Part 1 Study Unit 4. Cost Management Concepts Patricia Burnett, CMA Ronald Schmidt, CMA, CFM

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1 Part 1 Study Unit 4 Cost Management Concepts Patricia Burnett, CMA Ronald Schmidt, CMA, CFM 1

2 Remember most common reasons for missing questions! 1. Misreading the requirement (stem) Read the question first 2. Not understanding what is required 3. Making a math error Try to not do calculations of paper first, with the idea of transferring to the exam later. If you know how to use your memory button(s) well on your calculator, use it (i.e. save subcalculations in your calculator). 4. Applying the wrong rule or concept 5. Being distracted by one or more of the answers the most common wrong answers are the incorrect alternatives 6. Incorrectly eliminating answers from considerations read all answers first, some are more correct or complete then others 7. Not having any knowledge of the topic tested don t agonize over it. If possible try to make an educated guess by eliminating obvious wrong answers. If you guess, use the same letter each time. 8. Employing bad intuition when guessing 2

3 Required Cognitive Skills Knowledge: Ability to remember previously learned material such as specific facts, criteria, techniques, principles, and procedures (identify, define). Comprehension: Ability to grasp and interpret the menaing of material (classify, explain, distinguish). Application: Ability to break down material into its component parts so that its organizational structure can be understood (differentiate, estimate, order). Synthesis: Ability to put parts together to form a new whole or proposed set of operations; ability to relate ideas and formulate hypothesis (combine, formulate, revise). Evaluation: Ability to judge the value of material for a given purpose on the basis of consistency, logical accuracy, and comparison to standards (criticize, justify, conclude). 3

4 4.1 Cost Management Terminology Financial Accounting Reporting to external users Financial statements Historical focus Management Accounting Reporting to internal users Improve organizational decision making Future focus Cost Accounting Supports both financial and management accounting Information about the cost of resources acquired and consumed by an organization underlies effective reporting for both internal and external users. 4

5 4.1 Cost Management Terminology IMA Definition of Cost Management Accounting: Measurement in monetary terms of the amount of resources used for some purpose. The term by itself is not operational. It becomes operational when modified by a term that defines the purpose, such as acquisition cost, incremental cost, or fixed cost. 5

6 4.1 Cost Management Terminology Cost Object Entity to which costs can be attached Examples: Products Processes Employees Departments Facilities 6

7 4.1 Cost Management Terminology Manufacturing v. Nonmanufacturing Direct materials Direct labor Manufacturing overhead Indirect materials Tangible inputs unable to trace Indirect labor Labor that cannot be traced Factory operating costs Utilities, real estate taxes, insurance, depreciation 7

8 4.1 Cost Management Terminology Manufacturing Costs Prime cost Direct materials + direct labor Costs attributable to the product Conversion cost Direct labor + manufacturing overhead Costs of converting raw materials into finished product 8

9 4.1 Cost Management Terminology Nonmanufacturing Costs Selling (Marketing) expenses How much to get the product to the consumer Sales Personnel Salaries Expensive dinners Fancy sporting events Morale boosting trips to exotic locations Product Transportation Administrative Expenses Other costs not related to producing or marketing the product Adrien s salary Adrien s expensive dinners Fancy sporting events for Adrien to attend Trips to exotic locations to boost Adrien s morale 9

10 4.1 Cost Management Terminology Product v. Period To capitalize or to expense? Product Costs Capitalized as part of finished goods inventory. Become component of cost of goods sold Period Costs Expensed as incurred Not capitalized and excluded from cost of goods sold 10

11 4.1 Cost Management Terminology Distinction between product costs and period costs important for external reporting purposes. GAAP All manufacturing costs must be treated as product costs, and all selling and administrative costs must be treated as period costs. ABSORPTION COSTING Internal Reporting Capitalize only variable manufacturing costs as product costs, treat all other costs (variable S&A and the fixed portion of both production and S&A expenses) as period costs. VARIABLE COSTING 11

12 4.1 Cost Management Terminology Direct Costs - Can be TRACED Direct materials Direct Labor Indirect Costs - Cannot be associated with a particular cost objective Indirect materials Indirect labor 12

13 4.1 Cost Management Terminology Indirect costs collected in cost pools Cost Pool Account where similar cost elements are accumulated Example - Manufacturing Overhead 13

