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Basic Cost Management Concepts

Costs can be classified in several ways that are important for management accounting and decision making. A cost is an expense that is recognized when an asset is used up or sold, while an expense is a cost incurred to generate revenue. Costs can be either product costs, which are inventoried until goods are sold, or period costs, which are expensed as time passes. On financial statements, product costs are shown as cost of goods sold or inventory, while period costs are operating expenses. Manufacturing costs include direct materials, direct labor, and manufacturing overhead like indirect materials and labor. Cost classifications help managers understand which costs are variable versus fixed, and which costs can be controlled.

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244 views

Basic Cost Management Concepts

Costs can be classified in several ways that are important for management accounting and decision making. A cost is an expense that is recognized when an asset is used up or sold, while an expense is a cost incurred to generate revenue. Costs can be either product costs, which are inventoried until goods are sold, or period costs, which are expensed as time passes. On financial statements, product costs are shown as cost of goods sold or inventory, while period costs are operating expenses. Manufacturing costs include direct materials, direct labor, and manufacturing overhead like indirect materials and labor. Cost classifications help managers understand which costs are variable versus fixed, and which costs can be controlled.

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Imad
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© © All Rights Reserved
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Download as DOCX, PDF, TXT or read online on Scribd
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Basic Cost Management Concepts

What is the Difference between a Cost and an Expense?


Cost is a resource sacrificed to achieve a specific objective.
An expense is defined as the cost incurred when an asset is used up or sold for the
purpose of generating revenue.
Are All Expenses Similar in Terms of when they are Recognized in An Accounting
Period?
 Product costs are the costs of goods manufactured or the cost of
goods purchased for resale. These costs are inventoried until the
goods are sold.

 Period costs are all other non-product costs in an organization (e.g.,


selling and administrative). Such costs are not inventoried but are
expensed as time passes.

Where do Costs Show up on Financial Statements?

 Product costs are shown as cost of goods sold on the income statement
when goods are sold. Income statements of service enterprises lack a cost-
of-goods-sold section and instead reveal a firm's operating expenses.

 Product costs, housed on the balance sheet until sale, are found in three
inventory accounts:
 Raw materials—materials that await production
 Work in process—partially completed production
 Finished goods—completed production that awaits sale

 Gross profit (sometimes called gross margin) is the portion of revenues left
after deducting just the costs that have been classified as cost of sales (cost
of goods/products sold), without considering any other costs of operating
the company.

 Operating income (sometimes called operating profit) goes one step further
to report the profit remaining from revenues after deducting both cost of
sales and all period costs of operations

What are the Different types of Manufacturing Costs?


 Direct materials—materials easily traced to a finished product

 Direct labor—the wages of anyone who works directly on the product

 Manufacturing overhead—all other manufacturing costs such as:


 Indirect materials—materials and supplies other than those
classified as direct materials.
 Indirect labor—personnel who do not work directly on the product
(e.g., manufacturing supervisors), and
 Other manufacturing costs not easily traceable to a finished good
(insurance, property taxes, depreciation, utilities, and
service/support department costs). Overtime premiums and the
cost of idle time are also accounted for as overhead.
 Idle time — time that is not spent productively by an employee
due to such events as equipment breakdowns or new setups of
production runs.
 Conversion cost (the cost to convert direct materials into finished product):
direct labor + manufacturing overhead
 Prime cost: direct material + direct labor

Example: A foundry employee involved in forging operations worked a normal 40-


hour shift, but four hours were idle due to a small fire in the plant. The employee earns
$18 per hour. How much of the employee’s total compensation for the week is a direct-
labor cost? How much is the overhead?
Cost Flows for a Manufacturing Company

Direct material (DM) used in the accounting period


= Beginning DM inventory + Purchases of DM - Ending DM inventory

Total manufacturing costs incurred = DM used + Direct labor + Factory overhead or all
indirect manufacturing costs

Cost of goods manufactured (COGM) = Beginning work in process (WIP) inventory


+ Total manufacturing costs incurred - Ending WIP inventory

Cost of goods sold (COGS) = Beginning finished goods (FG) inventory + COGM
- Ending inventory of FG
Gross profit = Sales - Cost of goods sold

Operating income (before taxes) = Gross profit - Non-manufacturing costs (period costs)

In-Class Exercise (2-29)


Alexandria Aluminum Company, a manufacturer of recyclable soda cans, had the following inventory
balances at the beginning and end of 20x1.
  
