Chapter 2 Cost Terminology and Behavior

Chapter 2

Cost Terminology and

Cost Behaviors

Cost AccountingFoundations and Evolutions

Kinney, Prather, Raiborn

Cost

Monetary measure of resources

given up to attain an objective

(such as acquiring a good

or delivering a service)

Learning Objectives

• List the cost classifications and explain why the classifications are useful

• List product cost categories and their components

• Calculate the Cost of Goods Manufactured and explain how it is used in the Income Statement

Cost Classifications

• Association with cost objectCost object is anything for which management wants to collect or accumulate costs

– Direct - traceable to a cost object– Indirect - not conveniently or practically

traceable to a cost object• treated as overhead

• allocated

Cost Categories

• Association with cost object

• Reaction to changes in activity– Variable– Fixed– Mixed – Step

Relevant Range – normal operating range

Variable Cost

Fixed Cost

Cost Reaction to Changes in Activity

Total

$

# of Units

$

# of Units

Within the relevant range

Variable Cost

Fixed Cost

Cost Reaction to Changes in ActivityTotal Unit

$

# of Units

$

$

$

# of Units

# of Units # of Units

Within the relevant range

Total and Unit Cost Behavior

Varies in direct proportion to

changes in activity

Remains constant throughout

the relevant range

Remains constant throughout the relevant range

Varies inversely with changes in

activity throughout the relevant range

VariableCost

FixedCost

Total Cost Unit Cost

Step Cost

(Fixed)

Cost Reaction to Changes in Activity

$

Units

Within the relevant range

Mixed Cost

Cost Reaction to Changes in Activity

$

Unitsfixed

Within the relevant range

variable

Determining Cost Behavior

• Cost Predictor– Activity accompanied

by consistent, observable changes in a cost item

– Predicts but may not cause the cost to change

• Cost Driver– Activity that has a direct

cause-effect relationship on cost

– Directly causes the cost to change

Cost Classifications• Association with cost object

• Reaction to changes in activity

• Classification on the financial statements– Unexpired– Expired– Product– Period

Cost Classifications• Classification on the financial statements

– Unexpired – balance sheet assets– Expired – income statement expenses– Product – inventoriable costs

• Prime – direct material and direct labor

• Conversion – direct labor and overhead

– Period – expensed in period incurred

Product Costs• Direct material

– Measurable part of a product

• Direct labor– Labor used to manufacture a product or

perform a service

• Overhead– Indirect production cost

Product Costs

• First appear on the balance sheet in inventory accounts

• Transferred to the income statement when product is sold

Period Costs• Selling and administrative costs

• Distribution costs– Cost to warehouse, transport, and/or deliver a

product or service– Major impact on managerial decision making

Period Costs

• Appear on the income statement when incurred

• Expensed when incurred

Purchaseraw materialsor supplies

Input

Product orService

Output

Conversion ProcessChange Inputs into Outputs

CONVERSION

Low Degree of Conversion

• Department stores

• Gas stations

• Jewelry stores

• Travel agencies

Moderate Degree of Conversion

• Florists

• Meat markets

• Oil-change businesses

High Degree of Conversion

• Manufacturing

• Construction

• Agriculture

• Architecture

• Auditing

• Mining

• Printing

• Restaurants

Product Cost - Direct• Direct Material

– Conveniently and economically traced

to cost object

Product Cost - Direct• Direct Material

– Conveniently and economically traced

to cost object

• Direct Labor – to manufacture a product or perform a service – includes wages paid to direct labor employees,

production bonuses, payroll taxes– may include holiday and vacation pay,

insurance, retirement benefits

Product Cost - Indirect

• Overhead - indirect production costs– Fringe benefits, if cannot be easily traced to

product– Overtime, if due to random scheduling– Cost of quality

• Prevention costs

• Appraisal costs

• Failure costs

Product Cost Behavior

• Direct Material Variable

• Direct Labor Variable

• Overhead Variable, fixed, or mixed

Overhead Cost AllocationAssign indirect costs to one

or more cost objects

• To determine full absorption cost (GAAP)

• To motivate management

• To compare alternative courses of action for planning, controlling, and decision making

Allocation process should be

rational and systematic

Allocating OverheadActual Cost System

Product Cost

Direct Materials

Direct Labor

Overhead

Cost Used

Actual

Actual

Actual

Allocating OverheadActual Cost System

• The Actual Cost System is not timely

• All costs must be known before calculating product cost

Allocating OverheadActual vs. Normal

Product Cost

Direct Materials

Direct Labor

Overhead

Actual Cost System

Actual

Actual

Actual

Normal Cost System

Actual

Actual

Predetermined

Overhead Rate

Predetermined Overhead Rate

• Allows overhead to be assigned during the period

• Compensates for fluctuations– that are not related to activity level– in activity level that do not affect fixed

overhead

Flow of Product CostsRaw Materials Inventory

Accounts Payable

Work in Process InventoryRaw Materials Inventory

Flow of Product Costs

Work in Process Inventory

Variable Overhead Control

Fixed Overhead Control

Finished Goods Inventory

Work in Process Inventory

Flow of Product Costs

Accounts Receivable Sales

Cost of Goods Sold Finished Goods Inventory

Matches revenues and expenses on the income statement

Statement of Cost of Goods Manufactured

• Beginning work in process $ 145,000– Raw materials used $284,000– Direct labor 436,000– Variable overhead 115,200– Fixed overhead 98,880

• Current period manufacturing costs 934,080

• Total costs to account for $1,079,080

• Ending work in process 20,880

• Cost of goods manufactured $1,058,200

Statement of Cost of Goods Manufactured

Raw Materials Used

Beginning balance $ 73,000

Purchases of materials 280,000

Raw materials available $353,000

Ending balance 69,000

Total raw materials used $284,000

To Statement of Cost of Goods Manufactured

Schedule of Cost of Goods Sold

Beginning Finished Good $ 87,400

Cost of Goods Manufactured 1,058,200

Cost of Goods Available for Sale $1,145,600

Ending Finished Goods 91,600

Cost of Goods Sold $1,054,000

From Schedule of Cost of Goods Manufactured

Income Statement

• Revenue xxxx

• Cost of Goods Sold <1,054,000>

• Gross Profit xxxx

• Operating Expenses <xxxx>

• Operating Income xxxx

From Schedule of Cost of Goods Sold

Questions

• What is the difference between a fixed and variable cost?

• What are the three components of product cost?

• What are the three inventory accounts for a manufacturing company?