Basic Cost Management Concepts Managerial Accounting Creating Value in a Dynamic Business Environment Second Canadian Edition HILTON  FAVERE-MARCHESI Chapter 2: Basic Cost Management Concepts 1

Learning Objectives 1. Explain what is meant by the word "cost." 2. Distinguish among product costs, period costs, and expenses. 3. Describe the role of costs on published financial statements. 4. List five types of manufacturing operations and describe mass customization. Give examples of three types of manufacturing costs. 6. Prepare a schedule of cost of goods manufactured, a schedule of cost of goods sold, and an income statement for a manufacturer.

Learning Objectives (cont’d) 7. Understand the importance of identifying an organization's cost drivers. 8. Describe the behavior of variable and fixed costs, in total and on a per-unit basis. Distinguish among direct, indirect, controllable, and uncontrollable costs. 10. Define and give examples of an opportunity cost, an out-of-pocket cost, a sunk cost, a differential cost, a marginal cost, and an average cost per unit.

The meaning of costs LO1 A cost is the sacrifice made to achieve a particular purpose. There are different costs for different purposes.  An expense is the cost incurred when an asset is used up or sold to generate revenue. "product cost" and "period cost " describe timing with which expenses are recognized.

LO2 The meaning of costs Product costs are the costs of goods manufactured or the cost of goods purchased for resale. These costs are inventoried until the goods are sold. Period costs are all other non-product costs in an organization (e.g., selling and administrative). Such costs are not inventoried but are expensed as time passes.

COSTS ON FINANCIAL STATEMENTS LO3 COSTS ON FINANCIAL STATEMENTS Product costs, kept on the balance sheet until sale, are found in three inventory accounts: Raw materials—materials that await production Work in process—partially completed production  Finished goods—completed production that awaits sale Product costs are shown as cost of goods sold on the income statement when goods are sold.  

MANUFACTURING OPERATIONS AND COSTS LO4 MANUFACTURING OPERATIONS AND COSTS There are various types of production processes example: Job shop—low production volume, little standardization; one-of-a-kind products (movies, service, custom-made home) Batch—multiple products; low volume (bakery, airplanes) Assembly line—a few major products; higher volume (automobiles, TV)  Mass customization—high production volume; standardized components; customized combinations of components (Dell computers) Continuous flow—high volume; highly standardized commodity products (Oil & Gas)

MANUFACTURING OPERATIONS AND COSTS LO4 MANUFACTURING OPERATIONS AND COSTS In mass customization, many standardized components are combined to produce custom-made goods to customer order. Production is triggered by the placement of a customer order, which often takes place via the Internet. Inventories of finished goods and raw materials are relatively low, because raw materials are ordered only when needed in manufacturing and product is shipped as soon as it is completed.

MANUFACTURING OPERATIONS AND COSTS LO5 MANUFACTURING OPERATIONS AND COSTS There are 3 types of manufacturing costs: Direct materials—materials easily traced to a finished product (e.g., the seat on a bicycle) Direct labour—the wages of anyone who works directly on the product Manufacturing overhead—all other manufacturing costs such as: Indirect materials, indirect labour, and other manufacturing costs not easily traceable to a finished good (e.g., insurance, property taxes, depreciation, utilities).  

MANUFACTURING OPERATIONS AND COSTS LO5 MANUFACTURING OPERATIONS AND COSTS Overtime premiums and the cost of idle time are also accounted for as overhead. Conversion cost (the cost to convert direct materials into finished product): direct labour + manufacturing overhead Prime cost: direct material + direct labour

MANUFACTURING COST FLOWS Manufacturing costs (DM, DL, and MOH) "put in process" and attached to work-in-process (WIP) inventory. Cost of goods manufactured: DM used + DL + MOH + beg WIP – end WIP . This amount is transferred from WIP inventory to F/G inventory when goods are completed. The costs are then transferred from F/G inventory to CGS upon sale of the goods.

