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This document contains excerpts from a textbook chapter on cost accounting. It defines and provides examples of different types of costs including direct materials, direct labor, manufacturing overhead, prime costs, conversion costs, product costs and period costs. It also explains the classification of costs as variable or fixed and how they behave with changes in activity levels. Manufacturing cost flows and inventory valuations are demonstrated through examples of raw materials, work in process, finished goods and cost of goods sold calculations.

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Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 11th Edition Chapter 2
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Costs Terms, Concepts and Classifications Chapter Two
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Product Direct Materials Direct Labor Manufacturing Overhead Manufacturing Costs
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Direct Labor Those labor costs that can be easily traced to individual units of product. Example: Wages paid to automobile assembly workers
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Manufacturing costs that cannot be traced directly to specific units produced. Manufacturing Overhead Examples: Indirect labor and indirect materials Wages paid to employees who are not directly involved in production work. Examples: maintenance workers, janitors and security guards. Materials used to support the production process. Examples: lubricants and cleaning supplies used in the automobile assembly plant.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Classifications of Costs Direct Material Direct Labor Manufacturing Overhead Prime Cost Conversion Cost Manufacturing costs are often classified as follows:
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Non-manufacturing Costs Marketing or Selling Cost Costs necessary to get the order and deliver the product. Administrative Cost All executive, organizational, and clerical costs.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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 Balance Sheet Income Statement Sale Expense Income Statement
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Comparing Merchandising and Manufacturing Activities Merchandisers . . .  Buy finished goods.  Sell finished goods. Manufacturers . . .  Buy raw materials.  Produce and sell finished goods. MegaLoMart
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Balance Sheet Merchandiser Current assets ◆Cash ◆Receivables ◆Prepaid Expenses ◆Merchandise Inventory Manufacturer Current Assets Cash Receivables Prepaid Expenses Inventories Raw Materials Work in Process Finished Goods
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Balance Sheet Merchandiser Current assets ◆Cash ◆Receivables ◆Prepaid Expenses ◆Merchandise Inventory Manufacturer Current Assets Cash Receivables Prepaid Expenses Inventories Raw Materials Work in Process Finished Goods Partially complete products – some material, labor, or overhead has been added. Completed products awaiting sale. Materials waiting to be processed.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Income Statement Cost of goods sold for manufacturers differs only slightly from cost of goods sold for merchandisers. Manufacturing Company Cost of goods sold: Beg. finished goods inv. 14,200 $ + Cost of goods manufactured 234,150 Goods available for sale 248,350 $ - Ending finished goods inventory (12,100) = Cost of goods sold 236,250 $ 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 $
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Inventory Flows Beginning balance $$ Additions $$$ + Available $$$$$ = Ending balance $$ = Withdrawals $$$ _ Available $$$$$
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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. $1,000 + $100 = $1,100 $1,100 - $300 = $800
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Manufacturing Work Raw Materials Costs In Process Beginning raw Direct materials materials inventory + Raw materials purchased = Raw materials available for use in production – Ending raw materials inventory = Raw materials used in production As items are removed from raw materials inventory and placed into the production process, they are called direct materials. Product Cost Flows
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Manufacturing Work Raw Materials Costs In Process Beginning raw Direct materials materials inventory + Direct labor + Raw materials + Mfg. overhead purchased = Total manufacturing = Raw materials costs available for use in production – Ending raw materials inventory = Raw materials used in production Conversion costs are costs incurred to convert the direct material into a finished product. Product Cost Flows
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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 inventory = Raw materials used in production Product Cost Flows All manufacturing costs incurred during the period are added to the beginning balance of work in process.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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 work in process inventory = Cost of goods manufactured Product Cost Flows Costs associated with the goods that are completed during the period are transferred to finished goods inventory.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Work In Process Finished Goods Beginning work in Beginning finished process inventory goods inventory + Manufacturing costs + Cost of goods for the period manufactured = Total work in process = Cost of goods for the period available for sale – Ending work in - Ending finished process inventory goods inventory = Cost of goods Cost of goods manufactured sold Product Cost Flows
