D.1. Concepts of measurement and cost classification of costs
Why manage costs?
Basic transaction reporting and external financial reporting are two applications for cost management systems. In addition to providing accurate financial reports, cost management systems also keep track of expenses to aid management in making decisions.
Facilitating management's focus on the factors that contribute to the company's success is cost management's most crucial function. The management accountant is a crucial member of management because they identify, summarize, and report on the essential success factors for the company's success.
Note: A small number of characteristics, conditions, or variables that directly and significantly affect an organization's efficiency, effectiveness, and viability are referred to as critical success factors. They are the aspects of the company's performance that are crucial to its success and competitive advantage1 The critical success factors must be met with the highest possible level of excellence in all activities.
The management accountant, for instance, may be able to provide data regarding the sources of the company's competitive advantage, such as the cost, productivity, or efficiency advantage that the company possesses in comparison to rivals or the additional prices that the company may be able to charge for additional features that distinguish its offering about the costs of adding those features. Cost management that focuses specifically on strategic issues like these is called strategic cost management. As a result, cost management helps the business achieve its strategic goals and objectives.
Evaluating Operating Performance two key aspects of a company's operations must be taken into consideration when deciding whether or not it is achieving its goals and objectives:
efficiency and effectiveness
The maximization of shareholder value must be the primary objective of a publicly held for-profit company, as was emphasized in Section B's section on strategic planning. The owners are the shareholders. They have given the managers risk capital in the hope that they will use strategies to get good returns on their investments. As a result, managers are obligated to maximize shareholder value by investing in company profits.
When it comes to fulfilling that obligation, effectiveness and efficiency play a crucial role.
• An operation that meets or exceeds its objectives is considered to be successful. The primary objective is to maximize shareholder value. Analyzing the company's effectiveness in achieving its essential success factors can be used to gauge its success in achieving its objectives. A desired level of operating income, an increase in market share, the introduction of new products, or a specific return on investment are all examples of critical success factors. The desired operating income for the period is stated in the master budget, and comparing actual results to planned results is a fundamental starting point for assessing the company's success in achieving its profitability objectives.
• An operation that makes good use of its resources is considered to be efficient. A company may be effective, but it is not efficient if it achieves its goal of increasing sales while using more resources than necessary. Alternately, a company may be resource-efficient by spending less per unit sold than planned; however, if the company's goals for profitability and growth are not met because sales are too low, the operation was not effective.
As a result, evaluations of effectiveness and efficiency are distinct. Cost management helps evaluate both efficiency and effectiveness.
Cost Classifications It is essential to comprehend the various costs' classifications, treatments, and types.
The distinction between expenses and costs Costs and expenses are distinct concepts.
1) Costs are the loss of resources necessary to accomplish a goal.
2) Expenses are expenses that were deducted from revenue during a particular accounting period.
While "expense" is an accounting term, "cost" is an economic concept. Every expense began as a cost before it became an expense, so a cost doesn't need to be an expense. The majority of costs eventually become expenses, such as the cost of manufacturing, which is reflected in the income statement as the cost of goods sold when the units to which they are attached are sold, or the cost of administrative fixed assets, which are capitalized on the balance sheet and then depreciated over time.
However, the income statement does not include some costs. Even though implicit costs2 like opportunity costs3 are not recorded as expenses in the accounting records, they have still considered costs because they represent resources sacrificed to accomplish a goal.
Product Costs vs. Period Costs Costs are categorized by their intended use. Product (or production) costs and period costs are the two main categories of costs based on their purpose.
Product Costs, also known as Inventoriable Costs Product costs, also known as inventoriable costs, are expenses incurred during the manufacturing process that would not be necessary to produce the product. Product costs are "attached" to each unit, and until the unit is sold, they are recorded as inventory on the balance sheet as work-in-process inventory and finished goods inventory respectively. The cost of the item is transferred from the balance sheet to the income statement when a unit is sold, where it is reflected as an expense as the cost of goods sold.
The most common kinds of product costs are 1) materials directly, 2) labour directly, and 3) manufacturing overhead (both fixed and variable). As shown in the tables below, these various product costs can be combined and given various names. Candidates need to be aware of the kinds of costs that fall under each category.
Conversion costs are direct labour and manufacturing overhead. They are the costs associated with turning raw materials into finished goods during the manufacturing process.
Period costs, also known as nonmanufacturing overhead, are expenses incurred for activities other than the product's actual production. Expenses for a period are deducted as they are incurred.
