1

2

Types of Organizations• Three major types

Service Merchandising Manufacturing

• Differ in Nature of product Pattern of cost flows Magnitude of various costs

LO 1: Distinguish product costs from period costs. LO 1: Distinguish product costs from period costs.

3

Financial Reporting

• All three types of firms Produce financial reports that conform to

GAAP Distinguish between product costs and

period costs

• Have financial reports that are of limited use for internal decisions

LO 1: Distinguish product costs from period costs. LO 1: Distinguish product costs from period costs.

4

Product and Period Costs• Product costs: Costs related to getting a cost or

service ready for sale. Appear “above the line” for gross margin in income statements These costs can be inventoried

They flow through the inventory account in the balance sheet Sometime called “Inventoriable costs.”

• Period costs: Costs that are not product costs. Related to marketing and administration Appear “below the line” for gross margin These costs are expensed in the period they are incurred. These costs do not flow through inventory accounts

LO 1: Distinguish product costs from period costs. LO 1: Distinguish product costs from period costs.

5

Period Costs

Product Costs

LO 1: Distinguish product costs from period costs. LO 1: Distinguish product costs from period costs.

A Traditional Income Statement

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Usefulness for Internal Decisions

• The statement only considers expenses Cost versus expense

An expense is a cost recognized in the income statement

• The gross margin income statement mingles Controllable & non controllable costs Variable and fixed costs Direct and indirect costs

LO 1: Distinguish product costs from period costs. LO 1: Distinguish product costs from period costs.

7

Product Period

Controllability Materials to be bought One-time sales discount

Variability Direct labor Commissions

Plant manager salary Sales manager salary

Traceability Cost of components Transportation

Overhead Warehousing

Materials in hand (no other use)

Discount set per long-term contract

Relation to Earlier Ideas

LO 1: Distinguish product costs from period costs. LO 1: Distinguish product costs from period costs.

8

Service Firms

• Products are not tangible or storable Hotels, restaurants, consulting, airlines,

gyms, universities, museums,…

• Generally, there is no inventory of their final product Exceptions exist

We can inventory costs of software projects that go across accounting periods

LO 2: Understand the flow of costs in service LO 2: Understand the flow of costs in service firms. firms.

9

Flow of Costs: Service Settings

LO 2: Understand the flow of costs in service LO 2: Understand the flow of costs in service firms. firms.

10

Merchandising Firms

• Examples include JC Penney, Sears, Kroger, Office Depot, Staples,…

• These firms Sell substantively the same product they

purchase. Carry inventory to make goods available in

the quantities, varieties and delivery schedules demanded by customers.

LO 3: Discuss how inventories affect the flow of costs in merchandising LO 3: Discuss how inventories affect the flow of costs in merchandising firms. firms.

11

Inventory Equation• Need to flow costs via inventory account

Cost of purchase is NOT the cost of goods sold

• We can capture flow as:Cost of beginning inventory

+ Cost of goods purchased during the period– Cost of ending inventory= Cost of goods sold (COGS) during the period

• Make inventory cost flow assumption First In First Out (FIFO) Last In First Out (LIFO)

LO 3: Discuss how inventories affect the flow of costs in merchandising LO 3: Discuss how inventories affect the flow of costs in merchandising firms. firms.

12

Cost of beginning inventory $3,450,200+ Cost of goods purchased + 24,795,740- Cost of ending inventory - 3,745,600= Cost of goods sold = $24,500,340

Solution

13

Flow of Costs in Merchandising

LO 3: Discuss how inventories affect the flow of costs in merchandising LO 3: Discuss how inventories affect the flow of costs in merchandising firms. firms.

Transportation in,

stocking

Transportation in,

stocking

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Manufacturing Firms

• Use labor and equipment to transform raw materials into finished goods Have work-in-process Need inventory accounts for all three kinds of

stages in the production process

• Much variation in Nature of production process Relative amounts of different costs

LO 4: Explain the cost terminology and the flow of costs in manufacturing LO 4: Explain the cost terminology and the flow of costs in manufacturing firms. firms.

15 LO 4: Explain the cost terminology and the flow of costs in manufacturing LO 4: Explain the cost terminology and the flow of costs in manufacturing firms. firms.

Cost Terms in Manufacturing

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Names for Groups of Costs

LO 4: Explain the cost terminology and the flow of costs in manufacturing LO 4: Explain the cost terminology and the flow of costs in manufacturing firms. firms.

17 LO 4: Explain the cost terminology and the flow of costs in manufacturing LO 4: Explain the cost terminology and the flow of costs in manufacturing firms. firms.

Cost Terms in Manufacturing Prime

Costs

Prime

Costs

Conversion CostsConversion Costs

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Physical and Cost Flows in Manufacturing

LO 4: Explain the cost terminology and the flow of costs in manufacturing LO 4: Explain the cost terminology and the flow of costs in manufacturing firms. firms.

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Example: Cost Flow in Manufacturing

LO 4: Explain the cost terminology and the flow of costs in manufacturing LO 4: Explain the cost terminology and the flow of costs in manufacturing firms. firms.

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Cost Allocations & Cost Flows

• Overhead costs are

Not traceable

Part of product cost for individual products

• Problem: How to divide total overhead to pieces that belong to individual products.

• Solution: Perform a cost allocation

LO 5: Allocate overhead costs to LO 5: Allocate overhead costs to products. products.

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Mechanics of Cost Allocations

• Each allocation has four elements Cost Pool Denominator Volume Cost Driver Cost Object

• Each allocation has two steps Calculate rate

Rate = Cost in pool Denominator volume

Allocate cost to cost object Allocated amount = # of driver units in object rate

LO 5: Allocate overhead costs to LO 5: Allocate overhead costs to products. products.

