Ch. 2 - Cost Accounting

Finished goods

Product fully completed, but not yet sold.

Work in process

Product in the production process but not yet complete.

Relevant range

Refers to the activity levels within which a given total fixed cost or unit variable cost will be unchanged.

Cost allocation rule

Refers to the method or process used to assign costs in the cost pool to the cost objects.

Direct labor

Represents labor costs that can be identified with the product at reasonable cost. Direct labor of workers transforms the materials into a finished product.

Cost of goods sold

Expense assigned to products sold during a period.

Opportunity cost

Forgone benefit from the best forgone alternative course of action (such as the time and income sacrificed to get a college education).

Semivariable cost

Is a cost that has both fixed and variable components; also called mixed cost (Ex., electric utility costs, phone charges).

Step cost

Is a cost that increases with volume in steps; also called semifixed cost (Ex., supervisors' salaries as each supervisor has a limited span of control).

Cost flow diagram

Is a diagram or flowchart illustrating the cost allocation process.

Cost object

Is any end to which a cost is assigned. Examples include a unit of product or service, a department, or a customer.

Cost pool

Is the collection of costs to be assigned to the cost objects. Examples are department costs, rental costs, or travel costs a consultant incurs to visit multiple clients.

Cost allocation

Is the process of assigning indirect costs to product, services, people, business units, etc. Cost allocation is necessary when several departments share facilities or services.

Full cost

Is the sum of all fixed and variable costs of manufacturing and selling a unit of product.oFull absorption cost is the sum of all variable and fixed manufacturing costs.

Outlay cost

Past, present, or future cash outflow (such as tuition, books, and fees paid for a college education).

Operating profit

The excess of operating revenues over the operating costs necessary to generate those revenues.

Direct manufacturing costs

are product costs that can be identified with units (or batches of units) at relatively low cost, including:

Cost

is a sacrifice of resources (typically cash or a line of credit). The price of each item purchased measures the sacrifice made to acquire it.

Period costs (non manufacturing costs)

Costs recognized for financial reporting when incurred.

Administrative costs

Costs required to manage the organization and provide staff support, including executive salaries, costs of data processing, and legal costs.

Marketing costs

Costs required to obtain customer orders and provide customers with finished products, including advertising, sales commissions, and shipping costs.

Fixed costs

Costs that are unchanged as volume changes within the relevant range of activity (Ex., much of manufacturing overhead, many non manufacturing costs).

Variable costs

Costs that change in direct proportion with a change in volume within the relevant range of activity (Ex., for manufacturing companies, direct materials, and certain manufacturing overhead, direct labor in some cases; for merchandising businesses, cost of the product, some marketing and administrative costs; for service organizations, certain types of labor, supplies, copying, and printing costs).

Period costs can be determined once product costs are properly defined. Three approaches to determining product costs are available.

• Full absorption costing (traditional income statement) - As required by GAAP, all fixed and variable manufacturing costs are product costs. All other costs are period costs. • Variable costing (contribution margin income statement) - Only variable manufacturing costs are product costs.All other costs are period costs. • Managerial costing - Management determines which costs are associated with the product. Any new costs resulting from adding a product are considered product costs.

Manufacturing overhead represents all other costs of transforming the materials into a finished product, including:

• Indirect labor - the cost of workers who don't work directly on the product, yet are required so that the factory can operate (such as supervisors, maintenance workers, and inventory storekeepers). • Indirect materials - materials not a part of the finished product but are necessary to manufacture it (such as lubricants, polishing and cleaning materials). • Other manufacturing costs - expenses incurred to keep the factory running (such as depreciation of the factory building and equipment, taxes and insurance on the factory assets, heat, light, and power).

Manufacturing overhead

- All production costs except direct labor and direct materials. - In practice, manufacturing overhead is also called factory burden, factory overhead, burden, factory expense, or just overhead.

Direct materials

- Are those that can be feasibly identified directly, at relatively low cost, with the product. (For manufacturers, direct materials are purchased parts, including transportation-in.) - Direct materials are often called raw materials.

Gross margin

- As reported in the external financial statements is the difference between revenue and cost of goods sold on income statements. Per unit, the gross margin equals sales price - full absorption cost per unit. - The income statement format that emphasizes gross margin is referred to as the traditional income statement.

Fixed vs variable costs

- Cost behavior deals with the way costs respond to changes in activity levels; a cost driver is a factor that causes, or"drives," costs. - Managers need to know how costs behave to make informed decisions about products, to plan, and to evaluate performance.

Cost vs Expense

- Cost initially recorded as an asset becomes an expense when the asset has been consumed (for ex., prepaid rent for an office building becomes rent expense after the office space has been used for a period of time). - Cost accounting focuses on costs, not expenses; expenses are referred to only in the context of external financial reporting (in this text). - Generally accepted accounting principles (GAAP) and regulations such as tax laws govern when and how costs are to be treated as expenses.

Any production process involves three basic steps:

- Delivering direct materials to receiving area, inspecting, and then placing in direct material inventory area (store). - Transporting direct materials to an assembly line and undergoing the production process. Work in process is a product in the production process but not yet complete. - Moving the product to separate area in factory with other completed products. Finished goods are products fully completed, but not yet sold.

