Cost Concepts, Terms, Behavior
and Classification
Unit 2
Learning Objectives
Explain the basic concept of “cost.”
Explain how costs are presented in financial statements
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.
5. Define basic cost behaviors, including fixed, variable,
semivariable, and step costs.
6. Identify the components of a product’s costs.
7. Understand the distinction between financial and
contribution margin income statements.
1.
2.
3.
4.
Cost Accounting
•
•
•
•
Cost accounting systems provide information to help managers make better
decisions.
Managers who use cost accounting information to make decisions need to
understand the cost terms used in their organizations.
Because cost accounting systems are tailored to the needs of individual
companies, several terms are used in practice to describe the same or similar cost
concepts, depending on the use or the audience.
Therefore, before we discuss the design of cost systems to aid decision making,
we introduce a set of terms that will be used throughout the course. These terms
are important to the discussion because they will be the “language” we use to
communicate for the remainder of the lessons.
McGraw-Hill/Irwin
Copyright ©2008 The McGraw-Hill
Companies, Inc. All rights reserved.
Cost Concept
• A cost is a sacrifice of resources. Every day, we
buy many different things: clothing, food, books,
music, perhaps an automobile, and so on. When
we buy one thing, we give up (sacrifice) the ability
to use these resources (typically cash or a line of
credit) to buy something else. The price of each
item measures the sacrifice we must make to
acquire it.
• Whether we pay cash or use another asset,
whether we pay now or later (by using a credit
card), the cost of the item acquired is represented
by what we forgo as a result.
Cost versus Expenses
• It is important to distinguish cost from
expense. An expense is a cost charged
against
• revenue in an accounting period; hence,
expenses are deducted from revenue in that
• accounting period. We incur costs whenever
we give up (sacrifi ce) resources, regardless
• of whether we account for it as an asset or
McGraw-Hill/Irwin
Copyright ©2008 The McGraw-Hill
an expense. (We
may
incur costs that
Companies,
Inc. All even
rights reserved.
What is Cost?
LO1
Explain the basic concept of “cost”.
Cost
Outlay Cost
Past, present,
or future cash
outflow
Opportunity Costs
Forgone benefit
from the best
alternative course
of action
Expense
Cost charged against revenue in
an accounting period
Cost Example
Serra wants to go out with her friends for a night of fun and adventure.
Cost of the outing?
Outlay Cost
Opportunity Cost
$50 to pay for
dinner and drinks
Passing her accounting
exam and a new pair of
shoes!
Cost Example
Your education costs?
Outlay Cost
The cost of tuition,
books, and all other
educational expenses
Opportunity Cost
The interest on the money
you would save by not
attending college and the
income you will forgo while
in college
Recording Costs in Financial Statements
LO2
Explain how costs are presented in financial statements.
Income Statements
Service Company
Merchandising Company
Cost incurred
Service Revenues
Sales Revenues
to purchase
the goods sold
- Cost of Services Sold
= Gross Margin
- General Selling and
Administrative Costs
= Operating Profit
Cost of
billable
hours
- Cost of Goods Sold
= Gross Margin
- General Selling and
Administrative Costs
= Operating Profit
The excess of operating revenue over costs necessary to
generate those revenues
Manufacturing Company Costs
Two types of manufacturing company costs:
1. Product Costs: Costs relating to inventory
2. Period Costs: Non-manufacturing costs related to the firm
All Costs
Product Costs:
Costs incurred to product the product
Recorded as an asset “inventory” when
cost is incurred
Recognized as an expense when the
product is sold
Period Costs:
Costs incurred to sell a
product and operate the
business
Recognized as an expense
when the cost is incurred
A Manufacturing Company’s Income Statement
Cost incurred
to manufacture
the product
sold
Product costs
recorded as
“inventory”
when cost is
incurred
Sales Revenue
- Cost of Goods Sold
= Gross Margin
- General Selling &
Administrative Costs
Period costs recorded as
an expense in the period
the cost is incurred
= Operating Profit
Expensed
when
sold
Product vs. Period Costs
Product Costs:
Costs that are recorded as an asset in inventory
when incurred and expensed as Cost of Goods
Sold when sold.
