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Cost Concepts.ppt
This document provides an overview of different classifications of costs that are important for managerial accounting. It discusses direct materials, direct labor, and manufacturing overhead as the three main classifications of manufacturing costs. It also defines product costs, which become part of inventory, and period costs, which are expensed immediately. Additionally, it examines classifications of costs based on their behavior when activity changes, including variable, fixed, and mixed costs. Differential costs, opportunity costs, and sunk costs are identified as important classifications for decision making.
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Cost Concepts.ppt
- 1. PowerPoint Authors: Susan CoomerGalbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. Managerial Accounting and Cost Concepts Chapter 2
- 2. 2-2 The Product Classifications ofManufacturing Costs Direct Materials Manufacturing Overhead Direct Labor
- 3. 2-3 Direct Materials Raw materialsthat become an integral part of the product and that can be conveniently traced directly to it. Example: The flour in the dough.
- 4. 2-4 Direct Labor Those laborcosts that can be easily traced to individual units of product. Example: Wages paid to bakers.
- 5. 2-5 Manufacturing Overhead Manufacturing coststhat cannot be easily traced directly to specific units produced. Examples: Indirect materials and indirect labor Wages paid to employees who are not directly involved in production work. Examples: clean-up workers, janitors, and security guards. Materials used to support the production process. Examples: lubricants and cleaning supplies to maintain the bakery equipment.
- 6. 2-6 Classification of Nonmanufacturing Costs Selling Costs Costsnecessary to secure the order and deliver the product. Administrative Costs All executive, organizational, and clerical costs.
- 7. 2-7 Product costs andperiod costs
- 8. 2-8 Product Costs VersusPeriod Costs Product costs include direct materials, direct labor, and manufacturing overhead. Period costs include all selling costs and administrative costs. Inventory Cost of Good Sold Balance Sheet Income Statement Sale Expense Income Statement
- 9. 2-9 Classifications of Costs Manufacturingcosts are often classified as follows: Direct Material Direct Labor Manufacturing Overhead Prime Cost Conversion Cost
- 10. 2-10 Cost Classifications for PredictingCost Behavior Cost behavior refers to how a cost will react to changes in the level of activity. The most common classifications are: ▫Variable costs. ▫Fixed costs ▫Mixed costs.
- 11. 2-11 Variable Cost A costthat varies, in total, in direct proportion to changes in the level of activity. In some cases your total texting bill is based on how many texts you send. Number of Texts Sent Total Texting Bill
- 12. 2-12 Variable Cost PerUnit However, variable cost per unit is constant. In some cases the cost per text sent is constant at constant cost per text. Number of Texts Sent Cost Per Text Sent
- 13. 2-13 The Activity Base(Cost Driver) A measure of what causes the incurrence of a variable cost Labor hours Units produced Machine hours Miles driven
- 14. 2-14 Fixed Cost A costthat remains constant, in total, regardless of changes in the level of the activity. However, if expressed on a per unit basis, the average fixed cost per unit varies inversely with changes in activity. Number of Minutes Used Within Monthly Plan Monthly Cell Phone Contract Fee
- 15. 2-15 Fixed Cost PerUnit However, if expressed on a per unit basis, the average fixed cost per unit varies inversely with changes in activity. Number of Minutes Used Within Monthly Plan Monthly Cell Phone Contract Fee
- 16. 2-16 Examples Advertising and Research andDevelopment Examples Depreciation on Buildings and Equipment and Real Estate Taxes Types of Fixed Costs Discretionary May be altered in the short-term by current managerial decisions Committed Long-term, cannot be significantly reduced in the short term.
- 17. 2-17 A straight line closely approximatesa curvilinear variable cost line within the relevant range. The Linearity Assumption and the Relevant Range
- 18. 2-18 Fixed Costs andthe Relevant Range Fixed costs would increase in a step fashion at a rate of $30,000 for each additional 1,000 square feet. For example, assume office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet.
