CHAPTER 2

An Introduction to Cost
Terms and Purposes

2009
Pearson
Prentice
Hall.
rights
reserved.

2009
Pearson
Prentice
Hall.
AllAll
rights
reserved.

Basic Cost Terminology

Cost sacrificed resource to achieve a specific
objective
Actual cost a cost that has occurred
Budgeted cost a predicted cost
Cost object anything of interest for which a cost is
desired

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Cost Object Examples at BMW

Cost Object

Illustration

Product

BMW X 5 sports activity vehicle

Service

Dealer-support telephone hotline

Project

R&D project on DVD system

enhancement

Customer

Herb Chambers Motors, a dealer that

purchases a broad range of BMW
vehicles

Activity

Setting up production machines

Department

Environmental, Health & Safety

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Basic Cost Terminology

Cost accumulation cost data collected in an
organized way
Cost assignment attributing costs to a cost object.
Includes:
Tracing direct costs
Allocating indirect costs

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Direct & Indirect Costs

Direct costs
can be conveniently/economically traced to a cost object

Indirect costs

Cant be traced to a cost object

Are instead allocated to a cost object in a rational and
systematic way

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Cost Examples
Direct Costs
Parts
Assembly line wages

Indirect Costs
Electricity
Rent
Property taxes

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Factors Affecting Direct / Indirect Cost

Classification
Cost Materiality
Availability of information-gathering technology
Operational Design

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Cost Behavior
Variable costs
Total VCs change in proportion to changes in activity or volume
Unit VCs are constant on a per unit basis

Fixed costs
Total FCs are unchanged in response to changes in activity or volume
Unit FCs change inversely with the changes in activity or volume.
Costs are fixed or variable only with respect to a specific activity or
time period

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Cost Behavior Summarized

Variable Costs

In Total

Per Unit

Change in proportion
with output

Unchanged in
relation to output

(More output, more total cost)

Fixed Costs

Unchanged in relation
to output

Change inversely
with output
(More output, lower unit cost)

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Cost Behavior Visualized

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Other Cost Concepts

Cost Driver
a variable that causally affects costs

Relevant Range
An interval of activity in which the relation between driver
and cost is consistent.

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Relevant Range Visualized

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Cost Caveats
Use unit costs cautiously
Unit costs change when activity level changes, so it may be
more meaningful to calculate total cost

Unit costs that include fixed costs should reference the

activity level
Unit Costs are also called Average Costs

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Multiple Classification of Costs

Costs may be classified as:
Direct / Indirect
Variable / Fixed

(relation with cost object)

(cost behavior)

A given cost may be:

Direct Variable
Direct Fixed
Indirect Variable
Indirect Fixed

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Types of Firms
Manufacturers create and sell their own products
Merchandisers resellers
Service firms provide services (intangible products)

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Types of Manufacturing Inventories

Direct Materials (DM) resources in-stock and available
for use
Work-in-Process (WIP) products started but not yet
completed
Finished Goods (FG) products completed and ready for
sale

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Product Costs (Inventoriable costs)

Direct Materials (DM)
Direct Labor (DL)
Manufacturing Overhead (MOH) factory costs not traceable
to product. AKA Indirect overhead or Factory overhead

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Distinction Between Costs

Product costs

Product manufacturing costs. Capitalized as assets

(inventory) until sale, then transferred to Cost of Goods
Sold.

Period costs

No future value; expensed as incurred.

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Cost Flows

Represent actual
flow of costs through
a production system.

Schedule of Cost of Goods

Manufactured
Cost of Goods Sold section of Income
Statement

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Cost Flows Visualized

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Cost of Goods Manufactured

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Multiple-Step Income Statement

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Other Considerations
Prime cost Sum of direct labor and direct materials
Conversion cost Sum of direct labor and manufacturing
overhead
Overtime labor cost classified as overhead

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Different Costs for Different Applications

Pricing, product-mix decisions May use
comprehensive cost
Contracting with government For cost plus
contracts, cost is specifically defined
External-use financial statements GAAP product
costs

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Different Costs for Different Applications

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Common Cost Accounting/Cost

Management Activities
1. Calculate cost of products, services, other cost
objects
2. Obtain information for planning & control, and
performance evaluation
3. Analyzing relevant information for making decisions

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