Chapter 7
Basic Cost Management Concepts
Nature of Cost, Cost Pools, Cost Objects, Cost Drives
Cost – value forgone or sacrifice of resources w/c will promote the profit-making ability of the firm
– outlay or expenditure of money to acquire good and services
– classified differently based on type of organization(merchandising,service, or manufacturing)
Cost Pools – costs collected into meaningful groups classified by:
type of cost (labor cost in one pool, material cost in another)
source (department 1, department 2, and so on)
responsibility (manager 1, manager 2, and so on)
Cost Object – any product, service or organizational unit to which costs are assigned
Cost Drivers – any factor that has the effect of changing the level of total cost
Cost Assignment and Classification
Cost Assignment – process of assigning costs to cost pools or from cost pools to cost objects
Cost Allocation – assignment of indirect cost to cost pools
Cost Classification – necessary for the development of cost information to serve management needs
A. Costs classified by nature or management function
Manufacturing costs – all costs associated with production of goods
– classified as direct material, direct labor and factory overhead
– expenditures are usually capitalized
Direct Materials– all raw material costs that become an integral part of the finished product
– includes invoice price plus other costs paid to the vendor, shipping costs,
sale taxes, duty, cost of delivery containers and pallets and royalty
payment based on direct material quantities.
– also includes scrap, waste, defective units and routine quality assurance
samples.
Direct Labor– all labor costs related to time spent on products assigned to units
manufactured
Manufacturing Overhead– all costs of manufacturing except direct materials & direct labor.
– examples are indirect materials, indirect labor, property taxes,
insurance, supervisor’s salaries, depreciation of factory building
and factory equipment
Indirect Materials – materials and supplies used in the manufacturing operation that do
not become part of the product.
Indirect Labor– labor costs that cannot be identified or traced to specific units
manufactured.
Other Manufacturing Overhead – include overtime premiums and cost of the idle time.
Prime Cost = Direct Materials + Direct Labor
Conversion Cost = Direct Labor + Factory Overhead
Nonmanufacturing Costs– costs related to selling & other activities not related to production
Marketing Costs – include all costs associated with marketing and selling a product
– also called order-getting &order-filling costs
– advertising, shipping, sales commissions and storage costs
General Administrative Costs – include all executive, organizational and clerical costs
** Recording and classifying costs is important not only for manufacturing firms but for
service industry firms and non-profit organizations as well like schools, hotels, banks,
airlines accounting firms and automotive repair shops.
B. Costs classified according to the timing of recognition as expense
Expense – cost incurred when an asset is used or sold for the purpose of generating revenue
Product Costs – include all costs in acquiring or making a product.
– also called inventoriable costs
Period Costs– all costs identified with accounting periods & not included in product costs
C. Cost classification on Financial Statements
A financial statement prepared by a manufacturing company is more complex than the
statement of a merchandising company.
Manufacturing company’s product costs include not only the cost of purchasing but also
the cost of converting materials into saleable products.
Statement of Financial Position inventory accounts:
Raw materials– materials used to make a product
Work in process– consist of units of product that are only partially complete and
requires further work before sale to customers
Finished Goods– consist of units of product that have been completed but have not yet
sold to customers
Income Statement
Manufacturing :
Beginning finished goods inventory Pxx
Add: Cost of goods manufactured xx
Total available for sale Pxx
Less: Ending finished goods inventory xx
Cost of goods sold Pxx
Merchandising :
Beginning merchandise inventory Pxx
Add: Purchases xx
Total available for sale Pxx
Less: Ending merchandise inventory xx
Cost of goods sold Pxx
D. Cost classification for Predicting Cost Behavior
Cost Behavior – refers to how a cost will react or respond to changes in the business
activity. As the activity level rises and falls, a particular cost may rises and falls as well - or
it may remain constant.
To help make such distinction, costs are categorized as variable, fixed or semi- variable.
Variable Cost – cost that change directly in proportion to changes in activity
(volume). Direct labor and direct materials are examples of variable costs.
Fixed Cost – cost that remain unchanged for a given time period regardless of change
in activity (volume). Rent, insurance on property, maintenance, and repairs of
buildings and depreciation of factory equipment are examples of fixed costs. Semi-
variable Cost – cost that contain both fixed and variable elements. Examples of
social security taxes, materials handling, personnel services, heat, light & power.
E. Cost classified by Types of Inventory
Raw Materials Inventory– cost of all raw material and production supplies that have been
purchased but not used at the end of the period.
Work-in-process Inventory – cost associated with goods partially completed at the end of
the period.
Finished Good Inventory – cost of completed goods that have not been sold at the end of
the period.
F. Cost classification according to Traceability to Cost Objective to Cost Objective
Direct costs (traceable;separable) – cost that can be economically traced to a single cost
object. (i.e. product, department or unit)
Indirect Costs – cost that are not directly traceable to the cost object (i.e.
product,department, etc.)
G. Costs classification according to Managerial Influence
Controllable cost – cost that is subject to significant influence by a particular manager
within the time period under consideration.
Non controllable cost – cost over which a given manager does not have a significant
influence.
H. Cost Terminologies Used for Planning and Control
Standard Costs – a predetermined cost estimate that should be attained; usually expressed in
terms of costs per unit.
Budgeted Costs – used to represent the expected/planned cost for a given period.
Absorption Costing – costing method that includes all manufacturing cost, direct materials,
direct labor, and fixed manufacturing overhead- in the cost of a unit product.
Direct Costing – type of product costing where fixed costs are charged against revenue as
incurred and are not assigned to specific units of product manufactured. Also referred to as
variable costing.
Information Costs – costs of obtaining information
Ordering Costs– costs that increase with the number of orders placed for inventory.
Out-of-pocket Costs – costs that must be met with a current expenditure or cash outlay.
I. Cost classification according to a Time-frame Perspective
Committed Cost – cost that is inevitable consequence of a previous commitment.
Discretionary Costs (programmed;managed cost) – cost for which the size or the time of
incurrence is a matter of choice.
J. Costs classified according to Time Period for Which the Cost is Incurred
Historical costs (past cost)– costs that were incurred in a past period.
Future costs – budgeted costs that are expected to be incurred in a future period.
K. Costs classifications for Decision-making and other Analytical Purposes
Relevant Costs– future costs that are different under one decision alternative than under
another decision alternative.
Incremental Costs– the difference in cost between two or more alternatives. To be an
incremental cost, the cost must be a future cost and be different under various alternatives.
Sunk Costs– past costs that have been incurred and are irrelevant to a future decision.
Opportunity Costs– the value of the best alternative foregone as the result of selecting a
different use of resource or by choosing a particular strategy.
Marginal Costs– costs associated with the next unit or the next project or incremental cost
associated with an additional project as opposed to the next discrete.
Value-Added Costs– costs that are value to the product. These cost result from activities
that are necessary to satisfy the requirements of the consumer.
