Basic Cost Management Concepts and Accounting For Mass Customization Operations

Chapter 2
Basic Cost
Management Concepts
and Accounting for Mass
Customization Operations
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning
Objective
1
Process of Management
Strategy Planning
Formulation
Managers need cost information to

perform each of these functions.
Control Directing
Decision
Making
What Do We Mean By a Cost?
A cost
is the measure of
resources given
up to achieve a
particular purpose.
What Do We Mean By a Cost?
Cost is a forgoing,
measured in monetary terms,
incurred or potentially to be
incurred to achieve a
specific objective
Basic Cost Terminology
• Cost – sacrificed resource to achieve a
specific objective
• Actual cost – a cost that has occurred
• Budgeted cost – a predicted cost
• Cost object – anything of interest for which a
cost is desired or an entity (e.g., a specific
product, service, or department) to which a
cost is assigned is commonly known as a
cost object.
Cost Object Examples at BMW
Cost Object Illustration
Product BMW X 5 sports activity vehicle
Service Dealer-support telephone hotline
R&D project on DVD system
Project
enhancement
Herb Chambers Motors, a dealer that
Customer purchases a broad range of BMW
vehicles
Activity Setting up production machines
Department Environmental, Health & Safety
How Does a Cost System Determine
The Costs Of Various Cost Objects?
• Cost accumulation – a collection of cost data
in an organized manner
• Cost assignment – a general term that
includes gathering accumulated costs to a
cost object. This includes:
– Tracing accumulated costs with a direct
relationship to the cost object and
– Allocating accumulated costs with an indirect
relationship to a cost object
USE OF COST INFORMATION
• Decision Making: How to price different
models of cars.
• Decision Implementing: Influencing and
motivating employees to act and learn, for
example, by rewarding employees for
reducing costs.
Learning
Objective
2
Different Types of Firms
• Manufacturing-sector companies – create
and sell their own products
• Merchandising-sector companies – product
resellers
• Service-sector companies – provide services
(intangible products)
Types of Manufacturing Inventories
• Direct Materials – resources in-stock and
available for use
• Work-in-Process (or progress) – products
started but not yet completed. Often
abbreviated as WIP
• Finished Goods – products completed and
ready for sale
Product Costs, Period Costs and Expenses
Product costs are costs associated with goods for

sale until the time period during which the products
are sold, at which time the costs become expenses.
Period costs are costs that are expensed during the

time period in which they are incurred.
Expenses are the consumption of assets for the

purpose of generating revenue.
Types of Product Costs
• Also known as Inventoriable Costs
– Direct Materials
– Direct Labor
– Indirect Manufacturing – factory costs that are
not traceable to the product. Other common
names for this type of cost include
Manufacturing Overhead costs or Factory
Overhead costs.
Accounting Distinction Between Costs
• Inventoriable costs – product
manufacturing costs. These costs are
capitalized as assets (inventory) until they
are sold and transferred to Cost of Goods
Sold.
• Period costs – have no future value and
are expensed as incurred.
Learning
Objective
3
Cost Classifications on Financial
Statements – Income Statement
Product Costs Period Costs
Cost of goods sold Operating expenses

Statements – Balance Sheet
Merchandiser Manufacturer
Current Assets Current Assets
– Cash  Cash
– Receivables  Receivables
– Prepaid Expenses  Prepaid Expenses
– Merchandise  Inventories
Inventory Raw Materials
Work in Process
Finished Goods
– Cash  Cash
Those materials
– Receivables  waiting to be
Receivables
processed.
Prepaid Expenses
– Prepaid Expenses 
– Merchandise  Inventories
Work in Process
Finished Goods
PartiallyAssets
Current complete
Current Assets products – material to
 Cash
– Cash which some labor
 Receivables
and/or overhead has
– Receivables
been added.
 Prepaid Expenses
– Prepaid Expenses
 Inventories
– Merchandise
Work in Process
Finished Goods
– Cash  Cash
 Receivables
Completed products
– Receivables
awaiting sale.
 Prepaid Expenses
– Prepaid Expenses
 Inventories
– Merchandise
Work in Process
Finished Goods
Learning
Objective
4
Types of Production Processes
• Production processes can be classified into

five generic types.
• The nature of the manufacturing process can
affect the manufacturing costs incurred.
• The management team is in a better position
to control these costs if the relationship of the
production process to the types of costs
incurred is understood
Types of Production Processes
Type of Production Description of Example of
Process Process Manufacturer
Job Shop Low volume Disney

Little standardization
Unique products
Batch Multiple products Caterpillar

Low volume
Assembly Line A few major products Ford

Higher volume
Mass Customization High volume Dell

Many standardized components
Customized combination of components
Continuous Flow High volume Exxon

