1. Cost Terms, Concepts and Classifications
3-1
Cost Terms, Concepts and Classifications
Chapter Two
Managers need to rely upon different classifications of costs for different purposes. The four main purposes emphasized in this chapter include preparing external financial reports, predicting cost behavior, assigning costs to cost objects, and making business decisions. Our initial focus is on manufacturing companies since their basic activities include most of the activities found in other types of business organizations. Nonetheless, many of the concepts developed in this chapter apply to diverse organizations.

2. Manufacturing Overhead
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Manufacturing Costs
Direct Materials
Direct Labor
Manufacturing Overhead
Manufacturing costs are usually grouped into three main categories: direct materials, direct labor, and manufacturing overhead. These costs are incurred to make a product.
The Product

3. Example: A radio installed in an automobile
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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.
Direct materials are raw materials that become an integral part of the finished product and whose costs can be conveniently traced to it. Examples include the aircraft engines on a Boeing 777, the Intel processing chip in a personal computer, the blank video cassette in a pre-recorded video, and a radio in an automobile.
Example: A radio installed in an automobile

4. Example: Wages paid to automobile assembly workers
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Direct Labor
Those labor costs that can be easily traced to individual units of product.
Direct labor consists of that portion of labor cost that can be easily traced to a product. Direct labor is sometimes referred to as “touch labor,” since it consists of the costs of workers who “touch” the product as it is being made.
Example: Wages paid to automobile assembly workers

5. Manufacturing Overhead
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Manufacturing Overhead
Manufacturing costs that cannot be traced directly to specific units produced.
Examples: Indirect labor and indirect materials
Wages paid to employees who are not directly involved in production work. Examples: maintenance workers, janitors and security guards.
Materials used to support the production process. Examples: lubricants and cleaning supplies used in the automobile assembly plant.
Manufacturing overhead consists of all manufacturing costs, other than direct materials and direct labor. These costs cannot be conveniently traced to products. Such costs are also called indirect manufacturing costs, factory overhead, and factory burden. Examples include miscellaneous supplies such as rivets in a Boeing 777; salaries for supervisors, janitors, and security guards; factory facility charges, etc.

6. Non-manufacturing Costs
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Non-manufacturing Costs
Selling Costs
Costs necessary to get the order and deliver the product.
Administrative Costs
All executive, organizational, and clerical costs.
A manufacturing company incurs many other costs in addition to manufacturing costs. For financial reporting purposes, most of these other costs are typically classified as selling costs and administrative costs. These costs are also called selling, general and administrative costs, or SG&A. Selling and administrative costs are incurred in both manufacturing and merchandising firms.
Selling costs include all costs necessary to secure customer orders and get the finished product into the hands of the customer. These costs are also referred to as order-getting and order-filling costs. Examples of selling costs include advertising, shipping, sales travel, sales commissions, sales salaries, and costs of finished goods warehousing.
Administrative costs include all executive, organizational, and clerical costs associated with the general management of an organization. Examples of administrative costs include executive compensation, general accounting, secretarial, public relations, and similar costs involved in the overall general administration of the organization as a whole.

7. 3-7
Learning Objective 2
Distinguish between product costs and period costs and give examples of each.
Learning objective number 2 is to distinguish between product costs and period costs and give examples of each.

8. Product Costs Versus Period Costs
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Product Costs Versus Period Costs
Product costs include direct materials, direct labor, and manufacturing overhead.
Period costs include all selling costs and administrative costs.
Inventory
Cost of Good Sold
Balance Sheet
Income Statement
Sale
Expense
Income Statement
Costs can also be classified as period or product costs.
Product costs include all the costs that are involved in acquiring or making a product. More specifically, it includes direct materials, direct labor, and manufacturing overhead. Consistent with the matching principle, product costs are recognized as expenses when the products are sold. This can result in a delay of one or more periods between the time in which the cost is incurred and when it appears as an expense on the income statement. Product costs are also known as inventoriable costs. The discussion in the chapter follows the usual interpretation of GAAP in which all manufacturing costs are treated as product costs.
Period costs include all selling costs and administrative costs. These costs are expensed on the income statement in the period incurred. All selling and administrative costs are typically considered to be period costs. The usual rules of accrual accounting apply to period costs. For example, administrative salary costs are “incurred” when they are earned by the employees and not necessarily when they are paid to employees.

