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Chapter 2

An introduction to
costs terms and
inventory costing

PowerPoint to accompany:

LEARNING OBJECTIVES

Define and illustrate a cost object

Distinguish between direct costs and indirect costs

Explain variable costs and fixed costs

Interpret unit costs cautiously

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LEARNING OBJECTIVES

Distinguish inventoriable costs from period costs

Calculate income under absorption costing and variable costing,


and explain the difference in income

Describe the undesirable incentives for managers to build up


inventory when a company uses absorption costing

Explain why product costs are calculated in different ways for


different purposes

Describe a framework for cost accounting and cost management.

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Costs and cost terminology

Cost a 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.

Cost accumulation a collection of cost data presented


in some organised manner.

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Costs and cost terminology


Cost object examples at GM Holden

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Direct costs and 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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Direct costs and indirect costs

Cost allocation is the assignment of indirect costs to a particular


cost object.
Cost assignment is a general term used when 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 costs and indirect costs


GM Holden: Assigning costs to a cost object

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Direct costs and indirect costs


Direct costs:

parts

assembly line wages.

Indirect costs:

electricity

rent

property taxes.

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Direct costs and indirect costs


Factors affecting direct/indirect cost classifications:

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cost materiality

availability of information-gathering technology

operational design.

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Cost behaviour patterns: variable costs


and fixed costs

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Variable costs can change 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 behaviour patterns: variable costs


and fixed costs

12

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


product takes 5 kg of materials each, it stays the
same per unit regardless of whether 1, 10, or 1000
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 units, reducing the cost
per unit.

Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442563377/Horngren/Cost accounting/2e

Cost behaviour patterns: variable costs


and fixed costs

Variable costs

Fixed costs

13

Total dollars

Cost per unit

Change in proportion
with output

Unchanged in relation
to output

More output = more cost

Unchanged in
relation to output

Change inversely with


output
More output = lower cost
per unit

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Cost behaviour patterns: variable costs


and fixed costs
Cost behaviour visualised:

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Cost behaviour patterns: variable costs


and fixed costs
Other cost concepts

Cost driver is a variable that causally affects costs over a given


time span.

Relevant range is 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 .

15

Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442563377/Horngren/Cost accounting/2e

Cost behaviour patterns: variable costs


and fixed costs
Relevant range visualised:

16

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Cost behaviour patterns: variable costs and


fixed costs
Costs may be classified as:

direct/indirect, and

variable/fixed.

These multiple classifications give rise to important cost


combinations:

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direct and variable

direct and fixed

indirect and variable

indirect and fixed.

Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442563377/Horngren/Cost accounting/2e

Cost behaviour patterns: variable costs


and fixed costs
Multiple classification of costs visualised:

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Cost behaviour patterns: variable costs and


fixed costs web link

Things you must know summarised at:


http://www.learnmanagerialaccounting.com/FreeMaterial/costbehav
ior/index.html

This site also has graded questions and problems to solve.

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Total costs and unit costs

Total cost:

the sum of all costs, both direct and indirect, or

the sum of fixed and variable costs.

Unit cost:

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the total cost divided by the number of units expected to


be produced.

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Total costs and unit costs


Use unit costs cautiously
Unit costs should be used cautiously. Since unit costs change with
a different level of output or volume, it may be more prudent to
make decisions on a total dollar basis.

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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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Business sectors, types of inventory,


inventoriable costs and period costs
Manufacturing, retail, and service sector companies

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Manufacturing sector companies create and sell their own products.

Retail sector companies are product resellers.

Service sector companies provide services (intangible products).

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Business sectors, types of inventory,


inventoriable costs and period costs
Types of inventory

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Direct materials resources that are in stock and are 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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Business sectors, types of inventory,


inventoriable costs, and period costs
Commonly used classifications of manufacturing costs also
known as product costs:

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direct materials costs

direct manufacturing labour costs

indirect manufacturing costs 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.

Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442563377/Horngren/Cost accounting/2e

Business sectors, types of inventory,


inventoriable costs, and period costs
Inventoriable costs:
product manufacturing costs capitalised as assets (inventory)
until they are sold

become cost of goods sold only when the product is sold.

Period costs:

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have no future value and are expensed as they are incurred.

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Business sectors, types of inventory,


inventoriable costs, and period costs web link
Inventoriable costs and period costs

26

A tutorial on inventoriable and period costs, entitled Product


(manufacturing) costs and period (nonmanufacturing) costs, can
be found at:
http://simplestudies.com/manufacturing-nonmanufacturing-costs.h
tml/page/3
.

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Illustrating the flow of inventoriable costs


and period costs
Prime costs and conversion costs

27

Prime cost is a term referring to all direct manufacturing costs


(labour and materials).

Conversion cost is a term collectively referring to direct labour


and factory overhead costs.

Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442563377/Horngren/Cost accounting/2e

Illustrating the flow of inventoriable costs


and period costs
Illustrating the flow of inventoriable costs and period costs
The cost of goods manufactured and the cost of goods sold
sections of the income statement are accounting representations
of the actual flow of costs through a production system.

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Note the importance of inventory accounts accounting reports and


in the cost flowchart in the following slides.

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Illustrating the flow of inventoriable costs


and period costs
Cost flows visualised.

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Illustrating the flow of inventoriable costs


and period costs
Cost of goods manufactured:

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Illustrating the flow of inventoriable costs


and period costs
Multiple-step income statement:

31

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Variable costing and absorption costing


Absorption costing:

product costs are capitalised

period costs are expensed.

Variable costing:

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variable product and period costs are capitalised

fixed product and period costs are expensed.

Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442563377/Horngren/Cost accounting/2e

Variable costing and absorption costing


Comparing income statements for one year

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Variable costing is a method of inventory costing in which only


variable manufacturing costs are included as inventoriable costs.

Absorption costing is a method of inventory costing in which all


variable manufacturing costs and all fixed manufacturing costs are
included as inventoriable costs.

Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442563377/Horngren/Cost accounting/2e

Variable costing and absorption costing


Explaining differences in operating profit

Operating income will differ between absorption and variable


costing:
- the amount of the difference represents the amount of fixed
product costs capitalised as inventory under absorption
costing, and expensed as a period cost under variable costing.

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Variable costing and absorption costing


Austimber Ltds management wants to prepare an income
statement for 2014 to evaluate the performance of the
timber line. The operating information for 2014 is:

35

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Variable costing and absorption costing


Actual price and cost data for 2014 are:

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Variable costing and absorption costing

Austimber Ltd incurs manufacturing, and selling and administration


(S&A) costs only. The cost driver for all variable manufacturing
costs is metres produced; the cost driver for variable S&A costs is
metres sold. The budgeted (standard) price and cost data for 2014
are the same as the actual price and cost data.

Work-in-process inventory is zero.

Austimber Ltd budgeted production of 50 000 metres for 2014.


This was used to calculate the budgeted fixed manufacturing cost
per metre of $1.20 ($60 000 50 000 metres).

Austimber Ltd budgeted sales of 50 000 metres for 2014, which is


the same as the actual sales for 2014.

The actual production for 2014 is 50 000 metres. As a result, there


is no difference between actual and budgeted manufacturing costs
in 2014.

37

Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442563377/Horngren/Cost accounting/2e

Variable costing and absorption costing


The main difference between variable costing and absorption costing is
the way in which fixed manufacturing costs are accounted for:

under variable costing, fixed manufacturing costs are treated as an


expense of the period

under absorption costing, fixed manufacturing costs are inventoriable


costs. In our example, the fixed manufacturing cost is $1.20 per
metre ($60 000/50 000 metres) produced.

For Austimber Ltd, inventoriable costs per metre produced in 2014


under the two methods are:

38

Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442563377/Horngren/Cost accounting/2e

Variable costing and absorption costing


Comparative income statements one year:

39

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Variable costing and absorption costing


Comparative income statements three years:

40

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Variable costing and absorption costing

Are fixed
manufacturing costs
inventoried?
Is there a production
volume variance?
Are classifications
between variable and
fixed costs routinely
made?

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Variable costing

Absorption costing

No

Yes

No

Yes

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Yes

Seldom

Variable costing and absorption costing


Variable costing

Absorption costing

Production = sales

Equal

Equal

Production > sales

Lower

Higher

Production < sales

Higher

Lower

How do changes in unit


inventory levels affect
profit?

42

Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442563377/Horngren/Cost accounting/2e

Variable costing and absorption costing

Variable costing
What are the effects on
costvolumeprofit (for a
given level of fixed costs
and a given contribution
margin per unit)?

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Driven by
unit level
of sales

Absorption costing
Driven by:
a)
unit level of sales
b)
unit level of
production
c)
chosen denominator
level

Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442563377/Horngren/Cost accounting/2e

Variable costing and absorption costing web links

A YouTube lecture explaining absorption costing and variable


costing can be found at:
http://www.youtube.com/watch?v=Sy5BHS9b8-Y

And the Advantages & Disadvantages of Using Absorption Vs.


Variable Costing can be found at:
http://smallbusiness.chron.com/advantages-disadvantages-using-ab
sorption-vs-variable-costing-34282.html

44

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Absorption costing and performance measures


Undesirable build-up of inventories

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Managers may seek to manipulate income by producing


too many units.
Production beyond demand will increase the amount of
inventory on hand:
- resulting in more fixed costs being capitalised as
inventory
- leaving a smaller amount of fixed costs to be
expensed during the period.
Therefore:
- profit increases and so, potentially, does a managers
bonus

Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442563377/Horngren/Cost accounting/2e

Absorption costing and performance measures


Undesirable build-up of inventories
A manager may:

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decide to manufacture products that absorb the highest


amount of fixed costs, regardless of demand (cherrypicking)

accept an order to increase production, even though


another plant in the same firm is better suited to handle
that order

defer maintenance.

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Absorption costing and performance measures


Income effects of inventory build-up:

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Absorption costing and performance measures


Proposals for revising performance evaluation

Focus on careful budgeting and inventory planning.

Incorporate a carrying charge for inventory.

Change the period used to evaluate performance.

Include non-financial as well as financial variables in the measures


used to evaluate performance.

48

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A comparison of alternative inventory


costing methods

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Contribution margin versus gross margin

Contribution margin is different from gross margin:


- contribution margin = revenues all variable costs.

Gross margin is a measure of competitiveness:


- gross margin = revenues cost of goods sold.

50

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Measuring costs requires judgement


Different meanings of product costs
Pricing and product-mix decisions the managers interest is in the
overall (total) profitability of different products.

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Australian Accounting Standards state that product costs include


only inventoriable (manufacturing) costs.

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Measuring costs requires judgement

52

Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442563377/Horngren/Cost accounting/2e

Measuring costs requires judgement

53

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A framework for cost accounting and


cost management

54

Calculating the cost of products, services, and other


cost objects.

Obtaining information for planning and control, and


performance evaluation.

Analysing the relevant information for making decisions.

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A framework for cost accounting and cost


management web link

55

A research report A Management Accounting Framework can be


found at:
http://www.ues.ac.ir/files/education/dianati_84cf9/a_management
_accounting_framework.pdf

Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442563377/Horngren/Cost accounting/2e

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