Chapter 2

Cost definition and classifications

McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All

1-2

Basic Definitions
A cost is incurred when a firm uses a resource for
some purpose
The use of valuable resources, in order to
achieve a stated purpose. In accounting, cost
is reported in monetary terms.
Costs are assembled into meaningful groups called
cost pools (e.g., by type of cost or source)
Any factor that has the effect of changing the level
of total cost is called a cost driver
A cost object is any product, service, customer,
activity, or organizational unit to which costs are
assigned for some management purpose

1-3

Comparing Service, Retail and

Manufacturing Companies

Service firms . . .
Provide a service that is
consumed when produced.

Retailers . . .
Buy finished goods.
Sell finished goods.

Have no inventories.
MegaLoMart

Manufacturers . . .
Buy raw materials.
Produce and sell finished goods.

1-4

Manufacturing Companies
The
The 33 major
major categories
categories of
of manufacturing
manufacturing
costs:
costs:

Direct
DirectMaterials
Materials
Raw
Rawmaterials,
materials,
components,
components,and
and
other
otherparts
partsthat
that
can
canbe
betraced
tracedto
toaa
specific
specificproduct.
product.

Direct
DirectLabor
Labor
Payments
Paymentsand
and
benefits
benefitsfor
forthose
those
employees
employeeswho
who
convert
convertdirect
direct
materials
materialsinto
into
finished
finishedproduct.
product.

Manufacturing
Manufacturing
Overhead
Overhead
Indirect
Indirectmaterial
material
Indirect
Indirectlabor
labor
Other
Otheroverhead
overhead

1-5

Manufacturing Companies
Prime
Prime Costs
Costs include:
include:

Direct
DirectMaterials
Materials

Direct
DirectLabor
Labor

Manufacturing
Manufacturing
Overhead
Overhead

1-6

Manufacturing Companies
Conversion
Conversion Costs
Costs include:
include:

Direct
DirectMaterials
Materials

Direct
DirectLabor
Labor

Manufacturing
Manufacturing
Overhead
Overhead

1-7

Manufacturing Costs
Direct
Direct
Materials
Materials

Direct
Direct
Labor
Labor

The Product

Manufacturing
Manufacturing
Overhead
Overhead

1-8

Direct Materials
Raw materials that become an integral part of the
product and that can be conveniently traced
directly to it.

Example:
Example: A
A radio
radio installed
installed in
in an
an automobile
automobile

1-9

Direct Labor
Those labor costs that can be easily
traced to individual units of product.

Example:
Example: Wages
Wages paid
paid to
to automobile
automobile assembly
assembly workers
workers

1-10

Manufacturing Overhead
Manufacturing costs cannot be traced directly to
specific units produced.
Examples:
Examples: Indirect
Indirect materials
materials and
and indirect
indirect labor
labor

Materials used to support

the production process.
Examples: Lubricants and
cleaning supplies used in the
automobile assembly plant.

Wages paid to employees

who are not directly
involved in production
work.
Examples: Maintenance
workers, janitors and
security guards.

1-11

Classifications of
Nonmanufacturing Costs
Selling Costs

Administrative
Costs

Costs necessary to get

the order and deliver
the product.

All executive,
organizational, and
clerical costs.

1-12

Learning Objective
Distinguish between
product costs and period
costs and give examples
of each.

1-13

Product Costs Versus Period Costs

Product costs include
direct materials, direct
labor, and
manufacturing
overhead.
Cost of
Goods Sold

Inventory

Period costs are not

included in product
costs. They are
expensed on the
income statement.
Expense

Sale

Balance
Sheet

Income
Statement

Income
Statement

1-14

Quick Check
Which of the following costs would be
considered a period rather than a product cost
in a manufacturing company? (There may be
more than one correct answer.)
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.

1-15

Comparing Merchandising and

Manufacturing Activities
Merchandisers . . .
Purchase finished
goods from suppliers
for resale to
customers.

MegaLoMart

Manufacturers . . .
Purchases raw
materials from
suppliers.
Produce and sell
finished goods to
customers.

1-16

Balance Sheet
Merchandiser
Current Assets

Cash
Receivables
Prepaid Expenses
Merchandise Inventory

Manufacturer
Current Assets
Cash
Receivables
Prepaid Expenses
Inventories:
1. Raw Materials
2. Work in Process
3. Finished Goods

1-17

Balance Sheet
Merchandiser
Current Assets

Cash
Receivables
Prepaid Expenses
Merchandise
Inventory
Partially complete
products some
material, labor, or
overhead has been
added.

