1. An Introduction to Cost Terms,cost classification and Purposes © 2009 Pearson Prentice Hall. All rights reserved.

2. What is cost? All businesses have costs. A cost is any spending on goods and services for the business. Or 'the resources consumed or used up to achieve a certain objective' or Cost – sacrificed resource to achieve a specific objective or A cost is incurred when a firm uses a resource for some purpose.

3. © 2009 Pearson Prentice Hall. All rights reserved. Basic Cost Terminology Actual cost – a cost that has occurred Budgeted cost – a predicted cost Cost object – anything of interest for which a cost is desired A cost object is any product, service, customer, activity, or organizational unit to which costs are assigned for some management purpose

4. © 2009 Pearson Prentice Hall. All rights reserved. 4 Costs are assembled into meaningful groups called cost pools (e.g., by type of cost or source) Any factor that has the effect of changing the level of total cost is called a cost driver Basic Definitions

5. © 2009 Pearson Prentice Hall. All rights reserved. 5 There are four main ways to classify costs (“different costs for different purposes”): For product and service costing (GAAP) For strategic decision-making (cost-driver analysis) For planning and decision-making For control/feedback Cost Concepts: Overview

6. © 2009 Pearson Prentice Hall. All rights reserved. Direct cost ‘expenditure that can be attributed to a specific cost unit’ CIMA Official Terminology

7. © 2009 Pearson Prentice Hall. All rights reserved. Indirect cost ‘expenditure on labour, materials or services that cannot be economically identified with a specific saleable cost unit’. CIMA Official Terminology

8. © 2009 Pearson Prentice Hall. All rights reserved. 8 The process of assigning costs to cost pools or from cost pools to cost objects Direct costs can be conveniently and economically traced to a cost pool or a cost object Indirect costs cannot be traced conveniently or economically to a cost pool or a cost object Because indirect costs cannot be traced, assignment is made through the use of cost drivers (cost allocation) These cost drivers are often called allocation bases Product/Service Costing: Cost Assignment

9. © 2009 Pearson Prentice Hall. All rights reserved. 9 Cost Assignment: General Principles Costs Electric Motor Materials Handling Supervision Packing Materials Cost Pools Assembly Packing Cost Objects Dishwasher Washing Machine Final Inspection Cost Drivers and Cost Assignment

10. © 2009 Pearson Prentice Hall. All rights reserved. Period Cost Period costs are not manufacturing cost. However, they are incurred and paid based on the period They are deductible from revenue. Example: Rent, salaries, telephone etc.

11. © 2009 Pearson Prentice Hall. All rights reserved. Product Costs Product costs are manufacturing costs They are incurred for the manufacturing of goods They include direct material, direct labour, and manufacturing overheads. Example: direct material, labour cost, manufacturing overhead etc.

12. © 2009 Pearson Prentice Hall. All rights reserved. 12 Product costs include only the costs necessary to complete the product at the manufacturing step in the value chain (manufacturing) or to purchase and transport the product to the location of sale (merchandising) Period costs include all other costs incurred by the firm in managing or selling the product (indirect costs outside the manufacturing step of the value chain) Product and Service Costing Concepts (GAAP)

13. © 2009 Pearson Prentice Hall. All rights reserved. Types of Manufacturing Inventories Direct Materials – resources in-stock and available for use Work-in-Process (or progress) – products started but not yet completed. Often abbreviated as WIP Finished Goods – products completed and ready for sale

14. © 2009 Pearson Prentice Hall. All rights reserved. 14 Direct material costs = cost of materials that can be readily traced to outputs = purchase price of materials + freight – purchase discounts + reasonable allowance for scrap and defective units Indirect material costs = cost of materials that cannot readily be traced to outputs (e.g., lubricants, and small tools) Direct labor costs = labor that can be readily traced to outputs = wages paid plus a reasonable allowance for nonproductive time Indirect labor costs = labor costs that cannot be readily traced to outputs (i.e., they are manufacturing support costs) Direct and Indirect Product Costs for a Manufacturer

15. © 2009 Pearson Prentice Hall. All rights reserved. 15 All indirect costs for the manufacturer, including indirect materials, indirect labor, and other indirect items are often combined in a cost pool referred to as overhead (or, factory overhead, or indirect manufacturing costs) The three main types of costs, direct materials, direct labor, and overhead, are often condensed even further: Prime cost is a term referring to all direct manufacturing costs (labor and materials) Direct materials + Direct labor = “Prime costs” Direct and Indirect Product Costs: Further Comments

