An Introduction to Cost
Terms and Purposes
Chapter-2
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Learning Objective 1
Define and illustrate
a cost object.
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Cost and Cost Terminology
Cost is a resource sacrificed or forgone to achieve
a specific objective.
An actual cost is the cost incurred (a historical cost)
as distinguished from budgeted costs.
A cost object is anything for which a separate
measurement of costs is desired.
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Cost and Cost Terminology
Cost Object
Cost
Accumulation
Cost Object
Cost Object
Cost
Assignment
Tracing
Allocating
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Learning Objective 2
Distinguish between direct costs
and indirect costs.
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Direct and Indirect Costs
Direct Costs
Example: Paper on which
Sports Illustrated magazine
is printed
COST OBJECT
Example: Sports
Illustrated magazine
Indirect Costs
Example: Lease cost for
Time-Warner building
housing the senior editors
of its magazine
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Direct and Indirect Costs
Example
Direct Costs:
Maintenance Department
$40,000
Personnel Department
$20,600
Assembly Department
$75,000
Finishing Department
$55,000
Assume that Maintenance Department costs are
allocated equally among the production departments.
How much is allocated to each department?
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Direct and Indirect Costs
Example
Maintenance
$40,000
Assembly
Direct Costs
$75,000
Finishing
Direct Costs
$55,000
$20,000
$20,000
Allocated
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Learning Objective 3
Explain variable costs
and fixed costs.
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Cost Behavior Patterns Example
Bicycles by the Sea buys a handlebar
at $52 for each of its bicycles.
What is the total handlebar cost when
1,000 bicycles are assembled?
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Cost Behavior Patterns Example
1,000 units × $52 = $52,000
What is the total handlebar cost
when 3,500 bicycles are assembled?
3,500 units × $52 = $182,000
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Cost Behavior Patterns Example
Bicycles by the Sea incurred $94,500 in
a given year for the leasing of its plant.
This is an example of fixed costs with
respect to the number of bicycles assembled.
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Cost Behavior Patterns Example
What is the leasing (fixed) cost per bicycle
when Bicycles assembles 1,000 bicycles?
$94,500 ÷ 1,000 = $94.50
What is the leasing (fixed) cost per bicycle
when Bicycles assembles 3,500 bicycles?
$94,500 ÷ 3,500 = $27
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Cost Drivers
The cost driver of variable costs is the level
of activity or volume whose change causes
the (variable) costs to change proportionately.
The number of bicycles assembled is a
cost driver of the cost of handlebars.
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Relevant Range Example
Assume that fixed (leasing) costs are $94,500
for a year and that they remain the same for a
certain volume range (1,000 to 5,000 bicycles).
1,000 to 5,000 bicycles is the relevant range.
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Fixed Costs
Relevant Range Example
120000
100000
80000
60000
40000
20000
0
$94,500
0
1000
2000
3000
4000
5000
6000
Volume
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Relationships of Types of Costs
Direct
Variable
Fixed
Indirect
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Learning Objective 4
Interpret unit costs cautiously.
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Total Costs and Unit Costs
Example
What is the unit cost (leasing and handlebars)
when Bicycles assembles 1,000 bicycles?
Total fixed cost $94,500
+ Total variable cost $52,000 = $146,500
$146,500 ÷ 1,000 = $146.50
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Total Costs and Unit Costs
Example
$146,500
Total Costs
200000
150000
$94,500
100000
50000
0
0
500
1000
1500
Volume
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Use Unit Costs Cautiously
Assume that Bicycles management uses a
unit cost of $146.50 (leasing and wheels).
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
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Use Unit Costs Cautiously
What is their budgeted cost for an estimated
production of 3,500 bicycles?
3,500 × $146.50 = $512,750
What should the budgeted cost be for an
estimated production of 600 bicycles?
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Use Unit Costs Cautiously
Total fixed cost
$ 94,500
Total variable cost ($52 × 600)
31,200
Total
$125,700
$125,700 ÷ 600 = $209.50
Using a cost of $146.50 per unit would
underestimate actual total costs if output
is below 1,000 units.
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Use Unit Costs Cautiously
What should the budgeted cost be for an
estimated production of 3,500 bicycles?
Total fixed cost
$ 94,500
Total variable cost (52 × 3,500) 182,000
Total
$276,500
$276,500 ÷ 3,500 = $79.00
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Learning Objective 5
Distinguish among
manufacturing companies,
merchandising companies, and
service-sector companies.
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Manufacturing
Manufacturing companies
purchase materials and components and
convert them into finished goods.
A manufacturing company must also develop,
design, market, and distribute its products.
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Merchandising
Merchandising companies
purchase and then sell tangible products
without changing their basic form.
