1. BPC 32603 Industrial Production Costing
Topic 2: Type of Costs in Production
Types of cost
Cost Behavior
Instructor:
Ahmad Kaseri Ramin C.A(M),FAIA

2. Chapter Learning Outcomes
Acknowledge the basic type of production cost in production environment
Differentiate costs behavior

3. Productions Flow Planning CONVERSION INPUT OUTPUT TECHNOLOGY / SYSTEMS
MATERIAL + LABOR
Products
Services
Products &
Services
Controlling

4. Production Cost Flow Direct Material Direct Labor Overhead
Balance Sheet
Income Statement
Unused
Direct Material
Material
Inventory
Manufacturing
Process
Direct Labor
WIP
Inventory
unfinished
Overhead
Production Cost Flow is to show the value change of inputs into conversion processes and it final journey as final products / services. It shows the various type of cost associate to the different phase of conversion (operation). Most of the costs is directly associated to products /services whilst some portion of costs to be treated as period costs
Finished Good
Inventory
Cost of
Good Sold
Sold
Finished

5. Type of Costs
Variable
Fixed Costs

6. COSTS FUNCTION
TC = FC + VC (x)

7. Cost classification

8. Type of Production Costs
(manufacturing costs)
Direct Materials
Eg: flour, sugar, oils
Variable
Costs
Direct Labor
Wages of chiefs/ kitchen assistants
Factory Overhead
Factory Water, electricity, depreciation of machines, maintenance of machines
Period Cost (non-manufacturing costs)
Selling expenses
Advertising, dealer fees, sales commissions
Fixed Costs
Administrative expenses
Admin salaries, rental of office, transportations etcs
Semi
Variable
Direct Materials
PRIME COST
Direct Labor
Factory Overhead
CONVERSION COST

9. example

10. Manufacturing vs non-manufacturing costs

11. Variable and Fixed Cost Behavior
A variable cost
changes in direct
proportion to changes
in the cost-driver level.
A fixed cost is
not immediately
affected by changes
in the cost-driver.
To understand cost behavior, it is important to distinguish variable costs from fixed costs. Accountants classify costs as variable or fixed depending on how much they change as the level of a particular cost driver changes. A variable cost changes in direct proportion to changes in the cost driver. In contrast, changes in the cost driver do not immediately affect a fixed cost.
The per-unit variable
cost remains unchanged
regardless of changes in
the cost-driver.
Total fixed costs remain
unchanged regardless of
changes in the cost-driver.

12. Cost Drivers and Cost Behavior
Cost drivers are measures
of activities that require
the use of resources
and thereby cause costs.
Cost behavior is how the
activities of an
organization affect its costs.
Cost drivers, measures of activities that require the use of resources and thereby cause costs.
Cost behavior is how the activities of an organization affect its costs.
An organization has many cost drivers across the various activities of its value chain.

13. Linear-Cost Behavior
Costs are assumed to be fixed or variable within the relevant range of activity
Accountants and managers often assume that cost behavior is linear over some relevant range of activity levels or cost-driver levels. We can graph linear-cost behavior with a straight line because we assume each cost to be either fixed or variable.

14. Step-Cost Behavior Patterns
Step costs change abruptly at intervals
of activity because the resources and
their costs come in indivisible chunks.
Step costs change abruptly at intervals of activity because the resources and their costs come in indivisible chunks. If the individual chunks of cost are
relatively large and apply to a specific, broad range of activity, we consider the cost a fixed cost over that range of activity.

15. Step-Cost Behavior Patterns
When oil and gas exploration activity reaches a certain level in a given region, the company must lease an entire additional rig. One level of oil and gas rig leasing, however, will support all volumes of exploration activity within a relevant range of drilling. Within each relevant range, this step cost behaves as a fixed cost. In contrast, accountants often describe step costs as variable when the individual chunks of costs are relatively small and apply to a narrow range of activity. Panel B of Exhibit 3-2 shows the wage cost of cashiers at a supermarket. Suppose one cashier can serve an average of 20 shoppers per hour and that within the relevant range of shopping activity, the number of shoppers can range from 40 per hour to 440 per hour. The corresponding number of cashiers would range between 2 and 22. Because the steps are relatively small, this step cost behaves much like a variable cost, and we could assume it is variable for planning purposes with little loss of accuracy.

16. Mixed-Cost Behavior Patterns
Mixed costs contain elements of both
fixed- and variable-cost behavior.
The fixed-cost element is unchanged
over a range of cost-driver activity.
Mixed costs contain elements of both fixed- and variable-cost behavior. The fixed-cost element is unchanged over a range of cost-driver activity levels. The variable-cost element of the mixed cost varies proportionately with cost-driver activity within the relevant range. You might think of the fixed cost as the cost of having available the capacity necessary to operate at any volume within the relevant range and the variable cost as the additional cost of using that capacity to produce at the specified level of output.
The variable-cost element varies
proportionately with cost-driver activity.