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Manufacturing Cost Flows Finished Goods Cost of Goods Sold Selling and Administrative Period Costs Selling and Administrative Manufacturing Overhead Work in Process Direct Labor Balance Sheet Costs Inventories Income Statement Expenses Material Purchases Raw Materials
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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 Beg. raw materials 32,000 $ + Raw materials purchased 276,000 = Raw materials available for use in production 308,000 $ – Ending raw materials inventory 28,000 = Raw materials used in production 280,000 $
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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. Direct Materials 280,000 $ + Direct Labor 375,000 + Mfg. Overhead 180,000 = Mfg. Costs Incurred for the Month 835,000 $ Quick Check ✓
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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. Quick Check ✓ Beginning work in process inventory 125,000 $ + Mfg. costs incurred for the period 835,000 = Total work in process during the period 960,000 $ – Ending work in process inventory 200,000 = Cost of goods manufactured 760,000 $
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quick Check ✓ Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. And 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.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quick Check ✓ Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. And 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. $130,000 + $760,000 = $890,000 $890,000 - $150,000 = $740,000
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Cost Classifications for Predicting Cost Behavior How a cost will react 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.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Total Variable Cost Your total long distance telephone bill is based on how many minutes you talk. Minutes Talked Total Long Distance Telephone Bill
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Variable Cost Per Unit Minutes Talked Per Minute Telephone Charge The cost per long distance minute talked is constant. For example, 10 cents per minute.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Total Fixed Cost Your monthly basic telephone bill probably does not change when you make more local calls. Number of Local Calls Monthly Basic Telephone Bill
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Fixed Cost Per Unit Number of Local Calls Monthly Basic Telephone Bill per Local Call The average fixed cost per local call decreases as more local calls are made.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Assigning Costs to Cost Objects Direct costs • Costs that can be easily and conveniently traced to a unit of product or other cost object. • Examples: direct material and direct labor Indirect costs • Costs that cannot be easily and conveniently traced to a unit of product or other cost object. • Example: manufacturing overhead
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin • Every decision involves a choice between at least two alternatives. • Only those costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits can and should be ignored. Cost Classifications for Decision Making
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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: $2,000 – $1,500 = $500 Differential cost is: $300
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Sunk Costs Sunk costs have already been incurred and cannot be changed now or in the future. They 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.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quick Check ✓ 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? A. Yes, the cost of the train ticket is relevant. B. No, the cost of the train ticket is not relevant.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quick Check ✓ 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? A. Yes, the cost of the train ticket is relevant. B. No, the cost of the train ticket is not relevant.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quick Check ✓ 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? A. Yes, the licensing cost is relevant. B. No, the licensing cost is not relevant.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quick Check ✓ 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? A. Yes, the licensing cost is relevant. B. No, the licensing cost is not relevant.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Summary of the Types of Cost Classifications • Financial reporting • Predicting cost behavior • Assigning costs to cost objects • Decision making
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Idle Time The labor costs incurred during idle time are ordinarily treated as manufacturing overhead. Machine Breakdowns Material Shortages Power Failures
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Overtime The overtime premiums for all factory workers are usually considered to be part of manufacturing overhead.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Labor Fringe Benefits Fringe benefits include employer paid costs for insurance programs, retirement plans, supplemental unemployment programs, Social Security, Medicare, workers’ compensation and unemployment taxes. Some companies include all of these costs in manufacturing overhead. Other companies treat fringe benefit expenses of direct laborers as additional direct labor costs.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quality of Conformance When the overwhelming majority of products produced conform to design specifications and are free from defects.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Prevention and Appraisal Costs Prevention Costs Support activities whose purpose is to reduce the number of defects Appraisal Costs Incurred to identify defective products before the products are shipped
