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Chapter Three

Basic Cost-Management
Concepts
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Learning Objectives

• Understand the strategic role of basic cost


concepts

• Explain cost-driver concepts at the activity,


volume, structural, and executional levels

• Explain the cost concepts used in product and


service costing

• Demonstrate how costs flow through the formal


accounting system

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008


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Learning Objectives
(continued)
• Prepare and interpret an income statement for
both a manufacturing firm and a merchandising
firm

• Explain the cost concepts related to the use of


cost information in planning and decision-
making

• Explain the cost concepts related to the use of


cost information for control/feedback purposes

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008


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Basic Definitions
• A cost is incurred when a firm uses a resource for some
purpose

• Costs are assembled into meaningful groups called


cost pools (e.g., by type of cost or source)

• Any factor that has the effect of changing the level of


total cost is called a cost driver

• A cost object is any product, service, customer, activity,


or organizational unit to which costs are assigned for
some management purpose
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Cost Concepts: Overview

There are four main ways to classify costs


(“different costs for different purposes”):
– For product and service costing (GAAP)
– For strategic decision-making (cost-driver
analysis)
– For planning and decision-making
– For control/feedback

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008


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Product/Service Costing:
Cost Assignment
The process of assigning costs to cost pools or
from cost pools to cost objects
– Direct costs can be conveniently and economically
traced to a cost pool or a cost object
– Indirect costs cannot be traced conveniently or
economically to a cost pool or a cost object
– Because indirect costs cannot be traced, assignment
is made through the use of cost drivers (cost
allocation)
– These cost drivers are often called allocation bases
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Cost Assignment: General Principles


Costs Cost Drivers and Cost Assignment

Cost Pools Cost Objects


Electric Motor

Materials
Handling Assembly Dishwasher

Supervision

Packing
Materials Washing
Packing
Machine
Final
Inspection
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Product and Service


Costing Concepts (GAAP)
• Product costs include only the costs necessary
to complete the product at the manufacturing step
in the value chain (manufacturing) or to purchase
and transport the product to the location of sale
(merchandising)

• Period costs include all other costs incurred by


the firm in managing or selling the product
(indirect costs outside the manufacturing step of
the value chain)
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Direct and Indirect Product Costs


for a Manufacturer
• Direct material costs = cost of materials that can be readily
traced to outputs = purchase price of materials + freight –
purchase discounts + reasonable allowance for scrap and
defective units
• Indirect material costs = cost of materials that cannot
readily be traced to outputs (e.g., rags, lubricants, and small
tools)
• Direct labor costs = labor that can be readily traced to
outputs = wages paid plus a reasonable allowance for
nonproductive time
• Indirect labor costs = labor costs that cannot be readily
traced to outputs (i.e., they are manufacturing support costs)
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Direct and Indirect Product


Costs: Further Comments
• All indirect costs for the manufacturer, including
indirect materials, indirect labor, and other indirect
items are often combined in a cost pool referred to
as overhead (or, factory overhead, or indirect
manufacturing costs)

• The three main types of costs, direct materials,


direct labor, and overhead, are often condensed
even further:
– Direct materials + Direct labor = “Prime costs”
– Direct labor + Overhead = “Conversion costs”
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Manufacturing vs.
Merchandising

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Inventory and Related


Expense Accounts

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Costs for Strategic Decision-Making

• Inventory valuation (GAAP) vs. strategic costing?


• Cost drivers provide two roles for the management
accountant
– Assigning costs to cost objects
– Explaining cost behavior, i.e., how total cost changes as
the cost driver changes
• There are four types of cost drivers:
– Activity-based
– Volume-based
– Structural
– Executional
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Cost Drivers

• Activity-based cost (ABC) drivers are developed


at a detailed level of operations using activity
analysis–a cost driver is determined for each
activity
• Volume-based cost drivers relate to the amount
produced or quantity of service provided:
– The relationship between the cost driver and total cost
is approximately linear within the relevant range
– Outside of the relevant range, the Law of Diminishing
Marginal Returns generally applies (i.e., non-linearities
exist)
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Cost Drivers (continued)


• Structural cost drivers facilitate strategic
decision making because they involve plans and
decisions that have long-term effects
– Scale, experience, technology, and complexity are
considered in hopes of improving competitive position

• Executional cost drivers facilitate operational


decision making by focusing on short-term
effects
– Workforce involvement, design of the production
process, and supplier relationships are considered in
an attempt to reduce costs
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Cost Information for Short-term


Planning: Classification by Behavior
• What is meant by “cost behavior”?
• Common classifications of cost behavior:
– Fixed (capacity) cost is the portion of total cost that
does not change with changes in output
– Variable cost is the change in total cost associated
with each change in quantity of the cost driver
– Mixed cost is used to refer to a total cost figure that
includes both a fixed and variable component
– Step costs vary with the cost driver but do so in steps
• Applications:
– Budgeting
– Cost-Volume-Profit analysis (profit planning)
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Fixed Costs

Total
Cost

$6,600
$6,500

$3,000
Total Fixed Cost

3,500 3,600
Units of the Cost Driver
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Variable Costs

Total
Total Cost
Cost
$6,600
$6,500
Total Variable Cost
$3,000
3,500 3,600
Units of the Cost Driver

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008


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Short-Run Decision-Making
Cost Concepts
• Relevance is the most important characteristic for
information used in decision making
– Relevant costs have two properties: they differ for each
decision option and they will be incurred in the future

• Opportunity cost is the benefit lost when choosing


one option precludes receiving the benefits from
the alternative option

• Sunk costs are costs that have been incurred or


committed in the past and are therefore irrelevant
in current decision making
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Qualitative Characteristics of Cost


Information for Planning
and Decision-Making
There are three other characteristics that are
important for planning and decision making

– Accuracy (and the need to monitor internal accounting


controls)
– Cost and value of cost information (the cost of information
should be monitored by the management accountant to
ensure that costs do not outweigh the associated benefits)
– Timeliness (often involves sacrificing in the other two
areas)
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Cost Information for


Control/Feedback Purposes
• Controllability is a basic consideration in
evaluating managers and providing feedback
– A cost is considered “controllable” if the manager
or employee has discretion in choosing to incur it
or can influence the amount in a short period of
time

• The controllability of some costs is subject to


debate, for example, changes in interest rates,
foreign exchange fluctuations, or changes in state
or local taxes; should the manager be
responsible for these changes?
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Chapter Summary
• There are different ways to classify (or categorize) cost
information, depending on the information needs of
management (“different costs for different purposes”):
– To prepare financial statements (GAAP)
– For strategic decision-making
– For short-term planning
– For short-term decision-making
– For control/feedback purposes

• Product and service costing (GAAP) focuses on


differentiating product costs from period costs
• Costs flow through three inventory accounts in a
manufacturing firm; merchandising firms have one
inventory account
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
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Chapter Summary (continued)

• For strategic decision-making, we think about costs in


terms of the following types of drivers: activity-based,
volume-based, structural, and executional
• Cost concepts used in short-term planning relate to the
behavior of costs (i.e., how they change in response to
one or more activities)
• For decision-making we generally classify costs into one
of the following categories: relevant, opportunity, or sunk
– Relevance, accuracy, timeliness, and value that exceeds cost
are important information characteristics
• Controllability and risk preferences must be assessed
when using cost information for management and
operational control
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008