CAPITOLO 4 I COSTI PIENI E IL LORO IMPIEGO

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1 Copyright 2004 The Companies srl CAPITOLO 4 I COSTI PIENI E IL LORO IMPIEGO This chapter introduces the general concept of cost and describes, in a preliminary way, methods of recording costs in an accounting system. Some of the problems that many students seem to have are: 1. Students think that there is such a thing as "the" cost. They don't realize that the measurement of cost always relates to some specific cost object, and that what is an item of cost for one cost object may not be at all relevant for another cost object. As one way of overcoming this misconception, we have emphasized the idea of "cost object" from the outset. 2. Students think in terms of product costs. This is because in financial accounting the students' principal contact with "cost" was in connection with measuring inventory cost and cost of goods sold. They therefore fail to appreciate that products (literally "goods") are only one of a number of possible cost objects. They think, for example, that direct material and direct labor are always relevant costs, and that the word "direct" means that the material and labor are directly associated with the product, whereas for certain cost objects (e.g., advertising), direct material and direct labor are inappropriate terms. Furthermore, an item of cost may be direct to a certain cost object, such as the cost of a department or responsibility center, even though the item is indirect with respect to a product manufactured in that responsibility center. It is true that we do focus on product costs in Chapters 17 and 18, but the definitions and statements are made broad enough so that they can be used without modification when other cost objects are discussed. 3. Students think that the definitions are applied more precisely in practice than actually is the case. They tend to regard an item of cost as being direct labor only if they can visualize the worker as physically touching the product, for example. We do not attempt to describe the wide diversity that exists in actual practice because this diversity tends to confuse beginning students. The point is that students should not be overly concerned about drawing a fine line between direct and indirect costs, or between manufacturing and nonmanufacturing costs. We have decided not to stress the idea that cost is a "sacrifice," which is central to many definitions of cost. The word "sacrifice" implies something bad, something to be avoided, whereas a company gladly incurs a cost when it believes it will receive a revenue or some other benefit by doing so. We think it more meaningful to students to think of cost as measuring the use of resources. They should visualize the resources themselves the physical material, the hours of labor service and think of costs as being monetary measures of how much of these resources were used for a given cost object. In general, we think it desirable to use the word "product" as referring either to a good or to a service; that is, products are the sum of goods and services. We cannot do this uniformly, however, because the term "product cost" is in widespread use, whereas in the above terminology it really should be "goods cost." (This is a small point, but it can create confusion if not properly handled. The author of this paragraph did not comprehend the distinctions made above until many years after he had completed his first course in cost accounting.) The description of the cost flow through a pen factory is a central part of the pedagogy. Students should be able to explain each line on the flowchart and each of the related journal entries.

2 Copyright 2004 The Companies srl We have tried to avoid the twin dangers of, on the one hand, being critical of cost accounting because it does not yield costs that are entirely "true" or "accurate" and, on the other hand, creating the impression that cost accounting does in fact provide true and accurate costs. Students tend to go too far toward one or the other of these extremes, and it is difficult for them (as well as for many managers) to take the appropriate middle ground. This middle ground, we believe, is that although it is impossible to measure the costs of a cost object with absolute accuracy whenever indirect costs exist, it is nevertheless possible to measure costs with sufficient accuracy so that they are useful to management for many purposes. Managements would not continue to spend large amounts of money in the operation of cost accounting systems if they did not believe that the results were worthwhile. In recent years, full-cost pricing is being given an increasing amount of attention, for a number of reasons the growth of cost-reimbursement pricing in hospitals and in government relationships of various types, the fact that some foreign producers have been found to have sold goods in the U.S. at less than full cost, and the growth in the understanding that business has a social responsibility to set "fair" prices, that is, prices that do not produce extraordinarily high profits. Students who have been exposed to economics should also realize that contribution pricing is not slighted. As the text states, this topic is discussed in depth in Chapter 26, where it belongs, and in this discussion a distinction is drawn between situations in which full-cost pricing is appropriate and situations in which contribution pricing is appropriate. Of course, if students have not been exposed to a course in economics of the type implied above, then this problem will not even arise. It is desirable that the relationship between profit and assets employed be emphasized. This relationship was introduced in Chapter 13, and it will come up several times in later chapters in this book. It is not an easy relationship to grasp (especially the relationship between profit percentage, asset turnover, and return on investment), but once the student understands it, he or she has a model that explains how the parts of a business, and decisions on these parts, relate to one another. Since the general public (including newspaper stories and television news programs) tends to think of profits as a percentage of sales, it is not easy to get students to think in terms of the broader and more valid concept of return on investment. Any discussion of pricing necessarily includes a discussion of profit.. Some students are emotionally antagonized by the basic concept of profit; they confuse "profit" and "profiteering," or they have the impression that business extracts an unconscionable amount of profit from the consumer. If they are to understand what normal pricing practices actually are, they must overcome this emotional block. It is hoped that the reiteration of the point that a business must earn a reasonable return on its investment if it is to survive may help in overcoming this block.

