Chapter 2

Cost:
Resources sacrificed to achieve a specific goal and is measured in money
unit.
Actual cost:
Cost that actually incurred in the past and is distinguished from the budget.
Cost object:
Anything from which cost is allocated to.
In other word, cost object refers to any thing to which cost is assigned to
such as, for example, a soft drink could be a cost object because 100 fils is
assigned to it. Speednet services could be a cost object because BD 50 is
assigned to it.
Cost accumulation:
The collection of cost in an organized way.
Cost assignment:
1. The process of tracing accumulated cost to a cost object.
2. The process of allocating accumulated cost to a cost object.

Cost assignment

Cost tracing

Cost allocating

Direct cost

Indirect cost

From the graph:

1. If we can trace a cost to a cost object, it is direct cost.
2. If we can allocate a cost to a cost object, it is indirect cost.

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Direct cost of a cost object:

A cost that can be traced to a cost object in an economically feasible way
(Cost effective way).
Examples:
1. Soft drink company:
Cost of equipment used to produce 1 can of soft drink is direct cost
assuming that the cost object is the soft drink. (The cost of the
machine is directly related to the soft drink)
2. Cost of wood used to produce a table is a direct cost assuming that the
table is the cost object.
Cost tracing:
The process of assigning the direct cost to a cost object.
Indirect cost of a cost object:
A cost that cannot be traced to a cost object in an economically feasible
way.
Examples:
1. Soft drink company:
The salaries of supervisors are considered indirect cost if we take the
soft drink as a cost object, because the supervisor is responsible for
other products as well. (We dont pay him/her to supervise the soft
drink only)
2. Paying the rent of a building is an indirect cost assuming the cost
object is a book. (The cost of the rent has no relationship with the cost
of the book).
Cost allocation:
The process of assigning the indirect cost to a cost object.
(It depends on the cost object whether the cost is direct or indirect. Meaning
that based on the cost object the cost could be direct in one situation and
indirect in another)
Example:
The salaries paid to a manager in the production department.
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Direct cost: It could be a direct cost if the cost object is the production
department
Indirect cost: It could be indirect cost if the cost object is the product.
Factors affecting direct/ indirect cost classification:
1. The materiality of the cost in question.
The greater the cost, the more likely it is to be a direct cost.
2. Availability of technology used to gather information.
The more technology we have, the easier it is to trace costs to cost
objects.
3. Design of operation:
If a facility is used specially for a cost object, it is considered direct
cost.
Fixed costs and Variable costs:
Variable cost:
A cost that changes, in total, to the change in the level of activity. This
means that the total variable cost will change with the change in the level of
activity. However, the variable cost per unit remains constant and doesnt
respond to the level of activity.
Example:
Suppose that a company buys handlebars for bicycles at $52 for each
bicycle. What is the total cost of handlebars if:
I. 1,000 bicycles were assembled?
II. 3,500 bicycles were assembled?
I. Total variable cost = 1,000 $52 = $52,000
II. Total variable cost = 3,500 $52 = $ 182,000
As you can see that the total variable cost when producing 1,000 units is
different that when producing 3,500 units. However, the variable cost per
unit remains constant at $52 per handlebar.

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Fixed cost:
The cost that remains the same in total for a given range of activity. This
means that the total fixed cost will remain constant, but the fixed cost per
unit changes with the change in the level of activity.
Example:
Assume that the rent is $94,500, and it will be the same regardless of the
level of activity.
Situation A: 1,000 units were produced.
Situation B: 3,500 units were produced.
Required:
1. Calculate the total fixed cost for both situations.
2. Calculate the fixed cost per unit in both situations.
1. Total fixed cost will remain constant = $94,500
2. Situation A:
Fixed cost per unit = $94,500 1,000= $94 per unit
Situation B:
Fixed cost per unit = $94,500 3,500 = $ 26.86 per unit
As you can see from the example that the total fixed cost is constant
regardless of the change in the level of production. However, fixed cost per
unit changes with the change in the level of production. As the level of
production increases, fixed cost per unit decreases.
Cost driver:
Factors that affect the cost in a cost and effective relationship.
Look at the example on page 3. The cost driver is the number of units
produced. When the company produced 1,000 units (Cause), the cost was
$52,000 (Effect). But when they produced 3,500 units (Cause), the cost was
$182,000 (Effect).
Variable costs have cost drivers.
Fixed costs in the short run dont have cost drivers.
Fixed costs in the long run have cost drivers.
Relevant range:

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The range of activity level in which theres a relationship between the level
of activity and the cost.
Example:
Assume that the fixed cost is $94,500 for a relevant range of (1,000- 5,000)
cars assembled, but $100,000 for a relevant range of (5,001- - 10,000).
This means that if the company assembles between (1,000- 5,000) cars, the
fixed cost will be $94,500, but if they assemble cars between (5,001- 10,000), the fixed cost will be $100,000.
Example2:
If the variable cost is $5 per unit, and the fixed cost is $50,000 within the
range of activity of (0-10,000) units, $140,000 within the range of (10,00120,000)
Situation A: Production is 4,000 units.
Situation B: Production is 13,000 units.
Required: Calculate the total cost for both situations.
Answer
Situation A:
Total cost = (5 4,000) + $50,000= $70,000
Situation B:
Total cost = (5 13,000) + $140,000 = $ 205,000
Unit cost/ Average cost:
Total cost Number of units

