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Classification of cost

  1. 1. Classification of Cost
  2. 2. Classification of Cost Cost may be classified into different categories depending upon the purpose of classification. Some of the important categories in which the costs are classified are as follows: 1. Classification of cost methods on the basis of nature of production or manufacturing process i. Job Costing and ii. Process Costing 2. Classification of Costs on the basis of their variability in relation to output:- i. Fixed Cost ii. Variable Cost iii. Semi-Variable and Semi-Fixed Cost 3. Costs for Managerial Decision Making :- i. Marginal Costing ii. Incremental ( or Differential ) Cost iii. Uniform Costing iv. Opportunity Cost v. Replacement Cost vi. Sunk Cost vii. Relevant Cost Arunraj Arumugam
  3. 3. 4. Costs According to Functions (Manufacturing & Non-Manufacturing Cost):- i. Manufacturing or Production Cost ii. Administrative Cost iii. Selling and Distribution Cost iv. Research & Development Cost v. Pre-Production Cost 5. Classification of cost methods on the basis of Time:- 1. Historical Cost 2. Pre-Determined Costs 6. Classification of Costs based on establishment of relationship between input and output:- i. Engineering Cost ii. Managed Cost, discretionary or programmed Cost 7. Controllable and Uncontrollable costs 8. Other Types of Costs Costs which arises in a particular contests and which are used for particular purposes are :- Conversion Cost Common Cost Traceable Cost or Directly Attributable Cost Joint Cost Avoidable Cost Unavoidable Cost Total Cost Arunraj Arumugam
  4. 4. Fixed, Variable and Semi-Variable Costs The cost which varies directly in proportion with every increase or decrease in the volume of output or production is known as variable cost. Some of its examples are as follows: • Wages of laborers • Cost of direct material • Power Semi-variable costs are costs that have both a variable and fixed component. Commercial leases often have a fixed rent per month plus an additional rent based on the amount of production or sales. For example, rent is $5,000 plus five cents for each pencil that is made. The base rent of $5,000 is a fixed cost and the five cents per pencil is a variable cost. Step-variable costs are costs that are constant over a range of production. If one employee can make 10,000 pencils, then the employee’s wage is constant over a production range of one to 10,000 pencils. If you produce 11,000 pencils, you will need another employee. So your cost doubles. If you make 25,000 pencils your cost triples because you need three employees. Arunraj Arumugam
  5. 5. Arunraj Arumugam
  6. 6. Product Costs and Period Costs Product costs • The costs which are a part of the cost of a product rather than an expense of the period in which they are incurred are called as “product costs”. e.g., cost of raw materials and direct wages, depreciation on plant and equipment etc. Period costs. • The costs which are not associated with production are called period costs. • They are treated as an expense of the period in which they are incurred. They may also be fixed as well as variable. • Such costs include general administration costs, salaries salesmen and commission, depreciation on office facilities etc. Arunraj Arumugam
  7. 7. Arunraj Arumugam
  8. 8. Direct and Indirect Costs • The expenses incurred on material and labor which are economically and easily traceable for a product, service or job are considered as direct costs. In the process of manufacturing of production of articles, materials are purchased, laborers are employed and the wages are paid to them. • The expenses incurred on those items which are not directly chargeable to production are known as indirect costs. For example, salaries of timekeepers, storekeepers and foremen. Also certain expenses incurred for running the administration are the indirect costs. Arunraj Arumugam
  9. 9. Decision-Making Costs and Accounting Costs • Decision-making costs are future costs. They represent what is expected to happen under an assumed set of conditions. • Accounting costs are compiled primarily from financial statements. They have to be altered before they can be used for decision-making Arunraj Arumugam
  10. 10. Relevant and Irrelevant Costs • Relevant costs are those which change by managerial decision. • Irrelevant costs are those which do not get affected by the decision. For example, if a manufacturer is planning to close down an unprofitable retail sales shop, This will affect the wages payable to the workers of a shop. This is relevant in this connection since they will disappear on closing down of a shop. But prepaid rent of a shop or unrecovered costs of any equipment which will have to be scrapped are irrelevant costs which should be ignored. Arunraj Arumugam
