Cost Chapter 2

prime costs

(direct materials and direct labor) - the wholesale price is the cost of getting the jeans made. - The additional costs involved in selling the jeans to the customer, the administrative costs of the designing company (e.g., 7 For All Mankind or True Religion), and the costs of the retail store that carries them account for the difference between the wholesale cost, an average of $150 per pair, and the retail cost of $300.

The accounting information system can be divided into two major subsystems:

- (1) the financial accounting information system and (2) the cost management information system. - the two systems need not be independent. - Output of each of the two systems can be used as input for the other system.

Accounting Information Systems

- An information system is designed to provide information to people in the company who might need it. - The MRP is a computerized system that keeps track of the purchase and use of raw materials used in manufacturing. These systems may also have subsystems. - For example, a subsystem of the HR system is the payroll system. This is a transaction processing system.

The functional classification is the cost classification required for external reporting.

- In preparing an income statement, production and nonproduction costs are separated. - production costs attached to the units sold are recognized as an expense (cost of goods sold) on the income statement. - Production costs attached to units that are not sold are reported as inventory on the balance sheet. - Marketing and administrative expenses are viewed as costs of the period and must be deducted each and every period as expenses on the income statement. - Nonproduction costs never appear on the balance sheet.

Cost information is also needed for planning and control

- It should help managers decide what should be done, why it should be done, how it should be done, and how well it is being done. - The expected revenues and costs may cover the entire life of the new product. Thus, projected costs of research, development, testing, production, marketing, distribution, and servicing would be essential information. These costs form the basis of the value chain.

A fundamental cost management principle is "Different costs for different purposes."

- Product cost definitions can differ according to the objective being served. - For pricing decisions, product mix decisions, and strategic profitability analysis, all traceable costs along the value chain need to be assigned to the product. - For strategic product design decisions and tactical profitability analysis, costs for production, marketing, and customer service (including customer post-purchase costs) are needed. For external financial reporting, FASB rules and conventions mandate that only production costs be used in calculating product costs. Other objectives may use still other product cost definitions.

Relationship to Other Operational Systems and Functions

- The cost information produced by the cost management information system benefits the whole organization and should have an organization-wide perspective. Managers in many different areas of a business require cost information

Methods of Tracing

- Traceability means that costs can be assigned easily and accurately, using a causal relationship. - Tracing costs to cost objects can occur in one of two ways: (1) direct tracing and (2) driver tracing.

Overhead

- all production costs other than direct materials and direct labor. - Examples include depreciation on buildings and equipment, maintenance, supplies, supervision, materials handling, power, property taxes, landscaping of factory grounds, and plant security.

inseparability

- an attribute of services that means that production and consumption are inseparable. - means that producers of services and buyers of services must usually be in direct contact for an exchange to take place. In effect, services are often inseparable from their producers. For example, an eye examination requires both the patient and the optometrist to be present

Cost objects

- any item such as products, departments, projects, activities, and so on, for which costs are measured and assigned.

Traditional Cost Accounting

- assumes that all costs can be classified as fixed or variable with respect to changes in the units or volume of product produced. Thus, units of product or other drivers highly correlated with units produced, such as direct labor hours and machine hours, are the only drivers assumed to be of importance. These unit- or volume-based drivers are used to assign production costs to products.

indirect materials

- direct materials that form an insignificant part of the final product. - This treatment is justified on the basis of cost and convenience. The cost of the tracing is greater than the benefit of increased accuracy. The glue used in making furniture or toys is an example.

A system

- is a set of interrelated parts that performs one or more processes to accomplish specific objectives. - Notice that each part of the system is critical for achievement of the overall objective. - A system works by using processes to transform inputs into outputs that satisfy the system's objectives.

An accounting information system

- is one that consists of interrelated manual and computer parts and uses processes such as collecting, classifying, summarizing, analyzing, and managing data to provide information to users. - has objectives, interrelated parts, processes, and outputs.

