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Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin

Costs Terms, Concepts andClassifications

Chapter Two

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2-2

Learning Objective 1

Identify and give examplesof each of the three basicmanufacturing cost

categories.

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2-3

The Product

DirectMaterials Direct

Labor Manufacturing

Overhead

Manufacturing Costs

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2-4

Direct Materials

Raw materials that become an integral part of theproduct and that can be conveniently traced

directly to it.

Example: A radio installed in an automobile

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Direct Labor

Those labor costs that can be easily traced toindividual units of product.

Example: Wages paid to automobile assembly workers

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Manufacturing costs that cannot be traced directlyto specific units produced.

Manufacturing Overhead

Examples: Indirect labor and indirect materials

Wages paid to employeeswho are not directly

involved in productionwork.Examples: maintenance

workers, janitors andsecurity guards.

Materials used to supportthe production process.

Examples: lubricants andcleaning supplies used in theautomobile assembly plant.

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Non-manufacturing Costs

SellingCosts

Costs necessary to get

the order and deliver the product.

AdministrativeCosts

All executive,

organizational, andclerical costs.

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Distinguish betweenproduct costs and periodcosts and give examples

of each.

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2-9

Product Costs Versus Period Costs

Product costs includedirect materials, direct

labor, and

manufacturingoverhead.

Period costs include allselling costs and

administrative costs.

Inventory Cost of Good Sold

BalanceSheet

IncomeStatement

Sale

Expense

IncomeStatement

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2-10

Quick Check

Which of the following costs would be considered aperiod rather than a product cost in a manufacturingcompany?

A. Manufacturing equipment depreciation.B. Property taxes on corporate headquarters.

C. Direct materials costs.

D. Electrical costs to light the production

facility.

E. Sales commissions.

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Quick Check

Which of the following costs would be considered aperiod rather than a product cost in a manufacturingcompany?

A. Manufacturing equipment depreciation.B. Property taxes on corporate headquarters.

C. Direct materials costs.

D. Electrical costs to light the production

facility.

E. Sales commissions.

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Classifications of Costs

DirectMaterial

DirectLabor

ManufacturingOverhead

PrimeCost

ConversionCost

Manufacturing costs are oftenclassified as follows:

2 13 C i M h di i d

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2-13 Comparing Merchandising andManufacturing Activities

Merchandisers . . . Buy finished goods.

Sell finished goods.

Manufacturers . . . Buy raw materials.

Produce and sellfinished goods.

MegaLoMart

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Balance Sheet

Merchandiser

Current assets

Cash

Receivables

Prepaid Expenses

MerchandiseInventory

Manufacturer

Current Assets

Cash

ReceivablesPrepaid Expenses

Inventories • Raw Materials

• Work in Process• Finished Goods

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Merchandiser

Current assets

Cash

Receivables

Prepaid Expenses

MerchandiseInventory

Manufacturer

Current Assets

Cash

ReceivablesPrepaid Expenses

Inventories • Raw Materials

• Work in Process• Finished Goods

Balance Sheet

Partially completeproducts – some

material, labor, or overhead has been

added.

Completed productsawaiting sale.

Materials waiting tobe processed.

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2-16


Prepare an income

statement includingcalculation of the cost of

goods sold.

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The Income Statement

Cost of goods sold for manufacturers differs onlyslightly from cost of goods sold for merchandisers.

Manufacturing Company

Cost of goods sold:Beg. finished

goods inv. 14,200$

+ Cost of goods

manufactured 234,150

Goods available

for sale 248,350$- Ending

finished goods

inventory (12,100)

= Cost of goods

sold 236,250$

Merchandising Company

Cost of goods sold:Beg. merchandise

inventory 14,200$

+ Purchases 234,150

Goods available

for sale 248,350$

- Endingmerchandise

inventory (12,100)

= Cost of goods

sold 236,250$

2 18

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2-18

Basic Equation for Inventory Accounts

Beginningbalance

Additionsto inventory+ =

Endingbalance

Withdrawalsfrom

inventory

+

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Quick Check

If your inventory balance at the beginning of themonth was $1,000, you bought $100 during themonth, and sold $300 during the month, what wouldbe the balance at the end of the month?

A. $1,000.

B. $ 800.

C. $1,200.

D. $ 200.

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Quick Check

If your inventory balance at the beginning of themonth was $1,000, you bought $100 during themonth, and sold $300 during the month, what wouldbe the balance at the end of the month?

A. $1,000.

B. $ 800.

C. $1,200.

D. $ 200.

$1,000 + $100 = $1,100$1,100 - $300 = $800

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2-21


Prepare a schedule of costof goods manufactured.

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2 22

Schedule of Cost of Goods Manufactured

Calculates the cost of rawmaterial, direct labor andmanufacturing overhead

used in production.

Calculates the manufacturingcosts associated with goodsthat were finished during the

period.

