Cost Concepts, Terms, Behavior and Classification
Unit 2
Learning Objectives1. Explain the basic concept of “cost.”
2. Explain how costs are presented in financial statements
3. Explain the process of cost allocation.
4. Understand how material, labor, and overhead costs are added to a product at each stage of the production process.
5. Define basic cost behaviors, including fixed, variable, semivariable, and step costs.
6. Identify the components of a product’s costs.
7. Understand the distinction between financial and contribution margin income statements.
Cost Accounting• Cost accounting systems provide information to help managers make better
decisions.
• Managers who use cost accounting information to make decisions need to understand the cost terms used in their organizations.
• Because cost accounting systems are tailored to the needs of individual companies, several terms are used in practice to describe the same or similar cost concepts, depending on the use or the audience.
• Therefore, before we discuss the design of cost systems to aid decision making, we introduce a set of terms that will be used throughout the course. These terms are important to the discussion because they will be the “language” we use to communicate for the remainder of the lessons.
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Cost Concept• A cost is a sacrifice of resources. Every day, we
buy many different things: clothing, food, books, music, perhaps an automobile, and so on. When we buy one thing, we give up (sacrifice) the ability to use these resources (typically cash or a line of credit) to buy something else. The price of each item measures the sacrifice we must make to acquire it.
• Whether we pay cash or use another asset, whether we pay now or later (by using a credit card), the cost of the item acquired is represented by what we forgo as a result.
Cost versus Expenses
• It is important to distinguish cost from expense. An expense is a cost charged against
• revenue in an accounting period; hence, expenses are deducted from revenue in that
• accounting period. We incur costs whenever we give up (sacrifi ce) resources, regardless
• of whether we account for it as an asset or an expense. (We may even incur costs that
• the fi nancial accounting system never records as an asset or expense. An example is lost
• sales.) If the cost is recorded as an asset (for example, prepaid rent for an offi ce building),
• it becomes an expense when the asset has been consumed (i.e., the building has been used
• for a period of time after making the prepayment).
McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.
What is Cost?
Outlay Cost
Past, present, or future cash outflow
Opportunity CostsForgone benefit from the best alternative course of action
LO1 Explain the basic concept of “cost”.
Cost
ExpenseCost charged against revenue in an accounting period
Cost Example
Serra wants to go out with her friends for a night of fun and adventure.
Cost of the outing?
Outlay Cost
$50 to pay for dinner and drinks
Opportunity Cost
Passing her accounting exam and a new pair of
shoes!
Cost Example
Your education costs?
Outlay Cost
The cost of tuition, books, and all other educational expenses
Opportunity Cost
The interest on the money you would save by not
attending college and the income you will forgo while
in college
Recording Costs in Financial StatementsLO2 Explain how costs are presented in financial statements.
Income StatementsService Company
Service Revenues
- Cost of Services Sold
= Gross Margin
- General Selling and Administrative Costs
= Operating Profit
Merchandising Company
Sales Revenues
- Cost of Goods Sold
= Gross Margin
- General Selling and Administrative Costs
= Operating Profit
Cost incurred to purchase the goods sold
Cost of billable hours
The excess of operating revenue over costs necessary to generate those revenues
Manufacturing Company CostsTwo types of manufacturing company costs:
1. Product Costs: Costs relating to inventory2. Period Costs: Non-manufacturing costs related to the firm
All Costs
Product Costs:
Costs incurred to product the product
Recorded as an asset “inventory” when cost is incurred
Recognized as an expense when the product is sold
Period Costs:Costs incurred to sell a product and operate the business
Recognized as an expense when the cost is incurred
A Manufacturing Company’s Income Statement
Sales Revenue
- Cost of Goods Sold
= Gross Margin
- General Selling & Administrative Costs
= Operating Profit
Product costs recorded as “inventory” when cost is incurred
Cost incurred to manufacture the product sold
Expensed when sold
Period costs recorded as an expense in the period the cost is incurred
Product vs. Period Costs
Product Costs:
Costs that are recorded as an asset in inventory when incurred and expensed as Cost of Goods Sold when sold.
Period Costs:Costs that are expensed under General Selling and Administrative Costs when incurred.
Product Costs: Direct vs. Indirect
Direct Costs:Costs that, for a reasonable cost, can be directly traced to the product.
Direct Materials:Materials directly traceable to the product.
Direct Labor:Work directly traceable to transforming materials into the finished product.
Indirect Costs:Cost that cannot reasonably be directly traced to the product.
Manufacturing Overhead:All production costs except direct materials and direct labor.
Indirect Materials
Indirect Labor
Other Indirect Costs
McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.
Tracing Costs
Sara decides to go out with friends to a nice dinner and a movie.
Identify the object A night on the town
Direct Costs
The cost of the dinner and the
movie
Indirect Cost
The cost of Sara’s dress,
shoes, and car.
Manufacturing Costs: Product Costs
Inventory Costs
Prime Costs:The “primary” costs of
the product
Direct Materials
Direct Labor
Conversion Costs:Cost necessary to
“convert” materials into a product
Direct Labor
ManufacturingOverhead
Product Cost Review
• Given the following data →Direct Materials $8.00
Direct Labor $7.00
Manufacturing Overhead
$14.00Direct cost?
