November 10 2015 n Types of Costs n

November 10, 2015 n Types of Costs n Starting to Build the Income Statement n To build the Income Statement, we must know COGS n To know COGS for a manufacturing company, we must know Cost of Goods Manufactured n Build up and calculation of Cost of Goods Manufactured n Fixed versus Variable Costs n Other cost distinctions Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Purpose of Cost Classifications n We have seen there are many ways of classifying costs n Each type falls into one or more of the following purposes: n Financial Reporting n Inventory on Balance Sheet n COGS and S&A on Income Statement n Predicting Cost Behaviour n Fixed and variable costs n Assigning Costs to Objects n Product costs n Decision Making n Differential costs and revenues Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Classifying Costs n A good Managerial Accountant thinks and uses judgment to arrive at or develop the best approach to support decision making n This requires a deep understanding of costs and when to use the many classifications there are: n Period versus Product n Prime versus Conversion n Fixed versus Variable n Direct versus Indirect n Sunk Costs n Opportunity Costs n Differential Costs and Differential Revenue n Of course any cost item can fit into a number of these categories Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Summary of the Types of Cost Classifications Financial Reporting Predicting Cost Behavior Assigning Costs to Cost Objects Making Business Decisions Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

1. Manufacturing Costs n Manufacturing Costs are Product Costs (flow through balance sheet) n Direct Materials n Raw materials that become an integral part of the product and that can be conveniently traced directly to it n Direct Labour n Those labor costs that can be easily traced to individual units of product n Manufacturing Overhead Manufacturing costs cannot be traced directly to specific units produced. n Indirect materials, indirect labour, other indirect costs related to manufacture n n What are examples of each type of cost? Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Classifications of Manufacturing Costs Direct Materials Direct Labor Manufacturing Overhead The Product Mc. Graw-Hill

Direct Materials Raw materials that become an integral part of the product and that can be conveniently traced directly to it. Example: A radio installed in an automobile Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Direct Labor Those labor costs that can be easily traced to individual units of product. Example: Wages paid to automobile assembly workers Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Manufacturing Overhead Manufacturing costs that cannot be easily traced directly to specific units produced. Examples: Indirect materials and indirect labor Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

2. Non-Manufacturing Costs n Non Manufacturing Costs are Period Costs (through I/S) n Selling Costs n All costs associated with selling n Administrative Costs n All other costs which cannot be attributed to production or selling n What are examples of each type of cost? Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

2. Non-Manufacturing Costs n Non Manufacturing Costs are Period Costs (through I/S) n Selling Costs n All costs associated with selling n Marketing n Selling n Delivering n Customer satisfaction n Administrative Costs n All other costs which cannot be attributed to production or selling n Executive salaries n Clerical support n What are examples of each type of cost? Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Costs for a Manufacturing Company – An Example § Pick a manufacturing company Cost Examples Direct Labour • Direct Materials • Manufacturing Overhead • Selling • Administration • Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Nonmanufacturing Costs Administrative Costs All executive, organizational, and clerical costs. Mc. Graw-Hill /Irwin Copyright

