3, Cost Terminology

8/8/2019 3, Cost Terminology

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Costs Terms, Concepts and

Classifications


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The ProductThe Product

DirectMaterials

DirectMaterials

DirectLabor

DirectLabor

Manufacturing

Overhead

Manufacturing

Overhead

Manufacturing Costs


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Direct Materials

Raw materials that become an integralpart of the product and that can beconveniently traced directly to it.

Example: A radio installed in an automobile

Example: A radio installed in an automobile


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Direct Labor

Those labor costs that can be easilytraced to individual units of product.

Example: Wages paid to automobile assembly workers

Example: Wages paid to automobile assembly workers


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Manufacturing costs that cannot betraced directly to specific units

produced.

Manufacturing Overhead

Examples: Indirect labor and indirect materials

Examples: Indirect labor and indirect materials

Wages paid to employeeswho are not directly

involved in productionwork.

Examples: maintenanceworkers, janitors and

security guards.

Materials used to supportthe production process.

Examples: lubricants andcleaning supplies used in theautomobile assembly plant.


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Classifications of Costs

DirectMaterialDirect

MaterialDirectLaborDirectLabor

ManufacturingOverhead


PrimeCost

ConversionCost

Manufacturing costs are oftenclassified as follows:


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Non-manufacturing Costs

Marketing or Selling Cost

Costs necessary to get

the order and deliverthe product.

Administrative Cost

All executive,

organizational, andclerical costs.


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Quick Check

Which of the following costs would beconsidered a period rather than a productcost in a manufacturing company?

A. Manufacturing equipmentdepreciation. B. Property taxes on corporate

headquarters. C. Direct materials costs. D. Electrical costs to light the

production

facility.


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Quick Check

Which of the following costs would beconsidered a period rather than a productcost in a manufacturing company?

A. Manufacturing equipmentdepreciation. B. Property taxes on corporate

headquarters. C. Direct materials costs. D. Electrical costs to light the

production

facility.


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Comparing Merchandising andManufacturing Activities

Merchandisers . . . Buy finished

goods.

Sell finishedgoods.

Manufacturers . . . Buy raw

materials.

Produce and sellfinished goods.

MegaLoMart


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Balance Sheet

Merchandiser

Current assets

uCashuReceivablesuPrepaid

Expenses

uMerchandiseInventory

Manufacturer Current Assets

xCash

xReceivablesxPrepaid Expenses

xInventoriesRaw Materials

Work in ProcessFinished Goods


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Balance Sheet

Merchandiser

Current assets

uCashuReceivablesuPrepaid

Expenses

uMerchandiseInventory

Manufacturer Current Assets

xCash

xReceivablesxPrepaid Expenses

xInventoriesRaw Materials

Work in ProcessFinished Goods

Partially completeproducts some

material, labor, oroverhead has been

added.

Completed productsawaiting sale.

Materials waiting tobe processed.


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The Income Statement

Cost of goods sold for manufacturers differs onlyslightly from cost of goods sold for

merchandisers.

Manufacturing Compan

Cost of goods sold:

Beg. finished

goods inv. 14,2$

+ Cost of goods

manufactured 234,1Goods available

for sale 248,3$

- Ending

finished goods

inventory (12,1

Merchandising Company

Cost of goods sold:Beg. merchandise

inventory 14,200$

+ Purchases 234,150

Goods available

for sale 248,350$

- Endingmerchandise

inventory (12,100)

= Cost of goods

sold 236,250$


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Inventory Flows

Beginningbalance

$$

Beginningbalance

$$

Additions$$$

Additions$$$+

Available$$$$$

Available$$$$$=

Endingbalance

$$

Endingbalance

$$=

Withdrawals$$$

Withdrawals$$$

_Available

$$$$$

Available$$$$$


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Quick Check

If your inventory balance at the beginningof the month was $1,000, you bought $100during the month, and sold $300 during themonth, what would be the balance at the endof the month?

A. $1,000. B. $ 800.

C. $1,200. D. $ 200.


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Quick Check

If your inventory balance at the beginningof the month was $1,000, you bought $100during the month, and sold $300 during themonth, what would be the balance at the endof the month?

A. $1,000. B. $ 800.

C. $1,200. D. $ 200.

$1,000 + $100 = $1,100$1,100 - $300 = $800


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Schedule of Cost of GoodsManufactured

Calculates the cost of rawmaterial, direct labor and

manufacturing overhead used

in production.

Calculates the manufacturingcosts associated with goodsthat were finished during the

period.


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Manufacturing Work

Raw Materials Costs In Process

Beginning raw Direct materials

materials inventory

+ Raw materialspurchased

= Raw materials

available for use

in production

Ending raw materials

inventory= Raw materials used

in production

As items are removed from rawmaterials inventory and placed into

the production process, they arecalled direct materials.