MANUFACTURING COST FLOWS Product costs and cost of goods sold for a manufacturer:

MANUFACTURING COST FLOWS Manufacturers generally prepare a schedule of CGM and a schedule of CGS Production-cost concepts are applicable to service businesses and nonprofit organizations. For example, the DM concept can be applied to the food consumed in a restaurant or the jet fuel used by an airline. Similarly, DL would be equivalent to the cooks in a restaurant and the flight crews of an airline.

DIFFERENT COSTS FOR DIFFERENT PURPOSES LO7 DIFFERENT COSTS FOR DIFFERENT PURPOSES The most important classification involves how costs change in relation to changes in the activity of the organization (a measure of the output of products and services). The activities that cause costs to be incurred are called cost drivers. Examples include labour hours in manual assembly work and machine hours in automated production settings. The higher the degree of correlation between a cost increase and the increase in its cost driver, the better the cost management information.

Variable and fixed costs LO8 Variable and fixed costs Total Variable Costs move in direct proportion to a change in activity. For example, the total cost of bicycle seats goes up in proportion to the number of bicycles produced. Total Fixed Costs remain constant in total as the level of activity changes. For instance, property taxes for the manufacturing facilities remains the same whether 100 bicycles or 1,000 bicycles are produced.

Total Variable Cost Example The bicycle seat bill is based on how many bicycles are made. Total Bicycle Seat Bill Bicycles Made

Variable Cost Per Unit Example The cost per bicycle seat is constant. Per Seat Charge Bicycles made

Total Fixed Cost Example Your monthly property tax bill does not change when you make more bicycles. Number of Bicycles Made Monthly Charge for Property Taxes

Fixed Cost Per Unit Example The average cost per bicycle for property taxes decreases as more bicycles are made. Monthly Property Tax per Bicycle Made Number of Bicycles made

Direct and indirect costs LO9 Direct and indirect costs An entity (e.g., a specific product, service, or department) to which a cost is assigned is commonly known as a cost object. A direct cost is one that can be easily traced to a cost object (faculty’s salaries). An indirect cost is a cost that cannot be easily traced to a cost object (president’s salary). A cost management system traces costs to objects that caused them so that managers can isolate responsibility for spending and objectively evaluate operations.

Controllable and uncontrollable costs LO9 Controllable and uncontrollable costs Controllable costs—costs over which a manager has influence (e.g., direct materials) Uncontrollable costs—costs over which a manager has no influence (e.g., property taxes)

DIFFERENT COSTS FOR DIFFERENT PURPOSES LO10 DIFFERENT COSTS FOR DIFFERENT PURPOSES Opportunity cost—the benefit forgone by choosing an alternative course of action (e.g., wages forgone when attending university rather than working) Out-of-pocket cost—a cost that requires a cash outlay Sunk cost—a cost incurred in the past that cannot be changed by future action (e.g., tuition) Differential cost—the net difference in cost between two alternative courses of action Incremental cost—the increase in cost from one alternative to another

COSTS IN THE SERVICE INDUSTRY LO10 COSTS IN THE SERVICE INDUSTRY The preceding costs discussed in a manufacturing context are just as relevant for service providers. Although manufacturers and service firms are in very different businesses, they all must understand their costs in order to be successful in a competitive environment.

Costs and Benefits of Information More information does not mean more benefits if information overload results.

Example – Background data Costs Amount Indirect materials $ 300 Rent on factory building 500 Maintenance of equipment 50 Direct material used 1,200 Utilities on factory 250 Direct labour 1,500 Selling expense Administrative expense 300 WIP inventory, beginning 600 WIP inventory, ending 800 F/G inventory, beginning F/G inventory, ending

Example – Per Unit Approach Let’s first examine the monthly activity in terms of units, then we will look at cost.

Example – Units Manufactured and Sold Units partially completed at beginning of month (beginning WIP inventory) 400 Add: Units started during the month 2,400 Less: Units partially completed at end of month (ending WIP inventory) (500) Units transferred to FG inventory during the month 2,300 Add: Units in FG inventory at beginning of month 800 Units available for sale 3,100 Less: Units in FG inventory at end of month (400) Units sold during the month 2,700

Example – Cost Approach LO5 Example – Cost Approach Let’s isolate the manufacturing costs incurred during the month, which are the direct materials, the direct labour and the manufacturing overhead costs.

