WEEK 3-4 ignored)

- Opportunity cost
Managerial Accounting and Cost Concepts (forgone benefits)
Other Cost Classification
Lesson Proper: Manufacturing costs - Prime cost (Direct
Exhibit 1-1 summarizes the cost classifications materials + Direct
that will be defined in this module as well as on Labor)
the next modules (5 and 6), namely cost
classifications (1) for assigning costs to cost - Conversion cost
objects, (2) for manufacturing companies, 3) (Direct Labor +
for preparing financial statements, (4) for Manufacturing
predicting cost behavior, and (5) for making Overhead)
decisions.

Exhibit 1-1 Summary of Cost COST CLASSIFICATIONS FOR ASSIGNING

Classifications COSTS TO COST OBJECTS
Purpose of Cost
Cost Classification Costs are assigned to cost objects for a variety
Classification
Assigning costs to -Direct cost (can be of purposes including pricing, preparing
costs objects easily traced) profitability studies, and controlling spending. A
-Indirect cost (cannot cost object is anything for which cost data are
be easily traced) desired-including products, customers, jobs,
Accounting for costs Manufacturing costs and organizational subunits. For purposes of
for manufacturing -Direct Materials (DM) assigning costs to .cost objects, costs are
companies -Direct Labor (DL) classified as either direct or indirect.
-Manufacturing Direct Cost
Overhead
A direct cost is a cost that can be easily
Non-manufacturing and conveniently traced to a specified cost
costs object. For example, if Reebok is assigning
-Selling costs costs to its various regional and national sales
-Administrative costs offices, then the salary of the sales manager in
Preparing financial -Product costs its Tokyo office would be a direct cost of that
statements (Inventoriable) office. If a printing company made 10,000
Formula: brochures for a specific customer, then the
Direct Materials + cost of the paper used to make the brochures
Direct Labor + would be a direct cost of that customer.
Manufacturing Indirect Cost

