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What is the Cost? • Several years ago you purchased a bottle of wine for $25. Today it is worth $75. If you give the bottle to a friend as a gift, what is the cost of your gift? • $0 • $25 • $25+ • $75 • ($50)
Cost Objects • Anything whose cost we want to determine • Product, process, location, person, region, etc. • Whether a cost is direct or indirect depends on the cost object • As cost object becomes more detailed, fewer costs are directly related
Direct vs. Indirect Costs • Direct cost • Easily and conveniently traceable to the cost object • Indirect • Not easily or conveniently traceable • Cost is shared among cost objects • No apparent “link” between the cost and the object • Not cost effective to trace
Product vs. Period Costs • Product costs • Reasonable and necessary costs to prepare the product for sale to the customer • Direct materials • Direct labor • Overhead • Part of inventory until product is sold • Period costs • Non-manufacturing costs • Expensed when incurred
Product vs. Period Costs Direct material Prime costs Direct labor Product costs Conversion costs Overhead
Product vs. Period Costs • Distinction between product and period costs is blurred for internal reporting • Marketing cost may be considered part of the total cost of a product • Labor may be considered overhead • Only incremental costs may be considered • Etc.
Manufacturing Cost Flows Raw Materials Inventory (1) Work in Process Inventory (2) Finished Goods Inventory (3) Cost of Goods Sold Factory Labor • Materials are placed into production (Raw materials used in production) • (This plus direct labor and overhead equals total manufacturing costs, i.e. inputs) • Goods are completed (Cost of goods manufactured, i.e. outputs) • Goods are sold Overhead
Cost Drivers • The cause of a particular cost • Capacity driver • Decision to acquire capacity • Transaction driver • Each occurrence causes the cost • Duration driver • Amount of cost depends on the duration of the event
Cost Hierarchy • Unit level • Each additional unit (of something) creates more cost • Batch level • Each new batch, or the crossing of some threshold creates more cost • Product level • Change to product, or additional product, creates more cost
Cost Hierarchy • Customer level • Each new customer creates more cost • Facility level • Change to facility creates more cost
Cost Behavior • How a cost changes in relation to changes in volume of activity • Behavior depends on the definition of activity and relevant range • Unit of product or batch? • Fixed per batch, but vary inversely per unit • Narrow or wide range? • Fixed over a narrow range but step over a wider range
Fixed Cost • Total cost remains constant • Cost per unit varies inversely with activity
Step Fixed Cost • Fixed through some range, but increases when some increment is crossed
Variable Cost • Cost per unit remains constant • Total cost varies directly with activity
Mixed Cost • Contains a fixed and a variable component • Cost per unit is not constant
Absorption vs. Variable Costing • Absorption costing • Product costs include material, labor, variable and fixed overhead • All of the reasonable and necessary costs to produce the product • Income statement arranged by type of cost • Product or period • Revenue – cost of goods sold = gross profit • Gross profit – S&A expenses = net income
Absorption vs. Variable Costing • Variable costing • Product costs only include material, labor and variable overhead • Fixed overhead is treated as a period cost • Income statement arranged by cost behavior • Variable then fixed • Revenue – variable costs = contribution margin • Contribution margin – fixed costs = net income
Absorption vs. Variable Costing • Fixed overhead • Is it necessary to produce the product? • Is it related to production volume? • Is it a product or period cost? • Which is more useful? • Financial reporting • Absorption required • Decision making • Variable does not distort cost as volume changes
Throughput Costing • Product costs only include unit level spending for direct costs (i.e. incremental costs) • Materials, commissions, etc. • All other indirect, past or committed costs are treated as period costs • Labor (unless piece-rate), overhead, etc.
Resources Supplied vs. Resources Used • Cost of resource supplied • Capacity (hours, etc.) available * cost per unit of capacity • Cost of resource used • Capacity used * cost per unit of capacity • Cost of unused capacity • Cost of resource supplied – cost of resource used
Miscellaneous Cost Terms • Committed cost • Decision has been made to incur the cost in the future • Discretionary cost • Cost which can be increased or decreased at will • Sunk cost • Cost incurred previously • Opportunity cost • Benefit given up when one alternative is chosen over another