Cost Terms and Concepts

7/31/2019 Cost Terms and Concepts

1/65


2/65

Learning Objective 1

Define and illustrate

a cost object.


3/65

Cost and Cost Terminology

Costis a resource sacrificed or forgone to achieve

a specific objective.An actual costis the cost incurred (a historical cost)

as distinguished from budgeted costs.

A cost objectis anything for which a separatemeasurement of costs is desired.


4/65

Cost and Cost Terminology

CostAccumulation

Cost Object

Cost Object

Cost Object

CostAssignment

Tracing

Allocating


5/65


Distinguish between direct costs

and indirect costs.


6/65

Direct and Indirect Costs

Direct Costs

Example: Paper on which

Sports Illustratedmagazineis printed

Indirect Costs

Example: Lease cost for

Building housing the

senior editors

of its magazine

COST OBJECT

Example: SportsIllustrated magazine


7/65


ExampleDirect Costs:

Maintenance Department $40,000

Personnel Department $20,600Assembly Department $75,000

Finishing Department $55,000

Assume that Maintenance Department costs areallocated equally among the production departments.

How much is allocated to each department?


8/65


Example

Allocated$20,000

Maintenance

$40,000

Assembly

Direct Costs$75,000

Finishing

Direct Costs$55,000

$20,000


9/65


Explain variable costs

and fixed costs.


10/65

Cost Behavior Patterns Example

Bicycles by the Sea buys a handlebar

at $52 for each of its bicycles.What is the total handlebar cost when

1,000 bicycles are assembled?


11/65


1,000 units $52 = $52,000

What is the total handlebar costwhen 3,500 bicycles are assembled?

3,500 units $52 = $182,000


12/65


Bicycles by the Sea incurred $94,500 in

a given year for the leasing of its plant.This is an example of fixed costs with

respect to the number of bicycles assembled.


13/65


What is the leasing (fixed) cost per bicycle

when Bicycles assembles 1,000 bicycles?$94,500 1,000 = $94.50

What is the leasing (fixed) cost per bicycle

when Bicycles assembles 3,500 bicycles?

$94,500 3,500 = $27


14/65

Cost Drivers

The cost driver of variable costs is the level

of activity or volume whose change causesthe (variable) costs to change proportionately.

The number of bicycles assembled is a

cost driver of the cost of handlebars.


15/65

Relevant Range Example

Assume that fixed (leasing) costs are $94,500

for a year and that they remain the same for acertain volume range (1,000 to 5,000 bicycles).

1,000 to 5,000 bicycles is the relevant range.


16/65

Relevant Range Example

0

20000

40000

6000080000

100000

120000

0 1000 2000 3000 4000 5000 6000

Volume

FixedCo

sts

$94,500


17/65

Relationships of Types of Costs

Direct

Indirect

Variable Fixed


18/65


Interpret unit costs.


19/65

Total Costs and Unit Costs

Example

What is the unit cost (leasing and handlebars)

when Bicycles assembles 1,000 bicycles?Total fixed cost $94,500

+ Total variable cost $52,000 = $146,500

$146,500 1,000 = $146.50


20/65

Total Costs and Unit Costs

Example

0

50000

100000

150000

200000

0 500 1000 1500

Volume

TotalCosts

$94,500

$146,500


21/65

Use Unit Costs

Assume that Bicycles management uses a

unit cost of $146.50 (leasing and wheels).

Management is budgeting costs for

different levels of production.

What is their budgeted cost for anestimated production of 600 bicycles?

600 $146.50 = $87,900


22/65

Use Unit Costs

What is their budgeted cost for an estimated

production of 3,500 bicycles?

3,500 $146.50 = $512,750

What should the budgeted cost be for an

estimated production of 600 bicycles?


23/65

Use Unit Costs

Total fixed cost $ 94,500

Total variable cost ($52 600) 31,200

Total $125,700

$125,700 600 = $209.50

Using a cost of $146.50 per unit wouldunderestimate actual total costs if output

is below 1,000 units.


24/65

Use Unit Costs

What should the budgeted cost be for an

estimated production of 3,500 bicycles?

Total fixed cost $ 94,500

Total variable cost (52 3,500) 182,000Total $276,500

$276,500 3,500 = $79.00


25/65


Distinguish among

manufacturing companies,

merchandising companies, and

service-sector companies.


26/65

Manufacturing

Manufacturing companies

purchase materials and components and

convert them into finished goods.

