Chapter 2 - Texas A&M University–Corpus Christifaculty.tamucc.edu/shall/2302/Chapter Outlines/chap002.doc · Web viewAdministrative Costs. These costs include all executive, organizational,

Chapter 2

Cost Terms, Concepts, and Classifications

Learning Objectives LO1. Identify and give examples of each of the three basic manufacturing cost categories.LO2. Distinguish between product costs and period costs and give examples of each.LO3. Prepare an income statement including calculation of the cost of goods sold.LO4. Prepare a schedule of cost of goods manufactured.LO5. Understand the differences between variable costs and fixed costs.LO6. Understand the differences between direct and indirect costs.LO7. Define and give examples of cost classifications used in making decisions: differential

costs, opportunity costs, and sunk costs.LO8. (Appendix 2A) Properly account for labor costs associated with idle time, overtime, and

fringe benefits.LO9. (Appendix 2B) Identify the four types of quality costs and explain how they interact.LO10. (Appendix 2B) Prepare and interpret a quality cost report.

New in this Edition• Many new In Business boxes have been added.• New shorter exercises that cover a single learning objective have been created.

Chapter Overview A. General Theme. Costs can be classified in a number of ways—depending on the purpose of the classification. For example, classification of costs for purposes of determining inventory valuations and cost of goods sold for external reports differs from the classification of costs that would be carried out to aid decision-making. It is important to note that the classifications of costs are not mutually exclusive. That is, a particular cost may be classified in many different ways—depending on the purpose of the classification.

B. Cost Classifications for Preparing External Financial Statements. (Exercises 2-1, 2-2, 2-3, 2-4, 2-10, 2-11, and 2-12.) This section of the chapter focuses on the problem of valuing inventories and determining cost of goods sold for external financial reports. Before beginning this discussion, you may want to explain the difference between a manufacturing and a merchandising company. Manufacturing companies convert raw materials into a product. The company then sells that product either to other companies or, less commonly, directly to individuals. “Manufacturing” includes restaurants, movie studios, and other service-type companies as well as the more obvious examples of manufacturing such as automobile and clothing production. Merchandising companies, by contrast, buy finished products and resell the products to customers. Valuing inventories and determining cost of goods sold is simple in a merchandising company, but is difficult in a manufacturing company. For that reason, we concentrate on manufacturing in this section of the chapter.

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1. Manufacturing costs. These costs are incurred to make a product. Manufacturing costs are

usually grouped into three main categories: direct materials, direct labor, and manufacturing overhead.

a. Direct materials. Direct materials consist of those raw material inputs that become an integral part of a finished product and can be easily traced into it. Examples include the aircraft engines on a Boeing 777, the Intel processing chip in a personal computer, and the blank video cassette in a pre-recorded video.

b. Direct Labor. Direct labor consists of that portion of labor cost that can be easily traced to a product. Direct labor is sometimes referred to as “touch labor” since it consists of the costs of workers who “touch” the product as it is being made.

c. Manufacturing Overhead. Manufacturing overhead consists of all manufacturing costs other than direct materials and direct labor. These costs cannot be easily and conveniently traced to products. Examples include miscellaneous supplies such as rivets in a Boeing 777, supervisors, janitors, factory facility charges, etc.

d. Prime versus Conversion Costs. Prime cost consists of direct materials plus direct labor. Conversion cost consists of direct labor plus manufacturing overhead.

2. Non-manufacturing costs. A manufacturing company incurs many other costs in addition to manufacturing costs. For financial reporting purposes most of these other costs are typically classified as selling (marketing) costs and administrative costs. Marketing and administrative costs are incurred in both manufacturing and merchandising firms.

a. Marketing Costs. These costs include the costs of making sales, taking customer orders, and delivering the product to customers. These costs are also referred to as order-getting and order-filling costs.

b. Administrative Costs. These costs include all executive, organizational, and clerical costs that are not classified as production or marketing costs.

3. Period vs. product costs. Costs can also be classified as period or product costs.

a. 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. You should be careful to point out that the usual rules of accrual accounting apply. For example, administrative salary costs are “incurred” when they are earned and not necessarily when they are paid to employees.

b. Product Costs. Product costs are added to units of product (i.e., “inventoried”) as they are incurred and are not treated as expenses until the units are sold. This can result in a delay of one or more periods between the time in which the cost is incurred and when it appears as an expense on the income statement. Product costs are also known as inventoriable costs. The discussion in the chapter follows the usual interpretation of GAAP in which all manufacturing costs are treated as product costs.

4. 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

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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.

5. Schedule of Cost of Goods Manufactured. Because of inventories, the cost of goods sold for a period is not simply the manufacturing costs incurred during the period. Some of the cost of goods sold may be for units completed in a previous period. And some of the units completed in the current period may not have been sold and will still be on the balance sheet as assets. The cost of goods sold is computed with the aid of a schedule of costs of goods manufactured, which takes into account changes in inventories. The schedule of cost of goods manufactured is not ordinarily included in external financial reports, but must be compiled by accountants within the company in order to arrive at the cost of goods sold. You should take some time to explain the cost of goods manufactured schedule since it is often difficult for students to understand.

C. Cost Classifications to Describe Cost Behavior. (Exercises 2-5 and 2-11.) Managers often need to be able to predict how costs will change in response to changes in activity. The activity might be the output of goods or services or it might be some measure of activity internal to the company such as the number of purchase orders processed during a period. In this chapter, nearly all of the illustrations assume that the activity is the output of goods or services. In later chapters, other measures of activity will be introduced.

While there are other ways to classify costs according to how they react to changes in activity, in this chapter we introduce the simple variable and fixed classifications. A variable cost is constant per unit of activity but changes in total as the activity level rises and falls. A fixed cost is constant in total for changes in activity within the relevant range. (Just about any cost will change if there is a big enough change in activity. Fixed costs do not change for changes in activity that fall within the “relevant range.”) When expressed on a per unit basis, a fixed cost is inversely related to activity—the per unit cost decreases when activity rises and increases when activity falls.

