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Ch2 Cost Concepts.pptx

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Ch2 Cost Concepts.pptx

  1. 1. Needs of Management Financial accounting is concerned with reporting financial information to external parties, such as stockholders, creditors, and regulators. Managerial accounting is concerned with providing information to managers within an organization so that they can formulate plans, control operations, and make decisions.
  2. 2. Purposes of Cost Classification 1. Assigning costs to cost objects 2. Accounting for costs in manufacturing companies 3. Preparing financial statements 4. Predicting cost behavior in response to changes in activity 5. Making decisions
  3. 3. Learning Objective 1 Understand cost classifications used for assigning costs to cost objects: direct costs and indirect costs.
  4. 4. Assigning Costs to Cost Objects Direct costs • Costs that can be easily and conveniently traced to a unit of product or other cost object. • Examples: direct material and direct labor Indirect costs • Costs that cannot be easily and conveniently traced to a unit of product or other cost object. • Example: manufacturing overhead Common costs • Indirect costs incurred to support a number of cost objects. These costs cannot be traced to any individual cost object.
  5. 5. Exercise: Direct vs Indirect Cost Northwest hospital is a full service hospital that provides everything from major surgery and emergency room care to outpatient clinics. Required: For each cost incurred at Northwest hospital, indicate whether it would most likely be a direct cost or an indirect cost of the specified cost object by placing an X in the appropriate column. Cost Cost object Direct cost Indirect cost The wages of pediatric nurses The pediatric department Prescription drugs A particular patient Heating the hospital The pediatric department The salary of the head of pediatrics The pediatric department The salary of the head of pediatrics A particular pediatric patient Hospital chaplain’s salary A particular patient Lab tests by outside contractor A particular patient Lab tests by outside contractor A particular department
  6. 6. Direct vs Indirect Cost Required: For each cost incurred at Northwest hospital, indicate whether it would most likely be a direct cost or an indirect cost of the specified cost object by placing an X in the appropriate column. Cost Cost object Direct cost Indirect cost The wages of pediatric nurses The pediatric department X Prescription drugs A particular patient X Heating the hospital The pediatric department X The salary of the head of pediatrics The pediatric department X The salary of the head of pediatrics A particular pediatric patient X Hospital chaplain’s salary A particular patient X Lab tests by outside contractor A particular patient X Lab tests by outside contractor A particular department X
  7. 7. Learning Objective 2 Identify and give examples of each of the three basic manufacturing cost categories.
  8. 8. Direct Materials Direct Labor Manufacturing Overhead Classifications of Manufacturing Costs
  9. 9. Direct Materials Direct materials are raw materials that become an integral part of the product and that can be conveniently traced directly to it. Example: A radio installed in an automobile
  10. 10. Direct Labor Direct labor costs are those labor costs that can be easily traced to individual units of product. Example: Wages paid to automobile assembly workers
  11. 11. Manufacturing Overhead Includes indirect labor costs that cannot be easily or conveniently traced to specific units of product. Includes indirect materials that cannot be easily or conveniently traced to specific units of product. Manufacturing overhead includes all manufacturing costs except direct material and direct labor. These costs cannot be readily traced to finished products.
  12. 12. Manufacturing Overhead – Examples Examples of manufacturing overhead: • Depreciation of manufacturing equipment • Utility costs • Property taxes • Insurance premiums incurred to operate a manufacturing facility Only those indirect costs associated with operating the factory are included in manufacturing overhead.
  13. 13. Prime Costs and Conversion Costs Manufacturing costs are often classified as follows: Direct Material Direct Labor Manufacturing Overhead Prime Cost Conversion Cost
  14. 14. Nonmanufacturing Costs Selling Costs Costs necessary to secure the order and deliver the product. Selling costs can be either direct or indirect costs. Administrative Costs All executive, organizational, and clerical costs. Administrative costs can be either direct or indirect costs.
  15. 15. Exercise: Classifying Manufacturing Costs The PC Works assembles custom computers from components supplied by various manufacturers. The company is very small and its assembly shop and retail sales stores are housed in a single facility in a Redmond, Washington industrial park. Listed below are some of the costs the company incurs. Required: For each cost, indicate whether it would most likely be classified as direct materials, direct labour, manufacturing overhead, selling or an admin cost. 1. The cost of the hard drive installed in a computer. 2. The cost of advertising in the local newspaper. 3. The wages of employees who assemble computers from components. 4. Sales commission paid to the company’s sales people. 5. The salary of the assembly shop supervisor. 6. The salary of the company’s accountant. 7. Depreciation on equipment used to test assembled computers before release to customers. 8. Rent on the facility in the industrial park.
