Cost Terminology and Cost Flows

1. Cost Terminology and Cost Flows Chapter 2 © 2007 by Nelson, a division of Thomson Canada Limited.

2. Cost is of interest to everyone. Cost is a major factor both in achieving strategic success through competing effectively and in operating profitably. It is of interest to everyone. Before being able to effectively communicate information to others, accountants must clearly understand the differences among the various types of costs, their computations, and their usage. © 2007 by Nelson, a division of Thomson Canada Limited.

3. Learning Objectives What is the relationship between cost objects and direct costs? How does the conversion process work in manufacturing and service companies? What assumptions do accountants make about cost behaviour and why are these assumptions necessary? How can mixed costs be analyzed using the high–low method, scatter-graph method, and least-squares regression analysis (Appendix 2A)? © 2007 by Nelson, a division of Thomson Canada Limited. continued

4. Learning Objectives How are predetermined overhead rates developed and how does the selection of a capacity measure affect overhead application? How is underapplied or overapplied overhead accounted for at year-end and why are these accounting techniques appropriate? How is cost of goods manufactured calculated? Cost of goods sold? © 2007 by Nelson, a division of Thomson Canada Limited.

5. Components of Product Cost Cost – a monetary measure of the resources given up to acquire a good or service Cost Object – anything to which costs attach or are related Direct Cost – a cost that is clearly, conveniently, and economically traceable to a particular cost object Indirect Cost – a cost that cannot be clearly tracedto a particular cost object Allocate – assign indirect or overhead costs based on the use of a cost driver, predictor, or an arbitrary method Period Cost – a cost that is incurred during an accounting period to support the activities of the company; the cost of resources consumed during the period – an expense Product Cost – a cost associated with making or acquiring inventory or providing a service – an asset © 2007 by Nelson, a division of Thomson Canada Limited.

6. Product Costs Direct Material – readily identifiable, physical part of a product that is clearly, conveniently, and economically traceable to that product Direct Labour – the time spent by individuals who work specifically on manufacturing a product or performing a service and whose efforts are conveniently and economically traceable to that product or service; can also be viewed as the cost of the direct labour time Overhead – the expenses of a business such as rent, insurance, and utilities consumed in the production of a product or consumed in the supplying of a service © 2007 by Nelson, a division of Thomson Canada Limited.

7. Stages of Production Stage 1 Work Not Started Raw Items Stage 2 Work In Process Semi-finished goods Stage 3 Finished Work Completed product Product Ready for Sale Raw Materials + Supplies Raw Materials + Supplies + Direct Labour + Overhead © 2007 by Nelson, a division of Thomson Canada Limited.

8. Product Costs Prime Cost – the total cost of direct materials and direct labour; so called because these costs are most convincingly associated with and traceable to a specific product Conversion cost – the sum of direct labour and manufacturing overhead that is directly or indirectly necessary for transforming direct (raw) materials and purchased parts into a saleable finished product © 2007 by Nelson, a division of Thomson Canada Limited.

9. Product Costs Direct Material Direct Labour Overhead Prime Costs Conversion Costs © 2007 by Nelson, a division of Thomson Canada Limited.

10. Building the Product Cost All costs incurred to produce a product appear on the Cost of Goods Manufactured Statement Direct Materials Direct Labour Manufacturing Overhead Work-in- Process Inventory Finished Goods Inventory © 2007 by Nelson, a division of Thomson Canada Limited.

11. Cost Behaviour The manner in which a cost responds to a change in a related level of activity Cost Behaviour Relevant Range The specified range of activity over which a variable cost remains constant per unit or a fixed cost remains fixed in total Predictor An activity measure that is accompanied by a consistent, observable change in a cost item © 2007 by Nelson, a division of Thomson Canada Limited.

12. Variable Costs Variable costs are constant per unit, consequently total variable cost varies in direct proportion to the changes in activity. Examples of variable costs are direct materials, direct labour, and commissions. Variable costs $ Activity © 2007 by Nelson, a division of Thomson Canada Limited.

13. Fixed Costs Fixed costs remain constant in total within the relevant range of activity. Fixed costs per unit vary inversely with changes in activity: fixed cost per unit decreases with increases in activity and increases with decreases in activity. Examples of fixed costs are depreciation and insurance. $ Fixed Costs Activity © 2007 by Nelson, a division of Thomson Canada Limited.

14. Total and Unit Cost Behaviour Total CostUnit Cost Variable Varies in direct Is constant Cost proportion to throughout the changes in relevant range activity Fixed Is constant Varies inversely Cost throughout the with changes relevant range in activity throughout the relevant range © 2007 by Nelson, a division of Thomson Canada Limited.