14 4.1 Cost Management Terminology Common Costs Indirect cost Shared by two or more users Rationally allocated Examples: Depreciation for HQ building Allocated amongst departments 14

15 4.1 Cost Management Terminology Practice Question 1 A firm calculates that its annual cost to hold excess goods in order to avoid any chance of running out of inventory is $50,000. This $50,000 is an example of a A B C D Prime cost. Quality cost. Carrying cost. Stockout cost. 15

16 4.1 Cost Management Terminology Practice Question 1 Answer Correct Answer: C The costs of holding or storing inventory are carrying costs. Examples include the costs of capital, insurance, warehousing, breakage, and obsolescence. 16

17 4.1 Cost Management Terminology Practice Question 2 Roberta Johnson is the manager of Sleep-Well Inn, one of a chain of motels located throughout the U.S. An example of an operating cost at Sleep-Well that is both direct and fixed is A B C D Johnson s salary. Water. Toilet tissue. Advertising for the Sleep-Well Inn chain. 17

18 4.1 Cost Management Terminology Practice Question 2 Answer Correct Answer: A Direct costs are ones that can be associated with a particular cost object in an economically feasible way, that is, they can be traced to that object. Fixed costs are those that remain unchanged in total over the relevant range of production. A motel manager s salary is traceable to the single location she manages, and it remains fixed over a set period of time regardless of the number of guests. 18

19 4.1 Cost Management Terminology Practice Question 3 Finley Painters Co., a painting contractor, maintains a job-order cost system. Job costs are accumulated by tracking the actual cost of paint and other materials used on each job, as well as the actual cost of wages earned by the painters on each job. In addition, overhead is applied to each job by using a predetermined rate based on the actual painters wages. Leonard Wayne, painter, earned $168 today by working on Job In computing prime cost and conversion cost for Job 08-45, how would the wages earned today by Wayne be classified? A B C D As a component of both prime and conversion cost. As a component of prime cost but not as a component of conversion cost. As a component of conversion cost but not as a component of prime cost. As a component of neither prime cost nor conversion cost. 19

20 4.1 Cost Management Terminology Practice Question 3 Answer Correct Answer: A Manufacturing costs are often grouped into the following classifications: prime cost, which equals direct materials plus direct labor (i.e., those costs directly attributable to a product), and conversion cost, which equals direct labor plus manufacturing overhead (i.e., the costs of converting raw materials into the finished product). The wages earned by a painter working for a painting contractor are thus properly classified as both a prime cost and a conversion cost. 20

21 4.1 Cost Management Terminology Practice Question 4 Conversion cost pricing A B C D Places minimal emphasis on the cost of materials used in manufacturing a product. Could be used when the customer furnishes the material used in manufacturing a product. Places heavy emphasis on indirect costs and disregards consideration of direct costs. Places heavy emphasis on direct costs and disregards consideration of indirect costs. 21

22 4.1 Cost Management Terminology Practice Question 4 Answer Correct Answer: B Conversion costs consist of direct labor and factory overhead, the costs of converting raw materials into finished goods. Normally, a company does not consider only conversion costs in making pricing decisions, but if the customer were to furnish the raw materials, conversion cost pricing would be appropriate. 22

23 4.2 Cost Behavior and Relevant Range Relevant Range Limits within which per-unit variable cost remain constant and fixed cost are not changeable. In the short-run (All costs are considered variable in the long-run) The efficiency of a company s current manufacturing plant Cost behavior and estimates are valid only within a relevant range, or the normal level of operating activity. Beyond the relevant range, cost relationships are likely to change, and with them, cost estimates. Ask yourself How wide is the relevant range of activity? When does the company leave one relevant range and enter another one with a different cost function? The answer is company specific, and greatly affects the cost estimates used in decision making. 23

24 4.2 Cost Behavior and Relevant Range Types of Costs and their characteristics Variable cost Total cost varies in proportion to changes in the level of activity The cost per unit remains constant, regardless of the level of activity 24

25 Exhibit 1 - Variable Cost 25

26 4.2 Cost Behavior and Relevant Range Types of Costs and their characteristics Fixed cost Total cost remains fixed, regardless of changes in the level of activity. The cost per unit varies inversely with changes in the level of activity. 26

