a merchandising company • It has $50 million of inventory on Jan 1, 2015 • It purchased $10 million on Jan 13, 2015 • By Jan 31, 2015, it sold $42 million of its inventory stock • What was the company’s opening inventory on Feb 1, 2015?

35. Inventory Flow - Example • Pick a manufacturing company • It has $10 million of raw materials inventory on Feb 1, 2015 • It purchased $5 million of additional raw materials on Feb 2 • It started working on converting $7 million of raw materials during Feb • By Feb 28, 2015, it sold $15 million of its finished goods • What was the company’s opening raw materials inventory on March 1, 2015?

36. Calculating Cost of Goods Manufactured • A Merchandiser does not manufacture, so there is no Cost of Goods Manufactured • COGS are simply the costs of what inventory it purchased • (Note this is a bit simplified as some companies may add some processing costs) • For a manufacturer, in order to calculate COGS, we need to know the costs of what the company has produced that is available and for sale and sold • By definition, these must be Finished Goods only • Therefore, we must calculate the flows and balances through each inventory account

37. Schedule of Cost of Goods Manufactured As items are removed from raw materials inventory and placed into the production process, they are called direct materials.

38. Conversion costs are costs incurred to convert the direct material into a finished product. Schedule of Cost of Goods Manufactured As items are removed from raw materials inventory and placed into the production process, they arecalled direct materials.

39. Schedule of Cost of Goods Manufactured All manufacturing costs incurred during the period are added to the beginning balance of work in process.

40. Schedule of Cost of Goods Manufactured Costs associated with the goods that are completed during the period are transferred to finished goods inventory.

41. Cost of Goods Sold

42. Cost of Goods Manufactured – Example • At year end, a manufacturing company has the following inventory balances: • RM - $12m, WIP - $20m, FG - $10m • Assume the following: • $12m of RM materials are purchased • $10m of RM are drawn into production • DL of $10m, MOH of $3m in the period • WIP closing balance was $10m • FG closing balance was $12m • Prepare a schedule of Cost of Goods Manufactured and calculate COGS for the period • Assume revenues of $50m, S&A of $10m – Prepare an I/S

43. Cost of Goods Manufactured – Example • Which of these accounts are Balance Sheet Accounts? • Which are Income Statement Accounts?

44. Income Statement – Example • Is this a profitable company? • Would you invest in this company? • At what valuation?

45. Income Statement – Investment Decisions • Is this a profitable company? • Yes, of course • Look to the margin % • Is it profitable enough? • What industry is it in? • What are its competitors’ results? • Would you invest in this company? • What are the trends in the industry and with the company? • At what valuation? • What levels of returns are reasonable to expect from taking on this level of risk?

46. Fixed and Variable Costs • Fixed Costs • Total Fixed Costs do not change with changes in activity • Variable Costs • Total Variable Costs change with changes in activity • Plot cost on the X axis, and activity on the Y axis for the following cost examples: • Factory lease • Direct labour • Machinery depreciation

47. Other Cost Classifications • Differential Costs and Differential Revenues • Used for decisions among alternatives • Sunk Costs • Opportunity Costs • These are in addition to: • Fixed versus Variable • Direct versus Indirect • Period versus Product • Of course any cost item can fit into a number of these categories

48. Every decision involves a choice between at least two alternatives. Only those costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits can and should be ignored as irrelevant. Cost Classifications for Decision Making

49. Costs and revenues that differ among alternatives. What is the differential benefit? Differential Cost and Revenue Example: You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month. Differential revenue is: $2,000 – $1,500 = $500 Differential cost is: $300

50. The potential benefit that is given up when one alternative is selected over another. Opportunity Cost Example: If you werenot attending college,you could be earning$15,000 per year. Your opportunity costof attending college for one year is $15,000.