- 19. 2-19 Rent Cost in Thousands of Dollars 0 1,000 2,0003,000 Rented Area (Square Feet) 0 30 60 Fixed Costs and the Relevant Range 90 Relevant Range The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat.
- 20. 2-20 Cost Classifications forPredicting Cost Behavior
- 21. 2-21 Fixed Monthly Utility Charge Variable Costper KW Activity (Kilowatt Hours) Total Utility Cost X Y A mixed cost contains both variable and fixed elements. Consider the example of utility cost. Mixed Costs (also called semivariable costs)
- 22. 2-22 Mixed Costs The totalmixed cost line can be expressed as an equation: Y = a + bX Where: Y = The total mixed cost. a = The total fixed cost (the vertical intercept of the line). b = The variable cost per unit of activity (the slope of the line). X = The level of activity. Fixed Monthly Utility Charge Variable Cost per KW Activity (Kilowatt Hours) Total Utility Cost X Y
- 23. 2-23 Mixed Costs –An Example If your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, and your monthly activity level is 2,000 kilowatt hours, what is the amount of your utility bill? Y = a + bX Y = $40 + ($0.03 × 2,000) Y = $100
- 24. 2-24 Analysis of MixedCosts In account analysis, each account is classified as either variable or fixed based on the analyst’s knowledge of how the account behaves. The engineering approach classifies costs based upon an industrial engineer’s evaluation of production methods, and material, labor, and overhead requirements. Account Analysis and the Engineering Approach
- 25. 2-25 Scattergraph Plots –An Example Assume the following hours of maintenance work and the total maintenance costs for six months.
- 26. 2-26 Plot the datapoints on a graph (Total Cost Y vs. Activity X). The Scattergraph Method $7,000 $7,500 $8,000 $8,500 $9,000 $9,500 $10,000 400 500 600 700 800 900 Scattergraph Method X Y Hours of Maintenance Total Maintenance Cost
- 27. 2-27 The High-Low Method– An Example = $6.00/hour $2,400 400
- 28. 2-28 The High-Low Method– An Example Total Fixed Cost = Total Cost – Total Variable Cost Total Fixed Cost = $9,800 – ($6/hour × 850 hours) Total Fixed Cost = $9,800 – $5,100 Total Fixed Cost = $4,700
- 29. 2-29 The High-Low Method– An Example Y = $4,700 + $6.00X The Cost Equation for Maintenance
- 30. 2-30 The Traditional andContribution Formats Used primarily for external reporting. Used primarily by management.
- 31. 2-31 Uses of theContribution Format The contribution income statement format is used as an internal planning and decision-making tool. We will use this approach for: 1.Cost-volume-profit analysis (Chapter 3). 2.Budgeting (Chapter 9). 3.Segmented reporting of profit data (Chapter 5). 4.Special decisions such as pricing and make-or-buy analysis (Chapter 7).
- 32. 2-32 The differences between directand indirect costs
- 33. 2-33 Assigning Costs toCost 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
- 34.
- 35. 2-35 It is importantto 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. To make decisions, it is essential to have a grasp on three concepts shown on the following slides. Cost Classifications for Decision Making
- 36. 2-36 Differential Cost andRevenue 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
- 37. 2-37 Opportunity Cost The potentialbenefit 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.
- 38. 2-38 Sunk Costs Sunk costshave already been incurred and cannot be changed now or in the future. These costs should be ignored when making decisions. Example: Suppose you had purchased gold for $400 an ounce, but now it is selling for $250 an ounce. Should you wait for the gold to reach $400 an ounce before selling it? You may say, “Yes” even though the $400 purchase is a sunk costs.
- 39. 2-39 Summary of theTypes of Cost Classifications Financial Reporting Predicting Cost Behavior Assigning Costs to Cost Objects Making Business Decisions
- 40.
Editor's Notes
- #2 Chapter 2: Managerial Accounting and Cost Concepts This chapter explains how managers need to rely on different cost classifications for different purposes. The four main purposes emphasized in this chapter include preparing external financial reports, predicting cost behavior, assigning costs to cost objects, and decision making. We’ll begin by looking at manufacturing companies because their basic activities include most of the activities found in other types of business organizations.
