An Introduction to Cost Terms and Purposes Chapter 2

Learning Objectives 1Define and illustrate a cost object 2Distinguish between direct costs and indirect costs 3Explain cost drivers, variable costs and fixed costs 4Understand why unit costs must be interpreted with caution 5Distinguish among service-sector, merchandising-sector and manufacturing-sector companies 6Differentiate between capitalised costs and revenue costs 7Describe the three categories of stock commonly found in many manufacturing-sector companies 8Explain why different ways of computing product costs are appropriate for different purposes

Learning Objective 1 Define and illustrate a cost object

Cost objects

Learning Objective 1 (continued) Cost and Cost Terminology  Cost is a resource sacrificed or forgone to achieve a specific objective.  It is usually measured as the monetary amount that must be paid to acquire goods and services.  An actual cost is the cost incurred (a historical cost) as distinguished from budgeted costs.  A cost object is anything for which a separate measurement of costs is desired.

Learning Objective 1 (continued) There are two basic stages of accounting for costs: 1Cost accumulation 2Cost assignment to various cost objects Cost Accumulation Cost Object Cost Assignment Cost Object

Learning Objective 1 (continued) Cost accumulation is the collection of cost data in some organised way by means of an accounting system. Cost assignment is a general term that encompasses... –tracing accumulated costs to a cost object, and –allocating accumulated costs to a cost object.

Learning Objective 2 Distinguish between direct costs and indirect costs

Learning Objective 2 (continued) Direct Costs  Direct costs of a cost object are those that are related to a given cost object (product, department, etc.) and that can be traced to it in an economically feasible way. Cost-Tracing describes the assignment of direct costs to the particular cost object. Indirect Costs  Indirect cost are related to the particular cost object but cannot be traced to it in an economically feasible way.  Cost allocation describes the assigning of indirect costs to the particular cost object.

Direct/indirect costs

Learning Objective 2 (continued) Gnomes Ltd has two production departments, Assembly and Finishing, and two service departments, Maintenance and Personnel. Direct and Indirect Costs  Direct Costs: Maintenance Department€30,000 Personnel Department€24,600 Assembly Department€70,000 Finishing Department€50,000  Assume that Maintenance Department costs are allocated equally among the production departments.  How much is allocated to each department?

Learning Objective 2 (continued) Allocated €15,000 Maintenance €30,000 Assembly Direct Costs €70,000 Finishing Direct Costs €50,000

Learning Objective 2 (continued) Several factors affect the classification of a cost as direct or indirect: –The materiality (the amount) of the cost in question –Available information-gathering technology –Design of operations –Contractual arrangements The direct/indirect classification depends on the choice of the cost object.

Learning Objective 3 Explain cost drivers, variable costs and fixed costs

Cost-drivers

Learning Objective 3 (continued) Cost Behaviour Patterns  Variable costs change in total in proportion to changes in the related level of total activity or volume.  Fixed costs do not change in total for a given time period despite wide changes in the related level of total activity or volume.

Learning Objective 3 (continued) Assume that Kruger Bicycles buys handlebars at €52 for each of its bicycles. Total handlebar cost is an example of a cost that changes in total in proportion to changes in the number of bicycles assembled (variable cost). e.g.. the total handlebar cost when 1,000 bicycles are assembled is:  1,000 units × €52 = €52,000 e.g. the total handlebar cost when 3,500 bicycles are assembled is:  3,500 units × €52 = €182,000

Learning Objective 3 (continued) Total costs (€000) €182 €52 0 1,000 3,500 Units

Learning Objective 3 (continued) Assume that Kruger Bicycles incurred €94,500 in a given year for the leasing of its plant. This is an example of fixed costs with respect to the number of bicycles assembled. These costs are unchanged in total over a designated range of the number of bicycles assembled during a given time span. e.g. the leasing (fixed) cost per bicycle when Kruger assembles 1,000 bicycles is:  €94,500 ÷ 1,000 = €94.50 e.g. the leasing (fixed) cost per bicycle when Kruger assembles 3,500 bicycles is:  €94,500 ÷ 3,500 = €27

Learning Objective 3 (continued) Cost Drivers  A cost driver is a factor, such as the level of activity or volume, that causally affects costs (over a given time span).  The cost driver of variable costs is the level of activity or volume whose change causes the (variable) costs to change proportionately.  The number of bicycles assembled is a cost driver of the cost of handlebars. Relevant Range  is the band of the level of activity or volume in which a specific relationship between the level of activity or volume and the cost in question is valid.

