Chapter 2 Basic Cost Management Concepts and Accounting for Mass Customization Operations

Managers need cost information to perform each of these functions. Process of Management Decision Making Directing Control Planning Strategy Formulation Managers need cost information to perform each of these functions. Leaning Objective 1 Learning Objective 01

Product Costs, Period Costs and Expenses Product costs are costs associated with goods for sale until the time period during which the products are sold, at which time the costs become expenses. Period costs are costs that are expensed during the time period in which they are incurred. Learning Objective 2 Expenses are the consumption of assets for the purpose of generating revenue.

Cost Classifications on Financial Statements – Balance Sheet Merchandiser Current Assets Cash Receivables Prepaid Expenses Merchandise Inventory Manufacturer Current Assets Cash Receivables Prepaid Expenses Inventories Raw Materials Work in Process Finished Goods Leaning Objective 3 Product costs appear on the income statement as cost of goods sold in the period in which the products were sold. This is true for merchandising and manufacturing companies. Period costs appear on the income statement in the period in which they were incurred. Selling and administrative expenses are an example of period costs. (LO3) Since retailers, wholesalers, and manufacturers sell inventoriable products, their balance sheets are also affected by product costs. Merchandisers, such as Wal-Mart, list the product cost as merchandise inventories on the balance sheet in the current assets section. (LO3) Manufacturers have three types of inventory. Raw-material inventory includes all materials before they are placed into production. (LO3) Work-in-process inventory refers to manufactured products that are only partially completed at the date when the balance sheet is prepared. (LO3) Finished-goods inventory refers to manufactured goods that are complete and ready for sale. The values of the work-in-process and finished-goods inventories are measured by their product costs. (LO3)

Types of Production Processes Type of Production Description of Example of Process Manufacturer   Job Shop Low volume Disney Little standardization Unique products Batch Multiple products Caterpillar Assembly Line A few major products Ford Higher volume Mass Customization High volume Dell Many standardized components Customized combination of components Continuous Flow Exxon Highly standardized commodity products Learning Objective 4

Manufacturing Overhead Manufacturing Costs Direct Labor Manufacturing Overhead Direct Material The Product Leaning Objective 5 Managerial accountants classify costs by the functional area of the organization to which costs relate. Some examples of functional areas are manufacturing, marketing, administration, and research and development. Manufacturing costs are further classified into the following three categories: direct material, direct labor, and manufacturing overhead. (LO5) Raw material that is consumed in the manufacturing process, is physically incorporated in the finished product, and can be traced to products conveniently is called direct material. (LO5) The cost of salaries, wages, and fringe benefits for personnel who work directly on the manufactured products is classified as direct-labor cost. (LO5) All other costs of manufacturing are classified as manufacturing overhead, which includes three types of costs: indirect material, indirect labor, and other manufacturing costs. The cost of materials that are required for the production process but do not become an integral part of the finished product are classified as indirect material costs. Materials that do become an integral part of the finished product but are insignificant in cost are also often classified as indirect material. (LO5) The costs of personnel who do not work directly on the product, but whose services are necessary for the manufacturing process, are classified as indirect labor. (LO5) All other manufacturing costs that are neither material nor labor costs are classified as manufacturing overhead. (LO5)

Classifications of Costs in Manufacturing Companies Manufacturing costs are often combined as follows: Direct Material Direct Labor Manufacturing Overhead Direct material and direct labor are often referred to as prime costs. Direct labor and overhead are often called conversion costs, since they are the costs of “converting” raw material into finished products. (LO5) Prime Cost Conversion Cost

Manufacturing Cost Flows Direct Material Work in Process Inventory Direct Labor Manufacturing Overhead Finished Goods Inventory Cost of Goods Sold Learning Objective 6 As direct material is consumed in production, its cost is added to work-in-process inventory. Similarly, the costs of direct labor and manufacturing overhead are accumulated in work in process. (LO5) When products are finished, their costs are transferred from work-in-process inventory to finished-goods inventory. The total cost of direct material, direct labor, and manufacturing overhead transferred from work-in-process inventory to finished-goods inventory is called the cost of goods manufactured. (LO5) The costs then are stored in finished goods until the time period when the products are sold. At that time, the product costs are transferred from finished goods to cost of goods sold, which is an expense of the period when the sale is made.

