Cost Accounting: Refresher On Cost Terms

Cost Accounting
First Edition
Farmer and Fredin
Chapter 2
Refresher on Cost Terms
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Learning Objective
Learning Objective 1
1
Review financial statement terms to interpret a
company’s results.
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Cost versus Expense
From an accounting perspective, an expense means a
resource sacrificed to bring us benefit in this period; it
has no remaining future benefit.
Costs are a measure of a resource being sacrificed
• If costs have objective, measurable future benefit,
then they’re assets on the balance sheet.
• If not, they’re expenses on the income statement.

Comparing Expenses and Costs
Term Definition Future Benefit? Examples

Cost A measure of a resource being Yes—if on balance sheet as an asset. Raw materials inventory.
sacrificed; includes both assets and No—if on income statement as an Internet service used up during the
expenses. expense. current period and expensed.
Expense A resource sacrificed to bring us No—expenses reside on the income Continuing education course (future
benefit in this period but has no statement, so closed to zero at end benefit is hard to quantify), rent
remaining future benefit. of period. expense for this month, weekly floral
bouquets for the reception area
included in office expense.
Illustration 2.5 Comparing expenses and costs

Let’s Walk Through It: Costs and Expenses Categories
Now, let’s classify them into the right categories. Recall that expenses
go to the income statement in this period.
Expenses (This Period) Assets (Costs with Future
Benefits)
Total cost of revenues (or COGS) Inventory
Research and development Prepaid expenses and other
current assets
Selling, general, and administrative

Learning Objective
1
Examine financial statements to differentiate between
service providers, merchandisers, and manufacturers.

Service Providers
• Service providers often exclusively provide a service,
such as dentists, massage therapist, dry cleaners, and
drive-thru car washes.
• These businesses commonly carry no Inventory or Cost
of Goods Sold (COGS) accounts
• Most costs beyond long-term assets are easily expensed
as incurred without any intermediate stops on the
balance sheet as inventory.
• The financial statements of some service providers may
include goods for sale that complement the service.

Merchandiser
• Merchandisers (retailers) make a profit by buying
goods to resell at marked-up prices.
• Merchandisers may add price tags, fold, and organize
merchandise to complete readying the goods for sale.
• Merchandisers have one category of inventory on the
balance sheet: Merchandise Inventory.
• As customers buy goods, physical inventory decreases.
• Costs move from Merchandise Inventory on the
balance sheet to COGS on the income statement, to be
matched to sales for the period.

Manufacturer
• Manufacturers add benefit through a series of activities
representing the value chain to support their primary business:
conversion of raw inputs into a final product with additional
value to customers.
• Manufacturers have up to three categories of inventory on the
balance sheet: Raw Materials (RM) Inventory, Work-in-Process
(WIP) Inventory, and Finished Goods (FG) Inventory.
• Once items have completed the sales process move cost to
COGS on the income statement.
• Gross margin or gross profit displays the firm’s ability to mark-
up its product costs to selling price.
Learning Objective
1
Interpret commonly used cost terms used in decision-
making.

Product Costs
For a manufacturer, product costs are incurred to
make the product and ready it for sale.
The three components of product cost are:
1. Direct materials (DM)
2. Direct labor (DL)
3. Manufacturing overhead (MOH)
For a merchandiser, product costs include the
purchase costs of the merchandise, plus any additional
costs to ready the merchandise for sale.

Period Costs
Period costs encompass most costs on the income

statement, after COGS.
They’re costs of being in business – any kind of business,
not just manufacturing.
Since they’re on the income statement, they’re not assets
with future benefit but expenses of this period.

