Chapter 2

Basic Cost
Management Concepts

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 2-1 – Explain what is meant by the
word cost.

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 Process of Management
Strategy Planning
Formulation

Managers need cost information to

perform each of these functions.

Control Directing
Decision
Making
2-3
What Do We Mean By a Cost?

A cost
is the measure of
resources given
up to achieve a
particular purpose.

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Learning Objective 2-2 – Distinguish among product
costs, period costs, and expenses.

2-5
Product Costs, Period Costs, and Expenses

Product costs are costs assigned to inventory, to

goods that are either purchased or manufactured for
resale. Another term for product cost is inventoriable
cost.

Period costs are costs that are expensed during the

time period in which they are incurred.

Expenses are the consumption of assets for the

purpose of generating revenue.

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Learning Objective 2-3 – Describe the role of costs in
published financial statements.

2-7
Cost Classifications on Financial Statements
– Income Statement

Product Costs Period Costs

Cost of goods sold Operating expenses

2-8
Cost Classifications on Financial Statements
– Balance Sheet

Merchandiser Manufacturer
Current Assets Current Assets
Cash  Cash
Receivables  Receivables
Prepaid Expenses  Prepaid Expenses
Merchandise Inventory  Inventories
Raw Materials
Work in Process
Finished Goods

2-9
Cost Classifications on Financial Statements
– Balance Sheet

Merchandiser Manufacturer
Current Assets Current Assets
Cash Those
Cash materials
waiting to be
 Receivables
Receivables
processed.
Prepaid Expenses
Merchandise Inventory  Inventories
Raw Materials
Work in Process
Finished Goods

2-10
Cost Classifications on Financial Statements
– Balance Sheet

Merchandiser Manufacturer
PartiallyAssets
Current completed
Current Assets products – material to
 Cash
Cash which some labor
 Receivables
and/or overhead has
Receivables
Prepaid Expenses
been added.
 Prepaid Expenses
 Inventories
Merchandise Inventory
Raw Materials
Work in Process
Finished Goods

2-11
Cost Classifications on Financial Statements
– Balance Sheet

Merchandiser Manufacturer
Current Assets Current Assets
Cash  Cash
Receivables Completed products
 Receivables
awaiting sale.
 Prepaid Expenses
Prepaid Expenses
 Inventories
Merchandise Inventory
Raw Materials
Work in Process
Finished Goods

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Learning Objective 2-4 – List and describe four types of
manufacturing processes.

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Types of Production Processes

2-14
Learning Objective 2-5 – Give examples of three types of
manufacturing costs.

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 Manufacturing Costs

Direct Direct Manufacturing

Material Labor Overhead

The
Product

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 Direct Material

Cost of raw material that is used to

make, and can be conveniently
traced, to the finished product.
Example:
Example:
Steel
Steel used
usedto
to
manufacture
manufacture
the
theautomobile.
automobile.

2-17
 Direct Labor

Cost of salaries, wages, and fringe

benefits for personnel who work
directly on manufactured products.

Example:
Example:
Wages
Wagespaid
paidto
toan
an
automobile
automobileassembly
assembly
worker.
worker.

2-18
 Manufacturing Overhead
All other manufacturing costs
Indirect Indirect Other
Material Labor Costs

Materials used to support

the production process.
Examples: lubricants and
cleaning supplies used in an
automobile assembly plant.

2-19
 Manufacturing Overhead
All other manufacturing costs
Indirect Indirect Other
Material Labor Costs

Cost of personnel who

do not work directly on
the product. Examples:
maintenance workers,
janitors, and security
guards.
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 Manufacturing Overhead
All other manufacturing costs
Indirect Indirect Other
Material Labor Costs

Examples: depreciation
on plant and equipment,
property taxes,
insurance, utilities,
overtime premium, and
unavoidable idle time.
2-21
 Classifications of Costs in
Manufacturing Companies
Manufacturing costs are often
combined as follows:

Direct Direct Manufacturing

Material Labor Overhead

Prime Conversion
Cost Cost

2-22
Manufacturing Cost Flows

2-23
Learning Objective 2-6 – Prepare a schedule of cost of
goods manufactured, a schedule of cost of goods sold, and an
income statement for a manufacturer.

2-24
 Schedule of Cost of Goods
Manufactured

Comet Computer Corporation

Schedule of Cost of Goods Manufactured

Raw material used $ 134,980

Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs $ 414,980
Add: Work-in-process inventory, January 1 120
Subtotal $ 415,100
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured $ 415,000

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 Computation of Cost of Raw Material Used
Raw-material inventory, January 1 $ 6,000
Add: Purchases of raw materials 134,000
Raw material available for use 140,000
Deduct: Raw material inventory, December 31 5,020
Raw material used $ 134,980
Comet Computer Corporation
Schedule of Cost of Goods Manufactured

Raw material used $ 134,980

Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs $ 414,980
Add: Work-in-process inventory, January 1 120
Subtotal $ 415,100
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured $ 415,000

2-26
 Schedule of Cost of Goods
Manufactured
Include all direct labor
costs incurred during the
Cometcurrent period.
Computer Corporation
Schedule of Cost of Goods Manufactured

Raw material used $ 134,980

Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs $ 414,980
Add: Work-in-process inventory, January 1 120
Subtotal $ 415,100
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured $ 415,000

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 Computation of Total Manufacturing Overhead

