1. An Introduction to Cost Terms and Purposes © 2009 Pearson Prentice Hall. All rights reserved.

2. Comparing merchandising and manufacturing activities Merchandisers... buy finished goods. sell finished goods. Manufacturers... buy raw materials. produce and sell finished goods.

3. © 2009 Pearson Prentice Hall. All rights reserved. Basic Cost Terminology Cost – sacrificed resource to achieve a specific objective Actual cost – a cost that has occurred Budgeted cost – a predicted cost Cost object – anything of interest for which a cost is desired

4. © 2009 Pearson Prentice Hall. All rights reserved. Cost Object Examples at BMW Cost Object Illustration Product BMW X 5 sports activity vehicle Service Dealer-support telephone hotline Project R&D project on DVD system enhancement Customer Herb Chambers Motors, a dealer that purchases a broad range of BMW vehicles Activity Setting up production machines Department Environmental, Health & Safety

5. © 2009 Pearson Prentice Hall. All rights reserved. Cost classification allows the MA to collate relevant cost information Classifying costs means grouping them according to some common factor Many cost classifications depend on the cost object Cost Classification

6. © 2009 Pearson Prentice Hall. All rights reserved. Direct & Indirect Costs Direct costs – can be conveniently and economically traced (tracked) to a cost object Indirect costs – cannot be conveniently or economically traced (tracked) to a cost object. Instead of being traced, these costs are allocated to a cost object in a rational and systematic manner

7. © 2009 Pearson Prentice Hall. All rights reserved. The product BMW X5 Direct materials Direct labour Indirect costs Indirect costs

8. © 2009 Pearson Prentice Hall. All rights reserved. Direct Materials Those materials that become an integral part of the product and that can be conveniently traced directly to it. Example: cost of steel and tires for BMW X5

9. © 2009 Pearson Prentice Hall. All rights reserved. Direct Labor Those labor costs that can be easily traced to individual units of product Example: Example: Wages paid to the BMX X5 assembly workers

10. © 2009 Pearson Prentice Hall. All rights reserved. Indirect costs costs that cannot be traced directly to specific units produced Example: Example: the salaries of plant administrator Its indirect cost because he also oversee the production of other products Example: Example: the salaries of plant administrator Its indirect cost because he also oversee the production of other products

11. © 2009 Pearson Prentice Hall. All rights reserved. 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 Basic Cost Terminology

12. © 2009 Pearson Prentice Hall. All rights reserved. BMW: Assigning Costs to a Cost Object

13. © 2009 Pearson Prentice Hall. All rights reserved. Cost Examples Direct Costs Parts Assembly line wages Indirect Costs Electricity Rent Property taxes

14. © 2009 Pearson Prentice Hall. All rights reserved. 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 Example page # 52

15. © 2009 Pearson Prentice Hall. All rights reserved. Cost Behavior, continued Variable costs – are constant on a per-unit basis. If a product takes 5 pounds of materials each, it stays the same per unit regardless of one, ten or a thousand units are produced Fixed costs – change inversely with the level of production. As more units are produced, the same fixed cost is spread over more and more units, reducing the cost per unit

16. © 2009 Pearson Prentice Hall. All rights reserved. Cost Behavior Summarized Total DollarsCost per Unit Variable Costs Change in proportion with output More output = More cost Fixed Costs Unchanged in relation to output Change inversely with output More output = lower cost per unit Total DollarsCost Per Unit Variable Costs Change in proportion with output More output = More cost Unchanged in relation to output Fixed CostsUnchanged in relation to output Change inversely with output More output = lower cost per unit

17. © 2009 Pearson Prentice Hall. All rights reserved. Cost Behavior Visualized

18. © 2009 Pearson Prentice Hall. All rights reserved. Other Cost Concepts Cost Driver – a variable that causally affects costs over a given time span Relevant Range – 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, fixed costs are considered fixed only within the relevant range.

19. © 2009 Pearson Prentice Hall. All rights reserved. Relevant Range Visualized

20. © 2009 Pearson Prentice Hall. All rights reserved. Multiple Classification of Costs Costs may be classified as: Direct / Indirect, and Variable / Fixed These multiple classifications give rise to important cost combinations: Direct & Variable Direct & Fixed Indirect & Variable Indirect & Fixed

21. © 2009 Pearson Prentice Hall. All rights reserved. Multiple Classification of Costs, Visualized

22. © 2009 Pearson Prentice Hall. All rights reserved. Different Types of Firms Manufacturing-sector companies – create and sell their own products Merchandising-sector companies – product resellers Service-sector companies – provide services (intangible products)

23. © 2009 Pearson Prentice Hall. All rights reserved. Types of Manufacturing Inventories Direct Materials – resources in-stock and available for use Work-in-Process (or progress) – products started but not yet completed. Often abbreviated as WIP Finished Goods – products completed and ready for sale

24. © 2009 Pearson Prentice Hall. All rights reserved. Types of Product Costs Also known as Inventoriable Costs Direct Materials Direct Labor Indirect Manufacturing – factory costs that are not traceable to the product. Other common names for this type of cost include Manufacturing Overhead costs or Factory Overhead costs.

25. © 2009 Pearson Prentice Hall. All rights reserved. Inventoriable costs – product manufacturing costs. These costs are capitalized as assets (inventory) until they are sold and transferred to Cost of Goods Sold. Period costs – are all costs in the income statement other than cost of goods sold. have no future value and are expensed as incurred. Marketing, customer service costs.

26. © 2009 Pearson Prentice Hall. All rights reserved. Cost Flows The Cost of Goods Manufactured and the Cost of Goods Sold section of the Income Statement are accounting representations of the actual flow of costs through a production system. Note the importance of inventory accounts in the following accounting reports, and in the cost flow chart

27. © 2009 Pearson Prentice Hall. All rights reserved. Product costs (Inventoriable Costs) include direct materials, direct labor and manufacturing overhead. Period costs Period costs are not included in product costs. They are expensed on the profit statement.

28. © 2009 Pearson Prentice Hall. All rights reserved. Cost flows and classifications in a manufacturing company Raw materials Material purchases Costs Statement of Financial Position Income Statement Manufacturing overhead Work in progress Direct labour Finished goods Cost of goods sold Selling and administrative Period Costs marketing cost Distribution cost

29. © 2009 Pearson Prentice Hall. All rights reserved. Cost of Goods Manufactured

30. © 2009 Pearson Prentice Hall. All rights reserved. Multiple-Step Income Statement

31. © 2009 Pearson Prentice Hall. All rights reserved. Other Cost Considerations Prime cost is a term referring to all direct manufacturing costs (labor and materials) Conversion cost is a term referring to direct labor and factory overhead costs, collectively Overtime labor costs are considered part of overhead due to the inability to precisely know the true cause of these costs

32. © 2009 Pearson Prentice Hall. All rights reserved. Prime and conversion costs Direct materials Direct labour Manufacturing overhead Prime cost Conversion cost