Basic Cost Management Concepts

Prepared by

Douglas Cloud
Pepperdine University

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Objectives
1. Describe a cost management information After studying this system, its objectives, and its major chapter, you should subsystems, andbe indicate how it relates to able to: other operating and information systems. 2. Explain the cost assignment process. 3. Define tangible and intangible products, and explain why there are different product cost definitions.
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Objectives
4. Prepare income statements for manufacturing and service organizations. 5. Explain the differences between traditional and contemporary cost management systems.

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A Systems Framework
A system is a set of interrelated parts that performs one or more processes to accomplish specific objectives. Example: An air conditioning system for a home

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Operational Model of an Air Conditioning System

Cooling Process
Inputs: Freon Warm Air Electricity

Delivery Process
Inputs: Cooled Air Electricity Ducts

Output: Cooled Air

Output: Delivered Cooled Air

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Accounting Information System

An accounting information system is a system consisting of interrelated manual and computer parts, using processes such as collecting, recording, summarizing, analyzing, and managing data to provide information to users. Like any system, an accounting information system consists of: (1) objectives, (2) interrelated parts, (3) processes, and (4) outputs.

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Operational Model for an Accounting Information System

Collecting Classifying Summarizing Analyzing Managing Special Reports Financial Statements Budgets Performance Reports Personal Communication

Economic Events

Inputs

Processes

Outputs

Users

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Accounting Information Systems

The financial accounting information system is an accounting information subsystem that is primarily concerned with producing outputs for external users. The cost management information system is an accounting information subsystem that is primarily concerned with producing outputs for internal users using inputs and processes needed to satisfy management objectives.

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Accounting Information Systems

The cost management information system has three broad objectives that provide information for-1) Costing out services, products, and other objects of interest to management 2) Planning and control 3) Decision making

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An Integrated Cost Management System

Design and Development System Cost Management System
Production System

Marketing and Distribution System

Customer Servicing System

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The Subsystems of the Accounting Information System

Accounting Information System

Financial Accounting Information System

Cost Management Information System

Cost Accounting Information System

Operational Control System

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Basic Cost Concepts

Cost is the cash or cash equivalent value sacrificed

for goods and services that are expected to bring a current or future benefit to the organization.
Costs are incurred to produce future benefits. Expired costs are called expenses. Unexpired costs are classified as assets and appear

on the balance sheet. Assigning cost accurately to cost objects is crucial.

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Basic Cost Concepts

A cost object is any item, such as products, customers, departments, projects, activities, and so on, for which costs are measured and assigned.
Example: A bicycle is a cost object when you are determining the cost to produce a bicycle.

An activity is a basic unit of work performed within an organization.

Example: Setting up equipment, moving materials, maintaining equipment, designing products, etc.

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Basic Cost Concepts

Traceability is the ability to assign a cost to a cost object in an economically feasible way by means of a causal relationship. Direct costs are those costs that can be easily and accurately traced to a cost object.
Example: The salary of a supervisor of a department, where the department is defined as the cost object.

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Basic Cost Concepts

Indirect costs are those costs that cannot be traced easily and accurately to a cost object.
Example: The cost of heating and cooling a plant that manufactures five products.

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Cost Assignment Methods

Cost of Resources
Resource Drivers

Direct Tracing

Driver Tracing

Allocation

Physical Observation

Activity Drivers

Convenience Assumed Linkage

Cost Objects
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Product Cost Definitions

Value-Chain Product Costs
Research and Development

Operating Product Costs

Traditional Product Costs

Production Marketing Customer Service

Pricing Decisions Product Mix Decisions Strategic Profitability Analysis

Production Marketing

Production

Customer Service
Strategic Design Decisions Tactical Profitability Analysis External Financial Reporting

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Manufacturing Costs
Direct materials are those materials that are directly traceable to the goods or services being produced.
Example: The cost of wood in furniture.

Direct labor is the labor that is directly traceable to the goods or services being produced.
Example: Wages of assembly-line workers.

Overhead are all other manufacturing costs.

Example: Plant depreciation, utilities, property taxes, indirect materials, indirect labor, etc.

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Nonproduction Costs
Marketing (selling) costs are the costs necessary to market, distribute, and service a product or service.
Example: Advertising, storage costs, and freight out.

Administrative costs are the costs associated with research, development, and general administration of the organization that cannot reasonably be assigned to either marketing or production.
Example: Legal fees, salary of the chief executive officer.

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Nonproduction Costs
For external financial reporting, marketing and administrative costs are not inventoried. They are referred to as period costs.

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Production or Manufacturing Costs

Nonproduction or Operating Costs

Direct Materials Direct Labor

Overhead

Marketing Expense Prime Cost Order-Getting Costs Order-Filling Costs Conversion Cost Administrative Expense
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Manufacturing Organization Income Statement For the Year Ended December 31, 2004
Sales Less: Cost of goods sold Gross margin Less operating expenses: Selling expenses Administrative expenses Operating income $2,800,000 1,300,000 $ 700,000 $300,000 From the Cost 150,000 450,000 of Goods Sold Schedule $ 250,000

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Statement of Cost of Goods Manufactured For the Year Ended December 31, 2004
Direct materials: Beginning inventory $200,000 Add: Purchases 450,000 Materials available $650,000 Less: Ending inventory 50,000 Direct materials used in production $ 600,000 Direct labor 350,000 Manufacturing overhead: Indirect labor $122,500 Depreciation 177,500 Rent 50,000 Utilities 37,500 Property taxes 12,500 Maintenance 50,000 450,000 Total manufacturing costs continued added $1,400,000

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Total manufacturing costs added Add: Beginning work in process Less: Ending work in process Cost of goods manufactured

$1,400,000 200,000 400,000 $1,200,000

Work in process consists of all partially completed units found in production at a given point in time.

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Cost of Goods Sold Schedule For the Year Ended December 31, 2004
Cost of goods manufactured Add: Beginning inventory finished goods Cost of goods available for sale Less: Ending inventory finished goods Cost of goods sold $1,200,000 250,000 $1,450,000 150,000 $1,300,000

From the Statement of Cost of Goods Manufactured

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Activity-Based Management Model

Cost View Resources

Process View Driver Analysis Why? Activities What? Performance Analysis How well?

Products and Customers

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Functional-Based and ActivityBased Cost Management Systems

Functional-Based

1. Unit-based drivers
2. Allocation-intensive 3. Narrow and rigid product costing 4. Focus on managing costs 5. Sparse activity information

6. Maximization of individual unit performance

7. Uses financial measures of performance
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Functional-Based and ActivityBased Cost Management Systems

Activity-Based 1. Unit- and nonunit-based drivers 2. Tracing intensive 3. Broad, flexible product costing

4. Focus on managing activities

5. Detailed activity information 6. Systemwide performance maximization 7. Uses both financial and nonfinancial measures of performance
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Trade-Off Between Measurement and Error Costs

Cost Total Cost

Measurement Cost

Error Cost

Low Accuracy

Optimal Level

High Accuracy
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Shifting Costs
Cost
Old Measurement Cost

New Measurement Cost New Error Cost

Old Error Cost

Low

Old Optimum New Optimum Accuracy

High
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Chapter
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End of

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