1. An Introduction to Cost Terms and Purposes
Chapter 2
An Introduction to Cost Terms and Purposes
Copyright © 2015 Pearson Education, Inc. All Rights Reserved

2. Chapter 2 learning objectives
Define and illustrate a cost object
Distinguish between direct costs and indirect costs
Explain variable costs and fixed costs
Interpret unit costs cautiously
Distinguish inventoriable costs period costs
Illustrate the flow of inventoriable and period costs
What does the word cost mean to you?
In this chapter, we’ll distinguish among various types of costs and will explore the following objectives:
1. Define and illustrate a cost object
2. Distinguish between direct costs and indirect costs
3. Explain variable costs and fixed costs
4. Interpret unit costs cautiously
5. Distinguish inventoriable costs period costs
6. Illustrate the flow of inventoriable and period costs 2-

3. Chapter 2 learning objectives, concluded
Explain why product costs are computed in different ways for different purposes
Describe a framework for cost accounting and cost management
Our final 2 objectives for this chapter are:
7. Explain why product costs are computed in different ways for different purposes
8. Describe a framework for cost accounting and cost management 2-

4. Basic Cost Terminology
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.
Cost—a sacrificed 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
Managers use cost information in two main ways: when MAKING decisions and when IMPLEMENTING decisions 2-

5. Cost Object Examples at BMW
Illustration
Product
A BMW X6 sports activity vehicle
Service
Telephone hotline providing information and assistance to BMW dealers
Project
R&D project on DVD system enhancement in BMW cars
Customer
Herb Chambers Motors, a dealer that purchases a broad range of BMW vehicles
Activity
Setting up machines for production or maintaining production equipment
Department
Environmental, Health and Safety department
When we are thinking of the cost of something, it is a particular something: a car, a piano, a new outfit. That THING about which we want to know the cost is called a cost object.
In this slide, we have some examples of different things about which we may want to know the costs. Exhibit 2-1 page 30. 2-

6. Basic Cost Terminology, concluded
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 accumulated costs with a direct relationship to the cost object and
Allocating accumulated costs with an indirect relationship to a cost object.
Here, we have some additional terminology:
Cost accumulation—a 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 accumulated costs with a direct relationship to the cost object and
Allocating accumulated costs with an indirect relationship to a cost object 2-

7. 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.
One way that we differentiate between different kinds of costs is to identify them as direct or indirect.
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.
The salary of a plant administrator at BMW, as an example, is an indirect cost of a particular automobile because unlike the steel or tires used, it is virtually impossible to trace plant administration to a particular car line. 2-

8. Cost assignment to a cost object (bmw example)
Going back to our X6 BMW example, we see here an illustration of how costs for that line would be collected to the cost object.
If the BMW X6 is our cost object, the direct costs can be traced but the indirect costs must be allocated. Added together, we’ll obtain total costs for the cost object.
Exhibit 2-2 page 30. 2-

9. Cost Examples Direct Costs Indirect Costs
Parts (steel or tires for a car, as an exampe)
Assembly line wages
Indirect Costs
Electricity
Rent
Property taxes
Plant administration expenses
To gain a better understanding of the types of items that fit into each type of cost (direct or indirect), we present some examples:
Direct Costs
Parts (steel or tires for a car, as an exampe)
Assembly line wages
Indirect Costs
Electricity
Rent
Property taxes
One way to think about this is that association between the direct costs and the specific request for those items in the production process. We need 4 tires and x lbs of steel for each car, but we don’t requisition some number of hours of administration time or rent for each car or for the line.
Managers are generally more confident about the accuracy of the direct costs of cost objects. 2-

10. Factors Affecting Direct/Indirect Cost Classification
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.
A few factors affect the direct/indirect cost classification:
The materiality of the cost in question (the smaller the cost, the less likely it will be efficient to trace the cost)
The available information-gathering technology (technology allows us to treat more and more costs as direct)
Design of operations (if parts of a facility are dedicated to a particular cost object, we are generally able to classify more costs as direct)
A specific cost may be a direct cost for one cost object and an indirect cost for another. 2-

11. Cost Behavior
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 only with respect to a specific activity or a given time period.
Cost behavior defines how costs change. That will be in total, with a change of activity (variable costs) or per unit, with a change of activity (fixed costs).
Another way to look at it is this way:
Variable costs are constant on a per-unit basis. If a product takes 5 pounds of materials each, it stays the same per unit regardless if one, ten, or a thousand units are produced.
Fixed costs 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.
Costs are defined as variable or fixed for a specific activity and for a given time period. 2-

12. Cost Behavior, cont’d
Variable costs are constant on a per-unit basis. If a product takes 5 pounds of materials 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.
When considering variable and fixed costs, it is very important to know if you are looking at the cost IN TOTAL or PER UNIT.
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 2-

