Chapter 2: Basic Cost Management Concepts

A Cost Management System (CMS): is a management planning and control system with the following objectives

1) Measure the cost of the resources consumed in performing the organization's significant activities and measure the unused capacity of those resources 2) Identify and eliminate non-value-added costs. 3) Determine the efficiency and effectiveness of all major activities in the enterprise. 4) Identify and evaluate new activities that can improve the future performance of an organization.

After identifying cost and cost drivers for Comet's operations, the cost management team went on the examine the relationship of various costs to the activities performed.

1) Such a relationship is referred to as cost behavior. 2) Two types are fixed and variable costs.

Basic production processes can be classified into four standard types based on

1) The nature of the product and the manufacturing processes define the manufacturing costs incurred. 2) Therefore, the management team is in a better position to manage these costs if they understand the relationship between the production process and types of cost incurred.

Period Cost

1) These costs are identified with the period of time in which they are incurred rather than with units purchased or produced goods. 2) Period costs are recognized as expenses during the time period in which they are incurred.

Another important task of the manager and accountants is to weigh the benefits of providing information against the costs of generating, communicating, and using that information.

1) When managers receive more information than they can utilize effectively, information overload occurs. 2) Struggling to process large amounts of information, managers may be unable to recognize the most important facts.

Sunk Costs:

1) are costs that have been incurred in the past. 2) Consequently, they do not affect future costs and cannot be changed by any current or future action. 3)These costs are irrelevant to any future decisions.

Materials that do become an integral part of the finished product but are insignificant in cost are often also classified as

1) indirect material. 2) Various machine screws for computers as so inexpensive that its not worth tracing

Opportunity Cost:

1) is defined as the benefit that is sacrificed when the choice of one action precludes taking an alternative course of action. 2) From an economic perspective, a dollar of opportunity costs associated with an action should be treated as equivalent to a dollar out-of-pocket

Overtime premium and the cost of idle time should be classified as ________, rather than associated with a particular production job, because the

1) manufacturing overhead 2) particular job on which idle time or overtime premium may occur tends to be random.

Selling Costs: Include

1) salaries, commissions, and travel costs of personnel, 2) shipping costs included by a manufacturer 3) and the cost of advertising or promotion.

Assembly:

1: A few major projects; higher volume; lower diversity; minimal customization 2: Automobile assembly line.

The resource can be used up (expended) by any of the following:

1: Cash, expended directly 2: A promise to use up cash in the future, recognized as a liability (accounts payable) or; 3: The reduction in value of a recorded asset such as plant and equipment (via depreciation) or inventory (via cost of goods sold)

Air France provides transportation services

1: Direct materials include costs such as jet fuel, aircraft parts, food and beverages. 2: Direct labor includes the salaries of the flight crew and wages of aircraft maintenance personnel. 3: MO includes depreciation of bagging-handling equipment, insurance, overtime premium and airport landing fee.

Continuous Flow:

1: High production volume; highly standardized commodity products. 2: Production of gasoline

Research and Development Costs:

1: Include all costs of developing new products and services. 2: The cost of running labs, building prototypes of new products, and testing new products are all classified as R&D costs.

four standard types of Basic production processes

1: Job Shop 2: Batch 3: Assembly 4: Continous Flow

Job Shop production process:

1: Low production volume; little standardization; one-in-a-kind products. 2: Custom Home Builder

Batch production process:

1: Multiple products; low volume; high product diversity; some customization 2: Batch production of heavy equipment

Difference between direct materials and raw materials

1: There is a difference: before material is entered into the production process, its cost is classified as raw material 2: After it enters production; its cost are then reclassified as direct material (which is part of work-in-process inventory)

Out-of-pocket cost to make the softballs opposed to the baseball would be the

1: cost of manufacturing them 2: In making the decision to do the softball order, the company should both consider out of pocket costs and opportunity costs.

An overtime premium is the

1: extra compensation paid to an employee who works beyond the time normally scheduled. 2: Usually, 1.5x the normal rate.

Administrative Costs:

1: refer to all the costs of running the organization as a whole. 2: The salaries of top management personnel and the costs of accounting, legal, and public relations activities are examples.

A fixed cost:

1: remains unchanged in total as the level of activity (cost driver) varies. 2: If activity increases or decreases by 20%, total fixed costs remain the same.

A special case of the differential-cost concepts is marginal cost, which is

1: the incremental cost of producing one additional unit. 2: One laptop is 1000 total cost, 2 laptops is 1900 total cost. Marginal cost is 900$.

