Lecture 3

Cost flows and cost

terminology

Product and Period Costs

Characteristi
c

Product costs

Period costs

What
Costs related to getting a
constitutes this product or service ready
cost?
to be sold (i.e. costs
incurred in the production
process)

Costs that are other

than product costs.
Related to marketing
and administration

Can they be
inventoried?

Yes. They are inventoried

until the products or
services are sold to the
customer. Called
inventoriable costs

No. They cant be

inventoried and
therefore they cant flow
through inventory
accounts

When are they

expensed?

Expensed when sold

Expensed in the same

period that they are
incurred. Called period
costs

Where do they
appear in the

Above the gross margin

line

Below the gross

margin line

Flow of Costs: Service organizations

Consultant salaries,
Travel cost to client
sites

Administrator
salaries, Travel cost
for marketing staff,
advertising cost

Product
costs

Income
Statement
Revenues cost of
providing services =
Gross margin

Period
costs
- Selling &
administration costs
= Profit before taxes

Flow of Costs: Merchandising organizations

Balance Sheet

Cost of
merchandise

Accounting
,
advertising
,
Sales staff

Inventory
account

Period
costs

Produc
t costs

Income
Statement
Revenues
cost of goods
sold = Gross
margin

- Selling &
administration
costs
= Profit before
taxes

Manufacturing Costs
Direct
Labor

Direct
Material

The
Product

Manufacturing
Overhead

Manufacturing Overhead
All other manufacturing costs
Indirec
t
Materi
al
Materials used to
support the
production process.
Examples: lubricants
and cleaning
supplies used in an
automobile
assembly plant.

Indirec
t
Labor
Cost of personnel
who do not work
directly on the
product. Examples:
maintenance
workers, janitors and
security guards.

Other
Costs

Examples:
depreciation on
plant and
equipment,
property taxes,
insurance,
utilities.

Manufacturing Cost Flows

Costs

Income
Statement
Expenses

Balance Sheet
Inventories

Material
Purchases

Raw Material

Direct Labor

Work in
Process

Manufacturin
g
Overhead
Selling and
Administrativ
e

Finished
Goods
Period Expenses

Product
costs

Cost of
Goods
Sold
Selling and
Administrativ
e

Classifications of Costs in
Manufacturing Companies
Manufacturing costs are often
combined as follows:
Direct
Material

Direct
Labor

Prime
Cost

Manufacturing
Overhead

Conversion
Cost

Mechanics of Cost
Allocations
Each allocation has four elements

Cost Pool
Cost objects
Cost Driver
Allocation Volume

Each allocation has two steps

Calculate rate
Rate = Cost in pool Denominator volume

Allocate cost to cost object

Allocated amount = # of driver units in object rate

Cost allocation: example

Stan and James are married to Amy and Gail. The two
families plan a trip for Spring break from Dallas to
San Antonio (320 miles each way). They agree to
share the costs between the two families. The rental
and gas cost comes to $400. At the last minute,
Mark, Gails brother also decides to join the trip.
While on their way back from San Antonio, James,
Gail and Mark get down in Austin (100 miles from
San Antonio) to spend a couple of days in Austin with
family. Mark drops James and Gail back in Dallas.
How should the rental and gas cost to be shared by
the two families?
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Cost allocation: Example

Method 1: Number of families as the cost allocation driver.
Cost per family = $ 400 / 2 = $200 per family

Method 2: Number of persons as the cost allocation driver.

Cost per person = $ 400 / 5 = $80 per person
Allocated Cost to Stans family = 2 X $80 = $160
Allocated Cost to James family = 3 X $80 = $240

Method 3: Number of passenger miles as the cost allocation

driver. Total # of passenger miles travelled = (320 X 5) +
{(320 X 2)+(100 X 3) = 2,540
Cost per passenger mile = $400/2,540 = $0.1575
Cost allocated to Stans family =(640X2) X 0.1575 = $201.58
Cost allocated to Jamess family = (420X3) X 0.1575 =
$198.42
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Beware of cost allocations

Uses of allocations
Inventory valuation, decisions, behavioral

Allocation basis versus cost driver

GAAP needs allocations
Decisions need assignment
These two are not necessarily the same

Allocations make it appear as if the allocated cost

is variable in the number of driver units
Cost may be fixed in the short run
Using allocated cost for decision making can lead
to errors
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