Highly standardized commodity products
Learning
Objective
5
Manufacturing Costs
Direct Direct Manufacturing

Labor Material Overhead
The
Product
Direct Material
Cost of raw material that is used to

make, and can be conveniently
traced, to the finished product.
Example:
Steel used to
manufacture
the automobile
Direct Labor
Cost of salaries, wages, and fringe

benefits for personnel who work
directly on manufactured products.
Example:
Wages paid to an
automobile assembly
worker.
Manufacturing Overhead
All other manufacturing costs
Indirect Indirect Other
Material Labor Costs
Materials used to support

the production process.
Examples: lubricants and
cleaning supplies used in an
automobile assembly plant.
Cost of personnel who

do not work directly on
the product. Examples:
maintenance workers,
janitors and security
guards.
Examples: depreciation
on plant and equipment,
property taxes,
insurance, utilities,
overtime premium, and
unavoidable idle time.
Overtime premium
• Is the extra compensation paid to an
employee who works beyond the time
normally scheduled. For example a
technician earns $16 per hour. The
technician works 48 hours during a week
instead of the scheduled time of 40 hours.
• Direct Manufacturing labor (48 *$16)= $768
Overtime Premium (8*$8) = 64
Total Compensation for 48 hours = $832
Idle time
• Is the time that is not spent productively by
an employee due to such events as
equipment breakdowns or new setups for
production runs. For example, during one
40 hour shift, a machine breakdown resulted
in idle time of 11/ 2 hours and a power
failure idled workers for an additional ½
hour. Suppose an employee earns $14 per
hour, the employee wages for the week will
be classified in two categories.
Other Cost Considerations
• Prime cost is a term referring to all direct
manufacturing costs (labor and materials)
• Conversion cost is a term referring to direct
labor and factory overhead costs, collectively
• Overtime labor costs are considered part of
overhead due to the inability to precisely
know the true cause of these costs
Classifications of Costs in
Manufacturing Companies
Manufacturing costs are often
combined as follows:
Direct Direct Manufacturing
Material Labor Overhead
Prime Conversion
Cost Cost
Learning
Objective
6
Cost Flows
• The Cost of Goods Manufactured and the
Cost of Goods Sold section of the Income
Statement are accounting representations of
the actual flow of costs through a production
system.
– Note the importance of inventory accounts in the
following accounting reports, and in the cost flow
chart
Manufacturing Cost Flows
Direct Material
Work in
Direct Labor Process
Inventory
Manufacturing
Overhead
Direct Material
Work in
Inventory
Manufacturing
Overhead
Finished
Goods
Inventory
Direct Material
Work in
Inventory
Manufacturing
Overhead
Finished Cost of
Goods Goods
Inventory Sold
Cost Flows Visualized
Cost of Goods Manufactured
Multiple-Step Income Statement
Exh.
Schedule of Cost of Goods 2-9
Manufactured
Beginning work-in-
process inventory is
carried over from the
Comet Computer Corporation
prior period.
Schedule of Cost of Goods Manufactured
Raw material used $ 134,980
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs $ 414,980
Add: Work-in-process inventory, January 1 120
Subtotal $ 415,100
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured $ 415,000
Exh.
Manufactured

Direct labor 50,000
Subtotal $ 415,100
Exh.
Schedule of Cost of Goods

Computation of Cost of Raw Material Used
2-7
Manufactured
Raw-material inventory, January 1 $ 6,000
Add: Purchases of raw materials 134,000
Raw material available for use 140,000
Deduct: Raw material inventory, December 31 5,020
Direct labor 50,000
Subtotal $ 415,100
Exh.
Manufactured
Include all direct labor
costs incurred during the
Cometcurrent period.
Computer Corporation
Direct labor 50,000
Subtotal $ 415,100
Exh.
Manufactured
Computation of Total Manufacturing Overhead
Indirect material $ 10,000
Indirect labor 40,000
Depreciation on factory 90,000
Depreciation on equipment 70,000
Utilities 15,000
Insuranceof Cost of Goods Manufactured
Schedule 5,000
Total manufacturing overhead $ 230,000
Direct labor 50,000
Subtotal $ 415,100
Exh.
Manufactured
Ending work-in-process inventory
contains the cost of unfinished goods,
Cometand is reported
Computer in the current assets
Corporation
section
Schedule of Cost of the
of Goods balance sheet.
Manufactured
Direct labor 50,000
Subtotal $ 415,100
Exh.
Income Statement for a 2-7
Manufacturer

