Chapter 2

Basic Cost Terms

How much does it cost? The Merriam Webster Dictionary lists a number of different definitions for cost, many which are associated with specific situations. The answer depends on why you want to know and for what purpose the cost is needed. You may recall a number of costs from financial accounting such as historical cost, invoice cost, and acquisition cost. Because this texts initial focus begins with the production of products, our definition of cost will include several variations based on how a cost pertains to production. This chapter introduces you to some of the cost terms that will be used throughout the textbook. Dont take this chapter (and the next) lightly. Thoroughly understanding these costs will help you immensely throughout your study of managerial accounting.

Cost as a Financial Accounting Concept For financial reporting purposes, a cost can be an asset or an expense. Costs that are expected to produce future economic benefits are considered assets and are reported on the balance sheet. Costs that are not expected to produce future economic benefits are considered expenses and are reported on the income statement. A more practical definition may be more useful to you. Assets are unused resources, i.e., costs that are not used up. Expenses are resources (costs) that are used up. Many costs begin as assets and become expenses as they are used. Costs (expenses) are matched to the related revenues for which they helped to earn. Some costs are used so quickly that they become expenses when acquired. You will examine the timing of costs later in the chapter. Cost Terms Based on Behavior: Fixed and Variable Costs Because managers use cost information to make decisions, it is useful to know how costs behave so you can predict future behavior. Costs designated as variable and fixed are based on cost behavior, which is how the total costs react to changes in activity. Activity is most often the number of units produced and sold. As it pertains to variable and fixed costs at this point in the course, you can assume that the number of units produced is the same as units sold. When labeling a cost as variable or fixed, you must assume that the company is operating at its normal range of activity. In other words, sales and production are not extremely large or small compared to the companys normal sales and production. Variable Costs Total variable costs change in direct proportion to changes in activity. If more units are produced (i.e., activity increases), total variable costs increase. The variable cost per unit remains the same no matter how many units are produced and sold. Some examples include the cost of products, cost of hourly employee wages, cost of gasoline used to delivery pizzas, and the cost of straws used in a fast food restaurant. Fixed Costs If more units are produced (i.e., activity increases), fixed cost per unit declines. Total fixed costs remain the same no matter how many units are produced and sold. Some examples include the cost of rent, cost of property insurance, cost of depreciation on equipment, cost of supervisors salary, and cost of advertising.

Chapter 2 Basic Cost Terms

Notice that the variable and fixed cost labels describe what happens to the total cost. It may help to ask yourself this question if you get stumped: Question: What does more activity (sales) do to total costs? Answer: When activity varies, total variable costs vary. When activity varies, total fixed costs stay fixed (i.e., the same.) Controllable and Non-controllable Costs Controllable costs are those that can be influenced by the manager. That is, costs within a managers control can be modified by the manager. He or she is responsible for monitoring the cost and to some extent, can modify it by spending more or less money on it. A good example is the total lettuce cost for tacos at Taco Bell. The manager is responsible for insuring that employees use the correct amount of lettuce. A manager that wants to reduce the total lettuce cost might tell employees to put half as much letter on tacos, so that the total amount spent on lettuce is less than the budget allows. Non-controllable costs cannot be influenced by the manager. A manager of a department has no control over the salary of the vice president of the company. You would certainly not like to be evaluated on the profit of your department if costs over which you had no control appeared as expenses on a financial report. Only controllable costs should be used as performance criteria. Opportunity Costs An opportunity cost is an amount or benefit given up as a result of choosing a particular course of action. Suppose you are invited to a party on a night you are scheduled to work. If you work, you will get paid $80. If you choose to attend the party, you give up the right to earn the $80. Your opportunity cost is $80 if you choose to attend the party. Because opportunity costs are not amounts you actually pay, they are not costs in the traditional accounting sense. While they are never recorded in the accounting records, they are always given consideration in managerial accounting decision making.

Sunk Costs Sunk costs are amounts incurred in the past. They exist no matter what decision alternative you make and will be the same under either decision. Suppose you own a 2002 Corvette that cost you $42,000 when you bought it. You decide to trade it in and get a brand new Corvette which costs $48,000. The car dealer says your old Corvette is worth $28,000. If you keep your old car, its original cost is $42,000. If decide to go through with the trade, the original cost of your old car is $42,000. Because the cost of your old car occurred in the past, it will not change. Because the original cost remains at $42,000 regardless of which choice you make, it is considered a sunk cost. Sunk costs are generally ignored in decision making because the amount is already spent and will not impact the current decision at hand. Incremental Costs Incremental costs differ between decision alternatives. They are often called relevant costs because they have a connection to the decision that is being considered. Managers should always consider incremental costs in the decision making process.

Chapter 2 Basic Cost Terms

Costs Terms Based on Function: Product and Period Costs Because managers often need to know the function of a cost, they often classify costs as product or period costs. The distinction is based on the timing of when costs become an expense. Recall the matching concept from your financial accounting class. Product costs are matched with the related revenue, i.e., the sales revenue earned from selling the product. Costs that cannot be associated with a particular revenue amount are expensed as incurred and are referred to as period costs. Product Costs Product costs are inventoriable and are related to the production of goods. A product cost is reported as inventory on the balance sheet under assets. When the inventory is sold, is transferred to the income statement as cost of goods sold. However, it retains its original label as a product cost. In other words, product costs become an expense when the product is sold. Period Costs Period costs are not part of inventory and are not related to the production of goods. In fact, all costs that are not product costs are considered to be period costs. They are sometimes referred to as operating costs. You can find these costs on the balance sheet as supplies, prepaid items such as prepaid insurance or prepaid rent, or as long term assets such as equipment and buildings. Once they become used up, the cost is transferred to the income statement and reported as an operating expense. In other words, period costs become an expense in a period that is not related to the sale. The distinction of product and period costs is backed by Generally Accepted Accounting Principles (GAAP). GAAP requires companies with inventories to separate product costs from period costs on financial statements. While managerial accounting is not concerned with complying with GAAP, it is important to know how GAAP costs differ from those that are used for managerial decision making.

Why Are There So Many Cost Classifications?

There are different costs for different purposes. Decision making in managerial accounting is very broad and costs in a particular classification may be more useful than standard GAAP product and period costs. You will see and use all of these cost terms several times throughout the course. As flagged at the beginning of this chapter, spend enough time on this chapter so that you own the cost classification concepts. They will be back to haunt you if you take them lightly!