1. An Introduction to Cost Terms and Purposes © 2012 Pearson Education. All rights reserved.

2. Fall 2010Mugan 2/ 45 Accounting? Financial Managerial Cost Auditing Tax COST MANAGERIAL FINANCIAL AUDITING TAX

3. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 3/ 45 The Role of Accounting

4. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 4/ 45 Application of Managerial Accounting Applies to all types of business - Service, Merchandising, and Manufacturing Applies to all forms of business organizations – Proprietorships, Partnerships, and Corporations Applies to not-for-profit as well as profit-oriented companies

5. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 5/ 45 Differences and Similarities Both deal with the same accounting data Both managerial and financial accounting deal with economic events of a business Both require that economic events be quantified and communicated to interested parties Financial – external Managerial- internal Determining unit cost - managerial accounting, Reporting Cost of Goods Sold -financial accounting

6. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 6/ 45 Managerial or Management Accounting Industrial Revolution – more complex production process Cost became important Cost accounting (forerunner of managerial accounting) Cost of an object – product, segment, division First book 1897 – Garcke and Fell – Factory Accounting 20 th century – multinationals, and large companies Performance evaluation Budgeting Management accounting term used after Second World War

7. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 7/ 45 Management or Managerial Accounting Assist managerial decisions Provide timely and accurate information to control costs and to measure and improve productivity; and devise improved production process Accurate costs important for Pricing decisions New product Response to rival products

8. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 8/ 45 Main activities Planning- strategic and operational budgeting Implementing/Directing Generate, analyze and report relevant information Controlling Actual vs budget comparison Analysis and interpretation Feedback

9. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 9/ 45 Managerial Accounting Process of Identifying Measuring Analyzing Interpreting Communicating information in pursuit of a company’s goals Managerial accountants – business partners/consultants in companies Provides information to managers

10. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 10/ 45 Technology and Managerial Accounting New techniques created new roles for management accountants New technologies demanded new control techniques Emerging service organizations Teams with people from production, marketing, engineering, etc. More flexible approaches to effective cost controls

11. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 11/ 45 Managerial Accounting Objectives Provide information for planning and decision making – be a part of it Assist managers in daily control of operations Motivate the managers and other employees towards the company goals-goal congruence Performance measurement of managers Strategic planning – determine competitive position and long-run success of the company

12. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 12/ 45 Characteristics Internal – manager oriented Future looking – planning Involves estimates More timely and relevant data necessary Adaptive to changing business environment Cross-functional – brings together production, marketing, managerial accountants and other key personnel

13. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 13/ 45 Planning Objectives should be inline with the overall objective of increasing shareholders’ wealth E.g. increase sales by 10% in Central Anatolia – objective

14. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 14/ 45 Planning Identify alternatives. Select alternative that does the best job of furthering organization’s objectives. Develop budgets to guide progress toward the selected alternative.

15. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 15/ 45 Directing Coordinate diverse activities and human resources Implement planned objectives Provide incentives to motivate employees Hire and train employees including executives, managers, and supervisors Produce smooth-running operation

16. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 16/ 45 Controlling Process of keeping activities on track Determine whether goals are met Decide changes needed to get back on track May use an informal or formal system of evaluations Employee job assignments Routine problem solving Conflict resolution Effective communications Decision making is not a separate management function, but the outcome of the exercise of good judgment in planning, directing, and controlling. Feedback in the form of performance reports that compare actual results with the budget are an essential part of the control function

17. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 17/ 45 Management Control Assure that resources are obtained and used effectively and efficiently in the accomplishment of the organization’s objective Has financial and non financial performance measurement Concerned with the implementation of strategies and Task control

18. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 18/ 45 Planning and Control Cycle Decision Making Formulating long- and short-term plans (Planning) Measuring performance (Controlling) Implementing plans (Directing and Motivating) Comparing actual to planned performance (Controlling) Begin Exh. 1-1

19. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 19/ 45

20. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 20/ 45 Management accounting system To control costs To measure and improve productivity To devise improved production process To decide on new products To decide on obsolete products To decide on prices To respond to rival products (Johnson and Kaplan, 1987)

21. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 21/ 45 Cost Management Perspective Provide highest quality service/goods with lowest possible cost Objectives: Determine cost of resources consumed in company’s activities Eliminate non-value added activities as much as possible Determine efficiency and effectiveness of all major activities Identify and evaluate new activities that can improve the performance of the company

22. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 22/ 45 Comparison

23. © 2012 Pearson Education. All rights reserved. Basic Cost Terminology Cost—sacrificed resource to achieve a specific objective Actual cost—a cost that has occurred Budgeted cost—a predicted cost Cost object—anything of interest for which a cost is desired

24. © 2012 Pearson Education. All rights reserved. Cost Object Examples at BMW Cost Object Illustration Product BMW X 5 sports activity vehicle Service Dealer-support telephone hotline Project R&D project on DVD system enhancement Customer Borusan, a dealer that purchases a broad range of BMW vehicles Activity Setting up production machines Department Environmental, Health and Safety