Supplies

- materials necessary for production but that do not become part of the finished product or are not used in providing a service. - Dishwasher detergent in a fast-food restaurant and oil for production equipment are examples of supplies.

The financial accounting information system

- s primarily concerned with producing outputs for external users. - It uses well-specified economic events (e.g., payment of wages, purchases of materials) as inputs, and its processes follow certain rules and conventions. - Among its outputs are financial statements such as the balance sheet, income statement, and statement of cash flows for external users - Financial accounting information is used for investment decisions, stewardship evaluation, activity monitoring, and regulatory measures.

Cost of Goods Manufactured

- the total cost of goods completed during the current period. - The only costs assigned to goods completed are the manufacturing costs of direct materials, direct labor, and overhead. The details of this cost assignment are given in a supporting schedule, called the statement of cost of goods manufactured.

assets

-Many costs do not expire in a given period. These unexpired costs are classified as assets and appear on the balance sheet. - the main difference between a cost being classified as an expense or as an asset is timing

Assigning costs accurately to cost objects is crucial.

Accuracy is not evaluated based on knowledge of some underlying "true" cost. Rather, it is a relative concept and has to do with the reasonableness and logic of the cost assignment methods that are being used. The objective is to measure and assign as accurately as possible the cost of the resources used by a cost object. Some cost assignment methods are clearly more accurate than others.

Activities are a special kind of cost object

An activity is a basic unit of work performed within an organization. An activity can also be defined as an aggregation of actions within an organization useful to managers for purposes of planning, controlling, and decision making. - Notice that an activity is described by an action verb (e.g., paying or designing) and an object that receives the action (e.g., bills or products).

expenses

As costs are used up in the production of revenues, they are said to expire. Expired costs are called expenses. - In each period, expenses are deducted from revenues on the income statement to determine the period's profit. - A loss is a cost that expires without producing any revenue benefit

The cost management information system provides information for three broad objectives:

Costing services, products, and other objects of interest to management Planning and control Decision making

Unfortunately, it is often impossible to physically observe the exact amount of resources being used by a cost object. The next best approach is to use cause-and-effect reasoning to identify factors—called drivers—that can be observed and which measure a cost object's resource consumption.

Drivers are factors that cause changes in resource usage, activity usage, costs, and revenues. Driver tracing is the use of drivers to assign costs to cost objects. Although less precise than direct tracing, driver tracing can be accurate if the cause-and-effect relationship is sound.

Indirect costs cannot be traced to cost objects.

Either there is no causal relationship between the cost and the cost object, or tracing is not economically feasible. Assignment of indirect costs to cost objects is called allocation. Since no causal relationship exists, allocating indirect costs is based on convenience or some assumed linkage. - Arbitrarily allocating indirect costs to cost objects reduces the overall accuracy of the cost assignments.

An important objective of a cost management system is the calculation of product costs for external financial reporting.

Externally imposed conventions require costs to be classified in terms of the special purposes, or functions, they serve. Costs are subdivided into two major functional categories: production and nonproduction.

Two key features of the accounting information system distinguish it from other information systems.

First, an accounting information system's inputs are usually economic events. Second, the operational model of an accounting information system is critically involved with the user of information, since the output of the information system influences users and may serve as the basis for action.

What if 32,000 cell phones could be manufactured next year? Explain in words how that would affect the unit prime cost, the unit conversion cost, the unit variable product cost, and the unit total product cost.

If the number of units produced increases, there will be no impact on any unit variable cost. Thus, unit prime cost and unit variable cost would stay the same. However, unit conversion cost and unit product cost would go down because of fixed factory overhead. Fixed overhead will remain the same in total, but decrease per unit as the number of units goes up. Conversely, if the number of units goes down, unit fixed overhead will increase.

In deciding whether to implement an activity-based cost management system, a manager must assess the trade-off between the cost of measurement and the cost of errors.

