basic cost terms & concepts
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© The McGraw-Hill Companies, Inc., 1999 Irwin/McGraw-Hill
Basic Cost Terms
and Concepts; CostBehaviour
Chapters Eight and Nine 8
and
9
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Process of Management
DecisionMaking
Directing
ControlPlanning
Managers need cost information toperform each of these functions.
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Cost Classifications
Cost behavior meanshow a cost will react tochanges in the level of
business activity.
Total variable costschange when activitychanges.
Total fixed costs remainunchanged whenactivity changes.
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Cost Classifications
Cost behavior meanshow a cost will react tochanges in the level of
business activity. Total variable costs
change when activitychanges.
Total fixed costs remainunchanged whenactivity changes.
Activities thatcause costs to beincurred are called
cost drivers.
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Total Variable Cost Example
Your total long distance telephone bill isbased on how many minutes you talk.
Minutes Talked
T o t a l L
o n g D i s t a n c e
T e l e
p h o n e B i l l
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Variable Cost Per Unit Example
Minutes Talked
P e
r M i n u t e
T e l e p h
o n e C h a r g e
The cost per long distance minute talked isconstant. For example, 10 cents per minute.
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Total Fixed Cost Example
Your monthly basic telephone bill probablydoes not change when you make more local
calls.
Number of Local Calls
M o n
t h l y B a s i c
T e l e p h o n e B i l l
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Fixed Cost Per Unit Example
Number of Local Calls
M o n t h l y B a s i c T e l e p h o
n e
B i l l p e r L o c a l C a l l
The average cost per local call decreases asmore local calls are made.
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Cost Classifications
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
Total variable cost changes Variable cost per unit
Variable as activity level changes. remains the same over
wide ranges of activity.
Total fixed cost remains Fixed cost per unitFixed the same even when the goes down as activity
activity level changes. level goes up.
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Cost Behavior Question
Fixed costs are usually characterized by:
a. Unit costs that remain constant.
b. Total costs that increase as activitydecreases.
c. Total costs that increase as activity
increases.
d. Total costs that remain constant.
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Fixed costs are usually characterized by:
a. Unit costs that remain constant.
b. Total costs that increase as activitydecreases.
c. Total costs that increase as activity
increases.
d. Total costs that remain constant.
Cost Behavior Question
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Cost Behavior Question
Variable costs are usually characterized by:
a. Unit costs that decrease as activity
increases.b. Total costs that increase as activity
decreases.
c. Total costs that increase as activityincreases.
d. Total costs that remain constant.
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Variable costs are usually characterized by:
a. Unit costs that decrease as activity
increases.b. Total costs that increase as activity
decreases.
c. Total costs that increase as activityincreases.
d. Total costs that remain constant.
Cost Behavior Question
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Identifying Cost Drivers
Cost Driver Examples
Activity Cost Driver
Machining operations Machine hoursSetup Setup hours
Production scheduling Manufacturing orders
Inspection Pieces inspected
Purchasing Purchase ordersShop order handling Shop orders
Valve assembly support Customer requisitions
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Direct and Indirect Costs
Direct costs
Costs that can beeasily and conveniently
traced to a product or department.
Example: cost of paintin the paint department
of an automobileassembly plant.
Indirect costs
Costs that must beallocated in order to be
assigned to a product or department.
Example: cost of national advertising for
an airline is indirect to aparticular flight.
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A cost can be direct to the department, butindirect to units of product produced in the
department. Example: department manager’s salary.
Tracing costs directly to departments or
products facilitates responsibilityaccounting.
Direct and Indirect Costs
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A cost that can be significantly influencedby a manager is a controllable cost.
Controllable and
Uncontrollable Costs
Cost item Manager Classificaton
Cost of food used Restaurant Controllable
in a restaurant manager
Cost of national Restaurant Uncontrollable
advertising by a manager
restaurant chain
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Manufacturing Costs
TheProduct
ManufacturingOverhead
DirectLabor
DirectMaterial
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Direct Material
Example:Steel used tomanufacture
the automobile.
Raw material that is used to make,and can be conveniently
traced, to the finished product.
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Cost of salaries, wages, and fringebenefits for personnel who work
directly on manufactured products.
Direct Labor
Example: Wages paid to an
automobile assemblyworker.
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All other manufacturing costs
Manufacturing Overhead
Materials used to support
the production process.Examples: lubricants andcleaning supplies used inan automobile assembly
plant.
IndirectLabor
IndirectMaterial
Other Costs
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All other manufacturing costs
Manufacturing Overhead
Cost of personnel who
do not work directly onthe product. Examples:maintenance workers, janitors and security
guards.
IndirectLabor
IndirectMaterial
Other Costs
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All other manufacturing costs
Manufacturing Overhead
Examples: depreciation
on plant and equipment,property taxes,insurance, utilities,
overtime premium, andunavoidable idle time.
