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Chapter 2 Introduction to Cost Terms and Purposes Cost A cost is the value of economic resources (e.g., money) sacrificed or used up to achieve a particular objective (e.g., produce a product or perform a service). Following are some examples of costs that may be incurred by a business organization: o On Jan. 1, 2007 ABC Co. purchased a machine for $100,000 to be used in producing a certain product “X”. The cost of acquiring the machine is the amount paid or to be paid in future so as to acquire the machine for the purpose of using it in production activities. o During 2007, ABC consumed 20% of the value of the machine in production. Part of the cost of producing product “X” is the amount of resources consumed from the machine during 2007, which is called depreciation $20,000 (100,000 * 20%).

Cost Object A cost object is anything for which a separate measurement of cost is desired or needed (e.g., cost of a product, a machine, a service, or a process). Cost objects can vary in size from an entire company, to a division or program within the company, or down to a single product or service.

Cost Driver(s) A cost driver is any activity (e.g., production volume) or factor (e.g., time) that causes the total amount spent on a particular cost object to change. For example, the total cost of renting a car is driven by all or some of the following factors: number of miles driven, number of days the car is rented, the type and/size of the car,…etc. Each of these factors is a cost driver for cost of renting a car. Change in the cost driver result in a changes in the total costs incurred. As a manager, you should attempt to continuously reduce costs by efficiently managing the use of cost drivers. Thus, identifying the cost drivers is the first step to control costs. Drive the costs up or down.

Material Cost: Direct material:

1. seen in the final product2. economic/visible to trace

Indirect Material:

Labour Cost: Direct: related to productionIndirect: unrelated to the production, such as security guards.

Variable Overhead costRent/Insurance/Telephone charges -> Anything that’s not direct material/labour.

Fixed Overhead cost- Constant such as insurance.

Cost Behavior

For the purposes of planning, control, and decision making, managers need to understand how the TOTAL amount spent on a particular cost object reacts to changes in a cost driver as measured, for example, by production or sales volume.

- Unit variable cost is fixed or constant. - Total variable cost change

Rent is $500 - Total fixed cost is fixed or constant- Unit fixed cost is variable

o If 1 student comes then $500 rent/student, 2 students: 250/student, 5 students: $100/student etc.Ex: Lecture hall teaching

Cost Estimation Cost estimation is defined as the development of a well-defined relationship between a cost object and its cost drivers, for the purpose of identifying cost behavior and predicting future costs. 2

Cost Assignment Cost assignment is the process of measuring the amount of costs consumed by a particular cost object from the costs incurred. There are two stages in which an accounting system accounts for costs: 1. Cost accumulation (traced): collection of cost data in some organized means in an accounting system. Traced

2. Cost assignment (untraced): is a general term that describes the process of assigning (charging) costs incurred to a cost object. The method of assigning costs to cost objects depends on whether the relationship between the costs incurred and the cost objects is direct or indirect. Direct costs are traced to their particular cost objects while the indirect costs are allocated to cost objects. -> best cost driver such as # of students in faculty, man power etc. When something cannot be traced to a specific activity then you use cost drivers.

Glue, nails, paint may trace these costs to the product at the sole instruction of managers: True

Direct material are ALWAYS variable.

Sometimes its not viable economically to trace a direct material to an object so you may treat it as indirect: Such as paint coat on a small table which is very small.

1. Direct costs of a cost object are those costs that can be traced easily to a cost object in an accurate and economically feasible (cost-effective) way. Examples of direct costs in a manufacturing setting include:

Direct materials costs — the costs of all materials and parts that become an integral part of the finished product and can be easily traced into it. Direct labor costs — wages and fringe benefits paid to production line workers involved directly in manufacturing a product. 2. Indirect costs of a cost object are related to the particular cost object but cannot be traced to that cost object in an economically feasible (cost-effective) way. Indirect costs, therefore, should be allocated to the cost objects using an allocation BASE factor. Examples of indirect costs in a manufacturing setting include all production facilities required to transforming raw materials into finished goods such as depreciation of machines, maintenance cost, rent of the factory, and salary of supervisors.

