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

2. 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.

3. 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.

4. 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.

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

6. 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.

7. 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.

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

9. 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.

10. 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.

11. Solution

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

13. 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.

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

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

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

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

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

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

20. 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

21. 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.

22. 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.

23. LO 5: Allocate overhead costs to products.

24. 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.

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

26. 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

27. 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.

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

29. 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.

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

31. Revised Decision Variable costs are only:
$17.50 (=$ $ )
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.

32. 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.

33. 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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