There are no inventoried product costs at Southwestern Airlines (service firm)

1:Although this firm does engage in the production of air transportation services, its service output is consumed as soon as it is produced.

indirect cost of that cost object.

A cost that is not directly traceable to a particular cost object is called an

Schedule of goods sold:

A detailed schedule showing the cost of goods sold and the change in finished-goods inventory during an accounting period.

Schedule of goods manufactured:

A detailed schedule showing the manufacturing costs incurred during an accounting period and the change in work-in-progress inventory

In most organizations, different types of costs respond to widely different cost drivers.

1) For example, in a manufacturing firm, the cost of assembly labor would be driven by the quantity of products manufactured as well as the number of parts in each product. 2) Conversely, the cost of machine set up labor would be driven by the number of production runs. 3) The cost of material-handling labor would be driven by material-related factors such as quantity and size of raw materials used, the number of parts, and the number of raw material shipments received.

activity-based costing (ABC) system.

1) In the ABC system, the cost of the organization's significant activities are accumulated and then assigned to good and services in accordance with how the activities are used in the production of those goods and services. 2) An ABC system helps management understand the casual linkages between activities and cost.

Indirect Costs

Advertising, Plant manager: The plant manager's duties are important to the smoothe functioning of each of the plant's department, but there is no way to trace a portion of the plant manager's salary cost to each department

Manufacturing Overhead:

All other costs of manufacturing are classified as manufacturing overhead, which includes three types of costs: indirect material, indirect labor, and other manufacturing costs.

cost object

An entity, such as a particular product, service, or department, to which a cost is assigned is called a

activity accounting

An important objective of a cost management system is to trace as many costs as possible directly to the activities that cause them to be incurred Sometimes called activity accounting, this process is vital to management's objectives of eliminating non-value-added costs.

Out-of-pocket costs:

Are those that require the payment of cash or other assets as a result of their incurrance.

Illustration of an assembly production environment

Comet purchases computer parts such as motherboard, computer chip, hard drive, and then assemble these parts into a variety of devices such as tablet computers, desktops, or laptops.

But cost can have different meanings depending on the context.

Cost data that are classified and recorded in a particular way for one purpose may be inappropriate for another.

uncontrollable costs

Costs that a manager cannot influence greatly are classified as uncontrollable costs of that manager.

example of fixed cost

Examples: Depreciation, property tax, Salary of manager is fixed cost.....Her salary does not change with units produced 2) Graph is straight line

Cost data that are classified and recorded in a particular way for one purpose may be inappropriate for another.

For example, the cost incurred producing gasoline are important in measuring ExxonMobile's income for the year However, those cost may not be useful in planning the company's refinery operations for the next year if the cost of oil changes significantly or if the methods to produce gasoline have improved.

controllable cost

If a manager can control or heavily influence the level of a cost, then that cost is classified as a controllable cost of that manager.

Many costs are not under the control of an individual

In classifying costs as controllable or uncontrollable, managerial accountants generally focus on a managers ability to influence costs.

cost of goods sold.

In the period of sale, where the inventory asset is reduced, the product costs that have been recorded are reclassified as

operating expense

Service industry firms usually refer to the costs of producing services as

Gross Profit:

Sometimes called gross margin; is the portion of revenues left after deducting just the costs that have been classified as a class of sales (cost of goods/products sold), without considering any other costs of operating the company.

Operating Income:

Sometimes called operating profit; goes one step further to report the profit remaining from revenues after deducting both cost of sales and all period costs of operation.

responsibility accounting.

Sometimes cost management is facilitated by tracing costs to the department or work center in which the cost was incurred. Such tracing of a cost to a department is known as

Much of this information focuses on the cost incurred in the organization. For example in formulating its overall strategy, Southwest Airlines management team considered

Southwest Airlines management team considered the cost saving necessary to succeed as a low-price, high-service airline.

When managers receive more information than they can utilize effectively, information overload occurs

Struggling to process large amounts of information, managers may be unable to recognize the most important facts.

In addition to accounting cost classifications, such as production and period costs, there are also economic concepts in classifying cost.

Such concepts are often useful in helping managers decide what cost information is relevant to the decisions faced by the organization.

EXAMPLES of indirect labor

Such personnel include production department supervisors, quality control inspectors, and assembly plant security guard.

It is important to determine which of these cost concepts is most appropriate in each situation.

