chapter 4 cost terminology and cost flows. 1.what is the relationship between cost objects and...

Chapter 4

Cost Terminology and Cost Flows

1. What is the relationship between cost objects and

direct costs?

2. How do you classify product costs into direct materials,

direct labor, and factory overhead categories?

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Learning Objectives

3. How does the conversion process work in

manufacturing and service companies?

4. What are the assumptions accountants make about cost

behavior and why are these assumptions necessary?

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Continuing . . . Learning Objectives

5. How can mixed costs be analyzed using the high-low

method and (Appendix) least-squares regression

analysis?

6. What is the usefulness of flexible budgeting to managers?

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Continuing . . . Learning Objectives

7. How are predetermined factory overhead rates developed and how

does the selection of a capacity measure affect factory overhead

application?

8. How is underapplied or overapplied factory overhead accounted for

at year-end and why are these accounting techniques appropriate?

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Continuing . . . Learning Objectives

9. Why are separate predetermined overhead

rates generally more useful than combined rates?

10. How is cost of goods manufactured

calculated?

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Continuing . . . Learning Objectives

Cost Classification Categories

• Time of incurrence• Reaction to changes in activity• Classification on the financial

statements• Impact on decision making• Type of sacrifice

Continuing . . . Cost Classification Categories

Cost Classification Types of Costs

Associatedwith time ofincurrence

Historical (past)Replacement (present)Budgeted (future)

Continuing . . . Cost Classification Categories

Cost Classification Types of Costs

Cost behavior: reaction to changes in activity

Variable (fluctuates in total)Fixed (constant in total)Mixed (part variable;

part fixed)

Continuing . . . Cost Classification Categories

Cost Classification Types of Costs

Classification on the financial statements

Unexpired (balance sheet)Expired (income statement)Product (inventoriable) Direct (traceable) Indirect (nontraceable) Prime Conversion Period (expensed)

Continuing . . . Cost Classification Categories

Cost Classification Types of Costs

Impact on decision making

Relevant (important)Quality (conformity)

PreventionAppraisalFailure

Continuing . . . Cost Classification Categories

Cost Classification Types of Costs

Type of sacrifice

Out-of-pocket (cash)Sunk (historical)Opportunity (foregone benefit)

Components of Product Cost

Product costs relate to the products or services that generate an entity’s revenues. These costs are either direct or indirect in relation to a particular cost object.

Costs that are clearly traceable to the cost object are called direct costs.

Costs that cannot be traced to the cost object are indirect (or common) costs.

Direct Material

• Readily identifiable, physical part of a product

• Clearly, conveniently, and economically traceable to a product

Direct Labor• Individuals who work on product or

perform service• Basic compensation• Production efficiency bonuses• Employer’s share of Social Security

and Medicare taxes• Employer-paid insurance costs,

holiday and vacation pay, and retirement benefits — only if operations are relatively stable

Factory Overhead

Any factory or production cost that is not directly or conveniently traceable to manufacturing a

product or providing a service

Behavior of Product Costs

• Direct Material– Variable

• Direct Labor– Generally variable

• Factory Overhead– Some variable– Some fixed

Prime Cost

Prime Cost = Direct Material + Direct Labor

Conversion Cost

Conversion Cost = Direct Labor + Factory Overhead

Stages of Production

Production processing or conversion can be viewed as existing in three stages:1. Work not started (raw materials)2. Work in process3. Finished work

Determining Cost Behavior

• Cost driver– Activity has a direct cause-effect relationship with a

cost• Cost predictor

– Activity is accompanied by consistent, observable changes in a cost.

Basic Cost Graph

TotalCost

Activity Level0

y

x

Relevant Range

TotalCost

Activity Level

Variable Cost

y = bxb = slope of line

TotalCost

Activity Level

Fixed Cost

y = aa = y interceptTotal

Cost

Activity Level0

Total Cost

y = a + bxTotalCost

Activity Level0

Mixed Cost

TotalCost

Activity Level0

Step Cost

TotalCost

Activity Level0

Step Variable Cost

TotalCost

Activity Level0

Step Fixed Cost

TotalCost

Activity Level0

High-Low Method

• Cost estimation technique for separating mixed cost into variable and fixed components

• Uses activity and cost information• Select highest and lowest activity levels--if

