CHAPTER 2
An Introduction to Cost Terms and Purposes
Content
Basic cost terminology
Direct costs vs indirect costs
Variable costs vs fixed costs
Inventoriable costs vs period cost
The flow of cost
Basic cost terminology
❖Cost—a sacrificed or forgone resource to achieve a
specific objective.
❖Actual cost—a cost that has occurred.
❖Budgeted cost—a predicted cost.
❖Cost object—anything for which a cost
measurement is desired.
Basic cost terminology
❖Cost object is anything for which a cost measurement
is desired
Cost Object Illustration
Product A BMW X6 sports activity vehicle
Telephone hotline providing information and assistance
Service
to BMW dealers
R&D project on DVD system enhancement in BMW cars
Project
Herb Chambers Motors, a dealer that purchases a broad
Customer
range of BMW vehicles
Setting up machines for production or maintaining
Activity
production equipment
Department Environmental, Health and Safety department
Basic cost terminology
❖Cost accumulation—the collection of cost data in
an organized way by means of an accounting
system.
❖Cost assignment—a general term that
encompasses the gathering of accumulated
costs to a cost object in two ways:
▪ Tracing accumulated costs with a direct
relationship to the cost object and
▪ Allocating accumulated costs with an indirect
relationship to a cost object.
Basic cost terminology
True or False?
1. Products, services, departments, and customers
may be cost objects.
2. Costs are accounted for in two basic stages:
assignment followed by accumulation
3. Actual costs and historical costs are two different
terms referring to the same thing
4. Accountants define a cost as a resource to be
sacrificed to achieve a specific objective.
5. A cost object is always either a product or a
service.
6. A customer could be considered a cost object.
Cost classification by traceability
Direct costs Indirect costs
❖ Costs that can be ❖ Costs cannot be easily
easily and conveniently and conveniently traced
traced to a unit of product to a unit of product or
or other cost objective. other cost objective.
❖ Examples: direct material ❖ Example:
and direct labor manufacturing overhead
Direct and Indirect Costs
Direct and Indirect Costs
Cost assignment to a cost object
(BMW example)
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Cost assignment to a cost object
Cost object Direct costs
Coffee
Sugar
Milk
…..
Cost assignment to a cost object
Cost object Indirect cost
➢ Salary of manager
➢ Renting
➢ Advertisement
➢ Depreciation
…….
Factors Affecting Direct/Indirect Cost
Classification
❖The materiality of the cost in question.
❖The available information-gathering
technology.
❖Design of operations.
❖NOTE: a specific cost may be both a direct
cost of one cost object and an indirect cost
of another cost object.
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Quick Check ✓
A manufacturing plant produces two product lines:
golf equipment and soccer equipment. An example
of direct costs for the golf equipment line are:
A) beverages provided daily in the plant
break room
B) monthly lease payments for a specialized
piece of equipment needed to manufacture the golf
driver
C) salaries of the clerical staff that work in the
company administrative offices
D) utilities paid for the manufacturing plant
Quick Check ✓
A manufacturing plant produces two product lines:
golf equipment and soccer equipment. An example
of indirect cost for the soccer equipment line is:
A) material used to make the soccer balls
B) labor to shape the leather used to make
the soccer ball
C) shift supervisor for the soccer line
D) plant supervisor
Cost Classifications by Behaviors
❖Variable costs—change in total in proportion to
changes in the related level of activity or volume
of output produced.
❖Fixed costs—remain unchanged in total, for a
given time period, despite changes in the related
level of activity or volume of output produced.
❖Costs are fixed or variable only with respect to a
specific activity or a given time period.
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Cost Classifications by Behaviors
❖ Variable costs are constant on a per-unit basis. If a
product takes 5 pounds of materials each, it stays
the same per unit regardless if one, ten, or a
thousand units are produced.
❖ Fixed costs per unit change inversely with the level
of production. As more units are produced, the
same fixed cost is spread over more and more
units, reducing the cost per unit.
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Cost Classifications by Behaviors
Behavior of Cost (within the relevant range)
Cost In Total Per Unit
Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.
Variable Cost
Your total texting bill is based on how
many texts you send.
Total Texting Bill
Number of Texts Sent
Variable Cost Per Unit
The cost per text sent is constant at
5 cents per text message.
