CHAPTER 2

Managerial Accounting

COST TERMINOLOGY
LEARNING OBJECTIVES
After studying Chapter 2, you should be able to:
LO2–1 Understand cost classifications used for assigning costs to cost objects:
direct costs and indirect costs.
LO2–2 Identify and give examples of each of the three basic manufacturing cost
categories.
LO2–3 Understand cost classifications used to prepare financial statements:
product costs and period costs.
LO2–4 Understand cost classifications used to predict cost behavior: variable
costs, fixed costs, and mixed costs.
LO2–5 Understand cost classification used in making decision: differential costs,
opportunity costs, and sunk costs.
 What is a cost
 In accounting, cost is defined as the cash amount (or the cash equivalent) given u for an
asset. Cost includes all costs necessary to get an asset in place and ready for use. For
example, the cost of an item in inventory also include the item’s freight-in cost. Costs are
assigned to cost objects for a variety of purposes including pricing, preparing profitability
studies, and controlling spending. A cost object is anything for which cost data are desired
—including products, customers, jobs, and organizational subunits. For purposes of
assigning costs to cost objects, costs are classified as either direct or indirect. Example of a
cost objectives includes the cost of a product, the cost of rendering a service to a bank
customer or hospital patient.

Activity
An event that causes a cost or other amount to increase or decrease.
Unit Cost
 The cost of one unit of product or service.
Total Cost
 The cost of all units of product or services produced or sold during a period.
Direct Cost
 A direct cost is a cost that can be easily and conveniently traced to a specified
cost object. For example, if Reebok is assigning costs to its various regional
and national sales offices, then the salary of the sales manager in its Tokyo
office would be a direct cost of that office. If a printing company made
10,000 brochures for a specific customer, then the cost of the paper used to
make the brochures would be a direct cost of that customer.
Indirect Cost
 An indirect cost is a cost that cannot be easily and conveniently traced to a
specified cost object. Example: manufacture overhead.

Controllable and uncontrollable

 Another cost classification that can be helpful in cost control involves the
controllability of a cost item by a particular manager. If the a manager can
control or heavily influence the level of a cost, then that cost is classified as a
controllable cost.
 Costs that a manager cannot influence significantly are not completely under
the control of any individual.
Controllable Costs Uncontrollable Costs
Controllable costs are costs that can be Uncontrollable costs are those that are not under

