Chapter 2: Producing Costing Concepts and Systems
Usually two kinds of costs:
Direct costs (easily traceable, directly related to product or service, i.e. labour)
Indirect costs (hard or impossible to relate to product, i.e. rent, also called overhead or burden)
General equation: Total costs = Indirect costs + direct costs
Further explanation and distinctions of the concept of “cost”:
Cost: sacrifice to achieve a purpose, different kinds:
cash or out-of-pocket cost: Money price that needs to be paid now, e.g. when buying resources
accrual cost: Added up costs over a particular period of time, e.g. for measuring long term costs
opportunity cost: highest value that would have been gained if another alternative would have been
picked
Analyze costs to provide highest value for lowest price for customers.
Variable, Committed and Fixed Costs:
Variable costs vary proportionally to production values, often “per unit” costs e.g. price of resources,
Committed costs are there because of contracts or policies, cannot be changed on short note, e.g.
employees with a contract or owning a company vehicle
Fixed costs “do not change in total within a defined range of underlying productive activity”, i.e. the
rent of an office building that offers space for 100 working employees as long as there are not more
than 100 employees
Sunk & Accrual Costs:
Sunk costs lie in the past and cannot be changed by future decisions anymore, not directly relevant
for decisions at hand, e.g. price paid for a company vehicle
Accrual costs (as stated above), can be important for decision at hand, e.g. accrued costs for picking
up supplies vs. having them delivered
Reporting Costs & Expenses
Cost accounting system (accumulates accrual costs for external reporting)
expense (measure of cost incurred when resources are consumed or sold for the purpose of
revenues)
product cost (cost of purchase and/or manufacture of products for resale, related to the products,
assigned to inventory and costs of sales/goods sold in BS and P/L)
period cost (cost of selling and administrative operations, related to a period of time, recognized as
expenses)
Cost Analysis
Important equations:
Gross margin
margin ratio
ratio == Gross
Gross margin/Sales
margin/Sales turnover
turnover
Gross
Or
Or
Gross margin
margin ratio
ratio == (Sales
(Sales turnover
turnover –– Costs
Costs of
of goods
goods sold)/Sales
sold)/Sales turnover
turnover
Gross
Operating income
income == gross
gross margin
margin –– period
period expenses
expenses
Operating
Return on
on sales
sales ratio
ratio == operating
operating income/sales
income/sales
Return
Costs of Manufacturing include
Direct costs (consist of direct materials (e.g. raw materials, components…) and direct labour
(payments to employees who are converting the direct materials to the actual product))
Manufacturing overhead costs (consist of indirect material cost (material that is needed for
production but not part of the product, or parts of the product with insignificant cost), indirect
labour cost (payments to employees that are needed to run the manufacturing facility but are not
directly involved in production (if it is only a small part of total costs, sometimes direct labour +
manufacturing overhead = conversion cost) and other manufacturing costs (i.e. depreciation,
insurance, appliances as well as overtime premiums or idle time (time an employee cannot spend
productively because of unforeseen events)
Non-manufacturing costs include
Selling costs (sales commissions, sales personnel, related building etc.)
Administrative costs (costs to manage the organization, legal, computing & accounting services,
related building etc.)
Period costs (non-manufacturing costs over a period of time, such as advertising and promotion)
Stages of Production and the Flow of Costs
Production stages:
Receiving raw materials -> assembly/crafting -> finished products -> shipping
“Translated” to a cost accounting system:
Ordering raw materials -> raw materials inventory (materials not yet put into production) -> work in
progress (WIP) inventory (partially completed products) -> finished goods inventory (products ready
for sale/shipment)
According balancing relation:
Beginning balance + Transfers-in – Transfers-out = Ending Balance
(BB+TI+TO=EB)
WIP TIs include raw materials, direct labour, and manufacturing overhead
WIP TOs include cost of goods completed and waste (cost of defective products)
Finished goods TIs include cost of goods completed
Finished goods TOs include cost of sales and shrinkage (unrecovered stolen or mis-shipped
completed goods
Note: Waste and shrinkage are considered period costs
Important equations for financial models (Book p.64 for example)
Cost of direct raw materials used:
TO (RM) = BB (RM) + TI (RM) – EB (RM)
Cost of goods completed:
TO (WIP) = BB (WIP) + TI (WIP) – EB (WIP)
Cost of sales:
TO (FG) = BB (FG) + TI (FG) – EB (FG)