As items are removed from rawmaterials inventory and placed into

the production process, they arecalled direct materials.

Product Cost Flows


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Manufacturing

Raw Materials Costs In

Beginning raw Direct materials

materials inventory + Direct labor+ Raw materials + Mfg. overhead

purchased = Total manufacturing

= Raw materials costs

available for use

in production Ending raw materials

inventory

= Raw materials used

in production

Conversioncosts are costs

incurred toconvert thedirect materialinto a finished

product.

Conversioncosts are costs

incurred toconvert the

direct materialinto a finished

product.

Product Cost Flows


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Work

In P ro cess F in ish ed Go o d s

Be ginn ing w ork in Be ginn ing fin ishe d

p ro ce ss in ve n to ry g oo ds in ve n to ry

+ M a nufa cturing costs + Cost of goo dsfor the pe riod manufactured

= T o ta l w o r k i n p ro ce ss = C o st o f g o o ds

fo r the pe riod a va i la ble fo r sa le

Ending w ork in - End ing fin ishe d

p ro ce ss in ve n to ry g oo ds in ve n to ry

= Cost of goo ds Cost of goo dsmanufactured sold

Product Cost Flows


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Manufacturing Cost Flows

FinishedGoods

Cost of

GoodsSold

Selling andAdministrative

Period CostsSelling andAdministrative


Work inProcess

Direct Labor

Balance SheetCosts Inventories

IncomeStatementExpenses

Material Purchases Raw Materials


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Quick Check

Beginning raw materials inventory was$32,000. During the month, $276,000 of rawmaterial was purchased. A count at the endof the month revealed that $28,000 of raw

material was still present. What is the cost ofdirect material used?

A. $276,000

B. $272,000 C. $280,000 D. $ 2,000


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Quick Check

Beginning raw materials inventory was$32,000. During the month, $276,000 of rawmaterial was purchased. A count at the endof the month revealed that $28,000 of raw

material was still present. What is the cost ofdirect material used?

A. $276,000

B. $272,000 C. $280,000 D. $ 2,000

Beg. raw materials 32,000$

+ Raw materials

purchased 276,000

= Raw materials available

for use in production 308,000$

Ending raw materials

inventory 28,000

= Raw materials used

in production 280,000$


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Quick Check

Direct materials used in productiontotaled $280,000. Direct labor was$375,000 and factory overhead was

$180,000. What were totalmanufacturing costs incurred for themonth?

A. $555,000 B. $835,000 C. $655,000 D. Cannot be determined.


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Direct materials used in productiontotaled $280,000. Direct labor was$375,000 and factory overhead was

$180,000. What were totalmanufacturing costs incurred for themonth?

A. $555,000 B. $835,000 C. $655,000 D. Cannot be determined.

Direct Materials 280,000$+ Direct Labor 375,000

+ Mfg. Overhead 180,000

= Mfg. Costs Incurred

for the Month 835,000$

Quick Check


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Quick Check

Beginning work in process was$125,000. Manufacturing costsincurred for the month were

$835,000. There were $200,000 ofpartially finished goods remainingin work in process inventory at theend of the month. What was the

cost of goods manufactured duringthe month?

A. $1,160,000 B. $ 910,000 C. $ 760,000


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Beginning work in process was$125,000. Manufacturing costsincurred for the month were

$835,000. There were $200,000 ofpartially finished goods remainingin work in process inventory at theend of the month. What was the

cost of goods manufactured duringthe month?

A. $1,160,000 B. $ 910,000 C. $ 760,000

Quick Check

Beginning work in

process inventory 125,00$

+ Mfg. costs incurred

for the period 835,00

= Total work in process

during the period 960,00$

Ending work in

process inventory 200,00

= Cost of goods

manufactured 760,00$


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Quick Check

Beginning finished goodsinventory was $130,000. The cost ofgoods manufactured for the month

was $760,000. And the endingfinished goods inventory was$150,000. What was the cost ofgoods sold for the month?

A. $ 20,000. B. $740,000. C. $780,000.

D. $760,000.


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Quick Check

Beginning finished goodsinventory was $130,000. The cost ofgoods manufactured for the month

was $760,000. And the endingfinished goods inventory was$150,000. What was the cost ofgoods sold for the month?

A. $ 20,000. B. $740,000. C. $780,000.

D. $760,000.

$130,000 + $760,000 =$890,000

$890,000 - $150,000 =$740,000

os ass ca ons or


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os ass ca ons orPredicting Cost Behavior

How a cost will reactto changes in the

level of activity within

the relevant range. Total variable

costschangewhen activitychanges.

Total fixed costsremainunchanged whenactivity changes.


