CHAPTER 2

Cost Concepts

Prepared by
Rodney Delcourt,
CPA (CMA)
Algonquin College
School of Business
 Learning Objectives

1. Understand cost classification by behaviour.

2. Understand cost classification by traceability.
3. Understand cost classification by relevance.
4. Understand cost classification by function.
5. Prepare financial reports.
6. Understand and prepare manufacturing reports.

© 2020 McGraw-Hill Limited 2

 Cost Classifications by
Behaviour

How
How aa cost
cost will
will react
react to
to changes
changes inin
the
the level
level of
of business
business activity:
activity:
Total

Total variable
variable costs
costs change
change when
when
activity
activity changes.
changes.
Total

Total fixed
fixed costs
costs remain
remain unchanged
unchanged
when
when activity
activity changes.
changes.

© 2020 McGraw-Hill Limited 3

 Variable Costs

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 Fixed Costs

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 Cost Classifications for
Predicting Cost Behaviour
Behavior of Cost (within the relevant range)
Cost In Total Per Unit
Variable Total variable cost Variable cost per unit
changes as activity remains the same over
level changes. wide ranges of activity.
Fixed Total fixed cost Fixed cost per unit goes
remains the same down as activity level
even when the goes up.
activity level
changes.

© 2020 McGraw-Hill Limited 6

 Quick Check 
Which of the following costs would
be variable with respect to the
number of cones sold at a Baskins
& Robbins shop? (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.

© 2020 McGraw-Hill Limited 7

 Quick Check Solution 
Which of the following costs would be
variable with respect to the number
of cones sold at a Baskins & Robbins
shop? (There may be more than one
correct answer.)
C. The cost of ice cream.
D. The cost of napkins for customers.

© 2020 McGraw-Hill Limited 8

 Quick Check 

Which of the following costs would be

variable with respect to the number
of people who buy a ticket for a show
at a movie theatre? (There may be
more than one correct answer.)
A. The cost of renting the film.
B. Royalties on ticket sales.
C. Wage and salary costs of theatre employees.
D. The cost of cleaning up after the show.

© 2020 McGraw-Hill Limited 9

 Quick Check Solution 
Which of the following costs would be
variable with respect to the number of
people who buy a ticket for a show at a
movie theatre? (There may be more
than one correct answer.)

B. Royalties on ticket sales.

C. Wage and salary costs of theatre employees.

© 2020 McGraw-Hill Limited 10

 Cost Classifications by
Traceability

How
How costs
costs are
are assigned
assigned to
to Cost
Cost Objects:
Objects:
Cost

Cost Object:
Object: Anything
Anything for
for which
which cost
cost
information
information isis desired
desired (department,
(department,
division,
division, product,
product, product
product line,
line, etc).
etc).

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 Direct and Indirect Costs

Direct costs Indirect costs

 Costs that can be  Costs cannot be
easily and easily and
economically traced economically traced
to a unit of product to a unit of product
or other cost or other cost object.
object.  Example:
 Examples: direct manufacturing
material and direct overhead
labour

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 Direct and Indirect Costs of
an individual flight

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 Cost Classifications by
Relevance

Relevant

Relevant Costs:
Costs: Decision
Decision makers
makers must
must
only
only use
use costs
costs that
that are
are relevant
relevant to
to the
the
individual
individual decision.
decision.

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 Relevant Costs

 Every decision involves a choice from

among at least two alternatives.
 Only those costs and benefits that differ
between alternatives (i.e., differential
costs and benefits) are relevant in a
decision. All other costs and benefits can
and should be ignored.

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 Differential Costs and Revenues
Costs and revenues that differ among alternatives.

Retailer Distribution Online Selling Differential Costs and

(current) (proposed) Revenues
Revenues (V)* $700,000 $800,000 $100,000

Cost of goods sold (V) 350,000 400,000 50,000

Advertising (F) 80,000 115,000 35,000

Warehouse depreciation
50,000 80,000 30,000
(F)
Other expenses (F) 60,000 60,000 –0–

Total 540,000 655,000 115,000

Net income $160,000 $145,000 $(15,000)

*V = Variable; F = Fixed.