  16. 16. Classifying Manufacturing Costs Required: 1. The cost of the hard drive installed in a computer. (Direct material) 2. The cost of advertising in the local newspaper. (Selling) 3. The wages of employees who assemble computers from components. (Direct labour) 4. Sales commission paid to the company’s salespeople. (Selling) 5. The salary of the assembly shop supervisor. (Manufacturing overhead) 6. The salary of the company’s accountant. (Admin) 7. Depreciation on equipment used to test assembled computers before release to customers. (Manufacturing overhead) 8. Rent on the facility in the industrial park. (A mixture) - a combination of manufacturing overhead, selling, and administrative. The rent would most likely be prorated on the basis of the amount of space occupied by manufacturing, selling, and administrative operations.
  17. 17. Learning Objective 3 Understand cost classifications used to prepare financial statements: product costs and period costs.
  18. 18. Product Costs Product costs includes all the costs that are involved in acquiring or making a product. Product costs “attach” to a unit of product as it is purchased or manufactured, and they stay attached to each unit of product as long as it remains in inventory awaiting sale.
  19. 19. Manufacturing Product Costs For manufacturing companies, product costs include: • Raw materials: includes any materials that go into the final product. • Work in process: consists of units of product that are only partially complete and will require further work before they are ready for sale to the customer. • Finished goods costs: consists of completed units of product that have not yet been sold to customers.
  20. 20. Transfer of Product Costs • When direct materials are used in production, their costs are transferred from Raw Materials to Work in Process. • Direct labor and manufacturing overhead costs are added to Work in Process to convert direct materials into finished goods. • Once units of product are completed, their costs are transferred from Work in Process to Finished Goods. • When a manufacturer sells its finished goods to customers, the costs are transferred from Finished Goods to Cost of Goods Sold.
  21. 21. Cost Classifications for Preparing Financial Statements Product costs include direct materials, direct labor, and manufacturing overhead. Period costs include all selling costs and administrative costs. Inventory Cost of Good Sold Balance Sheet Income Statement Sale Expense Income Statement
  22. 22. Quick Check 1 Which of the following costs would be considered a period rather than a product cost in a manufacturing company? A. Manufacturing equipment depreciation. B. Property taxes on corporate headquarters. C. Direct materials costs. D. Electrical costs to light the production facility. E. Sales commissions.
  23. 23. Quick Check 1a Which of the following costs would be considered a period rather than a product cost in a manufacturing company? A. Manufacturing equipment depreciation. B. Property taxes on corporate headquarters. C. Direct materials costs. D. Electrical costs to light the production facility. E Sales commissions.
  24. 24. Learning Objective 4 Understand cost classifications used to predict cost behavior: variable costs, fixed costs, and mixed costs.
  25. 25. Cost Classifications for Predicting Cost Behavior Cost behavior refers to how a cost will react to changes in the level of activity. The most common classifications are: • Variable costs. • Fixed costs. • Mixed costs.
  26. 26. Variable Cost A cost that varies, in total, in direct proportion to changes in the level of activity. A variable cost per unit is constant.
  27. 27. An Activity Base (Cost Driver) A measure of what causes the incurrence of a variable cost Units produced Miles driven Machine hours Labor hours
  28. 28. Fixed Cost A cost that remains constant, in total, regardless of changes in the level of the activity. If expressed on a per unit basis, the average fixed cost per unit varies inversely with changes in activity.
  29. 29. Types of Fixed Costs Discretionary May be altered in the short-term by current managerial decisions Committed Long-term, cannot be significantly reduced in the short term
  30. 30. Relevant Range A straight line closely approximates a curvilinear variable cost line within the relevant range. Activity Total Cost Economist’s Curvilinear Cost Function The Linearity Assumption and the Relevant Range Accountant’s Straight-Line Approximation (constant unit variable cost)
  31. 31. Fixed Costs and the Relevant Range Fixed costs would increase in a step fashion at a rate of $30,000 for each additional 1,000 square feet. The relevant range of activity pertains to fixed cost as well as variable costs. For example, assume office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet.