DM + DL = $15.00
Prime cost?
DM + DL = $15.00Conversion cost?
DL + MOH = $21.00 Indirect Cost?
MOH $14.00Total Product Cost?
DM + DL + MOH = $29.00
Period Costs: Non-manufacturing Cost
Recognized as an expense when the cost is incurred.
Marketing:Costs necessary to sell the products.
Advertising
Sales Commissions
Shipping Costs
Administrative:Costs necessary to
operate the business.
Executive Salaries
Data Processing
Legal Costs
Cost AllocationLO3 Explain the process of cost allocation.
Assigning indirect cost to a cost object
1. Define the cost pool:The collection of costs to be assigned to cost objects.
2. Determine the cost allocation rule:The method used to assign costs in the cost pool to cost objects.
3. Assign the cost object:Any end to which a cost is assigned – product, product line, department, customer, etc.
Example: Cost Allocation Rockford Company
Situation: Rockford has two divisions, East Coast and West Coast. Both divisions are supported by the IT Department.
East Coast West Coast Total
Revenues $80 million $20 million $100 million
1. Define Cost Pool: IT Department’s Costs of $1,000,000
2. Determine the Cost Allocation Rule: IT costs are allocated based on divisional revenue. (% of Revenue)
3. Assign the Cost Object: East Coast: 80% of cost = $800,000West Coast: 20% of cost = $200,000
Manufacturing Cost FlowsLO4 Understand how material, labor, and overhead costs
are added to a product at each stage of the production process.
Product costs are recorded in inventory when cost is incurred.
A manufacturing company has three inventory accounts:1. Raw Materials Inventory: Materials purchased to make a
product.
2. Work-in-Process Inventory: Products currently in the production process, but not yet completed.
3. Finished Goods Inventory: Completed products that have not yet been sold.
Inventory Accounts – The Balance Sheet
Raw Materials Inventory
Beg. RM Inventory
+ Purchases
= Raw Materials Available for Production
- Raw Materials Transferred to WIP
= Ending RM Inventory
Work-in-Process Inventory
Beg. WIP Inventory
+ Direct Materials Transferred from Raw Materials
+ Direct Labor
+ Manufacturing Overhead
= Total Manufacturing Costs
- Cost of Good Completed & Transferred to Finished Goods
= Ending WIP Inventory
Finished Goods Inventory
Beg. FG Inventory
+ Cost of Goods Completed & Transferred from WIP
= Goods Available for Sale
- Cost of Good Sold
= Ending FG Inventory
To the Income Statement
Jackson GearsCost of Goods Manufactured Statement
For the Year Ending December 31, 200X
Beginning WIP Inventory, January 1 $ 270,000
Manufacturing Cost During the Year:
Direct Materials:
Beginning Raw Materials Inventory, Jan. 1 $ 95,000
Add: Purchases 5,627,000
Direct Materials Available $ 5,722,000
Less: Ending RM Inventory, Dec. 31 72,000
Direct Materials put into Production $5,650,000
Direct Labor 1,220,000
Manufacturing Overhead 6,780,000
Total Manufacturing Costs Incurred 13,650,000
Total Work-in-Process During the Year 13,920,000
Less: Ending Work-in-Process Inv, Dec. 31 310,000
Cost of Goods Manufactured $ 13,610,000
==========
Jackson GearsCost of Good Sold Statement
For the Year Ending December 31, 200X
Beginning Finished Goods Inventory, Jan. 1 $ 420,000
Cost of Goods Manufactured 13,610,000
Finished Goods Available for Sale 14,030,000
Less: Ending Finished Goods Inventory, Dec. 31 930,000
Cost of Goods Sold $ 13,100,000
=========
Jackson GearsIncome Statement
For the Year Ending December 31, 200XSales $ 20,450,000
Less: Cost of Goods Sold 13,100,000
Gross Margin 7,350,000
Less: Marketing & Administrative Expenses 3,850,000
Operating Profit $ 3,500,000
=========
Cost BehaviorLO5 Define basic cost behaviors including fixed,
variable, semi-variable, and step costs.
Cost Behavior?
How costs respond to a change in activity level within the relevant range
Relevant Range?
Activity levels within which a given total fixed cost or unit variable cost will be unchanged
Fixed Costs
Fixed costs remain unchanged as volume changes within the relevant range.
Fixed costs are “fixed” in “total” as activity changes.
Fixed costs per unit varies inversely to a change in activity.
Activity Level
Costs ($)
0
10
20
30
40
50
60
70
80
90
0 1 2 3 4
Total Fixed Cost
Sara’s Night on the TownFixed Costs
Fixed costs are “fixed” in “total” as activity changes
Fixed cost per unit varies inversely with a change in activity.
Cost of a dress ($)
Number of times the dress is worn0
10
20
30
40
50
60
70
80
90
0 1 2 3 4
Total Fixed Cost
Variable CostsCosts that change in direct proportion with a change in the volume within the relevant range.
Variable costs “vary” in “total” as activity changes.
