CHAPTER 2 THEORITICAL FOUNDATION Definition of Cost As stated by Matz and Usry (1976:41), cost must be justified on relevant

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1 CHAPTER 2 THEORITICAL FOUNDATION 2.1. Definition of Cost As stated by Matz and Usry (1976:41), cost must be justified on relevant facts, competently observed and considerably measured to facilitate management in making suitable decisions. Costs may have to be calculated under different conditions, for different purposes, by different people. According to The Committee on Cost Concepts and Standards of the American Accounting Association, as cited by Matz and Usry (1976:41), Cost is a foregoing, measured in monetary terms, incurred or potentially to be incurred to achieve a specific objective. In A Tentative Set of Broad Accounting Principles for Business Enterprises, as cited in Matz and Usry (1976:42), cost is defined as an exchange price, a foregoing, a sacrifice made to secure benefit. In the financial accounting, the foregoing or sacrifice at date if acquisition is represented by a current or future diminution in cash or other assets. Matz and Usry(1976:43) also mentioned that the gathering, presentation, and analysis of cost data should fulfill the following fundamental uses or aims: 1. Planning profit using budget 2. Controlling costs through responsibility accounting 3. Determining annual and or periodic profit, including inventory costing 4. Facilitating in setting up selling prices and a pricing policy 5. Providing relevant cost data for analytical processes for decision making

2 According to Hongren, Datar, and Foster (2003:30), cost is resource sacrificed or forgone to achieve a specific objective. Whereas according to Mulyadi (1993:8), cost is the sacrifice of economy resources, that can be measured in monetary unit, that already happen or may be happen for certain purposes. In accordance with Helmi Rony(1990:15), in determining the level of profit that will be received in specific period, the management needs to know the profit that will be get from the selling and the costs that have to be included in selling the products. In his book, Helmi Rony (1990:15) also quotes the definition of costs according to PAI (Prinsip Akuntansi Indonesia) issued by IAI (Ikatan Akuntansi Indonesia). According to PAI, cost is the sacrifice that is made to obtain products or services that can be measured by value of money; either in the form of money, barter, or providing services Classification of Costs According to Mulyadi (1993:14-17), cost can be classified according to: 1. The object of the expenditures 2. Company s primary functions 3. The relationship of cost and the cost object 4. Cost behavior in the relationship with the change of activities volume 5. The period of the benefit

3 Classification of cost according to the object of costs In this type of classification, the name of the object of cost is the used in determining the cost classification. For example, the name of cost object is fuel, then all of the costs related with fuel named fuel cost. Classification of cost according to the company s primary functions In manufacturing company, there are 3 primary functions: production, marketing, and general and administration function. Therefore, based on these functions, costs can be classified to 3 groups: 1. Production cost 2. Marketing cost 3. General and administration cost Production cost is the costs to turn raw materials into finished products that are ready to be sold. The example of production costs are machines and equipments depreciation cost, raw materials cost, support materials costs, salaries for employees directly and indirectly related with the production. Based on the cost object, primarily production costs are separated into raw material, direct labor, and factory overhead costs. Raw material cost is categorized as prime cost, whereas direct labor and factory overhead costs are classified as conversion costs. Marketing costs are the costs that incur to carry out marketing activities of the products. The examples are advertising expense, promotion expense, transportation expense, salaries of employees related with marketing activities, and sample cost. General and administration costs are the costs incurred to coordinate production process and marketing activities. For examples are salaries of employees

4 in finance, accounting, human resource department, auditing expense, and photocopy cost. Cost classification according to the relationship between cost and cost object The costs can be classified into 2 groups that are direct cost and indirect cost. As stated in The CCH Macquarie Dictionary of Accounting (1991:75), Direct cost is those costs which are capable of being identified with or traced to an activity, a product, a sales territory, a department, or any other segment or activity of the accounting entity which is the focus of management attention. The examples of direct costs include costs of raw materials needed to produce the goods. Mulyadi (1993:15) mentioned that direct costs consist of raw materials and direct labor costs. The CCH Macquarie Dictionary of Accounting (1991:122) also revealed that Indirect costs are those costs not directly or economically traceable to an activity, a product, a sales territory, a department or whatever the focus of management s interest is. Cost classification according to cost behavior in the relationship with the change of activities volume The cost can be classified into: Variable cost, semi variable cost, semi fixed cost, and fixed cost. Variable cost is the cost that has changing accumulation in relation with the change in the volume of activities. For example, raw materials cost, direct labor costs. Semi variable cost is the cost that has changing total accumulation not in relation with the change in the volume of activities. Semi