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To verify the amounts specified above, THREE calculations need to be made:To verify the amounts specified above, THREE calculations need to be made:

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Calculate Raw Materials UsedCalculate Raw Materials Used11

Procedure Result

22 Calculate Cost of Goods ManufacturedCalculate Cost of Goods Manufactured

Check It! Exercise #2 SolutionCheck It! Exercise #2 Solution

33 Calculate Cost of Goods SoldCalculate Cost of Goods Sold

Beginning materials inventory $240,000+ Purchases + 1,200,000- Ending materials inventory - 320,000= Raw materials used = $1,120,000

Beginning WIP inventory $50,000+ Materials used + 1,120,000+ Labor cost + 845,000+ Manufacturing overhead + 760,500- Ending WIP inventory - 100,000= Cost of goods manufactured = 2,675,500

Beginning FG inventory $375,000+ COGM + 2,675,500- Ending FG inventory - 294,500= Cost of goods sold = $2,765,000

Calculation

24 LO 5: Allocate overhead costs to LO 5: Allocate overhead costs to products. products.

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Cost Allocations: Properties

• The percent of cost allocated to a cost object is the percent of cost driver units in the cost object

The Smith and Jones family each contributes 50% of the cost driver units (families). Thus, each family gets 50% of cost to it

Smith family has 60% of the cost driver units (in persons). Thus, Smith family gets 60% of the cost allocated to it

LO 5: Allocate overhead costs to LO 5: Allocate overhead costs to products. products.

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Cost Allocations: Uses

• Uses of allocations Inventory valuation, decisions, behavioral

• Allocation basis versus cost driver GAAP needs allocations Decisions need assignment Two not the same

• We study allocations in more detail in Chapter 9.

LO 5: Allocate overhead costs to LO 5: Allocate overhead costs to products. products.

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Allocated Costs & Decisions

• Allocations make it appear as if the allocated cost is variable in the number of driver units

Cost allocated is variable in # of persons

• But, the cost is fixed in the short run

Might not be controllable

• Mixing the two can lead to errors

LO 5: Allocate overhead costs to LO 5: Allocate overhead costs to products. products.

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To verify the amounts specified above, the allocation rate and volume calculations need to be made.

To verify the amounts specified above, the allocation rate and volume calculations need to be made.

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Allocation Volume15,000 5-ton hooks x 25 labor hours per hook 375,000 labor hours

+ 10,000 10-ton hooks x 42.50 labor hours per hook 425,000 labor hours= Total labor cost 800,000

Allocation rate$16,000,000 in overhead costs / 800,000 labor hours = $20 per labor hour

Calculate Allocation Volume and Rate

Calculate Allocation Volume and Rate

Check It! Exercise #3 SolutionCheck It! Exercise #3 Solution

Calculate Amount Allocated to 5-ton Hooks

Calculate Amount Allocated to 5-ton Hooks

Allocation rate Cost driver units$20 per labor hour x 375,000 labor hours = $7,500,000

Allocation rate Cost driver units$20 per labor hour x 425,000 labor hours = $8,500,000

Calculate Amount Allocated to 10-ton Hooks

Calculate Amount Allocated to 10-ton Hooks

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Income Statement Example

LO 5: Allocate overhead costs to LO 5: Allocate overhead costs to products. products.

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Decision

• Suppose we sell one more unit for $23. What is change in profit?

• $0? (After all, cost = $23 per unit)

This answer is likely incorrect

Assumes that ALL costs change (are controllable)

This assumption is probably not true

LO 5: Allocate overhead costs to LO 5: Allocate overhead costs to products. products.

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Focus on Controllable Costs

LO 5: Allocate overhead costs to LO 5: Allocate overhead costs to products. products.

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Revised Decision

• Variable costs are only:

$17.50 (=$6 + 8 + $2 +1.50)

• Only these costs are controllable for decision to make one more unit

• Profit increase

$25 - $17.50 = $7.50!

LO 5: Allocate overhead costs to LO 5: Allocate overhead costs to products. products.

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Problem 3.30Cost flows in a service firm (LO2).

The following data pertain to Skogg Consulting. Skogg provides advice on structural engineering for large projects such as stadiums and bridges. Clients seek Skogg out because it has extensive contacts and can find the person who is “right” for the job. This is a nontrivial task, as often fewer than 10 persons worldwide might have the required expertise. Skogg bills clients at the rate of $350 per hour plus actual expenses for travel and board. The firm draws consultants from a roster it maintains, and it pays the consultant $300 per hour. The balance of $50 goes toward administrative support. The firm expects to accumulate 9,000 consulting hours for the year and projects a profit before taxes of $230,000.

Required: Complete a GAAP income statement to determine (a) the firm’s cost to provide service and (b) its marketing and administration costs.

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Complete a GAAP income statement to determine (a) the firm’s cost to provide service and (b) its marketing and administration costs.

Problem 3.30 (Concluded)

The following is the gross margin statement for Skogg Consulting.The following is the gross margin statement for Skogg Consulting.

Revenues 9,000 hours × $350/hour $3,150,000Cost of delivering service 9,000 hours × $300/hour 2,700,000Gross margin $450,000Marketing & administration Plug figure 220,000Profit before taxes Given $230,000

We can readily obtain the answers by noting that revenue – cost of services = gross

margin and gross margin – marketing and administration costs = profit before taxes.

Notice that we ignored the reimbursement of actual costs in this statement. If we included the

amounts, it would increase revenue and costs by identically.

We can readily obtain the answers by noting that revenue – cost of services = gross

margin and gross margin – marketing and administration costs = profit before taxes.

Notice that we ignored the reimbursement of actual costs in this statement. If we included the

amounts, it would increase revenue and costs by identically.