Learning Objective 3 (continued) Assume that fixed (leasing) costs are €94,500 for a year and that they remain the same for a certain volume range (1,000 to 5,000 bicycles).  i.e. 1,000 to 5,000 bicycles is the relevant range Volume €94,5 Relevant range Total cost (€ 000)

Direct/indirect – variabel/fixed costs

Learning Objective 4 Understand why unit costs must be interpreted with caution

Learning Objective 4 (continued) Total Costs and Unit Costs  A unit cost (also called an average cost) is computed by dividing some amount of cost total by some number of units.  The ‘units’ may be expressed in various ways: –Hours worked –Packages delivered –Bicycles assembled  i.e. the unit cost (leasing and handlebars) when Kruger Bicycles assembles 1,000 bicycles is: Total fixed cost €94,500 + Total variable cost €52,000 = €146,500 €146,500 ÷ 1,000 = €146.50

Learning Objective 4 (continued) Total cost (€ 000) €146,5 €94, volume

Learning Objective 4 (continued) Use Unit Costs Cautiously  Assume that Kruger Bicycles’ management uses a unit cost of € (leasing and handlebars).  Management is budgeting costs for different levels of production. 1.What is their budgeted cost for an estimated production of 600 bicycles? 2.What is their budgeted cost for an estimated production of 3,500 bicycles?

Learning Objective 4 (continued) × € = €87, ,500 × € = €512,750 What should the budgeted cost be for an estimated production of 600 bicycles?  Total fixed cost € 94,500 Total variable cost (€52 × 600) = € 31,200 Total €125,700  €125,700 ÷ 600 = € Using a cost of € per unit would underestimate actual total costs if output is below 1,000 units.

Learning Objective 4 (continued) What should the budgeted cost be for an estimated production of 3,500 bicycles?  Total fixed cost€ 94,500 Total variable cost (52 × 3,500) =€ 182,000 Total€276,500  €276,500 ÷ 3,500 = €79.00 Using a cost of € per unit instead of €79.00 would overestimate actual total costs if output is above 1,000 units. For decision making, managers should think in terms of total costs rather than unit costs.

Learning Objective 5 Distinguish among service- sector, merchandising- sector and manufacturing- sector companies

Learning Objective 5 (continued) Manufacturing  Manufacturing-sector companies purchase materials and components and convert them into finished goods.  A manufacturing company must also develop, design, market, and distribute its products. Merchandising  Merchandising-sector companies purchase and then sell tangible products without changing their basic form. Service Companies  provide services or intangible products to their customers.

Learning Objective 6 Differentiate between capitalised costs and revenue costs

Learning Objective 6 (continued) Types of Stock  Manufacturing-sector companies typically have one or more of the following three types of inventories: 1Direct materials – direct materials in stock and awaiting use in the manufacturing process. 2Work-in-progress – goods partially worked on but not yet fully completed. 3Finished goods – goods fully completed but not sold.  Merchandising-sector companies hold only one type of stock – the product in its original purchased form.  Service-sector companies do not hold stocks of tangible products. Classification of manufacturing Costs oDirect materials costs oDirect manufacturing labour costs oIndirect manufacturing costs

Learning Objective 6 (continued) Direct materials costs  Direct materials costs are the acquisition costs of all materials that eventually become part of the cost object.  Direct materials costs can be traced economically.  Purchase costs include inward delivery charges, VAT and other customs duties. Direct manufacturing labour costs  Direct manufacturing labour costs include the compensation of all manufacturing labour that can be traced to the cost object in an economically feasible way.  Wages and fringe benefits paid to: –Machine operators –Assembly-line workers

Learning Objective 6 (continued) Indirect manufacturing costs  Indirect manufacturing costs are all manufacturing costs that are considered to be part of the cost object, but that cannot be traced to that cost object in an economically feasible way.  Other terms for this cost category include manufacturing overhead costs and factory overhead costs. Capitalised Costs  Capitalised costs are all costs of a product that are regarded as an asset when they are incurred and then become cost of goods sold when the product is sold.  For manufacturing-sector companies, all manufacturing costs are capitalised costs.

Learning Objective 6 (continued)  Capitalised costs (direct materials, direct labour and indirect manufacturing costs) are included in work-in-progress and finished goods stock.  Capitalised costs flow to the P&L account as cost of the goods sold.  For merchandising-sector companies, capitalised costs are the costs of purchasing the goods which are resold in their same form.  For service-sector companies, the absence of stock means there are no capitalised costs.

Learning Objective 6 (continued) Revenue Costs  Revenue costs are all costs in the P&L account other than cost of goods sold.  Revenue costs are recorded as expenses of the accounting period in which they are incurred.  For manufacturing-sector companies, revenue costs include all non-manufacturing costs (research and development, distribution, etc.).  For merchandising-sector companies, revenue costs include all costs not related to the cost of goods purchased for resale.  For service-sector companies, all of their costs are revenue costs.

