Basic Cost Terms and Concepts

Basic Cost Terms and Concepts

1. Cost Classifications: Different Costs for Different Purposes

1. Generally: The first step in controlling costs in any business is achieving a good understanding of the types of costs incurred.
2. Cost defined: At the most basic level, a cost may be defined as the sacrifice made, usually measured by the resources given up, to achieve a particular purpose.

1. Definition is use dependent: Cost can have a different meaning depending on the context in which it is used.
2. Purpose sensitive: Cost data classified and recorded a particular way for one purpose may be inappropriate for another use.

1. Fixed & Variable Costs: One of the most important ways a cost changes is in relation to organizations’ outputs.

1. Activity measures output: The term activity is simply a measure of the organization’s output.

a. Activities that cause costs are cost drivers.

2. Output changes variable costs: A variable cost changes directly with output (or cost drivers).
3. Fixed costs stable: A fixed cost does not change as activity (or output) changes.

1. Example: A college student pays $700 per month to rent a two-bedroom apartment. The student can advertise for roommates to split the rent and monthly expenses. The monthly rent will be a fixed cost. The fixed cost per individual will decline, but the total cost remains unchanged ($700). The costs for other monthly expenses, such as food, will vary based upon the number of people consuming the food. Thus, food would be a variable cost.

1. Identifying Cost Drivers: An important step in understanding the cost behavior in any organization is effectively identifying the cost drivers that determine the organization’s costs.

1. Cost driver defined: A cost driver is an activity or event causing costs.
2. Cost drivers vary widely: Cost drivers vary widely among different firms and industries.
3. Example: One hospital responded to cost-reduction pressures by inducing physicians to reduce patient length-of-stay (LOS). The program resulted in a decline in average LOS; however, the program did not result in a decline in patient costs. A subsequent cost-driver analysis indicated that the number of medical procedures is a more appropriate cost driver than patient LOS.

1. Direct and Indirect Costs: An important object of a cost management system is to trace as many costs as possible directly to the activities causing them. This can often be the most effective method of cost control.

1. Direct costs traceable: A cost traced to a specific department is a direct cost of that department.
2. Indirect costs not traceable: A cost that cannot be applied to specific department is an indirect cost.
3. Department dependent: The categorizing of costs as either direct or indirect often depends on the department under consideration.

1. Example: A controller’s salary would be an indirect cost of managing the organization; however, the controller’s salary would be a direct cost of the accounting department.

1. Activity accounting traces costs: Activity accounting attempts to trace as many costs as possible to their cost drivers. This process can be vital to eliminating non-value-added costs.

1. Controllable and Uncontrollable Costs: The identification of the ability or inability of a particular manager to control a cost driver is important in cost control.

1. Specific managers influence controllable costs: A cost that a specific manager can substantially influence is a controllable cost.

1. Example: Travel costs constitute one of the largest manageable corporate expenses. Companies try to control travel costs by periodic evaluation of travel policies and negotiating deals with vendors.

1. Uncontrollable costs not influenced by specific managers: Costs that a specific manager cannot influence are uncontrollable costs.
2. Short-term and long-term difference: Some costs are controllable in the long run but not in the short run.

1. Example: A building with a ten-year lease is not controllable in the short term (once the lease is signed). The payments must be made until the lease expires. These costs are controllable at the time the lease is negotiated. Thus in the long-run, these costs are controllable.

1. Manufacturing Costs: Manufacturing costs are costs related to product production. These costs include direct material, direct labor, and manufacturing overhead. Direct labor and overhead are often called conversion costs because they are costs of "converting" raw material into finished products. Direct material and labor are often referred to as prime costs.

1. Direct material incorporated, consumed and traceable: Raw material that is consumed in the manufacturing process, is physically incorporated in the finished product, and can be traced to products conveniently is called direct material.

1. Direct distinct from raw: Before material is entered into the production process, it is called raw material. After it enters, production, it becomes direct material.
2. Raw materials cost = direct-material cost: Thus, the cost of raw materials used is equal to the direct-material cost.

1. Direct-labor manufactures: The cost of salaries, wages, and fringe benefits for personnel who work directly on the manufactured products is classified as direct-labor cost.

1. Fringe benefits are direct costs: The cost of fringe benefits for direct-labor personnel, such as employee-paid health-insurance premiums and the employer’s pension contributions, should also be classified as direct-labor costs.

1. Practice differs: While conceptually correct, this treatment of fringe benefit is not always observed in practice. Many companies classify all fringe-benefits as overhead.

1. Manufacturing overhead includes everything else: All other costs of manufacturing are classified as manufacturing overhead, which includes three types of costs: indirect material, indirect labor, and other manufacturing costs.

1. Indirect materials insignificant: The cost of required materials not forming an integral part of the finished product is classified as indirect materials.
2. Indirect labor supports: The cost of personnel who do not work directly on the product, but whose services are necessary for the manufacturing process is indirect labor.

1. Other Manufacturing Costs: All other manufacturing costs that are neither material nor labor costs are classified as manufacturing overhead.

