Cost Behavior in Manufacturing: Concepts and Applications

, ZLVK , FRXOG JHW EHWWHU LQIRUPDWLRQ IURP WKH ¿QDQFH work or not? Only then can I start to make decisions that people. I am trying to improve the processes here at will increase our value. Jackson Gears. Just like that company that makes I am meeting with Jessica Martinez, our plant sideline heaters [see the In Action item, “Higher Trans- cost analyst, tomorrow. She has promised to walk me portation Costs Lead Company to Move Manufacturing through the different cost terms used here at Jackson. Back to the United States”], we are bringing some of our She says I have to understand these cost terms to un- products back to be produced here at Jackson Gear’s derstand the cost information in our reports. Then she U.S. plant. I want to make sure we remain cost competi- will show me how we prepare the information for the WLYHHYHQLIWUDQVSRUWDWLRQFRVWVJRGRZQ2QHRIWKH¿rst ¿QDQFLDOUHSRUWVSUHSDUHGDWFRUSRUDWH)LQDOO\VKHZLOO WKLQJV,DVNHGWRVHHZDVWKH¿QDQFLDOVIRUWKHSODQW illustrate how different costs and statements might help Now that I have read them, I am confused. There seem me manage the plant. to be a lot of different categories of costs, but they don’t tell me what I need to know. They tell me how much was Barry Roberts is the new plant manager at Jackson spent, and that is helpful. But, what I really need is some Gears. He has been hired to streamline plant operations and ¿nancial information that tells me two things. First, how reduce costs, in order to improve the competitiveness of the will my decisions affect our costs—for example, what company’s products. He is looking for help in understanding costs will change as I increase our production? Second, some of the terminology that Jackson Gears uses in describ- why did we spend the money—was it for value-added ing and reporting costs. Higher Transportation Costs Lead Company to Move Manufacturing Back to the United States In Action Many manufacturing companies have moved production The privately held company, known for making the overseas recently, primarily because of lower manufactur- heaters that warm football players on ﬁeld sidelines, ing costs. Now, because of both higher transportation costs recently moved most of its production back to Bowling Green, Kentucky, from China. Mr. Hayes says the com- to ship ﬁnished products back to the United States and in- pany was lucky to have held onto its manufacturing creased prices and wages in other countries, many ﬁrms machinery. “What looked like an albatross a year and are moving their production back. For example: a half ago,” he says, “today looks like a pretty good asset.” “My cost of getting a shipping container here from China just keeps going up—and I don’t see any end in sight,” says Claude Hayes, president of the retail heating Source: T. Aeppel, “Stung by Soaring Transportation Costs, division at DESA LLC. He says that shipping costs have Factories Bring Jobs Home Again,” The Wall Street Journal, jumped 15 percent, to about $5,300 since January and June 18, 2008. are set to increase again next month to $5,600. Cost accounting systems provide information to help managers make better decisions. Managers who use cost accounting information to make decisions need to understand the cost terms used in their organizations. Because cost accounting systems are tailored to the needs of individual companies, several terms are used in practice to describe the same or similar cost concepts, depending on the use or the audience. Therefore, before we discuss the design of cost systems to aid decision making, we introduce a set of terms that will be used throughout the book. These terms are important to the discussion because they will be the “language” we use to communicate for the remainder of the book. These terms are common, but they are not universal, so you need to be aware that a company you work for may use different terms for some of the concepts we discuss here. In addition, managers need to understand how ﬁnancial statements are commonly prepared because this will often be the primary form in which the information is avail- able. The effects of the decisions made by managers are shown publicly in the ﬁrm’s published ﬁnancial statements. 37 38 Part I Introduction and Overview Although these statements allow investors to evaluate the ﬁrm, they are not useful for managing the business. Because most of you are familiar with traditional ﬁnancial statements, from either earlier course work in accounting, your own investment analysis, or access to publicly available ﬁnancial statements, we start by linking the fundamental concepts of cost accounting to ﬁnancial statements. We discussed in Chapter 1 the differences between cost and ﬁnancial accounting. Although the two systems serve different purposes, they are not completely separate. The ﬁnancial statements prepared by the ﬁrm for external reporting use information from the cost accounting system. Fundamentally, the cost accounting system records and maintains the use of economic resources by the organization. We illustrate how resources are used and costs are added to a product or service in different types of industries and how the use (cost) of these resources is reported in the ﬁnancial statements. We explain the types of costs that managers use in making decisions. Finally, we present several diagrams that will help you track the different components of a product’s cost. Exhibit 2.16 in the Chapter Summary highlights the most important cost concepts in this chapter; refer to it often as you review for exams or need a quick reference. What Is a Cost? L.O. 1 A cost is a sacriﬁce of resources. Every day, we buy many different things: clothing, food, books, music, perhaps an automobile, and so on. When we buy one thing, we give Explain the basic up (sacriﬁce) the ability to use these resources (typically cash or a line of credit) to buy concept of “cost.” something else. The price of each item measures the sacriﬁce we must make to acquire it. Whether we pay cash or use another asset, whether we pay now or later (by using a credit cost card), the cost of the item acquired is represented by what we forgo as a result. Sacriﬁce of resources. Cost versus Expenses expense It is important to distinguish cost from expense. An expense is a cost charged against Cost that is charged against revenue in an accounting period; hence, expenses are deducted from revenue in that revenue in an accounting accounting period. We incur costs whenever we give up (sacriﬁce) resources, regardless period. of whether we account for it as an asset or an expense. (We may even incur costs that the ﬁnancial accounting system never records as an asset or expense. An example is lost sales.) If the cost is recorded as an asset (for example, prepaid rent for an ofﬁce building), it becomes an expense when the asset has been consumed (i.e., the building has been used for a period of time after making the prepayment). In this book, we use the term expense only when referring to external ﬁnancial reports. The focus of cost accounting is on costs, not expenses. Generally accepted account- ing principles (GAAP) and regulations such as the income tax laws specify when costs are to be treated as expenses. Although the terms cost and expense are sometimes used as synonyms in practice, we use cost in this book for all managerial purposes. outlay cost The two major categories of costs are outlay costs and opportunity costs. An outlay Past, present, or future cash cost is a past, present, or future cash outﬂow. Consider the cost of a college education; outﬂow. clearly, the cash outﬂows for tuition, books, and fees are outlay costs. Cash is not all that college students sacriﬁce; they also sacriﬁce their time to get a college education. This opportunity cost sacriﬁce of time is an opportunity cost. Opportunity cost is the forgone beneﬁt that Forgone beneﬁt from the best could have been realized from the best forgone alternative use of a resource.1 For ex- (forgone) alternative course ample, many students give up jobs to take the time to earn a college degree. The forgone of action. income is part of the cost of getting a college degree and is the forgone beneﬁt that could 1 In some deﬁnitions, the outlay cost is also an opportunity cost because you forgo the use of the cash that could be used to purchase other goods and services. In this text, we reserve the use of the term opportunity costs to those costs that are not outlay costs. Chapter 2 Cost Concepts and Behavior 39 be realized from an alternative use of a scarce resource—time. These are other examples of opportunity costs: The