CHAPTER 2:

Cost Terms,
Concepts and
Classifications

Prepared by
Shannon Butler,
CPA, CA
Carleton University
 Learning Objectives

1 Identify each of the three basic manufacturing cost categories.

2 Distinguish between product costs and period costs.
3 Prepare an income statement, including the calculation of cost
of goods sold.
4 Prepare a schedule of cost of goods manufactured.
5 Explain the differences between variable and fixed costs.
6 Identify the differences between direct and indirect costs.
7 Describe the cost classifications used in making decisions:
differential costs, opportunity costs, and sunk costs.

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 Manufacturing Costs

Manufacturing companies typically divide

manufacturing costs into three broad
categories:

• Direct Materials
• Direct Labour
• Manufacturing Overhead

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 Direct Materials
• Materials that go into the final product are called raw
material.
• Raw materials may include both direct and indirect
materials.
• Direct materials are those materials that become an
integral part of the product and that can be physically
and conveniently traced directly to it.
• Indirect materials either can not or it is not worth the
expense or effort to trace the costs to the end product.
Indirect materials are included as part of manufacturing
overhead.
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 Direct Labour

• Direct Labour consists of labour costs that can

be easily (physically and conveniently) traced to
individual units of product.
• Labour costs that cannot be physically traced to
the creation of products (or it would be costly or
inconvenient to trace) are called indirect labour
and are treated as part of manufacturing
overhead.

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 Manufacturing Overhead
Manufacturing Overhead includes all costs of
manufacturing except direct material and direct
labour.
Examples: Indirect materials and indirect labour

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 Classifications of Costs

Manufacturing costs are often

classified as follows:

Direct Direct Manufacturing

Material Labour Overhead

Prime Conversion
Cost Cost

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 Overtime Premiums
• The overtime premiums for all factory
workers are usually considered to be part of
manufacturing overhead.

• Product specific overtime premiums are part

of direct labour.

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 Non-Manufacturing Costs
• Marketing or Selling Costs: Costs necessary
to get the order and deliver the product.

• Administrative Costs: All executive,

organizational, and clerical costs.

Factory insurance, maintenance cost of the

building is manufacturing overhead cost if
building is used for manufacturing.

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Product Costs Versus Period Costs

Product costs include Period costs include all

direct materials, direct marketing, selling costs
labour, and and administrative costs.
manufacturing overhead.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement

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 Summary of Cost Terms
Exhibit 2-1

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 Quick Check 

Which of the following costs would be considered a

period rather than a product cost in a manufacturing
company?

A. Manufacturing equipment
depreciation.
B. Property taxes on corporate
headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
© 2021 McGraw-Hill Limited 2-12
 Quick Check 

Which of the following costs would be considered a

period rather than a product cost in a manufacturing
company?

Answer:
B. Property taxes on corporate
headquarters.
E. Sales commissions.

© 2021 McGraw-Hill Limited 2-13

 Cost Classifications on Financial
Statements
• Financial statements prepared by a manufacturing
company are more complex than the statements prepared
by a merchandising or service company.
• Manufacturing companies must account for the
production of its goods as well as for the marketing of
them.
• Manufacturing companies therefore have many costs that
do not exist in a merchandising or service company.
• Merchandising companies simply purchase goods from
suppliers for resale to customers.

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 Balance Sheet
Merchandiser Manufacturer
Current Assets Current Assets
• Cash • Cash
• Receivables • Receivables
• Prepaid • Prepaid Expenses
Expenses • Inventories
• Merchandise • Raw Materials
Inventory • Work in Process
• Finished Goods

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 Balance Sheet
Merchandiser Manufacturer
Current Assets Current Assets
• Cash • Cash
• Receivables • Receivables
• Prepaid Materials
• Prepaidwaiting to
Expenses
be processed.
Expenses • Inventories
• Merchandise • Raw Materials
Inventory • Work in Process
• Finished Goods

Completed products
awaiting sale.
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 The Income Statement
Cost of goods sold for manufacturers differs only
slightly 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

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 Basic Equation for Inventory
Accounts

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

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 Quick Check 
If your inventory balance at the beginning of
the month was $1,000, you bought $100
during the month, and sold $300 during the
month, what would be the balance at the
end of the month?

A. $1,000.
B. $ 800.
C. $1,200.
D. $ 200.
© 2021 McGraw-Hill Limited 2-19
 Quick Check 
If your inventory balance at the beginning of
the month was $1,000, you bought $100
during the month, and sold $300 during the
month, what would be the balance at the
end of the month?

