Chapter Nine Cost Management by lhq12198


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									                                       CHAPTER 2
      Product Costing Systems: Concepts and Design Issues
Chapter Outline

A. Cost Management Challenges – There are three questions addressed in this chapter:

           1. What are the significant inputs to a production process, and how do cost managers
              track the flow of costs through the process?

           2. How can alternative methods to calculate product costs create different

           3. How should cost managers measure costs for internal decision making?

B. Learning objectives: This chapter has nine learning objectives:

           1. Explain the role of product costs, period costs, and expenses in financial

           2. Prepare an income statement and a schedule of cost of goods manufactured and

           3. List the components of manufacturing cost, and diagram their flow through a
              manufacturing process.

           4. Explain how unit-level, variable, and fixed costs differ.

           5. Understand the concepts of opportunity costs, sunk costs, committed costs, direct
              costs, and indirect costs.

           6. Prepare income statement using absorption, variable, and throughput costing.

           7. Reconcile income under absorption, variable, and throughput costing.

           8. Discuss the advantages and disadvantages of absorption, variable, and throughput

C. The role of product costs, period costs, and expenses in the financial statements is explained.

        1. At the most basic level, a cost can be defined as the sacrifice made, usually by the
           resources given up, to achieve a particular purpose.

        2. Expense is defined as the cost incurred when an asset is used up or sold for the
           purpose of generating revenue.

        3. Product cost is a cost assigned to goods that were either purchased or manufactured
           for resale. Product costs are inventoriable.

       4. Cost of goods sold is the expense measured by the cost of the units sold during a
          specific period of time.

       5. Period costs are identified with the time period in which they are incurred rather than
          with units of purchased or produced goods.

D. Preparing income statement and schedule of cost of goods manufactured and sold is explained.

       1. Service firms provide customers a product that is consumed as it is produced. Thus,
          service firms do not carry inventories of produced goods and do not have a line item
          for cost of goods sold in their income statements.

       2. Retail and wholesale companies (merchandising) sell tangible products that can be
          inventoried. These companies show a separate line item for cost of goods sold in their
          income statements. Subtracting cost of goods sold from revenues provides the gross
          margin. Other expenses (selling and administrative) are subtracted to arrive at
          operation income.

       3. At the end of the year, any inventory on hand for merchandising firms is considered
          an asset which is valued at its product cost. Merchandise bought is valued at cost
          plus transportation costs.

       4. Manufacturing companies carry three kinds of inventory: a) inventory of raw
          materials for goods bought to be converted, b) work in process inventory for goods
          which are being converted, and c) finished goods inventory for items completed and
          ready to be sold.

       5. For both merchandising and manufacturing companies, unsold inventories of any
          type are considered assets until they are sold.

       6. All expenses, except inventoriable costs, are considered period costs and are charged
          to expense and appear in the income statement of the period incurred.

       7. The components of a statement of cost of goods manufactured and sold for a
          manufacturing company are:         raw material inventory beginning of the period +
          purchases – raw materials end of the period = raw material used; raw material used +
          direct labor + manufacturing overhead = total manufacturing costs (TMC); TMC +
          work in process (WIP) beginning – WIP end of the period = cost of goods
          manufactured (CGM); CGM + finished goods inventory beginning = finished goods
          inventory ending = cost of goods sold.

       8. An income statement includes the following items: Sales – cost of goods sold (as
          illustrated in the above paragraph) = gross profit; gross profit – selling and
          administrative expenses = operating income; operating income – income tax = net

E. Components of manufacturing costs are explained.

        1. Direct materials are resources such as raw materials, parts, and components that one
           can feasibly observe being used to make a specific product. Insignificant items may
           be classified as indirect costs as part of the overhead accounts.

        2. Direct labor is the cost of compensating employees who transform direct materials
           into finished product. This cost includes the fringe benefits for these workers.

        3. Manufacturing overhead includes all costs of transforming materials into a finished
           product other than direct materials and direct labor. Indirect materials are those that
           either are not a part of the finished product but are necessary for its manufacture or
           are part of the finished product but are insignificant in cost. Indirect labor cost
           consist of the wages of production employees who do not work directly on the
           product but are required for the manufacturing facility to operate.

        4. Support services such as maintenance department do not work directly on the product
           but are necessary for the production process to operate as such they are part of the
           overhead cost.

        5. Overtime premium is the extra hourly component paid to an employee who works
           beyond the time normally allowed and is usually classified as part of the overhead

        6. Idle time is time not spent productively by employee due to part shortage, waiting
           time, etc. and is another overhead component.

        7. Prime costs include direct material and direct labor. Conversion costs include direct
           labor and manufacturing overhead. Notice the overlap.

        8. Non-manufacturing costs include the costs of selling and administration and are
           among the period costs for an entity.

        9. The cost flow in a manufacturing firm is from raw materials to work in process to
           finished goods and finally to cost of goods sold.

        10. Understanding of costs from different angles is important for effective cost

        11. An activity is any discrete task that an organization undertakes to make or deliver a
            good or service. A cost driver is a characteristic of an activity or event that causes
            costs to be incurred by that activity or event. For example, insurance claims is an
            activity and the primary cost driver is possibly the number of claims processed.

F. The difference between unit level fixed and variable costs is explained:

        1. Variable costs change in direct proportion with a change in the activity volume. We
           need more material when we produce more of a product. We may also need more
           workers if we want to produce more products.

        2. Fixed costs remain unchanged as the volume of activity changes. For example, we
           may still have one store manager even if our sales volume doubles. We may still pay
           the same rent for our plant even if our production volume decreases substantially.

