1. Cost Concepts, Terms, Behavior and Classification
Unit 2

2. Learning Objectives 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.

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

4. 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.

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

6. What is Cost? Cost Outlay Cost Past, present, or future cash outflow
LO1 Explain the basic concept of “cost”.
Cost
Outlay Cost
Past, present, or future cash outflow
Opportunity Costs
Forgone benefit from the best alternative course of action
Expense
Cost charged against revenue in an accounting period

7. Cost Example Cost of the outing? Opportunity Cost Outlay Cost
Serra wants to go out with her friends for a night of fun and adventure.
Cost of the outing?
Opportunity Cost
Outlay Cost
Passing her accounting exam and a new pair of shoes!
$50 to pay for dinner and drinks

8. The cost of tuition, books, and all other educational expenses
Cost Example
Your education costs?
Outlay Cost
Opportunity Cost
The interest on the money you would save by not attending college and the income you will forgo while in college
The cost of tuition, books, and all other educational expenses

9. Recording Costs in Financial Statements
LO2 Explain how costs are presented in financial statements.
Income Statements
Service Company
Merchandising Company
Service Revenues
- Cost of Services Sold
= Gross Margin
- General Selling and Administrative Costs
= Operating Profit
Cost incurred to purchase the goods sold
Sales Revenues
- Cost of Goods Sold
= Gross Margin
- General Selling and Administrative Costs
= Operating Profit
Cost of billable hours
The excess of operating revenue over costs necessary to generate those revenues

10. Manufacturing Company Costs
Two types of manufacturing company costs:
Product Costs: Costs relating to inventory
Period Costs: Non-manufacturing costs related to the firm
All Costs
Product Costs:
Period Costs:
Costs incurred to product the product
Costs incurred to sell a product and operate the business
Recorded as an asset “inventory” when cost is incurred
Recognized as an expense when the cost is incurred
Recognized as an expense when the product is sold

11. 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

12. 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.

13. 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

14. Tracing Costs
Sara decides to go out with friends to a nice dinner and a movie.
Identify the object
A night on the town
Indirect Cost
Direct Costs
The cost of the dinner and the movie
The cost of Sara’s dress, shoes, and car.
McGraw-Hill/Irwin
Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

15. Manufacturing Costs: Product Costs
Inventory Costs
Direct Materials
Prime Costs:
The “primary” costs of the product
Direct Labor
Conversion Costs:
Cost necessary to “convert” materials into a product
Direct Labor
Manufacturing
Overhead

16. Product Cost Review Given the following data → Direct cost?
Direct Materials
$8.00
Direct Labor
$7.00
Manufacturing Overhead
$14.00
Given the following data →
Direct cost?
DM + DL = $15.00
Prime cost?
DM + DL = $15.00
Conversion cost?
DL + MOH = $21.00
Indirect Cost?
MOH $14.00
Total Product Cost?
DM + DL + MOH = $29.00

17. Period Costs: Non-manufacturing Cost
Recognized as an expense when the cost is incurred.
Advertising
Marketing:
Costs necessary to sell the products.
Sales Commissions
Shipping Costs
Executive Salaries
Administrative:
Costs necessary to operate the business.
Data Processing
Legal Costs

18. Cost Allocation LO3 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.

19. 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 = $800,000
West Coast: 20% of cost = $200,000

20. Manufacturing Cost Flows
LO4 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.

21. 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

22. Jackson Gears Cost 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
==========

23. Jackson Gears Cost 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
=========

24. Jackson Gears Income Statement For the Year Ending December 31, 200X
Sales
$ 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
=========

25. Cost Behavior Cost Behavior?
LO5 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

26. Fixed Costs
Fixed costs remain unchanged as volume changes within the relevant range.
Fixed costs per unit varies inversely to a change in activity.
Fixed costs are “fixed” in “total” as activity changes.
Costs ($)
Activity Level