influenced or regulated by the manager. the control of a specified manager. These cannot
Or head responsible for it. be influenced by the decision or actions of the
For Example : direct material, direct manager. These costs are imposed by the top
labor, and certain factory overhead costs management or allocated to several departments.
are controlled by the production manager. For Example: depreciation, insurance
Another example: the sales manager has and share in rent.
Control over the salary and commission of
sales personnel.
 Identify and give examples of each of the three basic manufacturing
cost categories.
The two broad categories of costs are manufacturing costs and nonmanufacturing
costs. Each category is described in detail as follows.
Manufacturing Costs
• All costs related to the production of goods are called manufacturing costs; they
are also referred to as product costs. A manufacturer purchases materials,
employs workers who use the materials to assemble the goods, provides a
building where the materials are stored and goods are assembled, and sells the
goods. We classify the costs associated with these activities into three
categories: direct materials, direct labor, and manufacturing overhead.
• Direct materials: Raw materials used in the production process that are
easily traced to the product are called direct materials. Example: A radio
installed in an automobile, wood.
• Direct labor: Work of factory employees that can be physically & directly
associated with the converting raw material in to finished goods. Example:
Wages paid to automobile assembly workers.
• manufacturing overhead : All costs associated with the production process
other than direct material costs and direct labor costs are called
manufacturing overhead. Terms synonymous with manufacturing overhead
include factory overhead, factory burden, and overhead.
Example: Indirect materials and Indirect labor.
What items are included in manufacturing overhead?
o Indirect material costs. The cost of materials necessary to manufacture a
product that are not easily traced to the product or not worth tracing to the
product. For Example : lubricants and cleaning supplies used in the automobile
assembly plant.
o Indirect labor costs. The cost of workers who are involved in the production
process but whose time cannot easily be traced to the product. For example,
supervisors in the production process who oversee several different products
and are responsible for hiring employees, scheduling employees, and ordering
materials are considered indirect labor factory supervisor.
o Other manufacturing costs. These are all other costs for items associated with
the factory, including equipment maintenance, insurance, utilities, and
depreciation.
Nonmanufacturing Costs
Costs that are not related to the production of goods are called nonmanufacturing costs; they
are also referred to as period costs. These costs have two components selling costs and general
and administrative cost.
• Selling costs: Costs incurred to obtain customer orders and provide customers with a finished
product are called selling costs. (They are also often called marketing costs or selling and
advertising costs shipping, sales travel.).
• Administrative cost: include all costs associated with the general management of an
organization rather than with manufacturing or selling
Although selling costs and general and administrative costs are considered nonmanufacturing
costs, managers often want to assign some of these costs to products for decision-making
purposes. For example, sales commissions and shipping costs for a specific product could be
assigned to the product. This does not comply with U.S. GAAP because, under U.S. GAAP,
only product costs can be assigned to products. However, as we noted earlier, managerial
accounting information is tailored to meet the needs of the users and need not follow U.S.
GAAP.
include all costs associated with the general management of an
organization rather than with manufacturing or selling
 Understand cost classifications used to prepare financial statements:
product costs and period costs
Product Costs
• For financial accounting purposes, product costs include all costs involved in acquiring or
making a product. In the case of manufactured goods, these costs consist of direct materials,
direct labor, and manufacturing overhead.1 Product costs “attach” to units of product as the
goods are purchased or manufactured, and they remain attached as the goods go into
inventory awaiting sale. Product costs are initially assigned to an inventory account on the
balance sheet. When the goods are sold, the costs are released from inventory as expenses
(typically called cost of goods sold) and matched against sales revenue on the income
statement. Because product costs are initially assigned to inventories, they are also known as
inventoriable costs.
• We want to emphasize that product costs are not necessarily recorded as expenses on the
income statement in the period in which they are incurred. Rather, as explained above, they
are recorded as expenses in the period in which the related products are sold
Period Costs
• Period costs are all the costs that are not product costs. All selling and administrative
expenses are treated as period costs. For example, sales commissions, advertising, executive
salaries, public relations, and the rental costs of administrative offices are all period costs.
Period costs are not included as part of the cost of either purchased or manufactured goods;
instead, period costs are expensed on the income statement in the period in which they are
incurred using the usual rules of accrual accounting. Keep in mind that the period in which a
cost is incurred is not necessarily the period in which cash changes hands. For example, as
discussed earlier, the costs of liability insurance are spread across the periods that benefit
from the insurance regardless of the period in which the insurance premium is paid.
Prime Cost and Conversion Cost
• Two more cost categories are often used in discussions of manufacturing costs—prime cost
and conversion cost. Prime cost is the sum of direct materials cost and direct labor cost.
Conversion cost is the sum of direct labor cost and manufacturing overhead cost. The term
conversion cost is used to describe direct labor and manufacturing overhead because these
costs are incurred to convert materials into the finished product.
 Understand cost classifications used to predict cost behavior:
variable costs, fixed costs, and mixed costs.
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.
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 “some-
thing” is its activity base. An activity base is a measure of whatever causes the incurrence 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.
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 out- side force, such as a landlord increasing your monthly rental expense.
A mixed cost contains both variable and fixed cost elements. Mixed costs are also known as semi-
variable costs.
 Understand cost classification used in making decision: differential
costs, opportunity costs, and sunk costs.
Differential Cost and Revenue
• Decisions involve choosing between alternatives. In business decisions, each
alternative will have costs and benefits that must be compared to the costs and
benefits of the other available alternatives. A difference in costs between any
two alternatives is known as a differential cost. A difference in revenues
(usually just sales) between any two alternatives is known as differential
revenue.
A differential cost is also known as an incremental cost, although technically an
incremental cost should refer only to an increase in cost from one alternative to
another; decreases in cost should be referred to as decremental cost.
Opportunity cost is the potential benefit that is given up when one alternative is
selected over another. For example, assume that you have a part-time job while
attending college that pays $200 per week. If you spend one week at the beach
during spring break without pay, then the $200 in lost wages would be an
opportunity cost of taking the week off to be at the beach. Opportunity costs are
not usually found in accounting records, but they are costs that must be
explicitly considered in every decision a manager makes. Virtually every
alternative involves an opportunity cost.

Sunk cost is a cost that has already been incurred and that cannot be changed
by any decision made now or in the future. Because sunk costs cannot be
changed by any decision, they are not differential costs. And because only
differential costs are relevant in a decision, sunk costs should always be ignored.
• To illustrate a sunk cost, assume that a company paid $50,000 several
years ago for a special-purpose machine. The machine was used to make
a product that is now obsolete and is no longer being sold. Even though
in hindsight purchasing the machine may have been unwise, the $50,000
cost has already been incurred and cannot be undone. And it would be
folly to continue making the obsolete product in a misguided attempt to
“recover” the original cost of the machine. In short, the $50,000
originally paid for the machine is a sunk cost that should be ignored in
current decisions.