Variable cost per unit stays constant when activity changes within the relevant range.
Cost ($)
Activity Level0
5
10
15
20
25
30
35
0 1 2 3 4
Total VariableCost
Sara’s Entertainment Expenses
Variable Costs
Variable costs “vary” in “total” as activity changes over the relevant range.
Variable cost per unit remains constant when activity changes over the relevant range.
0
5
10
15
20
25
30
0 1 2 3 4
Total VariableCost
DrinkCost ($)
Number of drinks
Semi-variable Costs
Costs that have both fixed and variable components.
Also known as MIXED COSTS.
Activity Level
Cost
s
Semi-VariableCost
Sara’s Entertainment
Semi-variable costsThe fixed component is “fixed” in total as activity changes over the relevant range.
The variable component “varies in total as activity changes over the relevant range.
0
20
40
60
80
100
120
140
0 1 3 4 5 6
Semi-variablecost
Number of movies
Cost ($)
Step Costs
Costs that increase in total with steps when the volume changes to a particular level.
Step costs are also known as semi-fixed costs.Example: If a factory can produce 100,000 units a month and the firm needs to
produce 120,000 units then more factory space must be procured. The additional space will only be purchased if 100,000 units are exceeded.
Costs ($)
Activity LevelCost of original factory
Cost of 1st rented space
Cost of 2nd rented space
Product Cost ComponentsLO6 Identify the components of a product’s costs.
Full Cost: The sum of all costs of manufacturing and selling a unit of the product. (GAAP)
Full Absorption Cost: The sum of all variable and fixed costs of manufacturing a unit of the product.
Variable Cost: The sum of all variable costs of manufacturing and selling a unit of the product.
Costs: An Example
Given the following: Direct Materials = $8
Direct Labor = $7
Variable Manufacturing Overhead = $8
Fixed Manufacturing Overhead = $6
Variable Marketing & Admin = $4
Fixed Marketing & Admin = $7
1. What is the full cost per unit?
DM + DL + VMOH + FMOH + VMA + FMA
= $40
2. What is the full absorption cost per unit?
DM + DL + VMOH + FMOH = $29
3. What is the variable cost per unit?
DM + DL + VMOH + VMA = $27
Making Costs Information UsefulLO7 Understand the distinction between financial
and contribution margin income statements.
Full Absorption Costing:• Required by GAAP
Used for:• Financial purposes• External reporting
Sales Revenue
- Cost of Goods Sold
= Gross Margin
Variable Costing
Used for:• Managerial purposes• Internal decision-making
Sales Revenue
- Variable Costs
= Contribution Margin
Making Cost Information Useful, Continued…
Financial Income Statement
Full Absorption Costing
Sales Price
- Full Absorption Cost
= Gross Margin
Sales Price
- Variable Cost
= Contribution Margin
Variable Costing
Contribution Margin Income Statement
Product vs. Period
Full Absorption Costing
Variable Manufacturing Costs
Fixed Manufacturing Costs
Product Costs
Variable Costing
Variable Manufacturing Overhead
Variable Marketing & Admin Costs
Fixed Marketing & Admin Costs
Period Costs
Fixed Manufacturing Costs
Variable Marketing & Admin Costs
Fixed Marketing & Admin Costs
Income Statement: Full Absorption Costing
Sales Revenue
- Cost of Goods Sold
= Gross Margin
- Marketing & Admin Cost
= Operating Profit
Full Absorption
Variable and Fixed Manufacturing Costs
Period Costs
Variable and Fixed Marketing & Admin
Costs
Income Statement:Variable Costing
Sales Revenue
-Variable Costs
= Contribution Margin
- Fixed Costs
= Operating Profit
Variable Manufacturing Costs
and Variable Marketing & Admin
Costs
Fixed Manufacturing Costs and Fixed
Marketing & Admin Costs
Quick Check If your inventory balance at the beginning of the month
was $1,000, you bought $100 during the month, and sold $300 during the month, what would be the balance at the end of the month?
A. $1,000.
B. $ 800.
C. $1,200.
D. $ 200.
Quick Check If your inventory balance at the beginning of the month
was $1,000, you bought $100 during the month, and sold $300 during the month, what would be the balance at the end of the month?
A. $1,000.
B. $ 800.
C. $1,200.
D. $ 200.
$1,000 + $100 = $1,100$1,100 - $300 = $800
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. $280,000D. $ 2,000
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. $280,000D. $ 2,000
Quick Check Direct materials used in production totaled
$280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month?
A. $555,000B. $835,000C. $655,000D. Cannot be determined.
Direct materials used in production totaled $280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month?
A. $555,000B. $835,000C. $655,000D. Cannot be determined.
Quick Check
Quick Check Beginning work in process was $125,000.
Manufacturing costs incurred 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. $1,160,000B. $ 910,000C. $ 760,000D. Cannot be determined.
Beginning work in process was $125,000. Manufacturing costs incurred 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. $1,160,000B. $ 910,000C. $ 760,000D. Cannot be determined.
Quick Check
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.
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.
$130,000 + $760,000 = $890,000$890,000 - $150,000 = $740,000
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 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.
UNIT 2: END!!