5 variable cost encompasses fixed cost and variable cost. Semi fixed cost is the cost that remain static for some volume of activities and changing with constant amount for some volume of activities. Whereas fixed cost is the cost that has unchanging total accumulation in the volume of activities. For example is production director wages. Cost classification according to the period of the benefit Costs are classified as capital expenditures and revenue expenditures. Capital expenditures are the costs that have benefit for more than one accounting period. These capital expenditures at the time of occurrence are charged as assets cost and charged in the following years when the benefits occur through depreciation, amortization, or depletion. For example, cost to acquire fixed assets, reparation cost for fixed assets, promotion cost and research and development cost. Revenue expenditures are the costs that only have benefit for the period when the costs occur. For example, advertising, telex, and labor cost. Matz and Usry (1976:46-55) also provides us with classifications of costs. Cost classifications are required for the development of cost data that will be useful for management regarding the five purposes or aims described earlier (p.8). Hence, costs are classified: 1. By the nature of the item ( a natural classification) 2. With respect to the accounting period to which they apply 3. By their tendency to vary with volume or activity 4. By their relation to the product 5. By their relation to manufacturing departments

6 6. For planning and control 7. For analytical processes Natural classification of costs To classify the costs and expenses, we can begin with a simple grouping of all manufacturing costs in accordance with the three main elements of cost: materials, labor, and factory overhead. Total operating cost in manufacturing industry can be divided into two groups: (1) manufacturing cost and (2) commercial expenses. Manufacturing cost is the sum of direct materials, direct labor, and factory overhead costs. Part of manufacturing cost which represents work completed, during the accounting period is transferred to Finished Goods Inventory, whereas unfinished work remains in Work in Process. Commercial expenses can be categorized into two large classifications: (1) marketing expenses and (2) administrative (general and administrative) expenses. Marketing expenses start to incur when manufacturing has been completed and the product is ready to be sold. Administrative expenses are the expenses incurred in the direction, control, and administration of the organization. Costs with respect to the Accounting Period to which they Apply Expenses can be divided into two broad groups: (1) capital expenditures and (2) revenue expenditures. A capital expenditure is aimed to earn benefit in the future periods and is classified as an asset, whereas revenue expenditure is intended to benefits current period and is classified as an expense. An expenditure

7 classified initially as an assets when the assets is either consumed or charged off will flow into the expense stream. To properly matching the costs and revenue and to accurately measure periodic income, it is very important to distinct capital and revenue expenditures. The classification of the costs depends on: (1) the management s attitude and action towards these expenditures and (2) the character of the company s operations. In making decision of classification, management is often influenced by the ease and accuracy of costs may allocations among products, departments, territories, or any other desirable divisions. Costs in Their Tendency to vary with Volume or Activity Some costs differ directly according to the changes in the volume of output (production), while others, as they are incurred on the subject of time, stay more or less in fixed amount. Direct materials and direct labor are generally are included as variable costs. Factory overhead and non manufacturing costs have to be examined regarding items of a variable and fixed nature. Without the examination of the tendency to be fixed or variable, it is impossible to budget and control these costs successfully. In general, the characteristics of variable costs are as the following: (1) variability of total amount in proportion to volume directly; (2) comparatively fixed cost per unit in dealing with changing volume; (3) easy and reasonably precise assignments to operating departments; and (4) Their incurrence and consumption are controlled by the responsible department head.