Since all costs must be either product costs or period costs, the number of period costs is almost limitless because period costs basically include everything other than product costs. Selling, administration, and accounting are some of the more common examples of period costs, but period costs are the costs of any department that isn't involved in production.
Period costs can be either fixed, variable, or a combination of both, but they are not included in the cost of goods sold or manufactured (which are covered later). Period costs are expensed to the income statement as they are incurred for the purposes of financial reporting.
However, some period costs may be allocated to the production departments and then to the individual units for internal decision-making. For the business to establish a price for each product that covers all of its expenses, this allocation may be carried out internally. The topic of shared services cost allocation will discuss this kind of allocation.
Note: By U.S. GAAP and IFRS, the overhead allocation of period costs to production is not reported as such in the company's external financial statements.
Period costs ought to be expensed in the period in which they are incurred, by both IFRS and U.S. GAAP. Period costs would only be allocated to production for internal decision-making.
The number of classifications a company uses for period expenses on its income statement will vary from company to company. Selling expenses, general and administrative expenses, accounting, depreciation of administrative facilities, and so forth are examples.
Costs based on Activity Level (Fixed, Variable, and Mixed Costs) The main groups of costs in the table below are organized by how they change as the activity level changes. An event, task, or unit of work with a specific goal is an activity. In production, "activity" can mean the number of units of a resource used, like hours of direct labour, or the number of products produced. The level of activity can be used to classify both period costs and production costs, but the type of activity used to classify period costs is different from that used to classify production costs. The term "activity" is frequently used to describe period costs in terms of the number of units sold, but it can also be used to describe any activity that incurs costs.
Candidates must be aware of how the total cost and cost per unit of activity change with activity level for the following three types of costs:
Cost Behavior in the Production Process As the Production Level Changes, Fixed Costs, Variable Costs, and Mixed Costs behave fundamentally differently in the Production Process. Candidates must comprehend how production changes affect total costs as well as unit costs. Other sections of the CMA Part 1 exam as well as the CMA Part 2 exam will require this understanding of the fundamental behaviour of fixed and variable costs. Cost behaviour is not necessarily difficult, but because it is such an essential component of the production process, it will be discussed in depth.
Variable Costs A company only incurs variable costs when it actually produces something. Variable costs will not be incurred by a business if it does not produce any units or if it remains idle for the entire period. Variable costs typically include direct material and direct labour.4 • While the variable cost per unit will not change as production levels rise, total variable costs will rise.
• Variable costs per unit will not change, but total variable costs will decrease as production levels fall.
Costs that Do Not Change Overall Fixed costs are costs that do not change overall as long as production remains within the relevant range. The production range within which the fixed cost does not change is the relevant range. A rise in the number of units produced or a fall in the number of units produced will not result in an increase or decrease in the total fixed costs so long as the production activity remains within the relevant range.
The best way to explain fixed costs is to use factory production as an example. A factory can only make a certain number of units at a time. The factory's fixed cost will not change as long as production is between zero and the maximum number of units. However, the company will need to construct (or otherwise acquire) a second factory once the level of production exceeds the factory's capacity.
As the business expands into a new market, the construction of the second factory will result in an increase in fixed costs.
The total fixed costs will remain the same within the relevant range of production, but the fixed costs per unit will decrease as the production level rises.
Note: If a change in volume results in a volume that is outside the relevant range specified in the question, the question will provide information that can be used to recalculate the total fixed costs at the changed volume. If a question doesn't say anything about the relevant range, you should assume that any changes in volume are within the relevant range and that the volume change hasn't changed fixed costs all that much.
Note: All costs will behave like variable costs for enough time. In the short term, fixed costs like property, plant, and equipment However, the company's ability to relocate or expand its factory over a longer period means that fixed costs become variable.
Note: Both the cost of the period and the cost of the product can be fixed or variable.
Mixed Costs Numerous costs are mixed. There are both fixed and variable components in mixed costs. Step costs or step variable costs are other names for mixed costs, which can be either semi-variable costs or semi-fixed costs.
There is a fixed and a variable component to a semi-variable cost. It has a fundamental fixed amount that must be paid regardless of activity (or even in the absence of activity), and a variable amount that is added to that fixed amount. As an illustration, utilities Even if no production is taking place, a factory building's upkeep necessitates some basic utility costs. The basic amount is the fixed component of utilities because electricity, water, and other services typically need to be maintained. Depending on the level of production, if production begins (or resumes), the cost of utilities will rise by a variable amount because people will be using water and machines will be using electricity. When production activity increases, the total cost increases incrementally by the amount of the variable component, but the fixed component does not change. The cost of a salesperson who earns a base salary in addition to a commission for each sale is yet another illustration of a cost that is semivariable.