13. Cost Behavior Summarized
Total Dollars
Cost per Unit
Variable Costs
Change in proportion with output
More output = More cost
Fixed Costs
Unchanged in relation to output
Change inversely with output
More output = lower cost
per unit
Total Dollars
Cost Per Unit
Unchanged in relation to
output
Change in proportion with output
More output = More cost
Variable Costs
Change inversely with output
More output = lower
cost per unit
In this chart, we have a summary of the way our costs change in total or per unit.
Variable cost TOTAL DOLLARS change in proportion with output but remain unchanged PER UNIT
Fixed cost TOTAL DOLLARS remain unchanged in relation to output but change INVERSELY per unit
Unchanged in relation to output
Fixed Costs 2-

14. Graphs of variable and fixed costs
In these charts, we see the graphs for variable and fixed costs using the number of steering wheels for the BMW X6.
Panel A shows a graph of the total variable cost of steering wheels. The cost begins at zero because if we make no X6s, we’ll incur no cost for the steering wheels.
Fixed Costs are presented in Panel B where we have a line across at the $2,000,000 mark. The Annual total fixed supervision costs for the X6 are that amount and will be that amount whether we assemble zero, 20,000, 40,000 or 60,000 cars. Exhibit 2-3 page 32. 2-

15. Other Cost Concepts
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.
For example, fixed costs are considered fixed only within the relevant range.
We have a few additional concepts to review:
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
The idea of the relevant range is that at some point of increased production or assembly, fixed costs will likely increase. For example, if you run out of capacity and need to enlarge the facility, there will be additional costs involved. 2-

16. 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
We have introduced two major classifications of costs: direct and indirect; variable and fixed.
As a result, we can have the following combinations of costs:
Direct and variable
Direct and fixed
Indirect and variable
Indirect and fixed 2-

17. A Cost Caveat
Unit costs should be used cautiously. Because unit costs change with a different level of output or volume, it may be more prudent to base decisions on a total cost basis.
Unit costs that include fixed costs should always reference a given level of output or activity.
Unit costs are also called average costs.
Managers should think in terms of total costs rather than unit costs for many decisions.
We’ve been discussing how variable costs and fixed costs differ in terms of their unit costs. For this reason, unit costs should be used cautiously. Because unit costs change with a different level of output or volume, it may be more prudent to base decisions on a total dollar basis. 2-

18. Examples of the Multiple Classifications of Costs
Once again using the BMW X6 as an example, we see here examples of the various combinations that can occur for direct/indirect and variable/fixed costs.
Exhibit 2-5 page 36. 2-

19. Different Types of Firms
Manufacturing-sector companies purchase materials and components and convert them into finished products.
Merchandising-sector companies purchase and then sell tangible products without changing their basic form.
Service-sector companies provide services (intangible products) like legal advice or audits.
Cost accounting is used for all types of firms including:
Manufacturing-sector companies purchase materials and components and convert them into finished products.
Merchandising-sector companies purchase and then sell tangible products without changing their basic form.
Service-sector companies provide services (intangible products) like legal advice or audits. 2-

20. Types of inventory
Direct materials—resources in-stock and available for use
Work-in-process (or progress)—products started but not yet completed, often abbreviated as WIP
Finished goods—products completed and ready for sale
Note: Merchandising-sector companies hold only one type of inventory: merchandise inventory
Manufacturing-sector companies purchase materials and components and convert them into finished goods. These companies typically have one or more of the following three types of inventory:
Direct materials—resources in-stock and available for use
Work-in-process (or progress)—products started but not yet completed, often abbreviated as WIP
Finished goods—products completed and ready for sale
Note: Merchandising-sector companies hold only one type of inventory: merchandise inventory 2-

21. Commonly used classifications of manufacturing costs
Also known as inventoriable costs
Direct materials—acquisition costs of all materials that will become part of the cost object.
Direct labor—compensation of all manufacturing labor that can be traced to the cost object.
Indirect manufacturing—factory costs that are not traceable to the product in an economically feasible way. Examples include lubricants, indirect manufacturing labor, utilities, and supplies.
Three terms are commonly used when describing manufacturing costs. These terms build on the direct versus indirect cost distinctions we discussed earlier.
Direct materials—acquisition costs of all materials that will become part of the cost object.
Direct labor—compensation of all manufacturing labor that can be traced to the cost object.
Indirect manufacturing—factory costs that are not traceable to the product in an economically feasible way. Examples include lubricants, indirect manufacturing labor, utilities, and supplies.
These costs are also known as inventoriable costs. 2-

22. Inventoriable costs vs. period costs
Inventoriable costs are all costs of a product that are considered assets in a company’s balance sheet when the costs are incured and that are expensed as cost of goods sold only when the product is sold. For manufacturing companies, all manufacturing costs are inventoriable 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.
Inventoriable costs are all costs of a product that are considered assets in a company’s balance sheet when the costs are incured and that are expensed as cost of goods sold only when the product is sold. For manufacturing companies, all manufacturing costs are inventoriable 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. 2-