Manufacturing and Non-
Manufacturing Costs
• Product costs and manufacturing costs are synonyms
 They’re costs to make the product
• Period cost and non-manufacturing costs are synonyms
 Consists of most of the remaining expenses on the
income statement
 Incurred this period, to be in business
 Administrative, marketing, and selling expenses
 Often classified as selling, general, and administrative
expenses (SG&A)

Manufacturing and Non-
Manufacturing Costs Compared
Illustration 2.8 Product (or manufacturing) costs and period (or non-
manufacturing) costs compared

Period Costs Versus Product Cost
Illustration 2.9 Period costs in the front office, product costs in the factory

Cost Object
The cost object is the thing we are applying costs to – the

product, like a carton of orange juice, or the service, like a
haircut.

Direct Costs
• Direct costs are obvious components that can be easily
traced to the product or service:
 Direct Materials (DM)
 Direct Labor (DL)
• Obvious inputs are easy to trace, and their ease of
traceability is what makes a direct cost direct.
• Traceability from where to where? From the source of
direct materials and direct labor to the final product or
service.

Traceability of Direct Cost
Illustration 2.10 Direct costs of DM and DL are easily traced to the

final product

Indirect Costs
• Indirect costs are still product costs incurred in the
factory.
 Indirect costs are less obvious in the final product.
 Indirect costs are not easily traced to the final product.
• Indirect costs are the same as manufacturing overhead
(MOH).
• Both direct and indirect costs are necessary inputs in
manufacturing the product or rendering the service.

Let’s Walk Through It 2.7: Cost Terms
Direct Cost
For orange juice, the cost object is one carton, or one unit.
Of the product costs, which are direct and indirect?
Direct costs: Easily traced to the final product
• Direct materials (DM). Oranges, water, cartons, and
lids.
• Direct labor (DL). The workers who literally touch the
oranges, extract the pulp and juice, add water, stir the
mixture, bottle it, and package it for shipping. They
would use a variety of tools and machines for this but
also manual labor.

Indirect Costs
Indirect costs (manufacturing overhead or MOH): Still product costs
but not as easily traced to the final product:
• Depreciation on the factory if you own it.
• Rent on the factory if you don’t own it.
• Depreciation on factory machines and equipment.
• Property taxes on the factory.
• Insurance on the factory.
• Factory supervisors’ salaries.
• Utilities used in the factory to make a product.
• Repairs and maintenance on the machines and the factory itself.
• Factory supplies like hair nets and plastic gloves worn by workers.

Non-Manufacturing Cost
Any non-manufacturing costs associated with running the
business are period costs and would be grouped within
SG&A expenses on the income statement, as they are
immediately expensed as incurred.

Prime Cost & Conversion Cost
Primary Inputs:
Cost to convert raw materials into final product:

Prime Cost and Conversion Costs in
Action
Illustration 2.11 Prime costs and conversion costs in action

Learning Objective
1
Describe the basics of cost behavior within the
relevant range

Variable Costs
Variable costs are a constant cost per unit that change
in total with volume of activity (most commonly, the
number of units purchased, produced, or sold).

Managing Variable Costs
• Negotiate bulk purchases for discounts.
• Take advantage of cash payment discounts and/or
prompt payment discounts from the supplier.
• Change suppliers or alternate amongst suppliers.
• Modify the quality, or quantity of inputs used in
production.
• Change output/product size (but maintain price!)
• Minimize overtime hours where such hours are
discretionary.

Fixed Costs
• Fixed costs are fixed in total and do not change as
more units are made within the available capacity.
• While they are fixed in total, fixed costs per unit do
vary, based on how many units we make.