  11. 11. Shutdown and Sunk Costs • Sunk costs are historical or past costs. These are the costs which have been created by a decision that was made in the past and cannot be changed by any decision that will be made in the future. – Investments in plant and machinery, buildings etc. • A manufacturer or an organization may have to suspend its operations for a period on account of some temporary difficulties, e.g., shortage of raw material, non-availability of requisite labor etc. During this period, though no work is done yet certain fixed costs, such as rent and insurance of buildings, depreciation, maintenance etc., for the entire plant will have to be incurred. Such costs of the idle plant are known as shutdown costs. Arunraj Arumugam
  12. 12. Learning Objective 1 Identify and give examples of each of the three basic manufacturing cost categories. Arunraj Arumugam
  13. 13. Manufacturing Costs Direct Direct Direct Direct Manufacturing Manufacturing Materials Materials Labor Labor Overhead Overhead The Product Arunraj Arumugam
  14. 14. Direct Materials Raw materials that become an integral part of the product and that can be conveniently traced directly to it. Example: A radio installed in an automobile Example: A radio installed in an automobile Arunraj Arumugam
  15. 15. Direct Labor Those labor costs that can be easily traced to individual units of product. Example: Wages paid to automobile assembly workers Example: Wages paid to automobile assembly workers Arunraj Arumugam
  16. 16. Manufacturing Overhead Manufacturing costs cannot be traced directly to specific units produced. Examples: Indirect materials and indirect labor Examples: Indirect materials and indirect labor Materials used to support Wages paid to employees the production process. who are not directly involved in production Examples: Lubricants and work. cleaning supplies used in the Examples: Maintenance automobile assembly plant. workers, janitors and security guards. Arunraj Arumugam
  17. 17. Classifications of Nonmanufacturing Costs Arunraj Arumugam
  18. 18. Learning Objective 2 Distinguish between product costs and period costs and give examples of each. Arunraj Arumugam
  19. 19. Product Costs Versus Period Costs Product costs include Period costs are not direct materials, direct included in product labor, and costs. They are manufacturing expensed on the overhead. income statement. Cost of Inventory Goods Sold Expense Sale Balance Income Income Sheet Statement Statement Arunraj Arumugam
  20. 20. Quick Check  Which of the following costs would be considered a period rather than a product cost in a manufacturing company? A. Manufacturing equipment depreciation. B. Property taxes on corporate headquarters. C. Direct materials costs. D. Electrical costs to light the production facility. E. Sales commissions. Arunraj Arumugam
  21. 21. Quick Check  Which of the following costs would be considered a period rather than a product cost in a manufacturing company? A. Manufacturing equipment depreciation. B. Property taxes on corporate headquarters. C. Direct materials costs. D. Electrical costs to light the production facility. E. Sales commissions. Arunraj Arumugam
  22. 22. Prime Cost and Conversion Cost Manufacturing costs are often classified as follows: Direct Direct Direct Direct Manufacturing Manufacturing Material Material Labor Labor Overhead Overhead Prime Conversion Cost Cost Arunraj Arumugam
  23. 23. Comparing Merchandising and Manufacturing Activities Merchandisers . . . Manufacturers . . . – Buy finished goods. – Buy raw materials. – Sell finished goods. – Produce and sell finished goods. MegaLoMart Arunraj Arumugam
  24. 24. Balance Sheet Merchandiser Manufacturer Current Assets Current Assets  Cash Cash  Receivables Receivables  Prepaid Expenses Prepaid Expenses  Merchandise Inventories: Inventory 1. Raw Materials 2. Work in Process 3. Finished Goods Arunraj Arumugam
  25. 25. Balance Sheet Merchandiser Manufacturer Current Assets Current Assets  Cash Cash  Receivables Receivables Materials waiting to  Prepaid Expenses Prepaid Expenses be processed.  Merchandise Partially complete Inventories: Inventory – some products 1. Raw Materials material, labor, or 2. Work in Process overhead has been 3. Finished Goods added. Completed products Arunraj Arumugam awaiting sale.
