Chapter 2: Cost Terms, Concepts, and Classifications

1) Identify and give examples of each of the three basic manufacturing cost categories.

Manufacturing Costs

  • Direct Materials – Those materials that become an integral part of a finished product can be conveniently traced to it.
  • i.e. Passenger seats, electronic components in a stereo.
  • Indirect Materials – small items of material that may become an integral part of a finished product but whose costs of tracing exceed the benefits.
  • i.e. Solder and glue.
  • Direct Labour – Factory labour costs that can be traced easily to individual units of product.
  • i.e. Cost of assembly line workers, welders, operators.
  • Indirect LabourLabour costs of janitors, supervisors, materials handlers, and other factory workers that cannot be conveniently be traced directly to particular products.
  • Manufacturing Overhead – All costs associated with manufacturing except direct materials and direct labour.
  • Includes indirect materials (materials used to support the production process) and indirect labour (wages paid to employees not directly involved in production work)
  • Does not include operating costs.
  • Conversion CostManufacturing overhead + direct labour cost.
  • Prime Cost Direct materials + direct labour cost.

Classification of Manufacturing Labour Costs

  • Relatively straightforward classification of labour costs.
  • Overtime Premiums – Extra hourly wage rate paid to workers who must work more than their normal time requirements.
  • Employee benefit costs for indirect labour are classified as additional indirect overhead. (For direct labour, it’s added to base direct labour rate.)

Non-manufacturing cost

  • Marketing or Selling Costs – All costs necessary to secure customer orders and get the finished product or service to the customer.
  • i.e. Order filling costs such as packing and shipping
  • Administrative Costs – All executive, organizational, and clerical costs associated with general management of an organization rather than with manufacturing, marketing, or selling.
  • i.e. executive compensation, accounting, HR, public relationships

2) Distinguish between product costs and period costs and give examples of each.

Matching Principle – Costs incurred to generate revenue should be recognized as expenses in the same period that the revenue is recognized.

Image result for inventoryProduct Costs

  • All costs involved in the purchase or manufacture of goods.
  • In the case of manufactured goods, these costs consist of direct materials, direct labour, and manufacturing overhead.
  • A.k.a. inventoriable costs or manufacturing costs (Present in inventories and cost of goods sold)

Period Costs

  • All costs that are expensed on the income statement in the period in which they are incurred or accrued.
  • Selling (marketing) and administrative expenses are period costs.
  • They are not included on cost of purchased/manufactured costs – they are expenses on the income statement in the period in which they are incurred.

Cost Classification on Financial Statements

  • The Balance Sheet
  • A manufacturing company’s BS is similar to that of a merchandising one.
  • However, merchandising companies have one class of inventory and manufacturing companies have 3.
  • Raw (direct) materials inventory – Materials used to make a product that have not yet been placed into production.
  • Work in Progress Inventory – Inventory consisting of units of product that are only partially complete and require further work before sale.
  • Finished Goods Inventory – Inventory consisting of units of product that have been completed but not yet sold.

3) Prepare an income statement, including the calculation of Cost of Goods Sold

The Income Statement

  • Basic Equation for Inventory Accounts: Beginning Balance + Additions to Inventory = Ending Balance + Withdrawals from Inventory
  • Basic Equation for COGS
  • Merchandising Company - Beginning Balance Inventory + Purchases = Ending Merchandise Inventory + COGS
  • Or COGS = Beginning Merchandise Inventory + Purchases – Ending Merchandise Inventory
  • Manufacturing Company - Beginning Finished Goods Inventory + Cost of Goods Manufactured = Ending Finished Goods Inventory + COGS
  • Or COGS = Beginning Finished Goods Inventory + Cost of Goods Manufactured – Ending Finished Goods inventory
  • Cost of Goods Manufactured – costs that include the direct materials, direct labour, and manufacturing overhead used for the products finished during the period.
  • Sales – COGS = Gross Margin
  • Gross margin – selling and administrative expenses = Operating Income

4) Prepare a schedule of Cost of Goods Manufactured

Schedule of Cost of Goods Manufactured

  • A schedule that shows direct materials, direct labour, and manufacturing overhead costs incurred for a period and assigned to work in process and completed goods.
  • Direct Materials cost refers to cost of materials used during the period.
  • Total Manufacturing Costs – Costs that represent the direct materials, direct labour, and manufacturing overhead used to perform the production work for finished/unfinished products for the period.

