Lecture #3 Managerial Accounting

GENERAL COST CLASSIFICATIONS Manufacturing Costs Manufacturing cost is the sum of costs of all resources consumed in the process of making a product. The manufacturing cost is classified into three categories: direct materials cost, direct labor cost and manufacturing overhead Direct Materials: Direct materials are the raw materials that become a part of the finished product. Manufacturing adds value to raw materials by applying a chain of operations to maintain a deliverable product. There are many operations that can be applied to raw materials such as welding, cutting and painting. It is important to differentiate between the direct materials and indirect materials. Direct Labor: The direct labor cost is the cost of workers who can be easily identified with the unit of production. Types of labor who are considered to be part of the direct labor cost are the assembly workers on an assembly line Manufacturing O er!ea": Manufacturing overhead is any manufacturing cost that is neither direct materials cost nor direct labor cost. Manufacturing overhead includes all charges that provide support to manufacturing. Manufacturing o er!ea" inclu"es

Indirect labor cost: The indirect labor cost is the cost associated with workers, such as supervisors and material handling team, who are not directly involved in the production. Indirect materials cost: Indirect materials cost is the cost of associated with consumables, such as lubricants, grease, and water that are not used as raw materials. Other indirect manufacturing cost: Other indirect manufacturing costs include machine depreciation, land rent, property insurance, electricity or any e penses that keep the factory operating.

Non#anufacturing Costs

!on"manufacturing #osts are those costs that are not directly incurred to manufacture a product. $ amples of such costs are salary of sales personnel and advertising e penses. %enerally non" manufacturing costs are further classified into two categories Selling an" "istribution Costs$ A"#inistrati e Costs$ %ROD&CT COSTS 'ERS&S %ERIOD COSTS Su##ar( of %ro"uct an" %erio" Costs: &roduct #osts or Inventoriable #osts Direct Materials: Materials that can be physically and conveniently traced to a product, such as wood in a table. Direct 'abor: 'abor costs that can be physically and conveniently traced to a product such as assembly line workers in a plant. Direct labor is also called touch labor cost. Manufacturing Overhead: (ll costs of manufacturing a product other than direct materials and direct labor, such as indirect materials, indirect labor, factory utilities, and depreciation of factory e)uipment. &roduct #osts *e have already defined product costs as those costs that are involved in either the purchase or the manufacture of goods. +or manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. It will be helpful at this point to look briefly at the flow of costs in a manufacturing company. This will help us understand how product costs move through the various accounts and how they affect the balance sheet and the income statement.

&$,IOD #O-T- O, !O!"M(!.+(#T.,I!% #O-TMarketing or selling costs: (ll costs necessary to secure customer orders and get the finished product or service into the hands of the customer, such as sales commission, advertising, and depreciation of delivery e)uipment and finished goods warehouse. (dministrative #osts: (ll costs associated with the general management of the company as a whole, such as e ecutive compensation, e ecutive travel costs, secretarial salaries, and depreciation of office building and e)uipment. &eriod #osts

&eriod costs are all the costs that are not included in product costs. These costs are e pensed on the income statement in the period in which they are incurred, using the usual rules of accrual accounting that we learn in financial accounting. &eriod costs are not included as part of the cost of either purchased or manufactured goods. -ales commissions and office rent are good e amples of period costs. /oth items are e pensed on the income statement in the period in which they are incurred. Thus they are said to be period costs. Other e amples of period costs are selling and administrative e penses. #O-T #'(--I+I#(TIO!- +O, &,$DI#TI!% #O-T /$0(1IO, 1ariable #ost 1ariable costs are e penses that change in proportion to the activity of a business. +i ed #ost +i ed costs and variable costs make up the two components of total cost. Direct labor and overhead are often called conversion cost,234 while direct material and direct labor are often referred to as prime cost.2 COST CLASSIFICATIONS FOR DECISION MA)ING Differential Cost an" Re enue Differential Cost an" Differential Re enue* Decisions involve choosing between alternatives. In business, each alternative will have certain costs and benefits that must be compared to the costs and benefits of the other available alternatives. ( difference in cost between any two alternatives is known as differential cost. ( difference in revenue between any two alternatives is known as differential revenues. Differential cost includes both cost increase 5incremental cost6 and cost decrease 5decremental cost6. In general the difference 5cost and revenue6 between alternatives are relevant in decision making. Those items that are the same under all alternatives can be ignored. The accountant7s "ifferential cost concept can be compared to the economist7s marginal cost concept. In speaking of changes in cost and revenue, the economists employ the term #arginal cost an" #arginal re enue. The revenue that can be obtained from selling one more unit of product is called marginal revenue, and the cost involved in producing one more unit of a product is called marginal cost. The economists marginal cost is basically the same as the accountant7s differential concept applied to a single unit of out put.

E+a#,le*
Differential cost can be either variable or fi ed. To illustrate assume that a company is thinking about changing its marketing method from distribution through retailers to distribution by door to door direct sale. &resent cost and revenues are compared to pro8ected costs and revenues in the following table.

Descri,tion

Retailer

Direct

SaleDifferential

,evenue 5variable6 #ost of goods sold 516 (dvertising 516 #ommissions 5+6@ *arehouse depreciation 516@@ Other $ penses 5+6 Total !et Operating Income @+ C @@1 C 1ariable +i ed

Distribution -%resent. 9:;;,;;; """"""""" 3>;,;;; <;,;;; ";" >;,;;; A;,;;; """""""""" >?;,;;; """""""""" 9=A;,;;; CCCCCCC

Distribution -%ro,ose". 9<;;,;;; """"""""" ?;;,;;; ?>,;;; ?;,;;; <;,;;; A;,;;; """""""""" AB>,;;; """""""""" 9=:>,;;; CCCCCCC

Costs an" Re enues 9=;;,;;; """"""""" >;,;;; 53>;;;6 ?;,;;; 3;,;;; ";" """""""""" <>,;;; """""""""" 9=>,;;; CCCCCCC

(ccording to the above analysis, the differential revenue is 9=;;,;;; and the differential cost is 9<>,;;;,leaving a positive differential net operating income of 9=>,;;; under the proposed marketing plan. The net operating income under the present distribution is 9=A;,;;;, whereas the net operating income under door to door direct selling is estimated to be 9=:>,;;;. Therefore the door to door direct distribution method is preferred, since it would result in 9=>,;;; higher net operating income. !ote that we would have arrive at e actly the same conclusion by simply focusing on the differential revenue, differential cost, and differential net operating income, which also shows a net operating advantage of 9=>,;;; for the direct selling method. The company can ignore other e penses of 9A;,;;;. /ecause it has no effect on the decision. If it were removed from the calculation, the door to door selling method would still be preferred by 9=>,;;;. This is an e tremely important principle in management accounting.

Opportunity #ost Opportunity cost is the potential benefit that is given up when one alternative is selected over another. $ ample =: 1icki has a part"time 8ob that pays her 9B;; per week while attending college. -he would like to spend a week at the beach during spring break, and her employer has agreed to give her the time off, but without pay. The 9B;; in lost wages would be an opportunity cost of taking week off to be at the beach. -unk #ost

( sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in future. (ssume that a company paid 9>;,;;; several years ago for a special purpose machine. The machine was used to make a product that is now obsolete and is no longer being sold. $ven though in hindsight the purchase of the machine may have been unwise, no amount of regret can undo that decision. (nd it would be folly to continue making the obsolete product to recover the original cost of the machine. In short, the 9>;,;;; originally paid for the machine has already been incurred and cannot be differential cost in any future decision. +or this reason, such costs are said to be sunk costs and should be ignored in decision making