Period Costs:
Costs that are expensed under General
Selling and Administrative Costs when
incurred.
Product Costs: Direct vs. Indirect
Direct Costs:
Costs that, for a
reasonable cost,
can be directly
traced to the
product.
Indirect Costs:
Cost that cannot
reasonably be
directly traced to
the product.
Direct Materials:
Materials directly traceable to the
product.
Direct Labor:
Work directly traceable to
transforming materials into the
finished product.
Manufacturing
Overhead:
All production costs
except direct materials
and direct labor.
Indirect Materials
Indirect Labor
Other Indirect Costs
Tracing Costs
Sara decides to go out with friends to a nice dinner and a movie.
Identify the object
A night on the town
Direct Costs
Indirect Cost
The cost of the
dinner and the
movie
The cost of
Sara’s dress,
shoes, and car.
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Copyright ©2008 The McGraw-Hill
Companies, Inc. All rights reserved.
Manufacturing Costs: Product Costs
Inventory Costs
Prime Costs:
The “primary” costs of
the product
Direct Materials
Conversion Costs:
Cost necessary to
“convert” materials into
a product
Direct Labor
Direct Labor
Manufacturing
Overhead
Product Cost Review
•
Given the following data →
Direct cost?
Direct Materials
$8.00
Direct Labor
$7.00
Manufacturing
Overhead
DM + DL = $15.00
$14.00
Prime cost?
Conversion cost?
DL + MOH = $21.00
DM + DL = $15.00
Indirect Cost?
Total Product Cost?
DM + DL + MOH = $29.00
MOH $14.00
Period Costs: Non-manufacturing Cost
Recognized as an expense when the cost is incurred.
Marketing:
Costs necessary to
sell the products.
Advertising
Sales Commissions
Shipping Costs
Administrative:
Costs necessary to
operate the
business.
Executive Salaries
Data Processing
Legal Costs
Cost Allocation
LO3
Explain the process of cost allocation.
Assigning indirect cost to a cost object
1. Define the cost pool:
The collection of costs to be assigned to cost objects.
2. Determine the cost allocation rule:
The method used to assign costs in the cost pool to
cost objects.
3. Assign the cost object:
Any end to which a cost is assigned – product,
product line, department, customer, etc.
Example:
Cost Allocation Rockford Company
Situation: Rockford has two divisions, East Coast and West Coast.
Both divisions are supported by the IT Department.
Revenues
East Coast
West Coast
Total
$80 million
$20 million
$100 million
1. Define Cost Pool: IT Department’s Costs of $1,000,000
2. Determine the Cost Allocation Rule: IT costs are allocated based on
divisional revenue. (% of Revenue)
3. Assign the Cost Object:
East Coast: 80% of cost = $800,000
West Coast: 20% of cost = $200,000
Manufacturing Cost Flows
LO4
Understand how material, labor, and overhead costs
are added to a product at each stage of the
production process.
Product costs are recorded in inventory when cost is incurred.
A manufacturing company has three inventory accounts:
1. Raw Materials Inventory:
Materials purchased to make a
product.
2. Work-in-Process Inventory: Products currently in the
production process, but not
yet completed.
3. Finished Goods Inventory: Completed products that
have not yet been sold.
