Cost Concepts, Terms, Behavior and Classification

Unit 2

Learning Objectives1. Explain the basic concept of “cost.”

2. Explain how costs are presented in financial statements

3. Explain the process of cost allocation.

4. Understand how material, labor, and overhead costs are added to a product at each stage of the production process.

5. Define basic cost behaviors, including fixed, variable, semivariable, and step costs.

6. Identify the components of a product’s costs.

7. Understand the distinction between financial and contribution margin income statements.

Cost Accounting• Cost accounting systems provide information to help managers make better

decisions.

• Managers who use cost accounting information to make decisions need to understand the cost terms used in their organizations.

• Because cost accounting systems are tailored to the needs of individual companies, several terms are used in practice to describe the same or similar cost concepts, depending on the use or the audience.

• Therefore, before we discuss the design of cost systems to aid decision making, we introduce a set of terms that will be used throughout the course. These terms are important to the discussion because they will be the “language” we use to communicate for the remainder of the lessons.

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Cost Concept• A cost is a sacrifice of resources. Every day, we

buy many different things: clothing, food, books, music, perhaps an automobile, and so on. When we buy one thing, we give up (sacrifice) the ability to use these resources (typically cash or a line of credit) to buy something else. The price of each item measures the sacrifice we must make to acquire it.

• Whether we pay cash or use another asset, whether we pay now or later (by using a credit card), the cost of the item acquired is represented by what we forgo as a result.

Cost versus Expenses

• It is important to distinguish cost from expense. An expense is a cost charged against

• revenue in an accounting period; hence, expenses are deducted from revenue in that

• accounting period. We incur costs whenever we give up (sacrifi ce) resources, regardless

• of whether we account for it as an asset or an expense. (We may even incur costs that

• the fi nancial accounting system never records as an asset or expense. An example is lost

• sales.) If the cost is recorded as an asset (for example, prepaid rent for an offi ce building),

• it becomes an expense when the asset has been consumed (i.e., the building has been used

• for a period of time after making the prepayment).

McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

What is Cost?

Outlay Cost

Past, present, or future cash outflow

Opportunity CostsForgone benefit from the best alternative course of action

LO1 Explain the basic concept of “cost”.

Cost

ExpenseCost charged against revenue in an accounting period

Cost Example

Serra wants to go out with her friends for a night of fun and adventure.

Cost of the outing?

Outlay Cost

$50 to pay for dinner and drinks

Opportunity Cost

Passing her accounting exam and a new pair of

shoes!

Cost Example

Your education costs?

Outlay Cost

The cost of tuition, books, and all other educational expenses

Opportunity Cost

The interest on the money you would save by not

attending college and the income you will forgo while

in college

Recording Costs in Financial StatementsLO2 Explain how costs are presented in financial statements.

Income StatementsService Company

Service Revenues

- Cost of Services Sold

= Gross Margin

- General Selling and Administrative Costs

= Operating Profit

Merchandising Company

Sales Revenues

- Cost of Goods Sold

= Gross Margin

- General Selling and Administrative Costs

= Operating Profit

Cost incurred to purchase the goods sold

Cost of billable hours

The excess of operating revenue over costs necessary to generate those revenues

Manufacturing Company CostsTwo types of manufacturing company costs:

1. Product Costs: Costs relating to inventory2. Period Costs: Non-manufacturing costs related to the firm

All Costs

Product Costs:

Costs incurred to product the product

Recorded as an asset “inventory” when cost is incurred

Recognized as an expense when the product is sold

Period Costs:Costs incurred to sell a product and operate the business

Recognized as an expense when the cost is incurred

A Manufacturing Company’s Income Statement

Sales Revenue

- Cost of Goods Sold

= Gross Margin

- General Selling & Administrative Costs

= Operating Profit

Product costs recorded as “inventory” when cost is incurred

Cost incurred to manufacture the product sold

Expensed when sold

Period costs recorded as an expense in the period the cost is incurred

Product vs. Period Costs

Product Costs:

Costs that are recorded as an asset in inventory when incurred and expensed as Cost of Goods Sold when sold.

Period Costs:Costs that are expensed under General Selling and Administrative Costs when incurred.

Product Costs: Direct vs. Indirect

Direct Costs:Costs that, for a reasonable cost, can be directly traced to the product.

Direct Materials:Materials directly traceable to the product.

Direct Labor:Work directly traceable to transforming materials into the finished product.

Indirect Costs:Cost that cannot reasonably be directly traced to the product.

Manufacturing Overhead:All production costs except direct materials and direct labor.

Indirect Materials

Indirect Labor

Other Indirect Costs

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Tracing Costs

Sara decides to go out with friends to a nice dinner and a movie.

Identify the object A night on the town

Direct Costs

The cost of the dinner and the

movie

Indirect Cost

The cost of Sara’s dress,

shoes, and car.

