Managerial Accounting

Creating Value in a Dynamic Business Environment

Second Canadian Edition
HILTON  FAVERE-MARCHESI

Chapter 2:
Basic Cost
Management
Concepts

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Learning Objectives
1. Explain what is meant by the word "cost."
2. Distinguish among product costs, period costs, and
expenses.
3. Describe the role of costs on published financial
statements.
4. List five types of manufacturing operations and describe
mass customization.
5. Give examples of three types of manufacturing costs.
6. Prepare a schedule of cost of goods manufactured, a
schedule of cost of goods sold, and an income
statement for a manufacturer.

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 Learning Objectives
(cont’d)
7. Understand the importance of identifying an organization's
cost drivers.
8. Describe the behavior of variable and fixed costs, in total
and on a per-unit basis.
9. Distinguish among direct, indirect, controllable, and
uncontrollable costs.
10. Define and give examples of an opportunity cost, an out-
of-pocket cost, a sunk cost, a differential cost, a
marginal cost, and an average cost per unit.

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 LO1

The meaning of costs

 A cost is the sacrifice made to achieve a particular

purpose.
 There are different costs for different purposes.
 An expense is the cost incurred when an asset is
used up or sold to generate revenue.
 "product cost" and "period cost " describe timing
with which expenses are recognized.

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 LO2

The meaning of costs

 Product costs are the costs of goods
manufactured or the cost of goods purchased for
resale. These costs are inventoried until the
goods are sold.

 Period costs are all other non-product costs in an

organization (e.g., selling and administrative).
Such costs are not inventoried but are expensed
as time passes.

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 LO3

COSTS ON FINANCIAL STATEMENTS

 Product costs, kept on the balance sheet until

sale, are found in three inventory accounts:
 Raw materials—materials that await production
 Work in process—partially completed
production
 Finished goods—completed production that
awaits sale
 Product costs are shown as cost of goods sold
on the income statement when goods are sold.
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 LO4

MANUFACTURING OPERATIONS
AND COSTS
 There are various types of production processes
example:
 Job shop—low production volume, little standardization;
one-of-a-kind products (movies, service, custom-made
home)
 Batch—multiple products; low volume (bakery, airplanes)
 Assembly line—a few major products; higher volume
(automobiles, TV)
 Mass customization—high production volume;
standardized components; customized combinations of
components (Dell computers)
 Continuous flow—high volume; highly standardized
commodity products (Oil & Gas)
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 LO5

MANUFACTURING OPERATIONS
AND COSTS
 There are 3 types of manufacturing costs:
 Direct materials—materials easily traced to a
finished product (e.g., the seat on a bicycle)
 Direct labour—the wages of anyone who works
directly on the product
 Manufacturing overhead—all other manufacturing
costs such as: Indirect materials, indirect labour,
and other manufacturing costs not easily
traceable to a finished good (e.g., insurance,
property taxes, depreciation, utilities).
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 LO5

MANUFACTURING OPERATIONS
AND COSTS

 Overtime premiums and the cost of idle time are

also accounted for as overhead.
 Conversion cost (the cost to convert direct
materials into finished product): direct labour +
manufacturing overhead
 Prime cost: direct material + direct labour

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 LO6

MANUFACTURING COST FLOWS

 Manufacturing costs (DM, DL, and MOH) "put in
process" and attached to work-in-process (WIP)
inventory.
 Cost of goods manufactured: DM used + DL +
MOH + beg WIP – end WIP . This amount is
transferred from WIP inventory to F/G inventory
when goods are completed.
 The costs are then transferred from F/G inventory
to CGS upon sale of the goods.

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 LO6

MANUFACTURING COST FLOWS

 Product costs and cost of goods sold for a
manufacturer:
Beginning Cost of Goods Ending
Inventory, + Manufactured - Inventory, = Cost of
Finished Goods to Completion Finished Goods Goods Sold

Beginning CGM Ending Cost of

Finished Finished Goods
Goods Goods Sold

Supported by A schedule of Current Income

the prior year's production costs balance sheet statement
balance sheet

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 LO6

MANUFACTURING COST FLOWS

 Manufacturers generally prepare a schedule of
CGM and a schedule of CGS
 Production-cost concepts are applicable to service
businesses and nonprofit organizations. For
example, the DM concept can be applied to the food
consumed in a restaurant or the jet fuel used by an
airline. Similarly, DL would be equivalent to the
cooks in a restaurant and the flight crews of an
airline.