There is some controversy concerning the proper definition of the “relevant range.” Some refer to the relevant range as the range of activity within which the company usually operates. We refer to the relevant range as the range of activity within which the assumptions about variable and fixed costs are valid. Either definition could be used—our choice was dictated by our desire to highlight the notion that fixed costs can change if the level of activity changes enough. D. Cost Classifications for Assigning Costs. (Exercise 2-6.) Managers often want costs to be assigned to “cost objects” such as products, customers, departments, etc. for pricing or other purposes. A direct cost is a cost that can be conveniently and easily traced to a particular cost object. Indirect costs are everything else. 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.

1. Common costs. For example, it is impossible to trace the factory managers’ salary in a multi-product plant to any particular product made in the plant. Even if a product were dropped entirely, we would ordinarily expect the factory manager’s salary to remain the same. This is an example of a “common cost” and later in the text we emphasize that such costs should not be allocated for decision-making or performance evaluation purposes.

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2. Variable indirect costs. On the other hand, other costs are treated as indirect costs because it would not be practical to treat them otherwise. For example, it would be possible to measure the precise amount of solder used on each circuit board produced at a HP plant, but it wouldn’t be worth the effort. Instead, solder would typically be considered an indirect material and would be included in overhead.

E. Cost Classifications for Decision-Making. (Exercise 2-7.) Every decision involves choosing from among at least two alternatives. Only those costs and benefits that differ between alternatives are relevant in making the selection. This concept is explored in greater detail in the chapter on relevant costs. However, decision-making contexts crop up from time to time in the text before that chapter, so it is a good idea to familiarize students with relevant cost concepts. 1. Differential Costs. A differential cost is a cost that differs between alternatives. The cost

may exist in only one of the alternatives or the total amount of the cost may differ between the alternatives. In the latter case, the differential cost would be the difference between the cost under one alternative and the cost under the other. Differential costs are also called incremental costs. Differential costs and opportunity costs should be the focus of decision-making. They are the only relevant costs and all others should be ignored.

2. Opportunity Costs. An opportunity cost is the potential benefit that is given up by

selecting one alternative over another. The concept of an opportunity cost is rather difficult for students to understand because it is not an actual expenditure and it is rarely (if ever) shown on the accounting books of an organization. It is, however, a cost that must be considered in decisions.

3. Sunk Cost. A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Since sunk costs cannot be changed and therefore cannot be differential costs, they should be ignored in decision making. While students usually accept the idea that sunk costs should be ignored on an abstract level, like most people they often have difficulty putting this idea into practice.

F. Classification of Labor Costs (Appendix 2A). (Exercises 2-8 and 2-13.) Factory labor costs are classified as direct or indirect labor. Direct labor is basically “touch labor.” Indirect labor is the rest of the manufacturing labor cost and it is classified as part of manufacturing overhead. Examples of indirect labor include the wages and salaries of janitors, supervisors, material handlers, and maintenance workers. 1. Idle Time. Some labor costs, such as idle time, are not easily identified as either direct or

indirect labor. Idle time represents the wages of direct labor workers who are idle due to machine breakdowns, material shortages, and so forth. Typically, these costs are classified as overhead costs and are allocated across all products.

2. Overtime Premium. The overtime premium paid to factory workers is usually considered to be part of manufacturing overhead. It is argued that it would be unfair to charge an overtime premium against a product that happened to be scheduled for the overtime period. Therefore, the overtime premium is usually added to overhead and spread among all jobs of the period. It should be noted that if a company works overtime specifically because of a special request or a rush order job, the overtime premium may appropriately be charged against that particular job.

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3. Fringe Benefits. These costs include payments made to insurance and retirement plans as well as various employee taxes such as social security. Typically, companies treat these costs as manufacturing overhead. However, it would be more accurate to split fringe benefits between the portion that relates to direct labor and the portion that relates to indirect labor. Only those fringe benefits that relate to indirect labor should be included in manufacturing overhead; the rest should be considered as part of direct labor cost.

G. Quality Costs (Appendix 2B) (Exercise 2-9.) The term quality has many meanings. Quality can mean that a product has many features not found in other products; it can mean that it is well-designed; or it can mean that it is defect-free. In this appendix, the focus is on the presence or absence of defects. Quality of conformance is the degree to which the actual product or service meets its design specifications. Anything that does not meet design specifications is a defect and is indicative of low quality of conformance.

1. Costs of Internal and External Failure. The costs of not meeting design specifications are classified as internal failure costs and external failure costs. Defects that are detected internally result in costs such as scrap or rework. Defective units that are released to customers create external failure costs. Examples of external failure costs include customer returns and exchanges, repairs under warranties, product recalls, and lost sales due to a reputation for selling defective products.

2. Costs of Reducing Defects. There are basically only two ways to reduce defects and the resulting costs of internal and external failures. Either the defects can be prevented or they can be detected and corrected.

a. Defects can be prevented by designing products that are “robust;” that is, that are not sensitive to variations and errors in the production process. Defects can also be prevented by improving production processes. Statistical process control has been especially useful in driving variation out of production processes and thereby reducing defect rates. Most experts believe that until the late 1980s too little attention was paid in the United States to prevention. Instead, reliance was placed on detecting defects once they had occurred.

b. Defective units can be detected before they are delivered to customers by inspecting and testing units throughout the production process. This approach to reducing defects is expensive since it involves inspection labor and testing equipment. Moreover, when there is no idle capacity every defective unit that must be reworked or that is scrapped uses precious capacity. The resulting opportunity costs can be quite large.

H. The Trade-Off Between Prevention and Appraisal Costs and Internal and External Failure Costs. Generally speaking, companies should focus more effort on prevention and appraisal. And prevention is usually better than appraisal. Most authorities agree that the costs of internal and external failures have been largely hidden and as a consequence managers are unaware of the magnitude of the problem. Very simple steps can often be taken to prevent defects. These simple steps pay enormous dividends in terms of reducing the need for appraisal and in reducing the incidence of internal and external failures.