Cost Per Text Sent
Number of Texts Sent
Fixed Cost
Your monthly contract fee for your cell phone is
fixed for the number of monthly minutes in your
contract. The monthly contract fee does not
change based on the number of calls you make.
Monthly Cell Phone
Contract Fee
Number of Minutes Used
Within Monthly Plan
Fixed Cost Per Unit
Within the monthly contract allotment, the average
fixed cost per cell phone call made decreases as
more calls are made.
Monthly Cell Phone
Contract Fee
Number of Minutes Used
Within Monthly Plan
Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Where: Y = The total mixed cost.
a = The total fixed cost (the
Y vertical intercept of the line).
b = The variable cost per unit of
Total Utility Cost
activity (the slope of the line).
X = The level of activity.
Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
Quick Check ✓
Which of the following costs would be variable
with respect to the number of cones sold at a
Baskins & Robbins shop? (There may be more
than one correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
Quick Check ✓
Which of the following costs would be variable
with respect to the number of people who buy a
ticket for a show at a movie theater? (There
may be more than one correct answer.)
A. The cost of renting the film.
B. Royalties on ticket sales.
C. Wage and salary costs of theater
employees.
D. The cost of cleaning up after the show.
Other Cost Concepts
Cost drivers is the amount or volume of
something or the level of an activity, that causally
affects the level of a cost over a given time span.
Other Cost Concepts
❖Relevant range—the band or range of normal
activity level (or volume) in which there is a
specific relationship between the level of activity
(or volume) and the cost in question.
▪ For example, fixed costs are considered fixed only
within the relevant range.
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Total Costs and Unit Costs
❖ A unit cost - average cost, is calculated by dividing
the total cost by the related number of units
produced.
❖ Managers use the unit cost to decide the prices they
should charge, or which products they should invest
more resources, such as R&D and marketing
A Cost Warning
❖Unit costs should be used cautiously. Because
unit costs change with a different level of output
or volume, it may be more prudent to base
decisions on a total cost basis.
▪ Unit costs that include fixed costs should always
reference a given level of output or activity.
▪ Unit costs are also called average costs.
▪ Managers should think in terms of total costs
rather than unit costs for many decisions.
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Different Types of Firms
❖Manufacturing-sector companies
purchase materials and
components and convert them
into finished products.
❖Merchandising-sector companies
purchase and then sell tangible
products without changing their
basic form.
❖Service-sector companies
provide services (intangible
products) like legal advice or
audits. 2- 31
Types of inventory
Manufacturing-sector companies hold 3 types of
inventory
❖Direct materials—resources in-stock and
available for use
❖Work-in-process (or progress)—products
started but not yet completed, often abbreviated
as WIP
❖Finished goods—products completed and
ready for sale
Merchandising-sector companies hold only one
type of inventory: merchandise inventory
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Cost classification by functions
A. Manufacturing costs (Inventoriable costs).
B. Non-manufacturing costs (period costs).
Classifications of Manufacturing Costs
Direct Direct Manufacturing
Materials Labor Overhead
The Product
Direct Materials
Raw materials that become an integral
part of the product and that can be
conveniently traced directly to it.
Example: A radio installed in an automobile
Direct Labor
Those labor costs that can be easily
traced to individual units of product.
Example: Wages paid to automobile assembly workers
Manufacturing Overhead
Manufacturing costs that cannot be easily
traced directly to specific units produced.
Examples: Indirect materials and indirect labor
Materials used to support Wages paid to employees
the production process. who are not directly
involved in production
Examples: lubricants and work.
cleaning supplies used in the Examples: maintenance
automobile assembly plant. workers, janitors, and
security guards.
Classifications of Costs
Manufacturing costs are often
classified as follows:
Direct Direct Manufacturing
Material Labor Overhead
Prime Conversion
Cost Cost
Nonmanufacturing Costs
Selling Administrative
Costs Costs
Costs necessary to All executive,
secure the order and organizational, and
deliver the product. clerical costs.
Nonmanufacturing Costs
Quick Check ✓
Which of the following costs would be
considered manufacturing overhead at
Boeing? (More than one answer may be
correct.)