The commission is the variable portion of the salesperson's salary, while the base salary is the fixed portion.
A semi-fixed cost, also known as a step cost or a step variable cost, is fixed for a limited range of activities, but the cost suddenly rises above that level of activity. When the activity moves outside of the higher range, it jumps once more before returning to its previous fixed state. A step variable cost, also known as a semi-fixed cost, progresses incrementally upward over a narrow range before eventually
moving quickly to the next level. This is how all fixed costs work, and a cost that is completely fixed is only fixed as long as the activity stays within the relevant range. A semi-fixed cost, on the other hand, is fixed over a smaller range than a wholly fixed cost's relevant range.
Example: An illustration of a semi-fixed cost is the cost of a hospital's nursing staff. Since the hospital requires one nurse for every 25 patients, an additional nurse will be hired for each 25-patient increase. The total cost of nursing salaries rises by the amount of each additional nurse's salary when they are hired.
In contrast, salaries for hospital administrative staff do not change until there are 250 more patients to take care of, at which point an additional admitting clerk is needed. Nursing staff salaries are semi-fixed costs because the relevant range for the administrative staff (250 patients) is greater than the relevant range for the nursing staff (25 patients). However, the administrative staff salaries are wholly fixed costs over the relevant range.
Note: The fact that a semi-variable cost (also known as a step cost or step variable cost) begins at a predetermined base level and steadily rises as activity rises is what distinguishes it from a semi-fixed cost (also known as a step cost or step variable cost). A semi-fixed cost increases in stages.
The total costs include both the total fixed costs and the total variable costs. At an activity level 5 of zero, the only costs will be fixed costs, so the lowest possible total cost occurs when nothing is produced or sold. The total costs begin at the fixed cost level and rise with each unit of activity increase by the amount of variable cost per unit. At least theoretically, the total costs graph is a straight line that rises at the rate of the variable cost per unit for each unit of activity increase, starting at the fixed cost level on the Y-intercept.
Where is the cost function for the total costs of manufacturing? y is the total cost, F is the fixed cost, V is the variable cost per unit, and x is the total production. The order of the two terms on the right side of the equals sign is irrelevant when describing the cost function, which can also be written as y = Vx + F.
A graph of total manufacturing costs for a business with fixed manufacturing costs of $700,000 and variable manufacturing costs of $20 per unit produced is provided below for illustration. The y-axis represents total cost, while the x-axis represents total production. The total cost line on the graph is a straight line that begins at $700,000 on the y-axis where x is zero and increases by $200,000 for each production increase of 10,000 units (because 10,000 units multiplied by 5). "Activity level" or "level of activity" can refer to a variety of activities. The cost function for this company's total manufacturing costs is y = 700,000 + 20x. It can refer to the number of units of output produced, the number of units of production process inputs, sales volume, or any other activity in progress.
The sum of $20 is $200,000). The cost function graph is next. The equation for a linear regression line and the cost function on the graph are comparable.
6 At a production volume of 40,000, the total manufacturing costs equal $1,500,000 using the cost function y = 700,000 + 20x:
y = 700,000 plus 20x y = 700,000 plus (20 40,000) y = 1,500,000 Direct costs vs. indirect costs Direct costs are costs that can be directly attributed to a particular cost object. Anything for which a separate cost measurement is recorded is a cost object. Cost data can be requested for a function, an organizational division, a contract, or any other work unit that allows for the accumulation and measurement of the costs of processes, products, jobs, capitalized projects, and so on. Materials and labour used in product production are two examples of direct costs that will be discussed in detail.
Costs that are not associated with a specific cost object are known as indirect costs. Overhead is an indirect cost in manufacturing. Cost pools are created to allocate manufacturing indirect costs to product units. A cost pool is a collection of indirect costs that are allotted to the same cost allocation base. Cost pools can be very broad, like all overhead costs for a plant, or very narrow, like the cost of running a particular machine.
Vol. 6 covers linear regression. 1 in B.3 of this textbook. Techniques for Forecasting are listed under How to Use Linear Regression Analysis in Forecasting. This volume goes into greater detail about it in D.3. Under the topic of Estimating Fixed and Variable Costs and in F.4, overhead costs. Analytical Tools under the heading of Data Analytics
Note: The cost driver that is used to allocate costs is an allocation base. Common allocation bases in manufacturing include direct labour hours and machine hours, but an allocation base can be anything that drives costs.
Anything, including an activity, an event, or a volume of something, that results in the occurrence of costs is a cost driver.
