ie 475 advanced manufacturing costing techniques lecture notes #2 cost concepts
TRANSCRIPT
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Module Learning Objectives
After completing this module, IE 475 students should be able to: Understand the strategic role of basic cost concepts Explain the cost driver concepts at the activity, volume,
structural, and executional levels Explain the cost concepts used in product and service
costing Demonstrate how costs flow through the accounts Prepare an income statement for both a manufacturing firm
and a merchandising firm Explain the cost concepts related to the use of cost
information in planning and decision making
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Basic Definitions
A cost is
incurred when aresource is used for
some purpose
A cost isincurred when a
resource is used forsome purpose
Costs may be collected intogroups called cost pools
Costs may be collected intogroups called cost pools
A cost object is any product, service, or unit towhich costs are assigned forsome management purpose.
A cost object is any product, service, or unit towhich costs are assigned forsome management purpose.
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Basic Definitions (cont.)
Cost assignment Process of assigning costs to cost pools or from cost
pools to cost objects Direct cost
Can be conveniently and economically traced directly to a cost pool or a cost object
Indirect cost Has no convenient or economical way to be traced
from the cost to the cost pool or from the cost pool to the cost object
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Basic Definitions (cont.)
Cost allocation Assignment of indirect costs to cost pools and cost
objects Allocation bases
Cost drivers used to allocate costs
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Costs, Cost Pools, CostObjects, and Cost Drivers
Electric Motor
Materials Handling
Supervision
PackingMaterials
AssemblyAssembly
PackingPacking
Dishwasher
Washing Machine
FinalInspection
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Direct Materials
Direct materials include The cost of materials in the product
Less purchase discounts but including freight and related charges
Reasonable allowance for scrap and defective units
+ FLOURFLOUR+MILKMILKSUGARSUGAR =
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Indirect Materials
Materials used in manufacturing that are not physically part of the finished product
Sweeping
CompoundCleaning
Material
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Direct and Indirect Labor Costs
Direct labor Includes the labor used to manufacture the product or
to provide the serviceIndirect labor
Includes supervision, quality control, inspection, purchasing and receiving, and other manufacturing support costs
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Other Indirect Costs Other indirect costs such
as building and equipment depreciation,property taxes, insurance, and utilities . . . .
. . . . are combined with indirectlabor and indirect materials into
a single cost pool called . . . .
FactoryFactoryOverheadOverheadFactoryFactory
OverheadOverhead
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Prime Cost and Conversion Cost
Manufacturing costs are oftencombined as follows:
DirectMaterials
DirectMaterials
DirectLaborDirectLabor
FactoryOverheadFactory
Overhead
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Identifying Cost Drivers
A critical first step in achieving a competitive advantage is to identify the key cost drivers in the firm or organization
What is a cost driver? Any factor that has the effect of changing the level of
total cost Examples
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Cost Drivers
Cost drivers play two major roles in cost management: Enable the assignment of costs to cost objects Explain cost behavior
The four types of cost drivers are: Activity-based Volume-based Structural Executional
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Types of Cost Drivers Activity-basedActivity-based
Volume-basedVolume-based
StructuralStructural
ExecutionalExecutional
Identified using activity analysis, a detailed description of specific
activities performed inthe firm’s operations.
Relationship between costs andvolume measures such as unitsproduced, direct labor hours,or quantity of materials used.
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Volume-based Cost Drivers
Many cost drivers are volume-based
The cost driver is the amount produced or the quantity of service provided The more you produce, the more cost you incur
An important concept associated with volume-based cost drivers is that of the relevant range
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Volume-based Cost Drivers (cont.)
The relevant range is the range of the cost driver in which the actual value of the cost driver is
expected to fall, and for which the relationship is assumed to be
approximately linear
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Volume-based Cost Drivers (cont.)
Total Variable Cost
$6,600
$6,500
$3,000
3,500 3,600Units of the Cost Driver
Total Cost
Variable cost is the change in totalcost associated with each change in the
quantity of the cost driver
Total CostTotal Cost
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Volume-based Cost Drivers (cont.)
$6,600
$6,500
$3,000
3,500 3,600Units of the Cost Driver
Total Cost
Total Fixed Cost
Fixed cost is the portion ofthe total cost that does not
change with a change in the quantity of the cost driver,within the relevant range.
Fixed cost is the portion ofthe total cost that does not
change with a change in the quantity of the cost driver,within the relevant range.
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Volume-based Cost Drivers (cont.)