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Internal and External Failure Costs Internal Failure Costs Incurred as a result of identifying defects before they are shipped External Failure Costs Incurred as a result of defective products being delivered to customers
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Examples of Quality Costs Prevention Costs • Quality training • Quality circles • Statistical process control activities Appraisal Costs • Testing & inspecting incoming materials • Final product testing • Depreciation of testing equipment Internal Failure Costs • Scrap • Spoilage • Rework External Failure Costs • Cost of field servicing & handling complaints • Warranty repairs • Lost sales
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Distribution of Quality Costs When quality of conformance is low, total quality cost is high and consists mostly of internal and external failure. Companies can reduce their total quality cost by focusing on prevention and appraisal. The cost savings from reduced defects usually swamps the costs of the additional prevention and appraisal efforts.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quality cost reports provide an estimate of the financial consequences of the company’s current defect rate. Amount Percent* Amount Percent* Prevention costs: Systems development 400,000 $ 0.80% 270,000 $ 0.54% Quality training 210,000 0.42% 130,000 0.26% Supervision of prevention activities 70,000 0.14% 40,000 0.08% Quality improvement 320,000 0.64% 210,000 0.42% Total prevention cost 1,000,000 2.00% 650,000 1.30% Appraisal costs: Inspection 600,000 1.20% 560,000 1.12% Reliability testing 580,000 1.16% 420,000 0.84% Supervision of testing and inspection 120,000 0.24% 80,000 0.16% Depreciation of test equipment 200,000 0.40% 140,000 0.28% Total appraisal cost 1,500,000 3.00% 1,200,000 2.40% Internal failure costs: Net cost of scrap 900,000 1.80% 750,000 1.50% Rework labor and overhead 1,430,000 2.86% 810,000 1.62% Downtime due to defects in quality 170,000 0.34% 100,000 0.20% Disposal of defective products 500,000 1.00% 340,000 0.68% Total internal failure cost 3,000,000 6.00% 2,000,000 4.00% External failure costs: Warranty repairs 400,000 0.80% 900,000 1.80% Warranty replacements 870,000 1.74% 2,300,000 4.60% Allowances 130,000 0.26% 630,000 1.26% Cost of field servicing 600,000 1.20% 1,320,000 2.64% Total external failure cost 2,000,000 4.00% 5,150,000 10.30% Total quality cost 7,500,000 $ 15.00% 9,000,000 $ 18.00% * As a percentage of total sales. In each year sales totaled $50,000,000. Year 2 Year 1 Ventura Company Quality Cost Report For Years 1 and 2
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quality Cost Reports: Graphic Form $10 9 8 7 6 5 4 3 2 1 Appraisal 0 Prevention Prevention 1 2 Year Quality Cost (in millions) Appraisal Internal Failure External Failure Internal Failure External Failure 20 18 16 14 12 10 8 6 4 2 Appraisal 0 Prevention Prevention 1 2 Year Quality Cost as a Percentage of Sales Appraisal Internal Failure External Failure Internal Failure External Failure Quality reports can also be prepared in graphic form.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Uses of Quality Cost Information Help managers see the financial significance of defects. Help managers identify the relative importance of the quality problems. Help managers see whether their quality costs are poorly distributed.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Limitations of Quality Cost Information Simply measuring quality cost problems does not solve quality problems. Results usually lag behind quality improvement programs. The most important quality cost, lost sales, is often omitted from quality cost reports.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin ISO 9000 Standards ISO 9000 standards have become an international measure of quality. To become ISO 9000 certified, a company must demonstrate: 1. A quality control system is in use, and the system clearly defines an expected level of quality. 2. The system is fully operational and is backed up with detailed documentation of quality control procedures. 3. The intended level of quality is being achieved on a sustained basis.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin End of Chapter 2

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chap02notes.pdf

  • 1.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 11th Edition Chapter 2
  • 2.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Costs Terms, Concepts and Classifications Chapter Two
  • 3.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Product Direct Materials Direct Labor Manufacturing Overhead Manufacturing Costs
  • 4.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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
  • 5.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Direct Labor Those labor costs that can be easily traced to individual units of product. Example: Wages paid to automobile assembly workers
  • 6.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Manufacturing costs that cannot be traced directly to specific units produced. Manufacturing Overhead Examples: Indirect labor and indirect materials Wages paid to employees who are not directly involved in production work. Examples: maintenance workers, janitors and security guards. Materials used to support the production process. Examples: lubricants and cleaning supplies used in the automobile assembly plant.
