CH 2

CHAPTER 2
An Introduction to
Cost Terms and Purposes
Learning Objectives
1.Define and illustrate a cost object
2. Distinguish between direct costs and
indirect costs
3. Explain variable costs and fixed costs
4. Interpret unit costs cautiously
5. Distinguish inventoriable costs from period
costs
6. Explain why product costs are computed in
different ways for different purposes
7. Describe a framework for cost accounting
and cost management
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.
2-2
Learning Objective 1
Define and illustrate a cost object
2-3
Basic Cost Terminology

Cost is a resource sacrificed or forgone to achieve
a specific objective.
Actual cost is a cost incurred (a historical cost)
.
Budgeted Cost a predicted or forecasted cost

( future cost)
A cost object is anything for which a separate

measurement of costs is desired.
2-4
Distinguish between direct costs and
indirect costs
2-5

Direct Costs related to the particular cost object and can be traced (tracked) to it in an economically feasible (costeffective) way.
Examples:
Parts
Assembly line wages
2-6

Indirect Costs related to the particular cost object
but can not be traced (tracked) to it in an
economically feasible (cost-effective) way.
Examples
Electricity
Rent
Property taxes
2-7

Cost Accumulation:
The collection of cost data in some organized way
by means of accounting system.
Cost Assignment:
a general term that includes both:
(1) Cost tracing
(2) Cost allocation
2-8

Cost tracing: the assignment of direct costs to a
particular cost object.
Cost allocation: the assignment of indirect costs
to a particular cost object.
2-9
Direct and Indirect Costs

Example
Direct Costs
Example: Paper on which
Sports Illustrated magazine
is printed
Indirect Costs
Example: Lease cost for
Time-Warner building
housing the senior editors
of its magazine
Cost
Tracing
COST
COSTOBJECT
OBJECT
Example:
Example:
Sports
SportsIllustrated
Illustrated
magazine
magazine
Fashion
Fashionmagazine
magazine
Cost
Allocatio
n
2-10
Direct and Indirect Costs

Example
Maintenance Department
Personnel Department
Assembly Department
Finishing Department
$40,000
$20,600
$75,000
$55,000
Assume that Maintenance Department costs are

allocated equally among the production departments.
How much is allocated to each department?
2-11
Direct and Indirect Costs Example

Maintenance
$40,000
Assembly
Direct Costs
$75,000
Finishing
Direct Costs
$55,000
$20,000
$20,000
Allocated
2-12
Factors Affecting Direct/Indirect Cost

Classification
1. Cost Materiality
The smaller the amount of a cost, the less likely it is
economically feasible to trace to a particular cost object.
(e.g. the cost of invoice paper)
2. Availability of Information-gathering Technology
Improvements in information-gathering technology make
it possible to consider more and more costs as direct costs.
(e.g. Bar codes)
3. Operational Design
If a machine is used exclusively for a specific cost object, all
costs related to this machine can be classified as direct cost.
2-13
Explain variable costs and fixed costs
2-14
Cost-Behavior Patterns: Variable vs.

Fixed Cost
Two basic types of cost-behavior patterns:
Variable Cost changes in total in proportion to
changes in the related level of activity or volume.
Fixed Cost remains unchanged in total for a given
time period regardless of changes in the related level
of activity or volume
2-15
Cost Behavior Patterns Example

Variable cost:
Steering wheel cost is a variable cost because total
cost changes in proportion to changes in the
number of vehicles produced.
BMW buys a steering wheel
at $60 for each of its car.
What is the total steering wheel cost when
1,000 cars are assembled?
2-16

1,000 units $60 = $60,000
What is the total steering wheel cost
when 3,000 cars are assembled?
3,000 units $60 = $180,000
The total steering wheel cost increases with
the number of cars assembled, but the cost
per unit of a steering wheel keeps
unchanged.
2-17

Fixed cost
BMW incurred a total of $100,000,000 in
leasing costs per year for its plant.
These costs are unchanged in total over a
designated range of the number of vehicles
produced during a given time span.
2-18

What is the leasing (fixed) cost per car
when BMW assembles 10,000 cars?
$100,000,000 10,000 = $10,000
What is the leasing (fixed) cost per car
when BMW assembles 25,000 cars?
$100,000,000 25,000 = $4,000
The cost per unit of a fixed cost become
smaller and smaller as the number of
products produced increases.
2-19

Fixed Cost
Variable costs are constant on a per-unit
basis. If a product takes 5 pounds of

materials each, it stays the same per unit
regardless of whether one, ten, or a thousand
units are produced
Fixed costs per unit change inversely with
the level of production. As more units are
produced, the same fixed cost is spread over
more and more units, reducing the cost per
unit
2-20
Cost Behavior Summarized

