Chapter 1 An Introduction to Cost Terms and Purposes

Basic Cost Terminology Cost – resource sacrificed 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

Manufacturing Overhead Manufacturing Costs Direct Materials Direct Labor Manufacturing Overhead The Product

Further Classification of Labor Costs Idle Time Treated as manufacturing overhead cost Overtime Premium of Factory Workers Treated as manufacturing overhead cost Labor Fringe Benefits Treated as manufacturing overhead or direct labor

Nonmanufacturing Costs Marketing and Selling Cost Costs necessary to get the order and deliver the product. Administrative Cost All executive, organizational, and clerical costs. R&D

Manufacturing Cost Flows Balance Sheet Costs Inventories Income Statement Expenses Material Purchases Raw Material Work in Process Direct Labor Manufacturing Overhead Cost of Goods Sold Finished Goods Selling and Administrative Period Expenses Selling and Administrative

Product Costs Versus Period Costs Product costs include direct materials, direct labor, and manufacturing overhead. Period costs are not included in product costs. They are expensed on the income statement. Inventory Cost of Good Sold Balance Sheet Income Statement Sale Expense Income Statement

Balance Sheet Merchandiser Manufacturer Current assets Current Assets Cash Receivables Prepaid expenses Merchandise inventory Manufacturer Current Assets Cash Receivables Prepaid Expenses Inventories Raw Materials Work in Process Finished Goods

The Income Statement Cost of goods sold for manufacturers differs only slightly from cost of goods sold for merchandisers.

Cost of Goods Manufactured Calculates the cost of Direct Materials Used Accumulates the three product costs for the current period Adjusts the current period manufacturing costs to account for units actually completed

Income Statement Figure carries forward from the Schedule of Cost of Goods Manufactured Period Costs are expensed as incurred

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

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

Activities that cause costs to be incurred are called cost drivers. Cost Classifications Activities that cause costs to be incurred are called cost drivers.

Total Variable Cost Graph Unit Variable Cost Graph Variable Costs Total Variable Cost Graph Unit Variable Cost Graph $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 $20 $15 $10 $5 Total Costs Cost per Unit 10 20 30 Units Produced (000) 10 20 30 Units Produced (000) Units Total Cost Produced Cost per Unit 5,000 $ 50,000 $10 10,000 100,000 10 15,000 150,000 10 20,000 200,000 10 25,000 250,000 10 30,000 300,000 10

Fixed Costs Total Fixed Cost Graph Unit Fixed Cost Graph $150,000 $125,000 $100,000 $75,000 $50,000 $25,000 $1.50 $1.25 $1.00 $.75 $.50 $.25 Total Costs Cost per Unit 100 200 300 100 200 300 Units Produced (000) Units Produced (000) Units Total Cost Produced Cost per Unit 50,000 $75,000 $1.500 100,000 75,000 .750 150,000 75,000 .500 200,000 75,000 .375 250,000 75,000 .300 300,000 75,000 .250

Types of Fixed Costs Committed Discretionary Examples Examples Long-term, cannot be significantly reduced in the short term. Discretionary May be altered in the short-term by current managerial decisions Part I One type of fixed cost is known as committed fixed costs. These are long-term fixed costs that cannot be significantly reduced in the short term. Some examples include depreciation on manufacturing facilities and real estate taxes on factory property. Part II Another type of fixed cost is known as discretionary fixed costs. These types of fixed costs may be altered in the short-term by current management decisions. Some examples of discretionary fixed costs include advertising and research and development costs. Examples Depreciation on Equipment and Real Estate Taxes Examples Advertising and Research and Development

A Cost Caveat Unit costs should be used cautiously Unit costs change with a different level of volume (activity) Unit costs that include fixed costs should always reference the given level of activity Unit Costs are also called Average Costs

Cost Behavior Patterns Example Bicycles by the Sea incurs variable costs of $52 for each of its bicycles. Bicycles by the Sea also incurs $94,500 in fixed costs per year

Use Unit Costs Cautiously What is the unit cost when Bicycles assembles 1,000 bicycles in a year?

Use Unit Costs Cautiously Assume that Bicycles management uses a unit cost of $146.50 Management is budgeting costs for different levels of production. What is their budgeted cost for an estimated production of 600 bicycles? 600 × $146.50 = $87,900?

Use Unit Costs Cautiously What is their budgeted cost for an estimated production of 3,500 bicycles? 3,500 × $146.50 = $512,750?

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

Determining Product Costs Manufacturing overhead (OH) Applied to product using a predetermined rate Direct materials Traced directly to product Product Traced directly to product Direct labor

BMW: Assigning Costs to a Cost Object

Direct or Indirect? Consider a supervisor’s salary in the canning department of Campbell Soup Company. If the cost object is the department, the supervisor’s salary is a direct cost. If the cost object is a can of soup (the “product” of the company), the supervisor’s salary is an indirect cost.

Relationships of Types of Costs Direct Variable Fixed Indirect

Other Cost Definitions Differential cost Controllable/Uncontrollable costs Opportunity costs Sunk cost Marginal cost

Different Definitions of Costs for Different Applications Pricing and product-mix decisions – may use a “super” cost approach (comprehensive) Contracting with government agencies – very specific definitions of cost for “cost plus profit” contracts Preparing external-use financial statements – GAAP-driven product costs only