Inventory Classification January 1, 20x1 December 31, 20x1
Raw material $ 60,000   $ 70,000  
Work in process   120,000     115,000  
Finished goods   150,000     165,000  

  
During 20x1, the company purchased $260,000 of raw material and spent $400,000 on direct labor.
Manufacturing overhead costs were as follows:
  
 
Indirect material $ 10,000 
Indirect labor   25,000 
Depreciation on plant and equipment   100,000 
Utilities   25,000 
Other   30,000 

  
Sales revenue was $1,105,000 for the year. Selling and administrative expenses for the year
amounted to $110,000. The firm’s tax rate is 40 percent.

Required:
1. Prepare a schedule of cost of goods manufactured.
2. Prepare a schedule of cost of goods sold.
3. Prepare an Income statement
How to Classify Costs based on their Behavior with respect to underlying Cost
Drivers?

 A cost driver is any event or activity that causes costs to be incurred.


 The higher the degree of correlation between a cost-pool increase
and the increase in its cost driver, the better the cost management
information.

 Variable and fixed costs


Variable costs move in total in direct proportion to a change in activity. For
example, if the number of units produced doubles, direct materials (a variable
cost) would double in total. Note, however, that the variable cost per unit
remains constant.
Fixed costs remain constant in total as the level of activity changes. If the activity
level changes total fixed costs would not change. However, when expressed on a
per-unit of activity fixed costs per unit would change with a change activity
level.
Relevant range is the range of activity within which costs behave as predicted.
Outside this level of activity, costs behave differently.

How to Classify Costs based on their assignment to underlying Cost Objects?


 An entity (e.g., a specific product, service, or department) to which a cost is
assigned is commonly known as a cost object.

 A direct cost is one that can be easily traced to a cost object.


 An indirect cost is a cost that cannot be easily traced to a cost
object.

How are Indirect Costs Assigned to Cost Objects?


Through the mechanics of cost Allocations
 Each allocation has four elements
1) Cost Pool 2) Denominator Volume
3) Cost Driver 4) Cost Object
 Each allocation has two steps
a. Calculate rate
Rate = Cost in pool  Denominator volume
b. Allocate cost to cost object
Allocated amount = # of driver units in object x Rate
Question: How do the cost classifications discussed so far, combine in characterizing
typical costs in organizations?

Consider the following costs that were incurred during the current year:

1. Tire costs incurred by Ford Motor Company.


2. Sales commissions paid to the sales force of Dell Inc.
3. Wood glue consumed in the manufacture of Rooms To Go furniture.
4. Hourly wages of refinery security guards employed by ExxonMobil.
5. The salary of a financial vice president of Hewlett Packard.
6. Advertising costs of Coca-Cola.
7. Straight-line depreciation on factory machinery of Boeing Corporation.
8. Wages of assembly-line personnel of Whirlpool Corporation.
9. Delivery costs incurred by Ben & Jerry’s for a shipment of their ice cream to a grocery
store.
10. Newsprint consumed in printing The New York Times.
11. Plant insurance costs of Texas Instruments.
12. LED costs incurred in light-bulb manufacturing of GE Lighting.

Required: Evaluate each of the preceding and determine whether the cost is

(a) a product cost or a period cost, (b) variable or fixed in terms of behavior, and (c) for the
product costs only, whether the cost is properly classified as direct material, direct labor, or
manufacturing overhead.

Item 1 is done as an example:  1. Tire costs:  Product cost, variable, direct material
How are Costs Classified based on How Managers Influence them?
 Controllable costs—costs over which a manager has influence (e.g.,
direct materials)

 Uncontrollable costs—costs over which a manager has no


influence (e.g., the salary of a firm's CEO from the production
manager's viewpoint)

How are Costs Classified based on Economic Concepts for the Purposes of Decision
Making?
 Opportunity cost—the benefit forgone by choosing an alternative course
of action (e.g., the wages forgone when a student decides to attend college
full-time rather than be employed)

 Out-of-pocket cost—a cost that requires a cash outlay

 Sunk cost—a cost incurred in the past that cannot be changed by future
action (e.g., the cost of existing inventory or equipment)

 Differential cost—the net difference in cost between two alternative


courses of action

 Incremental cost—the increase in cost from one alternative to


another

 Marginal cost—the extra cost incurred when one additional unit is


produced

 Average cost per unit—total cost divided by the units of activity

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