Basic Cost Terms & Concepts

7/28/2019 Basic Cost Terms & Concepts

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© The McGraw-Hill Companies, Inc., 1999 Irwin/McGraw-Hill

Basic Cost Terms

and Concepts; CostBehaviour

Chapters Eight and Nine 8

and

9




Process of Management

DecisionMaking

Directing

ControlPlanning

Managers need cost information toperform each of these functions.




Cost Classifications

Cost behavior meanshow a cost will react tochanges in the level of

business activity.

Total variable costschange when activitychanges.

Total fixed costs remainunchanged whenactivity changes.





Cost behavior meanshow a cost will react tochanges in the level of

business activity. Total variable costs

change when activitychanges.

Total fixed costs remainunchanged whenactivity changes.

Activities thatcause costs to beincurred are called

cost drivers.




Total Variable Cost Example

Your total long distance telephone bill isbased on how many minutes you talk.

Minutes Talked

T o t a l L

o n g D i s t a n c e

T e l e

p h o n e B i l l




Variable Cost Per Unit Example

Minutes Talked

P e

r M i n u t e

T e l e p h

o n e C h a r g e

The cost per long distance minute talked isconstant. For example, 10 cents per minute.


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Total Fixed Cost Example

Your monthly basic telephone bill probablydoes not change when you make more local

calls.

Number of Local Calls

M o n

t h l y B a s i c

T e l e p h o n e B i l l



Fixed Cost Per Unit Example

Number of Local Calls

M o n t h l y B a s i c T e l e p h o

n e

B i l l p e r L o c a l C a l l

The average cost per local call decreases asmore local calls are made.




Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Total variable cost changes Variable cost per unit

Variable as activity level changes. remains the same over

wide ranges of activity.

Total fixed cost remains Fixed cost per unitFixed the same even when the goes down as activity

activity level changes. level goes up.



Cost Behavior Question

Fixed costs are usually characterized by:

a. Unit costs that remain constant.

b. Total costs that increase as activitydecreases.

c. Total costs that increase as activity

increases.

d. Total costs that remain constant.



Fixed costs are usually characterized by:

a. Unit costs that remain constant.

b. Total costs that increase as activitydecreases.

c. Total costs that increase as activity

increases.






Variable costs are usually characterized by:

a. Unit costs that decrease as activity

increases.b. Total costs that increase as activity

decreases.

c. Total costs that increase as activityincreases.




Variable costs are usually characterized by:

a. Unit costs that decrease as activity

increases.b. Total costs that increase as activity

decreases.

c. Total costs that increase as activityincreases.





Identifying Cost Drivers

Cost Driver Examples

Activity Cost Driver

Machining operations Machine hoursSetup Setup hours

Production scheduling Manufacturing orders

Inspection Pieces inspected

Purchasing Purchase ordersShop order handling Shop orders

Valve assembly support Customer requisitions




Direct and Indirect Costs

Direct costs

Costs that can beeasily and conveniently

traced to a product or department.

Example: cost of paintin the paint department

of an automobileassembly plant.

Indirect costs

Costs that must beallocated in order to be

assigned to a product or department.

Example: cost of national advertising for

an airline is indirect to aparticular flight.




A cost can be direct to the department, butindirect to units of product produced in the

department. Example: department manager’s salary.

Tracing costs directly to departments or

products facilitates responsibilityaccounting.

Direct and Indirect Costs




A cost that can be significantly influencedby a manager is a controllable cost.

Controllable and

Uncontrollable Costs

Cost item Manager Classificaton

Cost of food used Restaurant Controllable

in a restaurant manager

Cost of national Restaurant Uncontrollable

advertising by a manager

restaurant chain




Manufacturing Costs

TheProduct

ManufacturingOverhead

DirectLabor

DirectMaterial




Direct Material

Example:Steel used tomanufacture

the automobile.

Raw material that is used to make,and can be conveniently

traced, to the finished product.




Cost of salaries, wages, and fringebenefits for personnel who work

directly on manufactured products.

Direct Labor

Example: Wages paid to an

automobile assemblyworker.




All other manufacturing costs

Manufacturing Overhead

Materials used to support

the production process.Examples: lubricants andcleaning supplies used inan automobile assembly

plant.

IndirectLabor

IndirectMaterial

Other Costs






Cost of personnel who

do not work directly onthe product. Examples:maintenance workers, janitors and security

guards.

IndirectLabor

IndirectMaterial

Other Costs






Examples: depreciation

on plant and equipment,property taxes,insurance, utilities,

overtime premium, andunavoidable idle time.

IndirectLabor

IndirectMaterial

Other Costs




Classifications of Costs in

Manufacturing Companies

PrimeCost

ConversionCost

Manufacturing costs are oftencombined as follows:

DirectMaterial

DirectLabor





Merchandiser

Current Assets

Cash

Receivables

Prepaid Expenses

Merchandise Inventory

Manufacturer

Current Assets

Cash

Receivables

Prepaid Expenses

InventoriesRaw Materials

Work in Process

Finished Goods

Cost Classifications on Financial

Statements – Balance Sheet




Manufacturer

Current Assets

Cash

Receivables

Prepaid Expenses


Work in Process

Finished Goods

Merchandiser

Current Assets

Cash

Receivables

Prepaid Expenses




Those materialswaiting to beprocessed.




Manufacturer

Current Assets

Cash

Receivables

Prepaid Expenses


Work in Process

Finished Goods



Partially complete

products – material towhich some labor and/or overhead has

been added.

