Cost Terminology and Concepts

Basic Cost Terminology Cost – resource sacrificed 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

Manufacturing Costs The Product Direct Labor Direct Material Manufacturing Overhead

Further Classification of Labor Costs Idle Time Treated as manufacturing overhead cost Overtime Premium of Factory Workers Treated as manufacturing overhead cost Labor Fringe Benefits Treated as manufacturing overhead or direct labor

Classifications of Costs in Manufacturing Companies Prime Cost Conversion Cost Manufacturing costs are often combined as follows: Direct Material Direct Labor Manufacturing Overhead

Nonmanufacturing Costs Marketing and Selling Cost Costs necessary to get the order and deliver the product. Administrative Cost All executive, organizational, and clerical costs. R&D

Manufacturing Cost Flows Manufacturing Overhead Material Purchases Direct Labor Balance Sheet Costs Inventories Finished Goods Cost of Goods Sold Income Statement Expenses Selling and Administrative Period Expenses Work in Process Raw Material

Product Costs Versus Period Costs Product costs include direct materials, direct labor, and manufacturing overhead. Period costs are not included in product costs. They are expensed on the income statement. Inventory Cost of Good Sold Balance Sheet Income Statement Sale Expense Income Statement

Balance Sheet Merchandiser Current assets –Cash –Receivables –Prepaid expenses –Merchandise inventory Manufacturer Current Assets v Cash v Receivables v Prepaid Expenses v Inventories Raw Materials Work in Process Finished Goods

The Income Statement Cost of goods sold for manufacturers differs only slightly from cost of goods sold for merchandisers.

Schedule of Cost of Goods Manufactured

Income Statement for a Manufacturer

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

Cost Classifications Activities that cause costs to be incurred are called cost drivers.

Variable Costs Total Variable Cost Graph Total Costs $300,000 $250,000 $200,000 $150,000 $100,000 $50, Unit Variable Cost Graph $20 $15 $10 $5 0 Cost per Unit ,000 $ 50,000 $10 10, , , , , , , , , , Units Total Cost Produced Cost per Unit Units Produced (000)

Fixed Costs Total Fixed Cost Graph Total Costs 0 Unit Fixed Cost Graph Cost per Unit 50,000 $75,000 $ ,000 75, ,000 75, ,000 75, ,000 75, ,000 75, Units Total Cost Produced Cost per Unit $150,000 $125,000 $100,000 $75,000 $50,000 $25, $1.50 $1.25 $1.00 $.75 $.50 $ Units Produced (000)

Examples Advertising and Research and Development Examples Advertising and Research and Development Examples Depreciation on Equipment and Real Estate Taxes Examples Depreciation on Equipment and Real Estate Taxes Types of Fixed Costs Discretionary May be altered in the short-term by current managerial decisions Discretionary May be altered in the short-term by current managerial decisions Committed Long-term, cannot be significantly reduced in the short term. Committed Long-term, cannot be significantly reduced in the short term.

A Cost Caveat Unit costs should be used cautiously Unit costs change with a different level of volume (activity) –Unit costs that include fixed costs should always reference the given level of activity –Unit Costs are also called Average Costs

Cost Behavior Patterns Example Bicycles by the Sea incurs variable costs of $52 for each of its bicycles. Bicycles by the Sea also incurs $94,500 in fixed costs per year

Use Unit Costs Cautiously What is the unit cost when Bicycles assembles 1,000 bicycles in a year?

Use Unit Costs Cautiously Assume that Bicycles management uses a unit cost of $ Management is budgeting costs for different levels of production. What is their budgeted cost for an estimated production of 600 bicycles? 600 × $ = $87,900?

Use Unit Costs Cautiously What is their budgeted cost for an estimated production of 3,500 bicycles? 3,500 × $ = $512,750?

Assigning Costs to Cost Objects Direct costs Costs that can be easily and conveniently traced to a unit of product or other cost object. Examples: direct material and direct labor Indirect costs Costs that cannot be easily and conveniently traced to a unit of product or other cost object. Example: manufacturing overhead

Determining Product Costs Product Direct materials Direct labor Traced directly to product Manufacturing overhead (OH) Applied to product using a predetermined rate

BMW: Assigning Costs to a Cost Object

Direct or Indirect? Consider a supervisor’s salary in the canning department of Campbell Soup Company. If the cost object is the department, the supervisor’s salary is a direct cost. If the cost object is a can of soup (the “product” of the company), the supervisor’s salary is an indirect cost.

Differential Cost and Revenue Costs and revenues that differ among alternatives. Example: You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month. Differential revenue is: $2,000 – $1,500 = $500 Differential cost is: $300

A cost that can be significantly influenced by a manager is a controllable cost. Controllable and Uncontrollable Costs

Opportunity Cost The potential benefit that is given up when one alternative is selected over another. –Example: If you were not attending college, you could be earning $20,000 per year. Your opportunity cost of attending college for one year is $20,000.

Sunk Costs All costs incurred in the past that cannot be changed by any decision made now or in the future. Sunk costs should not be considered in decisions. –Example: You bought an automobile that cost $12,000 two years ago. The $12,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $12,000 cost.

Marginal Costs and Average Costs The extra cost incurred to produce one additional unit. The total cost to produce a quantity divided by the quantity produced. Marginal and average costs are largely a function of cost behavior -- variable and fixed costs.

Additional Cost Terminology Variable Costs – costs that change in total in relation to some chosen activity or output Fixed Costs – costs that do not change in total in relation to some chosen activity or output Mixed Costs – costs that have both fixed and variable components; also called semivariable costs

Fixed Charge Variable Cost per Mile Activity (Miles Driven) Total Cost X Y A mixed cost has both fixed and variable components. Consider the example of renting a car. Mixed Costs Total mixed cost

Fixed Charge Variable Cost per Mile Activity (Miles Driven) Total Cost X Y Mixed Costs Total mixed cost

Mixed Costs Example If your fixed daily rental charge is $40, your variable cost is $0.20 per mile, and your activity level is 100 miles, what is the amount of your rental cost? Y = a + bX Y = $40 + ($0.20 × 100) Y = $60