A. Depreciation on factory forklift trucks.
B. Sales commissions.
C. The cost of a flight recorder in a Boeing 767.
D. The wages of a production shift supervisor.
Quick Check ✓
Quick Check ✓
Inventoriable costs vs. period costs
❖Inventoriable costs are all costs of a product that
are considered assets in a company’s balance
sheet when the costs are incurred and that are
expensed as cost of goods sold only when the
product is sold. For manufacturing companies, all
manufacturing costs are inventoriable costs.
❖Period costs are all costs in the income statement
other than cost of goods sold. They are treated as
expenses of the accounting period in which they
are incurred.
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Inventoriable Costs Vs Period Costs
Inventoriable costs Period costs include all
include direct selling costs and
materials, direct labor, administrative costs.
and manufacturing
overhead.
Cost of Good Sold
Expense
Inventory
Sale
Balance Income Income
Sheet Statement Statement
Quick Check ✓
Which of the following costs would be
considered a period rather than a product cost
in a manufacturing company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production facility.
Manufacturing Cost Flows
Schedules of Cost of Goods Manufactured
and Cost of Goods Sold
The schedules contains three types of costs:
1. direct materials
2. direct labor
3. manufacturing overhead
The schedules calculate the:
1. cost of raw material and direct labor used in
production and the amount of manufacturing
overhead applied to production.
2. manufacturing costs associated with goods
that were finished during the period.
Raw materials used in production.
Raw material purchases made during the period are added to
beginning raw materials inventory. The ending raw materials
inventory is deducted to arrive at the raw materials used in
production.
As items are removed from raw materials inventory and placed
into the production process, they are called direct materials.
Total manufacturing costs
Direct labor used in production and manufacturing
overhead applied to production are added to direct
materials to arrive at total manufacturing costs.
Total work in process.
Total manufacturing costs are added to the
beginning work in process to arrive at total
work in process.
Cost of goods manufactured
The ending work in process inventory is deducted
from the total work in process for the period to
arrive at the cost of goods manufactured.
Cost of goods sold
The cost of goods manufactured is added to the beginning finished
goods inventory to arrive at cost of goods available for sale. The
ending finished goods inventory is deducted from this figure to arrive
at cost of goods sold.
Quick Check ✓
Beginning raw materials inventory was
$32,000. During the month, $276,000 of raw
material was purchased. A count at the end of
the month revealed that $28,000 of raw
material was still present. What is the cost of
direct material used?
A. $276,000
B. $272,000
C. $280,000
D. $2,000
Quick Check ✓
Direct materials used in production totaled
$280,000. Direct labor was $375,000, and
$180,000 of manufacturing overhead was added to
production for the month. What were total
manufacturing costs incurred for the month?
A. $555,000
B. $835,000
C. $655,000
D. Cannot be determined.
Quick Check ✓
Beginning work in process was $125,000.
Manufacturing costs added to production for the
month were $835,000. There were $200,000 of
partially finished goods remaining in work in
process inventory at the end of the month. What
was the cost of goods manufactured during the
month?
A. $1,160,000
B. $910,000
C. $760,000
D. Cannot be determined.
Quick Check ✓
Beginning finished goods inventory was $130,000.
The cost of goods manufactured for the month was
$760,000. And the ending finished goods inventory
was $150,000. What was the cost of goods sold for
the month?
A. $20,000
B. $740,000
C. $780,000
D. $760,000
Cost flows illustrated
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Multiple-step income statement
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Multiple-step income statement
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Quick Check ✓
Which of the following transactions would
immediately result in an expense? (There may
be more than one correct answer.)
A. Work in process is completed.
B. Finished goods are sold.
C. Raw materials are placed into production.
D. Administrative salaries are accrued and paid.
Different product Costs
for Different purposes
❖Pricing and product-mix decisions—decisions
about pricing and maximizing profits
❖Contracting with government agencies—very
specific definitions of allowable costs for “cost
plus profit” contracts
❖Preparing external-use financial statements—
GAAP-driven product costs only
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Different product Costs
for Different purposes
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A framework for cost accounting and
cost management
The following three features of cost accounting and
cost management can be used for a wide range of
applications (for helping managers make decisions):
1. Calculating the cost of products, services, and
other cost objects
2. Obtaining information for planning and control, and
performance evaluation
3. Analyzing the relevant information for making
decisions
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