Managerial Accounting Balakrishnan | Sivaramakrishnan | Sprinkle | Carty | Ferraro Chapter 3: Cost Flows and Cost Terminology Prepared by Debbie Musil, Kwantlen Polytechnic University

Types of Organizations Three major types Service Merchandising Manufacturing Differ in Nature of product Pattern of cost flows Magnitude of various costs LO 1: Distinguish product costs from period costs.

Financial Reporting All three types of firms Produce financial reports that conform to GAAP Distinguish between product costs and period costs Have financial reports that are of limited use for internal decisions LO 1: Distinguish product costs from period costs.

Product and Period Costs Product costs Related to getting a product or service ready for sale Appear “above the line” for gross margin (revenues less product costs) Can be inventoried (“inventoriable costs”) Period costs Costs that are not product costs. Related to marketing and administration Appear “below the line” for gross margin Expensed in the period they are incurred. Do not flow through inventory accounts LO 1: Distinguish product costs from period costs.

A Traditional Income Statement Period Costs Product Costs LO 1: Distinguish product costs from period costs.

Usefulness for Internal Decisions The statement only considers expenses Cost versus expense An expense is a cost recognized in the income statement The gross margin income statement mingles Controllable & non controllable costs Variable and fixed costs Direct and indirect costs LO 1: Distinguish product costs from period costs.

Service Firms Products are not tangible or storable Hotels, restaurants, consulting, airlines, gyms, universities, museums,… Generally, there is no inventory of their final product Exceptions exist We can inventory costs of software projects that go across accounting periods LO 2: Understand the flow of costs in service firms.

Flow of Costs: Service Settings LO 2: Understand the flow of costs in service firms.

Merchandising Firms Examples include The Bay, Sears, Sobeys, Staples,… These firms Sell substantively the same product they purchase. Carry inventory to make goods available in the quantities, varieties and delivery schedules demanded by customers. LO 3: Discuss how inventories affect the flow of costs in merchandising firms.

Inventory Equation Need to flow costs via inventory account Cost of goods purchased is different from cost of goods sold We can capture flow as: Cost of beginning inventory + Cost of goods purchased during the period – Cost of ending inventory = Cost of goods sold (COGS) during the period Make inventory cost flow assumption First-in-first-out (FIFO) Last-in-first-out (LIFO) LO 3: Discuss how inventories affect the flow of costs in merchandising firms.

Solution

Flow of Costs in Merchandising LO 3: Discuss how inventories affect the flow of costs in merchandising firms.

Manufacturing Firms Use labour and equipment to transform raw materials into finished goods Have work-in-process Need inventory accounts for all three kinds of stages in the production process Much variation in Nature of production process Relative amounts of different costs LO 4: Explain the cost terminology and the flow of costs in manufacturing firms.

Cost Terms in Manufacturing LO 4: Explain the cost terminology and the flow of costs in manufacturing firms.

Names for Groups of Costs LO 4: Explain the cost terminology and the flow of costs in manufacturing firms.

Cost Terms in Manufacturing Prime Costs Conversion Costs LO 4: Explain the cost terminology and the flow of costs in manufacturing firms.

Physical and Cost Flows in Manufacturing LO 4: Explain the cost terminology and the flow of costs in manufacturing firms.

Example: Cost Flow in Manufacturing LO 4: Explain the cost terminology and the flow of costs in manufacturing firms.

To verify the amounts specified above, THREE calculations need to be made:

1 2 3 Check It! Exercise #2 Solution Calculation Procedure Result Calculate Raw Materials Used 1 2 Calculate Cost of Goods Manufactured 3 Calculate Cost of Goods Sold Check It! Exercise #2 Solution

Cost Allocations & Cost Flows Overhead costs are not traceable to specific products But they are part of product cost for individual products Problem: How to divide total overhead to pieces that belong to individual products. Solution: Perform a cost allocation A procedure to allocate common costs LO 5: Allocate overhead costs to products.

Mechanics of Cost Allocations Each allocation has four elements Cost Pool Cost Object Cost Driver (Allocation Basis) Allocation (Denominator) Volume Each allocation has two steps Calculate allocation rate Rate = Cost in pool  Denominator volume Allocate cost to cost object Allocated amount = # of driver units in object x rate LO 5: Allocate overhead costs to products.

LO 5: Allocate overhead costs to products.

Cost Allocations: Properties The percent of cost allocated to a cost object is the percent of cost driver units in the cost object The Smith and Jones family each contributes 50% of the cost driver units (families). Thus, each family gets 50% of the cost allocated to it Smith family has 60% of the cost driver units (in persons). Thus, Smith family gets 60% of the cost allocated to it LO 5: Allocate overhead costs to products.

To verify the amounts specified above, the allocation rate and volume calculations need to be made.

Check It! Exercise #3 Solution Calculate Allocation Volume and Rate Calculate Amount Allocated to 5-tonne Hooks Calculate Amount Allocated to 10-tonne Hooks Check It! Exercise #3 Solution

Allocated Costs & Decisions Allocations make it appear as if the allocated cost is variable in the number of driver units Cost allocated is variable in # of persons But, the cost is fixed in the short run Might not be controllable Mixing the two can lead to errors LO 5: Allocate overhead costs to products.

Income Statement Example LO 5: Allocate overhead costs to products.

Decision Suppose we sell one more unit for $23. What is change in profit? $0? (After all, cost = $23 per unit) This answer is likely incorrect Assumes that ALL costs change (are controllable) This assumption is probably not true LO 5: Allocate overhead costs to products.

Focus on Controllable Costs LO 5: Allocate overhead costs to products.

Revised Decision Variable costs are only: $17.50 (=$6 + 8 + $2 +1.50) Only these costs are controllable for decision to make one more unit Profit increase $25 - $17.50 = $7.50! LO 5: Allocate overhead costs to products.

Problem 3.30 Cost flows in a service firm (LO2). The following data pertain to Skogg Consulting. Skogg provides advice on structural engineering for large projects such as stadiums and bridges. Clients seek Skogg out because it has extensive contacts and can find the person who is “right” for the job. This is not a trivial task, as often fewer than 10 people worldwide might have the required expertise. Skogg bills clients at the rate of $350 per hour plus actual expenses for travel and accommodation. The firm draws consultants from a roster it maintains, and it pays the consultant $300 per hour. The balance of $50 goes toward administrative support. The firm expects to accumulate 9,000 consulting hours for the year and projects a profit before taxes of $230,000. Required: Complete an income statement to determine (a) the firm’s cost to provide service and (b) its marketing and administration costs.

Problem 3.30 (Concluded) Complete an income statement to determine (a) the firm’s cost to provide service and (b) its marketing and administration costs. The following is the gross margin statement for Skogg Consulting. We can readily obtain the answers by noting that revenue – cost of services = gross margin and gross margin – marketing and administration costs = profit before taxes. Notice that we ignored the reimbursement of actual costs in this statement. If we included the amounts, it would increase revenue and costs by identical amounts.

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