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Total Variable Cost

Your total long distance telephonebill is based on how many minutes youtalk.

Minutes Talked

TotalL

ongDistanc

e

Teleph

oneBill


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Variable Cost Per Unit

Minutes Talked

Pe

rM

inute

Teleph

oneC

harge

The cost per long distanceminutetalked is constant. Forexample, 10 cents per minute.


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Total Fixed Cost

Your monthly basic telephonebillprobably does not change when

you make more local calls.

Number of Local Calls

Mon

thlyBasic

Tele

phoneB

ill


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Fixed Cost Per Unit

Number of Local Calls

Month

ly

Bas

icTelephon

e

Billp

erLoca

lCall

The average fixed cost per local calldecreases as more local calls are

made.

C Cl ifi i f


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Cost Classifications forPredicting Cost Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains

as activity level changes. the same over wide ranges

of activity.

Fixed Total fixed cost remains Average fixed cost per unit goes

the same even when the down as activity level goes up.

activity level changes.


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Quick Check

Which of the following costs would bevariable with respect to the number of conessold at a Baskins & Robbins shop? (Theremay be more than one correct answer.)

A. The cost of lighting the store. B. The wages of the store manager. C. The cost of ice cream. D. The cost of napkins for customers.


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Quick Check

Which of the following costs would bevariable with respect to the number of conessold at a Baskins & Robbins shop? (Theremay be more than one correct answer.)

A. The cost of lighting the store. B. The wages of the store manager. C. The cost of ice cream. D. The cost of napkins for customers.

A i i C t t C t


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Assigning Costs to CostObjects

Direct costs

Costs that can beeasily andconveniently traced

to a unit of product orother cost object.

Examples: directmaterial and directlabor

Indirect costs

Costs that cannot beeasily andconveniently traced

to a unit of product orother cost object.

Example:manufacturingoverhead

C t Cl ifi ti f


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Every decision involves a choicebetween at least two alternatives.

Only those costs and benefits thatdiffer between alternatives arerelevant in a decision. All other costs

and benefits can and should beignored.

Cost Classifications forDecision Making

Diff ti l C t d


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Differential Costs andRevenues

Costs and revenues that differamong alternatives.

Example: You have a job paying $1,500 per month inyour hometown. You have a job offer in a neighboringcity that pays $2,000 per month. The commuting costto the city is $300 per month.

Example: You have a job paying $1,500 per month inyour hometown. You have a job offer in a neighboringcity that pays $2,000 per month. The commuting costto the city is $300 per month.

Differential revenue is:$2,000 $1,500 = $500

Differential cost is:

$300

Opportunity Costs


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Opportunity Costs

The potential benefit that isgiven up when onealternative is selected overanother.

Example: If you werenot attending college,you could be earning

$15,000 per year.Your opportunity costof attending college forone year is $15,000.


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Sunk Costs

Sunk costs have already been incurred andcannot be changed now or in the future. They

should be ignored when making decisions.

Example: You bought an automobile that cost$10,000 two years ago. The $10,000 cost is sunkbecause whether you drive it, park it, trade it, or sellit, you cannot change the $10,000 cost.


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Quick Check

Suppose you are trying to decide whetherto drive or take the train to Portland to attenda concert. You have ample cash to do either,but you dont want to waste money

needlessly. Is the cost of the train ticketrelevant in this decision? In other words,should the cost of the train ticket affect thedecision of whether you drive or take the

train to Portland? A. Yes, the cost of the train ticket is

relevant. B. No, the cost of the train ticket is not

relevant.


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Quick Check


needlessly. Is the cost of the train ticketrelevant in this decision? In other words,should the cost of the train ticket affect thedecision of whether you drive or take the

train to Portland? A. Yes, the cost of the train ticket is

relevant. B. No, the cost of the train ticket is not

relevant.


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Quick Check


needlessly. Is the annual cost of licensingyour car relevant in this decision?

A. Yes, the licensing cost is relevant.

B. No, the licensing cost is not relevant.


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Quick Check


needlessly. Is the annual cost of licensingyour car relevant in this decision?

A. Yes, the licensing cost is relevant.

B. No, the licensing cost is not relevant.


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Quick Check

Suppose that your car could be sold nowfor $5,000. Is this a sunk cost?

A. Yes, it is a sunk cost.

B. No, it is not a sunk cost.


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Quick Check

Suppose that your car could be sold nowfor $5,000. Is this a sunk cost?

A. Yes, it is a sunk cost.

B. No, it is not a sunk cost.

S f th T f C t


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Summary of the Types of CostClassifications

Financial reporting

Predicting cost behavior

Assigning costs to cost objects

Decision making


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Idle Time

The labor costs incurredduring idle time are ordinarily

treated as manufacturingoverhead.

