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3-1

3
Basic Cost Concepts

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 Slide

3 Cost Drivers, Cost Pools, 3-2

and Cost Objects

Units Machine
produced hours

A cost driver is
any factor that has the
effect of changing the
level of total cost.

Miles Labor
driven hours
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
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3 Cost Drivers, Cost Pools, 3-3

and Cost Objects

AA cost
cost is
is
incurred
incurred when
when aa
resource
resource isis used
used for
for
some
some purpose.
purpose.
Costs
Costs may
may bebe
collected
collected into
into
groups
groups called
called
cost
cost pools.
pools.

A
A cost
cost object
object is
is any
any
product,
product, service,
service, oror unit
unit to
to
which
which costs
costs are
are assigned
assigned forfor
some
some meaningful
meaningful purpose.
purpose.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
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3 Cost Assignment and Cost 3-4

Allocation: Direct and Indirect Costs

AA direct
direct cost
cost can
can be
be
conveniently
conveniently and and
economically
economically traced
traced Indirect
Indirect costs
costs can
can
directly
directly toto aa cost
cost pool
pool not
not be
be conveniently
conveniently
or
or aa cost
cost object.
object. or
or economically
economically
traced
traced toto cost
cost pools
pools
or
or cost
cost objects.
objects.
The
The assignment
assignment of of indirect
indirect
costs
costs to
to cost
cost pools
pools and
and cost
cost
objects,
objects, using
using cost
cost drivers
drivers
(allocation
(allocation bases),
bases), isis called
called
cost
cost allocation.
allocation.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
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3 Costs, Cost Pools, Cost 3-5

Objects, and Cost Drivers

Costs Cost Drivers and Cost Assignment

Cost Pools Cost Objects

Electric Motor

Materials
Handling Assembly Dishwasher

Supervision

Packing
Materials Washing
Packing
Machine
Final
Inspection
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3-6

3
Direct Materials

MILK + SUGAR
+ FLOUR
=

Direct materials include the cost of materials in the product, less purchase
discounts, plus freight and a reasonable allowance for scrap and defective units.

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3-7

3
Indirect Materials
n g in g
i
an al e ep nd
l e
C teri Sw pou
Ma m
Co

Indirect materials are materials used in manufacturing

that are not part of the finished product.

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3-8

3
Direct Labor

Direct labor includes the labor used to

manufacture the product or to provide the service.
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3-9

3
Indirect Labor

Indirect labor includes supervision, quality control, inspection,

purchasing and receiving, and other manufacturing support costs.

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3-10

3
Other Indirect Costs
Other indirect costs such
as building and equipment depreciation,
property taxes, insurance, and utilities . . . .

. . . . are combined with indirect

labor and indirect materials into
a single cost pool called . . . .

Factory
Factory
Overhead
Overhead
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3-11

3
Classifications of Costs

Manufacturing costs are often

combined as follows:

Direct
Direct Direct
Direct Factory
Factory
Materials
Materials Labor
Labor Overhead
Overhead

Prime Conversion
Cost Cost

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3
Types of Cost Drivers

Activity-based
Activity-based Identified using activity analysis,
a detailed description of specific
activities and the relationship
between the activity and costs.
Volume-based
Volume-based

Relationship between costs and

Structural
Structural volume measures such as units
produced, direct labor hours,
or quantity of materials used.
Executional
Executional
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3-13

3
Types of Cost Drivers
Involves strategic plans and decisions:
Activity-based
Activity-based Scale
Experience
Technology

Volume-based Complexity
Volume-based

Short-term operational decisions:

Structural
Structural Workforce involvement
Production process design
Supplier relationships

Executional
Executional
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3 The Linearity Assumption 3-14

and the Relevant Range

AA straight
straight line
line
closely
closely
Economist’s
approximates
Curvilinear Cost approximates
aa curvilinear
curvilinear
Function
variable
variable cost
cost
line
line within
within the
the
Relevant relevant
Total Cost

relevant
Range range.
range.
Accountant’s Straight-Line
Approximation (constant
unit variable cost)

Activity
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3-15

3
Fixed and Variable Costs
Total
Cost Fixed
Fixedcost
costisisthat
thatportion
portionof
of
the
thetotal
totalcost
costthat
thatdoes
doesnot
not
change
changewith
withaachange
changeininthe
the
$6,600
quantity
quantityofofthe
thecost
costdriver,
driver,
$6,500 within
withinthe
therelevant
relevantrange.
range.