8 On the other hand, fixed costs shows the following characteristics: (1) Within a relevant output range, the amount is fixed; (2) increase in output will result in the decrease of fixed costs per unit; (3) Arbitrary managerial decisions or cost allocations methods often make assignments to departments; and (4) control for incurrence in most cases is the responsibility of executive management rather than operating supervisors. Some factory overhead items are semi variable in nature, comprising both fixed and variable elements. A semivariable expense is often characterized by a unchanging dollar element below which it will not fall, at all related levels of output. Costs in Their Relation to the Product The elements of manufacturing costs include direct materials, direct labor, and factory overhead. Direct materials and direct labor are classified as prime cost. Whereas direct labor and factory overhead are classified as conversion cost, that represent the costs of changing direct materials into finished products. Matz and Usry stated that direct materials are all materials that form an important part of the finished product and that can be included directly in calculating the production cost. Direct labor is labor directly involved upon the materials comprising the finished product. The cost of wages of direct labor can be allocated to the particular unit produced. Whereas factory overhead is the cost of indirect materials, indirect labor, and all other manufacturing costs that cannot easily be charged directly to the products or jobs. Factory overhead costs

9 comprises of all manufacturing costs that are not included in direct materials or direct labor costs. Indirect materials are materials needed for the completion of the product but have a very small or complex consumption in the production and thus, it would be ineffective to be treated as direct materials items. Indirect labor is the labor expended that does not have any effect in the production or in creating the finished product. The examples of indirect labor costs are costs of foremen, cleaners, maintenance or service works that are not directly related to the physical production Costs in Their Relation to Manufacturing Department A factory is usually structured by departmental lines for production purposes. This factory departmentalization is the basis for imperative classifications and subsequent accumulation of costs by departments to attain (1) cost budgeting with responsibility accounting and (2) larger degree of reliable costing. Producing and service departments. The departments of a factory in general classified into two categories: (1) producing departments and (2) service departments. A producing department is one in which manual and machines operations are involved directly in the production process. A service department is one that is not directly engaged in production but provides a particular type of service for the benefit of other departments. The cost incurred in the operation of service departments is a part of the total factory overhead and must be engaged in the cost of the product by determining the factory overhead rate.

10 Departmentalization for Product Costing and Responsibility Accounting. The organization chart separated a business into departments, segments, or functions. Although the divisions is often mainly for administrative functions, departmentalization or segmentation is considerable and imperative for (1) the costing of the products and (2) the control of costs through departmental budgets. Direct and Indirect Departmental Charges. Factory overhead is considered indirect relating to a product or job. Actual factory overhead expenses are incurred and charged to either a producing or a service department. The expense is considered to be a direct departmental charge if it is readily identifiable with the originating department. Expenses, for example rent and depreciation of a building, may be shared within a number of different departments. Cost for Planning and Controlling The data required for the preparation and operation of a budget and for establishing standard costs is provided by company s cost information system. In many companies the estimation of factory overhead can be the initial step in making a budget program. When all phases of a business have been coordinated into a carefully planned budget program, the budget becomes the written expression of management s plan for the future. The budget program involves all members of management in performing the duties of creating a practicable and acceptable plan of action, connects the plan into a uniform unit, communicates to all managerial levels the disparities

11 between planned activity and actual performance, and indicates unfavorable conditions that have to be corrected. Standard costs are the costs that have been determine earlier for direct materials, direct labor, and factory overhead. These costs are recognized by using information gathered from the past knowledge and data secured from research studies. Costs for Analytical Processes Costs as a basis for analysis are anticipated costs that may be incurred in the adoption of any one of several alternative courses of action. Different types of costs entail varying kinds of concerns in managerial analysis in making decisions Definition of Cost Accounting According to Mulyadi (1993: 6), cost accounting is the process of recording, classifying, summarizing, and providing the cost to make and sell products and services, with specific ways, as well as the interpretation towards it. Furthermore, Mulyadi (1993:7) also mentioned that cost accounting is aiming to determine the selling price, to control the costs, and for decision making. Helmi Rony (1990:17) stated that cost accounting is the media that will assist management in determining the production cost, since costs accounting is one if the accounting studies that will describe the methods, procedure and system applied in recording, accumulating, and distributing all of the production costs. Additionally, Matz and Usry (1976:41) affirmed that cost accounting measures cost in accordance with the plans and needs of management. Usry and