Manufacturer
Current Assets
Cash
Receivables
Materials waiting to
Prepaid
be processed.
Expenses
Inventories:
1. Raw Materials
2. Work in Process
3. Finished Goods

Completed products
awaiting sale.

1-18

Learning Objective
Prepare an income
statement including
calculation of the cost of
goods sold.

1-19

The Income Statement

Cost of goods sold for manufacturers differs only
slightly from cost of goods sold for merchandisers.
Merchandising Company
Cost of goods sold:
Beg. merchandise
inventory
+ Purchases
Goods available
for sale
- Ending
merchandise
inventory
= Cost of goods
sold

$ 14,200
234,150
$ 248,350

(12,100)
$ 236,250

1-20

Inventory Flows
Beginning
Beginning
balance
balance

Additions
Additions
to
to inventory
inventory

Ending
Ending
balance
balance

Withdrawals
Withdrawals
from
from
inventory
inventory

1-21

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.

1-22

Learning Objective

Prepare a schedule of cost

of goods manufactured.

1-23

Schedule of Cost of Goods

Manufactured
Calculates the cost of raw
materials, direct labor and
manufacturing overhead used
in production.

Calculates the manufacturing

costs associated with goods
that were finished during the
period.

1-24

Schedule of Cost of Goods

Manufactured
Raw Materials

+
=

Beginning raw
materials inventory
Raw materials
purchased
Raw materials
available for use
in production
Ending raw materials
inventory
Raw materials used
in production

Manufacturing
Work
As
items
are
removed
from
AsCosts
items are removed
from
In Process

raw
raw materials
materials inventory
inventory and
and
placed
placed into
into the
the production
production
process,
process, they
they are
are called
called direct
direct
materials.
materials.

1-25

Schedule of Cost of Goods

Manufactured
Raw Materials

+
=

Beginning raw
materials inventory
Raw materials
purchased
Raw materials
available for use
in production
Ending raw materials
inventory
Raw materials used
in production

Manufacturing
Costs

Direct materials
+ Direct labor
+ Mfg. overhead
= Total manufacturing
costs

Work
Conversion
Conversion
In Process
costs
costsare
arecosts
costs
incurred
incurredto
to
convert
convert the
the
direct
directmaterials
materials
into
into aafinished
finished
product.
product.

As
Asitems
itemsare
areremoved
removedfrom
fromraw
raw
materials
materialsinventory
inventoryand
andplaced
placedinto
into
the
theproduction
production process,
process, they
theyare
are
called
calleddirect
direct materials.
materials.

1-26

Schedule of Cost of Goods

Manufactured
Raw Materials

+
=

Beginning raw
materials inventory
Raw materials
purchased
Raw materials
available for use
in production
Ending raw materials
inventory
Raw materials used
in production

Manufacturing
Costs

Work
In Process

Direct materials
+ Direct labor
+ Mfg. overhead
= Total manufacturing
costs

Beginning work in
process inventory
+ Total manufacturing
costs
= Total work in
process for the
period
Ending work in
All
manufacturing
incurred
All manufacturing costs
costs
incurred
process
inventory
during
added
to
=are
Cost
of goods
during the
theperiod
period are
added
tothe
the
manufactured.
beginning balance of
work in

beginning balance of work in

process.
process.

1-27

Schedule of Cost of Goods

Manufactured
Raw Materials

Manufacturing
Costs

Beginning raw
Direct materials
materials inventory
+ Direct labor
+ Raw materials
+ Mfg. overhead
purchased
= Total manufacturing
= Raw materials
costs
available for use
in production
Ending raw materials
inventory
Costs
associated
with
Costs
associated
with the
thegoods
goodsthat
that
= Raw materials
used
are
completed
arein
completed
duringthe
the period
period are
are
production during

transferred
transferredto
tofinished
finished goods
goods
inventory.
inventory.

+
=

Work
In Process

Beginning work in
process inventory
Total manufacturing
costs
Total work in
process for the
period
Ending work in
process inventory
Cost of goods
manufactured.

1-28

Cost of Goods Sold

1-29

Manufacturing Cost Flows

Costs

Balance Sheet
Inventories

Material Purchases

Raw Materials

Direct Labor

Work in
Process

Manufacturing
Overhead

Selling and
Administrative

Finished
Goods

Period Costs

Income
Statement
Expenses

Cost of
Goods
Sold
Selling and
Administrative

1-30

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

1-31

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.
$555,000
B.
$835,000
C.
$655,000
D.
Cannot be determined.

1-32

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.
$1,160,000
B.
$ 910,000
C.
$ 760,000
D.
Cannot be determined.

