1. Chapter 2: Managerial Accounting and Cost Concepts.
This chapter explains the differences and similarities between financial and managerial accounting. It also explains how 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.
Cost Concepts
Chapter 2

2. Summary of the Types of Cost Classifications
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Summary of the Types of Cost Classifications
Financial Reporting
Predicting Cost Behavior
We have looked at the cost classifications used for financial reporting, predicting cost behavior, assigning costs to cost objects, and making business decisions. Now, let’s look at how to classify idle time, overtime, and fringe benefits.
Assigning Costs to Cost Objects
Making Business Decisions

3. 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

4. Nonmanufacturing Costs
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Nonmanufacturing Costs
Selling Costs
Costs necessary to secure 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 warehouses.
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.

5. 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.
Costs can also be classified as product or period 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.
Inventory
Cost of Good Sold
Balance Sheet
Income Statement
Sale
Expense
Income Statement

6. Classifications of Costs
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Classifications of Costs
Manufacturing costs are often classified as follows:
Direct Material
Direct Labor
Manufacturing Overhead
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.
Prime Cost
Conversion Cost

7. 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 changes in the level of activity within the relevant range. The most commonly used classifications of cost behavior are variable and fixed costs.

8. Cost Classifications for Predicting Cost Behavior
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Cost Classifications for Predicting Cost Behavior
It is helpful to think about variable and fixed cost behavior in a 2x2 matrix, as illustrated here. Take a few minutes and review this summary of cost behavior for variable and fixed costs.

9. Assigning Costs to Cost Objects
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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 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. Common costs are indirect costs incurred to support a number of cost objects. These costs cannot be traced to any individual cost object.

10. Cost Classifications for Decision Making
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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.
It is important to realize that every decision involves a choice between at least two alternatives. The goal of making decisions is to identify those costs that are either relevant or irrelevant to the decision. Costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits are irrelevant and can and should be ignored. To make decisions, it is essential to have a grasp on three concepts: differential costs, opportunity costs, and sunk costs.

11. Differential Cost and Revenue
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Differential Cost and Revenue
Costs and revenues that differ among alternatives.
Example: You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month.
Differential costs (or incremental costs) is a difference in cost between any two alternatives. Differential costs can be either fixed or variable. A difference in revenue between two alternatives is called “differential revenue.”
For example, assume you have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month. In this example, the differential revenue is $500 and the differential cost is $300.
Differential revenue is:
$2,000 – $1,500 = $500
Differential cost is:
$300

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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.
Opportunity cost is the potential benefit that is given up when one alternative is selected over another. These costs are not usually entered into the accounting records of an organization, but must be explicitly considered in all decisions.

13. 3-12
Sunk Costs
Sunk costs have already been incurred and cannot be changed now or in the future. These costs 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.
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Since sunk costs cannot be changed and therefore cannot be differential costs, they should be ignored in decision making. While students usually accept the idea that sunk costs should be ignored on an abstract level, like most people, they often have difficulty putting this idea into practice.

14. Further Classification of Labor Costs
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Appendix 2A: Further Classification of Labor Costs.
Further Classification of Labor Costs
Appendix 2A

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Idle Time
Machine Breakdowns
Material Shortages
Power Failures
Machine breakdowns, material shortages, power failures and the like, result in idle time. The labor costs incurred during idle time are ordinarily treated as manufacturing overhead. This enables the costs to be spread across all the production rather than the units in process when the disruptions occur.
The labor costs incurred during idle time are ordinarily treated as manufacturing overhead.

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Overtime
The overtime premiums for all factory workers are usually considered to be part of manufacturing overhead.
The overtime premiums for all factory workers are usually considered to be part of manufacturing overhead. This is done to avoid penalizing particular products or customer orders simply because they happen to fall on the tail end of the daily production schedule.
Exceptions may be found in some Asian companies which consistently have overtime due to the urge of full utilization of available capacity and shortage of workers. In those cases, they may have valid arguments to put overtime as part of the normal labor cost.
What if a company consistently has overtime? Can the overtime costs be part of labor expenses?