12 Hammer, as cited in Sirait Wibowo (1997:51), declared that cost accounting covered a system that is related with accurate recording and measuring of cost components since the costs are arisen and flown in the production cost. Mulyadi provides us with the flow chart of production process and cost accounting. Production process flow Cost accounting flow Purchasing and storing of raw materials Determining the price of raw materials purchased Direct labor cost Determining the price of raw materials used Factory overhead cost Turning raw materials into finished products Accumulation of production costs Storing finished products in the warehouse Determining production cost of finished products Figure 2.1 Flowcharts of Production Process and Cost Accounting Source: Mulyadi (1993:38) 2.4. Production Cost Definition of Production Cost Charles T. Hongren, as translated by Endah Susilaningtyas (1994:51) defined product cots as the accumulation of costs that are

13 allocated to product for specific reasons. Usry and Hammer, as cited by Sirait and Wibowo (1997:52), provided the flow of production cost. Cash Assets that can be depreciated Debt Accrual Paid for Materials purchased Stored in Stock of materials Paid for Used for Other production costs: Direct labor Factory overhead Indirect labor Indirect materials Heat Electricity Power source Insurance Depreciation Cost of finished goods Sent to Work in process inventory: Direct materials Direct labor Factory overhead Stock of finished goods To Total cost of product Figure 2.2 Flow of Production Cost

14 Source: Sirait and Wibowo (1997:52) The Essentials of Production Cost PAI, as cited in Helmi Rony (1990:17), pointed out that production cost can be categorized into: a. Direct Materials Cost Production cost can be mentioned as direct materials cost when the material is integral part, can be seen and measure clearly, and easily tracked physically, as well as, nominally, in the form of products generated. b. Direct Labor Cost Production cost can be called direct labor cost when the cost as the result of paying the salaries of workers that are directly involved in the production of finished products. This kind of cost can be trailed since the cost can be measured c. Factory Overhead Cost Factory overhead costs are the costs that are not categorized as direct material costs or direct labor cost. Additionally, according to Hongren, Datar, and Foster (2003:39), factory overhead costs are

15 All manufacturing costs that are related to the cost object (work in process and then finished goods) but that cannot be traced to that cost object in an economically feasible way. Helmi Rony (1990: 20), pointed out that to determine factory overhead cost, we have to choose the cost allocation basis. Some of the base alternatives are estimated direct labor working hours, estimated direct labor cost, estimated machine working hours, and estimated direct materials cost for next year in normal capacity. a. Cost allocation based on direct labor working hours Predetermined overhead rate = Budgeted factory overhead cost Estimated direct labor working hours b. Cost allocation based on direct labor cost Predetermined overhead rate = Budgeted factory overhead cost Estimated direct labor cost c. Cost allocation based on machine working hours Predetermined overhead rate = Budgeted factory overhead cost Estimated machine working hours d. Cost allocation based on direct materials cost Predetermined overhead rate = Budgeted factory overhead cost Estimated direct materials cost 2.5. Cost Accumulation Methods

16 According to Helmi Rony (1990:45), we should pay attention to the production cost per unit. This is important to as the managers requires to: 1. Determine the stock value in the balance sheet that is how much the value of the stocks that have not been sold in this period and will become the beginning value of the subsequent period. 2. Determine the Cost of Good Sold (COGS) in this period for the purpose of calculating the profit. If the calculation of production cost per unit is not accurate, then the calculation of profit and COGS will be incorrect as well. 3. Assist management in facing certain situations. Without the information regarding the production cost per unit, management will face problems in determining the selling price, deciding whether to increase or decrease production, whether to make their own materials or buy from others, etc Job order costing Matz and Usry (1976) mentioned that there are 2 cost accumulation procedures: job order costing and process costing method. The job order cost procedures maintains the costs of a variety of jobs or contracts separate throughout their production or construction. In job order costing, each job is an accounting unit to which materials, labor, and factory overhead costs are allocated by means of job order numbers. The cost producing the order for a specified customer is recorded on a summary sheet named a job order cost sheet, or simply a cost sheet. This

17 master sheet is made to accumulate the cost of materials, labor, and factory overhead that are related to a specific job. As stated by Mulyadi (1993:40), the characteristics of company that use full costing method are: 1. Production process is not continuously takes place. It means that when an order has been fulfilled, the production will be discontinued. Then the production will start with the new order. 2. The products are in accordance with the specifications ordered by the customers. Therefore the orders may be different one another. 3. The purpose of production is to fulfill the orders instead of maintaining the stock. Moreover, Mulyadi (1993: 41) also provides us with the characteristics of the full costing method: 1. The diversity of products produced by the company is consistent with customers specifications and the production cost of each kind of product needs to be calculated separately. 2. The production costs have to be classified, according to the relationship with the product, into two categories: direct and indirect production costs.