17. Mixed-Cost Behavior Patterns
Mixed costs contain elements of both fixed and variable costs.
The fixed-cost element is unchanged over a range of cost-driver activity levels.
The variable-cost element of the mixed cost varies proportionately with cost-driver activity within the relevant range.
For example, consider the monthly facilities maintenance department cost of the Parkview Medical Center (PMC), shown in Exhibit 3-3. Salaries of the maintenance personnel and costs of equipment are fixed at $10,000 per month. In addition, cleaning supplies and repair materials vary at a rate of $5 per patient-day delivered by the hospital.

18. Management’s Influence on Cost Behavior
Product or service attributes
Capacity
Technology
In addition to measuring and evaluating current cost behavior, managers can influence cost behavior through decisions about such factors as product or service attributes, capacity, technology, and policies to create incentives to control costs.
Policies to create incentives to control costs

19. What are capacity costs?
Capacity Decisions
What are capacity costs?
They are the fixed costs of being able
to achieve a desired level of production or
to provide a desired level of service while
maintaining product or service attributes.
Capacity costs are the fixed costs of being able to achieve a desired level of production or to provide a desired level of service while maintaining product or service attributes, such as quality. Most companies make a capacity decision infrequently. They consider capacity decisions as strategic because large amounts of resources are involved. An incorrect capacity decision can have serious consequences for the competitiveness of a company.

20. Committed Fixed Costs Committed fixed costs arise
from the possession of facilities,
equipment, and a basic organization.
Lease payments
Even if a company has chosen to minimize fixed capacity costs, every organization has some costs to which it is committed, perhaps for quite a few years. A company’s committed fixed costs usually arise from the possession of facilities, equipment, and a basic organizational structure.
They include mortgage or lease payments, interest payments on long-term debt, property taxes, insurance, and salaries of key personnel.
Property taxes
f key personnel

21. Discretionary Fixed Costs
Discretionary fixed costs are costs fixed at certain levels
only because management decided that these levels of cost
should be incurred to meet the organization’s goals.
These discretionary fixed costs have no obvious
relationship to levels of output activity but
are determined as part of the periodic planning process.
Some costs are fixed at certain levels only because management decided to incur these levels of cost to meet the organization’s goals. These discretionary fixed costs have no obvious relationship to levels of capacity or output activity. Companies determine them as part of the periodic planning process. Each planning period, management will determine how much to spend on discretionary items such as advertising and promotion costs, public relations, research and development costs, charitable donations, employee training programs, and purchased management consulting services. These costs then become fixed until the next planning period.
Each planning period, management will determine
how much to spend on discretionary items. These costs
then become fixed until the next planning period.

22. Examples of Discretionary Fixed Costs
Research and
development
Employee training
Advertising
and promotion
Management
salaries

23. Technology Decisions Choice of technology (e-commerce versus
in-store or mail-order sales) positions the
organization to meet its current goals and
to respond to changes in the environment.
One of the most critical decisions that managers make is choosing the type of technology the organization will use to produce its products or deliver its services. Choice of technology (for example, labor-intensive versus robotic manufacturing, personal banking services versus automated tellers, or e-commerce versus in-store sales) positions the organization to meet its current goals and to respond to changes in the environment (for example, changes in customer needs or actions by competitors). The use of high-technology methods rather than labor usually means a much greater fixed-cost component to the total cost. This type of cost behavior creates greater risks for companies with wide variations in demand.

24. Cost-Control Incentives
Managers use their
knowledge of cost
behavior to set
cost expectations.
Employees may
receive rewards that
are tied to meeting
these expectations.
The incentives that management creates for employees can affect future costs. Managers use their knowledge of cost behavior to set cost expectations, and employees may receive compensation or other rewards that are tied to meeting these expectations. For example, the administrator of Parkview Medical Center could give the supervisor of the facilities maintenance department a favorable evaluation if the supervisor maintained quality of service and kept department costs below the expected amount for the actual level of patient-days. This feedback motivates the supervisor to watch department costs carefully and to find ways to reduce costs without reducing quality of service.

25. Cost Functions Planning and controlling the activities
of an organization require accurate
and useful estimates of future
fixed and variable costs.
To describe the relationship between a cost and its cost driver(s), managers often use an algebraic equation called a cost function. When there is only one cost driver, the cost function is similar to the algebraic CVP relationships discussed in Chapter 2.

26. Cost Functions Understanding relationships between costs
and their cost drivers allows managers to...
Make better operating, marketing,
and production decisions
Plan and evaluate actions
Understanding relationships between costs and their cost drivers allows managers to make better operating, marketing, and production decisions, plan and evaluate actions, and determine appropriate costs for short-run and long-run decisions.
Determine appropriate costs for
short-run and long-run decisions.

