Chapter

Cost Terms,
Concepts, and
Classifications

Comparing Merchandising and

Manufacturing Activities
Merchandisers . .
.
Buy finished
goods.
Sell finished
Wally World
goods.
Mart

Manufacturers . .
.
Buy raw
materials.
Produce and sell
finished goods.

Manufacturing Costs
Direct
Direct
Materials
Materials

Direct
Direct
Labor
Labor

The Product

Manufacturing
Manufacturing
Overhead
Overhead

Direct Materials
Those materials that become an integral
part of the product and that can be
conveniently traced directly to it.

Example:
Example: A
A radio
radio installed
installed in
in an
an automobile
automobile

Direct Labor
Those labor costs that can be easily
traced to individual units of product.

Example:
Example: Wages
Wages paid
paid to
to automobile
automobile assembly
assembly workers
workers

Manufacturing Overhead
Manufacturing costs that cannot be
traced directly to specific units
produced.

Examples:
Examples: Indirect
Indirect labor
labor and
and indirect
indirect materials
materials

Wages paid to employees who

are not directly involved in
production work.

Examples: maintenance
workers, janitors and
security guards.

Materials used to support the

production process.

Examples: lubricants and

cleaning supplies used in
the automobile assembly
plant.

Classifications of Costs
Manufacturing costs are often
classified as follows:
Direct
Direct
Material
Material

Direct
Direct
Labor
Labor

Prime
Cost

Manufacturing
Manufacturing
Overhead
Overhead

Conversion
Cost

Nonmanufacturing Costs
Marketing and Selling
Cost

Costs necessary to get the order

and deliver the product.

Administrative Cost

All executive, organizational, and

clerical costs.

Product Costs Versus Period

Costs
Product costs
include direct
Period costs are not
materials, direct
included in
labor, and
product costs.
manufacturing
Cost of Good Sold
Inventoryoverhead.
Expense
They
are
Sale

Balance
Sheet

Income
Statement

expensed on the
income
statement.
Income
Statement

Balance Sheet
Merchandiser
Current assets

Cash
Receivables
Prepaid expenses
Merchandise
inventory

Manufacturer
Current Assets
Cash
Receivables
Prepaid Expenses
Inventories

Raw Materials
Work in Process
Finished Goods

The Income Statement

Cost of goods sold for manufacturers differs
only slightly from cost of goods sold for
merchandisers.
Merchandising Company
Cost of goods sold:
Beg. merchandise
inventory
+ Purchases
Goods available
for sale
- Ending
merchandise
inventory
= Cost of goods
sold

$ 14,200
234,150
$ 248,350

(12,100)
$ 236,250

Manufacturing Company

Cost of goods sold:

Beg. finished
goods inv.
+ Cost of goods
manufactured
Goods available
for sale
- Ending
finished goods
inventory
= Cost of goods
sold

$ 14,200
234,150
$248,350

(12,100)
$236,250

Manufacturing Cost Flows

Costs

Material Purchases
Direct Labor
Manufacturing
Overhead

Selling and
Administrative

Balance Sheet
Inventories

Income
Statement
Expenses

Raw Materials
Work in
Process
Finished
Goods
Period Costs

Cost of
Goods
Sold
Selling and
Administrative

Inventory Flows
Beginning
Beginning
balance
balance
$$
$$

Available
Available
$$$$$
$$$$$

Additions
Additions
$$$
$$$

_ Withdrawals
Withdrawals
$$$
$$$

Available
Available
$$$$$
$$$$$

Ending
Ending
balance
balance
$$
$$

Product Costs - A Closer

Look
Raw Materials
Beginning raw
materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production

Manufacturing
Costs

Work
In Process

Direct materials
+ Direct labor
+ Mfg. overhead
= Total manufacturing
costs

Beginning work in
process inventory
Total manufacturing
costs
Total work in
process for the
period
Ending work in
process inventory
Cost of goods
manufactured.

+
=

Costs
Costsassociated
associatedwith
withthe
thegoods
goodsthat
thatare
are
completed
completedduring
duringthe
theperiod
periodare
aretransferred
transferredto
to
finished
finishedgoods
goodsinventory.
inventory.

Cost Classifications for Predicting

Cost Behavior

How
How aa cost
cost will
will react
react to
to changes
changes in
in the
the
level
level of
of business
business activity.
activity.
Total
Total variable
variable costs
costs change
change when
when activity
activity
changes.
changes.
Total
Total fixed
fixed costs
costs remain
remain unchanged
unchanged when
when
activity
activity changes.
changes.
What
What do
do we
we mean
mean by
by ACTIVITY?
ACTIVITY?

