1 COST CONCEPTS Manager needs costs information to make a decision such as: Product managers evaluated market demand and product cost data for their own and their competitors Comparing manufacturing costs of various facilities Period costs  costs created as expenses in the period in which they incured because they can not be associated with manufacture of products Product costs  costs associated with the manufacture of products Traditional Cost Classification: a.Manufacturing  raw materials, labour, and overhead Direct costs  costs that can be traced directly to a product Indirect costs  costs that cannot be traced easily to a product b. Nonmanufacturing  distribution costs, selling costs, marketing costs, R & D costs, and general and administrative costs Cost Structure Today In 1900, direct labour represented > 50% In industrial environment, labour costs only 5 % - 15 % and direct materiaals 40% - 60%

2 Activity Based Analysis of Costs MANUFACTURING Overhead Costs  Indirect cost of transforming raw materials into finished product Type of Production Activities; a.Unit related activities  those whose volume or level is associated with number of units produced  DLH, manchine hours, and quality inspector related to number of unit produced b.Bacth related activities  related to number of batch produced  Machine set up, costs of materials handling, and first time quality inspection c,. Product sustaining activities  performed to support the production and sale of individual products  Administrative efforts for drawing and routing of parts, product engineering efforts for maintaining specifications for individual products Product sustaining activities for Ice cream company: design new ice cream flavor, developing, maintaining and improving recipes, designing packaging and marketing materials for individual products d.Facility sustaining activities  performed to provide the managerial infrastructure and to support maintaining the plants  Plant rental and depreciation, plant maintenance, insurances and taxes, housekeeping, landscaping, lighting, and security

3 Activity cost driver  unit of measurement for the level of quantity of the activity performed Catagories of Activities and their Activity Cost Driver Catagories Representative Activities Activity Cost Drivers Facility Sustaining Activities Plant management Plant management Accounting and personnel Accounting and personnel Housekeeping Housekeeping Rent and depreciation Rent and depreciation Square feet of space Square feet of space Number of workers Number of workers Product Sustaining Activities Product design Product design Parts administration Parts administration Engineering Engineering Expediting production orders Expediting production orders Number of products Number of products Number of parts Number of parts Batch related Activities Manchine set up Manchine set up First time inspection First time inspection Purchase ordering Purchase ordering Materials handling Materials handling Production scheduling Production scheduling Setup hours Setup hours Inspection hours Inspection hours Number of orders Number of orders Number of materials move Number of materials move Number of production run Number of production run Unit related Activities Every item inspection Every item inspection Supervision of direct labor Supervision of direct labor Consumption of power and oils to run machines Consumption of power and oils to run machines number of units number of units DLH DLH Machine hours Machine hours

4 Cost Distortion with One Driver Production process with 5 activities (X1, X2, X3, X4, and X5) Overhead rate for each activitiy: R1 = C1/X1, R2 = C2/X2, R3 = C3/X3, R4 = C4/X4, R5 = C5/X5 Total Overhead Costs = C1 +C2+C3+C4+C5 C1 +C2+C3+C4+C5 Single cost driver  R = C / X1 = X1 X1 = Direct labour hours, X2 = Setup hours C = 70 X X2, X1 = 1,000 DLH, X2 = 60 setup hours C = $ 100,000 With one driver (X1), R = $ 100,000 / 1,000 = $ 100 per DLH Prediction X1 = 90 DLH and X2 = 7 setup hours a.Estimated cost of overhead = 90 DLH x $ 100 = $ 900 (single driver) b.Estimated cost of overhead = 70 x x 7 = $ 9,800

5 Standard Cost Accounting System Standard Costs  Efficient and attainable benchmarks established in advance for the costs of activity resources that should be consumed by each product It involves measuring standard costs and actual costs and comparing them. Three principal uses of standard cost system: a.Estimated cost of product  Standards are developed for the consumption of DM, DL, and overhead activity resources per unit of each product b.Budget for Costs and Expenditure  TC representing the consumption of each activity estimated based on the standard amount consumption of an activity to produce each product and planned production levels for those products c.Control costs relative to standards  comparing actual and standard costs for finding favourable or unfavourable variances

6 Cost Behavior Fixed Costs  Costs that are independent of the level of production Costs Q FC

7 Costs Q TVC VC/Unit Variabel costs  Costs that change proportionally with the level of production Mixed Costs  Costs that comprising both fixed and variable costs Costs Q VC FC

8 Exp. Riverside General Hospital has information on 18 account names and expenses for the fiscal year 1994 ACCOUNT NUMBERACCOUNT NAMECOST Nursing services Nursing administration Pharmacy Laboratory Medical supplies Linen and laundry Dietary Employee cafeteria Housekeeping Medical records & library Social services Patient scheduling & administration Billing & collection Plant operation Plant maintenance Medical equipment operations Property insurance Depreciation $ 2,973,154 1,269, , , , , , , , , ,026 60, , , , ,275 38, ,573 Total operating costs$ 10,384,435

9 Activity Overhead rates for the fiscal year 1994 Account Number Account NameCost DriverActivity LevelOverhead rate Nursing services Nursing administration Pharmacy Laboratory Medical supplies Linen and laundry Dietary Employee cafeteria Housekeeping Medical records & library Social services Patient scheduling & administration Billing & collection Plant operation Plant maintenance Medical equipment operations Property insurance Depreciation Nursing hours Direct Number of test Number of patient days Pounds of laundry Number of meals Number of nurse-days Square feet of space Number of patients Square feet of space Number of procedures Value of property 280, ,224 45, ,749 88,673 35,078 23,798 8,367 23,798 62,179 $ 21,567, Total operating costs$ 10,384,435

10 Activity Classification: A. Unit Related Activities ACCOUNT NUMBER ACCOUNT NAMECOST Nursing services Nursing administration Pharmacy Laboratory Medical supplies Linen and laundry Dietary Employee cafeteria Medical equipment operations $ 2,973,154 1,269, , , , , , , ,275 Total unit related costs Number of patient days Cost per patient day $ 7,369,455 45,606 $ B. Batch Related Activities ACCOUNT NUMBERACCOUNT NAMECOST Medical records & library Social services Patient scheduling & administration Billing & collection 250, ,026 60, ,280 Batch Related costs Number of patients Cost per patient $ 621,889 8,367 $ 74.33

11 C. Facilities Sustaining Activities ACCOUNT NUMBER ACCOUNT NAMECOST Housekeeping Plant operation Plant maintenance Property insurance Depreciation 706, , ,622 38, ,573 Facilities sustaining costs$ 2,393,091