  • 7.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Classifications of Costs Direct Material Direct Labor Manufacturing Overhead Prime Cost Conversion Cost Manufacturing costs are often classified as follows:
  • 8.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Non-manufacturing Costs Marketing or Selling Cost Costs necessary to get the order and deliver the product. Administrative Cost All executive, organizational, and clerical costs.
  • 9.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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 Balance Sheet Income Statement Sale Expense Income Statement
  • 10.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
  • 11.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
  • 12.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Comparing Merchandising and Manufacturing Activities Merchandisers . . .  Buy finished goods.  Sell finished goods. Manufacturers . . .  Buy raw materials.  Produce and sell finished goods. MegaLoMart
  • 13.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Balance Sheet Merchandiser Current assets ◆Cash ◆Receivables ◆Prepaid Expenses ◆Merchandise Inventory Manufacturer Current Assets Cash Receivables Prepaid Expenses Inventories Raw Materials Work in Process Finished Goods
  • 14.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Balance Sheet Merchandiser Current assets ◆Cash ◆Receivables ◆Prepaid Expenses ◆Merchandise Inventory Manufacturer Current Assets Cash Receivables Prepaid Expenses Inventories Raw Materials Work in Process Finished Goods Partially complete products – some material, labor, or overhead has been added. Completed products awaiting sale. Materials waiting to be processed.
  • 15.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Income Statement Cost of goods sold for manufacturers differs only slightly from cost of goods sold for merchandisers. Manufacturing Company Cost of goods sold: Beg. finished goods inv. 14,200 $ + Cost of goods manufactured 234,150 Goods available for sale 248,350 $ - Ending finished goods inventory (12,100) = Cost of goods sold 236,250 $ 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 $
  • 16.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Inventory Flows Beginning balance $$ Additions $$$ + Available $$$$$ = Ending balance $$ = Withdrawals $$$ _ Available $$$$$
  • 17.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
  • 18.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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. $1,000 + $100 = $1,100 $1,100 - $300 = $800
  • 19.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
  • 20.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Manufacturing Work Raw Materials Costs In Process Beginning raw Direct materials materials inventory + Raw materials purchased = Raw materials available for use in production – Ending raw materials inventory = Raw materials used in production As items are removed from raw materials inventory and placed into the production process, they are called direct materials. Product Cost Flows
  • 21.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Manufacturing Work Raw Materials Costs In Process Beginning raw Direct materials materials inventory + Direct labor + Raw materials + Mfg. overhead purchased = Total manufacturing = Raw materials costs available for use in production – Ending raw materials inventory = Raw materials used in production Conversion costs are costs incurred to convert the direct material into a finished product. Product Cost Flows
  • 22.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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 inventory = Raw materials used in production Product Cost Flows All manufacturing costs incurred during the period are added to the beginning balance of work in process.
  • 23.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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 work in process inventory = Cost of goods manufactured Product Cost Flows Costs associated with the goods that are completed during the period are transferred to finished goods inventory.