A manufacturing company must also develop,

design, market, and distribute its products.


27/65

Merchandising

merchandise /Trading companies

purchase and then sell tangible products

without changing their basic form.


28/65

Merchandising

Service companies

provide services or intangible

products to their customers.

Labor is the most significant cost category.


29/65


Differentiate between

Product costs

and Period costs.


30/65

Product Cost and Period Cost

Cost

Unexpired

(Product)

Recorded as an asset inthe balance sheet and

become an expense in theprofit and loss account in

a later accounting period

Expired

(Period)

Recorded as an expense in theprofit and loss account of theCurrent accounting period


31/65

Inventoriable Costs OR Product

Cost

Inventoriable costs (assets)

become cost of goods sold

after a sale takes place.


32/65

Period Costs

Period costs are all costs in the income

statement other than cost of goods sold.Period costs are recorded as expenses of the

accounting period in which they are incurred.


33/65

Classification of

Manufacturing Costs

Direct materials Costs

Direct Labor Costs

Factory Overhead Costs


34/65


Describe the three categories of

inventories commonly found

in manufacturing companies.


35/65

Types of Inventory

Manufacturing-sector companies

typically have one or more of the

following three types of inventories:

1. Direct materials inventory

2. Work in process inventory (workin progress)

3. Finished goods inventory


36/65

Types of Inventory

Merchandising-sector companies hold

only one type of inventorythe

product in its original purchased form.

Service-sector companies do not

hold inventories of tangible products.


37/65

Flow of Costs Example

Bicycles by the Sea had $50,000 of direct

materials inventory at the beginning of the period.Purchases during the period amounted to

$180,000 and ending inventory was $30,000.

How much direct materials were used?$50,000 + $180,000$30,000 = $200,000


38/65


Direct labor costs incurred were $105,500.

Indirect manufacturing costs were $194,500.What are the total manufacturing costs incurred?

Direct materials used $200,000

Direct labor 105,500Indirect manufacturing costs 194,500

Total manufacturing costs $500,000


39/65


Assume that the work in process inventory

at the beginning of the period was $30,000,

and $35,000 at the end of the period.What is the cost of goods manufactured?

Beginning work in process $ 30,000

Total manufacturing costs 500,000Ending work in process 35,000

Cost of goods manufactured $495,000


40/65


Assume that the finished goods inventory

at the beginning of the period was $10,000,

and $15,000 at the end of the period.What is the cost of goods sold?

Beginning finished goods $ 10,000

Cost of goods manufactured 495,000Ending finished goods 15,000

Cost of goods sold $490,000


41/65

Manufacturing Company

MaterialsInventory

FinishedGoods

Inventory

Revenues

Cost ofGoods Sold

INCOME STATEMENT

PeriodCosts

InventoriableCosts

BALANCE SHEET

Equals Operating Income

whensalesoccur

deduct

Equals Gross Margin

deductWork inProcess

Inventory


42/65

Merchandising Company

INCOME STATEMENTBALANCE SHEET

whensalesoccur

InventoriableCosts

MerchandisePurchases

Inventory

Revenues

deductCost of

Goods Sold

Equals Gross Margin

deduct

PeriodCosts

Equals Operating Income


43/65

Prime Costs

Direct

Materials

Direct

Labor

Prime

Costs+ =


44/65

Prime Costs

What are the prime costs for Bicycles by the Sea?

Direct materials used $200,000+ Direct labor 105,500

= $305,000


45/65

Conversion Costs

Direct

Labor

Manufacturing

Overhead+ =Conversion

Costs

IndirectLabor

IndirectMaterials Other


46/65

Conversion Costs

What are the conversion costs for

Bicycles by the Sea?Direct labor $105,500

+ Indirect manufacturing costs 194,500

= $300,000


47/65

Measuring Costs

Requires Judgment

Manufacturing labor-cost classifications

vary among companies.The following distinctions are generally found:

Direct manufacturing labor

Manufacturing overhead


48/65

Measuring Costs

Requires Judgment

Manufacturing overhead

Indirect labor Managers salaries Payroll fringe costs

Forklift truck operators (internal handling of materials)

Rework labor

Overtime premium Idle time


49/65

Measuring Costs

Requires Judgment

Overtime premium is usually

considered part of overhead.Assume that a worker gets $18/hour

for straight time and gets

time and one-half for overtime.


50/65

Measuring Costs

Requires Judgment

How much is the overtime premium?

