Chapter 2

Basic Cost Management

Concepts
 Objectives
• Explain what is meant by the word cost.
• Distinguish among product costs, period costs, and expenses.
• Describe the role of costs in published financial statements.
• List and describe four types of manufacturing processes.
• Give examples of three types of manufacturing costs
 Objectives
• Prepare a schedule of cost of goods manufactured, a schedule of cost of goods sold, and an
income statement for a manufacturer.
• Understand the importance of identifying an organization’s cost drivers.
• Describe the behavior of variable and fixed costs, in total and on a per-unit basis.
• Distinguish among direct, indirect, controllable, and uncontrollable costs.
• 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.
 What Do We Mean by a Cost?
• cost may be defined as the sacrifice made, usually measured by the resources expended, or given
up, to achieve a particular purpose.
 Product Costs, Period Costs, and Expenses
One important way of classifying costs is by the timing of their recognition as expenses for financial reporting
 Expense: is defined as the cost incurred when a resource (asset) is used up for the purpose of generating revenue.
The resource used up can be:
• cash, expended directly;
• a promise to use up cash in the future, recognized as a liability (accounts payable); or
• the reduction in value of a recorded asset such as plant and equipment (via depreciation) or inventory (via cost of goods
sold).
• A product cost (inventoriable cost): is a cost assigned to inventory, to goods that are either
purchased or manufactured for resale.

• The product cost is used to value the inventory of manufactured goods or merchandise until the
goods are sold.

• In the period of the sale, when the inventory asset is reduced, the product costs that have been
recorded are reclassified as an expense called cost of goods sold:

1. The product cost of merchandise inventory acquired by a retailer or wholesaler for resale consists
of the purchase cost of the inventory plus any shipping charges paid by them.

2. The product cost of manufactured inventory includes all of the costs incurred in its manufacture.
 Continued
• Period costs: All costs that are not product costs
 These costs are identified with the period of time in which they are incurred rather than with units of
purchased or produced goods.
 Period costs are recognized as expenses during the time period in which they are incurred.
 research and development, selling, and administrative costs are treated as period costs. This is true in
manufacturing, retail, and service industry firms.
 Research and development: costs include all costs of developing new products and services. The costs of
running laboratories, building prototypes of new products, and testing new products are all classified as
research and development (or R&D) costs.
 Selling costs include salaries: commissions, and travel costs of sales personnel, shipping costs incurred by a
manufacturer, and the costs of advertising and promotion.
 Administrative costs: refer to all costs of running the organization as a whole. The salaries of top-
management personnel and the costs of the accounting, legal, and public relations activities are examples of
administrative costs.
Product Costs and Cost of Goods Sold
period costs
Income Statement
Selling and administrative costs are always period costs on any type
of company’s income statement.
Service industry firms generally refer to the costs of producing
services as operating expenses.
Operating expenses are treated as period costs and as such are
expensed during the period in which they are incurred.
Gross Profit and Operating Income
• the manufacturer and retailer income statements above include an item called gross profit, and
all three income statements include a subtotal called operating income (or operating profit).
These two views of profitability differ from net income and are very important to managers and
investors in understanding whether the company is successful in its core mission of producing and
selling goods and services profitably.
• Gross profit (sometimes called gross margin): is the portion of revenues left after deducting just
the costs that have been classified as cost of sales (cost of goods sold), without considering any
other costs of operating the company. (how much money are we receiving for our goods and
services after covering the costs of producing them?)
• Operating income (operating profit): the profit remaining from revenues after deducting both
cost of sales and all period costs of operations.
• Operating income is a very important profit number for managers because it represents the
profits resulting from operations, taking into account all costs of the operations but not the
effects of financing, taxes, or any other unusual business events.
Balance Sheet
• Manufacturers companies have three type of inventory
1- Raw-material inventory: includes all materials before they are
placed into production.
2- Work-in-process inventory: refers to manufactured products that are
only partially completed at the date when the balance sheet is
prepared.
3- Finished-goods inventory refers to manufactured goods that are
complete and ready for sale.