Answer: $1,000 + $100 = $1,100

B. $ 800. $1,100 - $300 = $800

© 2021 McGraw-Hill Limited 2-20

 Schedule of Cost of Goods
Manufactured
Exam-Prepare a schedule of cost of goods manufactured

• Calculates the cost of raw material, direct

labour 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

As items are removed from raw materials

inventory and placed into the production
process, they are
called direct materials.
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Product Cost Flows

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 Product Cost Flows

All manufacturing costs incurred during

the period are added to the beginning
balance of work in process.
Raw materials used in
the production not raw
material purchased
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 Product Cost Flows

Costs associated with the goods that are

completed during the period are
transferred to finished goods inventory.

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Product Cost Flows

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 Manufacturing Cost Flows
Exhibit 2-5

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 An Example of Manufacturing Cost
Flows
Exhibit 2-6

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 SUMMARY OF COST CLASSIFICATIONS
PURPOSE OF COST CLASSIFICATION COST CLASSIFICATIONS
Preparing external financial statements Product costs (inventoriable)
Direct materials
Direct labour
Manufacturing overhead
Period costs (expensed)
Non-manufacturing costs
Marketing or selling costs
Administrative costs
Predicting cost behaviour in response to changes Variable cost (proportional to activity)
in activity
Fixed cost (constant in total)
Assigning costs to cost objects such as Direct cost (can easily be traced)
departments or products
•Indirect cost (cannot easily be traced;
must be allocated)
Making decisions Differential cost (differs between alternatives)-
diff betw cost buying a product and cost of
manufacturing
Sunk cost (past cost not affected by a decision)

Opportunity cost (forgone benefit)

2-29
 Quick Check 
Beginning raw materials inventory was $32,000.
During the month, $276,000 of raw material was
purchased. A count at the end of the month
revealed that $28,000 of raw material was still
present. What is the cost of direct material used?
A. $276,000
B. $272,000
C. $280,000
D. $ 2,000

© 2021 McGraw-Hill Limited 2-30

 Quick Check 
Beginning raw materials inventory was $32,000.
During the month, $276,000 of raw material was
purchased. A count at the end of the month
revealed that $28,000 of raw material was still
present. What is the cost of direct material used?

Answer:
C. $280,000

© 2021 McGraw-Hill Limited 2-31

 Quick Check 

Direct materials used in production totalled

$280,000. Direct labour was $375,000 and
factory overhead was $180,000. What were
total manufacturing costs incurred for the
month?
A.$555,000
B.$835,000
C.$655,000
D.Cannot be determined.

© 2021 McGraw-Hill Limited 2-32

 Quick Check 

Direct materials used in production totalled

$280,000. Direct labour was $375,000 and
factory overhead was $180,000. What were
total manufacturing costs incurred for the
month?
Answer:
B.$835,000

© 2021 McGraw-Hill Limited 2-33

 Quick Check 
Beginning work in process was $125,000.
Manufacturing costs incurred for the month
were $835,000. There were $200,000 of
partially finished goods remaining in work in
process inventory at the end of the month.
What was the cost of goods manufactured
during the month?
A.$1,160,000
B.$ 910,000
C.$ 760,000
D.Cannot be determined.
© 2021 McGraw-Hill Limited 2-34
 Quick Check 
Beginning work in process was $125,000.
Manufacturing costs incurred for the month
were $835,000. There were $200,000 of
partially finished goods remaining in work in
process inventory at the end of the month.
What was the cost of goods manufactured
during the month?

Answer:
C.$ 760,000

© 2021 McGraw-Hill Limited 2-35

 Quick Check 

Beginning finished goods inventory was

$130,000. The cost of goods manufactured
for the month was $760,000. And the ending
finished goods inventory was $150,000.
What was the cost of goods sold for the
month?

A. $ 20,000.
B. $740,000.
C. $780,000.
D. $760,000.
© 2021 McGraw-Hill Limited 2-36
 Quick Check 

Beginning finished goods inventory was

$130,000. The cost of goods manufactured
for the month was $760,000. And the ending
finished goods inventory was $150,000.
What was the cost of goods sold for the
month?
$130,000 + $760,000 = $890,000
Answer:
$890,000 – $150,000 = $740,000
B. $740,000.

© 2021 McGraw-Hill Limited 2-37

Cost Classifications for Predicting
Cost Behaviour
• How a cost will react to changes in the
level of activity within the relevant range.
• Total variable costs change when
activity changes.
• Total fixed costs remain unchanged
when activity changes.