A Cell Phone Bill.

Family Plan for cell phone usage,
unlimited nights and weekends,
$60.00
Includes 250 text messages
Any text messages above 250 are
$0.10 per text sent AND $0.10 text
received.
You do NOT have a DATA PLAN and
pay $0.01 per KB

Variable Cost Per Unit

Per
Minute
DATA
COST Per KB
Telephone Charge
Used

The cost per KB of DATA is constant.

For example, $.01 cents per KB.

Per KBs used

Total Variable Cost

Total DATA COST on

your
Cell phone Bill

Your total DATA cost is based on

how many KB you use..

DATA used

Total Fixed Cost

Monthly Basic
Telephone Bill

Your monthly basic cellphone bill

does not change when you make more
calls.

Number of Local Calls

NTT DoCoMo's wristwatchstyle cellphone

Fixed Cost Per Unit

Monthly Basic
Telephone Bill per Local
Call

The average cost per call decreases as

more local calls are made.

Number of Local
Calls

Cost Classifications for Predicting

Cost Behavior
Behavior of Cost (within the relevant range)
Cost

In Total

Per Unit

Variable

Total variable cost changes

as activity level changes.

Variable cost per unit remains

the same over wide ranges
of activity.

Fixed

Total fixed cost remains

the same even when the
activity level changes.

Fixed cost per unit goes

down as activity level goes up.

Cost Classification for Assigning

Costs to Cost Objects
Direct costs
Costs that can be
easily and
conveniently traced
to a unit of product
or other cost
objective.
Examples: direct
material and direct
labor

Indirect costs
Costs cannot be
easily and
conveniently traced
to a unit of product
or other cost object.
Example:
manufacturing
overhead

Cost Classification for

Decision Making

Differential Costs and

Revenues
Costs and revenues that differ
among alternatives.
Example: You have a job paying $1,500 per month
in your hometown. You have a job offer in a
neighboring city that pays $2,000 per month. The
commuting cost to the city is $300 per month.
Differential revenue is:
$2,000 $1,500 = $500
Differential cost is:
$300

Quick Check -Relevant Costs

Suppose you are trying to decide whether
to drive or take the train to Portland to
attend a concert. You have ample cash to
do either, but you dont want to waste
money needlessly. Is the cost of the pizza
you ate last night relevant in this
decision? In other words, should the cost
of the pizza affect the decision of whether
you drive or take the train to Portland?
A. Yes, the cost of the pizza is relevant.
B. No, the cost of the pizza is not
relevant.

Quick Check Relevant Costs

Suppose you are trying to decide whether
to drive or take the train to Portland to
attend a concert. You have ample cash to
do either, but you dont want to waste
money needlessly. Is the cost of the pizza
you ate last night relevant in this
decision? In other words, should the cost
of the pizza affect the decision of whether
you drive or take the train to Portland?
A. Yes, the cost of the pizza is relevant.
B. No, the cost of the pizza is not
relevant.

Quick Check Relevant Costs

Suppose you are trying to decide whether
to drive or take the train to Portland to
attend a concert. You have ample cash to
do either, but you dont want to waste
money needlessly. Is the cost of the train
ticket relevant in this decision? In other
words, should the cost of the train ticket
affect the decision of whether you drive or
take the train to Portland?
A. Yes, the cost of the train ticket is
relevant.
B. No, the cost of the train ticket is not

Quick Check Relevant Costs

Suppose you are trying to decide whether
to drive or take the train to Portland to
attend a concert. You have ample cash to
do either, but you dont want to waste
money needlessly. Is the cost of the train
ticket relevant in this decision? In other
words, should the cost of the train ticket
affect the decision of whether you drive or
take the train to Portland?
A. Yes, the cost of the train ticket is
relevant.
B. No, the cost of the train ticket is not

Quick Check Relevant Costs

Suppose you are trying to decide whether
to drive or take the train to Portland to
attend a concert. You have ample cash to
do either, but you dont want to waste
money needlessly. Is the annual cost of
licensing your car relevant in this
decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.