18 3. Direct production cost consists of ram materials cost, and direct labor costs, whereas indirect production cost is named factory overhead costs 4. Direct production costs is included as the total production costs of an order according to the actual costs incurred in the production, while factory overhead cost is included in the production cost based on the tariff that has been settled from the beginning. 5. Production cost per unit is calculated when the order has been produced completely by divided the total production costs sacrificed by the total unit of product generated in an order. In companies that use the full costing method in the accumulation procedures, the production cost information is useful for the management to: 1. Determine the selling price of the products 2. As a consideration whether to accept or reject an order 3. To monitor the production costs 4. To calculate the profit and loss of each order 5. To determine the cost of finished goods and work in process inventory available in the balance sheet As stated by Layne (1984: 58-59), when the production order is begin to be processed, a job sheet that is identified by job order number is prepared by cost accounting department upon announcement from the

19 production department. The production order indicates that the order has been received from customers and agreed by the firm regarding the quantities, price, and shipment date. Moreover, Layne (1984: 59) mentioned that the production activity begins with the transfer direct materials from the warehouse to the production line. As the materials are issued, the cost accounting departments will records an entry on the job cost sheet and therefore charging specific job in process. In recording the labor costs, the labor hours are accumulated from the time tickets. The manufacturing overhead figure includes a combination of unlike items. Because the actual overhead costs of the company cannot be obtained until after an accounting period is over, the overhead cost will be an estimated measure. To allocate the overhead cost to the job cost sheet, we have to determine the predetermined overhead rate that is multiplied by the base activity for the job. Then the total amount is entered to the job cost sheet. Layne also provides us with the flow documents and general model of cost flows in a job order costing system. Material Requisition Form Sales order Production order Direct Labor time ticket Job cost sheet

20 Predetermined overhead rate Figure 2.3 Flows of Documents in a Job Order Costing System Source: Layne (1984: 59) Raw materials Work in process Finished goods Issue of Materials materials Wages Payable Payment of Incurral of Cost of good sold Labour labour cost Incurral of factory Overhead cost Manufacturing overhead Overhead applied Under applied Over applied Figure 2.4 General Model of Cost Flows in Job Order Costing System Source: Layne (1984:60) In the full costing method, the existence of job order cost sheet is important. This sheet is used to gather the production costs in each order. The production costs used to fulfill an order is documented in the related job order cost sheet. The following is the example of job order cost sheet:

21 Table 2.1 Example of Job Order Cost Sheet PT. ABC Customer : Mr. Abu Bakar Order no. : 1001 Product ordered : Chair Date of order : Model, Size, Color : L, 2 meters, grey Date of prouction begin : Amount 1 pair Date of production completed : Date of order received : Factory Overhead cost 110% of direct labor Direct Raw materials Direct Labor Date Type Size Amount Value Date Working hours Amount Date Amount 2- Mar Wood 25x Mar 2 x 4 = Sep 100% x = 2- Apr Board 25x4x Apr 3 x 4 = May Cloth - 50 m May 2 x 5 = Jul Glass 60x90 1 piece Jun 3 x 4 = Jul 2 x 5 = Aug 2 x 4 = Sep 2 x 3 = Total Selling price Raw Materials : Production cost : Direct Labor : Marketing cost : Factory overhead : Administration cost : Total Source: Helmi Rony (1990:47) Profit

22 Firdaus A. Dunia (1994:57) said that to simplify the record and allocation of direct materials, direct labor, and overhead costs, each job order cost sheet have to be numbered. The source document related to the sheet, such as material requisition form, time cards, etc., have to be numbered as well. With this identification, direct materials and direct labor costs can be directly documented in the related job order cost sheet. The overhead cost can be recorded and allocated based on predetermined tariff. Firdaus A. Dunia also mentioned that the form and content of job order cost sheet is different between one type of business and another Evaluation of Job Order Costing Layne (1984: 64) posted some advantages and disadvantages of job order costing method. The main advantage of job order costing system is that it accumulates cost data in a manner that is useful to the administration of the business. A cost system has to provide relevant cost data in a timely manner, that is as soon as the expenditures are incurred, and in a usable form. However, the cost to obtain the information must not exceed the benefit that will be got. In the industry that is suitable for job order costing system, job costing should enable the management to detect which job that is profitable and which job that is not profitable. Furthermore, job costing should also facilitate the management in controlling the operation and to prevent any possible fraud.