-Period costs An indirect cost is a cost that cannot be

(expensed) easily and conveniently traced to a specified
Formula: cost object. For example, a Campbell Soup
Selling Expenses + factory may produce dozens of varieties of
Manufacturing canned soups. The factory manager’s salary
Overhead would be an indirect cost of a particular variety
Predicting cost - Variable cost such as chicken noodle soup. The reason is
behavior in response (varies/changes) that the factory manager’s salary is incurred as
to changes in activity - Fixed cost (constant a consequence of running the entire factory-it
- Mixed costs (has is not incurred to produce any one soup
variable and fixed variety. To be traced to a cost object such as a
elements) particular product, the cost must be caused by
Making decisions - Differential cost the cost object. The factory manager’s salary is
(differs between called a common cost of producing the various
alternatives) products of the factory. A common cost is a
- Sunk cost (should be cost that is incurred to support a number of
cost objects but cannot be traced to them
individually. A common cost is a type of
indirect cost.
A particular cost may be direct or indirect,
depending on the cost object. While the
Campbell Soup factory manager’s salary is an
indirect cost of manufacturing chicken noodle
soup, it is a direct cost of the manufacturing
division. In the first case, the cost object is
chicken noodle soup. In the second case, the
cost object is the entire manufacturing division.
COST CLASSIFICATIONS FOR
MANUFACTURING COMPANIES
Manufacturing companies such as Texas
Instruments, Ford, and DuPont separate their
costs into two broad categories-manufacturing
and nonmanufacturing costs.
Manufacturing Costs
Most manufacturing companies further
separate their manufacturing costs into two
direct cost categories, direct materials and
direct labor, and one indirect cost category,
manufacturing overhead. A discussion of each
of these categories follows.
Direct Materials. The materials that go into
the final product are called raw materials. This
term is somewhat misleading because it
seems to imply unprocessed natural resources
like wood pulp or iron ore. Actually, raw
materials refer to any materials that are used in
the final product; and the finished product of
one company can become the raw materials of
another company. For example, the plastics
produced by Du Pont are a raw material used
by Hewlett-Packard in its personal computers.
Raw materials may include both direct and
indirect materials. Direct materials are those
materials that become an integral part of the
finished product and whose costs can be
conveniently traced to the finished product.
This would include, for example, the seats that
Airbus purchases from subcontractors to install
in its commercial aircraft and the electronic
components that Apple uses in its iPhones.
Sometimes it isn’t worth the effort to trace the
costs of relatively insignificant materials to end
products. Such minor items would include the
solder used to make electrical connections in a
Sony HDTV or the glue used to assemble an
Ethan Allen chair. Materials such as solder and
glue are called indirect materials and are
included as part of manufacturing overhead,
which is discussed shortly.
Direct Labor. Direct labor consists of
labor costs that can be easily (i.e., physically
and conveniently) traced to individual units of
product. Direct labor is sometimes called touch
labor because direct labor workers typically
touch the product while it is being made.
Examples of direct labor include assembly-line
workers at Toyota, carpenters at the home
builder KB Home, and electricians who install
equipment on aircraft at Bombardier Learjet.
Labor costs that cannot be physically traced to
particular products, or that can be traced only
at great cost and inconvenience, are termed
indirect labor. Just like indirect materials,
indirect labor is treated as part of
manufacturing overhead. Indirect labor
includes the labor costs of janitors,
supervisors, materials handlers; and night
security guards. Although the efforts of these
workers are essential, it would be either
impractical or impossible to accurately trace
their costs to specific units of product. Hence,
such labor costs are treated as indirect labor.
Manufacturing Overhead.
Manufacturing overhead, the third
manufacturing cost category, includes all
manufacturing costs except direct materials
and direct labor. Manufacturing overhead
includes items such as indirect materials;
indirect labor; maintenance and repairs on
production equipment; and heat and light,
property taxes, depreciation, and insurance on
manufacturing facilities. A company also incurs
costs for heat and light, property taxes,
insurance, depreciation, and so forth,
associated with its selling and administrative
functions, but these costs are not included as
part of manufacturing overhead. Only those
costs associated with operating the factory are
included in manufacturing overhead.
Various names are used for manufacturing
overhead, such as indirect manufacturing cost,
factory overhead, and factory burden. All of
these terms are synonyms for manufacturing
overhead.
Nonmanufacturing Costs company pays for liability insurance in advance
for two years, the entire amount is not
Nonmanufacturing costs are often divided into
considered an expense of the year in which the
two categories: (1) selling costs and (2)
payment is made. Instead, one-half of the cost
administrative costs.
would be recognized as an expense each year.
Selling costs include all costs that are The reason is that both years-not just the first
incurred to secure customer orders and get the year-benefit from the insurance payment. The
finished product to the customer. These costs unexpensed portion of the insurance payment
are sometimes called order-getting and order- is carried on the balance sheet as an asset
filling costs. Examples of selling costs include called prepaid insurance.
advertising, shipping, sales travel, sales
The matching principle is based on the accrual
commissions, sales salaries, and costs of
concept that costs incurred to generate a
finished goods warehouses. Selling costs can
particular revenue should be recognized as
be either direct or indirect costs. For example,
expenses in the same period that the revenue
the cost of an advertising campaign dedicated
is recognized. This means that if a ‘cost is
to one specific product is a direct cost of that
incurred to acquire or make something that will
product, whereas the salary of a marketing
eventually be sold, then the cost should be
manager who oversees numerous products is
recognized as an expense only when the sale
an indirect cost with respect to individual
takes place-that is, when the benefit occurs.
products.
Such costs are called product costs.
Administrative costs include all costs
 
associated with the general management of an
organization rather than with manufacturing or Product Costs
selling. Examples of administrative costs
For financial accounting purposes, product
include executive compensation, general
costs include all costs involved in acquiring or
accounting, secretarial, public relations, and
making a product. In the case of manufactured
similar costs involved in the overall, general
goods, these costs consist of direct materials,
administration of the organization as a whole.
direct labor, and manufacturing overhead.
Administrative costs can be either direct or
Product costs “attach” to units of product as
indirect costs. For example, the salary of an
the goods are purchased or manufactured, and
accounting manager in charge of accounts
they remain attached as the goods go into
receivable collections in the East region is a
inventory awaiting sale. Product costs are
direct cost of that region, whereas the salary of
initially assigned to an inventory account on
a chief financial officer who oversees all of a
the balance sheet. When the goods are sold,
company’s regions is an indirect cost with
the costs are released from inventory as
respect to individual regions.
expenses (typically called cost of goods sold)
Nonmanufacturing costs are also often called and matched against sales revenue on the
selling, general, and administrative (SG&A) income statement. Because product costs are
costs or just selling and administrative costs. initially assigned to inventories, they are also
known as inventoriable costs.
We want to emphasize that product costs are
COST CLASSIFICATIONS FOR PREPARING
not necessarily recorded as expenses on the
FINANCIAL STATEMENTS
income statement in the period in which they
When preparing a balance sheet and an are incurred. Rather, as explained above, they
income statement, companies need to classify are recorded as expenses in the period in
their costs as product costs or period costs. To which the related products are sold.
understand the difference between product
costs and period costs, we must first discuss
the matching principle from financial
accounting.
Period Costs
Generally, costs are recognized as expenses
Period costs are all the costs that are not
on the income statement in the period that
product costs. All selling and administrative
benefits from the cost. For example if a
expenses are treated as period costs. For These costs and expenses can be categorized
example, sales commissions, advertising, in a number of ways including product costs,
executive salaries, public relations, and the period costs, conversion costs, and prime
rental costs of administrative offices are all costs.
period costs. Period costs are not included as
part of the cost of either purchased or
manufactured goods; instead, period costs are Product cost Direct Materials +
expensed on the income statement in the Direct Labor +
period in which they are incurred using the Manufacturing
usual rules of accrual accounting. Keep in Overhead
mind that the period in which a cost is incurred
is not necessarily the period in which cash = $69,000 + $35,000
changes hands. For example, as discussed + $14,000
earlier, the costs of liability insurance are
spread across the periods that benefit from the = $118,000
insurance-regardless of the period in which the
insurance premium is paid.
Period Cost Selling Expenses +
Two more cost categories are often used in Administrative
discussions of manufacturing costs- prime cost Expenses
and conversion cost.
Prime Cost and Conversion Cost = $29,000 + $50,000

