Chapter 2: Cost Terminology and Cost Behaviors

COST - is a resource sacrificed or forgone to achieve a specific objective.

COST OBJECT - is anything for which a separate measurement of costs
is desired.
Ex.: product-Pepsi; service-telephone hotlines
COST DRIVERS - are any factors that affect cost. (Ex.: hours worked for
direct labor)

Cost Categories:
1. Association with cost object
 Cost object is anything for which management wants to collect or
accumulate costs
 Direct—traceable to a cost object
 Indirect—not conveniently or practically traceable to a cost object
o Treated as overhead
o Allocated

2. Reaction to changes in activity

 Variable
 Fixed
 Mixed
 Step
 3. Classification on the financial statements
 Unexpired—balance sheet assets
 Expired—income statement expenses
 Product—inventoriable costs
o Prime—direct material and direct labor
o Conversion—direct labor and overhead
 Product costs are unexpired before sale
 Product costs are expired when sold
 Period—expensed in period incurred

Cost Classifications for Predicting Cost Behavior

How a cost will react to changes in the level of business activity.
 Total variable costs change when activity changes.
 Total fixed costs remain unchanged when activity changes.

Semi-variable/mixed cost
 Cost with fixed and variable components.
 A base-level cost is always incurred regardless of the volume, as
well as an additional cost that is based only on volume.
 Ex: electricity cost with basic minimum charge plus a specified
cost per kilowatt hour
Total Fixed Cost
 Your monthly basic telephone bill probably does not change when
you make more local calls.
Fixed Cost Per Unit
 The average cost per local call decreases as more local calls are
made.
Total Variable Cost
 Your total long distance telephone bill is based on how many
minutes you talk.
Variable Cost Per Unit
 The cost per long distance minute talked is constant. For
example, 10 cents per minute.

Determining Cost Behavior

1. Cost Predictor
 Activity accompanied by consistent, observable changes in a cost
item
 Predicts but may not cause the cost to change
2. Cost Driver
 Activity that has a direct cause-effect relationship on cost
 Directly causes the cost to change
Product costs
 Direct material—Measurable part of a product
 Direct labor—Labor used to manufacture a product or perform a
service
 Overhead—Indirect production cost
 First appear on the balance sheet in inventory accounts
 Transferred to the income statement when product is sold

Period costs
 Selling and administrative costs
 Distribution costs
o Cost to warehouse, transport, and/or deliver a product or
service
o Major impact on managerial decision making
 Appear on the income statement when incurred
 Expensed when incurred
The Conversion Process
 Change inputs into outputs

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

Manufacturing Costs
1. Direct Materials
  Those materials that become an integral part of the product
and that can be conveniently traced directly to it.
2. Direct Labor
 Those labor costs that can be easily traced to individual units of
product.
3. Manufacturing Overhead
 Manufacturing costs that cannot be traced directly to specific
units produced.

Product Costs Versus Period Costs

 Product costs include direct materials, direct labor, and
manufacturing overhead.
 Period costs are not included in product costs. They are
expensed on the income statement.

Nonmanufacturing Costs
1. Marketing and selling costs . . .
 Costs necessary to get the order and deliver the product.
2. Administrative costs . . .
 All executive, organizational, and clerical costs.

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

2. Product Cost—Indirect
a. Overhead—indirect production costs
o Fringe benefits, if cannot be easily traced to product
o Overtime, if due to random scheduling
o Cost of quality
o Prevention costs-training programs, researching
customer needs, acquiring improved production
equipment
o Appraisal costs- to find mistakes (monitoring and
inspecting)
 o Failure costs – scrap & rework (internal); product
returncosts caused by quality problems, warranty costs,
and complaint department costs

Product Cost Behavior

Direct Material Variable
Direct Labor Variable
Overhead Variable, fixed, or mixed

Overhead Cost Allocation

o Assign indirect costs to one or more cost objects using some
reasonable allocation base or driver.
o To determine full absorption cost (GAAP)
o To motivate management
o To compare alternative courses of action for planning, controlling,
and decision making
o Allocation process should be rational and systematic
Allocating Overhead Actual Cost System

Product Cost Cost Used

Direct Materials Actual
Direct Labor Actual
Overhead Actual

o The Actual Cost System is not timely

o All costs must be known before calculating product cost

Sample Presentation of Income Statement under Manufacturing

Concern
Statement of Cost of Goods Manufactured—Raw 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

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

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

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

Standard Costs
o Predetermined costs for direct materials, direct labor, and factory
overhead.
 o They are established by using information accumulated from past
experience and data secured from research studies.
Controllable and Noncontrollable Costs
o A cost is considered to be a controllable cost at a particular level
of management if that level has power to authorize the cost.
o Ex: Entertainment expense by a sales manager.
Direct costs
o Costs that can be easily and conveniently traced to a unit of
product or other cost objective.
o Examples: direct material and direct labor
Indirect costs
o Costs cannot be easily and conveniently traced to a unit of
product or other cost object.
o Example: manufacturing overhead
Differential Costs and Revenues
o Costs and revenues that differ among alternatives.
Opportunity Costs
o The potential benefit that is given up when one alternative is
selected over another.
RELEVANT COST
o A future cost that changes across the alternatives.
Sunk Costs
 o Sunk costs is a cost for which an outlay has already been made
and it cannot be changed by any decision. They are not
differential costs and should be ignored when making decisions.
Common Cost
o Cost of facilities or services employed in two or more accounting
periods, operations, commodities, or services.
o Subject to allocation.
o Ex: Salary of the general counsel of the entire business,
depreciation cost of machines shared by several departments
Joint Cost
o Costs of materials, labor and overhead incurred in the
manufacture of two or more products at the same time.
o Indivisible costs and not specifically identifiable with any of the
products being simultaneously produced
o Subject to allocation
o Ex: cost of growing corn is a joint cost if after harvesting, the corn
is used in different ways such as a popcorn and a corn flour.
Capital Expenditure
o Expenditure intended to benefit more than one accounting period
and is recorded as an asset.
o Ex: Purchase of machinery
o Cost allocation to different periods
 o Depreciation – fixed tangible assets
o Amortization – intangible assets
o Depletion – wasting assets
Revenue Expenditure
o Expenditure that will benefit current period only and is recorded
as an expense
o Ex: Salary of the administrative staff of the company