9. 3-9
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.
E. Sales commissions.
Which of the following costs would be considered a period rather than a product cost in a manufacturing company?

10. 3-10
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.
E. Sales commissions.
Property taxes on corporate headquarters and sales commissions are period costs. All of the other costs listed are product costs.

11. Classifications of Costs
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Classifications of Costs
Manufacturing costs are often classified as follows:
Direct Material
Direct Labor
Manufacturing Overhead
Prime Cost
Conversion Cost
Two more cost categories are often used in discussions of manufacturing costs—prime cost and conversion cost. Prime cost is the sum of direct materials cost and direct labor cost. Conversion cost is the sum of direct labor cost and manufacturing overhead cost. The term conversion cost is used to describe direct labor and manufacturing overhead because these costs are incurred to convert materials into the finished product.

12. Comparing Merchandising and Manufacturing Activities
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Comparing Merchandising and Manufacturing Activities
Merchandisers . . .
Buy finished goods.
Sell finished goods.
Manufacturers . . .
Buy raw materials.
Produce and sell finished goods.
MegaLoMart
Merchandising companies purchase finished goods from suppliers for resale to customers. Manufacturing companies purchase raw materials from suppliers and produce and sell finished goods to customers.

13. Balance Sheet Manufacturer Merchandiser Current Assets Current assets
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Balance Sheet
Merchandiser
Current assets
Cash
Receivables
Prepaid Expenses
Merchandise Inventory
Manufacturer
Current Assets
Cash
Receivables
Prepaid Expenses
Inventories
Raw Materials
Work in Process
Finished Goods
Now, let’s consider similarities and differences on the balance sheet for merchandising and manufacturing companies. Both merchandising and manufacturing companies will likely have Cash, Receivables and Prepaid Expenses. However, merchandising companies do not have to distinguish between raw materials, work in process, and finished goods. They report one inventory number on their balance sheets, labeled merchandise inventory. Manufacturing companies report three types of inventory on their balance sheets: raw materials, work in process and finished goods.

14. Materials waiting to be processed. Completed products awaiting sale.
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Balance Sheet
Merchandiser
Current assets
Cash
Receivables
Prepaid Expenses
Merchandise Inventory
Manufacturer
Current Assets
Cash
Receivables
Prepaid Expenses
Inventories
Raw Materials
Work in Process
Finished Goods
Materials waiting to be processed.
Partially complete products – some material, labor, or overhead has been added.
Part I
Raw materials are the materials used to make the product.
Part II
Work in process consists of units of product that are partially complete, but will require further work to be saleable to customers.
Part III
Finished goods consists of units of product that have been completed but not yet sold to customers.
Completed products awaiting sale.

15. 3-15
Learning Objective 3
Prepare an income statement including calculation of the cost of goods sold.
Learning objective number 3 is to prepare an income statement including calculation of the cost of goods sold.

16. 3-16
The Income Statement
Cost of goods sold for manufacturers differs only slightly from cost of goods sold for merchandisers.
Merchandising companies calculate cost of goods sold as Beginning Merchandise Inventory plus Purchases minus Ending Merchandise Inventory.
For manufacturing companies, the cost of goods sold for a period is not simply the manufacturing costs incurred during the period. Manufacturing companies calculate cost of goods sold as Beginning Finished Goods Inventory plus Cost of Goods Manufactured minus Ending Finished Goods Inventory. Some of the cost of goods sold may be for units completed in a previous period. And some of the units completed in the current period may not have been sold and will still be on the balance sheet as assets. The cost of goods sold is computed with the aid of a schedule of costs of goods manufactured, which takes into account changes in inventories. The schedule of cost of goods manufactured is not ordinarily included in external financial reports, but must be compiled by accountants within the company in order to arrive at the cost of goods sold. We will learn more about a schedule of costs of goods manufactured later in this chapter.