Cost flow diagrams help managers understand

- How a cost system works - The likely effects on the reported costs of different cost objects from changes in the cost allocation rule.

Fundamental approach to cost allocation:

- Identify the cost objects - Determine the cost pools - Select a cost allocation rule

- Direct cost - Indirect cost

- Is any cost that can be directly (unambiguously) related to a cost object at reasonable cost. - Is any cost that cannot be directly related to a cost object. • A cost may be direct to one cost object and indirect to another. • Whether a cost is considered direct or indirect also depends on the costs of linking it to the cost object. (See Business Application box, "Indirect Costs and Allocating Costs to Contracts.")

Operating profit differs from net income

- Net income is operating profit adjusted for interest, income taxes, extraordinary items, and other adjustments required to comply with GAAP or other regulations. - Information generated by the cost accounting system is used to help managers make decisions that improve firm value. It is a means to an end. Such information is best (in terms of relevancy) for various decisions but not necessarily most accurate. - How the cost information is used in decision making and the costs of preparing and using such information should also be considered.

Managers tend to overlook or ignore opportunity cost while making decisions because:

- No one can ever know all possible opportunities available at any moment. - Typical accounting system only records outlay costs but not opportunity costs. • Opportunity costs are relevant for managerial decisions and should be captured in a well-designed cost accounting system.

Four aspects of cost behavior complicate the task of classifying costs into fixed or variable categories.

- Not all costs are strictly fixed or variable. - Some costs increase with volume in "steps." - The cost relations are valid only within a relevant range of activity. - The classification of costs as fixed or variable depends on the measure of activity used.

The two major categories of cost are:

- Outlay cost - Opportunity cost

Service organizations

- Provide customers an intangible product, such as advice and analyses. - Labor costs and/or costs of information technology represent the most significant cost category for service organizations.

Contribution margin

- Sales price - variable costs per unit. It is the amount available to cover fixed costs and earn a profit. - The income statement format that emphasizes contribution margin is referred to as the contribution margin income statement.

The distinction between manufacturing and non manufacturing costs is not always clear-cut. Companies usually set their own guidelines and follow them consistently.

- Service companies often have costs that are mostly indirect. Managing indirect costs is extremely important in these firms if they are to remain profitable. - Most firms are made up of activities that combine features of all three types of activities (service, retailing, and manufacturing). - In many of the firms which are usually considered to be of manufacturing type, virtually all employees are engaged in service-related activities.

Conversion costs

- Sum of direct labor and manufacturing overhead. - Are the costs that convert direct materials into the final product. Companies with high direct labor and/or manufacturing overhead tend to emphasize more about conversion costs.

Prime costs

- Sum of direct materials and direct labor. - Companies with relatively low manufacturing overhead tend to focus on managing prime costs.

Developing Financial Statements for Decision Making

- The cost accounting system is designed to provide managers with relevant information for decision making.Financial statements may be developed to serve special purposes. - Case in point is the development of a value income statement that classifies costs into value-added and nonvalue-added categories. By classifying activities as value added or non-value added, managers are better able to reduce or eliminate nonvalue-added activities and therefore reduce costs. - Depending on the business and strategic environment of the firm, it is possible to construct financial statements around activities related to quality, environmental compliance, or new product development.

- The cost flows - The inventory account balances - If the company uses (JIT) inventory

- The cost flows coincide with the physical flows of goods in and out of their respective storage areas. - The inventory account balances at the end of an accounting period appear on the balance sheet as part of the current assets. - If the company uses just-in-time (JIT) inventory people in direct materials receiving department send the components to the machining line immediately; if not, people in this department send the components to a materials warehouse until it is needed for production.

The gross margin and COGS in an income statement

- The gross margin reflects the amount available to cover marketing and administrative costs and earn a profit. - Cost of goods sold includes only the actual costs of the goods that were sold. It does not include the costs required to sell them, such as the salaries of salespeople, which are marketing costs, or the salaries of top executives, which are administrative costs.

Unit fixed cost can be misleading for decision making

- Unit fixed costs are valid only at one volume. - When fixed costs are allocated to each unit, accounting records often make the costs appear as though they are variable. - It is easy to interpret unit costs incorrectly and make incorrect decisions.

Retail and wholesale companies

- sell but do not make a tangible product, such as food, clothes, or a book.

Full absorption cost

All variable and fixed manufacturing costs; used to compute a product's inventory value under GAAP. As such, it excludes nonmanufacturing costs.

Indirect manufacturing costs

Are all product costs other than direct manufacturing costs, often referred to in total as manufacturing overhead.

Inventoriable costs

Are costs added (debited) to inventory accounts.

For financial accounting purposes, non manufacturing costs:

Are expensed in the period incurred; for managerial purposes, however, these costs (especially advertising and commissions) may be assigned to products.

Expense

Cost that is charged against (i.e., deducted from) revenue in an accounting period.

Product costs

Costs assigned to the manufacture of products and recognized for financial reporting when sold.

Manufacturing companies

Make the goods for sale and need to know the different costs associated with making them.