Machine Breakdowns Material Shortages

Power Failures


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Overtime

The overtime premiums for all factoryworkers are usually considered to be part

of manufacturing overhead.


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Labor Fringe Benefits

Fringe benefits include employer paidcosts for insurance programs, retirement

plans, supplemental unemployment

programs, Social Security, Medicare,workers compensation andunemployment taxes.

Some companiesinclude all of these

costs inmanufacturing

overhead.

Other companies treatfringe benefit

expenses of directlaborers as additional

direct labor costs.


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Quality of Conformance

When the overwhelming majority ofproducts produced conform to design

specifications and are free fromdefects.

Prevention and Appraisal


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Prevention and AppraisalCosts

PreventionCosts

Support activitieswhose purpose is to

reduce the number ofdefects

Appraisal Costs

Incurred to identifydefective products

before the products areshipped

Internal and External Failure


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Internal and External FailureCosts

Internal FailureCosts

Incurred as a result ofidentifying defects

before they are shipped

External FailureCosts

Incurred as a result ofdefective productsbeing delivered to

customers


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Examples of Quality Costs

Prevention CostsQuality trainingQuality circlesStatistical processcontrol activities

Appraisal CostsTesting & inspecting

incoming materialsFinal product testingDepreciation of testing

equipment

Internal Failure CostsScrapSpoilageRework

External Failure Costs

Cost of field servicing &handling complaints

Warranty repairsLost sales


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Distribution of Quality Costs

When quality of conformance is low,total quality cost is high and consistsmostly of internal and external failure.

Companies can reduce theirtotal quality cost by

focusing on prevention andappraisal. The cost savings

from reduced defectsusually swamps the costsof the additional prevention

and appraisal efforts.

Ventura CompanyQuality Cost Report

For Years 1 and 2


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Quality costreports providean estimate of

the financialconsequences

of thecompanys

current defect

rate.

Amount Percent* Amount Percent*

Prevention costs:

Systems development 400,000$ 0.80% 270,000$ 0.54%

Quality training 210,000 0.42% 130,000 0.26%

Supervision of prevention activities 70,000 0.14% 40,000 0.08%

Quality improvement 320,000 0.64% 210,000 0.42%

Total prevention cost 1,000,000 2.00% 650,000 1.30%

Appraisal costs :

Inspection 600,000 1.20% 560,000 1.12%

Reliability testing 580,000 1.16% 420,000 0.84%

Supervision of testing and inspection 120,000 0.24% 80,000 0.16%

Depreciation of test equipment 200,000 0.40% 140,000 0.28%

Total appraisal cost 1,500,000 3.00% 1,200,000 2.40%

Internal failure costs:

Net cost of scrap 900,000 1.80% 750,000 1.50%

Rework labor and overhead 1,430,000 2.86% 810,000 1.62%

Downtime due to defects in quality 170,000 0.34% 100,000 0.20%

Disposal of defective products 500,000 1.00% 340,000 0.68%

Total internal failure cost 3,000,000 6.00% 2,000,000 4.00%

External failure costs:

Warranty repairs 400,000 0.80% 900,000 1.80%

Warranty replacements 870,000 1.74% 2,300,000 4.60%

Allowances 130,000 0.26% 630,000 1.26%

Cost of field servicing 600,000 1.20% 1,320,000 2.64%

Total external failure cost 2,000,000 4.00% 5,150,000 10.30%

Total quality cost 7,500,000$ 15.00% 9,000,000$ 18.00%

* As a percentage of total sales. In each year sales totaled $50,000,000.

Year 2 Year 1

Quality Cost Reports:


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Quality Cost Reports:Graphic Form

$10

9

8

7

6

5

4

3

2

1Appraisal

0Prevention Prevention

1 2

Year

QualityCost(in

millions)

Appraisal

Internal

Failure

External

Failure

Internal

Failure

External

Failure

20

18

16

14

12

10

8

6

4

2Appraisal

0Prevention Prevention

1 2

Year

QualityCostasaPercentageofSales

Appraisal

Internal

Failure

External

Failure

Internal

Failure

External

Failure

Qualityreports

can also

beprepared

ingraphic

form.

Uses of Quality Cost


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Uses of Quality CostInformation

Help managers see thefinancial significance of

defects.

Help managers identifythe relative importance of

the quality problems.

Help managers seewhether their quality

costs are poorlydistributed.

Limitations of Quality Cost


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Limitations of Quality CostInformation

Simply measuring qualitycost problems does notsolve quality problems.

Results usually lagbehind quality

improvement programs.

The most importantquality cost, lost sales, is

often omitted fromquality cost reports.

Documents

3, Cost Terminology