IndirectLabor
IndirectMaterial
Other Costs
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Classifications of Costs in
Manufacturing Companies
PrimeCost
ConversionCost
Manufacturing costs are oftencombined as follows:
DirectMaterial
DirectLabor
ManufacturingOverhead
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Merchandiser
Current Assets
Cash
Receivables
Prepaid Expenses
Merchandise Inventory
Manufacturer
Current Assets
Cash
Receivables
Prepaid Expenses
InventoriesRaw Materials
Work in Process
Finished Goods
Cost Classifications on Financial
Statements – Balance Sheet
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Manufacturer
Current Assets
Cash
Receivables
Prepaid Expenses
InventoriesRaw Materials
Work in Process
Finished Goods
Merchandiser
Current Assets
Cash
Receivables
Prepaid Expenses
Merchandise Inventory
Cost Classifications on Financial
Statements – Balance Sheet
Those materialswaiting to beprocessed.
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Manufacturer
Current Assets
Cash
Receivables
Prepaid Expenses
InventoriesRaw Materials
Work in Process
Finished Goods
Cost Classifications on Financial
Statements – Balance Sheet
Partially complete
products – material towhich some labor and/or overhead has
been added.
Merchandiser
Current Assets
Cash
Receivables
Prepaid Expenses
Merchandise Inventory
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Costs
Manufacturing Cost Flows
ManufacturingOverhead
Material Purchases
Direct Labor
Costs
Selling andAdministrative
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Manufacturing Cost Flows
ManufacturingOverhead
Raw MaterialMaterial Purchases
Direct Labor
Balance Sheet Costs Inventories
Selling andAdministrative
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Manufacturing Cost Flows
ManufacturingOverhead
Raw Material
Work inProcess
Material Purchases
Direct Labor
Balance Sheet Costs Inventories
Selling andAdministrative
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Manufacturing Cost Flows
ManufacturingOverhead
Raw Material
Work inProcess
Finished
Goods
Material Purchases
Direct Labor
Balance Sheet Costs Inventories
Selling andAdministrative
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Manufacturing Cost FlowsIncome
StatementExpenses
ManufacturingOverhead
Raw Material
Work inProcess
Finished
Goods
Cost of
GoodsSold
Material Purchases
Direct Labor
Balance Sheet Costs Inventories
Income
StatementExpenses
Selling andAdministrative
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Manufacturing Cost Flows
ManufacturingOverhead
Raw Material
Work inProcess
Finished
Goods
Cost of
GoodsSold
Material Purchases
Direct Labor
Balance Sheet Costs Inventories
Income
StatementExpenses
Selling andAdministrative
Selling andAdministrative
Period Expenses
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Manufacturing Cost Flows
Selling andAdministrative
Selling andAdministrative
Period Expenses
ManufacturingOverhead
Raw Material
Work inProcess
Finished
Goods
Cost of
GoodsSold
Material Purchases
Direct Labor
Balance Sheet Costs Inventories
Income
StatementExpenses
Material, labor andmanufacturing
overhead costsremain in inventoryuntil the product issold, so they aresometimes called
inventoriable costs.
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Manufacturing Cost Flows
Selling andAdministrative
Selling andAdministrative
Period ExpensesPeriod expenses are not associated with manufacturingthe product and are expensed in the period incurred.
ManufacturingOverhead
Raw Material
Work inProcess
Finished
Goods
Cost of
GoodsSold
Material Purchases
Direct Labor
Balance Sheet Costs Inventories
Income
StatementExpenses
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Manufacturing Cost Flows
ManufacturingOverhead
Raw Material
Work inProcess
Finished
Goods
Cost of
GoodsSold
Selling andAdministrative
Material Purchases
Direct Labor
Balance Sheet Costs Inventories
Income
StatementExpenses
Selling andAdministrative
Period Expenses
h d l d
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Schedule of Cost of GoodsManufactured
Let’s look at a Schedule of Cost of
Goods Manufactured for Ringo Percussion Instruments.
h d l f f dExh.
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Ringo Percussion Instruments
Schedule of Cost of Goods Manufactured
Raw material used 105,000$
Direct labor 200,000
Total manufacturing overhead 115,000
Total manufacturing costs 420,000$
Add: Work-in-process inventory, January 1 25,000
Subtotal 445,000$
Deduct: Work-in-process inventory, December 31 30,000
Cost of goods manufactured 415,000$
Schedule of Cost of GoodsManufactured
2-9
S h d l f C f G d
Exh.
2 9
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Ringo Percussion Instruments
Schedule of Cost of Goods Manufactured
Raw material used 105,000$
Direct labor 200,000
Total manufacturing overhead 115,000
Total manufacturing costs 420,000$
Add: Work-in-process inventory, January 1 25,000
Subtotal 445,000$
Deduct: Work-in-process inventory, December 31 30,000
Cost of goods manufactured 415,000$
Schedule of Cost of GoodsManufactured
Computation of Cost of Raw Material Used
Raw-material inventory, January 1 10,000$
Add: Purchases of raw materials 100,000
Raw material available for use 110,000
Deduct: Raw material inventory, December 31 5,000
Raw material used 105,000$
2-9
S h d l f C f G d
Exh.
