11th Edition

Chapter 2

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 Costs Terms, Concepts and
Classifications

Chapter Two

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 Overview

• Costs can be classified in a number of ways—

depending on the purpose of the classification.
• It is important to note that the classifications of
costs are not mutually exclusive.
• That is, a particular cost may be classified in many
different ways—depending on the purpose of the
classification.
• The four main purposes emphasized in this chapter
include preparing external financial reports,
predicting cost behavior, assigning costs to
cost objects, and making business decisions.
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 Manufacturing Costs

• Manufacturing VS Merchandising businesses

• Manufacturing costs – These costs are incurred
to make a product.
• Manufacturing costs are usually grouped into three
main categories:
1. Direct Materials
2. Direct Labor
3. Manufacturing Overhead

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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.
Indirect Labor Indirect Materials

Wages paid to employees who Materials used to support the

are not directly involved in production process.
production work. Examples: lubricants and
Examples: maintenance cleaning supplies used in the
workers, janitors and security automobile assembly plant.
guards.
Other costs related to the
Other manufacturing facility.
Manufacturing
Examples: Heating, property tax
Overhead and insurance
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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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 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.

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 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.

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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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 Balance Sheet

Merchandiser Manufacturer
Current assets Current Assets
 Cash  Cash

 Receivables  Receivables
 Prepaid Expenses
 Prepaid Expenses
 Inventories
 Merchandise
Inventory Raw Materials
Work in Process
Finished Goods

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 Balance Sheet

Merchandiser Manufacturer
Current assets Current Assets
 Cash  Cash

 Receivables  Receivables
Materials waiting to
 Prepaid
be processed.
Expenses
 Prepaid Expenses
Partially complete  Inventories
 Merchandise
products – some
Inventory Raw Materials
material, labor, or Work in Process
overhead has been Finished Goods
added.
Completed products
awaiting sale.
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 Inventory Flows

Beginning
Additions Available
balance + $$$ = $$$$$
$$

_ Withdrawals Ending
Available
$$$$$ $$$ = balance
$$

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 The Income Statement

Cost of goods sold for manufacturers differs only

slightly from cost of goods sold for merchandisers.

Merchandising Company Manufacturing Company

Cost of goods sold:

Cost of goods sold:
Beg. merchandise Beg. finished
inventory $ 14,200 goods inv. $ 14,200
+ Purchases 234,150 + Cost of goods
Goods available manufactured 234,150
for sale $ 248,350 Goods available
- Ending for sale $248,350
merchandise - Ending
inventory (12,100) finished goods
= Cost of goods inventory (12,100)
sold $ 236,250 = Cost of goods
sold $236,250

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 Quick Check 

If your inventory balance at the beginning of the

month was $1,000, you bought $100 during the
month, and sold $300 during the month, what would
be the balance at the end of the month?
A. $1,000.
B. $ 800.
C. $1,200.
D. $ 200.

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 Quick Check 

If your inventory balance at the beginning of the

month was $1,000, you bought $100 during the
month, and sold $300 during the month, what would
be the balance at the end of the month?
A. $1,000.
$1,000 + $100 = $1,100
B. $ 800. $1,100 - $300 = $800
C. $1,200.
D. $ 200.

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 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.

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 Product Cost Flows

Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials

materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production
– Ending raw materials
inventory
= Raw materials used As items are removed from raw
in production materials inventory and placed into
the production process, they are
called direct materials.

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 Product Cost Flows

Manufacturing Work
Raw Materials Costs In Process
Conversion
Beginning raw Direct materials
materials inventory + Direct labor
costs are costs
+ Raw materials + Mfg. overhead incurred to
purchased = Total manufacturing convert the
= Raw materials costs
direct material
available for use
in production into a finished
– Ending raw materials product.
inventory
= Raw materials used
in production

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 Product Cost Flows

Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials
inventory All manufacturing costs incurred
= Raw materials used during the period are added to the
in production
beginning balance of work in
process.