16. © 2009 Pearson Prentice Hall. All rights reserved. Other Cost Considerations Direct labor + Overhead = “Conversion costs” Conversion cost is a term referring to direct labor and factory overhead costs, collectively or cost of converting raw material to finished goods = Production cost- direct material. Conversion cost which converts the direct material into finished goods

17. © 2009 Pearson Prentice Hall. All rights reserved. Classifying costs by element

18. © 2009 Pearson Prentice Hall. All rights reserved. 18 Manufacturing vs. Merchandising

19. © 2009 Pearson Prentice Hall. All rights reserved. Direct v indirect cost

20. © 2009 Pearson Prentice Hall. All rights reserved. 20 Costs for Strategic Decision-Making Inventory valuation (GAAP) vs. strategic costing? Cost drivers provide two roles for the management accountant Assigning costs to cost objects Explaining cost behavior, i.e., how total cost changes as the cost driver changes There are four types of cost drivers: Activity-based Volume-based Structural Executional

21. © 2009 Pearson Prentice Hall. All rights reserved. 21 Cost Drivers Activity-based cost (ABC) drivers are developed at a detailed level of operations using activity analysis– a cost driver is determined for each activity Volume-based cost drivers relate to the amount produced or quantity of service provided: The relationship between the cost driver and total cost is approximately linear within the relevant range

22. © 2009 Pearson Prentice Hall. All rights reserved. 22 Structural cost drivers facilitate strategic decision making because they involve plans and decisions that have long-term effects Scale, experience, technology, and complexity are considered in hopes of improving competitive position Executional cost drivers facilitate operational decision making by focusing on short-term effects Workforce involvement, design of the production process, and supplier relationships are considered in an attempt to reduce costs Cost Drivers (continued)

23. © 2009 Pearson Prentice Hall. All rights reserved. Cost classification by behaviour 'the way in which cost per unit of output is affected by fluctuations in the level of activity'. Variable cost Fixed cost

24. © 2009 Pearson Prentice Hall. All rights reserved. Factors Affecting Direct / Indirect Cost Classification Cost Materiality Availability of information-gathering technology Operational Design

25. © 2009 Pearson Prentice Hall. All rights reserved. 25 Cost Information for Short-term Planning: Classification by Behavior What is meant by “cost behavior”? Common classifications of cost behavior: Fixed (capacity) cost is the portion of total cost that does not change with changes in output Variable cost is the change in total cost associated with each change in quantity of the cost driver Mixed cost is used to refer to a total cost figure that includes both a fixed and variable component Step costs vary with the cost driver but do so in steps Applications: Budgeting Cost-Volume-Profit analysis (profit planning)

26. © 2009 Pearson Prentice Hall. All rights reserved. 26 Fixed Costs $6,600 $6,500 $3,000 3,500 3,600 Units of the Cost Driver Total Cost Total Fixed Cost

27. © 2009 Pearson Prentice Hall. All rights reserved. 27 Variable Costs Total Variable Cost $6,600 $6,500 $3,000 Units of the Cost Driver Total Cost Total Cost 3,500 3,600

28. © 2009 Pearson Prentice Hall. All rights reserved. 28 Relevance is the most important characteristic for information used in decision making Relevant costs have two properties: they differ for each decision option and they will be incurred in the future Opportunity cost is the benefit lost when choosing one option precludes receiving the benefits from the alternative option Sunk costs are costs that have been incurred or committed in the past and are therefore irrelevant in current decision making Short-Run Decision-Making Cost Concepts

29. © 2009 Pearson Prentice Hall. All rights reserved. 29 There are three other characteristics that are important for planning and decision making Accuracy (and the need to monitor internal accounting controls) Cost and value of cost information (the cost of information should be monitored by the management accountant to ensure that costs do not outweigh the associated benefits) Timeliness (often involves sacrificing in the other two areas) Qualitative Characteristics of Cost Information for Planning and Decision-Making

30. © 2009 Pearson Prentice Hall. All rights reserved. 30 Controllability is a basic consideration in evaluating managers and providing feedback A cost is considered “controllable” if the manager or employee has discretion in choosing to incur it or can influence the amount in a short period of time The controllability of some costs is subject to debate, for example, changes in interest rates, foreign exchange fluctuations, or changes in state or local taxes; should the manager be responsible for these changes? Cost Information for Control/Feedback Purposes