2 9
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Ringo Percussion Instruments
Schedule of Cost of Goods Manufactured
Raw material used 105,000$
Direct labor 200,000
Total manufacturing overhead 115,000
Total manufacturing costs 420,000$
Add: Work-in-process inventory, January 1 25,000
Subtotal 445,000$
Deduct: Work-in-process inventory, December 31 30,000
Cost of goods manufactured 415,000$
Schedule of Cost of GoodsManufactured
Include all direct labor costs incurred during the
current period.
2-9
S h d l f C f G d
Exh.
2 9
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Ringo Percussion Instruments
Schedule of Cost of Goods Manufactured
Raw material used 105,000$
Direct labor 200,000
Total manufacturing overhead 115,000
Total manufacturing costs 420,000$
Add: Work-in-process inventory, January 1 25,000 Subtotal 445,000$
Deduct: Work-in-process inventory, December 31 30,000
Cost of goods manufactured 415,000$
Schedule of Cost of GoodsManufactured
Computation of Total Manufacturing Overhead
Indirect material 8,000$
Indirect labor 17,000 Depreciation on factory 50,000
Depreciation on equipment 20,000
Utilities 15,000
Insurance 5,000
Total manufacturing overhead 115,000$
2-9
S h d l f C f G d
Exh.
2 9
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Ringo Percussion Instruments
Schedule of Cost of Goods Manufactured
Raw material used 105,000$
Direct labor 200,000
Total manufacturing overhead 115,000
Total manufacturing costs 420,000$
Add: Work-in-process inventory, January 1 25,000 Subtotal 445,000$
Deduct: Work-in-process inventory, December 31 30,000
Cost of goods manufactured 415,000$
Schedule of Cost of GoodsManufactured
Beginning work-in-process inventory iscarried over from the
prior period.
2-9
S h d l f C f G d
Exh.
2 9
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Ringo Percussion Instruments
Schedule of Cost of Goods Manufactured
Raw material used 105,000$
Direct labor 200,000
Total manufacturing overhead 115,000
Total manufacturing costs 420,000$
Add: Work-in-process inventory, January 1 25,000 Subtotal 445,000$
Deduct: Work-in-process inventory, December 31 30,000
Cost of goods manufactured 415,000$
Schedule of Cost of GoodsManufactured
Ending work-in-process inventorycontains the cost of unfinished
goods, and is reported in the currentassets section of the balance sheet.
2-9
I St t t f
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Now let’s look at an income
statement for RingoPercussion Instruments.
Income Statement for aManufacturer
I St t t fExh.
2 9
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Income Statement for aManufacturer
Ringo Percussion Instruments
Income StatementFor the Year Ended December 31, 19X9
Sales revenue 700,000$
Less: Cost of goods sold 425,000
Gross margin 275,000$
Selling and administrative expenses 175,000
Income before taxes 100,000$
Income tax expense 40,000
Net income 60,000$
2-9
I St t t f
Exh.
2-9
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Ringo Percussion Instruments
Income StatementFor the Year Ended December 31, 19X9
Sales revenue 700,000$
Less: Cost of goods sold 425,000
Gross margin 275,000$
Selling and administrative expenses 175,000
Income before taxes 100,000$
Income tax expense 40,000
Net income 60,000$
Income Statement for aManufacturer Ringo Percussion Instruments
Schedule of Cost of Goods Sold
For the Year Ended December 31, 19X9
Finished-goods inventory, Jan. 1 80,000$
Add: Cost of goods manufactured 415,000
Cost of goods available for sale 495,000
Deduct Finished-goods inventory, Dec. 31 70,000
Cost of goods sold 425,000$
2-9
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Opportunity Cost
The potential benefit that isgiven up when onealternative is selected over
another. Example: If you were
not attending college,you could be earning
$15,000 per year.Your opportunity costof attending college for oneyear is $15,000.
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Sunk Costs
All costs incurred in the past that cannot be changedby any decision made now or in the future.
Sunk costs should not be considered in decisions. Example: You bought an automobile that cost
$10,000 two years ago. The $10,000 cost issunk because whether you drive it, park it, trade
it, or sell it, you cannot change the $10,000 cost.
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Differential Costs
Costs that differ between alternatives.
Example: You can earn $1,500 per month in your hometown or $2,000 per month in a nearby city.
Your commuting costs are $50 per month in your hometown and $300 per month to the city.
What is your differential cost?
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Differential Costs
Costs that differ between alternatives.
Example: You can earn $1,500 per month in your hometown or $2,000 per month in a nearby city.
Your commuting costs are $50 per month in your hometown and $300 per month to the city.
What is your differential cost?$300 - $50 = $250
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Marginal Costs and Average Costs
The extra costincurred to produceone additional unit.
The total cost toproduce a quantity
divided by thequantity produced.
Marginal and average costs arelargely a function of cost behavior
-- variable and fixed costs.
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Costs and Benefits of Information
Costs Benefits
More information does not mean morebenefits if information overload results.
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