An Introduction to Cost Terms and Purposes © 2012 Pearson Education. All rights reserved.

CHAPTER 2An Introduction to Cost Terms and Purposes

© 2012 Pearson Education. All rights reserved.

© 2012 Pearson Education. All rights reserved.Fall 2010 2/ 45

Accounting?FinancialManagerialCostAuditingTax

COST

MANAGERIAL

FINANCIAL

AUDITING

TAX


The Role of AccountingRole Users Decisions Preferred CharacteristicsManagerial Internal Managers Planning Measure Inputs and Outputs

Directing TimelinessControlling Identify Responsibility

Forward-Looking

Financial Shareholders Investment VerifiableCreditors Credit Measure Organizational ValueOther External Measure Risk of OrganizationUsers Consistent with IFRS

Tax Taxing Authorities Tax Liability VerifiableMeasure Past Income


Application of Managerial AccountingApplies to all types of business -

Service, Merchandising, and Manufacturing

Applies to all forms of business organizations –Proprietorships, Partnerships, and Corporations

Applies to not-for-profit as well as profit-oriented companies


Differences and SimilaritiesBoth deal with the same accounting dataBoth managerial and financial accounting

deal with economic events of a businessBoth require that economic events be

quantified and communicated to interested partiesFinancial – external

Managerial- internal Determining unit cost - managerial accounting, Reporting Cost of Goods Sold -financial accounting


Managerial or Management AccountingIndustrial Revolution – more complex production process

Cost became importantCost accounting (forerunner of managerial accounting)

Cost of an object – product, segment, division First book 1897 – Garcke and Fell – Factory Accounting

20th century – multinationals, and large companies Performance evaluation Budgeting

Management accounting term used after Second World War


Management or Managerial AccountingAssist managerial decisions

Provide timely and accurate information to control costs and to measure and improve productivity; and devise improved production process

Accurate costs important forPricing decisionsNew product Response to rival products


Main activitiesPlanning- strategic and operational

budgetingImplementing/Directing

Generate, analyze and report relevant information

ControllingActual vs budget comparisonAnalysis and interpretationFeedback


Managerial AccountingProcess of

IdentifyingMeasuringAnalyzingInterpretingCommunicating

information in pursuit of a company’s goalsManagerial accountants – business

partners/consultants in companies Provides information to managers


Technology and Managerial AccountingNew techniques created new roles for

management accountantsNew technologies demanded new control

techniquesEmerging service organizationsTeams with people from production,

marketing, engineering, etc.More flexible approaches to effective cost

controls


Managerial Accounting ObjectivesProvide information for planning and decision

making – be a part of itAssist managers in daily control of operationsMotivate the managers and other employees

towards the company goals-goal congruencePerformance measurement of managersStrategic planning – determine competitive

position and long-run success of the company


CharacteristicsInternal – manager orientedFuture looking – planningInvolves estimatesMore timely and relevant data necessaryAdaptive to changing business environmentCross-functional – brings together

production, marketing, managerial accountants and other key personnel


PlanningObjectives should be inline with the overall

objective of increasing shareholders’ wealthE.g. increase sales by 10% in Central Anatolia

– objective


PlanningIdentify

alternatives.Identify

alternatives.

Select alternative that does the best job of furtheringorganization’s objectives.

Select alternative that does the best job of furtheringorganization’s objectives.

Develop budgets to guideprogress toward theselected alternative.

Develop budgets to guideprogress toward theselected alternative.


DirectingCoordinate diverse activities and human

resources

Implement planned objectives

Provide incentives to motivate employees

Hire and train employees including executives, managers, and supervisors

Produce smooth-running operation


Controlling Process of keeping activities on track Determine whether goals are met Decide changes needed to get back on track May use an informal or formal system of evaluations Employee job assignments Routine problem solving Conflict resolution Effective communications

Decision making is not a separate management function, but the outcome of the exercise of good judgment in planning, directing, and controlling.