Fixed Cost Per Unit Example
While the cost of the entire pizza is fixed in total, the cost per
slice varies with the activity level, that is the number of units or
slices. As we spread fixed costs over more units, the fixed cost
per unit decreases.
Illustration 2.12 Fixed costs per slice decrease as the number of

slices increase

Managing Fixed Costs
Since we incur fixed costs to obtain our capacity,
cutting fixed costs means cutting capacity. Therefore,
managing fixed costs means:
• Not paying for larger facilities than your operation
needs, thereby keeping excess capacity – and
unnecessary fixed costs – to a minimum.
• Spreading existing fixed costs over the most units
possible, given the lesser of two natural limits: (1)
market demand and (2) existing capacity.
To reduce fixed costs to zero means going out of
business.
Fixed Costs on a Per-Unit Basis
• Fixed costs are fixed in total and are not safely
expressed on a per-unit basis.
• Once you express a fixed cost on a per-unit basis, it
looks like a variable cost.
• This can mislead some decision-makers.
• Anytime you see fixed costs expressed on a per-unit
basis, immediately look to see what activity level
you’ve been given.
• You can determine what fixed costs are in total to
use in problem-solving.

Learning Objective
1
Trace the flow of costs from the balance sheet to the
income statement.

Cost Flows Manufacturing
• A manufacturer converts assets (from RM
Inventory) to assets of higher value accounted for
in WIP Inventory and FG Inventory.
• Since our inventory assets have future benefit, they
reside on the balance sheet.
• But once inventory is sold, costs move to COGS to
accompany the sale.

Inventoriable Costs
Inventoriable costs, otherwise known as inventory, are short-
term assets that we expect to sell, use in the production
process, or employ in the delivery of services.
Illustration 2.14 Flow of goods triggers the flow of costs

Raw Materials Inventory
Purchase and transportation-in cost of raw materials is recorded
in the Raw Materials Inventory account on the balance sheet.
Illustration 2.15 Component costs of Raw Materials Inventory

Let’s Walk Through It 2.12: Raw Materials Inventory
Journal Entry
Say we have no beginning RM Inventory. If we then
make $5,000 in purchases (all direct materials), added
to the Raw Materials Inventory account, we would
make the following journal entry.
Debit Credit
RM Inventory $5,000
Accounts Payable $5,000

Let’s Walk Through It 2.12: Raw
Materials Inventory on Balance Sheet
If nothing else happened this
period, we’d have:
• $5,000 in RM Inventory on
the balance sheet.
• $0 in WIP Inventory on the
balance sheet, $0 in FG
Inventory on the balance
sheet, and $0 in COGS on the
income statement for the
period.

Materials Requisition
• To start production, a production supervisor creates
a materials requisition form showing the types of
materials and quantities requested to be released
for production.
• The requisition form asks for direct materials (DM)
to be released from the Direct Materials Inventory
account, a subledger of Raw Materials Inventory.
• Once DM have been removed from Raw Materials
Inventory, they go to the production floor.
• Costs follow, moving from Raw Materials Inventory
to WIP Inventory
Use of Direct Materials
• To trace costs of production, we have to identify the direct materials used.
• When we use direct materials, we take them out of the raw materials
storage area and move them to into the production area of our factory, or
WIP.
• Ending Direct Materials Inventory is the amount on hand at a point in time,
such as quarter-end or year-end.
• Direct materials used is the quantity used in the production process all
quarter or all year.

Let’s Walk Through It 2.13: Direct
Materials Used
Continuing with our orange juice example, consider the following
information. Note that you will have counted the beginning and ending
inventory to verify the amounts.
Beginning DM Inventory $0
Add Purchases $5,000
Less Ending DM Inventory $1,600
DM used so far this period $3,400
Our DM Inventory account lives within the larger RM Inventory account, and
calculating DM used would work like the T- account shown.

Work-in-Process Inventory
As physical goods move, costs move too.
• Direct labor and manufacturing overhead costs are
added to direct materials that are already in WIP
Inventory.
• You’ll also have the lights on in the factory, which is
MOH. Direct materials, along with direct labor and
manufacturing overhead, are all added to WIP
Inventory.
• During production, all product costs are added to
WIP Inventory.

