1. Cost Concepts and Behavior
Chapter 2

2. Learning Objectives 1. Explain the basic concept of “cost.”
2. Explain how costs are presented in financial statements.
3. Explain the process of cost allocation.
Understand how material, labor, and overhead costs are added to a product at each stage of the production process.
Define basic cost behaviors including fixed, variable, semivariable, and step costs.
6. Identify the components of a product’s costs.
Understand the distinction between financial and contribution margin income statements.

3. Cost charged against revenue in an accounting period
What is a Cost?
L.O. 1 Explain the basic concept of “cost.”
Cost
a sacrifice of resources
Outlay Cost
past, present, or future cash outflow
Opportunity Cost
forgone benefit from best alternative course of action
Expense
Cost charged against revenue in an accounting period

4. Cost Example Cost of surfboard?
Josh wants to buy a new surfboard. If he buys the surfboard he can’t go on a spring break ski trip with his friends.
Cost of surfboard?
Outlay Cost
Opportunity Cost
$500 purchase price of the surfboard
No spring break trip

5. Cost Example Your education costs? Outlay Cost Opportunity Cost
The $15,000 you could make flipping burgers
The cost of tuition

6. Recording Costs in Financial Statements
L.O. 2 Explain how costs are presented in financial statements.
Income Statements
Service Company
Merchandise Company
Service revenues
Sales revenues
- Cost of services sold
Cost incurred to purchase the goods sold
- Cost of goods sold
= Gross margin
= Gross margin
- Marketing and administrative costs
Cost of billable hours
- Marketing and administrative costs
= Operating profit
= Operating profit
The excess of operating revenue over cost necessary to generate those revenues

7. Manufacturing Company Costs
Manufacturing Costs
Product Costs
Period Costs
Inventoriable Costs
Nonmanufacturing Costs
Costs incurred to manufacture a product
Costs incurred to sell a product and operate the business
Recorded as an asset in inventory when cost is incurred
Recognized as an expense when product is sold
Recognized as an expense when cost is incurred

8. Income Statement Manufacturing Company Sales revenues
Product costs recorded as an asset in inventory when cost is incurred.
Sales revenues
Cost incurred to manufacture the product sold
- Cost of goods sold
Recognized as an expense when the product is sold.
= Gross margin
Period costs recorded as an expense when cost is incurred.
- Marketing and administrative costs
= Operating profit

9. Product Costs Direct Costs Indirect Costs Manufacturing Costs
Inventory Costs
Recognized as an expense when product is sold
Recorded as an asset in inventory when cost is incurred
Direct Costs
Indirect Costs
Cost that can be directly traced to the product
Cost that cannot be directly traced to the product
Direct Materials
Manufacturing Overhead
Materials directly traceable to the product.
All production costs except direct materials and direct labor.
Direct Labor
Indirect Materials
Work directly traceable to transforming material into finished product
Indirect Labor
Other Indirect Costs

10. Traceability of Costs
Josh decides to go on the spring break ski trip. He is off to the slopes.
Identify the object
This ski trip
Direct Cost
Indirect Cost
Cost of lift tickets
The original cost of his equipment

11. Traceability of Cost Your education costs? Identify the object
This class
Direct Cost
Indirect Cost
The cost of your textbook
The cost of full time tuition

12. Product Costs Prime Costs Direct Materials Direct Labor Direct Labor
Manufacturing Costs
Product Costs
Inventory Costs
Prime Costs
Direct Materials
The “primary” cost of the product
Direct Labor
Direct Labor
Conversion Costs
Direct Labor
Cost necessary to “convert” materials into a product
Manufacturing Overhead

13. Product Cost Review Prime cost? Conversion cost? Direct cost?
DM + DL = $15
Direct Materials = $8
Direct Labor = $7
Conversion cost?
Manufacturing overhead = $14
DL + MOH = $21
Direct cost?
Indirect cost?
DM + DL = $15
MOH = $14
Total Product Cost
DM + DL + MOH = $29

14. Period Costs Marketing Administrative Nonmanufacturing Costs
Recognized as an expense when cost is incurred
Marketing
Administrative
Costs necessary to sell the products
Costs necessary to operate the business
Advertising
Executive salaries
Sales commissions
Data processing
Shipping costs
Legal costs

15. Cost Allocation Cost Object
L.O. 3 Explain the process of cost allocation.
The process of assigning indirect cost to a cost object
1. Define Cost Pool
Collection of costs to be assigned to cost objects
2. Determine Cost Allocation Rule
Method used to assign costs in the cost pool to the cost objects
3. Assign
Cost Object
Any end to which a cost is assigned
Product
Department
Product Line
Customer

