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Chapter 2:

Cost Terminology and Cost


Behaviors
Cost Accounting:
Foundations and Evolutions, 9e
Kinney Raiborn

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Learning Objectives
Why are costs associated with a cost object?
What assumptions do accountants make about cost
behavior, and why are such assumptions necessary?
How are costs classified on financial statements, and why
are such classifications useful?
How does the conversion process occur in manufacturing
and service companies?
What are the product cost categories, and what items
comprise those categories?
How and why does overhead need to be allocated to
products?
How is cost of goods manufactured calculated and used in
preparing an income statement?
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Cost

Monetary measure of resources given up to attain an objective (such as


acquiring a good or delivering a service)
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Cost Categories

Association with cost object


Cost object is anything for which management
wants to collect or accumulate costs
Reaction to changes in activity
Classification on the financial statements

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Association with a Cost Object

Directtraceable to a cost object


Indirectnot conveniently or practically
traceable to a cost object
Treated as overhead
Allocated

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Reaction to Changes in Activity

Variable
Fixed

Mixed

Step

Relevant Rangenormal operating range

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Cost Reaction to Changes in Activity

Variable
Fixed Cost
cost

$
$

# of Units # of Units
Within the
relevant range
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Cost Reaction to Changes in Activity

Variable
Fixed Cost
cost
$ $
Total Total

# of Units # of Units

Unit $ Unit $
Within the
# of Units relevant range # of Units
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Total and Unit Cost Behavior
Total Cost Unit Cost

Varies in direct Remains constant


Variable
proportion to throughout the
Cost
changes in activity relevant range

Fixed Varies inversely


Remains constant
Cost with changes in
throughout
activity throughout
the relevant range
the relevant range

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Cost Reaction to Changes in Activity

Step Cost
Mixed Cost(fixed)

variable
$ $
fixed
# of Units # of Units

Within the
relevant range
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Determining Cost Behavior
Cost Predictor Cost Driver
Activity accompanied Activity that has a
by consistent, direct cause-effect
observable changes in relationship on cost
a cost item
Predicts but may not Directly causes the
cause the cost to cost to change
change

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Classification on the Financial
Statements
Unexpiredbalance sheet assets
Expiredincome statement expenses
Productinventoriable costs
Primedirect material and direct labor
Conversiondirect labor and overhead
Product costs are unexpired before sale
Product costs are expired when sold
Periodexpensed in period incurred

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Product Costs

Product costs
Direct materialMeasurable part of a product
Direct laborLabor used to manufacture a
product or perform a service
OverheadIndirect production cost
First appear on the balance sheet in
inventory accounts
Transferred to the income statement when
product is sold
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Period Costs

Period costs
Selling and administrative costs
Distribution costs
Cost to warehouse, transport, and/or deliver a product or
service
Major impact on managerial decision making
Appear on the income statement when
incurred
Expensed when incurred

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The Conversion Process

Change inputs into outputs

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The Conversion Process
Input Output
Purchase Product or
raw materials Service
or supplies

CONVERSION

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Degrees of Conversion
Low Moderate High
Moderate
Low High
Department stores Manufacturing
Gas stations Construction
Jewelry stores Agriculture
Travel agencies Architecture
Moderate
Auditing
Mining
Florists
Printing
Meat markets
Restaurants
Oil-change businesses

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Service Company
Input
Purchase
supplies
Significant amount of labor
Tangible or intangible output

Use supplies,
labor, overhead Output
to provide service
Sell to
customer

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Retail Company

Input
Output
Purchase
Warehouse
products
and/or display
for resale

Purchase finished goods Sell to


Resell to customers customer

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Manufacturer
Significant amount of labor and machinery

Input
Tangible output Output
Purchase Finished
raw materials product
and supplies
Production
Center Sell to
add labor and
overhead
customer

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Cost Accumulation in a
Manufacturing Company
Materials
Inventory