Manufacturing Costs: Product Costs

Inventory Costs

Prime Costs:The “primary” costs of

the product

Direct Materials

Direct Labor

Conversion Costs:Cost necessary to

“convert” materials into a product

Direct Labor

ManufacturingOverhead

Product Cost Review

• Given the following data →Direct Materials $8.00

Direct Labor $7.00

Manufacturing Overhead

$14.00Direct cost?

DM + DL = $15.00

Prime cost?

DM + DL = $15.00Conversion cost?

DL + MOH = $21.00 Indirect Cost?

MOH $14.00Total Product Cost?

DM + DL + MOH = $29.00

Period Costs: Non-manufacturing Cost

Recognized as an expense when the cost is incurred.

Marketing:Costs necessary to sell the products.

Advertising

Sales Commissions

Shipping Costs

Administrative:Costs necessary to

operate the business.

Executive Salaries

Data Processing

Legal Costs

Cost AllocationLO3 Explain the process of cost allocation.

Assigning indirect cost to a cost object

1. Define the cost pool:The collection of costs to be assigned to cost objects.

2. Determine the cost allocation rule:The method used to assign costs in the cost pool to cost objects.

3. Assign the cost object:Any end to which a cost is assigned – product, product line, department, customer, etc.

Example: Cost Allocation Rockford Company

Situation: Rockford has two divisions, East Coast and West Coast. Both divisions are supported by the IT Department.

East Coast West Coast Total

Revenues $80 million $20 million $100 million

1. Define Cost Pool: IT Department’s Costs of $1,000,000

2. Determine the Cost Allocation Rule: IT costs are allocated based on divisional revenue. (% of Revenue)

3. Assign the Cost Object: East Coast: 80% of cost = $800,000West Coast: 20% of cost = $200,000

Manufacturing Cost FlowsLO4 Understand how material, labor, and overhead costs

are added to a product at each stage of the production process.

Product costs are recorded in inventory when cost is incurred.

A manufacturing company has three inventory accounts:1. Raw Materials Inventory: Materials purchased to make a

product.

2. Work-in-Process Inventory: Products currently in the production process, but not yet completed.

3. Finished Goods Inventory: Completed products that have not yet been sold.

Inventory Accounts – The Balance Sheet

Raw Materials Inventory

Beg. RM Inventory

+ Purchases

= Raw Materials Available for Production

- Raw Materials Transferred to WIP

= Ending RM Inventory

Work-in-Process Inventory

Beg. WIP Inventory

+ Direct Materials Transferred from Raw Materials

+ Direct Labor

+ Manufacturing Overhead

= Total Manufacturing Costs

- Cost of Good Completed & Transferred to Finished Goods

= Ending WIP Inventory

Finished Goods Inventory

Beg. FG Inventory

+ Cost of Goods Completed & Transferred from WIP

= Goods Available for Sale

- Cost of Good Sold

= Ending FG Inventory

To the Income Statement

Jackson GearsCost of Goods Manufactured Statement

For the Year Ending December 31, 200X

Beginning WIP Inventory, January 1 $ 270,000

Manufacturing Cost During the Year:

Direct Materials:

Beginning Raw Materials Inventory, Jan. 1 $ 95,000

Add: Purchases 5,627,000

Direct Materials Available $ 5,722,000

Less: Ending RM Inventory, Dec. 31 72,000

Direct Materials put into Production $5,650,000

Direct Labor 1,220,000

Manufacturing Overhead 6,780,000

Total Manufacturing Costs Incurred 13,650,000

Total Work-in-Process During the Year 13,920,000

Less: Ending Work-in-Process Inv, Dec. 31 310,000

Cost of Goods Manufactured $ 13,610,000

==========

Jackson GearsCost of Good Sold Statement

For the Year Ending December 31, 200X

Beginning Finished Goods Inventory, Jan. 1 $ 420,000

Cost of Goods Manufactured 13,610,000

Finished Goods Available for Sale 14,030,000

Less: Ending Finished Goods Inventory, Dec. 31 930,000

Cost of Goods Sold $ 13,100,000

=========

Jackson GearsIncome Statement

For the Year Ending December 31, 200XSales $ 20,450,000

Less: Cost of Goods Sold 13,100,000

Gross Margin 7,350,000

Less: Marketing & Administrative Expenses 3,850,000

Operating Profit $ 3,500,000

=========

Cost BehaviorLO5 Define basic cost behaviors including fixed,

variable, semi-variable, and step costs.

Cost Behavior?

How costs respond to a change in activity level within the relevant range

Relevant Range?

Activity levels within which a given total fixed cost or unit variable cost will be unchanged

Fixed Costs

Fixed costs remain unchanged as volume changes within the relevant range.

Fixed costs are “fixed” in “total” as activity changes.

Fixed costs per unit varies inversely to a change in activity.

Activity Level

Costs ($)

0

10

20

30

40

50

60

70

80

90

0 1 2 3 4

Total Fixed Cost

Sara’s Night on the TownFixed Costs

Fixed costs are “fixed” in “total” as activity changes

Fixed cost per unit varies inversely with a change in activity.