  26. 26. Learning Objective 3 Prepare an income statement including calculation of the cost of goods sold. Arunraj Arumugam
  27. 27. The Income Statement Cost of goods sold for manufacturers differs only slightly from cost of goods sold for merchandisers. Merchandising Company Cost of goods sold: Beg. merchandise inventory $ 14,200 + Purchases 234,150 Goods available for sale $ 248,350 - Ending merchandise inventory (12,100) = Cost of goods sold $ 236,250 Arunraj Arumugam
  28. 28. Inventory Flows Withdrawals Withdrawals Beginning Beginning Additions Additions Ending Ending balance balance + to inventory to inventory = balance balance + from from inventory inventory Arunraj Arumugam
  29. 29. Quick Check  If your inventory balance at the beginning of the month was $1,000, you bought $100 during the month, and sold $300 during the month, what would be the balance at the end of the month? A. $1,000. B. $ 800. C. $1,200. D. $ 200. Arunraj Arumugam
  30. 30. Quick Check  If your inventory balance at the beginning of the month was $1,000, you bought $100 during the month, and sold $300 during the month, what would be the balance at the end of the month? A. $1,000. $1,000 + $100 = $1,100 B. $ 800. $1,100 - $300 = $800 C. $1,200. D. $ 200. Arunraj Arumugam
  31. 31. Learning Objective 4 Prepare a schedule of cost of goods manufactured. Arunraj Arumugam
  32. 32. Schedule of Cost of Goods Manufactured Calculates the cost of raw material, direct labor and manufacturing overhead used in production. Calculates the manufacturing costs associated with goods that were finished during the period. Arunraj Arumugam
  33. 33. Schedule of Cost of Goods Manufactured Manufacturing Work As items are removed from As items are removed from Raw Materials Costs In Process raw materials inventory and raw materials inventory and Beginning raw materials inventory placed into the production placed into the production + Raw materials process, they are called direct process, they are called direct purchased = Raw materials materials. materials. available for use in production – Ending raw materials inventory = Raw materials used in production Arunraj Arumugam
  34. 34. Schedule of Cost of Goods Manufactured Manufacturing Work Conversion Conversion Raw Materials Costs In Process costs are costs costs are costs Beginning raw Direct materials incurred to incurred to materials inventory + Direct labor convert the + Raw materials + Mfg. overhead convert the purchased = Total manufacturing direct material direct material = Raw materials costs into a finished into a finished available for use product. product. in production – Ending raw materials inventory = Raw materials used As items are removed from raw As items are removed from raw in production materials inventory and placed into materials inventory and placed into the production process, they are the production process, they are called direct materials. called direct materials. Arunraj Arumugam
  35. 35. Schedule of Cost of Goods Manufactured Manufacturing Work Raw Materials Costs In Process Beginning raw Direct materials Beginning work in materials inventory + Direct labor process inventory + Raw materials + Mfg. overhead + Total manufacturing purchased = Total manufacturing costs = Raw materials costs = Total work in available for use process for the in production period – Ending raw materials – Ending work in inventory All manufacturing costs incurred All manufacturing costs incurred process inventory = Raw materials used during the period are added to the during the period = Cost of goods the are added to in production beginning balance of work in manufactured. beginning balance of work in process. process. Arunraj Arumugam
  36. 36. Schedule of Cost of Goods Manufactured Manufacturing Work Raw Materials Costs In Process Beginning raw Direct materials Beginning work in materials inventory + Direct labor process inventory + Raw materials + Mfg. overhead + Total manufacturing purchased = Total manufacturing costs = Raw materials costs = Total work in available for use process for the in production period – Ending raw materials – Ending work in inventory process inventory Costs associated with the goods that Costs associated with the goods that = Raw materials used = Cost of goods areincompletedduring the period are arecompleted during the period are production manufactured. transferred to finished goods transferred to finished goods inventory. inventory. Arunraj Arumugam
  37. 37. Cost of Goods Sold Arunraj Arumugam
  38. 38. Manufacturing Cost Flows Balance Sheet Income Costs Inventories Statement Material Purchases Raw Materials Expenses Direct Labor Work in Process Manufacturing Overhead Finished Cost of Goods Goods Sold Selling and Period Costs Selling and Administrative Administrative Arunraj Arumugam
  39. 39. Quick Check  Beginning raw materials inventory was $32,000. During the month, $276,000 of raw material was purchased. A count at the end of the month revealed that $28,000 of raw material was still present. What is the cost of direct material used? A. $276,000 B. $272,000 C. $280,000 D. $ 2,000 Arunraj Arumugam
  40. 40. Quick Check  Beginning raw materials inventory was $32,000. During the month, $276,000 of raw material was purchased. A count at the end of the month revealed that $28,000 of raw material was still present. What is the cost of direct material used? A. $276,000 B. $272,000 C. $280,000 D. $ 2,000 Arunraj Arumugam
