Cost Concepts and Behavior

Chapter Two
 What is Cost?
• Cost is a sacrifice of resources
• Cost is the sacrifice made that is usually measured by the
resources given up to achieve a particular purpose.
• It is a sacrifice made in order to obtain some goods or
services.
 What is Cost?

Cost
Outlay Cost Opportunity Costs
Past, present, Forgone benefit
or future cash from the best
outflow alternative course
of action

Expense
Cost charged against revenue in
an accounting period
 outlay cost
• An outlay cost is the sum of money that an individual or
entity spends on a particular project. Total cost consists
of both outlay cost and opportunity cost combined.
• An outlay is an expenditure we make to support an
activity. It is the total cost of achieving an objective,
acquiring something, or carrying out a decision. Put
simply; it is the amount of money we spend on
something.
 Cost Example
Sara 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 Passing her accounting

dinner and drinks exam and a new pair of
shoes!
 Cost Example

Your education costs?

Outlay Cost Opportunity Cost

The interest on the money

The cost of tuition, you would save by not
books, and all other attending college and the
educational expenses income you will forgo while
in college
 Recording Costs in Financial Statements
Income Statements
Service Company Merchandising Company
Service Revenues Cost incurred Service Revenues
to purchase
the goods sold
- Cost of Goods Sold
- Cost of Services Sold
Cost of = Gross Margin
= Gross Margin
billable

- General Selling and

hours - General Selling and
Administrative Costs Administrative Costs
= Operating Profit = 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: Period Costs:
Costs incurred to product the product Costs incurred to sell a
product and operate the
Recorded as an asset “inventory” when business
cost is incurred
Recognized as an expense
Recognized as an expense when the when the cost is incurred
product is sold
 Product Costs and Period Costs
• Product costs are costs that are incurred to create a
product that is intended for sale to customers. Product
costs include direct material (DM), direct labor (DL), and
manufacturing overhead (MOH).
• Product costs are the costs incurred during the
manufacturing process.
• Period costs are the costs that your business incurs that
are not directly related to production levels. These
expenses have no relation to the inventory or production
process.
 Product Costs and Period Costs
• Period costs are typically divided into two categories:
administrative costs and selling costs. Examples of period costs
include:
A. Office expenses such as rent, cleaning, and office supplies are
considered period costs.
B. Insurance: Insurance expenses are a period cost.
C. Advertising: Any advertising or marketing related expense is a
period cost.
D. Salaries paid to non-production employees, such as administrative
staff, managers, and other support personnel, are considered
indirect labor expenses, which are a period cost.
 Product versus Period Costs

Product costs: Costs related Period costs:

to inventory Non-manufacturing
costs related to the
firm
 A Manufacturing Company’s Income Statement

Product costs Sales Revenue

Cost incurred
recorded as Expensed
to manufacture - Cost of Goods Sold
“inventory” when
the product
when cost is sold
sold = Gross Margin
incurred
- General Selling &
Administrative Costs
Period costs recorded as
= Operating Profit
an expense in the period
the cost is incurred
 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: Direct Materials:

Costs that, for a Materials directly traceable to the
product.
reasonable cost,
can be directly
Direct Labor:
traced to the
Work directly traceable to
product. transforming materials into the
finished product.

Indirect Costs: Manufacturing Indirect Materials

Cost that cannot Overhead:
All production costs Indirect Labor
reasonably be except direct materials
directly traced to and direct labor. Other Indirect Costs
the product.
Manufacturing Costs: Product Costs
Inventory Costs
Prime Costs: Direct Materials
The “primary” costs of
Direct Labor
the product

Conversion Costs: Direct Labor

Cost necessary to
“convert” materials into Manufacturing
a product Overhead
 Prime Costs and Conversion Costs
 Two terms used to describe cost classifications in
manufacturing costing systems are prime costs and
conversion costs.
 A prime cost is the total direct costs of production,
including raw materials and labor
 Prime costs = Direct material costs + Direct manufacturing
labor costs = $76,000 + $9,000 = $85,000
 Conversion costs represent all manufacturing costs incurred
to convert direct materials into finished goods.
 Product Cost Review
Direct Materials $8.00
• Given the following data →
Direct Labor $7.00
Direct cost? Manufacturing $14.00
Overhead
DM + DL = $15.00

Prime cost?

Conversion cost? DM + DL = $15.00

DL + MOH = $21.00 Indirect Cost?

