Managers need to rely upon different classifications of costs for different purposes. The four main purposes emphasized in this chapter include preparing external financial reports, predicting cost behavior, assigning costs to cost objects, and making business decisions. Our initial focus is on manufacturing companies since their basic activities include most of the activities found in other types of business organizations. Nonetheless, many of the concepts developed in this chapter apply to diverse organizations.
Manufacturing costs are usually grouped into three main categories: direct materials, direct labor, and manufacturing overhead. These costs are incurred to make a product.
Direct materials are raw materials that become an integral part of the finished product and that can be physically and conveniently traced to it.
Examples include the aircraft engines on a Boeing 777, the Intel processing chip in a personal computer, the blank video cassette in a pre-recorded video, and a radio in an automobile.
Direct labor consists of that portion of labor cost that can be easily traced to a product. Direct labor is sometimes referred to as “touch labor” since it consists of the costs of workers who “touch” the product as it is being made.
Manufacturing overhead consists of all manufacturing costs other than direct materials and direct labor. These costs cannot be easily and conveniently traced to products. These costs are also called indirect manufacturing cost, factory overhead, and factory burden. Examples include miscellaneous supplies such as rivets in a Boeing 777; salaries for supervisors, janitors, and security guards; factory facility charges, etc.
Prime cost consists of direct materials plus direct labor. Conversion cost consists of direct labor plus manufacturing overhead.
A manufacturing company incurs many other costs in addition to manufacturing costs. For financial reporting purposes most of these other costs are typically classified as marketing or selling costs and administrative costs. These costs are also called selling, general and administrative costs, or S, G, and A. Marketing and administrative costs are incurred in both manufacturing and merchandising firms.
Marketing costs include all costs necessary to secure customer orders and get the finished product into the hands of the customer. These costs are also referred to as order-getting and order-filling costs.
Administrative costs include all executive, organizational, and clerical costs associated with the general management of an organization that are not classified as production or marketing costs.
Costs can also be classified as period or product costs.
Product costs include all the costs that are involved in acquiring or making a product. More specifically, it includes direct materials, direct labor, and manufacturing overhead. Consistent with the matching principle product costs are recognized as expenses when the products are sold. This can result in a delay of one or more periods between the time in which the cost is incurred and when it appears as an expense on the income statement. Product costs are also known as inventoriable costs. The discussion in the chapter follows the usual interpretation of GAAP in which all manufacturing costs are treated as product costs.
Period costs include all marketing or selling costs and administrative costs. These costs are expensed on the income statement in the period incurred. All selling and administrative costs are typically considered to be period costs. The usual rules of accrual accounting apply to period costs. For example, administrative salary costs are “incurred” when they are earned by the employees and not necessarily when they are paid to employees.
Which of the following costs would be considered a period rather than a product cost in a manufacturing company?
Property taxes on corporate headquarters and sales commissions are period costs. All of the other costs listed are product costs.
Merchandising companies purchase finished goods from suppliers for resale to customers. Manufacturing companies purchase raw materials from suppliers and produce and sell finished goods to customers.
Now, let’s consider similarities and differences on the balance sheet for merchandising and manufacturing companies. Both merchandising and manufacturing companies will likely have Cash, Receivables and Prepaid Expenses. However, merchandising companies do not have to distinguish between raw materials, work in process, and finished goods. They report one inventory number on their balance sheet labeled merchandise inventory. Manufacturing companies report three types of inventory on their balance sheets: raw materials, work in process and finished goods.
Part I
Raw materials are the materials used to make the product.
Part II
Work in process consists of units of product that are partially complete, but will require further work to be saleable to customers.
Part III
Finished goods consists of units of product that have been completed but not yet sold to customers.
Merchandising companies calculate cost of goods sold as Beginning Merchandise Inventory plus Purchases minus Ending Merchandise Inventory.