27. Sara’s Night on the Town
Fixed 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 worn

28. Variable Costs
Costs 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 Level

29. 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.
Drink
Cost ($)
Number of drinks

30. Semi-variable Costs
Costs that have both fixed and variable components.
Also known as MIXED COSTS.

31. Sara’s Entertainment Semi-variable costs
The 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.
Cost ($)
Number of movies

32. 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 ($)
Cost of 2nd rented space
Cost of 1st rented space
Cost of original factory
Activity Level

33. Product Cost Components
LO6 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.

34. DM + DL + VMOH + FMOH + VMA + FMA = $40
Costs: An Example
Given the following:
Direct Materials = $8
Direct Labor = $7
1. What is the full cost per unit?
Variable Manufacturing Overhead = $8
Fixed Manufacturing Overhead = $6
Variable Marketing & Admin = $4
DM + DL + VMOH + FMOH + VMA + FMA = $40
Fixed Marketing & Admin = $7
3. What is the variable cost per unit?
What is the variable cost per unit? The variable cost per unit is all variable costs of manufacturing and selling a unit of product. In this example, variable costs include direct materials, direct labor, variable manufacturing overhead and variable marketing and administrative costs. The variable cost for unit in this example is $27.
2. What is the full absorption cost per unit?
DM + DL + VMOH + VMA = $27
DM + DL + VMOH + FMOH = $29

35. Making Costs Information Useful
LO7 Understand the distinction between financial and contribution margin income statements.
Full Absorption Costing:
Variable Costing
Required by GAAP
Used for:
Financial purposes
External reporting
Used for:
Managerial purposes
Internal decision-making
Sales Revenue
- Cost of Goods Sold
= Gross Margin
Sales Revenue
- Variable Costs
= Contribution Margin

36. Making Cost Information Useful, Continued…
Contribution Margin Income Statement
Financial Income Statement
Full Absorption Costing
Variable Costing
Sales Price
- Full Absorption Cost
= Gross Margin
Sales Price
- Variable Cost
= Contribution Margin

37. Product vs. Period Full Absorption Costing Variable Costing
Variable Manufacturing Costs
Product Costs
Variable Manufacturing Overhead
Fixed Manufacturing Costs
Fixed Manufacturing Costs
Variable Marketing & Admin Costs
Period Costs
Variable Marketing & Admin Costs
Fixed Marketing & Admin Costs
Fixed Marketing & Admin Costs

38. Income Statement: Full Absorption Costing
Sales Revenue
Cost of Goods Sold
= Gross Margin
- Marketing & Admin Cost
= Operating Profit
Variable and Fixed Manufacturing Costs
Period Costs
Variable and Fixed Marketing & Admin Costs

39. Income Statement: Variable Costing
Variable Manufacturing Costs and Variable Marketing & Admin Costs
Sales Revenue
Variable Costs
= Contribution Margin
- Fixed Costs
= Operating Profit
Fixed Manufacturing Costs and Fixed Marketing & Admin Costs

40. 3-40
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. $
C. $1,200.
D. $

41. 3-41
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. $
C. $1,200.
D. $
$1,000 + $100 = $1,100
$1,100 - $300 = $800

42. 3-42
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. $280,000
D. $ 2,000

43. 3-43
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. $280,000
D. $ 2,000

44. 3-44
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. $555,000
B. $835,000
C. $655,000
D. Cannot be determined.

45. 3-45
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. $555,000
B. $835,000
C. $655,000
D. Cannot be determined.

46. 3-46
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. $1,160,000
B. $ 910,000
C. $ 760,000
D. Cannot be determined.

47. 3-47
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. $1,160,000
B. $ 910,000
C. $ 760,000
D. Cannot be determined.

48. 3-48
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.

49. 3-49
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

50. Quick Check  A. The cost of lighting the store.
3-50
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.

51. Quick Check  A. The cost of lighting the store.
3-51
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.

52. UNIT 2: END!!