Basic Cost Terminology

Basic Cost Terminology

• Cost is a sacrificed resource to achieve a specific objective
• Actual cost refers to a cost that has already occurred
• Budgeted cost is a predicted cost
• Cost object indicates anything of interest for which a cost is desired

Cost Object Examples at BMW

• Products: BMW X5 sports activity vehicle
• Service: Dealer-support telephone hotline
• Project: R&D project on DVD system enhancement
• Customer: Herb Chambers Motors purchases a broad range of BMW vehicles
• Activity: Setting up production machines
• Department: Environmental Health and Safety

Cost Accumulation and Assignment

• Cost accumulation involves collecting cost data in an organized manner
• Cost assignment is a general term that includes gathering accumulated costs to a cost object
• Tracing accumulated costs means they have a direct relationship to the cost object
• Allocating accumulated costs means they have an indirect relationship to a cost object

Direct and Indirect Costs

• Direct costs can be conveniently and economically traced to a cost object
• Indirect costs cannot be conveniently or economically traced to a cost object
• Indirect costs are allocated to a cost object in a rational and systematic manner

BMW: Assigning Costs to a Cost Object

• Type of Direct Cost: Cost of steel and tires for the BMW X5
• Method of Cost Assignment: Cost tracing; which is based on a material requisition document
• Cost Object: BMW X5
• Type of Indirect Costs: Lease cost for the Spartanburg plant where BMW makes X5 an other car models
• Method of Cost Assignment: Cost allocation, there is no requisition document

Cost Examples

• Direct Costs: Parts, Assembly line wages
• Indirect Costs: Electricity, Rent, Property taxes

Factors Affecting Direct/Indirect Cost Classification:

• Cost materiality
• Availability of information-gathering technology
• Operational design

Cost Behavior

• Variable costs: change in total in proportion to changes in the related level of activity or volume
• Fixed costs: remain unchanged in total regardless of changes in the related level of activity or volume
• Costs are fixed or variable only with respect to a specific activity or a given time period
• Variable costs are constant on a per-unit basis, like the amount of materials for each product
• Fixed costs: change inversely with the level of production

Cost Behavior Summarized:

• Variable Costs in Total Dollars: Change in proportion with output; more output = more cost
• Variable Costs Cost per Unit: Unchanged in relation to output
• Fixed Costs in Total Dollars: Unchanged in relation to output
• Fixed Costs Cost per Unit: Change inversely with output; more output = lower cost per unit

Additional Cost Concepts

• Cost driver refers to a variable that causally affects costs over a given time span
• Relevant range indicates the band of normal activity level in which there is a specific relationship between the level of activity and a given cost
• Fixed costs are considered fixed only within the relevant range

A Cost Caveat

• Unit costs should be used cautiously becasue unit costs change with different levels of output or volume
• Decisions should be based on a total dollar basis, not a unit cost basis
• Unit costs that include fixed costs should always reference a given level of output or activity
• Unit costs are also known as average costs
• Managers should think in terms of total costs rather than unit costs

Multiple Classification of Costs

• Costs may be classified as direct/indirect and variable/fixed
• Important cost combinations: direct and variable, direct and fixed, indirect and variable, indirect and fixed

Multiple Classification of Costs, Visualized

• Variable Costs may be: Direct (Tires used in the assembly of Automobile) or Indirect (Power costs at Spartanburg plant); Metered only to the plant, where multiple products are assembled
• Fixed Costs may be: Direct (Salary of supervisor on the BMW assembly line) or Indirect (Annual lease costs at Spartanburg plant); Lease for the whole plant, where multiple products are produced.

Different Types of Firms:

• Manufacturing-sector companies: purchase materials and components and convert them into finished products
• Merchandising-sector companies: purchase and then sell tangible products without changing their basic form
• Service-sector companies: provide services (intangible products)

Types of Manufacturing Inventories:

• Direct Materials: Resources in-stock and available for use
• Work-In-Process or WIP: Products started but not yet completed
• Finished Goods: Products completed and ready for sale

Types of Product Costs

• Also known as inventoriable costs
• Direct materials: acquisition costs of all materials that will become part of the cost object
• Direct labor: compensation of all manufacturing labor that can be traced to the cost object
• Indirect manufacturing: factory costs that are not traceable to the product in an economically feasible way (lubricants, indirect manufacturing labor, utilities, and supplies)

Accounting Distinction Between Costs:

• Inventoriable costs are product manufacturing costs and are capitalized as assets (inventory) until sold is transferred to the Cost of Goods Sold
• Period costs have no future value and are expensed in the period incurred

Cost Flows

• The Cost of Goods Manufactured and the Cost of Goods Sold section of the Income Statement are accounting representations of the actual cost flow through a production system
• Inventory accounts have importance in accounting reports as well as the cost flow chart

Other Cost Considerations

• Prime cost refers to all direct manufacturing costs (materials and labor)
• Conversion cost refers to direct labor and indirect manufacturing costs
• Overtime labor costs are considered part of indirect overhead costs

Different Definitions of Costs for Different Applications

• Pricing and product-mix decisions are about pricing and maximizing profits
• Contracting with government agencies has very specific definitions of allowable costs for "cost plus profit" contracts
• Preparing external-use financial statements means only using GAAP-driven product costs

Three Common Features of Cost Accounting and Cost Management:

• Calculating the cost of products, services, and other cost objects
• Obtaining information for planning and control, and performance evaluation
• Analyzing the relevant information for making decisions