Cost Terms and Objectives: A Comprehensive Guide for Beginners

1. CHAPTER 2 An Introduction to Cost Terms and Purposes

2. Basic Cost Terminology • Cost – sacrificed resource to achieve a specific objective. Such as (direct materials or advertising). • Actual Cost – a cost that has occurred ( a historical or past cost) • Budgeted Cost – a predicted cost or forecasted cost ( a future cost). • Cost Object – anything of interest for which a measurement of cost is desired.

3. Basic Cost Terminology • Cost Accumulation – a collection of cost data in an organized manner by means of an accounting system. • Cost Assignment – a general term that includes gathering accumulated costs to a cost object. This includes: • Tracing accumulated costs with a direct relationship to the cost object and, • Allocating accumulated costs with an indirect relationship to a cost object.

4. Direct and Indirect Costs • Direct Costs – can be conveniently and economically feasible (cost-effective) way traced (tracked) to a cost object • Indirect Costs – cannot be conveniently or economically feasible (cost-effective) way traced (tracked) to a cost object. Instead of being traced, these costs are allocated to a cost object in a rational and systematic manner.

5. Cost Examples • Direct Costs • Parts • Assembly line wages • Indirect Costs • Electricity • Rent • Property taxes

6. Direct and Indirect Costs COST OBJECT Example: Sports Illustrated magazine Direct Costs Example: Paper on which Sports Illustrated magazine is printed Tracing Indirect Costs Example: Lease cost for Time Allocating

7. Learning objective 3: Explain variable and fixed costs

8. Cost Behavior • Variable Costs – changes in total in proportion to changes in the related level of activity or volume • Fixed Costs – remain unchanged in total regardless of changes in the related level of activity or volume • Costs are fixed or variable only with respect to a specific activity or a given time period

9. Cost Behavior • Variable Costs: • If BMW buys a steering wheel at $60 for each of its BMW X5 vehicles, then the total cost of steering wheels is $60 times the number of vehicles produced, as the following table illustrates:

10. Cost Behavior

11. Cost Behavior • The steering wheel cost is an example of a variable cost because total cost changes in proportionto changes in the number of vehicles produced. • The cost per unit of a variable cost is constant.

12. Cost Behavior • It is precisely because the variable cost per steering wheel in column 2 is the same for each steering wheel that the total variable cost of steering wheels in column 3 changes proportionately with the number of X5s produced in column 1. • When considering how variable costs behave, always focus on total costs.

13. Cost Behavior • Fixed Costs: • Suppose BMW incurs a total cost of $2,000,000 per year for supervisors who work exclusively on the X5 line. • These costs are unchanged in total over a designated range of the number of vehicles produced during a given time span. • Fixed costs become smaller and smaller on a per unit basis as the number of vehicles assembled increases, as the following table shows.

14. Cost Behavior

15. Cost Behavior • Fixed Costs: • Suppose BMW incurs a total cost of $2,000,000 per year for supervisors who work exclusively on the X5 line. • These costs are unchanged in total over a designated range of the number of vehicles produced during a given time span. • Fixed costs become smaller and smaller on a per unit basis as the number of vehicles assembled increases, as the following table shows.

16. Cost Behavior • It is precisely because total line supervision costs are fixed at $2,000,000 that fixed supervision cost per X5 decreases as the number of X5s produced increases.

17. Cost Behavior Summarized Change in proportion with output More output = More cost Unchanged in relation to output constant Unchanged in relation to output constant Change inversely with output More output = lower cost per unit

18. Other Cost Concepts • Cost Driver – is a variable such as the level of activity or volume that causally affects costs over a given time span. • An activity is an event, task, or unit of work with a specified purpose—for example, designing products, setting up machines, or testing products.

19. Other Cost Concepts • The level of activity or volume is a cost driver if there is a cause-and-effect relationship between a change in the level of activity or volume and a change in the level of total costs. • For example, if product-design costs change with the number of parts in a product, the number of parts is a cost driver of product-design costs. • Similarly, miles driven is often a cost driver of distribution costs.

20. Other Cost Concepts • Relevant Range – is the band of normal activity level (or volume) in which there is a specific relationship between the level of activity (or volume) and a given cost • For example, a fixed cost is fixed only in relation to a given wide range of total activity or volume (at which the company is expected to operate) and only for a given time span.

21. Relationships of Types of Costs • We have introduced two major classifications of costs: direct/indirect and variable/fixed. • Costs may simultaneously be as follows: • Direct and variable • Direct and fixed • Indirect and variable • Indirect and fixed

23. Learning objective 4: Interpret unit costs Cautiously

24. Interpret unit costs Cautiously • Unit cost, also called an average cost, is calculated by dividingtotal cost by the related number of units. • The units might be expressed in various ways. Examples are automobiles assembled, packages delivered, or hours worked.

25. Interpret unit costs Cautiously • Suppose that, in 2011, its first year of operations, $40,000,000 of manufacturing costs are incurred to produce 500,000 speaker systems at the Memphis plant of Tennessee Products. • Then the unit cost is $80: • Total manufacturing costs ÷Number of units manufactured = • $40,000,000÷500,000 units = $80 per unit

26. Interpret unit costs Cautiously • If 480,000 units are sold and 20,000 units remain in ending inventory, the unit-cost concept helps in the determination of total costs in the income statement and balance sheet.

27. Interpret unit costs Cautiously

28. Cost Behavior Patterns Example(1) Bicycles by the Sea buys a handlebar at $52 for each of its bicycles. What is the total handlebar cost when 1,000 bicycles are assembled?

29. Cost Behavior Patterns Example(2) 1,000 units × $52 = $52,000 What is the total handlebar cost when 3,500 bicycles are assembled? 3,500 units × $52 = $182,000

30. Cost Behavior Patterns Example(3) Bicycles by the Sea 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.

31. Cost Behavior Patterns Example(4) What is the leasing (fixed) cost per bicycle when Bicycles assembles 1,000 bicycles? $94,500 ÷ 1,000 = $94.50 What is the leasing (fixed) cost per bicycle when Bicycles assembles 3,500 bicycles? $94,500 ÷ 3,500 = $27

32. Cost Drivers 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.

33. Relevant Range Example 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.

34. Total Costs and Unit Costs Example(1) What is the unit cost (leasing and handlebars) when Bicycles assembles 1,000 bicycles? Total fixed cost $94,500 + Total variable cost $52,000 =$146,500 $146,500 ÷ 1,000 = $146.50

35. Learning objective 5: Business Sectors, Types of Inventory, Inventoriable Costs, and Period Costs