ch02 ppt hongren costaccounting 2e

Chapter 2

An introduction tocosts terms andinventory costing

PowerPoint to accompany:

2 Copyright ©2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442563377/Horngren/Cost accounting/2e

LEARNING OBJECTIVES

• Define and illustrate a cost object• Distinguish between direct costs and indirect costs• Explain variable costs and fixed costs• Interpret unit costs cautiously


LEARNING OBJECTIVES

• Distinguish inventoriable costs from period costs• Calculate income under absorption costing and variable costing,

and explain the difference in income• Describe the undesirable incentives for managers to build up

inventory when a company uses absorption costing• Explain why product costs are calculated in different ways for

different purposes• Describe a framework for cost accounting and cost management.


Costs and cost terminology

• Cost – a sacrificed resource to achieve a specific objective.

• Actual cost – a cost that has occurred.• Budgeted cost – a predicted cost.• Cost object – anything of interest for which a cost is

desired.• Cost accumulation – a collection of cost data presented

in some organised manner.


Costs and cost terminologyCost object examples at GM Holden


Direct costs and indirect costs

• Direct costs can be conveniently and economically traced (tracked) to a cost object.

• Indirect costs cannot be conveniently or economically traced (tracked) to a cost object. Instead of being traced, these costs are allocated to a cost object in a rational and systematic manner.


Direct costs and indirect costs• Cost allocation is the assignment of indirect costs to a particular

cost object.• Cost assignment is a general term used when gathering

accumulated costs to a cost object. This includes:– tracing accumulated costs with a direct relationship to the

cost object, and – allocating accumulated costs with an indirect relationship to a

cost object.


Direct costs and indirect costsGM Holden: Assigning costs to a cost object



Direct costs:• parts• assembly line wages.

Indirect costs:• electricity• rent• property taxes.



Factors affecting direct/indirect cost classifications:• cost materiality• availability of information-gathering technology• operational design.


Cost behaviour patterns: variable costs and fixed costs

• Variable costs can change in total, in proportion to changes in the related level of activity or volume.

• Fixed costs remain unchanged in total, regardless of changes in the related level of activity or volume.

• Costs are fixed or variable only with respect to a specific activity, or a given time period.


Cost behaviour patterns: variable costs and fixed costs• Variable costs are constant on a per-unit basis. If a

product takes 5 kg of materials each, it stays the same per unit regardless of whether 1, 10, or 1000 units are produced.

• Fixed costs change inversely with the level of production. As more units are produced, the same fixed cost is spread over more units, reducing the cost per unit.



Total dollars Cost per unit

Variable costsChange in proportion

with outputMore output = more cost

Unchanged in relation to output

Fixed costs Unchanged in relation to output

Change inversely with output

More output = lower cost per unit



Cost behaviour visualised:



Other cost concepts• Cost driver is a variable that causally affects costs over a given

time span.• Relevant range is the band of normal activity level (or volume) in

which there is a specific relationship between the level of activity (or volume) and a given cost:- for example, fixed costs are considered fixed only within the

relevant range .


Cost behaviour patterns: variable costs and fixed costsRelevant range visualised:


Cost behaviour patterns: variable costs andfixed costsCosts may be classified as:• direct/indirect, and • variable/fixed.These multiple classifications give rise to important cost

combinations:• direct and variable• direct and fixed• indirect and variable• indirect and fixed.



Multiple classification of costs visualised:


Cost behaviour patterns: variable costs andfixed costs – web link• Things you must know – summarised at:

http://www.learnmanagerialaccounting.com/FreeMaterial/costbehavior/index.html

• This site also has graded questions and problems to solve.




Total costs and unit costs• Total cost:

‒ the sum of all costs, both direct and indirect, or‒ the sum of fixed and variable costs.

• Unit cost:‒ the total cost divided by the number of units expected to

be produced.


Total costs and unit costs

Use unit costs cautiously• Unit costs should be used cautiously. Since unit costs change with

a different level of output or volume, it may be more prudent to make decisions on a total dollar basis.