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2 23

Manufacturing Work

Raw Materials Costs In Process

Beginning raw Direct materials

materials inventory

+ Raw materialspurchased

= Raw materials

available for use

in production

– Ending raw materials

inventory= Raw materials used

in production

As items are removed from rawmaterials inventory and placed into

the production process, they arecalled direct materials.

Product Cost Flows

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2 24

Manufacturing Work


Beginning raw Direct materials

materials inventory + Direct labor

+ Raw materials + Mfg. overheadpurchased = Total manufacturing

= Raw materials costs

available for use

in production



in production

Conversioncosts are costs

incurred toconvert the

direct materialinto a finished

product.

Product Cost Flows

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2 25

Manufacturing Work


Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory

+ Raw materials + Mfg. overhead + Total manufacturingpurchased = Tota l manufacturing costs

= Raw materials costs = Total work in

available for use process for the

in production period



in production

Product Cost Flows

All manufacturing costs incurredduring the period are added to thebeginning balance of work in

process.

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Manufacturing Work


Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory

+ Raw materials + Mfg. overhead + Total manufacturingpurchased = 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

in production manufactured

Product Cost Flows

Costs associated with the goods thatare completed during the period are

transferred to finished goodsinventory.

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Work

In Process Finished Goods

Beginning work in Beginning finished

process inventory goods inventory+ Manufacturing costs + Cost of goodsfor the period manufactured

= Total work in process = Cost of goodsfor the period available for sale

– Ending work in - Ending finished

process inventory goods inventory= Cost of goods Cost of goods

manufactured sold

Product Cost Flows

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Manufacturing Cost Flows

FinishedGoods

Cost of

GoodsSold

Selling andAdministrative

Period CostsSelling andAdministrative

ManufacturingOverhead

Work inProcess

Direct Labor

Balance SheetCosts Inventories

IncomeStatementExpenses

Material Purchases Raw Materials

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Quick Check

Beginning raw materials inventory was $32,000.During the month, $276,000 of raw material waspurchased. A count at the end of the monthrevealed that $28,000 of raw material was stillpresent. What is the cost of direct material used?

A. $276,000

B. $272,000

C. $280,000

D. $ 2,000

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Quick Check

Beginning raw materials inventory was $32,000.During the month, $276,000 of raw material waspurchased. A count at the end of the monthrevealed that $28,000 of raw material was stillpresent. What is the cost of direct material used?

A. $276,000

B. $272,000

C. $280,000

D. $ 2,000

Beg. raw materials 32,000$

+ Raw materials

purchased 276,000

= Raw materials available

for use in production 308,000$ – Ending raw materials

inventory 28,000

= Raw materials used

in production 280,000$

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Quick Check

Direct materials used in production totaled$280,000. Direct labor was $375,000 andfactory overhead was $180,000. What were

total manufacturing costs incurred for themonth?

A. $555,000

B. $835,000

C. $655,000

D. Cannot be determined.

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Direct materials used in production totaled$280,000. Direct labor was $375,000 andfactory overhead was $180,000. What were

total manufacturing costs incurred for themonth?

A. $555,000

B. $835,000

C. $655,000

D. Cannot be determined.

Direct Materials 280,000$

+ Direct Labor 375,000

+ Mfg. Overhead 180,000

= Mfg. Costs Incurredfor the Month 835,000$

Quick Check

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Quick Check

Beginning work in process was $125,000.Manufacturing costs incurred for the monthwere $835,000. There were $200,000 of

partially finished goods remaining in workin process inventory at the end of themonth. What was the cost of goodsmanufactured during the month?

A. $1,160,000B. $ 910,000C. $ 760,000D. Cannot be determined.

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Beginning work in process was $125,000.Manufacturing costs incurred for the monthwere $835,000. There were $200,000 of

partially finished goods remaining in workin process inventory at the end of themonth. What was the cost of goodsmanufactured during the month?

A. $1,160,000B. $ 910,000C. $ 760,000D. Cannot be determined.

Quick Check

Beginning work inprocess inventory 125,000$

+ Mfg. costs incurredfor the period 835,000

= Total work in processduring the period 960,000$

–Ending work in

process inventory 200,000 = Cost of goods

manufactured 760,000$

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Quick Check

Beginning finished goods inventory was$130,000. The cost of goods manufacturedfor the month was $760,000. And the ending

finished goods inventory was $150,000.What was the cost of goods sold for themonth?

A. $ 20,000.

B. $740,000.C. $780,000.

D. $760,000.

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Quick Check

Beginning finished goods inventory was$130,000. The cost of goods manufacturedfor the month was $760,000. And the ending

finished goods inventory was $150,000.What was the cost of goods sold for themonth?

A. $ 20,000.

B. $740,000.C. $780,000.

D. $760,000.

$130,000 + $760,000 = $890,000

$890,000 - $150,000 = $740,000

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Understand the

differences betweenvariable costs and fixed

costs.

2-38 Cost Classifications for Predicting Cost

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Cost Classifications for Predicting CostBehavior

How a cost will react tochanges in the level of

activity within the

relevant range. Total variable costs

change when activitychanges.

