An Introduction To Cost Terms and Purposes

An Introduction to Cost Terms and Purposes
© 2009 Pearson Prentice Hall. All rights reserved.

Basic Cost Terminology
Cost – sacrificed resource to achieve a specific
objective
Actual cost – a cost that has occurred
Budgeted cost – a predicted cost
Cost object – anything of interest for which a cost
is desired

2
Cost Object Examples at BMW
Cost Object Illustration
Product BMW X 5 sports activity vehicle
Service Dealer-support telephone hotline
Project R&D project on DVD system enhancement
Herb Chambers Motors, a dealer that

Customer purchases a broad range of BMW vehicles
Activity Setting up production machines
Department Environmental, Health & Safety

3
Basic Cost Terminology
Cost accumulation – a collection of cost data in an
organized manner
Cost assignment – a general term that includes
gathering accumulated costs to a cost object.
This includes:
 Tracing accumulated costs with a direct relationship to
the cost object and
 Allocating accumulated costs with an indirect relationship
to a cost object

4
Direct & Indirect Costs
Direct costs – can be conveniently and economically
traced (tracked) to a cost object
Indirect costs – cannot be conveniently or
economically traced (tracked) to a cost object.
Instead of being traced, these costs are allocated to a cost
object in a rational and systematic manner

5
BMW: Assigning Costs to a Cost Object

6
Cost Examples
Direct Costs
Parts
Assembly line wages

Indirect Costs
Electricity
Rent
Property taxes

7
Factors Affecting Direct / Indirect Cost
Classification
Cost Materiality
Availability of information-gathering technology
Operational Design

8
Cost Behavior
Variable costs – changes in total in proportion to
changes in the related level of activity or volume.
Fixed costs – remain unchanged in total regardless
of changes in the related level of activity or volume.
Costs are fixed or variable only with respect to a
specific activity or a given time period

9
Cost Behavior, continued
Variable costs – are constant on a per-unit basis. If
a product takes 5 pounds of materials each, it stays
the same per unit regardless of one, ten or a
thousand units are produced.
Fixed costs – change inversely with the level of

production. As more units are produced, the same
fixed cost is spread over more and more units,
reducing the cost per unit.

10
Cost Behavior Summarized
Total Dollars
Total Dollars Cost per
Per Unit
Unit
Change in
Change in
proportion with
proportion with Unchanged in
Variable
Variable Costs output
output relation to output
Costs Moreoutput
output ==More cost
More More
cost Change inversely
Change inversely
Fixed Unchanged in with
with output
output
Unchanged in More output = lower
Fixed
CostsCosts relation to output More output = lower cost
cost
relation to output per unit
per unit

11
Cost Behavior Visualized

12
Other Cost Concepts
Cost Driver – a variable that causally affects costs
over a given time span.
Relevant Range – the band of normal activity level

(or volume) in which there is a specific relationship
between the level of activity (or volume) and a given
cost.
For example,
example fixed costs are considered fixed only within
the relevant range.

13
Relevant Range Visualized

14
A Cost Caveat
Unit costs should be used cautiously. Since unit
costs change with a different level of output or
volume, it may be more prudent to base decisions on
a total dollar basis.
Unit costs that include fixed costs should always
reference a given level of output or activity.
Unit Costs are also called Average Costs.

15
Multiple Classification of Costs
Costs may be classified as:
Direct / Indirect, and
Variable / Fixed
These multiple classifications give rise to

important cost combinations:
Direct & Variable
Direct & Fixed
Indirect & Variable
Indirect & Fixed

16
Multiple Classification of Costs,
Visualized

17
Different Types of Firms
Manufacturing-sector companies – create and sell
their own products

Merchandising-sector companies– product resellers
Service-sector companies – provide services
(intangible products)

18
Types of Manufacturing Inventories
Direct Materials – resources in-stock and available
for use.
Work-in-Process (or progress) – products started
but not yet completed. Often abbreviated as WIP.
WIP
Finished Goods – products completed and ready for
sale.

