Subtitles section Play video Print subtitles What we're going to do today is talk about a whole bunch a different areas that we need to understand because it will lead us into other areas where we talk about something called variance analysis, so it's going to be important to understand it for that. What is our goal here? Our goal, our objective is to accumulate the cost. That way we can value inventory and costs of goods sold. So, for example, you've got beginning, plus purchase is available, minus ending, is costs of goods sold, so our goal is going to be to come up with our ending inventory so we can back into things like costs of goods sold. And we will use this again and again, in job order costing, process costing, different manufacturing operations and so on, but that's what we're really looking at. Now, when we talk about cost accounting, we're looking at not just one type of inventory, but three. In financial accounting, we’re mainly looking at purchases, like you have one type of item...I'm buying a calculator, I sell the calculator. What is costs of goods sold? Whatever it cost me...FIFO, LIFO, oh yeah, I remember that stuff. So it cost me 3 dollars, and then cost in, cost out. Here, we’re manufacturing the calculator. So what do I have to manufacture it? I have some raw materials. I have some work in process. I have some finished goods inventory, raw materials inventory, work in process inventory, finished goods inventory and then finally costs of goods sold. So, you can see here that we have a manufacturing process, so we're going to have to look more at the actual cost as we produce the goods. It says here, the primary purpose of cost measurement is to allocate the cost of production, direct materials, direct labor, overhead to the units produced. It also provides important information for management decisions, such as product pricing decisions, so we can kind of figure out how much we should charge you for this product. Now, a formula that’s going to be very important who will come back to haunt us again and again and again and again is y=a + bx. Now, what does that mean? y=a + bx or total cost equals fixed plus variable times x. Now, what does this mean? It means fixed cost. Now what are fixed costs? Fixed cost...we've talked about those in the past. Those are costs that are fixed in total but variable per unit. So let's say, for example, we're all hungry, we haven't had lunch or dinner yet, so I buy 1 pizza. Mmm hmm. How much is that? Fixed price, 10 bucks. Little pepperoni, little sausage, little vegetables, yum, yum, yum. Ten bucks. So how much is it a person? One person, 10 dollars. Hey, it still cost us 10 dollars, but now there’s 2 people. Fixed cost 10 bucks, now it’s 5 dollars apiece. Oh, there’s 4 people. Now it’s 2.50 apiece. So, notice that it's fixed in total 10 bucks, but it’s variable per unit depending on how many people need to eat. We have variable costs. What are variable cost? Variable costs are fixed per unit but variable in total. For example, my electricity, it cost me what? It cost me a dollar an hour. Now, depending on how many hours I use this office, it's one hour's a dollar, 2 dollars, 2 hours is two dollars, 10 hours is 10 dollars...so notice it fixed per unit, but varies in total. Now, that's fixed, that’s variable. Why do we care? Because when I say y=a + bx, that’s total cost equals fixed plus variable times x. Remember in economics...wasn’t that ago, BEC 1. We had something like this. That was x and that was y. So if you look at this formula...Can you see all that? Mmm hmm...here, y=a + bx. a is fixed, b is variable times x. What is x? x is some activity level. Now, remember we talked about quantity and price, so for example, if it is a fixed cost, means it’s the same amount, then if you go across, boom, that would be a fixed cost because no matter what the quantity is, the price is the same. It cost me how much, for example, is my rent? 10,000 dollars, 100,000 for the year, whatever, so 100,000 for the year. It's fixed. No matter how my production is, it's fixed in total, but as I have more production, the variable cost per unit drops. Remember we talked about average variable cost and so on. What about variable cost? Let's look at it this way...boom. Here is your x, here’s your y. What's it say? It says that it’s 0 production, 0 cost. At this production, this cost. At this production, this cost, and so on. So that would be x and y. Notice here, again, x is your cost driver. What is a cost driver? It drives the cost. It could be direct labor dollars, direct labor hours, machine hours, some kind of quantity. That is called the cost driver. What cost driver basis will we use? Whatever base is best for your industry. So, it just depends on what you're doing, which you’re manufacturing and so forth. What is y? y would be, in this case, my total costs. So as we look at this, that's called variable. So this one’s fixed, this one's variable. What would total cost look like? Let’s put them together...boom, boom...here's x, here's y. Here would be my fixed costs, and this angle would be my variable costs. That’s total cost. What’s total cost? It says that at this level of activity, boom, boom is total cost. At this level of activity, boom, boom, that's total cost. So, notice that’s your total cost, that’s your y, x and y. So when we come back over to this formula, total cost equals fixed plus variable times x. x is called your cost driver. x is your independent variable. Why? Because your y is total cost. That’s dependent. What is that dependent upon? The x. So ifyou come back over here, independent, dependent. Why? Because total cost is dependent upon the x, so this is called the independent variable, this is called the dependent variable. What are we looking at? The cost driver. So let's look at the terms on page 1. It says y=a + bx, total cost equals fixed plus variable times x. The y is equal to total cost and is referred to as the what? Dependent variable since it’s amount is dependent upon other factors. The x is equal to volume, which is referred to as independent variable, since it can be increased or decreased at the company’s discretion. It's also called the what? Cost driver. a is called the fixed cost, b our variable cost. Note: these cost assumptions only remain valid between the...within the what? Relevant range. Now, what is the relevant range? That is defined as the range in which your cost assumptions remain valid. For example, fixed are fixed in total but variable per unit. Variable are fixed per unit but vary in total. So, for example, fixed costs are fixed in total. So the relevant range means that I assume if my factory rent’s 100,000 dollars, fixed is a 100,000. What if, in my capacity, I can only manufacture 100,000 units, but I want to manufacture 105,000? Then what's going to happen to total costs? They have to go up, because