COST COST OBJECT. Cost centre. Profit centre. Investment centre

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1 COST The amount of money or property paid for a good or service. Cost is an expense for both personal and business assets. If a cost is for a business expense, it may be tax deductible. A cost may be paid immediately in the form of cash or over time in a credit sale or similar transaction. Cost is the opposite of revenue: It may be thought of as money spent or property given up instead of made/received. Farlex Financial Dictionary Farlex, Inc. All Rights Reserved COST OBJECT A cost object is anything for which cost data are desired. Examples of possible cost objects are products, product lines, customers, jobs, and organizational sub-units such as departments or divisions of a company or departments in a hotel. Cost centre A cost centre is a business segment whose manager has control over costs but not over revenue or investment funds. Service departments such as accounting, finance, general administration, legal, personnel and so on, are usually considered to be cost centres. In addition, manufacturing facilities are often considered to be cost centres. The managers of cost centres are usually expected to minimize the costs while providing the level of services or the amount of products demanded by the other parts of the organization. For example, the manager of a production facility would be evaluated at least in part by comparing actual costs to how much costs should have been for the actual number of good units produced during the period. Standard costing and variance analysis deals with this evaluation of the performance of cost centres in detail. Profit centre A profit centre is any business segment whose manager has control over both cost and revenue. Like a cost centre, a profit centre generally does not have control over investment funds. Profit centre managers are often evaluated by comparing actual profit to targeted or budgeted profit. Segmented income statements should be used to evaluate the performance of profit centre managers. The Fairview Branch of Hi-Lo Food Stores would be considered a profit centre led by a Store Manager who is not in control of the investment activities of the organisation. Investment centre An investment centre is any segment of an organization whose manager has control over cost, revenue and investments in operating assets. Investment centres are usually evaluated using return on investment or residual income measures. For example, the country manager of BNS is responsible for the investment centre of Jamaica.

2 Direct Cost: Definition and explanation of direct cost: A direct cost is a cost that can be easily and conveniently traced to the particular cost object under consideration. A cost object is anything for which cost data is required including products, customers jobs and organizational subunits. For example, if a company is assigning costs to its various regional and national sales offices, then the salary of the sales manager in its Jamaica office would be a direct cost of that office. Indirect Cost: Definition and explanation of indirect cost: 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 varieties of canned soups. The factory manager's salary would be an indirect cost of a particular variety such as chicken noodle soup. The reason is that the factory manager's salary is not caused by any one variety of soup. To be traced to a cost object such as a particular product, the cost must be caused by the cost object. This salary of manger is called 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. A particular cost may be direct or indirect, depending on the cost object. While, in the above example, the soup factory manager's salary is an indirect cost of manufacturing chicken noodle soup, it is a direct cost of the manufacturing division. In the first case, the cost object is the chicken noodle soup product. In the second case, the cost object is the entire manufacturing division. Variable Cost: Definition and Explanation: 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 material is a good example of variable cost. The cost of direct materials will vary in direct proportions to the number of units produced. When we speak the term variable cost we mean that the total cost raises and falls as the activity rises and falls. Hence, if you were operating a bakery, the cost of raw material such as flour, would change based on the quantity of output (assuming there is no change in the price of the flour). One interesting aspect of variable cost is that a variable cost is constant if expressed on a per unit basis. For a cost to be variable, it must be variable with respect to something. That something is its activity base. An activity base is a measure of whatever causes the incurrence of variable cost. An activity base is sometimes referred to as cost driver. Some of the most common activity bases are direct labour hours, machine hours, units produced, and units sold. Other activity bases (cost drivers) might include the number of miles driven by sales persons, the number of pounds of laundry cleaned by a hotel, the number of calls handed by technical support staff at a software company, and the number

3 of beds occupied in a hospital. To plan and control variable costs, a manger must be well acquainted with the various activity bases within the firm.. People sometimes get the notion that if a cost doesn't vary with production or with sales, then it is not really a variable cost. This is not correct. As suggested by the range of bases listed below, costs are caused by many different activities within an organization. Whether a cost is considered to be variable depends on whether it is caused by the activity under consideration. For example, if a manager is analyzing the cost of service calls under a product warranty, the relevant activity measure will be the number of service calls made. Those costs that vary in total with the number of service calls made are the variable cost of making service calls. Nevertheless, unless stated otherwise, you can assume that the activity base under consideration is the total volume of goods and services provided by the organization. Some of the most frequently encountered variable costs are listed below. This is not a complete list of all costs that can be considered variable. More, some costs listed here may behave more like fixed than variable costs in some organizations. Most Frequently Encountered Variable Costs Type of organization Costs that are normally variable with respect to volume of output Merchandising company Manufacturing company Cost of goods (merchandise) sold Manufacturing costs: Both merchandising and manufacturing companies Direct materials Direct labour Variable portion of manufacturing overhead: Indirect materials Lubricants Supplies Power Selling, general and administrative costs: Commissions clerical costs, such as invoicing Shipping costs Service organizations Supplies, travel, clerical True Variable Vs Step Variable Costs: Not all variable costs have exactly the same behaviour pattern. Some variable costs behave in a true variable or proportionately variable pattern. Other variable costs behave in a stepvariable pattern. True Variable Cost: A cost that varies in direct proportion to the level of activity is called true variable cost. Direct material is an example of true variable cost because the amount used during a period