Measurement costs are the costs associated with the measurements required by the cost management system. Error costs are the costs associated with making poor decisions based on bad cost information. Optimally, a cost management system would minimize the sum of measurement and error costs. Note, however, that the two costs conflict.

Nonproduction Costs

Nonproduction costs are divided into two categories: marketing (selling) costs and administrative costs. Marketing and administrative costs are not inventoried and are called period costs.

The overall objective of an activity-based cost management system is to manage activities to reduce costs and improve customer value.

Operational activity-based management relates to efficiency or "doing things right." Thus, activity-based costing information is used to improve efficiency and lower cost while maintaining or improving customer value.

Each of these interrelated parts is itself a system and is therefore referred to as a subsystem of the accounting information system.

Processes of the database management system may include collecting, classifying, summarizing, and managing data. Some processes may also be formal decision models—models that use inputs and provide recommended decisions as the information output. The outputs are data and reports that provide needed information for users.

One of the most important cost objects is the output of organizations. The two types of output are tangible products and services.

Tangible products are goods produced by converting raw materials into finished products through the use of labor and capital inputs such as plant, land, and machinery. Televisions, hamburgers, automobiles, computers, clothes, and furniture are examples of tangible products.

Product costing in an activity-based system tends to be flexible.

The activity-based cost management system is capable of producing cost information for a variety of managerial objectives, including the financial reporting objective. More comprehensive product costing definitions are emphasized for better planning, control, and decision making. Therefore, the maxim of "different costs for different purposes" takes on real meaning.

Cost of Goods Sold

The cost of goods sold is the manufacturing cost of the units that were sold during the period. It is important to remember that the cost of goods sold may or may not equal the cost of goods manufactured. In addition, we must remember that the cost of goods sold is an expense, and it belongs on the income statement.

The activity-based operational control subsystem also differs significantly from that of a traditional system.

The emphasis of the traditional cost management accounting system is on managing costs. However, the management of activities—not costs—is the key to successful control in the advanced manufacturing environment, and activity-based management is at the heart of a contemporary operational control system.

The overall objective of an accounting information system is to provide information to users.

The interrelated parts include database(s) and database management programs. The databases are simply collections of data or information, usually in digital form. The database management system is needed to control, maintain, and use a given database.

The cost view serves as an important input to the control dimension, which is called the process view.

The process view identifies factors that cause an activity's cost (explains why costs are incurred), assesses what work is done (identifies activities), and evaluates the work performed and the results achieved (how well the activity is performed). Thus, an activity-based control system requires detailed information on activities.

The cost of overtime for direct labor is usually assigned to overhead as well.

The rationale is that typically no particular production run caused the overtime. Accordingly, overtime cost is common to all production runs and is therefore an indirect manufacturing cost. Note that only the overtime cost itself is treated this way. If workers are paid $16 per hour regular rate and a premium of $8 per overtime hour, then only the $8 overtime premium is assigned to overhead. The $16 regular rate is still regarded as a direct labor cost

An integrated cost management system receives information from and provides information to all operational systems.

To the extent possible, the cost management system should be integrated with the organization's operational systems. Integration reduces redundant storage and use of data, improves the timeliness of information, and increases the efficiency of producing reliable and accurate information. One way of accomplishing this is to implement an enterprise resource planning (ERP) system

Income Statement: Manufacturing Firm - This income statement is frequently referred to as absorption-costing income or full-costing income because all manufacturing costs (direct materials, direct labor, and overhead) are fully assigned to the product.

Under the absorption-costing approach, expenses are separated according to function and then deducted from revenues to arrive at operating income. - The two major functional categories of expense are cost of goods sold and operating expenses. These categories correspond to a firm's manufacturing and nonmanufacturing (marketing and administrative) expenses

Traceability

Understanding the relationship of costs to cost objects can increase the accuracy of cost assignments. Costs are directly or indirectly associated with cost objects.

activity-based cost (ABC) system

a cost accounting system that uses both unit- and non-unit-based cost drivers to assign costs to cost objects by first tracing costs to activities and then tracing costs from activities to products.