Feedback in the form of performance reportsthat compare actual results with the budgetare an essential part of the control function


Management ControlAssure that resources are obtained and used

effectively and efficiently in the accomplishment of the organization’s objective

Has financial and non financial performance measurement

Concerned with the implementation of strategies andTask control


Planning and Control Cycle

DecisionMaking

Formulating long-and short-term plans

(Planning)

Formulating long-and short-term plans

(Planning)

Measuringperformance (Controlling)

Measuringperformance (Controlling)

Implementing plans (Directing and Motivating)

Implementing plans (Directing and Motivating)

Comparing actualto planned

performance (Controlling)

Comparing actualto planned

performance (Controlling)

Begin

Exh.1-1



Management accounting systemTo control costs To measure and improve productivityTo devise improved production processTo decide on new productsTo decide on obsolete productsTo decide on pricesTo respond to rival products (Johnson and

Kaplan, 1987)


Cost Management Perspective

Provide highest quality service/goods with lowest possible cost

Objectives:Determine cost of resources consumed in

company’s activitiesEliminate non-value added activities as much as

possibleDetermine efficiency and effectiveness of all major

activitiesIdentify and evaluate new activities that can

improve the performance of the company


ComparisonFinancial Accounting Managerial Accounting

1. Users External persons who Managers who plan formake financial decisions and control an organization

2. Time focus Historical perspective Future emphasis

3. Verifiability Emphasis on Emphasis on relevance versus relevance verifiability for planning and control

4. Precision versus Emphasis on Emphasis on timeliness precision timeliness

5. Subject Primary focus is on Focuses on segments the whole organization of an organization

6. Accounting Standards Must follow IFRS or Need not follow IFRS

and prescribed formats or any prescribed format

7. Requirement Mandatory for Notexternal reports Mandatory


Basic Cost TerminologyCost—sacrificed resource to achieve a

specific objectiveActual cost—a cost that has occurredBudgeted cost—a predicted costCost object—anything of interest for which a

cost is desired


Cost Object Examples at BMWCost Object Illustration

Product BMW X 5 sports activity vehicle

Service Dealer-support telephone hotline

Project R&D project on DVD system enhancement

Customer Borusan, a dealer that purchases a broad range of BMW vehicles

Activity Setting up production machines

Department Environmental, Health and Safety


Basic Cost TerminologyCost accumulation—a collection of cost data

in an organized mannerCost assignment—a general term that

includes gathering accumulated costs to a cost object. This includes:Tracing accumulated costs with a direct

relationship to the cost object and Allocating accumulated costs with an indirect

relationship to a cost object

© 2012 Pearson Education. All rights reserved.Fall 2010 26/82

Types of Costs

differential costs- (benefits) – costs or benefits that change between/among alternatives

Irrelevant costs -Costs that don’t change are irrelevant to the decision

Choose the alternatives where differential benefits exceed differential costs

Opportunity costsSunk costsControllable /avoidable

costs/discretionary costs

The opportunity cost is the monetary amount associated with the next best use of the resource.

Costs that have already been incurred and cannot be changed no matter what action is taken in the future.

Costs that have already been incurred and cannot be changed no matter what action is taken in the future.


Problems in Identifying and Measuring Benefits

How do I measure the benefit of

employee training?

How do I measure the benefit of

employee training?What is the

monetary benefit of a happy customer?

What is the monetary benefit of a happy customer?

What is the monetary

benefit of an improved working

environment?

What is the monetary

benefit of an improved working

environment?

How do I measure the

benefit of improved quality?


benefit of improved quality?


Problems in Identifying and Measuring Costs

What is the cost of a dissatisfied

customer?

What is the cost of a dissatisfied

customer?


cost of setting my price too

high?


cost of setting my price too

high?

How do I measure the cost of poor

quality?

How do I measure the cost of poor

quality?

What is the cost of postponing

this year’s training

program?

What is the cost of postponing

this year’s training

program?


Graphical Analysis of Activity Costs and Rate of Output

Total Dollars

Start-up Range

Normal Operations

Exceeding Capacity

Output

Curvilinear Total Cost Curve

Curvilinear Total Cost Curve

Marginal Costs are the costs to produce one

more additional unit of output=slope.Marginal Costs are the costs to produce one

more additional unit of output=slope.


Relevant Range The relevant range is the portion of the curvilinear total cost curve that appears

in the normal operations area.

The relevant range is the portion of the curvilinear total cost curve that appears

in the normal operations area. }

Relevant Range

Relevant Range Total

Cost

Output

Total Dollars

Start-up

Range

Normal Operation

s

Exceeding Capacity


RelevantRange

A straight line closely

approximates a curvilinear

variable cost line within the

relevant range.