I. Quality Cost Report Quality consultants claim that top managers often do not pay enough attention to quality since the costs of low quality (i.e., high defect rates) are hidden by the typical cost accounting system. While accounting systems often report statistics concerning

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scrap and there may be a quality assurance department with its own budget, many of the other costs associated with defects are buried in general overhead or in other accounts. A quality cost report makes these costs visible and organizes the data so as to help managers make trade-offs. Since the reports are really just attention-directing devices, the numbers in the reports do not have to be precise.

1. Data for the Quality Cost Report. The costs of nonconformance (i.e., defects) often cut across departmental lines and are therefore somewhat difficult to collect. Moreover, some of the costs of nonconformance are entirely external to the company and are not captured by the accounting system at all. The most prominent example of this is the cost of lost sales. Nevertheless, as we indicated above, precision is not terribly important so these measurement and identification problems should not be overemphasized. All of the examples and problems in the text assume that the data collection work has already been done.

2. Format and use of the Quality Cost Report. It is very helpful to sort the various quality costs into the four categories of prevention, appraisal, internal failure, and external failure costs. By comparing the amounts in the various categories, managers can get some feel for what should be done. For example, if the prevention and appraisal costs are very small relative to the internal and external failure costs, it is likely that not enough is being spent to prevent and detect defects. If prevention costs are low relative to appraisal costs, it is likely that not enough is being spent on prevention relative to inspection. Moreover, by comparing results across years, managers can track the effects of their decisions and gauge the success of quality improvement programs.

3. The future of the Quality Cost Report. A company’s first quality cost report probably has the greatest effect. Managers are often surprised by the magnitude of the costs associated with defects. This is often enough by itself to propel the company into ambitious quality improvement programs. However, unless the company’s chart of accounts is modified, compiling periodic quality cost reports is a time-consuming task. Moreover, some of the most important data—the data external to the company—will almost always be missing. And, while the quality cost report can help steer managers in the appropriate direction (e.g., increase prevention costs), it cannot tell managers how to go about preventing defects. For these reasons, many companies stop producing quality cost reports once their quality improvement program is well-established.

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Assignment Materials

Assignment TopicLevel of

DifficultySuggested

TimeExercise 2-1 Classifying manufacturing costs......................................................... Basic 15 min.Exercise 2-2 Classification of costs as period or product cost................................. Basic 15 min.Exercise 2-3 Constructing an income statement...................................................... Basic 15 min.Exercise 2-4 Prepare a schedule of cost of goods manufactured............................. Basic 15 min.Exercise 2-5 Classification of costs as fixed or variable......................................... Basic 15 min.Exercise 2-6 Identifying direct and indirect costs.................................................... Basic 15 min.Exercise 2-7 Differential, opportunity, and sunk costs............................................ Basic 15 min.Exercise 2-8 (Appendix 2A) Classification of overtime cost.................................. Basic 15 min.Exercise 2-9 (Appendix 2B) Classification of quality costs.................................... Basic 15 min.Exercise 2-10 Preparation of a schedule of COGM and COGS................................ Basic 30 min.Exercise 2-11 Classification of costs as fixed or variable and as selling and

administrative or product............................................................... Basic 15 min.Exercise 2-12 Product cost flows; product versus period costs................................. Basic 30 min.Exercise 2-13 (Appendix 2A) Classification of labor costs ...................................... Basic 15 min.Problem 2-14 Cost identification............................................................................... Basic 30 min.Problem 2-15 Cost classification............................................................................... Basic 30 min.Problem 2-16 Cost classification............................................................................... Basic 30 min.Problem 2-17 (Appendix 2A) Allocating labor costs ............................................... Basic 30 min.Problem 2-18 (Appendix 2B) Quality cost report .................................................... Medium 60 min.Problem 2-19 Classification of various costs............................................................ Medium 30 min.Problem 2-20 Classification of salary cost as a period or product cost..................... Medium 15 min.Problem 2-21 Variable and fixed costs; subtleties of direct and indirect costs......... Medium 15 min.Problem 2-22 (Appendix 2B) Analyzing a quality cost report.................................. Medium 45 min.Problem 2-23 Ethics and the manager....................................................................... Medium 30 min.Problem 2-24 Schedule of cost of goods manufactured; cost behavior..................... Medium 60 min.Problem 2-25 Cost classification and cost behavior.................................................. Medium 45 min.Problem 2-26 Schedule of cost of goods manufactured; income statement.............. Medium 60 min.Problem 2-27 Schedule of cost of goods manufactured; income statement; cost

behavior.......................................................................................... Medium 60 min.Problem 2-28 Income statement; schedule of cost of goods manufactured.............. Difficult 60 min.Problem 2-29 Working with incomplete data from the income statement and

schedule of cost of goods manufactured........................................ Difficult 45 min.Case 2-30 Inventory computations from incomplete data................................... Difficult 60 min.Case 2-31 Missing data; income statement; schedule of cost of goods

manufactured.................................................................................. Difficult 60 min.

Essential Problems:* Problem 2-14 or 2-19, Problem 2-15 or 2-16, Problem 2-24 or 2-27, Problem 2-25

Supplementary Problems:* Problem 2-20, Problem 2-21, Problem 2-23, Problem 2-26, Problem 2-28, Problem 2-29, Case 2-30, Case 2-31

Appendix 2A Essential Problems: Problem 2-17Appendix 2B Essential Problems: Problem 2-18Appendix 2B Supplementary Problems: Problem 2-22

*See the front of the Solutions Manual for an explanation of “Essential” and “Supplementary” problems.

