An Introduction to Cost Terms and Purposes CHAPTER 2 An Introduction to Cost Terms and Purposes © 2009 Pearson Prentice Hall. 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

Cost Object Examples at BMW Illustration Product BMW X 5 sports activity vehicle Service Dealer-support telephone hotline Project R&D project on DVD system enhancement Customer Herb Chambers Motors, a dealer that purchases a broad range of BMW vehicles Activity Setting up production machines Department Environmental, Health & Safety

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

Direct & 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

BMW: Assigning Costs to a Cost Object

Cost Examples Direct Costs Indirect Costs Parts Assembly line wages Electricity Rent Property taxes

Factors Affecting Direct / Indirect Cost Classification Cost Materiality Availability of information-gathering technology Operational Design

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

Cost Behavior, continued 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 of 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

Cost Behavior Summarized Total Dollars Cost 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 Dollars Cost Per Unit Change in proportion with output More output = More cost Unchanged in relation to output Variable Costs Change inversely with output More output = lower cost per unit Fixed Costs Unchanged in relation to output

Cost Behavior Visualized

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.

Relevant Range Visualized

Multiple Classification of Costs Costs may be classified as: Direct / Indirect, and Variable / Fixed These multiple classifications give rise to important cost combinations: Direct & Variable Direct & Fixed Indirect & Variable Indirect & Fixed

Multiple Classification of Costs, Visualized

Different Types of Firms Manufacturing-sector companies – create and sell their own products Merchandising-sector companies – product resellers Service-sector companies – provide services (intangible products)

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

Types of Product Costs Also known as Inventoriable Costs Direct Materials Direct Labor Indirect Manufacturing – factory costs that are not traceable to the product. Other common names for this type of cost include Manufacturing Overhead costs or Factory Overhead costs.

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 as incurred.

Other Cost Considerations Prime cost is a term referring to all direct manufacturing costs (labor and materials) Conversion cost is a term referring to direct labor and factory overhead costs, collectively Overtime labor costs are considered part of overhead due to the inability to precisely know the true cause of these costs

Comparing Merchandising and Manufacturing Activities 3-22 Comparing Merchandising and Manufacturing Activities Merchandisers . . . Buy finished goods. Sell finished goods. Manufacturers . . . Buy raw materials. Produce and sell finished goods. MegaLoMart Merchandising companies purchase finished goods from suppliers for resale to customers. Manufacturing companies purchase raw materials from suppliers and produce and sell finished goods to customers.

Balance Sheet Merchandiser Current assets Cash Receivables 3-23 Balance Sheet Merchandiser Current assets Cash Receivables Prepaid Expenses Merchandise Inventory Manufacturer Current Assets Cash Receivables Prepaid Expenses Inventories Raw Materials Work in Process Finished Goods Now, let’s consider similarities and differences on the balance sheet for merchandising and manufacturing companies. Both merchandising and manufacturing companies will likely have Cash, Receivables and Prepaid Expenses. However, merchandising companies do not have to distinguish between raw materials, work in process, and finished goods. They report one inventory number on their balance sheets, labeled merchandise inventory. Manufacturing companies report three types of inventory on their balance sheets: raw materials, work in process and finished goods.

3-24 The Income Statement Cost of goods sold for manufacturers differs only slightly from cost of goods sold for merchandisers. Merchandising companies calculate cost of goods sold as Beginning Merchandise Inventory plus Purchases minus Ending Merchandise Inventory. For manufacturing companies, the cost of goods sold for a period is not simply the manufacturing costs incurred during the period. Manufacturing companies calculate cost of goods sold as Beginning Finished Goods Inventory plus Cost of Goods Manufactured minus Ending Finished Goods Inventory. Some of the cost of goods sold may be for units completed in a previous period. And some of the units completed in the current period may not have been sold and will still be on the balance sheet as assets. The cost of goods sold is computed with the aid of a schedule of costs of goods manufactured, which takes into account changes in inventories. The schedule of cost of goods manufactured is not ordinarily included in external financial reports, but must be compiled by accountants within the company in order to arrive at the cost of goods sold. We will learn more about a schedule of costs of goods manufactured later in this chapter.

Basic Equation for Inventory Accounts 3-25 Basic Equation for Inventory Accounts Beginning balance Additions to inventory Ending balance Withdrawals from inventory + = + The computation of Cost of Goods Sold relies on this basic equation for inventory accounts. The logic underlying this equation applies to any inventory account. Any units that are in inventory at the beginning of the period appear as the beginning balance. During the period, additions are made to the inventory through purchases or other means. The sum of the beginning balance and the additions to the account is the total amount of inventory available. During the period, withdrawals are made from inventory. The ending balance is whatever is left at the end of the period after the withdrawals.

3-26 Quick Check  If your inventory balance at the beginning of the month was $1,000, you bought $100 during the month, and sold $300 during the month, what would be the balance at the end of the month? A. $1,000. B. $ 800. C. $1,200. D. $ 200. If your inventory balance at the beginning of the month was $1,000, you bought $100 during the month, and sold $300 during the month, what would be the balance at the end of the month?