27 Exhibit 2 Fixed Cost 27

28 4.2 Cost Behavior and Relevant Range Types of Costs and their characteristics Mixed or semivariable cost Have both a fixed and variable component. Both the total cost and unit cost will vary changes in the level of activity. Two methods of estimating mixed: Regression or scattergraph method more complex, usually applied using computers and not tested on the exam. High-low method less accurate, but quicker. Cost at highest activity level Cost at lowest activity level Driver at highest activity level Driver at lowest activity level What is a driver? Machine Hours for examples 28

29 High Month: May Low Month: July Exhibit 3 - Mixed Cost High-Low Method Example (p. 138) Numerator: $3,400 -$1,900 = $1,500 Denominator: 1, = 800 hours Variable Costs: $1,500 / 800 = $1.875 per hour Fixed Costs: $1,900 (800 x $1.875) = $400 29

30 Exhibit 3 - Mixed Cost 30

31 4.2 Cost Behavior and Relevant Range Types of Costs and their characteristics (continued) Four of the five cost are linear-costs which change at a constant rate (or remain unchanged) over the short run Fixed cost per unit is an example of a nonlinear-cost function. Another type of nonlinear-cost is a step-cost function. Step cost Total cost remain constant over the. Unit cost decrease a usage within the step range. 31

32 Exhibit 4 Step Cost 32

33 4.2 Cost Behavior and Relevant Range Types of Costs and their characteristics (continued) Linear vs. Nonlinear Cost Functions Fixed cost per unit and step cost have non-linear-cost functions Fixed costs Has asymptotic (linear asymptote is not parallel to the x- or y-axis, it is called an oblique asymptote or slant asymptote ) character it will never intersect the X-axis. Step cost if steps are relatively narrow, cost are usually treated as variable, but if steps are wide they more similar to fixed costs. 33

34 Question #1 The difference between variable costs and fixed costs is? 1. Variable costs per unit fluctuate and fixed costs per unit remain constant. 2. Variable costs per unit are fixed over the relevant range and fixed costs per unit are variable. 3. Total variable costs are variable over the relevant range and fixed in the long term, while fixed costs never change. 4. Variable costs per unit change in varying increments, while fixed costs per unit change in equal increments. 34

35 Question #2 The difference between the sales price and total variable costs is? 1. Net profit. 2. The breakeven point. 3. The contribution margin. 4. Gross operating profit. 35

36 Question #3 Ace, Inc. estimates its total materials handling costs at two production levels as follows: Cost Gallons $160,000 80,000 $132,000 60,000 What is the estimated total cost for handling 75,000 gallons? (Hint: High/Low Method) 36

37 Question #3 (continued) 1. Numerator: $160k -$132k = $28k 2. Denominator: 80k gallons 60k gallons = 20k 3. Variable Costs: $28k / 20k gallons = $1.40 per gallon 4. Fixed Costs = Total Cost Variable Portion $160k (80k x $1.40) = $48k 5. $48k + (75k x $1.40) = $153,000 37

38 4.2 Cost Behavior and Relevant Range Types of Costs and their characteristics (continued) Relevant Range and Marginal Cost (MC) Marginal cost is the cost incurred by a one-unit increase in the activity level of a particular cost driver. Similar to variable cost in the relevant range it stays constant across the relevant range. 38

39 4.2 Cost Behavior and Relevant Range Practice Question 1 Which one of the following categories of cost is most likely not considered a component of fixed factory overhead? A. Rent. B. Property taxes. C. Depreciation. D. Power. 39

40 4.2 Cost Behavior and Relevant Range Practice Question 1 Answer Correct Answer: D A fixed cost is one that remains unchanged within the relevant range for a given period despite fluctuations in activity. Such items as rent, property taxes, depreciation, and supervisory salaries are normally fixed costs because they do not vary with changes in production. Power costs, however, are at least partially variable because they increase as usage increases. Incorrect Answers: A: Rent is an example of fixed factory overhead. B: Property taxes are an example of fixed factory overhead. C: Depreciation is an example of fixed factory overhead. 40