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Chapter 2Lecture Notes

Helpful Hint: Before beginning the lecture, show students the second segment from the first tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library. This segment introduces students to many of the concepts discussed in chapter 2. The lecture notes reinforce the concepts introduced in the video.

Chapter theme: Managers need to rely upon different classifications of costs for different purposes. The four main purposes emphasized in this chapter include preparing external financial reports, predicting cost behavior, assigning costs to cost objects, and making business decisions.

I. General cost classifications: Our initial focus is on manufacturing companies since their basic activities include most of the activities found in other types of business organizations. Nonetheless, many of the concepts developed in this chapter apply to diverse organizations.

A. Classifications of manufacturing costs (e.g., direct materials, direct labor, and manufacturing overhead):

i. Direct materials Raw materials that become an integral part of the finished product and that can be physically and conveniently traced to it.

ii. Direct labor Labor costs that can be easily traced to individual units of product (also called touch labor).

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iii. Manufacturing overhead Includes all manufacturing costs except direct materials

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and direct labor. These costs cannot be easily traced to specific units produced (also called indirect manufacturing cost, factory overhead, and factory burden).

1. Includes indirect materials that are part of the finished product, but that cannot be easily traced to it.

2. Includes indirect labor costs that cannot be physically or conveniently traced to the creation of products.

3. Other examples of manufacturing overhead include: maintenance and repairs on production equipment, heat and light, property taxes, depreciation and insurance on manufacturing facilities, etc.

Helpful Hint: Use something in the classroom such as a chair to illustrate manufacturing cost concepts. Center discussion on the raw materials classified as direct materials and as manufacturing overhead; labor costs classified as direct labor and as manufacturing overhead; and other costs incurred to produce the chair that are classified as manufacturing overhead.

iv. Prime cost Direct materials plus direct labor.

v. Conversion cost – Direct labor plus manufacturing overhead.

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“In Business Insights”The amount of manufacturing costs for a manufacturing company is often quite high when stated as a percentage of sales. For example:

“Dissecting the Value Chain” (page 39) The apparel company United Colors of Benetton

reports that cost of sales is 56.4% of sales. Even though the company spends large sums on

advertising, the cost of sales is still quite high in relation to net sales.

B. Classifications of nonmanufacturing costs (also called selling, general and administrative, or S, G & A costs).

i. Marketing or selling costs – Includes all costs necessary to secure customer orders and get the finished product into the hands of the customer.

ii. Administrative costs – Includes all executive, organizational, and clerical costs associated with the general management of an organization.

“In Business Insights”The amount of selling, general, and administrative expenses are significant for most organizations. For example:

“Bloated Sales and Administrative Expenses” (page 40)

The Boston Consulting Group found that S, G & A expenses at America’s 1,000 largest companies

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grew at an average rate of 1.7% per year between 1985 and 1996 and then exploded to an average of 10% growth per year between 1997 and 2000.

If companies had maintained their historical balance between sales revenue and S, G & A expenses from 1997-2000, the S, G & A expenses would have been $500 million lower in the year 2000 for the average company on the list.

These findings suggest that S, G & A expenses tend to creep up at a faster rate during economic booms, thus creating problems when the economy falls into recession.

“Why Is Tuition So High?” (page 38) Forbes magazine reports that administrative

costs are very high for colleges and universities. More specifically, an average of 2.5

administrators are employed for each faculty member in public colleges and 1.9 in private colleges.

C. Product costs versus period costs

i. Product costs (also called inventoriable costs) – Includes all the costs that are involved in acquiring or making a product. More specifically, it includes direct materials, direct labor, and manufacturing overhead.

1. Consistent with the matching principle, product costs are recognized as expenses when the products are sold.

ii. Period costs – Includes all marketing or selling costs and administrative costs.

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1. These costs are expensed on the income statement in the period incurred.

Quick Check product versus period costs

II. Cost classifications on financial statements

A. Merchandising vs. manufacturing companies

i. Merchandising companies Purchase finished goods from suppliers for resale to customers.

ii. Manufacturing companies Purchase raw materials from suppliers and produce and sell finished goods to customers.

B. The balance sheet: merchandising vs. manufacturing companies

i. Merchandising companies do not have to distinguish between raw materials, work in process, and finished goods. They report one inventory number on their balance sheet labeled merchandise inventory.

ii. Manufacturing companies report three types of inventory on their balance sheets.

1. Raw materials – The materials used to make the product.

2. Work in process – Consists of units of product that are partially complete, but will

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3. Finished goods – Consists of units of product that have been completed but not yet sold to customers.

C. The income statement: merchandising vs. manufacturing companies

i. Merchandising companies calculate cost of goods sold as:

COGS = BMI + Purchases – EMI

ii. Manufacturing companies calculate cost of goods sold as:

COGS = BFGI + COGM – EFGI

Helpful Hint: Before proceeding, enhance students’ understanding by explaining that the raw materials, work in process, and finished goods inventories all follow the same logic. They start out with some beginning inventory. Additions are made during the period. At the end of the period, everything that started in the inventory or that was added must either be in the ending inventory or have been transferred out to another inventory account or to cost of goods sold.

Quick Check inventory flows

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D. The schedule of cost of goods manufactured

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i. This schedule contains the three elements of costs mentioned previously, namely direct materials, direct labor, and manufacturing overhead.

ii. It calculates the cost of raw material, direct labor and manufacturing overhead used in production.

iii. It calculates the manufacturing costs associated with goods that were finished during the period.

E. Product cost flows

i. To create a schedule of cost of goods manufactured as well as a balance sheet and income statement, it is important to understand the flow of product costs:

1. Raw material purchases made during the period are added to beginning raw materials inventory. The ending raw materials inventory is deducted to arrive at the raw materials used in production.

a. As items are removed from raw materials inventory and placed into the production process, they are called direct materials.

2. Direct labor and manufacturing overhead (also called conversion costs) used in production are added to direct materials to arrive at total manufacturing costs.

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3. Total manufacturing costs are added to the beginning work in process to arrive at total work in process.