Example – Background Data LO5 Example – Background Data Costs Amount Indirect materials $ 300 Rent on factory building 500 Maintenance of equipment 50 Direct material used 1,200 Utilities on factory 250 Direct labour 1,500 Selling expense Administrative expense 300 WIP inventory, beginning 600 WIP inventory, ending 800 F/G inventory, beginning F/G inventory, ending

Example – Total Manufacturing Costs LO5 Example – Total Manufacturing Costs TOTAL MANUFACTURING COSTS Direct material used $1,200 Direct labour 1,500 Manufacturing overhead Indirect materials $ 300 Rent on factory building 500 Maintenance of equipment 50 Utilities on factory 250 Total manufacturing overhead 1,100 Total manufacturing costs $3,800 These are the total costs incurred during the month to (1) finish 400 units that were partially complete at the end of last month and (2) start 2,400 new units this month, of which 500 are partially complete at the end of the month

Example – Units Manufactured and Sold $3,800 total manufacturing costs incurred this month to finish the 400 units, to start 2,400 (1,900 were finished and 500 were partially complete LO5 Example – Units Manufactured and Sold UNITS MANUFACTURED AND SOLD Units partially completed at beginning of month (beginning WIP inventory) 400 Add: Units started during the month 2,400 Less: Units partially completed at end of month (ending WIP inventory) (500) Units transferred to FG inventory during the month 2,300 Add: Units in FG inventory at beginning of month 800 Units available for sale 3,100 Less: Units in FG inventory at end of month (400) Units sold during the month 2,700 1,900 500

Example – Cost of Goods Manufactured LO6 This cost was incurred last month on the units that were partially complete at the end of last month Example – Cost of Goods Manufactured COST OF GOODS MANUFACTURED Beginning WIP inventory $ 600 Add: Total manufacturing costs 3,800 Less: Ending WIP inventory (800) Cost of goods manufactured $3,600 This cost was incurred on units that were started this month but that are partially complete at the end of this month This cost represents the cost of all the units completed this month, some of which were partially complete at the end of last month and some of which were started and completed this month

Example – Units Manufactured and Sold LO6 The cost of good manufactured ($3,600) is the cost of the 400 units partially completed at the end of last month and finished this month and of the 1,900 units that were started and completed this month Example – Units Manufactured and Sold UNITS MANUFACTURED AND SOLD Units partially completed at beginning of month (beginning WIP inventory) 400 Add: Units started during the month 2,400 Less: Units partially completed at end of month (ending WIP inventory) (500) Units transferred to FG inventory during the month 2,300 Add: Units in FG inventory at beginning of month 800 Units available for sale 3,100 Less: Units in FG inventory at end of month (400) Units sold during the month 2,700 1,900 500

Example – Cost of Goods Sold LO6 This cost is associated with units that were unsold at the end of last month Example – Cost of Goods Sold COST OF GOODS SOLD Beginning F/G inventory $ 500 Add: Cost of goods manufactured 3,600 Cost of goods available for sale 4,100 Less: Ending F/G inventory (250) Cost of goods sold $3,850 This cost is associated with units that were unsold at the end of this month

Example – Units Manufactured and Sold LO6 Example – Units Manufactured and Sold MANUFACTURED AND SOLD Units $ Units partially completed at beginning of month (beginning WIP inventory) 400 Add: Units started during the month 2,400 Less: Units partially completed at end of month (ending WIP inventory) (500) Units transferred to FG inventory during the month 2,300 $3,600 Add: Units in FG inventory at beginning of month 800 500 Units available for sale 3,100 4,100 Less: Units in FG inventory at end of month (400) 250 Units sold during the month 2,700 $3,850 Cost of goods manufactured Cost of goods sold