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Managerial Accounting Cost terms, Concepts, and Classifications. Understanding of Manufacturing and nonmanufacturing costs, product costs and period costs, variable and fixed costs, direct and indirect costs, cost classification for decision making
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(Manufacturing and non manufacturing costs, product cost and period cost, variable and fixed costs, direct and indirect costs, cost classification for decision making)
Cost is used in many different ways in managerial accounting. 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 requires 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. In this chapter We discuss many of the possible use of cost data and how costs are defined and classified for each use.
Manufacturing cost is divided into three broad categories by most companies. A discussion of each category is as follows.
The materials that go into final product are called raw materials. Finished product of one company can become raw material of another company. For example plastic produced by manufacturer of plastics is a finished product for them but is a raw material for Compaq Computers for its personal computers.
Direct Materials are those material that become an integral part of the finished product and that can be physically and conveniently traced to it. Example include tiny electric motor that Panasonic uses in its CD players to make the CD spin. According to a study of 37 manufacturing industries material cost averaged about 55% of sales revenue
The term direct labor is reserved for those labor costs that can be essentially traced to individual units of products. Direct labor is sometime called touch labor, since direct labor workers typically touch the product while it is being made. The labor cost of assembly line workers is, for example, is a direct labor cost, as would the labor cost of carpenter, bricklayer and machine operator. According to a study of 37 manufacturing industries, direct labor averaged only about 10% of sales revenue.
Manufacturing overhead, the third element of manufacturing cost, includes all costs of manufacturing except direct material and direct labor. Manufacturing overhead includes items such as indirect material, indirect labor, maintenance and repairs on production equipment and heat and light, property taxes, depreciation, and insurance on manufacturing facilities. Indirect materials are minor items such as solder and glue in manufacturing industries. These are not included in direct materials costs. Indirect labor is a labor cost that cannot be trace to the creation of products or that can be traced only at great cost and inconvenience. Indirect labor includes the labor cost of janitors, supervisors, materials handlers and night security guards. Costs incurred for heat and light, property taxes, insurance, depreciation and so forth associated with selling and administrative functions are not included in manufacturing overhead. studies have found that manufacturing overhead averages about 16% of sales revenue.
Manufacturing overhead is known by various names, such as indirect manufacturing cost, factory overhead, and factory burden. All of these terms are synonymous with manufacturing overhead. Manufacturing Overhead combined with direct labor is called conversion cost. This term stems from the fact that direct labor costs and overhead costs are incurred to convert materials into finished products. Direct labor combined with direct materials is called prime cost
Generally nonmanufacturing costs are further classified into two categories.
Marketing and Selling Costs
Administrative Costs
marketing or selling costs include all costs necessary to secure customer orders and get the finished product into the hands of the customers. These costs are often called order getting or order filling costs. Examples include advertising costs, shipping costs, sales commission and sales salary.
Administrative costs include all executive, organizational, and clerical costs associated with general management of an organization rather than with manufacturing, marketing, 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.
For financial accounting purposes, Product costs include all the costs that are involved in acquiring of making product. In the case of manufactured goods, those costs consist of direct materials, direct labor, and manufacturing overhead. Product costs are viewed as "attaching" to units of product as the goods are purchased or manufactured, and they remain attached as the goods go into inventory awaiting sale. So initially, product costs are assigned to an inventory account on the balance sheet. When the goods are sold, the costs are released from inventory as expense (typically called Cost of Goods Sold) and matched against sales revenue. Since product costs are initially assigned to inventories, they are also known as inventoriable costs.
The purpose is to emphasize that product costs are not necessarily treated as expense 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. this means that a product cost such as direct materials or direct labor might be incurred during one period but not treated as an expense until a following period when the completed product is sold
Period costs are all the costs that are not included in product costs. These costs are expensed on the income statement in the period in which they are incurred, using the usual rules of accrual accounting in financial accounting. Period costs are not included as part of the cost of either purchased or manufactured goods. Sales commissions and office rent are good examples of period costs. Both items are expensed on the income statement in the period in which they are incurred. Thus they are said to be period costs. Other examples of period costs are selling and admn. expenses.
A variable cost is a cost that varies, in total, in direct proportion to changes in the level of activity. The activity can be expressed in many ways, Such as units produced, units sold, miles driven, beds occupied, hours worked and so forth. Direct materials is a good example of variable cost. The cost of direct materials will vary in direct proportions to the number of units that are produced.
When we speak the term variable cost we mean that the total cost rises and falls as the activity rises and falls. One interesting aspect of variable cost is that a variable cost is constant if expressed on a per unit basis.
A fixed cost is a cost that remains constant, in total, regardless of chages in the level of activity. Unlike variable costs, fixed costs are not affected by changes in activity. Consequently, as the activity level rises and falls, the fixed costs remain constant in total amount unless influenced by some outside forces, such as price changes. Rent is a good example of fixed cost.
Fixed cost can create confusion if they are expressed on per unit basis. This is because average fixed cost per unit increases and decreases inversely with changes in activity. Examples of fixed cost include straight line depreciation, insurance property taxes, rent, supervisory salary etc.
A direct cost is a cost that can be easily and conveniently traced to the particular cost object under consideration. A cost object is any thing for which cost data is required including products, customers jobs and organizational subunits.
An indirect cost is a cost that cannot be easily and conveniently traced to the particular cost object under consideration. For example a soup factory may produce dozens of verities of canned soups. The factory manager's salary would be an indirect cost of a particular verity such as chicken noodle soup. The reason is that the factory manager's salary is not caused by any one variety of soup. This salary of manger is treated as common cost of producing the various products of the factory. A common cost is a cost that is incurred to support a number of costing objects but cannot be traced to them individually. A common cost is a particular type of indirect cost.
Costs are important feature of many business decisions. It is essential to have a firm grasp of the concepts differential cost, opportunity cost, and sunk cost.
Decisions involve choosing between alternatives. In business, each alternative will have certain costs and benefits that must be compared to the costs and benefits of the other available alternatives. A difference in cost between any two alternatives is known as differential cost. A difference in revenue between any two alternatives is known as differential revenues. Differential cost includes both cost increase (incremental cost) and cost decrease (decremental cost).
In general the difference (cost and revenue) between alternatives are relevant in decision making. Those items that are the same under all alternatives can be ignored.
opportunity cost is the potential benefit that is given up when one alternative is selected over another. For example you are employed in a company that pays you $30,000 per year. You are thinking about leaving the company and returning to school. Since returning to school would require that you give up $30,000 salary. The forgone salary would be an opportunity cost of seeking further education.
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in future. They are not differential cost and should be ignored in decision making.
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