A straight line closely

approximates a curvilinear

variable cost line within the

relevant range.

Activity

Tota

l C

ost

Economist’sCurvilinear Cost

Function

The Linearity Assumption and the Relevant Range

Accountant’s Straight-Line Approximation (constant

unit variable cost)


Relevant Range Visualized

© 2012 Pearson Education. All rights reserved.Mugan

Fall 2010 33/82

Cost Classifications for Predicting Cost Behavior

By reaction to changes in the level of activity within the relevant range.

Total variable costs change when activity changes.

Total fixed costs remain unchanged when activity changes.

By reaction to changes in the level of activity within the relevant range.

Total variable costs change when activity changes.

Total fixed costs remain unchanged when activity changes.



Behavior – how costs react to changes in underlying cost driverVariable or Fixed

Function – related to production or salesProduct or PeriodProduct costs –

Direct Material Direct Labor Factory Overhead

Traceability (cost of tracing cost to a cost driver directly should be lower than the benefits.

Classifications of Costs


Non-manufacturing CostsMarketing or Selling Costs

Costs necessary to get the order and deliver

the product.

Administrative Costs

All executive, organizational, and

clerical costs.


Product Costs Versus Period Costs

Product costs include direct materials, direct

labor, and manufacturing

overhead.

Period costs include all marketing or selling costs and administrative

costs. Inventory Cost of Good Sold

BalanceSheet

IncomeStatement

Sale

Expense

IncomeStatement


Direct and Indirect CostsDirect costs can be conveniently and

economically traced (tracked) to a cost object.

Indirect costs cannot be conveniently or economically traced (tracked) to a cost object. Instead of being traced, these costs are allocated to a cost object in a rational and systematic manner.


BMW: Assigning Costs to a Cost Object


Cost ExamplesDirect Costs

PartsAssembly line wages

Indirect CostsElectricityRentProperty taxes


Factors Affecting Direct/Indirect Cost ClassificationCost materialityAvailability of information-gathering

technologyOperational design


Cost BehaviorVariable 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.

Costs are fixed or variable only with respect to a specific activity or a given time period.


Cost BehaviorVariable costs are constant on a per-unit

basis. If a product takes 5 pounds of materials each, it stays the same per unit regardless if one, ten, or a thousand units are produced.

Fixed costs change inversely with the level of production. As more units are produced, the same fixed cost is spread over more and more units, reducing the cost per unit.


Cost Behavior SummarizedTotal Dollars Cost per Unit

Variable Costs

Change in proportion with

outputMore output = More cost

Fixed CostsUnchanged in

relation to output

Change inversely with output

More output = lower cost per unit

Total Dollars Cost Per Unit

Variable CostsChange in

proportion with output

More output = More cost

Unchanged in relation to output

Fixed Costs Unchanged in relation to output

Change inversely with

outputMore output = lower cost

per unit


Cost Behavior Visualized


Other Cost ConceptsCost driver—a variable that causally affects

costs over a given time spanRelevant range—the band of normal activity

level (or volume) in which there is a specific relationship between the level of activity (or volume) and a given costFor example, fixed costs are considered fixed

only within the relevant range.


A Cost CaveatUnit costs should be used cautiously. Because

unit costs change with a different level of output or volume, it may be more prudent to base decisions on a total dollar basis.Unit costs that include fixed costs should

always reference a given level of output or activity.

Unit costs are also called average costs.Managers should think in terms of total costs

rather than unit costs.


Multiple Classification of CostsCosts may be classified as:

Direct/Indirect, and Variable/Fixed

These multiple classifications give rise to important cost combinations:Direct and variableDirect and fixedIndirect and variableIndirect and fixed


Multiple Classification of Costs, Visualized


Cost Classification Diagram

Cost Classification System• Cost types –

Product and Period

• Cost nature• Cost behavior –

Variable or Fixed• Sunk Costs vs.

Opportunity Costs• Controllable vs.

non controllable costs


Extent of Variable CostsThe proportion of variable costs differs across organizations. For example . . .

A public utility withlarge investments inequipment will tend

to have fewervariable costs.

A public utility withlarge investments inequipment will tend

to have fewervariable costs.

A manufacturing companywill often have many

variable costs.

