Cost terms & purposes

Management Accounting:Introduction

• Cost Flows• Cost terms & purposes

2

Cost:Definition

• Monetary measure of resources given up to attain an objective (such as acquiring a good or service) – Barfield, Raiborn, Kinney

• At the time of acquisition, the cost incurred is for present or future benefits. When these benefits are utilized, the costs become expenses. An expense is defined as a cost that has given a benefit and is now expired. Unexpired costs that give future benefits are classified as assets. – Polimeni, Fabozzi, Adelberg

3

Cost Categories

Relevant, differential, sunk, opportunity

Direct, indirect

Controllable, noncontrollable

Impact on decision making

Unexpired, expired

Product, period

Prime, Conversion

Classification on the F/S

Variable, fixed,

Mixed, step

Reaction to changes in activity

Historical, replacement, budgetedTime of incidence

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Basic Cost Terms:Cost Objects and Drivers

Cost• A sacrifice of resources. Distinguish from

“expense”.Cost Object• Any activity or item for which a separate

measurement of costs is desired.Cost Driver• Any factor whose change “causes” a change

in the total cost of a related cost object. (Note: Cost drivers can be factors other than volume.)

From: ocw.mit.edu

Direct and Indirect CostsDirect Costs• Costs that can be traced to a given cost

object (product, department, etc.) in an economically feasible way.

Indirect Costs• Costs that cannot be traced to a given cost

object in an economically feasible way. These costs are also known as “overhead”.

Cost Assignment• Direct costs are traced to a cost object.• Indirect costs are allocated or assigned to

a cost object.

DirectCost A

DirectCost B

IndirectCost C

ObjectX

ObjectY

From: ocw.mit.edu

Product and Period CostsProduct Costs• Costs that “attach” to the units that

are produced (i.e., manufacturing costs) and are not reported as expenses until the goods are sold.

Period Costs• Costs that must be charged against

income in the period incurred and cannot be inventoried (e.g., selling and administrative expenses.)

Unit Costs• Total cost of units divided by units

produced.

Product Costs PeriodCost

DirectCost

IndirectCost

Product X

Inventory

IncomeStatement

From: ocw.mit.edu

Cost BehaviorVariable Costs• Costs that change directly in proportion to changes in the

related cost driver.Fixed Costs• Costs that remain unchanged for a given time period

regardless of change in the related cost driver.Other common functions for Cost Behavior• Semi-variable costs (part variable and part fixed).• Step costs (give examples)Main Assumptions needed to define fixed/variable:• Cost object, Time span, Linear functional form.• Relevant range = the band of cost driver activity in which a

specific relationship between a cost and a driver holds.

From: ocw.mit.edu

Basic Cost Terms• Product costs can be Direct or Indirect

(Overhead)• Not all Direct costs are variable

– The depreciation of a special piece of equipment bought to manufacture a single product line.

• Not all Overheads are fixed– Processing of raw material purchase orders– Electricity used in operating production

equipment.

From: ocw.mit.edu

Answer the following:Kym Manufacturing provided the following

information for last month:Sales $12,000Variable costs 4,000Fixed costs 1,000Operating income $7,000

If sales double next month, what is the projected operating income?a. $14,000b. $15,000c. $18,000d. $19,000

Prime Costs and Conversion Costs

Prime Costs• all direct manufacturing costs. (would comprise

direct material costs and direct manufacturing labor costs) As information-gathering technology improves, companies may add additional direct-cost categories.

Conversion Costs• all manufacturing costs other than direct

materials costs. These costs are for transforming direct materials into finished goods. (would comprise direct manufacturing labor costs and indirect manufacturing costs)

