CMA01

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Managers need to rely upon different classifications of costs for different

purposes. 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. Our initial focus is on
manufacturing companies since their basic activities include most of the
activities found in other types of business organizations. Nonetheless, many of
the concepts developed in this chapter apply to diverse organizations.
McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.
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Learning objective number 1 is to identify and give examples of each of the three basic
manufacturing cost categories.
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Manufacturing costs are usually grouped into three main categories: direct
materials, direct labor, and manufacturing overhead. These costs are incurred
to make a product.
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Direct materials are raw materials that become an integral part of the finished
product and whose costs can be conveniently traced to it. Examples include the
aircraft engines on a Boeing 777, the Intel processing chip in a personal
computer, the blank video cassette in a pre-recorded video, and a radio in an
automobile.
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Direct labor consists of that portion of labor cost that can be easily traced to a
product. Direct labor is sometimes referred to as “touch labor,” since it consists
of the costs of workers who “touch” the product as it is being made.
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Manufacturing overhead consists of all manufacturing costs, other than direct

materials and direct labor. These costs cannot be conveniently traced to
products. Such costs are also called indirect manufacturing costs, factory
overhead, and factory burden. Examples include miscellaneous supplies such
as rivets in a Boeing 777; salaries for supervisors, janitors, and security guards;
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A manufacturing company incurs many other costs in addition to

manufacturing costs. For financial reporting purposes, most of these other costs
are typically classified as selling costs and administrative costs. These costs are
also called selling, general and administrative costs, or SG&A. Selling and
administrative costs are incurred in both manufacturing and merchandising
firms.
Selling costs include all costs necessary to secure customer orders and get the
finished product into the hands of the customer. These costs are also referred to
as order-getting and order-filling costs. Examples of selling costs include
advertising, shipping, sales travel, sales commissions, sales salaries, and costs
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Learning objective number 2 is to distinguish between product costs and period costs
and give examples of each.
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Costs can also be classified as period or product costs.
Product costs include all the costs that are involved in acquiring or making a
product. More specifically, it includes direct materials, direct labor, and
manufacturing overhead. Consistent with the matching principle, product costs
are recognized as expenses when the products are sold. This can result in a
delay of one or more periods between the time in which the cost is incurred and
when it appears as an expense on the income statement. Product costs are also
known as inventoriable costs. The discussion in the chapter follows the usual
interpretation of GAAP in which all manufacturing costs are treated as product
costs.
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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
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Merchandising companies purchase finished goods from suppliers for resale to

customers. Manufacturing companies purchase raw materials from suppliers
and produce and sell finished goods to customers.

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Now, let’s consider similarities and differences on the balance sheet for
merchandising and manufacturing companies. Both merchandising and
manufacturing companies will likely have Cash, Receivables and Prepaid
Expenses. However, merchandising companies do not have to distinguish
between raw materials, work in process, and finished goods. They report one
inventory number on their balance sheets, labeled merchandise inventory.
Manufacturing companies report three types of inventory on their balance
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Part I
Raw materials are the materials used to make the product.
Part II
Work in process consists of units of product that are partially complete, but
will require further work to be saleable to customers.
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Learning objective number 3 is to prepare an income statement including calculation

of the cost of goods sold.
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Merchandising companies calculate cost of goods sold as Beginning

Merchandise Inventory plus Purchases minus Ending Merchandise Inventory.
For manufacturing companies, the cost of goods sold for a period is not simply
the manufacturing costs incurred during the period. Manufacturing companies
calculate cost of goods sold as Beginning Finished Goods Inventory plus Cost
of Goods Manufactured minus Ending Finished Goods Inventory. Some of the
cost of goods sold may be for units completed in a previous period. And some
of the units completed in the current period may not have been sold and will
still be on the balance sheet as assets. The cost of goods sold is computed with
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The computation of Cost of Goods Sold relies on this basic equation for
inventory accounts. The logic underlying this equation applies to any
inventory account. Any units that are in inventory at the beginning of the
period appear as the beginning balance. During the period, additions are made
to the inventory through purchases or other means. The sum of the beginning
balance and the additions to the account is the total amount of inventory
available. During the period, withdrawals are made from inventory. The
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Learning objective number 4 is to prepare a schedule of cost of goods manufactured.

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The schedule of cost of goods manufactured contains the three elements of

costs mentioned previously, namely direct materials, direct labor, and
manufacturing overhead. It calculates the cost of raw material, direct labor and
manufacturing overhead used in production. It also calculates the
manufacturing costs associated with goods that were finished during the
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To create a schedule of cost of goods manufactured, as well as a balance sheet

and income statement, it is important to understand the flow of product costs.
Raw material purchases made during the period are added to beginning raw
materials inventory. The ending raw materials inventory is deducted to arrive
at the raw materials used in production. As items are removed from the raw
McGraw-Hill/Irwin
materials inventory and placed into the production process, they are called Copyright © 2008, The McGraw-Hill Companies, Inc.
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Direct labor and manufacturing overhead (also called conversion costs) used in
production are added to direct materials to arrive at total manufacturing costs.

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Total manufacturing costs are added to the beginning work in process to arrive
at total work in process.

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The ending work in process inventory is deducted from the total work in
process for the period to arrive at the cost of goods manufactured.