4 will vary in direct proportion to the level of production activity. Moreover, any amounts of direct materials purchased but not used can be stored and carried forward to the next period as inventory. Step-Variable Cost: The wages of maintenance workers are often considered to be a variable cost, but this variable cost does not behave in quite the same way as the cost of direct materials. unlike direct materials, the time of maintenance workers is obtainable only in large chunks. More any maintenance time not utilized cannot be stored as inventory and carried forward to the next period. If the time is not used effectively it is gone forever. Furthermore, a maintenance crew can work at a fairly leisurely pace if pressures are light but intensify its efforts if pressures build up. For this reason small changes in the level of production may have no effect on the number of maintenance people employed by the company. A resource that is obtained only in large chunks (such as maintenance workers) and whose costs increase or decrease only in response to fairly wide changes in activity is known as a stepvariable cost. Fixed Cost: Definition and Explanation: A fixed cost is a cost that remains constant, in total, regardless of changes 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. Committed Fixed Vs Discretionary Fixed Costs: Fixed costs are some time referred to as capacity costs since they result from out lays made for building, equipment, skilled professional employees, and other items indeed to provide the basic capacity for sustained operations. For planning purposes, fixed costs can be viewed as being either committed or discretionary. Committed Fixed Cost: Committed fixed costs relate to the investment in facilities, equipment, and the basic organizational structure of a firm. Examples of such costs include depreciation of buildings and equipment, taxes on real estate, insurance and salaries of top management and operating personnel. The two key characteristics of committed fixed cost are 1. They are long term in nature. 2. They cannot be significantly reduced even for short period of time without seriously impairing the profitability or long run goals of the organization. Even if operations are interrupted or cut back, the committed fixed costs will still continue largely unchanged. During a recession, for example, a firm shall not usually discharge key executives or sell of key facilities.

5 Since it is difficult to change a committed fixed cost once the commitment has been made, management should approach these decisions with particular care. Decisions to acquire major equipment or to take on other committed fixed costs involve a long planning horizon. Management should make such commitments only after careful analysis of the available alternatives. Once a decision is made to build a certain size facility, a firm becomes locked into that decision for many years to come. While not much can be done about committed fixed costs in the short run, management is concerned about how these resources are utilized. The strategy of management must be to utilize the capacity of the organization as effectively as possible. Discretionary Fixed Cost: Discretionary fixed costs (often referred to as managed fixed costs) usually arise from annual decisions by management to spend in certain fixed cost areas. Examples of discretionary fixed costs include advertising, research, public relations, management development programs, and internships for students. Basically two key differences exist between committed fixed cost and discretionary fixed cost. First, the planning horizon of a discretionary fixed cost is fairly short term usually single year. By contrast committed fixed cost has a planning horizon that encompasses many years. Second, the discretionary fixed costs can be cut for short period of time with minimal damage to the long run goals of the organization. For example, spending of management development programs can be reduced because of poor economic conditions. Although some unfavourable consequences may result from the cutback, it is doubtful that these consequences would be as great as those would result if the company decided to economize during the year by laying off key personnel. Whether a fixed cost is regarded as committed or discretionary may depend on management's strategy. For example during recessions when the level of home building is down, many construction companies may lay off most of their workers and virtually disband operations. Other construction companies retain large number of employees on the pay roll, even though the workers have little or no work to do. While these latter companies may face short term cash flow problems, it will be easier for them to respond quickly when economic conditions improve. And the higher moral and loyalty of their employees may give these companies significant competitive advantage. The most important characteristics of discretionary cost is that management is not locked into a decision regarding such costs. They can be adjusted from year to year or even perhaps during the course of a year if circumstances may demand such a modification.

