ACCG304 Lecture 1: Cost Concepts Learning Objectives To define Cost Concepts used in manufacturing and service industries, and identify examples of each. 1.0 Management Accounting - An Introduction • Financial Accounting V Management Accounting • Management Accounting V Cost Accounting • Planning & Control Definition of Cost Concepts • Cost • Cost Concepts for Production Accounting • Cost Concepts in Service Industries • Fixed, Variable and semi-variable costs • Direct & Indirect Costs • Prime Costs • Conversion Costs • Product Costs • Period Costs • Unit Costs • Work in Process, Finished Goods • Overhead Applied 1.1 1.0 Management Accounting - An Introduction Management Accounting is the process of producing financial and operating information which relates to the economic activity confronting the organisation. The management accounting process is driven by the informational needs of decision makers. Financial Accounting versus Management Accounting Financial accounting information and financial statements are produced for external parties such as shareholders, creditors and government authorities. Financial accounting is heavily constrained by standard setting, regulatory and tax authorities, as well as accounting and auditing standards which control reporting formats and contents. In contrast, Management Accounting (also referred to as internal accounting) is responsible for providing financial and operational information to support management decision making at all levels in the organisation. ACCG304 Lecture 1 – Introduction -2– Management Accounting versus Cost Accounting Cost accounting is a subset of the management accounting system. It provides decision support to managers in the form of information that relates to: (a) (b) (c) The establishment of the cost of a product or service The costing of an activity, department or cost centre The analysis and reporting of the results of historical business operations As such it relates to the planning and control of business activities of the firm. Planning and Control Planning may be defined as the formulation of corporate objectives as well as the detailed steps that need to be accomplished in order to meet these objectives. Control encompasses the continuous comparison of actual performance with budgets or standards. The comparison of actual results to budgets will enable the analyst to draw conclusions concerning the efficiency of operations, product profitability and pinpoint problem areas. The planning and control activity of the organisation may be represented as shown below: Input Data Historical costs Future costs Projected future costs Estimate Planning Plan of Action Formulate Actual future costs Compute Variances Evaluate Control Take corrective action Monitor ACCG304 Lecture 1 – Introduction -3– 1.1 Cost Definition of Cost Concepts The term "COST" may be defined as a sacrifice of values. A business incurs costs for the purpose of deriving revenue. The incurrence of costs necessitates the usage of scarce resources, for which management has primary responsibility. Cost Concepts for Production Accounting Production accounting deals with accounting for costs associated with the conversion of raw materials into finished goods. The costs associated with this process include: • Direct Materials • Direct Labour • Factory Overhead Cost Concepts for Service Industry Accounting Service industry costing deals with the assignment and allocation of costs to units of service. A service may include among other things: • The cost of one hour of an accountant's or solicitor's time; • The cost of a seat on an aeroplane; • The cost of a hospital bed on a daily basis, etc. Service sector industries are growing rapidly in the community and there is a management requirement to have knowledge of and be able to control costs associated with the provision of a service. Product and Service Industry Costing Compared Cost comparisons for the two types of industries are as follows: Production Industry Costing Costs Incurred Service Industry Costing Costs Incurred • Direct raw materials • Direct labour • Factory Overhead • Direct labour • Overhead • Direct Expenses Work In Process or Expensed ACCG304 Lecture 1 – Introduction -4– Fixed Costs and Variable Costs Fixed Costs Fixed costs do not vary with changing levels of activity. They remain the same in total. However the cost per unit decreases as activity increases. Variable Costs Variable costs are dependent upon the level of production or service activity for their incurrence. The cost per unit remains constant and increase in total as production increases. Semi-Variable Costs Those costs which contain a fixed component and a variable component. The fixed component represents the minimum cost of supplying a service. Direct and Indirect Costs DIAGRAM - COST TRACEABILITY TO PRODUCT DIRECTLY TRACED e.g. wood in manufacture of furniture INDIRECTLY IDENTIFIED e.g. lubricant used on the wood lathe ARBITRARILY ALLOCATED e.g. power to light the factory DIRECT COST INDIRECT COST Direct Costs Are costs that are worthwhile and easily traceable to a cost object (a cost object being either a department, process, job or activity). Indirect Cost Are "allocated" costs, since they must be assigned, apportioned or applied to the cost object. Overheads are referred to as indirect costs. Prime Cost Comprises the direct costs associated with the manufacture of a product and includes Direct Materials and Direct Labour. Prime Cost = Direct Materials + Direct Labour ACCG304 Lecture 1 – Introduction -5– Conversion Cost The costs associated with the conversion of Raw Materials into Finished Goods are referred to as Conversion Costs and comprise Direct Labour and Factory Overhead. Conversion Cost = Direct Labour + Factory Overhead Product Costs Product Costs = Direct Material + Direct Labour + Factory Overhead Period Costs Period Costs = Expired Costs = Expenses Product costs become period costs when the manufactured products are sold and charged against income as part of the Cost of Goods Sold. Unit Cost Comprises the cost of manufacturing a unit of production and would include: Manufacturing Organisation Service Organisation Direct Materials Direct Labour Factory Overhead Labour Costs Overhead Costs Direct Expenses ( or costs ) Work in Progress ( W.I.P. ) Work in process may be defined as incomplete production which has been commenced but is incomplete as to the amount of materials, labour and overhead required for its completion. Finished Goods Finished goods are the end result of the production process. Overhead Applied Overhead is applied to products or services using a predetermined rate, determined in advance of production, so as to enable the firm to recover those costs which are not related directly to production. ACCG304 Lecture 1 – Introduction -6– Lecture Demonstration Questions Cost of Production comprises: Direct Materials + Direct Labour + Factory Overhead Prime Costs Conversion Cost Illustrative Example 1 Direct Material Direct Labour Factory Overhead Required: Calculate: (i) (ii) (iii) = = Direct Material + Direct Labour Direct Labour + Factory Overhead $20 $24 $30 Unit manufacturing cost Prime Cost Conversion Cost Illustrative Example 2 Conversion costs amount to 60% of the unit manufacturing cost. The unit manufacturing cost is $40.00 Direct Labour is equal to 40% of Prime cost. Required: Calculate the unit cost of Direct materials, direct labour and factory overhead. Illustrative Example 3 A company revealed the following cost information: Direct materials used Direct labour Indirect materials used Indirect labour Rent for factory Depreciation on factory equipment Marketing expenses Administration expenses Units produced 5,000 units $4,000 2,000 2,500 1,500 3,000 3,000 2,000 1,200 For the above data, calculate: (a) calculate unit prime costs. (b) calculate the total conversion costs. (c) calculate the manufacturing cost per unit.