0. 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

1. 3-1
Identify and give examples of each of the three basic manufacturing cost categories.
Learning objective number 1 is to identify and give examples of each of the three basic manufacturing cost categories.

2. Manufacturing Overhead
3-2
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
3-3
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
3-4
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
3-5
Manufacturing Overhead
Manufacturing costs that cannot be traced directly to specific units produced.
Examples: Indirect materials and indirect labor
Materials used to support the production process. Examples: lubricants and cleaning supplies used in the automobile assembly plant.
Wages paid to employees who are not directly involved in production work. Examples: maintenance workers, janitors and security guards.
Manufacturing overhead includes all manufacturing costs except direct materials and direct labor. These costs cannot be easily traced to specific units produced (also called indirect manufacturing cost, factory overhead, and factory burden).
Manufacturing overhead includes indirect materials that are part of the finished product, but that cannot be easily traced to it. It includes indirect labor costs that cannot be conveniently traced to the creation of products.
Other examples of manufacturing overhead include: maintenance and repairs on production equipment, heat and light, property taxes, depreciation and insurance on manufacturing facilities, etc.

6. Nonmanufacturing Costs
3-6
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.

7. 3-7
Understand cost classifications used to prepare financial statements: product costs and period costs.
Learning objective number 2 is to distinguish between product costs and period costs and give examples of each.

8. Product Costs Versus Period Costs
3-8
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

9. Classifications of Costs
3-9
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

10. Comparing Merchandising and Manufacturing Companies
3-10
Comparing Merchandising and Manufacturing Companies
Merchandisers . . .
Buy finished goods.
Sell finished goods.
Manufacturers . . .
Buy raw materials.
Produce and sell finished goods.
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.
MegaLoMart

11. Balance Sheet Manufacturer Current Assets Merchandiser Current assets
3-11
Balance Sheet
Merchandiser
Current assets
Cash
Receivables
Merchandise Inventory
Manufacturer
Current Assets
Cash
Receivables
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 and Receivables. 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.

12. Materials waiting to be processed. Completed products awaiting sale.
3-12
Balance Sheet
Merchandiser
Current assets
Cash
Receivables
Merchandise Inventory
Manufacturer
Current Assets
Cash
Receivables
Inventories
Raw Materials
Work in Process
Finished Goods
Materials waiting to be processed.
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.
Partially complete products—some material, labor, or overhead has been added.
Completed products awaiting sale.

13. 3-13
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.

14. Schedule of Cost of Goods Manufactured
3-14
Schedule of Cost of Goods Manufactured
Calculates the cost of raw material, direct labor, and manufacturing overhead used in production.
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.
Calculates the manufacturing costs associated with goods that were finished during the period.

15. 3-15
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.

16. 3-16
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.

17. 3-17
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.

18. 3-18
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.

19. 3-19
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.

20. Manufacturing Cost Flows
3-20
Manufacturing Cost Flows
Income Statement Expenses
Balance Sheet Costs Inventories
Material Purchases
Raw Materials
Manufacturing Overhead
Work in Process
Direct Labor
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 in 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 in the income statement for the period the cost is incurred.
Finished Goods
Cost of Goods Sold
Selling and Administrative
Period Costs

21. 3-21
Understand cost classifications used to predict cost behavior: variable costs and fixed costs.
Learning objective number 5 is to understand the differences between variable costs and fixed costs.

22. Total cost of batteries
3-22
Total Variable Cost
The total cost of batteries is based on the number of autos produced in a month
Number of autos produced in a month
Total cost of batteries
A variable cost varies in direct proportion to changes in the level of activity. For example, if you don’t have a texting plan on your cell phone, text messaging costs 5 cents per text. Your total texting bill increases with the number of texts you send.

23. Number of autos produced in a month Cost of battery per auto
3-23
Variable Cost Per Unit
The cost of battery is constant per each auto produced
Number of autos produced in a month
Cost of battery per auto
Although variable costs change in total as the activity level rises and falls, variable cost per unit is constant. For example, the cost per text message sent is constant at 5 cents per text.

24. Number of autos produced in a month
3-24
Total Fixed Cost
The monthly rent for an auto factory is fixed regardless of the number of autos produced
Number of autos produced in a month
Monthly rent
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 contract fee for your cell phone is a fixed amount for a certain number of minutes. The monthly contract fee does not change based on the number of calls you make.
Of course, if you go over your monthly minutes allotment, you have exceed the relevant range for your monthly contract and will be charged above and beyond your monthly contract fee.

25. 3-25
Fixed Cost Per Unit
The average monthly rent per auto decreases as more autos are produced
Number of autos produced in a month
Unit cost of rent for each auto produced
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 cell phone call made decreases as more calls are made in the month.

26. Cost Classifications for Predicting Cost Behavior
3-26
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.

27. 3-27
Understand cost classifications used for assigning costs to cost objects: direct and indirect costs.
Learning objective number 6 is to understand the differences between direct and indirect costs.

28. Assigning Costs to Cost Objects
3-28
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.

29. 3-29
Understand cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.
Learning objective number 7 is to define and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.

30. Cost Classifications for Decision Making
3-30
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.

31. Differential Cost and Revenue
3-31
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

32. 3-32
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.

33. 3-33
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.

34. Summary of the Types of Cost Classifications
3-34
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

35. Further Classification of Labor Costs
3-35
Appendix 2A: Further Classification of Labor Costs.
Further Classification of Labor Costs
Appendix 2A

36. 3-36
(Appendix 2A)
Properly account for labor costs associated with idle time, overtime, and fringe benefits.
Learning objective number 8 is to properly account for labor costs associated with idle time, overtime, and fringe benefits.

37. 3-37
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.

38. 3-38
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?

39. Some companies include all of these costs in manufacturing overhead.
3-39
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.

40. 3-40
Appendix 2B: Cost of Quality.
Cost of Quality
Appendix 2B

41. 3-41
(Appendix 2B)
Identify the four types of quality costs and explain how they interact.
Learning objective number 9 is to identify the four types of quality costs and explain how they interact.

42. Quality of Conformance
3-42
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.

43. Prevention and Appraisal Costs
3-43
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

44. Internal and External Failure Costs
3-44
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

45. Examples of Quality Costs
3-45
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

46. Distribution of Quality Costs
3-46
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%.

47. 3-47
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.

48. Quality Cost Reports in Graphic Form
3-48
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.

49. Uses of Quality Cost Information
3-49
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.

50. End of Chapter 2
End of chapter 2.