1. Chapter 4 Cost Terminology and Cost Flows

2. 1.What is the relationship between cost objects and direct costs? 2. How do you classify product costs into direct materials, direct labor, and factory overhead categories? C4 Learning Objectives

3. 3.How does the conversion process work in manufacturing and service companies? 4.What are the assumptions accountants make about cost behavior and why are these assumptions necessary? C4 Continuing... Learning Objectives

4. 5.How can mixed costs be analyzed using the high-low method and (Appendix) least-squares regression analysis? 6.What is the usefulness of flexible budgeting to managers? C4 Continuing... Learning Objectives

5. 7.How are predetermined factory overhead rates developed and how does the selection of a capacity measure affect factory overhead application? 8.How is underapplied or overapplied factory overhead accounted for at year-end and why are these accounting techniques appropriate? C4 Continuing... Learning Objectives

6. 9. Why are separate predetermined overhead rates generally more useful than combined rates? 10. How is cost of goods manufactured calculated? C4 Continuing... Learning Objectives

7. Cost Classification Categories Time of incurrence Reaction to changes in activity Classification on the financial statements Impact on decision making Type of sacrifice

8. Continuing... Cost Classification Categories Cost Classification Types of Costs Associated with time of incurrence Historical (past) Replacement (present) Budgeted (future)

9. Continuing... Cost Classification Categories Cost Classification Types of Costs Cost behavior: reaction to changes in activity Variable (fluctuates in total) Fixed (constant in total) Mixed (part variable; part fixed)

10. Continuing... Cost Classification Categories Cost Classification Types of Costs Classification on the financial statements Unexpired (balance sheet) Expired (income statement) Product (inventoriable) Direct (traceable) Indirect (nontraceable) Prime Conversion Period (expensed)

11. Continuing... Cost Classification Categories Cost Classification Types of Costs Impact on decision making Relevant (important) Quality (conformity) Prevention Appraisal Failure

12. Continuing... Cost Classification Categories Cost Classification Types of Costs Type of sacrifice Out-of-pocket (cash) Sunk (historical) Opportunity (foregone benefit)

13. Components of Product Cost Product costs relate to the products or services that generate an entity’s revenues. These costs are either direct or indirect in relation to a particular cost object. Costs that are clearly traceable to the cost object are called direct costs. Costs that cannot be traced to the cost object are indirect (or common) costs.

14. Direct Material Readily identifiable, physical part of a product Clearly, conveniently, and economically traceable to a product

15. Direct Labor Individuals who work on product or perform service Basic compensation Production efficiency bonuses Employer’s share of Social Security and Medicare taxes Employer-paid insurance costs, holiday and vacation pay, and retirement benefits — only if operations are relatively stable

16. Factory Overhead Any factory or production cost that is not directly or conveniently traceable to manufacturing a product or providing a service

17. Behavior of Product Costs Direct Material –Variable Direct Labor –Generally variable Factory Overhead –Some variable –Some fixed

18. Prime Cost Prime Cost = Direct Material + Direct Labor

19. Conversion Cost Conversion Cost = Direct Labor + Factory Overhead

20. Stages of Production Production processing or conversion can be viewed as existing in three stages: 1. Work not started (raw materials) 2. Work in process 3. Finished work

21. Determining Cost Behavior Cost driver –Activity has a direct cause-effect relationship with a cost Cost predictor –Activity is accompanied by consistent, observable changes in a cost.

22. Basic Cost Graph Total Cost Activity Level 0 y x

23. Relevant Range Total Cost Activity Level

24. Variable Cost y = bx b = slope of line Total Cost Activity Level

25. Fixed Cost y = a a = y intercept Total Cost Activity Level 0

26. Total Cost y = a + bx Total Cost Activity Level 0

27. Mixed Cost Total Cost Activity Level 0

28. Step Cost Total Cost Activity Level 0

29. Step Variable Cost Total Cost Activity Level 0

30. Step Fixed Cost Total Cost Activity Level 0

31. High-Low Method Cost estimation technique for separating mixed cost into variable and fixed components Uses activity and cost information Select highest and lowest activity levels--if within relevant range Used to develop y = a + bx

32. High-Low Analysis of Utility Cost: Step 1 January February March April May June July 11,300 11,400 9,000 11,500 11,200 10,100 12,200 $1,712 1,716 1,469 1,719 1,698 1,691 1,989 MONTH LEVEL OF ACTIVITY UTILIT Y COST

33. High-Low Analysis of Utility Cost: Step 2 Associated Utility Cost Cups of Coffee High activity — April Low activity — March 11,500 9,000 $1,719 1,469 Changes 2,500 ==== $ 250 =====

34. High-Low Analysis of Utility Cost: Step 3 $ 250 2,500 = $.10 per cup Change in total cost Change in activity volume b ==

35. High-Low Analysis of Utility Cost: Step 4 High level of activity: TVC = $.10 (11,500) = $1,150 Low level of activity: TVC = $.10 (9,000) = $ 900 OR