15. Cost Behaviour Jabot Cosmetics makes and sells cologne. The company normally produces and sells between 10,000 and 13,000 bottles of cologne per year. The following cost data were drawn from the company’s accounting records. Number of Units 10,000 11,000 12,000 13,000 Total Costs Incurred Fixed $10,000 Variable 50,000 Total Costs $60,000 Cost Per Unit Fixed $ 1.00 Variable 5.00 Total Cost Per Unit $ 6.00 © 2007 by Nelson, a division of Thomson Canada Limited.

16. Cost Behaviour Number of Units 10,000 11,000 12,000 13,000 Total Costs Incurred Fixed $ 10,000 10,000 10,000 10,000 Variable 50,00055,00060,00065,000 Total Costs $ 60,00065,00070,00075,000 Cost Per Unit Fixed $ 1.00 .91 .83 .77 Variable 5.005.005.005.00 Total Cost Per Unit $ 6.005.915.835.77 © 2007 by Nelson, a division of Thomson Canada Limited.

17. Cost Behaviour Dollars Total Costs Variable Costs Fixed Costs 75,000 70,000 65,000 60,000 10,000 Activity 10,000 11,000 12,000 13,000 © 2007 by Nelson, a division of Thomson Canada Limited.

18. Mixed Costs Mixed Cost – a cost that has both a variable and a fixed component; it does not fluctuate in direct proportion to changes in activity, nor does it remain constant with changes in activity, for example, the electricity bill, or a rental truck Mixed costs $ Activity © 2007 by Nelson, a division of Thomson Canada Limited.

19. Step Costs Step Costs – a variable or fixed cost that shifts upward or downward when activity changes by a certain interval or step A step cost can be variable or fixed. Step variable costs have small steps and step fixed costs have large steps. When step costs exist, accountants must choose a specific relevant range of activity that will allow step variable costs to be treated as variable costs and step fixed costs to be treated as fixed costs. © 2007 by Nelson, a division of Thomson Canada Limited.

20. General Formula to Describe Costs y = a + bx where y = total cost a = fixed portion of total cost b = variable cost per unit x = activity base (or cost driver) This formula assumes linearity. (Accountants treat all costs as linear costs.) It is referred to as the straight-line formula. © 2007 by Nelson, a division of Thomson Canada Limited.

21. Analyzing Mixed Costs • High–low, scattergraph, and regression are simply cost • estimation techniques; none provides exact costs • of future activities. • The appropriateness of the cost formula depends on • the validity of the activity measure chosen to • predict the variable cost. • When significant changes are occurring in a business, • historical information may not be extremely useful • in attempting to predict future costs. © 2007 by Nelson, a division of Thomson Canada Limited.

22. High Low Method High Low Method – a technique for separating mixed costs that uses actual observations of a total cost at the highest and lowest levels of activity and calculates the change in both activity and cost; the levels chosen must be within the relevant range Outlier – a nonrepresentative point that falls outside of the relevant range of activity or that is a distortion of normal costs within the the relevant range Independent variable (x) – a variable that, when changed, will cause consistent, observable changes in another variable; a variable used as the basis of predicting the value of a dependent variable Dependent variable (y) – an unknown variable that is to be predicted by use of one or more independent variables © 2007 by Nelson, a division of Thomson Canada Limited.

23. High Low Method Cost formula: y = a + bx Estimated unit variable cost (b) is the slope of the line b = cost at highest activity level – cost at lowest activity level highest activity level – lowest activity level = change in the total cost change in activity level b represents the unit variable cost. a is calculated by subtracting total variable cost from total cost © 2007 by Nelson, a division of Thomson Canada Limited.

24. High Low Method Forrester Corporation recorded the following production activity and maintenance costs for two months. UnitsCost High activity level 9,000 $9,700 Low activity level 5,0006,100 Change 4,000$3,600 • Using these two levels of activity, compute • variable cost per unit • fixed cost • total cost © 2007 by Nelson, a division of Thomson Canada Limited.

25. High Low Method UnitsCost High activity level 9,000 $9,700 Low activity level 5,0006,100 Change 4,000$3,600 Unit variable cost = change in cost change in units Unit variable cost = $3,600 / 4,000 units = $0.90 per unit © 2007 by Nelson, a division of Thomson Canada Limited.

