Cost Terminology and
Concepts
Basic Cost Terminology
• Cost – resource sacrificed 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
Manufacturing Costs
Direct
Labor
Direct
Material
The
Product
Manufacturing
Overhead
Further Classification of Labor
Costs
Idle Time
Treated as
manufacturing
overhead cost
Overtime
Premium of
Factory Workers
Treated as
manufacturing
overhead cost
Labor Fringe
Benefits
Treated as
manufacturing
overhead or direct
labor
Classifications of Costs in
Manufacturing Companies
Manufacturing costs are often
combined as follows:
Direct
Material
Direct
Labor
Prime
Cost
Manufacturing
Overhead
Conversion
Cost
Nonmanufacturing Costs
Marketing and
Selling Cost
Administrative
Cost
R&D
Costs necessary to get the
order and deliver the
product.
All executive,
organizational, and
clerical costs.
Manufacturing Cost Flows
Costs
Material Purchases
Direct Labor
Balance Sheet
Inventories
Raw Material
Work in
Process
Manufacturing
Overhead
Finished
Goods
Selling and
Administrative
Income
Statement
Expenses
Period Expenses
Cost of
Goods
Sold
Selling and
Administrative
Product Costs Versus Period
Costs
Product costs include
direct materials, direct
labor, and
manufacturing
overhead.
Cost of Good Sold
Inventory
Period costs are not
included in product
costs. They are
expensed on the
income statement.
Expense
Sale
Balance
Sheet
Income
Statement
Income
Statement
Balance Sheet
Merchandiser
Current assets
–
–
–
–
Cash
Receivables
Prepaid expenses
Merchandise inventory
Manufacturer
Current Assets
 Cash
 Receivables
 Prepaid Expenses
 Inventories
Raw Materials
Work in Process
Finished Goods
The Income Statement
Cost of goods sold for manufacturers differs only slightly
from cost of goods sold for merchandisers.
Merchandising Company
Cost of goods sold:
Beg. merchandise
inventory
$ 14,200
+ Purchases
234,150
Goods available
for sale
$ 248,350
- Ending
merchandise
inventory
(12,100)
= Cost of goods
sold
$ 236,250
Manufacturing Company
Cost of goods sold:
Beg. finished
goods inv.
$
200
+ Cost of goods
manufactured
415,000
Goods available
for sale
$ 415,200
- Ending
finished goods
inventory
(190)
= Cost of goods
sold
$ 415,010
Schedule of Cost of Goods
Manufactured
Comet Computer Corporation
Schedule of Cost of Goods Manufactured
Raw material used
$
134,980
50,000
230,000
Direct labor
Total manufacturing overhead
Total manufacturing costs
Add: Work-in-process inventory, January 1
$
414,980
120
Subtotal
Deduct: Work-in-process inventory, December 31
$
415,100
100
Cost of goods manufactured
$
415,000
Computation of Cost of Raw Material Used
Schedule of Cost of Goods
Manufactured
Raw-material inventory, January 1
Add: Purchases of raw materials
$
Raw material available for use
Deduct: Raw material inventory, December 31
Raw material used
Comet Computer Corporation
6,000
134,000
140,000
5,020
$ 134,980
Schedule of Cost of Goods Manufactured
Raw material used
$
134,980
50,000
230,000
Direct labor
Total manufacturing overhead
Total manufacturing costs
Add: Work-in-process inventory, January 1
$
414,980
120
Subtotal
Deduct: Work-in-process inventory, December 31
$
415,100
100
Cost of goods manufactured
$
415,000
Schedule of Cost of Goods
Manufactured
Computation of Total Manufacturing Overhead
Indirect material
$
10,000
Indirect labor
40,000
Depreciation on factory
90,000
Depreciation on equipment
70,000
Utilities
15,000
Comet Computer Corporation
Insuranceof Cost of Goods Manufactured
5,000
Schedule
Total manufacturing overhead
$ 230,000
Raw material used
$
134,980
50,000
230,000
Direct labor
Total manufacturing overhead
Total manufacturing costs
Add: Work-in-process inventory, January 1
$
414,980
120
Subtotal
Deduct: Work-in-process inventory, December 31
$
415,100
100
Cost of goods manufactured
$
415,000
Income Statement for a
Manufacturer
Comet Computer Corporation
Income Statement
For the Year Ended December 31, 20X2
Sales revenue
Less: Cost of goods sold
$
700,000
415,010
Gross margin
Selling and administrative expenses
$
284,990
174,490
Income before taxes
Income tax expense
$
110,500
30,000
Net income
$
80,500
Income Statement for a
Manufacturer
Comet Computer Corporation
Schedule of Cost of Goods Sold
For the Year Ended December 31, 20X2
Finished-goods inventory, Jan. 1
Add: Cost of goods manufactured
$
Cost of goods available for sale
Comet Computer Corporation
Deduct Finished-goods inventory, Dec. 31
200
415,000
415,200
190
Income Statement
$ 415,010
For the Year Ended December 31, 20X2
Cost of goods sold
Sales revenue
Less: Cost of goods sold
$
700,000
415,010
Gross margin
Selling and administrative expenses
$
284,990
174,490
Income before taxes
Income tax expense
$
110,500
30,000
Net income
$
80,500
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
Cost Classifications
Activities that
cause costs to be
incurred are called
cost drivers.