A manufacturing companywill often have many

variable costs.

A merchandising companyusually will have a high

proportion of variable costslike cost of sales.

A merchandising companyusually will have a high

proportion of variable costslike cost of sales.

A service companywill normally have a highproportion of variable costs.

A service companywill normally have a highproportion of variable costs.


Different Types of FirmsManufacturing-sector companies purchase

materials and components and convert them into finished products.

Merchandising-sector companies purchase and then sell tangible products without changing their basic form.

Service-sector companies provide services (intangible products).


Examples of cost behavior


Types of Manufacturing InventoriesDirect materials—resources in-stock and

available for useWork-in-process (or progress)—products

started but not yet completed, often abbreviated as WIP

Finished goods—products completed and ready for sale


Types of Product CostsAlso known as inventoriable costs

Direct materials—acquisition costs of all materials that will become part of the cost object.

Direct labor—compensation of all manufacturing labor that can be traced to the cost object.

Indirect manufacturing—factory costs that are not traceable to the product in an economically feasible way. Examples include lubricants, indirect manufacturing labor, utilities, and supplies.


Accounting Distinction Between CostsInventoriable costs—product manufacturing

costs. These costs are capitalized as assets (inventory) until they are sold and transferred to Cost of Goods Sold.

Period costs—have no future value and are expensed in the period incurred.


Cost FlowsThe 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.


Cost Flows Visualized


Multiple-Step Income Statement

STEP 4

PANEL A: INCOME STATEMENT

Revenues $210,000Costs of goods sold:

Beginning finished goods inventory, January 1, 2011 $22,000Costs of goods available for sale $104,000Costs of goods manufactured (see Panel B) $126,000Ending finished goods inventory, December 31, 2011 $18,000

Cost of goods sold $108,000Gross margin (or gross profit) $102,000Operating costs

R&D, design, mktg., dist., & cust.-service cost $70,000Total operating costs $70,000

Operating income $32,000

Cellular ProductsIncome Statement

For the Year Ended December 31, 2011 (in thousands)


Cost of Goods Manufactured

STEP 1

STEP 3

STEP 2

PANEL B: COST OF GOODS MANUFACTURED

Direct materials:Beginning inventory, January 1, 2011 $11,000Purchases of direct materials $73,000Cost of direct materials available for use $84,000Ending inventory, December 31, 2011 $8,000

Direct materials used $76,000Direct manufacturing labor $9,000Manufacturing overhead costs:

Indirect manufacturing labor $7,000Supplies $2,000Heat, light, and power $5,000Depreciation-plant building $2,000Depreciation-plant equipment $3,000Miscellaneous $1,000

Total manufacturing overhead costs $20,000Manufacturing cost incurr3ed during 2011 $105,000Beginning work-in-progress inventory, January 1, 2011 $6,000Total manufacturing costs to account for $111,000Ending work-in-progress inventory, December 31, 2011 $7,000Cost of goods manufactured (to income Statement) $104,000

Schedule of Cost of Goods Manufactured*For the Year Ended December 31, 2011 (in Thousands)

* Note that this schedule can become a Schedule of Cost of Goods Manufactured and Sold simply by including the beginning and ending finished goods inventory figures in the supporting schedule rather than in the body of the income statement.

Cellular Products


Other Cost ConsiderationsPrime cost is a term referring to all direct

manufacturing costs (materials and labor).Conversion cost is a term referring to direct

labor and indirect manufacturing costs.Overtime labor costs are considered part of

indirect overhead costs.


Different Definitions of Costs for Different ApplicationsPricing and product-mix decisions—decisions

about pricing and maximizing profitsContracting with government agencies—very

specific definitions of allowable costs for “cost plus profit” contracts

Preparing external-use financial statements—GAAP-driven product costs only


Different Definitions of Costs for Different Applications


Three Common Features of Cost Accounting and Cost Management

1. Calculating the cost of products, services, and other cost objects

2. Obtaining information for planning and control, and performance evaluation

3. Analyzing the relevant information for making decisions


An Introduction to Cost Terms and Purposes © 2012 Pearson Education. All rights reserved.

Documents

pearson education

accounting databoth

role of accounting

fall 2010mugan10

fall 2010mugan6

fall 2010mugan9

fall 2010mugan7

fall 2010mugan11