Cost Accounting

Seventeenth Edition, Global Edition

Chapter 2
An Introduction to Cost Terms and
Purposes

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Learning Objectives (1 of 2)
2.1 Define and illustrate a cost object
2.2 Distinguish between direct costs and indirect costs
2.3 Explain variable costs and fixed costs
2.4 Interpret unit costs cautiously
2.5 Distinguish the financial accounting concepts,
inventoriable costs, and period costs

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Learning Objectives (2 of 2)
2.6 Illustrate the flow of inventoriable and period costs in
financial accounting
2.7 Explain why product costs are computed in different
ways for different purposes
2.8 Describe a framework for cost accounting and cost
management.

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LEARNING OBJECTIVES
• In this chapter the most important TOPICS we learn are listed as follows :

• 1. COSTS CLASSIFICATION
– DIRECT COSTS AND INDIRECT COSTS
– VARIABLE COSTS AND FIXED COSTS
– MANUFACTURING COSTS AND NON-
MANUFACTURING COSTS
– INVENTORIABLE COSTS AND PERIOD COSTS

• 2. INCOME STATEMENT OF MANUFACTURING BUSINESS

• 3. DIFFERENT COSTS FOR DIFFERENT PURPOSES

Basic Cost Terminology (1 of 2)

• Cost—a sacrificed or forgone resource to achieve a

specific objective
• Actual cost—a cost that has occurred
• Budgeted cost—a predicted cost
• Cost object—anything for which a cost measurement is
desired

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Cost Object Examples at Tesla
Exhibit 2.1 Examples of Cost Objects at Tesla

Cost Object Illustration

Product A Tesla Model 3 vehicle

Service Telephone hotline providing information and assistance to

Tesla stores and galleries

Project R&D project on an electric Tesla truck

Customer The Dubai Road and Transport Authority (RTA), which is

building a large fleet of electric taxis in the city

Activity Setting up machines for production or maintaining

production equipment

Department Worker health and safety department

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Basic Cost Terminology (2 of 2)
• Cost Accumulation—the collection of cost data in an
organized way by means of an accounting system
• Cost Assignment—a general term that encompasses the
gathering of accumulated costs to a cost object in two
ways:
– Tracing costs with a direct relationship to the cost
object
– Allocating accumulated costs with an indirect
relationship to a cost object

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Direct and Indirect Costs
• Direct costs can be conveniently and economically traced
(tracked) to a cost object.
• Indirect costs cannot be conveniently or economically
traced (tracked) to a cost object.
• Instead of being traced, these costs are allocated to a cost
object in a rational and systematic manner.

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Cost Assignment to a Cost Object
(Tesla Example)
Exhibit 2.2 Cost Assignment to a Cost Object

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Cost Assignment of a Cost Object
( diagram) – simple costing system
Cost Allocation Challenges
Direct Costs

Material (steel or tires for a car, as an example)

Labor (assembly-line worker wages)

Indirect Costs

Electricity
Rent
Property taxes
Plant administration expenses

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Factors Affecting Direct/Indirect Cost
Classifications.
• The materiality of the cost in question.
• The available information-gathering technology.
• Design of operations.
NOTE: a specific cost may be both a direct cost of one cost object
and an indirect cost of another cost object.
The direct/indirect classification depends on the choice of the cost
object.
For example: electricity cost in the Factory
Cost object – 1. product A ------ Indirect cost
2. Factory ------ Direct cost
Cost Behavior Patterns: Variable
Costs and Fixed Costs (1 of 2)
Variable costs change, in total, in proportion to
changes in the related level of activity or volume of
output produced.
Fixed costs remain unchanged, in total, for a given
time period, despite changes in the related level of
activity or volume of output produced.
Costs are fixed or variable for a specific activity
and/or for a given time period.

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Cost Behavior Patterns: Variable
Costs and Fixed Costs (2 of 2)
Variable costs are constant on a per-unit basis. That is, if a
product takes 5 pounds of material each, it stays the same
per unit regardless if one, ten, or a thousand units are
produced.

Fixed costs per unit change inversely with the level of

production. As more units are produced, the same fixed cost
is spread over more and more units, reducing the cost per
unit.

