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Chapter 17

Full Costs and Their Uses

McGraw-Hill/Irwin

Copyright 2011. The McGraw-Hill Companies. All Rights Reserved.

Cost
A measurement, In monetary terms, Of the amount of resources used for some purpose.

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Cost Object
Product, project, organizational unit, or other activity or purpose for which costs are measured. Can be defined broadly or narrowly.
E.g., an entire production run of jeans vs. one pair of jeans.

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Full Cost
All the resources used for a cost object. Includes:
Direct production costs. Indirect production costs. Selling cost. General and administrative cost.

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Direct Costs
Costs specifically traced to (caused by) the cost object. E.g., denim cloth used in jean manufacturing.

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Indirect Costs
Costs associated with (or caused by) two or more cost objects jointly. Not possible or feasible to trace directly to a single cost object. Terms direct and indirect are only meaningful in context of a specific cost object (i.e., can change as cost object(s) change).
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Allocation of Indirect Costs


Indirect costs are allocated to departments or organizational units using the following steps: 1. Choose an allocation base for the indirect cost. 2. Compute an indirect cost allocation rate. 3. Allocate the indirect cost.

Choose an Allocation Base


Cost or Expense Basis Indirect labour Time spent Building amortization Square metres Heat, lights, etc. Square metres Janitorial services Square metres Payroll and personnel # of employees Purchasing # of purchase orders placed

Choose an Allocation Base


Lets consider a medical clinic which has 2 tenants, a doctor and dentist Rent for the year is $120,000. Total square metres occupied by the clinic is 1200. What is the rent per square metre? $120,000 1,200 = $100 The rent would be allocated to the doctor and dentist bases on how much space they use in the clinic

Allocate the Indirect Cost


The doctor occupies 900 square metres. How much rent is allocated to the doctor? 900 $100 = $90,000 How much rent is allocated to the dentist? 1,200 900 = 300 square metres 300 $100 = $30,000

What is GAAP Cost?


Limited guidance. Any systematic and rational method of cost assignment is allowed.

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Elements of product cost


Cost organized into categories (i.e., materials, labor, overhead, etc.). Collected in a product costing system.
Accumulates and reports costs of product cost objects. Cost object can be a physical product or a service.
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Direct Material Cost


Quantities of material that can be specifically identified with a cost object in an economically feasible manner. Also know as raw materials. Usually priced at unit price of material.

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Direct Labor Cost


Quantities of labor that can be specifically identified with a cost object in an economically feasible manner. Usually priced at unit price of labor.

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Overhead Costs
All other production costs. Indirect production costs.
Indirect materials. Indirect labor. Utilities. Maintenance. Depreciation. Insurance. Taxes. Etc.

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Other Cost Terminology


Conversion costs.
All production costs needed to convert direct material into finished goods. Direct labor cost + overhead cost.

Full production cost.


Also called inventory cost, product cost. Direct materials + direct labor + overhead.
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Nonproduction Costs
Also known as period costs. Includes:
Selling costs.
Marketing (order-getting) costs. Logistics (order-filling) costs.

General and administrative costs. Research and development costs. Interest costs.
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Summary
Full cost:
Production costs.
Direct materials. Direct labor. Overhead.

Nonproduction costs.
Selling cost. General and administrative cost. Research and development costs. Interest costs.
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Product Costing Systems


Involves accounting for the:
1. Acquisition of resources needed for production. Production process. Sale of completed products.

2. 3.

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Production Inventory Accounts


Materials inventory.
Increased by acquisition of materials. Decreased when materials are used in production.

Work in process inventory.


Collects all costs of production Increased when material, labor, and overhead are added to (used in) the production process. Decreased when product is completed.

Finished goods inventory.


Increased when product is completed. Decreased when product is sold.
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Overhead Account
Clearing account (i.e., temporary holding account). Increased (debit) by incurrence of overhead costs (e.g., usage of indirect materials, incurrence of indirect labor costs, factory utilities cost, depreciation cost on factory assets, etc.). Decreased (credit) when costs are applied to the product(s) being produced (i.e., placed into Work in Process Inventory).

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Product Costing Systems: Visual Representation


Materials Inventory Wages Payable Overhead Work in Process Inventory Finished Goods Inventory Cost of Sales

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Nonmanufacturing Companies
Merchandising companies.
Since cost of goods sold is invoice cost, only requires simple system (relative to manufacturing company).

Service organizations.
Cost object is job (e.g., patient in a hospital, vehicle in a auto repair shop, client for an law office. Job cost record kept for each job. Cost record serves as work in process inventory account.
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Nonprofit Organizations
E.g., healthcare, educational, performing arts, government. Cost object is programs not products. Similar cost accounting practices to profit organizations.

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Life Cycle Costing


Cost system considers all of a products costs from birth to abandonment.
Birthing costs.
Necessary to develop product and bring it to market. Includes research and development, product testing, initial market creation, salesperson training.

Abandonment costs.
Incurred after product is discontinued and doesnt produce significant revenues. Disposal of plant and equipment, severance costs, restoring polluted land.
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Uses of Full Costs


Financial reporting.
Determine cost of inventory and cost of sales.

Analysis of profitability.
Entire business and parts of the business (e.g., product, product line, plant, division, sales territory, etc.).

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Uses of Full Costs


Product pricing.
Cost plus contracts. Contribution pricing.
Price set below full cost, but above variable costs.

Setting regulated prices (e.g., utilities, cable).

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Uses of Full Costs


Product pricing.
Normal pricing.
Recover direct costs, recover applicable indirect costs, make a satisfactory profit. Applicable for differentiated products (i.e., has distinct characteristics. For undifferentiated products (i.e., commodities), price set by market.

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Uses of Full Costs


Product pricing.
Time and material pricing.
Price material cost and labor cost separately (i.e., material loading charge, billing rate). Used by repair shops, physicians, lawyers, consultants, etc.

Target pricing (costing).


Price set first (based on competitive strategy). Then product is designed to cover full cost and profit.
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Uses of Full Costs


Strategic positioning.
Strategic cost management.
Use of cost management to help better understand ones advantages and disadvantages relative to competitors. Covers entire value chain.

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