The use of average cost:

Example: If the total cost of producing 500,000 units is $40,000,000.
480,000 units were sold, whereby 20,000 units remain in inventory.
Required: Calculate the cost of goods sold and ending inventory.
Answer
Unit cost = $40,000,000 500,000 = $ 80 per unit.
Cost of goods sold = 480,000 80 = $ 38,400,000.
Cost of ending inventory = 20,000 80 = $1,600,000
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Example2
What is the unit cost when a company assembles 1,000 units assuming that
fixed cost is $94,500 and variable cost is $52 per unit?
Answer
Total cost = (52 1,000) + $94,500 = $146,500
Unit cost = $146,500 1,000 = $ 146.50 per unit
Example3
Assume that the unit cost is $ 146.50 per unit, what is the estimated budget
to produce 600 units?
Answer:
600 $146.50 = $87,900
Look at example 1 & 3:
The use of unit costs is that we can calculate:
I. Cost of goods sold (Chapter9)
II. Ending inventory (Chapter9)
III. Budgets (Chapter7)
You should know that as the number of units increase, unit cost decreases.
Recall from Acc 112 that we have 3 types of companies:
1) Manufacturing companies:
Companies that purchase materials and convert them into finished
goods.
2) Merchandise companies:
Companies that purchase tangible products then resell them.
3) Service companies:
Companies that provide intangible products.
Now lets talk about the inventories within these companies
First: Service companies:
No inventory exists.

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Second: Merchandise companies:

They only have Merchandise inventory (Acc 112)
Third: Manufacturing companies:
We have three inventories:
1) Direct materials:
Materials waiting to be used in the manufacturing process.
2) Work in process:
Goods worked on, but not yet completed.
3) Finished goods:
Goods completed but not yet sold.
Inventoriable costs & Period costs:
Inventoriable costs:
Costs of production that are recorded as assets when purchased then cost of
goods sold when selling the product.
A. Inventoriable costs in service companies:
No such costs exist because we have no inventory.
B. Inventoriable costs in merchandising companies:
The cost of purchasing the product is inventoriable cost
C. Inventoriable costs in manufacturing companies:
We have three inventoriable costs:
I. Direct materials costs:
Cost of materials that can be directly traced to the cost object.
II.

Direct manufacturing labor:

Salaries of employee that can be directly traced to the cost object.

III. Indirect manufacturing costs

Costs that cant be traced to the cost object directly such as supplies,
depreciation and insurance.
Period costs:
All costs other than cost of goods sold.

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Lets go to some calculations:

Cost of goods sold in manufacturing companies:
Beginning finished goods
+ Cost of goods manufactured
Cost of goods available for sale
- Ending finished goods
Cost of goods sold

XX
XX
XX
XX
XX

Usually the beginning and the ending finished goods will be given.
Cost of goods manufactured:
To get this we use the schedule of goods manufactured:
XYZ COMPANY
Schedule of cost of goods manufactured
For year ended December 31,2004
Direct materials:
Beginning inventory Jan, 2004
XX
Purchase of direct materials
XX
Cost of direct materials available for sale
XX
Ending inventory Dec, 2004
(XX)
Direct materials used
Direct manufacturing labor
Indirect manufacturing costs:
Indirect manufacturing labor
XX
Supplies
XX
Heat, lighting, electricity
XX
Depreciation
XX
Total indirect manufacturing costs
Manufacturing costs incurred during 2004
Add: Beginning work in process inventory Jan, 2004
Total manufacturing costs to account for
Deduct: Ending work in process inventory Dec, 2004
Cost of goods manufactured

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XX1
XX2

XX3
XX (1+2+3)
XX
XX
(XX)
XX

The amount of the cost of goods manufactured will be used in the income
statement:
XYZ COMPANY
Income Statement
For Year Ended December 31,2004
Revenues
Cost of goods sold:
Beginning finished goods Jan, 2004
Cost of goods manufactured
Cost of goods available for sale
Ending finished goods Dec, 2004
Cost of goods sold
Gross margin
Operating costs
Operating income

XX
XX
XX
XX
(XX)
XX
XX
(XX)
XX

Note: All we did in the Schedule of cost of goods manufactured is:

Direct materials used
XX
+
Direct manufacturing labor
XX
+
Indirect manufacturing cost
XX
+
Beginning work in process
XX
Ending work in process
XX
Cost of goods manufactured
XX
Prime cost = Direct materials + Direct manufacturing labor
Conversion cost = Direct manufacturing labor + Indirect manufacturing costs
Overtime premium:
Wages paid to workers for working more than the original time.
Example:
Assume that normal working hours a week is 40 hours. An employee worked for 44
hours. The straight time wage rate is $20 per hour. The overtime rate is $30 per hour.
Required: Calculate the total compensation for the 44 hours.