Quick Check  $1,000 + $100 = $1,100 $1,100 - $300 = $800 A. $1,000. 3-27 Quick Check  If your inventory balance at the beginning of the month was $1,000, you bought $100 during the month, and sold $300 during the month, what would be the balance at the end of the month? A. $1,000. B. $ 800. C. $1,200. D. $ 200. $1,000 + $100 = $1,100 $1,100 - $300 = $800 Right. $800. This is calculated as beginning inventory of $1,000 plus purchases of $100 minus ending inventory of $300.

Schedule of Cost of Goods Manufactured 3-28 Schedule of Cost of Goods Manufactured Calculates the cost of raw material, direct labor and manufacturing overhead used in production. Calculates the manufacturing costs associated with goods that were finished during the period. The schedule of cost of goods manufactured contains the three elements of costs mentioned previously, namely direct materials, direct labor, and manufacturing overhead. It calculates the cost of raw material, direct labor and manufacturing overhead used in production. It also calculates the manufacturing costs associated with goods that were finished during the period.

3-29 Product Cost Flows To create a schedule of cost of goods manufactured, as well as a balance sheet and income statement, it is important to understand the flow of product costs. Raw material purchases made during the period are added to beginning raw materials inventory. The ending raw materials inventory is deducted to arrive at the raw materials used in production. As items are removed from the raw materials inventory and placed into the production process, they are called direct materials. As items are removed from raw materials inventory and placed into the production process, they are called direct materials.

3-30 Product Cost Flows Conversion costs are costs incurred to convert the direct material into a finished product. Direct labor and manufacturing overhead (also called conversion costs) used in production are added to direct materials to arrive at total manufacturing costs.

3-31 Product Cost Flows Total manufacturing costs are added to the beginning work in process to arrive at total work in process. All manufacturing costs incurred during the period are added to the beginning balance of work in process.

3-32 Product Cost Flows The ending work in process inventory is deducted from the total work in process for the period to arrive at the cost of goods manufactured. Costs associated with the goods that are completed during the period are transferred to finished goods inventory.

3-33 Product Cost Flows The cost of goods manufactured is added to the beginning finished goods inventory to arrive at cost of goods available for sale. The ending finished goods inventory is deducted from this figure to arrive at cost of goods sold.

Manufacturing Cost Flows 3-34 Manufacturing Cost Flows Income Statement Expenses Balance Sheet Costs Inventories Material Purchases Raw Materials Direct Labor Work in Process Manufacturing Overhead Part I All raw materials, work in process, and unsold finished goods at the end of the period are shown as inventoriable costs in the asset section of the balance sheet. Part II As finished goods are sold, their costs are transferred to cost of goods sold on the income statement. Part III Selling and administrative expenses are not involved in making the product; therefore, they are treated as period costs and reported on the income statement for the period the cost is incurred. Cost of Goods Sold Finished Goods Selling and Administrative Period Costs Selling and Administrative

3-35 Quick Check  Beginning raw materials inventory was $32,000. During the month, $276,000 of raw material was purchased. A count at the end of the month revealed that $28,000 of raw material was still present. What is the cost of direct material used? A. $276,000 B. $272,000 C. $280,000 D. $ 2,000 Beginning raw materials inventory was $32,000. During the month, $276,000 of raw material was purchased. A count at the end of the month revealed that $28,000 of raw material was still present. What is the cost of direct material used?

3-36 Quick Check  Beginning raw materials inventory was $32,000. During the month, $276,000 of raw material was purchased. A count at the end of the month revealed that $28,000 of raw material was still present. What is the cost of direct material used? A. $276,000 B. $272,000 C. $280,000 D. $ 2,000 Right. $280,000. Take a minute and review the solution before proceeding.

3-37 Quick Check  Direct materials used in production totaled $280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month? A. $555,000 B. $835,000 C. $655,000 D. Cannot be determined. Direct materials used in production totaled $280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month?

3-38 Quick Check  Direct materials used in production totaled $280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month? A. $555,000 B. $835,000 C. $655,000 D. Cannot be determined. Right. $835,000. Take a minute and review the solution before proceeding.

3-39 Quick Check  Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month? A. $1,160,000 B. $910,000 C. $760,000 D. Cannot be determined. Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month?

3-40 Quick Check  Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month? A. $1,160,000 B. $ 910,000 C. $ 760,000 D. Cannot be determined. Right. $760,000. Take a minute and review the solution before proceeding.

3-41 Quick Check  Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. And the ending finished goods inventory was $150,000. What was the cost of goods sold for the month? A. $ 20,000. B. $740,000. C. $780,000. D. $760,000. Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. And the ending finished goods inventory was $150,000. What was the cost of goods sold for the month?

3-42 Quick Check  Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. And the ending finished goods inventory was $150,000. What was the cost of goods sold for the month? A. $ 20,000. B. $740,000. C. $780,000. D. $760,000. $130,000 + $760,000 = $890,000 $890,000 - $150,000 = $740,000 Right. $740,000. Take a minute and review the solution before proceeding.