1-33

Quick Check
Beginning finished goods inventory was
$130,000. The cost of goods manufactured for
the month was $760,000. 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.

1-34

Learning Objective

Understand the
differences between
variable costs and fixed
costs.

1-35

Cost Classifications for Predicting

Cost Behavior
How
How aa cost
cost will
will react
react to
to
changes
changes in
in the
the level
level of
of
business
business activity.
activity.

Total
Total variable
variable costs
costs change
change
when
when activity
activity changes.
changes.
Total
Total fixed
fixed costs
costs remain
remain
unchanged
unchanged when
when activity
activity
changes.
changes.

1-36

Variable Cost

Total Texting Bill

Your total texting bill is based on how

many texts you send.

Number of Texts Sent

1-37

Variable Cost Per Unit

Cost Per Text Sent

The cost per text sent is constant at

5 cents per text.

Number of Texts Sent

5-38

True Variable Cost

Cost

Direct materials is a true or proportionately

variable cost because the amount used during
a period will vary in direct proportion to the
level of production activity.

Volume

5-39

Step-Variable Costs

Cost

A
A resource
resource that
that is
is obtainable
obtainable only
only in
in large
large chunks
chunks
(such
(such as
as maintenance
maintenance workers)
workers) and
and whose
whose costs
costs
increase
increase or
or decrease
decrease only
only in
in response
response to
to fairly
fairly
wide
wide changes
changes in
in activity.
activity.

Volume

5-40

Step-Variable Costs

Cost

Small
Small changes
changes in
in the
the level
level of
of production
production are
are not
not
likely
likely to
to have
have any
any effect
effect on
on the
the number
number of
of
maintenance
maintenance workers
workers employed.
employed.

Volume

5-41

Step-Variable Costs

Cost

Only fairly wide changes in the activity

level will cause a change in the number
of maintenance workers employed.

Volume

5-42

The Linearity Assumption and the

Relevant Range

Total Cost

A
A straight
straight line
line
Economists
closely
closely
Curvilinear Cost approximates
approximates aa
Function
curvilinear
curvilinear

Relevant
Range

variable
variable cost
cost
line
line within
within the
the
relevant
relevant range.
range.

Accountants Straight-Line
Approximation (constant
unit variable cost)
Activity

1-43

Fixed Cost

Monthly Cell Phone

Contract Fee

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.

Number of Minutes Used

Within Monthly Plan

1-44

Fixed Cost Per Unit

Monthly Cell Phone

Contract Fee

Within the monthly contract allotment, the average fixed cost

per cell phone call made decreases as more calls are
made.

Number of Minutes Used

Within Monthly Plan

5-45

Types of Fixed Costs

Committed
Committed

Discretionary
Discretionary

Long-term,
Long-term, cannot
cannot be
be
significantly
significantly reduced
reduced
in
in the
the short-term.
short-term.

May
May be
be altered
altered in
in the
the
short-term
short-term by
by current
current
managerial
managerial decisions
decisions

Examples
Examples

Examples
Examples

Depreciation
Depreciation on
on
Buildings
Buildings and
and
Equipment
Equipment and
and
Real
Real Estate
Estate Taxes
Taxes

Advertising
Advertising and
and
Research
Research and
and
Development
Development

1-46

Cost Classifications for Predicting

Cost Behavior
Behavior of Cost (within the relevant range)
Cost

In Total

Per Unit

Variable

Total variable cost changes

as activity level changes.

Variable cost per unit remains

the same over wide ranges
of activity.

Fixed

Total fixed cost remains

the same even when the
activity level changes.

Average fixed cost per unit goes

down as activity level goes up.

1-47

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.

5-48

Rent Cost in
Thousands of Dollars

Fixed Costs and Relevant Range

90
Relevant

60

Range

30
0

Total
Total cost
cost doesnt
doesnt
change
change for
for aa wide
wide
range
range of
of activity,
activity, and
and
then
then jumps
jumps to
to aa new
new
higher
higher cost
cost for
for the
the
next
next higher
higher range
range of
of
activity.
activity.

1,000
2,000
3,000
Rented Area (Square Feet)

5-49

Fixed Costs and Relevant Range

The relevant range of activity for a fixed cost is
the range of activity over which the graph of
the cost is flat.
Example: Office space is
available at a rental rate of
$30,000 per year in
increments of 1,000 square
feet. As the business grows,
more space is rented,
increasing the total cost.

5-50

Fixed Costs and Relevant Range

How does this type

of fixed cost differ
from a step-variable
cost?

