COST Concepts Classification and Cost Behavior

CONCEPTS, CLASSIFICATIONS AND COST BEHAVIOR

Group 2

COST

Joel Pre II

Cost Elements in Manufacturing

Product and Period Costs

The Income Statement

Schedule of Costs

Tacy Gonzalez

Cost Classifications for Predicting Cost Behavior

Analyzing Cost Behavior

Cost Classifications in Decision Making

Joel Ulysses S. Pre IIGraduate School of ManagementMasters in Business Administration (MBA-TEP)Pamantasan ng Lungsod ng Maynila

Identify and give examples of each of the three basic cost elements involved

in the manufacture of a product.

The Product

DirectMaterials

DirectMaterials

DirectLabourDirectLabour

ManufacturingOverhead


Manufacturing Costs

Raw materials that become an integral part of the product and that can be conveniently traced directly to it.

Direct Materials

Example: A radio installed in an automobileExample: A radio installed in an automobile

Those labour costs that can be easily traced to individual units of product.

Direct Labour

Example: Wages paid to automobile assembly workersExample: Wages paid to automobile assembly workers

Manufacturing costs that cannot be traced directly to specific units produced.

Manufacturing Overhead

Examples: Indirect labour and indirect materialsExamples: Indirect labour and indirect materials

Wages paid to employees who are not directly

involved in production work.

Examples: maintenance workers, janitors and

security guards.

Materials used to support the production process.

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

Manufacturing costs are oftenclassified as follows:

Classifications of Costs

DirectMaterialDirect

MaterialDirectLabourDirectLabour



PrimeCost

ConversionCost

Idle Time

The labour costs incurred during idle time are ordinarily treated as

manufacturing overhead.Product specific idle time is treated as direct labour.

Machine Breakdowns

Material Shortages

Power Failures

OvertimeThe overtime premiums for all factory

workers are usually considered to be part of manufacturing overhead. Product specific

overtime premiums are part of direct labour.

Employee Benefits

Employee benefits include employment taxes, medical plans, and pension costs.

Some companies include all of these

costs in manufacturing

overhead.

Other companies treat employee benefit

expenses of direct labourers as

additional direct labour costs.

Non-manufacturing Costs

Selling Costs

Costs necessary to get the order and deliver

the product.

Administrative Costs

All executive, organizational, and

clerical costs.

Distinguish between product costs and period costs and give examples of

each.

Period costs include all selling costs and

administrative costs.

Product costs include direct

materials, direct labour, and

manufacturing overhead.

Product Costs Versus Period Costs

Inventory Cost of Good Sold

BalanceSheet

IncomeStatement

Sale

Expense

IncomeStatement

Which of the following costs would be considered a period rather than a product cost in a manufacturing company?A. Manufacturing equipment depreciation.

B. Property taxes on corporate headquarters.

C. Direct materials costs.

D. Electrical costs to light the production

facility.

E. Sales commissions.

Quick Check

Manufacturers . . .• Buy raw materials.• Produce and sell finished goods.

Merchandisers . . .• Buy finished goods.• Sell finished goods.

Comparing Merchandising and Manufacturing Activities

MegaLoMart

Merchandiser Current assetsCashReceivablesPrepaid ExpensesMerchandise Inventory

Balance Sheet

Manufacturer Current Assets

Cash Receivables Prepaid Expenses Inventories

• Raw Materials• Work in Process• Finished Goods

Merchandiser Current assetsCashReceivablesPrepaid ExpensesMerchandise Inventory

Balance Sheet

Manufacturer Current Assets

Cash Receivables Prepaid Expenses Inventories

• Raw Materials

• Work in Process

• Finished Goods

Partially complete products – some material, labour, or overhead has

been added.

Completed products awaiting sale.

Materials waiting to be processed.

Prepare an income statement including calculation of the cost of goods sold.

Cost of goods sold for manufacturers differs only slightly from cost of goods sold for

merchandisers.

