Financial performance

1. Chapter Two: Cost
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2. WhatisCost?
 Cost is the measurement of resources that must be expended in order to
obtain an object or complete an activity.
 Cost is usually expressed in monetary terms.
 Cost has four essential purposes.
 It is used for planning for future activities or budgets.
 It is used for decision making throughout an organization.
 It is used to compare actual results with budgets and determine why
there are variances.
 It is used to calculate income from the company’s operations and
projects.
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3. Cost classifications
Financial Statements
• Product Cost
• Period Cost
Cost Behavior
• Variable
• Fixed
AssigningCosts
• Direct
• Indirect
Cost Decisions
• Differential Costs
• Sunk Costs
Cost of Quality
• Prevention
• Correction
• Warranty
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4. Product and Period Cost
 Period and product costs provide information to create financial statements
for external use.
 Product cost is the sum of all costs that are directly linked to the
production or acquisition of a product or service to be sold later. Product
costs might include direct materials and direct labor for a product.
 Period costs are all costs that are not related directly to creating the
product. For example, the cost of administration of a company or for
marketing and sales cannot be directly linked to the production of an
individual product. In addition, the cost of administration, such as human
resources services, salaries, or insurance and rent cannot be linked directly
to a product or service. These are period costs that are recognized as
expenses when the benefit occurs.
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5. Variable and Fixed costs
VARIABLECOSTS
 Variable costs are those that change in direct relationship to changes in the
activity that triggers the cost. For example, the cost of the material needed
to manufacture a bolt increases in direct proportion to the number of bolts
that are manufactured. A grocery retailer will incur increased cost as more
containers of milk are sold. A consulting company will incur increased cost
for each hour of service provided by hourly consultants.
FIXED COSTS
 In contrast to variable costs, fixed costs remain the same despite increases
or decreases in business activity. For example, a manufacturing plant must
heat the plant during the winter whether production increases or decreases.
The grocery retailer that rents its building must pay the rent no matter how
many containers of milk are sold, and the service company must pay the
rent for its offices, whether billable hours increase or decrease.
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6. Direct and Indirect costs
DIRECTCOSTS
 A direct cost is the measure of resources that must be given in order to
obtain an object or complete an activity that can be directly related to that
object or activity. In a manufacturing setting, direct materials and labor
would be direct costs. In a retail industry, the cost of acquiring goods for
sale would be a direct cost. In a service industry, the cost of paying the
employee to do consulting is a direct cost.
INDIRECT COSTS
 Indirect costs are those costs that are not related directly to the object or
activity that produce a project or service. Examples, the cost of heating a
factory is an indirect cost, as are the salaries of administrators not directly
working on the production of goods or services.
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7. Differential and sunk cost
DifferentialCost
 Differential cost is simply the difference in the cost of two alternatives. The
other side of differential cost is differential revenue. When considering the
different options to pursue, the differential cost and revenue of each option
is reviewed, and the option that presents the higher income usually is
chosen.
SUNKCOSTS
 A sunk cost is any cost that is already incurred or sunk into a project.
 Sunk costs should never have a place in deciding future activities or
operations.
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8. Cost of Quality
The three costs associated with quality are prevention costs, correction costs,
and warranty costs. As indicated, quality costs are a balance between
preventing mistakes and discovering and correcting them.
Prevention
 The best place to ensure quality in a product or service is at the time that
the product or service is created.
 In the case of a new product, this may be engineering tests.
Correction
 The cost of correction includes all of the activities that take place to find
and correct problems.
Warranty
 The cost of warranty includes all of those activities that correct problems
that occur after the product or service has been sold. Normally, this is the
most expensive quality cost. It can involve return, repair, or replacement of
merchandise and rework of services.
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9. Cost allocation
 Cost allocation is the process of identifying, aggregating, and assigning
costs to cost objects.
 Cost allocation is used for financial reporting purposes, to spread costs
among departments or inventory items.
 To track and allocate costs, the cost needs to first be associated with a
specific cost object.