23. 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 how inventoriable costs to through the balance sheet accounts of work-in-process and finished goods inventory before entering the cost of goods sold in the income statement.
Here, we begin our conversation about the flow of costs. Costs will flow from the balance sheet to the income statement or will originate on the income statement.
Let’s take a closer look. 2-

24. Cost flows illustrated
Here, we see Exhibit 2-7 page 41, representing the flow of costs through the balance sheet accounts (for inventoriable costs only) and into the income statement for both inventoriable and period costs. 2-

25. Multiple-step income statement, part one
To report the flow of costs just illustrated on the income statement, we calculate cost of goods sold as follows:
Beginning Finished Goods Inventory
PLUS Cost of Goods Manufactured (see next slide)
EQUALS Cost of Goods available for sale
SUBTRACT Ending Finished Goods Inventory
EQUALS Cost of Goods Sold
If you subtract Cost of Goods Sold from Net Revenues, you get Gross Margin.
Exhibit 2-8 page 42.
From Gross Margin we subtract period costs to obtain Operating Income 2-

26. Multiple-step income statement, part two
From our first panel on the Multiple-Step Income Statement, we used a figure called Cost of Goods Manufactured.
Step one is to calculate cost of direct materials used by adding beginning direct materials to purchases, then subtracting out ending direct materials inventory
Step 2 is to calculate the total manufacturing costs incurred which includes the cost of direct materials used plus direct manufacturing labor plus manufacturing overhead.
Finally in step 3, to Beginning Work in Process inventory, we add the manufacturing costs incurred calculated in step 2. That gives us the total manufacturing costs to account for. In other words, these costs will either remain in Work in Process or they will be transferred to Finished Goods.
Continuing step 3, subtracting ending work in process from total manufacturing costs to account for, we get the Cost of Goods Manufactured that we used in the last slide. 2-

27. 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 labor costs are considered part of indirect overhead costs.
Two additional terms we use to describe cost classifications in manufacturing costing systems are:
Prime costs -- a term referring to all direct manufacturing costs (materials and labor).
Conversion costs -- a term referring to direct labor and indirect manufacturing costs. 2-

28. Measuring costs requires judgment
Because there are alternative ways for management to define and classify costs, judgment is required. Managers, accountants, suppliers and others should agree on the classifications and meanings of the cost terms introduced in this chapter and throughout the book. 2-

29. Different product Costs for Different purposes
Pricing and product-mix decisions—decisions 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— GAAP-driven product costs only
Many cost terms used by organizations have ambiguous meanings. Consider the term product cost as an example. A product cost is the sum of the costs assigned to a product for a specific purpose. Some different purposes might include:
Pricing and product-mix decisions—decisions 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—GAAP-driven product costs only
These different purposes can result in different measures of product costs. You can see a pictorial view of this concept on the next slide. 2-

30. Different product Costs for Different purposes
Many cost terms used by organizations have ambiguous meanings. Consider the term product cost as an example. A product cost is the sum of the costs assigned to a product for a specific purpose. Some different purposes might include:
Pricing and product-mix decisions—decisions 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—GAAP-driven product costs only
These different purposes can result in different measures of product costs.
Exhibit 2-11 page 48. 2-

31. 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):
Calculating the cost of products, services, and other cost objects
Obtaining information for planning and control, and performance evaluation
Analyzing the relevant information for making decisions
This framework for cost accounting and cost management can help managers make decisions:
Calculating the cost of products, services, and other cost objects
Obtaining information for planning and control, and performance evaluation
Analyzing the relevant information for making decisions 2-

32. TERMS to learn TERMS to LEARN Page Number Reference Actual cost
Average cost
Page 36
Budgeted cost
Conversion costs
Page 46
Cost
Cost accumulation
Cost allocation
Page 30
Cost assignment
Cost driver
Page 34
Cost object
Cost of goods manufactured
Page 43
Cost tracing 2-

33. TERMS to learn, cont’d TERMS to LEARN Page Number Reference
Direct costs of a cost object
Page 30
Direct manufacturing labor costs
Page 39
Direct material costs
Direct materials inventory
Page 38
Factory overhead costs
Finished goods inventory
Fixed costs
Page 32
Idle time
Page 47
Indirect costs of a cost object
Indirect manufacturing costs
Inventoriable costs
Manufacturing overhead costs 2-

34. TERMS to learn, cont’d TERMS to LEARN Page Number Reference
Manufacturing-sector companies
Page 38
Merchandising-sector companies
Operating income
Page 44
Overtime premium
Page 47
Period costs
Page 39
Prime costs
Page 45
Product cost
Page 48
Relevant range
Page 35
Revenues
Service-sector companies
Unit cost
Page 36
Variable cost
Page 21
Work-in-process inventory
Work in progress 2-