Learning Objective 7 Describe the three categories of stock commonly found in many manufacturing-sector companies

Learning Objective 7 (continued) Categories of Stock  The three categories of stock found in many manufacturing companies depict stages in the conversion process: –materials –work-in-progress –finished goods

Learning Objective 7 (continued) Direct materials capitalised costs are used to calculate the cost of materials used. Opening direct materials stock +Purchases of direct materials –Closing direct materials stock =Direct materials used

Learning Objective 7 (continued) Work-in-progress capitalised costs are used to calculate the cost of goods manufactured. Opening work-in-progress stock +Manufacturing costs incurred during the period –Closing work-in-progress stock =Cost of goods manufactured

Learning Objective 7 (continued) Finished goods capitalised costs are used to calculate the cost of goods sold. Opening finished goods stock +Cost of goods manufactured –Closing finished goods stock =Cost of goods sold

Learning Objective 7 (continued) Kruger Bicycles had €50,000 of direct materials stock at the beginning of the period. Purchases during the period amounted to €180,000 and ending stock was €30,000. How much direct materials were used?  €50,000 + €180,000 – €30,000 = €200,000

Learning Objective 7 (continued) Direct labour costs incurred were €105,500. Indirect manufacturing costs were €194,500. What are the total manufacturing costs incurred?  Direct materials used€200,000 Direct labour 105,500 Indirect manufacturing costs 194,500 Total manufacturing costs€500,000

Learning Objective 7 (continued) Assume that the work-in-progress stock at the beginning of the period was €30,000, and €35,000 at the end of the period. What is the cost of goods manufactured? Opening work-in-progress€ 30,000 +Total manufacturing costs 500,000 –Closing work-in-progress 35,000 =Cost of goods manufactured€495,000

Learning Objective 7 (continued) Assume that the finished goods stock at the beginning of the period was €10,000, and €15,000 at the end of the period. What is the cost of goods sold? Opening finished goods€ 10,000 +Cost of goods manufactured 495,000 –Closing finished goods 15,000 =Cost of goods sold€490,000

Learning Objective 7 (continued) Work-in- progress Opening balance 30, ,000 Direct mtls. used200,000 Direct labour105,500 Indirect mfg. costs194,500 Closing balance 35,000

Learning Objective 7 (continued) Work-in-progress Finished Goods 495,000 10, , ,000 15,000 Cost of Goods Sold 490,000

Schedule of Cost of Goods Sold Opening direct materials stock +Purchases of direct materials = Available for use –Closing direct materials stock = Direct materials used +Direct manufacturing labour +Indirect manufacturing costs (Variable and Fixed) = Manufacturing costs incurred during the current period +Opening finished goods stock = Goods available for sale –Closing finished goods stock = Cost of goods sold Opening direct materials stock +Purchases of direct materials = Available for use –Closing direct materials stock = Direct materials used +Direct manufacturing labour +Indirect manufacturing costs (Variable and Fixed) = Manufacturing costs incurred during the current period +Opening finished goods stock = Goods available for sale –Closing finished goods stock = Cost of goods sold

Income Statement Revenues (Sales) –Cost of goods sold = Gross margin –Operating costs = Operating Profit Revenues (Sales) –Cost of goods sold = Gross margin –Operating costs = Operating Profit

Learning Objective 8 Explain how different ways of computing product costs are appropriate for different purposes

Learning Objective 8 (continued) Measuring Costs Requires Judgement  Judgement is frequently required when measuring costs.  Differences can exist in the way accounting terms are defined. Manufacturing labour-cost classifications vary among companies.  The following distinctions are generally found: –Direct manufacturing labour –Manufacturing overhead Indirect labour Managers’ salaries Payroll fringe costs

Learning Objective 8 (continued) Indirect labour –Forklift truck operators (internal handling of materials) –Cleaners –Rework labour –Overtime premium –Idle time  Overtime premium consists of the wages paid to all workers (for both direct labour and indirect labour) in excess of their standard wage rates.  Overtime premium is usually considered part of overhead.  Assume that a worker gets €18 per hour for straight-time and gets time and one-half for overtime.

Learning Objective 8 (continued) How much is the overtime premium?  €18 × 50% = €9 per overtime hour If this worker works 44 hours on a given week, how much are his gross earnings? Direct labour: 44 hours × €18 =€792 Overtime premium: 4 hours × €9 = 36 Total gross earnings€828

Learning Objective 8 (continued) Why is overtime premium of direct labour usually considered an indirect rather than a direct cost?  Because it does not add to the cost of a particular batch of work solely because it happened to be worked on during the overtime hours. Sometimes overtime is not random; for instance a rush job may clearly be the sole source of the overtime.  In this case the overtime premium is regarded as a direct cost of the services on that job. Idle time typically represents wages paid for unproductive time caused by lack of orders, machine breakdowns, material shortages, poor scheduling, etc.

Learning Objective 8 (continued) Many Meanings of Product Cost  A product cost is the sum of the costs assigned to a product for a specific purpose. 1Pricing and product emphasis decisions 2Contracting with government agencies 3Preparing financial statements for external reporting under generally accepted accounting principles

Learning Objective 8 (continued) For pricing and product emphasis decisions, the costs included are all areas of the value chain. When contracting with government agencies, companies must follow the guidelines provided on the allowable and non-allowable items in a product-cost amount. When preparing financial statements for external reporting, the focus is on capitalised costs. Usually under generally accepted accounting principles, only manufacturing costs are assigned to stocks in the financial statements.

Different costs for different purposes