Chapter 3

2. Chapter 3 Basic Cost Concepts

3. Learning Objectives • Explain the cost driver concepts at the activity, volume, structural, and executional levels • Explain the cost concepts used in product and service costing • Demonstrate how costs flow through the accounts

4. Learning Objectives • Prepare an income statement for both a manufacturing firm and a merchandising firm • Explain the cost concepts related to the use of cost information in planning and decision making • Explain the cost concepts related to the use of cost information for management and operational control

5. Critical First Step A critical first step in achieving a competitive advantage is to identify the key cost drivers in the firm or organization

6. Learning Objective One Explain the cost driver concepts at the activity, volume, structural, and executional levels

7. Unitsproduced Machinehours A cost driver isany factor that has the effect of changing thelevel of total cost. Milesdriven Laborhours Cost Drivers

8. Costs may becollected intogroups calledcost pools. A cost object is any product, service, or unit towhich costs are assigned forsome management purpose. Cost Drivers, Cost Pools,and Cost Objects A cost isincurred when aresource is used forsome purpose.

9. Cost Assignment and CostAllocation: Direct and Indirect Costs • Cost assignment is the process of assigning costs to cost pools or from cost pools to cost objects • A direct cost can be conveniently and economically traced directly to a cost pool or a cost object • An indirect cost has no convenient or economical way to trace from the cost to the cost pool or from the cost pool to the cost object

10. Cost Assignment and CostAllocation: Direct and Indirect Costs • Cost allocation is the assignment of indirect costs to cost pools and cost objects • Allocation bases are the cost drivers used to allocate costs

11. = SUGAR FLOUR MILK Direct Materials + + Direct materialsinclude the cost of materials in the product and a reasonable allowance for scrap and defective units.

12. Costs, Cost Pools, CostObjects, and Cost Drivers Cost Drivers and Cost Assignment Costs Cost Pools Cost Objects Electric Motor Assembly Materials Handling Dishwasher Supervision Packing Packing Materials Washing Machine Final Inspection

13. Costs, Cost Pools, CostObjects, and Cost Drivers Insert Exhibit 3.2 (Selected Examples) Here

14. Sweeping Compound Cleaning Material Indirect Materials Indirect materialsare materials used in manufacturing that are not physically part of the finished product.

15. Direct and Indirect Labor Costs • Direct labor includes the labor used to manufacture the product or to provide the service • Indirect labor includes supervision, quality control, inspection, purchasing and receiving, and other manufacturing support costs

16. . . . . are combined with indirectlabor and indirect materials intoa single cost pool called . . . . FactoryOverhead Other Indirect Costs Other indirect costs suchas building and equipment depreciation,property taxes, insurance, and utilities . . . .

17. Prime Cost and Conversion Cost • All indirect costs are commonly combined into a single cost pool call factory overhead • Prime cost refer to direct materials and direct labor that are sometimes considered together • Conversion cost refers to direct labor and factory overhead combined into a single amount

18. PrimeCost ConversionCost Prime Cost and Conversion Cost Manufacturing costs are oftencombined as follows: DirectMaterials DirectLabor FactoryOverhead

19. Types of Cost Drivers • Cost management requires a good understanding of how the total cost of a cost object changes as the cost drivers change. • The four types of cost drivers are: • activity-based • volume-based • structural • executional

20. Relationship between costs andvolume measures such as unitsproduced, direct labor hours,or quantity of materials used. Types of Cost Drivers Identified using activity analysis, a detailed description of specificactivities performed in the firm’s operations. Activity-based Volume-based Structural Executional

21. Types of Cost Drivers Activity-based • Involves strategic plans and decisions: • Scale • Experience • Technology • Complexity Volume-based • Short-term operational decisions: • Workforce involvement • Production process design • Supplier relationships Structural Executional

22. Bank Activities and Cost Drivers Insert Exhibit 3.4 (Bank Activities and Cost Drivers) Here

23. Examples of Cost and Cost Drivers Insert Exhibit 3.3 (Examples of Cost and Cost Drivers) Here

24. Relevant Range • The Relevant Range is the range of the cost driver: • in which the actual value of the cost driver is expected to fall and • for which the relations is assumed to be approximately linear

