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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?