The Income Statement

Manufacturing Company

Cost of goods sold: Beg. finished goods inv. 14,200$ + Cost of goods manufactured 234,150 Goods available for sale 248,350$ - Ending finished goods inventory (12,100) = Cost of goods sold 236,250$

Merchandising Company

Cost of goods sold: Beg. merchandise inventory 14,200$ + Purchases 234,150 Goods available for sale 248,350$ - Ending merchandise inventory (12,100) = Cost of goods sold 236,250$

Basic Equation for Inventory Accounts

Beginningbalance

Additionsto inventory+ =

Endingbalance

Withdrawalsfrom

inventory+

If your inventory balance at the beginning of the month was $1,000, you bought $100 during the month, and sold $300 during the month, what would be the balance at the end of the month?

A. $1,000.B. $ 800.C. $1,200.D. $ 200.

Quick Check

If your inventory balance at the beginning of the month was $1,000, you bought $100 during the month, and sold $300 during the month, what would be the balance at the end of the month?

A. $1,000.B. $ 800.C. $1,200.D. $ 200.

Quick Check

$1,000 + $100 = $1,100$1,100 - $300 = $800

Prepare a schedule of cost of goods manufactured.

Schedule of Cost of Goods Manufactured

Calculates the cost of raw material, direct labour and

manufacturing overhead used in production.

Calculates the manufacturing costs associated with goods that were finished during the

period.

Manufacturing WorkRaw Materials Costs In Process

Beginning raw Direct materials materials inventory

+ Raw materials purchased

= Raw materials

available for use in production

– Ending raw materials inventory

= Raw materials used

in production

As items are removed from raw materials inventory and placed into

the production process, they arecalled direct materials.

As items are removed from raw materials inventory and placed into

the production process, they arecalled direct materials.

Product Cost Flows


Beginning raw Direct materials materials inventory + Direct labour

+ Raw materials + Mfg. overhead purchased = Total manufacturing

= Raw materials costs

available for use in production



in production

Conversion costs are costs

incurred to convert the

direct material into a finished

product.

Conversion costs are costs

incurred to convert the

direct material into a finished

product.

Product Cost Flows


Beginning raw Direct materials Beginning work in materials inventory + Direct labour process inventory

+ Raw materials + Mfg. overhead + Total manufacturing purchased = Total manufacturing costs

= Raw materials costs = Total work in

available for use process for the in production period



in production

Product Cost Flows

All manufacturing costs incurred during the period are added to the

beginning balance of work in process.

All manufacturing costs incurred during the period are added to the

beginning balance of work in process.


Beginning raw Direct materials Beginning work in materials inventory + Direct labour process inventory

+ Raw materials + Mfg. overhead + Total manufacturing purchased = Total manufacturing costs

= Raw materials costs = Total work in

available for use process for the in production period

– Ending raw materials – Ending work in inventory process inventory

= Raw materials used = Cost of goods

in production manufactured

Product Cost Flows

Costs associated with the goods that are completed during the period are

transferred to finished goods inventory.

Costs associated with the goods that are completed during the period are

transferred to finished goods inventory.

WorkIn Process Finished Goods

Beginning work in Beginning finished process inventory goods inventory

+ Manufacturing costs + Cost of goods for the period manufactured

= Total work in process = Cost of goods for the period available for sale

– Ending work in - Ending finished process inventory goods inventory

= Cost of goods Cost of goods manufactured sold

Product Cost Flows

Manufacturing Cost Flows

FinishedGoods

Cost of GoodsSold

Selling andAdministrative

Period CostsSelling andAdministrative


Work in Process

Direct Labour

Balance Sheet Costs Inventories

Income StatementExpenses

Material Purchases Raw Materials

Quick Check

Beginning raw materials inventory was $32,000. During the month, $276,000 of raw material was purchased. A count at the end of the month revealed that $28,000 of raw material was still present. What is the cost of direct material used?

A. $276,000B. $272,000C. $280,000D. $ 2,000

Quick Check

Beginning raw materials inventory was $32,000. During the month, $276,000 of raw material was purchased. A count at the end of the month revealed that $28,000 of raw material was still present. What is the cost of direct material used?