36. High-Low Analysis of Utility Cost: Step 5 High level of activity: a = $1,719 - $1,150 = $569 ==== Low level of activity: a = $1,469 - $900 = $569 ==== OR

37. High-Low Analysis of Utility Cost: Step 6 y = $569 + $.10x where x = number of cups of coffee

38. Preparing a Flexible Budget Analyze overhead as to cost behavior –Find variable, fixed, and mixed costs Separate each mixed cost into variable and fixed components –Use cost formula (y = a + bx) for each mixed cost Prepare a series of individual financial plans that detail the individual costs at different levels of activity

39. Flexible Budget # of Units 5,000 7,000 9,000 Variable Cost $1.85 $1.85 $1.75 Fixed Cost $3,500 $5,200 $5,200 Variable Cost $8,750$12,950$15,750 Fixed Cost 3,500 5,200 5,200 Total Cost $12,250$18,150$20,950 ====== ====== ======

40. Variable Overhead Rate Computed for each variable overhead cost pool Activity measure should provide a logical relationship between activity and cost –Direct labor hours, direct labor dollars, machine hours, production orders, production-related physical measures Budgeted VOH cost for coming year Budgeted activity measure for coming year

41. Budgeted FOH cost for coming year Budgeted activity measure for coming year Fixed Overhead Rate Select a specific activity level –Expected capacity –Theoretical capacity –Practical capacity –Normal capacity

42. Disposition of Underapplied and Overapplied Overhead If immaterial: amount closed to Cost of Goods Sold –Cost of Goods Sold increased if underapplied OH –Cost of Goods Sold decreased if overapplied OH If material: amount allocated to –Work in Process Inventory –Finished Goods Inventory –Cost of Goods Sold Year-end disposition depends on materiality of the amount.

43. Combined Overhead Rate Advantages Clerical ease Clerical cost savings No formal requirement to separate overhead costs by behavior

44. Continuing... Combined Overhead Rate Disadvantages Reduces manager’s ability to determine the causes of underapplied or overapplied overhead Underlying cause-effect relationships between activities and costs are blurred –Contributes to inability to reduce costs –Limits attempts to improve productivity –Hinders ability to plan operations, control costs, and make decisions

45. Inventory Methods Periodic Inventory account balances stay the same throughout period Inventory account adjusted to new balance at end of period Perpetual Inventory accounts are adjusted as the product flows through the company

46. Exhibit 4-15: Purchase Materials Raw Materials Inventory85,000 Accounts Payable 85,000 To record cost of direct materials purchased on account.

47. Exhibit 4-15: Use Materials Work in Process Inventory69,000 Variable Factory Overhead12,600 Raw Materials Inventory 81,600 To record direct materials transferred to production.

48. Exhibit 4-15: Record Labor Costs Work in Process Inventory 5,000 Variable Factory Overhead13,800 Salaries and Wages Payable 18,800 To accrue factory wages for direct and indirect labor.

49. Exhibit 4-15: Record Labor Costs Fixed Factory Overhead 7,500 Salaries and Wages Payable 7,500 To accrue production supervisors’ salaries.

50. Exhibit 4-15: Record Other Overhead Variable Factory Overhead 1,200 Fixed Factory Overhead 670 Utilities Payable 1,870 To record mixed factory utility cost in its variable and fixed proportions.

51. Exhibit 4-15: Record Other Overhead Fixed Factory Overhead 2,692 Cash 2,692 To record payments for contract maintenance for the period.

52. Exhibit 4-15: Record Other Overhead Fixed Factory Overhead 8,333 Accumulated Depreciation (Factory Equipment) 8,333 To record depreciation on factory assets for the period.

53. Exhibit 4-15: Record Other Overhead Fixed Factory Overhead 355 Prepaid Factory Insurance 355 To record expiration of prepaid insurance on factory assets.

54. Exhibit 4-15: Apply Overhead Work in Process Inventory 47,150 Variable Factory Overhead 27,600 Fixed Factory Overhead 19,550 To record the transfer of predetermined overhead costs to Work in Process Inventory.

55. Exhibit 4-15: Complete Product Finished Goods Inventory 122,150 Work in Process Inventory 122,150 To record the transfer of work completed during the period.

56. Exhibit 4-15: Sell Product Accounts Receivable 242,000 Sales 242,000 To record the sale of goods on account during the period.

57. Exhibit 4-15: Sell Product (Cost of Sales) Cost of Goods Sold 119,958 Finished Goods Inventory 119,958 To record cost of goods sold for the period.

58. Least-Squares Regression Determines cost formula of a mixed cost by considering the best fit to ALL representative data points –Finds y = ax + b –Uses multiple activity levels and related costs Helps select the activity level that best predicts total cost

59. Least-Squares Regression The equations necessary to compute b and a values using the method of least squares are as follows:  xy – nxy b = --------------  x 2 – nx 2 a =  – bx

60. R e m e m b e r ! High-low and regression are cost ESTIMATION techniques. Appropriateness of cost formula depends on validity of activity measure chosen to predict the variable and fixed costs. When significant changes are occurring, historical information may not be useful in predicting future costs.