Chapter 2

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 Costs Terms, Concepts and
Classifications

Chapter Two

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 Learning Objective 1

Identify and give examples

of each of the three basic
manufacturing cost
categories.

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 Manufacturing Costs

Direct
Direct Direct
Direct Manufacturing
Manufacturing
Materials
Materials Labor
Labor Overhead
Overhead

The Product

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 Direct Materials

Raw 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

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 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

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 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 Materials used to support

who are not directly
involved in production
work.
Examples: maintenance
workers, janitors and
security guards.
the production process.
Examples: lubricants and
cleaning supplies used in the
automobile assembly plant.

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 Non-manufacturing Costs

Selling Administrative
Costs Costs

Costs necessary to get All executive,

the order and deliver organizational, and
the product. clerical costs.

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 COST CLASSIFICATION

Preparation of
external financial
statement

Predicting Cost
behavior

Assigning cost to
cost objects

Making Decision

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 Learning Objective 2

Distinguish between
product costs and period
costs and give examples
of each.

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 Product Costs Versus Period Costs

Product costs include Period costs include all

direct materials, direct selling costs and
labor, and administrative costs.
manufacturing
overhead.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
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 Classifications of Costs

Manufacturing costs are often

classified as follows:
Direct Direct Manufacturing
Material Labor Overhead

Prime Conversion
Cost Cost

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 Comparing Merchandising and
Manufacturing Activities
Merchandisers . . . Manufacturers . . .
 Buy finished goods.  Buy raw materials.
 Sell finished goods.  Produce and sell
finished goods.

MegaLoMart

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 Balance Sheet

Merchandiser Manufacturer
Current assets Current Assets
Cash ◆ Cash

Receivables ◆ Receivables

Prepaid Expenses ◆ Prepaid Expenses

◆ Inventories
Merchandise
Inventory • Raw Materials
• Work in Process
• Finished Goods

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 Balance Sheet

Merchandiser Manufacturer
Current assets Current Assets
Cash ◆ Cash

Receivables
Prepaid Expenses
Partially complete
Merchandise
products – some
Inventory
material, labor, or
overhead has been
added.
McGraw-Hill/Irwin
◆ Receivables
Materials waiting to
be processed.
◆ Prepaid Expenses
◆ Inventories
• Raw Materials
• Work in Process
• Finished Goods
Completed products
awaiting sale.
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 Learning Objective 3

Prepare an income
statement including
calculation of the cost of
goods sold.

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 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 $ 14,200
+ Purchases 234,150
Goods available
for sale $ 248,350
- Ending
merchandise
inventory (12,100)
= Cost of goods
sold $ 236,250

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 Basic Equation for Inventory Accounts

Withdrawals
Withdrawals
Beginning
Beginning Additions
Additions Ending
Ending
balance
balance
+ to
to inventory
inventory
= balance
balance
+ from
from
inventory
inventory

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 Learning Objective 4

Prepare a schedule of cost

of goods manufactured.

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 Schedule of Cost of Goods
Manufactured

Calculates the cost of raw

material, direct labor and
manufacturing overhead used
in production.

Calculates the manufacturing

costs associated with goods
that were finished during the
period.
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 Product Cost Flows

Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials

materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production
– Ending raw materials
inventory
= Raw materials used
in production As
As items
itemsare
are removed
removedfrom
fromrawraw
materials
materialsinventory
inventoryandandplaced
placedinto
into
the
theproduction
production process,
process, they
they are
are
called
called direct
direct materials.
materials.
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 Product Cost Flows

Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials

Conversion
Conversion
materials inventory + Direct labor costs
costsarearecosts
costs
+ Raw materials + Mfg. overhead
purchased = Total manufacturing incurred
incurredto to
= Raw materials costs convert
convert the
the
available for use
in production direct
directmaterial
material
– Ending raw materials into
into aafinished
finished
inventory
= Raw materials used product.
product.
in production

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 Product Cost Flows

Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials
inventory
= Raw materials used
in production
All
All manufacturing
manufacturing costs
costs incurred
incurred
during
during the
theperiod
period are
are added
addedto tothe
the
beginning
beginning balance
balanceof
of work
work in
in
process.
process.

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 Product Cost Flows

Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials – Ending work in
inventory process inventory
= Raw materials used = Cost of goods
Costs
Costsassociated
associatedwith
in productionwiththe
the goods
goods that
that manufactured
are
arecompleted
completed during
duringthe
the period
period are
are
transferred
transferredto
tofinished
finished goods
goods
inventory.
inventory.

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 Product Cost Flows

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 Manufacturing Cost Flows

Balance Sheet Income

Costs Inventories Statement
Expenses
Material Purchases Raw Materials

Direct Labor Work in

Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold

Selling and Period Costs Selling and

Administrative Administrative
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 Learning Objective 5

Understand the
differences between
variable costs and fixed
costs.

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 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
activity
activity within
within thethe
relevant
relevant range.
range.
 Total
Totalvariable
variablecosts
costs
change
changewhen
whenactivity
activity
changes.
changes.
 Total
Totalfixed
fixedcosts
costsremain
remain
unchanged
unchangedwhen
whenactivity
activity
changes.
changes.

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 Variable Cost

Your total long distance telephone bill is based

on how many minutes you talk.
Total Long Distance
Telephone Bill

Minutes Talked
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 Variable Cost Per Unit

The cost per long distance minute talked is

constant. For example, 10 cents per minute.

Telephone Charge
Per Minute

Minutes Talked
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 Fixed Cost

Your monthly basic telephone bill probably

does not change when you make more local
calls.
Telephone Bill
Monthly Basic

Number of Local Calls

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 Fixed Cost Per Unit

The average fixed cost per local call decreases

as more local calls are made.

Monthly Basic Telephone

Bill per Local Call
Number of Local Calls
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 Cost Classifications for Predicting Cost
Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Average fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.

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 Learning Objective 6

Understand the
differences between direct
and indirect costs.

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 Assigning Costs to Cost Objects

Direct costs Indirect costs

• Costs that can be • Costs that cannot be
easily and conveniently easily and conveniently
traced to a unit of traced to a unit of
product or other cost product or other cost
object. object.
• Examples: direct • Example: manufacturing
material and direct labor overhead

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 Learning Objective 7

Define and give examples

of cost classifications used
in making decisions:
differential costs,
opportunity costs, and
sunk costs.

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 Cost Classifications for Decision
Making

• Every decision involves a choice between at

least two alternatives.

• Only those costs and benefits that differ

between alternatives are relevant in a decision.
All other costs and benefits can and should be
ignored.

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 Differential Cost and Revenue

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
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 Opportunity Cost

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
of attending college for
one year is $15,000.
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 Sunk Costs

Sunk costs have already been incurred and cannot be changed now
or in the future. They 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.

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 Further Classification of
Labor Costs

Appendix 2A

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 Learning Objective 8

(Appendix 2A)
Properly account for labor
costs associated with idle
time, overtime, and fringe
benefits.

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 Idle Time

Machine Material
Breakdowns Shortages

Power
Failures

The labor costs incurred

during idle time are ordinarily
treated as manufacturing
overhead.
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 Overtime

The overtime premiums for all factory

workers are usually considered to be part
of manufacturing overhead.

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 Labor Fringe Benefits

Fringe benefits include employer paid

costs for insurance programs, retirement
plans, supplemental unemployment
programs, Social Security, Medicare,
workers’ compensation and
unemployment taxes.

Some companies Other companies treat

include all of these fringe benefit
costs in expenses of direct
manufacturing laborers as additional
overhead. direct labor costs.
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 End of Chapter 2

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