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 LO7

DIFFERENT COSTS FOR DIFFERENT

PURPOSES
 The most important classification involves how costs
change in relation to changes in the activity of the
organization (a measure of the output of products
and services).
 The activities that cause costs to be incurred are
called cost drivers. Examples include labour hours
in manual assembly work and machine hours in
automated production settings.
 The higher the degree of correlation between a
cost increase and the increase in its cost driver, the
better the cost management information.
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 LO8

Variable and fixed costs

 Total Variable Costs move in direct proportion

to a change in activity. For example, the total
cost of bicycle seats goes up in proportion to the
number of bicycles produced.
 Total Fixed Costs remain constant in total as
the level of activity changes. For instance,
property taxes for the manufacturing facilities
remains the same whether 100 bicycles or 1,000
bicycles are produced.

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 Total Variable Cost Example

The bicycle seat bill is based on how many

bicycles are made.
Total Bicycle Seat Bill

Bicycles Made
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 Variable Cost Per Unit Example
The cost per bicycle seat is
constant.
Per Seat Charge

Bicycles made
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 Total Fixed Cost Example
Your monthly property tax bill does not
change when you make more bicycles.
Monthly Charge for
Property Taxes

Number of Bicycles Made

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 Fixed Cost Per Unit Example
The average cost per bicycle for property taxes
decreases as more bicycles are made.
Monthly Property Tax per
Bicycle Made

Number of Bicycles
made
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 LO9

Direct and indirect costs

 An entity (e.g., a specific product, service, or
department) to which a cost is assigned is
commonly known as a cost object.
 A direct cost is one that can be easily traced to a
cost object (faculty’s salaries).
 An indirect cost is a cost that cannot be easily
traced to a cost object (president’s salary).
 A cost management system traces costs to objects
that caused them so that managers can isolate
responsibility for spending and objectively evaluate
operations.

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 LO9

Controllable and uncontrollable

costs

 Controllable costs—costs over which a manager

has influence (e.g., direct materials)
 Uncontrollable costs—costs over which a
manager has no influence (e.g., property taxes)

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 LO10

DIFFERENT COSTS FOR DIFFERENT

PURPOSES
 Opportunity cost—the benefit forgone by choosing
an alternative course of action (e.g., wages forgone
when attending university rather than working)
 Out-of-pocket cost—a cost that requires a cash
outlay
 Sunk cost—a cost incurred in the past that cannot
be changed by future action (e.g., tuition)
 Differential cost—the net difference in cost
between two alternative courses of action
 Incremental cost—the increase in cost from one
alternative to another

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 LO10

COSTS IN THE SERVICE INDUSTRY

 The preceding costs discussed in a
manufacturing context are just as relevant for
service providers.
 Although manufacturers and service firms are in
very different businesses, they all must
understand their costs in order to be successful
in a competitive environment.

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 Costs and Benefits of Information

Costs Benefits

More information does not mean more

benefits if information overload results.

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 Example – Background data
Costs Amount
Indirect materials $ 300
Rent on factory building 500
Maintenance of equipment 50
Direct material used 1,200
Utilities on factory 250
Direct labour 1,500
Selling expense 500
Administrative expense 300
WIP inventory, beginning 600
WIP inventory, ending 800
F/G inventory, beginning 500
F/G inventory, ending 250

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 Example – Per Unit Approach

 Let’s first examine the monthly activity in

terms of units, then we will look at cost.