1. Example: These costs include depreciation of plant and equipment, property taxes, insurance, and utilities such as electricity, as well as the costs of a service department.
2. Service departments perform maintenance: These are departments perform maintenance of manufacturing equipment.
3. Overtime premium is overhead: An overtime premium is the extra compensation paid to an employee who works beyond the time normally scheduled. Only the extra compensation is classified as an overtime premium. (i.e., the regular wage paid during overtime hours is still direct labor.)
4. Idle time is overhead: The time spent unproductively by employees (typically due to equipment break downs or new production setups) is idle time. The cost of the overtime is classified as overhead to spread over the cost of all production runs.

1. Rationale for overhead classification: Both overtime premiums and the cost of idle time should be included in manufacturing overhead because these costs incur on jobs rather randomly.

1. Production Costs in Service Industry Firms & Nonprofits Organizations: The process of recording and classifying costs is important in service industry firms and nonprofit organizations for the same reasons as in manufacturing firms. Cost analysis is used in pricing, location selection, budgeting and setting goals.
2. Product Costs, Period Costs & Expenses:

1. Expense = asset depletion: An expense is the cost incurred when an asset is used up.
2. Product costs assigned: Costs assigned to goods purchased or manufactured for resale is a product cost.

1. Inventoriable costs = product costs: The term inventoriable cost is used interchangeably with product cost because a product is stored as the cost of inventory until the goods are sold.
2. Cost of goods sold: Product costs are recognized in the period of sale as an expense called cost of goods sold.
3. Merchandise inventory includes shipping: The product cost of merchandise inventory acquired by a retailer or wholesaler for resale consists of the purchase cost of the inventory plus any shipping charges.
4. Manufactured inventory includes direct costs & overhead: The product cost of manufactured inventory consists of direct material, direct labor, and manufacturing overhead.

1. Period costs not assigned to specific goods: All costs that are not product costs are period costs. These costs are identified and recognized in the period when incurred rather than with units of production. All research and development, selling and administrative costs are treated as period costs.

1. Research & Development: These costs include all costs of developing new products and services (e.g., running a lab, building prototypes, testing products).
2. Selling Costs: These costs include salaries, commissions and travel costs of sales personnel, and the costs of advertising and promotion.

(1) Practical use: Leading supermarkets have adopted new approaches to improve profitability by reducing selling and administrative costs. They have invested in technology to reduce inventory and improve distribution. By combining scanners with frequent-shopper cards [that they use to track buying habits], grocers offer discounted items to loyal customers.

3. Administrative Costs: These costs refer to running the organization as a whole (e.g., salaries of top-management, accounting, legal, and public relations).

1. Costs on Financial Statements

1. Generally: The distinction between product costs and period costs is emphasized by examining the financial statement from three different types of firms (in the text at pages 42-3).
2. Balance Sheet: Balance sheets of firms that sell inventoriable products are affected by product costs.

1. Manufacturers three inventory types:

1. Raw-material: This includes inventory of all materials before they are placed into production.
2. Work-in-process: This includes all materials before they are placed into production.
3. Finished-goods: This includes manufactured goods that are complete and ready for sale.
4. Valuation: The values of work-in-process and finished-goods inventories are measured by their product costs.

1. Cost Flows in a Manufacturing Company

1. Generally: Direct material, direct labor, and manufacturing overhead are the three types of production costs incurred by manufacturers. These costs are product costs because they are stored in inventory until the time period when the manufacturer’s products are sold. Manufacturers have product-costing systems to keep track of the flow of these costs from the time production begins until finished products are sold.
2. Flow of Manufacturing Costs:

Direct Material

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Direct Labor Work-in-Process Finished-Goods

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Inventory Inventory

Manufacturing

Overhead

3. Cost of goods schedules
: Manufacturers generally prepare a schedule of cost of goods manufactured and a schedule of cost of goods sold to summarize the flow of manufacturing costs during an accounting period.

1. Schedules used internally: These schedules are intended for internal use by management and are generally not made available to the public.

1. Economic Characteristic of Costs

1. Generally: In addition to accounting cost classifications, such as product costs and period costs, managerial accountants also employ economic concepts in classifying costs.
2. Sunk costs previously incurred: Costs that have been incurred in the past and do not affect future costs and cannot be changed by any future action are sunk costs.

1. Often affects decisions: Although it is incorrect, from an economic perspective, to allow sunk costs to affect future decisions, people often do so. It is human nature to attempt to justify past decisions.
2. Understanding such behavioral tendencies: It is important for managerial accountants to be aware of such behavioral tendencies. Such an awareness enables the accountant to prepare the most relevant data for managers’ decisions and, sometimes, to assist the managers in using the information.

1. Differential costs = incremental costs: A differential cost is the amount by which the cost differs under two alternative actions.
2. Marginal costs at different production quantities: The extra cost incurred in producing one additional unit of output is a marginal cost.

1. Varies across production ranges: The marginal cost typically differs across ranges of production quantities because the efficiency of the production process changes.

1. Average costs: The average cost per unit is the total cost, for whatever quantity is manufactured, divided by the number of units manufactured.
2. Costs and Benefits of Information: An important task of the managerial accountant is to determine which of these cost concepts is most appropriate in each situation.

1. Usefulness: The accountant attempts to structure the organization’s accounting information system to record data that will be useful in a variety of purposes.
2. Benefits realized through improvements: The benefits of measuring and classifying costs in a particular way are realized through the improvements in planning, control, and decision-making that the information facilitates.
3. Human limitations: When managers receive more data than they can use effectively information overload occurs. In deciding how much and what type of information to provide, managerial accountants should consider these human limitations.