41 4.2 Cost Behavior and Relevant Range Practice Question 2 CMA StudyUnit 4.2: Ethics for Management Accountants and Cost Management Concepts Taylor Company is determining the cost behavior of several items in order to budget for the upcoming year. Past trends have indicated the following dollars were spent at three different levels of output: Unit Levels 10,000 12,000 15,000 Cost A $25,000 $29,000 $35,000 Cost B 10,000 15,000 15,000 Cost C 15,000 18,000 22,500 In establishing a budget for 14,000 units, Taylor should treat Costs A, B, and C, respectively, as A B C D Semivariable, fixed, and variable. Variable, fixed, and variable. Semivariable, semivariable, and semivariable. Variable, semivariable, and semivariable. 41

42 4.2 Cost Behavior and Relevant Range Practice Question 2 Answer Correct Answer: A To properly understand the nature of a cost, its behavior in total and on a per-unit basis can be examined. Dividing the total costs incurred by the activity levels yields the following per-unit results: 10,000 12,000 15,000 Cost A $2.50 $2.42 $2.33 Cost B Cost C Cost A increases disproportionately across the relevant range in total and decreases proportionately on a per-unit basis; A is thus a semivariable cost. Cost C increases steadily across the relevant range in total but remains constant on a per-unit basis; C is thus a variable cost. 42

43 4.2 Cost Behavior and Relevant Range Practice Question 3 Cell Company has discovered that the cost of processing customer invoices is strictly variable within the relevant range. Which one of the following statements concerning the cost of processing customer invoices is incorrect? A B The total cost of processing customer invoices will increase as the volume of customer invoices increases. The cost per unit for processing customer invoices will decline as the volume of customer invoices increases. C D The cost of processing the 100th customer invoice will be the same as the cost of processing the first customer invoice. The average cost per unit for processing a customer invoice will equal the incremental cost of processing one more customer invoice. 43

44 4.2 Cost Behavior and Relevant Range Practice Question 3 Answer Correct Answer: B Variable cost per unit remains constant in the short run regardless of the level of production. 44

45 4.2 Cost Behavior and Relevant Range Practice Question 4 Answer CMA StudyUnit 4.2: Ethics for Management Accountants and Cost Management Concepts Ace, Inc., estimates its total materials handling costs at two production levels as follows: Cost Gallons $160,000 80,000 $132,000 60,000 What is the estimated total cost for handling 75,000 gallons? A $146,000 B $150,000 C $153,000 D $165,000 45

46 4.2 Cost Behavior and Relevant Range Practice Question 4 Answer Correct Answer: C The high-low method can be applied to calculate the two portions of a mixed cost. The numerator is the difference between the cost at the highest level of activity and the cost at the lowest level ($160,000 $132,000 = $28,000). The denominator is the difference between the highest level of activity from the lowest level (80,000 60,000 = 20,000). The variable portion of the total mixed cost is derived by dividing these two figures ($28,000 20,000 = $1.40 per gallon). The fixed portion can be calculated by inserting the appropriate values for either the high or low level as follows: Total cost Variable Fixed portion = portion $160,000 (80,000 = $1.40) = $160,000 $112,000 = $48,000 The total handling cost for a production level of 75,000 can now be determined: $48,000 + (75,000 $1.40) = $153,

47 Cost of Goods Calculations Cost of Goods Sold Beginning Balance + Purchases (Costs added during the period) = available Ending = Used Or Beginning Balance + Purchases (Costs added during the period) - Costs removed during the period = Ending balance Straight forward for a retailer but more complex for a manufacturers since they have three distinct classes of inventory: Raw material Work in Process Inventory Finished Goods Inventory 47

48 Exhibit 5 Mfg. Cost flow 48

49 Cost of Goods Calculations ****See handout on Mfg. Cost of goods calculation**** Remember: Total manufacturing cost are calculated on a separate statement called a cost of Goods Manufacturing Statement (or Manufacturing Statement, which compiles three major elements of manufacturing costs: New Material Direct Labor Factory overhead Calculations through cost of goods manufactured are found on the Manufacturing Statement. The total and the remainder are found on the income statement. 49

50 Cost of Goods Calculations Example Madtack Company s beginning and ending inventories for the month of November are Production data for the month of November follows: 1-Nov 30-Nov Direct labor $200,000 Actual factory overhead 132,000 Direct materials Work-inprocess Finished goods $67,000 $62,000 Direct materials purchased 163, , ,000 Transportation in 4,000 85,000 78,000 Purchase returns and allowances 2,000 Madtack uses one overhead control account and charges overhead to production at 70% of direct labor cost. The company does not formally recognize overor underapplied overhead until year end. 50