A. $276,000B. $272,000C. $280,000D. $ 2,000

Beg. raw materials 32,000$ + Raw materials

purchased 276,000 = Raw materials available

for use in production 308,000$ – Ending raw materials

inventory 28,000 = Raw materials used

in production 280,000$

Direct materials used in production totaled $280,000. Direct labour was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month?

A. $555,000B. $835,000C. $655,000D. Cannot be determined.

Quick Check

Direct materials used in production totaled $280,000. Direct labour was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month?

A. $555,000B. $835,000C. $655,000D. Cannot be determined.

Quick Check

Direct Materials 280,000$ + Direct Labour 375,000 + Mfg. Overhead 180,000 = Mfg. Costs Incurred

for the Month 835,000$

Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month?

A. $1,160,000B. $ 910,000C. $ 760,000D. Cannot be determined.

Quick Check

Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month?

A. $1,160,000B. $ 910,000C. $ 760,000D. Cannot be determined.

Quick Check

Beginning work in process inventory 125,000$

+ Mfg. costs incurred for the period 835,000

= Total work in process during the period 960,000$

– Ending work in process inventory 200,000

= Cost of goods manufactured 760,000$

Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. And the ending finished goods inventory was $150,000. What was the cost of goods sold for the month?

A. $ 20,000.B. $740,000.C. $780,000.D. $760,000.

Quick Check

Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. And the ending finished goods inventory was $150,000. What was the cost of goods sold for the month?

A. $ 20,000.B. $740,000.C. $780,000.D. $760,000.

Quick Check

$130,000 + $760,000 = $890,000$890,000 - $150,000 = $740,000

Ma. Exaltation A. GonzalezGraduate School of ManagementMasters in Business Administration (MBA-TEP)Pamantasan ng Lungsod ng Maynila


Cost Classification by

Behavior

Variable

True Variable

Step-Variable

Fixed

Commited

Discretionary

Mixed

Variable

Fixed

VARIABLE COST is a cost that varies, in total, in direct proportion to changes in the level of activity.

Number of Cakes Made

Cost per Kilo of Flour

Total Variable Cost - Flour

1 ₱ 200.00 ₱ 200.007 ₱ 200.00 ₱

1,400.0015 ₱ 200.00 ₱

3,000.00

Variable Cost Illustration

Type of Organization

Normally variable with respect to volume of output

Merchandising company

Cost of goods (merchandise) sold

Manufacturing company

Direct materialsDirect labor*Variable elements of manufacturing overhead (indirect materials, supplies, power)

Service company TravelSupplies

Any Sales commissionShipping cost

Table 2. Examples of Variable Costs

Price starts at $40,140.00

Fully electric = 154 km /

gallon-e

Volt battery (direct material)

Chevy Volt

Number of Volts

Cost per Battery

Total Variable

Cost - Battery

1 $7,000 $7,00050 $7,000 $350,00

075 $7,000 $525,00

0

Island day trips

Package starts at PhP 2,500/person

Catered meals

Mabuhay Travel

Number of Tourists Cost per Tourist Total Variable Cost - Meals

50 ₱ 650.00 ₱ 32,500.00

150 ₱ 650.00 ₱ 97,500.00

700 ₱ 650.00 ₱ 455,000.00

FIXED COST is a cost that remains constant regardless of changes in the level of activity.

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97PhP0.00

PhP5,000.00

PhP10,000.00

PhP15,000.00

PhP20,000.00

PhP25,000.00

PhP30,000.00

Figure 1. Variable and Fixed Cost Behavior

Cost of Fuel

Cost of Vehicle Lease

Miles Travelled

The ACTIVITY BASE is a measure of whatever causes the incurrence of variable cost. It is also referred to as a COST DRIVER.