Step-variable costs
can be adjusted
more quickly and . . .
The width of the
activity steps is
much wider for the
fixed cost.

5-51

Quick Check
Which
Which of
of the
the following
following statements
statements about
about cost
cost
behavior
behavior are
are true?
true?
a.
a. Fixed
Fixed costs
costs per
per unit
unit vary
vary with
with the
the level
level of
of
activity.
activity.
b.
b. Variable
Variable costs
costs per
per unit
unit are
are constant
constant within
within the
the
relevant
relevant range.
range.
c.
c. Total
Total fixed
fixed costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.
d.
d. Total
Total variable
variable costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.

5-52

Mixed Costs
A mixed cost has both fixed and variable
components. Consider your utility costs.
Total Utility Cost

ta
o
T

xe
i
lm

s
o
dc

t
Variable
Cost per KW

Activity (Kilowatt Hours)

Fixed Monthly
Utility Charge

5-53

Mixed Costs

Total Utility Cost

ta
o
T

xe
i
lm

s
o
dc

t
Variable
Cost per KW

Activity (Kilowatt Hours)

Fixed Monthly
Utility Charge

5-54

Mixed Costs Example

IfIf your
your fixed
fixed monthly
monthly utility
utility charge
charge is
is $40,
$40, your
your
variable
variable cost
cost is
is $0.03
$0.03 per
per kilowatt
kilowatt hour,
hour, and
and your
your
monthly
monthly activity
activity level
level is
is 2,000
2,000 kilowatt
kilowatt hours,
hours, the
the
amount
amount of
of your
your utility
utility bill
bill is:
is:

Y = a + bX
Y = $40 + ($0.03 2,000)
Y = $100

5-55

Analysis of Mixed Costs

Account
Account analysis
analysis

Each
Each account
account is
is classified
classified as
as either
either
variable
variable or
or fixed
fixed based
based on
on the
the analysts
analysts
knowledge
knowledge of
of how
how the
the account
account behaves.
behaves.

Engineering
Engineering Approach
Approach

Cost
Cost estimates
estimates are
are based
based on
on an
an
evaluation
evaluation of
of production
production methods,
methods,
and
and material,
material, labor
labor and
and overhead
overhead
requirements.
requirements.

5-56

Learning Objective

Use a scattergraph plot

to diagnose cost behavior.

5-57

The Scattergraph Method

Plot
Plot the
the data
data points
points on
on aa graph
graph
(total
(total cost
cost vs.
vs. activity).
activity).

Maintenance Cost
1,000s of Dollars

Y
20

* *
* *

10

* ** *
**

Patient-days in 1,000s

5-58

The Scattergraph Method

Maintenance Cost
1,000s of Dollars

Y
20

* *
* *

10

* ** *
**

Patient-days in 1,000s

Draw
Draw aa line
line
through
through the
the
data
data points
points
with
with about
about
an
an equal
equal
number
number of
of
points
points above
above
and
and below
below
the
the line.
line.

5-59

Maintenance Cost
1,000s of Dollars

The Scattergraph Method

Y Total maintenance cost = $11,000
20

* ** *
**

* *
* *

10

Intercept = Fixed cost: $10,000

Patient-days in 1,000s
Patient days = 800

Use
Use one
one
data
data point
point
to
to estimate
estimate
the
the total
total
level
level of
of
activity
activity
and
and the
the
total
total cost.
cost.

5-60

The Scattergraph Method

Make a quick estimate of variable cost per
unit and determine the cost equation.

Variable cost per unit =

$1,000
800

= $1.25 per patient-day

Y = $10,000 + $1.25X
Total maintenance cost

Number of patient days

5-61

Learning Objective 3

Analyze a mixed cost

using the high-low method.

5-62

The High-Low Method

Assume the following hours of maintenance work
and the total maintenance costs for six months.

5-63

The High-Low Method

The variable cost

per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.

Hours Total Cost

High
800 $ 9,800
Low
500
7,400
Change
300 $ 2,400
$2,400
= $8.00/hour
300 hours

5-64

The High-Low Method

Total Fixed Cost = Total Cost Total Variable Cost

Total Fixed Cost = $9,800 ($8/hour 800 hours)
Total Fixed Cost = $9,800 $6,400
Total Fixed Cost = $3,400

5-65

The High-Low Method

The Cost Equation for Maintenance

Y = $3,400 + $8.00X

5-66

Quick Check
Sales
Sales salaries
salaries and
and commissions
commissions are
are $10,000
$10,000
when
when 80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when
120,000
120,000 units
units are
are sold.
sold. Using
Using the
the high-low
high-low
method,
method, what
what is
is the
the variable
variable portion
portion of
of sales
sales
salaries
salaries and
and commission?
commission?
a.
a. $0.08
$0.08 per
per unit
unit
b.
b. $0.10
$0.10 per
per unit
unit
c.
c. $0.12
$0.12 per
per unit
unit
d.
d. $0.125
$0.125 per
per unit
unit