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EXAMPLE 1 – EXERCISE 2-23
2-23 Classification of costs, service sector.
Market Focus is a marketing research firm that organizes focus groups for consumer-
product companies. Each focus group has eight individuals who are paid $60 per session
to provide comments on new products. These focus groups meet in hotels and are led by
a trained, independent marketing specialist hired by Market Focus. Each specialist is paid
a fixed retainer to conduct a minimum number of sessions and a per session fee of
$2,200. A Market Focus staff member attends each session to ensure that all the logistical
aspects run smoothly.
Required: Classify each cost item (A–H) as follows:
a. Direct or indirect (D or I) costs of each individual focus group.
b. Variable or fixed (V or F) costs of how the total costs of Market Focus change as the
number of focus groups conducted changes. (If in doubt, select on the basis of whether
the total costs will change substantially if there is a large change in the number of
groups conducted.)
You will have two answers (D or I; V or F) for each of the following items:
EXAMPLE 1 – EXERCISE 2-23
(a) (b)
Cost Item D or I V or F
A. Payment to individuals in each focus group to provide D V
comments on new products.
B. Annual subscription of Market Focus to Consumer Reports I F
magazine.

C. Phone calls made by Market Focus staff member to confirm I F

individuals will attend a focus group session (Records of
individual calls are not kept.)

D. Retainer paid to focus group leader to conduct 18 focus I F

groups per year on new medical products..
E. Recruiting cost to hire marketing specialists. I V

F. Lease payment by Market Focus for corporate office I F

G. Cost of tapes used to record comments made by individuals D V

in a focus group session (These tapes are sent to the
company whose products are being tested.)
Gasoline costs of Market Focus staff for company-owned
H. I V
vehicles (Staff members submit monthly bills with no
mileage breakdowns.)
I. Costs incurred to improve the design of focus groups to I F
make them more effective.
EXAMPLE 2 – EXERCISE 2-25
2-25 Classification of costs, manufacturing sector.

The Cooper Furniture Company of Potomac, Maryland, assembles two types of chairs
(Recliners and Rockers). Separate assembly lines are used for each type of chair.
Required: Classify each cost item (A–I) as follows:
a. Direct or indirect (D or I) cost for the total number of Recliners assembled.

b. Variable or fixed (V or F) cost depending on how total costs change as the total number
of Recliners assembled changes. (If in doubt, select on the basis of whether the total
costs will change substantially if there is a large change in the total number of Recliners
assembled.)
You will have two answers (D or I; V or F) for each of the following items:
EXAMPLE 2 – EXERCISE 2-25
(a) (b)
Cost Item D or I V or F
A. Cost of fabric used on Recliners. D V
B. Salary of public relations manager for Cooper Furniture. I F
C. Annual convention for furniture manufacturers; generally I F
Cooper Furniture attends.
D. Cost of lubricant used on the Recliner assembly line. D V
E. Freight costs of Recliner frames shipped from Durham to D V
Potomac, MD
F. Electricity costs for Recliner assembly line (single bill covers I V
Entire plant).
G. Wages paid to temporary assembly-line workers hired in D V
periods of high Recliner production (paid on hourly basis).
H. Annual fire-insurance policy cost for Potomac, MD plant. I F
I. Wages paid to plant manager who oversees the assembly I F
lines for both chair types
Cost Behavior Summarized

COSTS TOTAL DOLLARS COST PER UNIT

VARIABLE COSTS Change in proportion Unchanged in relation to
with output output
(more output = more
cost)

FIXED COSTS Unchanged in relation to Change inversely with

output (within the output
relevant range) (more output = lower
cost per unit)

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Graphs of Variable and Fixed Costs
Exhibit 2.3 Graphs of Variable and Fixed Costs

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Other Cost Concepts

Mixed costs have both fixed and variable elements.

Cost driver—a variable, such as the level of activity
or volume, that causally affects costs over a given
time span
Relevant range—the band or range of normal
activity level (or volume) in which there is a specific
relationship between the level of activity (or volume)
and the cost in question
Fixed costs are considered fixed only within the
relevant range.

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EXAMPLE 3
The representative cost drivers in the right column of this table are randomized so they do not
match the list of functions in the left column.