Total Product Cost? MOH $14.00
DM + DL + MOH = $29.00
Example- Prime Costs
 Example- Prime Costs
 According to above Table, Elizbeth Inc’s Prime cost can be
calculated as follows:
 Direct materials + Direct labor
= (A + B) + (C + D)
= ($20,000 + $200) + ($7,000 + $5,000)
= $20,200 + $12,000
= $32,200
 The Conversion cost of Elizbeth Inc is:
 Direct labor + Manufacturing overhead
= (C + D) + (E + F + G)
= ($7,000 + $5,000) + ($3,000 + $1,000 + $2,000)
= $12,000 + $6,000
= $18,000
 Test-Quiz
• During October, KPK Inc. incurred the following costs in
one of its manufacturing facility located in Alaska:
• Direct materials: $820,000
• Direct labor: $400,000
• Manufacturing overhead: $500,000
 Required: Using the above data, compute the prime cost
and conversion cost of Alaska manufacturing facility of
KPK Inc.
Period Costs: Non-manufacturing Cost
Recognized as an expense when the cost is incurred.

Marketing: Advertising
Costs necessary to
Sales Commissions
sell the products.
Shipping Costs

Administrative: Executive Salaries

Costs necessary to Data Processing
operate the
business. Legal Costs
 Cost Allocation
Business owners use cost allocation to assign costs to specific cost
objects. Cost objects include products, departments, programs, and
jobs. Cost allocation is necessary for any type of business, but it's more
frequently used in manufacturing businesses that incur a wider variety
of costs.
A cost object is any activity or item for which you want to separately
measure costs. Examples of cost objects are a product, a research
project, a customer, a sales region, and a department.
Cost allocation is used for financial reporting purposes, to spread
costs among departments or inventory items.
Cost allocation is also used in the calculation of profitability at the
department
 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.
East Coast West Coast Total
Revenues $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

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.
 Raw Materials Inventory
For accounting purposes, raw materials are considered an
inventory asset, debited to raw materials and credited to accounts
payable.
There are two different categories of raw materials — direct and
indirect
The formula to calculate the total cost of your raw materials
inventory is:

Total Raw Materials = Beginning inventory + Purchases added – Ending inventory

Total Raw Materials = Beginning inventory + Purchases added – Ending inventory
 Example-Raw Materials Inventory
Let’s say you own a scooter manufacturing company. For
this quarter, your starting inventory was worth $20,000.
During this period you bought $34,000 worth of raw
materials. At the end of this quarter, your raw materials on
hand were $18,000.
Total Raw Materials = Beginning inventory + Purchases added – Ending inventory
Total = $20,000 + $34,000 – $18,000 = $36,000
 Work-in-Process Inventory
Work-in-progress inventory refers to unfinished
items in the process of making finished goods for
sales.
Work-in-progress inventory is unfinished items or
components currently in production, but not yet
ready for sale to the customers
 Work-in-Process Inventory

McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill

Companies, Inc. All rights reserved.
 Finished Goods Inventory
Finished goods are the final items that are ready for sale in
the market.
These goods have passed through all stages of production
and quality checking.
Finished goods are your completed products available for
selling to customers.
Finished goods can be manufactured or purchased from a
supplier. Any product that is sold to your customers is your
finished goods.
 Inventory Accounts – The Balance Sheet

Raw Materials Work-in-Process Finished Goods

Inventory Inventory
Beg. RM Inventory Beg. WIP Inventory
+ Purchases + Direct Materials
= Raw Materials Transferred from Raw
Available for Materials
Production + Direct Labor
- Raw Materials + Manufacturing Overhead
Transferred to WIP = Total Manufacturing Costs
= Ending RM Inventory - Cost of Good Completed &
Transferred to Finished
Goods
= Ending WIP Inventory
Inventory
Beg. FG Inventory
+ Cost of Goods
Completed &
Transferred from WIP
= Goods Available for
Sale
- Cost of Good Sold
= Ending FG 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 $ 5,722,000
Less: Ending RM 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 Costs Incurred 13,650,000
Total Work-in-Process During the Year 13,920,000
Less: Ending Work-in-Process Inv, Dec. 31 310,000
Cost of Goods Manufactured $ 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. 31 930,000
Cost of Goods Sold $
13,100,000
=========
 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
Less: Marketing & Administrative Expenses 3,850,000
Operating Profit $ 3,500,000
=========
 Cost Behavior
Cost behavior is the manner in which expenses are impacted by
changes in business activity. A business manager should be aware of
cost behaviors when constructing the annual budget, to anticipate
whether any costs will point or decline.
Cost Behavior is the change in the behavior of a cost (or costs) due
to a change in business activity. The study of this change is the cost
behavior analysis. For example, the electricity cost will move up if a
business extends the working hours.
Cost behavior analysis refers to management’s attempt to
understand how operating costs change in relation to a change in an
organization’s level of activity. these costs may include direct
materials, direct labor, and overhead costs that are incurred from
developing a product.
 Examples of Cost Behavior
 Amacon Company manufactures computers. The rent of the factory
where the computers are manufactured is $1,00,000 per month. The
cost of raw materials required for one computer unit is $1,000. Every
month the company manufactures 100 units of computers.
 The cost of production every month is $1,00,000 + (1000*100) USD
= $1,00,000 + $1,00,000, which is $2,00,000
 After a certain point, Amacon Company decides to expand its
monthly production. It starts producing 120 units of computers. Thus,
the monthly production cost changes to $1,00,000 + (1000*120) =
$1,00,000 + $1,20,000, which is $2,20,000. This is a cost-behavior
analysis example.
 Fixed Costs

