Basic Cost Management Concepts Prepared by Douglas Cloud Pepperdine University

After studying this chapter, you should be able to: Objectives 1. Describe a cost management information system, its objectives, and its major subsystems, and indicate how it relates to other operating and information systems. 2. Explain the cost assignment process. 3. Define tangible and intangible products, and explain why there are different product cost definitions. After studying this chapter, you should be able to:

Objectives 4. Prepare income statements for manufacturing and service organizations. 5. Explain the differences between traditional and contemporary cost management systems.

A Systems Framework A system is a set of interrelated parts that performs one or more processes to accomplish specific objectives. Example: An air conditioning system for a home

Operational Model of an Air Conditioning System Cooling Process Delivery Process Inputs: Cooled Air Electricity Ducts Inputs: Freon Warm Air Electricity Output: Cooled Air Output: Delivered Cooled Air

Accounting Information System An accounting information system is a system consisting of interrelated manual and computer parts, using processes such as collecting, recording, summarizing, analyzing, and managing data to provide information to users. Like any system, an accounting information system consists of: (1) objectives, (2) interrelated parts, (3) processes, and (4) outputs.

Operational Model for an Accounting Information System Collecting Classifying Summarizing Analyzing Managing Special Reports Financial Statements Budgets Performance Reports Personal Communication Economic Events Inputs Processes Outputs Users

Accounting Information Systems The financial accounting information system is an accounting information subsystem that is primarily concerned with producing outputs for external users. The cost management information system is an accounting information subsystem that is primarily concerned with producing outputs for internal users using inputs and processes needed to satisfy management objectives.

Accounting Information Systems The cost management information system has three broad objectives that provide information for-- 1) Costing out services, products, and other objects of interest to management 2) Planning and control 3) Decision making

An Integrated Cost Management System Design and Development System Production System Cost Management System Customer Servicing System Marketing and Distribution System

The Subsystems of the Accounting Information System Financial Accounting Information System Cost Management Information System Operational Control System Cost Accounting Information System

Basic Cost Concepts Cost is the cash or cash equivalent value sacrificed for goods and services that are expected to bring a current or future benefit to the organization. Costs are incurred to produce future benefits. Expired costs are called expenses. Unexpired costs are classified as assets and appear on the balance sheet. Assigning cost accurately to cost objects is crucial.

Basic Cost Concepts A cost object is any item, such as products, customers, departments, projects, activities, and so on, for which costs are measured and assigned. Example: A bicycle is a cost object when you are determining the cost to produce a bicycle. An activity is a basic unit of work performed within an organization. Example: Setting up equipment, moving materials, maintaining equipment, designing products, etc.

Basic Cost Concepts Traceability is the ability to assign a cost to a cost object in an economically feasible way by means of a causal relationship. Direct costs are those costs that can be easily and accurately traced to a cost object. Example: The salary of a supervisor of a department, where the department is defined as the cost object.

Basic Cost Concepts Indirect costs are those costs that cannot be traced easily and accurately to a cost object. Example: The cost of heating and cooling a plant that manufactures five products.

Cost Assignment Methods Cost of Resources Direct Tracing Driver Allocation Resource Drivers Cost Objects Activity Drivers Convenience Assumed Linkage Physical Observation

Product Cost Definitions Value-Chain Product Costs Operating Product Costs Traditional Product Costs Research and Development Production Marketing Customer Service Production Marketing Customer Service Production Pricing Decisions Product Mix Decisions Strategic Profitability Analysis Strategic Design Decisions Tactical Profitability Analysis External Financial Reporting

Manufacturing Costs Direct materials are those materials that are directly traceable to the goods or services being produced. Example: The cost of wood in furniture. Direct labor is the labor that is directly traceable to the goods or services being produced. Example: Wages of assembly-line workers. Overhead are all other manufacturing costs. Example: Plant depreciation, utilities, property taxes, indirect materials, indirect labor, etc.

Nonproduction Costs Marketing (selling) costs are the costs necessary to market, distribute, and service a product or service. Example: Advertising, storage costs, and freight out. Administrative costs are the costs associated with research, development, and general administration of the organization that cannot reasonably be assigned to either marketing or production. Example: Legal fees, salary of the chief executive officer.

Nonproduction Costs For external financial reporting, marketing and administrative costs are not inventoried. They are referred to as period costs.

Administrative Expense Production or Manufacturing Costs Nonproduction or Operating Costs Direct Materials Direct Labor Overhead Prime Cost Marketing Expense Order-Getting Costs Order-Filling Costs Conversion Cost Administrative Expense

From the Cost of Goods Sold Schedule Manufacturing Organization Income Statement For the Year Ended December 31, 2004 Sales $2,800,000 Less: Cost of goods sold 1,300,000 Gross margin $ 700,000 Less operating expenses: Selling expenses $300,000 Administrative expenses 150,000 450,000 Operating income $ 250,000 From the Cost of Goods Sold Schedule

Statement of Cost of Goods Manufactured For the Year Ended December 31, 2004 Direct materials: Beginning inventory $200,000 Add: Purchases 450,000 Materials available $650,000 Less: Ending inventory 50,000 Direct materials used in production $ 600,000 Direct labor 350,000 Manufacturing overhead: Indirect labor $122,500 Depreciation 177,500 Rent 50,000 Utilities 37,500 Property taxes 12,500 Maintenance 50,000 450,000 Total manufacturing costs added $1,400,000 continued

Total manufacturing costs added $1,400,000 Add: Beginning work in process 200,000 Less: Ending work in process 400,000 Cost of goods manufactured $1,200,000 Work in process consists of all partially completed units found in production at a given point in time.

Cost of Goods Sold Schedule For the Year Ended December 31, 2004 Cost of goods manufactured $1,200,000 Add: Beginning inventory finished goods 250,000 Cost of goods available for sale $1,450,000 Less: Ending inventory finished goods 150,000 Cost of goods sold $1,300,000 From the Statement of Cost of Goods Manufactured

Activity-Based Management Model Cost View Resources Activities Process View Driver Analysis Performance Analysis Products and Customers Why? What? How well?

Functional-Based and Activity-Based Cost Management Systems 1. Unit-based drivers 2. Allocation-intensive 3. Narrow and rigid product costing 4. Focus on managing costs 5. Sparse activity information 6. Maximization of individual unit performance 7. Uses financial measures of performance

Functional-Based and Activity-Based Cost Management Systems 1. Unit- and nonunit-based drivers 2. Tracing intensive 3. Broad, flexible product costing 4. Focus on managing activities 5. Detailed activity information 6. Systemwide performance maximization 7. Uses both financial and nonfinancial measures of performance

Trade-Off Between Measurement and Error Costs Total Cost Measurement Cost Error Cost High Accuracy Low Accuracy Optimal Level

Shifting Costs Cost Old Optimum New Optimum Low Accuracy High Old Measurement Cost New Measurement Cost New Error Cost Old Error Cost Old Optimum New Optimum Low Accuracy High

End of Chapter