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97PhP0.00

PhP5,000.00

PhP10,000.00

PhP15,000.00

PhP20,000.00

PhP25,000.00

PhP30,000.00

Figure 1. Variable and Fixed Cost Behavior

Cost of Fuel

Cost of Vehicle Lease

Miles Travelled

Rents a machine to test blood

samples for the presence of

leukemia cells

Fixed Cost = $8,000/month

Mayo Clinic

Monthly Rental Number of Tests Average Cost per Test

$ 8,000.00 10 $800

$ 8,000.00 500 $16

$ 8,000.00 2,000 $4

Each new plant can produce

1.25 million chips per day

375 million chips a year

Volume output = 2.5x faster in

new plants

Intel

AVERAGE FIXED COST PER UNIT OF OUTPUTECONOMIES OF SCALE

TYPE OF VARIABLE COSTS

TRUE VARIABLE COSTS, like direct materials is a true variable cost because the amount used during a period will vary in direct proportion to the level of production activity. Moreover, any amounts purchased but not used can be stored and carried forward to the next period as inventory.STEP VARIABLE COSTS are the cost of a resource that is obtainable only in large chunks and that increases or decreases only in response to fairly wide changes in activity.

Telco costs = true variable

Shift managers = step-variable

Call Center XYZ

0

50

100

150

200

250

300

350

0

1

2

3

4

5

6

7True Variable versus Step-Variable Costs

Call Minutes in Thousands

Volume of Calls

Industry Study:

2003

7,629

companies

20-year period

1% increase in Sales = 0.55% increase in Sales/Administrative costs1% decrease in Sales = 0.35% decrease in Sales/Administrative costs

TYPE OF FIXED COSTS

COMMITTED FIXED COSTS are those costs that cannot be significantly altered or reduced even for short periods of time without making fundamental changes. You are locked-down to these costs, at least for the considerable term that can sometimes run to a few years. DISCRETIONARY FIXED COSTS are sometimes called “managed fixed costs”. They usually arise from annual decisions made by management on certain fixed costs items.

a company buys a

machine for $40,000

maintenance contract for

$2,000 in each of the

next three years

Committed Cost: Equipment

A multi-year property lease

agreement is also a

committed cost for the full

term of the lease, since it is

extremely difficult to

terminate a lease

agreement.

Committed Cost : Property

Advertising

Research

Management Development

Programs

Discretionary

Labor Cost: Variable or Fixed?

Type of Industry Country

Regulations Labor Contracts Union

Commitments Company Decision

Fixed Costs and the Relevant Range

The RELEVANT RANGE is the range of activity within which the assumptions about the variable and fixed costs are valid

$0.00

$500.00

$1,000.00

$1,500.00

$2,000.00

$2,500.00

$3,000.00

Fixed Vehicle Lease Cost and Its Relevant Range

Fixed Costs versus Step Variable Cost

$0.00

$500.00

$1,000.00

$1,500.00

$2,000.00

$2,500.00

$3,000.00

Fixed Vehicle Lease Cost and Its Relevant Range

0

1

2

3

4

5

6

7. True Variable versus Step-

Variable Costs

Volume of Calls

Type of Industry

Ease of Change in Response

Historical Accounting Practice

Per Unit Cost

Fixed

Variable

MIXED COST : a mix between fixed and variable costs.

Mixed Cost = Fixed Cost + ((Variable Cost Per Unit)( Number of Units))

Mixed Cost = Fixed Cost + Total Variable Cost

Mabuhay Travel and Tours

Annual License paid

to DOT₱ 41,000.00

Travel fees to DOT

paid per trip₱ 375.00

Number of Trips

Taken400MIXED COST = 41,000 + ((375)(400))

MIXED COST = 191,000

Training Cost in a Merchant Company

Regulatory Training:

PCI Training from the

Payment Card

Industry Security

Standards Council

Other Skills Training

Initiatives

MIXED COST = Regulatory Training Cost + ((Skills Training)(Number of Training))

$0.00

$5,000.00

$10,000.00

$15,000.00

$20,000.00

$25,000.00

$30,000.00

$35,000.00

$40,000.00

$45,000.00

$50,000.00 Figure 4. Training Cost as

Mixed Cost

Up-Skill TrainingRegulatory Train-ing


Cost Classification by

Behavior

Variable

True Variable

Step-Variable

Fixed

Commited

Discretionary

Mixed

Variable

Fixed

Analysis for Cost Behavior

Analysis for Cost Behavior

Linearity Assumption

High-Low Method

Scattergraph Plot Method

Least Squares Regression

LINEARITY ASSUMPTION: as activity increases, cost increases.