51 Cost of Goods Calculations Example Madtack Company s prime cost for November is Madtack Company s prime cost for November is A. $370,000 B. $168,000 C. $363,000 D. $170,000 51

52 Cost of Goods Calculations Example Correct Answer: A Prime costs are the combined costs of direct materials and direct labor. Beginning materials inventory $67,000 Add: purchases 163,000 Add: transportation in 4,000 Less: purchase returns -2,000 Materials available $232,000 Less: ending materials inventory -62,000 Materials used in production $170,000 Direct materials $170,000 Direct labor 200,000 Total prime costs $370,000 52

53 Cost of Goods Calculations Example Madtack Company s cost of goods sold for November is A. $484,000 B. $491,000 C. $502,000 D. $476,000 53

54 Cost of Goods Calculations Example Total manufacturing costs $510,000 Add: beginning work-in-process 145,000 Less: ending work-in-process -171,000 Costs transferred to finished goods $484,000 Beginning finished goods inventory $85,000 Add: cost of goods manufactured 484,000 Goods available for sale $569,000 Less: ending finished goods inventory -78,000 Cost of goods sold $491,000 54

55 Cost of Goods Calculations Example Madtack Company s total manufacturing cost for November is A. $370,000 B. $510,000 C. $502,000 D. $476,000 55

56 Cost of Goods Calculations Example Correct Answer: B This solution requires a series of computations. Total manufacturing cost is the sum of direct materials cost, direct labor cost, and manufacturing overhead. Beginning materials $67,000 Add: purchases 163,000 Add: transportation in 4,000 Less: purchase returns -2,000 Materials available $232,000 Less: ending materials -62,000 Materials used in production $170,000 Direct materials $170,000 Direct labor 200,000 Manufacturing overhead (DL 70%) 140, Total manufacturing costs $510,000

57 4.3 Cost Classifications Controllable VS. Noncontrollable Avoidable Vs. Committed Incremental vs. Differential Engineered s. Discretionary Outlays vs. Opportunity Relevant vs. Sunk 57

58 4.3 Cost Classifications Joined vs. Separable Normal vs. Abnormal Spoilage Rework, Scrap, and Waste Other Carrying costs Transferred-in costs Value-adding costs Manufacturing Capacity Normal capacity Practical capacity Theoretical (ideal) capacity 58

59 4.3 Cost Classifications Practice Question 1 In joint-product costing and analysis, which one of the following costs is relevant when deciding the point at which a product should be sold to maximize profits? A. Separable costs after the split-off point. B. Joint costs to the split-off point. C. Sales salaries for the period when the units were produced. D. Purchase costs of the materials required for the joint products. 59

60 Correct Answer: A 4.3 Cost Classifications Practice Question 1 Answer Joint products are created from processing a common input. Joint costs are incurred prior to the split-off point and cannot be identified with a particular joint product. As a result, joint costs are irrelevant to the timing of sale. However, separable costs incurred after the split-off point are relevant because, if incremental revenues exceed the separable costs, products should be processed further, not sold at the split-off point. Incorrect Answers: B: Joint costs have no effect on the decision as to when to sell a product. C: Sales salaries for the production period do not affect the decision. D: Purchase costs are joint costs. 60

61 4.3 Cost Classifications Practice Question 2 A company produces stereo speakers for automobile manufacturers. The automobile manufacturers reject approximately 3% of the stereo speakers received as being of unacceptable quality. The company inspects the rejected speakers to determine which ones should be reworked and which ones should be discarded. The discarded speakers are classified as A. Waste. B. Scrap. C. Spoilage. D. Rework costs. 61

62 Correct Answer: C 4.3 Cost Classifications Practice Question 2 Answer Rejected units that are discarded are classified as spoilage. Spoilage is separated into abnormal or normal spoilage. Normal spoilage is an inherent result of the normal production process. Abnormal spoilage is spoilage that is not expected to occur under normal, efficient operating conditions. Incorrect Answers: A: Waste is input material that is either lost in the production process or has no sales value. B: Scrap is input material that has a relatively minor sales value at the end of the production process. D: Rework costs are incurred to make unacceptable units appropriate for sale or use. 62