Indirect material $ 10,000

Indirect labor 40,000
Depreciation on factory 90,000
Depreciation on equipment 70,000
Comet Computer Corporation
Utilities 15,000
Insuranceof Cost of Goods Manufactured
Schedule 5,000
Total manufacturing overhead $ 230,000
Raw material used $ 134,980
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs $ 414,980
Add: Work-in-process inventory, January 1 120
Subtotal $ 415,100
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured $ 415,000

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 Schedule of Cost of Goods
Manufactured
Beginning work-in-
process inventory is
carried over from the
Comet Computer Corporation
prior period.
Schedule of Cost of Goods Manufactured

Raw material used $ 134,980

Direct labor 50,000
Total manufacturing overhead 230,000
Ending work-in-process
Total manufacturing costs $ 414,980
inventory contains the
Add: Work-in-process cost ofJanuary 1
inventory, 120
unfinished
Subtotal goods, and is $ 415,100
reported in the current inventory,
Deduct: Work-in-process assets December 31 100
section of the
Cost of goods balance sheet.
manufactured $ 415,000

2-29
Income Statement for a Manufacturer

Comet Computer Corporation

Income Statement
For the Year Ended December 31, 20X2
Sales revenue $ 700,000
Less: Cost of goods sold 415,010
Gross margin $ 284,990
Selling and administrative expenses 174,490
Income before taxes $ 110,500
Income tax expense 30,000
Net income $ 80,500

2-30
 Comet Computer Corporation
Schedule of Cost of Goods Sold
For the Year Ended December 31, 20X2
Finished-goods inventory, Jan. 1 $ 200
Add: Cost of goods manufactured 415,000
Cost of goods available for sale 415,200
Comet Computer Corporation
Deduct Finished-goods inventory, Dec. 31 190
Income Statement
Cost of goods sold $ 415,010
For the Year Ended December 31, 20X2
Sales revenue $ 700,000
Less: Cost of goods sold 415,010
Gross margin $ 284,990
Selling and administrative expenses 174,490
Income before taxes $ 110,500
Income tax expense 30,000
Net income $ 80,500

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Learning Objective 2-7 – Understand the importance of
identifying an organization's cost drivers.

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Activities that cause costs to be incurred are
called COST DRIVERS:

Cost Driver Examples

Activity Cost Driver
Machining operations Machine hours
Setup Setup hours
Production scheduling Manufacturing orders
Inspection Pieces inspected
Purchasing Purchase orders
Shop order handling Shop orders
Valve assembly support Customer requisitions

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Learning Objective 2-8 – Describe the behavior of
variable and fixed costs, in total and on a per-unit basis.

2-34
Cost Classifications

Cost behavior means

how a cost will react to
changes in the level of
business activity.
Total variable costs change
when activity changes.
Total fixed costs remain
unchanged when activity
changes.

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 Total Variable Cost Example
Your total cable pay-per-view bill is based on how many
movies you watch.
Total Pay-Per-View
Bill

Pay-Per-View
Movies Watched 2-36
 Variable Cost Per Unit Example
The cost per movie watched is constant. For example, $4.00
per movie.

Per Movie Charge

Movies Watched
2-37
 Total Fixed Cost Example
Your monthly cable bill probably does not change when
you watch movies on channels that you have elected to
be paid on a monthly basis.
Monthly Charge for
HBO Bill

Number of HBO Movies

Watched 2-38
 Graph of Unit Fixed Cost
The average cost per HBO movie decreases as more HBO
movies are watched.

Monthly HBO Bill per Movie

Watched

Number of HBO
Movies Watched 2-39
 Cost Classifications - Summary

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Total variable cost changes Variable cost per unit

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

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Learning Objective 2-9 – Distinguish among direct,
indirect, controllable, and uncontrollable costs.

2-41
 Direct and Indirect Costs
Direct costs Indirect costs
Costs that can be Costs that must be
easily and conveniently allocated in order to be
traced to a product or assigned to a product or
department. department.
Example: cost of paint in Example: cost of national
the paint department of an advertising for an airline is
automobile assembly plant. indirect to a particular
flight.

2-42
 Controllable and
Uncontrollable Costs

A cost that can be significantly influenced

by a manager is a controllable cost.

2-43
Learning Objective 2-10 – Define and give examples of
an opportunity cost, an out-of-pocket cost, a sunk cost, a
differential cost, a marginal cost, and an average cost.

2-44
 Opportunity Costs
The potential benefit that is
sacrificed when one alternative
is selected over another.
Example: If you were
not attending college,
you could be earning
$30,000 per year.
 Your opportunity cost
of attending college for one year is
$30,000.

2-45
 Out-of-Pocket Costs

Those costs that require the

payment of cash or other
assets as a result of its
incurrence.

These costs should be

considered when making
decisions.
 Sunk Costs
All costs incurred in the past that cannot be changed by
any decision made now or in the future are sunk costs.

Sunk costs should NOT be considered in decisions.

Example: You bought an automobile that cost $22,000 two years

ago. The $22,000 cost is sunk because whether you drive it, park it,
trade it, or sell it, you cannot change the $22,000 cost.

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 Differential Costs

Costs that differ between alternatives.

Example: You can earn $1,500 per month in your
hometown or $2,000 per month in a nearby city.
Your commuting costs are $50 per month in your
hometown and $300 per month to the city.

What is your differential cost?

$300 - $50 = $250

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Marginal Costs and Average Costs

The total cost to

The extra cost
produce a quantity
incurred to produce
divided by the
one additional unit.
quantity produced.

Marginal and average costs are

largely a function of cost behavior
-- variable and fixed costs.
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Costs and Benefits of Information

Costs Benefits

More information does not mean more

benefits if information overload results.

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End of Chapter 2

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