The accountant strives to communicate the cost information to the users in the most effective way possible, and to structure the organizations accounting information system to record data that will be useful for a variety of purposes.

Indirect Material:

The cost of materials that are required for the production process but do not become an integral part of the finished product are classified as indirect material cost. Example: Drill bit used in the metal-fabrication department at Ford.

Indirect Labor:

The cost of personnel who do not work directly on the product, but whose services are necessary for the manufacturing process are classified as indirect labor.

Direct-Labor Costs:

The costs of salary, wages, and fringe benefits for personnel who work directly on the manufactured product.

When identifying a cost driver, the manager or accountant should consider the extent to which a cost or pool of costs varies in accordance to the cost driver.

The higher the correlation between the cost and cost driver, the more accurate will be the resulting understanding of the cost behavior.

Cost Drivers:

The kinds of activities that cause cost to be incurred.

A cost can be a direct cost of one department or subunit but an indirect one of another department.

While the salary of the plant manager is an indirect cost of the plant's department, the manager's salary is a direct cost of the plant that he manages.

Sunk Cost examples

acquisition cost of equipment previously purchased, manufacturing cost of inventory on hand.

Notice the emphasis in a cost management system is on the organization's activities. This emphasis, sometimes called

activity accounting, is crucial to the goal of producing quality goods and services at the lowest possible cost.

An important objective of a cost management system is to trace as many costs as possible directly to the activities that cause them to be incurred Sometimes called

activity accounting, this process is vital to management's objectives of eliminating non-value-added costs.

Managerial accountants have developed a system for determining the costs of producing goods and services called

activity-based costing (ABC) system.

Using an ABC system to improve the operations of an organization is called

activity-based management, or ABM.

The product cost of manufactured inventory includes

all of the costs incurred in its manufacture.

In the period of sale, where the inventory asset is reduced, the product costs that have been recorded are reclassified as

an expense called cost of goods sold.

Low inventories, relative to its sales volume, are characteristics of manfuactuers using

an online sales business model

The cost of fringe benefits associated with any labor spending classified as direct labor should also be classified

as direct-labor costs.

All other manufacturing costs that are neither material nor labor costs are classified

as manufacturing overhead. 2) Examples: These costs include various costs of the plant such as the depreciation of building and equipment, property taxes, insurance, and utilities like electricity, overtime premium, idle time, as well as the cost of operating service departments.

Operating Expenses are treated

as period costs and as such are expensed during the period in which they are incurred.

Since retailers, wholesalers, and manufacturers sell inventoriable products, their balance sheet is also affected

by production costs.

One of the most important cost concepts involves the way a cost changes in relation to

changes in the activity of an organization. (cost driver)

A Variable Cost:

changes, in total, in direct proportion to a change in the level of activity (or cost driver). 2) Example: If activity increases 20%, then total variable cost will increase by 20%

A cost driver is a

characteristic of an activity or event that causes cost to be incurred.

Much of this information focuses on the cost incurred in the organization.....In planning Southwest flights and route schedules, managers must

consider aircraft fuel cost, salary of flight crew and airport landing fee.

Graph of variable cost

consistent incline

If a manager can control or heavily influence the level of a cost, then that cost is classified as a

controllable cost of that manager.

A product cost is a

cost assigned to inventory, to goods that are either purchased or manufactured for resale.

An expense is defined as the

cost incurred when a resource (asset) is used up for the purpose of generating revenue.

An entity, such as a particular product, service, or department, to which a cost is assigned is called a

cost object.

(Costs in service firm) Exercise equipment is fixed asset that depreciates, and the depreciation expense becomes part of

cost of service (or operating expense)

The amount of change in fixed cost per unit begins to

decline as activity level increases.

The phrase different cost for different purpose is often used to convey the notion that

different characteristics of costs can be important to understand in a variety of managerial circumstances.

A cost that can be traced to a particular cost object is called a

direct cost of that object. 2) Direct cost of paint on a BMW car is a direct cost of the painting department

Similarly, the salary of an auto mechanic of a walmart store is also

direct labor, a direct cost of the service being sold (the cost object)

Total Manufacturing Costs =

direct material + direct labor + manufacturing overhead

At the same time, the paint on the car is also a direct cost of the BMW that is being manufactured, and as we saw earlier, when the cost object is a product or service and the direct cost is a material, we call it

direct material.

Service departments also known as support departments are those that

do not work directly on manufacturing products but are necessary for the manufacturing process to occur, such as equipment-maintenance departments. (Sometimes called workcenters)

Net income is only discussed when the

effect of taxes impacts a decision.

