6Introduction To Cost Accounting  15.501/516      Accounting Spring 2004 Professor S. Roychowdhury Sloan School of Management Massachusetts Institute of Technology April 28, 2004 7 Outline ¾ ¾¾¾¾Overview of managerial accounting issues Brief discussion of performance evaluation Cost accounting terminology Cost behavior Product costing: traditional method Product costing: activity based costing (ABC) 8 ) Costing Cost Centers Mix or Buy Managerial Accounting What are the Goals? Performance Evaluation (ControlBudgeting Variance Analysis Profit and Decision Making Pricing Production Product Make Change Methods Discontinue Financial Reporting Page 1A few words about Performance Evaluation ¾“You get what you pay for” ¾Strongly recommended reading: “On the folly of rewarding A, while hoping for B”  Doctors and litigation – penalty for type II errors.  Where else is this evident? Auditors  Litigation risk induced conservatism  Insurance company – reward for attendance but hoping for performance.  Financial markets – focus on quarterly earnings while hoping for long-term growth in profitability 9 10 Basic Cost Terms: Cost ¾ ¾ Cost Driver ¾ $ Cost Objects and Drivers A sacrifice of resources. Distinguish from “expense.” Cost Object Any activity or item for which a separate measurement of costs is desired. Any factor whose change “causes” a change in the total cost of a related cost object. Note: Cost drivers can be factors other than volume Cost Driver e.g. Processing Sales Order Cost Object e.g., Product 11 Basic Cost Terms: ¾ (¾ ¾ j¾ jObjX ObjY Direct and Indirect Costs Direct Costs Costs that can be traced to a given cost object product, department, etc.) in an economically feasible way. Indirect Costs Costs that cannot be traced to a given cost object in an economically feasible way. These costs are also known as “overhead”. Cost Assignment Direct costs are traced to a cost ob ect. Indirect costs are allocated or assigned to a cost ob ect. Direct Cost A Direct Cost B ect ect Indirect Cost C Page 212 Basic Cost Terms: Product and Period Costs ¾ (as ¾ (). ¾ Product Costs Costs that “attach” to the units that are produced i.e., manufacturing costs) and are not reported expenses until the goods are sold. Period costs Costs that must be charged against income in the period incurred and cannot be inventoried e.g., selling and administrative expensesUnit Costs Total cost of units divided by units produced. Direct Cost Product X Indirect Cost Period Cost Income Statement Product Costs Sale Inventory Basic Cost Terms: Cost Behavior Variable Costs ¾ Costs that change directly in proportion to changes in the related cost driver Fixed Costs ¾ Costs that remain unchanged for a given time period regardless of changes in the related cost driver. Other Common Functions for Cost Behavior ¾ Semi-variable costs (part variable and part fixed) ¾ Step costs (aka semi-fixed costs) Main Assumptions Needed to Define Fixed and Variable Costs ¾ Cost object, Time span, Linear functional form ¾ Relevant range- the band of cost driver activity in which a specific relationship between a cost and a driver holds. Basic Cost Terms 13 ¾Product costs can be Direct or Indirect (Overhead) ¾Not all Direct costs are variable  The depreciation of a special piece of equipment bought to manufacture a single product line. ¾Not all Overheads are fixed  Processing of raw material purchase orders  Electricity used in operating production equipment. 14 Page 3The “Ins” of Inventory Accounting ¾ What costs are assigned to inventory as products are manufactured? ¾ GAAP requires Full Absorption Costing: the products fully absorb all manufacturing costs, including:  Variable manufacturing costs. e.g., direct material  Fixed manufacturing costs. e.g., building depreciation ¾ Results in unitizing fixed costs: convert total fixed costs (TFC) to a unit cost by allocating TFC to the units produced. 15 16 of Inventory Accounting (The “Ins” and “Outs” Raw Materials Inventory Work-in-process Inventory Finished Goods Inventory Raw Materials Direct Labor Transportation, Set-up, etc Indirect labor, Indirect materials, Depreciation Cost of Goods Sold I/S, Retained Earnings Non-manufacturing period) costs Examples of Product Costing ¾ Electron, Inc. produces 10,000 calculators in one month. ¾ Variable manufacturing costs are :  $6/unit for material,  $1/unit for direct labor, and  $1/unit for variable overhead. ¾ Fixed manufacturing overhead is $50,000/month. ¾ Unit costs are $8 (variable) + $50,000/10,000 (fixed) or $13/unit. ¾ How do these costs flow through Inventory Accounts? 17 Page 4Product Costing Events 11/ 1: Purchase and receive $60,000 of material (Nov. supply) 11/ 2: Requisition ½ of materials to the factory floor ($30,000) 11/ 5: Apply labor to the materials ($5,000) 11/ 7: Recognize depreciation expense for the month ($50,000) 11/ 8: Apply variable OH to the materials ($5,000) 11/ 9: Transfer 5,000 completed calculators from WIP to FG Inventory 11/10: Ship 2,000 completed calculators to customer 18 How do Costs Flow through Inventory Accounts? RM WIP FG Net Wages Cash Inv Inv Inv PPE = Payable RE Buy Materials Requisition ½ Of materials Apply labor Apply fixed OH (Depreciation) Apply variable OH Transfer to FG Inv Sell 2000 units How do Costs Flow through Inventory Accounts? 19 RM WIP FG Net Wages Cash Inv Inv Inv PPE = Payable RE Buy Materials –60 60 Requisition ½ Of materials Apply labor Apply fixed OH (Depreciation) Apply variable OH Transfer to FG Inv Sell 2000 units 20 Page 5How do Costs Flow through Inventory Accounts? RM WIP FG Net Wages Cash Inv Inv Inv PPE = Payable RE Buy Materials –60 60 Requisition ½ –30 30 Of materials Apply labor Apply fixed OH (Depreciation) Apply variable OH Transfer to FG Inv Sell 2000 units How do Costs Flow through Inventory Accounts? 21 RM WIP FG Net Wages Cash Inv Inv Inv PPE = Payable RE Buy Materials –60 60 Requisition ½ –30 30 Of materials Apply labor 5 5 Apply fixed OH (Depreciation) Apply variable OH Transfer to FG Inv Sell 2000 units How do Costs Flow through Inventory Accounts? 22 RM WIP FG Net Wages Cash Inv Inv Inv PPE = Payable RE Buy Materials –60 60 Requisition ½ –30 30 Of materials Apply labor 5 5 Apply fixed OH