ch 2 introduction to cost terms
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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Introduction to Cost Terms
And Purposes
2 Chapter Chapter TwoTwo
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Process of ManagementProcess of Management
DecisionMaking
DirectingControl
PlanningStrategy Formulation
Managers need cost information toperform each of these functions.
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What Do We Mean By a Cost?What Do We Mean By a Cost?
A costis the measure ofresources givenup to achieve a
particular purpose.
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Product Costs, Period Costs and ExpensesProduct Costs, Period Costs and Expenses
Product costs are costs associated with goods for sale until the time period during which the products are sold, at which time the costs become expenses.
Period costs are costs that are expensed during the time period in which they are incurred.
Expenses are the consumption of assets for the purpose of generating revenue.
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Product CostsProduct Costs
Cost of goods sold
Period CostsPeriod Costs
Operating expenses
Cost Classifications on Financial Cost Classifications on Financial Statements – Income StatementStatements – Income Statement
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MerchandiserMerchandiser Current Assets
– Cash
– Receivables
– Prepaid Expenses
– Merchandise Merchandise InventoryInventory
ManufacturerManufacturer Current Assets
CashCash ReceivablesReceivables Prepaid ExpensesPrepaid Expenses InventoriesInventories
Raw MaterialsRaw Materials
Work in ProcessWork in Process
Finished GoodsFinished Goods
Cost Classifications on Financial Cost Classifications on Financial Statements – Balance SheetStatements – Balance Sheet
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MerchandiserMerchandiser Current Assets
– Cash
– Receivables
– Prepaid Expenses
– Merchandise Merchandise InventoryInventory
ManufacturerManufacturer Current Assets
CashCash ReceivablesReceivables Prepaid ExpensesPrepaid Expenses InventoriesInventories
Raw MaterialsRaw Materials
Work in ProcessWork in Process
Finished GoodsFinished Goods
Cost Classifications on Financial Cost Classifications on Financial Statements – Balance SheetStatements – Balance Sheet
Those materials waiting to be processed.
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MerchandiserMerchandiser Current Assets
– Cash
– Receivables
– Prepaid Expenses
– Merchandise Merchandise InventoryInventory
ManufacturerManufacturer Current Assets
CashCash ReceivablesReceivables Prepaid ExpensesPrepaid Expenses InventoriesInventories
Raw MaterialsRaw Materials
Work in ProcessWork in Process
Finished GoodsFinished Goods
Cost Classifications on Financial Cost Classifications on Financial Statements – Balance SheetStatements – Balance Sheet
Partially complete products – material to
which some labor and/or overhead has
been added.
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MerchandiserMerchandiser Current Assets
– Cash
– Receivables
– Prepaid Expenses
– Merchandise Merchandise InventoryInventory
ManufacturerManufacturer Current Assets
CashCash ReceivablesReceivables Prepaid ExpensesPrepaid Expenses InventoriesInventories
Raw MaterialsRaw Materials
Work in ProcessWork in Process
Finished GoodsFinished Goods
Cost Classifications on Financial Cost Classifications on Financial Statements – Balance SheetStatements – Balance Sheet
Completed products awaiting sale.
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Manufacturing CostsManufacturing Costs
TheProduct
DirectLabor
DirectMaterial
Manufacturing Overhead
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Direct MaterialDirect Material
Example:Steel used tomanufacture
the automobile.
Example:Steel used tomanufacture
the automobile.
Cost of raw material that is used tomake, and can be convenientlytraced, to the finished product.
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Cost of salaries, wages, and fringebenefits for personnel who work
directly on manufactured products.
Direct LaborDirect Labor
Example:Wages paid to an
automobile assemblyworker.
Example:Wages paid to an
automobile assemblyworker.
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All other manufacturing costs
Manufacturing OverheadManufacturing Overhead
Materials used to support the production process. Examples: lubricants and
cleaning supplies used in an automobile assembly plant.
IndirectLabor
IndirectMaterial
OtherCosts
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All other manufacturing costs
Manufacturing OverheadManufacturing Overhead
Cost of personnel who do not work directly on
the product. Examples: maintenance workers, janitors and security
guards.