6 Summary of variable and fixed cost behaviour Cost Variable Cost Behaviour of the cost (within the relevant range) In Total Per Unit Total variable cost increases andvariable cost remains constant per unit decreases in proportion to changes in the activity level. Fixed cost Total fixed cost is not affected by changes in the activity level within the relevant range. AFixed cost per unit decreases as the activity level s the activity level fallsrises and increases a Product Costs: Definition and Explanation of Product Cost: For financial accounting purposes, product costs include all the costs that are involved in acquiring or making product. In the case of manufactured goods, these costs consist of direct materials, direct labour, 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 inventory 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 labour might be incurred during one period but not treated as an expense until a following period when the completed product is sold. Period Costs: Definition and Explanation of Period Costs: 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 that we learn 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 administrative expenses.

7 Summary of Product and Period Costs: PRODUCT COSTS OR INVENTORIABLE COSTS Direct Materials Materials that can be physically and conveniently traced to a product, such as wood in a table. Direct Labour Labour costs that can be physically and conveniently traced to a product such as assembly line workers in a plant. Direct labour is also called touch labour cost. Manufacturing Overhead All costs of manufacturing a product other than direct materials and direct labour, such as indirect materials, indirect labour, factory utilities, and depreciation of factory equipment. PERIOD COSTS OR NON-MANUFACTURING COSTS Marketing or selling costs All costs necessary to secure customer orders and get the finished product or service into the hands of the customer, such as sales commission, advertising, and depreciation of delivery equipment and finished goods warehouse. Administrative Costs All costs associated with the general management of the company as a whole, such as executive compensation, executive travel costs, secretarial salaries, and depreciation of office building and equipment. Product Costs-A Closer Look We have already defined product costs as those costs that are involved in either the purchase or the manufacture of goods. For manufactured goods, these costs consist of direct materials, direct labour, and manufacturing overhead. It will be helpful at this point to look briefly at the flow of costs in a manufacturing company. This will help us understand how product costs move through the various accounts and how they affect the balance sheet and the income statement.

8 Exhibit 1.1 Cost Flows and Classifications in a Manufacturing Company Exhibit 1.1 Exhibit illustrates the flow of costs in a manufacturing company. Raw materials purchases are recorded in the Raw materials inventory account. When raw materials are used in production, their costs are transferred to the work in process inventory account as direct materials. Not that direct labour cost and manufacturing overhead costs are directly added to work in process. Work in process account can be viewed most simply as an assembly line where workers are stationed and where products slowly take shape as they move from one end of the assembly line to the other. The direct materials, direct labour, and manufacturing overhead costs added to work in process in Exhibit 1.1 are the costs needed to complete these products as they move along this assembly line. Notice from the exhibit that as goods are completed, their costs are transferred from work in process to finished goods. Here the goods await sale to customers. As goods are sold, their costs are transferred from finished goods to cost of goods sold. At this point the various material, labour, and overhead costs required to make the product are finally treated as expenses. Until that point, these costs are in inventory accounts on the balance sheet.

9 Inventory Costs: As stated earlier products costs are often called inventory costs. The reason is that these costs go directly into inventory accounts as they are incurred (first into work in process WIP and then into finished goods), rather than going into expense accounts. Thus, they are termed inventory costs. This is a key concept since such costs can end up on the balance sheet as assets if goods are only partially completed or are unsold at the end of a period. To illustrate this point, refer again to Exhibit 1.1. At the end of the period, the materials, labour, and overhead costs that are associated with the units in the work in process and finished goods inventory accounts will appear on the balance sheet as part of the company's assets. These costs will not become expenses until later when the goods are completed and sold. Selling and administrative expenses are not involved in the manufacturing of a product. For this reason, they are not treated as product costs but rather as period costs that go directly into expense accounts as they are incurred, as shown by the Exhibit 1.1. An Example of Cost Flows: To provide an example of cost flows in a manufacturing company, assume that company's annual insurance cost is $2,000. Three fourth of this amount ($1,500) applies to factory operations, and one fourth ($500) applies to selling and administrative activities. Therefore, $1,500 of the $2,000 insurance cost would be a product (inventor) cost and would be added to the cost of goods produced during the year. This concept is illustrated in the Exhibit 1.2., where $1,500 of insurance cost is added into work in process. This portion of the year's insurance will not become an expense until the goods that are produced during the year are sold--which may not happen until the following year or even later. Until the goods are sold, the $1,500 will remain as part of the asset, inventory (either as part of work in process or as a part of finished goods), along with other costs of producing goods. By contrast, the $500 of insurance cost that applies to the company's selling and administrative activities will be expensed immediately. Thus far, we have been mainly concerned with classifications of manufacturing costs for the purpose of determining inventory valuations on the balance sheet and cost of goods sold on the income statement of external financial reports. However, costs are used for many other purposes, and each purpose requires a different classification of costs. Controllable costs Variable costs such as direct materials, direct labour, and variable overheads are usually considered controllable by the department manager. Further, a certain portion of fixed costs can also be controllable. For example, certain advertising spent specifically for a given department would be an expense controllable by the manager of that department. Advertising expenses that benefit many departments or products are, however, noncontrollable cost. Non-controllable cost Cost not subject to influence at a given level of managerial supervision. For instance, a manager's salary is not within the control of the manager himself. Rent of the factory building is another example.

