Cost Concepts and Behavior Chapter 2

Learning Objectives 1. Explain the basic concept of “cost.” 2. Explain how costs are presented in financial statements. 3. Explain the process of cost allocation. Understand how material, labor, and overhead costs are added to a product at each stage of the production process. Define basic cost behaviors including fixed, variable, semivariable, and step costs. 6. Identify the components of a product’s costs. Understand the distinction between financial and contribution margin income statements.

Cost charged against revenue in an accounting period What is a Cost? L.O. 1 Explain the basic concept of “cost.” Cost a sacrifice of resources Outlay Cost past, present, or future cash outflow Opportunity Cost forgone benefit from best alternative course of action Expense Cost charged against revenue in an accounting period

Cost Example Cost of surfboard? Josh wants to buy a new surfboard. If he buys the surfboard he can’t go on a spring break ski trip with his friends. Cost of surfboard? Outlay Cost Opportunity Cost $500 purchase price of the surfboard No spring break trip

Cost Example Your education costs? Outlay Cost Opportunity Cost The $15,000 you could make flipping burgers The cost of tuition

Recording Costs in Financial Statements L.O. 2 Explain how costs are presented in financial statements. Income Statements Service Company Merchandise Company Service revenues Sales revenues - Cost of services sold Cost incurred to purchase the goods sold - Cost of goods sold = Gross margin = Gross margin - Marketing and administrative costs Cost of billable hours - Marketing and administrative costs = Operating profit = Operating profit The excess of operating revenue over cost necessary to generate those revenues

Manufacturing Company Costs Manufacturing Costs Product Costs Period Costs Inventoriable Costs Nonmanufacturing Costs Costs incurred to manufacture a product Costs incurred to sell a product and operate the business Recorded as an asset in inventory when cost is incurred Recognized as an expense when product is sold Recognized as an expense when cost is incurred

Income Statement Manufacturing Company Sales revenues Product costs recorded as an asset in inventory when cost is incurred. Sales revenues Cost incurred to manufacture the product sold - Cost of goods sold Recognized as an expense when the product is sold. = Gross margin Period costs recorded as an expense when cost is incurred. - Marketing and administrative costs = Operating profit

Product Costs Direct Costs Indirect Costs Manufacturing Costs Inventory Costs Recognized as an expense when product is sold Recorded as an asset in inventory when cost is incurred Direct Costs Indirect Costs Cost that can be directly traced to the product Cost that cannot be directly traced to the product Direct Materials Manufacturing Overhead Materials directly traceable to the product. All production costs except direct materials and direct labor. Direct Labor Indirect Materials Work directly traceable to transforming material into finished product Indirect Labor Other Indirect Costs

Traceability of Costs Josh decides to go on the spring break ski trip. He is off to the slopes. Identify the object This ski trip Direct Cost Indirect Cost Cost of lift tickets The original cost of his equipment

Traceability of Cost Your education costs? Identify the object This class Direct Cost Indirect Cost The cost of your textbook The cost of full time tuition

Product Costs Prime Costs Direct Materials Direct Labor Direct Labor Manufacturing Costs Product Costs Inventory Costs Prime Costs Direct Materials The “primary” cost of the product Direct Labor Direct Labor Conversion Costs Direct Labor Cost necessary to “convert” materials into a product Manufacturing Overhead

Product Cost Review Prime cost? Conversion cost? Direct cost? DM + DL = $15 Direct Materials = $8 Direct Labor = $7 Conversion cost? Manufacturing overhead = $14 DL + MOH = $21 Direct cost? Indirect cost? DM + DL = $15 MOH = $14 Total Product Cost DM + DL + MOH = $29

Period Costs Marketing Administrative Nonmanufacturing Costs Recognized as an expense when cost is incurred Marketing Administrative Costs necessary to sell the products Costs necessary to operate the business Advertising Executive salaries Sales commissions Data processing Shipping costs Legal costs

Cost Allocation Cost Object L.O. 3 Explain the process of cost allocation. The process of assigning indirect cost to a cost object 1. Define Cost Pool Collection of costs to be assigned to cost objects 2. Determine Cost Allocation Rule Method used to assign costs in the cost pool to the cost objects 3. Assign Cost Object Any end to which a cost is assigned Product Department Product Line Customer

