1. Chapter 2 Cost Terms, Concepts and Classifications

2. Summary of the Types of Cost Classifications
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Summary of the Types of Cost Classifications
Financial Reporting
Predicting Cost Behavior
Assigning Costs to Cost Objects
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.
Making Business Decisions

3. Manufacturing Overhead
Manufacturing Costs
Direct Materials
Direct Labor
Manufacturing Overhead
The Product

4. Classifications of Manufacturing Costs
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Classifications of Manufacturing Costs
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.

5. Nonmanufacturing Costs
Marketing and Selling Cost
Costs necessary to get the order and deliver the product.
Administrative Cost
All executive, organizational, and clerical costs.

6. Product Costs Versus Period Costs
Product costs include direct materials, direct labor, and manufacturing overhead.
Period costs are not included in product costs. They are expensed on the income statement.
Inventory
Cost of Good Sold
Balance Sheet
Income Statement
Sale
Expense
Income Statement

7. Problem: Product or Period
Depreciation on salespersons’ cars
Rent on factory equipment
Lubricants used for machine maintenance
Salaries of finished goods warehouse personnel
Soap and paper towels used by factory personnel
Factory supervisors’ salaries
Heat, water, and power consumed by the factory

8. Problem: Continued Advertising costs
Worker’s compensation insurance for factory employees
Depreciation on chairs and tables in the factory lunchroom
Salary of the switchboard operator
Depreciation of a Lear Jet used by company execs
Rent for rooms at a Florida resort for the annual sales conference
Box designed for packaging breakfast cereal

9. Pop Quiz 
Which of the following costs would be considered manufacturing overhead at Boeing? (More than one answer may be correct.)
A. Depreciation on factory forklift trucks.
B. Sales commissions.
C. The cost of a flight recorder in a Boeing 767.
D. The wages of a production shift supervisor.

10. Pop Quiz 
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.

11. Pop Quiz 
Which of the following transactions would immediately result in an expense? (There may be more than one correct answer.)
A. Work in process is completed.
B. Finished goods are sold.
C. Raw materials are placed into production.
D. Administrative salaries are accrued and paid.

12. Balance Sheet Merchandiser Manufacturer Current assets Current Assets
Cash
Receivables
Prepaid expenses
Merchandise inventory
Manufacturer
Current Assets
Cash
Receivables
Prepaid Expenses
Inventories
Raw Materials
Work in Process
Finished Goods

13. Materials waiting to be processed. Completed products awaiting sale.
Balance Sheet
Manufacturer
Current Assets
Cash
Receivables
Prepaid Expenses
Inventories
Raw Materials
Work in Process
Finished Goods
Merchandiser
Current assets
Cash
Receivables
Prepaid Expenses
Merchandise Inventory
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.

14. The Income Statement
Cost of goods sold for manufacturers differs only slightly from cost of goods sold for merchandisers.

15. 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.

16. Schedule of Cost of Goods Manufactured

17. Income Statement for Manufacturing Company

18. Inventory

19. Pop Quiz 
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

20. Pop Quiz 
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.

21. Pop Quiz 
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.

22. Pop Quiz 
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.

23. Cost Classifications For Predicting Behavior
Cost behavior means how a cost will react to changes in the level of business activity.
variable costs
fixed costs

24. Total Variable Cost
The total cost of mufflers is based on how many cars are produced in a month.
No. of Autos Produced
Total Cost of Mufflers
Total 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.

25. The cost per muffler is constant. For example, $12 per muffler.
Variable Cost Per Unit
The cost per muffler is constant. For example, $12 per muffler.
No. of Autos Produced
Cost per Muffler
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.

26. Total Fixed Cost
The monthly rent for the machine does not change when you make more dolls.
Number of Dolls Produced
Total Cost of Rent
Total 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.

27. The fixed cost per doll decreases as more dolls are made.
Fixed Cost Per Unit
The fixed cost per doll decreases as more dolls are made.
Number of Dolls Produced
Fixed Cost per Doll
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.

28. 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.

29. Pop Quiz 
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.

30. Problem: Fixed or Variable
Hamburger buns in McDonald’s restaurant
Advertising by a dental office
Apples processed and canned by Del Monte
Shipping apples from Del Monte plant to customers
Insurance on a Bausch and Lomb factory producing contact lenses

31. Problem: Continued Insurance on IBM’s corporate headquarters
Salary of supervisor overseeing production of circuit boards at HP
Commissions paid to Encyclopedia Brit salespeople
Depreciation of factory lunchroom facilities at GE plant
Steering wheels installed in BMWs

32. Cost Classification for Assigning Costs to Cost Objects
Direct costs
Costs that can be easily traced to a cost object
Examples: Cost of paint in the paint department of an automobile assembly plant, direct labor, direct material
Indirect costs
Costs that cannot be easily traced to a cost object
Examples: Cost of national advertising for an airline is indirect to a particular flight, manufacturing overhead

33. Cost Concepts for Decision Making
Differential Cost/Differential Revenue – Costs and revenues that differ between two (or more) alternatives
Opportunity Cost – the potential benefit given up when one alternative is selected over another
Sunk Cost – a cost that has already been incurred and cannot be changed by any decision made now or in the future

34. 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.

35. 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 $20,000 per year. Your opportunity cost of attending college for one year is $20,000.
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.

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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.

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

39. 3-39
Idle Time
Machine Breakdowns
Material Shortages
Power Failures
The labor costs incurred during idle time are ordinarily treated as manufacturing overhead.
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.

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Overtime Premium
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.

41. Some companies include all of these costs in manufacturing overhead.
Labor Fringe Benefits
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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.