$18 50% = $9 per overtime hourIf this worker works 44 hours on a given

week, how much are his gross earnings?

Direct labor 44 hours $18 = $792Overtime premium 4 hours $ 9 = 36Total gross earnings $828


51/65


Illustrate:- Relevant and Irrelevant Cost and Revenues

- Avoidable and Unavoidable Costs

- Sunk Cost

- Opportunity Costs

- Incremental and Marginal Cost


52/65


53/65

Relevant and Irrelevant Cost and

Revenues

Example: if one is faced with a choice ofMaking a journey by car or by public transport,

the car tax and insurance costs are irrelevant,since they will remain the same whatever

alternative is chosen. However, petrol costs for the

Car will differ depending on which alternative is

chosen, and this cost will be relevant for

decision-making.


54/65

Avoidable and Unavoidable Cost

Sometimes the terms avoidable and unavoidableCosts are used instead of relevant and irrelevant

cost.

Avoidable costs are those costs that may be saved

by not adopting a given alternative, whereas

unavoidable costs cannot be saved. Therefore only

avoidable costs are relevant for decision-making

purposes.


55/65

Avoidable and Unavoidable Cost

Example:

The material Cost of $ 100 are unavoidable and

irrelevant, but the conversion cost of $200 areavoidable and hence relevant.

The decision rule is to accept those alternatives

that generate revenues in excess of the

avoidable costs.


56/65

Sunk Cost

These costs are the cost of resources alreadyAcquired where the total will be unaffected by

the choice between various alternatives.

They are costs that have been created by a

Decision made in the past and that cannot be

Changed by any decision that will be made inthe future.


57/65

Sunk Cost-EXAMPLE

The written down values of assets previouslyPurchased are sunk costs. For example, if a

machine was purchased four years ago for $100,00

with an expected life of five years and nil scrapvalue then the written down value will be $20,000

If straight line depreciation is used. This written

down value will have to be written off, no matter

what possible alternative future action might be

chosen. Sunk cost is irrelevant for decision

making but they are distinguished from irrelevant


58/65

Sunk Costs

Costs because not all irrelevant costs are sunk cost.For example , a comparison of two alternative

production methods may result in identical direct

Material expenditure for both alternatives, so theDirect material cost is irrelevant because it will

remain the same whichever alternative is chosen,

but material cost is not a suck cost since it will be

incurred in the future.


59/65

Opportunity Costs

An opportunity Cost is a cost that measures theopportunity that is lost or sacrificed when the

choice of one course of action requires that an

alternative course of action be given up.

Opportunity Costs EXAMPLE


60/65

Opportunity Costs- EXAMPLE

A company has an opportunity to obtain a contract

for the production of a special component. ThisComponent will require 100 hours of processing on

machine X. Machine X is working at full capacity on

The production of product A, and the only way inwhich the contract can be fulfilled is by reducing

the output of product A. This will mean a loss of

revenue $200. The contract will also result in

additional variable cost of $1000.

If the company takes on the contract, it will sacrifice

Opportunity Costs


61/65

Opportunity CostsRevenue of$200 from the lost output of

product A. This represents an opportunity cost,and should be included as part of the cost when

negotiating for the contract. The contract price

should at least cover the additional costs of$1000 plus the $200 opportunity cost to ensure

that the company will be better off in the short

term by accepting the contract.

Opportunity Costs


62/65

Opportunity Costs

It is important to note that opportunity costs

only apply to the use of scarce resources. Whereresources are not scarce , no sacrifice exists from

using these resources.

In our previous example If machine X wereoperating at 80% of its potential capacity then the

decision to accept the Contract would not have

resulted in reduced production of product A.

Consequently, there would have been no loss of

revenue, and the opportunity cost would be

ZERO.


63/65

Incremental and Marginal Costs

Incremental (also called differential) costsand revenues are the difference between

costs and revenues for the corresponding

items under each alternative beingconsidered. For example the incremental

costs of increasing output from 1000 to 1100

units per week are the additional costs ofproducing an extra 100 units per week.


64/65

Incremental and Marginal Costs

Incremental costs and revenues are similar inprinciple to the economists concept of

marginal cost and marginal revenue. The

main difference is that marginal cost/revenuerepresents the additional cost/revenue of one

extra unit of output whereas incremental

cost/revenues resulting from a group ofadditional units of output.


65/65

End

Documents

Cost Terms and Concepts