4. The ending work in process inventory is deducted from the total work in process for the period to arrive at the cost of goods manufactured.

5. The cost of goods manufactured is added to the beginning finished goods inventory to arrive at cost of goods available for sale. The ending finished goods inventory is deducted from this figure to arrive at cost of goods sold.

6. All raw materials, work in process, and unsold finished goods at the end of the period are shown as inventoriable costs in the asset section of the balance sheet.

7. As finished goods are sold, their costs are transferred to cost of goods sold on the income statement.

8. Selling and administrative expenses are not involved in making the product; therefore, they are treated as period costs and reported in the income statement for the period the cost is incurred.

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III. Cost classifications for predicting cost behavior

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A. Cost behavior refers to how a cost will react to changes in the level of activity within the relevant range. The most commonly used classifications of cost behavior are variable and fixed costs:

i. Variable cost A cost that varies, in total, in direct proportion to changes in the level of activity. However, variable cost per unit is constant.

ii. Fixed cost A cost that remains constant, in total, regardless of changes in the level of the activity. However, if expressed on a per unit basis, the average fixed cost per unit varies inversely with changes in activity.

iii. It is helpful to think about variable and fixed cost behavior in a 2x2 matrix.

Helpful Hint: To illustrate fixed costs, ask students for the cost of a large pizza. Then ask: What would be the cost per student if two students buy a pizza? What if four students buy a pizza? This makes it clear why average fixed costs change on a per unit basis. To illustrate variable costs, add that a beverage costs $1 and each student eating the pizza has one beverage. So, if two people were eating the pizza, the total beverage bill would come to $2; if four people, $4. The cost per beverage remains the same, but the total cost depends on the number of people ordering a beverage.

Quick Check – variable vs. fixed costs.

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“In Business Insights”Variable costs in some industries can be very low relative to fixed costs. For example:

“The Cost of a Call” (page 50) Costs in the telecommunications industry are

almost all fixed. The cost of physically transporting a call is only

about 7% of what customers pay for the call. It costs a telephone company more to bill a

customer for a phone call than it costs the phone company to actually make the call.

IV. Cost classifications for assigning costs to cost objects

A. Cost object Anything for which cost data are desired including products, customers, jobs, organizational subunits, etc. For purposes of assigning costs to cost objects costs are classified two ways:

i. Direct costs Costs that can be easily and conveniently traced to a unit of product or other cost object.

ii. Indirect costs Costs that cannot be easily and conveniently traced to a unit of product or other cost object.

1. Common costs Indirect costs incurred to support a number of cost objects. These costs cannot be traced to any individual cost object.

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V. Cost classifications for decision making

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A. It is important to realize that every decision involves a choice between at least two alternatives. The goal of making decisions is to identify those costs that are either relevant or irrelevant to the decision. To make decisions, it is essential to have a grasp on three concepts:

i. Differential costs (or incremental costs) A difference in cost between any two alternatives (a difference in revenue between two alternatives is called differential revenue).

1. Differential costs can be either fixed or variable.

“In Business Insights”Incremental costs can be negligible for some companies in certain situations. For example:

“Using Those Empty Seats” (page 52) The Corporate Angel Network arranges free

flights on some 1,500 corporate jets from over 500 companies for cancer patients who need specialized treatment outside their home areas.

Corporate jets typically fly with only one or two executives on board. The incremental cost of occupying an empty seat is negligible.

Since its founding, the Corporate Angel Network has leveraged the incremental cost concept by arranging over 14,000 free flights for cancer patients.

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ii. Opportunity cost The potential benefit that is given up when one alternative is selected over another.

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1. These costs are not usually entered into the accounting records of an organization, but must be explicitly considered in all decisions.

Helpful Hint: Ask students what opportunity costs they incur by attending class. Their opportunity cost is the value to them of the activity they would be doing otherwise (e.g., working, sleeping, partying, studying, etc.)

iii. Sunk cost A cost that has already been incurred and that cannot be changed now or in the future.

Helpful Hint: Ask students: “Suppose you had purchased gold for $400 an ounce, but now it is selling for $250 an ounce. Should you wait for the gold to reach $400 an ounce before selling it?” Many students will say “yes” even though the $400 purchase is a sunk cost.

Quick Check relevant costs

VI. Summary of the types of cost classifications

A. We have looked at the cost classifications used for financial reporting, predicting cost behavior, assigning costs to cost objects, and making business decisions.

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VII. Appendix 2A: further classification of labor costs

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A. Accounting for idle time, overtime, and fringe benefits

i. Idle time Machine breakdowns, material shortages, power failures and the like result in idle time. The labor costs incurred during idle time are ordinarily treated as manufacturing overhead. This enables the costs to be spread across all the production rather than the units in process when the disruptions occur.

ii. Overtime The overtime premiums for all factory workers are usually considered to be part of manufacturing overhead. This is done to avoid penalizing particular products or customer orders simply because they happen to fall on the tail end of the daily production schedule.

iii. Labor fringe benefits These costs relate to employment-related costs paid by an employer such as insurance programs, retirement plans, and supplemental unemployment programs. They also include the employer’s share of Social Security, Medicare, workers’ compensation, federal employment tax, and state unemployment insurance.

1. These costs often add up to 30% to 40% of an employee’s base pay.

2. Some companies include all of these costs in manufacturing overhead. Other companies

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opt for the conceptually superior method of treating fringe benefit expenses of direct laborers as additional direct labor costs.

VIII.Appendix 2B: cost of quality

A. Quality costs Costs incurred to prevent defects or that result from defects in products. Many companies are working hard to reduce their quality costs. Those companies that are succeeding have a high quality of conformance in the sense that the overwhelming majority of the products that they produce conform to design specifications and are free from defects.