  32. 32. Rent Cost in Thousands of Dollars 0 1,000 2,000 3,000 Rented Area (Square Feet) 0 30 60 Relevant Range: Graphic 90 Relevant Range The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat.
  33. 33. Comparison of Cost Classifications for Predicting Cost Behavior Behavior of Cost (within the relevant range) Cost In Total Per Unit Variable Total variable cost Increase Variable cost per unit and decrease in proportion remains constant. to changes in the activity level. Fixed Total fixed cost is not affected Fixed cost per unit decreases by changes in the activity as the activity level rises and level within the relevant range. increases as the activity level falls.
  34. 34. Quick Check 2 Which of the following costs would be variable with respect to the number of ice cream cones sold at a Baskin & Robbins? (There may be more than one correct answer.) A. The cost of lighting the store. B. The wages of the store manager. C. The cost of ice cream. D. The cost of napkins for customers.
  35. 35. Quick Check 2a Which of the following costs would be variable with respect to the number of ice cream cones sold at a Baskin & Robbins? (There may be more than one correct answer.) A. The cost of lighting the store. B. The wages of the store manager. C. The cost of ice cream. D. The cost of napkins for customers.
  36. 36. Guided Example Java Express operates a number of espresso coffee stands in busy suburban malls. The fixed weekly expense of a coffee stand is $1,500 and the variable cost per cup of coffee served is $0.19. Required: Estimate the total costs and average cost per cup of coffee at the indicated levels of activity for a coffee stand. Round off the cost of a cup of coffee to the nearest cent. Cups of Coffee Served in a Week Cups of Coffee Served in a Week Cups of Coffee Served in a Week 3,700 3,800 3,900 Fixed cost Variable cost Total cost Average cost per cup of coffee served
  37. 37. Guided Example Java Express operates a number of espresso coffee stands in busy suburban malls. The fixed weekly expense of a coffee stand is $1,500 and the variable cost per cup of coffee served is $0.19. Required: Estimate the total costs and average cost per cup of coffee at the indicated levels of activity for a coffee stand. Round off the cost of a cup of coffee to the nearest cent. Cups of Coffee Served in a Week Cups of Coffee Served in a Week Cups of Coffee Served in a Week 3,700 3,800 3,900 Fixed cost $1,500 $1,500 $1,500 Variable cost 703 722 741 Total cost $2,203 $2,222 $2,241 Average cost per cup of coffee served $ 0.60 $ 0.58 $ 0.57
  38. 38. Fixed Monthly Utility Charge Variable Cost per KW Activity (Kilowatt Hours) Total Utility Cost X Y A mixed cost contains both variable and fixed elements. Consider the example of utility cost. Mixed Costs – Part 1
  39. 39. Mixed Costs – Part 2 The total mixed cost line can be expressed as an equation: Y = a + bX Where: Y = The total mixed cost. a = The total fixed cost (the vertical intercept of the line). b = The variable cost per unit of activity (the slope of the line). X = The level of activity. Fixed Monthly Utility Charge Variable Cost per KW Activity (Kilowatt Hours) Total Utility Cost X Y
  40. 40. Mixed Costs – An Example If your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, and your monthly activity level is 2,000 kilowatt hours, what is the amount of your utility bill? Y = a + bX Y = $40 + ($0.03 × 2,000) Y = $100
  41. 41. High-Low Method The fixed and variable elements of semi-variable costs can be determined by the high-low method, using the following steps: Step 1: Select the highest and lowest activity levels, and their associated costs. (Note: do not take the highest and lowest costs). Step 2: Calculate the variable cost per unit: 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = 𝐶𝑜𝑠𝑡 𝑎𝑡 ℎ𝑖𝑔ℎ 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 − 𝐶𝑜𝑠𝑡 𝑎𝑡 𝑙𝑜𝑤 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝐻𝑖𝑔ℎ 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 − 𝐿𝑜𝑤 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 Step 3: Calculate the fixed cost by substitution, using either the high or low activity level. 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑙𝑒𝑣𝑒𝑙 − 𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 Step 4: Use the total fixed cost and the variable cost per unit values (steps 2 and 3) to calculate the estimated cost at different activity levels.
