2. Chapter 3 Basic Cost Concepts

3. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-3 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-4 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-5 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-6 Learning Objective One Explain the cost driver concepts at the activity, volume, structural, and executional levels

7. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-7 Cost Drivers Machine hours Labor hours Units produced Miles driven A cost driver is any factor that has the effect of changing the level of total cost.

8. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-8 Cost Drivers, Cost Pools, and Cost Objects A cost is incurred when a resource is used for some purpose. Costs may be collected into groups called cost pools. A cost object is any product, service, or unit to which costs are assigned for some management purpose.

9. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-9 Cost Assignment and Cost Allocation: 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-10 Cost Assignment and Cost Allocation: 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-11 Direct Materials Direct materials include the cost of materials in the product and a reasonable allowance for scrap and defective units. + FLOUR + MILK SUGAR =

12. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-12 Costs, Cost Pools, Cost Objects, and Cost Drivers Costs Electric Motor Materials Handling Supervision Packing Materials Cost Pools Assembly Packing Cost Objects Dishwasher Washing Machine Final Inspection Cost Drivers and Cost Assignment

13. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-13 Costs, Cost Pools, Cost Objects, and Cost Drivers Insert Exhibit 3.2 (Selected Examples) Here

14. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-14 Indirect Materials Indirect materials are materials used in manufacturing that are not physically part of the finished product. Sweeping Compound Cleaning Material

15. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-15 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-16 Other Indirect Costs Other indirect costs such as building and equipment depreciation, property taxes, insurance, and utilities........ are combined with indirect labor and indirect materials into a single cost pool called.... Factory Overhead

17. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-17 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-18 Prime Cost and Conversion Cost Prime Cost Conversion Cost Manufacturing costs are often combined as follows: Direct Materials Direct Labor Factory Overhead

19. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-19 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: 1. activity-based 2. volume-based 3. structural 4. executional

20. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-20 Types of Cost Drivers Activity-based Volume-based Structural Executional Identified using activity analysis, a detailed description of specific activities performed in the firm’s operations. Relationship between costs and volume measures such as units produced, direct labor hours, or quantity of materials used.

21. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-21 Types of Cost Drivers Activity-based Volume-based Structural Executional Involves strategic plans and decisions: Scale Experience Technology Complexity Short-term operational decisions: Workforce involvement Production process design Supplier relationships

22. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-22 Bank Activities and Cost Drivers Insert Exhibit 3.4 (Bank Activities and Cost Drivers) Here

23. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-23 Examples of Cost and Cost Drivers Insert Exhibit 3.3 (Examples of Cost and Cost Drivers) Here

24. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-24 Relevant Range The Relevant Range is the range of the cost driver: 1. in which the actual value of the cost driver is expected to fall and 2. for which the relations is assumed to be approximately linear

25. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-25 Total Cost and the Relevant Range Insert Exhibit 3.6

26. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-26 Linear Approximation Within the Relevant Range Insert Exhibit 3.7 (Linear Approximation) Here

27. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-27 Variable and Fixed Costs Total Variable Cost $6,600 $6,500 $3,000 3,500 3,600 Units of the Cost Driver Total Cost Variable cost is the change in total cost associated with each change in the quantity of the cost driver Total Cost

28. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-28 Variable and Fixed Costs $6,600 $6,500 $3,000 3,500 3,600 Units of the Cost Driver Total Cost Total Fixed 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. 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.

29. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-29 Step-Cost Activity Cost Total cost remains constant within a narrow range of activity.

30. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-30 Step-Cost Activity Cost Total cost increases to a new higher cost for the next higher range of activity.

31. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-31 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-32 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-33 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-34 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-35 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-36 Learning Objective Two Explain the cost concepts used in product and service costing

37. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-37 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-38 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-39 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-40 Cost of Goods Sold Cost of goods sold is the cost of the product transferred to the income statement when inventory is sold

41. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-41 Learning Objective Three Demonstrate how costs flow though the accounts

42. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-42 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-43 Inventory Formula Beginning Inventory Balance Cost Added Cost Transferred Out Ending Inventory Balance + + =

44. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-44 Cost flows in Manufacturing and Merchandising Firms Insert Exhibit 3.13 (Cost Flows ) Here

45. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-45 Account Relationships Insert Exhibit 3.14 (Account Relationships) Here

46. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-46 Learning Objective Four Prepare an income statement for both a manufacturing firm and a merchandising firm

47. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-47 Income Statement for a Manufacturing Firm The manufacturing firm requires a two-part calculation for cost of goods sold: 1. the first part combines the cost flows affecting the Work-in-Process Inventory account to determine the amount of Cost of Goods Manufactured 2. 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-48 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. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-49 Statements for Manufacturing and Merchandising Firms Insert Exhibit 3.15a

50. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-50 Income Statement for a Service Firm Insert Exhibit 3.15b

51. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-51 Learning Objective Five Explain the cost concepts related to the use of cost information in planning and decision making

52. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-52 Cost Concepts for Planning and Decision Making A relevant cost has the following two properties: 1. it differs for each decision option and 2. it will be incurred in the future A differential cost is a cost that differs for each decision option and is therefore relevant

53. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-53 Differential Costs Costs that differ among alternatives. Example: You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month. Differential cost is: $300 Differential cost is: $300 Differential revenue is: $500 Differential revenue is: $500

54. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-54 Opportunity Cost Opportunity Cost is the benefit lost when choosing one option precludes receiving the benefits from an alternative option Example: If you were not attending college, and you could be earning $18,000 per year, then your opportunity cost of attending college for one year is $18,000.

55. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-55 Sunk Costs Sunk costs are costs that have been incurred or committed in the past and are therefore irrelevant Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.

56. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-56 Attributes of Cost Information for Decision Making Accuracy Timeliness Cost and Value

57. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-57 Internal Accounting Controls Internal accounting controls is a set of policies and procedures that restrict and guide activities in the processing of financial data with the object to prevent or detect errors and fraudulent acts

58. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-58 Learning Objective Six Explain the cost concepts related to the use of cost information for management and operational control

59. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-59 Cost Concepts for Management and Operational Control Controllability Risk preferences

60. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-60 Cost Concepts for Management and Operational Control A cost is said to be controllable if the manager or employee has discretion in choosing to incur it or can significantly influence its amount with a given (usually short) period of time Risk preferences describe the way individuals differentially view decision options because they place a weight on certain outcomes that differs from the weight they place on uncertain outcomes

61. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-61 End of Chapter Three