• Unit costs that include fixed costs should always reference a given level of output or activity.

• Unit costs are also called average costs.


Business sectors, types of inventory,inventoriable costs and period costs

Manufacturing, retail, and service sector companies• Manufacturing sector companies create and sell their own products.• Retail sector companies are product resellers.• Service sector companies provide services (intangible products).


Business sectors, types of inventory,inventoriable costs and period costs

Types of inventory• Direct materials – resources that are in stock and are available

for use.• Work-in-process (or progress) – products started but not yet

completed. Often abbreviated as WIP.• Finished goods – products completed and ready for sale.


Business sectors, types of inventory,inventoriable costs, and period costs

Commonly used classifications of manufacturing costs – also known as product costs:• direct materials costs• direct manufacturing labour costs• indirect manufacturing costs – factory costs that are not traceable

to the product. Other common names for this type of cost include manufacturing overhead costs, or factory overhead costs.


Business sectors, types of inventory,inventoriable costs, and period costs

Inventoriable costs:• product manufacturing costs – capitalised as assets (inventory)

until they are sold• become cost of goods sold only when the product is sold.

Period costs:• have no future value and are expensed as they are incurred.


Business sectors, types of inventory,inventoriable costs, and period costs – web link

Inventoriable costs and period costs• A tutorial on inventoriable and period costs, entitled ‘Product

(manufacturing) costs and period (nonmanufacturing) costs’, can be found at: http://simplestudies.com/manufacturing-nonmanufacturing-costs.html/page/3.

http://simplestudies.com/manufacturing-nonmanufacturing-costs.html/page/3

http://simplestudies.com/manufacturing-nonmanufacturing-costs.html/page/3


Illustrating the flow of inventoriable costs and period costs

Prime costs and conversion costs• Prime cost is a term referring to all direct manufacturing costs

(labour and materials).• Conversion cost is a term collectively referring to direct labour

and factory overhead costs.



Illustrating the flow of inventoriable costs and period costs• The ‘cost of goods manufactured’ and ‘the cost of goods sold’

sections of the income statement are accounting representations of the actual flow of costs through a production system.

• Note the importance of inventory accounts accounting reports and in the cost flowchart in the following slides.



Cost flows visualised.



Cost of goods manufactured:



Multiple-step income statement:


Variable costing and absorption costing

Absorption costing:• product costs are capitalised• period costs are expensed.

Variable costing:• variable product and period costs are capitalised• fixed product and period costs are expensed.



Comparing income statements for one year• Variable costing is a method of inventory costing in which only

variable manufacturing costs are included as inventoriable costs.• Absorption costing is a method of inventory costing in which all

variable manufacturing costs and all fixed manufacturing costs are included as inventoriable costs.



Explaining differences in operating profit• Operating income will differ between absorption and variable

costing:- the amount of the difference represents the amount of fixed

product costs capitalised as inventory under absorption costing, and expensed as a period cost under variable costing.



Austimber Ltd’s management wants to prepare an income statement for 2014 to evaluate the performance of the timber line. The operating information for 2014 is:



Actual price and cost data for 2014 are:


Variable costing and absorption costing• Austimber Ltd incurs manufacturing, and selling and administration

(S&A) costs only. The cost driver for all variable manufacturing costs is metres produced; the cost driver for variable S&A costs is metres sold. The budgeted (standard) price and cost data for 2014 are the same as the actual price and cost data.

• Work-in-process inventory is zero.• Austimber Ltd budgeted production of 50 000 metres for 2014.

This was used to calculate the budgeted fixed manufacturing cost per metre of $1.20 ($60 000 – 50 000 metres).

• Austimber Ltd budgeted sales of 50 000 metres for 2014, which is the same as the actual sales for 2014.

• The actual production for 2014 is 50 000 metres. As a result, there is no difference between actual and budgeted manufacturing costs in 2014.