opportunity cost of funds that you invest in a bank certiﬁcate of deposit is the forgone interest you could have earned on another security, assuming that both secu- rities are equal in risk and liquidity. The opportunity cost of spending spring break in Mexico is the forgone income from a temporary job; the opportunity cost of taking a temporary job during spring break is the forgone pleasure of a trip to Mexico. The opportunity cost of time spent working on one question on an examination is the forgone beneﬁt of time spent working on another question. Of course, no one can ever know all of the possible opportunities available at any moment. Hence, some opportunity costs are undoubtedly not considered. Accounting systems typically record outlay costs but not opportunity costs. As a result, it is easy for managers to overlook or ignore opportunity costs in making decisions. A well-designed cost accounting system presents all relevant information to managers, including opportu- nity costs that they may otherwise ignore in decision making. Presentation of Costs in Financial Statements We are concerned with information for use by managers. Therefore, when we present or L.O. 2 discuss ﬁnancial statements, we assume that the statements are prepared for internal man- Explain how costs are agement use, not for external reporting. We also focus on operating proﬁt, the excess of operating revenues over the operating costs incurred to generate those revenues. This presented in financial ﬁgure differs from net income, which is operating proﬁt adjusted for interest, income statements. taxes, extraordinary items, and other adjustments required to comply with GAAP or other regulations such as tax laws. operating proﬁt It is important to remember that information from the cost accounting system is just a Excess of operating revenues means to an end; the ﬁnal products are managerial decisions and actions (and the change over the operating costs necessary to generate those in ﬁrm value) that result from the information generated by the system. We are not seek- revenues. ing the “most accurate” information; we are looking for the best information, understand- ing how the information is used in decision making, and recognizing the cost of preparing and using the information. The following sections present some examples of how cost information appears in ﬁnancial statements prepared for managers. These are basic state- ments on which we build. As we proceed through the book, we show you how to improve these basic statements and the data they contain to make them more informative. A generic income statement for a ﬁrm, a division, a product, or any unit is shown in Exhibit 2.1. It summarizes the revenues (sales) of the unit and subtracts the costs of the unit. The costs include the cost of the goods or service the activity sells. Although the basic form of the income statement is the same regardless of the product or service an organization sells, the details, especially with respect to costs, vary depending on how the organization acquires the resources used to produce the product or service. In the sections that follow we illustrate three types of income statements where the organization sells (1) a service, (2) a product that it acquires from another organization (a retailer), or (3) a product that it builds using materials from other organizations (a manu- facturer). It is important to remember, however, that most ﬁrms are made up of activities that combine features of all three types of activities. As the In Action item, “A New Manufactur- ing Mantra,” discusses, in many of the ﬁrms that we might consider to be manufacturing ﬁrms, such as Nike, virtually all employees are engaged in service-related activities. Revenue...... XXX Exhibit 2.1 Similarly, many service firms, such as those in Generic Income Costs......... YYY ﬁnancial services, have important transactions and billing Statement functions that use repeatable, discrete processes, not 2SHUDWLQJSUR¿W === 40 Part I Introduction and Overview unlike many manufacturing processes. Because service ﬁrms have no inventory to value, some ﬁrms have not taken steps to understand how these discrete processes are associated with costs. However, as competitive pressures force ﬁrms to become more efﬁcient and effective, even service ﬁrms have started to understand how important it is to associate costs and revenues with the distinct services they provide so that they can better evalute the value-added equation that we discussed in Chapter 1. Service ﬁrms are now adopting cost management practices that were originally developed in manufacturing. For exam- ple, banks and brokerage ﬁrms are using activity-based costing and distribution ﬁrms are using customer proﬁtability analysis to disentangle selling, general, and administrative (SG&A) costs. The methods of cost analysis that were ﬁrst developed in manufacturing are now being translated into services to meet the universal demands for understanding costs as a part of strategic management of the value proposition. In Action A New Manufacturing Mantra Most organizations are a mix of service and manufacturing workers. The majority are doing jobs more properly activities. For example, manufacturing ﬁrms in India com- categorized as service occupations. Sometimes—as in pete with rivals in other low labor-cost countries by taking the case of pure “product originators” such as Nike, the clothing company, which outsources virtually all of its what one observer refers to as “a ‘service’ approach to pro- production—the proportion falls close to zero. duction.” This involves a focus on areas that “include design, One reason for this is that manufacturers often turn development, links with suppliers and the ability to custom- to service as a defensive strategy to protect themselves ize output to meet changes in demand patterns.” from rivals muscling in on their territory. This is not unusual in manufacturing ﬁrms. According to the same observer, Source: Financial Times (London), May 15, 2006. In many manufacturing companies, no more than one-ﬁfth of employees are deﬁned as manufacturing Service Organizations A service company provides customers an intangible product. For example, consulting ﬁrms provide advice and analyses. Traditionally, labor costs were the most signiﬁcant cost category for most service organizations. However, as information services become increasingly important, this is changing. Some service ﬁrms provide information, and for these companies, information technology can represent the major cost. Other ﬁrms provide information analysis, and for these ﬁrms, labor costs will likely remain the most important single cost. The costs associated with RPE Associates, a compensation consulting ﬁrm, are shown in the income statement in Exhibit 2.2. The line item cost of services sold includes the costs of billable hours, which are the hours billed to clients plus the cost of other items billed to clients (for example, charges for performing an information search or printing Exhibit 2.2 RPE ASSOCIATES Income Statement for a Income Statement Service Company For the Year Ended December 31, Year 2 ($000) Revenues.......................... $32,000 Cost of services sold.................. 23,500 Gross margin...................... $ 8,500 Marketing and administrative costs....... 4,300 2SHUDWLQJSUR¿W $ 4,200 Chapter 2 Cost Concepts and Behavior 41 reports). Costs that are not part of services billable to clients are included in the market- ing and administrative costs. At RPE, many managers report costs both in the cost of ser- vices sold (working with a client) and in marketing and administrative costs (developing project proposals for new business). The distinction is based on the nature of the work, not who performs the task. Retail and Wholesale Companies When you buy food, clothes, or a book, you are buying from a retail (or maybe a whole- sale) ﬁrm. Retail and wholesale ﬁrms sell but do not make a tangible product. The in- come statement for these companies includes revenue and cost items as does that for service companies, but for retailers and wholesalers, it has an added category of cost information (called cost of goods sold ) to track the cost of the tangible goods they buy and sell. Southwest Ofﬁce Products is a retail company that sells ofﬁce supplies, such as paper products and computer accessories. The company’s income statement and cost of goods sold statement are shown in Exhibit 2.3. The cost of goods sold statement shows how the cost of goods sold was computed. Exhibit 2.3 shows the following information for South- west: It had a $300,000 beginning inventory on January 1. This represents the cost of the paper, writing supplies, toner cartridges, and other salable items on hand at the begin- ning of the year. The company purchased $1,830,000 of goods during the year and had transportation- in costs of $90,000. Therefore, its total cost of goods purchased was $1,920,000 ( $1,830,000 for the purchases $90,000 for the transportation-in costs). Based on the information so far, Southwest had a $2,220,000 cost of items available for sale ( $1,920,000 total cost of goods purchased $300,000 from beginning inventory). The $2,220,000 is the cost of the goods that the company could have sold, in other words, the cost of goods available for sale. At the end of the year, the company still had on hand inventory costing $445,000. Therefore, Southwest sold items costing $1,775,000 ( $2,220,000 $445,000). Exhibit 2.3 SOUTHWEST OFFICE PRODUCTS Income Statement for a Income Statement For the Year Ended December 31, Year 2 Merchandise Company ($000) Sales revenue................................................ $3,225 Cost of goods sold (see following statement)........................ 1,775 Gross margin............................................... $1,450 Marketing and administrative costs................................ 825 2SHUDWLQJSUR¿W Cost of Goods Sold Statement For the Year Ended December 31, Year 2 ($000) Beginning inventory................................. $ 300 Cost of goods purchased Merchandise cost................................ $1,830 Transportation-in costs............................ 90 Total cost of goods purchased....................... 1,920 Cost of goods available for sale....................... $2,220 Less cost of goods in ending inventory.................. 445 Cost of goods sold................................ $1,775 42 Part I Introduction and Overview The income statement summarizes Southwest’s operating performance with the fol- lowing information: Sales revenue for the year was $3,225,000. The cost of goods sold amount, $1,775,000, came from the cost of goods sold state- ment. Therefore, the gross margin (the difference between sales revenue and cost of goods sold) is $1,450,000 ( $3,225,000 sales revenue − $1,775,000 cost of goods sold). If you were Southwest’s manager, you would know that, on average, every $1 of sales gave you about $.45 ( $1,450,000 $3,225,000) to cover marketing and administrative costs and earn a proﬁt. The income statement also shows that marketing and administrative costs were $825,000 and operating proﬁts were $625,000 ( $1,450,000 gross margin − $825,000 marketing and administrative costs). cost of goods sold The term cost of goods sold includes only the actual costs of the goods that were sold. Expense assigned to It does not include the costs required to sell them, such as the salaries of salespeople, which products sold during a are marketing costs, or the salaries of top executives, which are administrative costs. period. Compare the income statement for Southwest Ofﬁce Products with that for the service company, RPE Associates (Exhibit 2.2). Like other retail and wholesale organizations, Southwest has an entire category of amounts that do not appear in a service company’s income statement. This category appears in the cost of goods sold statement, which ac- counts for the inventories, purchases, and sales of tangible goods. By contrast, the service company does not “purchase” anything to be held in inventory until sold. Service compa- nies are generally most interested in measuring the cost of providing services while retail and wholesale ﬁrms focus on two items. The gross margin reﬂects the ability to price the products while the marketing and administrative costs reﬂect relative efﬁciency in operat- ing the business itself. Manufacturing Companies You are probably acquainted with the term cost of goods sold from a ﬁnancial account- ing course. It is likely that most, if not all, of the examples you encountered in studying ﬁnancial accounting were retail ﬁrms. The reason is that in ﬁnancial accounting, the focus is on preparing and presenting the statements. In a retail ﬁrm, the unit cost of an item is known because it was purchased from a third party. A manufacturing company has a more complex income statement than do service or retail/wholesale companies. Whereas the retailer/wholesaler purchases goods for sale, the manufacturer makes them. For deci- sion making, it is not enough for the manufacturer to know how much it paid for a good; it must also know the different costs associated with making it. Financial reporting distinguishes costs in a manufacturing ﬁrm based on when the product costs costs are recognized as expenses on the ﬁnancial statements. Product costs are those Costs assigned to the costs assigned to units of production and recognized (expensed) when the product is manufacture of products sold. Product (manufacturing) costs follow the product through inventory. Period costs and recognized for ﬁnancial (nonmanufacturing costs) include all other costs and are expensed as they are incurred. reporting when sold. Although we are not directly concerned with ﬁnancial statement preparation in this book, period costs the cost accounting system must be able to provide cost information for the ﬁnancial re- Costs recognized for ﬁnancial porting system. reporting when incurred. Before we present example statements for a manufacturing ﬁrm, we need to deﬁne some additional terms. direct manufacturing costs Product costs that can be feasibly identiﬁed with units of Direct and Indirect Manufacturing (Product) Costs production. Product costs consists of two types—direct and indirect costs. Direct manufacturing indirect manufacturing costs are those product costs that can be identiﬁed with units (or batches of units) at rela- costs tively low cost. Indirect manufacturing costs are all other product costs. The glass in a All product costs except light bulb is a direct cost of the bulb. The depreciation on the light bulb manufacturing direct costs. plant is an indirect cost. Chapter 2 Cost Concepts and Behavior 43 Direct costs are classiﬁed further into direct materials cost and direct labor cost. The manufacturer purchases materials (for example, unassembled parts), hires workers to convert the materials to a ﬁnished good, and then offers the product for sale. Thus, there are three major categories of product costs: 1. Direct materials that can be feasibly identiﬁed directly, at relatively low cost, with direct materials the product. (To the manufacturer, purchased parts, including transportation-in, are Materials that can be included in direct materials.) Direct materials are often called raw materials. Mate- identiﬁed directly with the product at reasonable cost. rials that cannot be identiﬁed with a speciﬁc product (for example, paper for plant reports, lubricating oil for machines) are included in item 3. 2. Direct labor of workers who can be identiﬁed directly, at reasonable cost, with the direct labor product. These workers transform the materials into a ﬁnished product. Labor that can be identiﬁed 3. All other costs of transforming the materials into a ﬁnished product, often referred to in directly with the product at reasonable cost. total as manufacturing overhead. Some examples of manufacturing overhead follow. Indirect labor, the cost of workers who do not work directly on the product yet manufacturing overhead are required so that the factory can operate, such as supervisors, maintenance All production costs except workers, and inventory storekeepers. those for direct labor and Indirect materials, such as lubricants for the machinery, polishing and cleaning direct materials. materials, repair parts, and light bulbs, which are not a part of the ﬁnished prod- uct but are necessary to manufacture it. Other manufacturing costs, such as depreciation of the factory building and equip- ment, taxes on the factory assets, insurance on the factory building and equipment, heat, light, power, and similar expenses incurred to keep the factory operating. Although we use manufacturing overhead in this book, common synonyms used in practice are factory burden, factory overhead, burden, factory expense, and the unmodi- ﬁed word, overhead. Prime Costs and Conversion Costs You are likely to encounter the following two categories of costs in manufacturing com- panies: prime costs and conversion costs. Prime costs are the direct costs, namely, direct prime costs materials and direct labor. In some companies, managers give prime costs much attention Sum of direct materials and because they represent 80 to 90 percent of total manufacturing costs. direct labor. In other