Variable Costs
$300,000
$250,000
$200,000
$150,000
$100,000
$50,000
Unit Variable Cost Graph
Cost per Unit
Total Costs
Total Variable Cost Graph
$20
$15
$10
$5
0
10 20
30
Units Produced (000)
0
10 20
30
Units Produced (000)
Units
Produced
5,000
10,000
15,000
20,000
25,000
30,000
Total Cost
Cost per Unit
$ 50,000 $10
100,000 10
150,000 10
200,000 10
250,000 10
300,000 10
Fixed Costs
$150,000
$125,000
$100,000
$75,000
$50,000
$25,000
Unit Fixed Cost Graph
Cost per Unit
Total Costs
Total Fixed Cost Graph
$1.50
$1.25
$1.00
$.75
$.50
$.25
0
100 200 300
Units Produced (000)
0
100 200 300
Units Produced (000)
Units
Produced
Total Cost
Cost per Unit
50,000 $75,000 $1.500
100,000 75,000
.750
150,000 75,000
.500
200,000 75,000
.375
250,000 75,000
.300
300,000 75,000
.250
Types of Fixed Costs
Committed
Discretionary
Long-term, cannot be
significantly reduced
in the short term.
May be altered in the
short-term by current
managerial decisions
Examples
Examples
Depreciation on
Equipment and
Real Estate Taxes
Advertising and
Research and
Development
A Cost Caveat
• Unit costs should be used cautiously
• Unit costs change with a different level of
volume (activity)
– Unit costs that include fixed costs should
always reference the given level of activity
– Unit Costs are also called Average Costs
Cost Behavior Patterns Example
Bicycles by the Sea incurs variable costs of
$52 for each of its bicycles.
Bicycles by the Sea also incurs $94,500 in
fixed costs per year
Use Unit Costs Cautiously
What is the unit cost when Bicycles
assembles 1,000 bicycles in a year?
Use Unit Costs Cautiously
Assume that Bicycles management uses a
unit cost of $146.50
Management is budgeting costs for
different levels of production.
What is their budgeted cost for an
estimated production of 600 bicycles?
600 × $146.50 = $87,900?
Use Unit Costs Cautiously
What is their budgeted cost for an estimated
production of 3,500 bicycles?
3,500 × $146.50 = $512,750?
Summary of Variable and Fixed Cost Behavior
Cost
In Total
Per Unit
Variable
Total variable cost changes
as activity level changes.
Variable cost per unit
remains the same over
wide ranges of activity.
Total fixed cost remains
the same even when the
activity level changes.
Fixed cost per unit
goes down as activity
level goes up.
Fixed
Assigning Costs to Cost Objects
Direct costs
Indirect costs
• Costs that cannot be
• Costs that can be
easily and conveniently
easily and conveniently
traced to a unit of
traced to a unit of
product or other cost
product or other cost
object.
object.
• Examples: direct
material and direct
labor
• Example:
manufacturing
overhead
Determining Product Costs
Manufacturing
overhead (OH)
Applied to product
using a
predetermined
rate
Direct
materials
Product
Direct
labor
BMW: Assigning Costs to a Cost
Object
Direct or Indirect?
Consider a supervisor’s salary in the canning department of
Campbell Soup Company.
If the cost object is the department, the supervisor’s salary
is a direct cost.
If the cost object is a can of soup (the “product” of the
company), the supervisor’s salary is an indirect cost.
Differential Cost and Revenue
Costs and revenues that differ
among alternatives.
Example: You have a job paying $1,500 per month in your
hometown. You have a job offer in a neighboring city that
pays $2,000 per month. The commuting cost to the city is
$300 per month.
Differential revenue is:
$2,000 – $1,500 = $500
Differential cost is:
$300
Controllable and Uncontrollable Costs
A cost that can be significantly influenced
by a manager is a controllable cost.
Cost item
Manager
Classificaton
Cost of food used Restaurant
in a restaurant
manager
Controllable
Cost of national
advertising by a
restaurant chain
Uncontrollable
Restaurant
manager
Opportunity Cost
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
$20,000 per year.
Your opportunity cost
of attending college for one
year is $20,000.
Sunk Costs
All costs incurred in the past that cannot be changed by
any decision made now or in the future.
Sunk costs should not be considered in decisions.
– Example: You bought an automobile that cost
$12,000 two years ago. The $12,000 cost is sunk
because whether you drive it, park it, trade it, or sell
it, you cannot change the $12,000 cost.
Marginal Costs and Average
Costs
The extra cost
incurred to produce
one additional unit.
The total cost to
produce a quantity
divided by the
quantity produced.
Marginal and average costs are
largely a function of cost behavior
-- variable and fixed costs.
Additional Cost Terminology
• Variable Costs – costs that change in total
in relation to some chosen activity or output
• Fixed Costs – costs that do not change in
total in relation to some chosen activity or
output
• Mixed Costs – costs that have both fixed
and variable components; also called
semivariable costs
Mixed Costs
A mixed cost has both fixed and variable
components. Consider the example of renting a car.
Total Cost
Y
Variable
Cost per Mile
X
Activity (Miles Driven)
Fixed Charge
Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Where:
Total Cost
Y
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
Variable
Cost per Mile
X
Activity (Miles Driven)
Fixed Charge
Mixed Costs Example
If your fixed daily rental charge is $40, your variable cost is $0.20
per mile, and your activity level is 100 miles, what is the amount of
your rental cost?
Y = a + bX
Y = $40 + ($0.20 × 100)
Y = $60