An Introduction to Cost Terms and

Purposes

Chapter 2
Learning Objectives

(1) Define and illustrate a cost object

(2) Distinguish between direct costs and indirect costs

Explain variable costs and fixed costs and apply High –

(3)
Low method to estimate costs

(4) Distinguish inventoriable costs from period costs

Explain why product costs are computed in different

(5)
ways for different purposes
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Basic Cost Terminology

❖ Cost – sacrificed resource to achieve a specific

objective
❖ Actual cost – a cost that has occurred
❖ Budgeted cost – a predicted cost
❖ Cost object – anything of interest for which a cost
is desired
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Cost Object

❖ Cost object – anything of interest for which a cost is desired

A product A room-night A project

A department An activity A customer

Cost & business functions
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Supporting activities

Customer
Production Marketing Distribution R&D Design
service

Value chain
Cost & business functions

Total costs
Production
Selling cost General & Administrative cost
cost

Customer Supporting
Production Marketing Distribution R&D Design
service activities

Value chain
Production cost (Manufacturing cost)

Costs incurred in production process, including raw

materials and other costs required to covert those
materials into finished goods.
Nonmanufacturing cost

General &
Selling cost Administrative
cost

Costs required to get orders

Day-to-day cost required to
and deliver goods to
administer a business.
customers.
Basic Cost Terminology

❖ Direct costs – can be conveniently and

economically traced (tracked) to a cost object
❖ Indirect costs – cannot be conveniently or
economically traced (tracked) to a cost object.
Instead of being traced, these costs are allocated
to a cost object in a rational and systematic
manner
Exercise 1

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Text
Basic Cost Terminology

❖ Cost accumulation – a collection of cost data in

an organized manner
❖ Cost assignment – a general term that includes
gathering accumulated costs to a cost object.
This includes:
▪ Tracing accumulated costs with a direct
relationship to the cost object and
▪ Allocating accumulated costs with an indirect
relationship to a cost object
Assigning Costs to a Cost Object
Factors Affecting Direct / Indirect Cost
Classification

❖ The materiality of the cost in question

❖ Availability of information-gathering technology
❖ Design of operations
Exercise 2
Cost Behavior

❖ Variable costs
▪ changes in total in
proportion to changes
in the related level of
activity or volume.
▪ are constant on a
per-unit basis.
Cost Behavior, continued

❖ Fixed costs
▪ remain unchanged in
total regardless of
changes in the related
level of activity or
volume.
▪ change inversely with
the level of production
per unit basis.
Cost Behavior Summarized

Total Dollars
Total Dollars Cost per
Per Unit
Unit
Change in
Change in Unchanged in
Variable Costs proportion with
proportion with relation to output
Variable Costs output
output
Moreoutput
More output==More
Morecost
cost
Change
Change inversely
Fixed Costs Unchanged in inversely with
Unchanged in with output
Fixed Costs output
relation to output More output = lower cost
relation to output More output = lower cost
per unit
per unit
Exercise 3
Other Cost Concepts

❖ Cost Driver – a variable that causally affects

costs over a given time span
❖ Relevant Range – the band of normal activity
level (or volume) in which there is a specific
relationship between the level of activity (or
volume) and a given cost
▪ Fixed costs are considered fixed only within the
relevant range.
Relevant Range Visualized
Exercise 4
Exercise 5

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Multiple Classification of Costs, Visualized
A Cost Caveat

❖ Unit Costs (Average Costs) is calculated by dividing the

total cost by the related number of unit produced.
❖ Unit costs should be used cautiously. Since unit costs
change with a different level of output or volume, it may
be more prudent to base decisions on a total dollar basis.
Exercise 7
Classification of Manufacturing Costs
(Inventoriable costs)
❖ Manufacturing consists of activities and
processes that convert raw materials into finished
goods.

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Classification of Manufacturing Costs
(cont’d)

❖ Direct materials costs (DM)

▪ Costs of all materials that become part of the cost
object (work in process - WIP, finished goods - FG)
and can be traced to the cost object in an
economically feasible way.
▪ Example: seats installed in a car made by Toyota.

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Classification of Manufacturing Costs
(cont’d)
❖ Direct manufacturing labor costs (DL)
▪ Compensation of all manufacturing labor that can
be traced to the cost object (WIP and FG) in an
economically feasible way.
▪ Example: wages paid to automobile assembly
workers at Toyota.