Prime cost is the sum of direct = $79,000

materials cost and direct labor
cost. Conversion cost is the sum of direct
labor cost and manufacturing overhead cost. Conversion Cost Direct Labor +
The term conversion cost is used to describe Manufacturing
direct labor and manufacturing overhead Overhead
because these costs are incurred to convert
materials into the finished product. = $35,000 + $50,000
To improve your understanding of these
definitions, consider the following scenario: A = $49,000
company has reported the following costs and
expenses for the most recent month:
Prime Cost Direct Material +
Direct Labor
Direct Materials $ 69,000
= $69,000 + $35,00

Direct Labor $ 35,000 = $104,000

Manufacturing
$ 14,000
Overhead COST CLASSIFICATIONS FOR
PREDICTING COST BEHAVIOR

Selling Expenses $ 29,000 It is often necessary to predict how a certain

cost will behave in response to a change in
activity. For example, a manager at Under
Armour may want to estimate the impact a 5
Administrative
$ 50,000 percent increase in sales would have on the
Expenses
company’s total direct materials cost.
Cost behavior refers to how a cost
reacts to changes in the level of activity. As the
activity level rises and falls, a particular cost
may rise and fall as well-or it may remain
constant. For planning purposes, a manager
must be able to anticipate which of these will
happen; and if a cost can be expected to
change, the manager must be able to estimate
how much it will change. To help make such
distinctions, costs are often categorized as
variable, fixed, or mixed. The relative
proportion of each type of cost in an
organization is known as its cost structure.
For example, an organization might have many
fixed costs but few variable or mixed costs.
Alternatively, it might have many variable costs
but few fixed or mixed costs.
Cost behavior of Variable
Constant on a per unit basis
Change on a per total basis
Cost behavior of Fixed Cost
Constant on a per total basis
Changes on a per unit basis
Cost behavior of Mixed Cost
Contains both fixed and variables elements
It is also known a semi variable costs
Variable Cost
A variable cost varies in total, in direct
proportion to changes in the level of
activity. Common examples of variable costs
include cost of goods sold for a merchandising
company, direct materials, direct labor,
variable elements of manufacturing overhead,
such as indirect materials, supplies, and
power, and variable elements of selling and
administrative expenses, such as commissions
and shipping costs.
For a cost to be variable, it must be variable
with respect to something. That “something” is
its activity base. An activity base is a measure
of whatever causes the occurrence of a
variable cost. An activity base is sometimes
referred to as a cost driver: Some of the most
common activity bases are direct labor-hours,
machine-hours, units produced, and Units sold.
Other examples of activity bases (cost drivers)
include the number of miles driven by
salespersons, the number of pounds of laundry
cleaned by a hotel, the number of calls
handled by technical support staff at a software
company, and the number of beds occupied in
a hospital. While there are many activity bases
within organizations, throughout this textbook,
unless stated otherwise, you should assume
that the activity base under consideration is the
total volume of goods and services provided by
the organization. We will specify the activity
base only when it is something other than total
output.
To provide an example of a variable cost,
consider Nooksack Expeditions, a small
company that provides daylong whitewater
rafting excursions on rivers in the North
Cascade Mountains. The company provides all
of the necessary equipment and experienced
guides, and it serves gourmet meals to its
guests. The meals are purchased from a
caterer for $30 a person for a daylong
excursion. The behavior of this variable cost,
on both a per unit and a total basis, is shown
below:
Cost of
Total Cost of
Number of Meals per
Meals (per
Guests Guest (per
total)
unit)
250 $30 $7,500
500 $30 $15,000
750 $30 $22,500
1,000 $30 $30,000
While total variable costs change as the
activity level changes, it is important to note
that a variable cost is constant if expressed on
a per unit basis. For example, the per unit cost
of the meals remains constant at $30 even
though the total cost of the meals increases
and decreases with activity. The graph on the
left-hand side of Exhibit 1--2 illustrates that the
total variable cost rises and falls as the activity
level rises and falls. At an activity level of 250
guests, the total meal cost
is 7,500.Atanactivitylevelof1,000guests,thetotal
mealcostrisesto30,000.
Exhibit 1-2 Variable and Fixed Cost Behavior
Fixed Cost
A fixed cost is a cost that remains
constant, in total, regardless of changes in the
level of activity. Examples of fixed costs
include straight-line depreciation, insurance,
property taxes, rent, supervisory salaries,
administrative salaries, and advertising. Unlike
variable costs, fixed costs are not affected by
changes in activity. Consequently, as the
activity level rises and falls, total fixed costs
remain constant unless influenced by some
outside force, such as a landlord increasing
your monthly rental expense. To continue the
Nooksack Expeditions example, assume the
company rents a building for $500 per month '
to store its equipment. The total amount of rent
paid is the same regardless of the number of