16. Corporate Information Systems Costs of $1,000,000
Rockford Corporation
East Coast
West Coast
Total
Revenues
80 million
20 million
100 million
Corporate Information Systems Costs of $1,000,000
Cost pool
IS costs allocated based on division revenue
% Revenue
Cost allocation rule
80%
$80 million
$20 million
20%
East Coast
West Coast
Cost objects
$800,000
$200,000

17. Manufacturing Cost Flows
L.O. 4 Understand how manufacturing costs are added to a product.
Product costs recorded in inventory when cost incurred.
Also called Inventoriable Costs
A manufacturing company has three inventory accounts.
Inventory: Current asset representing materials and goods on hand
Raw materials
Work-in-process
Finished goods
Materials purchased to make product
Product in production process, but not yet complete
Product fully completed but not yet sold.

18. The Inventory Accounts
Balance Sheet
Raw Materials
Work-In-Process
Finished Goods
Beg. Inventory
Beg. Inventory
Beg. Inventory
Cost of Goods Completed and Transferred from WIP + +
Purchases
Direct Materials Transferred from Raw Materials +
Raw Materials Available for Production =
Direct Labor +
Goods Available for Sale =
Manufacturing Overhead +
Raw Materials Transferred to WIP -
Raw Materials Transferred to WIP -
Cost of Goods Sold -
Total Manufacturing Costs =
Ending Inventory =
Ending Inventory =
Cost of Goods Completed and Transferred to Finished Goods -
Cost of Goods Completed and Transferred to Finished Goods -
To the income statement
Ending Inventory =

19. Jackson Gears Jackson Gears Cost of Goods Manufactured Statement
For the Year Ending December 31, 200X
Beginning Work-In-Process Inventory, January 1
$270,000
Manufacturing cost during the year:
Direct Materials
Beginning Inventory, Jan. 1
95,000
Add Purchases
5,627,000
Direct Materials Available
$5,722,000
Less Ending Inventory, Dec. 31
72,000
Direct Materials put into production
5,650,000
Direct Labor
1,220,000
Manufacturing Overhead
6,780,000
Total Manufacturing cost incurred
13,650,000
Total Work-In-Process during the year
13,920,000
Less Ending Work-In-Process Inventory, Dec. 31
___310,000
$13,610,000
Cost of goods manufactured

20. Cost of Goods Sold Statement For the Year Ending December 31, 200X
Jackson Gears
Jackson Gears
Cost of Goods Sold Statement
For the Year Ending December 31, 200X
Beginning Finished Goods Inventory, Jan. 1
$420,000
Cost of goods manufactured
13,610,000
Finished goods available for sale
14,030,000
Less Ending Finished Goods Inventory, Dec. 31
_930,000
$13,100,000
Cost of goods sold

21. For the Year Ending December 31, 200X
Jackson Gears
Jackson Gears
Income Statement
For the Year Ending December 31, 200X
Sales
$20,450,000
Less cost of goods sold
13,100,000
Gross Margin
7,350,000
Marketing and Administrative Expenses
3,850,000
Operating Profit
$3,500,000

22. Cost Behavior Cost Behavior? Relevant range?
L.O. 5 Define basic cost behaviors including fixed, variable, semivariable, and step costs.
Cost Behavior?
How costs respond to a change in activity level within the relevant range.
Relevant range?
Range of activity where the total fixed costs or the unit variable costs remain unchanged.

23. Fixed Costs Fixed costs are “fixed” in “total” as activity changes.
Costs that are unchanged as volume changes within the relevant range of activity.
Fixed costs are “fixed” in “total” as activity changes.
On a per unit basis the cost varies inversely as activity changes.
Costs ($)
Activity level

24. Josh’s Spring Break Trip
Fixed Cost
Fixed costs are “fixed” in “total” as activity changes.
On a per unit basis the cost varies inversely as activity changes.
Airfare cost ($)
Days on the slopes

25. Variable Costs Variable costs “vary” in “total” as activity changes.
Costs that change in direct proportion with a change in volume within the relevant range of activity.
Variable costs “vary” in “total” as activity changes.
On a per unit basis the cost stays the same as activity changes.
Cost ($)
Activity level

26. Josh’s Spring Break Trip
Variable Cost
Variable costs “vary” in “total” as activity changes.
On a per unit basis the cost stays the same as activity changes.
Lift ticket cost ($)
Days on the slopes