31. © 2009 Pearson Prentice Hall. All rights reserved. 31 There are different ways to classify (or categorize) cost information, depending on the information needs of management (“different costs for different purposes”): To prepare financial statements (GAAP) For strategic decision-making For short-term planning For short-term decision-making For control/feedback purposes Product and service costing (GAAP) focuses on differentiating product costs from period costs Costs flow through three inventory accounts in a manufacturing firm; merchandising firms have one inventory account Chapter Summary

32. © 2009 Pearson Prentice Hall. All rights reserved. 32 Chapter Summary (continued) For strategic decision-making, we think about costs in terms of the following types of drivers: activity-based, volume-based, structural, and executional Cost concepts used in short-term planning relate to the behavior of costs (i.e., how they change in response to one or more activities) For decision-making we generally classify costs into one of the following categories: relevant, opportunity, or sunk –Relevance, accuracy, timeliness, and value that exceeds cost are important information characteristics Controllability and risk preferences must be assessed when using cost information for management and operational control

33. © 2009 Pearson Prentice Hall. All rights reserved. Different Types of Firms Manufacturing-sector companies – create and sell their own products Merchandising-sector companies – product resellers Service-sector companies – provide services (intangible products)

34. © 2009 Pearson Prentice Hall. All rights reserved. Cost Flows The Cost of Goods Manufactured and the Cost of Goods Sold section of the Income Statement are accounting representations of the actual flow of costs through a production system. Note the importance of inventory accounts in the following accounting reports, and in the cost flow chart

35. © 2009 Pearson Prentice Hall. All rights reserved. Cost Flows Demonstrate how costs flow through the formal accounting system?

36. © 2009 Pearson Prentice Hall. All rights reserved. Cost Flows Visualized

37. © 2009 Pearson Prentice Hall. All rights reserved. Cost of Goods Manufactured

38. © 2009 Pearson Prentice Hall. All rights reserved. Multiple-Step Income Statement

39. © 2009 Pearson Prentice Hall. All rights reserved. Opportunity Cost Not recordable in the books of account but are considered in every decisions of managers. It is the amount of benefit that is sacrificed when one alternative is selected.

40. © 2009 Pearson Prentice Hall. All rights reserved. The economic problem The basic economic problem is the scarcity of social resources to satisfy human wants and needs. An economic system must make choices about the allocation of resources among the many possible uses. The economic system also chooses how the goods and services are distributed -- who gets what.

41. © 2009 Pearson Prentice Hall. All rights reserved. Cost and the necessity of choice, even in health care When a high percentage of all spending in our economy is for health care, we wonder if some of the resources going into health care could be better used elsewhere, as other kinds of health care, that might give more benefit for the same resources other kinds of health-enhancing investments besides health care, such as education consumption goods and services that might enhance our lives more than spending on certain kinds of health care would, or as investments outside of health care that might improve our future ability to produce goods and services more than some investments in health do.

42. © 2009 Pearson Prentice Hall. All rights reserved. Opportunity cost Opportunity cost is the most fundamental cost concept. The opportunity cost of doing or getting something is: what you could have done or gotten instead

43. © 2009 Pearson Prentice Hall. All rights reserved. Opportunity cost is what you forgo. Example: The opportunity cost of buying a box of Cracklin Oat Bran is one-and-a half boxes of Wheat Chex, if that's your second favorite cereal.

44. © 2009 Pearson Prentice Hall. All rights reserved. Opportunity cost is what you forgo. Example: Your opportunity cost for taking this class includes: Whatever else you could have bought with your tuition and fee money plus the work, family participation, and recreation that you are not doing because you are here.

45. © 2009 Pearson Prentice Hall. All rights reserved. Opportunity cost is not resources used Strictly speaking, the cost of something is not the resources used up to get it. Instead, the cost is what else you could have done with those resources. Resources have value only because you can use them to make goods and services that have value.

46. © 2009 Pearson Prentice Hall. All rights reserved. Sunk costs Costs are the cost incurred a result of past decisions. Cost can not be changed by taking operating decision Sunk costs are irrelevant from decision making. Sunk costs are depreciation of assets, lease rent etc.