Chapter 2 - An Introduction to
Cost Terms and Purposes
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 Accumulation – the collection of cost data in
some organized way
Cost Assignment:
(a)– tracing accumulated costs that have a direct
relationship to a cost object
(b) – allocation of accumulated costs that have an
indirect relationship to a cost object
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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
Cost Tracing
Example: Sports
Illustrated magazine
Indirect Costs
Cost Allocation
Example: Lease cost for
Time-Warner building
housing the senior editors
of its magazine
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Learning Objective 3
Explain variable costs
and fixed costs.
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Cost Behavior Patterns Example –
Variable Costs
Bicycles limited buys a handlebar at $52 for each of
its bicycles.
What is the total handlebar cost when
1,000 bicycles are assembled?
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 –
Variable Costs
As we can see, the total cost varies in proportion to
changes in the related level of activity.
The cost of the handlebars is therefore a variable cost
However, note, the variable cost of handlebars
per bicycle remains constant
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Cost Behavior Patterns Example –
Fixed Costs
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 –
Fixed Costs
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
However, note the fixed cost per bicycle
decreases as the level of activity increases.
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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.
Note – the relevant range concept could also apply to variable cost
per unit when one factors in “discounts”
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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 => NO !
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Use Unit Costs Cautiously
What should the budgeted cost be for an
estimated production of 600 bicycles?
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
Whatis should
their budgeted
the budgeted
cost for
costanbeestimated
for an
estimated
production
production
of 3,500
of 3,500
bicycles?
bicycles?
3,500 × $146.50 = $512,750 => NO !
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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Service
Service companies
provide services or intangible
products to their customers.
Labor is the most significant cost category.
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Learning Objective 7
Describe the three categories of
inventories commonly found
in manufacturing companies.
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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*
* a.k.a. manufacturing overhead costs or factory overhead costs
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Learning Objective 6
Differentiate between
inventoriable costs
and period costs.
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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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Manufacturing Company
BALANCE SHEET
INCOME STATEMENT
Inventoriable Costs
Materials
Inventory
Finished
Goods
Inventory
Revenues
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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Flow of Costs Example
Bicycles Limited 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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Prime Costs
Direct
Materials
+
Direct
Labor
=
Prime
Costs
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Prime Costs
What are the prime costs for Bicycles Limited?
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 Limited?
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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Learning Objective 8
Explain why product costs are
computed in different ways
for different purposes.
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Many Meanings of Product Cost
A product cost is the sum of the costs
assigned to a product for a specific purpose.
1. Pricing and product emphasis decisions
2. Contracting with government agencies
3. Preparing financial statements for external
reporting under generally accepted
accounting principles
Video Clip
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