Total
Dollars
Total
Dollars
Variable
Variable
Costs
Costs
Change in
Change in
proportion with
proportion
with
output
output
More output = More cost
Cost
perUnit
Unit
Cost
per
Unchanged in
Unchanged
in
relation
to output
relation to output
More output = More

cost
Fixed
Fixed Costs
Costs
Unchanged in
Unchanged in
relation
to output
relation to output
Change inversely
Change
with inversely
output
with
Moreoutput
output = lower cost
More output = lower
per unit
cost per unit
2-21

Fixed Cost
Mixed cost (semi-variable cost)
both fixed and variable elements
e.g. telephone cost
2-22
Cost Drivers
The cost driver is the level of activity or
volume whose change causes the (variable)
costs to change proportionately.
The number of cars assembled is a
cost driver of the cost of steering wheels.
2-23
Relevant Range Example

Costs are defined as fixed or variable with respect to a
specific activity or a given time period.
Relevant Range the band of normal activity level (or
volume) in which there is a specific relationship between the
level of activity (or volume) and a given cost. e.g., fixed costs
are fixed only within the relevant range.
Assume that fixed (leasing) costs are $100,000,000 for a year
and that they remain the same for a certain volume range (5,000
to 25,000 cars).
5,000 to 25,000 cars is the relevant range.
2-24
Relationships of Types of Costs

Two major classifications of costs: direct/indirect,
variable/fixed
Costs may simultaneously be:
Direct and variable
Direct and fixed
Indirect and variable
Indirect and fixed
2-25
Relationships of Types of Costs

Direct
Variable
Fixed
Indirect
2-26
Interpret unit costs cautiously
2-27
Total Costs and unit costs

Unit costs should be used cautiously. Since
unit costs change with a different level of

output or volume, it may be more prudent to
base decisions on a total dollar basis.
The decision maker should think in terms of
total costs rather than unit costs.
2-28
Total Costs and Unit Costs

Example
2007: Total costs: $40,000,000
Fixed costs: $10,000,000
Variable costs: $30,000,000
(500,000 units produced)
Unit cost $40,000,000 500,000 = $80
2-29
Use Unit Costs Cautiously

Assume that management uses a
unit cost of $80.
Management is budgeting costs for
different levels of production.
What is their budgeted cost for an
estimated production of 100,000 products?
100,000 $80 = $8,000,000
2-30
Use Unit Costs Cautiously

What should the budgeted cost be for an
estimated production of 100,000?
Total fixed cost
$ 10,000,000
Total variable cost ($60 100,000) 6,000,000
Total
$16,000,000
Unit cost $16,000,000 100,000 = $160
2-31
Distinguish inventoriable costs from
period costs
2-32
Different Types of Firms

Manufacturing, Merchandising, and Service
companies
2-33
Manufacturing
Manufacturing
Manufacturing companies
companies
purchase
purchase materials
materials and
and components
components and
and
convert
convert them
them into
into finished
finished goods.
goods.
A
Amanufacturing
manufacturing company
company must
must also
also develop,
develop,
design,
design, market,
market, and
and distribute
distribute its
its products.
products.
2-34
Merchandising
Merchandising
Merchandising companies
companies
purchase
purchase and
and then
then sell
sell tangible
tangible products
products
without
without changing
changing their
their basic
basic form.
form.
2-35
Service
Service
Service companies
companies
provide
provide services
services or
or intangible
intangible
products
products to
to their
their customers.
customers.
Labor
Labor isis the
the most
most significant
significant cost
cost category.
category.
2-36
Describe the three categories of
inventories commonly found in
manufacturing companies
2-37
Types of Inventories
Manufacturing companies typically have one or
more of the following three types of inventories:
Direct Materials resources in stock and available for
use
Work-in-Process (or progress) products started but not
yet completed. WIP
Finished Goods products completed and ready for
sale
2-38
Types of Inventory
Merchandising companies hold only
one type of inventory the product in
its original purchased form.
Service companies do not hold
inventories of tangible products.
2-39
Classification of manufacturing costs

Manufacturing Costs
Manufacturing consists of activities to convert raw
materials into finished goods.
Categories of manufacturing costs include:
2-40

Direct material costs: the acquisition costs of
all materials that eventually become part of
the cost object and that can be traced to the
cost object in an economically feasible way.
Direct manufacturing labor costs: the
compensation of all manufacturing labor that
can be traced to the cost object in an
economically feasible way.
2-41

Indirect manufacturing costs all manufacturing costs
related to the cost object but that can not be traced to
the cost object in an economically feasible way.
Manufacturing Overhead or Factory Overhead
Indirect Materials: Materials that cannot be easily
associated with the finished product.
Indirect Labor: Work of factory employees that has no
physical association with the finished product or for which it
is impractical to trace to the goods produced.
Other indirect costs: electricity costs
2-42

Review Question
Which of the following is not an element of
manufacturing overhead?:
a. Sales managers salary.

b. Plant managers salary.
c. Factory repairmans wages.
d. Product inspectors salary.
LO 3 Define the three classes of manufacturing costs.