Income Statement
For the Year Ended December 31, 20X2
Sales revenue $ 700,000
Less: Cost of goods sold 415,010
Gross margin $ 284,990
Selling and administrative expenses 174,490
Income before taxes $ 110,500
Income tax expense 30,000
Net income $ 80,500
Exh.
Income Statement for a 2-7
Manufacturer
Schedule of Cost of Goods Sold
Finished-goods inventory, Jan. 1 $ 200
Add: Cost of goods manufactured 415,000
Cost of goods available for sale 415,200
Deduct Finished-goods inventory, Dec. 31 190
Income Statement
Cost of goods sold $ 415,010
Sales revenue $ 700,000
Less: Cost of goods sold 415,010
Gross margin $ 284,990
Selling and administrative expenses 174,490
Income before taxes $ 110,500
Income tax expense 30,000
Net income $ 80,500
Learning
Objective
7
Learning
Objective
8
Cost Classifications
Cost behavior means

how a cost will react
to changes in the
level of business
activity.
Cost behavior means

how a cost will react
to changes in the
level of business
activity.
– Total variable costs
change when activity
changes.
– Total fixed costs remain
unchanged when
activity changes.
Cost Behavior
 Variable costs – changes in total in proportion to
changes in the related level of activity or volume
 Fixed costs – remain unchanged in total regardless of
changes in the related level of activity or volume
 Costs are fixed or variable only with respect to a
specific activity or a given time period
© 2009 Pearson Prentice Hall. All rights reserved.

Cost Behavior, continued
 Variable costs – are constant on a per-unit basis. If
a product takes 5 pounds of materials each, it stays
the same per unit regardless of one, ten or a
thousand units are produced
 Fixed costs – change inversely with the level of
production. As more units are produced, the same
fixed cost is spread over more and more units,
reducing the cost per unit

Cost Behavior Summarized
Total Dollars
Total Dollars Cost per
Per Unit
Unit
Change in
Change in Unchanged in
Variable Costs proportion with
proportion with relation to output
Variable Costs output
output
Moreoutput
More output==More
Morecost
cost
Change
Change inversely
Fixed Costs Unchanged in inversely with
Unchanged in with output
Fixed Costs output
relation to output More output = lower cost
relation to output More output = lower cost
per unit
per unit

Total Variable Cost Example
Your total long distance telephone bill is
based on how many minutes you talk.
Total Long Distance
Telephone Bill
Minutes Talked
Variable Cost Per Unit Example
The cost per long distance minute talked is
constant. For example, 5 cents per minute.
Telephone Charge
Per Minute
Minutes Talked
Total Fixed Cost Example
Your monthly basic telephone bill probably
does not change when you make more local
calls.
Telephone Bill
Monthly Basic
Number of Local Calls

Fixed Cost Per Unit Example
The average cost per local call decreases as
more local calls are made.
Monthly Basic Telephone

Bill per Local Call
Number of Local Calls
Cost Behavior Visualized

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit
Total variable cost changes Variable cost per unit

Variable as activity level changes. remains the same over
wide ranges of activity.
Total fixed cost remains Fixed cost per unit
Fixed the same even when the goes down as activity
activity level changes. level goes up.
Other Cost Concepts
 Cost Driver – a variable that causally affects costs over
a given time span. A cost driver is any event or
activity that causes costs to be incurred.
 Activity refers to a measure of organization’s output
of products or services. Possible examples include
labor hours in manual assembly work and machine
hours in automated production settings or cost of
petrol is determined largely by the number of miles
driven.

Identifying Cost Drivers
Cost Driver Examples

Activity Cost Driver
Activities that
Machining operations Machine hours
Setup cause costs to be hours
Setup
incurred are called
Production scheduling Manufacturing orders
Inspection cost drivers.
Pieces inspected
Purchasing Purchase orders
Shop order handling Shop orders
Valve assembly support Customer requisitions
Other Cost Concepts
 Relevant Range – the band of normal activity level (or
volume) in which there is a specific relationship
between the level of activity (or volume) and a given
cost
 the range of activity over which the changes in the cost are
of interest is called the relevant range.
 For example, fixed costs are considered fixed only

within the relevant range.

Relevant Range Visualized

A Cost Caveat
 Unit costs should be used cautiously. Since unit costs
change with a different level of output or volume, it
may be more prudent to base decisions on a total
dollar basis.
 Unit costs that include fixed costs should always
reference a given level of output or activity
 Unit Costs are also called Average Costs

Learning
Objective
9
Direct & Indirect Costs
• Direct costs – can be conveniently and
economically traced (tracked) to a cost
object
• Indirect costs – cannot be conveniently or
economically traced (tracked) to a cost
object. Instead of being traced, these costs
are allocated to a cost object in a rational
and systematic manner
Direct and Indirect Costs
Direct costs Indirect costs
• Costs that can be • Costs that must be
easily and allocated in order to
conveniently traced to be assigned to a
a product or product or
department. department.
• Example: cost of • Example: cost of
paint in the paint national advertising
department of an for an airline is
automobile assembly indirect to a particular
plant. flight.
Direct and Indirect Costs
• A cost can be direct to the department,
but indirect to units of product produced
in the department.
– Example: department manager’s salary.
• Tracing costs directly to departments or

products helps to identify and eliminate
non-value added costs.
Cost Examples
• Direct Costs
– Parts
– Assembly line wages
• Indirect Costs
– Electricity
– Rent
– Property taxes
Multiple Classification of Costs
 Costs may be classified as:
 Direct / Indirect, and
 Variable / Fixed
 These multiple classifications give rise to important
cost combinations:
 Direct & Variable
 Direct & Fixed
 Indirect & Variable
 Indirect & Fixed