26. High Low Method UnitsCost High activity level 9,000 $9,700 Low activity level 5,0006,100 Change 4,000$3,600 Fixed cost = Total cost – Total variable cost Fixed cost = $9,700 - ($0.90 per unit X 9,000 units) = $9,700 - $8,100 = $1,600 © 2007 by Nelson, a division of Thomson Canada Limited.

27. High Low Method UnitsCost High activity level 9,000 $9,700 Low activity level 5,0006,100 Change 4,000$3,600 Total cost = Fixed cost + Variable cost Total cost = $1,600 + $0.90x = $1,600 + $8,100 = $9,700 © 2007 by Nelson, a division of Thomson Canada Limited.

28. High Low Method The following materials handling costs and moves have been observed during the past seven months: Moves Handling Costs 10* $ 150 20 200 30 300 40 350 50 400 60 450 70** 500 * Low point © 2007 by Nelson, a division of Thomson Canada Limited. ** High point

29. High Low Method VC = change in cost / change in activity = $500 - $150 70 - 10 = $5.83 per move FC = TC - VC x = $500 - ($5.83 X 70) = $91.90 TC = FC + VCx = $91.90 + $5.83x = $500 © 2007 by Nelson, a division of Thomson Canada Limited.

30. Scattergraph Method Scattergraph – A graphic presentation of two variables, i.e., total cost along the vertical (y) axis and some cost driver along the horizontal (x) axis The data for handling costs of moves is plotted © 2007 by Nelson, a division of Thomson Canada Limited.

31. Regression Analysis Regression analysis – a statistical procedure used to determine and measure a predictive relationship between one dependent variable and one or more other independent variables Correlation – a statistical measure of the strength of the relationship between two variables Regression analysis often results in a more reliable estimate of the cost formula than does the high–low method or the scattergraph method. Unlike the high–low method this method uses all of the data points to calculate the cost formula. (See Appendix 2A.) © 2007 by Nelson, a division of Thomson Canada Limited.

32. Overhead - A Closer Look Costs that cannot be traced to products and services in a cost effective manner are called indirect costs and are part of manufacturing overhead. Depreciation onManufacturingAssets FactoryUtilities Rent onManufacturingFacilities IndirectLabour SupervisorySalaries IndirectMaterials Maintenance Manufacturing Overhead © 2007 by Nelson, a division of Thomson Canada Limited.

33. Developing and Using Predetermined Overhead Rates Predetermined overhead rate – a budgeted constant charge to assign overhead costs to production or services © 2007 by Nelson, a division of Thomson Canada Limited.

34. Variable Overhead Rate • Computed for each variable overhead cost pool • Activity measure should provide a logical • relationship between activity and cost, • e.g., direct labour hours, direct labour dollars, • machine hours, production orders, production- • related physical measures Estimated VOH cost for coming year Estimated activity measure for coming year © 2007 by Nelson, a division of Thomson Canada Limited.

35. Fixed Overhead Rate CAPACITY – a measure of production volume or of some other cost driver related to plant production capability during a period Expected annual capacity – a short-run concept representing the anticipated level of activity for the upcoming year Ideal capacity / Theoretical capacity – the estimated absolute maximum potential production activity that could occur in a production facility during a specific time frame Practical capacity – the activity level that could be achieved during normal working hours given unused capacity and ongoing, regular operating interruptions, such as holidays, downtime, and start-up time Normal capacity – a firm's long-run average activity (over five to ten years) which gives effect to historical and estimated future production levels and to cyclical and seasonal fluctuations © 2007 by Nelson, a division of Thomson Canada Limited.

36. Fixed Overhead Rate • Select a specific activity level • expected annual capacity • theoretical capacity • practical capacity • normal capacity Estimated FOH cost for coming year Estimated activity measure for coming year © 2007 by Nelson, a division of Thomson Canada Limited.

37. Overhead Application Applied Overhead – the amount of overhead assigned to Work in Process Inventory as a result of the occurrence of the activity that was used to develop the application rate; the result of multiplying the quantity of actual activity by the predetermined rate © 2007 by Nelson, a division of Thomson Canada Limited.

38. Overapplied and Underapplied Overhead Underapplied overhead – overhead applied to Work in Process Inventory that is less than actual overhead incurred for a period Overapplied overhead – overhead applied to Work in Process Inventory that is greater than actual overhead incurred for a period © 2007 by Nelson, a division of Thomson Canada Limited.

39. Disposition of Underapplied Overhead Manufacturing Overhead Actual Overhead Applied Overhead XX XXX Debit Balance Cost of goods sold X Manufacturing Overhead X © 2007 by Nelson, a division of Thomson Canada Limited.