The values of the work-in-process and finished-goods inventories are

measured by their product costs
Manufacturing Operations and Manufacturing Costs (Types of Production Processes)
 1- Assembly Manufacturing

• To illustrate an assembly production environment, let’s focus on

Comet Computer Company, a manufacturer of computers and
peripheral devices. Comet purchases computer parts such as
motherboards, computer chips, hard drives, and displays, and then
assembles these parts into a variety of devices, such as tablet
computers, laptops, and desktop computers
 Manufacturing Costs
classify costs by the functional area of the organization to which costs relate.
 Some examples of functional areas are manufacturing, marketing, administration, and research
and development. Manufacturing costs are further classified into the following three categories:
1. Direct Material: that is consumed in the manufacturing process, is physically incorporated in
the finished product, and can be traced to products relatively easily.
2. Direct Labor: The cost of salaries, wages, and fringe benefits for personnel who work directly
on the manufactured products
3. Manufacturing Overhead :All other costs of manufacturing are classified as manufacturing
overhead (also known as production overhead), which includes three types of costs: indirect
material, indirect labor, and other manufacturing costs.
 Manufacturing Costs (continued)
1. Indirect Material: The cost of materials that are required for the production process but do not become an integral part of the finished
product.

 Materials that do become an integral part of the finished product but are insignificant in cost are also often classified as indirect
material. For example, the various machine screws used in assembling Comet computers are so inexpensive that it is not worth tracing
their costs to specific products as direct materials. Instead, they are added to the cost of indirect materials and become part of
manufacturing overhead cost.

2. Indirect Labor: The costs of personnel who do not work directly on the product, but whose services are necessary for the manufacturing
process

3. Other Manufacturing Costs: All other manufacturing costs that are neither material nor labor costs are classified as manufacturing
overhead. These costs include various costs of the plant such as depreciation of building and equipment, property taxes, insurance, and
utilities such as electricity, as well as the costs of operating service departments.
 Manufacturing Costs (continued)
• Service departments, also known as support departments, are those that do not work directly on
manufacturing products but are necessary for the manufacturing process to occur, such as
equipment-maintenance departments. In some firms, departments are referred to as work
centers.
• Other manufacturing overhead costs include overtime premiums and the cost of idle time.
• Idle time is time that is not spent productively by an employee due to such events as equipment
breakdowns or new setups of production runs. Such idle time is an unavoidable feature of most
manufacturing processes. The cost of an employee’s idle time is classified as overhead so that it
may be spread across all production jobs, rather than being associated with a particular
production job.
Manufacturing Costs (continued)
• Example: Suppose that during one 40-hour shift, a machine breakdown resulted in idle time of 1½ hours and
a power failure idled workers for an additional ½ hour. If an employee earns $14 per hour, the employee’s
wages for the week will be classified as follows:
Manufacturing Costs (continued)
Manufacturing Cost Flows
 Manufacturing Cost Flows
• Cost of goods manufactured, as indicated, is the cost of goods
completed and transferred from work-in-process inventory to
finished-goods.
• Total manufacturing cost is the sum of direct material, direct labor,
and manufacturing overhead incurred during the period, i.e. the
spending on manufacturing. Some of that spending may still be in
work-in process inventory and so not part of what is traditionally
called cost of goods manufactured
Manufacturing Cost Flows
Basic Cost Management Concepts: Different Costs
for Different Purposes
• Cost Drivers: the way a cost changes in relation to changes in the
activities of the organization.
• A cost driver: is a characteristic of an activity or event that causes
costs to be incurred.
• example, in a manufacturing firm, the cost of assembly labor would
• be driven by the quantity of products manufactured as well as the
number of parts in each product. In contrast, the cost of machine
setup labor would be driven by the number of production runs.
 Variable and Fixed Costs
• Variable Costs: A variable cost changes, in total, in direct proportion
to a change in the level of activity (or cost driver). If activity increases
by 20 percent, total variable cost increases by 20 percent also.
• Fixed Costs: A fixed cost remains unchanged in total as the level of
activity (or cost driver) varies. If activity increases or decreases by 20
percent, total fixed cost remains the same.
 cost classification
Direct and Indirect Costs
• Cost object: An entity, such as a particular product, service, or department, to which a cost is
assigned.
• Direct cost: A cost that can be traced to a particular cost object.
For example, the cost of paint used in the painting department of a Toyota plant is a direct cost of
the painting department. At the same time, it is also a direct cost of the car that Toyota is
manufacturing, and as we saw earlier, when the cost object is a product or service and the direct
cost is a material, we call it direct material.
• indirect cost: A cost that is not directly traceable to a particular cost object.
 cost classification
Controllable and Uncontrollable Costs
• cost control indicates the controllability of a cost item by a particular
manager.
• controllable cost: If a manager can control or heavily influence the
level of a cost.
• uncontrollable costs: Costs that a manager cannot influence
significantly
 Economic Cost Concepts
• opportunity cost: is defined as the benefit that is sacrificed when the choice of
one action precludes taking an alternative course of action.
• Out-of-pocket costs: are those that require the payment of cash or other assets
as a result of their incurrence.
• Sunk costs: are costs that have been incurred in the past. Consequently, they do
not affect future costs and cannot be changed by any current or future action.
Example: The acquisition cost of equipment previously purchased and the
manufacturing cost of inventory on hand.
A differential cost: is the amount by which the cost differs under two alternative
actions.
• Incremental cost: The increase in cost from one alternative to another
• Marginal cost: A special case of the differential-cost concept, which is the incremental cost of producing one
additional unit