25. © 2012 Pearson Education. All rights reserved. Basic Cost Terminology Cost accumulation—a collection of cost data in an organized manner Cost assignment—a general term that includes gathering accumulated costs to a cost object. This includes: Tracing accumulated costs with a direct relationship to the cost object and Allocating accumulated costs with an indirect relationship to a cost object

26. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 26/82 Types of Costs differential costs- (benefits) – costs or benefits that change between/among alternatives Irrelevant costs -Costs that don’t change are irrelevant to the decision Choose the alternatives where differential benefits exceed differential costs Opportunity costs Sunk costs Controllable /avoidable costs/discretionary costs The opportunity cost is the monetary amount associated with the next best use of the resource. Costs that have already been incurred and cannot be changed no matter what action is taken in the future.

27. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 27/82 Problems in Identifying and Measuring Benefits How do I measure the benefit of employee training? What is the monetary benefit of a happy customer? What is the monetary benefit of an improved working environment? How do I measure the benefit of improved quality?

28. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 28/82 Problems in Identifying and Measuring Costs What is the cost of a dissatisfied customer? How do I measure the cost of setting my price too high? How do I measure the cost of poor quality? What is the cost of postponing this year’s training program?

29. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 29/82 Graphical Analysis of Activity Costs and Rate of Output Total Dollars Start-up Range Normal Operations Exceeding Capacity Output Curvilinear Total Cost Curve Marginal Costs Marginal Costs are the costs to produce one more additional unit of output=slope.

30. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 30/82 Relevant Range The relevant range is the portion of the curvilinear total cost curve that appears in the normal operations area. } Relevant Range Total Cost Output Total Dollars Start- up Range Normal Operation s Exceeding Capacity

31. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 31/82 Relevant Range A straight line closely approximates a curvilinear variable cost line within the relevant range. Activity Total Cost Economist’s Curvilinear Cost Function The Linearity Assumption and the Relevant Range Accountant’s Straight-Line Approximation (constant unit variable cost)

32. © 2012 Pearson Education. All rights reserved. Relevant Range Visualized

33. © 2012 Pearson Education. All rights reserved. Fall 2010 Mugan 33/82 Cost Classifications for Predicting Cost Behavior By reaction to changes in the level of activity within the relevant range. Total variable costs change when activity changes. Total fixed costs remain unchanged when activity changes. By reaction to changes in the level of activity within the relevant range. Total variable costs change when activity changes. Total fixed costs remain unchanged when activity changes.

34. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 34/82

35. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 35/82 Behavior – how costs react to changes in underlying cost driver Variable or Fixed Function – related to production or sales Product or Period Product costs – Direct Material Direct Labor Factory Overhead Traceability (cost of tracing cost to a cost driver directly should be lower than the benefits. Classifications of Costs

36. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 36/82 Non-manufacturing Costs Marketing or Selling Costs Costs necessary to get the order and deliver the product. Administrative Costs All executive, organizational, and clerical costs.

37. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 37/82 Product Costs Versus Period Costs Product costs include direct materials, direct labor, and manufacturing overhead. Period costs include all marketing or selling costs and administrative costs. Inventory Cost of Good Sold Balance Sheet Income Statement Sale Expense Income Statement

38. © 2012 Pearson Education. All rights reserved. Direct and Indirect Costs Direct costs can be conveniently and economically traced (tracked) to a cost object. Indirect costs cannot be conveniently or economically traced (tracked) to a cost object. Instead of being traced, these costs are allocated to a cost object in a rational and systematic manner.

39. © 2012 Pearson Education. All rights reserved. BMW: Assigning Costs to a Cost Object

40. © 2012 Pearson Education. All rights reserved. Cost Examples Direct Costs Parts Assembly line wages Indirect Costs Electricity Rent Property taxes

41. © 2012 Pearson Education. All rights reserved. Factors Affecting Direct/Indirect Cost Classification Cost materiality Availability of information-gathering technology Operational design

42. © 2012 Pearson Education. All rights reserved. Cost Behavior Variable costs—changes in total in proportion to changes in the related level of activity or volume. Fixed costs—remain unchanged in total regardless of changes in the related level of activity or volume. Costs are fixed or variable only with respect to a specific activity or a given time period.

43. © 2012 Pearson Education. All rights reserved. Cost Behavior Variable costs are constant on a per-unit basis. If a product takes 5 pounds of materials each, it stays the same per unit regardless if one, ten, or a thousand units are produced. Fixed costs change inversely with the level of production. As more units are produced, the same fixed cost is spread over more and more units, reducing the cost per unit.