19
Types of Product Costs
Also known as Inventoriable Costs
Direct Materials
Direct Labor
Indirect Manufacturing – factory costs that are not
traceable to the product. Other common names for

this type of cost include Manufacturing Overhead
costs or Factory Overhead costs.
costs

20
Accounting Distinction Between
Costs
Inventoriable costs – product manufacturing costs.
These costs are capitalized as assets (inventory) until
they are sold and transferred to Cost of Goods Sold.
Period costs– have no future value and are

expensed as incurred.

21
Cost Flows
The Cost of Goods Manufactured and the Cost of
Goods Sold section of the Income Statement are
accounting representations of the actual flow of
costs through a production system.
Note the importance of inventory accounts in the

following accounting reports, and in the cost flow chart

22
Cost Flows Visualized

23
Cost of Goods Manufactured

24
Multiple-Step Income Statement

25
Other Cost Considerations
Prime cost is a term referring to all direct
manufacturing costs (labor and materials)

Conversion cost is a term referring to direct labor and
factory overhead costs, collectively

Overtime labor costs are considered part of overhead
due to the inability to precisely know the true cause of

these costs

26
Different Definitions of Costs for
Different Applications
Pricing and product-mix decisions – may use a
“super” cost approach (comprehensive).
Contracting with government agencies – very
specific definitions of cost for “cost plus profit”
contracts.
Preparing external-use financial statements –
GAAP-driven product costs only.

27
Different Definitions of Costs for
Different Applications

28
3 Common Features of Cost Accounting
& Cost Management
1. Calculating the cost of products, services, and
other cost objects.
2. Obtaining information for planning & control,
and performance evaluation.
3. Analyzing the relevant information for making
decisions.

29
30
31
Managerial Accounting
Sixteenth Edition
Chapter 1
Managerial
Accounting and
Cost Concepts
© McGraw-Hill Education. All rights

© 2009reserved.
PearsonAuthorized only for
Prentice Hall. instructor
All rights use in the classroom. No reproduction or
reserved.
further distribution permitted without the prior written consent of McGraw-Hill Education.
Needs of Management
Financial accounting is concerned with
reporting financial information to external
parties, such as stockholders, creditors, and
regulators.
Managerial accounting is concerned with
providing information to managers within an
organization so that they can formulate plans,
control operations, and make decisions.

© McGraw-Hill Education. 1-33
Purposes of Cost Classification
1.Assigning costs to cost objects
2.Accounting for costs in manufacturing
companies
3.Preparing financial statements
4.Predicting cost behavior in response to
changes in activity
5.Making decisions

Learning Objective 1
Understand cost classifications used for
assigning costs to cost objects: direct costs and
indirect costs.

Assigning Costs to Cost Objects (1
of 2)
Direct costs
 Costs that can be
easily and conveniently traced to a unit of
product or other cost object.
 Examples: direct material and direct labor
Indirect costs
 Costs that cannot be easily and conveniently
traced to a unit of product or other cost
object.
 Example: manufacturing overhead

Assigning Costs to Cost Objects (2
of 2)
Common costs
 Indirect costs incurred to support a number of
cost objects. These costs cannot be traced to
any individual cost object.

Identify and give examples of each of the three
basic manufacturing cost categories.

Classifications of Manufacturing Costs
Direct Materials
Direct Labor
Manufacturing Overhead

Direct Materials
Direct materials are raw materials that
become an integral part of the product and
that can be conveniently traced directly to it.
Example: A radio installed in an
automobile

Direct Labor
Direct labor costs are those labor costs that
can be easily traced to individual units of
product.
Example: Wages paid to automobile
assembly workers

Manufacturing Overhead
Manufacturing overhead includes all
manufacturing costs except direct material
and direct labor. These costs cannot be
readily traced to finished products.
 Includes indirect materials that cannot be
easily or conveniently traced to specific units
of product.
 Includes indirect labor costs that cannot be
easily or conveniently traced to specific units
of product.

Manufacturing Overhead – Examples
Examples of manufacturing overhead:
 Depreciation of manufacturing equipment
 Utility costs
 Property taxes
 Insurance premiums incurred to operate a
manufacturing facility
Only those indirect costs associated with
operating the factory are included in
manufacturing overhead.