IndirectLabor
IndirectMaterial
OtherCosts
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All other manufacturing costs
Manufacturing OverheadManufacturing Overhead
Examples: depreciation on plant and equipment,
property taxes, insurance, utilities,
overtime premium, and unavoidable idle time.
IndirectLabor
IndirectMaterial
OtherCosts
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Classifications of Costs in Classifications of Costs in Manufacturing CompaniesManufacturing Companies
PrimeCost
ConversionCost
Manufacturing costs are oftencombined as follows:
DirectMaterial
DirectLabor
ManufacturingOverhead
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Manufacturing Cost FlowsManufacturing Cost Flows
ManufacturingOverhead
Direct Material
Direct Labor Work in Process Inventory
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Manufacturing Cost FlowsManufacturing Cost Flows
ManufacturingOverhead
Direct Material
Direct Labor
FinishedGoods
Inventory
Work in Process Inventory
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Manufacturing Cost FlowsManufacturing Cost Flows
ManufacturingOverhead
Direct Material
Direct Labor
FinishedGoods
Inventory
Cost of GoodsSold
Work in Process Inventory
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Comet Computer Corporation
Schedule of Cost of Goods Manufactured
Raw material used 134,980$
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs 414,980$
Add: Work-in-process inventory, January 1 120
Subtotal 415,100$
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured 415,000$
Schedule of Cost of Goods Schedule of Cost of Goods ManufacturedManufactured
Exh. 2-7
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Comet Computer Corporation
Schedule of Cost of Goods Manufactured
Raw material used 134,980$
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs 414,980$
Add: Work-in-process inventory, January 1 120
Subtotal 415,100$
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured 415,000$
Schedule of Cost of Goods Schedule of Cost of Goods ManufacturedManufactured
Computation of Cost of Raw Material Used
Raw-material inventory, January 1 6,000$
Add: Purchases of raw materials 134,000
Raw material available for use 140,000
Deduct: Raw material inventory, December 31 5,020
Raw material used 134,980$
Exh. 2-7
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Comet Computer Corporation
Schedule of Cost of Goods Manufactured
Raw material used 134,980$
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs 414,980$
Add: Work-in-process inventory, January 1 120
Subtotal 415,100$
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured 415,000$
Schedule of Cost of Goods Schedule of Cost of Goods ManufacturedManufacturedInclude all direct labor
costs incurred during the current period.
Exh. 2-7
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Comet Computer Corporation
Schedule of Cost of Goods Manufactured
Raw material used 134,980$
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs 414,980$
Add: Work-in-process inventory, January 1 120
Subtotal 415,100$
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured 415,000$
Schedule of Cost of Goods ManufacturedSchedule of Cost of Goods Manufactured
Computation of Total Manufacturing Overhead
Indirect material 10,000$
Indirect labor 40,000
Depreciation on factory 90,000
Depreciation on equipment 70,000
Utilities 15,000
Insurance 5,000
Total manufacturing overhead 230,000$
Exh. 2-7
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Comet Computer Corporation
Schedule of Cost of Goods Manufactured
Raw material used 134,980$
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs 414,980$
Add: Work-in-process inventory, January 1 120
Subtotal 415,100$
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured 415,000$
Schedule of Cost of Goods Schedule of Cost of Goods ManufacturedManufactured
Beginning work-in-process inventory is carried over from the
prior period.
Exh. 2-9
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Comet Computer Corporation
Schedule of Cost of Goods Manufactured
Raw material used 134,980$
Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs 414,980$
Add: Work-in-process inventory, January 1 120
Subtotal 415,100$
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured 415,000$
Schedule of Cost of Goods Schedule of Cost of Goods ManufacturedManufactured
Ending work-in-process inventory contains the cost of unfinished
goods, and is reported in the current assets section of the balance sheet.