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Answer
Overtime wage premium = 30 20 = $10 per hour.
Direct labor (44 20)
Overtime premium (4 10)
Total 44 hour compensation

$880
40
$ 920

Idle time:
Wages paid for unproductive time.
Example
Assume the information from the previous example; further information is that the
machine broke down for 3 hours.
Required: Calculate the total compensation for the 44 hours.
Answer
Direct labor (41 20)
Idle time (3 20)
Overtime premium (4 10)
Total 44 hour compensation

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$820
60
40
$920

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Chapter 2 exercises:
Choose the best alternative for the following questions:
1. Which of the flowing statements is true?
A. Total fixed cost increases while total variable costs decrease when activity
level decreases.
B. Fixed cost per unit remains the same while total variable costs increase when
activity level increases.
C. Fixed cost per unit decreases while variable cost per unit remains constant as
activity level increases.
D. Fixed cost per unit and variable cost per unit increase as the activity volume
increases.
E. All of the above statements are incorrect.
Assume the following information for 2-3:
Beginning inventory = 0
Production = 5,000 units.
Total manufacturing costs = $20,000
Units sold = 4,000 units.
2. The cost of goods sold is:
A. $ 4,000.
B. $ 16,000
C. $ 20,000
D. $ 32,000
E. $ 50,000
3. The cost of ending inventory is:
A. $ 4,000.
B. $ 16,000
C. $ 20,000
D. $ 32,000
E. $ 50,000
Assume the following information for 4-9:
Bicycles by the sea had $50,000 of direct materials at the beginning of the
period, purchases of materials were $180,000, and the ending materials were
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$30,000. Direct labor costs were $105,500. Indirect manufacturing costs were
$194,500. Assume that work in process inventory at the beginning of the period was
$30,000 and $35,000 at the end. Finished goods inventory at the beginning of the
period was $10,000 but $15,000 at the end.
4. Cost of goods sold is:
A. $490,000
B. $495,000
C. $500,000
D. $305,500
E. $300,000
5. Manufacturing costs would be:
A. $490,000
B. $495,000
C. $500,000
D. $305,500
E. $300,000
6. Cost of goods manufactured is:
A. $490,000
B. $495,000
C. $500,000
D. $305,500
E. $300,000
7. Direct materials used would be:
A. $50,000
B. $180,000
C. $200,000
D. $250,000
E. $500,000
8. Prime cost is:
A. $490,000
B. $495,000
C. $500,000
D. $305,500
E. $300,000

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9. Conversion cost would be:

A. $490,000
B. $495,000
C. $500,000
D. $305,500
E. $300,000
10. The working hours a week is 40 in a factory. A machine operator works for 45
hours. The straight time wage rate is $10 per hour. The overtime rate is $15.
Suppose that the machine broke down for 3 hours. The direct manufacturing
labor cost would be:
A. $420
B. $450
C. $430
D. $475
E. $410
11. A company had $8,000 of direct materials at the beginning of the period,
purchases $86,500 of direct materials. The ending materials were $9,000. Direct
labor costs were $60,000; indirect manufacturing costs were $30,000. Work in
process at the beginning of the period was $2,500. At the end it was $7,500.
Calculate the cost of goods manufactured.
Assume the following information for 12-14:
Accounts receivable, beginning
$1,900
Revenues
$34,000
Purchase of direct materials
$8,000
Gross margin
$13,000
Direct manufacturing labor
$4,000
Direct materials used
C
Finished goods, beginning
$4,000
Work in process, beginning
$500
Work in process, ending
$1,500
Indirect manufacturing costs
B
Finished goods, ending
$7,000
Cost of goods sold
A
Indirect manufacturing costs are 60% of conversion costs.

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12. What is the value of A:

A. $21,000
B. $24,000
C. $30,000
D. $32,000
E. None of the above.
13. What is the value of B:
A. $2,000
B. $4,000
C. $6,000
D. $8,000
E. $10,000
14. What is the value of C:
A. $10,000
B. $12,000
C. $14,300
D. $15,000
E. $20,000
X is a manufacturing company, Y is a merchandise company and Z is a service
company. For 15-20 classify the costs as either inventoriable costs or period costs:
15. Soft drinks purchased by Y for resell.
16. Electricity used for the production department in X.
17. Depreciation of a building in Z.
18. Electricity used for heating in Y.
19. Depreciation of testing equipment used in Xs manufacturing process.
20. Salaries of Ys marketing department staff.
21. Soft drinks purchased by Z for its programmers.
22. Salaries of staff in Z.
23. A company has year end cost of goods manufactured of $5,000, beginning
finished goods of $700 and ending finished goods of $850. Cost of goods sold is:
A. $4,250
B. $4,000
C. $4,850
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D. $6,550
E. None of the above.
24. Compute the cost of goods manufactured from the following information:
Direct materials $192,500
Direct labor $65,150
Factory overhead costs $26,000
Work in process, Dec.31, 2004 $159,600
Work in process, Dec.31, 2005 $144,750
For more questions please visit:
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