- #3 Manufacturing costs are usually grouped into three main categories: direct materials, direct labor, and manufacturing overhead. These costs are incurred to make a product.
- #4 Direct materials are raw materials that become an integral part of the finished product and whose costs can be conveniently traced to it.
- #5 Direct labor consists of that portion of labor cost that can be easily traced to a product (also called touch labor).
- #6 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. It includes indirect labor costs that cannot be 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, etc.
- #7 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. Selling costs includes all costs necessary to secure customer orders and get the finished product into the hands of the customer. Administrative costs includes all costs associated with the general management of an organization.
- #8 Learning objective 2-2 is to distinguish between product costs and period costs and give examples of each.
- #9 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. More specifically, it includes direct materials, direct labor, and manufacturing overhead. Product costs are expensed in the income statement when the products are sold. Period costs include all selling costs and administrative costs. These costs are expensed on the income statement in the period incurred.
- #10 Direct materials cost plus direct labor cost. Direct labor cost plus manufacturing overhead costs.
- #11 Cost behavior refers to how a cost will react to changes in the level of activity. The most commonly used classifications of cost behavior are variable, fixed, and mixed costs.
- #12 A variable cost is a cost that varies, in total, in direct proportion to changes in the level of activity.
- #13 However, variable cost per unit is constant.
- #14 An activity base (also called a cost driver) is a measure of what causes the incurrence of variable costs. As the level of the activity base increases, the total variable cost increases proportionally.
- #15 A fixed cost is constant within the relevant range. In other words, fixed costs do not change for changes in activity that fall within the “relevant range.” For example, your monthly contract fee for your cell phone is a fixed amount for a certain number of minutes. The monthly contract fee does not change based on the number of calls you make. Of course, if you go over your monthly minutes allotment, you have exceed the relevant range for your monthly contract and will be charged above and beyond your monthly contract fee.
- #16 However, if expressed on a per unit basis, the average fixed cost per unit varies inversely with changes in activity.
- #17 Committed fixed costs represent investments with a multi-year planning horizon that cannot be easily adjusted in the short term. Discretionary fixed costs usually arise from annual decisions by management and they can be easily reduced in the short term.
- #18 Accountants usually assume that costs are strictly linear; however, economists point out that many costs are actually curvilinear. Nonetheless, within a narrow band of activity known as the relevant range, a curvilinear cost can be satisfactorily approximated by a straight line. The relevant range is that range of activity within which the assumptions made about cost behavior are valid.
- #19 The relevant range of activity pertains to fixed cost as well as variable costs. For example, assume office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet. Fixed costs would increase in a step fashion at a rate of $30,000 for each additional 1,000 square feet.
- #20 The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat.
- #21 It is helpful to think about variable and fixed cost behavior in a 2 by 2 matrix, as illustrated here.
- #22 Mixed costs (also called semivariable costs) contain both variable and fixed cost elements. The graph depicts the mixed costs of a normal utility bill. As illustrated in the graph, a utility bill contains a fixed and a variable cost component. The fixed portion of the utility bill is constant regardless of kilowatt hours consumed. This cost represents the minimum cost that is incurred to have the service ready and available for use. The variable portion of the utility bill varies in direct proportion to the consumption of kilowatt hours.
- #23 The mixed cost line can be expressed with the equation Y = a + bX. This equation should look familiar, from your algebra and statistics classes. In the equation, Y is the total mixed cost; a is the total fixed cost (or the vertical intercept of the line); b is the variable cost per unit of activity (or the slope of the line), and X is the actual level of activity. In our utility example, Y is the total mixed cost; a is the total fixed monthly utility charge; b is the cost per kilowatt hour consumed, and X is the number of kilowatt hours consumed.
- #24 For example, if your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, and your monthly activity level was 2,000 kilowatt hours, this equation can be used to calculate your total utility cost of $100.