5-67

Quick Check
Sales
Sales salaries
salaries and
and commissions
commissions are
are $10,000
$10,000
when
when 80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when
120,000
120,000 units
units are
are sold.
sold. Using
Using the
the high-low
high-low
method,
method, what
what is
is the
the fixed
fixed portion
portion of
of sales
sales
salaries
salaries and
and commissions?
commissions?
a.
a. $$ 2,000
2,000
b.
b. $$ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000

5-68

Least-Squares Regression Method

A
A method
method used
used to
to analyze
analyze mixed
mixed costs
costs ifif aa
scattergraph
scattergraph plot
plot reveals
reveals an
an approximately
approximately linear
linear
relationship
relationship between the X and Y variables.
This method uses all of the
data points to estimate
the fixed and variable
cost components of a
mixed cost.

The goal of this method is

to fit a straight line to the
data that minimizes the
sum of the squared errors.

5-69

Least-Squares Regression Method

Software can be used to
fit a regression line
through the data points.
The cost analysis
objective is the same:
Y = a + bX
The
The output
output from
from the
the regression
regression analysis
analysis can
can be
be
used
used to
to create
create an
an equation
equation that
that enables
enables you
you to
to
estimate
estimate total
total costs
costs at
at any
any activity
activity level.
level.

5-70

Comparing Results From the Three

Methods
The
The three
three methods
methods just
just discussed
discussed provide
provide
slightly
slightly different
different estimates
estimates of
of the
the fixed
fixed and
and
variable
variable cost
cost components
components of
of the
the mixed
mixed cost.
cost.
This
This is
is to
to be
be expected
expected because
because each
each method
method
uses
uses different
different amounts
amounts of
of the
the data
data points
points to
to
provide
provide estimates.
estimates.
Least-squares
Least-squares regression
regression provides
provides the
the most
most
accurate
accurate estimate
estimate because
because it
it uses
uses all
all of
of the
the
data
data points.
points.

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Learning Objective

Understand the
differences between
direct and indirect costs.

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Assigning Costs to Cost Objects

Direct costs

Indirect costs

Costs that can be

easily and conveniently
traced to a unit of
product or other cost
object.

Costs that cannot be

easily and conveniently
traced to a unit of
product or other cost
object.

Examples: Direct
material and direct labor

Example: Manufacturing
overhead

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Learning Objective
Understand cost
classifications used in making
decisions: differential costs,
opportunity costs, and sunk
costs.

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Cost Classifications for Decision

Making
Every decision involves a choice
between at least two alternatives.
Only those costs and
benefits that differ
between alternatives
are relevant to the
decision. All other
costs and benefits can
and should be ignored.

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Differential Costs and Revenues

Costs and revenues that differ
among alternatives.
Example: You have a job paying $1,500 per month in
your hometown. You have a job offer in a
neighboring city that pays $2,000 per month. The
commuting cost to the city is $300 per month.
Differential revenue is:
$2,000 $1,500 = $500

Differential cost is:

$300

Net Differential Benefit is:

$200

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Opportunity Costs
The potential benefit that is given up
when one alternative is selected
over another.
Example: If you were
not attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college for
one year is $15,000.

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Sunk Costs
Cannot be changed by any decision. They
are not differential costs and should be
ignored when making decisions.
Example: You bought an automobile that cost
$10,000 two years ago. The $10,000 cost is
sunk because whether you drive it, park it, trade
it, or sell it, you cannot change the $10,000 cost.

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Quick Check
Suppose you are trying to decide whether to
drive or take the train to Portland to attend a
concert. You have ample cash to do either, but
you dont want to waste money needlessly. Is
the cost of the train ticket relevant in this
decision? In other words, should the cost of the
train ticket affect the decision of whether you
drive or take the train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not
relevant.

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Quick Check
Suppose you are trying to decide whether to
drive or take the train to Portland to attend a
concert. You have ample cash to do either, but
you dont want to waste money needlessly. Is
the annual cost of licensing your car relevant
in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.

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Quick Check
Suppose that your car could be sold now for
$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.

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Summary of the Types of Cost

Classifications
Financial
Reporting

Predicting
Cost
Behavior

Assigning
Costs to Cost
Objects

Decision
Making

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End of Chapter 2