Prime Costs and Conversion Costs
Manufacturing costs are often
classified as follows:
Prime Cost
 Direct Material
 Direct Labor
Conversion Cost
– Direct Labor
– Manufacturing Overhead

Nonmanufacturing Costs
Selling Costs
– Costs necessary to secure the order and deliver
the product. Selling costs can be either direct or
indirect costs.
Administrative Costs
– All executive, organizational, and clerical costs.
Administrative costs can be either direct or
indirect costs.

Understand cost classifications used to prepare
financial statements: product costs and period
costs.

Product Costs
Product costs includes all the costs that are
involved in acquiring or making a product.
Product costs “attach” to a unit of product as
it is purchased or manufactured and they stay
attached to each unit of product as long as it
remains in inventory awaiting sale.

Manufacturing Product Costs
For manufacturing companies, product costs
include:
Raw materials: includes any materials that
go into the final product.
Work in process: consists of units of
product that are only partially complete and
will require further work before they are ready
for sale to the customer.
Finished goods costs: consists of completed
units of product that have not yet been sold
to customers.
Transfer of Product Costs
When direct materials are used in production,
their costs are transferred from Raw Materials to
Work in Process.
Direct labor and manufacturing overhead costs
are added to Work in Process to convert direct
materials into finished goods.
Once units of product are completed, their costs
are transferred from Work in Process to Finished
Goods.
When a manufacturer sells its finished goods to
customers, the costs are transferred from
Finished Goods to Cost of Goods Sold.
Cost Classifications for Preparing
Financial Statements (1 of 2)
Product costs include direct materials, direct
labor, and manufacturing overhead.

Cost Classifications for Preparing
Financial Statements (2 of 2)
Period costs include all selling costs and
administrative costs.

Quick Check 1
Which of the following costs would be considered a
period rather than a product cost in a manufacturing
company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production facility.
E. Sales commissions.

Quick Check 1a
Which of the following costs would be considered a
period rather than a product cost in a manufacturing
company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production facility.
E. Sales commissions.
Answer: B,E

Understand cost classifications used to predict

cost behavior: variable costs, fixed costs, and
mixed costs.

Cost Classifications for Predicting Cost
Behavior
Cost behavior refers to how a cost will react to
changes in the level of activity.
The most common classifications are:
 Variable costs.
 Fixed costs.
 Mixed costs.

Variable Cost
A cost that varies, in total, in direct proportion
to changes in the level of activity.
A variable cost per unit is constant.

An Activity Base (Cost Driver)
A measure of what causes the incurrence of a
variable cost
 Units produced
 Machine hours
 Miles driven
 Labor hours

Fixed Cost
A cost that remains constant, in total,
regardless of changes in the level of the
activity.
If expressed on a per unit basis, the average
fixed cost per unit varies inversely with
changes in activity.

Types of Fixed Costs
Committed
 Long-term, cannot be significantly reduced in
the short term
Discretionary
 May be altered in the short-term by current
managerial decisions

The Linearity Assumption and the
Relevant Range
A straight line closely approximates a curvilinear

variable cost line within the relevant range.

Fixed Costs and the Relevant Range
The relevant range of activity pertains to fixed
cost as well as variable costs. For example,
assume office space is available at a rental rate
of $30,000 per year in increments of 1,000
square feet.
Fixed costs would increase in a step fashion at
a rate of $30,000 for each additional 1,000
square feet.

Relevant Range: Graphic
The relevant range of activity for a fixed cost is the

range of activity over which the graph of the cost is
flat.

Comparison of Cost Classifications for
Predicting Cost Behavior
Behavior of Cost (within the relevant range)
Cost In Total Per Unit
Total variable cost Increase and

Variable cost per unit
Variable decrease in proportion to changes in
remains constant.
the activity level.
Fixed cost per unit

Total fixed cost is not affected by
decreases as the activity
Fixed changes in the activity level within
level rises and increases
the relevant range.
as the activity level falls.

Quick Check 2
Which of the following costs would be variable with
respect to the number of ice cream cones sold at a
Baskin & Robbins? (There may be more than one
correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.

Quick Check 2a
Which of the following costs would be variable with
respect to the number of ice cream cones sold at a
Baskin & Robbins? (There may be more than one
correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
Answer: C,D

Mixed Costs – Part 1
A mixed cost contains both variable and fixed
elements. Consider the example of utility cost.