23 However, job order costing system has several disadvantages. The disadvantage is that it is expensive to operate because it involves lots of clerical work.. The other disadvantage is that it involves production employees in clerical work and it may affect the productivity of the workers Process Costing Matz and Usry (1976:120) stated the characteristics of process costing are as the following: (1) A cost of production report is used to collect, summarize, and compute total and unit costs.(2) Costs are charged to departmental work in process accounts. (3) Production is accumulated and reported by departments. (4) Production in process at the end of a period is restated in terms of completed units. (5) Total cost charged to a department is divided by total computed production of the department to determine an average cost for a specific period. (6) A cost for lost or spoiled units is computed and added to the cost of satisfactory units completes. (7) Costs of completed units of a department are transferred to the next processing department in order to arrive eventually at the total costs of the finished products during a period. Mulyadi (1993: 69) mentioned that the characteristics of process costing method are as the following: 1. The product generated is the standard products 2. The product generated from month to month is similar

24 3. The production process is started with the issuance of production plan for the specific period. Mulyadi (1993:70) pointed out that the difference between job costing and process costing method are: 1. The method in accumulating the production costs 2. The calculation of production cost for each unit 3. The classification of production cost 4. The component of costs that are classified as the factory overhead cost The method in accumulating production cost Job order costing method accumulates the production costs based on the order, whereas process costing method accumulate production costs per production department per accounting period. The calculation of production costs for each unit Job order costing method computed the production cost for each unit by dividing the total cost sacrificed to an order by the number of products generated in relation to the order. This calculation is done when the products ordered are finished. Process costing method calculates the production cost per unit by dividing total production cost in specific period with the number of production unit produced. This calculation is done at the end of the period (usually at the end of month). The classification of production cost

25 In job order costing method, production costs have to be separated to direct production cost and indirect production cost. Direct production cost is allocated to the product based on the actual cost occurred, whereas indirect production cost are allocated to the product based on tariff determined from the beginning. In the process costing method, the difference in direct and indirect production cost is usually not needed, especially when the company is only produced one type of product. The component of costs that are classified as factory overhead cost In job order costing method, factory overhead cost consist of cost of materials, indirect labor cost, and other production costs that is not categorized as direct material costs and direct labor cost. In this method, factory overhead is allocated to product based on tariff that has been determined from the beginning. In process costing method, factory overhead cost consists of production cost other than raw material cost and supporting material cost and labor cost ( direct and indirect). In process costing method, factory overhead cost is allocated to the products based on the actual cost happen in the specific accounting period Pricing Decisions The definition of pricing decisions stated by Hongren, Datar,and Foster (2003:410) are Management decisions about what to charge for products and services. These are strategic decisions affecting the quantity

26 produced and sold, and, therefore, revenues and costs. To maximize operating income, companies should produce and sell units so long as the revenue from an additional unit exceeds the cost of producing it. Furthermore Hongren, Datar,and Foster (2003:410) also revealed three main factors that influence the determination of selling price : consumers, competitors, and costs. Consumer. Managers always have to verify the selling price decision through customers point of view. The sudden increase in selling price will cause consumers to reject the company s products and will choose similar products from the competitors. The rise in price will cause the consumers to choose alternative products that meet the specifications of customers with more effective cost. Competitor. The reaction of competitor influences the determination of selling price. Extremely, intense competitors force businesses to lower the price to remain competitive. Businesses with knowledge of technology, competitors, factory capacity, and operational policy can estimate competitors price that is one of important information in determining competitive price. Cost. Cost influence prices since cost have effect on supplies. If the production cost is lower than the price customers willing to pay, then there will be greater quantity of product suppliers willing to supply. Therefore, managers who understand the production cost set prices that make the customers attracted while maximizing company s operating income.