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 Example – Units Manufactured and Sold

UNITS MANUFACTURED AND SOLD

Units partially completed at beginning of month 400
(beginning WIP inventory)
Add: Units started during the month 2,400
Less: Units partially completed at end of month (500)
(ending WIP inventory)
Units transferred to FG inventory during the month 2,300
Add: Units in FG inventory at beginning of month 800
Units available for sale 3,100
Less: Units in FG inventory at end of month (400)
Units sold during the month 2,700

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 LO5

Example – Cost Approach

 Let’s isolate the manufacturing costs incurred
during the month, which are the direct
materials, the direct labour and the
manufacturing overhead costs.

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 LO5

Example – Background Data

Costs Amount
Indirect materials $ 300
Rent on factory building 500
Maintenance of equipment 50
Direct material used 1,200
Utilities on factory 250
Direct labour 1,500
Selling expense 500
Administrative expense 300
WIP inventory, beginning 600
WIP inventory, ending 800
F/G inventory, beginning 500
F/G inventory, ending 250
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 LO5

Example – Total Manufacturing Costs

TOTAL MANUFACTURING COSTS
Direct material used $1,200
Direct labour 1,500
Manufacturing overhead
These areIndirect materials
the total costs incurred $ 300
during the month to (1) finish 400
Rent
units that were on factory
partially completebuilding
at 500
the end of last month and (2) start
Maintenance of
2,400 new units this month, of
50
equipment
which 500 are partially complete at
the end of the month
Utilities on factory 250
Total manufacturing overhead 1,100
Total manufacturing costs $3,800

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 $3,800 total manufacturing costs LO5
incurred this month to finish the
Example – Units Manufactured and Sold
400 units, to start 2,400 (1,900
were finished and 500 were
partially complete
UNITS MANUFACTURED AND SOLD
Units partially completed at beginning of month 400
(beginning WIP inventory)
Add: Units started during the month 1,900 2,400 500

Less: Units partially completed at end of month (500)

(ending WIP inventory)
Units transferred to FG inventory during the month 2,300
Add: Units in FG inventory at beginning of month 800
Units available for sale 3,100
Less: Units in FG inventory at end of month (400)
Units sold during the month 2,700

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 LO6
This cost was incurred last
month on the units that were
Example – Cost of Goods partially complete at the end
of last month
Manufactured
COST OF GOODS MANUFACTURED
Beginning WIP inventory $ 600
Add: Total manufacturing costs 3,800
Less: Ending WIP inventory (800)
Cost of goods manufactured $3,600
This cost was incurred on
units that were started this
month but that are partially
complete at the end of this
month This cost represents the cost of all the units
completed this month, some of which were
partially complete at the end of last month
and some of which were started and
completed this month
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 LO6
The cost of good manufactured
($3,600) is the cost of the 400 units
Example – Units Manufactured and Sold
partially completed at the end of last
month and finished this month and of
UNITS theMANUFACTURED ANDand
1,900 units that were started SOLD
completed at
Units partially completed thisbeginning
month of month 400
(beginning WIP inventory)
Add: Units started during the month 1,900 2,400 500

Less: Units partially completed at end of month (500)

(ending WIP inventory)
Units transferred to FG inventory during the month 2,300
Add: Units in FG inventory at beginning of month 800
Units available for sale 3,100
Less: Units in FG inventory at end of month (400)
Units sold during the month 2,700

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 LO6
This cost is associated with
units that were unsold at the
Example – Cost of Goods Soldend of last month

COST OF GOODS SOLD

Beginning F/G inventory $ 500
Add: Cost of goods 3,600
manufactured
Cost of goods available for sale 4,100
Less: Ending F/G inventory (250)
This cost is associated with
Cost of goods sold
units that were unsold at the
$3,850
end of this month

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 LO6

Example – Units Manufactured and Sold

MANUFACTURED AND SOLD Units $

Units partially completed at beginning of month 400
(beginning WIP inventory)
Add: Units started during
Cost the month
of goods manufactured 2,400
Less: Units partially completed at end of month (500)
(ending WIP inventory)
Units transferred to FG inventory during the month 2,300 $3,600
Add: Units in FG inventory at of
Cost beginning of month
goods sold 800 500
Units available for sale 3,100 4,100
Less: Units in FG inventory at end of month (400) 250
Units sold during the month 2,700 $3,850

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