11th Edition

Chapter 2

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 Costs Terms, Concepts and
Classifications

Chapter Two

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 Manufacturing Costs

Direct Direct Manufacturing

Materials Labor Overhead

The Product

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 Direct Materials

Raw materials that become an integral part of the

product and that can be conveniently traced
directly to it.

Example: A radio installed in an automobile

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 Direct Labor

Those labor costs that can be easily traced to

individual units of product.

Example: Wages paid to automobile assembly workers

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 Manufacturing Overhead

Manufacturing costs that cannot be traced directly

to specific units produced.

Examples: Indirect labor and indirect materials

Wages paid to employees Materials used to support

who are not directly
involved in production
work.
Examples: maintenance
workers, janitors and
security guards.
the production process.
Examples: lubricants and
cleaning supplies used in the
automobile assembly plant.

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 Assigning Costs to Cost Objects

Direct costs Indirect costs

• Costs that can be
easily and conveniently
traced to a unit of product
or other cost object.
• Examples: direct material
and direct labor
• Costs that cannot be easily
and conveniently traced to
a unit of product or other
cost object.
• Example: manufacturing
overhead

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 Classifications of Costs

Manufacturing costs are often

classified as follows:

Direct Direct Manufacturing

Material Labor Overhead

Prime Conversion
Cost Cost

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 Non-manufacturing Costs

Marketing or Administrative
Selling Cost Cost

Costs necessary to get All executive,

the order and deliver organizational, and
the product. clerical costs.

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 Product Costs Versus Period Costs

Product costs include Period costs include all

direct materials, direct marketing or selling
labor, and manufacturing costs and
overhead.
administrative costs.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
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 Comparing Merchandising and
Manufacturing Activities
Merchandisers . . . Manufacturers . . .
 Buy finished goods.  Buy raw materials.
 Sell finished goods.  Produce and sell
finished goods.

MegaLoMart

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 Cost of Goods Manufactured

Direct materials:
Raw materials beginning inventory
Add: Purchases of raw materials
Raw materials available for use
Deduct: Raw materials ending inventory
Raw materials used in production

Direct Labor

Manufacturing overhead
Total manufacturing costs
Add: WIP beginning inventory
Deduct: WIP ending inventory
Cost of goods manufactured

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 Cost of Goods Sold

Finished goods beginning inventory

Add: Cost of goods manufactured
Goods available for sale
Deduct: Finished goods ending inventory
Cost of goods sold

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 Income Statement

Sales
Less cost of goods sold
Gross margin
Less selling and administrative expenses
Net operating income

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 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.

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 Total Variable Cost

Your total long distance telephone bill is based

on how many minutes you talk.
Total Long Distance
Telephone Bill

Minutes Talked
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 Variable Cost Per Unit

The cost per long distance minute talked is

constant. For example, 10 cents per minute.

Telephone Charge
Per Minute

Minutes Talked
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 Total Fixed Cost

Your monthly basic telephone bill probably

does not change when you make more local
calls.
Telephone Bill
Monthly Basic

Number of Local Calls

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 Fixed Cost Per Unit

The average fixed cost per local call decreases

as more local calls are made.

Monthly Basic Telephone

Bill per Local Call
Number of Local Calls
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 Cost Classifications for Predicting Cost
Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Average fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.

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 Cost Classifications for Decision
Making

• Every decision involves a choice between at

least two alternatives.

• Only those costs and benefits that differ

between alternatives are relevant in a decision.
All other costs and benefits can and should be
ignored.

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 Differential Costs and Revenues

Costs and revenues that differ among

alternatives.

Example: You have a job paying $1,500 per month in

your hometown. You have a job offer in a neighboring
city that pays $2,000 per month. The commuting cost
to the city is $300 per month.

Differential revenue is:

$2,000 – $1,500 = $500

Differential cost is:

$300
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 Opportunity Costs

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
$15,000 per year.
Your opportunity cost
of attending college for
one year is $15,000.
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 Sunk Costs

Sunk costs have already been incurred and cannot be

changed now or in the future. They should be
ignored when making decisions.

Example: You bought an automobile that cost

$10,000 two years ago. The $10,000 cost is sunk
because whether you drive it, park it, trade it, or sell
it, you cannot change the $10,000 cost.

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