Nonmanufacturing or period costs are another indirect cost. Support functions like IT, maintenance, and security, as well as managerial functions like executive management and other supervisory functions, are examples.
Other Costs and Cost Classifications Candidates must be familiar with several additional cost categories.
Out-of-pocket expenses are another name for explicit expenses. Wages and salaries, office supplies, loan interest, payments to vendors for raw materials, and so on are examples of explicit costs that require cash payment. The opposite of implicit costs is explicit costs. Although the timing of their recognition as expenses may be delayed, the majority of explicit costs eventually become expenses. For instance, the cost of inventory does not become an expense until it is sold.
Implicit costs An implicit cost, also known as an imputed cost, is a cost that is not recorded in the accounting records and does not require a specific cash payment. Economic costs are another name for implicit costs. Expenses do not arise from implicit costs. They are required for use in a decision-making process, but they cannot be specifically included in financial reports. A typical implicit or imputed cost is interest that is not earned on money that could have been invested in interest-paying security but was instead invested in manufacturing equipment. An opportunity cost of investing in the machine is the "lost" interest income. Although it is not included as an expense on the income statement, the lost interest is an important factor to take into account when deciding whether or not to invest in the machine because it will be different if it is not purchased.
Implicit costs come in a variety of forms, including opportunity costs. Opportunity cost is referred to as an economic cost in the field of economics. When a limited resource is not utilized to its full potential, it results in a loss of income. The term "opportunity cost" refers to the difference between the contribution that would have been earned if the alternative decision had been made and any administrative costs that would have been incurred for the alternative that was available but were not.
The potential return from the next best use of that money is lost whenever it is invested or used to buy something. Interest income is frequently the lost return. For instance, money that was not used to purchase inventory could be deposited in a bank and earn interest. Only the period in which the cash flows from the two options differ can be used to calculate the lost interest.
Costs associated with holding inventory Carrying costs are expenses incurred by the business. Rent and storage-related utility bills are examples of carrying costs; insurance and inventory-related taxes; costs associated with inventory management and security personnel; stolen or damaged inventory; the cost of capital (also known as the lost opportunity cost) of investing money in inventory; and additional costs associated with storage.
Carrying costs are deducted from the income statement as they are incurred because inventory storage does not add value to the items in the inventory. They are not shown on the balance sheet because they are not added to the cost of the inventory.
Costs that have already been incurred and cannot be recovered are known as "sunk costs." Because they have already been incurred and cannot be changed by any decision now or in the future, unnecessary expenses are irrelevant to any decision-making process.
Costs incurred for the company's infrastructure are referred to as committed costs. They are expenses necessary to establish and maintain business readiness. The acquisition of intangible assets like a franchise and fixed assets like property, plant, and equipment are examples of committed costs. They are fixed expenses that are typically listed as assets on the balance sheet and become expenses through depreciation and amortization.
Discretionary costs, also known as flexible costs Discretionary costs, also known as flexible costs, are expenses that can be incurred by participating in an activity or not, depending on the manager in charge of the expense. The business will not suffer in the short term if it does not engage in a discretionary activity. However, in the long run, the activities are required, and spending the money is necessary. Input and output decisions are not directly related to discretionary cost decisions, which are made periodically. In addition, it is impossible to precisely define the benefits and added value of spending money. Typically, examples of discretionary costs include employee training, advertising, and research and development (R&D). Flexible costs, also known as discretionary costs, can be fixed, variable, or a combination of the two.
The additional costs required to produce one more unit are referred to as marginal costs.
Note: Unless the need to work overtime is due to a specific job or a request from a customer, the overtime premium paid to production workers is accounted for as factory overhead. The amount of extra money paid per hour for working overtime is known as the overtime premium.
For instance, direct labourers are compensated at time and a half, or $30 per hour, for overtime hours worked more than 40 hours per week and are paid $20 per hour for regular hours. Each week requires ten hours of overtime to complete the required production for that week. Even though it is performed outside of regular working hours, the regular rate of $20 per hour multiplied by ten hours equals $200. Factory overhead is limited to the half-time premium of $100, or $10 extra paid per hour divided by 10 hours.
Because the units worked on during the overtime hours could just as easily have been different units if the jobs to be done had simply been scheduled differently, the $100 half-time premium is not applied to the specific units worked on during the overtime hours. The paid overtime premium is distributed equally among all units produced during the period as overhead.
However, if a specific job or customer request necessitates overtime, the overtime premium should be added to the direct labour cost of that job and not included in the total overhead amount to be allocated.