Identify the cost categories in a traditional format income statement

24

B

U S

I N

E S

S F

O C

U S

2

After studying Chapter 2, you

should be able to:

LO1 Identify and give examples of each of the three basic

manufacturing cost categories.

LO2 Distinguish between product costs and period costs and give

examples of each.

LO3 Understand cost behavior patterns including variable costs,

fixed costs, and mixed costs.

LO4 Analyze a mixed cost using a scattergraph plot and the high-

low method.

LO5 Prepare income statements for a merchandising company

using the traditional and

contribution formats.

LO6 Understand the differences between direct and indirect costs.

LO7 Understand cost classifications used in making decisions:

differential costs, opportunity

costs, and sunk costs.

LO8 (Appendix 2A) Analyze a mixed cost using a scattergraph

plot and the least-squares

regression method.

LO9 (Appendix 2B) Identify the four types of quality costs and

explain how they interact.

LO10 (Appendix 2B) Prepare and interpret a quality cost report.

Managerial Accounting and Cost Concepts

C h

a p

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LEARNING OBJECTIVES

Understanding Costs Aids the Growth of a Billion Dollar Company

In 1986, Women’s World of Fitness went bank-

rupt despite having 14 locations and 50,000

members. The company’s owner, Gary Heavin,

says the fitness centers contained too many

costly amenities such as swimming pools, tan-

ning beds, cardio machines, kid’s programs,

juice bars, personal trainers, and aerobics

classes. As costs escalated, he attempted to

increase revenues by offering memberships

to men, which alienated his female members.

What did Heavin learn from his experience?

In 1992, Heavin founded a new brand

of women’s fitness centers called Curves . Rather than investing in every conceivable

piece of fitness equipment and amenity, Heavin focused on simplicity. He created a

simple fitness circuit that uses minimal equipment and is quick and easy for members

to complete. Instead of operating almost 24 hours a day, he decided to close his gyms

early. Even showers were deemed unnecessary. In short, Heavin eliminated numerous

costs that did not provide benefits in the eyes of his customers. With dramatically

lower costs, he has been able to maintain his “women only” approach while building a

billion dollar company with nearly 10,000 locations worldwide. ■

Source: Alison Stein Wellner, “Gary Heavin Is on a Mission from God,” Inc. magazine, October 2006,

pp. 116–123.

Managerial Accounting and Cost Concepts 25

T his chapter explains that in managerial accounting the term cost is used in many different ways. The reason is that there are many types of costs, and these costs are classified differently according to the immediate needs of management. For example, managers may want cost data to prepare external

financial reports, to prepare planning budgets, or to make decisions. Each different use of cost data demands a different classification and definition of costs. For example, the preparation of external financial reports requires the use of historical cost data, whereas decision making may require predictions about future costs. This notion of different costs for different purposes is a critically important aspect of managerial accounting.

General Cost Classifications

We will start our discussion of cost concepts by focusing on manufacturing companies, because they are involved in most of the activities found in other types of organizations. Manufacturing companies such as Texas Instruments , Ford , and DuPont are involved in acquiring raw materials, producing finished goods, marketing, distributing, billing, and almost every other business activity. Therefore, an understanding of costs in a manufac- turing company can be very helpful in understanding costs in other types of organizations.

Manufacturing Costs

Most manufacturing companies separate manufacturing costs into three broad categories: direct materials, direct labor, and manufacturing overhead. A discussion of each of these categories follows.

Direct Materials The materials that go into the final product are called raw materi- als . This term is somewhat misleading because it seems to imply unprocessed natural resources like wood pulp or iron ore. Actually, raw materials refer to any materials that are used in the final product; and the finished product of one company can become the raw materials of another company. For example, the plastics produced by Du Pont are a raw material used by Hewlett-Packard in its personal computers.

Raw materials may include both direct and indirect materials. Direct materials are those materials that become an integral part of the finished product and whose costs can be conveniently traced to the finished product. This would include, for example, the seats that Airbus purchases from subcontractors to install in its commercial aircraft and the tiny electric motor Panasonic uses in its DVD players.

Sometimes it isn’t worth the effort to trace the costs of relatively insignificant materi- als to end products. Such minor items would include the solder used to make electrical connections in a Sony TV or the glue used to assemble an Ethan Allen chair. Materials such as solder and glue are called indirect materials and are included as part of manu- facturing overhead, which is discussed later in this section.

Direct Labor Direct labor consists of labor costs that can be easily (i.e., physi- cally and conveniently) traced to individual units of product. Direct labor is sometimes called touch labor because direct labor workers typically touch the product while it is being made. Examples of direct labor include assembly-line workers at Toyota , carpen- ters at the home builder KB Home, and electricians who install equipment on aircraft at Bombardier Learjet .