Mixed Costs – Part 2
The total mixed cost line can be expressed as an
equation: Y = a + bX
Where:
Y = The total mixed cost.
a = The total fixed cost (the vertical intercept of
the line).
b = The variable cost per unit of activity (the
slope of the line).
X = The level of activity.

Mixed Costs – An Example
If your fixed monthly utility charge is $40, your
variable cost is $0.03 per kilowatt hour, and
your monthly activity level is 2,000 kilowatt
hours, what is the amount of your utility bill?
Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100

Understand cost classifications used in making
decisions: differential costs, sunk costs, and
opportunity costs.

Cost Classifications for Decision
Making
Decisions involve choosing between
alternatives. The goal of making decisions is
to identify those costs that are either relevant
or irrelevant to the decision.
To make decisions, it is essential to have a
grasp on three concepts: differential costs,
sunk costs, and opportunity costs.

Differential Costs
Differential costs (or incremental costs) are
the difference in cost between any two
alternatives.
A difference in revenue between two
alternatives is called differential revenue.
Both are always relevant to decisions.
Differential costs can be either fixed or
variable.

Sunk Costs
Sunk costs have already been incurred and
cannot be changed now or in the future.
These costs should be ignored when making
decisions.

Opportunity Cost
The potential benefit that is given up when
one alternative is selected over another.
These costs are not usually found in
accounting records but must be explicitly
considered in every decision.
For students: What is the opportunity cost you
incur by attending class?

Quick Check 3
Suppose you are trying to decide whether to drive
or take the train to Portland to attend a concert.
You have ample cash to do either, but you don’t
want to waste money needlessly. Is the cost of the
train ticket relevant in this decision? In other
words, should the cost of the train ticket affect the
decision of whether you drive or take the train to
Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.

Quick Check 3a
want to waste money needlessly. Is the cost of the
train ticket relevant in this decision? In other
words, should the cost of the train ticket affect the
decision of whether you drive or take the train to
Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.
Answer: A

Quick Check 4
want to waste money needlessly. Is the annual cost
of licensing your car relevant in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.

Quick Check 4a
want to waste money needlessly. Is the annual cost
of licensing your car relevant in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
Answer: B

Quick Check 5
Suppose that your car could be sold now for
$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.

Quick Check 5a
Suppose that your car could be sold now for
$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.
Answer: B

Prepare income statements for a merchandising
company using the traditional and contribution
formats.

The Traditional and Contribution
Formats
Traditional Format Contribution Format
Sales $ 100,000 Sales $ 100,000
Cost of goods sold 70,000 Variable expenses 60,000
Gross margin $ 30,000 Contribution margin $ 40,000
Selling & admin.
20,000 Fixed expenses 30,000
expense
Net operating income $ 10,000 Net operating income $ 10,000
Traditional Format  Used primarily for

external reporting.
Contribution Format  Used primarily by
management.

Uses of the Contribution Format
The contribution income statement format is used
as an internal planning and decision-making tool.
We will use this approach for:
1.Cost-volume-profit analysis (Chapter 5).
2.Segmented reporting of profit data (Chapter 6).
3.Budgeting (Chapter 8).
4.Special decisions such as pricing and make-or-
buy analysis (Chapter 12).


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© 2009 Pearson Prentice Hall. All rights reserved.

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Product BMW X 5 sports activity vehicle

Service Dealer-support telephone hotline

Project R&D project on DVD system enhancement

Herb Chambers Motors, a dealer that

Activity Setting up production machines

Department Environmental, Health & Safety

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

Assembly line wages

© 2009 Pearson Prentice Hall. All rights reserved.

Availability of information-gathering technology

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

Fixed costs – change inversely with the level of

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

Relevant Range – the band of normal activity level

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

These multiple classifications give rise to

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

their own products

Service-sector companies – provide services

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

Indirect Manufacturing – factory costs that are not

traceable to the product. Other common names for

© 2009 Pearson Prentice Hall. All rights reserved.

Period costs– have no future value and are

© 2009 Pearson Prentice Hall. All rights reserved.

Note the importance of inventory accounts in the

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

manufacturing costs (labor and materials)

factory overhead costs, collectively

due to the inability to precisely know the true cause of

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© McGraw-Hill Education. All rights

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.

© 2009 Pearson Prentice Hall. All rights reserved.