COST TERMS, CONCEPTS & CLASSIFICATIONS CHAPTER LEARNING OBJECTIVES: - Be able to define and explain each term or concept in this chapter. - Be able to prepare a Cost of Goods Manufactured statement. - Understand the flow of costs through the accounting system. - Cost of quality www.AssignmentPoint.com

Purpose of classification COST TERMS, CONCEPTS & CLASSIFICATIONS Purpose of classification Cost classifications Preparing an income statement and balance sheet • Product costs    Direct materials    Direct labor    Manufacturing overhead • Period costs (nonmanufacturing costs)    Marketing and selling costs    Administrative costs Predicting changes in cost due to changes in activity • Variable costs • Fixed costs Assigning costs • Direct costs • Indirect costs Making decisions • Differential costs • Sunk costs • Opportunity costs www.AssignmentPoint.com

COST TERMS, CONCEPTS & CLASSIFICATIONS MANUFACTURING requires the use of DIRECT MATERIALS (DM), DIRECT LABOR (DL) and FACTORY OVERHEAD (FOH) to produce goods. www.AssignmentPoint.com

Direct Material DM is not difficult, inconvenient or expensive to trace to products. DM would include most of the raw materials necessary to construct the finished product. www.AssignmentPoint.com

Direct Labor: DL is not difficult, inconvenient or expensive to trace to products. DL would include most, if not all, the labor costs related to those who actually transform the materials or assemble the product. www.AssignmentPoint.com

Factory Overhead FOH includes all the costs incurred in the factory except for DM and DL. Every FOH item would be considered an Indirect Cost. DM and DL are Direct Costs. www.AssignmentPoint.com

Marketing (selling) costs Marketing (selling) costs are not part of FOH, nor are Administrative (ADM) costs. Both of these are also Period costs, whereas DM, DL and FOH are Product costs. www.AssignmentPoint.com

PRIME COST & CONVERSION costs PRIME costs are the combination of DM and DL. CONVERSION costs are the combination of DL and FOH. www.AssignmentPoint.com

PRODUCT COST PRODUCT costs are the combination of DM, DL and FOH. They are also known as Inventory costs. These costs are not expensed (classified as cost of goods sold on the income statement) until the related products are sold. www.AssignmentPoint.com

PERIOD COST PERIOD costs are the combination of Marketing and Administrative costs. These costs are expensed (show up on the income statement) in the period they are incurred. www.AssignmentPoint.com

COST CLASSIFICATIONS IN MANUFACTURING COMPANIES www.AssignmentPoint.com

Raw Material, Work in Process & Finished Goods RM are the tangible items that will be used to make the physical form of the product. In effect, those items that will become DM and/or IDM. WIP is the partially completed products. This would include some DM, DL and FOH but not all that is necessary to complete the products. FG is the completed units of product that are ready to be sold. www.AssignmentPoint.com

Financial statements Financial statements of manufacturing companies have some differences from merchandising or service businesses. The balance sheet would typically include three inventory accounts (RM, WIP & FG) instead of one inventory account for merchandising companies, or no inventory account for service businesses. www.AssignmentPoint.com

Financial statements There would also be an additional financial statement called the Statement of Cost of Goods Manufactured. This statement would show the details of the materials, labor and factory overhead plus the beginning and ending work in process balances. In effect, this statement is a detailed summary of the Work In Process account. www.AssignmentPoint.com

FIXED COST As production increases, or decreases, a cost that does not change in amount in total is called a FC. As a result of the cost not changing in total (as the number of units produced increases or decreases) the mathematical average, based upon the number of units produced, will change in an opposite direction. In effect, an increase in production will cause the average fixed cost per unit to decrease. www.AssignmentPoint.com

FIXED COST For example, if rent expense (generally a FC) is $1,000 per month and we produce 200 units, the cost per unit, for rent, is $5 ($1,000 / 200 = 5). But if we produce 500 units, then the cost per unit would be $2 ($1,000 / 500 = 2). www.AssignmentPoint.com

VARIABLE COST As production changes (increases or decreases) a cost that does change in amount in total, and in direct proportion to the change in production, is called a VC. www.AssignmentPoint.com

VARIABLE COST The wood materials used to make a desk is an example. The total amount of wood needed would be directly proportional to the number of desks made, but the amount of wood needed for each desk would be the same. For example, if the wood for one desk cost $10, then the total cost for 5 desks would be $50 ($10 * 5). www.AssignmentPoint.com

Variable Cost Behavior Variable cost per unit is constant. COST CLASSIFICATIONS TO DESCRIBE COST BEHAVIOR To describe how costs react to changes in activity, costs are often classified as variable or fixed. VARIABLE COSTS- Variable cost behavior can be summarized as follows: Variable Cost Behavior In Total Per Unit Total variable cost increases and decreases in proportion to changes in activity. Variable cost per unit is constant. www.AssignmentPoint.com