Activity-based management (ABM)

a cost accounting system that uses both unit- and non-unit-based cost drivers to assign costs to cost objects by first tracing costs to activities and then tracing costs from activities to products. - focuses on the management of activities with the objective of improving the value received by the customer and the profit received by the company in providing this value. It includes driver analysis, activity analysis, and performance evaluation and draws on ABC as a major source of information.

traditional cost system

a cost accounting system that uses only unit-based activity drivers to assign costs to cost objects. - Since unit-based activity drivers usually are not the only drivers that explain causal relationships, much of the product cost assignment activity must be classified as allocation (recall that allocation is cost assignment based on assumed linkages or convenience). Therefore, traditional cost accounting systems tend to be allocation intensive.

traditional operation control system

a system that assigns costs to organizational units and then holds the organizational unit manager responsible for controlling the assigned costs. - Performance is measured by comparing actual outcomes with standard or budgeted outcomes. The emphasis is on financial measures of performance; nonfinancial measures may be ignored. Managers are rewarded based on their ability to control costs. This approach traces costs to individuals who are responsible for the incurrence of costs. The reward system is used to motivate these individuals to manage costs. The approach assumes that maximizing the performance of the overall organization is achieved by maximizing the performance of individual organizational subunits (referred to as responsibility centers).

administrative costs

all costs associated with the general administration of the organization that cannot be reasonably assigned to either marketing or production. - Administration is responsible for ensuring that the various activities of the organization are properly integrated in accordance with the overall mission of the firm. - Examples of administrative costs are top-executive salaries, legal fees, printing and distributing the annual report, and general accounting. Research and development is also part of administrative costs, and is expensed in the period incurred

Perishability

an attribute of services that means that they cannot be inventoried but must be consumed when performed. - means that services cannot be stored (there are a few unusual cases where tangible goods cannot be stored).

Indirect costs

are costs that cannot be traced easily and accurately to a cost object. Direct costs are those costs that can be traced easily and accurately to a cost object.

Services

are tasks or activities performed for a customer or an activity performed by a customer using an organization's products or facilities. Services are also produced using materials, labor, and capital inputs. Insurance coverage, medical care, dental care, funeral care, and accounting are examples of service activities performed for customers. Car rental, video rental, and skiing are examples of services where the customer uses an organization's products or facilities.

Production (or product) costs

are those costs associated with manufacturing goods or providing services. - . Nonproduction costs are those costs associated with the functions of selling and administration. For tangible goods, production and nonproduction costs are often referred to as manufacturing costs and nonmanufacturing costs, respectively. Production costs can be further classified as direct materials, direct labor, and overhead.

Work in process

consists of all partially completed units found in production at a given point in time. - The cost of beginning work in process represents the manufacturing costs carried over from the prior period; the cost of ending work in process represents the manufacturing costs that will be carried over to the next period. In both cases, additional manufacturing costs must be incurred to complete the units in work in process.

Period costs

costs such as marketing and administrative costs that are expensed in the period in which they are incurred. - period costs are not inventoried and are not assigned to products. Period costs appear on the income statement—not the balance sheet

If the cost of goods manufactured is for a single product, then the average unit cost can be computed by

dividing the cost of goods manufactured by the number of units produced.

Strategic activity-based management relates to

effectiveness or "doing the right things." Thus, activity-based costing information helps managers choose which services or products to produce and which activities would be most appropriate to produce them.Footnote Generally, more managerial objectives can be met with an activity-based system than with a traditional system.

Activity-Based Cost Accounting

emphasizes tracing over allocation. The role of driver tracing is significantly expanded by identifying drivers unrelated to the volume of product produced (called non-unit-based activity drivers). The use of both unit- and non-unit-based activity drivers increases the accuracy of cost assignments and the overall quality and relevance of cost information.