For manufacturing companies, the cost of goods sold for a period is not simply the manufacturing costs incurred during the period. Some of the cost of goods sold may be for units completed in a previous period. And some of the units completed in the current period may not have been sold and will still be on the balance sheet as assets. The cost of goods sold is computed with the aid of a schedule of costs of goods manufactured, which takes into account changes in inventories. The schedule of cost of goods manufactured is not ordinarily included in external financial reports, but must be compiled by accountants within the company in order to arrive at the cost of goods sold. We will learn more about a schedule of costs of goods manufactured later in this chapter. Manufacturing companies calculate cost of goods sold as Beginning Finished Goods Inventory plus Cost of Goods Manufactured minus Ending Finished Goods Inventory.
Before proceeding, it is a good idea to understand that the raw materials, work in process, and finished goods inventories all follow the same logic. They start out with some beginning inventory. Additions are made during the period. At the end of the period, everything that started in the inventory or that was added must either be in the ending inventory or have been transferred out to another inventory account or to cost of goods sold.
If your inventory balance at the beginning of the month was one thousand dollars, you bought one hundred dollars during the month, and sold three hundred dollars during the month, what would be the balance at the end of the month?
Right. Eight hundred dollars. This is calculated as beginning inventory of one thousand dollars plus purchases of one hundred dollars minus ending inventory of three hundred dollars.
The schedule of cost of goods manufactured contains the three elements of costs mentioned previously, namely direct materials, direct labor, and manufacturing overhead. It calculates the cost of raw material, direct labor and manufacturing overhead used in production. It also calculates the manufacturing costs associated with goods that were finished during the period.
To create a schedule of cost of goods manufactured as well as a balance sheet and income statement, it is important to understand the flow of product costs. Raw material purchases made during the period are added to beginning raw materials inventory. The ending raw materials inventory is deducted to arrive at the raw materials used in production. As items are removed from the raw materials inventory and placed into the production process, they are called direct materials.
Direct labor and manufacturing overhead (also called conversion costs) used in production are added to direct materials to arrive at total manufacturing costs.
Total manufacturing costs are added to the beginning work in process to arrive at total work in process.
The ending work in process inventory is deducted from the total work in process for the period to arrive at the cost of goods manufactured.
The cost of goods manufactured is added to the beginning finished goods inventory to arrive at cost of goods available for sale. The ending finished goods inventory is deducted from this figure to arrive at cost of goods sold.
Part I
All raw materials, work in process, and unsold finished goods at the end of the period are shown as inventoriable costs in the asset section of the balance sheet.
Part II
As finished goods are sold, their costs are transferred to cost of goods sold on the income statement.
Part III
Selling and administrative expenses are not involved in making the product; therefore, they are treated as period costs and reported on the income statement for the period the cost is incurred.
Beginning raw materials inventory was thirty two thousand dollars. During the month, two hundred seventy six thousand dollars of raw material was purchased. A count at the end of the month revealed that twenty eight thousand dollars of raw material was still present. What is the cost of direct material used?
Right. Two hundred eighty thousand dollars. Take a minute and review the solution before proceeding.
Direct materials used in production totaled two hundred eighty thousand dollars. Direct labor was three hundred seventy five thousand dollars and factory overhead was one hundred eighty thousand dollars. What were total manufacturing costs incurred for the month?
Right. Eight hundred thirty five thousand dollars. Take a minute and review the solution before proceeding.
Beginning work in process was one hundred twenty five thousand dollars. Manufacturing costs incurred for the month were eight hundred thirty five thousand dollars. There were two hundred thousand dollars of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month?
Right. Seven hundred sixty thousand dollars. Take a minute and review the solution before proceeding.
Beginning finished goods inventory was one hundred thirty thousand dollars. The cost of goods manufactured for the month was seven hundred sixty thousand dollars. And the ending finished goods inventory was one hundred fifty thousand dollars. What was the cost of goods sold for the month?
Right. Seven hundred forty thousand dollars. Take a minute and review the solution before proceeding.
Managers often need to be able to predict how costs will change in response to changes in activity. The activity might be the output of goods or services or it might be some measure of activity internal to the company such as the number of purchase orders processed during a period. In this chapter, nearly all of the illustrations assume that the activity is the output of goods or services. In later chapters, other measures of activity will be introduced.