 Allocating an employee’s salary between two departments, allocating a
utility bill between administrative and manufacturing facilities, or a
nonprofit that needs to allocate costs between various programs are just a
few reasons almost any business may need to regularly allocate costs.
 When allocating costs, there are four allocation methods to choose from;
 Direct labor
 Machine time used
 Square footage
 Units produced
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10. Example1
Abebe owns a small manufacturing plant, with administrative offices housed
on the second floor. The square footage of the plant is 5,000 square feet, while
the administrative offices are 2,500 square feet, with rent for the entire facility
$15,000 per month. Rent must be allocated between the two departments.
Solution
$15,000 (rent) ÷ 7,500 (square feet) = $2 per square foot
Next, Ken, will calculate the rental cost for the plant:
$2 x 5,000 = $10,000
That means that Ken can allocate $10,000 to overhead
expenses for the factory.
Next, Ken will calculate the rental cost for the
administrative offices:
$2 x 2,500 = $5,000
The balance of the rent, $5,000, will be allocated to the
administrative offices.
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11. Example2
Carrie’s manufacturing company manufactures backpacks. In July, Carrie
produced 2,000 backpacks with direct material costs of $5.50 per backpack,
and $ 2.25 direct labor costs per backpack. She also had $7,250 in overhead
costs for the month of July. Using the number of units produced as the
allocation method, we can calculate overhead costs using the following
overhead cost formula:
$7,250 ÷ 2,000 = $3.63 per backpack
The cost to produce each backpack is $11.38, calculated as follows:
Direct Materials: $ 5.50 per backpack
Direct Labor: $ 2.25 per backpack
Overhead: $ 3.63 per backpack
Total Cost: $11.38 per backpack
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12. Example3
Company XYZ has its own building. There are ten projects running in that
building. The company is trying to find the overhead cost of the pantry and
administrative support for project A. The pantry supplies to all the ten
projects, and the total cost of pantry service is $500,000 for a year. The support
service is also shared by all the projects. The administrative support service is
$20,000 and is being shared by all the projects.
The Overhead Cost of Pantry for Project A = Total Cost of Pantry / Number of Projects
 The overhead cost of the pantry for project A = $500,000 / 10 = $50,000
The Overhead Cost of Administrative Support for Project A = Total Cost of Administrative
Support / Number of Projects
 Administrative Support for Project A= $20,000 / 10 = $2,000
Total Overhead Cost of Project A = Overhead Cost of Pantry for Project A + Overhead Cost of
Administrative Support for Project A
$50,000 + $2,000= $52,000
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13. Example 4
Consider a warehouse that is rented to produce cars. In a month, 100 cars are
produced in the warehouse. Rent of the warehouse is $10,000 monthly. If 100
cars are produced in a month, then each car will share an overhead rent cost of
= Number of Cars / Monthly Rent.
 Car will Share an Overhead Rent Cost = 10,000 / 100 = $100
 So $100 is the Allocation rate. Each car is using $100 of warehouse rent to
finish itself.
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14. Example5
A company produces two products, namely “A” and “B” on the premises of
the same factory.
• Factory Rent = $100,000
• Units Produced of “A” = 30,000
• Units Produced of “B” = 20,000
• Total no. of units produced = 50,000
Let us see how can the cost allocation of factory rent be done for the two
products. Here,
• Cost Object = Product “A” and “B”
• Cost Pool = Factory Rent
• Cost Driver = No. of Units Produced
$100,000 * 30,000/50,000 = $100,000 * 20,000/50,000
= $40,000 = $ 60,000
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15. Exercises
A company makes two products: A and B. The company uses a plant wide allocation
method to allocate manufacturing overhead costs of $ 90,000.
Product A Product B
Direct material per unit $20 $25
Direct labor per unit $20 $15
Units 1000 2000
Direct labor hours per unit 2 1.5
Machine hours per unit 0.5 1
How much manufacturing overhead per unit is allocated to each product if the
company uses the following as the allocation base?
 Units
 Direct labor
 Machine hours

16. reading assignment
Meaning of cost estimation
project cost estimation