Chapter 2

Basic Cost
Management Concepts

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Learning Objective1

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Process of Management
Strategy Planning
Formulation

Managers need cost information to

perform each of these functions.

Control Directing
Decision
Making
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What Do We Mean By a Cost?

A cost
is the measure of
resources given
up to achieve a
particular purpose.

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Learning Objective 2

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Product Costs, Period Costs, and Expenses

Product costs are costs associated with goods for

sale until the time period during which the products
are sold, at which time the costs become expenses.

Period costs are costs that are expensed during the

time period in which they are incurred.

Expenses are the consumption of assets for the

purpose of generating revenue.

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Learning Objective 3

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Cost Classifications on Financial
Statements – Income Statement

Product Costs Period Costs

Cost of goods sold Operating expenses

2-8
Cost Classifications on Financial
Statements – Balance Sheet

Merchandiser Manufacturer
Current Assets Current Assets
 Cash  Cash
 Receivables  Receivables
 Prepaid Expenses  Prepaid Expenses
 Merchandise Inventory  Inventories
Raw Materials
Work in Process
Finished Goods

2-9
Cost Classifications on Financial
Statements – Balance Sheet

Merchandiser Manufacturer
Current Assets Current Assets
 Cash  Cash materials
Those
 Receivables  waiting to be
Receivables

processed.
Prepaid Expenses
 Prepaid Expenses
 Merchandise Inventory  Inventories
Raw Materials
Work in Process
Finished Goods

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Cost Classifications on Financial
Statements – Balance Sheet

Merchandiser Manufacturer
PartiallyAssets
Current completed
Current Assets products – material to
 Cash
 Cash which some labor
 Receivables
and/or overhead has
 Receivables
been added.
 Prepaid Expenses
 Prepaid Expenses
 Inventories
 Merchandise Inventory
Raw Materials
Work in Process
Finished Goods

2-11
Cost Classifications on Financial
Statements – Balance Sheet

Merchandiser Manufacturer
Current Assets Current Assets
 Cash  Cash
 Receivables
Completed products
 Receivables
awaiting sale.
 Prepaid Expenses
 Prepaid Expenses
 Inventories
 Merchandise Inventory
Raw Materials
Work in Process
Finished Goods

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Learning Objective 4

2-13
Types of Production Processes
Type of Production Description of Example of
Process Process Manufacturer

Job Shop Low volume Disney

Little standardization
Unique products

Batch Multiple products Caterpillar

Low volume

Assembly Line A few major products Ford

Higher volume

Continuous Flow High volume Exxon

Highly standardized commodity products

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Learning Objective 5

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Manufacturing Costs

Direct Direct Manufacturing

Material Labor Overhead

The
Product

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Direct Material
Cost of raw material that is used to
make, and can be conveniently
traced, to the finished product.
Example:
Steel used to
manufacture
the automobile.

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Direct Labor
Cost of salaries, wages, and fringe
benefits for personnel who work
directly on manufactured products.

Example:
Wages paid to an
automobile assembly
worker.

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 Manufacturing Overhead
All other manufacturing costs

Indirect Indirect Other

Material Labor Costs

Materials used to support

the production process.
Examples: lubricants and
cleaning supplies used in an
automobile assembly plant.

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Manufacturing Overhead
All other manufacturing costs

Indirect Indirect Other

Material Labor Costs

Cost of personnel who

do not work directly on
the product. Examples:
maintenance workers,
janitors, and security
guards.
2-20
Manufacturing Overhead
All other manufacturing costs

Indirect Indirect Other

Material Labor Costs

Examples: depreciation
on plant and equipment,
property taxes,
insurance, utilities,
overtime premium, and
unavoidable idle time.
2-21
Classifications of Costs in Manufacturing
Companies
Manufacturing costs are often
combined as follows:

Direct Direct Manufacturing

Material Labor Overhead

Prime Conversion
Cost Cost

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Manufacturing Cost Flows
Direct Material
Work in
Direct Labor Process
Inventory

Manufacturing
Overhead

2-23
Manufacturing Cost Flows
Direct Material
Work in
Direct Labor Process
Inventory
Manufacturing
Overhead
Finished
Goods
Inventory

2-24
Manufacturing Cost Flows
Direct Material
Work in
Direct Labor Process
Inventory
Manufacturing
Overhead
Finished Cost of
Goods Goods
Inventory Sold

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Learning Objective 6

2-26
Schedule of Cost of Goods
Manufactured

Comet Computer Corporation

Schedule of Cost of Goods Manufactured
Raw material used $ 134,980
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs $ 414,980
Add: Work-in-process inventory, January 1 120
Subtotal $ 415,100
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured $ 415,000

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Schedule Computation
of Costofof Cost Goods
of Raw Material Used

Manufactured
Raw-material inventory, January 1 $ 6,000
Add: Purchases of raw materials 134,000
Raw material available for use 140,000
Deduct: Raw material inventory, December 31 5,020
Raw material used $ 134,980
Comet Computer Corporation
Schedule of Cost of Goods Manufactured
Raw material used $ 134,980
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs $ 414,980
Add: Work-in-process inventory, January 1 120
Subtotal $ 415,100
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured $ 415,000

2-28
Schedule of Cost of Goods
Manufactured
Include all direct labor
costs incurred during the
Cometcurrent period.
Computer Corporation
Schedule of Cost of Goods Manufactured
Raw material used $ 134,980
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs $ 414,980
Add: Work-in-process inventory, January 1 120
Subtotal $ 415,100
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured $ 415,000

