Chapter 2

CHAPTER 2An Introduction to Cost Terms and Purposes 2009 Pearson Prentice Hall. All rights reserved. 2009 Pearson Prentice Hall. All rights reserved.1Basic Cost TerminologyCost sacrificed resource to achieve a specific objectiveActual cost a cost that has occurredBudgeted cost a predicted costCost object anything of interest for which a cost is desired 2009 Pearson Prentice Hall. All rights reserved.2Cost Object Examples at BMWCost ObjectIllustrationProductBMW X 5 sports activity vehicleServiceDealer-support telephone hotlineProjectR&D project on DVD system enhancementCustomerHerb Chambers Motors, a dealer that purchases a broad range of BMW vehiclesActivitySetting up production machinesDepartmentEnvironmental, Health & Safety 2009 Pearson Prentice Hall. All rights reserved.3Basic Cost TerminologyCost accumulation a collection of cost data in an organized mannerCost assignment a general term that includes gathering accumulated costs to a cost object. This includes:Tracing accumulated costs with a direct relationship to the cost object and Allocating accumulated costs with an indirect relationship to a cost object 2009 Pearson Prentice Hall. All rights reserved.4Direct & Indirect CostsDirect costs can be conveniently and economically traced (tracked) to a cost objectIndirect costs cannot be conveniently or economically traced (tracked) to a cost object. Instead of being traced, these costs are allocated to a cost object in a rational and systematic manner 2009 Pearson Prentice Hall. All rights reserved.5BMW: Assigning Costs to a Cost Object

2009 Pearson Prentice Hall. All rights reserved.6Cost ExamplesDirect CostsPartsAssembly line wagesIndirect CostsElectricityRentProperty taxes 2009 Pearson Prentice Hall. All rights reserved.7Factors Affecting Direct / Indirect Cost ClassificationCost MaterialityAvailability of information-gathering technologyOperational Design 2009 Pearson Prentice Hall. All rights reserved.8Cost BehaviorVariable costs changes in total in proportion to changes in the related level of activity or volumeFixed costs remain unchanged in total regardless of changes in the related level of activity or volumeCosts are fixed or variable only with respect to a specific activity or a given time period 2009 Pearson Prentice Hall. All rights reserved.9Cost Behavior, continuedVariable costs are constant on a per-unit basis. If a product takes 5 pounds of materials each, it stays the same per unit regardless of one, ten or a thousand units are producedFixed costs change inversely with the level of production. As more units are produced, the same fixed cost is spread over more and more units, reducing the cost per unit 2009 Pearson Prentice Hall. All rights reserved.10Cost Behavior SummarizedTotal DollarsCost per UnitVariable CostsChange in proportion with outputMore output = More costFixed CostsUnchanged in relation to outputChange inversely with outputMore output = lower cost per unitTotal DollarsCost Per UnitVariable CostsChange in proportion with outputMore output = More costUnchanged in relation to output

Fixed CostsUnchanged in relation to outputChange inversely with outputMore output = lower cost per unit 2009 Pearson Prentice Hall. All rights reserved.11Cost Behavior Visualized

2009 Pearson Prentice Hall. All rights reserved.12Other Cost ConceptsCost Driver a variable that causally affects costs over a given time spanRelevant Range the band of normal activity level (or volume) in which there is a specific relationship between the level of activity (or volume) and a given costFor example, fixed costs are considered fixed only within the relevant range. 2009 Pearson Prentice Hall. All rights reserved.13Relevant Range Visualized

2009 Pearson Prentice Hall. All rights reserved.14A Cost CaveatUnit costs should be used cautiously. Since unit costs change with a different level of output or volume, it may be more prudent to base decisions on a total dollar basis.Unit costs that include fixed costs should always reference a given level of output or activityUnit Costs are also called Average Costs 2009 Pearson Prentice Hall. All rights reserved.15Multiple Classification of CostsCosts may be classified as:Direct / Indirect, and Variable / FixedThese multiple classifications give rise to important cost combinations:Direct & VariableDirect & FixedIndirect & VariableIndirect & Fixed 2009 Pearson Prentice Hall. All rights reserved.16Multiple Classification of Costs, Visualized

2009 Pearson Prentice Hall. All rights reserved.17Different Types of FirmsManufacturing-sector companies create and sell their own productsMerchandising-sector companies product resellersService-sector companies provide services (intangible products) 2009 Pearson Prentice Hall. All rights reserved.18Types of Manufacturing InventoriesDirect Materials resources in-stock and available for useWork-in-Process (or progress) products started but not yet completed. Often abbreviated as WIPFinished Goods products completed and ready for sale 2009 Pearson Prentice Hall. All rights reserved.19Types of Product CostsAlso known as Inventoriable CostsDirect MaterialsDirect LaborIndirect Manufacturing factory costs that are not traceable to the product. Other common names for this type of cost include Manufacturing Overhead costs or Factory Overhead costs. 2009 Pearson Prentice Hall. All rights reserved.20Accounting Distinction Between CostsInventoriable costs product manufacturing costs. These costs are capitalized as assets (inventory) until they are sold and transferred to Cost of Goods Sold.Period costs have no future value and are expensed as incurred. 2009 Pearson Prentice Hall. All rights reserved.21Cost FlowsThe Cost of Goods Manufactured and the Cost of Goods Sold section of the Income Statement are accounting representations of the actual flow of costs through a production system.Note the importance of inventory accounts in the following accounting reports, and in the cost flow chart 2009 Pearson Prentice Hall. All rights reserved.22Cost Flows Visualized

2009 Pearson Prentice Hall. All rights reserved.23Cost of Goods Manufactured

2009 Pearson Prentice Hall. All rights reserved.24Multiple-Step Income Statement

2009 Pearson Prentice Hall. All rights reserved.25Other Cost ConsiderationsPrime cost is a term referring to all direct manufacturing costs (labor and materials)Conversion cost is a term referring to direct labor and factory overhead costs, collectivelyOvertime labor costs are considered part of overhead due to the inability to precisely know the true cause of these costs 2009 Pearson Prentice Hall. All rights reserved.26Different Definitions of Costs for Different ApplicationsPricing and product-mix decisions may use a super cost approach (comprehensive)Contracting with government agencies very specific definitions of cost for cost plus profit contractsPreparing external-use financial statements GAAP-driven product costs only 2009 Pearson Prentice Hall. All rights reserved.27Different Definitions of Costs for Different Applications

2009 Pearson Prentice Hall. All rights reserved.28Three Common Features of Cost Accounting & Cost ManagementCalculating the cost of products, services, and other cost objectsObtaining information for planning & control, and performance evaluationAnalyzing the relevant information for making decisions 2009 Pearson Prentice Hall. All rights reserved.29

2009 Pearson Prentice Hall. All rights reserved.