  41. 41. Quick Check  Direct materials used in production totaled $280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month? A. $555,000 B. $835,000 C. $655,000 D. Cannot be determined. Arunraj Arumugam
  42. 42. Quick Check  Direct materials used in production totaled $280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month? A. $555,000 B. $835,000 C. $655,000 D. Cannot be determined. Arunraj Arumugam
  43. 43. Quick Check  Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month? A. $1,160,000 B. $ 910,000 C. $ 760,000 D. Cannot be determined. Arunraj Arumugam
  44. 44. Quick Check  Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month? A. $1,160,000 B. $ 910,000 C. $ 760,000 D. Cannot be determined. Arunraj Arumugam
  45. 45. Quick Check  Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. The ending finished goods inventory was $150,000. What was the cost of goods sold for the month? A. $ 20,000. B. $740,000. C. $780,000. D. $760,000. Arunraj Arumugam
  46. 46. Quick Check  Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. The ending finished goods inventory was $150,000. What was the cost of goods sold for the month? A. $ 20,000. B. $740,000. $130,000 + $760,000 = $890,000 $890,000 - $150,000 = $740,000 C. $780,000. D. $760,000. Arunraj Arumugam
  47. 47. Learning Objective 5 Define and give examples of variable costs and fixed costs. Arunraj Arumugam
  48. 48. Cost Classifications for Predicting Cost Behavior How a cost will react to How a cost will react to changes in the level of changes in the level of business activity. business activity.  Total variable costs  Total variable costs change when activity change when activity changes. changes.  Total fixed costs remain  Total fixed costs remain unchanged when activity unchanged when activity changes. changes. Arunraj Arumugam
  49. 49. Total Variable Cost Your total long distance telephone bill is based on how many minutes you talk. Minutes Talked Telephone Bill Total Long Distance Arunraj Arumugam
  50. 50. Variable Cost Per Unit The cost per long distance minute talked is constant. For example, 10 cents per minute. Minutes Talked Telephone Charge Per Minute Arunraj Arumugam
  51. 51. Total Fixed Cost Your monthly basic telephone bill probably does not change when you make more local calls. Number of Local Calls Telephone Bill Monthly Basic Arunraj Arumugam
  52. 52. Fixed Cost Per Unit The average fixed cost per local call decreases as more local calls are made. Monthly Basic Telephone Bill per Local Call Number of Local Calls Arunraj Arumugam
  53. 53. Cost Classifications for Predicting Cost Behavior Behavior of Cost (within the relevant range) Cost In Total Per Unit Variable Total variable cost changes Variable cost per unit remains as activity level changes. the same over wide ranges of activity. Fixed Total fixed cost remains Average fixed cost per unit goes the same even when the down as activity level goes up. activity level changes. Arunraj Arumugam
  54. 54. Quick Check  Which of the following costs would be variable with respect to the number of cones sold at a Baskins & Robbins shop? (There may be more than one correct answer.) A. The cost of lighting the store. B. The wages of the store manager. C. The cost of ice cream. D. The cost of napkins for customers. Arunraj Arumugam
  55. 55. Quick Check  Which of the following costs would be variable with respect to the number of cones sold at a Baskins & Robbins shop? (There may be more than one correct answer.) A. The cost of lighting the store. B. The wages of the store manager. C. The cost of ice cream. D. The cost of napkins for customers. Arunraj Arumugam
  56. 56. Learning Objective 6 Define and give examples of direct and indirect costs. Arunraj Arumugam
  57. 57. Assigning Costs to Cost Objects Direct costs Indirect costs • Costs that can be • Costs that cannot be easily and conveniently easily and conveniently traced to a unit of traced to a unit of product or other cost product or other cost object. object. • Examples: Direct • Example: Manufacturing material and direct labor overhead Arunraj Arumugam
  58. 58. Learning Objective 7 Define and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs. Arunraj Arumugam
  59. 59. Cost Classifications for Decision Making Every decision involves a choice between at least two alternatives. Only those costs and benefits that differ between alternatives are relevant to the decision. All other costs and benefits can and should be ignored. Arunraj Arumugam
  60. 60. Differential Costs and Revenues Costs and revenues that differ among alternatives. Example: You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month. Differential revenue is: Differential cost is: $2,000 – $1,500 = $500 $300 Net Differential Benefit is: $200 Arunraj Arumugam
  61. 61. Opportunity Costs The potential benefit that is given up when one alternative is selected over another. Example: If you were not attending college, you could be earning $15,000 per year. Your opportunity cost of attending college for one year is $15,000. Arumugam Arunraj
  62. 62. Sunk Costs Sunk costs cannot be changed by any decision. They are not differential costs and should be ignored when making decisions. Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost. Arunraj Arumugam