40. Disposition of Overapplied Overhead Manufacturing Overhead Actual Overhead Applied Overhead XX XXX Credit Balance Manufacturing Overhead X Cost of Goods Sold X © 2007 by Nelson, a division of Thomson Canada Limited.

41. Disposition of Underapplied and Overapplied Overhead • Year-end disposition depends on materiality of the amount. • If immaterial: amount is closed to Cost of Goods Sold • Cost of Goods Sold increases if underapplied OH • Cost of Goods Sold decreases if overapplied OH • If material: amount is allocated to • Work in Process Inventory • Finished Goods Inventory using relative value • Cost of Goods Sold © 2007 by Nelson, a division of Thomson Canada Limited.

42. Combined Overhead Rates • Advantages • Clerical ease • Clerical cost savings • No formal requirement to separate • overhead costs by behaviour © 2007 by Nelson, a division of Thomson Canada Limited.

43. Combined Overhead Rates • Disadvantages • Reduces manager's ability to determine the • causes of underapplied or overapplied • overhead • Underlying cause—effect relationships • between activities are blurred • contributes to inability to reduce costs • limits attempts to improve productivity • hinders ability to plan operations, • control costs, and make decisions © 2007 by Nelson, a division of Thomson Canada Limited.

44. Accumulation of Product Costs Raw Materials Work in Process Finished Goods Debit for cost Credit for Debit for cost Credit for cost Debit for cost Credit for cost of purchases amount put of direct of each finished of each of goods at into production material, direct job finished job time of sale Credit for labour and indirect manufacturing materials used overhead Factory Payroll Cost of Goods Sold Debit for Credit for direct Debit for the wages paid labour used in cost of goods production at the time of Credit for sale indirect labour Manufacturing Overhead Debit for Credit for indirect costs overhead applied (overhead) to production based on the predetermined rate © 2007 by Nelson, a division of Thomson Canada Limited.

45. Accumulation of Product Costs Raw Materials Work in Process Finished Goods 5,500 53,500 17,500 324,875 7,890 327,125 49,000 53,500324,875 1,000 117,500 5,640 161,300 24,925 Factory Payroll Cost of Goods Sold 165,500 117,500327,125 48,000 -0- Manufacturing Overhead Explain the amounts in each of the accounts and prepare journal entries. Sales were in the amount of $500,000. 117,300 161,300 48,000 4,000 © 2007 by Nelson, a division of Thomson Canada Limited.

46. Accumulation of Product Costs Beginning Inventories Raw Materials $ 5,500 Work in Process 17,500 Finished Goods 7,890 Manufacturing Overhead $117,300 is all overhead incurred Purchases Raw Materials Inventory 49,000 Accounts Payable 49,000 Materials Requisition Work in Process Inventory 53,500 Raw Materials Inventory 53,500 © 2007 by Nelson, a division of Thomson Canada Limited.

47. Accumulation of Product Costs • Allocated payroll costs • Work in Process 117,500 • Manufacturing Overhead 48,000 • Factory Payroll 165,500 • Paid Employees • Factory Payroll 165,500 • Cash 165,500 • Application of Overhead • Work in Process Inventory 161,300 • Manufacturing Overhead 161,300 © 2007 by Nelson, a division of Thomson Canada Limited.

48. Accumulation of Product Costs • Completed Goods Transferred • Finished Goods Inventory 324,875 • Work in Process Inventory 324,875 • Sold Product • Accounts Receivable 500,000 • Sales 500,000 • Cost of Goods Sold 327,125 • Finished Goods Inventory 327,125 © 2007 by Nelson, a division of Thomson Canada Limited.

49. Cost of Goods Manufactured and Sold Cost of goods manufactured – the total manufacturing costs attached to units produced during an accounting period Cost of goods manufactured Statement – the total cost of the goods that were completed and transferred to Finished Goods Inventory during the period Cost of goods sold – the cost of the products or services sold during the period © 2007 by Nelson, a division of Thomson Canada Limited.

50. Cost of Goods Manufactured and Sold Calculation: Cost of Goods Manufactured Additions: (DM, DL, MOH applied) + Beginning WIP - Ending WIP = Cost of Goods Manufactured Calculation: Cost of Goods Sold (manufacturing firm) Beginning Inventory (FG) + Additions: (cost of goods manufactured) - Ending Inventory (FG) +/- Under / overapplied OH = Cost of Goods Sold © 2007 by Nelson, a division of Thomson Canada Limited.