  42. 42. Example: High Low Method Output (Units) Total Cost ($) 200 7,000 300 8,000 400 9,000 1. Variable cost per unit = ($9,000−$7,000) (400−200) = $𝟏𝟎 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭 2. Total fixed cost by substituting at high activity level: 3. If output is 350 units or 600 Units: Total Cost = $9,000 Total variable cost = 400 x $10 = $4,000 Therefore, Fixed cost = $5,000 Variable cost = 350 x $10 = $3,500 = 600 x $10 = $6,000 Fixed Cost = $5,000 = $5,000 Therefore, Total cost = $8,500 = $11,000
  43. 43. Learning Objective 5 Understand cost classifications used in making decisions: relevant costs and irrelevant costs.
  44. 44. Cost Classifications for Decision Making • Decisions involve choosing between 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 the concepts of differential costs and revenues, opportunity costs, and sunk costs.
  45. 45. Differential Costs Differential costs (or incremental costs) are the difference in cost between any two alternatives. A difference in revenue between two alternatives is called differential revenue. Both are always relevant to decisions. Differential costs can be either fixed or variable.
  46. 46. Opportunity Cost The potential benefit that is given up when one alternative is selected over another. These costs are not usually found in accounting records but must be explicitly considered in every decision. For students: What is the opportunity cost you incur by attending class?
  47. 47. Sunk Costs Sunk costs have already been incurred and cannot be changed now or in the future. These irrelevant costs should be ignored when making decisions.
  48. 48. Quick Check 3 Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the cost of the train ticket relevant in this decision? In other words, should the cost of the train ticket affect the decision of whether you drive or take the train to Portland? A. Yes, the cost of the train ticket is relevant. B. No, the cost of the train ticket is not relevant.
  49. 49. Quick Check 3a Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the cost of the train ticket relevant in this decision? In other words, should the cost of the train ticket affect the decision of whether you drive or take the train to Portland? A. Yes, the cost of the train ticket is relevant. B. No, the cost of the train ticket is not relevant.
  50. 50. Quick Check 4 Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the annual cost of licensing your car relevant in this decision? A. Yes, the licensing cost is relevant. B. No, the licensing cost is not relevant.
  51. 51. Quick Check 4a Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the annual cost of licensing your car relevant in this decision? A. Yes, the licensing cost is relevant. B. No, the licensing cost is not relevant.
  52. 52. Quick Check 5 Suppose that your car could be sold now for $5,000. Is this a sunk cost? A. Yes, it is a sunk cost. B. No, it is not a sunk cost.
  53. 53. Quick Check 5a Suppose that your car could be sold now for $5,000. Is this a sunk cost? A. Yes, it is a sunk cost. B. No, it is not a sunk cost.
  54. 54. Learning Objective 6 Prepare income statements for a merchandising company using the traditional and contribution formats.
  55. 55. The Traditional and Contribution Formats Used primarily for external reporting. Used primarily by management.
  56. 56. Uses of the Contribution Format The contribution income statement format is used as an internal planning and decision-making tool. We will use this approach for: 1.Cost-volume-profit analysis (Chapter 5). 2.Segmented reporting of profit data (Chapter 6). 3.Budgeting (Chapter 8).