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 Product Cost Flows

Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending work in
Costs associated with the goods that process inventory
= Cost of goods
are completed during the period are manufactured
transferred to finished goods
inventory.

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 Product Cost Flows

Work
In Process Finished Goods

Beginning work in Beginning finished

process inventory goods inventory
+ Manufacturing costs + Cost of goods
for the period manufactured
= Total work in process = Cost of goods
for the period available for sale
– Ending work in - Ending finished
process inventory goods inventory
= Cost of goods Cost of goods
manufactured sold

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 Manufacturing Cost Flows

Balance Sheet Income

Costs Inventories Statement
Expenses
Material Purchases Raw Materials

Direct Labor Work in

Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold

Selling and Period Costs Selling and

Administrative Administrative
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 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

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 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 costBeg.
of direct material used?
raw materials $ 32,000
A. $276,000 + Raw materials
purchased 276,000
B. $272,000 = Raw materials available
for use in production $ 308,000
C. $280,000 – Ending raw materials
D. $ 2,000 inventory 28,000
= Raw materials used
in production $ 280,000

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 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.

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 Quick Check 

Direct materials used in production totaled

$280,000. Direct labor was $375,000 and
factory overhead was $180,000.
Direct Materials What were
$ 280,000
total manufacturing+ costs incurred for the
Direct Labor 375,000
+ Mfg. Overhead 180,000
month? = Mfg. Costs Incurred
A. $555,000 for the Month $ 835,000

B. $835,000
C. $655,000
D. Cannot be determined.

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 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.
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 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 atBeginning
the endwork in
of the $ 125,000
process inventory
month. What was the+ Mfg.
cost ofincurred
costs goods
for the period 835,000
manufactured during =the
Totalmonth?
work in process
A. $1,160,000 – Ending
during the period
work in
$ 960,000

B. $ 910,000 = Costprocess inventory

of goods
200,000

C. $ 760,000 manufactured $ 760,000

D. Cannot be determined.
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 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.
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 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. $130,000 + $760,000 = $890,000
B. $740,000. $890,000 - $150,000 = $740,000
C. $780,000.
D. $760,000.
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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 monthly fuel cost depends on how

many kilometers you drive in your car, in a month.
Total Monthly Fuel
Cost

Number of Kilometers
(Car Driven)
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 Variable Cost Per Unit

The cost per kilometer the car is driven, is

constant. For example: Rs. 8 per km.

Per Kilometer Fuel Cost

Number of Kilometers
(Car Driven)
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 Total Fixed Cost

Your month car rental fee does not change

when you drive the car more.
Monthly Car Rental

Number of Kilometers
(Car Driven)
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 Fixed Cost Per Unit

The car rental fee per kilometer decreases as

the car is driven more.

Monthly Car Rental per

Kilometer

Number of Kilometers
(Car Driven)
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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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 Quick Check 

Which of the following costs would be variable with

respect to the number of cones sold at a Baskins &
Robbins shop? (There may be more than one
correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.

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 Quick Check 

Which of the following costs would be variable with

respect to the number of cones sold at a Baskins &
Robbins shop? (There may be more than one
correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.

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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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 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 a shipwrecked
sailor on a desert island is
capable of catching 10 fish
or harvesting 5 coconut a
day. Going for either of the
option, will make benefit
lost from the other option
the opportunity cost.

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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: How long would you watch a bad movie?

 Let’s say you rent a movie and after half an hour decide it is
unbearable to watch; it’s not even “good”•enough that you can make
fun of it. Most of us would watch the rest of the movie since we paid
for it, but the truth is, the price of rental is a sunk cost.

 What we really face is the choice of watching the rest of a bad movie,
or using the time to do something more fun like visiting a friend or
make yourself healthy by going to the gym.

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 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.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 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.

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 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.

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 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.

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 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.

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 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.

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 Summary of the Types of Cost
Classifications

• Financial reporting
• Predicting cost behavior
• Assigning costs to cost objects
• Decision making

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 End of Chapter 2

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