“In Business Insights”Quality management is critically important to many organizations. In fact, many companies are investing significant resources training quality improvement experts known as “Black Belts.” For example:

“The Quality Black Belt” (Page 59) General Electric (GE) makes it clear to young

managers that they do not have much of a future with GE unless they become trained Black Belts.

GE hopes to save $7 to $10 billion over the next decade as a result of its Black Belt program.

B. There are four broad categories of quality costs:

i. Prevention costs Are incurred to support activities whose purpose is to reduce the number of defects.

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Helpful Hint: Suppose an ice cream company has been having problems with unpleasant gritty ice crystals in

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its ice cream. Ask students how they would prevent the ice crystal defect. One approach would be to investigate the manufacturing process. Perhaps the gritty ice crystals are caused by temperature variations in the freezer. Controlled experiments could be run varying the temperature and inspecting for ice crystals. If this is the cause, the variation in temperature could be decreased or the ingredients changed so they would be less sensitive to temperature changes.

ii. Appraisal costs Are incurred to identify defective products before the products are shipped to customers.

Helpful Hint: Continuing the ice cream example, ask students how they would “inspect out” the ice crystal problem. This may be more difficult and expensive than it first appears. For example, the problem could occur only in half-gallon containers or at random in a small (but important) number of containers. Or, the ice crystals could only be detected by tasting ice cream near the bottom of the container. “Inspecting out” the problem would make a lot of ice cream unsaleable.

iii. Internal failure costs Are incurred as a result of identifying defects before they are shipped to customers.

iv. External failure costs Are incurred as a result of defective products being delivered to customers.

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Helpful Hint: Continuing with the ice cream example, ask students to identify examples of internal and

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external failure costs. Internal failure costs could result from throwing away defective ice cream. External failure costs could result from customers returning defective ice cream or failing to purchase the ice cream company’s product at a later date.

v. Examples of each type of quality cost include:

1. Prevention Quality training, quality circles, statistical process control activities, etc.

2. Appraisal Testing and inspection of incoming materials, final product testing, depreciation of testing equipment, etc.

3. Internal failure Scrap, spoilage, rework, etc.

4. External failure Cost of field servicing and handling customer complaints, warranty repairs, lost sales arising from reputation of poor quality, etc.

vi. Distribution of quality costs Graphs are often used to depict the relationship between the four types of quality costs. The graph illustrates four key concepts.

1. When the quality of conformance is low, total quality cost is high and most of this cost consists of internal and external failure costs.

2. Total quality costs drop rapidly as the quality of conformance increases.

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3. Companies reduce their total quality costs by focusing their efforts on prevention and

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appraisal because the cost savings from reduced defects usually overwhelm the costs of additional prevention and appraisal.

Helpful Hint: Continuing with the ice cream example, the prevention activities mentioned earlier may reveal that, if fluctuating temperatures is the problem, a simple thermostat may solve the problem. The cost to identify the problem and install a thermostat is much less that the costs of scrapped ice cream, customer returns and complaints, and lost future business.

4. Total quality costs are minimized when the quality of conformance is less than 100%. This is a debatable point in the sense that some experts believe that total quality costs are not minimized until the quality of conformance is 100%.

C. Quality cost report This report details the prevention, appraisal, internal failure, and external failure costs that arise from a company’s current quality control efforts.

i. When interpreting a cost of quality report managers should look for two trends. First, increases in prevention and appraisal costs should be more than offset by decreases in internal and external failure costs. Second, the total quality costs as a percent of sales should decrease.

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“In Business Insights”

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The Cost of Quality can be very expensive for organizations. For example, companies that sell products that rely on software are well aware of the cost of “bugs” in their software:

“Fighting Bugs” (page 64) Raytheon Electronics Systems (RES) once

estimated that its cost of quality (i.e., the costs of preventing, detecting, and fixing bugs) was almost 60% of the total cost of producing software for its products.

RES reduced its cost of quality to 15% of total software production costs by using software management tools that are designed to prevent bugs from being written into the computer code in the first place.

ii. Quality cost reports can also be prepared in graphic form. Managers should still look for the same two trends whether the data is presented in a graphic or table format.

iii. Uses of quality cost information:

1. It helps managers see the financial significance of defects.

2. It helps managers identify the relative importance of the quality problems faced by the company.

3. It helps managers see whether their quality costs are poorly distributed. In general, costs should be distributed more toward prevention and to a lesser extent appraisal than toward failures.

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iv. Limitations of quality cost information

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1. Simply measuring and reporting quality cost problems does not solve quality problems.

2. Results usually lag behind quality improvement programs. Initially, prevention and appraisal cost increases may not be offset by decreases in failure costs.

3. The most important quality cost, lost sales arising from customer ill-will, is often omitted from quality cost reports because it is difficult to estimate.

“In Business Insights”External failure costs are often grossly understated by companies. For example:

“External Failure; It’s Worse Than You Think” (Page 65)

Venky Nagar and Madhav Rajan studied quality costs at 11 manufacturing plants of a large U.S. company.

Statistical analysis from these 11 plants revealed that a $1 increase in external failure costs was associated with a $26 decrease in cumulative future sales and a $10.40 cumulative decrease in future profits.

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IX. International aspects of quality

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A. The International Organization for Standardization, based in Geneva Switzerland, has established quality control guidelines know as the ISO 9000 standards. For a company to become ISO 9000 certified by a certifying agency it must demonstrate that:

i. A quality control system is in use, and the system clearly defines an expected level of quality.

ii. The system is fully operational and is backed up with detailed documentation of quality control procedures.

iii. The intended level of quality is being achieved on a sustained basis.

B. Although the ISO 9000 standards were developed in Europe they have become widely accepted elsewhere throughout the world including the United States.