While there are other ways to classify costs according to how they react to changes in activity, in this chapter we introduce the simple variable and fixed classifications. Just about any cost will change if there is a big enough change in activity. There is some controversy concerning the proper definition of the “relevant range.” Some refer to the relevant range as the range of activity within which the company usually operates. We refer to the relevant range as the range of activity within which the assumptions about variable and fixed costs are valid. Either definition could be used—our choice was dictated by our desire to highlight the notion that fixed costs can change if the level of activity changes enough.
Total variable cost varies in direct proportion to changes in the level of activity. For example, your long distance telephone bill may be based on how many minutes your talk—the total bill varies with the number of minutes used.
Although variable costs change in total as the activity level rises and falls, variable cost per unit is constant. For example, the cost per long distance minute may be ten cents a minute.
Total fixed cost is constant within the relevant range. In other words, fixed costs do not change for changes in activity that fall within the “relevant range.” For example, your monthly basic telephone bill probably is a set amount and does not change based on the number of calls you make.
However, when expressed on a per unit basis, a fixed cost is inversely related to activity—the per unit cost decreases when activity rises and increases when activity falls. For example, the average fixed cost per local call decreases as more local calls are made.
It is helpful to think about variable and fixed cost behavior in a two by two matrix, as illustrated here. Take a few minutes and review this summary of cost behavior for variable and fixed costs.
Which of the following costs would be variable with respect to the number of cones sold at a Baskins and Robbins shop? (There may be more than one correct answer.)
Right. The cost of ice cream and the cost of napkins for customers would be variable costs. As Baskins and Robbins sells more ice cream cones, we would expect the total cost of ice cream and napkins to increase.
A cost object is anything for which cost data are desired including products, customers, jobs, organizational subunits, etc. For purposes of assigning costs to cost objects costs are classified two ways:
Direct costs are costs that can be easily and conveniently traced to a unit of product or other cost object. Examples of direct costs are direct material and direct labor.
Indirect costs are costs that cannot be easily and conveniently traced to a unit of product or other cost object. An example of an indirect cost is manufacturing overhead. Common costs are indirect costs incurred to support a number of cost objects. These costs cannot be traced to any individual cost object.
It is important to realize that every decision involves a choice between at least two alternatives. The goal of making decisions is to identify those costs that are either relevant or irrelevant to the decision. Costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits are irrelevant and can and should be ignored.
Differential costs (or incremental costs) is a difference in cost between any two alternatives. A difference in revenue between two alternatives is called differential revenue. Differential costs can be either fixed or variable.
For example, assume you have a job paying one thousand five hundred dollars per month in your hometown. You have a job offer in a neighboring city that pays two thousand dollars per month. The commuting cost to the city is three hundred dollars per month. In this example, the differential revenue is five hundred dollars and the differential cost is three hundred dollars.
Opportunity cost is the potential benefit that is given up when one alternative is selected over another. These costs are not usually entered into the accounting records of an organization, but must be explicitly considered in all decisions.
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Since sunk costs cannot be changed and therefore cannot be differential costs, they should be ignored in decision making. While students usually accept the idea that sunk costs should be ignored on an abstract level, like most people they often have difficulty putting this idea into practice.
Take a minute and read the information on this slide. Should the cost of the train ticket affect the decision of whether you drive or take the train to Portland?
Yes, it should because the cost of the train ticket is relevant.
Take a minute and read the information on this slide. Is the annual cost of licensing your car relevant in this decision?
No, it is not because the licensing cost is not relevant.
Suppose that your car could be sold now for five thousand dollars. Is this a sunk cost?
No, it is not a sunk cost.
We have looked at the cost classifications used for financial reporting, predicting cost behavior, assigning costs to cost objects, and making business decisions. Now, let’s look at how to classify idle time, overtime, and fringe benefits.
Machine breakdowns, material shortages, power failures and the like result in idle time. The labor costs incurred during idle time are ordinarily treated as manufacturing overhead. This enables the costs to be spread across all the production rather than the units in process when the disruptions occur.