        3. The concept of fixed and variable costs is often discussed in terms of a relevant range
           where these possibilities hold true. The classification is also dependent on the time-
           frame; i.e., the shorter the time-frame, the more of the costs are fixed, and the longer,
           the time-frame, the more of the costs are variable; i.e., for more sales, we ultimately
           need perhaps, a larger space and a larger sales force – everything else being equal.

        4. The question of fixed and variable may be partially based on cost driver that we
           choose. For example, set up costs for machines may be a fixed cost if we consider
           volume of production as the cost driver. But set up costs may be considered variable
           if the cost driver in question is the number of set ups needed to produce certain

        5. Cost hierarchy expands on our initial limitation of fixed and variable costs and
           classifies costs into unit level, batch level, product level, and facility-related costs.

        6. Unit level costs are incurred for every unit of product manufactured or service
           produced. Example: electricity to run machines.

        7. Batch-level costs are incurred for every batch of product or service produced.
           Example: material handling.

        8. Product-level costs are incurred for each line of product or service. Example: product

        9. Facility or general-operations-level costs are incurred to maintain the overall facility
           and infrastructure of the organization.

G. The difference between cost of resources used and resources supplied is explained:

        1. The distinction is important. Only when resources supplied merge equally with the
           resources used, we are at an optimum level until other efficiencies are achieved.
           Otherwise, we would either have a bottleneck where too much is supplied for the
           next operation to be able to use or there might be not enough supplied for the
           operation for its normal needs. The management task is to find the optimum between
           resources supplied and resources used.

H. The terms, committed costs, opportunity costs, sunk costs, direct costs, and indirect costs are

        1. Committed cost do not vary with change in production or sales volume. For example,
           if we have a labor contract that forces us to pay regardless of needs, it becomes a
           committed cost.

        2. Opportunity cost is a foregone benefit that could have been realized from the best
           alternative use of resources. The money you could have earned instead of going to
           school is an opportunity cost.

       3. Sunk costs are past payments for resources that cannot be changed by any current or
          future decision. As such, they are irrelevant in managerial decision making.

       4. In cost-management decisions, we must look for relevant costs. Costs that make a
          difference with regard to choosing among certain alternative. If you want to buy a
          product rather than making it, what costs do you really save if you instead decide to
          buy the product.

       5. Direct costs of a cost object are traceable to that cost object. We can trace material
          and labor costs (direct portion) to a product but not overhead. On the other hand, we
          can trace salaries, material, labor, and supplies costs to a department but not the share
          of costs related to the department as claimed by personnel or facility planning

       6. Indirect cost of a cost object are not feasibly traceable to that cost object. For
          example, we can not trace the supervisor’s cost associated with a particular product.

       7. Cost object is any end to which a cost is assigned.

I.     Income statements may be prepared using absorption, variable, and throughput costing

       1. Absorption or full costing applies all manufacturing overhead costs to manufactured

       2. Variable or direct costing applies only variable manufacturing overhead to
          manufactured goods as a product cost along with direct material and direct labor.

       3. Assume that you produced 100 units that cost 20,000 – 75% of which is for fixed
          costs – and sell for $250 a unit. If you sell 100 units (assume no beginning
          inventory), your profit would be the same whether you use full costing or variable
          costing. Full costing income: 25,000 – 20,000 = $5,000. Variable costing income:
          25,000 – 5,000 – 15,000 = $5,000. However if you produce 100 and sell, say, 80
          units, there will be a difference: Full costing income:        (250 * 80) – (200 * 80) =
          $4,000. Variable costing income: (250 * 80) – (50 * 80) – 15,000 = $1,000. All
          fixed costs under variable costing is considered period cost whereas, under full
          costing, the portion of fixed costs attributable to the units not sold remains in
          inventory until sold.

       4. Under variable costing, we use a contribution margin format of income statement
          where we subtract variable costs from revenue to arrive at contribution margin and
          then subtract all fixed costs to arrive at operating income.

J. Reconcile income under absorption, variable, and throughput costing:

       1. The difference in income between absorption costing and variable costing is the fixed
          cost portion of cost in inventory that is deferred as asset under full costing and
          charged to expense under variable costing.

       2. Assume that you produced 100 units that cost 20,000 – 75% of which is for fixed
          costs – and sell for $250 a unit. Sales amounted to 80 units, and there was no

            beginning inventory. Income under full costing amounts to $4,000 and amounts to
            $1,000 under variable costing. The difference of $3,000 between the two methods
            can be reconciled as the fixed cost per unit times the number units in inventory:
            20 * 150 = $3,000.

        3. In a just-in-time inventory system where inventory is non-existent, there will be no
           difference in income if either method is used.

        4. In throughput costing all costs except material costs are considered period costs.
           Reconciliation method is similar in terms of approach to the other methods.

        5. In situations with increase in inventory, income under full costing would be higher
           than income under variable costing. Reverse is also true.

K. Advantages and disadvantages of absorption costing, variable costing, and throughput costing
   are discussed:

        1. Absorption costing is non-intuitive, confusing, and subject to manager’s
           manipulation of income; i.e., produce more to show a higher level of income.

        2. Absorption costing, however, is more representative of the long-term cost of the
           product because it incorporates the fixed cost into the product cost.

        3. Many managers prefer to use full costing for their product pricing decisions because
           it provides a more realistic measure of costs.

        4. Variable costing, however, is more helpful for short-term decisions with regard to
           pricing as well s profitability of the firm.

L. Throughput costing was not adequately discussed in this chapter. It is the extreme in variable
   costing in that it assigns only the unit-level spending for direct costs as the cost of products or
   services. Accordingly, with higher production and lower sales, it would show a considerably
   lower profit as compared to absorption costing or even variable costing. As more costs tend
   to be considered fixed in the short-run, this methods provides another good short-term
   measure of performance.


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