cases, managers give most of their attention to conversion costs, which are conversion costs the costs to convert direct materials into the ﬁnal product. These are the costs for direct Sum of direct labor and labor and manufacturing overhead. Managers who focus on conversion costs use a con- manufacturing overhead. trollability argument: “We can manage conversion costs. Direct materials costs are mostly outside of our control.” Generally, companies with relatively low manufacturing overhead focus on managing prime costs. Companies that have high direct labor and/or manufacturing overhead tend to be more concerned about conversion costs. In practice, you have to determine the cost information that decision makers need to manage effectively. It is not only the relative magnitude of costs that matters in determining which costs to monitor. The important is- sue is identifying the most important costs over which the ﬁrm has control. For example, in some processing ﬁrms, the largest costs are the direct materials costs. However, be- marketing costs Costs required to obtain cause those materials are commodities with prices set in well-functioning markets, it may customer orders and be infeasible to exercise much control over those costs other than monitoring usage. provide customers Exhibit 2.4 summarizes the relation between conversion costs and the three elements with ﬁnished products, of manufactured product cost: direct materials, direct labor, and manufacturing overhead. including advertising, sales commissions, and shipping costs. Nonmanufacturing (Period) Costs administrative costs Nonmanufacturing costs have two elements: marketing costs and administrative costs. Costs required to manage the Marketing costs are the costs required to obtain customer orders and provide customers organization and provide staff with ﬁnished products. These include advertising, sales commissions, shipping costs, and support, including executive marketing departments’ building occupancy costs. Administrative costs are the costs salaries; costs of data required to manage the organization and provide staff support, including executive and processing, and legal costs. 44 Part I Introduction and Overview Exhibit 2.4 Components of Manufactured Product Cost Direct Materials materials Prime Indirect costs materials Labor Direct Product labor cost Conversion Indirect costs labor Manufacturing Manufacturing overhead utilities, rent, etc. clerical salaries; costs for legal, ﬁnancial, data processing, and accounting services; and building space for administrative personnel. Nonmanufacturing costs are expensed periodically (often in the period they are in- curred) for ﬁnancial accounting purposes. For managerial purposes, however, managers often want to see nonmanufacturing costs assigned to products. This is particularly true for commissions and advertising related to a speciﬁc product. For example, managers at consumer products companies such as Procter & Gamble and Anheuser-Busch want the cost of advertising a speciﬁc product, which can be substantial, to be assigned to that product. For most of our purposes, this distinction between manufacturing and non- manufacturing costs is artiﬁcial because we are interested in the costs that products and services impose on the ﬁrm, not in the ﬁnancial accounting treatment of these costs. Sometimes distinguishing between manufacturing costs and nonmanufacturing costs is difﬁcult. For example, are the salaries of accountants who handle factory payrolls man- ufacturing or nonmanufacturing costs? What about the rent for ofﬁces for the manufac- turing vice president? There are no clear-cut classiﬁcations for some of these costs, so companies usually set their own guidelines and follow them consistently. In Action Indirect Costs in Banking All ﬁrms, not just manufacturing ﬁrms, classify costs as direct “while direct costs are generally under tight management or indirect. Service ﬁrms, such as investment banks, often control, indirect costs often are not.” Indirect costs cover ev- have costs that are mostly indirect. Managing indirect costs erything from IT development and risk control to taxation, is extremely important in these ﬁrms if they are to remain auditing, marketing, and public relations. proﬁtable. Research in Europe found that “indirect trading Source: Financial Times (London), January 7, 2004. costs could be as much as 85 percent of the total” for inter- national banks. Furthermore, the consulting ﬁrm found that Chapter 2 Cost Concepts and Behavior 45 Cost Allocation Many costs result from several departments sharing facilities (buildings, equipment) or L.O. 3 services (data processing, maintenance staff). If you share an apartment with someone, Explain the process of the rent is a cost to the people sharing the apartment. If we want to assign costs to each cost allocation. individual, some method must be devised for assigning a share of the costs to each user. This process of assigning costs is called cost allocation. We discuss implications of allocating costs throughout this book. However, cost al- cost allocation location is a process that is familiar to most people, even those who do not study cost Process of assigning indirect costs to products, services, accounting. First, we need some deﬁnitions. A cost object is any end to which a cost is people, business units, etc. assigned, for example, a unit of product or service, a department, or a customer. Managers make many decisions at the level of the cost object. Should we drop this cost object product? How can we make this customer proﬁtable? A cost pool is the cost we want to Any end to which a cost is assign to the cost objects. Examples are department costs, rental costs, or travel costs a assigned. consultant incurs to visit multiple clients. The cost allocation rule is the method or pro- cost pool cess used to assign the costs in the cost pool to the cost object. Collection of costs to be Consider the following simple example. Rockford Corporation has two divisions: East assigned to the cost objects. Coast (EC) and West Coast (WC). Computing services at Rockford are centralized and pro- cost allocation rule vided to the two divisions by the corporate Information Systems (IS) group. Total systems Method used to assign costs costs for the quarter are $1 million. Divisional ﬁnancial statements are being prepared, and in the cost pool to the cost the accountant has asked for your help in allocating these costs to the divisions. objects. How would you suggest the accountant proceed? You might suggest that because there are two divisions, they share the costs equally, that is, each is charged $500,000 for IS services. The West Coast manager argues, however, that this is unfair because WC is much smaller than EC. She argues that the allocation should be based on a measure of divisional size, such as revenues. The East Coast manager argues that this is not right because most of IS time is spent in the West Coast division, where the equipment is more complex and requires more maintenance. As we will see, there is often no “right” way to solve this dilemma (but there may be some ways that result in poor decisions). Let’s suppose the accountant chooses divisional revenue and that the revenue in EC is $80 million and the revenue in WC is $20 million. Then the allocation to the two divi- sions can be illustrated in the ﬂowchart, or cost ﬂow diagram, shown in Exhibit 2.5. cost ﬂow diagram Because the East Coast division earns 80 percent ( $80 million of the total $100 Diagram or ﬂowchart million in revenues), it is assigned, or allocated, 80 percent of the IS costs, or $800,000 illustrating the cost allocation ( 80% of $1,000,000). Similarly, the West Coast division is assigned $200,000 ( 20% process. of $1,000,000). Many of the cost allocation methods we discuss are more complex than this simple example, but the fundamental approach is the same: (1) identify the cost Exhibit 2.5 Cost Flow Diagram Cost Corporate IS Group pool $1,000,000 Cost allocation 80%a % Revenue 20%b rule Cost East Coast West Coast objects $800,000 $200,000 a 80% $80 million revenue ($80 million $20 million). b 20% $20 million revenue ($80 million $20 million). 