  • 24.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Work In Process Finished Goods Beginning work in Beginning finished process inventory goods inventory + Manufacturing costs + Cost of goods for the period manufactured = Total work in process = Cost of goods for the period available for sale – Ending work in - Ending finished process inventory goods inventory = Cost of goods Cost of goods manufactured sold Product Cost Flows
  • 25.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Manufacturing Cost Flows Finished Goods Cost of Goods Sold Selling and Administrative Period Costs Selling and Administrative Manufacturing Overhead Work in Process Direct Labor Balance Sheet Costs Inventories Income Statement Expenses Material Purchases Raw Materials
  • 26.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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
  • 27.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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 Beg. raw materials 32,000 $ + Raw materials purchased 276,000 = Raw materials available for use in production 308,000 $ – Ending raw materials inventory 28,000 = Raw materials used in production 280,000 $
  • 28.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
  • 29.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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. Direct Materials 280,000 $ + Direct Labor 375,000 + Mfg. Overhead 180,000 = Mfg. Costs Incurred for the Month 835,000 $ Quick Check ✓
  • 30.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
  • 31.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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. Quick Check ✓ Beginning work in process inventory 125,000 $ + Mfg. costs incurred for the period 835,000 = Total work in process during the period 960,000 $ – Ending work in process inventory 200,000 = Cost of goods manufactured 760,000 $
  • 32.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quick Check ✓ Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. And 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.
  • 33.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quick Check ✓ Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. And 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. $130,000 + $760,000 = $890,000 $890,000 - $150,000 = $740,000
  • 34.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Cost Classifications for Predicting Cost Behavior How a cost will react 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.
  • 35.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Total Variable Cost Your total long distance telephone bill is based on how many minutes you talk. Minutes Talked Total Long Distance Telephone Bill
  • 36.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Variable Cost Per Unit Minutes Talked Per Minute Telephone Charge The cost per long distance minute talked is constant. For example, 10 cents per minute.
  • 37.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Total Fixed Cost Your monthly basic telephone bill probably does not change when you make more local calls. Number of Local Calls Monthly Basic Telephone Bill
  • 38.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Fixed Cost Per Unit Number of Local Calls Monthly Basic Telephone Bill per Local Call The average fixed cost per local call decreases as more local calls are made.
  • 39.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
  • 40.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
  • 41.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
  • 42.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Assigning Costs to Cost Objects Direct costs • Costs that can be easily and conveniently traced to a unit of product or other cost object. • Examples: direct material and direct labor Indirect costs • Costs that cannot be easily and conveniently traced to a unit of product or other cost object. • Example: manufacturing overhead
  • 43.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin • Every decision involves a choice between at least two alternatives. • Only those costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits can and should be ignored. Cost Classifications for Decision Making
  • 44.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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: $2,000 – $1,500 = $500 Differential cost is: $300
  • 45.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
  • 46.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Sunk Costs Sunk costs have already been incurred and cannot be changed now or in the future. They 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.
  • 47.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quick Check ✓ 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? A. Yes, the cost of the train ticket is relevant. B. No, the cost of the train ticket is not relevant.
  • 48.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quick Check ✓ 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? A. Yes, the cost of the train ticket is relevant. B. No, the cost of the train ticket is not relevant.
  • 49.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quick Check ✓ 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? A. Yes, the licensing cost is relevant. B. No, the licensing cost is not relevant.
  • 50.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quick Check ✓ 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? A. Yes, the licensing cost is relevant. B. No, the licensing cost is not relevant.
  • 51.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
  • 52.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.
  • 53.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Summary of the Types of Cost Classifications • Financial reporting • Predicting cost behavior • Assigning costs to cost objects • Decision making
  • 54.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Idle Time The labor costs incurred during idle time are ordinarily treated as manufacturing overhead. Machine Breakdowns Material Shortages Power Failures
  • 55.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Overtime The overtime premiums for all factory workers are usually considered to be part of manufacturing overhead.
  • 56.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Labor Fringe Benefits Fringe benefits include employer paid costs for insurance programs, retirement plans, supplemental unemployment programs, Social Security, Medicare, workers’ compensation and unemployment taxes. Some companies include all of these costs in manufacturing overhead. Other companies treat fringe benefit expenses of direct laborers as additional direct labor costs.
  • 57.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quality of Conformance When the overwhelming majority of products produced conform to design specifications and are free from defects.