The main difference between variable costing and absorption costing is the way in which fixed manufacturing costs are accounted for:• under variable costing, fixed manufacturing costs are treated as an

expense of the period• under absorption costing, fixed manufacturing costs are inventoriable

costs. In our example, the fixed manufacturing cost is $1.20 per metre ($60 000/50 000 metres) produced.

For Austimber Ltd, inventoriable costs per metre produced in 2014 under the two methods are:



Comparative income statements – one year:



Comparative income statements – three years:



Variable costing Absorption costing

Are fixed manufacturing costs inventoried? No Yes

Is there a production volume variance? No Yes

Are classifications between variable and fixed costs routinely made?

Yes Seldom




How do changes in unit inventory levels affect profit?Production = sales Equal Equal

Production > sales Lower HigherProduction < sales Higher Lower




What are the effects on cost‒volume‒profit (for a given level of fixed costs and a given contribution margin per unit)?

Driven byunit level of sales

Driven by:a) unit level of salesb) unit level of

productionc) chosen denominator

level


Variable costing and absorption costing – web links• A YouTube lecture explaining absorption costing and variable

costing can be found at: http://www.youtube.com/watch?v=Sy5BHS9b8-Y

• And the ‘Advantages & Disadvantages of Using Absorption Vs. Variable Costing’ can be found at: http://smallbusiness.chron.com/advantages-disadvantages-using-absorption-vs-variable-costing-34282.html

http://www.youtube.com/watch?v=Sy5BHS9b8-Y

http://smallbusiness.chron.com/advantages-disadvantages-using-absorption-vs-variable-costing-34282.html

http://smallbusiness.chron.com/advantages-disadvantages-using-absorption-vs-variable-costing-34282.html


Absorption costing and performance measures

Undesirable build-up of inventories

• Managers may seek to manipulate income by producing too many units.

• Production beyond demand will increase the amount of inventory on hand:- resulting in more fixed costs being capitalised as

inventory- leaving a smaller amount of fixed costs to be

expensed during the period.

• Therefore:- profit increases and so, potentially, does a manager’s

bonus



Undesirable build-up of inventoriesA manager may:• decide to manufacture products that absorb the highest

amount of fixed costs, regardless of demand (‘cherry-picking’)

• accept an order to increase production, even though another plant in the same firm is better suited to handle that order

• defer maintenance.


Absorption costing and performance measuresIncome effects of inventory build-up:



Proposals for revising performance evaluation• Focus on careful budgeting and inventory planning.• Incorporate a carrying charge for inventory.• Change the period used to evaluate performance.• Include non-financial as well as financial variables in the measures

used to evaluate performance.


A comparison of alternative inventorycosting methods


Contribution margin versus gross margin

• Contribution margin is different from gross margin:- contribution margin = revenues – all variable costs.

• Gross margin is a measure of competitiveness:- gross margin = revenues – cost of goods sold.


Measuring costs requires judgement

Different meanings of product costs• Pricing and product-mix decisions – the manager’s interest is in the

overall (total) profitability of different products.• Australian Accounting Standards state that product costs include

only inventoriable (manufacturing) costs.


A framework for cost accounting and cost management

• Calculating the cost of products, services, and other cost objects.

• Obtaining information for planning and control, and performance evaluation.

• Analysing the relevant information for making decisions.


A framework for cost accounting and costmanagement – web link

• A research report ‘A Management Accounting Framework’ can be found at: http://www.ues.ac.ir/files/education/dianati_84cf9/a_management_accounting_framework.pdf

http://www.ues.ac.ir/files/education/dianati_84cf9/a_management_accounting_framework.pdf

http://www.ues.ac.ir/files/education/dianati_84cf9/a_management_accounting_framework.pdf

ch02 ppt hongren costaccounting 2e

Documents

cost assignment

cost objectdistinguish

cost management

cost accumulation

predicted cost

budgeted cost

actual cost

particular cost object