Corporate Information Systems Costs of $1,000,000 Rockford Corporation East Coast West Coast Total Revenues 80 million 20 million 100 million Corporate Information Systems Costs of $1,000,000 Cost pool IS costs allocated based on division revenue % Revenue Cost allocation rule 80% $80 million $20 million 20% East Coast West Coast Cost objects $800,000 $200,000

Manufacturing Cost Flows L.O. 4 Understand how manufacturing costs are added to a product. Product costs recorded in inventory when cost incurred. Also called Inventoriable Costs A manufacturing company has three inventory accounts. Inventory: Current asset representing materials and goods on hand Raw materials Work-in-process Finished goods Materials purchased to make product Product in production process, but not yet complete Product fully completed but not yet sold.

The Inventory Accounts Balance Sheet Raw Materials Work-In-Process Finished Goods Beg. Inventory Beg. Inventory Beg. Inventory Cost of Goods Completed and Transferred from WIP + + Purchases Direct Materials Transferred from Raw Materials + Raw Materials Available for Production = Direct Labor + Goods Available for Sale = Manufacturing Overhead + Raw Materials Transferred to WIP - Raw Materials Transferred to WIP - Cost of Goods Sold - Total Manufacturing Costs = Ending Inventory = Ending Inventory = Cost of Goods Completed and Transferred to Finished Goods - Cost of Goods Completed and Transferred to Finished Goods - To the income statement Ending Inventory =

Jackson Gears Jackson Gears Cost of Goods Manufactured Statement For the Year Ending December 31, 200X Beginning Work-In-Process Inventory, January 1 $270,000 Manufacturing cost during the year: Direct Materials Beginning Inventory, Jan. 1 95,000 Add Purchases 5,627,000 Direct Materials Available $5,722,000 Less Ending Inventory, Dec. 31 72,000 Direct Materials put into production 5,650,000 Direct Labor 1,220,000 Manufacturing Overhead 6,780,000 Total Manufacturing cost incurred 13,650,000 Total Work-In-Process during the year 13,920,000 Less Ending Work-In-Process Inventory, Dec. 31 ___310,000 $13,610,000 Cost of goods manufactured

Cost of Goods Sold Statement For the Year Ending December 31, 200X Jackson Gears Jackson Gears Cost of Goods Sold Statement For the Year Ending December 31, 200X Beginning Finished Goods Inventory, Jan. 1 $420,000 Cost of goods manufactured 13,610,000 Finished goods available for sale 14,030,000 Less Ending Finished Goods Inventory, Dec. 31 _930,000 $13,100,000 Cost of goods sold

For the Year Ending December 31, 200X Jackson Gears Jackson Gears Income Statement For the Year Ending December 31, 200X Sales $20,450,000 Less cost of goods sold 13,100,000 Gross Margin 7,350,000 Marketing and Administrative Expenses 3,850,000 Operating Profit $3,500,000

Cost Behavior Cost Behavior? Relevant range? L.O. 5 Define basic cost behaviors including fixed, variable, semivariable, and step costs. Cost Behavior? How costs respond to a change in activity level within the relevant range. Relevant range? Range of activity where the total fixed costs or the unit variable costs remain unchanged.

Fixed Costs Fixed costs are “fixed” in “total” as activity changes. Costs that are unchanged as volume changes within the relevant range of activity. Fixed costs are “fixed” in “total” as activity changes. On a per unit basis the cost varies inversely as activity changes. Costs ($) Activity level

Josh’s Spring Break Trip Fixed Cost Fixed costs are “fixed” in “total” as activity changes. On a per unit basis the cost varies inversely as activity changes. Airfare cost ($) Days on the slopes

Variable Costs Variable costs “vary” in “total” as activity changes. Costs that change in direct proportion with a change in volume within the relevant range of activity. Variable costs “vary” in “total” as activity changes. On a per unit basis the cost stays the same as activity changes. Cost ($) Activity level

Josh’s Spring Break Trip Variable Cost Variable costs “vary” in “total” as activity changes. On a per unit basis the cost stays the same as activity changes. Lift ticket cost ($) Days on the slopes