63 4.4 Costing Techniques Absorption vs. Variable Costing Need to understand: Under absorption costing, which costs are considered product costs and which are considered period costs? Under variable costing, which costs are considered products and which are considered period costs? When is income under variable costing higher than income under absorption costing? What formula can be used to calculate the difference between income under variable costing and income under absorption costing? What managerial behavior does variable costing render ineffective? 63

64 4.4 Costing Techniques Absorption vs. Variable Costing (continued) Absorption costing Also called full costing treats all manufacturing costs as product costs. Inventoried cost of the product thus includes all prodcution costs, fixed and variable. Required by GAAP. Gross Margin (gross profit) = Sales revenue and absorption cost of COGS, and covers S, G & A. 64

65 4.4 Costing Techniques Absorption vs. Variable Costing (continued) Variable costing Also called direct costing considers only variable manufacturing cost as product cost. Fixed cost are period costs and expensed as incurred. Simple and easy to calculate. First consideration in determining whether product should be manufactured (does it cover variable production costs). Contribution margin = net sales revenue minus all variable costs (mfg. & S, G & A). Contributions toward covering fixed costs. 65

66 4.4 Costing Techniques Practice Question 1 Which one of the following considers the impact of fixed overhead costs? A. Full absorption costing. B. Marginal costing. C. Direct costing. D. Variable costing. 66

67 Correct Answer: A 4.4 Costing Techniques Practice Question 1 Answer Full absorption costing treats fixed factory overhead costs as product costs. Thus, inventory and cost of goods sold include (absorb) fixed factory overhead. Incorrect Answers: B: Marginal costing considers only the incremental costs of producing an additional unit of product. In most cases marginal costs are variable costs. C: Direct (variable) costing treats only variable costs as product costs. D: Direct (variable) costing treats only variable costs as product costs. 67

68 4.4 Costing Techniques Practice Question 2 A standard costing system is most often used by a firm in conjunction with A. Management by objectives. B. Target (hurdle) rates of return. C. Participative management programs. D. Flexible budgets. 68

69 Correct Answer: D 4.4 Costing Techniques Practice Question 2 Answer A standard cost is an estimate of what a cost should be under normal operating conditions based on accounting and engineering studies. Comparing actual and standard costs permits an evaluation of the effectiveness of managerial performance. Because of the impact of fixed costs in most businesses, a standard costing system is usually not effective unless the company also has a flexible budgeting system. Flexible budgeting uses standard costs to prepare budgets for multiple activity levels. 69

70 4.4 Costing Techniques Practice Question 3 Which method of inventory costing treats direct manufacturing costs and manufacturing overhead costs, both variable and fixed, as inventoriable costs? A B C D Direct costing. Variable costing. Absorption costing. Conversion costing. 70

71 Correct Answer: C 4.4 Costing Techniques Practice Question 3 Answer Absorption (full) costing considers all manufacturing costs to be inventoriable as product costs. These costs include variable and fixed manufacturing costs, whether direct or indirect. The alternative to absorption is known as variable (direct) costing. 71

72 4.4 Costing Techniques Practice Question 4 CMA StudyUnit 4.4: Ethics for Management Accountants and Cost Management Concepts A difference between standard costs used for cost control and budgeted costs A Can exist because standard costs must be determined after the budget is completed. B C D Can exist because standard costs represent what costs should be, whereas budgeted costs represent expected actual costs. Can exist because budgeted costs are historical costs, whereas standard costs are based on engineering studies. Cannot exist because they should be the same amounts. 72

73 Correct Answer: B 4.4 Costing Techniques Practice Question 4 Answer Standard costs are predetermined, attainable unit costs. Standard cost systems isolate deviations (variances) of actual from expected costs. One advantage of standard costs is that they facilitate flexible budgeting. Accordingly, standard and budgeted costs should not differ when standards are currently attainable. However, in practice, budgeted (estimated actual) costs may differ from standard costs when operating conditions are not expected to reflect those anticipated when the standards were developed. 73

74 What to do next If you have not read the material for Study Unit 1, do so this Sunday. Make sure you complete the two multiple choice quizzes. Identify anything that you don t understand and it to Ron. Read Study Unit 2 and complete both multiple choice quizzes for next week. 74

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