Indian Institute of Management Rohtak

Management Accounting

Session 2
Cost Terms & Purposes
By
Prof Archana Patro
What Do We Mean By a Cost?

A cost
is the measure of
resources given
up to achieve a
particular purpose.
 Cost Terminology

• Actual cost – a cost that has occurred

• Budgeted cost – a predicted cost
• Cost object – anything of interest for
which a cost is desired
Ex :Products, services, activities, processes
and customers
Cost Object Examples at BMW
Cost Object Illustration
Product BMW X 5 sports activity vehicle
Service Dealer-support telephone hotline
R&D project on DVD system
Project
enhancement
Herb Chambers Motors, a dealer that
Customer purchases a broad range of BMW
vehicles
Activity Setting up production machines
Department Environmental, Health & Safety
 Direct and Indirect Costs
• Direct costs – can be conveniently and economically
traced (tracked) to a cost object
Ex-cost of a steel or tire
• 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
– Electricity
– Rent
– Property taxes
BMW: Assigning Costs to a Cost Object
Direct and Indirect Costs
 Factors Affecting Direct / Indirect Cost
Classification
• Cost Materiality

• Availability of information-gathering technology

• Operational Design

• The direct/indirect classification depends on the choice of

the cost object
Exercise 1
Cost Classifications for Predicting Cost
Behavior
How a cost will react to changes in the level of
activity within the relevant range.
• Total variable costs change when activity
changes.
• Total fixed costs remain unchanged when
activity changes.
 Cost Terminology
Variable Costs
- Change in proportion to changes in volume
or activity
 Cost Terminology
Fixed Costs
- Do not change in response to changes in
volume or activity
 Cost Behavior
• Costs are fixed or variable only with respect to a
specific activity or a given time period
• Variable costs – are constant on a per-unit basis.
If a product takes 5 pounds of materials each, it
stays the same per unit regardless of one, ten or a
thousand units are produced
• Fixed costs – change inversely with the level of
production. As more units are produced, the
same fixed cost is spread over more and more
units, reducing the cost per unit
Cost Classifications
EXERCISE 2
 Cost Driver
• Cost Driver – a variable that causally affects
costs over a given time span
• There is a cause and effect relationship
between the change in level of activity or
volume with the change in level of total cost
• Ex-If product design cost change with the
number of parts in a product, the number of
parts is a cost driver
EXERCISE 3
 Manufacturing Costs

Direct Direct Manufacturing

Material Labor Overhead

The
Product
 Direct Material

Cost of raw material that is used to

make, and can be conveniently
traced, to the finished product.
Example:
Steel used to
manufacture
the automobile.
 Direct Labor

Cost of salaries, wages, and fringe

benefits for personnel who work
directly on manufactured products.

Example:
Wages paid to an
automobile assembly
worker.
 Manufacturing Overhead
All other manufacturing costs

Indirect Indirect Other

Material Labor Costs

Materials used to support the

production process. Examples:
lubricants and cleaning supplies
used in an automobile assembly
plant.
 Manufacturing Overhead
All other manufacturing costs

Indirect Indirect Other

Material Labor Costs

Cost of personnel who do

not work directly on the
product.
Examples: maintenance
workers, janitors and
security guards.
 Manufacturing Overhead
All other manufacturing costs

Indirect Indirect Other

Material Labor Costs

Examples: depreciation on
plant and equipment,
property taxes, insurance,
utilities, overtime premium,
and unavoidable idle time.
 Classifications of Costs in
Manufacturing Companies
Manufacturing costs are often combined as follows:

Direct Direct Manufacturing

Material Labor Overhead

Prime Conversion
Cost Cost
 Manufacturing Cost Flows
Direct Material

Work in
Direct Labor
Process Inventory

Manufacturing
Overhead
 Manufacturing Cost Flows
Direct Material

Work in
Direct Labor
Process Inventory

Finished
Manufacturing Goods Inventory
Overhead
 Manufacturing Cost Flows
Direct Material
Work in
Direct Labor Process
Inventory
Manufacturing
Overhead
Finished Cost of
Goods Goods
Inventory Sold
 Product Costs Versus Period Costs
Product costs include direct Period costs include all selling
materials, direct labor, and costs and administrative
manufacturing overhead. costs.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
 Quick Check 
Which of the following costs would be
considered a period rather than a product cost
in a manufacturing company?
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.
 Quick Check 
Which of the following costs would be
considered a period rather than a product cost
in a manufacturing company?
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.
EXERCISE 4
Schedule of Cost of Goods
Manufactured

Calculates the cost of raw material,

direct labor, and manufacturing
overhead used in production.