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Chapter 2Transparency Masters

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TM 2-1

AN OVERVIEW OF COST TERMS IN CHAPTER 2

Purpose of classification

Cost classifications

Preparing an income statement and balance sheet

• Product costs • Direct materials • Direct labor • Manufacturing overhead• Period costs (nonmanufacturing costs) • Marketing and selling costs • Administrative costs

Predicting changes in cost due to changes in activity

• Variable costs • Fixed costs

Assigning costs • Direct costs • Indirect costs

Making decisions • Differential costs • Sunk costs • Opportunity costs

© The McGraw-Hill Companies, Inc., 2006. All rights reserved.

TM 2-2

COST CLASSIFICATIONS IN MANUFACTURING COMPANIES(Exhibit 2-1)


TM 2-3

COST FLOWS IN A MANUFACTURING COMPANY(Exhibit 2-6)


TM 2-4

COST FLOWS EXAMPLE

EXAMPLE: Ryarder Company incurred the following costs last month:

Purchases of raw materials..... $200,000Direct labor............................. $270,000Manufacturing overhead:

Indirect materials................. $ 5,000Indirect labor........................ 100,000Utilities, factory.................... 80,000Property taxes, factory......... 36,000Insurance, factory................. 9,000Equipment rental.................. 70,000Depreciation, factory............ 120,000

Total manufacturing overhead $420,000But:

• Some of the goods sold this month were produced in previous months.

• Some of the costs listed above were incurred to make goods that were not sold this month.

Therefore:• Cost of goods sold does not equal the sum of the above

costs.• We need to determine the values of the various

inventories.


TM 2-5

COST FLOWS EXAMPLE (cont’d)Additional data for Ryarder Company:

Raw materials inventory:Beginning raw materials inventory...... $10,000Purchases of raw materials.................. $200,00

0Ending raw materials inventory........... $30,000Raw materials used in production........ ?

Work in process inventory:Beginning work in process inventory... $40,000Total manufacturing costs................... ? Ending work in process inventory........ $60,000Cost of goods manufactured (i.e.,

finished)............................................?

Finished goods inventory:Beginning finished goods inventory..... $130,00

0Cost of goods manufactured (i.e.,

finished)............................................?

Ending finished goods inventory.......... $80,000Cost of goods sold............................... ?


TM 2-6

INVENTORY FLOWS(Exhibit 2-3)

Basic Equation for Inventory Accounts:

or


TM 2-7

COST FLOWS EXAMPLE (cont’d)

Computation of raw materials used in productionBeginning raw materials inventory......... $ 10,00

0+ Purchases of raw materials.................... 200,000– Ending raw materials inventory.............. 30,00

0= Raw materials used in production.......... $180,00

0

Computation of total manufacturing costRaw materials used in production.......... $180,00

0+ Direct labor............................................ 270,000+ Manufacturing overhead........................ 420,00

0= Total manufacturing costs...................... $870,00

0

Computation of cost of goods manufacturedBeginning work in process inventory..... $ 40,00

0+ Total manufacturing costs...................... 870,000– Ending work in process inventory.......... 60,00

0= Cost of goods manufactured (i.e.,

finished)...............................................$850,00

0


TM 2-8

Computation of cost of goods soldBeginning finished goods inventory....... $130,00

0+ Cost of goods manufactured (i.e.,

finished)...............................................850,000

– Ending finished goods inventory............ 80,00 0

= Cost of goods sold.................................. $900,000


TM 2-9

SCHEDULE OF COST OF GOODS MANUFACTURED

Ryarder CompanySchedule of Cost of Goods Manufactured

Direct materials:Beginning raw materials inventory... $ 10,000Add: Purchases of raw materials...... 200,000 Raw materials available for use....... 210,000Deduct: Ending raw materials

inventory........................................ 30,000

Raw materials used in production.... $180,000

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

Indirect materials............................. 5,000Indirect labor.................................... 100,000Utilities, factory................................ 80,000Property taxes, factory..................... 36,000Insurance, factory............................ 9,000Equipment rental.............................. 70,000Depreciation, factory........................ 120,000

Total overhead costs.......................... 420,00 0

Total manufacturing costs.................. 870,000Add: Beginning work in process

inventory.......................................... 40,00

0910,000

Deduct: Ending work in process inventory..........................................

60,00 0

Cost of goods manufactured............... $850,000

Cost of Goods SoldBeginning finished goods inventory.... $130,00

0Add: Cost of goods manufactured...... 850,00

0Goods available for sale...................... 980,000


TM 2-10

Deduct: Ending finished goods inventory..........................................

80,00 0

Cost of goods sold.............................. $900,000


TM 2-11

COST CLASSIFICATIONS TO DESCRIBE COST BEHAVIOR

To describe how costs react to changes in activity, costs are often classified as variable or fixed.

VARIABLE COSTSVariable cost behavior can be summarized as follows:

Variable Cost BehaviorIn Total Per Unit

Total variable cost increases and decreases in proportion

to changes in activity.

Variable cost per unit is constant.

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 10 $300$30 100 $3,000$30 200 $6,000


TM 2-12

FIXED COSTSFixed cost behavior can be summarized as follows:

Fixed Cost BehaviorIn Total Per Unit

Total fixed cost is not affected by changes in

activity (i.e., total fixed cost remains constant even if

activity changes).

Fixed cost per unit decreases as the activity level rises and increases as the activity level falls.

EXAMPLE: Assume again that a company manufactures microwave ovens. The company pays $9,000 per month to rent its factory building. The total and per unit cost of rent at various levels of activity would be:

Number ofRent Cost Ovens Rent Costper Month Produced per Oven$9,000 1 $9,000$9,000 10 $900$9,000 100 $90$9,000 200 $45


TM 2-13

A GRAPHIC VIEW OF COST BEHAVIOR

RELEVANT RANGEIf activity changes enough, fixed costs may change. For

example, if microwave production were doubled, another factory building might have to be rented.

The relevant range is the range of activity within which the assumptions that have been made about variable and fixed costs are valid. For example, the relevant range within which total fixed factory rent is $9,000 per month might be 1 to 200 microwaves produced per month.