Multiple Classification of Costs,
Visualized

BMW: Assigning Costs to a Cost
Object
Factors Affecting Direct / Indirect Cost
Classification
• Cost Materiality : The smaller the amount
of the cost, the less likely that it is
economically feasible to trace that cost to a
particular cost object.
• Availability of information-gathering
technology: For example bar-code
technology has made it possible to trace
just about any material used in the
manufacturing process.
• Operational Design: A cost used for a
specific cost object can be readily traced.
Learning
Objective
10
Controllable and
Uncontrollable Costs
A cost that can be significantly influenced
by a manager is a controllable cost.
Cost item Manager Classificaton

Cost of food used Restaurant Controllable
in a restaurant manager
Cost of national Restaurant Uncontrollable
advertising by a manager
restaurant chain
Opportunity Cost
The potential benefit that is

given up when one
alternative is selected
over another.
– Example: If you were
not attending college,
you could be earning
$20,000 per year.
Your opportunity cost
of attending college for one
year is $20,000.
Sunk Costs
All costs incurred in the past that cannot be
changed by any decision made now or in the
future are sunk costs. Sunk costs should not be
considered in decisions.
– Example: You bought an automobile that cost
$12,000 two years ago. The $12,000 cost is
sunk because whether you drive it, park it, trade
it, or sell it, you cannot change the $12,000
cost.
Differential Costs
Costs that differ between alternatives.
Example: You can earn $1,500 per month in your

hometown or $2,000 per month in a nearby city.
Your commuting costs are $50 per month in your
hometown and $300 per month to the city.
What is your differential cost?

$300 - $50 = $250
Marginal Costs and Average
Costs
The total cost to

The extra cost
produce a quantity
incurred to produce
divided by the
one additional unit.
quantity produced.
Marginal and average costs are

largely a function of cost behavior
-- variable and fixed costs.
Costs and Benefits of Information
Costs Benefits
More information does not mean more

benefits if information overload results.
Different Definitions of Costs
for Different Applications
• Pricing and product-mix decisions – may use
a “super” cost approach (comprehensive)
Managers are interested in overall
profitability of each product.
• Contracting with government agencies –
very specific definitions of cost for “cost plus
profit” contracts
• Preparing external-use financial statements
– GAAP-driven product costs only
Different Definitions of Costs
for Different Applications
Three Common Features of
Cost Accounting & Cost Management
1. Calculating the cost of products, services,
and other cost objects
2. Obtaining information for planning &
control, and performance evaluation
3. Analyzing the relevant information for
making decisions
End of Chapter 2

Basic Cost Management Concepts and Accounting For Mass Customization Operations

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Chapter 2

Managers need cost information to

Product costs are costs associated with goods for

Period costs are costs that are expensed during the

Expenses are the consumption of assets for the

Product Costs Period Costs

Cost of goods sold Operating expenses

• Production processes can be classified into

Job Shop Low volume Disney

Batch Multiple products Caterpillar

Assembly Line A few major products Ford

Mass Customization High volume Dell

Continuous Flow High volume Exxon

Direct Direct Manufacturing

Cost of raw material that is used to

Cost of salaries, wages, and fringe

Materials used to support

Cost of personnel who

Schedule of Cost of Goods 2-9

Schedule of Cost of Goods 2-7

Comet Computer Corporation

Schedule of Cost of Goods

Schedule of Cost of Goods 2-7

Schedule of Cost of Goods 2-7

Schedule of Cost of Goods 2-9

Income Statement for a 2-7

Comet Computer Corporation

Income Statement for a 2-7

Cost behavior means

Cost behavior means

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

Number of Local Calls

Monthly Basic Telephone

© 2009 Pearson Prentice Hall. All rights reserved.

Summary of Variable and Fixed Cost Behavior

Total variable cost changes Variable cost per unit

© 2009 Pearson Prentice Hall. All rights reserved.

Cost Driver Examples

 For example, fixed costs are considered fixed only

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

• Tracing costs directly to departments or

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

Cost item Manager Classificaton

The potential benefit that is

Example: You can earn $1,500 per month in your

What is your differential cost?

The total cost to

Marginal and average costs are

More information does not mean more

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