Chapter 2

An Introduction to
Cost Terms and Purposes

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 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.
Examples: product, service, or process.

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 Basic Cost Terminology
A costing system typically accounts for costs in
two basic stages:
1. Cost Accumulation a collection of cost data in
an organized manner
2. Cost Assignment a general term that includes
gathering accumulated costs to a cost object.
This includes:
Tracing accumulated costs with a direct relationship to
the cost object and
Allocating accumulated costs with an indirect
relationship to a cost object
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 Direct and Indirect Costs
Direct Costs can be conveniently and
economically traced (tracked) to a cost object
Direct Costs Examples:
Parts (Ex. The cost of the cans is a direct cost of Pepsi-
Colas)
Assembly line wages
Indirect Costs cannot be conveniently or
economically traced (tracked) to a cost object.
Instead of being traced, these costs are allocated
to a cost object in a rational and systematic
manner
Indirect Costs Examples:
Electricity, Rent, Property taxes, salary of supervisors.
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Direct and Indirect Costs

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 Factors Affecting Direct/Indirect Cost
Classification
Cost Materiality:
The smaller the amount of a cost (that is the more
immaterial the cost is) the less likely that it is economically
feasible to trace that cost to a particular cost object.
(example: a mail-order catalog- the cost of invoice paper
included in the package would be classified as indirect
cost)
Availability of Information-gathering Technology:
Example: Bar codes allow manufacturing plants to treat
certain low-cost materials such as clips and screws, which
were previously classified as indirect cost, as direct cost
Operational Design:
Classifying a cost as direct is easier if a companys facility
is used exclusively for a specific cost object.
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 Cost Behavior:
Variable Costs and Fixed Costs
Variable Costs changes in total in proportion to
changes in the related level of activity or volume
Example: If BMW buys a steering wheel at $60 for each
of its BMW X5 vehicles, then the total cost of steering
wheels should be $60 times the number of vehicles
produced.
Fixed Costs remain unchanged in total
regardless of changes in the related level of activity
or volume
Example: Rent
Costs are fixed or variable only with respect to a
specific activity or a given time period. Cost item is
not inherently variable or fixed. Example: labor cost
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 Cost Behavior (contd.)

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 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

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 Cost Behavior Summarized

Total Dollars Cost Per Unit

Variable Costs Change in proportion with Unchanged in relation

output to output
(more output=more cost)

Fixed Costs Unchanged in relation to Change inversely with

output output
(more output=lower
cost per unit)

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 Other Cost Concepts
Cost Driver a variable that causally affects
costs over a given time span (variable costs)
Example: the number of vehicles produced is a cost
driver of the cost of steering wheels.
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
For example, fixed costs are fixed only within the
relevant range.
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
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 Different Types of Firms

Manufacturing-sector companies
Create and sell their own products

Merchandising-sector companies
product resellers

Service-sector companies (intangible products)

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 Types of Inventories
Manufacturing-sector companies typically have one
or more of the following three types of inventory:
Direct Materials: resources in stock and available for use
Work-in-Process (or progress): products started but not
yet completed. Often abbreviated as WIP
Finished Goods: products completed and ready for sale

Merchandising-sector companies hold only one

type of inventory: Merchandise inventory

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 Types of Product Costs
Direct Material costs:
The acquisition cost 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.
Examples: the aluminum used to make Pepsi cans.
Direct Labor costs:
The compensation of all manufacturing labor that can be
traced to the cost object. Example: wages.
Indirect Manufacturing costs:
Factory costs that are not traceable to the product. Also
known as Manufacturing Overhead costs or Factory
Overhead costs. Examples: supplies, indirect material
(lubricants), indirect labor, plant rent, plant insurance,
plant and equipments depreciation, compensation of
managers. 13
 Distinctions Between Costs

Inventoriable Costs (product manufacturing costs):

These costs are capitalized as assets (inventory) until
they are sold and transferred to Cost of Goods Sold
(expenses) in the income statement .
Example: BMW (X5 SUV), direct martial costs, direct
manufacturing labor costs, and manufacturing overhead
costs create new assets starting as work in process
inventory and becoming finished goods.
Period Costs:
All costs other than cost of goods sold (all non-
manufacturing costs)
Examples: design costs, distribution costs, marketing
costs, and customer service.

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Cost Flowchart

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The Flow of Inventoriable Costs and Period
Costs
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.

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Income Statement

Figure carries
forward from the
Schedule of Cost
of Goods
Manufactured

Period Costs are

expensed as
incurred

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Cost of Goods Manufactured

Calculates the cost of

Direct Materials Used

Accumulates the three

product costs for the
current period

Adjusts the current period

manufacturing costs to
account for units actually
completed
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Cost Flowchart

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 Other Cost Considerations

Prime cost is a term referring to all direct

manufacturing costs (labor and materials)
Conversion cost is a term referring to direct labor
and factory overhead costs, collectively
Overtime labor costs are considered part of
overhead

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 Different Definitions of Cost for Different
Applications
Pricing and product-mix decisions may use a
super cost approach (comprehensive)
Contracting with government agencies very
specific definitions of cost for cost plus profit
contracts
Preparing external-use financial statements
GAAP-driven product costs only

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 Different Definitions of Cost for Different
Applications

HW # 2
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