Unit Cost (or average cost) Total manufacturing cost (materials, labor, and overhead) divided
by units of output Useful concept in setting prices and in evaluating product
profitability
Marginal cost Additional cost incurred as the cost driver increases by one unit
Used interchangeably with differential cost or incremental cost Under the assumption of linear cost within the relevant range, the
concept of marginal cost is equivalent to the concept of unit variable cost
Materials: Each unit of final product requires: Mat 1 20 $/unit 2 units of mat 1 Mat 2 10 $/unit 1 unit of mat 2 Mat 3 20 $/unit 3 units of mat 3Labor: 10 $/hr 3 hrs of laborOverhead: Rent 500 $/year Security 100 $/year Electricity 80 $/year Water 60 $/year
Units of Output
Variable Cost
Fixed Cost
Avg Unit Var Cost
Avg Unit Fixed Cost
Avg Unit Cost
0 $0 $0 $0.00 $0.00 $0.001 $140 $740 $140.00 $740.00 $880.002 $280 $740 $140.00 $370.00 $510.003 $420 $740 $140.00 $246.67 $386.674 $560 $740 $140.00 $185.00 $325.005 $700 $740 $140.00 $148.00 $288.006 $840 $740 $140.00 $123.33 $263.337 $980 $740 $140.00 $105.71 $245.718 $1,120 $740 $140.00 $92.50 $232.509 $1,260 $740 $140.00 $82.22 $222.22
10 $1,400 $740 $140.00 $74.00 $214.0011 $1,540 $740 $140.00 $67.27 $207.2712 $1,680 $740 $140.00 $61.67 $201.6713 $1,820 $740 $140.00 $56.92 $196.9214 $1,960 $740 $140.00 $52.86 $192.8615 $2,100 $740 $140.00 $49.33 $189.3316 $2,240 $740 $140.00 $46.25 $186.2517 $2,380 $740 $140.00 $43.53 $183.5318 $2,520 $740 $140.00 $41.11 $181.1119 $2,660 $740 $140.00 $38.95 $178.9520 $2,800 $740 $140.00 $37.00 $177.00
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Volume-based Cost Drivers (cont.)
Unit Cost (or average cost)
Illustration ofAverage Costs per Unit
$0
$100
$200
$300
$400
$500
$600
$700
$800
$900
$1,000
Ave
rag
e C
ost
Units of Output
Illustration ofAverage Costs per Unit
Avg Unit Var Cost
Avg Unit Fixed Cost
Avg Unit Cost
$0
$100
$200
$300
$400
$500
$600
$700
$800
$900
$1,000
Ave
rag
e C
ost
Units of Output
Illustration ofAverage Costs per Unit
Avg Unit Var Cost
Avg Unit Fixed Cost
Avg Unit Cost
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Types of Cost Drivers
Activity-basedActivity-based
Volume-basedVolume-based
StructuralStructural
ExecutionalExecutional
Involves strategic plans and decisions: Scale Experience Technology Complexity
Short-term operational decisions: Workforce involvement Production process design Supplier relationships
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Structural Cost Drivers
Scale How much should be invested?
Experience How much prior experience does the firm have in its
current and planned products and services? Technology
What process technologies are used in manufacturing, and in distributing the product or service?
Complexity What is the firm’s level of complexity?
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Executional Cost Drivers
Workforce involvement Are the employees dedicated to continual
improvement and quality? Design of the production process
Can the layout of equipment and processes and the scheduling of production be improved?
Supplier relationships Can the cost, quality, or delivery of materials and
purchased parts be improved to reduce overall costs?
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Value Chain of Product Costs
Product inventory for both manufacturing and merchandising firms is treated as an asset on their balance sheets
So long as the inventory has market value, it is considered an asset until the inventory is sold
Cost of goods sold Cost of the product transferred to the income
statement when inventory is sold
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Product Costs
Product costs for a manufacturing firm include only the costs necessary to complete the product
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Period Costs
Period costs are all non-product expenditures for managing the firm and selling the product Period costs are expenses because there is no expectation
that they will produce future value Include primarily the general, selling, and administrative
costs necessary for the management of the company but are not involved directly or indirectly in the manufacturing process
Sometimes referred to as operating expenses or selling and administrative expenses
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Manufacturing, Merchandising, and Service CostingThree Inventory Accounts
Materials inventory Keeps the cost of the supply of materials used in the
manufacturing process or to provide the service Work-in-Process inventory
Contains all costs put into the manufacture of products that are started but not complete at the financial statement date
Finished goods inventory Holds the cost of goods that are ready for sale
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Inventory Formula
BeginningInventoryBalance
CostAdded
CostTransferred
Out
EndingInventoryBalance
+ +=
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Income Statement for a Manufacturing Firm
Manufacturing firms require a two-part calculation for Cost of Goods Sold
The first part combines the cost flows affecting the Work-in-Process Inventory account to determine the amount of Cost of Goods Manufactured Cost of Goods Manufactured is the cost of goods
finished and transferred out of the Work-in-Process Inventory account this period
The second part combines the cost flows for the Finished Goods Inventory account to determine the amount of the cost of the goods sold and net income
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Cost Concepts for Planning andDecision Making
Relevant Cost This concept arises when the decision maker must
choose between two or more options Must determine which option offers the highest benefit
($) A relevant cost has the following two properties:
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Opportunity Cost
Opportunity Cost is the benefit lost when choosing one option precludes receiving the benefits from an alternative option
Example: If you werenot attending college, andyou could be earning$18,000 per year, then youropportunity cost of attendingcollege for one year is $18,000.
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Sunk Costs
Sunk costs are costs that have been incurred or committed in the past and are therefore irrelevant
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.