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 Variable Cost

Your total texting bill is based on how

many texts you send.
Total Texting Bill

Number of Texts Sent

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 Variable Cost Per Unit

The cost per text sent is constant at

5 cents per text message.
Cost Per Text Sent

Number of Texts Sent

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 The Activity Base (Cost Driver)

Units Machine
produced hours

A measure of what
causes the incurrence
of a variable cost

Miles Labour
driven hours
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 Fixed Cost
Your monthly contract fee for your cell phone is fixed for the
number of monthly minutes in your contract. The monthly
contract fee does not change based on the number of calls you
make.
Monthly Cell Phone
Contract Fee

Number of Minutes Used

Within Monthly Plan
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 Fixed Cost Per Unit
Within the monthly contract allotment, the average fixed
cost per cell phone call made decreases as more calls
are made.
Monthly Cell Phone
Contract Fee

Number of Minutes Used

Within Monthly Plan
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 Relevant Range

• The relevant range is the range of activity

within which the assumptions about
variable and fixed cost behaviour are
valid.

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 Mixed Costs

• Some costs contain variable and fixed

cost elements; these are called mixed
costs.

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Summary of Variable and
Fixed Cost Behaviour

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 Quick Check 

Which of the following costs would be variable

with respect to the number of cones sold at a
Baskin-Robbins shop? (There may be more
than one correct 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.
© 2021 McGraw-Hill Limited 2-47
 Quick Check 

Which of the following costs would be variable

with respect to the number of cones sold at a
Baskin-Robbins shop? (There may be more
than one correct answer.)

Answer:
C. The cost of ice cream.
D. The cost of napkins for customers.
© 2021 McGraw-Hill Limited 2-48
 Assigning Costs to Cost Objects

• Cost Objects: any unit of analysis for

which cost data are desired; including
products, customers, jobs, and
organizational subunits.
• For assigning costs to cost objects,
costs are classified as either direct or
indirect.

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 Assigning Costs to Cost Objects
• Direct costs: Costs that can be easily and
conveniently traced to a unit of product or
other cost object.
• Examples: direct material and direct
labour
• Indirect costs: Costs that cannot be easily
and conveniently traced to a unit of
product or other cost object.
• Example: manufacturing overhead

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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

• A difference in cost between any two

alternatives is known as a differential cost.
• A difference in revenues between any two
alternatives is known as differential revenue.
• A differential cost is also known as an
incremental cost (an increase in cost from
one alternative to another).

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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.
© 2021 McGraw-Hill Limited 2-54
 Quick Check 

Suppose you are trying to decide whether to drive or

take the train to Portland to attend a concert. You
have 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 decision of 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.
© 2021 McGraw-Hill Limited 2-55
 Quick Check 

Suppose you are trying to decide whether to drive or

take the train to Portland to attend a concert. You
have 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 decision of whether
you drive or take the train to Portland?

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

© 2021 McGraw-Hill Limited 2-56

 Quick Check 

Suppose you are trying to decide whether to

drive or take the train to Portland to attend a
concert. You have ample cash to do either, but
you don’t want to 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.

© 2021 McGraw-Hill Limited 2-57

 Quick Check 

Suppose you are trying to decide whether to

drive or take the train to Portland to attend a
concert. You have ample cash to do either, but
you don’t want to waste money needlessly. Is
the annual cost of licensing your car relevant
in this decision?

Answer:
B. No, the licensing cost is not relevant.

© 2021 McGraw-Hill Limited 2-58

 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.

© 2021 McGraw-Hill Limited 2-59

 Quick Check 

Suppose that your car could be sold now for

$5,000. Is this a sunk cost?

Answer:
B. No, it is not a sunk cost.

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 Summary of the Types of Cost
Classifications
• Financial reporting
• Predicting cost behaviour
• Assigning costs to cost objects
• Decision making

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End of Chapter Summary Part 1
• Manufacturing costs can be divided into three
categories: direct materials, direct labour, and
manufacturing overhead.
• Non-manufacturing costs are classified as
either marketing/selling costs or administrative
costs.
• When valuing inventories and determining
expenses for the balance sheet and income
statement, costs are classified as either
product costs or period costs.
© 2021 McGraw-Hill Limited 2-62
End of Chapter Summary Part 2
• Cost of goods sold is calculated by adding
cost of goods manufactured to beginning
finished goods inventory and then deducting
the ending finished goods inventory.
• To predict cost behaviour, managers
commonly classify costs into two categories,
variable and fixed.
• To assign costs to cost objects such as
products or departments, costs are classified
as direct or indirect.
© 2021 McGraw-Hill Limited 2-63