To summarize, the marginal cost of production is the

extra cost incurred when one more unit is produced.

(Costs in service firm)The fee's paid to play the music is a

fixed cost because this cost does not change with the amount of clients. 2) Exercise depreciation would also be fixed cost.

The important point is that different cost concepts and classifications are used

for different purposes.

Manufacturers and retails income statement have an item called

gross profit.

Fringe benefits include the costs of providing

health insurance, making pension and social security contributions, and other non-salary benefits provided by the employer to the employee.

While less commonly observed in service firms, the same classifications used

in manufacturing companies can be applied.

2) The increase from one alternative to another is called an (for differential costs)

incremental cost. (for differential costs)

A cost that is not directly traceable to a particular cost object is called an

indirect cost of that cost object.

Much of this information focuses on the cost incurred in the organization.... In making decisions about locating a new store, Walmart needs

info about the cost of the building, maintaining, equipping, and staffing the store.

Another term for product cost is

inventoriable cost, since a product cost is stored as the cost of inventory until the goods are sold.

(Costs in service firm) The cost of items that are ordered for re-sale, such as gold gym t-shirts, are stored in

inventory as product costs (or inventoriable costs) until the time period when they are purchased. At that time the product costs become cost of services.

Raw Material

inventory includes all materials before they were placed into production.

The product cost is used to value the

inventory of manufactured goods or merchandise until the goods are sold.

Work-in-Progress

inventory refers to manufactured products that are only partially completed at the date when the balance sheet is prepared

On Walmarts balance sheet, the cost of merchandise on store shelves and in warehouses, but not yet sold, is recorded as

inventory.

Included in the current-asset section of each of these balance sheets is

inventory. Manufacturers can have three types of inventory: Raw Material, Work-in-Progress, Finished-Goods inventory

Differential Costs:

is the amount by which the costs differ under two different alternative actions.

Operating income is a very important profit number for managers because

it represents the profits resulting from operations, taking into account all costs of the operations but not the effect of financing (e.g. interest expense), taxes or any other unusual business events.

With more activity means a ______ fixed cost per unit and unit fixed cost ______ as activity increases.

lower, declines

These costs of service firms can be traced to the company's service output, so they comprise part

of the operating expense that match with the operating revenue from the sales of the service.

Service industry firms usually refer to the costs of producing services as

operating expenses.

Manufacturers, retailers, and service all have item called

operating income.

2 Other manufacturing overhead costs include

overtime premium and the cost of idle time.

Selling and administrative costs are always

period costs on any type of company's income statement.

(Costs in service firm) Supplies (paper towel) and other operating costs (trainer salary, utilities, facility depreciation) are

period costs, and they are expensed as operating expense during the period which they are incurred.

All costs that are not product costs are

period costs.

Benefits of measuring and classifying costs are seen in improvements in

planning, controlling, and decision making that the information facilitates.

Cost of sales is valued by

product cost

Finished-Goods inventory

refers to manufactured goods that are complete and ready for sale.

The values of work-in-progress and finished goods are measured by their

refers to manufactured goods that are complete and ready for sale.

As the activity level raises, total fixed cost

remain constant but unit fixed costs decline.

Much of this information focuses on the cost incurred in the organization....Controlling the costs of Southwest Air CPG (Consumer Packed Goods) products requires

requires managers and accountants to carefully measure and manage cost of production.

Sometimes cost management is facilitated by tracing costs to the department or work center in which the cost was incurred. Such tracing of a cost to a department is known as

responsibility accounting.

Period costs are treated the

same way in all types of organizations: retailer/wholesaler, manufacutring and service.

Manufacturers generally prepare a _________ and __________ to summarize the flow of manufacturing costs during an accounting period.

schedule of goods manufactured and a schedule of goods sold 2) These schedules are for internal use by management and not made available to the public

The process of management involves formulating

strategy, planning, control, decision making, and directing operational activities.

Service industry firms and many nonprofit organizations are also engaged in production. What distinguishes these organizations from manufacturers is

that a service is consumed as it is produced, whereas a manufactured product can be stored in inventory.

Idle time is time

that is not spent productively by an employee due to such events such as equipment breakdowns or new setups of production runs.

Much of this information focuses on the cost incurred in the organization....Finally, in directing operational activities, managers in all of these companies need information about

the cost of salary, utilities, security, and a host of goods and services.