3 Copyright 2004 The Companies srl Problem 4-1: Martin SpA Problemi (000s omitted) Raw Materials Inventory Balance, Sept Issued for use Purchases To balance Balance, October Work in Process Inventory Balance, Sept Goods manufactured Direct material To balance Direct labor Overhead Balance, October Finished Goods Inventory Balance, Sept Cost of sales Goods manufactured To balance Balance, October Problema 4.2 Burtis SpA Cost of Sales 235 Calculation of normal selling price for 19x3 assuming continued use of full cost: 19x2 Increase 19x3 Direct material... $ 4.00 $.48* $ 4.48 Direct labor * 7.84 Indirect manufacturing Selling and administrative Total full cost Profit (10%) Selling price... $21.23 $2.11 $23.34 *12 percent increase for direct material (.12 x $4.00 = $.48) and for direct labor (.12 x $7.00 = $.84) +$6,000 increase with volume of 10,000 units is increase of $.60 per unit.

4 Copyright 2004 The Companies srl Problem 4-2: Martha Smith a. Total costs $5,700 + Desired Fee per hour = 150 hours = $60.00 per hour profit $3,300 b. Revenue, 100 $60... $6,000 Costs... 5,700 Profit... $ 300 Problem 4-3: Studio legale Stefano Bruno a. Calculation of selling prices: Total Company A B Direct manufacturing cost... $ 700,000 $400,000 $300,000 Indirect manufacturing cost , , ,000 Selling and administrative cost ,000 80,000 60,000 Full cost... 1,120, , ,000 Desired profit* , , ,000 Sales revenue... $1,400,000 $800,000 $600,000 Divide by units... 10,000 10,000 Selling price per unit... $80.00 $60.00 *The desired profit of 280,000 for the company as a whole is 25 percent of the company s full cost. Therefore, a 25 percent profit margin percentage is applied to the full cost of each product to obtain the selling price. The profit percentage is equal to: (Desired profit + Selling and administrative cost) Full production cost. For A it equals $208,000 $560,000 = 37.14%, which is the same as for product B = ($156,000 $420,000 = 37.14%). b. Total Company A B Sales revenue*... $1,248,000 $384,000 $864,000 Full cost+... 1,040, , ,000 Profit... $ 208,000 $ 64,000 $144,000 *Sales Revenue A: 5,000 $76.80 = $384,000 B: 15,000 $57.60 = $864,000 +Full Cost $640,000 A: (5,000) = $320,000 10,000 units $480,000 B: (15,000 units) = $720,000 10,000 units

5 Copyright 2004 The Companies srl c. Profit margin pricing results in product prices containing identical profit percentages. However, the product with the higher price will yield the higher total dollar profit. Therefore, a shift in product mix toward lower price items will reduce total dollar profits for the company as a whole.