46 Part I Introduction and Overview objects, (2) determine the cost pools, and (3) select a cost allocation rule. We will make extensive use of cost ﬂow diagrams such as the one in Exhibit 2.5 because they can help you understand (1) how a cost system works and (2) the likely effects on the reported costs of different cost objects from changes in the cost allocation rule. Direct versus Indirect Costs direct cost Any cost that can be unambiguously related to a cost object is a direct cost of that cost Any cost that can be directly object. Those that cannot be unambiguously related to a cost object are indirect costs. (unambiguously) related to We have already seen one use of this distinction in our discussion of manufacturing costs. a cost object at reasonable Accountants use the terms direct cost and indirect cost much as a nonaccountant might cost. expect. One difﬁculty is that a cost may be direct to one cost object and indirect to another. indirect cost For example, the salary of a supervisor in a manufacturing department is a direct cost of Any cost that cannot be the department but an indirect cost of the individual items the department produces. So directly related to a cost when someone refers to a cost as either direct or indirect, you should immediately ask, object. direct or indirect with respect to what cost object? Units produced? A department? A divi- sion? (When we use direct and indirect to describe labor and materials, the cost object is the unit being produced.) Whether a cost is considered direct or indirect also depends on the costs of linking it to the cost object. For example, it is possible to measure the amount of lubricating oil used to produce one unit by stopping the machine and measuring the amount of oil re- quired to ﬁll the reservoir. The cost of this is prohibitive in terms of lost production, so the oil cost is considered indirect. Details of Manufacturing Cost Flows L.O. 4 Jackson Gears is a small machining and manufacturing company that makes gears for Understand how original equipment manufacturers (OEMs), such as automobile and farm equipment material, labor, and companies. Even if you have never been in a machine shop, you can imagine the process of making a gear. It would consist of three basic steps: overhead costs are added to a product First, you would see metal (direct material) being delivered to the receiving area, at each stage of the inspected, and then placed in the direct material inventory area (store) of the shop. production process. Next, when it was time to produce gears, the metal would be transported to an as- sembly line. It would be fed to large machines (presses, lathes, and so on) that would turn the unformed metal into the ﬁnished gear. While the metal is in this part of the work in process factory, it is neither direct material nor a gear; it is work in process. Product in the production Finally, the gear is complete, and it is moved out to a separate area in the factory with process but not yet complete. other completed products. These gears are ﬁnished goods and ready for sale. ﬁnished goods Product fully completed but Just as the manufacturing plant at Jackson Gears has direct material, work-in-process, not yet sold. and ﬁnished goods inventories, the cost accounting system at Jackson has three major categories of inventory accounts—one category for each of these three stages: Direct Materials Inventory, Work-in-Process Inventory, and Finished Goods Inventory. Our goal with the cost accounting system is simple. By tracing the physical ﬂows with cost ﬂows through the inventory accounts, we can represent the use of resources in the plant to pro- duce the ﬁnished gears. Each inventory account is likely to have a beginning inventory amount, additions (debits) and withdrawals (credits) during the period, and an ending inventory based on what is still on hand at the end of the period. Those costs added (debited) to inventory inventoriable costs accounts are called inventoriable costs. Costs added to inventory To show how this works, Exhibit 2.6 illustrates a simpliﬁed version of the actual accounts. production process at Jackson Gears. It shows the stages of production from receipt of materials through manufacturing to shipment to the ﬁnished goods warehouse. Chapter 2 Cost Concepts and Behavior 47 Exhibit 2.6 Production Process at Jackson Gears Vendor 1 Store Process Complete Sell Assembly line Direct Finished (Work-in- Gear Metal materials goods process is sold inventory inventory inventory) Vendor 2 Jackson Gears receives raw metal (steel, brass, etc.) at its Direct Materials Receiv- ing Department. The people in this department are responsible for checking each order to be sure that it meets quality speciﬁcations and that the goods received are what was ordered. If Jackson Gears uses just-in-time (JIT) inventory methods, people in direct materials receiving send the components—metals, plastics—to the machining line immediately. If Jackson Gears does not use JIT, people in this department send the components to a materials warehouse until it is needed for production. Any product that has been purchased but not yet transferred to manufacturing departments will be part of Direct Materials Inventory on the balance sheet at the end of the accounting period. When the production process begins, the metal moves along the machining line as it is transformed (teeth added to the gears, individual gears cut, and so on). Any gears that are not complete—that is, those still on the machining line at the end of an accounting period—are part of Work-in-Process Inventory on the balance sheet. After the completed gears are inspected, they are moved to a holding area awaiting shipment to customers around the country. The cost of any product that is ﬁnished but not yet sold to customers is included in Finished Goods Inventory at the end of an accounting period. How Costs Flow through the Statements Income Statements Now that we understand the physical ﬂow of the product through the process, we next use a numerical example to show how to report Jackson Gears’s revenues and costs. The result is a typical income statement for a manufacturing company (see Exhibit 2.7). The income statement shows that Jackson Gears generated sales revenue of $20,450,000, had cost of goods sold of $13,100,000, and incurred marketing and administrative costs of $3,850,000 for the year, thereby generating an operating proﬁt of $3,500,000. Exhibit 2.7 JACKSON GEARS Income Statement for a Income Statement For the Year Ending December 31, Year 2 Manufacturing Firm ($000) Sales revenue............................................... $20,450 Cost of goods sold (see Exhibit 2.8).............................. 13,100 Gross margin.............................................. $ 7,350 Less marketing and administrative costs.......................... 3,850 2SHUDWLQJSUR¿WEHIRUHWD[HV 48 Part I Introduction and Overview Exhibit 2.8 JACKSON GEARS Cost of Goods Cost of Goods Manufactured and Sold Statement Manufactured and For the Year Ending December 31, Year 2 Sold Statement for a ($000) Manufacturing Firm Beginning work-in-process inventory, January 1.......... $270 Manufacturing costs during the year: Direct materials: Beginning inventory, January 1..................... $ 95 Add purchases.................................. 5,627 Direct materials available........................ $5,722 Less ending inventory, December 31................ 72 Direct material put into production................. $5,650 Direct labor...................................... 1,220 Manufacturing overhead............................ 6,780 Total manufacturing costs incurred.................. 13,650 Total work in process during the year.................. $13,920 Less ending work-in-process inventory, December 31..... 310 Cost of goods manufactured......................... $13,610 %HJLQQLQJ¿QLVKHGJRRGVLQYHQWRU\-DQXDU\ Finished goods available for sale..................... $14,030 /HVVHQGLQJ¿QLVKHGJRRGVLQYHQWRU\'HFHPEHU Cost of goods sold................................ $13,100 Cost of Goods Manufactured and Sold We now demonstrate how to derive the cost of goods manufactured and sold amount on the income statement from the company’s activities. The resulting statement is the cost of goods manufactured and sold statement, which appears in Exhibit 2.8. You will be able to see how these items appear in the cost of goods manufactured and sold statement if you trace each amount in the following example to Exhibit 2.8. Direct Materials Assume the following for the company: Direct materials inventory on hand January 1 totaled $95,000. Materials purchased during the year cost $5,627,000. Ending inventory on December 31 was $72,000. Therefore, the cost of direct materials put into production during the year was $5,650,000, computed as follows (in thousands of dollars): Beginning direct materials inventory, January 1...................... $ 95 Add purchases during the year................................... 5,627 Direct materials available during the year......................... $5,722 Less ending direct materials inventory, December 31................. 