Total fixed cost remain the same when activity is changed. However,

the fixed cost per unit changes with activity.

For Procter and Gamble (manufactuer), the costs of manufactured inventory are product costs....All costs incurred in making finished products are stored as inventory costs until the time period when the products are sold. then

the product costs of inventory sold become costs of product sold, an expense on the income statement.

The product cost of merchandise inventory acquired by a retailer or wholesaler for resale consists of

the purchase cost of inventory plus any shipping charges paid by them.

At the most basic level, a cost may be defined as

the sacrifice made to achieve a particular purpose, usually measured by the resources expended or given up.

Cost of Goods Manufactuered:

the total cost of direct materials, direct labor, and manufacturing overhead transferred from work-in-progress inventory to finished goods inventory.

Total variable cost increases proportionally with activity However,

the variable cost per unit remains the same.

Apples, timber, coal are all products that are inventoried at

their product cost until the time period during which they are sold.

Direct material, direct labor, and manufacturing overhead are called product costs because

they are assigned to products and stored in inventory cost until the time period when the manufacturer's products are sold.

One important way of classifying costs is by the

timing of their recognition as expenses for financial reporting.

The term product cost and period cost are used to describe the

timing with which various expenses are recognized.

The average cost per unit is the

total cost, divided by the number of units.

Costs that a manager cannot influence greatly are classified as

uncontrollable costs of that manager.

An important objective of managerial accounting is to assist managers in

understanding and controlling costs. (cost management system)

(Costs in service firm)The costs incurred in Gold's gym that vary directly with activity are

variable costs such as disinfectant wipes 2) The cost driver here would be the number of clients that visited during the period.

Example of Differential Costs:

1) Annual cost of site A for 180,000 vs annual cost of site B for 140,000 mean differential cost of 40,000 2) The increase from one alternative to another is called an incremental cost.

Flow of manufacturing costs: Manufacturers have product-costing systems to keep track of the flow of these product costs from the time production begins until finished products are sold.

1) As material is consumer in production, the cost of these direct materials is removed from the raw-materials inventory account and added to work-in-progress inventory. 2) Similarly, the cost of payroll classified as direct labor and manufacturing overhead expenditures are accumulated in work in progress. 3) When products are finished, their costs are transferred from work-in-progress inventory to finished goods inventory. 4) The costs are then stored in finished goods until the time period where the product is sold 5)At that time, the costs of those products are transferred from finished goods to cost of goods sold, which is an expense of the period when the sale is made.

Give examples of three types of manufacturing costs

Direct Cost(Usually materials), Direct Labor Costs, Manufacturing Overhead

Conversion Costs =

Direct Labor + Manufacturing Overhead 2) Often called conversion costs since they are the cost of converting raw materials into finished products.

Prime Costs =

Direct Material + Direct Labor

activity-based costing (ABC) system.

Managerial accountants have developed a system for determining the costs of producing goods and services called

Direct Costs:

Materials consumed in the manufacturing process, is physically incorporated in the finished product, and can be traced to the product relatively easily.

Manufacturers can have three types of inventory

Raw Material, Work-in-Progress, Finished-Goods inventory

Types of Period Costs

Research and Development Costs, Selling Cost, Administrative Costs

non-value-added costs.

These are the cost of activities that can be eliminated with no deterioration of product quality, performance, or perceived value.

Product costs for Walmart (retail/merchandise) include all costs of acquiring merchandise inventory for resale.

These product costs are classified as inventory until the time period during which the merchandise is sold. Then these costs become cost of sales (cost of goods sold)

These costs of service firms can be traced to the company's service output, so they comprise part of the operating expense that match with the operating revenue from the sales of the service.

They are not product costs, but period costs that are recorded in the accounting period of the expenditure. The reason? 2) Services can not be inventoried for future sale like a tangible product, so their costs don't flow through the WIP and finished good inventories accounts like product do.

Gross Profit means

This profit number provides a view of profitability that is specific to the production process: how much money are we receiving for our goods and services after covering the expense of producing it.

Another important consideration is the cost of measuring the cost driver.

Thus, there is a cost-benefit tradeoff in the identification of cost drivers. 2) As the number of cost drivers used in explaining an organization's cost behavior increases, the accuracy of the resulting information is likely to increase. 3) However, the cost of identifying and tracking the information will increase as well.

Two types of cost behavior

Two types are fixed and variable costs.

activity-based management, or ABM.

Using an ABC system to improve the operations of an organization is called