ANSWER Function Representative Cost Driver

1. Accounts payable A. Number of invoices sent

2. Recruiting B. Number of purchase orders
3. Data processing C. Number of research scientists
4. Research and development D. Hours of computer processing unit (CPU)
5. Purchasing E. Number of employees hired
6. Warehousing F. Number of payments processed
7. Billing G. Number of pallets moved

Required:
1. Match each function with its representative cost driver.
2. Give a second example of a cost driver for each function.
EXAMPLE 3
Function Representative Cost Driver
1. Accounts payable Number of payments processed
2. Recruiting Number of employees hired
3. Data processing Hours of computer processing unit (CPU)
4. Research and development Number of research scientists
5. Purchasing Number of purchase orders
6. Warehousing Number of pallets moved
7. Billing Number of invoices sent
Function Representative Cost Driver
1. Accounts payable Number of supplier invoices received
2. Recruiting Number of interviews conducted
3. Data Processing Number of computer transactions
4. Research and Development Number of new products being developed
5. Purchasing Number of different types of materials purchased
6. Warehousing Distance of deliveries made
7. Billing Number of credit sales transactions
Illustration of Fixed Cost Within
Relevant Range
Exhibit 2.4 Thomas Transport Company

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Multiple Classifications of Costs
• Costs may be classified as
– Direct/Indirect and
– Variable/Fixed.
• These multiple classifications give rise to important cost
combinations:
– Direct and variable
– Direct and fixed
– Indirect and variable
– Indirect and fixed

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Examples of the Multiple
Classifications of Costs
Exhibit 2.5 Examples of Costs in Combinations of the Direct/Indirect and
Variable/Fixed Cost Classifications for a Car Manufacturer

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Use Unit Costs Cautiously
Although unit costs are regularly used in financial reports
and for making product mix and pricing decisions, managers
should think in terms of total costs rather than unit costs for
many decisions.

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The Three Different Sectors of Economy

1. Manufacturing-sector companies purchase materials

and components and convert them into various finished
goods.

2. Merchandising-sector companies purchase and then

sell tangible products without changing their basic form.

3. Service-sector companies provide services (intangible

products) like legal advice or audits.

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Types of Inventory in Manufacturing

Direct materials—resources in-stock and available

for use for production
Work-in-process (or progress)—goods partially
worked on but not yet completed, often abbreviated
as W I P
Finished goods—goods completed but not yet sold
Note: Merchandising-sector companies hold
only one type of inventory: Merchandise
Inventory

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Manufacturing Costs and Non-Manufacturing Costs
Also known as inventoriable costs / product cost :
1. Direct materials (DM) – acquisition costs of all material
that will become part of the cost object.

2. Direct labor (DL) – compensation of all manufacturing

labor that can be traced to the cost object.

3. Indirect manufacturing cost ( Manufacturing

Overhead ) (MOH) – all manufacturing costs that are related
to the cost object but cannot be traced to that cost object in
an economically feasible way.
Manufacturing Costs and Non-Manufacturing Costs

EXPLANATION:
Data Base of Accounting

____ ____ ____ ____ Direct materials

____ ____ ____ ____
Direct labor
____ ____ ____ ____
____ ____ ____ _____
____ ____ ____ ____
____ ____ ____ _____
____ ____ ____ ____
____ ____ ____ _____
Manufacturing overhead
↑
↑
Non manufacturing Cost incurred in the
factory
Inventoriable Costs Versus Period
Costs
• Inventoriable costs are all costs of a product that are
considered assets in a company’s balance sheet when the
costs are incurred
• are expensed as cost of goods sold only when the product
is sold.

• For manufacturing companies, all manufacturing costs are

inventoriable costs / Product costs.
• Period costs are all costs in the income statement other
than cost of goods sold. They are treated as expenses of
the accounting period in which they are incurred.

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Cost Flows
The Cost of Goods Manufactured and the Cost of Goods
Sold section of the income statement are accounting
representations of the actual flow of costs through a
production system.
Note: Inventoriable costs go through the balance sheet
accounts of direct materials, work-in-process, and finished
goods inventory before entering the cost of good sold in the
income statement.