Merchandiser

Current Assets

Cash

Receivables

Prepaid Expenses







Costs

Manufacturing Cost Flows


Material Purchases

Direct Labor

Costs

Selling andAdministrative






Raw MaterialMaterial Purchases

Direct Labor

Balance Sheet Costs Inventories







Raw Material

Work inProcess

Material Purchases

Direct Labor








Raw Material

Work inProcess

Finished

Goods

Material Purchases

Direct Labor






Manufacturing Cost FlowsIncome

StatementExpenses


Raw Material

Work inProcess

Finished

Goods

Cost of

GoodsSold

Material Purchases

Direct Labor


Income

StatementExpenses







Raw Material

Work inProcess

Finished

Goods

Cost of

GoodsSold

Material Purchases

Direct Labor


Income

StatementExpenses



Period Expenses







Period Expenses


Raw Material

Work inProcess

Finished

Goods

Cost of

GoodsSold

Material Purchases

Direct Labor


Income

StatementExpenses

Material, labor andmanufacturing

overhead costsremain in inventoryuntil the product issold, so they aresometimes called

inventoriable costs.







Period ExpensesPeriod expenses are not associated with manufacturingthe product and are expensed in the period incurred.


Raw Material

Work inProcess

Finished

Goods

Cost of

GoodsSold

Material Purchases

Direct Labor


Income

StatementExpenses






Raw Material

Work inProcess

Finished

Goods

Cost of

GoodsSold


Material Purchases

Direct Labor


Income

StatementExpenses


Period Expenses

h d l d




Schedule of Cost of GoodsManufactured

Let’s look at a Schedule of Cost of

Goods Manufactured for Ringo Percussion Instruments.

h d l f f dExh.




Ringo Percussion Instruments

Schedule of Cost of Goods Manufactured

Raw material used 105,000$

Direct labor 200,000

Total manufacturing overhead 115,000

Total manufacturing costs 420,000$

Add: Work-in-process inventory, January 1 25,000

Subtotal 445,000$

Deduct: Work-in-process inventory, December 31 30,000

Cost of goods manufactured 415,000$


2-9

S h d l f C f G d

Exh.

2 9











Subtotal 445,000$




Computation of Cost of Raw Material Used

Raw-material inventory, January 1 10,000$

Add: Purchases of raw materials 100,000

Raw material available for use 110,000

Deduct: Raw material inventory, December 31 5,000


2-9

S h d l f C f G d

Exh.

2 9











Subtotal 445,000$




Include all direct labor costs incurred during the

current period.

2-9

S h d l f C f G d

Exh.

2 9










Add: Work-in-process inventory, January 1 25,000 Subtotal 445,000$




Computation of Total Manufacturing Overhead

Indirect material 8,000$

Indirect labor 17,000 Depreciation on factory 50,000

Depreciation on equipment 20,000

Utilities 15,000

Insurance 5,000

Total manufacturing overhead 115,000$

2-9

S h d l f C f G d

Exh.

2 9














Beginning work-in-process inventory iscarried over from the

prior period.

2-9

S h d l f C f G d

Exh.

2 9














Ending work-in-process inventorycontains the cost of unfinished

goods, and is reported in the currentassets section of the balance sheet.

2-9

I St t t f




Now let’s look at an income

statement for RingoPercussion Instruments.

Income Statement for aManufacturer

I St t t fExh.

2 9




Income Statement for aManufacturer


Income StatementFor the Year Ended December 31, 19X9

Sales revenue 700,000$

Less: Cost of goods sold 425,000

Gross margin 275,000$

Selling and administrative expenses 175,000

Income before taxes 100,000$

Income tax expense 40,000

Net income 60,000$

2-9

I St t t f

Exh.

2-9





Income StatementFor the Year Ended December 31, 19X9

Sales revenue 700,000$

Less: Cost of goods sold 425,000

Gross margin 275,000$

Selling and administrative expenses 175,000

Income before taxes 100,000$

Income tax expense 40,000

Net income 60,000$

Income Statement for aManufacturer Ringo Percussion Instruments

Schedule of Cost of Goods Sold

For the Year Ended December 31, 19X9

Finished-goods inventory, Jan. 1 80,000$

Add: Cost of goods manufactured 415,000

Cost of goods available for sale 495,000

Deduct Finished-goods inventory, Dec. 31 70,000

Cost of goods sold 425,000$

2-9




Opportunity Cost

The potential benefit that isgiven up when onealternative is selected over

another. Example: If you were

not attending college,you could be earning

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




Sunk Costs

All costs incurred in the past that cannot be changedby any decision made now or in the future.

Sunk costs should not be considered in decisions. Example: You bought an automobile that cost

$10,000 two years ago. The $10,000 cost issunk because whether you drive it, park it, trade

it, or sell it, you cannot change the $10,000 cost.




Differential Costs

Costs that differ between alternatives.

Example: You can earn $1,500 per month in your hometown or $2,000 per month in a nearby city.

Your commuting costs are $50 per month in your hometown and $300 per month to the city.

What is your differential cost?




Differential Costs

Costs that differ between alternatives.

Example: You can earn $1,500 per month in your hometown or $2,000 per month in a nearby city.

Your commuting costs are $50 per month in your hometown and $300 per month to the city.

What is your differential cost?$300 - $50 = $250




Marginal Costs and Average Costs

The extra costincurred to produceone additional unit.

The total cost toproduce a quantity

divided by thequantity produced.

Marginal and average costs arelargely a function of cost behavior

-- variable and fixed costs.




Costs and Benefits of Information

Costs Benefits

More information does not mean morebenefits if information overload results.



End of Presentation

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Basic Cost Terms & Concepts