Number of Ovens Produced Total Variable Cost-Timing Devices COST CLASSIFICATIONS TO DESCRIBE COST BEHAVIOR EXAMPLE: A company manufactures microwave ovens. Each oven requires a timing device that costs $30. The per unit and total cost of the timing device at various levels of activity (i.e., number of ovens produced) would be: Cost per Timing Device Number of Ovens Produced Total Variable Cost-Timing Devices $30 1 10 $300 100 $3,000 200 $6,000 www.AssignmentPoint.com

Fixed cost behavior can be summarized as follows: FIXED COSTS Fixed cost behavior can be summarized as follows: Fixed Cost Behavior In Total Per Unit Total fixed cost is not affected by changes in activity (i.e., total fixed cost remains constant even if activity changes). Fixed cost per unit decreases as the activity level rises and increases as the activity level falls. www.AssignmentPoint.com

FIXED COSTS EXAMPLE: Assume again that a company manufactures microwave ovens. The company pays $9,000 per month to rent its factory building. The total and per unit cost of rent at various levels of activity would be: Number of Rent Cost Ovens per Month Produced per Oven $9,000 1 10 $900 100 $90 200 $45 www.AssignmentPoint.com

A GRAPHIC VIEW OF COST BEHAVIOR RELEVANT RANGE If activity changes enough, fixed costs may change. For example, if microwave production were doubled, another factory building might have to be rented. The relevant range is the range of activity within which the assumptions that have been made about variable and fixed costs are valid. For example, the relevant range within which total fixed factory rent is $9,000 per month might be 1 to 200 microwaves produced per month. www.AssignmentPoint.com

OPPORTUNITY COSTS OC refer to the benefit forgone (given up) because of the decision made. For example, if you give up one hour of time to study for this class but instead you could have worked and earned $10, then your opportunity cost of studying for this one hour is $10. www.AssignmentPoint.com

SUNK COST A SUNK cost is the amount paid, or to be paid, because of a previous commitment, and the cost cannot be changed by any decision made now or in the future. For example, the cost previously incurred to make ten units of inventory, eight of which have been sold and two not, is a sunk cost. www.AssignmentPoint.com

DIFFERENTIAL COSTS When comparing two alternatives, the difference between the costs, or revenues, is referred to as the DIFFERENTIAL costs. Other similar terms are INCREMENTAL, AVOIDABLE, and CHANGABLE. www.AssignmentPoint.com

COST CLASSIFICATIONS FOR DECISION-MAKING DIFFERENTIAL COST- Every decision involves choosing from among at least two alternatives. Any cost that differs between alternatives is a differential cost. Only the differential costs are relevant in making a decision. EXAMPLE: Bill is currently employed as a lifeguard, but he has been offered a job in an auto service center in the same town. The differential revenues and costs between the two jobs are listed below: www.AssignmentPoint.com

DIFFERENTIAL COST- Auto Differential Life- service costs and guard center revenues Monthly salary $1,200 $1,500 $300  Monthly expenses: Commuting 30 90 60  Meals 150 0  Apartment rent 450 Uniform rental 50 50  Union dues      10        0  (10) Total monthly expenses    640    740  100  Net monthly income $  560 $  760 $200  www.AssignmentPoint.com

Quick Review Question #1 Which of the following is most likely to be a variable cost? Depreciation Materials costs Rent Advertising www.AssignmentPoint.com

Quick Review Answer #1 Which of the following is most likely to be a variable cost? Depreciation Materials costs Rent Advertising www.AssignmentPoint.com

Quick Review Question #2 Which of the following is most likely to be a fixed cost? Materials costs Rent Assembly labor cost Commissions www.AssignmentPoint.com

Quick Review Answer #2 Which of the following is most likely to be a fixed cost? Materials costs Rent Assembly labor cost Commissions www.AssignmentPoint.com

Quick Review Question #3 Costs incurred in the past are: Opportunity costs Direct costs Sunk costs Variable costs www.AssignmentPoint.com

Quick Review Question #3 Costs incurred in the past are: Opportunity costs Direct costs Sunk costs Variable costs www.AssignmentPoint.com

Product Cost Information in Financial Reporting and Decision Making GAAP (Generally Accepted Accounting Principles) requires that inventory on balance sheets and cost of goods sold on income statements be disclosed (reported) using Full Cost information. www.AssignmentPoint.com

Balance Sheet Presentation of Product Costs Raw Materials Inventory. Work in Process Inventory. Finished Goods Inventory. www.AssignmentPoint.com

Flow of Product Costs in Accounts Product costs flow from the Direct Materials, Direct Labor and Manufacturing Overhead through Work in Process to Finished Goods Inventory and finally to Cost of Goods Sold. www.AssignmentPoint.com

Income Statement Presentation of Product Costs When finished goods are sold they are moved from Finished Goods to Cost of Goods Sold. www.AssignmentPoint.com