Linearity of Variable Costs

Volume (units) - INDEPENDENT (x-axis)

Cost

- D

EP

EN

DEN

T (

y-a

xis

)

Linearity of Variable Costs

Volume (units) - INDEPENDENT (x-axis)

Cost

- D

EP

EN

DEN

T (

y-a

xis

)

Linear versus Non-Linear

HIGH-LOW METHOD: using the highest and lowest activity points to determine mixed cost behavior.

Month Cost HoursJanuary $1,000 100

February $1,250 200March $2,250 300April $2500 400May $3750 500June ? 350

Cost and Hours of Operation, Larson’s Company

High-Low Method



High-Low Method Variable rate = (3750 – 1000) / (500 – 100)

= 2750/400= 6.875

Fixed cost = 3750 – (6.875 x 500)= 312.50

June cost = 312.50 + (6.875 x 350)= 2718.75



THE SCATTERGRAPH PLOT: taking into account all data sets available and plotting them in a scattergraph.



Cost and Hours of Operation, Larson’s Company

50 100 150 200 250 300 350 400 450 500 550$0

$500 $1,000 $1,500 $2,000 $2,500 $3,000 $3,500 $4,000

Scattergraph for Larson Company

Scattergraph Plot Variable rate = (2250 – 1000) / (300 – 100)

= 1250/200= 6.25

Fixed cost = 2250 – (6.25x 300)= 375

June cost = 375 + (6.25 x 350)= 2562.50



LEAST SQUARES REGRESSION METHOD: defining the best-fit line

50 100 150 200 250 300 350 400 450 500 550$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

Least Squares Regression Method

Comparing Approaches

Y = a + bxTotal Cost = Fixed Cost + (Variable

Rate*Activity Level)

High - Low Scatterplot Regression

Fixed Cost 312.75 375 125

Variable Rate

6.875 6.25 6.75

Total Cost (June)

$2718.75 $2562.50 $2487.50

Cost Classifications for Decision Making

Cost Classifications for Decision Making

Differential Cost & Revenue

Opportunity Cost

Sunk Cost

DIFFERENTIAL COST: the difference in cost between two alternatives

DIFFERENTIAL REVENUE: the difference in REVENUE between two alternatives

INCREMENTAL COST

DECREMENTAL COST

Health implications of menu

Hydrogenated oil to soybean oil

Cut trans-fat by 48%

Soybean oil only lasts half-as-long

$ 186 to $571 per week

DIFFERENTIAL COST = $260 M per

year

McDonald’s

Nature’s Way

ITEMS RETAILER SALES REP DIFF COST/REV

REVENUE $700,000 $800,000 $100,000

Cost of Goods Sold (V) 350,000 400,000 50,000

Advertising (F) 80,000 45,000 (35,000)

Commission (V) 0 40,000 40,000

Warehouse depreciation (F)

50,000 80,000 30,000

Other Expenses (F) 60,000 60,000 0

TOTAL EXPENSES 540,000 625,000 85,000

NET OPERATING INCOME

$160,000 $175,000 $15,000

Incremental revenue = $100,000

Incremental cost = $85,000

Net Income difference = $15,000

Cancer patients with specialized

treatment

Corporate Jets flying with empty

seats

No tax breaks for participating

companies

ZERO INCREMENTAL COSTS

Corporate Angel Network

OPPORTUNITY COST: the potential benefit that is given up when one alternative is selected.

Rarely seen in accounting records, but managers use these figures all the time to make decisions.

Choosing one over the other means that the other option is a

lost opportunity

New Store

New Realty Project

Choosing one over the other means that the other option is a

lost opportunity

Team Building Continue

Work

SUNK COST: costs that stay the same regardless of the available alternatives or the decision made

Need to ignore sunk costs in making current and future decisions.

$100 Ticke

t

$50 Ticke

t

Source: Pricing and the Psychology of Consumption, Harvard Business Review, September 2002, pp. 92 -93.

“Throwing good money after bad.”

COST Concepts Classification and Cost Behavior

Documents

Transcript of COST Concepts Classification and Cost Behavior