Organizations that produce tangible products are called manufacturing organizations.

hose that produce intangible products are called service organizations. Managers of organizations that produce goods or services need to know how much individual products cost for a number of reasons, including profitability analysis and strategic decisions concerning product design, pricing, and product mix.

An activity-based cost management system offers significant benefits

including greater product costing accuracy, improved decision making, enhanced strategic planning, and an increased ability to manage activities. These benefits, however, are expensive. An activity-based cost management system is more complex and requires considerably more measurement activity—and measurement can be costly. As Kaplan and Anderson point out, "ABC systems (are) expensive to build, complex to sustain, and difficult to modify.

Services differ from tangible products on three important dimensions:

intangibility, perishability, and inseparability.

The cost management information system

is primarily concerned with producing outputs for internal users using inputs and processes needed to satisfy management objectives. The cost management information system is not bound by externally imposed criteria that define inputs and processes. Instead, the criteria that govern the inputs and processes are set by people in the company.

Cost

is the cash or cash equivalent value sacrificed for goods and services that are expected to bring a current or future benefit to the organization. - Costs are incurred to produce future benefits - In a profit-making firm, future benefits usually mean revenues.

Direct tracing

is the process of identifying and assigning costs to a cost object that are specifically or physically associated with the cost object. Direct tracing is most often accomplished by physical observation - all costs should be charged to cost objects using direct tracing.

Cost management systems typically deal with many cost objects.

it is possible for a particular cost item to be classified as both a direct cost and an indirect cost. It all depends on which cost object is the point of reference.

Direct Labor

labor that is traceable to the goods or services being produced. - physical observation is used to measure the quantity of labor used to produce a product or service. Employees who convert raw materials into a product or who provide a service to customers are classified as direct labor

Intangibility

refers to the nonphysical nature of services as opposed to products. - means that buyers of services cannot see, feel, hear, or taste a service before it is bought. Thus, services are intangible products.

If the number of units produced increases,

the cost of direct materials used in production will increase. Since there are sufficient direct materials in beginning inventory, it is not clear whether purchases would increase, or instead, if ending materials inventory would go down. Direct labor would increase to reflect the additional units. Overhead would increase due to the increase in variable overhead, but the fixed overhead component would remain the same. There is no clear need for changes in beginning and ending work in process as long as the additional 2,000 units come from current production.

Cost of goods sold

the cost of direct materials, direct labor, and overhead attached to the units sold. - To compute the cost of goods sold, it is first necessary to determine the cost of goods manufactured.

Conversion cost

the sum of direct labor cost and overhead cost. - For a manufacturing firm, conversion cost can be interpreted as the cost of converting raw materials into a final product.

marketing (selling) costs

those costs necessary to market and distribute a product or service. - referred to as order-getting and order-filling costs. Examples of marketing costs include the following: salaries and commissions of sales personnel, advertising, warehousing, shipping, and customer service. The first two items are examples of order-getting costs; the last three are order-filling costs

Direct materials

those materials that are traceable to the good or service being produced. - The cost of these materials can be directly charged to products because physical observation can be used to measure the quantity used by each product. Materials that become part of a tangible product or those materials that are used in providing a service are usually classified as direct materials. - example, steel in an automobile

For costs to be traced easily means that the costs can be assigned in an economically feasible way. For costs to be traced accurately means that the costs are assigned using a causal relationship

traceability is the ability to assign a cost directly to a cost object in an economically feasible way by means of a causal relationship. The more costs that can be traced to the object, the greater the accuracy of the cost assignments.

the vertical dimension, or cost view,

traces the cost of resources to activities and then to the cost objects.

Cost management systems can be broadly classified as

traditional or activity-based. - traditional cost management systems are more widely used than the activity-based systems. - As the need for highly accurate cost information increases, however, savvy cost accountants have learned to apply activity-based costing concepts to the determination of costs for management decision making.