2Module Learning Objectives After completing this module, IE 475 students should be able to:Understand the strategic role of basic cost conceptsExplain the cost driver concepts at the activity, volume, structural, and executional levelsExplain the cost concepts used in product and service costingDemonstrate how costs flow through the accountsPrepare an income statement for both a manufacturing firm and a merchandising firmExplain the cost concepts related to the use of cost information in planning and decision making
3Basic DefinitionsA cost is incurred when a resource is used for some purposeCosts may be collected into groups called cost poolsA cost object is any product, service, or unit to which costs are assigned for some management purpose.
4Basic Definitions (cont.) Cost assignmentProcess of assigning costs to cost pools or from cost pools to cost objectsDirect costCan be conveniently and economically traced directly to a cost pool or a cost objectIndirect costHas no convenient or economical way to be traced from the cost to the cost pool or from the cost pool to the cost object
5Basic Definitions (cont.) Cost allocationAssignment of indirect costs to cost pools and cost objectsAllocation basesCost drivers used to allocate costs
6Costs, Cost Pools, Cost Objects, and Cost Drivers Electric MotorAssemblyMaterialsHandlingDishwasherSupervisionPackingPackingMaterialsWashingMachineFinalInspection
7Costs, Cost Pools, Cost Objects, and Cost Drivers (cont.)
8Direct Materials + = Direct materials include The cost of materials in the productLess purchase discounts but including freight and related chargesReasonable allowance for scrap and defective units+FLOURMILKSUGAR=
9Indirect MaterialsMaterials used in manufacturing that are not physically part of the finished productSweeping CompoundCleaning Material
10Direct and Indirect Labor Costs Includes the labor used to manufacture the product or to provide the serviceIndirect laborIncludes supervision, quality control, inspection, purchasing and receiving, and other manufacturing support costs
11Other Indirect Costs Factory Overhead Other indirect costs such as building and equipment depreciation, property taxes, insurance, and utilitiesare combined with indirect labor and indirect materials into a single cost pool calledFactory Overhead
12Prime Cost and Conversion Cost Manufacturing costs are often combined as follows:Direct MaterialsDirect LaborFactory Overhead
13Identifying Cost Drivers A critical first step in achieving a competitive advantage is to identify the key cost drivers in the firm or organizationWhat is a cost driver?Any factor that has the effect of changing the level of total costExamples
14Cost Drivers Cost drivers play two major roles in cost management: Enable the assignment of costs to cost objectsExplain cost behaviorThe four types of cost drivers are:Activity-basedVolume-basedStructuralExecutional
15Types of Cost Drivers Activity-based Identified using activity analysis, a detailed description of specific activities performed inthe firm’s operations.Volume-basedRelationship between costs and volume measures such as units produced, direct labor hours, or quantity of materials used.StructuralExecutional
16Activity-based Cost Drivers Pennsylvania Blue Shield
17Volume-based Cost Drivers Many cost drivers are volume-basedThe cost driver is the amount produced or the quantity of service providedThe more you produce, the more cost you incurAn important concept associated with volume-based cost drivers is that of the relevant range
18Volume-based Cost Drivers (cont.) The relevant range is the range of the cost driverin which the actual value of the cost driver is expected to fall, andfor which the relationship is assumed to be approximately linear
20Volume-based Cost Drivers (cont.) Linear Approximation for Actual Cost Behavior
21Volume-based Cost Drivers (cont.) Total Variable Cost$6,600$6,500$3,0003, ,600Units of the Cost DriverTotalCostVariable cost is the change in totalcost associated with each change in thequantity of the cost driverTotal Cost
22Volume-based Cost Drivers (cont.) TotalCost$6,600$6,500$3,000Fixed cost is the portion ofthe total cost that does notchange with a change in thequantity of the cost driver,within the relevant range.Total Fixed Cost3, ,600Units of the Cost Driver
24Volume-based Cost Drivers (cont.) Unit Cost (or average cost)Total manufacturing cost (materials, labor, and overhead) divided by units of outputUseful concept in setting prices and in evaluating product profitabilityMarginal costAdditional cost incurred as the cost driver increases by one unitUsed interchangeably with differential cost or incremental costUnder the assumption of linear cost within the relevant range, the concept of marginal cost is equivalent to the concept of unit variable cost
25Volume-based Cost Drivers (cont.) Unit Cost (or average cost) Illustration ofAverage Costs per Unit
26Types of Cost Drivers Involves strategic plans and decisions: Activity-basedInvolves strategic plans and decisions:ScaleExperienceTechnologyComplexityVolume-basedShort-term operational decisions:Workforce involvementProduction process designSupplier relationshipsStructuralExecutional
27Structural Cost Drivers ScaleHow much should be invested?ExperienceHow much prior experience does the firm have in its current and planned products and services?TechnologyWhat process technologies are used in manufacturing, and in distributing the product or service?ComplexityWhat is the firm’s level of complexity?
28Executional Cost Drivers Workforce involvementAre the employees dedicated to continual improvement and quality?Design of the production processCan the layout of equipment and processes and the scheduling of production be improved?Supplier relationshipsCan the cost, quality, or delivery of materials and purchased parts be improved to reduce overall costs?
29Value Chain of Product Costs Product inventory for both manufacturing and merchandising firms is treated as an asset on their balance sheetsSo long as the inventory has market value, it is considered an asset until the inventory is soldCost of goods soldCost of the product transferred to the income statement when inventory is sold
30Product CostsProduct costs for a manufacturing firm include only the costs necessary to complete the product
31Period CostsPeriod costs are all non-product expenditures for managing the firm and selling the productPeriod costs are expenses because there is no expectation that they will produce future valueInclude primarily the general, selling, and administrative costs necessary for the management of the company but are not involved directly or indirectly in the manufacturing processSometimes referred to as operating expenses or selling and administrative expenses
32Manufacturing, Merchandising, and Service Costing Three Inventory Accounts Materials inventoryKeeps the cost of the supply of materials used in the manufacturing process or to provide the serviceWork-in-Process inventoryContains all costs put into the manufacture of products that are started but not complete at the financial statement dateFinished goods inventoryHolds the cost of goods that are ready for sale
34Cost Flows in Manufacturing and Merchandising Firms
35Income Statement for a Manufacturing Firm Manufacturing firms require a two-part calculation for Cost of Goods SoldThe first part combines the cost flows affecting the Work-in-Process Inventory account to determine the amount of Cost of Goods ManufacturedCost of Goods Manufactured is the cost of goods finished and transferred out of the Work-in-Process Inventory account this periodThe 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
36Statements for Manufacturing and Merchandising Firms
37Cost Concepts for Planning and Decision Making Relevant CostThis concept arises when the decision maker must choose between two or more optionsMust determine which option offers the highest benefit ($)A relevant cost has the following two properties:
38Opportunity CostOpportunity Cost is the benefit lost when choosing one option precludes receiving the benefits from an alternative optionExample: 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.
39Sunk CostsSunk costs are costs that have been incurred or committed in the past and are therefore irrelevantExample: 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.
40Attributes of Cost Information for Decision Making AccuracyTimelinessCost and Value