  • 58.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Prevention and Appraisal Costs Prevention Costs Support activities whose purpose is to reduce the number of defects Appraisal Costs Incurred to identify defective products before the products are shipped
  • 59.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Internal and External Failure Costs Internal Failure Costs Incurred as a result of identifying defects before they are shipped External Failure Costs Incurred as a result of defective products being delivered to customers
  • 60.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Examples of Quality Costs Prevention Costs • Quality training • Quality circles • Statistical process control activities Appraisal Costs • Testing & inspecting incoming materials • Final product testing • Depreciation of testing equipment Internal Failure Costs • Scrap • Spoilage • Rework External Failure Costs • Cost of field servicing & handling complaints • Warranty repairs • Lost sales
  • 61.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Distribution of Quality Costs When quality of conformance is low, total quality cost is high and consists mostly of internal and external failure. Companies can reduce their total quality cost by focusing on prevention and appraisal. The cost savings from reduced defects usually swamps the costs of the additional prevention and appraisal efforts.
  • 62.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quality cost reports provide an estimate of the financial consequences of the company’s current defect rate. Amount Percent* Amount Percent* Prevention costs: Systems development 400,000 $ 0.80% 270,000 $ 0.54% Quality training 210,000 0.42% 130,000 0.26% Supervision of prevention activities 70,000 0.14% 40,000 0.08% Quality improvement 320,000 0.64% 210,000 0.42% Total prevention cost 1,000,000 2.00% 650,000 1.30% Appraisal costs: Inspection 600,000 1.20% 560,000 1.12% Reliability testing 580,000 1.16% 420,000 0.84% Supervision of testing and inspection 120,000 0.24% 80,000 0.16% Depreciation of test equipment 200,000 0.40% 140,000 0.28% Total appraisal cost 1,500,000 3.00% 1,200,000 2.40% Internal failure costs: Net cost of scrap 900,000 1.80% 750,000 1.50% Rework labor and overhead 1,430,000 2.86% 810,000 1.62% Downtime due to defects in quality 170,000 0.34% 100,000 0.20% Disposal of defective products 500,000 1.00% 340,000 0.68% Total internal failure cost 3,000,000 6.00% 2,000,000 4.00% External failure costs: Warranty repairs 400,000 0.80% 900,000 1.80% Warranty replacements 870,000 1.74% 2,300,000 4.60% Allowances 130,000 0.26% 630,000 1.26% Cost of field servicing 600,000 1.20% 1,320,000 2.64% Total external failure cost 2,000,000 4.00% 5,150,000 10.30% Total quality cost 7,500,000 $ 15.00% 9,000,000 $ 18.00% * As a percentage of total sales. In each year sales totaled $50,000,000. Year 2 Year 1 Ventura Company Quality Cost Report For Years 1 and 2
  • 63.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quality Cost Reports: Graphic Form $10 9 8 7 6 5 4 3 2 1 Appraisal 0 Prevention Prevention 1 2 Year Quality Cost (in millions) Appraisal Internal Failure External Failure Internal Failure External Failure 20 18 16 14 12 10 8 6 4 2 Appraisal 0 Prevention Prevention 1 2 Year Quality Cost as a Percentage of Sales Appraisal Internal Failure External Failure Internal Failure External Failure Quality reports can also be prepared in graphic form.
  • 64.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Uses of Quality Cost Information Help managers see the financial significance of defects. Help managers identify the relative importance of the quality problems. Help managers see whether their quality costs are poorly distributed.
  • 65.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Limitations of Quality Cost Information Simply measuring quality cost problems does not solve quality problems. Results usually lag behind quality improvement programs. The most important quality cost, lost sales, is often omitted from quality cost reports.
  • 66.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin ISO 9000 Standards ISO 9000 standards have become an international measure of quality. To become ISO 9000 certified, a company must demonstrate: 1. A quality control system is in use, and the system clearly defines an expected level of quality. 2. The system is fully operational and is backed up with detailed documentation of quality control procedures. 3. The intended level of quality is being achieved on a sustained basis.
  • 67.
    Copyright © 2006,The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin End of Chapter 2