25. Total Cost and the Relevant Range Insert Exhibit 3.6

26. Linear Approximation Within the Relevant Range Insert Exhibit 3.7 (Linear Approximation) Here

27. Total Cost Variable and Fixed Costs Total Cost $6,600 $6,500 $3,000 Total Variable Cost Variable cost is the change in total cost associated with each change in the quantity of the cost driver 3,500 3,600 Units of the Cost Driver

28. Variable and Fixed Costs Total Cost Fixed cost is the portion of the total cost that does not change with a change in the quantity of the cost driver, within the relevant range. $6,600 $6,500 $3,000 Total Fixed Cost 3,500 3,600 Units of the Cost Driver

29. Step-Cost Total cost remainsconstant within anarrow range ofactivity. Cost Activity

30. Step-Cost Total cost increases to a new higher cost for the next higher range of activity. Cost Activity

31. Unit Cost and Marginal Cost • Unit Cost (or average cost) is the total manufacturing cost (materials, labor, and overhead) divided by units of output • Marginal cost is the additional cost incurred as the cost driver increases by one unit

32. Structural Cost Drivers Structural Cost Drivers are strategic in nature and involve plans and decision that have a long-term effect with regard to issues such as scale, experience, technology, and complexity

33. Structural Cost Drivers • Scale (i.e., how much should be invested?) • Experience (i.e., how much prior experience does the firm have in its current and planned products and services?) • Technology (i.e., what process technologies are used in manufacturing, and distributing the product or service?) • Complexity (i.e., what is the firm’s level of complexity?)

34. Executional Cost Drivers Executional Cost Drivers are factors the firm can manage in the short term to reduce costs, such as workforce involvement, design of the production process, and supplier relationships

35. Executional Cost Drivers • Workforce involvement (i.e., are the employees dedicated to continual improvement and quality?) • Design of the production process (i.e., can the layout of equipment and processes and the scheduling of production be improved?) • Supplier relationships (i.e., can the cost, quality, or delivery of materials and purchased parts be improved to reduce overall costs?)

36. Learning Objective Two Explain the cost concepts used in product and service costing

37. Product Costs and Period Costs • Product costs for a manufacturing firm include only the costs necessary to complete the product (direct materials, direct labor, and factory overhead) • Period costs are all nonproduct expenditures for managing the firm and selling the product

38. Product Costs • Product inventory for both manufacturing and merchandising firms is treated as an asset on their balance sheets • So long as the inventory has market value, it is considered an asset until the inventory is sold • Once sold, the cost of the inventory is transferred to the income statement as cost of goods sold

39. Period Costs • Period costs are expenses because there is no expectation that they will produce future value • Period costs primarily include the general, selling, and administrative costs that are necessary for the management of the company but are not involved directly or indirectly in the manufacturing process

40. Cost of Goods Sold Cost of goods sold is the cost of the product transferred to the income statement when inventory is sold

41. Learning Objective Three Demonstrate how costs flow though the accounts

42. Manufacturing, Merchandising, and Service Costing • Materials inventory keeps the cost of the supply of materials used in the manufacturing process or to provide the service • Work-in-Process inventory contains all costs put into the manufacture of products that are started but not complete at the financial statement date • Finished goods inventory holds the cost of goods that are ready for sale

43. Inventory Formula BeginningInventory Balance CostAdded Cost Transferred Out EndingInventoryBalance + + =

44. Cost flows in Manufacturing and Merchandising Firms Insert Exhibit 3.13 (Cost Flows) Here

45. Account Relationships Insert Exhibit 3.14 (Account Relationships) Here

46. Learning Objective Four Prepare an income statement for both a manufacturing firm and a merchandising firm

47. Income Statement for a Manufacturing Firm • The manufacturing firm requires a two-part calculation for cost of goods sold: • the first part combines the cost flows affecting the Work-in-Process Inventory account to determine the amount of Cost of Goods Manufactured • the second part combines the cost flows for the Finished Goods Inventory account to determine the amount of the cost of the goods sold and net income

48. Cost of Goods Manufactured Cost of goods manufactured is the cost of goods finished and transferred out of the Work-in-Process Inventory account this period

49. Statements for Manufacturing and Merchandising Firms Insert Exhibit 3.15a

50. Income Statement for a Service Firm Insert Exhibit 3.15b