guests the company takes on its expeditions
during any given month. The concept of a fixed
cost is Shown graphically on the right-hand
side of Exhibit 1-2.
Because total fixed costs remain constant for
large variations in the level of activity, the
average fixed cost per unit becomes
progressively smaller as the level of activity
increases. lf Nooksack Expeditions has only
250 guests in a month,
the 500fixedrentalcostwouldamounttoanaverag
eof2 per guest. If there are 1,000 guests, the
fixed rental cost would average only 50 cents
per guest. The table below illustrates this
aspect of the behavior of fixed costs Note that
as the number of guests increase, the average
fixed cost per guest drops.
Average
Monthly
Number of Cost per
Rental Cost
Guests Guest (per
(per total)
unit)
$500 250 $2.00
$500 500 $1.00
$500 750 $0.67
$500 1,000 $0.50
As a general rule, we caution against
expressing fixed costs on an average per wait
basis in internal reports because it creates the
false impression that fixed costs are like
variable costs and that total fixed costs actually
change as the level of activity changes.
For planning purposes, fixed costs can be
viewed as either committed or discretionary. 
Committed fixed costs represent
organizational investments with a multiyear
planning horizon that can’t be significantly
reduced even for short periods of time without
making fundamental changes. Examples
include investments in facilities and equipment
as well as real estate taxes, insurance
expenses, and salaries of top management.
Even if operations are interrupted or cut back,
committed fixed costs remain largely
unchanged in the short term because the costs
of restoring them later are likely to be far
greater than any short-run savings that might
be realized. 
Discretionary fixed costs (often referred to
as managed fixed costs) usually arise from
annual decisions by management to spend on
certain fixed cost items, Examples of
discretionary fixed costs include advertising,
research, public relations, management
development programs, and internships for
students. Discretionary fixed costs can be cut
for short periods of time with minimal damage
to the long-run goals of the organization.
The Linearity Assumption and the Relevant
Exhibit 1-3 Fixed Cost and Relevant Range
Range
Management accountants ordinarily assume
that costs are strictly linear; that is, the relation
between cost on the one hand and activity on
the other can be represented by a straight line.
Economists point out that many costs are
actually curvilinear; that is, the relation
between cost and activity is a curve.
Nevertheless, even if a cost is not strictly
linear, it can be approximated within a narrow
band of activity known as the relevant range by
a straight line.
The relevant range is the gauge of activity
within which the assumption that cost behavior
This step-oriented cost behavior pattern can
is strictly linear is reasonably valid. Outside of
also be used to describe other costs, such as
the relevant range, a fixed cost may no longer
some labor costs. For example, salaried
be strictly fixed or a variable cost may not be
employee expenses can be characterized
strictly variable. Managers should always keep
using a step pattern. Salaried employees are
in mind that assumptions made about cost
paid a fixed amount, such
behavior may be invalid if activity falls outside
as 40,000peryear,forprovidingthecapacitytowor
of the relevant range.
kapre−specifiedamountoftime,suchas40hoursp
The concept of the relevant range is important erweekfor50weeksayear(=2,000hoursperyear).
in understanding fixed costs. For example, Inthisexample,thetotalsalariedemployeeexpens
suppose the Mayo Clinic rents a machine eis40,000 within a relevant range of 0 to 2,000
for 20,000permonththattestsbloodsamplesforth hours of work. The total salaried employee
epresenceofleukemiacells.Furthermore,suppos expense increases to $80,000 (or two
ethatthecapacityoftheleukemiadiagnosticmachi employees) if the organization’s work
neis3,000testspermonth.Theassumptionthatthe requirements expand to a relevant range of
rentforthediagnosticmachineis20,000 per 2,001 to 4,000 hours of work. Cost behavior
month is only valid within the relevant range of patterns such as salaried employees are often
0 to 3,000 tests per month. If the Mayo Clinic called step-variable costs. Step-variable costs
needed test 5,000 blood samples per month, can often be adjusted quickly as conditions
then it would need to rent another machine for change. Furthermore, the width of the steps for
an additional $20,000 per month. It would be step-variable costs is generally so narrow that
difficult to rent half of a diagnostic machine; these costs can be treated essentially as
therefore, the step pa" tern depicted in Exhibit variable costs for most purposes. The width of
1-3 is typical for such costs. This exhibit shows the steps 'for fixed costs, on the other hand, is
that the fix rental expense so wide that these costs should be treated as
is 20,000forarelevantrangeof0to3,000tests.The entirely fixed within the relevant range.
fixedrentalexpenseincreasesto40,000 within
Exhibit 1-4 summarizes four key concepts
the relevant range of 3,001 to 6,000 tests. The
related to variable and fixed costs. Study it
rental expense increases in discrete steps or
carefully before reading further.
increments of 3,000 tests, rather than
increasing in a lineal fashion per test. Exhibit 1-4 Summary of Variable and Fixed
Cost Behavior