72 Cost of direct materials put into production........................ $5,650 Work in Process Consider the following: The Work-in-Process Inventory account had a beginning balance of $270,000 on January 1, as shown in Exhibit 2.8. Chapter 2 Cost Concepts and Behavior 49 Exhibit 2.8 shows that costs incurred during the year totaled $5,650,000 in direct materials (as shown in the preceding direct materials inventory schedule), $1,220,000 in direct labor costs, and $6,780,000 in manufacturing overhead. The sum of materials, labor, and manufacturing overhead costs incurred, $13,650,000, is the total manufacturing costs incurred during the year. Managers in production and operations give careful attention to these costs. Companies that want to be competitive in setting prices must manage these costs diligently. From here on the process can seem complicated, but it’s not really so difﬁcult if you realize that accountants are just adding and subtracting inventory values. In other words, just as materials, in different forms, are moving from one inventory in the plant to another, the costs in the cost accounting system are moving from one inven- tory account to another. Adding the $270,000 beginning work-in-process inventory to the $13,650,000 total manufacturing costs gives $13,920,000, the total cost of work in process during the year. This is a measure of the resources that have gone into production. Some of these costs were in the work-in-process inventory on hand at the beginning of the period (that is the $270,000 in beginning inventory), but most has been incurred this year (that is the $13,650,000 total manufacturing costs). At year-end, the work-in-process inventory has a $310,000 cost, which is sub- tracted to arrive at the cost of goods manufactured during the year: $13,610,000 ( $13,920,000 − $310,000), which represents the cost of gears ﬁnished during the year. Production departments usually have a goal for goods completed each period. Managers would compare the cost of goods manufactured to that goal to see whether the production departments were successful in meeting it. Finished Goods Inventory The work ﬁnished during the period is transferred from the production department to the ﬁnished goods storage area or is shipped to customers. If goods are shipped to custom- ers directly from the production line, no ﬁnished goods inventory exists. Jackson Gears has a ﬁnished goods inventory, however, because some of the gears are common across manufacturers and so it keeps some of them on hand to expedite orders. Here’s how the amounts appear on the ﬁnancial statements: Exhibit 2.8 shows that Jackson Gears had $420,000 of ﬁnished goods inventory on hand at the beginning of the year (January 1). From the discussion about work in process, we know that Jackson Gears completed $13,610,000 worth of product, which was transferred to ﬁnished goods inventory. Therefore, Jackson Gears had $14,030,000 ﬁnished goods inventory available for sale, in total. Of the $14,030,000 available, Jackson Gears had $930,000 ﬁnished goods still on hand at the end of the year. This means that the cost of goods sold was $13,100,000 ( $14,030,000 available $930,000 in ending inventory). Cost of Goods Manufactured and Sold Statement As part of its internal reporting system, Jackson Gears prepares a cost of goods manufac- tured and sold statement (Exhibit 2.8). Such statements are for managerial use; you will rarely see one published in external ﬁnancial statements. Exhibit 2.8 incorporates and summarizes information from the preceding discussion. Manufacturing companies typically prepare a cost of goods manufactured and sold statement to summarize and report manufacturing costs such as those discussed for Jackson Gears, most often for managers’ use. Some companies have experimented with preparing these statements for production workers and supervisors, who in some cases have found them effective communication devices once these people learn how to read them. For example, managers at Jackson Gears use the cost of goods manufactured and sold statement to communicate the size of manufacturing overhead and inventories to stimulate creative ideas for reducing these items. 50 Part I Introduction and Overview The cost of goods manufactured and sold statement in Exhibit 2.8 has three build- ing blocks. The ﬁrst reports the cost of direct materials. Next is the work-in-process ac- count with its beginning balance, costs added during the period, ending balance, and cost of goods manufactured. Third, the statement reports the beginning and ending ﬁnished goods inventory and cost of goods sold. These ﬁnancial statements are presented in a standard format that you will ﬁnd used by many companies and on the CPA and CMA examinations. Please be aware that we discuss many variations in this book, but many more exist in practice. For example, some companies prepare separate statements of cost of goods sold and cost of goods manufac- tured. It is important that ﬁnancial statements effectively present the information that best suits the needs of your customers or information users (for example, managers of your company or your clients). For managerial purposes, it is important that the format of ﬁ- nancial statements be tailored to what users want (or to what you want if you are the user of ﬁnancial information). Self-Study Questions 1. A review of accounts showed the following for Paciﬁc Parts for last year: Plant maintenance and repairs........... 296,000 Sales revenue........................ 8,144,000 Supervisory and indirect labor........... 508,000 Administrative costs................... $1,216,000 Supplies and indirect materials........... 56,000 Depreciation, manufacturing............. 412,000 Work-in-process inventory, January 1..... 540,000 Direct labor.......................... 1,928,000 Work-in-process inventory, December 31... 568,000 Direct materials purchases.............. 1,252,000 Direct materials inventory, January 1...... 408,000 Direct materials inventory, December 31... 324,000 Prepare an income statement with a supporting Finished goods inventory, January 1...... 640,000 cost of goods manufactured and sold statement. Refer Finished goods inventory, December 31... 588,000 to Exhibits 2.7 and 2.8. Heat, light, and power—plant............ 348,000 2. Using the data from question 1, place dollar amounts in Marketing costs....................... 1,088,000 each box in Exhibit 2.4. Miscellaneous manufacturing costs....... 48,000 (continued ) The solutions to these questions are at the end of this chapter on pages 78 and 79. An Interim Debrief Barry Roberts and Jessica Martinez take a break from their are related to the production ﬂow; that’s something I meeting. Barry summarizes what he has learned so far: understand. I understand now why some of these costs are not useful for managing the plant. For example, I Learning the cost terms will really help me communicate know that for any decision I might make, some of the with both Jessica and the ﬁnance staff at corporate. costs—plant supervision, for example—are not likely to One important lesson I learned is that there are different change. When Jessica returns, I am going to ﬁnd out costs for different purposes. Financial reporting is im- how to identify the costs that will be important for my portant, but for the day-to-day management of the plant, decisions and how I can get the cost information sum- I am going to need more detailed cost information. marized in a way that helps me. I also have a better understanding of the different types of costs. It really helped to see how these costs Chapter 2 Cost Concepts and Behavior 51 Cost Behavior The ﬁnancial statements of Jackson Gears report what happened, but they fail to show L.O. 5 why. For that we need to understand how costs behave and how managers analyze costs Define basic cost to arrive at their decisions. Managerial decisions lead to the activities that the ﬁrm behaviors, including undertakes, and these activities create (or destroy) the value in an organization. Informa- fixed, variable, tion from the cost accounting system is a key ingredient in making these decisions. semivariable, and step Cost behavior deals with the way costs respond to changes in activity levels. Through- out this book we refer to the idea of a cost driver. As deﬁned in Chapter 1, a cost driver is costs. a factor that causes, or “drives,” costs. For example, the cost driver for the cost of lumber for the activity of building a house could be the number of board feet of lumber used or the size of the house in square feet. The cost driver for direct labor