MAC3761_ STUDY SUMMARY NOTES.

MAC3761_ STUDY SUMMARY NOTES. MAC3761 - Management Accounting III.A cost object is any activity for which a separate measurement of costs is desired. In other words, if the users of accounting information want to know the cost of something, this something is called a cost object. Examples of cost objects include the cost of a product, the cost of rendering a service to a bank customer or hospital patient, the cost of operating a particular department or sales territory or indeed anything for which one wants to measure the cost of resources used. We shall see that the cost collection system typically accounts for costs in two broad stages: 1. It accumulates costs by classifying them into certain categories such as by type of expense (e.g. direct labour, direct materials and indirect costs) or by cost behaviour (such as fixed and variable costs). 2. It then assigns these costs to cost objects. In this chapter we shall focus on the following cost terms and concepts:  direct and indirect costs;  period and product costs;  cost behaviour in relation to volume of activity;  relevant and irrelevant costs;  avoidable and unavoidable costs;  sunk costs;  opportunity costs;  incremental and marginal costs. Manufacturing, Merchandising and Service Organizations To provide a better understanding of how different cost terms are used in organizations it is appropriate to describe the major features of activities undertaken in the manufacturing, merchandising and service organizations. Manufacturing organizations purchase raw materials from suppliers and convert these materials into tangible products through the use of labour and capital inputs (e.g. plant and machinery). This process results in manufacturing organizations having the following types of inventories:  Raw material inventories consisting of purchased raw materials in stock awaiting use in the manufacturing process.  Work in progress inventory (also called work in process) consisting of partially complete products awaiting completion.  Finished goods inventory consisting of fully completed products that have not yet been sold. Merchandising companies such as supermarkets, retail departmental stores and wholesalers sell tangible products that they have previously purchased in the same basic form from suppliers. Therefore they have only finished goods inventories. Service organizations such as accounting firms, insurance companies, advertising agencies and hospitals provide tasks or activities for customers. A major feature of service organizations is that they provide perishable services that cannot be stored for future use. Therefore service organizations do not have finished goods inventory but some service organizations do have work in process. For example, a firm of lawyers may have clients whose work is partially complete at the end of the accounting period. Direct and Indirect Costs Direct materials Direct labour Indirect costs Distinguishing between direct and indirect costs Assigning direct and indirect costs to cost objects Costs that are assigned to cost objects can be divided into two broad categories – direct and indirect costs. Both categories can be further divided into direct and indirect materials and direct and indirect labour costs. Direct materials Direct material costs represent those material costs that can be specifically and exclusively identified with a particular cost object. In manufacturing organizations where the cost object is a product, physical observation can be used to measure the quantity consumed by each individual product and the cost of direct materials can be directly charged to them. In other words, direct materials become part of a physical product. For example, wood used in the manufacture of different types of furniture can be directly identified with each specific type of furniture such as chairs, tables and bookcases. The term direct material is normally not applicable to merchandising and service organizations. The equivalent term in a merchandising organization is the purchase cost of the items that are for resale. For example, with a departmental store where the cost object is a department (e.g. televisions and DVD players, computers, clothing and furniture departments) the purchase cost of the goods from the suppliers will be directly charged to the appropriate department that resells the goods. Some service organizations do purchase materials or parts to provide a service. For example, a garage may purchase parts for vehicle repairs. These parts can be identified with the repair of each customer's vehicle (i.e. the cost object) and thus are equivalent to direct materials. Direct labour Direct labour costs are those labour costs that can be specifically and exclusively identified with a particular cost object. Physical observation can be used to measure the quantity of labour used to produce a specific product or provide a service. The direct labour cost in producing a product includes the cost of converting the raw materials into a product, such as the costs of the machine operatives engaged in the production process in the manufacture of televisions. The direct labour cost used to provide a service includes the labour costs in providing a service that can be specifically identified with an individual client or with a specific instance of service. The direct labour costs for a departmental store are the labour costs of the staff that can be attributed specifically to a department. Indirect costs Indirect costs cannot be identified specifically and exclusively with a given cost object. They consist of indirect labour, materials and expenses. In a manufacturing organization where products are the cost object, the wages of all employees whose time cannot be identified with a specific product, represent indirect labour costs. Examples include the labour cost of staff employed in the maintenance and repair of production equipment and staff employed in the stores department. The cost of materials used to repair machinery cannot be identified with a specific product and can therefore be classified as indirect material costs. Examples of indirect expenses in manufacturing, service or a departmental store where products, the provision of a service or departments are the cost objectives, include lighting and heating expenses and property taxes. These costs cannot be specifically identified with a particular product, service or department. The term ‘overheads ’ is widely used instead of indirect costs. In a manufacturing organization overhead costs are categorized as either manufacturing, administration and marketing (or selling) overheads. Manufacturing overheads include all the costs of manufacturing apart from direct labour and material costs. Administrative overheads consist of all costs associated with the general administration of the organization that cannot be assigned to either manufacturing, marketing and distribution overheads. Examples of administrative overheads include top-executive salaries, general accounting, secretarial and research and development costs. Those costs that are necessary to market and distribute a product or service are categorized as marketing (selling) costs, also known as order-getting and order-filling costs. Examples of marketing costs include advertising, sales personnel salaries/commissions, warehousing and delivery transportation