Note the following: 1. The classification of costs into direct and indirect are defined with reference to a specific cost object. A particular cost can be classified as direct with respect to a certain cost object and indirect with respect to another cost object.

2. A cost would be considered indirect for one of two reasons: either it is impractical or it is impossible to trace the cost to the cost object. For example, it could be possible to measure the precise amount of nails or the amount of glue used on each table produced at a furniture plant, but it wouldn’t be worth the effort. Instead, cost of nails and glue would typically be considered an indirect material and would be included in overhead. 3

Raw Materials (R.M.) ***Know terminology very well !!! ***

BB R.M used + purchase R.M.

D.M.Direct materials indirect materials Purchased (D.M.) purchased (I.M.)

____________________________E.B.

Work in Progress or process (WIP)

BB cost of goods manufactured (C.O.G.M)+ DM used+ Direct Labor (D.L)+ Manufacturing overhead (MOH)__________________________________E.B.

DM + DL used = Prime CostsD.L. + MOH = Conversion costs

DM + DL + MOH = Total Manufacturing costs (TMC)

Conversion costs may be assigned to a product rather than accumulated to a product. -> False

Prime costs may be allocated to a product rather -> FalseDirect costs are not allocated!

Finished Goods (F.G.)

BB ? = Cost of goods sold (COGS)+ C.O.G.MFrom W.I.P Cost of goods available for sale (COGAS)_____________________E.B

Example:

A

manufacturer of machinery currently produces equipment for a single client. The job is expected to take the entire month of April to complete. The client supplies all required raw material on a no-cost basis. The manufacturer contracts to complete the desired units from this raw material. The total production costs incurred by the manufacturer are correctly identified as: A) Direct Lbor. B) Factory overhead. DL + MOH <- MOH becomes direct in this case since it’s their only client

C) Direct costs. D) None of the above. 4 . <- never ‘none of the above’ an answer on exams

Exactly equal amount of numbers between A, B, C, D, E

Cost ClassificationsDifferent costs for Different Purposes

Different types of cost information are needed for different purposes. There are two basic uses of cost information:

1. Product Costing: Product costing means calculating the cost of production for the purpose of determining the Cost of Goods Sold (CGS) for income determination and cost of Ending Inventory to prepare the balance sheet.

2. Decision Making. Mangers need to make different types of decisions to run the company. Each decision requires different information.

1. Cost Flows in a Manufacturing Company(Product Costing for External users)

Inventory valuations and Cost of Goods Sold. In a manufacturing company, raw materials purchases are recorded in a raw materials inventory account. These costs are transferred to a work in process inventory account when the materials are released to the production departments. Other manufacturing costs—direct labor and manufacturing overhead—are charged to the work in process inventory account as incurred. As work in process is completed, its costs are transferred to the finished goods inventory account. These costs become expenses only when the finished goods are sold. Period expenses are taken directly to the income statement as expenses of the period.

Product (Inventoriable) Costs vs. Period Costs. A. Product Costs. Product costs are the costs charged to the units produced as they are incurred. They

become part of the cost of goods manufactured and treated as inventory (i.e., asset) until they are sold. At this point, they become cost of goods sold and charged to the income statement at the end of the period.

B. Period Costs. Period costs are expensed in the time period in which they are incurred. All selling and administrative costs are typically considered to be period costs. 5

MANUFACTURING of a product requires the use of Raw Materials, Labor, and Production Facilities (e.g. Machines, Building, Electricity, etc).

• Raw Materials (RM) are the tangible items that will be used to make the physical form of the product. RM Could be classified as either Direct Materials (DM) or Indirect Materials (IDM). DM would include most of the raw materials necessary to construct the finished product. IDM would include all others materials used in production.

• Direct Labor (DL) represents the wages paid to those who actually transform the materials or assemble the product. This would usually include those who operate the machines that transform the product. Indirect labor (IDL) would include all others who work in the factory and don’t actually transform the materials or assemble the product.

• Factory Overhead (FOH) or Manufacturing Overhead (MOH) includes all the costs incurred in the factory except for DM and DL. Every FOH item would be considered an Indirect Cost.

COST FLOWS EXAMPLE Ryder Company incurred the following costs last month: Purchases of raw materials ............................................................................

