Chapter 2: An Introduction to Cost Terms and Purposes

Learning Objectives Define and illustrate a cost object Distinguish between direct costs and indirect costs Explain variable costs and fixed costs Interpret unit costs cautiously Distinguish inventoriable costs from period costs Illustrate the flow of inventoriable and period costs

Learning Objectives Explain why product costs are computed in different ways for different purposes Describe a framework for cost accounting and cost management

Define and Illustrate a Cost Object In this learning objective, we will define and understand a cost object. Learning Objective 1

Cost Object Anything for which a measurement of costs is desired Mangers need to know budgeted as well as actual costs of a cost object The costs of various objects are determined in two basic stages Cost accumulation Cost assignment Often manufacturing companies measure the cost of their products and hence product is a common cost object. Companies not only want to know the cost of various products, but they also want to know the costs of projects, services, customers, activities, and departments. For example, BMW managers would want to know the cost of various products such as the BMW X6 sports activity coupe and also the costs of projects and services. Comparing budgeted costs to actual costs helps managers evaluate how well they did controlling costs and learn about how they can do better in the future. Cost accumulation is the collection of cost data in some organized way by means of an accounting system. For example, company X collects costs in various categories like different machines used, type of labor required behind production, etc. The accumulated costs are then assigned to designated cost objects. Such as, the same company X then assigns those costs to its various objects.

Distinguish Between Direct Costs and Indirect Costs In this learning objective, we will understand the differences between direct costs and indirect costs. Learning Objective 2

Direct Costs Related to the particular cost object and can be traced to it in an economically feasible way Cost tracing refers to the assignment of direct costs to a particular cost object Examples of direct costs would include the raw materials required for production, the wages paid to labors for production, etc. These costs are easily traceable to the final product and hence are assigned to products, not allocated.

Indirect Costs Related to a particular cost object but cannot be traced to it in a cost-effective way Cost allocation is used particularly to describe the assignment of indirect costs to a particular cost object For example, the electricity charges of a factory are related to production, but can be difficult to trace to individual products. Cost assignment is a general term that is used for allocating direct as well as indirect costs to their particular cost objects.

Exhibit 2.2—Cost Assignment to a Cost Object Exhibit 2-2 depicts direct costs and indirect costs and both forms of cost assignment—cost tracing and cost allocation—using the example of the BMW X6. The exhibit shows that direct costs such as cost of steel for BMW cars are traced to cost object, BMW X6. On the other hand, the indirect costs such as cost incurred to lease the plant for production needs to be allocated to a particular model of BMW, as these are no attributable to only one model of the car.

Factors Affecting Direct/Indirect Cost Classifications Materiality of the cost in question Availability of information-gathering technology Design of operations The first factor one is the value of the cost in question. The smaller the amount of a cost—that is, the more immaterial the cost is—the less likely that it is economically feasible to trace that cost to a particular cost object. The second factor is an improvement in information-gathering technology that makes it possible to consider more and more costs as direct costs. This can help trace cost objects in a more economically feasible way. The third factor affecting the direct and indirect cost classifications is that classifying a cost as direct becomes easier if a company’s facility (or some part of it) is used exclusively for a specific cost object, such as a specific product or a particular customer.

Explain Variable Costs and Fixed Costs In this learning objective, we will understand the variable and fixed costs of a business. Learning Objective 3

Variable Costs Change in total in proportion to changes in the related level of total activity or volume One common example of variable costs is the cost of raw materials required for production, as it varies with the number of units produced.

Fixed Costs Remain unchanged in total for a given time period, despite changes in the related level of total activity or volume The salary paid to the staff of the production unit is fixed and does not change with a change in number of units produced. The fixed cost per unit tends to reduce as the number of units produced reduces.

Exhibit 2.3—Graphs of Variable and Fixed Costs Panel A illustrates the total variable cost of steering wheels for BMW. The total variable costs tends to increase proportionately with increase in production. Panel B illustrates the typical behavior total fixed costs. These costs are remain unchanged in total over a relevant range production.

Cost Drivers A variable that casually affects costs over a given time span Level of activity is a cost driver if there is a cause- and-effect relationship between a change in the level of activity and a change in the level of total costs For example, if product-design costs change with the number of parts in a product, the number of parts is a cost driver of product-design costs. Similarly, miles driven is often a cost driver of distribution costs.

Relevant Range The band or range of normal activity level or volume in which there is a specific relationship between the level of activity or volume and the cost in question For example, the level of fixed cost would be limited to a range of total activity and a given time span of a company. Anything more or less than the range might lead the fixed cost to vary accordingly. (Exhibit 2-4 exemplifies the fixed-cost behavior at Thomas Transport Company.)

Interpret Unit Costs Cautiously In this learning objective, we will understand the how to interpret unit costs. Learning Objective 4

Unit Cost Also known as average cost For example, the unit cost of a batch having a total production cost of $25,000 and a total output of 1,000 units is $25. However, managers should think in terms of total costs rather than unit costs for many decisions. Unit costs can lead to underestimation of actual total costs. An overreliance on unit cost may lead to insufficient cash being available to pay costs if volume declines. Refer to the example provided in the text for Tennessee Products to understand how unit costs can be interpreted incorrectly and the implications of the same.