$3,000
Total Fixed Cost

3,500 3,600
Units of the Cost Driver
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3-16

3
Fixed and Variable Costs
Total Cost
Total
Totalvariable
variablecost
costisisthe
thechange
change
inTotal
in total
totalcost
Total costassociated
associatedwith
with
Cost
each
each change
changein
Cost inthe
thequantity
quantity
of
ofthe
thecost
costdriver.
driver.
$6,600
$6,500
Total Variable Cost

$3,000
Total Fixed Cost

3,500 3,600
Units of the Cost Driver
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3-17

3
Total Variable Cost Example

Your total long distance telephone bill is

based on how many minutes you talk.
Total Long Distance
Telephone Bill

Minutes Talked
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3
Variable Cost Per Unit Example
The cost per minute talked is constant.
For example, 5 cents per minute.

Telephone Charge
Per Minute

Minutes Talked
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3-19

3
Total Fixed Cost Example
Your monthly basic telephone bill is
probably fixed and does not change when
you make more local calls.
Telephone Bill
Monthly Basic

Number of Local Calls

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3-20

3
Fixed Cost Per Unit Example
The fixed cost per local call decreases as
more local calls are made.

Monthly Basic Telephone

Bill per Local Call
Number of Local Calls
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

3
Fixed and Variable Costs
Summary of Variable and Fixed Cost Behavior
Cost In Total
Variable Total variable cost is
proportional to the activity
level within the relevant range.
Fixed Total fixed cost remains the
same even when the activity
level changes within the
relevant range.
McGraw-Hill/Irwin
Slide
3-21
Per Unit
Variable cost per unit remains
the same over wide ranges
of activity.
Fixed cost per unit goes
down as activity level goes up.
© The McGraw-Hill Companies, Inc., 2002
 Slide
3-22

3
Step-Costs

Total cost remains

constant within a
narrow range of
activity.

Cost
Activity

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3-23

3
Step-Costs

Total cost increases to a

new higher cost for the
next higher range of
activity.

Cost
Activity

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

 Slide
3-24

3 Multiple Classification of Costs,

Visualized

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 Slide
3-25

3
Product Costs and Period Costs
Product costs for a manufacturing firm include--
 Direct materials, the materials used in the manufacture of
the product, which becomes a physical part of the final
product.
 Direct labor, the labor used in the manufacture of the
product, and
 Factory overhead, the indirect costs for materials, labor,
and facilities used to support the manufacturing process,
but not used directly in the manufacture of the product.

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3-26

3
Product Costs and Period Costs

All other expenditures for managing the

firm and selling the product are expenses
as they are incurred and are referred to as

PERIOD COSTS.

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 Slide

3 Cost flows in a 3-27

Merchandising Firm
Merchandise
Merchandise
Purchases
Purchases

Product
Product
Inventory
Inventory

Cost
Cost of
of
Goods
Goods Sold
Sold

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3-28

3
Inventory Cost Flow Formula

Beginning Cost Ending

Cost
Inventory + Added = Transferred + Inventory
Balance Out Balance

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3
Manufacturing Inventories

materials
 materials inventory
inventory--the
-- store
--
--the store of
of
materials
materials used
used in
in the
the manufacturing
manufacturing
process.
process.
work-in-process
 work-in-process inventory
inventory--all-- costs
--
--all costs
put
put into
into manufacture
manufacture of of products
products that
that
are
are not
not complete
complete at at the
the financial
financial
statement
statement date.
date.
finished
 finished goods
goods inventory
inventory--the-- cost
--
--the cost
of
of goods
goods that
that are
are ready
ready forfor sale.
sale.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
 Slide