In the decision to move from current method of selling to online

selling (proposed), there is a negative net income effect of
$15,000.
© 2020 McGraw-Hill Limited 16
 Quick Check 
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 pizza
you ate last night relevant in this decision?
In other words, should the cost of the pizza
affect the decision of whether you drive or
take the train to Portland?
A. Yes, the cost of the pizza is relevant.
B. No, the cost of the pizza is not relevant.

© 2020 McGraw-Hill Limited 17

 Quick Check Solution 
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 pizza you ate last night
relevant in this decision? In other words,
should the cost of the pizza affect the
decision of whether you drive or take the
train to Portland?

B. No, the cost of the pizza is not relevant.

© 2020 McGraw-Hill Limited 18

 Quick Check 
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.

© 2020 McGraw-Hill Limited 19

 Quick Check Solution 

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.

© 2020 McGraw-Hill Limited 20

 Quick Check 
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 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.

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 Quick Check Solution 

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 annual cost of licensing your car relevant
in this decision?

B. No, the licensing cost is not relevant.

© 2020 McGraw-Hill Limited 22

 Quick Check 

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 depreciation on your car
relevant in this decision?
A. Yes, the depreciation is relevant.
B. No, the depreciation is not relevant.

© 2020 McGraw-Hill Limited 23

 Quick Check Solution 
Suppose you are trying to decide whether to
drive or take the train to Portland to attend
a concert. You have ample cash Depreciation that
to do either,
is a function
but you don’t want to waste money of kilometres
drivenon
needlessly. Is the depreciation would
yourbe
carrelevant.
relevant in this decision?
A. Yes, the depreciation is relevant.
B. No, the depreciation is not relevant.
Depreciation that is a
function of the passage of
time would not be relevant.

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 Opportunity Costs

The potential benefit that is given up 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.

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 Sunk Costs

Sunk costs cannot be changed by any decision.

They are not differential costs and should be
ignored when making decisions.

Example: You bought an automobile that cost

$10,000 two years ago. The $10,000 cost is sunk
because whether you drive it, park it, trade it, or
sell it, you cannot change the $10,000 cost.

© 2020 McGraw-Hill Limited 26

 Quick Check 

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.

© 2020 McGraw-Hill Limited 27

 Quick Check Solution 

Suppose that your car could be sold

now for $5,000. Is this a sunk cost?

B. No, it is not a sunk cost.

© 2020 McGraw-Hill Limited 28

 Cost Classifications by
Function

Value

Value Chain:
Chain: The
The series
series of
of steps
steps that
that
every
every organization
organization carries
carries out
out to
to fulfill
fulfill
its
its mission.
mission. The
The activities
activities within
within these
these
steps
steps are
are performed
performed by by the
the various
various
functions
functions within
within the
the organization.
organization.

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 Value Chain

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 Comparing Merchandising and
Manufacturing Activities
Merchandisers . . . Manufacturers . . .
 Buy finished goods.  Buy raw materials.
 Sell finished goods.  Produce and sell finished
goods.

MegaLoMart

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 Manufacturing Costs
Direct
Direct
Direct
Direct Labour
Labour
Materials
Materials
Manufacturing
Manufacturing
Overhead
Overhead

The Product

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 Direct Materials
Those materials that become an
integral part of the product and
that can be easily and
economically traced directly to
it.

Example:
Example: metals
metals used
used to
to make
make
the
the automobile’s
automobile’s bodywork
bodywork

The Product
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 Direct Labour
Those labour costs that can be
easily and economically traced
to individual units of product.

Example:
Example: Wages
Wages paid
paid
to
to the
the automobile
automobile
assembly
assembly workers
workers

The Product
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 Manufacturing Overhead

Manufacturing costs that cannot be easily and economically

traced directly to specific units produced.

Indirect
Indirect labour,
labour, indirect
indirect materials
materials &
& costs
costs incurred
incurred to
to run
run factory
factory

Wages paid to employees

who are not directly
involved in production
work.
Examples: maintenance
workers, janitors and
security guards.
© 2020 McGraw-Hill Limited
Costs incurred to run
Materials used to the factory
support the Examples: rent,
production process. utilities, maintenance
Examples: lubricants
and cleaning supplies
used in the cane
assembly plant.
35
 Classifications of Costs

Manufacturing costs are often

classified as follows:

Direct
Direct Direct
Direct Manufacturing
Manufacturing
Material
Material Labour
Labour Overhead
Overhead

Prime Conversion
Cost Cost

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 Non-Manufacturing Costs
Marketing and selling Administrative costs . . .
costs . . .  Costs associated
 Costs incurred to with the general
secure orders, management of
deliver the the company. All
products to executive,
customers and organizational,
follow up with and clerical costs.
them.  Examples: Company
 Examples: advertising, president’s salary,
sales commissions and office supplies
salaries

© 2020 McGraw-Hill Limited 37

 Quick Check 

Which of the following costs would be

considered manufacturing overhead
at Boeing? (More than one answer
may be correct.)
A. Depreciation on factory forklift trucks.
B. Sales commissions.
C. The cost of a flight recorder in a Boeing 767.
D. The wages of a production shift supervisor.

© 2020 McGraw-Hill Limited 38

 Quick Check Solution 

Which of the following costs would

be considered manufacturing
overhead at Boeing? (More than one
answer may be correct.)
A. Depreciation on factory forklift trucks.

D. The wages of a production shift supervisor.

© 2020 McGraw-Hill Limited 39

 Product Costs vs Period Costs

Product costs include Period costs are not

direct materials, direct
labour, and
manufacturing overhead.
Inventory
included in product
costs. They are expensed
on the income
statement.
Cost of Goods Sold Expense

Sale

Balance Income Income

Sheet Statement Statement

© 2020 McGraw-Hill Limited 40

 Quick Check 
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.

© 2020 McGraw-Hill Limited 41

 Quick Check Solution 

Which of the following costs would

be considered a period rather than
a product cost in a manufacturing
company?

B. Property taxes on corporate headquarters.

© 2020 McGraw-Hill Limited 42

 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

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 Balance Sheet -
Manufacturer

Current Assets
 Cash
 Receivables Materials waiting to
be processed.
 Prepaid Expenses
 Inventories
Partially complete products
Raw Materials
– some material, labour, or
Work in Process
overhead has been added.
Finished Goods

Completed products
awaiting sale.

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 The Income Statement
Cost of goods sold for manufacturers differs only slightly
from cost of goods sold for merchandisers.

Merchandising Company Manufacturing Company

Cost of goods sold: Cost of goods sold:
Beg. merchandise Beg. finished
inventory $ 14,200 goods inv. $ 14,200
+ Purchases 234,150 + Cost of goods
Goods available manufactured 234,150
for sale $ 248,350 Goods available
- Ending for sale $ 248,350
merchandise - Ending
inventory (12,100) finished goods
= Cost of goods inventory (12,100)
sold $ 236,250 = Cost of goods
sold $ 236,250
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 Quick Check 

Which of the following transactions

would immediately result in an
expense? (There may be more than
one correct answer.)
A. Work in process is completed.
B. Finished goods are sold.
C. Raw materials are placed into production.
D. Administrative salaries are incurred and paid.

© 2020 McGraw-Hill Limited 46

 Quick Check Solution 

Which of the following transactions

would immediately result in an
expense? (There may be more than
one correct answer.)

B. Finished goods are sold.

D. Administrative salaries are incurred and paid.

© 2020 McGraw-Hill Limited 47

 Inventory Flows

Generic cost flow through an inventory account

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 Inventory Flows
Beginning
Beginning Additions
Additions Available
Available
balance
balance + $$$
$$$
= $$$$$
$$$$$
$$
$$

Then...

Available
Available _ Withdrawals
Withdrawals
Ending
Ending
$$$$$
$$$$$ $$$
$$$
= balance
balance
$$
$$

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 Quick Check 
If your bank balance at the beginning
of the month was $1,000, you
deposited $100 during the month,
and withdrew $300 during the
month, what would be the balance
at the end of the month?
A. $1,000
B. $800
C. $1,200
D. $200

© 2020 McGraw-Hill Limited 50

 Quick Check Solution 

If your bank balance at the beginning of

the month was $1,000, you deposited
$100 during the month, and withdrew
$300 during the month, what would be
the balance at the end of the month?
$1,000 + $100 = $1,100
B. $800 $1,100 - $300 = $800

© 2020 McGraw-Hill Limited 51

 Inventory Cost Flows and
Cost of Goods Sold

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 Schedule of Cost of
Goods Manufactured

*
*

* $410,000 + 60,000 + 350,000 = $820,000

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 Product Costs: A Closer Look
Manufacturing Cost Flows

© 2020 McGraw-Hill Limited 54

 Product Costs: A Closer Look
at Raw Materials Part 1
Manufacturing Work
Raw Materials Costs In Process

Beginning raw
materials inventory

Beginning
Beginning inventory
inventory
is
is the
the inventory
inventory
carried
carried overover from
from
the
the prior
prior period.
period.

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 Product Costs: A Closer Look
at Raw Materials Part 2
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials

materials inventory
+ Raw materials
purchased
= Raw materials
available for use As
As items
items are
are removed
removed from
from raw
raw
in production
– Ending raw materials
materials
materials inventory
inventory and
and placed
placed into
into
inventory the
the production
production process,
process, they
they are
are
= Raw materials used called
called direct
direct materials.
materials.
in production

© 2020 McGraw-Hill Limited 56

 Quick Check 
Beginning raw materials inventory was
$32,000. During the month, $276,000 of raw
material was purchased. A count at the end
of the month revealed that $28,000 of raw
material was still present. What is the cost
of direct material used?
A. $276,000
B. $272,000
C. $280,000
D. $2,000

© 2020 McGraw-Hill Limited 57

 Quick Check Solution 
Beginning raw materials inventory was $32,000. During
the month, $276,000 of raw material was purchased. A
count at the end of the month revealed that $28,000 of
raw material was still present. What is the cost of
direct material used?
A. $276,000
Beg. raw materials $ 32,000
B. $272,000 + Raw materials
purchased 276,000
C. $280,000 = Raw materials available
for use in production $ 308,000
D. $2,000 – Ending raw materials
inventory 28,000
= Raw materials used
in production $ 280,000

© 2020 McGraw-Hill Limited 58

 Product Costs: A Closer Look
at Conversion Costs
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials

materials inventory + Direct labour
+ Raw materials + Mfg. overhead
purchased = Total manufacturing
= Raw materials costs
available for use
in production
– Ending raw materials
inventory
= Raw materials used
in production

© 2020 McGraw-Hill Limited 59

 Product Costs: A Closer Look
at Conversion Costs Part 2
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials Conversion

Conversion
materials inventory + Direct labour costs
costs are
are costs
costs
+ Raw materials + Mfg. overhead
incurred
incurred to to
purchased = Total manufacturing
= Raw materials costs convert
convert thethe
available for use direct
direct material
material
in production into
into aa finished
finished
– Ending raw materials
inventory
product.
product.
= Raw materials used
in production

© 2020 McGraw-Hill Limited 60

 Quick Check 
Direct materials used in production
totaled $280,000. Direct labour was
$375,000 and factory overhead was
$180,000. What were total
manufacturing costs incurred for the
month?
A. $555,000
B. $835,000
C. $655,000
D. Cannot be determined.

© 2020 McGraw-Hill Limited 61

 Quick Check Solution 
Direct materials used in production
totaled $280,000. Direct labour was
$375,000 and factory overhead was
$180,000. What were total manufacturing
costs incurred for the month?
A. $555,000 Direct Materials $ 280,000
+ Direct Labour 375,000
B. $835,000 + Mfg. Overhead 180,000
= Mfg. Costs Incurred
C. $655,000 for the Month $ 835,000

D. Cannot be determined.

© 2020 McGraw-Hill Limited 62

 Product Costs: A Closer Look
at WIP Inventory Part 1
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials Beginning work in

materials inventory + Direct labour process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials
inventory
All
All manufacturing
manufacturing costs
costs incurred
incurred
= Raw materials used during
during the
the period
period are
are added
added toto the
the
in production beginning
beginning balance
balance of
of work
work inin process.
process.

© 2020 McGraw-Hill Limited 63

 Product Costs: A Closer Look
at WIP Inventory Part 2
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials Beginning work in

materials inventory + Direct labour process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending work in
process inventory
Costs
Costs associated
associated with
with the
the goods
goods = Cost of goods
that
that are
are completed
completed during
during the
the manufactured.

period
period are
are transferred
transferred toto
finished
finished goods
goods inventory.
inventory.

© 2020 McGraw-Hill Limited 64

 Quick Check 
Beginning work in process was $125,000.
Manufacturing costs incurred for the month
were $835,000. There were $200,000 of
partially finished goods remaining in work in
process inventory at the end of the month.
What was the cost of goods manufactured
during the month?
A. $1,160,000
B. $910,000
C. $760,000
D. Cannot be determined.

© 2020 McGraw-Hill Limited 65

 Quick Check Solution 
Beginning work in process was $125,000.
Manufacturing costs incurred for the month were
$835,000. There were $200,000 of partially finished
goods remaining in work in process inventory at the
end of the month. What was the cost of goods
manufactured during the month?
A. $1,160,000
B. $910,000 Beginning work in

C. $760,000
process inventory $ 125,000
+ Mfg. costs incurred
for the period
D. Cannot be determined.
835,000
= Total work in process
during the period $ 960,000
– Ending work in
process inventory 200,000
= Cost of goods
manufactured $ 760,000

© 2020 McGraw-Hill Limited 66

 Product Costs: A Closer Look at
Cost of Goods Manufactured
Work
In Process Finished Goods

Beginning work in Beginning finished

process inventory goods inventory
+ Manufacturing costs + Cost of goods
for the period manufactured
= Total work in process = Cost of goods
for the period available for sale
– Ending work in - Ending finished
process inventory goods inventory
= Cost of goods Cost of goods
manufactured sold

© 2020 McGraw-Hill Limited 67

 Quick Check 
Beginning finished goods inventory was
$130,000. The cost of goods manufactured for
the month was $760,000. And the ending
finished goods inventory was $150,000. What
was the cost of goods sold for the month?
A. $20,000
B. $740,000
C. $780,000
D. $760,000

© 2020 McGraw-Hill Limited 68

 Quick Check Solution 

Beginning finished goods inventory was

$130,000. The cost of goods manufactured for
the month was $760,000. And the ending
finished goods inventory was $150,000. What
was the cost of goods sold for the month?

B. $740,000 $130,000 + $760,000 = $890,000

$890,000 - $150,000 = $740,000

© 2020 McGraw-Hill Limited 69

 Chapter Summary
 Costs can be classified in many ways depending on the
information that a manager needs.
 While the income statements look similar for
merchandising and manufacturing companies, the cost
of goods sold calculation is different. This is because
manufacturing companies make their products whereas
merchandising companies buy the products they sell.
 Manufacturing companies must calculate the cost of
goods completed by preparing a schedule of cost of
goods manufactured. This schedule includes: direct
material used, direct labor and manufacturing overhead
along with an analysis of WIP inventory.

© 2020 McGraw-Hill Limited 70