Cost of Goods Manufactured Cost of Goods Manufactured includes all costs of goods completed during the period. www.AssignmentPoint.com

Cost of Goods Sold www.AssignmentPoint.com

Ryder Company incurred the following costs last month: COST FLOWS EXAMPLE Ryder Company incurred the following costs last month: But: • Some of the goods sold this month were produced in previous months. • Some of the costs listed above were incurred to make goods that were not sold this month. Therefore: • Cost of goods sold does not equal the sum of the above costs. • We need to determine the values of the various inventories. Purchases of raw materials $200,000 Direct labor $270,000 Manufacturing overhead: Indirect materials $   5,000 Indirect labor 100,000 Utilities, factory 80,000 Property taxes, factory 36,000 Insurance, factory 9,000 Equipment rental 70,000 Depreciation, factory  120,000 Total manufacturing overhead $420,000 www.AssignmentPoint.com

COST FLOWS EXAMPLE (cont’d) Raw materials inventory: Beginning raw materials inventory $10,000 Purchases of raw materials $200,000 Ending raw materials inventory $30,000 Raw materials used in production ?    Work in process inventory: Beginning work in process inventory $40,000 Total manufacturing costs Ending work in process inventory $60,000 Cost of goods manufactured (i.e., finished) Finished goods inventory: Beginning finished goods inventory $130,000 Ending finished goods inventory $80,000 Cost of goods sold www.AssignmentPoint.com

Basic Equation for Inventory Accounts: INVENTORY FLOWS Basic Equation for Inventory Accounts: or www.AssignmentPoint.com

COST FLOWS EXAMPLE (cont’d) Computation of raw materials used in production- Beginning raw materials inventory $  10,000 + Purchases of raw materials 200,000 – Ending raw materials inventory    30,000 = Raw materials used in production $180,000 Computation of total manufacturing cost- Raw materials used in production $180,000 + Direct labor 270,000 Manufacturing overhead  420,000 = Total manufacturing costs $870,000 www.AssignmentPoint.com

Computation of cost of goods manufactured- + – = Beginning work in process inventory $  40,000 + Total manufacturing costs 870,000 – Ending work in process inventory    60,000 = Cost of goods manufactured (i.e., finished) $850,000 Computation of cost of goods sold- Beginning finished goods inventory $130,000 + Cost of goods manufactured (i.e., finished) 850,000 – Ending finished goods inventory    80,000 = Cost of goods sold $900,000 www.AssignmentPoint.com

Many different products are produced each period. JOB-ORDER COSTING Many different products are produced each period. www.AssignmentPoint.com

THE FLOW OF DOCUMENTS IN A JOB-ORDER COSTING SYSTEM www.AssignmentPoint.com

MATERIALS REQUISITION FORM www.AssignmentPoint.com

EMPLOYEE TIME TICKET www.AssignmentPoint.com

JOB COST SHEET www.AssignmentPoint.com

APPLICATION OF OVERHEAD In a job-order costing system, the cost of a job consists of: Actual direct material costs traced to the job. 2. Actual direct labor costs traced to the job. Manufacturing overhead applied to the job using a predetermined overhead rate. Actual overhead costs are not assigned to jobs. www.AssignmentPoint.com

APPLICATION OF OVERHEAD Why overhead Predetermined and difficult to trace- indirect cost either impossible or difficult to trace. many different items fluctuates but remain constant Due to fixed costs. www.AssignmentPoint.com

APPLICATION OF OVERHEAD • A predetermined overhead rate is used to assign overhead cost to products and services. It is: • Based on estimated data. • Established before the period begins. www.AssignmentPoint.com

PREDETERMINED OVERHEAD RATE FORMULA The formula for computing a predetermined overhead rate is: The company in the preceding example applies overhead costs to jobs on the basis of direct labor-hours. In other words, direct labor-hours or machine hours are the allocation base. www.AssignmentPoint.com

PREDETERMINED OVERHEAD RATE FORMULA At the beginning of the year the company estimated that it would incur $320,000 in manufacturing overhead costs and would work 40,000 direct labor-hours. The company’s predetermined overhead rate is: www.AssignmentPoint.com

APPLICATION OF OVERHEAD TO JOBS The process of assigning overhead to jobs is known as applying overhead. In the preceding example, Job 2B47 required 27 direct labor-hours. Therefore, $216 of overhead cost was applied to the job as follows: Predetermined overhead rate $8 per DLH Direct labor-hours required for Job 2B47 × 27 DLHs Overhead applied to Job 2B47 $216 www.AssignmentPoint.com

Overapplied or Underapplied overhead Actual >Estimated = Underapplied Dr. COGS Cr. M/O Actual<Estimated = Overapplied Dr. M/O Cr. COGS www.AssignmentPoint.com

Disposition of Under or Overapplied Overhead Closed out COGS Add- Underapplied Deduct- Overapplied Allocated between WIP, FG and COGS in the ending balances of these accounts. www.AssignmentPoint.com