  63. 63. Quick Check  Suppose you are trying to decide whether to drive or take the train to Agra to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the cost of the train ticket relevant in this decision? In other words, should the cost of the train ticket affect the decision of whether you drive or take the train to Agra? A. Yes, the cost of the train ticket is relevant. B. No, the cost of the train ticket is not relevant. Arunraj Arumugam
  64. 64. Quick Check  Suppose you are trying to decide whether to drive or take the train to Agra to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the cost of the train ticket relevant in this decision? In other words, should the cost of the train ticket affect the decision of whether you drive or take the train to Agra? A. Yes, the cost of the train ticket is relevant. B. No, the cost of the train ticket is not relevant. Arunraj Arumugam
  65. 65. Quick Check  Suppose you are trying to decide whether to drive or take the train to Agra to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the annual cost of licensing your car relevant in this decision? A. Yes, the licensing cost is relevant. B. No, the licensing cost is not relevant. Arunraj Arumugam
  66. 66. Quick Check  Suppose you are trying to decide whether to drive or take the train to Agra to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the annual cost of licensing your car relevant in this decision? A. Yes, the licensing cost is relevant. B. No, the licensing cost is not relevant. Arunraj Arumugam
  67. 67. Quick Check  Suppose that your car could be sold now for $5,000. Is this a sunk cost? A. Yes, it is a sunk cost. B. No, it is not a sunk cost. Arunraj Arumugam
  68. 68. Quick Check  Suppose that your car could be sold now for $5,000. Is this a sunk cost? A. Yes, it is a sunk cost. B. No, it is not a sunk cost. Arunraj Arumugam
  69. 69. Summary of the Types of Cost Classifications Predicting Financial Cost Reporting Behavior Assigning Decision Costs to Making Cost Objects Arumugam Arunraj

Editor's Notes

  • Arunraj Arumugam
  • Learning objective number 1 is to identify and give examples of each of the three basic manufacturing cost categories. Arunraj Arumugam
  • Manufacturing costs are usually grouped into three main categories: direct materials, direct labor, and manufacturing overhead. These costs are incurred to make a product. Arunraj Arumugam
  • Direct materials are raw materials that become an integral part of the finished product and that can be physically and conveniently traced to it. Examples include the aircraft engines on a Boeing 777, the Intel processing chip in a personal computer, the blank video cassette in a pre-recorded video, and a radio in an automobile. Arunraj Arumugam
  • Direct labor consists of that portion of labor cost that can be easily traced to a product. Direct labor is sometimes referred to as “touch labor” since it consists of the costs of workers who “touch” the product as it is being made. Arunraj Arumugam
  • Manufacturing overhead includes all manufacturing costs except direct materials and direct labor. These costs cannot be easily traced to specific units produced (also called indirect manufacturing cost, factory overhead, and factory burden). Manufacturing overhead includes indirect materials that are part of the finished product, but that cannot be easily traced to it and indirect labor costs that cannot be physically or conveniently traced to the creation of products. Other examples of manufacturing overhead include: maintenance and repairs on production equipment, heat and light, property taxes, depreciation and insurance on manufacturing facilities, and salaries for supervisors, janitors, and security guards. Arunraj Arumugam
  • A manufacturing company incurs many other costs in addition to manufacturing costs. For financial reporting purposes, most of these other costs are typically classified as selling costs and administrative costs. These costs are also called selling, general and administrative costs, or SG&A. Selling and administrative costs are incurred in both manufacturing and merchandising firms. Selling costs include all costs necessary to secure customer orders and get the finished product into the hands of the customer. These costs are also referred to as order-getting and order-filling costs. Administrative costs include all executive, organizational, and clerical costs associated with the general management of an organization that are not classified as production or marketing costs. Arunraj Arumugam
  • Learning objective number 2 is to distinguish between product costs and period costs and give examples of each. Arunraj Arumugam