Labor costs that cannot be physically traced to particular products, or that can be traced only at great cost and inconvenience, are termed indirect labor . Just like indi- rect materials, indirect labor is treated as part of manufacturing overhead. Indirect labor includes the labor costs of janitors, supervisors, materials handlers, and night security guards. Although the efforts of these workers are essential, it would be either impractical

LEARNING OBJECTIVE 1

Identify and give examples of each of the three basic manufacturing cost categories.

26 Chapter 2

or impossible to accurately trace their costs to specific units of product. Hence, such labor costs are treated as indirect labor.

Manufacturing Overhead Manufacturing overhead , the third element of manu- facturing cost, includes all manufacturing costs except direct materials and direct labor. Manufacturing overhead includes items such as indirect materials; indirect labor; main- tenance and repairs on production equipment; and heat and light, property taxes, depre- ciation, and insurance on manufacturing facilities. A company also incurs costs for heat and light, property taxes, insurance, depreciation, and so forth, associated with its selling and administrative functions, but these costs are not included as part of manufacturing overhead. Only those costs associated with operating the factory are included in manu- facturing overhead.

Various names are used for manufacturing overhead, such as indirect manufacturing cost, factory overhead, and factory burden. All of these terms are synonyms for manufac- turing overhead.

Nonmanufacturing Costs

Nonmanufacturing costs are often divided into two categories: (1) selling costs and (2) administrative costs. Selling costs include all costs that are incurred to secure cus- tomer orders and get the finished product to the customer. These costs are sometimes called order-getting and order-filling costs. Examples of selling costs include advertis- ing, shipping, sales travel, sales commissions, sales salaries, and costs of finished goods warehouses.

Administrative costs include all costs associated with the general management of an organization rather than with manufacturing or selling. Examples of administrative costs include executive compensation, general accounting, secretarial, public relations, and similar costs involved in the overall, general administration of the organization as a whole.

Nonmanufacturing costs are also often called selling, general, and administrative (SG&A) costs or just selling and administrative costs.

I N B U S I N E S S IS SENDING JOBS OVERSEAS ALWAYS A GOOD IDEA? M any companies send jobs from high labor-cost countries such as the United States to lower labor- cost countries such as India and China. But is chasing labor cost savings always the right thing to do? In manufacturing, the answer is no. Typically, total direct labor costs are around 7% to 15% of cost of goods sold. Because direct labor is such a small part of overall costs, the labor savings real- ized by “offshoring” jobs can easily be overshadowed by a decline in efficiency that occurs simply because production facilities are located farther from the ultimate customers. The increase in inven- tory carrying costs and obsolescence costs coupled with slower response to customer orders, not to mention foreign currency exchange risks, can more than offset the benefits of employing geographically dispersed low-cost labor.

One manufacturer of casual wear in Los Angeles, California, understands the value of keeping jobs close to home in order to improve performance. The company can fill orders for as many as 160,000 units in 24 hours. In fact, the company carries less than 30 days’ inventory and is consid- ering fabricating clothing only after orders are received from customers rather than attempting to forecast what items will sell and making them in advance. How would they do this? The company’s entire manufacturing process—including weaving, dyeing, and sewing—is located in downtown Los Angeles, eliminating shipping delays.

Source: Robert Sternfels and Ronald Ritter, “When Offshoring Doesn’t Make Sense,” The Wall Street Journal, October 19, 2004, p. B8.

Managerial Accounting and Cost Concepts 27

In addition to classifying costs as manufacturing or nonmanufacturing costs, there are other ways to look at costs. For instance, they can also be classified as either product costs or period costs. To understand the difference between product costs and period costs, we must first discuss the matching principle from financial accounting.

Generally, costs are recognized as expenses on the income statement in the period that benefits from the cost. For example, if a company pays for liability insurance in advance for two years, the entire amount is not considered an expense of the year in which the payment is made. Instead, one-half of the cost would be recognized as an expense each year. The reason is that both years—not just the first year—benefit from the insurance payment. The unexpensed portion of the insurance payment is carried on the balance sheet as an asset called prepaid insurance.

The matching principle is based on the accrual concept that costs incurred to gener- ate a particular revenue should be recognized as expenses in the same period that the

revenue is recognized. This means that if a cost is incurred to acquire or make something that will eventually be sold, then the cost should be recognized as an expense only when the sale takes place—that is, when the benefit occurs. Such costs are called product costs.