Cost flows in a
3-30

3
Manufacturing Firm
Materials Purchases

Materials Used

Labor Overhead

Work in Process

Finished Goods Cost of Goods Sold

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 Slide

Cost flows in a
3-31

3
Manufacturing Firm
Raw Materials Wages Payable
BI 10 75
70 Purchased
Purchasedrawraw
EI 5 materials
materialsonon
Work in Process
account,
account,$70.
$70.
Factory Overhead
Credit
CreditAccounts
Accounts
BI 10
75 Payable.
Payable.

Cost of Goods Sold Requisitioned

Requisitioned
direct
directmaterials
materials
Finished Goods
for
forproduction,
production,
BI 20
$75.
$75.

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 Slide

Cost flows in a
3-32

3
Manufacturing Firm
Raw Materials Wages Payable
BI 10 75 80
70 Accrued
EI 5 Accrueddirect
direct
labor,
labor,$80.
$80.
Work in Process Factory Overhead
BI 10 100
75
Applied
Applied
80 manufacturing
manufacturing
100 overhead,
overhead,$100.
$100.
Cost of Goods Sold
Finished Goods
BI 20

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

 Slide

Cost flows in a
3-33

3
Manufacturing Firm
Raw Materials Wages Payable
BI 10 75 80
70 Transferred
Transferred
EI 5 completed
completedgoods
goods
to
tofinished
finishedgoods,
goods,
Work in Process Factory Overhead $215.
$215.
BI 10 215 100
75
80
100
EI 50 Sold
Soldgoods
goods
Cost of Goods Sold
that
thatcost
cost$210
$210
Finished Goods 210
to
tomake.
make.
BI 20 210
215
EI 25
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
 Slide

3 Cost of Goods 3-34

Manufactured Statement
Direct Materials
Beginning inventory $10
Purchases 70
Cost of Materials Available $80Ending
Inventory 5
Direct Materials Used 75
Direct Labor Used 80
Factory Overhead 100
Total Manufacturing Cost $255
ADD: Beginning Work-in-Process Inventory 10
Total Manufacturing Costs to Account For $265
LESS: Ending Work-in-Process Inventory 50
Cost of Goods Manufactured $215

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3
Income Statement

Sales $300
Cost of Goods Sold:
Beginning Finished Goods Inventory $ 20
Cost of Goods Manufactured 215
Cost of Goods Available for Sale 235
Ending Finished Goods Inventory 25210
Gross Margin 90
Selling and Administrative Expenses 50
Net Income $ 40

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3
Differential Costs

Costs that differ among alternatives.

Example:
Example: You You have
have aa job
job paying
paying $1,500
$1,500 perper month
month in
in
your
your hometown.
hometown. You You have
have aa job
job offer
offer in
in aa neighboring
neighboring
city
city that
that pays
pays $2,000
$2,000 per
per month.
month. TheThe commuting
commuting cost
cost
to
to the
the city
city is
is $300
$300 per
per month.
month.

Differential
Differential revenue
revenue is:
is:
$500
$500

Differential
Differential cost
cost is:
is:
$300
$300
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3
Opportunity Costs
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
$18,000 per year.
Your opportunity cost
of attending college for
one year is $18,000.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
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3
Sunk Costs
Sunk costs cannot be changed by any decision. They are not differential costs and 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.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

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3 Attributes of Cost Information 3-39

for Decision Making

Accuracy
Accuracy Timeliness
Timeliness

Cost
Cost
versus
versus
Value
Value
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 Slide

3 Cost Concepts for Management 3-40

and Operational Control

Controllability

Management
risk
preferences

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

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3
End of Chapter 3

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002