Traditional Costing System

Product

Costs

Direct CostsDirect labor

Direct materials

Overhead CostsIndirect labor

Indirect materialsDepreciation

Traceddirectly

Traced using allocation base,e.g. direct labor hrs, machine hrs

From: ocw.mit.edu

Activity-Based Costing (ABC) System

Product

Costs

Direct CostsDirect labor

Direct materials

Overhead CostsIndirect labor

Indirect materialsDepreciation

Activities thatdrive

overhead

From: ocw.mit.edu

13

Movement of Expenditures into F/S

ExpenditureExpenditure

CostCost

DeferredDeferred

Balance SheetBalance Sheet

ExpiredExpired

Income StatementIncome Statement

ExpenseExpense LossLoss

• or unexpired• future use• capital expenditure

or inventoriable

costs

• no future use• incl. period costs

• no benefit

was derived

Service Company

Purchasesupplies

Purchasesupplies

Use supplies,labor, overhead

to provide service

Use supplies,labor, overhead

to provide service

Input Output

Sell to customer

Sell to customer

Purchaseproductsfor resale

Purchaseproductsfor resale Sell to

customer

Sell to customer

Warehouseand/or display

Warehouseand/or display

Retail Company

Purchaseraw materials and supplies

Purchaseraw materials and supplies

Production Center

add labor and overhead

Manufacturer

Sell to customer

Sell to customer

Finished Product

Finished Product

Cost Accumulation in aManufacturing Company

MaterialsInventory

MaterialsInventory

Work in ProcessInventory

Work in ProcessInventory

FinishedGoods

Inventory

FinishedGoods

Inventory

Cost of GoodsSold

Balance SheetIncome

Statement

Accumulation Procedures

DM DL FOHDM DL FOH

WIPJob #1

WIPJob #1

WIPJob #2

WIPJob #2

WIPJob #3

WIPJob #3

FGJob #1

FGJob #1

FGJob #2

FGJob #2

FGJob #3

FGJob #3

WIPDept 1

WIPDept 1

WIPDept 2

WIPDept 2

WIPDept 3

WIPDept 3

FGInv.

FGInv.

DM DL FOHDM DL FOH

Job Order Costing Process Costing

Flow of Product Costs (entries)

Raw Materials InventoryAccounts Payable

Work in Process InventoryRaw Materials Inventory

Work in Process Inventory Salaries/Wages Payable

Fixed OH Control (actual)Salaries/Wages Payable

Variable OH Control (actual)Utilities Payable

Work in Process InventoryVariable OH Control (applied)Fixed OH Control (applied)

Finished Goods InventoryWork in Process Inventory

Accounts ReceivableSales

Cost of Goods SoldFinished Goods Inventory

Statement of Cost of Goods Manufactured

Raw Materials Used

Beginning raw materials xxx

Purchases of raw materials xxx

Raw materials available xxx

Ending raw materials <xxx>

Total raw materials used xxx

To Statement of Cost of Goods Manufactured

Statement of Cost of Goods Manufactured

• Beginning work in process xxxx– Raw materials used xxx– Direct labor xxx– Variable overhead xxx– Fixed overhead xxxx

• Current period manufacturing costs xxxx• Total costs to account for xxxx• Ending work in process <xxxx>• Cost of goods manufactured xxxx

Schedule of Cost of Goods Sold

Beginning Finished Good xxxx

Cost of Goods Manufactured xxxx

Cost of Goods Available for Sale xxxx

Ending Finished Goods <xxxx>

Cost of Goods Sold xxxx

From Schedule of Cost of Goods Manufactured

Costing Approaches• Actual Costing – allocates:

Indirect costs based on the actual indirect-cost rates times the actual activity consumption

•Normal Costing – allocates:Indirect costs based on the budgeted indirect-

cost rates times the actual activity consumption•Both methods allocate Direct costs to a cost object the same way: by using actual direct-cost rates times actual consumption.

Cost System and Cost Accumulation ProcedureA

CT

UA

LN

OR

MA

LS

TA

ND

AR

D

JOB ORDER PROCESS

Actual direct materialsActual direct laborActual OH assigned to jobs after end of period

Actual direct materialsActual direct laborActual overhead costs assigned to process at end of period using FIFO or wtd. ave. cost flow

Actual direct materialsActual direct laborOH applied at completion of job or end of period (predetermined rate x actual input)

Actual direct materialsActual direct laborPredetermined OH applied at the end of the process using FIFO or wtd ave. cost flow

Standard direct materialsStandard direct laborOH applied at completion of job or end of period (predetermined rate x standard input)

Standard direct materialsStandard direct laborStandard overhead applied using FIFO cost flow

Other Cost Terms:• Several key points:

Cost Objects – including responsibility centers, departments, customers, products, etc.

Direct costs and Tracing – materials and labor Indirect Costs and Allocation – overhead

•Cost Pool – any logical grouping of related cost objects•Cost-allocation Base – a cost driver is used as a basis upon which to build a systematic method of distributing indirect costs

For example, let’s say that direct labor hours cause indirect costs to change. Accordingly, direct labor hours will be used to distribute or allocate costs among objects based on their usage of that cost driver