Three Components of Costs Within WIP Inventory
Illustration 2.16 WIP Inventory includes direct materials, direct

labor, and manufacturing overhead

Let’s Walk Through It 2.14: Work-in-Process Inventory
Journal Entries
We had no beginning WIP Inventory, and the materials requisition
form requested $3,400 in DM, which were moved to production. This
period:
• Workers incurred DL costs of $2,500 on this production run.
• We incurred $1,000 in MOH for utilities.
Here are the journal entries to get us here:
Debit Credit
WIP Inventory 6,900
DM Inventory 3,400
Wages Payable 2,500
Utilities Payable 1,000

Let’s Walk Through It 2.14: Work-in-
Process Inventory on the Balance Sheet
If nothing else happened this period, we’d have:
• $1,600 ending balance in DM Inventory (a sub-
ledger of RM Inventory), which means $1,600 in
RM Inventory on the balance sheet.
• DM costs that were formerly in Raw Materials
Inventory have moved to WIP Inventory. We’ve also
added DL and MOH to WIP Inventory, which has an
ending balance of $6,900 right now.
• There would be no costs in FG Inventory on the
balance sheet, and none in COGS on the income
statement for the period.
Let’s Walk Through It 2.14: Work-in-Process Inventory
T-Account
Since we aren’t done making this
batch of OJ, we are still “in
process,” so the corresponding
costs on the balance sheet are
within WIP Inventory as well.

Finished Goods Inventory
• Once products are finished, no more costs are
added.
• Physical goods leave WIP Inventory and go to
Finished Goods Inventory.

Let’s Walk Through It 2.15: Finished Goods
Inventory Example
In our OJ example, we have no beginning FG Inventory. This
period, we finished goods with a total cost of $5,500 and moved
them out of WIP Inventory into FG Inventory. Remember, no
additional costs are added once goods are in FG Inventory.
• The cartons of juice, then placed in boxes on palettes, are
assets in FG Inventory on the balance sheet, simply waiting
to be sold to thirsty OJ drinkers.
• The items moved out of WIP Inventory into FG Inventory are
Cost of Goods Manufactured (COGM) since they were
completed this period. Past tense. Done being
manufactured.

Let’s Walk Through It 2.15: Finished Goods Inventory T-
Accounts

Let’s Walk Through It 2.15: Finished Goods Inventory
Journal Entry
This period we finished goods with a cost of $5,500, so here are
the related journal entry:
Debit Credit
FG Inventory $5,500
WIP Inventory $5,500

Let’s Walk Through It 2.15: Finished Goods
Inventory Summary
If nothing else happened this period, we’d have:
 $1,600 in ending RM Inventory on the balance sheet.
 DM costs that were formerly in RM Inventory have moved to
WIP Inventory. We’ve also added DL and MOH to WIP
Inventory.
 Since OJ costing $5,500 has been finished, those costs were
moved out of WIP Inventory, leaving it with an ending balance
of $1,400.
 The $5,500 costs moved from WIP Inventory to FG Inventory
on the balance sheet.
 At this moment, there are no costs in COGS on the income
statement for the period.

Let’s Walk Through It: Finished Goods
Inventory Partial Balance Sheet
The various inventory account balances are shown here.
RM Inventory $1,600
WIP Inventory 1,400
FG Inventory 5,500
Inventory $8,500

Let’s Walk Through It: Finished Goods
Inventory Constantly Moving
However, the factory is busy. As one batch is in process, another
one begins. Physical goods and costs are constantly moving
from one category to another. Right now:
 We are receiving more shipments of oranges from growers in
Florida, to be added to RM Inventory.
 Oranges and water are being retrieved from the raw materials
storage area to make more orange juice.
 Workers are peeling and squeezing oranges, and pouring
water, and costs are added to WIP Inventory.
 Some cartons of OJ are being finalized and wrapped for
shipping, so they’re moved from WIP Inventory to FG
Inventory