Product Costs

For financial accounting purposes, product costs include all costs involved in acquiring or making a product. In the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. Product costs “attach” to units of product as the goods are purchased or manufactured, and they remain attached as the goods go into inventory awaiting sale. Product costs are initially assigned to an inven- tory account on the balance sheet. When the goods are sold, the costs are released from inventory as expenses (typically called cost of goods sold) and matched against sales revenue. Because product costs are initially assigned to inventories, they are also known as inventoriable costs .

We want to emphasize that product costs are not necessarily treated as expenses in the period in which they are incurred. Rather, as explained above, they are treated as expenses in the period in which the related products are sold.

Period Costs

Period costs are all the costs that are not product costs. All selling and administrative expenses are treated as period costs. For example, sales commissions, advertising, exec- utive salaries, public relations, and the rental costs of administrative offices are all period costs. Period costs are not included as part of the cost of either purchased or manufac- tured goods; instead, period costs are expensed on the income statement in the period in which they are incurred using the usual rules of accrual accounting. Keep in mind that the period in which a cost is incurred is not necessarily the period in which cash changes hands. For example, as discussed earlier, the costs of liability insurance are spread across the periods that benefit from the insurance—regardless of the period in which the insur- ance premium is paid.

Prime Cost and Conversion Cost

Two more cost categories are often used in discussions of manufacturing costs— prime cost and conversion cost. Prime cost is the sum of direct materials cost and direct labor cost. Conversion cost is the sum of direct labor cost and manufacturing overhead cost. The term conversion cost is used to describe direct labor and manufacturing overhead because these costs are incurred to convert materials into the finished product.

Exhibit 2–1 contains a summary of the cost terms that we have introduced so far.

Product Costs versus Period Costs

LEARNING OBJECTIVE 2

Distinguish between product costs and period costs and give examples of each.

28 Chapter 2

E X H I B I T 2 – 1

Summary of Cost Terms

Administrative CostsSelling Costs

Prime Cost Conversion Cost

Nonmanufacturing Costs (Also called Period Costs

or Selling and Administrative Costs)

All costs necessary to secure customer orders and get the finished product or service to the customer (such as sales commissions, advertising, and depreciation of delivery equipment and finished goods warehouses).

All costs associated with the gen- eral management of the company as a whole (such as executive compensation, executive travel costs, secretarial salaries, and depreciation of office buildings and equipment).

Manufacturing OverheadDirect LaborDirect Materials

Materials that can be conveniently traced to a product (such as wood in a table).

Labor cost that can be physically and conveniently traced to a product (such as assembly-line workers in a plant). Direct labor is sometimes called touch labor.

All costs of manufacturing a product other than direct materials and direct labor (such as indirect materials, indirect labor, factory utilities, and depreciation of factory buildings and equipment).

Manufacturing Costs (Also called Product Costs

for financial accounting purposes)

I N B U S I N E S S THE CHALLENGES OF MANAGING CHARITABLE ORGANIZATIONS Charitable organizations, such as Harlem Children’s Zone, Sports4Kids , and Citizen Schools , are facing a difficult situation. Many donors—aware of stories involving charities that spent excessively on themselves while losing sight of their mission—have started prohibiting their charity of choice from using donated funds to pay for administrative costs. However, even the most efficient charitable organizations find it difficult to expand without making additions to their infrastructure. For example, Sports4Kids’ nationwide expansion of its sports programs drove up administrative costs from 5.6% to 14.7% of its total budget. The organization claims that this cost increase was necessary to build a more experienced management team to oversee the dramatically increased scale of operations.

Many charitable organizations are starting to seek gifts explicitly to fund administrative expenses. Their argument is simple—they cannot do good deeds for other people without incurring such costs.

Source: Rachel Emma Silverman and Sally Beatty, “Save the Children (But Pay the Bills, Too),” The Wall Street Journal, December 26, 2006, pp. D1–D2.

Managerial Accounting and Cost Concepts 29

LEARNING OBJECTIVE 3

Understand cost behavior patterns including variable costs, fixed costs, and mixed costs.

Cost Classifications for Predicting Cost Behavior

It is often necessary to predict how a certain cost will behave in response to a change in ac - tivity. For example, a manager at Qwest , a telephone company, may want to estimate the impact a 5 percent increase in long-distance calls by customers would have on Qwest’s total electric bill. Cost behavior refers to how a cost reacts to changes in the level of activity. As the activity level rises and falls, a particular cost may rise and fall as well—or it may remain constant. For planning purposes, a manager must be able to anticipate which of these will happen; and if a cost can be expected to change, the manager must be able to estimate how much it will change. To help make such distinctions, costs are often categorized as variable, fixed, or mixed. The relative proportion of each type of cost in an organization is known as its cost structure . For example, an organization might have many fixed costs but few variable or mixed costs. Alternatively, it might have many variable costs but few fixed or mixed costs.