17. Basic Equation for Inventory Accounts
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Basic Equation for Inventory Accounts
Beginning
balance
Additions to inventory + =
Ending
Withdrawals from
inventory
The computation of Cost of Goods Sold relies on this basic equation for inventory accounts. The logic underlying this equation applies to any inventory account. Any units that are in inventory at the beginning of the period appear as the beginning balance. During the period, additions are made to the inventory through purchases or other means. The sum of the beginning balance and the additions to the account is the total amount of inventory available. During the period, withdrawals are made from inventory. The ending balance is whatever is left at the end of the period after the withdrawals.

18. 3-18
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. $
C. $1,200.
D. $
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?

19. Quick Check  $1,000 + $100 = $1,100 $1,100 - $300 = $800
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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. $
C. $1,200.
D. $
$1,000 + $100 = $1,100
$1,100 - $300 = $800
Right. $800. This is calculated as beginning inventory of $1,000 plus purchases of $100 minus ending inventory of $300.

20. Prepare a schedule of cost of goods manufactured.
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Learning Objective 4
Prepare a schedule of cost of goods manufactured.
Learning objective number 4 is to prepare a schedule of cost of goods manufactured.

21. 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.
The schedule of cost of goods manufactured contains the three elements of costs mentioned previously, namely direct materials, direct labor, and manufacturing overhead. It calculates the cost of raw material, direct labor and manufacturing overhead used in production. It also calculates the manufacturing costs associated with goods that were finished during the period.

22. 3-22
Product Cost Flows
To create a schedule of cost of goods manufactured, as well as a balance sheet and income statement, it is important to understand the flow of product costs. Raw material purchases made during the period are added to beginning raw materials inventory. The ending raw materials inventory is deducted to arrive at the raw materials used in production. As items are removed from the raw materials inventory and placed into the production process, they are called direct materials.
As items are removed from raw materials inventory and placed into the production process, they are called direct materials.

23. 3-23
Product Cost Flows
Conversion costs are costs incurred to convert the direct material into a finished product.
Direct labor and manufacturing overhead (also called conversion costs) used in production are added to direct materials to arrive at total manufacturing costs.

24. 3-24
Product Cost Flows
Total manufacturing costs are added to the beginning work in process to arrive at total work in process.
All manufacturing costs incurred during the period are added to the beginning balance of work in process.

25. 3-25
Product Cost Flows
The ending work in process inventory is deducted from the total work in process for the period to arrive at the cost of goods manufactured.
Costs associated with the goods that are completed during the period are transferred to finished goods inventory.

26. 3-26
Product Cost Flows
The cost of goods manufactured is added to the beginning finished goods inventory to arrive at cost of goods available for sale. The ending finished goods inventory is deducted from this figure to arrive at cost of goods sold.

27. Manufacturing Cost Flows
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Manufacturing Cost Flows
Income Statement Expenses
Balance Sheet Costs Inventories
Material Purchases
Raw Materials
Manufacturing Overhead
Work in Process
Direct Labor
Finished Goods
Part I
All raw materials, work in process, and unsold finished goods at the end of the period are shown as inventoriable costs in the asset section of the balance sheet.
Part II
As finished goods are sold, their costs are transferred to cost of goods sold on the income statement.
Part III
Selling and administrative expenses are not involved in making the product; therefore, they are treated as period costs and reported on the income statement for the period the cost is incurred.
Cost of Goods Sold
Selling and Administrative
Period Costs

28. 3-28
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
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?

29. 3-29
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
Right. $280,000. Take a minute and review the solution before proceeding.

30. 3-30
Quick Check 
Direct materials used in production totaled $280,000. Direct labor 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.
Direct materials used in production totaled $280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month?

31. 3-31
Quick Check 
Direct materials used in production totaled $280,000. Direct labor 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.
Right. $835,000. Take a minute and review the solution before proceeding.

32. 3-32
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.
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?