Classifications of Costs Manufacturing costs are often classified as follows: Direct Material Direct Labor Prime Cost Mc. Graw-Hill /Irwin Manufacturing Overhead Conversion Cost Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Cost Classifications for Predicting Cost Behavior Cost behavior refers to how a cost will react to changes in the level of activity. The most common classifications are: ▫ Variable costs ▫ Fixed costs ▫ Mixed costs Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Variable Cost Total Texting Bill Your total texting bill is based on how many texts you send. Number of Texts Sent Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Variable Cost Per Unit Cost Per Text Sent The cost per text sent is constant at 5 cents per text message. Number of Texts Sent Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Activity Base (Cost Driver) Machinehours Units produced A measure of what causes the incurrence of a variable cost Miles driven Mc. Graw-Hill /Irwin Laborhours Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Fixed Cost Monthly Cell Phone Contract Fee Your monthly contract fee for your cell phone is fixed for the number of monthly minutes in your contract. The monthly contract fee does not change based on the number of calls you make. Mc. Graw-Hill /Irwin Number of Minutes Used Within Monthly Plan Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Fixed Cost Per Unit Monthly Cell Phone Contract Fee Within the monthly contract allotment, the average fixed cost per cell phone call made decreases as more calls are made. Number of Minutes Used Within Monthly Plan Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Types of Fixed Costs Committed Discretionary Long term, cannot be significantly reduced in the short term. May be altered in the short term by current managerial decisions Examples Depreciation on Buildings and Equipment and Real Estate Taxes Advertising and Research and Development Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Linearity Assumption and the Relevant Range Total Cost Economist’s Curvilinear Cost Function Relevant Range A straight line closely approximates a curvilinear variable cost line within the relevant range. Accountant’s Straight-Line Approximation (constant unit variable cost) Activity Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Fixed Costs and the Relevant Range For example, assume office space is available at a rental rate of RMB 30, 000 per year in increments of 1, 000 square feet. Fixed costs would increase in a step fashion at a rate of RMB 30, 000 for each additional 1, 000 square feet. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Rent Cost in Thousands of RMB Fixed Costs and the Relevant Range Mc. Graw-Hill /Irwin 90 Relevant 60 Range 30 0 0 The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat. 1, 000 2, 000 3, 000 Rented Area (Square Feet) Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Cost Classifications for Predicting Cost Behavior Mc. Graw-Hill /Irwin Copyright © 2008 by The

Mixed Costs (also called semivariable costs) A mixed cost contains both variable and fixed elements. Consider the example of utility cost. Total Utility Cost Y l a t o ed x i m t s o c T Variable Cost per KW Activity (Kilowatt Hours) Mc. Graw-Hill /Irwin X Fixed Monthly Utility Charge Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Mixed Costs Total Utility Cost Y l a t o ed x i m t s o c T Variable Cost per KW Activity (Kilowatt Hours) Mc. Graw-Hill /Irwin X Fixed Monthly Utility Charge Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Mixed Costs – An Example If your fixed monthly utility charge is RMB 400, your variable cost is RMB 0. 30 per kilowatt hour, and your monthly activity level is 2, 000 kilowatt hours, what is the amount of your utility bill? Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Analysis of Mixed Costs Account Analysis and the Engineering Approach In account analysis, each account is classified as either variable or fixed based on the analyst’s knowledge of how the account behaves. The engineering approach classifies costs based upon an industrial engineer’s evaluation of production methods, and material, labor, and overhead requirements. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Traditional and Contribution Formats Used primarily for external reporting. Mc. Graw-Hill /Irwin Copyright

Assigning Costs to Cost Objects Direct costs Indirect costs • Costs that can be easily and conveniently traced to a unit of product or other cost object. • Costs that cannot be easily and conveniently traced to a unit of product or other cost object. • Examples: direct material and direct labor • Example: manufacturing overhead Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Setting up the Income Statement n Revenues – n Relatively straight forward, from your Financial Accounting n Less Cost of Goods Sold (COGS) Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Inventory Flows n Calculating inventory balances n Beginning inventory, plus n Additions to inventory, less n Withdrawals from inventory, equals n Ending balance n This straight forward formula holds true n For a simple merchandising situation where inventory is in a single account, n For each inventory account of a manufacturing company n Raw Materials, Work in Progress and Finished Goods Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Inventory Flow - Example n Pick a merchandising company n It has $50 million of inventory on Jan 1, 2015 n It purchased $10 million on Jan 13, 2015 n By Jan 31, 2015, it sold $42 million of its inventory stock n What was the company’s opening inventory on Feb 1, 2015? Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Inventory Flow - Example n Pick a manufacturing company n It has $10 million of raw materials inventory on Feb 1, 2015 n It purchased $5 million of additional raw materials on Feb 2 n It started working on converting $7 million of raw materials during Feb n By Feb 28, 2015, it sold $15 million of its finished goods n What was the company’s opening raw materials inventory on March 1, 2015? Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Calculating Cost of Goods Manufactured n A Merchandiser does not manufacture, so there is no Cost of Goods Manufactured n COGS are simply the costs of what inventory it purchased n (Note this is a bit simplified as some companies may add some processing costs) n For a manufacturer, in order to calculate COGS, we need to know the costs of what the company has produced that is available and for sale and sold n By definition, these must be Finished Goods only n Therefore, we must calculate the flows and balances through each inventory account Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Schedule of Cost of Goods Manufactured As items are removed from raw materials inventory and placed into the production process, they are called direct materials. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Schedule of Cost of Goods Manufactured Conversion costs are costs incurred to convert the direct material into a finished product. As items are removed from raw materials inventory and placed into the production process, they are called direct materials. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Schedule of Cost of Goods Manufactured All manufacturing costs incurred during the period are added to the beginning balance of work in process. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Schedule of Cost of Goods Manufactured Costs associated with the goods that are completed during the period are transferred to finished goods inventory. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Cost of Goods Sold Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill

Cost of Goods Manufactured – Example n At year end, a manufacturing company has the following inventory balances: n RM - $12 m, WIP - $20 m, FG - $10 m n Assume the following: n $12 m of RM materials are purchased n $10 m of RM are drawn into production n DL of $10 m, MOH of $3 m in the period n WIP closing balance was $10 m n FG closing balance was $12 m n Prepare a schedule of Cost of Goods Manufactured and calculate COGS for the period n Assume revenues of $50 m, S&A of $10 m – Prepare an I/S Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Cost of Goods Manufactured – Example n Which of these accounts are Balance Sheet Accounts? n Which are Income Statement Accounts? Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Income Statement – Example n Is this a profitable company? n Would you invest in this company? n At what valuation? Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Income Statement – Investment Decisions n Is this a profitable company? n Yes, of course n Look to the margin % n Is it profitable enough? n What industry is it in? n What are its competitors’ results? n Would you invest in this company? n What are the trends in the industry and with the company? n At what valuation? n What levels of returns are reasonable to expect from taking on this level of risk? Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Fixed and Variable Costs n Fixed Costs n Total Fixed Costs do not change with changes in activity n Variable Costs n Total Variable Costs change with changes in activity n Plot cost on the X axis, and activity on the Y axis for the following cost examples: n Factory lease n Direct labour n Machinery depreciation Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Other Cost Classifications n Differential Costs and Differential Revenues n Used for decisions among alternatives n Sunk Costs n Opportunity Costs n These are in addition to: n Fixed versus Variable n Direct versus Indirect n Period versus Product n Of course any cost item can fit into a number of these categories Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Cost Classifications for Decision Making Every decision involves a choice between at least two alternatives. Only those costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits can and should be ignored as irrelevant. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Differential Cost and Revenue Costs and revenues that differ among alternatives. Example: You have a job paying $1, 500 per month in your hometown. You have a job offer in a neighboring city that pays $2, 000 per month. The commuting cost to the city is $300 per month. Differential revenue is: $2, 000 – $1, 500 = $500 Differential cost is: $300 What is the differential benefit? Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Opportunity Cost The potential benefit that is given up when one alternative is selected over another. Example: If you were not attending college, you could be earning $15, 000 per year. Your opportunity cost of attending college for one year is $15, 000. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Sunk Costs Sunk costs have already been incurred and cannot be changed now or in the future. These costs should be ignored when making decisions. Example: Suppose you had purchased gold for $1, 700 an ounce, but now it is selling for $1, 250 an ounce. Should you wait for the gold to reach $1, 700 an ounce before selling it? You may say, “Yes” even though the $1, 700 purchase is a sunk cost. Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Purpose of Cost Classifications n We have seen there are many ways of classifying costs n Each type falls into one or more of the following purposes: n Financial Reporting n Inventory on Balance Sheet n COGS and S&A on Income Statement n Predicting Cost Behaviour n Fixed and variable costs n Assigning Costs to Objects n Product costs n Decision Making n Differential costs and revenues Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Review n Starting to Build the Income Statement n Understand how inventories flow through the income statement n Build up and calculation of Cost of Goods Manufactured n Only for manufacturing companies n Fixed versus Variable Costs n Businesses can control variable costs in the shorter term n Other cost distinctions Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Tutorial n Review and simplify financial statements for Case Study n Group by group n Presentations on company selection n Working session on presentations Presentation on Case Study company: Description Rationale Outlook Select paper stock portfolio Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.