costs could be the number of labor-hours worked. Managers need to know how costs behave to make informed decisions about products, to plan, and to evaluate performance. We classify the behavior of costs as being in one of four basic categories: ﬁxed, variable, semivariable, and step costs, as discussed next. Fixed versus Variable Costs Suppose that management contemplates a change in the volume of a company’s activity. Some questions different managers might ask follow: An operations manager at United Airlines: How much will our costs decrease if we reduce the number of ﬂights by 5 percent? A manager at the U.S. Post Ofﬁce: How much will our costs decrease if we eliminate Saturday deliveries? A business school dean: How much will costs increase if we reduce average class size by 10 students by increasing the number of classes offered? To answer questions such as these, we need to For Air France, the cost of H[HFXWLYHVDODULHVLV¿xed. know which costs are ﬁxed costs that remain un- The cost of fuel is variable changed as the volume of activity changes and SHUKRXURUSHUPLOHÀown. which are variable costs that change in direct proportion to the change in volume of activity. If the activity is producing units, variable manufacturing costs typically include direct materials, certain manufacturing overhead (for example, indirect materials, materials-handling labor, energy costs), and direct labor in some cases (such as temporary workers). Certain nonmanufacturing costs such as distribution ﬁxed costs costs and sales commissions are typically variable. Much of manufacturing overhead and Costs that are unchanged as many nonmanufacturing costs are typically ﬁxed costs. volume changes within the relevant range of activity. Although labor has traditionally been considered a variable cost, today the produc- tion process at many ﬁrms is capital intensive and the amount of labor required is not variable costs sensitive to the amount produced. In a setting in which a ﬁxed amount of labor is needed Costs that change in direct only to keep machines operating, labor is probably best considered to be a ﬁxed cost. proportion with a change in In merchandising, variable costs include the cost of the product and some marketing volume within the relevant and administrative costs. All of a merchant’s product costs are variable. In manufacturing, range of activity. a portion of the product cost is ﬁxed. In service organizations, variable costs typically include certain types of labor (such as temporary employees), supplies, and copying and printing costs. Exhibit 2.9 depicts variable cost behavior—(a), and ﬁxed cost behavior— (b). Note in the graph that volume is on the horizontal axis, and total costs (measured in dollars) are on the vertical axis. Item (a) shows that total variable costs increase in direct proportion to changes in volume. Thus, if volume doubles, total variable costs also dou- ble. Item (b) shows that ﬁxed costs are at a particular level and do not increase as volume increases. 52 Part I Introduction and Overview Exhibit 2.9 Four Cost Behavior Patterns (a) (b) (c) (d) Variable costs Fixed costs Semivariable costs Step costs $ $ $ $ Volume Volume Volume Volume The identiﬁcation of a cost as ﬁxed or variable is valid only within a certain range of activity. For example, the manager of a restaurant in a shopping mall increased the capacity from 150 to 250 seats, requiring an increase in rent costs, utilities, and many other costs. Although these costs are usually thought of as ﬁxed, they change when activ- ity moves beyond a certain range. This range within which the total ﬁxed costs and unit relevant range variable costs do not change is called the relevant range. Activity levels within which Four aspects of cost behavior complicate the task of classifying costs into ﬁxed and a given total ﬁxed cost or variable categories. First, not all costs are strictly ﬁxed or variable. For example, electric unit variable cost will be utility costs may be based on a ﬁxed minimum monthly charge plus a variable cost for unchanged each kilowatt-hour. Such a semivariable cost has both ﬁxed and variable components. semivariable cost Semivariable costs, also called mixed costs, are depicted in Exhibit 2.9 (c). Cost that has both ﬁxed and Second, some costs increase with volume in “steps.” Step costs, also called semiﬁxed variable components; also costs, increase in steps as shown in Exhibit 2.9 (d). For example, one supervisor might be called mixed cost. needed for up to four ﬁreﬁghters in a ﬁre station, two supervisors for ﬁve to eight, and so step cost forth as the number of ﬁreﬁghters increases. The supervisors’ salaries represent a step cost. Cost that increases with Third, as previously indicated, the cost relations are valid only within a relevant range volume in steps; also called of activity. In particular, costs that are ﬁxed over a small range of activity are likely to semiﬁxed cost. increase over a larger range of activity. Finally, the classiﬁcation of costs as ﬁxed or variable depends on the measure of activity used. For example, at Jackson Gears, part of the production cost is setting up the machines to run a speciﬁc part. Plant engineers have to calibrate the machine for each production run, but each run can produce up to 4,000 parts. If production volume is the activity measure, then the plant engineer costs are a step cost. However, if the number of production runs is the activity measure, then the plant engineer costs are vari- able; they spend the same amount of time for each run. Understanding cost behavior is an important part of using cost accounting information wisely for decisions. Consider a recent example at Jackson Gears. Eastern Nursing costs are a step cost in a hospital. Transmission Company, a longtime customer of Jackson, has requested a price quotation from Jackson for a modi- ﬁed version of a common gear. The modiﬁed gear is the J12. Eastern wants the quotation to cover a volume of J12 gears from 2,000 to 6,000, because it is not sure of its ﬁnal re- quirement. Jessica Martinez, the plant cost analyst, has prepared the preliminary cost data in Exhibit 2.10 for Sandy Ventura, the Jackson sales representative for Eastern. The cost for developing production speciﬁcations is ﬁxed. It does not depend on the volume of gears actually produced. The direct materials and the direct labor costs are variable. They increase proportionately with volume. Chapter 2 Cost Concepts and Behavior 53 A B C D Exhibit 2.10 1 Cost Item Amount Notes Cost Data for Price This is a one-time expenditure for Quotation 2 Develop production specifications for J12 $ 2,000 drawings. 3 Direct materials (metal) 10.00 This is the cost per gear. 4 Direct labor 2.00 This is the cost per gear. Up to 4,000 gears can be produced in a 5 Set up machinery 1,000 single production run. 6 Inspect gears: Equipment 500 A new measuring device is required. 7 Labor 0.25 Per gear. 8 The cost for setting up the machinery is neither ﬁxed nor variable with respect to volume. The setup costs are semiﬁxed—they are incurred to set up the initial production run, and then they are not affected by production until 4,000 gears have been produced. To produce more than 4,000 gears, another ﬁxed amount must be spent. The inspection costs are semivariable. The new measuring device is a ﬁxed cost and the $0.25 per gear is variable. Components of Product Costs We have now seen that various concepts of costs exist. Some are determined by the rules L.O. 6 of ﬁnancial accounting. Some are more useful for managerial decision making. In this Identify the components section, we develop several diagrams to explain various cost concepts and identify the of a product’s cost. differences. Starting with Exhibit 2.11, assume that Jackson Gears estimates the cost to produce a specialized tractor gear during year 3. The full cost to manufacture and sell one gear full cost is estimated to be $40, as shown on the left side of Exhibit 2.11. The unit cost of manu- Sum of all costs of facturing the gear is $29, also shown on the left side of the exhibit. (One unit is 1 gear.) manufacturing and selling a This full cost of manufacturing the one unit is known as the full absorption cost. It is the unit of product (includes both ﬁxed and variable costs). amount of inventoriable cost for external ﬁnancial reporting according to GAAP. The full absorption cost “fully absorbs” the variable and ﬁxed costs of manufacturing a product. full absorption cost The full absorption cost excludes nonmanufacturing costs, however, so marketing All variable and ﬁxed and administrative costs are not inventoriable costs. These nonmanufacturing costs