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

2. 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

3. 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.

4. 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

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

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

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

8. 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 =

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

10. 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

11. 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

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

13. 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

14. 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

15. 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

16. Activity-based Cost Drivers
Pennsylvania Blue Shield

17. 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

18. 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

19. Volume-based Cost Drivers (cont.)

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

21. Volume-based Cost Drivers (cont.)
Total Variable Cost
$6,600
$6,500
$3,000
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

22. 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, ,600
Units of the Cost Driver

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

24. 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

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

26. 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

27. 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?

28. 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?

29. 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

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

31. 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

32. 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

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

34. Cost Flows in Manufacturing and Merchandising Firms

35. 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

36. Statements for Manufacturing and Merchandising Firms

37. 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:

38. 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.

39. 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.

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