Semivariable Costs Costs that have both fixed and variable components. Also called mixed costs. Fixed component is “fixed” in total as activity changes. Variable component “varies” in total as activity changes. Costs ($) Activity level

Josh’s Spring Break Trip Semivariable Cost Fixed component is “fixed” in total as activity changes. Variable component “varies” in total as activity changes. Cost of trip ($) Days on the slopes

Step Costs Costs that increase in total with steps in volume changes. Also called semifixed costs. Costs ($) Activity level

Product Cost Components L.O. 6 Identify the components of a product’s costs. Full cost: sum of all costs of manufacturing and selling a unit of product Full absorption cost: sum of all variable and fixed costs of manufacturing a unit of product Variable cost: sum of all variable costs of manufacturing and selling a unit of product

absorption cost per unit? Costs: An Example Direct Materials = $8 What is the full cost per unit? Direct Labor = $7 Variable manufacturing overhead = $8 What is the full absorption cost per unit? Fixed manufacturing overhead = $6 Variable marketing and administrative = $4 What is the variable cost per unit? Fixed marketing and administrative = $7

Full Cost What is the full cost per unit? = $40 Direct Materials = $8 What is the full cost per unit? Direct Labor = $7 Variable manufacturing overhead = $8 All costs of manufacturing and selling a unit of product Fixed manufacturing overhead = $6 Variable marketing and administrative = $4 Fixed marketing and administrative = $7 = $40

absorption cost per unit? Full Absorption Cost What is the full absorption cost per unit? Direct Materials = $8 Direct Labor = $7 All variable and fixed costs of manufacturing a unit of product sold Variable manufacturing overhead = $8 Fixed manufacturing overhead = $6 = $29

Variable Cost What is the variable cost per unit? = $27 Direct Materials = $8 Direct Labor = $7 All variable costs of manufacturing and selling a unit of product Variable manufacturing overhead = $8 Variable marketing and administrative = $4 = $27

Making Cost Information Useful L.O. 7 Understand distinction between financial and contribution margin income statements. Full Absorption Costing Variable Costing Required by GAAP Used for: Used for: Financial purposes Managerial purposes External reporting Internal decision making Sales revenues Sales revenues - Cost of goods sold - Variable costs = Gross margin = Contribution margin

Making Cost Information Useful Continued Financial Income Statement Contribution Margin Income Statement Full Absorption Costing Variable Costing Gross margin Sales price Full absorption cost Contribution margin Sales price Variable cost

Product vs Period Costs Full Absorption Costing Variable Costing Variable manufacturing costs Variable manufacturing costs Product costs Fixed manufacturing costs Fixed manufacturing costs Variable marketing and administrative costs Variable marketing and administrative costs Period costs Fixed Marketing and administrative costs Fixed Marketing and administrative costs

Income Statements Full Absorption Costing Variable Costing Sales revenues Sales revenues - Cost of goods sold - Variable costs = Gross margin = Contribution margin - Marketing and administrative cost - Fixed costs = Operating profit = Operating profit Variable and fixed manufacturing costs Full absorption costs Variable manufacturing costs and variable marketing and administrative costs Sales – variable costs Fixed manufacturing costs and fixed marketing and administrative costs Sales – Full absorption cost Period costs

Gross Margin per Unit Variable manufacturing cost = $23 Full absorption cost per unit = $29 Variable manufacturing cost = $23 Full cost per unit = $40 Sales price per unit = $45 DM + DL + VMOH Fixed manufacturing cost = $6 Gross margin = $16 ($45 - $29) Variable marketing and administrative = $4 Fixed marketing and administrative = $7 Operating profit = $5 Excess of price over full unit cost = $5

Contribution Margin per Unit Variable cost per unit =$27 Variable manufacturing cost = $23 Full cost per unit = $40 Sales price per unit =$45 DM + DL + VMOH Variable marketing and administrative = $4 Contribution margin =$18 ($45 - $27) Fixed manufacturing cost = $6 Fixed marketing and administrative = $7 Operating profit =$5 Excess of price over full unit cost = $5

Chapter 2 The End