costs. Figure 2.1 illustrates the various classifications of manufacturing and non-manufacturing costs. You will see from this figure that two further classifications of manufacturing costs are sometimes used. Prime cost consists of all direct manufacturing costs (i.e. it is the sum of direct material and direct labour costs). Conversion cost is the sum of direct labour and manufacturing overhead costs. It represents the cost of converting raw materials into finished products. FIGURE 2.1 Manufacturing and non-manufacturing costs Distinguishing between direct and indirect costs Sometimes, direct costs are treated as indirect because it is not cost effective to trace costs directly to the cost object. For example, the nails used to manufacture a particular desk can be identified specifically with the desk, but, because the cost is likely to be insignificant, the expense of tracing such items does not justify the possible benefits from calculating more accurate product costs. The distinction between direct and indirect costs also depends on the cost object. A cost can be treated as direct for one cost object but indirect in respect of another. For example, if the cost object is the cost of using different distribution channels, then the rental of warehouses and the salaries of storekeepers will be regarded as direct for each distribution channel. If, on the other hand, the cost object is the product, both the warehouse rental and the salaries of the storekeepers will be an indirect cost because these costs cannot be specifically identified with the product. Assigning direct and indirect costs to cost objects Direct costs can be traced easily and accurately to a cost object. For example, where products are the cost object, direct materials and labour used can be physically identified with the different products that an organization produces. It is a relatively simple process to establish an information technology system that records the quantity and cost of direct labour and material resources used to produce specific products. In contrast, indirect costs cannot be traced to cost objects. Instead, an estimate must be made of the resources consumed by cost objects using cost allocations . A cost allocation is the process of assigning costs when a direct measure does not exist for the quantity of resources consumed by a particular cost object. Cost allocations involve the use of surrogate rather than direct measures. For example, consider an activity such as receiving incoming materials. Assuming that the cost of receiving materials is strongly influenced by the number of receipts, then costs can be allocated to products (i.e. the cost object) based on the number of material receipts each product requires. If 20 per cent of the total number of receipts for a period were required for a particular product then 20 per cent of the total costs of receiving incoming materials would be allocated to that product. If that product was discontinued, and not replaced, we would expect action to be taken to reduce the resources required for receiving materials by 20 per cent. In this example, the surrogate allocation measure is assumed to be a significant determinant of the cost of receiving incoming materials. The process of assigning indirect costs (overheads) and the accuracy of such assignments will be discussed in Chapter 3, but at this stage you should note that only direct costs can be accurately assigned to cost objects. Therefore, the more direct costs that can be traced to a cost object, the more accurate is the cost assignment. Period and Product Costs For profit measurement and inventory/stock valuation (i.e. the valuation of completed unsold products and partly completed products or services) purposes it is necessary to classify costs as either product costs or period costs. Product costs are those costs that are identified with goods purchased or produced for resale. In a manufacturing organization they are costs that are attached to the product and that are included in the inventory valuation for finished goods, or for partly completed goods (work in progress), until they are sold; they are then recorded as expenses and matched against sales for calculating profit. Period costs are those costs that are not included in the inventory valuation and as a result are treated as expenses in the period in which they are incurred. Hence no attempt is made to attach period costs to products for inventory valuation purposes. In a manufacturing organization all manufacturing costs are regarded as product costs and nonmanufacturing costs are regarded as period costs. The treatment of period and product costs for a manufacturing organization is illustrated in Figure 2.2. You will see that both product and period costs are eventually classified as expenses. The major difference is the point in time at which they are so classified. There are two reasons why non-manufacturing costs are treated as period costs and not included in the inventory valuation. First, inventories are assets (unsold production) and assets represent resources that have been acquired and that are expected to contribute to future revenue. Manufacturing costs incurred in making a product can be expected to generate future revenues to cover the cost of production. There is no guarantee, however, that non-manufacturing costs will generate future revenue, because they do not represent value added to any specific product. Therefore, they are not included in the inventory valuation. Second, many non-manufacturing costs (e.g. distribution costs) are not incurred when the product is being stored. Hence it is inappropriate to include such costs within the inventory valuation. You should now refer to Example 2.1, which provides an illustration of the accounting treatment of period and product costs for income (profit) measurement purposes for a manufacturing organization. Do merchandising and service organizations need to distinguish between product and period costs? The answer is yes. Companies operating in the merchandising sector purchase goods for resale without changing their basic form. The cost of the goods purchased is regarded as a product cost and all other costs, such as administration and selling and distribution expenses, are considered to be period costs. Therefore, the cost of goods sold for a merchandising company would consist of the beginning merchandise inventory, plus the purchase of merchandise during the period, less the closing merchandise inventory. Note that the opening and closing inventories would be valued at the purchase cost of acquiring the inventories. Service organizations do not have beginning and closing finished goods inventories since it is not possible to store services but they may have work in progress (WIP). The cost FIGURE 2.2 Treatment of period and product costs EXAMPLE 2.1 The costs for Lee Manufacturing Company for period 1 are as follows: The accounting records indicate that 70 per cent of the above costs were assigned to the cost of the goods that were sold during the period, 10 per cent to work in progress and 20 per cent to finished goods inventory. Sales were £910 000 for the period. The opening and closing inventory of raw materials were identical and there were no opening WIP and finished goods inventories at the start of the period. The profit statement for period 1 will be as follows: