Product Costing Systems:
Concepts and Design Issues
Chapter 2
What is the Cost?
Several years ago you purchased a bottle
of wine for $25. Today it is worth $75. If
you give the bottle to a friend as a gift,
what is the cost of your gift?
$0
$25
$25+
$75
($50)
Cost Objects
Anything whose cost we want to determine
Product, process, location, person, region, etc.
Whether a cost is direct or indirect
depends on the cost object
As cost object becomes more detailed, fewer
costs are directly related
Direct vs. Indirect Costs
Direct cost
Easily and conveniently traceable to the cost
object
Indirect
Not easily or conveniently traceable
Cost is shared among cost objects
No apparent “link” between the cost and the object
Not cost effective to trace
Product vs. Period Costs
 Product costs
 Reasonable and necessary costs to prepare the
product for sale to the customer
Direct materials
Direct labor
Overhead
 Part of inventory until product is sold
 Period costs
 Non-manufacturing costs
 Expensed when incurred
Product costs
Product vs. Period Costs
Direct material
Prime costs
Direct labor
Conversion costs
Overhead
Product vs. Period Costs
Distinction between product and period
costs is blurred for internal reporting
Marketing cost may be considered part of the
total cost of a product
Labor may be considered overhead
Only incremental costs may be considered
Etc.
Manufacturing Cost Flows
Raw Materials
Inventory
(1) Work in Process (2)
Inventory
Factory Labor
Overhead
Finished Goods (3)
Inventory
Cost of
Goods Sold
(1) Materials are placed into production (Raw
materials used in production)
(This plus direct labor and overhead equals
total manufacturing costs, i.e. inputs)
(2) Goods are completed (Cost of goods
manufactured, i.e. outputs)
(3) Goods are sold
Manufacturing Cost Flows
Example Company
Statement of Cost of Goods Manufactured and Sold
Beginning raw materials inventory
Add: Purchases of raw materials
Raw materials available
Less: Ending raw materials inventory
Raw materials used in production
$
$
$
Direct labor
Overhead
Total manufacturing cost
71,000
134,000
$
390,000 Input
$
6,000
396,000
(8,000)
$
388,000 Output (2)
$
3,000
391,000
Add: Beginning work in process inventory
Less: Ending work in process inventory
Cost of goods manufactured
Add: Beginning finished goods inventory
Goods available for sale
Less: Ending finished goods inventory
Cost of goods sold
5,000
187,000
192,000
(7,000)
185,000 (1)
(2,000)
$
389,000 Expense (3)
Cost Drivers
The cause of a particular cost
Capacity driver
Decision to acquire capacity
Transaction driver
Each occurrence causes the cost
Duration driver
Amount of cost depends on the duration of the
event
Cost Hierarchy
Unit level
Each additional unit (of something) creates
more cost
Batch level
Each new batch, or the crossing of some
threshold creates more cost
Product level
Change to product, or additional product,
creates more cost
Cost Hierarchy
Customer level
Each new customer creates more cost
Facility level
Change to facility creates more cost
Cost Behavior
How a cost changes in relation to changes
in volume of activity
Behavior depends on the definition of
activity and relevant range
Unit of product or batch?
Fixed per batch, but vary inversely per unit
Narrow or wide range?
Fixed over a narrow range but step over a wider
range
Fixed Cost
Total cost remains constant
Cost per unit varies inversely with activity
Cost
Fixed Cost
120
100
80
60
40
20
0
Total Cost
Cost per Unit
1
2
3
4
5
6
Units of activity
7
8
9
10
Step Fixed Cost
Fixed through some range, but increases
when some increment is crossed
Cost
Step Fixed Cost
140
120
100
80
60
40
20
0
Total cost
Cost per unit
1
2
3
4
5
6
7
Units of activity
8
9
10
Variable Cost
Cost per unit remains constant
Total cost varies directly with activity
Cost
Variable Cost
120
100
80
60
40
20
0
Total Cost
Cost per Unit
1
2
3
4
5
6
Units of Activity
7
8
9
10
Mixed Cost
Contains a fixed and a variable component
Cost per unit is not constant
Cost
Mixed Cost
140
120
100
80
60
40
20
0
Total cost
Cost per unit
1
2
3
4
5
6
7
Units of activity
8
9
10
Absorption vs. Variable Costing
Absorption costing
Product costs include material, labor, variable
and fixed overhead
All of the reasonable and necessary costs to
produce the product
Income statement arranged by type of cost
Product or period
Revenue – cost of goods sold = gross profit
Gross profit – S&A expenses = net income
Absorption vs. Variable Costing
Variable costing
Product costs only include material, labor and
variable overhead
Fixed overhead is treated as a period cost
Income statement arranged by cost behavior
Variable then fixed
Revenue – variable costs = contribution margin
Contribution margin – fixed costs = net income
Absorption vs. Variable Costing
Selling price
$
100 per unit
Material
Labor
Variable overhead
$
$
$
30 per unit
15 per unit
5 per unit
Fixed overhead
$ 50,000
Variable selling expenses
$
Fixed selling expenses
$ 10,000
Units produced
Units sold
Year 1
2,000
2,000
10 per unit
Year 2
4,000
2,000
Year 3
2,000
4,000
Absorption vs. Variable Costing
Absorption costing income statements
Year 1
Year 2
Year 3
Sales
$
200,000 $
200,000 $
400,000
Cost of goods sold
150,000
125,000
275,000
Gross profit
$
50,000 $
75,000 $
125,000
Selling expenses
30,000
30,000
50,000
Net income
$
20,000 $
45,000 $
75,000
Variable costing income statements
Sales
$
200,000 $
200,000
Var. cost of goods sold
100,000
100,000
Var. selling expenses
20,000
20,000
Contribution margin
$
80,000 $
80,000
Fixed overhead
50,000
50,000
Fixed selling expenses
10,000
10,000
Net income
$
20,000 $
20,000
Difference
$
-
$
25,000
$
$
400,000
200,000
40,000
160,000
50,000
10,000
100,000
$
(25,000)
$
Absorption vs. Variable Costing
Fixed overhead
Is it necessary to produce the product?
Is it related to production volume?
Is it a product or period cost?
Which is more useful?
Financial reporting
Absorption required
Decision making
Variable does not distort cost as volume changes
Throughput Costing
Product costs only include unit level
spending for direct costs (i.e. incremental
costs)
Materials, commissions, etc.
All other indirect, past or committed costs
are treated as period costs
Labor (unless piece-rate), overhead, etc.
Resources Supplied vs. Resources Used
Cost of resource supplied
 Capacity (hours, etc.) available * cost per unit of capacity
Cost of resource used
 Capacity used * cost per unit of capacity
Cost of unused capacity
 Cost of resource supplied – cost of resource used
A worker is paid for an 8-hour day. The worker can produce 10 units per hour and is
paid $10 per hour ($1 per unit). The worker only produced 50 units on Monday.
Cost of capacity available: $80 Cost of capacity used: 50 units * $1 per unit = $50
Cost of unused capacity: $80 - $50 = $30
Miscellaneous Cost Terms
 Committed cost
 Decision has been made to incur the cost in the future
 Discretionary cost
 Cost which can be increased or decreased at will
 Sunk cost
 Cost incurred previously
 Opportunity cost
 Benefit given up when one alternative is chosen over
another