TM 2-14

COST CLASSIFICATIONS FOR ASSIGNING COSTS

COST OBJECTA cost object is anything for which cost data are desired.

Examples:• Products• Customers• Departments• Jobs

DIRECT COSTSA direct cost is a cost that can be easily and conveniently

traced to a particular cost object.Examples:

• The direct costs of a Ford SUV would include the cost of the steering wheel purchased by Ford from a supplier, the costs of direct labor workers, the costs of the tires, and so on.

• The direct costs of a hospital’s radiology department would include X-ray film used in the department, the salaries of radiologists, and the costs of radiology lab equipment.

INDIRECT COSTSAn indirect cost is a cost that cannot be easily and

conveniently traced to a particular cost object.Examples:

• Manufacturing overhead, such as the factory managers’ salary at a multi-product plant, is an indirect cost of any one product.

• General hospital administration costs are indirect costs of the radiology lab.


TM 2-15

COST CLASSIFICATIONS FOR DECISION-MAKING

DIFFERENTIAL COSTEvery decision involves choosing from among at least two alternatives. Any cost that differs between alternatives is a differential cost. Only the differential costs are relevant in making a decision.EXAMPLE: Bill is currently employed as a lifeguard, but he has been offered a job in an auto service center in the same town. The differential revenues and costs between the two jobs are listed below:

Auto Differential

Life- service costs andguard center revenues

Monthly salary................. $1,200 $1,500 $300 Monthly expenses:

Commuting................... 30 90 60 Meals............................

...................................150 150 0

Apartment rent............. 450 450 0 Uniform rental............... 0 50 50 Union dues.................... 10 0 (10 )

Total monthly expenses. . 640 740 100 Net monthly income........ $ 560 $ 760 $200


TM 2-16

OPPORTUNITY COSTAn opportunity cost is the potential benefit given up when

selecting one course of action over another.EXAMPLE: Linda is employed in the campus bookstore and is paid $65 per day. One of her friends is getting married and Linda would like to attend the wedding, but she would have to miss a day of work. If she attends the wedding, the $65 in lost wages will be an opportunity cost of attending the wedding.EXAMPLE: The reception for the wedding mentioned above will be held in the ballroom at the Lexington Club. The manager of the Lexington Club had to decide between accepting the booking for the wedding reception or accepting a booking for a corporate seminar. The hall could have been rented to the corporation for $600. The lost rental revenue of $600 is an opportunity cost of accepting the reservation for the wedding.

SUNK COSTA sunk cost is a cost that has already been incurred and

that cannot be changed by any decision made now or in the future. Sunk costs are irrelevant and should be ignored in decisions.EXAMPLE: Linda has already purchased a ticket to a rock concert for $35. Unfortunately, if she goes to the wedding, she will be unable to attend the concert. The $35 is a sunk cost that she should ignore when deciding whether or not to attend the wedding. [However, any amount she can get by reselling the ticket is NOT a sunk cost.]


TM 2-17

ACCOUNTING FOR LABOR COSTS (Appendix 2A)

Labor costs can be categorized as follows:

Direct labor

Indirect labor (part of manufacturing

overhead) Other labor costs(Discussed earlier)

Janitors Idle time

Supervisors Overtime premium

Materials handlers Labor fringe benefits

EngineersNight security guardsMaintenance workers

IDLE TIMEIdle time represents the wages of direct labor workers

who are idle due to machine breakdowns, material shortages, power failures, and the like. The cost of idle time is often added to manufacturing 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, labor cost would be allocated as follows between direct labor and manufacturing overhead:

Direct labor cost ($15 per hour × 38 hours)......... $570Manufacturing overhead cost ($15 per hour × 2

hours) 30

Total cost for the week......................................... $600


TM 2-18

OVERTIME PREMIUMAny overtime premium paid to factory workers (direct as well as indirect labor) is usually considered to be part of manufacturing overhead.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 per hour × 46 hours).............. $690

Manufacturing overhead cost ($7.50 per hour × 6 hours)

45

Total cost for the week.............................................. $735

LABOR FRINGE BENEFITSLabor 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 companies treat all such costs as indirect labor and

add them to manufacturing overhead.2. Other companies treat that portion of fringe benefits that

relates to direct labor as additional direct labor cost.


TM 2-19

QUALITY COSTS (Appendix 2B)

• The costs of correcting defective units before they reach customers are called internal failure costs. Examples:

• Scrapped units.• Rework of defective units.

• Costs that are incurred by releasing defective units to customers are called external failure costs. Examples:

• Costs of fixing products under warranty.• Loss of sales due to a tarnished reputation.

• The costs of internal and external failures can be avoided by:• Preventing defects.• Finding defective units before they are released.The costs associated with these activities are called prevention costs and appraisal costs, respectively.

• Generally, prevention is the best policy. It is usually far easier and less expensive to prevent defects than to fix them.


TM 2-20

EXAMPLES OF QUALITY COSTS(Exhibit 2B-1)


TM 2-21

TRADING-OFF QUALITY COSTS(Exhibit 2B-2)


TM 2-22

QUALITY COST REPORTS

• Quality cost reports summarize prevention costs, appraisal costs, internal failure costs, and external failure costs that would otherwise be hidden in general overhead.• Managers are often surprised by how much defects cost. • The report helps identify where the biggest quality

problems lie.• The report helps managers assess how resources should

be distributed. If internal and external failure costs are high relative to prevention and appraisal costs, more should probably be spent on prevention and appraisal.

• Since quality cost reports are largely an attention-directing device, the costs do not have to be precise.

• Unfortunately, the cost of lost sales due to external failures is usually excluded from the reports due to measurement difficulties.


TM 2-23

SAMPLE QUALITY COST REPORT(Exhibit 2B-3)


Documents

Chapter 2 - Texas A&M University–Corpus Christifaculty.tamucc.edu/shall/2302/Chapter Outlines/chap002.doc · Web viewAdministrative Costs. These costs include all executive, organizational,