44. © 2012 Pearson Education. All rights reserved. Cost Behavior Summarized Total DollarsCost per Unit Variable Costs Change in proportion with output More output = More cost Fixed Costs Unchanged in relation to output Change inversely with output More output = lower cost per unit Total DollarsCost Per Unit Variable Costs Change in proportion with output More output = More cost Unchanged in relation to output Fixed CostsUnchanged in relation to output Change inversely with output More output = lower cost per unit

45. © 2012 Pearson Education. All rights reserved. Cost Behavior Visualized

46. © 2012 Pearson Education. All rights reserved. Other Cost Concepts Cost driver—a variable that causally affects costs over a given time span Relevant range—the band of normal activity level (or volume) in which there is a specific relationship between the level of activity (or volume) and a given cost For example, fixed costs are considered fixed only within the relevant range.

47. © 2012 Pearson Education. All rights reserved. A Cost Caveat Unit costs should be used cautiously. Because unit costs change with a different level of output or volume, it may be more prudent to base decisions on a total dollar basis. Unit costs that include fixed costs should always reference a given level of output or activity. Unit costs are also called average costs. Managers should think in terms of total costs rather than unit costs.

48. © 2012 Pearson Education. All rights reserved. Multiple Classification of Costs Costs may be classified as: Direct/Indirect, and Variable/Fixed These multiple classifications give rise to important cost combinations: Direct and variable Direct and fixed Indirect and variable Indirect and fixed

49. © 2012 Pearson Education. All rights reserved. Multiple Classification of Costs, Visualized

50. © 2012 Pearson Education. All rights reserved. Cost Classification Diagram Cost Classification System Cost types – Product and Period Cost nature Cost behavior – Variable or Fixed Sunk Costs vs. Opportunity Costs Controllable vs. non controllable costs

51. © 2012 Pearson Education. All rights reserved. Fall 2010Mugan 51/82 Extent of Variable Costs The proportion of variable costs differs across organizations. For example... A public utility with large investments in equipment will tend to have fewer variable costs. A manufacturing company will often have many variable costs. A merchandising company usually will have a high proportion of variable costs like cost of sales. A merchandising company usually will have a high proportion of variable costs like cost of sales. A service company will normally have a high proportion of variable costs. A service company will normally have a high proportion of variable costs.

52. © 2012 Pearson Education. All rights reserved. Different Types of Firms Manufacturing-sector companies purchase materials and components and convert them into finished products. Merchandising-sector companies purchase and then sell tangible products without changing their basic form. Service-sector companies provide services (intangible products).

53. © 2012 Pearson Education. All rights reserved. Examples of cost behavior

54. © 2012 Pearson Education. All rights reserved. Types of Manufacturing Inventories Direct materials—resources in-stock and available for use Work-in-process (or progress)—products started but not yet completed, often abbreviated as WIP Finished goods—products completed and ready for sale

55. © 2012 Pearson Education. All rights reserved. Types of Product Costs Also known as inventoriable costs Direct materials—acquisition costs of all materials that will become part of the cost object. Direct labor—compensation of all manufacturing labor that can be traced to the cost object. Indirect manufacturing—factory costs that are not traceable to the product in an economically feasible way. Examples include lubricants, indirect manufacturing labor, utilities, and supplies.

56. © 2012 Pearson Education. All rights reserved. Accounting Distinction Between Costs Inventoriable costs—product manufacturing costs. These costs are capitalized as assets (inventory) until they are sold and transferred to Cost of Goods Sold. Period costs—have no future value and are expensed in the period incurred.

57. © 2012 Pearson Education. All rights reserved. Cost Flows The Cost of Goods Manufactured and the Cost of Goods Sold section of the Income Statement are accounting representations of the actual flow of costs through a production system. Note the importance of inventory accounts in the following accounting reports, and in the cost flow chart.

58. © 2012 Pearson Education. All rights reserved. Cost Flows Visualized

59. © 2012 Pearson Education. All rights reserved. Multiple-Step Income Statement STEP 4

60. © 2012 Pearson Education. All rights reserved. Cost of Goods Manufactured STEP 1 STEP 3 STEP 2

61. © 2012 Pearson Education. All rights reserved. Other Cost Considerations Prime cost is a term referring to all direct manufacturing costs (materials and labor). Conversion cost is a term referring to direct labor and indirect manufacturing costs. Overtime labor costs are considered part of indirect overhead costs.

62. © 2012 Pearson Education. All rights reserved. Different Definitions of Costs for Different Applications Pricing and product-mix decisions—decisions about pricing and maximizing profits Contracting with government agencies—very specific definitions of allowable costs for “cost plus profit” contracts Preparing external-use financial statements—GAAP- driven product costs only

63. © 2012 Pearson Education. All rights reserved. Different Definitions of Costs for Different Applications

64. © 2012 Pearson Education. All rights reserved. Three Common Features of Cost Accounting and Cost Management 1. Calculating the cost of products, services, and other cost objects 2. Obtaining information for planning and control, and performance evaluation 3. Analyzing the relevant information for making decisions

65. © 2012 Pearson Education. All rights reserved.