Fixed costs remain constant (in total) over some relevant range of
output. Depreciation, insurance, property taxes, and administrative
salaries are examples of fixed costs.
These costs do not change with any change in business activity. For
example, a business will still need to pay rent even if it is generating
zero sales.
A point to note is that a fixed cost per unit may increase or decrease
with the change in the level of business activity. For example, suppose
fixed cost for a business is $15,000, but the units produced for the three
straight quarters were 3000, 5000 and 1000. The fixed cost per unit in
the three cases is $5, $3, and $15, respectively.
 Fixed Costs
 Suppose BMW incurs a total cost of $2,000,000 per year for
supervisors who work exclusively on the X6 line. These costs are
unchanged in total over a designated range of vehicles produced
during a given time span.
 Fixed costs become smaller and smaller on a per-unit basis as the
number of vehicles assembled increases, as the following table
shows.
 Variable Costs
 Such costs vary directly (or in direct proportion) with the change in
the business activity. In direct proportion means if the activity level
changes by 10%, then the variable cost must also change by 10%.
 An interesting observation is that the variable cost per unit remains
constant despite a change in the level of business activity. For
example, the total variable cost of Company ABC for three straight
quarters is $5000, $20,000, and $15,000. Company ABC produces
5000, 20000, and 15000 units, respectively. The variable cost per
unit in all three cases will be $1.
 Example- Variable Costs
• If BMW buys a steering wheel at $600 for each of its BMW X6 vehicles, then the
total cost of steering wheels is $600 times the number of vehicles produced, as
the following table illustrates.
 Example- Variable Costs
 The steering wheel cost is an example of a variable cost
because total cost changes in proportion to changes in the
number of vehicles produced. However, the cost per unit of
a variable cost is constant.
 For example, the variable cost per steering wheel in
column 2 is the same regardless of whether 1,000 or 3,000
X6s are produced. As a result, the total variable cost of
steering wheels in column 3 changes proportionately with
the number of X6s produced in column 1. So, when
considering how variable costs behave, always focus on
total costs.
 Product Cost Components

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 Variable Manufacturing Overhead = $8
per unit? Fixed Manufacturing Overhead = $6

DM + DL + VMOH + Variable Marketing & Admin = $4

FMOH + VMA + FMA Fixed Marketing & Admin = $7
= $40

3. What is the variable cost per

unit?
2. What is the full
absorption cost per unit? DM + DL + VMOH + VMA = $27

DM + DL + VMOH + FMOH = $29

 Making Costs Information Useful

Full Absorption Costing: Variable Costing

• Required by GAAP
Used for: Used for:
• Financial purposes • Managerial purposes
• External reporting • Internal decision-making

Sales Revenue Sales Revenue

- Cost of Goods Sold - Variable Costs
= Gross Margin = Contribution Margin
 Making Costs Information Useful

Contribution Margin Income

Financial Income Statement Statement

Full Absorption Costing Variable Costing

Sales Price Sales Price

- Full Absorption Cost - Variable Cost
= Gross Margin = Contribution Margin
 Income Statement:
Full Absorption Costing

Full Absorption
Sales Revenue
Variable and Fixed
- Cost of Goods Sold Manufacturing Costs

= Gross Margin Period Costs

- Marketing & Admin Cost

Variable and Fixed
= Operating Profit Marketing & Admin
Costs
 Income Statement:
Variable Costing
Variable
Sales Revenue Manufacturing Costs
and Variable
-Variable Costs Marketing & Admin
Costs
= Contribution Margin
Fixed Manufacturing
- Fixed Costs Costs and Fixed
Marketing & Admin
Costs
= Operating Profit
 Problem
1.T Company has provided the following data for the month of July:

Beginning Ending

Work-in-process inventory $23,000 $21,000

Finished goods inventory 26,000 35,000

July Activity
Direct materials used $56,000
Direct labor incurred 91,000
Manufacturing overhead 61,000

Determine total manufacturing costs, cost of goods manufactured and

cost of goods sold for July.
2 .Renka’s Heaters selected data for October 2014 are presented here (in millions):

Calculate the following costs:

1. Direct materials inventory 10/31/2014
2. Fixed manufacturing overhead costs for October 2014
3. Direct manufacturing labor costs for October 2014
4. Work-in-process inventory 10/31/2014
5. Cost of finished goods available for sale in October 2014
6. Finished goods inventory 10/31/2014
 Problem
3. In May 2020, Roberts Furniture House worked exclusively to complete a job of 10
office tables. The cost data relevant to this job is given below:
•Timber purchased and used during May: $5,500
•Glue and nails used: $200
•Sheets of glass purchased and used: $1,500
•Finishing materials used: $800
•Direct labor cost (200 hours @ $30 per hour)
•Indirect materials used for this job: $500
•Electricity charges allocable to this job: $1,000
•Engineering and supervision salaries: $2,500
Required: Work out the prime cost and conversion cost of Robert Furniture
House.

4. During June, Excite Company’s prime cost was $325,000 and conversion cost was
$300,000. Total manufacturing overhead cost was $160,000. Compute the total direct
materials cost of Excite Company for June.
 Problem
5.The following data are for Marvin Department Store. The account balances (in
thousands) are for 2014.

Marketing, distribution, and customer-service costs $ 37,000

Merchandise inventory, January 1, 2014 27,000
Utilities 17,000
General and administrative costs 43,000
Merchandise inventory, December 31, 2014 34,000
Purchases 155,000
Miscellaneous costs 4,000
Transportation-in 7,000
Purchase returns and allowances 4,000
Purchase discounts 6,000
Revenues 280,000

1.Compute (a) the cost of goods purchased and (b) the cost of goods sold.
2.Prepare the income statement for 2014.
 Problem
6. Gibson Corporation has compiled the following information from the accounting
system for the one product it sells:

Determine each of the following unit costs:

a.Variable manufacturing cost.
b.Variable cost.
c. Full absorption cost.
d. Full cost.
 Problem
7. The following balances are from the accounts of Hill Components:

Direct materials used during the year amount to $46,000, and the cost of goods sold
for the year was $53,000.
Required: Find the following by completing a cost of goods sold statement:
A. Cost of direct materials purchased during the year.
B. Cost of goods manufactured during the year.
C. Total manufacturing costs incurred during the year.
 Problem
8. Accounting firm Weetman, Doemen, & Co conducts a variety of activities for
small and medium (SM) firms. The number of employees on January 1, 2009, was 25.
Due to frequent mergers and acquisitions, a lot of SM firms are taken over. The
consequence of this is that the accountant of the larger firm also provides services to
the merged SM firm.
As Weetman, Doemen, & Co’s clients consist mainly of SM firms, business has
decreased. The acquisition of new clients and/or increasing business with existing
clients hasn’t had any results. Weetman, Doemen, & Co was forced to decrease its
number of employees, mainly through natural outflow, and by the end of 2013 the
number of employees was 17. When the contract of an employee is terminated, a
notice period of two months must be taken into account. In January and February 2013
no employees were notified to leave the company.
1. Are the labor costs concerning the month of March 2013 fixed or variable?
2.Are the labor costs concerning the period between January 2009 and March
2013 fixed or variable?
9. Terracotta, Inc., provides you with the following data for their single product:

Required: Give the amounts for each of the following:

A.Prime cost per unit.
B.Gross margin per unit.
C. Conversion cost per unit.
D. Variable cost per unit.
E. Full absorption cost per unit.
F. Variable production cost per unit.
G. Full cost per unit.
 Problem
10.For each of the following costs incurred in a manufacturing firm, indicate whether
the costs are most likely fixed (F) or variable (V) and whether they are most likely
period costs (P) or product costs (M) under full absorption costing .
A. Depreciation on the building for administrative staff offices.
B. Cafeteria costs for the factory.
C.Overtime pay for assembly workers.
D. Transportation-in costs on materials purchased.
E. Salaries of top executives in the company.
F. Sales commissions for sales personnel.
G. Assembly line workers' wages.
H. Controller's office rental.
I. Administrative support for sales supervisors.
J. Energy to run machines producing units of output in the factory.