Schedule of Cost of Goods Manufactured Learning Objective 7 Manufacturers generally prepare a schedule of cost of goods manufactured and a schedule of cost of goods sold to summarize the flow of manufacturing costs during an accounting period. Let’s take a look at the schedule of cost of goods manufactured for Comet Computer Corporation. (LO6) Raw materials used in production is calculated by adding raw materials purchases for the period to the beginning raw materials inventory. This is the value of the raw materials that were available for use during the period. The raw materials at the end of the period is subtracted from raw materials available to arrive at the raw materials used in production during the period. (LO6) All direct labor costs incurred during the period is added to raw materials used. (LO6)

Costs incurred during the period that fall into the category of manufacturing overhead are totaled and then added to raw materials used and direct labor to arrive at total manufacturing costs. (LO6) The value of the work-in-process inventory at the beginning of the period is added to the total manufacturing costs. (LO6) The value of the ending work-in-process inventory is subtracted from the subtotal to arrive at cost of goods manufactured for the period. (LO6) Beginning work-in-process inventory is carried over from the prior period. Ending work-in-process inventory contains the cost of unfinished goods, and is reported in the current assets section of the balance sheet.

Income Statement for a Manufacturer Now let’s look at the income statement for Comet. Remember, cost of goods sold is the expense measured by the cost of the finished goods sold during a period of time. (LO6)

Income Statement for a Manufacturer The cost of goods sold amount can be obtained from the cost of goods sold schedule. This schedule starts with the finished goods inventory value at the beginning of the period. Cost of goods manufactured from the cost of goods manufactured schedule is added to arrive at cost of goods available for sale. The value of the finished goods inventory at the end of the period is deducted to determine the cost of goods sold amount for the period. (LO6)

Activities that cause costs to be incurred are called COST DRIVERS Cost Driver Examples Activity Cost Driver Machining operations Machine hours Setup Setup hours Production scheduling Manufacturing orders Inspection Pieces inspected Purchasing Purchase orders Shop order handling Shop orders Valve assembly support Customer Requisitions Learning Objective 7

Cost Classifications Learning Objective 8 In summary, the total variable cost changes as activity changes. But the cost per unit of variable costs stays the same, regardless of the level of activity. On the other hand, total fixed costs stay the same, regardless of the level of activity. The fixed cost per unit changes as the level of activity changes. (LO8)

Various Costs Direct costs: Costs that can be easily and conveniently traced to a product or department. Indirect costs: Costs that must be allocated in order to be assigned to a product or department. Controllable and Uncontrollable Costs: A cost that can be significantly influenced by a manager is a controllable cost. Opportunity Costs: The potential benefit that is given up when one alternative is selected over another. Sunk Costs: All costs incurred in the past that cannot be changed by any decision made now or in the future are sunk costs. Sunk costs should not be considered in decisions. Differential Costs: Costs that differ between alternatives. Marginal Cost: The extra cost incurred to produce one additional unit. Average Cost: The total cost to produce a quantity divided by the quantity produced. Learning Objectives 9 and 10 An entity, such as a particular product, service, or department, to which a cost is assigned is called a cost object. A cost that can be traced to a particular cost object is called a direct cost of that cost object. A cost that is not directly traceable to a particular cost object is called an indirect cost of that cost object. (LO9) Whether a cost is a direct cost or an indirect cost of a department often depends on which department is under consideration. A cost can be a direct cost of one department or subunit in the organization but an indirect cost of other departments. While the salary of a General Electric Company plant manager is an indirect cost of the plant’s departments, the manager’s salary is a direct cost of the plant. An important objective of a cost management system is to trace as many costs as possible directly to the activities that cause them to be incurred. Sometimes called activity accounting, this process is vital to management’s objective of eliminating non-value-added costs. These are costs of activities that can be eliminated without deterioration of product quality, performance, or perceived value. (LO9) If a manager can control or heavily influence the level of a cost, then that cost is classified as a controllable cost of that manager. Costs that a manager cannot influence significantly are classified as uncontrollable costs of that manager. Many costs are not completely under the control of any individual. In classifying costs as controllable or uncontrollable, managerial accountants generally focus on a manager’s ability to influence costs. The question is not, Who controls the cost? but, Who is in the best position to influence the level of a cost item? (LO9) An opportunity cost is defined as the benefit that is sacrificed when the choice of one action precludes taking an alternative course of action. (LO10) Sunk costs are costs that have been incurred in the past. Consequently, they do not affect future costs and cannot be changed by any current or future action. (LO10) A differential cost is the amount by which the cost differs under two alternative actions. (LO10) A special case of the differential-cost concept is the marginal cost, which is the extra cost incurred when one additional unit is produced. Marginal costs typically differ across different ranges of production quantities because the efficiency of the production process changes. (LO10)