$200,000

Direct labor 270,000 Manufacturing overhead: Indirect materials .......................................................................................

$ 5,000

Indirect labor..............................................................................................

100,000

Utilities, factory .........................................................................................

80,000

Property taxes, factory ...............................................................................

36,000

Insurance, factory ......................................................................................

9,000

Equipment rental .......................................................................................

70,000

Depreciation, factory .................................................................................

120,000 420,000

Required: Calculate the following:

• Cost of direct materials used in production last month

• Cost of goods manufactured during last month

• Cost of goods sold during last month

SOME ISSUES RELATED TO MEASURING THE COST OF LABOR:

I DLE TIME Idle time represents the wages of direct labour workers who are idle due to machine breakdowns, material shortages, power failures, and the like. Although the cost of the idle time can be traced to direct labor, it should be treated as indirect labor added to overhead.

EXAMPLE: An assembly line worker is idle for 2 hours during the week due to a power failure. If the worker is paid $15 per hour and works a normal 40 hour week, labour cost would be assigned as follows between direct labour and manufacturing overhead: Direct labour cost ($15 X 38 hours)............................................................. $570 Manufacturing overhead cost ($15 x 2 hours) ............................................ 30 Total cost for the week ............................................................................... $600

OVERTIME PREMIUM Overtime premium is the wage rate paid to workers (for both direct labor and indirect labor) in excess of their straight-time wage rates. Any overtime premium paid to factory workers (direct as well as indirect labor) is usually considered to be part of manufacturing overhead. However, if the customer is responsible for causing the overtime, then the overtime premium paid to direct workers will be treated as direct labor. Note that this case has to be explicitly stated, otherwise it should be treated indirect labor.

1. Idle time 2. Bad scheduling3. A Client requests it (they want their product done today).

***Rodney W is paid $20/hour for straight-time and $40 an hour for overtime. One week he worked 50 hours, which included 40 hours of regular time and 10 hours of overtime. The 10 hours of overtime include: 4 hours of idle time caused by material shortages; 4 hours of overtime due to bad scheduling; and 2 hours caused by a special request from a customer who made a late order. How much is charged as direct labour and indirect labour. TRY AT HOME!!!!

EXAMPLE: Assume again that an assembly line worker is paid $15 per hour. The worker is paid time and a half for overtime (time in excess of 40 hours per week). During a given week this employee works 46 hours and has no idle time. Labor cost would be allocated as follows: Direct labor cost ($15 X 46 hours) ................................................................ $690 Manufacturing overhead cost ($7.50 X 6 hours) ........................................... 45 Total cost for the week ................................................................................ $735

LABOUR FRINGE BENEFITS Labor fringe benefits are made up of employment related costs paid by the employer. These costs are handled in two different ways by companies: 1. Many firms treat all such costs as indirect labor and add them to manufacturing overhead. 2. Other firms treat the fringe benefits that relate to direct labor as additional direct labor cost and those relate to indirect labor as FOH. 8

2. Classifying Costs for Decision Making

Understanding Cost Behavior Cost behavior describes the way that the total amount spent on a specific cost reacts to changes in activity levels in terms of production or sales volume. Costs may stay the same or may change proportionately in response to a change in activity. The range of activity over which cost behaviour pattern remains valid is called “Relevant Range”. Knowing how a cost reacts to a change in the level of activity helps us to classify costs as either variable or fixed cost. This classification help managers to make optimal decisions and perform their planning and control functions. Variable costs A variable cost is a cost that changes (increases and decreases) in total in direct proportion to changes in the related level of activity or volume. Total variable costs for a given situation are equal to the number of units multiplied by the variable cost per unit. Variable costs include things like labor and materials. Some overhead [indirect costs] such as indirect labor, supplies and some utilities are also variable EXAMPLE:

A company manufactures microwave ovens. Each oven requires a timing device that costs $30. The per unit and total cost of the timing device at various levels of activity (i.e., number of ovens produced) would be: Cost per

Number of Total Variable

Timing Ovens Cost—Timing Device Produced Devices $30 1 $ 30 30 100 3,000 30 200 6,000