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2 Types of Organizations Three major types  Service  Merchandising  Manufacturing Differ in  Nature of product  Pattern of cost flows  Magnitude of various costs LO 1: Distinguish product costs from period costs.

3 Financial Reporting All three types of firms  Produce financial reports that conform to GAAP  Distinguish between product costs and period costs Have financial reports that are of limited use for internal decisions LO 1: Distinguish product costs from period costs.

4 Product and Period Costs Product costs: Costs related to getting a cost or service ready for sale.  Appear “above the line” for gross margin in income statements  These costs can be inventoried  They flow through the inventory account in the balance sheet  Sometime called “Inventoriable costs.” Period costs: Costs that are not product costs. Related to marketing and administration  Appear “below the line” for gross margin  These costs are expensed in the period they are incurred.  These costs do not flow through inventory accounts LO 1: Distinguish product costs from period costs.

5 Period Costs Product Costs LO 1: Distinguish product costs from period costs. A Traditional Income Statement

6 Usefulness for Internal Decisions The statement only considers expenses  Cost versus expense  An expense is a cost recognized in the income statement The gross margin income statement mingles  Controllable & non controllable costs  Variable and fixed costs  Direct and indirect costs LO 1: Distinguish product costs from period costs.

7 Relation to Earlier Ideas LO 1: Distinguish product costs from period costs.

8 Service Firms Products are not tangible or storable  Hotels, restaurants, consulting, airlines, gyms, universities, museums,… Generally, there is no inventory of their final product  Exceptions exist  We can inventory costs of software projects that go across accounting periods LO 2: Understand the flow of costs in service firms.

9 Flow of Costs: Service Settings LO 2: Understand the flow of costs in service firms.

10 Merchandising Firms Examples include JC Penney, Sears, Kroger, Office Depot, Staples,… These firms  Sell substantively the same product they purchase.  Carry inventory to make goods available in the quantities, varieties and delivery schedules demanded by customers. LO 3: Discuss how inventories affect the flow of costs in merchandising firms.

11 Inventory Equation Need to flow costs via inventory account  Cost of purchase is NOT the cost of goods sold We can capture flow as: Cost of beginning inventory +Cost of goods purchased during the period – Cost of ending inventory =Cost of goods sold (COGS) during the period Make inventory cost flow assumption  First In First Out (FIFO)  Last In First Out (LIFO) LO 3: Discuss how inventories affect the flow of costs in merchandising firms.

12 Solution

13 Flow of Costs in Merchandising LO 3: Discuss how inventories affect the flow of costs in merchandising firms. Transportation in, stocking

14 Manufacturing Firms Use labor and equipment to transform raw materials into finished goods  Have work-in-process  Need inventory accounts for all three kinds of stages in the production process Much variation in  Nature of production process  Relative amounts of different costs LO 4: Explain the cost terminology and the flow of costs in manufacturing firms.

15 LO 4: Explain the cost terminology and the flow of costs in manufacturing firms. Cost Terms in Manufacturing

16 Names for Groups of Costs LO 4: Explain the cost terminology and the flow of costs in manufacturing firms.

17 LO 4: Explain the cost terminology and the flow of costs in manufacturing firms. Cost Terms in Manufacturing Prime Costs Conversio n Costs

18 Physical and Cost Flows in Manufacturing LO 4: Explain the cost terminology and the flow of costs in manufacturing firms.

19 Example: Cost Flow in Manufacturing LO 4: Explain the cost terminology and the flow of costs in manufacturing firms.

20 Cost Allocations & Cost Flows Overhead costs are  Not traceable  Part of product cost for individual products Problem: How to divide total overhead to pieces that belong to individual products. Solution: Perform a cost allocation LO 5: Allocate overhead costs to products.

21 Mechanics of Cost Allocations Each allocation has four elements  Cost Pool  Denominator Volume  Cost Driver  Cost Object Each allocation has two steps  Calculate rate  Rate = Cost in pool  Denominator volume  Allocate cost to cost object  Allocated amount = # of driver units in object  rate LO 5: Allocate overhead costs to products.

22 To verify the amounts specified above, THREE calculations need to be made:

23 Calculate Raw Materials Used 1 1 ProcedureResult 2 2 Calculate Cost of Goods Manufactured Check It! Exercise #2 Solution 3 3 Calculate Cost of Goods Sold Calculation

24 LO 5: Allocate overhead costs to products.

25 Cost Allocations: Properties The percent of cost allocated to a cost object is the percent of cost driver units in the cost object  The Smith and Jones family each contributes 50% of the cost driver units (families). Thus, each family gets 50% of cost to it  Smith family has 60% of the cost driver units (in persons). Thus, Smith family gets 60% of the cost allocated to it LO 5: Allocate overhead costs to products.

26 Cost Allocations: Uses Uses of allocations  Inventory valuation, decisions, behavioral Allocation basis versus cost driver  GAAP needs allocations  Decisions need assignment  Two not the same We study allocations in more detail in Chapter 9. LO 5: Allocate overhead costs to products.

27 Allocated Costs & Decisions Allocations make it appear as if the allocated cost is variable in the number of driver units  Cost allocated is variable in # of persons But, the cost is fixed in the short run  Might not be controllable Mixing the two can lead to errors LO 5: Allocate overhead costs to products.

28 To verify the amounts specified above, the allocation rate and volume calculations need to be made.

29 Calculate Allocation Volume and Rate Check It! Exercise #3 Solution Calculate Amount Allocated to 5-ton Hooks Calculate Amount Allocated to 10-ton Hooks

30 Income Statement Example LO 5: Allocate overhead costs to products.

31 Decision Suppose we sell one more unit for $23. What is change in profit? $0? (After all, cost = $23 per unit)  This answer is likely incorrect  Assumes that ALL costs change (are controllable)  This assumption is probably not true LO 5: Allocate overhead costs to products.

32 Focus on Controllable Costs LO 5: Allocate overhead costs to products.

33 Revised Decision Variable costs are only:  $17.50 (=$ $ ) Only these costs are controllable for decision to make one more unit Profit increase  $25 - $17.50 = $7.50! LO 5: Allocate overhead costs to products.

34 Problem 3.30 Cost flows in a service firm (LO2). The following data pertain to Skogg Consulting. Skogg provides advice on structural engineering for large projects such as stadiums and bridges. Clients seek Skogg out because it has extensive contacts and can find the person who is “right” for the job. This is a nontrivial task, as often fewer than 10 persons worldwide might have the required expertise. Skogg bills clients at the rate of $350 per hour plus actual expenses for travel and board. The firm draws consultants from a roster it maintains, and it pays the consultant $300 per hour. The balance of $50 goes toward administrative support. The firm expects to accumulate 9,000 consulting hours for the year and projects a profit before taxes of $230,000. Required: Complete a GAAP income statement to determine (a) the firm’s cost to provide service and (b) its marketing and administration costs.

35 Complete a GAAP income statement to determine (a) the firm’s cost to provide service and (b) its marketing and administration costs. Problem 3.30 (Concluded) The following is the gross margin statement for Skogg Consulting. We can readily obtain the answers by noting that revenue – cost of services = gross margin and gross margin – marketing and administration costs = profit before taxes. Notice that we ignored the reimbursement of actual costs in this statement. If we included the amounts, it would increase revenue and costs by identically.