2-43
Distinctions Between Inventoriable

Costs and Period Costs
Inventoriable Costs
Manufacturing company: manufacturing
costs. These costs are capitalized as assets

(inventory) until they are sold and transferred
to Cost of Goods Sold
For merchandising company: costs of
purchasing the goods.( purchase price,
incoming freight, insurance, handling costs)
For service company: no
2-44
Inventoriable Costs
Inventoriable costs (assets)

become cost of goods sold
after a sale takes place.
2-45

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.
2-46

Inventoriable Costs
2-47
Multiple Classification of Costs, Visualized
2-48
Cost Flows
The Cost of Goods Manufactured and the
Cost of Goods Sold section of the income

statement are accounting representations of
the actual flow of costs through a production
system.
2-49
Cost Flows Visualized
2-50
Multiple-Step Income Statement
STEP 4
2-51
Cost of Goods Manufactured
STEP 1
STEP 2
STEP 3
2-52
Other Cost Considerations

Prime cost: all direct manufacturing costs
(labor and materials)

Conversion cost: direct labor and factory
overhead costs
2-53
Prime Costs
Direct
Materials
Direct
Labor
Prime
Costs
2-54
Conversion Costs
Direct
Labor
Manufacturing
Overhead
Indirect
Labor
Indirect
Materials
Conversion
Costs
Other
2-55
Measuring Costs
Requires Judgment
Manufacturing labor cost classifications
vary among companies.
The following distinctions are generally found:
Direct manufacturing labor
Manufacturing overhead
2-56
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
2-57
Measuring Costs
Requires Judgment
Overtime premium: wage rate paid to workers
in excess of their straight-time wage rates.
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.
2-58
Measuring Costs
Requires Judgment
How much is the overtime premium?
$18 50% = $9 per overtime hour
If this worker works 44 hours (including 4
overtime 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
2-59
Measuring Costs
Requires Judgment
Idle time: wages paid for unproductive time
caused by lack of orders, machine break-downs,
materials shortages, poor scheduling, etc.
Idle time is considered as overhead costs.
2-60
Explain why product costs are
computed in different ways for
different purposes
2-61
Different Definitions of Cost for

Different Applications
A product cost is the sum of the costs
assigned to a product for a specific purpose.
1. Preparing financial statements for external
reporting under GAAP: Only manufacturing costs
2. Contracting with government agencies very
specific definitions of cost for cost plus prespecified margin contracts
3. Pricing and product-mix decisions may use

a super cost approach (comprehensive)
2-62
Different Definitions of Costs

for Different Applications
2-63
Describe a framework for cost
accounting and cost management
2-64
Three Common Features of Cost

Accounting and Cost Management
1. Calculating the cost of products, services, and other
cost objects
2. Obtaining information for planning and control, and
performance evaluation
3. Analyzing the relevant information for making
decisions
2-65

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CH 2

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CHAPTER 2

Basic Cost Terminology

Budgeted Cost a predicted or forecasted cost

A cost object is anything for which a separate

Basic Cost Terminology

Basic Cost Terminology

Basic Cost Terminology

Basic Cost Terminology

Direct and Indirect Costs

Direct and Indirect Costs

Assume that Maintenance Department costs are

Direct and Indirect Costs Example

Factors Affecting Direct/Indirect Cost

Cost-Behavior Patterns: Variable vs.

Cost Behavior Patterns Example

Cost Behavior Patterns Example

Cost Behavior Patterns Example

Cost Behavior Patterns Example

Cost-Behavior Patterns: Variable vs.

basis. If a product takes 5 pounds of

Cost Behavior Summarized

More output = More

Cost-Behavior Patterns: Variable vs.

Relevant Range Example

Relationships of Types of Costs

Relationships of Types of Costs

Total Costs and unit costs

unit costs change with a different level of

Total Costs and Unit Costs

Use Unit Costs Cautiously

Use Unit Costs Cautiously

Different Types of Firms

Classification of manufacturing costs

Classification of manufacturing costs

Classification of manufacturing costs

Classification of manufacturing costs

a. Sales managers salary.

LO 3 Define the three classes of manufacturing costs.

Distinctions Between Inventoriable

costs. These costs are capitalized as assets

Inventoriable costs (assets)

Distinctions Between Inventoriable

Distinctions Between Inventoriable

Multiple Classification of Costs, Visualized

Cost of Goods Sold section of the income

Cost Flows Visualized

Multiple-Step Income Statement

Cost of Goods Manufactured

Other Cost Considerations

(labor and materials)

Payroll fringe costs

Forklift truck operators (internal handling of materials)

Different Definitions of Cost for

3. Pricing and product-mix decisions may use

Different Definitions of Costs

Three Common Features of Cost

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