Cost of Goods Manufactured
• It’s the credit to WIP Inventory,
the items manufactured:
finished and moved to FG
Inventory this period
• It is a continuity of the costs
moved in and out of WIP
Inventory.
• It’s also the debit to FG
Inventory.
• Once complete, goods move
from WIP Inventory to FG Illustration 2.18 The credit to WIP Inventory
Inventory is COGM being moved to FG Inventory

Schedule of COGM
Cost of Goods Manufactured (COGM)
Beginning DM Inventory $ 0
+ DM purchases $5,000
− Ending DM Inventory 1,600
DM used $3,400
+ Direct labor 2,500
+ Manufacturing overhead 1,000
Total manufacturing costs 6,900
+ Beginning WIP Inventory 0
− Ending WIP Inventory 1,400
Cost of Goods Manufactured $5,500
Illustration 2.19 Schedule of COGM

COGM Formulas
COGM is also a component within cost of goods available for
sale, as shown in the following formula:
The schedule of COGM can be simplified to the following

formula:

Cost of Goods Sold (COGS)
• As finished goods are being sold, they’re physically
leaving the building and moving to the possession
and ownership of customers.
• This reduces the FG Inventory account and moves
costs to COGS on the income statement.
• No costs move to COGS until sales are made.

Schedules of COGS
Cost of Goods Sold—Manufacturer Cost of Goods Sold—Retailer

Beginning FG Inventory $ 0 Beginning Merchandise Inventory $ xx
Add: COGM 5,500 Add: Purchases xx
Cost of goods available for sale 5,500 Cost of goods available for sale xx
Less: Ending FG Inventory 300 Less: Ending Merchandise Inventory xx
Cost of Goods Sold $5,200 Cost of Goods Sold $xx
Illustration 2.20 Schedules of Cost of Goods Sold

Let’s Walk Through It 2.16: Cost of
Goods Sold Moving Costs
As the T-accounts on the next slide show, of the $5,500
goods in FG Inventory, we just sold goods with a cost
of $5,200, at a cash selling price of $7,000. This leaves
$300 in FG Inventory as an ending balance. As these OJ
cartons represent the first sales of the year, there’s no
beginning balance of COGS.

Let’s Walk Through It 2.16: Cost of Goods Sold
T-accounts
• Doing a simple continuity of the FG Inventory account

enables you to determine COGS.
• We determine beginning and ending FG Inventory by
physically counting it at the end of a period.

Goods Sold Journal Entries
Here are the journal entries :
Debit Credit
Cash $7,000
COGS $5,200
Sales $7,000
FG Inventory $5,200

Goods Sold Schedule
Amount
Beginning FG Inventory $0
Add: COGM 5,500
Cost of goods available for sale $5,500
Less: ending FG Inventory 300
Cost of Goods Sold $5,200

Full Costs
More inclusive than just product cost, full cost is the per-unit cost of all
activities in the company’s value chain.
• COGS (product costs) of $350
• SG&A (period costs) of $400
• Combined, this $750 represents a company’s full cost for its products.
• Assuming that 100 units were sold, full cost per unit must be ($750 ÷
100) $75.

Value Chain
The value chain includes value-added business functions:
variable and fixed costs of research and development,
design, supply, production, marketing, distribution, and
customer service.
Full cost is often used as the “all-in” basis for pricing
products and making other critical business decisions.

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Cost Accounting

Farmer and Fredin

Refresher on Cost Terms

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Term Definition Future Benefit? Examples

Illustration 2.5 Comparing expenses and costs

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Period costs encompass most costs on the income

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The cost object is the thing we are applying costs to – the

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Illustration 2.10 Direct costs of DM and DL are easily traced to the

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Cost to convert raw materials into final product:

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Illustration 2.11 Prime costs and conversion costs in action

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Illustration 2.12 Fixed costs per slice decrease as the number of

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Illustration 2.14 Flow of goods triggers the flow of costs

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Illustration 2.15 Component costs of Raw Materials Inventory

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Illustration 2.16 WIP Inventory includes direct materials, direct

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