  • Costs can also be classified as product or period costs. Product costs include all the costs that are involved in acquiring or making a product. In the case of manufactured goods, it includes direct materials, direct labor, and manufacturing overhead. Consistent with the matching principle, product costs are recognized as expenses when the products are sold. This can result in a delay of one or more periods between the time in which the cost is incurred and when it appears as an expense on the income statement. Product costs are also known as inventoriable costs. The discussion in the chapter follows the usual interpretation of GAAP, whereby all manufacturing costs are treated as product costs. Period costs include all selling and administrative costs. These costs are expensed on the income statement in the period incurred. All selling and administrative costs are typically considered to be period costs. The usual rules of accrual accounting apply to period costs. For example, administrative salary costs are “incurred” when they are earned by the employees and not necessarily when they are paid to employees. Arunraj Arumugam
  • Which of the following costs would be considered a period rather than a product cost in a manufacturing company? A. Manufacturing equipment depreciation. B. Property taxes on corporate headquarters. C. Direct materials costs. D. Electrical costs to light the production facility. E. Sales commissions. Arunraj Arumugam
  • Property taxes on corporate headquarters and sales commissions are period costs. All of the other costs listed are product costs. Arunraj Arumugam
  • Prime cost consists of direct materials plus direct labor. Conversion cost consists of direct labor plus manufacturing overhead. Arunraj Arumugam
  • Merchandising companies purchase finished goods from suppliers for resale to customers. Manufacturing companies p urchase raw materials from suppliers and produce and sell finished goods to customers. Arunraj Arumugam
  • Now, let’s consider the similarities and differences on the balance sheet for merchandising and manufacturing companies. Both merchandising and manufacturing companies will likely have Cash, Receivables and Prepaid Expenses. However, merchandising companies do not have to distinguish between raw materials, work in process, and finished goods. They report one inventory number on their balance sheet labeled merchandise inventory. Manufacturing companies report three types of inventory on their balance sheets: raw materials, work in process and finished goods. Arunraj Arumugam
  • Part I Raw materials are the materials used to make the product. Part II Work in process consists of units of product that are partially complete, but will require further work to be saleable to customers. Part III Finished goods consists of units of product that have been completed, but not yet sold to customers. Arunraj Arumugam
  • Learning objective number 3 is to prepare an income statement including calculation of the cost of goods sold. Arunraj Arumugam
  • Merchandising companies calculate cost of goods sold as Beginning Merchandise Inventory plus Purchases minus Ending Merchandise Inventory. For manufacturing companies, the cost of goods sold for a period is not simply the manufacturing costs incurred during the period. They calculate cost of goods sold as Beginning Finished Goods Inventory plus Cost of Goods Manufactured minus Ending Finished Goods Inventory. For a manufacturing company, some of the cost of goods sold may be for units completed in a previous period. And some of the units completed in the current period may not have been sold and will still be on the balance sheet as an asset. The cost of goods sold is computed with the aid of a schedule of costs of goods manufactured, which takes into account changes in inventories. The schedule of cost of goods manufactured is not ordinarily included in external financial reports, but must be compiled by accountants within the company in order to arrive at the cost of goods sold. We will learn more about a schedule of costs of goods manufactured later in this chapter. Arunraj Arumugam
  • The computation of Cost of Goods Sold relies on this basic equation for inventory accounts: beginning inventory balance plus additions to inventory equals ending inventory balance plus withdrawals from inventory. The logic underlying this equation applies to any inventory account. Any units that are in inventory at the beginning of the period appear as the beginning balance. During the period, additions are made to the inventory through purchases or other means. At the end of the period, everything that was in the beginning inventory or that was added must be in the ending inventory account or have been transferred out to another inventory account or to cost of goods sold. Arunraj Arumugam
  • If your inventory balance at the beginning of the month was $1,000, you bought $100 during the month, and sold $300 during the month, what would be the balance at the end of the month? Arunraj Arumugam
  • Right. $800. This is calculated as beginning inventory of $1,000 plus purchases of $100 minus ending inventory of $300. Arunraj Arumugam
  • Learning objective number 4 is to prepare a schedule of cost of goods manufactured. Arunraj Arumugam
  • The schedule of cost of goods manufactured contains the three elements of costs mentioned previously, namely, direct materials, direct labor, and manufacturing overhead. The purpose of the schedule is to calculate the cost of raw materials, direct labor, and manufacturing overhead used in production. In addition, it is used to calculate the manufacturing costs associated with goods that were finished during the period. Arunraj Arumugam