- #25 In account analysis, each account under consideration is classified as variable and fixed based on the analyst’s prior knowledge about how costs behave. This approach is limited in value in the sense that it glosses over the fact that some accounts may have both fixed and variable components. The engineering approach classifies costs based upon an industrial engineer’s evaluation of production methods, materials specifications, labor requirements, equipment usage, power consumption, and so on. This approach is particularly useful when no past experience is available concerning activity and costs.
- #26 The high-low method can be used to analyze mixed costs if a scattergraph plot reveals a linear relationship between the X and Y variables. For illustrative purposes, assume the information regarding hours of maintenance work and the total maintenance costs for six months as shown on this slide.
- #27 The maintenance cost, which is known as the dependent variable, is plotted on the Y (vertical) axis. The activity (hours of maintenance), which is known as the independent variable, is plotted on the X (horizontal) axis. After plotting the data, examine the dots on the scattergraph to see if they are linear, such that a straight line can be drawn that approximates the relation between cost and activity. If the dots are not linear, do not analyze the data any further. Instead, search for another independent variable that bears a stronger linear relationship with the dependent variable. In this example, the dots are linear so we can proceed to the high-low method.
- #28 The first step is to choose the data points pertaining to the highest and lowest activity levels. In this case, the high level of activity was in June at 850 hours of maintenance and the low level of activity is in February with 450 hours of maintenance. Notice that this method relies upon two data points to estimate the fixed and variable portions of a mixed cost, as opposed to one data point with the scattergraph method. The second step is to determine the total costs associated with the two chosen points. We incurred costs of $9,800 at the high level of activity and $7,400 at the low level of activity. The third step is to calculate the change in cost between the two data points. The change in maintenance hours was 400 hours and the change in maintenance dollars was $2,400. Notice, this method relies upon two data points to estimate the fixed and variable portions of a mixed costs, as opposed to one data point with the scattergraph method. For this example, we divide $2,400 by 400 and determine that the variable cost per hour of maintenance is $6.00.
- #29 The fourth step is to take the total cost at either activity level (in this case, $9,800). Deduct the variable cost component ($6 per hour times 850 hours) for the total cost of $5,100. The difference represents the estimate of total fixed costs ($4,700). The variable cost component ($5,100) is determined by multiplying the level of activity (850 units) by the estimated variable cost per unit of the activity ($6.00 per unit).
- #30 The fifth step is to construct an equation that can be used to estimate the total cost at any activity level (Y = $4,700 + $6.00X). The basic equation of Y is equal to $4,700 (the total fixed cost) plus $6 times the actual level of activity. You can verify the equation by calculating total maintenance costs at 450 hours, the low level of activity. It will be worth your time to make the calculation.
- #31 The traditional approach separates product costs as required for external reporting purposes from selling and administrative expenses. It does not focus on cost behavior. The contribution approach separates costs into fixed and variable categories. Sales variable costs = contribution margin. The contribution margin fixed costs = net operating income.
- #32 This approach is used as an internal planning and decision-making tool. For example, this approach is useful for and discussed further in Cost-volume-profit analysis (Chapter 3), Budgeting (Chapter 9), Segmented reporting of profit data (Chapter 5), Special decisions such as pricing and make or buy analysis (Chapter 7).
- #33 Learning objective number 2-6 is to understand the differences between direct and indirect costs.
- #34 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 specified 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 specified 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. Common costs are costs Indirect costs incurred to support a number of cost objects. These costs cannot be traced to any individual cost object.
- #35 Learning objective number 2-7 is to understand cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.
- #36 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. To make decisions, it is essential to have a grasp on three concepts shown on the following slides.
- #37 Differential costs (or incremental costs) is a difference in cost between any two alternatives. Differential costs can be either fixed or variable. 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.
- #38 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.
- #39 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 and therefore cannot be differential costs, they 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.
- #40 We have looked at the cost classifications used for financial reporting, predicting cost behavior, assigning costs to cost objects, and making business decisions. Now, let’s look at how to classify idle time, overtime, and fringe benefits.
- #41 End of chapter 2.