61. Cost concepts, classification, and allocation.

One of a company’s owners expect to earn profits, managers have a responsibility to use the company’s resources wisely and to generate revenues that will exceed the cost of the company’s operating, investing, and financing activities. Managers use information about operating cost to plan, perform, evaluate and communicate the results of operating activities.

Cost concept.

Planning. Managers in service organizations use the estimated costs of rendering services to develop budget, estimate revenues, and manage the organization’s work force. In retail companies managers work with estimates of the cost of merchandise to develop budgets for purchases and net income, as well as to determine the selling prices or sales units required to cover all costs. Managers of manufacturing companies use estimates of product costs to develop budget production, materials, labor, and overhead, as well as to determine the selling price or sales level required to cover all costs.

Performing. Managers in service organizations find estimated costs of services helpful in monitoring profitability and making decisions about such matters as bidding on future business, lowering or negotiating their fees, or dropping one of their services. In retail organizations managers work with the estimated costs of merchandise purchases to predict gross margin, operating income, and value of merchandise sold. They also use this information to make decisions about matters like reducing selling prices for clearance sales, lowering selling prices for bulk sales, or dropping a product line. Managers of manufacturing companies use estimated product costs to predict the gross margin and operating income on sales and to make decisions about such matters as dropping a product line, outsourcing the manufacture of a part to another company, bidding on a special order, or negotiating a selling price.

Evaluating. When managers evaluate performance they want to know about significant differences between the estimated costs and actual costs of their products, merchandise purchases or services. The identification of variances between estimated and actual costs helps them determine the causes of cost overruns, which may enable them to make decisions that will avoid such problems in the future.

Communicating. When managers look at external reports, they expected income statements that communicate the actual costs of operating activities and balance sheets that show the value of inventory. They also expect internal performance reports that summarize their plans, their performance outcomes, and their evaluation of performance, such as the variance analyses done in the evaluating stage of the management process.

All organizations use cost information to determine profits and selling prices and to value inventories, different types of organizations have different types of costs:

- service organizations need information about the costs of providing services, which include the costs of labor and related overhead;

- retail organizations need information about the costs of purchasing products for resale. These costs include adjustments for freight-in costs, purchase returns and allowances, and purchase discounts;

- manufacturing organizations need information about the costs of manufacturing products. Products costs include the costs of direct materials, direct labor, and overhead.

Cost classification.

A single cost can be classified in several ways, depending on the purpose of the analysis.

1. Control costs by determining which are traceable to a particular cost object, such as a service or product

2. Calculate the number of units that must be sold to achieve a certain level of profit (cost behavior)

3. Identify the costs of activities that do and do not add value to a product or services

4. Classify costs for the preparation of financial statements

Costs:

1. Costs Traceability:

- direct costs – costs that can be conveniently and economically traced to a cost object. In some cases, even though a material becomes part of a finished product or service, the expense of tracing its costs is too great;

- indirect costs – costs that cannot be conveniently and economically traced to a costs object. These costs must be included in the costs of a product or service.

Examples:

• In a service organization such as accounting firm, costs can be traced to a specific services such as preparation of tax returns. Direct costs such a service include the costs of government reporting forms, computer usage and the accounting’s labor. Indirect costs include the costs of supplies, office rental, utilizes. Secretarial labor, telephone usage and depreciation of office furniture.

• In retail organization such as good foods store, costs can be traced to a department. The direct costs of the produce department include the costs of fruits and vegetables and the wages of employees working, indirect costs include the costs of utilities, storage

• In manufacturing organization – direct costs include the costs of the materials and labor. Indirect costs include the costs of utilities, depreciation.

2. Cost’s Behavior:

- variable costs – costs that changes in direct proportion to a change in productive output;

- fixed costs – is a cost that remains constant within a defined range of activity or time period.

3. Value-Adding Attributes:

- value-adding cost – is the cost of an activity that increases the market value of a product or service (human research management, administrative costs);

- non value-adding cost – is the cost of an activity that adds cost to a product or service but does not increase its market value.

4. Financial Reporting:

- product costs – or inventoriable costs, are costs assigned to inventory, they include direct materials, direct labor, and overhead. Product costs appear on the income statement as cost of goods sold and on the balance sheet as inventory;

- period costs – or noninventoriable – are costs of resources used during the accounting period that are not assigned to product. They appear as operating expenses on the income statement.

Allocation of costs

Cost Allocation is a process of assigning a collection of indirect costs to a specific cost object. Such as a product or service, a department, or an operating activity, using an allocation base known as a cost driver. A cost driver might be direct labor hours, direct labor costs, units produced, or another activity base that has a cause-and-effect relationship with the cost. As the cost driver increases in volume, it causes the cost pool – the collection of indirect costs assigned to a cost object – to increase amount.

Allocating overhead costs to products or services is a four-step process that corresponds to the four stages of management process:

1. Planning. Managers estimate overhead cost and calculate a rate at which they will assign those costs to products or services. Before and accounting period begins, managers should determine cost pools and cost drivers and calculate the predetermined overhead rate by dividing the cost pool of total estimated overhead costs by the total estimated cost driver level.

2. Performing. This rate is applied to product or services as overhead costs are incurred and recorded during production. The overhead rate for each cost pool is multiplied by that’s pool actual cost driver level. The purpose is to assign a consistent overhead cost to each unit produced during accounting period.

3. Evaluating. Actual overhead costs are recorded as they are incurred,

4. Communicating. Managers calculate the difference between the estimated and actual costs., managers report on this difference. If the overhead costs applied to production are greater than the actual overhead costs, the difference represents over applied overhead costs. The costs of goods sold is decreased by the difference. If the overhead costs applied to production are less than the actual overhead costs the difference represents under applied overhead costs. The costs of gods sold account is increased by this amount. This adjustment should be taken into account in income statement.