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Merchandising
Service companies
provide services or intangible
products to their customers.
Labor is the most significant cost category.
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Learning Objective 6
Differentiate between
inventoriable costs
and period costs.
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Types of Inventory
Manufacturing-sector companies
typically have one or more of the
following three types of inventories:
1. Direct materials inventory
2. Work in process inventory (work
in progress)
3. Finished goods inventory
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Types of Inventory
Merchandising-sector companies hold
only one type of inventory – the
product in its original purchased form.
Service-sector companies do not
hold inventories of tangible products.
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Classification of
Manufacturing Costs
Direct materials costs
Direct manufacturing labor costs
Indirect manufacturing costs
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Learning Objective 7
Describe the three categories of
inventories commonly found
in manufacturing companies.
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Inventoriable Costs
Inventoriable costs (assets)…
become cost of goods sold…
after a sale takes place.
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Period Costs
Period costs are all costs in the income
statement other than cost of goods sold.
Period costs are recorded as expenses of the
accounting period in which they are incurred.
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Flow of Costs Example
Bicycles by the Sea had $50,000 of direct
materials inventory at the beginning of the period.
Purchases during the period amounted to
$180,000 and ending inventory was $30,000.
How much direct materials were used?
$50,000 + $180,000 – $30,000 = $200,000
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Flow of Costs Example
Direct labor costs incurred were $105,500.
Indirect manufacturing costs were $194,500.
What are the total manufacturing costs incurred?
Direct materials used
Direct labor
Indirect manufacturing costs
Total manufacturing costs
$200,000
105,500
194,500
$500,000
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Flow of Costs Example
Assume that the work in process inventory
at the beginning of the period was $30,000,
and $35,000 at the end of the period.
What is the cost of goods manufactured?
Beginning work in process
Total manufacturing costs
Ending work in process
Cost of goods manufactured
$ 30,000
500,000
35,000
$495,000
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Flow of Costs Example
Assume that the finished goods inventory
at the beginning of the period was $10,000,
and $15,000 at the end of the period.
What is the cost of goods sold?
Beginning finished goods
Cost of goods manufactured
Ending finished goods
Cost of goods sold
$ 10,000
495,000
15,000
$490,000
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Flow of Costs Example
Beg. Balance
Direct mtls. used
Direct labor
Indirect mfg. costs
Ending Balance
Work in Process
30,000 495,000
200,000
105,500
194,500
35,000
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Flow of Costs Example
Work in Process
495,000
Finished Goods
10,000 490,000
495,000
15,000
Cost of Goods Sold
490,000
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Manufacturing Company
BALANCE SHEET
INCOME STATEMENT
Inventoriable
Costs
Materials
Inventory
Revenues
Finished
Goods
Inventory
when
sales
occur
deduct
Cost of
Goods Sold
Equals Gross Margin
deduct
Work in
Process
Inventory
Period
Costs
Equals Operating Income
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Merchandising Company
BALANCE SHEET
INCOME STATEMENT
Inventoriable
Costs
Merchandise
Purchases
Revenues
Inventory
when
sales
occur
deduct
Cost of
Goods Sold
Equals Gross Margin
deduct
Period
Costs
Equals Operating Income
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Prime Costs
Direct
Materials
+
Direct
Labor
=
Prime
Costs
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Prime Costs
What are the prime costs for Bicycles by the Sea?
Direct materials used
+ Direct labor
=
$200,000
105,500
$305,000
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Conversion Costs
Direct
Labor
+
Manufacturing
Overhead
Indirect
Labor
Indirect
Materials
=
Conversion
Costs
Other
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Conversion Costs
What are the conversion costs for
Bicycles by the Sea?
Direct labor
$105,500
+ Indirect manufacturing costs
194,500
=
$300,000
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Measuring Costs
Requires Judgment
Manufacturing labor-cost classifications
vary among companies.
The following distinctions are generally found:
Direct manufacturing labor
Manufacturing overhead
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Measuring Costs
Requires Judgment
Manufacturing overhead
Indirect labor Managers’ salaries Payroll fringe costs
Forklift truck operators (internal handling of materials)
Janitors
Rework labor
Overtime premium
Idle time
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Measuring Costs
Requires Judgment
Overtime premium is usually
considered part of overhead.
Assume that a worker gets $18/hour
for straight time and gets
time and one-half for overtime.
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Measuring Costs
Requires Judgment
How much is the overtime premium?
$18 × 50% = $9 per overtime hour
If this worker works 44 hours on a given
week, how much are his gross earnings?
Direct labor
44 hours × $18 = $792
Overtime premium
4 hours × $ 9 = 36
Total gross earnings
$828
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End of Chapter 2
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