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Chapter 2

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  1. Cost Concepts and Behavior Chapter 2

  2. 1. Explain the basic concept of “cost.” 2. Explain how costs are presented in financial statements. 3. Explain the process of cost allocation. • Understand how material, labor, and overhead costs are added to a product at each stage of the production process. • Define basic cost behaviors including fixed, variable, semivariable, and step costs. 6. Identify the components of a product’s costs. • Understand the distinction between financial and contribution margin income statements. Learning Objectives

  3. L.O. 1 Explain the basic concept of “cost.” Outlay Cost Opportunity Cost past, present, or future cash outflow forgone benefit from best alternative course of action Expense Cost charged against revenue in an accounting period What is a Cost? Cost a sacrifice of resources

  4. Josh wants to buy a new surfboard. If he buys the surfboard he can’t go on a spring break ski trip with his friends. Outlay Cost Opportunity Cost $500 purchase price of the surfboard No spring break trip Cost Example Cost of surfboard?

  5. Your education costs? Opportunity Cost Outlay Cost The cost of tuition The $15,000 you could make flipping burgers Cost Example

  6. L.O. 2 Explain how costs are presented in financial statements. Service revenues Sales revenues - Cost of services sold - Cost of goods sold Cost incurred to purchase the goods sold Cost of billable hours = Gross margin = Gross margin - Marketing and administrative costs - Marketing and administrative costs = Operating profit = Operating profit The excess of operating revenue over cost necessary to generate those revenues Recording Costs in Financial Statements Income Statements Service Company Merchandise Company

  7. Costs incurred to manufacture a product Costs incurred to sell a product and operate the business Recorded as an asset in inventory when cost is incurred Recognized as an expense when cost is incurred Recognized as an expense when product is sold Manufacturing Company Costs Manufacturing Costs Product Costs Period Costs Inventoriable Costs Nonmanufacturing Costs

  8. Cost incurred to manufacture the product sold Sales revenues - Cost of goods sold Recognized as an expense when the product is sold. Product costs recorded as an asset in inventory when cost is incurred. = Gross margin Period costs recorded as an expense when cost is incurred. - Marketing and administrative costs = Operating profit Income Statement Manufacturing Company

  9. Cost that cannot be directly traced to the product Cost that can be directly traced to the product Materials directly traceable to the product. All production costs except direct materials and direct labor. Indirect Materials Indirect Labor Work directly traceable to transforming material into finished product Other Indirect Costs Manufacturing Costs Product Costs Inventory Costs Recognized as an expense when product is sold Recorded as an asset in inventory when cost is incurred Indirect Costs Direct Costs Direct Materials Manufacturing Overhead Direct Labor

  10. Josh decides to go on the spring break ski trip. He is off to the slopes. Identify the object This ski trip Direct Cost Indirect Cost The original cost of his equipment Cost of lift tickets Traceability of Costs

  11. Your education costs? Identify the object This class Direct Cost Indirect Cost The cost of your textbook The cost of full time tuition Traceability of Cost

  12. Manufacturing Costs Direct Materials Prime Costs The “primary” cost of the product Direct Labor Direct Labor Direct Labor Conversion Costs Cost necessary to “convert” materials into a product Manufacturing Overhead Product Costs Inventory Costs

  13. Direct Materials = $8 Direct Labor = $7 DM + DL = $15 DM + DL = $15 Manufacturing overhead = $14 DL + MOH = $21 MOH = $14 DM + DL + MOH = $29 Product Cost Review Prime cost? Conversion cost? Direct cost? Indirect cost? Total Product Cost

  14. Costs necessary to sell the products Costs necessary to operate the business Advertising Executive salaries Sales commissions Data processing Shipping costs Legal costs Period Costs Nonmanufacturing Costs Recognized as an expense when cost is incurred Marketing Administrative

  15. L.O. 3 Explain the process of cost allocation. Collection of costs to be assigned to cost objects Method used to assign costs in the cost pool to the cost objects Any end to which a cost is assigned Cost Allocation The process of assigningindirectcost to a cost object 1. DefineCost Pool 2. DetermineCost Allocation Rule 3. Assign Cost Object Product Department Product Line Customer

  16. East Coast West Coast Total Revenues 80 million 20 million 100 million IS costs allocated based on division revenue Corporate Information Systems Costs of $1,000,000 $200,000 West Coast East Coast $800,000 Rockford Corporation Cost pool % Revenue Cost allocation rule 80% $80 million $20 million 20% Cost objects

  17. L.O. 4 Understand how manufacturing costs are added to a product. A manufacturing company has three inventory accounts. Also called Inventoriable Costs Inventory:Current asset representing materials and goods on hand Raw materials Work-in-process Finished goods Product in production process, but not yet complete Product fully completed but not yet sold. Materials purchased to make product Manufacturing Cost Flows Product costs recorded in inventory when cost incurred.

  18. Raw Materials Work-In-Process Finished Goods Beg. Inventory Beg. Inventory Beg. Inventory Cost of Goods Completed and Transferred from WIP + Direct Materials Transferred from Raw Materials + + Purchases Raw Materials Available for Production = + Direct Labor Manufacturing Overhead + = Goods Available for Sale - - Raw Materials Transferred to WIP Raw Materials Transferred to WIP = Total Manufacturing Costs Cost of Goods Sold - = Ending Inventory = Ending Inventory - - Cost of Goods Completed and Transferred to Finished Goods Cost of Goods Completed and Transferred to Finished Goods To the income statement = Ending Inventory The Inventory Accounts Balance Sheet

  19. Cost of goods manufactured $13,610,000 Jackson Gears Jackson Gears Cost of Goods Manufactured Statement For the Year Ending December 31, 200X

  20. Cost of goods sold $13,100,000 Jackson Gears Jackson Gears Cost of Goods Sold Statement For the Year Ending December 31, 200X

  21. Jackson Gears Jackson Gears Income Statement For the Year Ending December 31, 200X

  22. L.O. 5 Define basic cost behaviors including fixed, variable, semivariable, and step costs. Cost Behavior? Cost Behavior How costs respond to a change in activity level within the relevant range. Relevant range? Range of activity where the total fixed costs or the unit variable costs remain unchanged.

