chapter 4 cost terminology and cost flows. 1.what is the relationship between cost objects and...
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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? C4 Continuing... Learning ObjectivesTRANSCRIPT
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?
C4
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?
C4
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?
C4
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?
C4
Continuing . . . Learning Objectives
9. Why are separate predetermined overhead
rates generally more useful than combined rates?
10. How is cost of goods manufactured
calculated?
C4
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.