33. 3-33
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.
Right. $760,000. Take a minute and review the solution before proceeding.

34. 3-34
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.
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?

35. 3-35
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.
$130,000 + $760,000 = $890,000
$890,000 - $150,000 = $740,000
Right. $740,000. Take a minute and review the solution before proceeding.

36. Understand the differences between variable costs and fixed costs.
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Learning Objective 5
Understand the differences between variable costs and fixed costs.
Learning objective number 5 is to understand the differences between variable costs and fixed costs.

37. Cost Classifications for Predicting Cost Behavior
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Cost Classifications for Predicting Cost Behavior
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.
Quite frequently, it is necessary to predict how a certain cost will behave in response to a change in activity. For example, a manager may want to estimate the impact that a 5% increase in sales would have on the company’s total electric bill. Cost behavior refers to how a cost will react to changed in the level of activity within the relevant range. The most commonly used classifications of cost behavior are variable and fixed costs.

38. Total Long Distance Telephone Bill
3-38
Variable Cost
Your total long distance telephone bill is based on how many minutes you talk.
Minutes Talked
Total Long Distance Telephone Bill
A variable cost varies in direct proportion to changes in the level of activity. For example, your long distance telephone bill may be based on how many minutes your talk—the total bill varies with the number of minutes used.

39. Per Minute Telephone Charge
3-39
Variable Cost Per Unit
The cost per long distance minute talked is constant. For example, 10 cents per minute.
Minutes Talked
Per Minute Telephone Charge
Although variable costs change in total as the activity level rises and falls, variable cost per unit is constant. For example, the cost per long distance minute may be ten cents a minute.

40. Monthly Basic Telephone Bill
3-40
Fixed Cost
Your monthly basic telephone bill probably does not change when you make more local calls.
Number of Local Calls
Monthly Basic Telephone Bill
A fixed cost is constant within the relevant range. In other words, fixed costs do not change for changes in activity that fall within the “relevant range.” For example, your monthly basic telephone bill probably is a set amount and does not change based on the number of calls you make.

41. Monthly Basic Telephone Bill per Local Call
3-41
Fixed Cost Per Unit
The average fixed cost per local call decreases as more local calls are made.
Number of Local Calls
Monthly Basic Telephone Bill per Local Call
However, when expressed on a per unit basis, a fixed cost is inversely related to activity—the per unit cost decreases when activity rises and increases when activity falls. For example, the average fixed cost per local call decreases as more local calls are made.

42. Cost Classifications for Predicting Cost Behavior
3-42
Cost Classifications for Predicting Cost Behavior
It is helpful to think about variable and fixed cost behavior in a two by two matrix, as illustrated here. Take a few minutes and review this summary of cost behavior for variable and fixed costs.

43. 3-43
Quick Check 
Which of the following costs would be variable with respect to the number of cones sold at a Baskins & 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.
Which of the following costs would be variable with respect to the number of cones sold at a Baskins and Robbins shop? (There may be more than one correct answer.)

44. 3-44
Quick Check 
Which of the following costs would be variable with respect to the number of cones sold at a Baskins & 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.
Right. The cost of ice cream and the cost of napkins for customers would be variable costs. As Baskins and Robbins sells more ice cream cones, we would expect the total cost of ice cream and napkins to increase.

45. Understand the differences between direct and indirect costs.
3-45
Learning Objective 6
Understand the differences between direct and indirect costs.
Learning objective number 6 is to understand the differences between direct and indirect costs.

46. Assigning Costs to Cost Objects
3-46
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 labor
Indirect costs
Costs that cannot be easily and conveniently traced to a unit of product or other cost object.
Example: manufacturing overhead
A cost object is anything for which cost data are desired including products, customers, jobs, organizational subunits, etc. For purposes of assigning costs to cost objects, costs are classified two ways:
Direct costs are costs that can be easily and conveniently traced to a specified cost object. Examples of direct costs are direct material and direct labor.
Indirect costs are costs that cannot be easily and conveniently traced to a specified cost object. An example of an indirect cost is manufacturing overhead.