IE 475 Advanced Manufacturing Costing Techniques Lecture Notes #2 Cost Concepts

Module Learning Objectives After completing this module, IE 475 students should be able to: Understand the strategic role of basic cost concepts Explain the cost driver concepts at the activity, volume, structural, and executional levels Explain the cost concepts used in product and service costing Demonstrate how costs flow through the accounts Prepare an income statement for both a manufacturing firm and a merchandising firm Explain the cost concepts related to the use of cost information in planning and decision making

Basic Definitions A cost is incurred when a resource is used for some purpose Costs may be collected into groups called cost pools A cost object is any product, service, or unit to which costs are assigned for some management purpose.

Basic Definitions (cont.) Cost assignment Process of assigning costs to cost pools or from cost pools to cost objects Direct cost Can be conveniently and economically traced directly to a cost pool or a cost object Indirect cost Has no convenient or economical way to be traced from the cost to the cost pool or from the cost pool to the cost object

Basic Definitions (cont.) Cost allocation Assignment of indirect costs to cost pools and cost objects Allocation bases Cost drivers used to allocate costs

Costs, Cost Pools, Cost Objects, and Cost Drivers Electric Motor Assembly Materials Handling Dishwasher Supervision Packing Packing Materials Washing Machine Final Inspection

Costs, Cost Pools, Cost Objects, and Cost Drivers (cont.)

Direct Materials + = Direct materials include The cost of materials in the product Less purchase discounts but including freight and related charges Reasonable allowance for scrap and defective units + FLOUR MILK SUGAR =

Indirect Materials Materials used in manufacturing that are not physically part of the finished product Sweeping Compound Cleaning Material

Direct and Indirect Labor Costs Includes the labor used to manufacture the product or to provide the service Indirect labor Includes supervision, quality control, inspection, purchasing and receiving, and other manufacturing support costs

Other Indirect Costs Factory Overhead Other indirect costs such as building and equipment depreciation, property taxes, insurance, and utilities . . . . . . . . are combined with indirect labor and indirect materials into a single cost pool called . . . . Factory Overhead

Prime Cost and Conversion Cost Manufacturing costs are often combined as follows: Direct Materials Direct Labor Factory Overhead

Identifying Cost Drivers A critical first step in achieving a competitive advantage is to identify the key cost drivers in the firm or organization What is a cost driver? Any factor that has the effect of changing the level of total cost Examples

Cost Drivers Cost drivers play two major roles in cost management: Enable the assignment of costs to cost objects Explain cost behavior The four types of cost drivers are: Activity-based Volume-based Structural Executional

Types of Cost Drivers Activity-based Identified using activity analysis, a detailed description of specific activities performed in the firm’s operations. Volume-based Relationship between costs and volume measures such as units produced, direct labor hours, or quantity of materials used. Structural Executional

Activity-based Cost Drivers Pennsylvania Blue Shield

Volume-based Cost Drivers Many cost drivers are volume-based The cost driver is the amount produced or the quantity of service provided The more you produce, the more cost you incur An important concept associated with volume-based cost drivers is that of the relevant range

Volume-based Cost Drivers (cont.) The relevant range is the range of the cost driver in which the actual value of the cost driver is expected to fall, and for which the relationship is assumed to be approximately linear

Volume-based Cost Drivers (cont.)

Volume-based Cost Drivers (cont.) Linear Approximation for Actual Cost Behavior

Volume-based Cost Drivers (cont.) Total Variable Cost $6,600 $6,500 $3,000 3,500 3,600 Units of the Cost Driver Total Cost Variable cost is the change in total cost associated with each change in the quantity of the cost driver Total Cost

Volume-based Cost Drivers (cont.) Total Cost $6,600 $6,500 $3,000 Fixed cost is the portion of the total cost that does not change with a change in the quantity of the cost driver, within the relevant range. Total Fixed Cost 3,500 3,600 Units of the Cost Driver

Volume-based Cost Drivers (cont.) Step Cost Cost Activity

Volume-based Cost Drivers (cont.) Unit Cost (or average cost) Total manufacturing cost (materials, labor, and overhead) divided by units of output Useful concept in setting prices and in evaluating product profitability Marginal cost Additional cost incurred as the cost driver increases by one unit Used interchangeably with differential cost or incremental cost Under the assumption of linear cost within the relevant range, the concept of marginal cost is equivalent to the concept of unit variable cost

Volume-based Cost Drivers (cont.) Unit Cost (or average cost) Illustration of Average Costs per Unit

Types of Cost Drivers Involves strategic plans and decisions: Activity-based Involves strategic plans and decisions: Scale Experience Technology Complexity Volume-based Short-term operational decisions: Workforce involvement Production process design Supplier relationships Structural Executional

Structural Cost Drivers Scale How much should be invested? Experience How much prior experience does the firm have in its current and planned products and services? Technology What process technologies are used in manufacturing, and in distributing the product or service? Complexity What is the firm’s level of complexity?

Executional Cost Drivers Workforce involvement Are the employees dedicated to continual improvement and quality? Design of the production process Can the layout of equipment and processes and the scheduling of production be improved? Supplier relationships Can the cost, quality, or delivery of materials and purchased parts be improved to reduce overall costs?

Value Chain of Product Costs Product inventory for both manufacturing and merchandising firms is treated as an asset on their balance sheets So long as the inventory has market value, it is considered an asset until the inventory is sold Cost of goods sold Cost of the product transferred to the income statement when inventory is sold

Product Costs Product costs for a manufacturing firm include only the costs necessary to complete the product

Period Costs Period costs are all non-product expenditures for managing the firm and selling the product Period costs are expenses because there is no expectation that they will produce future value Include primarily the general, selling, and administrative costs necessary for the management of the company but are not involved directly or indirectly in the manufacturing process Sometimes referred to as operating expenses or selling and administrative expenses

Manufacturing, Merchandising, and Service Costing Three Inventory Accounts Materials inventory Keeps the cost of the supply of materials used in the manufacturing process or to provide the service Work-in-Process inventory Contains all costs put into the manufacture of products that are started but not complete at the financial statement date Finished goods inventory Holds the cost of goods that are ready for sale

Ending Inventory Balance Inventory Formula Beginning Inventory Balance Cost Added Cost Transferred Out Ending Inventory Balance + = +

Cost Flows in Manufacturing and Merchandising Firms

Income Statement for a Manufacturing Firm Manufacturing firms require a two-part calculation for Cost of Goods Sold The first part combines the cost flows affecting the Work-in-Process Inventory account to determine the amount of Cost of Goods Manufactured Cost of Goods Manufactured is the cost of goods finished and transferred out of the Work-in-Process Inventory account this period The second part combines the cost flows for the Finished Goods Inventory account to determine the amount of the cost of the goods sold and net income

Statements for Manufacturing and Merchandising Firms

Cost Concepts for Planning and Decision Making Relevant Cost This concept arises when the decision maker must choose between two or more options Must determine which option offers the highest benefit ($) A relevant cost has the following two properties:

Opportunity Cost Opportunity Cost is the benefit lost when choosing one option precludes receiving the benefits from an alternative option Example: If you were not attending college, and you could be earning $18,000 per year, then your opportunity cost of attending college for one year is $18,000.

Sunk Costs Sunk costs are costs that have been incurred or committed in the past and are therefore irrelevant Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.

Attributes of Cost Information for Decision Making Accuracy Timeliness Cost and Value