27. Semivariable Costs Costs that have both fixed and variable components.
Also called mixed costs.
Fixed component is “fixed” in total as activity changes.
Variable component “varies” in total as activity changes.
Costs ($)
Activity level

28. Josh’s Spring Break Trip
Semivariable Cost
Fixed component is “fixed” in total as activity changes.
Variable component “varies” in total as activity changes.
Cost of trip ($)
Days on the slopes

29. Step Costs Costs that increase in total with steps in volume changes.
Also called semifixed costs.
Costs ($)
Activity level

30. Product Cost Components
L.O. 6 Identify the components of a product’s costs.
Full cost: sum of all costs of manufacturing and selling a unit of product
Full absorption cost: sum of all variable and fixed costs of manufacturing a unit of product
Variable cost: sum of all variable costs of manufacturing and selling a unit of product

31. absorption cost per unit?
Costs: An Example
Direct Materials = $8
What is the full
cost per unit?
Direct Labor = $7
Variable manufacturing overhead = $8
What is the full
absorption cost per unit?
Fixed manufacturing overhead = $6
Variable marketing and administrative = $4
What is the variable
cost per unit?
Fixed marketing and administrative = $7

32. Full Cost What is the full cost per unit? = $40
Direct Materials = $8
What is the full
cost per unit?
Direct Labor = $7
Variable manufacturing overhead = $8
All costs of manufacturing and selling a unit of product
Fixed manufacturing overhead = $6
Variable marketing and administrative = $4
Fixed marketing and administrative = $7
= $40

33. absorption cost per unit?
Full Absorption Cost
What is the full
absorption cost per unit?
Direct Materials = $8
Direct Labor = $7
All variable and fixed costs of manufacturing a unit of product sold
Variable manufacturing overhead = $8
Fixed manufacturing overhead = $6
= $29

34. Variable Cost What is the variable cost per unit? = $27
Direct Materials = $8
Direct Labor = $7
All variable costs of manufacturing and selling a unit of product
Variable manufacturing overhead = $8
Variable marketing and administrative = $4
= $27

35. Making Cost Information Useful
L.O. 7 Understand distinction between financial and contribution margin income statements.
Full Absorption Costing
Variable Costing
Required by GAAP
Used for:
Used for:
Financial purposes
Managerial purposes
External reporting
Internal decision making
Sales revenues
Sales revenues
- Cost of goods sold
- Variable costs
= Gross margin
= Contribution margin

36. Making Cost Information Useful Continued
Financial Income Statement
Contribution Margin Income Statement
Full Absorption Costing
Variable Costing
Gross margin
Sales price
Full absorption cost
Contribution margin
Sales price
Variable cost

37. Product vs Period Costs
Full Absorption Costing
Variable Costing
Variable manufacturing costs
Variable manufacturing costs
Product costs
Fixed manufacturing costs
Fixed manufacturing costs
Variable marketing and administrative costs
Variable marketing and administrative costs
Period costs
Fixed Marketing and administrative costs
Fixed Marketing and administrative costs

38. Income Statements Full Absorption Costing Variable Costing
Sales revenues
Sales revenues
- Cost of goods sold
- Variable costs
= Gross margin
= Contribution margin
- Marketing and administrative cost
- Fixed costs
= Operating profit
= Operating profit
Variable and fixed manufacturing costs
Full absorption costs
Variable manufacturing costs and variable marketing and administrative costs
Sales – variable costs
Fixed manufacturing costs and fixed marketing and administrative costs
Sales – Full absorption cost
Period costs

39. Gross Margin per Unit Variable manufacturing cost = $23
Full absorption cost per unit = $29
Variable manufacturing cost = $23
Full cost per unit = $40
Sales price per unit = $45
DM + DL + VMOH
Fixed manufacturing cost = $6
Gross margin = $16 ($45 - $29)
Variable marketing and administrative = $4
Fixed marketing and administrative = $7
Operating profit = $5
Excess of price over full unit cost = $5

40. Contribution Margin per Unit
Variable cost per unit =$27
Variable manufacturing cost = $23
Full cost per unit = $40
Sales price per unit =$45
DM + DL + VMOH
Variable marketing and administrative = $4
Contribution margin =$18 ($45 - $27)
Fixed manufacturing cost = $6
Fixed marketing and administrative = $7
Operating profit =$5
Excess of price over full unit cost = $5

41. Chapter 2
The End