• The average cost per unit: is the total cost, for whatever quantity is manufactured, divided by the number of
units manufactured.
 Costs in the Service Industry (Midas, Inc)
• Product and Period Costs: Midas service shops purchase auto parts and supplies, such as exhaust pipes,
brake pads, oil filters, and engine oil, from vendors. These costs are stored in inventory as product costs (or
inventoriable costs) until the time period when they are consumed in the repair process. At that time, these
product costs become part of cost of services (or operating expenses, as discussed earlier), an expense. All of
a Midas shop’s other costs are period costs, and they are expensed as operating expenses during the period
they are incurred. Examples of these period costs include employee salaries and wages, utilities, and
depreciation on equipment and facilities.
• Variable and Fixed Costs: The costs incurred in the Midas service shop that vary directly with activity are
variable costs. For example, the cost of lubricant, engine oil, and oil filters is a variable cost, because it varies
in proportion to the number of lube oil-filter (LOF) jobs the shop provides. Thus, a likely cost driver for this
cost would be the number of LOF jobs performed. In contrast, any costs that do not tend to vary with service
activity are fixed costs. Examples include the Midas shop’s managerial salaries, depreciation on equipment
and facilities, insurance, and property taxes.
• Direct and Indirect Costs Consider a typical service and repair job. The customer has requested a
routine lube-oil-filter job and an exhaust system repair, which requires a new muffler. The direct
costs of this service and repair job (the cost object) include the parts and supplies used (lubricant,
engine oil, oil filter, and a new muffler) and the wages of the automotive service technician for
the time spent on this job. The many indirect costs of this service job include the shop manager’s
salary, the depreciation on the building, and local media advertising purchased by the franchise
• Controllable and Uncontrollable Costs: the Costs that are controllable by the manager of this
Midas auto shop include local advertising, assuming the shop manager is responsible for such
local ad buys. A cost that is partially controllable by the manager might include heating costs.
Although the manager has little control over electricity or heating oil prices, the manager can
ensure that the shop’s heating system is properly maintained and the windows and doors have
the proper weather stripping. Many of the shop’s costs are largely uncontrollable by the shop
manager. The depreciation, insurance, and property taxes on the building, for example, are the
result of Midas policies regarding location and shop size.
• Opportunity, Out-of-Pocket, and Sunk Costs These cost types all are represented in the Midas
auto service business. Suppose the Midas shop manager decides to shut down one of the service
bays on a particular day to inspect and maintain the lift and other equipment. Any customer
business that is lost that day due to a shortage of service bays would be an opportunity cost of
the shut-down decision. (Note that such an opportunity cost does not necessarily mean the shut-
down decision was a poor one. The opportunity cost of any lost business could well be exceeded
by the additional operating costs that could be incurred if the service bay was not properly
maintained.) The wages paid to service technicians and utility costs are examples of out-of-pocket
costs. The money spent last year to replace an auto lift is an example of a sunk cost.
• Differential, Marginal, and Average Costs: Suppose the Midas shop owns a small van to make
short runs to pick up auto parts needed on short notice. The van needs to be replaced, and two
vehicles are under consideration. The difference in the cost of these two alternative vehicles is a
differential cost of the vehicle replacement decision. The cost of performing one additional lube-
oil-filter (LOF) job in a given time period is the marginal cost of that type of service. The total cost
of all LOF jobs in a time period, divided by the number of jobs, is the average cost of an LOF job