  23. Costs that are unchanged as volume changes within the relevant range of activity. On a per unit basis the cost varies inversely as activity changes. Fixed Costs Fixed costs are “fixed” in “total” as activity changes. Costs ($) Activity level

  24. On a per unit basis the cost varies inversely as activity changes. Josh’s Spring Break Trip Fixed Cost Fixed costs are “fixed” in “total” as activity changes. Airfare cost ($) Days on the slopes

  25. Costs that change in direct proportion with a change in volume within the relevant range of activity. On a per unit basis the cost stays the same as activity changes. Variable Costs Variable costs“vary” in“total”as activity changes. Cost ($) Activity level

  26. On a per unit basis the cost stays the same as activity changes. Josh’s Spring Break Trip Variable Cost Variable costs “vary” in “total” as activity changes. Lift ticket cost ($) Days on the slopes

  27. Costs that have both fixed and variable components. Also called mixed costs. Fixed component is “fixed” in total as activity changes. Variable component “varies” in total as activity changes. Semivariable Costs Costs ($) Activity level

  28. Fixed component is “fixed” in total as activity changes. Variable component “varies” in total as activity changes. Josh’s Spring Break Trip Semivariable Cost Cost of trip ($) Days on the slopes

  29. Costs that increase in total with steps in volume changes. Also called semifixed costs. Step Costs Costs ($) Activity level

  30. L.O. 6 Identify the components of a product’s costs. Full cost: sum of all costs of manufacturing and selling a unit of product Full absorption cost: sum of all variable and fixed costs of manufacturing a unit of product Variable cost: sum of all variable costs of manufacturing and selling a unit of product Product Cost Components

  31. Direct Materials = $8 What is the full Direct Labor = $7 absorption cost per unit? Variable manufacturing overhead = $8 What is the variable What is the full Fixed manufacturing overhead = $6 cost per unit? cost per unit? Variable marketing and administrative = $4 Fixed marketing and administrative = $7 Costs: An Example

  32. Direct Materials = $8 All costs of manufacturing and selling a unit of product Direct Labor = $7 Variable manufacturing overhead = $8 What is the full Fixed manufacturing overhead = $6 cost per unit? Variable marketing and administrative = $4 Fixed marketing and administrative = $7 Full Cost = $40

  33. Direct Materials = $8 What is the full Direct Labor = $7 absorption cost per unit? Variable manufacturing overhead = $8 All variable and fixedcosts of manufacturing a unit of product sold Fixed manufacturing overhead = $6 Full Absorption Cost = $29

  34. Direct Materials = $8 Direct Labor = $7 Variable manufacturing overhead = $8 All variable costs of manufacturing and selling a unit of product What is the variable cost per unit? Variable marketing and administrative = $4 Variable Cost = $27

  35. L.O. 7 Understand distinction between financial and contribution margin income statements. Used for: Used for: Required by GAAP Sales revenues Sales revenues Financial purposes Internal decision making - Cost of goods sold - Variable costs External reporting Managerial purposes = Gross margin = Contribution margin Making Cost Information Useful Full Absorption Costing Variable Costing

  36. Gross margin Contribution margin Sales price Sales price Full absorption cost Variable cost Making Cost Information Useful Continued Financial Income Statement Contribution Margin Income Statement Full Absorption Costing Variable Costing

  37. Variable manufacturing costs Variable manufacturing costs Product costs Fixed manufacturing costs Fixed manufacturing costs Variable marketing and administrative costs Variable marketing and administrative costs Period costs Fixed Marketing and administrative costs Fixed Marketing and administrative costs Product vs Period Costs Full Absorption Costing Variable Costing

  38. Sales revenues - Cost of goods sold Sales revenues - Variable costs - Marketing and administrative cost = Contribution margin = Gross margin = Operating profit = Operating profit - Fixed costs Variable manufacturing costs and variable marketing and administrative costs Full absorption costs Sales – Full absorption cost Fixed manufacturing costs and fixed marketing and administrative costs Period costs Variable and fixed manufacturing costs Sales – variable costs Income Statements Full Absorption Costing Variable Costing

  39. Variable manufacturing cost = $23 Full absorption cost per unit = $29 Fixed manufacturing cost = $6 Full cost per unit = $40 Variable marketing and administrative = $4 Sales price per unit = $45 Fixed marketing and administrative = $7 Gross margin = $16 ($45 - $29) DM + DL + VMOH Excess of price over full unit cost = $5 Operating profit = $5 Gross Margin per Unit

  40. Variable manufacturing cost = $23 Variable cost per unit =$27 Variable marketing and administrative = $4 Full cost per unit = $40 Fixed manufacturing cost = $6 Sales price per unit =$45 Fixed marketing and administrative = $7 Contribution margin =$18 ($45 - $27) DM + DL + VMOH Excess of price over full unit cost = $5 Operating profit =$5 Contribution Margin per Unit

  41. Chapter 2 The End