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 Computation of Total Manufacturing Overhead
Indirect material $ 10,000
Indirect labor 40,000
Depreciation on factory 90,000
Depreciation on equipment 70,000
Comet Computer Corporation
Utilities 15,000
Insuranceof Cost of Goods Manufactured
Schedule 5,000
Total manufacturing overhead $ 230,000
Raw material used $ 134,980
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs $ 414,980
Add: Work-in-process inventory, January 1 120
Subtotal $ 415,100
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured $ 415,000

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Schedule of Cost of Goods
Manufactured
Beginning work-in-
process inventory is
carried over from the
Comet Computer Corporation
prior period.
Schedule of Cost of Goods Manufactured

Raw material used $ 134,980

Direct labor 50,000
Total manufacturing overhead 230,000
Ending work-in-process
Total manufacturing costs $ 414,980
inventory contains the
Add: Work-in-process cost ofJanuary 1
inventory, 120
unfinished
Subtotal goods, and is $ 415,100
reported in the current inventory,
Deduct: Work-in-process assets December 31 100
section of themanufactured
Cost of goods balance sheet. $ 415,000

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Income Statement for a Manufacturer

Comet Computer Corporation

Income Statement
For the Year Ended December 31, 20X2
Sales revenue $ 700,000
Less: Cost of goods sold 415,010
Gross margin $ 284,990
Selling and administrative expenses 174,490
Income before taxes $ 110,500
Income tax expense 30,000
Net income $ 80,500

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 Comet Computer Corporation
Schedule of Cost of Goods Sold
For the Year Ended December 31, 20X2
Finished-goods inventory, Jan. 1 $ 200
Add: Cost of goods manufactured 415,000
Cost of goods available for sale 415,200
Comet Computer Corporation
Deduct Finished-goods inventory, Dec. 31 190
Income Statement
Cost of goods sold $ 415,010
For the Year Ended December 31, 20X2
Sales revenue $ 700,000
Less: Cost of goods sold 415,010
Gross margin $ 284,990
Selling and administrative expenses 174,490
Income before taxes $ 110,500
Income tax expense 30,000
Net income $ 80,500

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Learning Objective7

2-34
Activities that cause costs to be incurred
are called COST DRIVERS:

Cost Driver Examples

Activity Cost Driver
Machining operations Machine hours
Setup Setup hours
Production scheduling Manufacturing orders
Inspection Pieces inspected
Purchasing Purchase orders
Shop order handling Shop orders
Valve assembly support Customer requisitions

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Learning Objective 8

2-36
Cost Classifications

Cost behavior means how a

cost will react to changes
in the level of business
activity.
 Total variable costs change
when activity changes.
 Total fixed costs remain
unchanged when activity
changes.

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Total Variable Cost Example
Your total cable pay-per-view bill is based on how many movies you
watch.
Total Pay-Per-View
Bill

Pay-Per-View
Movies Watched 2-38
Variable Cost Per Unit Example
The cost per movie watched is constant. For example, $4.00 per
movie.

Per Movie Charge

Movies Watched
2-39
Total Fixed Cost Example
Your monthly cable bill probably does not change when you
watch movies on channels that you have elected to be paid on a
monthly basis (HBO).
Monthly Charge for
HBO Bill

Number of HBO Movies

Watched 2-40
Fixed Cost Per Unit Example
The average cost per HBO movie decreases as more HBO movies are
watched.

Monthly HBO Bill per Movie

Watched

Number of HBO
Movies Watched 2-41
Cost Classifications

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Total variable cost changes Variable cost per unit

Variable as activity level changes. remains the same over
wide ranges of activity.
Total fixed cost remains Fixed cost per unit
Fixed the same even when the goes down as activity
activity level changes. level goes up.

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Learning Objective 9

2-43
Direct and Indirect Costs
Direct costs Indirect costs
 Costs that can be  Costs that must be allocated
easily and conveniently traced in order to be assigned to a
to a product or department. product or department.
 Example: cost of paint in the  Example: cost of national
paint department of an advertising for an airline is
automobile assembly plant. indirect to a particular flight.

2-44
Controllable and
Uncontrollable Costs

A cost that can be significantly influenced

by a manager is a controllable cost.

Cost item Manager Classificaton

Cost of food used Restaurant Controllable
in a restaurant manager
Cost of national Restaurant Uncontrollable
advertising by a manager
restaurant chain
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Learning Objective10

2-46
Opportunity Cost
The potential benefit that is given
up when one alternative is
selected over another.
 Example: If you were
not attending college,
you could be earning
$30,000 per year.
Your opportunity cost
of attending college for one year is
$30,000.

2-47
Sunk Costs
All costs incurred in the past that cannot be changed by any
decision made now or in the future are sunk costs. Sunk
costs should not be considered in decisions.
 Example: You bought an automobile that cost $22,000 two years ago.
The $22,000 cost is sunk because whether you drive it, park it, trade
it, or sell it, you cannot change the $22,000 cost.

2-48
Differential Costs
Costs that differ between alternatives.

Example: You can earn $1,500 per month in your

hometown or $2,000 per month in a nearby city.
Your commuting costs are $50 per month in your
hometown and $300 per month to the city.

What is your differential cost?

$300 - $50 = $250

2-49
Marginal Costs and Average Costs

The total cost to

The extra cost
produce a quantity
incurred to produce
divided by the
one additional unit.
quantity produced.

Marginal and average costs are

largely a function of cost behavior
-- variable and fixed costs.
2-50
Costs and Benefits of Information

Costs Benefits

More information does not mean more

benefits if information overload results.

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End of Chapter 2

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