Product Costs – Closer Look

  • Cost Flow identifies how product costs move through various accounts and how they affect BS and IS.
  • Product costs → Balance Sheet inventories → Income Statement as COGS
  • Period Costs → Income Statement as Selling and Administrative Expenses

Inventoriable Costs

  • Product costs go directly into inventory accounts as they are incurred rather than into expense accounts.
  • First into work in process and then into finished goods.
  • Costs can end up on the BS as assets if goods are either partially completed or unsold at the end of a period.
  • Selling & Administrative costs are period costs expensed as they are incurred.

Cost Flows

  • As goods are being worked on, costs for direct materials, direct labour, and manufacturing overhead are Debited to Work in Process Inventory.
  • Once completed, Credit work in process inventory with the Debit to finished goods inventory.
  • Once sold, credit finished goods inventory for the cost of the items, with the Debit to cost of goods sold, an income statement amount.
  • Selling/administrative expenses are expensed to income statement.

5) Explain the differences between variable and fixed costs.

  • Cost Behaviour – The way in which a cost reacts or responds to changes in the level of activity
  • A manager must anticipate changes in cost and by how much it changes.

Variable Cost

  • A cost that varies, in total, in direct proportion to changes in level of activity.
  • Expressed in many ways, i.e. units produced, units sold, kilometres driven
  • Cost of Direct Materials used during a period varies in direct proportion to number of units produced.
  • As more is produced, more materials must be used.
  • Costs may be variable with respect to products and services provided or other activities such as number of hours.

Fixed Cost

  • A cost that remains constant, in total, regardless of changes in the level of activity.
  • i.e. straight-line depreciation, insurance, property tax
  • Very few costs are completely fixed – many change if there is a large level of activity, it is only fixed in a relative range.
  • Relative Range – range of activity within which assumptions about variable and fixed cost behaviour are valid.
  • Mixed Cost – costs that contain both variable and fixed cost elements.
  • i.e. total wages paid to sales staff, some may be fixed salary and some may be commission.

6) Identify the differences between direct and indirect costs.

Cost Object – Any unit of analysis for which cost data are desired.

  • Costs are classified as direct or indirect, and products, customers, jobs, and other organizational subunits may be analyzed.

Direct Cost

  • A cost that can be easily and conveniently traced to the particular cost object under consideration.
  • Includes direct materials, direct labour, and other directly traceable items, such as salary.

Indirect Cost

  • A cost that cannot be easily and conveniently traced to the particular cost object under consideration.
  • To be directly traced, the cost must be caused by the cost object.
  • Common Cost – Cost incurred to support a number of cost objects but cannot be traced to any of them individually.
  • i.e. salary of a factory manager is not caused by one variety of product but is a consequence of running the whole factory.

7) Describe the cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.

Differential Cost and Revenue

  • A difference in cost between any two alternatives.
  • Differential Revenue – A difference in revenue between any two alternatives
  • Incremental Cost – An increase in cost between two alternatives.
  • Similar to concepts of Marginal Cost and Marginal Revenue (cost and revenue of producing and selling one more unit respectively)
  • Analyze the differences in operating income to determine the advantageous alternative.
  • We can ignore the items that are the same under all alternatives and that are not affected by the decision.

Opportunity Cost

  • The potential benefit that is given up when one alternative is selected over another.
  • Not explicitly entered, but they must be explicitly considered in managerial decisions.
  • Every alternative has an associated opportunity cost.

Sunk Cost

  • Any cost that has already been incurred and that cannot be changed by any decision made now or in the future.
  • As they are not differential costs and therefore not relevant in decisions, they should always be ignored.

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