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Classification of Manufacturing Costs
(cont’d)
❖ Manufacturing overhead (MOH)
▪ All manufacturing costs that are related to the cost
object (WIP and FG), but cannot be traced to that cost
object in an economically feasible way.
▪ Includes all manufacturing costs except direct
materials and direct labor.
▪ Example: indirect materials, indirect labor, depreciation
and insurance on manufacturing facilities.
▪ Also called factory overhead, indirect manufacturing
costs, or burden.

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 Accounting Distinction Between Costs

❖ Inventoriable costs – product manufacturing

costs. These costs are capitalized as assets
(inventory) until they are sold and transferred to
Cost of Goods Sold.
❖ Period costs – have no future value and are
expensed as incurred.
Types of Manufacturing Inventories

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
Inventory: a Manufacturer vs. a Merchandiser

37
Cost flows in a manufacturer

Costs Balance sheet

Direct materials Direct materials

purchased inventory
Inventoriable costs

Direct materials used

Income
Direct labor
Work-In-Proces Statement
s
Cost of goods
MOH manufactured
Finished goods sold Cost of goods
inventory sold

Selling & Adm.

Period

Selling & Adm.

costs

expense
 Direct materials

Inventoriable costs
Direct labor Indirect materials
All costs
(Manufacturing costs)

Manufacturing overhead Indirect labor

Selling expenses Other indirect costs

Period costs
(Nonmanufacturing
costs)
Administrative expenses
Exercise 8

❖ Your Boat, Inc., is a small company that assembles

custom sailboats from components supplied by various
manufacturers. Its assembly shop and retail sales store
are housed in a small boathouse.
Cost Classification
(DM, DL, MOH, selling, admin.)
Wages of employees who build sailboats.
Advertising in newspaper.
Aluminum mast installed in sailboat.
Wages of company’s bookkeeper.
Depreciation on power tools.

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Exercise 9

❖ Your company manufactures radar sets for commercial aircraft.

You want to borrow money from a bank and the bank requests
financial data. This requires you to classify costs as either
inventoriable (product) or period costs.

Cost Product vs. Period

Memory chips used in radar sets.
Factory heating costs.
Training costs for new administrative employees.
Costs of shipping radar sets to customers.
Telephone expenses incurred by factory
management.

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Cost flow visualized

Beginning
Cost of Goods Ending Finished Cost of Goods
Finished Goods
Manufactured Goods Inventory Sold
Inventory

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Cost Flows Visualized (Cont’d)
Cost Flows Visualized (Cont’d)
Cost Flows Visualized (Cont’d)
Cost Flows Visualized (Cont’d)
Cost Flows Visualized (Cont’d)
Cost Flows Visualized (Cont’d)
Cost of Goods Manufactured
Multiple-Step Income Statement
 Exercise 10
Black Company has the following cost data. Compute cost of goods manufactured:

Manufacturing overhead:
Property taxes, factory $3,000
Utilities, factory 5,000
Indirect labor 10,000
Depreciation, factory 24,000
Insurance, factory 8,000
Total MOH $50,000
Other costs:
Purchase of raw materials $32,000
Direct labor cost 40,000
Inventories:
Raw materials, beginning $8,000
Raw materials, ending 7,000
Work in process, beginning 6,000
Work in process, ending 7,500

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Prime cost and Conversion cost

❖ Prime cost is a term referring to all direct manufacturing

costs (labor and materials)
❖ Conversion cost is a term referring to direct labor and
factory overhead costs, collectively
Conversion cost

Manufacturing
Direct materials Direct labor
overhead

Prime cost
Example – Prime cost & Conversion cost
Other Cost Considerations

❖ Overtime premium
▪ wages paid in excess of straight-time rates for
overtime work
❖ Idle time
▪ wages paid for unproductive time caused by lack
of orders, machine breakdowns, delays, poor
scheduling
❖ are considered part of overhead due to the
inability to precisely know the true cause of these
costs
Example – Overtime Premium & Idle time

A man works 44 hours, including 4 overtime hours. He is paid $40 per

hour for straight-time and $60 per hour for overtime.

If this man had no work for 3 hours 🡪 Idle time

Different Definitions of Costs
for Different Applications
Three Common Features of
Cost Accounting & Cost Management

1. Calculating the cost of products, services, and

other cost objects
2. Obtaining information for planning & control,
and performance evaluation
3. Analyzing the relevant information for making
decisions
Learning Materials

❖Chapter 2 (Horngren’s Cost Accounting)

❖ Exercises: 2-21, 2-22, 2-23, 2-24, 2-25, 2-27, 2-28, 2-30,
2-32, 2-33, 2-34, 2-35, 2-37, 2-38, 2-40, 2-41, 2-42, 2-43,
2-44