The overtime premiums for all factory workers are usually considered to be part of manufacturing overhead. This is done to avoid penalizing particular products or customer orders simply because they happen to fall on the tail end of the daily production schedule.
Labor fringe benefits costs are employment-related costs paid by an employer such as insurance programs, retirement plans, and supplemental unemployment programs. They also include the employer’s share of Social Security, Medicare, workers’ compensation, federal employment tax, and state unemployment insurance. These costs often add up to thirty to forty percent of an employee’s base pay. Some companies include all of these costs in manufacturing overhead. Other companies opt for the conceptually superior method of treating fringe benefit expenses of direct laborers as additional direct labor costs.
The term quality has many meanings. Quality can mean that a product has many features not found in other products; it can mean that it is well-designed; or it can mean that it is defect-free. In this appendix, the focus is on the presence or absence of defects. Quality of conformance is the degree to which the actual product or service meets its design specifications. Anything that does not meet design specifications is a defect and is indicative of low quality of conformance.
There are four broad categories of quality costs: prevention costs, appraisal costs, internal failure costs, and external failure costs. Prevention costs are incurred to support activities whose purpose is to reduce the number of defects. Appraisal costs are incurred to identify defective products before the products are shipped to customers.
Internal failure costs are incurred as a result of identifying defects before they are shipped to customers. External failure costs are incurred as a result of defective products being delivered to customers.
Here are some examples of each type of quality cost.
Prevention costs include quality training, quality circles, and statistical process control activities.
Appraisal costs include testing and inspection of incoming materials, final product testing, and depreciation of testing equipment.
Internal failure costs include scrap, spoilage, and rework.
External failure costs include the cost of field servicing and handling customer complaints, warranty repairs, and lost sales arising from reputation of poor quality.
Here are four key concepts about the relationship between the four types of quality costs.
When the quality of conformance is low, total quality cost is high and most of this cost consists of internal and external failure costs.
Total quality costs drop rapidly as the quality of conformance increases.
Companies reduce their total quality costs by focusing their efforts on prevention and appraisal because the cost savings from reduced defects usually overwhelm the costs of additional prevention and appraisal.
Total quality costs are minimized when the quality of conformance is slightly less than one hundred percent. This is a debatable point in the sense that some experts believe that total quality costs are not minimized until the quality of conformance is one hundred percent.
A quality cost report details the prevention, appraisal, internal failure, and external failure costs that arise from a company’s current quality control efforts. When interpreting a cost of quality report managers should look for two trends. First, increases in prevention and appraisal costs should be more than offset by decreases in internal and external failure costs. Second, the total quality costs as a percent of sales should decrease.
Quality cost reports can also be prepared in graphic form. Managers should still look for the same two trends whether the data is presented in a graphic or table format.
Uses of quality cost information include the following.
It helps managers see the financial significance of defects.
It helps managers identify the relative importance of the quality problems faced by the company.
It helps managers see whether their quality costs are poorly distributed. In general, costs should be distributed more toward prevention and to a lesser extent appraisal than toward failures.
Limitations of quality cost information include the following.
Simply measuring and reporting quality cost problems does not solve quality problems.
Results usually lag behind quality improvement programs. Initially, prevention and appraisal cost increases may not be offset by decreases in failure costs.
The most important quality cost, lost sales arising from customer ill-will, is often omitted from quality cost reports because it is difficult to estimate.
The International Organization for Standardization, based in Geneva Switzerland, has established quality control guidelines known as the ISO nine thousand standards. For a company to become ISO nine thousand certified by a certifying agency it must demonstrate that:
A quality control system is in use, and the system clearly defines an expected level of quality,
The system is fully operational and is backed up with detailed documentation of quality control procedures, and
The intended level of quality is being achieved on a sustained basis.
Although the ISO nine thousand standards were developed in Europe they have become widely accepted elsewhere throughout the world including the United States.
In this chapter we learned that costs can be classified in a number of ways—depending on the purpose of the classification. It is important to note that the classifications of costs are not mutually exclusive. That is, a particular cost may be classified in many different ways—depending on the purpose of the classification. You may want to review the different cost classifications before continuing to the next chapter.