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Cost Flows Illustrated
Exhibit 2.7 Flow of Revenue and Costs for a Manufacturing-Sector Company,
Cellular Products (in thousands)

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Multiple-Step Income Statement (1 of 2)
Exhibit 2.8 Income Statement and Schedule of Cost of Goods Manufactured of a
Manufacturing-Sector Company, Cellular Products

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Multiple-Step Income Statement (2 of 2)
Exhibit 2.8 Income Statement and Schedule of Cost of Goods Manufactured of a
Manufacturing-Sector Company, Cellular Products

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Flow of Revenues and Costs for a
Merchandising Company
Exhibit 2.10 Flow of Revenues and Costs for a Merchandising Company
(Retailer or Wholesaler)

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EXAMPLE 4 – EXERCISE 2-37
2-37 Cost of goods manufactured, income statement, manufacturing company. Consider the
following account balances (in thousands) for the Peterson Company:

Beginning of End of
Peterson Company 2017 2017
Direct materials inventory 21,000 23,000
Work-in-process inventory 26,000 25,000
Finished-goods inventory 13,000 20,000
Purchases of direct materials 74,000
Direct manufacturing labor 22,000
Indirect manufacturing labor 17,000
Plant insurance 7,000
Depreciation—plant, building, and 11,000
equipment
Repairs and maintenance—plant 3,000
Marketing, distribution, and customer- 91,000
service costs
General and administrative costs 24,000

Required:

1. Prepare a schedule for the cost of goods manufactured for 2017.

2. Revenues for 2017 were $310 million. Prepare the income statement for 2017.
EXAMPLE 4 – EXERCISE 2-37
Peterson Company
Schedule of Cost of Goods Manufactured
Year Ended December 31, 2017
(in thousands)

Direct materials cost

Beginning inventory, January 1, 2017 $ 21,000
Purchases of direct materials 74,000
Cost of direct materials available for use 95,000
Ending inventory, December 31, 2017 23,000
Direct materials used $ 72,000
Direct manufacturing labor costs 22,000
Indirect manufacturing costs
Indirect manufacturing labor 17,000
Plant insurance 7,000
Depreciation—plant building & equipment 11,000
Repairs and maintenance—plant 3,000
Total indirect manufacturing costs 38,000
Manufacturing costs incurred during 2017 132,000
Add beginning work-in-process inventory, January 1, 2017 26,000
Total manufacturing costs to account for 158,000
Deduct ending work-in-process inventory, December 31, 2017 25,000
Cost of goods manufactured (to Income Statement) $133,000
EXAMPLE 4 – EXERCISE 2-37
Peterson Company
Income Statement
Year Ended December 31, 2017
(in thousands)

Revenues $310,000
Cost of goods sold:
Beginning finished goods, January 1, 2017 $ 13,000
Cost of goods manufactured 133,000
Cost of goods available for sale 146,000
Ending finished goods, December 31, 2017 20,000
Cost of goods sold 126,000
Gross margin 184,000
Operating costs:
Marketing, distribution, and customer-service costs 91,000
General and administrative costs 24,000
Total operating costs 115,000
Operating income $ 69,000
Other Cost Considerations

• Prime cost is a term referring to all direct manufacturing

costs (materials and labor).
• Conversion cost is a term referring to direct labor and
indirect manufacturing costs.
• Overtime premium labor costs are considered part of
indirect overhead costs.
• Idle time refers to the wages paid for unproductive time
caused by lack of orders, machine or computer
breakdown, work delays, poor scheduling, and the like.

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Other Cost Considerations
• Prime cost is a term referring to all direct
manufacturing costs (materials and labor).
• Prime cost = DM + DL

• Conversion cost is a term referring to direct labor

and indirect manufacturing costs.
• Conversion cost = DL + MOH
• Overtime premium labor costs are considered part
of indirect overhead costs.
Different Product Costs for Different
Purposes (1 of 2)
Pricing and product-mix decisions—decision about
pricing and maximizing profits
Contracting with government agencies—very
specific definitions of allowable costs for “cost plus
profit” contracts
Preparing external-use financial statements—GAA
P-driven product costs only

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Different Product Costs for Different
Purposes (2 of 2)
Exhibit 2.11 Different Product Costs for Different Purposes

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A Framework for Cost Accounting
and Cost Management

The following three features of cost accounting and cost

management can be used for a wide range of applications
(for helping managers make decisions):
1. Calculating the cost of products, services, and other cost
objects
2. Obtaining information for planning and control and
performance evaluation
3. Analyzing the relevant information for making decisions

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