  • At first glance, the schedule of cost of goods manufactured appears complex. However, it is all quite logical. The schedule of cost of goods manufactured contains the three types of product costs that we discussed earlier—direct materials, direct labor, and manufacturing overhead. The raw materials cost is not simply the cost of raw materials purchased during the period—rather it is the cost of materials used during the period. Raw material purchases made during the period are added to the beginning raw materials inventory balance to determine the cost of materials available for use during the period. The ending materials inventory is deducted from this amount to arrive at the cost of raw materials used in production. As items are removed from raw materials inventory and placed into the production process, they are called direct materials. Arunraj Arumugam
  • After we calculated the raw materials used in production, we take that amount and add the conversion costs (direct labor and manufacturing overhead) to get total manufacturing costs for the period. Arunraj Arumugam
  • After we calculate our total manufacturing costs, we take beginning work in process inventory, add to that, total manufacturing costs, and we get the total work in process for the period. Arunraj Arumugam
  • Finally, we subtract ending work-in-process inventory from work in process for the period to get cost of goods manufactured. Completed goods are transferred to finished goods inventory. Arunraj Arumugam
  • You can see that the cost of goods manufactured is added to the beginning finished goods inventory to get the cost of goods available for sale. The ending finished goods inventory is subtracted to arrive at the cost of goods sold. Arunraj Arumugam
  • Part I Let’s briefly look at the flow of costs in a manufacturing company. This will help us understand how product costs move through the various accounts and how they affect the balance sheet and the income statement. Raw materials are purchased and placed into raw materials inventory. Part II Raw materials are requisitioned out of raw materials inventory into work in process. Direct labor and manufacturing overhead are charged directly to work in process inventory. Part III When we complete the product, the product and its costs are transferred out of work in process inventory into finished goods. All raw materials, work in process and unsold finished goods at the end of the period are shown as inventoriable costs in the asset section of the balance sheet. Part IV As finished goods are sold, their costs are transferred to cost of goods sold on the income statement. Part V Selling and administrative expenses are not involved in making the product; therefore, they are treated as period costs and reported in the income statement for the period the cost is incurred. Arunraj Arumugam
  • Beginning raw materials inventory was $32,000. During the month, $276,000 of raw material was purchased. A count at the end of the month revealed that $28,000 of raw material was still present. What is the cost of direct material used? Arunraj Arumugam
  • Right. $280,000. Take a minute and review the solution before proceeding. Arunraj Arumugam
  • Direct materials used in production totaled $280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month? Arunraj Arumugam
  • Right. $835,000. Take a minute and review the solution before proceeding. Arunraj Arumugam
  • Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month? Arunraj Arumugam
  • Right. $760,000. Take a minute and review the solution before proceeding. Arunraj Arumugam
  • Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. The ending finished goods inventory was $150,000. What was the cost of goods sold for the month? Arunraj Arumugam
  • Right. $740,000. Take a minute and review the solution before proceeding. Arunraj Arumugam
  • Learning objective number 5 is to define and give examples of variable costs and fixed costs. Arunraj Arumugam
  • Managers often need to be able to predict how costs will change in response to changes in activity. The activity might be the output of goods or services or it might be some measure of activity, internal to the company, such as the number of purchase orders processed during a period. In this chapter, nearly all of the illustrations assume that the activity is the output of goods or services. In later chapters, other measures of activity will be introduced. Cost behavior refers to how a cost will react to changes in the level of activity within the relevant range. The most commonly used classifications of cost behavior are variable and fixed costs, which we will discuss in this chapter. The total of just about any cost will change if there is a big enough change in activity. There is some controversy concerning the proper definition of the “relevant range.” Some refer to the relevant range as the range of activity within which the company usually operates. We refer to the relevant range as the range of activity within which the assumptions about variable and fixed costs are valid. Either definition could be used—our choice was dictated by our desire to highlight the notion that fixed costs can change if the level of activity changes enough. Arunraj Arumugam
  • A variable costs varies, in total, in direct proportion to changes in the level of activity. For example, your long distance telephone bill may be based on how many minutes you talk—the total bill varies with the number of minutes used. Arunraj Arumugam
