An Introduction to Cost Terms and Purposes

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Basic Cost Terminology

Cost sacrificed resource to achieve a specific

objective Actual cost a cost that has occurred Budgeted cost a predicted cost Cost object anything of interest for which a cost is desired

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Cost Object Examples at BMW

Cost Object Product Service Project Customer Activity Department Illustration BMW X 5 sports activity vehicle Dealer-support telephone hotline R&D project on DVD system enhancement Herb Chambers Motors, a dealer that purchases a broad range of BMW vehicles

Setting up production machines

Environmental, Health & Safety

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Basic Cost Terminology

Cost accumulation a collection of cost data in an

organized manner Cost assignment a general term that includes gathering accumulated costs to a cost object. This includes:
Tracing accumulated costs with a direct relationship to

the cost object and Allocating accumulated costs with an indirect relationship to a cost object

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Direct & Indirect Costs

Direct costs can be conveniently and economically

traced (tracked) to a cost object Indirect costs cannot be conveniently or economically traced (tracked) to a cost object. Instead of being traced, these costs are allocated to a cost object in a rational and systematic manner

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BMW: Assigning Costs to a Cost Object

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Cost Examples
Direct Costs Parts Assembly line wages Indirect Costs Electricity Rent Property taxes

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Factors Affecting Direct / Indirect Cost Classification

Cost Materiality Availability of information-gathering technology Operational Design

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Cost Behavior
Variable costs changes 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

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Cost Behavior, continued

Variable costs are constant on a per-unit basis. If a

product takes 5 pounds of materials each, it stays the same per unit regardless of one, ten or a thousand units are produced Fixed costs change inversely with the level of production. As more units are produced, the same fixed cost is spread over more and more units, reducing the cost per unit

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Cost Behavior Summarized

Variable Costs Variable Costs

Total Dollars Dollars Total Change in in Change proportion with with proportion output output
Moreoutput output= =More Morecost cost More

Cost per Per Unit Unit

Unchanged in relation to output

Fixed Costs Fixed Costs

Change Change inversely inversely with Unchanged in with output Unchanged in output = lower cost relation to output More output More output = lower cost relation to output per unit
per unit
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Cost Behavior Visualized

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Other Cost Concepts

Cost Driver a variable that causally affects costs over

a given time span Relevant Range the band of normal activity level (or volume) in which there is a specific relationship between the level of activity (or volume) and a given cost
For example, fixed costs are considered fixed only within

the relevant range.

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Relevant Range Visualized

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A Cost Caveat
Unit costs should be used cautiously. Since unit costs

change with a different level of output or volume, it may be more prudent to base decisions on a total dollar basis.
Unit costs that include fixed costs should always

reference a given level of output or activity Unit Costs are also called Average Costs

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Multiple Classification of Costs

Costs may be classified as: Direct / Indirect, and Variable / Fixed These multiple classifications give rise to important

cost combinations:
Direct & Variable Direct & Fixed

Indirect & Variable

Indirect & Fixed
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Multiple Classification of Costs, Visualized

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Different Types of Firms

Manufacturing-sector companies create and sell

their own products Merchandising-sector companies product resellers Service-sector companies provide services (intangible products)

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Types of Manufacturing Inventories

Direct Materials resources in-stock and available for

use Work-in-Process (or progress) products started but not yet completed. Often abbreviated as WIP Finished Goods products completed and ready for sale

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Types of Product Costs

Also known as Inventoriable Costs Direct Materials Direct Labor Indirect Manufacturing factory costs that are not traceable to the product. Other common names for this type of cost include Manufacturing Overhead costs or Factory Overhead costs.

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Accounting Distinction Between Costs

Inventoriable costs product manufacturing costs.

These costs are capitalized as assets (inventory) until they are sold and transferred to Cost of Goods Sold. Period costs have no future value and are expensed as incurred.

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Cost Flows
The Cost of Goods Manufactured and the Cost of

Goods Sold section of the Income Statement are accounting representations of the actual flow of costs through a production system.
Note the importance of inventory accounts in the

following accounting reports, and in the cost flow chart

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Cost Flows Visualized

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Cost of Goods Manufactured

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Multiple-Step Income Statement

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Other Cost Considerations

Prime cost is a term referring to all direct

manufacturing costs (labor and materials) Conversion cost is a term referring to direct labor and factory overhead costs, collectively Overtime labor costs are considered part of overhead due to the inability to precisely know the true cause of these costs

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Different Definitions of Costs for Different Applications

Pricing and product-mix decisions may use a super

cost approach (comprehensive) Contracting with government agencies very specific definitions of cost for cost plus profit contracts Preparing external-use financial statements GAAPdriven product costs only

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Different Definitions of Costs for Different Applications

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Three Common Features of Cost Accounting & Cost Management

Calculating the cost of products, services, and other cost objects 2. Obtaining information for planning & control, and performance evaluation 3. Analyzing the relevant information for making decisions
1.

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 2009 Pearson Prentice Hall. All rights reserved.