27. Cost Functions The first step in estimating or predicting
costs is measuring cost behavior as a
function of appropriate cost drivers.
The second step is to use these cost
measures to estimate future costs at
expected levels of cost-driver activity.
The first step in estimating or predicting costs is measuring cost behavior as a function of appropriate cost drivers. The second step is to use these cost measures to estimate future costs at expected levels of cost-driver activity.

28. Cost Function Equation
Let:
Y = Total cost
F = Fixed cost
V = Variable cost per unit
X = Cost-driver activity in number of units
The mixed-cost function is called a linear-cost function.
This mixed-cost function has the familiar form of a straight line—it is called a linear cost function.
Mixed-cost function:
Y = F + VX
Y = $10,000 + $5.00X

29. Developing Cost Functions
Plausibility:
The cost function must be believable.
Reliability:
A cost function’s estimates of costs
at actual levels of activity must reliably
conform with actually observed costs.
The cost function must be plausible, that is, believable. Personal observation of costs and activities, when it is possible, provides the best evidence of a plausible relationship between a resource cost and its cost driver. In addition to being plausible, a cost function’s estimates of costs at actual levels of activity must reliably conform to actually observed costs. We assess reliability in terms of “goodness of fit”—how well the cost function explains past cost behavior. If the fit is good and conditions do not change in the future, the cost function should be a reliable predictor of future costs.

30. Choice of Cost Drivers: Activity Analysis
Choosing a cost function starts
with choosing cost drivers.
Managers use activity analysis to
identify appropriate cost drivers.
Managers use activity analysis to identify appropriate cost drivers and their effects on the costs of making a product or providing a service. The final product or service may have several cost drivers because production may involve many separate activities. The greatest benefit of activity analysis is that it directs management accountants to the appropriate cost drivers for each cost.
Activity analysis directs management
accountants to the appropriate
cost drivers for each cost.

31. Choice of Cost Drivers: Activity Analysis
Northwestern Computers makes two
products: Mozart-Plus and Powerdrive
In the past, most of the support costs
were twice as much as labor costs.
Northwestern Computers makes two products: Mozart-Plus and Powerdrive. In the past, most of the support costs were twice as much as labor costs. Northwest has upgraded the production function, which has increased support costs and reduced labor cost.
Northwest has upgraded the production
function, which has increased support
costs and reduced labor cost.

32. Choice of Cost Drivers: Activity Analysis
Using the old cost driver, labor cost, the
prediction of support costs would be:
Mozart-Plus Powerdrive
Labor cost $ $130.00
Support cost:
2 × Direct labor
cost $ $260.00
Consider Northwestern Computers, which makes two products for personal computers: a plug-in music board (Mozart-Plus) and a hard-disk drive (Powerdrive). These two products consist of material costs, labor costs, and support costs. In the past, most of the work on Northwestern’s products was done by hand. In such a situation, labor costs were the primary driver of support costs. Support costs were twice as much as labor costs, on average.
Northwestern has just finished upgrading the production process. Now the company uses computer-controlled assembly equipment, which has increased the costs of support activities, such as engineering and maintenance, and has reduced labor cost. Its cost function has now changed; specifically, labor cost is now only 5% of the total costs at Northwestern. An activity analysis has shown that the number of components added to products (a measure of product complexity), not labor cost, is the primary cost driver for support costs.

33. Choice of Cost Drivers: Activity Analysis
Using the more appropriate cost driver,
the number of components added to products,
companies can predict support costs more accurately.
Mozart-Plus Powerdrive
Support cost at $20
per component
$20 × 5 components $100.00
$20 × 9 components $180.00
Difference in predicted
support cost $ $
higher lower
Northwestern has just finished upgrading the production process. Now the company uses computer-controlled assembly equipment, which has increased the costs of support activities, such as engineering and maintenance, and has reduced labor cost. Its cost function has now changed; specifically, labor cost is now only 5% of the total costs at Northwestern. An activity analysis has shown that the number of components added to products (a measure of product complexity), not labor cost, is the primary cost driver for support costs. Northwestern estimated support costs to be $20 per component. Mozart-Plus has five component parts, and Powerdrive has nine.
Managers will make better decisions with this more accurate information.

34. Costing Systems
Measure,
Record and
Report product costs
For:
Controlling cost
Pricing decision
Product mix decision
Investment decision

35. Type of Costing Systems
JOB COSTING
Provide cost of each quantity of product manufactured
Each qty of product is called “JOB”
Industry example: apparel, Furniture, machine components etcs
PROCESS COSTING
Provide cost for each manufacturing department or process
Product are indistinguishable from each other and manufacture using continuous production.
Example: oil product, foods, paper production etcs

36. Type of Costing Systems and allocation of costs
JOB COSTING or BATCH
PROCESS COSTING
Traditional costing approach
Activity Based Costing Approach
preferred
Full absorption
Related cost allocation to product
MATERIAL – LABOR -OVERHEAD

37. Topic 2
End of TOPIC 2