  • Although variable costs change in total as the activity level rises and falls, variable cost per unit is constant. For example, the cost per long distance minute may be ten cents a minute. Arunraj Arumugam
  • A fixed cost remains constant, in total, within the relevant range, regardless of changes in the level of the activity. In other words, fixed costs do not change as long as the activity level falls within the “relevant range.” For example, your monthly basic telephone bill probably is a set amount and does not change based on the number of local calls you make. Arunraj Arumugam
  • When expressed on a per unit basis, the average fixed cost per unit varies inversely with changes in activity. In other words, for a fixed cost, the per unit cost decreases when activity rises and increases when activity falls. For example, the average fixed cost per local call decreases as more local calls are made. Arunraj Arumugam
  • It is helpful to think about variable and fixed cost behavior in a two by two matrix, as illustrated here. Take a few minutes and review this summary of cost behavior for variable and fixed costs. Arunraj Arumugam
  • Which of the following costs would be variable with respect to the number of cones sold at a Baskins and Robbins shop? (There may be more than one correct answer.) A. The cost of lighting the store. B. The wages of the store manager. C. The cost of ice cream. D. The cost of napkins for customers. Arunraj Arumugam
  • Right. The cost of ice cream and the cost of napkins for customers would be variable costs. As Baskins and Robbins sells more ice cream cones, we would expect the total cost of ice cream and napkins to increase. Arunraj Arumugam
  • Learning objective number 6 is to define and give examples of direct and indirect costs. Arunraj Arumugam
  • A cost object is anything for which cost data are desired including products, customers, jobs, organizational subunits, etc. For purposes of assigning costs to cost objects, costs are classified two ways: Direct costs are costs that can be easily and conveniently traced to a unit of product or other cost object. Examples of direct costs are direct material and direct labor. Indirect costs are costs that cannot be easily and conveniently traced to a unit of product or other cost object. An example of an indirect cost is manufacturing overhead. Common costs are indirect costs incurred to support a number of cost objects. These costs cannot be traced to any individual cost object. Arunraj Arumugam
  • Learning objective number 7 is to define and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs. Arunraj Arumugam
  • It is important to realize that every decision involves a choice between at least two alternatives. The goal of making decisions is to identify those costs that are either relevant or irrelevant to the decision. Costs and benefits that differ between alternatives are relevant to the decision. All other costs and benefits are irrelevant and can and should be ignored. To make decisions, it is essential to have a grasp on three concepts: Differential costs, opportunity cost, and sunk cost. Let’s take a look at each of these on the next few slides. Arunraj Arumugam
  • Differential costs (or incremental costs) is a difference in cost between any two alternatives. A difference in revenue between two alternatives is called differential revenue. Differential costs can be either fixed or variable. For example, assume you have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month. In this example, the differential revenue is $500 and the differential cost is $300. The net differential benefit associated with accepting the new job is $200. Arunraj Arumugam
  • An opportunity cost is the potential benefit that is given up when one alternative is selected over another. These costs are not usually entered into the accounting records of an organization, but must be explicitly considered in all decisions. Arunraj Arumugam
  • A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Since sunk costs cannot be changed, they cannot be differential costs; therefore, sunk costs should be ignored in decision making. While students usually accept the idea that sunk costs should be ignored on an abstract level, like most people, they often have difficulty putting this idea into practice. Arunraj Arumugam
  • Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the cost of the train ticket relevant in this decision? In other words, should the cost of the train ticket affect the decision of whether you drive or take the train to Portland? Arunraj Arumugam
  • Yes, it should be considered because the cost of the train ticket is relevant. Arunraj Arumugam
  • Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the annual cost of licensing your car relevant in this decision? Arunraj Arumugam
  • No, the licensing cost is not relevant. Arunraj Arumugam
  • Suppose that your car could be sold now for $5,000. Is this a sunk cost? Arunraj Arumugam
  • No, it is not a sunk cost. Arunraj Arumugam
  • We have looked at the cost classifications used for financial reporting, predicting cost behavior, assigning costs to cost objects, and making business decisions. Arunraj Arumugam
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