Cost of a dress ($)

Number of times the dress is worn0

10

20

30

40

50

60

70

80

90

0 1 2 3 4

Total Fixed Cost

Variable CostsCosts that change in direct proportion with a change in the volume within the relevant range.

Variable costs “vary” in “total” as activity changes.

Variable cost per unit stays constant when activity changes within the relevant range.

Cost ($)

Activity Level0

5

10

15

20

25

30

35

0 1 2 3 4

Total VariableCost

Sara’s Entertainment Expenses

Variable Costs

Variable costs “vary” in “total” as activity changes over the relevant range.

Variable cost per unit remains constant when activity changes over the relevant range.

0

5

10

15

20

25

30

0 1 2 3 4

Total VariableCost

DrinkCost ($)

Number of drinks

Semi-variable Costs

Costs that have both fixed and variable components.

Also known as MIXED COSTS.

Activity Level

Cost

s

Semi-VariableCost

Sara’s Entertainment

Semi-variable costsThe fixed component is “fixed” in total as activity changes over the relevant range.

The variable component “varies in total as activity changes over the relevant range.

0

20

40

60

80

100

120

140

0 1 3 4 5 6

Semi-variablecost

Number of movies

Cost ($)

Step Costs

Costs that increase in total with steps when the volume changes to a particular level.

Step costs are also known as semi-fixed costs.Example: If a factory can produce 100,000 units a month and the firm needs to

produce 120,000 units then more factory space must be procured. The additional space will only be purchased if 100,000 units are exceeded.

Costs ($)

Activity LevelCost of original factory

Cost of 1st rented space

Cost of 2nd rented space

Product Cost ComponentsLO6 Identify the components of a product’s costs.

Full Cost: The sum of all costs of manufacturing and selling a unit of the product. (GAAP)

Full Absorption Cost: The sum of all variable and fixed costs of manufacturing a unit of the product.

Variable Cost: The sum of all variable costs of manufacturing and selling a unit of the product.

Costs: An Example

Given the following: Direct Materials = $8

Direct Labor = $7

Variable Manufacturing Overhead = $8

Fixed Manufacturing Overhead = $6

Variable Marketing & Admin = $4

Fixed Marketing & Admin = $7

1. What is the full cost per unit?

DM + DL + VMOH + FMOH + VMA + FMA

= $40

2. What is the full absorption cost per unit?

DM + DL + VMOH + FMOH = $29

3. What is the variable cost per unit?

DM + DL + VMOH + VMA = $27

Making Costs Information UsefulLO7 Understand the distinction between financial

and contribution margin income statements.

Full Absorption Costing:• Required by GAAP

Used for:• Financial purposes• External reporting

Sales Revenue

- Cost of Goods Sold

= Gross Margin

Variable Costing

Used for:• Managerial purposes• Internal decision-making

Sales Revenue

- Variable Costs

= Contribution Margin

Making Cost Information Useful, Continued…

Financial Income Statement

Full Absorption Costing

Sales Price

- Full Absorption Cost

= Gross Margin

Sales Price

- Variable Cost

= Contribution Margin

Variable Costing

Contribution Margin Income Statement

Product vs. Period

Full Absorption Costing

Variable Manufacturing Costs

Fixed Manufacturing Costs

Product Costs

Variable Costing

Variable Manufacturing Overhead

Variable Marketing & Admin Costs

Fixed Marketing & Admin Costs

Period Costs

Fixed Manufacturing Costs

Variable Marketing & Admin Costs

Fixed Marketing & Admin Costs

Income Statement: Full Absorption Costing

Sales Revenue

- Cost of Goods Sold

= Gross Margin

- Marketing & Admin Cost

= Operating Profit

Full Absorption

Variable and Fixed Manufacturing Costs

Period Costs

Variable and Fixed Marketing & Admin

Costs

Income Statement:Variable Costing

Sales Revenue

-Variable Costs

= Contribution Margin

- Fixed Costs

= Operating Profit

Variable Manufacturing Costs

and Variable Marketing & Admin

Costs

Fixed Manufacturing Costs and Fixed

Marketing & Admin Costs

Quick Check If your inventory balance at the beginning of the month

was $1,000, you bought $100 during the month, and sold $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.

Quick Check If your inventory balance at the beginning of the month

was $1,000, you bought $100 during the month, and sold $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.

$1,000 + $100 = $1,100$1,100 - $300 = $800

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. $280,000D. $ 2,000

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. $280,000D. $ 2,000

Quick Check Direct materials used in production totaled

$280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month?

A. $555,000B. $835,000C. $655,000D. Cannot be determined.

Direct materials used in production totaled $280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month?

A. $555,000B. $835,000C. $655,000D. Cannot be determined.

Quick Check

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. $1,160,000B. $ 910,000C. $ 760,000D. Cannot be determined.

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. $1,160,000B. $ 910,000C. $ 760,000D. Cannot be determined.

Quick Check

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.

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.

$130,000 + $760,000 = $890,000$890,000 - $150,000 = $740,000

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.

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.

UNIT 2: END!!