Work in Process
Inventory
Finished Goods Cost of
Inventory Goods Sold
Income
Balance Sheet Statement
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Product CostDirect

Direct Material
Conveniently and economically traced
to cost object
Direct Labor
To manufacture a product or perform a service
Includes wages paid to direct labor employees,
production bonuses, payroll taxes
May include holiday and vacation pay, insurance,
retirement benefits

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Product CostIndirect

Overheadindirect production costs


Fringe benefits, if cannot be easily traced to
product
Overtime, if due to random scheduling
Cost of quality
Prevention costs
Appraisal costs
Failure costs

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Product Cost Behavior

Direct Material Variable

Direct Labor Variable

Overhead Variable, fixed, or mixed

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Overhead Cost Allocation
Assign indirect costs to one or more
cost objects
To determine full absorption cost (GAAP)
To motivate management
To compare alternative courses of action for
planning, controlling, and decision making
Allocation process should be
rational and systematic

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Allocating Overhead
Actual Cost System
Product Cost Cost Used

Direct Materials Actual

Direct Labor Actual

Overhead Actual

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Allocating Overhead:
Actual Cost System
The Actual Cost System is not timely
All costs must be known before calculating
product cost

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Allocating Overhead:
Actual vs. Normal
Product Cost Actual Cost Normal Cost
System System
Direct Materials Actual Actual

Direct Labor Actual Actual

Overhead Actual Predetermined


Overhead Rate

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Predetermined Overhead Rate
Allows overhead to be assigned during the
period
Compensates for fluctuations
that are not related to activity level
in activity level that do not affect fixed overhead

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Flow of Product Costs
Raw Materials Inventory XXX
Accounts Payable XXX

Work in Process Inventory XXX


Raw Materials Inventory XXX

Work in Process Inventory XXX


Variable Overhead Control XXX
Fixed Overhead Control XXX
Salaries/Wages Payable XXX

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Flow of Product Costs

Variable Overhead Control XXX


Fixed Overhead Control XXX
Utilities Payable XXX
Supplies Inventory XXX
Accumulated DepreciationEquipment XXX

Other accounts XXX

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Flow of Product Costs

Work in Process Inventory XXX


Variable Overhead Control XXX
Fixed Overhead Control XXX

Finished Goods Inventory XXX


Work in Process Inventory XXX

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Flow of Product Costs
Accounts Receivable XXX Matches
Sales XXX revenues
and
Cost of Goods Sold XXX expenses
Finished Goods Inventory XXX on the
income
statement

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Statement of Cost of Goods
ManufacturedRaw Materials
Used
Beginning balance $ 73,000
Purchases of materials 280,000
Raw materials available $353,000
Ending balance <69,000>
Total raw materials used $284,000

To Statement of Cost of Goods Manufactured

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Statement of Cost of Goods
Manufactured
Beginning work in process $145,000
Raw materials used $284,000
Direct labor 436,000
Variable overhead 115,200
Fixed overhead 98,880
Current period manufacturing costs
934,080
Total costs to account for $1,079,080
Ending work in process <20,880> Cost
of goods manufactured $1,058,200
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Schedule of Cost of Goods Sold
Beginning Finished Goods $ 87,400
Cost of Goods Manufactured 1,058,200
Cost of Goods Available for Sale $1,145,600
Ending Finished Goods <91,600>
Cost of Goods Sold $1,054,000

From Schedule of Cost of Goods Manufactured

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Income Statement
Revenue XXXX
Cost of Goods Sold <1,054,000>
Gross Profit XXXX
Operating Expenses <XXXX>
Operating Income XXXX

From Schedule of Cost of Goods Sold

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Questions

What is the difference between a fixed and


variable cost?
What are the three components of product
cost?
What are the three inventory accounts for a
manufacturing company?

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Ethical Issues

Expired costsnot on the balance sheet


Period costsnot inventory
Product costsnot selling or administrative
costs
Direct labornot overstated
Ending inventorynot overstated

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