Distinguish Inventoriable Costs from Period Costs In this learning objective, we will learn the differences between inventoriable costs and period costs. Learning Objective 5

Distribution of Economy in Three Sectors Manufacturing-sector companies Merchandising-sector companies Service-sector companies Manufacturing-sector companies purchase materials and components and convert them into various finished goods like furniture workshops. They purchase wood and convert them into tables, chairs, beds, and so on. Merchandising-sector companies purchase and then sell tangible products without changing their basic form. They mainly include retailers, distributors, and wholesalers. For example, certain furniture shops purchase finished goods from the furniture workshops and sell them in to other vendors or directly in the market. Service-sector companies provide services (intangible products)—for example, legal advice or audits—to their customers.

Three Categories of Inventory Manufacturing-sector companies typically have one or more of the following three types of inventory Direct materials Work-in-process inventory Finished goods inventory Direct materials refers to the stock that is awaiting use in the manufacturing process - for example, the wool required for the production of pullovers in winters. Goods that are partially worked on but not yet completed are goods that are in process are called work-in-process inventory - for example, the cars at various stages of completion in the manufacturing process. Goods that are complete with respect to production but not yet sold are called finished goods inventory.

Manufacturing Costs Three terms commonly used when describing manufacturing costs are Direct material costs Direct manufacturing labor costs Indirect manufacturing costs Direct material costs are the acquisition costs of all materials that eventually become part of the cost object (work in process and then finished goods) and can be traced to the cost object in an economically feasible way. Direct manufacturing labor costs include the compensation of all manufacturing labor that can be traced to the cost object (work in process and then finished goods) in an economically feasible way. Indirect manufacturing costs are all manufacturing costs that are related to the cost object (work in process and then finished goods) but cannot be traced to that cost object in an economically feasible way.

Inventoriable Costs Are considered as assets in the balance sheet when they are incurred Become cost of goods sold only when the product is sold For manufacturing-sector companies, all manufacturing costs are inventoriable costs. Consider a cellular phones manufacturer, costs of direct materials, such as computer chips, issued to production (from direct material inventory), direct manufacturing labor costs, and manufacturing overhead costs create new assets, starting as work in process and becoming finished goods (the cellular phones). So, manufacturing costs are included in work-in-process inventory and in finished goods inventory (they are “inventoried”) to accumulate the costs of creating these assets. When these phones are sold, the cost of manufacturing appears in the income statement as cost of goods sold.

Period Costs All costs in the income statement other than cost of goods sold Expensed in the period in which these are incurred Some of the examples of period costs include office rent, distribution, and customer service costs. Unlike product costs, that are inventoried and shown as assets till the products are sold, period costs are treated as expenses of the accounting period in which they are incurred. This is because managers expect those costs to benefit revenues in only that period and not in future periods.

Illustrate the Flow of Inventoriable and Period Costs In this learning objective, we will understand the flow of inventoriable and period costs. Learning Objective 6

Flow of Inventoriable and Period Costs Inventoriable costs go through the balance sheet accounts of work-in-process inventory and finished goods inventory before entering cost of goods sold in the income statement Period costs are expensed directly in the income statement

Exhibit 2.7—Flow of Revenue and Costs for a Manufacturing-Sector Company Refer to Exhibits 2-7 and 2-8 to see how inventoriable costs and period expenses appear in the income statement and schedule of cost of goods manufactured of a manufacturing company. Inventoriable costs go through the balance sheet accounts of work-in-process inventory and finished goods inventory before entering cost of goods sold in the income statement. Period costs are expensed directly in the income statement.

Prime Costs and Conversion Costs Prime costs are all direct manufacturing costs Conversion costs are all manufacturing costs other than direct material costs

Explain Why Product Costs are Computed in Different Ways for Different Purposes In this learning objective, we will explain why product costs are computed in different ways for different purposes. Learning Objective 7

Measuring Costs Requires Judgment Different companies may define and classify costs differently Mangers must define and understand the way costs are measured in a company or situation Consider the cost of labor for a company. Although labor cost classifications vary among companies, many companies use multiple labor cost categories like direct labor and indirect labor compensation for office staff, security, re-work labor. Also, salaries are paid to managers, supervisors, and department heads. The payroll fringe cost borne by the companies is another type of a labor cost classification. An indirect cost category is overtime premium that is paid to wage rate workers in excess of their straight-time wage rates. Overtime premium is considered as an overhead rather than direct cost. This is because tracing this cost to one particular product would lead to inaccurate costing. Idle time is wages paid for unproductive time caused by lack of orders, machine or computer breakdowns, work delays, poor scheduling, etc. Similar to overtime premium, idle time is treated as overhead and is allocated to all products.

Different Meanings of Product Costs Different purposes can result in different measures of product cost The pricing and product mix decisions of the company Reimbursement under government contracts Preparation of financial statements for external reporting under Generally Accepted Accounting Principles Pricing and product mix decisions. While making decisions about pricing, managers would be interested in overall profitability and hence will assign costs incurred in all business functions to products. Reimbursement under government contracts. Government contracts often reimburse contractors on the basis of the “cost of a product” plus a prespecified margin of profit. Preparing financial statements for external reporting under Generally Accepted Accounting Principles. Under GAAP, only manufacturing costs can be assigned to inventories in the financial statements. (A list of different product costs for different purposes has been listed in Exhibit 2-11.)

Describe a Framework for Cost Accounting and Cost Management In this learning objective, we will describe a framework for cost accounting and cost management. Learning Objective 8

Three features of Cost Accounting and Cost Management Three features of cost accounting and cost management across a wide range of applications are Calculating the cost of products, services, and other costs Analyzing the relevant information for making decisions Obtaining information for planning and control and performance evaluation