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The cost of goods manufactured is added to the beginning finished goods

inventory to arrive at cost of goods available for sale. The ending finished
goods inventory is deducted from this figure to arrive at cost of goods sold.
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Part I
All raw materials, work in process, and unsold finished goods at the end of the
period are shown as inventoriable costs in the asset section of the balance
sheet.
Part II
As finished goods are sold, their costs are transferred to cost of goods sold on
the income statement.
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Learning objective number 5 is to understand the differences between variable costs

and fixed costs.
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Quite frequently, it is necessary to predict how a certain cost will behave in

response to a change in activity. For example, a manager may want to estimate
the impact that a 5% increase in sales would have on the company’s total
electric bill. Cost behavior refers to how a cost will react to changed in the
level of activity within the relevant range. The most commonly used
classifications of cost behavior are variable and fixed costs.
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A variable cost varies in direct proportion to changes in the level of activity.

For example, your long distance telephone bill may be based on how many
minutes your talk—the total bill varies with the number of minutes used.
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Although variable costs change in total as the activity level rises and falls,
variable cost per unit is constant. For example, the cost per long distance
minute may be ten cents a minute.
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A fixed cost is constant within the relevant range. In other words, fixed costs
do not change for changes in activity that fall within the “relevant range.” For
example, your monthly basic telephone bill probably is a set amount and does
not change based on the number of calls you make.
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However, when expressed on a per unit basis, a fixed cost is inversely related
to activity—the per unit cost decreases when activity rises and increases when
activity falls. For example, the average fixed cost per local call decreases as
more local calls are made.
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It is helpful to think about variable and fixed cost behavior in a two by two
matrix, as illustrated here. Take a few minutes and review this summary of
cost behavior for variable and fixed costs.
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Learning objective number 6 is to understand the differences between direct and

indirect costs.
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A cost object is anything for which cost data are desired including products,
customers, jobs, organizational subunits, etc. For purposes of assigning
costs to cost objects, costs are classified two ways:
1. Direct costs are costs that can be easily and conveniently traced to a
specified cost object. Examples of direct costs are direct material
and direct labor.
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Learning objective number 7 is to define and give examples of cost classifications

used in making decisions: differential costs, opportunity costs, and sunk costs.
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It is important to realize that every decision involves a choice between at least

two alternatives. The goal of making decisions is to identify those costs that are
either relevant or irrelevant to the decision. Costs and benefits that differ
between alternatives are relevant in a decision. All other costs and benefits are
irrelevant and can and should be ignored. To make decisions, it is essential to
McGraw-Hill/Irwin
have a grasp on three concepts: differential costs, opportunity costs, and sunk Copyright © 2008, The McGraw-Hill Companies, Inc.
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Differential costs (or incremental costs) is a difference in cost between any two
alternatives. Differential costs can be either fixed or variable. A difference in
revenue between two alternatives is called differential revenue.
For example, assume 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. In this
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Opportunity cost is the potential benefit that is given up when one alternative is
selected over another. These costs are not usually entered into the accounting
records of an organization, but must be explicitly considered in all decisions.
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A sunk cost is a cost that has already been incurred and that cannot be changed
by any decision made now or in the future. Since sunk costs cannot be changed
and therefore cannot be differential costs, they should be ignored in decision
making. While students usually accept the idea that sunk costs should be
ignored on an abstract level, like most people, they often have difficulty
putting this idea into practice.
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We have looked at the cost classifications used for financial reporting,

predicting cost behavior, assigning costs to cost objects, and making business
decisions. Now, let’s look at how to classify idle time, overtime, and fringe
benefits.
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Appendix 2A: Further Classification of Labor Costs

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Learning objective number 8 is to properly account for labor costs associated with idle
time, overtime, and fringe benefits.
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Machine breakdowns, material shortages, power failures, and the like, result in
idle time. The labor costs incurred during idle time are ordinarily treated as
manufacturing overhead. This enables the costs to be spread across all the
production rather than the units in process when the disruptions occur.
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The overtime premiums for all factory workers are usually considered to be
part of manufacturing overhead. This is done to avoid penalizing particular
products or customer orders simply because they happen to fall on the tail end
of the daily production schedule.
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Labor fringe benefit costs are employment-related costs paid by an employer,

such as insurance programs, retirement plans, and supplemental unemployment
programs. They also include the employer’s share of Social Security and
Medicare, workers’ compensation, federal employment tax, and state
unemployment insurance. These costs often add up to thirty to forty percent of
an employee’s base pay. Some companies include all of these costs in
manufacturing overhead. Other companies opt for the conceptually superior
method of treating fringe benefit expenses of direct laborers as additional direct
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End of chapter 2.

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2-1

Managers need to rely upon different classifications of costs for different

Manufacturing overhead consists of all manufacturing costs, other than direct

A manufacturing company incurs many other costs in addition to

Costs can also be classified as period or product costs.

Merchandising companies purchase finished goods from suppliers for resale to

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

Learning objective number 3 is to prepare an income statement including calculation

Merchandising companies calculate cost of goods sold as Beginning

Learning objective number 4 is to prepare a schedule of cost of goods manufactured.

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

The schedule of cost of goods manufactured contains the three elements of

To create a schedule of cost of goods manufactured, as well as a balance sheet

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

The cost of goods manufactured is added to the beginning finished goods

Learning objective number 5 is to understand the differences between variable costs

Quite frequently, it is necessary to predict how a certain cost will behave in

A variable cost varies in direct proportion to changes in the level of activity.

Learning objective number 6 is to understand the differences between direct and

Learning objective number 7 is to define and give examples of cost classifications

It is important to realize that every decision involves a choice between at least

We have looked at the cost classifications used for financial reporting,

Appendix 2A: Further Classification of Labor Costs

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

Labor fringe benefit costs are employment-related costs paid by an employer,

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

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