  57. 57. Guided Example Otsego, Inc., is a merchandiser that provided the following information: Required: 1. Prepare a traditional income statement. 2. Prepare a contribution format income statement. Number of units sold 12,000 Selling price per unit $25 Variable selling expense per unit $2.50 Variable administrative expense per unit $2 Total fixed selling expense $16,000 Total fixed administrative expense $17,000 Merchandise inventory, beginning balance $25,000 Merchandise inventory, ending balance $18,000 Merchandise purchases $101,000
  58. 58. Guided Example Requirement 1: Prepare a traditional income statement. Otsego, Inc. Traditional Income Statement Sales ($25 per unit X 12,000 units) $ 300,000 Cost of goods sold ($25,000 + 101,000 - 18,000) 108,000 Gross margin 192,000 Selling and administrative expenses: Selling expenses (($2.50 per unit X 12,000 units) + $16,000) $46,000 Administrative expenses (($2 per unit X 12,000 units) + $17,000) 41,000 87,000 Net operating income $ 105,000
  59. 59. Guided Example Requirement 2: Prepare a contribution format income statement. Otsego, Inc. Contribution Format Income Statement Sales ($25 per unit X 12,000 units) $ 300,000 Variable expenses: Cost of goods sold ($25,000 + 101,000 - 18,000) $ 108,000 Selling expenses ($2.50 per unit X 12,000 units) 30,000 Administrative expenses ($2 per unit X 12,000 units) 24,000 162,000 Contribution margin 138,000 Fixed expenses: Selling expenses 16,000 Administrative expenses 17,000 33,000 Net operating income $ 105,000
  60. 60. Guided Example Hough Company manufactures and sells a single product. A partially completed schedule of the company’s total and per unit costs over a relevant range of 80,000 to 120,000 units produced and sold each year is given below: Required: 1. Complete the schedule of the company’s total and unit costs. 2. Assume that the company produces and sells 110,000 units during the year at the selling price of $6.50 per unit. Prepare a contribution format income statement for the year. Units produced and sold 80,000 100,000 120,000 Total costs: Variable costs $240,000 Fixed costs 320,000 Total costs $560,000 Cost per unit: Variable cost Fixed cost Total cost per unit
  61. 61. Guided Example Requirement 1: Complete the schedule of total costs and unit costs. Variable cost per unit = Total variable cost/Number of units Variable cost per unit = $240,000/80,000 units Variable cost per unit = $3.00/unit Units produced and sold 80,000 100,000 120,000 Total costs: Variable costs $240,000 $300,000 $360,000 Fixed costs 320,000 320,000 320,000 Total costs $560,000 $620,000 $680,000 Cost per unit: Variable cost $3.00 $3.00 $3.00 Fixed cost 4.00 3.20 2.67 Total cost per unit $7.00 $6.20 $5.67
  62. 62. Guided Example Requirement 2: Assume that the company produces and sells 110,000 units during the year at the selling price of $6.50 per unit. Prepare a contribution format income statement for the year. Hough Company Contribution Format Income Statement For the year Sales (110,000 units × $6.50 per unit) $715,000 Variable expenses (110,000 units × $3.00 per unit) 330,000 Contribution margin 385,000 Fixed expenses 320,000 Net operating income $ 65,000
  63. 63. Guided Example Maui Mike’s is a large retailer of surfboards. The company assembled the information shown below for the quarter ended May 31: Required: 1. Prepare a traditional income statement for the quarter ended May 31. 2. Prepare a contribution format income statement for quarter ended May 31. 3. What was the contribution toward fixed expenses and profits for each surfboard sold during the quarter? (State this figure in a single dollar amount per surfboard.) Amount Total sales revenue $750,000 Selling price per unit $500 Variable selling expense per unit $40 Variable administrative expense per unit $15 Total fixed selling expense $125,000 Total fixed administrative expense $100,000 Merchandise inventory, beginning balance $65,000 Merchandise inventory, ending balance $85,000 Merchandise purchases $295,000
  64. 64. Guided Example Requirement 1: Prepare a traditional income statement. Maui Mike’s Traditional Income Statement Sales $ 750,000 Cost of goods sold ($65,000 + 295,000 - 85,000) 275,000 Gross margin 475,000 Selling and administrative expenses: Selling expenses (($40 per unit X 1,500 units) + $125,000) $185,000 Administrative expenses (($15 per unit X 1,500 units) + $100,000) 122,500 307,500 Net operating income $ 167,500 ($750,000/$500 = 1,500 units)
  65. 65. Guided Example Requirement 2: Prepare a contribution format income statement. Requirement 3: What was the contribution towards fixed expenses and profits for each surfboard sold during the quarter? (State this figure in a single dollar amount per surfboard.) Maui Mike’s Contribution Format Income Statement Sales ($750,000/$500 = 1,500 units) $ 750,000 Variable expenses: Cost of goods sold $ 275,000 Selling expenses ($40 per unit X 1,500 units) 60,000 Administrative expenses ($15 per unit X 1,500 units) 22,500 357,500 Contribution margin 392,500 Fixed expenses Selling expenses 125,000 Administrative expenses 100,000 225,000 Net operating income $ 167,500 Contribution margin: $392,500 # boards sold 1,500 CM per board: $262
  66. 66. End of Chapter 2

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