Quick Check Relevant Costs

Suppose you are trying to decide whether
to drive or take the train to Portland to
attend a concert. You have ample cash to
do either, but you dont want to waste
money needlessly. Is the depreciation on
your car relevant in this decision?
A. Yes, the depreciation is relevant.
B. No, the depreciation is not relevant.

Quick Check Relevant Costs

Suppose you are trying to decide whether
Depreciation that
to drive or take the train to Portland to
is a function of miles driven
attend a concert. You have ample cash to
would be relevant.
do either, but you dont want to waste
money needlessly. Is the depreciation on
your car relevant
in this decision?
Depreciation
that is a
A. Yes, the depreciation
is relevant.
function of the
passage of
time wouldisnot
be relevant.
relevant.
B. No, the depreciation
not

Opportunity Costs
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
$15,000 per year.
Your opportunity
cost

Sunk Costs
Sunk costs cannot be changed by any decision. They
are not differential costs and should be ignored when
making decisions.

Example: You bought an automobile that

cost $10,000 two years ago. The $10,000
cost is sunk because whether you drive it,
park it, trade it, or sell it, you cannot
change the $10,000 cost.

Quick Check Sunk Costs

Suppose that your car could be sold now
for $5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.

Quick Check Sunk Costs

Suppose that your car could be sold now
for $5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.

Further Classification of Labor Costs

Idle Time

Treated as manufacturing
overhead cost

Overtime Premium of
Factory Workers

Treated as manufacturing
overhead cost

Labor Fringe Benefits

Treated as indirect labor

or direct labor

Product Costs - A Closer

Look
Raw Materials

Manufacturing
Costs

Work
In Process

Beginning raw
materials inventory

Beginning
Beginning
inventory
inventory is
is the
the
inventory
inventory carried
carried
over
over from
from the
the prior
prior
period.
period.

Product Costs - A Closer

Look
Raw Materials

+
=

Beginning raw
materials inventory
Raw materials
purchased
Raw materials
available for use
in production
Ending raw materials
inventory
Raw materials used
in production

Manufacturing
Costs

Work
In Process

Direct materials

As
Asitems
itemsare
areremoved
removedfrom
fromraw
rawmaterials
materials
inventory
inventoryand
andplaced
placedinto
intothe
theproduction
production
process,
process,they
theyare
are
called
calleddirect
directmaterials.
materials.

Product Costs - A Closer

Look
Raw Materials

+
=

Beginning raw
materials inventory
Raw materials
purchased
Raw materials
available for use
in production
Ending raw materials
inventory
Raw materials used
in production

Manufacturing
Costs
Direct materials
+ Direct labor
+ Mfg. overhead
= Total manufacturing
costs

Work
In Process

Conversion
Conversioncosts
costs
are
arecosts
costsincurred
incurredto
to
convert
convertthe
thedirect
direct
material
materialinto
intoaa
finished
finishedproduct.
product.

Product Costs - A Closer

Look
Raw Materials

+
=

Beginning raw
materials inventory
Raw materials
purchased
Raw materials
available for use
in production
Ending raw materials
inventory
Raw materials used
in production

Manufacturing
Costs
Direct materials
+ Direct labor
+ Mfg. overhead
= Total manufacturing
costs

Work
In Process
Beginning work in
process inventory
+ Total manufacturing
costs
= Total work in
process for the
period

All
Allmanufacturing
manufacturingcosts
costsincurred
incurredduring
duringthe
the
period
periodare
areadded
addedto
tothe
thebeginning
beginningbalance
balanceof
of
work
workin
inprocess.
process.

Product Costs - A Closer

Look
Raw Materials
Beginning raw
materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production

Manufacturing
Costs

Work
In Process

Direct materials
+ Direct labor
+ Mfg. overhead
= Total manufacturing
costs

Beginning work in
process inventory
Total manufacturing
costs
Total work in
process for the
period
Ending work in
process inventory
Cost of goods
manufactured.

+
=

Costs
Costsassociated
associatedwith
withthe
thegoods
goodsthat
thatare
are
completed
during
the
period
are
transferred
completed during the period are transferredto
to
finished
finishedgoods
goodsinventory.
inventory.

Product Costs - A Closer

Look
Work
In Process

+
=

Beginning work in
process inventory
Manufacturing costs
for the period
Total work in process
for the period
Ending work in
process inventory
Cost of goods
manufactured

Finished Goods
Beginning finished
goods inventory
+ Cost of goods
manufactured
= Cost of goods
available for sale
- Ending finished
goods inventory
Cost of goods
sold