Inventory Accounts – The Balance Sheet
Raw Materials
Inventory
Beg. RM Inventory
+ Purchases
= Raw Materials
Available for
Production
Work-in-Process
Inventory
Beg. WIP Inventory
Finished Goods
Inventory
Beg. FG Inventory
+ Direct Materials
Transferred from Raw
Materials
+ Cost of Goods
Completed &
Transferred from WIP
+ Direct Labor
- Raw Materials
Transferred to WIP
+ Manufacturing Overhead
= Goods Available for
Sale
= Total Manufacturing Costs
- Cost of Good Sold
= Ending RM Inventory
- Cost of Good Completed &
Transferred to Finished
Goods
= Ending FG Inventory
= Ending WIP Inventory
To the Income
Statement
Jackson Gears
Cost of Goods Manufactured Statement
For the Year Ending December 31, 200X
Beginning WIP Inventory, January 1
$ 270,000
Manufacturing Cost During the Year:
Direct Materials:
Beginning Raw Materials Inventory, Jan. 1
$ 95,000
Add: Purchases
5,627,000
Direct Materials Available
Less: Ending RM Inventory, Dec. 31
Direct Materials put into Production
$ 5,722,000
72,000
$5,650,000
Direct Labor
1,220,000
Manufacturing Overhead
6,780,000
Total Manufacturing Costs Incurred
13,650,000
Total Work-in-Process During the Year
13,920,000
Less: Ending Work-in-Process Inv, Dec. 31
Cost of Goods Manufactured
310,000
$ 13,610,000
==========
Jackson Gears
Cost of Good 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
Cost of Goods Sold
930,000
$ 13,100,000
=========
Jackson Gears
Income Statement
For the Year Ending December 31, 200X
Sales
Less: Cost of Goods Sold
$ 20,450,000
13,100,000
Gross Margin
7,350,000
Less: Marketing & Administrative Expenses
3,850,000
Operating Profit
$ 3,500,000
=========
Cost Behavior
LO5
Define basic cost behaviors including fixed,
variable, semi-variable, and step costs.
Cost Behavior?
How costs respond to a change
in activity level within the
relevant range
Relevant Range?
Activity levels within which a
given total fixed cost or unit
variable cost will be
unchanged
Fixed Costs
Fixed costs remain unchanged as volume changes within the
relevant range.
Fixed costs per unit varies inversely to a change in activity.
Fixed costs are “fixed” in “total” as activity changes.
Costs ($)
90
80
70
60
50
Total Fixed Cost
40
30
20
10
0
0
1
2
3
4
Activity Level
Sara’s Night on the Town
Fixed Costs
Fixed costs are “fixed” in “total” as activity changes
Fixed cost per unit varies inversely with a change in activity.
Cost of a
dress ($)
90
80
70
60
50
Total Fixed Cost
40
30
20
10
0
0
1
2
3
4
Number of times the dress is worn
Variable Costs
Costs that change in direct proportion with a change in the
volume within the relevant range.
Variable costs “vary” in “total” as activity changes.
Variable cost per unit stays
constant when activity changes
within the relevant range.
Cost ($)
35
30
25
20
Total Variable
Cost
15
10
5
0
0
1
2
3
4
Activity Level
Sara’s Entertainment Expenses
Variable Costs
Variable costs “vary” in “total” as activity changes over the
relevant range.
Variable cost per unit remains constant when
activity changes over the relevant range.
Drink
Cost ($)
30
25
20
Total Variable
Cost
15
10
5
Number of drinks
0
0
1
2
3
4
Semi-variable Costs
Costs that have both fixed and variable components.
Costs
Also known as MIXED COSTS.
Semi-Variable
Cost
Activity Level
Sara’s Entertainment
Semi-variable costs
The fixed component is “fixed” in total as activity changes
over the relevant range.
The variable component “varies in total as activity changes
over the relevant range.
Cost ($)
140
120
100
80
Semivariable
cost
60
40
20
0
0
1
3
4
5
6
Number of movies
Step Costs
Costs that increase in total with steps when the volume
changes to a particular level.
Step costs are also known as semi-fixed costs.
Example: If a factory can produce 100,000 units a month and the firm needs to
produce 120,000 units then more factory space must be procured.
The additional space will only be purchased if 100,000 units are
exceeded.
Costs ($)
Cost of 2nd rented space
Cost of 1st rented space
Cost of original factory
Activity Level
Product Cost Components
LO6
Identify the components of a product’s costs.
Full Cost:
The sum of all costs of
manufacturing and selling a
unit of the product. (GAAP)
Full Absorption Cost:
The sum of all variable and fixed
costs of manufacturing a unit of
the product.
Variable Cost:
The sum of all variable costs of
manufacturing and selling a unit
of the product.
Costs: An Example
Given the following: Direct Materials = $8
Direct Labor = $7
1. What is the full cost
per unit?
DM + DL + VMOH +
FMOH + VMA + FMA
= $40
Variable Manufacturing Overhead = $8
Fixed Manufacturing Overhead = $6
Variable Marketing & Admin = $4
2. What is the full
absorption cost per unit?
