Product Costs

1
Product Costs

• How are Product Costs for Decision Making
  Different from Product Costs for Financial
  Reporting?

2
Objective Understand . . .

• That for decision making, what is important is
  how spending will change with
• Increases or decreases in output
• Adding or dropping a product line
• Adding or dropping a department
• That there is no true cost.

3
Cost Concepts

• Important vocabulary
• Resources
• Costs
• Cost object
• Product costs
• Direct costs
• Indirect costs
• Fixed costs
• Variable costs

4
Basic Definitions

• Resources are economic inputs that are consumed
  in performing activities.
• Costs use or sacrifice of resources
• Cost object is any item such as products,
  customers, departments, projects, activities, and
  so on, for which costs are measured and traced.
• Traceability is the ability to assign a cost to
  a cost object in an economically feasible way by
  means of a causal relationship.

5
Components of product costs

• Direct material are those materials that are
  directly traceable to the goods or services being
  produced.
• Direct labor is the labor that is directly
  traceable to the goods or services being
  produced.
• Indirect manufacturing costs (O/H)
• Cost pool/s
• Factory costs
• May vary, but not always with units of production

6
Statement of COGM
Direct materials Beginning inventory 200,000 A
dd Purchases 450,000 Materials
available 650,000 Less Ending inventory
50,000 Direct materials used in production
600,000 Direct labor 350,000 Manufacturing
overhead Indirect labor 122,500 Depreciation
on building 177,500 Rental of equipment 50,000 U
tilities 37,500 Property taxes 12,500 Maintenanc
e 50,000 450,000 Total manufacturing
costs added 1,400,000 Add Beginning work in
process 200,000 Less Ending work in process
400,000 Cost of goods manufactured 1,200,000

7
Direct vs. Indirect Costs

• Direct costs are those costs that can be easily
  and accurately traced to a cost object.
• Example The salary of a supervisor of a
  department, where the department is defined as
  the cost object.
• Indirect costs are those costs that cannot be
  easily and accurately traced to a cost object.
• Example The salary of a plant manager, where
  departments within the plant are defined as the
  cost objects.

8
Variable vs. Fixed Costs
Cost Behavior
Fixed Cost Behavior
Variable Cost Behavior


Relevant Range
Activity
Activity
9
The Behavior of a Mixed Cost
Linearity Assumption
Total Costs
Cost
Fixed Costs
Variable Costs
Number of Units Produced
Y F VX
10
Methods for Measuring the Fixed and Variable
Components of a Mixed Cost

• The High-Low Method
• Scatterplot Method
• The Method of Least Squares

11
High-Low Method An Example
Month Utility Costs
Units Produced January
2,000 200 February
2,500 400 March
4,500 600 April
5,000 800 May
7,500 1,000
Basic Formula
Y F VX
12
The High-Low Method (continued)

• V (Y2 - Y1)/(X2 - X1)
• V (7,500-2,000)/(1,000-200)
• V 5,500/800
• V 6.875 per unit

• Y F VX
• 7,500 F 6.875 (1,000)
• F 7,500 - 6,875
• F 625

The cost formula using the high-low method is
Y 625 6.875 (X)
13
Scatterplot Method
Utility Cost
8,000 6,000 4,000 2,000 0
.
Important Cost function is only relevant within
relevant range
.
.
Analyst can fit line based on his or
her experience
.
.
200 400 600 800
1,000
Units Produced
14
How are Product Costs Attached?
Cost Measurement Classify Costs
Cost Assignment Assign to Cost Objects
Cost Accumulation Record Costs
Purchase materials Assemblers payroll Finishers
payroll Supervisors payroll Depreciation Utilitie
s Property taxes Landscaping
Direct Materials Direct Labor Overhead
Product 1 Product 2
15
Overhead Application

• A predetermined overhead rate is calculated using
  the following formula
• Overhead rate Budgeted annual overhead/Budgeted
  annual activity level
• Overhead is applied using the following formula
• Overhead applied actual amount of product
  produced x
  standard amount of cost driver allowed
  x predetermined overhead
  rate.
• Choosing the Activity Base
• 1. Units produced
• 2. Direct labor hours
• 3. Direct labor dollars
• 4. Machine hours
• 5. Direct materials

ABC
VS.
16
Traditional Product Costing

• Budgeted output 500,000 units
• Budgeted overhead costs 500,000
• Actual direct materials cost 2 per unit
• Actual direct labor cost 3 per unit
• Actual overhead costs 495,000
• Labor costs 3 per hour, 500,000 units are
  manufactured 505,000 DL hours are used.

17
Traditional Product Costing

• What is predetermined overhead rate?
• What is a unit of product expected to cost?
• How much did the company spend building 500,000
  units?
• By how much was overhead over- or under-applied?
• How much would we expect them to spend building
  400,000 units?

18
Support and Producing DepartmentsTransfer prices
or cost allocation

• Support departments are units within an
  organization that provide essential support
  services for producing departments.
• Examples maintenance, grounds, engineering,
  housekeeping, personnel, and stores
• Producing departments are units within an
  organization that are directly responsible for
  creating the products and services sold to
  customers.
• Examples Services auditing, tax, management
  advisory Manufacturing grinding and assembly

19
Steps in Allocating Support Department Costs to
Producing Departments

• 1. Departmentalize the firm.
• Classify each department as a support or a
  producing department.
• Trace all overhead costs in the firm to a support
  or producing department.
• 4. Allocate support department costs to the
  producing departments.
• 5. Calculate predetermined overhead rates for
  producing departments.
• 6. Allocate overhead costs to the units of
  individual product through the predetermined
  overhead rates.

20
Examples of Cost Drivers forSupport Departments
Support Department Possible Driver
Accounting
Number of transactions Cafeteria
Number of
employees Engineering
Number of change orders Maintenance
Machine
hours Payroll
Number of employees Personnel
Number of new hires
21
Cost Allocation vs. Transfer Prices

• The service department does not sell outside and
  the producing department cannot buy outside.
• The service department manager has a budget and
  is evaluated based on his budget
• If user departments are allowed to purchase
  services outside the company, competition will
  supply the necessary discipline for service
  departments to produce the appropriate quality
  and quantity of service and market prices will
  guide transfer prices
• If service departments are allowed to sell
  outside, competition will insure efficiency or
  the capacity will be divested.