10 Manufacturing, Merchandising and Service Companies Managerial accounting is just as important in a service company as it is in a manufacturing company or a merchandising company. However, there is a significant difference in the cost determination between the different types of companies. A manufacturing company uses labor and other inputs to transforms raw materials into finished product and then sells the product. A merchandising company completes the later function of the buying and selling products. A service company, on the other hand, does not produce/sell products, instead it provides service. The major difference between the three types of companies can be found in the cost of goods sold (services provided) calculation. Service Company Merchandising Company Manufacturing Company Cost of services provided: Primarily labor and overhead costs Cost of goods sold: Net purchase price Cost of goods manufactured: Materials Labor Overhead

11 Income Statement Comparison Merchandising versus Manufacturing Company The income statement of a manufacturing company is identical to that of a merchandising company. The difference between the two types of companies lies in the Determination of cost of goods sold Merchandising Company Beginning Inventory Purchases (net) (Ending Inventory) Cost of Goods Sold Manufacturing Company A. Beginning work in Process Beginning Raw materials Raw materials purchases (Ending raw materials inventory) Raw materials used Direct labor Overhead Total manufacturing costs (ending work in process) Cost of Goods Manufactured B. Finished goods inventory (beginning) Plus cost of goods manufactured (Finished goods inventory - ending) Cost of Goods Sold

12 Inventory Inventory is defined as a stock or store of goods. These goods are maintained on hand at or near a business's location so that the firm may meet demand and fulfill its reason for existence. If the firm is a retail establishment, a customer may look elsewhere to have his or her needs satisfied if the firm does not have the required item in stock when the customer arrives. If the firm is a manufacturer, it must maintain some inventory of raw materials and work-in-process in order to keep the factory running. In addition, it must maintain some supply of finished goods in order to meet demand. Sometimes, a firm may keep larger inventory than is necessary to meet demand and keep the factory running under current conditions of demand. If the firm exists in a volatile environment where demand is dynamic (i.e., rises and falls quickly), an on-hand inventory could be maintained as a buffer against unexpected changes in demand. This buffer inventory also can serve to protect the firm if a supplier fails to deliver at the required time, or if the supplier's quality is found to be substandard upon inspection, either of which would otherwise leave the firm without the necessary raw materials. Other reasons for maintaining an unnecessarily large inventory include buying to take advantage of quantity discounts (i.e., the firm saves by buying in bulk), or ordering more in advance of an impending price increase. Generally, inventory types can be grouped into three classifications: raw material, work-inprocess, and finished goods RAW MATERIALS Raw materials are inventory items that are used in the manufacturer's conversion process to produce components, subassemblies, or finished products. These inventory items may be commodities or extracted materials that the firm or its subsidiary has produced or extracted. They also may be objects or elements that the firm has purchased from outside the organization. Even if the item is partially assembled or is considered a finished good to the supplier, the purchaser may classify it as a raw material if his or her firm had no input into its production. Typically, raw materials are commodities such as ore, grain, minerals, petroleum, chemicals, paper, wood, paint, steel, and food items. However, items such as nuts and bolts, ball bearings, key stock, casters, seats, wheels, and even engines may be regarded as raw materials if they are purchased from outside the firm. WORK-IN-PROCESS Work-in-process (WIP) is made up of all the materials, parts (components), assemblies, and subassemblies that are being processed or are waiting to be processed within the system. This generally includes all material from raw material that has been released for initial processing up to material that has been completely processed and is awaiting final inspection and acceptance before inclusion in finished goods. FINISHED GOODS A finished good is a completed part that is ready for a customer order. Therefore, finished goods inventory is the stock of completed products. These goods have been inspected and have passed final inspection requirements so that they can be transferred out of work-inprocess and into finished goods inventory. From this point, finished goods can be sold

13 directly to their final user, sold to retailers, sold to wholesalers, sent to distribution centers, or held in anticipation of a customer order. Any item that does not have a parent can be classified as a finished good. By looking at the rolling cart product structure tree example one can determine that the finished good in this case is a cart.