now, instead of manufacturing 100,000, I want to manufacture 105, I need a new factory. So we're assuming that your costs are within the relevant range, where fixed are fixed in total, variable are also fixed per unit. So what's electricity? A dollar an hour. That is the assumption within the relevant range. Now the next thing down the page is called a mixed cost or semi-variable cost. Now, with a mixed cost, that's a cost that is both fixed and variable components, fixed and variable components. Now, when we talk about a mixed cost, basically this would be like, let's say your phone bill. Ok? In the olden days, when you had a phone and you had to pay a monthly fee. So, you pay 20 dollars a month. That's my fixed, and every minute on the phone, you're paying an extra dollar, let's say. So, that's when I pick up the phone, and I would call my girlfriend because you can't see her because you're studying, “Hi Pookie!” “No, you’re Pookie.” “I love you [kissing sounds].” “I love you, too [kissing sounds.]” So what happens? You’ve got a fixed and a variable component. So what we're trying to do is, we use this thing called the high-low method in order to break out the fixed and variable components. Because when you think about your phone bill, you’ve got a fixed portion and a variable portion. What is consistent between the low and the high activity? What costs are fixed? The fixed costs. So if we, for example, let's look at this graph. We're going to look at our high level of activity. We're going to look at our low level activity. Now, within both of these, what costs are the same? This fixed cost is the same. So what we do is, we're going to take the high from the low. When you take the high from the low, your fixed costs disappear. You're just left with the variable costs. Then what we're going to do is we’re going to try to force the slope of the angle because the slope of the angle are what? Your variable costs. Because this is fixed, that angle is variable. This is total because it starts with the fixed and the variable. So notice that we're going to try to force the slope of the line. That'll give us an estimate of what our variable costs are. This method is called the high hyphen low, high hyphen low method. Now, in the high hyphen low...What is a hyphen in mathematics? It’s a minus. Very good. So, it's a high minus low. Hmmm....that sounds interesting. Let's look at it. It says high-low method, total cost and total hours. Here's our total cost. Here's our hours. What it says is, at the high 110 and 30,000 hours. At the low...what is it? 80,000 total cost and 20,000 hours. So if you take the high hyphen low, then that gives us 30,000 dollars and 10,000 hours. Now, if you divide the high and the low, that gives us 3 dollars per base. What's our base? Hour. 3 dollars an hour. That is an estimate of your variable costs because what happens is, back on this picture, at the high minus low, you...your fixed costs disappear, you're left with variable costs. Now, incidentally, mark this in your notes, what is this point right here called? The intercept, because that is where it crosses the y-axis. That is called the intercept. Important to understand that. So, if I wanted to then take this and set up a formula, my formula could be...oh, right here. What is it? You would say total cost, 110, equals my fixed plus variable, which we just figured as 3, times activity level is either one of these. Well, at 110, it must be 30. So, 30 times 3 is 90, 110, this must be 20. Let's try it again. Let's see if it works. Let's try the other one. 80 equals fixed plus 3 times x. What's x? 20 times 3 is 60 plus 20 is, so it works. So if I want to set up a formula, what is the formula I'm going to use? You’re going to say, total cost equals fixed, 20, plus 3 times x. Now, what does x represent? Any activity level. What will this formula give me? It'll give me anything on this line. Mmmmm....so, if I were to pick a point here, go up, boom, that's going to give me total cost. What's the formula? Total cost equals 20 plus variable times x...well not variable, times 3 times x. So, whatever this is, you plug it in here. That'll tell you what this total cost should be. Remember, this is called the what? Dependent. What is this? Independent. This is independent. This is dependent upon this. Now that's an important concept. Why? Because later on, this becomes something called our flexible budget equation. It’s flexible. Wooo! What does that mean? It tells you what total cost will be at different levels of activity based on your cost driver, so that is called your flexible budget equation. So, as we go through this later on, we're going to be doing something called variance analysis and all of your overhead variances are done using the flexible budget equation. So you're going to see, as we go through time, that this formula will be used again and again and again and again and again and again. Woo! Woo! Alrighty, let's turn to the next page. Cost classifications. Now, with our cost classifications, we are looking at different types of costs and we have here what we call manufacturing costs, and those are going to be called our manufacturing or our product costs. We also have what we call non-manufacturing costs. Those are called our period costs. So what I want to compare are the manufacturing costs, also called a product cost, versus our non-manufacturing costs, also called a period cost. So, we're going to look at what are the differences. Well, what is a non-manufacturing cost? A non-manufacturing cost is considered a period cost. It is considered an expense in the period whether you sell them or not. What’s an example? SG & A. What is SG & A? Selling general administrative expenses. Those are considered an expense in the period. It says they’re marketing costs, freight out, re-handling. Also, very important, abnormal spoilage, and I’m going to talk about that throughout the course, but abnormal versus normal spoilage. Those are all non-manufacturing. Those are all period costs and expense in the period whether you sell it or not. SG & A, selling general administrative marketing cost and abnormal spoilage versus, the other cost is called a product cost. Those are manufacturing costs. They become part of the cost of the product. The product that you are manufacturing. Now, as far as manufacturing costs, they include 3 basic elements...direct materials, direct labor, and manufacturing or factory overhead. So, I’m going to call that direct materials, DM, direct labor and factory overhead. Those are the 3 different types of manufacturing costs. For example, I'm going to build this wooden lectern I have right here. Now, if I want a build that podium or that lectern, what do I need? I need 1, 2, 3, 4, 5, 6 pieces of fake wood, alright? That’s 6 pieces. That is called my direct material. What is direct materials? Those are the materials