BPC 32603Industrial Production Costing

Lecturer:Dr. Kamilah Ahmad

25 February 2014

Topic 2: Type of Costs in Production

Chapter Learning Outcomes

Acknowledge the basic types of production cost in production environment

Differentiate costs behavior

IntroductionAll types of organizations incur costs.

The kind of costs incurred and the way in which these costs are classified depend on the type of organization.

Will focus the cost characteristics of manufacturing firms since their basic activities include most activities found in other types of organizations.

General cost classification

Manufacturing costs

Non-Manufacturing costs

Direct materials Selling costs

Direct labor Administrative costs

Manufacturing overhead

Manufacturing operations purchase raw materials and converts these materials into finished goods through the process of production.

1. Direct Raw MaterialBasic materials that are used to process new

products.Indirect materials are usually used in small amounts and do not physically become part of the finished product.

2. Direct LaborThe cost of employees that can be directly traceable to a manufactured product

3. Manufacturing overheadinclude all manufacturing costs other than the costs of direct materials and direct labor.

Production Cost Flow

Direct Material

Overhead

Direct Labor ManufacturingProcess

Material Inventory

Finished Good Inventory

WIP Inventory

Cost of Good Sold

Sold

Finished

unfinished

Unused

Balance Sheet

Income Statement

AKR @2013

Product cost vs. Period cost

Product Cost

(Manufacturing costs)

Direct Materials

Eg: flour, sugar, oilsPrime Cost

Direct Labor Wages

FactoryOverhead

Factory utilities, depreciation of machines, machines maintenance

Conversion

cost

Period Cost (non-

manufacturing costs)

Selling expenses

Advertising, fees, sales commissions

Administrative expenses

Salaries, rent, office utilities

example

Manufacturing vs non-manufacturing costs

Cost behaviorTo predict how a certain cost will behave in response to a change of productivity

Variable , Fixed and Mixed Costs

A VC is a cost that varies in direct proportion to changes in the level of activity(units produced, hours Worked, miles driven)

A FC is a cost that remains constant regardless of changes in the levelof activity within relevant range(range of activity)

Is expressed on a per-unit basis.

The per-unit variable cost remains unchanged regardless of changes in the cost-driver.

Think of fixed costs on a total-cost basis.

Total fixed costs remain constant regardless of changes in the cost-driver.

Mixed costs contain elements of bothfixed- and variable-cost behavior.

Mixed-Cost Behavior PatternsMixed costs contain elements of both fixed and variable costs. The fixed-cost element is unchanged over a range of cost-driver activity levels. The variable-cost element of the mixed cost varies proportionately with cost-driver activity within the relevant range.

Cost Drivers

Cost drivers are measures of activities that requirethe use of resources and thereby cause costs.

Measurement of Cost BehaviorCost Driver• an activity which influences a

cost.

Relevant Range• range over which we can assume

that the cost behavior is linear

Variable Costs• vary in proportion to changes in

their cost driver

Fixed Costs• are not affected by changes in the

cost driver

$

Volume

$

Volume

$

Volume

Linear-Cost BehaviorCosts are assumed to be fixed or variable within the

relevant range of activity

Variations in Cost BehaviourStep Costs• change abruptly at intervals of

activity because the resources and their costs come in indivisible chunks. e.g supervisory salaries

Mixed Costs• contain both variable and fixed cost

elements• e.g. maintenance costs

Volume

$

Volume

$

Step-Cost Behavior Patterns

Expenses that are constant for a given level of activity, but increase or decrease once a threshold is crossed.

these types of expenses will be represented by a stairstep pattern.

For example, a coffee shop might be able to serve 30 customers an hour with one employee. If the

shop receives anywhere from zero to 30 customers per hour, it will only need to pay the cost of having one employee. If the shop begins receiving 31 or more customers per hour, it must hire a second

employee, increasing its costs of doing business.

Step-Cost Behavior PatternsFixed cost that increases to a new level in step with the significant changes in activity or usage.

Mixed-Cost Behavior Patterns

1. Product or service attributes2. Capacity decisions3. Technology4. Policies to create incentives to control costs

Management’s Influence on Cost Behavior

3 types of cost that relate to management’s influence on cost behavior

• Capacity costs• Committed costs

• Discretionary Fixed Costs

Capacity Decisions

Fixed costs incurred to provide facilities that increase a firm's ability to produce such as those relating to

space, equipment, and factory buildings. They include rents, depreciation, property taxes, & insurance.