Cost Behavior of the Cost (within the

relevant range)
 each rafting party the company organizes, the
In Total Per Unit total cost of the state fees will increase
by 3.Therefore,thetotalcostlineslopesupwardas
thevariablecostof3 per party is added to the
Variable Cost Total variable Variable costs fixed cost of $25,000 per year.
cost increases per unit
and decreases remains Because the mixed cost in Exhibit 1-5 is
in proportion to constant. represented by a straight line, the following
changes in the equation for a straight line can be used to
activity level. express the relationship between a mixed 005
and the level of activity:  

Fixed Cost Total fixed cost Fixed cost per

is not affected unit decreases Y = a + bX
by changes in as the activity
the activity level rises and Where:
level within the increase as
relevant range. the activity Y = total mixed cost
level fails. a = total fixed cost
b = variable cost per unit
X = level of activity
Mixed Costs
Because the variable cost per unit equals the
A mixed cost contains both variable and slope of the straight line, the steeper the slope,
fixed cost elements. Mixed costs are also the higher the variable cost per unit.
known as semi-variable costs. To continue the
Nooksack Expeditions example, the company In the case of the state fees paid by Nooksack
incurs a mixed cost called fees paid to the Expeditions, the equation is written as follows:
state. It includes a license fee Y = 25,000+3X
of 25,000peryearplus3 per rafting party paid to
the state’s Department of Natural Resources. If This equation makes it easy to calculate the
the Company runs 1,000 rafting parties this total mixed cost for any level of activity within
year, then the total fees paid to the state would the relevant range. For example, suppose that
be 28,000,madeupof25,000 in fixed cost plus the company expects to organize 800 rafting
$3,000 in variable cost. Exhibit 1-5 depicts the parties in the next year. The total state fees
behavior of this mixed cost. would be calculated as follows:
Y = 25,000+(3 per rafting party X 800 rafting
parties)
Exhibit 1-5 Mixed Cost Behavior
= $27,400
Example:
Professional Fee (constant) of a Doctor plus
the amount of the prescribed medicine to a
patient (variable)
Should pay the constant fee or medicine + the
service
Total School fees of a student (Miscellaneous
Fee (constant) plus total number of units
enrolled (variables)
Even if Nooksack fails to attract any
customers, the company will still have to pay
the license fee
of 25,000.ThisiswhythecostlineinExhibit1−5inte
rsectstheverticalcostaxisatthe25,000 point. For