DM + DL + VMOH + FMOH = $29
Fixed Marketing & Admin = $7
3. What is the variable cost per
unit?
DM + DL + VMOH + VMA = $27
Making Costs Information Useful
LO7
Understand the distinction between financial
and contribution margin income statements.
Full Absorption Costing:
• Required by GAAP
Used for:
• Financial purposes
• External reporting
Variable Costing
Used for:
• Managerial purposes
• Internal decision-making
Sales Revenue
Sales Revenue
- Cost of Goods Sold
- Variable Costs
= Gross Margin
= Contribution Margin
Making Cost Information Useful, Continued…
Financial Income Statement
Full Absorption Costing
Contribution Margin Income
Statement
Variable Costing
Sales Price
- Full Absorption Cost
Sales Price
- Variable Cost
= Gross Margin
= Contribution Margin
Product vs. Period
Full Absorption Costing
Variable Manufacturing Costs
Fixed Manufacturing Costs
Variable Costing
Product
Costs
Variable Manufacturing
Overhead
Fixed Manufacturing Costs
Variable Marketing & Admin
Costs
Fixed Marketing & Admin
Costs
Period
Costs
Variable Marketing &
Admin Costs
Fixed Marketing & Admin
Costs
Income Statement:
Full Absorption Costing
Full Absorption
Sales Revenue
- Cost of Goods Sold
= Gross Margin
Variable and Fixed
Manufacturing Costs
Period Costs
- Marketing & Admin Cost
= Operating Profit
Variable and Fixed
Marketing & Admin
Costs
Income Statement:
Variable Costing
Sales Revenue
-Variable Costs
Variable
Manufacturing Costs
and Variable
Marketing & Admin
Costs
= Contribution Margin
- Fixed Costs
= Operating Profit
Fixed Manufacturing
Costs and Fixed
Marketing & Admin
Costs
Quick Check 
If your inventory balance at the beginning of the month
was $1,000, you bought $100 during the month, and sold
$300 during the month, what would be the balance at the
end of the month?
A. $1,000.
B. $ 800.
C. $1,200.
D. $ 200.
Quick Check 
If your inventory balance at the beginning of the month
was $1,000, you bought $100 during the month, and sold
$300 during the month, what would be the balance at the
end of the month?
A. $1,000.
B. $ 800.
C. $1,200.
D. $ 200.
$1,000 + $100 = $1,100
$1,100 - $300 = $800
Quick Check 
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.
B.
C.
D.
$276,000
$272,000
$280,000
$ 2,000
Quick Check 
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?
Beg. raw materials
$ 32,000
A.
B.
C.
D.
$276,000
$272,000
$280,000
$ 2,000
+ Raw materials
purchased
276,000
= Raw materials available
for use in production $ 308,000
– Ending raw materials
inventory
28,000
= Raw materials used
in production
$ 280,000
Quick Check 
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.
Quick Check 
Direct materials used in production totaled
$280,000. Direct labor was $375,000 and
Materials What$were
280,000
factory overhead wasDirect
$180,000.
+ Direct Labor
375,000
total manufacturing+ costs
incurred for the
Mfg. Overhead
180,000
month?
= Mfg. Costs Incurred
for the Month
$ 835,000
A. $555,000
B. $835,000
C. $655,000
D. Cannot be determined.
Quick Check 
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.
Quick Check 
Beginning work in process was $125,000.
Manufacturing costs incurred for the month
were $835,000. There were $200,000 of
partially finished goods Beginning
remaining
in work
work in
inventory
$ 125,000
in process inventory at theprocess
end of
the month.
+ Mfg. costs incurred
What was the cost of goods
for manufactured
the period
835,000
= Total work in process
during the month?
during the period
$ 960,000
work in
A. $1,160,000 – Ending
process inventory
200,000
B. $ 910,000 = Cost of goods
manufactured
$ 760,000
C. $ 760,000
D. Cannot be determined.
Quick Check 
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.
Quick Check 
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.
$130,000 + $760,000 = $890,000
$890,000 - $150,000 = $740,000
Quick Check 
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.
Quick Check 
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.
UNIT 2: END!!