Exh. 2-9
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Income Statement for a Income Statement for a ManufacturerManufacturer
Comet Computer Corporation
Income Statement
For the Year Ended December 31, 20X2
Sales revenue 700,000$
Less: Cost of goods sold 415,010
Gross margin 284,990$
Selling and administrative expenses 174,490
Income before taxes 110,500$
Income tax expense 30,000
Net income 80,500$
Exh. 2-7
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Comet Computer Corporation
Income Statement
For the Year Ended December 31, 20X2
Sales revenue 700,000$
Less: Cost of goods sold 415,010
Gross margin 284,990$
Selling and administrative expenses 174,490
Income before taxes 110,500$
Income tax expense 30,000
Net income 80,500$
Income Statement for a ManufacturerIncome Statement for a ManufacturerComet Computer Corporation
Schedule of Cost of Goods Sold
For the Year Ended December 31, 20X2
Finished-goods inventory, Jan. 1 200$
Add: Cost of goods manufactured 415,000
Cost of goods available for sale 415,200
Deduct Finished-goods inventory, Dec. 31 190
Cost of goods sold 415,010$
Exh. 2-7
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Identifying Cost DriversIdentifying Cost Drivers
Cost Driver Examples
Activity Cost Driver
Machining operations Machine hoursSetup Setup hoursProduction scheduling Manufacturing ordersInspection Pieces inspectedPurchasing Purchase ordersShop order handling Shop ordersValve assembly support Customer requisitions
Activities thatcause costs to be
incurred are calledcost drivers.
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Cost ClassificationsCost Classifications
Cost behavior means how a cost will react to changes in the level of business activity.
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Cost ClassificationsCost Classifications
Cost behavior means how a cost will react to changes in the level of business activity.– Total variable costs
change when activity changes.
– Total fixed costs remain unchanged when activity changes.
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Total Variable Cost ExampleTotal Variable Cost Example
Your total long distance telephone bill is based on how many minutes you talk.
Minutes Talked
Tot
al L
ong
Dis
tanc
eT
elep
hone
Bill
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Variable Cost Per Unit ExampleVariable Cost Per Unit Example
Minutes Talked
Per
Min
ute
Tel
eph
on
e C
har
ge
The cost per long distance minute talked is constant. For example, 5 cents per minute.
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Total Fixed Cost ExampleTotal Fixed Cost Example
Your monthly basic telephone bill probably does not change when you make more local
calls.
Number of Local Calls
Mo
nth
ly B
asic
T
elep
ho
ne
Bill
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Fixed Cost Per Unit ExampleFixed Cost Per Unit Example
Number of Local Calls
Mo
nth
ly B
asic
Tel
eph
on
e B
ill p
er L
oca
l Cal
l
The average cost per local call decreases as more local calls are made.
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Cost ClassificationsCost Classifications
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
Total variable cost changes Variable cost per unitVariable 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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Direct and Indirect CostsDirect and Indirect CostsDirect costs
• Costs that can beeasily and conveniently traced to a product or department.
• Example: cost of paint in the paint department of an automobile assembly plant.
Indirect costs
• Costs that must be allocated in order to be assigned to a product or department.
• Example: cost of national advertising for an airline is indirect to a particular flight.
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• A cost can be direct to the department, but indirect to units of product produced in the department.– Example: department manager’s salary.
• Tracing costs directly to departments or products helps to identify and eliminate non-value added costs.
Direct and Indirect CostsDirect and Indirect Costs
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A cost that can be significantly influencedby a manager is a controllable cost.
Controllable andControllable andUncontrollable CostsUncontrollable Costs
Cost item Manager Classificaton
Cost of food used Restaurant Controllablein a restaurant manager
Cost of national Restaurant Uncontrollableadvertising by a managerrestaurant chain
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Opportunity CostOpportunity Cost
The potential benefit that is given up when one alternative is selected over another.– Example: If you were
not attending college,you could be earning$20,000 per year. Your opportunity costof attending college for one year is $20,000.
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Sunk CostsSunk Costs
All costs incurred in the past that cannot be changed by any decision made now or in the future are sunk costs. Sunk costs should not be considered in decisions.
– Example: You bought an automobile that cost $12,000 two years ago. The $12,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $12,000 cost.
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Differential CostsDifferential Costs
Costs that differ between alternatives.
Example: You can work in your home town or 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 Marginal Costs and Average CostsCosts
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 InformationCosts and Benefits of Information
Costs Benefits
More information does not mean more benefits if information overload results.