equal manufacturing costs; used $11 per unit, which is the sum of the two blocks at the bottom of Exhibit 2.11. to compute a product’s The variable costs to make and sell the product are variable manufacturing costs, $23 inventory value under GAAP. per unit, and variable nonmanufacturing costs, $4 per unit. Variable nonmanufacturing costs could, in general, be either administrative or marketing costs. For Jackson Gears, variable nonmanufacturing costs are primarily selling costs. In other cases, variable ad- ministrative costs could include costs of data processing, accounting, or any administra- tive activity that is affected by volume. Exhibit 2.11 also includes unit ﬁxed costs. The unit ﬁxed costs are valid only at one volume—2,000 units (of this gear) per year—for Jackson Gears. By deﬁnition, total ﬁxed costs do not change as volume changes (within the relevant range, of course). Therefore, a change in volume results in a change in the unit ﬁxed cost, as demonstrated by Self- Study Question 3. Unit Fixed Costs Can Be Misleading for Decision Making When analyzing costs for decisions, you should use unit ﬁxed costs very carefully. Many managers fail to realize that they are valid at only one volume. When ﬁxed costs are al- located to each unit, accounting records often make the costs appear as though they are 54 Part I Introduction and Overview Exhibit 2.11 Product Cost Components—Jackson Gears Direct materials $8 Variable Direct labor $7 manufacturing cost $23 Full absorption cost per Variable manufacturing unit $29 overhead $8 Full cost Unit per variable unit $40 cost $27 Fixed manufacturing overhead $6 ( $12,000 2,000 units) Variable Variable marketing and marketing and administrative administrative costs $4 costs $4 Fixed marketing and administrative costs $7 ( $14,000 2,000 units) variable. For example, allocating some of factory rent to each unit of product results in in- cluding rent as part of the “unit cost” even though the total rent does not change with the manufacture of another unit of product. Cost data that include allocated common costs therefore may be misleading if used incorrectly. The following example demonstrates the problem. One of the parts Jackson Gears sells has a unit manufacturing cost of $2.80 ($1.50 per unit variable manufacturing cost + $1.30 per unit ﬁxed manufacturing cost), com- puted as follows (each part is one unit): Variable manufacturing costs per unit............................... $1.50 Fixed manufacturing costs: Fixed manufacturing cost per month $130,000 Unit cost _____________________________ ___________ 1.30 Units produced per month 100,000 units Total unit cost used as the inventory value for H[WHUQDO¿QDQFLDOUHSRUWLQJ Chapter 2 Cost Concepts and Behavior 55 Jackson Gears received a special order for 10,000 parts at $2.75 each. These units could be produced with currently idle capacity. Marketing, administrative, and the total ﬁxed manufacturing costs of $130,000 would not be affected by accepting the order, nor would accepting this special order affect the regular market for this part. Marketing managers believed the special order should be accepted as long as the unit price of $2.75 exceeded the cost of manufacturing each unit. When the marketing man- agers learned from accounting reports that the inventory value was $2.80 per unit, their initial reaction was to reject the order because, as one manager stated, “We are not going to be very proﬁtable if our selling price is less than our production cost!” Fortunately, some additional investigation revealed the variable manufacturing cost to be only $1.50 per unit. Marketing management accepted the special order, which had the following impact on the company’s operating proﬁt: Revenue from special order (10,000 units $2.75)................. $27,500 Variable costs of making special order (10,000 units $1.50)......... 15,000 &RQWULEXWLRQRIVSHFLDORUGHUWRRSHUDWLQJSUR¿W The moral of this example is that it is easy to interpret unit costs incorrectly and make incorrect decisions. In this example, ﬁxed manufacturing overhead costs had been allocated to units, most likely to value inventory for external ﬁnancial reporting and tax purposes. The resulting $2.80 unit cost appeared to be the cost to produce a unit. Of course, only $1.50 was a per unit variable cost; the $130,000 per month ﬁxed cost would not be affected by the decision to accept the special order. Self-Study Question 3. Refer to the Jackson Gears example in Exhibit 2.11 that ufacturing costs per unit and the fixed marketing and is based on a volume of 2,000 units per year. Assume administrative costs per unit? the same total fixed costs and unit variable costs but The solution to this question is at the end of this chapter on a volume of only 1,600 units. What are the fixed man- page 79. Exhibits 2.12 and 2.13 are designed to clarify deﬁnitions of gross margin, contribu- tion margin, and operating proﬁt. You may recall from your study of ﬁnancial accounting statements that the gross margin appears on external ﬁnancial statements as the differ- gross margin ence between revenue and cost of goods sold. We refer to this format as a traditional Revenue Cost of goods income statement. Cost of goods sold is simply the full absorption cost per unit times the sold on income statements. number of units sold. Exhibit 2.12 presents the gross margin per unit for the gears that Per unit, the gross margin equals Sales price Full Jackson Gears produces and sells for $45 each. absorption cost per unit. Recall from Exhibit 2.11 that each gear is estimated to have a $29 full absorption cost. Therefore, the gross margin per unit is $16 ( $45 − $29). The operating proﬁt per unit is the difference between the sales price and the full cost of making and selling the product. For Jackson Gears, Exhibit 2.12 shows the operating proﬁt per unit to be $5 ( $45 sales price − $40 full cost). Exhibit 2.13 also shows the contribution margin per unit. On a per unit basis, the contribution margin is the difference between the sales price and the variable cost per unit. contribution margin Think of the contribution margin as the amount available to cover ﬁxed costs and earn a proﬁt. Sales price Variable costs The contribution margin is important information for managers because it allows per unit. them to assess the proﬁtability of products before factoring in ﬁxed costs (which tend to be more difﬁcult to change in the short run). For example, a coffee shop sells both drip coffee and espresso drinks. A cup of drip coffee sells for $1.50 and a cappuccino sells for $2.50. Which product contributes more per unit to proﬁts? Answer: We don’t know until 56 Part I Introduction and Overview Exhibit 2.12 Gross Margin per Unit—Jackson Gears Variable manufacturing cost $23 Full absorption cost per unit $29 Fixed manufacturing cost $6 Full cost per unit $40 Sales price Sales price per Variable marketing and per unit $45 administrative $4 unit $45 Gross margin $16 Fixed marketing and ($45 $29) administrative $7 Operating profit $5 Excess of price over full unit cost $5 we know the contribution margin per unit for each product. Suppose that the variable cost per cup is $.25 for drip coffee and $1.50 for cappuccino. Then the contribution margins (per unit) are as follows: Drip coffee $1.25 ( $1.50 sales price $.25 variable cost). Cappuccino $1.00 ( $2.50 sales price $1.50 variable cost). Although the cappuccino sells for more, the drip coffee provides a higher contribu- tion per unit toward covering ﬁxed costs and earning a proﬁt. Self-Study Questions Refer to the Jackson Gears examples in Exhibits 2.12 5. Assume that the fixed manufacturing cost dropped and 2.13. from $12,000 to $10,000 in total, or from $6 to $5 per unit. All other unit cost numbers remain the same as in 4. Assume that the variable marketing and administrative Exhibits 2.12 and 2.13. What are the new gross margin, cost falls to $3 per unit; all other cost numbers remain contribution margin, and operating profit amounts? the same. What are the new gross margin, contribution margin, and operating profit amounts? The solutions to these questions are at the end of the chapter on page 79. Chapter 2 Cost Concepts and Behavior 57 Exhibit 2.13 Contribution Margin per Variable manufacturing Unit—Jackson Gears cost $23 Variable cost per unit $27 Variable marketing and administrative $4 Full cost per unit $40 Sales price Sales price per Fixed manufacturing per unit $45 cost $6 unit $45 Contribution margin Fixed marketing and $18 administrative $7 ($45 $27) Operating

Cost Behavior in Manufacturing: Concepts and Applications

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