Calculates the manufacturing costs

associated with goods that were
finished during the period.
 Schedule of Cost of Goods
Manufactured

Comet Computer Corporation

Schedule of Cost of Goods Manufactured
Raw material used $ 134,980
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs $ 414,980
Add: Work-in-process inventory, January 1 120
Subtotal $ 415,100
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured $ 415,000
 Schedule of Cost of Goods
Computation of Cost of Raw Material Used
Manufactured
Raw-material inventory, January 1 $ 6,000
Add: Purchases of raw materials 134,000
Raw material available for use 140,000
Deduct: Raw material inventory, December 31 5,020
Raw material used $ 134,980
Comet Computer Corporation
Schedule of Cost of Goods Manufactured
Raw material used $ 134,980
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs $ 414,980
Add: Work-in-process inventory, January 1 120
Subtotal $ 415,100
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured $ 415,000
 Schedule of Cost of Goods
Manufactured
Include all direct labor costs
incurred during the current
period.Corporation
Comet Computer
Schedule of Cost of Goods Manufactured
Raw material used $ 134,980
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs $ 414,980
Add: Work-in-process inventory, January 1 120
Subtotal $ 415,100
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured $ 415,000
 Computation of Total Manufacturing Overhead
Indirect material $ 10,000
Indirect labor 40,000
Depreciation on factory 90,000
Depreciation on equipment 70,000
Comet Computer Corporation
Utilities 15,000
Insuranceof Cost of Goods Manufactured
Schedule 5,000
Total manufacturing overhead $ 230,000
Raw material used $ 134,980
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs $ 414,980
Add: Work-in-process inventory, January 1 120
Subtotal $ 415,100
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured $ 415,000
 Schedule of Cost of Goods
Manufactured
Beginning work-in-process
inventory is carried over
from the prior period.
Comet Computer Corporation
Schedule of Cost of Goods Manufactured

Raw material used $ 134,980

Direct labor 50,000
Total manufacturing overhead 230,000
Ending work-in-process
Total manufacturing inventory
costs $ 414,980
contains the cost of unfinished
Add: Work-in-process inventory, January 1 120
goods, and is reported in the
Subtotal $ 415,100
current
Deduct:assets section of the
Work-in-process inventory, December 31 100
balance sheet.manufactured
Cost of goods $ 415,000
Income Statement for a Manufacturer

Comet Computer Corporation

Income Statement
For the Year Ended December 31, 20X2
Sales revenue $ 700,000
Less: Cost of goods sold 415,010
Gross margin $ 284,990
Selling and administrative expenses 174,490
Income before taxes $ 110,500
Income tax expense 30,000
Net income $ 80,500
 Comet Computer Corporation
Schedule of Cost of Goods Sold
For the Year Ended December 31, 20X2
Finished-goods inventory, Jan. 1 $ 200
Add: Cost of goods manufactured 415,000
Cost of goods available for sale 415,200
Comet Computer Corporation
Deduct Finished-goods inventory, Dec. 31 190
Income Statement
Cost of goods sold $ 415,010
For the Year Ended December 31, 20X2
Sales revenue $ 700,000
Less: Cost of goods sold 415,010
Gross margin $ 284,990
Selling and administrative expenses 174,490
Income before taxes $ 110,500
Income tax expense 30,000
Net income $ 80,500
 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
 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 $28,000 of raw material was still
present. What is the cost of direct
Beg. raw material$used?
materials 32,000
+ Raw materials
A. $276,000 purchased 276,000
B. $272,000 = Raw materials available
for use in production $ 308,000
C. $280,000 – Ending raw materials
inventory 28,000
D. $ 2,000 = Raw materials used
in production $ 280,000
 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.
 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 Direct Materials $ 280,000
C. $655,000 + Direct Labor 375,000
+ Mfg. Overhead 180,000
D. Cannot be=determined.
Mfg. Costs Incurred
for the Month $ 835,000
 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.
 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 Beginning work in
B. $ 910,000 process inventory $ 125,000
+ Mfg. costs incurred
C. $ 760,000 for the period 835,000
D. Cannot be determined.
= Total work in process
during the period $ 960,000
– Ending work in
process inventory 200,000
= Cost of goods
manufactured $ 760,000
 Quick Check 
Beginning finished goods inventory was
$130,000. The cost of goods manufactured for
the month was $760,000. And 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.
 Quick Check 
Beginning finished goods inventory was
$130,000. The cost of goods manufactured for
the month was $760,000. And the ending
finished goods inventory was $150,000. What
was the cost of goods sold for the month?
A. $ 20,000.
B. $740,000. $130,000 + $760,000 = $890,000
C. $780,000. $890,000 - $150,000 = $740,000
D. $760,000.
EXERCISE 5
 Opportunity Cost

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
$20,000 per year.
Your opportunity cost
of attending college for one year is $20,000.
 Sunk Costs
All costs incurred in the past that cannot be
changed by any decision made now or in the
future are sunk costs. Sunk costs should not be
considered in decisions.
– Example: You bought an automobile that cost
$12,000 two years ago. The $12,000 cost is
sunk because whether you drive it, park it,
trade it, or sell it, you cannot change the
$12,000 cost.
 Differential Costs
Costs that differ between alternatives.

Example: You can earn $1,500 per month in your

hometown or $2,000 per month in a nearby city.
Your commuting costs are $50 per month in your
hometown and $300 per month to the city.

What is your differential cost?

$300 - $50 = $250
Marginal Costs and Average Costs

The total cost to

The extra cost
produce a quantity
incurred to produce
divided by the
one additional unit.
quantity produced.

Marginal and average costs are

largely a function of cost behavior
-- variable and fixed costs.
 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 don’t 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.
 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 don’t 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.
 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 don’t 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.
 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 don’t 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.
 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.
 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.