Total fixed costs remainunchanged when activitychanges.

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C

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Variable Cost

Your total long distance telephone bill is basedon how many minutes you talk.

Minutes Talked

T o t a l L

o n g D i s t a n c e

T e l e p h o n e B i l l

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V i bl C t P U it

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Variable Cost Per Unit

Minutes Talked

P e

r M i n u t e

T e l e p h o n e C h a r g e

The cost per long distance minute talked isconstant. For example, 10 cents per minute.

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Fi d C t

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Fixed Cost

Your monthly basic telephone bill probablydoes not change when you make more local

calls.

Number of Local Calls

M o n t h l y B a s i c

T e l e

p h o n e B i l l

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Fi d C t P U it

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Fixed Cost Per Unit

Number of Local Calls

M o n t h l y

B a s i c T e l e p h o n e

B i l l p

e r L o c a l C a l l

The average fixed cost per local call decreasesas more local calls are made.

2-43 Cost Classifications for Predicting Cost

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Cost Classifications for Predicting CostBehavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remainsas 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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Q i k Ch k

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Quick Check

Which of the following costs would be variable withrespect to the number of cones sold at a Baskins &Robbins shop? (There may be more than onecorrect answer.)

A. The cost of lighting the store.

B. The wages of the store manager.

C. The cost of ice cream.

D. The cost of napkins for customers.

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Q i k Ch k

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Quick Check

Which of the following costs would be variable withrespect to the number of cones sold at a Baskins &Robbins shop? (There may be more than onecorrect answer.)

A. The cost of lighting the store.

B. The wages of the store manager.

C. The cost of ice cream.

D. The cost of napkins for customers.

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L i Obj ti 6

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Understand thedifferences between directand indirect costs.

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A i i C t t C t Obj t

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Assigning Costs to Cost Objects

Direct costs

• Costs that can beeasily and convenientlytraced to a unit of

product or other costobject.

• Examples: directmaterial and direct labor

Indirect costs

• Costs that cannot beeasily and convenientlytraced to a unit of

product or other costobject.

• Example: manufacturingoverhead

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Learning Objecti e 7

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Define and give examplesof cost classifications used

in making decisions:differential costs,

opportunity costs, and

sunk costs.

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Cost Classifications for Decision Making

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• Every decision involves a choice between atleast 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.

Cost Classifications for Decision Making

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Differential Cost and Revenue

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Differential Cost and Revenue

Costs and revenues that differ amongalternatives.

Example: You have a job paying $1,500 per month inyour hometown. You have a job offer in a neighboringcity that pays $2,000 per month. The commuting costto the city is $300 per month.

Differential revenue is: $2,000 – $1,500 = $500

Differential cost is:

$300

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Opportunity Cost

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Opportunity Cost

The potential benefitthat is given up when

one alternative isselected over another.

Example: If you werenot attending college,you could be earning

$15,000 per year.Your opportunity costof attending college for one year is $15,000.

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Sunk Costs

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Sunk Costs

Sunk costs have already been incurred andcannot be changed now or in the future.

They should be ignored when makingdecisions.

Example: You bought an automobile that cost$10,000 two years ago. The $10,000 cost is sunkbecause whether you drive it, park it, trade it, or sell

it, you cannot change the $10,000 cost.

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Quick Check

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Quick Check

Suppose you are trying to decide whether to driveor take the train to Portland to attend a concert. Youhave ample cash to do either, but you don’t want to

waste money needlessly. Is the cost of the train

ticket relevant in this decision? In other words,should the cost of the train ticket affect the decisionof whether you drive or take the train to Portland?

A. Yes, the cost of the train ticket is relevant.

B. No, the cost of the train ticket is not relevant.

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Quick Check

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Quick Check


waste money needlessly. Is the cost of the train

ticket relevant in this decision? In other words,should the cost of the train ticket affect the decisionof whether you drive or take the train to Portland?

A. Yes, the cost of the train ticket is relevant.

B. No, the cost of the train ticket is not relevant.

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Quick Check

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Quick Check


waste money needlessly. Is the annual cost of

licensing your car relevant in this decision?

A. Yes, the licensing cost is relevant.

B. No, the licensing cost is not relevant.

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Quick Check

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Quick Check


waste money needlessly. Is the annual cost of

licensing your car relevant in this decision?

A. Yes, the licensing cost is relevant.

B. No, the licensing cost is not relevant.

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Quick Check

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Quick Check

Suppose that your car could be sold now for $5,000. Is this a sunk cost?

A. Yes, it is a sunk cost.

B. No, it is not a sunk cost.

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Quick Check

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Quick Check

Suppose that your car could be sold now for $5,000. Is this a sunk cost?

A. Yes, it is a sunk cost.

B. No, it is not a sunk cost.

2-59 Summary of the Types of Cost

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y ypClassifications

• Financial reporting

• Predicting cost behavior

• Assigning costs to cost objects

• Decision making

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End of Chapter 2

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End of Chapter 2

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NBG_02_1e