17. Some companies include all of these costs in manufacturing overhead.
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Labor Fringe Benefits
Fringe benefits include employer paid costs for insurance programs, retirement plans, supplemental unemployment programs, Social Security, Medicare, workers’ compensation, and unemployment taxes.
Labor fringe benefit costs are employment-related costs paid by an employer, such as insurance programs, retirement plans, and supplemental unemployment programs. They also include the employer’s share of Social Security and Medicare, workers’ compensation, federal employment tax, and state unemployment insurance. These costs often add up to 30 to 40 percent of an employee’s base pay.
Some companies include all of these costs in manufacturing overhead. Other companies opt for the conceptually superior method of treating fringe benefit expenses of direct laborers as additional direct labor costs.
Some companies include all of these costs in manufacturing overhead.
Other companies treat fringe benefit expenses of direct laborers as additional direct labor costs.

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Appendix 2B: Cost of Quality.
Cost of Quality
Appendix 2B

19. Quality of Conformance
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Quality of Conformance
When the overwhelming majority of products produced conform to design specifications and are free from defects.
The term quality has many meanings. Quality can mean that a product has many features not found in other products; it can mean that it is well-designed; or it can mean that it is defect-free. In this appendix, the focus is on the presence or absence of defects. Quality of conformance is the degree to which the actual product or service meets its design specifications. Anything that does not meet design specifications is a defect and is indicative of low quality of conformance. There are four broad categories of quality costs: prevention costs, appraisal costs, internal failure costs, and external failure costs.

20. Prevention and Appraisal Costs
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Prevention and Appraisal Costs
Prevention Costs
Support activities whose purpose is to reduce the number of defects
Prevention costs are incurred to support activities whose purpose is to reduce the number of defects. Appraisal costs are incurred to identify defective products before the products are shipped to customers.
Appraisal Costs
Incurred to identify defective products before the products are shipped to customers

21. Internal and External Failure Costs
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Internal and External Failure Costs
Internal Failure Costs
Incurred as a result of identifying defects before they are shipped
Internal failure costs are incurred as a result of identifying defects before they are shipped to customers. External failure costs are incurred as a result of defective products being delivered to customers.
External Failure Costs
Incurred as a result of defective products being delivered to customers

22. Examples of Quality Costs
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Examples of Quality Costs
Prevention Costs
Quality training
Quality circles
Statistical process
control activities
Appraisal Costs
Testing and inspecting
incoming materials
Final product testing
Depreciation of testing
equipment
Here are some examples of each type of quality cost. 
Prevention costs include: quality training, quality circles, and statistical process control activities.
Appraisal costs include: testing and inspection of incoming materials, final product testing, and depreciation of testing equipment.
Internal failure costs include: scrap, spoilage, and rework.
External failure costs include: the cost of field servicing and handling customer complaints, warranty repairs, and lost sales arising from reputation of poor quality.
Internal Failure Costs
Scrap
Spoilage
Rework
External Failure Costs
Cost of field servicing and
handling complaints
Warranty repairs
Lost sales

23. Distribution of Quality Costs
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Distribution of Quality Costs
Graphs are often used to depict the relationship between the four types of quality costs. The graph on this slide illustrates four key concepts.
When the quality of conformance is low, total quality cost is high and most of this cost consists of internal and external failure costs.
Total quality costs drop rapidly as the quality of conformance increases.
Companies reduce their total quality costs by focusing their efforts on prevention and appraisal because the cost savings from reduced defects usually overwhelm the costs of additional prevention and appraisal.
Total quality costs are minimized when the quality of conformance is slightly less than 100%. This is a debatable point in the sense that some experts believe that total quality costs are not minimized until the quality of conformance is 100%.

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Quality cost reports provide an estimate of the financial consequences of the company’s current defect rate.
A quality cost report details the prevention, appraisal, internal failure, and external failure costs that arise from a company’s current quality control efforts. When interpreting a cost of quality report managers should look for two trends. First, increases in prevention and appraisal costs should be more than offset by decreases in internal and external failure costs. Second, the total quality costs as a percent of sales should decrease.

25. Quality Cost Reports in Graphic Form
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Quality Cost Reports in Graphic Form
Quality reports can also be prepared in graphic form.
Quality cost reports can also be prepared in graphic form. Managers should still look for the same two trends whether the data are presented in a graphic or table format.

26. Uses of Quality Cost Information
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Uses of Quality Cost Information
Help managers see the financial significance of defects.
Help managers identify the relative importance of the quality problems.
Uses of quality cost information include the following:
It helps managers see the financial significance of defects.
It helps managers identify the relative importance of the quality problems faced by the company.
It helps managers see whether their quality costs are poorly distributed. In general, costs should be distributed more toward prevention and to a lesser extent appraisal than toward failures.
Help managers see whether their quality costs are poorly distributed.

27. End of Chapter 2
End of chapter 2.