within relevant range• Used to develop y = a + bx

High-Low Analysis of Utility Cost: Step 1

JanuaryFebruaryMarchAprilMayJuneJuly

11,30011,400 9,00011,50011,20010,10012,200

$1,712 1,716 1,469 1,719 1,698 1,691 1,989

MONTHLEVEL OFACTIVITY

UTILITYCOST

High-Low Analysis of Utility Cost: Step 2

AssociatedUtility Cost

Cups ofCoffee

High activity — AprilLow activity — March

11,500 9,000

$1,719 1,469

Changes 2,500 ==== $ 250

=====

High-Low Analysis of Utility Cost: Step 3

$ 2502,500 = $.10 per cup

Change in total costChange in activity volume

b = =

High-Low Analysis of Utility Cost: Step 4

High level of activity: TVC = $.10 (11,500) = $1,150

Low level of activity: TVC = $.10 (9,000) = $ 900

OR

High-Low Analysis of Utility Cost: Step 5

High level of activity: a = $1,719 - $1,150 = $569 ====

Low level of activity: a = $1,469 - $900 = $569 ====

OR

High-Low Analysis of Utility Cost: Step 6

y = $569 + $.10x

where x = number of cups of coffee

Preparing a Flexible Budget• Analyze overhead as to cost behavior

– Find variable, fixed, and mixed costs• Separate each mixed cost into variable

and fixed components– Use cost formula (y = a + bx) for each

mixed cost• Prepare a series of individual financial

plans that detail the individual costs at different levels of activity

Flexible Budget

# of Units 5,000 7,000 9,000Variable Cost $1.85 $1.85 $1.75Fixed Cost $3,500 $5,200 $5,200

Variable Cost $8,750 $12,950 $15,750Fixed Cost 3,500 5,200 5,200Total Cost $12,250 $18,150 $20,950 ====== ====== ======

Variable Overhead Rate

• Computed for each variable overhead cost pool• Activity measure should provide a logical

relationship between activity and cost– Direct labor hours, direct labor dollars, machine

hours, production orders, production-related physical measures

Budgeted VOH cost for coming year Budgeted activity measure for coming year

Budgeted FOH cost for coming year Budgeted activity measure for coming year

Fixed Overhead Rate• Select a specific activity level

– Expected capacity– Theoretical capacity– Practical capacity– Normal capacity

Disposition of Underappliedand Overapplied Overhead

• If immaterial: amount closed to Cost of Goods Sold– Cost of Goods Sold increased if underapplied OH– Cost of Goods Sold decreased if overapplied OH

• If material: amount allocated to– Work in Process Inventory– Finished Goods Inventory– Cost of Goods Sold

Year-end disposition depends on materiality of the amount.

Combined Overhead Rate

Advantages• Clerical ease• Clerical cost savings• No formal requirement to separate overhead costs by

behavior

Continuing . . . Combined Overhead Rate

Disadvantages• Reduces manager’s ability to determine the

causes of underapplied or overapplied overhead• Underlying cause-effect relationships between

activities and costs are blurred– Contributes to inability to reduce costs– Limits attempts to improve productivity– Hinders ability to plan operations, control costs, and

make decisions

Inventory MethodsPeriodic• Inventory account

balances stay the same throughout period

• Inventory account adjusted to new balance at end of period

Perpetual• Inventory accounts are

adjusted as the product flows through the company

Exhibit 4-15: Purchase Materials

Raw Materials Inventory 85,000Accounts Payable

85,000 To record cost of direct materials purchased on

account.

Exhibit 4-15: Use Materials

Work in Process Inventory 69,000Variable Factory Overhead 12,600

Raw Materials Inventory 81,600

To record direct materials transferred to production.

Exhibit 4-15: Record Labor Costs

Work in Process Inventory 5,000Variable Factory Overhead 13,800

Salaries and Wages Payable 18,800

To accrue factory wages for direct and indirect labor.

Exhibit 4-15: Record Labor Costs

Fixed Factory Overhead 7,500Salaries and Wages Payable

7,500 To accrue production supervisors’ salaries.

Exhibit 4-15: Record Other Overhead

Variable Factory Overhead 1,200Fixed Factory Overhead 670

Utilities Payable 1,870

To record mixed factory utility cost in its variable and fixed proportions.

Exhibit 4-15: Record Other Overhead

Fixed Factory Overhead 2,692Cash

2,692 To record payments for contract maintenance for the

period.

Exhibit 4-15: Record Other Overhead

Fixed Factory Overhead 8,333Accumulated Depreciation (Factory Equipment)

8,333 To record depreciation on factory assets for the

period.

Exhibit 4-15: Record Other Overhead

Fixed Factory Overhead 355Prepaid Factory Insurance 355

To record expiration of prepaid insurance on factory assets.

Exhibit 4-15: Apply Overhead

Work in Process Inventory 47,150Variable Factory Overhead 27,600Fixed Factory Overhead 19,550

To record the transfer of predetermined overhead costs to Work in Process Inventory.

Exhibit 4-15: Complete Product

Finished Goods Inventory 122,150Work in Process Inventory

122,150 To record the transfer of work completed during the

period.

Exhibit 4-15: Sell Product

Accounts Receivable 242,000Sales 242,000

To record the sale of goods on account during the period.

Exhibit 4-15: Sell Product (Cost of Sales)

Cost of Goods Sold 119,958Finished Goods Inventory 119,958

To record cost of goods sold for the period.

Least-Squares Regression

• Determines cost formula of a mixed cost by considering the best fit to ALL representative data points

– Finds y = ax + b – Uses multiple activity levels and related costs

• Helps select the activity level that best predicts total cost

Least-Squares Regression

The equations necessary to compute b and a values using the method of least squares are as follows:

xy – nxy

b = --------------x2 – nx2

a = – bx

R e m e m b e r !

• High-low and regression are cost ESTIMATION techniques.

• Appropriateness of cost formula depends on validity of activity measure chosen to predict the variable and fixed costs.

• When significant changes are occurring, historical information may not be useful in predicting future costs.