What are capacity costs?

Capacity costs generally do not vary with production levels and can be reduced or avoided only by shutting

down business locations or outsourcing.

Committed Fixed CostsCommitted fixed costs are those fixed costs that are difficult to adjust and arise from the investment in

facilities, equipment, and a basic organizational structure of a firm. Committed costs are generally long-term costs.

• Large, indivisible chunks of cost that the organization is obligated to incur and usually would not consider avoiding• Can only be changed by changing the basic philosophy, scale or scope of the organization's operations.

mortgage, lease payments, property taxes, Insurance, salaries of key personnel

Discretionary Fixed Costs• Discretionary fixed costs are costs fixed at certain

levels only because management decided that these levels of cost should be incurred to meet theorganization’s goals.

• Companies have more flexibility with these.

• Generally short-term costs and;

• Are determined each year, and are subject to changewhenever the company decides to do so.

These discretionary fixed costs have no obvious relationship to levels of output activity but

are determined as part of the periodic planning process.

Each planning period, management will determine how much to spend on discretionary items. These costs then become fixed until the next

planning period.

Discretionary Fixed Costs..cont..

Examples

Advertising and promotion

Research and development

Management salaries

Employee training

Technology Decisions

Choice of technology (e-commerce versusin-store or mail-order sales) positions theorganization to meet its current goals andto respond to changes in the environment.

Cost-Control Incentives

Managers use their knowledge of costbehavior to set

cost expectations.

Employees may receive rewards thatare tied to meeting these expectations.

Cost Functions

Planning and controlling the activitiesof an organization require accurate

and useful estimates of futurefixed and variable costs.

Cost FunctionsUnderstanding relationships between costs And their cost drivers allows managers to:

Make better operating, marketing, and production decisions

Plan and evaluate actions

Determine appropriate costs for short-run and long-run decisions.

Cost FunctionsThe first step in estimating or predicting

costs is measuring cost behavior as afunction of appropriate cost drivers.

The second step is to use these costmeasures to estimate future costs atexpected levels of cost-driver activity.

Cost Function EquationLet:Y = Total cost F = Fixed costV = Variable cost per unitX = Cost-driver activity in number of units

Mixed-cost function:Y = F + VX

Y = $10,000 + $5.00X

The mixed-cost function is called a linear-cost function.

Developing Cost Functions

A cost function’s estimates of costsat actual levels of activity must reliablyconform with actually observed costs.

The cost function must be believable.

Choice of Cost Drivers: Activity Analysis

Choosing a cost function startswith choosing cost drivers.

Managers use activity analysis toidentify appropriate cost drivers.

Activity analysis directs managementaccountants to the appropriate

cost drivers for each cost.

Choice of Cost Drivers: Activity Analysis

Northwestern Computers makes twoproducts: Mozart-Plus and Powerdrive

In the past, most of the support costswere twice as much as labor costs.

Northwest has upgraded the productionfunction, which has increased support

costs and reduced labor cost.

Choice of Cost Drivers: Activity Analysis

Using the old cost driver, labor cost, theprediction of support costs would be:

Mozart-Plus Powerdrive Labor cost $ 8.50 $130.00Support cost:2 × Direct laborcost $17.00 $260.00

Choice of Cost Drivers: Activity AnalysisUsing the more appropriate cost driver,

the number of components added to products, companies can predict support costs more accurately.

Mozart-Plus PowerdriveSupport cost at $20 per component $20 × 5 components $100.00 $20 × 9 components $180.00Difference in predicted support cost $ 83.00 $ 80.00

higher lower

Managers will make better decisions with this more accurate information.

Type of Costing Systems (traditional)JOB COSTING Provide cost of each

quantity of product manufactured

Each qty of product is called “JOB”

Industry example: apparel, Furniture, machine components etcs

PROCESS COSTINGProvide cost for each

manufacturing department or process

Product are indistinguishable from each other and manufacture using continuous production.

Example: oil product, foods, paper production etcs

Type of Costing Systems and allocation of costs

JOB COSTING or BATCH

PROCESS COSTING

Traditional costing approach

Activity Based Costing Approach

preferred

Full absorption Related cost allocation to product

MATERIAL – LABOR -OVERHEAD

End of TOPIC 2Topic 2